(1) Explain the three key activities of Financial Management.
correlation between assets reduces the portfolio's overall volatility, making
The three key activities of Financial Management are :-
1. Investment Decision (Capital Budgeting): This involves deciding where to
allocate the firm’s long-term capital assets to generate the highest possible
returns. It includes evaluating potential projects or investments to
determine their viability and profitability.
2. Financing Decision (Capital Structure): This activity revolves around
determining the best mix of debt and equity to finance the firm's operations
and growth. It involves decisions related to raising capital, whether through
issuing new shares, taking on loans, or other forms of financing.
3. Dividend Decision (Profit Distribution): This involves deciding how much
of the firm’s profits should be distributed to shareholders in the form of
dividends and how much should be retained within the company for
reinvestment. The decision takes into account factors such as the company’s
earnings, growth opportunities, cash flow needs, and shareholders'
preferences.
(2) What is the goal of a firm? Discuss how to measure achievement of this
goal?
The primary goal of a firm is to maximize shareholder wealth. This objective
reflects the long-term focus on increasing the value of the firm as perceived
by its shareholders. Here’s a discussion on how to measure the achievement
of this goal:
Measuring Achievement of Shareholder Wealth Maximization:-
1. Market Value of Shares
a. Stock Price: The most direct measure of shareholder wealth is the market
price of the firm's shares. An increase in stock price indicates that investors
have confidence in the firm's future prospects and profitability.
b. Market Capitalization: This is calculated by multiplying the current stock
price by the total number of outstanding shares. It reflects the total market
value of the firm’s equity and serves as a comprehensive measure of the
firm's size and value.
2.Earnings and Profitability:
a. Earnings Per Share (EPS): EPS is the portion of a company's profit
allocated to each outstanding share of common stock. A consistently
growing EPS indicates strong financial health and efficient management.
b. Return on Equity (ROE): ROE measures the profitability of a company in
generating income from shareholders' equity. Higher ROE values typically
indicate more efficient use of equity investments to generate profits.
3. Cash Flows:
Free Cash Flow (FCF): Positive and growing free cash flows suggest that a
firm can fund its operations, pay dividends, and invest in growth
opportunities without relying on external financing.
4. Dividend Policy:
Regular and increasing dividends can be a sign of a firm’s strong financial
health and its ability to generate consistent profits. Dividend yield,
calculated as the annual dividend per share divided by the stock price,
shows the return on investment from dividends alone.
5. Economic Value Added (EVA): EVA measures a firm’s economic profit and
is calculated by subtracting the cost of capital from the firm's net operating
profit after taxes (NOPAT). Positive EVA indicates that the firm is generating
value over and above the cost of capital.
6. Total Shareholder Return (TSR): TSR combines share price appreciation
and dividends paid to show the total return to shareholders over a specific
period. It is a comprehensive measure of how well a firm is performing in
terms of increasing shareholder value.
7. Return on Investment (ROI): ROI measures the efficiency of an
investment by comparing the gain from the investment to its cost. A higher
ROI indicates more effective use of capital.
(3) What is economic value added? How is it used?
Economic Value Added (EVA) is a financial performance metric that
calculates the true economic profit of a company. It measures the value
created above and beyond the required return of the company's
shareholders.
Uses of EVA :-
1. Performance Measurement: EVA provides a clear picture of how much
value the company is creating for its shareholders. It helps in assessing
whether the company’s operations are generating returns above the cost of
capital.
2. Management Incentives: Companies often use EVA as a basis for
executive compensation. Linking management bonuses to EVA encourages
managers to make decisions that will increase economic profit and,
consequently, shareholder value.
3. Capital Allocation: EVA helps in making better capital allocation decisions.
By focusing on projects that yield returns greater than the cost of capital,
firms can ensure that they are investing in value-creating activities.
4. Strategic Planning: EVA can be used in strategic planning and
performance benchmarking. It helps in setting performance targets and
comparing the company’s performance with competitors or industry
standards.
5. Financial Analysis: Analysts and investors use EVA to evaluate a
company’s financial health and its ability to generate shareholder value. It
provides a more accurate measure of profitability than traditional
accounting profits.
(4) Why is the correlation between securities and returns in a portfolio
important?
The correlation between securities and their returns in a portfolio is crucial
for several reasons, primarily related to diversification, risk management,
and overall portfolio performance. Here's a detailed explanation:
1. Diversification and Risk Reduction:
a. Principle of Diversification: Diversification involves spreading investments
across various assets to reduce the overall risk of the portfolio. The idea is
that the performance of different assets will not move in the same direction
at the same time.
b. Impact of Correlation: The correlation coefficient, which ranges from -1
to +1, measures the degree to which two securities move in relation to each
other.
2. Portfolio Volatility:
Calculation of Portfolio Risk: The overall risk (volatility) of a portfolio is not
just the weighted sum of the individual asset risks but also depends on the
correlations between the returns of the assets. A lower or negative
5. Risk Analysis: Consider credit ratings and historical payment behavior to
the portfolio more stable.
3. Efficient Frontier and Optimal Portfolios:
a. Modern Portfolio Theory (MPT): According to MPT, investors can achieve
an optimal portfolio by choosing a mix of assets that maximizes returns for a
given level of risk or minimizes risk for a given level of return.
b. Efficient Frontier: The set of optimal portfolios that offer the highest
expected return for a given level of risk. The position of a portfolio on this
frontier depends significantly on the correlations between the constituent
assets.
4. Impact on Expected Returns:
Balancing Risk and Return: While focusing on maximizing returns, investors
must also consider the associated risks. By understanding correlations,
investors can construct portfolios that achieve better risk-adjusted returns.
5. Stress Testing and Scenario Analysis: Robustness of Portfolio:
Understanding correlations helps in stress testing portfolios under different
market conditions.
(5) Beta is not the sole factor affecting security required rate of return?
Illucidate the statement.
Factor affecting the security required rate of return" acknowledges that
while beta is a significant determinant of an asset's expected return in the
Capital Asset Pricing Model (CAPM), there are other factors and models to
consider that also influence the required rate of return.
(6) What is the importance of ratio-analysis? Briefly discuss the importance
of the following ratios: a. Liquidity ratio b. Debt-equity ratio c. Stock-
turnover ratio d. Debtors-turnover ratio.
Ratio analysis is a crucial tool in financial analysis that involves the
calculation and interpretation of various financial ratios derived from a
company's financial statements.
Importance of Ratio Analysis:
1. Performance Evaluation: Ratios help in assessing a company's
performance over time and in comparison to competitors or industry
benchmarks.
2. Financial Health Assessment: Ratios provide a snapshot of a company's
financial condition, highlighting areas of strength and potential risk.
3. Decision Making: Managers use ratios to make informed decisions
regarding operations, investments, and financing.
4. Creditworthiness: Creditors and investors use ratios to evaluate the risk
associated with lending to or investing in a company.
5. Operational Efficiency: Ratios can indicate how efficiently a company
utilizes its assets and manages its operations.
Key Financial Ratios and Their Importance:
1. Liquidity Ratio:
Significance: High liquidity ratios indicate a strong ability to pay off short-
term debts, which is crucial for maintaining creditor confidence and avoiding
liquidity crises.
2. Debt-Equity Ratio:
a. Risk Assessment: This ratio indicates the financial leverage of a company.
A higher ratio suggests higher financial risk because the company relies
more on debt financing.
b. Investor Insight: Investors look at this ratio to assess the risk associated
with their investment. A lower ratio is generally preferred as it indicates a
more stable financial structure.
c. Creditworthiness: Lenders use this ratio to evaluate the company’s ability
to meet long-term obligations. High leverage can be a red flag for potential
insolvency.
3. Stock-Turnover Ratio:
a. Operational Efficiency: This ratio indicates how many times inventory is
sold and replaced over a period. A higher ratio suggests efficient inventory
management and strong sales.
b. Cash Flow Management: Efficient inventory turnover can lead to better
cash flow management, as less capital is tied up in inventory.
c. Demand Forecasting: Helps in assessing whether the company has
effective inventory policies and whether it can meet market demand
without overstocking or stockouts.
4. Debtors-Turnover Ratio:
a. Credit Management: This ratio indicates how quickly the company
collects cash from credit sales. A higher ratio suggests efficient credit
management and quicker collection of receivables.
b. Liquidity Insight: It helps in assessing the liquidity of receivables and the
effectiveness of the company's credit policies.
c. Customer Relationship: Analyzing this ratio over time can provide insights
into customer payment behaviors and the effectiveness of the company’s
collection processes.
(7) How would you analyse the financial position of a company from the
POV of a. An investor b. A creditor c. A financial executive of a company.
a. Analysis from the Point of View of an Investor
Analytical Steps:
1. Examine Profitability: Analyze the Income Statement for revenue trends,
gross profit margin, operating profit margin, and net profit margin.
2. Assess Financial Health: Review the Balance Sheet for liquidity and
leverage.
3. Evaluate Cash Flow: Study the Cash Flow Statement to ensure the
company generates sufficient cash from operations.
4. Growth Analysis: Look at historical growth rates and forward-looking
estimates for sales, earnings, and dividends.
5. Compare with Peers: Compare the company’s financial ratios with
industry peers to gauge relative performance.
b. Analysis from the Point of View of a Creditor
Analytical Steps:
1. Liquidity Assessment: Analyze the company's Current Ratio and Quick
Ratio to evaluate its ability to cover short-term liabilities.
2. Solvency Check: Review the Debt-to-Equity Ratio to understand the
company's financial leverage.
3. Cash Flow Analysis: Examine the Cash Flow Statement to ensure that the
company generates enough cash from its operations to meet its debt
obligations.
4. Review of Covenants: Ensure that the company complies with financial
covenants set by lenders.
1
assess default risk.
c. Analysis from the Point of View of a Financial Executive
Analytical Steps:
1. Operational Review: Examine operational efficiency ratios like Inventory
Turnover and Receivables Turnover to identify areas for improvement.
2. Profitability Analysis: Analyze Income Statement trends, focusing on
margins and profitability ratios to identify cost-saving opportunities and
revenue-enhancing strategies.
3. Capital Structure Management: Evaluate the Debt-to-Equity Ratio and
the Weighted Average Cost of Capital (WACC) to optimize the company’s
financing mix.
4. Cash Flow Management: Monitor Cash Flow Statements to ensure
sufficient liquidity for operations and strategic investments.
5. Strategic Decision Support: Use scenario analysis and financial modeling
to support long-term strategic decisions.
6. Budgeting and Forecasting: Prepare detailed budgets and financial
forecasts to guide the company’s financial planning and performance
management.
(8) What are the limitations of ratio analysis?
1. Historical Data Dependence: Ratios are typically calculated using
historical financial statements, which may not accurately predict future
performance. They reflect past performance and may not account for
current or future market conditions, economic changes, or company-specific
events.
2. Comparison Challenges: Companies may use different accounting
methods (e.g., FIFO vs. LIFO inventory accounting), making direct
comparisons between firms difficult. Ratios can vary significantly between
industries.
3. Lack of Context: Ratios provide numerical insights but do not offer
qualitative information about factors such as management quality, market
conditions, or competitive landscape.
4. Potential for Manipulation: Companies can engage in creative accounting
practices to present more favorable ratios. Short-term actions taken at the
end of reporting periods to enhance financial statement appearances can
mislead ratio analysis.
5. Inadequate for Short-Term Analysis: Ratios based on annual or quarterly
data may not capture short-term fluctuations and seasonal variations.
6. Over-Simplification: Ratios can oversimplify complex financial situations.
For example, a high current ratio may indicate good liquidity, but it could
also result from excessive inventory, which is not ideal.
(9) What are the critical factors to be observed while making replacement
investment decisions?
Making replacement investment decisions involves evaluating whether to
replace existing assets or equipment with new ones to improve operational
efficiency, reduce costs, or enhance productivity. Several critical factors
should be considered during this decision-making process:
1. Cost-Benefit Analysis: Compare the upfront cost of the new asset with
the potential savings and benefits it will generate over its useful life.
2. Technological Advancements: Assess whether existing equipment is
becoming technologically obsolete. Evaluate how advancements in
technology can improve operational performance and competitiveness.
3. Operational Requirements: Ensure that the new asset aligns with current
operational needs and enhances production capacity, quality, or flexibility.
4. Maintenance and Reliability: Compare ongoing maintenance costs of
existing equipment with those of the new asset. Assess the reliability of
existing equipment and potential downtime costs.
5. Environmental and Regulatory Considerations: Evaluate the
environmental footprint of existing equipment versus new options. Newer
equipment may offer improved energy efficiency. Ensure that replacement
equipment meets current regulatory requirements and standards.
6. Financial Feasibility: Determine how the replacement investment will be
financed (e.g., internal funds, loans, leasing). Consider the impact on cash
flow, debt service, and financial stability.
(10) What is weighted average cost of capital? Explain the rationale behind
the use of WACC
The Weighted Average Cost of Capital (WACC) is a financial metric that
represents the average cost a company incurs to finance its assets,
considering the proportional mix of debt, equity, and other sources of
financing. It is used as a discount rate in financial decision-making processes
such as capital budgeting, valuation, and determining the feasibility of
investment projects.
Rationale Behind the Use of WACC
1. Cost of Capital: WACC reflects the blended cost of equity and debt
financing. It considers the proportion of each component (debt and equity)
in the company's capital structure. Companies aim to achieve an optimal mix
of debt and equity to minimize WACC, thereby reducing the overall cost of
capital.
2. Discount Rate in Valuation: WACC serves as the discount rate for
evaluating potential investments and projects. It represents the minimum
rate of return that a company must earn on its existing assets to satisfy its
investors and creditors.
3. Capital Budgeting Decisions: When assessing new investment
opportunities, such as capital expenditures or acquisitions, companies
compare the expected return on investment (ROI) with the WACC.
4. Determining the Cost of Equity and Debt: WACC helps in determining the
required rates of return for equity and debt holders. The cost of equity is
influenced by investors' expectations of future earnings growth and risk,
while the cost of debt is influenced by prevailing interest rates and the
company's credit risk profile.
5. Capital Structure Decisions: WACC guides decisions on the company's
capital structure. By understanding the impact of changes in debt levels
management can make informed choices that balance financial risk and cost
of capital.
6. Comparison and Benchmarking: WACC serves as a benchmark for
evaluating a company's financial performance relative to its peers within the
same industry. Companies with lower WACC may have a competitive
advantage, as they can potentially undertake investments at a lower cost.
(11) Explain the different approaches to the calculation of cost of equity
capital.

The cost of equity capital is the return that a company is expected to

generate for its equity investors, typically shareholders, in order to
compensate them for the risk they undertake by investing in the company's
stock. Here are the main approaches:

1. Capital Asset Pricing Model (CAPM): CAPM focuses on the systematic risk
(beta) of a company relative to the overall market. It assumes that investors
require compensation for bearing systematic risk, which cannot be
diversified away.
2. Dividend Discount Models (DDM): Assumes that investors value equity
based on the dividends they expect to receive. The cost of equity is
calculated as the dividend yield plus the expected growth rate of dividends.
Applicable when dividends are expected to grow at a stable rate indefinitely.
3. Bond Yield Plus Risk Premium Approach: Additional return required by
investors to compensate for the higher risk associated with equity compared
to risk-free assets. Assumes that the cost of equity is equal to the risk-free
rate plus a risk premium that reflects the additional risk inherent in equity
investments.
4. Build-Up Method: Incorporates various risk factors to estimate the
required return on equity, customized to reflect the specific characteristics
and risks of the company.

15. What is risk?

Ans. Risk is defined in financial terms as the chance that an outcome or
investment's actual gains will differ from an expected outcome or return.
Risk includes the possibility of losing some or all of an original investment.

16. How do you measure Risk?

Ans. There are various methods to measure risk, depending on the context.
In finance, some common metrics include:
.Standard deviation: This captures the volatility of an investment's returns
by showing how much they deviate from the average.
.Beta: This measures an investment's sensitivity to market movements. A
beta of 1 indicates the investment moves exactly in line with the market,
while a beta greater than 1 suggests it amplifies market movements (more
risk).
.Sharpe ratio: This helps assess risk-adjusted returns, considering both
potential gains and volatility.

17. How do you measure the risk portfolio?

Ans. To measure portfolio risk, calculate metrics like standard deviation for
volatility, beta for market sensitivity, and VaR for potential losses. Assess
diversification and use tools like the Sharpe ratio for risk-adjusted return.
Regularly monitor and adjust strategies based on these metrics.

18. What is Beta?

Ans. Beta (β) is a financial metric that measures the volatility of a stock or
investment relative to the overall market. It essentially indicates how much
a stock's price fluctuates in comparison to market movements.

19. Different types of risk?

Ans. Risk is the possibility of something bad happening. It's a part of life, and
there are many different types of risk that we face every day. Some common
types of risk include:
.Financial risk: The risk of losing money on an investment or business
venture.
.Operational risk: The risk of something going wrong in the day-to-day
operations of a business.
.Strategic risk: The risk of making a bad decision about the future of a
business.
Reputational risk: The risk of damaging a company's reputation.
Safety risk: The risk of being injured or killed.
Security risk: The risk of having your personal information stolen or
hacked.
Environmental risk: The risk of damage to the environment.