DRIVE SPRING 2015

PROGRAM- MBADS/ MBAFLEX/ MBAHCSN3/ MBAN2/ PGDBAN2

SEMESTER- 2
SUBJECT CODE & NAME- MB0045 FINANCIAL MANAGEMENT
BK ID- B1628

1- Explain the liquidity decisions and its important elements. Write complete information on
dividend decisions.
Ans: The liquidity decision is concerned with the management of the current assets, which
is a pre-requisite to long-term success of any business firm. This is also called as working
capital decision.The main objective of the current assets management is the trade-off
between profitability andliquidity, and there is a conflict between these two concepts. If a
firm does not have adequateworking capital, it may become illiquid and consequently fail to
meet its current obligations thus inviting the risk of bankruptcy. On the contrary, if the
current assets are too enormous, the profitability is adversely affected. Hence, the major
objective of the liquidity decision is to ensure a trade-off between profitability and liquidity.
Besides, the funds should be invested optimally in theindividual current assets to avoid
inadequacy or excessive locking up of funds. Thus, the liquidity decision should balance the
basic two ingredients, i.e. working capital management and the efficientallocation of funds
on the individual current assets. In other terms, liquidity decisions deal with working capital
management. It is concerned with the day-to-day financial operations that involve
current assets and current liabilities.The important elements of liquidity decisions are:

Formulation of inventory policy

Policies on receivable management
Formulation of cash management strategies
Policies on utilisation of spontaneous finance effectively

DIVIDEND DECISIONS.
Dividends are payouts to shareholders. Dividends are paid to keep the shareholders happy. Dividend
decision is a major decision made by the finance manager.
Dividend is that portion of profits of a company which is distributed among its shareholders according to the
resolution passed in the meeting of the Board of Directors. This may be paid as a fixed percentage on the
share capital contributed by them or at a fixed amount per share. The dividend decision is always a problem
before the top management or the Board of
Directors as they have to decide how much profits should be transferred to reserve funds to meet any
unforeseen contingencies and how much should be distributed to the shareholders.
Payment of dividend is always desirable since it affects the goodwill of the concern in the market on the one
hand, and on the other, shareholders invest their funds in the company in a hope of getting a reasonable
return. Retained earnings are the sources of internal finance for financing of corporates future projects but
payment of dividend constitute an outflow of cash to shareholders. Although both - expansion and payment
of dividend -are desirable, these two are in conflicting tasks. It is, therefore, one of the important functions of
the financial management to constitute a dividend policy which can balance these two contradictory view
points and allocate the reasonable amount of profits after tax between retained earnings and dividend. All of
this is based on formulation of a good dividend policy.
Since the goal of financial management is maximisation of wealth of shareholders, dividend policy
formulation demands the managerial attention on the impact of its policy on dividend and on the market

value of its shares. Optimum dividend policy requires decision on dividend payment rates so as to maximise
the market value of shares. The payout ratio means what portion of earnings per share is given to the
shareholders in the form of cash dividend. In the formulation of dividend policy, the management of
accompany will have to consider the relevance of its policy on bonus shares. Dividend policy influences the
dividend yield on shares. Dividend yield is an important determinant of an investors attitude towards the
security (stock) in his portfolio management decisions.
2. Explain about the doubling period and present value. Solve the below given problem:
Under the ABC Banks Cash Multiplier Scheme, deposits can be made for periods ranging
from 3 months to 5 years and for every quarter, interest is added to the principal. The
applicable rate of interest is 9% for deposits less than 23 months and 10% for periods more
than 24 months. What will be the amount of Rs. 1000 after 2 years?

Doubling period
A very common question arising in the minds of an investor is how long will it take for the amount invested
to double for a given rate of interest. There are 2 ways of answering this question:
1. One way is to answer it by a rule known as rule of 72. This rule states that the period within which the
amount doubles is obtained by dividing72 by the rate of interest. Though it is a crude way of calculating, this
rule is followed by most.
For instance, if the given rate of interest is 10%, the doubling period is
72/10, that is, 7.2 years.
2. A much accurate way of calculating doubling period is by using the rule known as rule of 69. By this
method,
Doubling Period = 0.35+69/Interest rate
Going by the same example given above, we get the number of years as
7.25 years {(0.35 + 69/10) or (0.35 +6.9)}.
Solution:

( mi )

FV n=PV 1+

mXn

m = 12/3 = 4 (quarterly compounding)

1000 (1+0.10/4)4*2
1000 (1+0.10/4)8
Rs. 1218
The amount of Rs. 1000 after 2 years would be Rs. 1218.

Present value
Given the interest rate, compounding technique can be used to compare the cash flows separated by more
than one time period. With this technique, the amount of present cash can be converted into an amount of
cash of equivalent value in future. Likewise, we may be interested in converting the future cash flow into
their present values. Present value can be simply defined as the current value of a future sum. It can also
be defined as the amount to be invested today (present value) at a given rate of interest over a specified
period to equal the future sum.
If we reverse the flow by saying that we expect a fixed amount after nnumber of years and we also know
the present prevailing interest rate, then by discounting the future amount at the given interest rate, we will
get the present value of investment to be made.
The present value of a sum to be received at a future date is determined by discounting the future value at
the interest rate that the money could earn over the period. This process is known as discounting.

Present value of a single flow

Ascertaining Present Value (PV) is simply the reverse of finding Future Value (FV). Hence, the formula for
FV can be simply transformed into thePV formula.

Present value of even series of cash flows

In a business scenario, the businessman will receive periodic amounts(annuity) for a certain number of
years. An investment done today will fetch him returns spread over a period of time. He would like to know
if it is worthwhile to invest a certain sum now in anticipation of returns he expects after a certain number of
years. He should, therefore, equate the anticipated future returns to the present sum he is willing to forego

Present value of perpetuity

An annuity for an infinite time period is perpetuity. It occurs indefinitely. Aperson may like to find out the
present value of his investment assuming he will receive a constant return year after year.

Capital recovery factor

Capital recovery factor is the annuity of an investment for a specified time ata given rate of interest.
3. Write short notes on: a) Operating Leverage b) Financial leverage c) Combined leverage
ans:-

A) OPERATING LEVERAGE
Operating leverage arises due to the presence of fixed operating expenses in the firms income flows. It has a
close relationship to business risk. Operating leverage affects business risk factors, which can be viewed as
the uncertainty inherent in estimates of future operating income. The operating leverage takes place when a
change in revenue produces greater change in Earnings Before Interest and Taxes (EBIT). It indicates the
impact of changes in sales on operating income. A firm with a high operating leverage has a relatively
greater effect on EBIT for small changes in sales. A small rise in sales may enhance profits considerably,
while small decline in sales may reduce and even wipe out the EBIT. The operating leverage is the firms
ability to use fixed operating costs to increase the effects of changes in sales on its EBIT. Operating leverage
occurs any time if a firm has fixed costs. The percentage of change in profits with a change in volume of sales
is more than the percentage of change in volume. The higher the fixed costs, the greater the leverage and the
more frequent the changes in the rate of profit (or loss) with alternations in the volume of activity.

B) FINANCIAL LEVERAGE
Financial leverage relates to the financing activities of a firm and measures the effect of EBIT on Earnings
Per Share (EPS) of the company. A companys sources of funds fall under two categories:
Those which carry fixed financial charges like debentures, bonds, and preference shares Those which
do not carry any fixed charges like equity shares
Debentures and bonds carry a fixed rate of interest and are to be paid off irrespective of the firms
revenues. The dividends are not contractual obligations, but the dividend on preference shares is a
fixed charge and should be paid off before equity shareholders. The equity holders are entitled to
only the residual income of the firm after all prior obligations are met.
Financial leverage refers to a firm's use of fixed-charge securities like debentures and preference shares
(though the latter is not always included in debt) in its plan of financing the assets.
The concept of financial leverage is a significant one because it has direct relation with capital structure
management. It determines the relationship that could exist between the debt and equity securities. A firm
which does not issue fixed-charge securities has an equity capital structure and does not have any financial
leverage. However, it is common for firms to issue
Some debt securities, in which case, the leverage is either favorable or unfavorable. Financial leverage is a
process of using debt capital to increase the rate of return on equity. For this reason, it is also referred to as
trading on equity. Borrowing is done by a company because of the financial advantage that is expected from
it. The use of borrowings for the purpose of such advantage for residual shareholders is also called trading
on equity or leverage. Financial leverage refers to the mix of debt and equity in the capital structure of the
firm. This results from the presence of fixed financial charges in the companys income stream. Such
expenses have nothing to do with the firms performance and earnings and should be paid off regardless of
the amount of EBIT.

C) COMBINED LEVERAGE
The combination of operating and financial leverage is called combined leverage. Operating leverage affects
the firms operating profit EBIT and financial leverage affects PAT or the EPS. These cause wide
fluctuations inEPS. A company having a high level of operating or financial leverage will find a drastic
change in its EPS even for a small change in sales volume. Companies whose products are seasonal in nature
have fluctuating EPS,but the amount of changes in EPS due to leverages is more pronounced.

DTL measures the total risk of the company as DTL is a combined measure of both operating and
financial risk
DTL measures the variability of EPS

4. Explain the factors affecting Capital Structure. Solve the below given problem:
Given below are two firms, A and B, which are identical in all aspects except the
degree of leverage employed by them. What is the average cost of capital of
both firms?
Capital structure should be planned at the time a company is promoted. The initial capital structure should
be designed very carefully. The management of the company should set a target capital structure, and the
subsequent financing decisions should be made with a view to achieve the target capital structure. Every
time the funds have to be procured, the financial manager weighs the pros and cons of various sources of
finance and selects the most advantageous sources keeping in view the target capital structure. Thus, the
capital structure decision is a continuous one and has to be taken whenever firm needs additional finance.
The major factor affecting the capital structure is leverage. There are also few other factors affecting them.
All the factors are explained briefly here.

Leverage
The use of sources of funds that have a fixed cost attached to them, such as preference shares, loans from
banks and financial institutions, and debentures in the capital structure, is known as trading on equity or
financial leverage.
If the assets financed by debt yield a return greater than the cost of the debt, the EPS will increase without
an increase in the owners investment. Similarly, the EPS will also increase if preference share capital is used
to acquire assets. But the leverage impact is felt more in case of debt because of the following reasons:
The cost of debt is usually lower than the cost of preference share capital
The interest paid on debt is a deductible charge from profits for calculating the taxable income while
dividend on preference shares is not
The other factors to be considered before deciding on an ideal capital structure are:
Cost of capital High cost funds should be avoided. However attractive an investment proposition may
look like, the profits earned may be eaten away by interest repayments.
Cash flow projections of thecompany Decisions should be taken in the light of cash flow projected
for the next 3-5 years. The company officials should not get carried away at the immediate results expected.
Consistent lesser profits are any way preferable than high profits in the beginning and not being able to get
any profits after 2 years.
Dilution of control The top management should have the flexibility to take appropriate decisions at
the right time. Fear of having to share control and thus being interfered by others often delays the decision
of the closely held companies to go public. To avoid the risk of loss of control, the companies may issue
preference shares or raise debt capital. An excessive amount of debt may also cause bankruptcy, which
means a complete loss of control. The capital structure planned should be one in this direction.
Floatation costs Floatation costs are incurred when the funds are raised. Generally, the cost of floating
a debt is less than the cost of floating an equity issue. A company desiring to increase its capital byway of
debt or equity will definitely incur floatation costs. Effectively, the amount of money raised by any issue will
be lower than the amount expected because of the presence of floatation costs. Such costs should be
compared with the profits and right decisions should be taken.

Solution:
Average cost of capital of firm A is:
10% * 0/Rs. 666667 + 15% * 666667/666667 = 0 + 15= 15%
Average cost of capital of firm B is:
10% * 25000/750000 + 15% * 533333/750000 = 3.34 + 10= 13.4%

Interpretation:
The use of debt has caused the total value of the firm to increase and the overall cost of capital to decrease.

5. Explain all the sources of risk in capital budgeting with examples. Solve the
below given problem: An investment will have an initial outlay of Rs 100,000. It is
expected to generate cash inflows. Cash inflow for four years.
Ans: There are several definitions for the term risk. It may vary depending on the situation, context and
application. Risk may be termed as a degree of uncertainty. It may be defined as the possibility that the
actual result from an investment will differ from the expected result. Risk in capital budgeting maybe
defined as the variation of actual cash flows from the expected cash flows.
Capital budgeting involves four types of risks in a project: stand-alone risk, portfolio risk, market risk and
corporate risk..

Stand-alone risk
Stand alone risk of a project is considered when the project is in isolation. Stand-alone risk is measured by
the variability of expected returns of the project.

Portfolio risk
A firm can be viewed as portfolio of projects having a certain degree of risk. When new project is added to
the existing portfolio of project, the risk profile of the firm will alter. The degree of the change in the risk
depends on the following:
The co-variance of return from the new project
The return from the existing portfolio of the projects
If the return from the new project is negatively correlated with the return from portfolio, the risk of the firm
will be further diversified.

Market risk
Market risk is defined as the measure of the unpredictability of a given stock value. However, market risk is
also referred to as systematic risk. The market risk has a direct influence on stock prices. Market risk is
measured by the effect of the project on the beta of the firm. The market risk for a project is difficult to
estimate, as it includes a wide range of external factors like recessions, wars, political issues, etc.

Corporate risk
Corporate risk focuses on the analysis of the risk that might influence the project in terms of entire cash flow
of the firms. Corporate risk is the projects risks of the firm.

Sources of risk
The five different sources of risk are:
Project-specific risk
Competitive or competition risk
Industry-specific risk
International risk
Market risk

a) NPV can be computed using risk free rate

PV Using Risk Free Rate
Year Cash flows (inflows) Rs.
1
40000
2
50000
3
15000
4
30000
PV of cash inflows 1,09,415
PV of cash outflows (1,00,000)
NPV 9,415

PV factor at10%
0.909
0.826
0.751
0.683

PV of cash flows(inflows)
36,360
41,300
11,265
20,490

b) NPV can be computed using risk-adjusted discount.

Year Cash inflows Rs.
1
40000
2
50000
3
15000
4
30000
PV of Cash inflows 91,165
PV of cash outflows (100, 000)
NPV (8, 835)

PV factor at 20%
0.833
0.694
0.579
0.482

PV of cash inflows
33,320
34,700
8,685
14,460

The project would be acceptable when no allowance is made for risk.

However, it will not be acceptable if risk premium is added to the risk free rate. By doing so, it moves from
positive NPV to negative NPV. If the firm were to use the internal rate of return (IRR), then the project
would be accepted, when IRR is greater than the risk-adjusted discount rate.

6. Explain the objectives of Cash Management. Write about the Baumol model
with their assumptions.

4. EXPLAIN THE FACTORS AFFECTING CAPITAL STRUCTURE. SOLVE

THE BELOW GIVEN PROBLEM:
Capital structure should be planned at the time a company is promoted. The initial capital structure
should be designed very carefully. The management of the company should set a target capital
structure, and the subsequent financing decisions should be made with a view to achieve the target
capital structure. Every time the funds have to be procured, the financial manager weighs the pros
and cons of various sources of finance and selects the most advantageous sources keeping in view the
target capital structure. Thus, the capital structure decision is a continuous one and has to be taken
whenever firm needs additional finance. The major factor affecting the capital structure is leverage.
There are also few other factors affecting them. All the factors are explained briefly here.

Leverage
The use of sources of funds that have a fixed cost attached to them, such as preference shares, loans
from banks and financial institutions, and debentures in the capital structure, is known as trading
on equity or financial leverage.
If the assets financed by debt yield a return greater than the cost of the debt, the EPS will increase
without an increase in the owners investment. Similarly, the EPS will also increase if preference
share capital is used to acquire assets. But the leverage impact is felt more in case of debt because of
the following reasons:
The cost of debt is usually lower than the cost of preference share capital
The interest paid on debt is a deductible charge from profits for calculating the taxable
income while dividend on preference shares is not
The other factors to be considered before deciding on an ideal capital structure are:
Cost of capital High cost funds should be avoided. However attractive an investment
proposition may look like, the profits earned may be eaten away by interest repayments.
Cash flow projections of thecompany Decisions should be taken in the light of cash flow
projected for the next 3-5 years. The company officials should not get carried away at the immediate
results expected. Consistent lesser profits are any way preferable than high profits in the beginning
and not being able to get any profits after 2 years.
Dilution of control The top management should have the flexibility to take appropriate
decisions at the right time. Fear of having to share control and thus being interfered by others often
delays the decision of the closely held companies to go public. To avoid the risk of loss of control, the
companies may issue preference shares or raise debt capital. An excessive amount of debt may also
cause bankruptcy, which means a complete loss of control. The capital structure planned should be
one in this direction.
Floatation costs Floatation costs are incurred when the funds are raised. Generally, the cost of
floating a debt is less than the cost of floating an equity issue. A company desiring to increase its
capital byway of debt or equity will definitely incur floatation costs. Effectively, the amount of money
raised by any issue will be lower than the amount expected because of the presence of floatation
costs. Such costs should be compared with the profits and right decisions should be taken.

Solution:
Average cost of capital of firm A is:
10% * 0/Rs. 666667 + 15% * 666667/666667 = 0 + 15= 15%
Average cost of capital of firm B is:
10% * 25000/750000 + 15% * 533333/750000 = 3.34 + 10= 13.4%

Interpretation:
The use of debt has caused the total value of the firm to increase and the overall cost of capital to
decrease.

5. EXPLAIN ALL THE SOURCES OF RISK IN CAPITAL BUDGETING

WITH EXAMPLES.
Ans. There are several definitions for the term risk. It may vary depending on the situation,
context and application. Risk may be termed as a degree of uncertainty. It may be defined as the
possibility that the actual result from an investment will differ from the expected result. Risk in
capital budgeting maybe defined as the variation of actual cash flows from the expected cash flows.
Capital budgeting involves four types of risks in a project: stand-alone risk, portfolio risk, market
risk and corporate risk..

Stand-alone risk
Stand alone risk of a project is considered when the project is in isolation. Stand-alone risk is
measured by the variability of expected returns of the project.

Portfolio risk
A firm can be viewed as portfolio of projects having a certain degree of risk. When new project is
added to the existing portfolio of project, the risk profile of the firm will alter. The degree of the
change in the risk depends on the following:
The co-variance of return from the new project
The return from the existing portfolio of the projects
If the return from the new project is negatively correlated with the return from portfolio, the risk of
the firm will be further diversified.

Market risk
Market risk is defined as the measure of the unpredictability of a given stock value. However, market
risk is also referred to as systematic risk. The market risk has a direct influence on stock prices.
Market risk is measured by the effect of the project on the beta of the firm. The market risk for a
project is difficult to estimate, as it includes a wide range of external factors like recessions, wars,
political issues, etc.

Corporate risk
Corporate risk focuses on the analysis of the risk that might influence the project in terms of entire
cash flow of the firms. Corporate risk is the projects risks of the firm.

Sources of risk
The five different sources of risk are:
Project-specific risk
Competitive or competition risk
Industry-specific risk
International risk
Market risk

SOLVE THE BELOW GIVEN PROBLEM:

IF THE RISK FREE RATE AND THE RISK PREMIUM IS 10%,
A) COMPUTE THE NPV USING THE RISK FREE RATE
B) COMPUTE NPV USING RISK-ADJUSTED DISCOUNT RATE
Solution

a) NPV can be computed using risk free rate

PV Using Risk Free Rate
Year Cash flows (inflows) Rs.
1
40000
2
50000
3
15000
4
30000
PV of cash inflows 1,09,415
PV of cash outflows (1,00,000)
NPV 9,415

PV factor at10%
0.909
0.826
0.751
0.683

PV of cash flows(inflows)
36,360
41,300
11,265
20,490

b) NPV can be computed using risk-adjusted discount.

Year Cash inflows Rs.
1
40000
2
50000
3
15000
4
30000
PV of Cash inflows 91,165
PV of cash outflows (100, 000)
NPV (8, 835)

PV factor at 20%
0.833
0.694
0.579
0.482

PV of cash inflows
33,320
34,700
8,685
14,460

The project would be acceptable when no allowance is made for risk.

However, it will not be acceptable if risk premium is added to the risk free rate. By doing so, it moves
from positive NPV to negative NPV. If the firm were to use the internal rate of return (IRR), then the
project would be accepted, when IRR is greater than the risk-adjusted discount rate.

6. EXPLAIN THE OBJECTIVES OF CASH MANAGEMENT. WRITE

ABOUT THE BAUMOL MODEL WITH THEIR ASSUMPTIONS.
Ans. The major objectives of cash management in a firm are:

Meeting payments schedule

Minimising funds held in the form of cash balances

Meeting payments schedule

In the normal course of functioning, a firm has to make various payments by cash to its employees,
suppliers and infrastructure bills. Firms will also receive cash through sales of its products and
collection of receivables. Both of these do not occur simultaneously.
The basic objective of cash management is therefore to meet the payment schedule on time. Timely
payments will help the firm to maintain its creditworthiness in the market and to foster cordial
relationships with creditors and suppliers. Creditors give cash discount if payments are made in time
and the firm can avail this discount as well. Trade credit refers to the credit extended by the supplier
of goods and services in the normal course of business transactions.

Minimising funds held in the form of cash balances

Trying to achieve the second objective is very difficult. A high level of cash balance will help the firm
to meet its first objective, but keeping excess reserves is also not desirable as funds in its original
form is idle cash and anon-earning asset. It is not profitable for firms to maintain huge balances.
A low level of cash balance may mean failure to meet the payment schedule. The aim of cash
management is therefore to have an optimal level of cash by bringing about a proper synchronization
of inflows and outflows, and to check the spells of cash deficits and cash surpluses.
Seasonal industries are classic examples of mismatches between inflows and outflows. The efficiency
of cash management can be augmented by controlling a few important factors:
Prompt billing and mailingThere is a time lag between the dispatch of goods and
preparation of invoice. Reduction of this gap will bring in early remittances.
Collection of cheques and remittances of cashGenerally, we find a delay in the receipt of
cheques and their deposits in banks. The delay can be reduced by speeding up the process of
collecting and depositing cash or other instruments from customers.
FloatThe concept of float helps firms to a certain extent in cash management. Float arises
because of the practice of banks not crediting the firms account in its books when a cheque
is deposited by it and not debiting the firms account in its books when a cheque is issued by
it, until the cheque is cleared and cash is realized or paid respectively.

Baumol model
The Baumol model helps in determining the minimum amount of cash that manager can obtain by
converting securities into cash. Baumol model is an approach to establish a firms optimum cash balance
under certainty. As such, firms attempt to minimise the sum of the cost of holding cash and the cost of
converting marketable securities to cash. Baumol model of cash
management trades off between opportunity cost or carrying cost or holding cost and the transaction cost.
The Baumol model is based on the following assumptions:
The firm is able to forecast its cash requirements in an accurate way.
The firms payouts are uniform over a period of time.
The opportunity cost of holding cash is known and does not change with time.

The firm will incur the same transaction cost for all conversions of securities into cash.