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Master of Business Administration- MBA Semester 2

MB0045 Financial Management - 4 Credits

(Book ID: B1134)

Assignment Set- 1 (60 Marks)

Note: Each question carries 10 Marks. Answer all the questions.

Q.1 Write the short notes on 5X2= (10 Marks)

1. Financial management

2. Financial planning

3. Capital structure

4. Cost of capital

5. Trading on equity.

1. Financial management: Financial Management is art and science of managingmoney. It embraces all managerial activities that are required to procure funds at the leastcost and their effective deployment Traditionally, Financial Management was considereda branch of knowledge with focus on procurement of funds. The core of modernapproach evolved around the procurement of the least cost funds and its effective

utilization for maximization of shareholders wealth.

The most admired Indian companies are Reliance and Infosys. They employ the besttechnology, produce good quality goods or render services at the least cost andcontinuously contribute to the shareholders wealth. The three core elements of financialmanagement are:Financial control, Financial Planning and Financial decisions.

Financial planning is the assurance of capital investment to procure real assets to run thebusiness smoothly.

Financial control involves management of day to day business of the company byreceiving or collecting money due from clients or debtors and payments to varioussuppliers or creditors.

Financial decisions: decisions as regards to the funds that are needed by the companyfrom various sources namely debt and equity. How much is needed from these sourceswould be decided for formulating the financial plan.

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- Pyramid shaped capital structure: this has a large proportion consisting ofequity capita; and retained earnings.

- Inverted pyramid shaped capital structure: this has a small component ofequity capital, reasonable level of retained earnings but an ever-increasing

component of debt.

SIGNIFICANCE OF CAPITAL STRUCTURE:

- Reflects the firms strategy- Indicator of the risk profile of the firm- Acts as a tax management tool- Helps to brighten the image of the firm.

FACTORS INFLUENCING CAPITAL STRUCTURE:

- Corporate strategy- Nature of the industry- Current and past capital structure

4. Cost of capital

The cost ofcapital is a term used in the field of financial investment to refer to the costof a company's funds (both debt and equity), or, from an investor's point of view "theshareholder's required return on a portfolio of all the company's existing securities.For aninvestment to be worthwhile, the expected return on capital must be greater than the cost

of capital. The cost of capital is the rate of return that capital could be expected to earn inan alternative investment of equivalent risk. A company not being able to meet thesedemands may face the risk of investors taking back their investments thus leading tobankruptcy. Loans and debentures come with a pre-determined interest rate. Preferenceshares also have a fixed rate of dividend while equity holders expect a minimum return ofdividend, based on their risk perception and the companys past performance in terms ofpay-out dividends. Given below are costs of different sources of finance:

1. Cost of debentures: the cost of debenture is the discount rate which equates thenet proceeds from issue of debentures to the expected cash outflows.

2. Cost of term loans: term loans are taken from banks or financial institutions at a

pre-determined interest rate for a specified number of years. The cost of termloans is equal to the interest rate multiplied by 1-tax rate.

3. Cost of preference capital: the cost of preference share Kp is the discount ratewhich equates the proceeds from preference capital issue to the dividend andprincipal repayments.

4. Cost of equity capital: Equity shareholders do not have a fixed rate of return ontheir investment. There is no legal requirement (unlike in the case of loans or

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debentures where the rates are governed by the deed) to pay regular divisons tothem.

5. Trading on equity

In finance,equity trading is the buying and selling of company stockshares.Trading on equity occurs when a corporation uses bonds, other debt, and preferred stockto increase its earnings on common stock. For example, a corporation might use longterm debt to purchase assets that are expected to earn more than the interest on the debt.The earnings in excess of the interest expense on the new debt will increase the earningsof the corporations common stockholders. The increase in earnings indicates that thecorporation was successful in trading on equity.If the newly purchased assets earn less than the interest expense on the new debt, theearnings of the common stockholders will decrease.

Shares in largepublicly-traded companies are bought and sold through one of the major

stock exchanges, such as the New York Stock Exchange, London Stock Exchange orTokyo Stock Exchange, which serve as managed auctions for stock trades. Stock sharesin smaller public companies are bought and sold in over-the-counter(OTC) markets.

Equity trading can be performed by the owner of the shares, or by an agent authorized tobuy and sell on behalf of the share's owner. Proprietary trading is buying and selling forthe trader's own profit or loss. In this case, the principal is the owner of the shares.Agency trading is buying and selling by an agent, usually a stock broker, on behalf of aclient. Agents are paid a commission for performing the trade.

Major stock exchanges have market makers who help limit price variation (volatility) by

buying and selling a particular company's shares on their own behalf and also on behalfof other clients.

Q.2 a. Write the features of interim divined and also write the factors (08 Marks)

Influencing divined policy?

Usually, board of directors ofcompany declares dividend in annual general meeting after

finding the real net profit position. If boards of directors give dividend for current year

before closing of that year, then it is called interim dividend. This dividend is declaredbetween two annual general meetings.

Before declaring interim dividend, board of directors should estimate the net profit

which will be in future. They should also estimate the amount ofreserves which will

deduct from net profit in profit and loss appropriation account. If they think that it is

sufficient for operating of business after declaring such dividend. They can issue but after

completing the year, if profits are less than estimates, then they have to pay the amount of

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declared dividend. For this, they will have to take loan. Therefore, it is the duty of

directors to deliberate with financial consultant before taking this decision.

Accounting treatment of interim dividend in final accounts of company :-

# First Case : Interim dividend is shown both in profit and loss appropriation account

and balance sheet , if it is outside thetrial balance in given question.

( a) It will go to debit side of profit and loss appropriation account

(b) It will also go to current liabilities head in liabilities side.

# Second Case: Interim dividend is shown only in profit and loss appropriation account,

if it is shown in trial balance.

( a) It will go only to debit side of profit and loss appropriation account.

If in final declaration is given outside of trial balance and this will be proposed dividend

and interim dividend in trial balance will be deducted for writing proposed dividend in

profit and loss appropriation account and balance sheet of company, because if we will

not deducted interim dividend, then it will be double deducted from net profit that is

wrong and error shows when we will match balance sheets assets with liabilities.

Factors affecting dividend policy.

The dividend decision is difficult decision because of conflicting objectives and alsobecause of lack of specific decision-making techniques. It is not easy to lay down anoptimum dividend policy which would maximize the long-run wealth of the shareholders.The factors affecting dividend policy are grouped into two broad categories.

1. Ownership considerations2. Firm-oriented considerations

Ownership considerations: Where ownership is concentrated in few people, there are no

problems in identifying ownership interests. However, if ownership is decentralized on awide spectrum, the identification of their interests becomes difficult.

Various groups of shareholders may have different desires and objectives. Investorsgravitate to those companies which combine the mix of growth and desired dividends.

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Firm-oriented considerations: Ownership interests alone may not determine thedividend policy. A firms needs are also an important consideration, which include thefollowing:

Contractual and legal restrictions

Liquidity, credit-standing and working capital Needs of funds for immediate or future expansion Availability of external capital. Risk of losing control of organization Relative cost of external funds Business cycles Post dividend policies and stockholder relationships.

1. Stability of Earnings. The nature of business has an important bearing on the dividend policy. Industrial units having stability of earnings may formulate a more consistent

dividend policy than those having an uneven flow of incomes because they can predicteasily their savings and earnings. Usually, enterprises dealing in necessities suffer lessfrom oscillating earnings than those dealing in luxuries or fancy goods.

2. Age of corporation. Age of the corporation counts much in deciding the dividendpolicy. A newly established company may require much of its earnings for expansion andplant improvement and may adopt a rigid dividend policy while, on the other hand, anolder company can formulate a clear cut and more consistent policy regarding dividend.

3. Liquidity of Funds. Availability of cash and sound financial position is also animportant factor in dividend decisions. A dividend represents a cash outflow, the greater

the funds and the liquidity of the firm the better the ability to pay dividend. The liquidityof a firm depends very much on the investment and financial decisions of the firm whichin turn determines the rate of expansion and the manner of financing. If cash position isweak, stock dividend will be distributed and if cash position is good, company candistribute the cash dividend.

4. Extent of share Distribution.Nature of ownership also affects the dividend decisions.A closely held company is likely to get the assent of the shareholders for the suspensionof dividend or for following a conservative dividend policy. On the other hand, acompany having a good number of shareholders widely distributed and forming low ormedium income group, would face a great difficulty in securing such assent because theywill emphasize to distribute higher dividend.

5. Needs for Additional Capital. Companies retain a part of their profits forstrengthening their financial position. The income may be conserved for meeting theincreased requirements of working capital or of future expansion. Small companiesusually find difficulties in raising finance for their needs of increased working capital forexpansion programmes. They having no other alternative, use their ploughed back profits.Thus, such Companies distribute dividend at low rates and retain a big part of profits.

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6. Trade Cycles. Business cycles also exercise influence upon dividend Policy. Dividendpolicy is adjusted according to the business oscillations. During the boom, prudentmanagement creates food reserves for contingencies which follow the inflationary period.Higher rates of dividend can be used as a tool for marketing the securities in an otherwise

depressed market. The financial solvency can be proved and maintained by thecompanies in dull years if the adequate reserves have been built up.

7. Government Policies. The earnings capacity of the enterprise is widely affected by thechange in fiscal, industrial, labour, control and other government policies. Sometimesgovernment restricts the distribution of dividend beyond a certain percentage in aparticular industry or in all spheres of business activity as was done in emergency. Thedividend policy has to be modified or formulated accordingly in those enterprises.

8. Taxation Policy. High taxation reduces the earnings of he companies and

consequently the rate of dividend is lowered down. Sometimes government leviesdividend-tax of distribution of dividend beyond a certain limit. It also affects the capitalformation. N India, dividends beyond 10 % of paid-up capital are subject to dividend taxat 7.5 %.

9. Legal Requirements. In deciding on the dividend, the directors take the legalrequirements too into consideration. In order to protect the interests of creditors anoutsider, the companies Act 1956 prescribes certain guidelines in respect of thedistribution and payment of dividend. Moreover, a company is required to provide fordepreciation on its fixed and tangible assets before declaring dividend on shares. Itproposes that Dividend should not be distributed out of capita, in any case. Likewise,

contractual obligation should also be fulfilled, for example, payment of dividend on preference shares in priority over ordinary dividend.

10. Past dividend Rates. While formulating the Dividend Policy, the directors must keepin mind the dividend paid in past years. The current rate should be around the averagepast rat. If it has been abnormally increased the shares will be subjected to speculation. Ina new concern, the company should consider the dividend policy of the rivalorganization.

11. Ability to Borrow. Well established and large firms have better access to the capitalmarket than the new Companies and may borrow funds from the external sources if therearises any need. Such Companies may have a better dividend pay-out ratio. Whereassmaller firms have to depend on their internal sources and therefore they will have tobuilt up good reserves by reducing the dividend pay out ratio for meeting any obligationrequiring heavy funds.

12. Policy of Control. Policy of control is another determining factor is so far asdividends are concerned. If the directors want to have control on company, they wouldnot like to add new shareholders and therefore, declare a dividend at low rate. Because by

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adding new shareholders they fear dilution of control and diversion of policies andprogrammes of the existing management. So they prefer to meet the needs throughretained earning. If the directors do not bother about the control of affairs they will followa liberal dividend policy. Thus control is an influencing factor in framing the dividendpolicy.

13. Repayments of Loan. A company having loan indebtedness are vowed to a high rateof retention earnings, unless one other arrangements are made for the redemption of debton maturity. It will naturally lower down the rate of dividend. Sometimes, the lenders(mostly institutional lenders) put restrictions on the dividend distribution still such timetheir loan is outstanding. Formal loan contracts generally provide a certain standard ofliquidity and solvency to be maintained. Management is bound to hour such restrictionsand to limit the rate of dividend payout.

14. Time for Payment of Dividend. When should the dividend be paid is anotherconsideration. Payment of dividend means outflow of cash. It is, therefore, desirable to

distribute dividend at a time when is least needed by the company because there are peaktimes as well as lean periods of expenditure. Wise management should plan the paymentof dividend in such a manner that there is no cash outflow at a time when the undertakingis already in need of urgent finances.

15. Regularity and stability in Dividend Payment. Dividends should be paid regularlybecause each investor is interested in the regular payment of dividend. The managementshould, inspite of regular payment of dividend, consider that the rate of dividend shouldbe all the most constant. For this purpose sometimes companies maintain dividendequalization Fund.

b. What is reorder level? 2 marks

This is that level of materials at which a new order for supply of materials is to be placed.In other words, at this level a purchase requisition is made out. This level is fixedsomewhere between maximum and minimum levels. Order points are based on usageduring time necessary to requisition order, and receive materials, plus an allowance forprotection against stock out.

The order point is reached when inventory on hand and quantities due in are equal to thelead time usage quantity plus the safety stock quantity.

Formula of Re-order Level or Ordering Point:

The following two formulas are used for the calculation ofreorder level or point.

[Ordering point or re-order level = Maximum daily or weekly or monthly usage

Lead time]

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The above formula is used when usage and lead time are known with certainty; therefore,no safety stock is provided. When safety stock is provided then the following formulawill be applicable:

[ Ordering point or re-order level = Maximum daily or weekly or monthly usage

Lead time + Safety stock ]

Examples:

Example 1:

Minimum daily requirement 800 unitsTime required to receive emergency supplies 4 daysAverage daily requirement 700 units

Minimum daily requirement 600 unitsTime required for refresh supplies One month (30 days)

Calculate ordering point or re-order level

Calculation:

Ordering point = Ordering point or re-order level = Maximum daily or weekly ormonthly usage Lead time

= 800 30

= 24,000 units

Example 2:

Tow types of materials are used as follows:

Minimum usage

20 units per week eachMaximum usage 40 units per week eachNormal usage 60 units per week eachRe-order period or Lead timeMaterial A:Material B

3 to 5 weeks2 to 4 weeks

Calculate re order point for two types of materials

Calculation:

Ordering point or re-order level = Maximum daily or weekly or monthly usage Maximum re-order period

A: 60 5 = 300 units

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B: 60 4 = 240 units

Q.3 Sales Rs.400, 000 less returns Rs 10, 000, Cost of Goods Sold Rs 300,000,Administration and selling expenses Rs.20, 000, Interest on loans Rs.5000,

Income tax Rs.10000, preference dividend Rs. 15,000, Equity Share Capital

Rs.100, 000 @Rs. 10 per share. Find EPS. (10marks)

Sales 400000

Less returns 10000

390000

Less: Cost of

goods sold 300000Contributions 90000

Less:Administration &selling expenses 20000 20000

Earning beforeinterest (EBI) 70000

Less: Interest onloans 5000

Earnings beforetax(EBT) 65000

Less: Income tax 10000Earnings aftertax(EAT) 55000

Less: preferenceshares 15000

Earnings availableto equity holders 40000

Earnings per share= Earning availableNo. of shares outstanding

=40000 x 10 =Rs.4

100000

Q.4 What are the techniques of evaluation of investment? (10 Marks)

Three steps are involved in the evaluation of an investment:

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Estimation of cash flows Estimation of the required rate of return (the cast of capital) Application of a decision rule for decision rule for making the choice

Investment decision rule

The investment decision rules may be referred to as capital budgeting techniques, orinvestment criteria. A sound appraisal technique should be used to measure the economicworth of an investment project. The essential property of a sound technique is that isshould maximize the shareholders wealth. The following other characteristics should alsobe possessed by a sound investment evaluation criterion:

It should consider all cash flows to determine the true profitability of then project. It should provide for an objective and unambiguous way of separate good projects from bad projects. It should help ranking of projects according to their true profitability.

It should recognize the fact that bigger cash flows are preferable to smaller ones andearly cash flows are preferable to later ones. It should help to choose among mutually exclusive projects that project whichmaximizes the shareholders wealth. It should be a criterion which is applicable to any conceivable investment projectindependent of others.

These conditions will be clarified as we discuss the features of various investment criteriain the following posts.

The methods of appraising an investment proposal can be grouped into

1. Traditional methods2. Modern methods

Traditional methods are:

Payback method

Accounting rate of return

Modern techniques are:

Net present value Internal rate of return

Modified internal rate of return

Profitability index

Traditional method:

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Payback method is defined as the length of time required to recover the initial cashoutlay. Its advantages are that its simple in concept and application, recovery of initialoutlay, its the best method for evaluation of projects with high uncertainty. It favors aproject which is less then or equal to the standard payback set by the management. In thisprocess early cash flows get due recognition then later cash flows. Therefore payback

period could be used as a tool to deal with the ranking of projects on the basis of riskcriterion. For firms with short age funds this is preferred because it measures liquidity ofthe project.

If projects are mutually exclusive, select the project which has the least payback period.In respect of other projects, select the project which have pay-back period less than orequal to the standard payback stipulated by the management.

Accounting rate of return (ARR) measures the profitability of investment using theinformation taken from financial statements.

It is based on accounting information, simple to understand. It considers the profits ofentire economic life of the project. Since it is based on accounting information, thebusiness executives are familiar with the accounting information understand it.

If any project which has an excess ARR, the minimum rate fixed by the management isaccepted. If actual ARR is less than the cut-off rate then that project. When projects are tobe ranked for deciding on the allocation of capital on account of the need for capitalrationing, project with higher ARR are preferred to the ones with lower ARR.

Discounted pay back period

The length in years required to recover the initial outlay on the value basis is called thediscounted pay back period. Discounted pay back period for a project will always behigher then simple pay back period.

Discounted cash flow method

Discounted cash flow method or time adjusted technique is an improvement over thetraditional techniques. In evaluation of the projects the needs to give weight age to thetiming of return is effectively considered in all DCF methods.

Modern methods

Net present value

Net present value (NPV) method recognizes the time value of money. It correctly admitsthat cash flows occurring at different time periods differ in value. Therefore there is aneed to find out the present values of all cash flows. NPV is the most widely usedtechnique among the DCF method.

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If Net present value is positive the project should be accepted. If NPV is negative theproject should be rejected. NPV method can be used to select between mutually exclusiveprojects by examining whether incremental investment generate a positive net presentvalue.

Internal rate of return (IRR)

Internal rate of return is the rate which makes the NPV of any project zero. IRR is therate of interest which equates the PV of cash inflows with the PV of cash outflows.

IRR is also called as yield on investment, managerial efficiency of capital, marginalproductivity of capital, rate of return and time adjusted rate of return. IRR is the rate ofreturn that a project earns.

If the projects internal rate of return is greater than the firms cost of capital, accept theproposal, otherwise reject the proposal.

Modified internal rate of return

Modified internal rate of return (MIRR) is a distinct improvement over the IRR- internalrate of return. Managers find IRR intuitively more appealing than the rupees of NPbecause IRR is expressed on a percentage rate of return. Modified rate of return is abetter indicator of relative profitability of the projects.

Profitability Index

Profitabilty index is also known as benefit cost index. Profitability index is the ratio of

the present value of cash inflows to initial cash outlay. The discount factor based on therequired rate of return is used to discount the cash inflows .

P1=Present value of cash inflows/ Initial cash outlay

If profitability index is 1then the management may accept the project because the sum ofthe present value of cash inflows is equal to the sum of present value of cash outflows.

Q.5 what are the problems associated with inadequate working capital? (10 Marks)

When working capital is inadequate, a firm faces the following problems.

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Fixed Assets cannot efficiently and effectively be utilized on account of lack of sufficientworking capital. Low liquidity position may lead to liquidation of firm. When a firm isunable to meets its debts at maturity, there is an unsound position. Credit worthiness ofthe firm may be damaged because of lack of liquidity. Thus it will lose its reputation.There by, a firm may not be able to get credit facilities. It may not be able to take

advantages of cash discount.

Disadvantages of Redundant or Excessive Working Capital1. Excessive Working Capital means ideal funds which earn no profits for the businessandhence the business cannot earn a proper rate of return on its investments.2. When there is a redundant working capital, it may lead to unnecessary purchasing andaccumulation of inventories causing more chances of theft, waste and losses.3. Excessive working capital implies excessive debtors and defective credit policy whichmay cause higher incidence of bad debts.4. It may result into overall inefficiency in the organization.

5. When there is excessive working capital, relations with banks and other financialinstitutions may not be maintained.6. Due to low rate of return on investments, the value of shares may also fall.7. The redundant working capital gives rise to speculative transactions.Disadvantages or Dangers of Inadequate Working Capital1. A concern which has inadequate working capital cannot pay its short-term liabilitiesin time. Thus, it will lose its reputation and shall not be able to get good creditfacilities.2. It cannot buy its requirements in bulk and cannot avail of discounts, etc.3. It becomes difficult for the firm to exploit favourable market conditions andundertake profitable projects due to lack of working capital.

4. The firm cannot pay day-to-day expenses of its operations and its createsinefficiencies, increases costs and reduces the profits of the business.5. It becomes impossible to utilize efficiently the fixed assets due to non-availabilityof liquid funds.

6. The rate of return on investments also falls with the shortage of working capital.

Disadvantages or Dangers of Inadequate or Short Working Capital

Cant pay off its short-term liabilities in time. Economies of scale are not possible.

Difficult for the firm to exploit favourable market situations

Day-to-day liquidity worsens

Improper utilization the fixed assets and ROA/ROI falls sharply

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A firm must have adequate working capital, i.e.; as much as needed the firm. It should beneither excessive nor inadequate. Both situations are dangerous. Excessive workingcapital means the firm has idle funds which earn no profits for the firm. Inadequateworking capital means the firm does not have sufficient funds for running its operations.It will be interesting to understand the relationship between working capital, risk and

return. The basic objective of working capital management is to manage firms currentassets and current liabilities in such a way that the satisfactory level of working capital ismaintained, i.e.; neither inadequate nor excessive. Working capital some times is referredto as circulating capital. Operating cycle can be said to be t the heart of the need forworking capital. The flow begins with conversion of cash into raw materials which are, inturn transformed into work-in-progress and then to finished goods. With the sale finishedgoods turn into accounts receivable, presuming goods are sold as credit. Collection ofreceivables brings back the cycle to cash.The company has been effective in carrying working capital cycle with low workingcapital limits. It may also be observed that the PBT in absolute terms has been increasingas a year to year basis as could be seen from the above table although profit percentage

turnover may be lower but in absolute terms it is increasing. In order to further increaseprofit margins, SSL can increase their margins by extending credit to good customers andalso by paying the creditors in advance to get better rates.

Working capital is the life blood and nerve centre of a business. Just as circulation ofblood is essential in the human body for maintaining life, working capital is veryessential to maintain the smooth running of a business. No business can run successfullywith out an adequate amount of working capital.

Working capital refers to that part of firms capital which is required for financing shortterm or current assets such as cash, marketable securities, debtors, and inventories. Inother words working capital is the amount of funds necessary to cover the cost ofoperating the enterprise.

Working capital means the funds (i.e.; capital) available and used for day to dayoperations (i.e.; working) of an enterprise. It consists broadly of that portion of assets of abusiness which are used in or related to its current operations. It refers to funds which areused during an accounting period to generate a current income of a type which isconsistent with major purpose of a firm existence.

Every business needs some amount of working capital. It is needed for followingpurposes-

For the purchase of raw materials, components and spares. To pay wages and salaries. To incur day to day expenses and overhead costs such as fuel, power, and officeexpenses etc. To provide credit facilities to customers etc.

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Q.6 What is leverage? Compare and Contrast between operating (10 Marks)Leverage and financial leverage

Leverage is the action of a lever or the mechanical advantage gained by it; it also meanseffectiveness or power. The common interpretation of leverage is derived from the useor manipulation of a tool or device termed as lever, which provides a substantive clue tothe meaning and nature of financial leverage.

When an organization is planning to raise its capital requirements (funds), these may beraised either by issuing debentures and securing long term loan 0r by issuing share-capital. Normally, a company is raising fund from both sources. When funds are raised

from debts, the Co. investors will pay interest, which is a definite liability of thecompany. Whether the company is earning profits or not, it has to pay interest on debts.But one benefit of raising funds from debt is that interest paid on debts is allowed asdeduction for income tax. When funds are raised by issue of shares (equity) , theinvestor are paid dividend on their investment. Dividends are paid only when theCompany is having sufficient amount of profit. In case of loss, dividends are not paid.But dividend is not allowed as deduction while computing tax on the income of theCompany. In this way both way of raising funds are having some advantages anddisadvantages. A Company has to decide that what will be its mix of Debt and Equity,considering the liability, cost of funds and expected rate of return on investment of fund.A Company should take a proper decision about such mix, otherwise it will face many

financial problems. For the purpose of determination of mix of debt and equity, leveragesare calculated and analyzed

In finance, leverage is a general term for any technique to multiply gains and losses.Common ways to attain leverage are borrowing money, buying fixed assets and usingderivatives. Important examples are:

Apublic corporation may leverage its equity by borrowing money. The more itborrows, the less equity capital it needs, so any profits or losses are shared amonga smaller base and are proportionately larger as a result.

A business entity can leverage its revenue by buying fixed assets. This willincrease the proportion of fixed, as opposed to variable, costs, meaning that achange in revenue will result in a larger change inoperating income.

Hedge funds often leverage their assets by using derivatives. A fund might getany gains or losses on $20 million worth of crude oil by posting $1 million ofcash as margin

Accounting leverage has the same definition as in investments. There are several ways todefine operating leverage, the most common is:

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Comparison between operating and financial leverage

Operating leverage =Revenue-variable cost/ Revenue-variable cost-Fixed cost= Revenue-variable cost/Operating income

Financial leverage is usually defined as:= Operating income/ Net income

Operating leverage is an attempt to estimate the percentage change in operating income(earnings before interest and taxes or EBIT) for a one percent change in revenue.

Financial leverage tries to estimate the percentage change in net income for a one percentchange in operating income.

The product of the two is called Total leverage, and estimates the percentage change innet income for a one percent change in revenue.

There are several variants of each of these definitions, and the financial statements areusually adjusted before the values are computed. Moreover, there are industry-specificconventions that differ somewhat from the treatment above.

Financial leverage is in contrast to operating leverage as it relates to the financialactivities of a firm and measures the effect of earnings before interest and tax on earningper share of the company.

A companies source of funds fall under two categories

Those which carry a fixed charge like debentures, bonds and preference shares Those which do not carry a fixed charge like equity shares.

Debentures and bonds carry a fixed rate of interest and have to be paid off irrespective ofthe firms revenues. Dividend on preference shares have to be paid off before equityshares. Whereas equity share holders are paid the residual income of the firm after all theother obligations are met.Financial leverage refers to the mix of debt and equity in the capital structure of the firm.This results from the fixed financial charges which are present in the companys incomestream. These expenses have nothing to do with the firms earnings or performance and

should be paid off regardless of the amount of earnings before income and tax.

It is the Firms ability to use fixed financial charges to increase the effects of changes inEBIT on the EPS. It is the use of funds obtained at fixed costs which increase the returnson shareholders.

A company which earns more by use of assets funded by fixed sources is said to behaving a favorable or positive leverage.

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Unfavorable leverage occurs when the firm is not earning sufficiently to cover the cost offunds. Financial leverage is also referred to as Trading in Equity

Operating leverage arises due to the presence of fixed operating expenses in the firmsincome flows. A companys operating costs can be categorized into three main sections

Fixed costs

Variable cost

Semi variable cost

Fixed costs do not change with an increase in production or sales activities for aparticular period of time. Examples are salaries to employees, rents, insurance of the firmand the accountancy cost.

Variable costs are those which vary in direct proportion to output and sales. Examples

cost of labor, amount of raw materials and administrative expenses. They are not fixedcost but keep on changing with change in conditions.

Semi-variable cost is fixed nature upto a certain level beyond which they vary with thefirms activities. Examples are production cost, wages paid to labor can shift betweenvariable and fixed cost.

The operating leverage is the firms ability to use fixed operating costs to increase theeffect of changes in sales on its earnings before interest and taxes (EBIT). Operatingleverage occurs anytime a firm has fixed cost. The [percentage change in profits with achange in volume of sales is more than the percentage change in volume.

An operating leverage can be favorable or unfavorable, high risks are attached to higherdegrees of leverage. A larger amount of fixed expenses increases the operating risks ofthe company and hence a higher degree of operating leverage.

Both operating and financial leverage result in the magnification of changes to earningsdue to the presence of fixed costs in a company's cost structure. The difference is only thepart of the income statement we are looking at. Operating leverage is the magnificationon the top half of the income statement. how EBIT changes in response to changes insales; the relevant fixed cost is the fixed cost of operating the business. Financial leverage

is the magnification on the bottom half of the income statement. how earnings per sharechanges in response to changes in EBIT; the relevant fixed cost is the fixed cost offinancing, in particular interest

Operating leverage is the name given to the impact on operating income of a change inthe level of output. Financial leverage is the name given to the impact on returns of achange in the extent to which the firms assets are financed with borrowed money.

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Master of Business Administration- MBA Semester 2

MB0045 Financial Management - 4 Credits

(Book ID: B1134)

Assignment Set- 2 (60 Marks)

Note: Each question carries 10 Marks. Answer all the questions.

Q. 1 Discuss the three broad areas of Financial Decision making (10 Marks)

Three broad areas of financial decision making are:1. Investment decisions

Investment decisions are made by investors and managers. Investors commonly performinvestment analysis by making use offundamental analysis, technical analysis and feel.Investment decisions are often supported by decision tools. Theportfolio theory is oftenapplied to help the investor achieve a satisfactory return compared to the risktaken

One of the most important long term decisions for any business relates to investment.Investment is the purchase or creation of assets with the objective of making gains in thefuture. Typically investment involves using financial resources to purchase a machine/building or other asset, which will then yield returns to an organization over a period oftime.

Key considerations in making investment decisions are:

1. What is the scale of the investment - can the company afford it?

2. How long will it be before the investment starts to yield returns? 3

. How long will it take to pay back the investment?

4. What are the expected profits from the investment?

5. Could the money that is being ploughed into the investment yield higher returnselsewhere?

Hazlewood Sandwiches invested 25m in a new purpose built plant at Manton Woods. Inweighing up the investment they had to consider the questions outlined above. One of theapproaches they used was the payback period. The payback period is the amount of timerequired for a project to repay its initial cost. The calculation is based on cash flows andnot on profits. An investment project costs 24m.

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The projected cash flows back into the business are:

Year 1 - Net cash inflow 6mYear 2 - Net cash inflow 6mYear 3 - Net cash inflow 6m

Year 4 - Net cash inflow 6m

Cash inflow

You can see from the illustration above that the cumulative net cash inflow will pay backthe investment at the end of the fourth year. Projects with the shortest payback periodsare preferred as longer payback periods increase the risk of unforeseen circumstancesarising. However, the problem of payback is that it gives no indication of the profitabilityof the project. An alternative method that can be employed therefore to weigh up theinvestment is the Accounting rate of return method.

This is calculated in the following way:Where there are several projects under consideration, the project with the highest rate ofreturn is the preferred project. The main problem with the techniques described so far isthat they fail to account fully for the timing of cash flows. Instinctively we all know thatRs. 50 in the hand today is worth more than a promised Rs50 for receipts on some futuredate.

Capital investment decisions are long-term choices about which projects receiveinvestment, whether to finance that investment with equity ordebt, and when or whetherto pay dividends to shareholders. On the other hand, short term decisions deal with the

short-term balance ofcurrent assets and current liabilities; the focus here is on managingcash, inventories, and short-term borrowing and lending (such as the terms on creditextended to customers.

Decisions are based on several inter-related criteria. (1) Corporate management seeks tomaximize the value of the firm by investing in projects which yield a positive net presentvalue when valued using an appropriate discount rate. (2) These projects must also befinanced appropriately. (3) If no such opportunities exist, maximizing shareholder valuedictates that management must return excess cash to shareholders (i.e., distribution viadividends). Capital investment decisions thus comprise an investment decision, afinancing decision, and a dividend decision.

Management must allocate limited resources between competing opportunities (projects)in a process known as capital budgeting. Making this investment, or capital allocation,decision requires estimating the value of each opportunity or project, which is a functionof the size, timing and predictability of future cash flows.

Capital budgeting decisions demand considerable time, attention and energy of themanagement. They are strategic in nature as the success or failure of an organization is

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directly attributable to the execution of capital budgeting decisions taken. Investmentdecisions are also known as capital Budgeting decisions and hence lead to investments inreal assets

2. Financing decision

Achieving the goals of corporate finance requires that any corporate investment befinanced appropriately. As above, since both hurdle rate and cash flows (and hence theriskiness of the firm) will be affected, the financing mix can impact the valuation.Management must therefore identify the "optimal mix" of financingthe capitalstructure that results in maximum value.

The sources of financing will, generically, comprise some combination ofdebt and equityfinancing. Financing a project through debt results in a liability or obligation that must beserviced, thus entailing cash flow implications independent of the project's degree of

success. Equity financing is less risky with respect to cash flow commitments, but resultsin a dilution of ownership, control and earnings. Thecost of equity is also typically higherthan the cost of debt(see CAPM and WACC), and so equity financing may result in anincreased hurdle rate which may offset any reduction in cash flow risk.

Management must also attempt to match the financing mix to the asset being financed asclosely as possible, in terms of both timing and cash flows.

One of the main theories of how firms make their financing decisions is the PeckingOrder Theory, which suggests that firms avoid external financing while they haveinternal financing available and avoid new equity financing while they can engage in new

debt financing at reasonably low interest rates. Another major theory is the Trade-OffTheory in which firms are assumed to trade-off the tax benefits of debt with thebankruptcy costs of debt when making their decisions. An emerging area in financetheory is right-financing whereby investment banks and corporations can enhanceinvestment return and company value over time by determining the right investmentobjectives, policy framework, institutional structure, source of financing (debt or equity)and expenditure framework within a given economy and under given market conditions.One last theory about this decision is the Market timing hypothesis which states thatfirms look for the cheaper type of financing regardless of their current levels of internalresources, debt and equity.

3. The Dividend Decision is a decision made by the directors of a company. It relates tothe amount and timing of any cash payments made to the company's stockholders.The decision is an important one for the firm as it may influence its capital structureand stock price. In addition, the decision may determine the amount oftaxation thatstockholders pay.

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There are three main factors that may influence a firm's dividend decision:

Free-cash flow Dividend clienteles Information signaling

The firm simply pays out, as dividends, any cash that is surplus after it invests in allavailable positive net present value projects.

Most companies pay relatively consistent dividends from one year to the next andmanagers tend to prefer to pay a steadily increasing dividend rather than paying adividend that fluctuates dramatically from one year to the next.

A particular pattern of dividend payments may suit one type of stock holder more thananother. A retiree may prefer to invest in a firm that provides a consistently high dividendyield, whereas a person with a high income from employment may prefer to avoid

dividends due to their high marginal tax rate on income. If clienteles exist for particularpatterns of dividend payments, a firm may be able to maximize its stock price andminimize its cost of capital by catering to a particular clientele. This model may help toexplain the relatively consistent dividend policies followed by most listed companies.

Dividend clienteles is that investors do not need to rely upon the firm to provide thepattern of cash flows that they desire. An investor who would like to receive some cashfrom their investment always has the option of selling a portion of their holding. Thisargument is even more cogent in recent times, with the advent of very low-cost discountstockbrokers. It remains possible that there are taxation-based clienteles for certain typesof dividend policies.

A model developed by Merton Millerand Kevin Rockin 1985 suggests that dividendannouncements convey information to investors regarding the firm's future prospects.Many earlier studies had shown that stock prices tend to increase when an increase individends is announced and tend to decrease when a decrease or omission is announced.Miller and Rock pointed out that this is likely due to the information content ofdividends.

When investors have incomplete information about the firm (perhaps due to opaqueaccounting practices) they will look for other information that may provide a clue as tothe firm's future prospects. Managers have more information than investors about the

firm, and such information may inform their dividend decisions. When managers lackconfidence in the firm's ability to generate cash flows in the future they may keepdividends constant, or possibly even reduce the amount of dividends paid out.Conversely, managers that have access to information that indicates very good futureprospects for the firm (e.g. a full order book) are more likely to increase dividends.

Investors can use this knowledge about managers' behavior to inform their decision tobuy or sell the firm's stock, bidding the price up in the case of a positive dividend

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surprise, or selling it down when dividends do not meet expectations. This, in turn, mayinfluence the dividend decision as managers know that stock holders closely watchdividend announcements looking for good or bad news. As managers tend to avoidsending a negative signal to the market about the future prospects of their firm, this alsotends to lead to a dividend policy of a steady, gradually increasing payment.

In a fully informed, efficient market with no taxes and no transaction costs, the free cashflow model of the dividend decision would prevail and firms would simply pay as adividend any excess cash available. The observed behaviors of firm differs markedlyfrom such a pattern. Most firms pay a dividend that is relatively constant over time. Thispattern of behavior is likely explained by the existence of clienteles for certain dividendpolicies and the information effects of announcements of changes to dividends.

The dividend decision is usually taken by considering at least the three questions of: howmuch excess cash is available? What do our investors prefer? and What will be the effecton our stock price of announcing the amount of the dividend?

The result for most firms tends to be a payment that steadily increases over time, asopposed to varying wildly with year-to-year changes in free cash flow.

Q.2 What is the future value of an annuity and state the formulae for (10 Marks)

future value of an annuity

The term annuity is used in finance theory to refer to any terminating stream of fixed

payments over a specified period of time. This usage is most commonly seen indiscussions of finance, usually in connection with the valuation of the stream ofpayments, taking into account time value of money concepts such as interest rate andfuture value.

Examples of annuities are regular deposits to a savings account, monthly home mortgagepayments and monthly insurance payments. Annuities are classified by payment dates.The payments (deposits) may be made weekly, monthly, quarterly, yearly, or at any otherinterval of time

Future Value of Annuities

An annuity is a series of equal payments or receipts that occur at evenly spaced intervals.Leases and rental payments are examples. The payments or receipts occur at the end ofeach period for an ordinary annuity while they occur at the beginning of eachperiod.for an annuity due.

Future Value of an Ordinary Annuity

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The Future Value of an Ordinary Annuity (FVoa) is the value that a stream ofexpected or promised future payments will grow to after a given number of periods at aspecific compounded interest.

The Future Value of an Ordinary Annuity couldbe solved by calculating the future value

of each individual payment in the series using the future value formula and then summingthe results. A more direct formula is:

FVoa = PMT [((1 + i)n - 1) / i]

Where:

FVoa = Future Value of an Ordinary AnnuityPMT = Amount of each payment

i = Interest Rate Per Periodn = Number of Periods

Q.3 The equity stock of ABC Ltd is currently selling for Rs. 30 per share. The

dividend expected next year is Rs 2.00. The investors required rate of return on this

stock is 15 per cent. If the constant growth model applies to ABC Ltd, What is the

expected growth rate?

(10 Marks)

Po=D1/ Ke-g

Where Po= current market price of the share

D1= expected dividend after one year

Ke= required rate of return on the equity share

Where, g stands for growth rate

Po=D1/Ke-g

30 = 2

(0.15-g)

30 (0.15-g) =2

0.15-g=2

30

0.15-g=0.067

g=8.37%=8%

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Q.4 State the assumptions underlying the CAPM model and MM model (10 Marks)

Theassumptions underlying the CAPM model are given below:

All investors:

1. Aim to maximize economic utilities.2. Are rational and risk-averse.3. Are broadly diversified across a range of investments.4. Are price takers, i.e., they cannot influence prices.5. Can lend and borrow unlimited amounts under the risk free rate of interest.6. Trade without transaction or taxation costs.7. Deal with securities that are all highly divisible into small parcels.8. Assume all information is available at the same time to all investors.

The model assumes that either asset returns are (jointly) normally distributed

random variables or that investors employ a quadratic form of utility. It ishowever frequently observed that returns in equity and other markets are notnormally distributed. As a result, large swings (3 to 6 standard deviations from themean) occur in the market more frequently than the normal distributionassumption would expect

The model assumes that the variance of returns is an adequate measurement ofrisk. This might be justified under the assumption of normally distributed returns, but for general return distributions other risk measures (like coherent riskmeasures) will likely reflect the investors' preferences more adequately. Indeedrisk in financial investments is not variance in itself, rather it is the probability oflosing: it is asymmetric in nature.

The model assumes that all investors have access to the same information andagree about the risk and expected return of all assets (homogeneous expectationsassumption).

The model assumes that the probability beliefs of investors match the truedistribution of returns. A different possibility is that investors' expectations arebiased, causing market prices to be informational inefficient. This possibility isstudied in the field ofbehavioral finance, which uses psychological assumptionsto provide alternatives to the CAPM such as the overconfidence-based assetpricing model of Kent Daniel, David Hirshleifer, and Avanidhar Subrahmanyam(2001).

The model does not appear to adequately explain the variation in stock returns.Empirical studies show that low beta stocks may offer higher returns than themodel would predict. Some data to this effect was presented as early as a 1969conference in Buffalo, New York in a paper by Fischer Black, Michael Jensen,and Myron Scholes. Either that fact is itself rational (which saves the efficient-market hypothesis but makes CAPM wrong), or it is irrational (which savesCAPM, but makes the EMH wrong indeed, this possibility makes volatilityarbitrage a strategy for reliably beating the market).

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The model assumes that given a certain expected return investors will preferlower risk (lower variance) to higher risk and conversely given a certain level ofrisk will prefer higher returns to lower ones. It does not allow for investors whowill accept lower returns for higher risk. Casino gamblers clearly pay for risk, andit is possible that some stock traders will pay for risk as well.

The model assumes that there are no taxes or transaction costs, although thisassumption may be relaxed with more complicated versions of the model.

The market portfolio consists of all assets in all markets, where each asset isweighted by its market capitalization. This assumes no preference betweenmarkets and assets for individual investors, and that investors choose assets solelyas a function of their risk-return profile. It also assumes that all assets areinfinitely divisible as to the amount which may be held or transacted

The market portfolio should in theory include all types of assets that are held byanyone as an investment (including works of art, real estate, human capital...) inpractice, such a market portfolio is unobservable and people usually substitute astock index as a proxy for the true market portfolio. Unfortunately, it has been

shown that this substitution is not innocuous and can lead to false inferences as tothe validity of the CAPM, and it has been said that due to the inobservability ofthe true market portfolio, the CAPM might not be empirically testable. This waspresented in greater depth in a paper by Richard Roll in 1977, and is generallyreferred to as Roll's critique.

The model assumes just two dates, so that there is no opportunity to consume andrebalance portfolios repeatedly over time. The basic insights of the model areextended and generalized in the intertemporal CAPM (ICAPM) of Robert Merton,and the consumption CAPM (CCAPM) of Douglas Breeden and MarkRubinstein.

CAPM assumes that all investors will consider all of their assets and optimize oneportfolio. This is in sharp contradiction with portfolios that are held by individualinvestors: humans tend to have fragmented portfolios or, rather, multipleportfolios: for each goal one portfolio seebehavioral portfolio theory andMaslowian Portfolio Theory.

ASSUMPTIONS OF MODIGLIANI & MILLER APPROACH

1. The capital markets are assumed to be perfect. This means that investors are free tobuy and sell securities. They are well informed about the risk-return on all type ofsecurities. These are no transaction costs. The investors behave rationally. They canborrow without restrictions on the same terms as the firms do.

2. The firms can be classified into homogeneous risk class. They belongs to this class iftheir expected earnings is having identical risk characteristics.

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3. All investors have the same expectations from a firms net operating income (EBIT)which are necessary to evaluate the value of a firm.

4. The dividend payment ratio is 100%. In other words, there are no retained earnings.

5. There are no corporate taxes. However this assumption has been removed later.

Modigliani and Miller agree that while companies in different industries face different

risks which will result in their earnings being capitalized at different rates, it is notpossible for these companies to affect their market values, and therefore their overallcapitalization rate by use of leverage. That is, for a company in a particular risk class, thetotal market value must be same irrespective of proportion of debt in companys capitalstructure. The support for this hypothesis lies in the presence of arbitrage in the capitalmarket. They contend that arbitrage will substitute personal leverage for corporateleverage. This is illustrated below:

Suppose there are two companies A & B in the same risk class. Company A is financed

by equity and company B has a capital structure which includes debt. If market price ofshare of company B is higher than company A, market participants would take advantageof difference by selling equity shares of company B, borrowing money to equate therepersonal leverage to the degree of corporate leverage in company B, and use these fundsto invest in company A. The sale of Company B share will bring down its price until themarket value of company B debt and equity equals the market value of the companyfinanced only by equity capital.

Q.5 Write the cash flow analysis? (10 Marks)

Cash flow is essentially the movement of money into and out of your business; it's thecycle of cash inflows and cash outflows that determine your business' solvency.

Cash flow analysis is the study of the cycle of your business' cash inflows and outflows,with the purpose of maintaining an adequate cash flow for your business, and to providethe basis for cash flow management.

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Cash flow analysis involves examining the components of your business that affect cashflow, such as accounts receivable, inventory, accounts payable, and credit terms. Byperforming a cash flow analysis on these separate components, you'll be able to moreeasily identify cash flow problems and find ways to improve your cash flow.

A quick and easy way to perform a cash flow analysis is to compare the total unpaidpurchases to the total sales due at the end of each month. If the total unpaid purchases aregreater than the total sales due, you'll need to spend more cash than you receive in thenext month, indicating a potential cash flow problem

1. This type of cash flow analysis is called cash budgeting analysis. It is part of yourfirm's financial forecasting plan. Determine the amount of cash that will flow intoyour firm during the month. If you are just starting your business, you should includethe beginning balance in cash that you want to have available every month. Therewould also be the amount of sales you have during the first month. Sales wouldinclude both cash sales and sales that you make to your customers who pay on credit.

Here's an example you can follow to develop your Schedule of Cash Receipts (SalesReceipts).

2. Determine the amount of cash that will flow out of your firm during the month.You will have expenses. You will probably have to buy office supplies. Othermonthly expenses may include advertising, vehicle expenses, payroll expenses, justto name a few. You will have some quarterly expenses, such as taxes. You may haveexpenses that just occur occasionally, like purchases of computer equipment,vehicles, or other larger expenses. Here is an example of a Schedule of CashPayments that is the second step of the cash budget.

3. You want the cash that will flow into your firm (Step 1) to be greater than thecash that will flow out of your firm (Step 2). This means that your monthly cashinflow needs to be greater than your monthly cash outflow so you will havesufficient cash to operate your firm. Here's a blank worksheet you can use tocalculate your cash inflow or cash receipts and another worksheet you can use tocalculate your cash payments.

4. Your ending balance for the first month becomes the beginning balance for thesecond month. You do the same type of analysis. Each month, you may have to addmore items to your cash flow analysis as your business grows. You need to decide

what the minimum ending cash balance is that you find acceptable for your firm andaim toward that figure each month.

5. If your cash flow turns negative for any one month, you will have to borrowmoney for that month from family or friends, investors, or from a bank or otherfinancial institutions. Then, if your cash flow is positive the next month, you canrepay that loan.

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6. Keep on doing this each month for your forecasting period. Try to keep your borrowing to a minimum and your cash inflow greater than your outflows.Remember that this cash budget is a financial forecasting document but try to followit as closely as possible. Here is an example of a completed Cash Budget, based onthe schedules already completed, that you can look at. Here is a blank worksheet you

can use for your own company.

Measurement of cash flow can be used

To determine a project's rate of return or value. The time of cash flows into andout of projects are used as inputs in financial models such as internal rate ofreturn, and net present value.

To determine problems with a business's liquidity. Being profitable does notnecessarily mean being liquid. A company can fail because of a shortage of cash,even while profitable.

As an alternate measure of a business's profits when it is believed that accrual

accounting concepts do not represent economic realities. For example, a companymay be notionally profitable but generating little operational cash (as may be thecase for a company that barters its products rather than selling for cash). In such acase, the company may be deriving additional operating cash by issuing shares, orraising additional debt finance.

Cash flow can be used to evaluate the 'quality' of Income generated by accrualaccounting. When Net Income is composed of large non-cash items it isconsidered low quality.

to evaluate the risks within a financial product. E.g. matching cash requirements,evaluating default risk, re-investment requirements, etc.

Cash flow is a generic term used differently depending on the context. It may be definedby users for their own purposes. It can refer to actual past flows, or to projected futureflows. It can refer to the total of all the flows involved or to only a subset of those flows.Subset terms include 'net cash flow', operating cash flow and free cash flow.

Q.6 The following two projects A and B requires an investment of Rs 2, 00,000 each.

The income returns after tax for these projects are as follows: (10 Marks)

Year Project A Project B

1 Rs.80,000 Rs.20,000

2 Rs.80,000 Rs.40,000

3 Rs.40,000 Rs.40,000

4 Rs.20,000 Rs.40,000

5 Rs.60,000

6 Rs.60,000

Using the following criteria determine which of the projects is preferable.

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