financial management NAME: ROLL NUMBER: KOTIAN SUBHA RAMESH 511016602

COURSE:

MASTER OF BUSINESS ADMINISTRATION

SEMESTER:

Second

SUBJECT:

financial management

SUBJECT CODE:

MB0045

Centre code:

02542

ASSIGNMENT SET: I

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financial management
Q.1 Write the short notes on: 1. Financial management: Financial management is basically concerned with decision-making and decision is concerned with the utilization of fund and composition of assets and the level and structure of financing to benefit its stakeholder. Financial Management can be defined as The management of the finances of a business or organization in order to achieve financial objectives. Management of funds acts as the foremost concern whether it is in a business undertaking or in an educational institution. In order to make right decision, it is necessary to have a clear understanding of the objectives. Such an objective provides a framework for right kind of financial decision making. The objectives are concerned with designing a method of operating the Internal Investment and financing of a firm. Moreover Financial Management is the art and science of managing money which helps in Profit Maximization and Wealth Maximization. Financial Management deals with procurement of funds and their effective utilization in the business. So the analysis simply states two main aspects of financial management like procurement of funds and an effective use of funds to achieve business objectives. Importance of Financial Management Financial Management is indeed the key to successful business operations. Without proper administration and effective utilization of finance, no business enterprise can utilize its potentials for growth and expansion. The importance of financial management is: 1. Successful promotion: Successful promotion of a business concern depends upon efficient financial management. If the plan adopted fails to provide
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adequate capital to meet the requirements of fixed and working capital and particularly the latter, the firm cannot carry on its business successfully. Therefore, sound financial planning is quite essential for the success of a business firm. 2. Smooth Running: Since finance is required at each stage of the business such as promotion, incorporation, development, expansion and management of day-to-day expenses, proper financial administration becomes necessary for the smooth running of a business enterprise. 3. Decision making: Financial management provides scientific analysis of all facts and figures through various financial tools such as ratio analysis, variance analysis, budgets etc., Such an analysis helps the management to evaluate the profitability of the plan in the given circumstances so that a proper decision can be taken to minimize the risk. 4. Solutions to Financial Problems: The efficient Financial Management helps the top management by providing solutions to the various financial problems faced by it. 5. Measure of performance: Financial Management is considered as a yard stick to measure the Functions of financial management The functions of financial management are classified on the basis of Liquidity, Profitability and Management. 1. Liquidity: It is ascertained on the basis of three important considerations. a) Forecasting cash flows: matching the inflows against cash outflows. b) Raising funds: financial manager will have to ascertain the sources from which funds may be raised and the time when these funds are needed. c) Managing the flow of internal funds

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2. Profitability: While ascertaining profitability, the following factors are taken into account. a) Cost control b) Pricing c) Forecasting future profits d) Measuring cost of capital 2. Management: Asset management has assumed an important role in financial management. It includes: (a) the management of long term funds. (b) The management of short term funds. 2. Financial planning: Financial Planning is deciding in advance the course or line of action for the future in respect of the financial management of a concern. It includes: (i) estimating the amount of finance or capital to be raised (ii) determining the forms and the proportionate amount of the securities to be issued for raising the capital and (iii) Laying down the policies as to the administration of the financial plan. Financial Planning plays a vital role to get the most out of from individuals money. In the competing world to survive in industry a firm need has to plan strategy accordingly hence Financial planning is a process of setting objectives, assessing assets and resources, estimating future financial needs, and making plans to achieve monetary goals.. Resources like Plan and Machinery, buildings, technology and any other assets is necessary to execute the strategy. Management need to ensure that enough funding is available at the right time to meet the needs of the business. Financial Planning has to be done short term as well long term. In the short term, funding may be needed to invest in equipment and stocks, pay employees and
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fund sales made on credit. Long term, funding may be required for significant additions to the productive capacity of the business or to make acquisitions. A proper financial planning helps the company to achieve its goal and ensures effective utilization of funds during shortage of funds it also helps in elimination of wastages in the process execution. Careful planning can help management to set priorities and work steadily towards long-term goals. It may also provide protection against the unexpected loss of income. Financial Planning should be never ignored a proper planning helps to eliminate the drawbacks and move forward to right goal. 3. Capital Structure: Capital structure refers to the mix or proportions of a firms permanent long-term financing represented by debt, preference capital and equity capital. The Capital structure includes debt-equity mix and dividend decision. Various types of equity and debt that constitute a capital structure, the components that make up these two asset classes are bonds and preferred stock. Bonds are a form of debt, and include loans that a company takes out with a financial institution or with investors. Debt is also considered leverage, and when a company has too much debt on its balance sheet, it is said to be over-levered. The right capital structure supports strategic-financial goals by optimizing flexibility and minimizing cost. Capital structure is the combination of debt and equity that funds a firms strategic plan. The particular mix of debt and equity which maximizes the value of the firm is known as optimum capital structure. The existence of an optimal capital structure, there is a difference of opinion. According to one school of thought, capital structure decision is irrelevant, as it does not affect the value of the firm. According to them there is nothing like optimum capital structure. According to the other school of thought, the capital structure decision is relevant to the valuation of the firm. So by changing the debt equity mix, we can change the
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value of the firm. The value of the firm will be maximum at the optimum capital structure. So every firm wants to have optimum capital structure. Features of an Appropriate Capital Structure The financial manager should develop an appropriate capital structure, which is most advantageous to the company. This can be done only when all the factors, which are relevant to the companys capital structure decision, are properly analysed and balanced. Capital structure so arrived may not be optimum but most reasonable. So some people call it as appropriate or sound capital structure. A capital structure is considered as appropriate if it possesses the following features: 1. Profitability: A capital structure is most profitable when the overall cost of capital is minimum and gives highest EPS. 2. Solvency: Excess use of debt threatens the solvency and liquidity of the company. While designing the capital structure, the financial manager must try to reduce cost of capital and also limit the financial risk to acceptable level. 3. Flexibility: The capital structure should be such that it can be easily adjusted to meet the changing conditions. It should also maintain the ability of the firm to borrow for future growth and development. 4. Control: Capital structure should be so designed that it involves minimum risk of loss of control of the company. This is highly relevant because in many of the Indian companies promoters do not have a majority stake. 4. Cost of Capital: Cost of capital is a composite cost of the individual sources of funds including common stock, debt, preferred stock, and retained earnings. The overall cost of capital depends on the cost of each source and the proportion that source represents of all capital used by the firm. The goal of an individual or business is
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to limit investment to assets that provide a return that is higher than the cost of the capital that was used to finance those assets. Cost of capital may be defines as the minimum rate of return the company must earn on the investments to keep the price of the shares at the same level. If a company earns a return which is more than a cost of capital, the market price per share is expected to increase. If the company earns a rate of return, which is less than the cost of capital, the market price per share is expected to fall. Therefore cost of capital is the minimum rate of return to be earned on the investments to ensure that the price of the share does not fall in the market. Cost of capital is crucial in financial management it should be used in the most effective manner unless that cost can be accurately determined and taken into account. The ultimate goal is for the investment to generate a positive cost of capital. The term cost of capital, as the acceptance criterion or investment proposals, is used in the sense of the combined cot of all sources of financing. This is mainly because focus is on the valuation of the firm as a whole. It is related to the firms objective of wealth maximization. Significance of Cost of Capital Cost of capital is an extremely important concept in financial decision-making. The determination of cost of capital is important for the following reasons: 1. Capital budgeting decisions: Cost of capital is basic input information required in investment decisions. Under NPV method, a project is accepted if it has a positive NPV when cash flows are discounted at cost of capital. Under IRR method, a project is accepted if it has a return greater than the cost of capital. Even in case of discounted payback and profitability index method cost of capital is used to discount the cash flows. 2. Designing debt policy: While designing debt policy and determining the debt equity proportions, the firm aims at minimizing the overall cost of capital. Costs of capital of different sources are not same. Therefore the firm should
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always aim at raising the source of finance which is cheap, in an effort to reduce overall cost of capital. 3. Performance appraisal: Cost of capital figure is used as a benchmark to measure the performance of the management in rising finance. Actual cost of capital is compared with the standard cost of capital to evaluate the performance of the management. 4. Dividend decision: Cost of capital is also very useful while taking dividend decision. Whether the earnings of the company should be retained or distributed also depends on cost of capital. 5. Trading on Equity: Trading on the equity means making use of borrowed funds to increase the investment of capital. The concept of trading on equity is the financial process of using debt to produce gain for the residual owners or the equity shareholders. Trading on the equity is not an unusual means of leveraging finances in order to position a company to take advantage of emerging markets or opportunities to expand the companys presence in an existing market. The use of fixed charges sources of funds such debt and preference capital along with equity capital is described as financial leverage or trading on equity. 2 .a. Write the features of interim divined and also write the factors Influencing divined policy? Dividend is that portion of net profits which is distributed among the shareholders. The dividend decision of the firm is of crucial importance for the finance manager since it determines the amount to be distributed among shareholders and the amount of profit to be retained in the business. A company might pay dividends in two stages during the course of their accounting year: In the mid year, after the half financial results are known, the company might pay an interim dividend and at the end of the year the company might pay a further final dividend.
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The dividend declared by a company after finalisation of accounts in the annual general body meeting with the approval of the share holders is final dividend. Whilst the dividend declared by the company in anticipation of good profits before the finalisation of accounts, with the approval of the board of directors is called interim dividend. It is called interim, because it is paid, in between two annual general board meeting n without finalisation of accounts n without approval of the share holders. It favourably affects the share holders in two ways.1.The share holders get cash before the end of the year in the form of dividend.2.The share price of the company increases due to improved sentiment for interim dividend. Internal Factors: The following are the internal factors, which affect the dividend policy of the firm. (a) Desires of shareholders: Even if the directors have considerable liberty regarding the disposal of firms earnings, the shareholders are technically the owners of the company and therefore their desire cannot be overlooked by the directors while taking the dividend decision. In case of a closely held company, the desires of shareholders are usually known and hence there is no problem. But in the case of a widely held company, it is very difficult to ascertain the preferences of shareholders. The interests of various shareholders are usually in conflict. Here the management can try to satisfy majority of shareholders by its dividends policy. Further the dividend policy once established should be continued as long as possible to create a clientele effect. (to attract those investors who are happy with the firms dividend policy.) (b) Financial needs of the company: Financial needs of the company may be in direct conflict with the desire of the shareholders to receive large dividends. However a prudent management should give proper weightage to the financial needs of the company. So growth firms are likely to follow low payout ratio and declining companies are likely to follow high payout ratio.
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(c) Nature of earnings: The companies with stable earnings need to follow high payout ratio and vice versa. Public utilities are the classic examples of firms with stable earnings and they follow high payout ratio. (d) Desire for control: If a growth company pays dividend it has to issue additional equity shares. If the existing shareholders are unable to buy the additional shares their voting power will be diluted. So the management may not pay more dividends in the fear of losing control over the company. (e) Liquidity position: Liquidity is the continuous ability of a company to meet the maturing obligations as and when they become due. Payment of dividends means outflow of cash. So a firm may have adequate earnings but it may not be in a position to pay dividend due to liquidity problems. (f) Return on investment: The firm should not retain the earnings if return on investment is less than the cost of capital. External Factors : The following are the external factors which affects the dividend policy of a firm. a) General state of the economy: The general state of the economy affects to a great extent the managements decision to retain or to distribute earnings of the firm. In case of uncertain economic and business conditions, the management may like to retain whole or part of the firms earnings to build up reserves to absorb shock in the future. Similar policy may be followed by the management during depression to improve the liquidity position of the firm. During boom, the management may not declare liberal dividends though the earnings are high because of availability of profitable investment opportunities. b) State of the capital market: A company, which is not sufficiently liquid, can pay dividends if it is able to raise debt or equity in the capital market. Generally sound and big companies will not find it difficult to raise funds in the capital market. But a small company which does not have a sound
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cash position and also unable to raise capital in the market, will not be able to pay more dividends. Thus favorable conditions in the capital market will enable the company to pay liberal dividends even if it is not liquid. c) Contractual restrictions: Lenders generally put restrictions on dividend payments to protect their own interest. For example loan argument may prohibit the payment of dividend as long as current ratio is less than 2:1 d) Tax policy: 1. Corporate tax: Heavy taxes reduce the residual profits available for distribution. 2. Dividend tax: Dividend tax discourages the company from paying liberal dividends. Dividend tax has to be paid when dividends are paid. e) Legal restrictions: The Companies Act of 1956 has put several restrictions regarding payment and declaration of dividends. Some of them are: 1. Dividends can be paid out of current profits. Payment of dividend out of capital is illegal. 2. A company is not entitled to pay dividend unless it has provided for present as well as arrears of depreciations. 3. Certain percentage of net profits of that year as specified by the Act not exceeding 10% must be transferred to the reserves of the company. 4. Past profits can be used for declaration of dividends only as per rules framed by the Central Govt. Similarly Indian Income Tax Act also lays down certain restrictions on payment of dividends. The management has to consider all these restrictions while determining the dividend policy.

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2 (b) Reorder Level: Reorder level is that level of stock at which purchase orders is to be placed for its replenishment. In other words this is the point fixed between the maximum and minimum stock levels and at this time, it is essential to initiate purchase action for fresh supplies of the material. This level is fixed somewhere between the maximum level and the minimum level. The idea behind the fixation of the order level is to ensure that the fresh supply of materials is obtained before the minimum level is reached. . In order to cover the abnormal usage of material or unexpected delay in delivery of fresh supplies, this point will usually be fixed slightly higher than the minimum stock level. This level is fixed after considering after considering the following factors: Rate of consumption Lead-time Maximum delivery time Minimum delivery time EOQ

Formula for Computing Reorder Level: Reorder Level = Maximum Reorder Period Maximum Usage

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Q.3 Sales Rs.400, 000 less returns Rs 10, 000, Cost of Goods Sold Rs 300,000, Administration and selling expenses Rs.20, 000, Interest on loans Rs.5000, Income tax Rs.10000, preference dividend Rs. 15,000, Equity Share Capital Rs.100, 000 @Rs. 10 per share. Find EPS.

Particulars Sales Less: returns Net sales cost of goods sold Gross profit Administration and selling expenses EBIT Interest on loan EBT Income Tax EAT Preference Dividend Earnings holders EPS (earning available / no. shares ) of equity available to equity share

Amount 400,000 -10,000 390,000 -300,000 90,000 -20,000 70,000 -5,000 65,000 -10,000 55,000 -15,000 40,000 40,000/10000= 4

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Q.4 What are the techniques of evaluation of investment? Investment decision involves the evaluation of future long-range projects or courses of activity to effectively and efficiently allocate limited resources. It consists of comparing and evaluating alternative projects within a budgetary framework. 1. Non-discounted Cash Flow Criteria a. Payback period method b. Accounting rate of return method 2. Discounted cash flow Criteria a. The net present value method b. Internal rate of return c. Discounted Payback Period (DPB) Non-discounted Cash Flow Criteria a) Payback period The payback period is the time it takes an investor to recoup an original investment through cash flows from a project. The longer it takes to recover the initial investment, the greater is the projects risk because cash flows in the more distant future are more uncertain than relatively current cash flows. The faster that capital is returned from an investment, the more rapidly it can be invested in other projects. Payback period for a project having unequal cash inflows is determined by accumulating cash flows until the original investment is recovered. An annuity is a series of equal cash flows (either positive or negative) per period. The payback period method ignores three important aspects: inflows occurring after the payback period have been reached; the companys desired rate of return and the time value of money.

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b) Accounting Rate of Return (ARR) The accounting rate of return is found out by dividing the average income after taxes by the average investment. For this purpose, capital employed and related income are determined according to commonly accepted accounting principles and practices, over the entire economic life of the project and then the average yield is calculated. This method is based on conventional accounting concepts. The rate of return is expressed as a percentage of the earnings of the investment in a particular project. Following formula can be used to know the ARR. Estimated Average Income ARR= Estimated Average Investment x 100

Original investment scrap value Average investment = 2

Discounted cash flow Criteria a) Net present value The net present value method is a process that uses the discounted cash flows of a project to determine whether the rate of return on that project is equal to, higher than, or lower than the desired rate of return. A projects net present value (NPV) is the difference between the present values of all cash outflows for an investment project. The actual rate of return on the project is equal to the
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desired rate of return if the NPV is zero. The actual rate of return on the project is greater than the desired rate of return if the NPV is positive. The actual rate of return on the project is less than the desired rate of return if the NPV is negative. The net present value method provides information on how the actual rate compares to the desired rate, allowing managers to eliminate from consideration any projects on which the rates of return are less than the desired rate and, therefore, not acceptable. b) Internal Rate of Return (IRR) The internal rate of return (IRR) is the discount rate that causes the present value of the net cash inflows to equal the present value of the net cash outflows and is the projects expected rate of return; if the IRR is used to determine the NPV of a project, the NPV is zero c) Discounted payback period The discounted payback period is the number of periods taken in recovering the investment outlay on the present value basis. The discounted payback period still fails to consider the cash flows occurring after the payback period

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Q.5 What are the problems associated with inadequate working capital? The concept of working capital has been a matter of great controversy among the financial wizards. Different views on working capital can be classified into two groups, Viz. Gross working capital concept and Net working capital concept. Gross Working Capital: According to this concept, working capital refers to the sum total of all current assets of the enterprise employed in the business process. This is a going concern concept, since the finance manager is highly concerned with the management of assets with a view to bringing about productivity from other assets. Net Working Capital: This concept represents excess of current assets over current liabilities. It is also that portion of a firms current assets which is financed by long term funds. Thus, the gross concept is in the nature of a quantitative definition that focuses attention on the levels of current assets for given activity. Whilst the Net working capital is in the nature of a qualitative definition which highlights the character of the sources from which the funds have been procured to support that portion of current assets which is in excess of current liabilities. Problems associated with Inadequate Working Capital 1. A concern which has inadequate working capital cannot pay its shortterm liabilities in time. Thus, it will lose its reputation and shall not be able to get good credit facilities. 2. Implementation of operating plans becomes difficult and a concern may not achieve its profit target. 3. Bargaining capacity is reduced in credit purchases and cash discount could not be availed.
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4. Fixed Assets cannot efficiently and effectively be utilized on account of lack of sufficient working capital. 5. A concern may be bound to sale its product at a very reduced rates to collect funds which may harm its image 6. It becomes difficult for the firm to exploit favourable market conditions and undertake profitable projects due to lack of working capital. 7. Operating inefficiencies may creep in when a concern cannot meet it financial promises. 8. Low liquidity position may lead to liquidation of firm. Q.6 What is leverage? Compare and Contrast between operating Leverage and financial leverage The term leverage may be defined as the employment of an asset or sources of funds for which the firm has to pay a fixed cost or fixed return. James Horne has defined the leverage as the employment of an asset or funds for which the firm pays a fixed cost or fixed return. Thus according to him leverage results when the firm employs an asset or source of funds for which the firm has to pay a fixed cost or fixed return. Leverage refers to the use of an asset or source of funds which involves fixed costs or fixed returns. Leverage may be operating, or financial leverage. Operating leverage exits when fixed costs are present. The variability in the EBIT due to change in sales is affected by the composition of fixed and variable costs. As fixed costs remain the same, total cost increases less than proportionality as and when the output is increased. Therefore one percent change in sales is followed by more than one percent change in EBIT. The percentage change in EBIT occurring due to a given percentage change in sales is referred to as degree of operating leverage (DOL). High operating leverage is good news when the sales are rising and a bad news when the sales are falling.

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Financial leverage occurs when fixed cost funds such as debt or preference capital is employed by the company. The main purpose of using fixed cost funds is to increase the shareholders return. Financial leverage involves the uses of fixed cost sources of finance like debt and preference capital. Interestingly, financial leverage is acquired by the firm by choice while operating leverage is not. The firm employs financial leverage in the hope of increasing return to the shareholders. This happens when the firm earns more return from the debt or preference capital than what is paid to them. As the shareholders are residual owners, they enjoy the entire profits left after paying interest and preference dividend. If the company earns a return which is more than the cost of debt or preference capital, there is a favorable financial leverage and vice versa. When there is financial leverage, 1% change in EBIT will be followed by more than 1% change in EPS. Relationship: Financial and Operating leverage: Relationship between financial and operating leverage: In business terminology, leverage is used in two senses: Financial leverage & Operating Leverage Financial leverage: The effect which the use of debt funds produces on returns is called financial leverage. Operating leverage: Operating leverage refers to the use of fixed costs in the operation of the firm. A firm has a high degree of operating leverage if it employs a greater amount of fixed costs. The degree of operating leverage may be defined as the percentage change in profit resulting from a percentage change in sales. This can be expressed as: = Percent Change in Profit/Percent Change in Sales The degree of financial leverage is defined as the percent change in earnings available to common shareholders that is associated with a given percentage change in EBIT. Thus, operating leverage affects EBIT while financial leverage affects earnings after interest and taxes the earnings available to equity shareholders. For this reason operating leverage is sometimes referred to as first stage leverage and financial leverage as second stage leverage. Therefore, if a
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firm uses a considerable amount of both operating leverage and financial leverage even small changes in the level of sales will produce wide fluctuations in earnings per share (EPS). The combined effect of both these types of leverages is after called total leverage which, is closely tied to the firms total risk. Thus we find that the financial leverage is a double edged sword.

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