9.
Financial Management
January-2004 [22]
1. Give
brief (one or two sentence) answers to the following questions:
g) Define Break-even
analysis. [2]
Ans: Break-even analysis is a technique widely used by
production management and management accountants. It is based on categorising
production costs between those which are "variable" (costs that
change when the production output changes) and those that are "fixed"
(costs not directly related to the volume of production).
Total
variable and fixed costs are compared with sales revenue in order to determine
the level of sales volume, sales value or production at which the business
makes neither a profit nor a loss (the "break-even point").
h) What are the main
decisions that are taken by a finance manager in a company?
[2]
Ans: The main decision that are taken by a finance manager in a company
are:
1. Investment Decision.
2. Financial Decision.
3. Dividend Decision.
4. Capital Budgeting Decision.
4.
a) What factors should be taken into
account for determining the capital structure of a company? [6]
Ans: Capital budgeting (or investment appraisal)
is the planning process used to determine whether a firm's long term investments
such as new machinery, replacement machinery, new plants, new products, and
research development projects are worth pursuing. It is budget for major
capital, or investment, expenditures.Factors:-
·
One
is the firm's business risk—the risk pertaining to the line of business in
which the company is involved. Firms in risky industries, such as high
technology, have lower optimal debt levels than other firms
·
Another factor in determining capital structure involves a
firm's tax position. Since the interest paid on debt is tax deductible, using
debt tends to be more advantageous for companies that are subject to a high tax
rate and are not able to shelter much of their income from taxation.
·
A third important factor is a firm's financial flexibility, or
its ability to raise capital under less than ideal conditions. Companies that
are able to maintain a strong balance sheet will generally be able to obtain
funds under more reasonable terms than other companies during an economic
downturn.
·
Managerial attitude (conservatism or aggressiveness)—some financial
managers are more
conservative than others when it comes to using debt, thus they are inclined to
use less debt,
all else equal.
b) Discuss
the following as a tool for investment decisions: [6]
i) Payback
Period
Ans: Payback
period in
business and economics refers to the period of time required for the return on
an investment to "repay" the sum of the original investment. For
example, a $1000 investment which returned $500 per year would have a two year
payback period. It intuitively measures how long something takes to "pay
for itself." Shorter payback periods are obviously preferable to longer
payback periods (all else being equal).
ii)
NPV.
Ans: Net present value (NPV) or net
present worth (NPW)[1]
is defined as the total present value (PV) of a time series of cash flows. It
is a standard method for using the time value of money to appraise long-term
projects. Used for capital budgeting, and widely throughout economics, it
measures the excess or shortfall of cash flows, in present value terms, once
financing charges are met.
iii) IRR.
Ans: The internal rate of return on an investment or
potential investment is the annualized effective compounded return rate
that can be earned on the invested capital.In more familiar terms, the IRR of an investment is the interest rate at which the costs of the investment lead to the benefits of the investment. This means that all gains from the investment are inherent to the time value of money and that the investment has a zero net present value at this interest rate.
c) What is the difference between Gross
Working Capital and Net Working Capital? State the sources of financing working
capital requirement of a company. [6]
|
Gross Working Capital |
Net Working Capital |
|
1. Cash and
short-term assets expected to be converted to cash within a year 2. Businesses use the calculation of gross working capital to measure cash flow 3. Include Current Assets and current liabilities 4. Gross working capital is sum of current assets of a company |
1. , is a
financial metric which represents operating liquidity available to a business 2. It Does Not. 3. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. 4. Net working capital is difference of Current assets and current liabilities. |
1.) Seed Capital: This is the money required to turn the business idea or concept into an operating business. The capital may be used to produce a sample run of our product, for initial marketing or premises or even to actively lunch the company.
2.) Operational Capital: Once we have set up our business, we may need t have an investment of operating capital to cover expenditure until such point as revenue can generate a profit and subsequent cash surplus. The term of this cash requirement will depend on our business and its success in the market.
Source of financing working capital requirement of a company are-
a)
Banks:- Many banks will offer start-up business
loans to companies that perceive as relatively low risk and that have assets
against which a loan can be secured.
b)
Friends and family: Money can be borrow from
friends and family can be cheap source of capital, there are personal
relationships risks if the business venture doesn’t go according to plan.
c)
Business angels: while usually a high net worth
individual, business angels can sometimes from a consortium for lending to, or
investing in small companies. This can be a beneficial option as business
angels often expect to invest their time and experience as well as their money.
d)
Government
grant: The government promotes small business. They encourage small business
with financial and information based support.
e)
Reduce operating cost: a merger of companies will
often be motivated by the potential of economies of scale which enable the company
to buy for less, as it will generally be buying more units.
f)
Growth
through acquisition: An acquisition could also be made of a company which
offers a complementary product or a supplier , thus growing the company while
providing cost-saving benefits.
July-2004 [20]
1. Give very brief (2-3 lines) answers to
the following questions:
i) Define Break Even Analysis. [2]
3.
a) Discuss the broad areas and objectives
of Financial Management. [4]
Ans: Objective of financial management are:
- meet day-to-day cash flow needs;
- pay wages and salaries when they fall due;
- pay creditors to ensure continued supplies of goods and services;
- pay government taxation and providers of capital – dividends; and
- ensure the long term survival of the business entity.
b) Discuss the factors, which determine
fixed capital and working capital of a company. [6]
Ans: The factors that determine the fixed capital are:
a.
Nature
of business: it determines the amount of fixed capital in a business.
b.
Huge
fixed investment is required in public enterprises such as railways,
electricity; sewerage etc manufacturing concerns also need sizeable amount of
fixed capital trading and financial firms
need less fixed capital. They require more working capital to invest in current assets.
c.
Size
of business: capital required by a business depends upon its size. Generally
the large size of business, the greater is the need of fixed capital and vice
versa.
d.
Type
of business: if an industry requires automatic machines and uses modern
techniques of production, it calls for the larger investment in fixed assets.
e. Non current assets: investment in non current
assets, like goodwill, patent, copy right, long
term investment etc
are a part of fixed capital and influence the fixed capital of a business.
Factors determining working capital are:
a.
Nature and Volume of Business: The nature and volume of
business is an important factor in deciding the amount of working capital.
b.
Length of Manufacturing Cycle: The time that elapses from
the purchase and use of raw materials to the production of finished goods is
called manufacturing cycle. The longer the period a manufacturing cycle takes,
the larger is the amount of working capital required, because the funds get
locked up in production process for a longer period of time.
c.
Business Fluctuations: Business fluctuations are
of two types: seasonal fluctuations which arise out of seasonal changes in
demand for the product and cyclical fluctuations which occur due to ups and
downs of economic activities in the country as a whole.
d.
Production Policy: The production policy of
business is also an important determinant of working capital requirement.
e.
Credit Policy: In the present-day
circumstances, almost all units have to sell goods on credit. The nature of
credit policy is an important consideration in deciding the amount of working
capital requirement.
c) Describe the methods for investment
decision by an enterprise. [8]
Ans: The methods of investment decision are:--
Pay Back Method
Net Present Value
Internal Rate of Return
January-2005 [16]
1.
b) Define the following:
i)
IRR [1]
3.
a) Every manager in an organisation is
supposed to take some decisions and so is the finance manager. Discuss what the
main decisions taken by a finance manager in an organisation and also; the
objective followed by him while taking these decisions. [10]
Ans
: The
main decision taken by finance manager are:-
Objectives are :
a)
Non-financial
benefits
b)
Financial
Returns
c)
Ability
to Attract Funds in future
b.Financial Decision:- It is the decision that is taken by manager which
include when and how to invest the fund in a project effectively.
Objectives are:-
(1)
determining the proper amount of funds to employ in a firm;
(2)
selecting projects and capital expenditure analysis;
(3) raising funds on the most favorable terms
possible;
(4) managing working capital such as inventory and
accounts receivable.
c. Dividend Decision: The Dividend Decision, in Corporate finance, is a decision made by the directors of a company. It relates to the amount and timing of any cash payments made to the company's stockholders. The decision is an important one for the firm as it may influence its capital structure and stock price. In addition, the decision may determine the amount of taxation that stockholders pay.
There are three main factors that may influence a firm's dividend decision:
- Free-cash flow
- Dividend clienteles
- Information signalling
.
b) Why should a firm carry Working Capital
though such a capital do not earn a high rate of return? Also, state, the
difference between Net Working Capital and Gross Working Capital. [5]
July-2005 [10]
5.
a) List and explain the factors, which
influence the working capital needs of a firm. [10]
Ans: Factors are
---------
(1) Nature and Volume of
Business:
The nature and volume of business is an important factor in deciding the amount
of working capital. For example, the amount of working capital is generally more
in trading concerns and in service units as compared to the manufacturing
units. The retail trading units have also to invest large funds in working
capital. In some manufacturing units also, the working capital holds a
significant place. On the other hand, public utilities require less working
capital. Other manufacturing units need more working capital as compared to
public utilities.
The
relation between the volume of business and the requirement of working capital
is more direct and clear. The bigger the size of the units, the more will be
the requirement of working capital.
(2) Length of Manufacturing Cycle: The time that elapses from
the purchase and use of raw materials to the production of finished goods is
called manufacturing cycle. The longer the period a manufacturing cycle takes,
the larger is the amount of working capital required, because the funds get
locked up in production process for a longer period of time.
It
is in view of this that, when alternative methods of production are available,
the method with the shortest manufacturing cycle should be chosen (assuming
other factors to be equal). Once a choice is made, care is taken to see that
the manufacturing cycle is completed within a specified period. Any delay in
production is bound to increase the requirement of working capital.
(3) Business Fluctuations: Business fluctuations are
of two types: seasonal fluctuations which arise out of seasonal changes in
demand for the product and cyclical fluctuations which occur due to ups and
downs of economic activities in the country as a whole.
If
demand for the product is seasonal, production will have to be increased during
the season, and it will have to be reduced during the off-season.
Correspondingly, there will be fluctuations in the requirement of working
capital. The business unit will have to face some other problems in addition to
this one. It has to bear extra expenses to increase production when product
demand increases. It has to bear, costs even to maintain work force and
physical facilities during slack season. For this reason, many units prefer to
continue production even during slack season and increase the level of their
inventories.
The
cyclical fluctuations are made up of periods of prosperity and depression. The
sales and prices increase during prosperity necessitating more working capital
in the form of inventories and book-debts. If new investment is made in fixed
capital to meet additional demand for the product, then also there will be an
increase in working capital requirement. Generally, business units adopt the
policy to borrow funds on a large scale to increase investment in working
capital. As against this, the requirement of working capital gets reduced
during depression and therefore they adopt the policy of reducing their short
term debts.
(4) Production Policy: The production policy of business is also
an important determinant of working capital requirement. If the policy of
Constant Production is adopted, there are two possible effects. If demand for
the product is regular and constant, this policy helps in reducing working
capital requirement to the lowest possible level. But if demand for the product
is seasonal, this policy raises the level of inventory during off season and
thereby increases the working capital requirement. If the cost of maintaining
inventory is considerably high, the policy of varying production according to
demand is preferred. If the unit produces varied products, it can reduce the
requirement of working capital by adjusting the structure of production to the
changes in demand.
(5) Credit Policy: In the present-day circumstances, almost all units
have to sell goods on credit. The nature of credit policy is an important
consideration in deciding the amount of working capital requirement. The larger
the volume of credit sales, the greater will be the requirement of working
capital. Also, the longer the period the collection of payment takes, the
greater will be the requirement of working capital.
Generally,
the credit policy of an individual firm depends on the norms of the industry to
which the firm belongs. Yet it is possible to pursue different credit policies
for different customers in accordance with their creditworthiness. To ignore
creditworthiness of the individual customers can be dangerous to the firm. In
addition, it is necessary that the firm should be prompt in collection of
payments. Any slackness in this respect will increase the requirement of
working capital and will increase the chance of bad debts.
January-2006 [14]
1.
d) “Investment decisions are irreversible
in nature and hence, more risky.” Discuss. [4]
2.
b) Describe various capital budgeting techniques. [5]
Ans: Many formal methods are used in capital budgeting,
including the techniques such as- Net present value: Each potential project's value should be estimated using a discounted cash flow (DCF) valuation, to find its net present value (NPV). This valuation requires estimating the size and timing of all of the incremental cash flows from the project.
- Profitability index: The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency
- Internal rate of return: The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor. It is often used when assessing only the costs of specific projects that have the same cash inflows
- Modified Internal Rate of Return: Real options analysis try to value the choices - the option value - that the managers will have in the future and adds these values to the NPV
·
Equivalent annuity: The real value of
capital budgeting is to rank projects. Most organizations have many projects
that could potentially be financially rewarding
3.
c) “Balance Sheet records stock of assets and liabilities while
Profit and Loss Account records flows of income and expenses.” In the light of
this statement, distinguish balance sheet from Profit and Loss account. [5]
July-2006[18]
5.
a) Compare NPV (Net Present Value) and IRR
(Internal Rate of Return) methods of Investment decisions. Which one of the
two, you find to be more rational and why?
[9]
Ans:
IRR is directly linked with
the NPV rate and their relation may be summarized as:
1) When the IRR = the firm’s hurdle rate, NPV = 0
2) When the IRR < the firm’s hurdle rate, NPV < 0
3) When the IRR > the firm’s hurdle rate, NPV > 0
1) When the IRR = the firm’s hurdle rate, NPV = 0
2) When the IRR < the firm’s hurdle rate, NPV < 0
3) When the IRR > the firm’s hurdle rate, NPV > 0
When
using the IRR and NVP rates:
• mutually exclusive projects are always ranked the same
• direct estimates of the increase or decrease in shareholder value can be obtained
• the time value of money is taken into account
• accounting measures of profit are considered
• mutually exclusive projects are always ranked the same
• direct estimates of the increase or decrease in shareholder value can be obtained
• the time value of money is taken into account
• accounting measures of profit are considered
Possible
decision conflicts among NPV and IRR
A ranking conflict occurs when one project has a higher NPV
than another while the lower NPV project has a higher IRR. Ranking conflicts
are unusual but can occur. These conflicts are relevant only when there are
multiple acceptable mutually exclusive projects.
Compare and
contrast
The internal rate of return (IRR)
and the net present value (NPV) techniques are 2 investment decision tools that
satisfy the 2 major criteria for the correct evaluation of capital projects.
This criterion is that the techniques should incorporate the use of cash flows
and the use of the time value of money. This makes them viable techniques for
evaluating investment proposals.The Net Present Value is one of the techniques that are used by firms when evaluating which investment proposals to take on board and which ones to reject. The net present value is calculated by discounting all flows to the present and subtracting the present value of all inflows.
IRR
is usually more effective in determining whether a single project is worth
investing in rather than comparing 2 mutually exclusive projects to determine
which is better for investment.
In conclusion,
both the NPV and IRR techniques are important tools in the decision making process
in determining which projects a firm should invest in and which ones they
should reject. They give the analyst an idea of the future earning potential of
projects and as such make investment decisions easier. Whether the techniques
are used together or separately will depend on the nature of the
b) Why do firms need working capital? What
are the main components of working capital management? [9]
Ans: Needs of working capital: The working capital need can be separated into two
parts:
• A fixed part: The fixed part is
probably defined in amount as the minimum working capital requirement for the
year.
• A fluctuating : the fluctuating element
should be financed from a short-term source (e.g. a bank overdraft), which can
be drawn on and repaid easily and at short notice.
Working capital is used to
pay short-term obligations such as our accounts payable and buying inventory.
If our working capital dips too low, ou risk running out of cash. Even very
profitable businesses can run into trouble if they lose the ability to meet
their short-term obligations.
Component of working capital are:
a)
Cash:
The three motives for
holding cash balances are
·
Transactions
motive – to conduct day-to-day business of paying for purchases, labor, etc.
·
Precautionary
motive – to cover unexpected expenditures.
If the delivery truck breaks down, it must be repaired or replaced if
you want to stay in business.
· Speculative motive – unusually good opportunities occasionally arise. If you have the money available, you can take advantage of these opportunities
b) Marketable Securities:
Marketable securities are a way of holding cash but
with the attribute of earning interest.
Market securities have three characteristics:
1.
Short-term
maturity (less than one year, or “money market instruments”
2.
High
marketability
3.
Virtually
no risk of default
c) Accounts Receivable:
Accounts receivable are
generated when a firm offers credit to its customers. The first thing that needs to be addressed
when establishing a credit policy is to set the standards by which a firm is
judged in determining whether or not credit will be extended. There is what’s known as the 5 Cs of credit:
1.
Character
– the willingness of the borrower to repay the obligation
2.
Capacity
– the capability of the borrower to earn the money to repay the obligation
3.
Capital
– sufficient assets available to support operations (as opposed to a firm that
is undercapitalized). Sometimes capital
is interpreted to mean equity capital;
i.e., to make sure the owners of the firm have sufficient money at stake
to give them proper incentive to repay the loan and not let the company go
bankrupt.
4.
Collateral
– assets to support the loan which can be liquidated if default occurs
5.
Conditions
– current and future anticipated conditions of the firm and the industry.
d) Inventories:
Inventories (raw materials,
work-in-process, finished goods) make up a large portion of most firm’s current
assets, and for many, total assets. As
such, the extent to which a firm efficiently manages its inventories can have a
large influence on its profitability.
Thus, keeping abreast of inventory policy is critical to the
profitability (and value) of the firm.
Inventory costs can be
broken down into three major categories:
A.
Ordering
Costs
1.
Fixed
costs – stocking, clerical
2.
Shipping
costs – often fixed
3.
Missed
quantity discounts – an opportunity cost
B.
Carrying
Costs
1.
Time
value of money tied-up in inventories
2.
Warehousing
costs
3.
Insurance
4.
Handling
5.
Obsolescence,
breakage, “shrinkage”
C.
Stock-out
Costs
1.
Lost
sales
2.
Loss
of goodwill
3.
Special
shipping costs
January-2007 [9]
2.
b) Explain the functions of Financial
Management and its applications. [9]
Ans: Functions of financial management is to study and
implement
(1)
Investment
decision
(2)
Financing decision and
(3)
Dividend decision.
Application of Financial Management:
1.
Planning
2.
Budgeting
3.
financial
reporting
4.
internal
controls evaluation
5.
monitoring
6.
Decision
taking
7.
Controlling
investment
8.
Calculating
net income
9.
Maintain
salary among employees
July-2007 [9]
3.
a) Explain the main components of ‘Working
Capital’. What is importance of working capital management?
[9]
Importance of working capital management are:
1.
They
convert the Current Assets into cash
2.
They
help in case settlement
3.
They
report the company’s balance sheet.
4.
Working
capital management is to maintain the optimum balance of each of the working
capital components.
5.
They
look after the deposit in banks.
6.
They
look after the investment.
January-2008 [12]
5.
b) Describe various capital budgeting
techniques. [6]
7.
c) What is the importance of working
capital management in an organization? [6]
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