NIBM MBA FIRST SEMESTER Exam 252 : Financial

Management
Exam 252 - Subject: Financial Management

Q1.

What is the importance of cost of capital in Financial Decisions?

Explain.
When making investment decisions, the Finance Manager needs to know the minimum
expected return that is acceptable to the investors. This minimum acceptable return is
called Cost of the capital. This it is the price the firm pays for the use of money.
Knowing the cost of capital, the Finance Manager can take decision on whether to make
or not to make any capital investments.
i.

Two different approaches to determine cost of capital are :

Capital Asset Pricing Model (CAPM)
The capital asset pricing model (CAPM) is a theory of the relationship between the risk
of a security or a portfolio of securities and the expected rate of return that is
commensurate with that risk. The theory is based on the assumption that security
markets are efficient and dominated by risk averse investors. In other words, the CAPM
argues that investors are willing to take on more risk only if they can reasonably expect
a higher return.
The CAPM accepts the risk/return trade-off economic principle and quantifies that tradeoff. Further, the model assumes that most investors diversify their investment holdings
so as to not put .all of their eggs in one basket..
Indeed, the tendency for investors to diversify their investment portfolios implies that,
in a CAPM context, the only type of risk that is rewarded or relevant in the risk/return
trade-off is systematic or market-related risk. Thus, the additional risk created by
notdiversifying among investments is not rewarded by the securities markets under the
CAPM.
The measurable relationship between risk and expected return in the CAPM is
summarized by the following expression:
Rt = Rf + i [Rm - Rf],
Where Ri is the expected return on security or portfolio i, Rf is the return on a risk-free
security

ii.

Weighted Average Cost of Capital

A company has different sources of finance, namely common stock, retained earnings,
preferred stock and debt. Weighted average cost of capital (WACC) is the average after
tax cost of all the sources. It is calculated by multiplying the cost of each source of
finance by the relevant weight and summing the products up.
For a company which has two sources of finance, namely equity and debt, WACC is
calculated using the following formula:
WACC = Weight of Equity x Cost of Equity + Weight of Debt x Cost of Debt

Importance or Significance of Cost of Capital in Financial Decisions:

Following are the different importance or significance of Cost of Capital while making
financial decisions:
1.

Making Investment Decision

Cost of capital is used as discount factor in determining the net present value. Similarly,
the actual rate of return of a project is compared with the cost of capital of the firm.

Thus, the cost of capital has a significant role in making investment decisions.
2. Designing Capital structure
The proportion of debt and equity is called capital structure. The proportion which can
minimize the cost of capital and maximize the value of the firm is called optimal capital
structure. Cost of capital helps to design the capital structure considering the cost of
each sources of financing, investor's expectation, effect of tax and potentiality of
growth.
3. Evaluating The Performance
Cost of capital is the benchmark of evaluating the performance of different
departments. The department is considered the best which can provide the highest
positive net present value to the firm. The activities of different departments are
expanded or dropped out on the basis of their performance.
4.

Formulating Dividend Policy

Out of the total profit of the firm, a certain portion is paid to shareholders as dividend.
However, the firm can retain all the profit in the business if it has the opportunity of
investing in such projects which can provide higher rate of return in comparison of cost
of capital. On the other hand, all the profit can be distributed as dividend if the firm has
no opportunity investing the profit. Therefore, cost of capital plays a key role
formulating the dividend policy.

Q2.
Explain the factors determining Capital Structure.
Capital structure refers to the composition of long term funds such as debentures,
preference shares, long term borrowings and equity shares ie., Debt / Equity ratio
It is significant because it affects shareholders return and risk and consequently the
market value of shares
The Finance Manager should plan the optimal capital structure in order to minimize
the cost of capital and maximize the total market value of the company
A. Basic Factors Determining Capital Structure:
Basically, three factors ie., Rissk, Cost and Control determine the capital structure of a
Company

Type
1. Equity Capital

Risk
Low Risk - No
Question of
repayment of
capital except in
the event of
liquidation.

2. Preference
Capital

Slightly higher
risk when
compared to
Equity. Principal
is redeemable
after a certain
period.
High Risk
Comparatively
Capital should be cheaper
repaid as per
agreement and
interest should
be paid
irrespective of
profits or loss.

3. Loan Funds

B.

Cost
Most Expensive
Dividend
expectation from
shareholder sis
normally higher
than the interest
rate.
Slightly cheaper
cost than Equity
but higher than
the interest rate
on loan funds

Control
Dilution of
Control Capital
base might be
expanded and
new
shareholders /
public involved
No dilution of
Control since
voting rights are
restricted.

No dilution of
control but some
financial
institutions may
insists on
nomination of
their
representatives
in the Board of
Directors.

Other Factors determining Capital Structure:

Apart from the above three factors certain other factors are also relevant in determining
capital structure and are as under:

a. Trading on Equity : When the Return on Total capital Employed (ROCE), is more than
the rate of interest on borrowed funds or the rate of dividend on preference shares,
financial leverage can be used favorably to maximize Earnings Per Share (EPS). Finance
Manager should analyse the effect on EPS and ROCE carefully.
b. Corporate Taxation: Interest on debt is a tax-deductible expense, but dividend is not.
Also, the cost of raising finance through borrowing is deductible in the year in which it is
borrowed. If it is incurred during the pre-commencement period, it can be capitalized.
Due to tax- saving advantage, debt has a cheaper effective cost than Preference Capital
or Equity Capital. Finance Manager should analyze the impact of taxation more carefully.
c.

Government Policies: Raising finance by way of borrow or issue of equity is subject

to policies of the Government and its regulatory bodies like SEBI, RBI etc.,. The
monetary, fiscal and lending policies, as well as rules and regulations stipulated from
time to time by these bodies have to be complied with for acquiring funds through the

particular mode. The Finance Manager has the responsibility over the compliance
aspects.
d. Legal Requirements: Legal provisions like maximum limit of borrowings by a
Company, approvals for Foreign Direct Investments etc., need to be complied. Finance
Manager role includes legal compliance.
e. Marketability: The company has to consider its ability to obtain public subscription
and hence the mode of obtaining finance also depends on the marketability of the
Companys shares or debt instruments
f.

Maneuverability: Having many possible alternatives at the time of expanding or

contracting the requirements of funds enables use of proper type of funds available at a
given point in time and also enhancing the bargaining power when dealing with the
supplier of funds.

g. Flexibility: Capital structure should provide freedom to adjust expected and

unexpected changes in the business environment thus maintaining optimal cost
structure
h. Timing: Proper timing of a security issue often brings substantial savings because of
the dynamic nature of the capital market. Management should continuously study the
trend in the Capital Market and time its issue carefully
i.

Size of The Company: Usually small size companies heavily depends on owners
fund and bigger companies goes to public funds by way of equity shares. Also larger
companies will have different types of debt funds.

j.

Purpose of Financing: Long term funds should be used for long term productive
purposes like manufacturing facility set up, new project set up etc., and the same
should not be used for non productive expenses like welfare facilities.

k.

Period of Finance: Funds required for medium and long term period say 8 to 10 years
may be raised by way of borrowings. But if the funds are for permanent requirement, it
will be appropriate to raise them by the issue of equity shares.

l.

Track Record of Companies: Companies enjoying proven track record in terms of

earnings, dividend declaration etc., can attract more funds as against companies which
do not have proven track record

m. Future Growth Prospects: Expansion plans, in the medium and long term should be
considered into account while determine the capital structure and this should facilitate
in easy expansion.

Q4.
What is a fund flow statement? Explain its uses.
Finance Manager has the responsibility to measure trading performance, operational
efficiency, profitability and financial position of a concern revealed by Trading, Profit and
Loss Account and Balance Sheet and to find out the Gross Profit or Gross Loss, Net Profit
or Net Loss and financial soundness of a firm a whole for a particular period of time.

From the management point of view, the usefulness of information provided by these
income statements functions effectively and efficiently.
In the true sense they do not disclose the nature of all transactions. Management,
Creditors and Investors etc. want to determine or evaluate the sources and application
of funds employed by the firm for the future course of action. Based on these
backgrounds, it is essential to analyse the movement of assets, liabilities, funds from
operations and capital between the components of two year financial statements. The
analysis of financial statements helps to the management by providing additional
information in a meaningful manner.
Components of Flow of Funds:
In order to analyse the sources and application of funds, it is essential to know the
meaning and components of flow of funds given below :
a.
b.
c.
d.
e.
f.

Current Assets
Non-Current Assets (Fixed or Permanent Assets)
Current Liabilities
Non-Current Liabilities (Capital & Long-Term Liabilities)
Provision for Tax
Proposed Dividend

a.

Current Assets:
The term "Current Assets" refer to the assets of a business of a transitory nature which
are intended for resale or conversion into different form during the course of business
operations.
For example, raw materials are purchased and the amount unused at the end of the
trading period forms part of the current as stock on hand. Materials in process at the
end of the trading period and the labour incurred in processing them also form part of
current assets.

b.

Non-Current Assets (Permanent Assets):

Non-Current Assets also refer to as Permanent Assets or Fixed Assets. This class of asset
include those of tangible and intangible nature having a specific value and which are
not consumed during the course of business and trade but provide the means for
producing saleable goods or providing services. Land and Building, Plant and Machinery,
Goodwill and Patents etc. are the few examples of Non-Current assets.

c.

Current Liabilities:
The term Current Liabilities refer to amount owing by the business which are currently
due for payment. They consist of amount owing to creditors, bank loans due for
repayment, proposed dividend and proposed tax for payment and expenses accrued
due.

d.

Non-Current Liabilities:

The term Non-Current Liabilities refer to Capital and Long-Term Debts. It is also called as
Permanent Liabilities. Any amount owing by the business which are payable over a
longer period time, i.e., after a year are referred as Non-Current Liabilities. Debenture,
long-term loans and loans on mortgage etc., are the few examples of non-current
liabilities.
e.

Provision for Taxation:

Provision for taxation may be treated as a current liability or an appropriation of profit.
When it is made during the year it is not used for adjusting the net profit, it is advisable
to treat the same as current liability. Any amount of tax paid during the year is to be
treated as application of funds or non-current liability. Because it is used for adjusting
the net profit made during the year.

f.

Proposed Dividend:
Like provision for taxation, it is also treated as a current liability and noncurrent liability,
when dividend may be considered as being declared. And thus, it will not be used for
adjusting the net profit made during the year. If it is treated as an appropriation, i.e., an
non-current liability when the dividend paid during the year.

g.

Provisions
Against Current Assets and Current Liabilities: Provision for bad and doubtful debts,
provision for loss on inventories, provision for discount on creditors and provision made
against investment etc. are made during the year, they may be treated separately as
current assets or current liabilities or reduce the same from the respective gross value
of the assets or liabilities.
Fund Flow Statements are prepared for financial analysis in order to meet the
needs of people serving the following purposes:

i.
ii.
iii.

It highlights the different sources and applications or uses of funds between the two
accounting period.
It brings into light about financial strength and weakness of a concern.
It acts as a effective tool to measure the causes of changes in working capital.

iv.

It helps the management to take corrective actions while deviations between two
balance sheet figure.

v.

It also presents detailed information about profitability, operational efficiency and

financial affairs of a concern.

vi.

It serves as a guide to the management to formulate its dividend policy, retention

policy and investment policy etc.

vii.

It helps to evaluate the financial consequences of business transactions involved in

operational finance and investment.

viii.

It gives the detailed explanation about movement of funds from different sources or
uses of funds during a particular accounting period.

Q5.
Explain financial statement analysis and tools of financial analysis.
Financial statement analysis is the process of understanding the risk and profitability of
a firm (business, sub-business or project) through analysis of reported financial
information, by using different accounting tools and techniques. Thus it is an evaluative
method of determining the past, current and projected performance of a company.
Financial statement analysis consists of:
i.
ii.

reformulating reported financial statements,

analysis and adjustments of measurement errors, and

iii.

financial ratio analysis on the basis of reformulated and adjusted financial statements
Types of Financial Analysis:
Financials tools are designed especially for carrying out specific functions. Among these
different types of financial analysis tools, the Balanced Scorecard is one tool which
can be of good assistance to gauge the financial position of a company This financial
analysis tool is helpful in subjective as well as objective measurement of special
processes. Moreover, this financial tool is also helpful in evaluation of a companys
overall return, the operating income, and the capital financing processes.
Another important financial analysis tool is Benchmarking which is used for assessing
the intrinsic strengths and weaknesses of a business organization. Besides, this also
sways the stock price of the company. Also, there are some professional agencies which
use this type of financial analysis tools to generate advices for their clients.
In addition to the aforementioned financial analysis tools, other important financial
analysis tools include ratio analysis, trend analysis, comparative financial
statement analysis or horizontal analysis, and common size statement
analysis or vertical analysis.
1.

Ratio Analysis: This refers to the systematic use of ratios to interpret the financial
statements in terms of the operating performance and financial position of a firm. It
involves comparison for a meaningful interpretation of the financial statements.
In view of the needs of various uses of ratios the ratios, which can be calculated from
the accounting data are classified into the following broad categories

i.
ii.
iii.
iv.
2.

Liquidity Ratio
Turnover Ratio
Solvency or Leverage ratios
Profitability ratios
Trend analysis: Investors use this analysis tool a lot in order to determine the
financial position of the business. In a trend analysis, the financial statements of the

company are compared with each other for the several years after converting them in
the percentage. In the trend analysis, the sales of each year from the 2010 to 2013 will
be converted into percentage form in order to compare them with each other.
In order to convert the figures into percentages for the comparison purposes, the
percentages are calculated in the following way:
Trend analysis percentage = [figure of the previous period Minus figure of the
current period] / total of both figures
The percentage can be found this way and if the current-year percentages were greater
than previous year percentage, this would mean that current-year result is better than
the previous year result.
Trend analysis has a great advantage that it can also be used to predict the future
events. This is possible by forecasting the future cash flow based on the data available
of the past. With the help of trend analysis, one can predict the future and track the
variances to add performance.
However, in management accountancy, the calculation of trends is based on the data of
the past. This is favorable in deducing the current situation of the company and the
increase in the financial position of the company and growth over the past years.
Apart from investments and financial data of the company, the trend analysis is also a
useful tool that can be used effectively for the projections. This allows the company to
conduct market research and draw trends to forecast the demand of different products.
This helps in the marketing purposes, and company can deduce results to select the
right marketing approach to address the issues. Trend analysis can pretty much apply to
all the techniques, which requires forecasting therefore, that it is a very useful tool in
business.
3.

Comparative financial statements: These are the complete set of financial

statements that an entity issues, revealing information for more than one accounting
period. The financial statements that may be included in this package are:

1.

The income statement (showing results for multiple periods)

2.

The balance sheet (showing the financial position of the entity as of more than
one balance sheet date)

3.

The statement of cash flows (showing the cash flows for more than one period)
Another variation on the comparative concept is to report information for each of the 12
preceding months on a rolling basis. Comparative financial statements are quite useful
for the following reasons:

1.

Provides a comparison of an entity's financial performance over multiple periods,

so that you can determine trends (seehorizontal analysis). The statements may also
reveal unusual spikes in the reported information that can indicate the presence of
accounting errors.

2.

Provides a comparison of expenses to revenues and the proportions of various

items on the balance sheet over multiple periods (see vertical analysis). This
information can be useful for cost management purposes.

3.

May be useful for predicting future performance, though you should rely more on
operational indicators and leading indicators than on historical performance for this type

4.

of analysis.
Common-size analysis: This is the restatement of financial statement information in
a standardized form.
Horizontal common-size analysis uses the amounts in accounts in a specified year
as the base, and subsequent years amounts are stated as a percentage of the base
value.
This is most useful when comparing growth of different accounts over time.
Vertical common-size analysis uses the aggregate value in a financial statement for
a given year as the base, and each accounts amount is restated as a percentage of the
aggregate.
Balance sheet: Aggregate amount is total assets.
Income statement: Aggregate amount is revenues or sales.