Spring 2015

MB0045 FINANCIAL MANAGEMENT

Ques1. Explain the liquidity decisions and its important elements. Write
complete information on dividend decisions?
Answer 1.
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. 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 strategies
Policies on utilization 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 dividend decision is always a problem
before the top management or 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. Retained earnings are the

sources of internal finance for financing of corporates future projects but payment
of dividend constitute an outflow of cash to shareholders. Although both - expansion
and payment of dividend - are desirable, these two are in conflicting tasks. It is,
therefore, one of the important functions of the financial management to constitute
a dividend policy which can balance these two contradictory view points and
allocate the reasonable amount of profits after tax between retained earnings and
dividend.
All of this is based on formulation of a good dividend policy. Since the goal of
financial management is maximization of wealth of shareholders, dividend policy
formulation demands the managerial attention on the impact of its policy on
dividend and on the market value of its shares. Optimum dividend policy requires
decision on dividend payment rates so as to maximize the market value of shares.
The payout ratio means what portion of earnings per share is given to the
shareholders in the form of cash dividend. In the formulation of dividend policy, the
management of a company will have to consider the relevance of its policy on
bonus shares. Dividend policy influences the dividend yield on shares.

Ques2 Explain about the doubling period and present value. Solve the
below given problem:
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?

Answer 2.
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 dividing72 by the rate of
interest. Though it is a crude way of calculating, this rule is followed by most. For
instance, 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
Present Value

Given the interest rate, compounding technique can be used to compare the cash
flows separated by more than one time period. With this technique, the amount of
present cash can be converted into an amount of cash of equivalent value in future.
Likewise, we may be interested in converting the future cash flow into their present
values. 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

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. Thus, we
can determine the PV of a future cash flow or a stream of future cash flows using
the formula:

Where, PV = Present Value

FVn = Amount (Future value after n years)
i = Interest rate
n = Number of years for which discounting is done
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 him 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. He
should, therefore, equate the anticipated future returns to the present sum he is
willing to forego. The PV of a series of cash flows can be represented by the
following formula:

The above formula or the equation reduces to:

The expression {(1 i) 1/ i(1 i) } n 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.
Solution:

= 1000/ (1+0.10)1
= Rs. 909.09
The same can be calculated with the help of tables
= 1000*PVIF (10%, 1y)
= 1000*0.909

= Rs. 909
The amount to be invested today to have an amount of Rs, 1000 after one year is
Rs. 909.

Ques3. Write short notes on:

a) Operating Leverage
b) Financial leverage
c) Combined leverage

Answer 3.
Operating Leverage
Operating leverage arises due to the presence of fixed operating expenses in the
firms income flows. It has a close relationship to business risk. Operating leverage
affects business risk factors, which can be viewed as the uncertainty inherent in
estimates of future operating income. 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.
Let us now discuss these three categories in detail.

Fixed costs Fixed costs are those which do not vary with an increase in
production or sales activities for a particular period of time. These are

incurred irrespective of the income and value of sales and generally cannot
be reduced. For example, consider that a firm named XYZ Enterprises is
planning to start a new business. The main aspects that the firm should
concentrate on are salaries to the employees, rents, insurance of the firm,
and the accountancy costs. All these aspects are referred to as fixed costs.
Variable costs Variable costs are those which vary in direct proportion to
output and sales. An increase or decrease in production or sale activities will
have a direct effect on such types of costs incurred. For example, we have
discussed about fixed costs in the above context. Now, the firm has to
concentrate on some other features like cost of labor, amount of raw
materials, and the administrative expenses. All these features relate to or are
referred to as Variable costs, as these costs are not fixed and keep
changing depending upon the conditions.
Semi-variable costs Semi-variable costs are those which are partly fixed
and partly variable in nature. These costs are typically of fixed nature up to a
certain level beyond which they vary with the firms activities. For example,
after considering both the fixed costs and the variable costs, the firm should
concentrate on some other features like production cost and the wages paid
to the workers. At some point in time, these will act as fixed costs and can
also shift to variable costs. These features relate to or are referred to as
Semi-variable costs.
The operating leverage refers to the degree to which a firm has built-in fixed
costs due to its particular or unique production process. The extent of the
operating leverage at any single sales volume is calculated as follows:

Marginal contribution/EBIT)
(Revenue Variable costs)/(Revenue Variable costs Fixed costs)

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

Debentures and bonds carry a fixed rate of interest and are to be paid off
irrespective of the firms revenues. The dividends are not contractual obligations,
but the dividend on preference shares is a fixed charge and should be paid off
before equity shareholders. The equity holders are entitled to only the residual
income of the firm after all prior obligations are met. Financial leverage refers to a
firm's use of fixed-charge securities like debentures and preference shares (though
the latter is not always included in debt) in its plan of financing the assets.

The concept of financial leverage is a significant one because it has direct relation
with capital structure management. It determines the relationship that could exist
between the debt and equity securities. A firm which does not issue fixed-charge
securities has an equity capital structure and does not have any financial leverage.
However, it is common for firms to issue some debt securities, in which case, the
leverage is either favorable or unfavorable. Financial leverage is a process of using
debt capital to increase the rate of return on equity. For this reason, it is also
referred to as trading on equity. Borrowing is done by a company because of the
financial advantage that is expected from it. The use of borrowings for the purpose
of such advantage for residual shareholders is also called trading on equity or
leverage.
Thus, financial leverage refers to the mix of debt and equity in the capital structure
of the firm. This results from the presence of fixed financial charges in the
companys income stream. Such expenses have nothing to do with the firms
performance and earnings and should be paid off regardless of the amount of EBIT.
It is the firms ability to use fixed financial charges to increase the effects of
changes in EBIT on the EPS. It is the use of funds obtained at fixed costs which
increase the returns on shareholders.
A company earning more by the use of assets funded by fixed sources is said to be
having a favorable or positive leverage. Unfavorable leverage occurs when the firm
is not earning sufficiently to cover the cost of funds. Financial leverage is also
referred to as trading on equity.
Thus, the effect of financial leverage is also measured through another variable, viz,
EPS. This is done in the case of joint stock companies which have raised their
proprietary capital by selling units of such capital known as equity shares. EPS is
obtained by dividing earnings (after interest and taxes) by total equity. If a company
has preference shares also on its capital structure, net equity earnings will be
arrived at after deducting interest, taxes, and preference dividends.

Capital structure refers to the permanent long-term financing of a company

represented by a mix of long-term debt, preference shares, and net worth (which
included paid-up capital, reserves, and surplus). Financial leverage and its effects
are a crucial consideration in planning and designing capital structures.
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 combined effect is quite significant for the earnings available to ordinary
shareholders. Combined leverage is the product of DOL and DFL.

Ques4. Explain the factors affecting Capital Structure. Solve the below
given 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 4.

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. 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. 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. If the

assets financed by debt yield a return greater than the cost of the debt, the EPS will
increase without an increase in the owners investment.
Similarly, the EPS will also increase if preference share capital is used to acquire
assets. But 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. Debt equity 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. Creditors insist on a debt-equity ratio of 2:1 for
medium-sized and large-sized companies, while they insist on 3:1 ratio for Small
Scale Industries (SSI).
A debt-equity ratio of 2:1 indicates that for every 1 unit of equity, the company can
raise 2 units of debt. By normal standards, 2:1 is considered as a healthy ratio, but
it is not always a hard and fast rule that this standard is insisted upon. A ratio of 5:1
is considered good for a manufacturing company while a ratio of 3:1 is good for
heavy engineering companies. Generally, in debt-equity ratio, the lower the ratio,
the higher is the element of uncertainty in the minds of lenders. Increased use of
leverage increases commitments of the company (the outflows being in the nature
of higher interest and principal repayments), thereby increasing the risk of the
equity shareholders.

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 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.

Solution:
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% * 25000/750000 + 15% * 533333/750000 = 3.34 + 10 = 13.4%
Interpretation:
The use of debt has caused the total value of the firm to increase and the overall
cost of capital to decrease.

Ques5. Explain all the sources of risk in capital budgeting with examples.
Solve the below given problem:
An investment will have an initial outlay of Rs 100,000. It is expected to
generate cash inflows. Cash inflow for four years.
Years
1
2
3
4

Cash Inflows
40000
50000
15000
30000

Answer 5.
Risk in Capital Budgeting
Definition of risk
There are several definitions for the term risk. It may vary depending on the
situation, context and application. Risk may be termed as a degree of uncertainty. It
may be defined as the possibility that the actual result from an investment will differ
from the expected result. Risk in capital budgeting may be defined as the variation
of actual cash flows from the expected cash flows.
Types and Sources of Risk in Capital Budgeting
Capital budgeting involves four types of risks in a project: stand-alone risk, portfolio
risk, market risk and corporate risk.
Stand-alone risk
Stand-alone risk of a project is considered when the project is in isolation. Standalone risk 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 risk profile of the firm
will alter. The degree of the change in the risk depends on the following:

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 portfolio, the risk of
the firm will be further diversified.

Market risk
Market risk is defined as the measure of the unpredictability of a given stock value.
However, market risk is also referred to as systematic risk. The market risk has a
direct influence on stock prices. Market risk is measured by the effect of the project
on the beta of the firm. The market risk for a project is difficult to estimate, as it
includes a wide range of external factors like recessions, wars, political issues, etc.
Corporate risk
Corporate risk focuses on the analysis of the risk that might influence the project in
terms of entire cash flow of the firms. Corporate risk is the projects risks of the firm.
Sources of risk
The five different sources of risk are:

Project-specific risk
Competitive or competition risk
Industry-specific risk
International risk
Market 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 realized 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 industry specific risks, as follows:

Technological risk The changes in technology affect all the firms not
capable of adapting themselves in emerging into a new technology. ExampleThe 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
technology had to shut down their operations.

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. Example -The imposition of service tax on
apartments by the government of India, when the total number of
apartments built by a firm engaged in that industry exceeds a prescribed
limit. Similarly, changes in import/export policy of the government of India
have led to either closure of some firms or sickness of some firms.

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 crises affected the software and BPOs, because it drastically
reduced their profitability. Another example is that of the textile units in
Tripura 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.

Solution
a) NPV can be computed using risk free rate. Table shows NPV calculation using
the risk free rate.
Using Risk Free Rate
Year

1
2
3
4

Cash
flow(inflows)
Rs
40000
50000
15000
30000
PV of Cash Inflows
PV of Cash Outflows
NPV

PV factor at
10%
0.909
0.826
0.751
0.683

PV of Cash flows
(Inflows)
36,360
41,300
11,265
20,490
1,09,415

(1,00,000)

b) NPV can be computed using risk-adjusted discount. Table 9.4 shows NPV
calculation using the risk-adjusted discount.

9,415

Year

1
2
3
4

Cash
flow(inflows)
Rs
40000
50000
15000
30000
PV of Cash Inflows
PV of Cash Outflows
NPV

PV factor at
10%
0.833
0.694
0.579
0.482

PV of Cash flows
(Inflows)
33,320
34,700
8,685
14,460
91,165
(1,00,000)
8,835

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 riskadjusted discount rate.

Ques6. Explain the objectives of Cash Management. Write about the

Baumol model with their assumptions?

Answer.
The major objectives of cash management in a firm are:

Meeting payments schedule

Minimizing 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.
Generally, cash is not paid immediately for purchases but after an agreed period of
time. This is deferral of payment and is also considered as a source of finance. Trade
credit does not involve explicit interest charges, but there is an implicit cost
involved. If the credit term is for example, 2/10, net 30; it means the company will
get a cash discount of 2% for a payment made within 10 days, or else the entire

payment is to be made within 30 days. Since the net amount is due within 30 days,
not availing discount means paying an extra 2% for the 20-day period.

Minimizing 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
synchronization 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

Collection of cheque and remittances of cash
Float

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 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 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.

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.