You are on page 1of 9

Master of Business Administration - MBA Semester 2 MB0045 Financial Management - 4 Credits

(Book ID: B1134) Assignment Set- 1 (60 Marks) Note: Each question carries 10 marks. Answer all the questions. Q.1 What are the 4 finance decisions taken by a finance manager. Answer: Finance functions deal with the functions performed by the finance manager. They are closely related to financial decisions. In the course of performing these functions, finance manager takes several decisions Finance decisions Investment decisions Liquidity decisions Dividend decisions Organisation of a finance function

Finance decisions Financing decisions relate to the acquisition of funds at the least cost. Cost has two dimensions: Explicit Cost Implicit cost Explicit cost refers to the cost in the form of coupon rate, cost of floating and issuing the security. Implicit cost is not a visible cost but it may seriously affect the companys operations especially when it is exposed to business and financial risk In India, if a company is unable to pay its debts, creditors of the company may use legal means to sue the company for winding up. This risk is normally known as risk of insolvency. A company which employs debt as a means of financing normally faces this risk especially when its operations are exposed to high degree of business risk. In all financing decisions, a firm has to determine the proportion of equity

and debt. The composition of debt and equity is called the capital structure of the firm. Debt is cheap because interest payable on loan is allowed as deductions in computing taxable income on which the company is liable to pay income tax to the Government of India. An investor in a companys shares has two objectives for investing: Income from capital appreciation (capital gains on sale of shares at market price) Income from dividends It is the ability of the company to give both these incomes to its shareholders that determines the market price of the companys shares. The most important goal of financial management is maximisation of net wealth of the shareholders. Therefore, management of every company should strive hard to ensure that its shareholders enjoy both dividend income and capital gains as per the expectation of the market. Financing decision involves the consideration of managerial control, flexibility and legal aspects and regulatory and managerial elements. Investment decisions To survive and grow, all organisations have to be innovative. Innovation demands managerial proactive actions. Proactive organisations continuously search for innovative ways of performing the activities of the organisation. Innovation is wider in nature. It could be: expansion through entering into new markets adding new products to its product mix performing value added activities to enhance customer satisfaction adopting new technology that would drastically reduce the cost of production rendering services or mass production at low cost or restructuring the organisation to improve productivity These innovations change the profile of an organisation. These decisions are strategic because they are risky. However, if executed successfully with a clear plan of action, investment decisions generate super normal growth to the organisation. A firm may become bankrupt, if the management fails to execute the decisions taken. Therefore, such decisions have to be taken after taking into account all the facts affecting the decisions and their execution. There are two critical issues to be considered in these decisions. Evaluation of expected profitability of the new investments. Rate of return required on the project. The Rate of Return required by an investor is normally known as the hurdle rate or the cut-off rate or the opportunity cost of capital. Investments in buildings and machineries are to be conceived and executed by a firm to enter into any business or to expand its business. The process involved is called Capital Budgeting. Capital Budgeting decisions demand considerable time, attention and energy of the management. They are strategic in nature as the success or failure of an organisation is directly attributable to the execution of Capital Budgeting decisions taken. Investment decisions are also known as Capital Budgeting Decisions and hence lead to investments in real assets. Dividend decisions

Dividends are pay-outs to shareholders. Dividends are paid to keep the shareholders happy. Dividend decision is a major decision made by a finance manager. It is based on formulation of dividend policy. Since the goal of financial management is maximisation of wealth of shareholders, dividend policy formulation demands the managerial attention on the impact of its policy on dividend and on the market value of its shares. Optimum dividend policy requires decision on dividend payment rates so as to maximise the market value of shares. The payout ratio means what portion of earnings per share is given to the shareholders in the form of cash dividend. In the formulation of dividend policy, the management of a company will have to consider the relevance of its policy on bonus shares. Dividend policy influences the dividend yield on shares. Dividend yield is an important determinant of an investors attitude towards the security (stock) in his portfolio management decisions. The following issues need adequate consideration in deciding on dividend policy: Preferences of share holders Do they want cash dividend or capital gains? Current financial requirements of the company Legal constraints on paying dividends Striking an optimum balance between desires of share holders and the companys funds requirements Liquidity decision Liquidity decisions deals with Working Capital Management. It is concerned with the day-to-day financial operations that involve current assets and current liabilities. The important elements of liquidity decisions are: Formulation of inventory policy Policies on receivable management Formulation of cash management strategies Policies on utilisation of spontaneous finance effectively Organisation of finance function Financial decisions are strategic in character and therefore, an efficient organisational structure is required to administer the same. Finance is like blood that flows throughout the organisation. In all organisations, CFOs play an important role in ensuring proper reporting based on substance of the stake holders of the company. Finance functions are organised directly under the control of board of directors, because of the crucial role these functions play. For the survival of the firm, there is a need to ensure both long term and short term financial solvency. Weak functional performance by financial department will weaken production, marketing and HR activities of the company. The result would be the organisation becoming anaemic. Once anaemic, unless crucial and effective remedial measures are taken up, it will pave way for corporate bankruptcy. Under the CFO, normally two senior officers manage the treasurer and controller functions. Q.2 What are the factors that affect the financial plan of a company?


Status of the company in the industry A well established company enjoys a good market share, for its products normally commands investors confidence. Such a company can tap the capital market for raising funds in competitive terms for implementing new projects to exploit the new opportunities emerging from changing business environment Sources of finance available Sources of finance could be grouped into debt and equity. Debt is cheap but risky whereas equity is costly. A firm should aim at optimum capital structure that would achieve the least cost capital structure. A large firm with a diversified product mix may manage higher quantum of debt because the firm may manage higher financial risk with a lower business risk. Selection of sources of finance is closely linked to the firms capability to manage the risk exposure. The capital structure of a company The capital structure of a company is influenced by the desire of the

Q.3 Show the relationship between required rate of return and coupon rate on the value of a bond. Answer:

Example To show the effect of the above, consider a case of a bond whose face value is Rs. 100 with a coupon rate of 11% and a maturity of 7 years. If Kd is 13%, then, V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n) = 11*PVIFA (13%, 7) + 100*PVIF (13%, 7) = 11*4.423 + 100*0.425 = 48.65 + 42.50 = Rs.91.15 After 1 year, the maturity period is 6 years, the value of the bond is V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n) = 11*PVIFA (13%, 6) + 100*PVIF (13%, 6) = 11* 3.998 + 100*0.480 = 43.98 + 48 = Rs. 91.98. We see that the discount on the bond gradually decreases and value of the bond increases with the passage of time as required rate of interest (Kd) is higher than the coupon rate. Continuing with the same problem above, let us see the effect on the bond value if the required rate is 8%. If Kd is 8%, V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n) = 11*PVIFA (8%, 7) + 100*PVIF (8%, 7) = 11*5.206 + 100*0.583 = 57.27 + 58.3 = Rs. 115.57 One year later, with Kd at 8%,

V0 = I*PVIFA (Kd, n) + F*PVIF (Kd, n) = 11*PVIFA (8%, 6) + 100*PVIF (8%, 6) = 11*4.623 + 100* 0.630 = 50.85 + 63 = Rs. 113.85 For a required rate of return of 8%, the bond value decreases with passage of time and premium on bond declines as maturity approaches.

Q.4 Discuss the implication of financial leverage for a firm. Answer: Financial leverage as opposed to operating leverage relates to the financing activities of a firm and measures the effect of earnings before interest and tax (EBIT) on earnings per share (EPS) of the company. A companys sources of funds fall under two categories Those which carry a fixed financial charges like debentures, bonds and preference shares and Those which do not carry any fixed charges like equity shares Debentures and bonds carry a fixed rate of interest and have to be paid off irrespective of the firms revenues. Though dividends are not contractual obligations, dividend on preference shares is a fixed charge and should be paid off before equity shareholders are paid any. The equity holders are entitled to only the residual income of the firm after all prior obligations are met. Financial leverage refers to the mix of debt and equity in the capital structure of the firm. This results from the presence of fixed financial charges in the companys income stream. Such expenses have nothing to do with the firms performance and earnings and should be paid off regardless of the amount of earnings before income and tax (EBIT). It is the firms ability to use fixed financial charges to increase the effects of changes in EBIT on the EPS. It is the use of funds obtained at fixed costs which increase the returns on shareholders. A company earning more by the use of assets funded by fixed sources is said to be having a favourable or positive leverage. Unfavourable leverage occurs when the firm is not earning sufficiently to cover the cost of funds. Financial leverage is also referred to as Trading on Equity. Use of Financial Leverage Studying the degree of financial leverage (DFL) at various levels makes financial decision-making, on the use of fixed sources of funds, for funding activities easy. One can assess the impact of change in earnings before interest and tax (EBIT) on earnings per share (EPS). Like operating leverage, the risks are high at high degrees of financial leverage (DFL). High financial costs are associated with high DFL. An increase in financial costs implies higher level of EBIT to meet the necessary financial commitments. A firm which is not capable of honouring its financial commitments may be forced to go into liquidation by the lenders of funds. The existence of the

firm is shaky under these circumstances. On one side the trading on equity improves considerably by the use of borrowed funds and on the other hand, the firm has to constantly work towards higher EBIT to stay alive in the business. All these factors should be considered while formulating the firms mix of sources of funds. One main goal of financial planning is to devise a capital structure in order to provide a high return to equity holders. But at the same time, this should not be done with heavy debt financing which drives the company on to the brink of winding up. Impact of financial leverage Highly leveraged firms are considered very risky and lenders and creditors may refuse to lend them further to fuel their expansion activities. On being forced to continue lending, they may do so with their own conditions like earning a minimum of X% EBIT or stipulating higher interest rates than the market rates or no further mortgage of securities. Financial leverage is considered to be favourable till such time that the rate of return exceeds the rate of return obtained when no debt is used. The company not using debt to finance its assets has a higher DFL compared to that of a company using it. Financial leverage does not exist when there is no fixed charge financing.

Q.5 The cash flows associated with a project are given below: Year Cash flow 0 (100,000) 1 25000 2 40000 3 50000 4 40000 5 30000 Calculate the a) payback period. b) Benefit cost ratio for 10% cost of capital Answer:

Therefore, payback period for project is: = 3 + (100000 93315) /27320 = 3+ 0.24 = 3.24 Discounted Pay-back period for project is 2.24 years For complete solution plz vist