Financial Management

Q 1. Define financial management?

According to Joseph and Massie, “Financial management is the operational activity of a business that is responsible
for obtaining and effectively utilizing the funds necessary for efficient operations”.

According to Van Horne Wachowicz, “Financial management is concerned with the acquisition, financing and
management of assets with some overall goal in mind”.

The financial management is concerned with planning and controlling of firms financial resources. In other words it
is mainly concerned with acquisition and use of funds.

Q 2. What is Money market?

A segment of the financial market in which financial instruments with high liquidity and very short maturities are
traded. The money market is used by participants as a means for borrowing and lending in the short term, from
several days to just under a year. Money market securities consist of negotiable certificates of deposit (CDs),
bankers acceptances, U.S. Treasury bills, commercial paper, municipal notes, federal funds and repurchase
agreements (repos).

Q 3. What is Time value of Money?

Time Value of Money is based on the concept that a dollar that you have today is worth more than the promise or
expectation that you will receive a dollar in the future. Money that you hold today is worth more because you can
invest it and earn interest. After all, you should receive some compensation for foregoing spending. For instance,
you can invest your dollar for one year at a 6% annual interest rate and accumulate $1.06 at the end of the year. You
can say that the future value of the dollar is $1.06 given a 6% interest rate and a one-year period. It follows that
the present value of the $1.06 you expect to receive in one year is only $1.

Time Value of Money (TVM) is an important concept in financial management. It can be used to compare
investment alternatives and to solve problems involving loans, mortgages, leases, savings, and annuities.

Q 4. What is time line?

A timeline is a graphical device used to clarify the timing of the cash flows for an investment. Each tick represents
one time period.

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Q 5. What is Pay Back period?

Payback period is the one of the oldest and most widely used method used for evaluating a capital investment
proposal. As the name implies it refers to the time required to recover the initial investment or the initial cash outlay
as it is called in financial terms.

The payback period of a given investment or project is an important determinant of whether to undertake the
position or project, as longer payback periods are typically not desirable for investment positions.

Calculated as: Cost of Project / Annual Cash Inflow.

There are two main problems with the payback period method:

1. It ignores any benefits that occur after the payback period and, therefore, does not measure profitability.

2. It ignores the time value of money.

Because of these reasons, other methods of capital budgeting, like net present value, internal rate of return or
discounted cash flow, are generally preferred.

Q 6. What is Discount payback?

Discounting payback is a capital budgeting procedure used to determine the profitability of a project. In contrast to
an NPV analysis, which provides the overall value of an project, a discounted payback period gives the number of
years it takes to break even from undertaking the initial expenditure. Future cash flows are considered are
discounted to time "zero". This procedure is similar to a payback period; however, the payback period only measure
how long it take for the initial cash outflow to be paid back, ignoring the time value of money.
Projects that have a negative net present value will not have a discounted payback period, because the initial outlay
will never be fully repaid. This is in contrast to a payback period where the gross inflow of future cash flows could
be greater than the initial outflow, but when the inflows are discounted, the NPV is negative.

Q 7. What is Accounting rate of return?

The accounting rate of return is used in capital budgeting to estimate whether you should proceed with an
investment. The calculation is the accounting profit from the project, divided by the initial investment in the project.
You would then accept a project if the measure yields a percentage that exceeds a certain hurdle rate used by the
company as its minimum rate of return.

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The formula for the accounting rate of return is: Average annual accounting profit / Initial investment

Where the profit is calculated as the profit related to the project using all accruals and non-cash expenses required
under the GAAP or IFRS frameworks (thus, it includes the costs of depreciation and amortization). If the project
involves cost reduction instead of earning a profit, then the numerator is the amount of cost savings generated by the
project.
Where the initial investment is calculated as the fixed asset investment plus any change in working caused by the
investment.

Q 8. What is Internal Rate of Return?

The IRR is the interest rate that makes the net present value of all cash flow equal to zero. In financial analysis
terms, the IRR can be defined a discount rate at which the present value of a series of investments is equal to the
present value of the returns on those investments.

The internal rate of return (or IRR) is a common financial valuation metric used by financial analysts to calculate
and assess the financial attractiveness / viability of capital intensive projects or investments.

As the IRR is normally easier to understand than the result of discounted (i.e. the net present value or NPV) for non-
financial executives, it is often used to explain and justify investment decisions, although a good financial modeler
should know that the IRR is after all an estimated value, especially when calculated in Excel, and should be used in
conjunction with other financial metrics such as the NPV and comparable valuation multiples when presenting a
business or investment case.

Q 9. What is Profitability Index?

Profitability index (PI), alternatively referred to as a profit investment ratio or a value investment ratio, is a method
for discerning the relationship between the costs and benefits of investing in a possible project. It calculates the
cost/benefit ratio of the present value (PV) of a project’s future cash over the price of the project’s initial investment.

This formula is commonly written as PI = PV of future cash flows ÷ initial investment. The figure this formula
yields helps investors decide on whether or not a project is financially attractive enough to pursue.

A profitability index of 1 designates the lowest measure by which it is logically acceptable to pursue a project. A
value lower than 1 suggests that the project's possible value is lower than the initial investment. This means that the

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investor does not make a profit and should not invest in the project. A value exceeding 1 indicates financial gain,
and as the number goes up, the investment becomes more attractive.

Q 10. What is Modified IRR method?

While the internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR, the modified
IRR assumes that positive cash flows are reinvested at the firm's cost of capital, and the initial outlays are financed
at the firm's financing cost. Therefore, MIRR more accurately reflects the cost and profitability of a project.

The formula for MIRR is:

Q 11. What is Net Present Value?

The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in
capital budgeting to analyze the profitability of an investment or project.

NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield.
Formula:

In addition to the formula, net present value can often be calculated using tables, and spreadsheets such as
Microsoft Excel.

NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns
into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the
project should probably be rejected because cash flows will also be negative.

Q 12. What is market risk?

Risk is the variability of actual return from the expected return associated with a given asset or investment.
Risk which is common to an entire class of assets or liabilities. The value of investments may decline over a given

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time period simply because of economic changes or other events that impact large portions of the market. Asset
allocation and diversification can protect against market risk because different portions of the market tend
to underperform at different times. Also called systematic risk.

The greater the variability – the greater the risk. For ex: Shares

The less the variability – the less the risk. For ex: Bills

Q 13. What is average rate of return?

The average rate of return is an accounting method of investment appraisal which determines return on
investment by totaling the cash flows over the years for which the money was invested and then dividing that
amount by the number of years. The average rate of return does not assure that the cash inflows are the same in a
given year; it simply guarantees that the return averages out to the average rate of return.

ARR is a method which is often used internally when selecting projects. It can also be used to measure the
performance of projects and subsidiaries within an organization. It is rarely used by investors because cash flows are
more important to investors and is based on numbers that includes non-cash items. This method does not adjust for
the greater risk to. Finally longer term forecasts there are better alternatives which are easier to calculate.

Q 14. What is cost of capital?

According to Solomon Ezra, “Cost of capital is the minimum required rate of earnings or the cut-off rate of capital
expenditure.”

According to Hampton, John J, “The rate of return the firm requires, from investment in order to increase the value
of the firm in the market place.”

Cost of capital represents the rate of return that the firm must pay to the fund suppliers, who have provided the
capital. In other words, cost of capital is the weighted average cost of various sources of finance used by the firm.
The sources are equity, preference, long-term debt and short-term debt.

Q 15. What is gross working capital and net working capital?

Gross Working Capital – Cash and short-term assets expected to be converted to cash within a year. Businesses
use the calculation of gross working capital to measure cash flow. Gross working capital does not account
for current liabilities, but is simply the measure of total cash and cash equivalent on hand. Gross working capital
tends not to add much to the business' assets, but helps keep it running on a day-to-day basis.

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Net Working Capital – Cash and short-term assets expected to be converted to cash within a year less short-term
liabilities. Businesses use net working capital to measure cash flow and the ability to service debts. A positive net
working capital indicates that the firm has money in order to maintain or expand its operations. Net working capital
tends not to add much to the business' assets, but helps keep it running on a day-to-day basis

Q 16. What is agency cost?

Agency costs usually refer to the conflicts between shareholders and their company's managers. A shareholder wants
the manager to make decisions which will increase the share value. Managers, instead, would prefer to expand the
business and increase their salaries, which may not necessarily increase share value.

How It Works/Example: In a publicly-held company, agency costs occur when a company's management or "agent"
places his own personal financial interests above those of the shareholder or "principal."
Agency costs can be either:
A) the costs incurred if the agent uses to company's resources for his own benefit; or
B) the cost of techniques that principals use to prevent the agent from prioritizing his interests over the shareholders'

Q 17. What is financial risk?

Financial risk is the possibility that shareholders will lose money when they invest in a company that has debt, if the
company's cash flow proves inadequate to meet its financial obligations. When a company uses debt financing, its
creditors will be repaid before its shareholders if the company becomes insolvent.

Financial risk is the possibility of whether a bond issuer will default, by failing to repay principal and/or interest in a
timely manner. Usually bonds issued by the federal government, for the most part, are immune from default (if the
government needs money. more is printed). Bonds issued by corporations are more probable to be defaulted on,
since companies often go bankrupt. Municipalities occasionally default as well, but it is much less common. Can
also be called default risk or credit risk.

Q 18. What is Operating Leverage?

Operating leverage is a measurement of the degree to which a firm or project incurs a combination of fixed and
variable costs.
1. A business that makes few sales, with each sale providing a very high gross margin, is said to be highly
leveraged. A business that makes many sales, with each sale contributing a very slight margin, is said to be less
leveraged. As the volume of sales in a business increases, each new sale contributes less to fixed costs and more to

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profitability.
2. A business that has a higher proportion of fixed costs and a lower proportion of variable costs is said to have used
more operating leverage. Those businesses with lower fixed costs and higher variable costs are said to employ less
operating leverage.

Q 19. What is financial leverage?

According to Lawrence, “financial leverage is the ability of the firm to use fixed financial charges to magnify the
effects of changes in EBIT on the firm’s earnings per share.

Financial leverage may be defined as the payment of fixed rate of interest for the use of fixed interest bearing
securities, to magnify the rate of return as equity shares. It is also known as ‘trading as equity’.

Q 20. What is combined leverage?

Combined leverage is the product of financial and operating leverage. Both the leverages are closely related with the
ascertainment of the firm’s ability to cover fixed charges (fixed operating costs in the case of operating leverage and
fixed financial costs in the case of financial leverage) the sum of them all gives us the total leverage or combined
leverage. Degree of combined leverage is the percentage change in EPS due to the percentage change in sales.

Q 21. What is Weighted Average Cost of Capital – WACC?

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its
security holders to finance its assets.

The WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors,
owners, and other providers of capital, or they will invest elsewhere. Companies raise money from a number of
sources: common equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants and
options, pension liabilities, executive stock options, governmental subsidies, and so on. Different securities, which
represent different sources of finance, are expected to generate different returns. The WACC is calculated taking
into account the relative weights of each component of the capital structure. The more complex the company's
capital structure, the more laborious it is to calculate the WACC.

Q 22. Difference between stock split and bonus issue?

In case of bonus shares the value of the share decreases proportionate to the number of bonus shares issued. for eg:
if company issues bonus shares in ratio of 1:1 and the price of share is 900 , then after bonus issue, the
corresponding value of the share gets Rs. 450.genreally company issue this in place of giving dividends. The market
capitalisation doesn’t get affected. As if shares doubles the prices is halved.

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Whereas in split shares the face value of share decreases. Generally the face value of share is 10 Rs. but face value
can be high. Eg: if face value is 100 Rs. the company can split the share in ratio of 100:10. Now the person holding
100 shares of Rs 100 now will hold 1000 shares of 10 Rs each. Now shares can be traded more frequently and this
will in turn increase the liquidity of the share.

Q 23. What is future value and present value?

Future value is the value of an asset at a specific date. It measures the nominal future sum of money that a given
sum of money is "worth" at a specified time in the future assuming a certain interest, or more generally, rate of
return; it is the present value multiplied by the accumulation function. The value does not include corrections for
inflation or other factors that affect the true value of money in the future. This is used in time value of
money calculations.

Present value, also known as present discounted value, is the value on a given date of a payment or series of
payments made at other times. If the payments are in the future, they are discounted to reflect the time value of
money and other factors such as investment risk. If they are in the past, their value is correspondingly enhanced to
reflect that those payments have been (or could have been) earning interest in the intervening time. Present value
calculations are widely used in business and economics to provide a means to compare cash flows at different times
on a meaningful "like to like" basis.

Q 24. What is cash cycle?

The length of time between the purchase of raw materials and the collection of accounts receivable generated in
the sale of the product, also called cash conversion cycle.

The cash cycle, also called the cash conversion cycle, is a measure of the length of time it takes to get from paying
cash for stock to getting cash after selling it. It is equal to:

Stock days + debtor days - creditor days

Q 25. Difference between Diversifiable and non-Diversifiable?

Diversifiable risk is the risk which can be mitigated by investing in different companies, different sectors, different
assets and also different regions. Here we are trying to minimize the risk of huge loss by taking the whole risk
against one or few companies/ sectors / assets / regions.

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Non-Diversifiable risk cannot be mitigated at all. This is the risk you are exposed to in individual investment. Every
investment holds Market risk, i.e. uncertainty of market moving up or down and respective movement of your
investment.

Q 26. What is optimum capital structure?

The best debt-to-equity ratio for a firm that maximizes its value. The optimal capital structure for a company is one
which offers a balance between the ideal debt-to-equity range and minimizes the firm's cost of capital. In theory,
debt financing generally offers the lowest cost of capital due to its tax deductibility. However, it is rarely the optimal
structure since a company's risk generally increases as debt increase

A company's ratio of short and long-term debt should also be considered when examining its capital structure.
Capital structure is most often referred to as a firm's debt-to-equity ratio, which provides insight into how risky a
company is for potential investors. Determining an optimal capital is a chief requirement of any firm’s corporate
finance department.

Q 27. What is commodity market?

Commodity market is a physical or virtual marketplace for buying, selling and trading raw or primary products. For
investors' purposes there are currently about 50 major commodity markets worldwide that facilitate investment trade
in nearly 100 primary commodities.

Commodities are split into two types: hard and soft commodities. Hard commodities are typically natural resources
that must be mined or extracted (gold, rubber, oil, etc.), whereas soft commodities are agricultural products or
livestock (corn, wheat, coffee, sugar, soybeans, pork, etc.)

There are numerous ways to invest in commodities. An investor can purchase stock in corporations whose business
relies on commodities prices, or purchase mutual funds, index funds or exchange-traded funds (ETFs) that have a
focus on commodities-related companies. The most direct way of investing in commodities is by buying into a
futures contract.

Q 28. What is business and financial risk?

Business Risk
A company's business risk is the risk of the firm's assets when no debt is used. Business risk is the risk inherent in
the company's operations. As a result, there are many factors that can affect business risk: the more volatile these
factors, the riskier the company. Some of those factors are as follows:
Sales risk - Sales risk is affected by demand for the company's product as well as the price per unit of the product.

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Input-cost risk - Input-cost risk is the volatility of the inputs into a company's product as well as the company's
ability to change pricing if input costs change.
Financial Risk
A company's financial risk, however, takes into account a company's leverage. If a company has a high amount of
leverage, the financial risk to stockholders is high - meaning if a company cannot cover its debt and enters
bankruptcy, the risk to stockholders not getting satisfied monetarily is high.

Q 29. What is capital budgeting?

According to Charles T. Horngren, “Capital budgeting is long-term planning for making and financing proposed
capital outlays”

Capital expenditure budget or capital budgeting is a process of making decision regarding investments in fixed
assets which are not meant for sale such as land, building ,machinery or furniture. The word investment refers to
the expenditure which is required to be made in connection which the acquisition and the development by which
management selects those investment proposals which are worthwhile for investing available funds . For this
purpose, management is to decide whether or not to acquire or add to or replace fixed assets in the light of overall
objectives of the firm.

Q 30. What is underwriting?

Underwriting – contract makes the share predictable and removes the element of uncertainty in the subscription. It
means a person gives an assurance to the issuer to the effect that the former would subscribe to the securities offered
in the event of non subscription by the person to whom they were offered. The person who assured is called an
underwriter.

Underwriters are divided into 2 categories:

1. Financial institutions and banks.

2. Brokers and approved investment companies.

Q 31. Who is debenture trustee and what is his role?

A debenture trustee means a trustee of a trust deed for securing any issue of debentures of a body corporate. To act
as debenture trustee, the entity should either be a scheduled bank carrying on commercial activity, a public financial
institution, an insurance company, or a body corporate. The entity should be registered with SEBI to act as a
debenture trustee.

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Role of debenture trustee

1. Call for periodical reports from the body corporate, i.e., issuer of debentures.

2. Take possession of trust property in accordance with the provisions of the trustee deed.

3. Enforce security in the interest of the debenture holders.

4. Appoint a nominee director on the board of the body corporate when required.

5. Exercise due diligence to ensure compliance by the body corporate with the provisions of the Companies
Act, the listing agreement of the stock exchange or the trust deed.

6. Inform the Board immediately of any breach of trust deed or provision of any law.

Q 32. What is Profit maximization?

Profit maximization is a primary objective and a social obligation.

It is a process that companies undergo to determine the best output and price levels in order to maximize its return.
The company will usually adjust influential factors such as production costs, sale prices, and output levels as a way
of reaching its profit goal.

There are two main profit maximization methods used, and they are Marginal Cost-Marginal Revenue Method
and Total Cost-Total Revenue Method.

Profit maximization is a good thing for a company, but can be a bad thing for consumers if the company starts to use
cheaper products or decides to raise prices.

Q 33. What is Wealth maximization?

Wealth maximization has been accepted by the finance managers, because it overcomes the limitations of profit
maximization. Wealth maximization means maximizing the net wealth of the company’s share holders. Wealth
maximization is possible only when the company pursues policies that would increase the market value of shares of
the company.

Wealth maximization is based on the concept of cash flows. It considers time value of money translates cash flows
occurring of different periods into a comparable value of cash flows is considered critically in all decisions as it
incorporates the risk associated with the cash flow stream.

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Q 34. Write a note on stability of Dividend.

Under stability of dividend policy, stable or almost stable rate of dividend is maintained. Company maintains
reserves in the years of prosperity and uses them in paying dividend in lean year. If company follows stable dividend
policy, the market price of its shares shall be higher.

3 forms of stability may be distinguished:

1. Constant dividend per share or dividend rate.

2. Constant payout.
3. Constant dividend per share plus extra dividend.
There are reasons why investors prefer stable dividend policy. Main reasons are: -
1. Confidence among shareholders.
2. Income Conscious Investors.
3. Stability in Market Price of Shares.
4. Encouragement to Institutional Investors.

Q 35. What is trading on equity?

Trading on equity is sometimes referred to as financial leverage or the leverage factor.

Trading on equity occurs when a corporation uses bonds, other debt, and preferred stock to increase its earnings on
common stock. For example, a corporation might use long term debt to purchase assets that are expected to earn
more than the interest on the debt. The earnings in excess of the interest expense on the new debt will increase the
earnings of the corporation’s common stockholders. The increase in earnings indicates that the corporation was
successful in trading on equity.

If the newly purchased assets earn less than the interest expense on the new debt, the earnings of the common
stockholders will decrease.

Q 36. What do mean by permanent and temporary working capital?

Permanent working capital refers to the minimum amount of all current assets that is required at all times to
ensure a minimum level of uninterrupted business operations. Some minimum amount of raw materials, work-in-
progress, bank balance, finished goods etc., and a business has to carry all the time irrespective of the level of
manufacturing or marketing operations. This level of working capital is referred to as core working capital or core
current assets.

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The temporary or varying working capital varies with the volume of operations. It fluctuates with the scale of
operations. This is the additional working capital required from time to time over and above the permanent or fixed
working capital. During seasons, more production/sales take place resulting in larger working capital needs. The
reverse is true during off-seasons. As seasons vary, temporary working capital requirement moves up and down.
Temporary working capital can be financed through short term funds like current liabilities.

Q 37. What do you mean by corporate governance?

Corporate governance is a term that refers broadly to the rules, processes, or laws by which business are operated,
regulated and controlled. The term can refer to internal factor defined by the officers, stockholders or constitution of
corporation, as well as to external focus such as consumer groups, clients, and government regulations.

Characteristics of Corporate governance

1) Discipline
2) Transparency
3) Independence
4) Accountability
5) Responsibility
Q 38. What do you mean by Forex market?

According to Kindleberger “Foreign exchange market is a place where foreign money’s are bought and sold”.

Forex (Foreign Exchange market) is an inter-bank market that took shape in 1971 when global trade shifted from
fixed exchange rates to floating ones. This is a set of transactions among forex market agents involving exchange of
specified sums of money in a currency unit of any given nation for currency of another nation at an agreed rate as of
any specified date. During exchange, the exchange rate of one currency to another currency is determined simply: by
supply and demand – exchange to which both parties agree.

The foreign exchange market is the largest and most liquid financial market in the world. It includes trading between
large banks like central banks, currency speculators, corporate, governments and financial institutions.

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Q 39. What are sweat equity shares?

“Sweat Equity Shares” means equity shares issued by the company to employees or directors at a discount or for
consideration other than cash for providing know how or making available rights in the nature of intellectual
property rights or value additions, by whatever name called. (Section 79A of the Companies Act, 1956 permits a
company to issue sweat equity shares of a company subject to the guidelines to be issued in this regard.)

Conditions

· Such issue is authorised by a special resolution of the company in the general meeting

· Such resolution specifies the number of shares, current market price, consideration, if any, and the class or
classes of the directors or employees to whom such shares are to be issued

· Such issue is after an expiry of one year from the date on which the company was entitled to commence
business.

Q 40. What do you mean by stable dividend?

Stabile dividends have a positive impact on the market price of shares. If dividends are stable it reduces the chance
of speculation in the market and investors desiring a fixed rate of return will naturally be attracted towards such
securities. Stability of dividend means either a constant amount per shares or a constant percentage of net earnings.

A stable dividend policy may be established in any of the following three forms:

i) Constant dividend per share

ii) Constant payout ratio
iii) Stable rupee dividend plus extra dividend

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