ANSWER.

1
The liquidity decision is concerned with the management of the current
assets. Which is a pre-requisite to long terms 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, there is a conflicts 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 fund should be
invested optimally in the individual current assets to avoid inadequacy or
excessive locking up of fund thus, the liquidity should balance the basic two
ingredients i.e. working capital management and the efficient allocation of
fund on the individual currents 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 utilization of spontaneous finance effectively

Dividend Decisions
Dividends are payouts to shareholders. Dividend are paid to keep the
shareholders Happy .Dividend decision is a major decision made by the
finance manger .Dividend is that portion of profit of a company which is
distributed among its shareholders according to the resolution passed in the
meeting of the board of director. 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 profit should be
transferred to ted reserve fund to meet any unforeseen contingencies and
how much should be distributed to the shareholders. Dividend policy
influences the dividend yield on shares. Dividend yield is an important
determinant of an investor, s attitude towards the security (stock) in his
portfolio management decisions on

The following issues need adequate consideration in deciding on

dividend policy.

Preferences of shareholders Do they want cash dividend or capital

again?
Current financial requirement of the company
Legal Constraints on paying dividends
Striking an optimum balance between desire of shareholders and the
companys funds requirement

ANSWER. 2
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
given rate of interest there are 2 way of answering this question
1. One way is to answer it by a rule known as rule of 72 this rules
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 ,for instance if the given rates
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
rules 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 year as 7.25 year {(o.35+69/10) or
(0.35+ 6.9)}
Solve the problem
FVn =PV (1+i/m)mxn
M=123 =4 (QUARTLY COMPAUNDING)
1000 (1+0.10/4)4*2
1000(1+0.10/4)8
Rs: - 1216
The amount of rs 1000 after 2 year would be Rs 1218
Present value given the interest rate compounding technique can be
used to compare the cash flows separated by more the one time period
with this technique the amount of present cash can be convertated into
an amount of cash of equivalent value in future
Likewise we may be interested in converting the future cash flow into
their present value

Present value can be simply defined as the current value of a future sum
it can also be define as the amt to be invested today (present value ) at
given rate of interest over a specified period to equal the future sum.
Present value of a single flow : Ascertaining present value (PV) is
simply the reverse of finding future value (FV) Hence the for FV can be
simply transferred into the pv formula .thus we can determine the PV of a
future cash flow or a stream of future cash flows using the formula
PV = FVn/(1+(i)n
PV =present value
FVn = amount (future value aftern)
I= interest rate
n= number of year for which discounting is done
Present value of even series of cash flows: in a business scenario
the business man will receive periodic amounts (annuity) for a certain
number of year ,an investment done today will fetch him return spread
over a period of time ,he would like to know if it is worthwhile to invest a
certain sum now in anticipation of return he expects after a certain
number of year ,he should therefore forego.
Present value of perpetuity: An annuity for an infinite time period is
perpetuity; it occurs indefinitely .A person may like to find out the present
value of his investment assuming he will receive a constant return year
after year
Present value of an uneven periodic sum : In some investment
decision of a firm the returns may not be constant .in such cases the PV
is calculated as follows
P=A1/(1+i)1+ A2/(1+i)2+A3(1+i)3+.+An/(1+i)n
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
ANSWER. 3
Operating Leverage:-

Operating leverage arise due to the presence of fixed operating expenses

in the firms income flows. it has 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 a
greater change in earnings before interest and taxes (EBIT)
Operating leverage having a three categories
Fixed Costs
Variable Costs
Semi-Variable cost
Fixed cost:
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.
Example: that a firm named xyz enterprise is planning to start a new
business. the man aspects that the firm should concentrate on are
salaries to the employee, rent ,insurance of the firm and the
accountancy costs .All these aspects are referred to as fixed cost.
Variable cost:
Variable cost are those which vary in direct proportion to output and
sales .an increase or decrease in production or sales activates will have
a direct effect on such types of cost incurred
Example: we have discussed about fixed cost in the above context
now, the firm has to concentrate on some other feature like cost of
labour amount of raw material, and the administrative expenses. All
these feature relate to are referred as variable cost
Semi-Variable cost:
Semi variable costs are those are those which are partly fixed and
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
Example: After considering both variable and fixed them firm should
concentrate on some other like production cost and the wages paid to
the workers. at some points in time, these will acts as fixed costs and
can also shift to variable costs. These features related to or are
referred to as semi- variable Costs

Application of operating leverage

1. Business risk measurement :-Formula of DOL is DOL= {Q(SV)} /{Q(S-V)-F}
2. Production Planning: - A Change in production method
increases or decreases DOL. A firm can change its cost
structure by mechanizing its operations ,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 achivieving a higher amount of
sales thereby increasing its earning

1. Financial leverages
Financial leverages relates to the financing activities of a firm and
measures the effect of earnings per share (EPS) of the company shares
A companys sources of fund fall under two categories
Those which carry fixed financial charges like debentures, bond
and preference shares.
Those which do not carry any fixed charges like equity
Financial leverages refer to a firm use of fixed charges security like
debenture and preference shares (though the latter is not always included in
debt) in its plan of financing the assets.
The concept of financial leverages 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 leverages .A company earning more by the use of assets
funded by fixed sources is said to be having a favourable or positive leverage
. unfavourable leverages occurs when the firm is not earning sufficiently to
cover the cost of fund .financial leverages is also referred to as trading on
equity.
Capital Structure refer to the permanent long terms financing of a company
represented by a mix of long term debt ,preferences shares and net worth
(which included paid-up capital,reserves,and surplus)
Financial leverages and its effects are a crucial consideration in planning and
designing capital structures.

Use of financial leverages studying the DFL at various levels make financial
decision making on the use of fixed sources of fund for funding activities
easy. One can assess the impact of change in EBIT on EPS.
3. Combined leverages
The combination of operating and financial leverages is called combined
leverages .operating leverages affects the firm operating profit EBIT and
financial leverages affects PAT or the EPS .
These cause wide fluctuations in EPS .A Company Having a high level of
operating or financial leverages will find drastic changes 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
The combined effect is quite significant for the earnings available to ordinary
shareholders. Product of DOL and DFL.
Formula :

DTL =Q(S-V)
-----------------------------------Q(S-V)-F-I--{Dp/(1-T(}

ANSWER. 4
Factor affecting 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 target capital structure and the
subsequent financing decision should be made with a view to achieve the
target capital structure .the major factor affecting the capital structure is
leverages .there are also a few other factor affecting them all the factors are
explained briefly here
Leverages: The use of sources of food have a fixed cost attached to them
such as preference shares ,loans from bank and financial institutions and
debenture in the capital structure is known as trading an equity or financial
leverages
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 owner investment similarly,
the EPS will also increase .if preference share capital is used to acquire

assets but the leverages impact is felt more in case of debt because of the
following reason

The cost of debt is usually lower than the cost of presence shares
capital
The interest paid on debt is a deductible charge from profit for
calculating the taxable income while dividend an preference shares is
not the company with high level of earnings before interest and taxes
(EBIT) make profitable use of the high degree of leverages to increase
return on the shareholder ,equity

The other factors to be considered before deciding on an ideal capital

structure are:

Cost of capital
Cash flow projection of the company
Dilution of control
Floatation costs

Cost of capital:
High cost fund should be avoided however attractive an investment
proposition may look like the profit earned may be eaten away by interest
repayments.
Cash flow projections of the company:
Decision should be taken in the light of cash flow projected for the next 3-5
year the company official should not get carried away at the immediate.
Consistent lesser profit are way preferable then high profits in the beginning
and not being able to get any profit after 2 years.
Dilution control:
The top management should have the flexibility to take appropriate decision
at the right time fear of having to share controls and thus beings interfered
by the others often delay 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
Solution for the Q.4
Averages cost capital of firm A is :

10% * 0/Rs.666667+15%*666667/666667=0+15=15%
Averages cost of capital of firm B is :
10%*25000/750000+15% *533333/7500000=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

ANSWER. 5
Definition: Before we start to discuss about risk analysis in capital
budgeting let us first understood the meaning of risk and it relevance n
capital budgeting decision. there are several definition for the terms riskit
may vary depending on the situation context and application risk may be
defined as the possibility that the actual result from an investment will differ
from the expected result .
Types and sources of risk in capital budgeting

Stand alone risk

Portfolio risk
Market risk
Corporate risk

Stand alone risk: stand alone risk of a project is considered when the
project is in isolation stand alone risk is measured by the variability of
expectation returns of the project.
Portfolio risk: A 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 profit 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 projects
Market risk: Market risk is defined as the measure of the unpredictability
of given stock value .however market rise is also referred to as systematic
risk. the market risk has 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 to estimate as it includes a wide range of

external factors like recessions wars political issue etc.
Five different sources of risk:

Project specific risk

Competitive or competitions risk
Industry specific risk
International risk
Market risk

Project specific risk: could be traced to something quite specific to the

project managerial deficiencies or error in estimation of cash flows or discuss
rate may lead to situation of actual cash flow realized being less than the
projected cash flow
Competitive or competition risk : unanticipated actions of a firms will
materially affects the cash flow expected from a project as a result of this the
actual cash flow from a project will be less than that of the forecast .
Technological risk: the changes in technological affect all the firms not
capable of adapting themselves in emerging into a new technology.
Example: the best example in the cash of firms manufacturing motor cycles
with two stock engines when technology innovations replaced the two stork
engines by the four stork engines, those firms which could not adapt to new
technology had to shut down their operation
Commodity risk: it is the risk arising from the effect of price changes on
good produced and marketed
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. Lets us discuss the
groups in industries specific risk as follow
Legal risk: its arises from changes in laws and regulation applicable to the
industries to which the firm belongs
Example: The imposition of services tax on apartments by the government
of India .when the total number of apartment built by a firm engaged in that
industry exceeds prescribed limit .similarly changes in import export policy of
the government of India have led to either closure of some firms or sickness
of some firms

Solve the problem

YE
AR

PV USING RISK FREE RATE

CASH FLOWS
PV FACTORS
PV FLOWS OF CASH
(INFLOWS)Rs.
AT 10%
(INFLOWS)V

1
2
3
4

40000
0.909
36360
50000
0.826
41300
15000
0.751
11265
30000
0.683
20490
PV OF CASH INFLOWS
109415
PV OF CASH OUTFLOW
NPV
9415
NPV can be computed using risk adjusted discount
NPV USING RISK ADJUSTED DISCOUNT RATE
YE
CASH FLOWS
PV FACTORS
PV FLOWS OF CASH
AR (INFLOWS)Rs.
AT 10%
(INFLOWS)
1
2
3
4

40000
50000
15000
30000
PV OF CASH IN FLOWS
PV OF CASH OUTFLOW
NPV

0.833
0.694
0.579
0.482

33320
34700
8685
14460
91165
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 acceptance when
IRR is greater then the risk adjusted discount rate.
ANSWER NO 6
Meaning of cash management before getting into various other concepts of
cash management lets us first discuss the meaning of cash and near cash
assets cash can be classified into or can be used in two senses (see figure
12.1)narrow sense and broader sense
Objective of cash management:
The major objectives of cash management in a firm

Meeting payment schedule

Minimizing funds held in the form of cash balance

Meeting payment schedule: in the normal courses of functioning a firm

has to make various payment s by cash to it employee, suppliers and
infrastructure bills. Firms will also receive cash through sales of its
products and collection of receivable 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 faster cordial relationships with
creditors and supplies .creditor given cash discount if payment are made
in time and the firm can avail this discount as well the other advantages
of meeting the payment on time is that is prevent bankruptcy that arises
out of the firm inability to honour its commitments at the same time .case
should be taken not to keep large cash reserve as it involves high cost.
Minimizing funds held in the form of cash balance : Trying to
achieve the second objective is very difficult a high level cash balance will
help the firm to meet its original form is idle cash and a non earning
assets it is not profitable for firms to maintain huge balance.
A low level of cash balance may mean failure to meet the payment
schedule the aim of cash by bringing about a proper synchronization of
inflow and outflow and to check the spells of cash deficits and cash
surplus seasonal industries are classic examples of mismatches between
inflows and outflows

Prompt billing and mailing

Collection of cheque and remittances of cash
Float

Baumol model : the baumol model helps in determining minimum amount

of cash that a manager can obtain by converting securities into cash .baumol
model is an approach to establish a firm a optimum cash balance under
certainty .As such ,firms attempt to minimize 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 assumption.
The firm is able to forecast its cash requirement 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 charge
with time
The firm will incur the same transaction cost for all conversions of
securities into cash