FINANCIAL MANAGEMENT ASSIGNMENT CYCLE 1

UNIT 1 (CLUSTER 1)

Q5. Interpret the role of financial management in traditional context.

ANS

Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the

financial activities such as procurement and utilization of funds of the enterprise. It
means applying general management principles to financial resources of the
enterprise.

Role of financial management in traditional context:

Financial Decisions and Controls

 A crucial role of financial managers is in making financial decisions and exercising
control over finances in the organization. They make use of techniques like ratio
analysis, financial forecasting, profit and loss analysis, etc. These are all tasks that
help a firm understand how efficiently they are working and what activities will
help them improve their earnings.
  
Financial Planning
 A crucial role of financial management is the planning of financial activities and
resources in the organization. To this end, they use available data to understand the
needs and priorities of the establishment as well as the overall economic situation
and make plans and budgets for the same. This is an important task that helps
maintain financial stability by balancing outflow and inflow of cash.
  
Capital Management
 As part of financial management functions, these officials must estimate the capital
requirements of the organization from time to time, determine the capital structure
and composition, and make the choice of source of funding for the capital needs.
This ensures that a company has enough cash flow to meet its immediate and
distant needs for smooth operation. Companies can complete day-to-day expenses
and short-term financial commitments quickly.

Allocation and Utilization of Financial Resources

 Financial management ensures that all financial resources of the organizations are
used and invested effectively and efficiently so that the organization is profitable,
sustainable, and viable in the long run. Companies are working in a highly
competitive environment, and this makes it necessary for finance heads to ensure
that available funds are used most beneficially. This activity probably answers the
question of what is financial management ideally.

Cash Flow Management

 It is extremely important for organizations to have sufficient working capital and
cash flow to meet their operational expenses and emergencies. Financial
management tracks account payable and receivable to ensure there is the adequate
cash flow available at all times. This is the role of financial management that is vital
in all companies but especially crucial for small establishments as a shortage in
cash flow can affect their functioning badly 

Disposal of Surplus
 The decisions on how the surplus or profits of the organizations is utilized are
taken by the financial managers of the organizations. They decide if dividends
should be distributed and how much, and the proportion of profits that must be
retained and plowed back into the business. It is also paid to employees as a bonus
for performing well.
 
Financial Reporting
 Financial management maintains all necessary reports related to the finance of the
organization and uses this as the database for forecasting and planning financial
activities. Reporting is a very important function for all organizations. It is a way of
knowing the firm’s financial position and performance. This is usually done
periodically, either on a quarterly basis or annually. It tells how much money is
there, where it came from and what expenses were incurred in that period.
Q16. Summarize and re-tell in your own words how finance function plays a
pivotal role of the three functions in financial management.

ANS

Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the

financial activities such as procurement and utilization of funds of the enterprise. It
means applying general management principles to financial resources of the
enterprise.

Financial Management Functions:

1. Financial Planning and Forecasting

It is the financial manager’s responsibility to plan and estimate the business’s

financial needs. He needs to provide details regarding the amount of money that
would be required to purchase different assets for the company.

The management through the financial manager needs to know what they need to
spend on working capital and fixed assets for the business too.

Another vital duty of the financial manager is to make futuristic plans for funds

that the company would need. And the manner in which the funds will be realized
and used is also of utmost importance to the financial manager.

2. Determination of capital composition

Once the Planning and Forecasting have been made, the capital structure has to
be decided. The mix of debt and equity used to finance the company’s future
profitable investment opportunities is referred to as capital structure.

3. Fund Investment
The financial manager has to ensure that funds made available to the business are
used adequately to grow the business. The cost of acquiring the said fund and value
of the returns need to be compared and balanced.

The financial manager also needs to look into the channels of the business that is
yielding higher returns and improve them.

4. Maintain Proper Liquidity

Cash is the best source for maintaining liquidity. The business requires it to buy
raw materials, pay salaries, and tackle other financial needs of the company.

However, the financial manager has to determine if there is a demand for liquid

ASSETS.

He also has to arrange these assets in a manner that the business won’t experience
scarcity of funds.

5. Disposal of Surplus

Selling surplus assets and investing in more productive ways will increase

profitability and therefore increase the ROCE.

6. Financial Controls

Financial control may be construed as the analysis of a company’s actual

results, approached from different perspectives at different times, compared to its
short, medium, and long-term objectives and business plans.

Conclusion

Financial management is a hot topic in the business world because of the

importance of finance to the business.

The reason for establishing a company is to make a profit and also run for many
years. However, it’s the financial manager’s responsibility that the finances of the
company are used adequately.
 UNIT 2 (CLUSTER 2)
Q25. Interpret the assumptions of traditional approach of capital structure theory.

ANS

* Capital Structure:
Capital structure is the particular combination of debt and equity used by a
company to finance its overall operations and growth.

Equity capital arises from ownership shares in a company and claims to its future
cash flows and profits. Debt comes in the form of bond issues or loans, while
equity may come in the form of common stock, preferred stock, or retained
earnings. Short-term debt is also considered to be part of the capital structure.

*Traditional Theory of Capital Structure:

The traditional theory of capital structure states that when the weighted average
cost of capital (WACC) is minimized, and the market value of assets is maximized,
an optimal structure of capital exists. This is achieved by utilizing a mix of both
equity and debt capital. This point occurs where the marginal cost of debt and the
marginal cost of equity are equated, and any other mix of debt and equity financing
where the two are not equated allows an opportunity to increase firm value by
increasing or decreasing the firm’s leverage. 

 The traditional theory of capital structure says that for any company or
investment there is an optimal mix of debt and equity financing that
minimizes the WACC and maximizes value.
 Under this theory, the optimal capital structure occurs where the marginal
cost of debt is equal to the marginal cost of equity. 
 This theory depends on assumptions that imply that the cost of either debt or
equity financing vary with respect to the degree of leverage.

Assumptions under Traditional Approach: 

1. The rate of interest on debt remains constant for a certain period and
thereafter with an increase in leverage, it increases. 
2. The expected rate by equity shareholders remains constant or increase
gradually. After that, the equity shareholders starts perceiving a financial
risk and then from the optimal point and the expected rate increases
speedily.
 3. As a result of the activity of rate of interest and expected rate of return, the
WACC first decreases and then increases. The lowest point on the curve is
optimal capital structure. 

DIAGRAM:
Q35. Draw inferences on why companies issue hybrid securities?

ANS

A hybrid security is a single financial product that combines different types of

financial securities, or has features of multiple kinds of securities. Typically, this
means that the security has aspects of both debt (bonds) and equity (stocks). In this
case, the security will have the guaranteed payment nature of a bond while also
having the potential for capital appreciation of a stock. 

What Is A Hybrid Security?

Let’s start by defining security: a tradable financial product that generates

returns based on either the performance of a company or an established rate of
return. The two main types of securities are equities (stocks), in which you buy
partial ownership of a company; and debt (bonds), in which you lend a company
money and receive payments and interest according to a set rate and schedule.

Hybrid securities include components of both security types, and they accomplish
what their underlying assets accomplish: they enable an issuing company to raise
capital without having either the full commitment of a bond or the exposure of a
stock offering.

Example: Convertible Bonds

The most common example of a hybrid security is called a “convertible bond.”

This is a bond that comes with an option to convert the instrument into a different
type of security at a future date. Ordinarily the bond will convert into shares of
stock in the issuing company.

This makes the convertible bond a hybrid security. It has the interest payments and
guarantee of a bond, but its value also depends on the asset underlying the bond’s
conversion option. Again, in a typical case, this means that the bond’s value is
influenced by the company’s stock price.

Convertible bonds typically come in two forms: holder options and issuer options.
In a holder-option bond, the investor who owns the bond can choose whether to
convert the bond into shares of stock. In an issuer-option bond, the company which
issued the bond can choose whether to convert it into shares of stock. Holder
option bonds generally pay lower interest rates than issuer option bonds because
the investor can choose to convert the bond if the company’s stock goes up.

Convertible bonds are based on a maturity date. This is the point at which either
the investor or the issuer (depending on the nature of the bond) can convert it into
equity. They will also come with what is known as a “stock conversion price.”
This is the price at which the bond will convert into equity.

Example: Convertible Preferred Shares

Convertible preferred shares, also known as convertible preference shares, are a

specialized form of security that comes with the option to convert into either
common shares of the company or a cash payment, depending on the specific asset.

Like most preferred shares, convertible preferred shares come with secured
dividend payments. Unlike common stock, which issues dividends on an as-
approved basis, preferred shares will typically have a guaranteed schedule of
dividend payments. These can have either a fixed or floating basis, but the regular
payments create a bond-like aspect to this security.

WHY COMOANIES ISSUES HYBRID SECURITIES:

 the potential to receive an income stream for an agreed period.

 generally lower price volatility than shares.

 usually higher interest rates than are paid on bonds, reflecting the higher
risk.

 diversification, and the potential to benefit from changes in interest rates or

equity prices.
 UNIT 3(CLUSTER 3)

Q45. Classify various conventional and nonconventional investment avenues in the

modern times and suggest a portfolio of the same.

ANS

As an investor, everyone has a clear desire to attain sky-rocketed returns as quick

as possible with minimum risk of losing money. An investor must understand that
investment is not a casino, where you will hit the jackpot overnight.

Interestingly, there is no investment alternative which assure high return with low
risk. In the practical world and its bitter reality, risk and return are directly
proportional, i.e. higher the risk, higher are the returns and vice versa. However, it
is very important to build a strong, sustainable and long term portfolio, which puts
your excess corpus to earn for you. This leads to the base of investor profiling.

Also, an investor must understand that all investment products fall into two broader
baskets- financial assets and non-financial assets. The former category comprises
market linked products like stocks and mutual funds along with fixed income
products like bank fixed deposits, public provident fund, whereas the latter one is
more prominent in India, which includes physical investment in gold and real
estate.

1.Equity

Equity as an asset class is gaining traction but it is not everyone’s cup of tea. It is
probably the most volatile asset class with no guaranteed returns. Investment in
equity is not just restricted to stock selection, but timing of entry and exit is very
important. However, in the longer run, stock markets can be the best performing
asset class with much superior alpha.

While putting your money into equity, investors shall opt for strict stop loss to
curtail the extent of damage. It is advised to have an expert opinion and view
before buying stocks. To put your hard earned money into direct equity, one needs
to have a demat account.

2.Mutual Funds

A mutual fund is a professionally managed investment fund that pools money from
many investors to purchase securities. They can put their money into one or more
kinds of securities. Mutual Funds can put their money into stocks, debt or both and
even in gold. They can be actively managed or passive funds.

In active funds, the fund manager plays a vital role in choosing scrips to generate
return, while passive funds or exchange traded funds (ETFs) invest the money
based on the underlying benchmarked indices. Equity schemes are categorized
according to market-capitalization or the sectors in which they invest.

3.Bonds or Debentures

Debentures or bonds are long-term investment options with a fixed stream of cash
flows depending on the quoted rate of interest. They are considered relatively less
risky. An amount of risk involved in debentures or bonds is dependent upon who
the issuer is. They include Government securities, savings bonds, public sector unit
bonds etc.
4.Bank Fixed Deposits (FDs)

FD in banks is considered as one of the safest and traditional choices of investing

in the nation. It is different from deposits in savings accounts. They provide a fixed
rate of interest on the principal amount over a predetermined duration. Bank FD
provides a higher rate of interest than savings accounts. However, The interest rate
earned is added to one’s income and is taxed as per one’s income slab.

5.Public Provident Fund (PPF)

The Public Provident Fund is one the popular investment products, with a longer
maturity tenure of 15 years. The impact of compounding of tax-free interest is
hefty, especially in the later years. It is a safe investment as the interest earned
(reviewed every quarter by the government) and the principal invested is backed
by sovereign guarantee.

6.Real Estate

Buying property is one of the most popular investment alternatives in the country.
However, a property for self consumption should never be considered as an
investment. Investment in real estate is not just limited to housing as the segments
like office, commercial real estate, warehousing, student housing, data centers,
shared spaces is also gaining traction amongst the investors.

Location of the property is the most important factor that affects the price of the
property and rental income that is likely to be earned. Investments in real estate
deliver returns in two ways- capital appreciation and rentals. However, unlike other
asset classes, real estate is highly illiquid.
7.Gold

It is the most traditional form of investment amongst Indians, but possessing gold
in the form of jewelry has concerns related to safety and high cost in the form of
‘making charges’. However, buying gold coins or biscuits is still an option but gold
ETF could be ranked as a more viable one. Investment in gold papers via ETFs is
more safe and cost effective.

Despite being a liquid asset class, many novice investors are cheated with
‘duplicate’ or ‘mixed’ jewelry, if purchased without proper knowledge or from a
dubious jeweler.

8.Life Insurance

Insurance plans sold as life insurance shall not be considered as investment options
as they provide risk coverage in case of any mishap. However, many Indians
consider insurance as an investment. Life insurance is an instrument for the
security of life. The main objective of other investment avenues is to earn a return
but the primary objective of life insurance is to secure our families against
unfortunate events.

Summary

Investment is made with the objective of wealth creation and all above mentioned
instruments fulfil their objectives, in accordance to the risk associated with it. An
investor must understand the his risk appetite, time horizon and tax treatment on
different investment avenues to make a judicious and sagacious investment call.
Q55. Compare and contrast capital budgeting and capital rationing.

Capital Budgeting:
Capital budgeting is the process a business undertakes to evaluate potential major
projects or investments. Construction of a new plant or a big investment in an
outside venture are examples of projects that would require capital budgeting
before they are approved or rejected.

As part of capital budgeting, a company might assess a prospective project's

lifetime cash inflows and outflows to determine whether the potential returns that
would be generated meet a sufficient target benchmark. The capital budgeting
process is also known as investment appraisal.

Capital Budgeting Techniques

To assist the organization in selecting the best investment there are various

techniques available based on the comparison of cash inflows and outflows.  These

techniques are:

Payback period method

In this technique, the entity calculates the time period required to earn the initial

investment of the project or investment. The project or investment with the shortest

duration is opted for.

 Net Present value

The net present value is calculated by taking the difference between the present

value of cash inflows and the present value of cash outflows over a period of time.

The investment with a positive NPV will be considered. In case there are multiple

projects, the project with a higher NPV is more likely to be selected.

Accounting Rate of Return

In this technique, the total net income of the investment is divided by the initial or

average investment to derive at the most profitable investment.

Internal Rate of Return (IRR)

For NPV computation a discount rate is used. IRR is the rate at which the NPV

becomes zero.  The project with higher IRR is usually selected.

 Profitability Index

Profitability Index is the ratio of the present value of future cash flows of the

project to the initial investment required for the project.   Each technique comes

with inherent advantages and disadvantages. An organization needs to use the best-

suited technique to assist it in budgeting.  It can also select different techniques and

compare the results to derive at the best profitable projects.

Capital Rationing:
Capital rationing is defined as the process of placing a limit on the extent of new
projects or investments that a company decides to undertake. This is made possible
by placing a much higher cost of capital for the consideration of the investments or
by placing a ceiling on a particular proportion of a budget.

A company might intend to implement capital rationing in scenarios where the past

revenues generated through investments were not up to the mark.

Capital Budgeting vs. Capital Rationing

Capital budgeting is not the same thing as capital rationing, although the two
often go hand in hand. Capital budgeting simply identifies which projects are
worth pursuing, regardless of their upfront cost. When a company has a finite
amount of capital to invest -- a familiar situation to the small business owner --
capital rationing helps the business choose the projects it can afford that will
produce the greatest return. One common method for doing this is the
"profitability index." To get a project's "PI," divide its net present value by its
upfront cost. This tells you how much return you get for each dollar invested. In
other words, it measures bang for the buck.