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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.

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

Influencing divined policy?

b. What is reorder level ?

(02Marks)

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, (10 Marks)

Income tax Rs.10000, preference dividend Rs. 15,000, Equity Share Capital

Rs.100, 000 @Rs. 10 per share. Find EPS.

Q.4 What are the techniques of evaluation of investment?

(10 Marks)

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

Q.6 What is leverage? Compare and Contrast between operating (10 Marks)

Leverage and financial leverage

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Q1) Write the short notes:-

1 Financial Management :-

Financial Management is the art and science of managing money. Regulatory and

economic environments have undergone drastic changes due to liberalisation and

globalisation of Indian economy. This has changed the profile of Indian financemanagers. Indian financial managers have transformed themselves from licensed raj

managers to well-informed dynamic proactive managers capable of taking decisions of

complex nature.

Traditionally, financial management was considered a branch of knowledge with focus

on the procurement of funds. Instruments of financing, formation,merger and

restructuring of firms and legal and institutional frame work occupied the prime place

in this traditional approach.

The modern approach transformed the field of study from the traditional narrow

approach to the most analytical nature. The core of modern approach evolved around

the procurement of the least cost funds and its effective utilisation for maximisation

of share holders‟ wealth. Financial Management is concerned with the procurement of

the least cost funds and its effective utilisation for maximisation of the net wealth of

the firm. There exists a close relation between the maximisation of net wealth of

shareholders and the maximisation of the net wealth of the company. The broad areasof decision are capital budgeting, financing, dividend and working capital. Dividend

decision demands the managerial attention to strike a balance between the investor‟s

expectation and the organisations‟ growth.

2. financial planning

A financial plan has to consider capital structure, capital expenditure and cash flow.

Decisions on the composition of debt and equity must be taken.

Financial planning or financial plan indicates:

s

business, new business to be taken up and the dynamics of capital market conditions

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Benefits of financial planning

Financial planning also helps firms in the following ways.

process can effectively meet the bench-marks of investor‟s expectations.

funds, planning helps the firms to obtain funds at the right time, in the right quantity

and at the least cost as per the requirements of finance emerging opportunities.

Surplus is deployed through well planned treasury management. Ultimately, the

productivity of assets is enhanced.

of funds that constitute its capital structure in accordance with the changing

conditions of the capital market.

and instituting procedures for

elimination of wastages in the process of execution of strategic plans.

capital refers to the ratio of capital employed to the sales generated. Maintaining the

operating capability of the firm through the evolution of scientific replacement

schemes for plant and machinery and other fixed assets will help the firm in reducing

its operating capital.Financial planning deals with the planning, execution and the

monitoring of the procurement and utilisation of the funds. Financial planning process

gives birth to financial plan. It could be thought of as a blue-print explaining the

proposed strategy and its execution There are many financial planning models. All

these models forecast the future operations and then translate them to income

statements and balance sheets. It will also help the finance managers to ascertain the

funds to be procured from the outside sources The essence of all these is to achieve a

least cost capital structure which would match with the risk exposure of the company

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Failure to follow the principle of financial planning may lead a new firm of over or

under capitalisation, when the economic environment undergoes a change

Ideally every firm should aim at optimum capitalisation or it might lead to a situation

of over or under capitalisation. Both are detrimental to the interests of the society.

There are two theories of capitalisation - cost theory and earnings theory.

3) Capital Structure

The capital structure of a company refers to the mix of long-term finances used by the

firm. In short, it is the financing plan of the company. With the objective of

maximising the value of the equity shares, the choice should be that pattern of using

of debt and equity in a proportion which will lead towards achievement of the firm‟s

objective. The capital structure should add value to the firm. Financing mix decisions

are investment decisions and have no impact on the operating earnings of the firm.

Such decisions influence the firm‟s value through the earnings available to the

shareholders.

The value of a firm is dependent on its expected future earnings and the required rate

of return. The objective of any company is to have an ideal mix of permanent sources

of funds in a manner that it will maximise the company‟s market price. The proper

mix of funds is referred to as optimal capital structure. The capital structure decisions

include debt-equity mix and dividend decisions. Both these have an effect on the EPS.

As we are aware, equity and debt are the two important sources of long-term sources

of finance of a firm. The proportion of debt and equity in a firm‟s capital structure has

to be independently decided case to case.

A proposal, though not being favourable to lenders, may be taken up if they are

convinced with the earning potential and long-term benefits. Many theories have been

propounded to understand the relationship between financial leverage and firm value.

Assumptions

The following are some common assumptions made:

– debt and ordinary shares.

– both corporate and personal

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-out ratio is 100%, that is, the firm pays off the entire

earnings to its equity holders and retained earnings are zero

invest any further in its assets

tors shall have identical subjective probability distribution of the future

expected EBIT

transaction costs

4) Cost of Capital

Cost of capital is the minimum required rate of return needed to justify the use of

capital. A company obtains resources from various sources – issue of debentures,

availing term loans from banks and financial institutions, issue of preference and

equity shares or it may even withhold a portion or complete profits earned to be

utilised for further activities.

Retained earnings are the only internal source to fund the company„s future plans.

Weighted Average Cost of Capital is the overall cost of all sources of finance. The

debentures carry a fixed rate of interest. Interest qualifies for tax deduction in

determining tax liability. Therefore the effective cost of debt is less than the actual

interest payment made by the firm.

It is always advisable for companies to plan their capital structure. Decisions taken by

not assessing things in a correct manner may jeopardise the very existence of the

company. Firms may prosper in the short-run by not indulging in proper planning but

ultimately may face problems in future. With unplanned capital structure, they may

also fail to economise the use of their funds and adapt to the changing conditions.

With the above points on ideal capital structure, raising funds at the appropriate time

to finance firm„s investment activities is an important activity of the Finance Manager.

Golden opportunities may be lost for delaying decisions to this effect.

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A combination of debt and equity is used to fund the activities. What should be the

proportion of debt and equity? This depends on the costs associated with raising

various sources of funds.

The cost of capital is the minimum rate of return of a company, which must earn to

meet the expenses of the various categories of investors who have made investment

in the form of loans, debentures and equity and preference shares.

A company now 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.

5) Trading on Equity

Financial leverage as opposed to operating leverage relates to the financing activities

of a firm and measures the effect of earnings before interest and tax (EBIT) on

earnings per share (EPS) of the company.

A company‟s sources of funds fall under two categories –

shares and

Debentures and bonds carry a fixed rate of interest and have to be paid off

irrespective of the firm‟s revenues. Though dividends are not contractual obligations,

dividend on preference shares is a fixed charge and should be paid off before equity

shareholders are paid any. The equity holders are entitled to only the residual income

of the firm after all prior obligations are met. Financial leverage refers to the mix of

debt and equity in the capital structure of the firm. This results from the presence of

fixed financial charges in the company‟s income stream. Such expenses have nothing

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to do with the firm‟s performance and earnings and should be paid off regardless of

the amount of earnings before income and tax (EBIT).

Sikkim Manipal University Page No. 114 It is the firm‟s 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 earning more by the use of assets funded by fixed sources is said to be

having a favourable or positive leverage. Unfavourable leverage occurs when the firm

is not earning sufficiently to cover the cost of funds. Financial leverage is also referred

to as “Trading on Equity”.

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Q2) B. What is reorder level ?

Ans:-

Ordering level is that level at which action for replenishment of inventory is

initiated.

OL = MRC X MLTWhere, MRC = Maximum rate of consumption

MLT = Maximum lead time

Managerial significance of fixation of Inventory level

Inventory level ensures the smooth productions of the finished goods by making

available the raw material of right quality in right quantity at the right time.

can avoid both overstocking and shortage of each and every essential and vital item of

inventory.

moving items of inventory. This brings about better co-ordination between materials

management and production management on one hand and between stores manager

and marketing manager on the other.

Re-order Point

“When to order” is another aspect of inventory management. This is answered by re-

order point.

The re-order point is that inventory level at which an order should be placed to

replenish the inventory.

To arrive at the re-order point under certainty, the two key required details are:

Average usage

Lead time refers to the average time required to replenish the inventory after placing

orders for inventory.

Under certainty, re-order point refers to that inventory level which will meet the

consumption needs during the lead time.

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Safety Stock

Since it is difficult to predict in advance usage and lead time accurately, provision is

made for handling the uncertainty in consumption due to changes in usage rate and

lead time. The firm maintains a safety stock to manage the stock – out arising out of

this uncertainty. When safety stock is maintained, (When variation is only in usage

rate)

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Q4) What are the techniques of evaluation of investment?

Ans :-

Steps involved in the evaluation of any investment proposal are:

project life cycle

Examination of the risk profile of the project to be taken up and arriving at the

required rate of return

Estimation of cash flows

Estimating the cash flows associated with the project under consideration is the most

difficult and crucial step in the evaluation of an investment proposal. Estimation is the

result of the team work of many professionals in an organisation.

aspects of production process

revenue during the period of accrual of benefits from project executions

ws and cash out flow statement is prepared by the cost

accountant on the basis of the details generated in the above steps The ability of the

firm to forecast the cash flows with reasonable accuracy lies at the root of the success

of the implementation of any capital expenditure decision.

Estimation of incremental cash flows

Investment (capital budgeting) decision requires the estimation of incremental cash

flow stream over the life of the investment. Incremental cash flows are estimated on

tax basis. Incremental cash flows stream of a capital expenditure decision has three

components.

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Initial cash outlay (Initial investment)

Initial cash outlay to be incurred is determined after considering any post tax cash

inflows. In replacement decisions existing old machinery is disposed of and a new

machinery incorporating the latest technology is installed in its place. On disposal of

existing old machinery the firm has a cash inflow. This cash inflow has to be computed

on post tax basis.

The net cash out flow (total cash required for investment in capital assets minus post

tax cashinflow on disposal of the old machinery being replaced by a new one)

therefore is the incremental cash outflow. Additional net working capital required on

implementation of new project is to be added to initial investment.

Operating cash inflows

Operating cash inflows are estimated for the entire economic life of investment

(project). Operating cash inflows constitute a stream of inflows and outflows over the

life of the project. Here also incremental inflows and outflows attributable to

operating activities are considered. Any savings in cost on installation of a new

machinery in the place of the old machinery will have to be accounted on post tax

basis. In this connection incremental cash flows refer to the change in cash flows on

implementation of a new proposal over the existing positions.

Terminal cash inflows

At the end of the economic life of the project, the operating assets installed will be

disposed off. It is normally known as salvage value of equipments. This terminal cash

inflows are computed on post tax basis. Prof. Prasanna Chandra in his book Financial

Management (Tata McGraw Hill, published in 2007) has identified certain basic

principles of cash flow estimation. The knowledge of these principles will help a

student in understanding the basics of computing incremental cash flows.

Separation principle

The essence of this principle is the necessity to treat investment element of the

project separately (i.e. independently) from that of financing element.

The financing cost is computed by the cost of capital. Cost of capital is the cut off

rate and rate of return expected on implementation of the project. Therefore, we

compute separately cost of funds for execution of project through the financing mode.

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The rate of return expected on implementation if the project is arrived at by the

investment profile of the projects. Therefore, interest on debt is ignored while

arriving at operating cash inflows.

Incremental principle

Incremental principle says that the cash flows of a project are to be considered in

incremental terms. Incremental cash flows are the changes in the firms total cash

flows arising directly from the implementation of the project. Keep the following in

mind while determining incremental cash flows.

Ignore sunk costs

Sunk costs are costs that cannot be recovered once they have been incurred.

Therefore, sunk costs are ignored when the decisions on project under consideration is

to be taken.

Opportunity costs

If the firm already owns an asset or a resource which could be used in the execution of

the project under consideration, the asset or resource has an opportunity cost. The

opportunity cost of such resources will have to be taken into account in the evaluation

of the project for acceptance or rejection.

Need to take into account all incident effect

Effects of a project on the working of other parts of a firm also known as externalities

must be taken into account.

Cannibalisation

Another problem that a firm faces on introduction of a new product is the reduction in

the sale of an existing product. This is called cannibalisation. The most challenging

task is the handling the problems of cannibalisation. Depending on the company‟s

position with that of the competitors in the market, appropriate strategy has to be

followed. Correspondingly the cost of cannibalisation will have to be treated either as

relevant cost of the decision or ignored.

Post tax principle

All cash flows should be computed on post tax basis

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Consistency principle

Cash flows and discount rates used in project evaluation need to be consistent with

the investor group and inflation.

Q.5) What are the problems associated with inadequate working

capital?

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Q.6) What is leverage? Compare and Contrast between operating.

Leverage and financial leverage.

Ans:-

A company uses different sources of financing to fund its activities. These sources can

be classified as those which carry a fixed rate of return and those whose returns vary.

The fixed sources of finance have a bearing on the return on shareholders. Borrowing

funds as loans have an impact on the return on shareholders and this is greatly

affected by the magnitude of borrowing in the capital structure of a firm. Leverage is

the influence of power to achieve something. The use of an asset or source of funds

for which the company has to pay a fixed cost or fixed return is termed as leverage.

Leverage is the influence of an independent financial variable on a dependent

variable. It studies how the dependent variable responds to a particular change in

independent variable.

There are three types of leverage as shown in the following diagram 6.1 – operating,

financial and combined.

Operating Leverage

Operating leverage arises due to the presence of fixed operating expenses in the

firm‟s income flows. A company‟s operating costs can be categorised into three main

sections as shown fixed costs, variable costs and semi-variable 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 at are salaries to the employees, rents, insurance of the firm

and the accountancy costs. All these aspects relate to or are referred to as ―fixed

costs‖.

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Variable costs

Variable costs are those which vary in direct proportion to output and sales. An

increase or decrease in production or sales activities will have a direct effect on such

types 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 material

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 a certain level beyond which they vary

with the firm‟s 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 which act at some point of time 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 is the firm‟s ability to use fixed operating costs to increase the

effects of changes in sales on its earnings before interest and taxes (EBIT). Operating

leverage occurs any time a firm has fixed costs. The percentage change in profits with

a change in volume of sales is more than the percentage change in volume.

The illustration clearly tells us that when a firm has fixed operating expenses, an

increase in sales results in a more proportionate increase in earnings before interest

and taxes (EBIT) and vice versa. The former is a favourable operating leverage and the

latter is unfavourable.

Financial Leverage

Financial leverage as opposed to operating leverage relates to the financing activities

of a firm and measures the effect of earnings before interest and tax (EBIT) on

earnings per share (EPS) of the company.

A company’s sources of funds fall under two categories –

shares and

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carry a fixed rate of interest and have to be paid off irrespective of the firm‟s

revenues. Though dividends are not contractual obligations, dividend on preference

shares is a fixed charge and should be paid off before equity shareholders are paid

any. The equity holders are entitled to only the residual income of the firm after all

prior obligations are met.

Financial leverage refers to the mix of debt and equity in the capital structure of the

firm. This results from the presence of fixed financial charges in the company‟s

income stream. Such expenses have nothing to do with the firm‟s performance and

earnings and should be paid off regardless of the amount of earnings before income

and tax (EBIT).

It is the firm‟s 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 earning more by the use of assets funded by fixed sources is said to be

having a favourable or positive leverage. Unfavourable leverage occurs when the firm

is not earning sufficiently to cover the cost of funds. Financial leverage is also referred

to as “Trading on Equity”.

This example shows that the presence of fixed interest source funds leads to a value

more than that occurs due to proportional change in EPS. The presence of such fixed

sources implies the presence of financial leverage. This can be expressed in a different

way. The degree of financial leverage (DFL) is a more precise measurement. It

examines the effect of the fixed sources of funds on EPS.

Use of Financial Leverage

Studying the degree of financial leverage (DFL) at various levels makes financial

decision-making, on the use of fixed sources of funds, for funding activities easy. One

can assess the impact of change in earnings before interest and tax (EBIT) on earnings

per share (EPS).

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Like operating leverage, the risks are high at high degrees of financial leverage (DFL).

High financial costs are associated with high DFL. An increase in financial costs implies

higher level of EBIT to meet the necessary financial commitments.

A firm which is not capable of honouring its financial commitments may be forced to

go into liquidation by the lenders of funds. The existence of the firm is shaky under

these circumstances.

On one side the trading on equity improves considerably by the use of borrowed funds

and on the other hand, the firm has to constantly work towards higher EBIT to stay

alive in the business. All these factors should be considered while formulating the

firm‟s mix of sources of funds.

One main goal of financial planning is to devise a capital structure in order to provide

a high return to equity holders. But at the same time, this should not be done with

heavy debt financing which drives the company on to the brink of winding up.

Impact of financial leverage

Highly leveraged firms are considered very risky and lenders and creditors may refuse

to lend them further to fuel their expansion activities. On being forced to continue

lending, they may do so with their own conditions like earning a minimum of X% EBIT

or stipulating higher interest rates than the market rates or no further mortgage of

securities.

Financial leverage is considered to be favourable till such time that the rate of return

exceeds the rate of return obtained when no debt is used.

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