SUBJECT CODE & NAME-MB0045

FINANCIAL MANAGEMENT
Q1. Explain the liquidity decisions and its important elements. Write complete information on
dividend decisions.
(Explanation of liquidity decisions with its important elements, Explanation of dividend
decisions)5, 5
Answer.
Liquidity decisions with its important elements

Liquidity refers to a company's ability to pay its current bills and expenses. In other words,
liquidity relates to the availability of cash and other assets to cover accounts payable, shortterm debt, and other liabilities. All small businesses require a certain degree of liquidity in
order to pay their bills on time, though start-up and very young companies are often not very
liquid. In mature companies, low levels of liquidity can indicate poor management or a need
for additional capital. Of course, any company's liquidity may vary due to seasonal
variations, the timing of sales, and the state of the economy.

Companies tend to run into problems with liquidity because cash outflows are not flexible,
while income is often uncertain. Creditors expect their money when promised, and employees
expect regular paychecks. However, the cash coming in to a business does not often follow a
set schedule. Sales volumes fluctuate as do collections from customers. Because of this
difference between cash generation and cash payments, businesses should maintain a certain
ratio of current assets to current liabilities in order to ensure adequate liquidity.
Dividend decisions
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. 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.
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.

Companies attempt to maintain a stable dividend policy whereby a stable rate of dividend is
maintained. This also ensures that the companys market value of shares stays higher.

Q2. 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?
(Explanation of doubling period, Solving the problem, Explanation of present value) 2, 3, 5
Answer.
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.
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

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)}.
Solution.
We know that,

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
The current worth of a future sum of money or stream of cash flows given a specified rate of return.
Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the
present value of the future cash flows. Determining the appropriate discount rate is the key to properly
valuing future cash flows, whether they be earnings or obligations.
Q3. Write short notes on:
a) Operating Leverage
b) Financial leverage
c) Combined leverage
Answer.
a) Operating Leverage
Operating leverage is a measure of how revenue growth translates into growth in operating income. It
is a measure of leverage, and of how risky, or volatile, a company's operating income is.

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.
The following two scenarios describe an organization having high operating leverage and low
operating leverage.
1. High operating leverage. A large proportion of the companys costs are fixed costs. In this
case, the firm earns a large profit on each incremental sale, but must attain sufficient sales
volume to cover its substantial fixed costs. If it can do so, then the entity will earn a major
profit on all sales after it has paid for its fixed costs.
2. Low operating leverage. A large proportion of the companys sales are variable costs, so it
only incurs these costs if there is a sale. In this case, the firm earns a smaller profit on each
incremental sale, but does not have to generate much sales volume in order to cover its lower
fixed costs. It is easier for this type of company to earn a profit at low sales levels, but it does
not earn outsized profits if it can generate additional sales.
b) Financial leverage
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. Mary uses $400,000 of her cash to purchase 40 acres of land with a total cost of
$400,000. Mary is not using financial leverage.
Sue uses $400,000 of her cash and borrows $800,000 to purchase 120 acres of land having a total cost
of $1,200,000. Sue is using financial leverage. Sue is controlling $1,200,000 of land with only
$400,000 of her own money.

c) Combined leverage
The combination of operating and financial leverage is called combined leverage. The combined
effect is quite significant for the earnings available to ordinary shareholders. Combined leverage is the
product of DOL and DFL.

Q4. 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?

(Explanation of factors affecting capital structure, Solution for the problem, Interpretation)
6,3,1
Answer.
Factors affecting Capital Structure
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.
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

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. Creditors insist on a debt-equity ratio of 2:1 for mediumsized and largesized 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.

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.
Q5. 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.

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
Answer.
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.
Sources of risk
The five different sources of risk are:

Project-specific risk
Competitive or competition risk
Industry-specific risk
International risk
Market risk

Let us discuss the sources of risk in detail.

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.

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.

Solution.
a) NPV can be computed using risk free rate. Table shows NPV calculation using the risk free rate.

Table : PV Using Risk Free Rate

Year
1
2
3
4

Cash flows (inflows)

PV factor at

PV of cash flows

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

10%
0.909
0.826
0.751
0.683

(inflows)
36,360
41,300
11,265
20,490
1,09,415

(1,00,000)
9,415

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

Table: NPV Using Risk-adjusted Discount Rate

Year
1
2
3
4

Cash flows (inflows)

PV factor at

PV of cash flows

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

20%
0.833
0.694
0.579
0.482

(inflows)
33,320
34,700
8,685
14,460
91,165
(100, 000)
(8, 835)

(1,00,000)

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.

Q6. Explain the objectives of Cash Management. Write about the Baumol model with their
assumptions.
(Explanation of objectives of cash management, Explanation of Baumol model with
assumptions)5,5
Answer.
Objectives of cash management

1) To make Payment According to Payment Schedule:Firm needs cash to meet its routine expenses including wages, salary, taxes etc. Following are
main advantages of adequate casha)To prevent firm from being insolvent.
b)The relation of firm with bank does not deteriorate.
c)Contingencies can be met easily.
d)It helps firm to maintain good relations with suppliers.
(2) To minimise Cash Balance:The second objective of cash management is to minimise cash balance. Excessive amount of
cash balance helps in quicker payments, but excessive cash may remain unused & reduces
profitability of business. Contrarily, when cash available with firm is less, firm is unable to
pay its liabilities in time. Therefore optimum level of cash should be maintain.
Baumol model with assumptions

Baumol model of cash management helps in determining a firm's optimum cash balance
under certainty. It is extensively used and highly useful for the purpose of cash management.
As per the model, cash and inventory management problems are one and the same.
William J. Baumol developed a model (The transactions Demand for Cash: An Inventory
Theoretic Approach) which is usually used in Inventory management & cash management.
Assumptions
There are certain assumptions or ideas that are critical with respect to the Baumol model of
cash management:

The particular company should be able to change the securities that they own into cash,
keeping the cost of transaction the same. Under normal circumstances, all such deals have

variable costs and fixed costs.

The company is capable of predicting its cash necessities. They should be able to do this
with a level of certainty. The company should also get a fixed amount of money. They

should be getting this money at regular intervals.

The company is aware of the opportunity cost required for holding cash. It should stay the

same for a considerable length of time.

The company should be making its cash payments at a consistent rate over a certain
period of time. In other words, the rate of cash outflow should be regular.