MB0045 Financial Management Set-1

Q1. What are the implication of operating leverage for a firm. Ans. A firm performs finance functions simultaneously and continuously in the normal course of the business. They do not necessarily occur in a sequence. Finance functions call for skilful planning, control and execution of a firms activities. Let us note at the outset hat shareholders are made better off by a financial decision that increases the value of their shares, Thus while performing the finance function, the financial manager should strive to maximize the market value of shares. Whatever decision does a manger takes need to result in wealth maximization of a shareholder. Investment Decision Investment decision or capital budgeting involves the decision of allocation of capital or commitment of funds to long-term assets that would yield benefits in the future. Two important aspects of the investment decision are: (a) the evaluation of the prospective profitability of new investments, and (b) the measurement of a cut-off rate against that the prospective return of new investments could be compared. Future benefits of investments are difficult to measure and cannot be predicted with certainty. Because of the uncertain future, investment decisions involve risk. Investment proposals should, therefore, be evaluated in terms of both expected return and risk. Besides the decision for investment managers do see where to commit funds when an asset becomes less productive or non-profitable. There is a broad agreement that the correct cut-off rate is the required rate of return or the opportunity cost of capital. However, there are problems in computing the opportunity cost of capital in practice from the available data and information. A decision maker should be aware of capital in practice from the available data and information. A decision maker should be aware of these problems. Financing Decision Financing decision is the second important function to be performed by the financial manager. Broadly, her or she must decide when, where and how to acquire funds to meet the firms investment needs. The central issue before him or her is to determine the proportion of equity and debt. The mix of debt and equity is known as the firms capital structure. The financial manager must strive to obtain the best financing mix or the optimum capital structure for his or her firm. The firms capital structure is considered to be optimum when the market

value of shares is maximized. The use of debt affects the return and risk of shareholders; it may increase the return on equity funds but it always increases risk. A proper balance will have to be struck between return and risk. When the shareholders return is maximized with minimum risk, the market value per share will be maximized and the firms capital structure would be considered optimum. Once the financial manager is able to determine the best combination of debt and equity, he or she must raise the appropriate amount through the best available sources. In practice, a firm considers many other factors such as control, flexibility loan convenience, legal aspects etc. in deciding its capital structure. Dividend Decision Dividend decision is the third major financial decision. The financial manager must decide whether the firm should distribute all profits, or retain them, or distribute a portion and retain the balance. Like the debt policy, the dividend policy should be determined in terms of its impact on the shareholders value. The optimum dividend policy is one that maximizes the market value of the firms shares. Thus if shareholders are not indifferent to the firms dividend policy, the financial manager must determine the optimum dividend payout ratio. The payout ratio is equal to the percentage of dividends to earnings available to shareholders. The financial manager should also consider the questions of dividend stability, bonus shares and cash dividends in practice. Most profitable companies pay cash dividends regularly. Periodically, additional shares, called bonus share (or stock dividend), are also issued to the existing shareholders in addition to the cash dividend. Liquidity Decision Current assets management that affects a firms liquidity is yet another important finances function, in addition to the management of long-term assets. Current assets should be managed efficiently for safeguarding the firm against the dangers of illiquidity and insolvency. Investment in current assets affects the firms profitability. Liquidity and risk. A conflict exists between profitability and liquidity while managing current assets. If the firm does not invest sufficient funds in current assets, it may become illiquid. But it would lose profitability, as idle current assets would not earn anything. Thus, a proper trade-off must be achieved between profitability and liquidity. In order to ensure that neither insufficient nor unnecessary funds are invested in current assets, the financial manager should develop sound techniques of managing current assets. He or she should estimate firms needs for current assets and make sure that funds would be made available when needed. It would thus be clear that financial decisions directly concern the firms decision to acquire or dispose off assets and require commitment or recommitment of funds on a continuous basis. It is in this context that finance functions are said to influence production, marketing and other functions of the firm. This, in consequence, finance functions may affect the size, growth, profitability and risk of the firm, and ultimately, the value of the firm. To quote Ezra Solomon

The function of financial management is to review and control decisions to commit or recommit funds to new or ongoing uses. Thus, in addition to raising funds, financial management is directly concerned with production, marketing and other functions, within an enterprise whenever decisions are about the acquisition or distribution of assets. Various financial functions are intimately connected with each other. For instance, decision pertaining to the proportion in which fixed assets and current assets are mixed determines the risk complexion of the firm. Costs of various methods of financing are affected by this risk. Likewise, dividend decisions influence financing decisions and are themselves influenced by investment decisions. In view of this, finance manager is expected to call upon the expertise of other functional managers of the firm particularly in regard to investment of funds. Decisions pertaining to kinds of fixed assets to be acquired for the firm, level of inventories to be kept in hand, type of customers to be granted credit facilities, terms of credit should be made after consulting production and marketing executives. However, in the management of income finance manager has to act on his own. The determination of dividend policies is almost exclusively a finance function. A finance manager has a final say in decisions on dividends than in asset management decisions. Financial management is looked on as cutting across functional even disciplinary boundaries. It is in such an environment that finance manager works as a part of total management. In principle, a finance manager is held responsible to handle all such problem: that involve money matters. But in actual practice, as noted above, he has to call on the expertise of those in other functional areas to discharge his responsibilities effectively. Q.2 Explain the factors that affect the financial plan of a company? Ans. To help your organization succeed, you should develop a plan that needs to be followed. This applies to starting the company, developing new product, creating a new department or any undertaking that affects the companys future. There are several factors that affect planning in an organization. To create an efficient plan, you need to understand the factors involved in the planning process. A businessman an businesswoman having a meeting image by sumos from Fotolia.com A businessman an businesswoman having a meeting image by sumos from Fotolia.com Organizational planning is affected by many factors. 4e634960-1e4b-65e0-9d0e-ed699b8d2ca4400300

Priorities

In most companies, the priority is generating revenue, and this priority can sometimes interfere with the planning process of any project. For example, if you are in the process of planning a large expansion project and your largest customer suddenly threatens to take their business to your competitor, then you might have to shelve the expansion planning until the customer issue is resolved. When you start the planning process for any project, you need to assign each of the issues facing the company a priority rating. That priority rating will determine what issues will sidetrack you from the planning of your project, and which issues can wait until the process is complete.

Company Resources

Having an idea and developing a plan for your company can help your company to grow and succeed, but if the company does not have the resources to make the plan come together, it can stall progress. One of the first steps to any planning process should be an evaluation of the resources necessary to complete the project, compared to the resources the company has available. Some of the resources to consider are finances, personnel, space requirements, access to materials and vendor relationships.

Forecasting

A company constantly should be forecasting to help prepare for changes in the marketplace. Forecasting sales revenues, materials costs, personnel costs and overhead costs can help a company plan for upcoming projects. Without accurate forecasting, it can be difficult to tell if the plan has any chance of success, if the company has the capabilities to pull off the plan and if the plan will help to strengthen the companys standing within the industry. For example, if your forecasting for the cost of goods has changed due to a sudden increase in material costs, then that can affect elements of your product roll-out plan, including projected profit and the long-term commitment you might need to make to a supplier to try to get the lowest price possible.

Contingency Planning

To successfully plan, an organization needs to have a contingency plan in place. If the company has decided to pursue a new product line, there needs to be a part of the plan that addresses the possibility that the product line will fail. The reallocation of company resources, the acceptable financial losses and the potential public relations problems that a failed product can cause all need to be part of the organizational planning process from the beginning Q.3 Show the relationship between required rate of return and coupon rate on the value of a bond. Ans. It is important for prospective bond buyers to know how to determine the price of a bond because it will indicate the yield received should the bond be purchased. In this section, we will run through some bond price calculations for various types of bond instruments. Bonds can be priced at a premium, discount, or at par. If the bonds price is higher than its par value, it will sell at a premium because its interest rate is higher than current prevailing rates. If the

bonds price is lower than its par value, the bond will sell at a discount because its interest rate is lower than current prevailing interest rates. When you calculate the price of a bond, you are calculating the maximum price you would want to pay for the bond, given the bonds coupon rate in comparison to the average rate most investors are currently receiving in the bond market. Required yield or required rate of return is the interest rate that a security needs to offer in order to encourage investors to purchase it. Usually the required yield on a bond is equal to or greater than the current prevailing interest rates. Fundamentally, however, the price of a bond is the sum of the present values of all expected coupon payments plus the present value of the par value at maturity. Calculating bond price is simple: all we are doing is discounting the known future cash flows. Remember that to calculate present value (PV) which is based on the assumption that each payment is re-invested at some interest rate once it is receivedwe have to know the interest rate that would earn us a known future value. For bond pricing, this interest rate is the required yield. (If the concepts of present and future value are new to you or you are unfamiliar with the calculations, refer to Understanding the Time Value of Money.) Here is the formula for calculating a bonds price, which uses the basic present value (PV) formula:

C = coupon payment n = number of payments i = interest rate, or required yield M = value at maturity, or par value The succession of coupon payments to be received in the future is referred to as an ordinary annuity, which is a series of fixed payments at set intervals over a fixed period of time. (Coupons on a straight bond are paid at ordinary annuity.) The first payment of an ordinary annuity occurs one interval from the time at which the debt security is acquired. The calculation assumes this time is the present.
You may have guessed that the bond pricing formula shown above may be tedious to calculate, as it requires adding the present value of each future coupon payment. Because these payments are paid at an ordinary annuity, however, we can use the shorter PV-of-ordinary-annuity formula that is mathematically equivalent to the summation of all the PVs of future cash flows. This PV-of-ordinary-annuity formula replaces the need to add all the present values of the future coupon. The following diagram illustrates how present value is calculated for an ordinary annuity:

Each full moneybag on the top right represents the fixed coupon payments (future value) received in periods one, two and three. Notice how the present value decreases for those coupon payments that are further into the future the present value of the second coupon payment is worth less than the first coupon and the third coupon is worth the lowest amount today. The farther into the future

a payment is to be received, the less it is worth today is the fundamental concept for which the PV-of-ordinary-annuity formula accounts. It calculates the sum of the present values of all future cash flows, but unlike the bond-pricing formula we saw earlier, it doesnt require that we add the value of each coupon payment. (For more on calculating the time value of annuities, see Anything but Ordinary: Calculating the Present and Future Value of Annuities and Understanding the Time Value of Money. )
By incorporating the annuity model into the bond pricing formula, which requires us to also include the present value of the par value received at maturity, we arrive at the following formula:

Lets go through a basic example to find the price of a plain vanilla bond. Example 1: Calculate the price of a bond with a par value of $1,000 to be paid in ten years, a coupon rate of 10%, and a required yield of 12%. In our example well assume that coupon payments are made semi-annually to bond holders and that the next coupon payment is expected in six months. Here are the steps we have to take to calculate the price: 1. Determine the Number of Coupon Payments: Because two coupon payments will be made each year for ten years, we will have a total of 20 coupon payments. 2. Determine the Value of Each Coupon Payment: Because the coupon payments are semiannual, divide the coupon rate in half. The coupon rate is the percentage off the bonds par value. As a result, each semi-annual coupon payment will be $50 ($1,000 X 0.05). 3. Determine the Semi-Annual Yield: Like the coupon rate, the required yield of 12% must be divided by two because the number of periods used in the calculation has doubled. If we left the required yield at 12%, our bond price would be very low and inaccurate. Therefore, the required semi-annual yield is 6% (0.12/2). 4. Plug the Amounts Into the Formula:

From the above calculation, we have determined that the bond is selling at a discount; the bond price is less than its par value because the required yield of the bond is greater than the coupon rate. The bond must sell at a discount to attract investors, who could find higher interest elsewhere in the prevailing rates. In other words, because investors can make a larger return in the market, they need an extra incentive to invest in the bonds. Accounting for Different Payment Frequencies In the example above coupons were paid semi-annually, so we divided the interest rate and coupon payments in half to represent the two payments per year. You may be now wondering whether there is a formula that does not require steps two and three outlined above, which are required if the coupon payments occur more than once a year. A simple modification of the above formula

will allow you to adjust interest rates and coupon payments to calculate a bond price for any payment frequency:

Notice that the only modification to the original formula is the addition of F, which represents the frequency of coupon payments, or the number of times a year the coupon is paid. Therefore, for bonds paying annual coupons, F would have a value of one. Should a bond pay quarterly payments, F would equal four, and if the bond paid semi-annual coupons, F would be two.

Q.4 Discuss the implication of financial leverage for a firm. Ans. The financial leverage implies the employment of source of funds, involving fixed return so as to cause more than a proportionate change in earnings per share (EPS) due to change in operating profits. Like the operating leverage, financial leverage can be positive when operating profits are increasing and can be negative in the situation of decrease in such profits. In view of these, financial leverage will affect the financial risk of the firm. An important analytical tool for financial leverage is the indifference point at which the EPS/market price is the same for different financial plans under consideration. The objective of this study was to provide additional evidence on the relationship between financial leverage and the market value of common stock. Numerous empirical studies have been done in this area, and, concurrently, many theories have been developed to explain the relationship between financial leverage and the market value of common stock. Because of the methodological weaknesses of past studies, however, no conclusions can be drawn as to the validity of the theories. Theories on financial leverage may be classified into three categories: irrelevance theorem, rising from value indefinitely with increase in financial leverage, and optimal financial leverage. Empirical implications of these categories along with the consequences of serious confounding effects are analyzed. The implications are then compared with evidence from actual events involving financial leverage changes, and distinguished from each other as finely as possible, using simple and multiple regression analyses, normal Z-test, and a simulation technique. The evidence shows that changes in the market value of common stock are positively related to changes in financial leverage for some firms and negatively related for other firms. This evidence is consistent with the existence of an optimal financial leverage for each firm, assuming that financial leverages of firms with a positive relationship are below the optimum and those of firms with a negative relationship are above the optimum. The results of the study do not depend upon the definition of the market portfolio, the definition of the event period, or the choice of financial leverage measure. Betas estimated from equally weighted market portfolios were generally higher than those estimated from value weighted market portfolios during 1981-1982. However, the results of the study were the same for both portfolios. Abnormal returns were computed for seven and two day event periods, and the results were the same for both periods. Seven different definitions of financial leverage were tested, and the results were the same for all measures.

Set-2

Q.1 Discuss the objective of profit maximization vs wealth maximization. The financial management come a long way by shifting its focus from traditional approach to modernapproach. The modern approach focuses on wealth maximization rather thanprofit maximization.Thisgives a longer term horizon for assessment, making way for sustainable performance by businesses.A myopic person or business is mostly concerned about short term benefits. A short term horizon canfulfill objective of earning profit but may not help in creating wealth. It is because wealth creation needsa longer term horizon Therefore, Finance Management or Financial Management emphasizes on wealthmaximization rather than profit maximization.For a business, it is not necessary that profit should be the only objective; it may concentrate on various other aspects like increasing sales, capturing more marketshare etc, which will take care of profitability. So, we can say that profit maximizationis a subset of wealth and being a subset, it will facilitate wealth creationGiving priority to value creation, managers have now shifted from traditional approach to modernapproach of financial management that focuses on wealth maximization. This leads to better and trueevaluation of business. For e.g., under wealth maximization, more importance is given to cash flowsrather than profitability. As it is said that profit is a relative term, it can be a figure in some currency, itcan be in percentage etc. For e.g. a profit of say $10,000 cannot be judged as good or bad for a business,till it is compared with investment, sales etc. Similarly, duration of earning the profit is also importanti.e. whether it is earned in short term or long term.In wealth maximization, major emphasizes is on cash flows rather than profit. So, to evaluate variousalternatives for decision making, cash flows are taken under consideration. For e.g. to measure theworthof a project, criteria like: present value of its cash inflow present value of cash outflows (netpresent value) is taken. This approach considers cash flows rather than profits into consideration andalso use discounting technique to find out worth of a project. Thus, maximization of wealth approachbelieves that money has time value.An obvious question that arises now is that how can we measure wealth. Well, a basic principle is thatultimately wealth maximization should be discovered in increased net worth or value of business. So, tomeasure the same, value of business is said to be a function of two factors - earnings per share andcapitalization rate. And it can be measured by adopting following relation:Value of business = EPS / Capitalization rateAt times, wealth maximization may create conflict, known as agency problem. This describes conflictbetween the owners and managers of firm. As, managers are the agents appointed by owners, a strategicinvestor or the owner of the firm would be majorly concerned about the longer term performance of thebusiness that can lead to maximization of shareholders wealth. Whereas, a manager might focus ontaking such decisions that can bring quick result, so that he/she can get credit for good performance. However, in course of fulfilling the same, a manager might opt for risky decisions which can puton stake the owners objectives.Hence, a manager should align his/her objective to broad objective of organization and achieve atradeoff between risk and return while making decision; keeping in mind the ultimate goal of financial management i.e. to maximize the wealth of its current shareholdershe objections are:-(i) Profit cannot be ascertained well in advance to express the probability of return as future isuncertain. It is not at possible to maximize what cannot be known. (ii) The executive or the decision maker may not have enough confidence in the estimates of future returns so that he does not attempt future to maximize. It is argued that firm's goal cannotbe to

maximize profits but to attain a certain level or rate of profit holding certain share of themarket or certain level of sales. Firms should try to 'satisfy' rather than to 'maximize'(iii) There must be a balance between expected return and risk. The possibility of higher expectedyields are associated with greater risk to recognise such a balance and wealth Maximization isbrought in to the analysis. In such cases, higher capitalisation rate involves. Such combination of expected returns with risk variations and related capitalisation rate cannot be considered in theconcept of profit maximization. (iv) The goal of Maximization of profits is considered to be a narrow outlook. Evidentlywhen profit maximization becomes the basis of financial decisions of the concern, it ignoresthe interests of the community on the one hand and that of the government, workers andother concerned persons in the enterprise on the other hand.Keeping the above objections in view, most of the thinkers on the subject have come to theconclusion that the aim of an enterprise should be wealth Maximization and not the profitMaximization. Prof. Soloman of Stanford University has handled the issued very logically. Heargues that it is useful to make a distinction between profit and 'profitability'. Maximization of profits with a vie to maximising the wealth of shareholders is clearly an unreal motive. On theother hand, profitability Maximization with a view to using resources to yield economic valueshigher than the joint values of inputs required is a useful goal. Thus the proper goal of financialmanagement is wealth maximization.

Q2. Explain the Net operating approach to capital structure. Ans. net operating income approach examines the effects of changes in capital structure in terms of net operating income. In the net income approach discussed above net income available to shareholders is obtained by deducting interest on debentures form net operating income. Then overall value of the firm is calculated through capitalization rate of equities obtained on the basis of net operating income, it is called net income approach. In the second approach, on the other hand overall value of the firm is assessed on the basis of net operating income not on the basis of net income. Hence this second approach is known as net operating income approach. The NOI approach implies that (i) whatever may be the change in capital structure the overall value of the firm is not affected. Thus the overall value of the firm is independent of the degree of leverage in capital structure. (ii) Similarly the overall cost of capital is not affected by any change in the degree of leverage in capital structure. The overall cost of capital is independent of leverage. If the cost of debt is less than that of equity capital the overall cost of capital must decrease with the increase in debts whereas it is assumed under this method that overall cost of capital is unaffected and hence it remains constant irrespective of the change in the ratio of debts to equity capital. How can this assumption be justified? The advocates of this method are of the opinion that the degree of risk of business increases with the increase in the amount of debts. Consequently the rate of equity over investment in equity shares thus on the one hand cost of capital decreases with the increase in the volume of debts; on the other hand cost of equity capital increases to the same extent. Hence the benefit of leverage is wiped out and overall cost of capital remains at the same level as before. Let us illustrate this point.

If follows that with the increase in debts rate of equity capitalization also increases and consequently the overall cost of capital remains constant; it does not decline. To put the same in other words there are two parts of the cost of capital. One is the explicit cost which is expressed in terms of interest charges on debentures. The other is implicit cost which refers to the increase in the rate of equity capitalization resulting from the increase in risk of business due to higher level of debts. Optimum capital structure This approach suggests that whatever may be the degree of leverage the market value of the firm remains constant. In spite of the change in the ratio of debts to equity the market value of its equity shares remains constant. This means there does not exist a optimum capital structure. Every capital structure is optimum according to net operating income approach. Q.3 What do you understand by operating cycle. Ans. An operating cycle is the length of time between the acquisition of inventory and the sale of that inventory and subsequent generation of a profit. The shorter the operating cycle, the faster a business gets a return on investment (ROI) for the inventory it stocks. As a general rule, companies want to keep their operating cycles short for a number of reasons, but in certain industries, a long operating cycle is actually the norm. Operating cycles are not tied to accounting periods, but are rather calculated in terms of how long goods sit in inventory before sale. When a business buys inventory, it ties up money in the inventory until it can be sold. This money may be borrowed or paid up front, but in either case, once the business has purchased inventory, those funds are not available for other uses. The business views this as an acceptable tradeoff because the inventory is an investment that will hopefully generate returns, but keeping the operating cycle short is still a goal for most businesses so they can keep their liquidity high. Keeping inventory during a long operating cycle does not just tie up funds. Inventory must be stored and this can become costly, especially with items that require special handling, such as humidity controls or security. Furthermore, inventory can depreciate if it is kept in a store too long. In the case of perishable goods, it can even be rendered unsalable. Inventory must also be insured and managed by staff members who need to be paid, and this adds to overall operating expenses. There are cases where a long operating cycle in unavoidable. Wineries and distilleries, for example, keep inventory on hand for years before it is sold, because of the nature of the business. In these industries, the return on investment happens in the long term, rather than the short term. Such companies are usually structured in a way that allows them to borrow against existing inventory or land if funds are needed to finance short-term operations. Operating cycles can fluctuate. During periods of economic stagnation, inventory tends to sit around longer, while periods of growth may be marked by more rapid turnover. Certain products can be consistent sellers that move in and out of inventory quickly. Others, like big ticket items,

may be purchased less frequently. All of these issues must be accounted for when making decisions about ordering and pricing items for inventory.

Q.4 What is the implication of operating leverage for a firm. Ans. Operating leverage: Operating leverage is the extent to which a firm uses fixed costs in producing its goods or offering its services. Fixed costs include advertising expenses, administrative costs, equipment and technology, depreciation, and taxes, but not interest on debt, which is part of financial leverage. By using fixed production costs, a company can increase its profits. If a company has a large percentage of fixed costs, it has a high degree of operating leverage. Automated and high-tech companies, utility companies, and airlines generally have high degrees of operating leverage. As an illustration of operating leverage, assume two firms, A and B, produce and sell widgets. Firm A uses a highly automated production process with robotic machines, whereas firm B assembles the widgets using primarily semiskilled labor. Table 1 shows both firms operating cost structures. Highly automated firm A has fixed costs of $35,000 per year and variable costs of only $1.00 per unit, whereas labor-intensive firm B has fixed costs of only $15,000 per year, but its variable cost per unit is much higher at $3.00 per unit. Both firms produce and sell 10,000 widgets per year at a price of $5.00 per widget. Firm A has a higher amount of operating leverage because of its higher fixed costs, but firm A also has a higher breakeven pointthe point at which total costs equal total sales. Nevertheless, a change of I percent in sales causes more than a I percent change in operating profits for firm A, but not for firm B. The degree of operating leverage measures this effect. The following simplified equation demonstrates the type of equation used to compute the degree of operating leverage, although to calculate this figure the equation would require several additional factors such as the quantity produced, variable cost per unit, and the price per unit, which are used to determine changes in profits and sales: Operating leverage is a double-edged sword, however. If firm As sales decrease by I percent, its profits will decrease by more than I percent, too. Hence, the degree of operating leverage shows the responsiveness of profits to a given change in sales. Implications: Total risk can be divided into two parts: business risk and financial risk. Business risk refers to the stability of a companys assets if it uses no debt or preferred stock financing. Business risk stems from the unpredictable nature of doing business, i.e., the unpredictability of consumer demand for products and services. As a result, it also involves the uncertainty of longterm profitability. When a company uses debt or preferred stock financing, additional risk financial riskis placed on the companys common shareholders. They demand a higher expected

return for assuming this additional risk, which in turn, raises a companys costs. Consequently, companies with high degrees of business risk tend to be financed with relatively low amounts of debt. The opposite also holds: companies with low amounts of business risk can afford to use more debt financing while keeping total risk at tolerable levels. Moreover, using debt as leverage is a successful tool during periods of inflation. Debt fails, however, to provide leverage during periods of deflation, such as the period during the late 1990s brought on by the Asian financial crisis.