Master of Business Administration- MBA Semester 2

MB0045 – Financial Management - 4 Credits

(Book ID: B1134)

Assignment Set- 1 (60 Marks)

Note: Each question carries 10 Marks. Answer all the questions.

Q.1 Write the short notes on 5X2= (10 Marks)

1. Financial management
2. Financial planning
3. Capital structure
4. Cost of capital
5. Trading on equity.

1. Financial management: Financial Management is art and science of managing

money. It embraces all managerial activities that are required to procure funds at the least
cost and their effective deployment Traditionally, Financial Management was considered
a branch of knowledge with focus on procurement of funds. The core of modern
approach evolved around the procurement of the least cost funds and its effective
utilization for maximization of shareholders wealth.
The most admired Indian companies are Reliance and Infosys. They employ the best
technology, produce good quality goods or render services at the least cost and
continuously contribute to the shareholders wealth. The three core elements of financial
management are:Financial control, Financial Planning and Financial decisions.
Financial planning is the assurance of capital investment to procure real assets to run the
business smoothly.
Financial control involves management of day to day business of the company by
receiving or collecting money due from clients or debtors and payments to various
suppliers or creditors.
Financial decisions: decisions as regards to the funds that are needed by the company
from various sources namely debt and equity. How much is needed from these sources
would be decided for formulating the financial plan.
2. Financial planning:
In business, a financial plan can refer to the three primary financial statements (balance
sheet, income statement, and cash flow statement) created within a business plan.
Financial forecast or financial plan can also refer to an annual projection of income and
expenses for a company, division or department. A financial plan can also be an
estimation of cash needs and a decision on how to raise the cash, such as through
borrowing or issuing additional shares in a company
Financial planning is the assurance of capital investment to procure real assets to run the
business smoothly. A financial plan can also be an investment plan, which allocates
savings to various assets or projects expected to produce future income, such as a new
business or product line, shares in an existing business, or real estate Financial planning
is the task of determining how a business will afford to achieve its strategic goals and
objectives. Financial plan can be a budget, a plan for spending and saving future income..
While a financial plan refers to estimating future income, expenses and assets, a
financing plan or finance plan usually refers to the means by which cash will be
acquired to cover future expenses, for instance through earning, borrowing or using saved
cash.

3. Capital structure
In finance, capital structure refers to the way a corporation finances its assets through
some combination of equity, debt, or hybrid securities. The mix of long term sources of
funds like debentures, loans, preference shares and retained earnings in different ratios. A
firm's capital structure is then the composition or 'structure' of its liabilities. For example,
a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-
financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this
example is referred to as the firm's leverage. In reality, capital structure may be highly
complex and include dozens of sources. In short, it is the financing plan of the company.
With the object of maximizing the value of the equity share, by using correct proportion
of debt and equity which will aim achieving the firm objective. The value of the company
is dependant on its expected future earnings and the required rate of return. The proper
mix of funs is referred to as optimal capital structure. The caital structure decisions
include debt-equity mix and dividend decisions.
Capital structure can be of various kinds as described below:

- Horizontal capital structure: the firm has zero debt component in the structure
mix. Expansion of the firm takes through equity or retained earnings only.

- Vertical capital structure: the base of the structure is formed by a small

amount of equity share capital. This base serves as the foundation on which
the super structure of preference share capital and debt is built.
 - Pyramid shaped capital structure: this has a large proportion consisting of
equity capita; and retained earnings.

- Inverted pyramid shaped capital structure: this has a small component of

equity capital, reasonable level of retained earnings but an ever-increasing
component of debt.

SIGNIFICANCE OF CAPITAL STRUCTURE:

- Reflects the firm’s strategy

- Indicator of the risk profile of the firm
- Acts as a tax management tool
- Helps to brighten the image of the firm.

FACTORS INFLUENCING CAPITAL STRUCTURE:

- Corporate strategy
- Nature of the industry
- Current and past capital structure

4. Cost of capital
The cost of capital is a term used in the field of financial investment to refer to the cost
of a company's funds (both debt and equity), or, from an investor's point of view "the
shareholder's required return on a portfolio of all the company's existing securities. For an
investment to be worthwhile, the expected return on capital must be greater than the cost
of capital. The cost of capital is the rate of return that capital could be expected to earn in
an alternative investment of equivalent risk. A company not being able to meet these
demands may face the risk of investors taking back their investments thus leading to
bankruptcy. Loans and debentures come with a pre-determined interest rate. Preference
shares also have a fixed rate of dividend while equity holders expect a minimum return of
dividend, based on their risk perception and the company’s past performance in terms of
pay-out dividends. Given below are costs of different sources of finance:
1. Cost of debentures: the cost of debenture is the discount rate which equates the
net proceeds from issue of debentures to the expected cash outflows.
2. Cost of term loans: term loans are taken from banks or financial institutions at a
pre-determined interest rate for a specified number of years. The cost of term
loans is equal to the interest rate multiplied by 1-tax rate.
3. Cost of preference capital: the cost of preference share Kp is the discount rate
which equates the proceeds from preference capital issue to the dividend and
principal repayments.
4. Cost of equity capital: Equity shareholders do not have a fixed rate of return on
their investment. There is no legal requirement (unlike in the case of loans or
 debentures where the rates are governed by the deed) to pay regular divisons to
them.

5. Trading on equity
In finance, equity trading is the buying and selling of company stock shares.
Trading on equity occurs when a corporation uses bonds, other debt, and preferred stock
to increase its earnings on common stock. For example, a corporation might use long
term debt to purchase assets that are expected to earn more than the interest on the debt.
The earnings in excess of the interest expense on the new debt will increase the earnings
of the corporation’s common stockholders. The increase in earnings indicates that the
corporation was successful in trading on equity.
If the newly purchased assets earn less than the interest expense on the new debt, the
earnings of the common stockholders will decrease.

Shares in large publicly-traded companies are bought and sold through one of the major
stock exchanges, such as the New York Stock Exchange, London Stock Exchange or
Tokyo Stock Exchange, which serve as managed auctions for stock trades. Stock shares
in smaller public companies are bought and sold in over-the-counter (OTC) markets.

Equity trading can be performed by the owner of the shares, or by an agent authorized to
buy and sell on behalf of the share's owner. Proprietary trading is buying and selling for
the trader's own profit or loss. In this case, the principal is the owner of the shares.
Agency trading is buying and selling by an agent, usually a stock broker, on behalf of a
client. Agents are paid a commission for performing the trade.

Major stock exchanges have market makers who help limit price variation (volatility) by
buying and selling a particular company's shares on their own behalf and also on behalf
of other clients.

Q.2 a. Write the features of interim divined and also write the factors (08 Marks)
Influencing divined policy?

Usually, board of directors of company declares dividend in annual general meeting after
finding the real net profit position. If boards of directors give dividend for current year
before closing of that year, then it is called interim dividend. This dividend is declared
between two annual general meetings.
Before declaring interim dividend, board of directors should estimate the net profit
which will be in future. They should also estimate the amount of reserves which will
deduct from net profit in profit and loss appropriation account. If they think that it is
sufficient for operating of business after declaring such dividend. They can issue but after
completing the year, if profits are less than estimates, then they have to pay the amount of
declared dividend. For this, they will have to take loan. Therefore, it is the duty of
directors to deliberate with financial consultant before taking this decision.

Accounting treatment of interim dividend in final accounts of company :-

# First Case : Interim dividend is shown both in profit and loss appropriation account
and balance sheet , if it is outside the trial balance in given question.

( a) It will go to debit side of profit and loss appropriation account

(b) It will also go to current liabilities head in liabilities side.

# Second Case: Interim dividend is shown only in profit and loss appropriation account,
if it is shown in trial balance.

( a) It will go only to debit side of profit and loss appropriation account.

If in final declaration is given outside of trial balance and this will be proposed dividend
and interim dividend in trial balance will be deducted for writing proposed dividend in
profit and loss appropriation account and balance sheet of company, because if we will
not deducted interim dividend, then it will be double deducted from net profit that is
wrong and error shows when we will match balance sheets assets with liabilities.

Factors affecting dividend policy.

The dividend decision is difficult decision because of conflicting objectives and also
because of lack of specific decision-making techniques. It is not easy to lay down an
optimum dividend policy which would maximize the long-run wealth of the shareholders.
The factors affecting dividend policy are grouped into two broad categories.

1. Ownership considerations
2. Firm-oriented considerations

Ownership considerations: Where ownership is concentrated in few people, there are no

problems in identifying ownership interests. However, if ownership is decentralized on a
wide spectrum, the identification of their interests becomes difficult.

Various groups of shareholders may have different desires and objectives. Investors
gravitate to those companies which combine the mix of growth and desired dividends.
Firm-oriented considerations: Ownership interests alone may not determine the
dividend policy. A firm’s needs are also an important consideration, which include the
following:

• Contractual and legal restrictions

• Liquidity, credit-standing and working capital
• Needs of funds for immediate or future expansion
• Availability of external capital.
• Risk of losing control of organization
• Relative cost of external funds
• Business cycles
• Post dividend policies and stockholder relationships.

1. Stability of Earnings. The nature of business has an important bearing on the dividend
policy. Industrial units having stability of earnings may formulate a more consistent
dividend policy than those having an uneven flow of incomes because they can predict
easily their savings and earnings. Usually, enterprises dealing in necessities suffer less
from oscillating earnings than those dealing in luxuries or fancy goods.

2. Age of corporation. Age of the corporation counts much in deciding the dividend
policy. A newly established company may require much of its earnings for expansion and
plant improvement and may adopt a rigid dividend policy while, on the other hand, an
older company can formulate a clear cut and more consistent policy regarding dividend.

3. Liquidity of Funds. Availability of cash and sound financial position is also an

important factor in dividend decisions. A dividend represents a cash outflow, the greater
the funds and the liquidity of the firm the better the ability to pay dividend. The liquidity
of a firm depends very much on the investment and financial decisions of the firm which
in turn determines the rate of expansion and the manner of financing. If cash position is
weak, stock dividend will be distributed and if cash position is good, company can
distribute the cash dividend.

4. Extent of share Distribution. Nature of ownership also affects the dividend decisions.
A closely held company is likely to get the assent of the shareholders for the suspension
of dividend or for following a conservative dividend policy. On the other hand, a
company having a good number of shareholders widely distributed and forming low or
medium income group, would face a great difficulty in securing such assent because they
will emphasize to distribute higher dividend.

5. Needs for Additional Capital. Companies retain a part of their profits for
strengthening their financial position. The income may be conserved for meeting the
increased requirements of working capital or of future expansion. Small companies
usually find difficulties in raising finance for their needs of increased working capital for
expansion programmes. They having no other alternative, use their ploughed back profits.
Thus, such Companies distribute dividend at low rates and retain a big part of profits.
6. Trade Cycles. Business cycles also exercise influence upon dividend Policy. Dividend
policy is adjusted according to the business oscillations. During the boom, prudent
management creates food reserves for contingencies which follow the inflationary period.
Higher rates of dividend can be used as a tool for marketing the securities in an otherwise
depressed market. The financial solvency can be proved and maintained by the
companies in dull years if the adequate reserves have been built up.

7. Government Policies. The earnings capacity of the enterprise is widely affected by the
change in fiscal, industrial, labour, control and other government policies. Sometimes
government restricts the distribution of dividend beyond a certain percentage in a
particular industry or in all spheres of business activity as was done in emergency. The
dividend policy has to be modified or formulated accordingly in those enterprises.

8. Taxation Policy. High taxation reduces the earnings of he companies and

consequently the rate of dividend is lowered down. Sometimes government levies
dividend-tax of distribution of dividend beyond a certain limit. It also affects the capital
formation. N India, dividends beyond 10 % of paid-up capital are subject to dividend tax
at 7.5 %.

9. Legal Requirements. In deciding on the dividend, the directors take the legal
requirements too into consideration. In order to protect the interests of creditors an
outsider, the companies Act 1956 prescribes certain guidelines in respect of the
distribution and payment of dividend. Moreover, a company is required to provide for
depreciation on its fixed and tangible assets before declaring dividend on shares. It
proposes that Dividend should not be distributed out of capita, in any case. Likewise,
contractual obligation should also be fulfilled, for example, payment of dividend on
preference shares in priority over ordinary dividend.

10. Past dividend Rates. While formulating the Dividend Policy, the directors must keep
in mind the dividend paid in past years. The current rate should be around the average
past rat. If it has been abnormally increased the shares will be subjected to speculation. In
a new concern, the company should consider the dividend policy of the rival
organization.

11. Ability to Borrow. Well established and large firms have better access to the capital
market than the new Companies and may borrow funds from the external sources if there
arises any need. Such Companies may have a better dividend pay-out ratio. Whereas
smaller firms have to depend on their internal sources and therefore they will have to
built up good reserves by reducing the dividend pay out ratio for meeting any obligation
requiring heavy funds.

12. Policy of Control. Policy of control is another determining factor is so far as

dividends are concerned. If the directors want to have control on company, they would
not like to add new shareholders and therefore, declare a dividend at low rate. Because by
adding new shareholders they fear dilution of control and diversion of policies and
programmes of the existing management. So they prefer to meet the needs through
retained earning. If the directors do not bother about the control of affairs they will follow
a liberal dividend policy. Thus control is an influencing factor in framing the dividend
policy.

13. Repayments of Loan. A company having loan indebtedness are vowed to a high rate
of retention earnings, unless one other arrangements are made for the redemption of debt
on maturity. It will naturally lower down the rate of dividend. Sometimes, the lenders
(mostly institutional lenders) put restrictions on the dividend distribution still such time
their loan is outstanding. Formal loan contracts generally provide a certain standard of
liquidity and solvency to be maintained. Management is bound to hour such restrictions
and to limit the rate of dividend payout.

14. Time for Payment of Dividend. When should the dividend be paid is another
consideration. Payment of dividend means outflow of cash. It is, therefore, desirable to
distribute dividend at a time when is least needed by the company because there are peak
times as well as lean periods of expenditure. Wise management should plan the payment
of dividend in such a manner that there is no cash outflow at a time when the undertaking
is already in need of urgent finances.

15. Regularity and stability in Dividend Payment. Dividends should be paid regularly
because each investor is interested in the regular payment of dividend. The management
should, inspite of regular payment of dividend, consider that the rate of dividend should
be all the most constant. For this purpose sometimes companies maintain dividend
equalization Fund.

Q2b. What is reorder level? 2 marks

This is that level of materials at which a new order for supply of materials is to be placed.
In other words, at this level a purchase requisition is made out. This level is fixed
somewhere between maximum and minimum levels. Order points are based on usage
during time necessary to requisition order, and receive materials, plus an allowance for
protection against stock out.

The order point is reached when inventory on hand and quantities due in are equal to the
lead time usage quantity plus the safety stock quantity.

Formula of Re-order Level or Ordering Point:

The following two formulas are used for the calculation of reorder level or point.

[Ordering point or re-order level = Maximum daily or weekly or monthly usage ×

Lead time]
The above formula is used when usage and lead time are known with certainty; therefore,
no safety stock is provided. When safety stock is provided then the following formula
will be applicable:

[ Ordering point or re-order level = Maximum daily or weekly or monthly usage ×

Lead time + Safety stock ]

Examples:

Example 1:

Minimum daily requirement 800 units

Time required to receive emergency supplies 4 days
Average daily requirement 700 units
Minimum daily requirement 600 units
Time required for refresh supplies One month (30 days)

Calculate ordering point or re-order level

Calculation:

Ordering point = Ordering point or re-order level = Maximum daily or weekly or

monthly usage × Lead time

= 800 × 30

= 24,000 units

Example 2:

Tow types of materials are used as follows:

Minimum usage 20 units per week each

Maximum usage 40 units per week each
Normal usage 60 units per week each
Re-order period or Lead time
Material A: 3 to 5 weeks
Material B 2 to 4 weeks

Calculate re order point for two types of materials

Calculation:

Ordering point or re-order level = Maximum daily or weekly or monthly usage ×

Maximum re-order period
A: 60 × 5 = 300 units
 B: 60 × 4 = 240 units

Q.3 Sales Rs.400, 000 less returns Rs 10, 000, Cost of Goods Sold Rs 300,000,
Administration and selling expenses Rs.20, 000, Interest on loans Rs.5000,
Income tax Rs.10000, preference dividend Rs. 15,000, Equity Share Capital
Rs.100, 000 @Rs. 10 per share. Find EPS. (10marks)

Sales 400000
Less returns 10000
390000
Less: Cost of
goods sold 300000
Contributions 90000
Less:
Administration &
selling expenses 20000 20000
Earning before
interest (EBI) 70000
Less: Interest on
loans 5000
Earnings before
tax(EBT) 65000
Less: Income tax 10000
Earnings after
tax(EAT) 55000
Less: preference
shares 15000
Earnings available
to equity holders 40000

Earnings per share= Earning available

No. of shares outstanding

=40000 x 10 =Rs.4
100000

Q.4 What are the techniques of evaluation of investment? (10 Marks)

Three steps are involved in the evaluation of an investment:

• Estimation of cash flows
• Estimation of the required rate of return (the cast of capital)
• Application of a decision rule for decision rule for making the choice

Investment decision rule

The investment decision rules may be referred to as capital budgeting techniques, or

investment criteria. A sound appraisal technique should be used to measure the economic
worth of an investment project. The essential property of a sound technique is that is
should maximize the shareholders wealth. The following other characteristics should also
be possessed by a sound investment evaluation criterion:

• It should consider all cash flows to determine the true profitability of then project.
• It should provide for an objective and unambiguous way of separate good projects from
bad projects.
• It should help ranking of projects according to their true profitability.
• It should recognize the fact that bigger cash flows are preferable to smaller ones and
early cash flows are preferable to later ones.
• It should help to choose among mutually exclusive projects that project which
maximizes the shareholders wealth.
• It should be a criterion which is applicable to any conceivable investment project
independent of others.

These conditions will be clarified as we discuss the features of various investment criteria
in the following posts.

The methods of appraising an investment proposal can be grouped into

1. Traditional methods
2. Modern methods

Traditional methods are:

• Payback method
• Accounting rate of return

Modern techniques are:

• Net present value

• Internal rate of return
• Modified internal rate of return
• Profitability index

Traditional method:
Payback method is defined as the length of time required to recover the initial cash
outlay. Its advantages are that its simple in concept and application, recovery of initial
outlay, it’s the best method for evaluation of projects with high uncertainty. It favors a
project which is less then or equal to the standard payback set by the management. In this
process early cash flows get due recognition then later cash flows. Therefore payback
period could be used as a tool to deal with the ranking of projects on the basis of risk
criterion. For firms with short age funds this is preferred because it measures liquidity of
the project.

If projects are mutually exclusive, select the project which has the least payback period.
In respect of other projects, select the project which have pay-back period less than or
equal to the standard payback stipulated by the management.

Accounting rate of return (ARR) measures the profitability of investment using the
information taken from financial statements.

It is based on accounting information, simple to understand. It considers the profits of

entire economic life of the project. Since it is based on accounting information, the
business executives are familiar with the accounting information understand it.

If any project which has an excess ARR, the minimum rate fixed by the management is
accepted. If actual ARR is less than the cut-off rate then that project. When projects are to
be ranked for deciding on the allocation of capital on account of the need for capital
rationing, project with higher ARR are preferred to the ones with lower ARR.

Discounted pay back period

The length in years required to recover the initial outlay on the value basis is called the
discounted pay back period. Discounted pay back period for a project will always be
higher then simple pay back period.

Discounted cash flow method

Discounted cash flow method or time adjusted technique is an improvement over the
traditional techniques. In evaluation of the projects the needs to give weight age to the
timing of return is effectively considered in all DCF methods.

Modern methods

Net present value

Net present value (NPV) method recognizes the time value of money. It correctly admits
that cash flows occurring at different time periods differ in value. Therefore there is a
need to find out the present values of all cash flows. NPV is the most widely used
technique among the DCF method.
If Net present value is positive the project should be accepted. If NPV is negative the
project should be rejected. NPV method can be used to select between mutually exclusive
projects by examining whether incremental investment generate a positive net present
value.

Internal rate of return (IRR)

Internal rate of return is the rate which makes the NPV of any project zero. IRR is the
rate of interest which equates the PV of cash inflows with the PV of cash outflows.

IRR is also called as yield on investment, managerial efficiency of capital, marginal

productivity of capital, rate of return and time adjusted rate of return. IRR is the rate of
return that a project earns.

If the projects internal rate of return is greater than the firms cost of capital, accept the
proposal, otherwise reject the proposal.

Modified internal rate of return

Modified internal rate of return (MIRR) is a distinct improvement over the IRR- internal
rate of return. Managers find IRR intuitively more appealing than the rupees of NP
because IRR is expressed on a percentage rate of return. Modified rate of return is a
better indicator of relative profitability of the projects.

Profitability Index

Profitabilty index is also known as benefit cost index. Profitability index is the ratio of
the present value of cash inflows to initial cash outlay. The discount factor based on the
required rate of return is used to discount the cash inflows.

P1=Present value of cash inflows/ Initial cash outlay

If profitability index is 1then the management may accept the project because the sum of
the present value of cash inflows is equal to the sum of present value of cash outflows.

Q.5 what are the problems associated with inadequate working capital? (10 Marks)

When working capital is inadequate, a firm faces the following problems.

Fixed Assets cannot efficiently and effectively be utilized on account of lack of sufficient
working capital. Low liquidity position may lead to liquidation of firm. When a firm is
unable to meets its debts at maturity, there is an unsound position. Credit worthiness of
the firm may be damaged because of lack of liquidity. Thus it will lose its reputation.
There by, a firm may not be able to get credit facilities. It may not be able to take
advantages of cash discount.
Disadvantages of Redundant or Excessive Working Capital
1. Excessive Working Capital means ideal funds which earn no profits for the business
and
hence the business cannot earn a proper rate of return on its investments.
2. When there is a redundant working capital, it may lead to unnecessary purchasing and
accumulation of inventories causing more chances of theft, waste and losses.
3. Excessive working capital implies excessive debtors and defective credit policy which
may cause higher incidence of bad debts.
4. It may result into overall inefficiency in the organization.
5. When there is excessive working capital, relations with banks and other financial
institutions may not be maintained.
6. Due to low rate of return on investments, the value of shares may also fall.
7. The redundant working capital gives rise to speculative transactions.
Disadvantages or Dangers of Inadequate Working Capital
1. A concern which has inadequate working capital cannot pay its short-term liabilities
in time. Thus, it will lose its reputation and shall not be able to get good credit
facilities.
2. It cannot buy its requirements in bulk and cannot avail of discounts, etc.
3. It becomes difficult for the firm to exploit favourable market conditions and
undertake profitable projects due to lack of working capital.
4. The firm cannot pay day-to-day expenses of its operations and its creates
inefficiencies, increases costs and reduces the profits of the business.
5. It becomes impossible to utilize efficiently the fixed assets due to non-availability
of liquid funds.

6. The rate of return on investments also falls with the shortage of working capital.

Disadvantages or Dangers of Inadequate or Short Working Capital

• Can’t pay off its short-term liabilities in time.

• Economies of scale are not possible.
• Difficult for the firm to exploit favourable market situations
• Day-to-day liquidity worsens
• Improper utilization the fixed assets and ROA/ROI falls sharply

A firm must have adequate working capital, i.e.; as much as needed the firm. It should be
neither excessive nor inadequate. Both situations are dangerous. Excessive working
capital means the firm has idle funds which earn no profits for the firm. Inadequate
working capital means the firm does not have sufficient funds for running its operations.
It will be interesting to understand the relationship between working capital, risk and
return. The basic objective of working capital management is to manage firms current
assets and current liabilities in such a way that the satisfactory level of working capital is
maintained, i.e.; neither inadequate nor excessive. Working capital some times is referred
to as “circulating capital”. Operating cycle can be said to be t the heart of the need for
working capital. The flow begins with conversion of cash into raw materials which are, in
turn transformed into work-in-progress and then to finished goods. With the sale finished
goods turn into accounts receivable, presuming goods are sold as credit. Collection of
receivables brings back the cycle to cash.
The company has been effective in carrying working capital cycle with low working
capital limits. It may also be observed that the PBT in absolute terms has been increasing
as a year to year basis as could be seen from the above table although profit percentage
turnover may be lower but in absolute terms it is increasing. In order to further increase
profit margins, SSL can increase their margins by extending credit to good customers and
also by paying the creditors in advance to get better rates.

Working capital is the life blood and nerve centre of a business. Just as circulation of
blood is essential in the human body for maintaining life, working capital is very
essential to maintain the smooth running of a business. No business can run successfully
with out an adequate amount of working capital.

Working capital refers to that part of firm’s capital which is required for financing short
term or current assets such as cash, marketable securities, debtors, and inventories. In
other words working capital is the amount of funds necessary to cover the cost of
operating the enterprise.

Working capital means the funds (i.e.; capital) available and used for day to day
operations (i.e.; working) of an enterprise. It consists broadly of that portion of assets of a
business which are used in or related to its current operations. It refers to funds which are
used during an accounting period to generate a current income of a type which is
consistent with major purpose of a firm existence.

Every business needs some amount of working capital. It is needed for following
purposes-

• For the purchase of raw materials, components and spares.

• To pay wages and salaries.
• To incur day to day expenses and overhead costs such as fuel, power, and office
expenses etc.
• To provide credit facilities to customers etc.
Q.6 What is leverage? Compare and Contrast between operating (10 Marks)
Leverage and financial leverage

‘Leverage’ is the action of a lever or the mechanical advantage gained by it; it also means
‘effectiveness’ or ‘power’. The common interpretation of leverage is derived from the use
or manipulation of a tool or device termed as lever, which provides a substantive clue to
the meaning and nature of financial leverage.

When an organization is planning to raise its capital requirements (funds), these may be
raised either by issuing debentures and securing long term loan 0r by issuing share-
capital. Normally, a company is raising fund from both sources. When funds are raised
from debts, the Co. investors will pay interest, which is a definite liability of the
company. Whether the company is earning profits or not, it has to pay interest on debts.
But one benefit of raising funds from debt is that interest paid on debts is allowed as
deduction for income tax. ‘When funds are raised by issue of shares (equity) , the
investor are paid dividend on their investment. Dividends are paid only when the
Company is having sufficient amount of profit. In case of loss, dividends are not paid.
But dividend is not allowed as deduction while computing tax on the income of the
Company. In this way both way of raising funds are having some advantages and
disadvantages. A Company has to decide that what will be its mix of Debt and Equity,
considering the liability, cost of funds and expected rate of return on investment of fund.
A Company should take a proper decision about such mix, otherwise it will face many
financial problems. For the purpose of determination of mix of debt and equity, leverages
are calculated and analyzed

In finance, leverage is a general term for any technique to multiply gains and losses.
Common ways to attain leverage are borrowing money, buying fixed assets and using
derivatives. Important examples are:

• A public corporation may leverage its equity by borrowing money. The more it
borrows, the less equity capital it needs, so any profits or losses are shared among
a smaller base and are proportionately larger as a result.
• A business entity can leverage its revenue by buying fixed assets. This will
increase the proportion of fixed, as opposed to variable, costs, meaning that a
change in revenue will result in a larger change in operating income.
• Hedge funds often leverage their assets by using derivatives. A fund might get
any gains or losses on $20 million worth of crude oil by posting $1 million of
cash as margin

Accounting leverage has the same definition as in investments. There are several ways to
define operating leverage, the most common is:

Comparison between operating and financial leverage

Operating leverage =Revenue-variable cost/ Revenue-variable cost-Fixed cost= Revenue-
variable cost/Operating income

Financial leverage is usually defined as:= Operating income/ Net income

Operating leverage is an attempt to estimate the percentage change in operating income

(earnings before interest and taxes or EBIT) for a one percent change in revenue.

Financial leverage tries to estimate the percentage change in net income for a one percent
change in operating income.

The product of the two is called Total leverage, and estimates the percentage change in
net income for a one percent change in revenue.

There are several variants of each of these definitions, and the financial statements are
usually adjusted before the values are computed. Moreover, there are industry-specific
conventions that differ somewhat from the treatment above.

Financial leverage is in contrast to operating leverage as it relates to the financial

activities of a firm and measures the effect of earnings before interest and tax on earning
per share of the company.

A companies source of funds fall under two categories

• Those which carry a fixed charge like debentures, bonds and preference shares
• Those which do not carry a fixed charge like equity shares.

Debentures and bonds carry a fixed rate of interest and have to be paid off irrespective of
the firms revenues. Dividend on preference shares have to be paid off before equity
shares. Whereas equity share holders are paid the residual income of the firm after all the
other obligations are met.
Financial leverage refers to the mix of debt and equity in the capital structure of the firm.
This results from the fixed financial charges which are present in the company’s income
stream. These expenses have nothing to do with the firm’s earnings or performance and
should be paid off regardless of the amount of earnings before income and tax.

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 which earns more by 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 in Equity”
Operating leverage arises due to the presence of fixed operating expenses in the firm’s
income flows. A company’s operating costs can be categorized into three main sections
• Fixed costs
• Variable cost
• Semi variable cost

Fixed costs do not change with an increase in production or sales activities for a
particular period of time. Examples are salaries to employees, rents, insurance of the firm
and the accountancy cost.

Variable costs are those which vary in direct proportion to output and sales. Examples
cost of labor, amount of raw materials and administrative expenses. They are not fixed
cost but keep on changing with change in conditions.

Semi-variable cost is fixed nature upto a certain level beyond which they vary with the
firm’s activities. Examples are production cost, wages paid to labor can shift between
variable and fixed cost.

The operating leverage is the firm’s ability to use fixed operating costs to increase the
effect of changes in sales on its earnings before interest and taxes (EBIT). Operating
leverage occurs anytime a firm has fixed cost. The [percentage change in profits with a
change in volume of sales is more than the percentage change in volume.

An operating leverage can be favorable or unfavorable, high risks are attached to higher
degrees of leverage. A larger amount of fixed expenses increases the operating risks of
the company and hence a higher degree of operating leverage.

Both operating and financial leverage result in the magnification of changes to earnings
due to the presence of fixed costs in a company's cost structure. The difference is only the
part of the income statement we are looking at. Operating leverage is the magnification
on the top half of the income statement. how EBIT changes in response to changes in
sales; the relevant fixed cost is the fixed cost of operating the business. Financial leverage
is the magnification on the bottom half of the income statement. how earnings per share
changes in response to changes in EBIT; the relevant fixed cost is the fixed cost of
financing, in particular interest

Operating leverage is the name given to the impact on operating income of a change in
the level of output. Financial leverage is the name given to the impact on returns of a
change in the extent to which the firm’s assets are financed with borrowed money.
 Master of Business Administration- MBA Semester 2

MB0045 – Financial Management - 4 Credits

(Book ID: B1134)

Assignment Set- 2 (60 Marks)

Note: Each question carries 10 Marks. Answer all the questions.

Q. 1 Discuss the three broad areas of Financial Decision making (10 Marks)

Three broad areas of financial decision making are:

1. Investment decisions

Investment decisions are made by investors and managers. Investors commonly perform
investment analysis by making use of fundamental analysis, technical analysis and feel.
Investment decisions are often supported by decision tools. The portfolio theory is often
applied to help the investor achieve a satisfactory return compared to the risk taken

One of the most important long term decisions for any business relates to investment.
Investment is the purchase or creation of assets with the objective of making gains in the
future. Typically investment involves using financial resources to purchase a machine/
building or other asset, which will then yield returns to an organization over a period of
time.

Key considerations in making investment decisions are:

1. What is the scale of the investment - can the company afford it?

2. How long will it be before the investment starts to yield returns? 3

. How long will it take to pay back the investment?

4. What are the expected profits from the investment?

5. Could the money that is being ploughed into the investment yield higher returns
elsewhere?

Hazlewood Sandwiches invested £25m in a new purpose built plant at Manton Woods. In
weighing up the investment they had to consider the questions outlined above. One of the
approaches they used was the payback period. The payback period is the amount of time
required for a project to repay its initial cost. The calculation is based on cash flows and
not on profits. An investment project costs £24m.

The projected cash flows back into the business are:

Year 1 - Net cash inflow £6m
Year 2 - Net cash inflow £6m
Year 3 - Net cash inflow £6m
Year 4 - Net cash inflow £6m

Cash inflow

You can see from the illustration above that the cumulative net cash inflow will pay back
the investment at the end of the fourth year. Projects with the shortest payback periods
are preferred as longer payback periods increase the risk of unforeseen circumstances
arising. However, the problem of payback is that it gives no indication of the profitability
of the project. An alternative method that can be employed therefore to weigh up the
investment is the Accounting rate of return method.

This is calculated in the following way:

Where there are several projects under consideration, the project with the highest rate of
return is the preferred project. The main problem with the techniques described so far is
that they fail to account fully for the timing of cash flows. Instinctively we all know that
Rs. 50 in the hand today is worth more than a promised Rs50 for receipts on some future
date.

Capital investment decisions are long-term choices about which projects receive
investment, whether to finance that investment with equity or debt, and when or whether
to pay dividends to shareholders. On the other hand, short term decisions deal with the
short-term balance of current assets and current liabilities; the focus here is on managing
cash, inventories, and short-term borrowing and lending (such as the terms on credit
extended to customers.

Decisions are based on several inter-related criteria. (1) Corporate management seeks to
maximize the value of the firm by investing in projects which yield a positive net present
value when valued using an appropriate discount rate. (2) These projects must also be
financed appropriately. (3) If no such opportunities exist, maximizing shareholder value
dictates that management must return excess cash to shareholders (i.e., distribution via
dividends). Capital investment decisions thus comprise an investment decision, a
financing decision, and a dividend decision.

Management must allocate limited resources between competing opportunities (projects)

in a process known as capital budgeting. Making this investment, or capital allocation,
decision requires estimating the value of each opportunity or project, which is a function
of the size, timing and predictability of future cash flows.

Capital budgeting decisions demand considerable time, attention and energy of the
management. They are strategic in nature as the success or failure of an organization is
directly attributable to the execution of capital budgeting decisions taken. Investment
decisions are also known as capital Budgeting decisions and hence lead to investments in
real assets

2. Financing decision

Achieving the goals of corporate finance requires that any corporate investment be
financed appropriately. As above, since both hurdle rate and cash flows (and hence the
riskiness of the firm) will be affected, the financing mix can impact the valuation.
Management must therefore identify the "optimal mix" of financing—the capital
structure that results in maximum value.

The sources of financing will, generically, comprise some combination of debt and equity
financing. Financing a project through debt results in a liability or obligation that must be
serviced, thus entailing cash flow implications independent of the project's degree of
success. Equity financing is less risky with respect to cash flow commitments, but results
in a dilution of ownership, control and earnings. The cost of equity is also typically higher
than the cost of debt (see CAPM and WACC), and so equity financing may result in an
increased hurdle rate which may offset any reduction in cash flow risk.

Management must also attempt to match the financing mix to the asset being financed as
closely as possible, in terms of both timing and cash flows.

One of the main theories of how firms make their financing decisions is the Pecking
Order Theory, which suggests that firms avoid external financing while they have
internal financing available and avoid new equity financing while they can engage in new
debt financing at reasonably low interest rates. Another major theory is the Trade-Off
Theory in which firms are assumed to trade-off the tax benefits of debt with the
bankruptcy costs of debt when making their decisions. An emerging area in finance
theory is right-financing whereby investment banks and corporations can enhance
investment return and company value over time by determining the right investment
objectives, policy framework, institutional structure, source of financing (debt or equity)
and expenditure framework within a given economy and under given market conditions.
One last theory about this decision is the Market timing hypothesis which states that
firms look for the cheaper type of financing regardless of their current levels of internal
resources, debt and equity.

3. The Dividend Decision is a decision made by the directors of a company. It relates to

the amount and timing of any cash payments made to the company's stockholders.
The decision is an important one for the firm as it may influence its capital structure
and stock price. In addition, the decision may determine the amount of taxation that
stockholders pay.

There are three main factors that may influence a firm's dividend decision:
 • Free-cash flow
• Dividend clienteles
• Information signaling

The firm simply pays out, as dividends, any cash that is surplus after it invests in all
available positive net present value projects.

Most companies pay relatively consistent dividends from one year to the next and
managers tend to prefer to pay a steadily increasing dividend rather than paying a
dividend that fluctuates dramatically from one year to the next.

A particular pattern of dividend payments may suit one type of stock holder more than
another. A retiree may prefer to invest in a firm that provides a consistently high dividend
yield, whereas a person with a high income from employment may prefer to avoid
dividends due to their high marginal tax rate on income. If clienteles exist for particular
patterns of dividend payments, a firm may be able to maximize its stock price and
minimize its cost of capital by catering to a particular clientele. This model may help to
explain the relatively consistent dividend policies followed by most listed companies.

Dividend clienteles is that investors do not need to rely upon the firm to provide the
pattern of cash flows that they desire. An investor who would like to receive some cash
from their investment always has the option of selling a portion of their holding. This
argument is even more cogent in recent times, with the advent of very low-cost discount
stockbrokers. It remains possible that there are taxation-based clienteles for certain types
of dividend policies.

A model developed by Merton Miller and Kevin Rock in 1985 suggests that dividend
announcements convey information to investors regarding the firm's future prospects.
Many earlier studies had shown that stock prices tend to increase when an increase in
dividends is announced and tend to decrease when a decrease or omission is announced.
Miller and Rock pointed out that this is likely due to the information content of
dividends.

When investors have incomplete information about the firm (perhaps due to opaque
accounting practices) they will look for other information that may provide a clue as to
the firm's future prospects. Managers have more information than investors about the
firm, and such information may inform their dividend decisions. When managers lack
confidence in the firm's ability to generate cash flows in the future they may keep
dividends constant, or possibly even reduce the amount of dividends paid out.
Conversely, managers that have access to information that indicates very good future
prospects for the firm (e.g. a full order book) are more likely to increase dividends.

Investors can use this knowledge about managers' behavior to inform their decision to
buy or sell the firm's stock, bidding the price up in the case of a positive dividend
surprise, or selling it down when dividends do not meet expectations. This, in turn, may
influence the dividend decision as managers know that stock holders closely watch
dividend announcements looking for good or bad news. As managers tend to avoid
sending a negative signal to the market about the future prospects of their firm, this also
tends to lead to a dividend policy of a steady, gradually increasing payment.

In a fully informed, efficient market with no taxes and no transaction costs, the free cash
flow model of the dividend decision would prevail and firms would simply pay as a
dividend any excess cash available. The observed behaviors of firm differs markedly
from such a pattern. Most firms pay a dividend that is relatively constant over time. This
pattern of behavior is likely explained by the existence of clienteles for certain dividend
policies and the information effects of announcements of changes to dividends.

The dividend decision is usually taken by considering at least the three questions of: how
much excess cash is available? What do our investors prefer? and What will be the effect
on our stock price of announcing the amount of the dividend?

The result for most firms tends to be a payment that steadily increases over time, as
opposed to varying wildly with year-to-year changes in free cash flow.

Q.2 What is the future value of an annuity and state the formulae for (10 Marks)
future value of an annuity

The term annuity is used in finance theory to refer to any terminating stream of fixed
payments over a specified period of time. This usage is most commonly seen in
discussions of finance, usually in connection with the valuation of the stream of
payments, taking into account time value of money concepts such as interest rate and
future value.

Examples of annuities are regular deposits to a savings account, monthly home mortgage
payments and monthly insurance payments. Annuities are classified by payment dates.
The payments (deposits) may be made weekly, monthly, quarterly, yearly, or at any other
interval of time

Future Value of Annuities

An annuity is a series of equal payments or receipts that occur at evenly spaced intervals.
Leases and rental payments are examples. The payments or receipts occur at the end of
each period for an ordinary annuity while they occur at the beginning of each
period.for an annuity due.

Future Value of an Ordinary Annuity

The Future Value of an Ordinary Annuity (FVoa) is the value that a stream of
expected or promised future payments will grow to after a given number of periods at a
specific compounded interest.

The Future Value of an Ordinary Annuity could be solved by calculating the future value
of each individual payment in the series using the future value formula and then summing
the results. A more direct formula is:

FVoa = PMT [((1 + i)n - 1) / i]

Where:

FVoa = Future Value of an Ordinary Annuity

PMT = Amount of each payment
i = Interest Rate Per Period
n = Number of Periods

Q.3 The equity stock of ABC Ltd is currently selling for Rs. 30 per share. The
dividend expected next year is Rs 2.00. The investors required rate of return on this
stock is 15 per cent. If the constant growth model applies to ABC Ltd, What is the
expected growth rate?
(10 Marks)
Po=D1/ Ke-g

Where Po= current market price of the share

D1= expected dividend after one year
Ke= required rate of return on the equity share
Where, g stands for growth rate

Po=D1/Ke-g

30 = 2
(0.15-g)

30 (0.15-g) =2

0.15-g=2
30

0.15-g=0.067

g=8.37%=8%
Q.4 State the assumptions underlying the CAPM model and MM model (10 Marks)

The assumptions underlying the CAPM model are given below:

All investors:

1. Aim to maximize economic utilities.

2. Are rational and risk-averse.
3. Are broadly diversified across a range of investments.
4. Are price takers, i.e., they cannot influence prices.
5. Can lend and borrow unlimited amounts under the risk free rate of interest.
6. Trade without transaction or taxation costs.
7. Deal with securities that are all highly divisible into small parcels.
8. Assume all information is available at the same time to all investors.

• The model assumes that either asset returns are (jointly) normally distributed
random variables or that investor’s employ a quadratic form of utility. It is
however frequently observed that returns in equity and other markets are not
normally distributed. As a result, large swings (3 to 6 standard deviations from the
mean) occur in the market more frequently than the normal distribution
assumption would expect
• The model assumes that the variance of returns is an adequate measurement of
risk. This might be justified under the assumption of normally distributed returns,
but for general return distributions other risk measures (like coherent risk
measures) will likely reflect the investors' preferences more adequately. Indeed
risk in financial investments is not variance in itself, rather it is the probability of
losing: it is asymmetric in nature.
• The model assumes that all investors have access to the same information and
agree about the risk and expected return of all assets (homogeneous expectations
assumption).
• The model assumes that the probability beliefs of investors match the true
distribution of returns. A different possibility is that investors' expectations are
biased, causing market prices to be informational inefficient. This possibility is
studied in the field of behavioral finance, which uses psychological assumptions
to provide alternatives to the CAPM such as the overconfidence-based asset
pricing model of Kent Daniel, David Hirshleifer, and Avanidhar Subrahmanyam
(2001).
• The model does not appear to adequately explain the variation in stock returns.
Empirical studies show that low beta stocks may offer higher returns than the
model would predict. Some data to this effect was presented as early as a 1969
conference in Buffalo, New York in a paper by Fischer Black, Michael Jensen,
and Myron Scholes. Either that fact is itself rational (which saves the efficient-
market hypothesis but makes CAPM wrong), or it is irrational (which saves
CAPM, but makes the EMH wrong – indeed, this possibility makes volatility
arbitrage a strategy for reliably beating the market).
 • The model assumes that given a certain expected return investors will prefer
lower risk (lower variance) to higher risk and conversely given a certain level of
risk will prefer higher returns to lower ones. It does not allow for investors who
will accept lower returns for higher risk. Casino gamblers clearly pay for risk, and
it is possible that some stock traders will pay for risk as well.
• The model assumes that there are no taxes or transaction costs, although this
assumption may be relaxed with more complicated versions of the model.
• The market portfolio consists of all assets in all markets, where each asset is
weighted by its market capitalization. This assumes no preference between
markets and assets for individual investors, and that investors choose assets solely
as a function of their risk-return profile. It also assumes that all assets are
infinitely divisible as to the amount which may be held or transacted
• The market portfolio should in theory include all types of assets that are held by
anyone as an investment (including works of art, real estate, human capital...) in
practice, such a market portfolio is unobservable and people usually substitute a
stock index as a proxy for the true market portfolio. Unfortunately, it has been
shown that this substitution is not innocuous and can lead to false inferences as to
the validity of the CAPM, and it has been said that due to the inobservability of
the true market portfolio, the CAPM might not be empirically testable. This was
presented in greater depth in a paper by Richard Roll in 1977, and is generally
referred to as Roll's critique.
• The model assumes just two dates, so that there is no opportunity to consume and
rebalance portfolios repeatedly over time. The basic insights of the model are
extended and generalized in the intertemporal CAPM (ICAPM) of Robert Merton,
and the consumption CAPM (CCAPM) of Douglas Breeden and Mark
Rubinstein.
• CAPM assumes that all investors will consider all of their assets and optimize one
portfolio. This is in sharp contradiction with portfolios that are held by individual
investors: humans tend to have fragmented portfolios or, rather, multiple
portfolios: for each goal one portfolio — see behavioral portfolio theory and
Maslowian Portfolio Theory .

ASSUMPTIONS OF MODIGLIANI & MILLER APPROACH

1. The capital markets are assumed to be perfect. This means that investors are free to
buy and sell securities. They are well informed about the risk-return on all type of
securities. These are no transaction costs. The investors behave rationally. They can
borrow without restrictions on the same terms as the firms do.

2. The firms can be classified into ‘homogeneous risk class’. They belongs to this class if
their expected earnings is having identical risk characteristics.
3. All investors have the same expectations from a firm’s net operating income (EBIT)
which are necessary to evaluate the value of a firm.

4. The dividend payment ratio is 100%. In other words, there are no retained earnings.

5. There are no corporate taxes. However this assumption has been removed later.

Modigliani and Miller agree that while companies in different industries face different
risks which will result in their earnings being capitalized at different rates, it is not
possible for these companies to affect their market values, and therefore their overall
capitalization rate by use of leverage. That is, for a company in a particular risk class, the
total market value must be same irrespective of proportion of debt in company’s capital
structure. The support for this hypothesis lies in the presence of arbitrage in the capital
market. They contend that arbitrage will substitute personal leverage for corporate
leverage. This is illustrated below:

Suppose there are two companies A & B in the same risk class. Company A is financed
by equity and company B has a capital structure which includes debt. If market price of
share of company B is higher than company A, market participants would take advantage
of difference by selling equity shares of company B, borrowing money to equate there
personal leverage to the degree of corporate leverage in company B, and use these funds
to invest in company A. The sale of Company B share will bring down its price until the
market value of company B debt and equity equals the market value of the company
financed only by equity capital.

Q.5 Write the cash flow analysis? (10 Marks)

Cash flow is essentially the movement of money into and out of your business; it's the
cycle of cash inflows and cash outflows that determine your business' solvency.

Cash flow analysis is the study of the cycle of your business' cash inflows and outflows,
with the purpose of maintaining an adequate cash flow for your business, and to provide
the basis for cash flow management.
Cash flow analysis involves examining the components of your business that affect cash
flow, such as accounts receivable, inventory, accounts payable, and credit terms. By
performing a cash flow analysis on these separate components, you'll be able to more
easily identify cash flow problems and find ways to improve your cash flow.

A quick and easy way to perform a cash flow analysis is to compare the total unpaid
purchases to the total sales due at the end of each month. If the total unpaid purchases are
greater than the total sales due, you'll need to spend more cash than you receive in the
next month, indicating a potential cash flow problem

1. This type of cash flow analysis is called cash budgeting analysis. It is part of your
firm's financial forecasting plan. Determine the amount of cash that will flow into
your firm during the month. If you are just starting your business, you should include
the beginning balance in cash that you want to have available every month. There
would also be the amount of sales you have during the first month. Sales would
include both cash sales and sales that you make to your customers who pay on credit.
Here's an example you can follow to develop your Schedule of Cash Receipts (Sales
Receipts).

2. Determine the amount of cash that will flow out of your firm during the month.
You will have expenses. You will probably have to buy office supplies. Other
monthly expenses may include advertising, vehicle expenses, payroll expenses, just
to name a few. You will have some quarterly expenses, such as taxes. You may have
expenses that just occur occasionally, like purchases of computer equipment,
vehicles, or other larger expenses. Here is an example of a Schedule of Cash
Payments that is the second step of the cash budget.

3. You want the cash that will flow into your firm (Step 1) to be greater than the
cash that will flow out of your firm (Step 2). This means that your monthly cash
inflow needs to be greater than your monthly cash outflow so you will have
sufficient cash to operate your firm. Here's a blank worksheet you can use to
calculate your cash inflow or cash receipts and another worksheet you can use to
calculate your cash payments.

4. Your ending balance for the first month becomes the beginning balance for the
second month. You do the same type of analysis. Each month, you may have to add
more items to your cash flow analysis as your business grows. You need to decide
what the minimum ending cash balance is that you find acceptable for your firm and
aim toward that figure each month.

5. If your cash flow turns negative for any one month, you will have to borrow
money for that month from family or friends, investors, or from a bank or other
financial institutions. Then, if your cash flow is positive the next month, you can
repay that loan.
 6. Keep on doing this each month for your forecasting period. Try to keep your
borrowing to a minimum and your cash inflow greater than your outflows.
Remember that this cash budget is a financial forecasting document but try to follow
it as closely as possible. Here is an example of a completed Cash Budget, based on
the schedules already completed, that you can look at. Here is a blank worksheet you
can use for your own company.

Measurement of cash flow can be used

• To determine a project's rate of return or value. The time of cash flows into and
out of projects are used as inputs in financial models such as internal rate of
return, and net present value.
• To determine problems with a business's liquidity. Being profitable does not
necessarily mean being liquid. A company can fail because of a shortage of cash,
even while profitable.
• As an alternate measure of a business's profits when it is believed that accrual
accounting concepts do not represent economic realities. For example, a company
may be notionally profitable but generating little operational cash (as may be the
case for a company that barters its products rather than selling for cash). In such a
case, the company may be deriving additional operating cash by issuing shares, or
raising additional debt finance.
• Cash flow can be used to evaluate the 'quality' of Income generated by accrual
accounting. When Net Income is composed of large non-cash items it is
considered low quality.
• to evaluate the risks within a financial product. E.g. matching cash requirements,
evaluating default risk, re-investment requirements, etc.

Cash flow is a generic term used differently depending on the context. It may be defined
by users for their own purposes. It can refer to actual past flows, or to projected future
flows. It can refer to the total of all the flows involved or to only a subset of those flows.
Subset terms include 'net cash flow', operating cash flow and free cash flow.

Q.6 The following two projects A and B requires an investment of Rs 2, 00,000 each.
The income returns after tax for these projects are as follows: (10 Marks)

Year Project A Project B

1 Rs.80,000 Rs.20,000
2 Rs.80,000 Rs.40,000
3 Rs.40,000 Rs.40,000
4 Rs.20,000 Rs.40,000
5 Rs.60,000
6 Rs.60,000
Using the following criteria determine which of the projects is preferable.
Solutions.

Project A

Year Income PVIF@10% PVCI

1 80000 0.909 72720

2 80000 0.826 66080

3 40000 0.751 30040

4 20000 0.683 13660

PVCI 182500

PVCI - NPV

182500 -200000 = 17500

Project B

Year Income PVIF@10% PVCI

1 20000 0.909 18180

2 40000 0.826 33040

3 40000 0.751 30040

4 40000 0.683 27320

5 60000 0.621 37260

6 60000 0.564 33840

PVCI 179680
PVCI - NPV

179680 - 200000 = 20320

As Project A is preferable option as it has minimal losses.