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1. Explain why debt is usually considered the cheapest source of financing


Debt financing is the act of raising operating capital or other capital by borrowing for a business.
Most often, this refers to the issuance of a bond, debenture, or other debt security.

When a company takes loan from third party then it is considered as debt financing. It is one of
the most commonly used ways of financing. Debt can be of short term, midterm and long term.

Why debt is the cheapest source of financing:

Company can manage its required funds through debt or equity or combination of both.
Choosing an optimal capital structure different company use different ratio of debt and equity.
But question is how an optimal capital structure can be formed. Basically the capital structure is
formed by considering the financial strength of the company and cost of funds of different

Many people say that retained earnings is the cheapest source of financing but debt can be
cheapest source of financing from different perspectives. From the share holders perspective
tax deductibility feature of debt finance is lucrative. And from the lenders perspective debt is
secured because creditors get the preference of getting their principal and interest before
making any benefit to the share holders.
Tax deductibility feature of debt is the main point, on which we can say debt is the cheapest
source of financing.
There are some other points that may include with deductibility feature. These are

Time value of money and preference of funds.

Dividends not payable to lenders
Interest rate.
Let us consider an example to show how debt financing helps to reduce the tax burden that is
the tax deductibility features of interest.

Example: Suppose XYZ company take loan of $1000000from ABC bank at the rate of 15%. Tax
payable to the government is 30% of the income. Income is = $500000
Only Equity is used
If there is no debt financing then XYZ company has to pay tax of total = $500000 X 30% =

After tax income = $ 500000 $150000 = $350000

If Debt and equity is used
On the other hand if company use debt financing then,

Interest on load amount = $1000000 X 15% = $150000

Taxable income is = $500000 $150000 = $350000

Tax payable = $350000 X .3 = 105000

After tax income is = $500000 105000 = $395000

From the example it is clear that because of debt financing XYZ Company is paying less
amount of tax which increases the net income after tax. Normally company making profit of
$350000 but because of using Debt Company is making profit of 395000. Thats why company
prefers debt financing.

Let us consider other example: XYZ company take loan at the rate of 14% and corporate tax
rate is 30%.

Here cost of debt capital is 14% but because of using debt capital companys cost of capital for
debut is 14 X (1 30%) = 9.80%. Cost of capital is reduced because of tax deductibility feature
of debt financing.

So we can say that debt can be cheapest source of financing for the company.

2. Differenciate between financial and business risks?


Financial Risk

Financial risk refers to the chance a business's cash flows are not enough to pay creditors
and fulfill other financial responsibilities. The level of financial risk, therefore, relates less to
the business's operations themselves and more to the amount of debt a business incurs to
finance those operations. The more debt a business owes, the more likely it is to default on
its financial obligations. Taking on higher levels of debt or financial liability therefore
increases a business's level of financial risk.

Business Risk

Business risk refers to the chance a business's cash flows are not enough to cover its
operating expenses like cost of goods sold, rent and wages. Unlike financial risk, business
risk is independent of the amount of debt a business owes. There are two types of business
risk: systematic risk and unsystematic risk.

Business risk is the possibility that an organization's operations or

competitive environment will cause it to generate financial results that are
worse than expected. Financial risk is the possibility that the use of debt to
financial operations will have a negative impact on earnings.

Business Risk vs Financial Risk

The running of businesses involves a considerable amount of risk. It is important

for business owners and entrepreneurs to identify and understand the various risks
involved in running a business so that they can adapt their business strategies to
deal with such risks in a better manner.

Financial risk is the risk that a business will not be able to generate enough cash
flow and income to pay their debts and meet their other financial obligations.

Business risk is the risk that a business faces in not being able to generate
adequate income to cover operating expenses.

Financial risk can arise from volatile interest rates, exchange rate risk, and
companys debt to equity ratio, etc.

Business risk can arise from a number of factors such as fluctuations in demand,
market competition, costs of raw materials, etc.

Business risk is independent of the portion of the debt that a business holds, as
opposed to financial risk that is very much influenced by the level of debt.

3 .Discuss the different approaches of financing of working capital requirements?


Working capital is a measure of the companys efficiency and short term financial
health. It refers to that part of the companys capital, which is required for financing
short-term or current assets such a cash marketable securities, debtors and
inventories. It is a companys surplus of current assets over current liabilities, which
measures the extent to which it can finance any increase in turnover from other fund
sources. Funds thus, invested in current assets keep revolving and are constantly
converted into cash and this cash flow is again used in exchange for other current
assets. That is why working capital is also known as revolving or circulating
capital or short-term capital.
Formula for Working Capital: "Current Assets Current Liabilities"

There are mainly 3 approaches to determine financing of working capital. Let us

discuss them one by one:

1) Hedging approach or matching approach: this approach means matching

the maturities of debt with the maturity of financial needs. It means the sources of
funds should match with the nature of assets to be financed. There are two types of
working capital permanent and temporary working capital. The hedging approach
suggests that the permanent working capital requirement should be financed
through long term funds, while temporary working capital should be financed
through the short term funds. There is low cost, high risk and high profit in this

2) Conservative approach: as the name suggests it is a conservative approach

which suggests that the entire requirement of current assets should be financed
through long term sources and short term sources should be used only in case of
emergency. There is high cost, low risk and low profit in this approach.

3) Aggressive approach: as the name suggests it is an aggressive approach which

suggests that the entire requirement of current assets should be financed through
short term sources. There is low cost, high risk and high profit in this approach.

Case Detail :

Working capitalDo you have enough?

Lending institutions are scrutinizing an operations working capital status as part of

the lending decision. Now more than ever, its time to do a little scrutinizing
yourself. When I hit the road to speak, one of the most important slides I regularly
use highlights how lending criteria has changed since the financial crisis. To
illustrate that point, the slide includes a quote from Nick Parsons, head of research
with the National Australia Bank: "So capitalism has changedthe owner or the
custodian of capital [i.e. lending institutions] is much more careful about where they
use that capital.

To that end, most readers have likely experienced increased scrutiny from their
lenders in this post-crisis world. And one of the key criteria that lenders use to make
decisions revolves around availability of working capital within any operation;
working capital being a function of current assets less current liabilities. Its a
measure of an operations buffer to meet its short-term obligations, hence the
importance to lenders.

Perhaps equally important, its a key indicator of cash reserve availability to meet
unexpected emergencies. Thus, it is an important component of risk management
to ensure business continuity within the operation without the need to borrow
additional funds. As an example, albeit simplified, a pickup is typically a critical
operational asset for most cow-calf operations. What if it catches on fire and
suddenly needs to be replaced, else the cows dont get fed? After insurance
provides some portion towards replacement, does the operation have sufficient
working capital to meet the remainder of the obligation? This type of assessment
has become more important to lenders since the financial crisis.

This weeks graph highlights USDAs updated aggregate working capital estimates
in agriculture. Clearly, as last weeks illustration depicts, declining revenue has
taken a big hit out of working capital reserves for agriculture. Working capital has
declined nearly 50% - the loss exceeds $82 billion in just three years. Thats a
concerning trend and if it continues, will clearly have implications in the coming

What are you doing to maintain strong cash and working capital reserves amidst
declining revenue? What new expectations do you your lenders have during the
past several years and going into 2017? How will you adjust going forward? Leave
your thoughts in the comments section below.

1. Provide the brief summary of the case in your own words?

The present case study talks about the latest trend regarding working
capital. Present case study also define working capital as cash reserve
availability to meet unexpected emergencies and component of risk
management. Case study emphasize that in todays modern time, working
capital is importance criteria for lenders. Alas, working capital as declined
50%.Therefore, companies need to take strategic decision to maintain
working capital to meet the expectations of lenders.

2. What new expectations do your lenders have during the past several
years and going into future?
Working capital becomes important criteria for lenders. Their decision
revolves around the ability to maintain working capital in operations as it
is important measure to meet short-term obligations and can save
business in short-term risk or unfortunate events.
3. What should be done to maintain strong cash and working capital reserves
amidst declining revenue?
Managing working capital involves maintaining an adequate portion of the
asset base that can be easily converted to cash, and/or controlling the
short-term drains on that cash resulting from debt service, capital
expenditures, or cash withdrawals. So one of the easiest ways to
manage working capital is to protect cash. When the business generates
cash from the sale of products, it can be held in that form, committed to
the purchase of inputs for the upcoming production season, or it can be
used to purchase capital items or withdrawn from the business.
Purchasing assets or withdrawing cash from the business may be
necessary in specific instances. However, it is extremely important in
todays environment to carefully monitor these uses of cash because their
use can significantly reduce the liquid financial reserves of the business.
Other techniques to preserve cash are to lease capital assets or hire
custom services; to reduce expenditures that dont increase production; to
improve yield through timely operations; and to sell at higher prices. The
discussion above suggests that maintaining a strong cash position is an
important way to manage working capital.

1. Dividend has no relationship with the value of the firm as per Walter Model.

B No

2. Wealth management and profit maximisation are the





Can't say

3. Traditionally the role of finance manager was restricted to . Of funds.

B Procurement
4. The sales of a business or other form of revenue from operations of the
business is called as .

D Turnover

5. Implicit cost is the cost of using the funds.


6. The process of calculating present value of projected cash flows.





7. A part of the organisation where the manager has responsibility for

generating revenues, controlling costs and producing a satisfactory return on
capital invested in the division.

C Division

8. Business practices designed by companies to make production and delivery

systems more competitive in world markets by eliminating or minimizing
waste, errors, and costs.

A Reengineering

9. Cash in hand and cash at bank are examples of . Assets.

A Current

10. Baumol model and the Miller-Orr model belong to . Management.

A Cash

11. Current assets /Current liabilities describes . Ratio.

B Quick
12. Inventory and receivables are both current assets.


13. Credit analysis, or the assessment of creditworthiness, is undertaken by

analysing and evaluating information relating to a customers

C Financial

14.The objective of liquidity ensures that companies are able to meet their
liabilities as they fall due, and thus remain in business.


15. Funds held in the form of cash do not earn a return.


16.Holding costs can be . by reducing the level of inventory held by a


A minimised

17. Which technique brings inventory and cash requirment drastically down?





18.Which model belongs to cash management?

B Miller Orr

19.JIT stands for just in . .

D time

20.The factors to be considered in formulating a trade receivables policy relate

to credit analysis, credit control and receivables collection.

21.Companies with the same business operations may have levels of
investment in working capital as a result of adopting different working capital

C different

22.Receivables management is all about?

C Credit Management

23.The main reason that companies fail, though, is because they run out of

C Cash

24.Is it right to say that good cash management is an essential part of good
working capital management.

C Always

25.Optimum cash balance must reflect the expected need for cash in the next
budget period.

B Always

26.The cash operating cycle is the average ... of time between paying
trade payables and receiving cash from trade receivables.

C length

27.The length of the cash .. depends on working capital policy in

relation to the level of investment in working capital, and on the nature of the
business operations of a company.


Operating Cycle



28.Liquid funds, for example cash, earn no return and so will not increase

29... are your business scores that come from your Income
Statement and Balance Sheet, not the Cash Flow Statement.
D Ratios
30.Working capital investment policy is concerned with the level of investment in
assets, with one company being compared with another.

C Current

31... can also be used to cover some of the risks associated with
giving credit to foreign customers.



C Insurance


32.Aggressive working capital finance means using more . term finance

B Short

33.Short-term finance is more flexible than long-term finance.


34.Short-term finance tends to be more .. than long-term finance.

C Flexible

35.Sales made but not collected is known as.?

B A/Cs Receivables

36.. Interest rate depends upon an index and increases or decreases.

B Variable

37.Short-term finance is more risky than long-term finance.


C Sometimes


38.Rate risk refers to the fact that when short-term finance is renewed, the rates
may vary when compared to the .. rate.





39.The . principle suggests that long-term finance should be used for

long-term investment.



Dual Aspect


40.Money paid (cost of credit) for the use of money.

A Interest


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