MCO-07 SOLVED ASSIGNMENT FOR MCOM

Course Code: MCO-07

Course Title: Financial Management
Assignment Number: MCO-06/TMA/2017-18
Last Date of Submission: 15th March, 2018 (for Jul-2017 batch)
: 15th Sept, 2018(for Jan-2018 batch)

Question No.1 a) What is weighted average cost of capital? Examine the rationale for using
weighted average cost of capital?

Solution: Weighted Average cost of capital is also called as composite cost of capital, overall

KHOJI.NET
cost of capital, weighted marginal cost of capital, combined cost of debt and equity etc. It
comprises the costs of various components of financing. These components are weighted
according to their relative proportions in the total capital.

The following steps are involved for calculating the firm‟s Weighted Average cost of capital:

1. Calculate the cost of specific sources of funds i.e. cost of Debt, Cost of Preference Shares, Cost
of Equity, Cost of Retained Earnings
2. Multiply the cost of each sources by its proportion in capital structure
3. Add the weighted component costs to get the Weighted Average cost of capital

Ko = k1w1 + k2w2 + k3w3 + …….

Where, Ko = Weighted Average cost of capital

k1, k2… are component costs and

w1, w2….. are weights of various type of capital employed by the company

The weights to be employed can be book value, market values, historic or target. Book value
weights are based on the accounting values to assess the proportion of each type of capital in the
firm‟s structure. Market value weights measure the proportion of each type of financing at its
market value. Market value weights are preferred because they approximate the current value of
various instruments of finance employed by the company.

Historic weights can be book or market weights based on actual data. Such weights however
Page 1

would represent actual rather than desired proportions of various types of capital in the capital
structure. Target weights, which can also be based on book or market values, reflect the desired
capital structure proportions. If the firm‟s historic capital structure is not much different from
`optimal‟ or desired capital structure, the cost of capital in both the cases is mostly similar.
However, from a strictly theoretical point of view, the target market value weighting scheme
should be preferred.

LIKE OUR FACEBOOK PAGE FOR UPDATES facebook.com/khojinet

 MCO-07 SOLVED ASSIGNMENT FOR MCOM
Marginal weights are determined on the basis of financing mix in additional new capital to be
raised for investments. The new capital to be raised is marginal capital. The propositions of new
capital raised will be the marginal weights.

Rationale For Using Weighted Average Cost Of Capital

The rationale for the use of Weighted Average cost of capital is that by financing in the
proportion specified and accepting projects yielding more than the weighted average required
returns, the firm is able to increase the market price of its shares. This is because the projects
accepted are expected to return more on their equity financed portions than the cost of equity
capital Ke. Once these expectations are apparent to the market place, the market price of the
shares should rise, other things remaining the same.

KHOJI.NET
Question No.1 b) Calculate the cost of equity for a firm whose share price in Rs 120. The
dividend at the end of year is expected to be Rs 9.72/Share and growth rate is 8%.

Solution: Cost of Equity using Dividend Price Ratio Method:

Ke = (D1/P0) + g

Where, D1 = Dividend Per Share at the end of period

P0 = Market Price per Share in the beginning of period
g = Growth Rate

Given: D1 = 9.72 ; P0 = 120 ; g = 8%

Putting the values in the above formula:

Ke = 9.72/120 + 0.08
= 0.081 + 0.080
= 0.161 or 16.10%

Question No.2 a) What is financial leverage ? Examine the impact of financial leverage on the
EPS. Does the financial leverage always increase EPS? Explain.
Page 2

Solution: Financial Leverage (FL) refers to usage of Debt in the capital structure. It is the use of
fixed cost of capital (debt) in the total capitalization of the fir,. Fixed cost capital includes loans,
debentures and preference share capital. It is also collect capital gearing.

It, also called “Trading on Equity”, is expressed as the firm‟s ability to use fixed financial cost in
such a manner so as to have magnifying impact on the EPS due to any change in EBIT (Earning

LIKE OUR FACEBOOK PAGE FOR UPDATES facebook.com/khojinet

 MCO-07 SOLVED ASSIGNMENT FOR MCOM
Before Interest and Taxes). In other words, it is a process of using debt capital to increase the
return on Equity.

A firm with high FL will have relatively high fixed financing costs compared to a firm with low
FL.

According to Guthman, “It is the ability of the firm to use fixed financial charges to magnify the
effect of changes in EBIT on the firms‟s EPS.

The following are the Essential of FL:

1. It relates to liabilities side of balance sheet.

KHOJI.NET
2. It is related to capital structure.
3. It is related to financial risk.
4. It affects earning after tax and earning per share.
5. It may be favourable or unfavourable. Unfavourable leverage occurs when the firm does not
earn as much as the funds cost.

Financial leverage is useful in:

(i) Capital structure planning

(ii) Profit Planning

It helps the finance managers while devising the capital structure of the company. A high FL
means high fixed financial costs and high financial risk. Increase in fixed financial costs may
force the company into liquidation. Shareholders of company will be benefited by the use of FL
in terms of the increased Earning Per Share (EPS) and Return on Equity (ROE) only when firms
return on investment (assets) is higher than the interest cost.

The financial Leverage (FL) can be calculated by the following formula:

FL = EBIT
. EBT

where EBIT refers to earnings before interest and tax and EBT refers to earnings before tax but
after interest.

It shows the percentage change in EPS in relation to percentage change in EBIT. In other words,
if there is increase in EBIT of the firm it will increase the EPS of the firm.
Page 3

The behaviour of FL may be measured by the Degree of Financial Leverage (DFL). The DFL
may be in the form of the following equation :

DFL = Percentage change in EBT

. Percentage change in EBIT

LIKE OUR FACEBOOK PAGE FOR UPDATES facebook.com/khojinet

 MCO-07 SOLVED ASSIGNMENT FOR MCOM
Alternatively, this may be calculated in terms of EPS.

DFL = Percentage change in EPS

. Percentage change in EBIT

Thus, DFL reflects the responsiveness of EPS to change in EBIT. It can also be used the in the
context of establishing relationship between EBIT and EPS.

Favourable or positive leverage occurs when the firm earn more on the assets purchased with the
funds, than the cost of their use. Unfavourable or negative leverage occurs when the firm does
not earn as much as the funds cost. Thus, FL is based on the assumption that the firm is to earn
more on the assets that are acquired by the use of funds on which a fixed rate of interest/dividend

KHOJI.NET
is to be paid. The differnece between the earnings from the assets and the fixed cost on the use of
the funds goes to the equity holders. In a way therefore use of fixed interest sources of funds
provides increased return on equity investment without additional requirement of funds from the
shareholders. However, in periods of persisting adversity when earnings are not adequate, the
presence of fixed charges will imply that the shareholders will have to bear the burden Thus, the
leverage will operate in the opposite direction such that the earnings per share, instead of
increasing, will actually fall as a result of the funds carrying.

Question No.2 The information relating to X & Co. is given below:-

EBIT = Rs11,20,000
PBT = Rs3,20,000
Fixed Cost = Rs7,00,000
Calculate the change in EPS if sales are expected to increase by 5%.

Solution: Degree of Combined Leverage i.e. Multiplication of Operating Leverage and Financial
leverage denotes the relationship between Sales and Earning per share (EPS) of the firm. In other
words, % change in EPS as a result of % change in Sales. Thus we are required to compute
Combined Leverage

Combined Leverage = Contribution

. PBT

Contribution = EBIT + Fixed Cost

. = 11,20,000 + 7,00,000
. = 18,20,000
Page 4

PBT = 3,20,000

Combined Leverage = 18,20,000

. = 3,20,000
. = 5.6875

LIKE OUR FACEBOOK PAGE FOR UPDATES facebook.com/khojinet

 MCO-07 SOLVED ASSIGNMENT FOR MCOM
Combined Leverage shows the 5.6875 times change in Earning per share of the firm due to
change in sales of the firm.

Therefore, if Sales of the Firm are expected to increase by 5% then EPS of the firm will increase
by 28.4375% ( 5% x 5.6875 ).

Question No.3 a) What do you understand by stable dividend policy? Why should the firms
follow it?

KHOJI.NET
Solution: Stability of dividends is considered a desirable policy by the management of most
companies in practice. Shareholders also seem generally to favour this policy and value stable
dividends higher than the fluctuating ones. All other things being the same, the stable dividend
policy may have a positive impact on the market price of the share.

Stability of dividends also means regularity in paying some dividend annually, even though the
amount of dividend may fluctuate over years and may not be related with earnings. There are a
number of companies which have records of paying dividend for a long, unbroken period. More
precisely, stability of dividends refers to the amounts paid out regularly.

Three forms of such stability maybe distinguished:

 Constant dividend per share or dividend rate

 Constant payout
 Constant dividend per share plus extra dividend

A stable dividend policy also helps the sale of debentures and preference shares. The fact that the
company has been paying dividend regularly in the past is a sufficient assurance to the
purchasers of these securities that no default will be made by the company in paying their
interest or preference dividend and returning the principal sum. The financial institutions are the
largest purchasers of these securities. They purchase debentures and preference shares of those
companies, which have a history of paying stable dividends.

If dividend policy is strictly a financing decision, whether dividends are paid out of profits or
earnings are retained, will depend open the available investment opportunities. It implies that
when a firm has sufficient investment opportunities, it will retain the earnings to finance them.
Conversely, if acceptable investment opportunities are inadequate, the implication is that the
earnings would be distributed to the shareholders. The test of adequate acceptable investment
Page 5
opportunities is the relationship between the return on the Investments (r) and the cost of capital
(k). As long as return on the Investments (r) exceeds the cost of capital (k), a firm has acceptable
investment opportunities. In other words if a firm can earn a return (r) higher than its cost of
capital (k), it will retain the earnings to finance investment projects. If the retained earnings fall
short of the total funds required, It will raise external funds – both equity and debt – to make up
the shortfall. If, however, the retained earnings exceed the requirements of funds to finance
acceptable Investment opportunities, the excess earnings would be distributed to the shareholders

LIKE OUR FACEBOOK PAGE FOR UPDATES facebook.com/khojinet

 MCO-07 SOLVED ASSIGNMENT FOR MCOM
in the form of cash dividends. The amount of dividend will fluctuate from year to year depending
upon the availability of acceptable investment opportunities. With abundant opportunities, the
dividend payout ratio (D/P Ratio, that is, the ratio of dividends to net earnings) would be zero.
When there are no profitable opportunities, the D/P Ratio will be 100. For situations between
these extremes, the D/P ratio will range between Zero to 100.

That dividends are irrelevant, or are a passive residual, is based on the assumption that the
investors are indifferent between dividends and capital gains. So long as the firm Is able to earn
more than the equity capitalization rate (Ke) the investors would be content with the firm
retaining the earnings. In contrast, if the return is less than the Ke, investors would prefer to
receive the earnings (i.e. dividends).

KHOJI.NET
Question No.3 b) Explain the internal and external factors that influence in the company’s
capital structure.

Solution: Ross, Westerfield & Jaffe in their book titled Corporate Finance say that they do not
have a unique formula to determine optimal capital structure for all the firms. There is empirical
research evidence that firms do have target debt equity ratio and they consider the following four
factors while making choice of size of debt in the capital structure:

1. Taxes

The interest on loan funds reduces the tax liability of a profitable firm, whereas it is chargeable
to income tax in the hands of the bondholders. In India corporate tax rate is 35%, and individuals
are taxed at 20% or 30% depending upon the tax bracket, in which the taxpayer is. Since the
corporate tax rates are higher than bondholder tax rates, the CFO create value by using debt in
the capital structure of the firm.

2. Type of assets

The firms with a huge investment in tangible assets such as land & buildings, plant and
machinery, equipments, furniture & fixtures, and vehicles tend to have high debt ratio. For
example, oil refineries, petrochemicals plant. The lenders feel comfortable, since they get the
collateral against the loan. The debt ratio is low in case of research and development companies,
pharmaceuticals companies, and software companies, since they have more intangible assets
such as knowledge capital.
Page 6
3. Uncertainty of operating income

The firms that are influenced by the business cycles like automobile industry; cement industry
may have uncertain operating profits before interest and tax (EBIT) and hence may not be able to
service the debt and lead to default. Thus, they may have low debt ratio. On the other, the fast
moving consumer goods (FMCG) industry or power utility may have little uncertainty in their
operating profits. They can afford to use more debt in their capital structure. The actual use of

LIKE OUR FACEBOOK PAGE FOR UPDATES facebook.com/khojinet

 MCO-07 SOLVED ASSIGNMENT FOR MCOM
debt may depend upon the growth needs and profitability of the operations of the company. The
Hindustan Lever Limited has no debt in their capital structure, as their operations are highly
profitable in terms of cash.

4. Pecking order & Financial slack

The pecking order theory states that CFOs prefer internally generated funds to finance growth
needs of the company. If funds requirement is more, debt is preferred to equity. The equity issue
is considered as a last resort. The rationale for this is external financing either through debt or
equity is more expensive because of fees to investment bankers and issue expenses.

Secondly, existing shareholders are not comfortable with the pricing of fresh equity issue as

KHOJI.NET
management has access to more information than the existing shareholders.

It is normal human mindset to save cash during good times to avoid external financing during
bad times. Similarly, the CFOs do not exhaust their debt capacity fully during good times, and
plan to use the same during bad times. The economists term this practice as a financial slack.

Question No.4 a) Investment decisions and finance decisions are interrelated, comment.

Solution: Both Financing decisions and investing decisions are part of the financial
management. Both decision required to be taken very carefully so that the financial management
of the firm can be fruitful in long run. In a very limited both can be inter-related, but however
there are differences exist between these two terms which can be understood by reading
following:

According to Ezra Solomon, “the function of financial management is to review and control
decision to commit and recommit funds to new and on going uses. In addition to raising funds,
financial management is directly concel.ned with production, marketing and other functions
within an enterprise whatever decisions are made about the acquisition or distribution of assets”.
From this statement, it is clear that the main function of financial management is not only to raise
funds but includes the broader area of managing the finances for the firm more efficiently. Thus,
the two main decisions involved in a firm are:

1) Investment Decision and

2) Financing decision including Dividend decision
Page 7
1. Investment decision

The funds available may be invested in any project. The financial management provides a
framework to make investment wisely. Investment decision relates to:

1) Management of working capital

LIKE OUR FACEBOOK PAGE FOR UPDATES facebook.com/khojinet

 MCO-07 SOLVED ASSIGNMENT FOR MCOM
2) Capital budgeting decision

3) Management of mergers, reorganisation and disinvestment

4) Buy or lease decisions

5) Securities analysis and portfolio management

The investment in fixed assets and management of current assets is major investment related
problems in a company. Assets represent investment (or uses) of funds. Investment decision
includes the decisions primarily relating to assets composition – fixed as well as current assets.

KHOJI.NET
2. Financing Decision

The second function of financial management deals with financing pattern of the firm. The
financing decision is mainly concerned with identification of sources of finance and determining
financing mix and cultivating sources of funds and raising funds. The two main sources of funds
are Shareholders‟ Funds (owners‟ equity) and borrowed funds. The cost of funds, determination
of debt equity mix, impact of tax, depreciation, consideration of control and financial strain,
interest rate and inflation are some of tile factors that affect the financing decision. A balance is
to be maintained between owners‟ funds and outsiders‟ funds and long term and short term
funds.

A firm usually makes use of both 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,

Dividend Decision

This decision relates to disposition of distributable profit between dividends and retained
earnings. Retained earnings being a source of funding, dividend decision is concerned as part of
financing decision of the firm. The impact of levels of dividends and retention of earnings on
market value of share and future earnings of the firm, funds required for future expansion,
impact of legal and cash flow constraints and the future boom or recession are some factors that
affect this decision. Retention of earnings depends upon re-investment opportunities available
and the opportunity to generate satisfactory rate of return for the shareholders. Dividends may be
paid in cash or in the form of bonus shares. Page 8

Question No.4 b) Define financial management. Explain its basic objectives.

Solution: 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. Management is concerned with planning, organising, directing and control of any
activity in a business. The successful business management is closely linked with efficient use of

LIKE OUR FACEBOOK PAGE FOR UPDATES facebook.com/khojinet

 MCO-07 SOLVED ASSIGNMENT FOR MCOM
its finances. Financial management is concerned with planning, organising, directing and control
of fillancial activities in a business. A firm has to decide the following:

1. From what sources the funds must be raised and how much from each source i.e., what should
be the finance mix?
2. Where to invest those funds? What should be the composition of the assets of the firm?
3. how should the firm analyse, plan and control its affairs?
4. How large should a firm be so that it call grow fast?

Financial management, also called managerial finance or corporate finance, has been defined by
different writers as follows :

KHOJI.NET
“Financial management is concerned with efficient use of an important economic resource
namely: capital funds. It is the study of the problems involved in the use and acquisition of
funds”. Ezra Solomon, The Theory of Financial Management: Columbia University Press (N.Y.)
(1978).

“It can be broadly defined as the activity concerned with planning, raising, controlling and
administering of funds used in the business.” H. Guthman and H. Dougall : Corporate Financial
Policy (Engleword Clifers)N. Y. Prentice Hall 1980.

Thus, financial management is concerned with managerial decision that results in procurement of
funds and their effective utilization in the business. Financial management is nothing but
managerial decision making on asset mix, capital mix and profit allocation.

Objective of Financial Management

A good goal must be clear, timely measureable and consistent. So must be the goal of financial
management. A firm may have different goals e.g., production goals, sales goal, and financial
management goal. But what is the main goal of financial management? The main goal of
financial management should be such that is directed to achieve the ultimate goal of a firm.

The ultimate goal, as a good consensus, of a firm is to maximise the shareholders‟ wealth.

This in operational terms means:

1. a) Maximisation of profit
2. b) Maximisation of Return on capital employed
3. c) Growth in earning per share or market value of a share or dividends
4. d) Optimum level of leverage
Page 9
5. e) Minimisation of costs of capital.

The separation of ownership from management and the increase in intensity of competition has
lead to the redefinition of profit maximisation objective of a firm. Financial theory, in general
rests upon the promise that the objective of the firm should be maximisation of the value of the
firm to the equity shareholders. It means maximising the market value of its equity shares. the

LIKE OUR FACEBOOK PAGE FOR UPDATES facebook.com/khojinet

 MCO-07 SOLVED ASSIGNMENT FOR MCOM
justification of this objective is that it provides a rational guide for business decision making and
helps in efficient allocation of resources. A second reason in favor of this objective is that equity
Shareholders provide risk (venture) capital for. starting a company. They appoint the board of
management. So this objective brings a responsibility on management to promote the welfare of
equity Shareholders.

The shareholders‟ wealth can be maximized by maximizing value of shares of a firm. The
economic value of the shareholders‟ wealth is the market price of the share which is the present
value of all future dividends and benefits expected from the firm. The underlying assumption in
this approach is that shares are traded in efficient capital market where the effect of a decision is
reflected in market price of a share. With this objective is view the management will allocate the

KHOJI.NET
available economic resources in the best possible way keeping in view the risk involved. This
objective timely guides three function of financial management (investment, financing and
dividend decision). The main problem of this objective is that an efficient capital market must
exist which can really discover and reflect time market price. Thus, wealth maximization of
shareholders is the main objective, though profit maximization can be considered as a part of
wealth maximization objective.

Question No.5 a) What are the reasons to hold inventory?

Solution: The firm holds inventory to ensure continuous production and to avoid a situation of
stock-out. In the process, it incurs the carrying and handling costs. These are insurance, interest
on funds blocked in the inventories, obsolescence, and handling & maintenance. The need for
holding the inventories appears to be same as for the cash. The generally accepted arguments for
holding inventories are transaction needs, precautionary needs, and speculative needs.

1. Transaction needs

The transaction need of holding inventories is dependent upon the manufacturing cycle & normal
production level of the firm and policy of the management. The manufacturing cycle of the firm
will vary from industry to industry. It will be very large (months) in case engineering,
procurement, & construction contractor and will be small in case of food processing, and
detergent & soap manufacturer. The policy of the management such as aggressive, moderate, and
conservative will also guide the inventory-holding period of the firm. An aggressive
management will hold minimal inventories and conservative firm will hold high level of
inventories.
Page 10
2. Precautionary needs

The firm will like to hold some level of inventory for precautionary needs. The actual level of
production may exceed the planned level and thus there is need for higher level of inventories. It
may be in case of firm, which is in a seasonal industry or has just come out of a recession. The
objective is not to have stock out but at the same time not to erode the profitability of the firm by
maintaining excessive inventories.

LIKE OUR FACEBOOK PAGE FOR UPDATES facebook.com/khojinet

 MCO-07 SOLVED ASSIGNMENT FOR MCOM
3. Speculative needs

The management of the firm depending on its attitude may like to benefit from speculative
activities by maintaining the higher level of inventories to benefit from the price fluctuations.

Maintaining inventories entails cost. Lack of inventories causes disruption in production,

unsatisfied demand, and customer switching to the competitors. Thus, there is a need that firm
should be able to quantify optimum level of inventories and hold it.

KHOJI.NET
Question No. 5. b) Discuss the techniques available to monitor the receivables with
examples.

Solution: For control or monitor receivables/ account receivables, there are two methods which
can be used. There are:

(a)Ratio Analysis;
(b) Aging Schedule.

1. Ratio Analysis:

The ratio analysis employs daily sales outstanding ratio (DOS) which is calculated by formula:
DOS = Accounts Receivables at Time t
. Average Daily Sales

The four weekly receivables are Rs.800, Rs.720, Rs.640, Rs.620 and weekly sales are Rs.300,
Rs.312 and Rs.316 respectively. The DOS for six weeks will be as follows:
Rs.620 =20 days approximately
(300+312+315)/30

The DOS should be below 4 predetermined periods. A better method is to show the Pattern of
collection associated with credit sales by matrix method. If we divide credit sales by average
debtors it will give us, average collection period. The average collection period be shown as
follows:

Week of Sales I Week II Week III Week IV Week

Percentage of Receivable
Collected During: I Week 20% 15% 10% 35%
Page 11
II Week 45% 25% 15% 10%
III Week 10% 25% 35% 50%
IV Week 20% 50% 15% 10%

This method helps to remove the drawback of DOS payment behaviour. The matrix method
helps to know when collection is improved, same or declining.

LIKE OUR FACEBOOK PAGE FOR UPDATES facebook.com/khojinet

 MCO-07 SOLVED ASSIGNMENT FOR MCOM
2. Aging Schedule

This method is also a traditional method to monitor receivables. It also suffers from the same
defect as the DOS. The quality of receivables is determined by their age. It is compared with
predetermined credit period. For example, if the normal credit period is 30 days and their age is
as follows:

Age (No. Of Days) %age of Total Outstanding Receivables

Less than 30 Days 80%
31 to 60 Days 20%
61 to 90 Days 10%

KHOJI.NET
From the above, the aging shows that credit policy is good.

Page 12

LIKE OUR FACEBOOK PAGE FOR UPDATES facebook.com/khojinet