FIN 7702

Assignment

Harshit Garg(1920063)

(190010301027)

MBA II

Q1. State the significance of cost of capital.

ANS- COST OF CAPITAL :- Cost of capital is the rate of return that a firm must earn on its
project investments to maintain its market value and attract funds. Cost of capital is the required
rate of return on its investments which belongs to equity, debt and retained earnings. If a firm
fails to earn return at the expected rate, the market value of the shares will fall and it will result
in the reduction of overall wealth of the shareholders.

According to the definition of Solomon Ezra, “Cost of capital is the minimum required rate of
earnings or the cut-off rate of capital expenditure”.

 SIGNIFICANCE OF COST OF CAPITAL

1. Importance to Capital Budgeting Decision:- Decisions on the capital budget mostly
depend on the capital cost of each source. According to the net present value equation,
cash inflow current value must be greater than the real cash outflow value. Cost of capital
is also used to settle on capital budgeting.
2.  Importance to Structure Decision:- Capital structure is the combination or proportion
of long-term securities of the different types. A company uses different types of sources
if the capital expense is sufficient. Cost of capital therefore allows to take strategic
decisions.
3. Importance to Evolution of Financial Performance:- Capital cost is one of the
significant determinations that influences the company's capital budgeting, capital
structure and valuation. Hence, it helps to determine the company's financial results.
4.  Importance to Other Financial Decisions:- In addition to the above, capital costs are
also used in certain other fields, such as equity market valuation, bond earning potential,
and so it plays an important role in financial management.
Q-2 Briefly explain the factors to be considered in capital structure planning.

ANS :- The planning of capital structures is very necessary for long-term survival of the
company. You see two sides of the balance sheet after easy looking at the company's balance
sheet. One side is one of responsibility and the other side is one of assets. Liability is the mixture
of corporate financing obtained by the organization from internal and external sources and used
or used to grow the business.

 Factors to be considered in capital structure planning

1) Trading of equity or financial leverage :- The use of equity and preferred share capital
as well as fixed-interest long-term debt is known as financial leverage. Leverage can have
a detrimental impact because the company's desired earnings are less than the interest on
long-term loans. It is therefore essential to prepare the enterprise capital structure.
2) Stability and growth of sales :- Stability and revenue growth have a major effect on a
company's capital structure. Sales stability, means company is in a strong position and
can deliver on its debt reduction obligations and interest payments. If a company's
revenues are assumed to be stable then business will raise its debt. In the same way,
market growth influences struc's decisions
3) Flexibility :- Business capital structure should be versatile in nature, so that the changing
requirements can be easily altered. Under such a process, a company can prepare its
capital structure, so that one form of financing can be replaced by another.
4) Capital cost :- Capital cost is the cost suppliers require the least returns. The returns the
suppliers want depend on the amount of risk they're going through. The capital structure
should be such that less amount of the cost of capital is given. While designing the capital
structure an effort is made to decrease the total cost of capital.
5) Capital market situations :- Business conditions are inflexible, sometimes it can
experience depression and sometimes boom. Though share markets face downturn,
business should not issue equity shares and when the market is booming, it is very
favorable for issuing equity shares.
6) Reason of financing :- Financing is a very critical component of business operations.
Debt funding is suitable for companies seeking funds for production purposes. There is a
need for long-term equity investment and it is better to go to equity markets.
7) Profitability:- From the point of view of equity owners a financial structure would be
most competitive. Therefore, maximum loan funding should be chosen within the
specified barriers to increase the returns available to shareholders.
Que-3 . How will you determine the working capital requirement for a
chemical industry?

Ans – Working Capital :- Working capital is basically an indicator of the organization's short-
term financial status and also a measure of its overall performance. Working capital is acquired
by subtracting the existing liabilities from the current assets. This ratio shows that the company
has adequate assets to support its short-term debt.

Working Capital defines the liquidity rates of the companies to handle day-to-day expenditures
and includes inventory, currency, accounts payable, accounts receivable and short-term debts
due. Working capital is generated from a variety of business processes, such as debt and
inventory management, customer payments and revenue collection.

 Factors Determining the Requirements of Working Capital

1. Sale :- Among the different factors, the size of revenue is one of the significant
considerations for deciding the amount of working capital. To order to increase revenue
volumes, the organization has to retain its existing assets. Over the course of the century,
the organization is in a position to sustain a steady ratio of its current assets to annual
revenue. As a result, the turnover ratio, i.e. the existing assets, is to the turnover ratio.
2. Length of Operating Cycle :- Conversion of cash by various stages, i.e., raw materials,
semi-processed goods, finished products, sales, debtors and bills of accounts receivable
into cash, takes a certain amount of time known as the 'duration of the operating cycle.'
The longer the operating cycle period, the more labor capital is required.
3. Nature of Business :- The need for working capital often varies between undertakings
depending on the nature of the undertaking. For example, trading companies need more
operating capital than manufacturing companies. It is because the trading industry needs
large quantities of goods to be kept in stock and therefore to hold large sums of working
capital than the output issues.
4. Terms of Credit :- Another significant factor deciding the sum of working capital
requirements relates to the terms of credit provided to the customer. An company may, for
example, offer only 15 days of credit, while another may offer 90 days of credit to its
customers. In addition, an enterprise may extend credit facilities to all its customers, while
another company in the same company can extend credit only.
5. Turnover of inventories ;- If the inventories are high but the turnover is slow, the small
business will need more working capital. On the contrary, if the inventories are low but
their turnover is high, the business would need a low amount of working capital.
6. Nature of Production Technology :- In the case of labor- intensive manufacturing, the
company will need more to pay wages and will also require more working capital. On the
other hand, if the manufacturing process is capital intensive, the company will have to pay
less for costs such as wages. As a result, a company would need less working capital
Que-4 Briefly explain operating leverage.

Ans- The leverage associated with investment activities is referred to as operating leverage. It's
triggered by the firm's fixed operating expenses. Operating leverage can be described as the
ability of the company to use fixed operating costs to magnify the impact of revenue adjustments
on its earnings before interest and taxes. The operational flexibility involves two major costs,
namely fixed costs and variable cost. Operating leverage reproduces the effect a shift in
productivity level has on the operating profits. The degree to which a firm or particular project
requires the combined of both fixed and variable costs is calculated by operational leverage.
Fixed costs are not altered by an increase or decrease in the overall amount of products or
services that a business produces.
Operation Leverages can be calculated with the help of the following formula :-

OL = Operating Leverage
C = Contribution
OP = Operating Profits

Uses of Operating Leverage :-

a) Operating leverage is one of the ways of calculating the effect of improvements in

revenue that contribute to a difference in the company's earnings. When the sales change,
this will result in subsequent changes in earnings.
b) Operating flexibility helps in defining the fixed cost role and variable cost role.
c) Operating leverage tests the relationship between the company's sales and income for a
given period.
d) Operating efficiency helps to consider the amount of fixed cost that is being spent in
company operating expenses.
e) Operating leverage determines the total fixed operating cost role.

Q5. What is MM irrelevance dividend hypothesis? Critically evaluate its

assumptions.
Ans. Solo man, Modigliani, and Miller are concerned with the irrelevance principle of
dividends. According to them Dividend Policy has no impact on the Company's share price. In
their view creditors do not distinguish the capital gains from the dividend. Their basic goal is to
gain a greater return on their investment. The Company has sufficient investment opportunities
that offer a higher return rate than the cost of retained earnings, the investors will be happy with
the company retaining the earnings.

Dividend Decision is a financial decision whether to support company's fund requirements by

retained earnings or not. In case a Company has attractive investment opportunities, it must hold
the profits to fund them otherwise allocate there. Shareholders 'interest is income, whether in
Dividend form or in capital gains.

ASSUMPTIONS OF THE MODEL

MODIGLIANI – MILLER'S THEORY IS BASED ON THE FOLLOWING ASSUMPTIONS:

1. Perfect Capital Markets :- This theory is based on the existence of 'perfect capital
markets.' It assumes that all investors are rational, have access to free information, that
there are no floating or transaction costs and that no large investor can influence the
market price of the share.
2. No Taxes:- There is no tax existence. Alternatively, dividends and capital gains are taxed
at the same rate.
3. Fixed Investment Policy :- The company does not change its current investment policy.
This means that whatever the dividend payment may be, the company will make the
investment as it has already decided. If the company pays more dividends, it will have
more equity shares and vice versa.
4. No Risk of Uncertainty :- All the investors are certain about the future market prices and
the dividends. This means that the same discount rate is applicable for all types of stocks
in all time periods.
5. Investor is Indifferent between dividend income and capital gain income :- It is assumed
that investor is indifferent between dividend income and capital gain income. It means if
he requires total return of Rs. 500, he may get Rs. 200 dividend income and Rs. 300 as
capital gain income or reverse, in either of the case he gets equal satisfaction.