MBA FINANCIAL MANAGEMENT QUESTION AND ANSWERS ANDHRA

UNIVERSITY
FINANCIAL LEVERAGE:
Financial leverage is the degree to which a company uses fixed-income securities such as
debt and preferred equity. The more debt financing a company uses, the higher its financial
leverage.
Financial leverage refers to the use of debt to acquire additional assets. Financial leverage is
also known as trading on equity.
Example :
Mary uses Rs. 400,000 of her cash to purchase 40 acres of land with a total cost of
Rs.400,000. Mary is not using financial leverage.
John uses Rs.400,000 of her cash and borrows Rs.800,000 to purchase 120 acres of land
having a total cost of Rs.1,200,000. He is using financial leverage. He is controlling
Rs.1,200,000 of land with only Rs.400,000 of her own money.
Financial Leverage Definition
Financial leverage is the amount of debt that an entity uses to buy more assets. Leverage is
employed to avoid using too much equity to fund operations. An excessive amount of financial
leverage increases the risk of failure, since it becomes more difficult to repay debt.
The financial leverage formula is measured as the ratio of total debt to total assets.
As the proportion of debt to assets increases, so too does the amount of financial leverage.
Financial leverage is favourable when the uses to which debt can be put generate
returns greater than the interest expense associated with the debt. Many companies
use financial leverage rather than acquiring more equity capital, which could reduce the
earnings per share of existing shareholders.
Financial leverage has two primary advantages:
Enhanced earnings. Financial leverage may allow an entity to earn a disproportionate
amount on its assets.
Favorable tax treatment. In many tax jurisdictions, interest expense is tax deductible,
which reduces its net cost to the borrower.
However, financial leverage also presents the possibility of disproportionate losses, since the
related amount of interest expense may overwhelm the borrower if it does not earn sufficient
returns to offset the interest expense. This is a particular problem when interest rates rise or
the returns from assets decline.
The unusually large swings in profits caused by a large amount of leverage
increase the volatility of a company's stock price. This can be a problem when
accounting for stock options issued to employees, since highly volatile stocks are considered
to be more valuable, and so create a higher compensation expense than would less volatile
shares.
Financial leverage is an especially risky approach in a cyclical business, or one in
which there are low barriers to entry, since sales and profits are more likely to fluctuate
considerably from year to year, increasing the risk of bankruptcy over time. Conversely,
financial leverage may be an acceptable alternative when a company is located in an industry
with steady revenue levels, large cash reserves, and high barriers to entry, since operating
conditions are sufficiently steady to support a large amount of leverage with little downside.
There is usually a natural limitation on the amount of financial leverage, since lenders are less
likely to forward additional funds to a borrower that has already borrowed a large amount of
debt.
DEBT/EQUITY RATIO :
The debt to equity ratio is a financial, liquidity ratio that compares a company's total debt to
total equity. The debt to equity ratio shows the percentage of company financing that comes
from creditors and investors. A higher debt to equity ratio indicates that more creditor
financing (bank loans) is used than investor financing (shareholders).
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Formula
The debt to equity ratio is calculated by dividing total liabilities by total equity. The debt to
equity ratio is considered a balance sheet ratio because all of the elements are reported on
the balance sheet.

Analysis
Each industry has different debt to equity ratio benchmarks, as some industries tend
to use more debt financing than others. A debt ratio of .5 means that there are half as many
liabilities than there is equity. In other words, the assets of the company are funded 2-to-1 by
investors to creditors. This means that investors own 66.6 cents of every dollar of company
assets while creditors only own 33.3 cents on the dollar.
A debt to equity ratio of 1 would mean that investors and creditors have an equal stake in the
business assets.
A lower debt to equity ratio usually implies a more financially stable business.
Companies with a higher debt to equity ratio are considered more risky to creditors
and investors than companies with a lower ratio. Unlike equity financing, debt must be
repaid to the lender. Since debt financing also requires debt servicing or regular interest
payments, debt can be a far more expensive form of financing than equity financing.
Companies leveraging large amounts of debt might not be able to make the payments.
Creditors view a higher debt to equity ratio as risky because it shows that the
investors haven't funded the operations as much as creditors have. In other words,
investors don't have as much skin in the game as the creditors do. This could mean that
investors don't want to fund the business operations because the company isn't performing
well. Lack of performance might also be the reason why the company is seeking out extra
debt financing.
Example
Assume a company has $100,000 of bank lines of credit and a $500,000 mortgage on its
property. The shareholders of the company have invested $1.2 million. Here is how you
calculate the debt to equity ratio.

WEIGHTED AVERAGE COST OF CAPITAL :

Weighted average cost of capital (WACC) is the average after-tax cost of a companys
various capital sources, including common stock, preferred stock, bonds and any other longterm debt.
A company has two primary sources of financing - debt and equity - and, in simple terms,
WACC is the average cost of raising that money.
WACC is calculated by multiplying the cost of each capital source (debt and equity) by its
relevant weight, and then adding the products together to determine the WACC value:

WACC =
* Re +
Where:
Re = cost of equity
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* Rd * (1 Tc)

Rd = cost of debt
E = market value of the firms equity
D = market value of the firms debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
When calculating a firm's WACC, the first step is to determine what proportion of a firm is
financed by equity and what proportion is financed by debt by entering the appropriate values
into the

and

components of the equation. Next, the proportion of equity (

multiplied by the cost of equity (Re); and the proportion of debt (

of debt (Rd).

) is

) is multiplied by the cost

The debt side of the equation ( * Rd) is then multiplied by (1 - Tc) to get the aftertax cost of debt (there is a tax shield associated with interest). The final step is to add the
equity side of the equation to the debt side of the equation to determine WACC.
For example, a firm's financial data shows the following:
Equity = $8,000
Debt = $2,000
Re = 12.5%
Rd = 6%
Tax rate = 30%
To find WACC, enter the values into the equation and solve:
WACC =[(
* 0.125)] + [(
* 0.06 * (1 - 0.3)]
WACC = 0.1 + .0084 = 0.1084 or 10.84%; the WACC for this firm then is 10.84%.
Because the calculation takes time, most investors use online stock analysis tools to find a
company's WACC.

CURRENT RATIO :
The current ratio is a financial ratio that investors and analysts use to examine the
liquidity of a company and its ability to pay short-term liabilities (debt and
payables) with its short-term assets (cash, inventory, receivables).
The current ratio is calculated by dividing current assets by current liabilities:
Current ratio = current assets / current liabilities
As of March 31, 2014, for example, Microsofts (MSFT) balance sheet listed the following:
Current Assets:
Cash and cash
equivalents

$11,572,000

Short-term investments

$76,853,000

Net receivables

$14,921,000

Inventory

$1,920,000

Other current assets

$3,740,000

Total current assets

$109,006,000

Current Liabilities:
Accounts payable
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$9,958,000

Short-term debt

$2,000,000

Other current liabilities

$21,945,000

Total current liabilities

$33,903,000

To determine MSFTs current ratio, we divide current assets by current liabilities:

MSFT current ratio = $109,006,000 / $33,903,000 = 3.22
The current ratio can provide investors and analysts with clues about the efficiency of a
companys operating cycle or its ability to monetize its products.
The higher the ratio, the more able a company is to pay off its obligations. While
acceptable ratios vary depending on the specific industry, a ratio between 1.5 and 3 is
generally considered healthy. Investors and analysts would consider MSFT, with a current ratio
of 3.22, financially healthy and capable of paying off its obligations.
Liquidity problems can arise for companies that have difficulty getting paid on their
receivables or that have slow inventory turnover because they cant satisfy their obligations.
A ratio under 1 implies that a company would be unable to pay off its obligations if they
become due at that point in time. A ratio under 1 does not necessarily mean that a
company will go bankrupt since it may be able to secure other forms of financing;
however, it does indicate the company is not in good financial health. A ratio that is
too high may indicate that the company is not efficiently using its current assets or
short-term financing.
As with other financial ratios, it is more useful to compare various companies within the same
industry than to look at only one company, or to attempt to compare companies from
different industries. In addition, investors should consider more than one ratio (or number)
when making investment decisions since one cannot provide a comprehensive view of the
company.
INTERNAL RATE OF RETURN:
internal rate of return (IRR) method also takes into account the time value of
money. It analyzes an investment project by comparing the internal rate of return to
the minimum required rate of return of the company.
The internal rate of return is the rate at which an investment project promises to
generate a return during its useful life. The minimum required rate of return is set
by management. Most of the time, it is the cost of capital of the company.
Under this method, If the internal rate of return promised by the investment project is greater
than or equal to the minimum required rate of return, the project is considered acceptable
otherwise the project is rejected. Internal rate of return method is also known as timeadjusted rate of return method.
To understand how computations are made and how a proposed investment is accepted or
rejected under this method, consider the following example:
Example:
The management of VGA Textile Company is considering to replace an old machine with a new
one. The new machine will be capable of performing some tasks much faster than the old one.
The installation of machine will cost $8,475 and will reduce the annual labor cost by $1,500.
The useful life of the machine will be 10 years with no salvage value. The minimum required
rate of return is 15%.
Required: Should VGA Textile Company purchase the machine? Use internal rate of return
(IRR) method for your conclusion.
Solution:
To conclude whether the proposal should be accepted or not, the internal rate of return
promised by machine would be found out first and then compared to the companys minimum
required rate of return.
The first step in finding out the internal rate of return is to compute a discount factor
called internal rate of return factor. It is computed by dividing the investment required for the
project by net annual cash inflow to be generated by the project. The formula is given below:
Formula of internal rate of return factor:
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In our example, the required investment is $8,475 and the net annual cost saving is $1,500.
The cost saving is equivalent to revenue and would, therefore, be treated as net cash inflow.
Using this information, the internal rate of return factor can be computed as follows:
Internal rate of return factor = $8,475 /$1,500
=5.650
After computing the internal rate of return factor, the next step is to locate this discount
factor in present value of an annuity of $1 in arrears table. Since the useful life of
the machine is 10 years, the factor would be found in 10-period line or row. After finding this
factor, see the rate of return written at the top of the column in which factor 5.650 is written.
It is 12%. It means the internal rate of return promised by the project is 12%. The final step is
to compare it with the minimum required rate of return of the VGA Textile Company. That is
15%.
Conclusion:
According to internal rate of return method, the proposal is not acceptable because the
internal rate of return promised by the proposal (12%) is less than the minimum required rate
of return (15%).
Notice that the internal rate of return promised by the proposal is a discount rate that equates
the present value of cash inflows with the present value of cash out flows as proved by the
following computation:
Present value of cash
$8,475 1.000 =
Now
outflow
$8,475
Present value of cash
1-10 year-period @ $1,500 5.650 =
inflow
12%
$8,475
CASH FLOW ANALYSIS:
In financial accounting, a cash flow statement, also known as statement of cash flows, is a
financial statement that shows how changes in balance sheet accounts and income affect cash and
cash equivalents, and breaks the analysis down to operating, investing and financing activities.
The statement of cash flows is part of the financial statements issued by a
business, and describes the cash flows into and out of the organization. Its particular
focus is on the types of activities that create and use cash, which are operations,
investments, and financing. Though the statement of cash flows is generally considered
less critical than the income statement and balance sheet, it can be used to discern trends in
business performance that are not readily apparent in the rest of the financial statements. It is
especially useful when there is a divergence between the amount of profits reported and the
amount of net cash flow generated by operations.
There can be significant differences between the results shown in the income statement and
the cash flows in this statement, for the following reasons:
There are timing differences between the recordation of a transaction and when the related
cash is actually expended or received.
Management may be using aggressive revenue recognition to report revenue for which cash
receipts are still some time in the future.
The business may be asset intensive, and so requires large capital investments that do not
appear in the income statement, except on a delayed basis as depreciation.
Many investors feel that the statement of cash flows is the most transparent of the
financial statements (i.e., most difficult to fudge), and so they tend to rely upon it
more than the other financial statements to discern the true performance of a
business.
Cash flows in the statement are divided into the following three areas:
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Operating activities. These constitute the revenue-generating activities of a business.

Examples of operating activities are cash received and disbursed for product sales, royalties,
commissions, fines, lawsuits, supplier and lender invoices, and payroll.
Investing activities. These constitute payments made to acquire long-term assets, as well
as cash received from their sale. Examples of investing activities are the purchase of fixed
assets and the purchase or sale of securities issued by other entities.
Financing activities. These constitute activities that will alter the equity or borrowings of a
business. Examples are the sale of company shares, the repurchase of shares, and dividend
payments.
There are two ways in which to present the statement of cash flows, which are the
direct method and the indirect method.
The direct method requires you to present cash flow information that is directly associated
with the items triggering cash flows, such as:
1. Cash collected from customers
2. Interest and dividends received
3. Cash paid to employees
4. Cash paid to suppliers
5. Interest paid
6. Income taxes paid
Few organization collect information as required for the direct method, so they instead use the
indirect method.
Under the indirect approach, the statement begins with the net income or loss
reported on the company's income statement, and then makes a series of
adjustments to this figure to arrive at the amount of net cash provided by
operating activities.

METHODS OF CASH FLOW STATEMENT: There are two ways in which to present the statement of cash flows, which are the direct method
and the indirect method.
Direct Method: The direct method of presenting the statement of cash flows presents the

specific cash flows associated with items that affect cash flow.
Items that typically do so include:
1. Cash collected from customers
2. Interest and dividends received
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3. Cash paid to employees

4. Cash paid to suppliers
5. Interest paid
6. Income taxes paid
The advantage of the direct method over the indirect method is that it reveals operating
cash receipts and payments.
The standard-setting bodies encourage the use of the direct method, but it is rarely used, for
the excellent reason that the information in it is difficult to assemble; companies simply do
not collect and store information in the manner required for this format. Using the direct
method may require that the chart of accounts be restructured in order to collect different
types of information. Instead, they use the indirect method, which can be more easily derived
from existing accounting reports.
Statement of Cash Flows Direct Method Example
Lowry Locomotion constructs the following statement of cash flows using the direct method:
Lowry Locomotion -- Statement of Cash Flows -- for the year ended 12/31/x1
Cash flows from operating activities
Cash receipts from customers
$45,800,000
Cash paid to suppliers
(29,800,000)
Cash paid to employees
(11,200,000)
Cash generated from operations
4,800,000
Interest paid
Income taxes paid
Net cash from operating activities

(310,000)
(1,700,000)
$2,790,000

Cash flows from investing activities

Purchase of property, plant, and equipment
Proceeds from sale of equipment
Net cash used in investing activities

(580,000)
110,000

Cash flows from financing activities

Proceeds from issuance of common stock
Proceeds from issuance of long-term debt
Principal payments under capital lease obligation
Dividends paid
Net cash used in financing activities

1,000,000
500,000
(10,000)
(450,000)

Net increase in cash and cash equivalents

Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period

(470,000)

1,040,000
3,360,000
1,640,000
$5,000,000

Reconciliation of net income to net cash provided by operating activities:

Net income
$2,665,000
Adjustments to reconcile net income to net cash provided by operating
activities:
Depreciation and amortization
$125,000
Provision for losses on accounts receivable
15,000
Gain on sale of equipment
(155,000)
Increase in interest and income taxes payable
32,000
Increase in deferred taxes
90,000
Increase in other liabilities
18,000
Total adjustments
125,000
Net cash provided by operating activities
$2,790,000
CASH FLOW STATEMENT INDIRECT METHOD:
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The statement of cash flows is one of the components of a company's set of financial
statements, and is used to reveal the sources and uses of cash by a business. It
presents information about cash generated from operations and the effects of various
changes in the balance sheet on a company's cash position.
Under the indirect method of presenting the statement of cash flows, the
presentation of this statement begins with net income or loss, with subsequent
additions to or deductions from that amount for non-cash revenue and expense
items, resulting in net income provided by operating activities.
The format of the indirect method appears in the following example. In the presentation
format, cash flows are divided into the following general classifications:
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities
The indirect method of presentation is very popular, because the information
required for it is relatively easily assembled from the accounts that a business
normally maintains in its chart of accounts. The indirect method is less favored by the
standard-setting bodies, since it does not give a clear view of how cash flows through a
business (as is shown under the direct method of presentation).
Statement of Cash Flows Indirect Method Example
For example, Lowry Locomotion constructs the following statement of cash flows using the
indirect method:
Lowry Locomotion - Statement of Cash Flows -- for the year ended 12/31x1
Cash flows from operating activities
Net income
$3,000,000
Adjustments for:
Depreciation and amortization
$125,000
Provision for losses on accounts receivable
20,000
Gain on sale of facility
(65,000)
80,000
Increase in trade receivables
(250,000)
Decrease in inventories
325,000
Decrease in trade payables
(50,000)
25,000
Cash generated from operations
3,105,000
Cash flows from investing activities
Purchase of property, plant, and equipment
Proceeds from sale of equipment
Net cash used in investing activities

(500,000)
35,000

Cash flows from financing activities

Proceeds from issue of common stock
Proceeds from issuance of long-term debt
Dividends paid
Net cash used in financing activities

150,000
175,000
(45,000)

(465,000)

Net increase in cash and cash equivalents

Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period

OBJECTIVES OF FINANCIAL RATIOS:

Objectives of financial statement analysis are as follows

280,000
2,920,000
2,080,000
$5,000,000

1.Assessment Of Past Performance : Past performance is a good indicator of future

performance. Investors or creditors are interested in the trend of past sales, cost of goods
sold, operating expenses, net income, cash flows and return on investment. These trends offer
a means for judging management's past performance and are possible indicators of future
performance.
2.Assessment of current position : Financial statement analysis shows the current
position of the firm in terms of the types of assets owned by a business firm and the different
liabilities due against the enterprise.
3.Prediction of profitability and growth prospects : Financial statement analysis helps in
assessing and predicting the earning prospects and growth rates in earning which are used by
investors while comparing investment alternatives and other users in judging earning
potential of business enterprise.
4.Prediction of bankruptcy and failure : Financial statement analysis is an important tool
in assessing and predicting bankruptcy andprobability of business failure.
5. Assessment of the operational efficiency : Financial statement analysis helps
to assess the operational efficiency of the management of a company. The actual
performance of the firm which are revealed in the financial statements can be compared with
some standards set earlier and the deviation of any between standards and actual
performance can be used as the indicator of efficiency of the management.

FINANCE FUNCTION:

Functions of Financial Management : Financial management performs different function

for the effective management of funds of any organization. Financial management is
concerned with the supervision of the capital invested in the business enterprise, allocation of
finance to resources and overall increase in the value of business.
The function of financial management include the following Resource mobilization from the economy
Resource development
Resource generation and distribution for growth and risk comparison
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Basically these decisions are divided under three broad categories. These are financial
decision, investment decision and dividend decisions.
Financial Decision- Financing decision of an enterprise includes decision for short term
capital and long term capital requirement. Financing decision include decision upon the needs
and source of new outside financing and caring on negotiations for new outside financing.
Financing means procurement of finance at most convenient and economic rates.
Investment Decisions- Funds acquired from different sources are to be invested in
profitable projects so that maximum profit can be earned and the value of the wealth
becomes maximum. Long term funds are invested for the acquisition of fixed assets and
current assets also. The investment of funds in different projects should be made carefully so
that the funds can be utilized in the maximum possible ways. Capital budgeting techniques is
used or making investment decisions. Investment decision considers the management of
current assets such as cash, marketable securities, etc. Capital budgeting which includes
identification, selection, implementation of capital projects, etc. and management of mergers,
reorganization, disinvestment, etc.
Dividend Decisions- The financial managers takes dividend decisions. For taking decision in
respect of dividend, the factor to be consider include- availability of cash, tax position of the
shareholders, trend of earnings, requirements of funds for the future, etc. Dividend decision
considers the allocation of net profit. Dividend decision gives emphasis on the checking on
financial performance. The financial manager takes initiatives to take proper dividend
decisions as to the amount of dividend to be paid and the time of payment of dividend. He
tries to set balance between dividend retention and distribution. Dividend decisions are taken
considering the overall liquidity and profitability of the enterprise. Dividend decisions are
taken taking into account the disposition of profits between dividend and retained earnings.
RIGHTS ISSUE:
New stock (share) issue offered to existing stockholders (shareholders) in proportion to
their current stock/shareholding, for a specified period and at a specified (usually
discounted) price. Its objective is to afford them the opportunity to maintain their
percentage of ownership of the firm. See also scrip issue. Also called rights offering
Fully paid-up new common stock (ordinary shares) issued free to
existing stockholders (shareholders) in proportion to their current stock/shareholdings.
A bookkeeping transaction (because no cash changes hands), it capitalizes a part
of reserves (retained earnings) to bring
(1) share capital more in line with the assets employed; and (2) a high share price back to a
more manageable amount, thus enhancing its marketability. Although the number
of shares held by each shareholder increases, the value of the total shareholding remains the
same as before the bonus issue. Also called as scrip issue, bonus shares, capitalisation issue.
BONUS ISSUE:

Stock split is done to infuse liquidity and to make shares affordable

for various investors who could not buy the shares of that company before due to
high prices.
Definition: When a company declares a stock split, the number of shares of that
company increases, but the market cap remains the same. Existing shares split, but
the underlying value remains the same. As the number of shares increases, price per share
goes down.
Description: Stock split is done to infuse liquidity and to make shares affordable for various
investors who could not buy the shares of that company before due to high prices.
People often confuse bonus shares with stock split. Distribution of bonus shares only changes
its issued share capital whereas stock split splits the company's authorized share capital.
STOCK SPLITS:

STABLE DIVIDEND POLICY :

Types of Dividend Policis:

(1) Strict or Conservative dividend Policy which envisages the retention

of profits on the cost of dividend pay-out. It helps in strengthening the financial position of the company; (2)
Lenient Dividend Policy which views the payment of dividend at the maximum rate possible taking in view the
current earing of the company. Under such policy company retains the minimum possible earnings; (3) Stable

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Dividend Policy suggests a mid-way of the above two views. Under this policy, stable or almost stable rate
of dividend is maintained. Company maintains reserves in the years of prosperity and uses them in paying
dividend in lean year. If company follows stable dividend policy, the market price of tis shares shall be higher.
There are reasons why investors prefer stable dividend policy.
Main reasons are:1. Confidence Among Shareholders. A regular and stable dividend payment may serve to resolve uncertainty in
the minds of shareholders. The company resorts not to cut the dividend rate even if its profits are lower. It
maintains the rate of dividends by appropriating the funds from its reserves. Stable dividend presents a bright
future of the company and thus gains the confidence of the shareholders an the goodwill of the company increases
in the eyes of the general investors.
2. Income Conscious Investors. The second factor favouring stable dividend policy is that some investors are
income conscious and favour a stable rate of dividend. They too, never favour an unstable rte of dividend. A Stable
dividend policy may also satisfy such investors.
3. Stability in Market Price of Shares. Other things beings equal, the market price very with the rate of
dividend the company declares on its equity shares. The value of shares of a company having a stable dividend
policy fluctuates not widely even if the earnings of the company turn down. Thus, this policy buffer the market
price of the stock.
4. Encouragement to Institutional Investors. A stable dividend policy attracts investments from institutional
investors such institutional investors generally prepare a list of securities, mainly incorporating the securities of the
companies having stable dividend policy in which they invest their surpluses or their long term funds such as
pensions or provident funds etc. In this way, stability and regularity of dividends not only affects the market price
of shares but also increases the general credit of the company that pays the company in the long run.

----------------------------------------------------------------------------------------------------------------------------FINANCIAL RISK :

Financial Risk is one of the major concerns of every business across fields and geographies.
Risk can be referred as the chances of having an unexpected or negative outcome. Any action
or activity that leads to loss of any type can be termed as risk. There are different types of
risks that a firm might face and needs to overcome. Widely, risks can be classified into three
types: Business Risk, Non-Business Risk and Financial Risk.
Business Risk: These types of risks are taken by business enterprises themselves in order to
maximize shareholder value and profits.
As for example: Companies undertake high cost risks in marketing to launch new product in
order to gain higher sales.
Non- Business Risk: These types of risks are not under the control of firms. Risks that arise
out of political and economic imbalances can be termed as non-business risk.
Financial Risk: Financial Risk as the term suggests is the risk that involves financial loss to
firms. Financial risk generally arises due to instability and losses in the financial market
caused by movements in stock prices, currencies, interest rates and more.
Types of Financial Risks:
Financial risk is one of the high-priority risk types for every business. Financial risk is caused
due to market movements and market movements can include host of factors. Based on this,
financial risk can be classified into various types such as Market Risk, Credit Risk,
Liquidity Risk, Operational Risk and Legal Risk.
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Market Risk: This type of risk arises due to movement in prices of financial instrument.
Market risk can be classified as Directional Risk and Non - Directional Risk. Directional risk is
caused due to movement in stock price, interest rates and more. Non- Directional risk on the
other hand can be volatility risks.
Credit Risk: This type of risk arises when one fails to fulfil their obligations towards their
counter parties. Credit risk can be classified into Sovereign Risk and Settlement Risk.
Sovereign risk usually arises due to difficult foreign exchange policies. Settlement risk on the
other hand arises when one party makes the payment while the other party fails to fulfil the
obligations.
Liquidity Risk: This type of risk arises out of inability to execute transactions. Liquidity risk
can be classified into Asset Liquidity Risk and Funding Liquidity Risk. Asset Liquidity risk arises
either due to insufficient buyers or insufficient sellers against sell orders and buy orders
respectively.
CAPITL GEARING :
DEFINITION of 'Capital Gearing' The degree to which a company acquires assets or to which it
funds its ongoing operations with long- or short-term debt. Capital gearing will differ between
companies and industries, and will often change over time. Capital gearing is also known as
"financial leverage".
Capital gearing ratio is a useful tool to analyze the capital structure of a company and is
computed by dividing the common stockholders equity by fixed interest or dividend
bearing funds.
Analysing capital structure means measuring the relationship between the funds provided by
common stockholders and the funds provided by those who receive a periodic interest or
dividend at a fixed rate.
A company is said to be low geared if the larger portion of the capital is composed of common
stockholders equity. On the other hand, the company is said to be highly geared if the larger
portion of the capital is composed of fixed interest/dividend bearing funds.
Formula:

In the above formula, the numerator consists of common stockholders equity that is equal to
total stockholders equity less preferred stock and the denominator consists of fixed interest
or dividend bearing funds that usually include long term loans, bonds, debentures and
preferred stock etc.
All the information required to compute capital gearing ratio is available from the balance
sheet.
Example:

The following information have been taken from the balance sheet of PQR limited:
2011

2012

Common stockholders equity 3,500,0002,800,000

Preferred stock 9%
12

1,400,0001,800,000

Bonds payable 6%

1,600,0001,400,000

We can compute the capital gearing ratio for the years 2011 and 2012 from the above
information as follows: For the year 2011: Capital gearing ratio = 3,500,000 / 3,000,000
= 7 : 6 (Low geared)
For the year 2012: Capital gearing ratio = 2,800,000 / 3,200,000 = 7 : 8 (Highly geared)

The company has a low geared capital structure in 2011 and highly geared capital structure in
2012.
Notice that the gearing is inverse to the common stockholders equity.
Highly
geared

>>Less common stockholders

> equity

Low geared

>>More common stockholders

> equity

Significance and interpretation: Capital gearing ratio is the measure of capital structure analysis
and financial strength of the company and is of great importance for actual and potential investors.
Borrowing is a cheap source of funds for many companies but a highly geared company is considered a
risky investment by the potential investors because such a company has to pay more interest on loans
and dividend on preferred stock and, therefore, may have to face problems in maintaining a good level
of dividend for common stockholders during the period of low profits.
Banks and other financial institutions reluctant to give loans to companies that are already highly
geared.

FUNDS FROM OPERATIONS:

Funds from operations is the cash flows generated by the operations of a business. The term
is most commonly used in relation to the cash flows from real estate investment trusts (REITs).
This measure is commonly used to judge the operational performance of REITs, especially in
regard to investing in them.
Funds from operations does not include any financing-related cash flows, such as
interest income or expense. It also does not include any gains or losses from the
disposition of assets, or any depreciation or amortization of fixed assets.
Thus, the calculation of funds from operations is:

Net income - Interest income + Interest expense + Depreciation ( -) Gains on asset

sales + Losses on asset sales = Funds from operations
For example, the ABC REIT reports net income of $5,000,000, depreciation of $1,500,000, and
a gain of $300,000 on the sale of a property. This results in funds from operations of
$6,200,000.
A variation on the funds from operations concept is to compare it to the stock price of a
company (usually an REIT). This is can be used in place of the price-earnings ratio, which
includes the additional accounting factors just noted.
The funds from operations concept is needed, especially for the analysis of an REIT, because
depreciation should not be factored into the results of operations when the underlying assets
are appreciating in value, rather than depreciating; this is a common situation when dealing
with real estate assets.
The funds from operations concept is considered to be a better indicator of the operational
results of a business than net income, but keep in mind that accounting chicanery can impact
a variety of aspects of the financial statements. Thus, it is always better to rely upon a mix of
measurements, rather than a single measure that can potentially be twisted.
13

Adjusted Funds from Operations : It is possible to adjust the formula even further for some types of
capital expenditures that are recurring in nature; depreciation related to recurring expenditures to maintain a property
(such as carpet replacements, interior painting, or parking lot resurfacing) should be included in the FFO calculation.
This altered format results in lower profitability figures. This revised version of the concept is called adjusted funds
from operations.
-------------------------------------------------------------------------------------------------- -----------------------------PAY BACK PERIOD: Payback period in capital budgeting refers to the period of time required to recoup the funds
expended in an investment, or to reach the break-even point.
For example, a Rs.1000 investment which returned Rs.500 per year would have a twoyear payback period. The time value of money is not taken into account.
The formula for the payback method is simplistic: Divide the cash outlay (which is
assumed to occur entirely at the beginning of the project) by the amount of net cash flow
generated by the project per year (which is assumed to be the same in every year).
Payback Period Example
Alaskan Lumber is considering the purchase of a band saw that costs Rs.50,000 and which
will generate Rs.10,000 per year of net cash flow. The payback period for this capital
investment is 5.0 years.
Alaskan is also considering the purchase of a conveyor system for Rs.36,000, which will
reduce saw mill transport costs by Rs.12,000 per year. The payback period for this capital
investment is 3.0 years.
If Alaskan only has sufficient funds to invest in one of these projects, and if it were only using
the payback method as the basis for its investment decision, it would buy the conveyor
system, since it has a shorter payback period.
Payback Method Advantages and Disadvantages
The payback period is useful from a risk analysis perspective, since it gives a quick
picture of the amount of time that the initial investment will be at risk. If you were to analyze
a prospective investment using the payback method, you would tend to accept those
investments having rapid payback periods, and reject those having longer ones. It tends to be
more useful in industries where investments become obsolete very quickly, and where a full
return of the initial investment is therefore a serious concern. Though the payback method is
widely used due to its simplicity, it suffers from the following problems:
Asset life span. If an assets useful life expires immediately after it pays back the initial
investment, then there is no opportunity to generate additional cash flows. The payback
method does not incorporate any assumption regarding asset life span.
Additional cash flows. The concept does not consider the presence of any additional cash
flows that may arise from an investment in the periods after full payback has been achieved.
Cash flow complexity. The formula is too simplistic to account for the multitude of cash
flows that actually arise with a capital investment. For example, cash investments may be
required at several stages, such as cash outlays for periodic upgrades. Also, cash outflows
may change significantly over time, varying with customer demand and the amount of
competition.
Profitability. The payback method focuses solely upon the time required to pay back the
initial investment; it does not track the ultimate profitability of a project at all. Thus, the
method may indicate that a project having a short payback but with no overall profitability is
a better investment than a project requiring a long-term payback but having substantial longterm profitability.
Time value of money. The method does not take into account the time value of money,
where cash generated in later periods is work less than cash earned in the current period. A
variation on the payback period formula, known as the discounted payback formula,
eliminates this concern by incorporating the time value of money into the calculation.
14

Individual asset orientation. Many fixed asset purchases are designed to improve the
efficiency of a single operation, which is completely useless if there is a process bottleneck
located downstream from that operation that restricts the ability of the business to generate
more output. The payback period formula does not account for the output of the entire
system, only a specific operation. Thus, its use is more at the tactical level than at the
strategic level.
Incorrect averaging. The denominator of the calculation is based on the average cash flows
from the project over several years - but if the forecasted cash flows are mostly in the part of
the forecast furthest in the future, the calculation will incorrectly yield a payback period that is
too soon. The following example illustrates the problem.
Payback Method Example #2
ABC International has received a proposal from a manager, asking to spend $1,500,000 on
equipment that will result in cash inflows in accordance with the following table:
Year
Cash Flow
1
+$150,000
2
+150,000
3
+200,000
4
+600,000
5
+900,000
The total cash flows over the five-year period are projected to be $2,000,000, which is an
average of $400,000 per year. When divided into the $1,500,000 original investment, this
results in a payback period of 3.75 years. However, the briefest perusal of the projected cash
flows reveals that the flows are heavily weighted toward the far end of the time period, so the
results of this calculation cannot be correct.
Instead, the company's financial analyst runs the calculation year by year, deducting the cash
flows in each successive year from the remaining investment. The results of this calculation
are:
Year
Cash Flow
Net Invested Cash
0
-$1,500,000
1
+$150,000
-1,350,000
2
+150,000
-1,200,000
3
+200,000
-1,000,000
4
+600,000
-400,000
5
+900,000
0
The table indicates that the real payback period is located somewhere between Year 4 and
Year 5. There is $400,000 of investment yet to be paid back at the end of Year 4, and there is
$900,000 of cash flow projected for Year 5. The analyst assumes the same monthly amount of
cash flow in Year 5, which means that he can estimate final payback as being just short of 4.5
years.
OPERATING LEVERAGE :
operating leverage measures a companys fixed costs as a percentage of its total
costs. It is used to evaluate the break even point of a business, as well as the likely profit
levels on individual sales.
The following two scenarios describe an organization having high operating leverage and low
operating leverage.
High operating leverage. A large proportion of the companys costs are fixed costs. In this
case, the firm earns a large profit on each incremental sale, but must attain sufficient sales
volume to cover its substantial fixed costs. If it can do so, then the entity will earn a major
profit on all sales after it has paid for its fixed costs.
Low operating leverage. A large proportion of the companys sales are variable costs, so it
only incurs these costs if there is a sale. In this case, the firm earns a smaller profit on each
incremental sale, but does not have to generate much sales volume in order to cover its lower
fixed costs. It is easier for this type of company to earn a profit at low sales levels, but it does
not earn outsized profits if it can generate additional sales.
15

For example, a software company has substantial fixed costs in the form of developer salaries,
but has almost no variable costs associated with each incremental software sale; this firm has
high operating leverage. Conversely, a consulting firm bills its clients by the hour, and incurs
variable costs in the form of consultant wages. This firm has low operating leverage.
To calculate operating leverage, divide an entitys contribution margin by its net operating
income. The contribution margin is sales minus variable expenses.
For example, the Alaskan Barrel Company (ABC) has the following financial results:
Revenues
$100,0
00
Variable expenses
30,00
0
Fixed expenses
60,00
0
Net operating income
$10,0
00
ABC has a contribution margin of 70% and net operating income of $10,000, which gives it a
degree of operating leverage of 7. ABCs sales then increase by 20%, resulting in the following
financial results:
Revenues
$120,0
00
Variable expenses
36,00
0
Fixed expenses
60,00
0
Net operating income
$24,0
00
The contribution margin of 70% has stayed the same, and fixed costs have not changed.
Because of ABCs high degree of operating leverage, the 20% increase in sales translates into
a greater than doubling of its net operating income.
When using the operating leverage measurement, constant monitoring of operating leverage
is more important for a firm having high operating leverage, since a small percentage change
in sales can result in a dramatic increase (or decrease) in profits. A firm must be especially
careful to forecast its revenues carefully in such situations, since a small forecasting error
translates into much larger errors in both net income and cash flows.
Knowledge of the level of operating leverage can have a profound impact on pricing policy,
since a company with a large amount of operating leverage must be careful not to set its
prices so low that it can never generate enough contribution margin to fully offset its fixed
costs.

EXPLICIT COST/ IMPLICIT COST :

An implicit cost is a cost that has occurred but it is not initially shown or reported as a
separate cost. On the other hand, an explicit cost is one that has occurred and is
clearly reported as a separate cost.
Below are some examples to illustrate the difference between an implicit cost and an explicit
cost.
Let's assume that a company gives a promissory note for Rs.10,000 to someone in exchange
for a unique used machine for which the fair value is not known. The note will come due in
three years and it does not specify any interest. Due to the company's weak financial position
it will have to pay a high interest rate if it were to borrow money. In this example, there is no
16

explicit interest cost. However, due to the issuer's financial difficulty and the seller having
to wait three years to collect the money, there has to be some interest cost. In other words,
there is some interest and it is implicit. To properly record the note and the machine,
the accountant must determine the amount of the interest, which is known as imputing the
interest. In effect the accountant must convert the implicit interest to explicit interest. This is
done by discounting the $10,000 by using the interest rate that the issuer of the note would
have to pay to another lender. If the rate is 12% per year, the interest that was implicit in the
note is $2,880 and the principal portion of the note is the remaining $7,120.
If another company with the same financial condition purchased this unique machine by
issuing a $7,120 note with a stated interest rate of 12% per year, the interest cost of $2,880
would be explicit. In this situation, there is no need to impute the interest.
Another example of an implicit cost is the opportunity cost of a sole proprietor working in her
own business. For example, Gina works as a sole proprietor and her business reported a net
income of $30,000 for the year. Since a sole proprietor does not receive a salary or wages,
there is no explicit cost reported for Gina's work in her business. However, if Gina is foregoing
a salary of $40,000 from another company, that is an implicit cost for her business. After
considering this implicit cost, Gina is losing $10,000 by working in her proprietorship.
If Gina operates her business as a corporation, Gina will be an employee of the corporation. If
her annual salary is $40,000 the corporation's income statement would report the $40,000
salary as an explicit cost for Gina's work.

LEVERAGED BUYOUTS:
A leveraged buyout (LBO) is an acquisition of a company or a segment of a
company funded mostly with debt. A financial buyer (e.g. private equity fund) invests a
small amount of equity (relative to the total purchase price) and uses leverage (debt or other
non-equity sources of financing) to fund the remainder of the consideration paid to the seller.
The LBO analysis generally provides a "floor" valuation for the company, and is useful in
determining what a financial sponsor can afford to pay for the target and still realize an
adequate return on its investment.
Transaction Structure
Below is a simple diagram of an LBO structure. The new investors (e.g. and LBO firm or
management of the target) form a new corporation for the purpose of acquiring the target.
The target becomes a subsidiary of NewCo, or NewCo and the target can merge.

Applications of the LBO Analysis

Determine the maximum purchase price for a business that can be paid based on certain
leverage (debt) levels and equity return parameters.
Develop a view of the leverage and equity characteristics of a leveraged transaction at a
given price.
Calculate the minimum valuation for a company since, in the absence of strategic buyers, an
LBO firm should be a willing buyer at a price that delivers an expected equity return that
meets the firm's hurdle rate.
Steps in the LBO Analysis

17

Develop operating assumptions and projections for the standalone company to arrive at
EBITDA and cash flow available for debt repayment over the investment horizon (typically 3 to
7 years).
Determine key leverage levels and capital structure (senior and subordinated debt,
mezzanine financing, etc.) that result in realistic financial coverage and credit statistics.
Estimate the multiple at which the sponsor is expected to exit the investment (should
generally be similar to the entry multiple).
Calculate equity returns (IRRs) to the financial sponsor and sensitize the results to a range
of leverage and exit multiples, as well as investment horizons.
Solve for the price that can be paid to meet the above parameters (alternatively, if the
price is fixed, solve for achievable returns).
Returns
In LBO transactions, financial buyers seek to generate high returns on the equity investments
and use financial leverage (debt) to increase these potential returns. Financial buyers
evaluate investment opportunities with by analyzing expected internal rates of return (IRRs),
which measure returns on invested equity. IRRs represent the discount rate at which the net
present value of cash flows equals zero. Historically, financial sponsors' hurdle rates
(minimum required IRRs) have been in excess of 30%, but may be as low as 15-20% for
particular deals under adverse economic conditions. Hurdle rates for larger deals tend to be a
bit lower than hurdle rates for smaller deals.
Advantaes:
De-levering (paying down debt)
Operational improvement (e.g. margin expansion, revenue growth)
Multiple expansion (buying low and selling high)
Risk
Equity holders In addition to the operating risk assumed risk arises due to significant
financial leverage. Interest costs resulting from substantial amounts of debt are "fixed costs"
that can force a company into default if not paid. Furthermore, small changes in the
enterprise value (EV) of a company can have a magnified effect on the equity value when the
company is highly levered and the value of the debt remains constant.
Debt holders The debt holders bear the risk of default equated with higher leverage as
well, but since they have the most senior claims on the assets of the company, they are likely
to realize a partial, if not full, return on their investments, even in bankruptcy.
Exit Strategies
Ideally, an exit strategy enables financial buyers to realize gains on their investments. Exit
strategies most commonly include an outright sale of the company to a strategic buyer or
another financial sponsor, an IPO, or a recapitalization. A financial buyer typically expects to
realize a return on its LBO investment within 3 to 7 years via one of these strategies.

Q: FINANCIAL MANAGEMENT IS NOTHING BUT MANAGERIAL DECISION

MAKING ON ASSET MIX, CAPITAL MIX, AND PROFIT ALLOCATION. EXPLAIN.
Q: DISCUSS THE ROLE OF FINANCE MANAGER IN MODERN BUSINESS FIRM.
Q: DISCUSS THE MAJOR TYPES OF FINANCIAL MANAGEMENT DECISIONS
THAT BUSINESS FIRMS MAKE.
Q: WEALTH MAXIMISATION OBJECTIVE PROVIDES AN OPERATIONALLY
APPROPRIATE DECISIONS CRITERION. COMMENT.
Q; DISCUSS THE SCOPE AND OBJECTIVES OF FINANCIAL MANAGEMENT IN
THE CONTEXT OF CHANGING BUSINESS ENVIRONMENT.
Q; OUTLINE THE FACTORS BEHIND INDIAN COMPANIES ACCORDING GREATER
IMPORTANCE TO THE GOAL OF SHAREHOLDERS WEALTH MAXIMIZATION.
18

Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise. It means applying
general management principles to financial resources of the enterprise.
Scope/Elements
Investment decisions includes investment in fixed assets (called as capital budgeting).
Investment in current assets are also a part of investment decisions called as working capital
decisions.
Financial decisions - They relate to the raising of finance from various resources which will
depend upon decision on type of source, period of financing, cost of financing and the returns
thereby.
Dividend decision - The finance manager has to take decision with regards to the net profit
distribution. Net profits are generally divided into two:
Dividend for shareholders- Dividend and the rate of it has to be decided.
Retained profits- Amount of retained profits has to be finalized which will depend upon
expansion and diversification plans of the enterprise.
Objectives of Financial Management
The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be To ensure regular and adequate supply of funds to the concern.
To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders.
To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
To ensure safety on investment, i.e, funds should be invested in safe ventures so that
adequate rate of return can be achieved.
To plan a sound capital structure-There should be sound and fair composition of capital
so that a balance is maintained between debt and equity capital.
Functions of Financial Management
Estimation of capital requirements: A finance manager has to make estimation with
regards to capital requirements of the company. This will depend upon expected costs and
profits and future programmes and policies of a concern. Estimations have to be made in an
adequate manner which increases earning capacity of enterprise.
Determination of capital composition: Once the estimation have been made, the capital
structure have to be decided. This involves short- term and long- term debt equity analysis.
19

This will depend upon the proportion of equity capital a company is possessing and additional
funds which have to be raised from outside parties.
Choice of sources of funds: For additional funds to be procured, a company has many
choices likeIssue of shares and debentures
Loans to be taken from banks and financial institutions
Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and demerits of each source and period of
financing.
Investment of funds: The finance manager has to decide to allocate funds into profitable
ventures so that there is safety on investment and regular returns is possible.
Disposal of surplus: The net profits decision have to be made by the finance manager. This
can be done in two ways:
Dividend declaration - It includes identifying the rate of dividends and other benefits like
bonus.
Retained profits - The volume has to be decided which will depend upon expansional,
innovational, diversification plans of the company.
Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current liabilities,
maintainance of enough stock, purchase of raw materials, etc.
Financial controls: The finance manager has not only to plan, procure and utilize the funds
but he also has to exercise control over finances. This can be done through many techniques
like ratio analysis, financial forecasting, cost and profit control, etc.

Some of the important functions which every finance manager has to take
are as follows:

i. Investment decision
ii. Financing decision
iii. Dividend decision
A. Investment Decision (Capital Budgeting Decision):
This decision relates to careful selection of assets in which funds will be invested by the firms.
A firm has many options to invest their funds but firm has to select the most appropriate
investment which will bring maximum benefit for the firm and deciding or selecting most
appropriate proposal is investment decision.
The firm invests its funds in acquiring fixed assets as well as current assets. When decision
regarding fixed assets is taken it is also called capital budgeting decision.
Factors Affecting Investment/Capital Budgeting Decisions
1. Cash Flow of the Project:
Whenever a company is investing huge funds in an investment proposal it expects some
regular amount of cash flow to meet day to day requirement. The amount of cash flow an
investment proposal will be able to generate must be assessed properly before investing in
the proposal.
2. Return on Investment:
The most important criteria to decide the investment proposal is rate of return it will be able
to bring back for the company in the form of income for, e.g., if project A is bringing 10%
return and project is bringing 15% return then we should prefer project B.
3. Risk Involved:
With every investment proposal, there is some degree of risk is also involved. The company
must try to calculate the risk involved in every proposal and should prefer the investment
proposal with moderate degree of risk only.
4. Investment Criteria:
Along with return, risk, cash flow there are various other criteria which help in selecting an
investment proposal such as availability of labour, technologies, input, machinery, etc.
The finance manager must compare all the available alternatives very carefully and then only
decide where to invest the most scarce resources of the firm, i.e., finance.
Investment decisions are considered very important decisions because of following reasons:
20

(i) They are long term decisions and therefore are irreversible; means once taken cannot be
changed.
(ii) Involve huge amount of funds.
(iii) Affect the future earning capacity of the company.
B. Importance or Scope of Capital Budgeting Decision:
Capital budgeting decisions can turn the fortune of a company. The capital budgeting
decisions are considered very important because of the following reasons:
1. Long Term Growth:
The capital budgeting decisions affect the long term growth of the company. As funds
invested in long term assets bring return in future and future prospects and growth of the
company depends upon these decisions only.
2. Large Amount of Funds Involved:
Investment in long term projects or buying of fixed assets involves huge amount of funds and
if wrong proposal is selected it may result in wastage of huge amount of funds that is why
capital budgeting decisions are taken after considering various factors and planning.
3. Risk Involved:
The fixed capital decisions involve huge funds and also big risk because the return comes in
long run and company has to bear the risk for a long period of time till the returns start
coming.
4. Irreversible Decision:
Capital budgeting decisions cannot be reversed or changed overnight. As these decisions
involve huge funds and heavy cost and going back or reversing the decision may result in
heavy loss and wastage of funds. So these decisions must be taken after careful planning and
evaluation of all the effects of that decision because adverse consequences may be very
heavy.
C. Financing Decision:
The second important decision which finance manager has to take is deciding source of
finance. A company can raise finance from various sources such as by issue of shares,
debentures or by taking loan and advances. Deciding how much to raise from which source is
concern of financing decision. Mainly sources of finance can be divided into two categories:
1. Owners fund.
2. Borrowed fund.
Share capital and retained earnings constitute owners fund and debentures, loans, bonds,
etc. constitute borrowed fund.
The main concern of finance manager is to decide how much to raise from owners fund and
how much to raise from borrowed fund.
While taking this decision the finance manager compares the advantages and disadvantages
of different sources of finance. The borrowed funds have to be paid back and involve some
degree of risk whereas in owners fund there is no fix commitment of repayment and there is
no risk involved. But finance manager prefers a mix of both types. Under financing decision
finance manager fixes a ratio of owner fund and borrowed fund in the capital structure of the
company.
Factors Affecting Financing Decisions:
While taking financing decisions the finance manager keeps in mind the following factors:
1. Cost: The cost of raising finance from various sources is different and finance managers
always prefer the source with minimum cost.
2. Risk: More risk is associated with borrowed fund as compared to owners fund securities.
Finance manager compares the risk with the cost involved and prefers securities with
moderate risk factor.
3. Cash Flow Position: The cash flow position of the company also helps in selecting the
securities. With smooth and steady cash flow companies can easily afford borrowed fund
securities but when companies have shortage of cash flow, then they must go for owners
fund securities only.

21

4. Control Considerations: If existing shareholders want to retain the complete control of

business then they prefer borrowed fund securities to raise further fund. On the other hand if
they do not mind to lose the control then they may go for owners fund securities.
5. Floatation Cost: It refers to cost involved in issue of securities such as brokers
commission, underwriters fees, expenses on prospectus, etc. Firm prefers securities which
involve least floatation cost.
6. Fixed Operating Cost: If a company is having high fixed operating cost then they must
prefer owners fund because due to high fixed operational cost, the company may not be able
to pay interest on debt securities which can cause serious troubles for company.
7. State of Capital Market: The conditions in capital market also help in deciding the type
of securities to be raised. During boom period it is easy to sell equity shares as people are
ready to take risk whereas during depression period there is more demand for debt securities
in capital market.
D. Dividend Decision: This decision is concerned with distribution of surplus funds. The
profit of the firm is distributed among various parties such as creditors, employees, debenture
holders, shareholders, etc.
Payment of interest to creditors, debenture holders, etc. is a fixed liability of the company, so
what company or finance manager has to decide is what to do with the residual or left over
profit of the company.
The surplus profit is either distributed to equity shareholders in the form of dividend or kept
aside in the form of retained earnings. Under dividend decision the finance manager decides
how much to be distributed in the form of dividend and how much to keep aside as retained
earnings.
To take this decision finance manager keeps in mind the growth plans and investment
opportunities.
If more investment opportunities are available and company has growth plans then more is
kept aside as retained earnings and less is given in the form of dividend, but if company
wants to satisfy its shareholders and has less growth plans, then more is given in the form of
dividend and less is kept aside as retained earnings.
This decision is also called residual decision because it is concerned with distribution of
residual or left over income. Generally new and upcoming companies keep aside more of
retain earning and distribute less dividend whereas established companies prefer to give more
dividend and keep aside less profit.
Factors Affecting Dividend Decision:
The finance manager analyses following factors before dividing the net earnings between
dividend and retained earnings:
1. Earning:
Dividends are paid out of current and previous years earnings. If there are more earnings
then company declares high rate of dividend whereas during low earning period the rate of
dividend is also low.
2. Stability of Earnings:
Companies having stable or smooth earnings prefer to give high rate of dividend whereas
companies with unstable earnings prefer to give low rate of earnings.
3. Cash Flow Position:
Paying dividend means outflow of cash. Companies declare high rate of dividend only when
they have surplus cash. In situation of shortage of cash companies declare no or very low
dividend.
4. Growth Opportunities:
If a company has a number of investment plans then it should reinvest the earnings of the
company. As to invest in investment projects, company has two options: one to raise
additional capital or invest its retained earnings. The retained earnings are cheaper source as
they do not involve floatation cost and any legal formalities.
If companies have no investment or growth plans then it would be better to distribute more in
the form of dividend. Generally mature companies declare more dividends whereas growing
companies keep aside more retained earnings.
5. Stability of Dividend:
22

Some companies follow a stable dividend policy as it has better impact on shareholder and
improves the reputation of company in the share market. The stable dividend policy satisfies
the investor. Even big companies and financial institutions prefer to invest in a company with
regular and stable dividend policy.
There are three types of stable dividend policies which a company may follow:
(i) Constant dividend per share:
In this case, the company decides a fixed rate of dividend and declares the same rate every
year, e.g., 10% dividend on investment.
(ii) Constant payout ratio:
Under this system the company fixes up a fixed percentage of dividends on profit and not on
investment, e.g., 10% on profit so dividend keeps on changing with change in profit rate.
(iii) Constant dividend per share and extra dividend:
Under this scheme a fixed rate of dividend on investment is given and if profit or earnings
increase then some extra dividend in the form of bonus or interim dividend is also given.
6. Preference of Shareholders:
Another important factor affecting dividend policy is expectation and preference of
shareholders as their expectations cannot be ignored by the company. Generally it is observed
that retired shareholders expect regular and stable amount of dividend whereas young
shareholders prefer capital gain by reinvesting the income of the company.
They are ready to sacrifice present day income of dividend for future gain which they will get
with growth and expansion of the company.
Secondly poor and middle class investors also prefer regular and stable amount of dividend
whereas wealthy and rich class prefers capital gains.
So if a company is having large number of retired and middle class shareholders then it will
declare more dividend and keep aside less in the form of retained earnings whereas if
company is having large number of young and wealthy shareholders then it will prefer to keep
aside more in the form of retained earnings and declare low rate of dividend.
7. Taxation Policy:
The rate of dividend also depends upon the taxation policy of government. Under present
taxation system dividend income is tax free income for shareholders whereas company has to
pay tax on dividend given to shareholders. If tax rate is higher, then company prefers to pay
less in the form of dividend whereas if tax rate is low then company may declare higher
dividend.
8. Access to Capital Market Consideration:
Whenever company requires more capital it can either arrange it by issue of shares or
debentures in the stock market or by using its retained earnings. Rising of funds from the
capital market depends upon the reputation of the company.
If capital market can easily be accessed or approached and there is enough demand for
securities of the company then company can give more dividend and raise capital by
approaching capital market, but if it is difficult for company to approach and access capital
market then companies declare low rate of dividend and use reserves or retained earnings for
reinvestment.
9. Legal Restrictions:
Companies Act has given certain provisions regarding the payment of dividends that can be
paid only out of current year profit or past year profit after providing depreciation fund. In
case company is not earning profit then it cannot declare dividend.
Apart from the Companies Act there are certain internal provisions of the company that is
whether the company has enough flow of cash to pay dividend. The payment of dividend
should not affect the liquidity of the company.
10. Contractual Constraints:
When companies take long term loan then financier may put some restrictions or constraints
on distribution of dividend and companies have to abide by these constraints.
11. Stock Market Reaction:
The declaration of dividend has impact on stock market as increase in dividend is taken as a
good news in the stock market and prices of security rise. Whereas a decrease in dividend
may have negative impact on the share price in the stock market. So possible impact of
dividend policy in the equity share price also affects dividend decision.
23

Q: WHAT ARE THE DISTINCTION BETWEEN FUND FLOW AND CASH FLOW
STATEMENT?
Q: WHAT DO YOU MEAN BY FUNDS FLOW ANALYSIS? EXPLAIN THE
MECHANICS INVOLVED IN THE PREPARATION OF FUNDS FLOW STATEMENT.
Q: HOW DOES A FUNDS FLOW STATEMENT DIFFER FROM BALANCE SHEET?
EXPAIN THE MANAGERIAL USES OF FUNDS FLOW STATEMENT.

Cash flow refers to the current format for reporting the inflows and outflows of cash, while
funds flow refers to an outmoded format for reporting a subset of the same information.
Cash flow is derived from the statement of cash flows. This statement is required under
Generally Accepted Accounting Principles (GAAP), and shows the inflows and outflows of cash
generated by a business during a reporting period.
The information in a statement of cash flows is aggregated into the following three
areas:
Operating activities. Comprised of the main revenue-generating activities of a
business, such as receipts from the sale of goods and payments to suppliers and
employees.
Investing activities. Involves the acquisition and disposal of long-term assets, such as
cash received from the sale of property.
Financing activities. Involves changes in cash from selling or paying off financing
instruments, such as from the issuance or repayment of debt.
The statement of cash flows is part of the main group of financial statements that a
business issues, though it is commonly considered to be third in importance after the income
statement and balance sheet. The statement can be of considerable use in detecting
movements of cash that are not readily apparent by perusing the income statement. For
example, the income statement may reveal that a business earned a large profit, while the
statement of cash flows shows that the same business actually lost cash while doing so
(probably due to large investments in fixed assets or working capital). Thus, cash flow analysis
is useful for determining the underlying health of a business.
The funds flow statement. The statement primarily reported changes in an entity's
net working capital position between the beginning and end of an accounting period. Net
working capital is an entity's current assets minus its current liabilities.
The statement of cash flows is a more comprehensive document than the earlier funds flow statement, with a
focus on multiple types of cash flows.

Importance Of Funds Flow Statement : Funds flow statement is an

important financial tool, which analyze the changes in financial position of a firm showing the
sources and applications of its funds. It provides useful information about the
firm's operating, financing and investing activities during a particular period.
T he following points highlight the importance of funds flow statement.
1. Funds flow statement helps in identifying the change in level of current
assets investment and current liabilities financing.
2. Funds flow statement helps in analyzing the changes in working capital level of a firm.
3. Funds flow statement shows the relationship of net income to the changes in funds from
business operation.
4. Funds flow statement reports about past fund flow as an aid to predict future funds flow.
24

5. Funds flow statement helps in determining the firms' ability to pay interest and dividend,
and pay debt when they become due.
6. Funds flow statement shows the firms' ability to generate long-term financing to satisfy the
investment in long-term assets.
7. Funds flow statements helps in identifying the factor responsible for changes in assets,
liabilities and owners' equity at two balance sheet date.
Difference Between Balance Sheet And Funds Flow Statement
The main differences between balance sheet and fund flow statement are as below:
1. Meaning : Balance Sheet: Balance sheet is a statement of assets, liabilities and capital.

Funds Flow Statement: Funds flow statement is a statement if changes in assets, liabilities
and capital accounts.
2. Objective : Balance Sheet: Balance sheet is prepared to ascertain the financial position of a
firm.
Funds Flow Statement: It is prepared to ascertain the sources and application of funds.
3. Preparation: Balance Sheet: It is prepared with the help of trial balance. Funds Flow
Statement: It is prepared with the help of balance sheets of two subsequent dates.
4. Information: Balance Sheet: It provides static view of financial affairs. Funds Flow
Statement: It provides the changes in assets, liabilities and capital accounts.

Steps for Preparing Funds Flow Statement:

Determine the change (increase or decrease) in working capital.

Determine the adjustments account to be made to net income.
For each non-current account on the balance sheet, establish the increase or decrease
in that account. Analyze the change to decide whether it is a source (increase) or use
(decrease) of working capital.
Be sure the total of all sources including those from operations minus the total of all
uses equals the change found in working capital in Step 1.
General Rules for Preparing Funds Flow Statement: The following general rules should
be observed while preparing funds flow statement:
Increase in a current asset means increase (plus) in working capital.
Decrease in a current asset means decrease (minus) in working capital.
Increase in a current liability means decrease (minus) in working capital.
Decrease in a current liability means increase (plus) in working capital.
Increase in current asset and increase in current liability does not affect working
capital.
Decrease in current asset and decrease in current liability does not affect working
capital.
Changes in fixed (non-current) assets and fixed (non-current) liabilities affects working
capital.
Format of Funds Flow Statement:
A funds flow statement can be prepared in statement form or T form. Both the formats are
given below:

25

Schedule of Changes in Working Capital:

Many business enterprises prefer to prepare another statement, known as schedule of
changes in working capital, while preparing a funds flow statement, on a working capital
basis. This schedule of changes in working capital provides information concerning the
changes in each individual current assets and current liabilities accounts (items).
This schedule is a part of the funds flow statement and increase (decrease) in
working capital indicated by the schedule of changes in working capital will be
equal to the amount of changes in working capital as found by funds flow
statement. The schedule of changes in working capital can be prepared by
comparing the current assets and current liabilities at two periods.

26

The format of schedule of changes in working capital is as follows:

Illustration:
The following are the balance sheet of a company for the years 2012 and 2013 and income
statement for the year 2013:

27

The above statement presentation is a two parts statement; the sources are first
detailed and then totalled, followed by the detail information and total for uses.
The difference between the sources and uses must equal the change in working
capital.
It can be noticed that sources of funds (working capital is sub-divided into two parts; the
first part is concerned with sources from operations, and the second part deals
with other sources. Uses of working capital in the above statement do not include
any uses for operations, such as salaries and rent, because these have been
included automatically by starting the funds flow statement with the net income
rather than with revenue. Generally, the most common uses of funds shown are for the
firms investment activities such as the purchase of the new equipment, declaration of
dividends, or payment of long-term liabilities.
Using the figures given in the Illustration, the Schedule of Changes in Working capital can be
prepared as follows:

28

Q: WHAT IS CAPITAL BUDGETING? EXPLAIN THE ASSUMPTIONS AND

DECISION RULES OF THE DISCOUNTED FLOW TECHNIQUES OF CAPITAL
BUDGETING.
Q: BRIEFLY EXPLAIN THE VARIOUS TECHNIQUES OF CAPITAL BUDGETING.
Q: WHAT DO YOU MEAN BY DISCOUNTED CASH FLOW TECHNIQUES OF
CAPITAL BUDGETING? DISCUSS THE MERITS AND LIMITATIONS OF NET
PRESENT VALUE AND INTERNAL RATE OF RETURN METHODS.

What is capital budgeting? Capital budgeting is a process used by companies for

evaluating and ranking potential expenditures or investments that are significant in amount.
The large expenditures could include the purchase of new equipment, rebuilding existing
equipment, purchasing delivery vehicles, constructing additions to buildings, etc. The large
amounts spent for these types of projects are known as capital expenditures.
Capital budgeting usually involves the calculation of each project's future accounting
profit by period, the cash flow by period, the present value of the cash flows after considering
the time value of money, the number of years it takes for a project's cash flow to pay back
the initial cash investment, an assessment of risk, and other factors.
Capital budgeting is a tool for maximizing a company's future profits since most companies
are able to manage only a limited number of large projects at any one time.
Some of the major techniques used in capital budgeting are as follows:
Payback period
Accounting Rate of Return method
Net present value method
Internal Rate of Return Method
Profitability index.
1. Payback period: The payback (or pay out) period is one of the most popular and widely
recognized traditional methods of evaluating investment proposals, it is defined as the
number of years required to recover the original cash outlay invested in a project, if the
project generates constant annual cash inflows, the payback period can be computed dividing
cash outlay by the annual cash inflow.
Payback period = Cash outlay (investment) / Annual cash inflow = C / A
Advantages:
29

1. A company can have more favourable short-run effects on earnings per share by setting up
a shorter payback period.
2. The riskiness of the project can be tackled by having a shorter payback period as it may
ensure guarantee against loss.
3. As the emphasis in pay back is on the early recovery of investment, it gives an insight to
the liquidity of the project.
Limitations:
1. It fails to take account of the cash inflows earned after the payback period.
2. It is not an appropriate method of measuring the profitability of an investment project, as it
does not consider the entire cash inflows yielded by the project.
3. It fails to consider the pattern of cash inflows, i.e., magnitude and timing of cash inflows.
4. Administrative difficulties may be faced in determining the maximum acceptable payback
period.
2. Accounting Rate of Return method:
The Accounting rate of return (ARR) method uses accounting information, as revealed by
financial statements, to measure the profit abilities of the investment proposals. The
accounting rate of return is found out by dividing the average income after taxes by the
average investment.
ARR= Average income/Average Investment
Advantages:
1. It is very simple to understand and use.
2. It can be readily calculated using the accounting data.
3. It uses the entire stream of incomes in calculating the accounting rate.
Limitations:
1. It uses accounting, profits, not cash flows in appraising the projects.
2. It ignores the time value of money; profits occurring in different periods are valued equally.
3. It does not consider the lengths of projects lives.
4. It does not allow for the fact that the profit can be reinvested.
3. Net present value method:
The net present value (NPV) method is a process of calculating the present value of cash flows
(inflows and outflows) of an investment proposal, using the cost of capital as the appropriate
discounting rate, and finding out the net profit value, by subtracting the present value of cash
outflows from the present value of cash inflows.
The equation for the net present value, assuming that all cash outflows are made in the initial
year (tg), will be:

Where A1, A2. represent cash inflows, K is the firms cost of capital, C is the cost of the
investment proposal and n is the expected life of the proposal. It should be noted that the
cost of capital, K, is assumed to be known, otherwise the net present, value cannot be known.
Advantages:
1. It recognizes the time value of money
2. It considers all cash flows over the entire life of the project in its calculations.
3. It is consistent with the objective of maximizing the welfare of the owners.
30

Limitations:
1. It is difficult to use
2. It presupposes that the discount rate which is usually the firms cost of capital is known.
But in practice, to understand cost of capital is quite a difficult concept.
3. It may not give satisfactory answer when the projects being compared involve different
amounts of investment.
4. Internal Rate of Return Method:
The internal rate of return (IRR) equates the present value cash inflows with the present value
of cash outflows of an investment. It is called internal rate because it depends solely on the
outlay and proceeds associated with the project and not any rate determined outside the
investment, it can be determined by solving the following equation:

Advantages:
1. Like the NPV method, it considers the time value of money.
2. It considers cash flows over the entire life of the project.
3. It satisfies the users in terms of the rate of return on capital.
4. Unlike the NPV method, the calculation of the cost of capital is not a precondition.
5. It is compatible with the firms maximising owners welfare.
Limitations:
1. It involves complicated computation problems.
2. It may not give unique answer in all situations. It may yield negative rate or multiple rates
under certain circumstances.
3. It implies that the intermediate cash inflows generated by the project are reinvested at the
internal rate unlike at the firms cost of capital under NPV method. The latter assumption
seems to be more appropriate.
5. Profitability index:
It is the ratio of the present value of future cash benefits, at the required rate of return to the
initial cash outflow of the investment. It may be gross or net, net being simply gross minus
one. The formula to calculate profitability index (PI) or benefit cost (BC) ratio is as follows.
PI = PV cash inflows/Initial cash outlay A,

1. It gives due consideration to the time value of money.

2. It requires more computation than the traditional method but less than the IRR method.
3. It can also be used to choose between mutually exclusive projects by calculating the
incremental benefit cost ratio.

Capital budgeting with discounted cash flows

(DCF) allows you to value a project, based on the

time value of money. In essence, you are discounting the value of future cash flows to determine if the value today
makes the project worthwhile.
Equation Basics
The DCF equation is:
31

Discounted Present Value (DPV) = Future Value / (1 + interest rate)^ time period
The equation is used to allow you to determine the value today of a future cash flows. For example, if investing
$100,000 today will result in a cash flow of $125,000 in two years. In order to make a fair judgment of whether the
return is a good one, you will need to consider the cost of capital. If it will cost you 8% per year to borrow the
money, the return is less attractive. Using the equation, you get $125,000 / (1 + 0.08) ^ 2 = 107,167.40. After you
return the original $100,000, you will only earn $7,167.40. While this is not a great return, it is positive, so the
project may worth consideration.
Drawback
The drawback to this method is that it assumes that the cost of capital, or the interest rate used will not vary.
Another problem is that it assumes cash flow can be accurately projected. While you can make both of these
factors variable, it makes the calculation cumbersome and increases the chances of error.

Q: WHAT ARE THE FACTORS INFLUENCING PLANNING OF CAPITAL

STRUCTURE?
Q:WHAT IS OPTIMUM CAPITAL STRUCTURE? EXPLAIN THE FACTORS
INFLUENCING THE CAPITAL STURCTURE DECISION OF A CORPORATE FIRM.
The following are the factors influencing planning of capital structure:
(1) Cash Flow Position: While making a choice of the capital structure the future cash flow
position should be kept in mind. Debt capital should be used only if the cash flow position is
really good because a lot of cash is needed in order to make payment of interest and refund
of capital.
(2) Interest Coverage Ratio-ICR: With the help of this ratio an effort is made to find out
how many times the EBIT (Earnings Before Interest and Taxes) is available to the payment of
interest. The capacity of the company to use debt capital will be in direct proportion to this
ratio.
It is possible that in spite of better ICR the cash flow position of the company may be weak.
Therefore, this ratio is not a proper or appropriate measure of the capacity of the company to
pay interest. It is equally important to take into consideration the cash flow position.
(3) Debt Service Coverage Ratio-DSCR: This ratio removes the weakness of ICR. This
shows the cash flow position of the company.
This ratio tells us about the cash payments to be made (e.g., preference dividend, interest
and debt capital repayment) and the amount of cash available. Better ratio means the better
capacity of the company for debt payment. Consequently, more debt can be utilised in the
capital structure.
(4) Return on Investment-ROI: The greater return on investment of a company increases
its capacity to utilise more debt capital.
(5) Cost of Debt: The capacity of a company to take debt depends on the cost of debt. In
case the rate of interest on the debt capital is less, more debt capital can be utilised and vice
versa.
(6) Tax Rate: The rate of tax affects the cost of debt. If the rate of tax is high, the cost of
debt decreases. The reason is the deduction of interest on the debt capital from the profits
considering it a part of expenses and a saving in taxes.
For example, suppose a company takes a loan of Rs 100 and the rate of interest on this debt
is 10% and the rate of tax is 30%. By deducting 10/- from the EBIT a saving of in tax will take
place (If 10 on account of interest are not deducted, a tax of @ 30% shall have to be paid).
(7) Cost of Equity Capital: Cost of equity capital (it means the expectations of the equity
shareholders from the company) is affected by the use of debt capital. If the debt capital is
utilised more, it will increase the cost of the equity capital. The simple reason for this is that
the greater use of debt capital increases the risk of the equity shareholders.
Therefore, the use of the debt capital can be made only to a limited level. If even after this
level the debt capital is used further, the cost of equity capital starts increasing rapidly. It
32

adversely affects the market value of the shares. This is not a good situation. Efforts should be
made to avoid it.
(8) Floatation Costs: Floatation costs are those expenses which are incurred while issuing
securities (e.g., equity shares, preference shares, debentures, etc.). These include commission
of underwriters, brokerage, stationery expenses, etc. Generally, the cost of issuing debt
capital is less than the share capital. This attracts the company towards debt capital.
(9) Risk Consideration: There are two types of risks in business:
Operating Risk or Business Risk: This refers to the risk of inability to discharge
permanent operating costs (e.g., rent of the building, payment of salary, insurance
installment, etc),
Financial Risk: This refers to the risk of inability to pay fixed financial payments (e.g.,
payment of interest, preference dividend, return of the debt capital, etc.) as promised
by the company.
The total risk of business depends on both these types of risks. If the operating risk in
business is less, the financial risk can be faced which means that more debt capital can be
utilised. On the contrary, if the operating risk is high, the financial risk likely occurring after
the greater use of debt capital should be avoided.
(10) Flexibility: According to this principle, capital structure should be fairly flexible.
Flexibility means that, if need be, amount of capital in the business could be increased or
decreased easily. Reducing the amount of capital in business is possible only in case of debt
capital or preference share capital.
If at any given time company has more capital than as necessary then both the abovementioned capitals can be repaid. On the other hand, repayment of equity share capital is not
possible by the company during its lifetime. Thus, from the viewpoint of flexibility to issue
debt capital and preference share capital is the best.
(11) Control: According to this factor, at the time of preparing capital structure, it should be
ensured that the control of the existing shareholders (owners) over the affairs of the company
is not adversely affected.
If funds are raised by issuing equity shares, then the number of companys shareholders will
increase and it directly affects the control of existing shareholders. In other words, now the
number of owners (shareholders) controlling the company increases.
This situation will not be acceptable to the existing shareholders. On the contrary, when funds
are raised through debt capital, there is no effect on the control of the company because the
debenture holders have no control over the affairs of the company. Thus, for those who
support this principle debt capital is the best.
(12) Regulatory Framework: Capital structure is also influenced by government
regulations. For instance, banking companies can raise funds by issuing share capital alone,
not any other kind of security. Similarly, it is compulsory for other companies to maintain a
given debt-equity ratio while raising funds.
Different ideal debt-equity ratios such as 2:1; 4:1; 6:1 have been determined for different
industries. The public issue of shares and debentures has to be made under SEBI guidelines.
(13) Stock Market Conditions:
Stock market conditions refer to upward or downward trends in capital market. Both these
conditions have their influence on the selection of sources of finance. When the market is dull,
investors are mostly afraid of investing in the share capital due to high risk.
On the contrary, when conditions in the capital market are cheerful, they treat investment in
the share capital as the best choice to reap profits. Companies should, therefore, make
selection of capital sources keeping in view the conditions prevailing in the capital market.
(14) Capital Structure of Other Companies:
Capital structure is influenced by the industry to which a company is related. All companies
related to a given industry produce almost similar products, their costs of production are
similar, they depend on identical technology, they have similar profitability, and hence the
pattern of their capital structure is almost similar.
Q: WHAT IS THE CONCEPT OF OPERATING CYCLE? WHY IS IT IMPORTANT
IN WORKING CAPITAL MANAGEMENT. EXPLAIN. (REPEATED)
33

Working Capital Estimation Operating Cycle Method

Operating cycle method of working capital estimation is based on the duration of operating
cycle. Longer the period of operating cycle bigger will be the working capital requirements.
Operating cycle means the cycle of raw material to work in progress to finished goods to
accounts payable and finally to cash. Operating cycle time is the time taken starting from raw
material purchases to its conversion bank into cash.
How to calculate or estimate working capital using this method?
For calculating the working capital, we would need 3 important things and they are estimated
cost of goods sold, operating cycle time, and desired cash levels.
Formula for calculating working capital requirement directly is as follows:
Working Capital = {Estimated Cost of Goods Sold * (Operating Cycle/ 365)}
+Desired Cash and Bank Balance
Calculating the total working capital will not suffice the purpose. How this working capital is
formed is also important. It means each components of working capital will have to be known.
For that, we would first need the activity level of the company under review.
Let us see how to calculate each item of working capital below:
Raw Material (RM) Stock: The formula for determining the RM stock is mentioned below.
RM and many other calculations are based on estimated production units and therefore it
should be calculated with utmost accuracy.
Estimated Production Units * Per Unit Cost of RM * (RM Holding Period / 365 Days)
Work In Progress (WIP): In calculating the WIP, special care has to be taken of the
percentage of labor and overheads. These may vary depending on the stage of the product
and completion percentage. We have taken the percentage for an example.
Estimated Production * {Per Unit Cost of RM (100%) + Labor (50%) + Overheads
(50%)} * (Work In Progress Period / 365 Days)
Finished Goods Stock: In Finished Goods workings, we have to know the cost of production
with the help of the previous year cost sheets or budgeted cost sheets of the companys
products.
Estimated Production * Per Unit Cost of Goods Produced * (Finished Goods Holding
Period / 365 Days)
Accounts Receivables: This calculation is simple and we just need to put the estimates and
average collection period right.
Estimated Production * Selling Price * (Collection Period / 365 Days)
Accounts Payables: The calculation of accounts payable is similar but the major difference
is of raw material cost. We take finished goods selling price in accounts receivable calculation
whereas raw material cost in case of accounts payable.
34

Estimated Production * Per Unit RM Cost * (Payment Period / 365 Days)

Advantages and Disadvantages of Operating Cycle Method of Working Capital
Calculations
The advantage is that it is a detailed method and based on the actual economic conditions
prevailing in the market. It gives detailed understanding of the business as well and it is
precise compared to other methods.
The disadvantage is that it is a lengthy process to arrive at component wise calculation of
working capital. It needs a lot of estimate like estimated production, holding period of
inventory, collection and payment period, etc. So, it is a risky matter. There are probable
chances of going wrong in estimating these data and that may hurt the whole process. It is
advisable to keep a cushion while estimating things on the darker side.

Q: WHAT IS INVENTORY? EXPLAIN THE OBJECTIVES OF INVENTORY

MANAGEMENT.
Q: WHAT IS INVENTORY AND WHY SHOULD IT BE HELD? EXPLAIN THE COSTS
ASSOCIATED WITH INVENTORY MANAGEMENT
inventory as a company's goods on hand, which is often a significant current asset. Inventory
serves as a buffer between a company's sales of goods and its production or purchase of
goods. Companies strive to find the proper amount of inventory to avoid lost sales, disruptions
in production, high holding costs, etc.
Manufacturers usually have the following categories of inventories: raw materials, work-inprocess, finished goods, and manufacturing supplies. The amounts of these categories are
usually listed in the notes to its balance sheet.
A company's cost of inventory is related to the company's cost of goods sold that is reported
on the company's income statement.
Since the costs of the items purchased or produced are likely to likely to change, companies
must elect a cost flow assumption for valuing its inventory and its cost of goods sold. In the
U.S. the common cost flow assumptions are FIFO, LIFO, and average.
Sometimes a company's inventory of goods is referred to as its stock of goods, which is held
in its stockroom or warehouse. Inventory management is the active control program which
allows the management of sales, purchases and payments.
Inventory management software helps create invoices, purchase orders, receiving lists,
payment receipts and can print bar coded labels. An inventory management software system
configured to your warehouse, retail or product line will help to create revenue for your
company.
The Inventory Management will control operating costs and provide better understanding. We
are your source for inventory management information, inventory management software and
tools.
objective of inventory management
1.Protect your company against theft - Make sure that the only people in your warehouse
belong in your warehouse. Pilferage is a larger problem than most distributors realize.
2.Establish an approved stock list for each warehouse - Most dead inventory is "D.O.A"
(dead on arrival). Order only the amount of non-stock or special order items that your
customer has committed to buy. Before adding an item to inventory, try to get a purchase
commitment from your customer. If this is not possible, inform the salesperson who requests
the item that he or she is personally responsible for half the carrying cost of any part of the
initial shipment that isn't sold within nine months.
35

3.Assign and use bin locations - Assign primary and surplus bin locations for every stocked
item. All picking and receiving documents should list the primary bin location (in either
characters or a bar code). With correct bin locations on documents, order picking is probably
the least complicated job in your warehouse. Assign inexperienced people to this task and
your most experienced warehouse workers to receiving inventory and stock management.
4.Record all material leaving your warehouse - There should be appropriate paperwork
for every type of stock withdrawal. Under no circumstances should material leave the
warehouse without being entered in the computer. Eliminate "no charge/no paperwork"
material swaps. Product samples should be charged to a salesperson's account until they are
either returned to stock or charged to the customer.
5.Process paperwork in a timely manner - All printed picking documents should be filled
by the end of the day. Stock receipts should be put away and entered in the computer system
within 24 hours of arrival.
6.Set appropriate objectives for your buyers - Buyers should be judged and rewarded
based on the customer service level, inventory turns, and return on investment for the
product lines for which they are responsible.
7.Ensure that stock balances are accurate and will remain accurate - Implement a
comprehensive cycle counting program. A good cycle counting program can replace your
traditional year-end physical inventory.
Costs Associated with Inventory Management
1
Purchase Costs
2
Ordering costs
3
Carrying cost
A
Direct Costs
i. Capital Costs
ii. Storage space costs
iii. Service Costs
iv. Risk costs
B
Indirect Costs
i. Business Risk
ii. Opportunity Costs
iii. Incremental increases in Infrastructure costs
4
Stock out cost
5
Warehousing cost
6
Damage, Pilferage (Stealing) and obsolescence cost
7
Exchange rate differentials
Purchase Costs :
Nominal cost of inventory

Purchase price of the items or raw materials or

The production cost if produced within the organization
It may be constant or may vary based on variations in quantity

2. Ordering costs/Set up costs

Also known as procurement cost

Costs associated with the processing and chasing of the purchase order,
transportation, quality inspection etc.
Set up cost: for production within organization
Costs to develop production schedule, resources etc.

3. Carrying cost

Storage and maintenance etc.

A. Direct costs
1. Capital costs
Includes the costs of investments, interest on working capital, taxes on inventory paid,
insurance costs and other costs associate with legal liabilities.
36

depends upon and varies with the decision of the management to manage inventory in house
or through outsourced vendors and third party service providers.
Storage and maintenance etc.

2. Storage space costs

Includes storage requirements for all categories of inventories
An excess of stocks requires additional capacity
Storage space and inventory level are interrelated
Storage and maintenance etc.
3. Service costs

Volume related
Inventory insurance
Storage and maintenance etc.

4. Risk costs

Vary with the nature of the business

Obsolescence, Damage & Shrinkage
Related to the overall role of inventory within a logistics system

B. Indirect costs
i. Business Risk
Situation 1: A company carrying insufficient inventory unable to meet & satisfy
demand
Situation 2: Reverse Satisfies demand but increases direct costs by increasing capital
cost, Service costs, storage costs and risk costs.
Related to the overall role of inventory within a logistics system
ii. Opportunity costs

Range of investment alternatives

Lack of capital availability to invest in alternatives
Related to the overall role of inventory within a logistics system

iii. Incremental Increases in Infrastructure costs

Excess inventory can increase cost

Facilities
Transportation
Service Companies

Q DIVIDEND POLICIES IN INDIA

Some of the major different theories of dividend in financial management are as follows:
1. Walters model
2. Gordons model
3. Modigliani and Millers hypothesis.
1. Walters model:
Professor James E. Walterargues that the choice of dividend policies almost always affects the value of
the enterprise. His model shows clearly the importance of the relationship between the firms internal
rate of return (r) and its cost of capital (k) in determining the dividend policy that will maximise the
wealth of shareholders.

Walters model is based on the following assumptions:

1. The firm finances all investment through retained earnings; that is debt or new equity is not
issued;
2. The firms internal rate of return (r), and its cost of capital (k) are constant;
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3. All earnings are either distributed as dividend or reinvested internally immediately.

4. Beginning earnings and dividends never change. The values of the earnings pershare (E), and
the divided per share (D) may be changed in the model to determine results, but any given
values of E and D are assumed to remain constant forever in determining a given value.
5. The firm has a very long or infinite life.

Walters formula to determine the market price per share (P) is as follows:
P = D/K +r(E-D)/K/K

The above equation clearly reveals that the market price per share is the sum of
the present value of two sources of income:
i)
ii)

The present value of an infinite stream of constant dividends, (D/K) and

The present value of the infinite stream of stream gains.

[r (E-D)/K/K]
Criticism:
Walters model is quite useful to show the effects of dividend policy on an all equity firm under different
assumptions about the rate of return. However, the simplified nature of the model can lead to
conclusions which are net true in general, though true for Walters model.
The criticisms on the model are as follows:
1. Walters model of share valuation mixes dividend policy with investment policy of the firm. The
model assumes that the investment opportunities of the firm are financed by retained earnings only
and no external financing debt or equity is used for the purpose when such a situation exists either the
firms investment or its dividend policy or both will be sub-optimum. The wealth of the owners will
maximise only when this optimum investment in made.
2. Walters model is based on the assumption that r is constant. In fact decreases as more investment
occurs. This reflects the assumption that the most profitable investments are made first and then the
poorer investments are made.
The firm should step at a point where r = k. This is clearly an erroneous policy and fall to optimise the
wealth of the owners.
3. A firms cost of capital or discount rate, K, does not remain constant; it changes directly with the
firms risk. Thus, the present value of the firms income moves inversely with the cost of capital. By
assuming that the discount rate, K is constant, Walters model abstracts from the effect of risk on the
value of the firm.
2. Gordons Model:
One very popular model explicitly relating the market value of the firm to dividend policy is developed
by Myron Gordon.
Assumptions:
Gordons model is based on the following assumptions.
1. The firm is an all Equity firm
2. No external financing is available
3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K) of the firm remains constant.
5. The firm and its stream of earnings are perpetual
6. The corporate taxes do not exist.
7. The retention ratio (b), once decided upon, is constant.
Thus, the growth rate (g) = br is constant forever.
8. K > br = g if this condition is not fulfilled, we cannot get a meaningful value for the share.
According to Gordons dividend capitalisation model, the market value of a share (Pq) is equal to the
present value of an infinite stream of dividends to be received by the share. Thus:

The above equation explicitly shows the relationship of current earnings (E,), dividend policy, (b),
internal profitability (r) and the all-equity firms cost of capital (k), in the determination of the value of
the share (P0).
3. Modigliani and Millers hypothesis:
According to Modigliani and Miller (M-M), dividend policy of a firm is irrelevant as it does not affect the
wealth of the shareholders. They argue that the value of the firm depends on the firms earnings which
result from its investment policy.
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Thus, when investment decision of the firm is given, dividend decision the split of earnings between
dividends and retained earnings is of no significance in determining the value of the firm. M Ms
hypothesis of irrelevance is based on the following assumptions.
1. The firm operates in perfect capital market
2. Taxes do not exist
3. The firm has a fixed investment policy
4. Risk of uncertainty does not exist. That is, investors are able to forecast future prices and
dividends with certainty and one discount rate is appropriate for all securities and all time
periods. Thus, r = K = Kt for all t.
Under M M assumptions, r will be equal to the discount rate and identical for all shares. As a result,
the price of each share must adjust so that the rate of return, which is composed of the rate of
dividends and capital gains, on every share will be equal to the discount rate and be identical for all
shares.

Thus, the rate of return for a share held for one year may be calculated as follows:

Where P^ is the market or purchase price per share at time 0, P, is the market price per share at time 1
and D is dividend per share at time 1. As hypothesised by M M, r should be equal for all shares. If it is
not so, the low-return yielding shares will be sold by investors who will purchase the high-return
yielding shares.
This process will tend to reduce the price of the low-return shares and to increase the prices of the
high-return shares. This switching will continue until the differentials in rates of return are eliminated.
This discount rate will also be equal for all firms under the M-M assumption since there are no risk
differences.
From the above M-M fundamental principle we can derive their valuation model as follows:

Multiplying both sides of equation by the number of shares outstanding (n), we obtain the value of the
firm if no new financing exists.

If the firm sells m number of new shares at time 1 at a price of P^, the value of the firm at time 0 will
be

The above equation of M M valuation allows for the issuance of new shares, unlike Walters and
Gordons models. Consequently, a firm can pay dividends and raise funds to undertake the optimum
investment policy. Thus, dividend and investment policies are not confounded in M M model, like
waiters and Gordons models.
Criticism:
Because of the unrealistic nature of the assumption, M-Ms hypothesis lacks practical relevance in the
real world situation. Thus, it is being criticised on the following grounds.
1. The assumption that taxes do not exist is far from reality.
2. M-M argue that the internal and external financing are equivalent. This cannot be true if the
costs of floating new issues exist.
3. According to M-Ms hypothesis the wealth of a shareholder will be same whether the firm pays
dividends or not. But, because of the transactions costs and inconvenience associated with the
sale of shares to realise capital gains, shareholders prefer dividends to capital gains.
4. Even under the condition of certainty it is not correct to assume that the discount rate (k) should
be same whether firm uses the external or internal financing.
If investors have desire to diversify their port folios, the discount rate for external and internal
financing will be different.
5. M-M argues that, even if the assumption of perfect certainty is dropped and uncertainty is
considered, dividend policy continues to be irrelevant. But according to number of writers,
dividends are relevant under conditions of uncertainty.
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Return on Capital Employed = Net Operations Profit (EBIT)

Capital Employed
Capital Employed= Total Assets Current Employed
Return on Total Assets = Net income____
Avg Total Assets
Avg Total Assets = (Opening Tot Assets + Closing Tot Assets) / 2
Return on Net Worth = ________Net after tax profits___________

Scott's Auto Body Shop customizes cars for celebrities and movie sets. During the year, Scott had a
net operating profit of $100,000. Scott reported $100,000 of total assets and $25,000 of current
liabilities on his balance sheet for the year.
Accordingly, Scott's return on capital employed would be calculated like this:

As you can see, Scott has a return of 1.33. In other words, every dollar invested in employed capital,
Scott earns $1.33. Scott's return might be so high because he maintains low assets level.
Share Holder Capital + Retained Earnings

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