Answer No. 1

(a)Liquidity Decisions

Current assets management that affects a firms liquidity is yet another important finances function, in addition to the management of long-term assets. Current assets should be managed efficiently for safeguarding the firm against the dangers of illiquidity and insolvency. Investment in current assets affects the firms profitability. Liquidity and risk. A conflict exists between profitability and liquidity while managing current assets. If the firm does not invest sufficient funds in current assets, it may become illiquid. But it would lose profitability, as idle current assets would not earn anything. Thus, a proper trade-off must be achieved between profitability and liquidity. In order to ensure that neither insufficient nor unnecessary funds are invested in current assets, the financial manager should develop sound techniques of managing current assets. He or she should estimate firms needs for current assets and make sure that funds would be made available when needed. It would thus be clear that financial decisions directly concern the firms decision to acquire or dispose off assets and require commitment or recommitment of funds on a continuous basis. It is in this context that finance functions are said to influence production, marketing and other functions of the firm. This, in consequence, finance functions may affect the size, growth, profitability and risk of the firm, and ultimately, the value of the firm. To quote Ezra Solomon the function of financial management is to review and control decisions to commit or recommit funds to new or ongoing uses. Thus, in addition to raising funds, financial management is directly concerned with production, marketing and other functions, within an enterprise whenever decisions are about the acquisition or distribution of assets. Various financial functions are intimately connected with each other. For instance, decision pertaining to the proportion in which fixed assets and current assets are mixed determines the risk complexion of the firm. Costs of various methods of financing are affected by this risk. Likewise, dividend decisions influence financing decisions and are themselves influenced by investment decisions. In view of this, finance manager is expected to call upon the expertise of other functional managers of the firm particularly in regard to investment of funds. Decisions pertaining to kinds of fixed assets to be acquired for the firm, level of inventories to be kept in hand, type of customers to be granted credit facilities, terms of credit should be made after consulting production and marketing executives. However, in the management of income finance manager has to act on his own. The determination of dividend policies is almost exclusively a finance function. A finance manager has a final say in decisions on dividends than in asset management decisions. Financial management is looked on as cutting across functional even disciplinary boundaries. It is in such an environment that finances manager works as a part of total management. In principle, a finance manager is held responsible to handle all such problem: that involve money matters. But in actual practice, as noted above, he has to call on the expertise of those in other functional areas to discharge his responsibilities effectively.(b) Dividend Decisions

Dividend decisionrefers to the policy that the management formulates in regard to earnings for distribution as dividends among shareholders.Dividend decision determines the division of earnings between payments to shareholders and retained earnings.The Dividend Decision, in corporate finance, is a decision made by the directors of a company about the amount and timing of any cash payments made to the company's stockholders.The Dividend Decisionis an important part of the present day corporate world.TheDividend decisionis an important one for the firm as it may influence its capital structure and stock price. In addition, theDividend decisionmay determine the amount of taxation that stockholders pay.Factors influencing Dividend Decisions

There are certain issues that are taken into account by the directors while making thedividend decisions: Free Cash Flow Signaling of Information Clients of DividendsFree Cash Flow TheoryThe free cash flow theory is one of the prime factors of consideration when adividend decisionis taken. As per this theory the companies provide the shareholders with the money that is left after investing in all the projects that have a positive net present value.

Signaling of Information

It has been observed that the increase of the worth of stocks in the share market is directly proportional to the dividend information that is available in the market about the company. Whenever a company announces that it would provide more dividends to its shareholders, the price of the shares increases.

Clients of Dividends

While takingdividend decisionsthe directors have to be aware of the needs of the various types of shareholders as a particular type of distribution of shares may not be suitable for a certain group of shareholders.It has been seen that the companies have been making decent profits and also reduced their expenditure by providing dividends to only a particular group of shareholders.

Factors influencing the dividend decision

Liquidity of funds Stability of earnings Financing policy of the firm Dividend policy of competitive firms Past dividend rates Debt obligation Ability to borrow Growth needs of the company Profit rates Legal requirements Policy of control Corporate taxation policy Tax position of shareholders Effect of trade policy Attitude of the investor group Leverage

Answer No. 2(a) Doubling PeriodDoubling period is the period which makes the investment as "Doubled", that is the amount invested fetches 100% return.There are two different approaches Viz.1. Rule of 722. Rule of 691. Rule of 72The initial amount of investment gets Doubled within which 72/IWhere, I = Interest Rate of the investment.For exampleThe amount of the investment is Rs.1,00,000. The annual rate of interest is 12%. Then the doubling period of Rs.1,00,000 is 72/12 = 6 years2. Rule of 69The amount method is found to crude logic in determining the doubling period which has its own limitations. The rule of 69 eliminates the bottleneck associated with the rule of 72 methods.The rule of 69 is originate to be a scientific and rational method in determining the doubling period of the investment madeAs per rule of 69 method the doubling period is calculated as 0.35+ 69/IFor exampleThe amount of the investment is Rs.1 00,000. The annual rate of interest is 12%. Then the doubling period of Rs.1,00,000 is 0.35+ 69/12= 6.1 yrs(b) NumericalTotal Amount = Principal + CI (Compound Interest)Formulae for Interest Compounded QuarterlyTotal Amount = A = P(1 + r/n)nt=1000{ 1 + (10 /4) 42 =1218.4(c) Present ValueThe current worth of a future sum of money or stream of cash flows given a pacified rate of Return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows. Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they be earnings or obligations.This sounds a bit confusing, but it really isn't. The basis is that receiving 1000 now is worth more than 1000 five years from now, because if you got the money now, you could invest it and receive an additional return over the five years.The calculation of discounted or present value is extremely important in many financial calculations. For example, net present value, bond yields, spot rates, and pension obligations all rely on the principle of discounted or present value. Learning how to use a financial calculator to make present value calculations can help you decide whether you should accept a cash rebate, 0% financing on the purchase of a car or to pay points on a mortgage.

Answer No. 3

1)Operating Leverage : It is defined as the "firm's ability to use fixed operating costs to magnify effects of changes in sales on its EBIT ". When there is an incr ease or decrease in sales level the EBIT also changes. The effect of changes in sales on the level EBIT is measured by operating leverage. Operating leverage = % Change in EBIT / % Change in sales = [Increase in EBIT/EBIT] / [Increase in sales/sales] Significance of operating leverage: Analysis of operating leverage of a firm is useful to the financial manager. It tells the impact of changes in sales on operating income. A firm having higher D.O.L. (Degree of Operating Lever age) can experience a magnified effect on EBIT for even a small change in sales level. Higher D.O.L. can dramatically increase operating profits. But, in case of decline in sales level, EBIT may be wiped out and a loss may be operated. As operating leverage, depends on fixed costs, if they are high, the firm's operating risk and leverage would be high. If Operating leverage is high, it automatically means that the break -even point would also be reached at a high level of sales. Also, in case of high operat ing leverage, the margin of safety would be low. Thus, it is preferred to operate sufficiently above the break -even point to avoid the danger of fluctuations in sales and profits. 2) Financial Leverage : It is defined as the ability of a firm to use fixe d financial charges to magnify the effects of changes in EBIT/Operating profits, on the firm's earnings per share. The financial leverage occurs when a firm's capital structure contains obligation of fixed charges e.g. interest on debentures, dividend on preference shares, etc. along with owner's equity to enhance earnings of equity shareholders. The fixed financial charges do not vary with the operating profits or EBIT. They are fixed and are to be repaid irrespective of level of operating profits or EBIT . The ordinary shareholders of a firm are entitled to residual income i.e. earnings after fixed financial charges. Thus, the effect of changes in operating profit or EBIT on the level of EPS is measured by financial leverage. Financial leverage = % change in EPS/% change in EBIT or = (Increase in EPS/EPS)/{Increase in EBIT/EBIT} The financial leverage is favorable when the firm earns more on the investment/assets financed by sources having fixed charges. It is obvious that shareholders gain a situation where the company earns a high rate of return and pays a lower rate of return to the supplier of long term funds, in such cases it is called 'trading on equity'. The financial leverage at the levels of EBIT is called degree of financial leverage and is calculated as ratio of EBIT to profit before tax. Degree of financial leverage = EBIT/Profit before tax Shareholders gain in a situation where a company has a high rate of return and pays a lower rate of interest to the suppliers of long term funds. The difference accrues to the shareholders. However, where rate of return on investment falls below the rate of interest, the shareholders suffer, as their earnings fall more sharply than the fall in the return on investment. Financial leverage helps the finance manager in designing the appropriate capital structure. One of the objective of planning an appropriate capital structure is to maximize return on equity shareholders' funds or maximize EPS. Financial leverage is double edged s word i.e. it increases EPS on one hand, and financial risk on the other. A high financial leverage means high fixed costs and high financial risk i.e. as the debt component in capital structure increases, the financial risk also increases i.e. risk of insolvency increases. The finance manager thus, is required to trade off i.e. to bring a balance between risk and return for determining the appropriate amount of debt in the capital structure of a firm. Thus, analysis of financial leverage is an important too l in the hands of the finance manager who are engaged in financing the capital structure of business firms, keeping in view the objectives of their firm.

3) Combined leverage: Combined Leverage = Operating leverage * Financial leverage = (% change in EBIT/% change in sales) * (% change in EPS/% change in EBIT) = % change in EPS/% change in sales The ratio of contribution to earnings before tax, is given by a combined effect of financial and operating leverage. A high operating and high financial leverage is very risky, even a small fall in sales would affect tremendous fall in EPS. A company must thus, maintain a proper balance between these 2 leverage. A high operating and low financial leverage indicates that the management is careful as higher amount of risk involved in high operating leverage is balanced by low financial leverage. But, a more preferable situation is to have a low operating and a high financial leverage. A low operating leverage automatically implies that the company reaches its break -even point at a low level of sales, thus, risk is diminished. A highly cautious and conservative manager would keep both its operating and financial leverage at very low levels. The approach may, mean that the company is losing profitable opportunities. Answer No. 4(a) Factors Affecting capital structure(1) Cash Flow Position:While making a choice of the capital structure the future cash flow position should be kept in mind. Debt capital should be used only if the cash flow position is really good because a lot of cash is needed in order to make payment of interest and refund of capital.(2) Interest Coverage Ratio-ICR:With the help of this ratio an effort is made to find out how many times the EBIT is available to the payment of interest. The capacity of the company to use debt capital will be in direct proportion to this ratio.It is possible that in spite of better ICR the cash flow position of the company may be weak. Therefore, this ratio is not a proper or appropriate measure of the capacity of the company to pay interest. It is equally important to take into consideration the cash flow position.

(3) Debt Service Coverage Ratio-DSCR:This ratio removes the weakness of ICR. This shows the cash flow position of the company.This ratio tells us about the cash payments to be made (e.g., preference dividend, interest and debt capital repayment) and the amount of cash available. Better ratio means the better capacity of the company for debt payment. Consequently, more debt can be utilized in the capital structure.(4) Return on Investment-ROI:The greater return on investment of a company increases its capacity to utilize more debt capital.(5) Cost of Debt:The capacity of a company to take debt depends on the cost of debt. In case the rate of interest on the debt capital is less, more debt capital can be utilized and vice versa.

(6) Tax Rate:The rate of tax affects the cost of debt. If the rate of tax is high, the cost of debt decreases. The reason is the deduction of interest on the debt capital from the profits considering it a part of expenses and a saving in taxes.For example, suppose a company takes a loan of 0ppp 100 and the rate of interest on this debt is 10% and the rate of tax is 30%. By deducting 10/- from the EBIT a saving of in tax will take place (If 10 on account of interest are not deducted, a tax of @ 30% shall have to be paid).(7) Cost of Equity Capital:Cost of equity capital (it means the expectations of the equity shareholders from the company) is affected by the use of debt capital. If the debt capital is utilized more, it will increase the cost of the equity capital. The simple reason for this is that the greater use of debt capital increases the risk of the equity shareholders.Therefore, the use of the debt capital can be made only to a limited level. If even after this level the debt capital is used further, the cost of equity capital starts increasing rapidly. It adversely affects the market value of the shares. This is not a good situation. Efforts should be made to avoid it.

(b)NumericalFirm AFirm B

Weighted KW*KWeightedKW*K

Equity share Capital115%15%.6715%10.05%

Debt 10%-10%-.3310%3.3%

Total Cost15%13.35%

Answer No. 5(a)Numerical(i) Net Present Value (NPV Using risk free rate)YearCash InflowPresent Value FactorNet cash InflowCash inflow*PVF

1-40,0000.909036,360

2-50,0000.826441,320

3-15,0000751311,269

430,0000.684920,547

Total1,09496.5

Total PV of Cash Inflows 109,496.5 Initial Investment -100,000Net Present Value (NPV Using risk free rate) 9,496.5 thousand

(ii) NPV using risk-adjusted discount rateRisk-adjusted discount rate = Risk free rate + Risk premiumRisk premium = 9496.5*10%=949.65Then risk adjusted discount rate = 9496.5+949.65 = 10446.15

(b) Risk In capital Budgeting Like anything, projects do have risks. There are three types of project risks associated with capital budgeting: 1. Stand-Alone Risk This risk assumes the project a company intends to pursue is a single asset that is separate from the company's other assets. It is measured by the variability of the single project alone. Stand-alone risk does not take into account how the risk of a single asset will affect the overall corporate risk.2. Corporate RiskThis risk assumes the project a company intends to pursue is not a single asset but incorporated with a company's other assets. As such, the risk of a project could be diversified away by the company's other assets. It is measured by the potential impact a project may have on the company's earnings.3. Market RiskThis looks at the risk of a project through the eyes of the stockholder. It looks at the project not only from a company's perspective, but from the stockholder's overall portfolio. It is measured by the effect the project may have on the company's beta.

Answer No. 6(a) Objectives of cash management

In order to ensure you meet the objectives of an effective cash management policy, the financial manager must ensure that the company meets the payment schedule and also minimize idle funds committed to cash balances.Meeting Cash BalancesThe financial manager must ensure he has enough cash in hand to pay suppliers, creditors, employees, shareholders, banks, etcMost financial managers at times go a step further and keep even more than required. This can be the result of various factors such as: Enhancing the companys reputation settling payments on time keeps creditors and suppliers happy Taking advantage of trade discounts by paying your debts on time Stronger negotiating power when dealing with suppliers Unexpected cash requirements can be met with no problem at allMinimizing idle balancesToo much cash tied up in idle balances waiting for something to happen involves an opportunity cost and hence loss of profits. As you minimize the cash balance, you increase the chance of a shortfall and of failing to meet your payments schedule. A company must always try to find a suitable cash management policy and this at times can be facilitated by having a cash budget in place. By doing so, a company could forecast its cash inflows and outflows for the coming period and thus estimate with reasonable precision the amount of cash balance that it must keep idle.As a compromise, many companies try to hold some of their cash in short-term investments such as Deposit/Savings AccountsandFixed Term Deposits Accounts.Government Securitiesare also attractive for those opting for marketable securities.Cash is one of the most important aspects of a business. Lack of cash could and would probably lead to financial problems hence it is vital for a company to have a financial manager who is responsible for managing its cash to ensure it has enough to pay off creditors whilst also making profit from possible investment schemes with its idle cash.

(b) Baumol Model of Cash Management

Baumol model of cash managementhelps in determining a firm's optimum cash balance under certainty. It is extensively used and highly useful for the purpose of cash management. As per the model, cash and inventory management problems are one and the same.William J. Baumol developed a model (The transactions Demand for Cash: An Inventory Theoretic Approach) which is usually used in Inventory management & cash management.Baumol model of cash managementtrades off between opportunity cost or carrying cost or holding cost & the transaction cost. As such firm attempts to minimize the sum of the holding cash & the cost of converting marketable securities to cash.RelevanceAt present many companies make an effort to reduce the costs incurred by owning cash. They also strive to spend less money on changing marketable securities to cash. TheBaumol model of cash managementis useful in this regard.AssumptionsThere are certain assumptions or ideas that are critical with respect to the Baumol model of cash management:

The particular company should be able to change the securities that they own into cash, keeping the cost of transaction the same. Under normal circumstances, all such deals have variable costs and fixed costs. The company is capable of predicting its cash necessities. They should be able to do this with a level of certainty. The company should also get a fixed amount of money. They should be getting this money at regular intervals. The company is aware of the opportunity cost required for holding cash. It should stay the same for a considerable length of time. The company should be making its cash payments at a consistent rate over a certain period of time. In other words, the rate of cash outflow should be regular.

Equational Representations in Baumol Model of Cash Management:

Holding Cost= k(C/2) Transaction Cost= c(T/C) Total Cost= k(C/2) + c(T/C)

Where T is the total fund requirement, C is the cash balance, k is the opportunity cost & c is the cost per transaction.

Limitations of the Baumol model:1. It does not allow cash flows to fluctuate.2. Overdraft is not considered.3. There are uncertainties in the pattern of future cash flows.