MB0045 – Financial Management

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Q.1 Write the short notes on

1. Financial management
2. Financial planning
3. Capital structure
4. Cost of capital
5. Trading on equity
Ans:-
Financial Management:-Financial Management of a firm is concerned with procurement and effective
utilization of funds for the benefit of its stakeholders. It embraces all those managerial activities that are
required to procure funds at the least cost and their effective deployment.
The most admired Indian companies are Reliance and Infosys. They have been rated well by the financial
analysts on many crucial aspects that enabled them to create value for its share holders. They employ the
best technology, produce good quality goods or render services at the least cost and continuously
contribute to the shareholders’ wealth.

Financial planning: - Liberalization and globalization policies initiated by the government have changed
the dimension of business environment. Therefore, for survival and growth, a firm has to execute planned
strategies systematically. To execute any strategic plan, resources are required. Resources may be
manpower, plant and machinery, building, technology or any intangible asset. To acquire all these assets,
financial resources are essentially required. Therefore the finance manager of a company must have both
long-range and short-range financial plans. Integration of both these plans is required for the effective
utilization of all the resources of the firm.

Capital structure:-The design of an ideal capital structure requires five factors to be considered

a) Return:- The capital structure of a company should be most advantageous. It should generate
maximum returns to the shareholders for a considerable period of time and such returns should keep
increasing.

b) Risk:-Debt does increase equity holders‘returns and this can be done till such time that no risk is
involved. Use of excessive debt funds may threaten the company‘s survival.

c) Flexibility:-The Company should be able to adapt itself to situations warranting changed

circumstances with minimum cost and delay.

d) Capacity:-The capital structure of the company should be within the debt capacity. Debt capacity
depends on the ability for funds to be generated. Revenues earned should be sufficient enough to pay
creditors‘interests, principal and also to shareholders to some extent.

Cost of capital: - we have calculated the cost of each component in the overall capital of the
company. The term cost of capital refers to the overall composite cost of capital or the weighted
average cost of each specific type of fund. The purpose of using weighted average is to consider
each component in proportion of their contribution to the total fund available.
Trading on equity:-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 should be paid off regardless
of the amount of earnings before income and tax (EBIT).

It is the firm’s ability to use fixed financial charges to increase the effects of changes in EBIT on the EPS.
It is the use of funds obtained at fixed costs which increase the returns on shareholders.
A company earning more by the use of assets funded by fixed sources is said to be having a favorable or
positive leverage. Unfavorable leverage occurs when the firm is not earning sufficiently to cover the cost
of funds. Financial leverage is also referred to as “Trading on Equity”.

Q.2 a. Write the features of interim divined and also write the factors Influencing divined
policy?

b. What is reorder level ?

Q.3 Sales Rs.400, 000 less returns Rs 10, 000, Cost of Goods Sold Rs 300,000,
Administration and selling expenses Rs.20, 000, Interest on loans Rs.5000, Income tax
Rs.10000, preference dividend Rs. 15,000, Equity Share Capital Rs.100, 000 @Rs. 10 per
share. Find EPS.
Q.4 What are the techniques of evaluation of investment?

Answer:-

To survive and grow, all organisations have to be innovative. Innovation demands managerial proactive
actions. Proactive organisations continuously search for innovative ways of performing the activities of
the organisation. Innovation is wider in nature. It could be:

 expansion through entering into new markets

 adding new products to its product mix

 performing value added activities to enhance customer satisfaction

 adopting new technology that would drastically reduce the cost of production

 rendering services or mass production at low cost or restructuring the organisation to improve
productivity

These innovations change the profile of an organisation. These decisions are strategic because they are
risky. However, if executed successfully with a clear plan of action, investment decisions generate super
normal growth to the organisation.
A firm may become bankrupt, if the management fails to execute the decisions taken. Therefore, such
decisions have to be taken after taking into account all the facts affecting the decisions and their
execution.
There are two critical issues to be considered in these decisions.

 Evaluation of expected profitability of the new investments.

 Rate of return required on the project.

The Rate of Return required by an investor is normally known as the hurdle rate or the cut-off rate or the
opportunity cost of capital.
Investments in buildings and machineries are to be conceived and executed by a firm to enter into any
business or to expand its business. The process involved is called Capital Budgeting. Capital Budgeting
decisions demand considerable time, attention and energy of the management. They are strategic in nature
as the success or failure of an organisation is directly attributable to the execution of Capital Budgeting
decisions taken.
Investment decisions are also known as Capital Budgeting Decisions and hence lead to investments in
real assets.

Q.5 What are the problems associated with inadequate working capital?
Working capital is defined as the excess of current assets over current liabilities and provisions. It is that
portion of asset of a business which is used frequently in current operations and in the operating cycle of
the firm.
Inadequacy or mismanagement of working capital is the leading cause of many business failures. A
financial manger, therefore, spends a larger part of his time in managing working capital. There are two
important elements to be considered under the working capital management:

 Decisions on the amount of current assets to be held by a firm for efficient operations of its business

 Decisions on financing working capital requirement

The need for proper management of working capital management is even more important in the modern
era of information technology. In support of the above argument, let us consider the performance of Dell
computers as reported in one of the recent Fortune articles. A perusal of the article will give you an
insight into how Dell could use the technology for improving the performance of components of working
capital.
 Use of internet as a tool for reducing costs of linking manufacturer with their suppliers and dealers

 Outsourcing on operations, if the firms’ competence does not permit the performance of the operation
effectively

 Training the employees to accept change

 Introducing to internet business.

 Releasing capital by reduction in investment in inventory for improving the profitability of operating
capital.

Learning Objectives
After studying this unit, you should be able to:

 Explain the meaning, definition and various concepts of working capital

 State the objectives of working capital management

 Recognise the importance of working capital management

 Estimate the process of working capital

Components of Current Assets and Current Liabilities

Working capital management is concerned with managing the different components of current assets and
current liabilities.
The following are the components of current assets:

 Inventories
 Sundry debtors
 Bills receivables
 Cash and bank balances
 Short-term investments
 Advances such as advances for purchase of raw materials, components and consumable stores and pre-
paid expenses.

The components of current liabilities are:

 Sundry creditors
 Bills payable
 Creditors for out-standing expenses

Q.6 What is leverage? Compare and Contrast between operating Leverage

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 as leverage. Leverage is the influence of an
independent financial variable on a dependent variable. It studies how the dependent variable responds to
a particular change in independent variable.
There are three types of leverage – operating, financial and combined
Operating Leverage

Fixed costs
Fixed 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.
 Variable costs

Variable costs are those which vary in direct proportion to output and sales. An increase or decrease in
production or sales activities will have a direct effect on such types of costs incurred.
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 the administrative 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 costs

Semi-variable costs are those which are partly fixed and partly variable in nature. These costs are
typically of fixed nature up to a certain level beyond which they vary with the firm’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 wages paid to the workers which act at some point of
time as fixed costs and can also shift to variable 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 the effects of changes
in sales on its earnings before interest and taxes (EBIT). Operating leverage occurs any time a firm has
fixed costs. The percentage change in profits with a change in volume of sales is more than the percentage
change in volume.
Financial leverage
Financial leverage as opposed to operating leverage relates to the financing activities of a firm and
measures the effect of earnings before interest and tax (EBIT) on earnings per share (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 preference shares and
 Those which do not carry any fixed charges like equity shares

Debentures 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 on preference shares is a fixed
charge and should be paid off before equity shareholders are paid any. The equity holders are entitled to
only the residual income of the firm after all prior obligations are met.
It is the firm’s ability to use fixed financial charges to increase the effects of changes in EBIT on the EPS.
It is the use of funds obtained at fixed costs which increase the returns on shareholders.
A company earning more by the use of assets funded by fixed sources is said to be having a favourable or
positive leverage. Unfavourable leverage occurs when the firm is not earning sufficiently to cover the cost
of funds. Financial leverage is also referred to as “Trading on Equity”.
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 should be paid off regardless of the amount
of earnings before income and tax (EBIT)