Assignment MB0045- Financial Management - Set 1

Course MBA – 2^nd Semester

Subject:   Financial Management

Assignment MB0045 – Set 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.

1. Financial Management

Financial Management is planning, directing, monitoring, organizing, and controlling of the monetary resources of an organization. The management of the finances of a business / organization in order to achieve financial objectives. Financial Management is the efficient and effective planning and controlling of financial resources so as to maximize profitability and ensuring liquidity for an individual(called personal finance), government(called public finance) and for profit and non-profit organization/firm (called corporate or managerial finance). Generally, it involves balancing risks and profitability.  

The decision function of financial management can be divided into the following 3 major areas:

INVESTMENT DECISION

1. Determine the total amount of assets needed by a firm hence closely tied to the allocation of funds
2. Two type of investment decisions namely:

• Capital Investment decisions re: large sums, non routine, longer term, critical to the business like purchase of plant and machinery or factory
• Working Capital Investment decisions re: more routine in nature, short term but are also very critical decisions like how much and how long to invest in inventories or receivables 

FINANCING DECISION

1. After deciding on the amount and type of assets to buy, the financial manager needs to decide on HOW TO FINANCE these assets with the sources of fund
2. Financing decisions for example:

• Whether to use external borrowings/debts or share capital or retained earnings

• Whether to borrow short, medium or long term

• What sort of mix – all borrowings or part debts part share capital or 100% share capital

• The needs to determine how much dividend to pay out as this will directly affects the financial decision.

2. Financial Planning

Financial Planning is an exercise aimed to ensure availability of right amount of money at the right time to meet the individual’s financial goals

Concept of Financial Planning

Financial Goals refer to the dreams of the investor articulated in financial terms. Each dream implies a purpose, and a schedule of funds requirements for realising the purpose

Asset Allocation refers to the distribution of the investor’s wealth between different asset classes (gold, property, equity, debt etc.)

Portfolio Re-balancing is the process of changing the investor’s asset allocation

Risk Tolerance / Risk Preference refers to the appetite of the investor for investment risk viz. risk of loss

Financial Plan Is a road map, a blue print that lists the investors’ financial goals and outlines a strategy for realising them

Quality of the Financial Plan is a function of how much information the prospect shares, which in turn depends on comfort that the planner inspires

3. Capital Structure

Capital structure of a firm is a reflection of the overall investment and financing strategy of the firm.

Capital structure can be of various kinds as described below:

• Horizontal capital structure: the firm has zero debt component in the structure mix. Expansion of the firm takes through equity or retained earnings only.

• Vertical capital structure: the base of the structure is formed by a small amount of equity share capital. This base serves as the foundation on which the super structure of preference share capital and debt is built.

• Pyramid shaped capital structure: this has a large proportion consisting of equity capita; and retained earnings.

• Inverted pyramid shaped capital structure: this has a small component of equity capital, reasonable level of retained earnings but an ever-increasing component of debt.

SIGNIFICANCE OF CAPITAL STRUCTURE:

• Reflects the firm’s strategy
• Indicator of the risk profile of the firm
• Acts as a tax management tool
• Helps to brighten the image of the firm.

FACTORS INFLUENCING CAPITAL STRUCTURE:

• Corporate strategy
• Nature of the industry
• Current and past capital structure

4. Cost of Capital

Cost of capital is the rate of return the firm requires from investment in order to increase the value of the firm in the market place. In economic sense, it is the cost

of raising funds required to finance the proposed project, the borrowing rate of the firm. Thus under economic terms, the cost of capital may be defined as the weighted average cost of each type of capital.

There are three basic aspects about the concept of cost

1. It is not a cost as such: The cost of capital of a firm is the rate of return which it requires on the projects. That is why; it is a ‘hurdle’ rate.

2. It is the minimum rate of return: A firm’s cost of capital represents the minimum rate of return which is required to maintain at least the market value of equity shares.

3. It consists of three components. A firm’s cost of capital includes three components

a. Return at Zero Risk Level: It relates to the expected rate of return when a project involves no financial or business risks.

b. Business Risk Premium: Business risk relates to the variability in operating profit (earnings before interest and taxes) by virtue of changes in sales. Business risk premium is determined by the capital budgeting decisions for investment proposals.

c. Financial Risk Premium: Financial risk relates to the pattern of capital structure (i.e., debt-equity mix) of the firm, In general, a firm which has higher debt content in its capital structure should have more risk than a firm which has comparatively low debt content. This is because the former should have a greater operating profit with a view to covering the periodic interest payment and repayment of principal at the time of maturity than the latter.

5. Trading on Equity

When a co. uses fixed interest bearing capital along with owned capital in raising finance, is said “Trading on Equity”.

(Owned Capital = Equity Share Capital + Free Reserves )

Trading on equity represents an arrangement under which a company uses funds carrying fixed interest or dividend in such a way as to increase the rate of return on equity shares.

It is possible to raise the rate of dividend on equity capital only when the rate of interest on fixed – interest – bearing – security is less than the rate of return earned in business.

•Two other terms:

•Trading on Thick Equity :- When borrowed capital is less than owned capital

•Trading on Thin Equity :- When borrowed capital is more than owned capital, it is called Trading on thin Equity.

Q.2 a. Write the features of interim divined and also write the factors influencing divined policy?

Interim Dividend and factors affecting it:

Usually, board of directors of company declares dividend in annual general meeting after finding the real net profit position. If boards of directors give dividend for current year before closing of that year, then it is called interim dividend. This dividend is declared between two annual general meetings.

 Before declaring interim dividend, board of directors should estimate the net profit which will be in future. They should also estimate the amount of reserves which will deduct from net profit in profit and loss appropriation account.  If they think that it is sufficient for operating of business after declaring such dividend. They can issue but after completing the year, if profits are less than estimates, then they have to pay the amount of declared dividend. For this, they will have to take loan. Therefore, it is the duty of directors to deliberate with financial consultant before taking this decision.

Accounting treatment of interim dividend in final accounts of company :-

First Case: Interim dividend is shown both in profit and loss appropriation account and balance sheet , if it is outside the trial balance in given question.

(a) It will go to debit side of profit and loss appropriation account

(b) It will also go to current liabilities head in liabilities side.

Second Case: Interim dividend is shown only in profit and loss appropriation account, if it is shown in trial balance.

(a) It will go only to debit side of profit and loss appropriation account.

If in final declaration is given outside of trial balance and this will be proposed dividend and interim dividend in trial balance will be deducted for writing proposed dividend in profit and loss appropriation account and balance sheet of company, because if we will not deducted interim dividend, then it will be double  deducted from net profit that is wrong and error shows when we will  match balance sheets assets with liabilities.

Factors affecting dividend policy:

The dividend decision is difficult decision because of conflicting objectives and also because of lack of specific decision-making techniques. It is not easy to lay down an optimum dividend policy which would maximize the long-run wealth of the shareholders. The factors affecting dividend policy are grouped into two broad categories.

1. Ownership considerations
2. Firm-oriented considerations

Ownership considerations: Where ownership is concentrated in few people, there are no problems in identifying ownership interests. However, if ownership is decentralized on a wide spectrum, the identification of their interests becomes difficult.

Various groups of shareholders may have different desires and objectives. Investors gravitate to those companies which combine the mix of growth and desired dividends.

Firm-oriented considerations: Ownership interests alone may not determine the dividend policy. A firm’s needs are also an important consideration, which include the following:

• Contractual and legal restrictions
• Liquidity, credit-standing and working capital
• Needs of funds for immediate or future expansion
• Availability of external capital.
• Risk of losing control of organization
• Relative cost of external funds
• Business cycles
• Post dividend policies and stockholder relationships.

The following factors affect the shaping of a dividend policy:

Nature of Business: Companies with unstable earnings adopt dividend policies which are different from those which have steady earnings.

Composition of Shareholding: In the case of a closely held company, the personal objectives of the directors and of a majority of shareholders may govern the decision. To the contrary, widely held companies may take a dividend decision with a greater sense of responsibility by adopting a more formal and scientific approach.

Investment Opportunities: Many companies retain earnings to facilitate planned expansion. Companies with low credit ratings may feel that they may not be able to sell their securities for raising necessary finance they would need for future expansion. So, they may adopt a policy for retaining larger portion of earnings.

Similarly, is a company has lucrative opportunities for investing its funds and can earn a rate which is higher than its cost of capital, it may adopt a conservative dividend policy.

Liquidity: This is an important factor. There are companies, which are profitable but cannot generate sufficient cash, since profits are to be reinvested in fixed assets and working capital to boost sales.

Restrictions by Financial Institutions: Sometimes financial institutions which grant long-term loans to a company put a clause restricting dividend payment till the loan or a substantial part of it is repaid.

Inflation: In period of inflation, funds generated from depreciation may not be adequate to replace worn out equipment. Under inflationary situation, the firm has to depend upon retained earnings as a source of funds to make up for the shortfall. Consequently, the dividend pay out ratio will tend to be low.

Other factors: Age of the company has some effect on the dividend decision.

The demand for capital expenditure, money supply, etc., undergoes great oscillations during the different stages of a business cycle. As a result, dividend policies may fluctuate from time to time.

b. What is reorder level?

Reorder Level

This is that level of materials at which a new order for supply of materials is to be placed. In other words, at this level a purchase requisition is made out. This level is fixed somewhere between maximum and minimum levels. Order points are based on usage during time necessary to requisition order, and receive materials, plus an allowance for protection against stock out.

The order point is reached when inventory on hand and quantities due in are equal to the lead time usage quantity plus the safety stock quantity.

Formula of Re-order Level or Ordering Point:

The following two formulas are used for the calculation of reorder level or point.

Ordering point or re-order level = Maximum daily or weekly or monthly usage × Lead time

The above formula is used when usage and lead time are known with certainty; therefore, no safety stock is provided. When safety stock is provided then the following formula will be applicable:

Ordering point or re-order level = Maximum daily or weekly or monthly usage × Lead time + Safety stock

Q.3 Sales Rs.400, 000 less returns Rs 10, 000, Cost of Goods Sold Rs 300,000,

Administration and selling expenses Rs.20, 000, Interest on loans Rs.5000,

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

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

Ans 3.

Sales			400,000
Less Returns			10,000	390,000
Less
COGS			30,000
S&A			20,000
Int on Loan			5,000
IT			10,000	325,000
Div			15,000
ESC			100,000	@ 10/-
NPAT - Pref Share Div
No of Shares
NPAT			55,000
less Pref Share Div			15,000	40,000
EPS			40,000	= Rs.4/-
			10,000

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

Techniques of Investment Evaluation 

Three steps are involved in the evaluation of an investment: 

•Estimation of cash flows 

•Estimation of the required rate of return (the opportunity cost of capital) 
•Application of a decision rule for making the choice. 

The first two steps, discussed in the subsequent chapters, are assumed as given. Thus, our discussion in this chapter is confined to the third step. Specifically, we focus on the merits and demerits of various decision rules. 

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 it 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 separating good projects form bad projects. 

• It should help ranking of projects according to their true profitability. 
• It should recognize the fact that bigger cash flows true profitability. 
• It should recognize the fact that bigger cash flows are preferable to smaller once and early cash flows are preferable to later ones. 

• It should help top 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 other. 

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

Evaluation criteria 

A number of investments criteria (or capital budgeting techniques) are in use in proactive. They may be grouped in the following two categories: 
1. Discounted cash flow (DCF) criteria 

• Net present value (NPV) 

• Internal rate of return (IIR) 

• Profitability index (PI) 

2. Non-discounted cash flow criteria 

• Payback period (PB) 

• Discounted payback period 

• Accounting rate of return (ARR). 

Discounted payback is a variation of the payback method. It involves discounted cash flows, but as we shall see later, it is not a true measure of investment profitability. We will show in the following pages that the net present value criterion is the most valid technique of maximizing the shareholders wealth.

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

Problems associated with inadequate working capital

Working capital may be regarded as the life blood of business. Working capital is of major importance to internal and external analysis because of its close relationship with the current day-to-day operations of a business. Every business needs funds for two purposes.

• Long term funds are required to create production facilities through purchase of fixed assets such as plants, machineries, lands, buildings & etc
• Short term funds are required for the purchase of raw materials, payment of wages, and other day-to-day expenses. . It is other wise known as revolving or circulating capital

It is nothing but the difference between current assets and current liabilities. i.e. Working Capital = Current Asset – Current Liability.

Businesses use capital for construction, renovation, furniture, software, equipment, or machinery. It is also commonly used to purchase inventory, or to make payroll. Capital is also used often by businesses to put a down payment down on a piece of commercial real estate. Working capital is essential for any business to succeed. It is becoming increasingly important to have access to more working capital when we need it.

Importance of Adequate Working Capital

A business firm must maintain an adequate level of working capital in order to run its business smoothly. It is worthy to note that both excessive and inadequate working capital positions are harmful. Working capital is just like the heart of business. If it becomes weak, the business can hardly prosper and survive. No business can run successfully without an adequate amount of working capital.

Danger of inadequate working capital

When working capital is inadequate, a firm faces the following problems.

Fixed Assets cannot efficiently and effectively be utilized on account of lack of sufficient working capital. Low liquidity position may lead to liquidation of firm. When a firm is unable to meets its debts at maturity, there is an unsound position. Credit worthiness of the firm may be damaged because of lack of liquidity. Thus it will lose its reputation. There by, a firm may not be able to get credit facilities. It may not be able to take advantages of cash discount.

Disadvantages of Redundant or Excessive Working Capital

1. Excessive Working Capital means ideal funds which earn no profits for the business and hence the business cannot earn a proper rate of return on its investments.

2. When there is a redundant working capital, it may lead to unnecessary purchasing and

Accumulation of inventories causing more chances of theft, waste and losses.

3. Excessive working capital implies excessive debtors and defective credit policy which

May cause higher incidence of bad debts.

4. It may result into overall inefficiency in the organization.

5. When there is excessive working capital, relations with banks and other financial

institutions may not be maintained.

6. Due to low rate of return on investments, the value of shares may also fall.

7. The redundant working capital gives rise to speculative transactions.

Disadvantages or Dangers of Inadequate Working Capital

1. A concern which has inadequate working capital cannot pay its short-term liabilities

in time. Thus, it will lose its reputation and shall not be able to get good credit facilities.

2. It cannot buy its requirements in bulk and cannot avail of discounts, etc.

3. It becomes difficult for the firm to exploit favorable market conditions and undertake profitable projects due to lack of working capital.

4. The firm cannot pay day-to-day expenses of its operations and its creates inefficiencies, increases costs and reduces the profits of the business.

5. It becomes impossible to utilize efficiently the fixed assets due to non-availability of liquid funds.

6. The rate of return on investments also falls with the shortage of working capital.

Disadvantages or Dangers of Inadequate or Short Working Capital

• Can’t pay off its short-term liabilities in time.
• Economies of scale are not possible.
• Difficult for the firm to exploit favorable market situations
• Day-to-day liquidity worsens
• Improper utilization the fixed assets and ROA/ROI falls sharply

Q6. What is Leverage? Compare and contrast Financial and operating leverage.

‘Leverage’ is the action of a lever or the mechanical advantage gained by it; it also means ‘effectiveness’ or ‘power’. The common interpretation of leverage is derived from the use or manipulation of a tool or device termed as lever, which provides a substantive clue to the meaning and nature of financial leverage.

When an organization is planning to raise its capital requirements (funds), these may be raised either by issuing debentures and securing long term loan 0r by issuing share-capital. Normally, a company is raising fund from both sources. When funds are raised from debts, the Co. investors will pay interest, which is a definite liability of the company. Whether the company is earning profits or not, it has to pay interest on debts. But one benefit of raising funds from debt is that interest paid on debts is allowed as deduction for income tax. ‘When funds are raised by issue of shares (equity) , the investor are paid dividend on their investment. Dividends are paid only when the Company is having sufficient amount of profit. In case of loss, dividends are not paid. But dividend is not allowed as deduction while computing tax on the income of the Company. In this way both way of raising funds are having some advantages and disadvantages. A Company has to decide that what will be its mix of Debt and Equity, considering the liability, cost of funds and expected rate of return on investment of fund. A Company should take a proper decision about such mix, otherwise it will face many financial problems. For the purpose of determination of mix of debt and equity, leverages are calculated and analyzed.

Concept of Financial Leverage

Leverage may be defined as the employment of an asset or funds for which the firm pays a fixed cost or fixed return. The fixed cost or return may, therefore be thought of as the full annum of a lever. Financial leverage implies the use of funds carrying fixed commitment charge with the objective of increasing returns to equity shareholders. Financial leverage or leverage factor is defined, as the ratio of total value of debt to total assets or the total value of the firm. For example, a firm having a total value of Rs. 2,00,000 and a total debt of Rs. 1,00,000 would have a leverage factor of 50 percent. There are difficult measures of leverage such as.

1. The ratio of debt to total capital
2. The ratio of debt to equity
3. The ratio of net operating income (earning before interest and taxes) to fixed’ charges) The first two measures of leverage can be expressed either in book v8lue or market value the debt of equity ratio as a measure of financial leverage is more popular in practice. “

Risk & Financial Leverage:

Effects of financial Leverage: The use of leverage results in two obvious effects:

1. Increasing the shareholders earning under favorable economic conditions, and
2. Increasing the financial risk of the firm. Suppose there are two companies each having a Rs. 1,00,000 capital structure. One company has borrowed half of its investment while the other company has only equity capital: Both earn Rs. 2,00,000 profit. The ratio of interest on the borrowed capital is 10%and the rate of corporate tax 50%. Let us calculate the effect of financial leverage, both in the shareholders earnings and the Company’s financial risk in these two companies.

(a) Effect of Leverage on Shareholders Earnings:

			Company A Rs.		Company B Rs.
	Profit before Interest and Taxes		2,00,000		2,00,000
	Equity		10,00,000		5,00,000
	Debt		—-		5,00,000
	Interest (10%)		—-		50,000
	Profit after interest but before Tax		2,00,000		1,50,000
	Taxes @ 50%		1,00,000		75,000

Rate of return on Equity of Company A Rs. 1,00,000/Rs. 10,00,000 = 10%
Rate of return on Equity of Company B Rs. 75,000/Rs. 5,00,000 = 15%

The above illustration points to the favorable effect of the leverage factor on earnings of shareholders. The concept of leverage is 5 if one can earn more on the borrowed money that it costs but detrimental to the man who fails to do so far there is such a thing as a negative leverage i.e. borrowing money at 10% to find that, it can earn 5%. The difference comes out of the shareholders equity so leverage can be a double-edged sword.

(b) Effect of Leverage on the financial risk of the company: Financial risk broadly defined includes both the risk of possible insolvency and the changes in the earnings available to equity shareholders. How the leverage factor leads to the risk possible insolvency does is self-explanatory. As defined earlier the inclusion of more and more debt in capital structure leads to increased fixed commitment charges on the part of the firm as the firm continues to lever itself, the changes of cash insolvency leading’ to legal bankruptcy increase because the financial ‘charges incurred, by the firm exceed the expected earnings. Obviously this leads to fluctuations in earnings’ available to the equity shareholders.

Relationship: Financial and Operating leverage:

Relationship between financial and operating leverage: In business terminology, leverage is used in two senses: Financial leverage & Operating Leverage

Financial leverage: The effect which the use of debt funds produces on returns is called financial leverage.

Operating leverage: Operating leverage refers to the use of fixed costs in the operation of the firm. A firm has a high degree of operating leverage if it employs a greater amount of fixed costs. The degree of operating leverage may be defined as the percentage change in profit resulting from a percentage change in sales. This can be expressed as:

= Percent Change in Profit/Percent Change in Sales

The degree of financial leverage is defined as the percent change in earnings available to common shareholders that is associated with a given percentage change in EBIT. Thus, operating leverage affects EBIT while financial leverage affects earnings after interest and taxes the earnings available to equity shareholders. For this reason operating leverage is sometimes referred to as first stage leverage and financial leverage as second stage leverage. Therefore, if a firm uses a considerable amount of both operating leverage and financial leverage even small changes in the level of sales will produce wide fluctuations in earnings per share (EPS). The combined effect of both these types of leverages is after called total leverage which, is closely tied to the firm’s total risk.