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END TERM EXAMINATION FINANCIAL MANAGEMENT -2010 Attempt any 5 questi ns in!"u#in$ %1 &'i!' is ! mpu"s (y) %1* Explain briefly any five of the following -: (a) Loan Syndication. (b) Decision Tree- refer to %/+a* 0 FM12011. (c) apital !ationing. (d) "#E !atio. (e) oncentration $an%ing. (f) Explicit cost of capital. (g) Econo&ic 'rder ()antity. +,-5.15*

Ans)1+a* * syndicated facility is a lending facility+ defined by a single loan agree&ent+ in which several ban%s participate. ,t occ)rs when a borrower wants to raise relatively large a&o)nt of &oney ()ic%ly and conveniently. The a&o)nt exceeds the expos)re li&its of any one lender and the $orrower does not want to deal with a large n)&ber of lenders. Featu(es2-. Two or &ore ban%s contract with a borrower to provide credit on co&&on ter&s and conditions. .. * single doc)&ent or an agree&ent is &ade. /. *ltho)gh co&&on doc)&entation+ a ban% has )lti&ately+ the individ)al right to ta%e legal action against borrower. 0. ,nterest )s)ally accr)es at a variable or floating rate and is reset periodically+ at agreed intervals. 1. 2at)rity period is /--3 years. 3a(ties in!"u#e#2-. Lead $an%- this ban% is responsible for the arrange&ent with other ban%s and is answerable to the borrower. ,t has the a)thority over other ban%s and borrower deals with it directly.

.. 4nder-writing ban%- ,t is the ban% that co&&its to s)pplying the f)nds to the borrower 5 if necessary fro& its own reso)rces if the loan is not f)lly s)bscribed. /. The ban% that participates in the syndication by lending a portion of the total a&o)nt re()ired. 0. $orrower- the co&pany which re()ires loan. 6ollowing are the steps in4 "4e# in p( !ess 0 " an syn#i!ati n2 -. Lead ban% prepares a detailed pro7ect report and &a%es an esti&ate of the capital that wo)ld be re()ired for the pro7ect. .. Enlisting of interested ban%s is done+ who according to the lead ban% wo)ld be interested in giving a loan for financing. /. 2eetings+ disc)ssions+ are organi8ed between lead ban% and lenders to negotiate rate of interest+ loan a&o)nt+ etc. 0. Loan applications are prepared with necessary ter&s and conditions. 1. S)b&ission of applications to financial instit)tions (lenders) is followed by disb)rse&ent of loan to the borrower. F "" &in$ a(e t'e a#4anta$es 0 " an syn#i!ati n as so)rce of finance: 1) I#enti0i!ati n 0 p tentia" 0inan!e - the borrower does not have to search for potential so)rce of finance+ it contacts the lead ban% and the lead ban% ens)res the participation of interested ban%s. 2) G # #ea"- $eca)se of preli&inary disc)ssions with financial instit)tions the co&pany can rely for best deal. ,) 5&i0t p( !ess- Since all the doc)&entations are carried o)t by the ban%s+ the process is &)ch &ore swift and s&ooth. 1+6*. !efer to 9:+ .3--. 1+!* Capita" (ati nin$ is the process of finali8ing a pro7ect having highest rate of ret)rn which the co&pany will )nderta%e in a sit)ation of constraints of f)nds. ,n an econo&ic scenario no co&pany has )nli&ited f)nds to invest+ so there are li&ited f)nds and reso)rces available. There is a fixed ann)al b)dget to be invested in pro7ect. Therefore there is a need of selecting one or

two pro7ects which can pro&ise high ret)rns. Since in a practical corporate world there are a large vol)&e of pro7ects to be selected fro&+ the &ethodology of capital rationing is greatly in need. 6ollowing are t'e steps in4 "4e# in !apita" (ati nin$: -. ;ro)ping of pro7ects - S)itable proposals are identified. These are gro)ped as acceptable and non-acceptable pro7ects. .. !an%ing of pro7ects- o&binations of pro7ects are selected thro)gh internal rate of ret)rn calc)lation or profitability index. This step also incl)de selection or re7ection of proposal co&pletely beca)se it is indivisible or it has &any parts and so&e parts can be accepted # re7ected . * fir& also considers growth and control factor of a pro7ect. ,t not only selects the best pro7ect b)t also ran%s the pro7ects in a fir& in order to get the highest priority. The &ethodology is to have a c)t off point and f)nd all the pro7ect above the c)t off point and re7ect or delay the pro7ect which are below the c)t off point. The ai& of capital rationing is to &axi&i8e the val)e of fir& . Exa&ple: * fir& has following invest&ent opport)nities. The f)nds available with the co&pany are !s.:3+33+333. <hich proposal sho)ld be accepted= 3( p sa" initia" !as' ut 0" & net p(esent 4a"ue -. :3+33+333 0.+:3+333 .. /3+33+333 ..+13+333 /. /3+33+333 .-+33+333 0. 13+33+333 /.+13+333 5 "uti n 2 The fir& sho)ld select the proposal which has the highest net present val)e. "roposal - gives the highest npv that is !s.0.+:3+333. >owever since the fir& has :3+33+333 b)dget it can ta%e either pro7ect - which is the highest ran% or ta%e pro7ect . or / to give an npv of 0/+13+333 . Therefore+ )nder capital rationing it has to decide whether it will ta%e pro7ect - or a co&bination of pro7ect . and /.

1+#* 3(i!e-Ea(nin$ Rati +3E*- ,t is defined as &ar%et price per share divided by ann)al earnings per share. ,t is a val)ation ratio of a co&pany?s c)rrent share price co&pared to its per-share earnings. "#E ratio@ 2ar%et val)e of the share#Earning per share(E"S). 6or exa&ple+ if a co&pany is c)rrently trading at !s.13 a share and earnings over the last -. &onths were !s.1 per share+ the "#E ratio for the stoc% wo)ld be -3 (13#1). ,n general+ a high "#E s)ggests that investors are expecting higher earnings growth in the f)t)re co&pared to co&panies with a lower "#E. ,t?s )s)ally &ore )sef)l to co&pare the "#E ratios of one co&pany to other co&panies in the sa&e ind)stry+ or to the &ar%et in general or against the co&pany?s own historical "#E. ,t also helps in val)ing the correct &ar%et price of a share i.e. ,f the &ar%et price of a share is !s.-33 and E"S is .3 the "E is 1. $)t if the "E ratio of si&ilar co&panies is : then it &eans that it is )nder val)ed and the &ar%et price sho)ld have been !s.-.3 instead of !s.-33. Si&ilarly if the "E ratio of other fir&s is 0 then the &ar%et price sho)ld be !s.A3. The share is over-val)ed by !s..3. "E ratio plays an i&portant part in deciding whether an investor sho)ld invest in the co&pany or not. ,nvestors expect high growth in f)t)re of co&panies with high "E ratio. Short-comings of PE ratio- while calc)lating the "E ratio earnings per share play an i&portant role. $)t the earnings are )s)ally &anip)lated and window-dressed which res)lts in wrong "E ratio. 1+e* C n!ent(ati n 7an8in$2 after having prepared the cash b)dget+ the finance &anager sho)ld ens)re that there does not exist a significant deviation between expected cash flows and act)al cash flows. To achieve this+ cash &anage&ent efficiency will have to be i&proved thro)gh a proper control of cash collection and disb)rse&ent. The t&in 69e!ti4es in &anaging the cash flows sho)ld be:-

-. *ccelerate cash collections as &)ch as possible. .. Decelerate or delay cash disb)rse&ents. * fir& can )se decentrali8ed collection syste& %nown as oncentration $an%ing. ,n concentration ban%ing the co&pany establishes a n)&ber of strategic collection centres in different regions instead of a single collection centre at the head office. This syste& red)ces the period between the ti&e a c)sto&er &ails in his re&ittances and the ti&e when they beco&e spendable f)nds with the co&pany. "ay&ents received by the different collection centres are deposited with their respective local ban%s which in t)rn transfer all s)rpl)s f)nds to the concentration ban% of head office. The concentration ban% with which the co&pany has its &a7or ban% acco)nt is generally located at the head()arters. oncentration ban%ing is one i&portant and pop)lar way of red)cing the si8e of the float. * concern having large n)&ber of branches at different places adopts the syste& of decentrali8ed syste& of ban%ing where instead of collection &ade at the >.' and deposited at its ban% at >.' + the >.' + &a%es an arrange&ent where c)sto&ers are re()ired to send their pay&ent at local collection centre and deposited there at local branch of the ban%. 6)nds beyond a predeter&ined level shall be transferred to a concentration ban% daily. A#4anta$es2-. !ed)ction in &ailing ti&e. .. !ed)ction in clearing ti&e. /. Effective storage of cash. 1+0* E-p"i!it ! st 0 !apita"- The ?cost of capital? refers to the cost of a co&pany?s f)nds (both debt and e()ity)+ and is )sed to eval)ate a co&pany?s new pro7ects. ,t is the &ini&)& ret)rn that investors expect for providing capital to the co&pany+ th)s setting a target that the new pro7ect has to &eet. ost of apital @ cost of debtB cost of e()ity. ost of capital is

-. The borrowing rate of the fir&+ at which it can ac()ire f)nds to finance the proposed pro7ect .. The lending rate which the fir& co)ld have earned if the fir& had invested elsewhere. Explicit cost- * b)siness expense that is easily identified and acco)nted for is ter&ed as an explicit cost. Explicit costs represent clear and obvio)s cash o)tflows fro& a b)siness. ,t is opposite to goodwill a&orti8ation+ which is not as clear. C"assi0i!ati n 0 C st 0 Capita"21) E-p"i!it ! st 0 !apita" is that c)t off rate which e()ates present val)e of cash inflows to present val)e of cash o)tflows. ,n other words+ it is nothing b)t internal rate of ret)rn. ,n capital b)dgeting decision+ investor will see which invest&ent provides high internal rate of ret)rn b)t which co&pany gets the &oney at high internal rate of ret)rnC it &eans that co&pany is accepting &oney at high explicit cost of capital. Do) sho)ld re&e&ber: a) This cost will be in &oney for&. b) 6or deciding explicit cost of capital+ co&pany will add all so)rcesE cost of capital and try to &ini&i8e it. F ( E-amp"e2 * co&pany accepts loans by iss)ing new debent)res of !s. A+33+333. This co&pany also pro&ises to pay !s. A+333 per year+ co&panyEs total inflow will be F A+33+333 and total o)tflow of cash will be F A3+333 per year and if there is nothing cost of capital+ then this loan can be repaid within -3 years. $)t it is not possible that co&pany wo)ld receive loan witho)t giving interest. So+ &ini&)& val)e of interest which co&pany pays on the condition that it will e()al the present val)e of !s. A+33+333 and !s. A3+333 will be explicit cost of capital. This decision will be ta%en at the ti&e when co&pany gets loan. ,f co&pany is giving high interest rate on loan+ then its net explicit cost will be less beca)se+ interest is given o)t of net profit and co&pany can save tax and if we ad7)sted this tax rate+ explicit cost will be less than act)al interest on loan. 2) Imp"i!it ! st 0 !apita"- is also %nown as the opport)nity cost of capital. <hen profits are earned by a co&pany+ instead of

distrib)ting it to the shareholders+ it is retained and plo)ghed bac%. >ad the profits been distrib)ted+ the shareholders co)ld have invested it and earned &ore. ,&plicit cost is nothing b)t the opport)nity foregone to invest it elsewhere. 1+$* E! n mi! (#e( quantity- refers to the order ()antity that &ini&i8es total inventory holding carrying and ordering costs. >ere a f)nda&ental ()estion is answered i.e. >ow &)ch to order= Gow+ the si8e of the order sho)ld be s)ch that the costs associated with the &anage&ent of inventory are &ini&)&. T'e ! sts ass !iate# &it' In4ent (y2-. *nn)al ")rchase ost(D ) - which is *nn)al De&and(D) x "rice of the prod)ct( ) or D . .. *nn)al 'rder ost(D#9 HS)- where D#9 @ no. of orders per year(9@order ()antity) S@ cost of placing one order. Therefore &)ltiplying the orders per year with cost of one order wo)ld res)lt in total order cost in a year. (,nspection+ re7ection+ delay costs refers to the order cost). /. *nn)al arrying or >olding osts- average inventoryHholding cost per )nit wo)ld give the ann)al holding cost. *verage inventory@ 9#. and holding cost per )nit is >. Therefore the holding cost wo)ld be 9#.H>. (wareho)se+ power+ pilferage costs and the cost of capital(interest) are the carrying and holding costs.) The ann)al p)rchase costs is variable with the ()antity ordered+ therefore it is not considered as a cost associated with inventory control+ as it is the cost for the inventory and not the cost for its &anage&ent. arrying costs and ordering costs are inversely proportional i.e. if there are few orders+ high ()antity is ordered+ therefore ordering costs wo)ld be less b)t the carrying#holding cost wo)ld be &ore as the ()antity ordered wo)ld be high and vice-versa.

The E.'.9 6or&)la:- %:. 9H@Econo&ic 'rder 9)antity E.g. for E.'.9- 'ne )nit of I costs( ) !s.033 and the ann)al de&and(D) is .333 )nits. ost of one order(S) is !s. .3 and holding cost(>) is -3J per ann)&.(of the cost) Therefore E.'.9 wo)ld be :@K.333@01 )nits.

;NIT -I %2* <hat are the &a7or types of financial &anage&ent decision that b)siness fir& &a%e. Describe briefly each one of the& and highlight the inter-relationship a&ong these decisions. +15* Ans)2) There are / &a7or decision types in financial &anage&ent na&ely: - ,nvest&ent+ 6inancing L Dividend decisions. In4estment *n invest&ent decision revolves aro)nd spending capital on assets that will yield the highest ret)rn for the co&pany over a desired ti&e period. ,n other words+ the decision is abo)t what to b)y in order to generate &axi&)& ret)rn. To do so+ the co&pany needs to find a balance between its shortter& and long-ter& goals. ,n the very short-ter&+ a co&pany needs &oney to pay its bills+ b)t if the co&pany %eeps all of its cash+ then how wo)ld it invest in order to grow. *nd in case of long-ter& goal+ the co&pany needs to invest+ b)t what if it invests all of its &oney= >ow wo)ld it f)nction on daily

basis if it doesnEt have eno)gh cash to &eet its day-to-day expenses. Therefore+ ,nvesting decision is an essential one which re()ires the right &ix and balance between long-ter& and short ter& goal. The invest&ent decision also concerns what specific invest&ents to &a%e. Since there is no g)arantee of a ret)rn for &ost invest&ents+ the finance depart&ent &)st deter&ine an expected ret)rn. This ret)rn is not g)aranteed+ b)t is the average ret)rn on an invest&ent if it were to be &ade &any ti&es. The invest&ents &)st &eet three &ain criteria: ,t &)st &axi&i8e the val)e of the fir&. ,t &)st &aintain right balance between long-ter& and short-ter& goals. ,t &)st &axi&i8e shareholder val)e. Finan!in$ De!isi n *ll f)nctions of a co&pany need to be paid for one way or another. ,t is )p to the finance depart&ent to fig)re o)t how to pay for the& thro)gh the process of financing. There are two ways to finance an invest&ent: )sing a co&pany?s own &oney or by raising &oney fro& external f)nders. Each has its advantages and disadvantages. There are two ways to raise &oney fro& external f)nders: by ta%ing on debt or selling e()ity. Ta%ing on debt is the sa&e as ta%ing on a loan. The loan has to be paid bac% with interest+ which is the cost of borrowing. Selling e()ity is essentially selling part of yo)r co&pany. <hen a co&pany goes p)blic+ for exa&ple+ they decide to sell their co&pany to the p)blic instead of to private investors. ;oing p)blic entails selling stoc%s which represent owning a s&all part of the co&pany. The co&pany is selling itself to the p)blic in ret)rn for &oney. Every invest&ent can be financed thro)gh co&pany &oney or fro& external f)nders. ,t is the financing decision process that deter&ines the opti&al way to finance the invest&ent. ,t also considers the right finance &ix. That is+ the capital str)ct)re of any organi8ation sho)ld be appropriately designed. * capital str)ct)re consists of own &oney or borrowed &oney.

,f all the &oney is borrowed then interest wo)ld be too &)ch and profit wo)ld conse()ently decrease. *nd if all the &oney is owned then there wo)ld be no chance to ded)ct interest fro& profit which wo)ld event)ally lead to higher tax. (,nterest is allowed to be ded)cted fro& profit while calc)lating tax) Therefore+ an appropriate capital str)ct)re is also within the scope of financing decision. Di4i#en# #e!isi n Dividend refers to that part of profits of a co&pany which is distrib)ted by the co&pany a&ong its shareholders. ,t is the ret)rn to the shareholders on the invest&ents &ade by the& in the shares of the co&pany. This decision is &ade by the directors of the co&pany. This decision affects not only the share val)e of the co&pany b)t also the capital str)ct)re. Liqui#ity #e!isi ns- refers to the &aintaining li()idity position of a fir& to avoid insolvency. ,t is i&portant to have cash or near cash assets in order to &aintain li()idity position in an organisation. $)t high invest&ents in s)ch c)rrent assets can affect the profitability of an organisation. ,f excess cash is held in hands then the opport)nity cost is of co)rse lost. That cash co)ld have been )sed to p)rchase fixed assets. There are 2 situations:1. High liquidity & low profitability- ,n this case+ if it re&ains )nprofitable+ it will event)ally go ban%r)pt. ,ts available cash will be )sed to finance the losses+ b)t when the cash r)ns o)t+ the assets of the co&pany will have to sold off beca)se there will be ins)fficient f)nds to replace the& as they wear o)t. The co&pany will beco&e s&aller and s&aller and will event)ally fail. 2. High profitability & low liquidity- if a co&pany expands so rapidly that it is constantly ac()iring new assets+ it &ay very well get behind on its pay&ents to the s)ppliers and creditors d)e to the lac% of cash. ,n other words+ the co&pany is spending &oney &)ch faster than it is &a%ing it+ even tho)gh it is &a%ing a lot. Event)ally+ the creditors wo)ld de&and their &oney and+ if the co&pany does not have eno)gh cash to pay )p+ the creditors will ta%e the co&pany to co)rt. * 7)dge wo)ld order that the creditors

are entitled to their &oney and the assets of the co&pany wo)ld be sold off in order to raise cash to pay the&. So far the ob7ective is concerned the above stated three decisions are sa&e i.e. &axi&i8ing shareholders wealth. *s their ob7ectives are sa&e the decisions are interrelated. * co&pany having profitable invest&ent opport)nities generally prefer lower dividend pay o)t ratio. 'n the other hand having a good invest&ent &eans profit of the co&pany wo)ld be &ore+ and &ore dividend can be paid to shareholders. Si&ilarly+ finance f)nction and invest&ent f)nctions are also highly correlated. ost of capital plays a &a7or role in deciding whether to accept or re7ect invest&ent opport)nities. 6inancing decisions also dependent on a&o)nt of to be retained in the profit. So+ it can be concl)ded that invest&ent+ financing and dividend decisions are interrelated and are to be ta%en 7ointly %eeping in view their 7oint effect on the shareholders wealth. %,* Explain the long ter& and short ter& so)rces of raising finance. +15* Ans),) There are a n)&ber of ways fro& which a b)siness can raise finance fro&. S&all b)sinesses finance the&selves instead of ta%ing loans. They can borrow fro& friends L fa&ilies as well. 6inance- is a process or a transaction which provides f)nds for a b)siness. So)rces of finance- so)rces which f)nds or finances a b)siness. On t'e 6asis 0 time pe(i #1 s u(!es 0 0inan!e !an eit'e( 6e " n$-te(m ( s' (t-te(m) I) 5' (t te(m 0inan!in$- )s)ally the repay&ent ti&e is --1years. Short ter& finance is concerned with decisions relating to c)rrent assets and c)rrent liabilities and is also called as wor%ing capital finance. ,t incl)des the following:-

1) 7an8 C(e#it- it involves the cash credit+ over draft and bills disco)nting facility wherein short-ter& financial needs of a fir& is &et. ash credit- a loan a&o)nt is sanction and credited to the )serEs acco)nt. ,nterest is charged fro& the ti&e the a&o)nt is credited. 'ver-draft- a facility which allows the )ser to withdraw an a&o)nt in excess of the a&o)nt present in the acco)nt. There is a li&it to which an )ser can withdraw. $ill Disco)nting is a short ter& so)rce of finance+ whereby $ills !eceivable received fro& debtors is en cashed fro& the ban% at a disco)nted rate. 2) T(a#e C(e#it- trade credit is the credit extended by the seller to the p)rchaser for the p)rchase of goods and services. Trade credit facilitates the p)rchase of s)pplies witho)t i&&ediate pay&ent. ,t is co&&only )sed by b)siness organisations as a so)rce of short-ter& financing. ,t is granted to those c)sto&ers who have reasonable a&o)nt of financial standing and goodwill. ,. Fa!t (in$- it is a short-ter& finance where a fir& sells its acco)nt receivables to another fir& %nown as factor. The title also transfers and the factor is entitled to receive a&o)nt directly fro& the debtors. *ct)ally the factor b)ys a fir&Es receivables and the collection of these receivables is the factorEs 7ob. <) C mme(!ia" 3ape(- * co&pany can )se co&&ercial papers to raise f)nds. ,t is a pro&issory note carrying the )nderta%ing to repay the a&o)nt or# on after a partic)lar date. " can be iss)ed for &at)rities between a &ini&)& of -1 days and a &axi&)& )p to one year fro& the date of iss)e. 5) Insta""ment- Gow days the ban%s allow facilities where a b)yer can pay a no&inal a&o)nt at the ti&e of delivery and the rest of the a&o)nt is paid in e()al install&ents for a specified no. of years. ,t allows the )ser to pay a s&all a&o)nt &onthly for a defined period. The interest a&o)nt is charged in the install&ent itself. 4s)ally the period does not extend to &ore than 1 years. II) L n$-te(m Finan!e- 4s)ally the repay&ent ti&e is )pto .3 years.

,t can either be internal or external. 1) Inte(na" s u(!es in!"u#e2+a* Equity s'a(es- They represent the ownership position in a co&pany. The holders of the e()ity shares+ called shareholders+ are the legal owners of the co&pany. 'rdinary shares are also called permanent capital since they donEt have a &at)rity period. *ltho)gh these do not en7oy the preferential rights s)ch as clai& on dividends#assets etc they have voting rights which the preference shareholders lac%. They are also eligible for right iss)es. +6* 3(e0e(en!e s'a(es- These shares carry preferential rights over other shares. "reference shareholders have the right to receive dividends prior to other shares. They also have a clai& on assets. These are %nown as hybrid sec)rities beca)se it has the feat)res of both e()ity shares and debent)res. ,t si&ilar to e()ity shares in the sense that dividend is not ded)ctable while calc)lating tax. Go legal obligation to pay dividend. !epresent the ownership of the holders. ,t is si&ilar to debent)res in the sense that Dividend rate is fixed in both debent)res and preference shares. lai& on assets and dividends prior to e()ity share holders. +NOTE2 Equity = 3(e0e(en!e s'a(es a(e a"s 8n &n as se!u(ity 0inan!in$* +!* Retaine# Ea(nin$s- 4s)ally a co&pany does not distrib)te all its profits as dividends. ,t retains a part of it and can )se it for expansion and growth. ,t is also %nown as plo)ghing bac% of profits. * balance sheet fig)re shown )nder the heading retained earnings is the s)& of all profits retained since the inception of the co&pany. 2) E-te(na" s u(!es in!"u#e+a* De6entu(es- it is an ac%nowledge&ent &ade by a co&pany which agrees that it has ta%en loan. ,t is a doc)&ent iss)ed by a co&pany )nder its co&&on seal wherein all the details li%e the

a&o)nt+ &at)rity period etc are stated. The holders of this doc)&ent are the creditors of the co&pany. The fir& pro&ises to pay both the interest and principal. ,t is a sec)red for& of financing where the clai& on both the interest and assets is prior to both the preference and e()ity shares. *n )nsec)red debent)re is %nown as na%ed debent)res. +6* 3u6"i! Dep sits- ")blic deposits are an i&portant so)rce of financing the long-ter& re()ire&ents of a co&pany. The ter& ?p)blic deposit? i&plies any &oney received by a co&pany thro)gh the deposits or loans collected fro& the p)blic. The p)blic incl)des the general p)blic+ e&ployees and shareholders of the co&pany b)t excl)des the &oney received in the for& of shares and debent)res. The rate of interest payable by the co&pany on p)blic deposits is lower than the interest on loans fro& ban%s and other financial instit)tions. S)ch an interest is a tax ded)ctible expense. p)blic deposits are )nsec)red+ the depositors &ay have to bear the ris% of loss of &oney in the event of fail)re of the co&pany. +!* L ans 0( m 6an8s- * loan is the p)rchase of the present )se of &oney with the pro&ise to repay the a&o)nt in the f)t)re within a specified date and at a specified rate of interest. * for&al agree&ent is &ade to facilitate s)ch loans. The lenders esti&ate the worth and goodwill of the co&pany before lending. ,t is ta%en to finance long-ter& capital needs of a co&pany s)ch as p)rchasing fixed assets etc. "ay&ent ter&s can either be &onthly+ ()arterly or yearly as agreed. +#* 3( 9e!t Finan!in$"ro7ect finance is a long ter& financing of infrastr)ct)re and ind)strial pro7ects based )pon the pro7ected cash flows of the pro7ect rather than the balance sheets of the pro7ect sponsors. There is a high debt 5e()ity ratio in financing of pro7ects. The financier principally loo%s to the assets and reven)e of the pro7ect in order to sec)re the loan. ,t is )s)ally &ore e-pensi4e d)e to its non reco)rse nat)re. ;NIT -II

%<* >The best way to val)e e()ity share is that based on dividendsM. Exa&ine this state&ent. >ow wo)ld yo) val)e a share on which on dividend is being paid= +15* Ans)<) The val)ation of e()ity share is the &ost diffic)lt one beca)se:-. The rate of dividend is not &entioned. .. The rate also varies over the years and is not fixed li%e the preference shares. 7asi! 0eatu(es2-. Dividend is not g)aranteed on e()ity shares. .. Go rede&ption date is specified. ?a"uati n 0 equity s'a(es &it' ut in!"u#in$ #i4i#en#s21) Fa!e ?a"ue- it refers to the total capital of the owners#no. of shares iss)ed. This wo)ld give the face val)e or the boo% val)e of each share. De0i!ien!ies2(i) *ll the assets wo)ld be sold in the sa&e val)e as &entioned in the balance sheet. (ii) ,t is based on the historical infor&ation which has beco&e obsolete. (iii) ,gnores the profitability of the fir&. 2) Liqui#ati n ?a"ue- refers to the a&o)nt which wo)ld be realised after selling all the assets and paying the liabilities. This a&o)nt is then distrib)tes to all the shareholders. ,f the liabilities exceed the assets then no pay&ent wo)ld be done to the shareholders. De0i!ien!ies2-. *ltho)gh based on the present val)es )nli%e face val)e concept+ it ignores the profitability of the fir&. .. The real val)es have to be fo)nd o)t+ it is not a wor% of esti&ation. Therefore it re()ires a lot of ti&e and effort. ?a"uati n 0 equity s'a(es in!"u#in$ #i4i#en#s2E()ity shares are bo)ght for dividends and for the resale price of the share.

Dividends are )s)ally paid till the co&pany is operating profitability+ therefore holder is expected to hold it till then. Therefore the dividends play a cr)cial role in e()ity shares. Assumpti ns2-. Dividends are paid at the end of the year after the date of p)rchase. ?a"uati n2The val)e of e()ity shares is the s)& of the present val)es of f)t)re cash flows(dividends) disco)nted at the re()ired rate of ret)rn of investors. @'en #i4i#en#s a(e ! nstant an# # n t $( &23 . DABe1 &'e(e D. #i4i#en#1 Be. Rate 0 (etu(n1 3 . ?a"ue 0 equity s'a(es) <here:"o@ Nal)e of the e()ity share. D@Expected Dividend. Oe@ !ate of ret)rn. @'en #i4i#en#s $( & at a ! nstant (ate23 . +DABe*C$1 &'e(e $. $( &t' (ate) %5* The following infor&ation is available fro& the balance sheet of a co&pany E()ity share capital (A333 share of !s .-33 each) A33+333 -.J debent)re A33+333 -AJ ter& loan .0+33+333 03+33+333 Deter&ine the weighted average cost of capital of the co&pany. ,t had been paying dividend at a rate of !s .3 per share (g@3). ,nco&e tax rate is 03J. +15* Ans)5) o&p)tation of cost of each so)rce +a* C st 0 equity s'a(e !apita" a0te( e(*T)@E"S#2"H-33. <here E"S@ Earning "er Share+ 2."@ 2ar%et "rice @ .3#-33H-33@ .3J Ta-

+6* C st 0 #e6entu(e 7e0 (e Ta- +7T) d($T)@ ,"#G"H-33+ G"@Get "roceeds@ A33+333. ,nterest "ayable(,") @-.HA33333#-33@P:+333. Therefore d($T)@ P:333#A33333H-33@-.J d(*T)@ -.H(--tax)@-.H(--3.03)@Q..J +!* C st 0 te(m " an +AT* l(*T)@-AJ ost of ter& loan $efore Tax ($T) @-AH(--3.03) @ -3.AJ. R l(*T)H(--tax)S As!e(tainin$ &ei$'ts25 u(!e Am unt @ei$'t E()ity A33333 3.. Debent)res A33333 3.. $an% Loan .033333 3.: <000000 1)00 C mputati n 0 @ACC- +@ei$'te# A4e(a$e C 5 u(!e @ei$'t+@* A0te( TaC st D +-* E()ity 3.. .3 Debent)res 3.. Q.. Loan 3.: -3.A E@.1 @ACC A0te( Ta-+AT*. E@-. 11)F2D ;NIT G III %/* <hat is G"N= >ow is it different fro& ,!!= st 0 Capita"* @0 -.00 :.0A E@- .11)F2

+15*

Ans)/) $oth of these &eas)re&ents are pri&arily )sed in capital b)dgeting+ the process by which co&panies deter&ines whether a new invest&ent or expansion opport)nity is worthwhile. ;iven an invest&ent opport)nity+ a fir& needs to decide whether )nderta%ing the invest&ent will generate net econo&ic profits or losses for the co&pany. To do this+ the fir& esti&ates the f)t)re cash flows of the pro7ect

and disco)nts the& into present val)e a&o)nts )sing a disco)nt rate that represents the pro7ect?s cost of capital and its ris%. Gext+ all of the invest&ent?s f)t)re positive cash flows are red)ced into one present val)e n)&ber. S)btracting this n)&ber fro& the initial cash o)tlay re()ired for the invest&ent provides the net present val)e (G"N) of the invest&ent. The steps t !a"!u"atin$ net p(esent 4a"ue a(e2-) Deter&ine the net cash inflow in each year of the invest&ent. .) Select the desired rate of ret)rn. /) 6ind the disco)nt factor for each year based on the desired rate of ret)rn selected. 0) Deter&ine the present val)es of the net cash flows by &)ltiplying the cash flows by the disco)nt factors. 1) Total the a&o)nts for all years in the life of the pro7ect. :) Lastly s)btract the total net initial invest&ent. Internal Rate of Return Method The internal rate of ret)rn &ethod considers the ti&e val)e of &oney+ the initial cash invest&ent+ and all cash flows fro& the invest&ent. $)t )nli%e the net present val)e &ethod+ the internal rate of ret)rn &ethod does not )se the desired rate of ret)rn b)t esti&ates the disco)nt rate that &a%es the present val)e of s)bse()ent net cash flows e()al to the initial invest&ent. This disco)nt rate is called ,!!. ,nternal rate of ret)rn for an invest&ent proposal is the disco)nt rate that e()ates the present val)e of the expected net cash flows with the initial cash o)tflow. This ,!! is then co&pared to a criterion rate of ret)rn that can be the organi8ationEs desired rate of ret)rn for eval)ating capital invest&ents. Me(its 0 IRR2-

-. ,!! ta%es Ti&e Nal)e of &oney into consideration while calc)lating cash flows. .. >elps in &axi&i8ing the shareholderEs wealth by selecting the appropriate pro7ect where !', is &ore than ' (cost of capital). /. Effective &eans to select a proposal. 0. "refers cash flows to acco)nting ratios which &a%es it &ore realistic in nat)re. Deme(its 0 IRR21) 2)ch of calc)lation is re()ired. .. *ss)&es that ,!! re&ains sa&e for the f)t)re cash flows. /. Got advisable to rate . &)t)ally excl)sive pro7ects Let?s ill)strate with an exa&ple: s)ppose O*G o&pany wants to b)y a s&all p)blishing co&pany. O*G deter&ines that the f)t)re cash flows generated by the p)blisher+ when disco)nted at a -.J ann)al rate+ yields a present val)e of /3 &illion. ,f the p)blishing co&pany?s owner is willing to sell for .3 &illion+ then the G"N of the pro7ect wo)ld be -3 &illion (/3 - .3 @ -3). The -3 &illion dollar G"N represents the intrinsic val)e that will be added to O*G if it )nderta%es this ac()isition. So+ O*GEs pro7ect has a positive G"N+ b)t fro& a b)siness perspective+ the fir& sho)ld also %now what rate of ret)rn will be generated by this invest&ent. To do this+ the fir& wo)ld si&ply recalc)late the G"N e()ation+ this ti&e setting the G"N factor to 8ero(not )sing G"N)+ and solve for the now )n%nown disco)nt rate. The rate that is prod)ced by the sol)tion is the pro7ect?s internal rate of ret)rn(,!!). 6or this exa&ple+ the pro7ect?s ,!! co)ld+ depending on the ti&ing and proportions of cash flow distrib)tions+ be e()al to .3J. Th)s+ O*G+ given its pro7ected cash flows+ has a pro7ect with a .3J ret)rn. ,f there were a pro7ect that O*G co)ld )nderta%e with a higher ,!!+ it wo)ld probably p)rs)e the higher-yielding pro7ect instead. Th)s+ the )sef)lness of the ,!! &eas)re&ent lies in its ability to represent any invest&ent opport)nity?s ret)rn and to co&pare it with other possible invest&ents.

Di00e(en!es2There are circ)&stances#scenarios )nder which the net present val)e &ethod and the internal rate of ret)rn &ethods will reach different concl)sions. LetEs disc)ss these scenarios 5!ena(i s 1-La($e initia" in4estment G"N: The net present val)e &ethod will favo)r a pro7ect with a large initial invest&ent beca)se the pro7ect is &ore li%ely to generate large net cash inflows. ,!!: $eca)se the internal rate of ret)rn &ethod )ses percentages to eval)ate the relative profitability of an invest&ent+ the a&o)nt of the initial invest&ent has no effect on the o)tco&e. oncl)sion: Therefore+ the internal rate of ret)rn &ethod is &ore appropriate in this scenario. 5!ena(i s 2-Di00e(en!e in t'e timin$ an# am unt 0 net !as' in0" &s G"N: The net present val)e &ethod ass)&es that all net cash inflows fro& an invest&ent earn the desired rate of ret)rn )sed in the calc)lation. The desired rate of ret)rn )sed by the net present val)e &ethod is )s)ally the organi8ationEs weighted-average cost of capital+ a &ore conservative and &ore realistic expectation in &ost cases. ,!!: Differences in the ti&ing and a&o)nt of net cash inflows affect a pro7ectEs internal rate of ret)rn. This res)lts fro& the fact that the internal rate of ret)rn &ethod ass)&es that all net cash inflows fro& a pro7ect earn the sa&e rate of ret)rn as the pro7ectEs internal rate of ret)rn. oncl)sion: ,n this scenario choosing G"N is a better choice. 5!ena(i ,-3( 9e!ts &it' " n$ use0u" "i0e G"N: $oth &ethods favo)r pro7ects with long )sef)l lives as a pro7ect earns positive net cash inflow d)ring the extended years. *s long as the net cash inflows in a year is positive+ no &atter how s&all+ the net present val)e increases+ and the pro7ects desirability i&proves. ,!!: Li%ewise+ the internal rate of ret)rn &ethod considers each additional )sef)l year of a pro7ect another year that its c)&)lative

net cash inflow will earn a ret)rn e()al to the pro7ectEs internal rate of ret)rn. oncl)sion: $oth G"N and ,!! s)itable. 5!ena(i <-?a(yin$ ! st 0 !apita" ,n an organi8ationEs financial condition or operating environ&ent changes+ its cost of capital co)ld also change. * proper capital b)dgeting proced)re sho)ld incorporate changes in the organi8ationEs cost of capital or desired rate of ret)rn in eval)ating capital invest&ents. G"N: The net present val)e &ethod can acco&&odate different rate of ret)rn over the years by )sing the appropriate disco)nt rates for the net cash inflow of different periods. ,!!: The internal rate of ret)rn &ethod calc)lates a single rate that reflects the ret)rn of the pro7ect )nder consideration and cannot easily handle sit)ations with varying desired rates of ret)rn. oncl)sion: G"N is a better &ethod in these circ)&stances. 5!ena(i 5-Mu"tip"e In4estments G"N: The net present val)e &ethod eval)ates invest&ent pro7ects in cash a&o)nts. The net present val)es fro& &)ltiple pro7ects can be added to arrive at a single total net present val)e for all invest&ent. ,!!: The internal rate of ret)rn &ethod eval)ates invest&ent pro7ects in percentages or rates. The percentages or rates of ret)rn on &)ltiple pro7ects cannot be added to deter&ine an overall rate of ret)rn. * co&bination of pro7ects re()ires a recalc)lation of the internal rate of ret)rn. oncl)sion: G"N is a better &ethod in these circ)&stances. %H* * pro7ect re()ired an initial o)tlay of !s. .3+333. ,t generates year ending profits of !s -.+333+ !s :333+ !s 0333+ !s -3+333 and !s -3+333 fro& the end of the first year to the end of the fifth year. The re()ired rate of ret)rn is -3J and pays tax at 13J rate. The pro7ect has a life of 1 years and is depreciated on straight line &ethod basis. *ss)&e that the above year ending profits are before depreciated and tax .yo) are re()ired to co&pare -:

(-) "ay bac% period (.) *verage rate of ret)rn. (/) Get present val)e. Ans)H) Initia" ut"ayAIn4estment.201000) Iea( Cas' F" &

+15* Cumu"ati4e 0" & -.333 -A333 ..333 /.333 0.333 !as'

-.333 . :333 / 0333 0 -3333 1 -3333 1) 3ay 6a!8 pe(i #. EC+7AC*J E@n)&ber of years i&&ediately preceding the year of final recovery 2 $@ balance a&o)nt to be recovered(.3+333--A+333@.+333S @ ash flow d)ring year of final recovery 0333 "ay bac% period@ .B(.3333--A333)#0333@ .B-#.@ 2yea(s an# / m nt's) +2*A4e(a$e Rate 0 Retu(n+ARR )@ *verage ann)al profits#*verage invest&entH-33. *verage ann)al profits@ Total profits#no.of years@ 0.333#1@A033. *verage o)tlay@ initial o)tlay#.@ .3333#.@ -3333 Therefore *!!@ A033#-3333H-33@ A0J. +,* Net 3(esent ?a"ue+N3?* alc)lation of ".N of cash inflows Iea( Ris8 Fa!t ( Cas' In0" &s 3(esent K10D ?a"ue +3)?* .3P3 -.333 -3P3A . .A.: :333 0P1: / .Q10333 /330 0 .:A/ -3333 :A/3 1 .:.-3333 :.-3 <21000 ,11F0L G.".N@ ".N-,nitial invest&ent@ /-+P3A-.3+333@ ---+P3A. The G.".N of the pro7ect is positive therefore the proposal sho)ld be accepted.

;NIT G I? %L* <hat is the i&portance of wor%ing capital &anage&ent for &an)fact)ring fir&= Describe the factors that affect wor%ing capital re()ire&ent of a co&pany= +15* Ans)L) <or%ing capital &eas)res how &)ch li()id assets a fir& has to carry on with its b)siness. <or%ing capital refers to the operating li()idity of an organisation. ;ross wor%ing capital e()als to c)rrent assets. Get wor%ing capital (G< ) is calc)lated as c)rrent assets &in)s c)rrent liabilities. ,f c)rrent assets are less than c)rrent liabilities+ an entity has a & (8in$ !apita" #e0i!it) @ (8in$ !apita" Rati is Cu((ent AssetsACu((ent Lia6i"ities) ,f the answer is less than -+ it indicates a negative wor%ing capital whereas a high positive ratio &eans that the fir& has invested a lot of &oney in inventory or it has excess cash which is not being )tili8ed efficiently. T'e & (8in$ !apita" !y!"eA pe(atin$ !y!"e &eas)res the ti&e between paying for goods s)pplied to yo) and the final receivng of cash fro& their sale. ,t is desirable to %eep the cycle as short as possible as it increases the effectiveness of wor%ing capital. The operating cycle is &ade )p of fo)r core co&ponents: ash (f)nds available)+ reditors (acco)nts payable)+ ,nventory (stoc% on hand)+ Debtors (acco)nts payable). From initial cash paid for the raw materials to production process and consequent sale of the finished goods is known as the operating cycle. @ (8in$ !apita" mana$ement- The &anage&ent of wor%ing capital involves &anaging inventories+ acco)nts receivable and payable+ and cash. Decisions relating to wor%ing capital and short ter& financing are referred to as working capital management. The goal of wor%ing capital &anage&ent is to ens)re that the fir& is able to contin)e its operations and that it has s)fficient cash flow to satisfy its short-ter& debt and operating expenses.

Imp (tan!e21) Cas' Mana$ement- ,dentifies the cash balance which allows for the b)siness to &eet day to day expenses+ and red)ces cash holding costs. 2) In4ent (y mana$ement- ,dentifies the level of inventory which allows for )ninterr)pted prod)ction b)t red)ces the invest&ent in raw &aterials and &ini&i8es reordering costs hence increases the cash flow. $esides this+ the lead ti&es in prod)ction sho)ld be lowered to red)ce <or% in "rocess (<,") and si&ilarly+ the 6inished ;oods sho)ld be %ept at low level as possible to avoid over prod)ction. ,) De6t (s mana$ement- hooses the appropriate credit policy+ credit ter&s which wo)ld attract c)sto&ers+ s)ch that any delay in cash flows and the cash conversion cycle wo)ld be offset by increased reven)e and high profitability. <) 5' (t te(m 0inan!in$- ,dentifies the appropriate so)rce of financing. redit granted by the s)ppliers for appropriate ti&e also acts as a short-ter& financeC however+ it &ay be necessary to )tili8e a ban% loan (or overdraft)+ or to Tconvert debtors to cashT thro)gh TfactoringT. 5) Man#"in$ 3( 0ita6i"ity an# G( &t'- Efficiency in &anaging profitability and growth of an organisation is an cr)cial part of any organisation. ;rowth rate can be increased with cash by reg)lating its invest&ent plans and by handling profit efficiently. /) G #&i"" = Reputati n- $)sinesses &ay face to)gh sit)ations where creditors &ay )n-expectantly de&and bac% all the &oney. 6ixed assets &ay not be easy to sell off in a shortti&e. >ence high wor%ing capital helps in paying off the debts+ th)s+ ens)ring good i&age and rep)tation of the fir&. H) 3( te!ti n a$ainst 6an8(upt!y- Efficient wor%ing capital ens)res ade()ate level of wor%ing capital at all ti&es. Geither too high nor too low wor%ing capital is &aintained at any ti&e th)s ens)ring protection against ban%r)ptcy. Fa!t (s #ete(minin$ 6usiness2& (8in$ !apita" (equi(ements in

1) 5iNe 0 t'e 0i(m : * large fir& needs &ore wor%ing capital than a s&all fir&. ,n order to s)stain the high vol)&e of prod)ction and sales+ a large fir& has to &aintain greater c)rrent assets. 2) Natu(e 0 7usiness2 * trading concern has to &aintain &ore inventory than a &an)fact)ring concern. Therefore+ &ore wor%ing capital is re()ired by a trading concern. ")blic )tility concerns s)ch as railways+ electricity s)pply concerns+ gas agencies re()ire less wor%ing capital beca)se &ost of their transactions are on cash basis. Si&ilarly+ hotels and resta)rants need little wor%ing capital as stoc% and debtors are not high. ,) Type 0 3( #u!ti n 3( !ess2 * fir& )sing labo)r intensive techni()e needs &ore wor%ing capital to pay wages and salaries. * highly a)to&atic plant will need less wor%ing capital and &ore fixed capital. <or%ing capital re()ire&ents are higher when raw &aterials acco)nt for a &a7or proportion of the total cost. <) Len$t' 0 Ope(atin$ Cy!"e: Longer is the ti&e gap between p)rchase of raw &aterials and receipt of cash fro& debtors+ greater is the need for wor%ing capital. That is why fir&s having a lengthy and ro)ndabo)t &an)fact)ring process re()ire &ore wor%ing capital. 6or exa&ple+ a heavy engineering fir& has a longer operating cycle than a rice &ill. 5) In4ent (y Tu(n 4e(: <here the inventory is large and its t)rnover is slow+ wor%ing capital re()ired is &ore. ,nventory t)rnover &eans the speed with which sales are &ade. 6or exa&ple+ a 7eweller has to &aintain a high inventory of different types of 7ewellery and the &ove&ent of inventory is slow. Therefore+ the wor%ing capital re()ire&ents of a 7eweller are &ore than those of a grocer. /) Te(ms 0 C(e#it: *n enterprise with a liberal credit policy re()ire &ore wor%ing capital. S)ch a fir& allows credit to all its c)sto&ers+ the period of credit is co&paratively long and debts are high+ collected strictly within the credit period. Si&ilarly+ a concern en7oying liberal credit fro& the s)ppliers need less wor%ing capital. H) 7an8in$ 0a!i"ities2 <here good+ ()ic% and dependable credit is available fro& co&&ercial ban%s+ a concern can &anage its

operations with relatively less wor%ing capital. ,n s)ch a case+ cash re()ire&ents are s&all. L) 5eas na" 4a(iati ns: So&e enterprises need greater wor%ing capital d)ring partic)lar seasons. 6or exa&ple+ a s)gar &ill re()ires &ore wor%ing capital d)ring Dece&ber to *pril when prod)ction ta%es place. ,t re()ires &)ch less wor%ing capital in other &onths. F) C ntin$en!ies: ,f the de&and for and prices of prod)cts of a s&all enterprise are s)b7ect to wide and )nexpected fl)ct)ations+ provision has to be &ade for arranging higher a&o)nts of wor%ing. capital. Trade cycles &ay affect the a&o)nt of wor%ing capital re()ired in an enterprise. 10) Te(ms 0 pu(!'ase an# sa"e : ,f the fir& p)rchases raw &aterials on credit and sells on cash basis+ it re()ires less wor%ing capital. ,f it b)ys on cash basis and sells its prod)ct on credit+ it will need a large a&o)nt of wor%ing capital beca)se of instant pay&ents and slow collections. 11) Imp (tan!e 0 "a6 u(: ,f pro7ect is labo)r intensive+ large a&o)nt of wor%ing capital is re()ired. %F* The finance depart&ent of a co&pany provides the following infor&ation (-) The carrying cost per )nit of inventory are !s.-3 (.) The fixed cost per order are !s..3 (/) The n)&ber of )nits re()ired is /3+333 per year. Deter&ine the econo&ic order ()antity (E'9)+ total n)&ber in year and the ti&e gap between two orders. +15* Ans)F) *nn)al De&and(!)@ /3+333 )nits arrying cost per )nit( h)@ !s.-3 'rdering cost( p)@ !s..3 !@ /3333+ p@ .3+ h@ -3. -. E.'.9@ @ /0: approxi&ately.

.. Total orders in a year@ /3333#/0:@ AQ (approx). /. ;ap between . orders@ /:1#AQ@ 0days (approx).