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-1
Explain the liquidity decisions and its important elements. Write complete
information on dividend decisions.
Answer
Liquidity Decision
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.
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 effectively
Dividend Decision
Dividends are pay-outs 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.
Question No.-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?
Answer
Doubling Period
A 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:
Solution to problem
FVn = PV (1+i/m) m X n
m = 12/3 = 4 (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
Present Value
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 n number 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.
1. Present value of a single flow
Ascertaining Present Value (PV) is simply the reverse of finding Future
Value (FV). Hence, the formula for FV can be simply transformed into the
PV formula.
PV=FVn / (1+i) ^n
Where, PV = Present Value
FVn = Amount (Future value after n years)
i = Interest rate
n = Number of years for which discounting is done
Question No.-3
Write short notes ona)
Operating leverage
b)
Financial leverage
c)
Combined leverage
Answer
a) Operating leverage
Operating leverage arises due to the presence of fixed operating expenses
in the firms income flows. It has a close relationship to business risk.
Question No.-4
Explain the factors affecting Capital Structure. Solve the below given
problem:
Given below are two firms, A and B, which are identical in all aspects
except the degree of leverage employed by them. What is the average
cost of capital of both firms?
Details of Firms A and B
Net operating income
EBIT
Interest on debentures
Equity earnings E
Cost of equity Ke
Cost of debentures Kd
Market value of equity
S=E/Ke
Market value of debt B
Total value of firm V
Firms A
Firms B
Rs 100000
Rs 100000
nil
Rs 100000
15%
10%
Rs 25000
Rs 75000
15%
10%
Rs 666667
Rs 500000
nil
Rs 666667
Rs 250000
Rs 750000
Answer
Factors Affecting Capital Structures
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.
The major factor affecting the capital structure is leverage. There are also
a few other factors affecting them. All the factors are explained briefly
here.
1. Leverage
The 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.
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
not.
2. 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.
3. Cash flow projections of the company
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.
4. 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.
5. 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 by way of debt or equity will
definitely incur floatation costs.
Solution of problem-
Question No.-5
Explain all the sources of risk in capital budgeting with examples.
Solve the below given problemAn investment will have an initial outlay of Rs 100,000. It is expected to
generate cash inflows. Cash inflow for four years.
Year
1
2
3
4
Cash Inflow
40000
50000
15000
30000
Answer
Capital budgeting involves four types of risks in a project: stand-alone risk,
portfolio risk, market risk and corporate risk.
a. Stand-alone risk
Project-specific risk
Competitive or competition risk
Industry-specific risk
International risk
Market risk
Cash flows
PV factor for 10% PV for cash flow
40000
0.909
36360
50000
0.826
41300
15000
0.751
11265
30000
0.683
20490
PV for cash inflows
109415
PV for cash
outflows
NPV
(100000)
9415
Cash inflows
40000
50000
15000
30000
PV for cash flows
PV for cash
outflows
NPV
PV factor at 20%
0.833
0.694
0.579
0.482
Question No.-6
Explain the objectives of Cash Management. Write about the Baumol
model with their assumptions.
Answer
Objectives of cash management
The major objectives of cash management in a firm are:
Meeting payments schedule
Minimising funds held in the form of cash balances
Meeting payments schedule
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.