Manipal University Jaipur, Rajasthan

Roll No-2314508841

PRATYUSH KUMAR SARANGI

FINANCIAL MANAGEMENT
Subject Code-DMBA202
Set-1&2

Paper Due Date

July 31, 2024

 Set-1

1. Ans :-

Over-Capitalization

Causes:

1. Issuance of Excessive Capital: Companies may issue more capital than needed for their
actual operational requirements.
2. High Promotion Costs: Overstated expenses during the formation of the company,
including marketing and promotions.
3. Inflated Asset Values: Overvaluation of assets leading to higher capital requirements.
4. Inefficient Management: Poor management decisions leading to inefficient use of capital.
5. Excessive Borrowing: High levels of debt that increase the financial burden on the
company.

Effects:

1. Reduced Earnings: The company earns insufficient returns on the excessive capital
invested, leading to lower profits.
2. High Dividend Payouts: Shareholders expect high dividends, which may not be sustainable
in the long run.
3. Decreased Stock Value: The market value of shares may drop as investors lose confidence
in the company's financial health.
4. Difficulty in Raising Funds: Potential investors may be hesitant to invest, making it hard
for the company to raise additional funds in the future.
5. Financial Distress: The company may face financial distress and insolvency due to the
inability to meet financial obligations.

Under-Capitalization

Causes:

1. Conservative Financing: Raising less capital than required due to conservative financing
strategies.
2. Rapid Expansion: Quick growth and expansion without adequate capital to support
operations.
3. Underestimation of Needs: Underestimating the capital requirements of the business.
4. High Dividend Policies: Excessive dividend payments leaving insufficient retained earnings
for business needs.
5. Inefficient Utilization: Inefficient use of available capital, leading to inadequate
operational funding.

Effects:

1. Operational Constraints: Lack of sufficient capital can hinder day-to-day operations and
growth opportunities.
 2. High Borrowing Costs: The company may need to rely on high-cost borrowing to meet
capital requirements, increasing financial risk.
3. Competitive Disadvantage: Inability to invest in new projects, technology, or marketing,
leading to a loss of competitive edge.
4. Decreased Employee Morale: Financial constraints may lead to inadequate compensation
and benefits, affecting employee morale and productivity.
5. Reputational Damage: Persistent under-capitalization can damage the company’s
reputation among investors and creditors.

Comparison of Consequences

Over-Capitalization:

 Long-Term Financial Health: Over-capitalization leads to a long-term decline in financial

health due to inefficient use of excessive capital.
 Shareholder Impact: Shareholders may face reduced dividends and a decrease in share
value.
 Market Perception: The company may struggle with a poor market perception and find it
difficult to attract new investments.

Under-Capitalization:

 Operational Efficiency: Under-capitalization directly affects operational efficiency and

growth potential.
 Increased Risk: Higher reliance on debt increases financial risk and vulnerability to
economic fluctuations.
 Competitive Position: The company may lose its competitive position due to an inability to
invest in critical areas.

Conclusion

While both over-capitalization and under-capitalization have serious consequences, the effects of
over-capitalization can be more severe due to the long-term decline in financial health and
market perception. Over-capitalization can lead to a prolonged period of inefficiency and financial
distress, making recovery more challenging. Under-capitalization, although harmful, can often be
corrected more quickly through strategic financing and operational adjustments.
 2. Ans :-

To help Zubi choose the best option for investing in bonds, we need to calculate the present value
of the bond for each of the given options forannually, bi-annually, and quarterly accrued interest
using the provided details.

Given:

 Bond Price (P) = Rs. 500

 Coupon Rate (C) = 8%
 Life of Bond (n) = 5 Years
 Redemption Value (F) = Rs. 500
 Required Rate of Return (r) = 10%

The coupon payment depends on the frequency of interest accrual:

1. Annually: Coupon payment once per year.

2. Bi-Annually: Coupon payment twice per year.
3. Quarterly: Coupon payment four times per year.

1. Interest Accrued Annually

 Coupon Payment (C) = 0.08×500=Rs.400.08 \times 500 = Rs. 400.08×500=Rs.40

 Number of periods (n) = 5
 Rate of return (r) = 10%

The present value of the bond (PV) is given by:

PV=∑t=1n(1+r)tC+(1+r)nF

2. Interest Accrued Bi-Annually

 Coupon Payment (C) = 0.08×500/2=Rs.200.08 \times 500 / 2 = Rs. 200.08×500/2=Rs.20

 Number of periods (n) = 5 \times 2 = 10
 Rate of return (r) = 10% / 2 = 5%

The present value of the bond (PV) is given by:

PV=∑t=1n(1+2r)2tC+(1+2r)2nF

3. Interest Accrued Quarterly

 Coupon Payment (C) = 0.08×500/4=Rs.100.08 \times 500 / 4 = Rs. 100.08×500/4=Rs.10

 Number of periods (n) = 5 \times 4 = 20
 Rate of return (r) = 10% / 4 = 2.5%

The present value of the bond (PV) is given by:

PV=PV=∑t=1n(1+4r)4tC+(1+4r)4nF

We'll use these formulas to calculate the present value for each option and then determine the
best investment choice for Zubi.

Let's proceed with the calculations.

The present values of the bond for each interest accrual option are as follows:

1. Annually: Rs. 462.09

2. Bi-Annually: Rs. 461.39
3. Quarterly: Rs. 461.03

Since the goal is to maximize the present value, Zubi should choose the option where the present
value is the highest. Therefore, the best option is:

Interest accrued Annually with a present value of Rs. 462.09.

3. Ans :-

a) Differentiation between Operating and Financial Leverage

Operating Leverage:

1. Definition: Operating leverage measures the impact of fixed costs on a company's

operating income (EBIT). It indicates how a change in sales will affect the operating
income.
2. Focus: It is concerned with the cost structure of the company, specifically the proportion
of fixed to variable costs.
3. Impact: High operating leverage means that a small change in sales can lead to a large
change in operating income due to high fixed costs.
4. Measurement: It is measured using the Degree of Operating Leverage (DOL), which is
calculated as: \text{DOL} = \frac{\text{% Change in EBIT}}{\text{ % Change in Sales}}
5. Risk: High operating leverage increases the business risk because it makes the company
more sensitive to changes in sales volume.

Financial Leverage:

1. Definition: Financial leverage measures the impact of fixed financial costs (such as interest
expenses) on a company's earnings per share (EPS). It indicates how a change in operating
income will affect the net income available to shareholders.
2. Focus: It is concerned with the capital structure of the company, specifically the use of
debt financing versus equity financing.
3. Impact: High financial leverage means that a small change in operating income can lead to
a large change in net income due to high interest expenses.
4. Measurement: It is measured using the Degree of Financial Leverage (DFL), which is
calculated as: \text{DFL} = \frac{\text{% Change in EPS}}{\text{ % Change in EBIT}}
 5. Risk: High financial leverage increases the financial risk because it makes the company
more sensitive to changes in operating income.

b) Future Value of an Annuity

To calculate the future value of an annuity where you contribute Rs. 2,400 every year for 30 years
at an annual rate of return of 7%, we use the future value of an annuity formula:

FV=P×(1+r)n−1/r

Where:

 FV = Future Value of the annuity

 P = Annual contribution (Rs. 2,400)
 r = Annual rate of return (7% or 0.07)
 n = Number of years (30)

Let's calculate the future value:

FV=2400×(1+0.07)30−1/0.07

Let's compute this value.

The future value of contributing Rs. 2,400 every year to a retirement account for 30 years at an
annual rate of return of 7% is approximately Rs. 226,705.89

Set-2
4. Ans :-

Yes, different factors affecting capital structure decisions can indeed be viewed differently by
different companies. This variation in perspective is influenced by the unique characteristics,
goals, and circumstances of each company. Here are some key factors affecting capital structure
decisions and examples illustrating how companies might view them differently:

1. Business Risk

 Definition: Business risk refers to the inherent risk associated with the industry and
operations of a company.
 Example:
o A technology startup might prioritize equity financing over debt due to the high
business risk and uncertain revenue streams. Equity investors bear the business
risk without fixed repayment obligations.
o Conversely, a utility company with stable and predictable cash flows might be more
comfortable with higher debt levels, as its business risk is lower.

2. Growth Opportunities

 Definition: Growth opportunities refer to the potential for future expansion and revenue
increases.
  Example:
o A high-growth company in the biotech sector may prefer equity financing to avoid
the burden of fixed debt payments, allowing it to reinvest earnings into research
and development.
o A mature company in a saturated market might use debt financing to take
advantage of tax benefits and improve returns on equity since it has fewer growth
opportunities to invest in.

3. Tax Considerations

 Definition: Tax considerations involve the benefits a company can derive from debt
financing, such as interest tax shields.
 Example:
o A profitable manufacturing firm might leverage debt financing to reduce taxable
income through interest deductions, thus lowering overall tax liability.
o A company with significant tax loss carryforwards, like a recently restructured firm,
might not prioritize debt for tax reasons since it already has low taxable income.

4. Financial Flexibility

 Definition: Financial flexibility is the ability of a company to adapt to financial needs and
opportunities.
 Example:
o A cyclical business, such as a construction company, might favor equity to maintain
financial flexibility during downturns, avoiding the risk of bankruptcy due to debt
obligations.
o A retail chain with steady cash flows might prefer a higher debt ratio, utilizing long-
term debt to finance expansion while retaining flexibility in equity markets.

5. Cost of Capital

 Definition: The cost of capital is the cost of obtaining funds, either through debt or equity.
 Example:
o A large, creditworthy corporation might have access to low-cost debt and thus use
more debt in its capital structure to minimize overall capital costs.
o A smaller, less established company might find equity more cost-effective despite
higher dilution, as it may face higher interest rates and restrictive covenants on
debt.

6. Market Conditions

 Definition: Market conditions involve the state of financial markets, including interest
rates and investor sentiment.
 Example:
o During periods of low interest rates, a real estate company might prefer debt
financing to lock in cheap borrowing costs for long-term projects.
o If the equity market is bullish, a tech company might issue new shares to capitalize
on high valuations and raise funds without increasing debt levels.
7. Control Considerations

 Definition: Control considerations relate to the desire of current owners to maintain

control over the company.
 Example:
o Family-owned businesses or founder-led startups might avoid equity financing to
prevent dilution of control and instead use debt despite higher financial risk.
o Publicly traded companies with dispersed ownership may not be as concerned with
dilution and might prefer equity if it aligns with strategic goals.

Conclusion

Different companies view factors affecting capital structure decisions through the lens of their
specific circumstances, industry characteristics, financial health, and strategic goals. This diversity
in perspectives underscores the importance of a tailored approach to capital structure decisions,
ensuring alignment with the company's long-term objectives and risk profile.

5. Ans :-

o determine the working capital required to finance the level of activity of 18,000 units per year,
we need to calculate the different components of current assets and current liabilities based on the
given information.

Here's a breakdown of the calculation:

Current Assets

Raw Materials in Stock

Value of raw materials in stock:-

=Annual consumption /12×Number of months in stock

=18,000×12/12×2

=18,000×2=36,000

Work in Progress

Value of work in progress

=Annual production cost/12×Time in process

Annual production cost per unit=Raw material cost+Labor cost+Overheads

=12+3+9=24

Value of work in progress

 =18,000×24/12×0.5

=36,000

Finished Goods in Stock

Value of finished goods in stock

=Annual production cost/12×Number of months in stock

=18,000×24/12×2

=36,000×2=72,000

Debtors

Value of debtors

=Annual sales/12×Credit period

Annual sales per unit=Selling price

= 30

Value of debtors=18,000×30/12×3

=45,000×3

=135,000

Cash in Hand and at Bank Cash in hand and at bank=7,000 Rs.

Total Current Assets

Total Current Assets=Value of raw materials in stock+Value of work in progress+Value of finished

goods in stock+Value of debtors+Cash in hand and at bank

=36,000+36,000+72,000+135,000+7,000=286,000

Current Liabilities

Creditors for Raw Materials

Value of creditors=Annual raw material cost/12×Credit period

Annual raw material cost=18,000×12=216,000

Value of creditors=216,000/12×2
 =18,000×2=36,000

Wages Outstanding

Value of wages outstanding=Annual wages cost/12×Lag in payment

Annual wages cost=18,000×3=54,000

Value of wages outstanding=54,000/12×0.5

=4,500 Rs.

Total Current Liabilities

Total Current Liabilities=Value of creditors+Value of wages outstanding

=36,000+4,500=40,500

Net Working Capital

Net Working Capital=Total Current Assets−Total Current Liabilities

=286,000−40,500=245,500 Rs.

Thus, the working capital required to finance the level of activity of 18,000 units per year is Rs.
245,500.

6. Ans :-

a) Economic Order Quantity (EOQ) Calculation

To determine the most economical order quantity, we use the Economic Order Quantity (EOQ)
formula. The EOQ formula is given by:

EOQ=√2DS/H

Where:

 D = Annual demand (units)

 S = Order cost per order (Rs.)
 H = Holding (carrying) cost per unit per year (Rs.)

Given:

 Semi-annual order of 24,000 units implies an annual demand D=24,000×2=48,000 units

 Price per unit = Rs. 20
 Carrying cost = 15% of the unit price
 Order cost per order = Rs. 12
First, calculate the holding cost per unit per year:

H=20×0.15=3 Rs.

Now, use the EOQ formula:

EOQ=√2×48,000×12/3

EOQ=√1,152,000/3

EOQ=√384,000

EOQ=620 units

Number of Orders

To determine the number of orders to be placed per year, divide the annual demand by the EOQ:

Number of Orders=D/EOQ

Number of Orders=48,000/620

Number of Orders=77.42

Since you can't place a fraction of an order, you would typically round up to ensure demand is
met:

Number of Orders=78

Thus, the most economical order quantity is approximately 620 units, and the company needs to
place around 78 orders per year.

b) Differences between Hard and Soft Capital Rationing

Hard Capital Rationing:

1. Definition: Hard capital rationing occurs when external constraints limit a company's
ability to raise funds. These constraints are typically imposed by external capital markets
or institutions.
2. Causes:

o Market Conditions: Poor market conditions or a lack of investor confidence can

restrict access to capital.
o Regulatory Constraints: Legal or regulatory requirements can limit the ability to
issue new equity or debt.
o Creditworthiness: Low credit ratings or a history of financial instability can make it
difficult to secure loans or attract investors.
 3. Impact: Hard capital rationing can significantly restrict a company's ability to invest in new
projects, leading to slower growth and limited operational flexibility.
4. Example: A company unable to secure additional funding due to a downturn in the
financial markets would experience hard capital rationing.

Soft Capital Rationing:

1. Definition: Soft capital rationing occurs when internal constraints within the company
limit the amount of capital available for investment. These constraints are usually the
result of internal policies or management decisions.
2. Causes:

o Internal Policies: Management may impose limits on investment spending to

maintain control over operations or ensure financial stability.
o Budgeting Practices: Companies may follow strict budgeting processes that limit
the amount of capital allocated to various projects.
o Risk Management: Internal risk assessments may lead to conservative investment
strategies, limiting the amount of capital committed to new projects.

3. Impact: Soft capital rationing can be more flexible than hard capital rationing, as it results
from internal decisions rather than external market conditions. Companies can adjust
policies and budgets as needed.
4. Example: A company choosing to limit its capital expenditure to avoid overextending itself
financially, despite having the ability to raise additional funds, would be experiencing soft
capital rationing.

Summary

 Hard Capital Rationing: Imposed by external factors (market conditions, regulations,

creditworthiness), less flexible, often beyond the company's control.
 Soft Capital Rationing: Resulting from internal decisions and policies, more flexible, within
the company's control to adjust or change.