1. EXPLAIN THE LIQUIDITY DECISIONS AND ITS IMPORTANT ELEMENTS. WRITE COMPLETE NFORMATION ON DIVIDEND DECISIONS.Ans. LIQUIDITY DECISIONS.

The liquidity decision is concerned with the management of the current assets, which is a pre-requisite to long-term success of any business firm. This is also called as working capital decision. The main objective of the current assets management is the trade-off between profitability and liquidity, and there is a conflict between these two concepts. If a firm does not have adequate working capital, it may become illiquid and consequently fail to meet its current obligations thus inviting the risk of bankruptcy. On the contrary, if the current assets are too enormous, the profitability is adversely affected. Hence, the major objective of the liquidity decision is to ensure a trade-off between profitability and liquidity. Besides, the funds should be invested optimally in the individual current assets to avoid inadequacy or excessive locking up of funds. Thus, the liquidity decision should balance the basic two ingredients, i.e. working capital management and the efficient allocation of funds on the individual current assets.In other terms, liquidity decisions deal with working capital management. It is concerned with the day-to-day financial operations that involve current assets and current liabilities.The important elements of liquidity decisions are: Formulation of inventory policy Policies on receivable management Formulation of cash management strategies Policies on utilisation of spontaneous finance effectivelyDIVIDEND DECISIONS. Dividends are payouts to shareholders. Dividends are paid to keep the shareholders happy. Dividend decision is a major decision made by the finance manager.Dividend is that portion of profits of a company which is distributed among its shareholders according to the resolution passed in the meeting of the Board of Directors. This may be paid as a fixed percentage on the share capital contributed by them or at a fixed amount per share. The dividend decision is always a problem before the top management or the Board ofDirectors as they have to decide how much profits should be transferred to reserve funds to meet any unforeseen contingencies and how much should be distributed to the shareholders.Payment of dividend is always desirable since it affects the goodwill of the concern in the market on the one hand, and on the other, shareholders invest their funds in the company in a hope of getting a reasonable return. Retained earnings are the sources of internal finance for financing of corporates future projects but payment of dividend constitute an outflow of cash to shareholders. Although both - expansion and payment of dividend -are desirable, these two are in conflicting tasks. It is, therefore, one of the important functions of the financial management to constitute a dividend policy which can balance these two contradictory view points and allocate the reasonable amount of profits after tax between retained earnings and dividend. All of this is based on formulation of a good dividend policy.Since the goal of financial management is maximisation of wealth of shareholders, dividend policy formulation demands the managerial attention on the impact of its policy on dividend and on the market value of its shares. Optimum dividend policy requires decision on dividend payment rates so as to maximise the market value of shares. The payout ratio means what portion of earnings per share is given to the shareholders in the form of cash dividend. In the formulation of dividend policy, the management of accompany will have to consider the relevance of its policy on bonus shares. Dividend policy influences the dividend yield on shares. Dividend yield is an important determinant of an investors attitude towards the security (stock) in his portfolio management decisions.

2. EXPLAIN ABOUT THE DOUBLING PERIOD AND PRESENT VALUE. SOLVE THE BELOW GIVEN PROBLEM: UNDER THE ABC BANKS CASH MULTIPLIER SCHEME, DEPOSITS CAN BE MADE FOR PERIODS RANGING FROM 3 MONTHS TO 5 YEARS AND FOR EVERY QUARTER; INTEREST IS ADDED TO THE PRINCIPAL. THE APPLICABLE RATE OF INTEREST IS 9% FOR DEPOSITS LESS THAN 23 MONTHS AND 10% FOR PERIODS MORE THAN 24 MONTHS. WHAT WILL BE THE AMOUNT OF RS .1000 AFTER 2 YEARS? Ans. Doubling periodA very common question arising in the minds of an investor is how long will it take for the amount invested to double for a given rate of interest. There are 2 ways of answering this question:1. One way is to answer it by a rule known as rule of 72. This rule states that the period within which the amount doubles is obtained by dividing72 by the rate of interest. Though it is a crude way of calculating, this rule is followed by most.For instance, if the given rate of interest is 10%, the doubling period is72/10, that is, 7.2 years.2. A much accurate way of calculating doubling period is by using the rule known as rule of 69. By this method,Doubling Period = 0.35+69/Interest rateGoing by the same example given above, we get the number of years as7.25 years {(0.35 + 69/10) or (0.35 +6.9)}.

Solution:mXnm = 12/3 = 4 (quarterly compounding)1000 (1+0.10/4)4*21000 (1+0.10/4)8Rs. 1218The amount of Rs. 1000 after 2 years would be Rs. 1218.

Present value

Given the interest rate, compounding technique can be used to compare the cash flows separated by more than one time period. With this technique, the amount of present cash can be converted into an amount of cash of equivalent value in future. Likewise, we may be interested in converting the future cash flow into their present values. Present value can be simply defined as the current value of a future sum. It can also be defined as the amount to be invested today (present value) at a given rate of interest over a specified period to equal the future sum.If we reverse the flow by saying that we expect a fixed amount after nnumber of years and we also know the present prevailing interest rate, then by discounting the future amount at the given interest rate, we will get the present value of investment to be made.The present value of a sum to be received at a future date is determined by discounting the future value at the interest rate that the money could earn over the period. This process is known as discounting.Present value of a single flowAscertaining Present Value (PV) is simply the reverse of finding Future Value (FV). Hence, the formula for FV can be simply transformed into thePV formula.Present value of even series of cash flowsIn a business scenario, the businessman will receive periodic amounts(annuity) for a certain number of years. An investment done today will fetch him returns spread over a period of time. He would like to know if it is worthwhile to invest a certain sum now in anticipation of returns he expects after a certain number of years. He should, therefore, equate the anticipated future returns to the present sum he is willing to foregoPresent value of perpetuityAn annuity for an infinite time period is perpetuity. It occurs indefinitely. Aperson may like to find out the present value of his investment assuming he will receive a constant return year after year.Capital recovery factorCapital recovery factor is the annuity of an investment for a specified time ata given rate of interest.

3.WRITE SHORT NOTES ON:A) OPERATING LEVERAGEOperating leverage arises due to the presence of fixed operating expenses in the firms income flows. It has a close relationship to business risk. Operating leverage affects business risk factors, which can be viewed as the uncertainty inherent in estimates of future operating income. The operating leverage takes place when a change in revenue produces greater change in Earnings Before Interest and Taxes (EBIT). It indicates the impact of changes in sales on operating income. A firm with a high operating leverage has a relatively greater effect on EBIT for small changes in sales. A small rise in sales may enhance profits considerably, while small decline in sales may reduce and even wipe out the EBIT. The operating leverage is the firms ability to use fixed operating costs to increase the effects of changes in sales on its EBIT. Operating leverage occurs any time if a firm has fixed costs. The percentage of change in profits with a change in volume of sales is more than the percentage of change in volume. The higher the fixed costs, the greater the leverage and the more frequent the changes in the rate of profit (or loss) with alternations in the volume of activity.B) FINANCIAL LEVERAGEFinancial leverage relates to the financing activities of a firm and measures the effect of EBIT on Earnings Per Share (EPS) of the company. A companys sources of funds fall under two categories: Those which carry fixed financial charges like debentures, bonds, and preference shares Those which do not carry any fixed charges like equity shares Debentures and bonds carry a fixed rate of interest and are to be paid off irrespective of the firms revenues. The dividends are not contractual obligations, but the dividend on preference shares is a fixed charge and should be paid off before equity shareholders. The equity holders are entitled to only the residual income of the firm after all prior obligations are met.Financial leverage refers to a firm's use of fixed-charge securities like debentures and preference shares (though the latter is not always included in debt) in its plan of financing the assets.The concept of financial leverage is a significant one because it has direct relation with capital structure management. It determines the relationship that could exist between the debt and equity securities. A firm which does not issue fixed-charge securities has an equity capital structure and does not have any financial leverage. However, it is common for firms to issueSome debt securities, in which case, the leverage is either favorable or unfavorable. Financial leverage is a process of using debt capital to increase the rate of return on equity. For this reason, it is also referred to as trading on equity. Borrowing is done by a company because of the financial advantage that is expected from it. The use of borrowings for the purpose of such advantage for residual shareholders is also called trading on equity or leverage. 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 companys income stream. Such expenses have nothing to do with the firms performance and earnings and should be paid off regardless of the amount of EBIT.

C) COMBINED LEVERAGEThe combination of operating and financial leverage is called combined leverage. Operating leverage affects the firms operating profit EBIT and financial leverage affects PAT or the EPS. These cause wide fluctuations inEPS. A company having a high level of operating or financial leverage will find a drastic change in its EPS even for a small change in sales volume. Companies whose products are seasonal in nature have fluctuating EPS,but the amount of changes in EPS due to leverages is more pronounced. DTL measures the total risk of the company as DTL is a combined measure of both operating and financial risk DTL measures the variability of EPS

4. EXPLAIN THE FACTORS AFFECTING CAPITAL STRUCTURE. SOLVE THE BELOW GIVEN PROBLEM:

Capital structure should be planned at the time a company is promoted. The initial capital structure should be designed very carefully. The management of the company should set a target capital structure, and the subsequent financing decisions should be made with a view to achieve the target capital structure. Every time the funds have to be procured, the financial manager weighs the pros and cons of various sources of finance and selects the most advantageous sources keeping in view the target capital structure. Thus, the capital structure decision is a continuous one and has to be taken whenever firm needs additional finance. The major factor affecting the capital structure is leverage. There are also few other factors affecting them. All the factors are explained briefly here.LeverageThe use of sources of funds that have a fixed cost attached to them, such as preference shares, loans from banks and financial institutions, and debentures in the capital structure, is known as trading on equity or financial leverage.If the assets financed by debt yield a return greater than the cost of the debt, the EPS will increase without an increase in the owners investment. Similarly, the EPS will also increase if preference share capital is used to acquire assets. But the leverage impact is felt more in case of debt because of the following reasons: The cost of debt is usually lower than the cost of preference share capital The interest paid on debt is a deductible charge from profits for calculating the taxable income while dividend on preference shares is notThe other factors to be considered before deciding on an ideal capital structure are:Cost of capital High cost funds should be avoided. However attractive an investment proposition may look like, the profits earned may be eaten away by interest repayments.Cash flow projections of thecompany Decisions should be taken in the light of cash flow projected for the next 3-5 years. The company officials should not get carried away at the immediate results expected. Consistent lesser profits are any way preferable than high profits in the beginning and not being able to get any profits after 2 years.Dilution of control The top management should have the flexibility to take appropriate decisions at the right time. Fear of having to share control and thus being interfered by others often delays the decision of the closely held companies to go public. To avoid the risk of loss of control, the companies may issue preference shares or raise debt capital. An excessive amount of debt may also cause bankruptcy, which means a complete loss of control. The capital structure planned should be one in this direction.Floatation costs Floatation costs are incurred when the funds are raised. Generally, the cost of floating a debt is less than the cost of floating an equity issue. A company desiring to increase its capital byway of debt or equity will definitely incur floatation costs. Effectively, the amount of money raised by any issue will be lower than the amount expected because of the presence of floatation costs. Such costs should be compared with the profits and right decisions should be taken.

Solution:Average cost of capital of firm A is:10% * 0/Rs. 666667 + 15% * 666667/666667 = 0 + 15= 15%Average cost of capital of firm B is:10% * 25000/750000 + 15% * 533333/750000 = 3.34 + 10= 13.4%Interpretation:The use of debt has caused the total value of the firm to increase and the overall cost of capital to decrease.

5. EXPLAIN ALL THE SOURCES OF RISK IN CAPITAL BUDGETING WITH EXAMPLES.Ans. There are several definitions for the term risk. It may vary depending on the situation, context and application. Risk may be termed as a degree of uncertainty. It may be defined as the possibility that the actual result from an investment will differ from the expected result. Risk in capital budgeting maybe defined as the variation of actual cash flows from the expected cash flows.Capital budgeting involves four types of risks in a project: stand-alone risk, portfolio risk, market risk and corporate risk..Stand-alone riskStand alone risk of a project is considered when the project is in isolation. Stand-alone risk is measured by the variability of expected returns of the project.Portfolio riskA firm can be viewed as portfolio of projects having a certain degree of risk. When new project is added to the existing portfolio of project, the risk profile of the firm will alter. The degree of the change in the risk depends on the following: The co-variance of return from the new project The return from the existing portfolio of the projectsIf the return from the new project is negatively correlated with the return from portfolio, the risk of the firm will be further diversified.Market riskMarket risk is defined as the measure of the unpredictability of a given stock value. However, market risk is also referred to as systematic risk. The market risk has a direct influence on stock prices. Market risk is measured by the effect of the project on the beta of the firm. The market risk for a project is difficult to estimate, as it includes a wide range of external factors like recessions, wars, political issues, etc.Corporate riskCorporate risk focuses on the analysis of the risk that might influence the project in terms of entire cash flow of the firms. Corporate risk is the projects risks of the firm.Sources of riskThe five different sources of risk are: Project-specific risk Competitive or competition risk Industry-specific risk International risk Market riskSOLVE THE BELOW GIVEN PROBLEM:IF THE RISK FREE RATE AND THE RISK PREMIUM IS 10%,A) COMPUTE THE NPV USING THE RISK FREE RATEB) COMPUTE NPV USING RISK-ADJUSTED DISCOUNT RATESolutiona) NPV can be computed using risk free ratePV Using Risk Free RateYear Cash flows (inflows) Rs. PV factor at10% PV of cash flows(inflows)1 40000 0.909 36,3602 50000 0.826 41,3003 15000 0.751 11,2654 30000 0.683 20,490PV of cash inflows 1,09,415PV of cash outflows (1,00,000)NPV 9,415

b) NPV can be computed using risk-adjusted discount. Year Cash inflows Rs. PV factor at 20% PV of cash inflows1 40000 0.833 33,3202 50000 0.694 34,7003 15000 0.579 8,6854 30000 0.482 14,460PV of Cash inflows 91,165PV of cash outflows (100, 000)NPV (8, 835) The project would be acceptable when no allowance is made for risk.However, it will not be acceptable if risk premium is added to the risk free rate. By doing so, it moves from positive NPV to negative NPV. If the firm were to use the internal rate of return (IRR), then the project would be accepted, when IRR is greater than the risk-adjusted discount rate.

6. EXPLAIN THE OBJECTIVES OF CASH MANAGEMENT. WRITE ABOUT THE BAUMOL MODEL WITH THEIR ASSUMPTIONS.Ans. The major objectives of cash management in a firm are: Meeting payments schedule Minimising funds held in the form of cash balancesMeeting payments scheduleIn the normal course of functioning, a firm has to make various payments by cash to its employees, suppliers and infrastructure bills. Firms will also receive cash through sales of its products and collection of receivables. Both of these do not occur simultaneously.The basic objective of cash management is therefore to meet the payment schedule on time. Timely payments will help the firm to maintain its creditworthiness in the market and to foster cordial relationships with creditors and suppliers. Creditors give cash discount if payments are made in time and the firm can avail this discount as well. Trade credit refers to the credit extended by the supplier of goods and services in the normal course of business transactions.Minimising funds held in the form of cash balancesTrying to achieve the second objective is very difficult. A high level of cash balance will help the firm to meet its first objective, but keeping excess reserves is also not desirable as funds in its original form is idle cash and anon-earning asset. It is not profitable for firms to maintain huge balances.A low level of cash balance may mean failure to meet the payment schedule. The aim of cash management is therefore to have an optimal level of cash by bringing about a proper synchronization of inflows and outflows, and to check the spells of cash deficits and cash surpluses.Seasonal industries are classic examples of mismatches between inflows and outflows. The efficiency of cash management can be augmented by controlling a few important factors: Prompt billing and mailingThere is a time lag between the dispatch of goods and preparation of invoice. Reduction of this gap will bring in early remittances. Collection of cheques and remittances of cashGenerally, we find a delay in the receipt of cheques and their deposits in banks. The delay can be reduced by speeding up the process of collecting and depositing cash or other instruments from customers. FloatThe concept of float helps firms to a certain extent in cash management. Float arises because of the practice of banks not crediting the firms account in its books when a cheque is deposited by it and not debiting the firms account in its books when a cheque is issued by it, until the cheque is cleared and cash is realized or paid respectively.

Baumol modelThe Baumol model helps in determining the minimum amount of cash that manager can obtain by converting securities into cash. Baumol model is an approach to establish a firms optimum cash balance under certainty. As such, firms attempt to minimise the sum of the cost of holding cash and the cost of converting marketable securities to cash. Baumol model of cashmanagement trades off between opportunity cost or carrying cost or holding cost and the transaction cost.The Baumol model is based on the following assumptions: The firm is able to forecast its cash requirements in an accurate way. The firms payouts are uniform over a period of time. The opportunity cost of holding cash is known and does not change with time. The firm will incur the same transaction cost for all conversions of securities into cash.