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ASSIGNMENT SOLUTIONS GUIDE (2015-2016)

M.C.O.-7
Financial Management
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Answer all the questions.

Q. 1. (a) Explain the Interrelationship between investment, financing and dividend decisions.
Ans. Nature of Finance Function
It is said that the finance is the life blood of business. Money begets Money and money makes the mare go,
are the famous proverbs that highlight that finance actually matters to everybody. It is difficult to separate the
finance function from production, marketing and other functions, but the function themselves can be readily identified.
The functions of raising funds, investing them in assets and distributing returns earned from assets to shareholders
are respectively known as financing decision, investment decisions and dividend decision. Thus, it makes clear that
finance functions call for skilful planning, control and execution of a firms activities.
1. Investment Decision: A firms investment decisions involve capital expenditures which may be invested in
any project. The financial management provides a framework to make investment wisely. It relates to:
(a) Management of working capital
(b) Capital budgeting decision
(c) Management of mergers, reorganisation and disinvestment
(d) Buy or lease decisions
(e) Securities analysis and portfolio management
Investment decision includes the decisions primarily relating to assets compositionfixed as well as current
assets.
2. Financing Decision: Financing decision is the second important function to be performed by the financial
manager. Broadly one must decide when, where from and how to acquire funds to meet the firms investment needs.
The central issue is to determine the appropriate proportion of equity and debt, leading to the Optimum Capital
Structure. The firms capital structure is considered optimum when the market value of shares is maximised. Once
the financial manager is able to determine the best combination of debt and equity, he/she, must raise the appropriate
amount through the best available sources, which can be both from internal and external funds. The employment of
these sources in various combinations is called financial leverage. Different types of analysis are required for this
decision e.g., leverage analysis, EBIT-EPS analysis.
3. Dividend Decision: Dividend decision is the third major financial decision. The financial manager must
decide whether the firm should distribute all profits, or retain them, or distribute a portion and retain the balance.
The proportion of profits distributed as dividends is called the dividend-payout ratio and the retained portion of
profits is known as the retention ratio, like the debt policy, the dividend policy should be determined in terms of its
impact on the shareholders value. The optimum dividend policy is one that maximises the market value of the firms

shares. Retention of earnings depends upon reinvestment opportunities available and the opportunity to generate.
Dividends may be paid in cash or in the form of bonus shares.
(b) Discuss the role of Financial Manager in the changing scenario of financial management in India.
Ans. Key Activities of Financial Manager
Who is a financial manager? What is his or her role? In a business firm the financial manager occupies a very
important position. He is one of the dynamic members of corporate managerial team who is responsible in a significant
way, to carry out the finance functions. It should be noted that, in a modern enterprise, the financial manager
occupies a key position whose job is not that of an accountant to record and prepare financial statement. Whereas he
or she is expected to manage the funds in such a manner, to ensure their optimum utilisation and their procurement
in order to maintain a balance between risk, cost and control considerations.
They occupy a key position and is one of the members of the top management. The finance manager is now
responsible for shaping the fortunes of the enterprise, and is involved in the most vital decision of the allocation of
capital. He or she must realise that his or her actions have far-reaching consequences for the firm as they influence
the size, profitability, growth, risk and survival of the firm, and as a consequence, affect the overall value of the
firm. The responsibilities and duties of financial manager are indeed the organisation-wide.
Owing to momentous changes in the business enviourment, the nature of challenges faced by financial manager
has undergone immense swifts. A finance manager occupies a job of an expert and holds the prime responsibility of
mobilization of funds and investment of funds.
1. Shareholders value creation constitutes to the first challenge before the finance manager, under this finance
manager has to concentrate not only on earning per share but also on the market capitalization. This holds true as
the shareholders want growing return along with the increasing sales, or decreasing costs.
2. Another crucial challenge comes from investers. The finance manager must possess a good understanding of
the psychology of investors.
3. Dealing with increasing risks in the market pose another challenge before the financial manager. The business
risks have been multiplied with the outset of liberalisation, privitisation and globalisation. The greatest expectation
of the CEOs from financial managers is to make them look smart. Which essentially means to be able to base your
arguments or facts and figures. He should have sound inter personal and communication skills, and overall
organisational knowledge. But rewards, whether financial or not can be great who enjoy the challenge. All in all
financial manager is in the new world of business and finance.
Q. 2. Disucss the dividend-price approach and earning price approach to estimate cost of equity capital
with example.
Ans. The cost of equity capital means the cost of the sale of new equity for the present stockholders of the
corporation.
The following are the approaches to computation of cost of equity capital:
1. Earning Price Ratio Method: Cost of equity capital is measure by earning price ratio.

Cost of Equity capital Ke =

Eo
100
Po

EO = Current earnings per share

PO = Current market price per share
The limitation of this method are:
1. Earnings do not represent real expectations of shareholders.
2. Earnings per share is not constant.
3. Which earnings, is to be considered, whether current earnings or average earnings, is not clear.
The method is useful in the following circumstances:
1. The firm does not-have debt capital.
2. All the earning are paid to the shareholders.
3. There is no growth in earnings.
Dividend Price Ratio Method: Cost of equity capital is measured by dividends price ratio.

Ke =

Do (Dividend per share)

Po (Market price per share)

The following are the assumptions:

(i) The risk remains unchanged.
(ii) The investors give importance to dividend.
(iii) The investors purchase the shares at par value.
Under this method, the future dividend stream of a firm as expected by the investors is estimated. The current
price of the share is used to determine shareholders expected rate of return. Thus, if Ke is the risk-adjusted rate of
return expected by investors, the present value of future dividends, discounted by Ke would be equal to the price of
the share. Thus:
Po

D1
(1 K e )1

D2
(1 K e )2

D3
(1 K e )3

Dn
D4
...
(1 K e )4 (1 K e )n

Where,
Po = market price of the share
D1 . Dn = dividends in periods 1,2,3, n,
Ke = the risk adjusted rate of return expected by equity investors.
Given the current price Po and values for future dividends Dn, one can calculate Ke by using IRR procedure.
If the firm has maintained some regular pattern of dividends in the past, it is not unreasonable to expect that the
same pattern will prevail. If a firm is paying a dividend of 20% an a share with a par value of Rs. 10 as a level
perpetual dividend, and its market price is Rs. 20, then:
Po =
20 =
Ke =

Do
Ke
2
Ke
2
20

Ke = 10%
Q. 3. (a) Financing a business through borrowing is cheapter than using equity. Explain.
Ans. Theres a pervasive myth that nodebt is good debt. Whenever we are talking about owing money these
days. It is almost always in a negative light. We hear it everyday, home owners are underwater, the national deficit is
surging, consumer are saddled by shortsighted credit card spending, the nations graduales are buried under students
loan.
For business, the truth about debt is for less ominous. As the high finance set under stands, not all borrowing is
bad.
(1) Borrowing is usually expensive than giving up equity
When raising fund for the business, giving up equity is more expensive in long run than taking on debt. When
we starting out our small business need inventory and equipment and to make payroll. Investors are going to help us
with capital, but we are sacrificing future profit in definitely to fill a short to mid term need with debt, we incur cost
but it is temporary and capped once we pay it back our equity remains intact.
(2) Paying Interest on Borrowing Reduces Tax Burdenmany businessmen are nt aware of this surprises benefit
borrowing. The cost of interest reducess taxable profit and therefore reduces taxable profit of that business. The
effective interest paid by the business firm is lower than the nominal interest.
(3) Debt Encourages discipline.
This is common knowledge among private equity firms, but is something that small businesss generally overlook
debt brings with it a discipline about spending and investing that can help the company especially in its formative
and growth years.

(b) Discuss the important factors taken into consideration while investing surplus cash in marketable
securities.
Ans. There is close relationship between cash and money market securities Excess cash should normally be
invested in those alternatives that can be conveniently and promptly converted into cash. Cash in excess of the
requirement of operating cash balance may be held for two reasons. First, the working capital requirements of the
firm fluctuate because of the elements of seasonality and business cycles.
Second, excess cash may be held as a buffer to meet unpredictable financial needs.
The excess amount of cash held by the firm to meet its variable cash requirements and future contingencies
should be temporarily invested in marketable securities, which can be regarded as near moneys. A number of
marketable securities may be available in the market. The financial manager must decide about the portfolio of
marketable securities in which the firms surplus cash should be invested.
An evaluation of the following criteria can provide insights for selection of proper marketable security.
Financial/Default Risk: It refers to the uncertainty of expected returns from a security attributable to possible
changes in the financial capacity of the security-issuer to make future payments to the security owner. If the chance
of default on the terms of the investment is high (low), then the financial risk is said to be high (low). As the
marketable securities portfolio is designed to provide a return o funds that would be otherwise bed up in idle cash
held for transaction or precautionary purposes, the financial manager will not usually be willing to assume such
financial/default risk in the hope of greater return within the makeup of the portfolio.
Interest Rate Risk: The uncertainty that is associated with the expected returns from a financial instrument
attributable to changes in interest rate is known as interest rate risk. Of particular concern to the corporate financial
manager is the price volatility associated with instruments that have long, as opposed to short-terms to maturity.
If prevailing interest rates rise compared with the date of purchase, the market price of the securities will fall to
bring their yield to maturity in line with what financial managers could obtain by buying a new issue of a given
instrument, for instance, treasury bills. The longer the maturity of the instrument, the larger will be the fall in prices.
Taxability: Another factor affecting observed difference in market yields is the differential impact of taxes.
Securities, income on which is tax-exempt, sell in the market at lower yields to maturity that other securities of the
same maturity. A differential impact on yields arises also because interest income is taxes at the ordinary tax rate
while capital gains are taxed at a lower rate. As a result, fixed-interest securities that sell at a discount, because of
low coupon rate in relation to the prevailing yields are attractive to taxable investors.
Liquidity: With reference to marketable securities portfolio, liquidity refers to the ability to transform a security
into cash. Should an unforeseen event require that a significant amount of cash be immediately available, a sizeable
portion of the portfolio might have to be sold. The financial manager will want the cash quickly and will not want
to accept a large price reduction in order to convert the securities. Thus, in the formulation of preferences for the
inclusion of particular instruments in the portfolio, consideration will be given to (i) the time period needed to sell
the security and (ii) the likelihood that the security can be sold at or near its prevailing market price. The latter
element, here, means that thin markets, where relatively few transactions take place or where trades are accomplished
only with large price changes between transactions, should be avoided.
Yield: The final selection criterion is the yields that are available on the different financial assets suitable for
inclusion in the marketable/near cash portfolio. All the four factors listed above, financial risk interest, rate risk,
liquidity and taxability; influence the available yields on financial instruments. Therefore, the yield criterion involves
a weighing of the risks and benefits inherent in these factors. If a given risk is assumed, such as lack of liquidity,
then a higher yield may be expected on the instrument lacking the liquidity characteristics.
In brief, the finance manager must focus on the risk-return trade-off associated with the four factors on yield
through his analysis. Coming to grips with these trade-offs will enable the finance manager to determine the proper
marketable securities mix for his firm.
Q. 4. There are two projects A and B. The initial capital outlay of A and B are Rs. 1,35,000 and Rs. 5,40,000
respectively. There will be no scrap value at the end of the life of both the projects. The Cost of Capital is
16% The company has to choose one project out of the two. The Cash inflows as under:
Year
Project A (Rs.)
Project B (Rs.)
1
-60,000
2
30,000
84,000
3
1,32,000
96,000
4
84,000
1,02,000
5
84,000
90,000
You are required to calculate and comment for each project:

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(a) Discounted payback period

(b) Profitability index and
(c) Net present value
Ans.
Project A

Project B

Year Cash flows Cummulative

cash flow

(Rs.)
1
2
3.
4.
8.

30,000
1,32,000
84,000
84,000

Discounted Discounted Cash

cash
communflows
flow (16%) lative

CommuDiscounted
lative cash cash
flow
flow

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(Rs.)

(Rs.)

30,000
1,62,000
2,46,000
3,30,000

(Rs.)

(Rs.)
60,000
84,000
96,000
1,02,000
90,000

25,200
1,36,080
2,06,640
2,77,200

25,200
1,10,880
70,560
70,560

(Rs.)
60,000
1,44,000
2,40,000
3,42,000
4,32,000

(Rs.)
50,400
70,560
80,640
84680
75600

Discounted Pay back for

Discounted pay back

Project A

for Project B

1, 35,000 25, 200

12
1, 36080 25, 200

2, 40, 000 201600

12
2,87, 280 2,01, 600

1, 09800
12
1,10,880

38400
12
85650

3 + 11 months

Commulative
cass Discounted
cash flow

4 + 5 months

3 years 11 months

4 years 5 months

The net present value of Project A

n

NPV =

i 1

(1 + k)t

C0

Ct = cash flow at time

k = the rate of interest or cost of capital at which funds are to be discounted

C0 = The initial amount spent.

30, 000

1, 32, 000

84000

84000

1, 35, 000
NVP = (1.16)
(1.16) 2
(1.16)3
(1.16) 4 (1.16) 5

30, 000

1,32, 000

84,000

84,000

1,35,000
= 0
1.3456 1.560896
1.81
2.10

= 22294.88 84566.81 4632.45 39993.50 1, 35,000

= 1,93,248 1,35,000
Rs. 582,248
P.I. of Project A =

Present value of inflows

Present Value of outflows

(Rs.)
50,400
1,20,960
2,01,600
2,87,280
3,62,280

9,93,248

= 1,35,000
= 1.43:1

Comment: Project As present value of cash flows is greater than that of rest outflow. Thus is generates a
positive net present value. Project A should be accepted as it adds to the wealth of the owner.
Net Present Value of Project B
60000

NPV =

84000

(1.16)

(1.16)

96000
(1.16)

1,02,000
(1.16)

90, 000
2, 40, 000
(1.16)5

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60000

84000

96000

1, 02, 000

90, 000

=
2, 40,000
1.16
1.3456
1.560896
1.81063936
2.100341

= [51,724.24 + 62425.68 + 61503.14 + 56333.69 + 42850.18] 2,40,000

= 2,74,836,83 2,40,000
= Rs. 34,836.83
= 34837 Rs.

Projectility Index =

Present Value of inflows

Present Value of outflows

2,74837
.
2,40,000

Comment: Project Bs Present value of cash flows is also greater than that of lost outflow. Thus, it generates a
positive net value.
Conclusion: Profitability Index of Project A >
Profitability Index of Project B
1,43> 1.15

Therefore, project A with higher PI should have a higher ranking.

Q. 5. Following is the Balance Sheet of a Company as on March 31, 2014
Liabilities and Equity

Equity Share Capital

(one lakh shares of Rs. each)
Reserves and Surplus
15% Debentures
Current Liabilities

Rs. (lakh)

Assets

10
2
20
8
40

Fixed Assets (Net)

Current Assets

Rs. (lakh)
25
15

40

The additional information given is as under

Fixed Costs per annum (excluding interest)
Variable operating costs ratio
Total sales
Income-tax rate
Calculate the following
(a) Earnings per share
(b) Operating Leverage
(c) Financial Leverage and
(d) Combined Leverage

Rs. 8 lakhs
65%
100 lakhs
40%

Ans.
Solution

(Rs.)

Sales
Less: Variable cost
Contribution
Less fixed cost
Earning Before Interest and tax
Less Interest
Earning Before Interest and tax
Less Income tax
Earning from equity shares

100,00,000
(65,00,000)
35,00,000
(8,00,000)
27,00,000
(3,00,000)
24,00, 000
(9,60,000)
14,40,000

Earning per share =

Earning for equity shares

Number of shares

14,40,000

= 1,00,000
= 14.40 Ans.

Contribution

Operating Leverage = Earning before Interest and tax

35,00,000

= 27,0000
=

Financial Leverage =

35
1.30
27

Earning before Interest and tax

Earning before tax

27,00,000

= 24,00,000
=

9
1.125
8

Combined Leverage = Operative Leverage Financial Leverage

=

35 27

27 24

35
24

= 1.46

n n