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Sub Code:-MB 0045

Center Code:-03458

Q. No 1: Explain the liquidity decisions and its important elements. Write complete
information on dividend decisions.
Ans:
Liquidity decisions:
The liquidity decision is concerned with the management of the current assets, which is a prerequisite to long-term success of any business firm, This is also called as working capital decision.
The main objective of the current assets management is the trade-off between profitability and
liquidity, and there is a conflict between these two concepts. If a firm does not have adequate working
capital, it may become illiquid and consequently fail to meet its current obligations thus inviting the risk
of bankruptcy. On the contrary, if the current assets are too enormous, the profitability is adversely
affected. Hence, the major objective of the liquidity decision is to ensure a trade-off between
profitability and liquidity. Besides, the funds should be invested optimally in the individual current
assets to avoid inadequacy or excessive locking up of funds. Thus, the liquidity decision should
balance the basic two ingredients, i.e. working capital management and the efficient allocation of
funds on the individual current assets. In other terms, liquidity decisions deal with working capital
management. It is concerned with the day-to-day financial operations that involve current assets and
current liabilities.
The important elements of liquidity decisions are:
Formulation of inventory policy
Policies on receivable management
Formulation of cash management strategies
Policies on utilisation of spontaneous finance effectively
Dividend decisions:
Dividends are payouts to shareholders. Dividends are paid to keep the shareholders happy. Dividend
decision is a major decision made by the finance manager. Dividend is that portion of profits of a
company which is distributed among its shareholders according to the resolution passed in the
meeting of the Board of Directors. This may be paid as a fixed percentage on the share capital
contributed by them or at a fixed amount per share. The dividend decision is always a problem before
the top management or the Board of Directors as they have to decide how much profits should be
transferred to reserve funds to meet any unforeseen contingencies and how much should be
distributed to the shareholders. Payment of dividend is always desirable since it affects the goodwill of
the concern in the market on the one hand, and on the other, shareholders invest their funds in the
company in a hope of getting a reasonable return. Retained earnings are the sources of internal
finance for financing of corporates future projects but payment of dividend constitute an outflow of
cash to shareholders. Although both - expansion and payment of dividend - are desirable, these two
are in conflicting tasks. It is, therefore, one of the important functions of the financial management to
constitute a dividend policy which can balance these two contradictory view points and allocate the
reasonable amount of profits after tax between retained earnings and dividend. All of this is based on
formulation of a good dividend policy.
Since the goal of financial management is maximisation of wealth of shareholders, dividend policy
formulation demands the managerial attention on the impact of its policy on dividend and on the
market value of its shares. Optimum dividend policy requires decision on dividend payment rates so
as to maximise the market value of shares. The payout ratio means what portion of earnings per
share is given to the shareholders in the form of cash
dividend. In the formulation of dividend policy, the management of a company will have to consider
the relevance of its policy on bonus shares. Dividend policy influences the dividend yield on shares.

Dividend yield is an important determinant of an investors attitude towards the security (stock) in his
portfolio management decisions.

Q.No.2: Explain about the doubling period and present value. Solve the below given
Problem:
Under the ABC Banks Cash Multiplier Scheme, deposits can be made for periods
ranging from 3 months to 5 years and for every quarter, interest is added to the
principal. The applicable rate of interest is 9% for deposits less than 23 months and
10% for periods more than 24 months. What will be the amount of Rs. 1000 after 2
years?
Ans:
Doubling period:
A very common question arising in the minds of an investor is how long will
it take for the amount invested to double for a given rate of interest.
There are 2 ways of answering this question:
1. One way is to answer it by a rule known as rule of 72. This rule states that the period within
which the amount doubles is obtained by dividing 72 by the rate of interest. Though it is a
crude way of calculating, this rule is followed by most. For instance, if the given rate of interest
is 10%, the doubling period is 72/10, that is, 7.2 years.
2. A much accurate way of calculating doubling period is by using the rule
known as rule of 69. By this method, Doubling Period = 0.35+69/Interest rate Going by the
same example given above, we get the number of years as 7.25 years {(0.35 + 69/10) or (0.35
+6.9)}.
Solution:
FVn=PV [1+i/m] mXn
m = 12/3 = 4 (quarterly compounding)
1000 (1+0.10/4)4*2
1000 (1+0.10/4)8
Rs. 1218
The amount of Rs. 1000 after 2 years would be Rs. 1218.
Present Value:
Given the interest rate, compounding technique can be used to compare the cash flows separated by
more than one time period. With this technique, the amount of present cash can be converted into an
amount of cash of equivalent value in future. Likewise, we may be interested in converting the future
cash flow into their present values. Present value can be simply defined as the current value of a
future sum. It can also be defined as the amount to be invested today (present value) at a given rate
of interest over a specified period to equal the future sum. If we reverse the flow by saying that we
expect a fixed amount after n number of years and we also know the present prevailing interest rate,
then by discounting the future amount at the given interest rate, we will get the present value of
investment to be made. The present value of a sum to be received at a future date is determined by
discounting the future value at the interest rate that the money could earn over the period. This
process is known as discounting.

Q.No. 3: Write short note on


A) Operating leverage.
B) Financial leverage.
C) Combined leverage.
Ans:
Operating Leverage:
Operating leverage arises due to the presence of fixed operating expenses in the firms income flows.
It has a close relationship to business risk. Operating leverage affects business risk factors, which can
be viewed as the uncertainty inherent in estimates of future operating income. The operating leverage
takes place when a change in revenue produces a greater change in Earnings Before Interest and
Taxes (EBIT). It indicates the impact of changes in sales on operating income. A firm with a high
operating leverage has a relatively greater effect on EBIT for small changes in sales. A small rise in
sales may enhance profits considerably, while a small decline in sales may reduce and even wipe out
the EBIT.
Three categories of a companys operating costs.
Fixed costs Fixed costs are those which do not vary with an increase in production or sales
activities for a particular period of time.
Variable costs Variable costs are those which vary in direct proportion to output and sales.
An increase or decrease in production or sales activities will have a direct effect on such types
of costs incurred.
Semi-variable costs Semi-variable costs are those which are partly fixed and partly
variable in nature. These costs are typically of fixed nature up to a certain level beyond which
they vary with the firms activities.
Financial Leverage:
Financial leverage relates to the financing activities of a firm and measures the effect of EBIT
on Earnings Per Share (EPS) of the company. A companys sources of funds fall under two
categories:
Those which carry fixed financial charges like debentures, bonds, and preference
shares
Those which do not carry any fixed charges like equity shares.
Debentures and bonds carry a fixed rate of interest and are to be paid off irrespective of the
firms revenues. The dividends are not contractual obligations, but the dividend on preference
shares is a fixed charge and should be paid off before equity share holders. The equity
holders are entitled to only the residual income of the firm after all prior obligations are met.
Financial leverage refers to a firm's use of fixed-charge securities like debentures and
preference shares (though the latter is not always included in debt) in its plan of financing the
assets.
The concept of financial leverage is a significant one because it has direct relation with capital
structure management. It determines the relationship trading on equity. Borrowing is done by a
company because of the financial advantage that is expected from it. The use of borrowings
for the purpose of such advantage for residual shareholders is also called trading on equity or
leverage.
Thus, financial leverage refers to the mix of debt and equity in the capital structure of the firm.
This results from the presence of fixed financial charges in the companys income stream.

Such expenses have nothing to do with the firms performance and earnings and should be
paid off regardless of the amount of EBIT.
A company earning more by the use of assets funded by fixed sources is said to be having a
favourable or positive leverage. Unfavourable leverage occurs when the firm is not earning
sufficiently to cover the cost of funds. Financial leverage is also referred to as trading on
equity.
Thus, the effect of financial leverage is also measured through another variable, viz, EPS.
This is done in the case of joint stock companies which have raised their proprietary capital by
selling units of such capital known as equity shares.
EPS is obtained by dividing earnings (after interest and taxes) by total equity. If a company
has preference shares also on its capital structure, net equity earnings will be arrived at after
deducting interest, taxes, and preference dividends.
Financial leverage and its effects are a crucial consideration in planning and
designing capital structures.
Combined Leverage:
The combination of operating and financial leverage is called combined leverage. Operating
leverage affects the firms operating profit EBIT and financial leverage affects PAT or the EPS.
These cause wide fluctuations in EPS. A company having a high level of operating or financial
leverage will find a drastic change in its EPS even for a small change in sales volume.
Companies whose products are seasonal in nature have fluctuating EPS, but the amount of
changes in EPS due to leverages is more pronounced.
The combined effect is quite significant for the earnings available to ordinary shareholders.
Combined leverage is the product of DOL and DFL.
Q.No.4: Explain factor affecting the capital structure. Solve the below given

problem.
Given below are two firms, A and B, which are identical in all aspects except the
degree of leverage employed by them. What is the average cost of capital of
both firms?
Net operating income EBIT
Interest on debentures I
Equity earnings E
Cost of equity Ke
Cost of debentures Kd
Market value of equity S = E/Ke
Market value of debt B
Total value of firm V

Firm A
Rs. 1, 00, 000
Nil
Rs. 1, 00, 000
15%
10%
Rs. 6, 66, 667
Nil
Rs. 6, 66, 667

Firm B
Rs. 1, 00, 000
Rs. 25, 000
Rs. 75, 000
15%
10%
Rs. 5,00, 000
Rs. 2, 50, 000
Rs. 7, 50, 000

Ans:
Factors Affecting Capital Structure:
Capital structure should be planned at the time a company is promoted. The initial capital structure
should be designed very carefully. The management of the company should set a target capital
structure, and the subsequent financing decisions should be made with a view to achieve the target
capital structure. Every time the funds have to be procured, the financial manager weighs the pros
and cons of various sources of finance and selects the most advantageous sources keeping in view

the target capital structure. Thus, the capital structure decision is a continuous one and has to be
taken whenever a firm needs additional finance. The major factor affecting the capital structure is
leverage. There are also a few other factors affecting them. All the factors are explained briefly here.
Leverage
The use of sources of funds that have a fixed cost attached to them, such as preference shares, loans
from banks and financial institutions, and debentures in the capital structure, is known as trading on
equity or financial leverage. If the assets financed by debt yield a return greater than the cost of the
debt, the EPS will increase without an increase in the owners investment. Similarly, the EPS will also
increase if preference share capital is used to acquire assets. But the leverage impact is felt more in
case of debt because of the following reasons:
The cost of debt is usually lower than the cost of preference share capital
The interest paid on debt is a deductible charge from profits for calculating the taxable income while
dividend on preference shares is not.
The companies with high level of Earnings Before Interest and Taxes (EBIT) can make profitable use
of the high degree of leverage to increase return on the shareholders equity.
Debt-equity ratio is another parameter that comes into play here. Debt equity ratio is an indicator of
the relative contribution of creditors and owners. The debt component includes both long-term and
short-term debt, and this is represented as debt/equity. Creditors insist on a debt-equity ratio of 2:1 for
medium-sized and large sized companies, while they insist on 3:1 ratio for Small Scale Industries
(SSI). A debt-equity ratio of 2:1 indicates that for every 1 unit of equity, the company can raise 2 units
of debt. By normal standards, 2:1 is considered as a healthy ratio, but it is not always a hard and fast
rule that this standard is insisted upon. A ratio of 5:1 is considered good for a manufacturing company
while a ratio of 3:1 is good for heavy engineering companies. Generally, in debt-equity ratio, the lower
the ratio, the higher is the element of uncertainty in the minds of lenders. Increased use of leverage
increases commitments of the company (the outflows being in the nature of higher
interest and principal repayments), thereby increasing the risk of the equity shareholders.
The other factors to be considered before deciding on an ideal capital structure are:
Cost of capital High cost funds should be avoided. However attractive an investment proposition
may look like, the profits earned may be eaten away by interest repayments.
Cash flow projections of the company Decisions should be taken in the light of cash flow
projected for the next 3-5 years. The company officials should not get carried away at the immediate
results expected. Consistent lesser profits are any way preferable than high profits in the beginning
and not being able to get any profits after 2 years.
Dilution of control The top management should have the flexibility to take appropriate decisions at
the right time. Fear of having to share control and thus being interfered by others often delays the
decision of the closely held companies to go public. To avoid the risk of loss of control, the companies
may issue preference shares or raise debt capital. An excessive amount of debt may also cause
bankruptcy, which means a complete loss of control. The capital structure planned should be one in
this direction.
Floatation costs Floatation costs are incurred when the funds are raised. Generally, the cost of
floating a debt is less than the cost of floating an equity issue. A company desiring to increase its
capital by way of debt or equity will definitely incur floatation costs. Effectively, the amount of money
raised by any issue will be lower than the amount expected because of the presence of floatation
costs. Such costs should be compared with the profits and right decisions should be taken.
Solution:
Average cost of capital of firm A is:
10% * 0/Rs. 666667 + 15% * 666667/666667 = 0 + 15 = 15%
Average cost of capital of firm B is:
10% * 250000/750000 + 15% * 500000/750000 = 3.34 + 10 = 13.4%

Interpretation:
The use of debt has caused the total value of the firm to increase and the
overall cost of capital to decrease.

Q.No. 5: Explain all the sources of risk in capital budgeting with examples.
Solve the below given problem.
An investment will have an initial outlay of Rs 100,000. It is expected to

generate cash inflows. Cash inflow for four years.


Year
1
2
3
4

Cash inflow
40000
50000
15000
30000

If the risk free rate and the risk premium is 10%,


a) Compute the NPV using the risk free rate

b) Compute NPV using risk-adjusted discount rate


Ans:
Sources of risk:
The five different sources of risk are:

Project-specific risk
Competitive or competition risk
Industry-specific risk
International risk
Market risk

Project-specific risk: Project-specific risk could be traced to something quite specific to the
project. Managerial deficiencies or error in estimation of cash flows or discount rate may lead to a
situation of actual cash flows realised being less than the projected cash flow.
Competitive or competition risk: Unanticipated actions of a firms competitors will materially affect
the cash flows expected from a project. As a result of this, the actual cash flows from a project will be
less than that of the forecast.
Industry-specific risk: Industry-specific risks are those that affect all the firms in the particular
industry. Industry-specific risk could be again grouped into technological risk, commodity risk and
legal risk. Let us discuss the groups in industry specific risks, as follows:
Technological risk The changes in technology affect all the firms not capable of adapting
themselves in emerging into a new technology.
Example:
The best example is the case of firms manufacturing motor cycles with two stroke engines. When
technological innovations replaced the two stroke engines by the four stroke engines, those firms
which could not adapt to new technology had to shut down their operations.

Commodity risk It is the risk arising from the effect of price-changes on goods produced and
marketed.
Legal risk It arises from changes in laws and regulations applicable to the industry to which the firm
belongs.
Example:
The imposition of service tax on apartments by the government of India, when the total number of
apartments built by a firm engaged in that industry exceeds a prescribed limit. Similarly, changes in
import export policy of the government of India have led to either closure of some firms or sickness of
some firms. All these risks will affect the earnings and cash flows of the project.
International risk:
These types of risks are faced by firms whose business consists mainly of exports or those who
procure their main raw material from international markets. The firms facing such kind of risks are as
follows:
The rupee-dollar crisis affected the software and BPOs, because it drastically reduced their
profitability.
Another example is that of the textile units in Tirupur in Tamil Nadu, which exports the major part of
the garments produced. Strengthening of rupee and weakening of dollar, reduced their
competitiveness in the global markets.
The surging crude oil prices coupled with the governments delay in taking decision on pricing of petro
products eroded the profitability of oil marketing companies in public sector like Hindustan Petroleum
Corporation Limited.
Another example is the impact of US sub-prime crisis on certain segments of Indian economy. The
changes in international political scenario also affected the operations
of certain firms.
Market risk:
Factors like inflation, changes in interest rates, and changing general economic conditions affect all
firms and all industries. Firms cannot diversify this risk in the normal course of business. There are
many techniques of incorporation of risk perceived in the evaluation of capital budgeting proposals.
They differ in their approach and methodology as far as incorporation of risk in the evaluation process
is concerned.
Solution:
a) NPV can be computed using risk free rate.
Year

1
2
3
4

Cash flows
(inflows)
Rs.
40000
50000
15000
30000
PV of cash inflows
PV of cash outflows
NPV

PV factor at
10%

PV of cash flows
(inflows)

0.909
0.826
0.751
0.683

36360
41300
11265
20490
109415

100000
9415

b) NPV can be computed using risk-adjusted discount.


.
Year

Cash flows
(inflows)

PV factor at
20%

PV of cash flows
(inflows)

Rs.
1
2
3
4

40000
50000
15000
30000
PV of cash inflows
PV of cash outflows
NPV

0.833
0.694
0.579
0.482

33320
34700
8685
14460
91165
(100000)
(8835)

The project would be acceptable when no allowance is made for risk. However, it will not be
acceptable if risk premium is added to the risk free rate. By doing so, it moves from positive NPV to
negative NPV. If the firm were to use the internal rate of return (IRR), then the project would be
accepted, when IRR is greater than the risk-adjusted discount rate.

Q.No.6: Explain the objectives of Cash Management. Write about the Baumol model
with their assumptions.
Ans:
Objectives of Cash Management: The major objectives of cash management in a firm are:
Meeting payments schedule
Minimising funds held in the form of cash balances
Meeting payments schedule:
In the normal course of functioning, a firm has to make various payments by cash to its employees,
suppliers and infrastructure bills. Firms will also receive cash through sales of its products and
collection of receivables. Both of these do not occur simultaneously. The basic objective of cash
management is therefore to meet the payment schedule on time. Timely payments will help the firm to
maintain its creditworthiness in the market and to foster cordial relationships with creditors and
suppliers. Creditors give cash discount if payments are made in time and the firm can avail this
discount as well. Trade credit refers to the credit extended by the supplier of goods and services in
the normal course of business transactions. Generally, cash is not paid immediately for purchases but
after an agreed period of time. This is deferral of payment and is also considered as a source of
finance. Trade credit does not involve explicit interest charges, but there is an implicit cost involved. If
the credit term is for example, 2/10, net 30; it means the company will get a cash discount of 2% for a
payment made within 10 days, or else the entire payment is to be made within 30
days. Since the net amount is due within 30 days, not availing discount means paying an extra 2% for
the 20-day period. The other advantage of meeting the payments on time is that it prevents
bankruptcy that arises out of the firms inability to honour its commitments.
At the same time, care should be taken not to keep large cash reserves as it involves high cost.
Minimising funds held in the form of cash balances:
Trying to achieve the second objective is very difficult. A high level of cash balance will help the firm to
meet its first objective, but keeping excess reserves is also not desirable as funds in its original form is
idle cash and a non-earning asset. It is not profitable for firms to maintain huge balances. A low level
of cash balance may mean failure to meet the payment
schedule. The aim of cash management is therefore to have an optimal level of cash by bringing
about a proper synchronisation of inflows and outflows, and to check the spells of cash deficits and
cash surpluses. Seasonal industries are classic examples of mismatches between inflows and
outflows.
Baumol model:

The Baumol model helps in determining the minimum amount of cash that a manager can obtain by
converting securities into cash. Baumol model is an approach to establish a firms optimum cash
balance under certainty. As such, firms attempt to minimise the sum of the cost of holding cash and
the cost of converting marketable securities to cash. Baumol model of cash management trades off
between opportunity cost or carrying cost or holding
cost and the transaction cost.
The Baumol model is based on the following assumptions:

The firm is able to forecast its cash requirements in an accurate way.


The firms payouts are uniform over a period of time.
The opportunity cost of holding cash is known and does not change with time.
The firm will incur the same transaction cost for all conversions of securities into cash.

A company sells securities and realises cash, and this cash is used to make payments. As the cash
balance decreases and reaches a point, the finance manager replenishes its cash balance by selling
marketable securities available with it and this pattern continues.