ROUNAK KHANDELWAL

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

 Strategies Policies on utilization of spontaneous finance effectively

b) 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.
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. 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.
Dividend policy influences the dividend yield on shares. Dividend yield is an important determinant
of an investors attitude towards the security (stock) in his portfolio management decisions. Dividend
is that portion of profits of a company which is distributed among its shareholder according to the
resolution passed in the meeting of the Board of Directors.
2) Explain about the doubling period and present value. Solve the below given problem:
Answer: Explanation of doubling period: 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.
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)}.
Solving the 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?

Solution:- FV n mXn PVM m = 12/3 = 4 (quarterly compounding)

=1000 (1+0.10/4)4*2
=1000 (1+0.10/4)8
The amount of Rs. 1000 after 2 years would be Rs. 1218.
Note- The generalized formula for these calculation FV n mXn PVM
Where, FVn= future value after n years
PV = cash flow today
i = nominal interest rate per annum
m = number of times compounding is done during a year
n = number of years for which compounding is done
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.
The present value of a sum to be received at a future date is determined by discounting the future
value at the interest rate that the money could earn over the period. This process is known as
discounting.

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

returns may not be constant. In such cases, the PV is calculated.

Capital recovery factor- Capital recovery factor is the annuity of an investment for a
specified time according rate of interest.

3) Write short notes on:

a) Operating leverage: It 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. 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 according Marginal contribution/EBIT) & (Revenue Variable
costs)/(Revenue Variable costs Fixed costs)
b) 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 as opposed to operating leverage relates to the financing activities of a firm. It
measures the effect of earnings before interest and tax (EBIT) on earnings per share (EPS) of the
company. Financial leverage refers to the mix of debt and equity in the capital structure of the
firm. It is the firms ability to use fixed financial charges to increase the effects of changes in
EBIT on the EPS. 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.

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

structure, is known as trading on equity or financial leverage

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 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

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
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

NET OPERATING INCOME EBIT

Rs. 1,00,000 Rs.1,00,000

INTEREST ON DEBENTURES I

NIL

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

TOTAL VALUE OF FIRM V

Rs. 6,66,667 Rs. 7,50,000

Rs. 25,000

Rs. 2,50,000

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.
5) Explain all the sources of risk in capital budgeting with examples.

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

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

Market risk: Defined as the measure of the unpredictability of a given stock value. It has a
direct influence on stock prices and is measured by the effect of the project on the beta of the

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

technology had to shut down their operations.

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.

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

PV of cash inflows: Rs.1,09,415

PV of cash outflows: Rs.1,00,000
NPV:
ii)

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

The project would be acceptable when no allowance is made for risk.

Interpretation:- 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.
6) Explain the objectives of Cash Management. Write about the Baumol model with their
assumptions.
Answer: Explanation of objectives of cash managementa. 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. The other
advantage of meeting the payments on time is that it prevents bankruptcy that arises out of the
firms inability to honor its commitments. At the same time, care should be taken not to keep
large cash reserves as it involves high cost.
b. 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 nonearning 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

 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:

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.
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.