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Section A for financial management is shown below as a

sample.
Financial Management
Assignment A:

1) Explain why debt is usually considered the cheapest source of financing av

Ans:
Company can manage its required funds through debt or equity or
combination of both. Choosing an optimal capital structure different
company use different ratio of debt and equity. But question is how an
optimal capital structure can be formed. Basically the capital structure is
formed by considering the financial strength of the company and cost of
funds of different sources.
Many people say that retained earnings is the cheapest source of financing
but debt can be cheapest source of financing from different perspectives.
From the share holders perspective tax deductibility feature of debt finance
is lucrative. And from the lenders perspective debt is secured because
creditors get the preference of getting their principal and interest before
making any benefit to the share holders.
Tax deductibility feature of debt is the main point, on which we can say
debt is the cheapest source of financing.
There are some other points that may include with deductibility feature.
These are

Time value of money and preference of funds.

Dividends not payable to lenders
Interest rate.
 Let us consider an example to show how debt financing helps to reduce the
tax burden that is the tax deductibility features of interest.
Example: Suppose XYZ company take loan of $1000000from ABC bank
at the rate of 15%. Tax payable to the government is 30% of the income.
Income is = $500000
Only Equity is used
If there is no debt financing then XYZ company has to pay tax of total =
$500000 X 30% = $150000
After tax income = $ 500000 $150000 = $350000

If Debt and equity is used

On the other hand if company use debt financing then,
Interest on load amount = $1000000 X 15% = $150000
Taxable income is = $500000 $150000 = $350000
Tax payable = $350000 X .3 = $105000
After tax income is = $500000 $105000 = $395000

2) Differenciate between financial and business risks?

Ans:

The risk is the possibility of loss or danger. The equity shareholders have to go
through with two types of risk, i.e. Business Risk, and Financial Risk. The former
is the risk related to the business of the entity while the latter is the risk due to
the use of debt funds. However, if there will be no risk there will be no profit and
the higher the risk, the more will be the chances of getting high returns. In this
article, we have compiled the substantial differences between business risk and
financial risk considering various parameters.

Content: Business Risk Vs Financial Risk

1. Comparison Chart

2. Definition
3. Key Differences

4. Conclusion

The following are the major differences between business risk and financial
risk:

The uncertainty caused due to insufficient profits in the business due to

which the firm is not able to pay out expenses in time is known as Business
Risk. Financial Risk is the risk originating due to the use of debt funds by
the entity.

Business Risk can be evaluated by fluctuations in Earning Before Interest

and Tax. On the other hand, Financial Risk can be checked with the help of
leverage multiplier and Debt to Asset Ratio.

Business Risk is linked with the economic environment of business.

Conversely, Financial Risk associated with the use of debt financing.

Business Risk cannot be reduced while Financial Risk can be avoided if the
debt capital is not used at all.

Business Risk can be disclosed by the difference in net operating income

and net cash flows. In contrast to Financial Risk, which can be disclosed by
the difference in the return of equity shareholders.
Risk and Return are closely interrelated as you have heard many times that if you
do not bear risk, you will not get any profit. Business Risk is a comparatively
bigger term than Financial Risk; even financial risk is a part of the business risk.
Financial Risk can be ignored, but Business Risk cannot be avoided. The former
is easily reflected in EBIT while the latter can be shown in EPS of the company.
Definition of Financial Risk
Financial Risk is the uncertainty arising due to the use of debt finance in the
capital structure of the company. The capital structure of the company can be
made up of equity capital or preference capital or debt capital or the combination
 of any. The firm, whose capital structure contains debt finance are known as
Levered firms whereas Unlevered firms are the firms whose capital structure is
debt free.

Now, you may wonder that debt capital is one of the cheapest sources of funds,
then how will it become a risk for shareholders? Because at the time of winding
up of the company the creditors are given priority over the shareholders, and they
will be repaid first. So in this way, the risk arises that the company will not be
able to fulfil the financial obligations of the shareholders due to debt financing.
Moreover, financial risk does not end up here as it is a myriad of risks which are
given as under:

Market Risk: Risk arising due to the fluctuations in the financial assets.

Exchange Rate Risk: The risk arising out of the variations in the
currency rates.

Credit Risk: The risk emerging because of non-payment of debt by a

borrower.

Liquidity Risk: The risk originating as a result of a financial instrument

is not traded quickly in the market.

3) Discuss the different approaches of financing of working capital requireme

Ans:

The aggressive approach is a high-risk strategy of working capital

financing wherein short-term finances are utilized not only to finance the
temporary working capital but also a reasonable part of the permanent
working capital. In this approach of financing, the levels of inventory,
accounts receivables and bank balances are just sufficient with no cushion
for uncertainty. There is a reasonable dependence on the trade creditFixed
assets and a part of permanent working capital are financed by long-term
financing sources and the remaining part of permanent working capital and
total temporary working capital is only is financed by short-term financing
sources. It is explained in the equation below:
Long Term Funds will Finance = Fixed Assets + Part of Permanent
Working Capital
Short Term Funds will Finance = Remaining Part of Permanent Working
Capital + Temporary Working Capital

Advantages of Aggressive Strategy of Working Capital Financing

Lower Financing Cost, High Profitability: In this strategy, the cost of

interest is low because of the maximum usage of short term finances. There
are two reasons of this. Firstly, the rate of interest is cheaper and secondly,
in the off seasons, the loan can be repaid and hence, no idle funds. If the
operating cycle is moving smoothly, it is called most effective working
capital management.

Lower Carrying and Handling Cost: Lower level of inventory makes the
carrying and holding cost also go down and that directly affect the
profitability.

Highly Efficient Working Capital Management: The task of working capital

manager is to smoothly run the operating cycle of the company with the
lowest level of working capital. Precisely, that is what this strategy is all
about. If the strategy is successful with no dissatisfied stakeholders, there is
nothing better than this.

Disadvantages of Conservative Strategy of Working Capital Financing

Insolvency Risk: This strategy faces the high level of insolvency risk because
the permanent assets are financed by the short-term financing sources. To
maintain those permanent assets, the firm would need to be repeated
refinancing and renewals. It is not necessary that all the time the
refinancing is smooth. For any reason, if the financial institution rejects the
renewal, the firm will not be in a position to maintain those permanent
assets and will have to forcibly sell them. If failed in realizing those assets,
the options left is liquidation. Liquidating the permanent working capital is
very difficult as it consists of accounts receivables and inventory.
Lost Opportunities and Unexpected Shocks: Since, there is no cushions or
margin in this strategy of financing, sudden big contracts of sales are not
possible to execute. On the other hand, if there are other uncertainties like
delay in an abnormal raw material acquisition, machinery break downs etc,
the firm will disturb the business operating cycle and therefore will face
sustainability problems.