Spring 2012, MBA-2nd Semester

FEBRUARY 2012 Master of Business Administration (MBA) Semester – 2 MB0045 – Financial Management (4 Credits) (Book ID: B1134) Assignment Set- 1

MB0045: Financial Management

Roll No. : 541110058

Page 1

Spring 2012, MBA-2nd Semester

Q1. 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 bond’s 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 bond’s 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 bond’s 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 received–we have to know the interest rate that would earn us a known future value. For bond pricing, this interest rate is the required yield. Here is the formula for calculating a bond’s 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.

MB0045: Financial Management

Roll No. : 541110058

Page 2

as it requires adding the present value of each future coupon payment. 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. This PVof-ordinary-annuity formula replaces the need to add all the present values of the future coupon. The farther into the future a payment is to be received. we have determined that the bond is selling at a discount. the required semi-annual yield is 6% (0. and a required yield of 12%. it doesn’t require that we add the value of each coupon payment. the bond price is less than its par value because the required yield of the bond is greater than the coupon rate. however. Each full moneybag on the top right represents the fixed coupon payments (future value) received in periods one. The coupon rate is the percentage off the bond’s par value. divide the coupon rate in half. who could find higher interest MB0045: Financial Management Roll No. 2. each semi-annual coupon payment will be $50 ($1. In our example we’ll assume that coupon payments are made semi-annually to bond holders and that the next coupon payment is expected in six months.000 to be paid in ten years. the required yield of 12% must be divided by two because the number of periods used in the calculation has doubled. It calculates the sum of the present values of all future cash flows. As a result. : 541110058 Page 3 . Determine the Number of Coupon Payments: Because two coupon payments will be made each year for ten years.05). If we left the required yield at 12%. but unlike the bond-pricing formula we saw earlier. which requires us to also include the present value of the par value received at maturity. 4. MBA-2nd Semester You may have guessed that the bond pricing formula shown above may be tedious to calculate. Therefore.12/2). we arrive at the following formula: Let’s go through a basic example to find the price of a plain vanilla bond. Determine the Value of Each Coupon Payment: Because the coupon payments are semiannual. Here are the steps we have to take to calculate the price: 1. 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. By incorporating the annuity model into the bond pricing formula. The bond must sell at a discount to attract investors.000 X 0. two and three. Because these payments are paid at an ordinary annuity. Plug the Amounts Into the Formula: From the above calculation. a coupon rate of 10%. our bond price would be very low and inaccurate. Determine the Semi-Annual Yield: Like the coupon rate.Spring 2012. the less it is worth today – is the fundamental concept for which the PV-of-ordinary-annuity formula accounts. 3. we will have a total of 20 coupon payments. Example 1: Calculate the price of a bond with a par value of $1.

they need an extra incentive to invest in the bonds. inventory can depreciate if it is kept in a store too long. and this adds to overall operating expenses. but keeping the operating cycle short is still a goal for most businesses so they can keep their liquidity high. so we divided the interest rate and coupon payments in half to represent the two payments per year. it ties up money in the inventory until it can be sold. for bonds paying annual coupons. As a general rule. but in either case. In the case of perishable goods. MBA-2nd Semester elsewhere in the prevailing rates. which represents the frequency of coupon payments. This money may be borrowed or paid up front. companies want to keep their operating cycles short for a number of reasons. F would have a value of one. the faster a business gets a return on investment (ROI) for the inventory it stocks. Furthermore. Q2. Keeping inventory during a long operating cycle does not just tie up funds. The shorter the operating cycle. or the number of times a year the coupon is paid. which are required if the coupon payments occur more than once a year. Should a bond pay quarterly payments. : 541110058 Page 4 . A simple modification of the formula will allow you to adjust interest rates and coupon payments to calculate a bond price for any payment frequency. because investors can make a larger return in the market. especially with items that require special handling. Accounting for different payment frequencies In the example above coupons were paid semi-annually. When a business buys inventory. those funds are not available for other uses. Notice that the only modification to the original formula is the addition of ―F‖. MB0045: Financial Management Roll No. Inventory must be stored and this can become costly. You may be now wondering whether there is a formula that does not require steps two and three outlined above. F would equal four. but are rather calculated in terms of how long goods sit in inventory before sale. What do you understand by operating cycle? Ans. In other words.Spring 2012. Therefore. a long operating cycle is actually the norm. it can even be rendered unsalable. 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. once the business has purchased inventory. such as humidity controls or security. but in certain industries. Operating cycles are not tied to accounting periods. Inventory must also be insured and managed by staff members who need to be paid. and if the bond paid semi-annual coupons. F would be two. The business views this as an acceptable tradeoff because the inventory is an investment that will hopefully generate returns.

rather than the short term. and taxes. but not for firm B. like big ticket items. which are used to determine changes in profits and sales: MB0045: Financial Management Roll No.Spring 2012. In these industries. Table 1 shows both firm’s operating cost structures. MBA-2nd Semester There are cases where a long operating cycle in unavoidable. may be purchased less frequently.000 widgets per year at a price of $5. and airlines generally have high degrees of operating leverage. Q3. Firm A has a higher amount of operating leverage because of its higher fixed costs. while periods of growth may be marked by more rapid turnover. Nevertheless. inventory tends to sit around longer. it has a high degree of operating leverage. If a company has a large percentage of fixed costs. What is the implication of operating leverage for a firm? Operating leverage: Operating leverage is the extent to which a firm uses fixed costs in producing its goods or offering its services.000 per year and variable costs of only $1. a company can increase its profits. Highly automated firm A has fixed costs of $35. but firm A also has a higher breakeven point—the point at which total costs equal total sales. Both firms produce and sell 10. Others. The following simplified equation demonstrates the type of equation used to compute the degree of operating leverage.00 per unit. All of these issues must be accounted for when making decisions about ordering and pricing items for inventory. As an illustration of operating leverage. whereas labor-intensive firm B has fixed costs of only $15. because of the nature of the business. Firm A uses a highly automated production process with robotic machines. variable cost per unit. but its variable cost per unit is much higher at $3. Operating cycles can fluctuate. the return on investment happens in the long term.00 per unit. but not interest on debt.00 per widget. 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. depreciation. By using fixed production costs. : 541110058 Page 5 . Fixed costs include advertising expenses. Certain products can be consistent sellers that move in and out of inventory quickly.000 per year. assume two firms. administrative costs. which is part of financial leverage. a change of I percent in sales causes more than a I percent change in operating profits for firm A. although to calculate this figure the equation would require several additional factors such as the quantity produced. During periods of economic stagnation. Automated and high-tech companies. produce and sell widgets. utility companies. A and B. for example. equipment and technology. and the price per unit. Wineries and distilleries. keep inventory on hand for years before it is sold. whereas firm B assembles the widgets using primarily semiskilled labor. The ―degree of operating leverage‖ measures this effect.

Company Resources . using debt as leverage is a successful tool during periods of inflation. MB0045: Financial Management Roll No. creating a new department or any undertaking that affects the company’s future. 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. you need to understand the factors involved in the planning process. then you might have to shelve the expansion planning until the customer issue is resolved. They demand a higher expected return for assuming this additional risk. raises a company’s costs. Moreover. to provide leverage during periods of deflation. Business risk refers to the stability of a company’s assets if it uses no debt or preferred stock financing. Implications: Total risk can be divided into two parts: business risk and financial risk. you need to understand the factors involved in the planning process. To help your organization succeed. Business risk stems from the unpredictable nature of doing business. Debt fails. For example. however. Organizational planning is affected by many factors: Priorities .In most companies. which in turn. developing new product. you need to assign each of the issues facing the company a priority rating. This applies to starting the company.2 What are the factors that affect the financial plan of a company? Ans. it can stall progress. As a result. MBA-2nd Semester Operating leverage is a double-edged sword. and this priority can sometimes interfere with the planning process of any project. If firm A’s sales decrease by I percent. the degree of operating leverage shows the responsiveness of profits to a given change in sales. and which issues can wait until the process is complete. companies with high degrees of business risk tend to be financed with relatively low amounts of debt. but if the company does not have the resources to make the plan come together. Consequently. When you start the planning process for any project. One of the first steps to any planning process should be an evaluation of the resources necessary to complete the project. too. Q. To create an efficient plan.Spring 2012. such as the period during the late 1990s brought on by the Asian financial crisis. To create an efficient plan. the priority is generating revenue. additional risk— financial risk—is placed on the company’s common shareholders.Having an idea and developing a plan for your company can help your company to grow and succeed. Hence. i. it also involves the uncertainty of longterm profitability. That priority rating will determine what issues will sidetrack you from the planning of your project.e. its profits will decrease by more than I percent. however. When a company uses debt or preferred stock financing.. the unpredictability of consumer demand for products and services. There are several factors that affect planning in an organization. : 541110058 Page 6 . 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. you should develop a plan that needs to be followed.

Short term funds required to MB0045: Financial Management Roll No. Without accurate forecasting. if your forecasting for the cost of goods has changed due to a sudden increase in material costs. Forecasting sales revenues. it can be difficult to tell if the plan has any chance of success. If the company is a well-recognized and a reputed one.A company constantly should be forecasting to help prepare for changes in the marketplace. Contingency Planning . if the company is a new entrant into the field. He should also verify the conditions attached to the funds he procures. including projected profit and the long-term commitment you might need to make to a supplier to try to get the lowest price possible. then that can affect elements of your product roll-out plan. Such companies prefer to raise additional amounts by debenture issue or bond issue. personnel costs and overhead costs can help a company plan for upcoming projects. it will have no problems in raising finance at short notices. For example. there needs to be a part of the plan that addresses the possibility that the product line will fail. access to materials and vendor relationships.intensive industry requires less capital than a capital-intensive industry.To successfully plan. that are the contractual restrictions placed by the lenders. Some of the resources to consider are finances. If the company has decided to pursue a new product line. if the company has the capabilities to pull off the plan and if the plan will help to strengthen the company’s standing within the industry. Factors Affecting Financial Plan Nature of industry: The nature of the industry in which the company is performing is a major factor which affects financial plans. Status of the company in the industry: The status of the company is a factor which has to be considered while drawing a financial plan. space requirements. Attitude of management towards control: If the management wants to have control over the firm. especially so if the company wants to go public. New firms may find it easier and better to take loans and function rather than going public. Extent of working capital requirements: The Finance Manager formulates his plan considering the short and long term financial needs of the firm. But on the other hand. The reallocation of company resources. MBA-2nd Semester compared to the resources the company has available. it will need time to establish itself and therefore raising money is slightly difficult.Spring 2012. an organization needs to have a contingency plan in place. personnel. it may not go in for the equity form of finance for control vests with equity shareholders and it gets diluted with every new issue of equity shares. A lab our. 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. : 541110058 Page 7 . materials costs. Alternative sources of finance: The Finance Manager will assess the alternative sources of funds and get the cheapest source of funds. Forecasting .

The financial plan should be flexible enough to adjust to the needs of the changing conditions. It is always a prudent policy to use short term avenues for short term requirements and long term needs can be funded by the issue of shares and debentures. : 541110058 Page 8 .An employee of a bank deposits Rs. Capital structure: Capital of a firm has two components – debt and equity. Running the company with loans and debentures will certainly help equity shareholders to get more income but the company is also functioning under a great risk.Spring 2012. statutory provisions and controls should be considered. MBA-2nd Semester finance working capital needs are to be procured through short term sources only. There should be flexibility to raise the amount from any source and similarly the repayments may be done any time the company has excess funds. 30000 into his PF A/c at the end of each year for 20 years. The proportion of these should be so decided that the company gets the advantage of leverage. if the rate of interest given by PF authorities is 9%? Solution Year 1 2 3 4 5 Amount 30000 30000 30000 30000 30000 Interest 9% 9% 9% 9% 9% Total 30000 32700 35643 38851 42347 MB0045: Financial Management Roll No. Flexibility: This is one important factor that should be kept in mind while planning. What is the amount he will accumulate in his PF at the end of 20 years. Q5. Government policy with regard to financial controls. The firm should also have the flexibility of substituting one form of financing with another if the need arises. The SEBI guidelines should be strictly adhered to wherever applicable and necessary permissions from concerned authorities should be taken if necessary.

What is the price he should be willing to pay now to purchase the bond? MB0045: Financial Management Roll No.250 1.Spring 2012. MBA-2nd Semester 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 46159 50313 54841 59777 65157 71021 77413 84380 91974 100252 109274 119109 129829 141514 154250 The rate of interest at the end of 20 years accumulated by PF account holder is 1. 54. Mr. The maturity period is 5 years. Anant purchases a bond whose face value is Rs. : 541110058 Page 9 . The required rate of return is 10%. and which has a nominal interest rate of 8%.1000.

MBA-2nd Semester Solution: Interest payable=1000*8% =Rs. n) Value of the bond = 80*PVIFA (10%. The investor may not be willing to pay more than Rs.621 = 303.80. 1000 but is worth Rs. 924.28 This implies that the company is offering the bond at Rs.28 At the required rate of return of 10%. Therefore Mr. Principal repayment is Rs. : 541110058 Page 10 . 1000 Required rate of return is 10% V0= I*PVIFA (kd.791 + 1000*0.28 to purchase the bond. 924. 5y) + 1000*PVIF (10%. 924. n) + F*PVIF (kd. MB0045: Financial Management Roll No.28 for the bond today.28 + 621 = Rs.Spring 2012. 5y) = 80*3. Anant would be willing to pay 924.

1= 0.Spring 2012.25 % Kp = [D + {(F—P)/n}] / {F+P)/2} = [14 + (105—84)/8] / (105+84)/2 =16.5 = 0. The following data is available in respect of a company : Equity Rs.cost of debt 13% Calculate the weighted average cost of funds taking market values as weights assuming tax rate as 40% Solution To determine the cost of each component Ke = (D1/P0) + g = (2/32) + 0.cost of capital 18% Debt Rs.10lakhs.6% MB0045: Financial Management Roll No.096 or 9.1759 or17.25% Kd = [I (1—T) + {(F–P)/n}] / {F+P)/2} = [12(1—0.1625 Or 16.4) + (105—90)/7] / (105+90) / 2 = [7.625/94. MBA-2nd Semester Set -2 1.2 + 2. : 541110058 Page 11 .5lakhs.14] / 97.59% Kr = Ke which is 16.5 = 0.

133 Wd = 300/750 = 0.022 + 0.21 regarding the cost.1625) + (0.004= 0.066) = 0.133*0.092) + (0.023 + 0.57% 2. Calculate the DFL.4) = 0.1457 or 14.57% The value of WACC is 14. ABC Ltd.1759) + (0.1625) + (0.11(1–0.267*0.043 + 0.066 or 6. We = 200/750 = 0.133 Wr = 100/750 = 0.Spring 2012.0384 + 0. interests and selling prices.133*0. MBA-2nd Semester Kt = I(1–T)= 0.4*0.267 Wp = 100/750 = 0.06 Multiply the costs of various sources of finance with corresponding weights and WACC is calculated by adding all these components. MB0045: Financial Management Roll No.6% To calculate the weights of each source. sales.06*0. : 541110058 Page 12 .4 Wt = 50/750 = 0. provides the information as shown in table 6. WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt = (0.

Company X has 14%debentures worth Rs. Output Fixed costs Variable cost Interest on borrowed funds Selling price per unit 20.0. 00.000 units Rs.0. Assuming a tax rate of 40%. : 541110058 Page 13 .05 per unit Nil 0.Spring 2012. MBA-2nd Semester Details of ABC Ltd. and cost of equity capital to be 22%. Two companies are identical in all respects except in the debt equity profile.NIL EBT 150000 DFL= EBIT ÷ {EBIT—I—{Dp /(1-T)}} 200000 / (200000—50000—{25000 / (1—0.0 Therefore the Degree of Financial Leverage of ABC ltd is 2.50)} DFL=2.20 Solution EBIT 200000 Less interest on borrowed funds . 3.3. Both companies earn 20% before interest and taxes on their total assets of Rs. find out the value of the companies X and Y using NOI approach? MB0045: Financial Management Roll No. 25. 00. 50.000 whereas company Y does not have any debt.500 Rs.000.

: 541110058 Page 14 . Decision for production of new goods or rendering of new services Decisions to comply with the regulatory structure affecting the operations of the company.5/2500000+4545454. 00.1915 = 26. These decisions make or mar a business organization.22 =4545454. 66 The value of company X & Y = 26.5)].15% V = 5000000/0. 000/. These decisions could be grouped into:     Decision to replace the equipment’s for maintenance of current level of business or decisions aiming at cost reductions.000 =K0 = [25.14+[4545454.5)].e.  Decisions on investment to build township for providing residential accommodation to employees working in a manufacturing plant. 109. Capital budgeting decisions are the most important decisions in corporate financial management. 66 4. 00. Long-term assets) with the hope of employing those most efficiently to generate a series of cash flow in future.Spring 2012.22 0.0496+. like investments in assets to comply with the conditions imposed by environmental protection act. known as replacement decisions Decisions on expenditure for increasing the present operating level or expansion through improved network of distribution. 109.5 B=25. MB0045: Financial Management Roll No. Examine the importance of capital budgeting. These decisions commit a firm to invest its current funds in the operating assets (i. MBA-2nd Semester Solution: S= 1000. These decisions commit a firm to invest its current funds in the operation.000 / [2500000+4545454.1915 or 19.142 =.

huge investments in R & D in packaging industry brought about new packaging medium totally replacing metal as an important component of packing boxes. • Any serious error in forecasting sales. creating wealth for shareholders. Quite a lot of empirical examples are there in public sector in India in support of this argument that cost overrun and time over run can make a company’s operation unproductive. It affected the standard of living and cash flow position of its employees. Failure to achieve the required coordination between the inflow and outflow may cause time over run and cost over-run. The best example is the Reliance Group. deciding on the scale of operations. Employees lost their jobs. the amount of capital expenditure can significantly affect the firm. • Any downward bias in forecasting might lead the firm to a situation of losing its market to its competitors. The projections of cash flows anticipated involve forecasts of many financial variables. • Most of the capital budgeting decisions involve huge outlay. At the end of the expansion metal box ltd. This highlights the element of risk involved in these type of decisions. • Long time investments of the funds sometimes may change the risk profile of the firm. The most crucial variable is the sales forecast.Spring 2012. selection of relevant technology and finally procurement of costly equipment. For example. investment in plant and machinery. Metal box spent large sums of money on expansion of its productions facilities based on its own sales forecast. The economic life of such assets has long periods. The end result is that metal box became a sick company from the position it enjoyed earlier prior to the execution of expansion as a blue chip. The funds required during the phase of execution must be synchronized with the flow of funds. These two problems of time over run and cost overrun have to be prevented from occurring in the beginning of execution of the project. : 541110058 Page 15 . laying the path for the cancer of sickness. An upward bias might lead to a situation of the firm creating idle capacity. found itself that the market for its metal boxes has declined drastically. MB0045: Financial Management Roll No. During this period. • Capital budgeting decisions involve assessment of market for company’s product and services. • Equally we have empirical evidence of companies which took decisions on expansion through the addition of new products and adoption of the latest technology. MBA-2nd Semester 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.

: 541110058 Page 16 . economic and technological forces generate high level of uncertainty in future cash flow streams associated with capital budgeting decisions. • The social. • Liberalization and globalization gave birth to economic institutions like world trade organizations. MB0045: Financial Management Roll No. will strategically affect the firms profitability.Spring 2012. These three elements are:  Cost  Quality  Timing Decisions must be taken at the right time which would enable the firm to procure the assets at the least cost for producing products of required quality for the customer. capital budgeting decisions are irreversible. Loss incurred by the firm on account of this would be heavy if the firm were to scrap the equipments bought specifically for implementing the decision taken. The composition of debt and equity must be optimal keeping in view the expectations of investors and risk profile of the selected project. Therefore capital budgeting decisions for growth have become an essential characteristic of successful firms today. then the firm would have experienced a situation of inability to sell the equipments bought. Any lapse on the part of the firm in understanding the effect of these elements on implementation of capital expenditure decision taken. To implement these decisions. MBA-2nd Semester If a firm were to realize after committing itself to considerable sums of money in the process of implementing the capital budgeting decisions taken that the decision to diversify or expand would become a wealth destroyer to the company. Pro-active firms cannot avoid the risk of taking challenging capital budgeting decisions for growth. firms will have to tap the capital market for funds. Sometimes these equipments will be specialized costly equipments. political. Therefore. the growth and survival of any firm in today’s business environment demands a firm to be pro-active. • Capital budgeting decisions are very expensive. Therefore. These factors make these decisions highly complex. Ability of GE to sell its products in India at a rate less than the rate at which Indian companies sell cannot be ignored. General Electrical can expand its market into India snatching the share already enjoyed by firms like Bajaj Electricals or Kirloskar Electric Company. All capital budgeting decisions involves three elements.

Capital rationing needed due to:   External factors Internal constraints imposed by management. : 541110058 Page 17 .(iii) It helps a company use limited resources to the best advantage by investing only in the projects that offer the highest return. and (ii) Internal Constraints Imposed by management. the investment policy of the company may not be the optimal one. Such a situation may be due to external factors or due to the need to impose internal constraints. keeping in view of the need to exercise better financial control.Spring 2012. In nutshell Capital Rationing leads to:(i) Allocation of limited resources among ranked acceptable investments.(iv) Either the internal rate of return method or the net present value method may be used in ranking investments. In times of Capital Rationing. MBA-2nd Semester 5. Preference should be given to interdependent projects. Firms may have to make a choice from among profitable investment opportunities.IRR or NPV are the best basis of evaluation even under Capital Rationing situations. The objective is to select those projects which have maximum and positive NPV. Briefly explain the process of capital rationing.Where there is multiperiod Capital Rationing. Projects are to be ranked in the order of NPV.(ii) This function enables management to select the most profitable investment first. Capital rationing may arise due to (i) external factors such as high borrowing rate or non -availability of loan funds due to constraints of Debt-Equity Ratio. MB0045: Financial Management Roll No. The firm must be able to maximize the profits by combining the most profitable proposals. Linear Programming Technique should be used to maximize NPV. limiting to capacity to take up and execute all the profitable projects. It cannot be accepted and executed in piecemeal. Capital rationing refers to a situation in which the firm is under a constraint of funds. because of the limited financial resources. Project should be accepted as a whole or rejected.

MBA-2nd Semester External factors Reasons for capital rationing Internal factors Reasons for capital rationing External capital rationing – is due to the imperfections of capital market.Spring 2012. Imperfections are caused mainly due to:   Deficiencies in market information Rigidities that hamper the force flow of capital between firms Internal capital rationing – Impositions of restrictions by a firm on the funds allocated for fresh investment is called internal capital rationing. Restriction may be imposed on individual heads on the total amount that they can commit on new project. Generally internal capital rationing is used by a firm as a means of financial control. MB0045: Financial Management Roll No. : 541110058 Page 18 . This decision may be the result of conservative policy pursued by a firm.

however. Working capital. It is mostly dept is circulation by releasing it back after selling the products and reinvesting it in further production. Though. marketable securities. the differences lies in the rate of their recovery. and current liabilities are usually paid within an accounting year. : 541110058 Page 19 . As the process of production become more roundabout and complicated the production to fixed working capital increase correspondingly. inventories and bills receivables. Working capital shall be recovered much more quickly as compared to fixed capitals which would last for several years. Money required by the company to meet out day – today expenses to finance production and stocks to pay wages and other production etc. It is because of this regular cycle that the working capital requirements are usually for short periods. notes payable and miscellaneous accruals. working capital management refers to the management of current assets and current liabilities.Spring 2012. Therefore. Current assets are those assets which are normally converted into cash within an accounting year. such as cash. MBA-2nd Semester 6. both fixed and working capitals shall be recovered from the business. The four most important concepts of working capital are shown in the below figure: Concepts Gross Working Capital Net Working Capital Temporary Working Capital Permanent Working Capital MB0045: Financial Management Roll No. Working capital is used in operating the business. represents investment in current assets. Net working capital is the excess of current assets over current liabilities here. is called the working capital of the company. Explain the concepts of working capital. Current liabilities mainly include bills payable.

as applied to current assets. : 541110058 Page 20 . 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 operations of the firms business. Net Working Capital – Net working capital is the excess of current assets over current liabilities and provisions. MB0045: Financial Management Roll No. Temporary Working Capital – Is also known as variable working capital or fluctuating working capital. Net working capital is positive when current assets exceed current liabilities and negative when current liabilities exceed current assets. This minimum level of current assets has been given the name of core current assets by the Tandon Committee.    Management of current assets is the crucial aspect of working capital management.Spring 2012. Permanent working capital also known as fixed working capital. The firm’s working capital requirements vary depending upon the seasonal and cyclical changes in demand for firms products. This concept has the following practical relevance. The need to plan and monitor the utilization of funds of a firm demands working capital management. The extra working capital required as per the changing production and sales levels of a firm is known as temporary working capital. Gross working capital helps in the fixation of various areas of financial responsibility. MBA-2nd Semester Gross Working Capital – Gross working capital refers to the amounts invested in various components of current assets.

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