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Question No.

-1
Explain the liquidity decisions and its important elements. Write complete
information on dividend decisions.

Answer
Liquidity Decision
The liquidity decision is concerned with the management of the current
assets, which is a pre-requisite to long-term success of any business firm.
This is also called as working capital decision. The main objective of the
current assets management is the trade-off between profitability and
liquidity, and there is a conflict between these two concepts. If a firm does
not have adequate working capital, it may become illiquid and
consequently fail to meet its current obligations thus inviting the risk of
bankruptcy. On the contrary, if the current assets are too enormous, the
profitability is adversely affected. Hence, the major objective of the
liquidity decision is to ensure a trade-off between profitability and liquidity.
In other terms, liquidity decisions deal with working capital management.
It is concerned with the day-to-day financial operations that involve
current assets and current liabilities.
The important elements of liquidity decisions are:
Formulation of inventory policy
Policies on receivable management
Formulation of cash management strategies
Policies on utilisation of spontaneous finance effectively

Dividend Decision
Dividends are pay-outs to shareholders. Dividends are paid to keep the
shareholders happy. Dividend decision is a major decision made by the
finance manager.
Dividend is that portion of profits of a company which is distributed among
its shareholders according to the resolution passed in the meeting of the
Board of Directors. This may be paid as a fixed percentage on the share
capital contributed by them or at a fixed amount per share. The dividend
decision is always a problem before the top management or the Board of
Directors as they have to decide how much profits should be transferred
to reserve funds to meet any unforeseen contingencies and how much
should be distributed to the shareholders.

Since the goal of financial management is maximisation of wealth of


shareholders, dividend policy formulation demands the managerial
attention on the impact of its policy on dividend and on the market value
of its shares. Optimum dividend policy requires decision on dividend
payment rates so as to maximise the market value of shares. The pay-out
ratio means what portion of earnings per share is given to the
shareholders in the form of cash dividend.

Question No.-2
Explain about the doubling period and present value. Solve the below
given problem:
Under the ABC Banks Cash Multiplier Scheme, deposits can be made for
periods ranging from 3 months to 5 years and for every quarter, interest is
added to the principal. The applicable rate of interest is 9% for deposits
less than 23 months and 10% for periods more than 24 months. What will
be the amount of Rs. 1000 after 2 years?

Answer
Doubling Period
A very common question arising in the minds of an investor is how long will it
take for the amount invested to double for a given rate of interest.
There are 2 ways of answering this question:

1. One way is to answer it by a rule known as rule of 72.


This rule states that the period within which the amount doubles is obtained by
dividing 72 by the rate of interest. Though it is a crude way of calculating, this
rule is followed by most.
For instance, if the given rate of interest is 10%, the doubling period is
72/10, that is, 7.2 years.

2. A much accurate way of calculating doubling period is by using


the rule known as rule of 69. By this method,
Doubling Period = 0.35+69/Interest rate
Going by the same example given above, we get the number of years as

7.25 years {(0.35 + 69/10) or (0.35 +6.9)}.

Solution to problem
FVn = PV (1+i/m) m X n
m = 12/3 = 4 (quarterly compounding)
1000 (1+0.10/4)4*2
1000 (1+0.10/4)8
Rs. 1218
The amount of Rs. 1000 after 2 years would be Rs. 1218

Present Value
Present value can be simply defined as the current value of a future
sum. It can also be defined as the amount to be invested today (present
value) at a given rate of interest over a specified period to equal the
future sum. If we reverse the flow by saying that we expect a fixed
amount after n number of years and we also know the present prevailing
interest rate, then by discounting the future amount at the given interest
rate, we will get the present value of investment to be made.
The present value of a sum to be received at a future date is determined
by discounting the future value at the interest rate that the money could
earn over the period. This process is known as discounting.
1. Present value of a single flow
Ascertaining Present Value (PV) is simply the reverse of finding Future
Value (FV). Hence, the formula for FV can be simply transformed into the
PV formula.
PV=FVn / (1+i) ^n
Where, PV = Present Value
FVn = Amount (Future value after n years)
i = Interest rate
n = Number of years for which discounting is done

2. Present value of even series of cash flows


The PV of a series of cash flows can be represented by the following formula:
PVAn= A/ (1+i) ^1 + A/ (1+i) ^2 + A/ (1+i) ^3 ++ A/ (1+i) ^n

3. Present value of perpetuity


An annuity for an infinite time period is perpetuity. It occurs indefinitely. A person
may like to find out the present value of his investment assuming he will receive
a constant return year after year.
The present values of perpetuity can be expressed as follows:

PVIFAi, infinity = Sigma n=1 to infinity 1/ (1+i) ^n = 1/i

4. Present value of an uneven periodic sum


In some investment decisions of a firm, the returns may not be constant. In such
cases, the PV is calculated as follows:
P = A1/ (1+i) ^1 + A2/ (1+i) ^2 + A3/ (1+i) ^3 ++ An/ (1+i) ^n

5. Capital recovery factor


Capital recovery factor is the annuity of an investment for a specified time at a
given rate of interest.
The reciprocal of the present value annuity factor is called capital recovery
factor.
A = PVAn{i(1+i)^n / (1+i)^n-1)}

Question No.-3
Write short notes ona)
Operating leverage
b)
Financial leverage
c)
Combined leverage

Answer
a) Operating leverage
Operating leverage arises due to the presence of fixed operating expenses
in the firms income flows. It has a close relationship to business risk.

Operating leverage affects business risk factors, which can be viewed as


the uncertainty inherent in estimates of future operating income.
The operating leverage takes place when a change in revenue produces a
greater change in Earnings before Interest and Taxes (EBIT).
3 categories are:
Fixed costs are those which do not vary with an increase in production
or sales activities for a particular period of time. These are incurred
irrespective of the income and value of sales and generally cannot be
reduced.
Variable costs - are those which vary in direct proportion to output and
sales. An increase or decrease in production or sales activities will have a
direct effect on such types of costs incurred.
Semi-variable costs are those which are partly fixed and partly variable
in nature. These costs are typically of fixed nature up to a certain level
beyond which they vary with the firms activities.
b) Financial leverage
Financial leverage relates to the financing activities of a firm and
measures the effect of EBIT on Earnings per Share (EPS) of the company.
A companys sources of funds fall under two categories:
Those which carry fixed financial charges like debentures, bonds, and
preference shares
Those which do not carry any fixed charges like equity shares
Debentures and bonds carry a fixed rate of interest and are to be paid off
irrespective of the firms revenues. The dividends are not contractual
obligations, but the dividend on preference shares is a fixed charge and
should be paid off before equity shareholders. The equity holders are
entitled to only the residual income of the firm after all prior obligations
are met.
Financial leverage refers to a firms use of fixed-charge securities like
debentures and preference shares (though the latter is not always
included in debt) in its plan of financing the assets.
Financial leverage refers to the mix of debt and equity in the capital
structure of the firm. This results from the presence of fixed financial
charges in the companys income stream. Such expenses have nothing to
do with the firms performance and earnings and should be paid off
regardless of the amount of EBIT.
c) Combined leverage

The combination of operating and financial leverage is called combined


leverage. Operating leverage affects the firms operating profit EBIT and
financial leverage affects PAT or the EPS. These cause wide fluctuations in
EPS. A company having a high level of operating or financial leverage will
find a drastic change in its EPS even for a small change in sales volume.
Combined leverage is the product of DOL and DFL.
DTL = Q(S V) / Q(S-V)-F-I-{Dp/ (1-T)}

Question No.-4
Explain the factors affecting Capital Structure. Solve the below given
problem:
Given below are two firms, A and B, which are identical in all aspects
except the degree of leverage employed by them. What is the average
cost of capital of both firms?
Details of Firms A and B
Net operating income
EBIT
Interest on debentures
Equity earnings E
Cost of equity Ke
Cost of debentures Kd
Market value of equity
S=E/Ke
Market value of debt B
Total value of firm V

Firms A

Firms B

Rs 100000

Rs 100000

nil
Rs 100000
15%
10%

Rs 25000
Rs 75000
15%
10%

Rs 666667

Rs 500000

nil
Rs 666667

Rs 250000
Rs 750000

Answer
Factors Affecting Capital Structures
Capital structure should be planned at the time a company is promoted.
The initial capital structure should be designed very carefully. The
management of the company should set a target capital structure, and
the subsequent financing decisions should be made with a view to achieve
the target capital structure.

The major factor affecting the capital structure is leverage. There are also
a few other factors affecting them. All the factors are explained briefly
here.
1. Leverage
The use of sources of funds that have a fixed cost attached to them, such
as preference shares, loans from banks and financial institutions, and
debentures in the capital structure, is known as trading on equity or
financial leverage.
The leverage impact is felt more in case of debt because of the following
reasons:
The cost of debt is usually lower than the cost of preference share
capital
The interest paid on debt is a deductible charge from profits for
calculating the taxable income while dividend on preference shares is
not.
2. Cost of capital
High cost funds should be avoided. However attractive an investment
proposition may look like, the profits earned may be eaten away by
interest repayments.
3. Cash flow projections of the company
Decisions should be taken in the light of cash flow projected for the next
3-5 years. The company officials should not get carried away at the
immediate results expected.
4. Dilution of control
The top management should have the flexibility to take appropriate
decisions at the right time. Fear of having to share control and thus being
interfered by others often delays the decision of the closely held
companies to go public. To avoid the risk of loss of control, the companies
may issue preference shares or raise debt capital.
5. Floatation costs
Floatation costs are incurred when the funds are raised. Generally, the
cost of floating a debt is less than the cost of floating an equity issue. A
company desiring to increase its capital by way of debt or equity will
definitely incur floatation costs.
Solution of problem-

Average cost of capital of firm A is:


10% * 0/Rs. 666667 + 15% * 666667/666667 = 0 + 15 = 15%
Average cost of capital of firm B is:
10% * 25000/750000 + 15% * 533333/750000 = 3.34 + 10 = 13.4%
Interpretation:
The use of debt has caused the total value of the firm to increase and the
overall cost of capital to decrease.

Question No.-5
Explain all the sources of risk in capital budgeting with examples.
Solve the below given problemAn investment will have an initial outlay of Rs 100,000. It is expected to
generate cash inflows. Cash inflow for four years.
Year
1
2
3
4

Cash Inflow
40000
50000
15000
30000

If the risk free rate and the risk premium is 10%,


a) Compute the NPV using the risk free rate
b) Compute NPV using risk-adjusted discount rate

Answer
Capital budgeting involves four types of risks in a project: stand-alone risk,
portfolio risk, market risk and corporate risk.
a. Stand-alone risk

Standalone risk of a project is considered when the project is in isolation.


Stand-alone risk is measured by the variability of expected returns of the
project.
b. Portfolio risk
A firm can be viewed as portfolio of projects having a certain degree
of risk. When new project is added to the existing portfolio of project, the
risk profile of the firm will alter. The degree of the change in the risk
depends on the following:
The co-variance of return from the new project
The return from the existing portfolio of the projects
c. Market risk
Market risk is defined as the measure of the unpredictability of a given
stock value. However, market risk is also referred to as systematic risk.
The market risk has a direct influence on stock prices. Market risk is
measured by the effect of the project on the beta of the firm. The market
risk for a project is difficult to estimate, as it includes a wide range of
external factors like recessions, wars, political issues, etc.
d. Corporate risk
Corporate risk focuses on the analysis of the risk that might influence the
project in terms of entire cash flow of the firms. Corporate risk is the
projects risks of the firm.
Sources of risk
The five different sources of risk are:

Project-specific risk
Competitive or competition risk
Industry-specific risk
International risk
Market risk

Solution of problemA. NPV can be computed using risk free rate.


Year
1
2
3
4

Cash flows
PV factor for 10% PV for cash flow
40000
0.909
36360
50000
0.826
41300
15000
0.751
11265
30000
0.683
20490
PV for cash inflows
109415

PV for cash
outflows
NPV

(100000)
9415

B. NPV can be computed using risk-adjusted discount


Year
1
2
3
4

Cash inflows
40000
50000
15000
30000
PV for cash flows
PV for cash
outflows
NPV

PV factor at 20%
0.833
0.694
0.579
0.482

PV for cash inflow


33320
34700
8685
14460
91165
(100000)
(8835)

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


However, it will not be acceptable if risk premium is added to the risk free
rate. By doing so, it moves from positive NPV to negative NPV. If the firm
were to use the internal rate of return (IRR), then the project would be
accepted, when IRR is greater than the risk-adjusted discount rate.

Question No.-6
Explain the objectives of Cash Management. Write about the Baumol
model with their assumptions.

Answer
Objectives of cash management
The major objectives of cash management in a firm are:
Meeting payments schedule
Minimising funds held in the form of cash balances
Meeting payments schedule
The basic objective of cash management is therefore to meet the
payment schedule on time. Timely payments will help the firm to maintain
its creditworthiness in the market and to foster cordial relationships with
creditors and suppliers. Creditors give cash discount if payments are
made in time and the firm can avail this discount as well.
Trade credit refers to the credit extended by the supplier of goods and
services in the normal course of business transactions.

The other advantage of meeting the payments on time is that it prevents


bankruptcy that arises out of the firms inability to honour
its commitments. At the same time, care should be taken not to keep
large cash reserves as it involves high cost.
Minimising funds held in the form of cash balances
A high level of cash balance will help the firm to meet its first objective,
but keeping excess reserves is also not desirable as funds in its original
form is idle cash and a non-earning asset. It is not profitable for firms to
maintain huge balances.
A low level of cash balance may mean failure to meet the payment
schedule. The aim of cash management is therefore to have an optimal
level of cash by bringing about a proper synchronisation of inflows and
outflows, and to check the spells of cash deficits and cash surpluses.
Seasonal industries are classic examples of mismatches between inflows
and outflows.
The efficiency of cash management can be augmented by controlling a
few important factors:
Prompt billing and mailing
There is a time lag between the dispatch of goods and preparation of
invoice. Reduction of this gap will bring in early remittances.
Collection of cheques and remittances of cash
Generally, we find a delay in the receipt of cheques and their deposits in
banks. The delay can be reduced by speeding up the process of collecting
and depositing cash or other instruments from customers.
Float
The concept of float helps firms to a certain extent in cash management.
Float arises because of the practice of banks not crediting the firms
account in its books when a cheque is deposited by it and not debiting the
firms account in its books when a cheque is issued by it, until the cheque
is cleared and cash is realised or paid respectively.
Baumol model
The Baumol model helps in determining the minimum amount of cash that
a manager can obtain by converting securities into cash. Baumol model is
an approach to establish a firms optimum cash balance under certainty.
As such, firms attempt to minimise the sum of the cost of holding cash
and the cost of converting marketable securities to cash. Baumol model of
cash management trades off between opportunity cost or carrying cost or
holding cost and the transaction cost.

The Baumol model is based on the following assumptions:


The firm is able to forecast its cash requirements in an accurate way.
The firms pay-outs are uniform over a period of time.
The opportunity cost of holding cash is known and does not change with
time.
The firm will incur the same transaction cost for all conversions of
securities into cash.
Baumol cut-off model
The total cost associated with cash management has two elements:
Cost of conversion of marketable securities into cash and
Opportunity cost
The firm incurs a holding cost for keeping cash balance, which is the
opportunity cost. Opportunity cost is the benefit foregone on the next best
alternative for the current action. Holding cost is k*(C/2).