BASICS OF FINANCIAL

MANAGEMENT
ASSIGNMENT

SUBMITTED BY:
SUBMITTED TO: AYUSH RAJ
Dr. SUSHIL KUMAR BBA/15009/19

BIRLA INSTITUTE OF TECHNOLOGY

1. Discuss following methods of evaluating investment projects.
i. Pay Back Period Method: It represents the period in which the total
investments in permanent assets pay backs itself. This method is based on
the principal that every capital expenditures pays itself back within a
certain period out of the additional earnings generated from the capital
assets thus it measures the period of time for the original cost of a project to
be recovered from the additional earnings of the project itself.
In case of evaluation of a single project, it is adopted if it pays back itself
within a period specified by the management and if the project does not pay
back itself within the period.

Where the annual cash inflows are equal, Divide the initial outlay (cost)
of the project by annual cash flows, where the project generates constant
annual cash inflows.
Where the annual cash inflows are unequal, the pat back period can be
found by adding up the cash inflows until the total is equal to the initial
cash outlay of project or original cost of the asset.

Payback period = Cash outlay of the project or original cost of the

asset\
Annual cash Inflows

ii. Average rate of return method (ARR): Under this method average
profit after tax and deprecation is calculated and then it is divided by the
total capital outlay or total investment in the project.
ARR= Total Profits (after dep. & taxes) X 100
Net Investment in project x No. Of years of profits
Or
Average annual profit X 100
Net investment in the Project

iii. Internal Rate of Return Method: It is a modern technique of capital

budgeting that take into account the time value of money. It is also known
as “time adjusted rate of return discounted cash flows” “yield method”
“trial and error yield method”
Under this method, the cash flows of the project are discounted at a suitable
rate by hit and trial method, which equates the net present value so
calculated to the amount of the investment. Under this method, since the
discount rate is determined internally, this method is called as the internal
 rate of return method. It can be defined as the rate of discount at which the
present value
of cash inflows is equal to the present value of cash outflows.

When the annual net cash flows are equal over the life of the assets.

Present Value Factor = Initial Outlay

Annual Cash Flows

iv. Net Present Value Method: This method is the modern method of
evaluating the investment proposals. This method takes into consideration
the time value of money and attempts to calculate the return in investments
by introducing the factor of time element. It recognizes the fact that a rupee
earned today is more valuable earned tomorrow. The net present value of
all inflows and outflows of cash occurring during the entire life of the
project is determined separately for each year by discounting these flows
by the firm’s cost of capital.

v. Profitability Index or PI: This is also known as benefit cost ratio. This
is similar to the NPV method. The major drawback of NPV method that
does not give satisfactory results while evaluating the projects requiring
different initial investments. PI method provides solution to this.
PI is calculated as:

PI = Present value of cash Inflows

Present value of cash outflows

2. Explain factors affecting capital structure decisions.

Ans. The factors affecting capital structure decisions are as follows:
i. Financial Leverage: The use of long term fixed interest bearing debt and
preference share capital along with equity share capital is called financial
leverage. The use of long term debt magnifies the earning per share if the
firm yields a return higher than the cost of debt. The earning per share also
increases with use of preference share capital but due to the fact that
interest is allowed to be deducted while computing tax, the leverage impact
of debt is more.
ii. Growth and Stability of Sales: The capital structure of a firm is highly
influenced by the growth and stability of its sales. If the sales are expected
 to remain fairly stable, it can raise a higher level of debt. Stability of sales
ensures that the firm will not face any difficulty in meeting its fixed
commitments of interest payment and repayments of debts.
iii. Cost of Capital: Cost of capital refers to the minimum rate of return
expected by its suppliers. The capital structure should also provide for the
minimum cost of capital. Usually, debt is cheaper source of finance
compared to preference and equity.
iv. Nature and Size of Firm: Nature and size of firm also influences the
capital structure. A public utility concern has different capital structure as
compared to manufacturing concern. Public utility concern may employ
more of debt because of stability and regularity of their earnings. Small
companies have to depend upon owned capital, as it is very difficult for
them to raise ling term loans on reasonable terms.
v. Flexibility: Capital structure of the firm should be flexible. I.e. it should be
capable of the being adjusted according top the needs of changing
conditions. A firm should arrange its capital structure in such a way that it
can substitute one form of financing by other.
vi. Capital Market Conditions: The choice of securities is also influenced by
the market conditions. If share market is depressed the company should not
issue equity share capital.

3. Discuss determinants of dividend policy along with different

forms of dividends.
Ans. The determinants of dividend policy are as follows:
I. Legal Restrictions: Legal provisions relating to dividends in the
Companies Act, 1956 lay down a framework within which dividend policy
is formulated. These provisions require that:
 Dividend can be paid only out of current profits or past profits after
providing for depreciation or out of the moneys provided by Government
for the payment of dividends in pursuance of a guarantee given by the
Government.
 A company providing more than ten per cent dividend is required to
transfer certain percentage of the current year's profits to reserves.
 The dividends cannot be paid out of capital because it will amount to
reduction of capital adversely affecting the security of its creditors.
II. Desire and Type of Shareholders: Desires of shareholders for dividends
depend upon their economic status. Investors, such as retired persons,
 widows and other economically weaker persons view dividends as a source
of funds to meet their day-to-day living expenses. To benefit such
investors, the companies should pay regular dividends.
III. Magnitude and Trend of Earnings: As dividends can be paid only out of
present or past year's profits, earnings of a company fix the upper limits on
dividends. The dividends should, generally, be paid out of current year's
earnings only as the retained earnings of the previous years become more
or less a part of permanent investment in the business to earn current
profits. The past trend of the company's earnings should also be kept in
consideration while making the dividend decision.
IV. Age of the Company: The age of the company also influences the dividend
decision of a company. A newly established concern has to limit payment
of dividend and retain substantial part of earnings for financing its future
growth and development, while older companies which have established
sufficient reserves can afford to pay liberal dividends.
V. Inflation: Inflation acts as a constraint in the payment of dividends. when
prices rise, funds generated by depreciation would not be adequate to
replace fixed assets, and hence to maintain the same assets and capital
intact, substantial part of the current earnings would be retained.
VI. Control Objectives: As in case of a high dividend pay-out ratio, the
retained earnings are insignificant, and the company will have to issue new
shares to raise funds to finance its future requirements. The control of the
existing shareholders will be diluted if they cannot buy the additional
shares issued by the company.
The types of dividend policy are as follows:
I. Regular Dividend Policy: Payment of dividend at the usual rate is termed
as regular dividend. The investors such as retired persons, widows and other
economically weaker persons prefer to get regular dividends.
II. Stable Dividend Policy: The term 'stability of dividends' means consistency
in the stream of dividend payments. In more precise terms, it means payment
of certain minimum amount of dividend regularly. A stable dividend policy
may be established in any of the following three forms:
a. Constant dividend per share
b. Constant payout ratio
c. Stable rupee dividend plus extra dividend
III. Irregular Dividend Policy: Some companies follow irregular dividend
payments on account of the following: (i) Uncertainty of earnings(ii)
Unsuccessful business operations(iii) Lack of liquid resources
IV. No Dividend Policy: A company can follow a policy of paying no dividends
presently because of its unfavorable working capital position or on account
of requirements of funds for future expansion and growth.