Spring 2012, MBA-2nd Semester

FEBRUARY 2012 Master of Business Administration (MBA) Semester 2 MB0045 Financial Management (4 Credits) (Book ID: B1134) Assignment Set- 1

MB0045: Financial Management

Roll No. : 541110058

Page 1

Spring 2012, MBA-2nd Semester

Q1. Show the relationship between required rate of return and coupon rate on the value of a bond. Ans. It is important for prospective bond buyers to know how to determine the price of a bond because it will indicate the yield received should the bond be purchased. In this section, we will run through some bond price calculations for various types of bond instruments. Bonds can be priced at a premium, discount, or at par. If the bonds price is higher than its par value, it will sell at a premium because its interest rate is higher than current prevailing rates. If the bonds price is lower than its par value, the bond will sell at a discount because its interest rate is lower than current prevailing interest rates. When you calculate the price of a bond, you are calculating the maximum price you would want to pay for the bond, given the bonds coupon rate in comparison to the average rate most investors are currently receiving in the bond market. Required yield or required rate of return is the interest rate that a security needs to offer in order to encourage investors to purchase it. Usually the required yield on a bond is equal to or greater than the current prevailing interest rates. Fundamentally, however, the price of a bond is the sum of the present values of all expected coupon payments plus the present value of the par value at maturity. Calculating bond price is simple: all we are doing is discounting the known future cash flows. Remember that to calculate present value (PV) which is based on the assumption that each payment is re-invested at some interest rate once it is receivedwe have to know the interest rate that would earn us a known future value. For bond pricing, this interest rate is the required yield. Here is the formula for calculating a bonds price, which uses the basic present value (PV) formula: C = coupon payment n = number of payments i = interest rate, or required yield M = value at maturity, or par value

The succession of coupon payments to be received in the future is referred to as an ordinary annuity, which is a series of fixed payments at set intervals over a fixed period of time. (Coupons on a straight bond are paid at ordinary annuity.) The first payment of an ordinary annuity occurs one interval from the time at which the debt security is acquired. The calculation assumes this time is the present.

MB0045: Financial Management

Roll No. : 541110058

Page 2

Spring 2012, MBA-2nd Semester

You may have guessed that the bond pricing formula shown above may be tedious to calculate, as it requires adding the present value of each future coupon payment. Because these payments are paid at an ordinary annuity, however, we can use the shorter PV-of-ordinary-annuity formula that is mathematically equivalent to the summation of all the PVs of future cash flows. This PVof-ordinary-annuity formula replaces the need to add all the present values of the future coupon.

Each full moneybag on the top right represents the fixed coupon payments (future value) received in periods one, two and three. Notice how the present value decreases for those coupon payments that are further into the future the present value of the second coupon payment is worth less than the first coupon and the third coupon is worth the lowest amount today. The farther into the future a payment is to be received, the less it is worth today is the fundamental concept for which the PV-of-ordinary-annuity formula accounts. It calculates the sum of the present values of all future cash flows, but unlike the bond-pricing formula we saw earlier, it doesnt require that we add the value of each coupon payment. By incorporating the annuity model into the bond pricing formula, which requires us to also include the present value of the par value received at maturity, we arrive at the following formula: Lets go through a basic example to find the price of a plain vanilla bond. Example 1: Calculate the price of a bond with a par value of $1,000 to be paid in ten years, a coupon rate of 10%, and a required yield of 12%. In our example well assume that coupon payments are made semi-annually to bond holders and that the next coupon payment is expected in six months. Here are the steps we have to take to calculate the price: 1. Determine the Number of Coupon Payments: Because two coupon payments will be made each year for ten years, we will have a total of 20 coupon payments. 2. Determine the Value of Each Coupon Payment: Because the coupon payments are semiannual, divide the coupon rate in half. The coupon rate is the percentage off the bonds par value. As a result, each semi-annual coupon payment will be $50 ($1,000 X 0.05). 3. Determine the Semi-Annual Yield: Like the coupon rate, the required yield of 12% must be divided by two because the number of periods used in the calculation has doubled. If we left the required yield at 12%, our bond price would be very low and inaccurate. Therefore, the required semi-annual yield is 6% (0.12/2). 4. Plug the Amounts Into the Formula: From the above calculation, we have determined that the bond is selling at a discount; the bond price is less than its par value because the required yield of the bond is greater than the coupon rate. The bond must sell at a discount to attract investors, who could find higher interest

MB0045: Financial Management

Roll No. : 541110058

Page 3

Spring 2012, MBA-2nd Semester

elsewhere in the prevailing rates. In other words, because investors can make a larger return in the market, they need an extra incentive to invest in the bonds.

Accounting for different payment frequencies In the example above coupons were paid semi-annually, so we divided the interest rate and coupon payments in half to represent the two payments per year. You may be now wondering whether there is a formula that does not require steps two and three outlined above, which are required if the coupon payments occur more than once a year. A simple modification of the formula will allow you to adjust interest rates and coupon payments to calculate a bond price for any payment frequency.

Notice that the only modification to the original formula is the addition of F, which represents the frequency of coupon payments, or the number of times a year the coupon is paid. Therefore, for bonds paying annual coupons, F would have a value of one. Should a bond pay quarterly payments, F would equal four, and if the bond paid semi-annual coupons, F would be two.

Q2. What do you understand by operating cycle? Ans. An operating cycle is the length of time between the acquisition of inventory and the sale of that inventory and subsequent generation of a profit. The shorter the operating cycle, the faster a business gets a return on investment (ROI) for the inventory it stocks. As a general rule, companies want to keep their operating cycles short for a number of reasons, but in certain industries, a long operating cycle is actually the norm. Operating cycles are not tied to accounting periods, but are rather calculated in terms of how long goods sit in inventory before sale. When a business buys inventory, it ties up money in the inventory until it can be sold. This money may be borrowed or paid up front, but in either case, once the business has purchased inventory, those funds are not available for other uses. The business views this as an acceptable tradeoff because the inventory is an investment that will hopefully generate returns, but keeping the operating cycle short is still a goal for most businesses so they can keep their liquidity high. Keeping inventory during a long operating cycle does not just tie up funds. Inventory must be stored and this can become costly, especially with items that require special handling, such as humidity controls or security. Furthermore, inventory can depreciate if it is kept in a store too long. In the case of perishable goods, it can even be rendered unsalable. Inventory must also be insured and managed by staff members who need to be paid, and this adds to overall operating expenses.
MB0045: Financial Management Roll No. : 541110058 Page 4

Spring 2012, MBA-2nd Semester

There are cases where a long operating cycle in unavoidable. Wineries and distilleries, for

example, keep inventory on hand for years before it is sold, because of the nature of the business. In these industries, the return on investment happens in the long term, rather than the short term. Such companies are usually structured in a way that allows them to borrow against existing inventory or land if funds are needed to finance short-term operations. Operating cycles can fluctuate. During periods of economic stagnation, inventory tends to sit around longer, while periods of growth may be marked by more rapid turnover. Certain products can be consistent sellers that move in and out of inventory quickly. Others, like big ticket items, may be purchased less frequently. All of these issues must be accounted for when making decisions about ordering and pricing items for inventory.

Q3. What is the implication of operating leverage for a firm? Operating leverage: Operating leverage is the extent to which a firm uses fixed costs in producing its goods or offering its services. Fixed costs include advertising expenses, administrative costs, equipment and technology, depreciation, and taxes, but not interest on debt, which is part of financial leverage. By using fixed production costs, a company can increase its profits. If a company has a large percentage of fixed costs, it has a high degree of operating leverage. Automated and high-tech companies, utility companies, and airlines generally have high degrees of operating leverage. As an illustration of operating leverage, assume two firms, A and B, produce and sell widgets. Firm A uses a highly automated production process with robotic machines, whereas firm B assembles the widgets using primarily semiskilled labor. Table 1 shows both firms operating cost structures. Highly automated firm A has fixed costs of $35,000 per year and variable costs of only $1.00 per unit, whereas labor-intensive firm B has fixed costs of only $15,000 per year, but its variable cost per unit is much higher at $3.00 per unit. Both firms produce and sell 10,000 widgets per year at a price of $5.00 per widget. Firm A has a higher amount of operating leverage because of its higher fixed costs, but firm A also has a higher breakeven pointthe point at which total costs equal total sales. Nevertheless, a change of I percent in sales causes more than a I percent change in operating profits for firm A, but not for firm B. The degree of operating leverage measures this effect. The following simplified equation demonstrates the type of equation used to compute the degree of operating leverage, although to calculate this figure the equation would require several additional factors such as the quantity produced, variable cost per unit, and the price per unit, which are used to determine changes in profits and sales:
MB0045: Financial Management Roll No. : 541110058 Page 5

Spring 2012, MBA-2nd Semester

Operating leverage is a double-edged sword, however. If firm As sales decrease by I percent, its profits will decrease by more than I percent, too. Hence, the degree of operating leverage shows the responsiveness of profits to a given change in sales. Implications: Total risk can be divided into two parts: business risk and financial risk. Business risk refers to the stability of a companys assets if it uses no debt or preferred stock financing. Business risk stems from the unpredictable nature of doing business, i.e., the unpredictability of consumer demand for products and services. As a result, it also involves the uncertainty of longterm profitability. When a company uses debt or preferred stock financing, additional risk financial riskis placed on the companys common shareholders. They demand a higher expected return for assuming this additional risk, which in turn, raises a companys costs. Consequently, companies with high degrees of business risk tend to be financed with relatively low amounts of debt. The opposite also holds: companies with low amounts of business risk can afford to use more debt financing while keeping total risk at tolerable levels. Moreover, using debt as leverage is a successful tool during periods of inflation. Debt fails, however, to provide leverage during periods of deflation, such as the period during the late 1990s brought on by the Asian financial crisis.

Q.2 What are the factors that affect the financial plan of a company? Ans. To help your organization succeed, you should develop a plan that needs to be followed. This applies to starting the company, developing new product, creating a new department or any undertaking that affects the companys future. There are several factors that affect planning in an organization. To create an efficient plan, you need to understand the factors involved in the planning process. To create an efficient plan, you need to understand the factors involved in the planning process. Organizational planning is affected by many factors: Priorities - In most companies, the priority is generating revenue, and this priority can sometimes interfere with the planning process of any project. For example, if you are in the process of planning a large expansion project and your largest customer suddenly threatens to take their business to your competitor, then you might have to shelve the expansion planning until the customer issue is resolved. When you start the planning process for any project, you need to assign each of the issues facing the company a priority rating. That priority rating will determine what issues will sidetrack you from the planning of your project, and which issues can wait until the process is complete. Company Resources - Having an idea and developing a plan for your company can help your company to grow and succeed, but if the company does not have the resources to make the plan come together, it can stall progress. One of the first steps to any planning process should be an evaluation of the resources necessary to complete the project,

MB0045: Financial Management

Roll No. : 541110058

Page 6

Spring 2012, MBA-2nd Semester

compared to the resources the company has available. Some of the resources to consider are finances, personnel, space requirements, access to materials and vendor relationships. Forecasting - A company constantly should be forecasting to help prepare for changes in the marketplace. Forecasting sales revenues, materials costs, personnel costs and overhead costs can help a company plan for upcoming projects. Without accurate forecasting, it can be difficult to tell if the plan has any chance of success, if the company has the capabilities to pull off the plan and if the plan will help to strengthen the companys standing within the industry. For example, if your forecasting for the cost of goods has changed due to a sudden increase in material costs, then that can affect elements of your product roll-out plan, including projected profit and the long-term commitment you might need to make to a supplier to try to get the lowest price possible. Contingency Planning - To successfully plan, an organization needs to have a contingency plan in place. If the company has decided to pursue a new product line, there needs to be a part of the plan that addresses the possibility that the product line will fail. The reallocation of company resources, the acceptable financial losses and the potential public relations problems that a failed product can cause all need to be part of the organizational planning process from the beginning.

Factors Affecting Financial Plan Nature of industry: The nature of the industry in which the company is performing is a major factor which affects financial plans. A lab our- intensive industry requires less capital than a capital-intensive industry. Status of the company in the industry: The status of the company is a factor which has to be considered while drawing a financial plan. If the company is a well-recognized and a reputed one, it will have no problems in raising finance at short notices. But on the other hand, if the company is a new entrant into the field, it will need time to establish itself and therefore raising money is slightly difficult, especially so if the company wants to go public. New firms may find it easier and better to take loans and function rather than going public. Alternative sources of finance: The Finance Manager will assess the alternative sources of funds and get the cheapest source of funds. He should also verify the conditions attached to the funds he procures, that are the contractual restrictions placed by the lenders. Attitude of management towards control: If the management wants to have control over the firm, it may not go in for the equity form of finance for control vests with equity shareholders and it gets diluted with every new issue of equity shares. Such companies prefer to raise additional amounts by debenture issue or bond issue. Extent of working capital requirements: The Finance Manager formulates his plan considering the short and long term financial needs of the firm. Short term funds required to
MB0045: Financial Management Roll No. : 541110058 Page 7

Spring 2012, MBA-2nd Semester

finance working capital needs are to be procured through short term sources only. It is always a prudent policy to use short term avenues for short term requirements and long term needs can be funded by the issue of shares and debentures. Capital structure: Capital of a firm has two components debt and equity. The proportion of these should be so decided that the company gets the advantage of leverage. Running the company with loans and debentures will certainly help equity shareholders to get more income but the company is also functioning under a great risk. Flexibility: This is one important factor that should be kept in mind while planning. The financial plan should be flexible enough to adjust to the needs of the changing conditions. There should be flexibility to raise the amount from any source and similarly the repayments may be done any time the company has excess funds. The firm should also have the flexibility of substituting one form of financing with another if the need arises. Government policy with regard to financial controls, statutory provisions and controls should be considered. The SEBI guidelines should be strictly adhered to wherever applicable and necessary permissions from concerned authorities should be taken if necessary.

Q5.An employee of a bank deposits Rs. 30000 into his PF A/c at the end of each year for 20 years. What is the amount he will accumulate in his PF at the end of 20 years, if the rate of interest given by PF authorities is 9%?

Solution

Year 1 2 3 4 5

Amount 30000 30000 30000 30000 30000

Interest 9% 9% 9% 9% 9%

Total 30000 32700 35643 38851 42347

MB0045: Financial Management

Roll No. : 541110058

Page 8

Spring 2012, MBA-2nd Semester

6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000 30000

9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 9% 9%

46159 50313 54841 59777 65157 71021 77413 84380 91974 100252 109274 119109 129829 141514 154250

The rate of interest at the end of 20 years accumulated by PF account holder is 1, 54,250

1. Mr. Anant purchases a bond whose face value is Rs.1000, and which has a nominal interest rate of 8%. The maturity period is 5 years. The required rate of return is 10%. What is the price he should be willing to pay now to purchase the bond?

MB0045: Financial Management

Roll No. : 541110058

Page 9

Spring 2012, MBA-2nd Semester

Solution: Interest payable=1000*8% =Rs.80, Principal repayment is Rs. 1000 Required rate of return is 10% V0= I*PVIFA (kd, n) + F*PVIF (kd, n) Value of the bond = 80*PVIFA (10%, 5y) + 1000*PVIF (10%, 5y) = 80*3.791 + 1000*0.621 = 303.28 + 621 = Rs. 924.28 This implies that the company is offering the bond at Rs. 1000 but is worth Rs. 924.28 At the required rate of return of 10%. The investor may not be willing to pay more than Rs. 924.28 for the bond today.

Therefore Mr. Anant would be willing to pay 924.28 to purchase the bond.

MB0045: Financial Management

Roll No. : 541110058

Page 10

Spring 2012, MBA-2nd Semester

Set -2

1. The following data is available in respect of a company : Equity Rs.10lakhs,cost of capital 18% Debt Rs.5lakhs,cost of debt 13% Calculate the weighted average cost of funds taking market values as weights assuming tax rate as 40%

Solution To determine the cost of each component Ke = (D1/P0) + g = (2/32) + 0.1= 0.1625 Or 16.25 % Kp = [D + {(FP)/n}] / {F+P)/2} = [14 + (10584)/8] / (105+84)/2 =16.625/94.5 = 0.1759 or17.59%

Kr = Ke which is 16.25% Kd = [I (1T) + {(FP)/n}] / {F+P)/2} = [12(10.4) + (10590)/7] / (105+90) / 2 = [7.2 + 2.14] / 97.5 = 0.096 or 9.6%
MB0045: Financial Management Roll No. : 541110058 Page 11

Spring 2012, MBA-2nd Semester

Kt = I(1T)= 0.11(10.4) = 0.066 or 6.6%

To calculate the weights of each source. We = 200/750 = 0.267 Wp = 100/750 = 0.133 Wr = 100/750 = 0.133 Wd = 300/750 = 0.4 Wt = 50/750 = 0.06

Multiply the costs of various sources of finance with corresponding weights and WACC is calculated by adding all these components. WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt = (0.267*0.1625) + (0.133*0.1759) + (0.133*0.1625) + (0.4*0.092) + (0.06*0.066) = 0.043 + 0.023 + 0.022 + 0.0384 + 0.004= 0.1457 or 14.57%

The value of WACC is 14.57%

2. ABC Ltd. provides the information as shown in table 6.21 regarding the cost, sales, interests and selling prices. Calculate the DFL.

MB0045: Financial Management

Roll No. : 541110058

Page 12

Spring 2012, MBA-2nd Semester

Details of ABC Ltd.

Output Fixed costs Variable cost Interest on borrowed funds Selling price per unit

20,000 units Rs.3,500 Rs.0.05 per unit Nil 0.20

Solution

EBIT 200000 Less interest on borrowed funds - NIL EBT 150000 DFL= EBIT {EBITI{Dp /(1-T)}} 200000 / (20000050000{25000 / (10.50)} DFL=2.0

Therefore the Degree of Financial Leverage of ABC ltd is 2.0.

3. Two companies are identical in all respects except in the debt equity profile. Company X has 14%debentures worth Rs. 25, 00,000 whereas company Y does not have any debt. Both companies earn 20% before interest and taxes on their total assets of Rs. 50, 00,000. Assuming a tax rate of 40%, and cost of equity capital to be 22%, find out the value of the companies X and Y using NOI approach?

MB0045: Financial Management

Roll No. : 541110058

Page 13

Spring 2012, MBA-2nd Semester

Solution:

S= 1000, 000/.22 =4545454.5 B=25, 00,000 =K0 = [25, 00,000 / [2500000+4545454.5)].14+[4545454.5/2500000+4545454.5)].22 0.0496+.142 =.1915 or 19.15%

V = 5000000/0.1915 = 26, 109, 66

The value of company X & Y = 26, 109, 66

4. Examine the importance of capital budgeting. Capital budgeting decisions are the most important decisions in corporate financial management. These decisions make or mar a business organization. These decisions commit a firm to invest its current funds in the operation. These decisions commit a firm to invest its current funds in the operating assets (i.e. Long-term assets) with the hope of employing those most efficiently to generate a series of cash flow in future. These decisions could be grouped into: Decision to replace the equipments for maintenance of current level of business or decisions aiming at cost reductions, known as replacement decisions Decisions on expenditure for increasing the present operating level or expansion through improved network of distribution. Decision for production of new goods or rendering of new services Decisions to comply with the regulatory structure affecting the operations of the company, like investments in assets to comply with the conditions imposed by environmental protection act.

Decisions on investment to build township for providing residential accommodation to employees working in a manufacturing plant.

MB0045: Financial Management

Roll No. : 541110058

Page 14

Spring 2012, MBA-2nd Semester

The reasons that make the capital budgeting decisions most crucial for finance managers are: These decisions involve large outlay of funds in anticipation of cash flows in future for example, investment in plant and machinery. The economic life of such assets has long periods. The projections of cash flows anticipated involve forecasts of many financial variables. The most crucial variable is the sales forecast. For example, Metal box spent large sums of money on expansion of its productions facilities based on its own sales forecast. During this period, huge investments in R & D in packaging industry brought about new packaging medium totally replacing metal as an important component of packing boxes. At the end of the expansion metal box ltd, found itself that the market for its metal boxes has declined drastically. The end result is that metal box became a sick company from the position it enjoyed earlier prior to the execution of expansion as a blue chip. Employees lost their jobs. It affected the standard of living and cash flow position of its employees. This highlights the element of risk involved in these type of decisions. Equally we have empirical evidence of companies which took decisions on expansion through the addition of new products and adoption of the latest technology, creating wealth for shareholders. The best example is the Reliance Group. Any serious error in forecasting sales, the amount of capital expenditure can significantly affect the firm. An upward bias might lead to a situation of the firm creating idle capacity, laying the path for the cancer of sickness. Any downward bias in forecasting might lead the firm to a situation of losing its market to its competitors. Long time investments of the funds sometimes may change the risk profile of the firm. Most of the capital budgeting decisions involve huge outlay. The funds required during the phase of execution must be synchronized with the flow of funds. Failure to achieve the required coordination between the inflow and outflow may cause time over run and cost over-run. These two problems of time over run and cost overrun have to be prevented from occurring in the beginning of execution of the project. Quite a lot of empirical examples are there in public sector in India in support of this argument that cost overrun and time over run can make a companys operation unproductive. Capital budgeting decisions involve assessment of market for companys product and services, deciding on the scale of operations, selection of relevant technology and finally procurement of costly equipment.

MB0045: Financial Management

Roll No. : 541110058

Page 15

Spring 2012, MBA-2nd Semester

If a firm were to realize after committing itself to considerable sums of money in the process of implementing the capital budgeting decisions taken that the decision to diversify or expand would become a wealth destroyer to the company, then the firm would have experienced a situation of inability to sell the equipments bought. Loss incurred by the firm on account of this would be heavy if the firm were to scrap the equipments bought specifically for implementing the decision taken. Sometimes these equipments will be specialized costly equipments. Therefore, capital budgeting decisions are irreversible. All capital budgeting decisions involves three elements. These three elements are: Cost Quality Timing Decisions must be taken at the right time which would enable the firm to procure the assets at the least cost for producing products of required quality for the customer. Any lapse on the part of the firm in understanding the effect of these elements on implementation of capital expenditure decision taken, will strategically affect the firms profitability. Liberalization and globalization gave birth to economic institutions like world trade organizations. General Electrical can expand its market into India snatching the share already enjoyed by firms like Bajaj Electricals or Kirloskar Electric Company. Ability of GE to sell its products in India at a rate less than the rate at which Indian companies sell cannot be ignored. Therefore, the growth and survival of any firm in todays business environment demands a firm to be pro-active. Pro-active firms cannot avoid the risk of taking challenging capital budgeting decisions for growth. The social, political, economic and technological forces generate high level of uncertainty in future cash flow streams associated with capital budgeting decisions. These factors make these decisions highly complex. Capital budgeting decisions are very expensive. To implement these decisions, firms will have to tap the capital market for funds. The composition of debt and equity must be optimal keeping in view the expectations of investors and risk profile of the selected project. Therefore capital budgeting decisions for growth have become an essential characteristic of successful firms today.

MB0045: Financial Management

Roll No. : 541110058

Page 16

Spring 2012, MBA-2nd Semester

5. Briefly explain the process of capital rationing. Firms may have to make a choice from among profitable investment opportunities, because of the limited financial resources. Capital rationing refers to a situation in which the firm is under a constraint of funds, limiting to capacity to take up and execute all the profitable projects. Such a situation may be due to external factors or due to the need to impose internal constraints, keeping in view of the need to exercise better financial control. The firm must be able to maximize the profits by combining the most profitable proposals. Capital rationing may arise due to (i) external factors such as high borrowing rate or non -availability of loan funds due to constraints of Debt-Equity Ratio; and (ii) Internal Constraints Imposed by management. Project should be accepted as a whole or rejected. It cannot be accepted and executed in piecemeal.IRR or NPV are the best basis of evaluation even under Capital Rationing situations. The objective is to select those projects which have maximum and positive NPV. Preference should be given to interdependent projects. Projects are to be ranked in the order of NPV.Where there is multiperiod Capital Rationing, Linear Programming Technique should be used to maximize NPV. In times of Capital Rationing, the investment policy of the company may not be the optimal one. In nutshell Capital Rationing leads to:(i) Allocation of limited resources among ranked acceptable investments.(ii) This function enables management to select the most profitable investment first.(iii) It helps a company use limited resources to the best advantage by investing only in the projects that offer the highest return.(iv) Either the internal rate of return method or the net present value method may be used in ranking investments.

Capital rationing needed due to: External factors Internal constraints imposed by management.

MB0045: Financial Management

Roll No. : 541110058

Page 17

Spring 2012, MBA-2nd Semester

External factors

Reasons for capital rationing

Internal factors

Reasons for capital rationing

External capital rationing is due to the imperfections of capital market. Imperfections are caused mainly due to: Deficiencies in market information Rigidities that hamper the force flow of capital between firms

Internal capital rationing Impositions of restrictions by a firm on the funds allocated for fresh investment is called internal capital rationing.

This decision may be the result of conservative policy pursued by a firm. Restriction may be imposed on individual heads on the total amount that they can commit on new project. Generally internal capital rationing is used by a firm as a means of financial control.

MB0045: Financial Management

Roll No. : 541110058

Page 18

Spring 2012, MBA-2nd Semester

6. Explain the concepts of working capital. Money required by the company to meet out day today expenses to finance production and stocks to pay wages and other production etc. is called the working capital of the company. Working capital is used in operating the business. It is mostly dept is circulation by releasing it back after selling the products and reinvesting it in further production. It is because of this regular cycle that the working capital requirements are usually for short periods. Though, both fixed and working capitals shall be recovered from the business, the differences lies in the rate of their recovery. Working capital shall be recovered much more quickly as compared to fixed capitals which would last for several years. As the process of production become more roundabout and complicated the production to fixed working capital increase correspondingly. Therefore, working capital management refers to the management of current assets and current liabilities. Working capital, however, represents investment in current assets, such as cash, marketable securities, inventories and bills receivables. Current liabilities mainly include bills payable, notes payable and miscellaneous accruals. Net working capital is the excess of current assets over current liabilities here. Current assets are those assets which are normally converted into cash within an accounting year; and current liabilities are usually paid within an accounting year. The four most important concepts of working capital are shown in the below figure:

Concepts

Gross Working Capital

Net Working Capital

Temporary Working Capital

Permanent Working Capital

MB0045: Financial Management

Roll No. : 541110058

Page 19

Spring 2012, MBA-2nd Semester

Gross Working Capital Gross working capital refers to the amounts invested in various components of current assets. This concept has the following practical relevance.

Management of current assets is the crucial aspect of working capital management. Gross working capital helps in the fixation of various areas of financial responsibility. The need to plan and monitor the utilization of funds of a firm demands working capital management, as applied to current assets.

Net Working Capital Net working capital is the excess of current assets over current liabilities and provisions. Net working capital is positive when current assets exceed current liabilities and negative when current liabilities exceed current assets. Temporary Working Capital Is also known as variable working capital or fluctuating working capital. The firms working capital requirements vary depending upon the seasonal and cyclical changes in demand for firms products. The extra working capital required as per the changing production and sales levels of a firm is known as temporary working capital.

Permanent Working Capital is the minimum amount of investment required to be made in current assets at all times to carry on the day to day operations of the firms business. This minimum level of current assets has been given the name of core current assets by the Tandon Committee. Permanent working capital also known as fixed working capital.

MB0045: Financial Management

Roll No. : 541110058

Page 20