FINANCE MANAGEMENT 1 ANS B) FINANCIAL RISK is the possibility of whether a bond issuer will default, by failing to repay principal

and/or interest in a timely manner. The higher level of risk are attached to higher degrees of financial leverage. If EBIT(Earnings before interest and tax) decreases, financial risk

increases as the firm is not in a position to pay its interest obligations. Thus the risk of default is called Financial risk. The firm should overcome the situation accordingly or will be forced towards liquidation. There are three main sources of financial risk: 1. Financial risks arising from an organizations exposure to changes in market prices, such as interest / exchange rates, and commodity prices 2. Financial risks arising from the actions of, and transactions with, other organizations such as vendors, customers, and counterparties in derivatives transactions 3. Financial risks resulting from internal actions or failures of the organization, particularly people, processes, and systems ANS D) An operating lease is defined as a contract in which lessee is not committed to paying more than the original cost of the equ ipment during construal period. The operating lease is a lease in which the term is short when compared to the economic life of the equipment or assets (a ship, an airliner, etc.) being leased. The operating lease is generally utilized to acquire assets or equipments on comparatively shortterm basis. For instance, a ship that has 35 years of economic life could be leased to a shipping company for ten years on an operating lease. Operating lease is a lease contract which has a smaller period of time compared to the useful life of the asset being leased. In this contract, two parties are involved i.e. lessor and lessee. It is commonly used to acquire asset on short term basis. In this lease contract, lessor selects and purchases the asset and allows the lessee to use the asset but do not transfer the ownership in the asset. After the lease period is over the lessee returns the assets to the lessor. The lease rent paid by the lessee does not contain any part towards the cost of the asset. He only bears the cost of repairs, maintenance and insurance of the asset. Since the lessee does not assume the risk of ownership, the lease expense is treated as operating expense. The accounting for an operating lease is straightforward, since there is no transfer of ownership. The asset remains on the lessor's books and the lease is accounted for the same way rent is accounted for on the financial statements. When an asset is leased, the lessor sets up a lease revenue account to record and account for payments received from the lessee, while the lessee sets up a lease expense account to record and account for lease payments. Operating lease rentals are viewed as an annual expense of the business and should be charged to the income statement on a systematic basis (normally straight-line method) over the term of the lease. The accounting policies would normally state the policies. Rentals payable under the operating leases are posted on the income reports as incurred. The main advantages of operating lease are: No incidence of the rents on the balance sheet: they are operating expenses deductible from profits. Improvement of cash-flow Economy of corporate taxes ANS E) Financial leverage is defined in this study as the ratio of total debt (current liabilities+ long-term liabilities + other liabilities) to total book value of assets. The financial leverage measure for each firm is based on the book value of debt and assets. Financial leverage arises as a result of fixed financial charges related to the presence of bonds or preferred stock. Such charges do not vary with the firms earnings before interest and taxes. The effect of financial leverage is that an increase in the firms earnings before interest and taxes results in a greater than proportional increase in the firms earnings per share. A decrease in the firms earnings before interest and taxes results in a more than proportional decrease in the firms earnings per share. The degree of financial leverage (DFL) is measured by the following formula: DFL = Percentage change in earnings per share . Percentage change in earnings before Interest and taxes The degree of financial leverage indicates how large a change in earnings per share will result from a given percentage change in earnings before interest and taxes. Whenever the degree of financial leverage is greater than one, financial leverage exists. The higher this quotient the larger the degree of financial leverage. Since debt financing incurs fixed interest charges, the ratio of debt to equity is considered a measure of financial leverage. Conclusion Financial Leverage is the extent to which a firm uses debt, rather than equity, financing. In general, leverage has a beneficial impact on stockholders when EBIT is high and a detrimental impact when EBIT is low. This is due to the fixed interest cost associated with debt financing. When EBIT is low, the fixed obligation to creditors consumes a substantial portion of the firms earnings, so the return to stockholders is relatively low. However, at higher levels of EBIT, the return to creditors remains constant, while the stockholders derive a proportionately larger benefit from the increased earnings ANS F) A Letter of Credit is a payment term generally used for international sales transactions. It is basically a mechanism, which allows importers/buyers to offer secure terms of payment to exporters/sellers in which a bank (or more than one bank) gets involved. The technical term for Letter of credit is 'Documentary Credit'. At the very outset one must understand is that Letters of credit deal in documents, not goods. The idea in an international trade transaction is to shift the risk from the actual buyer to a bank. Thus a LC (as it is commonly referred to) is a payment undertaking given by a bank to the seller and is issued on behalf of the applicant i.e. the buyer. The Buyer is the Applicant and the Seller is the Beneficiary. The Bank that issues the LC is referred to as the Issuing Bank which is generally in the country of the Buyer. The Bank that Advises the LC to the Seller is called the Advising Bank which is generally in the country of the Seller.

2 The specified bank makes the payment upon the successful presentation of the required documents by the seller within the specified time frame. Note that the Bank scrutinizes the 'documents' and not the 'goods' for making payment. Thus the process works both in favor of both the buyer and the seller. The Seller gets assured that if documents are presented on time and in the way that they have been requested on the LC the payment will be made and Buyer on the other hand is assured that the bank will thoroughly examine these presented documents and ensure that they meet the terms and conditions stipulated in the LC.
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Letters of credit (LC) deal in documents, not goods. The LC could be 'irrevocable' or 'revocable'. An irrevocable LC cannot be changed unless both the buyer and seller agree. Whereas in a revocable LC changes to the LC can be made without the consent of the beneficia ry. A 'sight' LC means that payment is made immediately to the beneficiary/seller/exporter upon presentation of the correct documents in the required time frame. A 'time' or 'date' LC will specify when payment will be made at a future date and upon presentation of the required documents. ANS H) Takeover is the acquisition of a majority or controlling interest in a company, normally through the purchase of shares. A takeover may be friendly or hostile. In business, a takeover is the purchase of one company (the target) by another (the acquirer, or bidder). Depending on how many shares a potential acquirer buys in the market, a formal offer to other shareholders may be required under stock exchange regulations. If this potential acquirer (see raider) makes a hostile takeover bid, the takeover target (also called target company) could put into effect a variety of strategies aimed at fending off the attempt (see poison pill). In particular: A shareholder must make an offer when its shareholding, including that of parties acting in concert, reaches 30% of the target; Information relating to the bid must not be released except by announcements regulated by the Code; The bidder must make an announcement if rumour or speculation have affected a company's share price; The level of the offer must not be less than any price paid by the bidder in the three months before the announcement of a firm intention to make an offer; If shares are bought during the offer period at a price higher than the offer price, the offer must be increased to that price;

The Rules Governing the Substantial Acquisition of Shares, which used to accompany the Code and which regulated the announcement of certain levels of shareholdings, have now been abolished, though similar provisions still exist in the Companies Act 1985. Takeovers also tend to substitute debt for equity. In a sense, any government tax policy of allowing for deduction of interest expenses but not of dividends, has essentially provided a substantial subsidy to takeovers. It can punish more-conservative or prudent management that do not allow their companies to leverage themselves into a high-risk position. High leverage will lead to high profits if circumstances go well, but can lead to catastrophic failure if circumstances do not go favorably. This can create substantial negative externalities for governments, employees, suppliers and other stakeholders ANS I) In finance, the capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk. The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta () in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. A model that describes the relationship between risk and expected return; it is used to price securities. The general idea behind CAPM is that investors need to be compensated for investing their cash in two ways: (1) time value of money and (2) risk. (1) The time value of money is represented by the risk-free (rf) rate in the formula and compensates investors for placing money in any investment over period of time. (2) Risk calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf). The CAPM is a model for pricing an individual security or portfolio. For individual securities, we make use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio, thus:

The market reward-to-risk ratio is effectively the market risk premium and by rearranging the above equation and solving for E(Ri), we obtain the Capital Asset Pricing Model (CAPM). where: is the expected return on the capital asset is the risk-free rate of interest such as interest arising from government bonds (the beta) is the sensitivity of the expected excess asset returns to the expected excess market returns, or also , is the expected return of the market is sometimes known as the market premium (the difference between the expected market rate of return and the risk-free rate of return). is also known as the risk premium

3 ANS K) Dividend payout ratio is the fraction of net income a firm pays to its stockholders in dividends. The dividend payout ratio is the amount of dividends paid to stockholders relative to the amount of total net income of a company. The amount that is not paid out in dividends to stockholders is held by the company for growth. The amount that is kept by the company is called retained earnings.

The part of the earnings not paid to investors is left for investment to provide for future earnings growth. Investors seeking high current income and limited capital growth prefer companies with high Dividend payout ratio. However investors seeking capital growth may prefer lower payout ratio because capital gains are taxed at a lower rate. High growth firms in early life generally have low or zero payout ratios. As they mature,they tend to return more of the earnings back to investors. Note that dividend payout ratio is calculated as DPS/EPS. This formula is used by some when considering whether to invest in a profitable company that pays out dividends versus a profitable company that has high growth potential. In other words, this formula takes into consideration steady income versus reinvestment for possible future earnings, assuming the company has a net income. For example, if a company paid out $1 per share in annual dividends and had $3 in EPS, the DPR would be 33%. ($1 / $3 = 33%) According to Financial Accounting by Walter T. Harrison, the calculation for the payout ratio is as follows: Payout Ratio = (Dividends - Preferred Stock Dividends)/Net Income ANS L) CAPITAL RATIONING is restrictions put of the amount planned for new expenditures. A limitation on the amount of money a company is able to spend on capital projects. Capital rationing causes a company to choose among available investment projects, even when all the investments meet the firm's minimum return requirement. Capital rationing can be experienced due to external factors, mainly imperfections in capital markets which can be attributed to non-availability of market information, investor attitude etc. Internal capital rationing is due to the self-imposed restrictions imposed by management like not to raise additional debt or laying down a specified minimum rate of return on each project. There are various ways of resorting to capital rationing. For instance, a firm may effect capital rationing through budgets. It may also put up a ceiling when it has been financing investment proposals only by way of retained earnings (ploughing back of profits). Since the amount of capital expenditure in that situation cannot exceed the amount of retained earnings, it is said to be an example of capital rationing Capital rationing may also be introduced by following the concept of Responsibility Accounting, whereby management may introduce capital rationing by authorizing a particular department to make investment only upto a specified limit, beyond which the investment decisions are to be taken by higher-ups. The selection of project under capital rationing involves two steps: (i) To identify the projects which can be accepted by using the technique of evaluation discussed above. (ii) To select the combination of projects. In capital rationing it may also be more desirable to accept several small investment proposals than a few large investment proposals so that there may be full utilization of budgeting amount. This may result in accepting relatively less profitable investment proposals if full utilization of budget is a primary consideration. Similarly, capital rationing may also mean that the firm foregoes the next most profitable investment following after the budget ceiling even through it is estimated to yield a rate much higher than the required rate of return. Thus capital rationing does not always lead to optimum results.