MBA 06 R

M.B.A. DEGREE EXAMINATION,

JUNE 2015

Second Semester

FINANCIAL MANAGEMENT

Time: Three hours Maximum: 100 marks

SECTION A – (5 x 6 = 30)

Answer and FIVE questions

1. Explain the importance of financial management

Answer

Financial management is important mainly because it helps to make decisions towards the

maximization of value of the firm . The importance of financial management to a firm are as

follows:

1. Financial Management Helps Setting Clear Goal Clarity of the goal is important for any firm. Financial management defines the goal of the firm in

clear terms (maximization of the shareholders wealth). Setting goal helps to judge whether the

decisions taken are in the best interest of the shareholders or not. Financial management also direct

the efforts of all functional areas of business towards achieving the goal and facilitates among the

functional areas of the firm.

2. Financial Management Helps Efficient Utilization Of Resources Firms use fixed as well as current assets which involve huge investment. Acquiring and holding

assets that do not earn minimum return do not add value to the shareholders. Moreover, wrong

decision regarding the purchase and disposal of fixed assets can cause threat to the survival of the

firm. The application of financial management techniques (such as capital budgeting techniques)

helps to answer the questions like which asset to buy, when to buy and whether to replace the

existing asset with new one or not. The firm also requires current assets for its operation. They

absorb significant amount of a firm's resources. Excess holdings of these assets mean inefficient

use and inadequate holding exposes the firm into higher risk. Therefore, maintaining proper

balance of these assets and financing them from proper sources is a challenge to a firm. Financial

management helps to decide what level of current assets is to be maintained in a firm and how to

finance them so that these assets are utilized efficiently.

3. Financial Management Helps Deciding Sources Of Financing Firms collect long-term funds mainly for purchasing permanent assets. The sources of long term

finance may be equity shares, preference shares, bond, term loan etc. The firm needs to decide the

appropriate mix of these sources and amount of long-term funds; otherwise the firm will have to

bear higher cost and expose to higher risk. Financial management (capital structure theories)

guides in selecting these sources of financing.

4. Financial Management Helps Making Dividend Decision Dividend is the return to the shareholders. The firm is not legally obliged to pay dividend to the

shareholders. However, how much to pay out of the earning is a vital issue. Financial management

(dividend policies and theories) helps a firm to decide how much to pay as dividend and how much

to retain in the firm. It also suggests answering questions such as when and in what form (cash

dividend or stock dividend) should the dividend be paid?

The importance of financial management is not limited to the managers who make decisions in the

firm. Proper financial management will help firms to supply better product to its customers at

lower prices, pay higher salary to its employees and still provide greater return to investors.

2. State the significance of cost of capital

Answer

Significance Of Cost Of Capital

Cost of capital is considered as a standard of comparison for making different business

decisions. Such importance of cost of capital has been presented below.

1. Making Investment Decision

Cost of capital is used as discount factor in determining the net present value. Similarly, the

actual rate of return of a project is compared with the cost of capital of the firm. Thus, the cost

of capital has a significant role in making investment decisions.

2. Designing Capital structure

The proportion of debt and equity is called capital structure. The proportion which can

minimize the cost of capital and maximize the value of the firm is called optimal capital

structure. Cost of capital helps to design the capital structure considering the cost of each

sources of financing, investor's expectation, effect of tax and potentiality of growth.

3. Evaluating The Performance

Cost of capital is the benchmark of evaluating the performance of different departments. The

department is considered the best which can provide the highest positive net present value to

the firm. The activities of different departments are expanded or dropped out on the basis of

their performance.

4. Formulating Dividend Policy

Out of the total profit of the firm, a certain portion is paid to shareholders as dividend.

However, the firm can retain all the profit in the business if it has the opportunity of investing

in such projects which can provide higher rate of return in comparison of cost of capital. On

the other hand, all the profit can be distributed as dividend if the firm has no opportunity

investing the profit. Therefore, cost of capital plays a key role formulating the dividend policy.

3. Examine the advantages of capital budgeting

Answer

Advantages of Capital Budgeting:

Capital budgeting helps a company to understand various risks involved in an

investment opportunity and how these risks affect the returns of the company.

It helps the company to estimate which investment option would yield the best

possible return.

A company can choose a technique/method from various techniques of capital

budgeting to estimate whether it is financially beneficial to take on a project or not.

It helps the company to make long-term strategic investments.

It helps to make an informed decision about an investment taking into consideration

all possible options.

It helps a company in a competitive market to choose its investments wisely.

All the techniques/methods of capital budgeting try to increase shareholders wealth

and give the company an edge in the market.

Capital budgeting presents whether an investment would increase the company’s

value or not.

It offers adequate control on expenditure for projects.

Also, it allows management to abstain from over investing and under investing.

4. Briefly explain operating leverage

Answer

Operating leverage is the ratio of a company's fixed costs to its variable costs.

(EXAMPLE):

Here is the formula for operating leverage:

Operating Leverage = [Quantity x (Price - Variable Cost per Unit)] / Quantity x (Price - Variable

Cost per Unit) - Fixed Operating Cost

To see how operating leverage works, let's assume Company XYZ sold 1,000,000 widgets for

Rs12 each. It has Rs10,000,000 of fixed costs (equipment, salaried personnel, etc.). It only costs

Rs 0.10 per unit to make each widget.

Using this information and the formula above, we can calculate that Company XYZ's operating

leverage is:

Operating Leverage = [1,000,000 x (Rs 12 – Rs 0.10)] / 1,000,000 x (Rs12 - Rs0.10) -

Rs10,000,000 = Rs 11,900,000/Rs 1,900,000 = 6.26 or 626%

This means that a 10% increase in revenues should yield a 62.6% increase in operating

income (10% * 6.26).

In a sense, operating leverage is a means to calculating a company's breakeven point. However,

it's also clear from the formula that companies with high operating leverage ratios can essentially

make more money from incremental revenues than other companies, because they don't have to

increase costs proportionately to make those sales. Accordingly, companies with high operating

leverage ratios are poised to reap more benefits from good marketing, economic pickups, or other

conditions that tend to boost sales.

Likewise, however, companies with high operating leverage are more vulnerable to declines

in revenue, whether caused by macroeconomic events, poor decision-making, etc.

It is important to note that some industries require higher fixed costs than others. This is why

comparing operating leverage is generally most meaningful among companies within the same

industry, and the definition of a "high" or "low" ratio should be made within this context.

5. What are the types of dividend?

Answer

Cash dividend. The cash dividend is by far the most common of the dividend types used. On

the date of declaration, the board of directors resolves to pay a certain dividend amount in cash to

those investors holding the company's stock on a specific date. The date of record is the date on

which dividends are assigned to the holders of the company's stock. On the date of payment, the

company issues dividend payments.

Stock dividend. A stock dividend is the issuance by a company of its common stock to its common

shareholders without any consideration. If the company issues less than 25 percent of the total

number of previously outstanding shares, you treat the transaction as a stock dividend. If the

transaction is for a greater proportion of the previously outstanding shares, then treat the

transaction as a stock split. To record a stock dividend, transfer from retained earnings to the

capital stock and additional paid-in capital accounts an amount equal to the fair value of the

additional shares issued. The fair value of the additional shares issued is based on their fair market

value when the dividend is declared.

Property dividend. A company may issue a non-monetary dividend to investors, rather than making

a cash or stock payment. Record this distribution at the fair market value of the assets distributed.

Since the fair market value is likely to vary somewhat from the book value of the assets, the

company will likely record the variance as a gain or loss. This accounting rule can sometimes lead

a business to deliberately issue property dividends in order to alter their taxable and/or reported

income.

Scrip dividend. A company may not have sufficient funds to issue dividends in the near future, so

instead it issues a scrip dividend, which is essentially a promissory note (which may or may not

include interest) to pay shareholders at a later date. This dividend creates a note payable.

Liquidating dividend. When the board of directors wishes to return the capital originally

contributed by shareholders as a dividend, it is called a liquidating dividend, and may be a

precursor to shutting down the business. The accounting for a liquidating dividend is similar to

the entries for a cash dividend, except that the funds are considered to come from the additional

paid-in capital account.

6. State and explain the source of working capital

Answer

The sources of short-term funds used for financing variable part of working capital mainly include

the following:

1. Loans from commercial banks

2. Public deposits

3. Trade credit

4. Factoring

5. Discounting bills of exchange

6. Bank overdraft and cash credit

7. Advances from customers

8. Accrual accounts

These are discussed in turn.

1. Loans from Commercial Banks:

Small-scale enterprises can raise loans from the commercial banks with or without security. This

method of financing does not require any legal formality except that of creating a mortgage on the

assets. Loan can be paid in lump sum or in parts. The short-term loans can also be obtained from

banks on the personal security of the directors of a country.

Such loans are known as clean advances. Bank finance is made available to small- scale enterprises

at concessional rate of interest. Hence, it is generally a cheaper source of financing working capital

requirements of enterprise. However, this method of raising funds for working capital is a time-

consuming process.

2. Public Deposits:

Often companies find it easy and convenient to raise short- term funds by inviting shareholders,

employees and the general public to deposit their savings with the company. It is a simple method

of raising funds from public for which the company has only to advertise and inform the public

that it is authorised by the Companies Act 1956, to accept public deposits.

Public deposits can be invited by offering a higher rate of interest than the interest allowed on bank

deposits. However, the companies can raise funds through public deposits subject to a maximum

of 25% of their paid up capital and free reserves.

But, the small-scale enterprises are exempted from the restrictions of the maximum limit of public

deposits if they satisfy the following conditions:

The amount of deposit does not exceed Rs. 8 lakhs or the amount of paid up capital whichever is

less.

(i) The paid up capital does not exceed Rs. 12 lakhs.

(ii) The number of depositors is not more than 50%.

(iii) There is no invitation to the public for deposits.

The main merit of this source of raising funds is that it is simple as well as cheaper. But, the biggest

disadvantage associated with this source is that it is not available to the entrepreneurs during

depression and financial stringency.

3. Trade Credit:

Just as the companies sell goods on credit, they also buy raw materials, components and other

goods on credit from their suppliers. Thus, outstanding amounts payable to the suppliers i.e., trade

creditors for credit purchases are regarded as sources of finance. Generally, suppliers grant credit

to their clients for a period of 3 to 6 months.

Thus, they provide, in a way, short- term finance to the purchasing company. As a matter of fact,

availability of this type of finance largely depends upon the volume of business. More the volume

of business more will be the availability of this type of finance and vice versa.

Yes, the volume of trade credit available also depends upon the reputation of the buyer company,

its financial position, degree of competition in the market, etc. However, availing of trade credit

involves loss of cash discount which could be earned if payments were made within 7 to 10 days

from the date of purchase of goods. This loss of cash discount is regarded as implicit cost of trade

credit.

4. Factoring:

Factoring is a financial service designed to help firms in managing their book debts and receivables

in a better manner. The book debts and receivables are assigned to a bank called the 'factor' and

cash is realised in advance from the bank. For rendering these services, the fee or commission

charged is usually a percentage of the value of the book debts/receivables factored.

This is a method of raising short-term capital and known as 'factoring'. On the one hand, it helps

the supplier companies to secure finance against their book debts and receivables, and on the other,

it also helps in saving the effort of collecting the book debts.

The disadvantage of factoring is that customers who are really in genuine difficulty do not get the

opportunity of delaying payment which they might have otherwise got from the supplier company.

In the present context where industrial sickness is spreading like an epidemic, the reason for which

particularly in SSI sector being delayed payments from their suppliers; there is a clear-cut rationale

for introduction of factoring system. There has been some progress also on this front.

The recommendations of the Study Group (RBI 1996) to examine the feasibility of setting up of

factoring organisations in the country, under the Chairmanship of Shri C. S. Kalyanasundaram

have been accepted by the Government of India. The Group is of the view that factoring for SSI

units could prove to be mutually beneficial to both Factors and SSI units and Factors should make

every effort to orient their strategy to crystallize the potential demand from the sector.

5. Discounting Bills of Exchange:

When goods are sold on credit, bills of exchange are generally drawn for acceptance by the buyers

of goods. The bills are generally drawn for a period of 3 to 6 months. In practice, the writer of the

bill, instead of holding the bill till the date of maturity, prefers to discount them with commercial

banks on payment of a charge known as discount.

The term 'discounting of bills' is used in case of time bills whereas the term, 'purchasing of bills'

is used in respect of demand bills. The rate of discount to be charged by the bank is prescribed by

the Reserve Bank of India (RBI) from time to time. It generally amounts to the interest for the

period from the date of discounting to the date of maturity of bills.

If a bill is dishonoured on maturity, the bank returns the dishonoured bill to the company who then

becomes liable to pay the amount to the bank. The cost of raising finance by this method is the

amount of discount charged by the bank. This method is widely used by companies for raising

short-term finance.

6. Bank Overdraft and Cash Credit:

Overdraft is a facility extended by the banks to their current account holders for a short-period

generally a week. A current account holder is allowed to withdraw from its current deposit account

upto a certain limit over the balance with the bank. The interest is charged only on the amount

actually overdrawn. The overdraft facility is also granted against securities.

Cash credit is an arrangement whereby the commercial banks allow borrowing money up to a

specified-limit known as 'cash credit limit.' The cash credit facility is allowed against the security.

The cash credit limit can be revised from time to time according to the value of securities. The

money so drawn can be repaid as and when possible.

The interest is charged on the actual amount drawn during the period rather on limit sanctioned.

The rate of interest charged on both overdraft and cash credit is relatively higher than the rate of

interest given on bank deposits. Arranging overdraft and cash credit with the commercial banks

has become a common method adopted by companies for meeting their short- term financial, or

say, working capital requirements.

7. Advances from Customers:

One way of raising funds for short-term requirement is to demand for advance from one's own

customers. Examples of advances from the customers are advance paid at the time of booking a

car, a telephone connection, a flat, etc. This has become an increasingly popular source of short-

term finance among the small business enterprises mainly due to two reasons.

First, the enterprises do not pay any interest on advances from their customers. Second, if any

company pays interest on advances, that too at a nominal rate. Thus, advances from customers

become one of the cheapest sources of raising funds for meeting working capital requirements of

companies.

8. Accrual Accounts:

Generally, there is a certain amount of time gap between incomes is earned and is actually received

or expenditure becomes due and is actually paid. Salaries, wages and taxes, for example, become

due at the end of the month but are usually paid in the first week of the next month. Thus, the

outstanding salaries and wages as expenses for a week help the enterprise in meeting their working

capital requirements. This source of raising funds does not involve any cost.

7. How will you determine the stable dividend policy

Answer

The following are the various factors that impact the dividend policy of a company:

Type of Industry: The nature of the industry to which the company belongs has an

important effect on the dividend policy. Industries, where earnings are stable, may adopt

a consistent dividend policy as opposed to the industries where earnings are uncertain

and uneven. They are better off in having a conservative approach to dividend payout.

Ownership Structure: The ownership structure of a company also impacts the policy.

A company with a higher promoter’ holdings will prefer a low dividend payout as paying

out dividends may cause a decline in the value of the stock. Whereas, a high institutional

ownership will favour a high dividend payout as it helps them to increase the control

over the management.

Age of corporation: Newly formed companies will have to retain major part of their

earnings for further growth and expansion. Thus, they have to follow a conservative

policy unlike established companies, which can pay higher dividends from their

reserves.

The extent of Share Distribution: A company with a large number of shareholders will

have a difficult time in getting them to agree to a conservative policy. On the other hand,

a closely held company has more chances of succeeding to finalize conservative

dividend payouts.

Different Shareholders’ Expectations: Another factor that impacts the policy is the

diversity in the type of shareholders a company has. A different group of shareholders

will have different expectations. A retired shareholder will have a different requirement

vis-a-vis a wealthy investor. The company needs to clearly understand the different

expectations and formulate a successful dividend policy.

Leverage: A company having more leverage in their financial structure and

consequently, frequent interest payments will have to decide for a low dividend payout.

Whereas a company utilizing their retained earnings will prefer high dividends.

Future Financial Requirements: Dividend payout will also depend on the future

requirements for the additional capital. A company having profitable investment

opportunities is justified in retaining the earnings. However, a company with no internal

or external capital requirements should opt for a higher dividend.

Business Cycles: When the company experiences a boom, it is prudent to save up and

make reserves for dips. Such reserves will help a company declare high dividends even

in depressing markets to retain and attract more shareholders.

Growth: Companies with a higher rate of growths, as reflected in their annual sales

growth, a ratio of retained earnings to equity and return on net worth, prefer high

dividend payouts to keep their investors happy.

Changes in Government Policies: There could be the change in the dividend policy of

a company due to the imposed changes by the government. The Indian government had

put temporary restrictions on companies to pay dividends during 1974-75.

Profitability: The profitability of a firm is reflected in net profit ratio, current

ratio and ratio of profit to total assets. A highly profitable company generally pays

higher dividends and a company with less or no profits will adopt a conservative

dividend policy.

Taxation Policy: The corporate taxes will affect dividend policy, either directly or

indirectly. The taxes directly reduce the residual earnings after tax available for the

shareholders. Indirectly, the dividend distribution is taxable after a certain limit.

Trends of Profits: Even if the company has been profitable over the years, the trend

should be properly analyzed to find the average earnings of the company. This average

number should be then studied in relation to the general economic conditions. This will

help in opting for a conservative policy if a depression is approaching.

Liquidity: Liquidity has a direct relation with the dividend policy. If a firm has a strong

liquidity and enough cash for its working capital, it can afford to pay higher dividends.

However, a firm with less liquidity will choose a conservative dividend policy.

Legal Rules: There are certain legal restrictions on the companies for dividend

payments. It is legal to pay a dividend only if the capital is not reduced post payment.

These rules are in place to protect creditors’ interest.

Inflation: Inflationary environments compel companies to retain major part of their

earnings and indulge in lower dividends. As the prices rise, the companies need to

increase their capital reserves for their purchases and other expenses.

Control Objectives: The firms aiming for more control in the hands of current

shareholders prefer a conservative dividend payout policy. It is imperative to pay fewer

dividends to retain more control and the earnings in the company.

8. Explain the different approaches of capital structure

Answer

Traditional Approach to Capital Structure:

The traditional approach to capital structure advocates that there is a right combination of equity

and debt in the capital structure, at which the market value of a firm is maximum. As per this

approach, debt should exist in the capital structure only up to a specific point, beyond which, any

increase in leverage would result in the reduction in value of the firm.

It means that there exists an optimum value of debt to equity ratio at which the WACC is the lowest

and the market value of the firm is the highest. Once the firm crosses that optimum value of debt

to equity ratio, the cost of equity rises to give a detrimental effect to the WACC. Above the

threshold, the WACC increases and market value of the firm starts a downward movement.

Assumptions under Traditional Approach:

The rate of interest on debt remains constant for a certain period and thereafter with an

increase in leverage, it increases.

The expected rate by equity shareholders remains constant or increase gradually. After that,

the equity shareholders starts perceiving a financial risk and then from the optimal point

and the expected rate increases speedily.

As a result of the activity of rate of interest and expected rate of return, the WACC first

decreases and then increases. The lowest point on the curve is optimal capital structure.

Modigliani and Miller Approach

This approach was devised by Modigliani and Miller during 1950s. The fundamentals of

Modigliani and Miller Approach resemble that of Net Operating Income Approach. Modigliani

and Miller advocate capital structure irrelevancy theory. This suggests that the valuation of a firm

is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or has lower

debt component in the financing mix, it has no bearing on the value of a firm.

Modigliani and Miller Approach further states that the market value of a firm is affected by its

future growth prospect apart from the risk involved in the investment. The theory stated that value

of the firm is not dependent on the choice of capital structure or financing decision of the firm. If

a company has high growth prospect, its market value is higher and hence its stock prices would

be high. If investors do not see attractive growth prospects in a firm, the market value of that firm

would not be that great.

Assumptions of Modigliani and Miller Approach

There are no taxes.

Transaction cost for buying and selling securities as well as bankruptcy cost is nil.

There is a symmetry of information. This means that an investor will have access to

same information that a corporate would and investors would behave rationally.

The cost of borrowing is the same for investors as well as companies.

Debt financing does not affect companies EBIT.

Net Income Approach

Net Income Approach was presented by Durand. The theory suggests increasing value of the firm

by decreasing the overall cost of capital which is measured in terms of Weighted Average Cost of

Capital. This can be done by having a higher proportion of debt, which is a cheaper source of

finance compared to equity finance.

Weighted Average Cost of Capital (WACC) is the weighted average costs of equity and debts

where the weights are the amount of capital raised from each source.

WACC =

Required Rate of Return x Amount of Equity + Rate of Interest x Amount of

Debt

Total Amount of Capital (Debt + Equity)

According to Net Income Approach, change in the financial leverage of a firm will lead to a

corresponding change in the Weighted Average Cost of Capital (WACC) and also the value of the

company. The Net Income Approach suggests that with the increase in leverage (proportion of

debt), the WACC decreases and the value of firm increases. On the other hand, if there is a decrease

in the leverage, the WACC increases and thereby the value of the firm decreases.

For example, vis-à-vis equity-debt mix of 50:50, if the equity-debt mix changes to 20: 80, it

would have a positive impact on the value of the business and thereby increase the value per

share.

Assumptions of Net Income Approach

Net Income Approach makes certain assumptions which are as follows.

The increase in debt will not affect the confidence levels of the investors.

The cost of debt is less than the cost of equity.

There are no taxes levied.

PART B – (5 X 10 = 50)

Answer any FIVE questions

9. Briefly discuss the key strategies of financial management

Answer

10. Explain the different methods of computation of cost of capital

Answer

Cost of capital is the minimum rate of investment which a company has to earn for getting

fund .When any company investor invests his money , he sees the rate of return . So company

has to mention , what will company pay , if investors provide their money to company . That

average cost on the investment is called cost of capital . We calculate it with following way :

Cost of capital = interest rate at zero level risk + premium for business risk + premium

for financial risk

If a company has not power to earn , cost of capital , then this company can not get fund from

public .

Method of calculation cost of capital:-

1. cost of debt : company wants to get debt from public, then calculating the cost of debt is the

rate which calculated by dividing value of interest on loan with amount of principal.

a) cost of debt before tax adjustment

if company issues debentures on premium or discount , then for calculating cost of debt ,

principal amount will be adjusted with these amount . After adjust amount will be net proceed

b) Cost of debt after tax adjustment

2. Cost of pref. share capital

Cost of pref. share capital is rate which should company earn for paying dividend to pref. share

holders because , it effects also the value of shares . With following formula we can calculate cost

of pref. share capital

3. Cost of equity

Cost of equity is calculated with dividend yield method , or dividend yield plus growth rate method

or earning yield method or realised yield method .

I) Dividend yield method :-

Under this method , company can calculate cost of equity on the basis of following formula

II) Dividend yield plus growth rate of dividend method :-

C) Earning yield method

4. Weighted average cost of capital

if we multiply all cost of capital with proportion of capital structure and divides with the total of

proportion of capital structure % . After this what we receive is called weighted average of cost of

capital .

11. Describe the various techniques of capital budgeting.

Answer

Techniques of Investment decision

Discounted Cash Flow (DCF) Criteria

Net present value (NPV)

Internal rate of return (IRR)

Profitability index (PI)

Non-discounted Cash Flow Criteria

Pay-back period

Discounted payback period

Accounting rate of return (ARR).

Non-discounted Cash Flow Criteria

Payback period Method

This method is popularly known as pay off, pay-out, recoupment period method also. It gives the

number of years in which the total investment in a particular capital expenditure pays back itself.

This method is based on the principle that every capital expenditure pays itself back over a number

of years. It means that it generates income within a certain period. When the total earnings (or net

cash-inflow] from investment equals the total outlay, that period is the payback period of the

capital investment. An investment project is adopted so long as it pays for itself within a specified

period of time — says 5 years or less. This standard of recoupment period is settled by the

management taking into account a number of considerations. While there is a comparison between

two or more projects, the lesser the number of payback years, the project will be acceptable.

The formula for the payback period calculation is simple. First of all, net-cash-inflow is

determined. Then we divide the initial cost (or any value we wish to recover) by the annual cash-

inflows and the resulting quotient is the payback period. As per formula:

Original Investment

Payback period = -----------------------------------

Annual Cash-inflows

Accounting Rate of Return Method

It is also known as Accounting Rate of Return Method / Financial Statement Method/

Unadjusted Rate of Return Method also. According to this method, capital projects are ranked in

order of earnings. Projects which yield the highest earnings are selected and others are ruled out.

The return on investment method can be expressed in several ways a follows:

(i) Average Rate of Return Method

Under this method we calculate the average annual profit and then we divide it by the total outlay

of capital project. Thus, this method establishes the ratio between the average annual profits and

total outlay of the projects.

As per formula,

Average Annual Profits

Rate of Return = ------------------------------------ x 100

Outlay of the Project

Thus, the average rate of return method considers whole earnings over the entire economic life of

an asset. Higher the percentage of return, the project will be acceptable.

(ii) Earnings per unit of Money Invested

As per this method, we find out the total net earnings and then divide it by the total investment.

This gives us the average rate of return per unit of amount (i.e. per rupee) invested in the project.

As per formula:

Total Earnings

Earnings per unit of investment = -------------------------------------

Total Outlay of the Project

The higher the earnings per unit, the project deserves to be selected.

(iii) Return on Average Amount of Investment Method

Under this method the percentage return on average amount of investment is calculated. To

calculate the average investment the outlay of the projects is divided by two. As per formula:

Unrecovered Capital at the beginning +

Unrecouped capital at the end

Average Investment = ----------------------------------------------------

2

Initial investment + scrap value

Or = ---------------------------------------------

2

(i) Net Present Value Method

This method is also known as Excess Present Value or Net Gain Method. To implement this

approach, we simply find the present value of the expected net cash inflows of an investment

discounted at the cost of capital and subtract from it the initial cost outlay of the project. If the net

present value is positive, the project should be accepted: if negative, it should be rejected.

NPV = Total Present value of cash inflows – Net Investment

(ii) Internal Rate of Return Method

This method is popularly known as time adjusted rate of return method/discounted rate of return

method also. The internal rate of return is defined as the interest rate that equates the present value

of expected future receipts to the cost of the investment outlay. This internal rate of return is found

by trial and error. First we compute the present value of the cash-flows from an investment, using

an arbitrarily elected interest rate. Then we compare the present value so obtained with the

investment cost. If the present value is higher than the cost figure, we try a higher rate of interest

and go through the procedure again. Conversely, if the present value is lower than the cost, lower

the interest rate and repeat the process. The interest rate that brings about this equality is defined

as the internal rate of return. This rate of return is compared to the cost of capital and the project

having higher difference, if they are mutually exclusive, is adopted and other one is rejected. As

the determination of internal rate of return involves a number of attempts to make the present value

of earnings equal to the investment, this approach is also called the Trial and Error Method,

(iii) Profitability Index Method

One major disadvantage of the present value method is that it is not easy to rank projects on the

basis of net present value particularly when the cost of projects differs significantly. To compare

such projects the present value profitability index is prepared.

iv) Terminal Value Method

This approach separates the timing of the cash-inflows and outflows more distinctly. Behind this

approach is the assumption that each cash-inflow is re-invested in other assets at the certain rate

of return from the moment, it is received until the termination of the project. Then the present

value of the total compounded sum is calculated and it is compared with the initial cash-outflow.

The decision rule is that if the present value of the sum total of the compounded re-invested cash-

inflows is greater than the present value of cash-outflows, the proposed project is accepted

otherwise not. The firm would be different if both the values are equal.

This method has a number of advantages. It incorporates the advantage of re-investment of cash-

inflows by compounding and then discounting it. Further, it is best suited to cash budgeting

requirements. The major practical problem of this method lies in projecting the future rates of

interest at which the intermediate cash inflows received will be re-invested.

12. .

Answer

Leverage table

Particulars @60,00,000 @ 90,00,000

Operating profit / EBIT 60,00,000 90,00,000

Less interest Nil Nil

EBT 60,00,000 90,00,000

Less tax@ 50% 30,00,000 45,00,000

EAT 30,00,000 45,00,000

Less Preference share dividend 10,00,000 10,00,000

Earnings avaliable for Equity

shareholders

20,00,000 35,00,000

EPS = 20,00,000/ 10,00,000 = 2

At 90,00,000 = 35,00,000/ 10,00,000 = 3.5

FL = EBIT / EBT

@ 60,00,000 = 60,00,000/ 60,00,000 = 0

@ 90,00,000 = 90,00,000/90,00,000 = 0

13. Critically evaluate MM theory and what do you feel about the relevance of the theory

answer

Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern

thinking on capital structure. The basic theorem states that, in the absence of taxes, bankruptcy

costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by

how that firm is financed. It does not matter if the firm’s capital is raised by issuing stock or selling

debt. It does not matter what the firm’s dividend policy is. The theorem is made up of two

propositions which can also be extended to a situation with taxes.

Propositions Modigliani-Miller theorem (1958) (without taxes)

Consider two firms which are identical except for their financial structures. The first (Firm U) is

unleveraged: that is, it is financed by equity only. The other (Firm L) is leveraged: it is financed

partly by equity, and partly by debt. The Modigliani-Miller theorem states that the value the two

firms is the same

Proposition I

where VU is the value of an unlevered firm = price of buying all the firm’s equity, and VL is the

value of a levered firm = price of buying all the firm’s equity, plus all its debt

Proposition II

rS is the cost of equity

r0 is the cost of capital for an all equity firm

rB is the cost of debt

B / S is the debt-to-equity ratio

This proposition states that the cost of equity is a linear function of the firm´s debt to equity ratio.

A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk

involved for equity-holders in a companies with debt. The formula is derived from the theory of

weighted average cost of capital.

These propositions are true assuming

no taxes exist

no transaction costs exist

individuals and corporations borrow at the same rates

These results might seem irrelevant (after all, none of the conditions are met in the real

world), but the theorem is still taught and studied because it tells us something very important.

That is, if capital structure matters, it is precisely because one or more of the assumptions is

violated. It tells us where to look for determinants of optimal capital structure and how those

factors might affect optimal capital structure.

Propositions Modigliani-Miller theorem (1963) (with taxes)

Proposition I

VL is the value of a levered firm

VU is the value of an unlevered firm

TCB is the tax rate (T_C) x the value of debt (B)

This means that there are advantages for firms to be levered, since corporations can deduct

interest payments. Therefore leverage lowers tax payments. Dividend payments are non-deductible

Proposition II

rS is the cost of equity

r0 is the cost of capital for an all equity firm

rB is the cost of debt

B / S is the debt-to-equity ratio

Tc is the tax rate

The same relationship as earlier described stating that the cost of equity rises with leverage,

because the risk to equity rises, still holds. The formula however has implications for the difference

with the WACC

Assumptions made in the propositions with taxes are

Corporations are taxed at the rate T_C, on earnings after interest

No transaction cost exist

Individuals and corporations borrow at the same rate

Miller and Modigliani published a number of follow-up papers discussing some of these issues.

The theorem first appeared in: F. Modigliani and M. Miller, “The Cost of Capital, Corporation

Finance and the Theory of Investment,” American Economic Review (June 1958)

14. How will you determine the working capital requriement for a chemical industry

Answer

Working capital requirement is influenced by various factors. In fact, any and every activity of a

company affects the working capital requirements of the company. The magnitude of influence

may be different. Some important of them are listed below:Factors Influencing Working Capital

Management

Nature of the Industry / Business: The management of working capital is completely different from

industry to industry. A simple comparison of the service industry and manufacturing industry can

clarify the point. In a service industry, there is no inventory and therefore, one big component of

working capital is already avoided. So, the nature of the industry is a factor in determining the

working capital requirement.

Seasonality of Industry and Production Policy: Businesses based on seasons like manufacturing of

ACs whose demand peaks in summer and dips in winter. The requirement of working capital will

be more in summer compared to winter if they are produced in the fashion of their demand. The

policy of producing throughout the year can smoothen the fluctuation of working capital

requirement.

Competition: If the industry is competitive, quick response to customer needs is compulsory and

therefore a higher level of inventory is maintained. Liberal credit terms are also mandatory with

good service to survive in the market. So, higher the competition, higher would be the requirement

of working capital.

Production Cycle Time: The production cycle time refers to the time required for converting the

raw materials into finished goods. Higher, this time, higher would be the time of blocking funds

in the working capital.

Credit Policy: Liberal credit policy demands a higher level of working capital and tight credit

policy reduces it.

Growth and Expansion: Some industries are static and others are growing. Obviously, growing

industry grows the requirement of working capital also as compared to static industry.

Raw Material Short Supply: If the raw material supply is not smooth for any reason, companies

tend to store more of raw materials than needed and that increased requirement of working capital.

Net Cash Profit: Profit or retained earnings are one of the sources of working capital for the

business. It will depend on net cash profits as to how much working capital financing is required

from external sources.

Taxes: Taxes are often paid in advance. This also blocks a part of working capital. Depending on

the tax environment of the industry, working capital needs are also affected.

Dividend Policy: Dividend policy determines the level of retained profits with the business and

retained profits are also used for working capital. This is how; dividend policy affects the need for

working capital.

Price Levels: The price levels of inventory and other expenses such as labour rates etc increase the

working capital requirement. If the company also is able to increase the price of their finished

goods, it reduces this impact.

15. Briefly explain the factors to be considered in capital structure planning

Answer

1. Trading on Equity- The word “equity” denotes the ownership of the company. Trading on

equity means taking advantage of equity share capital to borrowed funds on reasonable

basis. It refers to additional profits that equity shareholders earn because of issuance of

debentures and preference shares. It is based on the thought that if the rate of dividend on

preference capital and the rate of interest on borrowed capital is lower than the general rate

of company’s earnings, equity shareholders are at advantage which means a company

should go for a judicious blend of preference shares, equity shares as well as debentures.

Trading on equity becomes more important when expectations of shareholders are high.

2. Degree of control- In a company, it is the directors who are so called elected representatives

of equity shareholders. These members have got maximum voting rights in a concern as

compared to the preference shareholders and debenture holders. Preference shareholders

have reasonably less voting rights while debenture holders have no voting rights. If the

company’s management policies are such that they want to retain their voting rights in their

hands, the capital structure consists of debenture holders and loans rather than equity

shares.

3. Flexibility of financial plan- In an enterprise, the capital structure should be such that there

is both contractions as well as relaxation in plans. Debentures and loans can be refunded

back as the time requires. While equity capital cannot be refunded at any point which

provides rigidity to plans. Therefore, in order to make the capital structure possible, the

company should go for issue of debentures and other loans.

4. Choice of investors- The company’s policy generally is to have different categories of

investors for securities. Therefore, a capital structure should give enough choice to all kind

of investors to invest. Bold and adventurous investors generally go for equity shares and

loans and debentures are generally raised keeping into mind conscious investors.

5. Capital market condition- In the lifetime of the company, the market price of the shares has

got an important influence. During the depression period, the company’s capital structure

generally consists of debentures and loans. While in period of boons and inflation, the

company’s capital should consist of share capital generally equity shares.

6. Period of financing- When company wants to raise finance for short period, it goes for

loans from banks and other institutions; while for long period it goes for issue of shares

and debentures.

7. Cost of financing- In a capital structure, the company has to look to the factor of cost when

securities are raised. It is seen that debentures at the time of profit earning of company

prove to be a cheaper source of finance as compared to equity shares where equity

shareholders demand an extra share in profits.

8. Stability of sales- An established business which has a growing market and high sales

turnover, the company is in position to meet fixed commitments. Interest on debentures

has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are

high and company is in better position to meet such fixed commitments like interest on

debentures and dividends on preference shares. If company is having unstable sales, then

the company is not in position to meet fixed obligations. So, equity capital proves to be

safe in such cases.

9. Sizes of a company- Small size business firms capital structure generally consists of loans

from banks and retained profits. While on the other hand, big companies having goodwill,

stability and an established profit can easily go for issuance of shares and debentures as

well as loans and borrowings from financial institutions. The bigger the size, the wider is

total capitalization.

16. .

Answer

Cost of debenture

1/NP (1 – t)

1/0.10(1 – 0.5)

= 5

Cost of Preference Share

Dp/Np

12/100 = 12

Cost of equity

Dp/ Np + G

8/90+ 0.04

0.089 + 0.04

= 0.129 x 100

= 12.9

Cost of retained earning

Kr = Ke

Therefore Kr = 12.9

12.9 (1 – 0.5)

= 6.45

Overall cost of capital

Source Amount Weightage Cost Total

Retained

earnings

100000 4.76% 6.45 30.70

8% debenenture 800000 38.10% 5 190.5

9% preference

share

200000 9.52% 12 114.24

Equity 1000000 47.62% 12.9 614.30

Total 2100000 100 949.74

Overal cost = 949.74/100= 9.4974