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Q.

1 Write the short notes on 5X2= (10


Marks)

1. Financial management
2. Financial planning
3. Capital structure
4. Cost of capital
5. Trading on equity.

Answer:
1. Financial management: Financial management is the branch of the finance that concerns
itself with the managerial significance of finance techniques. It is focused on assessment
rather than technique. The difference between a managerial and a technical approach can
be seen in the questions one might ask of annual reports. One concerned with technique
would be primarily interested in measurement. One concerned with management though
would want to know what the figures mean. They might compare the returns to other
businesses in their industry and ask: are we performing better or worse than our peers? If
so, what is the source of the problem? Do we have the same profit margins? If not why?
Do we have the same expenses? Are we paying more for something than our peers? They
may look at changes in asset balances looking for red flags that indicate problems with bill
collection or bad debt. They will analyze working capital to anticipate future cash flow
problems. Managerial finance is an interdisciplinary approach that borrows from both
managerial accounting and corporate finance. Sound financial management creates value
and organisational agility through the allocation of scarce resources amongst competing
business opportunities. It is an aid to the implementation and monitoring of business
strategies and helps achieve business objectives.

2. Financial planning: A financial planning or financial planner is a practicing professional


who helps people deal with various personal financial issues through proper planning,
which includes but is not limited to these major areas: cash flow management, education
planning, retirement planning, investment planning, risk management and insurance
planning, tax planning, estate planning and business succession planning (for business
owners). The work engaged in by this professional is commonly known as personal
financial planning. In carrying out the planning function, he is guided by the financial
planning process to create a
financial plan; a detailed strategy tailored to a client's specific situation, for meeting a
client's specific goals. The key defining aspect of what the financial planner does is that he
considers all questions, information and advice as it impacts and is impacted by the entire
financial and life situation of the client.

3. Capital structure: In finance, capital structure refers to the way a corporation finances
its assets through some combination of equity, debt, or hybrid securities. A firm's capital
structure is then the composition or 'structure' of its liabilities. For example, a firm that sells
$20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80%
debtfinanced.
The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's
leverage. In reality, capital structure may be highly complex and include dozens of
sources. Gearing Ratio is the proportion of the capital employed of the firm which come
from outside of the business finance, e.g. by taking a short term loan etc. The Modigliani-
Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for
modern thinking on capital structure, though it is generally viewed as a purely theoretical
result since it assumes away many important factors in the capital structure decision. The
theorem states that, in a perfect market, how a firm is financed is irrelevant to its value.
This result provides the base with which to examine real world reasons why capital
structure is relevant, that is, a company's value is affected by the capital structure it
employs. Some other reasons include bankruptcy costs, agency costs, taxes, and
information asymmetry. This analysis can then be extended to look at whether there is in
fact an optimal capital structure: the one which maximizes the value of the firm.

4. Cost of capital: The cost of capital is the cost of a company's funds (both debt and
equity), or, from an investor's point of view "the expected return on a portfolio of all the
company's existing securities". It is used to evaluate new projects of a company as it is the
minimum return that investors expect for providing capital to the company, thus setting a
benchmark that a new project has to meet. For an investment to be worthwhile, the
expected return on capital must be greater than the cost of capital. The cost of capital is
the rate of return that capital could be expected to earn in an alternative investment of
equivalent risk. If
a project is of similar risk to a company's average business activities it is reasonable to
use the company's average cost of capital as a basis for the evaluation. A company's
securities typically include both debt and equity, one must therefore calculate both the cost
of debt and the cost of equity to determine a company's cost of capital. The cost of debt is
relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the
interest-rate paid by the company can be modelled as the risk-free rate plus a risk
component (risk premium), which itself incorporates a probable rate of default (and
amount of recovery given default). For companies with similar risk or credit ratings, the
interest rate is largely exogenous (need to explain use of "exogenous" in this context). The
cost of equity is more challenging to calculate as equity does not pay a set return to its
investors. Similar to the cost of debt, the cost of equity is broadly defined as the risk-
weighted projected return required by investors, where the return is largely unknown. The
cost of equity is therefore inferred by comparing the investment to other investments
(comparable) with similar risk
profiles to determine the "market" cost of equity.

5. Trading on equity: In finance, equity trading is the buying and selling of company stock
shares. Shares in large publicly-traded companies are bought and sold through one of the
major stock exchanges, such as the New York Stock Exchange, London Stock Exchange
or Tokyo Stock Exchange, which serve as managed auctions for stock trades. Stock
shares in smaller public companies are bought and sold in over-the-counter (OTC)
markets. Equity trading can be performed by the owner of the shares, or by an agent
authorized to buy and sell on behalf of the share's owner. Proprietary trading is buying and
selling for the trader's own profit or loss. In this case, the principal is the owner of the
shares. Agency trading is buying and selling by an agent, usually a stock broker, on behalf
of a client. Agents are paid a commission for performing the trade. Major stock exchanges
have market makers who help limit price variation (volatility) by buying and selling a
particular company's shares on their own behalf and also on behalf of other clients.

Q.2 a. Write the features of interim dividend and also write the factors (08
Marks)
Influencing divined policy?
b. What is reorder level ? (02Marks)
Answer:
(a.) An interim dividend is a partial dividend payment that is issued to shareholders at the
discretion of a company’s board of directors. This type of dividend is often extended after the
interim or mid-year auditing of the company’s accounting records takes place. Directors typically
assess the progress of the business during the first half of the year and issue a somewhat
conservative partial dividend based on their expectations of how the company will perform for the
remainder of the business year. In most instances, an interim dividend is less than the final
dividend that is issued once the final accounting for the business year is completed and accepted.

The issuance of an interim dividend is common in a number of countries around the world.
Shareholders with investments in companies based in the United Kingdom often receive this type
of partial dividend payment shortly after the second quarter of the business year is completed and
the financial accounting taken place. In other nations, companies may or may not provide mid-year
dividend payments to shareholders, depending on governmental trading regulations that may
apply, and the provisions found in the companies' articles of incorporation that pertain to the
issuance of stock and stock dividends.

In nations where an interim dividend is relatively common, directors typically assess the outcome
of the company’s finances during the first half of the year, using data that was collected during the
mid-year audit This information is considered along with the projected performance of the
corporation for the remainder of the business year. At that point, the directors will determine what
they feel is an equitable interim dividend amount for distribution.

It is important to note that the process of determining the amount of an interim dividend is not
based solely on the most recent performance of the business. Company officers rarely assume that
performance levels for the second half of the year will equal the levels achieved during the first
half. More often, directors will assume that the remaining two quarters of the year could possibly
generate lower returns, and allow for that possibility when calculating the amount of the interim
dividend. This means that directors may conservatively extend a mid-year dividend that amounts
to thirty or forty percent of the dividend that is anticipated to come due after the financial year is
closed out. Doing so helps to insulate the company from potential downturns in revenue or other
events that could negatively impact the return on the issued shares.

(b). This is that level of materials at which a new order for supply of materials is to be placed. In
other words, at this level a purchase requisition is made out. This level is fixed somewhere
between maximum and minimum levels. Order points are based on usage during time necessary to
requisition order, and receive materials, plus an allowance for protection against stock out.

The order point is reached when inventory on hand and quantities due in are equal to the
lead time usage quantity plus the safety stock quantity.

Formula of Re-order Level or Ordering Point:


The following two formulas are used for the calculation of reorder level or point.
[Ordering point or re-order level = Maximum daily or weekly or monthly usage ×
Lead time]

The above formula is used when usage and lead time are known with certainty; therefore, no
safety stock is provided. When safety stock is provided then the following formula will be
applicable:

[ Ordering point or re-order level = Maximum daily or weekly or monthly usage ×


Lead time + Safety stock ]

Examples:
Example 1:

Minimum daily requirement 800 units


Time required to receive emergency supplies 4 days
Average daily requirement 700 units
Minimum daily requirement 600 units
Time required for refresh supplies One month (30 days)

Calculate ordering point or re-order level

Calculation:

Ordering point = Ordering point or re-order level = Maximum daily or weekly or monthly
usage × Lead time

= 800 × 30

= 24,000 units

Q.3 Sales Rs.400, 000 less returns Rs 10, 000, Cost of Goods Sold Rs 300,000,
Administration and selling expenses Rs.20, 000, Interest on loans Rs.5000, (10 Marks)
Income tax Rs.10000, preference dividend Rs. 15,000, Equity Share Capital
Rs.100, 000 @Rs. 10 per share. Find EPS.
Answer: 3).

400,000.0
Sales 0
10,000.0
Less Returne 0
390,000.0
0
300,000.0
Less Cost of Sales 0
90,000.0
Gross Profit 0
20,000.0
Less Admin & Selling Exp. 0
70,000.0
Administrative Profit 0
5,000.0
Less Int. on Loan 0
65,000.0
Profit before Tax 0
10,000.0
Less Income Tax 0
55,000.0
Profit after Tax 0
15,000.0
Less Prefrence Dividend 0
Earning Avilability to equaity 40,000.0
shares 0

Net Income
EPS = No. of Share

= 40,000/10,000
= 4 Ans.

Q.4 What are the techniques of evaluation of investment? (10 Marks)

Answer: Three steps are involved in the evaluation of an investment:

• Estimation of cash flows


• Estimation of the required rate of return (the cast of capital)
• Application of a decision rule for decision rule for making the choice

Investment decision rule

The investment decision rules may be referred to as capital budgeting techniques, or investment
criteria. A sound appraisal technique should be used to measure the economic worth of an
investment project. The essential property of a sound technique is that is should maximize the
shareholders wealth. The following other characteristics should also be possessed by a sound
investment evaluation criterion:
• It should consider all cash flows to determine the true profitability of then project.
• It should provide for an objective and unambiguous way of separate good projects from bad
projects.
• It should help ranking of projects according to their true profitability.
• It should recognize the fact that bigger cash flows are preferable to smaller ones and early cash
flows are preferable to later ones.
• It should help to choose among mutually exclusive projects that project which maximizes the
shareholders wealth.
• It should be a criterion which is applicable to any conceivable investment project independent of
others.

These conditions will be clarified as we discuss the features of various investment criteria in the
following posts.

Investment Appraisal Criteria

A number of investment appraisal criteria or capital budgeting techniques are in use of practice.
They may be grouped in the following two categories:

1. Discounted cash flow criteria


• Net present value
• Internal rate of return
• Profitability index (PI)

2. Not discounted cash flow criteria


• Payback period
• Accounting rate of return
• Discounted payback period

Discounted payback is a variation of the payback method. It involves discounted method, but it is
not a true measure of investment profitability. We will show in our following posts the net present
value criterion is the most valid technique of evaluating an investment project. It is consistent with
the objective of maximizing the shareholders wealth.

Q.5 What are the problems associated with inadequate working capital? (10
Marks)

Answer:

Working capital Introduction Working capital typically means the firm’s holding of current
or short-term assets such as cash, receivables, inventory and marketable securities.
These items are also referred to as circulating capital Corporate executives devote a
considerable amount of attention to the management of working capital.

Concept of working capital There are two possible interpretations of working capital
concept: Balance sheet concept Operating cycle concept Balance sheet concept There
are two interpretations of working capital under the balance sheet concept. a. Excess of
current assets over current liabilities b. gross or total current assets.

Excess of current assets over current liabilities are called the net working capital or net
current assets. Working capital is really what a part of long term finance is locked in and
used for supporting current activities. The balance sheet definition of working capital is
meaningful only as an indication of the firm’s current solvency in repaying its creditors.
When firms speak of shortage of working capital they in fact possibly imply scarcity of
cash resources. In fund flow analysis an increase in working capital, as conventionally
defined, represents employment or application of funds.

Operating cycle concept A company’s operating cycle typically consists of three primary
activities: Purchasing resources, Producing the product and Distributing (selling) the
product. These activities create funds flows that are both unsynchronized and uncertain.
Unsynchronized because cash disbursements (for example, payments for resource
purchases) usually take place before cash receipts (for example collection of
receivables). They are uncertain because future sales and costs, which generate the
respective receipts and disbursements, cannot be forecasted with complete accuracy.
The firm has to maintain cash balance to pay the bills as they come due. In addition, the
company must invest in inventories to fill customer orders promptly. And finally, the
company invests in accounts receivable to extend credit to customers. Operating cycle is
equal to the length of inventory and receivable conversion periods.

Operating cycle of a typical company Payable Deferral period Inventory conversion period
Cash conversion cycle Operating cycle Pay for Resources purchases Receive Cash
Purchase resources Sell Product On credit Receivable Conversion period.
Cash conversion cycle = operating cycle – payables deferral period. Importance of
working capital Risk and uncertainty involved in managing the cash flows Uncertainty in
demand and supply of goods, escalation in cost both operating and financing costs.
Strategies to overcome the problem Manage working capital investment or financing such
as.
Holding additional cash balances beyond expected needs Holding a reserve of short term
marketable securities Arrange for availability of additional short-term borrowing capacity One of
the ways to address the problem of fixed set-up cost may be to hold inventory. One or combination
of the above strategies will target the problem Working capital cycle is the life-blood of the firm

Resource flows for a manufacturing firm Fixed Assets Production Process Generates Inventory
Via Sales Generator Accounts receivable Used in Accrued Direct Labour and materials Accrued
Fixed Operating expenses Cash and Marketable Securities Suppliers Of Capital External Financing
Return on Capital Collection process Used to purchase Used to purchase Used in Working Capital
cycle

Working capital investment The size and nature of investment in current assets is a function of
different factors such as type of products manufactured, the length of operating cycle, the sales
level, inventory policies, unexpected demand and unanticipated delays in obtaining new
inventories, credit policies and current assets.
Q.6 What is leverage? Compare and Contrast between operating (10 Marks)
Leverage and financial leverage

Answer:
1. The use of various financial instruments or borrowed capital, such as margin, to
increase the potential return of an investment.

2. The amount of debt used to finance a firm's assets. A firm with significantly
more debt than equity is considered to be highly leveraged.
Leverage is most commonly used in real estate transactions through the use of
mortgages to purchase a home.

Leverage helps both the investor and the firm to invest or operate. However, it comes
with greater risk. If an investor uses leverage to make an investment and the investment
moves against the investor, his or her loss is much greater than it would've been if the
investment had not been leveraged - leverage magnifies both gains and losses. In the
business world, a company can use leverage to try to generate shareholder wealth, but if
it fails to do so, the interest expense and credit risk of default destroys shareholder value.

As insurers participate in match-funded transactions that involve the raising of external


funding, Standard & Poor's Ratings Services is often asked whether these companies'
debt or debt-like obligations are viewed as financial leverage or operating leverage.
Financial leverage is generally meant to measure the amount of debt or debt-like funding
that is used by an insurer to meet its general capital needs. Alternatively, insurers might
use debt or debtlike instruments to fund a discrete pool of financial assets—such as
bonds or other high-quality, fixed-interest instruments. In these cases, Standard &
Poor's may treat this debt as operational leverage when there is strong asset/liability
matching or active risk management employed and when there is little to no risk that the
assets will not be able to repay the funding. A distinct version of operational leverage,
financial intermediation, is when the assets do not exist on the balance sheet when the
transaction is initiated or when a third party's assets are match-funded. The purpose of
this article is to codify and document Standard & Poor's treatment of operational leverage
and financial intermediation activities in its analysis of insurance companies.
The difference in the credit impact between funding viewed as financial leverage and
funding viewed as operational leverage can be large. For example, debt raised to meet
an insurer's general capital needs would be viewed as financial leverage, and typically,
highly rated companies could have 10%-35% of their capital in these debt or debt-like
instruments. Alternatively, insurers may issue funding agreements, GICs, or even debt
backed by highquality, fixed-interest assets with matching durations, tightly corresponding
cash flows, and positive convexity. Standard & Poor's would view such an issuance as a
financial-intermediation activity, these funds would be considered operational leverage as
long as the residual risk is insignificant,and the sums would be excluded from financial-
leverage ratios. By contrast to funding viewed as financial leverage, these lines of
business can commonly have funding levels that are 10x-30x the amount of total equity
for highly rated insurers. Standard & Poor's will continue to be conservative in its interpretation of
the nature of the issuance of these funding instruments. Standard & Poor's will view both types as
financial leverage in the absence of a thorough analysis of the assets and controls supporting these
funding mechanisms, including segregation of pools of assets. Historically, Standard & Poor's has
found that individual instances of financial intermediation and operational leverage in its analyses
of insurance companies tended to fall into a handful of classes. One of the most common classes is
the institutional spread-based business of some U.S. life insurance companies. However, the
number and variety of types of activities that arearguably instances of financial intermediation and
potentially worthy of operational leverage treatment in Standard & Poor's analysis have multiplied
in recent years. No longer are they always obviously identifiable as belonging to an existing class
of operational-leverage transactions, nor do they lend themselves to the ready application of rules-
based criteria. Rather than establish a formal rules-based approach, Standard & Poor's has elected
to set clear definitions of terms, to enunciate the principles underlying its views on financial
intermediation and operational leverage, and to establish a process that will insure a consistent
application of these principles.