MB0045 FINANCIAL MANAGEMENTQ1. Explain the liquidity decisions and its important elements. Write complete information on dividend decisions.Answer : Liquidity DecisionThe liquidity decision is concerned with the management of the current assets, which is a pre-requisite to long-term success of any business firm. This is also called as working capital decision. The main objective of the current assets management is the trade off between profitability and liquidity, and there is a conflict between these two concepts. If a firm does not have adequate working capital, it may become illiquid and consequently fail to meet its current obligations thus inviting the risk of bankruptcy. On the contrary, if the current assets are too enormous, the profitability is adversely affected. Hence, the major objective of the liquidity decision is to ensure a trade-off between profitability and liquidity.In other terms, liquidity decisions deal with working capital management. It is concerned with the day to day financial operations that current assets and current liabilities.The important elements of liquidity decisions are :Formulation of inventory policy.Policies on receivable managementFormulation of cash management strategies.Policies on utilization of spontaneous finance effectively.Dividend DecisionDividends are payouts to shareholders. Dividends are paid to keep the shareholders happy. Dividend decision is a major decision made by the finance manager.Dividend is that portion of profits of a company which is distributed among its shareholders according to the resolution passed in the meeting of the Board of Directors. This may be paid as a fixed percentage on the share capital contributed by them or at a fixed amount per share. The dividend decision is always a problem before the top management or the Board of Directors as they have to decide how much profits should be transferred to reserve funds to meet any unforeseen contingencies and how much should be distributed to the shareholders.

Since the goal of financial management is maximization of wealth of shareholders, dividend policy formulation demands the managerial attention on the impact of its policy on dividend and on the market value of its shares. Optimum dividend policy requires decision on dividend payment rates so as to maximise the market value of shares. The payout ratio means what portion of earnings per share is given to the shareholders in the form of cash dividend.Q2. Explain about the doubling period and present value. Solve the below given problem :Under the ABC Banks Cash Multiplier Scheme, deposits can be made for periods ranging from 3 months to 5 years and for every quarter, interest is added to the principal. The applicable rate of interest is 9% for deposits less than 23 months and 10% for periods more than 24 months. What will be the amount of Rs. 1000 after 2 years?Explanation of present valueAns : Doubling Period A very common question arising in the minds of an investor is how long will it take for the amount invested to double for a given rate of interest. There are 2 ways of answering this question :One way is to answer it by a rule known as rule of 72. This rule states that the period within which the amount doubles is obtained by dividing 72 by the rate of interest. Though it is a crude way of calculating, this rule is followed by most.For instance, if the given rate of interest is 10%, the doubling period is 72/10, that is, 7.2 years.A much accurate way of calculating doubling period is by using the rule known as rule of 69. By this method, doubling period = 0.35+69/Interest rateGoing by the same example given above, we get the number of years as 7.25 years {(0.35+69/10) or (0.35+6.9)}.Solution to the problemFVn=PV(1+i/m)mXnM=12/3=4 (quarterly compounding)1000(1+0.10/4)4*2 1000(1+0.10/4)8Rs. 1218Present Value Present Value can be simply defined as the current value of a future sum. It can be defined as the amount to be invested today (present value) at a given rate of interest over a specified period to equal the futuresum. If we reverse the flow by saying that we expect a fixed amount after n number of years and we also know the present prevailing interest rate, then by discounting the future amount at the given interest rate, we will get the present value of investment to be made.The present value of a sum to be received at a future date is determined by discounting the future value at the interest rate that the money could earn over the period. This process is known as discounting.

Q3. Write short notes on :a) Operating Leverageb) Financial Leveragec) Combined LeverageANS:- (a) Operating Leverage:- Operating leverages arises due to the presence of fixed operating expenses in the firms income flows. It has a close relationship to business risk factors, which can be viewed as the uncertainty inherent in estimates of future operating income.The operating leverage takes place when a change in revenue produces a greater change in Earnings Before Interest and Taxes (EBIT). It indicates the impact of changes in sales on operating income. A firm with a high operating leverage has a relatively greater effect on EBIT for small changes in sales. A small rise in sales may enhance profits considerably, while a small decline in sales may reduce and even wipe out the EBIT.Following figure depicts the three categories of a companys operating costs. Fixed costs Fixed costs are those which do not vary with an increase in production or sales activities for a particular period of time. These are incurred irrespective of the income and value of sales and generally cannot be reduced.For example, consider that a firm named XYZ Enterprises is planning to start a new business. The main aspects that the firm should concentrate on are salaries to the employees, rents, insurance of the firm, and the accountancy costs. All these aspects are referred to as fixed costs.

Variable costs Variable costs are those which vary in direct proportion to outputs and sales. An increase or decrease in production or sales activities will have a direct effect on such type of costs incurred.For example, we have discussed about fixed costs in the above context. Now, the firm has to concentrate on some other features like cost of labour, amount of raw materials, and the administrative expenses. All these features relate to or are referred to as Variable costs, as these costs are not fixed and keep changing depending upon the conditions.

Semi-variable costs- Semi-variable costs are those which are partly fixed and partly variable in nature. These costs are typically of fixed nature up to certain level beyond which they vary with the firms activities.For example, after considering both the fixed costs and the variable costs, the firm should concentrate on some other features like production cost and the wages paid to the workers. At some point in time, these will act as fixed costs and can also shift to variable costs. These features relate to or are referred to as Semi-variable costs.

The operating leverage refers to the degree to which a firm has built-in fixed costs due to its particular or unique production process.

The extent of the operating leverage at any single sales volume is calculated as follows: Marginal contribution/EBIT) (Revenue-Variable costs)/(Revenue-Variable costs-Fixed costs) In most cases, a firm would in position to exercise a degree of control on the choice of its technology and the related production processes. The production processes which are accompanied by high fixed costs but low variable costs are generally the highly mechanized and automated processes. With such processes, the degree of operating leverage is generally high, the break even point is relatively higher, and thus changes in the sales level have a magnified (or leveraged) effects on profits. Break-even sales volume goes up with operating leverage (i.e., fixed cost s), thus, greater impact on profits for a given change in sales volume.Thus, the operating leverage is the firms ability to use fixed operating costs to increase the effects of changes in sales on its EBIT. Operating leverage occurs any time if a firm has fixed costs. The percentage of change in profits with a change in volume of sales is more than the percentage of change in volume. The higher the fixed costs, the greater the leverage and the more frequent the changes in the rate of profit (or loss) with alternations in the volume of activity.Application of operating leverageThe applications of operating leverages are as follows: Business risk measurement Production planning

Measurement of business riskRisk refers to the uncertain conditions in which a company performs. A business risk is measured using the DOL and the formula of DOL is: DOL= {Q(S-V)} / {Q(S-V)-F} The greater the DOL, the more sensitive will be the EBIT to a given change in unit sales. A high DOL is the measure of high business risk and vice versa. Production planningA change in production method increases or decreases DOL. A firm can change its cost structure by mechanizing its operations, thereby, reducing its variable costs and increasing its fixed costs. This will have a positive impact on DOL. This situation can be justified only if the company is confident of achieving a higher amount of sales thereby increasing its earnings.

(b) Financial Leverage Financial leverage relates to the financing activities of a firm and measures the effect of EBIT on Earnings Per Share (EPS) of the company.

A companys sources of funds fall under two categories: Those which carry fixed financial charges like debentures, bonds, and preference shares Those which do not carry any fixed charges like equity shares

Debentures and bonds carry a fixed rate of interest and are to be paid off irrespective of the firms revenues. The dividends are not contractual obligations, but the dividend on preference shares is a fixed charge and should be paid off before equity shareholders. The equity holders are entitled to only the residual income of the firm after all prior obligations are met.

Financial leverage refers to a firms use of fixed charge securities like debentures and preference shares (though the latter is not always included in debt) in its plan of financing the assets.

The concept of financial leverage is a significant one because it has direct relation with capital structure management. It determines the relationship that could exist between the debt and equity securities. A firm which does not issue fixed-charge securities has an equity capital structure and does not have any financial leverage. However it is common for firms to issue some debt securities, in which case, the leverage is either favorable or unfavorable. Financial leverage is a process of using debt capital to increase the rate of return on equity. For this reason, it is also referred to as trading on equity. Borrowing is done by a company because of the financial advantage that is expected from it. The use of borrowings for the purpose of such advantage for residual share holders is also called Trading on equity or leverage.

Thus, financial leverage refers to the mixed of debt and equity in the capital structure of the firm. This results from the presence of fixed financial charges in the companys income stream. Such expenses have nothing to do with the firms performance and earnings and should be paid of regardless of the amount of EBIT.

It is the firms ability to use fixed financial charges to increase the effects of changes in EBIT. It is the use of funds obtained at fixed costs which increase the returns on shareholders.

A company earning more by the use of assets funded by fixed sources is said to be having a favourable or positive leverages. Unfovourable leverage occurs when the firm is not earning sufficiently to cover the cost of funds. Financial leverages is also referred to as trading on equity. (C) Total or Combined Leverage:the combination of operating and financial leverages is called combined leverages. Operation leverages affects the firms operating profit EBIT and financial leverages affects PAT or the EPS. These cause wide fluctuations in EPS. A company having a high level of operating or financial leverages will find a drastic change in its EPS even foe a small change in sale volume.Companies whose products are seasonal in nature have fluctuating EPS, but the amount of changes in EPS due to leverages in more pronounced. The combined effect is quite significant for the earning available to ordinary shareholders. Combined leverage is the product of DOL and DFL. DTL = Q(S-V) / Q(S-V)-F-I-{Dp/(1-T)}Uses of Degree of Total Levarage (DTL) DTL measures the total risk of the company as DTL is a combined mrasure of both operating and financial risk. DTL measures the variability of EPS.

Q4. Explain the factors affecting Capital Structure. ANS :- Factors affecting capital structure Capital structure should be planned at the time a company is promoted. The initial capital structure should be designed very carefully. The management of the company should set a target capital structure, and the subsequent financing decisions should be made with a view to achieve the target capital structure.Every time the funds have to be procured, the financial manager weighs the pros and cons of various sources of finance and selects the most advantageous sources keeping in view the target capital structure. Thus, the capital structure decision is a continuous one and has to be taken whenever a firm needs additional finance.LEVERAGEThe use of sources of funds that have a fixed cost attached to them, such as preference shares, loans from banks and financial institutions, and debentures in the capital structure, is known as trading on equity or financial leverage.If the assets financed by debt yield a return greater than the cost of the debt, the EPS will increase without an increase in the owners investment. Similarly, the EPS will also increase if preference share capital is used to acquire assets. But the leverage impact is felt more in case of debt because of the following reasons: The cost of debt is usually lower than the cost of preference share capital The interest paid on debt is a deductible charge from profits for calculating the taxable income while dividend on preference shares is notThe companies with high level of Earnings Before Interest and Taxes (EBIT) can make profitable use of the high degree of leverage to increase return on the shareholders equity.

The other factor to be considered before deciding on an ideal capital structure are:1. Cost of capital: high cost funds should be avoided. However attractive an investment proportion for the next 3-5 years. The company officials should not get carried away at the immediate results expected. Consistent lesser profits are any way preferable that high profits in the beginning and not being able to get any profits after 2 years.2. Dilution of controls: the top management should have the flexibility to take appropriate decision at the right time. Fear of having to share control and thus begin interfered by others often delays the decision of the closely held companies may issue preference shares or raise debt capital. An excessive amount of debt may also cause bankruptcy which means a complete loss of control.3. Floating costs: floating costs are incurred when the funds are raised. Generally, the cost of floating a debt is less that the cost of floating an equity issue. A company desiring to increase its capital by way of debt or equity will definitely incur floating costs. Effectively, the amount of money raised by any issue will be lower that the amount expected because of the presence of floating costs. Such costs should be compared with the profits and right decisions should be taken.

4. Solve the below given problem:Given below are two firms, A and B, which are identical in all aspects except the degree of leverage employed by them. What is the average cost of capital of both firms?Firm AFirm B

Net operating income EBITRs. 1,00,000Rs. 1,00,000

Interest on debentures INilRs. 25,000

Equity earning ERs. 1,00,000Rs. 75,000

Cost of equity Ke15%15%

Cost of debentures Kd10%10%

Market value of equity S=E/KeRs. 6,66,667Rs. 5,00,000

Market Value of debt BNilRs. 2,50,000

Total value of firm VRs. 6,66,667Rs. 7,50,000

Solution:Average cost of capital of firm A is:10%*0/Rs. 6666667 + 15% * 666667/666667= 0 + 15= 15%Average cost of capital of firm B is:10% * 25000/750000 + 15% * 533333/750000 = 3.34 + 10= 13.4%Interpretation:The use of debt has caused the total value of the firm to increase and the overall cost of capital to decrease.

Q5. A) Explain all the sources of risk in capital budgeting with example. The sources of risk in capital budgeting are as follows:

1. Project specific risk:It could be traced to something quite specific to the project. Managerial deficiencies or error in estimation of the cash flows or discount rate may lead to a situation of actual cash flows realized begin less that the projected cash flow.2. Competitive or competition risk:Unanticipated actions of a firms competitors with materially affect the cash flows expected from a project. As a result of this, the actual cash flows from a project will be less than that of the forecast.3. Industry specific risk:It is those that affect all the firms in the particular industry. It could be again grouped into technological risk, commodity risk and legal risk. Let us discuss the groups in industry-specific risks, as follows: Technological risk: the changes in technology affect all the firm not capable of adapting themselves in emerging into a new technology. Commodity risk: it is the risk arising from the effect of price-changes on goods produced and marketed. Legal risk: it arises from changes in laws and regulations applicable to the industries to which the firm belongs.4. International risk:These types of risk are faced by firms whose business consists mainly of exports or those who procure their main raw material from international markets.The firms facing such kind of risks are ass follows: The rupee-dollar crisis affected the software and BPOs, because it drastically reduced their profitability. Another example is that of the textile units in Tirupur in Tamil Nadu, which exports that major part of the garments produced. Strengthening of rupee and weakening of dollar, reduced their competitiveness in the global markets. The surging crude oil prices coupled with the government delay in taking decision on pricing of petro products eroded the profitability of oil marketing companies in public sector like Hindustan Petroleum Corporation Limited. Another example is the impact of US sub-prime crisis on certain segments of Indian economy.5. Market risk:Factors like inflation, changes in interest rates, and changing general economic conditions affect all firms and all firms and all industries. Firms cannot diversity this risk in the normal course of business.There are many techniques of incorporation of risk perceived in the evaluation of capital budgeting proposals. They differ in their approach and methodology as far as incorporation of risk in the evaluation process is concerned.

B) An investment will have an initial outlay of Rs. 100,000. It is expected to generate cash inflows. Cash inflow for four years.YearCash inflow

140000

250000

315000

430000

If the risk free rate and the risk premium is 10%,a) Compute the NPV using the risk free rateb) Compute NPV using risk adjusted discount rate a) NPV can be computed using risk free rate.

YearCash flow (inflow)Rs.PV factor at10%PV of cash flows(inflow)

1400000.90936,360

2500000.82641,300

3150000.75111,265

4300000.68320,490

PV of cash inflows1,90,415

PV of cash outflows(1,00,000)

NPV9,415

c) NPV can be computed using risk-adjusted discount.

YearCash flow (inflow)Rs.PV factor at10%PV of cash flows(inflow)

1400000.83333,320

2500000.69434,700

3150000.5798,685

4300000.48214,460

PV of cash inflows91,165

PV of cash outflows(1,00,000)

NPV(8,835)

The project would be acceptable when no allowance is made for risk.However, it will not be accepted if risk premium is added to the risk free rate. By doing so, it moves from positive NPV to negative NPV. If the firm were to use the internal rate of return (IRR), then the project would be accepted, when IRR is greater than the risk-adjusted discount rate.

6) Explain the objectives of Cash Management. Write about the Baumol model with their assumptions? The major objectives of cash management in a firm are: Meeting payments schedule:In the normal course of functioning, a firm has to make various payments by cash to its employees, suppliers and infrastructure bills. Firms will also receive cash through sales of its products and collection of receivables. Both of these do not occur simultaneously.The basic objective of cash management is therefore to meet the payment schedule on time. Timely payments will help the firm to maintain its creditworthiness in the market and to foster cordial relationship with creditors and suppliers. Creditors give cash discount if payments are made in time and the firm can avail this discount as well.Trade credit refers to the credit extended by the supplier of goods and services in the normal courses of business transactions,Generally, cash is not paid immediately for purchases but after an agreed period of time. This is deferral of payment and also considered as a source of finance. Trade credit does not involve explicit interest charges, but there is an implicit cost involved. If the term is for example, 2/10, net 30: it means the company will get a cash discount of 2% for a payment made within 10 days, or else the entire payment is to be made within 30 days. Since the net amount is due within 30days, not availing discount means paying an extra 2% for the 20 day period.

Minimizing funds held in the form of cash balances Trying to achieve the second objective is very difficult. A high level of cash balance will help the firm to meet its firm objective, but keeping excess reserves is also not desirable as funds in its original form is idle cash and a non-earning asset. It is not profitable for firms to maintain huge balances.

A low level of cash balance may mean failure to meet the payment schedule. The aim of cash management is therefore to have an optimal level of cash by bringing about a proper synchronization of inflows and outflows, and to check the spells of cash deficits and cash surpluses. Seasonal industries are classic examples of mismatches between inflows and outflows. The efficiency of cash management can be augmented by controlling a few important factors: Prompt billing and mailing :- There is a time lag between the dispatch of goods and preparation of invoice. Reduction of this gap will bring in early remittances. Collection of cheques and remittances of cash :- Generally, we find a delay in receipt of cheques their deposits in banks. The delay can be reduced by speeding up the process of collecting and depositing cash or other instruments from customers. Float:- The concept of float helps firm to a certain extent in cash management. Float arises because of the practice of banks not crediting the firms account in its books when the cheque is deposited by it and not debiting the firms account in its book when the cheque is issued by it, until the cheque is cleared and cash is released or paid respectively.

A firm issues and receives cheques on a regular basis. It can take advantage of the concept of float. Whenever cheques are deposited in bank, credit balance increases in the firms books but not in banks book until the cheque is cleared and the money is released. This refers to collection float, that is , the amount of cheque deposited into the bank and clearance awaited.

Likewise the firm may take benefit of payment float. Net float = Payment float Collection float

When net float is positive, the balance in the firms books is less than the firms books; when net float is negative; the firms book balance is higher than the banks books.

Baumol modelThe Baumol model helps in determining the minimum amount of cash that a manager can obtain by converting securities in cash. Baumol model is an approach to establish a firms optimum cash balance under certainty. As such, firms attempt to minimize the sum of the cost of holding cash and the cost of converting marketable securities to cash. Baumol model of cash, management trades off between opportunity cost or carrying cost or holding cost and the transaction cost.The Baumol model is based on the following assumptions: The firm is able to forecast its cash requirements in an accurate way. The firms payouts are uniform over a period of time. The opportunity cost of holding cash is known and does not change with the time. The firm will incur the same transaction cost for all conversions of securities into cash.A company sells securities and realized cash, and this cash is used to make payments. As the cash balance decreases and reaches a point, the finance manager replenished its cash balance by selling marketable securities available with it and this patter continues.Cash balances are refilled and bought back to normal levels by the sale of securities. The average cash balance is C/2. The firm buys securities as and when it has above normal cash balances. Baumol cut-off model The total cost associated with cash management has two elements: Cost of conversion of marketable securities into cash and Opportunity costThe firm incurs a holding cost for keeping cash balance, which is the opportunity cost. Opportunity cost is the benefits foregone on the next best alternatives for the current action. Holding cost is k*(C/2).The firm also incurs a transaction cost whenever it converts its marketable securities into cash. Total number of transactions during the year will be the total funds requirement, T, divided by the cash balance, C , i.e., T/C. if per transaction cost is c, then the total transaction cost is c*(T/C).The total annual cost of the demand for cash is k*(C/2) + c*(T/C)