FINANCIAL MANAGEMENT

DMGT 405
 Financial Management (DMGT 405)
Q1.Define Inventory Management.
Ans.Activities employed in maintaining the optimum number or amount of each inventory item.The objective of
inventory management is to provide uninterrupted production, sales,and/or customer-service levels at the
minimum cost. Since for many companies inventory is the largest item in the current assets category,
inventory problems can and do contribute to losses or even business failures. Also called inventory control.

Q2.Discuss the meaning of capital rationing.

Ans.Capital rationing is the process of putting restrictions on the projects that can be undertaken by the company
or the capital that can be invested by the company. This aims in choosing only the most profitable investments
for the capital investment decision. This can be accomplished by putting restrictive limits on the budget or
selecting a higher cost of capital as thehurdle rate for all the projects under consideration. Capital rationing can
be either hard or soft.

Q3.Define Capital Budgeting.

Ans. Capital budgeting, or investment appraisal, is the planning process used to determine whether an
organization's long term investmentssuch as new machinery, replacement machinery, new plants, new
products, and research development projects are worth the funding of cash through the firm's capitalization
structure (debt, equity or retained earnings). It is the process of allocating resources for major capital, or
investment, expenditures. One of the primary goals of capital budgeting investments is to increase the value of
the firm to the shareholders.
Q4.What do mean by optimum capital structure?
Ans. The capital structure is said to be optimum when the firm has selected such a combination of
equity and debt so that the wealth of firm (shareholder) is maximum. At this capital structure, the cost of
capital is minimum and market price per share is maximum.
Q5.Write a short note on EVA.
Ans. Economic Value Added (EVA) is a popular measure used by many firms to determine whether an
investment – proposed or existing – contribute positively to the owner’s wealth. EVA is calculated by
subtracting, the cost of funds used to finance or investment from its after-tax- operations profits.
Investments with positive EVA increase shareholder value as those with negative EVA reduce shareholders
value.
Q6.What do understand by time value of money?
Ans. The time value of money (TVM) is the idea that money available at the present time is worth more
than the same amount in the future due to its potential earning capacity. This core principle of finance
holds that, provided money can earn interest, any amount of money is worth more the sooner it is
received.
Q7.What is leasing?
Ans. Leasing is a financial instrument in which the property of the leased asset remains with the leasing
company while the lessee obtains the right to use the asset by paying lease rentals for the life time of the
leasing contract. At the maturity of the leasing contract the ownership of the leased asset is transferred to
the lessee at a symbolic cost.
Q8.Discuss the concept of venture capital.
Ans.The venture capital financing refers to financing of new high risky venture promoted by qualified
entrepreneurs who lack experience and funds to give shape to their ideas. In a broad sense,under venture capital
financing, venture capitalists make investments to purchase equity or debt securities from inexperienced
entrepreneurs, who undertake highly risky ventures with a potential of success.
Q8.Define Financial Management.
 Ans.financial management is that specialized activity which is responsible for obtaining and affectively utilizing
the funds for the efficient functioning of the business and, therefore, it includes financial planning, financial
administration and financial control

Q9. Write a short note on working capital.

Ans. Working capital refers to the funds invested in current assets, i.e., investment in sundry debtors, cash and
other current assets. Current assets are essential to utilize facilities provided by plant and machinery, land and
buildings. In case of the manufacturing organization, a machine cannot be used without raw material.
Gross working capital: The gross working capital refers to investment in all the current assets taken together.
The total of investments in all current assets is known as gross working capital.
Net working capital: Net working capital refers to the excess of total current assets over total current liabilities.
Current liabilities are those liabilities that are intended to be paid in the ordinary course of business within a year,
out of the current assets or earnings of the concern.

Q10. Write a short note on Expected Return.

Ans. The amount one would anticipate receiving on an investment that has various known or expected rates of
return. For example, if one invested in a stock that had a 50% chance of producing a 10% profit and a 50%
chance of producing a 5% loss, the expected return would be 2.5% (0.5 * 0.1 + 0.5 * -0.05). It is important to
note, however, that the expected return is usually based on historical data and is not guaranteed. the expected
return is a tool used to determine whether or not an investment has a positive or negative average net outcome
- it is not a hard and fast figure of profit or loss. In the example above, for instance, the 2.5% expected return
cannot, in fact, be realized - it is merely an average.

Q11. What is cost of capital to a company?

Ans. Cost of capital is the minimum rate of return that a business must earn before generating value. Before a
business can turn a profit, it must at least generate sufficient income to cover the cost of the capital it uses to
fund its operations. Cost of capital consists of both the cost of debt and the cost of equity used for financing a
business. A company’s cost of capital depends to a large extent on the type of financing the company chooses
to rely on. The company may rely solely on equity or debt, or use a combination of the two.
Q12. What is financial management?
Ans. Financial Management means planning, organizing, directing and controlling the financial activities such
as procurement and utilization of funds of the enterprise. It means applying general management principles to
financial resources of the enterprise.
Q13.Define Annuity.
Ans. An annuity is a financial product that pays out a fixed stream of payments to an individual, primarily used
as an income stream for retirees. Annuities are created and sold by financial institutions, which accept and invest
funds from individuals and then, upon annuitization, issue a stream of payments at a later point in time. The
period of time when an annuity is being funded and before payouts begin is referred to as the accumulation
phase. Q14.What are the advantages of lease financing?
Ans. Leasing is a popular business strategy due to its following advantages:
▪ Instead of paying all of the cost of an asset upfront, the lessee pays the total cost over a number of periods,
which reduces the drag on its cash flows in a particular period. Payments for the use of asset are due exactly
when the asset is generating cash flows which makes it more manageable.
▪ Leasing adequately guards the lessee against the risk of obsolescence, i.e. the risk that assets may lose their
utility due to rapid changes in technology. A lessee can adjust the term of the lease such that it is no longer
burdened with the asset when it is no longer efficient to operate.
▪ For companies who are already high on debt, leasing provides a means of obtaining financing without worsening
their debt ratio i.e. obtaining off-balance sheet financing. A lease when classified as an operating lease is not
reported on the balance sheet even though it involves provision of asset against payments to be made in future.
Q15.Differentiate equity and preference shares.
Ans. There is a vast difference between equity shares and preference shares.

1. Equity shares represent the ownership in the company but preference shares can be treated as a
loan to company having no ownership right.
2. Dividend on equity shares is not fixed and may or may not be paid but dividend has generally to be
paid on preference shares at a fixed rate with some exceptions.
3. Preference shareholders are to be paid ahead of equity shareholders both in case of dividend or
liquidation.
4. Equity shareholders have a voting right in the administration of the company but preference
shareholders can vote on matters related to their concern.
Q16. What is capital structure?
Ans. Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as long-term
finance. The capital structure involves two decisions-

a. Type of securities to be issued are equity shares, preference shares and long term borrowings
(Debentures).
b. Relative ratio of securities can be determined by process of capital gearing. On this basis, the companies
are divided into two-
i. Highly geared companies - Those companies whose proportion of equity capitalization is small.
ii. Low geared companies - Those companies whose equity capital dominates total capitalization.
Q17. Define degree of operating leverage.
Ans. The degree of operating leverage (DOL) is a measure used to evaluate how a company's operating
income changes with respect to a percentage change in its sales. A company's operating leverage involves
fixed costs and variable costs. A company with a high degree of operating leverage has high fixed costs
relative to its variable costs. If the degree of operating leverage is high, the earnings before interest and
taxes (EBIT) experiences volatility with respect to a percentage change in sales, all else remaining the same,
and vice versa. There are a few formulas you can use to calculate a company's degree of operating leverage.
The main formula used to calculate the degree of operating leverage divides the percent change in EBIT by the
percent change in sales. For example, The Walt Disney Company (DIS) had its EBIT increase by 8.58% from
2015 to 2016, and its sales increased by 6.04% during the same period. The degree of operating leverage is:

%change in EBIT / %change in sales = 8.58% / 6.04% = 1.42. Therefore, if there is a 15% increase in the
company's sales, its EBIT increases by 21.3%.

Q18. Differentiate Gross and Net working Capital.

Ans. Gross working capital: The gross working capital refers to investment in all the current assets taken
together. The total of investments in all current assets is known as gross working capital.
Net working capital: Net working capital refers to the excess of total current assets over total current liabilities.
Current liabilities are those liabilities that are intended to be paid in the ordinary course of business within a year,
out of the current assets or earnings of the concern.
Q19. 'Payment of dividend involves legal considerations'. Discuss.
Ans. It is illegal to pay a dividend, if after its payment; the capital would be impaired (reduced). This
requirement might be met if only capital surplus existed. An upward revaluation of assets, however, would
create a capital surplus, but at the same time might operate as a fraud on creditors and for that reason is
illegal.
Basically the dividend laws were intended to protect creditors and therefore prohibit payment of a dividend if a
corporation is insolvent or if the dividend payment will cause insolvency.
Q20. What do you trade credit.
Ans. Trade credit is the credit extended to you by suppliers who let you buy now and pay later. Any time you
take delivery of materials, equipment or other valuables without paying cash on the spot, you're using trade
credit.
MOST IMPORTANT QUESTIONS(1-8)
Long Ques:
Q1. Discuss Profit Maximization Vs Wealth Maximization as objectives of Financial Management.
Or
What is the difference between profit maximization and wealth maximization? Why there is a conflict
between wealth maximization and profit maximization?
Ans. Traditional Approach—Profit Maximization
It has been traditionally argued that the objective of a company is to earn profit. This means that the finance
manager has to make decision in a manner that the profit is maximized. Each alternative, therefore, is to be seen
as to whether or not it gives maximum profit.
Profit maximization objective gives rise to a number of problems as below:
1. Profit maximization concept should be considered in relation to risks involved. There is a direct
relationship between risk and profit. Many risky propositions yield high profit. Higher the risk, higher is
the possibility of profits. If profit maximization is the only goal, then risk factor is altogether ignored.
2. Profit maximization, as an objective does not take into account time pattern of return.
3. Profit maximization, as an objective is too narrow. It fails to take into account the social considerations
as also the obligations to various interests of workers, consumers, society as well as ethical trade
practices.
4. Profits do not necessarily result in cash flows available to the stockholder. Owners receive cash flow in
the form of either cash dividends paid to them or proceeds from selling their shares for a higher price
than paid initially.
Modern Approach—Wealth Maximization
The alternative to profit maximization is wealth maximization. This is also known as Value Maximization or Net
Present Worth Maximization. Value is represented by the market price of the company’s equity shares. Prices
in the share market at a given point of time, are the result of many factors like general economic outlook,
particularly if the companies are under consideration, technical factors and even mass psychology. However,
taken on a long-term basis, the share market prices of a company’s shares do reflect the value, which the various
parties put on a company. Normally, the value is a function of two factors:
1. The likely rate of earnings per share (EPS) of a company and
2. The capitalization rate
EPS are calculated by dividing the periods total earnings available for the firm’s common shares by the number
of shares of common shares outstanding. The likely rate of earnings per share (EPS) depends on the
assessment as to how profitably a company is going to operate in the future.

Q2. What is meant by financial management? Explain its role and functions in detail.(lpu dec 2016)
Ans. Financial Management means planning, organizing, directing and controlling the financial activities such
as procurement and utilization of funds of the enterprise. It means applying general management principles to
financial resources of the enterprise.
Functions of Financial Management

Estimation of capital requirements: A finance manager has to make estimation with regards to capital
requirements of the company. This will depend upon expected costs and profits and future programmes and
policies of a concern. Estimations have to be made in an adequate manner which increases earning capacity
of enterprise.

Determination of capital composition: Once the estimation have been made, the capital structure have to
be decided. This involves short- term and long- term debt equity analysis. This will depend upon the
proportion of equity capital a company is possessing and additional funds which have to be raised from
outside parties.

Choice of sources of funds: For additional funds to be procured, a company has many choices like-

a. Issue of shares and debentures

b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period of financing.

Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so that
there is safety on investment and regular returns is possible.

Disposal of surplus: The net profits decision have to be made by the finance manager. This can be done in
two ways:

d. Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus.
e. Retained profits - The volume has to be decided which will depend upon expansional,
innovational, diversification plans of the company.

Management of cash: Finance manager has to make decisions with regards to cash management. Cash is
required for many purposes like payment of wages and salaries, payment of electricity and water bills,
payment to creditors, meeting current liabilities, maintainance of enough stock, purchase of raw materials,
etc.

Financial controls: The finance manager has not only to plan, procure and utilize the funds but he also has
to exercise control over finances. This can be done through many techniques like ratio analysis, financial
forecasting, cost and profit control, etc.

Q3. Discuss in detail the various sources of finance.

or
You are starting your new company & wanted to raise capital from public. Analyse the sources of
finance available to you.
or
Explain Short term and long term sources of finance?
Ans. Sources of Finance of a Business
Long-Term
(a) Share capital or equity share: A public limited company may raise funds from promoters or from the
investing public by way of owners’ capital or equity capital by issuing ordinary equity shares. Ordinary
shareholders are owners of the company and they undertake the risks inherent in business.
(b) Preference shares: These are a special kind of shares, the holders of such shares enjoy priority, both as
regards to the payment of a fixed amount of dividend and repayment of capital on winding up of the company.
Long-term funds from preference shares can be raised through a public issue of shares. Such shares are
normally cumulative
(c) Internal Accruals: This basically means what is being ploughed back in business i.e., retained earnings and
the depreciation charge. While depreciation is used for replacing an old machinery, etc., retained earnings can
be used, for finding other long-term requirements of the business. The major advantage of using this as a source
of long-term finance are its easy availability, elimination of issue expenses and avoiding the problem of dilution
of control
(d) Debentures/Bonds of different types: Loans can be raised from public by issuing debentures or funds by
public limited companies. Debentures are normally issued in different denominations ranging from 100 to 1,000
and carry different rates of interest. By issuing debentures, a company can raise long-term loans from public.
Types of Debentures
Non-Convertible Debentures (NCDs)
Fully Convertible Debentures (FCDs)
Partly Convertible Debentures (PCDs)
(e) Loans from financial institutions: In India, specialized institutions provide long-term financial assistance to
industry. Thus, the Industrial Finance Corporation of India, the State Financial Corporations, the Life Insurance
Corporation of India, the National Small Industries Corporation Limited, the Industrial Credit and Investment
Corporation, the Industrial Development Bank of India and the Industrial Reconstruction Corporation of India
provide term loans to companies.
Short-Term
(a) Trade credit: Trade credit refers to the credit extended by the supplier of goods or services to his/her
customer in the normal course of business. Trade credit occupies very important position in short-term financing
due to the competition. Almost all the traders and manufacturers are required to extend credit facility, without
which there is no possibility of staying back in the business.
(b) Bridge finance: Bridge finance refers to loans taken by a company normally from commercial banks for a
short period, pending disbursement of loans sanctioned by financial institutions. Normally, it takes time for
financial institutions to disburse loans to companies.
(c) Commercial banks: The primary role of the commercial bank is to short-term requirements of industry. Of
late, however, banks have started taking an interest in term financing of industries in several ways, though the
formal term lending is so far small and is confined to major banks only.
(d) Commercial paper: Commercial paper represents a short-term unsecured promissory note issued by firms
that have a fairly high credit (standing) rating. It was first introduced in USA and it was an important money
market instruments. In India, Reserve Bank of India introduced CP on the recommendations of the Vaghul
Working Group on money market. CP is a source of short-term finance to only large firms with sound financial
position.
(e) Inter-corporate Deposits (ICDs): A deposit made by one firm with another firm is known as Inter-corporate
Deposits (ICDs). Generally, these deposits are usually made for a period up to six months. Such deposits may
be of three types: 1. Call Deposits, 2. Three Months Deposits, 3. Six Months Deposits
(f) Venture Capital Financing: The venture capital financing refers to financing of new high risky venture
promoted by qualified entrepreneurs who lack experience and funds to give shape to their ideas. In a broad
sense, under venture capital financing, venture capitalists make investments to purchase equity or debt
securities from inexperienced entrepreneurs, who undertake highly risky ventures with a potential of success.
Q4. What do you think are the determinants of the dividend policy of corporate enterprise?

or

Factors affecting dividend decision of a company?

Or

As a financial manager, what are the factors which you will consider while framing the Dividend policy
for your organization.

Ans. The declaration of dividends involves some legal as well as financial considerations. From the point of
legal considerations, the basic rule is that dividend can only be paid out profits without the impairment of
capital in any way. But the various financial considerations present a difficult situation to the management for
coming to a decision regarding dividend distribution.

These considerations are discussed below:

(i) Type of Industry:

Industries that are characterised by stability of earnings may formulate a more consistent policy as to dividends
than those having an uneven flow of income. For example, public utilities concerns are in a much better
position to adopt a relatively fixed dividend rate than the industrial concerns.

(ii) Age of Corporation:

Newly established enterprises require most of their earning for plant improvement and expansion, while old
companies which have attained a longer earning experience, can formulate clear cut dividend policies and may
even be liberal in the distribution of dividends.

(iii) Extent of share distribution:

A closely held company is likely to get consent of the shareholders for the suspension of dividends or for
following a conservative dividend policy. But a company with a large number of shareholders widely scattered
would face a great difficulty in securing such assent. Reduction in dividends can be affected but not without the
co-operation of shareholders.

(iv) Need for additional Capital:

The extent to which the profits are ploughed back into the business has got a considerable influence on the
dividend policy. The income may be conserved for meeting the increased requirements of working capital or
future expansion.

(v) Business Cycles:

During the boom, prudent corporate management creates good reserves for facing the crisis which follows the
inflationary period. Higher rates of dividend are used as a tool for marketing the securities in an otherwise
depressed market.

(vi) Changes in Government Policies:

Sometimes government limits the rate of dividend declared by companies in a particular industry or in all
spheres of business activity. The Government put temporary restrictions on payment of dividends by
companies in July 1974 by making amendment in the Indian Companies Act, 1956. The restrictions were
removed in 1975.

(vii) Trends of profits:

The past trend of the company’s profit should be thoroughly examined to find out the average earning position
of the company. The average earnings should be subjected to the trends of general economic conditions. If
depression is approaching, only a conservative dividend policy can be regarded as prudent.
(viii) Taxation policy:

Corporate taxes affect dividends directly and indirectly— directly, in as much as they reduce the residual profits
after tax available for shareholders and indirectly, as the distribution of dividends beyond a certain limit is itself
subject to tax. At present, the amount of dividend declared is tax free in the hands of shareholders.

(ix) Future Requirements:

Accumulation of profits becomes necessary to provide against contingencies (or hazards) of the business, to
finance future- expansion of the business and to modernise or replace equipments of the enterprise. The
conflicting claims of dividends and accumulations should be equitably settled by the management.

Q5. Methods of Analyze Capital Budgeting Decisions.

Or
Explain various methods for analyzing capital budgeting decisions. Also explain the difference
between NPV (Net Present Value) and IRR (Internal Rate of Return). [10 Marks]

Ans. There are many methods of evaluating profitability of capital investment proposals. The various commonly
used methods are as follows:
A. Traditional Methods
1. Pay-Back period Method or Pay out or Pay off Method: The Pay back sometimes called as pay out or
pay off period method represents the period in which the total investment in permanent assets pays back
itself. This method is bases on the principle that every capital expenditure pays itself back within a certain
period out of the additional earnings generated from the capital assets. The pay-back period can be
ascertained in the following manner:
a. Calculate annual net earnings (Profits) before depreciation and after taxes; these are called annual cash
inflows.
b. Divide the initial outlay (cost) of the project by the annual cash inflow, where the project generates constant
annual cash inflows. Thus, where the project generates constant cash inflows.
c. 𝐶𝑎𝑠ℎ 𝑜𝑢𝑡𝑙𝑎𝑦 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑜𝑟 𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑡ℎ𝑒 𝐴𝑠𝑠𝑒𝑡
Pay –Back Period = 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠

d. Where the annual cash inflows (Profit before depreciation and after taxes) are unequal, the Pay-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.
2. Improvements in traditional approach to Pay Back Period Method:
a. Post Pay-Back Profitability Method: One of the serious limitations of Pay-back period method is that it
does not take into account the cash inflows earned after pay-back period and hence the true profitability of
the project cannot be assessed. Hence, an, improvement over this method can be made by taking into
account the returns receivable beyond the pay-back period. These returns are called post pay-back profits.
Post Pay-back Profitability = Annual Cash Inflow X Remaining Life after pay-back period
b. Pay-back Reciprocal Method: sometimes, pay-back reciprocal method is employed to
estimate the internal rate of return generated by a project. Pay-back Reciprocals can be
calculated as under: 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤
Pay Back Reciprocal = 𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
B. Time-adjusted method or discounted Methods:
1. Net Present Value Method: The net present value method is a modern method of evaluating investment
proposals. This method take into consideration the time value of money and attempts to calculate the return
on investments by introducing the factor of time element. The following are the steps to be followed for
adopting NPV method:
a. First of all determine an appropriate rate of interest that should be selected as the minimum required rate of
return called cut-off rate or discount rate.
b. Compute the present value of total investment outlay, i.e. cash outflows at the determined discount rate.
c. Compute the present values of total investment proceeds, i.e., cash inflows, at the above determined discount
rate.
d. Calculate the net present value of each project by subtracting the present value of cash inflow from the present
value of cash outflows for teach project.
e. If the net present value is positive or Zero, the proposal may be accepted. But in case the Negative Net
present value, the proposal should be rejected.
2. Internal Rate of Return Method: In the net present value method the net present value is determined by
discounting the future cash flows of a project at a predetermined or specified rate called the cut-off rate. But
under the internal rate or return method, the cash flows or 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. The
following steps are required to practice the internal rate or return method.
i. Determine the future net cash flows during the entire economic life of the project.
ii. Determine the rate of discount at which the value of cash inflows is equal to the present value of cash
outflows.
iii. Accept the proposal if the internal rate or return is higher than or equal to the minimum required rate of return.
iv. In case of alternative proposals select the proposal with the highest rate or return as long as the rates are
higher than the cost of capital or cut-off-rate.

Q6. List the factors that affect the Capital Budgeting decision.

Ans. Factors influencing capital expenditure decisions

1. Availability of Funds: All the projects are not requiring the same level of investments. Some projects require
huge amount and having high profitability. If the company does not have adequate funds, such projects may be
given up.
2. Minimum Rate of Return on Investment: Every management expects a minimum rate of return or cut-off
rate on capital investment. It refers to the point of below which a project would not be accepted.
3. Future Earnings: The future earnings may be uniform or fluctuating. Even though, the company expects
guaranteed future earnings in total which affects the choice of a project.
4. Quantum of Profit Expected: It is necessary to assess the quantum of profit expected on implementation of
selected project. Here, the term profit refers to realized amount of projects as per the accounting records.
5. Cash Inflows: The term cash inflows refers to profit after tax but before depreciation. The reason is that
recording of depreciation is a book entry and there is no actual cash outflow. Hence, depreciation amount is
included in the cash inflow.
6. Legal Compulsions: The management should consider the legal provisions while-selecting a project. In the
case of leather and chemical industries, there are number of legal provisions created to protect environment
pollution. Now, the management gives much importance to legal provisions rather than cost and profit.
7. Ranking of the Capital Investment Proposal: Sometimes, a company has two or more profitable projects
in hand. If there is only one profitable project out of many and huge amount is available in the hands of
management, there is no need of ranking of capital investment proposal. Ranking is necessary if there is many
profitable projects in hand and limited funds is available in the hands of management.
8. Degree of Risk and Uncertainty: Every proposal involves certain risk and uncertainty due to economic
conditions, competition, demand and supply conditions, consumer preferences etc. The degree of risk and
uncertainty affects the profitability of the project. Hence, degree of risk and uncertainty of the project is taken
into consideration for selection.
9. Urgency: A project may be selected immediately due to emergency or urgency. The reason is that such
immediate selection saves the life of the company i.e. survival of a company is the primary importance than other
factors.
10. Research and Development Projects: Research and Development project is highly required for technology
based industries. The reason is that there is a lot of changes made within short period in technology. The
research and development project gives more benefits in the long run. Hence, profitability is getting less
importance and survival of business is getting much importance in the case of research and development project.
11. Obsolescence: The replacement of existing fixed assets is compulsory since there is an obsolescence of
plant and machinery.
12. Competitors Activities: Every company should watch the activities of the competitors. The company should
take a decision by considering the activities of the competitors. If so, the company can withstand in competition
by implementing new projects.
13. Intangible Factors: Goodwill of the company, industries relations, safety and welfare of the employees are
considered while selecting a project instead of considering profit alone. These factors are also high responsible
for selection of any project.

Q7. What are the factors that influence the Working Capital requirements of a firm?
Or
What do you mean by working capital? Explain various factors affecting working capital requirement of
an organization.
Ans. . Working capital refers to the funds invested in current assets, i.e., investment in sundry debtors, cash
and other current assets. Current assets are essential to utilize facilities provided by plant and machinery, land
and buildings. In case of the manufacturing organization, a machine cannot be used without raw material.
Gross working capital: The gross working capital refers to investment in all the current assets taken together.
The total of investments in all current assets is known as gross working capital.
Net working capital: Net working capital refers to the excess of total current assets over total current liabilities.
Current liabilities are those liabilities that are intended to be paid in the ordinary course of business within a year,
out of the current assets or earnings of the concern.

1. General Nature of Business: In some organizations, the sales are mostly in cash basis and the operating
cycle (explained) later is also short. In these concerns, the working capital requirement is comparatively low.
Mostly, service companies come under this category. In manufacturing companies, usually the operating cycle
is very long and a firm is also required to give credit to customers to boost sales. In such cases, working
capital requirement is high.
2. Production Policy: Working capital requirements also fluctuate according to production policy adopted by
the company.
3. Credit Policy: A company, which allows liberal credit to its customers, may have higher sales, but
consequently will have larger amount of funds tied up in sundry debtors. Similarly a company, which has very
efficient debt collection machinery and offers strict credit terms, may require lesser amount of working capital
4. Inventory Policy: The inventory policy of a company also has an impact on the working capital requirements.
An efficient firm may stock raw material for a smaller period and may, therefore, require lesser amount of
working capital.
5. Abnormal Factors: Abnormal factors like strikes and lockouts require additional working capital.
Recessionary conditions necessitate a higher amount of stock of finished goods remaining in stock.
6. Market Conditions: In case of competitive pressure, large inventory is essential, as delivery has to be off
the shelf or credit has to be extended on liberal terms.
7. Conditions of Supply: If prompt and adequate supply of raw materials, spares, stores, etc., is available it
is possible to manage with small investments in inventory or work on Just-In-Time (JIT) inventory principles.
8. Business Cycle: Business fluctuations lead to cyclical and seasonal changes in the production and sales
and affect the working capital requirements.
9. Growth and Expansion Activities: The working capital of the firm increases as it grows in terms of sale or
fixed assets.
10. Level of Taxes: The amount of taxes to be paid is determined by the prevailing tax regulations. Very often
taxes have to be paid in advance on the basis of the profit of the preceding year.
11. Dividend Policy: Payment of dividend utilizes cash while retaining profit acts as a source of working capital.
Thus working capital gets affected by dividend policies.
12. Operating Efficiency: Efficient and co-ordinated utilization of capital reduces the amount required to be
invested in working capital.
13. Price Level Charges: Inflationary trends in the economy necessitate more working capital to maintain the
same level of activity.
14. Depreciation Policy: Depreciation charges do not involve any cash outflow. The effect of depreciation
policy on working capital is, therefore, indirect. In the first place, depreciation affects the tax liability and
retention of profits and on dividend.

Q8. Discuss in detail the theories/ Models of dividend policy.

Ans.
1. Traditional Approach: The traditional approach to the dividend policy was given by Mr. B Graham and D.L.
Dodd and it lays clear relationship between dividends and the stock market prices. According to this
approach, the stock value responds positively to higher dividends and negatively with low dividends. The
following expression expresses the relationship by using a multiplier:
P = m (D + E/3)
Where, P = Market Price M = Multiplier
D = Dividend per share E = Earnings per share
2. Walter’s Model : Walter’s Model supports the doctrine that dividends are relevant. The investment policy
of a firm cannot be separated from its dividend policy and both are, according to Walter, interlinked. The
choice of an appropriate dividend policy affects the value of an enterprise. The relationship between
dividend and share price on the basis of Walter’s formula is shown below:

The Walter formula gives an added weight to the retained earning portion of the earnings formula. The factor
Ra/Rc is placed in front of retained earnings to change its weighted value under three different situations as
follows:
• If Ra/Rc is greater than I i.e., the firms earnings are more than the norm. In this situation we want the firm to
retain its earnings since other alternative investment offer a lower return than the firm is about to secure.
• R a/Rc is equal to I, when the actual and normal capitalization rates are identical. In this case, the retained
earnings have the same weighted value as dividends and the Walter Formula gives the same value as the
Capitalization Earnings formula.
• Ra/Rc is less than I i.e., retained earnings have a lower weight than dividends. Thus less the firm retain, the
higher its value. In the above example, if the capitalization (actual) is 5%.
3. Gordon’s Dividend Capitalization Model: Another model that has given importance to dividend policy of
the firm is the Gordon Model. Gordon Model assumes that future dividends are the sole determinant of the
intrinsic value of the common shares.

4. Miller and Modigliani Model: The irrelevance of dividends is provided by the MM Hypothesis. MM maintains
that dividend policy has no effect on the share prices of the firm. What matters, according to them, is the
investment policy through which the firm can increase its earnings and thereby the value of the firm given
the investment decision of the firm, the dividend decision – splitting the earnings into packages of retentions
and dividends – is a matter of detail and does not matter.
MM Hypothesis is based on the following critical assumptions:
1. Perfect capital markets, in which all investors are rational. Information is available to all free of cost, there
are no transaction costs, securities are infinitely divisible; no investor is large enough to influence the market
price of securities, there are no floatation costs.
2. There are no taxes. Alternatively, there are no differences in tax rate applicable to capital gains and
dividends.
3. A firm has a given investment policy which does not change. The operational implication of this assumption
is that financing of new investment out of retained earnings will not change the business risk complexion of
the firm and therefore, no change in the required rate of return.
4. There is a perfect certainty by every investor as to future investments and profits of the firm. In other words,
investors are able to forecast future prices and dividends with certainty. This assumption is dropped by MM
later.

Q9. Explain Walters and Gordon’s theories regarding Dividend decisions. Also comment upon the
similarity between theories given by them.
Ans. Walter’s Model : Walter’s Model supports the doctrine that dividends are relevant. The investment policy
of a firm cannot be separated from its dividend policy and both are, according to Walter, interlinked. The choice
of an appropriate dividend policy affects the value of an enterprise. The relationship between dividend and share
price on the basis of Walter’s formula is shown below:
The Walter formula gives an added weight to the retained earning portion of the earnings formula. The factor
Ra/Rc is placed in front of retained earnings to change its weighted value under three different situations as
follows:
• If Ra/Rc is greater than I i.e., the firms earnings are more than the norm. In this situation we want the firm to
retain its earnings since other alternative investment offer a lower return than the firm is about to secure.
• R a/Rc is equal to I, when the actual and normal capitalization rates are identical. In this case, the retained
earnings have the same weighted value as dividends and the Walter Formula gives the same value as the
Capitalization Earnings formula.
• Ra/Rc is less than I i.e., retained earnings have a lower weight than dividends. Thus less the firm retain, the
higher its value. In the above example, if the capitalization (actual) is 5%.
Gordon’s Dividend Capitalization Model: Another model that has given importance to dividend policy of the
firm is the Gordon Model. Gordon Model assumes that future dividends are the sole determinant of the intrinsic
value of the common shares.

Q10. Explain briefly the major considerations in capital structure planning.

Or
What do you mean by capital structure? Explain various factors which affect the capital structure of an
organization.
Ans. Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as long-term
finance. The capital structure involves two decisions-

c. Type of securities to be issued are equity shares, preference shares and long term borrowings
(Debentures).
d. Relative ratio of securities can be determined by process of capital gearing. On this basis, the companies
are divided into two-
i. Highly geared companies - Those companies whose proportion of equity capitalization is small.
ii. Low geared companies - Those companies whose equity capital dominates total capitalization.

Factors Determining Capital Structure

1. Trading on Equity- The word “equity” denotes the ownership of the company. Trading on equity means taking
advantage of equity share capital to borrowed funds on reasonable basis. It refers to additional profits that equity
shareholders earn because of issuance of debentures and preference shares. It is based on the thought that if
the rate of dividend on preference capital and the rate of interest on borrowed capital is lower than the general
rate of company’s earnings, equity shareholders are at advantage which means a company should go for a
judicious blend of preference shares, equity shares as well as debentures. Trading on equity becomes more
important when expectations of shareholders are high.
2. Degree of control- In a company, it is the directors who are so called elected representatives of equity
shareholders. These members have got maximum voting rights in a concern as compared to the preference
shareholders and debenture holders. Preference shareholders have reasonably less voting rights while
debenture holders have no voting rights. If the company’s management policies are such that they want to retain
their voting rights in their hands, the capital structure consists of debenture holders and loans rather than equity
shares.
3. Flexibility of financial plan- In an enterprise, the capital structure should be such that there is both
contractions as well as relaxation in plans. Debentures and loans can be refunded back as the time requires.
While equity capital cannot be refunded at any point which provides rigidity to plans. Therefore, in order to make
the capital structure possible, the company should go for issue of debentures and other loans.
4. Choice of investors- The company’s policy generally is to have different categories of investors for securities.
Therefore, a capital structure should give enough choice to all kind of investors to invest. Bold and adventurous
investors generally go for equity shares and loans and debentures are generally raised keeping into mind
conscious investors.
5. Capital market condition- In the lifetime of the company, the market price of the shares has got an important
influence. During the depression period, the company’s capital structure generally consists of debentures and
loans. While in period of boons and inflation, the company’s capital should consist of share capital generally
equity shares.
6. Period of financing- When company wants to raise finance for short period, it goes for loans from banks and
other institutions; while for long period it goes for issue of shares and debentures.
7. Cost of financing- In a capital structure, the company has to look to the factor of cost when securities are
raised. It is seen that debentures at the time of profit earning of company prove to be a cheaper source of finance
as compared to equity shares where equity shareholders demand an extra share in profits.
8. Stability of sales- An established business which has a growing market and high sales turnover, the
company is in position to meet fixed commitments. Interest on debentures has to be paid regardless of profit.
Therefore, when sales are high, thereby the profits are high and company is in better position to meet such fixed
commitments like interest on debentures and dividends on preference shares. If company is having unstable
sales, then the company is not in position to meet fixed obligations. So, equity capital proves to be safe in such
cases.
9. Sizes of a company- Small size business firms capital structure generally consists of loans from banks and
retained profits. While on the other hand, big companies having goodwill, stability and an established profit can
easily go for issuance of shares and debentures as well as loans and borrowings from financial institutions. The
bigger the size, the wider is total capitalization.

Q11. Critically evaluate net operating income approach of capital structure.

Ans. This theory was also developed by David Durand (Pandey 2005). He probably realized the shortcomings
of NI Approach and therefore, he modified the NI approach to NOI approach.
As per this approach, the market value of the firm is based on the earning available for fund providers after
paying all other expenses except interest on debt. The profit available for funds providers or for calculating the
market value of the firm is called Net operating Income (NOI).
This theory is just opposite to NI approach. NI approach is relevant to capital structure decision. It means
decision of debt equity mix does affect the WACC and value of the firm. As per NOI approach the capital structure
decision is irrelevant and the degree of financial leverage does not affect the WACC and market value of the
firm. NOI approach evaluates the cost of capital and therefore the optimal Capital Structure on the basis of
operating leverage by means of NOI approach.
The NOI approach is based on following assumptions:
(i) There are no corporate taxes.
(ii) Cost of debt remains constant at all level of debt.
(iii) Overall cost of capital remains constant.
(iv) Value of the firm depends on expected net operating income and overall capitalization rate or the opportunity
cost of capital.
(v) Net operating income of the firm is not affected by the degree of financial leverage.
(vi) The operating risk or business risk does not change with the change in debt equity mix. (vii) WACC does not
change with the change in financial leverage
Criticisms of NOI approach
The NOI approach is criticized on the following grounds:
(i) The assumption of absence of corporate tax is not correct.
(ii) The cost of debt increases with the increase in the quantum of debt.
(iii) As the cost of debt increases with the increase in financial leverage, the overall cost of capital also increases
with increase in financial leverage.
(iv) An investor values differently the firm having higher level of debt in its capital structure than the firm having
less debt or no debt
Q12. Explain Capital Structure Theories
Ans. Different kinds of theories have been propounded by different authors to explain the relationship between
capital structure, cost of capital and value of the firm. The main contributors to the theories are Durand, Ezra,
Solomon, Modigliani and Miller.
The important theories are discussed below:
1. Net Income Approach
2. Net Operating Income Approach
3. The Traditional Approach
4. Modigliani and Miller Approach
1. Net Income Approach: According to this approach, a firm can minimize the weighted average cost of capital
and increase the value of the firm as well as market price of equity shares by using debt financing to the
maximum possible extent. The theory propounds that a company can increase its value and decrease the
overall cost of capital by increasing the proportion of debt in its capital structure. This approach is based
upon the following assumptions:
1. The cost of debt is less than the cost of equity.
2. There are no taxes.
3. The risk perception of investors is not changed by the use of debt.
The total market value of a firm on the basis of Net Income Approach can be ascertained as below:
V=S+D
Where, V = Total market value of a Firm
S = Market value of equity shares Earnings Available to Equity Shareholders (NI)
=
Equity Capitalisation Rate
D = Market value of debt.
And, Overall Cost of Capital or Weighted Average Cost oEf BCIT apital can be calculated as:
K0 =
V
2. Net Operating Income Approach: This theory as suggested by Durand is another extreme of the
effect of leverage on the value of the firm. It is diametrically opposite to the net income approach. According to
this approach, change in the capital structure of a company does not affect the market value of the firm and the
overall cost of capital remains constant irrespective of the method of financing. It implies that the overall cost of
capital remains the same whether the debt-equity mix is 50:50, or 20:80 or 0:100. Thus, there is nothing as an
optimal capital structure and every capital structure is the optimum capital structure. This theory presumes that:
1. The market capitalizes the value of the firm as a whole;
2. The business risk remains constant at every level of debt equity mix;
3. There are no corporate taxes.
The value of a firm on the basis of Net Operating Income EBAIp
Tproach can be determined as below:
V = K0
Where, V = Value of a firm
EBIT = Net operating income or Earnings before interest and tax
K0 = Overall cost of capital
The market value of the equity, according to this approach is the residual value which is determined by
deducting the market value of debentures from the total market value of the firm.
S = V-D
Where, S = Market value of equity shares
V = Total Market value of a firm
D = Market Value of Debt
The cost of equity or equity capitalization rate can be Ecaarlnciu
nglaAtfe
tedr a
Insteb
reesltoaw
nd: Before Tax
Cost of Equity or Equity Capitalization Rate (Ke) = Market Value of Firm−Market Value of Debt
EBIT−I
= V−D

4. The Traditional Approach: The traditional approach, also known as Intermediate approach, is a compromise
between the two extremes of net income approach and net operating income approach. According to this
theory, the value of the firm can be increased initially or the cost of capital can be decreased by using more
debt as the debt is a cheaper source of funds than equity. Thus, optimum capital structure can be reached by
a proper debt-equity mix. Beyond a particular point, the cost of equity increases because increased debt
increases the financial risk of the equity shareholders.
5. Modigliani and Miller Approach: M&M hypothesis is identical with the Net Operating Income approach if
taxes are ignored. However, when corporate taxes are assumed to exist, their hypothesis is similar to the Net
Income Approach.
1. In the absence of taxes (Theory of Irrelevance): The theory proves that the cost of capital is not affected
by changes in the capital structure or say that the debt-equity mix is irrelevant in the determination of the
total value of a firm. The reason argued is that though debt is cheaper to equity, with increased use of
debt as a source of finance, the cost of equity increases. This increase in cost of equity offsets the
advantage of the low cost of debt.
The M&M approach is based upon the following assumption:
1. There are no corporate taxes.
 2. There is a perfect market.
3. Investors act rationally.
4. The expected earnings of all the firms have identical risk characteristics.
5. The cut-off point of investment in a firm is capitalization rate.
6. Risk to investors depends upon the random fluctuations of expected earnings and the possibility that the
actual value of the variables may turn out to be different from their best estimates.
7. All earnings are distributed to the shareholders.
2. When the corporate taxes are assumed to exist (Theory of Relevance): Modigliani and Miller, in their
article of 1963 have recognized that the value of the firm will increase or the cost of capital will decrease
with the use of debt on account of deductibility of interest charges for tax purpose. Thus, the optimum
capital structure can be achEiearvneindgsbByem
foraexIinm
teirzeisntg& t𝑇h
𝑎e𝑥 debt m EBixITin the equity of a firm.
Value of Unlevered Firm = Overall Cost of Caital
= i. e. K (1 − t)
0

And, the value of Levered Firms is: VL = Vu + tD

Where, Vu is value of unlevered firm

Q13. Advantages of Equity Financing.

Ans. Equity financing refers to raising funds for business use by trading complete or partial ownership of the
company's equity for money or other assets. In financing corporations, this is most commonly done by selling
either common stock, preferred stock, or some combination of these. Where a proprietorship may be funded
entirely by its owner or with money that the owner receives from family, friends, or venture capitalists,
corporations will be funded by stockholders who may include individuals, venture capitalists, or institutional
investors.

The Advantages

Lower risk. Generally, it’s less risky to use equity financing rather than take out a loan from a lender
because you don’t have to pay equity back like you would a loan. Equity can a good option for businesses that
aren’t in a place where they can take on additional debt.

Equity tends to increase your credibility. If you can successfully raise equity for your business, it will likely
boost your business’ reputation, at least with investors. Your ability to tap into investor networks will likely
lend to the credibility of your business venture.

Long-term equity vs. short-term debt. In most cases with equity, investors will take a long-term view of the
business, i.e. they typically won’t expect a return on their investment anytime soon (the key word being
“typically”).

No repayments. With equity, you won’t have to budget for loan repayments out of your profits. Not having to
budget a loan payment into your business’ monthly budget can mean the difference between the ability to hire
additional employees to help grow your business. Furthermore, if the business ultimately fails, you’re not on
the hook to the investors like you would be to the creditor in a debt financing scenario.

Increase Your Cash Flow. With equity, you’ll generally end up with more cash on hand that you can use for
growing the business. Because investors are hoping to obtain a high return on their investment , they’ll
generally prefer leaving their money in the business to help promote growth. The ability to reinvest money
within the company is vital for many small businesses.
Q14. What are the advantages of is Debt Financing from point of view of company and investor?

Ans. Debt is borrowing money from an outside source with the promise to return the principal, in addition to an
agreed-upon level of interest. Although the term tends to have a negative connotation, startup companies often
turn to debt to finance their operations. In fact, even the healthiest of corporate balance sheets will include
some level of debt. In finance, debt is also referred to as “leverage.” The most popular source for debt
financing is the bank, but debt can also be issued by a private company or even a friend or family member.

Advantages to Debt Financing

• Maintain ownership: When you borrow from the bank or another lender, you are obligated to make the
agreed-upon payments on time. But that is the end of your obligation to the lender. You can choose to run
your business however you choose without outside interference.
• Tax deductions: This is a huge attraction for debt financing. In most cases, the principal and interest
payments on a business loan are classified as business expenses, and thus can be deducted from your
business income taxes. It helps to think of the government as a “partner” in your business, with a 30 percent
ownership stake (or whatever your business tax rate is). If you can cut the government out of the equation,
then it’s beneficial to your business.
• Lower interest rate: Furthermore, you should analyze the impact of tax deductions on the bank interest rate.
If the bank is charging you 10 percent for your loan, and the government taxes you at 30 percent, then there
is an advantage to taking a loan you can deduct. Take 10 percent and multiply it by (1-tax rate), in this case
it’s: 10 percent times (1-30 percent), which equals 7 percent. After your tax deductions, you’ll be paying the
equivalent of a 7 percent interest rate.
• Utilization of Resources – When a business use debt to finance its operation, they got no option than to fully
utilise their resources because they will have to payback the debt and interest to their creditor.
• Short Term Needs – Debt finance can easily be secured on a short term bases. This make it very
advantagious to the small business as finance of this type can easily be secured for short term business
needs.
• Tax Advantage – Debt financing also offers tax advantage to business as interest is deductible for income
tax purposes.
• No Future Lender Claims - Lenders has no direct claim on future earnings
• Not Dillutive – Debt does not dilute the ownership of your small business.
• Simple Loan Repayment - Lenders are only entitled to loan repayment and interest on loan.
• Future Impact Forecasting – Interest and principal repayment are based on fixed percentage and can be
forecast.

Q15. What do you mean by venture capital financing and what are the methods of this type of
financing.

Ans. Venture finance, conceptually being risk finance, should be available in the form of equity or quash-
equity (conditional or convertible loans). A straight or conventional loan, involving fixed payments, would be
unsuitable form of providing assistance to a new, risky venture. New ventures have the problem of cash flows
in the initial years of their development; hence they are not able to service debt. However, the requirement for
this kind of assistance could still arise in a few cases, particularly during the second stage of financing after the
venture has taken off. Venture capital financing in India in the past took three forms: equity, conditional loans
and income notes. Conventional loan has been a quite popular source of funds made available by VCFs in
India in the past.
Equity

All VCFs in India provide equity. Generally, their contribution may not exceed 49 per cent of the total equity
capital. Thus, the effective control and majority ownership of the firm may remain with the entrepreneur. When
a venture capitalist contributes equity capital, he acquires the status of an owner, an becomes entitled to a
share in the firm’s profits as much as he is liable for losses. VCFs buy shares of an enterprise with an intention
to ultimately sell them off to make capital gains. The advantage of the equity financing for the company seeking
venture finance is that it does not have the burden of serving the capital, as dividends will not be paid if the
company has no cash flows. The advantage to the VCF is that it can share in the high value of the venture and
makes capital gains if the venture succeeds. But the flip side is that the VCF will lose if the venture is
unsuccessful. Venture financing is a risky business.

Conditional loan

A conditional loan is repayable in the form of a royalty after the venture is able to generate sales. No interest is
paid on such loans in India, VCFs charged royalty ranging between 2 and 15 per cent gestation period, cost-
flow patterns, risk and other factors of the enterprise. Some VCFs gave a choice to the enterprise of paying a
high rate of interest (which could be well above 20 per cent) instead of royalty on sales once it becomes
commercially sound. Some funds recovered only half of the loan if the venture failed.

Income note

A unique way of venture financing in India was income note. It was a hybrid security which combined the
features of both conventional loan and conditional loan. The entrepreneur had to bay both interest on royalty
on sales, but at substantially low rates. Some venture funds provided funding equal to about 80 percent of a
project’s cost for commercial application of indigenous technology adapting imported technology to wider
domestic applications. Funds were made available in the form of unsecured loans at a lower rate of interest
during development phase and at a higher rate after development. In addition to interest charges, royalty on
sales could also be charged.

Other financing methods

A few venture capitalists, particularly in the private sector introduced innovative financial securities. The
participating debenture; is an example of innovative venture financial. Such security carries charges in three
phases: in the start-up phase, before the venture attains operations to a minimum level, no interest is charged.
After this, a low rate of interest is charged up to a particular level of operation. Once the venture starts
operating on full commercial basis, a high rate of interest is required to be paid. A variation could be in terms of
paying a certain share of the post-tax profits of royalty.

VCFs in India provide venture finance through partially or fully convertible debentures and cumulative
convertible preference share (CPP). CPP could be particularly attractive in the Indian context since CPP
shareholders do not have a right to vote.

In developed countries, like the USA and the UK, the venture capital firms are accustomed to using a wide
range of financial instruments. They include.

1. Deferred shares: – where ordinary share rights are deferred for a certain number of years.

2. Convertible loan stock: – which is unsecured long-term loan convertible into ordinary shares and
subordinated to all creditors.
3. Special ordinary shares: – with voting rights bit without a commitment towards dividends.

4. Preferred ordinary shares: – with voting rights and a modest fixed dividend right and a right to share in
profits.

Venture capital funds abroad also provide conventional loans, hire-purchase finance, lease finance and even
overdraft finance, but the overall financial package is always tilted in favour of equity component.

Q16. Write short notes on:

(a) Zero interest fully convertible
(b) Deep discount bonds
(c) Inflation bonds
(d) Sales tax deferments and Exemptions.

Ans. (a)

Zero Coupon and Specific Rate Debentures: Zero coupon debentures do not carry any coupon rate or we can
say that there is zero coupon rate. The debenture holder will not get any interest on these types of debentures.
Need not to get surprised, for compensating against no interest, companies issue them at a discounted price
which is very less compared to the face value of it. The implicit interest or benefit is the difference between the
issue price and the face value of that debenture. These are also known as ‘Deep Discount Bonds’ .All other
debentures with specified rate of interest are specific rate debentures which are just like a normal debenture.

4(b)

A deep discount bond is a bond that sells at a price which is 20% or more below the face value of the bond,
and carries a low rate of interest during the term of the bond.

How it works/Example:

The investor purchases the bond at a price that is below face value. The bond may be purchased at a
significant discount because the coupon rate is significantly less than the market rate, or because of perceived
instability of the issuing firm. Since the coupon rate is significantly less than the market rate, the price paid for
the bond by the investor is significantly lower as well. The discount factors the higher risk into the price.

A zero-coupon bond is similar, but such bonds do not offer any return during the life of the bond, and then pay
the holder the face value at maturity only. The discount on a zero coupon bond represents the interest that will
be paid, in its entirety, on the maturity date of the bond.

Why it Matters:

Deep discount bonds allow investors to lock in a better rate of return for a longer period of time, since these
bonds are not likely to be called. Investors also enjoy the leverage that comes with such investments.
However, investors must be prepared since these bonds are typically higher risk

4(c)

Daily inflation-indexed bonds (also known as inflation-linked bonds or colloquially as linkers) are bonds where
the principal is indexed to inflation or deflation on a daily basis in terms of the official Daily CPI or monetized
daily indexed unit of account like the Unidad de Fomento in Chile and the Real Value unit if Colombia. They
are thus designed to hedge the inflation risk of a bond.[1] The first known inflation-indexed bond was issued by
the Massachusetts Bay Company in 1780.[2] The market has grown dramatically since the British government
began issuing inflation-linked Gilts in 1981. As of 2008, government-issued inflation-linked bonds comprise
over $1.5 trillion of the international debt market.

Q17. What are the advantages of lease financing?

Ans. Leasing brings six major advantages, and all directly involve the company’s cash flow. Essentially,
the advantage to leasing over buying is that there’s usually no large outlay of cash at the beginning of
the lease as there is with an outright purchase.

100 percent financing: Many business leases come with 100 percent financing terms, which means no
money changes hands at the inception of the lease. Can you imagine what a boon to cash flow this can be?

Well, it’s not totally cash-free, because the lessee has to make the lease payments each month. But many
times the assumption is that the company will be making the payments from future cash flows — in other
words, from enhanced revenues that the company earns because of the lease.

Obsolescence: Another advantage to leasing is working around obsolescence, which means the company
anticipates frequently replacing the fixed asset. For example, many larger clients lease rather than purchase
their computer equipment so they can stay current with new and faster computer processing technology.

Flexibility: Asset flexibility is another leasing advantage. Based on the relationship between the lessor and the
lessee, the lease may be for either just a few months or the entire expected life of the asset. Or let’s say an
employee for whom the company leases a vehicle leaves the company.

Predicated on the terms of the lease, the company doesn’t have to worry about advertising the car for sale and
trying to find a buyer, as it would with an owned vehicle — the company just turns the car back in to the leasing
company.

Lower-cost financing: Based on many different variables, a company may be able to utilize tax benefits
associated with leasing. This topic is a more complicated tax issue that is more appropriate for your taxation
classes.

Tax advantages: Separate from any tax benefit a company may gain, lease payments can reduce taxable
income in a more appropriate manner than depreciation expense. Remember that you treat operating leases
like rentals by expensing the entire lease payment when the business makes it.

Before you get all excited about paying fewer taxes, there’s usually only a timing difference in taxes paid with
leased versus purchased assets. Basically, taxes saved today will eventually have to be paid tomorrow.

Off-balance-sheet financing: Finally, operating leases provide off-the-books (or balance sheet) financing. In
other words, the company’s obligation to pay the lease, which is a liability, doesn’t reflect on the balance sheet.
This can affect a financial statement user’s evaluation of how solvent the company is because he will be
unaware of the debt—hence the importance of footnotes to financial statements.

Q18. “Is Trade Credit is source of working capital finance”. Discuss.

Ans. When a business buys raw materials, components, services or other goods from another business it will
often look to pay for those at a later date. If it is allowed to do so, then that supplier is said to offer “trade credit”
to the business. The supplier becomes a trade creditor – someone to whom the business owes money.

The amount of trade credit and the period allowed before the invoice must be settled will vary from industry to
industry.

For example, in the building trade, it is common for trade creditors to require settlement of invoices after 30
days. However, it is not uncommon for businesses in some industries to extend the time taken to up to 90 days
(3 months).

Trade credit is a short-term, external source of finance. It has several important advantages to a business:

• It is flexible – the amount of credit reflects the value of business done with a supplier

• It is low cost – trade creditors don’t charge interest on the amount outstanding (unless payment is delayed well
beyond the settlement date)

• It matches the purchase of goods and services – e.g. stocks can be bought and held for a period, with the
finance provided by trade credit rather than cash

A common complain amongst small businesses is the time it takes for their (larger) customers to settle bills. By
delaying payment to a trade creditor, a business holds onto its cash balances for longer.

However, by delaying payment, a business has to be careful not to damage its credit reputation and rating. Trade
creditors are seen (wrongly) as a “free” source of capital. Some firms habitually delay payment to creditors in
order to enhance their cash flow - a short sighted policy which also raises ethical issues.

Q19. Taking the example of the Indian corporate, analyse the importance of issuing the CPs for the firm
& to the investors.

Ans. commercial paper, in the global financial market, is an unsecured promissory note with a fixed maturity
of no more than 270 days.

Commercial paper is a money-market security issued (sold) by large corporations to obtain funds to meet
short-term debt obligations (for example, payroll), and is backed only by an issuing bank or corporation's
promise to pay the face amount on the maturity date specified on the note. Since it is not backed by collateral,
only firms with excellent credit ratings from a recognized credit rating agency will be able to sell their
commercial paper at a reasonable price. Commercial paper is usually sold at a discount from face value, and
carries higher interest repayment rates than bonds. Typically, the longer the maturity on a note, the higher the
interest rate the issuing institution pays. Interest rates fluctuate with market conditions, but are typically lower
than banks' rates.

Advantages of commercial papers:

1) It is quick and cost effective way of raising working capital.

2) Best way to the company to take the advantage of short term interest fluctuations in the market
3) It provides the exit option to the investors to quit the investment.

4) They are cheaper than a bank loan.

5) As commercial papers are required to be rated, good rating reduces the cost of capital for the company.

6) It is unsecured and thus does not create any liens on assets of the company.

7) It has a wide range of maturity

8) It is exempt from federal SEC and State securities registration requirements.

Q20. Do you agree that lease is the efficient source of finance for corporates? How?
Ans. yes lease is the efficient source of finance due to its following advantages

Leasing brings six major advantages, and all directly involve the company’s cash flow. Essentially, the
advantage to leasing over buying is that there’s usually no large outlay of cash at the beginning of the lease
as there is with an outright purchase.

• 100 percent financing: Many business leases come with 100 percent financing terms, which means no
money changes hands at the inception of the lease. Can you imagine what a boon to cash flow this can be?

Well, it’s not totally cash-free, because the lessee has to make the lease payments each month. But many
times the assumption is that the company will be making the payments from future cash flows — in other
words, from enhanced revenues that the company earns because of the lease.

• Obsolescence: Another advantage to leasing is working around obsolescence, which means the company
anticipates frequently replacing the fixed asset. For example, many larger clients lease rather than purchase
their computer equipment so they can stay current with new and faster computer processing technology.
• Flexibility: Asset flexibility is another leasing advantage. Based on the relationship between the lessor and
the lessee, the lease may be for either just a few months or the entire expected life of the asset. Or let’s say
an employee for whom the company leases a vehicle leaves the company.

Predicated on the terms of the lease, the company doesn’t have to worry about advertising the car for sale and
trying to find a buyer, as it would with an owned vehicle — the company just turns the car back in to the
leasing company.

• Lower-cost financing: Based on many different variables, a company may be able to utilize tax benefits
associated with leasing. This topic is a more complicated tax issue that is more appropriate for your taxation
classes.
• Tax advantages: Separate from any tax benefit a company may gain, lease payments can reduce taxable
income in a more appropriate manner than depreciation expense. Remember that you treat operating leases
like rentals by expensing the entire lease payment when the business makes it.

Before you get all excited about paying fewer taxes, there’s usually only a timing difference in taxes paid
with leased versus purchased assets. Basically, taxes saved today will eventually have to be paid tomorrow.
• Off-balance-sheet financing: Finally, operating leases provide off-the-books (or balance sheet) financing. In
other words, the company’s obligation to pay the lease, which is a liability, doesn’t reflect on the balance
sheet. This can affect a financial statement user’s evaluation of how solvent the company is because he will
be unaware of the debt—hence the importance of footnotes to financial statements.

Q21. What is the difference between economic value added and earning per share? Explain the
advantages of economic value added.
Ans. Economic value added is a measure of surplus value created on a given investment. When a person is
investing his funds, he does this only because he expects to earn a profit from the investment. Let us say, gold
seems to be a good instrument to invest with a high profit margin.
• Total investment (i.e. price at which gold is purchased) = $ 1000
• Brokerage paid to the dealer for purchase of gold = $ 15
In a year, I would like to sell off the gold on account of liquidity crunch.
• Selling price of gold = $ 1200
• Brokerage paid to the dealer on sale of gold = $ 10
In the above Economic Value Added example,
• Economic Value Added = Selling price – Expenses associated with selling the asset – Purchase price –
Expenses associated with buying the asset
• Economic Value Added = $ 1200 – $ 10 – $ 1000 – $ 15 = $ 175
If we just see the profit, then the profit on selling gold was $ 1200 – $ 1000 i.e. $ 200. But the actual creation of
wealth is only $ 175 on account of expenses incurred. This is a very crude example of Economic Value Added
(EVA).
'Earnings Per Share - EPS'

Earnings per share (EPS) is the portion of a company's profit allocated to each share of common stock. Earnings
per share serves as an indicator of a company's profitability. It is common for a company to report EPS that are
adjusted for extraordinary items, potential share dilution. Most simply EPS is calculated as:

Advantages of EVA

1. EVA combines profit centre and investment centre concepts. With EVA, management establishes a target
profit or target rate of return for the business segment. Any income in excess of the target level is the residual
income/EVA. To illustrate, the target rate of return for DD Ltd., is 20 per cent on total net assets. Total net
assets are 800,000 and actual net income 200,000 so the target net income is 800,000 × 0.20 = 160,000. The
EVA for the company is actual net income minus target net income = 200,000 – 160,000 = 40,000.

2. In case of EVA, different interest rates may be used for different types of assets e.g., low rates can be used
for inventories while a higher rate can be used for investments in fixed assets. Furthermore, different rates may
be used for different of fixed assets to take into account different degrees of risk.

3. With EVA all business units have the same profit objective for comparable investments.The ROI approach,
on the other hand provides different incentives for investments across business units.

4. The EVA in contrast to ROI has a stronger positive correlation with changes in company’s market share.
Shareholders are important stakeholders in a company’s market value.
5. EVA eliminates economic distortions of GAAP to focus decisions on real economic results.

6. Provision of correct incentives for capital allocations.

7. EVA provides for better assessment of decisions that affect balance sheet and income
statement or trade-offs between each through the use of the capital charge against NOPAT.

8. Long-term performance that is not compromised in favor of short-term results.

9. EVA decouples bonus plans from budgetary targets.

10. EVA covers all aspects of the business cycle.

11. EVA aligns and speeds decision making, and enhances communication and teamwork.

12. Provision of significant information value beyond traditional accounting measures of EPS, ROA and ROE.

13. Goal congruence of managerial and shareholder goals achieved by tying compensation of
managers and other employees to EVA measures.

14. Annual performance measured tied to executive compensation.

Q22. Elucidate the advantages which a firm will obtain by using EVA approach.
or
Analyse the need for EVA in today’s competitive scenario.
or
Elucidate how EVA is much better & efficient approach than other traditional approaches.
Or
Write a note on the evaluation of EVA (economic value added) as a measure of performance
management.
Or
What is economic value added? How is it used in context of financial management?

Ans. Economic Value Added (EVA) is a method to calculate the economic profit of a company. EVA can be
calculated as Net Operating Profit after taxes less a charge for the opportunity cost of the capital invested. The
underlying principal of this method is to determine whether company is earning higher rate of return on the
funds invested than the cost of the funds. If it is earning higher rate of return then it implies that management is
adding more wealth to the shareholders value.

Advantages of EVA

1. EVA combines profit centre and investment centre concepts. With EVA, management establishes a target
profit or target rate of return for the business segment. Any income in excess of the target level is the residual
income/EVA. To illustrate, the target rate of return for DD Ltd., is 20 per cent on total net assets. Total net
assets are 800,000 and actual net income 200,000 so the target net income is 800,000 × 0.20 = 160,000. The
EVA for the company is actual net income minus target net income = 200,000 – 160,000 = 40,000.

2. In case of EVA, different interest rates may be used for different types of assets e.g., low rates can be used
for inventories while a higher rate can be used for investments in fixed assets. Furthermore, different rates may
be used for different of fixed assets to take into account different degrees of risk.
3. With EVA all business units have the same profit objective for comparable investments.The ROI approach,
on the other hand provides different incentives for investments across business units.

4. The EVA in contrast to ROI has a stronger positive correlation with changes in company’s market share.
Shareholders are important stakeholders in a company’s market value.

5. EVA eliminates economic distortions of GAAP to focus decisions on real economic results.

6. Provision of correct incentives for capital allocations.

7. EVA provides for better assessment of decisions that affect balance sheet and income
statement or trade-offs between each through the use of the capital charge against NOPAT.

8. Long-term performance that is not compromised in favor of short-term results.

9. EVA decouples bonus plans from budgetary targets.

10. EVA covers all aspects of the business cycle.

11. EVA aligns and speeds decision making, and enhances communication and teamwork.

12. Provision of significant information value beyond traditional accounting measures of EPS, ROA and ROE.

13. Goal congruence of managerial and shareholder goals achieved by tying compensation of
managers and other employees to EVA measures.

14. Annual performance measured tied to executive compensation.

Q23. Critically appraise the Economic value added approach.

OR
Critically explain the concept of EVA (economic value added). Also specify the limitations of EVA
analysis.
Ans. Economic value added is a measure of surplus value created on a given investment. When a person is
investing his funds, he does this only because he expects to earn a profit from the investment. Let us say, gold
seems to be a good instrument to invest with a high profit margin.
• Total investment (i.e. price at which gold is purchased) = $ 1000
• Brokerage paid to the dealer for purchase of gold = $ 15
In a year, I would like to sell off the gold on account of liquidity crunch.
• Selling price of gold = $ 1200
• Brokerage paid to the dealer on sale of gold = $ 10
In the above Economic Value Added example,
• Economic Value Added = Selling price – Expenses associated with selling the asset – Purchase price –
Expenses associated with buying the asset
• Economic Value Added = $ 1200 – $ 10 – $ 1000 – $ 15 = $ 175
If we just see the profit, then the profit on selling gold was $ 1200 – $ 1000 i.e. $ 200. But the actual creation of
wealth is only $ 175 on account of expenses incurred. This is a very crude example of Economic Value Added
(EVA).
Limitations of EVA Analysis
1. The EVA analysis does not necessarily eliminate the problem of comparing the performance of large and
small divisions. For example, a company has three divisions, each of which earns a 25 per cent return on its
total net assets. However, the EVA of the
divisions is significantly different. Below are the data for three divisions:
Division
X Y Z
Total net assets 100,000 500,000 1000,000
Net income 25,000 125,000 250,000
ROI on net assets 25% 25% 25%
Target net income (15% of net assets) 15,000 75,000 150,000
EVA (net income – target net income) 10,000 50,000 100,000
Each division earned the same rate of return on net assets, and each has the same percentage target net
income requirement. Still the EVA measures are dramatically different among the divisions. This approach has
a tendency to highlight the divisions that generate the largest rupee profits for the firm.
2. Most of the problem in measuring the divisional income and divisional investment base are also present in
the measurement of EVA.
3. There is additional risk of selecting a fair and equitable measure of the required cut-off percentage (i.e., the
cost of capital).
4. EVA can be readily transformed into ROI and many firms tend to convert EVA into ROI.
The relationship between EVA and ROI is as follows:
ROI = EVA K
Where, ROI = Return on investment
EVA = Economic Value Added
I = Investment
K = Cost of capital
The two methods however, may show different results. In face of such a conflict, a question may arise: which
of two must be considered more reliable?

Q24. Elucidate the importance of CAPM approach for calculation of cost of equity.

Ans. In capital budgeting, corporate accountants and finance analysts often use the capital asset pricing model,
or CAPM, to estimate the cost of shareholder equity. The CAPM formula requires only three pieces of
information: the rate of return for the general market, the beta value of the stock in question and the risk-free
rate.

Cost of Equity = Risk-Free Rate + Beta * (Market Rate of Return - Risk-Free Rate)

The rate of return refers to the returns generated by the market in which the company's stock is traded. If
company CBW trades on the Nasdaq and the Nasdaq has a return rate of 12%, this is the rate used in the CAPM
formula to determine the cost of CBW's equity financing. The beta of the stock refers to the risk level of the
individual security relative to the wider marker. A beta value of 1 indicates the stock moves in tandem with the
market. If the Nasdaq gains 5%, so does the individual security. A higher beta indicates a more volatile stock
and a lower beta reflects greater stability. The risk-free rate is generally defined as the rate of return on short-
term U.S. Treasury bills, or T-bills, because the value of this type of security is extremely stable and return is
backed by the U.S. government.

Numerous online calculators can determine the CAPM cost of equity, but calculating the formula by hand or in
Microsoft Excel is simple. Assume CBW trades on the Nasdaq, which has a rate of return of 9%. The company's
stock is slightly more volatile than the market, with a beta of 1.2. The risk-free rate based on the three-month T-
bill is 4.5%. Based on this information, the cost of the company's equity financing is 4.5 + 1.2 * (9 - 4.5), or 9.9%.
The cost of equity is an integral part of the weighted average cost of capital, or WACC, which is widely used to
determine the total anticipated cost of all capital under different financing plans.

Q25. Explain Capital Budgeting Process in detail.

Ans. Capital budgeting is a complex process as it involves decisions relating to the investment of current funds
for the benefit to the achieved in future and the future is always uncertain. However, the following procedure
may be adopted in the process of capital budgeting:
Identification of Investment Proposals: The capital budgeting process begins with the identification of
investment proposals. The departmental head analyses the various proposals in the light of the corporate
strategies and submits the suitable proposals the suitable proposals to the Capital Expenditure Planning
Committee in the case of large organizations or to the officers concerned with the process of long term
investment decisions.
Screening the Proposals: The Expenditure Planning Committee screens the various proposals received from
different departments. The committee views these proposals from various angles to ensure that these are in
accordance with the corporate strategies or selection criterion of the firm and also do not lead to departmental
imbalances.
Evaluation of Various Proposals: The next step in the capital budgeting process is to evaluate the profitability
of various proposals. There are many methods which may be used for this purpose such as pay back period
method, rate of return method, net present value method, internal rate of return method etc.
Fixing Priorities: After evaluating various proposals, the unprofitable or uneconomic proposals may be rejected
straight away. But it may not be possible for the firm to invest immediately in all the acceptable proposals due to
limitation of funds. Hence, it is very essential to rank the various proposals and to establish priorities after
considering urgency, risk and profitability involved therein.
Final Approval and preparation of Capital Expenditure Budget: Proposals meeting the evaluation and other
criteria are finally approved to be included in the Capital Expenditure Budget.
Implementing Proposal: Preparation of a capital expenditure budgeting and incorporation of a particular
proposal in the budget does not itself authorize to go ahead with the implementation of the project. A request for
authority to spend the amount should further be made to the capital expenditure committee which may like to
review the profitability of the project in the changed circumstances.
Performance Review: The last stage in the process of capital budgeting is the evaluation of the performance of
the project. The evaluation on the project with the budgeted one, and also by comparing the actual return from
the investment with the anticipated return. The unfavorable variances, if any should be looked into and the
causes of the same be identified so that corrective action may be taken in future.

Q26. How far do you agree with the proposition that dividends are irrelevant?
Ans. Miller and Modigliani Model: The irrelevance of dividends is provided by the MM Hypothesis. MM maintains
that dividend policy has no effect on the share prices of the firm. What matters, according to them, is the
investment policy through which the firm can increase its earnings and thereby the value of the firm given the
investment decision of the firm, the dividend decision – splitting the earnings into packages of retentions and
dividends – is a matter of detail and does not matter.
MM Hypothesis is based on the following critical assumptions:
1. Perfect capital markets, in which all investors are rational. Information is available to all free of cost, there are
no transaction costs, securities are infinitely divisible; no investor is large enough to influence the market price
of securities, there are no floatation costs.
2. There are no taxes. Alternatively, there are no differences in tax rate applicable to capital gains and dividends.
3. A firm has a given investment policy which does not change. The operational implication of this assumption is
that financing of new investment out of retained earnings will not change the business risk complexion of the firm
and therefore, no change in the required rate of return.
4. There is a perfect certainty by every investor as to future investments and profits of the firm. In other words,
investors are able to forecast future prices and dividends with certainty. This assumption is dropped by MM later.

Q27. What is weighted average cost of Capital? Explain its significance and components.

Ans. A company has to employ a combination of creditors and fund owners. The composite cost of capital lies
between the least and most expensive funds. This approach enables the maximization of profits and the wealth
of the equity shareholders by investing the funds in projects earning in excess of the overall cost of capital. The
composite cost of capital implies an average of the costs of each of the source of funds employed by the firm
property, weighted by the proportion they hold in the firm’s capital structure.
Steps Involved in Computation of WACC
1. Determination of the type of funds to be raised and their individual share in the total capitalisation of the firm.
2. Computation of cost of specific source of funds.
3. Assignment of weight to specific costs.
4. Multiply the cost of each source by the appropriate assigned weights.
5. Dividing the total weighted cost by the total weights to get overall cost of capital.
Once the company decides the funds that will be raised from different sources, then the computation of specific
cost of each component or source is completed after which, the third step in computation of cost of capital is,
assignment of weights to specific costs, or specific sources of funds.

IMPORTANCE AND USES OF WEIGHTED AVERAGE COST OF CAPITAL (WACC)

The following points will explain why WACC is important and how it is used by investors and the company for
their respective purposes:

Investment Decisions by Company

WACC is widely used for making investment decisions in the corporate by evaluating their projects. Let us
categorize the investments in projects in the following 2 ways:

Importance and Use of Weighted Average Cost of Capital (WACC)Evaluation of Projects with the Same Risk

When the new projects are of similar risk like existing projects of the company, it is an appropriate benchmark
rate to decide the acceptance or rejection of these projects. For example, a furniture manufacturer wishes to
expand its business in new locations i.e. establishing a new factory for the same kind of furniture in a different
location. To generalize it to some extent, a company entering new projects in its own industry can reasonably
assume the similar risk and use WACC as a hurdle rate to decide whether it should enter into the project or not.

Evaluation of Projects with Different Risk

WACC is an appropriate measure to be used to evaluate a project provided two underlying assumptions are
true. The assumptions are ‘same risk’ and ‘same capital structure’. What to do in this situation? Still, WACC can
be used with certain modification with respect to the risk and target capital structure. Risk-adjusted WACC,
adjusted present value etc are the concepts to circumvent the problems of WACC assumptions.
Discount Rate in Net Present Value Calculations

Net present value (NPV) is the widely used method of evaluating projects to determine the profitability of the
investment. WACC is used as discount rate or the hurdle rate for NPV calculations. All the free cash flows and
terminal values are discounted using the WACC.

Calculate Economic Value Added (EVA)

EVA is calculated by deducting the cost of capital from the net profits of the company. In calculating the EVA,
WACC serves as the cost of capital of the company. This is how WACC may also be called a measure of value
creation.

Valuation of Company

Any rational investor will invest time before investing money in any company. The investor will try to find out the
valuation of the company. Based on the fundamentals, the investor will project the future cash flows and discount
them using the WACC and divide the result by no. of equity shareholders. He will get the per-share value of the
company. He can simply compare this value and the current market price (CMP) of the company and decide
whether it is worth investment or not. If the valuations are more than the CMP, the scrip is under-priced and if it
is less than CMP, it is overpriced. If the value is $25 and CMP is 22, the investor will invest at 22 expecting the
prices to rise till 25 and vice versa.

Q28. What is Weighted Average Cost of capital, and also explain factors affecting WACC.
Ans. A company has to employ a combination of creditors and fund owners. The composite cost of capital lies
between the least and most expensive funds. This approach enables the maximization of profits and the wealth
of the equity shareholders by investing the funds in projects earning in excess of the overall cost of capital. The
composite cost of capital implies an average of the costs of each of the source of funds employed by the firm
property, weighted by the proportion they hold in the firm’s capital structure.
Steps Involved in Computation of WACC
1. Determination of the type of funds to be raised and their individual share in the total capitalisation of the firm.
2. Computation of cost of specific source of funds.
3. Assignment of weight to specific costs.
4. Multiply the cost of each source by the appropriate assigned weights.
5. Dividing the total weighted cost by the total weights to get overall cost of capital.
Once the company decides the funds that will be raised from different sources, then the computation of specific
cost of each component or source is completed after which, the third step in computation of cost of capital is,
assignment of weights to specific costs, or specific sources of funds.
Assignment of Weights: The weights to specific funds may be assigned, based on the following:
1. Book Values: Book value weights are based on the values found on the balance sheet. The weight applicable
to a given source of fund is simply the book value of the source of fund divided by the book value of the total
funds.
2. Capital Structure Weights: Under this method, weights are assigned to the components of capital structure
based on the targeted capital structure.
3. Market Value Weights: Under this method, assigned weights to a particular component of capital structure
is equal to the market value of the component of capital divided by the market value of all components of capital
and capital employed by the firm.

Factors Affecting WACC

Weighted average cost of capital is affected by a number of factors. They are divided into two categories such
as:
Controllable Factors: Controllable factors are those factors that affect WACC, but the firm can control them.
They are:
(a) Capital Structure Policy: As we have assured, a firm has a given target capital structure where it assigns
weights based on that target capital structure to calculate WACC. However, a firm can change its capital structure
or proportions of components of capital that affect its WACC.
(b) Dividend Policy: The required capital may be raised by equity or debt or both. Equity capital can be raised
by issue of new equity shares or through retained earnings. Sometimes companies may prefer to raise equity
capital by retention of earnings, due to issue of new equity shares, which are expensive (they involve flotation
costs).
(c) Investment Policy: While estimating the initial cost of capital, generally we use the starting point as the
required rate of return on the firm’s existing stock and bonds. Therefore, we implicitly assume that new capital
will be invested in assets of the same type and with the same degree of risk. But it is not correct as no firm invest
in assets similar to the ones that currently operate, when a firm changes its investment policy.
Uncontrollable Factors: The factors that are not possible to be controlled by the firm and mostly affects the
cost of capital. These factors are known as External factors.
(a) Tax Rates: Tax rates are beyond the control of a firm. They have an important effect on the overall cost of
the capital. Computation of debt involves consideration of tax. In addition, lowering capital gains tax rate relative
to the rate on ordinary income makes stocks more attractive and reduces cost of equity and lower the overall
cost of capital.
(b) Level of Interest Rates: Cost of debt is interest rate. If interest rates increases, automatically cost of debt
also increases. On the other hand, if interest rates are low then the cost of debt is less. The reduced cost of debt
decreases WACC and this will encourage an additional investment.
(c) Market Risk Premium: Market risk premium is determined by the risk in investing proposed stock and the
investor’s aversion to risk. Market risk is out of control risk, i.e., firms have no control on this factor.
Q29. Examine the relevance of cost of capital in capital budgeting decisions.
Ans. Cost of capital may be used as the measuring road for adopting an investment proposal. The firm, naturally,
will choose the project which gives a satisfactory return on investment which would in no case be less than the
cost of capital incurred for its financing. In various methods of capital budgeting, cost of capital is the key factor
in deciding the project out of various proposals pending before the management. It measures the financial
performance and determines the acceptability of all investment opportunities.
Q30. Explain various techniques of Inventory management
Ans.
A. Setting of Various Stock Levels
Reorder Level: This level is between minimum and maximum levels, such that before the material ordered is
received into stores, there is sufficient quantity on hand to cover with normal and abnormal consumption
situations. It is the level at what order for replenishment of stock should be placed.
Reorder Level = Maximum Consumption X Maximum Reorder Period.
Minimum Stock Level: It indicates the lowest figure of inventory balance which must be maintained in hand at
all times, so that there is no stoppage of production due to non-availability of inventory.
Minimum Stock Level = Reorder Level – (Normal Consumption X Normal Reorder Period)
Maximum Stock Level: It indicates the maximum figure of inventory balance.
Maximum Stock Level = Reorder Quantity + Reorder Level – (Minimum Consumption X Minimum Reorder
Period)
Maximum Stock Level+Minimum Stock Level
Average Stock
Level =
2
B. ABC Analysis (called Always Better Control): It is a system of inventory control where discriminating
control is exercised over different items of stores classified on the basis of investment involved. Usually, the
items are divided into three categories according to their importance, namely their value and frequency of
replenishment during a period.
1. ‘A’ category of items consists of only a small percentage i.e., about 10% of the total items handled by the
stores but require heavy investment (in rupee value) about 70% of the total inventory value.
2. ‘B’ category of items (relatively less important) constitutes 20% of the total items handled by stores, having
an investment (in rupee value) of about 20% of the total inventory value.
3. ‘C’ category consists of large number of items handled by stores say 70%, having relatively small investment
say 10% of the total inventory value.
Economic Order Quantity: Economic Order Quantity (EOQ) is the order size for some particular inventory item
that results in lowest total inventory cost for the period. Total inventory cost consists of inventory ordering cost
and investment carrying cost. An EOQ may be computed for each inventory item.

C. Use of Control Ratios:

1. Input-output ratio: Inventory control can also be exercised by the use of input-output ratio. Input Output ratio
is the ratio of the quantity of input of material to production and the standard material content of the actual output.
This ratio enables comparison of actual consumption and standard consumption, thus indicating the usage of
material is favourable or adverse.
2. Inventory Turnover ratio: It is computed as follows:
Cost of materials consumed during the period
Inventory turnover ratio =
Cost of average stock held during the period

D. Just-in-Time (JIT) System: The Just-in-Time (JIT) system is used to minimize inventory investment. The
philosophy is that materials should arrive exactly the time they are needed for production. Ideally the firm should
have work-in-process inventory. Because its objective is to minimize inventory investment, a JIT system uses no
(or little) safety stock.

Q31. Explain the objectives of credit polity of firm. What are the elements of a credit policy?
Or
What do you mean by credit policy? Give various components of credit policy along with the important
areas of considerations.
Ans. Establishing the basic framework for the extension of business credit is vital to the long term success of
any organization regardless of its size. A sound credit policy will facilitate greater levels of sales, foster stronger
relationships with your customers and above all protect your investment in accounts receivable.

Some of the key elements to be considered and implemented:

1. Purpose of the policy

2. Objectives
3. Credit limit authority
4. Credit evaluation
5. Credit limits
6. Terms
7. Account Review
8. Collections

Purpose
The purpose of the policy should be the establishment of the basic framework for governance of the plan. Sub-
sections will describe in specificity the details of the policy.

Objectives
Metrics should be defined which will provide the basis for policy effectiveness.

Credit limit authority

Establish levels of authority varied by sales volume. An organization's risk tolerance should largely determine
the thresholds of authority at each level elevating ultimately up to senior financial management and principals.

These authority limits should be given thoughtful consideration as improper implementation can unduly delay
the credit approval process leading to lost customers and sales.

Credit evaluation
This step is typically handled at the analyst level. Data sources such as the NACM National Trade Credit Report
are a valuable resource providing credit and risk managers with a unique illustration as to how potential
customers are paying other trade creditors. Data received from such sources should be incorporated into your
decision model providing a basis for the ultimate decision on whether to extend trade credit and the establishment
of a limit. If the credit limit sought by the prospective customer is below a certain threshold, this information may
be sufficient in making a credit decision.

Credit limits
There are many schools of thought on how best to establish credit limits. A balanced approach should take into
consideration the:

a) Customer's anticipated purchasing volume.

b) Customer's payment history with other trade creditors.

c) Customer's statement of cash flows.

d) Customer's balance sheet and overall financial condition.

e) Condition of the customer's market and industry.

Establishing the limit may be somewhat subjective, within certain tolerances, based upon any combination of the
criteria measured.

Terms
Terms establishment may largely be dictated by the norms of any given industry sector. Weekly terms may be
customary in certain industries whereas seasonal terms may be the norm in others. Regardless of the terms
that are established, it is imperative that these terms be uniformly adhered to from the outset of the relationship
with your customer. Your customers may, and probably do, have internal policies on when and how frequently
trade payables are processed, so requiring a customer's compliance from the start is critical.
Account review
Establishing the limits and terms is not the end of the game. Policies regarding the periodic review of your
customer's credit worthiness should be instituted. In addition to the usual tracking of a customer's aging,
creditors should implement a plan to review a customer's credit at regular intervals such as yearly. This
procedure may include having the customer complete an updated credit application which may alert you to
important information such as a change in the legal composition of the business.

Collections
Despite the establishment and implementation of a sound credit policy, a percentage of your customers will
ultimately be unable or unwilling to honor their commitment. It is, therefore, important that a procedure be
established on how to address these situations. An approach that begins with a friendly reminder at the early
stages of delinquency graduating to a final demand should be considered. It is important to remember that the
more an account ages the less likely it is to be collected.

Q32. Define the terms a. Future Value, b. Present Value, c. Annuity

Ans. a. Future Value: A sum of money invested today at compound interest accumulates to a larger sum
called the amount or future value. The future value of 1000 invested at 6% compounded annually for 2 years is
1123.60. The future value includes the original principal and the accumulated interest. The future value varies
with the interest rate, the compounding frequency and the number of periods.
b. Present Value: If 1 can be invested at 8% today to become 1.08 in the future, then 1 is the present value of
the future amount of 1.08. The present value of future receipts of money is important in business decision-
making. It is necessary to decide how much future receipts are worth today in order to determine whether an
investment should be made or how much should be invested.
c. Annuity: An annuity is a series of equal payments made at equal time intervals, with compounding or
discounting taking place at the time of each payment. Each annuity payment is called a rent. There are several
types of annuities, out of which in an ordinary annuity each rent is paid or received at the end of each period.

Q28. Explain the terms a. Specific Risks

Ans.

Q33. What is meant by the term leverage? How are operating leverage, financial leverage and total
leverage related to the income statement?
OR
Q33. Explain the terms a. Operating Leverage, b. Financial Leverage, c. Combined Leverage
Ans.

In finance, leverage is very closely related to fixed expenses. We can safely state that by the introduction of
expenses which are fixed in nature, we are leveraging a firm. By fixed expenses, we refer to the expenses, the
amount of which remains unchanged irrespective of the activity of the business. For example, an amount of
investment made in fixed assets or interest paid on loans does not change with a normal change in a number of
sales. Neither they decrease with a decrease in sales and nor they increase with an increase in sales.

There is a different basis for classifying business expenses. For our convenience, let us classify fixed expenses
into operating fixed expenses such as depreciation on fixed expenses, salaries etc, and financial fixed expenses
such as interest and dividend on preference shares. Similar to them, leverages are also of two types – financial
leverage and operating leverage.

Financial Leverage: Financial leverage is a leverage created with the help of debt component in the capital
structure of a company. Higher the debt, higher would be the financial leverage because with higher debt comes
the higher amount of interest that needs to be paid. Leverage Leverage and Types of Leveragescan be both
good and bad for a business depending on the situation. If a firm is able to generate a higher return on investment
(ROI) than the interest rate it is paying, leverage will have its positive effect shareholder’s return. The darker side
is that if the said situation is opposite, higher leverage can take a business to a worst situation like bankruptcy.
Operating Leverage: Operating leverage, just like the financial leverage, is a result of operating fixed expenses.
Higher the fixed expense, higher is the operating leverage. Like the financial leverage had an impact on the
shareholder’s return or say earnings per share, operating leverage directly impacts the operating profits (Profits
before Interest and Taxes (PBIT)). Under good economic conditions, due to operating leverage, an increase of
1% in sales will have more than 1% change in operating profits.

Combined leverage or total leverage can be defined as potential use of fixed costs, both operating and financial,
to magnify the effect of changes in sales on the firms, earnings per share. Total leverage or combined leverage
can therefore be viewed as the total impact of the fixed cost in the firms operating and financial structure.
Combined leverage = operating leverage × financial leverage

Q34. Explain the terms bonus shares and share splits. What is their rationale?

Ans. Bonus Shares (Stock Dividend) Bonus shares occur when new shares are issued on a pro rata basis to
the current shareholders while the firm’s assets, its earnings, the risk being assured and the investor’s
percentage ownership in the company remain uncharged.

Example: If a shareholder owns 100 shares of common stock at a time when the firm distributes bonus shares
in the ratio of 1:20 (1 share for every 20 shares held), the shareholder will receive 5 additional shares.

There are several favourable aspects of a bonus issue:

1. Conserves cash: The stock dividend (bonus shares) allows the firms to declare a dividend without using up
cash that may be needed for operations or expansion.

2. Indicates higher future profits: Normally a bonus share is an indication of higher future profits.

3. Raises future dividends for investors: If the regular cash dividend is continued after the bonus issue, the
individual shareholder will receive higher total dividends.

4. Has high psychological value: Because of the positive aspects of bonus shares, issue of bonus shares
receives positive response by the market.

5. Retains proportional ownership for shareholders: It helps the majority shareholders in retaining the
proportional ownership as compared to rights issue of shares where the shareholders are expected to pay for
the shares including the premium as per issue criteria.

Stock (Share) Split

A stock split is a change in the number of outstanding shares through a proportional reduction or increase in
the par value of the shares. Only the face value (par value) and number of outstanding shares are affected.
The market price of the stock will adjust immediately to reflect the stock split. Example: a firm may have
20,00,000 outstanding shares selling for 20 per share.

The firm declares a 2–for–1 stock split. After the split, the outstanding share will go up to 40,00,000 and will
sell for approximately 10 per share. A shareholder with 100 shares worth 2000 before the split will hold 200
shares worth 2000.
Why firms go for stock splits?

1. Reduction of market price of stock: The major objective behind most stock split is to reduce the per share
price of a firm’s common shares. A lower price per share makes the stock more affordable in marketable lots
(usually 100 shares) to more investors.

2. Indication of future growth: The announcement of the stock split is perceived as a favourable news by the
investors in that with growing earnings, the company has bright prospects and the investors can reasonably
look for increase in future dividends.

3. Reverse split: An indication of trouble. In case of reverse split, the firm reduces the number of outstanding
shares. The declaration of reverse split is an indication that the firm does not have good prospects

Q35. What is capital Budgeting. why it is significant for firm?

Ans. Capital budgeting, or investment appraisal, is the planning process used to determine whether an
organization's long term investmentssuch as new machinery, replacement machinery, new plants, new
products, and research development projects are worth the funding of cash through the firm's capitalization
structure (debt, equity or retained earnings). It is the process of allocating resources for major capital, or
investment, expenditures. One of the primary goals of capital budgeting investments is to increase the value of
the firm to the shareholders.
the need of capital budgeting can be emphasised taking into consideration the very nature of the capital
expenditure such as heavy investment in capital projects, long-term implications for the firm, irreversible
decisions and complicates of the decision making. Its importance can be illustrated well on the following other
grounds:-

(1) Indirect Forecast of Sales. The investment in fixed assets is related to future sales of the firm during the
life time of the assets purchased. It shows the possibility of expanding the production facilities to cover
additional sales shown in the sales budget. Any failure to make the sales forecast accurately would result in
over investment or under investment in fixed assets and any erroneous forecast of asset needs may lead the
firm to serious economic results.

(2) Comparative Study of Alternative Projects Capital budgeting makes a comparative study of the
alternative projects for the replacement of assets which are wearing out or are in danger of becoming obsolete
so as to make the best possible investment in the replacement of assets. For this purpose, the profitability of
each projects is estimated.

(3) Timing of Assets-Acquisition. Proper capital budgeting leads to proper timing of assets-acquisition and
improvement in quality of assets purchased. It is due to ht nature of demand and supply of capital goods. The
demand of capital goods does not arise until sales impinge on productive capacity and such situation occur
only intermittently. On the other hand, supply of capital goods with their availability is one of the functions of
capital budgeting.

(4) Cash Forecast. Capital investment requires substantial funds which can only be arranged by making
determined efforts to ensure their availability at the right time. Thus it facilitates cash forecast.
(5) Worth-Maximization of Shareholders. The impact of long-term capital investment decisions is far
reaching. It protects the interests of the shareholders and of the enterprise because it avoids over-investment
and under-investment in fixed assets. By selecting the most profitable projects, the management facilitates the
wealth maximization of equity share-holders.

(6) Other Factors. The following other factors can also be considered for its significance:-

(a) It assist in formulating a sound depreciation and assets replacement policy.

(b) It may be useful n considering methods of coast reduction. A reduction campaign may necessitate the
consideration of purchasing most up-to—date and modern equipment.

(c) The feasibility of replacing manual work by machinery may be seen from the capital forecast be comparing
the manual cost an the capital cost.

(d) The capital cost of improving working conditions or safety can be obtained through capital expenditure
forecasting.

(e) It facilitates the management in making of the long-term plans an assists in the formulation of general
policy.

(f) It studies the impact of capital investment on the revenue expenditure of the firm such as depreciation,
insure and there fixed assets.

Q36. Analyse the importance of the preparation of the cash budget for corporates?

Ans. The importance of cash budget may be summarised as follow:-

(1) Helpful in Planning. Cash budget helps planning for the most efficient use of cash. It points out cash
surplus, or deficiency at selected point of time and enables the management to arrange for the deficiency
before time or to plan for investing the surplus money as profitable as possible without any threat to the
liquidity.
(2) Forecasting the Future needs. Cash budget forecasts the future needs of funds, its time and the amount
well in advance. It, thus, helps planning for raising the funds through the most profitable sources at reasonable
terms and costs.
(3) Maintenance of Ample cash Balance. Cash is the basis of liquidity of the enterprise. Cash budget helps
in maintaining the liquidity. It suggests adequate cash balance for expected requirements and a fair margin for
the contingencies.
(4) Controlling Cash Expenditure. Cash budget acts as a controlling device. The expenses of various
departments in the firm can best be controlled so as not to exceed the budgeted limit.
(5) Evaluation of Performance. Cash budget acts as a standard for evaluating the financial performance.
(6) Testing the Influence of proposed Expansion Programme. Cash budget forecasts the inflows from a
proposed expansion or investment programme and testify its impact on cash position.
(7) Sound Dividend Policy. Cash budget plans for cash dividend to shareholders, consistent with the liquid
position of the firm. It helps in following a sound consistent dividend policy.
(8) Basis of Long-term Planning and Co-ordination. Cash budget helps in co-ordinating the various finance
functions, such as sales, credit, investment, working capital etc. it is an important basis of long term financial
planning and helpful in the study of long term financing with respect to probable amount, timing, forms of
security and methods of repayment.
Q37. What do you mean by Risk- Return trade off? Why it is important from investment perspective

Ans. Risk may be defined as the likelihood that the actual return from an investment will be less than the
forecast return. Stated differently, it is the variability of return form an investment.

Financial decisions incur different degree of risk. Your decision to invest your money in government bonds has
less risk as interest rate is known and the risk of default is very less. On the other hand, you would incur more
risk if you decide to invest your money in shares, as return is not certain. However, you can expect a lower return
from government bond and higher from shares. Risk and expected return move in one behind another.

The greater the risk, the greater the expected return. Financial decisions of a firm are guided by the risk-return
trade off. These decisions are interrelated and jointly affect the market value of its shares by influencing return
and risk of the firm. The relationship between return and risk can be simply expressed as:

Return = Risk free rate + Risk Premium

Risk-Return Tradeoff

Risk free rate is a rate obtainable from a default risk free government security. An investor assuming risk from
his investment requires a risk premium above the risk free rate. Risk free rate is a compensation for time and
risk premium for risk. Higher the risk of an action, higher will be the risk premium leading to higher required return
on that action. A proper balance between return and risk should be maintained to maximize the market value of
a firms share. Such balance is called risk-return trade off and every financial decision involves this trade off.

The financial manager in order to maximize shareholders wealth should strive to maximize returns in relation to
the given risk. He should seek courses of actions that avoid unnecessary risks. To ensure maximum return,
funds flowing in and out of the firm should be constantly monitored to assure that they are safeguarded and
properly utilized. The financial reporting system must be designed to provide timely and accurate picture of the
firm’s activities.

Q38. What do you mean by cost of capital? Explain its relevance from the perspective of capital
budgeting and capital structure.
Ans. Cost of capital is the minimum rate of return that a business must earn before generating value. Before a
business can turn a profit, it must at least generate sufficient income to cover the cost of the capital it uses to
fund its operations. Cost of capital consists of both the cost of debt and the cost of equity used for financing a
business. A company’s cost of capital depends to a large extent on the type of financing the company chooses
to rely on. The company may rely solely on equity or debt, or use a combination of the two.
The cost of capital is very important concept in the financial decision making. Cost of capital is the measurement
of the sacrifice made by investors in order to invest with a view to get a fair return in future on his investments
as a reward for the postponement of his present needs. On the other hand from the point of view of the firm
using the capital, cost of capital is the price paid to the investor for the use of capital provided by him. Thus, cost
of capital is reward for the use of capital. The progressive management always likes to consider the importance
cost of capital while taking financial decisions as it’s very relevant in the following spheres:
Designing the capital structure: The cost of capital is the significant factor in designing a balanced and optimal
capital structure of a firm. While designing it, the management has to consider the objective of maximizing the
value of the firmand minimizing cost of capital. Comparing the various specific costs of different sources of
capital, the financial managercan select the best and the most economical source of finance and can designed
a sound and balanced capital structure.

Capital budgeting decisions: The cost of capital sources as a very useful tool in the process of making capital
budgetingdecisions. Acceptance or rejection of any investment proposal depends upon the cost of capital. A
proposal shall not be accepted till its rate of return is greater than the cost of capital. In various methods of
discounted cash flows of capital budgeting, cost of capital measured the financial performance and determines
acceptability of all investment proposals by discounting the cash flows.

Q39. What do you mean by present and future value of money? Explain the rationale behind the
calculation of time value of money.
Ans. What Is Future Value?

Future value is the amount of money that an original investment will grow, over time, at a specific compounded
rate of interest. In simpler terms, an investment of $1,000 today in an account paying 4 percent interest will be
worth $1,217 in five years. That's an example of the time value of money.

Example of Future Value

How is this concept of time value useful in managerial decision-making? Suppose you have an old piece of
machinery that you would like to replace, but a replacement will cost $50,000. You don't want to borrow the
money, so you decide to save enough each month for three years to pay cash. How much will you need to
save each month to reach the goal of $50,000?

Let's assume the current interest rate for savings is 4 percent. A future value calculator shows that 36
payments of $645 per month will yield $50,051 in three years. If you work this monthly payment into your
company's budget, you can replace the obsolete equipment in three years, paying cash and not taking on
additional debt.

What Is Present Value?

Present value is a measure in today's dollars of the receipts from future cash flow. In other words, it is a
comparison of the purchasing power of a dollar today versus the buying power of a dollar in the future. For
clarity, consider this example. Suppose someone offered to pay you $1,000 today or $1,100 in five years.
Which would you take?

With a discount rate of 4 percent, an $1,100 payment in five years would have a present-day value of $904.
Therefore, taking the $1,000 payment today is the better choice.

Example of Present Value

Managers and analysts use present value calculations to determine the attractiveness of a project. If the net
present value of future cash flow from a project exceeds the original investment, then the project could be
accepted.
Take this example. You have a proposal to invest $30,000 in a new piece of equipment that will improve
production efficiency. This new machine will reduce operating costs by $10,000 per year for at least five years.
You require that all new projects produce a minimum return of 11 percent. The financial calculator shows that
the present value of $10,000/year discounted at 11 percent yields a present value of $36,959. Because this
present value exceeds the original investment of $30,000 by $6,959, this investment in the new machine
should be accepted.

The time value of money is an economic concept that small business owners must use when evaluating
investments and projects. The financial consequences are significant. Calculations of future and present
values provide basic data on which to make rational business decisions.

The time value of money sounds like one of those boring economic concepts that a small business owner doesn't
have time for – but that would be wrong. Future value and present value are monetary concepts that a business
owner uses every day, whether he realizes it or not. The idea is simple: Money in your pocket today is worth
more than the same amount received several years in the future. The difference is the effect of inflation and the
risk that you may not actually receive the money you expect in the future.

Q40. What is effective rate of interest? How it differ from nominal rate of interest? Also explain the rule
of 72 in context of time value of money.

Ans. Nominal Interest Rate

The nominal interest rate is conceptually the simplest type of interest rate. It is quite simply the stated interest
rate of a given bond or loan. This type of interest rate is referred to as the coupon rate for fixed-income
investments, as it is the interest rate guaranteed by the issuer that was traditionally stamped on the coupons
that were redeemed by the bondholders.

The nominal interest rate is, in essence, the actual monetary price that borrowers pay to lenders to use their
money. If the nominal rate on a loan is 5%, borrowers can expect to pay $5 of interest for every $100 loaned to
them

Effective Interest Rate

One other type of interest rate that investors and borrowers should know is called the effective rate, which
takes the concept of compounding into account.

For example, if a bond pays 6% on an annual basis and compounds semiannually, then an investor who
places $1,000 in this bond will receive $30 of interest after the first 6 months ($1,000 x .03), and $30.90 of
interest after the next six months ($1,030 x .03). The investor received a total of $60.90 for the year, which
means that while the nominal rate was 6%, the effective rate was 6.09%.

Mathematically speaking, the difference between the nominal and effective rates increases with the number
of compounding periods within a specific period. Note that the rules pertaining to how the annual equivalent
rate (AER) on a financial product is calculated and advertised are less stringent than for the annual percentage
rate (APR).

The Rule of 72 in finance is a phrase (and a formula) that, when solved, calculates the approximate number of
periods (typically years) in which you can double your money at a certain interest rate. Should the formula
include the number of years in which you desire to double your money, the interest rate needed to double the
money can be identified.
It should be noted that the formula gives an approximation of the number of years needed or the interest rate
needed to double the money, and is not exact. Further, interest rates are very rarely guaranteed, so it is
important to keep this in mind when attempting to plan or project using this formula.

Formula
With this formula, provided you have all but one variable, you can solve the equation for the missing variable.
N = 72 / r
Where:
N = number of periods, usually years
72 = constant
r = interest rate

Examples
Let's start with a relatively simple example. Assuming an investment will earn 8% per year, the formula can be
solved as follows to determine the number of years it will take for the investment, growing at 8% per year, to
double.
In this instance, 8 is the interest rate, so we will plug it in for r.
N = 72 / 8
N=9
Thus, the investment will double in approximately 9 years.
Rearranging the formula to solve for the approximate number of years in which the investment will double can
be done as follows:
9 = 72 / r
r = 72 / 9
r = 8, or 8%
Thus, the investment needs to grow at 8% per year to double in approximately 9 years.

Q41. What do you mean by EOQ (Economic order quantity)? Explain various method of EOQ.

Ans. Economic order quantity (EOQ) is a decision tool used in cost accounting. It’s a formula that allows you to
calculate the ideal quantity of inventory to order for a given product. The calculation is designed to minimize
ordering and carrying costs. It goes back to 1913, when Ford W. Harris wrote an article called “How Many
Parts to Make at Once.”
EOQ is based on the following set of assumptions:
• Reorder point: The reorder point is the time when the next order should be placed. EOQ assumes that
you order the same quantity at each reorder point.
• Demand, relevant ordering cost, and relevant carrying cost: Customer demand for the product is
known. Also, the ordering and carrying costs are certain. A relevant cost refers to a cost you need to
consider when you make a decision. The term is used throughout this book.
• Purchase order lead time: The lead time is the time period from placing the order to order delivery. EOQ
assumes that the lead time is known.
 • Purchasing cost per unit: The cost per unit doesn’t change with the amount ordered. This removes any
consideration of quantity discounts. Assume you’ll pay the same amount per unit, regardless of the order
size.
• Stockouts: No stockouts occur. You maintain enough inventory to avoid a stockout cost. That means you
monitor your customer demand and inventory levels carefully.
• Quality costs: EOQ generally ignores quality costs.
Economic order quantity uses three variables: demand, relevant ordering cost, and relevant carrying cost.
Use them to set up an EOQ formula:
• Demand: The demand, in units, for the product for a specific time period.
• Relevant ordering cost: Ordering cost per purchase order.
• Relevant carrying cost: Carrying costs for one unit. Assume the unit is in stock for the time period used
for demand.
Note that the ordering cost is calculated per order. The carrying costs are calculated per unit. Here’s the
formula for economic order quantity:
Economic order quantity = square root of [(2 x demand x ordering costs) ÷ carrying costs]
That’s easier to visualize as a regular formula:

various method of EOQ

1. Formula Method
With the help of following formula, the economic order quantity can be calculated.

2. Graphical Method
Under this method, the carrying cost, ordering cost and total cost are shown on graph. It is based on the principle
that the total carrying cost increases as the order size increases. However, the ordering cost decreases if the
order size increases. The point at which the ordering cost and carrying cost intersects each other, total cost is
minimum.

3. Trial And Error Method

If the total needs of inventory for a form are known, the firm has different alternatives to purchase its inventories.
It can buy its total needs in a single order at the beginning of the year or the inventories may be purchased in
small orders periodically. If the purchase are made in one order, the average inventory holdings will be relatively
large whereas they will be relatively small when the acquisition of inventory is in small lots. High average
inventory would involve high carrying cost and low average inventory holdings are associated with high ordering
costs. According to this method, the carrying and ordering costs for different sizes of orders to purchase
inventories are computed and the order size with the lowest total cost of inventory is the economic order quantity.
Q42. Calculate the future value in following cases
1. Rs. 5000 deposited into PNB for 2 years at 7 percent rate of interest compounded annually.
2. Rs. 5000 deposited into PNB for 2 years at 7 percent rate of interest compounded semiannually.
3. Rs. 5000 deposited into PNB for 2 years at 7 percent rate of interest compounded quarterly.

Ans.
1.PV = 5,000
Compounding period (n) = 2
Annual interest rate (r) = 7%
FV = 5,000 * (1 + 0.07) ^ 2
FV = 5,000 * (1.07) ^ 2
FV = 5724.5

2. PV = 5,000
Compounding period (n) = 4
Annual interest rate (r) = 3.5%
FV = 5,000 * (1 + 0.035) ^ 4
FV = 5,000 * (1.035) ^ 4
FV = 5737.61

3. PV = 5,000
Compounding period (n) = 8
Annual interest rate (r) = 3.5%
FV = 5,000 * (1 + 0.0175) ^ 8
FV = 5,000 * (1.0175) ^ 8
FV = 5744.409

Q43. Q1 Calculate the future value in following cases

1. Rs. 10000 deposited into SBI for 3 years at 8 percent rate of interest compounded annually.
2. Rs. 10000 deposited into SBI for 3 years at 8 percent rate of interest compounded semiannually.
3. Rs. 10000 deposited into SBI for 3 years at 8 percent rate of interest compounded quarterly.

Ans.
1.PV = 10,000
Compounding period (n) = 3
Annual interest rate (r) = 8%
FV = 10,000 * (1 + 0.08) ^ 3
FV = 10,000 * (1.08) ^ 3
FV = 12597.12

2. PV = 10,000
Compounding period (n) = 6
Annual interest rate (r) = 4%
FV = 10,000 * (1 + .04) ^ 6
FV = 10,000 * (1.04) ^ 6
FV = 12653.19

3. PV = 10,000
Compounding period (n) = 12
Annual interest rate (r) = 2%
FV = 10,000 * (1 + 0.02) ^ 12
FV = 10,000 * (1.02) ^ 12
FV = 12682.42