Professional Documents
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Financ
Financ
Unit- 4
Risk and return
8. Explain the concept of portfolio risk?
A portfolio is a combination of wealth in to two or more assets. The portfolio theory deals with
forming an efficient portfolio of assets that offers higher return and minimizes the risk. It is
possible for an investor that a single asset might be very risky when held in isolation but not as
much risky when held in combination with other assets in the portfolio. Thus, first the portfolio
risk depends on the riskiness of individual assets in the portfolio other things remaining the same
higher the level of risk associated with individual assets higher will be the portfolio risk.
9. Capital asset pricing model (CAPM).
Capital asset pricing model shows the relationship between risk and return of an asset. The
capital asset pricing model postulates that required rate of return on any assets is the total of risk
free rate plus the risk premium. The capital assets pricing model equation is stated as follows:
E(Rj) = Rf + [Rm-Rf]βj
10. Systematic and unsystematic risk.
Systematic risk refers to the risk which affects the whole market and therefore it cannot be
reduce or diversified away.it refers to the variability in security‟s return with respect to overall
market. This arises due to imbalance in the political situation or fluctuation in the market etc. In
other hand, unsystematic risk is the extent of variability in security‟s return on account of factors
which are unique to a firm. In other words, it is the variability in security‟s return with respect to
unique factors associated with individual firm. It can be diversified away. This risk arises from
management inefficiency unsuccessful planning etc.
11. Define the term of coefficient of variation?
Coefficient of variation is an investor has to choose one investment between two investment that
have the same expected returns but different standard deviations, he/she would choose the one
with the lower standard deviation and therefore the lower risk. The investor is given a choice
between two investments with the risk but different expected return, he/she would generally
prefer the investment with the higher expected return. Coefficient of variation is a measure to
relative dispersion that is useful in comparing the risk of assets with differing expected return.
The CV as a measure of risk in this case neutralizes the influence of size of the investment.
Unit-5
Financial assets valuation
A. Bond valuation
12. Define premium bond and gives an example of premium bond.
A bond is said to be a premium bond if it sells at price higher than the par value. For example,
suppose par value of bond is re1000. If the bond currently sells at 1050, it is called a premium
bond. The bond sells at premium when the market interest rate is lower than the coupon rate.
13. How do you determine value of coupon bond with finite maturity?
Value of coupon bond with finite maturity is the total present value of periodic steam of interest
payments plus the present value of maturity value all discounted at bondholders required rate of
return. It is determined as using following model:
Vo= I×[PVIFA i%, n] + M×[PVIF i%, n]
14. Define the discount bond and gives an example of discount bond.
Or, how does value of a discount bond change over the time if all other things remain the
same?
A discount bond is the bond that sells at a price below par value. The bond sells at discount when
the market rate exceeds the coupon rate. For example, any bond issued by a corporation usually
has a par value of rs1000 and it has a stated coupon rate. If the coupon rate of the bond is less
than the prevailing market interest rate on similar risk class bond, then it sell at a price less than
rs1000. The value of such bond increase as it approaches to the maturity.
15. What are the key features of the bond?
A bond is a long term promissory note-issued by corporation. It is called a promissory note
because the issuer promises to pay stated amount of interest regularly and repay the maturity
value at the expiry of maturity period. While issuing bond, the issuer prepares a legal documents
called indenture which is duly signed by the issuer and the trustee on behalf of the bondholders.
The specific features are as follows:
Par value
Coupon rate
Maturity period
Call provision
Conversion feature
16. Yield to maturity.
The yield to maturity is the annualized rate of return that a bondholder can realize from bond
investment if the bond is held until the maturity period. Technically speaking, YTM is the
discount rate at which the present value of all future cash flows associated with bond investment
remains equal to the current selling price of the bond. The YTM is the total annualized yield that
contains both capital gain yield and the current yield from the bond.
B. Stock valuation
17. Discuss features of common stock.
Common stock is securities issued by corporation to raised ownership capital. Capital raised by
issuing share of common stock is used to finance major portion of the firm‟s fixed assets.
Common stock certificate represents the evidence of ownership right of the holders in the
corporation. Some of the basic features of common stock are as follows:
Par value
Limited liability
No maturity
Voting rights
Residual claim
18. How do you calculate the value of irredeemable preferred stock?
Irredeemable preferred stock has no specified maturity. Therefore, value of an irredeemable
preferred stock is the total of the present value of indefinite steam of preferred stock dividend
discounted at preferred stockholders required rate of return. For example, if an irredeemable
preferred stock has rs100 par value and that pays a 12% preferred stock dividend and preferred
stockholder required rate of return is 10%, we calculate the value of irredeemable preferred stock
as follows:
VPS = DPS / KP
19. What are the features of preferred stock?
Preferred stock has an immediately position between long term debt and common stock in term
of claim on assets and dividend payment. In the event of liquidation, a preferred stockholders
claim on assets comes after that of creditors but before that of common stockholders. Similarly,
preferred stock dividend is distributed after payment of interest but before distribution of
common stock dividend. It is called the hybrid form of financing because it has combined
features of both debt and common stock. Its features are as follows:
Par value
Fixed dividend
Cumulative feature
Maturity
Participating features
20. If stock is not in equilibrium, explain how financial markets adjust to bring it into
equilibrium.
If stock is not in equilibrium but over or under priced then financial markets adjust to bring it
into equilibrium. If the stock is overpriced, selling pressure increase in the market. This leads to
increase in supply of the stock, which ultimately causes stock price to decline to adjust towards
equilibrium. In opposite case, when stock is under-priced buying pressure increase in the market.
This will cause the demand for stock to increase and the price of stock also to increase to adjust
towards equilibrium.
Unit-6
Cost of capital
1. What are the key factors affecting cost of capital?
The key factors affecting cost of capital are as follows:
General economic condition
Marketability of the security
Amount of financing need of the firm
Operating and financing decision associated with the firm
Tax rate
Capital structure and dividend policy
2. Describe the uses of weighted average cost of capital.
The WACC is the minimum required rate of return on firm‟s investment. It represents the
weighted average cost of all components of capital employed by the firm to finance its project. If
the project return is higher than the WACC, the project is considered profitable. Therefore, it is
considered an appropriate acceptance criterion for evaluating the project investment. However,
in this calculation the WACC has been computed for existing capital employed by the firm. If
the firm plans to invest in new project, it has to raise additional capital.
3. What is weighted cost of capital?
Weighted average cost of capital is the overall cost of capital applicable to the firm. It is the
weighted average of the cost of each components of capital employed by a firm, where the
weight corresponds to the proportion of each components of capital employed by the firm in its
overall capitalization.
4. What are the assumptions of cost of capital?
In calculating cost of capital, we assume that risk to the firm being unable to cover operating
and financing costs are assumed to be constant, the cost of capital are measured on an after tax
basis and the corporate marginal tax rate is assumed to be constant and the firm‟s dividend policy
doesn‟t change.
5. What is the significance of marginal cost of capital in decision making?
Use in investment decision
Use in financing decision
Use in dividend decision
Unit- 8
The basics of capital budgeting
6. State the limitation of pay back method.
Some limitations of payback period are as follows:
It does not take into account all cash flows over the life of the project
It does not recognized the timing and riskiness of cash flows
It is not consistent of the value maximization objective
7. Why NPV method is preferred over IRR?
IRR method has certain shortcoming such as it gives the multiple IRR when cash flows are nonnormal; IRR assumes that all
cash flows from the project are reinvested at IRR. This is not valid
assumption because cash flows should be reinvested at cost of capital which reflects the level of
risk associate with the project. Similarly, the NPV method does not have all these shortcoming of
IRR.
8. Define NPV with merits and demerits.
Net present value is one of the widely used discounted cash flow techniques of evaluating capital
budgeting projects. NPV is the difference between present value of cash inflows and outflows
from the projects. According to this method, benefits of the project measured in term of cash
flow is discounted and sum up, and then initial cash outlay of the project is deducted. The
remaining value is known as net present value.
Merits:
It recognizes the concept of time value of money
It takes into account all cash flows over the life of the project
This method is based on the cash flows rather accounting profits
It is consistent with the shareholder‟s wealth maximization objective.
Demerits:
This method is based on the expected cash flows of the project. However, in real life, it is
very difficult to forecast the cash flows with accuracy.
Lack of simplicity
Sensitive to cost of capital
Difficulty in selection of discount factor
9. Define IRR with merits and demerits.
Internal rate of return is the discount rate at which present value of future cash flows is equal to
the present value of cost. In other words, IRR is the discount rate at which the net present value
is zero.
Merits:
It considered the time value of money and all cash flow of the project
It is based on the cash flows of the project.
Useful to achieve the firm‟s goal
Consider to total cash flow
Suitable for comparison
Demerits:
Difficulty in calculation
Possibility of multiple IRR
Misleading assumptions
10. Cross over rate.
Crossover rate is the discount rate at which two mutually exclusive projects have equal net
present value. In case of two mutually exclusive projects, NPV of one project may be higher than
that of other at lower cost of capital, while the net present value of the same project may be
lower than that of other at higher cost of capital. In this situation there exists a crossover rate at
which NPVs of two projects remain equal. If NPV of one project remains always higher than that
of other at any level of cost of capital then there exists no cross over rate.
11. Meaning of Payback period.
The payback period is the expected number of years required to recover the initial investment of
the project. According to this method, the project with lower payback period is selected. For
decision making purpose, the maximum cost recovery time is established, and payback period of
the project is compared with this time. Shorter payback period means earlier recovery of
investment.
12. Define the meaning of mutually exclusive project?
A mutually exclusive project is one where acceptance of such a project will have an effect on the
acceptance of another project. In mutually exclusive projects, the cash flows of one project can
have an impact on the cash flows of another. For example, if you are planning to install the
window frame in your new building, you have three options: wooden frame, metal frame, and
metal frame. You can install one among the available in the market. Installing one option is
rejection to another option.
Unit-7
Capital structure and leverage
13. How does financial structure differ from capital structure? Describe the factors that
affect capital structure of a firm. Or what are the factors affecting target capital structure?
Financial structure refers to the composition of entire components of liabilities in equity in a
firm‟s balance sheet. It refers to the proportionate mix of current liabilities, long term debt,
preferred stock, and equity in the balance sheet of the firm. On the other hand, capital structure
only refers to the proportionate mix of long term and permanent capital such as long term debt,
preferred stock, and equity. It does not include the short term liabilities. Thus, capital structure is
only a part of financial structure of a firm.
The capital structure of a firm is affected by various factors as follows:
a) Business risk: the level of business risk is determined by the use of fixed operating cost
or operating leverage. The chance of business failure is higher for the firm with higher
level of business risk. Thus, they tend to use lower debt.
b) Cash flow stability: a firm with relatively stable cash flows finds no difficulties in
meeting its fixed charge obligation. Thus such firm tends to use more debt.
c) Firm size: the larger firms have easy access to the capital market as they have higher
credit rating for debt issues. Therefore they tend to use more debt capital than smaller
firms.
d) Sales growth: the firms with significant growth in sales have high market price per
share. Thus they prefer to use more equity.
e) Control and risk: management‟s attitude towards control and risk also affect capital
structure decision, if management wants to maintain control in the firm, they prefer to use
more debt financing. Similarly, if the management of a firm is more risk seeker, they
attempt to use more debt to take the advantage of financial leverage.
f) Debt service capacity: debt service capacity of the firm is indicated by interest coverage
ratio. The firms with higher interest coverage ratio tend to use more debt.
g) Assets structure: maturity structure of assets to be financed also affects the capital
structure. A firm with relatively higher longer-term assets and stable demand of products
tends to use more long term debt.
14. What is meant by the term leverage? With which type of risk leverage generally
associated?
Leverage is a more popular term used in physics, which refers to the use of a lever to raise a
heavy object with relatively small forces, in finance leverage refers to the potential use of fixed
costs to magnify the earnings. There are three types of leverage:
Operating leverage: operating leverage shows the responsiveness of change in operating profit
to the change in sales. A given change in sales usually brings more than proportionate change in
operating profit because of the use of fixed operating costs. Thus operating leverage refers to the
potential use of fixed cost by a firm. The numerical measure of operating leverage is called the
degree of operating leverage.
Financial leverage: financial leverage explains how a given change in operating income of the
firm affects its earnings per share and earning to common stockholders. It is the responsiveness
of change in firm‟s EPS to the change in operating profit. Financial leverage exists because of
the use of fixed charge bearing securities, such as bond and preferred stock. In fact the financial
leverage refers to the use of debt in firm.
Total leverage: total leverage is the combination of operating and financial leverage. Degree of
operating leverage measures the degree of business risk associated with a firm. The operating
leverage results from the existence of fixed operating cost. On the other hand, the degree of
financial leverage measures the financial risk associated with a firm. It results from the existence
of fixed financing cost. The combined use of operating and financial leverage causes
considerable change in net income and EPS even there is only a small change in sales.
15. What is business risk? What are the some determinants of business risk?
Business risk is the riskiness on a firm‟s stock provided that the firm has used no debt capital. It
is the risk inherent in operation of the business. A firm‟s business risk arises because of
uncertainty associated with projections of return on invested capital. Return on investment varies
due to the number of factors such as variability in demand price of the product and general
economic condition, competition and so on. Business risk also called operating risk. Some
determinants are as follows:
Demand volatility
Selling price volatility
Technological changes
Level of fixed operating costs
Input costs volatility
Efficiency of price adjustment
Unit-10
Distribution of shareholder’s
16. What is repurchases of stock?
Stock repurchases refers to the repurchasing own outstanding shares of common stock by the
firm itself in the market place. There may be several motives for share repurchases. Some of the
motives may be to obtain shares to be used in acquisitions, to have shares available for employee
stock option plans, to achieve a gain in the book value of equity when shares are selling below
their book value, to retire outstanding share and so on.
17. In what situations should a firm declare stock dividend?
A firm usually issues a stock dividend when it does not have the cash available to issue a normal
cash dividend, but still wants to give the appearance of having issued a payment to stockholders.
The firm should declare stock dividend instead of a cash dividend when it happens to increase
the number of outstanding shares or to capitalize its retained earnings as paid in capital, or to
conserve the firm‟s cash for other purpose.
18. In what situations should a firm consider the repurchase of the stock?
Repurchase of stock is buying back outstanding share of common stock of a firm by itself from
open market. The basic motive of repurchase of stock is to retire the share and reduce the number
of outstanding shares. Similarly, a firm should consider the repurchase of the stock to make the
shares available for employee stock option. Repurchase of stock for retirement of outstanding
share is considered similar to the payment of cash dividend. If earning remain constant
repurchase of shares reduce the number of outstanding shares thereby increasing the earnings per
share and market price per share.
19. What are the factors influencing dividend policy? Also explain the types of dividend
payout schemes.
Dividend policy of a firm is influenced by many factors. Some major factors are explained
below:
1) Legal requirements: certain conditions imposed by law restrict the dividend payment.
For example, dividend should not exceed the sum of current earnings and past
accumulated earnings; accumulated loss must be set off out of the current earnings before
paying out any dividends; firm cannot pay dividend out of its paid up capital because it
adversely affects the firm‟s equity base; it is strictly prohibited by law to pay dividends.
2) Repayments need: a firm uses debt financing for investment is assets. These debts must
be repaid at the maturity. The firm has to retain certain proportion of the profits every
year to meet the repayment need of debt at maturity. This reduces the dividend payment
capacity of the firm.
3) Expected rate of return: if a firm expects higher rate of return from new investment, the
firm prefers to retain the earnings for reinvestment rather than distributing cash
dividends.
4) Earnings stability: firms with relatively stable earnings tend to pay higher dividend. A
firm with unstable earnings is relatively uncertain about its future earnings prospects.
Such firm prefers to retain more out of current earnings.
5) Desire for control: the management with high desire for control in the company does not
prefer to issue additional common stock even the need for additional capital arises.
Issuing additional common stock may dilute their control authority. Instead of paying
dividend, the management prefers to retain the profits for reinvestment in such case.
6) Liquidity position:
7) Restrictions by creditors:
8) Personal tax bracket of shareholders:
9) Access to the capital market:
Types of dividend payout schemes:
Dividend payout schemes can be of two types: residual dividend policy and stability in
dividends. They are discussed below:
a) Residual dividend policy: under this policy, a firm pays dividend only after meeting its
investment need at desired debt-assets ratio. This policy assumes that the firm wises to
minimize the need of external equity, and attempts to maintain current capital structure.
Thus under this policy, the firm uses internally generated equity more to finance the new
projects that have positive NPV. Dividends are paid out of residual income left after
meeting equity financing need of new investment. Under this policy, net income is first
set aside to meet the equity requirement of new investment. If net income is left this,
dividend is paid otherwise not. The amount of dividend under this policy is worked out as
follows:
Dividend = net income – equity requirement of new investment
b) Stable dividend policy: under stable dividend policy, firm attempts to maintain stability
in dividend payment behavior. The stability in dividend is maintained according to the
following dividend payment schemes.
Constant rupee per share dividend: under this scheme, a constant rupee per share
dividend is paid. The fixed amount of dividend per share is paid on an annual basis
irrespective of earnings for the year. The earnings may fluctuate from year to year but
dividends per share remain constant.
Constant payout ratio: under this scheme the firm maintains constant dividend payout
ratio over the years. For example, if the dividend payout ratio is 30% maintain, it implies
that the firm pay 30% of its earnings in dividend every year. Dividend per share under
this policy fluctuates with earnings in the exact proportion.
Minimum regular plus extra: under this policy, the firm always pay minimum regular
dividend per share and also pay extra dividend over the minimum regular dividend if
earnings increase as targeted. For example, with a minimum re2 per share regular
dividend plus extra 30% on the EPS exceeding rs10 policy, firm regular pays rs2 per
share in dividend and pays extra 30% dividend on the earnings exceeding rs10 per share
in any year.
20. What are Advantages of stock dividends?
Stock dividend conserves the cash in the firm, so that it can be used in new projects
Paying stock dividend does not result into cash outflows from the firm
It simply involves a book keeping transfer from retained earnings to the capital stock
account
Stock dividend is a way of recapitalization of earnings
21. In what situations should a firm consider the use of stock dividend?
Stock dividend is simply a book keeping transfer of equity account from retained earnings to
common stock and additional paid up capital account. It simply results into increase in number of
outstanding share with no change in total value of shareholder‟s equity. Stock dividend is a way
to recapitalize earnings. Thus a firm should consider paying stock dividend when it happens to
recapitalize earnings for reinvesting into profitable opportunities.
.
22. Unit-9
Working capital management
23. What is working capital management? Discuss the importance of working capital
management in a manufacturing firm.
Working capital management is concerned with managing firm‟s current assets and current
liabilities to maintain a proper trade of between profitability and liquidity. The working capital
management is important for the financial health of the firm due to the following reason:
A. It requires significant managerial consideration: for most manufacturing concerns, the
current assets represent significant part of total assets. The size and volatility of current
assets make working capital management a major managerial concern. Financial manager
spends much of their time in day-to-day internal operation of the firm, which revolves
around working capital management.
B. It is helpful to maintaining desired scale of operation: the relation between growth in
sales and working capital used in direct and close. So far as the firm is more concerned
about maximizing sales revenue, must involve in working capital management. For
example, as sales increase, firms must increase inventory and accounts payable to meet
the increasing sales requirement.
C. It assists in maintaining continuous cash flow: working capital management is also
important from the viewpoint of maintain continuous cash flow. A good working capital
management reflects in terms of adequate level of accounts receivable, inventory and
cash flow in and out of the firm. A firm doing better in working capital management can
maintain control over its accounts receivable and inventory and ensure the regular flow of
cash.
D. It is more significant to small firm: working capital management is particularly
significant for smaller firms, since they carry a higher percentage of current assets and
current liabilities. They survival of these firm largely depends on the effective working
capital management. Due to their limited approach to the long term capital market, they
have to rely heavily on the short term borrowing, trade credit and so on.
Importance of working capital management in a manufacturing firm:
Firm‟s liquidity has two major aspects: ongoing liquidity and protective liquidity. Ongoing
liquidity refers to the inflow and outflow of cash through the firm as the product acquisition,
production, sales, payment and collection takes place over time. Protective liquidity refers to the
ability to adjust rapidly to unforeseen cash demands and to have backup means available to raise
cash. The firm‟s ongoing liquidity is a function of its working capital cash flow cycle or cash
conversion cycle.
One important model to look at the working capital cash flows cycle is to analyze firm‟s cash
conversion cycle. This represents the net time interval in days between actual cash expenditure
of the firm and the ultimate recovery of cash. The cash conversion cycle model focuses on the
length of time between the company makes payments and when it receives cash flows. It
calculated as:
CCC= operating cycle – payable deferral period
A firm‟s operating cycle has two components: inventory conversion period and receivables
collection period.
Inventory conversion period (ICP) reefers to the length of time required for converting raw
materials in to finished goods and then into sales. It calculated as
ICP = inventory / sales per day
Receivable collection period (RCP), also called days sale outstanding or average collection
period, is the average length of time required to collect accounts receivable after credit sales has
taken place. It is calculated as:
RCP = receivable / credit sales per day
Payables deferral period (PDP), is defined as the average length of time between purchase of
materials and labor and the payment of cash for them. It is calculated as:
PDP = payables / credit purchase per day
Having determined all these three components, the cash conversion cycle (CCC) is given by:
CCC ICP RCP PDP
The calculation of cash conversion cycle is meaningful in a sense that it represents the average
length of time that the firm must hold investment in working capital. This discussion explores
one important point that the length of working capital investment depends on the length of cash
conversion cycle. If the firm is able to shorten its cash conversion cycle, the working capital
requirement also could be reduced. However, the length cash conversion cycle is positively
related with inventory conversion period and receivable collection period, whereas it is
negatively related with payables deferral period.
24. Explain the elements of credit policy of a firm with examples.
A firm‟s credit policy provides guidelines for determining whether to extend credit to a customer
and how much credit to extend. A firm‟s credit policy included three elements: credit standard,
credit terms, and collection policy as described below:
a) Credit standard: credit standards are minimum criteria for the extension of credit to a
customer. Credit standards refer to the financial strength and creditworthiness a customer must
exhibit in order to the quality for credit. Therefore setting a credit standard is the job of assessing
the credit quality of the customer. However assessment of credit quality of the customer on the
basis of given credit standard is totally based on the subjective judgment of credit manager. Firm
can use five Cs scoring factors, which includes character, capacity, capital, collateral and
conditions, to evaluate the credit standard.
Character is the moral state of customer determining the possibility of timely repayment of credit
granted. For evaluating moral character of customers, the credit manager may rely on past
background of customers regarding the behavior and intention of repayment effort. Capital refers
to the indicator of general financial condition of the credit customer as depicted by financial
statement. Collateral refers to the assets that a credit customer can present as security against
credit going to be granted to him. Capacity refers to the ability of customer to generate sufficient
cash required for serving credit granted to him. Finally, condition refers to the general economic
condition of the business with which the credit firm belongs.
b) Credit term: the credit term refers to the condition under which a firm sells its goods and
services for credit. After the creditworthiness of customers has been evaluated, the terms and
conditions on which credits are granted must be determined. Therefore, a firms credit terms
specify the repayment terms required of its entire credit customer.
A typical credit terms may be “ 2/10 net 30” which means that the customer gets a 2% cash
discount if the amount is paid within 10 days from the billing date. If customer fails to accept
discount offer the full amount of credit must be paid within 30 days from the billing date. Such
credit terms cover three components: cash discount, cash discount period and credit period.
A firm may offer cash discount to its credit customer for early payment of dues, when a firm
increase a cash discount, this increase the sales volume and reduce the investment in accounts
receivable, bad debt expenses and ultimately may put positive or negative impact on profit
figure. Therefore, the use of cash discounted for early payment is evaluated on the basis of
relative costs and benefits associated with cash discount offer.
c) Collection policy: collection policy refers to the procedure for collecting accounts receivable
when they are due. The basic aim of any collection policy is to speed up the collection of dues. If
collections are delayed, the firm should have to make alternative arrangements for financing the
production and sales. The effectiveness of collection policies can be evaluated by looking at the
level of bad debt expenses. Assuming the level of bad debts attributable to credit policies
constant, increasing collection expenditures is expected to reduce bad debts. In other words
greater the relative amount expended for credit collection, the lower the proportion of bad debts
and shorter the average collection period, assuming all other things remained constant.
26. What is the working capital management? Why is the management of working capital
important in a business? Explain the role of cash budget in the management of working
capital.
Working capital management is concerned with managing firm‟s current assets and current
liabilities to maintain a proper trade of between profitability and liquidity. The working capital
management is important for the financial health of the firm due to the following reason:
It requires significant managerial consideration
It is helpful to maintaining desired scale of operation
It assists in maintaining continuous cash flows
It is more significant to small firm
The extent of firm‟s efficiency of cash management depends on its ability to forecast cash inflow
and outflow, more accurately. If cash inflow and outflow were perfectly predicted, no cash
management would be required. But cash outflows are almost certain whereas cash inflows are
uncertain and fluctuating. Therefore first of all, the firm should determine the extent to which
cash flows are non-synchronized. This required the preparation of a schedule forecasting the cash
receipts and payments during the month of a year. Cash budget, perhaps, serves as the most
important technique of planning and controlling the use of cash. Cash budget is simply defined
as the statement that depicts the firms estimate cash receipt and estimated cash disbursement
during the plan period. It serves the following purpose:
It shows the amount of cash received from different sources each period
It shows the cash payment need of the firm for given period
It suggest on the surplus of deficit cash for the forecasted period
The firm can plan for investment of surplus cash and financing of deficit cash
Thus, preparation of cash budget can ensure that the firm has sufficient cash during peak times
for purchasing and for other purpose. The firm can meet obligatory cash outflows when they fall
due. It can plan properly for capital expenditure to be incurred.