UNIT – 1

FINANCIAL MANAGEMENT

Q1. What is financial management and explain the nature and scope of
financial management.

Financial management involves planning, organizing, directing, and controlling financial

resources within an organization or business. Its purpose is to ensure that financial decisions are
made efficiently and effectively to meet the organization's goals, maximize value, and manage
financial risks.

Importance of Financial Management:

 Sustainability: Financial management ensures that businesses can operate efficiently and
sustainably over time.
 Informed Decision-Making: By analyzing financial data, managers can make well-
informed decisions that drive growth and profitability.
 Regulatory Compliance: Proper financial management ensures compliance with tax
laws, accounting standards, and financial regulations.

Financial management is crucial for the long-term success of any organization. It combines both
strategic and operational aspects of managing an entity’s resources, aiming to achieve financial
stability and growth.

Nature of Financial Management:

Financial management refers to the planning, organizing, directing, and controlling of financial
resources within an organization. The primary goal is to maximize the value of the firm for its
shareholders while ensuring that financial risks are appropriately managed. The nature of
financial management involves:

1. Decision-Making: Financial management is about making key financial decisions,

including investment, financing, and dividend decisions. These decisions ensure the long-
term growth and stability of the company.
2. Resource Allocation: It involves allocating financial resources effectively to the most
profitable and strategically important areas of the business.

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 3. Risk Management: Financial management helps in identifying, assessing, and
mitigating financial risks, ensuring that the firm is protected from unnecessary financial
uncertainties.
4. Optimization of Financial Performance: A key objective is to optimize the
performance of the company by utilizing financial resources efficiently. This can include
enhancing profitability, liquidity, and ensuring an adequate return on investments.
5. Financial Planning and Control: Financial management includes forecasting the
company's financial needs and planning to meet these needs. Budgeting and controlling
expenses are also vital components.
6. Strategic Role: Financial management helps in aligning the financial resources with the
company’s strategic goals, enabling it to compete effectively in the market.

Scope of Financial Management:

The scope of financial management covers all aspects of financial activities in an organization. It
broadly includes the following areas:

1. Investment Decisions (Capital Budgeting): This involves decisions about which long-
term investments or projects the firm should pursue. The goal is to invest in assets or
projects that will generate returns greater than the cost of capital.
2. Financing Decisions: It relates to determining how the firm will raise capital, whether
through equity, debt, or internal funds. The firm must maintain a balance between debt
and equity to minimize financial risk and cost.
3. Dividend Decisions: These decisions determine the portion of profits that should be
distributed to shareholders versus reinvested back into the company for growth. The
dividend policy should align with the company's overall financial strategy.
4. Working Capital Management: This focuses on managing short-term assets and
liabilities to ensure the company can meet its day-to-day operational expenses without
financial strain.
5. Financial Analysis and Planning: Financial managers must regularly analyze financial
data to assess the firm's performance, profitability, liquidity, and solvency. Financial
planning includes preparing budgets, forecasts, and making decisions based on financial
data.
6. Risk Management: Identifying and managing financial risks, such as interest rate risk,
currency risk, and inflation risk, are key components of financial management.
7. Corporate Governance and Financial Reporting: Ensuring the integrity and
transparency of financial information through proper accounting and reporting practices
is essential for stakeholders' trust and regulatory compliance.

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 8. Cost Control and Profit Planning: Financial management is responsible for controlling
costs and planning for optimal profitability, ensuring that the company operates
efficiently.

In essence, the nature and scope of financial management are both comprehensive and dynamic,
requiring financial managers to balance multiple objectives, including profitability, growth, risk
management, and financial stability.

Q2. Explain the evolution of financial management in briefly.

The evolution of financial management is a fascinating journey, shaped by changes in the

economy, technology, regulatory environments, and business practices. Here’s an overview of
the key stages:

1. Pre-Industrial Revolution (Before the 18th Century)

 Early Accounting Practices: The origins of financial management can be traced back to
ancient civilizations such as Mesopotamia and Egypt. Early forms of accounting were
used for managing agricultural surpluses, trade, and taxes.
 Double-Entry Bookkeeping: In the 15th century, the introduction of double-entry
bookkeeping by Luca Pacioli laid the foundation for modern accounting, offering a more
systematic approach to recording financial transactions.

2. Industrial Revolution (18th-19th Century)

 Growth of Corporations: As industries like manufacturing expanded, businesses

became more complex, requiring systematic approaches to finance, budgeting, and
investment.
 Corporate Finance Emerges: With the rise of large-scale enterprises, financial
management began focusing on raising capital (e.g., stocks and bonds), managing
operating costs, and ensuring profitability.
 Cost Accounting: The need to track costs, especially in mass production, led to the
development of cost accounting as a tool for businesses to improve efficiency and
profitability.

3. Early 20th Century: Scientific Management Era

 Financial Management Formalized: Financial management became more formalized,

focusing on budgeting, and financial planning, and reporting. Early concepts of capital
structure and investment analysis were explored.

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  The Rise of Financial Theory: Theoretical foundations such as the "time value of
money" and basic investment analysis emerged, driven by scholars like Irving Fisher and
John Maynard Keynes.

4. Mid 20th Century: Post-World War II Era

 Corporate Finance Theory: The 1950s and 1960s saw the rise of corporate finance
theories such as the Modigliani-Miller theorem, which dealt with capital structure and the
idea that the market value of a company is independent of its capital structure under
certain conditions.
 Financial Management Becomes Specialized: Financial management became a distinct
discipline within business schools, with textbooks and theories focusing on capital
budgeting, risk management, and financial analysis.
 Emergence of Financial Instruments: Financial markets evolved, and new financial
instruments (e.g., derivatives, mutual funds) became popular, requiring businesses to
adopt sophisticated financial management strategies.

5. Late 20th Century: Information Technology and Globalization

 Technological Advancements: The rise of computers and software applications like

spreadsheets transformed financial management, making tasks like financial modeling,
budgeting, and forecasting more efficient.
 Globalization: As businesses expanded globally, financial management had to adapt to
deal with currency exchange risk, cross-border taxation, international investments, and
global financial markets.
 Risk Management Focus: The late 20th century saw an increasing emphasis on risk
management, including the use of financial derivatives to hedge against risks in markets,
interest rates, and currency fluctuations.
 Corporate Governance and Ethics: Following corporate scandals (e.g., Enron,
WorldCom), there was a renewed focus on financial transparency, corporate governance,
and ethical standards in financial management.

6. 21st Century: Digital Transformation and Financial Innovation

 Big Data and AI: The integration of big data analytics and artificial intelligence into
financial decision-making has allowed for more precise financial forecasting, real-time
data analysis, and enhanced risk management strategies.
 Fintech Revolution: The rise of financial technology (fintech) companies has
transformed personal and corporate finance. Technologies like blockchain, digital
currencies, and peer-to-peer lending have disrupted traditional financial systems.

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  Sustainable Finance: The importance of environmental, social, and governance (ESG)
factors has risen in financial management. Investors are increasingly focusing on
sustainability and ethical considerations when making financial decisions.
 Automation and Block chain: Block chain technology and smart contracts are making
financial transactions more secure and efficient. Automation is streamlining many
financial processes, reducing human error, and improving decision-making.
 Crypto currency and Decentralized Finance: Crypto currencies, such as Bitcoin, and
decentralized finance (DeFi) systems have introduced new paradigms for financial
transactions and investments.

Future of Financial Management

 AI and Machine Learning: Continued advancements in AI and machine learning will

revolutionize financial decision-making, offering deeper insights into financial health,
market trends, and investment opportunities.
 Sustainability and Impact Investing: There will likely be a growing focus on financial
management that accounts for climate change, ethical investing, and social impact.
 Increased Automation and Robotics: Automation will continue to reshape the financial
industry, with algorithms managing more aspects of personal and corporate finance.

Overall, financial management has evolved from simple accounting practices to a complex,
multifaceted discipline that blends technology, economics, and strategic decision-making to
create value in an increasingly interconnected world.

Q3. Explain the new role in the contemporary scenario in financial

management.

The role of financial management has evolved significantly in the contemporary business
environment due to changes in technology, globalization, regulatory frameworks, and shifting
business needs. In the past, financial management was primarily focused on controlling costs,
maintaining liquidity, and ensuring profitability. Today, however, its scope has expanded to
encompass a more strategic, forward-looking, and data-driven approach. Below are key aspects
of the new role of financial management in the contemporary scenario:

1. Strategic Financial Planning

Financial managers are now expected to play a pivotal role in strategic planning. Beyond merely
tracking financial performance, they are involved in shaping business strategy by providing
insights into resource allocation, investment decisions, and long-term financial goals. This

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strategic alignment ensures that financial decisions support broader organizational objectives,
such as growth, innovation, and market expansion.

2. Data-Driven Decision Making

With the advent of big data, artificial intelligence (AI), and advanced analytics, financial
managers now have access to vast amounts of data that can guide decision-making. They use
predictive analytics, machine learning, and financial modeling to make more accurate forecasts,
assess risk, and identify new opportunities. Financial management is less about intuition and
more about leveraging data to drive informed decisions.

3. Risk Management and Mitigation

The role of financial management now heavily emphasizes risk management. Financial managers
need to assess, identify, and mitigate financial risks related to market fluctuations, credit risks,
regulatory changes, and geopolitical factors. In the context of a more volatile global economy,
they employ sophisticated tools like derivatives, hedging strategies, and stress testing to ensure
the organization's financial stability.

4. Sustainability and ESG (Environmental, Social, Governance)

Financial management is increasingly intertwined with the corporate social responsibility (CSR)
agenda, including Environmental, Social, and Governance (ESG) factors. Companies are
expected to not only deliver financial returns but also adhere to sustainability standards and
ethical business practices. Financial managers are now responsible for integrating ESG
considerations into financial strategies and ensuring that sustainability initiatives align with
financial performance.

5. Technological Integration and Fintech

The rapid growth of financial technologies (fintech) has transformed financial management.
Automation tools, blockchain technology, cloud computing, and digital payment systems are
reshaping how financial transactions and management processes are handled. Financial managers
must not only keep up with these technologies but also assess their potential for driving
efficiencies, reducing costs, and improving service offerings.

6. Corporate Governance and Compliance

Modern financial managers must ensure compliance with an ever-evolving regulatory landscape.
They are responsible for maintaining transparent financial reporting and adhering to local and

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international financial regulations (e.g., IFRS, GAAP). Corporate governance is also a critical
area of focus, as stakeholders demand more accountability and ethical conduct from
organizations.

7. Capital Structure and Financing Decisions

Financial managers are responsible for making capital structure decisions that balance debt and
equity financing. In today's complex global financial environment, they must evaluate alternative
financing options such as venture capital, private equity, crowdfunding, and public offerings.
This requires a deep understanding of global capital markets, investor sentiment, and financial
instruments.

8. Cash Flow Management and Liquidity

Maintaining adequate liquidity remains a core responsibility. However, financial managers must
balance this with the need for investments that drive growth. Efficient cash flow management—
using technology like cash flow forecasting software—ensures businesses can meet their
obligations while also investing in future opportunities.

9. Performance Measurement and Value Creation

Financial management now includes more sophisticated methods of measuring and driving
performance. Key performance indicators (KPIs) are used not just to monitor financial health but
also to assess the value creation process, including operational efficiency, profitability, and
shareholder value. This may include the use of value-based management tools, like economic
value added (EVA) or return on invested capital (ROIC).

10. Globalization and Cross-Border Financial Management

As businesses expand globally, financial managers must deal with the complexities of managing
finances across different currencies, tax regimes, and regulatory environments. They are
responsible for managing foreign exchange risk, transfer pricing, and cross-border investments
while optimizing global tax strategies.

11. Focus on Stakeholder Value

Financial managers are increasingly focused on delivering value not just to shareholders but also
to a broader group of stakeholders, including employees, customers, and communities. This
holistic approach to value creation reflects a shift away from profit maximization alone to a more
sustainable and socially responsible model of business.

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12. Crisis Management and Business Continuity Planning

Financial managers also play a crucial role in crisis management. Whether it's a global pandemic,
economic downturn, or an internal financial crisis, financial managers must ensure the business
can continue to operate and recover quickly. This includes having contingency plans, managing
liquidity in times of stress, and identifying new revenue streams.

Conclusion:

In summary, the role of financial management has expanded far beyond traditional functions like
bookkeeping and budgeting. Today, financial managers are key players in strategic decision-
making, risk management, data analytics, and sustainability efforts. They need to be adaptive,
technologically savvy, and capable of navigating a complex and fast-paced global business
environment. The modern financial manager is expected to be a strategic partner to the CEO and
other executives, using their expertise to drive organizational success and long-term value
creation.

Q4. Explain the goals and objectives of financial management.

The goals and objectives of financial management focus on ensuring the efficient use of an
organization's financial resources to achieve its overall objectives. Here are the key goals and
objectives:

1. Profit Maximization

 Goal: To maximize the profit of the business by managing resources efficiently, reducing
unnecessary costs, and increasing revenue.
 Objective: Ensure the company achieves the highest level of profitability while maintaining
business sustainability.

2. Wealth Maximization (Value Maximization)

 Goal: To increase the value of the company for shareholders.

 Objective: Focus on long-term growth of stock value and market share, considering factors like
dividends, earnings growth, and capital investment. This goal aims to enhance shareholder wealth
rather than just short-term profit maximization.

3. Liquidity Management

 Goal: To ensure the company can meet its short-term obligations without sacrificing long-term
financial health.

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  Objective: Maintain sufficient cash flow and working capital for daily operations, while
balancing profitability with liquidity needs.

4. Risk Management

 Goal: To identify, assess, and manage financial risks such as market volatility, credit risks, and
operational risks.
 Objective: Mitigate risks through diversified investment strategies, hedging, insurance, and other
financial tools.

5. Cost Control

 Goal: To minimize costs while ensuring that the business runs smoothly and remains
competitive.
 Objective: Identify and eliminate wasteful expenses, improve efficiency, and optimize cost
structures.

6. Capital Structure Optimization

 Goal: To determine the ideal mix of debt and equity financing for the company.
 Objective: Find the right balance that minimizes the cost of capital and maximizes returns while
maintaining financial stability.

7. Ensuring Efficient Fund Utilization

 Goal: To use the company's financial resources effectively to maximize returns.

 Objective: Invest in projects and assets that offer the best returns, considering risk and return
trade-offs.

8. Sustainable Growth

 Goal: To grow the business in a sustainable manner, considering both profitability and social
responsibility.
 Objective: Plan for growth by reinvesting profits, accessing external funding, and ensuring that
expansion does not put undue strain on the company's resources.

9. Financial Reporting and Transparency

 Goal: To maintain clear and transparent financial records and reports.

 Objective: Ensure accurate reporting of financial health, compliance with regulations, and
transparent communication with stakeholders, including shareholders and regulators.

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In summary, financial management's core objectives revolve around maximizing profitability,
ensuring liquidity, minimizing risk, and enhancing the overall value of the business for
stakeholders.

Q5. Explain the firm’s mission and its objectives.

A firm's mission and objectives are essential components of its overall strategic framework.
Here’s a breakdown of both:

Firm’s Mission:

The mission of a firm defines its core purpose and primary reason for existing. It outlines what
the firm does, which it serves, and the value it aims to deliver. The mission typically reflects the
firm’s values, principles, and long-term goals, providing both employees and stakeholders with a
sense of direction and a shared understanding of the company’s role in society or the market.

Key Characteristics of a Mission Statement:

1. Purpose: Why does the firm exist? What is its main goal?
2. Values: What values guide the firm’s operations and decision-making?
3. Target Market: Who are the firm’s customers or beneficiaries?
4. Core Services or Products: What does the firm do? What is its main offering?

Firm’s Objectives:

Objectives are specific, measurable, and time-bound targets that a firm aims to achieve in
alignment with its mission. They are short- to long-term goals that direct the firm's activities and
performance. Objectives help in the allocation of resources, monitoring progress, and making
adjustments to strategies as needed.

Types of Objectives:

1. Financial Objectives:
o Profitability (e.g., increasing revenue, maximizing profits)
o Cost reduction (e.g., minimizing operational costs)
o Return on investment (ROI) targets

2. Market Objectives:
o Expanding market share
o Entering new geographic markets or demographic segments

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 o Increasing customer retention or loyalty

3. Operational Objectives:
o Improving operational efficiency (e.g., reducing lead times, enhancing
productivity)
o Upgrading technology or systems
o Streamlining supply chains

4. Social and Environmental Objectives:

o Corporate social responsibility (CSR) goals (e.g., sustainability, community
involvement)
o Reducing carbon footprint
o Ethical sourcing and production

5. Employee-Related Objectives:
o Improving employee satisfaction and engagement
o Developing talent through training and leadership programs
o Enhancing workplace diversity and inclusion

Importance of Mission and Objectives:

1. Alignment and Focus: They provide clear guidance, ensuring that every decision and
action within the firm aligns with its overarching purpose.
2. Measuring Success: Objectives act as benchmarks for success, helping firms track
progress and make adjustments when necessary.
3. Motivating Employees: A well-defined mission and clear objectives motivate
employees, creating a shared sense of purpose and direction.
4. Stakeholder Confidence: A strong mission and clear objectives build trust with
stakeholders (investors, customers, suppliers, etc.), demonstrating that the firm is
focused, strategic, and forward-thinking.

In summary, a firm’s mission is its foundational "why" and guiding principle, while its
objectives are concrete, actionable steps designed to achieve that mission. Both are critical for
the firm’s strategic planning, decision-making, and long-term success.

Q6. Explain the difference between Profit maximization and wealth

maximization.

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Profit maximization and wealth maximization are two distinct goals in the context of business
and finance, though they are related. Here’s a breakdown of each concept and the key differences
between them:

1. Profit Maximization

 Definition: Profit maximization is the objective of increasing a company’s short-term

profits to the highest possible level. It focuses on increasing the difference between
revenue and costs.
 Key Characteristics:
o Short-term focus: Profit maximization typically emphasizes achieving the
highest profits in the current period or in the immediate future.
o Revenue and cost control: Companies pursue strategies to boost revenue (sales,
pricing strategies) and reduce costs (efficiency, cost-cutting).
o Earnings per share (EPS): A common metric used in profit maximization.
o Risk considerations: Risks to long-term sustainability (e.g., overextending credit
or exploiting cheap labor) may not be fully considered.
 Potential Issues:
o It may ignore long-term sustainability, social responsibility, and stakeholder
interests.
o It could encourage decisions that harm the company’s reputation or lead to
unethical practices.
o Might not account for cash flow, long-term asset appreciation, or capital
investment.

2. Wealth Maximization

 Definition: Wealth maximization (also called value maximization) is the goal of

increasing the long-term value of the company for its shareholders. It focuses on
maximizing the market value of the firm’s stock, which reflects the company’s future
cash flows, risk, and growth potential.
 Key Characteristics:
o Long-term focus: Wealth maximization considers the long-term impact on the
company’s financial health, market position, and future profitability.
o Maximizing shareholder value: Wealth maximization aims to increase the
overall wealth of the shareholders by enhancing the company's stock price and
long-term growth prospects.

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 o Risk and timing: Unlike profit maximization, wealth maximization considers the
risk-adjusted return and the time value of money (i.e., future cash flows are
discounted back to present value).
o Sustainability: Encourages businesses to adopt strategies that ensure continued
growth, innovation, and market share over time.
 Potential Benefits:
o Greater focus on long-term sustainability and ethical business practices.
o Balances risk with reward, making it more suitable for long-term planning.
o Aligns with the interests of investors who seek steady returns over time.
 Potential Challenges:
o Could involve greater investment or risk-taking in the short term to achieve long-
term gains.
o It may require more complex decision-making and planning.

Key Differences

Aspect Profit Maximization Wealth Maximization

Maximizing short-term
Objective Maximizing long-term shareholder wealth.
profits.
Short-term (immediate or
Time Horizon Long-term (future growth and sustainability).
near future).
Risk Lower consideration for risk. Takes risk and time value of money into account.
Immediate revenue and cost Long-term growth, market value, and shareholder
Focus
management. returns.
Profit (e.g., net income, Market value of the firm (e.g., stock price,
Measurement
earnings). discounted cash flows).
Primarily focuses on profit Considers a broader range of stakeholders
Stakeholders
for the business. (including investors, employees, customers).

In practice, wealth maximization is often considered a more balanced and responsible goal for a
business, as it incorporates not only profitability but also sustainability, risk management, and
ethical practices.

Q7. Explain the difference between maximization and satisfying.

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In financial management, maximization and satisfying are two distinct approaches to decision-
making and goal-setting. Both relate to how a firm or individual seeks to achieve financial
objectives, but they differ in terms of their goals and strategies. Here's a breakdown:

1. Maximization

Maximization refers to the approach where the goal is to achieve the highest possible outcome in
a given financial decision, often in terms of profitability or wealth.

 Primary Focus: Maximizing shareholder wealth, profit, or firm value.

 Typical Goal: The goal is to achieve the highest possible value for stakeholders, often
reflected in the maximization of profits, return on investment (ROI), or stock price.
 Decision-Making Process: Under a maximization approach, decisions are made with the
assumption that the firm or individual will choose the option that provides the highest
return or utility, even if it involves risk or uncertainty.

Example: A company may decide to reinvest all its earnings into high-risk, high-return ventures
(such as expanding into new markets or developing innovative products) to maximize its future
profits and stockholder value.

Advantages:

 Clear, measurable goals such as profit or ROI.

 Maximizes long-term growth and financial performance.
 Can attract investors focused on high returns.

Disadvantages:

 May overlook social or ethical considerations (e.g., environmental impacts, employee

well-being).
 Can lead to excessive risk-taking.
 Short-term focus may undermine long-term stability.

2. Satisfying

Satisfying is a more conservative or pragmatic approach, where the goal is not to achieve the
absolute best outcome, but rather to find a satisfactory solution that meets certain predefined
criteria.

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  Primary Focus: Achieving adequate or acceptable outcomes, rather than maximizing
them.
 Typical Goal: Meeting a specific, often modest, financial target such as achieving a
reasonable level of profitability, maintaining a stable financial position, or meeting
stakeholder needs.
 Decision-Making Process: Under satisfying, decision-makers settle for a solution that is
good enough to meet certain predefined goals, rather than striving for the highest possible
return. This approach often involves balancing multiple objectives like risk,
sustainability, and ethical concerns.

Example: A company may choose to invest in projects that provide a stable return (e.g., 10%
annually) rather than pursuing high-risk projects that could yield higher returns but with greater
uncertainty. This strategy ensures stability and meets the minimum expectations of shareholders,
employees, and customers.

Advantages:

 More practical in managing risk and uncertainty.

 Less likely to cause financial strain due to high-risk investments.
 Can lead to more balanced, sustainable growth.

Disadvantages:

 May lead to missed opportunities for higher returns.

 Can be seen as too conservative by investors looking for aggressive growth.
 May result in complacency if the bar for success is set too low.

Key Differences

Aspect Maximization Satisficing

Achieving the highest possible Achieving an acceptable, "good enough"
Goal
outcome. outcome.
Risk Appetite Often higher risk for higher returns. Lower risk, more conservative.
Focused on long-term growth, Focused on achieving adequate returns and
Focus
profitability, or stock value. stability.
Decision- Focuses on optimizing returns and Focuses on meeting criteria, sometimes at

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Aspect Maximization Satisficing
Making value. the expense of maximization.
Stakeholder Primarily on shareholders and Broader focus, including employee
Focus financial gains. welfare, ethics, and sustainability.
Aggressive growth, reinvestment,
Strategy Stability, risk-averse strategies.
expansion.

Which is better?

Neither approach is inherently superior to the other; the choice depends on the circumstances, the
company's risk profile, and the stakeholders' priorities.

 Maximization is suitable when the objective is aggressive growth, and the firm has the
capacity to absorb higher risks (e.g., growth-focused startups, tech companies, or firms in
highly competitive markets).
 Satisficing is more appropriate for companies or individuals who want stability and a
balanced approach, particularly in industries where long-term sustainability is valued
over high risk (e.g., utility companies, mature businesses, or conservative investors).

Ultimately, many firms might adopt a combination of both approaches, focusing on maximizing
growth while also ensuring that their decisions are reasonable and meet baseline financial and
ethical standards.

Q8. Explain the major decisions which are taken by the modern financial
manager.

A financial manager plays a crucial role in making key decisions that affect the financial health
and stability of an organization. The major decisions made by financial managers can be broadly
categorized into three areas:

1. Investment Decisions (Capital Budgeting)

 Capital budgeting involves deciding where to allocate the company’s resources to

achieve the best possible return on investment. These decisions are related to long-term
investments in projects, assets, or ventures.
o Example: Deciding whether to invest in new machinery, research and
development, or expanding the company’s operations into a new market.
o Tools Used: Net Present Value (NPV), Internal Rate of Return (IRR), Payback
Period, and Profitability Index.

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2. Financing Decisions (Capital Structure)

 Capital structure decisions focus on determining the right mix of debt and equity
financing to fund the company’s operations and growth. The goal is to optimize the cost
of capital and maintain a balance between risk and return.
o Example: Deciding whether to issue new shares (equity), take on more debt
(loans or bonds), or use retained earnings to fund a new project.
o Considerations: Cost of debt vs. equity, financial leverage, the company’s risk
profile, and market conditions.

3. Dividend Decisions (Payout Policy)

 Dividend decisions involve determining how much of the company’s earnings will be
distributed to shareholders as dividends and how much will be retained for reinvestment.
The goal is to maintain a balance between rewarding shareholders and ensuring enough
capital for future growth.
o Example: Deciding whether to pay a dividend and how much it should be, or
reinvesting the earnings back into the business.
o Considerations: Profitability, cash flow, investment opportunities, and
shareholder expectations.

Additional Key Considerations:

 Risk Management: Financial managers also access and manage financial risks (e.g.,
market risk, credit risk, operational risk) to protect the organization from financial
instability.
 Liquidity Management: Ensuring the organization has enough liquidity to meet short-
term obligations without compromising long-term profitability.
 Working Capital Management: Managing the company’s short-term assets and
liabilities to ensure it can maintain day-to-day operations efficiently.

In summary, the major decisions of a financial manager involve:

 Where to invest? (Investment decisions)

 How to fund those investments? (Financing decisions)
 How to return profits to shareholders? (Dividend decisions)

These decisions require a deep understanding of the financial position of the company, market
conditions, and the long-term goals of the organization.

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18
 UNIT – 2
FINANCING DECISION

Q1. Explain the sources of finance briefly.

In financing decisions, businesses have various sources of finance they can use to fund
operations, investments, or expansions. These sources of finance can be broadly categorized into
equity and debt, with some additional options for hybrid or alternative financing methods. Here
are the key sources:

1. Equity Financing

 Owners' Capital: The money provided by the business owners (e.g., sole proprietors or
partners) from their personal savings.
 Issuing Shares: Public or private companies can issue common or preferred shares to
raise equity capital. This could be done through an Initial Public Offering (IPO) or a
private placement.
 Retained Earnings: Profits that a company has earned but not distributed to shareholders
as dividends, which are reinvested into the business for future growth.
 Venture Capital (VC): Private equity funding provided to startups and early-stage
businesses with high growth potential in exchange for ownership stakes.
 Angel Investors: Wealthy individuals who provide capital for startups or small
businesses in exchange for equity or debt.
 Private Equity: Investment firms or funds that provide capital to businesses (often in the
form of equity) in exchange for control or significant influence in decision-making.

2. Debt Financing

 Bank Loans: Borrowed funds from banks or other financial institutions. Loans may be
short-term, medium-term, or long-term and typically involve regular interest payments.
 Bonds: Companies can issue corporate bonds to raise large amounts of capital. Investors
buy bonds, and the company agrees to pay interest (coupon) and repay the principal at
maturity.
 Trade Credit: Suppliers may offer goods or services to a business with delayed payment
terms, essentially allowing the business to finance purchases on credit.
 Overdraft: A short-term borrowing arrangement with a bank that allows a company to
withdraw more than its account balance up to a certain limit.
 Leasing: Companies may lease assets (e.g., equipment or property) instead of purchasing
them outright. This allows businesses to use assets without upfront capital expenditure.

19
  Factoring: A business can sell its receivables (invoices) to a factoring company at a
discount in exchange for immediate cash.

3. Hybrid Financing

 Convertible Bonds: These are bonds that can be converted into a predetermined number
of the company’s shares, giving the bondholder the option to convert debt into equity.
 Mezzanine Financing: A blend of debt and equity financing that typically involves
subordinated debt or preferred equity. It is often used for expanding companies and
carries higher interest rates.

4. Alternative Financing

 Crowd funding: Raising small amounts of money from a large number of people,
typically via online platforms (e.g., Kickstarter, Indiegogo). This is commonly used by
startups and small businesses.
 Peer-to-Peer Lending (P2P): Platforms that allow individuals to lend money directly to
businesses, bypassing traditional financial institutions.
 Government Grants and Subsidies: In some regions, governments offer grants,
subsidies, or low-interest loans to businesses, particularly in specific industries or sectors
(e.g., technology, renewable energy).
 Invoice Financing: A business can use its accounts receivable to secure a loan, allowing
it to receive funds immediately without waiting for customers to pay.

Factors Influencing the Financing Decision:

 Cost of Capital: The cost of obtaining funds through debt or equity will influence the
decision. Debt may be cheaper, but it also carries risk.
 Risk: Debt financing comes with the obligation of repayment, which may add financial
risk, while equity financing dilutes ownership but doesn’t have a repayment obligation.
 Control: Issuing equity means sharing ownership and possibly losing some control,
whereas debt does not affect ownership.
 Business Lifecycle: Early-stage companies may rely more on equity or venture capital,
while mature businesses may have easier access to debt markets.

Each financing option has its advantages and disadvantages, and businesses typically use a mix
of sources to optimize their capital structure. The choice depends on factors like the company’s
size, industry, growth stage, risk profile, and market conditions.

20
Q2. Explain the concept of leverage and its types.

Leverage refers to the use of various financial instruments or borrowed capital—such as debt—
to increase the potential return of an investment or business operation. By utilizing leverage, an
individual or company can amplify both gains and losses. The basic idea is to use a small amount
of equity or capital to control a larger amount of an asset or investment.

Types of Leverage:

1. Financial Leverage:
o This involves borrowing money to increase the size of an investment. For example, a
company might issue debt (e.g., bonds or loans) to finance its operations, rather than
using only its own equity.
o Example: A real estate investor may take out a mortgage to buy a property, thus
controlling a larger asset with less of their own money. If the property increases in value,
the investor can make a significant profit relative to their initial investment. However, if
the value decreases, the losses are amplified.

2. Operating Leverage:
o Operating leverage refers to the proportion of fixed costs in a company's cost structure.
Companies with high operating leverage have higher fixed costs and lower variable costs.
A small increase in sales can lead to a large increase in profit, but similarly, a decrease in
sales can lead to a large decline in profits.
o Example: A tech company with significant investment in machinery may not need to
spend much more to produce additional units, meaning its profit increases rapidly as sales
grow.

3. Investment Leverage:
o In the context of investments, leverage refers to using borrowed funds to invest in
financial markets, such as stocks, bonds, or derivatives, to enhance returns.
o Example: An investor may borrow money from a broker to buy more shares than they
could afford with their own capital. If the stock price rises, the investor can sell and repay
the loan, keeping the excess profit.

Pros and Cons of Leverage:

Pros:

 Increased Returns: Leverage allows individuals and companies to magnify their potential
returns on investment or business operations. A small increase in the value of an asset or sales
can lead to large profits.

21
  Capital Efficiency: It allows investors and businesses to control more assets with less capital,
increasing the return on equity.
 Diversification: Leverage can help businesses expand more quickly, enabling them to diversify
their operations or investment portfolio.

Cons:

 Increased Risk: Leverage amplifies both gains and losses. If things go wrong (e.g., investments
decline in value or sales drop), the losses are also magnified. For businesses, this could lead to
financial distress or bankruptcy.
 Interest Payments: Borrowing money often requires interest payments, which can erode profits.
If the return on an investment doesn’t exceed the cost of borrowing, it could result in a net loss.
 Asset Liquidation: If a company or individual fails to repay borrowed funds, the lender can seize
assets (e.g., through foreclosure in real estate or liquidation in business).

Common Examples of Leverage:

1. Real Estate: A mortgage allows homebuyers or investors to leverage borrowed money to acquire
property that would otherwise be unaffordable. The buyer may only need a 20% down payment
but controls 100% of the property.
2. Corporate Leverage: A company may issue bonds to raise funds for expansion, using leverage
to scale faster than if it only relied on equity.
3. Margin Trading in Stocks: Investors can borrow funds from a broker to buy stocks on margin,
amplifying both potential gains and losses.

Leverage Ratios:

 Debt-to-Equity Ratio: A key measure of financial leverage, showing the proportion of

debt used to finance the company's assets relative to equity.

Debt-to-Equity Ratio= Total Debt / Shareholders’ Equity

 Degree of Operating Leverage (DOL): Measures how sensitive a company's operating

income is to changes in sales? A higher DOL means a company’s profitability is more
sensitive to sales volume.

Conclusion:

Leverage can be a powerful tool to magnify returns but comes with significant risk. It's essential
to carefully manage leverage to avoid the possibility of devastating financial consequences.

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Q3. Explain the financial effects of leverages.

Leverage in finance refers to the use of borrowed funds (debt) to increase the potential return on
investment (ROI). By using leverage, a company or investor can control a larger amount of
assets than they could by only using their own equity. However, it introduces both the potential
for higher profits and higher risks.

1. Amplification of Returns

Leverage can amplify both gains and losses. When an investor uses leverage, they borrow money
to invest more than they could with just their own capital. If the investment performs well, the
returns are magnified because the profit is earned on the larger, leveraged amount, not just the
equity.

Example:

 Without Leverage: An investor with Rs.100,000 invests in an asset that returns 10%.
The gain is Rs.10,000 (10% of Rs.100,000).
 With Leverage: If the investor borrows an additional Rs.100,000 and now has
Rs.200,000 to invest, the same 10% return generates Rs.20,000 in profit. The return on
the investor's original Rs.100,000 is now 20% (Rs.20,000 gain on Rs.100,000 equity).

2. Increased Risk

While leverage can magnify returns, it can also magnify losses. If the value of the leveraged
asset declines, the investor still needs to repay the borrowed funds, leading to a potentially larger
loss than if no leverage had been used.

Example:

 Without Leverage: A Rs.100,000 investment that drops 10% results in a Rs.10,000 loss.
 With Leverage: If the same Rs.100,000 investment is leveraged with Rs.100,000 of
borrowed funds, and the value drops 10%, the total loss is Rs.20,000. The investor still
owes the original Rs.100,000 borrowed, but now their equity is reduced, and they could
even face a margin call if their equity falls too low.

3. Debt Servicing and Interest Costs

23
Leverage involves borrowing money, which means the company or investor must pay interest on
the debt. The interest payments reduce the overall return on investment. If the return on the
investment is less than the cost of borrowing (interest), leverage can result in a net loss.

Example:

 An investor borrows Rs.100,000 at 5% interest. The annual interest payment is Rs.5,000.

 If the investment return is only 4%, the investor earns Rs.4,000, which is less than the
Rs.5,000 interest expense, leading to a net loss.

4. Effect on Profitability and Equity

Using leverage can affect a company’s profitability and its equity structure. A company that uses
leverage has higher debt obligations, and its profitability is more sensitive to changes in revenue
or interest rates.

 Increased ROI (Return on Equity): If the return on the investment exceeds the cost of
debt, the use of leverage increases the company's return on equity (ROE), which can be
attractive to shareholders.
 Decreased ROE or even Negative Equity: If returns fall short of debt costs, ROE will
decrease, and in extreme cases, the company’s equity could turn negative if it cannot
meet its debt obligations.

5. Impact on Financial Ratios

Leverage affects key financial ratios, including:

 Debt-to-Equity Ratio (D/E): A higher level of debt increases this ratio, indicating higher
financial risk. A very high D/E ratio can signal potential solvency issues.
 Interest Coverage Ratio: This ratio measures a company’s ability to pay interest on its
debt. Lower values indicate higher risk of default.
 Return on Assets (ROA): Leverage can increase the ROA if the return from the asset
exceeds the cost of debt.

6. Tax Advantages

In many countries, interest on debt is tax-deductible, which provides a tax shield. This reduces
the effective cost of borrowing, making debt financing potentially more attractive than equity
financing.

24
Example:

 A company borrows money and pays Rs.1,000 in interest. If the tax rate is 30%, the after-
tax cost of the interest is reduced to Rs.700 (since the interest expense reduces taxable
income). This tax advantage makes debt financing more attractive in some cases.

7. Leverage in the Broader Economy

Leverage isn’t limited to individual investors or companies. When a large number of firms or
households use leverage, it can increase systemic risk. During economic downturns, high levels
of leverage can lead to widespread defaults or bankruptcies, as seen in the 2008 global financial
crisis, where excessive mortgage-backed securities and borrowing led to a collapse in global
markets.

Conclusion

Leverage can significantly enhance returns when investments perform well but exposes investors
and companies to substantial risks when investments underperform. It is a double-edged sword,
and careful consideration is required regarding the level of debt, the cost of debt, and the risk
profile of the investment.

Q4. Explain the EBIT –EPS analysis.

The EBIT-EPS analysis is a financial tool used by companies and investors to understand the
relationship between a company's operating income (EBIT) and its earnings per share (EPS)
under different capital structures. This analysis helps determine the optimal capital structure—
the mix of debt and equity—that maximizes shareholder value.

Key Components

1. EBIT (Earnings Before Interest and Taxes):

o EBIT represents a company's operating income, which is the profit earned from
its core business activities before interest expenses and taxes are deducted.
o It reflects the firm's ability to generate profit from operations without considering
how it is financed (i.e., whether it has debt or equity financing).
2. EPS (Earnings Per Share):

25
 o EPS measures the profitability of a company on a per-share basis. It’s calculated
as the net income (after interest and taxes) divided by the number of outstanding
shares.
o EPS is important because it indicates how much profit a company is generating
for each share owned by an investor, and it’s a key metric used in stock valuation.

The Purpose of EBIT-EPS Analysis

The EBIT-EPS analysis helps assess the impact of different financing decisions (debt vs. equity)
on a company's financial performance. This is important because the choice between using debt
or equity financing affects both EBIT and EPS in different ways.

 Debt Financing: Increases financial leverage, which can increase EPS if the firm’s EBIT
is high enough to cover interest expenses. However, too much debt can be risky if EBIT
drops because interest payments are fixed.
 Equity Financing: Avoids the risks associated with debt (such as interest payments) but
dilutes ownership, which may lower EPS, as more shares are in circulation.

How does EBIT-EPS analysis work?

 Identify capital needs
 Factor in debt costs
 Calculate after-tax earnings
 Determine EPS with outstanding shares

Key Points in EBIT-EPS Analysis:

1. Leverage Effect: Debt increases the leverage of a company, meaning that small changes
in EBIT can result in large changes in EPS. However, too much debt increases financial
risk.
2. Optimal Capital Structure: The goal of EBIT-EPS analysis is to find the capital
structure that maximizes EPS, considering both debt and equity. The analysis helps to
assess the risk-return tradeoff at various levels of debt.
3. Breakeven EBIT: The breakeven EBIT tells the company at what level of operating
income debt financing no longer improves or worsens EPS. Below this level, equity
financing may be preferable.

26
Conclusion

The EBIT-EPS analysis is a useful tool for determining the impact of different financing
strategies on a company's profitability per share. By evaluating various debt-equity mixes,
businesses can find the optimal capital structure that maximizes EPS and shareholder value while
managing the risks associated with debt.

Q5. Define the concept of cost of capital. State how you would determine the
weighted average cost of capital of a firm.

Concept of Cost of Capital:

The cost of capital refers to the required return that a company must provide to its investors
(both equity and debt holders) in order to compensate them for the risks associated with
investing in the company. It is essentially the cost of financing a company's operations and
growth through either debt or equity. The cost of capital is a critical measure because it serves as
a benchmark for evaluating investment opportunities. If a project’s return is higher than the cost
of capital, it is considered value-creating; otherwise, it is value-destroying.

The cost of capital typically includes:

1. Cost of Debt: The effective rate a company pays on its borrowed funds, adjusted for tax
advantages (since interest is tax-deductible).

27
 2. Cost of Equity: The return required by equity investors, based on the risk of owning the
company’s stock, and is often estimated using models like the Capital Asset Pricing
Model (CAPM).

Weighted Average Cost of Capital (WACC):

The WACC represents the overall rate of return that a company must earn on its assets, weighted
by the proportion of debt and equity in its capital structure. It provides a single measure of the
cost of financing that accounts for the relative weights of debt and equity in the company’s
capital structure.

Formula for WACC:

WACC = (E / V) × Re) + (D/V) × Rd × (1−Tc) )

Where:

 E = Market value of equity

 D = Market value of debt
 V = Total value of the company (E + D)
 Re = Cost of equity
 Rd = Cost of debt
 Tc = Corporate tax rate

Steps to Determine WACC:

1. Calculate the Cost of Debt (Rd):

Use the yield to maturity (YTM) on existing debt or the interest rate on new debt
as the cost of debt.

Adjust for taxes because interest on debt is tax-deductible:

After-tax Cost of Debt = Rd × (1−Tc)

Calculate the Cost of Equity (Re):

The cost of equity can be estimated using models like the Capital Asset Pricing
Model (CAPM):

28
 Re = Rf + β × (Rm − Rf)

Where:

Rf = Risk-free rate (e.g., yield on government bonds)

β = Beta coefficient (measures the stock’s volatility relative to the market)

Rm = Expected return on the market

Rm - Rf = Market risk premium

2. Determine the Market Value of Debt (D) and Equity (E):

The market value of equity (E) is typically the current stock price multiplied by
the number of shares outstanding.

The market value of debt (D) is often approximated using the book value of debt
unless market prices are available for outstanding bonds or loans.

3. Determine the Total Value (V):

The total value of the company is the sum of its debt and equity:

V =E+D

4. Plug Values into the WACC Formula: After obtaining the values for each of the
components, substitute them into the WACC formula to calculate the company's overall
cost of capital.

Importance of WACC:

 Investment Decisions: WACC serves as a discount rate for evaluating investment

opportunities using techniques like Net Present Value (NPV) or Economic Value Added
(EVA). Projects that generate returns higher than the WACC add value to the firm.
 Valuation: When valuing a company using Discounted Cash Flow (DCF) models,
WACC is used as the discount rate to determine the present value of future cash flows.
 Optimal Capital Structure: A company aims to find the optimal balance of debt and
equity that minimizes WACC and maximizes firm value.

29
Thus, WACC is a central concept in corporate finance, linking a company's risk and its cost of
financing.

Q6. Calculate operating leverage, financial leverage and combined leverage under situation
1 and 2 in financial plans A & B from the following information relating to the operation
and capital structure of a company.
Installed capacity – 2,000 units
Actual production and sales – 50% of the capacity
Selling price Rs.20 per unit
Variable Cost Rs.10 per unit
Fixed Cost:
Under Situation I Rs. 4,000
Under Situation II Rs.5,000

Capital Structure:
Financial Plan
A (Rs.) B (Rs.)
Equity 5,000 15,000
Debt (Rate of Interest 10%) 15,000 5,000

20,000 20,000

Solution:

Statement of Profitability
Situation I Situation II
Plan A Plan B Plan A Plan B
Particulars (1,000 Units) (1,000 Units) (1,000 Units) (1,000 Units)

Amt P.U Amt P.U Amt P.U Amt P.U

Sales 20,000 20 20,000 20 20,000 20 20,000 20

(–) Variable Cost 10,000 10 10,000 10 10,000 10 10,000 10

Contribution 10,000 10,000 10,000 10,000

Less: Fixed Cost 4,000 4,000 5,000 5,000

30
EBIT 6,000 6,000 5,000 5,000

(–) Interest 1,500 500 1,500 500

EBT 4,500 5,500 3,500 4,500

1. Operating Leverage = Contribution / EBIT

Situation I Situation II

Plan A Plan B Plan A Plan B

=10000/6000 =10000/6000 =10000/5000 =10000/5000

= 1.67 = 1.67 =2 =2

2. Financial Leverage = EBIT / EBT

Situation I Situation II

Plan A Plan B Plan A Plan B

= 6000/4500 = 6000/5500 = 5000/3500 = 5000/ 4500

= 1.33 = 1.09 = 1.428 = 1.1

3. Combined Leverage = Contribution / EBT

Situation I Situation II

Plan A Plan B Plan A Plan B

=10000/4500 =10000/5500 =10000/3500 =10000/4500

= 2.22 = 1.818 = 2.857 = 2.22

Working Note:

Interest: Plan A: Rs.15, 000 x 10% = Rs.1, 500

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 Plan B: Rs.5, 000 x 20% = Rs.500

Q7. The following key information pertains to Ashika Ltd. for the year 2013-14.

Rs. in lakhs
Rs.
Sales 82.50
Variable Cost 46.20
Fixed Cost 6.60
9% Debentures 50.00
Equity Shares (Rs. 100 each) 60
Corporate Tax 35%

You are required to work out:

1. What is the Company’s ROI?
2. Does it have favourable financial leverage?
3. If the firm belongs to an industry whose asset turnover is 3, does it have high or low
asset leverage?
4. What is the operating, financial and combined leverage of the firm?
5. What is the Company’s EPS?
6. What will be the expected EPS if the Sales of Ashika Ltd. increase by 10% in the
next year and cost structure as well as Financial structure remains same?

32
Solution:

Rs. in lakhs

Particulars Rs. Rs. in lakhs

Sales 82.50 Capital Employed

(–) Variable Cost 46.20 Debt 50

Contribution 36.30 Equity 60

(–) Fixed Cost 6.60 110

Earnings before Interest & Tax (EBIT) 29.70

(–) Interest (Rs. 50 lakhs x 9%) 4.50

Earnings before Tax (EBT) 25.20

(–) Tax (35%) 8.82

EAT 16.38

1) Return on Investment (ROI) = (EBIT / Capital Employed) x 100

= (29.70/110) x 100

= 27%

2) Performance of Financial Leverage: Since the ROI is 27% is higher than cost of
debt i.e.9%. The firm has favorable financial leverage.

3) Assets T/O Ratio = Sales / Total Assets

= 82.50 / 110

= 0.75 times

Since 0.75 times is less than the industries average i.e. 3 times, therefore the firm
has low asset leverage.

33
4) Operating Leverage = Contribution / EBIT

= 36.30/29.70

= 1.22

Financial Leverage = EBIT / EBT

= 29.70/25.20

= Rs.1.18

Combined Leverage = Contribution / EBT

= 36.30/ 25.20

= 1.44

OR Combined Leverage = OL x FL

= 1.22 x 1.18

= 1.44

5) Earnings per Share:

EPS = (Profit to Equity Shareholders / No. of Equity Shares)

= (16,38,000 / 60,000)

= Rs. 27.30

e) If the sales increase by 10% what will be the new EPS : Increase in Combined
Leverage : 1.44 x 10% = 0.144

 Increase in EPS: Rs. 27.30 + (Rs. 27.30 x 0.144) = Rs. 31.2312

OR

34
Particulars Rs. in lakhs

Rs.

Sales [Rs. 82.50 + 10%] 90.75

(–) Variable Cost [Rs. 46.20 + 10%] 50.82

Contribution 39.93

(–) Fixed Cost 6.60

Earnings before Interest & Tax (EBIT) 33.33

(–) Interest (Rs. 50 lakhs x 9%) 4.50

Earnings before Tax (EBT) 28.83

(–) Tax (35%) 10.0905

EAT 18.7395

EPS = Profit to Equity Shareholders / No. of Equity Shares

= Rs. 18, 73,950 / 60,000 shares

= Rs. 31.2325
Q8. The capital structure of Vikas limited is as follows:
Share Book Value Market Value
Equity Share Capital 10,00,000 20,00,000 (200%
Retained earnings 5,00,000 of book value)
14% Preference share -
capital 7, 00,000 7, 00,000 ( Just
12% Debentures Par)
6, 00,000 6, 00,000 ( Just
Par)

35
After tax, Cost of capital of these different sources is Equity share capital 18%, Retained
earnings 15%, Preference Share capital 14% and Debentures 8%. Calculate Weighted average
cost of capital of the company.

Solution:

Source Amount (Rs.) %to total funds After tax Cost of Cost of capital
Capital (3) X (4)
(1) (2) (3) (4) (5)
Equity Share 10,00,000 35.71 18 6.43
Capital

5,00,000 17.86 15 2.68

14% Preference 7,00,000 25.00 14 3.50

share capital

12% Debentures 6,00,000 21.43 8 1.71

Total 28,00,000 100.00 WACC = 14.32

Therefore Weighted Average Cost of Capital is 14.32%

36
 UNIT – 3
INVESTMENT DECISION

Q1. What is investment decision and explain the key factors influencing
investment decisions.

Investment decisions are a critical aspect of personal and business finance, where individuals or
organizations allocate their resources (typically money) into various assets with the expectation
of generating a return over time. These decisions can involve a wide range of investment options,
from stocks, bonds, and real estate to more complex instruments like derivatives or venture
capital investments.

What is an Investment Decision?

An investment decision refers to the process of selecting where to place resources (usually
money) to achieve a financial return or capital growth. The goal is to make choices that will
maximize returns while minimizing risk.

Types of Investment Decisions:

 Individual Investment Decisions: These are made by individual investors who might
invest in stocks, bonds, mutual funds, real estate, or other assets.
 Corporate Investment Decisions (Capital Budgeting): Businesses make investment
decisions when allocating funds for long-term projects such as expanding operations,
purchasing new equipment, or launching new products.
 Government Investment Decisions: Governments invest in infrastructure, public
services, or research & development.

Key Factors Influencing Investment Decisions:

 Risk and Return: Every investment carries some level of risk. Typically, higher
potential returns come with higher risks. Understanding this trade-off is fundamental.
 Time Horizon: How long you intend to hold the investment affects the decision. Long-
term investments may involve less risk compared to short-term investments, though this
is not always the case.
 Liquidity: The ease with which an asset can be converted to cash. Some investments
(like stocks) are highly liquid, while others (like real estate) are less so.

37
  Inflation: Inflation erodes the value of money over time, so investments should ideally
outpace inflation to ensure a positive real return.
 Diversification: Spreading investments across different assets or markets to reduce risk.
 Market Conditions: Interest rates, economic trends, and market sentiment can
significantly affect investment outcomes.

Investment Decision Process:

1. Set Objectives: Define what you want to achieve (e.g., retirement savings, capital
appreciation, income generation).
2. Assess Risk Tolerance: Understand how much risk you are comfortable taking on.
3. Research and Evaluate Options: Study various investment vehicles and strategies.
4. Make the Investment: Allocate resources based on your evaluation.
5. Monitor and Adjust: Regularly assess the performance of your investments and make
adjustments as needed.

Conclusion:

Investment decisions are a complex but essential part of growing wealth, managing financial
risk, and achieving long-term financial goals. To make informed decisions, one must carefully
evaluate the risks and potential returns of different investment options, consider one’s financial
objectives, and understand the broader economic environment.

Q2. Explain the concept of time value of money

The Time Value of Money (TVM) is a financial concept that explains the idea that a sum of
money today is worth more than the same amount in the future. This is because money has the
potential to earn interest or generate returns over time. In other words, the value of money
decreases as time passes due to factors like inflation and the opportunity cost of not investing it.

Key Ideas in TVM:

1. Present Value (PV): The value today of a sum of money that will be received or paid in
the future.
2. Future Value (FV): The value of a sum of money at a future point in time, after
accounting for interest or investment returns.

38
 3. Interest Rate: The rate at which money grows over time due to earning interest or
returns on investment.
4. Compounding: The process of earning interest on both the initial amount of money (the
principal) and any accumulated interest.
5. Discounting: The process of determining the present value of a future sum of money by
applying an interest rate to account for the time value of money.

Why TVM is Important:

 Investment Decisions: TVM helps individuals and businesses decide where and when to
invest money by comparing the value of cash flows at different points in time.
 Loans & Financing: It is crucial in determining the cost of loans, mortgages, and other
financial products, as well as assessing how much a future payment is worth today.
 Financial Planning: Understanding TVM is key to effective budgeting, retirement
planning, and understanding the cost of delaying purchases or receiving payments.

Common Formulae in TVM:

1. Future Value (FV):

FV=PV × (1+r)n Where:

PV = Present Value
r = interest rate per period
n = number of periods
2. Present Value (PV):

PV= FV / (1+r)n

3. Annuities (Regular payments):

There are formulas for calculating the present and future values of annuities, which are
cash flows that occur regularly over time.

Example:

If you have Rs.1,000 today and you invest it at an interest rate of 5% per year, the future value of
that Rs.1,000 in 3 years would be:

39
FV= 1000 × (1+0.05)3

=1000×1.157625

=1157.63

In this case, the Rs.1,000 today is worth Rs.1,157.63 in 3 years due to the interest earned. In
short, TVM helps to explain why it’s generally better to receive money now rather than later and
why future payments or investments must be adjusted for time when making financial decisions.

Q3. Explain the techniques of Time value of Money.

Several techniques are commonly used in TVM calculations to account for the passage of time,
including:

1. Present Value (PV)

 The Present Value is the current worth of a future sum of money or stream of cash
flows, discounted at a specific interest rate.

Present Value (PV):

PV= FV / (1+r)n

FV = Future Value
r = interest rate per period
n = number of periods

2. Future Value (FV)

 The Future Value is the value of a current amount of money after earning interest over a
set number of periods.

FV=PV × (1+r)n Where:

PV = Present Value
r = interest rate per period
n = number of periods

3. Compounding

 Compounding refers to the process of earning interest on both the original amount
(principal) and the accumulated interest from previous periods.

40
  The more frequently interest is compounded, the higher the future value.

 Formula for compound interest:

A= P × (1+ (r / n))nt

Where:
A = Amount after interest
P = Principal (initial investment)
r = Annual interest rate (decimal)
n = Number of compounding periods per year
t = Time in years

4. Annuities

 Annuities are series of equal payments made at regular intervals, either at the beginning
(annuity due) or at the end (ordinary annuity) of each period.

Present Value of Annuity (PVA):

PVA = PMT × ((1− (1+r) −n)) / r

Where:

PVA = Present Value of Annuity

PMT = Payment amount per period
r = Discount rate per period
n = Number of periods

Future Value of Annuity (FVA):

FVA = PMT × ((1+r) n −1)) / r

Where:

FVA = Future Value of Annuity

5. Internal Rate of Return (IRR)

 The Internal Rate of Return is the discount rate that makes the Net Present Value
(NPV) of all cash flows (both positive and negative) from a particular investment equal to
zero. It's the rate at which the present value of future cash inflows equals the initial
investment.

6. Net Present Value (NPV)

41
  Net Present Value is the difference between the present value of cash inflows and
outflows. It is a widely used method for evaluating investments or projects.

7. Discount Rate

 The Discount Rate is the rate used to calculate the present value of future cash flows. It
represents the opportunity cost of capital or the return that could be earned on an
investment of similar risk.

These techniques are integral to making sound financial decisions, including evaluating
investments, valuing cash flows, and comparing financial products or projects that have different
timelines and cash flow patterns. The choice of method depends on the nature of the financial
decision and the specific cash flow characteristics involved.

Q4. Explain the nature and significance of investment decision.

An investment decision refers to the process of selecting where to place resources (usually
money) to achieve a financial return or capital growth. The goal is to make choices that will
maximize returns while minimizing risk.

Nature of Investment Decision

An investment decision refers to the process of deciding where, how, and when to allocate
financial resources to various assets or projects. It involves assessing potential opportunities with
the objective of achieving a return that justifies the risk taken. Investment decisions are typically
made by individuals, corporations, or institutions and are crucial for wealth creation and long-
term financial stability.

The nature of investment decisions includes several key aspects:

1. Allocation of Resources: Investment decisions primarily involve the allocation of funds

or capital across various options such as stocks, bonds, real estate, business ventures, or
other forms of assets.
2. Risk and Return Trade-off: Every investment carries some level of risk, and an investor
must balance this risk with the expected return. Higher risk investments generally offer
higher potential returns, and vice versa.
3. Time Horizon: Investment decisions can be short-term or long-term, depending on the
financial goals of the investor. Long-term investments may involve less frequent changes
but could yield greater returns, while short-term investments are typically more liquid but
may involve more volatility.

42
 4. Diversification: Investors often aim to diversify their investments across different asset
classes or sectors to reduce risk. A well-diversified portfolio can reduce the impact of
losses in any single investment.
5. Capital Appreciation or Income: Investments may be made for capital gains (increase
in asset value over time) or for income generation (such as dividends or interest
payments).
6. Strategic or Tactical Decision-Making: Investment decisions may be part of a broader
strategic plan or made tactically to take advantage of short-term market movements or
economic trends.

Significance of Investment Decision

1. Wealth Maximization: The primary objective of investment decisions is wealth creation.

By making informed investment choices, an individual or organization can increase its
capital over time, achieving long-term financial goals.
2. Financial Stability: For individuals and businesses, sound investment decisions
contribute to financial stability and independence. A well-balanced portfolio can help
weather financial downturns and ensure sufficient funds for future needs.
3. Economic Growth: At the macroeconomic level, investment decisions play a crucial role
in economic growth. Investments in infrastructure, technology, and innovation drive
productivity improvements, create jobs, and foster economic development.
4. Risk Management: Good investment decisions help manage financial risks by
diversifying holdings and carefully choosing where to invest. Investors who understand
risk can avoid significant losses during periods of market volatility.
5. Opportunities for Innovation: Strategic investment decisions can fund innovation,
research, and development, particularly in emerging industries. This fosters new
technologies, products, and services that can have broad economic and societal benefits.
6. Inflation Protection: Investing can be a way to protect against inflation, as assets like
stocks, real estate, or commodities may provide returns that outpace rising prices,
preserving purchasing power over time.
7. Capital Formation: Businesses rely on investment decisions to raise capital for
expansion, research, and development. This enables companies to innovate, improve
products and services, and create more value for stakeholders.
8. Corporate Growth and Value Creation: Investment decisions are essential for
businesses to grow. Whether through mergers, acquisitions, or investments in new
projects, companies seek ways to increase their market share, profitability, and value to
shareholders.

43
In conclusion, investment decisions are a cornerstone of both personal and corporate financial
strategy. They have significant implications for risk management, financial growth, and
economic stability, and are a key factor in the creation of wealth and long-term financial success.

Q5. Define capital budgeting and explain the process of Capital budgeting.
Capital budgeting is the process by which businesses evaluate and make decisions about long-
term investments in projects, assets, or ventures. These investments typically involve large
expenditures, such as purchasing new equipment, launching new products, or expanding
operations. Since these decisions have long-term financial implications, capital budgeting is a
critical process for ensuring the financial health and growth of the company.

Key Steps in the Capital Budgeting Process:

1. Identifying Investment Opportunities

 The first step involves identifying potential investment opportunities that align with the
company’s strategic objectives. These can be new projects, acquisitions, upgrades to
existing assets, or expansion plans.
 The organization needs to assess which investment opportunities align with its long-term
goals and fit within the available budget or financing capabilities.

2. Estimating Cash Flows

 For each investment opportunity, companies must estimate the expected cash inflows and
outflows over the life of the project.
 This includes the initial investment required (capital expenditure), operating costs, and
any expected revenues or savings generated by the project.
 Cash flows are typically forecasted on an annual basis, although this can vary depending
on the nature of the investment.

3. Evaluating Investment Alternatives

 This step involves assessing the expected financial performance of each potential
investment using various evaluation techniques.
 Common methods include:
o Net Present Value (NPV): NPV calculates the present value of future cash
inflows minus the initial investment. A positive NPV indicates that the project is
expected to add value to the company.

44
 o Internal Rate of Return (IRR): IRR is the discount rate at which the NPV of a
project becomes zero. If the IRR exceeds the company’s required rate of return
(or cost of capital), the project is considered acceptable.
o Payback Period: This measures how long it will take to recover the initial
investment. Shorter payback periods are typically preferred, but this method does
not account for cash flows beyond the payback period.
o Profitability Index (PI): PI is the ratio of the present value of future cash flows
to the initial investment. A PI greater than 1 indicates a profitable investment.

4. Risk Assessment

 It’s important to assess the risk associated with each investment. Companies need to
consider factors like market volatility, economic conditions, technological changes, and
regulatory risks.
 Sensitivity analysis, scenario analysis, and Monte Carlo simulations are often used to
evaluate how changes in assumptions (e.g., sales volume, costs, or discount rates) impact
the project's financial outcomes.

5. Decision Making

 Based on the evaluation and risk analysis, decision-makers must choose which projects to
accept, reject, or defer.
 This step may involve prioritizing investments based on available capital, strategic
importance, or risk appetite.

6. Implementation

 Once a project is approved, it moves to the implementation phase. This involves securing
funding (e.g., from internal cash reserves, debt, or equity), procuring necessary resources,
and executing the project according to the planned timeline and budget.

7. Monitoring and Post-Implementation Review

 After the investment is implemented, the company should continuously monitor its
performance to ensure it meets the expected cash flows and goals.
 This step includes tracking actual performance against projections and conducting a post-
implementation review to learn from any deviations. If the investment doesn’t meet
expectations, corrective actions may be necessary.

Conclusion

45
The capital budgeting process helps businesses make informed decisions about which long-term
investments to pursue. By estimating cash flows, evaluating alternatives, assessing risks, and
applying financial metrics like NPV and IRR, companies can choose investments that maximize
value and align with their goals. Effective capital budgeting ensures that capital is allocated
efficiently, contributing to the company’s financial success and growth over time.

Q6. Explain the non - discounting cash flow techniques of investment

appraisal.
In view of the significance of capital budgeting decisions, it is absolutely necessary that
the method adopted for appraisal of capital investment proposals is a sound one. Any appraisal
method should provide for the following.

 A basis of distinguishing between acceptable and non acceptable projects.

 Ranking of projects in order of their desirability.
 Choosing among several alternatives.
 A criterion which is applicable to any conceivable project.

Recognizing the fact that bigger benefits are preferable to smaller ones and early benefits
to later ones. There are several methods for evaluating the investment proposals. In case of all
these methods the main emphasis is on the return which will be derived on the capital invested in
the project.

46
The following are the main methods generally used:

Capital Budgeting Techniques

Non – DCF Criteria DCF Criteria

Net present value (NPV)

Pay back period (PBP)

Internal rate of return (IRR)

Accounting rate of return (ARR)

Profitability Index (PI)

Non DCF criteria

a) Payback period
The payback period one of the most popular and widely recognized traditional
methods of evaluation investment proposals. Pay back period is the number of years required to
recover the original cash outlay invested in a project.

If the project generates constant annual cash flows, the payback period can be computed by
dividing cash outlay by the annual cash inflows.

Payback period = Initial investment

Annual cash inflows

Co = Initial investment

C =Annual cash inflows.

Procedure for computation of single payback period:

 Determine the total outflow of the project.

47
  Determine the cash inflow after taxes (CAFT)for each year.
 Determine the cumulative CAFT at the end of the year.
 Determine the year in which cumulative CFAT exceeds initial investment

Compute payback period as under:

 In case uniform annual CFAT:

 Payback period=Initial investment/CFAT per annum.
 In case of differential annual CFAT:
 Payback period = time at which cumulative CFAT = Initial investment

In the case of unequal cash inflows, the payback period can be out by adding up
the cash inflow until the total is equal to the initial cash outlay.

Merits:

 This method is simple to understand and easy to calculate. Surplus arises only if the investment is
fully recovered. Hence, there is no profit on any project unless the payback period is over.
 When funds are limited, projects having shorter payback period should be selected, since they can
be rotated more number of times
 This method focuses on projects which generate cash inflows in earlier years. As time period of
cash inflows increases, risk and uncertainty also increases.

Limitations:

 It stresses on capital recovery rather than profitability.

 It does not consider the return from the project after its payback period.

Administrative difficulties may be faced in the determining the maximum acceptable payback
period.

(b) Accounting Rate of Return (ARR)

The accounting rate of return (ARR) also known as the return on investment (ROI) used
accounting information, as revealed by financial statement, to measure to profitability of an
investment.

48
 The accounting rate of return is the ratio of investment. The average investment would be
equal to half of the original investment if it were depreciated constantly.

ARR= Average Income X 100

Average investment

Procedure for computation of ARR:

Determine the net investment of the project.

Determine the profit after tax (PAT) for each year.

PAT = CFAT - Depreciation.

Determine the Cumulative PAT for N years, where N=Project life.

Compute Average PAT per annum= Cumulative PAT/N years.

A R R = Average Income X 100

Average investment

Merits:

a) This method is simple to understand.

b) It is easy to operate and compute.
c) Income through the project life is considered.
d) It can be readily calculated using the accounting data.

Limitations:

 It does not consider cash inflows which is important in project evaluation rather
than PAT
 It takes the rough average of profits of future years. The project or fluctuations in
profits are ignored.
 It ignores time value of money, which is important in capital budgeting decisions.

49
Q7. Explain the discounting cash flow techniques of investment appraisal.
Recognizing the fact that bigger benefits are preferable to smaller ones and early benefits
to later ones. There are several methods for evaluating the investment proposals. In case of all
these methods the main emphasis is on the return which will be derived on the capital invested in
the project.

DCF Criteria

a) Net present value (NPV):

The NPV present value (NPV) method is the classic method of evaluating the
investment proposals. If is a DCF technique that explicitly recognizes the time value at different
time periods differ in value and comparable only when their equipment present – are found out.

Formula:

NPV= (Ct / (1+r) t) − C0

Where:

Ct = Cash inflow at time t

r = Discount rate (also known as the required rate of return or interest rate)

t = Time period (usually years)

C0 = Initial investment (outflow at time 0)

Procedure for computation of NPV

 Determine the total cash inflow of the project and the time periods in which they
occur.
 Compute the total discounted cash inflow (DCO) = Out flow X pv factor
 Determine the total cash inflows of the project and the time periods in which they are
arise.
 Compute the total discounted cash inflows (DCF) = Inflow X PV factor
 Compute NPV = Discounted cash inflows less discounted cash outflows.
 Accept project if NPV is positive. Else reject.

50
Merits:

 NPV method takes account the time value of money.

 All cash inflows are considered.
 All cash inflows are converted into present value.
 It satisfies value additively principle i.e., NPV of two or more projects can be added.

Limitations:

 It may not satisfactory answer when the projects being compared involved different
amounts of investment.
 It is difficult to use.
 It may miss lead when dealing with alternative projects or limited funds.
 It involves difficult calculations.
 It involves forecasting cash flows and applications of discount rate.

B) Internal rate of Return (IRR):

The internal rate of return (IRR) method is another discounted cash flow technique
which takes account of the magnitude and thing of cash flows, other terms used to describe
the IRR method are yield on an investment, marginal efficiency of capital, rate of return over
cost, time –adjusted rate of internal return and soon.

IRR = LR + NPV at LR x different rate

Different NPV
Where

LR = Lower Discount rate at which NPV is positive

H = Higher discount rate at which NPV is negative

A = NPV at lower discount rate, L

B = NPV at higher discount rate, H

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Procedure for computations of IRR:-

 Determine the total cash outflow of the project and the time periods in which they
occur.
 Determine the total cash outflow of the project and the time periods in which they
arise.
 Compute the NPV at an arbitrary discount rate, say 10%
 Choose another discount rate and NPV. The second discount rate chosen in such a
way that one of the NPV’s is negative and the other is positive. Suppose NPV is
positive at 10% a higher discount rate so as to get negative NPV. In case of NPV is at
10% choose a lower rate.
 Compute the change in NPV over the two selected discount rates.
 On proportionate basis, compute the discount rate at which NPV is zero.

Merits:
 This method considers the time value of money.
 All cash inflows are considered.
 It has psychological appeal to the users.

Limitations:

 It may not give unique answer in all situations.

 It is difficult to understand and use in practices,
 It implies that the intermediate cash inflows generated by the project.

C) Profitability Index (PI):

Yet another time – adjusted method of evaluating the investment proposals in the
benefit- cost (B/C.) ratio or profitability index (PI) profitability index is the ratio of the present
valued of cash inflows, at the required rate of return, to the initial cash out of the investment.

PI = PV of cash Inflow

Initial cash Outlay

Merits:

52
  This method considers the time value of money.
 All cash inflows are considered.
 It is a better evaluation technique than NPV.
Limitations:

 It fails as a guide in resolving capital rationing when projects are indivisible.

Q8. A company is considering whether to purchase a new machine. Machines A and b are
available for Rs. 80,000 each. Earnings after taxation are as follows:

Year Machine A Machine B

Rs. Rs.
1 24,000 8,000
2 32,000 24,000
3 40,000 32,000
4 24,000 48,000
5 16,000 32,000
You are required to evaluate the two alternatives using the following: (a) Payback Period (b)
ARR (c) Net Present Value method. You should use discount rate of 10%.

Solution
(a) Payback method

24,000 of 40,000 = 2 years and 7.2 months

Payback period:

Machine A: (24,000 + 32,000 + 1 3/5 of 40,000) = 2 3/5 years.

Machine B: (8,000 + 24,000 + 32,000 + 1/3 of 48,000) = 3 1/3 years.

According to the payback method, Machine A is preferred.

53
(b) Average Rate of return on investment method

Particular Machine A Machine B

Total Cash Flows 1,36,000 1,44,000

Average Annual Cash Flows 1,36,000 / 5 = Rs.27,000 1,44,000 / 5 = Rs.28,800

Annual Depreciation 80,000 / 5 = Rs.16,000 80,000 / 5 = Rs.16,000

27,200 - 16,000 = 28,800 - 16,000 =

Annual Net Savings
Rs.11,200 Rs.12,800

Average Investment 80,000 / 2 = Rs.40,000 80,000 / 2 = Rs.40,000

ROI = (Annual Net Savings /

(11,200 / 40,000) x 100 (12,800 / 40,000) x 100
Average Investments) x 100

= 28% = 32%

According to the Average rate of return on investment (ROI) method, Machine B is preferred
due to the higher ROI rate.

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(c) Net present value method

The idea of this method is to calculate the present value of cash flows.

Yea Discount
Machine A Machine B
r Factor

Cash Flows P.V Cash Flows P.V

(at 10%)
(Rs.) (Rs.) (Rs.) (Rs.)

1 .909 24,000 21,816 8,000 7,272

2 .826 32,000 26,432 24,000 19,824

3 .751 40,000 30,040 32,000 24,032

4 .683 24,000 16,392 48,000 32,784

5 .621 16,000 9,936 32,000 19,872

1,36,000 1,04,616 1,44,000 1,03,784

Net Present Value = Present Value - Investment

Net Present Value of Machine A: Rs.1,04,616 - Rs.80,000 = Rs.24,616

Net Present Value of Machine B: Rs.1,03,784 - 80,000 = Rs.23,784

According to the net present value (NPV) method, Machine A is preferred because its NPV is
greater than that of Machine B.

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 UNIT – 4
DIVIDEND DECISION

Q1. Explain the meaning and significance of dividend decision.

The dividend decision refers to the choice made by a company's board of directors regarding the
distribution of profits to shareholders in the form of dividends. It is a key financial decision that
involves determining how much of the company's earnings should be paid out as dividends and
how much should be retained within the business for reinvestment or other purposes.

Meaning of Dividend Decision:

The dividend decision involves two main components:

1. Dividend Payout: This refers to the amount of profit to be paid out as dividends to
shareholders.
2. Retention of Earnings: This refers to the portion of profits that is retained by the
company and reinvested into the business (e.g., for expansion, reducing debt, or funding
capital projects).

Dividend decisions refer to the choices made by a company’s board of directors regarding the
distribution of profits to shareholders in the form of dividends. These decisions involve
determining:

1. Whether to pay a dividend: The company decides if it will distribute profits to

shareholders or retain earnings for reinvestment in the business.
2. How much to pay: The board determines the proportion of profits to distribute, typically
expressed as a dividend payout ratio (i.e., the percentage of earnings paid out as
dividends).
3. When to pay: This includes the timing and frequency of the dividend payments
(quarterly, annually, etc.).

These decisions are crucial because they have direct financial implications for both the company
and its shareholders.

Significance of Dividend Decisions

1. Impact on Shareholder Value:

o Attracting and Retaining Investors: Dividends are a key source of income for
investors, especially for income-focused investors such as retirees or institutional
56
 investors. The dividend policy, therefore, influences investor sentiment and
demand for the company’s shares.
o Signal of Financial Health: A stable or growing dividend often signals to the
market that the company is financially strong and capable of generating consistent
cash flows. Conversely, a reduction in dividends might suggest financial distress
or a lack of profitability.
2. Internal Financing vs. External Financing:
o By retaining earnings (i.e., not paying a dividend), a company can reinvest those
profits into its own operations, such as for expansion, research and development,
or debt reduction. This reduces the need to raise funds externally, which might
involve issuing new equity (diluting existing shareholders) or taking on debt
(increasing financial leverage and risk).
o A higher dividend payout can reduce the company’s cash reserves, possibly
limiting its ability to finance future growth internally.
3. Tax Implications:
o In some countries, dividends are taxed at a different rate than capital gains. As a
result, the company might choose to retain earnings and grow the business to
create capital gains for shareholders, instead of paying out dividends that could be
more heavily taxed.
o This also impacts investor preferences; some may prefer dividends for their
immediate income, while others may prefer capital gains, which could be more
tax-efficient.
4. Maintaining Stability and Confidence:
o Dividend Stability: Companies often aim to maintain a stable dividend payout to
signal reliability and maintain investor trust. Even in challenging financial times,
investors may prefer a consistent (if not growing) dividend over an unpredictable
payout.
o Signaling Effect: The dividend policy can signal management's expectations for
future earnings. An increase in dividends can signal optimism, while a decrease or
suspension may raise concerns about the company’s future performance.
5. Balancing Shareholder Expectations:
o Companies must strike a balance between satisfying current shareholders' desire
for immediate returns (dividends) and the need for long-term growth, which may
require reinvestment of profits into the business.
o Growth companies, particularly in sectors like technology, may prefer to reinvest
profits, paying little or no dividend, while more mature companies (e.g., utilities,
consumer goods) may be more likely to distribute substantial dividends.

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Q2. Explain the major forms of dividends.

Dividends are payments made by a corporation to its shareholders, usually as a distribution of

profits. There are several major forms of dividends that companies can use to reward their
shareholders:

1. Cash Dividends

 Description: The most common type of dividend, where a company distributes cash to
shareholders on a per-share basis.
 Payment: Typically paid in cash, either by check or direct deposit.
 Example: If a company declares a $1 dividend per share, and you own 100 shares, you
would receive $100 in cash.
 Frequency: Can be paid quarterly, semi-annually, or annually.

2. Stock Dividends

 Description: Instead of paying cash, a company issues additional shares of stock to its
shareholders, typically in proportion to the number of shares they already own.
 Payment: For example, a 10% stock dividend means that for every 10 shares a
shareholder owns, they will receive 1 additional share.
 Example: If you own 100 shares and the company declares a 10% stock dividend, you
will receive 10 additional shares.
 Impact on Shareholder: The total number of shares increases, but the value of each
share typically decreases, so the overall value of the investment remains the same,
assuming no other changes in the company.

3. Property Dividends

 Description: A company distributes assets other than cash or stock to shareholders.

These assets could be physical goods, other securities, or tangible items.
 Payment: The property could be anything from real estate to products or even shares in
another company.
 Example: A company might distribute shares of a subsidiary it owns to its shareholders.
 Considerations: Property dividends can be complex to value and may involve tax
implications.

4. Special Dividends (or Extra Dividends)

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  Description: These are one-time payments made by a company in addition to its regular
dividend. Special dividends are typically issued when the company has accumulated
excess cash, often following a major event like a sale of assets or a particularly profitable
quarter.
 Payment: They are usually higher than regular dividends but are not guaranteed to recur.
 Example: A company may issue a special dividend of $5 per share after selling a major
part of its business.
 Impact on Shareholders: While special dividends can be an attractive one-off reward
for shareholders, they are often not seen as a sustainable source of income.

5. Scrip Dividends

 Description: A company issues "scrip" instead of cash or stock dividends. Scrip is

essentially a promise to pay in the future, often in the form of a promissory note or a
bond.
 Payment: Shareholders can typically choose to receive cash, stock, or accept the scrip as
a form of deferred payment.
 Use: Scrip dividends are typically used by companies facing cash flow issues but still
want to provide dividends to shareholders.
 Example: A company facing a temporary liquidity issue may offer scrip dividends,
which shareholders can exchange for cash at a later date.

6. Dividend Reinvestment Plans (DRIPs)

 Description: While not a form of dividend per se, DRIPs allow shareholders to
automatically reinvest their cash dividends into additional shares of the company, often at
a discounted rate and without commission fees.
 Payment: Shareholders don't receive the cash payout directly; instead, the dividends are
used to purchase more shares of the company's stock.
 Example: If you receive $100 in dividends and the stock price is $50, you would receive
2 additional shares of the company.
 Benefit: DRIPs can be a convenient way for investors to compound their returns without
having to manually reinvest.

Q3. Explain the theories of dividends briefly.

Dividend irrelevance theory postulates that dividends do not affect the stock price of a company.
A dividend is usually a payment in cash from one company's profits to the shareholders as
returns for investing in such a company. Theories of dividends examine the motives behind
dividend policy decisions that companies use to distribute some profits back to shareholders as a

59
form of cash outflow. Prominent amongst these are the Modigliani- Miller theorem postulating
that dividend policy is irrelevant in a perfect market, and Dividend Irrelevance Theory stating
dividends have no impact on firm value. Other noteworthy theories include the Dividend
Signaling Hypothesis, which states that dividends are a way to communicate the financial status
of companies in an attempt to attract investors. Knowing these theories can help you as an
investor to make smarter decisions about what your investments are worth and how safe they are.
Given numerous constraints, each theory handles the relationship between dividend policies and
stockholder wealth increase.

Meaning of Dividend

A dividend is a share of profit that a public company pays to shareholders based on the amount
and kind of its shares. It is a piece of the profits that belongs to the company and can be
distributed in different ways like cash payment, one more share on stocks, or some other thing.
Payment of the particular dividends are usually done at a periodicity such as quarterly or
annually and declared by board of directors. They offer a path to earn an ROI as investors, apart
from the likely appreciation of stock price. The choice to pay dividends (and how large, and
when) is at the discretion of the company management, because there must be no expectation by
shareholders that a corporation has to generate profits.

Dividend Theories

Dividend theories investigate the When and Why companies pay dividends to shareholders as
well as how these distributions affect a company's value and shareholder wealth. These theories
underpin our knowledge of the purpose and effects of dividends in corporate finance, and help
explain its connection to investment decisions. Also find the dividend decision theories
mentioned below.

Modigliani-Miller Theorem

According to the modigliani-miller theorem, in a perfect market, firm dividend policy does not
affect its value, that is shareholders' wealth. Under this theory, investors can tailor their own
dividend policy by modifying the composition of portfolio thereby dividends are immaterial to
company valuation. Within this view taxes, transaction costs and information asymmetries are
absent.

Dividend Signaling Hypothesis

Snapchat is irrelevant when it comes to dividends, but broader dividend interpretation can be a
critical part of our investor analysis too. Dividend signaling hypothesis tells us that changes in

60
company dividend payments signal firm financial health and future prospects. If it raises its
dividend, that could imply the company foresees strong earnings to come, while a cut in
dividends might suggest financial troubles on the horizon. This theory is grounded in the concept
that dividends are a way for a company to communicate its information with shareholders.

Bird-in-the-Hand Theory (Gordon Theorem)

The bird-in-the-hand theory is based on the assumption that investors like dividends more than
potential future capital gains since owning cash in hand pays right now (in today's dollars, as
opposed to stock values). This theory dictates that investors will pay a premium for the certainty
of receiving dividends today as opposed to an uncertain future capital gain (which ultimately is
grounded in theoretical market fluctuations).

The Tax Preference Theory

 Key Idea: Investors prefer capital gains to dividends due to tax considerations.
 Explanation: This theory suggests that because dividends are taxed at a higher rate than
capital gains in many tax systems, investors would prefer companies to retain earnings
and reinvest them, leading to capital appreciation rather than paying out dividends. This
results in a lower demand for dividends and a preference for capital gains.
 Implication: Firms might prefer to reinvest their earnings rather than pay out dividends,
especially when tax policies favor capital gains.

Residual Dividend Policy

Paying dividends out of remaining earnings after all good projects are funded. People agree to be
paid dividends only when the company has sufficient surplus of funds which means from a
finance point it is backed by cash flows rather than external financing. This highlights the key
that you should be focusing on your opportunities to invest when thinking about paying out
dividends.

Q4. Explain the various factors which influence the dividend decision of a
firm.

The dividend decision of a firm, which refers to how much of its earnings it will distribute to
shareholders as dividends and how much will be retained for reinvestment or other purposes, is
influenced by a combination of internal and external factors. These factors ensure that the
dividend policy aligns with the firm's financial health, growth prospects, and shareholder
expectations. Here are the key factors that influence a firm's dividend decision:

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1. Profitability

 Earnings Level: A firm’s ability to pay dividends largely depends on its profitability. If
a firm is generating strong profits, it is more likely to distribute a portion of those
earnings as dividends.
 Consistency of Earnings: Companies with stable and predictable earnings are more
likely to offer consistent dividends, as they can reliably forecast future cash flows.
Volatile earnings might discourage dividend payouts or lead to irregular dividends.

2. Cash Flow Position

 Liquidity: While a firm may be profitable on paper, its ability to pay dividends depends
on its available cash flow. A firm must have sufficient liquid assets to meet dividend
payments without impairing its operational activities.
 Cash Flow vs. Profit: Some profitable firms may not have enough cash on hand to pay
dividends due to high capital expenditures, debt repayments, or working capital needs.

3. Retention Needs (Growth Opportunities)

 Reinvestment Needs: Firms that are in a high-growth phase may retain earnings to
reinvest in new projects, research and development, or expansion, rather than paying
dividends. Companies with profitable investment opportunities often prefer to retain
profits to finance these activities.
 Return on Investment (ROI): If a firm can generate high returns on retained earnings
(i.e., high internal rate of return), it may prefer to reinvest rather than pay out dividends.

4. Debt Obligations

 Debt Covenants: Many companies with outstanding debt have debt covenants that
restrict dividend payments if certain financial ratios (such as debt-to-equity ratio or
interest coverage ratio) are not met. This can limit the amount a company can pay out as
dividends.
 Interest Payments: Firms with high levels of debt may prioritize servicing debt
obligations over dividend payments to ensure they maintain financial stability.

5. Tax Considerations

 Dividend Taxation vs. Capital Gains Taxation: The taxation of dividends and capital
gains can influence a firm's dividend policy. In countries where dividend income is

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 heavily taxed, shareholders may prefer capital gains (i.e., stock price appreciation) over
cash dividends, prompting firms to retain earnings or repurchase shares.
 Corporate Tax Rates: Some jurisdictions provide tax incentives for paying dividends
(such as tax credits or exemptions for shareholders), which can encourage firms to
distribute profits as dividends.

6. Legal and Regulatory Factors

 Legal Restrictions: There are often legal constraints on dividend payments in many
jurisdictions. For example, a company may not be allowed to pay dividends if its net
assets are negative or if the payment would reduce the company’s capital below the
required legal minimum.
 Regulatory Environment: Regulatory bodies may impose specific rules on financial
institutions or public companies regarding dividend payments, especially during times of
economic uncertainty or financial crisis.

7. Shareholder Preferences

 Type of Shareholders: Different shareholders may have different preferences regarding

dividends. For instance, income-focused investors (e.g., retirees) may prefer high
dividends, while growth-oriented investors may prefer the firm to reinvest profits into
expansion.
 Investor Expectations: The firm's reputation and track record in paying dividends can
influence investor expectations. A consistent dividend payout history builds trust among
investors, and any change to this policy (especially a reduction) can negatively impact the
stock price.

8. Market Conditions

 Economic Environment: In periods of economic downturn or uncertainty, companies

might reduce or suspend dividends to conserve cash. Conversely, in periods of economic
prosperity, firms may increase dividends if their profits and cash.

Conclusion

A company's dividend policy is shaped by a complex interaction of factors, including

profitability, growth opportunities, liquidity, tax considerations, and industry dynamics.
While mature, low-growth firms may focus on paying steady or increasing dividends,

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 growth-focused companies often reinvest earnings to fuel expansion. The ultimate goal is
to find a balance between rewarding shareholders and ensuring the long-term financial
health of the company.

Q5. Explain the dividend valuation models.

Dividend valuation refers to methods used to estimate the value of a stock or business based on
the expected future dividends it will generate. The core idea is that the value of an investment
should be tied to the present value of all future cash flows (in the form of dividends, in this case)
that it is expected to produce.

1. Dividend Discount Model (DDM)

The most widely used dividend valuation method is the Dividend Discount Model (DDM),
which determines the present value of a stock based on its future dividend payments. There are
different variations of this model:

a. Gordon Growth Model (Constant Growth DDM)

This is the simplest and most common form of DDM. It assumes that dividends will grow at a
constant rate indefinitely. The formula is:

P0 = D1 / (r – g) or
P0 = E (1-b) / (ke-br)

Where:

 P0 = Price of the stock today (intrinsic value)

 D1 = Dividend expected next year
 r = Required rate of return (or discount rate)
 g = Dividend growth rate

This model is appropriate for companies that have a stable and predictable growth rate for
dividends.

What are the Assumptions of the Gordon Growth Model?

The Gordon Growth Model assumes the following conditions:

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  The company’s business model is stable; i.e. there are no significant changes in its
operations
 The company grows at a constant, unchanging rate
 The company has stable financial leverage
 The company’s free cash flow is paid as dividends

Limitations

The assumption that a company grows at a constant rate is a major problem with the Gordon
Growth Model. In reality, it is highly unlikely that companies will have their dividends increase
at a constant rate. Another issue is the high sensitivity of the model to the growth rate and
discount factor used.

The model can result in a negative value if the required rate of return is smaller than the growth
rate. Moreover, the value per share approaches infinity if the required rate of return and growth
rate have the same value, which is conceptually unsound.

b. Walter Model:

The Walter Model of dividend policy is a well-known approach in corporate finance, developed
by James E. Walter in 1956. It focuses on the relationship between a company's dividend policy
and its value, assuming that the firm operates under certain conditions. The model provides a
framework for determining the optimal dividend payout based on the company’s internal rate of
return (IRR) and the cost of equity.

Formula: P = (D + (r/k (E-D))) / k

Key Components of the Walter Model:

1. Internal Rate of Return (k): The rate of return the company earns on reinvested
earnings.
2. Cost of Equity (r): The required rate of return by shareholders, or the return expected by
investors in the company's equity.
3. Dividend Payout Ratio (D/E): The proportion of earnings paid out as dividends.
4. Retention Ratio: The proportion of earnings retained for reinvestment.

Dividend Decision According to the Walter Model:

 When k > r (Internal Rate of Return > Cost of Equity):

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 oThe company should retain earnings and reinvest them into profitable projects.
Since the company can generate a return higher than the cost of equity, retaining
earnings will enhance the value of the firm more than paying dividends. In this
case, the optimal dividend payout is zero.
 When k < r (Internal Rate of Return < Cost of Equity):
o The company should pay out dividends to shareholders. Since the return on
reinvested earnings is less than the cost of equity, paying out dividends will
provide a higher return to shareholders than reinvesting. In this case, the optimal
dividend payout is 100%.
 When k = r (Internal Rate of Return = Cost of Equity):
o The dividend payout does not affect the value of the firm, as reinvestment and
dividends both result in the same value to the shareholders. The company can
choose any level of dividend payout.

Assumptions of the Walter Model:

 No taxes or transaction costs: The model assumes that there are no taxes or costs
associated with dividends or capital gains.
 Constant earnings: The company is assumed to have constant earnings and stable
investment opportunities.
 Perfect capital markets: The model assumes there are no market imperfections, such as
agency costs or information asymmetry.

The Walter model emphasizes that the optimal dividend policy is dependent on the firm’s ability
to generate returns on reinvested earnings relative to the cost of equity. It suggests that firms
with better growth prospects should retain earnings to maximize shareholder wealth, while firms
with fewer growth opportunities should distribute dividends.

Q6. Explain the bonus shares and stock split in briefly.

Bonus shares are additional shares issued by a company to its existing shareholders, usually
without any extra cost. These are typically given in proportion to the number of shares that
shareholders already own.

How It Works:

 Proportional Allocation: For example, if a company announces a 1:1 bonus issue, a

shareholder with 100 shares will receive an additional 100 shares for free.
 No Payment: Shareholders don't have to pay anything to receive bonus shares. They're
issued by the company out of its retained earnings or reserves.

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Reasons Companies Issue Bonus Shares:

1. Reward Shareholders: A company may want to reward its existing shareholders by

increasing the number of shares they own.
2. Increase Liquidity: Issuing bonus shares can make the stock more affordable and
increase liquidity in the market, as more shares are in circulation.
3. Sign of Confidence: Companies with surplus reserves may issue bonus shares to signal
financial strength and positive outlook.
4. Regulatory Requirements: In some cases, it may be a strategy to adjust the share price
to make it more marketable.

Impact on Shareholders:

 No Change in Total Value: Although the number of shares owned increases, the value
of each share typically decreases proportionally. For instance, if a shareholder has 100
shares worth $10 each, and the company issues 100 bonus shares, they’ll now have 200
shares, but each share will be worth around $5 (the total value remains the same).

STOCK SPLIT

A stock split is a corporate action in which a company divides its existing shares into multiple
new shares. The main purpose of a stock split is to make shares more affordable to investors
without changing the overall value of their investment.

For example, in a 2-for-1 stock split, for every share an investor owns, they would receive an
additional share. If someone owned 100 shares before the split, they would own 200 shares
afterward. However, the price per share would be halved, so the total value of their holdings
remains the same (ignoring other factors like market conditions).

There are two common types of stock splits:

1. Forward Stock Split: This is the most common type. The company issues additional
shares to shareholders, reducing the price per share but maintaining the total value of the
investment. For example:
o A 2-for-1 split means that for every 1 share owned, the shareholder will now have
2 shares, and the price per share is halved.
o A 3-for-1 split means for every 1 share owned, the shareholder will now have 3
shares, and the price per share is reduced to one-third.

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 2. Reverse Stock Split: This is less common and occurs when a company consolidates its
shares. In a reverse stock split, shareholders receive fewer shares but the price per share
increases. For example:
o A 1-for-2 reverse split means that for every 2 shares owned, shareholders will
now have 1 share, but the price per share will double.

Why Do Companies Do Stock Splits?

 To make shares more affordable: If a company's stock price becomes too high, it may
deter smaller investors. A stock split makes shares more accessible without affecting the
overall value of the investment.
 Marketability and liquidity: Lower share prices can increase the number of shares
available to trade, improving liquidity.
 Perception: A stock split can signal to investors that a company is performing well and
its stock price is rising. It's often seen as a positive signal, even though it doesn't affect
the company's actual financial health.

Important Considerations:

 Stock splits don’t change the total market value of the company. A 2-for-1 split, for
example, just halves the price per share but doubles the number of shares in circulation,
leaving the total market value unchanged.
 Tax treatment: Generally, stock splits are not taxable events for shareholders, but any
future capital gains tax will be based on the split-adjusted cost basis.

Q7. What is dividend policy and explain the dividend policies of Indian
corporate.

Dividend Policy refers to the strategy or guidelines that a company follows in determining the
amount and timing of dividend payments to its shareholders. A company's dividend policy
reflects how much profit it distributes to shareholders and how much it retains for reinvestment.

The dividend policy is important because it impacts shareholders' returns, the company's
financial structure, and its future growth prospects. The key factors that influence a company's
dividend policy include profitability, cash flow, debt levels, and investment opportunities.

There are different types of dividend policies, including:

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 1. Stable Dividend Policy: The Company pays a fixed or gradually increasing dividend
over time. The goal is to maintain a consistent dividend, regardless of fluctuations in
earnings.
2. Constant Dividend Payout Ratio: The Company pays a fixed percentage of its earnings
as dividends, which means dividends may fluctuate depending on earnings.
3. Residual Dividend Policy: Dividends are paid out of the leftover earnings after funding
all profitable investment opportunities.
4. No Dividend Policy: Some companies, particularly in their growth stages, might prefer
to reinvest all earnings for expansion, avoiding dividends altogether.

Dividend Policies of Indian Corporate:

In India, corporate dividend policies are influenced by several factors, including legal
requirements, shareholder expectations, tax laws, and corporate governance. Indian companies
tend to follow a more conservative approach in terms of paying dividends. However, the policies
can vary based on the sector, company’s profitability, and growth stage. Below are the key
features of dividend policies typically followed by Indian corporates:

1. High Dividend Payout Policy:

o Many large and well-established Indian companies, such as Reliance Industries,
Hindustan Unilever, ITC, and Tata Consultancy Services (TCS), follow a high
dividend payout policy.
o These companies have a stable and growing cash flow and prefer to distribute a
substantial portion of their earnings as dividends to attract investors.
o They generally maintain a consistent and increasing dividend payout over time.
o This is often preferred by investors who seek regular income from dividends,
especially retail investors.
2. Moderate Dividend Policy:
o Companies in sectors like automobile manufacturing, telecom, and energy may
follow a moderate dividend policy.
o They distribute dividends, but a portion of their earnings is retained for business
expansion or reinvestment in new projects.
o For example, companies like Maruti Suzuki, Bharti Airtel, and Power Grid
Corporation typically have a moderate dividend payout policy.

3. Low or No Dividend Policy:

o Newer and high-growth companies or startups often follow a low or no dividend
policy, as they prefer to reinvest profits for expansion and growth.

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 oFor instance, tech companies like Infosys or companies in the pharmaceutical
sector may have lower dividend payouts, focusing on reinvestment in R&D and
capital expansion.
o These companies target capital gains through share price appreciation, rather than
focusing on dividend distribution.
4. Dividend Stability:
o Some Indian firms, especially in sectors like consumer goods, have an aim to
provide stable dividends regardless of economic cycles.
o They focus on ensuring that the dividend payouts are steady and predictable to
maintain investor confidence.
o Hindustan Unilever and ITC are examples of companies with such a policy.
5. Tax Considerations:
o Historically, Dividend Distribution Tax (DDT) was levied on the company
paying the dividend. However, in 2020, India abolished DDT, and dividends
became taxable in the hands of the shareholders. This change had an impact on
the dividend policies of Indian companies.
o This may encourage some companies to either reduce dividend payouts or
increase them depending on the taxation impact on their shareholders.
6. Legal Restrictions:
o Indian companies are also subject to certain legal restrictions, such as the
requirement to pay dividends only out of profits (i.e., from current or accumulated
earnings).
o If a company has negative reserves or accumulated losses, it may not be allowed
to declare dividends.

Conclusion:

Dividend policies in Indian companies reflect a balance between rewarding shareholders and
ensuring that the company has sufficient capital for reinvestment and future growth. Well-
established companies tend to have stable or high dividend policies, while growth-oriented and
high-risk companies might focus on reinvesting earnings rather than paying dividends.

Q8. Calculate market price of Walter’s model.

r = 10%, k = 10%, Eps = Rs. 100
Different payout ratios are 10%, 50%, 80% and 100%.
Solution:

If payout ratio is 10%:

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Dividend = 100 x 10/100

= Rs. 10

P = [10 + (0.10/0.10)(100-10)] / 0.10

= [10+90]/ 0.10

= 100/0.10

= Rs. 1000

If payout ratio is 50%:

Dividend = 100 x 50/100

= Rs. 50

P = [50 + (0.10/0.10)(100-50)] / 0.10

= [50+50]/ 0.10

= 100/0.10

= Rs. 1000

If payout ratio is 80%:

Dividend = 100 x 80/100

= Rs. 80

P = [80 + (0.10/0.10)(100-80)] / 0.10

= [80+20]/ 0.10

= 100/0.10

= Rs. 1000

If payout ratio is 100%:

Dividend = 100 x 100/100

= Rs. 100

P = [100 + (0.10/0.10)(100-100)] / 0.10

= [100+0]/ 0.10

= 100/0.10

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 = Rs. 1000

UNIT – 5
LIQUIDITY DECISION

Q1. What is working capital and explain the classification and significance of
working capital.

Working capital refers to the difference between a company's current assets and current
liabilities. It represents the funds that a business has available to meet its short-term obligations
and carry out day-to-day operations. In other words, working capital is the liquidity available to a
company to finance its regular activities like paying employees, suppliers, and managing
inventory.

Formula:

Working Capital = Current Assets - Current Liabilities

 Current Assets: Cash, accounts receivable, inventory, and other assets that are expected
to be converted to cash or used up within one year.
 Current Liabilities: Debts and obligations that the company needs to pay off within one
year, such as accounts payable, short-term loans, etc.

Working capital is essential for day-to-day operations of a business. It is generally classified into
two main categories:

1. Gross Working Capital:

Definition: Gross working capital refers to the total investment a business has in its short-term
assets, such as cash, accounts receivable, and inventories.

Formula: Gross Working Capital = Current Assets

Components: Cash, Accounts receivable, Inventory and Short-term investments

2. Net Working Capital:

Definition: Net working capital is the difference between a company’s current assets and current
liabilities. It indicates the liquidity position of a company and its ability to meet short-term
obligations.

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 Formula: Net Working Capital = Current Assets − Current Liabilities

Components:

o Current Assets: Cash, accounts receivable, inventory, marketable securities, and other
short-term assets.
o Current Liabilities: Accounts payable, short-term debts, accrued expenses, and other
short-term obligations.

Significance of Working Capital:

1. Liquidity Management: Working capital helps measure a company’s liquidity and

short-term financial health. A positive working capital means the company can cover its
short-term liabilities, while negative working capital suggests potential liquidity
problems.
2. Operational Efficiency: Sufficient working capital enables a business to fund its day-to-
day operations, ensuring it can maintain smooth functioning without disruptions. It helps
the company avoid delays in production or payment issues.
3. Growth and Expansion: Positive working capital provides the resources necessary for
growth opportunities such as launching new products, expanding operations, or making
strategic investments.
4. Risk Mitigation: A healthy working capital cushion can help mitigate risks from
unforeseen financial crises or economic downturns. It provides a buffer against
unexpected expenses or revenue shortfalls.
5. Creditworthiness: Lenders and investors often look at a company’s working capital
when evaluating its financial stability. A business with strong working capital is more
likely to secure loans or attract investment.
6. Financial Planning: Regular monitoring of working capital helps a company plan its
cash flow, manage seasonality in sales, and ensure that there is no shortage of cash when
needed for essential expenditures.

In summary, working capital is crucial for maintaining a company's ability to operate smoothly
and grow, while also ensuring it can manage both expected and unexpected financial demands.

Q2. Explain the components of working capital.

Working capital refers to the capital that a company uses to finance its day-to-day operations. It
is calculated by subtracting a company’s current liabilities from its current assets. The
components of working capital are the elements that make up these assets and liabilities, and

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understanding them is essential for managing a company’s short-term financial health. Here's a
breakdown:

1. Current Assets

These are assets that are expected to be converted into cash, sold, or consumed within one year
or within the company's operating cycle (whichever is longer). Key components include:

 Cash and Cash Equivalents: The most liquid assets, such as currency, bank balances,
and short-term investments that are easily converted to cash.
 Accounts Receivable (AR): Money owed to the business by customers for goods or
services already delivered. This amount is expected to be collected within a short period,
usually within 30 to 90 days.
 Inventory: Goods that are either finished products or raw materials used in production
that a company plans to sell within a year. This can include raw materials, work-in-
progress, and finished goods.
 Prepaid Expenses: Payments made in advance for goods or services to be received in the
future, such as insurance premiums or rent.
 Other Current Assets: Any other assets that are expected to be liquidated or used within
one year.

2. Current Liabilities

These are the obligations a company must settle within one year. Key components include:

 Accounts Payable (AP): Money the company owes to suppliers for goods or services it
has received but has not yet paid for. This represents short-term credit extended by
suppliers.
 Short-Term Debt: Any loans or borrowings that must be repaid within a year. This
could include bank loans, credit lines, or short-term bonds.
 Accrued Liabilities: Expenses that a company has incurred but has not yet paid, such as
wages, taxes, or interest payments.
 Unearned Revenue: Payments received in advance for goods or services that the
company has not yet delivered.
 Other Current Liabilities: Other obligations due within a year, such as dividends
payable or short-term provisions.

3. Working Capital Formula

Working Capital is calculated as:

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Working Capital = Current Assets − Current Liabilities

4. Importance of Working Capital

 Liquidity Management: Working capital ensures that a company has enough cash flow
to meet its short-term obligations and continue operating.
 Efficiency: Effective management of working capital helps in maintaining smooth
operations by ensuring that resources are being utilized efficiently without overextending
the company’s liabilities.
 Profitability: Excessive working capital might indicate inefficiency, while too little
working capital can lead to liquidity problems and financial strain.

5. Types of Working Capital

 Permanent Working Capital: The minimum amount of current assets required to run
the business smoothly. This amount remains relatively stable over time.
 Temporary Working Capital: The additional working capital needed to support
seasonal fluctuations or temporary growth. It changes in response to the company’s
operational needs.

Managing Working Capital

Proper management of working capital is crucial to maintaining a balance between profitability

and liquidity. Companies need to manage their inventory levels, accounts receivable, and
accounts payable effectively to ensure they don’t have too much tied up in assets that aren’t
generating returns or running into liquidity issues.

Q3. Explain the factors determining the working capital.

Working capital is a measure of a company's operational efficiency and short-term financial

health. It represents the difference between current assets and current liabilities, and it is crucial
for day-to-day operations. Several factors influence the amount of working capital a company
needs or has at any given time. These factors include:

1. Nature of the Business

Industry Type: Different industries have varying working capital requirements. For
instance, manufacturing companies typically need more working capital than service
companies because they carry inventory and have longer production cycles.

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 Business Model: Companies with a business model that involves long production cycles
or large amounts of inventory will require more working capital than those that operate
on shorter cycles or have a just-in-time inventory system.

2. Operating Cycle

The operating cycle refers to the time it takes for a company to purchase inventory, sell it,
and collect cash from customers. The longer the operating cycle, the higher the working
capital needed, as the company has to support the ongoing process of converting
inventory to cash.

3. Seasonality

Some businesses experience seasonal fluctuations in sales or production. Seasonal

businesses may need to maintain higher working capital during peak seasons to support
increased inventory, labor, and other operational costs. Conversely, during off-seasons,
working capital requirements may decrease.

4. Credit Policy

The company’s credit policy (how it manages receivables) has a direct impact on
working capital. If a company offers extended credit to customers, it may need more
working capital because cash inflows are delayed.

Receivables Management: If the company has a high level of outstanding receivables, it

will need more working capital to cover day-to-day expenses until those receivables are
collected.

5. Inventory Management

Inventory Turnover: If a company holds a large amount of inventory, it may need more
working capital to finance this stock. Efficient inventory management and faster turnover
can help reduce the need for excessive working capital. Stock Levels: Companies that
deal with perishable goods or face the risk of supply shortages may need to keep higher
inventory levels, thus requiring more working capital.

6. Payment Terms with Suppliers

If a company has favorable payment terms with its suppliers (e.g., extended credit terms),
it may be able to manage working capital more effectively by delaying cash outflows.

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 Conversely, companies that need to pay their suppliers quickly may require higher
working capital to avoid cash flow disruptions.

7. Growth Rate

Rapidly growing companies generally require more working capital to fund their
expansion, as they often need to buy more raw materials, hire more workers, and hold
more inventory before sales are realized. Companies in stable or declining phases may
require less working capital, as their operations are more predictable and less reliant on
new investment.

8. Cash Management and Liquidity

Companies with stronger cash flow and liquidity positions can maintain lower working
capital since they can rely on their liquidity to meet short-term obligations. If a company
faces cash flow challenges or has low liquidity, it may need to maintain higher working
capital to ensure smooth operations and avoid financial strain.

9. Capital Structure

Companies with high levels of short-term debt may face more pressure to manage
working capital carefully, as they need to meet these obligations in the near future.
Conversely, companies with minimal short-term debt or good access to credit may not
need as much working capital because they can rely on external financing.

10. Economic Conditions

Economic conditions, such as inflation, interest rates, and overall market stability, can
affect working capital needs. In times of economic instability, businesses may need
higher working capital to cope with rising costs or reduced sales. In periods of rapid
economic growth, businesses may also need more working capital to capitalize on new
opportunities or higher demand.

Conclusion

Working capital is dynamic and needs to be tailored to each company’s specific situation.
Effective management of working capital can improve liquidity, reduce financial risks, and
contribute to better profitability. Companies must continuously assess and adjust their working
capital strategies based on the factors mentioned above to ensure they can meet short-term
obligations without tying up too many resources.

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Q4. Explain the cash management models.

Cash management models are techniques and strategies used by businesses and organizations to
manage their cash flow effectively, ensuring they have enough liquidity to meet their operational
needs while maximizing returns on surplus cash. These models are essential for maintaining
financial stability, minimizing risks, and optimizing the use of available cash.

Here are some common cash management models:

1. The Transactional Model

 Purpose: Focuses on ensuring that a company has enough cash to meet its daily
transactions and obligations.
 Key Features:
o Managing inflows (e.g., customer payments) and outflows (e.g., supplier
payments, payroll).
o Maintaining a buffer or reserve of cash to cover short-term liabilities.
 Goal: Minimize cash holdings while ensuring enough liquidity to meet day-to-day
operations.

2. The Baumol Model (Economic Order Quantity or EOQ Model)

 Purpose: Optimizes the amount of cash a firm should hold, balancing transaction costs
and opportunity costs of holding cash.
 Key Features:
o A company must decide the optimal cash balance, taking into account the cost of
converting securities into cash and the opportunity cost of holding too much cash.
o The model is based on minimizing the sum of transaction costs and the holding
costs of cash.
 Goal: Determine the optimal transaction size and frequency of cash replenishment.

Formula:

Optimal Cash Balance = the root of (2 × Total Transaction Costs × Cash Flow /
Opportunity Cost per Unit of Cash

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3. The Miller-Orr Model

 Purpose: Extends the Baumol Model to account for fluctuating cash flows and the cost
of transferring funds.
 Key Features:
o It assumes that cash flows are stochastic (variable and unpredictable).
o The model recommends maintaining a cash balance that falls within an upper and
lower limit, with automatic transfers of cash when the balance exceeds or falls
below the target range.
 Goal: Set a target range for cash balances and trigger automatic transfers (e.g., borrowing
or investing) when the balance reaches the limits.

Formula:

Upper Limit = Target Cash Balance + Spread

Lower Limit = Target Cash Balance − Spread

4. Disbursement and Collection Models

 Purpose: Optimizes the timing of cash receipts and payments.

 Key Features:
o Focuses on minimizing idle cash by speeding up collections and delaying
disbursements.
o Techniques include negotiating favorable credit terms with suppliers or
customers, automating collections, and making payments just before the due date
to maximize interest on cash.
 Goal: Ensure cash is used efficiently without missing deadlines or incurring penalties.

5. The Cash Conversion Cycle (CCC) Model

 Purpose: Evaluates the efficiency of a company’s cash management by analyzing how

quickly cash is converted into sales and then back into cash.
 Key Features:
o The CCC model considers the time it takes to sell inventory, collect receivables,
and pay payables.
o It’s a measure of how long it takes a company to turn its investments into cash.
 Goal: Minimize the cash conversion cycle to increase liquidity and profitability.

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Formula:

Cash Conversion Cycle (CCC) = Days Sales Outstanding (DSO) +

Days Inventory Outstanding (DIO) − Days Payables Outstanding (DPO)

These models can be applied individually or in combination depending on the size and
complexity of the business. Businesses often use a mix of strategies to adapt to changing market
conditions and optimize their cash flow management.

Q5. Neha limited is engaged retail business. You are required to forecast working capital
requirements.

1. Projected annual sales - Rs. 1, 30, 00,000

2. % of net profit on cost of sales- 25%
3. Average credit period allowed to debtors - 8weeks
4. Average credit period allowed by creditors - 4weeks
5. Average stock carrying 8 weeks
6. Add 10% to compute figures to allow for contingencies.

Solution:

Working note:

Calculation of cost of goods sold:

Sales = 1, 30, 00,000

Net profit = 1, 30, 00,000 x 25% = 32, 50,000

Cost of goods sold = Sales - Net profit

= 1, 32, 00,000 – 32, 50,000

= 97, 50,000

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 Statement showing working capital

Particulars Amount (Rs.)

Current assets

Debtors 97, 50,000 x 8/52 15, 00,000

Stock 97, 50,000 x 8/52 15, 00,000

Total Assets 30, 00,000

Current Liabilities

Creditors 97, 50,000 x 4/52 7, 50,000

Net working capital (CA – CL) 22, 50,000

Add: Contingencies 10 % 2, 25,000

Net working capital required 24, 75,000

Q6. What is receivable Management and explain how it is useful for business
Concerns?

Receivable Management refers to the process of managing and overseeing the accounts
receivable (AR) of a business. Accounts receivable are the amounts of money owed to a
company by its customers for goods or services delivered on credit. Effective receivable
management ensures that businesses can optimize their cash flow and minimize the risk of bad
debts.

The key aspects of receivable management include:

1. Credit Policy: Establishing clear credit terms for customers (such as the payment period,
interest on overdue payments, and credit limits).
2. Invoicing: Ensuring that invoices are issued promptly and accurately to customers.
3. Collections: Monitoring payments and following up on overdue invoices to ensure
timely collection.
4. Cash Flow Forecasting: Estimating future cash inflows based on outstanding
receivables to manage business operations effectively.

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 5. Credit Risk Assessment: Evaluating the creditworthiness of potential customers to
minimize the chances of non-payment.
6. Reporting: Keeping track of accounts receivable balances, aging reports, and other
financial reports to measure performance and identify potential issues early.

Types of accounts receivables

1. Trade receivables. Trade receivables are amounts customers owe for selling goods or
services as part of the normal course of business.
2. Non-trade receivables.
3. Secured receivables.
4. Unsecured receivables.

How Receivable Management is Useful for Business Concerns:

1. Improved Cash Flow: Effective management helps ensure that payments are collected
on time, improving the liquidity of the business. It allows the company to pay its own
bills, invest in new opportunities, and cover operational costs without depending too
much on external financing.
2. Minimized Risk of Bad Debts: By carefully screening customers and following up on
overdue payments, receivable management reduces the chances of non-payment or bad
debts that can harm the financial health of the company.
3. Better Credit Decisions: A structured receivable management process allows businesses
to assess the creditworthiness of potential customers more accurately. This helps in
granting credit selectively, reducing the risk of defaults.
4. Operational Efficiency: Proper receivable management improves internal processes,
reducing the administrative burden of chasing payments, tracking overdue invoices, and
managing cash flow.
5. Financial Health Monitoring: Receivable management provides insights into the
financial health of a business. By tracking the aging of accounts receivable, businesses
can identify problems early and take corrective actions before they grow into larger
issues.
6. Customer Relationship Management: Efficient management of receivables can
improve relationships with customers, as it ensures clear communication regarding
payment expectations and terms. This helps in maintaining trust and fostering long-term
business relationships.

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Special uses:
Companies can use their accounts receivable as collateral when obtaining a loan (asset-
based lending). They may also sell them through factoring. Pools or portfolios of
accounts receivable can be sold to third parties through securitization.

For tax reporting purposes, a general provision for bad debts is not an allowable
deduction from profit — a business can only get relief for specific debtors that have gone
bad. However, for financial reporting purposes, companies may choose to have a general
provision against bad debts consistent with their past experience of customer payments in
order to avoid overstating debtors in the balance sheet.

Q7. Explain credit policies briefly.

Credit policies refer to the guidelines and rules that an organization sets to govern how it extends
credit to its customers or clients. These policies are crucial for managing risk and ensuring that
the business maintains financial stability while offering credit. Here are some key aspects
typically covered in credit policies:

1. Credit Terms

 Payment terms: Defines when payments are due (e.g., 30 days, 60 days, etc.).
 Interest rates: Specifies the interest rate charged for credit balances or late payments.
 Credit limits: Determines the maximum amount a customer is allowed to owe at any
given time.

2. Credit Approval Process

 Eligibility criteria: Defines which customers are eligible for credit (e.g., credit score,
financial history, business size).
 Approval workflow: Describes the steps and individuals involved in approving a
customer's credit.
 Required documentation: Outlines what documentation is needed (e.g., credit
applications, financial statements, etc.).

3. Risk Assessment

 Credit checks: How the business assesses the risk of offering credit to a customer,
typically involving credit score checks or financial analysis.

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  Risk tolerance: Defines the level of risk the company is willing to accept in offering
credit.
 Monitoring: Procedures for monitoring a customer's creditworthiness over time.

4. Collection Policy

 Late payment penalties: Details any fees or penalties applied if payments are missed or
late.
 Debt recovery procedures: Steps the business will take to recover unpaid debts,
including legal action, use of collection agencies, etc.
 Write-offs: When a company decides to write off bad debts as uncollectible.

5. Credit Limits and Adjustments

 Initial limits: Specifies the initial credit limit extended to a customer.

 Periodic review: Outlines how often credit limits will be reviewed and adjusted based on
a customer’s payment history, credit usage, and financial situation.
 Temporary increases or decreases: Guidelines for increasing or reducing credit limits
based on business conditions or customer needs.

6. Credit Reporting and Communication

 Reporting practices: The process of reporting credit activity to relevant credit bureaus,
if applicable.
 Customer communication: How the company will communicate with customers about
their credit status, such as reminders, warnings, or notices about missed payments.

By clearly outlining these areas, businesses can manage credit risk more effectively and maintain
good customer relationships while ensuring that they are paid for their products or services. Let
me know if you want more details on any specific aspect of credit policies!

Q8. Explain the key aspects of inventory management.

Inventory management refers to the process of overseeing and controlling the flow of goods,
materials, and products within an organization. It involves tracking inventory levels, ordering,
storing, and controlling stock to ensure that the right products are available at the right time and
in the right quantities to meet customer demand, while avoiding overstocking or stock outs.
Effective inventory management is critical for reducing costs, optimizing supply chains, and
improving customer satisfaction.

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Here are some key aspects of inventory management:

1. Inventory Tracking

 Stock Levels: Constantly monitor how much of each product is in stock.

 Barcode/RFID: Use barcodes or RFID technology to track products in real-time and
maintain accuracy.
 Inventory Turnover: Track how frequently inventory is sold or used within a specific
period.

2. Inventory Control Techniques

 Just-in-Time (JIT): Inventory is replenished only when needed, minimizing holding

costs.
 Economic Order Quantity (EOQ): Determines the optimal order size to minimize
ordering and holding costs.
 ABC Analysis: Classifies inventory into categories (A, B, C) based on value and usage
frequency to prioritize management efforts.
 First-In, First-Out (FIFO): Products that are sold or used first are those that were added
to the inventory first, often used for perishable goods.
 Last-In, First-Out (LIFO): The most recently acquired inventory is sold or used first,
generally used for non-perishable goods or financial strategies.

3. Inventory Optimization

 Demand Forecasting: Predict customer demand based on historical data, trends, and
market conditions to avoid excess inventory.
 Safety Stock: Keep an additional buffer of stock to cover for unexpected increases in
demand or supply chain disruptions.
 Reorder Point (ROP): The stock level at which a new order should be placed to
replenish inventory before it runs out.
 Lead Time: The amount of time it takes for inventory to arrive after an order is placed. It
impacts reorder points and stock levels.

4. Inventory Systems

 Manual Inventory: Traditional method of counting and tracking stock on paper or

spreadsheets.

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  Automated Systems (ERP/Software): Use of software like ERP (Enterprise Resource
Planning) systems (e.g., SAP, Oracle) or specialized inventory management tools (e.g.,
Trade Gecko, Net Suite) to track and manage stock in real time.
 Cloud-based Inventory Management: These systems allow businesses to access
inventory data remotely, collaborate in real-time, and integrate with other business
operations.

5. Warehouse Management

 Storage and Organization: Proper storage techniques (e.g., shelving, palletizing,

racking) ensure items are easy to find, minimize damage, and maximize space.
 Order Fulfillment: Efficient systems for picking, packing, and shipping inventory to
meet customer orders in a timely manner.

6. Inventory Audits

 Physical Count: Periodically counting inventory manually to compare with system

records.
 Cycle Counting: Continuously counting a subset of inventory on a rotating schedule to
reduce disruptions.
 Stocktaking: The process of verifying inventory levels, reconciling any discrepancies
between physical counts and recorded stock.

7. Challenges in Inventory Management

 Stock outs: Running out of stock due to inaccurate demand forecasting or supply chain
disruptions.
 Overstocking: Holding too much inventory, which increases carrying costs and the risk
of obsolescence?
 Dead Stock: Products that does not sell and may become obsolete, leading to waste and
inefficiencies.
 Supply Chain Disruptions: Delays in shipments or disruptions in manufacturing can
lead to gaps in inventory levels.

8. Benefits of Good Inventory Management

 Reduced Costs: Lower holding and storage costs, reduced waste, and better cash flow
management.
 Improved Customer Satisfaction: Ensures products are available when customers need
them, increasing sales and loyalty.

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  Better Decision Making: Accurate data helps with demand forecasting, purchasing, and
overall business planning.
 Streamlined Operations: Reduces errors, improves accuracy, and enables efficient order
fulfillment.

Effective inventory management is crucial to any business, whether you're in retail,

manufacturing, or wholesale. The goal is to balance supply and demand while keeping costs in
check, ensuring smooth operations, and providing excellent service to customers.

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