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1408019475
ASSINGMNET
DRIVE
PROGRAM
SEMESTER
SUBJECT CODE & NAME
BK ID
CREDIT & MARKS
SPRING 2015
MBA/ MBADS/ MBAFLEX/ MBAHCSN3/ PGDBAN2
II
MB0045 FINANCIAL MANAGEMENT
B1628
4Credits, 60 marks
1) Explain the liquidity decisions and its important elements. Write complete information on
dividend decisions.
Answer: Liquidity decisions with its important elements: 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. If a firm does not have adequate working capital, it may become illiquid and
consequently fail to meet its current obligations thus inviting the risk of bankruptcy. On the contrary,
if the current assets are too enormous, the profitability is adversely affected. Hence, the major
objective of the liquidity decision is to ensure a trade-off between profitability and liquidity. Besides,
the funds should be invested optimally in the individual current assets to avoid inadequacy or
excessive locking up of funds. Thus, the liquidity decision should balance the basic two ingredients,
i.e. working capital management and the 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
Present value of a single flow-Ascertaining Present Value (PV) is simply the reverse of
finding Future Value (FV). Hence, the formula for FV can be simply transformed into the PV
formula.
Present value of even series of cash flows-In a business scenario, the businessman will
receive periodic amounts (annuity) for a certain number of years. An investment done today
will fetch he returns spread over a period of time. He would like to know if it is worthwhile to
invest a certain sum now in anticipation of returns he expects after a certain number of years.
Present value of perpetuity- An annuity for an infinite time period is perpetuity. It occurs
indefinitely. A person may like to find out the present value of his investment assuming he
will receive a constant return year after year.
Present value of an uneven periodic sum- In some investment decisions of a firm, the
c) Combined leverage: The combination of operating and financial leverage is called combined
leverage. Operating leverage affects the firms operating profit EBIT and financial leverage affects
PAT or the EPS. These cause wide fluctuations 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.
Companies whose products are seasonal in nature have fluctuating EPS, but the amount of changes in
EPS due to leverages is more pronounced. 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. The combined effect is quite significant for the earnings available to
ordinary shareholders. Combined leverage is the product of degree of operating leverage (DOL) and
degree of financial leverage (DFL).
4) Explain the factors affecting Capital Structure. Solve the below given problem?
Answer: Capital structure should be planned at the time a company is promoted. The initial capital
structure should be designed very carefully. The management of the company should set a target
capital structure, and the subsequent financing decisions should be made with a view to achieve the
target capital structure.
Every time the funds have to be procured, the financial manager weighs the pros and cons of various
sources of finance and selects the most advantageous sources keeping in view the target capital
structure. Thus, the capital structure decision is a continuous one and has to be taken whenever a firm
needs additional finance. The major factor affecting the capital structure is leverage.
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
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 result 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
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
Solution for the problem:- Given below are two firms, A and B, which are identical in all aspects
except the degree of leverage, employed by them. What is the average cost of capital of both firms?
Answer: Details of Firms A and B
PARTICULARS
FIRM A
FIRM B
INTEREST ON DEBENTURES I
NIL
EQUITY EARNINGS E
COST OF EQUITY KE
15%
15%
COST OF DEBENTURES KD
10%
10%
NIL
Rs. 25,000
Rs. 2,50,000
Answer: Risk in capital budgeting may be defined as the variation of actual cash flows from the
expected cash flows. Risk exists on account of the inability of a firm to make perfect forecasts of
cash flows.
Some factors that affect forecasts of investment, cost and revenue are:
The business: Affected by changes in political situations, monetary policies, taxation, interest
rates and policies of the central bank of the country on lending by banks.
Industry specific: Factors influence the demand for the products of the industry to which the
firm belongs
Company specific: Factors like change in management, wage negotiations with the workers,
strikes or lockouts affect companys cost and revenue positions. Stand-alone risk of a project is
considered when the project is in isolation. It is measured by the variability of expected returns
of the project.
Portfolio risk: A firm can be viewed as portfolio of projects having a certain degree of risk.
When new project is added to the existing portfolio of project
The co-variance of return from the new project
The return from the existing portfolio of the projects
If the return from the new project is negatively correlated with the return from
firm.
Corporate risk: Focuses on the analysis of the risk that might influence the project in terms of
entire cash flow of the firms. It is the projects risks of the firm.
Technological risk: The changes in technology affect all the firms not capable of adapting
themselves in emerging into a new technology. Example: The best example is the case of firms
manufacturing motor cycles with two stroke engines. When technological innovations replaced
the two stroke engines by the four stroke engines, those firms which could not adapt to new
Solution for the problem with interpretation: An investment will have an initial outlay of Rs
100,000. It is expected to generate cash inflows. Cash inflow for four years. If the risk free rate and
the risk premium is 10%, Compute the NPV using the risk free rate, b) Compute NPV using riskadjusted discount rate
i)
Following NPV calculation using the risk free rate NPV Using Risk Free Rate
Solution:
YEAR CASH FLOW (INFLOW) RS.PV FACTOR AT 10% CASH FLOWS (INFLOWS) RS.
1
40,000
0.909
36,360
50,000
0.826
41,300
15,000
0.751
11,265
30,000
0.683
20,490
Rs. 9415
Following NPV calculation using the risk-adjusted discount. NPV Using Risk-adjusted
Discount Rate
Solution:
YEAR
CASH FLOW
PV FACTOR AT
CASH FLOW
(INFLOW) RS.
20%
(INFLOW) RS.
40,000
0.833
33,320
50,000
0.694
34,700
15,000
0.579
8,685
30,000
0.482
14,460
PV of cash inflows:
Rs.91,165
PV of cash outflows:
Rs.1,00,000
NPV:
Rs.8, 835
Prompt billing and mailing: There is a time lag between the dispatch of goods and
preparation of invoice. Reduction of this gap will bring in early remittances.
Collection of cheques and remittances of 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 realized or paid
respectively.
Baumol model with assumptions: 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 minimize 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 helps in determining the minimum amount of cash that a
manager can obtain by converting securities into cash.
The Baumol model is based on the following assumptions:
A company sells securities and realizes cash, and this cash is used to make payments. As the cash
balance decreases and reaches a point, the finance manager replenishes its cash balance by selling
marketable securities available with it and this pattern continues. 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 above-normal cash balances.
A firm issues and receives cheques on a regular basis. It can take advantage of the concept of float.
Whenever cheques are deposited in the bank, credit balance increases in the firms books but not in
banks books until the cheque is cleared and money is realized. This refers to collection float, that is,
the amount of cheques deposited into a bank and clearance awaited. 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. We can, thus, say that the
objectives of cash management are straightforward (a) meeting payments schedule and (b)
maximize the value of funds while minimizing the cost of funds.