Financial Management

Q 1. Capitalization of a firm refers to the composition of its long term funds debt and equity. Discuss
the theories of capitalization?
Answer
Theories of
capitalisation

Earnings
theory

Cost theory

(i)

Cost Theory: According to the cost theory of capitalization, the value of a company is
arrived at by adding up the cost of fixed assets like plants, machinery patents, etc., the
capital regularly required for the continuous operation of the company (working capital),
the cost of establishing business and expenses of promotion. The original outlays on all
these items become the basis for calculating the capitalization of company

(ii)

Earnings Theory: The earnings theory of Capitalization recognizes the fact that the true
value (capitalization) of an enterprise depends upon its earnings and earning capacity.
According to it, therefore, the value or Capitalization of a company is equal to the
capitalized value of its estimated earnings. For this purpose a new company has to
prepare an estimated profit and loss account. For the first few year of its life, the sales are
forecast ad the manager has to depend upon his experience for determining the probable
cost.

(iii)

Under Capitalisation: Under Capitalisation is just the reverse of the over Capitalisation.
A company is considered to be Under Capitalisation when its actual Capitalisation is lower
than the proper Capitalisation as warranted by the earning capacity

Causes of Under Capitalisation:

under estimation of the future earnings at the time of the promotion of the
company

under estimation of total funds requirements

purchase of assets at exceptionally low prices during recession

Remedies:

splitting up of the shares which will be reduce the dividend per share

issue of bonus shares, which will reduce both the dividend per share and the
earnings per share

(iv)

Over Capitalisation: A company is said to be Over Capitalisation when its total capital
(both equity and debt) exceeds the true value of its assets.
Over Capitalisation may be considered on the account of:
Acquiring assets at inflated rates
Acquiring unproductive assets
High initial cost of establishing the firm

Existence of idle funds

Total funds requirements have been over estimated.

Q 2. A) The share of Megha Ltd is sold at Rs 500 a share. The dividend likely to be declared by the
company after one year is Rs 25 per share. Hence, the price after one year is expected to be Rs 550.
What is the return at the end of the year on the basis of likely dividend and price per share?
Solution:
Holding Period Return = (D1 + Price gain/loss) / Purchase Price
= (25 + 50) / 500 = 15%
The return at the end of the year will be 15%

B) A bond of face value of Rs 1000 and a maturity of 3 years pays 15% interest annually. What is the
market price of the bond if YTM is also 15 %.
Solution:
P = Interest PVIFA (15% , 3y) + Redemption Value * PVIF (15% , 3y)
P = 150*2.283 + 1000*0.658
P = 342.45 + 658 = Rs. 1000.45

The Market price of the bond is Rs. 1000.45.

Q 3. Discuss the sources of capital of a company. Analyse the factors that affect the capital structure.
Ans. sources of capital:

Issue of equity shares in domestics capital market.

Issue of equity (depository share) in the international capital market.
Equity financing from financial institution
Private equity
Issue of debentures in domestics capital market
Issue of debentures to financial institutions
Long term loans
Mortgage loans
Issue of preference share

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 view to achieve the target
Capital Structure.
Every time the fund have to be procured , the financial manager weights 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
The major factor affecting the Capital Structure is leverage. There are also a few other factors affecting
them.
Leverage:
The use of sources of funds that have a fixed cost attached to them, such as preference shares, loans
from banks and financial institution, and debentures in the Capital Structure ,is known as trading on
equity or financial leverage
Cost of Capital:
High cost funds should be avoided. However attractive an investment proposition may look like the
profit earned may be eaten away by interest repayments.
Cash flow projections of the company:
Decisions should be taken in the light of cash flow projected for the next 3-5 years. The company
officials should not get carried away at the immediate results expected.

Dilution of control:
The top management should have the flexibility to take appropriate decisions at the right time.
Fear of having to share control and thus being interfered by other often delays the decisions of the
closely held companies to go public.
Floatation Costs

Q 4. A project costs Rs 50,000. It is expected to generate cash inflows as shown in table. If the risk free
rate is 10%, compute NPV.
Year

Cash inflows

Certainty equivalent

32000

0.9

27000

0.6

20000

0.5

10000

0.3

Solution
Computation of NPV
Year
1
2
3
4

Uncertain cash
inflows
32000
27000
20000
10000

CE
0.9
0.6
0.5
0.3
PV certain
cash inflows

Certain cash
inflows
28800
16200
10000
30000

Initial cash
out- lay

NPV

The project has negative NPV, therefore it is rejected.

PV factor at
10%
0.909
0.826
0.751
0.683

PV certain
cash inflows
26179
13381
7510
2049
49119

(50000)

(881)

5.) Annual demand of a company is 30,000 units. The ordering cost per order is Rs 20 (fixed) along
with a carrying cost of Rs 10 per unit per anum. The purchase cost per unit i.e., price per unit is Rs 32
per unit. Determine EOQ, total number of orders in a year and the time gap between two orders.
a) EOQ
b) Total number of orders in a year
c) The time gap between two orders.

Solution:

A).

= 346 Units

K= Rs.20
Kc = Rs.10
D = 30,000
B). The Total Number of orders in a year =

C). Time gap between two orders

= 87 orders

Q 6. Discuss the dividend policy of Dabur India Ltd for the last three years:-

Ans: - The company is currently headed by Mr. Sunil Duggal. Dabur is leading Indian FMCG
company, offering products in the hair oil, shampoo, oral care, home care, skin care, foods and
healthcare categories.
DIVIDENT SHALL BE DECLARED OR PAID ONLY OUT OF:I) Current Years profit
a) After providing for depreciation in accordance with law.
b) After transferring to the reserves such amount of profit.
As may be prescribed, or
Dividend payout

Announced
10/28/13
4/30/13
4/30/12
4/28/11
10/27/10
6/18/10
10/26/09
4/29/09
1/28/09

Amount
INR 0.75

0.75

Period
Q2 14

Change

Record
11-06-2013

N/A

1/28/09

Payable
10/28/13
7/19/13
7/20/12
4/28/11
10/27/10
6/18/10
10/26/09
4/29/09
1/28/09