Ya Ram Final Notes 1 and 2 Units Foe 1 Unit Test Ya

UNIT I FOUNDATIONS OF FINANCE:
Ramu Vasu., MBA.,M.PHIL., MNM JAIN ENGG COLLEGE

Financial management
Page 1
Financial management An overview- Time
Management and factoring - Inventory
value of money- Introduction to the concept
management Cash management - Working
of risk and return of a single asset and of a
capital finance : Trade credit, Bank finance
portfolio- Valuation of bonds and shares-
and Commercial paper.
Option valuation.
UNIT V LONG TERM SOURCES OF
UNIT II INVESTMENT DECISIONS:
FINANCE:
Capital Budgeting: Principles and techniques
Indian capital and stock market, New issues
- Nature of capital budgeting- Identifying
market
relevant
debentures and term loans, lease, hire
cash flows - Evaluation Techniques: Payback,
purchase, venture capital financing, Private
Accounting rate of return, Net Present Value,
Equity.
Long
term
finance:
Shares,
Internal Rate of Return, Profitability Index Comparison of DCF techniques - Project

selection under capital rationing - Inflation
and
capital
budgeting
Concept
and
measurement of cost of capital - Specific cost

and overall cost of capital.
UNIT III FINANCING AND DIVIDEND
DECISION:
Financial and operating leverage - capital
structure - Cost of capital and valuation designing capital structure. Dividend policy Aspects
of
dividend
policy
11 Title of the Question

a
Synopsis
1 Introduction of
a Meaning of
b Definition
2 Main Question
3 Diagrammatic represent
4 Conclusion
practical
consideration - forms of dividend policy forms of dividends - share splits.

UNIT
IV
WORKING
UNIT
CAPITAL
MANAGEMENT:
Principles of working capital: Concepts,
Needs, Determinants, issues and estimation of
working capital - Accounts Receivables
FOUNDATIONS
OF
FINANCE
1. Financial management An overview2. Time value of money
3. Introduction to the concept of risk
and return of a single asset and

Page 2
4. Concept of risk and return of a
1. Private Finance, which includes the
portfolio.
5. Valuation of bonds and shares
6. Option valuation.
Individual, Firms, Business or Corporate

Financial activities to meet the
requirements.
1. Financial An overview -Meaning
2. Public Finance which concerns with
Finance is regarded as the life blood of a
revenue
and
disbursement
of
business enterprise. This is because in the
Government
modern money oriented economy, finance
Government, State Government and
is one of the basic foundations of all kinds of

economic activities.
According to the Wheeler, Business
Central
Semi-Government Financial matters.

3. Finance and other related disciplines:
management and other disciplines
Finance and economics:
finance is that business

which
as
Explain the relationship between financial
2. Definition of business finance
activity
such
concerns
with
the
The relevance of economics to financial
acquisition and conversation of capital
management can be described in
funds in meeting financial needs and
the light of the two broad areas of economics:
overall
macroeconomics and microeconomics.
objectives
of
business
Macroeconomics is concerned with the overall
enterprise.
3. Types of finance
institutional environment in which the firm
Finance is one of the important and integral
operates. It looks at the economy as a whole.
part of business concerns, hence, it plays a
Macroeconomics
major role in every part of the business
institutional structure of the banking system,
activities. It is used in all the area of the
money
activities under the different names.
intermediaries, monetary and fiscal policies.
Finance can be classified into two major
Since
and
business
is
concerned
capital
firms
markets,
operate
with
the
financial
in
the
macroeconomic environment, it is important for
parts:
financial managers to understand the broad

economic environment. They should recognize
and understand how monetary policy affects the
cost and the availability of funds; they should be
versed in fiscal policy and its effects on the
Page 3
economy; they should be aware of the various
obligations. Thus finance and accounting are
financial institutions; they should understand the
functionally closely related.
consequences of various levels of economic
But there are two key differences between
activity and changes in economic policy for their
finance and accounting.
decision environment and so on.
1. Treatment of funds: the measurement of
Microeconomics deals with the economic
funds in accounting is based on the
decisions of individuals and organizations. It
accrual principle. For example, revenue
concerns itself with the determination of optimal
is recognized at the point of sale and not
operating strategies. In other words, the theories
when collected. Similarly, expenses are
of
effective
recognized when they are incurred rather
operations of business firms. The concepts and
than when actually paid. The view point
theories of microeconomics relevant to financial
of finance relating to the treatment of
management are those involving supply and
funds is based on cash flows. The
demand relationships and profit maximization
revenues are recognized only when
strategies, issues related to the mix of productive
actually received in cash and expenses
factors, optimal sales level and product pricing
are recognized on actual payment.
strategies, measurement of utility preference,
Financial manager is concerned with
risk and value and rationale of depreciating
maintaining solvency of the firm and
assets.
acquiring
microeconomics
provide
for
1. Finance and accounting:

Accounting function is a necessary input into the
and
financing
the
assets
needed to achieve the goals of the firm.

2. Decision
making:
finance
and
finance function. That is, accounting is a sub
accounting also differ in respect of their
function of finance. Accounting generates
purpose. The purpose of accounting is
information or data relating to operations of the
collection and presentation of financial
firm. The end product of accounting constitutes
data. It provides consistently developed
financial statements. The information contained
and easily interpreted data. The financial
in these statements assists financial managers in
manager uses such data for financial
assessing the past performance and future
decision making. It does not mean that
directions of the firm and in meeting legal
accounts
never
make
decisions
or
financial managers never collect data.

Page 4
Generally
finance
begins
where
accounting ends.
4. Finance includes three areas..

(1) Financial management: corporate finance,
3. Financial managers should consider the
which deals with decisions related to how many
impact of new product development and
and what types of assets a firm needs to acquire
promotion plans made in marketing area
(investment
since their plans will require capital
decisions), how a firm should raise capital to
outlays and have an impact on the
purchase assets (financing
projected cash flows.
decisions), and how a firm should do to
4. Changes in the production process may

necessitate capital expenditures which
the financial managers must evaluate and
finance.
maximize its shareholders wealth (goal of a

firm) - the focus of this class
(2) Capital markets: study of financial markets
and institutions, which deals with interest
5. The recruitment, training and placement
rates, stocks, bonds, government securities,
of staff is the responsibility of the
and other marketable securities. It also
personnel department. However, all this
covers Federal Reserve System and its
requires finance and therefore, the
policies.
decisions regarding these aspects cannot
(3) Investments: study of security analysis,
be taken by the personnel department in
portfolio theory, market analysis, and
isolation of the finance department.

6. The tools of analysis developed in the
quantitative methods area are helpful in
analyzing
complex
financial
management problems.
behavioral finance.
5. Definition of financial management
Financial management is an integral part of

overall management. It is concerned with
the duties of the financial managers in the
business firm.
The term financial management has been
defined by Solomon, It is concerned with
the efficient use of an important
economic resource namely, capital
funds.

Page 5
It refers to Managerial activity which is

concerned
with
the
planning
and
3. Financial Management or
Mathematics
controlling of the firms financial resources.

5. Define financial asset
Modern approaches of the

financial management applied large
It is also called securities that are financial
number of mathematical and statistical
papers or instruments such as shares, bonds,
tools and techniques. They are also
debentures etc.
called as econometrics.
6. Scope of financial management
4. Financial Management and
Financial management is one of the
Production Management
important parts of overall management,
Production management is the
which is directly related with various
operational part of the business concern,
functional
which helps to multiple the money into
departments
like
personnel,
marketing and production.
profit. Profit of the concern depends
Financial management covers wide area
upon the production performance.
with multidimensional approaches. The
5. Financial Management and Marketing
following are the important scope of

financial management.
1. Financial
Produced goods are sold in the

market with innovative and modern
Management
and
approaches. For this, the marketing
Economics
department needs finance to meet their
Economic concepts like micro and
requirements.
macroeconomics are directly applied

with the financial management
6. Financial Management and Human

Resource
approaches.
Financial management is also
2. Financial Management and

Accounting
related with human

resource department, which provides
Accounting records includes the
manpower to all the functional areas of
financial information of the business
the management. Financial manager
concern. Hence, we can easily
should
understand the relationship between the
requirement
financial management and accounting.
department and allocate the finance to
carefully
of
evaluate
manpower
to
the
each

Page 6
the human resource department as
functions of financial management/ Decisions
wages,
remuneration,
taken by financial mangers (i.e. the investment,
commission, bonus, pension and other
financing, and dividend policy decisions)
monetary benefits to the human resource
should be oriented towards maximization of
department.
profits or Rupee income of the firm. Or the
salary,
7. Objectives of financial management
Company should select those assets, projects,
[2 Marks]
and decisions which are profitable and reject
Effective procurement and efficient use

of finance lead to proper utilization of
those which are not.

The profit maximization criterion has
the finance by the business concern. It is
however been criticized on several grounds.
the essential part of the financial
The main technical flaws are ambiguity, timing
manager. Hence, the financial manager
of benefits and quality of benefits.
must determine the basic objectives of
1. AMBIGUITY.
the financial management. Objectives of
One practical difficulty with profit
Financial Management may be broadly
maximization
divided into two parts such as:
decision making is that, the term profit is
criterion
for
financial
A. Profit maximization
a vague and ambiguous concept. It is
B. Wealth maximization
amenable to different interpretations by

different people. It is not clear in what
sense the term profit has been used. It
may be total profit before tax or after tax
or profitability rate.
2. TIMING OF BENEFIT
more
important
technical
objection to profit maximization is that it

ignores the differences in the time
1. Profit maximisation approach.

According to this approach, actions that
increase profits should be undertaken and that
decrease profits should be avoided. Profits
maximization
approach
implies
that
the
pattern of the benefits received. The

profit maximization criterion does not
consider the distinction between returns
received in different time periods and

Page 7
treats all benefits irrespective of the
is desirable. A financial action resulting in
timings, as equally valuable. This is not
negative NPV should be rejected.
true in actual practice as benefits in early
The objective of wealth maximisation takes
years should be valued more highly than
care of the questions of the timing and risk of
equivalent benefits in later years. The
expected benefits. These problems are handled
assumption
by selecting an appropriate rate for discounting
of
equal
value
is
in
consistent with the real world situation.

3. QUALITY OF BENEFITS
the expected flow of future benefits. It should

be remembered that the benefits are measured
Profit maximization ignores the quality aspect
in terms of cash flows. In investment and
of benefits associated with
financing decisions it is flow of cash which is
a financial course of action. The term quality
important, not the accounting profits. The
refers to the degree of certainty with which
Wealth created by a Company through its
benefits can be expected. As a rule, the more
actions is reflected in the market value of
certain the expected return, the higher is the
companies' shares. The value of the companies
quality of the benefits. An uncertain and
share is represented by the market price, which
fluctuating return implies risk to the investors.
in turn, is a reflection of the firm's financial
B. Wealth maximization approach.

This
maximization
is
also
or
Net
known
as
Present
decisions. The market price of the share serves

value
Worth
maximization.
as the performance indicator.
Profit Maximization
Profit earning is the main aim of every
It removes the technical limitations of
economic
activity.
A business
being
an
profit maximization criterion.(i.e. ambiguity,
economic institution must earn profit to cover
timing of benefit and quality of benefit.)
and provide funds for growth. No business can
Wealth maximization means maximizing
survive without earning profit. Profit is a
the Net Present Value (or wealth) of a course of
measure of efficiency of a business enterprise.
action. The Net present value of a course of
Profits also serve as a protection against risks
action is the difference between the present
which cannot be ensured. The accumulated
value of its benefits and the present value of its
profits enable a business to face risks like fall in
costs. A financial action which has a positive
prices, competition from other units, advertise
Net Present Value creates wealth and therefore it
government
policies
etc.
thus,
profit

Page 8
maximization
is
considered
as
the
main
objective of business.
rupee received later is ignored in this

concept.
4) Change in Organization Structure:
Limitations of profit maximization

The profit maximization criterion is criticized on
Principle of Profit maximization was,

earlier, accepted when the structure of
the business was sole proprietorship. In
the following grounds:

1) Quality of benefits: profit maximization
approach ignores the quality aspects of
benefits associated with a financial
course of action. The quality means the
degree of certainty with which benefits
are expected.
2) Ambiguity-vague: the term profit is
vague and has different interpretations. It
means different people. It can be pre-tax
or post-tax profit or long term profit.
Does it mean operating profit or profit
available for shareholders? The other
equivalent term, often used, is Return.
Return can be on total capital employed
or total capital employed or total assets
or shareholders equity and so on.
3) Timing and value of money-Ignored:
The concept of profit maximization does
not help in making a choice between
projects, giving different benefits, spread
over a period of time. It ignores the
difference in time in respect of benefits
this type of structure, sole proprietor

managed the business, individually, and
was the recipient of total profits. As total
profit belonged to him, his wealth
maximized. This was the picture in 19th
century, when the business was, totally,
self-managed.
5) Social Welfare may be Ignored: Due
to
Profit
maximization
objective,
business may produce goods and service,

which may not be necessary and
beneficial to the society.
So, it is,
indeed, doubtful how far the Profit

maximization
promotes
objective
social
serves
welfare,
let
optimizes social welfare.

6) Ignores Financing and
Aspects:
or
alone
Dividend
The profit maximization
concept concentrates on profitability

aspect alone and impact of financing and
dividend decisions on the market value
of shares are, totally ignored.
arising from the similar amount of
Thus,
investment. The fact that a rupee
maximization should be the basic criteria for
received today is more valuable than the
decision-making. The primary responsibility
it
is
concluded
that
Profit

Page 9
of financial manager is to strike judicious
the wealth of stockholders of the firm. A
balance between return and risk in order to
particular decision may be taken to
maximize the profits.
exhibit their managerial utility and that
Wealth Maximization:
decision may not be in the exclusive
This is also known as net present worth
interests of the firm.
maximization
individuals
approach,
it
takes
consideration the time value of money.

operational
features
satisfy
all
the
into
Its
three
requirements of a suitable operational objective

of financial courses of action i.e. quality of
benefits, timing of benefits and exactness.
Limitations of Wealth Maximization:
The Wealth maximization criterion is criticized
on the following grounds:
1) The objective of wealth maximization is
The
difference
maximization
Basis of
Distinction
1) Definition or
Nature
firm were maximized, it would be

benefiting the interests of debenture
holders and preferences shareholders too.
3) In corporate sector, ownership and
2) Purpose or
Concept
agents of real owners i.e. shareholders.

However, there is always a possibility of
of
interest
between
the
shareholders interests and managerial

interests.
between
and
Profit
Wealth
maximization
the firm or stockholders. If wealth of
conflict
personal
the institutional interests.
objective of maximization of wealth is of
proprietorship. Management acts as the
their
preferences and selfish interest, ahead of
not, necessarily, socially desirable.

2) There is some controversy whether the
management are separate unlike in a sole
place
Many a time,
3) Formulae
The managers may act to
maximize their managerial utility but not
Profit Maximization
Wea
The concept of profit

maximization implies
that a firm either
produces
maximum
output for a given input,
or uses minimum inputs
for producing a given
output. Thus, it relates
to optimizing the inputoutput relationship of
resources to minimize
the wasteful costs.
The main purpose of
profit maximization is
to
maximize
the
profitability derived out
of economic activity of
the business.
Profit
maximization
concept is based on the
determination
of
maximization of profits.
In a simple way:
The
shareho
maxim
maxim
the han
by wa
value-c
Presen
course
future
maxim
determ
The m
concep
value o
market
of the s

Page 10
The st
status
firm is
price a
shares
Profit = Total Revenue

Receipts Total Costs
4) Rationale
5) Time Span
The rationale behind

this concept is the need
for maximum profits
and accumulated profits
for growth in future and
shelter
against
contingencies
like
economic
recession,
natural
calamity,
unforeseen losses in
future,
severe
competition, etc.
This concept relates to
relatively shorter time
period, say a financial
year. Thus, a short-term
myopic vision.
8) Limitation
and
Constraints
Explain
various
The
profit The w
maximization concept concep
has
the
following constra
i) It suf
constraints:
cha
i) It ignores the time value
flu
of money concept.
fin
ii) Short-term
vision
ii) Tenden
based.
sho
iii)
Exploitative
ob
tendency towards
bu
resources,
iii) Very lo
employees,
inc
customers if this
val
concept is pursued
beyond
viableiv) Conflic
the
limits.
ma
iv)
Gives
lower
ow
priority
to
shareholders
interest.
setbacks
of
profit
maximization and how that can be

6) Time Value of
Money (i.e., the
Recognition that
Value in Money
Decreases Over
Time)
7) Immediate
Beneficiaries
Management
versus
Owners
This concept does not

give due consideration
to the issues of time
value of money.
It
determines profits for
the financial year and
ignores
discounting
factor of earnings.
The immediate benefit
of this concept is
derived by management
and later by the
shareholders, especially
when there is separation
of management from
ownership.
overcome
through
wealth
maximization?
Critically evaluate different objectives of
1. Profit maximization:
Maximizing the Rupee Income of
Firm
a
Resources
are
efficiently
utilized
b
Appropriate measure of firm

performance
Serves interest of society also
Limitations:
Page 11
It is Vague
It Ignores the Timing
of Returns
It Ignores Risk
Assumes
Perfect
Competition
In
new
business
environment
maximization
regarded as
p
r
p
profit
is
r
I
e
a
c
D
i
f
f
i
c
u
l
t
I
.
2. Wealth maximization:
a. Maximizes the net present value of a
course of action to shareholders.
b. Accounts for the timing and risk of the
expected benefits.
c. Benefits are measured in terms of cash
flows.
d. Fundamental objectivemaximize the
market value of the firms shares.
8. What is the role of financial
management/ Manager :
a) Determining
financial needs

Page 12
b) Choosing
the
sources of funds
c) Financial analysis
and interpretation
d) Cost volume profit
analysis
e) Capital budgeting
f) Working capital
management
g) Profit
planning
and control
h) Dividend Policy.
1. Profit
maximization
The
main
objective of financial management is

profit
maximization.
The
finance
manager tries to earn maximum profits

for the company in the short-term and
the long-term. He cannot guarantee
profits in the long term because of
business
uncertainties.
However,
company can earn maximum profits even

in the long-term, if:-
9. What objectives of financial
i.
management?
The
Finance
manager
takes
proper financial decisions.

ii.
He uses the finance of the

company properly.
2. Wealth
maximization
maximization
Wealth
(shareholders'
value
maximization) is also a main objective of

financial
management.
Wealth
maximization means to earn maximum

wealth for the shareholders. So, the
finance
manager
tries
to
give
maximum dividend to the shareholders.

He also tries to increase the market value
of the shares. The market value of the
shares
is
directly
related
to
the
performance of the company. Better the

performance, higher is the market value
of shares and vice-versa. So, the finance
Page 13
manager
must
try
to
maximise
shareholder's value.
There must be a proper balance between

owned finance and borrowed finance.
The company must borrow money at a
3. Proper estimation of total financial
low rate of interest.
requirements : Proper estimation of

total financial requirements is a very
important
objective
of
financial
5. Proper utilisation of finance: Proper

utilisation of finance is an important
management. The finance manager must
objective
of
financial
management.
estimate the total financial requirements
The finance manager must make
of the company. He must find out how

much finance is required to start and run
the company. He must find out the fixed
capital and working capital requirements
of the company. His estimation must be
correct. If not, there will be shortage or
surplus
of
finance.
Estimating
the
financial requirements is a very difficult

job. The finance manager must consider
many factors, such as the type of
technology used by company, number of
employees
employed,
scale
of
operations, legal requirements.

4. Proper
mobilization:
Mobilisation
(collection) of finance is an important

objective of financial management. After
estimating the financial requirements, the
finance manager must decide about the
sources of finance. He can collect
finance from many sources such as
shares, debentures, bank loans, etc.
optimum utilisation of finance. He must

use the finance profitable. He must not
waste the finance of the company. He
must not invest the company's finance in
unprofitable projects. He must not block
the company's finance in inventories. He
must have a short credit period.
6. Maintaining
proper
cash
flow
Maintaining proper cash flow is a shortterm objective of financial management.

The company must have a proper cash
flow to pay the day-to-day expenses such
as purchase of raw materials, payment of
wages and salaries, rent, electricity bills,
etc. If the company has a good cash flow,
it
can
take
opportunities
discounts
on
advantage
such
as
of
getting
purchases,
many
cash
large-scale
purchasing, giving credit to customers,

etc. A healthy cash flow improves the

Page 14
chances of survival and success of the
helps the company to survive in the
company.
short-term and succeed in the long-term.

It also helps the company during bad
7. Survival of company : Survival is the
times.
most important objective of financial

management. The company must survive
11. Increase
efficiency
Financial
in this competitive business world. The
management also tries to increase the
finance manager must be very careful
efficiency of all the departments of the
while making financial decisions. One
company. Proper distribution of finance
wrong decision can make the company
to all the departments will increase the
sick, and it will close down.
efficiency of the entire company.
8. Creating
reserves
One
of
the
12. Financial
discipline
Financial
objectives of financial management is to
management also tries to create a
create reserves. The company must not
financial discipline. Financial discipline
distribute the full profit as a dividend to
means:-
the shareholders. It must keep a part of it

1. To invest finance only in
profit as reserves. Reserves can be used
productive areas. This
for future growth and expansion. It can
will bring high returns
also be used to face contingencies in the
(profits) to the company.
future.
9. Proper
coordination
management must try to have

coordination
between
the
2. To avoid wastage and
Financial
misuse of finance.
proper
finance
department and other department of the

company.
13. Reduce cost of capital : Financial

management tries to reduce the cost of
capital. That is, it tries to borrow money
10. Create goodwill : Financial management

must try to create goodwill for the
company. It must improve the image and
reputation of the company. Goodwill
at a low rate of interest. The finance

manager must plan the capital structure
in such a way that the cost of capital it
minimised.

Page 15
14. Reduce operating risks : Financial
(b)
management also tries to reduce the
Financin
operating risks. There are many risks and
uncertainties in a business. The finance
decisions,
manager must take steps to reduce these
(c)
risks. He must avoid high-risk projects.
Dividend
He must also take proper insurance.
decisions.
10. Prepare capital structure : Financial

management
also
prepares
the
capital
structure. It decides the ratio between owned

finance and borrowed finance. It brings a
proper balance between the different sources
of. capital. This balance is necessary for
liquidity, economy, flexibility and stability.
i) Explain major decisions of financial
11. Explain the functions of financial

decisions management:
[ 2 Marks ]
management.
[16
Marks ]
a) Investment
The modern approach to the
decision:
financial management is concerned with

the solution of major problems like
The investment decision relates to the selection
investment
of assets in which funds will be invested by a
financing
and
dividend
decisions of the financial operations of a
firm.
business enterprise. Thus, the functions
The assets which can be acquired fall into two
of financial management can be broadly
broad groups: (i) long term assets which yield a
classified into three major decisions,
return over a period of time in future, (ii) current
namely:
assets which in the normal course of business

(a)
are convertible into cash without diminution in
Investme
the value usually within a year.
nt
Capital budgeting is probably the most crucial
decisions,
financial decision of a firm. It relates to the

Page 16
selection of an asset or investment proposal
debt implies a higher return and also higher risk.
whose benefits are likely to be available in
Therefore, it is necessary to have balance
future over the lifetime of the project. The first
between risk and return. A capital structure with
aspect of the capital budgeting decision relates
a reasonable proportion of debt and equity
to the choice of the new asset out of the
capital is called the optimum capital structure.
alternatives
c) Dividend policy decision:
available.
Working
capital
management is concerned with the management
The dividend decision should be analyzed in
of current assets. It is important as short term
relation to the financing decision of a firm. Two
survival is a prerequisite for long term success.
alternatives are available in dealing with the
It is the trade off between profitability and
profits of a firm: (i) they can be distributed to
liquidity. If a firm does not have adequate
the shareholders in the form of dividends or (ii)
working capital, it may not have the ability to
they can be retained in the business itself. The
meet its current obligations and thus, invite the
proportion of profits distributed as dividends is
risk of bankruptcy. If the current assets are too
called the dividend payout ratio and the retained
large, profitability is adversely affected. In
portion of profits is known as the retention ratio.
addition, the individual current assets should be

efficiently managed so that neither inadequate
nor unnecessary funds are locked up.
b) Financing decision:
The concern of the financing decision is with the

financing mix or capital structure or leverage.
The term capital structure refers to the
proportion of debt and equity capital. The
financing decision of a firm relates to the choice
of the proportion of these sources to finance the
investment requirements. There are two aspects
of the financing decision. First, the theory of
capital structure which shows the theoretical
relationship between the employment of debt
and the return to the shareholders. The use of
Page 17
What are the functions of Financial
12.
Manager /Management?
management is not only essential for effective

utilization of cash but it also helps to meet the
Finance manager performs the following
short-term liquidity position of the concern.
major functions:
5. Interrelation with Other Departments
1. Forecasting Financial Requirements
Finance manager deals with various functional
It is the primary function of the Finance
departments such as marketing, production,
Manager. He is responsible to estimate the
personnel, system, research, development, etc.
financial requirement of the business concern.
Finance manager should have sound knowledge
He should estimate, how much finances required
not only in finance related area but also well
to acquire fixed assets and forecast the amount
versed in other areas. He must maintain a good
needed to meet the working capital requirements
relationship with all the functional departments
in future.
of the business organization.

1. Funds raising
2. Funds allocation
3. Dividend
2. Acquiring Necessary Capital

After deciding the financial requirement, the
finance manager should concentrate how the
distribution
4. Profit planning
5. Understanding
finance is mobilized and where it will be

available. It is also highly critical in nature.
capital markets
13. How do you measure Time value of
3. Investment / Policy Decision

The finance manager must carefully select best
money? Illustrate
the
Future value or compound value
the
Compounding is the Process of finding the
investment. He must be well versed in the field
future values of cash flows by applying the
of capital budgeting techniques to determine the
concept of compound interest.
investment
alternatives
reasonable
and
stable
and
consider
return
from
effective utilization of investment. The finance
1. Compound value of lump sum

F=P(1+i)n
manager must concentrate to principles of

safety, liquidity and profitability while investing
F- future value at the nth
capital.
period
4. Cash Management
i- interest rate
Present days cash management plays a major
n- number of years
role in the area of finance because proper cash

Page 18
Suppose that Rs.1000 is placed in the

savings account of a bank at 5 percent
interest rate. How much shall it grow at the
end of three years?
Suppose that an investor wants to find out

after 15 years. The interest rate is 9 percent.
F = 1157.60
P=50000[1/(1+0.09)15=13750
Compound value of an annuity

Annuity is the fixed payment or receipt for
specified number of years. Suppose Rs.100
is deposited at the end of each of the next
three years at 10 percent interest rate. What
will be the value at the end of third year? For
Present value of an annuity

An investor may have an investment
opportunity of receiving a constant period
amount for certain specific period. The
present value of this amount can be
estimated with following equation.
which, the following formula can be used for
F=A
1 i n 1
i
P=A
1
1

n
i i 1 i
To illustrate, let us suppose that a person
A-annuity
F=100
P=F 1 i
n
the present value of Rs.50000 to be received
F = 1000(1+0.05)
calculation
receives an annuity of Rs.5000 for four
( 1+ 0.1 )1
=331
0.1
Present value:
Present value is also called discount value
that is the future cash flow is discounted to
present worth.
years. If the rate of interest is 10 percent, the

present value is
P=5000
Present value of perpetuity

Perpetuity
Present value of lump sum
1
1
0.1 0.1( 1+ 0.1)4
is
an
annuity
that
occurs
indefinitely. Its present value is arrived at
The present values can be worked out for
using following equation.
any combination of number
A
P= i
of years and interest rate. The following

general formula can be employed to
To take an example, let us assume that an
calculate the present value of single cash
investor expects a perpetual sum of Rs.500
flow to be received after some periods.
annually from his investment. The present

value if interest rate is 10 percent is

Page 19
P = 500/0.1=5000.
P=F 1 i
Present value of an
annuity
1
1

i i 1 i n
P=A
Present value of
perpetuity
A
P= i
Present value of growing annuity

In financial decision making there are number of
situations where cash flows may grow at a
constant rate. In this case the present value is
P=
[ ( )]
A
1+ g
1
ig
1+i
A company paid a dividend of Rs.60 last year.

This dividend stream is expected to grow at 10
percent per annum for 15 years and then ends. If
Value of money at different point of times or

period is called as time value of money.
present value?
[ (
Present value of money is more value than
)]
15
=456.36
Present value of growing perpetuity

Constantly growing perpetuities are annuities
growing indefinitely. Suppose dividends of
Rs.66 after one year are expected to grow at 10
percent indefinitely and discount rate is 21
percent. The present value calculation uses
following equation.
A
P=
ig
P =66/ (0.21-0.1)=Rs.600
12. Explain the methods of measuring the
changes in the value of money?
Compound value of lump
sum
F=P(1+i)n
Compound value of an
annuity
1 i n 1
12. What is time value of money?
the discount rate is 21 percent, what is the
66
1+ 0.1
P=
1
0.210.1
1+ 0.21
F=P i
Present value of lump
sum
future value of money.

13. Why time value of money is important?
There are several reasons.
Individuals
in
general
prefer
current
consumption to future consumption.
Capital can be employed productively to

generate positive returns. An investment of
one rupee today would grow to (1+r) a year
hence.
in an inflationary period a rupee today

represents a greater real purchasing power
than a rupee a year hence.
13. What is meant by yield to maturity?

It is the measure of a bonds return that
considers both the interest income and
capital gain.
14. What do you mean by the term required
rate of return?

Page 20
It is minimum return expected by investors.
strike price. The asset on which the put or
In other words it is known as cost of capital
call option is created is referred to as the
or discount rate.
underlying asset.
15. What is EPS?
European option is an option that is allowed
Earning per share is net profit per share or
to be exercised only on the maturity date.
ratio of net profit to number of shares
American option is an option that can be
outstanding.
exercised any time before its maturity. An
16. What do you mean by risk return trade
option holder will exercise his option when
off?
it provides him a benefit over buying or
It explains the direct relationship between
selling a underlying asset from the market at
return and risk. That means if you want more
the prevailing price.
return you have to bear more risk and vice
There are three possibilities
versa.
17. Differentiate between put option and call

option
Put option is the contract by which the
holder of option has right to sell underlying
asset at specified price on or before
particular period where as call option gives
right to the holder to buy.
18. Explain Meaning and features of
In the money: a call or put option is said
to be in the money when it is advantages for

the investor to exercise it.
Out of the money: a call or put option is
out of the money if it is not advantageous for

At the money: when the holder of a call
or a put option does not lose or gain whether

or not he exercise.
Options
An option is a claim without liability. More
specifically, an option is a contract that gives
the holder a right, without any obligation, to
buy or sell an asset at an agreed price on or
before a specified period of time. The option
to buy an asset is known as a call option.
The option to sell an asset is called a put
option. The price at which option can be
exercised is called an exercise price or a
19. Explain
Meaning
and
features
of
Options?
An option is a claim without liability.
More specifically, an option is a contract that
gives the holder a right, without any
obligation, to buy or sell an asset at an
agreed price on or before a specified period
of time. The option to buy an asset is known
as a call option. The option to sell an asset is

Page 21
called a put option. The price at which
option can be exercised is called an exercise
the share at an agreed exercise price. The
price or a strike price. The asset on which
call option holder exercises his option, when
the put or call option is created is referred to
he benefits from it.
as the underlying asset.
Exercise call option when
Share price at expiration>exercise price
European option is an option that is
A call option on a share is a right to buy
allowed to be exercised only on the maturity
= St>E
date.
Do not exercise call option when
Share price at exirationexercise price =
exercised any time before its maturity.
StE
An option holder will exercise his option
The value of call option at expiration is:
when it provides him a benefit over buying
Value of call option at expiration =
or selling a underlying asset from the market
Maximum[share price-Exercise price,0]
at the prevailing price.
Ct = Max[St-E,0]
Call premium:
A call buyer exercises his right only
when the outcomes are favourable to him.
The seller of a call option being the owner of
the asset gives away the good outcomes in
favour of the option buyer. The buyer,
therefore, pay up front a price called call
premium to the call seller to buy the option.
The call premium is a cost to the option
or not he exercise his option, it is called as at
buyer and a gain to the call seller. The net
the money.
pay off is value of call option minus call
premium.
The option premium is the price that the
holder of an option has to pay for obtaining a
Put option:
call or put option.
A put option is a contract that gives the
holder a right to sell a specified share at an
Call option
agreed exercise price on or before a given

Page 22
maturity period. A put buyer gains when the
share price falls below the exercise price. He
exercised any time before its maturity.
will forgo his put option if the share price
An option holder will exercise his option
rises above the exercise price.
when it provides him a benefit over buying
Exercise put option when
or selling a underlying asset from the market
Exercise price>Share price at expiration
at the prevailing price.
= E>St
Do not exercise put option when
Exercise price Share price at expiration
= ESt
The value of a put option = Maximum
[Exercise price Share price at expiration, 0]
Pt = Max [E-St,0]
Put option pay off is put option value
minus put option premium.
4. Explain Meaning and features of Options
or not he exercise his option, it is called as at
An option is a claim without liability. More
the money.
specifically, an option is a contract that gives
The option premium is the price that the
the holder a right, without any obligation, to
holder of an option has to pay for obtaining a
buy or sell an asset at an agreed price on or
call or put option.
before a specified period of time. The option
Call option
to buy an asset is known as a call option.
A call option on a share is a right to buy the
The option to sell an asset is called a put
share at an agreed exercise price. The call
option. The price at which option can be
option holder exercises his option, when he
exercised is called an exercise price or a
benefits from it.
strike price. The asset on which the put or
Exercise call option when
call option is created is referred to as the
Share price at expiration>exercise price =
underlying asset.
St>E
European option is an option that is allowed
Do not exercise call option when
to be exercised only on the maturity date.

Page 23
Share price at exirationexercise price =
Exercise price Share price at expiration =
StE
ESt
The value of call option at expiration is:
The value of a put option = Maximum
Value of call option at expiration =
[Exercise price Share price at expiration, 0]
Maximum[share price-Exercise price,0]
Pt = Max [E-St,0]
Ct = Max[St-E,0]
Put option pay off is put option value minus
Call premium:
put option premium.
A call buyer exercises his right only when
20. Explain the Options?
the outcomes are favourable to him. The
Options are derivative instruments that
seller of a call option being the owner of the
provide the opportunity to buy or sell an
asset gives away the good outcomes in
underlying asset on a future date. An option
favour of the option buyer. The buyer,
is a derivative contract between a buyer and
therefore, pay up front a price called call
a seller, where one party (say First
premium to the call seller to buy the option.
Party) gives to the other (say Second Party)
The call premium is a cost to the option
the right, but not the obligation, to buy from
buyer and a gain to the call seller. The net
(or sell to) the First Party the underlying
pay off is value of call option minus call
asset on or before a specific day at an
premium.
agreed-upon price. In return for granting the
Put option:
option, the party granting the option collects
A put option is a contract that gives the
a payment from the other party. This
holder a right to sell a specified share at an
payment collected is called the premium
agreed exercise price on or before a given
or price of the option. The right to buy or
maturity period. A put buyer gains when the
sell is held by the option buyer (also called
share price falls below the exercise price. He
the option holder); the party granting the
will forgo his put option if the share price
right is the option seller or option writer.
rises above the exercise price.
Unlike forwards and futures contracts,
Exercise put option when
options require a cash payment (called the
Exercise price>Share price at expiration =
premium) upfront from the option buyer to
E>St
the option seller. This payment is called
Do not exercise put option when
option premium or option price. Options can

Page 24
be traded either on the stock exchange or in
expiry date of the contract. The buyer of the
over the counter (OTC) markets. Options
call option does not have an obligation to
traded on the exchanges are backed by the
buy if he does not want to.
Clearing Corporation thereby minimizing
Put option
the risk arising due to default by the counter
A put option is a contract granting the right
parties involved. Options traded in the OTC
to the buyer of the option to sell the
market however are not backed by the
underlying asset on or before a specific day
Clearing Corporation. There are two types
at an agreed upon price, but not the
of optionscall options and put options
obligation to do so. It is the seller who grants
which are explained below.
this right to the buyer of the option. The
Call option
person who has the right to sell the
A call option is an option granting the right
underlying asset is known as the buyer of
to the buyer of the option to buy the
the put option. The price at which the buyer
underlying asset on a specific day at an
has the right to sell the asset is agreed upon
agreed upon price, but not the obligation to
at the time of entering the contract. This
do so. It is the seller who grants this right to
price is known as the strike price of the
the buyer of the option. It may be noted that
contract (put option strike price in this case).
the person who has the right to buy the
Since the buyer of the put option has the
underlying asset is known as the buyer of
right (but not the obligation) to sell the
the call option. The price at which the
underlying asset, he will exercise his right to
buyer has the right to buy the asset is agreed
sell the underlying asset if and only if the
upon at the time of entering the contract.
price of the underlying asset in the market is
This price is known as the strike price of the
less than the strike price on or before the
contract (call option strike price in this case).
expiry date of the contract. The buyer of the
Since the buyer of the call option has the
put option does not have the obligation to
right (but no obligation) to buy the
sell if he does not want to.
underlying asset, he will exercise his right to
Illustration Suppose A has bought a call
buy the underlying asset if and only if the
option of 2000 shares of Hindustan
price of the underlying asset in the market is
Unilever Limited (HLL) at a strike price of
more than the strike price on or before the
Rs 260 per share at a premium of Rs 10.

Page 25
This option gives A, the buyer of the option,
European Options: European options are
the right to buy 2000 shares of HLL from the
options that can be exercised only on the
seller of the option, on or before August 27,
expiration date. American options: American
2009 (expiry date of the option). The seller
options are options that can be exercised on
of the option has the obligation to sell 2000
any day on or before the expiry date. They
shares of HLL at Rs 260 per share on or
can be exercised by the buyer on any day on
before August 27, 2009 (i.e. whenever asked
or before the final settlement date or the
by the buyer of the option). Suppose instead
expiry date.
of buying a call, A has sold a put option on
Contract size
100 Reliance Industries (RIL) shares at a
As futures and options are standardized
strike price of Rs 2000 at a premium of Rs 8.
contracts traded on an exchange, they have a
This option is an obligation to A to buy 100
fixed
shares of Reliance Industries (RIL) at a price
derivatives instrument represents a certain
of Rs 2000 per share on or before August 27
number of shares of the underlying asset.
(expiry date of the option) i.e., as and when
For example, if one contract of BHEL
asked by the buyer of the put option. It
consists of 300 shares of BHEL, then if one
depends on the option buyer as to when he
buys one futures contract of BHEL, then for
exercises the option. As stated earlier, the
every Re 1 increase in BHELs futures price,
buyer does not have the obligation to
the buyer will make a profit of 300 X 1 = Rs
exercise the option.
300 and for every Re 1 fall in BHELs
Terminology of
contract size. One contract of a
Derivatives
futures price, he will lose Rs 300.
In this section we explain the general terms
Contract
and concepts related to derivatives.
Contract value is notional value of the

transaction in case one contract is bought or
sold. It is the contract size multiplied but the
Types of options
price of the futures. Contract value is used to
Options can be divided into two different
calculate margins etc. for contracts. In the
categories depending upon the primary
example above if BHEL futures are trading
exercise styles associated with options.
at Rs. 2000 the contract value would be Rs.
These categories are:
2000 x 300 = Rs. 6 lacs.

Page 26
Margins
both, the buyer and the seller of a futures
In the spot market, the buyer of a stock has
contract.
to pay the entire transaction amount (for
Moneyness of an Option
purchasing the stoc k) to the seller. For
Moneyness of an option indicates whether
example, if Infosys is trading at Rs. 2000 a
an option is worth exercising or not i.e. if the
share and an investor wants to buy 100
option is exercised by the buyer of the
Infosys shares, then he has to pay Rs. 2000
option whether he will receive money or not.
X 100 = Rs. 2,00,000 to the seller. The
Moneyness of an option at any given time
settlement will take place on T+2 basis; that
depends on where the spot price of the
is, two days after the transaction date. In a
underlying is at that point of time relative to
derivatives contract, a person enters into a
the strike price. The premium paid is not
trade today (buy or sell) but the settlement
taken into consideration while calculating
happens on a future date. Because of this,
moneyness of an Option, since the premium
there is a high possibility of default by any
once paid is a sunk cost and the profitability
of the parties. Futures and option contracts
from exercising the option does not depend
are traded through exchanges and the
on the size of the premium. Therefore, the
counter party risk is taken care of by the
decision (of the buyer of the option) whether
clearing corporation. In order to prevent any
to exercise the option or not is not affected
of the parties from defaulting on his trade
by the size of the premium. The following
commitment, the clearing corporation levies
three terms are used to define the moneyness
a margin on the buyer as well as seller of the
of an option.
futures and option contracts. This margin is a
In-the-money option
percentage (approximately 20%) of the total
An option is said to be in-the-money if on
contract value. Thus, for the aforementioned
exercising the option, it would produce a
example, if a person wants to buy 100
cash inflow for the buyer. Thus, Call Options
Infosys futures, then he will have to pay
are in-the-money when the value of spot
20% of the contract value of Rs 2,00,000 =
price of the underlying exceeds the strike
Rs 40,000 as a margin to the clearing
price. On the other hand, Put Options are in-
corporation. This margin is applicable to
the-money when the spot price of the

underlying is lower than the strike price.

Page 27
Moneyness of an option should not be
These investors have a position (i.e., have
confused with the profit and loss arising
bought stocks) in the underlying market but
from holding an option contract. It should be
are worried about a potential loss arising out
noted that while moneyness of an option
of a change in the asset price in the future.
does not depend on the premium paid,
Hedgers participate in the derivatives market
profit/loss do. Thus a holder of an in-the-
to lock the prices at which they will be able
money option need not always make profit
to transact in the future. Thus, they try to
as the profitability also depends on the
avoid price risk through holding a position in
premium paid.
the derivatives market. Different hedgers
Participants in the Derivatives Market
take different positions in the derivatives
As equity markets developed, different
market based on their exposure in the
categories of investors started participating
underlying market. A hedger normally takes
in the market. In India, equity market
an opposite position in the derivatives
participants
retail
market to what he has in the underlying
investors, corporate investors, mutual funds,
market. Hedging in futures market can be
banks, foreign institutional investors etc.
done through two positions, viz. short hedge
Each of these investor categories uses the
and long hedge.
derivatives market to as a part of risk
Short Hedge
management,
A short hedge involves taking a short
currently
include
investment
strategy
or
speculation.
position in the futures market. Short hedge
Based on the applications that derivatives
position is taken by someone who already
are put to, these investors can be broadly
owns the underlying asset or is expecting a
classified into three groups:
future receipt of the underlying asset.
or
Hedgers
example, an investor holding Reliance
Speculators, and
shares may be worried about adverse future
Arbitrageurs
price movements and may want to hedge the
We shall now look at each of these
price risk. He can do so by holding a short
categories in detail.
position in the derivatives market. The
Hedgers
investor can go short in Reliance futures at

the NSE. This protects him from price

Page 28
movements in Reliance stock. In case the
can hold a long position in the sugar futures.
price of Reliance shares falls, the investor
If the price of sugar rises, the chocolate
will lose money in the shares but will make
manufacture may have to pay more to
up for this loss by the gain made in Reliance
acquire sugar in the normal market, but he
Futures. Note that a short position holder in
will be compensated against this loss
a futures contract makes a profit if the price
through a profit that will arise in the futures
of the underlying asset falls in the future. In
market. Note that a long position holder in a
this way, futures contract allows an investor
futures contract makes a profit if the price of
to manage his price risk.
the underlying asset increases in the future.
Similarly, a sugar manufacturing company
Long hedge strategy can also be used by
could hedge against any probable loss in the
those investors who desire to purchase the
future due to a fall in the prices of sugar by
underlying asset at a future date (that is,
holding a short position in the futures/
when he acquires the cash to purchase the
forwards market. If the prices of sugar fall,
asset) but wants to lock the prevailing price
the company may lose on the sugar sale but
in the market. This may be because he thinks
the loss will be offset by profit made in the
that the prevailing price is very low.
futures contract.
For example, suppose the current spot price
Long Hedge
of Wipro Ltd. is Rs. 250 per stock. An
A long hedge involves holding a long
investor is expecting to have Rs. 250 at the
position in the futures market. A Long
end of the month. The investor feels that
position holder agrees to buy the underlying
Wipro Ltd. is at a very attractive level and he
asset at the expiry date by paying the agreed
may miss the opportunity to buy the stock if
futures/ forward price. This strategy is used
he waits till the end of the month. In such a
by those who will need to acquire the
case, he can buy Wipro Ltd. in the futures
underlying asset in the future. For example,
market. By doing so, he can lock in the price
a chocolate manufacturer who needs to
of the stock.
acquire sugar in the future will be worried
Basic
about any loss that may arise if the price of

sugar increases in the future. To hedge
against this risk, the chocolate manufacturer
terms
in
financial
Management
1. Money markets vs. capital
markets

Page 29
a. Money markets are markets for
7. What is the emerging role of the
short-term and highly liquid debt
financial management?
8. Briefly explain any two setbacks of Profit
securities (less than one year)

b. Capital markets are markets for
intermediate
and
long-term
debts and stocks (one year or

longer)
2. Primary
markets
vs.
secondary markets
a. Primary markets are markets for
issuing new securities
b. Secondary markets are markets
for trading existing securities
UNIT
FOUNDATIONS
OF
FINANCE
1. Financial management An overview2. Time value of money
3. Introduction to the concept of risk
and return of a single asset
4. Concept of risk and return of a
portfolio.
5. Valuation of bonds and shares
6. Option valuation.
PART A
maximization.
10. Explain compound value concept.
11. What is the concept of risk and return of
portfolio?
12. What is systematic risk & unsystematic
risk?
13. What are the types of return?
14. What is effective rate of interest?
15. What do you mean by portfolio?
16. What is the formula of valuation of
bond?
17. Distinguish between call option and put
option?
18. What is present value?
PART B
1. Explain major decisions of financial
management.
2. What are the functional areas of financial
management?
3. What are the functions/ role of financial
manager/Management?
4. What are the difference between profit
maximization and wealth maximization
1. What is finance and financial assets?

2. Define financial management?
3. How is the term finance more
comprehensive than money
and its limitations?

5. In what ways is the wealth maximization
objective superior to the profit
maximization objective? Explain.
management?
4. What is scope of financial management?
5. What are the objectives of financial
6. Explain the changing scenario of
management?
6. What is modern & traditional view on
7. Discuss fully the organization of the
financial management in India.[Ans 4]

finance functions in a business?

Page 30
8. List out and explain the method of

measuring the changes in the value of
money?
9. What is risk? How can risk of a security
be calculated? Explain your answer with
an example.
10. What are the basic financial decisions?
How do they involve risk- return trade
off?
11. Explain how do you concept / measure
Time value of money? Illustrate
12. Distinguish between the risk and return
of a single asset and that of a portion?
13. Define an option and explain briefly the
Black Scholes option model?
UNIT 2 INVESTMENT DECISIONS:
1. Capital Budgeting: Principles and
2.
3.
4.
5.
6.
techniques,
Nature of capital budgeting,
Identifying relevant cash flows,
Evaluation Techniques,
a. Payback,
b. Accounting rate of return,
c. Net Present Value,
d. Internal Rate of Return,
e. Profitability Index,
Comparison of DCF techniques
Project selection under capital
rationing,
7. Inflation and capital budgeting.
8. Concept and measurement of cost of
capital,
9. Specific costs and overall cost of
capital.
1. Capital Budgeting: Principles and

techniques.
What is capital budgeting? (May 2013)
Page 31
It refers to planning the deployment of

available capital for the purpose of
maximizing the long-term profitability of
a firm. It is the decision-making process
by
which
the
firm
evaluates
the
purchases of fixed assets.

2. Explain the importance and types of
capital budgeting
a) The investment decisions of a firm are
generally
known
budgeting,
or
as
capital
the
capital
expenditure
decisions.
b) The firms investment decisions would
generally
include
acquisition,
expansion,
modernisation
and
o The future benefits will occur to

the firm over a series of years.
Importance
o Growth
o Risk
o Funding
o Irreversibility
o Complexity
Types:
o One classification is as follows:
o Expansion of existing business
o Expansion of new business
o Replacement and modernisation
o Yet another useful way to classify
investments is as follows:
o Mutually exclusive investments
o Independent investments
o Contingent investments
List out Factors affecting capital budgeting:
Capital
budgeting
or
capital
expenditure
replacement of the long-term assets.
decision depends on many factors such as
Sale
1. Opportunities:
of
division
or
business
(divestment) is also as an investment

decision.
c) Decisions
like
the
change
in
the
methods of sales distribution, or an

advertisement campaign or a research
and development programme have
long-term implications for the firms
expenditures and benefits, and therefore,
they should also be evaluated as
investment decisions.
Features:
o The exchange of current funds
for future benefits.
o The funds are invested in longterm assets.
The first and foremost factor which decides the

capital
budgeting
decision
is
investment
opportunities available for the firm. Without

investment opportunity, there is no need of
considering capital expenditure. When firm has
more
opportunities,
the
capital
budgeting
becomes significant and complex.

2. Certainty:
Every project has its own risk. The cash flow
variation differs from project to project. Greater
the risk the firm has, more the profitability it
earns and vice versa. Though aim of the finance

Page 32
manager is to maximise wealth, he has to look in
Cost of capital, cost of production, opportunity
to quality of cash flow.
cost of capital etc., are other consideration
3. Urgency:
involved in the capital budgeting decisions.
Sometimes
an
investment
may
require
8. Intangible factors:
immediate attention in view of survival of
Sometimes a capital expenditure has to be made
business. Owing to urgency of investment, the
due to certain emotional and intangible factors
firm may not follow stringent evaluation
such as safety and welfare of workers,
procedure.
prestigious project, social welfare, goodwill etc.
4. Availability of funds:
9. Legal factors:
It is another important factor that decides capital
An investment which is required by the
budgeting decision. Some due to lack of funds,
provisions of law is solely influenced by this
even highly profitable project may not be in a
factor. Though projects may not be profitable,
position to undertake. When a firm posses
investment should be made.
abundant resources, even low profitable project
3. What is capital rationing? (Nov 2013)
may undertaken.
Capital rationing refers to a situation in which a
5. Future earnings:
firm has more acceptable investments than it can
A project may not be profitable today or in short
finance. It is concerned with the selection of a
term but it may be more profitable in long term
group of investment proposals out of many
or in future. When projects are evaluated this
investment proposals a acceptable under the
case may be short listed for investment.
accept reject decision. It employs ranking of
6. Obsolescence:
the acceptable investment projects. The projects
There are certain projects which have greater
can be ranked on the basis of a predetermined
risk of obsolescence than others. In case of
criterion such as the rate of return.
projects with high rate of obsolescence, the
4.
project with lesser payback period may be
examples
preferred than one which may have higher
A capital expenditure is an expenditure intended
profitability but still longer pay back period.
to benefit future periods. Other words, any
7. cost considerations:
investment involves the commitment of funds
What
is
capital
expenditure?
Give
now with the expectations of earning a

Page 33
satisfactory return on these funds over a period
will generate the necessary cash to recover the
of time in future.
investment.
Example: a) amount incurred on acquisition of
If cash flows are conventional:
fixed assets
Pay back period = initial investment/annual

b) Amount incurred on making
additions to the existing machinery etc

c) Amount spent on replacing existing
machinery etc
cash inflow
In cash flows are unconventional:
Calculation of period will take cumulative form.
In such a case the pay back period can be found
d) Amount spent on research and

development
by adding up the amount of net cash inflows

until the total is equal to the Initial investment.
1. List out the various assumptions of

capital structure theories
5. What is discounted pay back period?
8. How PI is superior to NPV?

The serious drawback of NPV method is that,
being an absolute measure, it is not a reliable
One of the serious limitations of the payback
method to evaluate projects requiring different
method is that it does not discount the cash
initial investments. The PI or Benefit-Cost
flows for calculating the pay back period. Some
method provides a solution to this kind of
people, therefore, discount cash flows and
problem.
calculate the discounted payback period. The
measure. The PI approach measures the present
number of periods taken in recovering the
value of returns per rupee invested, while the
investment outlay on the present value basis is
NPV is based on the difference between the
called the discounted payback period.
present value of future cash inflows and present
6. What is time value of money in capital
value of cash outlays.
budgeting decisions?
9. What is IRR?
Money has time value. A rupee today is more
It is, in other words, a relative
The internal rate of return of a project is the
valuable than a rupee a year hence.
discount rate which makes its NPV equal to
7. What is pay back period? How do you
zero.
calculate it? (Nov 2013)
which equates the present value of future cash
The term payback period refers to the period in
flows with the initial investment.
which the project
10. What do you mean by mutually exclusive
Put differently, it is the discount rate
and independent projects?

Page 34
Mutually exclusive projects: If the firm accepts
b) It does not take consider the interest factor.
one project, it may rule out the need for another.
c) It does not consider income beyond the pay-
These are called mutual exclusive projects.
back period and looks upon it a windfall.
They
14. What is cash flow?
do
not
depend
upon
each
other.
Independent projects: These are projects that do
Net profit + Non operating and non cash
not complete with one another in such a way
expenses
that the acceptance of one precludes the
15. What is salvage value?
possibility of acceptance of another.
The value of asset at the end of useful life of the
11. Make a comparison between NPV and
asset.
IRR
17. What are thee financial problems involve
Though both are discounted cash flows methods,
cash flows occurring at different points of
there are certain
time?
fundamental differences:
These cash flows have to be brought to the same
The IRR and NPV methods can give different
point of time for the purposes of comparison and
results in the ranking of proposals. IRR method
aggregation.
assumes that future cash receipts are invested at
decisions cash flows are to be discounted at the
the rate of return forecasted for the project. The
firms cost of capital to know the present value
NPV method assumes that proceeds are invested
of cash flows
at the required return. If the forecasted return on
18. What is cost of capital?
the project exceeds the required rate as an
Minimum expected rate of return by the
unknown factor. The basic presumption of the
investors.
NPV method is that intermediate cash inflows
19. What is opportunity cost of capital?
are reinvested at the cut off rate, whereas, in the
The return foregone by not choosing the next
case of the IRR method, intermediate cash flows
best alternative investment.
are presumed to be reinvested at the IRR.
20. What is average cost of capital?
12. What are the limitations of pay back
It is overall cost of capital assigning weight to
method?
various specific cost of capital respectively.
a) It ignores the time value of money.
21. What are the various methods of
It treats all the cash flows generated at different
evaluating capital budgeting proposals?(May
periods of time are equal.
2014)
Hence
in
capital
budgeting

Page 35
The various tools and techniques of capital
The cost of capital is 12 %. Compute the
budgeting
method,
NPV and IRR for each project. Which
discounted payback period method, accounting
project should be undertaken? Why?.
rate of return method, net present
Suppose cost of capital declines to 10%,
are
payback
period
value
method and internal rate of return method.
what would be the change in NPV of
22. What is cut- off point?
projects?
The cut-off point refers to the point below which
Project A NPV @10% =Rs 2674
a project would not be accepted. For example, if
NPV @ 12%=Rs 1518.13
10% is the desired rate of return, the cut-off rate
Difference = Rs 1155.87
is 10%. The cut-off point may also be in terms
IRR=15%
of period. Ex: If the management desires that the
Project B NPV @10%=Rs 3193.99
investment in the Project should be recovered in
NPV @ 12%=Rs 2175.01
three years, the period of three years would be
Difference =Rs1018.98
taken as the cut-off period. A project, incapable
IRR=17%
of generating necessary cash to pay for the
24. Explain various capital budgeting
initial investment in the project within three
techniques with merits and demerits.
years, will not be accepted.
Discounted cash flow methods: Net
23. ABC Ltd pays no dividends anticipate in a
Present Value
long run level of future earnings of Rs.7 per
Ct
(1 K )
Co
share. The current price ABC Ltds share is
NPV=
Rs.55.45, floatation cost for the sale of new
Accept if NPV is positive and reject if
equity shares would average about 10% of
NPV is negative
the price of the share. What is the cost of new

equity capital to ABC Ltd?(May 2014)
Merits
Considers all cash flows
Cost of new equity = 7/(55.45-5.545)=14.014%
True measure of profitability
1. A firm is considering the following two

mutually exclusive investments
projects
A
B
Cash flows
C0
C1
C2
-25000 5000
5000
-28000 12672 12672
t 1
Require
tedious
Based on the concept of the time
Require
cost o
difficul
Satisfies the value additive principle

C3
25640
12672
Sensitiv
Consistent with the shareholders wealth
maximization
Internal rate of return

Page 36
The discount rate which equates
Non-discounted cash flow criteria
the present value of an investments cash
Pay back
The number of years required to recover
inflows and outflows is its internal rate
the initial outlay of the investment is
of return.
called pay back.
n
Merits
De
Ct
0
Easy to understand and compute Ignores time val
o
t
t 1 (1 K )
where K is IRR
and inexpensive to use
Ignores cash flo
Emphasizes liquidity
the pay back per
Accept if IRR is more than cost of
Easy and crude way to cope with Not a measure o
capital and reject if IRR is less than cost
risk
No objective w
of capital.
Uses cash flows information
standard paybac
No relation
Merits
Requires estimates of cash flows
maximization pr
True measure of profitability
which is a tedious
work
Accounting
rate of return
average
Based on the concept of the time Does not holdAn the
value rate
of of return found by
value of money
additive principledividing the average net operating profit
byindicate
the average
investment
Generally consistent with wealth At times, fails to
correct
maximization principle
choice between mutually exclusiveMerits
projects
Uses accounting data
with
which Ignores th
executives
are familiar
At times yields multiple
rates
Easy to understand and calculate
Relatively difficult to compute
Gives more weightage to future receipts
Profitability index
The ratio of the present value of the cash

flows to the initial outlay is profitability
index
Accept if profitability index is more than
one and reject if PI is less than one.
25. Explain the various factors influencing

capital expenditure decisions?
Capital investment decisions are not governed
by one or two factors because the investment
problem is not simply one of replacing old
Merits
equipment by a new one but is concerned with
Recognizes the time value of money
replacing an existing process in a system with
Relative measure of profitability
another process which makes the entire system
Generally
consistent
with
wealth
more effective. Management outlook
maximization principle
(a) Competitors strategy

Page 37
Does not
No obje
minimum
(b) Opportunities
created
at the end of its
by technological changes
normal
(c) Market forecast
Tax effect of
(d) Fiscal incentives
salvage value
(e) Cash flow budget

(f) Non economic factors
11. Explain components of cash flow?
1. Initial Investment
b) Release of Net Working Capital

14. What is capital expenditure? Give
examples
A capital expenditure is an expenditure
2. Net Cash Flows
intended to benefit future periods. Other
a) Revenues and Expenses
words,
b) Depreciation and Taxes
commitment of funds
c) Change in Net Working Capital
expectations of earning a satisfactory return
Change in
accounts
receivable
Change in
involves
the
now with the
future.
Exampl: a) amount incurred on acquisition of
fixed assets
b) Amount incurred on making
additions to the existing machinery etc
c) Amount spent on replacing existing
accounts payable
d) Change in Capital Expenditure
investment
on these funds over a period of time in
inventory
Change in
any
machinery etc
d) Amount spent on research and
e) Free Cash Flows
development
3. Terminal Cash Flows
15. What is time value of money in capital
a) Salvage Value
Salvage value of
budgeting decisions?
the new asset
Money has time value. A rupee today is
Salvage value of
more valuable than a rupee a year hence.
the existing asset
9. Explain Return and risk of single security
now
and portfolio?
Salvage value of
Return is the excess earnings over investment.
the existing asset
Return consists of regular income and capital

Page 38
gain or loss. For shares, the regular income is
of
dividend and capital appreciation is price
portfolio
changes between two periods.
single
= 2
1 +(P 1P0)
P0
year
Return
P1- current price, P0- last year price and DIV1-
current dividend, and R- return
Risk is variation in return or volatility in return.
R=
Difference sq
It can be calculated using range, variance and
8
Mean return =6
standard deviation.
Variance = 10/3 =
Range is the difference between highest return
3.33
and lowest return. Suppose a share earns returns
Standard deviation
of 5%, 4%, 7% and 8% for 1 through 4 years
= 1,825
Return with probability:
respectively.
The range
Expected return is the sum of the product of
is 4% (8-
each outcome or return and its associated
4).
probability.
Variance
E(R) =
Ri Pi
i=1
2= [ RiE ( R ) ] Pi
i=1
R
i
2=
= 2
The share of hypothetical company limited has
the following anticipated returns with associated
probabilities.
Return
Probability
-20
0.05
-10
0.10
10
0.20
15
0.25
Standard
Using formula the expected return and standard
deviation
deviation are calculated.

E(R) = 13%

Page 39
20
0.20
Standard deviation = 12.49%

Risk and return of two assets portfolio:
The return of the portfolio is equal to the
R1
R1 iE() ( R2 i E(R 2) )
Cov 12=
weighted average of the returns

of individual assets in the portfolio with the
weights being equal to
the proportion of investment value in each asset
There is a direct and simple method of
calculating the expected rate of return on a
portfolio if we know the expected rates of return
on individual assets and their weights.
i=1
The variance of two asset portfolio is not the

weighted average of assets since they covary as
well. The standard deviation of two security
portfolio is given by the following equation.
p = w21 21 +w 22 22+2 w 1 w2 Cov 12
It is noted from equation that the variance of a

portfolio includes the proportion of variances of
R p=w1 R 1+ w2 R 2
We can use variance or standard deviation to
measure the risk of the portfolio of assets. The
portfolio variance or standard deviation depends
on the co movements of returns on two assets.
Covariance of returns on two assets measures
their comovement.
Three steps are involved in the calculation of
the
individual
depends
on
between
the
capital and weighted average cost of capital.

Computation of cost of capital consists of two
important parts:
1.
Measurement
of
specific costs
2.
assets
2. Determine the deviation of possible
of each deviation of returns of two
correlation
covariance
15. Explain the calculation of specific cost of
1. Determine the expected returns on
for each asset.

3. Determine the sum of the product
the
The
securities in the portfolio.
covariance between two assets:
returns from the expected return
securities.
Measurement
of
overall cost of capital

1.
Measurement of Cost of Capital
It refers to the cost of each specific sources of

finance like:
assets and respective probability.
a)
Cost
of
equity
b)
Cost
of
debt

Page 40
c)
Cost
of
preference share
Cost
of
ke=
D
NP
d)
Where,
retained earnings
a)
Ke= Cost of equity capital
Cost of Equity
D = Dividend per equity share
Cost of equity capital is the rate at which
NP = Net proceeds of an equity
investors discount the expected dividends of the

firm to determine its share value. Conceptually
the cost of equity capital (Ke) defined as the
Minimum rate of return that a firm must earn
on the equity financed portion of an investment
project in order to leave unchanged the market
price of the shares. Cost of equity can be
calculated from the following approach:
A. Dividend
price
B.
Dividend Price Plus Growth Approach
The cost of equity is calculated on the basis of

the expected dividend
rate per share plus growth in dividend. It can be
measured with the help of
the following formula:
ke=
D1
+g
NP
g = growth of
approach
B. Dividend
growth
(D/P)
share
price
(D/P
approach
C. Earning price
plus
+
g)
dividend
C.
Earning Price Approach
Cost of equity determines the market price of

(E/P)
approach
D. Realized yield approach.
the shares. It is based on the future earnings

prospects of the equity. The formula for
calculating the cost of equity according to this
approach is as follows.
ke=
A.
E
NP
Dividend Price Approach
E=earnings
The cost of equity capital will be that rate of
per
share
expected dividend which will maintain the

present market price of equity shares. Dividend
price approach can be measured with the help of
b. Cost of Debt
the following formula:

Page 41
Cost of debt is the after tax cost of long-term
share capital is calculated with the help of the
funds through borrowing. Debt may be issued at
following formula:
par, at premium or at discount and also it may be

perpetual or redeemable.
1
n ( PNP )
1
2 ( P+ NP )
PDIV +
k p=
Debt Issued at Par

Debt issued at par means, debt is issued at the
face value of the debt. It may be calculated with
the help of the following formula.
d) Cost of Retained Earnings

Retained earnings are one of the sources of
finance for investment proposal; it is different
k d =I (1t )
from other sources like debt, equity and
I=interest rate
preference shares. Cost of retained earnings is
t=tax rate
the same as the cost of an equivalent fully
Debt Issued at Premium or Discount
subscripted issue of additional shares, which is
If the debt is issued at premium or discount, the
measured by the cost of equity capital.
cost of debt is calculated with the help of the
The opportunity cost of its retained earnings is
following formula.
the
kd =
I
(1t)
NP
rate
of
return
foregone
by
equity
shareholders. The shareholders generally expect
Cost of Perpetual Debt and Redeemable Debt

It is the rate of return which the lenders expect.
The debt carries a certain rate
dividend and capital gain from their investment.

2.Measurement of Overall Cost of Capital
It is also called as weighted average cost of
capital and composite cost of capital. Weighted
of interest.
average cost of capital is the expected average
1
I+
n ( PNP )
kd =
(1t)
1
2 ( P+ NP )
future cost of funds over the long run found by

weighting the cost of each specific type of
capital by its proportion in the firms capital
c) Cost of Preference Share Capital
structure.
Cost of preference share capital is the annual
The overall cost of capital can be calculated with
preference share dividend by the net proceeds
the help of the following formula;
from the sale of preference share. There are two

types of preference shares irredeemable and
redeemable. Cost of redeemable preference
Ko= KdWd + KpWp + Ke We +

KrWr
Where,

Page 42
Ko = Overall cost of capital

Kd = Cost of debt
Kp = Cost of preference share
Ke = Cost of equity
Kr = Cost of retained earnings
Wd= Percentage of debt of total
capital.
UNIT III
UNIT III FINANCING AND DIVIDEND
DECISION:
UNIT -2 PART B
1) What is equity? What is its yield to
Financial and operating leverage - capital

structure - Cost of capital and valuation -
maturity?
2) What is DCF of capital budgeting
designing capital structure. Dividend policy Aspects
techniques?
3) Calculate
1. Payback period method
2. NPV
3. IRR
of
dividend
policy
practical
consideration - forms of dividend policy forms of dividends - share splits.
4. Profitability Index
5. How will you calculate cost of
1.The current market price of a companys

share is Rs.90 and the expected dividend per
capital? Explain with an
share next year is Rs.4.50. If the dividends
illusteration?
are expected to grow at a constant rate of 8%,
4) Discuss
objectives
and
functions
of
financial management. Explain Meaning
what is the shareholders required rate of

return?
Ke = D + g
and features of Options?

5) Discuss
objectives
and
functions
Po
of
Where D = dividend =
6) Explain Meaning and features of Options
Rs.4.50
g = growth rate =
8%
Po
present
market value = Rs.90

Ke = Rs 4.50 + 8% or
0.08 = 0.05 + 0.08 = 0.13
Rs.90
Page 43
or 90% debt because, debt implies compulsory
Ke = 13%
2.
Define the degree of operating and

degree of financial leverage
payment of interest, which the company is

legally bound to pay. In case the company is
The degree of operating leverage (DOL) may be
unable to meet its interest obligations, it has to
defined as the percentage change in operating
resort to external borrowing to meet it. In which
profits (earnings before interest and taxes)
case,
resulting from a percentage change in sales.
operationally costlier than equity.
Thus,
5. What is Walters formula to determine the

DOL = % change in operating
ultimately
debt
works
out
to
be
market price per share?

Walters formula to determine the market price
profit
% change in sales
per share is as follows
The degree of financial leverage (DFL) is

defined as the percentage change in EPS due to
P=
a given percentage change in EBIT. Thus,
Where P = price of equity shares, D =
DFL = % change in EPS

% change in EBIT
3.What is the effect of leverage on the cost of
capital under the Net operating income
D/(Ke g)
initial dividend, Ke = cost of equity

capital g = expected growth rate of
earnings
6. What is stable dividend policy?
Stable or regular dividend policy is considered
approach (NOI)?
The NOI approach states that the capital
a desirable policy by the management of most
structure decision of a firm is irrelevant. Any
companies in practice. This implies regularity in
change in leverage will not lead to any change in
paying some dividend annually, even though the
the real value of the firm and the market price of
amount of dividend may fluctuate over years,
shares as well as the overall cost of capital is
and may not be related with earnings. Some of
independent of the degree of leverage.
the most distinct forms of stable dividends are :
4. If debt is cheaper than equity why do
i) constant dividend per share or dividend rate
companies not finance their assets with 80%
ii) constant payout iii) constant dividend per
or 90% debt?
share plus extra dividend.
Even though debt is cheaper than equity,
7. A companys current price of share is Rs.60
companies will not finance their assets with 80%
and dividend per share is Rs.4.
If its

Page 44
capitalization rate is 12%, what is the
. Financial leverage is defined as the ability of a
dividend growth rate?
firm to use fixed
Po =
= D (1+ g)
ke - g
financial charges to magnify the effects of
ke g
changes in EBIT on the earnings per share. It
60 = 4 ( 1 1 g)
involves the use of funds obtained at a fixed cost
0.12 - g
7.2 60g = 4+4g
in the hope of increasing the return to the

-
64g = - 3.2
shareholders.
10. Define operating leverage
g = 3.2 = 0.05 or 5%.

64
The operating leverage may be defined as the

firms ability to use fixed operating costs to
8. What are the steps involved in calculating a
magnify the effects of changes in sales on its
firms WACC?
earnings before interest and taxes. Operating
The various steps involved in calculating a
leverage results from the existence of fixed
firms WACC are as follows:
operating expenses in the firms income stream.
i) Estimate the cost of each source of financing
11. What is debt-service-coverage ratio?
for various levels of its use through an
State the formula and name the variables
analysis of current market conditions and an
Debt-service
assessment of the expectations of investors
capacity of the company to meet fixed financial
and lenders
charges.
ii) Identify the levels of total new financing at
coverage
iv)
indicates
the
It shows the number of times the
interest charges are covered by funds that are
which the cost of the new components would
ordinarily available for their payment.
change, given the capital structure policy of
Interest coverage ratio =
the firm.
iii)
ratio
EBDIT
Interest
Calculate the WACC for various
Where EBDIT = earnings before depreciation,
ranges of total financing between the
interest and taxes
breaking points.
Too high a ratio indicates that the firm is very
Prepare the weighted marginal cost
conservative in using debt, and that it is not
of capital schedule which reflects the WACC
using
credit
to
the
best
advantage
of
for each level of total new financing.
shareholders. A lower ratio indicates excessive
9. Define financial leverage (May 2013)
use of debt, or inefficient operations. The firm

Page 45
should make efforts to improve the operating

efficiency, or to retire debt to have a comfortable
Walters share valuation model formula is as

follows
coverage ratio.
P=
12.What is EBIT EPS analysis?
where
Ke g
The EBIT EPS analysis, as a method to study
P = price of equity shares
the effect of leverage, essentially involves the
D = initial dividend
comparison of alternative methods of financing
Ke = cost of equity capital
under various assumptions of EBIT. A firm has
G = expected growth rate of earnings
the choice to raise funds for financing its
15. Who presented dividend irrelevance
investment proposals from different sources in
theorem? state any three criticisms of this
different proportions.
theorem
The choice of the
combination of the various sources would be
The
dividend
irrelevance
theorem
was
one which, given the level of earnings before
associated with Soloman, Modigliani and Miller.
interest and taxes, would ensure the largest EPS.
According to them, dividend policy has no effect
13. Compare bonus issue and stock split
on the share prices of a company and is
A stock dividend or bonus issue represents a
therefore, of no consequence. This school of
distribution of shares in lieu of or in addition to
thought has come under severe criticism on
the cash dividend to the existing shareholders.
account of unrealistic nature of assumptions
The declaration of stock dividend will increase
such as :- i) tax differential, ii) floatation costs
the equity share capital and reduces the reserves
iii) transaction costs etc.
and
the
16. Explain the concept of scrip dividend
company. A stock split is a method to increase
(May 2013, Nov 2013)

Scrip dividend is dividend paid in terms of
surpluses
(retained
earnings)
of
the no. of outstanding shares through a

proportional reduction in the par value of the
share. With stock split, the total net worth does
not change and the no. of outstanding shares
increases
with
dilution
in
EPS
and
proportionate fall in the market price of a share.

14. Write the formula of Walter share
valuation model. State the variables
shares
17. What is composite leverage?(May 2014)
It is a product of financial leverage and
operating leverage.
18. What are the
different
forms
of
dividends?(May 2014)
The forms of dividends are cash dividends,
stock dividend and bond dividend
19. Define the concept of dividend

Page 46
It is portion of earnings distributed to the
e) Growth prospects
shareholders.
20. List out different kind of dividend policies
Regular dividend policy, stable dividend policy,
f) Investment requirements
g) Availability of funds
h) Earning stability
constant dividend policy, constant pay-out ratio
i) Control
and irregular dividend.
j) Taxes
1. What is optimum capital structure?
k) Opportunities
2. Explain the features, advantage and
l) Capital market conditions
objectives of capital budgeting.

3. In what manner is the discounted cash
m) Inflation
flow technique useful in capital budgeting
3. The capital structure of PRL Ltd consists of
decision Discuss?
an ordinary share capital of Rs 10, 00,000 and
UINT III PART B
Rs 10, 00,000 of 10% debentures. The number
1. The following information is available in
of units sold has increased from the present 1,
respect
of
firm. Capitalization
00,000 units to 1, 20,000 units. The selling price
rate=10%, EPS=Rs.100. assumed rate
per unit is Rs 10. Variable cost is estimated to Rs
of return on investment is (i) 8% (ii)
6 per unit and fixed expenses amount to Rs 2,
15% (iii) 10%. Show the effect of
00,000. The income tax rate is assumed to be
dividend policy on market price of
35%. Calculate the following

(i)
The
shares applying Gordons formula
degree
of
when dividend payout ratio is (1) 40%
operating leverage, the
(2) 60% (3) 90%
degree
D/P ratio
40%
60%
90%
r=0.08
769.23
882.35
978.26
r=0.15
4000
1500
1058.82
financial
leverage and the degree of
r=0.1
1000
1000
1000
2. What are the various factors influencing
of
combined leverage at 1,
00, 000 and 1, 20,000
units.
(ii) Earning per share at
1, 00, 000 and 1, 20,000
Dividend Policy? Explain

a) Dividend payout ratio
b) Stability of dividend
c) Legal aspects
d) Contractual requirements
units.
100000unit
120

Page 47
Operating
leverage
Financial
leverage
Combined
liverage
EPS
0.65
Net Operating Income (NOI) Approach

According to NOI approach the value of
Explain in detail the Net Income and Net
the firm and the weighted average cost of
Operating Income approach of capital
capital are independent of the firms
structure theories.
Net Income (NI) Approach
According to NI approach both the cost
capital structure. In the absence of taxes,

an individual holding all the debt and
of debt and the cost of equity are
equity securities will receive the same
independent of the capital structure; they
cash flows regardless of the capital
remain constant regardless of how much
structure and therefore, value of the
debt the firm uses. As a result, the
company is the same.

Diagram
overall cost of capital declines and the

firm value increases with debt. This
Cost
approach has no basis in reality; the

optimum capital structure would be 100
per cent debt financing under NI
approach.
Diagram
Debt
Cost
ke, ko
ke
ko
kd
kd
5. The operating income of Hypothetical Ltd

Debt
amounts to Rs.1,86,000. It pays
35
percent tax on its income. Its capital

structure consists of the following:
Page 48
14% debentures
5
55.25
Rs. 5,00,000
15% preference shares
Rs. 1,00,000
Equity shares(Rs.100 each)
%
6. The following information is available in
respect of the firm
The capitalization rate =0.10
Rs. 4,00,000
i
Determine the firms EPS.
ii
Determine the percentage
Earning per share = Rs.10

Assumed rate of return on investment: (i)
15% (ii) 10% and (iii) 8%. Show the
change in EPS associated
effect of dividend policy on the market
with 30% change (both
price of shares using Walters model at
increase and decrease) in
D/P ratio of 25%, 50% and 75%
EBIT.
iii
Determine the degree of

financial leverage at the
current level of EBIT.
iv
What additional data do you

need to compute operating
as
well
as
combined
EBIT
INTEREST
I
INTEREST
70000
T I
INTERES
r=0.08
r=0.10
25%
85
100
50%
90
100
75%
95
100
What are the criticisms of the same?

MM Approach
Assumption:
24180
0 EBIT
INTERES
D/P ratio
7. Explain the MM Theory of capital structure.
leverage?
18600
Perfect capital market
13020
Homogeneous risk classes
0 EBIT
INTERES
Risk
70000 T I
INTERES
70000
15000
II
15000 T II
10100
15000 T II
15680
EBT
TAX
0 EBT
35350 TAX
0 EBT
54880 TAX
10192
EAT
EPS
65650 EAT
16.412 EPS
0 EAT
25.48 EPS
No taxes
Full payout
Propositions:
MMs Proposition I states that the firms value

45200
15820 is independent of its capital structure. With
personal leverage, shareholders can
29380
receive exactly the same return, with the

same risk, from a levered firm and an

-55%
Page 49
unlevered firm. Thus, they will sell shares
Assets
of the over-priced firm and buy shares of
Growth opportunities
the under-priced firm until the two values
Debt and Non debt tax
equate. This is called arbitrage.
shields
The cost of equity for a levered firm equals the
Financial flexibility and

operating strategy
constant overall cost of capital plus a risk
premium that equals the spread between
Sustainability
and
flexibility
the overall cost of capital and the cost of
Control
be
Marketability and timing
irrelevant, the overall cost of capital must
Issue cost
remain constant, regardless of the amount
Capacity of raising fund
debt multiplied by the firms debt-equity

ratio.
For
financial
leverage
to
of debt employed. This implies that the
9. Calculate (a) the operating leverage, (b) the
cost of equity must rise as financial risk
financial
increases
combined leverage from the following
Proposition three states that the cut off rate of
leverage
plans A and B.
sources of finance
Sales :3000 units
Lending
(c)
the
under situations I and II and financial
investment depends on the project not on

Criticisms:
and
Selling price: Rs 30 per unit

and
borrowing
rate
Variable cost: Rs 15 per unit
discrepancy
Fixed cost:
Non substitutability of personal
Under situation I: Rs 15, 000
and corporate leverages
Under situation II: Rs 20, 000
Transaction costs
Capital structure:
Institutional restrictions
Particulars
Existence of corporate tax

8. Explain the factors determining optimum
Equity
Debt @ 20
Financial plans
A
B
10000 15000
10000 5000
capital structure
Page 50
Normal Firms Distribute all

Answer
earnings
Situation I
Operating leverage
Financial leverage
Combined leverage
Situation II
Operating leverage
Financial leverage
Combined leverage
Plan A
1.5
1.07
1.605
Declining Firms No effect

Criticism
No external Financing
Constant Rate of Return
1.8
1.087
1.9566
10. Briefly discuss Walter and Gordon model

of dividend with numerical example
Constant opportunity cost of

capital
Gardon model:
Assumptions
All Equity Firm
Walters Model
No External Financing
Assumptions
Constant Return and Cost of
Internal Financing
Capital
Perpetual Earnings
Capital
No Taxes
100% Payout or Retention
Constant Retention
Constant EPS and DIV
Cost of Capital greater than
Infinite Time
Growth Rate
Valuation
Market price per share is the sum
Valuation
Market value of a share is equal
of the present value of the infinite
to the present value of an infinite
stream of constant dividends and
stream of dividends to be
present value of the infinite
received by shareholders
stream of capital gains
P
P
D r / k ( E D)
k
EPS (1 b)
K br
Optimum Payout Ratio
Optimum Payout Ratio

Growth Firms Retain all
earnings

earnings
earnings

Page 51
11. What is stability of dividend and its

significances?
Constant Dividend per Share or

Dividend Rate.
Constant Payout.
Constant Dividend per Share Plus Extra

Dividend.
Significances:
Resolutions of investors uncertainty.
Investors desire for current income.
Institutional Investors Requirement.
Raising Additional Finances.
UNIT IV PART A
Page 52
UNIT
IV
WORKING
CAPITAL
It is the time duration required to convert sales
MANAGEMENT:
after the conversion of resources into inventories
Principles of working capital: Concepts,
into cash.
Needs, Determinants, issues and estimation of
5. What is Factoring?
working capital - Accounts Receivables
It is an agreement in which receivables arising
Management and factoring - Inventory
out of sale of goods are sold by a firm to the
management Cash management - Working
factor(financial intermediary). Hence forth, the
capital finance : Trade credit, Bank finance
factor becomes responsible for all credit control,
and Commercial paper.
sales accounting and debt collections from the
1. Distinguish between Permanent or Fixed
buyers.
working capital
6. What is Cash budget? (May 2014)
A certain minimum level of working capital is
It is a statement showing the estimated cash
necessary on a continuous and uninterrupted
inflows and cash outflows over the planning
basis is known as fixed working capital. Any
horizon. It helps a firm to plan and control the
amount over and above the permanent level of
use of cash.
working capital.
7. Define Bank float
2. What is Trade credit?
It is the time taken by the bank in collecting the
It refers to the credit extended by the supplier of
payment from the customers bank.
goods and services in the normal course of
8. What is Concentration banking?
transaction. In other words it is deferral payment
It is a system of decentralized billing and
that represents a source of finance.
multiple collection point and is a useful
3. Write a note on commercial paper (Nov
technique
2013)
receivables.
CP is a short term unsecured negotiable
9. What is Lock-Box system?
instrument consisting of usance promissory
It is an arrangement under which firms hire a
notes with a fixed maturity. It is issued on a
post office lock box at important collection
discount on face value basis or interest bearing
centers. The customers are required ti remit
form.
payments to the post office lock box. The local
4. Define Operating cycle
banks of the firm are authorized to open the box
to
expedite
the
collection
of
and pick up the remittances.

Page 53
10. Define Float
operations. It includes raw materials, work in
Float represents the difference between the bank
process and finished goods.
balance and book balance of cash of a firm.
18. What is ordering costs?
11. What is Default cost?
Expenses involved for the firm to place orders
It is also called as bad debt that is the firm may
with suppliers to replenish inventory of raw
not be able to recover the overdue because of the
materials.
inability of the customers.
19. What is carrying costs?
12. What is Credit policy?
Costs involved in maintaining and carrying
It explains to whom, credit to be extended and
inventory which includes storing costs and
how much credit to extend. That is, it consists of
opportunity cost of funds.
credit analysis and credit standard.
20. What are the types of working capital?
13. What is Credit Standard?
(May 2013, 2014)
It represents the basic criteria for the extension
Net working capital and Gross working capital
of credit to customers.
Fixed working capital or permanent working
14. What do you mean by Credit analysis?
capital and flexible or temporary working
It refers to procedures for evaluation credit
capital
applicants which includes obtaining credit
21. What are the significance of factoring?
information and analysis of credit information.
(May 2013)
Time saving, good use of growth, no need of
15. Define Cash discount

It is the amount that is to be reduced from the
collateral and qualify for more funding

UNIT IV PART B
overdue of the customers to the firm.
1. Purchase Manager places order each time for
16. Explain 2/10 net 30

The customer is entitled to 2 percent discount
rate if he pays within 10 days after the beginning
of the credit period. If however, he does not
a lot of 500 numbers of a particular item.

From the available data, the following
results are obtained.
want he may pay within 30 days.

17. Define Inventory
It is composition of assets that will be used or
sold in future in the normal course of business
Inventory carrying cost

Ordering cost per order
Cost per unit
Annual demand

Page 54
40%
Rs. 6
Rs.60
1000
Find out the loss to the organization due to his
month; finished goods in stock, on
ordering policy.
average, one month.
Existing: ordering cost= 1000/500X600=
Credit allowed by suppliers is one
1200
month; credit allowed to debtors is two

Carrying cost= 500/2X 20%
of 50= 5000
months; average time lag in payment of

wages is 1.5 weeks and one month in
Total =
overhead expenses; one fourth of the
6200
output is sold against cash; cash in hand
2 1000 600
245
20
As per EOQ:
and at bank is desired to be maintained at
Units
the working capital needed to finance a
Ordering cost 1000/245X600 = 2400
level of activity of 1,04,000 units of
Carrying cost 245/2X20
production.
You
production
is
Rs. 365000. Prepare a statement showing
= 2450
Total cost
may
carried
assume
on
that
evenly
4850
throughout the year and wages and
Loss to the company =6200-4850= 1250.
overheads
accrue
immediately.
For
2. A proforma cost sheet of a company provides
calculation purposes, 4 weeks may be
the following particulars:
taken as equivalent to a month.
Particulars
Elements of cost
Amount
Rs.
Raw materials
80
Direct labor
30
Overheads
60
Total costs
170
Profit
30
Selling price
200
The following particulars are available:
Answer
Current assets
In
Raw material
Rs
6400
Work in Process
00
3400
Finished goods
00
1360
Debtors
000
2040
Cash
000
3650
Raw materials in stock, on average, one

month; work in progress (completion
stage 50 percent); on average, half a
00
Total current assets
47450

Page 55
00
Current liabilities
Creditors
6400
Overheads
00
4800
Labour
00
9000
0
Current liabilities
12100
Working capital
00
35350
00
3. Explain the factors determining working
Particulars
Raw materials
Direct labour
Over heads
Total cost
Profit
Selling price
Rs.per uni
160
60
120
340
60
400
Raw materials are held in stock on an

average for one month. materials are in
process on an average for half-month.
finished goods are in stock on an average
for one month.
capital of the firm
Nature of business
Credit allowed by suppliers is one month
Production cycle
and credit allowed to debtors is 2 months
Business cycle
. time lag in payment of wages is 1
Production policy
weeks. Time lag in payment of overhead
Growth and expansion
Vagaries in availability of
raw materials
expenses is 1 month. One fourth of the

finished goods are sold against cash.
Cash in hand and at bank is expected to
Profit level
Level of taxes
Dividend policy
Depreciation policy
You may assume that production is
Price level changes
carried on evenly throughout the year
Credit policy
,wages and overheads accure similarly
be Rs.50,000; and expected level of

production amounts to 1,04,000 units.
4. Calculate the amount of working capital

requirement for Jolly & co.
Limited
and a time period of four weeks is

equivalent to a month.
from the following information:

Current assets
Raw material
1280000

Page 56
Work in process
Finished goods
Debtors
Cash
Current liabilities
Creditors
Wages
Others
Working capital
-Loans
1360000
2720000
4800000
50000
1280000
180000
960000
5. Explain the importance and scope of
-Letter of credit
-Commercial paper
-Factoring
-Long term sources
7. Explain features and mechanism of factoring

Factoring
It is a mechanism of managing,
accounts receivable management
financing and collecting receivables.
Scope:
Factoring services
Credit policy
Credit standard
Credit granting decisions
Collection policy and procedures
credit management
losses
It is a marketing tool to expand
firms sale
Credit collection and protection

against default and bad debt
Importance:
Sales ledger administration and
It involves an element of risk that
the assigned book debts

Types of factoring
should be carefully analyzed
It is based on economic value
It implies futurity
6. Explain different sources of Working capital

-Short term sources:
Financial accommodation against
Full service non-recourse
Full service recourse factoring
Bulk/agency factoring
Non notification factoring
8. What are different methods for forecasting
-Trade credit
-Accrued expenditure
-Advanced payments
-Bank credit
-Cash /overdraft
-Bill discounting
working capital needs?

The most appropriate method forecasting the
working capital needs of a firm is concept of
operating cycle. However, a number of other
methods may be used to determine working
capital needs in practice. The three

Page 57
approaches which have been successfully
o administration costs
applied in practice are as follows:
o bad-debt losses
a) Current assets holding period:

Here working capital requirements are
estimated on the basis of average holding
period of current assets and relating them
to cost based on the companys
experience in the previous years. This
method is essentially based on the
operating cycle concept.
b) Ratio of sales:
o Estimation of incremental
profit
investment in receivable
o Estimation of incremental rate
of return (IRR)
o Comparison of incre-mental
rate of return with required
rate of return (RRR)
Working capital requirements are

estimated as a ratio of sales is calculated
on the assumption that current assets
change with sales.
c) Ratio of fixed investments:
Working capital requirements are
estimated as a percentage of fixed
o Optimum credit policy: IRR =

RRR
o Credit standards
o Credit analysis
o collection period
o default rate
character
9. Elucidate role and characteristics of credit
capacity
policy in receivable management
condition
capital
collateral
investment.
o Credit policy
o credit standards
o credit terms
o collection efforts
o Marketing tool
o Maximisation of sales Vs.
incremental profit
o production and selling
o Credit terms
o credit period
o cash discount
o Collection policy and
procedures
o regularity of collections
costs
Page 58
o clarity of collection
o It gives a complete picture of all
procedures
the items of expected cash flows.
o responsibility for
o It is a sound tool of managing
collection and follow-up

o case-by-case approach
o cash discount for prompt
daily cash operations.
This method, however, suffers from

the following limitations:
o Its reliability is reduced because
payment
o Collection period
of the uncertainty of cash
o Aging schedule
forecasts. For example,
o Collection experience matrix
collections may be delayed, or
10. What are the methods used for forecasting
unanticipated demands may
cash requirement?
cause large disbursements. It fails
Short term forecast:
to highlight the significant

movements in the working
o The important functions of
capital items.
short-term cash forecasts
To determine operating
cash requirements
To anticipate short-term
The adjustment Net Income method:

o The benefits of the adjusted net
income method are:
o It highlights the movements in
financing
the working capital items, and
To manage investment of
thus helps to keep a control on a
surplus cash.
firms working capital.
o Short-term Forecasting Methods
disbursements method
o It helps in anticipating a firms
The receipt and

The adjusted net income
financial requirements.
o The major limitation of this method is:
o It fails to trace cash flows, and
method.
therefore, its utility in controlling
Receipt and disbursements method
The virtues of the receipt and payment

methods are:
daily cash operations is limited.

Long term forecasts

Page 59
The major uses of the long-term cash
opportunity cost; that is, the return
forecasts are:
foregone on the marketable securities. If
o It indicates as companys future
the opportunity cost is k, then the firms
financial needs, especially for its
holding cost for maintaining an average
working capital requirements.
cash balance is as follows:
o It helps to evaluate proposed
o The firm incurs a transaction cost
capital projects. It pinpoints the
whenever it converts its marketable
cash required to finance these
securities to cash. Total number of
projects as well as the cash to be
transactions during the year will be total
generated by the company to
funds requirement, T, divided by the
support them.
cash balance, C, i.e., T/C. The per
o It helps to improve corporate
transaction cost is assumed to be
planning. Long-term cash
constant. If per transaction cost is c, then
forecasts compel each division to
the total transaction cost will be:
plan for future and to formulate

projects carefully.
o The total annual cost of the demand for

cash will be:
11. Explain different methods used for

o The optimum cash balance, C*, is
management of cash
obtained when the total cost is minimum.
Baumols model:
o The firm is able to forecast its cash needs
The formula for the optimum cash

balance is as follows:
with certainty.
o The firms cash payments occur
uniformly over a period of time.
Miller orr model:
control limitsthe upper control limit
o The opportunity cost of holding cash is
and the lower control limit as well as
known and it does not change over time.
a return point.
o The firm will incur the same transaction

cost whenever it converts securities to
The MO model provides for two
If the firms cash flows fluctuate

randomly and hit the upper limit,
cash.
o The firm incurs a holding cost for
keeping the cash balance. It is an
then it buys sufficient marketable

securities to come back to a normal

Page 60
level of cash balance (the return

point).
Similarly, when the firms cash flows

UNIT V PART A
wander and hit the lower limit, it
sells sufficient marketable securities
1. Define lease.
to bring the cash balance back to the
A contract of lease may be defined as a
normal level (the return point).
contract whereby the owner of an asset (lesser)
The difference between the upper
grants to another party(lessee) the exclusive
limit and the lower limit depends on
right to use the asset usually for an agreed
the following factors:
period of time in return for the payment of rent
o the transaction cost (c)
2. What do you mean by domestic lease and
o the interest rate, (i)
international lease?
o the standard deviation (s) of net

cash flows.
The formula for determining the

distance between upper and lower
control limits (called Z) is as follows:
A lease transaction is classified as a domestic

leases if all parties to the lease transaction the
equipment supplier, the lesser and lessee are
domiciled in the same country. A lease
transaction is classified as an international lease
if one or more of the parties to the transaction
are domiciled in different countries.
3. What is swap lease?
It is a lease under which the lesser maintain the
asset and if necessary replaces It with a similar
equipment in working condition.
4. What are the differences between lease and
hire purchase?
Leasing
Hire purchase
a. cant claim depreciation for tax purpose
entitled to claim depreciation for tax

Page 61
b.
entire
lease
rental
is
tax
deductible
only interest component is tax
of sale and arranges with a leasing company to

buy
Expense
for
lessee
deductible for hirer.
it.
The
lessee
uses
the
equipment
exclusively, maintains it, insures and avails of

the after sales service and warranty backing it.
c. Lessee does not enjoy the salvage

hirer enjoys the salvage value of
Value
He also bears the risk of obsolescence as it

stands committed to pay the rental for the rental
of
the
asset
for the entire lease period.
the asset.
7. What are the advantages to lessee? (May
5. What is operating lease?
2013)
It is also known as service lease, short term
a. Efficient use of funds
lease or true lease.
In this lease, the
b. Cheaper source
contractual period between lesser and lessee is
c. Flexible source
less than the full expected economic life of
d. Enhanced borrowing capacity
equipment. This lease is terminable by giving
e. Tax benefits
stipulated
8. What are the various types of lease?
notice
as
per
the
agreement.
Normally, the lease rentals will be higher as
a. financial lease
compared to other leases on account of short
b. Full payout lease
period of primary lease.
c. True lease
The risk of
obsolescence is enforced on the lesser who will
d. Operating lease
also bear the cost maintenance and other
e. Net lease
relevant expenditure. The lesser also does the
f. Leveraged lease
services like handling warranty claims, payment
g. Baloon lease
of
9. What are the limitations of leasing?
taxes,
scheduling
and
performing
maintenance and keeping complete records. This
a. Costly option
lease is suitable for computers, copy machines,
b. Loss of tax shield
vehicles, material handling equipment etc.
c. Double sales tax
6. What is financial lease?
d. Loss of Residual value
It is also known as capital lease, long term lease,
e. Unfavorable gearing
net lease and close lease. In this lease, the lessee
10. List the leasing process.
selects the equipment, settles the price and terms
a. Lease selection

Page 62
b. Order and delivery
Internal
c. Lease contract
retained earnings, sale of assets, and sale of
d. Lease period
stocks.
11. What are the methods of interest
16. What is meant by convertible debenture?
calculation in leasing?
(Nov 2013)
a. Effective rate of interest
The debenture which has the option of
b. Sum-of-years digit method
converting in to the equity share of a company is
c. Straight line method
called convertible debenture.
12 Hire Purchase features.
17. What are the key functions of venture
1. Payment of periodic installments

2. Immediate possession of goods
sources
are
owners
investment,
capital? (May 2014)

The major functions are equity participation,
long term investment and participation in
by the buyer
3. Ownership of goods remaining
with the vendor
4. Vendors right to repossess the
goods in the event of default
5. Treatment of each installment as
hire charges
13. Define Hire purchase finance.
An agreement under which goods are let on hire
and under which the hirer has an option to
purchase them in accordance with the terms of
management.
18. What is private equity?
Equity capital that is not quoted on a public
exchange. Private equity consists of investors
and funds that make investments directly into
private companies
19. Define capital market
It is type of financial market where in long term
securities are traded.
20. What is derivative?
Derivatives are securities derived from other
securities like equity, debt or any other type of
security.
the agreement.
14. Explain the role of Indian capital market (
May 2013)
Promoting and sustain the growth of a country,
UNIT V PART B
1. What is venture capital financing?
Explain.
1. Early stage financing seed financing
mobilisation of saving for productive and

efficient investment, providing liquidity and so
on
15. What are the sources of internal financing
financing
of a firm? (May 2014)
capital
R&D
Startup

Page 63
First
(i) Hire purchase
stage financing
(ii) Long term sources of finance
2. Expansion stage financing second
stage financing
(i) Hire purchase

The owner of the asset (hiree) gives the
Development financing
possession of asset to the hirer with the

understanding that the hirer will pay
Bridge financing
agreed installments over a specified

period of time
3. Acquisition/buyout financing growth

Acquisition financing
The ownership of the asset will transfer

to the hirer on the payment of all
installments
- Management buyout
The hirer will have the option of

terminating the agreement any time
- Turnaround financing
before the transfer of ownership of the

asset
Or
Call option and right of termination in
2. Define a lease. How does it differ from a hire
the hands of hirer
purchase? What are the cash flows
The hirer is required to show the hired
consequences of a lease? Illustrate.
assets on his balance sheet and is entitled

to claim depreciation
Hire purchase
Leasing
The payment is split into interest and
Depreciation: hirer is entitled to claim Lessor is entitled to claim depreciation
principal.
depreciation
(ii) Long
term
sources
of finance
Hire purchase payments include interest Lease payments
is only
rent
and does
not
(a) Equity shares
and repayment of principal
include principal
Only interest portion of payment is claimed Total rent is tax deductible
(b) Preference shares
for tam
(c) Debentures and bonds
After becoming owner the hirer can claim Lessee cannot become owner of the asset
(d) Term loans
salvage value
(e) Leasing and Hire purchase
3. Write short notes on the following:
(f) Venture capital

Page 64
(g) Hybrid financing instruments
(c) Debentures and bonds
4. What are the functions of Indian capital and
(d) Term loans
stock market? Explain briefly
(e) Leasing and Hire purchase
Raise capital for industry
(f) Venture capital
Fair price for securities
(g) Hybrid financing instruments
Provide liquidity for financial

instruments that trade in a secondary
7. Discuss briefly recent developments in Indian

capital market
Features of capital market developments in
market
Maintains active trading
Ensure safe and fair dealing
Dissemination of information
Performance inducer
Self regulating
India
Repeal Of CCI Act/SEBI Act 1992 &

Amendments
Dematerialization of Securities-1997
Disclosure
and
Inv
Protection
Guidelines-2000-compliance with due
5. What are the functions of Indian capital and

stock market? Explain briefly
skill, diligence and care, disclose truth
Raise capital for industry
Fair price for securities
Provide liquidity for financial

instruments that trade in a secondary
Trading
Cycle-Uniform
Rolling
Settlement-2001
Screen Based Trading-2003-matching

orders in time/price priority
market
Globalization on Raising ResourcesADR/GDR/FCCB AND ECB,MF can set
Maintains active trading
up offshore funds for investing in
Ensure safe and fair dealing
equities
Dissemination of information
Straight through processing
Performance inducer
Demutualization and Corporatisation2004
Self regulating
6. What are Long term sources of finance?
(a) Equity shares
Derivative Trading
Risk Management-
(b) Preference shares
o Clearing Corporation

Page 65
o Settlement Guarantee Fund
Redemption
o Real Time Monitoring
Sinking Fund
o Var Based Margining-2001
Buy-back (call) provisions
o Automatic Disablement Etc.
Indenture
o IMSS(Exchange/Clg Corp/Dep)-
Security
Yield
Claim on Assets and Income
Non Convertible Debentures
Fully Convertible Debentures
Partly Convertible Debentures
Advantages
2007
8. What are the features of ordinary shares?
How is it better from other sources?
Claim on Income
Claim on Assets
Right to Control
Voting Rights
Pre-Emptive Rights
Limited Liability
Advantages
o Less Costly
o No ownership Dilution
o Fixed payment of interest
o Permanent Capital
o Borrowing Base
o Reduced real obligation
Disadvantages
o Obligatory Payment
o Dividend Payment
o Financial Risk
Discretion
o Cash outflows
Disadvantages
o Cost
o Risk
o Earnings Dilution
o Ownership Dilution
o Restricted Covenants
10. Explain features and advantages and
disadvantages of Preference shares
Similarity to Ordinary Shares:
9. Critically examine the features and merits and

demerits of debentures
Interest Rate
Maturity
1. Non payment of dividends does

not force company to insolvency.
2. Dividends are not deductible for
tax purposes.

Page 66
3. In some cases it has no fixed

maturity dates.
Similarity to Debentures:
1. Dividend rate is fixed.
2. Do not share in residual earnings.
3. Usually do not have voting
11. Explain characteristics of term loans
Maturity
Direct Negotiations
Security
Restrictive Covenants
o Asset related covenants
rights.
o Liability related covenants
Features
o Cash flow related covenants
o Claim on Income and Assets

o Fixed Dividend
o Cumulative Dividend
o Redemption
o Control related covenants
Convertibility
Repayment Schedule
o Sinking Fund
o Call Feature
o Participation Feature
o Voting Rights
o Convertibility
Advantages
1. Risk less Leverage
advantage
2. Dividend postponability
3. Fixed dividend
4. Limited Voting Rights
Disadvantages
1. Non-deductibility of
Dividends
2. Commitment to pay
dividends
Page 67

Page 68
2. List out and explain the method of

measuring the changes in the value of
money?
3. Calculate NPV and IRR?
4. Discuss fully the organization of the
FINANCIAL MANAGEMENT Unit 1

SUB: / BA 9222
PART A
1.
2.
3.
4.
What is finance?
Define financial management?
What is scope of financial management?
What is objective of financial
finance functions in a business?
UNIT 2 PART A
1. What is capital budgeting?
2. What is capital budgeting management?
3. What are the features of capital
budgeting?
4. What is the importance of capital
management?
5. What is function of financial
budgeting?
5. What are the principles and techniques of
management?
6. What is modern & traditional view on
capital budgeting?
6. Define IRR?
7. List the phases of capital budgeting?
8. What are the various types of projects?
9. Explain the concept of capital rationing?
10. Define cost of capital?
11. What is the significant of cost of capital?
12. What is the cost of retained earning?
13. What risk free rate?
14. What is meant by cash inflow and cash
7. What is the emerging role of the
9. What do you mean by portfolio?
10. What is the concept of risk and return of
portfolio?
11. What is systematic risk & unsystematic
risk?
12. What are the types of return?
13. What do you mean investment
decisions?
14. What is the formula of valuation of
bond?
15. What is call option and put option?
PART B
1. What are the objective and functions of
outflow?
UNIT -2
PART B
7) State the different kinds of capital budgeting

proposal. How would you rank them for the
Purpose of their selection?
8) What are the basic financial decisions? How
do they involve risk- return trade off?
9) What is equity? What is its yield to
maturity?
10) What is DCF of capital budgeting
techniques?
11) Calculate

Page 69
1. Payback period
method
2. NPV
3. IRR
1. Explain the consideration involved in
4. Profitability Index
5. How will you
corporation?
2. Explain in detail the impact of financial
calculate cost of
capital? Explain with
an illusteration?
UNIT 3
PART B
PART A
1. Explain the concept of leverage?

2. What are the types of leverages?
3. Define financial leverage?
4. Define financial structure?
5. What are the two bases which capital
evolving a balanced capital structure of a
leverage on earning per share?

3. What factors determine the dividend
decisions?
4. What factors determine the dividend policy
of a particular business enterprise?
5. Define dividend? Explain the various
theories of dividend with examples?
6. Explain modigliani and miller approach on
cost of capital?
7. Calculate
A. Operating leverage and
financial leverage?
B. Walters formula on dividend
structure is determined? And what is

optimum capital structure?
payout ratio at 0% ,
6. What is a share split?
20%,40%,80%,100%
7. What is indifference point in EBIT Eps
A Various factors influencing
analysis?
8. What is dividend?
9. What are various forms of dividend?
Dividend Policy
Dividend payout ratio
Stability of dividend
Legal aspects
Contractual requirements
12. What is MM approach?
Growth prospects
13. Compare a bonus issue and share split?
Investment requirements
14. What is commercial paper? And its features?
Availability of funds
Earning stability
Control
10. What are the different forms of dividend

policy?
11. What is NOI (NET OPERATING
INCOME) approach?
15. What are Payout Ration and its factors?
16. What is trading on Equity?

Page 70
Taxes
Opportunities
Capital market conditions
Inflation
the Net Income and
Cost
ke, ko
kd
Net Operating Income
Debt
approach of capital
structure theories.
Theories of
Capital
structure
1.Net
Income
(NI)
Approach
According to NI approach both the
cost of debt and the cost of equity
are
independent
structure;
they
of
the
remain
capital
constant
regardless of how much debt the
2.Net Operating
Income (NOI)
firm uses. As a result, the overall
Approach
cost of capital declines and the firm
According to NOI approach the
value increases with debt. This
value of the firm and the weighted
approach has no basis in reality;
average cost of capital are
the
independent of the firms capital
would
optimum
be
100
capital
per
structure
cent
debt
financing under NI approach.

Diagram
structure. In the absence of taxes,

an individual holding all the debt
and equity securities will receive
the same cash flows regardless of
the capital structure and therefore,
value of the company is the same.
Diagram

Page 71
unlevered firm. Thus, they will sell

shares of the over-priced firm and buy
Cost
shares
of the under-priced firm until
ke
the two values equate. This is called
arbitrage.
ko
kd
The cost of equity for a levered firm

Debt
equals the constant overall cost of

capital plus a risk premium that equals
the spread between the overall cost of
capital and the cost of debt multiplied
by the firms debt-equity ratio. For
financial leverage to be irrelevant, the
overall cost of capital must remain
constant, regardless of the amount of
3. MM
Theory of capital structure.
debt employed. This implies that the
MM Approach
cost of equity must rise as financial
Assumption:
risk increases

Homogeneous risk classes
Proposition three states that the cut off
Risk
rate of investment depends on the
No taxes
project not on sources of finance

Criticisms:
Full payout
Lending
Propositions:
MMs Proposition I states that the
and
borrowing
rate
discrepancy
firms value is independent of its
Non substitutability of personal
capital structure. With
and corporate leverages
personal
leverage, shareholders can receive
Transaction costs
exactly the same return, with the same
Institutional restrictions
risk, from a levered firm and an
Existence of corporate tax

Page 72
Factors determining optimum
known and it does not change over time.
capital structure
o The firm will incur the same transaction
Assets
Growth opportunities
Debt and Non debt tax
o The opportunity cost of holding cash is
cost whenever it converts securities to

cash.
o The firm incurs a holding cost for
shields
keeping the cash balance. It is an
Financial flexibility and
opportunity cost; that is, the return
operating strategy
foregone on the marketable securities. If
Sustainability
and
the opportunity cost is k, then the firms
flexibility
holding cost for maintaining an average
Control
cash balance is as follows:
Marketability and timing
Issue cost
Capacity of raising fund
o The firm incurs a transaction cost

whenever it converts its marketable
securities to cash. Total number of
transactions during the year will be total
funds requirement, T, divided by the
cash balance, C, i.e., T/C. The per
transaction cost is assumed to be
constant. If per transaction cost is c, then
the total transaction cost will be:
Different methods used for
o The total annual cost of the demand for

cash will be:
management of cash
Baumols model:
o The optimum cash balance, C*, is
o The firm is able to forecast its cash needs

with certainty.
obtained when the total cost is minimum.

The formula for the optimum cash
o The firms cash payments occur

uniformly over a period of time.
balance is as follows:
Miller orr model:

Page 73
The MO model provides for two
cash requirements
control limitsthe upper control limit

and the lower control limit as well as
a return point.
If the firms cash flows fluctuate
o Short-term Forecasting Methods
securities to come back to a normal
level of cash balance (the return
Similarly, when the firms cash flows

sells sufficient marketable securities
Receipt and disbursements method
The virtues of the receipt and payment

methods are:
normal level (the return point).
o It gives a complete picture of all
The difference between the upper
the items of expected cash flows.
limit and the lower limit depends on
o It is a sound tool of managing
the following factors:

o the interest rate, (i)
The adjusted net income

method.
to bring the cash balance back to the
o the transaction cost (c)
The receipt and

disbursements method
point).
wander and hit the lower limit, it
To manage investment of
surplus cash.
then it buys sufficient marketable
To anticipate short-term
financing
randomly and hit the upper limit,
To determine operating
daily cash operations.
This method, however, suffers from

the following limitations:
o the standard deviation (s) of net
o Its reliability is reduced because
cash flows.
of the uncertainty of cash

forecasts. For example,
collections may be delayed, or
Methods used for forecasting cash
unanticipated demands may
requirement
cause large disbursements. It fails
Short term forecast:
to highlight the significant

movements in the working
o The important functions of
capital items.
short-term cash forecasts
The adjustment Net Income method:

Page 74
o The benefits of the adjusted net

income method are:
o It highlights the movements in
Role and characteristics of credit

policy in receivable management
the working capital items, and

thus helps to keep a control on a
firms working capital.
o It helps in anticipating a firms
financial requirements.
o The major limitation of this method is:
o It fails to trace cash flows, and
therefore, its utility in controlling
o Credit policy
o credit standards
o credit terms
o collection efforts
o Marketing tool
o Maximisation of sales Vs.
incremental profit
o production and selling
costs
daily cash operations is limited.
o administration costs
Long term forecasts
The major uses of the long-term cash
o bad-debt losses
forecasts are:
o It indicates as companys future
financial needs, especially for its
working capital requirements.
o It helps to evaluate proposed
capital projects. It pinpoints the
cash required to finance these
profit
investment in receivable
o Estimation of incremental rate
of return (IRR)
o Comparison of incre-mental
projects as well as the cash to be
rate of return with required
generated by the company to
rate of return (RRR)
support them.
o Optimum credit policy: IRR =
o It helps to improve corporate
RRR
planning. Long-term cash
o Credit standards
forecasts compel each division to
o Credit analysis
plan for future and to formulate
o collection period
projects carefully.
o default rate

Page 75
Constant EPS and DIV

Infinite Time
Market price per share is the
character
capacity
condition
sum of the present value of the
capital
infinite stream of constant
collateral
dividends and present value of

the infinite stream of capital
o Credit terms
o credit period
o cash discount
o Collection policy and
procedures
o regularity of collections
gains.
OPTIMUM PAYOUT RATIO
earnings
o clarity of collection
procedures
o responsibility for
Growth firm r >k

EPS= 10, r=0.15, K=0.10
Normal firm r =k
collection and follow-up

o case-by-case approach
EPS= 10, r=0.10, K=0.10
Declining firm r < k
o cash discount for prompt

payment
o Collection period
o Aging schedule
o Collection experience matrix
Dividend Theorys
Dividend theory
Walters model
Gordons model
Modigliani and Miller model
Assumptions
Internal Financing
Capital
100% Payout or Retention
earnings
EPS= 10, r=0.08, K=0.10

Gordon's Model
Assumptions
All Equity Firm
No External Financing
Capital
Perpetual Earnings
No Taxes
Constant Retention
Cost of Capital greater than
Growth Rate
Valuation
Market value of a share is
equal to the present value of
an infinite stream of dividends
to be received by shareholders

Page 76
Growth firm
EPS=10, r=0.15, k=0.1

Normal firm
EPS=10, r=0.10, k=0.1

Declining firm
EPS=10, r=0.08, k=0.1

Modigliani and Miller model
Dividend policy has no effect on
the share price of the firm and
is , therefore, of no
consequence.
Assumptions :
No taxes
No change in risk due to
investment through
retained earnings
Investors are able to
forecast investments and
profits with certainty

Arbitrage and home made
dividend
Firm pays dividend from its
cash balance
Firm pays dividend by issuing
new shares because of no cash
balance
If firm does not pay dividend,
investors sell portion of their
shares and take as dividend

Arbitrage is a process of selling
and buying shares
simultaneously that will lead to
remove the gap between value
of different firms.

Page 77
6. What is float in cash management?
UNIT 4 PART A
1. Define the term working capital? What
are the various forms?
2. What is the concept and need of working
capital?
3. What is fluctuating working capital?
4. What are the methods used to forecasting
Explain different kind of floats in cash

management?
7. Explain the objectives of credit policy?
What is an optimum credit policy?
8. Sum calculates the working capital?
UNIT 5
PART A
working capital requirement?

5. What are the elements of working
1. What is authorized share capital and paid
capital?
6. What is permanent or fixed working
up share capital?
2. Who are associated with a company
capital?
7. Explain zero working capital?
8. Define Receivables?
9. Define operating cycle?
10. What are the functions of Factor?
11. What are the advantages of inventory
issue of capital?
3. What is authorized share capital and paid
control?
12. Explain the term Float?
13. Explain the nature of cash?
14. Explain the concept of re order point?
15. Explain stock out cost?
16. What is lead time?
17. What is trade credit? And letter of credit?
18. What is bank finance?
19. What is commercial paper?
PART B
up capital?
4. What is meant by debenture?
5. What is rule 72?
6. What is leasing? What are the various
types of financing?
7. Name
the
three
parties
in
leveraged
transactions?
8. Distinguish between term loans and bought
out loan deal?
9. Define Hire purchase?
PART B
1. Explain primary Market? And Explain
secondary
Market?
And
what
is
the
1. Write the format of working capital?

2. Explain the various determinations of
difference?
2. What are the sources of raising long term
working capital in a concern?

3. What is the concept of working capital
fund?
3. Distinguish
cycle? What is cash conversion cycle?

Why are these concepts important in
working capital management?
4. What are the various types of cost and
risk associated with receivables?
5. What are the various techniques of
between
share
holder
and
debenture holder?
4. What are the right and position of equity
share holders?
5. What is debenture? Explain the features?
What are the pros and cons from the view of
company and investors?
6. Explain lease and Hire purchase?
inventory management?
Page 78

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UNIT I FOUNDATIONS OF FINANCE:

Ramu Vasu., MBA.,M.PHIL., MNM JAIN ENGG COLLEGE

Financial management An overview- Time

Management and factoring - Inventory

value of money- Introduction to the concept

management Cash management - Working

of risk and return of a single asset and of a

capital finance : Trade credit, Bank finance

portfolio- Valuation of bonds and shares-

and Commercial paper.

UNIT V LONG TERM SOURCES OF

UNIT II INVESTMENT DECISIONS:

Capital Budgeting: Principles and techniques

Indian capital and stock market, New issues

- Nature of capital budgeting- Identifying

debentures and term loans, lease, hire

cash flows - Evaluation Techniques: Payback,

purchase, venture capital financing, Private

Accounting rate of return, Net Present Value,

Internal Rate of Return, Profitability Index Comparison of DCF techniques - Project

measurement of cost of capital - Specific cost

11 Title of the Question

consideration - forms of dividend policy forms of dividends - share splits.

Ramu Vasu., MBA.,M.PHIL., MNM JAIN ENGG COLLEGE

4. Concept of risk and return of a

1. Private Finance, which includes the

Individual, Firms, Business or Corporate

1. Financial An overview -Meaning

2. Public Finance which concerns with

Finance is regarded as the life blood of a

business enterprise. This is because in the

modern money oriented economy, finance

Government, State Government and

is one of the basic foundations of all kinds of

Semi-Government Financial matters.

finance is that business

Explain the relationship between financial

2. Definition of business finance

The relevance of economics to financial

acquisition and conversation of capital

management can be described in

funds in meeting financial needs and

the light of the two broad areas of economics:

macroeconomics and microeconomics.

Macroeconomics is concerned with the overall

institutional environment in which the firm

Finance is one of the important and integral

operates. It looks at the economy as a whole.

part of business concerns, hence, it plays a

major role in every part of the business

institutional structure of the banking system,

activities. It is used in all the area of the

activities under the different names.

intermediaries, monetary and fiscal policies.

Finance can be classified into two major

macroeconomic environment, it is important for

financial managers to understand the broad

economy; they should be aware of the various

obligations. Thus finance and accounting are

financial institutions; they should understand the

functionally closely related.

consequences of various levels of economic

But there are two key differences between