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Summer / May 2012

Master OF Business Administration

Second Semester
Financial Management - (MB0045) Assignment Set- 1 (60 Marks)

Name Registration Number Learning Center Code Learning Center Name

: : : :

PAWAN KUMAR 571122876 01713 Apar India College of management & Technology (Delhi)

Q1. What is financial management? Explain its importance. Financial Management is the art and science of managing money. Regulatory and economic environments have undergone drastic changes due to liberalization and globalization of Indian economy. Financial Management of a firm is concerned with procurement and effective utilization of funds for the benefit of its stakeholders. It embraces all those managerial activities that are required to procure funds at the least cost and their effective deployment Traditionally, financial management was considered a branch of knowledge with focus on the procurement of funds. Instruments of financing, formation, merger and restructuring of firms and legal and institutional frame work occupied the prime place in this traditional approach. The modern approach transformed the field of study from the traditional narrow approach to the most analytical nature. The core of modern approach evolved around the procurement of the least cost funds and its effective utilization for maximization of share holders’ wealth. There are three core elements of financial management show its importance are: a. Financial Planning Financial Planning is to ensure the availability of capital investments to acquire the real assets. Real assets are land and buildings, plants and equipments. Capital investments are required for establishing and running the business smoothly. b. Financial Control Financial Control involves managing the costs and expenses of a business. For example, it includes taking decisions on the routine aspects of day to day management of collecting money due from the firms’ customers and making payments to the suppliers of various resources. c. Financial Decisions · Decision needs to be taken on the sources from which the funds required for the capital investments could be obtained. · There are two sources of funds – debt and equity. In what proportion the funds are to be obtained from these sources is to be decided for formulating the financing plan.

Q2. What is meant by capital budgeting? Explain the importance of capital budgeting. Capital budgeting is the process by which the financial manager decides whether to invest in specific capital projects or assets. In some situations, the process may entail in acquiring assets that are completely new to the firm. In other situations, it may mean replacing an existing obsolete asset to maintain efficiency. According to Larence J Gitman (Principles of Managerial Finance), Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the firms goal of maximizing owner wealth. Importance of Capital Budgeting Capital budgeting decisions are the most important decisions in corporate financial management. These decisions make or mar a business organization. These decisions commit a firm to invest its current funds in the operating assets (i.e. long-term assets) with the hope of employing them most efficiently to generate a series of cash flows in future. These decisions could be grouped into:

• Decision to replace the equipments for maintenance of current level of business or decisions aiming at cost reductions, known as replacement decisions • Decisions on expenditure for increasing the present operating level or expansion through improved network of distribution • Decisions for production of new goods or rendering of new services • Decisions on penetrating into new geographical area • Decisions to comply with the regulatory structure affecting the operations of the company, like investments in assets to comply with the conditions imposed by Environmental Protection Act • Decisions on investment to build township for providing residential accommodation to employees working in a manufacturing plant The reasons that make the capital budgeting decisions most crucial for finance managers are: • These decisions involve large outlay of funds in anticipation of cash flows in future For example, investment in plant and machinery. The economic life of such assets has long periods. The projections of cash flows anticipated involve forecasts of many financial variables. The most crucial variable is the sales forecast.

Q3. Describe the concept of working capital. Money required by the company to meet out day – today expenses to finance production and stocks to pay wages and other production etc. is called the working capital of the company. Working capital is used in operating the business. It is mostly dept is circulation by releasing it back after selling the products and reinvesting it in further production. It is because of this regular cycle that the working capital requirements are usually for short periods. Though, both fixed and working capitals shall be recovered from the business, the differences lies in the rate of their recovery. Working capital shall be recovered much more quickly as compared to fixed capitals which would last for several years. As the process of production become more roundabout and complicated the production to fixed working capital increase correspondingly. Concepts of Working Capital The four most important concepts of working capital are: –Gross working capital, Net working capital, Temporary working capital and Permanent working capital.

Concepts

Gross working capital

Net working capital

Temporary working capital

Permanent working capital

Gross working capital Gross Working Capital refers to the amounts invested in various components of current assets. This concept has the following practical relevance. · Management of current assets is the crucial aspect of working capital management · Gross working capital helps in the fixation of various areas of financial responsibility

· Gross working capital is an important component of operating capital. Therefore, for improving the profitability on its investment a finance manager of a company must give top priority to efficient management of current assets · The need to plan and monitor the utilization of funds of a firm demands working capital management, as applied to current assets Net working capital Net working capital is the excess of current assets over current liabilities and provisions. Net working capital is positive when current assets exceed current liabilities and negative when current liabilities exceed current assets. This concept has the following practical relevance. · Net working capital indicates the ability of the firm to effectively use the spontaneous finance in managing the firm’s working capital requirements · A firm’s short term solvency is measured through the net working capital position it commands Temporary Working Capital Temporary working capital is also known as variable working capital or fluctuating working capital. The firm’s working capital requirements vary depending upon the seasonal and cyclical changes in demand for a firm’s products. The extra working capital required as per the changing production and sales levels of a firm is known as temporary working capital. Permanent Working Capital Permanent working capital is the minimum amount of investment required to be made in current assets at all times to carry on the day to day operation of firm’s business. This minimum level of current assets has been given the name of core current assets by the Tandon Committee. Permanent working capital is also known as fixed working capital.

Q4. What are the types of leverages? What is the implication of operating leverage for a firm? Leverage is the influence of power to achieve something. The use of an asset or source of funds for which the company has to pay a fixed cost or fixed return is termed as leverage. Leverage is the influence of an independent financial variable on a dependent variable. It studies how the dependent variable responds to a particular change in independent variable. In financial terms Leverage refers to the utilization of credit or the borrowed amount to enhance one's capability for speculation and raise the arts of return from a particular investment, such as purchasing security on a margin. In simpler words, it is the usage of loaned fund to increase one's purchasing power and in turn, to raise the investment’s profitability factor. There are three types of leverage as shown in the following diagram:-

Leverage Operating leverage
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 hightech 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.

Financial leverage

Combined leverage

Firm’s 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 $15,000per 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 point the 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 doubleedge sword, however. If firm A’s 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 company’s 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 long-term profitability. When a company uses debt or preferred stock financing, additional risk Financial risk is placed on the company’s common shareholders. They demand a higher expected return for assuming this additional risk, which in turn, raises a company’s 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.

Q5. Explain the factor affecting financial plan. We live in a society and interact with people and environment. What happens to us is not always accordance to our wishes. Many things turn out in our live are uncontrollable by us. Many decisions we take are the result of external influences. So do our financial matters. There are many factors affect our personal financial planning. Range from economic factors to global influences. Aware of factors affecting your money matters below will certainly benefit your planning. Factors Affecting Financial Plan

1. Nature of the industry: - Here, we must consider whether it is a capital intensive of labour intensive industry. This will have a major impact on the total assets that the firm owns. 2. Size of the company: - The size of the company greatly influences the availability of funds from different sources. A small company normally finals it difficult to raise funds from long term sources at competitive terms. On the other hand, large companies like Reliance enjoy the privilege of obtaining funds both short term and long term at attractive rates. 3. Status of the company in the industry:- A well established company enjoying a good market share, for its products normally commands investor’s confidence. Such a company can tap the capital market for raising funds in competitive term for implementation new projects to exploit the new opportunity emerging from changing business environment. 4. Sources of finance available: - Sources of finance could be group into debt and equity. Debt is cheap but risky whereas equity is costly. A firm should aim at optimum capital structure that would achieve the least cost capital structure. A large firm with a diversified product mix may manage higher quantum of debt because the firm may manage higher financial risk with a lower business risk. Selection of sources of finances us closely linked to the firm’s capacity to manage the risk exposure. 5. The capital structure of a company: - Capital structure of a company is influenced by the desire of the existing management of the company to remain control over the affairs of the company. The promoters who do not like to lose their grip over the affairs of the company normally obtain extra funds for growth by issuing preference shares and debentures to outsiders. 6. Matching the sources with utilization: - The product policy of any good financial plan is to match the term of the source with the term of investment. To finance fluctuating working capital needs, the firm resorts to short term finance. All fixed assets-investment are to be finance by long term sources. It is a cardinal principal of financial planning. 7. Flexibility:- The financial plan of company should possess flexibility so as to effect changes in the composition of capital structure when ever need arises. If the capital structure of a company is flexible, it will not face any difficulty in changing the sources of funds. This factor has become a significant one today because of the globalization of capital market. 8. Government Policy:- SEBI guidelines, finance ministry circulars, various clauses of Standard Listing Agreement and regulatory mechanism imposed by FEMA and Department of Corporate Affairs (Govt of India) influence the financial plans of corporate today. Management of public issues of shares demands the companies with many status in India. They are to be compiled with a time constraint.

Q6. Mr. X purchases a bond whose face value is Rs. 1000, maturity period 5 years coupled with a nominal interest rate of 8%. The required rate of return is 10%. What is the price he should be willing to pay now to purchase the bond?
Solution:

Interest payable=1000*8%=Rs. 80 Principal repayment is Rs. 1000 Required rate of return is 10% V0=I*PVIFA(kd, n) + F*PVIF(kd, n) Value of the bond = 80*PVIFA(10%, 5y) + 1000*PVIF(10%, 5y) = 80*3.791 + 1000*0.621 = 303.28 + 621
= Rs. 924.28