ASSIGNMENT

Name:
Registration No:
Learning Center:

VINAY KUMAR
1402000509
SYSTEMS DOMAIN PRIVATE LIMITED

Learning Center Code:

2862

Course:

MBA

Subject:

FINANCIAL MANAGEMENT

Semester:
Subject Code:
Date of submission:
Marks awarded:

SECOND
MB0045
________________________________________
________________________________________

Directorate of Distance Education

Sikkim Manipal University
II Floor, Syndicate House
Manipal 576 104

Signature of Coordinator
Evaluator

Signature of Center

Signature of

1.Explain the liquidity decisions and its important elements. Write

complete information 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. 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 effectively
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 of Directors 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.

2. Explain about the doubling period and present value.

Ans: Doubling time or doubling period
Doubling time = log(2)/ log(l+r)
R= rate of return
The Doubling Time formula is used in Finance to calculate the length of time
required to double an investment or money in an interest bearing account.
r in the doubling time formula is the rate per period. If one wishes to
calculate the amount of time to double their money in a money market
account that is compounded monthly, then r needs to express the monthly
rate and not the annual rate. The monthly rate can be found by dividing the
annual rate by 12. With this situation, the doubling time formula will give the
number of months that it takes to double money and not years
In addition to expressing r as the monthly rate if the account is compounded
monthly, one could also use the effective annual rate, or annual percentage
yield, as r in the doubling time formula..
Example of Doubling Time Formula
Jacques would like to determine how long it would take to double the money
in his money market account. He is earning 6% per year, which is
compounded monthly. Looking at the doubling time formula, we need to
consider that the 6% would need to be divided by 12 in order to come to a
monthly rate since the account is compounded monthly. Given this, r in the
doubling time formula would be .005 (.06/12). After putting this into the
doubling time formula, we have:

After solving, the doubling time formula shows that Jacques would double his
money within 138.98 months, or 11.58 years.
As stated earlier, another approach to the doubling time formula that could
be used with this example would be to calculate the annual percentage yield,
or effective annual rate, and use it as r. The annual percentage yield on 6%

compounded monthly would be 6.168%. Using 6.168% in the doubling time

formula would return the same result of 11.58 years.
Present value: PV=C1 / (1+r)n
C1 = Cash flow at period 1
r = rate of return
n = number of periods

Present Value (PV) is a formula used in Finance that calculates the present
day value of an amount that is received at a future date. The premise of the
equation is that there is "time value of money".
Time value of money is the concept that receiving something today is worth
more than receiving the same item at a future date. The presumption is that
it is preferable to receive $100 today than it is to receive the same amount
one year from today, but what if the choice is between $100 present day or
$106 a year from today? A formula is needed to provide a quantifiable
comparison between an amount today and an amount at a future time, in
terms of its present day value.

Use of Present Value Formula

The Present Value formula has a broad range of uses and may be applied to
various areas of finance including corporate finance, banking finance, and
investment finance. Apart from the various areas of finance that present
value analysis is used, the formula is also used as a component of other
financial formulas.
Example of Present Value Formula
An individual wishes to determine how much money she would need to put
into her money market account to have $100 one year today if she is earning
5% interest on her account, simple interest.
The $100 she would like one year from present day denotes the C1 portion of
the formula, 5% would be r, and the number of periods would simply be 1.
Putting this into the formula, we would have

When we solve for PV, she would need $95.24 today in order to reach $100
one year from now at a rate of 5% simple interest.

Solution:
The generalised formula for shorter compounding periods is:
Fv(n) = PV(1+i/m)^mXn
Where, FVn= future value after n years
PV = cash flow today
i = nominal interest rate per annum
m = number of times compounding is done during a year
n = number of years for which compounding is done
M= 12/3 (quarterly compounding)
1000(1+0.10/4)^4*2
1000(1+0.10/4)^8
Rs 1218
The amount of rs 1000 after 2 years would be Rs 1218.

3. Write short notes on:

a) Operating Leverage
Ans: Operating leverage is the ratio of a company's fixed costs to its variable
costs.
How it works/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 $12 each. It has $10,000,000 of fixed
costs (equipment, salaried personnel, etc.). It only costs $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 ($12 - $0.10)] / 1,000,000 x ($12 - $0.10)
- $10,000,000 = $11,900,000/$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).
Why it Matters:
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 inrevenue, 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.
b) Financial Leverage: Financial leverage is the amount of debt that an
entity uses to buy more assets. This is done to avoid investing an
organization's own equity capital in such purchases.
The financial leverage formula is measured as the ratio of total debt to total
assets. As the proportion of debt to assets increases, so too does the amount
of financial leverage. Financial leverage is favorable when the uses to which
debt can be put generate returns greater than the interest expense
associated with the debt. Many companies use financial leverage rather than

acquiring more equity capital, which could reduce the earnings per share of
existing shareholders.
Example Able Company uses $1,000,000 of its own cash to buy a factory,
which generates $150,000 of annual profits. The company is not using
financial leverage at all, since it incurred no debt to buy the factory.
Baker Company uses $100,000 of its own cash and a loan of $900,000 to buy
a similar factory, which also generates a $150,000 annual profit. Baker is
using financial leverage to generate a profit of $150,000 on a cash
investment of $100,000, which is a 150% return on its investment.
Baker's new factory has a bad year, and generates a loss of $300,000, which
is triple the amount of its original investment.
Formula: Financial leverage=Operating Income/ Net Income
c) Combined leverage : This leverage shows the relationship between a
change in sales & the corresponding variation in taxable income. If the
management feels that a certain percentage change in sale would result in
percentage change to taxable income they would like to know the level or
degree of change & hence they adopt this leverage.
The formula which is used to calculate this is as followsDegree of combined leverage = Degree of operating leverage * Degree of
financial leverage.
4. Explanation of factors affecting capital structure
Ans: Factors affecting capital structure
(1) Cash Flow Position:
While making a choice of the capital structure the future cash flow position
should be kept in mind. Debt capital should be used only if the cash flow
position is really good because a lot of cash is needed in order to make
payment of interest and refund of capital.

(2) Interest Coverage Ratio-ICR: With the help of this ratio an effort is
made to find out how many times the EBIT is available to the payment of
interest. The capacity of the company to use debt capital will be in direct
proportion to this ratio.
(3) Debt Service Coverage Ratio-DSCR:
This ratio removes the weakness of ICR. This shows the cash flow position of
the company.
This ratio tells us about the cash payments to be made (e.g., preference
dividend, interest and debt capital repayment) and the amount of cash
available. Better ratio means the better capacity of the company for debt
payment. Consequently, more debt can be utilised in the capital structure.
(4) Return on Investment-ROI:
The greater return on investment of a company increases its capacity to
utilise more debt capital.
(5) Cost of Debt:
The capacity of a company to take debt depends on the cost of debt. In case
the rate of interest on the debt capital is less, more debt capital can be
utilised and vice versa.
(6) Tax Rate:
The rate of tax affects the cost of debt. If the rate of tax is high, the cost of
debt decreases. The reason is the deduction of interest on the debt capital
from the profits considering it a part of expenses and a saving in taxes.

(7) Cost of Equity Capital:

Cost of equity capital (it means the expectations of the equity shareholders
from the company) is affected by the use of debt capital. If the debt capital is
utilised more, it will increase the cost of the equity capital. The simple reason
for this is that the greater use of debt capital increases the risk of the equity
shareholders.
Therefore, the use of the debt capital can be made only to a limited level. If
even after this level the debt capital is used further, the cost of equity capital
starts increasing rapidly. It adversely affects the market value of the shares.
This is not a good situation. Efforts should be made to avoid it.

(8) Floatation Costs:

Floatation costs are those expenses which are incurred while issuing
securities (e.g., equity shares, preference shares, debentures, etc.). These
include commission of underwriters, brokerage, stationery expenses, etc.
Generally, the cost of issuing debt capital is less than the share capital. This
attracts the company towards debt capital.
(9) Risk Consideration: There are two types of risks in business:
(i) Operating Risk or Business Risk:
(ii) Financial Risk:
(10) Flexibility:

According to this principle, capital structure should be fairly flexible.

Flexibility means that, if need be, amount of capital in the business could be
increased or decreased easily. Reducing the amount of capital in business is
possible only in case of debt capital or preference share capital.
If at any given time company has more capital than as necessary then both
the above-mentioned capitals can be repaid. On the other hand, repayment
of equity share capital is not possible by the company during its lifetime.
Thus, from the viewpoint of flexibility to issue debt capital and preference
share capital is the best.
(11) Control:
According to this factor, at the time of preparing capital structure, it should
be ensured that the control of the existing shareholders (owners) over the
affairs of the company is not adversely affected.
If funds are raised by issuing equity shares, then the number of companys
shareholders will increase and it directly affects the control of existing
shareholders. In other words, now the number of owners (shareholders)
controlling the company increases.
This situation will not be acceptable to the existing shareholders. On the
contrary, when funds are raised through debt capital, there is no effect on
the control of the company because the debenture holders have no control
over the affairs of the company. Thus, for those who support this principle
debt capital is the best.
(12) Regulatory Framework:

Capital structure is also influenced by government regulations. For instance,

banking companies can raise funds by issuing share capital alone, not any
other kind of security. Similarly, it is compulsory for other companies to
maintain a given debt-equity ratio while raising funds.
Different ideal debt-equity ratios such as 2:1; 4:1; 6:1 have been determined
for different industries. The public issue of shares and debentures has to be
made under SEBI guidelines.
(13) Stock Market Conditions:Stock market conditions refer to upward or
downward trends in capital market. Both these conditions have their
influence on the selection of sources of finance. When the market is dull,
investors are mostly afraid of investing in the share capital due to high risk.
On the contrary, when conditions in the capital market are cheerful, they
treat investment in the share capital as the best choice to reap profits.
Companies should, therefore, make selection of capital sources keeping in
view the conditions prevailing in the capital market.
(14) Capital Structure of Other Companies:
Capital structure is influenced by the industry to which a company is related.
All companies related to a given industry produce almost similar products,
their costs of production are similar, they depend on identical technology,
they have similar profitability, and hence the pattern of their capital
structure is almost similar.
5. Explanation of risk in capital budgeting with examples
Risk is the potential that a chosen action or activity (including the choice of
inaction) will lead to a loss (an undesirable outcome). The notion implies that

a choice having an influence on the outcome exists (or existed). Potential

losses themselves may also be called "risks. "
The five different sources of risk are:
Project-specific risk Project-specific risk could be traced to something
quite specific to the project. Managerial deficiencies or error in estimation of
cash flows or discount rate may lead to a situation of actual cash flows
realised being less than the projected cash flow.
Competitive or competition risk: Unanticipated actions of a firms
competitors will materially affect the cash flows expected from a project. As
a result of this, the actual cash flows from a project will be less than that of
the forecast.
Industry-specific risk: Industry-specific risks are those that affect all the
firms in the particular industry. Industry-specific risk could be again grouped
into technological risk, commodity risk and legal risk. Let us discuss the
groups in industryspecific risks, as follows:

Technological risk : The changes in technology affect all the firms not
capable of adapting themselves in emerging into a new technology.
Example The best example is the case of firms manufacturing motor cycles
with two stroke engines. When technological innovations replaced the two
stroke engines by the four stroke engines, those firms which could not adapt
to new technology had to shut down their operations.

Commodity risk : It is the risk arising from the effect of price-changes on

goods produced and marketed.
Legal risk: It arises from changes in laws and regulations applicable to the
industry to which the firm belongs.
Example The imposition of service tax on apartments by the government of
India, when the total number of apartments built by a firm engaged in that
industry exceeds a prescribed limit. Similarly, changes in importexport policy
of the government of India have led to either closure of some firms or
sickness of some firms. All these risks will affect the earnings and cash flows
of the project.
International risk : These types of risks are faced by firms whose business
consists mainly of exports or those who procure their main raw material from
international markets.
The firms facing such kind of risks are as follows:
The rupee-dollar crisis affected the software and BPOs, because it
drastically reduced their profitability.
Another example is that of the textile units in Tirupur in Tamil Nadu, which
exports the major part of the garments produced. Strengthening of rupee
and weakening of dollar, reduced their competitiveness in the global
markets.

The surging crude oil prices coupled with the governments delay in taking
decision on pricing of petro products eroded the profitability of oil marketing
companies in public sector like Hindustan Petroleum Corporation Limited.
Another example is the impact of US sub-prime crisis on certain segments
of Indian economy.
The changes in international political scenario also affected the operations of
certain firms.
Market risk
Factors like inflation, changes in interest rates, and changing general
economic conditions affect all firms and all industries. Firms cannot diversify
this risk in the normal course of business.
There are many techniques of incorporation of risk perceived in the
evaluation of capital budgeting proposals. They differ in their approach and
methodology as far as incorporation of risk in the evaluation process is
concerned.
a) NPV can be computed using risk free rate.
Year

Cash Flows(in
flows) in RS

PV factor at
10%

PV ofCash Flows
(inflow)

1
2
3
4

40000
50000
15000
30000
PV of Cash
inflows
PV of Cash
Outflows
NPV

0.909
0.826
0.751
0.683

36360
41300
11265
20490
109415

-100000
9415

b) NPV can be computed using risk-adjusted discount.

Year

Cash Flows(in
flows) in RS

PV factor at
20%

PV ofCash Flows
(inflow)

1
2
3
4

40000
50000
15000
30000
PV of Cash
inflows

0.833
0.694
0.579
0.482

33320
34700
8685
14460
91165

PV of Cash
Outflows
NPV

-100000
-8835

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. Objectives of cash management :

Ans: Cash management is a broad term that refers to the collection,
concentration, and disbursement of cash. It encompasses a company's level
of liquidity, its management of cash balance, and its short-term investment
strategies. In some ways, managing cash flow is the most important job of
business managers. If at any time a company fails to pay an obligation when
it is due because of the lack of cash, the company is insolvent. Insolvency is
the primary reason firms go bankrupt. Obviously, the prospect of such a dire
consequence should compel companies to manage their cash with care.
Moreover, efficient cash management means more than just preventing
bankruptcy. It improves the profitability and reduces the risk to which the
firm is exposed
Objective of cash management
1) To make Payment According to Payment Schedule:Firm needs cash to meet its routine expenses including wages, salary, taxes
etc.
Following are main advantages of adequate casha)To prevent firm from being insolvent.
b)The relation of firm with bank does not deteriorate.
c)Contingencies can be met easily.
d)It helps firm to maintain good relations with suppliers.
(2) To minimise Cash Balance:The second objective of cash management is to minimise cash balance.
Excessive amount of cash balance helps in quicker payments, but excessive
cash may remain unused & reduces profitability of business. Contrarily, when
cash available with firm is less, firm is unable to pay its liabilities in time.
Therefore optimum level of cash should be maintain.
Baumol model with assumptions

Most firms try to minimise the sum of the cost of holding cash and the cost of
converting marketable securities to cash.
Baumols cash management model helps in determining a firms optimum
cash balance under certainty. As per the model, cash and inventory
management problems are one and the same.
There are certain assumptions that are made in the model. They are as
follows:
1. The firm is able to forecast its cash requirements with certainty and
receive a specific amount at regular intervals.
2. The firms cash payments occur uniformly over a period of time i.e. a
steady rate of cash outflows.
3. The opportunity cost of holding cash is known and does not change
over time. Cash holdings incur an opportunity cost in the form of
opportunity foregone.
4. The firm will incur the same transaction cost whenever it converts
securities to cash. Each transaction incurs a fixed and variable cost.
For example, let us assume that the firm sells securities and starts with
a cash balance of C rupees. When the firm spends cash, its cash
balance starts decreasing and reaches zero. The firm again gets back
its money by selling marketable securities. As the cash balance
decreases gradually, the average cash balance will be: C/2. This can be
shown in following figure:

.
The firm incurs a cost known as holding cost for maintaining the cash
balance. It is known as opportunity cost, the return inevitable on the
marketable securities. If the opportunity cost is k, then the firms holding
cost for maintaining an average cash balance is as follows:
Holding cost = k (C/2)

Whenever the firm converts its marketable securities to cash, it incurs a cost
known as transaction cost. Total number of transactions in a particular year
will be total funds required (T), divided by the cash balance (C) i.e. T/C. The
assumption here is that the cost per transaction is constant. If the cost per
transaction is c, then the total transaction cost will be:
Transaction cost = c (T/C)
The total annual cost of the demand for cash will be:
Total cost = k (C/2) + c (T/C)