Financial Management

Q.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. 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 dayto-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 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 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. Although both - expansion and payment of dividend - are desirable, these two are in conflicting tasks.
The following issues need adequate consideration in deciding on dividend policy:
Preferences of shareholders Do they want cash dividend or capital gains?
Current financial requirements of the company.
Legal constraints on paying dividends.
Striking an optimum balance between desire of shareholders and the companys funds requirements.
The main reasons why a stable dividend is preferred are:
a) A regular and stable dividend payment may serve to resolve uncertainty in the minds of shareholders,
and it creates confidence among shareholders.
b) Many investors are income conscious and favour a stable dividend.
c) Other things being in balance, the market price invariably vary with the rate of dividend declared by the
company on its equity shares. The value of shares of a company that has a stable dividend policy does
not fluctuate as much, even if the earnings of the company fluctuate now and then.
d) A stable dividend policy encourages investments from institutional investors.
Q.2:- Explain about the doubling period and present value. Solve the given problem:
Ans.

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:

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 dividing 72 by the rate of interest. Though it is a crude way of
calculating, this rule is followed by most. If the given rate of interest is 10%, the doubling period is
72/10, 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 rate Going by the same example given above, we get the
number of years as 7.25 years {(0.35 + 69/10) or (0.35 +6.9)}.
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?
Solution for the given problem
i mXn
1+
m
n

FV = PV

( )

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.
1) Present value of a single flow
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.
FV n

PV =

(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
2) Present value of even series of cash flow
The PV of a series of cash flows can be represented by the following formula:
( 1+i )n1
PVAn = A i(1+i)n

The expression {(1+i)n-1/i(1+i)n} is known as Present Value Interest Factor Annuity (PVIFA). It
represents the present value of a regular annuity of Re. 1 for the given values of i and n.
3) Present value of perpetuity

An annuity for an infinite time period is perpetuity. It occurs indefinitely. The present values of
perpetuity can be expressed as follows:

P = A PVIFAi,
Where, P = Present value of perpetuity
A = constant annual payment
PVIFAi, = Present value interest factor for a perpetuity

1
1
=

n
Therefore, the value of PVIFAi, is n=1 (1+i) i
It can be said that PVIF of perpetuity is simply one divided by interest rate expressed in decimal form.
Hence, PV of perpetuity is simply equal to the constant annual payment divided by the interest rate. This
can be expressed as follows:
A
P = i
4) Present value of an uneven periodic sum
In some investment decisions of a firm, the returns may not be constant. In such cases, the PV is calculated as
follows:

P=

A1

(1+i)

A2

(1+i)

A3

(1+i)

++

An

(1+i)n

or
PV= A1 PVIF (i, 1) + A2 PVIF (i, 2) + A3 PVIF (i, 3) + A4 PVIF (i, 4) +. + An PVIF (i, n)
5) Capital recovery factor
Capital recovery factor is the annuity of an investment for a specified time at a given rate of interest. The
reciprocal of the present value annuity factor is called capital recovery factor.
n
i (1+ I )
A = PVAn ( 1+i )n1

i (1+ I )
( 1+i )n1

is known as the Capital Recovery Factor.

Q.3:- Write short notes on:- a) Operating Leverage, b) Financial leverage, c) Combined leverage.
Ans.

Operating Leverage
Operating leverage arises due to the presence of fixed operating expenses in the firms income flows.
The operating leverage takes place when a change in revenue produces a 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 a small decline in sales may reduce and even wipe out the EBIT.
There are three categories of a compatys operating costs.
Fixed costs Fixed costs are those which do not vary with an increase in production or sales activities
for a particular period of time. These are incurred irrespective of the income and value of sales and
generally cannot be reduced.
Variable costs Variable costs are those which vary in direct proportion to output and sales. An increase
or decrease in production or sales activities will have a direct effect on such types of costs incurred.

Semi-variable costs Semi-variable costs are those which are partly fixed and partly variable in nature.
These costs are typically of fixed nature up to a certain level beyond which they vary with the firms activities.

Application of operating leverage

Measurement of business risk
Risk refers to the uncertain conditions in which a company performs. A business risk is measured using
the DOL and the formula of DOL is:
DOL = {Q(SVV)} / {Q(SVV)VF}
The greater the DOL, the more sensitive will be the EBIT to a given change in unit sales. A high DOL is
a measure of high business risk and vice versa.
Production planning
A change in production method increases or decreases DOL. A firm can change its cost structure by
mechanising its operations, thereby, reducing its variable costs and increasing its fixed costs. This will
have a positive impact on DOL. This situation can be justified only if the company is confident of
achieving a higher amount of sales thereby increasing its earnings.

Financial Leverage
Financial 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
Financial leverage refers to a firm's use of fixed-charge securities like debentures and preference shares in its
plan of financing the assets. The Degree of Financial Leverage (DFL) is a more precise measurement. It
examines the effect of the fixed sources of funds on EPS.
DFL = %change in EPS
%change in EBIT
DFL={EPS/EPS} {EBIT/EBIT}
Or DFL = EBIT {EBIT.I.{Dp/(1-T)}}
I is Interest, Dp is dividend on preference shares, T is tax rate.

Use of financial leverage

One main goal of financial planning is to devise a capital structure in order to provide a high return to
equity holders. But at the same time, this should not be done with heavy debt financing which drives the
company on to the brink of winding up.

Impact of financial leverage

Highly leveraged firms are considered very risky and lenders and creditors may refuse to lend them
further to fuel their expansion activities. On being forced to continue lending, they may do so with their
own conditions like earning a minimum of X% EBIT or stipulating higher interest rates than the market
rates or no further mortgage of securities.

Total or Combined Leverage

The 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 in EPS. 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. The combined effect is quite significant for the earnings
available to ordinary shareholders. Combined leverage is the product of DOL and DFL.
Q( SV )
DTL = Q ( S V ) FI {D p /(1T )}
Where DTL = Degree of Total Leverage

Uses of Degree of Total Leverage (DTL)

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

Q.4:- Explain the factors affecting Capital Structure. Solve the given problem.
Ans

Factors Affecting Capital Structure

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 capital
structure decision is a continuous one and has to be taken whenever a firm needs additional finance. 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.
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
The companies with high level of Earnings Before Interest and Taxes (EBIT) can make profitable use of the
high degree of leverage to increase return on the shareholders equity.
Debt-equity ratio is another parameter that comes into play here. Debtequity ratio is an indicator of the
relative contribution of creditors and owners. The debt component includes both long-term and short-term
debt, and this is represented as debt/equity. A debt-equity ratio of 2:1 indicates that for every 1 unit of
equity, the company can raise 2 units of debt.
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 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.
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 by way 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.
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 I
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

Firm A
Rs. 1,00,000
Nil
Rs. 1,00,000
15%
10%
Rs. 6,66,667
Nil
Rs. 6,66,667

Firm B
Rs. 1,00,000
Rs. 25,000
Rs. 75,000
15%
10%
Rs. 5,00,000
Rs. 2,50,000
Rs. 7,50,000

Solution for the given problem.

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% * 250000/750000 + 15% * 500000/750000 = 3.34 + 10 = 13.3%
Interpretation:
The use of debt has caused the total value of the firm to increase and the overall cost of capital to decrease.
Q.5:- Explain all the sources of risk in capital budgeting with examples. Solve the given problem:
Ans

Sources of risk
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.
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.

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.
An investment will have an initial outlay of Rs 100,000. It is expected to generate cash inflows. Cash
inflow for four years.
Year
Cash Flow
1

40000

50000

15000

30000

If the risk free rate and the risk premium is 10%,

a) Compute the NPV using the risk free rate
b) Compute NPV using risk-adjusted discount rate

Solution for the given problem :

a) PV Using Risk Free Rate:
Cash flows (inflows)
Rs.
40000
50000
15000
30000
PV of cash inflows
PV of cash outflows
NPV

Year
1
2
3
4

PV factor at
10%
0.909
0.826
0.751
0.683

PV of cash flows
(inflows)
36360
41300
11265
20490
109415

(100000)
9415

b) NPV Using Risk-adjusted Discount Rate

Year
1
2
3
4

Cash inflows Rs.

40000
50000
15000
30000
PV of cash inflows
PV of cash outflows
NPV

PV factor at 20%
0.833
0.694
0.579
0.482

PV of cash inflows
33320
34700
8685
14460
91165

(100000)
(8835)

Interpretation:
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.
Q.6:- Explain the objectives of Cash Management. Write about the Baumol model with their
assumptions.
Ans

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
In 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.
The other advantage of meeting the payments on time is that it prevents bankruptcy that arises out of the
firms inability to honour its commitments. At the same time, care should be taken not to keep large cash
reserves as it involves high cost.
Minimising funds held in the form of cash balances
Trying 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 a non-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 synchronisation 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 mailing
There is a time lag between the dispatch of goods and preparation ofinvoice. Reduction of this gap will
bring in early remittances.
Collection of cheques and remittances of cash
Generally, 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.
Float
The 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
realised or paid respectively.
Likewise the firm may take benefit of payment float.
Net float = Payment float Collection float
When net float is positive, the balance in the firms books is less than the banks books; when net float is
negative; the firms book balance is higher than in the banks books.

Baumol model
The Baumol model helps in determining the minimum amount of cash that a 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 cash management 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.
Cash balances are refilled and brought back to normal levels by the sale of securities. The average cash balance
is C/2. The firm buys securities as and when it has above-normal cash balances. This pattern is explained in
figure:Baumol Model
C
Cash balance

C/2

Average

T1

T2

T3

Time

Baumol cut-off model

The total cost associated with cash management has two elements:
Cost of conversion of marketable securities into cash and
Opportunity cost
The firm incurs a holding cost for keeping cash balance, which is the opportunity cost. Opportunity cost is the
benefit foregone on the next best alternative for the current action. Holding cost is k*(C/2). The firm also incurs
a transaction cost whenever it converts its marketable securities into cash. Total number of transactions during
the year will be the total funds requirement, T, divided by the cash balance, C, i.e., T/C. If per transaction cost
is c, then the total transaction cost is c*(T/C). The total annual cost of the demand for cash is k*(C/2) +
c*(T/C).
The Baumol Cut-off Model is represented in figure:Baumol Cut-off Model

Total Cost

Cost

Holding Cost

Transaction Cost
Cash Balance

C*

The optimum cash balance, C*, is obtained when the total cost is minimum, which is expressed as:

C* = 2cT/k
where C* is the optimum cash balance,
c is the cost per transaction,
T is the total cash needed during the year and
k is the opportunity cost of holding cash balance.
The optimum cash balance will increase with the increase in per-transaction cost and total funds required, and
decrease with the opportunity cost.