MB0045 – Financial Management Set-1

Q1. What are the implication of operating leverage for a firm. Ans. A firm performs finance functions simultaneously and continuously in the normal course of the business. They do not necessarily occur in a sequence. Finance functions call for skilful planning, control and execution of a firm’s activities. Let us note at the outset hat shareholders are made better off by a financial decision that increases the value of their shares, Thus while performing the finance function, the financial manager should strive to maximize the market value of shares. Whatever decision does a manger takes need to result in wealth maximization of a shareholder. Investment Decision Investment decision or capital budgeting involves the decision of allocation of capital or commitment of funds to long-term assets that would yield benefits in the future. Two important aspects of the investment decision are: (a) the evaluation of the prospective profitability of new investments, and (b) the measurement of a cut-off rate against that the prospective return of new investments could be compared. Future benefits of investments are difficult to measure and cannot be predicted with certainty. Because of the uncertain future, investment decisions involve risk. Investment proposals should, therefore, be evaluated in terms of both expected return and risk. Besides the decision for investment managers do see where to commit funds when an asset becomes less productive or non-profitable. There is a broad agreement that the correct cut-off rate is the required rate of return or the opportunity cost of capital. However, there are problems in computing the opportunity cost of capital in practice from the available data and information. A decision maker should be aware of capital in practice from the available data and information. A decision maker should be aware of these problems. Financing Decision Financing decision is the second important function to be performed by the financial manager. Broadly, her or she must decide when, where and how to acquire funds to meet the firm’s investment needs. The central issue before him or her is to determine the proportion of equity and debt. The mix of debt and equity is known as the firm’s capital structure. The financial manager must strive to obtain the best financing mix or the optimum capital structure for his or her firm. The firm’s capital structure is considered to be optimum when the market

the financial manager should develop sound techniques of managing current assets. It is in this context that finance functions are said to influence production. This. as idle current assets would not earn anything. But it would lose profitability. it may increase the return on equity funds but it always increases risk. called bonus share (or stock dividend). the dividend policy should be determined in terms of its impact on the shareholders’ value. are also issued to the existing shareholders in addition to the cash dividend. A conflict exists between profitability and liquidity while managing current assets. in addition to the management of long-term assets. flexibility loan convenience. legal aspects etc. he or she must raise the appropriate amount through the best available sources. bonus shares and cash dividends in practice. The payout ratio is equal to the percentage of dividends to earnings available to shareholders. The financial manager should also consider the questions of dividend stability. It would thus be clear that financial decisions directly concern the firm’s decision to acquire or dispose off assets and require commitment or recommitment of funds on a continuous basis. a proper trade-off must be achieved between profitability and liquidity. additional shares. Thus if shareholders are not indifferent to the firm’s dividend policy. the financial manager must determine the optimum dividend – payout ratio. marketing and other functions of the firm. When the shareholders’ return is maximized with minimum risk. Investment in current assets affects the firm’s profitability. profitability and risk of the firm. Most profitable companies pay cash dividends regularly. in deciding its capital structure. Liquidity Decision Current assets management that affects a firm’s liquidity is yet another important finances function. Like the debt policy. Current assets should be managed efficiently for safeguarding the firm against the dangers of illiquidity and insolvency. The use of debt affects the return and risk of shareholders. The financial manager must decide whether the firm should distribute all profits. growth. in consequence. and ultimately. A proper balance will have to be struck between return and risk. it may become illiquid. Dividend Decision Dividend decision is the third major financial decision.value of shares is maximized. Liquidity and risk. a firm considers many other factors such as control. the market value per share will be maximized and the firm’s capital structure would be considered optimum. Thus. or retain them. In order to ensure that neither insufficient nor unnecessary funds are invested in current assets. Periodically. finance functions may affect the size. If the firm does not invest sufficient funds in current assets. Once the financial manager is able to determine the best combination of debt and equity. In practice. To quote Ezra Solomon . or distribute a portion and retain the balance. He or she should estimate firm’s needs for current assets and make sure that funds would be made available when needed. the value of the firm. The optimum dividend policy is one that maximizes the market value of the firm’s shares.

he has to call on the expertise of those in other functional areas to discharge his responsibilities effectively. you need to understand the factors involved in the planning process. To create an efficient plan. type of customers to be granted credit facilities.com A businessman an businesswoman having a meeting image by sumos from Fotolia. Likewise. level of inventories to be kept in hand.The function of financial management is to review and control decisions to commit or recommit funds to new or ongoing uses. Decisions pertaining to kinds of fixed assets to be acquired for the firm. To help your organization succeed. within an enterprise whenever decisions are about the acquisition or distribution of assets. A finance manager has a final say in decisions on dividends than in asset management decisions. There are several factors that affect planning in an organization. as noted above. The determination of dividend policies is almost exclusively a finance function. But in actual practice. Financial management is looked on as cutting across functional even disciplinary boundaries. creating a new department or any undertaking that affects the company’s future. a finance manager is held responsible to handle all such problem: that involve money matters. financial management is directly concerned with production. 4e634960-1e4b-65e0-9d0e-ed699b8d2ca4400300 • Priorities . For instance. in addition to raising funds. Costs of various methods of financing are affected by this risk.2 Explain the factors that affect the financial plan of a company? Ans. decision pertaining to the proportion in which fixed assets and current assets are mixed determines the risk complexion of the firm.com Organizational planning is affected by many factors. in the management of income finance manager has to act on his own. Q. dividend decisions influence financing decisions and are themselves influenced by investment decisions. terms of credit should be made after consulting production and marketing executives. Various financial functions are intimately connected with each other. In view of this. This applies to starting the company. developing new product. finance manager is expected to call upon the expertise of other functional managers of the firm particularly in regard to investment of funds. A businessman an businesswoman having a meeting image by sumos from Fotolia. Thus. However. marketing and other functions. In principle. It is in such an environment that finance manager works as a part of total management. you should develop a plan that needs to be followed.

Forecasting sales revenues. • Contingency Planning To successfully plan. For example. When you start the planning process for any project. For example. In this section. • Company Resources Having an idea and developing a plan for your company can help your company to grow and succeed. personnel. if your forecasting for the cost of goods has changed due to a sudden increase in material costs. space requirements. or at par. if you are in the process of planning a large expansion project and your largest customer suddenly threatens to take their business to your competitor. if the company has the capabilities to pull off the plan and if the plan will help to strengthen the company’s standing within the industry. That priority rating will determine what issues will sidetrack you from the planning of your project. If the .3 Show the relationship between required rate of return and coupon rate on the value of a bond. there needs to be a part of the plan that addresses the possibility that the product line will fail. then that can affect elements of your product roll-out plan. it can be difficult to tell if the plan has any chance of success. The reallocation of company resources. • Forecasting A company constantly should be forecasting to help prepare for changes in the marketplace. Bonds can be priced at a premium. we will run through some bond price calculations for various types of bond instruments. it will sell at a premium because its interest rate is higher than current prevailing rates. but if the company does not have the resources to make the plan come together. it can stall progress. materials costs. It is important for prospective bond buyers to know how to determine the price of a bond because it will indicate the yield received should the bond be purchased. the acceptable financial losses and the potential public relations problems that a failed product can cause all need to be part of the organizational planning process from the beginning Q. including projected profit and the long-term commitment you might need to make to a supplier to try to get the lowest price possible. access to materials and vendor relationships. Ans. then you might have to shelve the expansion planning until the customer issue is resolved. an organization needs to have a contingency plan in place. and this priority can sometimes interfere with the planning process of any project. Without accurate forecasting. One of the first steps to any planning process should be an evaluation of the resources necessary to complete the project. compared to the resources the company has available. and which issues can wait until the process is complete. discount. If the bond’s price is higher than its par value. you need to assign each of the issues facing the company a priority rating. If the company has decided to pursue a new product line.In most companies. Some of the resources to consider are finances. personnel costs and overhead costs can help a company plan for upcoming projects. the priority is generating revenue.

or required yield M = value at maturity. given the bond’s coupon rate in comparison to the average rate most investors are currently receiving in the bond market. as it requires adding the present value of each future coupon payment. Notice how the present value decreases for those coupon payments that are further into the future the present value of the second coupon payment is worth less than the first coupon and the third coupon is worth the lowest amount today. this interest rate is the required yield. refer to Understanding the Time Value of Money. You may have guessed that the bond pricing formula shown above may be tedious to calculate. For bond pricing. which is a series of fixed payments at set intervals over a fixed period of time. which uses the basic present value (PV) formula: C = coupon payment n = number of payments i = interest rate. the price of a bond is the sum of the present values of all expected coupon payments plus the present value of the par value at maturity. Usually the required yield on a bond is equal to or greater than the current prevailing interest rates. This PV-of-ordinary-annuity formula replaces the need to add all the present values of the future coupon. we can use the shorter PV-of-ordinary-annuity formula that is mathematically equivalent to the summation of all the PVs of future cash flows. Calculating bond price is simple: all we are doing is discounting the known future cash flows. The following diagram illustrates how present value is calculated for an ordinary annuity: Each full moneybag on the top right represents the fixed coupon payments (future value) received in periods one. The farther into the future . (If the concepts of present and future value are new to you or you are unfamiliar with the calculations. Fundamentally. When you calculate the price of a bond. Required yield or required rate of return is the interest rate that a security needs to offer in order to encourage investors to purchase it.bond’s price is lower than its par value. Because these payments are paid at an ordinary annuity. you are calculating the maximum price you would want to pay for the bond. two and three.) Here is the formula for calculating a bond’s price. or par value The succession of coupon payments to be received in the future is referred to as an ordinary annuity. the bond will sell at a discount because its interest rate is lower than current prevailing interest rates. however.) The first payment of an ordinary annuity occurs one interval from the time at which the debt security is acquired. (Coupons on a straight bond are paid at ordinary annuity. however. Remember that to calculate present value (PV) – which is based on the assumption that each payment is re-invested at some interest rate once it is received–we have to know the interest rate that would earn us a known future value. The calculation assumes this time is the present.

we will have a total of 20 coupon payments. Determine the Semi-Annual Yield: Like the coupon rate. the required semi-annual yield is 6% (0. we have determined that the bond is selling at a discount. The bond must sell at a discount to attract investors. see Anything but Ordinary: Calculating the Present and Future Value of Annuities and Understanding the Time Value of Money. Determine the Number of Coupon Payments: Because two coupon payments will be made each year for ten years. Plug the Amounts Into the Formula: From the above calculation. (For more on calculating the time value of annuities. it doesn’t require that we add the value of each coupon payment.000 X 0. the bond price is less than its par value because the required yield of the bond is greater than the coupon rate. In other words. The coupon rate is the percentage off the bond’s par value. 3. Example 1: Calculate the price of a bond with a par value of $1. As a result. Accounting for Different Payment Frequencies In the example above coupons were paid semi-annually.05). which are required if the coupon payments occur more than once a year. A simple modification of the above formula .a payment is to be received. 4. It calculates the sum of the present values of all future cash flows.000 to be paid in ten years. we arrive at the following formula: Let’s go through a basic example to find the price of a plain vanilla bond. a coupon rate of 10%. You may be now wondering whether there is a formula that does not require steps two and three outlined above. Therefore. our bond price would be very low and inaccurate. each semi-annual coupon payment will be $50 ($1. and a required yield of 12%. the required yield of 12% must be divided by two because the number of periods used in the calculation has doubled. divide the coupon rate in half. 2. which requires us to also include the present value of the par value received at maturity. ) By incorporating the annuity model into the bond pricing formula. In our example we’ll assume that coupon payments are made semi-annually to bond holders and that the next coupon payment is expected in six months. but unlike the bond-pricing formula we saw earlier. they need an extra incentive to invest in the bonds.12/2). the less it is worth today – is the fundamental concept for which the PV-of-ordinary-annuity formula accounts. If we left the required yield at 12%. Determine the Value of Each Coupon Payment: Because the coupon payments are semiannual. Here are the steps we have to take to calculate the price: 1. who could find higher interest elsewhere in the prevailing rates. because investors can make a larger return in the market. so we divided the interest rate and coupon payments in half to represent the two payments per year.

normal Z-test. The results of the study do not depend upon the definition of the market portfolio. Theories on financial leverage may be classified into three categories: irrelevance theorem. using simple and multiple regression analyses. and optimal financial leverage. the results of the study were the same for both portfolios. An important analytical tool for financial leverage is the indifference point at which the EPS/market price is the same for different financial plans under consideration. financial leverage will affect the financial risk of the firm. The evidence shows that changes in the market value of common stock are positively related to changes in financial leverage for some firms and negatively related for other firms. or the choice of financial leverage measure. Empirical implications of these categories along with the consequences of serious confounding effects are analyzed. The implications are then compared with evidence from actual events involving financial leverage changes. rising from value indefinitely with increase in financial leverage. financial leverage can be positive when operating profits are increasing and can be negative in the situation of decrease in such profits. However. The financial leverage implies the employment of source of funds. and the results were the same for all measures. assuming that financial leverages of firms with a positive relationship are below the optimum and those of firms with a negative relationship are above the optimum. and. Seven different definitions of financial leverage were tested.4 Discuss the implication of financial leverage for a firm. Therefore. F would be two. the definition of the event period. and the results were the same for both periods. Betas estimated from equally weighted market portfolios were generally higher than those estimated from value weighted market portfolios during 1981-1982. The objective of this study was to provide additional evidence on the relationship between financial leverage and the market value of common stock. Like the operating leverage. Ans. however. F would have a value of one. or the number of times a year the coupon is paid. Abnormal returns were computed for seven and two day event periods. involving fixed return so as to cause more than a proportionate change in earnings per share (EPS) due to change in operating profits. for bonds paying annual coupons. and distinguished from each other as finely as possible. Because of the methodological weaknesses of past studies. and a simulation technique. and if the bond paid semi-annual coupons. no conclusions can be drawn as to the validity of the theories. Q. Numerous empirical studies have been done in this area. which represents the frequency of coupon payments. Should a bond pay quarterly payments. .will allow you to adjust interest rates and coupon payments to calculate a bond price for any payment frequency: Notice that the only modification to the original formula is the addition of “F”. F would equal four. In view of these. This evidence is consistent with the existence of an optimal financial leverage for each firm. concurrently. many theories have been developed to explain the relationship between financial leverage and the market value of common stock.

Set-2 .

So. so that he/she can get credit for good performance. As it is said that profit is a relative term. more importance is given to cash flowsrather than profitability.earnings per share andcapitalization rate. it will facilitate wealth creationGiving priority to value creation. value of business is said to be a function of two factors . Whereas.A myopic person or business is mostly concerned about short term benefits. This leads to better and trueevaluation of business. a manager might opt for risky decisions which can puton stake the owner‘s objectives. it is not necessary that profit should be the only objective. we can say that profit maximizationis a subset of wealth and being a subset. capturing more marketshare etc. wealth maximization may create conflict. making way for sustainable performance by businesses. For e. The financial management come a long way by shifting its focus from traditional approach to modernapproach. criteria like: ― present value of its cash inflow – present value of cash outflows (netpresent value) is taken. This describes conflictbetween the owners and managers of firm. a basic principle is thatultimately wealth maximization should be discovered in increased net worth or value of business. Similarly.In wealth maximization. Well. Thus. it may concentrate on various other aspects like increasing sales.g. For e. (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. A short term horizon canfulfill objective of earning profit but may not help in creating wealth. tomeasure the same. a strategicinvestor or the owner of the firm would be majorly concerned about the longer term performance of thebusiness that can lead to maximization of shareholder‘s wealth. And it can be measured by adopting following relation:Value of business = EPS / Capitalization rateAt times. to maximize the wealth of its current shareholdershe objections are:-(i) Profit cannot be ascertained well in advance to express the probability of return as future isuncertain. maximization of wealth approachbelieves that money has time value. Finance Management or Financial Management emphasizes on wealthmaximization rather than profit maximization. itcan be in percentage etc. For e. However.g. So. whether it is earned in short term or long term. a manager should align his/her objective to broad objective of organization and achieve atradeoff between risk and return while making decision. duration of earning the profit is also importanti. It is not at possible to maximize what cannot be known. sales etc.000 cannot be judged as good or bad for a business.For a business. known as agency problem.An obvious question that arises now is that how can we measure wealth. in course of fulfilling the same. which will take care of profitability.till it is compared with investment. It is because wealth creation needsa longer term horizon Therefore.1 Discuss the objective of profit maximization vs wealth maximization. As.e.. a profit of say $10. So. major emphasizes is on cash flows rather than profit. The modern approach focuses on wealth maximization rather thanprofit maximization. cash flows are taken under consideration. to measure theworthof a project. keeping in mind the ultimate goal of financial management i. under wealth maximization.Hence. to evaluate variousalternatives for decision making. It is argued that firm's goal cannotbe to . a manager might focus ontaking such decisions that can bring quick result. managers are the agents appointed by owners. This approach considers cash flows rather than profits into consideration andalso use discounting technique to find out worth of a project.g. managers have now shifted from traditional approach to modernapproach of financial management that focuses on wealth maximization. it can be a figure in some currency.Thisgives a longer term horizon for assessment.e.Q.

Firms should try to 'satisfy' rather than to 'maximize'(iii) There must be a balance between expected return and risk. Maximization of profits with a vie to maximising the wealth of shareholders is clearly an unreal motive. In such cases. Such combination of expected returns with risk variations and related capitalisation rate cannot be considered in theconcept of profit maximization. In the second approach. The possibility of higher expectedyields are associated with greater risk to recognise such a balance and wealth Maximization isbrought in to the analysis. net operating income approach examines the effects of changes in capital structure in terms of net operating income.Keeping the above objections in view. Hence the benefit of leverage is wiped out and overall cost of capital remains at the same level as before. profitability Maximization with a view to using resources to yield economic valueshigher than the joint values of inputs required is a useful goal. Explain the Net operating approach to capital structure. Then overall value of the firm is calculated through capitalization rate of equities obtained on the basis of net operating income. On theother hand. most of the thinkers on the subject have come to theconclusion that the aim of an enterprise should be wealth Maximization and not the profitMaximization. Let us illustrate this point. Thus the overall value of the firm is independent of the degree of leverage in capital structure. Evidentlywhen profit maximization becomes the basis of financial decisions of the concern. 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. Heargues that it is useful to make a distinction between profit and 'profitability'. it is called net income approach. In the net income approach discussed above net income available to shareholders is obtained by deducting interest on debentures form net operating income. it ignoresthe interests of the community on the one hand and that of the government. Q2. The overall cost of capital is independent of leverage. on the other hand cost of equity capital increases to the same extent. . (ii) Similarly the overall cost of capital is not affected by any change in the degree of leverage in capital structure. (iv) The goal of Maximization of profits is considered to be a narrow outlook. Hence this second approach is known as net operating income approach. Ans. The NOI approach implies that (i) whatever may be the change in capital structure the overall value of the firm is not affected. Prof.maximize profits but to attain a certain level or rate of profit holding certain share of themarket or certain level of sales. Thus the proper goal of financialmanagement is wealth maximization. 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. 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. workers andother concerned persons in the enterprise on the other hand. 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. Soloman of Stanford University has handled the issued very logically. higher capitalisation rate involves.

but in certain industries. those funds are not available for other uses. This means there does not exist a optimum capital structure. An operating cycle is the length of time between the acquisition of inventory and the sale of that inventory and subsequent generation of a profit. the faster a business gets a return on investment (ROI) for the inventory it stocks. To put the same in other words there are two parts of the cost of capital. it ties up money in the inventory until it can be sold. In spite of the change in the ratio of debts to equity the market value of its equity shares remains constant. rather than the short term. Every capital structure is optimum according to net operating income approach. This money may be borrowed or paid up front. for example. There are cases where a long operating cycle in unavoidable. it does not decline. but keeping the operating cycle short is still a goal for most businesses so they can keep their liquidity high. Wineries and distilleries. When a business buys inventory. like big ticket items. Ans. once the business has purchased inventory. inventory can depreciate if it is kept in a store too long.3 What do you understand by operating cycle. 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. Such companies are usually structured in a way that allows them to borrow against existing inventory or land if funds are needed to finance short-term operations. Keeping inventory during a long operating cycle does not just tie up funds. . As a general rule. Others. Certain products can be consistent sellers that move in and out of inventory quickly. inventory tends to sit around longer.If follows that with the increase in debts rate of equity capitalization also increases and consequently the overall cost of capital remains constant. Inventory must also be insured and managed by staff members who need to be paid. In these industries. Operating cycles can fluctuate. The shorter the operating cycle. because of the nature of the business. Inventory must be stored and this can become costly. Furthermore. In the case of perishable goods. Q. Operating cycles are not tied to accounting periods. and this adds to overall operating expenses. One is the explicit cost which is expressed in terms of interest charges on debentures. During periods of economic stagnation. keep inventory on hand for years before it is sold. while periods of growth may be marked by more rapid turnover. the return on investment happens in the long term. it can even be rendered unsalable. The business views this as an acceptable tradeoff because the inventory is an investment that will hopefully generate returns. especially with items that require special handling. Optimum capital structure This approach suggests that whatever may be the degree of leverage the market value of the firm remains constant. but are rather calculated in terms of how long goods sit in inventory before sale. companies want to keep their operating cycles short for a number of reasons. but in either case. a long operating cycle is actually the norm. such as humidity controls or security.

00 per unit. assume two firms. If firm A’s sales decrease by I percent. additional risk— financial risk—is placed on the company’s common shareholders. All of these issues must be accounted for when making decisions about ordering and pricing items for inventory. Business risk stems from the unpredictable nature of doing business. but its variable cost per unit is much higher at $3.00 per unit. the unpredictability of consumer demand for products and services. although to calculate this figure the equation would require several additional factors such as the quantity produced. utility companies. but not for firm B.. When a company uses debt or preferred stock financing. and the price per unit. Highly automated firm A has fixed costs of $35. By using fixed production costs. The following simplified equation demonstrates the type of equation used to compute the degree of operating leverage. which is part of financial leverage. it also involves the uncertainty of longterm profitability. Ans.00 per widget.000 widgets per year at a price of $5. Firm A has a higher amount of operating leverage because of its higher fixed costs. equipment and technology. but firm A also has a higher breakeven point—the point at which total costs equal total sales. Automated and high-tech companies. which are used to determine changes in profits and sales: Operating leverage is a double-edged sword. administrative costs. its profits will decrease by more than I percent. Business risk refers to the stability of a company’s assets if it uses no debt or preferred stock financing. the degree of operating leverage shows the responsiveness of profits to a given change in sales.4 What is the implication of operating leverage for a firm. Both firms produce and sell 10. If a company has a large percentage of fixed costs. however. Nevertheless. produce and sell widgets.may be purchased less frequently. Table 1 shows both firm’s operating cost structures. a company can increase its profits. Operating leverage: Operating leverage is the extent to which a firm uses fixed costs in producing its goods or offering its services. A and B.000 per year. As a result. depreciation. and airlines generally have high degrees of operating leverage. Firm A uses a highly automated production process with robotic machines. a change of I percent in sales causes more than a I percent change in operating profits for firm A. Fixed costs include advertising expenses. Q. it has a high degree of operating leverage. Hence. Implications: Total risk can be divided into two parts: business risk and financial risk. whereas labor-intensive firm B has fixed costs of only $15. but not interest on debt. The “degree of operating leverage” measures this effect.e. too. variable cost per unit. i. whereas firm B assembles the widgets using primarily semiskilled labor.000 per year and variable costs of only $1. As an illustration of operating leverage. They demand a higher expected . and taxes.

Consequently. to provide leverage during periods of deflation. raises a company’s costs. such as the period during the late 1990s brought on by the Asian financial crisis. Debt fails. . which in turn. The opposite also holds: companies with low amounts of business risk can afford to use more debt financing while keeping total risk at tolerable levels. using debt as leverage is a successful tool during periods of inflation. Moreover.return for assuming this additional risk. companies with high degrees of business risk tend to be financed with relatively low amounts of debt. however.