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Q. 1: Explain the liquidity decisions and its important elements.

Write
complete information on dividend decisions.
Ans.:
Liquidity decisions with its important elements: The liquidity decision is
concerned with the management of the current assets, which is a pre-requisite to
long-term success of any business firm.
This is also called as working capital decision. The main objective of the current
assets management is the trade-off between profitability and liquidity, and there is
a conflict between these two concepts. If a firm does not have adequate working
capital, it may become illiquid and consequently fail to meet its current obligations
thus inviting the risk of bankruptcy. On the contrary, if the current assets are too
enormous, the profitability is adversely affected. Hence, the major objective of the
liquidity decision is to ensure a trade-off between profitability and liquidity. The
liquidity decision should balance the basic two ingredients, i.e. working capital
management and the efficient allocation of funds on the individual current assets.
In other terms, liquidity decisions deal 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
Dividend Decisions : Dividends are payouts to shareholders. Dividend is that
portion of profits of a company which is distributed among its shareholders
according to the resolution passed in the meeting of the Board of Directors. This
may be paid as a fixed percentage on the share capital contributed by them or at a
fixed amount per share.
Payment of dividend is always desirable since it affects the goodwill of the
concern in the market on the one hand, and on the other, shareholders invest their
funds in the company in a hope of getting a reasonable return. Retained earnings
are the sources of internal finance for financing of corporates future projects but
payment of dividend constitute an outflow of cash to shareholders. one of the
important functions of the financial management to constitute a dividend policy
which can balance these two contradictory view points and allocate the reasonable
amount of profits after tax between retained earnings and dividend. All of this is

based on formulation of a good dividend policy. 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.
The following issues need adequate consideration in deciding on dividend policy:
Preferences of shareholders Do they want cash dividend or capital gains?
Current financial requirements of the company.
Legal constraints on paying dividends.
Striking an optimum balance between desire of shareholders and the
companys funds requirements.
Companies attempt to maintain a stable dividend policy whereby a stable rate of
dividend is maintained. This also ensures that the companys market value of
shares stays higher. The main reasons why a stable dividend is preferred are:
(a) A regular and stable dividend payment may serve to resolve uncertainty in the
minds of shareholders, and it creates confidence among shareholders.
(b) Many investors are income conscious and favour a stable dividend.
(c) Other things being in balance, the market price invariably vary with the rate of
dividend declared by the company on its equity shares. The value of shares of a
company that has a stable dividend policy does not fluctuate as much, even if the
earnings of the company fluctuate now and then.
(d) A stable dividend policy encourages investments from institutional investors.
Dividend decisions are thus highly significant.
Q.2 : Explain about the doubling period and present value. Solve the below
given problem:
Under the ABC Banks Cash Multiplier Scheme, deposits can be made for
periods ranging from 3 months to 5 years and for every quarter, interest is
added to the principal. The applicable rate of interest is 9% for deposits less
than 23 months and 10% for periods more than 24 months. What will be the
amount of Rs. 1000 after 2 years?
Ans.: Doubling period:
A very common question arising in the minds of an investor is how long will it
take for the amount invested to double for a given rate of interest. There are 2
ways of answering this question:
1. One way is to answer it by a rule known as rule of 72. This rule states that the
period within which the amount doubles is obtained by dividing 72 by the rate of
interest. Though it is a crude way of calculating, this rule is followed by most.

For instance, if the given rate of interest is 10%, the doubling period is 72/10, that
is, 7.2 years.
2. A much accurate way of calculating doubling period is by using the rule known
as rule of 69. By this method,
Doubling Period = 0.35+69/Interest rate
Going by the same example given above, we get the number of years as
7.25 years {(0.35 + 69/10) or (0.35 +6.9)}.
Solution.
We know that,
m

12/3

(quarterly
compounding)
1000 (1+0.10/4)4*2
1000 (1+0.10/4)8
Rs. 1218
The amount of Rs. 1000 after 2 years would be Rs. 1218.
Present Value:
Given the interest rate, compounding technique can be used to compare the cash
flows separated by more than one time period. With this technique, the amount of
present cash can be converted into an amount of cash of equivalent value in future.
Likewise, we may be interested in converting the future cash flow into their
present values. Present value can be simply defined as the current value of a
future sum. It can also be defined as the amount to be invested today (present
value) at a given rate of interest over a specified period to equal the future sum.
If we reverse the flow by saying that we expect a fixed amount after n number of
years and we also know the present prevailing interest rate, then by discounting
the future amount at the given interest rate, we will get the present value of
investment to be made.
The present value of a sum to be received at a future date is determined by
discounting the future value at the interest rate that the money could earn over the
period. This process is known as discounting.

Q. 3: Write short notes on:


a) Operating Leverage
b) Financial leverage
c) Combined leverage
Ans.: Operating Leverage:
Operating leverage arises due to the presence of fixed operating expenses in the
firms income flows. It has a close relationship to business risk. Operating
leverage affects business risk factors, which can be viewed as the uncertainty
inherent in estimates of future operating income.
The operating leverage takes place when a change in revenue produces a greater
change in Earnings Before Interest and Taxes (EBIT). It indicates the impact of
changes in sales on operating income. A firm with a high operating leverage has a
relatively greater effect on EBIT for small changes in sales. A small rise in sales
may enhance profits considerably, while a small decline in sales may reduce and
even wipe out the EBIT.
Classification of Operating Cost
Fixed costs Fixed costs are those which do not vary with an increase in
production or sales activities for a particular period of time.
Variable costs Variable costs are those which vary in direct proportion to output
and sales. An increase or decrease in production or sales activities will have a
direct effect on such types of costs incurred.
Semi-variable costs Semi-variable costs are those which are partly fixed and
partly variable in nature. These costs are typically of fixed nature up to a certain
level beyond which they vary with the firms activities.
The operating leverage refers to the degree to which a firm has built-in
fixed costs due to its particular or unique production process.
The extent of the operating leverage at any single sales volume is
calculated as follows:
Marginal contribution/EBIT)
(Revenue Variable costs)/(Revenue Variable costs Fixed costs)
Thus, the operating leverage is the firms ability to use fixed operating costs to
increase the effects of changes in sales on its EBIT. Operating leverage occurs any
time if a firm has fixed costs. The percentage of change in profits with a change in
volume of sales is more than the percentage of change in volume. The higher the
fixed costs, the greater the leverage and the more frequent the changes in the rate
of profit (or loss) with alternations in the volume of activity.

Financial Leverage:
Financial leverage relates to the financing activities of a firm and measures the
effect of EBIT on Earnings Per Share (EPS) of the company.
A companys sources of funds fall under two categories:
Those which carry fixed financial charges like debentures, bonds, and
preference shares
Those which do not carry any fixed charges like equity shares
Debentures and bonds carry a fixed rate of interest and are to be paid off
irrespective of the firms revenues. The dividends are not contractual obligations,
but the dividend on preference shares is a fixed charge and should be paid off
before equity shareholders. The equity holders are entitled to only the residual
income of the firm after all prior obligations are met.
Financial leverage refers to a firm's use of fixed-charge securities like debentures
and preference shares (though the latter is not always included in debt) in its plan
of financing the assets. The concept of financial leverage is a significant one
because it has direct relation with capital structure management. It determines the
relationship that could exist between the debt and equity securities. Financial
leverage is a process of using debt capital to increase the rate of return on equity.
Financial leverage refers to the mix of debt and equity in the capital structure of
the firm.
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.
Financial leverage and its effects are a crucial consideration in planning and
designing capital structures.
Combined Leverage:
The combination of operating and financial leverage is called combined leverage.
Operating leverage affects the firms operating profit EBIT and financial leverage
affects PAT or the EPS. These cause wide fluctuations in EPS. A company having
a high level of operating or financial leverage will find a drastic change in its EPS
even for a small change in sales volume. Companies whose products are seasonal
in nature have fluctuating EPS, but the amount of changes in EPS due to leverages
is more pronounced.
The combined effect is quite significant for the earnings available to ordinary
shareholders. Combined leverage is the product of DOL and DFL.

Q(S V)
DTL = --------------------------Q(S V) F I {Dp /(1 T)}
Where DTL = Degree of Total Leverage
Q. 4: Explain the factors affecting Capital Structure. Solve the below given
problem:
Given below are two firms, A and B, which are identical in all aspects except
the degree of leverage employed by them. What is the average cost of capital
of both firms?

Ans.: Factors Affecting Capital Structure:


Capital structure should be planned at the time a company is promoted.
The major factor affecting the capital structure is leverage. There are also a few
other factors affecting them.

Leverage
The use of sources of funds that have a fixed cost attached to them, such as
preference shares, loans from banks and financial institutions, and debentures in
the capital structure, is known as trading on equity or financial leverage.
If the assets financed by debt yield a return greater than the cost of the debt, the
EPS will increase without an increase in the owners investment.
Similarly, the EPS will also increase if preference share capital is used to acquire
assets. But the leverage impact is felt more in case of debt because of the
following reasons:
The cost of debt is usually lower than the cost of preference share capital.
The interest paid on debt is a deductible charge from profits for calculating
the taxable income while dividend on preference shares is not.
The other factors to be considered before deciding on an ideal capital structure are:
Cost of capital High cost funds should be avoided. However attractive an
investment proposition may look like, the profits earned may be eaten away by
interest repayments.
Cash flow projections of the company Decisions should be taken in the light of
cash flow projected for the next 3-5 years. The company officials should not get
carried away at the immediate results expected.
Dilution of control The top management should have the flexibility to take
appropriate decisions at the right time. Fear of having to share control and thus
being interfered by others often delays the decision of the closely held companies
to go public. To avoid the risk of loss of control, the companies may issue
preference shares or raise debt capital.
Floatation costs Floatation costs are incurred when the funds are raised.
Generally, the cost of floating a debt is less than the cost of floating an equity
issue. A company desiring to increase its capital by way of debt or equity will
definitely incur floatation costs. Effectively, the amount of money raised by any
issue will be lower than the amount expected because of the presence of floatation
costs.
Solution:
Average cost of capital of firm A is:
10% * 0/Rs. 666667 + 15% * 666667/666667 = 0 + 15 = 15%
Average cost of capital of firm B is:
10% * 25000/750000 + 15% * 533333/750000 = 3.34 + 10 = 13.4%
Interpretation:

The use of debt has caused the total value of the firm to increase and the overall
cost of capital to decrease.

Q. 4: Explain all the sources of risk in capital budgeting with examples.


Solve the below given problem:
An investment will have an initial outlay of Rs 100,000. It is expected to
generate cash inflows. Cash inflow for four years.
If the risk
free rate and
the
risk
premium is
10%,
a) Compute
the
NPV
using the risk
free rate
b) Compute
NPV
using
risk-adjusted
discount rate
Ans.: Risk in Capital Budgeting:
Capital budgeting involves four types of risks in a project: stand-alone risk,
portfolio risk, market risk and corporate risk.
Stand-alone risk
Stand alone risk of a project is considered when the project is in isolation. Standalone risk is measured by the variability of expected returns of the project.
Portfolio risk
A firm can be viewed as portfolio of projects having a certain degree of risk. When
new project is added to the existing portfolio of project, the risk profile of the firm
will alter.
Market risk

Market risk is defined as the measure of the unpredictability of a given stock


value. However, market risk is also referred to as systematic risk. The market risk
has a direct influence on stock prices.
Corporate risk
Corporate risk focuses on the analysis of the risk that might influence the project
in terms of entire cash flow of the firms. Corporate risk is the projects risks of the
firm.
Sources of risk
The five different sources of risk are:
Project-specific risk
Competitive or competition risk
Industry-specific risk
International risk
Market risk
Let us discuss the sources of risk in detail.
Project-specific risk
Project-specific risk could be traced to something quite specific to the project.
Managerial deficiencies or error in estimation of cash flows or discount rate may
lead to a situation of actual cash flows realised being less than the projected cash
flow.
Competitive or competition risk
Unanticipated actions of a firms competitors will materially affect the cash flows
expected from a project. As a result of this, the actual cash flows from a project
will be less than that of the forecast.
Industry-specific risk
Industry-specific risks are those that affect all the firms in the particular industry.
Industry-specific risk could be again grouped into technological risk, commodity
risk and legal risk.
Technological risk The changes in technology affect all the firms not
capable of adapting themselves in emerging into a new technology.
Commodity risk It is the risk arising from the effect of price-changes on
goods produced and marketed.
Legal risk It arises from changes in laws and regulations applicable to the
industry to which the firm belongs.
International risk

These types of risks are faced by firms whose business consists mainly of exports
or those who procure their main raw material from international markets.
Market risk
Factors like inflation, changes in interest rates, and changing general economic
conditions affect all firms and all industries. Firms cannot diversify this risk in the
normal course of business.
Solution.
a) NPV can be computed using risk free rate. Table shows NPV calculation using
the risk free rate.
Table : PV Using Risk Free Rate
Year
Cash
flows
(inflows)
Rs.
1
40000
2
50000
3
15000
4
30000
PV of cash inflows
PV
of
cash
outflows
NPV

PV factor at
10%

PV of cash flows
(inflows)

0.909
0.826
0.751
0.683

36,360
41,300
11,265
20,490
1,09,415

(1,00,000)
9,415

b) NPV can be computed using risk-adjusted discount. Table


calculation using the risk-adjusted discount.
Table: NPV Using Risk-adjusted Discount Rate
Year
Cash
flows PV factor at
(inflows)
20%
Rs.
1
40000
0.833
2
50000
0.694
3
15000
0.579
4
30000
0.482
PV of cash inflows
PV
of
cash (1,00,000)
outflows
NPV

shows NPV

PV of cash flows
(inflows)
33,320
34,700
8,685
14,460
91,165
(100, 000)
(8, 835)

The project would be acceptable when no allowance is made for risk. However, it

will not be acceptable if risk premium is added to the risk free rate. By doing so, it
moves from positive NPV to negative NPV. If the firm were to use the internal rate
of return (IRR), then the project would be accepted, when IRR is greater than the
risk-adjusted discount rate.
Q. 6 : Explain the objectives of Cash Management. Write about the Baumol
model with their assumptions.
Ans.: Objectives of Cash Management
The major objectives of cash management in a firm are:
Meeting payments schedule
Minimising funds held in the form of cash balances
Meeting payments schedule
In the normal course of functioning, a firm has to make various payments by cash
to its employees, suppliers and infrastructure bills. Firms will also receive cash
through sales of its products and collection of receivables. Both of these do not
occur simultaneously.
The basic objective of cash management is therefore to meet the payment schedule
on time. Timely payments will help the firm to maintain its creditworthiness in the
market and to foster cordial relationships with creditors and suppliers.
Trade credit refers to the credit extended by the supplier of goods and services in
the normal course of business transactions.
Generally, cash is not paid immediately for purchases but after an agreed period of
time. This is deferral of payment and is also considered as a source of finance.
Trade credit does not involve explicit interest charges, but there is an implicit cost
involved.
The other advantage of meeting the payments on time is that it prevents
bankruptcy that arises out of the firms inability to honour its commitments. At the
same time, care should be taken not to keep large cash reserves as it involves high
cost.
Minimising funds held in the form of cash balances
Trying to achieve the second objective is very difficult. A high level of cash
balance will help the firm to meet its first objective, but keeping excess reserves is
also not desirable as funds in its original form is idle cash and a non-earning asset.
It is not profitable for firms to maintain huge balances.
A low level of cash balance may mean failure to meet the payment schedule. The
aim of cash management is therefore to have an optimal level of cash by bringing
about a proper synchronisation of inflows and outflows, and to check the spells of
cash deficits and cash surpluses.
The efficiency of cash management can be augmented by controlling a few

important factors:
Prompt billing and mailing
There is a time lag between the dispatch of goods and preparation of invoice.
Reduction of this gap will bring in early remittances.
Collection of cheques and remittances of cash
Generally, we find a delay in the receipt of cheques and their deposits in banks.
The delay can be reduced by speeding up the process of collecting and depositing
cash or other instruments from customers.
Float
The concept of float helps firms to a certain extent in cash management. Float
arises because of the practice of banks not crediting the firms account in its books
when a cheque is deposited by it and not debiting the firms account in its books
when a cheque is issued by it, until the cheque is cleared and cash is realised or
paid respectively.
Baumol model
The Baumol model helps in determining the minimum amount of cash that a
manager can obtain by converting securities into cash. Baumol model is an
approach to establish a firms optimum cash balance under certainty. As such,
firms attempt to minimise the sum of the cost of holding cash and the cost of
converting marketable securities to cash. Baumol model of cash management
trades off between opportunity cost or carrying cost or holding cost and the
transaction cost.
The Baumol model is based on the following assumptions:
The firm is able to forecast its cash requirements in an accurate way.
The firms payouts are uniform over a period of time.
The opportunity cost of holding cash is known and does not change with
time.
The firm will incur the same transaction cost for all conversions of
securities into cash.
A company sells securities and realises cash, and this cash is used to make
payments. As the cash balance decreases and reaches a point, the finance manager
replenishes its cash balance by selling marketable securities available with it and
this pattern continues.
Cash balances are refilled and brought back to normal levels by the sale of
securities. The average cash balance is C/2. The firm buys securities as and when
it has above-normal cash balances. This pattern is explained in the figure.