Question Paper Financial Management (MB211) : July 2003

Part A : Basic Concepts (30 Points)

1. This part consists of questions with serial number 1 - 30. Answer all questions. Each question carries one point. Maximum time for answering Part A is 30 Minutes.

In which of the following types of issue, new securities are offered to the existing shareholders of the company on a pro rata basis? a. b. c. d. e. Public issue Rights issue Bonus issue Private placement None of the above. Primary market Secondary market Capital market Money market None of the above. Company strike Bankruptcy of major supplier Bankruptcy of major customer Unexpected entry of new competitors into the market Industrial recession. Investors use the expected return and standard deviation of returns as the appropriate measures of return and risk of the portfolios Investors are risk averse Investors do not agree with each other on the nature of return and the risk associated with each investment The assets can be bought and sold in any unit desired Transaction costs are low. Maximise the revenues Minimise the expenses Maximise the return on investment Minimise the risk Maximise the wealth of the owners by increasing the value of the firm. Systematic risk Unsystematic risk Total risk Financial risk Business risk.

2.

In which of the following markets are short-term financial instruments traded? a. b. c. d. e.

3.

Which of the following is not a diversifiable risk in the context of investment in stocks? a. b. c. d. e.

4.

Which of the following is not an assumption in the CAPM? a. b. c. d. e.

5.

The objective of financial management is to a. b. c. d. e.

6.

The beta coefficient of a stock is an indicator of the a. b. c. d. e.

7.

Which of the following is equal to the expected rate of return for a security according to the CAPM? a. b. c. d. e. Risk free rate of return plus risk premium Risk free rate of return minus risk premium Risk free rate of return multiplied by risk premium Risk free rate of return divided by risk premium None of the above. I. Current yield is equal to the coupon rate if the market price is equal to the face value of the bond. II. Current yield is equal to the coupon rate if the bond is trading at its face value. III. Current yield is equal to the interest paid divided by the face value of the bond. a. b. c. d. e. Only (I) above Both (I) and (II) above Both (I) and (III) above Both (II) and (III) above All (I), (II) and (III) above. Price risk Market risk Trading risk Liquidity risk Financial risk. Call money market Treasury bills market Commercial paper market Stock market None of the above.

8.

Which of the following statements is/are true?

9.

The risk arising out of the use of debt financing is called a. b. c. d. e. a. b. c. d. e.

10. Which of the following is not a part of the money market?

11. Which of the following is true when the required rate of return on a bond is less than the coupon rate? a. b. c. d. e. The discount on the bond decreases as the maturity approaches The premium on the bond decreases as the maturity approaches The value of the bond is equal to its par value The value of the bond is less than its par value The discount on the bond increases as the maturity approaches.

12. Which of the following is true with respect to commercial papers (CP)? a. b. c. d. e. These are issued in multiples of Rs.1 lakh The minimum amount to be invested by a single investor is Rs.5 lakhs The minimum maturity period is 30 days The issuer cannot buy back these instruments These can be raised upto the extent of 80% of working capital limit.

13. Other things remaining unchanged, which of the following will cause an increase in bond value? a. b. c. d. e. Decrease in coupon rate Increase in yield to maturity Decrease in the amount repayable at maturity Increase in the amount repayable at maturity None of the above.

14. Which of the following factors is/are considered when a capital structure decision is taken? a. b. c. d. e. a. b. c. d. e. a. b. c. d. e. Cost of capital Size of the company Dilution of control Floatation costs All of the above. Make investments without borrowing or raising external equity Make investments that are financed by a small amount of debt Make investments keeping the debt-equity ratio constant Make investments by resorting to a high level of debt Earn high profits. The company transacts a large volume in the stock market The assets of the company are auctioned The shares of the company witness a large trading volume in the stock exchanges The turnover of current assets is very high in comparison to the sales of the company Volume of sales exceeds that of production.

15. Walters model on dividend policy can be applied only to those companies which

16. Which of the following can be noticed in the situation of overtrading in a company?

17. In which of the following arrangements with the bank, a company does not directly assume the risk of default by its customers? a. b. c. d. e. a. b. c. d. e. a. b. c. d. e. a. b. c. d. e. a. b. c. d. e. Cash credit Overdraft Letter of credit Pledge Hypothecation. Constant purchase price per unit Constant demand Constant ordering cost Zero carrying cost Zero delivery time. Transaction motive Precautionary motive Speculative motive Lack of proper synchronization between cash inflows and outflows Capital investments. If credit standards are liberalized, then sales will increase Strict credit standards will tend to reduce the incidence of bad debt loss Increase in credit period will tend to increase the investment in receivables Liberalizing cash discount policy will tend to increase the average collection period A rigorous collection effort tends to increase the collection expense. The firms balance in the books of the bank is higher than the bank balance in the books of the firm The firms balance in the books of the bank is less than the bank balance in the books of the firm The current assets are more than current liabilities The current assets are less than current liabilities The receivables are more than current liabilities. 3

18. Which of the following is not an assumption in the economic order quantity model?

19. Which of the following is not a motive for the companies to hold cash?

20. Which of the following statements is not true?

21. When the net float is positive

22. In economic appraisal of projects the project is studied from the point of view of the a. b. c. d. e. a. b. c. d. e. a. b. c. d. e. Suppliers Customers Employees Shareholders Society. Net Present Value > 0 0 < Benefit Cost Ratio < 1 0 < Net Benefit Cost Ratio < 1 Internal Rate of Return Cost of capital > 0 All of the above. Avoidance of lost sales Obtaining quantity discounts Reduction in ordering cost Elimination of carrying cost Reducing the chance of stoppage of production.

23. In which of the following cases will a project not be accepted?

24. Which of the following is not the valid reason for maintaining inventories?

25. Which of the following techniques of project appraisal does not take into account the time value of money? a. b. c. d. e. a. b. c. d. e. a. b. c. d. e. a. b. c. d. e. Net present value Benefit cost ratio Payback period Internal rate of return Annual capital charge. Interest on long term funds must be excluded from the determination of net cash flows All revenues and costs accrued must be considered as benefits and costs respectively The cash flows must be determined in incremental terms All costs and benefits must be measured in terms of cash flows Cash flows must be defined in post tax terms. Recourse Factoring Full Factoring Maturity Factoring Invoice Discounting All of the above. Profitability Liquidity Flexibility Control Solvency.

26. Which of the following is not a principle for determining the costs and benefits of projects?

27. In which of the following types of factoring the bad debt loss is not borne by the factor?

28. Which of the following is not a relevant feature of an optimal capital structure?

29. Which of the following is not an assumption in Miller and Modiglianis theory of capital structure? a. b. c. d. e. Capital markets are perfect Investors are rational and behave accordingly The expected probability distribution of the values of the future operating earnings of the firm is same for all the investors There is corporate tax but no personal income tax None of the above. 4

30. Which of the following is not an advantage of private placement of securities? a. b. c. d. e. Easy access for any company Fewer procedural difficulties Lower issue cost Access to funds is faster Complete certainty of availability of funds. END OF PART A

Part B : Problems (50 Points)

This part consists of questions with serial number 1 6. Answer all questions. Points are indicated against each question. Detailed workings should form part of your answer. Do not spend more than 110 - 120 minutes on Part B.

Caselet 1
Read the following caselet carefully and answer the question: 1. Do you think that investment in the cement industry is suitable for Mahashakthi Plastics Pvt. Ltd.? Justify your answer. (8 points) Mahashakthi Plastics Pvt. Ltd. has been operating for the last four years. Compared to other players in the plastic industry it operates at a small scale and has a modest workforce of fifty employees. It has managed to accumulate retained earnings of Rs.3 crores in the last four years. Presently it is considering a plan for diversification into the cement industry in order to expand its product portfolio. Cement is an entirely new area for the company as it has been operating in the field of plastic products from the beginning. Already there are well established players existing in the cement industry. The major inputs for cement manufacturing are lime and water. The company has identified a location near Nalgonda District (A.P), where a large number of lime quarries are available. The location is facing a severe drought from the past few years. As per the pollution control norms of the government, the byproducts and wastes should not be left to the environment. In a recent survey done by an industrial magazine, it has been reported that the investors are showing a preference for other lines of business.

Caselet 2
Read the following caselet carefully and answer the question: 2. Why, do you think, the management of the group has been concentrating upon return maximization only? What should be the liquidity mix of the three companies in the group, under the given circumstances? (8 points) The companies Andhra Electricals Ltd., Ooty Tea Ltd. and Best Finance Ltd. are promoted by the same group. Best Finance Ltd. has been performing well and has substantial retained earnings. It is expected that the companys future income will be growing steadily. Andhra Electricals Ltd. manufactures electrical appliances. The company has been experiencing a consistently growing demand and has established its image successfully in the market. It is expected that the demand for the companys products will continue to grow steadily in the future. Ooty Tea Ltd. has been facing an uncertain demand. The tea plantations of the company were adversely affected by untimely hailstorms. The future cash flows of the company will be affected by this adverse development and the management of the group foresees uncertainty in the near future. For quite sometime, the management of the group has been concentrating upon return maximization only.

Caselet 3
Read the following caselet carefully and answer the question: 3. What do the information on the first two years of operation of Raj Industries Pvt. Ltd., indicate with regard to the state of working capital management in the company during that period? (8 points) Raj Industries Pvt. Ltd., an engine valve manufacturer, is a recent entrant in the industry. It has completed only two business years. It is the first business experience for the promoters of the company. Before entering into this business they analyzed the present and foreseeable demand and came to a conclusion that there is a good and growing demand for engine valves. After a careful study, they started the business with adequate capital, skilled labour and a sophisticated factory. However, the company has been facing problems in managing its working capital, during the first two years of its operations. The management of the company is completely dissatisfied by the operations of the company in these two years. The company has provided the following details: Current ratio Year1 Year2 High Low Quick ratio Low High Inventory turnover Low High Credit standards High High Demand Normal Good

On the basis of these details an assessment of the state of working capital management during the first two years of operation, is required. 4. The risk-free rate of return is 8%. The shares of Pragati Pharmaceuticals Ltd. (PPL) have a beta of 1.5 and the return on the market portfolio is 16%. The company has recently paid a dividend of Rs.3.00 per share and the dividends are expected to grow at the rate of 5%. The current market price of the equity share of PPL is Rs.15.75 per share. Assume that the CAPM is applicable. You are required to answer the following questions: a. b. Is the present market price of the share at equilibrium? If the market adjusts in such a way that the share is valued at its equilibrium price then what will be the change in the market value of an investment in 1000 shares of the company? (3 + 2 = 5 points) 5. The manager of a departmental store is deliberating on the quantity of a particular bath soap to be ordered. The sales of the bath soap over the next six months, which is the planning period, is forecasted to be 9000 cakes. The purchase price of the soap is Rs.8.00 per cake. The ordering cost is Rs.400 per order and the carrying cost is 20 percent of the average inventory value per annum. The company which manufactures the soap has offered a discount of 6.25 percent on the price for orders of 4000 cakes and above. You are required to answer the following questions: a. b. What was the economic order quantity of the product before the introduction of the discount? What would be the optimal order size after the introduction of the discount? Clearly show the relevant costs and benefits. Ignore taxes. (2 + 6 = 8 points)

6.

The following details pertain to Agarwal Industries Ltd. (Rs. in lakh) Raw materials, stores and spares etc. Work-in-process Finished goods Accounts receivable Accounts payable Opening balance 22 40 10 68 60 Closing balance 30 52 23 87 75 (Rs. in lakh) Purchases of raw materials, stores and spares etc. Manufacturing expenses Depreciation Excise duty Selling and administration expenses Interest Sales 423 150 50 100 50 20 900

It is assumed that all sales and purchases are on credit basis. You are required to calculate the net operating cycle period of the company. (Assume 1 year = 360 days). (13 points) END OF PART B

Part C : Applied Theory (20 Points)

This part consists of questions with serial number 7 - 9. Answer all questions. Points are indicated against each question. Do not spend more than 25 -30 minutes on Part C.

7. 8.

Explain the various reasons behind holding of cash by the companies. (8 points) Many business organizations undertake business largely on a credit basis. Briefly explain the costs associated with maintaining receivables arising out of credit sales. (5 points) Briefly explain the functions performed by the financial system in an economy. (7 points) END OF PART C END OF QUESTION PAPER

9.

Suggested Answers Financial Management (MB211) : July 2003

Part A : Basic Concepts
1. Answer : (b) Reason : In rights issue, new securities are offered to the existing shareholders of the company on a pro rata basis. Answer : (d) Reason : Short term financial instruments are traded in money market. Answer : (e) Reason : Industrial recession is not a diversifiable risk in the context of investment in stocks because it affects all companies in general. All other alternatives state those risks which are company specific and which can be diversified away. Answer : (c) Reason : CAPM assumes that the investors agree on the nature of return and risk associated with each investment. Answer : (e) Reason : When the market value of the firm increases the wealth of its owners increases. The ultimate objective of financial management is to maximize the wealth of the owners. All the other alternatives may not necessarily maximize the wealth of the owners. Answer : (a) Reason : The beta coefficient of a stock is an indicator of systematic risk. Answer : (a) Reason : According to the CAPM the expected rate of return on a security is equal to the risk free rate of return plus a premium to compensate for the risk taken on investing in the security. Answer : (b) Reason : Current yield Coupon rate = = Coupon amount Market price Coupon amount Face value

2. 3.

4.

5.

6. 7.

8.

Current yield = Coupon rate implies that market price = face value. Further this means that the bond is trading at its face value.

Hence both (I) and (II) are true. 9. Answer : (e) Reason : The risk arising out of the use of debt financing is called financial risk.

10. Answer : (d) Reason : Stock market is a part of the capital market. Alternatives (a), (b) and (c) are parts of the money market. 11. Answer : (b) Reason : When the required rate of return on a bond is less than the coupon rate the intrinsic value of the bond is more than its par value; hence there exists a premium above its par value. This premium on the bond decreases as the maturity approaches. All other alternatives than (b) are false.

12. Answer : (b) Reason : Commercial papers are short term, unsecured promissory notes issued by corporates which are financially strong and have high credit rating. The minimum amount to be invested by a single investor is Rs.5 lakhs. Hence, the answer is (b). These instruments are issued in multiples of Rs.5 lakhs. Hence, (a) is not correct. The maturity period varies from 15 days to a year. Hence, (c) is also not correct. Unlike certificate of deposits, CPs can be bought back by the issuers. Hence, (d) is also not correct. The companies can raise commercial papers upto the extent of 100 percent of the working capital limit. Hence, (e) is also not correct. 13. Answer : (d) Reason : Intrinsic value of bond = C PVIFA(k,n) + F PVIF(k,n) Where, C = coupon payment on the bond F = amount payable at maturity k = discount rate n = number of years to maturity. From the expression of intrinsic value of bond we can see that other things remaining the same if the amount payable at maturity increases then the value of bond increases. 14. Answer : (e) Reason : When a capital structure decision is taken all the factors stated in the alternatives are considered. 15. Answer : (a) Reason : Walter model on dividend policy assumes that the firm does not resort to any external financing in the form of external equity or debt. All the other alternatives are not related with any of the assumptions of the model. 16. Answer : (d) Reason : In the situation of overtrading the current asset turnover is observed to be very high in comparison to the sales. 17. Answer : (c) Reason : Under the letter of credit (L/C) arrangement the credit risk of customers is not borne by a company; it is borne by the bank issuing the L/C. 18. Answer : (d) Reason : The economic order quantity (EOQ) model does not assume zero carrying cost; it assumes constant carrying cost. All other alternatives state assumptions under the EOQ model. 19. Answer : (e) Reason : Capital investments decisions are special decisions and are not undertaken as routine business activity. Hence, a company does not require readily available cash to undertake capital investments. All other alternatives state the motives for holding cash. 20. Answer : (d) Reason : A liberal cash discount policy provides incentives to customers to make early payments in order to avail of the discount. Hence, it tends to reduce the average collection period. 21. Answer : (a) Reason : When the net float is positive the balance in the books of bank is higher than the balance in the books of the firm. 22. Answer : (e) Reason : In economic appraisal of projects, the project is studied from the point of view of society. 23. Answer : (b) Reason : Project will not be accepted if the BCR is less than 1.

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24. Answer : (d) Reason : Inventories are not maintained to reduce carrying cost (carrying costs will always increase if inventories increase). 25. Answer : (c) Reason : The payback period does not take into account the time value of money. 26. Answer : (b) Reason : According to the principles for determining the costs and benefits of projects only cash flows (cash inflows and outflows) are considered as benefits and costs. All revenues accrued may not result in actual cash inflows and all expenses accrued may not result in actual cash outflows. 27. Answer : (a) Reason : In recourse factoring the bad debts are not borne by the factor. 28. Answer : (b) Reason : Liquidity is not the relevant feature of an optimal capital structure. It is the feature of the mode of deployment of capital. 29. Answer : (d) Reason : Miller Modigliani model assumes that neither corporate tax nor personal income tax are present. All other alternatives state the assumptions of the model. 30. Answer : (e) Reason : Private placement of funds cannot ensure complete certainty of availability of funds; availability of funds is subject to the willingness of the parties to invest in the securities which are to be placed privately. All other alternatives are advantages of private placements.

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Part B : Problems
1. The new diversification is prima facie not suitable for the company because of the following reasons: Lack of compatibility with the promoter: Any entrepreneur promoting a new project must ensure that physical, financial and human resources available at their disposal are adequate to meet the requirements of the project under consideration. Here the present work force of the company is just 50 and the retained earnings amount to Rs.3 crores. Both of these are grossly inadequate for a cement industry. Even if it plans to expand its workforce it will face a shortage of funds for meeting the other requirements. Moreover it should not take a disproportionately high level of debt for meeting the capital expenditure. Compatibility with governmental priorities: In order to comply with the governmental norms for pollution control it has to make additional capital expenditure on pollution control system and recycling plants. This will put further strain on the companys available resources. Availability of inputs: Though one of the major inputs, lime, is available, the location is facing a severe drought. Thus there is a severe shortage of another major input, water. Size of the potential market: It is mentioned that there are well established players in the cement industry. It implies that the company will face tough competition from the existing players, in order to establish itself in the cement industry. Acceptability of risk level: As it is a venture into an entirely new field, there will be a lot of uncertainty about future performance of the company. It is also indicated that investors are shifting towards other types of ventures. This indicates that the investors are not finding the cement industry to be very attractive. It seems that a diversification into the cement industry will not be beneficial for the company. Andhra Electricals is an electrical appliances manufacturing company with an established image and it has been experiencing a good growing demand. Hence it appears that its future cashflows are less affected by uncertainty. Therefore the liquidity mix of the company may be tilted more towards marketable securities and intercorporate deposits (for return maximization). Best Finance is already running very well and a growth in income is expected. So the future uncertainty is less. So here also the consequent liquidity mix should aim at maximizing returns. Therefore the liquidity mix of this company should be similar to Andhra Electricals. Ooty Tea This company is facing an uncertain demand. It is given that the tea plantations have been adversely affected by bad weather and the management is foreseeing that the uncertainty will be very high in the near future. In such circumstances the liquidity mix should be tilted largely towards free cash balances and as far as possible reserve drawing power under the cash credit /overdraft arrangements and to a lesser extent in gilt edged securities. When a company is favorably placed in a position to have ready access to non bank funds it can afford to have less proportion of cash and more of intercorporate deposits and marketable securities. Since Ooty Tea is facing cash shortage, the other two companies promoted by the group may provide the necessary financial help. How the group will manage its funds flows, ultimately depends upon the policies fixed by the top management. It seems that, because of the good financial position of the two companies in the group (viz. Andhra Electricals and Best Finance) and the possibility that the surplus generated by these two companies may be used to improve the financial condition of Ooty Tea (the third company in the group); the group is concentrating on return maximization. Year1: Given that current ratio is high and quick ratio is low, it is implied that though the investment in current assets was high, the investment in quick assets (viz. cash, bank balance and marketable securities etc.) was low. Even the most profitable companies may face cash shortages in such situations. It is also evident from the levels of the ratios that the inventory level was high and inventory turnover was low. This indicates that the funds were locked up in the slow moving inventories. It is also given that the credit standards were high. This might have adversely affected the volume of sales because some prospective customers might not have come forward due to the high credit standards. Year2: Given that current ratio is low and quick ratio is high, it is implied that a large proportion of current assets was held in the form of cash, bank balances and marketable securities, compared to the inventories. By this the liquidity position of the company improves, but at the cost of sacrificing profitability, as idle cash fetches no return. It is also evident from the ratios that the inventory level is low and inventory turnover is high. Low level of inventory affects the profitability due to stoppage of work for the want of raw materials. Also low level of inventory of finished goods coupled with high inventory turnover may result in frequent stockouts and consequently the loss of customers and profitability. The company has been 12 still maintaining high credit standards in the second year. This might prevent an expansion of its customer base.

2.

3.

4.

raw materials. Also low level of inventory of finished goods coupled with high inventory turnover may result in frequent stockouts and consequently the loss of customers and profitability. The company has been still maintaining high credit standards in the second year. This might prevent an expansion of its customer base. a. According to CAPM kj = Rf + i (km Rf) Given: Rf = 8%, i = 1.5, km = 16% Required rate of return of the share of EPL is kj = 8 + 1.5(16 8) = 20% Current market price per share = Rs.15.75 Present expected rate of return = D (1 + g ) D1 3.00(1.05) +g = 0 +g = + 0.05 = 0.25 i.e. 25%. P0 P0 15.75

b.

Since the expected rate of return is more than the required rate of return as per the CAPM, we can say that the share is priced below its equilibrium price. Thus, the present market price of the share is not at equilibrium. The market adjusts itself in such a way that the share is valued at its equilibrium price. Let the equilibrium price be P0. or, or, 0.20 = 0.15 = P0 = 3(1.05) + 0.05 P0 3.15 P0 3.15 = Rs.21 0.15

The market price will increase from Rs.15.75 per share to Rs.21 per share. For an investment in 1000 shares of the company the change in market value = 1000 (21 15.75) = Rs.5250 (increase). Economic order quantity (Q*) = Given : 2FU PC

5.

a.

F = Rs.400 U = Rs.9000 cakes P = Rs.8.00 Carrying cost, C = 20 percent annum. For the planning period of six months, C = 10 percent = 0.10 2 9000 400 = 3000 cakes. 8 0.10 Since the minimum order size for availing the discount, Q , is 4000 which is higher than the EOQ, Q*, the incremental benefits and costs associated with the discount offer have to be calculated. Total discount available in planning period if the order size is 4000 cakes = UD = 9000 8 0.0625 = Rs.4500 .(1) Savings due to reduction in ordering costs Q* = b. = = U U F Q * Q 9000 9000 400 = Rs.300 3000 4000 Q '(P D)C Q * PC 2 2 13 .(2)

Incremental carrying cost =

4000(8 0.50) 0.10 3000 8 0.10 = 1500 1200 = Rs.300 . (3) 2 2 Net incremental benefit = (1) + (2) (3) = Rs.4,500 Since the net incremental benefit is positive the optimal order size would be 4000 cakes of the soap. = 6. Raw material storage period 1. Annual raw material consumption = Opening stock + Purchases Closing stock = 22 + 423 30 = Rs.415 lakh 2. Average daily consumption of raw materials = = 3. Annual raw material consumption 360 415 = Rs.1.153 lakh 360 Opening stock + Clo sin g stock 2 22 + 30 = Rs.26 lakh 2

Average stock of raw materials = =

4. Raw material storage period = (3) (2) = 22.55 days Conversion period 5. Annual cost of production = Opening stock of work-in-process + Raw material consumption + Other manufacturing expenses + Depreciation Closing stock = 40 + 415 + 150 + 50 52 = Rs.603 lakh 6. 7. 8. Average daily cost of production = (5) 360 = Rs.1.675 lakh Average stock of work-in-process = Conversion period = (7) (6) = 40 + 52 = Rs.46 lakh. 2

46 = 27.46 days 1.675

Finished goods storage period 9. Annual cost of sales = Opening stock of finished goods + Annual cost of production + Excise duty + Selling and administration expenses + Interest Closing stock of finished goods = 10 + 603 + 100 + 50 + 20 23 = Rs.760 lakh 10. Average daily cost of sales = (9) 360 = 11. Average stock of finished goods = 760 = Rs.2.11 lakh 360

Opening stock + Clo sin g stock 10 + 23 = = Rs.16.5 lakh 2 2

12. Finished goods storage period = (11) (10) = 7.82 days Average collection period 13. Annual credit sales = Rs.900 lakh 14. Average daily sales = 900 = Rs.2.50 lakh 360 Opening balance + Clo sin g balance 68 + 87 = = Rs.77.5 lakh 2 2 14

15. Average balance of receivables =

16. Average collection period = (15) (14) = Average payment period 17. Annual credit purchases = Rs.423 lakh

77.5 = 31 days 2 .5

18. Average daily credit purchases = (17) 360 = Rs.1.175 lakh 19. Average balance of payables = 20. Average payment period = Operating cycle period = = = 60 + 75 = Rs.67.5 lakh 2 (19) (18) = 57.45 days (4) + (8) + (12) + (16) (20) 22.55 + 27.46 + 7.82 + 31 57.45 31.38 31.4 days

Part C: Applied Theory

7. Reasons behind holding of cash by the companies The need for holding cash arises from a variety of reasons which are briefly summarized below: Transaction Motive A company is always entering into transactions with other entities. While some of these transactions may not result in an immediate inflow/outflow of cash (e.g.: credit purchases and sales), other transactions cause immediate cash inflows and outflows. So firms always keep a certain amount of cash to deal with routine transactions where immediate cash payment is required. Precautionary Motive Contingencies have a habit of cropping up when least expected. A sudden fire may break out, accidents may happen, employees may go on strike, creditors may present bills earlier than expected or debtors may make payments later than warranted. The company has to be prepared to meet these contingencies to minimize its losses. For this purpose companies generally maintain some amount in the form of cash. Speculative Motive Firms also maintain cash balances in order to take advantage of opportunities that do not take place in the course of routine business activities. For example, there may be a sudden decrease in the price of raw materials which is not expected to last long or the firm may want to invest in securities of other companies when the price is just right. These transactions are of a purely speculative nature for which the firms need cash. Lack of Proper Synchronization between Cash Inflows and Outflows In the case of reasonably well-managed profitable companies, the total amount of cash inflows for the year is usually higher than the total amount of cash outflows. However, the company can have spells of cash deficits and surpluses. This kind of a situation arises mainly due to lack of proper synchronization between cash inflows and outflows. Seasonal industries such as tea, jute are typical examples for mismatching of inflows and outflows. Consequently, these companies tend to follow a conservative cash management policy by holding more cash. Asymmetry in the occurrences of `Shortages and `Surpluses of Cash Orgler has an interesting argument that the finance manager is more worried about the situation of an `uncovered cash deficit than the situation of surplus cash lying idle in the bank. This attitude on the part of finance manager is quite understandable as the deficiencies in cash management are more likely to come out into the open during a period of cash crunch than in a period of cash surplus. As the opportunity loss sustained by the company for keeping excess cash at bank is not likely to affect all sections of the employees while inability to meet wages and salaries does, the finance manager may feel tempted to err, if at all, on the conservative side. This will have the impact of the need for additional cash lying at bank.

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8.

The costs involved in maintaining the accounts receivables by an organization are: Additional fund requirement for the company When a firm maintains receivables, some of the firms resources remain blocked in them because there is a time lag between the credit sales to customers and receipt of cash from them as payment. To the extent that the firms resources are blocked in its receivables, it has to arrange for additional finance to meet its own obligations towards its creditors and employees, like payments for purchases, salaries and other production and administrative expenses. Whether this additional finance is met from its own resources or from outside, it involves a cost to the firm in terms of interest (if financed from outside) or opportunity costs (if internal resources which could have been put to some other use are taken). Administrative costs When a company maintains receivables, it has to incur additional administrative expenses in the form of salaries to clerks who maintain records of debtors, expenses on investigating the creditworthiness of debtors etc. Collection costs These are costs which the firm has to incur for collection of the amounts at the appropriate time from the customers. Defaulting costs When customers make default in payments, not only is the collection effort to be increased but the firm may also have to incur losses from bad debts. Functions performed by a financial system The Savings Function The public savings find their way into the hands of those in production through the financial system. Financial claims are issued in the money and capital markets which promise future income flows. The funds in the hands of the producers result in production of better goods and services, increasing society's living standards. When savings flows decline, however, the growth of investment and living standard begins to fall. Liquidity Function Money in the form of deposits offers the least risk, of all financial instruments. But its value is most eroded by inflation. That is why one always prefers to store the funds in financial instruments like stocks, bonds, debentures, etc. The compromise one makes in such investments is (1) that the risk involved is more, and (2) the degree of liquidity, i.e. conversion of the claims into money is less. The financial markets provides the investor with the opportunity to liquidate the investments. Payment Function The financial system offers a very convenient mode of payment for goods and services. The cheque system, credit card system et al are the easiest methods of payments in the economy. The cost and time of transactions are drastically reduced. In India, the cheque system of payment is widely practiced. The credit card system has entered only urban India and is widely used in these areas for payments of consumption expenditure. Risk Function The financial markets provide protection against life, health and income risks. These are accomplished through the sale of life and health insurance and property insurance policies. The financial markets provide immense opportunities for the investor to hedge himself against or reduce the possible risks involved in various investments. Policy Function India is a mixed economy. The government intervenes in the financial system to influence macroeconomic variables like interest rates or inflation. In 1996-97, by bringing about several cuts in the CRR from 12% to 10% the government, the RBI has tried to force the interest rates down and increase the availability of credit to the corporates at cheaper rates.

9.

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Modern day economies require huge sums of money for investment in capital assets (land, equipment, factory, etc.) which are then used for providing goods and services. The funds required are so huge that it is not possible for a single government/firm to provide for the requirement. By selling financial claims like stocks, bonds, etc. the required funds can be quickly raised from a variety of investors. The business firm/government issuing such a financial claim then hopes to return the borrowed funds from expected future inflows. Indeed, we see that the financial markets within the financial system have made possible the exchange of current income for future income and transformation of savings into investments, so that production and income grow.

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