FINANCIAL MANAGEMENT

MB 0045
SPRING ASSIGNMENT
Nandeshwar Singh
Roll no. 1408001255

Q1. Explain liquidity Decisions and its important elements. Write complete
information on Dividend Decisions?

Answer. Dividend is that part of profits of the company which is distributed among the
shareholders according to the resolution passed in the meeting of the Board of Directors. This
may be paid as a fixed percentage on share capital contributed by them or at a fixed amount per
share. The Dividend decision is always a problem before the top management or Board of
Directors as that have to decide how much profits should be transferred to the reverse funds to
meet any unforeseen contingencies and how much should be distributed to the shareholders.

Dividend policy influences the dividend yield on shares. Dividend yield is an important
determinant of an investor’s attitude towards the security in his portfolio management decisions.
The following issues need adequate consideration in deciding on dividend policy:

• Preference of shareholders – Do they want cash Dividend or Capital gains?

• Current financial requirements of the company.

• Legal constraints on paying dividends.

• Striking an optimum balance between desire of shareholders and the company’s funds
requirements.

Comparison attempt to maintain a stable dividend policy whereby a stable rate of dividend is
maintained. This also ensures that the company’s market value of shares stays higher. The
main reasons why a stable dividend is preferred are:

A. A regular and stable dividend payment serves to resolve uncertainty in the minds of
shareholders, and it creates confidence among shareholders.

B. Many investors are income conscious and favor a stable dividend.

C. Other thing being is income conscious and favors a stable dividend.

D. Other things being in balance, the market price invariability vary with the rate of
dividend declared by the company on its equity shares. The value of shares of a company
a stable dividend policy does not fluctuate as much, even if the earning of the company
fluctuates now and then.

E. A stable dividend policy encourages investments from institutional investors.

Q2. Explain about the doubling period and present value solve the
below question.

Under the ABC Bank’s cash Multiplier Scheme, deposits can be made
for periods ranging from 3 months to 5 years and for every quarter;
interest is added to the principal. The applicable rate of interest is 9%
for deposits less than 23 months and 10% for periods more than 24
months. What will be the amount of Rs. 1000 after 2 year?

Answer.

FVṉ = PV (1+i/m) mXn

M = 12 = 4 (quarterly compounding)

1000 (1 + 0.10/4)4*2

1000 (1 + 0.10/4)8

Rs. 1218

The amount of Rs. 1000 after 2 year would be Rs. 1218

1. Doubling period – A very common questioning arising in the minds of investors

is “how long will it take for amount invested to double for a given rate of interest”.
These are 2 ways of answering this question :

• One way is to answer it by rule known as ‘rule of 72’. This rule states that the
period within which the amount doubles is obtained by dividing 72 by the rate
 of interest. Though it is a crude way of calculating, this rule is followed by
most. For instance, if the given rate of interest is 10%, the doubling period is
72/10, that is 7.2 years.

• A much accurate way of calculating double period is by using the rule known
as ‘rule of 69’. By this method,

Doubling period = 0.35 + 69/ Interest rate

2. Present value – The present value is sum of to be received at a future date is

determined by discounting the future value at the interest rate that the money could
earn over the period. This process is discounting.

Present value on single flow – Ascertaining Present Value (PV) is simply the
reverse of finding future value (FV). Hence, the formula for FV can be simply
transformed into the PV formula. Thus, we can determine the PV of a future cash
flow or a stream of future cash flows using the formula.

Where, PV = Present Value

FVn = Amount

I = Interest rate

n = Number of years for which discounting id done

Q3. Write a short note on:

A. Operational Leverage

B. Financial leverage

C. Combined leverage.

Answer. A. Operational leverage – Operating leverage is arise due to the

presence of fixed operating expenses in the firm’s income flows. It has a close
relationship to business risk. Operating leverage affects business risk factors, which can
be viewed as the uncertainty inherent of future operating income.

• Fixed Costs – Fixed costs are costs which do not vary with an increase in
production or sales activates for a particular period of time. These are incurred
irrespective of the income and value of sales and generally cannot be reduced.
 • Variable costs – Variable costs are those costs which vary in direct proportion
to output and sales. An increase or decrease in production of sales activates will
have a direct effect on such types of costs incurred.

• Semi variable costs – These costs are partly fixed and partly variable in
nature. These costs are typically of fixed nature up to a certain level beyond
which they vary with the firm’s activates.

B. Financial leverage – Financial leverage refers to a firm’s use of fixed-

charge securities like debentures and preference share in its plan of financing the
assets. Financial leverage relates to the financing activates of the firm and
measures the effect of EBIT on Earning per Share (EPS) of the company. A
company’s source of funds fall under two categories:

• Those which carry fixed financial charges like debentures, boons, and
preference shares.

• Those which do not carry any fixed charges like equity shares.

C Combined Leverage – The combination of operating and financial

leverage is called combined leverage. Operating leverage affects the firm’s
operating profit EBIT financial leverage affects PAT or the EPS. A company has
and a high level of operating or financial leverage will find a drastic change in its
EPS even for a small change in sales volume. Companies whose products are
seasonable in nature have fluctuating EPS, but the amount of changes in EPS due
to leverages is more pronounced.

Q4. A. Explain the factors Affecting Capital Structure? Solve the

given problem.

B. Given below are two firms, a and B, which are identical in all
aspects except the degree of leverage, employed by them. What is
the average cost of capital of both firms?

Details of firms A and B

Firm A Firm B

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

Interest on debentures I Nil Rs.25000

Equity earnings E Rs. 1,00,000 Rs.75,000

Cost of equity Ke 15% 15%

Cost of debentures Kd 10% 10%

Market Value of Equity S = E/ Ke Rs.6,66,667 Rs. 1,00,000

Market Value of Debt B Nil Rs.2,50,000

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

Answer A. Factors Affecting Capital Structure:

1. Leverage - Use of sources of funds that have a fixed cost attached to them,
such as preference shares, loans from banks and financial institutions and
debentures in the capital structure, is known as “trading on equity” or
“financial Leverage”. If the assets financed by debt yield a return greater than
the cost of the debt, the debt EPS will increase without an increase in the
owner’s investment. Similarly, the EPS will also increase if preference share
capital is used to acquire assets. But the leverage impact is left more in case of
debt.

2. Cost of capital – High cost funds should be avoided. However attractive

an investment proposition may look like, the profits earned may be eaten
away by interest repayments.

3. Cash flow projections of the company – Decisions should be taken in

the light of cash flow projected for the next 3-5 years. The company officials
should not get carried forward away at the immediate result expected.
Consistent lesser profits are any way preferable than high profits in the
beginning and not being able to get any profit after 2 years.

4. Dilution of control – The top management should have the flexibility to

take appropriate decisions at the right time. Fear of having to share control
and thus being interfered by others often delays the decision of the closely
 held companies to go public. To avoid the risk of loss of control, the
companies may issue preference shares or issue debt capital.

5. Floatation costs – These costs are incurred when funds are raised.
Generally, the cost of floating a debt is less than a cost of floating an equity
issue. A company desiring to increase its capital by way of debt or equity will
definitely incur flotation coats. Effectively, the amount raised by an issue will
be lower than the amount expected because of the presence of floatation costs.

Solution .B

Averages cost of capital of firm A is:

10% * 0/Rs.666667 + 15% * 6666667/666667 = 0 + 15 = 15%

Average cost of capital of firm B is:

10% * 250000/75000 + 15% * 533333/750000 = 3.34 + 10 = 13.9

Q5. Explain the all kind of sources of risk in Capital budgeting

with examples?

Solve the Question that below given.

An Investment will have an initial outlay of Rs1, 00,000. It is

expected to generate cash inflows.

Cash Inflows

YEAR CASH FLOWS

1 40000

2 50000

3 15000

4 30000

If the risk free rate and the risk premium is 10%

A. Compute the NPV using the risk free rate.

B. Compute NPV using the risk free-adjusted discount rate.

Answer. The Five different source of risk are as following:

• Project- specific risk – Project-specific risk could be traced to

something quite specific to the project. Managerial deficiencies or error in
estimation of cash flows or discount rate may lead to a situation of actual
flows realized being less than the projected cash flow.

• Competitive or competition risk – Unanticipated actions of a

firm’s competitors will materially affect the cash flows expected from a
project. As a result of this, the actual cash flows from a project will be less
than of the forecast.

• Industry specific risk – These are risk that affects the entire firms in
the particular industry. Industry specific risk could be again grouped into
technological risk, commodity risk and legal risk. The groups of industry
specific risks, as follows.

1. Technological risk – The change in technology affect all the firms

not capable of adapting themselves in emerging into a new technology.

2. Commodity risk – It is the risk arising from the affect of price

change on goods produced and marketed.

3. Legal risk – It arises from changes in laws and regulations

applicable to the industry to which the firm belongs.

• International risk – These types of risks are faced by firms whose

business consists mainly of exports or those who procure their main raw
material from international markets like the rupee-dollar crises affected
the software and BPOs, because it drastically reduced their profitability.

• Market risk – Factors like inflation changes in interest rates, firms

cannot diversify this kind of risks in the normal course of business. There
are many techniques of incorporation of risk perceived in the evolution of
capital budgeting proposals. They differ in their approach methodology as
far as incorporation of risk in the evolution process is concerned.
A. NPV can be computed using risk free rate. Table shoes NPV calculation using
risk free rate.

PV Using Risk Free Rate

Year Cash Flow Rs. PV factor at 10% PV of cash flows (inflows)

1 40000 0.909 36,360

2 50000 0.826 41,300

3 15000 0.751 11,265

4 30000 0.683 20,490

PV of cash
inflows

PV of cash (1,00,000)
outflows

NPV 9,415

B. NPV can be computed using risk-adjusted discount. NPV calculation using

Table shows NPV calculation using the risk adjusted discount.
NPV Using Risk Adjusted Discount Rate

Year Cash Flow Rs. PV factor at 10% PV of cash flows PV of Cash

1 40000 0.909 36,360 33,320

2 50000 0.826 41,300 34,700

3 15000 0.751 11,265 8,685

4 30000 0.683 20,490 14,460

PV of cash 91,165
inflows

PV of cash (1,00,000) (100000)

outflows

NPV 9,415 (8,835)

The Project would be acceptable when no allowance is made for risk.

However, it will not be acceptable if risk premium is added to the risk free rate.
By doing so, it moves from NPV to negative NPV. If the firm were to use the
internal rate of return (IRR), then the project would be accepted, when IRR is
greater than the risk- adjusted discount rate.
 Q6. What is the objective cash management? Write about the
Baumol model and their assumptions?

Answer. Cash management is concerned with the Management of cash flow in

and out of the firm. Cash management tries to accomplish at a minimum cost, the
various tasks of collection, payment of out- standing and arranging for deficit
financing or surplus investment within the firm. Management of cash balance held
by the firm Deficit financing or investing surplus cash there are some following
objective are:

• Meeting payments schedule – A firm has to make a various

payments by cash to its employees, suppliers and infrastructure bills.
Firms will also receive cash through sales of its products and collection of
receivables. Both of these do not occur simultaneously. The basic
objective is to meet the payment schedule on time. Timely payment will
help the firm to maintain its creditworthiness in the market and to foster
cordial relationships with creditors and suppliers. Creditors give cash
discount if payments are made in time and the firm can avail this discount
as well.

• Minimizing funds held in the form of cash balances – A high

level of cash balance will help the firm to meet its first objective, but
keeping excess reserves is also not desirable as funds in its original form is
idle cash and a non-earning. It is not profitable for firms to maintain huge
balance. A low level of cash balance may mean failure to meet the
payment schedule. The aim of cash management is therefore to have an
optional level of cash by bringing about a proper synchronization of flows
and outflows, and to check the spells of cash deficits and cash surpluses
and outflows. Arguments by controlling a few important factors:

Prompt billing and mailing – There is a time lag between the

dispatch of goods and perception of invoice. Reduction of this gap will
bring in early remittances.

Collection of claques and remittances of cash – Generally, we

find a delay in the receipt of claque and their deposits in banks. The delay
can be reduced by speeding the process of collecting and depositing cash
or other instruments from customers.
 Float – The concept of ‘Float’ helps firms to a certain extent in cash
management. Float arises because of the practice of banks not cresting the
firm’s account in its books when cheque is deposited by it and not debiting
the firm’s account in its books when a cheque is issued by it, until the
cheque is cleared and cash is realized or paid respectively.

Payment Float = Payment Float – Collection Float

Baumol Model:

This model helps in determining the minimum amount of cash that a

manger can obtain by converting securities into cash. It is an approach to
establish a firm’s optimal cash balance under certainty. As such, firms
attempt to minimize the sum of the cost of holding cash and the cost of
converting marketable securities to cash. Baumol Model of cash
management trades off between opportunity cost or carrying cost or
holding cost and the transaction cost. Some assumptions are:

1. The firm is able to forecast its cash requirements in an accurate way.

2. The firm’s payouts are uniform over a period of time.

3. The opportunity cost of holding cash is known and does not change with
time.

4. The firm will incur the same transaction cost for all conversations of
securities into cash.