MCO-07

Important Questions and Answers including Numericals

What is Financial management? State the nature of financial management.

• Financial management means management of finance or funds.
• It is said that the finance is the lifeblood of business.
• Financial management is also called as managerial finance or corporate
finance.
• Financial management is the process of planning, organising, directing and
controlling the financial activities of a firm.
• It involves issues like:
• How to procure funds?
• What are the sources of raising funds?
• where to invest?
• How to manage and control funds?
Nature of financial management
The nature of financial management can be understood by the financial decisions
taken by it. We can divide the financial decisions into 3 categories such as:
1. Investment decisions
2. Financing decisions
3. Dividend decisions
1. Investment decisions it relates to decisions regarding investments in
different assets like securities, assets, instruments, bonds etc. Investment
decisions generally involve the following decisions
• Management of working capital.
• Buying of fixed assets.
• Capital budgeting decisions.
• Analysis of securities.
• Managing these investments and merger.
2. Financing decisions it relates to raising finance through equity and debt
capital. The important decisions relating to financing are:

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 • Identifying the sources of finance.
• Cost of raising finance.
• Analysis of interest rates, taxes and depreciation.
• Requirement of funds.
• Amount of working and fixed capital required.
3.Dividend decisions it relates to how much dividend should be paid to the
shareholders out of the profits earned. The important decisions relating to
dividends are:
• How much dividend should be paid to the shareholders?
• How much funds are to be taken out of profits?
• Determining the market value of present equity shares.
Write a short note on Risk-Return trade off.
• The risk return trade-off is the principle of investment.
• It states that higher the risk, higher will be the reward.
• Risk is directly proportional to reward.
• By using this principle an investor takes his financial decisions.
• It helps him to compare the amount of risk associated with investments.
• It depends on factors like how much risk an investor can sustain and which
stocks can be replaced?
• A proper balance between risk and return should be maintained to
maximise the market value of the investments.
What are the goals of financial management?
1. Maximization of profit.
2. Maximization of return on capital.
3. Growth in the market value of shares.
4. Identification of the sources of finance at minimum cost.
1. Maximization of shareholders wealth When the value of shares of a firm
increases it results in maximization of shareholders wealth. The economic
value of the shareholders wealth is the market price of the shares which is
the present value of all future dividends and benefits expected from the
firm. Wealth maximization is also possible through profit maximization.

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 2. Maximization of return on capital every investor expects maximum return
on his investment. The shareholders of a company also expect good return
on their investment. Therefore, the main object of financial management is
to maximise the return on capital employed by the investors.
3. Market value of shares the growth of a company is reflected by the market
value of its shares. If the market value of the shares is increasing that
means the company is making a steady growth. Therefore, financial
management aims at growing the market value of shares.
4. Optimum level of leverage There are different types of leverages like
financial leverages, operating leverage and mix leverages. In simple words,
it is the earning per share. Therefore, a company always tries to maximise
the leverage.
5. Minimum cost of capital a company can raise funds through debt capital or
equity capital. A firm should consider the cost of capital before raising
funds through various sources. Cost of capital is the return on the capital
invested.
What is the role of a Financial manager?
1. Estimation of the funds required.
2. Appropriate capital structure of the company.
3. Investment decisions.
4. Financing decisions.
5. Dividend decisions.
6. Allocation of funds in the organization.
7. Evaluation of return on capital.
8. Financial negotiations with banks and financial institutions.
9. Relationship with stock exchanges.
10. Increasing wealth of the shareholders and the company.
What is Appropriate Capital Structure? State its features.
• The capital structure in which the equity debt capital is maximum and cost
of capital is minimum is called appropriate capital structures.
• In appropriate capital structure, market value of equity debt capital is
maximum.
• Market value of cost of capital is minimum.
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Features of appropriate capital structure
1. Flexibility
2. Profitability
3. Solvency
4. Control
Flexibility The capital structure of the firm should be flexible and dynamic. That
means it can be changed according to time and situation. If new growth
opportunity comes in future, the company should be capable of getting easy
finance for the same.
Profitability The main object of the firm is to have the capital structure which
ensures maximum returns to the shareholders. Therefore, the amount of capital
structure and its size should be properly designed.
Solvency An appropriate capital structure should have the features of solvency. A
firm should have proper control over its capital structure. Its size should be big
enough to create market value in the market so that a company can easily raise
money from the public.
Control the choice of capital structure should consider that it should not result in
dilution of control of the existing management. Therefore, the firm should raise
more debt capital for an appropriate capital structure.
Discuss the Net Income (NI) Approach of capital structure.
• Net income approach was introduced by Durant.
• According to this theory, the market value of a company can be increased
by decreasing the cost of capital and increasing the debt capital.
• Cost of capital is measured by weighted average cost of capital (WACC).
• Debt capital is a cheaper source of capital as compared to equity capital.
Assumptions of Net Income Approach
1. There are only two sources of capital such as debt capital and equity
capital.
2. The market value of a firm is not affected by an increase or decrease of
debt capital.
3. All companies have uniform dividend pay-out ratio of 1:1.
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 4. There are no transaction costs, taxes etc.
5. There is perfect competition in the market which means all the companies
are known to investors.
6. Investors are rational that means they want maximum returns on their
investments.
Why do firms pay dividends? Explain the advantages of stable dividend policy.
• Income earned by shareholders on their investments is called dividends.
• During a given year, if a company earns sufficient profits, it is likely to
distribute a part of its profit among the shareholders after retaining some
profit.
• But not all companies pay dividends.
• It depends on the policy of the company whether it wants to reinvest the
whole of the prophets for its growth and expansion or boot distribute apart
of profit as dividends.
Advantages of paying dividends
1. Investors usually like dividends.
2. It builds confidence among shareholders that the firm has good financial
position.
3. It increases the demands for their stocks.
4. It increases the market value of their shares.
5. The company has stable growth.
6. It increases the market worthiness and the company can get loans from the
market easily.
7. Regular dividend acts as a source of income for few shareholders.

Describe the rational of buyback of shares. Discuss the advantages for

shareholders and the company.
• Buyback of shares refers to repurchase of shares by a company which it had
issued earlier to the shareholders.
• It is done by paying the shareholders back at market values either in the
open market or directly.

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Advantages of buyback of shares
1. It helps to reduce excess share capital not required by the company at
present.
2. It helps to increase the reserves of a company.
3. It helps to protect against unfriendly takeovers from other companies.
4. It increases earning per share and P/E ratio.
5. It increases the market value of shares of the company.
6. If a company thinks that its share prices are low as expected it can go for
buyback of shares.
7. It results in saving taxes.
8. It boosts the prices of shares.
9. A company can use excess amount of cash for its growth and expansion of
business.
Explain the objectives of Credit policy. What is the role of credit period and
credit standard in the credit policy of a firm?
• Credit policy refers to the decisions on the maximum amount of credit that
will be allowed to customers.
• In simple words, amount of risk a firm is willing to undertake in its sales
activities is called its credit policy.
• A credit policy may be of two types such as liberal credit policy and rigid
credit policy.
• In liberal credit policy, a firm allows credit facilities freely without much
hesitation.
• In rigid credit policy, limited amount of credit is allowed to customers.
Objectives of credit policy
1. To increase sales the most important object of a credit policy is to increase
the sales and profits of a company. some customers are unable to pay
immediate cash so they opt for credit.
2. To increase profits which are directly linked to sales. More the sales more
will be the profit. A firm can earn high profits in credit sales.
3. To maintain liquidity stocks can be converted into cash immediately. There
is no chance of deadstock.

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 4. To meet competition a sound credit policy can challenge the competitors
of the firm. A firm should have a lucrative credit policy to beat its
competitors.
Role of credit period
• The time period allowed to customers to pay for their purchases is known
as credit.
• It directly affects investments.
• Longer the credit period, longer will be the investments.
• Long credit periods increase the chances of bad debts.
• Some factors should be considered while framing a proper credit.
1. Buyers stock turnover.
2. Nature of commodity.
3. Profit margin.
4. Availability of funds.
5. Competitors policies.
Role of Credit standard
• This is the most important base to decide credit policy.
• Credit policy should be designed according to the standard of customers.
• It should be well balanced.
• The factors that affect credit standard are
1. Creditworthiness of a customer.
2. Capacity to pay.
3. Character of the customer.
4. Capital invested by the customer.
5. Collateral or security offered by the customers.
What is the concept of risk and return? State the different types of risks.
• Risk is the possibility of adverse happening.
• If a situation is deviated largely from the expectation, risk arises.
• There are three states of possibilities such as certainty, uncertainty and
risk.
• Certainty is a happening of an event with zero deviation.
• Uncertainty is the happening of an event with large deviation.

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 • Risk lies between certainty and uncertainty.
• There are some statistical tools to measure risks such as
1. Standard deviation,
2. Variance,
3. Coefficient of variation,
4. Skewness
5. Probability distribution.

Different types of risks

Risk may be of 2 types such as
1. Systematic risk
2. Unsystematic risk

1. Systematic risk
• This type of risk is caused by external factors such as change in economic
conditions, political uncertainty and social conditions.
• It affects the whole economy and is also known as market risk.
• Systematic risks can be classified into 4 categories such as
1. Interest rate risk in this type of risk the government changes the rate of
interests.
2. Market risk this type of risk is associated with stock market. It arises due to
the change in attitude of the investors.
3. Exchange rate risk this type of risk arises due to devaluation of domestic
currency.
4. Political risk this type of risk arises due to in stable government, riots, wars,
frequent elections and in stable government.

2. Unsystematic risk
• This type of risk arises due to internal events in the organization.
• The firm has control over such risks.
• Examples of unsystematic risks are equipment failure, power cut, labour
problem, change in top management etc.

Systematic risk Unsystematic risk

These risks arise due to external factors. These risks rise due to internal
factors.

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 External factors include change in Internal factors include labour
economic conditions, political problems, equipment failure, over
conditions and social conditions. management etc.
The main components of systematic These risks are also known as
risk are market risk, interest rate risk specific risk.
and income risk.

Concept of Return
• Return is something which is received back.
• The amount of benefit received by an investor from his investments is
known as returns.
• There are different types of returns such as
1. Book Return and Market Return: Book return is calculated from the
accounting books. it is also known as return on assets. Calculations are
made by using various variables like capital employed, earnings per share,
dividends per share etc.
On the other hand, market return refers to the returns calculated on the
basis of market values of the assets of a company. The market value of
assets generally fluctuates from time to time.
2. Single period Return and multi period Return: Single period returns are
calculated for a particular period of time. These are calculated for only a
year. On the other hand, multi period returns are calculated for different
periods.
3. Ex-ante (expected) Return and Ex-post (realised) Return: Ex-ante return is
the one that an investor hopes to get from his investment. There is no
guarantee that what the investor has hoped for would come true. It is
calculated by adding anticipated dividend and anticipated market price
divided by initial investment.
Whereas, the Ex-post return is the actual or realised return. It is calculated
by adding actual dividend received and actual market price divided by initial
investment.
4. Security Return and Portfolio Return: Security return refers to the return
received from single investment. Whereas, portfolio return refers to the
returns received from multiple investments.

Write a short note on Capital Asset Pricing Model (CAPM)

• This model tells us the relationship between risk and return.

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 • According to this model greater the risk of a security, greater will be the
return.
• There is an implied equilibrium relationship between risk and return.
• More the unavoidable risk more will be the return on investment.
• Returns is directly proportional to risk.

Assumptions of the model

• Investors make their decisions only on the basis of expected return and risk
associated with the security.
• An investor cannot influence the price of the stock in the market.
• Investors can lend or borrow funds add the riskless rate of interest.
• There are no transaction costs involved in buying and selling of stocks.
• There is no personal income tax.

Write a short note on Arbitrage Pricing Theory.

• This model was developed by Stephen Ross.

• Arbitrage is a process of earning profit by taking advantage of differential
pricing for the same asset.
• This process generates riskless profit.
• According to this model, security should be sold at a high price and
simultaneously we should purchase the security at relatively lower prices.
• The difference between the high price and low price gives us the maximum
return on investment.
• According to this model, profit can be earned through arbitrage or riskless
process.
• According to this model, returns on the securities are influenced by a
number of macro economic factors such as industrial growth rate, rate of
inflation, interest rates etc.

Assumptions
• The investors have homogeneous expectations.
• The investors are risk takers and want to maximise returns.
• There is perfect competition in the market.
• There is no transaction cost.

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Explain the ABC analysis of inventory control
• Under this method stocks are divided into 3 categories such as A, B and C.

Category A
• Stocks included in category A are the most important.
• They have high consumption rate.
• Strict control is required on these stocks.
• The items in category A are generally expensive.
• Nearly about 75% of the value of consumption is from category A.

Category B
• It contains items of moderate value.
• These items do not require strict control.
• Nearly about 20% of the consumption is from category b.

Category C
• This category contains items of least value.
• They do not require much control.
• They are consumed nearly about 25% of the total value.

Write a short note on Just-In-Time technique of inventory control.

• According to this technique, goods are ordered only when they are needed.
• The main object is to control stocks of goods.
• It helps to reduce inventory wastage.
• It helps the producer to concentrate more on production rather than
handling stocks.
• It helps producers to produce good quality of products.
• Producers are burden free.
• It needs small investments.
• This model is suitable for computer appliances, electronics producing
companies.
• Producers must have good relationship with the suppliers so that
purchasing can be done in time.
• There is no risk of overproduction.
• A firm can concentrate more on consumers satisfaction.

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Write a short note on Factoring

• It is a financial transaction in which a firm sells its accounts receivables or

invoices to a 3rd party or factor at a discount.
• It is done to meet immediate cash requirements.
• There are 3 parties involved in factoring such as seller, factor and debtor.
• A factor gets the right to collect from the debtors.
• It is also known as invoice discounting.
• Factoring is more popular method used by exporters in international trade.

Write a short note on Financial leverage.

• Financial leverage is a technique of using debt instead of equity to acquire

assets and projects.
• It is also known as trading on equity.
• Companies should maintain a proper balance between debt and equity.
• They must generate a higher rate of return than the rate of interest to be
paid on debts.
• Financial leverage is suitable for companies which are in profits.
• There are many types of leverage ratios to determine the financial health of
a firm such as debt-capital ratio, debt-equity ratio etc.

What is Cost of Capital? State the different types of cost of capital.

• Cost of capital is the rate of return the firm requires from investment in
order to increase the value of the firm.
• It is the weighted average cost of their different sources of financing.
• In simple words, the minimum rate of return required from investment is
known as cost of capital.

Types of cost of capital

1. Explicit cost of capital & Implicit cost of capital Explicit cost of capital is the
present value of the funds received by the firm with the present value of
expected cash outflows. In simple words, explicit cost refers to raising of
funds.
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On the other hand, implicit cost refers to the rate of return associated with the
best investment opportunity for the firm. In simple words, implicit cost refers to
the uses of funds.
2. Specific cost of capital and combined cost specific cost of capital refers to
the individual component of capital whereas, combined cost of capital is
the average cost of capital. Combined cost of capital is mostly used by a
company while taking decisions regarding accepting or rejecting a proposal.
3. Average cost and marginal cost the average cost is the weighted average of
the cost of each component of funds. On the other hand, marginal cost of
capital is the weighted average cost of new funds raised by a firm.
4. Future cost and historical cost future cost is also known as expected cost of
funds to finance a project. It includes all the expected costs associated with
the project. On the other hand, historical cost refers to the past costs which
were incurred while executing a project.

Write a short note on Securitization

• It is a process of converting debts or illiquid assets into securities which are

traded to raise money.
• It helps to raise funds easily.
• It helps in liquidity of assets.
• It assures good return to investors.
• This process involves 3 parties such as originator, special purpose vehicle
(SPV) and investors.

What is Working capital? State the objectives of working capital. What are the
factors that influence working capital requirement?

Working capital refers to the capital used to meet day to day operations of a
company. Working capital is the difference of current assets and current
liabilities.

Objectives of working capital

• To strengthen the liquidity position of the firm.

• To smoothen operating cycle.
• To manage cash flows.

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 • Optimal return on investments.

Factors influencing working capital requirement

1) Nature of business- A manufacturing company needs more fixed capital

than a trading company.
2) Scale of the unit- If the size or scale of business is large, it requires large
amount of fixed capital.
3) Method of production- Capital intensive organisation requires more fixed
capital than labour intensive organisation.
4) Technology- If an organisation uses modern technology, it needs more
fixed capital. Whereas if an organisation uses old technology, it needs less
capital.
5) Growth prospects- Higher growth of an organisation generally requires
higher investment in fixed assets.

Discuss the methods available to finance working capital requirements.

The two main ways of financing a business are equity financing and debt financing.
There are two methods to finance working capital requirements such as:

A. Informal forms of credit

1. Trade credit
2. Stretching accounts payable
3. Accrued expenses and deferred income

B. Formal credit arrangements

1. Commercial paper
2. Bank credit
3. Line of credit
4. unsecured and secured borrowing
5. Inventory loans

Trade credit when firms purchase goods and services on credit terms, it is known
as trade credit. It is generally given on open account basis. The supplier evaluates

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the creditworthiness of the buyer before giving trade credit. This method is more
attractive and not very difficult and therefore firms prefer this method of credit.

Stretching accounts payable is also a very attractive source of credit. The firm may
have to pay interest on the extra credit period.

Accrued expenses at deferred income expenses which are due but not paid are
called accrued expenses. Deferred income consists of payment received from
customers for goods and services yet to be delivered.

Commercial paper is a short term unsecured promissory note issued by large

corporations. The maturity could range from days to months. Commercial paper is
typically bought by large corporations and banks with surplus funds to invest. This
is not very reliable form of funding and may not be available to corporations at all
points of time because they are dependent on external market conditions.

Bank credit arrangements it is available in several different forms such as working

capital term loan, cash credit, overdraft, bill discounting, etc. each of these options
have interest and maturity.

Line of credit is an agreement between the bank and the borrower wherein, the
bank promises a certain line of credit permitting the company to borrow up to that
limit during a specified period. It is available when the company needs it and it is
quite flexible.

Unsecured and secured borrowing unsecured borrowings refer to the borrowings

in which there is no mortgage or security kept by a company. This source of credit
has high rate of interest and requires creditworthiness of the borrower. Whereas,
secured borrowings can be undertaken by keeping assets mortgage for security.

Inventory loans can be taken loans from financial institutions and banks on the
basis of stocks or inventory they have. These inventories act as collateral or
mortgage for short term borrowings.

What is Lease financing? Discuss the differences between lease finance and hire
purchase finance.

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 • A lease is a contract whereby the owner of the asset grants to another
party the exclusive right to use the asset, usually for an agreed period of
time, in return for the payment of rent.
• The lease contract may vary from few hours to the entire life of an asset.
• The lessee pays fixed rent in instalments over period of time.
• In the lease agreement, options may be given to lessee to renew the lease
for another lease period or to purchase the asset after the termination of
the agreement.
• It is an arrangement whereby a firm uses an asset without actually buying
the same.
• It is a form of renting a fixed asset.
• The owner of the asset is called lessor and the user is known as lessee.

Difference between leasing and hire purchase

Leasing Hire Purchase

The user of the asset or the lessee The hirer is deemed to be the
is not the owner of the asset. owner of the asset.
A lessee cannot claim depreciation Depreciation can be claimed by
on asset. the hirer.
Lessee cannot charge depreciation A hirer may charge depreciation
to profit and loss account. to profit and loss account.
The rent paid by lessee is a tax- In hire purchase, the interest
deductible expense. paid on loan is considered as a
revenue expenditure and hence
tax deductible.
The asset is not shown in the The asset is shown in the balance
balance sheet of the lessee. sheet of the hirer.
It is done usually for industrial It is generally done for vehicles.
equipment.

Discuss various forms of lease finance.

Generally, leases are classified into:

1. Financial lease
2. Operating lease
3. Direct leasing
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 4. Sale and leaseback
5. Leveraged leasing
6. Sublease and secondary lease

Financial lease
• In this type of lease, the lease period is generally equal to the expected
economic life of the assets.
• The lease agreement cannot be cancelled.
• The lessee has to pay fixed rents until the lease period expires.
• The lessee has the exclusive right to use the asset for a period of time.
• The lessee may purchase the equipment after the expiry of the agreement.
• This type of lease is more popular in costly equipment like locomotives,
earthmoving equipment, office equipment, plant and machinery, textile
machinery, etc.

Operating lease
• In this type of lease, the lease period is less than the expected economic life
of the assets.
• The lease contract can be cancelled with proper prior notice.
• The lessor is expected to maintain the assets in good working conditions.
• It is also known as short term or maintenance lease because the lease
period is usually for a short period which may stretch from one day to 5
years.
• The lease rent is generally higher.
• This type of leases is more suitable for highly sensitive equipment like
computers, automobiles, office equipment, etc.

Direct leasing
• In this type of leasing, accompany acquires the right to use an asset which it
did not own previously.
• The manufacturers sell the asset to the lessor, who in turn, leases it to the
lessee.
• Lessee firm may also lease the asset from the manufacturer directly.
• The important lessor may be manufacturers, finance companies, banks, etc.

Sale and leaseback

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 • In this type of lease, a firm, that owns a given asset sells it to the leasing
company and gets it back on lease.
• Usually, the asset is sold at the market value.
• The lessee receives the sale price in cash and the economic use of the
asset.
• The lessee has to pay lease rent periodically.
• The lessee pays all the maintenance expenses, property taxes, insurance,
etc.
• The lessee may purchase the property after the termination of the
agreement.
• This type of leasing is more popular in retail stores, office buildings,
multipurpose industrial buildings, etc.

Leveraged leasing
• This type of leasing has been popular in recent years.
• There are 3 parties involved in leveraged leasing such as the lessee, the
lessor and the lender.
• The lessor acquires the asset and finances the asset in part by an equity
investment.
• The remaining part is financed by a long-term lender.
• The lessor is the borrower in this type of lease.
• This loan is secured by a mortgage on the asset.
• This type of leasing is more popular in aircraft, railroad, coal mining, electric
power plants, pipeline, ships, etc.

Sublease and secondary lease

A sublease is the type of lease in which the original lazy lease is a part of the asset
to a 3rd party.

Explain the various benefits and costs of lease financing.

Advantages
• Risk of ownership of asset is avoided. When a firm purchases machinery it
has to bear the risk that the machinery may become obsolete before the
completion of its service life. However, this risk can be avoided by taking
the machinery on lease.

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 • Convenience of payment. Leasing enables the lessee firm to make full use
of the asset without making immediate payments of the purchase price
which it would otherwise have been required to pay.
• Tax advantage. leasing can provide the tax advantages to the lessee. When
a company acquires an asset on lease, the full amount of the lease
payments is deductible for tax purposes.

Disadvantages / Problems in lease financing

• Expensive. Leasing may prove to be costlier than a straight purchase
particularly in the case of leveraged leasing where the lessor is only the
financial intermediary who has obtained finance from banks and has added
to the cost his own profit.
• Strict actions against defaulters. If the lazy fails to pay the lease rent
regularly strict actions are taken against him.
• Lessor loses the economic value of the asset at the end of lease term. The
lazy may not maintain the asset properly and thereby the value of the asset
decreases rapidly.
• Risk of obsolescence. After the expiry of the lease agreement, the
equipment may be obsolete and not usable anymore. therefore, the asset
loses its economic value add utility. Because technology is rapidly changing
and the asset may prove to be a useful.
• Competition With rising competition, the major players are diverting their
activities to other activities. it has been reported that the rate of interest is
13% to 14% only which is below the average cost of capital.
• Lack of qualified personnel In India, the concept of leasing business is a
recent one and naturally it is very difficult to get the right person to deal
with the problems of this new business. The leasing companies have to
develop expertise in handling new types of business.

What are the factors that affect the valuation of securities?

1. Nature of business.
2. Demand of shares.
3. Past performance of the company.
4. Growth prospects of the company.
5. Management of the company.
6. Accumulated reserves.

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 7. Dividend declared.
8. Government policies.

Write a short note on Capital rationing.

• It is a process of imposing restrictions on the number of new investments

or projects undertaken by a company.
• The project is to ensure that capital has been used properly and there will
not be any shortage of funds.
• It is a management function of allocating funds to various investment
projects.
• It helps to achieve optimal use of available capital.

What is Safety stock? State its role.

• It is the additional inventory held by a company to avoid the risk of stock

out due to fluctuations in demand and supply.
• It is also known as emergency stocks or buffer stock.

Role and importance

• It helps to meet uncertain demand of stocks.

• It helps to carry out smooth production process.
• It avoids stock outs.

What are the objectives of Inventory management?

Inventory management is the process of ordering, storing and using inventory.
The main object is to avoid overstocking and understocking of inventory.

Objectives
• To ensure continuous supply of raw materials.
• To avoid overstocking and understocking of inventory.
• To maintain minimum working capital.
• To reduce order costs, holding cost and transport cost.
• It reduces wastages.
• It helps to maintain systematic record of inventories.

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What are the sources of long-term finance?

1. Retained earnings
2. Equity capital
3. Preference capital
4. Debentures and bonds
5. Term loans
6. Venture capital

Retained earnings
• These are the earnings of a company for the current accounting year after
distribution of dividends.
• It also includes accumulated profits of the past periods like reserve fund.
• Retained earnings are those earnings that are kept as reserves in the form
of various reserve accounts.
• They are shareholders funds and are used for the purpose of capital or
revenue expenditure of the company.
• They may be distributed as bonus shares to the existing equity
shareholders.
• Have retained earnings can be used for buying back shares, have
reinvesting for growth, paying off the debts, etc.
• it is one of the best sources of long-term finance for a company.

Equity capital
• The stock or shares of a company issued to investors is called equity capital.
• It is of 2 types such as equity shares and preference shares.
• Equity capital is divided into a number of equal parts known as shares
having a specified nominal value.
• Dividends on equity shares is paid after paying dividends to the preference
shareholders.
• Whenever a company needs finance, it can issue equity capital to raise
money.
• It is one of the major sources of long-term finance.
• It has no maturity and as long as the company exists its equity capital also
exists.

Preference capital
SANTOSH SHARMA 21
 • Preference shares have preferential rights to receive dividends at fixed rate
and repayment of capital at the time of winding up of a company.
• They carry a fixed rate of dividend.
• Preference shares may be of different types such as cumulative and non
cumulative preference shares, redeemable and irredeemable preference
shares, convertible and non convertible preference shares.
• Preference shareholders are less risky.
• They don’t have voting rights in the management of a company.

Debentures or bonds
• Debenture is a document acknowledging a loan made by a company.
• A fixed rate of interest is paid on debentures.
• Debentures are also transferable like equity shares.
• These are also of different types such as transferable and non-transferable
debentures, redeemable and irredeemable debentures.
• It is also one of the major sources of raising funds buyer company.

Term loans
• These are loans taken from banks and financial institutions to purchase
fixed assets.
• The period of loan may vary from 3 years to 10 years.
• The borrower has to pay a fixed amount at regular intervals of time.
• Term loans carry a fixed or floating interest rate.
• These loans are generally taken by small business organisations.
• The borrower may need to pay down payment or keep mortgage to avail
such loans.
• These are the primary sources of income for banks and financial
institutions.
• Term loans may be of 3 types such as short-term loans, medium term loans
and long-term loans.
• Short term loans are generally for less than one year.
• Medium term loans are generally between one to 3 years.
• Long term loans are taken up to 30 years.

Venture capital

SANTOSH SHARMA 22
 • It is an equity capital seeking investment in new companies, new ideas, new
production, new processes or new services that offer the potential of high
returns on investment.
• Venture capital is used to finance high risk ventures.
• The ventures are generally new and sunshine industries but may also be old
and risky ones.
• These enterprises have a high mortality rate and therefore do not find
finance from banks or private sector companies.
• It does not look into current income but returns off future expectations.
• Venture capitalists finance new, young and rapidly growing or changing
companies.
• They help to invent or produce new products and services.
• They take high risks with the expectation of higher rewards.
• They have a long-term investment plan.
• Venture capitalist also work actively with the management of the company
and frames strategy.

What is Capital budgeting? State its processes.

• It is a process of making capital investment decisions.

• Capital investment expenditures include expenditures on plant and
machinery, equipment, land and building, and all other fixed assets.
• These expenses are generally of higher amounts.
• The decisions taken on capital expenditures are not reversible.
• These decisions are generally long-term decisions taken by the company.
• Capital budgeting decisions are taken after analysing the initial outflow of
funds compensated by future inflow of funds.
• This is a very complex and critical decision taken by the finance manager
because future is uncertain.
• It is very difficult to predict the cost and benefit associated with a given
project.

Processes
1. Generation of idea the whole process of capital budgeting decision starts
with an idea. The owner or the top executive of a company identifies the
business opportunity and then ask their subordinates to gather information
about the opportunity.
SANTOSH SHARMA 23
 2. Estimating cash flows the next step is to estimate the cash flows of the
project. In this step the cost of the whole project including different types
of costs are calculated and estimated.
3. Evaluating cash flows then evaluation of cash flows is done carefully. It is
done to find out the certainty and future value of the project. This is one of
the most complex functions of the finance manager.
4. Selecting a project the next step is to select the appropriate project or the
most suitable project among the various alternatives. Pros and cons of the
projects are properly analysed before taking the final decision.
5. Execution of the project Finally, the execution of the project it has to be
started by a team of engineers, financial experts, marketing experts under
the leadership of the owner or the executive. Proper monitoring of the
implementation process is very important to avoid time and cost vestige.

What are the different types of Capital budgeting projects or expenditure or

project investment?

1. New project It refers to expenditure on creation of new assets. For

example, setting up a new factory or building. These projects are generally
of big size and takes a long time for completion.
2. Expansion of existing project in this type of project the existing project is
expanded and developed. More investment is done on the existing project
rather than new project.
3. Renewal project It refers to the renovation of the projects. Here
expenditure is done to replace old machineries and plants. New machinery
is installed and new technology is adopted.
4. Research and development project Research and development projects
are those projects in which present expenditure is being incurred to get a
new product or design in future. this type of project takes a long time for
completion and there is a degree of uncertainty too.

Describe the requisites of a good method of investment appraisal.

• It should be based on cash flows rather than on profits or expenditure.

• Cash should be covered for the entire expected life of the asset rather than
few years only.
• It should give the absolute value of gain or loss.

SANTOSH SHARMA 24
 • It should consider time value of money.
• It should show relative profitability between different alternative projects
to make a better comparison analysis.
• It should indicate the degree of risk associated with the investment.

What are the different methods of Capital budgeting?

The following are the different methods of capital budgeting

1. Payback Period
2. Accounting Rate of Return (ARR)
3. Discounted payback

Payback Period
• It is the time duration required to recover the initial cash outflows or
expenditures.
• This is also known as pay off or capital recovery period method.
• Payback. Is calculated by initial cash outflow / annual cash inflow.
• For example, if a company spends ₹50,000 on any project and expects that
within 2 years it will get back the amount, then the payback. Is 2 years.
• Shorter the payback, higher will be the ranking of the investment proposal.

Advantages
• This method is easy to understand and use.
• This is one of the most popular methods widely used for initial screening of
the project.
• The risk associated with the project can be easily calculated.
• This method is quite suitable for small projects.

Limitations
• It takes into account only early cash flows and ignores the future cash
outflows.
• This method ignores time value of money.
• This method is considered only a measure of capital recovery and it is not a
perfect measure for profitability.

Accounting Rate of Return (ARR)

SANTOSH SHARMA 25
 • It is the average of the rate of return for different years for the whole life of
an asset.
• It is a ratio between the Net Profit After Tax (PAT) and the amount of initial
investment.

Advantages of ARR
• It is a simple method involving the calculation of averages.
• It is easy to understand because easy accounting information like EBIT, PAT,
depreciation, investment etc. are considered.

Disadvantages of ARR
• It is not properly defined because we do not know whether to use EBIT or
PAT.
• Accounting information itself are not very accurate and subject to many
assumptions.
• It ignores time value of money and hence not suitable for scientific decision
making.

Discounted payback
• In this method, the discounted cash flows of different years are considered
to calculate the payback period.
• In other words, the number of periods taken to recover the investment is
calculated on the basis of present value of the cash outflows.
• Obviously, this method takes a longer time to calculate payback.

Advantages
• This method is more accurate and reliable.
• It considers the time value of money.

Limitations
• This method is too lengthy and takes a lot of time to calculate payback
period.
• This method is not very popular because it is a very complex method and
involves a lot of mathematical calculations.

What are the different Scientific methods of investment appraisal? State their
merits and demerits.
SANTOSH SHARMA 26
There are basically three scientific methods of investment appraisal. These are:
1. Net present value method.
2. Profitability index method.
3. Internal rate of return method.

Net Present Value Method (NPV)

• It is the net present value of all cash flows that occur during the entire life
span of a project.
• The total cash flows occurred during the completion of a project is called
Net Present Value.
• The outflows will have negative values while the inflows will have positive
values.
• If the cash inflow is greater than outflow, then NPV is positive.
• If cash inflow is less than cash outflow, there is a negative NPV.

Advantages
• It is quite scientific technique of capital budgeting.
• It considers time value of money.
• It is an absolute value.
• NPV of two or more projects can be added up.

Limitations
• Comparison of two or more different projects is a complex process.
• NPV is not applicable in case of change in rate of interest.

Profitability Index Method

• It is a ratio between present value of inflows and present value of outflows.
• If profitability index is greater than 1, the project should be accepted.
• If the profitability index is less than 1, the project should be rejected.
• This method is also known as benefit-cost ratio method.

Advantages
• It is a more scientific method and reliable.
• It considers the time value of money.
• It gives a relative measure of a project’s profitability.

SANTOSH SHARMA 27
Internal rate of return method (IRR)

• IRR is the rate of discount at which NPV is zero.

• It shows the relationship between the rate of discount and the NPV.
• There is always an inverse relationship between NPV and discount rate.
• If discount rate increases NPV decreases and vice versa.
• Therefore, IRR is the rate when NPV is zero.
• It is also known as marginal rate of return.
• If IRR is greater than the discount rate or cost of capital, the project should
be accepted.
• A project with higher IRR should be ranked higher than other projects.

Advantages
• It considers the entire cash flows of a project. Therefore, it is more reliable
and accurate.
• It takes into account time value of money.
• It is useful in ranking of projects because it is a rate and not any absolute
value.
• It is not dependent of any external rate.
• It is useful to assess the margin of safety in a project.
• It is more scientific in terms of cost and return.

Distinguish between NPV and IRR.

NPV

1. Net present value (NPV) discounts the stream of expected cash flows
associated with a proposed project to their current value, which presents a
cash surplus or loss for the project.
2. NPV refers to netting the present value of the initial investment.
3. Here cash inflows are conventional.
4. The cost of capital is considered discount rate at the NPV method.
5. In this method, if the net present value of a project is mite that is accepted.
6. It is easy than IRR.
7. The NPV method presents an outcome that forms the foundation for an
investment decision since it presents a dollar return

IRR

SANTOSH SHARMA 28
 1. The internal rate of return (IRR) calculates the percentage rate of return at
which those same cash flows will result in a net present value of zero.
2. IRR is defined as that discount rate that equates the PV of projects
expected cash inflows with its initial cost or the present value of the
outflow.
3. Here cash inflows are unconventional.
4. The discount rate is calculated by trial-and-error method.
5. In this method, if the IRR is greater than discount rate that is accepted
6. It is difficult than NPV.
7. The IRR method does not help in making this decision since its percentage
return does not tell the investor how much money will be made.

What is Project financing? State the requirements for project financing.

• Project financing is the most popular form of financing large infrastructure

projects.
• Project financing is financing of a project as an Independent economic unit.
• Cash flows from the project is used to recover the investments made by the
sponsors.
• It is a source of raising funds through loans for mega projects in power,
telecommunication, roads, railways, oil and gas etc.
• A special purpose vehicle (SPV) is created for the project. For example, the
construction of Konkan railways project, Konkan Railway Corporation
limited was created as SPV.
• The funding of long-term infrastructure, projects and public services is
known as project financing arrangements.
• The loan is repaid from cash flows after the completion of the project.
• There are two types of financing arrangements such as debt financing and
equity financing.
• Funds are arranged from public and private companies.

Requirements of project financing

• Environmentally friendly technology: The technology used for the project

should be latest and environmentally friendly. For this purpose, the
opinions of consultants and engineering firms should be taken.

SANTOSH SHARMA 29
 • The project should have economic value after completion. The project
should be completed within the stipulated date. it should start generating
cash close to recover the investments.

• Availability of factors of production: It should be ensured that raw

materials and labour should be available near the site of the project.

• Professional management: The project must have competent management

in order to ensure successful execution of the project.

Identify different risks associated with project financing.

1. Completion risk
2. Technological risk
3. Raw material risk
4. Maintenance risk
5. Economic value risk
6. Financial risk
7. Political risk
8. Environmental risk

Completion risk refers to the risk that project may not be completed within time.
If the project does not get completed in time, it will affect the lenders the most.

Technological risk as we know technology changes very fast. There is every

chance of change in technology during the completion of the project. The project
may not meet the desired quality specifications.

Raw material risks the quality and quantity of resources availability is critical to
the project success. availability of resources ensures smooth operation of the
project.

Maintenance risk the ability of the management of the SPV who successfully
operate and maintain the plant after its implementation is important for the
project to be successful.

SANTOSH SHARMA 30
Economic value risk the economic risks refers to the market demand for the
project output and its market price. The demand for the project may not be
sufficient in order to recover the investments of the sponsors. The prices maybe
very competitive making the project margins very low.

Financial risk generally there is a very high debt ratio in case of project finance. If
the debt carries floating rate of interest, there is a possibility of rising interest
rates wish me affect the profitability of the project.

Political risk There may be a change in the government policies towards the
execution of the project. If there are frequent elections in that country and has an
environment of political instability, it will badly affect the execution of the
project.

Environmental risk when the environmental impact causes a delay in the

completion of the project it creates environmental risk. Therefore, a proper
assessment of the environment must be made before the start of the project.

Distinguish between corporate finance and project finance.

Corporate finance Project Finance

The board of directors monitors and The special purpose vehicle is
control the overall performance of appointed to manage project
corporate finance. finance.
The debt ratio is generally very low. The debt ratio is generally very
high.
A company can raise finance quickly in In case of project financing. it is
case of corporate finance. highly structural and involve a lot of
transaction costs.
The company is a going concern that The SPV has a specific life and
means it has perpetual succession. comes to an end once the
concession period is over.
The board of directors take decisions The SPV cannot take such decisions
regarding cash flows to be paid as regarding distribution of profits and
dividends and reinvestment. cash flows.
The lenders have interest in the The lenders Decide on the strength
balance sheet of a company. of the project assets and future cash

SANTOSH SHARMA 31
 flows expected to be generated by
the project.
All the projects undertaken buy a each project is a separate legal
corporate are reported together in the entity and therefore have separate
balance sheet. balance sheet.

What is Modigliani and Miller Proposition.

Modigliani and Miller (MM)

• In a series of papers that would lead to a Nobel Prize, M&M made important
contributions to understanding the relationship between a firm's capital
structure, value, and cost of capital.
• In the absence of taxes, firm capital structure is irrelevant.
• With taxes, a firm's cost of capital can be lowered through issuing debt. This
highlights the importance of debt as a tax shield.

MM Proposition I (No Taxes)

Assumptions
• There are no taxes.
• There are no transaction costs.
• Both individuals and corporations can borrow at the same rate.

In this case MM show that: The value of the levered and unlevered firms is the
same.

MM Proposition I (No Taxes)

This result rests on the assumption that individuals and corporations can borrow at
the same rate.

• If they do, and leveraged firms are priced higher than unleveraged firms,
then investors can buy the unleveraged firms on margin.
• By doing so investors create leveraged firms, which increases the values of
these firms, earning the investors profits.

SANTOSH SHARMA 32
 • The key here is that it does not matter to the investor if the debt is held by
the company or by the investor herself. The latter case is termed homemade
leverage.

MM Proposition II (No Taxes)

The cost of equity rises linearly with leverage according to the equation: RE=R0+DE

• RE is the return on equity.

• R0 is the return on the firm's unlevered equity.
• RD is the return on the firm's debt.
• D and E are the market values of the firm's debt and equity respectively.

MM Proposition II (No Taxes)

• The cost of debt is generally less than the cost of equity.

• What MM II says is that if you increase borrowing to get the cheaper rate,
you will also increase the amount you will have to pay on your equity.
• So, in effect, you cannot lower your cost of capital by exchanging debt for
equity.

MM Proposition I (With Taxes)

• If we now allow for taxes, the firm can increase its value by financing with
debt. This is because debt allows the firm to pay less in taxes.

• So, in the case of perpetual debt the value of the levered firm is VL=VU+tcD.

• Without taxes the firm does not benefit from financing with debt

MM Proposition II (With Taxes)

• With corporate taxes there is still a positive relationship between leverage

and the cost of equity, however the cost of equity is lower than it would be
without taxes. The exact relationship is:

RE=R0+RD(1-tc)

What are the different approaches for valuation of equity shares?

SANTOSH SHARMA 33
Valuation of equity shares is rather difficult as the cash flows are not stable and
measurable. The two important methods to value equity shares are
1. Dividend capitalization approach.
2. Earning capitalization approach

1. Dividend capitalization approach

• This approach assumes that dividends do not grow in futures rather

dividends grow at a constant rate or multiple rates in future.
• This approach can again be subdivided into 2 parts such as single period
and multiple periods.
• Single period valuation assumes as one year and the formula is
𝐷1 +𝑃1
• 𝑃0 = 1+𝑟
𝑃0 = = current price of shares
𝐷1 == Expected dividends
𝑃1 == Expected price after one year
r= required rate of return
• In multiple period valuation, it is assumed that equity shares have no
maturity period. They are paid dividend for an indefinite period of time.
therefore, the formula is

𝐷
1 𝐷 2 𝐷 3 𝐷
𝑛
𝑃0 = (1+𝑟) 1 + (1+𝑟)2 + (1+𝑟)3 +……………..+ (1+𝑟)𝑛

3. Earning Capital Approach in this approach 3 factors are considered such as

• Future earnings
• Growth rate
• P/E ratio It is the ratio between price and earning per share. The greater
the expected growth rates, higher will be the P/E ratio. If normal price
earnings ratio exceeds P/E ratio then shares are under-priced and vice
versa. Average P/E ratio should be less than 20 which provides good
investment opportunities. Lower the PE ratio better will be the investment.
P/E Ratio = Price per share / Earning per share

Briefly describe the Basic Valuation Model of valuation of securities.

SANTOSH SHARMA 34
 • Any investor would take 2 steps before making an investment decision
such as risk return of the security and risk return of difference in
securities.
• An investor also considers 3 factors such as cost, benefit and uncertainty
of securities before making an investment.
• According to basic valuation model, an asset derives its value from the
cash flow associated with it.
• The value of an asset is equal to the present value of its expected cash
flows.
• The formula used to calculate the value of an asset in this model is
𝑐𝑓1 𝑐𝑓2 𝑐𝑓3 𝑐𝑓𝑛
𝑉0 = + + + ⋯ +
(1 + 𝑖)1 (1 + 𝑖)2 (1 + 𝑖)3 (1 + 𝑖)𝑛
Whereas,
𝑉0 == value at time 0
cf= cash flow during a year
i=rate of interest
n= no of years

Briefly explain the valuation of bonds.

• Bonds are the dates of a company.

• Its face value is also known as power value.
• It has a certain rate of interest called coupon rate.
• Its maturity. Varies from 5 to 20 years.
• Realizable value or economic value of a bond is equal to the present value
of the expected cash flows.
• The formula:
𝐼 𝑇𝑉
PV = (1+𝑟)𝑡 + (1+𝑟)𝑛
Whereas, PV= Present value at time 0.
I= Interest or Coupon rate
TV= Terminal value at maturity
R= Required rate of return
N= Number of years
• If rate of return = Coupon rate (Bond value = Par value)
• If rate of return > Coupon rate (Bond value < Par value)
• If rate of return < Coupon rate (Bond value > Par value)

SANTOSH SHARMA 35
What is Capital market? State important functions.

• Capital markets are a part of financial markets where financial assets are
purchased or sold.
• The main participants in these markets are households, business firms,
governments etc.
• In other words, it is a marketplace for investments that have a lock-in period
greater than a year, or their maturity period is at least more than one year.
• The capital market involves the sale and purchase of both equity and debt
instruments, including equity shares, debentures, preference shares,
secured premium notes, and zero-coupon bonds.
• Capital market maybe of 2 types such as primary capital market and
secondary capital market.

Functions of capital markets

1) Mobilize savings: Financial market helps to utilize the savings of the people.
The investors can invest their hard-earned savings to earn healthy returns.
Their investment is put in the productive work which may yield heavy profits.
2) Price fixing: Financial market helps to determine the prices of financial
securities. In other words, the exchange rates of shares and debentures are
automatically fixed due to interaction of suppliers of funds and demand of
funds.
3) Liquidity of financial assets: Financial market acts as a place for buying and
selling of securities. Thus, financial assets can be converted into cash as and
when required.
4) Economical: It helps to save time, effort and money of both buyers and
sellers of assets. It provides a platform where they can interact with each
other to do a transaction.

What are the differences between capital market and money market?

Difference between Capital Market and Money Market

Capital Market Money Market

SANTOSH SHARMA 36
 The main participants are The main participants are RBI,
companies, banks and public. commercial banks and no public.
The main instruments traded are The main instruments trade is
shares, debentures and bonds. Treasury Bills, Commercial Paper,
Certificate of Deposits, etc.
Investments can be made in small Investment is made in huge
amounts. amounts.
It deals in long term securities. It deals in short term securities.
This market is risky for the investors. This market is safe for the investors
as the duration is short.
Return on investment is generally Return on investment is low.
very high.

What are the differences between Primary markets and Secondary markets?

Capital Market: It is a place where long-term securities are bought and sold by
the companies. It mobilises the public savings into the most productive uses. The
main instruments traded are shares, debentures and bonds. These market places
include stock exchanges, development banks and commercial banks.
This market can be divided into Primary Market and Secondary Market.
Primary Market Secondary Market
It is a place where new securities of It is a place where existing
the companies are bought & sold. securities of the companies are
bought and sold.
Securities are traded between Securities are exchanged between
companies and investors directly. investors only.
Prices are determined by the Prices are determined by the action
management of the companies. of demand & supply of securities in
the market.
Here securities are only bought. Securities are bought & sold.
These markets do not have fixed These markets have fixed
geographical location. geographical locations.

What is Stock Exchange? Explain its roles.

SANTOSH SHARMA 37
Stock Exchange is a place or institution where securities are bought and sold. It
controls, regulates and helps in trading of securities.

Functions of a Stock Exchange:

1) Provides liquidity: Liquidity here means buying and selling of securities. A
stock exchange helps to buy and sell securities. This is the place where
people can invest their savings in buying share and debentures of the
companies. There are authorised brokers who guide the investors in buying
or selling securities.
2) Pricing of securities: The prices of shares are determined by the action of
demand and supply forces in a stock exchange. It is the place where people
can get immediate information about the prices of securities. Prices of
securities fluctuate every hour on a stock exchange.
3) Safety: Stock exchanges are regulated and controlled by SEBI, which is a
government department. So, there is very less possibility of fraud and
cheating in a stock exchange. Public money is safe and all the transactions
are genuine.
4) Economic growth: A stock exchange helps to mobilize the savings of the
people into the most productive uses. This helps to multiply the savings of
the people. They can earn more and have high purchasing power. All these
things lead to overall economic growth of the economy.
5) Speculation: A stock exchange encourages healthy speculation within the
controlled limits. All the speculative activities are done within the provisions
of law.

What is Cash management? Explain the motives for holding cash.

Cash Management refers to the collection, handling, control and investment of the
organizational cash and cash equivalents, to ensure optimum utilization of the
firm’s liquid resources. Money is the lifeline of the business, and therefore it is
essential to maintain a sound cash flow position in the organization.

SANTOSH SHARMA 38
Objectives of Cash Management

• Fulfil Working Capital Requirement: The organization needs to maintain

ample liquid cash to meet its routine expenses which possible only through
effective cash management.
• Planning Capital Expenditure: It helps in planning the capital expenditure
and determining the ratio of debt and equity to acquire finance for this
purpose.
• Handling Unorganized Costs: There are times when the company
encounters unexpected circumstances like the breakdown of machinery.
These are unforeseen expenses to cope up with; cash surplus is a lifesaver
in such conditions.
• Initiates Investment: The other aim of cash management is to invest the
idle funds in the right opportunity and the correct proportion.
• Better Utilization of Funds: It ensures the optimum utilization of the
available funds by creating a proper balance between the cash in hand
• Avoiding Insolvency: If the business does not plan for efficient cash
management, the situation of insolvency may arise. It is either due to lack
of liquid cash or not making a profit out of the money available.

Functions of Cash Management

Cash management is required by all kinds of organizations irrespective of their

size, type and location. Following are the multiple managerial functions related to
cash management:

SANTOSH SHARMA 39
 • Investing Idle Cash: The company needs to look for various short term
investment alternatives to utilize surplus funds.
• Controlling Cash Flows: Restricting the cash outflow and accelerating the
cash inflow is an essential function of the business.
• Planning of Cash: Cash management is all about planning and decision
making in terms of maintaining sufficient cash in hand and making wise
investments.
• Managing Cash Flows: Maintaining the proper flow of cash in the
organization through cost-cutting and profit generation from investments is
necessary to attain a positive cash flow.
• Optimizing Cash Level: The organization should continuously function to
maintain the required level of liquidity and cash for business operations.

What are the techniques of Cash Management?

Managing cash flow is a contemplative process and requires a lot of analytical

thinking. The various techniques or tools used by the managers to practice cash
flow management are as follows:

SANTOSH SHARMA 40
 • Accelerating Collection of Accounts Receivable: One of the best ways to
improve cash inflow and increase liquid cash by collecting the debts and
dues from the debtors readily.
• Stretching of Accounts Payable: On the other hand, the company should
try to extend the payment of dues by acquiring an extended credit period
from the creditors.
• Cost Cutting: The company must look for the ways of reducing its operating
cost to main a good cash flow in the business and improve profitability.
• Regular Cash Flow Monitoring: Keeping an eye on the cash inflow and
outflow, prioritizing the expenses and reducing the debts to be recovered,
makes the organization’s financial position sound.
• Wisely Using Banking Services: The services such as a business line of
credit, cash deposits, lockbox account and sweep account should be used
efficiently and intelligently.
• Upgrading with Technology: Digitalization makes it convenient for the

Discuss the concept of transaction exposure, translation exposure and economic

exposure or risk.

Transaction exposure

• It is the simplest type of foreign currency exposure.

• It deals with actual foreign currency transactions.
• It occurs due to foreign currency Gators of sale, payment of imported goods
or services, receipts or payments of dividends, payment of EMI, etc.
SANTOSH SHARMA 41
 • For example, if you have bought goods from a foreign country to be paid
after 3 months. but the value of foreign currency rises in between that, you
end up paying higher than your actual dept.

Translation exposure

• It is also known as accounting exposure.

• It occurs due to translation of books of accounts into the home currency.
• It affects the valuation of assets and liabilities.
• It is equivalent to comparing cash flow accounting treatment with
accounting book treatment.

Economic exposure

• It deals with the whole economic system of a country.

• It is not applicable to a single firm rather it affects all the forms of a country.
• The impact of this higher than the other exposures.
• It directly affects the market value of a firm.
• It affects the cash flows and also the assets and liabilities of a firm.

(Numerical)

Q1. A company issued 10% debentures of Rs.10000. the company is in 50% tax
bracket. Find the cost of debt capital i) at par, ii) 10% discount and iii) 10%
premium.

𝑰 (𝟏−𝑻)
Sol: Cost of debt capital (Kd) =
𝒏𝒑
Kd = Cost of capital, I = Interest, np = Net proceeds, t = Tax
I = 10% of 10,000 = 1,000
Np = 10,000
T = 50% = 0.5

𝟏𝟎𝟎𝟎 (𝟏−𝟎.𝟓)
i) Kd (at par) = 𝒙 𝟏𝟎𝟎% = 5%
𝟏𝟎𝟎𝟎𝟎

𝟏𝟎𝟎𝟎 (𝟏−𝟎.𝟓)
ii) Kd (at discount) = 𝒙 𝟏𝟎𝟎% = 5.56%
𝟗𝟎𝟎𝟎

SANTOSH SHARMA 42
 𝟏𝟎𝟎𝟎 (𝟏−𝟎.𝟓)
iii) Kd (at premium) = 𝒙 𝟏𝟎𝟎% = 4.54%
𝟏𝟏𝟎𝟎𝟎

Q2. A company issued Rs.100 face value Preference shares with 12% dividend
repayable after 10 years. The net amount realised is Rs.92. Find the cost of
preference capital.

(𝑭−𝑷)
𝑫+ 𝒏
Kp = 𝑷+𝑭
𝟐
Kp = Cost of preference capital
D = Dividend
P = Redemption price
n = no. of years
F = Face Value

(𝟏𝟎𝟎−𝟗𝟐)
𝟏𝟐+ 𝟏𝟎
Kp = 𝟗𝟐+𝟏𝟎𝟎
𝟐

12+0.8
= 96
= 0.133 x 100%
= 13.3%

Q3. Sales=7,50,000, Variable cost= 4,20,000, Fixed cost= 60,000, Debt= 4,50,000,
Interest on debt= 9%, Equity capital= 5,50,000
Find:
i) Operating Leverage
ii) Financial Leverage
iii) Total Leverage
iv) Rate of Return on investment

Contribution = Sales – V.C

= 7,50,000 – 4,20,000
= 3,30,000

SANTOSH SHARMA 43
EBIT (Earnings before interest & tax) = Contribution – F.C
EBIT = 3,30,000 – 60,000 = 2,70,000

EBT (Earning before tax) = EBIT – Interest

= 2,70,000 – 9% of 4,50,000
= 2,29,500

𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝟑,𝟑𝟎,𝟎𝟎𝟎
i) Operating Leverage = = 𝟐,𝟕𝟎,𝟎𝟎𝟎 = 1.22
𝑬𝑩𝑰𝑻

𝑬𝑩𝑰𝑻 𝟐,𝟕𝟎,𝟎𝟎𝟎
ii) Financial Leverage = = = 𝟐,𝟐𝟗,𝟓𝟎𝟎 = 1.17
𝑬𝑩𝑻

iii) Total Leverage = O.L X F.L = 1.22 X 1.17 = 1.43

𝑬𝑩𝑰𝑻
iv) Rate of Return = 𝑻𝒐𝒕𝒂𝒍 𝒔𝒉𝒂𝒓𝒆 𝒄𝒂𝒑𝒊𝒕𝒂𝒍+𝑫𝒆𝒃𝒕 𝒄𝒂𝒑𝒊𝒕𝒂𝒍

𝟐,𝟕𝟎,𝟎𝟎𝟎
= 𝟓,𝟓𝟎,𝟎𝟎𝟎+𝟒,𝟓𝟎,𝟎𝟎𝟎

= 0.27 x 100% = 27%

SANTOSH SHARMA 44
Q5.

Cash flows Project-A Project-B Project-C

𝑪𝟎 -25,000 -25,000 -25,000
𝑪𝟏 0 15,400 28,700
𝑪𝟐 33,050 15,400 0

Discount rate is 10%

Present value of Rs.1 for 1st & 2nd year is 0.893 & 0.797
Find the NPV for each project.
Which project is to be selected and why?

NPV
Project-A = (-25,000) + (0 X 0.893) + (33,050 X 0.797)
= Rs.1,340.85

Project-B = (-25,000) + (0.893 x 15,400) + (0.797 x 15,400)

= Rs. 1,026
Project-C = (-25,000) + (0.893 x 28,750) + (0.797 x 0)
= Rs. 673.75
NPV of project-A is more profitable.

Q.6 A company needs Rs. 5,00,000 for a new plant. The company issues 50,000
equity shares @ Rs.10. If the company’s earnings before interest and tax are
Rs.10,000, Rs.20,000, Rs.40,000, Rs.60,000 and Rs.1,00,000 for 5 years. What is
the earning per share? (Assuming that corporate tax is 50%)

Items 1st year 2nd year 3rd year 4th year 5th year
EBIT 10,000 20,000 40,000 60,000 1,00,000
Tax (50%) (5,000) (10,000) (20,000) (30,000) (50,000)
Total earning 5,000 10,000 20,000 30,000 50,000
No. of shares 50,000 50,000 50,000 50,000 50,000
EPS 0.1 0.2 0.4 0.6 1.0

SANTOSH SHARMA 45