Wednesday, May 20, 2020


Course Code : MCO – 07
Course Title : Financial Managements
Assignment Code : MCO - 07 /TMA/2019-20
Coverage : All Blocks
Maximum Marks: 100
Attempt all the questions
1. (a) Describe the three broad areas of financial decision making.                                          (10)
Ans: Types of Decisions to be taken under financial management
The finance function encompasses the activities of raising funds, investing them in assets and distributing returns earned from assets to shareholders. While doing these activities, a firm attempts to balance cash inflow and outflow. It is evident that the finance function involves the four decisions viz., financing decision, investment decision, dividend decision and liquidity decision. Thus the finance function includes:
a)      Investment decision
b)      Financing decision
c)       Dividend decision
1. Investment Decision: The investment decision, also known as capital budgeting, is concerned with the selection of an investment proposal/ proposals and the investment of funds in the selected proposal. A capital budgeting decision involves the decision of allocation of funds to long-term assets that would yield cash flows in the future. Two important aspects of investment decisions are:
(a) The evaluation of the prospective profitability of new investments, and
(b) The measurement of a cut-off rate against that the prospective return of new investments could be compared.
Future benefits of investments are difficult to measure and cannot be predicted with certainty. Risk in investment arises because of the uncertain returns. Investment proposals should, therefore, be evaluated in terms of both expected return and risk. Besides the decision to commit funds in new investment proposals, capital budgeting also involves replacement decision, that is decision of recommitting funds when an asset become less productive or non-profitable. The computation of the risk-adjusted return and the required rate of return, selection of the project on these bases, form the subject-matter of the investment decision.
Long-term investment decisions may be both internal and external. In the former, the finance manager has to determine which capital expenditure projects have to be undertaken, the amount of funds to be committed and the ways in which the funds are to be allocated among different investment outlets. In the latter case, the finance manager is concerned with the investment of funds outside the business for merger with, or acquisition of, another firm.
2. Financing Decision: Financing decision is the second important function to be performed by the financial manager. Broadly, he or she must decide when, from where and how to acquire funds to meet the firm’s investment needs. The central issue before him or her is to determine the appropriate proportion of equity and debt. The mix of debt and equity is known as the firm’s capital structure. The financial manager must strive to obtain the best financing mix or the optimum capital structure for his or her firm. The firm’s capital structure is considered optimum when the market value of shares is maximized.
The use of debt affects the return and risk of shareholders; it may increase the return on equity funds, but it always increases risk as well. The change in the shareholders’ return caused by the change in the profit is called the financial leverage. A proper balance will have to be struck between return and risk. When the shareholders’ return is maximized with given risk, the market value per share will be maximized and the firm’s capital structure would be considered optimum. Once the financial manager is able to determine the best combination of debt and equity, he or she must raise the appropriate amount through the best available sources. In practice, a firm considers many other factors such as control, flexibility, loan covenants, legal aspects etc. in deciding its capital structure. 
3. Dividend Decision: Dividend decision is the third major financial decision. The financial manager must decide whether the firm should distribute all profits, or retain them, or distribute a portion and return the balance. The proportion of profits distributed as dividends is called the dividend-payout ratio and the retained portion of profits is known as the retention ratio. Like the debt policy, the dividend policy should be determined in terms of its impact on the shareholders’ value. The optimum dividend policy is one that maximizes the market value of the firm’s shares. Thus, if shareholders are not indifferent to the firm’s dividend policy, the financial manager must determine the optimum dividend-payout ratio. Dividends are generally paid in cash. But a firm may issue bonus shares. Bonus shares are shares issued to the existing shareholders without any charge. The financial manager should consider the questions of dividend stability, bonus shares and cash dividends in practice. 
(b) Discuss the role and challenges of the financial manager in India.                                    (10)
Ans: Role and challenges of Finance Manager
In the modern enterprise, a finance manager occupies a key position, he being one of the dynamic member of corporate managerial team. His role, is becoming more and more pervasive and significant in solving complex managerial problems. Traditionally, the role of a finance manager was confined to raising funds from a number of sources, but due to recent developments in the socio-economic and political scenario throughout the world, he is placed in a central position in the organisation. He is responsible for shaping the fortunes of the enterprise and is involved in the most vital decision of allocation of capital like mergers, acquisitions, etc. A finance manager, as other members of the corporate team cannot be averse to the fast developments, around him and has to take note of the changes in order to take relevant steps in view of the dynamic changes in circumstances.
The nature of job of an accountant and finance manager is different, an accountant's job is primarily to record the business transactions, prepare financial statements showing results of the organisation for a given period and its financial condition at a given point of time. He is to record various happenings in monetary terms to ensure that assets, liabilities, incomes and expenses are properly grouped, classified and disclosed in the financial statements. Accountant is not concerned with management of funds that is a specialised task and in modern times a complex one. The finance manager or controller has a task entirely different from that of an accountant, he is to manage funds. Some of the important decisions as regards finance are as follows:
1)      Estimating the requirements of funds: A business requires funds for long term purposes i.e. investment in fixed assets and so on. A careful estimate of such funds is required to be made.  An assessment has to be made regarding requirements of working capital involving, estimation of amount of funds blocked in current assets and that likely to be generated for short periods through current liabilities. Forecasting the requirements of funds is done by use of techniques of budgetary control and long range planning.
2)      Decision regarding capital structure: Once the requirement of funds is estimated, a decision regarding various sources from where the funds would be raised is to be taken. A proper mix of the various sources is to be worked out, each source of funds involves different issues for consideration. The finance manager has to carefully look into the existing capital structure and see how the various proposals of raising funds will affect it. He is to maintain a proper balance between long and short term funds. 
3)      Investment decision: Funds procured from different sources have to be invested in various kinds of assets. Long term funds are used in a project for fixed and also current assets. The investment of funds in a project is to be made after careful assessment of various projects through capital budgeting. A part of long term funds is also to be kept for financing working capital requirements. Asset management policies are to be laid down regarding various items of current assets, inventory policy is to be determined by the production and finance manager, while keeping in mind the requirement of production and future price estimates of raw materials and availability of funds.
4)      Dividend decision: The finance manager is concerned with the decision to pay or declare dividend. He is to assist the top management in deciding as to what amount of dividend should be paid to the shareholders and what amount is retained by the company, it involves a large number of considerations. The principal function of a finance manager relates to decisions regarding procurement, investment and dividends. 
5)      Maintain Proper Liquidity: Every concern is required to maintain some liquidity for meeting day-to-day needs. Cash is the best source for maintaining liquidity. It is required to purchase raw materials, pay workers, meet other expenses, etc. A finance manager is required to determine the need for liquid assets and then arrange liquid assets in such a way that there is no scarcity of funds.
6)      Management of Cash, Receivables and Inventory: Finance manager is required to determine the quantum and manage the various components of working capital such as cash, receivables and inventories. On the one hand, he has to ensure sufficient availability of such assets as and when required, and on the other there should be no surplus or idle investment.
7)      Disposal of Surplus: A finance manager is also expected to make proper utilization of surplus funds. He has to make a decision as to how much earnings are to be retained for future expansion and growth and how much to be distributed among the shareholders.
8)      Evaluating financial performance: Management control systems are usually based on financial analysis, e.g. ROI (return on investment) system of divisional control. A finance manager has to constantly review the financial performance of various units of the organisation. Analysis of the financial performance helps the management for assessing how the funds are utilised in various divisions and what can be done to improve it.
9)      Financial negotiations: Finance manager's major time is utilised in carrying out negotiations with financial institutions, banks and public depositors. He has to furnish a lot of information to these institutions and persons in order to ensure that raising of funds is within the statutes. Negotiations for outside financing often require specialised skills.
10)   Helping in Valuation Decisions: A number of mergers and consolidations take place in the present competitive industrial world. A finance manager is supposed to assist management in making valuation etc. For this purpose, he should understand various methods of valuing shares and other assets so that correct values are arrived at.

2. (a) What is an annuity? Explain and illustrate how is future value of an annuity determined.                                (3+7)

(b) What are capital budgeting decisions? How is cost of capital relevant in capital budgeting decisions?            (5+5)
Ans: Meaning of Capital Budgeting or Investment Decisions
The term capital budgeting or investment decision means planning for capital assets. Capital budgeting decision means the decision as to whether or not to invest in long-term projects such as setting up of a factory or installing a machinery or creating additional capacities to manufacture a part which at present may be purchased from outside and so on. It includes the financial analysis of the various proposals regarding capital expenditure to evaluate their impact on the financial condition of the company for the purpose to choose the best out of the various alternatives.
According to Milton “Capital budgeting involves planning of expenditure for assets and return from them which will be realized in future time period”.
According to I.M Pandey “Capital budgeting refers to the total process of generating, evaluating, selecting, and follow up of capital expenditure alternative”
Capital budgeting decision is thus, evaluation of expenditure decisions that involve current outlays but are likely to produce benefits over a period of time longer than one year. The benefit that arises from capital budgeting decision may be either in the form of increased revenues or reduced costs. Such decision requires evaluation of the proposed project to forecast likely or expected return from the project and determine whether return from the project is adequate.
Nature / Features of Capital budgeting decisions
a)      Long term effect: Such decisions have long term effect on future profitability and influence pace of firms growth. A good decision may bring amazing returns and wrong decision may endanger very survival of firm. Hence capital budgeting decisions determine future destiny of firm.
b)      High degree of risk: Decision is based on estimated return. Changes in taste, fashion, research and technological advancement leads to greater risk in such decisions.
c)       Huge funds: Large funds are required and sparing huge funds is problem and hence decision to be taken after proper care .
d)      Irreversible decision: Reverting back from a decision is very difficult as sale of high value asset would be a problem.
e)      Most difficult decision: Decision is based on future estimates/uncertainty. Future events are affected by economic, political and technological changes taking place.
f)       Impact on firm’s future competitive strengths: These decisions determine future profit or cost and hence affect the competitive strengths of firm.
g)      Impact on cost structure – Due to this vital decision, firm commits itself to fixed costs such as supervision, insurance, rent, interest etc. If investment does not generate anticipated profit, future profitability would be affected.

3. The following are the details of a firm:
Amount (Rs.)
Variable cost
Fixed Cost
Equity Capital
55,00,000 (9%)
Calculate its operating, financial and combined leverage. What will be its new EBIT if sales drop to 60,00,000.  (20)
Solution: Calculation of various types of leverage:
Less: Variable cost
Less: Fixed Cost
Earning before interest and tax (EBIT)
Less: Interest on Debt (55,00,000*9%)
Earning Before Tax (EBT)
Operating Leverage =Contribution/EBIT = 33,00,000/26,00,000 = 1.269
Financial leverage = EBIT/EBT = 26,00,000/21,05,000 = 1.235
Combined leverage = Contribution/EBT = 33,00,000/21,05,000 = 1.568

Calculation of EBIT if sales brought down to 60,00,000
Less: Variable cost (52,00,000*60,00,000/85,00,000)
Less: Fixed Cost
Earning Before Interest and Tax (EBIT)

4. (a) What is dividend irrelevance view? What are the assumptions used by Modi Giliani and Miller in support of the irrelevance of dividends?                                            (4+6)
Ans: Modigliani and Miller approach (M & M Hypothesis) and Its Assumptions:
The residuals theory of dividends tends to imply that the dividends are irrelevant and the value of the firm is independent of its dividend policy. The irrelevance of dividend policy for a valuation of the firm has been most comprehensively presented by Modigliani and Miller. They have argued that the market price of a share is affected by the earnings of the firm and not influenced by the pattern of income distribution. What matters, on the other hand, are the investment decisions which determine the earnings of the firm and thus affect the value of the firm. They argue that subject to a number of assumptions, the way a firm splits its earnings between dividends and retained earnings has no effect on the value of the firm.
Like several financial theories, M&M hypothesis is based on the argument of efficient capital markets. In addition, there are two options:
(a) It retains earnings and finances its new investment plans with such retained earnings;
(b) It distributes dividends, and finances its new investment plans by issuing new shares.
The intuitive background of the M&M approach is extremely simple, and in fact, almost self explanatory. It is based on the following assumptions:
a)      The capital markets are perfect and the investors behave rationally.
b)      All information is freely available to all the investors.
c)       There is no transaction cost.
d)      Securities are divisible and can be split into any fraction. No investor can affect the market price.
e)      There are no taxes and no flotation cost.
f)       The firm has a defined investment policy and the future profits are known with certainty. The implication is that the investment decisions are unaffected by the dividend decision and the operating cash flows are same no matter which dividend policy is adopted.
Their conclusion is that, the shareholders get the same benefit from dividend as from capital gain through retained earnings. So, the division of earnings into dividend and retained earnings does not influence shareholders' perceptions. So whether dividend is declared or not, and whether high or low payout ratio is follows, it makes no difference on the value of the share. In order to satisfy their model, MM has started with the following valuation model.
P0= 1* (D1+P1)/ (1+ke)
P0 = Present market price of the share
Ke = Cost of equity share capital
D1 = Expected dividend at the end of year 1
P1 = Expected market price of the share at the end of year 1
With the help of this valuation model we will create a arbitrage process, i.e., replacement of amount paid as dividend by the issue of fresh capital. The arbitrage process involves two simultaneous actions. With reference to dividend policy the two actions are:
a)      Payment of dividend by the firm
b)      Rising of fresh capital.
With the help of arbitrage process, MM have shown that the dividend payment will not have any effect on the value of the firm. Even if the firm pays dividends, resulting in a increase in market value of the share, the effect on the value of the firm will be neutralized by the decrease in terminal value of the share.
(b) Discuss the determinants of divided payout ratio.                                    (10)
Ans: The dividend payout ratio measures the percentage of net income that is distributed to shareholders in the form of dividends during the year. In other words, this ratio shows the portion of profits the company decides to keep to fund operations and the portion of profits that is given to its shareholders. Investors are particularly interested in the dividend payout ratio because they want to know if companies are paying out a reasonable portion of net income to investors. The dividend payout formula is calculated by dividing total dividend by the net income of the company i.e.
Dividend Payout Ratio = Total Dividend/Net income
There are various factors which affect dividend payout decision. These are enumerated below with brief explanation.
a)      Legal position: Section 123 of the Companies Act, 2013 which lays down the sources from which dividend can be paid, provides for payment of dividend (i) out of past profits and (ii) out of moneys provided by the Central/State Government, apart from current profits. Thus, by law itself, a company may be allowed to declare a dividend even in a year when the profits are inadequate or when there is absence of profit.
b)      Magnitude and Trend in EPS: EPS is the basis for dividend. The size of the EPS and the trend in EPS in recent years set how much can be paid as dividend a high and steadily increasing EPS enables a high and steadily increasing DPS. When EPS fluctuates a different dividend policy has to be adopted.
c)       Taxability: According to Section 123 of the Companies Act, 2013 'no dividend shall be payable except in cash'. However, the Income-Tax Act defines the term dividend so as to include any distribution of property or rights having monetary value. Therefore liberal dividend policy becomes unattractive from the point of view of the shareholders/investors in high income brackets. Thus a company which considers the taxability of its shareholders, may not declare liberal dividend though there may be huge profit, but may alternatively go for issuing bonus shares later.
d)      Liquidity and Working Capital Position: Apparently, distribution of dividend results in outflow of cash and as such a reduction in working capital position. Even in a year when a company has earned adequate profit to warrant a dividend declaration, it may confront with a week liquidity position. Under the circumstance, while one company may prefer not to pay dividend since the payment may impair liquidity, another company following a stable dividend policy, may wish to declare dividends even by resorting to borrowings for dividend payment in cash.
e)      Impact on share price: The impact of dividends on market price of shares, though cannot be precisely measured, still one could consider the influence of dividend on the market price of shares. The dividend policy pursued by a company naturally depends on how far the management is concerned about the market price of shares. Generally, an increase in dividend payout results in a hike in the market price of shares. This is significant as it has a bearing on new issues.
f)       Control consideration: Where the directors wish to retain control, they may desire to finance growth programmes by retained earnings, since issue of fresh equity shares for financing growth plan may lead to dilution of control of the dominating group. So, low dividend payout is favoured by Board.
g)      Type of Shareholders: When the shareholders of the company prefer current dividend rather man capital gain a high payment is desirable. This happens so, when the shareholders are in low tax brackets, they are less moneyed and require periodical income or they have better investment avenues than the company. Retired persons, economically weaker sections and similarly placed investors prefer current income i.e. dividend. If, on the other hand, majority of the shareholders are moneyed people, and want capital gain, then low payout ratio is desirable. This is known as clientele effect on dividend decision.
h)      Industry Norms: The industry norms have to be adhered to the extent possible. It most firms in me industry adopt a high payout policy, perhaps others also have to adopt such a policy.
i)        Age of the company: Newly formed companies adopt a conservative dividend policy so that they can get stabilized and think of growth and expansion.
j)        Investment opportunities for the company: If the company has better investment opportunities, and it is difficult to raise fresh capital quickly and at cheap costs, it is better to adopt a conservative dividend policy. By better investment opportunities we mean those with higher 'r' relative to the 'k'. So, if r>k, low payout is good. And vice versa.
k)      Restrictive covenants imposed by debt financiers: Debt financiers, especially term lending financial institutions, may impose restrictive conditions on the rate, timing and form of dividends declared. So, that consideration is also significant.
l)        Floatation cost, cost of fresh equity and access capital market: When floatation costs and cost of fresh equity are high and capital market conditions are not congenial for a fresh issue, a low payout ratio is adopted.
m)    Financial signaling: Dividends are the best medium to tell shareholder of better days ahead of the company. When a company enhances the target dividend rate, it overwhelmingly signals the shareholders that their company is on stable growth path. Share prices immediately react positively.
5. (a) Explain the different methods of ascertaining working capital requirement.                          (10)
Ans: Methods for Estimating Working Capital Requirement
There are broadly three methods of estimating the requirement of working capital of a company viz. percentage of revenue or sales, regression analysis, and operating cycle method. Estimating working capital means calculating future working capital. It should be as accurate as possible because planning of working capital would be based on these estimates and bank and other financial institutes finances the working capital needs based on such estimates only.
a) Percentage of Sales Method: It is the easiest of the methods for calculating the working capital requirement of a company. This method is based on the principle of ‘history repeats itself’. For estimating, relationship of sales and working capital is worked out for say last 5 years. If it is constantly coming near say 40% i.e. working capital level is 40% of sales, the next year estimation is done based on this estimate. If the expected sales are 500 million dollars, 200 million dollars would be required as working capital.
Advantage of this method is that it is simple to understand and calculate also. Disadvantage includes its assumption which is difficult to be true for many organizations. So, where there is no linear relationship between the revenue and working capital, this method is not useful. In new startup projects also this method is not applicable because there is no past.
b) Regression Analysis Method: This statistical estimation tool is utilized by mass for various types of estimation. It tries to establish trend relationship. We will use it for working capital estimation. This method expresses the relationship between revenue & working capital in the form of an equation (Working Capital = Intercept + Slope * Revenue). Slope is the rate of change of working capital with one unit change in revenue. Intercept is the point where regression line and working capital axis meets.
c) Operating cycle method: Operating cycle is the time duration required to convert sales, after the conversion of resources into inventories and cash.  The operating  cycle of a manufacturing co involves 3 segments:
i)  Acquisition of resources like  raw labor, material, fuel and power 
ii) Manufacture of the product that includes conversion of raw material into  work  in  process  and into finished goods, and
iii) Sales of the product either for cash or credit.  Credit sales create book debts for collection (debtors).
The length  of  the  operating  cycle  of a  manufacturing co  is  the  sum  of - i)   inventory conversion period (ICP) and ii)   Book debts conversion period (BDCP) collectively, they are sometimes called as gross operating cycle (GOC).
The Inventory conversion period is the entire time needed for producing and selling the product and includes:
(a) Raw material conversion time (RMCP)
(b) Work in process conversion period (WIPCP) and
(C)  Finished good conversion period (FGCP).
The payables deferral period (PDP) is the length of time the firm is capable to defer payments on various resource purchases. The variation between the gross operating cycle and payables deferrals period is the net operating cycle (NOC).
NOC = GOC- Payables deferral period.

(b) What is economic order quantity? Discuss the process of its determination.                                               (5+5)

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