Financial Management

Q.1:- Explain the liquidity decisions and its important elements. Write
complete information on dividend decisions.
Ans. Liquidity decisions
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 and liquidity, and there is a conflict between these two
concepts. The liquidity decision should balance the basic two ingredients, i.e. working
capital management and the efficient allocation 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 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. Although both - expansion and
payment of dividend - are desirable, these two are in conflicting tasks.
The following issues need adequate consideration in deciding on dividend policy:
Preferences of shareholders Do they want cash dividend or capital gains?
Current financial requirements of the company.
Legal constraints on paying dividends.
Striking an optimum balance between desire of shareholders and the companys
funds requirements.
The main reasons why a stable dividend is preferred are:
a) A regular and stable dividend payment may serve to resolve uncertainty in the
minds of shareholders, and it creates confidence among shareholders.
b) Many investors are income conscious and favour a stable dividend.
c) Other things being in balance, the market price invariably vary with the rate of
dividend declared by the company on its equity shares. The value of shares of a
company that has a stable dividend policy does not fluctuate as much, even if the
earnings of the company fluctuate now and then.
d) A stable dividend policy encourages investments from institutional investors.

Q.2:- Explain about the doubling period and present value. Solve the given
problem:
Ans. 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 dividing 72 by the rate of
interest. Though it is a crude way of calculating, this rule is followed by most. 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)}.
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?
Solution for the given problem.
i mXn
1+
m
n

FV = PV

( )

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
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 n
number 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.
1) Present value of a single flow
Present Value (PV) is simply the reverse of finding Future Value (FV). Hence, the
formula for FV can be simply transformed into the PV formula.
FV n

PV =

(1+i)n

Where, PV = Present Value

FVn = Amount (Future value after n years)

i = Interest rate
n = Number of years for which discounting is done
2) Present value of even series of cash flow
The PV of a series of cash flows can be represented by the following formula:
( 1+i )n1
PVAn = A i(1+i)n

The expression {(1+i)n-1/i(1+i)n} is known as Present Value Interest Factor

Annuity (PVIFA). It represents the present value of a regular annuity of Re. 1 for the
given values of i and n.
3) Present value of perpetuity
An annuity for an infinite time period is perpetuity. It occurs indefinitely. The
present values of perpetuity can be expressed as follows:

P = A PVIFAi,
Where, P = Present value of perpetuity
A = constant annual payment
PVIFAi, = Present value interest factor for a perpetuity

1
1
=
n
Therefore, the value of PVIFAi, is
i
n=1 (1+i)
It can be said that PVIF of perpetuity is simply one divided by interest rate
expressed in decimal form. Hence, PV of perpetuity is simply equal to the constant
annual payment divided by the interest rate. This can be expressed as follows:
A
P = i
4) Present value of an uneven periodic sum
In some investment decisions of a firm, the returns may not be constant. In such cases,
the PV is calculated as follows:

P=

A1

(1+i)

A2

(1+i)

A3

(1+i)

++

An

(1+i)

or
PV= A1 PVIF (i, 1) + A2 PVIF (i, 2) + A3 PVIF (i, 3) + A4 PVIF (i, 4) +. + An PVIF (i, n)
5) Capital recovery factor
Capital recovery factor is the annuity of an investment for a specified time at a
given rate of interest. The reciprocal of the present value annuity factor is called
capital recovery factor.
i(1+ I )n
A = PVAn ( 1+i)n1

i (1+ I )n
( 1+i )n1

is known as the Capital Recovery Factor.

Q.3:- Write short notes on:- a) Operating Leverage, b) Financial leverage, c)

Combined leverage.

Ans. Operating Leverage

Operating leverage arises due to the presence of fixed operating expenses in the
firms income flows. The operating leverage takes place when a change in revenue
produces a 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 a small decline in sales may reduce and even
wipe out the EBIT.
There are three categories of a compatys operating 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.
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.
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.

Application of operating leverage

Measurement of business risk
Risk refers to the uncertain conditions in which a company performs. A business
risk is measured using the DOL and the formula of DOL is:
DOL = {Q(SVV)} / {Q(SVV)VF}
The greater the DOL, the more sensitive will be the EBIT to a given change in unit
sales. A high DOL is a measure of high business risk and vice versa.
Production planning
A change in production method increases or decreases DOL. A firm can change its
cost structure by mechanising its operations, thereby, reducing its variable costs
and increasing its fixed costs. This will have a positive impact on DOL. This
situation can be justified only if the company is confident of achieving a higher
amount of sales thereby increasing its earnings.
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
Financial leverage refers to a firm's use of fixed-charge securities like debentures and
preference shares in its plan of financing the assets. The Degree of Financial Leverage
(DFL) is a more precise measurement. It examines the effect of the fixed sources of funds
on EPS.
DFL = %change in EPS
%change in EBIT
DFL={EPS/EPS} {EBIT/EBIT}
Or DFL = EBIT {EBIT.I.{Dp/(1-T)}}

I is Interest, Dp is dividend on preference shares, T is tax rate.

Use of financial leverage
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.
Total or 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 in EPS. 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. The combined effect is quite significant for the earnings
available to ordinary shareholders. Combined leverage is the product of DOL and DFL.
Q(SV )
DTL = Q ( S V ) FI {D p /(1T )}
Where DTL = Degree of Total Leverage
Uses of Degree of Total Leverage (DTL)
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
Q.4:- Explain the factors affecting Capital Structure. Solve the given problem.
Ans Factors Affecting Capital Structure
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. The capital structure decision is
a continuous one and has to be taken whenever a firm needs additional finance. The
major factor affecting the capital structure is leverage. There are also a 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. 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 companies with high level of Earnings Before Interest and Taxes (EBIT) can make
profitable use of the high degree of leverage to increase return on the shareholders
equity.

Debt-equity ratio is another parameter that comes into play here. Debtequity ratio is
an indicator of the relative contribution of creditors and owners. The debt component
includes both long-term and short-term debt, and this is represented as debt/equity. A
debt-equity ratio of 2:1 indicates that for every 1 unit of equity, the company can
raise 2 units of debt.
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 the company - 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 by way 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.
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?
Details of Firms A and B
Firm A
Firm B
Net operating income EBIT
Rs. 1,00,000
Rs. 1,00,000
Interest on debentures I
Nil
Rs. 25,000
Equity earnings E
Rs. 1,00,000
Rs. 75,000
Cost of equity Ke
15%
15%
Cost of debentures Kd
10%
10%
Market value of equity S = E/Ke
Rs. 6,66,667
Rs. 5,00,000
Market Value of debt B
Nil
Rs. 2,50,000
Total value of firm V
Rs. 6,66,667
Rs. 7,50,000
Solution for the given problem.
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% * 250000/750000 + 15% * 500000/750000 = 3.34 + 10 = 13.3%
Interpretation:
The use of debt has caused the total value of the firm to increase and the overall cost of
capital to decrease.
Q.5:- Explain all the sources of risk in capital budgeting with examples. Solve
the given problem:

Ans Sources of risk

Project-specific risk
Project-specific risk could be traced to something quite specific to the project. Managerial
deficiencies or error in estimation of cash flows or discount rate may lead to a situation
of actual cash flows realised being less
than the projected cash flow.
Competitive or competition risk
Unanticipated actions of a firms competitors will materially affect the cash flows
expected from a project. As a result of this, the actual cash flows from a project will be
less than that of the forecast.
Industry-specific risk
Industry-specific risks are those that affect all the firms in the particular industry.
Industry-specific risk could be again grouped into technological risk, commodity risk and
legal risk. Let us discuss the groups in industryspecific risks, as follows:
Technological risk The changes in technology affect all the firms not capable of
adapting themselves in emerging into a new technology.
Commodity risk It is the risk arising from the effect of price-changes on goods
produced and marketed.
Legal risk It arises from changes in laws and regulations applicable to the industry
to which the firm belongs.
International risk
These types of risks are faced by firms whose business consists mainly of exports or
those who procure their main raw material from international markets. The firms facing
such kind of risks are as follows:
The rupee-dollar crisis affected the software and BPOs, because it drastically reduced
their profitability.
Another example is that of the textile units in Tirupur in Tamil Nadu, which exports the
major part of the garments produced. Strengthening of rupee and weakening of
dollar, reduced their competitiveness in the global markets.
The surging crude oil prices coupled with the governments delay in taking decision on
pricing of petro products eroded the profitability of oil marketing companies in public
sector like Hindustan Petroleum Corporation Limited.
Another example is the impact of US sub-prime crisis on certain segments of Indian
economy.
The changes in international political scenario also affected the operations of certain
firms.
Market risk
Factors like inflation, changes in interest rates, and changing general economic
conditions affect all firms and all industries. Firms cannot diversify this risk in the normal
course of business.
An investment will have an initial outlay of Rs 100,000. It is expected to
generate cash inflows. Cash inflow for four years.
Year
Cash Flow
1

40000

50000

15000

30000

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 for the given problem.
a) PV Using Risk Free Rate
Year

Cash flows
PV factor at
10%
(inflows)
Rs.
1
40000
0.909
2
50000
0.826
3
15000
0.751
4
30000
0.683
PV of cash inflows
PV of cash outflows
(100000)
NPV
b) NPV Using Risk-adjusted Discount Rate
Year

Cash inflows Rs.

1
2
3
4

40000
50000
15000
30000
PV of cash inflows
PV of cash outflows
NPV

PV factor at
20%
0.833
0.694
0.579
0.482

PV of cash
flows
(inflows)
36360
41300
11265
20490
109415
9415
PV of cash
inflows
33320
34700
8685
14460
91165

(100000)
(8835)

Interpretation:
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.
Q.6:- Explain the objectives of Cash Management. Write about the Baumol
model with their assumptions.
Ans Objectives of Cash Management
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.
The other advantage of meeting the payments on time is that it prevents
bankruptcy that arises out of the firms inability to honour its commitments. At the same
time, care should be taken not to keep large cash reserves as it involves high cost.
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 a non-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 synchronisation 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 mailing
There is a time lag between the dispatch of goods and preparation ofinvoice.
Reduction of this gap will bring in early remittances.
Collection of cheques and remittances of cash
Generally, 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.
Float
The 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 realised or paid
respectively.
Likewise the firm may take benefit of payment float.
Net float = Payment float Collection float
When net float is positive, the balance in the firms books is less than the banks books;
when net float is negative; the firms book balance is higher than in the banks books.
Baumol model
The Baumol model helps in determining the minimum amount of cash that a
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.

Cash balances are refilled and brought back to normal levels by the sale of securities.
The average cash balance is C/2. The firm buys securities as and when it has abovenormal cash balances. This pattern is explained in figure:Baumol Model
C
Cash balance

C/2

Average

T1

T2

T3

Time

Baumol cut-off model

The total cost associated with cash management has two elements:
Cost of conversion of marketable securities into cash and
Opportunity cost
The firm incurs a holding cost for keeping cash balance, which is the opportunity cost.
Opportunity cost is the benefit foregone on the next best alternative for the current
action. Holding cost is k*(C/2). The firm also incurs a transaction cost whenever it
converts its marketable securities into cash. Total number of transactions during the year
will be the total funds requirement, T, divided by the cash balance, C, i.e., T/C. If per
transaction cost is c, then the total transaction cost is c*(T/C). The total annual cost of
the demand for cash is k*(C/2) + c*(T/C).
The Baumol Cut-off Model is represented in figure:Baumol Cut-off Model
Total Cost

Cost

Holding Cost

Transaction Cost
Cash Balance

C*

The optimum cash balance, C*, is obtained when the total cost is minimum, which is
expressed as:

C* = 2cT/k

where C* is the optimum cash balance,

c is the cost per transaction,

T is the total cash needed during the year and

k is the opportunity cost of holding cash balance.
The optimum cash balance will increase with the increase in per-transaction cost and
total funds required, and decrease with the opportunity cost.