Master of Business Administration- MBA Semester 2

MB0045 – Financial Management - 4 Credits

(Book ID: B1134)
Assignment Set- 1

Q.1 Write the short notes on

1. Financial management
2. Financial planning
3. Capital structure
4. Cost of capital
5. Trading on equity.

Financial management

Financial Management is the art and science of managing money. Regulatory and economic
environments have undergone drastic changes due to liberalisation and globalisation of Indian
economy. This has changed the profile of Indian finance managers. Indian financial managers
have transformed themselves from licensed raj managers to well-informed dynamic proactive
managers capable of taking decisions of complex nature.

Traditionally, financial management was considered a branch of knowledge with focus on the
procurement of funds. Instruments of financing, formation, merger and restructuring of firms and
legal and institutional frame work occupied the prime place in this traditional approach.

The modern approach transformed the field of study from the traditional narrow approach to the
most analytical nature. The core of modern approach evolved around the procurement of the
least cost funds and its effective utilisation for maximisation of share holders’ wealth.

The three core elements of financial management are:

a. Financial Planning

Financial Planning is to ensure the availability of capital investments to acquire the real assets.
Real assets are land and buildings, plants and equipments. Capital investments are required for
establishing and running the business smoothly.

b. Financial Control
Financial Control involves managing the costs and expenses of a business. For example, it
includes taking decisions on the routine aspects of day to day management of collecting money
due from the firms’ customers and making payments to the suppliers of various resources.

c. Financial Decisions

· Decision needs to be taken on the sources from which the funds required for the capital
investments could be obtained.

· There are two sources of funds – debt and equity. In what proportion the funds are to be
obtained from these sources is to be decided for formulating the financing plan.

Financial planning

Liberalisation and globalisation policies initiated by the government have changed the dimension
of business environment. Therefore, for survival and growth, a firm has to execute planned
strategies systematically. To execute any strategic plan, resources are required. Resources may
be manpower, plant and machinery, building, technology or any intangible asset.

To acquire all these assets, financial resources are essentially required. Therefore the finance
manager of a company must have both long-range and short-range financial plans. Integration of
both these plans is required for the effective utilisation of all the resources of the firm.

The long-range plans must include:

· Funds required for executing the planned course of action

· Funds available at the disposal of the company

· Determination of funds to be procured from outside sources

Financial planning has the following objects:

Let us start with defining financial planning as an essential objective.

Financial planning is a process by which funds required for each course of action is decided.

A financial plan has to consider capital structure, capital expenditure and cash flow. Decisions on
the composition of debt and equity must be taken.

Financial planning or financial plan indicates:

· The quantum of funds required to execute business plans

· Composition of debt and equity, keeping in view the risk profile of the existing business, new
business to be taken up and the dynamics of capital market conditions
· Formulation of policies, giving effect to the financial plans under consideration

Capital structure

The capital structure of a company refers to the mix of long-term finances used by the firm. In
short, it is the financing plan of the company. With the objective of maximising the value of the
equity shares, the choice should be that pattern of using of debt and equity in a proportion which
will lead towards achievement of the firm’s objective. The capital structure should add value to
the firm. Financing mix decisions are investment decisions and have no impact on the operating
earnings of the firm. Such decisions influence the firm’s value through the earnings available to
the shareholders.

The value of a firm is dependent on its expected future earnings and the required rate of return.
The objective of any company is to have an ideal mix of permanent sources of funds in a manner
that it will maximise the company’s market price. The proper mix of funds is referred to as
optimal capital structure. The capital structure decisions include debt-equity mix and dividend
decisions. Both these have an effect on the EPS.

The features of an ideal capital structure are (see figure 7.1) – profitability, flexibility, control
and solvency.

Figure 7.1: Features of an ideal capital structure

Profitability

The firm should make maximum use of leverage at a minimum cost.

Flexibility

An ideal capital structure should be flexible enough to adapt to changing conditions. It should be
in a position to raise funds at the shortest possible time and also repay the money it borrowed, if
they appear to be expensive.

This is possible only if the company’s lenders have not put forth any conditions like restricting
the company from taking further loans, no restrictions placed on the assets usage or laying a
restriction on early repayments. In other words, the finance authorities should have the power to
take decisions on the basis of the circumstances warrant.

Control

The structure should have minimum dilution of control.

Solvency

Use of excessive debt threatens the very existence of the company. Additional debt involves
huge repayments. Loans with high interest rates are to be avoided however attractive some
investment proposals look. Some companies resort to issue of equity shares to repay their debt
for equity holders do not have a fixed rate of dividend

Cost of capital

Capital structure is the mix of long-term sources of funds like debentures, loans, preference
shares, equity shares and retained earnings in different ratios.

It is always advisable for companies to plan their capital structure. Decisions taken by not
assessing things in a correct manner may jeopardise the very existence of the company. Firms
may prosper in the short-run by not indulging in proper planning but ultimately may face
problems in future. With unplanned capital structure, they may also fail to economise the use of
their funds and adapt to the changing conditions.

The Cost of Different Sources of Finance is:

 Cost of debentures

 Cost of term loans

 Cost of preference capital

 Cost of equity capital

 Cost of retained earnings

 Capital asset pricing model approach

 Earnings price ratio approach

Trading on equity

Trading on equity is sometimes referred to as financial leverage or the leverage factor.

Trading on equity occurs when a corporation uses bonds, other debt, and preferred stock to
increase its earnings on common stock. For example, a corporation might use long term debt to
purchase assets that are expected to earn more than the interest on the debt. The earnings in
excess of the interest expense on the new debt will increase the earnings of the
corporation’s common stockholders. The increase in earnings indicates that the corporation was
successful in trading on equity.

If the newly purchased assets earn less than the interest expense on the new debt, the earnings of
the common stockholders will decrease.
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 company’s 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
firm’s 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 company’s income stream. Such
expenses have nothing to do with the firm’s performance and earnings and should be paid off
regardless of the amount of earnings before income and tax (EBIT).

It is the firm’s 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. Un-favourable 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”.

Q.2 a. Write the features of interim divined and also write the factors
Influencing divined policy?

b. What is reorder level ?

A dividend declared before a firm's annual earnings and dividend-paying ability are accurately
known by its management. An interim dividend is ordinarily paid in each of the first three
quarters of the fiscal year. These payments are followed by a final dividend at the time that
earnings can be accurately determined.

Dividend to be deposited in a separate bank account — S. 205(1A) :

Ss.(1A) of S. 205 provides that the Board of directors may declare interim dividend. In the
case of interim dividend there is no declaration of dividend, but there is payment of
dividend by the Board without its declaration. Hence the word ‘declare’ may in the context
be construed as ‘pay’ giving thereby statutory sanction to the payment of interim dividend
as provided in Regulation 86 of Table A. The sub-section further provides that the amount
of dividend including interim dividend shall be deposited in a separate bank account within
five days from the date of declaration of ‘such dividend’ i.e., dividend including interim
dividend referred to in the earlier part of the sub-section. Both the final dividend and the
interim dividend are to be deposited in a separate bank account within the period afore-said.
Ramaiya’s observation that “the interim dividend shall be deposited in a separate bank
account” (Ramaiya’s Guide to the Companies Act, 15th edition, p. 1789) is not correct and
needs revision.

As the interim dividend is paid by the Board without any declaration of dividend, it may be
deposited in a separate bank account within five days from the date on which the Board
resolves to pay such dividend. The Board has no doubt the power to rescind the resolution
before such dividend is paid. In such case the provision regarding the deposit of such
dividend in a separate bank account would become ineffective or otiose in law. Further
since ‘dividend’ as defined by S. 2(14A) includes interim dividend, the expression
‘including interim dividend’ after the word ‘dividend’ used in Ss.(1A) as well as Ss.(1B)
seems unnecessary.

Ss.(1A) of S. 205 is not happily worded and needs amendment to bring out clearly the
intent of Government in the matter.
Payment of dividend out of amount deposited — S. 205(1B) :
Ss.(1B) of S. 205 provides that the amount of dividend includ-ing interim dividend so
deposited U/ss.(1A) shall be used for payment of interim dividend. The amount of the final
dividend and the interim dividend are to be used for payment of such dividend. The
expression ‘interim dividend’ used at the end of the sub-section is obviously an inadvertent
error. Having regard to the intention of Parliament the said expression should be read as
‘such dividend’, i.e., the final dividend or the interim dividend, as the case may be. This is
permissible in view of the well accepted rule of con-struction of statutes enunciated by
Denning L J in Seaford Courts Estates Ltd. v. Asher, (1949) 2 All E.R. 155, 154 (CA),
namely, that “A judge should not alter the material of which the Act is woven, but he can
and should iron out the creases.”
Provisions applicable to interim dividend — S. 205(2C) :
Ss.(1C) of S. 205 provides that the provisions contained in S. 205, S. 205A, S. 205C, S.
206, S. 206A and S. 207 shall, as far as may be, also apply to any interim dividend. These
Sections are to be applied to interim dividend, so far as they may be applicable or relevant
for the purpose. Each and every provision contained in these Sections would not be
applicable to interim dividends since final dividend and interim dividend have distinct
features and powers for the purpose are vested in different authorities.
Dividend to be paid within 30 days — S. 205A(1) :
S. 205A(1) provides for the payment of dividend declared by a company within thirty days
from the date of declaration. This provision is applicable to the final dividend declared by
the company in general meeting. It is difficult to apply this provision in the case of the
interim dividend, where payment of the dividend is made without its declaration. However,
in view of the definition of ‘dividend’ contained in S. 2(14A) as well as S. 205(1C)
provisions of S. 205A should be construed as applicable to interim dividend as well. Interim
dividend should be paid within 30 days from the date of the Board’s resolution authorising
payment of such dividend. Dividend is to be paid only to the registered holder of shares or
to his order or to his bankers as provided in S. 206(1)(a). Unpaid or unclaimed dividend,
whether final or interim, must be transferred to the Unpaid Dividend Account of the
company within seven days from the expiry of 30 days from the date of declaration of the
dividend as provided in S. 205A(1). Before the expiry of the said period, the Board may
rescind the resolution for payment of interim dividend. In such a case the question of
transfer of the unpaid or unclaimed interim dividend to the Unpaid Dividend Account
would not arise.
Clause 16 of the Listing Agreement needs amendment :
Clause 16 of the Listing Agreement requires a listed company (a company listed on a stock
exchange) to give 42 days’ notice to the stock exchange for fixing the record date or for the
book closure. This can be done when the actual date of dividend proposed to be declared is
made known as required by stock exchange regulations. In respect of shares held in the
demat form the stock exchange requires 30 days’ notice for purposes aforesaid. For these
purposes stock exchanges may be required to agree to notice of a shorter period. Clause 16
requires to be duly amended by reducing the period of notice of book closure from 42 days
to a shorter period. The matter needs to be taken up by the Department with the Securities
and Exchange Board of India for necessary action.
Penalty for failure to distribute dividend within thirty days :
S. 207 provides for penalty for default to distribute dividend within thirty days from the
date of declaration. Besides imprison-ment for a term upto three years and a fine of
Rs.1000/- for every day during which the default continues, the company is liable to pay
interest at the rate of 18% per annum during the period for which such default continues.
Such interest must enure to the benefit of the members of the company. See in this
connection the provision contained in S. 205A(4) regarding default in transferring unpaid
dividend to the unpaid dividend account of the company.
Tax on interim dividend :
A mere resolution of the Board of directors to pay a certain amount as interim dividend
does not create a debt enforce-able against the company. Interim dividend is taxable as the
income of the year in which the dividend warrant is actually issued. S. 205(1A) authorises
the Board of directors to declare interim dividend and not to pay interim dividend as
provided in Regulation 86 of Table A. How-ever, that makes no difference in the true
character of the right arising in favour of the shareholders of the company on the exercise of
the power by the Board. [J. Dalmia v. CIT, (1964) 43 ITR 83, 87 (SC). See also Potel v.
IRC, (1971) 46 T.C. 658, 667; CIT v. Godfrey Philips, (1986) 161 ITR 684]. The above
principle is now given statutory effect by clause (b) of S. 8 of the Income-tax Act, 1961,
which makes interim dividend taxable as the income of the year in which it is
‘unconditionally made available’ (i.e. paid) to the shareholder. Dividend is taxable in the
hands of the share-holder as recipient subject to deduction u/s.80L upto the ceiling of
Rs.9,000/-. With effect from 1-6-2002 tax on dividend is required to be deducted at source.
No deduction shall, however, be made in the case of a shareholder, being an individual, if
the amount of such dividend distributed or paid during the financial year by the company to
the shareholder does not exceed Rs.1,000/-. [S. 194].

The factors influencing the dividend policy are:

1. Stability of Earnings. The nature of business has an important bearing on the dividend
policy. Industrial units having stability of earnings may formulate a more consistent
dividend policy than those having an uneven flow of incomes because they can predict
easily their savings and earnings. Usually, enterprises dealing in necessities suffer less from
oscillating earnings than those dealing in luxuries or fancy goods.

2. Age of corporation. Age of the corporation counts much in deciding the dividend policy.
A newly established company may require much of its earnings for expansion and plant
improvement and may adopt a rigid dividend policy while, on the other hand, an older
company can formulate a clear cut and more consistent policy regarding dividend.

3. Liquidity of Funds. Availability of cash and sound financial position is also an

important factor in dividend decisions. A dividend represents a cash outflow, the greater the
funds and the liquidity of the firm the better the ability to pay dividend. The liquidity of a
firm depends very much on the investment and financial decisions of the firm which in turn
determines the rate of expansion and the manner of financing. If cash position is weak,
stock dividend will be distributed and if cash position is good, company can distribute the
cash dividend.

4. Extent of share Distribution. Nature of ownership also affects the dividend decisions. A
closely held company is likely to get the assent of the shareholders for the suspension of
dividend or for following a conservative dividend policy. On the other hand, a company
having a good number of shareholders widely distributed and forming low or medium
income group, would face a great difficulty in securing such assent because they will
emphasise to distribute higher dividend.

5. Needs for Additional Capital. Companies retain a part of their profits for strengthening
their financial position. The income may be conserved for meeting the increased
requirements of working capital or of future expansion. Small companies usually find
difficulties in raising finance for their needs of increased working capital for expansion
programmes. They having no other alternative, use their ploughed back profits. Thus, such
Companies distribute dividend at low rates and retain a big part of profits.

6. Trade Cycles. Business cycles also exercise influence upon dividend Policy. Dividend
policy is adjusted according to the business oscillations. During the boom, prudent
management creates food reserves for contingencies which follow the inflationary period.
Higher rates of dividend can be used as a tool for marketing the securities in an otherwise
depressed market. The financial solvency can be proved and maintained by the companies
in dull years if the adequate reserves have been built up.

7. Government Policies. The earnings capacity of the enterprise is widely affected by the
change in fiscal, industrial, labour, control and other government policies. Sometimes
government restricts the distribution of dividend beyond a certain percentage in a particular
industry or in all spheres of business activity as was done in emergency. The dividend
policy has to be modified or formulated accordingly in those enterprises.
8. Taxation Policy. High taxation reduces the earnings of he companies and consequently
the rate of dividend is lowered down. Sometimes government levies dividend-tax of
distribution of dividend beyond a certain limit. It also affects the capital formation. N India,
dividends beyond 10 % of paid-up capital are subject to dividend tax at 7.5 %.

9. Legal Requirements. In deciding on the dividend, the directors take the legal
requirements too into consideration. In order to protect the interests of creditors an
outsiders, the companies Act 1956 prescribes certain guidelines in respect of the
distribution and payment of dividend. Moreover, a company is required to provide for
depreciation on its fixed and tangible assets before declaring dividend on shares. It proposes
that Dividend should not be distributed out of capita, in any case. Likewise, contractual
obligation should also be fulfilled, for example, payment of dividend on preference shares
in priority over ordinary dividend.

10. Past dividend Rates. While formulating the Dividend Policy, the directors must keep
in mind the dividend paid in past years. The current rate should be around the average past
rat. If it has been abnormally increased the shares will be subjected to speculation. In a new
concern, the company should consider the dividend policy of the rival organisation.

11. Ability to Borrow. Well established and large firms have better access to the capital
market than the new Companies and may borrow funds from the external sources if there
arises any need. Such Companies may have a better dividend pay-out ratio. Whereas
smaller firms have to depend on their internal sources and therefore they will have to built
up good reserves by reducing the dividend pay out ratio for meeting any obligation
requiring heavy funds.

12. Policy of Control. Policy of control is another determining factor is so far as dividends
are concerned. If the directors want to have control on company, they would not like to add
new shareholders and therefore, declare a dividend at low rate. Because by adding new
shareholders they fear dilution of control and diversion of policies and programmes of the
existing management. So they prefer to meet the needs through retained earing. If the
directors do not bother about the control of affairs they will follow a liberal dividend policy.
Thus control is an influencing factor in framing the dividend policy.

13. Repayments of Loan. A company having loan indebtedness are vowed to a high rate of
retention earnings, unless one other arrangements are made for the redemption of debt on
maturity. It will naturally lower down the rate of dividend. Sometimes, the lenders (mostly
institutional lenders) put restrictions on the dividend distribution still such time their loan is
outstanding. Formal loan contracts generally provide a certain standard of liquidity and
solvency to be maintained. Management is bound to hour such restrictions and to limit the
rate of dividend payout.

14. Time for Payment of Dividend. When should the dividend be paid is another
consideration. Payment of dividend means outflow of cash. It is, therefore, desirable to
distribute dividend at a time when is least needed by the company because there are peak
times as well as lean periods of expenditure. Wise management should plan the payment of
dividend in such a manner that there is no cash outflow at a time when the undertaking is
already in need of urgent finances.

15. Regularity and stability in Dividend Payment. Dividends should be paid regularly
because each investor is interested in the regular payment of dividend. The management
should, inspite of regular payment of dividend, consider that the rate of dividend should be
all the most constant. For this purpose sometimes companies maintain dividend
equalization Fund.

Reorder Level

This is that level of materials at which a new order for supply of materials is to be placed.
In other words, at this level a purchase requisition is made out. This level is fixed
somewhere between maximum and minimum levels. Order points are based on usage
during time necessary to requisition order, and receive materials, plus an allowance for
protection against stock out.

The order point is reached when inventory on hand and quantities due in are equal to the
lead time usage quantity plus the safety  stock quantity.

Formula of Re-order Level or Ordering Point:

The following two formulas are used for the calculation of reorder level or point.

[ Ordering point or re-order level = Maximum daily or weekly or monthly usage ×

Lead time ]

The above formula is used when usage and lead time are known with certainty; therefore,
no safety stock is provided. When safety stock is provided then the following formula will
be applicable:

[ Ordering point or re-order level = Maximum daily or weekly or monthly usage ×

Lead time + Safety stock ]

Examples:

Example 1:

Minimum daily requirement 800 units

Time required to receive emergency supplies 4 days
Average daily requirement 700 units
Minimum daily requirement 600 units
Time required for refresh supplies One month (30 days)
Calculate ordering point or re-order level

Calculation:

Ordering point = Ordering point or re-order level = Maximum daily or weekly or monthly
usage ×  Lead time

= 800 × 30

= 24,000 units
Example 2:

Tow types of materials are used as follows:  

Minimum usage 20 units per week each

Maximum usage 40 units per week each
Normal usage 60 units per week each
Re-order period or Lead time
Material A: 3 to 5 weeks
Material B 2 to 4 weeks

Calculate re order point for two types of materials

Calculation:

Ordering point or re-order level = Maximum daily or weekly or monthly usage × 

Maximum re-order period
A: 60 × 5 = 300 units
B: 60 × 4 = 240 units

Q.3 Sales Rs.400, 000 less returns Rs 10, 000, Cost of Goods Sold Rs 300,000,
Administration and selling expenses Rs.20, 000, Interest on loans Rs.5000, (10 Marks)
Income tax Rs.10000, preference dividend Rs. 15,000, Equity Share Capital

Rs.100, 000 @Rs. 10 per share. Find EPS.

Answer.

400,00
Sales 0
390,00
Less Returns 10,000 0
 Less
COGS 30,000
S&A 20,000
Int on
Loan 5,000
325,00
IT 10,000 0

Div 15,000
100,00
ESC 0 @ 10/-
NPAT - Pref
Share Div
No of Shares

NPAT 55,000
less Pref Share
Div 15,000 40,000

=
EPS 40,000 Rs.4/-
10,000

Q.4 What are the techniques of evaluation of investment?

Steps involved in the evaluation of any investment proposal are:

· Estimation of cash flows both inflows and outflows occurring at different stages of project
life cycle

· Examination of the risk profile of the project to be taken up and arriving at the required
rate of return

· Formulation of the decision criteria

8.8.1 Estimation of cash flows

Estimating the cash flows associated with the project under consideration is the most
difficult and crucial step in the evaluation of an investment proposal. Estimation is the
result of the team work of many professionals in an organisation.

· Capital outlays are estimated by engineering departments after examining all aspects of
production process

· Marketing department on the basis of market survey forecasts the expected sales revenue
during the period of accrual of benefits from project executions

· Operating costs are estimated by cost accountants and production engineers

· Incremental cash flows and cash out flow statement is prepared by the cost accountant on
the basis of the details generated in the above steps

The ability of the firm to forecast the cash flows with reasonable accuracy lies at the root of
the success of the implementation of any capital expenditure decision.

8.8.2 Estimation of incremental cash flows

Investment (capital budgeting) decision requires the estimation of incremental cash flow
stream over the life of the investment. Incremental cash flows are estimated on tax basis.

Incremental cash flows stream of a capital expenditure decision has three components.

· Initial cash outlay (Initial investment)

Initial cash outlay to be incurred is determined after considering any post tax cash inflows.
In replacement decisions existing old machinery is disposed of and a new machinery
incorporating the latest technology is installed in its place.

On disposal of existing old machinery the firm has a cash inflow. This cash inflow has to be
computed on post tax basis. The net cash out flow (total cash required for investment in
capital assets minus post tax cash inflow on disposal of the old machinery being replaced by
a new one) therefore is the incremental cash outflow. Additional net working capital
required on implementation of new project is to be added to initial investment.

· Operating cash inflows

Operating cash inflows are estimated for the entire economic life of investment (project).
Operating cash inflows constitute a stream of inflows and outflows over the life of the
project. Here also incremental inflows and outflows attributable to operating activities are
considered. Any savings in cost on installation of a new machinery in the place of the old
machinery will have to be accounted on post tax basis. In this connection incremental cash
flows refer to the change in cash flows on implementation of a new proposal over the
existing positions.

· Terminal cash inflows

At the end of the economic life of the project, the operating assets installed will be disposed
off. It is normally known as salvage value of equipments. This terminal cash inflows are
computed on post tax basis.

Prof. Prasanna Chandra in his book Financial Management (Tata McGraw Hill, published
in 2007) has identified certain basic principles of cash flow estimation. The knowledge of
these principles will help a student in understanding the basics of computing incremental
cash flows.

The basic principles of cash flow estimation, by Prof. Prasanna Chandra, are (see figure
8.2) – Separation principle, Increment principle, Post-tax principle and Consistency
principle.

Figure 8.2: Principles of Prof. Prasanna Chandra

Separation principle

The essence of this principle is the necessity to treat investment element of the project
separately (i.e. independently) from that of financing element. The financing cost is
computed by the cost of capital. Cost of capital is the cut off rate and rate of return expected
on implementation of the project. Therefore, we compute separately cost of funds for
execution of project through the financing mode. The rate of return expected on
implementation if the project is arrived at by the investment profile of the projects.
Therefore, interest on debt is ignored while arriving at operating cash inflows.
The following formula is used to calculate profit after tax

EBIT = earnings (profit) before interest and taxes

t = tax rate

Incremental principle

Incremental principle says that the cash flows of a project are to be considered in
incremental terms. Incremental cash flows are the changes in the firms total cash flows
arising directly from the implementation of the project. Keep the following in mind while
determining incremental cash flows.

· Ignore sunk costs

Sunk costs are costs that cannot be recovered once they have been incurred. Therefore, sunk
costs are ignored when the decisions on project under consideration is to be taken.

· Opportunity costs

If the firm already owns an asset or a resource which could be used in the execution of the
project under consideration, the asset or resource has an opportunity cost. The opportunity
cost of such resources will have to be taken into account in the evaluation of the project for
acceptance or rejection.

Q.5 What are the problems associated with inadequate working capital?

Working capital may be regarded as the life blood of business. Working capital is of major
importance to internal and external analysis because of its close relationship with the
current day-to-day operations of a business. Every business needs funds for two purposes.

 Long term funds are required to create production facilities through purchase of fixed
assets such as plants, machineries, lands, buildings & etc
 Short term funds are required for the purchase of raw materials, payment of wages, and
other day-to-day expenses. . It is otherwise known as revolving or circulating capital

It is nothing but the difference between current assets and current liabilities. i.e. Working
Capital = Current Asset – Current Liability.
Businesses use capital for construction, renovation, furniture, software, equipment, or
machinery. It is also commonly used to purchase inventory, or to make payroll. Capital is
also used often by businesses to put a down payment down on a piece of commercial real
estate. Working capital is essential for any business to succeed. It is becoming increasingly
important to have access to more working capital when we need it.

Importance of Adequate Working Capital

A business firm must maintain an adequate level of working capital in order to run its
business smoothly. It is worthy to note that both excessive and inadequate working capital
positions are harmful. Working capital is just like the heart of business. If it becomes weak,
the business can hardly prosper and survive. No business can run successfully without an
adequate amount of working capital.

Danger of inadequate working capital

When working capital is inadequate, a firm faces the following problems.

Fixed Assets cannot efficiently and effectively be utilized on account of lack of sufficient
working capital. Low liquidity position may lead to liquidation of firm. When a firm is
unable to meets its debts at maturity, there is an unsound position. Credit worthiness of the
firm may be damaged because of lack of liquidity. Thus it will lose its reputation. There by,
a firm may not be able to get credit facilities. It may not be able to take advantages of cash
discount.

Disadvantages of Redundant or Excessive Working Capital

1. Excessive Working Capital means ideal funds which earn no profits for the business and
hence the business cannot earn a proper rate of return on its investments.

2. When there is a redundant working capital, it may lead to unnecessary purchasing and
Accumulation of inventories causing more chances of theft, waste and losses.

3. Excessive working capital implies excessive debtors and defective credit policy which

May cause higher incidence of bad debts.

4. It may result into overall inefficiency in the organization.

5. When there is excessive working capital, relations with banks and other financial

institutions may not be maintained.

6. Due to low rate of return on investments, the value of shares may also fall.

7. The redundant working capital gives rise to speculative transactions.

Disadvantages or Dangers of Inadequate Working Capital

1. A concern which has inadequate working capital cannot pay its short-term liabilities

in time. Thus, it will lose its reputation and shall not be able to get good credit facilities.

2. It cannot buy its requirements in bulk and cannot avail of discounts, etc.

3. It becomes difficult for the firm to exploit favorable market conditions and undertake
profitable projects due to lack of working capital.

4. The firm cannot pay day-to-day expenses of its operations and its creates inefficiencies,
increases costs and reduces the profits of the business.

5. It becomes impossible to utilize efficiently the fixed assets due to non-availability of

liquid funds.

6. The rate of return on investments also falls with the shortage of working capital.

Disadvantages or Dangers of Inadequate or Short Working Capital

1. Can’t pay off its short-term liabilities in time.

2. Economies of scale are not possible.
3. Difficult for the firm to exploit favorable market situations
4. Day-to-day liquidity worsens
5. Improper utilization the fixed assets and ROA/ROI falls sharply

Q.6 What is leverage? Compare and Contrast between operating leverage and financial
leverage

A company uses different sources of financing to fund its activities. These sources can be
classified as those which carry a fixed rate of return and those whose returns vary. The
fixed sources of finance have a bearing on the return on shareholders. Borrowing funds as
loans have an impact on the return on shareholders and this is greatly affected by the
magnitude of borrowing in the capital structure of a firm.

Leverage is the influence of power to achieve something. The use of an asset or source of
funds for which the company has to pay a fixed cost or fixed return is termed as leverage.
Leverage is the influence of an independent financial variable on a dependent variable. It
studies how the dependent variable responds to a particular change in independent variable.

Operating Leverage
Operating leverage arises due to the presence of fixed operating expenses in the firm’s
income flows. A company’s operating costs can be categorised into three main sections as
shown in figure 6.2 – fixed costs, variable costs and semi-variable costs.

Figure 6.2: Classification of operating costs

 Fixed costs

Fixed costs are those which do not vary with an increase in production or sales activities for
a particular period of time. These are incurred irrespective of the income and value of sales
and generally cannot be reduced. Financial Management Unit 6 Sikkim Manipal University
Page No. 108
For example, consider that a firm named XYZ enterprises is planning to start a new
business. The main aspects that the firm should concentrate at are salaries to the employees,
rents, insurance of the firm and the accountancy costs. All these aspects relate to or are
referred to as ―fixed costs‖.
 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.
For example, we have discussed about fixed costs in the above context. Now, the firm has
to concentrate on some other features like cost of labour, amount of raw material and the
administrative expenses. All these features relate to or are referred to as ―Variable costs‖,
as these costs are not fixed and keep changing depending upon the conditions.
 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
firm’s activities.
For example, after considering both the fixed costs and the variable costs, the firm should
concentrate on some-other features like production cost and the wages paid to the workers
which act at some point of time as fixed costs and can also shift to variable costs. These
features relate to or are referred to as ―Semi-variable costs‖.

The operating leverage is the firm’s ability to use fixed operating costs to increase the
effects of changes in sales on its earnings before interest and taxes (EBIT). Operating
leverage occurs any time a firm has fixed costs. The percentage change in profits with a
change in volume of sales is more than the percentage change in volume.

As operating leverage can be favourable or unfavourable, high risks are attached to higher
degrees of leverage. As DOL considers fixed expenses, a larger amount of these expenses
increases the operating risks of the company and hence a higher degree of operating
leverage. Higher operating risks can be taken when income levels of companies are rising
and should not be ventured into when revenues move southwards.

Application of Operating Leverage

The applications of operating leverage are as follows:
 Business risk measurement
 Production planning

Measurement of business risk

Risk refers to the uncertain conditions in which a company performs. A business risk is
measured using the degree of operating leverage (DOL) and the formula of DOL is:
DOL = {Q(S–V)} / {Q(S–V)–F}
Greater the DOL, more sensitive is the earnings before interest and tax (EBIT) to a given
change in unit sales. A high DOL is a measure of high business risk and vice versa.
Production planning

A change in production method increases or decreases DOL. A firm can change its cost
structure by mechanising its operations, thereby reducing its variable costs and increasing
its fixed costs. This will have a positive impact on DOL. This situation can be justified only
if the company is confident of achieving a higher amount of sales thereby increasing its
earnings.

Financial Leverage
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 company’s 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 firm’s 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 company’s income stream.
Such expenses have nothing to do with the firm’s performance and earnings and should be
paid off regardless of the amount of earnings before income and tax (EBIT).

It is the firm’s 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”.

This example shows that the presence of fixed interest source funds leads to a value more
than that occurs due to proportional change in EPS. The presence of such fixed sources
implies the presence of financial leverage. This can be expressed in a different way. The
degree of financial leverage (DFL) is a more precise measurement. It examines the effect of
the fixed sources of funds on EPS.
DFL = %change in EPS
%change in EBIT
DFL={ΔEPS/EPS} ÷ {ΔEBIT/EBIT}
Or DFL = EBIT ÷ {EBIT—I—{Dp/(1-T)}}
I is Interest, Dp is dividend on preference shares, T is tax rate.

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 commitmen

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 firm’s 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 favorable till such time that the rate of return exceeds
the rate of return obtained when no debt is used.
 Master of Business Administration- MBA Semester 2
MB0045 – Financial Management
Assignment Set- 2

Q. 1 Discuss the three broad areas of Financial Decision Making

Financial Management of a firm is concerned with procurement and effective utilisation of

funds for the benefit of its stakeholders. It embraces all those managerial activities that are
required to procure funds at the least cost and their effective deployment.

The most admired Indian companies are Reliance and Infosys. They have been rated well
by the financial analysts on many crucial aspects that enabled them to create value for its
share holders. They employ the best technology, produce good quality goods or render
services at the least cost and continuously contribute to the shareholders’ wealth. The three
core elements of financial management are:

Financial Planning

Financial Planning is to ensure the availability of capital investments to acquire the real
assets. Real assets are land and buildings, plants and equipments. Capital investments are
required for establishing and running the business smoothly.
Objectives of financial planning
Let us start with defining financial planning as an essential objective.
Financial planning is a process by which funds required for each course of action is
decided.
A financial plan has to consider capital structure, capital expenditure and cash flow.
Decisions on the composition of debt and equity must be taken.
Financial planning or financial plan indicates:
 The quantum of funds required to execute business plans
 Composition of debt and equity, keeping in view the risk profile of the existing business,
new business to be taken up and the dynamics of capital market conditions
 Formulation of policies, giving effect to the financial plans under consideration

Benefits of financial planning

Financial planning also helps firms in the following ways.
 A financial plan is at the core of value creation process. A successful value creation
process can effectively meet the bench-marks of investor‟s expectations.
 Financial planning ensures effective utilisation of the funds. To manage shortage of
funds, planning helps the firms to obtain funds at the right time, in the right quantity and at
the least cost as per the requirements of finance emerging opportunities. Surplus is
deployed through well planned treasury management. Ultimately, the productivity of assets
is enhanced.
 Effective financial planning provides firms the flexibility to change the composition of
funds that constitute its capital structure in accordance with the changing conditions of the
capital market.
 Financial planning helps in formulation of policies and instituting procedures for
elimination of wastages in the process of execution of strategic plans.
 Financial planning helps in reducing the operating capital of a firm. Operating capital
refers to the ratio of capital employed to the sales generated. Maintaining the operating
capability of the firm through the evolution of scientific replacement schemes for plant and
machinery and other fixed assets will help the firm in reducing its operating capital.
A study of annual reports of Dell computers will throw light on how Dell strategically
minimised the operating capital required to support sales. Such companies are admired by
investing community.

Financial Control
Financial Control involves managing the costs and expenses of a business. For example, it
includes taking decisions on the routine aspects of day to day management of collecting
money due from the firms’ customers and making payments to the suppliers of various
resources.

Financial Decisions
 Decision needs to be taken on the sources from which the funds required for the capital
investments could be obtained.
 There are two sources of funds - debt and equity. In what proportion the funds are to be
obtained from these sources is to be decided for formulating the financing plan.
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 company’s 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.

Caselet
The interest rate on loan taken is 12%, tax rate applicable to the company is 50%, and then
when the company pays Rs.12 as interest to the lender, taxable income of the company will
be reduced by Rs.12.
In other words, when the actual cost is 12% with a tax rate of 50%, the effective cost
becomes 6%. Therefore, the debt is cheap. But, every instalment of debt brings along with it
corresponding insolvency risk.
Another thing notable in connection to this is that the firm cannot avoid its obligation to pay
interests and loan instalments to its lenders and debentures.

An investor in a company’s 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 company’s 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.

Q 2. What is the future value of an annuity and state the formulae for future value of an
annuity

Future value of an annuity

Annuity refers to the periodic flows of equal amounts. These flows can be either termed
as receipts or payments.

Example
If you have subscribed to the Recurring Deposit Scheme of a bank requiring you to pay
Rs. 5000 annually for 10 years, this stream of pay-outs can be called “Annuities”.
Annuities require calculations based on regular periodic contribution of a fixed sum of
money.

The future value of a regular annuity for a period of n years at “i” rate of interest can be
FVAn = A { (1 + i)n-1/i }

summed up as under:

Where, FVAn = Accumulation at the end of n years

i = Rate of interest
n = Time horizon or no. of years
A = Amount invested at the end of every year for n years

The expression is called the Future Value Interest Factor for Annuity (FVIFA). This
represents the accumulation of Re.1 invested at the end of every year for n number of
years at “i” rate of interest. From the tables 3.4 and 3.5, different combinations of “i” and
“n” can be calculated. We just have to multiply the relevant value with A and get the
accumulation in the formula given above. )

Solved Problem
 Mr. Ram Kumar deposits Rs. 3000 at the end of every year for five years into his account.
Interest is being compounded annually at a rate of 5%. Determine the amount of money
he will have at the end of the fifth year.
Solution
The amount of money Mr. Ram Kumar will have at the end of the fifth year is calculated
from the table 3.5.

Table 3.5: Computation

of future value of
annuity Amount Number of Compounded FV
invested years interest factors in
(Rs) compounded from tables Rs.
End of year
1 2000 4 1.216 2432
2 2000 3 1.158 2316
3 2000 2 1.103 2206
4 2000 1 1.050 2100
5 2000 0 1.000 2000

Amount at the end of the fifth year 11054

OR
Refer FVIFA table to compute the value at the end of 5th year:
= 2000 * FVIFA (5%, 5y)
= 2000 * 5.526

= Rs. 11052

We notice that we can get the accumulations at the end of n period using the tables.
Calculations for a long time horizon are easily done with the help of reference tables.
Annuity tables are widely used in the field of investment banking as ready beckoners.

Q.3 The equity stock of ABC Ltd is currently selling for Rs 30 per share. The dividend
expected next year is Rs 2.00. the investors required rate of return on this stock is 15 per
cent. If the constant growth model applies to ABC Ltd, What is the expected growth rate?

Formula to be used to resolve this problem

P0=D1/Ke-g

In this case,

P0 = Price of One share = Rs. 30

Ke=Required rate of return on the equity share = 15% = 0.15

D1=Expected dividend after one year = Rs. 2

g = growth rate = ?

Hence,

P0=D1/Ke-g

Ke-g = D1/P0

0.15-g = 2/30

0.15-g = 0.0666

g=0.15-0.0666

g = 0.0834
 Hence Growth Rate of ABC Ltd = 8.34%

Q.4 State the assumptions underlying the CAPM model and MM model

Capital Asset Pricing Model Approach

This model establishes a relationship between the required rate of return of a security and its
systematic risks expressed as ―β‖. According to this model,
Ke = Rf + β (Rm — Rf)
Where Ke is the rate of return on share,
Rf is the risk free rate of return,
β is the beta of security,
Rm is return on market portfolio

The CAPM model is based on some assumptions, some of which are:

 Investors are risk-averse.

 Investors make their investment decisions on a single-period horizon.
 Transaction costs are low and therefore can be ignored. This translates to assets being
bought and sold in any quantity desired. The only considerations that matter are the price
and amount of money at the investor‘s disposal.
 All investors agree on the nature of return and risk associated with each investment.

MM's key assumptions and the role played by each are:

(1) Unlimited borrowing and lending is available to all market participants at one rate of
interest. Role: makes the cost of personal and corporate borrowing and lending the same.

(2) Individual margin borrowing is secured by the shares purchased, the borrower's
liability is limited to the value of these shares, there are no costs to bankruptcy. Role:
makes the risk of personal and corporate borrowing and lending the same.

(3) All companies can be grouped into equivalent risk classes. Role: enables investors to
identify companies with identical business risk.

(4) Capital markets are perfect. Role: permits investors to easily and costlessly arbitrage
between securities of companies which differ only in their financing mix.

(5) There are no corporate income taxes. Role: prevents the tax code from making debt
financing more valuable by allowing interest and not dividends as a tax deduction.
 (6) Shareholders are indifferent to the form of their returns, all returns are taxed at the
same rate. Role: prevents investors from seeing any difference in value between interest,
dividends, and capital gains.

Q.5 Write the cash flow analysis?

Cash flow analysis is a method of analyzing the financing, investing, and operating activities of a
company. The primary goal of cash flow analysis is to identify, in a timely manner, cash flow
problems as well as cash flow opportunities. The primary document used in cash flow analysis is
the cash flow statement. Since 1988, the Securities and Exchange Commission (SEC) has
required every company that files reports to include a cash flow statement with its quarterly and
annual reports. The cash flow statement is useful to managers, lenders, and investors because it
translates the earnings reported on the income statement—which are subject to reporting
regulations and accounting decisions—into a simple summary of how much cash the company
has generated during the period in question. "Cash flow measures real money flowing into, or out
of, a company's bank account," Harry Domash notes on his Web site, WinningInvesting.com.
"Unlike reported earnings, there is little a company can do to overstate its bank balance."

THE CASH FLOW STATEMENT

A typical cash flow statement is divided into three parts: cash from operations (from daily
business activities like collecting payments from customers or making payments to suppliers and
employees); cash from investment activities (the purchase or sale of assets); and cash from
financing activities (the issuing of stock or borrowing of funds). The final total shows the net
increase or decrease in cash for the period.

Cash flow statements facilitate decision making by providing a basis for judgments concerning
the profitability, financial condition, and financial management of a company. While historical
cash flow statements facilitate the systematic evaluation of past cash flows, projected (or pro
forma) cash flow statements provide insights regarding future cash flows. Projected cash flow
statements are typically developed using historical cash flow data modified for anticipated
changes in price, volume, interest rates, and so on.
To enhance evaluation, a properly-prepared cash flow statement distinguishes between recurring
and nonrecurring cash flows. For example, collection of cash from customers is a recurring
activity in the normal course of operations, whereas collections of cash proceeds from secured
bank loans (or issuances of stock, or transfers of personal assets to the company) is typically not
considered a recurring activity. Similarly, cash payments to vendors is a recurring activity,
whereas repayments of secured bank loans (or the purchase of certain investments or capital
assets) is typically not considered a recurring activity in the normal course of operations.

In contrast to nonrecurring cash inflows or outflows, most recurring cash inflows or outflows
occur (often frequently) within each cash cycle (i.e., within the average time horizon of the cash
cycle). The cash cycle (also known as the operating cycle or the earnings cycle) is the series of
transactions or economic events in a given company whereby:

1. Cash is converted into goods and services.

2. Goods and services are sold to customers.
3. Cash is collected from customers.

To a large degree, the volatility of the individual cash inflows and outflows within the cash cycle
will dictate the working-capital requirements of a company. Working capital generally refers to
the average level of unrestricted cash required by a company to ensure that all stakeholders are
paid on a timely basis. In most cases, working capital can be monitored through the use of a cash
budget.

The other major factors involving in cash flow are:

THE CASH BUDGET

In contrast to cash flow statements, cash budgets provide much more timely information
regarding cash inflows and outflows. For example, whereas cash flow statements are often
prepared on a monthly, quarterly, or annual basis, cash budgets are often prepared on a daily,
weekly, or monthly basis. Thus, cash budgets may be said to be prepared on a continuous rolling
basis (e.g., are updated every month for the next twelve months). Additionally, cash budgets
provide much more detailed information than cash flow statements. For example, cash budgets
will typically distinguish between cash collections from credit customers and cash collections
from cash customers.

A thorough understanding of company operations is necessary to reasonably assure that the

nature and timing of cash inflows and outflows is properly reflected in the cash budget. Such an
understanding becomes increasingly important as the precision of the cash budget increases. For
example, a 360-day rolling budget requires a greater knowledge of a company than a two-month
rolling budget.

While cash budgets are primarily concerned with operational issues, there may be strategic issues
that need to be considered before preparing the cash budget. For example, predetermined cash
amounts may be earmarked for the acquisition of certain investments or capital assets, or for the
liquidation of certain indebtedness. Further, there may be policy issues that need to be considered
prior to preparing a cash budget. For example, should excess cash, if any, be invested in
certificates of deposit or in some form of short-term marketable securities (e.g., commercial
paper or U.S. Treasury bills)?

Generally speaking, the cash budget is grounded in the overall projected cash requirements of a
company for a given period. In turn, the overall projected cash requirements are grounded in the
overall projected free cash flow. Free cash flow is defined as net cash flow from operations less
the following three items:

1. Cash used by essential investing activities (e.g., replacements of critical capital assets).
2. Scheduled repayments of debt.
3. Normal dividend payments.

If the calculated amount of free cash flow is positive, this amount represents the cash available to
invest in new lines of business, retire additional debt, and/or increase dividends. If the calculated
amount of free cash flow is negative, this amount represents the amount of cash that must be
borrowed (and/or obtained through sales of nonessential assets, etc.) in order to support the
strategic goals of the company. To a large degree, the free cash flow paradigm parallels the cash
flow statement.
Using the overall projected cash flow requirements of a company (in conjunction with the free
cash flow paradigm), detailed budgets are developed for the selected time interval within the
overall time horizon of the budget (i.e., the annual budget could be developed on a daily, weekly,
or monthly basis). Typically, the complexity of the company's operations will dictate the level of
detail required for the cash budget. Similarly, the complexity of the corporate operations will
drive the number of assumptions and estimation algorithms required to properly prepare a budget
(e.g., credit customers are assumed to remit cash as follows: 50 percent in the month of sale; 30
percent in the month after sale; and so on). Several basic concepts germane to all cash budgets
are:

1. Current period beginning cash balances plus current period cash inflows less current
period cash outflows equals current period ending cash balances.
2. The current period ending cash balance equals the new (or next) period's beginning cash
balance.
3. The current period ending cash balance signals either a cash flow opportunity (e.g.,
possible investment of idle cash) or a cash flow problem (e.g., the need to borrow cash or
adjust one or more of the cash budget items giving rise to the borrow signal).

RATIO ANALYSIS

In addition to cash flow statements and cash budgets, ratio analysis can also be employed as an
effective cash flow analysis technique. Ratios often provide insights regarding the relationship of
two numbers (e.g., net cash provided from operations versus capital expenditures) that would not
be readily apparent from the mere inspection of the individual numerator or denominator.
Additionally, ratios facilitate comparisons with similar ratios of prior years of the same company
(i.e., intracompany comparisons) as well as comparisons of other companies (i.e., intercompany
or industry comparisons). While ratio analysis may be used in conjunction with the cash flow
statement and/or the cash budget, ratio analysis is often used as a stand-alone, attention-directing,
or monitoring technique.

ADDITIONAL BENEFITS
In his book, Buy Low, Sell High, Collect Early, and Pay Late: The Manager's Guide to
Financial Survival, Dick Levin suggests the following benefits that stem from cash forecasting
(i.e., preparing a projected cash flow statement or cash budget):

1. Knowing what the cash position of the company is and what it is likely to be avoids
embarrassment. For example, it helps avoid having to lie that the check is in the mail.
2. A firm that understands its cash position can borrow exactly what it needs and no more,
there by minimizing interest or, if applicable, the firm can invest its idle cash.
3. Walking into the bank with a cash flow analysis impresses loan officers.
4. Cash flow analyses deter surprises by enabling proactive cash flow strategies.
5. Cash flow analysis ensures that a company does not have to bounce a check before it
realizes that it needs to borrow money to cover expenses. In contrast, if the cash flow
analysis indicates that a loan will be needed several months from now, the firm can turn
down the first two offers of terms and have time for further negotiations.

LOAN APPLICATIONS

Potential borrowers should be prepared to answer the following questions when applying for
loans:

1. How much cash is needed?

2. How will this cash help the business (i.e., how does the loan help the business accomplish
its business objectives as documented in the business plan)?
3. How will the company pay back the cash?
4. How will the company pay back the cash if the company goes bankrupt?
5. How much do the major stakeholders have invested in the company?

Admittedly, it is in the best interest of the potential borrower to address these questions prior to
requesting a loan. Accordingly, in addition to having a well-prepared cash flow analysis, the
potential borrower should prepare a separate document addressing the following information:

1. Details of the assumptions underpinning the specific amount needed should be prepared
(with cross-references to relevant information included in the cash flow analysis).
 2. The logic underlying the business need for the amount of cash requested should be
clearly stated (and cross-referenced to the relevant objectives stated in the business plan
or some other strategic planning document).
3. The company should clearly state what potential assets would be available to satisfy the
claims of the lender in case of default (i.e., the company should indicate the assets
available for the collateralization of the loan).
4. Details of the equity interests of major stakeholders should be stated.

In some cases, the lender may also request personal guarantees of loan repayment. If this is
necessary, the document will need to include relevant information regarding the personal assets
of the major stakeholders available to satisfy the claims of the lender in case of default.

INADEQUATE CAPITALIZATION

Many businesses fail due to inadequate capitalization. Inadequate capitalization basically implies
that there were not enough cash and/or credit arrangements secured prior to initiating operations
to ensure that the company could pay its debts during the early stages of operations (when cash
inflows are nominal, if any, and cash outflows are very high). Admittedly, it is extremely
difficult to perform a cash flow analysis when the company does not have a cash flow history.
Accordingly, alternative sources of information should be obtained from trade journals,
government agencies, and potential lenders. Additional information can be solicited from
potential customers, vendors, and competitors, allowing the firm to learn from others's mistakes
and successes.

UNCONSTRAINED GROWTH

While inadequate capitalization represents a front-end problem, unconstrained growth represents

a potential back-end problem. Often, unconstrained growth provokes business failure because the
company is growing faster than their cash flow. While many cash flow problems are operational
in nature, unconstrained growth is a symptom of a much larger strategic problem. Accordingly,
even to the extent that cash flow analyses are performed on a timely basis, such analyses will
never overcome a flawed strategy underpinning the unconstrained growth.

BANKRUPTCY
A company is said to be bankrupt when it experiences financial distress to the extent that the
protection of the bankruptcy laws is employed for the orderly disposition of assets and settlement
of creditors's claims. Significantly, not all bankruptcies are fatal. In some circumstances,
creditors may allow the bankrupt company to reorganize its financial affairs, allowing the
company to continue or reopen. Such a reorganization might include relieving the company from
further liability on the unsatisfied portion of the company's obligations. Admittedly, such
reorganizations are performed in vain if the reasons underlying the financial distress have not
been properly resolved. Unfortunately, properly-prepared and timely cash flow analyses can not
compensate for poor management, poor products, or weak internal controls.

Q.6 The following two projects A and B requires an investment of Rs 2, 00,000 each. The
income returns after tax for these projects are as follows:

Year Project A Project B

1 Rs. 80,000 Rs. 20,000
2 Rs. 80,000 Rs. 40,000
3 Rs. 40,000 Rs. 40,000
4 Rs. 20,000 Rs. 40,000
5 Rs. 60,000
6 Rs. 60,000

Using the following criteria determine which of the projects is preferable.

Project A
 year Income PVIF@10% PVCI
1 80000 0.909 72720
2 80000 0.826 66080
3 40000 0.751 30040
4 20000 0.683 13660
PVCI 182500
PVCI - NPV
182500 200000 = -17500

Project B

year Income PVIF@10% PVCI

1 20000 0.909 18180
2 40000 0.826 33040
3 40000 0.751 30040
4 40000 0.683 27320
5 60000 0.621 37260
6 60000 0.564 33840
PVCI 179680

PVCI - NPV
179680 200000 = -20320

As Project A is preferable option as it has minimal losses.