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Master of 8us|ness Adm|n|strat|on
M8004S I|nanc|a| Management
Ass|gnment Set 1


1 Wr|te the short notes on

A I|nanc|a| management
I|nanc|a| Management |s the art and sc|ence of manag|ng money kegu|atory and econom|c
env|ronments have undergone drast|c changes due to ||bera||sat|on and g|oba||sat|on of
Ind|an economy 1h|s has changed the prof||e of Ind|an f|nance managers Ind|an f|nanc|a|
managers have transformed themse|ves from ||censed ra[ managers to we|||nformed
dynam|c proact|ve managers capab|e of tak|ng dec|s|ons of comp|ex nature
1rad|t|ona||y f|nanc|a| management was cons|dered a branch of know|edge w|th focus on the
procurement of funds Instruments of f|nanc|ng format|on merger and restructur|ng of f|rms
and |ega| and |nst|tut|ona| frame work occup|ed the pr|me p|ace |n th|s trad|t|ona| approach
1he modern approach transformed the f|e|d of study from the trad|t|ona| narrow approach to
the most ana|yt|ca| nature 1he core of modern approach evo|ved around the procurement of
the |east cost funds and |ts effect|ve ut|||sat|on for max|m|sat|on of share ho|ders' wea|th
8 I|nanc|a| p|ann|ng
linoncio/ p/onninq is o process by which funds required for eoch course of oction is decided
A f|nanc|a| p|an has to cons|der cap|ta| structure cap|ta| expend|ture and cash f|ow Dec|s|ons
on the compos|t|on of debt and equ|ty must be taken
I|nanc|a| p|ann|ng or f|nanc|a| p|an |nd|cates
1he quantum of funds requ|red to execute bus|ness p|ans
Compos|t|on of debt and equ|ty keep|ng |n v|ew the r|sk prof||e of the ex|st|ng bus|ness
new bus|ness to be taken up and the dynam|cs of cap|ta| market cond|t|ons
Iormu|at|on of po||c|es g|v|ng effect to the f|nanc|a| p|ans under cons|derat|on



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C Cap|ta| structure
1he cap|ta| structure of a company |s |nf|uenced by the des|re of the ex|st|ng management
(promoters) of the company to reta|n contro| over the affa|rs of the company 1he promoters
who do not ||ke to |ose the|r gr|p over the affa|rs of the company norma||y obta|n extra funds
for growth by |ssu|ng preference shares and debentures to outs|ders

D Cost of cap|ta|
@he cost of copito/ is the minimum rote of return of o compony which must eorn to meet the
expenses of the vorious coteqories of investors who hove mode investment in the form of
/oons debentures ond equity ond preference shores

L 1rad|ng on equ|ty

A company earn|ng more by the use of assets funded by f|xed sources |s sa|d to be hav|ng a
favourab|e or pos|t|ve |everage Unfavourab|e |everage occurs when the f|rm |s not earn|ng
suff|c|ent|y to cover the cost of funds I|nanc|a| |everage |s a|so referred to as "1rad|ng on
Lqu|ty"

2 a Wr|te the features of |nter|m d|v|ned and a|so wr|te the factors Inf|uenc|ng d|v|ned
po||cy?

ANS Inter|m D|v|dend
A d|v|dend wh|ch |s dec|ared before the dec|arat|on of the f|na| d|v|dend |s ca||ed the |nter|m
d|v|dend In other words |nter|m d|v|dend |s a d|v|dend wh|ch |s dec|ared between two
annua| genera| meet|ngs If the prof|ts of the company appear to be [ust|f|ed for the payment
of |nter|m d|v|dend the 8oard of d|rectors may from t|me to t|me pay to the members such
d|v|dends Wh||e dec|d|ng to dec|are an |nter|m d|v|dend the d|rectors shou|d take |nto
cons|derat|on the future prospects of the prof|ts cash resources etc of the company

DIVIDLND CLIC
D|v|dend po||cy |s the po||cy concern|ng the amount of prof|ts to be d|str|buted as d|v|dend
Usua||y compan|es through the|r 8oard of D|rectors evo|ve a pattern of d|v|dend payment
wh|ch has a bear|ng on future act|on 1he power to recommend]dec|are d|v|dends vests
comp|ete|y |n the board of d|rectors of the company





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Iactors Affect|ng D|v|dend o||cy

1he factors affect|ng d|v|dend po||cy are d|v|ded |nto

Lxterna| Iactors
1he fo||ow|ng are the var|ous externa| factors affect|ng d|v|dend po||cy of the company

1 Genera| State of Lconomy
1he management's dec|s|on to reta|n or d|str|bute earn|ngs of the f|rm ma|n|y re|ates to the
genera| state of economy nowever the management may prefer to reta|n the who|e or part
of the earn|ngs w|th a v|ew to bu||d|ng up reserves dur|ng Uncerta|n econom|c and bus|ness
cond|t|ons depress|on prosper|ty and |nf|at|on

2 State of Cap|ta| Market
A f|rm can fo||ow a ||bera| d|v|dend po||cy |f |t has an easy access to the cap|ta| market on
account of |ts f|nanc|a| strength or favourab|e cond|t|ons preva|||ng |n the cap|ta| market
nowever a f|rm |s ||ke|y to adopt a more conservat|ve d|v|dend po||cy |f |t has no easy access
to cap|ta| market because of |ts weak f|nanc|a| pos|t|on or unfavorab|e cond|t|ons |n the
cap|ta| market

3 Lega| kestr|ct|ons
A f|rm may a|so be |ega||y restr|cted from dec|ar|ng and pay|ng of d|v|dends 1he Compan|es
Act of 19S6 conta|ns severa| restr|ct|ons re|at|ng to the dec|arat|on and payments of
d|v|dends

Interna| Iactors
Var|ous |nterna| factors wh|ch affect the d|v|dend po||c|es of the f|rm are as fo||ows

1 Des|re of the Shareho|ders
Shareho|ders expect returns from the|r |nvestment |n a f|rm |n the form of both cap|ta| ga|ns
and d|v|dends Cap|ta| ga|n re|ates to the prof|t as a resu|t of the sa|e of cap|ta| |nvestment
|e equ|ty shares |n the case of shareho|ders D|v|dends are the regu|ar return expected by
the shareho|ders on the|r |nvestment |n a f|rm 1he des|re of the shareho|ders to get
d|v|dends takes pr|or|ty over the des|re to earn cap|ta| ga|ns on account of the fo||ow|ng
reasons

2 Iuture requ|rements
1he prudent management shou|d g|ve more we|ghtage to the f|nanc|a| needs of the company
than the des|re of the shareho|ders Wh||e reta|ned earn|ngs he|p for the further growth of
the f|rm the payment of d|v|dend w||| adverse|y affect both the owner's wea|th and |ong
term growth of the f|rm 1hus a f|rm requ|res an opt|mum d|v|dend po||cy wh|ch shou|d
max|m|se the f|rm's wea|th and prov|de enough funds for the growth |n future

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3 Nature of Larn|ngs
A f|rm whose |ncome |s stab|e can afford to have a h|gher
d|v|dend payout rat|o than a f|rm wh|ch does not have such stab|||ty |n |ts earn|ngs
4 L|qu|d|ty os|t|on
1he payment of d|v|dends usua||y |nvo|ves cash outf|ow 1hus somet|mes a f|rm wh|ch has
adequate earn|ngs may not have suff|c|ent cash to pay d|v|dends It |s therefore the duty of
the management to see the ||qu|d|ty aspect of the f|rm before and after payment of d|v|dends
wh1'e tak|ng the d|v|dend dec|s|on 1he management shou|d keep |n m|nd that |n no case
can the ||qu|d|ty rat|o be |ess than 11 after the payment of d|v|dends

S Des|re of Contro|
1he des|res of the shareho|ders or management shou|d a|so |nf|uence the d|v|dend po||cy of
the f|rm If a f|rm |ssues add|t|ona| equ|ty shares for ra|s|ng funds |t w||| d||ute contro| wh|ch
|s detr|menta| to the ex|st|ng equ|ty shareho|ders 1hus |n the case of strong des|re for
contro| the management prefers a sma||er d|v|dend payout rat|o and hence |ow rate of
d|v|dend

6 Age of the company
A new|y estab||shed concern has to ||m|t payment of d|v|dend and reta|n substant|a| part of
earn|ngs for f|nanc|ng |ts future growth and deve|opment wh||e o|der compan|es can afford
to pay ||bera| d|v|dends because of suff|c|ent reserves

b What |s reorder |eve| ?

ANS Method of ca|cu|at|ng reorder |eve| |nvo|ves the ca|cu|at|on of usage rate per
day |ead t|me wh|ch |s the amount of t|me between p|ac|ng an order and rece|v|ng
the goods and the safety stock |eve| expressed |n terms of severa| days sa|es
keorder |eve| Average da||y usage rate x |eadt|me |n days

Irom the above formu|a |t can be eas||y deduced that an order for rep|en|shment of
mater|a|s be made when the |eve| of |nventory |s [ust adequate to meet the needs of
product|on dur|ng |eadt|me

If the average da||y usage rate of a mater|a| |s S0 un|ts and the |eadt|me |s seven
days
then

keorder |eve| Average da||y usage rate x Lead t|me |n days S0 un|ts x 7 days 3S0
un|ts
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When the |nventory |eve| reaches 3S0 un|ts an order shou|d be p|aced for mater|a|
8y the t|me the |nventory |eve| reaches zero towards the end of the seventh day
from p|ac|ng the order mater|a|s w||| reach and there |s no cause for concern

keorder po|nt Average Lead 1|me*Average Demand + 2*Sk1(Avg Lead
1|me*Standard Dev|at|on of Demand2 + Avg Demand2*Standard Dev|at|on of
Lead 1|me2)


keorder po|nt S x L + I ( S x k x L) Where

S Usage |n un|ts
L Lead t|me |n days
k Average number of un|ts per order
I Stock out acceptance factor

1he stockout acceptance factor `I depends on the stockout percentage rate
spec|f|ed and the probab|||ty d|str|but|on of usage (wh|ch |s assumed to fo||ow a
o|sson d|str|but|on)

3 Sa|es ks400 000 |ess returns ks 10 000 Cost of Goods So|d ks 300000 Adm|n|strat|on
and se|||ng expenses ks20 000 Interest on |oans ksS000 Income tax ks10000 preference
d|v|dend ks 1S000 Lqu|ty Share Cap|ta| ks100 000 Qks 10 per share I|nd LS

ANS
SALLS ks 400000
LLSS kL1UkNS ks 10000 ks390000

LLSS CCGS ks 30000
LLSS SA ks 20000
LLSS IN1 CN LCAN ks S000
LLSS I1 ks 10000 ks32S000

ulv 13000
LSC 100000 [ 10/
nA1 ref Share
ulv
no of Shares

nA1 8s 33000
Less ref Share ulv 8s 13000 8s 40000

LS 8s 40000/10000 8s4/

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4 What are the techn|ques of eva|uat|on of |nvestment?

ANS 1echn|ques of Investment Lva|uat|on

1hree sLeps are lnvolved ln Lhe evaluaLlon of an lnvesLmenL

-LsLlmaLlon of cash flows
-LsLlmaLlon of Lhe requlred raLe of reLurn (Lhe opporLunlLy cosL of caplLal)
-AppllcaLlon of a declslon rule for maklng Lhe cholce

1he flrsL Lwo sLeps dlscussed ln Lhe subsequenL chapLers are assumed as glven
1hus our dlscusslon ln Lhls chapLer ls conflned Lo Lhe Lhlrd sLep Speclflcally we
focus on Lhe merlLs and demerlLs of varlous declslon rules

Investment dec|s|on ru|e
1he lnvesLmenL declslon rules may be referred Lo as caplLal budgeLlng Lechnlques or
lnvesLmenL crlLerla A sound appralsal Lechnlque should be used Lo measure Lhe
economlc worLh of an lnvesLmenL pro[ecL 1he essenLlal properLy of a sound
Lechnlque ls LhaL lL should maxlmlze Lhe shareholders' wealLh 1he followlng oLher
characLerlsLlcs should also be possessed by a sound lnvesLmenL evaluaLlon crlLerlon

- lL should conslder all cash flows Lo deLermlne Lhe Lrue proflLablllLy of Lhe pro[ecL
- lL should provlde for an ob[ecLlve and unamblguous way of separaLlng good pro[ecLs form bad
pro[ecLs
- lL should help ranklng of pro[ecLs accordlng Lo Lhelr Lrue proflLablllLy
- lL should recognlze Lhe facL LhaL blgger cash flows Lrue proflLablllLy
- lL should recognlze Lhe facL LhaL blgger cash flows are preferable Lo smaller once
and early cash flows are preferable Lo laLer ones
- lL should help Lop choose among muLually excluslve pro[ecLs LhaL pro[ecL whlch
maxlmlzes Lhe shareholders' wealLh
- lL should be a crlLerlon whlch ls appllcable Lo any concelvable lnvesLmenL pro[ecL
lndependenL of oLher
1hese condlLlons wlll be clarlfled as we dlscuss Lhe feaLures of varlous lnvesLmenL
crlLerla ln Lhe followlng pages

Lva|uat|on cr|ter|a
A number of lnvesLmenLs crlLerla (or caplLal budgeLlng Lechnlques) are ln use ln
proacLlve 1hey may be grouped ln Lhe followlng Lwo caLegorles

1 D|scounted cash f|ow (DCI) cr|ter|a

- neL presenL value (nv)
- lnLernal raLe of reLurn (ll8)
- roflLablllLy lndex (l)
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2 Nond|scounted cash f|ow cr|ter|a

- ayback perlod (8)
- ulscounLed payback perlod
- AccounLlng raLe of reLurn (A88)

ulscounLed payback ls a varlaLlon of Lhe payback meLhod lL lnvolves dlscounLed cash
flows buL as we shall see laLer lL ls noL a Lrue measure of lnvesLmenL proflLablllLy
We wlll show ln Lhe followlng pages LhaL Lhe neL presenL value crlLerlon ls Lhe mosL
valld Lechnlque of maxlmlzlng Lhe shareholders wealLh

S What are the prob|ems assoc|ated w|th |nadequate work|ng cap|ta|?

ANS rob|ems assoc|ated w|th |nadequate work|ng cap|ta|

Worklng caplLal may be regarded as Lhe llfe blood of buslness Worklng caplLal ls of
ma[or lmporLance Lo lnLernal and exLernal analysls because of lLs close relaLlonshlp
wlLh Lhe currenL dayLoday operaLlons of a buslness Lvery buslness needs funds for
Lwo purposes

Long Lerm funds are requlred Lo creaLe producLlon faclllLles Lhrough purchase
of flxed asseLs such as planLs machlnerles lands bulldlngs eLc

ShorL Lerm funds are requlred for Lhe purchase of raw maLerlals paymenL of
wages and oLher dayLoday expenses lL ls oLher wlse known as revolvlng
or clrculaLlng caplLal

lL ls noLhlng buL Lhe dlfference beLween currenL asseLs and currenL llablllLles le
Worklng CaplLal CurrenL AsseL CurrenL LlablllLy

8uslnesses use caplLal for consLrucLlon renovaLlon furnlLure sofLware equlpmenL
or machlnery lL ls also commonly used Lo purchase lnvenLory or Lo make payroll
CaplLal ls also used ofLen by buslnesses Lo puL a down paymenL down on a plece of
commerclal real esLaLe Worklng caplLal ls essenLlal for any buslness Lo succeed lL ls
becomlng lncreaslngly lmporLanL Lo have access Lo more worklng caplLal when we
need lL

Importance of Adequate Work|ng Cap|ta|
A buslness flrm musL malnLaln an adequaLe level of worklng caplLal ln order Lo run lLs
buslness smooLhly lL ls worLhy Lo noLe LhaL boLh excesslve and lnadequaLe worklng
caplLal poslLlons are harmful Worklng caplLal ls [usL llke Lhe hearL of buslness lf lL
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becomes weak Lhe buslness can hardly prosper and survlve no buslness can run
successfully wlLhouL an adequaLe amounL of worklng caplLal



Danger of |nadequate work|ng cap|ta|
When worklng caplLal ls lnadequaLe a flrm faces Lhe followlng problems
llxed AsseLs cannoL efflclenLly and effecLlvely be uLlllzed on accounL of lack of
sufflclenL worklng caplLal Low llquldlLy poslLlon may lead Lo llquldaLlon of flrm
When a flrm ls unable Lo meeLs lLs debLs aL maLurlLy Lhere ls an unsound poslLlon
CredlL worLhlness of Lhe flrm may be damaged because of lack of llquldlLy 1hus lL
wlll lose lLs repuLaLlon 1here by a flrm may noL be able Lo geL credlL faclllLles lL may
noL be able Lo Lake advanLages of cash dlscounL

D|sadvantages of kedundant or Lxcess|ve Work|ng Cap|ta|

1 Lxcesslve Worklng CaplLal means ldeal funds whlch earn no proflLs for Lhe
buslness and hence Lhe buslness cannoL earn a proper raLe of reLurn on lLs
lnvesLmenLs
2 When Lhere ls a redundanL worklng caplLal lL may lead Lo unnecessary purchaslng and
AccumulaLlon of lnvenLorles causlng more chances of LhefL wasLe and losses
3 Lxcesslve worklng caplLal lmplles excesslve debLors and defecLlve credlL pollcy
Whlch May cause hlgher lncldence of bad debLs
4 lL may resulL lnLo overall lnefflclency ln Lhe organlzaLlon
3 When Lhere ls excesslve worklng caplLal relaLlons wlLh banks and oLher flnanclal
lnsLlLuLlons may noL be malnLalned
6 uue Lo low raLe of reLurn on lnvesLmenLs Lhe value of shares may also fall
7 1he redundanL worklng caplLal glves rlse Lo speculaLlve LransacLlons

D|sadvantages or Dangers of Inadequate Work|ng Cap|ta|

1 A concern whlch has lnadequaLe worklng caplLal cannoL pay lLs shorLLerm
llablllLles
ln Llme 1hus lL wlll lose lLs repuLaLlon and shall noL be able Lo geL good credlL faclllLles
2 lL cannoL buy lLs requlremenLs ln bulk and cannoL avall of dlscounLs eLc
3 lL becomes dlfflculL for Lhe flrm Lo explolL favorable markeL condlLlons and underLake
proflLable pro[ecLs due Lo lack of worklng caplLal
4 1he flrm cannoL pay dayLoday expenses of lLs operaLlons and lLs creaLes lnefflclencles
lncreases cosLs and reduces Lhe proflLs of Lhe buslness
3 lL becomes lmposslble Lo uLlllze efflclenLly Lhe flxed asseLs due Lo nonavallablllLy of llquld
funds
6 1he raLe of reLurn on lnvesLmenLs also falls wlLh Lhe shorLage of worklng caplLal

D|sadvantages or Dangers of Inadequate or Short Work|ng Cap|ta|
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rrCan'L pay off lLs shorLLerm llablllLles ln Llme
rrLconomles of scale are noL posslble
rrulfflculL for Lhe flrm Lo explolL favorable markeL slLuaLlons
rruayLoday llquldlLy worsens


6 What |s |everage? Compare and Contrast between operat|ng Leverage and f|nanc|a|
|everage ?

ANS Leverage |s the |nf|uence of power to ach|eve someth|ng 1he use of an asset or source
of funds for wh|ch the company has to pay a f|xed cost or f|xed return |s termed as |everage
Leverage |s the |nf|uence of an |ndependent f|nanc|a| var|ab|e on a dependent var|ab|e It
stud|es how the dependent var|ab|e responds to a part|cu|ar change |n |ndependent var|ab|e

Cperat|ng |everage ar|ses due to the presence of f|xed operat|ng expenses |n the f|rm's
|ncome f|ows A company's operat|ng costs can be categor|sed |nto three ma|n sect|ons




I|xed costs
I|xed costs are those wh|ch do not vary w|th an |ncrease |n product|on or sa|es act|v|t|es for a
part|cu|ar per|od of t|me 1hese are |ncurred |rrespect|ve of the |ncome and va|ue of sa|es and
genera||y cannot be reduced


Var|ab|e costs
Var|ab|e costs are those wh|ch vary |n d|rect proport|on to output and sa|es An |ncrease or
decrease |n product|on or sa|es act|v|t|es w||| have a d|rect effect on such types of costs
|ncurred

Sem|var|ab|e costs
Sem|var|ab|e costs are those wh|ch are part|y f|xed and part|y var|ab|e |n nature 1hese costs
are typ|ca||y of f|xed nature up to a certa|n |eve| beyond wh|ch they vary w|th the f|rm's
act|v|t|es
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I|nanc|a| |everage as opposed to operat|ng |everage re|ates to the f|nanc|ng act|v|t|es of a
f|rm and measures the effect of earn|ngs before |nterest and tax (L8I1) on earn|ngs per share
(LS) of the company



A company's sources of funds fa|| under two categor|es

1hose wh|ch carry a f|xed f|nanc|a| charges ||ke debentures bonds and preference shares and
1hose wh|ch do not carry any f|xed charges ||ke equ|ty shares

ke|at|onsh|p I|nanc|a| and Cperat|ng |everage

ke|at|onsh|p between f|nanc|a| and operat|ng |everage ln buslness Lermlnology
leverage ls used ln Lwo senses llnanclal leverage CperaLlng Leverage
llnanclal leverage 1he effecL whlch Lhe use of debL funds produces on reLurns ls
called flnanclal leverage
Cperat|ng |everage CperaLlng leverage refers Lo Lhe use of flxed cosLs ln Lhe
operaLlon of Lhe flrm A flrm has a hlgh degree of operaLlng leverage lf lL employs a
greaLer amounL of flxed cosLs 1he degree of operaLlng leverage may be deflned as
Lhe percenLage change ln proflL resulLlng from a percenLage change ln sales

1hls can be expressed as
ercenL Change ln roflL/ercenL Change ln Sales

1he degree of flnanclal leverage ls deflned as Lhe percenL change ln earnlngs
avallable Lo common shareholders LhaL ls assoclaLed wlLh a glven percenLage change
ln L8l1 1hus operaLlng leverage affecLs L8l1 whlle flnanclal leverage affecLs
earnlngs afLer lnLeresL and Laxes Lhe earnlngs avallable Lo equlLy shareholders lor
Lhls reason operaLlng leverage ls someLlmes referred Lo as flrsL sLage leverage and
flnanclal leverage as second sLage leverage 1herefore lf a flrm uses a conslderable
amounL of boLh operaLlng leverage and flnanclal leverage even small changes ln Lhe
level of sales wlll produce wlde flucLuaLlons ln earnlngs per share (LS) 1he
comblned effecL of boLh Lhese Lypes of leverages ls afLer called LoLal leverage whlch
ls closely Lled Lo Lhe flrm's LoLal rlsk