Master of Business Administration- MBA Semester 2

MB0045 Financial Management

Assignment Set 2
Q1. What is meant by operating cycle? Explain

Ans. An operating cycle is the length of time between the acquisition of i n v e n t o r y and the sale of that inventory and subsequent generation of a profit. The shorter the operating cycle, the faster a business gets a return on investment (ROI) for the inventory it stocks. As a general rule, companies want to keep their operating cycles short for a number of reasons, but in certain industries, a long operating cycle is actually the norm. Operating cycles are not tied to accounting periods, but are rather calculated in terms of how long goods sit in inventory before sale. When a business buys inventory, it ties up money in the inventory until it can be sold. This money may be borrowed or paid up front, but in either case, once the business has purchased inventory, those funds are not available for other uses. The business views this as an acceptable trade off because the inventory is an investment that will hopefully generate returns, but keeping the operating cycle short is still a goal for most businesses so they can keep their liquidity high. Keeping inventory during a long operating cycle does not just tie up funds. Inventory must be stored and this can become costly, especially with items that require special handling, such as humidity controls or security. Furthermore, inventory can depreciate if it is kept in a store too long. In the case of perishable goods, it can even be rendered unsalable. Inventory must also be insured and managed by staff members who need to be paid, and this adds to overall operating expenses. There are cases where a long operating cycle in unavoidable. Wineries and distilleries, for example, keep inventory on hand for years before it is sold, because of the nature of the business. In these industries, the return on investment happens in the long term, rather than the short term. 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. Operating cycles can fluctuate. During periods of economic stagnation, inventory tends to sit around longer, while periods of growth may be marked by more rapid turnover. Certain products can be consistent sellers that move in and out of inventory quickly. Others, like big ticket items, may be purchased less frequently. All of these issues must be accounted for when making decisions about ordering and pricing items for inventory.

Q2. Discuss the concept of capital rationing.

Ans. (a) Capital Rationing: When there is a scarcity of funds, capital rationing is resorted to. Capital rationing means the utilization of existing funds in most profitable manner by selecting the acceptable projects in the descending order or ranking with limited available funds. The firm must be able to maximize the profits by combining the most profitable proposals. Capital rationing may arise due to (i) external factors such as high borrowing rate or non -availability of loan funds due to constraints of Debt-Equity Ratio; and (ii) Internal Constraints Imposed by management. Project should be accepted as a whole or rejected. It cannot be accepted and executed in piece meal .IRR or NPV are the best basis of evaluation even under Capital Rationing situations. The objective is to select those projects which have maximum and positive NPV. Preference should be given to interdependent projects. Projects are to be ranked in the order of NPV. Where there is multi-period Capital Rationing, Linear Programming Technique should be used to maximize NPV. In times of Capital Rationing, the investment policy of the company may not be the optimal one. In nutshell Capital Rationing leads to: (i) Allocation of limited resources among ranked acceptable investments.(ii) This function enables management to select the most profitable investment first.(iii) It helps a company use limited resources to the best advantage by investing only in the projects that offer the highest return.(iv) Either the internal rate of return method or the net present value method may be used in ranking investments. Ways of Resorting Capital Rationing : There are various ways of resorting to capital rationing, some of which are : (i) By Way of Retained Earnings : A firm may put up a ceiling when it has been financing investment proposals only by way of retained earnings (ploughing back of profits). Since the amount of capital expenditure in that situation cannot exceed the amount of retained earnings, it is said to be an example of capital rationing. (ii) By Way of Responsibility Accounting : Capital Rationing may also be introduced by following the concept of responsibility accounting Whereby management may introduce capital rationing by authorising a particular department to make investment only up to a specified limit, beyond which the investment decisions are to be taken by higher-ups.(iii) By Making Full Utilization of Budget as Primary Consideration : In Capital Rationing it may also be more desirable to accept several small investment proposals than a few large investment proposals so that there may be full utilisation of budgeted amount. This may result in accepting relatively less profitable investment proposals if full utilisation of budget is a primary consideration. Thus Capital Rationing does not always lead to optimum results.

Q3. Write short notes on (a) Cost of capital and (b) Stock Split Ans. (a)

c. Financial risk premium: Financial risk relates to the pattern of capital structure ( i.e. debt equity mix) of the firm. In general a firm which has higher debt content in its capital structure should have more risk than firm which has comparatively low debt content. This is because the former should have a greater operating profit with a view to covering the periodic interest payment and repayment of principal at the time of maturity than latter.

Ans.(b) Stock Split

A stock split is a method to increase the number of outstanding share by proportionately reducing the face value of share. A stock split affects only the par value and does not have any effect on the total outstanding amount in share capital. The reasons for splitting shares are: 1. To make share attractive The prime reason for affecting a stock split is to reduce the market price of the share to make it more attractive to investors. Shares of some companies are entering in to higher trading zone making it out to reach to small investors. Splitting the shares will place them in more popular trading range thus providing marketability and motivating small investors to buy them. 2. Indication of higher future profits Share split is generally considered a method of management communication to investors that the company is expecting high profit in future. 3. Higher dividend to shareholders When shares are split, the company does not resort to reducing the cash dividends. If the company follows a system of stable dividend per share, the investors would surely get higher dividends with stock split.

Q4. Discuss the techniques of inventory control

Ans. There are many techniques of management of inventory. Some of them are as shown in figure 1

Figure 1. Inventory Management Technique Economic order quantity (EOQ) Economic order quantity (EOQ) refers to the optimal order size that will result in the lowest ordering and carrying costs for an item of inventory based on its expected usage. EOQ is defined as the order quantity that minimises the total cost associated with inventory management. EOQ is based on the following assumptions: Constant or uniform demand: The demand or usage is even through-out period Known Demand or usage: Demand or usage for a given period is known Constant unit price: per unit price of material does not change and is constant irrespective of order size Constant Carrying Costs: The cost of carrying is fixed percentage of the average value of inventory Constant Ordering Cost: Cost per order is constant whatever the size of the order Inventories can be replenished immediately as the stock level reaches exactly to zero. Constantly there is no shortage of inventory. Economic order quantity is represented using the following formula: Qx = 2DK/ Kc Where D = Annual usage or Demand Qx = Economic order quantity K = Order cost per order Kc = Pc = price per unit x percent carrying cost = carrying cost of inventory per unit per annum ABC System The inventory of an industrial firm generally comprises of thousands of items with diverse prices, large lead time and procurement problems. It is not possible to exercise the same degree of control over all these items. Items of high value require high maximum attention while item of low value do not require same degree of control. The firm has to be selective in its approach to control its investment in various items of inventory. Such an approach is called selective inventory control. ABC system belongs to selective inventory control. ABC analysis classifies all the inventory items in an organisation in to three categories. 1. Items are high in value but small in number. All items require strict control

2. Items of moderate value and size will require reasonable attention of the management 3. Items represent relatively small value items and require simple control This method concentrates attention on the basis of the relative importance of various items of inventory, it is also known as control by importance and exception. As the items are classified in order of their relative importance in terms of value, it is also known as proportional value analysis. Advantages of ABC analysis 1. ABC analysis ensures closure controls on costly elements in which firms greater part of resources are invested 2. By maintaining stocks at optimum level it reduces the clerical costs of inventory control 3. Facilitates inventory control over usage of materials, leading to effective cost control Limitations 1 A never ending problem in inventory management is adequately handling thousands of low value of C items. ABC analysis fails to answer this problem 2. If ABC analysis is not periodically reviewed and updated, it defeats the basic Purpose of ABC approach

Q.5 Examine the features of decision tree analysis.

Ans. Features of decision tree approach Many project decisions are complex investment decisions. Decision tree can handle the sequential decisions of complex investment proposals. The decision of taking up an investment project is broken into different stages. At each stage proposal is examined to decide whether to go ahead or not. The multi- stages approach can be handled effectively with the help of decision trees. A decision tree presents graphically the relationship between 1. Present decision and future events 2. Future decisions and the consequences of such decisions Evaluation of decision tree approach The evaluation of decision tree approach lads to the following assumptions 1. Decision tree approach portrays inter- related, sequential and critical multidimensional elements of major project decisions 2. Adequate attention is given to the critical aspects in an investment decision which spread over a time sequence 3. Complex projects involve huge out lay and hence are risky. There is the need to define and evaluate scientifically the complex managerial problems arising out

the sequence of inter related decisions with consequential outcomes of high risk. It is effectively answered by decision tree approach 4. Structuring a complex project decision with many sequential investment decisions demands effective project risk management. This is possible only with the help of an analytical tool like decision tree approach 5. Ability to eliminate unprofitable outcomes helps in arriving at optimum decision stages in time sequence.

Q6. The following data is available in respect of a company :

Equity Rs.10 lakhs, cost of capital 18% Debt Rs.5 lakhs, cost of debt 13% Calculate the weighted average cost of funds taking market values as weights assuming tax rate as 40% Solution: Step I is to determine the cost of each component. Ke = ( D1/P0) + g= (2/32) + 0.1= 0.1625 or 16.25%Kp = [D + {(F P)/n}] / {F+P)/2} = [14 + (105 84)/8] / (105+84)/2 =16.625/94.5= 0.1759 or 17.59%Kr = Ke which is 16.25%Kd = [I(1 T) + {(F P)/n}] / {F+P)/2} = [12(1 0.4) + (105 90)/7] / (105+90)/2= [7.2 + 2.14] / 97.5= 0.096 or 9.6% Kt = I(1 T)= 0.11(1 0.4)= 0.066 or 6.6% Step II is to calculate the weights of each source. We = 200/750 = 0.267Wp = 100/750 = 0.133Wr = 100/750 = 0.133Wd = 300/750 = 0.4Wt = 50/750 = 0.06 Step III Multiply the costs of various sources of finance with corresponding weights and WACC is calculated by adding all these components WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt = (0.267*0.1625) + (0.133*0.1759) + (0.133*0.1625) + (0.4*0.092) + (0.06*0.066)= 0.043 +

0.023 + 0.022 + 0.0384 + 0.004= 0.1457 or 14.57% The value of WACC is 14.57%