SMU Assignment paper- MB045

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Master of Business Administration- MBA Semester 2MB0045 – Financial Management

1. Write the short notes on

1. Financial management

2. Financial planning

3. Capital structure

4. Cost of capital

5. Trading on equity

Answer:

1. Financial management: Financial management is the branch of the finance that concerns itself withthe managerial significance of finance techniques. It is focused on assessment rather than technique. Thedifference between a managerial and a technical approach can be seen in the questions one might ask of annual reports. One concerned with technique would be primarily interested in measurement. Oneconcerned with management though would want to know what the figures mean. They might comparethe returns to other businesses in their industry and ask: are we performing better or worse than our peers? If so, what is the source of the problem? Do we have the same profit margins? If not why? Do wehave the same expenses? Are we paying more for something than our peers? They may look at changesin asset balances looking for red flags that indicate problems with bill collection or bad debt. They willanalyze working capital to anticipate future cash flow problems. Managerial finance is aninterdisciplinary approach that borrows from both managerial accounting and corporate finance. Soundfinancial management creates value and organisational agility through the allocation of scarce resourcesamongst competing business opportunities. It is an aid to the implementation and monitoring of businessstrategies and helps achieve business objectives.

2. Financial planning: A financial planning or financial planner is a practicing professional who helps people deal with various personal financial issues through proper planning, which includes but is notlimited to these major areas: cash flow management, education planning, retirement planning,investment planning, risk management and insurance planning, tax planning, estate planning and business succession planning (for business owners). The work engaged in by this professional iscommonly known as personal financial planning. In carrying out the planning function, he is guided bythe financial planning process to create afinancial plan; a detailed strategy tailored to a client's specific situation, for meeting a client's specificgoals. The key defining aspect of what the financial planner does is that he considers all questions,information and advice as it impacts and is impacted by the entire financial and life situation of theclient.

3. Capital structure: In finance, capital structure refers to the way a corporation finances its assetsthrough some combination of equity, debt, or hybrid securities. A firm's capital structure is then thecomposition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debtfinanced.



The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's leverage. Inreality, capital structure may be highly complex and include dozens of sources. Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the business finance, e.g. bytaking a short term loan etc. The Modigliani-Miller theorem, proposed by Franco Modigliani andMerton Miller, forms the basis for modern thinking on capital structure, though it is generally viewed asa purely theoretical result since it assumes away many important factors in the capital structure decision.

The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. This result provides the base with which to examine real world reasons why capital structure is relevant, that is, acompany's value is affected by the capital structure it employs. Some other reasons include bankruptcycosts, agency costs, taxes, and information asymmetry. This analysis can then be extended to look atwhether there is in fact an optimal capital structure: the one which maximizes the value of the firm.

4. Cost of capital: The cost of capital is the cost of a company's funds (both debt and equity), or, froman investor's point of view "the expected return on a portfolio of all the company's existing securities". Itis used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet. For aninvestment to be worthwhile, the expected return on capital must be greater than the cost of capital. The

cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk. If a project is of similar risk to a company's average business activities it is reasonable to use thecompany's average cost of capital as a basis for the evaluation. A company's securities typically include both debt and equity, one must therefore calculate both the cost of debt and the cost of equity todetermine a company's cost of capital. The cost of debt is relatively simple to calculate, as it iscomposed of the rate of interest paid. In practice, the interest-rate paid by the company can be modelledas the risk-free rate plus a risk component (risk premium), which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or credit ratings, theinterest rate is largely exogenous (need to explain use of "exogenous" in this context). The cost of equityis more challenging to calculate as equity does not pay a set return to its investors. Similar to the cost of

debt, the cost of equity is broadly defined as the risk-weighted projected return required by investors,where the return is largely unknown. The cost of equity is therefore inferred by comparing theinvestment to other investments (comparable) with similar risk profiles to determine the "market" cost of equity.

5. Trading on equity: In finance, equity trading is the buying and selling of company stock shares.Shares in large publicly-traded companies are bought and sold through one of the major stock exchanges, such as the New York Stock Exchange, London Stock Exchange or Tokyo Stock Exchange,which serve as managed auctions for stock trades. Stock shares in smaller public companies are boughtand sold in over-the-counter (OTC) markets. Equity trading can be performed by the owner of theshares, or by an agent authorized to buy and sell on behalf of the share's owner. Proprietary trading is

buying and selling for the trader's own profit or loss. In this case, the principal is the owner of the shares.Agency trading is buying and selling by an agent, usually a stock broker, on behalf of a client. Agentsare paid a commission for performing the trade. Major stock exchanges have market makers who helplimit price variation (volatility) by buying and selling a particular company's shares on their own behalf and also on behalf of other clients.

2. a.Write the features of interim divined and also write the factorsInfluencing divined policy?

b. What is reorder level ?



Answer:a. Interim Dividend : A dividend which is declared and distributed before the company'sannual earnings have been calculated; often distributed quarterly.

Usually, board of directors of company declares dividend in annual general meeting afterfinding the real net profit position. If boards of directors give dividend for current yearbefore closing of that year, then it is called interim dividend. This dividend is declaredbetween two annual general meetings.Before declaring interim dividend, board of directors should estimate the net profit whichwill be in future. They should also estimate the amount of reserves which will deduct fromnet profit in profit and loss appropriation account. If they think that it is sufficient foroperating of business after declaring such dividend. They can issue but after completingthe year, if profits are less than estimates, then they have to pay the amount of declareddividend. For this, they will have to take loan. Therefore, it is the duty of directors todeliberate with financial consultant before taking this decision.Accounting treatment of interim dividend in final accounts of company :# First Case : Interim dividend is shown both in profit and loss appropriation account andbalance sheet , if it is outside the trial balance in given question.( a) It will go to debit side of profit and loss appropriation account(b) It will also go to current liabilities head in liabilities side.# Second Case: Interim dividend is shown only in profit and loss appropriation account, if it is shown in trial balance.

b.Reorder Level

The reorder point for replenishment of stock occurs when the level of inventory dropsdown to zero. In view of instantaneous replenishment of stock the level of inventory jumpsto the original level from zero level.

In real life situations one never encounters a zero lead time. There is always a time lag

from the date of placing an order for material and the date on which materials arereceived. As a result the reorder point is always higher than zero, and if the firm places theorder when the inventory reaches the reorder point, the new goods will arrive before thefirm runs out of goods to sell. The decision on how much stock to hold is generally referredto as the order point problem, that is, how low should the inventory be depleted before itis reordered.

3. What are the techniques of evaluation of investment?

Answer:Steps involved in the evaluation of any investment proposal are:

• Estimation of cash flows both inflows and outflows occurring at different stages of

project life cycle• Examination of the risk profile of the project to be taken up and arriving at the required

rate of return

• Formulation of the decision criteria

Estimation of cash flows

Estimating the cash flows associated with the project under consideration is the most

difficult and crucial step in the

evaluation of an investment proposal. Estimation is the result of the team work of many



professionals in an organisation.

• Capital outlays are estimated by engineering departments after examining all aspects of

production process

• Marketing department on the basis of market survey forecasts the expected sales

revenue during the period of accrual of benefits from project executions

• Operating costs are estimated by cost accountants and production engineers

• Incremental cash flows and cash out flow statement is prepared by the cost accountanton the basis of the details generated in the above steps

The ability of the firm to forecast the cash flows with reasonable accuracy lies at the root

of the success of the implementation of any capital expenditure decision.

Estimation of incremental cash flows

Investment (capital budgeting) decision requires the estimation of incremental cash flow

stream over the life of the investment. Incremental cash flows are estimated on tax basis.

Incremental cash flows stream of a capital expenditure decision has three components.

Initial cash outlay (Initial investment)Initial cash outlay to be incurred is determined after considering any post tax cash inflows.

In replacement decisions existing old machinery is disposed of and a new machinery

incorporating the latest technology is installed in its place.

On disposal of existing old machinery the firm has a cash inflow. This cash inflow has to be

computed on post tax basis. The net cash out flow (total cash required for investment in

capital assets minus post tax cash inflow on disposal of the old machinery being replaced

by a new one) therefore is the incremental cash outflow. Additional net working capital

required on implementation of new project is to be added to initial investment.

Operating cash inflows

Operating cash inflows are estimated for the entire economic life of investment (project).

Operating cash inflows constitute a stream of inflows and outflows over the life of the

project. Here also incremental inflows and outflows attributable to operating activities are

considered. Any savings in cost on installation of a new machinery in the place of the old

machinery will have to be accounted on post tax basis. In this connection incremental cash

flows refer to the change in cash flows on implementation of a new proposal over the

existing positions.

Terminal cash inflows

At the end of the economic life of the project, the operating assets installed will be

disposed off. It is normally known as salvage value of equipments. This terminal cash

inflows are computed on post tax basis.

Prof. Prasanna Chandra in his book Financial Management (Tata McGraw Hill, published in2007) has identified certain basic principles of cash flow estimation. The knowledge of

these principles will help a student in understanding the basics of computing incremental

cash flows.

The basic principles of cash flow estimation, by Prof. Prasanna Chandra, are (see figure)

– Separation principle, Increment principle, Post-tax principle and Consistency principle.

Principles of Prof. Prasanna Chandra Separation principle The essence of this principle is

the necessity to treat investment element of the project separately (i.e. independently)



from that of financing element.

The financing cost is computed by the cost of capital. Cost of capital is the cut off rate and

rate of return expected on implementation of the project. Therefore, we compute

separately cost of funds for execution of project through the financing mode. The rate of

return expected on implementation if the project is arrived at by the investment profile of

the projects. Therefore, interest on debt is ignored while arriving at operating cash inflows.

The following formula is used to calculate profit after tax

Incremental PAT = Incremental EBIT ( 1-t ) (Incremental) (Incremental)

EBIT = earnings (profit) before interest and taxes t = tax rate

Incremental principle

Incremental principle says that the cash flows of a project are to be considered in

incremental terms. Incremental cash flows are the changes in the firms total cash flows

arising directly from the implementation of the project. Keep the following in mind while

determining incremental cash flows.

Ignore sunk costs

Sunk costs are costs that cannot be recovered once they have been incurred. Therefore,sunk costs are ignored when the decisions on project under consideration is to be taken.

Opportunity costs

If the firm already owns an asset or a resource which could be used in the execution of the

project under consideration, the asset or resource has an opportunity cost. The

opportunity cost of such resources will have to be taken into account in the evaluation of

the project for acceptance or rejection.

Need to take into account all incident effect

Effects of a project on the working of other parts of a firm also known as externalities must

be taken into account.

Need to take into account all incident effect

Effects of a project on the working of other parts of a firm also known as externalities must

be taken into account.

Cannibalisation

Another problem that a firm faces on introduction of a new product is the reduction in the

sale of an existing product. This is called cannibalisation. The most challenging task is the

handling the problems of cannibalisation. Depending on the company’s position with that

of the competitors in the market, appropriate strategy has to be followed. Correspondingly

the cost of cannibalisation will have to be treated either as relevant cost of the decision or

ignored.

Depending on the company’s position with that of the competitors in the market,

appropriate strategy has to be followed. Correspondingly the cost of cannibalisation willhave to be treated either as relevant cost of the decision or ignored. Product

cannibalisation will affect the company’s sales if the firm is marketing its products in a

market characterised by severe competition, without any entry barriers. In this case costs

are not relevant for decision.

However, if the firm’s sales are not affected by competitor’s activities due to certain

unique protection that it enjoys on account of brand positioning or patent protection, the

costs of cannibalisation cannot be ignored in taking decisions.

Post tax principle



All cash flows should be computed on post tax basis

Consistency principle

Cash flows and discount rates used in project evaluation need to be consistent with the

investor group and inflation.

4.

What are the problems associated with inadequate working capital?

Answer: When working capital is inadequate, a firm faces the following problems.

1 Fixed Assets cannot efficiently and effectively be utilized on account of lack of sufficient

working capital.

2 Low liquidity position may lead to liquidation of firm.

3 When a firm is unable to meets its debts at maturity, there is an unsound position.

4 Credit worthiness of the firm may be damaged because of lack of liquidity.

5 Thus it will lose its reputation. There by, a firm may not be able to get credit facilities.

6 It may not be able to take advantages of cash discount.

7 Firm may not exploit favorable market conditions and undertake profitable projects

8 It may not buy its requirement in bulk

9 It may not pay day to day expenses of its operations

10 It may not utilize efficiently its fixed assets due to non availability of liquid funds

5. What is leverage? Compare and Contrast between operatingLeverage and financial leverage

Answer : Leverage is the influence of power to achieve something. The use of an asset or

source of funds for which the company has to pay a fixed cost or fixed return is termed asleverage. Leverage is the influence of an independent financial variable on a dependentvariable. It studies how the dependent variable responds to a particular change inindependent variable.Operating leverage arises due to the presence of fixed operating expenses in the firm’sincome flows. A company’s operating costs can be categorised into three main sections as shown infigure fixed costs, variable costs and semi-variable costs.

Classification of operating costs• Fixed costsFixed costs are those which do not vary with an increase in production or sales activities

for a particular period of time. These are incurred irrespective of the income and value of sales and generally cannot be reduced.For example, consider that a firm named XYZ enterprises is planning to start a newbusiness. The main aspects that the firm should concentrate at are salaries to theemployees, rents, insurance of the firm and the accountancy costs. All these aspectsrelate to or are referred to as ―fixed costs.• Variable costsVariable costs are those which vary in direct proportion to output and sales. An increase ordecrease in production or sales activities will have a direct effect on such types of costsincurred.For example, we have discussed about fixed costs in the above context. Now, the firm has



to concentrate on some other features like cost of labour, amount of raw material and theadministrative expenses. All these features relate to or are referred to as ―Variable costs,as these costs are not fixed and keep changing depending upon the conditions.• Semi-variable costsSemi-variable costs are those which are partly fixed and partly variable in nature. Thesecosts are typically of fixed nature up to a certain level beyond which they vary with thefirm’s activities. For example, after considering both the fixed costs and the variable costs,

the firm should concentrate on some-other features like production cost and the wagespaid to the workers which act at some point of time as fixed costs and can also shift tovariable costs. These features relate to or are referred to as ―Semi-variable costs.

The operating leverage is the firm’s ability to use fixed operating costs to increase theeffects of changes in sales on its earnings before interest and taxes (EBIT). Operatingleverage occurs any time a firm has fixed costs. The percentage change in profits with achange in volume of sales is more than the percentage change in volume.As operating leverage can be favourable or unfavourable, high risks are attached to higherdegrees of leverage. As DOL considers fixed expenses, a larger amount of these expensesincreases the operating risks of the company and hence a higher degree of operatingleverage. Higher operating risks can be taken when income levels of companies are risingand should not be ventured into when revenues move southwards.

Financial LeverageFinancial leverage as opposed to operating leverage relates to the financing activities of afirm and measures the effect of earnings before interest and tax (EBIT) on earnings pershare (EPS) of the company.A company’s sources of funds fall under two categories –• Those which carry a fixed financial charges like debentures, bonds and preferenceshares and• Those which do not carry any fixed charges like equity sharesDebentures and bonds carry a fixed rate of interest and have to be paid off irrespective of the firm’s revenues. Though dividends are not contractual obligations, dividend onpreference shares is a fixed charge and should be paid off before equity shareholders arepaid any. The equity holders are entitled to only the residual income of the firm after allprior obligations are met.Financial leverage refers to the mix of debt and equity in the capital structure of the firm.

This results from the presence of fixed financial charges in the company’s income stream.Such expenses have nothing to do with the firm’s performance and earnings and shouldbe paid off regardless of the amount of earnings before income and tax (EBIT). It is thefirm’s ability to use fixed financial charges to increase the effects of changes in EBIT onthe EPS. It is the use of funds obtained at fixed costs which increase the returns onshareholders.A company earning more by the use of assets funded by fixed sources is said to be havinga favourable or positive leverage. Unfavourable leverage occurs when the firm is notearning sufficiently to cover the cost of funds. Financial leverage is also referred to as“Trading on Equity”.

SMU Assignment paper- MB045

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