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Name : ///DEEP SINGH

Registration / Roll No. : 331630152

Course : Master of Business Administration


Subject : Financial Management

Semester : Sem II

Subject Number : MB0045 ( SET-I )

_______________ _______________ ______________

Sign of Center Head Sign of Evaluator Sign of Coordinator
Q.1. what are 4 Finance decisions taken by a Finance Manager.

Answer : Corporate finance is the field of finance dealing with financial decisions that
business enterprises make and the tools and analysis used to make these decisions. The
primary goal of corporate finance is to maximize corporate value while managing the
firm's financial risks. Although it is in principle different from managerial finance which
studies the financial decisions of all firms, rather than corporations alone, the main
concepts in the study of corporate finance are applicable to the financial problems of all
kinds of firms.

The discipline can be divided into long-term and short-term decisions and techniques.
Capital investment decisions are long-term choices about which projects receive
investment, whether to finance that investment with equity or debt, and when or whether
to pay dividends to shareholders. On the other hand, short term decisions deal with the
short-term balance of current assets and current liabilities; the focus here is on managing
cash, inventories, and short-term borrowing and lending (such as the terms on credit
extended to customers).[citation needed]

The terms corporate finance and corporate financier are also associated with investment
banking. The typical role of an investment bank is to evaluate the company's financial
needs and raise the appropriate type of capital that best fits those needs. Thus, the terms
“corporate finance” and “corporate financier” may be associated with transactions in
which capital is raised in order to create, develop, grow or acquire businesses.

Capital investment decisions are long-term corporate finance decisions relating to fixed
assets and capital structure. Decisions are based on several inter-related criteria.
(1) Corporate management seeks to maximize the value of the firm by investing in
projects which yield a positive net present value when valued using an appropriate
discount rate in consideration of risk.

(2) These projects must also be financed appropriately.

(3) If no such opportunities exist, maximizing shareholder value dictates that management
must return excess cash to shareholders (i.e., distribution via dividends).

Capital investment decisions thus comprise an investment decision, a financing decision,

and a dividend decision.

The investment decision Main article: Capital budgeting

Management must allocate limited resources between competing opportunities (projects)
in a process known as capital budgeting Making this investment, or capital allocation,
decision requires estimating the value of each opportunity or project, which is a function
of the size, timing and predictability of future cash flows.

Project valuation Further information: Business valuation, stock valuation, and

fundamental analysis
In general,each project's value will be estimated using a discounted cash flow (DCF)
valuation, and the opportunity with the highest value, as measured by the resultant net
present value (NPV) will be selected (applied to Corporate Finance by Joel Dean in 1951;
see also Fisher separation theorem, John Burr Williams: theory). This requires estimating
the size and timing of all of the incremental cash flows resulting from the project. Such
future cash flows are then discounted to determine their present value (see Time value of
money). These present values are then summed, and this sum net of the initial investment
outlay is the NPV. See Financial modeling.

The NPV is greatly affected by the discount rate. Thus, identifying the proper discount
rate - often termed, the project "hurdle rate"[5] - is critical to making an appropriate
decision. The hurdle rate is the minimum acceptable return on an investment—i.e. the
project appropriate discount rate. The hurdle rate should reflect the riskiness of the
investment, typically measured by volatility of cash flows, and must take into account the
financing mix. Managers use models such as the CAPM or the APT to estimate a discount
rate appropriate for a particular project, and use the weighted average cost of capital
(WACC) to reflect the financing mix selected. (A common error in choosing a discount
rate for a project is to apply a WACC that applies to the entire firm. Such an approach
may not be appropriate where the risk of a particular project differs markedly from that of
the firm's existing portfolio of assets.)

In conjunction with NPV, there are several other measures used as (secondary) selection
criteria in corporate finance. These are visible from the DCF and include discounted
payback period, IRR, Modified IRR, equivalent annuity, capital efficiency, and ROI.
Alternatives (complements) to NPV include MVA / EVA (Joel Stern, Stern Stewart &
Co) and APV (Stewart Myers). See list of valuation topics.

Valuing flexibility In many cases, for example R&D projects, a project may open (or
close) the paths of action to the company, but this reality will not typically be captured in
a strict NPV approach. Management will therefore (sometimes) employ tools which place
an explicit value on these options. So, whereas in a DCF valuation the most likely or
average or scenario specific cash flows are discounted, here the “flexibile and staged
nature” of the investment is modelled, and hence "all" potential payoffs are considered.
The difference between the two valuations is the "value of flexibility" inherent in the

The two most common tools are Decision Tree Analysis (DTA) and Real options analysis
(ROA);[9] they may often be used interchangeably:
DTA values flexibility by incorporating possible events (or states) and consequent
management decisions. (For example, a company would build a factory given that
demand for its product exceeded a certain level during the pilot-phase, and outsource
production otherwise. In turn, given further demand, it would similarly expand the
factory, and maintain it otherwise. In a DCF model, by contrast, there is no "branching" -
each scenario must be modelled separately.) In the decision tree, each management
decision in response to an "event" generates a "branch" or "path" which the company
could follow; the probabilities of each event are determined or specified by management.
Once the tree is constructed: (1) "all" possible events and their resultant paths are visible
to management; (2) given this “knowledge” of the events that could follow, and assuming
rational decision making, management chooses the actions corresponding to the highest
value path probability weighted; (3) this path is then taken as representative of project
value. See Decision theory: Choice under uncertainty.
ROA is usually used when the value of a project is contingent on the value of some other
asset or underlying variable. (For example, the viability of a mining project is contingent
on the price of gold; if the price is too low, management will abandon the mining rights, if
sufficiently high, management will develop the ore body. Again, a DCF valuation would
capture only one of these outcomes.) Here: (1) using financial option theory as a
framework, the decision to be taken is identified as corresponding to either a call option
or a put option; (2) an appropriate valuation technique is then employed - usually a variant
on the Binomial options model or a bespoke simulation model, while Black Scholes type
formulae are used less often; see Contingent claim valuation. (3) The "true" value of the
project is then the NPV of the "most likely" scenario plus the option value. (Real options
in corporate finance were first discussed by Stewart Myers in 1977; viewing corporate
strategy as a series of options was originally per Timothy Luehrman, in the late 1990s.)
Quantifying uncertaintyFurther information: Sensitivity analysis, Scenario planning, and
Monte Carlo methods in finance Given the uncertainty inherent in project forecasting and
valuation] analysts will wish to assess the sensitivity of project NPV to the various inputs
(i.e. assumptions) to the DCF model. In a typical sensitivity analysis the analyst will vary
one key factor while holding all other inputs constant, ceteris paribus. The sensitivity of
NPV to a change in that factor is then observed, and is calculated as a "slope": ΔNPV /
Δfactor. For example, the analyst will determine NPV at various growth rates in annual
revenue as specified (usually at set increments, e.g. -10%, -5%, 0%, 5%....), and then
determine the sensitivity using this formula. Often, several variables may be of interest,
and their various combinations produce a "value-surface" (or even a "value-space"),
where NPV is then a function of several variables. See also Stress testing.

Using a related technique, analysts also run scenario based forecasts of NPV. Here, a
scenario comprises a particular outcome for economy-wide, "global" factors (demand for
the product, exchange rates, commodity prices, etc...) as well as for company-specific
factors (unit costs, etc...). As an example, the analyst may specify various revenue growth
scenarios (e.g. 5% for "Worst Case", 10% for "Likely Case" and 25% for "Best Case"),
where all key inputs are adjusted so as to be consistent with the growth assumptions, and
calculate the NPV for each. Note that for scenario based analysis, the various
combinations of inputs must be internally consistent, whereas for the sensitivity approach
these need not be so. An application of this methodology is to determine an "unbiased"
NPV, where management determines a (subjective) probability for each scenario – the
NPV for the project is then the probability-weighted average of the various scenarios.

A further advancement is to construct stochastic or probabilistic financial models – as

opposed to the traditional static and deterministic models as above.For this purpose, the
most common method is to use Monte Carlo simulation to analyze the project’s NPV.
This method was introduced to finance by David B. Hertz in 1964, although has only
recently become common: today analysts are even able to run simulations in spreadsheet
based DCF models, typically using an add-in, such as Crystal Ball. Here, the cash flow
components that are (heavily) impacted by uncertainty are simulated, mathematically
reflecting their "random characteristics". In contrast to the scenario approach above, the
simulation produces several thousand random but possible outcomes, or "trials"; see
Monte Carlo Simulation versus “What If” Scenarios. The output is then a histogram of
project NPV, and the average NPV of the potential investment – as well as its volatility
and other sensitivities – is then observed. This histogram provides information not visible
from the static DCF: for example, it allows for an estimate of the probability that a project
has a net present value greater than zero (or any other value).

Continuing the above example: instead of assigning three discrete values to revenue
growth, and to the other relevant variables, the analyst would assign an appropriate
probability distribution to each variable (commonly triangular or beta), and, where
possible, specify the observed or supposed correlation between the variables. These
distributions would then be "sampled" repeatedly - incorporating this correlation - so as to
generate several thousand random but possible scenarios, with corresponding valuations,
which are then used to generate the NPV histogram. The resultant statistics (average NPV
and standard deviation of NPV) will be a more accurate mirror of the project's
"randomness" than the variance observed under the scenario based approach. These are
often used as estimates of the underlying "spot price" and volatility for the real option
valuation as above; see Real options valuation: Valuation inputs. A more robust Monte
Carlo model would include the possible occurrence of risk events (e.g., a credit crunch)
that drive variations in one or more of the DCF model inputs.

[edit] The financing decisionMain article: Capital structure

Achieving the goals of corporate finance requires that any corporate investment be
financed appropriately.[12] As above, since both hurdle rate and cash flows (and hence
the riskiness of the firm) will be affected, the financing mix can impact the valuation.
Management must therefore identify the "optimal mix" of financing—the capital structure
that results in maximum value. (See Balance sheet, WACC, Fisher separation theorem;
but, see also the Modigliani-Miller theorem.)

The sources of financing will, generically, comprise some combination of debt and equity
financing. Financing a project through debt results in a liability or obligation that must be
serviced, thus entailing cash flow implications independent of the project's degree of
success. Equity financing is less risky with respect to cash flow commitments, but results
in a dilution of share ownership, control and earnings. The cost of equity is also typically
higher than the cost of debt (see CAPM and WACC), and so equity financing may result
in an increased hurdle rate which may offset any reduction in cash flow risk.

Management must also attempt to match the financing mix to the asset being financed as
closely as possible, in terms of both timing and cash flows.

One of the main theories of how firms make their financing decisions is the Pecking
Order Theory, which suggests that firms avoid external financing while they have internal
financing available and avoid new equity financing while they can engage in new debt
financing at reasonably low interest rates. Another major theory is the Trade-Off Theory
in which firms are assumed to trade-off the tax benefits of debt with the bankruptcy costs
of debt when making their decisions. An emerging area in finance theory is right-
financing whereby investment banks and corporations can enhance investment return and
company value over time by determining the right investment objectives, policy
framework, institutional structure, source of financing (debt or equity) and expenditure
framework within a given economy and under given market conditions. One last theory
about this decision is the Market timing hypothesis which states that firms look for the
cheaper type of financing regardless of their current levels of internal resources, debt and

The dividend decision Main article: The Dividend Decision

Whether to issue dividends,[13] and what amount, is calculated mainly on the basis of the
company's unappropriated profit and its earning prospects for the coming year. The
amount is also often calculated based on expected free cash flows i.e. cash remaining after
all business expenses, and capital investment needs have been met.

If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle
rate, then - finance theory suggests - management must return excess cash to investors as
dividends. This is the general case, however there are exceptions. For example,
shareholders of a "Growth stock", expect that the company will, almost by definition,
retain earnings so as to fund growth internally. In other cases, even though an opportunity
is currently NPV negative, management may consider “investment flexibility” / potential
payoffs and decide to retain cash flows; see above and Real options.

Management must also decide on the form of the dividend distribution, generally as cash
dividends or via a share buyback. Various factors may be taken into consideration: where
shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a
stock buyback, in both cases increasing the value of shares outstanding. Alternatively,
some companies will pay "dividends" from stock rather than in cash; see Corporate
action. Today, it is generally accepted that dividend policy is value neutral (see
Modigliani-Miller theorem).
Q.2. What are the factors that effect the financial plan of a company?

The income statement is a simple and straightforward report on the proposed business's
cash-generating ability. It is a score card on the financial performance of your business
that reflects when sales are made and when expenses are incurred. It draws information
from the various financial models developed earlier such as revenue, expenses, capital (in
the form of depreciation), and cost of goods. By combining these elements, the income
statement illustrates just how much your company makes or loses during the year by
subtracting cost of goods and expenses from revenue to arrive at a net result -- which is
either a profit or a loss.
For a business plan, the income statement should be generated on a monthly basis during
the first year, quarterly for the second, and annually for each year thereafter. It is formed
by listing your financial projections in the following manner:
1. Income -- Includes all the income generated by the business and its sources.
2. Cost of goods -- Includes all the costs related to the sale of products in inventory.
3. Gross profit margin -- The difference between revenue and cost of goods. Gross profit
margin can be expressed in dollars, as a percentage, or both. As a percentage, the GP
margin is always stated as a percentage of revenue.
4. Operating expenses -- Includes all overhead and labor expenses associated with the
operations of the business.
5. Total expenses -- The sum of all overhead and labor expenses required to operate the
6. Net profit -- The difference between gross profit margin and total expenses, the net
income depicts the business's debt and capital capabilities.
7. Depreciation-- Reflects the decrease in value of capital assets used to generate income.
Also used as the basis for a tax deduction and an indicator of the flow of money into new
8. Net profit before interest -- The difference between net profit and depreciation.
9. Interest -- Includes all interest derived from debts, both short-term and long-term.
Interest is determined by the amount of investment within the company.
10. Net profit before taxes -- The difference between net profit before interest and
11. Taxes -- Includes all taxes on the business.
12. Profit after taxes -- The difference between net profit before taxes and the taxes
accrued. Profit after taxes is the bottom line for any company.
Following the income statement is a short note analyzing the statement. The analysis
statement should be very short, emphasizing key points within the income statement.

Cash-Flow Statement
The cash-flow statement is one of the most critical information tools for your business,
showing how much cash will be needed to meet obligations, when it is going to be
required, and from where it will come. It shows a schedule of the money coming into the
business and expenses that need to be paid. The result is the profit or loss at the end of the
month or year. In a cash-flow statement, both profits and losses are carried over to the
next column to show the cumulative amount. Keep in mind that if you run a loss on your
cash-flow statement, it is a strong indicator that you will need additional cash in order to
meet expenses.
Like the income statement, the cash-flow statement takes advantage of previous financial
tables developed during the course of the business plan. The cash-flow statement begins
with cash on hand and the revenue sources. The next item it lists is expenses, including
those accumulated during the manufacture of a product. The capital requirements are then
logged as a negative after expenses. The cash-flow statement ends with the net cash flow.
The cash-flow statement should be prepared on a monthly basis during the first year, on a
quarterly basis during the second year, and on an annual basis thereafter. Items that you'll
need to include in the cash-flow statement and the order in which they should appear are
as follows:
1. Cash sales -- Income derived from sales paid for by cash.
2. Receivables -- Income derived from the collection of receivables.
3. Other income -- Income derived from investments, interest on loans that have been
extended, and the liquidation of any assets.
4. Total income -- The sum of total cash, cash sales, receivables, and other income.
5. Material/Merchandise -- The raw material used in the manufacture of a product (for
manufacturing operations only), the cash outlay for merchandise inventory (for
merchandisers such as wholesalers and retailers), or the supplies used in the performance
of a service.
6. Production labor -- The labor required to manufacture a product (for manufacturing
operations only) or to perform a service.
7. Overhead -- All fixed and variable expenses required for the production of the product
and the operations of the business.
8. Marketing/Sales -- All salaries, commissions, and other direct costs associated with
the marketing and sales departments.
9. R&D -- All the labor expenses required to support the research and development
operations of the business.
10. G&A -- All the labor expenses required to support the administrative functions of the
11. Taxes -- All taxes, except payroll, paid to the appropriate government institutions.
12. Capital -- The capital required to obtain any equipment elements that are needed for
the generation of income.
13. Loan payment -- The total of all payments made to reduce any long-term debts.
14. Total expenses -- The sum of material, direct labor, overhead expenses, marketing,
sales, G&A, taxes, capital, and loan payments.
15. Cash flow -- The difference between total income and total expenses. This amount is
carried over to the next period as beginning cash.
16. Cumulative cash flow -- The difference between current cash flow and cash flow
from the previous period.
As with the income statement, you will need to analyze the cash-flow statement in a short
summary in the business plan. Once again, the analysis statement doesn't have to be long
and should cover only key points derived from the cash-flow statement.

The Balance Sheet

The last financial statement you'll need to develop is the balance sheet. Like the income
and cash-flow statements, the balance sheet uses information from all of the financial
models developed in earlier sections of the business plan; however, unlike the previous
statements, the balance sheet is generated solely on an annual basis for the business plan
and is, more or less, a summary of all the preceding financial information broken down
into three areas:
1. Assets
2. Liabilities
3. Equity
To obtain financing for a new business, you may need to provide a projection of the
balance sheet over the period of time the business plan covers. More importantly, you'll
need to include a personal financial statement or balance sheet instead of one that
describes the business. A personal balance sheet is generated in the same manner as one
for a business.
As mentioned, the balance sheet is divided into three sections. The top portion of the
balance sheet lists your company's assets. Assets are classified as current assets and long-
term or fixed assets. Current assets are assets that will be converted to cash or will be used
by the business in a year or less. Current assets include:
1. Cash -- The cash on hand at the time books are closed at the end of the fiscal year. This
refers to all cash in checking, savings, and short-term investment accounts.
2. Accounts receivable -- The income derived from credit accounts. For the balance
sheet, it is the total amount of income to be received that is logged into the books at the
close of the fiscal year.
3. Inventory -- This is derived from the cost of goods table. It is the inventory of material
used to manufacture a product not yet sold.
4. Total current assets -- The sum of cash, accounts receivable, inventory, and supplies.
Other assets that appear in the balance sheet are called long-term or fixed assets. They are
called long-term because they are durable and will last more than one year. Examples of
this type of asset include:
1. Capital and plant -- The book value of all capital equipment and property (if you own
the land and building), less depreciation.
2. Investment -- All investments by the company that cannot be converted to cash in less
than one year. For the most part, companies just starting out have not accumulated long-
term investments.
3. Miscellaneous assets -- All other long-term assets that are not "capital and plant" or
4. Total long-term assets -- The sum of capital and plant, investments, and miscellaneous
5. Total assets -- The sum of total current assets and total long-term assets.
After the assets are listed, you need to account for the liabilities of your business. Like
assets, liabilities are classified as current or long-term. If the debts are due in one year or
less, they are classified as a current liabilities. If they are due in more than one year, they
are long-term liabilities. Examples of current liabilities are as follows:
1. Accounts payable -- All expenses derived from purchasing items from regular
creditors on an open account which are due and payable.
2. Accrued liabilities -- All expenses incurred by the business which are required for
operation but have not been paid at the time the books are closed. These expenses are
usually the company's overhead and salaries.
3. Taxes -- These are taxes that are still due and payable at the time the books are closed.
4. Total current liabilities -- The sum of accounts payable, accrued liabilities, and taxes.
Long-term liabilities include:
1. Bonds payable -- The total of all bonds at the end of the year that are due and payable
over a period exceeding one year.
2. Mortgage payable -- Loans taken out for the purchase of real property that are repaid
over a long-term period. The mortgage payable is that amount still due at the close of
books for the year.
3. Notes payable -- The amount still owed on any long-term debts that will not be repaid
during the current fiscal year.
4. Total long-term liabilities -- The sum of bonds payable, mortgage payable, and notes
5. Total liabilities -- The sum of total current and long-term liabilities.
Once the liabilities have been listed, the final portion of the balance sheet -- owner's
equity -- needs to be calculated. The amount attributed to owner's equity is the difference
between total assets and total liabilities. The amount of equity the owner has in the
business is an important yardstick used by investors when evaluating the company. Many
times it determines the amount of capital they feel they can safely invest in the business.
In the business plan, you'll need to create an analysis statement for the balance sheet just
as you need to do for the income and cash-flow statements. The analysis of the balance
sheet should be kept short and cover key points about the company.

Q.3. What is the relationship between the coupon rate & the required rate of return
that will result in a bond?

if the coupon rate is lower, the bond is selling at a discount

if the coupon rate is the same, the bond is selling at a face value
if the coupon rate is higher , the bond is selling at a premium
So coupon has an inverse relationship with required rate of return.
Q.4. Discuss the implication of financial leverage for a firm.

In finance, leverage is a general term for any technique to multiply gains and losses.[1]
Common ways to attain leverage are borrowing money, buying fixed assets and using
derivatives. Important examples are:

A public corporation may leverage its equity by borrowing money. The more it borrows,
the less equity capital it needs, so any profits or losses are shared among a smaller base
and are proportionately larger as a result.
A business entity can leverage its revenue by buying fixed assets. This will increase the
proportion of fixed, as opposed to variable, costs, meaning that a change in revenue will
result in a larger change in operating income.
Hedge funds often leverage their assets by using derivatives. A fund might get any gains
or losses on $20 million worth of crude oil by posting $1 million of cash as margin.

Measuring leverageA good deal of confusion arises in discussions among people who use
different definitions of leverage. The term is used differently in investments and corporate
finance, and has multiple definitions in each field.[7]

InvestmentsAccounting leverage is total assets divided by total assets minus total

liabilities.Notional leverage is total notional amount of assets plus total notional amount
of liabilities divided by equity.[1] Economic leverage is volatility of equity divided by
volatility of an unlevered investment in the same assets. To understand the differences,
consider the following positions, all funded with $100 of cash equity.

Buy $100 of crude oil. Assets are $100 ($100 of oil), there are no liabilities. Accounting
leverage is 1 to 1. Notional amount is $100 ($100 of oil), there are no liabilities and there
is $100 of equity. Notional leverage is 1 to 1. The volatility of the equity is equal to the
volatility of oil, since oil is the only asset and you own the same amount as your equity,
so economic leverage is 1 to 1.
Borrow $100 and buy $200 of crude oil. Assets are $200, liabilities are $100 so
accounting leverage is 2 to 1. Notional amount is $200, equity is $100 so notional
leverage is 2 to 1. The volatility of the position is twice the volatility of an unlevered
position in the same assets, so economic leverage is 2 to 1.
Buy $100 of crude oil, borrow $100 worth of gasoline and sell the gasoline for $100. You
now have $100 cash, $100 of crude oil and owe $100 worth of gasoline. Your assets are
$200, liabilities are $100 so accounting leverage is 2 to 1. You have $200 notional amount
of assets plus $100 notional amount of liabilities, with $100 of equity, so your notional
leverage is 3 to 1. The volatility of your position might be half the volatility of an
unlevered investment in the same assets, since the price of oil and the price of gasoline are
positively correlated, so your economic leverage might be 0.5 to 1.
Buy $100 of a 10-year fixed-rate treasury bond, and enter into a fixed-for-floating 10-year
interest rate swap to convert the payments to floating rate. The derivative is off-balance
sheet, so it is ignored for accounting leverage. Accounting leverage is therefore 1 to 1.
The notional amount of the swap does count for notional leverage, so notional leverage is
2 to 1. The swap removes most of the economic risk of the Treasury bond, so economic
leverage is near zero.

Corporate finance

Degree of Operating Leverage (DOL)= (EBIT + Fixed costs) / EBIT;

Degree of Financial Leverage (DFL)= EBIT / ( EBIT - Total Interest expense );

Degree of Combined Leverage (DCL)= DOL * DFL

Accounting leverage has the same definition as in investments. There are several ways to
define operating leverage, the most common. is:

Financial leverage is usually defined as:

Operating leverage is an attempt to estimate the percentage change in operating income

(earnings before interest and taxes or EBIT) for a one percent change in revenue.

Financial leverage tries to estimate the percentage change in net income for a one percent
change in operating income.

The product of the two is called Total leverage, and estimates the percentage change in
net income for a one percent change in revenue.

There are several variants of each of these definitions, and the financial statements are
usually adjusted before the values are computed. Moreover, there are industry-specific
conventions that differ somewhat from the treatment above.

Leverage and ROE

If we have to check real effect of leverage on ROE, we have to study financial leverage.
Financial leverage refers to the use of debt to acquire additional assets. Financial leverage
may decrease or increase return on equity in different conditions. Financial over-
leveraging means incurring a huge debt by borrowing funds at a lower rate of interest and
utilizing the excess funds in high risk investments in order to maximize returns.

Leverage and risk

The most obvious risk of leverage is that it multiplies losses. A corporation that borrows
too much money might face bankruptcy during a business downturn, while a less-levered
corporation might survive. An investor who buys a stock on 50% margin will lose 40% of
his money if the stock declines 20%.

There is an important implicit assumption in that account, however, which is that the
underlying levered asset is the same as the unlevered one. If a company borrows money to
modernize, or add to its product line, or expand internationally, the additional
diversification might more than offset the additional risk from leverage.[9] Or if an
investor uses a fraction of his or her portfolio to margin stock index futures and puts the
rest in a money market fund, he or she might have the same volatility and expected return
as an investor in an unlevered equity index fund, with a limited downside.[6] So while
adding leverage to a given asset always adds risk, it is not the case that a levered company
or investment is always riskier than an unlevered one. In fact, many highly-levered hedge
funds have less return volatility than unlevered bond funds,[6] and public utilities with
lots of debt are usually less risky stocks than unlevered technology companies.

Popular risks
There is a popular prejudice against leverage rooted in the observation that people who
borrow a lot of money often end up badly. But the issue here is those people are not
leveraging anything, they're borrowing money for consumption.

In finance, the general practice is to borrow money to buy an asset with a higher return
than the interest on the debt. That at least might work out. People who consistently spend
more than they make have a problem, but it's overspending (or underearning), not
leverage. The same point is more controversial for governments.

People sometimes borrow money out of desperation rather than calculation. That also is
not leverage. But it is true that leverage sometimes increases involuntarily. When Long-
Term Capital Management collapsed with over 100 to 1 leverage, it wasn't that the
principals tried to run the firm at 100 to 1 leverage, it was that as equity eroded and they
were unable to liquidate positions, the leverage level was beyond their control. One
hundred to one leverage was a symptom of their problems, not the cause (although, of
course, part of the cause was the 27 to 1 leverage the firm was running before it got into
trouble, and the 55 to 1 leverage it had been forced up to by mid-August 1998 before the
real troubles started).[9] But the point is the fact that collapsing entities often have a lot of
leverage does not mean that leverage causes collapses.
Involuntary leverage is a risk.It means that as things get bad, leverage goes up,
multiplying losses as things continue to go down. This can lead to rapid ruin, even if the
underlying asset value decline is mild or temporary.The risk can be mitigated by
negotiating the terms of leverage, and by leveraging only liquid assets.

Forced position reductions A common misconception is that levered entities are forced to
reduce positions as they lose money. This is only true if the entity is run at maximum
leverage.[1] For example, if a person has $100, borrows another $100 and buys $200
worth of oil, he has 2 to 1 accounting leverage. If the price of oil declines 25%, he has
$50 of equity supporting $150 worth of oil, 3 to 1 accounting leverage. If 2 to 1 is the
maximum his counterparties will allow him, he has to sell one-third of his position to pay
his debt down to $50. Now if oil goes back up to the original price, he has only $83 of
equity. He lost 17 percent of his equity, even though the p (say) $10 of cash margin to
enter into $200 of long oil futures contracts. Now if the price of oil declines 25%, the
investor has to put up an additional $50 of margin, but she still has $40 of unencumbered
cash. She may or may not wish to reduce the position, but she is not forced to do so. The
point is that it is using maximum leverage that can force position reductions, not simply
using leverage.[6] It often surprises people to learn that hedge funds running at 10 to 1 or
higher notional leverage ratios hold 80 percent or 90 percent cash.
Name : ///DEEP SINGH

Registration / Roll No. : 331630152

Course : Master of Business Administration


Subject : Financial Management

Semester : Sem II

Subject Number : MB0045 ( SET-II )

_______________ _______________ ______________

Sign of Center Head Sign of Evaluator Sign of Coordinator
SET -2

Q.1 Discuss the objectives of profit maximization vs wealth maximization.

In economics, profit maximization is the (short run) process by which a firm determines
the price and output level that returns the greatest profit. There are several approaches to
this problem. The total revenue–total cost method relies on the fact that profit equals
revenue minus cost, and the marginal revenue–marginal cost method is based on the fact
that total profit in a perfectly competitive market reaches its maximum point where
marginal revenue equals marginal cost.

Basic Definition : Any costs incurred by a firm may be classed into two groups: fixed
costs and variable costs. Fixed costs are incurred by the business at any level of output,
including zero output. These may include equipment maintenance, rent, wages, and
general upkeep. Variable costs change with the level of output, increasing as more
product is generated. Materials consumed during production often have the largest impact
on this category. Fixed cost and variable cost, combined, equal total cost.

Revenue is the amount of money that a company receives from its normal business
activities, usually from the sale of goods and services (as opposed to monies from security
sales such as equity shares or debt issuances).

Marginal cost and revenue, depending on whether the calculus approach is taken or not,
are defined as either the change in cost or revenue as each additional unit is produced, or
the derivative of cost or revenue with respect to quantity output. It may also be defined as
the addition to total cost or revenue as output increase by a single unit. For instance,
taking the first definition, if it costs a firm 400 USD to produce 5 units and 480 USD to
produce 6, the marginal cost of the sixth unit is approximately 80 dollars, although this is
more accurately stated as the marginal cost of the 5.5th unit due to linear interpolation.
Calculus is capable of providing more accurate answers if regression equations can be
Total revenue - total cost method

Profit Maximization - The Totals Approach

To obtain the profit maximizing output quantity, we start by recognizing that profit is
equal to total revenue (TR) minus total cost (TC). Given a table of costs and revenues at
each quantity, we can either compute equations or plot the data directly on a graph.
Finding the profit-maximizing output is as simple as finding the output at which profit
reaches its maximum. That is represented by output Q in the diagram.

There are two graphical ways of determining that Q is optimal. First, the profit curve is at
its maximum at this point (A). Secondly, at the point (B) the tangent on the total cost
curve (TC) is parallel to the total revenue curve (TR), meaning that the surplus of revenue
net of costs (B,C) is at its greatest. Because total revenue minus total costs is equal to
profit, the line segment C,B is equal in length to the line segment A,Q.Computing the
price at which to sell the product requires knowledge of the firm's demand curve. The
price at which quantity demanded equals profit-maximizing output is the optimum price
to sell the product.

Marginal revenue-marginal cost method

Profit maximization using the marginal approach

An alternative argument says that for each unit sold, marginal profit (Mπ) equals marginal
revenue (MR) minus marginal cost (MC). Then, if marginal revenue is greater than
marginal cost, marginal profit is positive, and if marginal revenue is less than marginal
cost, marginal profit is negative. When marginal revenue equals marginal cost, marginal
profit is zero.Since total profit increases when marginal profit is positive and total profit
decreases when marginal profit is negative, it must reach a maximum where marginal
profit is zero - or where marginal cost equals marginal revenue. If there are two points
where this occurs, maximum profit is achieved where the producer has collected positive
profit up until the intersection of MR and MC (where zero profit is collected), but would
not continue to after, as opposed to vice versa, which represents a profit minimum.In
calculus terms, the correct intersection of MC and MR will occur when

The intersection of MR and MC is shown in the next diagram as point A. If the industry is
perfectly competitive (as is assumed in the diagram), the firm faces a demand curve (D)
that is identical to its Marginal revenue curve (MR), and this is a horizontal line at a price
determined by industry supply and demand. Average total costs are represented by curve
ATC. Total economic profit are represented by area P,A,B,C. The optimum quantity (Q)
is the same as the optimum quantity (Q) in the first diagram.

If the firm is operating in a non-competitive market, minor changes would have to be

made to the diagrams. For example, the Marginal Revenue would have a negative
gradient, due to the overall market demand curve. In a non-competitive environment,
more complicated profit maximization solutions involve the use of game theory.

Maximizing revenue method

In some cases a firm's demand and cost conditions are such that marginal profits are
greater than zero for all levels of production. In this case the Mπ = 0 rule has to be
modified and the firm should maximize revenue. In other words the profit maximizing
quantity and price can be determined by setting marginal revenue equal to zero. Marginal
revenue equals zero when the marginal revenue curve has reached its maximum value. An
example would be a scheduled airline flight. The marginal costs of flying the route are
negligible. The airline would maximize profits by filling all the seats. The airline would
determine the Π max conditions by maximizing revenues.

Changes in total costs and profit maximization

A firm maximizes profit by operating where marginal revenue equal marginal costs. A
change in fixed costs has no effect on the profit maximizing output or price. The firm
merely treats short term fixed costs as sunk costs and continues to operate as before. This
can be confirmed graphically. Using the diagram illustrating the total cost total revenue
method the firm maximizes profits at the point where the slope of the total cost line and
total revenue line are equal. A change in total cost would cause the total cost curve to shift
up by the amount of the change. There would be no effect on the total revenue curve or
the shape of the total cost curve. Consequently, the profit maximizing point would remain
the same. This point can also be illustrated using the diagram for the marginal revenue
marginal cost method. A change is fixed cost would have no effect on the position or
shape of these curves.

Markup pricing
In addition to using methods to determine a firm's optimal level of output, a firm can also
set price to maximize profit. Profit maximization requires that a firm produce where
marginal revenue equals marginal costs. Firm managers are unlikely to have complete
information concerning their marginal revenue function or their marginal costs.

Fortunately the profit maximization conditions can be expressed in a "more easily

applicable" form or rule of thumb. The first step is to rewrite the expression for marginal
revenue as MR = ∆TR/∆Q =(P∆Q+Q∆P)/∆Q=P+Q∆P/∆Q. The marginal revenue from an
"incremental unit of quantity" has two parts: first, the revenue the firm gains from selling
the additional units or P∆Q. The additional units are called the marginal units. Producing
one extra unit and selling it a P brings in revenue of P. Second, "the revenue the firm loses
on the units it could have sold at the higher price." These lost units are called the infra-
marginal units. That is selling the extra unit results in a small drop in price which reduces
the revenue for all units sold. Q(∆P/∆Q) Thus MR = P + Q(∆P/∆Q) = P +P (Q/P)
((∆P/∆Q) = P + P(1/(PED) Then setting MR = MC MC = P + P(1/(PED) P - MC/P = -
1/PED P = MC/1 + (1/PED). The optimal markup rule is:

(P - MC)/P = 1/ -Ep
P = (Ep/(1 + Ep)) MC

Where MC equals marginal costs and Ep equals price elasticity of demand for the firm
(not the market PED). Ep is a negative number. Therefore, -Ep is a positive number.

In English the rule is that the size of the markup is inversely related to the price elasticity
of demand for a good.

The optimal markup rule also implies that a non-competitive firm will produce on the
elastic region of its market demand curve. Marginal costs are positive. The term 1/ -Ep
would be positive only if the PED is between -1 and -∝ that is if demand is elastic.

MPL, MRPL and profit maximization

The general rule is that firm maximizes profit by producing that quantity of output where
marginal revenue equals marginal costs. The profit maximization issue can also be
approached from the input side. That is, what is the profit maximizing usage of the
variable input? To maximize profits the firm should increase usage "up to the point
where the input's marginal revenue product equals its marginal costs". So mathematically
the profit maximizing rule is MRPL = MCL The marginal revenue product is the change in
total revenue per unit change in the variable input assume labor. That is MRPL = ∆TR/∆L.
MRPL is the product of marginal revenue and the marginal product of labor or MRPL =

Wealth Maximization

Wealth maximization is all about; How to achieve maximum wealth while minimizing
costs and inefficiencies
• how to spend and enjoy your wealth without the fear of ever outliving it
• how to pass along your wealth to whomever you choose
• how to ensure your plan for financial success works under all circumstances

Modern Approach is about the idea of wealth maximization. This involves increasing the
Earning per share of the shareholders and to maximize the net present worth. Wealth is
equal to thed ifferen ce between gross present worth of some decision or course of action
and the investment required to achieve the expected benefits. Gross present worth
involves the capitalized value of the expected benefits. This value is discounted a some
rate, thisrate depends on the certainty or uncertainty factor of the expected benefits. The
Wealth Maximization approach is concerned with the amount of cash flow generated by a
course of action rather than the profits. Hence we can have; Profit maximization relates to
profits *only* while shareholder wealth also involves total
company equity, debt ratios, etc. Management could focus on profit maximization over a
longer period of time, while the shareholder would rather see stock values and corporate
total value increase immediately. If management focused on short-term profit
maximization, say at the expense of long term sales revenues, then shareholder wealth
(stock price) could actually decrease as a result of the loss of market share.

Shareholder wealth (more commonly referred to as shareholder value) is talking about the
value of the company generally expressed in the value of the stock. Profit maximization
refers to how much dollar profit the company makes. It might seem like making as much
profit as possible would yield the highest value for the stock but that is not always the

When investors look at a company they not only look at dollar profit but also profit
margins, return on capital and other indicators of efficiency. Say there are two companies
doing the same thing. Company A had sales of $100 million and profit of $10 million.
Company B had sales of $200 million and profit of $12 million. Wall Street could look at
Company B and say they are less valuable because they clearly do no operate as
efficiently as Company A. So even though Company B had more profit Company A will
have more shareholder value.

Q.2. Explain the Net operating approach to capital structure.

Answer: We have discussed above the goals of financial management. Now the question
arises of the choice, i.e., which should be the goal of decision making be profit
maximization or which strengthen the case for wealth Maximization as the goal of
business enterprise.

The objections are:-

(i) Profit cannot be ascertained well in advance to express the probability of return as
future is uncertain. It is not at possible to maximize what cannot be known.

(ii) The executive or the decision maker may not have enough confidence in the estimates
of future returns so that he does not attempt future to maximize. It is argued that firm's
goal cannot be to maximize profits but to attain a certain level or rate of profit holding
certain share of the market or certain level of sales. Firms should try to 'satisfy' rather than
to 'maximize'

(iii) There must be a balance between expected return and risk. The possibility of higher
expected yields are associated with greater risk to recognise such a balance and wealth
Maximization is brought in to the analysis. In such cases, higher capitalisation rate
involves. Such combination of expected returns with risk variations and related
capitalisation rate cannot be considered in the concept of profit maximization.
(iv) The goal of Maximization of profits is considered to be a narrow outlook. Evidently
when profit maximization becomes the basis of financial decisions of the concern, it
ignores the interests of the community on the one hand and that of the government,
workers and other concerned persons in the enterprise on the other hand.

Keeping the above objections in view, most of the thinkers on the subject have come to
the conclusion that the aim of an enterprise should be wealth Maximization and not the
profit Maximization. Prof. Soloman of Stanford University has handled the issued very
logically. He argues that it is useful to make a distinction between profit and 'profitability'.
Maximization of profits with a vie to maximising the wealth of shareholders is clearly an
unreal motive. On the other hand, profitability Maximization with a view to using
resources to yield economic values higher than the joint values of inputs required is a
useful goal. Thus the proper goal of financial management is wealth maximization.
The second approach as propounded by David Durand the net operating income approach
examines the effects of changes in capital structure in terms of net operating income. In
the net income approach discussed above net income available to shareholders is obtained
by deducting interest on debentures form net operating income. Then overall value of the
firm is calculated through capitalization rate of equities obtained on the basis of net
operating income, it is called net income approach. In the second approach, on the other
hand overall value of the firm is assessed on the basis of net operating income not on the
basis of net income. Hence this second approach is known as net operating income

The NOI approach implies that (i) whatever may be the change in capital structure the
overall value of the firm is not affected. Thus the overall value of the firm is independent
of the degree of leverage in capital structure. (ii) Similarly the overall cost of capital is not
affected by any change in the degree of leverage in capital structure. The overall cost of
capital is independent of leverage.
If the cost of debt is less than that of equity capital the overall cost of capital must
decrease with the increase in debts whereas it is assumed under this method that overall
cost of capital is unaffected and hence it remains constant irrespective of the change in the
ratio of debts to equity capital. How can this assumption be justified? The advocates of
this method are of the opinion that the degree of risk of business increases with the
increase in the amount of debts. Consequently the rate of equity over investment in equity
shares thus on the one hand cost of capital decreases with the increase in the volume of
debts; on the other hand cost of equity capital increases to the same extent. Hence the
benefit of leverage is wiped out and overall cost of capital remains at the same level as
before. Let us illustrate this point.
If follows that with the increase in debts rate of equity capitalization also increases and
consequently the overall cost of capital remains constant; it does not decline.
To put the same in other words there are two parts of the cost of capital. One is the
explicit cost which is expressed in terms of interest charges on debentures. The other is
implicit cost which refers to the increase in the rate of equity capitalization resulting from
the increase in risk of business due to higher level of debts.
Optimum capital structure
This approach suggests that whatever may be the degree of leverage the market value of
the firm remains constant. In spite of the change in the ratio of debts to equity the market
value of its equity shares remains constant. This means there does not exist a optimum
capital structure. Every capital structure is optimum according to net operating income

Q3. What do you understand by Operating cycle?

Answer: The operating cycle of a business is also known as the "Cash Operating Cycle",
the "Cash to Cash Cycle", the "Cash Conversion Cycle" or simply the "Cash Cycle".

Business conducts a stream of value-adding activities designed to satisfy customer needs.

The key components of this value-adding stream include management's decision making
and actions, the equipment and assets that transform raw materials into the finished
products and a ready access to cash. Cash is a critical support factor in the value-adding
process of businesses. If it is unavailable at critical times then the other factors of
production cannot operate and the sustainability of the business is threatened. Cash can be
locked-up in assets like inventory and accounts receivables (debtors). This cash cannot be
invested in activities that may further enhance the value-adding stream. Excessive
amounts of cash lock-up in these assets becomes unproductive and therefore a waste of
valuable resources.

Business decision makers wish to monitor the amount of cash that is locked up and out of
reach because it impacts on the working capital requirements of the business. The metric
that has been developed to do this is the called the Operating Cycle ratio of the
business. The Operating Cycle ratio is a metric that expresses the length of time, in days,
that it takes for a business to convert resource inputs into cash flows. The Operating Cycle
incorporates the amount of time that is needed to sell inventory, the amount of time that is
needed to collect account receivables and the length of time the business takes to pay its
bills, without incurring penalties.

Having calculated the Operating Cycle for their business, management are able to
compare this result with previous periods, industry benchmarks and key competitors to
identify potential unproductive cash resources. The Operating cycle will vary from
business to business and is dependent on the nature of the business, the type of inventory
carried and the credit terms of the business. For example, a takeaway food businesses will
have an operating cycle of less than 14 days while construction firms may have an
operating cycle of over 12 months. Such is the nature of these industries.

Operating Cycle of a business

The Operating Cycle of a business is the length of time between the cash outflow on
purchased material and cash inflow from the sale of goods. The Operating Cycle
determines the amount of working capital that a business requires to operate on a day-to-
day basis. The shorter the Operating Cycle the lower the amount of working capital
required for the business and the greater opportunity for investments in other value-
adding activities.

The Operating Cycle for a manufacturing based business can involve many stages,

1. Purchase - the receipt of raw materials from suppliers on account.

2. Conversion - the conversion of these raw materials into finished
3. Inventory - the holding and storage of raw materials, Work-In-
Progress (WIP) and Finished Goods.
4. Payment - the payment of the supplier's account for the raw
materials received earlier.
5. Sale - the sale of finished goods to customers on account
6. Collection - the collection of money from these customers in
payment of their account

The operating cycle

Q.4. What is the implications of operating cycle.


1. A firm with a high break-even point is more risky than one with a low Break-even
point. In periods of increasing sales, operating income (OI or EBIT) of the leveraged firm
tends to increase rapidly. This increase in OI (EBIT) is the ‘pay-off’ for being more
risky. But in periods of decreasing sales, operating income of the firm tends to decrease
rapidly, that is the risk.

2. Firms with small amounts of fixed operating costs have low break-even points and
are therefore less risky and have low operating leverage. Variable costs in these firms
tend to be high and both the CM and UC is low. In periods of increasing sales, ,Operating
income (EBIT) for these firms tends to increase slowly. But in periods of decreasing
sales, Operating income will tend to decrease slowly making the firm less risky.

3. In conclusion, if a company has high operating leverage, then the operating

income (OI or EBIT) will become very sensitive to changes in sales volume. Just a small
percentage (%) chance in sales can yield (produce) a large percentage change in
Operating Income. A Company with low operating leverage the reverse is true.


Financial leverage is the extent to which debt (liability) is used in the Capital Structure
(financing) of the firm. Capital Structure refers to the relationship between assets, debt
(liability) and equity. The more debt a firm has relative to equity the greater the financial
leverage (these firms have a higher Debt to Asset ratios).

Formula(s) for calculating Operating leverage:

Percent Change in Operating Income

Degree of Operating Leverage = Percent Change in Sales

Contributi on Margin
Degree of Operating Leverage = Earnings Before Interest and Taxes
Degree of Operating Leverage =

Total Sales − Total Variable Cost

Total Sales −Total Variable Cost −Total Operating Fixed Cost

Degree of Operating Leverage =

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