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SAVIOUR PUBLICATIONS

FINANCIAL MANAGEMENT 2012 Attempt any five questions, Q1. Is compulsory. Q1. (a) Evaluate wealth maximisation objective of financial management (b) hat is an annuity! hat is the "ifference between an or"inary annuity # annuity "ue! (c) $ow is the cost of preference share calculate"! (d) hat "o you un"erstan" by resi"ual "ivi"en" policy! (e) hy "o you thin% excess of cash hol"ing is not goo"! 1(a) &inancial 'anagement is an art an" science of managing fun"s. It is an effective an" efficient means of managing money in or"er to achieve the objectives of an organi(ation. )reviously, the scope of &inancial 'anagement was limite" to raising capital, but now it "oes not only "eal with raising the capi tal, rather the allocation an" efficient use of the fun"s is also within the scope of financial management. Financial Management has 2 b!ecti"es#$ 1. ealth maximisation *. )rofit maximisation 1. %ealth ma&imi'ati n refers to the sharehol"er+s wealth, which is shown in the mar%et value of the shares. ,he mar%et price of the share is a present value of all the future cash flows in terms of "ivi"en"s an" other benefits. It is base" on the principles of financial management. It is a -ong.run concept as compare" to profit maximisation. In this objective, the value of the shares of an organi(ation is given importance. It is base" on the concept of cash flows, earnings per share of sharehol"ers rather than profit. It consi"ers both the quantity an" the quality "imensions of ,ime value of money concept. It means that value of a unit of

money is "ifferent in "ifferent time perio"s. ,he value of a sum receive" to"ay is more than the value of the same sum receive" after. In other wor"s, value of a rupee in han" to"ay is worth more than a rupee to be receive" in future. ,he objective of wealth maximisation is compatible with the objective of sharehol"ers as the "ecisions are ta%en in such a way as to have the highest combination of "ivi"en"s an" increase" value of shares of an organi(ation. ,he ris% involve" in ta%ing "ecisions is consi"ere" by wealth maximisation objective. /bviously the profits are an important part for both the organi(ation an" sharehol"ers, but wealth maximisation stresses on high earnings as well as increase" wealth. ealth maximisation is a long.run perspective. ,he objectives of wealth maximisation is clear an" complete, there exists no ambiguity as in case of profit maximisation. 0)rofit can be after or before tax, after or before interest etc.1 2. () *it ma&imisati n$ is more concerne" with the optimum utilisation fun"s. It is rather a short.term perspective wherein emphasis is more on receiving quic% returns than to maximise its wealth. 2riticism3. 1. It ignores the time value of money. *. 4nclear as because profit can refer to after or before tax. 5. 6oes not inclu"e the finance aspect an" concentrates on more on profitability. 7. Ignores ris%. 8. ,he interest of the sharehol"er+s is not compatible with profit maximisation. ealth 'aximisation is superior to profit maximi(ation. It ta%es into consi"eration time value of money, cash flow ris% an" return an" consi"ers only incremental cash flows of the organi(ation. ,heir main objective is to create an" manage wealth of the sharehol"ers to maximi(e it while organi(ing it. ealth can be maximi(e" by analy(ing the features of ris% an" fin"ing out the amount of return.

%ealth 1. 9ot only the profits, but earning per share is given importance. *. 2onsi"ers the time value of money concept 5. 2ash &low analysis is ta%en into consi"eration. 7. :is%s are also analyse" an" consi"ere". 8. 6ecisions are ta%en on quantitative an" qualitative basis. ;. -ong.run concept =. 4niversally accepte" as the sharehol"er+s get the maximum utility from their investment.

() *it )erformance is earning profits.

ju"ges

by

6oes not consi"er the time value of money concept. 2ash flow analysis is not ta%en into consi"eration. :is%s are not ta%en into consi"eration. 6ecisions are ta%en on quantitative basis. <hort.run concept. -ess compatible with the interest of the sharehol"er.

1.(b) An annuity is a series of equal payments ma"e at fixe" intervals for a specifie" time perio". E.g. :s. 1>>> is to be pai" for next 8 years. ,his is a five.year annuity. )ayments can either occur at the en" of each perio" or at the beginning. If payments occur at the en" of each perio" it is %nown as an or"inary?"eferre" annuity. E.g. )ayments on mortgages, stu"ent loans are usually on or"inary annuity. In case of annuity "ue, payments are ma"e at the beginning of each perio". E.g. :ents pai" for apartments, life insurance premiums etc. +)dina), ann-it,. equal payments ma"e at fixe" intervals at the en" of each perio". E.g. If :s.1>>> is "eposite" at the en" of each year for 8 years in return for 8@ p.a. ,he amount receive" after five years is %nown as the future value of annuity. ,o calculate the future value of the total amount "eposite" the formula is AB, where ACequal payments, iCinterest, nCtotal no. of perio"s. ,he future value of the above example woul" be 1>>>B C88*8.;5.

&or calculating the present value of or"inary annuity formula woul" be AB. Ann-it, d-e. payment "one at the beginning of each perio" is %nown as annuity "ue. -i%e in case of or"inary annuity, the last payment is not compoun"e" because when the last payment is "one, it is time to get the return bac%. Dut as in case of annuity "ue, payment "one at the beginning of each perio" allows the last annuity to be compoun"e". &or the above example the return on :s.1>>> for 8 years at 8@ p.a. woul" be more incase of annuity "ue than in or"inary annuity. ,he future value for annuity can be calculate" by this formula AB. ,he answer woul" be :s.8E>1.F1. ,he present value of annuity "ue can be calculate" by ABB01Gi1. +)dina), Ann-it, Ann-it, .-e 1. ,he payment is at the en" of )ayment is "one at the each perio". beginning of each perio". *. ,he last annuity is not ,he last annuity is also compoun"e" when calculating compoun"e" while calculating the future value. the future value. 5. &irst annuity is "iscounte" &irst annuity is not "iscounte" while calculating the present while calculating the present value. value. 1. (c) )reference shares have a fixe" rate of "ivi"en". ,hey are calle" hybri" securities because it has similarities of both equity shares an" "ebentures. /imila)it, t e0-it, sha)es#$ 6ivi"en" is pai" at a fixe" rate. ,ax is not "e"uctable for paying "ivi"en". )reference shares can or cannot have a maturity perio". /imila)it, t debent-)es#$ 6ivi"en" rate is fixe". 2laim on assets an" return before equity share hol"ers. 9o voting right. )reference sharehol"ers

Meth d * calc-lating C st * ()e*e)ence sha)e#$ )referre" shares have the qualities of a stoc% an" a bon", which ma%es valuation a little "ifferent than a common share. ,he owner of the preferre" share is part owner of the company, just li%e an equity sharehol"er. Also, there is a fixe" payment which is similar to a "ebentures issue" by the company. ,he fixe" payment is in the form of a "ivi"en" an" is the basis of the valuation metho" for a preferre" share. ,hese payments can come monthly, quarterly or yearly, "epen"ing upon the policy of the company. Also, there is no tax a"justment while calculating the cost of preference share. e shall calculate only the cost of the irre"eemable preference share. C st * 1)e*e)ence sha)e ca1ital is the ann-al 1)e*e)ence sha)e di"idend di"ided b, the net iss-ing 1)ice * 1)e*e)ence sha)es (net iss-ing 1)ice 2 iss-ing 1)ice 3*l tati n c st). ,he formula is 6p?)n, where 6pC6ivi"en" the company pays, )nC selling price of one preference share.flotation cost. E.g. A company pays :s.1>> as "ivi"en" per share on a preferre" stoc%, an" the selling price of one share is :s.1>>>. 9ow, the floatation cost incurre" is 1@ or :s.1>01@ of 1>>>1. <o, 6pC 1>>, )nC1>>>.1>CFF>. ,herefore the cost woul" be 1>>?FF>C1>.1@. 1.(d1 :esi"ual "ivi"en" policy. A "ivi"en" policy is the "ecision to pay out earnings versus retaining them. A resi"ual "ivi"en" policy is use" for internal fun"ing of projects from business owne" capital. /ne of the assumptions of this theory is that external financing to re.invest is either not available, or that it is too costly to invest in any profitable opportunity. 6ivi"en" payments are "one from equity thatHs left over after the project has been finance" are then pai" out. 2ompanies using the resi"ual "ivi"en" policy will only pay "ivi"en"s after all the other nee"s of the project is fulfille". ,herefore, the pay out of "ivi"en"s "epen"s on whether any profits are left after the

financing of propose" investments. ,his equity which is left over is %nown as resi"ual equity. ,ypically, resi"ual metho" of "ivi"en" payment creates a sense of uncertainty amongst the investors. 2ompanies that use the resi"ual "ivi"en" policy first use the cash flow to fulfill necessary capital expen"itures an" the remaining amount available 0the resi"ual1 is pai" out to sharehol"ers. ,he firm has to "eci"e how much profits to be retaine" an" the rest can then be "istribute" as "ivi"en"s. Also, if the company+s capital structure is a mixture of "ebt an" equity, then the full amount of the capital expen"iture will not be pai" entirely by equity but also with part "ebt. :esi"ual policy minimi(es new stoc% issues an" flotation costs. A profitable firm usually retain the fun"s an" "oes not "istribute its profit as "ivi"en"s, as it helps in maximi(ing wealth, but it results in variable "ivi"en"s, sen"s conflicting signals, an" increases uncertainty. ,he ratio of retaining profit an" "istribution "epen"s on resi"ual "ivi"en" policy. C ncl-si n#$ ,he firm paying out "ivi"en"s is obviously generating incomes for an investor, however even if the firm ta%es some investment opportunity then the incomes of the investors rise at a later stage "ue to this profitable investment. (e) 2ash for any business is a boon. It helps re"ucing a number of problems such as obtaining loan easily, %eeping the sharehol"ers satisfie", ensuring liqui"ity at any time, low ris% of insolvency etc. Dut there are a number of reasons why excessive cash hol"ing can be ba" for any business. $ol"ing cash has an opportunity cost of * )eg ing the )et-)n 4hich c -ld ha"e been ea)ned i* the cash 4as in"ested . &or e.g. if an organi(ation hol"s :s. E>-acs at the en" of a financial year which is not at all use". ,his :s.E>-acs coul" have fetche" interest if it was investe" in a ban%. ,he interest amount woul"

not have been less the :s.E-acs 0if the rate of interest is 1>@ p.a.1 . ,his amount is foregone for %eeping excessive cash in the organi(ation. Another problem cause" by hol"ing extra cash can be the c st * ca1ital or the interest amount pai". If an organi(ation has ta%en a loan to form its capital an" the capital so forme" is more than require", then there woul" be excess cash again. /bviously, the organi(ation woul" have to pay interest for the loan ta%en. &or the extra amount of cash, interest has to be pai". ,he interest pai" for the extra cash is a waste. E.g. If an organi(ation ta%es a loan of :s.8>-acs an" has its own capital of 8>-acs, the total capital equals to :s.1crore. At the en" of the financial year it is %nown that :s.5>lacs was unuse". ,he organi(ation "i" not only forego the opportunity cost of earning interest, rather pai" interest for the loan ta%en. $a" the organi(ation ta%en a loan of :s.5>lacs less, the interest save" woul" have been equal to :s.5lacs approximately0ta%ing 1>@ as the interest rate1. At times, extra cash is thought as increase" flexibility for the managers to wor% well. ,his can have a major impact on the organi(ations. ,he managers can "o 4aste*-l ac0-isiti ns an" invest on ba" projects in or"er to maintain their prestige. ,his can be harmful for the organi(ations. In*lati n is another reason for not having excess cash. 6ue to extra cash the organi(ations either invest it in small term investments or %eep it i"le. Inflation lea"s to a rise in the price level. 9ow the cash investe" in short term bon"s "o not give returns equal to the rise in price level. ,his lea"s to a loss of spen"ing power of the organi(ation. ,he value of money "ecreases. 2ash creates problems because hol"ing excessive cash is often just as ba" as hol"ing excessive "ebt. Q2) IJ -t". is consi"ering two "ifferent investment proposals. ,he "etails are as un"er3 Investment estimate" )roposals I )roposals II /utflow :s.F,8>> :s.*>,>>>

Jear 1 7>>> E>>> Jear * 7>>> E>>> Jear 5 78>> 1*>>> <uggest the most attractive proposals on the basis of the 9)K metho" consi"ering that "iscounting rate is 1*@. Also fin" out the I:: proposals. 0181 Ans.2. () 1 sal I Jear Inflow 1 7>>> * 7>>> 5 78>> 1*@ L"isc >.EF* >.=F= >.=11 )KI& 58;E 51EE 51FF.8 T tal25566.6

N(7C)resent Kalue of In &low.Estimate" outflow CFF88.8 . F8>> C866.6. () 1 sal II Jear 1 * 5 Inflow E>>> E>>> 1*>>> 1*@ L"isc >.EF* >.=F= >.=11 )KI& =15; ;5=; E85* T tal222088

N(7C )resent Kalue of In &low.Estimate" outflow C**>77 .*>,>>> C2088 Q9) ,he following financial "ata have been furnishe" by A -t". # D -t". for the year en"e" 51.>5.*>1*3 (a)tic-la)s A Ltd. : Ltd. /perating -everage 531 731 &inancial -everage *31 531 Interest charges 1* -acs 1> -acs ).A. 2orporate tax rates 7>@ 7>@ Kariable cost as @ ;>@ 8>@ of sales

)repare income statement of the two companies. Also comment on the financial position an" structure of the two companies. 0181 Ans.9. C m1an, A3. ED,. Earning Defore ,ax, EDI,. Earning Defore Interest an" ,ax. Financial Le"e)age(FL1C EDI,?ED,C*?1 or *0ED,1CEDI,........011 EDI,.InterestCED,. EDI,.1*,>>,>>>CED,............ 0*1 ,a%ing 011 an" 0*1 we get3. *0ED,1.1*,>>,>>>CED, or ED,C1*,>>,>>>EDI,C*7,>>,>>>. +1e)ating Le"e)age(+L)C 2ontribution?EDI,C5?1 2ontributionC5BEDI,C5B*7,>>,>>>C=*,>>,>>>. 9ow Kariable 2ostC ;>@ of sales, therefore contributionC01>>. ;>1C7>@ of sales. $ence, sales C=*, >>,>>>B1>>?7>C1,E>,>>,>>>. C mbined Le"e)age2 FL;+L2(9<1);(2<1)2=. C m1an, :#$ Financial Le"e)age(FL1C EDI,?ED,C5?1 or 50ED,1CEDI,........051 EDI,.InterestCED,. EDI,.1>,>>,>>>CED,............ 071 ,a%ing 051 an" 071 we get3. 50ED,1.1>,>>,>>>CED, *0ED,1C1>,>>,>>> ED,C8,>>,>>>. EDI,C5B8,>>,>>>18,>>,>>>. +1e)ating Le"e)age(+L)C 2ontribution?EDI,C7?1 2ontributionC7BEDI,C7B18,>>,>>>C;>,>>,>>>. N 4 7a)iable C stC 8>@ of sales, therefore contributionC01>>. 8>1C8>@ of sales. >ence? sales C;>,>>,>>>B1>>?8>C1,*>,>>,>>> INC+ME /TATEMENT#$ (a)tic-la)s A LT.. : LT..

<ales 1,E>,>>,>>> -ess3 variable cost 01,>E,>>,>>>1 2ontribution =*,>>,>>> -ess3 &ixe" costB 07E,>>,>>>1 EDI, *7,>>,>>> interest 01*,>>,>>>1 ED, 1*,>>,>>> taxL7>@ 07,E>,>>>1 () *it a*te) ta& @?20?000 B&ixe" costC2ontribution.EDI,.

1,*>,>>,>>> 0;>,>>,>>>1 ;>,>>,>>> 078,>>,>>>1 18,>>,>>> 01>,>>,>>>1 8,>>,>>> 0*,>>,>>>1 9?00?000

Q8) Explain the 'o"igliani an" 'iller+s hypothesis of "ivi"en" irrelevance. 6oes this hypothesis suffer form any "eficiencies! (16) Ans.8. ,he 'o"igliani an" 'iller school of thought believes that investors "o not state any preference between current "ivi"en"s an" capital gains. ,hey say that "ivi"en" policy is irrelevant an" is not "eterministic of the mar%et value. ,herefore, the sharehol"ers are in"ifferent between the two types of "ivi"en"s. All they want are high returns either in the form of "ivi"en"s or in the form of re.investment of retaine" earnings by the firm. ,here are two con"itions "iscusse" in relation to this approach 3 1. "ecisions regar"ing financing an" investments are ma"e an" "o not change with respect to the amounts of "ivi"en"s receive". *. when an investor buys an" sells shares without facing any transaction costs an" firms issue shares without facing any floatation cost, it is terme" as a perfect capital mar%et. ,he 'o"iglianiM'iller theorem states that the "ivision of retaine" earnings between new investment an" "ivi"en"s "o not influence the value of the firm. It is the investment pattern an" consequently the earnings of the firm which affect the share price or the value of the firm. The MM a11) ach has taAen int c nside)ati n the * ll 4ing ass-m1ti ns#

1. ,here is a rational behavior by the investors an" there exists perfect capital mar%ets. *. Investors have free information available for them. 5. 9o time lag an" transaction costs exist. 7. <ecurities can be split into any parts i.e. they are "ivisible 8. 9o taxes an" floatation costs. ;. ,he investment "ecisions are ta%en firmly an" the profits are therefore %nown with certainty. ,he "ivi"en" policy "oes not affect these "ecisions. .esc)i1ti n ,he "ivi"en" irrelevancy in this mo"el exists because sharehol"ers are in"ifferent between paying out "ivi"en"s an" investing retaine" earnings in new opportunities. ,he firm finances opportunities either through retaine" earnings or by issuing new shares to raise capital. ,he amount use" up in paying out "ivi"en"s is replace" by the new capital raise" through issuing shares. ,his will affect the value of the firm in an opposite way. ,he increase in the value because of the "ivi"en"s will be offset by the "ecrease in the value for new capital raising. C ncl-si ns#$ 1. 6ivi"en" policy is a tra"e.off between higher or lower "ivi"en"s, issuing or repurchasing or"inary shares to replace cash pai" out. *. )ay "ivi"en" or issue new shares to replace cash3 . 6oes not change the value of the companyN an" .6oes not change the wealth of the ol" sharehol"ers because the value of their shares falls by an amount equal to the cash pai" to them. 5. If a company increases its "ivi"en"s, it must replace the cash by ma%ing a share issue.

7. /l" sharehol"ers receive a higher current "ivi"en", but a proportion of future "ivi"en"s must be "iverte" to the new sharehol"ers ,he present value of these forgone future payments is equal to the increase in current "ivi"en"s. 8. ,he '' "ivi"en" irrelevance proposition is vali" in a perfect capital mar%et with no taxes. ;. ,herefore, if the "ivi"en" policy is important in practice, the reasons for its importance must relate to factors that '' exclu"e" from their analysis. =. -arge bo"y of research has examine" whether the policies that companies a"opt can be explaine" by an imperfect mar%et. :ecent stu"ies by .e Angel B .e Angel 0*>>;1 0661 argue" that concept of full payout is a more logical starting point for "iscussion of payout policy O full present value of company+s free cash flow shoul" be pai" out to sharehol"ers. $ence, '' irrelevance theorem is itself irrelevant but not wrong analysis .e*iciencies#$ ,here are some critics who argue that the assumptions ma"e by '' "ivi"en"s are irrelevant. Accor"ing to them "ivi"en"s matter because of the uncertainty characterising the future, the imperfections in the capital mar%et, an" the existence of taxes. 1. In* )mati n Ab -t () s1ects 3In a worl" of uncertainty the "ivi"en"s pai" by the company, base" as they are on the ju"gment of the management about future, convey information about the prospects of the company. A higher "ivi"en" payout ratio may suggest that the future of the company, as ju"ge" by management, is promising. A lower "ivi"en" payout ratio may suggest that the future of the company as consi"ere" by management is uncertain. Por"on has eloquently expresse" this view. An allie" argument is that "ivi"en"s re"uce uncertainty perceive" by investors. $ence investors prefer "ivi"en"s to

capital gains. <o shares with higher current "ivi"en"s, other things being equal, comman" a high in the mar%et. 2. Cnce)taint, and Fl-ct-ati ns3 6ue to uncertainty, share prices ten" to fluctuate, sometimes rather wi"ely. hen share prices fluctuate, con"itions for conversion of current income into capital value an" vice versa may not be regar"e" as satisfactory by investors. <ome investors who wish to enjoy more current income may be reluctant to sell a portion of their sharehol"ing in a fluctuating mar%et. <uch investors woul" naturally prefer, an" value more, a higher payout ratio. <ome investors who wish to get less current income may be hesitant to buy shares in a fluctuating mar%et. <uch investors woul" prefer, an" value a lower payout ratio. 9. +**e)ing * Additi nal E0-it, at L 4e) ()ices 3 '' assume that a firm can sell a""itional equity at the current mar%et price. In practice, firms following the a"vice an" suggestions of merchant ban%ers offer a""itional equity at a price lower than the current mar%et price. ,his practice of Hun"erpricingH mostly "ue to mar%et compulsions, ceteris paribus, ma%es a rupee of retaine" earnings more valuable than a rupee of "ivi"en"s. 8. Iss-e c st3 ,he '' irrelevance proposition is base" on the premise that a rupee of "ivi"en"s be replace" by a rupee of external financing. ,his is possible when there is no issue cost. In the real worl" where issue cost is incurre", the amount of external financing has to be greater than the amount of "ivi"en" pai". 6ue to this, other things being equal, it a"vantageous to retain earnings rather than pays "ivi"en"s an" resort to external finance. 6. T)ansacti n C sts3 In the absence of transaction costs, current income 0"ivi"en"s1 an" 2apital gains are ali%e.a rupee of capital value can be converte" into a rupee of current income an" vice versa. In such a situation if a sharehol"er "esires

current income 0from shares1 greater than the "ivi"en"s receive", he can sell a portion of his capital equal in value to the a""itional current income sought. -i%ewise, if he wishes to enjoy current income less than the "ivi"en"s pai", he can buy a""itional shares equal in value to the "ifference between "ivi"en"s receive" an" the current income "esire". In the real worl", however, transaction costs are incurre". 6ue to this, capital value cannot be converte" into an equal current income an" vice versa. =. .i**e)ential Dates * Ta&es3 '' have assume" that the investors are in"ifferent between a rupee of "ivi"en"s an" a rupee of capital appreciation. ,his assumption is true when the taxation is the same for current income an" capital gains. In the real worl", the effective tax on capital gains is lower than that for current income. 6ue to this "ifference, investors woul" prefer capital gains to current income. Q6) IJQ company buys in lots of 8>> boxes which is a 5 month supply. ,he cost per box is :s. 1*8 an" or"ering cost is :s.1*>. ,he inventory carrying cost is estimate" at *>@ of unit value. hat is the total annual cost of the existing inventory policy! $ow much money coul" be save" by employing the economic or"er quantity! 0181 Ans.6. Annual 6eman"0:1C 8>>B7C*,>>> boxes 2ost per box0)1C:s.1*8 $ol"ing?carrying cost per unit02h1C :s.*>?1>>B1*8C:s.*8 /r"ering cost02p1C :s.1*>

E./.QC C15F units. T tal In"ent ), c st#$ 1. 2ost of materialC :B)C*>>>B1*8C *,8>,>>>

*. /r"ering costC :?E/QB2pC18>>?15FB1*>C1*F8 5. ,otal carrying costC E/Q?*B2hC15F?*B*8C1=5E ,herefore total inventory costC*,8>,>>>G1*F8G1=5EC *,85,>55. Q=) $ow "o you view financial management as a science or as a art! 0181 Ans.=. &inancial 'anagement is that branch of management which is concerne" with the fun"s of an organi(ation. -i%e 'ar%eting management is concerne" with the customer, )ro"uction "epartment is concerne" with the pro"uct, similarly financial management is concerne" with the fun"s. &un"s usually refer to the money with which the organi(ation functions. 'anagement of all the assets an" liabilities of an organi(ation is "one in financial management. &inancial management refers to the art an" science of managing the fun"s of an organi(ation in such a way as to generate maximum possible returns. &inancial management has t4 a11) aches namel,3. 1. T)aditi nal$ in this, the scope of financial management was limite" to raising finance. It neglecte" other important aspects of financial management such as utili(ing, allocation etc. 2. M de)n$ this approach "ealt not only with raising of fun"s but also with efficient allocation an" utili(ing of the same. ,his approach was wi"er in scope an" hence substitute" the tra"itional approach consequently. ,he three important "ecisions of financial management0Investment "ecision, &inancing "ecision an" "ivi"en" "ecision has to be ta%en un"er financial management1 1. Investment "ecisions. "ecisions such as which asset has to be acquire", the return on investment, cost of capital etc. are consi"ere". *. &inancing "ecisions. "ecisions such as choosing the best source of finance, capital structure "ecisions etc. are ta%en

5. 6ivi"en" "ecisions. it relates to the "ecisions regar"ing the profit management of an organi(ation. 6ecisions such as amount of profit to be retaine", amount to be reinveste" an" the amount to be "istribute" as "ivi"en" are ta%en. It ta%es "ecisions which "irectly affect the mar%et value of the shares. Financial Management and the) disci1lines#$ &inancial management is an integral part of overall management, is not a totally in"epen"ent area. It "raws heavily on relate" "isciplines an" fiel"s of stu"y, such as economics, accounting, mar%eting, pro"uction an" quantitative metho"s. 1. Finance B Ec n mics$ &' is concerne" with both 'icroeconomics # 'acroeconomics. 'acroeconomics is concerne" with the overall environment in which a company functions. It ta%es monetary an" fiscal policy into consi"eration because they affect the availability of fun"s an" the entire functioning of the economy. &inancial institutions an" ban%s also relate to the functioning of the firms. 'icroeconomics. it is concerne" with the firm itself an" the strategies to function. ,he "ecisions are ta%en without consi"ering the external factors mentione" in macroeconomics. 2. Finance B Acc -nting$ these * "isciplines are closely relate" as accounting ratios are an integral part of financial "ecision ma%ing. 'oreover, accounts han"ling is a part of financial management. Accounting is an input to the financial "ecision ma%ing. It is the "ata which is converte" into information. $owever accounting may "iffer from financial management in the sense that accounting calculates the fun"s at the point of sale itself an" not when the cash is actually realise". ,his may not a give a real picture of financial status. hereas financial management ta%es only those fun" into consi"eration when the it is actually realise".

9. Finance and Ma)Aeting$ 'ar%eting is an essential part of management which "eals from pro"uct "evelopment to sale of it. Dut mar%eting requires research which cannot be a possibility without a"equate fun"s. 'oreover, the price of the pro"uct "evelope" affects not only the mar%eting "epartment but also the finance "epartment as it is the main source of revenue. 8. Finance B () d-cti n$ )ro"uction process requires fun"s which are supplie" by the finance "epartment. ,he heavy equipments an" machines are manage" by the pro"uction "epartment, which are fun"e" by the finance "epartment. 6. Finance B (e)s nnel Management$ right person shoul" be at the right place is the motive of personnel management. &inance "epartment supports the compensation part of the personnel "epartment. It "eci"es the structure an" layout of compensation that the personnel woul" receive. ,he recruitment, training an" placement of staff requires finance which is given by the finance "epartment. =. Finance B Mathematics$ 'o"ern approaches of the financial management applie" large number of mathematical an" statistical tools an" techniques. ,hey are also calle" as econometrics. Economic or"er quantity, "iscount factor, time value of money, present value of money, cost of capital, capital structure theories, "ivi"en" theories, ratio analysis an" wor%ing capital analysis are use" as mathematical an" statistical tools an" techniques in the fiel" of financial management.

Financial management as a science$ It is a science because systematic rules, regulations, policies are lai" "own to manage finance of an organisation. <cience is a systematic bo"y of %nowle"ge pertaining to a specific fiel" of stu"y that contains general facts which explains a phenomenon.

It establishes cause an" effect relationship between two or more variables an" un"erlines the principles governing their relationship. ,hese principles are "evelope" through scientific metho" of observation an" verification through testing. Feat-)es * science# 1. Cni"e)sall, acce1tance 1)inci1les $ <cientific principles represents basic truth about a particular fiel" of enquiry. ,hese principles may be applie" in all situations, at all time # at all places 2. E&1e)imentati n B +bse)"ati n $ <cientific principles are "erive" through scientific investigation # researching i.e. they are base" on logic. 9. Ca-se B E**ect Delati nshi1 $ )rinciples of science lay "own cause an" effect relationship between various variables 8. Test * 7alidit, B ()edictabilit, $ Kali"ity of scientific principles can be teste" at any time or any number of times i.e. they stan" the test of time. Each time these tests will give same result. 'oreover future events can be pre"icte" with reasonable accuracy by using scientific principles &inancial management is an applie" science. &inance in an organi(ation is effectively governe" in accor"ance with the principles foun" out by continuous experiment an" observation. It cannot be "enie" that financial management has a systematic bo"y of %nowle"ge but it is not as exact as that of other physical sciences li%e biology, physics, an" chemistry etc. ,he main reason for the inexactness of science of management is the existence uncertain elements. Financial Management as an a)t$ Art implies application of %nowle"ge # s%ill to trying about "esire" results. An art may be "efine" as personali(e" application of general theoretical principles for achieving best possible results

1. Art is the expression or application of human creative s%ill an" imagination. *. Art helps to get along with people an" get wor% "one. 5. Art enables to see the big picture, to plan ahea" an" ma%e effective "ecisions. 7. &inancial 'anagement is an art because of the un%nown elements involve". 4nforeseen circumstances are tac%le" by the help of art. 8. It is a creative an" strategic ability of the "ecision ma%er along with their RintuitiveR un"erstan"ing of financial mar%et. ()inci1les * a)t#$ 1. ()actical En 4ledge# Every art requires practical %nowle"ge therefore learning of theory is not sufficient. It is very important to %now practical application of theoretical principles 2. (e)s nal /Aill# Although theoretical base may be same for every artist, but each one has his own style an" approach towar"s his job. ,hat is why the level of success an" quality of performance "iffers from one person to another. 5. C)eati"it,# Every artist has an element of creativity in line. ,hat is why he aims at pro"ucing something that has never existe" before which requires combination of intelligence # imagination. 7. (e)*ecti n th) -gh 1)actice# )ractice ma%es a man perfect. Every artist becomes more an" more proficient through constant practice. 8. G al$+)iented# Every art is result oriente" as it see%s to achieve concrete results. In the same manner, management is also "irecte" towar"s accomplishment of pre."etermine" goals. /f course financial management has to be in accor"ance with the systematic proce"ures an" rules lai" "own by the concerne" authority. Dut practical application of those rules is an art. An element of ju"gment is involve" where important "ecisions are ta%en on the basis of financial "ata, which ma%es financial management an art.

To conclude, we can say that science is the root and art is the fruit. Q@) 2ompanies I an" J are i"entical in all respects for "ebt. equity ratio. I having issue" 1>@ "ebentures of :s.1E la%h while J has issue" only equity. Doth the companies earn *>@ before interest an" taxes on their total assets of :s.5> la%h. Assuming a tax rate of 7>@ capitalisation rate of 18@ for an all equity company compute value of companies I an" J using3. 011 net income approach 0*1 net operating income approach (16) Ans.@. (a)tic-la)s *>@ of 5>-acs -ess3 interest Earning on equity E:ITC5>>>>>>x*>@ F ;,>>,>>> 1,E>,>>> 8?20?000 C;>>>>> G ;,>>,>>> . =?00?000

(I) Acc )ding t Net Inc me A11) ach 7al-e * the *i)m is#$ Kalue of 4nlevere" firm 0G1 CSKuC EDI, 01.t1?Ae C;>>>>>01.>.7>1?>.18 C 28?00?000 Kalue of a levere" &irm (F1 KlCKuG6 x, N 6C Kalue of "ebentures C*7>>>>>G1E>>>>> x 7>@ 291?20?000 (II) Acc )ding t the Net +1e)ating Inc me A11) ach#$ (.-)and) J I EDI,L*>@ ;>>>>> ;>>>>> on 5>,>>,>>> Interest 9I1E>>>> ED, ;>>>>> 7*>>>>

,axesL7>@ Ea)nings * ) e0-it, sha)eh lde)s Ae 02apitalisation


rate1

*7>>>> 9=0000 18@ *7>>>>>05;>>>>B1>>?18 1 9I28?00?000

1;E>>> 262000 18@ 1;E>>>>0*8*>>>B1>>?181 1E>>>>> 98?H0?000

Kalue /f EquityL18@ Kalue /f 6ebt 7al-e +* Fi)m

QH) rite short note on an, th)ee3 (16) 0a1 &actoring 0b1 &orfeiting 0c1 /ver an" un"er tra"ing 0"1 Doo% buil"ing Ans.H. (a) Defore "escribing factoring, some terms nee" to be clear. 1. Account receivables. refers to the money which has arisen from the sale of goo"s an" woul" be receive" in future as agree". *. &actor?buyer. refers to the firm which buys the account receivables of the selling firm. 5. 2lient?seller. the firm which sells the account receivables. 7. 6ebtor. the firm which owes money to the client. 8. ithout recourse. it means that the selling firm shall not be liable for any receivables not collecte" by the factor. Fact )ing$ )e*e)s t the selling * acc -nt )ecei"ables t the b-,e)<*act ) 4ith -t ha"ing an, liabilit, * c llecting it. The *act ) has the s le )es1 nsibilit, * c llecting the debts. The title * the acc -nt )ecei"ables 1asses n *) m the client t *act ). It is n thing b-t a meth d * sh )t$te)m *inancing.

Mechanism$ factoring happens only when there are cre"it sales. ,he main wor% a factor has is to collect the "ebts from the "ebtor. E.g. AC buyer, DC seller, 2C6ebtor. D has sol" goo"s worth :s.18>>> on cre"it to 2 which expires after 5> "ays. In the mean time, D has an urgency of fun"s an" approaches A to purchase the invoice of 20i.e. account receivables from 21 at a "iscounte" rate of 1@. ,he agreement is usually Twithout recourseU0where D has no liability if A fails to realise "ebt from 21 an" A pays the full amount to D minus "iscount i.e. 018>>>.18>1 C17E8>. -ater A realises :s.18>>> from 2 after the expiry of 5> "ays. If factoring is "one Twith recourseU then finance given to D shall be ta%en bac% in case 2 fails to pay "ebt to A. F-ncti ns * a Fact )#$ 1. &inancing the selling firm by purchasing its account receivables. *. 2ollecting facility is of the factor. 5. ,a%ing the ris% of not receiving the money from the "ebtor. H(b) /ha)e * )*eit-)e is the process by which the "irectors of a company cancel the power of sharehol"er if he "oes not pay his money when the company "eman"s for it. 2ompany will give 17 "ays notice, after 17 "ays if sharehol"er "i" not pay then company will forfeit his shares an" cut off his name from the register of sharehol"er. 2ompany will not pay his receive" fun"s from sharehol"er. In or"er to "o share forfeiture the Articles of Association of the company shoul" contain provision for that. A share in a company that the sharehol"er loses 0forfeits1 by failing to meet the purchase requirements such as paying allotment money, call money etc. hen a share is forfeite", the sharehol"er no longer owes any remaining balance, shares become the property of the issuing company. ,he issuing company can re.issue forfeite" shares at par, a premium or a "iscount as per their wish. ,he rights lost

may inclu"e claims on "ivi"en"s or capital gains or ability to purchase a""itional stoc%. In certain cases, companies allow executives an" employees to receive a portion of their cash compensation by purchasing shares in the company at a "iscount. ,his is commonly referre" to as an employee stoc% purchase plan. ,ypically, there will be restrictions on the purchase 0i.e. stoc% cannot be sol" or transferre" within a set perio" of time after the initial purchase1. If an employee remains with the company an" meets the qualifications, he or she becomes fully veste" in those shares on the state" "ate. If the employee leaves the company an"?or violates the terms of the initial purchase he?she will most li%ely get their shares forfeite". Meth d * * )*eit-)e#$ 1. ,he notice by the Doar" of 6irectors shoul" be given to the sharehol"er which allows the sharehol"er, a minimum of 17 "ays time perio" to pay the amount "ue. 2. ,he format of the notice shoul" be in accor"ance with the 2ompanies Act,1F8; an" moreover the warning shoul" be clear regar"ing the failure of non.payment. 9. If the "ue amount still remains unpai", the shares can be forfeite" by the Doar" of 6irectors by passing a resolution. 8. After the sai" shares are forfeite", a further notice to the sharehol"ers is ma"e notifying that their shares are forfeite". 6. A "eclaration regar"ing the forfeiture is ma"e by the 6irectors bac%e" by enough proof of such forfeiture. =. ,he names of such sharehol"ers are remove" from the members list of the company. @. ,he <ecurities Exchange Doar" of In"ia0<EDI1 shoul" be notifie" about such forfeitures. H(c) +"e)$t)ading, as the name suggests, occurs when companies expan" their own operations too quic%ly. ,hey ta%e up opportunities which may seem profitable but ultimately lea"s to losses. ,his usually happens when an organi(ation may be "ue

to excessive enthusiasm ta%es up wor% which it shoul" not. It also happens when an organi(ation copies its competitors an" feels that they shoul" expan" their operations faster than them. ,his ultimately lea"s to losses in form of high interest payment on loans ta%en to "o these unprofitable wor%s. ,his has a negative impact on the net profit an" less wor%ing capital. ,he firm again opts for loan in or"er to increase the wor%ing capital, an" the cycle continues so on an" so forth. ,his eventually lea"s to low liqui"ity position an" the firm runs out of wor%ing capital. Cnde)$t)ading$ it means that an organi(ation fears to exploit new opportunities an" tries to remain in the area in which it alrea"y is. It "oes not expan" the its operations an" misses opportunities. It "oes not ta%e ris%s, moreover fears to enter new mar%ets where it can grow. 4n"er.tra"ing is the reverse of over.tra"ing. It means %eeping fun"s i"le an" not using them properly. ,his is "ue to the un"er employment of assets of the business, lea"ing to the fall in sales an" results in financial crises. ,his ma%es the business unable to meet its commitments an" ultimately lea"s to force" liqui"ation. ,he symptoms in this case woul" be very high current ratio an" very low turnover ratio. If an organization is overtrading, it can make their trading plan more restrictive for entries and exits. If an organization is undertrading, they can relax their trading plan criteria to take advantage of potentially profitable moves in the market. H(d) Doo% buil"ing is a process use" by companies raising capital through )ublic /fferings.both Initial )ublic /ffers 0I)/s1 or &ollow.on )ublic /ffers 0 &)/s1 to %now mainly two things3. 1. ,he demand for the securities to be issue". *. ,he 1)ice is estimate" at which these securities shoul" be issue". It is mainly a price # "eman" "iscovery process, where a company "oesn+t fix up a price rather it sets a price range within which the share price shoul" be fixe". E.g. ,he company can set the range between :s.1>>>.*>>>.

After which the investors are calle" to bi" for these shares within the range. E.g. ,he lowest bi" possible is :s.1>>> %nown as the floor price, an" the highest bi" can be of :s.*>>> %nown as the cap price. ,he price at which the share is given is %nown as the cut.off price. Feat-)es#$ 1. ,he bi" receive" from the investors are confi"ential to the issuer, boo%runner0the main un"er.writer1. *. Di""ing is mainly by invitation to the clients of the un"er.writer. 5. ,he price range an" issue si(e is "eci"e" by the issuer an" boo%.runner. 7. 4sually, the price is fixe" an" all the shares are given at the same price. Mechanism$ ,he issuing company approaches an un"er.writer whose job is to bring the issue to the public. Doth the un"er. writer an" the issuer "eci"es the price range an" the no. of shares to be issue". &urther syn"icate members are hire" to ta%e bi"s from the investors. ,he syn"icate members input the bi"s into the Tboo%U. ,he bi""ing time is normally for 8 "ays, when the boo% is open. After the boo% is close", the "eman" of securities is evaluate" at various price levels, an" the most appropriate price correspon"ing to the "eman" is chosen. ,his final price is fixe" at which the securities are issue". After which allocation is "one. E.g. If the price is fixe" at :s.18>>, then the bi""ers of :s.1>>> either pay extra :s.8>> per share or ta%e bac% their refun", an" the bi""ers of :s. *>>> receive :s.8>> per share as a refun".