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.
Q.2 a. Write the features of interim divined and also write the factors Influencing divined policy? b. What is reorder level ? (02Marks) 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. (10 Marks) (08 Marks)

Q.4 What are the techniques of evaluation of investment? (10 Marks) Q.5 What are the problems associated with inadequate working capital? (10 Marks)

Q.6 What is leverage? Compare and Contrast between operating Leverage and financial leverage

(10 Marks)

Q1) Write the short notes:1 Financial Management :Financial Management is the art and science of managing money. Regulatory and economic environments have undergone drastic changes due to liberalisation and globalisation of Indian economy. This has changed the profile of Indian finance managers. Indian financial managers have transformed themselves from licensed raj managers to well-informed dynamic proactive managers capable of taking decisions of complex nature. Traditionally, financial management was considered a branch of knowledge with focus on the procurement of funds. Instruments of financing, formation,merger and restructuring of firms and legal and institutional frame work occupied the prime place in this traditional approach. The modern approach transformed the field of study from the traditional narrow approach to the most analytical nature. The core of modern approach evolved around the procurement of the least cost funds and its effective utilisation for maximisation of share holders wealth. Financial Management is concerned with the procurement of the least cost funds and its effective utilisation for maximisation of the net wealth of the firm. There exists a close relation between the maximisation of net wealth of shareholders and the maximisation of the net wealth of the company. The broad areas of decision are capital budgeting, financing, dividend and working capital. Dividend decision demands the managerial attention to strike a balance between the investors expectation and the organisations growth. 2. financial planning A financial plan has to consider capital structure, capital expenditure and cash flow. Decisions on the composition of debt and equity must be taken. Financial planning or financial plan indicates: s

business, new business to be taken up and the dynamics of capital market conditions

Benefits of financial planning Financial planning also helps firms in the following ways.

process can effectively meet the bench-marks of investors expectations.

funds, planning helps the firms to obtain funds at the right time, in the right quantity and at the least cost as per the requirements of finance emerging opportunities. Surplus is deployed through well planned treasury management. Ultimately, the productivity of assets is enhanced.

of funds that constitute its capital structure in accordance with the changing conditions of the capital market.

and instituting procedures for elimination of wastages in the process of execution of strategic plans.

capital refers to the ratio of capital employed to the sales generated. Maintaining the operating capability of the firm through the evolution of scientific replacement schemes for plant and machinery and other fixed assets will help the firm in reducing its operating capital.Financial planning deals with the planning, execution and the monitoring of the procurement and utilisation of the funds. Financial planning process gives birth to financial plan. It could be thought of as a blue-print explaining the proposed strategy and its execution There are many financial planning models. All these models forecast the future operations and then translate them to income statements and balance sheets. It will also help the finance managers to ascertain the funds to be procured from the outside sources The essence of all these is to achieve a least cost capital structure which would match with the risk exposure of the company

Failure to follow the principle of financial planning may lead a new firm of over or under capitalisation, when the economic environment undergoes a change Ideally every firm should aim at optimum capitalisation or it might lead to a situation of over or under capitalisation. Both are detrimental to the interests of the society. There are two theories of capitalisation - cost theory and earnings theory.

3) Capital Structure The capital structure of a company refers to the mix of long-term finances used by the firm. In short, it is the financing plan of the company. With the objective of maximising the value of the equity shares, the choice should be that pattern of using of debt and equity in a proportion which will lead towards achievement of the firms objective. The capital structure should add value to the firm. Financing mix decisions are investment decisions and have no impact on the operating earnings of the firm. Such decisions influence the firms value through the earnings available to the shareholders. The value of a firm is dependent on its expected future earnings and the required rate of return. The objective of any company is to have an ideal mix of permanent sources of funds in a manner that it will maximise the companys market price. The proper mix of funds is referred to as optimal capital structure. The capital structure decisions include debt-equity mix and dividend decisions. Both these have an effect on the EPS. As we are aware, equity and debt are the two important sources of long-term sources of finance of a firm. The proportion of debt and equity in a firms capital structure has to be independently decided case to case. A proposal, though not being favourable to lenders, may be taken up if they are convinced with the earning potential and long-term benefits. Many theories have been propounded to understand the relationship between financial leverage and firm value. Assumptions The following are some common assumptions made: debt and ordinary shares. both corporate and personal

-out ratio is 100%, that is, the firm pays off the entire earnings to its equity holders and retained earnings are zero

invest any further in its assets

tors shall have identical subjective probability distribution of the future expected EBIT

transaction costs

4) Cost of Capital Cost of capital is the minimum required rate of return needed to justify the use of capital. A company obtains resources from various sources issue of debentures, availing term loans from banks and financial institutions, issue of preference and equity shares or it may even withhold a portion or complete profits earned to be utilised for further activities. Retained earnings are the only internal source to fund the companys future plans. Weighted Average Cost of Capital is the overall cost of all sources of finance. The debentures carry a fixed rate of interest. Interest qualifies for tax deduction in determining tax liability. Therefore the effective cost of debt is less than the actual interest payment made by the firm. It is always advisable for companies to plan their capital structure. Decisions taken by not assessing things in a correct manner may jeopardise the very existence of the company. Firms may prosper in the short-run by not indulging in proper planning but ultimately may face problems in future. With unplanned capital structure, they may also fail to economise the use of their funds and adapt to the changing conditions. With the above points on ideal capital structure, raising funds at the appropriate time to finance firms investment activities is an important activity of the Finance Manager. Golden opportunities may be lost for delaying decisions to this effect.

A combination of debt and equity is used to fund the activities. What should be the proportion of debt and equity? This depends on the costs associated with raising various sources of funds. The cost of capital is the minimum rate of return of a company, which must earn to meet the expenses of the various categories of investors who have made investment in the form of loans, debentures and equity and preference shares. A company now being able to meet these demands may face the risk of investors taking back their investments thus leading to bankruptcy. Loans and debentures come with a pre-determined interest rate. Preference shares also have a fixed rate of dividend while equity holders expect a minimum return of dividend, based on their risk perception and the companys past performance in terms of pay-out dividends.

5) Trading on Equity Financial leverage as opposed to operating leverage relates to the financing activities of a firm and measures the effect of earnings before interest and tax (EBIT) on earnings per share (EPS) of the company. A companys sources of funds fall under two categories

shares and

Debentures and bonds carry a fixed rate of interest and have to be paid off irrespective of the firms revenues. Though dividends are not contractual obligations, dividend on preference shares is a fixed charge and should be paid off before equity shareholders are paid any. The equity holders are entitled to only the residual income of the firm after all prior obligations are met. 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 earnings before income and tax (EBIT). Sikkim Manipal University Page No. 114 It is the firms ability to use fixed financial charges to increase the effects of changes in EBIT on the EPS. It is the use of funds obtained at fixed costs which increase the returns on shareholders. A company earning more by the use of assets funded by fixed sources is said to be having a favourable or positive leverage. Unfavourable leverage occurs when the firm is not earning sufficiently to cover the cost of funds. Financial leverage is also referred to as Trading on Equity.

Q2) B. What is reorder level ?

Ans:Ordering level is that level at which action for replenishment of inventory is initiated. OL = MRC X MLT Where, MRC = Maximum rate of consumption MLT = Maximum lead time Managerial significance of fixation of Inventory level Inventory level ensures the smooth productions of the finished goods by making available the raw material of right quality in right quantity at the right time.

can avoid both overstocking and shortage of each and every essential and vital item of inventory.

moving items of inventory. This brings about better co-ordination between materials management and production management on one hand and between stores manager and marketing manager on the other. Re-order Point When to order is another aspect of inventory management. This is answered by reorder point. The re-order point is that inventory level at which an order should be placed to replenish the inventory. To arrive at the re-order point under certainty, the two key required details are:

Average usage Lead time refers to the average time required to replenish the inventory after placing orders for inventory. Under certainty, re-order point refers to that inventory level which will meet the consumption needs during the lead time.

Safety Stock Since it is difficult to predict in advance usage and lead time accurately, provision is made for handling the uncertainty in consumption due to changes in usage rate and lead time. The firm maintains a safety stock to manage the stock out arising out of this uncertainty. When safety stock is maintained, (When variation is only in usage rate)

Q4) What are the techniques of evaluation of investment?

Ans :Steps involved in the evaluation of any investment proposal are:

project life cycle Examination of the risk profile of the project to be taken up and arriving at the required rate of return

Estimation of cash flows Estimating the cash flows associated with the project under consideration is the most difficult and crucial step in the evaluation of an investment proposal. Estimation is the result of the team work of many professionals in an organisation.

aspects of production process

revenue during the period of accrual of benefits from project executions

ws and cash out flow statement is prepared by the cost accountant on the basis of the details generated in the above steps The ability of the firm to forecast the cash flows with reasonable accuracy lies at the root of the success of the implementation of any capital expenditure decision. Estimation of incremental cash flows Investment (capital budgeting) decision requires the estimation of incremental cash flow stream over the life of the investment. Incremental cash flows are estimated on tax basis. Incremental cash flows stream of a capital expenditure decision has three components.

Initial cash outlay (Initial investment) Initial cash outlay to be incurred is determined after considering any post tax cash inflows. In replacement decisions existing old machinery is disposed of and a new machinery incorporating the latest technology is installed in its place. On disposal of existing old machinery the firm has a cash inflow. This cash inflow has to be computed on post tax basis. The net cash out flow (total cash required for investment in capital assets minus post tax cashinflow on disposal of the old machinery being replaced by a new one) therefore is the incremental cash outflow. Additional net working capital required on implementation of new project is to be added to initial investment. Operating cash inflows Operating cash inflows are estimated for the entire economic life of investment (project). Operating cash inflows constitute a stream of inflows and outflows over the life of the project. Here also incremental inflows and outflows attributable to operating activities are considered. Any savings in cost on installation of a new machinery in the place of the old machinery will have to be accounted on post tax basis. In this connection incremental cash flows refer to the change in cash flows on implementation of a new proposal over the existing positions. Terminal cash inflows At the end of the economic life of the project, the operating assets installed will be disposed off. It is normally known as salvage value of equipments. This terminal cash inflows are computed on post tax basis. Prof. Prasanna Chandra in his book Financial Management (Tata McGraw Hill, published in 2007) has identified certain basic principles of cash flow estimation. The knowledge of these principles will help a student in understanding the basics of computing incremental cash flows. Separation principle The essence of this principle is the necessity to treat investment element of the project separately (i.e. independently) from that of financing element. The financing cost is computed by the cost of capital. Cost of capital is the cut off rate and rate of return expected on implementation of the project. Therefore, we compute separately cost of funds for execution of project through the financing mode.

The rate of return expected on implementation if the project is arrived at by the investment profile of the projects. Therefore, interest on debt is ignored while arriving at operating cash inflows. Incremental principle Incremental principle says that the cash flows of a project are to be considered in incremental terms. Incremental cash flows are the changes in the firms total cash flows arising directly from the implementation of the project. Keep the following in mind while determining incremental cash flows. Ignore sunk costs Sunk costs are costs that cannot be recovered once they have been incurred. Therefore, sunk costs are ignored when the decisions on project under consideration is to be taken. Opportunity costs If the firm already owns an asset or a resource which could be used in the execution of the project under consideration, the asset or resource has an opportunity cost. The opportunity cost of such resources will have to be taken into account in the evaluation of the project for acceptance or rejection. Need to take into account all incident effect Effects of a project on the working of other parts of a firm also known as externalities must be taken into account. Cannibalisation Another problem that a firm faces on introduction of a new product is the reduction in the sale of an existing product. This is called cannibalisation. The most challenging task is the handling the problems of cannibalisation. Depending on the companys position with that of the competitors in the market, appropriate strategy has to be followed. Correspondingly the cost of cannibalisation will have to be treated either as relevant cost of the decision or ignored. Post tax principle All cash flows should be computed on post tax basis

Consistency principle Cash flows and discount rates used in project evaluation need to be consistent with the investor group and inflation.

Q.5) What are the problems associated with inadequate working capital?

Q.6) What is leverage? Compare and Contrast between operating. Leverage and financial leverage.
Ans:A company uses different sources of financing to fund its activities. These sources can be classified as those which carry a fixed rate of return and those whose returns vary. The fixed sources of finance have a bearing on the return on shareholders. Borrowing funds as loans have an impact on the return on shareholders and this is greatly affected by the magnitude of borrowing in the capital structure of a firm. Leverage is the influence of power to achieve something. The use of an asset or source of funds for which the company has to pay a fixed cost or fixed return is termed as leverage. Leverage is the influence of an independent financial variable on a dependent variable. It studies how the dependent variable responds to a particular change in independent variable. There are three types of leverage as shown in the following diagram 6.1 operating, financial and combined. Operating Leverage Operating leverage arises due to the presence of fixed operating expenses in the firms income flows. A companys operating costs can be categorised into three main sections as shown fixed costs, variable costs and semi-variable costs Fixed costs Fixed costs are those which do not vary with an increase in production or sales activities for a particular period of time. These are incurred irrespective of the income and value of sales and generally cannot be reduced. For example, consider that a firm named XYZ enterprises is planning to start a new business. The main aspects that the firm should concentrate at are salaries to the employees, rents, insurance of the firm and the accountancy costs. All these aspects relate to or are referred to as fixed costs.

Variable costs Variable costs are those which vary in direct proportion to output and sales. An increase or decrease in production or sales activities will have a direct effect on such types of costs incurred. For example, we have discussed about fixed costs in the above context. Now, the firm has to concentrate on some other features like cost of labour, amount of raw material and the administrative expenses. All these features relate to or are referred to as Variable costs, as these costs are not fixed and keep changing depending upon the conditions. Semi-variable costs Semi-variable costs are those which are partly fixed and partly variable in nature. These costs are typically of fixed nature up to a certain level beyond which they vary with the firms activities. For example, after considering both the fixed costs and the variable costs, the firm should concentrate on some-other features like production cost and the wages paid to the workers which act at some point of time as fixed costs and can also shift to variable costs. These features relate to or are referred to as Semi-variable costs. The operating leverage is the firms ability to use fixed operating costs to increase the effects of changes in sales on its earnings before interest and taxes (EBIT). Operating leverage occurs any time a firm has fixed costs. The percentage change in profits with a change in volume of sales is more than the percentage change in volume. The illustration clearly tells us that when a firm has fixed operating expenses, an increase in sales results in a more proportionate increase in earnings before interest and taxes (EBIT) and vice versa. The former is a favourable operating leverage and the latter is unfavourable. Financial Leverage Financial leverage as opposed to operating leverage relates to the financing activities of a firm and measures the effect of earnings before interest and tax (EBIT) on earnings per share (EPS) of the company. A companys sources of funds fall under two categories shares and

carry a fixed rate of interest and have to be paid off irrespective of the firms revenues. Though dividends are not contractual obligations, dividend on preference shares is a fixed charge and should be paid off before equity shareholders are paid any. The equity holders are entitled to only the residual income of the firm after all prior obligations are met. 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 earnings before income and tax (EBIT). It is the firms ability to use fixed financial charges to increase the effects of changes in EBIT on the EPS. It is the use of funds obtained at fixed costs which increase the returns on shareholders. A company earning more by the use of assets funded by fixed sources is said to be having a favourable or positive leverage. Unfavourable leverage occurs when the firm is not earning sufficiently to cover the cost of funds. Financial leverage is also referred to as Trading on Equity. This example shows that the presence of fixed interest source funds leads to a value more than that occurs due to proportional change in EPS. The presence of such fixed sources implies the presence of financial leverage. This can be expressed in a different way. The degree of financial leverage (DFL) is a more precise measurement. It examines the effect of the fixed sources of funds on EPS. Use of Financial Leverage Studying the degree of financial leverage (DFL) at various levels makes financial decision-making, on the use of fixed sources of funds, for funding activities easy. One can assess the impact of change in earnings before interest and tax (EBIT) on earnings per share (EPS).

Like operating leverage, the risks are high at high degrees of financial leverage (DFL). High financial costs are associated with high DFL. An increase in financial costs implies higher level of EBIT to meet the necessary financial commitments. A firm which is not capable of honouring its financial commitments may be forced to go into liquidation by the lenders of funds. The existence of the firm is shaky under these circumstances. On one side the trading on equity improves considerably by the use of borrowed funds and on the other hand, the firm has to constantly work towards higher EBIT to stay alive in the business. All these factors should be considered while formulating the firms mix of sources of funds. One main goal of financial planning is to devise a capital structure in order to provide a high return to equity holders. But at the same time, this should not be done with heavy debt financing which drives the company on to the brink of winding up. Impact of financial leverage Highly leveraged firms are considered very risky and lenders and creditors may refuse to lend them further to fuel their expansion activities. On being forced to continue lending, they may do so with their own conditions like earning a minimum of X% EBIT or stipulating higher interest rates than the market rates or no further mortgage of securities. Financial leverage is considered to be favourable till such time that the rate of return exceeds the rate of return obtained when no debt is used.