ASSIGNMNET

MB0045- FINANCIAL MANAGEMENT

NAME: JASRAJ SINGH GILL
ROLL NO: 1408008019

Ans.1

(a) 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. If
a firm does not have adequate working capital, it may become illiquid and
consequently fail to meet its current obligation thus inviting the risk of
bankruptcy. Hence the major objective of the liquidity decision is to ensure
a trade-off between profitability and liquidity. Thus, the liquidity decision
should balance between working capital management and the efficient
allocation of funds on the individual current assets. Liquidity decision is
also called as a working capital decision.
The Important elements of liquidity decisions are as follows:
1. Formulation of inventory policy.
2. Policies on receivable management.
3. Formulation of cash management strategies.
4. Policies on utilization of spontaneous finance effectively.
(b) Dividends are payouts to shareholders. Dividend decision is a major
decision made by the finance manager.
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. The dividend decision is always a problem before the
top management or the board of directors as they have to decide how
much profits should be transferred to reserve funds.
Payment of dividend is always desirable as it affects the goodwill of the
company on one hand, and on the other, shareholders invest their funds in
the company in a hope of getting a reasonable return.
Ans.2
(a) Doubling period is that time period in which the amount invested is to be
doubled at a given rate of interest. There are two ways in doubling period
which are as follows:
1. First is the rule of 72. This rule states that the period within which the
amount doubles is obtained by dividing 72 by the rate of interest.
2. Second is the much accurate way of calculating doubling period is by
using the rule of 69.
Doubling period = 0.35+69/interest rate.

(b)

(c) 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 at a given rate
of interest over a specified period to equal the future sum.

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.
Ans.3
(a) Operating leverage is associated with the asset purchase activities and it
arises due to the presence of fixed operating expenses in the firms
income flow. 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. A firm
with a high operating leverage has a relatively greater effect on EBIT for
small changes in sales.
Operating costs has three categories: fixed cost, variable cost, semivariable cost.
(b) Financial leverage relates to the financing activities of a firm and
measures the effect of EBIT on Earnings per Share (EPS) of the company.
Financial leverage refers to a firms use of fixed-charge securities like
debentures and preferences shares 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. A firm which does
not issue fixed-charge securities has an equity capital structure and does
not have any financial leverage. Financial leverage is a processof using
debt capital to increase the rate of return on equity. For this reason, it is
also referred to as trading on equity. Financial leverage and it effects are
a crucial consideration in planning and designing capital structures.
Financial leverage refers to the mix of debt and equity in the capital
structure of the firm. Financial leverage is also referred to as trading on
equity.
(c) 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.
The combined effect is quite significant for the earnings available to
ordinary shareholders. Combined leverage is the product of DOL and DFL.
Ans. 4
(a) Factors affecting Capital structure:
Capital structure should be planned at the time a company is promoted.
The initial capital structure should be designed very carefully. The management
of the company should set a target capital structure, and the subsequent
financing decisions should be made with a view to achieve the target capital
structure.
The major factors affecting the capital structure is leverage. There are also a few
other factors affecting them which are given below:
1. 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.
The companies with high level of earnings before interest and taxes (EBIT)
can make profitable use of the high degree of leverage to increase return
on the shareholders equity.
Generally, in debt-equity ratio, the lower the ratio, the higher is the
element of uncertainty in the minds of lenders. Increased use of leverage
increases commitments of the company, thereby increasing the risk of the
equity shareholders.
The other factors to be considered before deciding on an ideal capital
structure are:
1. 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.
2. 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.
3. 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.
4. 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.

(b)

Ans. 5
There are five different sources of risk which are as follows:
1. Project-specific risk: This 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
realized being less than the projected cash flow.
2. 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.
3. 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.
4. 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, the firms facing such kind of risks are
as follows:
(a)The rupee-dollar crisis affected the software and BPOS because it
drastically reduced their profitability.
(b)The surging crude oil prices coupled with the governments delay in
taking decision on pricing of petro products eroded the profitability of
oil marketing companies in public sector like Hindustan Petroleum
Corporation limited.
(c) Another example is the impact of US sub-prime crisis on certain
segments of indian economy.
5. 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.
Ans. 6
(a) Objectives of cash management:
1. 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 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 objectives 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.
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.
2. Minimizing funds held in the form of cash balances: Trying to
achieve this 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 synchronization 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:
(a)Prompt billing and mailing.
(b)Collection of cheques and remittances of cash.
(c) Float : 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 realized or paid respectively.
(b)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 minimize 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:
1. The firm is able to forecast its cash requirements in an accurate way.
2. The firms payouts are uniform over a period of time.
3. The opportunity cost of holding cash is known and does not change
with time.
4. The firm will incur the same transaction cost for all conversions of
securities into cash.