NARANLALA SCHOOL OF INDUSTRIAL MANAGEMENT

AND COMPUTER SCIENCE,

NAVSARI.
MBA PROGRAMME
AFFILIATED GUJARAT TECHNOLOGICAL UNIVERSITY,

AHMEDABAD.

ASSIGNMENT
FOR

FINANCIAL
MANAGEMENT (FM)
SUBMITTED TO
MR. DIVYESH GANDHI
SUBMITTED BY
GROUP NO : 3

ACHARYA KRUTIKA (157990592001)

PATEL JIGNESHA (157990592027)
SINGH NEHA (157990592052)
SHAH MITI (157990592047)
PUJARI POOJA (157990592041)
1. Explain net income approach (NI) and net operating income (NOI)
approach of capital structure in brief?
Answer: NET INCOME APPROACH

According to this approach, the cost of debt ,r d and the cost of equity , rE, remain unchanged
when D/E varies. The constancy of r D and rE with respect to D/E means that r A the average
cost of capital ,measured as
r A =r D

] [

D
D
+r E
D+ E
D+ E

declines as D/E increases .This happens because when D/E increases, r D , which is lower than
rE ,receives a higher weight in the calculation of rA

Assumptions of Net Income Approach

Net Income Approach makes certain assumptions which are as follows:
1. Increase in debt will not affect the confidence levels of the investors.
2. The cost of debt is less than cost of equity.
3. There are no taxes levied.

NET OPERATING INCOME APPROACH

According to the net operating approach ,the overall capitalisation rate and the cost of debt
remain constant for all degrees of leverage .In Equation
r A =r D

] [

D
E
+r E
D+ E
D+ E

rA and rD are constant for all degrees of leverage .Given this, the cost of equity can be
expressed as:
r E=r A + ( r A + r D ) (D/ E)

The critical premise of this approach is that the market capitalises the firm as a whole at a
discount rate which is independent of the firms debt-equity ratio. As a consequence1 the
division between debt and equity is irrelevant. An increase in the use of debt funds which are
apparently cheaper is offset by an increase in the equity capitalisation rate. This happens
because equity investors seek higher compensation as they are exposed to greater risk arising
from increase in the degree of leverage. They raise the capitalisation rate

rE

price-earnings
ratio,
P/E),
as
the
degree
starting with Eq. (19.1), Eq. (19.2) is derived as follows:

increases.

of

leverage

(lower the

r A =r D

rE

rE

] [

rA

D
r
D
D+ E

D
E
+r E
D+ E
D+ E

D
D+ E

]=

E
D+ E

][

D+ E
E

]= [
rA

D
D+ E

]
][

D+ E
E

r E=r A + ( D/ E ) (r A r D )

Assumptions of Net Operating Income Approach

Net Operating Income Approach makes certain assumptions which are as follows:
1. The overall capitalization rate remains constant irrespective of the degree of leverage.
At a given level of EBIT, value of the firm would be EBIT/Overall capitalization
rate.
2. Value of equity is the difference between total firm value less value of debt i.e.
Value of equity = total value of the firm value of debt
3. WACC (Weightage Average Cost of Capital) remains constant; and with the increase in
debt, the cost of equity increases. Increase in debt in the capital structure results in
increased risk for shareholders. As a compensation of investing in highly leveraged
company, the shareholders expect higher return resulting in higher cost of equity.

2. Give meaning of leasing, hire purchase and venture capital.

Distinguish between leasing and hire purchase?
Answer : A lease is a contractual arrangement calling for the lessee (user) to pay the lessor
(owner) for use of an asset. property, buildings and vehicles are common assets that are leased.
industrial or business equipment is also leased.

Type of Leasing:
The following are the major types of leasing as follows:

A. Lease based on the term of lease

1.

Finance Lease: Financing lease is also known as full payout lease. It is one of the longterm leases and cannot be cancelled before the expiry of the agreement. It means a lease for
terms that approach the economic life of the asset, the total payments over the term of the
lease are greater than the leasers initial cost of the leased asset.

2.

Operating Lease: Operating lease is also termed as service lease. Operating lease is one
of the short-term and cancelable leases. It means a lease for a time shorter than the economic
period of the assets, normally the payments over the term of the lease are less than the
leasers initial cost of the leased asset.

B. Lease based on the method of lease

1.

Sale and lease back: Sale and lease back is a lease under which the leasee sells an asset for
cash to a potential leaser and then leases back the same asset, making fixed periodic
payments for its use. It may be in the firm of operating leasing or financial leasing. It is
useful process of leasing which enables the financial liquidity of the company.

2. Direct lease: When the lease belongs to the proprietor of the assets and users of the assets
with direct relationship, it is called as direct lease. Direct lease may be Dipartite lease
(Two parties in the lease) or Tripartite lease. (Three parties in the lease).

C. Lease based in the parties involved

1.

Single investor lease: single investor lease is the kind of lease which belongs to only two
parties such as leaser. It consists of only one investor (owner). Normally, all types of leasing
such as operating, financially, sale and lease back and direct lease fall in this categories.

2.

Leveraged lease: This category of lease is used to obtain the high level capital cost of
assets and equipments. There are three parties involved in this lease; the leaser, the lender

and the lessee. In the leverage lease, the leaser acts as equity participant supplying a fraction
of the total cost of the assets while the lender supplies the major part.

D. Lease based in the area

1.

Domestic lease: In the lease contract, if both the parties belong to the domicile of the same
country it is known as domestic leasing.

2.

International lease: international leasing is one in which the lease transaction and the
leasing parties belong to the domicile of different countries.

Hire purchase is a method of financing of the fixed asset to be purchased on future date.
Under this method of financing the purchase price is paid in installments. ownership of the
asset is transferred after the payment of the last installment.

Characteristics
1. Possession
2. Ownership upon the full payment
3. Instalment buying
4. Social innovation
5. Expands economy
6. Additional income

Venture capital is a type of funding for a new or growing business. It usually comes from
venture capital firms that specialize in building high risk financial portfolios with venture
capital , the venture capital firm gives funding to the startup. This is most commonly found in
high growth technology industries like biotech and software.

FEATURES
The main features of venture capital are as under:
1. Long-time horizon: In general, venture capital activities take a longer time such as 5-10
years at a minimum to come out commercially successful; one should, thus, be able to wait
patiently for the outcome of the venture.
2. Lack of liquidity: Since the project is expected to run at start-up stage for several years,
liquidity may be a greater problem.

3. High risk: The risk of the project is related with management, product and operations.
4. High-tech: A venture capitalist looks not only for high-technology but the innovativeness
through which the project can thrive.
5. Equity participation and capital gains: A venture capitalist invests his money in terms of
equity. He does not look for any dividend or other benefits, but when the project
commercially succeeds, then he can enjoy the capital gain which is his main benefit.
6. Participation in management: Dissimilar to the traditional financier or banker, the venture
capitalist can provide managerial expertise to entrepreneurs besides money.

Difference between Lease and Hire Purchase:

SR.
NO
1.

POINT
OF LEASE
DIFFERENCE
Ownership of the In lease, ownership lies
asset
with the lessor. The lessee
has the right to use the
equipment and does not
have an option to purchase.

2.

Depreciation

3.

Rental purchase

4.

Duration

5.

Tax impact

In lease funding, the

depreciation is demanded
as an expense in the books
of lessor.
The lease rentals cover the
cost of using an asset.
Usually, it is derived with
the cost of an asset over the
asset life

HIRE PURCHASE
In hire purchase, the hirer has
the choice to purchase. The
hirer becomes the owner of
the
asset/equipment
immediately after the last
instalment is paid.
The depreciation claim is
allowed to the hirer in case of
hire purchase deal.
In the process of hire
purchase,
instalment
is
inclusive of the principal
amount and the interest for
the time period the asset is
used.

Normally lease agreements

are done for longer Hire Purchase agreements are
duration and for big assets done generally for shorter
duration and cheaper assets
such as land, property.
such as hiring a car or
machinery.
In lease agreement, the In hire purchase, the hirer
total lease rentals are claims the depreciation of

6.

7.

revealed as expenditure by asset as an expense.

the lessee.
Repairs
and Repairs and maintenance of
maintenance
the asset in financial lease In hire purchase, hirer is
is the responsibility of the responsible for maintenance.
lessee but in operating
lease, it is the responsibility
of the lessor.
Extent of finance

Lease financing can be

called
the
complete
financing choice in which
no down payments are
required

in
hire
purchase,
the
normally 20 to 25 % margin
money is required to be paid
upfront by the hirer.

3. Define working capital. Distinguish between permanent and

temporary working capital?
Answer : Working capital is the amount of a company's current assets minus the amount of its
current liabilities .
Working capital = current assets current liability
For example, if a company's balance sheet dated June 30 reports total current assets of
$323,000 and total current liabilities of $310,000 the company's working capital on June 30
was $13,000. If another company has total current assets of $210,000 and total current
liabilities of $60,000 its working capital is $150,000.
This permanent need and the variable requirements are the basis for a convenient
classification of working capital as regular, permanent, or variable as follows:
1. Permanent or fixed working capital:
A part of the investment in current assets is as permanent as the investment in fixed assets. It
covers the minimum amount necessary for maintaining the circulation of the current assets.
Working capital invested in the circulation of the current assets and keeping it moving is
permanently locked up.
2. Variable working capital:
The variable working capital fluctuates with the volume of business.
The distinction between permanent and variable working capital is important in arranging the
finance for an enterprise.

DIFFERENCE BETWEEN PERMANENT AND TEMPORARY WORKING

CAPITAL

SR.N
O

PERMANENT
CAPITAL

1.

Permanent working capital is defined

as the part of the total capital of the
enterprise which is invested in long
term assets.
Permanent
working
capital
investments include durable goods,

2.

WORKING TEMPORARY
CAPITAL

WORKING

Temporary Working Capital refers

to the capital, which is used to
perform day to day business
operations.
Temporary
Working
capital
comprises of short term assets and

3.

4.
5.

6.

7.

which will remain in the business for

more than one accounting period.
Permanent working capital is
relatively illiquid because it cannot
be converted into cash easily.

liabilities of the business.

Permanent working capital is used to

buy non-current assets for business.
Permanent working capital serves
strategic objectives of the entity
which includes long term business
plans.
In permanent working capital the
company needs the amount of
current assets and current liability
required at all times by a company.

Temporary Working capital is used

for short term financing
Temporary working capital, which
serves.

Company with permanent working

capital needs require additional
financing to fund the gap between
the time it takes to convert assets to
cash and liability to payment.

Temporary
working
investments which are
convertible into cash.

capital
readily

Temporary working capital is the

remainder the additional balance of
working capital that comes and goes
with business cycle, the time of year
(seasonality) or simply day to day
events.
Business may require additional
working capital only at some points
during the year. For example during
holiday season a retail business may
require additional funds to pay for
extra inventory and additional staff.

To carry on a business, a certain minimum level of working capital is necessary on a

continuous and uninterrupted basis. For all practical purposes, this requirement has to be met
permanently as with other fixed assets. This requirement is referred to as permanent or fixed
working capital. Any amount over and above the permanent level of working capital is
temporary, fluctuating or variable working capital. The position of the required working
capital is needed to meet fluctuations in demand consequent upon changes in production and
sales as a result of seasonal changes.

4. What do you understand by term internal rate of return? Is it the

same as the value determine under net present value method?
Answer : INTERNAL RATE OF RETURN
The internal rate of return (IRR)of a project is the discount rate which makes its NPV equal to
zero. Put differently, it is the discount rate which equates the present value of future cash
flows with the initial investment. It is the value of r in the following equation:
Ct

Investment =

(1+r )t

t =1

Where,

Ct

= cash flow at the end of the year t

r = internal rate of return

n = life of the project
In the NPV calculation we assume that the discount rate (cost of capital) is known and
determine the NPV. In the IRR calculation, we set the NPV equal to zero and determine the
discount rate that satisfies this condition.

NET PRESENT VALUE

The net present value (NPV) of a project is the sum of the present values of all the cash flows
positive as well as negative that are expected to occur over the life of the project. The
general formula of NPV is:
Ct

(1+r ) initial investment

NPV =

t=1

Where,

Ct

= cash flow at the end of the year t

r = internal rate of return

n = life of the project
To illustrate the calculation of IRR, consider the cash flows of a project being evaluated by
Techtron Limited:
Year
Cash flow

0
(100000)

1
30000

2
30000

3
40000

4
45000

The IRR is the value of r which satisfies the following equation:

100000=

30000 30000 40000 45000

+
+
+
(1+r )1 ( 1+ r )2 ( 1+r )3 ( 1+ r )4

The calculation of r involves a process of trial and error. We try different values of r till we
find the right-handed side of the above equation is equal to 100,000. Let us assume that
r=15%.
30000 30000 40000 45000
+
+
+
( 1.15 )1 (1.15)2 (1.15 )3 ( 1.15 )4 =100,802

This value is slightly higher than 100,000. So we will know increase the value of r from 15%
to 16%.
30000 30000 40000 45000
+
+
+
( 1.16 )1 (1.16)2 ( 1.16 )3 ( 1.16 ) 4

= 98,641

This value is less than 100000, we conclude that the value of r lies between 15% to 16%.
If a single estimate of r is needed, use the following procedure:
1. Determine the NPV of the two closet rates of return.
(NPV/ 15%) = 100802-100000 = 802
(NPV/ 16%) = 98641 100000 = -1359
2. Find the sum of the absolute values of the net present values obtained in step 2:

802 + 1359 = 2,161

3. Calculate ratio of the NPV of the smaller discount rate, identified in step 1, to the sum
obtained in step 2:
802
=0.37
2161

4. Add the number obtained in step 3 to the smaller discount rate:

15 + 0.37 = 15.37
The IRR, calculated in this manner, is a very close approximation to the true internal rate
of return.
The decision rule for IRR is as follows:
Accept : If the IRR is greater than the cost of capital
Reject : If the IRR is less than the cost of capital
The spreadsheet calculation is given below:
1
2
3

A
Year
Cash flow

B
C
0
1
-100000
30000
= IRR (B2:F2)

D
2
30000

E
3
40000
15.3%

F
4
45000

Net Present value and Internal Rate of Return both are the methods of discounted cash
flows, in this way we can say that both considers the time value of money. Similarly, the two
methods, considers all cash flows over the life of the project.
During the computation of Net Present value, the discount rate is assumed to be known
and it remains constant. But, while calculating IRR, the NPV is fixed at 0 and the rate which
fulfils such a condition is known as IRR.

5. Discuss the various sources of working capital finance?

Answer : The two segments of working capital viz., regular or fixed or permanent and
variable are financed by the long-term and the short-term sources of funds respectively. The
main sources of long-term funds are shares, debentures, term- loans, retained earnings etc.
The sources of short-term funds used for financing variable part of working capital
mainly include the following:
1. Loans from commercial banks
2. Public deposits

3. Trade credit
4. Factoring
5. Discounting bills of exchange
6. Bank overdraft and cash credit
7. Advances from customers
8. Accrual accounts
These are discussed in turn.

1. Loans from Commercial Banks:

Small-scale enterprises can raise loans from the commercial banks with or without security.
This method of financing does not require any legal formality except that of creating a
mortgage on the assets. Loan can be paid in lump sum or in parts. The short-term loans can
also be obtained from banks on the personal security of the directors of a country.
Such loans are known as clean advances. Bank finance is made available to small- scale
enterprises at concessional rate of interest. Hence, it is generally a cheaper source of financing
working capital requirements of enterprise. However, this method of raising funds for working
capital is a time-consuming process.

2. Public Deposits:
Often companies find it easy and convenient to raise short- term funds by inviting
shareholders, employees and the general public to deposit their savings with the company. It is
a simple method of raising funds from public for which the company has only to advertise and
inform the public that it is authorized by the Companies Act 1956, to accept public deposits.
Public deposits can be invited by offering a higher rate of interest than the interest allowed on
bank deposits. However, the companies can raise funds through public deposits subject to a
maximum of 25% of their paid up capital and free reserves.
But, the small-scale enterprises are exempted from the restrictions of the maximum limit
of public deposits if they satisfy the following conditions:
The amount of deposit does not exceed Rs. 8 lakhs or the amount of paid up capital whichever
is less.
(i) The paid up capital does not exceed Rs. 12 lakhs.
(ii) The number of depositors is not more than 50%.

(iii) There is no invitation to the public for deposits.

The main merit of this source of raising funds is that it is simple as well as cheaper. But, the
biggest disadvantage associated with this source is that it is not available to the entrepreneurs
during depression and financial stringency.

3. Trade Credit:
Just as the companies sell goods on credit, they also buy raw materials, components and other
goods on credit from their suppliers. Thus, outstanding amounts payable to the suppliers i.e.,
trade creditors for credit purchases are regarded as sources of finance. Generally, suppliers
grant credit to their clients for a period of 3 to 6 months.
Thus, they provide, in a way, short- term finance to the purchasing company. As a matter of
fact, availability of this type of finance largely depends upon the volume of business. More the
volume of business more will be the availability of this type of finance and vice versa.
Yes, the volume of trade credit available also depends upon the reputation of the buyer
company, its financial position, degree of competition in the market, etc. However, availing of
trade credit involves loss of cash discount which could be earned if payments were made
within 7 to 10 days from the date of purchase of goods. This loss of cash discount is regarded
as implicit cost of trade credit.

4. Factoring:
Factoring is a financial service designed to help firms in managing their book debts and
receivables in a better manner. The book debts and receivables are assigned to a bank called
the 'factor' and cash is realized in advance from the bank. For rendering these services, the fee
or commission charged is usually a percentage of the value of the book debts/receivables
factored.
This is a method of raising short-term capital and known as 'factoring'. On the one hand, it
helps the supplier companies to secure finance against their book debts and receivables, and
on the other, it also helps in saving the effort of collecting the book debts.
The disadvantage of factoring is that customers who are really in genuine difficulty do not get
the opportunity of delaying payment which they might have otherwise got from the supplier
company.
In the present context where industrial sickness is spreading like an epidemic, the reason for
which particularly in SSI sector being delayed payments from their suppliers; there is a clearcut rationale for introduction of factoring system. There has been some progress also on this
front.
The recommendations of the Study Group (RBI 1996) to examine the feasibility of setting up
of factoring organizations in the country, under the Chairmanship of Shri C. S.
Kalyanasundaram have been accepted by the Government of India. The Group is of the view

that factoring for SSI units could prove to be mutually beneficial to both Factors and SSI units
and Factors should make every effort to orient their strategy to crystallize the potential
demand from the sector.

5. Discounting Bills of Exchange:

When goods are sold on credit, bills of exchange are generally drawn for acceptance by the
buyers of goods. The bills are generally drawn for a period of 3 to 6 months. In practice, the
writer of the bill, instead of holding the bill till the date of maturity, prefers to discount them
with commercial banks on payment of a charge known as discount.
The term 'discounting of bills' is used in case of time bills whereas the term, 'purchasing of
bills' is used in respect of demand bills. The rate of discount to be charged by the bank is
prescribed by the Reserve Bank of India (RBI) from time to time. It generally amounts to the
interest for the period from the date of discounting to the date of maturity of bills.
If a bill is dishonoured on maturity, the bank returns the dishonoured bill to the company who
then becomes liable to pay the amount to the bank. The cost of raising finance by this method
is the amount of discount charged by the bank. This method is widely used by companies for
raising short-term finance.

6. Bank Overdraft and Cash Credit:

Overdraft is a facility extended by the banks to their current account holders for a short-period
generally a week. A current account holder is allowed to withdraw from its current deposit
account upto a certain limit over the balance with the bank. The interest is charged only on the
amount actually overdrawn. The overdraft facility is also granted against securities.
Cash credit is an arrangement whereby the commercial banks allow borrowing money up to a
specified-limit known as 'cash credit limit.' The cash credit facility is allowed against the
security. The cash credit limit can be revised from time to time according to the value of
securities. The money so drawn can be repaid as and when possible.
The interest is charged on the actual amount drawn during the period rather on limit
sanctioned. The rate of interest charged on both overdraft and cash credit is relatively higher
than the rate of interest given on bank deposits. Arranging overdraft and cash credit with the
commercial banks has become a common method adopted by companies for meeting their
short- term financial, or say, working capital requirements.

7. Advances from Customers:

One way of raising funds for short-term requirement is to demand for advance from one's own
customers. Examples of advances from the customers are advance paid at the time of booking
a car, a telephone connection, a flat, etc. This has become an increasingly popular source of
short-term finance among the small business enterprises mainly due to two reasons.

First, the enterprises do not pay any interest on advances from their customers. Second, if any
company pays interest on advances, that too at a nominal rate. Thus, advances from customers
become one of the cheapest sources of raising funds for meeting working capital requirements
of companies.

8. Accrual account:
Generally, there is a certain amount of time gap between incomes is earned and is actually
received or expenditure becomes due and is actually paid. Salaries, wages and taxes, for
example, become due at the end of the month but are usually paid in the first week of the next
month. Thus, the outstanding salaries and wages as expenses for a week help the enterprise in
meeting their working capital requirements. This source of raising funds does not involve any
cost.

6. Under what circumstances do the net present value and the internal
rate of return differ? Which method would you prefer and why?
Answer: The net present value (NPV) of a project is the sum of the present values of
all the cash flows positive as well as negative that are expected to occur over the life of
the project. The general formula of NPV is:
Ct

NPV =

(1+r )t initial investment

t=1

Where,

Ct

= cash flow at project the end of the year t

r = internal rate of return

n = life of the
The internal rate of return (IRR)of a project is the discount rate which makes its NPV
equal to zero. Put differently, it is the discount rate which equates the present value of future
cash flows with the initial investment. It is the value of r in the following equation:
Ct

Investment =

(1+r )t

t =1

Where,

Ct

= cash flow at the end of the year t

r = internal rate of return

n = life of the project
The basic difference between NPV and IRR are presented below:
1. The aggregate of all present value of the cash flows of an asset, immaterial of positive
or negative is known as NPV. IRR is the discount rate at which NPV = 0.
2. The calculation of NPV is made in absolute terms as compared to IRR which is
computed in percentage terms.
3. The purpose of calculation of NPV is to determine the surplus from the project,
whereas IRR represents the state of no profit no loss.
4. When the timing of cash flows differs, the it will show multiple IRR which will cause
confusion. This is not with the case of NPV.
5. When the amount of initial investment is high, the NPV will always show large cash
inflows while IRR will represents the profitability of the project irrespective of the
initial invest. So, the IRR will show better result.
6. Intermediate cash flows are reinvested at the cut off rate in NPV whereas in IRR such
an investment is made at the rate of IRR.
7. Decision making is easy in NPV while in IRR does not helps in making decision.
In conclusion, NPV is a better method for evaluating mutually exclusive projects than the
IRR method. The NPV method employs more realistic reinvestment rate assumptions, is a
better indicator of profitability and shareholder wealth, and mathematically will return the
correct accept-or-reject decision regardless whether the project experiences non-normal cash
flows or if differences in project size or timing of cash flows exist.