MBA SEMESTER 2

MB0045–Financial Management- 4 Credits

(Book ID: B1134)
Assignment Set- 1 (6

1
Q.1 Write the short notes on:
1. Financial Management
2. Financial Planning
3. Capital Structure
4. Cost of Capital
5. Trading on Equity

A. (1) Financial Management:

Financial Management is the art and science of managing money. It is concerned with procurement
and effective utilisation of funds for the benefit of its stakeholders. It embraces all those managerial
activities that are required to procure funds at the least cost and their effective deployment.

(2) Financial Planning:

Financial planning is a process by which funds required for each course of action is decided.

A financial plan has to consider capital structure, capital expenditure and cash flow. Decisions on the
composition of debt and equity must be taken.

Financial planning or financial plan indicates:

• The quantum of funds required to execute business plans

• Composition of debt and equity, keeping in view the risk profile of the existing business, new
business to be taken up and the dynamics of capital market conditions

• Formulation of policies, giving effect to the financial plans under consideration

(3) Capital Structure:

The capital structure of a company refers to the mix of long-term finances used by the firm. In short, it
is the financing plan of the company. With the objective of maximising the value of the equity shares,
the choice should be that pattern of using of debt and equity in a proportion which will lead towards
achievement of the firm’s objective. The capital structure should add value to the firm.

(4) Cost of Capital:

2
The cost of capital is the minimum rate of return of a company, which must earn to meet the
expenses of the various categories of investors who have made investment in the form of loans,
debentures and equity and preference shares.

(5) Trading on Equity:

Trading on equity is sometimes referred to as financial leverage or the leverage factor. Trading on
equity occurs when a corporation uses bonds, other debt, and preferred stock to increase its earnings
on common stock.
For example, a corporation might use long term debt to purchase assets that are expected to earn
more than the interest on the debt. The earnings in excess of the interest expense on the new debt
will increase the earnings of the corporation’s common stockholders. The increase in earnings
indicates that the corporation was successful in trading on equity.
If the newly purchased assets earn less than the interest expense on the new debt, the earnings of
the common stockholders will decrease.

Q.2 (A) Write the features of Interim dividend and also write the factors influencing dividend
policy?

(B) What is reorder level?

A2. (A) A dividend declared before a firm's annual earnings and dividend-paying ability are
accurately known by its management. An interim dividend is ordinarily paid in each of the first three
quarters of the fiscal year. These payments are followed by a final dividend at the time that earnings
can be accurately determined..

An interim dividend may be distributed by the board of directors in the current year on condition that
the articles of association (bylaws) empower them to do so.

The Companies Code (NL / FR) provides specific procedures to be followed in the case of public
limited liability companies, private limited liability companies or cooperative limited liability companies.
The only profit available for distribution is the profit of the current financial year, decreased by any
losses brought forward or increased by the profits brought forward, without drawing on any the
statutory or legal reserves and taking into account the reserves that need to be set up according to
bylaws or legal requirements, if any.
The board of directors needs to prepare a report and a statement of assets and liabilities, which has
to be reviewed by the statutory auditor.

As prescribed by the IBR/IRE, this appointment represents a limited review and not an audit. The
auditor will not express an opinion on the fair view of the equity, the financial position and the results
of the company.

The decision of the board may not be taken later than 2 months after the date of the statement of
assets and liabilities referred to above.
3
Furthermore, no distribution may be decided earlier than:
• 6 months after the closing date of the previous financial year
• The approval of these accounts by the general meeting of shareholders
• For a second interim dividend in the year, not earlier than 3 months after the first interim
dividend.

Factors affecting dividend policy are described briefly:

• Stability of Earnings. The nature of business has an important bearing on the dividend policy.
Industrial units having stability of earnings may formulate a more consistent dividend policy than
those having an uneven flow of incomes because they can predict easily their savings and
earnings. Usually, enterprises dealing in necessities suffer less from oscillating earnings than
those dealing in luxuries or fancy goods.

• Age of corporation. Age of the corporation counts much in deciding the dividend policy. A
newly established company may require much of its earnings for expansion and plant
improvement and may adopt a rigid dividend policy while, on the other hand, an older company
can formulate a clear cut and more consistent policy regarding dividend.

• Liquidity of Funds. Availability of cash and sound financial position is also an important factor
in dividend decisions. A dividend represents a cash outflow, the greater the funds and the liquidity
of the firm the better the ability to pay dividend.

• Extent of share Distribution. Nature of ownership also affects the dividend decisions. A
closely held company is likely to get the assent of the shareholders for the suspension of dividend
or for following a conservative dividend policy. On the other hand, a company having a good
number of shareholders widely distributed and forming low or medium income group would face a
great difficulty in securing such assent because they will emphasize to distribute higher dividend.

• Needs for Additional Capital. Companies retain a part of their profits for strengthening their
financial position. The income may be conserved for meeting the increased requirements of
working capital or of future expansion. Small companies usually find difficulties in raising finance
for their needs of increased working capital for expansion programmes. They having no other
alternative, use their ploughed back profits. Thus, such Companies distribute dividend at low rates
and retain a big part of profits.

• Trade Cycles. Business cycles also exercise influence upon dividend Policy. Dividend policy is
adjusted according to the business oscillations.

4
• Government Policies. The earnings capacity of the enterprise is widely affected by the
change in fiscal, industrial, labor, control and other government policies. Sometimes government
restricts the distribution of dividend beyond a certain percentage in a particular industry or in all
spheres of business activity as was done in emergency.

• Taxation Policy. High taxation reduces the earnings of he companies and consequently the
rate of dividend is lowered down. Sometimes government levies dividend-tax of distribution of
dividend beyond a certain limit. It also affects the capital formation. N India, dividends beyond 10
% of paid-up capital are subject to dividend tax at 7.5 %.

• Legal Requirements. In deciding on the dividend, the directors take the legal requirements
too into consideration. In order to protect the interests of creditors an outsiders, the companies Act
1956 prescribes certain guidelines in respect of the distribution and payment of dividend .

• Past dividend Rates. While formulating the Dividend Policy, the directors must keep in mind
the dividend paid in past years. The current rate should be around the average past rat. If it has
been abnormally increased the shares will be subjected to speculation. In a new concern, the
company should consider the dividend policy of the rival organization.

• Ability to Borrow. Well established and large firms have better access to the capital market
than the new Companies and may borrow funds from the external sources if there arises any
need. Such Companies may have a better dividend pay-out ratio.

• Policy of Control. If the directors want to have control on company, they would not like to add
new shareholders and therefore, declare a dividend at low rate.

• Repayments of Loan. A company having loan indebtedness are vowed to a high rate of
retention earnings, unless one other arrangements are made for the redemption of debt on
maturity. It will naturally lower down the rate of dividend.

• Time for Payment of Dividend. When should the dividend be paid is another consideration.
Payment of dividend means outflow of cash. It is, therefore, desirable to distribute dividend at a
time when is least needed by the company

• Regularity and stability in Dividend Payment. Dividends should be paid regularly because
each investor is interested in the regular payment of dividend.

(B) Re-Order Level: A level of inventory at which a replenishment order should be placed.
Traditional "optimizing" systems use a variation on the computation of maximum usage multiplied
by maximum lead, which builds in a measure of safety.

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

5
 • Lead time

• Average usage

Lead time refers to the average time required to replenish the inventory after placing orders for
inventory.

Re- Order Level = Lead Time * Average Usage

Under certainty, re-order level refers to that inventory level which will meet the consumption needs
during the lead time.

Q.3 Sales Rs. 400,000 Less Returns Rs. 10,000 Cost of Goods sold Rs. 300,000.
Administration and Selling Expenses Rs. 20,000. Interest on loans Rs. 5,000. Income Tax Rs.
10,000. Preference Dividend Rs. 15,000. Equity Share Capital Rs. 100,000 @ Rs. 10 per Share.
Find EPS

A. 3

Particulars Amount

Sales 4,00,000

Less: Returns 10,000

Less: Cost of goods sold 3,00,000

Less: Administration & Selling Expenses 20,000

Less: Interest on Loan 5,000

EBIT (Earnings before income tax) 65,000

Less: Income Tax 10,000

EAT (Earnings after tax) 55,000

Less: Preference Dividend 15,000

Earnings available to Equity Holders 40,000

*EPS (Earnings Per Share) Rs. 4.00

* Working Note:

1. EBIT = Sales – Returns – Cost of goods sold – Administration & selling expenses – Interest
on loan

i.e., EBIT = 4, 00,000 – 10,000 – 3, 00,000 – 20,000 – 5,000

6
 EBIT = 65,000

2. EAT = EBIT – Income Tax

i.e., EAT = 65,000 – 10,000

EAT = 55,000

3. Earnings available to equity holders = EAT – Preference Dividend

i.e., Earnings available to equity holders = 55,000 – 15,000

Earnings available to equity holders = 40,000

4. No. of shares = Equity Share Capital / Rate per share

i.e., No. of shares = 1, 00,000 / 10

No. of shares = 10,000

Therefore EPS = Earnings available to equity holders / No. of Shares

EPS = 40,000 / 10,000

EPS = Rs. 4.00

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

A. 4 Three steps are involved in the evaluation of an investment:

• Estimation of cash flows
• Estimation of the required rate of return (the cast of capital)
• Application of a decision rule for decision rule for making the choice

Estimation of cash flows

7
Estimating the cash flows associated with the project under consideration is the most difficult and
crucial step in the evaluation of an investment proposal. Estimation is the result of the team work of
many professionals in an organization.

• Capital outlays are estimated by engineering departments after examining all aspects of
production process

• Marketing department on the basis of market survey forecasts the expected sales
revenue during the period of accrual of benefits from project executions

• Operating costs are estimated by cost accountants and production engineers

• Incremental cash flows and cash out flow statement is prepared by the cost accountant
on the basis of the details generated in the above steps

The ability of the firm to forecast the cash flows with reasonable accuracy lies at the root of the
success of the implementation of any capital expenditure decision.

Estimation of incremental cash flows:

Investment (capital budgeting) decision requires the estimation of incremental cash flow stream over
the life of the investment. Incremental cash flows are estimated on tax basis.

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

• Initial cash outlay (Initial investment)

Initial cash outlay to be incurred is determined after considering any post tax cash inflows. In
replacement decisions existing old machinery is disposed of and new machinery incorporating the
latest technology is installed in its place.

On disposal of existing old machinery the firm has a cash inflow. This cash inflow has to be
computed on post tax basis. The net cash out flow (total cash required for investment in capital assets
minus post tax cash inflow on disposal of the old machinery being replaced by a new one) therefore is
the incremental cash outflow. Additional net working capital required on implementation of new
project is to be added to initial investment.

• Operating cash inflows

Operating cash inflows are estimated for the entire economic life of investment (project).
Operating cash inflows constitute a stream of inflows and outflows over the life of the project. Here
also incremental inflows and outflows attributable to operating activities are considered. Any savings
in cost on installation of a new machinery in the place of the old machinery will have to be accounted
on post tax basis. In this connection incremental cash flows refer to the change in cash flows on
implementation of a new proposal over the existing positions.
8
 • Terminal cash inflows

At the end of the economic life of the project, the operating assets installed will be disposed off.
It is normally known as salvage value of equipments. These terminal cash inflows are computed on
post tax basis.

Estimation of the required rate of return:

• Separation principle

The essence of this principle is the necessity to treat investment element of the project
separately (i.e. independently) from that of financing element. The financing cost is computed by the
cost of capital. Cost of capital is the cut off rate and rate of return expected on implementation of the
project. Therefore, we compute separately cost of funds for execution of project through the financing
mode. The rate of return expected on implementation if the project is arrived at by the investment
profile of the projects. Therefore, interest on debt is ignored while arriving at operating cash inflows.

The following formula is used to calculate profit after tax

Incremental PAT = Incremental EBIT (1-t)

EBIT = earnings (profit) before interest and taxes

t = tax rate

• Incremental principle:

Incremental principle says that the cash flows of a project are to be considered in incremental terms.
Incremental cash flows are the changes in the firm’s total cash flows arising directly from the
implementation of the project. Keep the following in mind while determining incremental cash flows.

• Ignore sunk costs

Sunk costs are costs that cannot be recovered once they have been incurred. Therefore, sunk
costs are ignored when the decisions on project under consideration is to be taken.

• Opportunity costs

If the firm already owns an asset or a resource which could be used in the execution of the
project under consideration, the asset or resource has an opportunity cost. The opportunity cost of

9
such resources will have to be taken into account in the evaluation of the project for acceptance or
rejection.

Investment decision rule:

The investment decision rules may be referred to as capital budgeting techniques, or investment
criteria. A sound appraisal technique should be used to measure the economic worth of an
investment project. The essential property of a sound technique is that is should maximize the
shareholders wealth. The following other characteristics should also be possessed by a sound
investment evaluation criterion:

• It should consider all cash flows to determine the true profitability of the project.

• It should provide for an objective and unambiguous way of separate good projects from bad
projects.

• It should help ranking of projects according to their true profitability.

• It should recognize the fact that bigger cash flows are preferable to smaller ones and early
cash flows are preferable to later ones.

• It should help to choose among mutually exclusive projects that project which maximizes the
shareholders wealth.

• It should be a criterion which is applicable to any conceivable investment project independent

of others.

These conditions will be clarified as we discuss the features of various investment criteria in the
following posts.

Investment Appraisal Criteria

A number of investment appraisal criteria or capital budgeting techniques are in use of practice. They
may be grouped in the following two categories:

 Discounted cash flow criteria

• Net present value
• Internal rate of return
• Profitability index (PI)

 Not discounted cash flow criteria

• Payback period
• Accounting rate of return
• Discounted payback period

10
Discounted payback is a variation of the payback method. It involves discounted method, but it is not
a true measure of investment profitability. We will show in our following posts the net present value
criterion is the most valid technique of evaluating an investment project. It is consistent with the
objective of maximizing the shareholders wealth.

Q 5. What are the problems associated with inadequate working capital?

Ans 5:Working capital is the life blood and nerve centre of a business. Just as circulation of blood is
essential in the human body for maintaining life, working capital is very essential to maintain the
smooth running of a business. No business can run successfully with out an adequate amount of
working capital.

Working capital refers to that part of firm’s capital which is required for financing short term or
current assets such as cash, marketable securities, debtors, and inventories. In other words
working capital is the amount of funds necessary to cover the cost of operating the enterprise.

Every business needs some amount of working capital. It is needed for following purposes-

• For the purchase of raw materials, components and spares.

• To pay wages and salaries.
• To incur day to day expenses and overhead costs such as fuel, power, and office expenses etc.
• To provide credit facilities to customers etc.

Sources of working capital:

The working capital requirements should be met both from short term as well as long term sources of
funds.

* Financing of working capital through short term sources of funds has the benefits of lower cost and
establishing close relationship with banks.

*Financing of working capital through long term sources provides the benefits of reduces risk and
increases liquidity

Advantages of working capital:

• It helps the business concern in maintaining the goodwill.

• It can arrange loans from banks and others on easy and favorable terms.
• It enables a concern to face business crisis in emergencies such as depression.
• It creates an environment of security, confidence, and over all efficiency in a business.
11
• It helps in maintaining solvency of the business.

Problems associated with excess and inadequate Working capital.

Demerits of Excess Working Capital

• It can accumulate unnecessary inventories Thus chance of mishandling, theft, wastage of

inventories may occur.
• It also indicates poor collection of receivables and liberal credit policy regarding sales. The bad
debts will increase such situation,
• It leads to speculative profit, making dividend policy liberal, creating future problems.
• It may tempt the executives to spend more.

Demerits of Inadequate Working Capital

• It may create difficulty for the firm to undertake profitable projects due to the shortage of
Working Capital.
• The firm may face problems in implementing the operating plans and achieving the profit
target.
• It creates problems in covering routine expenses.
• Fixed assets may be utilized more, thus lowering the overall return.
• Firm may loose some good credit opportunities.
• Firm may fail to honour short term obligations, thus facing tight credit policy.
• Rate of return on investments also fall with the shortage of working capital.

Management of working capital:

A firm must have adequate working capital, i.e.; as much as needed the firm. It should be neither
excessive nor inadequate. Both situations are dangerous. Excessive working capital means the firm
has idle funds which earn no profits for the firm. Inadequate working capital means the firm does not
have sufficient funds for running its operations. It will be interesting to understand the relationship
between working capital, risk and return. The basic objective of working capital management is to
manage firms current assets and current liabilities in such a way that the satisfactory level of working
capital is maintained, i.e.; neither inadequate nor excessive.

Q.6 What is Leverage? Compare & Contrast between Operating & Financial Leverage.

12
A 6. Leverage is a business term that refers to borrowing. If a business is "leveraged," it means
that the business has borrowed money to finance the purchase of assets. The other way to purchase
assets is through use of owner funds, or equity.

One way to determine leverage is to calculate the Debt-to-Equity ratio, showing how much of the
assets of the business are financed by debt and how much by equity (ownership).

Leverage is not necessarily a bad thing. Leverage is useful to fund company growth and development
through the purchase of assets. But if the company has too much borrowing, it may not be able to pay
back all of its debts.

Operating Leverage

Operating leverage arises due to the presence of fixed operating expenses in the firm’s income flows.
A company’s operating costs can be categorized into three:

 Fixed costs: Fixed costs are those which do not vary with an increase in production or sales
activities for a particular period of time. These are incurred irrespective of the income and
value of sales and generally cannot be reduced.

 Variable costs: Variable costs are those which vary in direct proportion to output and sales. An
increase or decrease in production or sales activities will have a direct effect on such types of
costs incurred.

 Semi-variable costs: Semi-variable costs are those which are partly fixed and partly variable in
nature. These costs are typically of fixed nature up to a certain level beyond which they vary
with the firm’s activities.

When a firm has fixed operating expenses, an increase in sales results in a more proportionate
increase in earnings before interest and taxes (EBIT) and vice versa.

This phenomenon is explained, examining the effect of the degree of operating leverage (DOL). The
DOL is a more precise measurement. It examines the effect of the change in the quantity produced
on earnings before interest and taxes (EBIT).

DOL = % change in EBIT / % change in output

To put in a different way,

(ΔEBIT/EBIT) / (ΔQ/Q)

EBIT is Q(S—V)—F

Where Q is quantity

S is sales

13
V is variable cost

F is fixed cost

Substituting this we get,

{Q(S—V)} / {Q(S—V)—F}

Financial Leverage: Financial leverage as opposed to operating leverage relates to the financing
activities of a firm and measures the effect of earnings before interest and tax (EBIT) on earnings per
share (EPS) of the company.

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

o Those which carry a fixed financial charges like debentures, bonds and preference
shares and

o Those which do not carry any fixed charges like equity shares

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

Financial leverage refers to the mix of debt and equity in the capital structure of the firm. This results
from the presence of fixed financial charges in the company’s income stream. Such expenses have
nothing to do with the firm’s performance and earnings and should be paid off regardless of the
amount of earnings before income and tax (EBIT).

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

A company earning more by the use of assets funded by fixed sources is said to be having a
favorable or positive leverage. Unfavorable leverage occurs when the firm is not earning sufficiently to
cover the cost of funds. Financial leverage is also referred to as “Trading on Equity”.

DFL=%change in EPS

%change in EBIT

DFL={ΔEPS/EPS} ÷ {ΔEBIT/EBIT}

Or DFL = EBIT ÷ {EBIT—I—{Dp/(1-T)}}

I is Interest, Dp is dividend on preference shares, T is tax rate.

14
Use of Financial Leverage

Studying the degree of financial leverage (DFL) at various levels makes financial decision-making, on
the use of fixed sources of funds, for funding activities easy. One can assess the impact of change in
earnings before interest and tax (EBIT) on earnings per share (EPS).

Like operating leverage, the risks are high at high degrees of financial leverage (DFL). High financial
costs are associated with high DFL. An increase in financial costs implies higher level of EBIT to meet
the necessary financial commitments.

A firm which is not capable of honouring its financial commitments may be forced to go into liquidation
by the lenders of funds. The existence of the firm is shaky under these circumstances.

On one side the trading on equity improves considerably by the use of borrowed funds and on the
other hand, the firm has to constantly work towards higher EBIT to stay alive in the business. All
these factors should be considered while formulating the firm’s mix of sources of funds.

One main goal of financial planning is to devise a capital structure in order to provide a high return to
equity holders. But at the same time, this should not be done with heavy debt financing which drives
the company on to the brink of winding up.

Impact of financial leverage

Highly leveraged firms are considered very risky and lenders and creditors may refuse to lend them
further to fuel their expansion activities. On being forced to continue lending, they may do so with their
own conditions like earning a minimum of X% EBIT or stipulating higher interest rates than the market
rates or no further mortgage of securities.

Financial leverage is considered to be favorable till such time that the rate of return exceeds the rate
of return obtained when no debt is used.

The company not using debt to finance its assets has a higher DFL compared to that of a company
using it. Financial leverage does not exist when there is no fixed charge financing.

_________________________________________________________________________________
_______________________________________________________________________________

15