BBS 2nd year Fundamentals of Financial Management (Finance Notes)

BBS 2nd year finance note

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MGT 215 : Fundamentals of Financial Management (Full Marks : 100)

Introduction To Financial Management Unit 1.

Financial Statement Analysis – Unit 2.

Time Value of Money -Unit 3.

Fundamentals of Risk and Return – Unit – 4

Financial Assets Valuation – Unit – 5

Cost of Capital – Unit 6

Capital Structure and Leverage – Unit 7

Basics of Capital Budgeting – Unit 8

Working Capital Management – Unit 9

Distributions to Shareholders – Unit 10

Objective: This Course Fundamentals of Financial Management aims to lay the foundation for understandings fundamentals concepts and principles of financial management. This course has been structured as a compulsory course in finance. This Course equips the students with fundamental tools and techniques of financial management to prepare them to resolve complex financial issues concerning corporate firms.

Unit 1. Introduction of Financial Management

  1. What is financial management?
    Financial management refers to the management of funds in the context of a business firm.
    Finance includes the set of activities dealing with management of funds. In a broader term, it
    describes how money is managed and the actual process of acquiring needed funds. Financial
    management is the decision of collection and use of funds. In the context of business firm,
    finance is used to describe the money resources used by firm and the management of these
    resources.
  2. Mention the career opportunities available for finance graduates.
    Or where do finance graduates may seek career opportunities?
    The career opportunities for finance graduates are ever expanding. The important fields where
    finance graduates may pursue their career are:
    a) Corporate business houses
    b) Investment companies
    c) Financial institution
    d) International financial institution
    e) Local and federal government organization. However corporate businesses are most
    suitable for financial management graduates.
  3. What are the functions of managerial finance?
    Or what are the functions of financial management?
    The functions of financial management are as follows:
    i. To make financing decision that minimizes the cost of capital
    ii. To make investment decision as such that present values of benefits are greater than the
    present value of costs
    iii. To make dividend decision that maximizes the market price of share
    iv. To make working capital decision that result into proper trade- off between profitability
    and liquidity associated with current assets investment and financing.
  4. What is profit maximization goal?
    Profit maximization refers to the maximization of rupee income of the firm. Under this goal, all
    profitable financial courses of actions are undertaken and unprofitable project are avoided. Profit
    maximization goal emphasizes on productivity improvement effort of the firm. It emphasizes on
    achieving maximum output form a given level of input or minimizing the use of inputs to
    achieve a given level of output. The productivity improvement leads to profit maximization.
  5. What are the major executive functions performed by the financial manager in a
    corporate firm? Discuss the significance of these functions for better financial performance
    of Nepalese firm.

    The major executive finance functions performed by the financial manager in a corporate firm
    are as follows:
    * Investment decision: investment decision is concerned with allocating resources into
    long term investment project. Financial manager should estimate the cost and benefits of
    each investment alternatives, use correct project appraisal method and reach at the right
    investment decision. It includes both acquisitions of long term assets as well as
    maintaining appropriate investment in working capital.
    *Financing decision: the financial manager is also supposed to play significant role in
    identify and using different sources of financing to satisfy its investment need of long
    term assets and working capital. The financial manager rely on long term and short term
    funds. Similarly s/he can evaluate the use of debt versus equity capital. While deciding on
    these different sources of funds the financial manager should think of the maturity
    composition of assets and liabilities.
    * Dividend decision: dividend decision is concerned with determining the proportion of
    earning to be distributed to shareholders in the form of dividend. Financial manager
    should determine appropriate dividend policy of the firm that can enhance shareholder
    wealth. For this the financial manager should consider the cost of capital, capital
    expenditure need of the firm, tax situation of shareholder, and their effect on market price
    of share.
    * Working capital decision: working capital decision is concerned with current assets
    investment and financing decision. Under current assets investment decision, the
    financial manager should maintain appropriate size of investment in current assets
    considering the impact of current assets size on firm liquidity and profitability. Similarly
    under current assets financing decision, the financial manager should decide on
    appropriate mix of long term and short term funds to finance the current assets.
    Traditionally, financial management used to focus only on the procurement of funds required
    to set up a business firm and expansion of its activities. Accordingly, the responsibility of the
    financial manager was limited only to estimate the financial requirements of the firm and
    raise the funds to meet its projected financial projected. Importance of executive finance
    functions cannot be over-looked in the context of Nepal. They are indeed, the key to
    successful business operations. Without proper administration of finance functions, no
    business enterprises can reach its full potential for growth and success executive finance
    functions are all about planning investment. The significance of finance functions can be
    highlighted as follows:
    * They help in avoiding over investment in fixed assets
    * They cash outflow with cash inflow
    * They ensure that there is a sufficient level of working capital
    * They help is setting sales revenue targets that will deliver growth
    * They help in increasing profits by setting the correct pricing of products or services
    * They help in tax planning that will minimize the taxes a business has to pay.
  6. Will profit maximization always result in stock price maximization? Discuss.
    According to conventional theory of the firm, profit maximization is considered to be the
    principal objective of the firm because price and output decision associated with a firm is usually
    based on the profit maximization criteria. Profit maximization refers to maximizing rupees
    income of the firm. Accordingly to this goal the actions that increase profits should be
    undertaken and those that decrease profits are to be avoided. Those who are in favor of profit
    maximization argue that profit is a test of economic efficiency. It leads to effective utilization of
    scarce economic resources in every business firm it leads total economic welfare since it
    increases the economic efficiency of every individual firm. Profit maximization is considered to
    be a basic criterion for financial decision-making.
    However, there is an alternate goal to profit maximization called as stock price maximization
    which is considered to be the better goal than profit maximization. According to this goal, the
    managers take decisions that maximize the shareholder wealth. Shareholder wealth is maximized
    when a decision generates net present value. The net present value is the difference between
    present value of the benefits of a project and present value of its costs. Investor pays higher
    prices of shares of a company which undertake projects with positive net present value. As a
    result, wealth maximization is reflected in the market price of shares.
    A firm‟s stock price is determined by a number of factors. Any financial decisions that affect the
    level, timing and riskiness of expected cash flows will have impact on stock price. For example,
    investment decision, financing decision, and dividend decision are likely to affect the level,
    timing and riskiness of the firm cash flows, and therefore the price of its stock. Stock prices are
    affected by external factors such as state of economy, tax laws, interest rates and condition is
    stock market.
  7. What is wealth maximization? Why should a firm concentrate primarily on wealth
    maximization instead of profit maximization? Explain.
    0r “maximization of stakeholder’s welfare should be the ultimate goal of modern corporate
    firm.” Discuss.

    A corporation exists to create value for its shareholders. Creating value for shareholder is similar
    to maximizing the market values of the firm, which leads to maximization of stockholder
    welfare. It is reflected in maximum share price. In finance, we call it value maximization or
    wealth maximization or stock price maximization. Value maximization is the superior goal of a
    firm. This goal emphasizes on initiating those financial decisions that maximize the shareholders
    welfare. Shareholder welfare can be maximized by generating positive net present value from a
    course of action.
    It makes sense for the corporations to maximize stockholders welfare because of the following
    reasons:
    * Clear goal: under value maximization goal, financial decisions are evaluated in terms of cash
    flows rather than accounting profits. According to this goal, the financial manager attempts to
    make the size of cash flow to the shareholder as large as possible. Larger size of cash flows to
    shareholders results into their wealth maximization. The concept of cash flow is clear. It refers to
    the difference between cash benefits and cash costs.
    *Recognizes time value of money concept: the value of cash flows occurring at different time
    periods are different. According to the concept of time value of money, cash flows occurring at
    earlier period have large value. this concept is well recognize in value maximization criterion
    since every financial decision is undertaken on the basis of comparison between present value of
    benefits and present value of costs.
    *Recognizes the quality of cash flows: two investment projects may have same quantity of
    cash flows over their life, but their quality may differ. The quality of cash flows here refers to the
    riskiness of the cash flows. Under value maximization criterion, we selected higher required
    return to estimate the present value of risky cash flows. Thus, this considered the quality of cash
    flows.
    *It represents all stakeholders: shareholders, managers, employees, creditors, customers and
    society are the stakeholders of a corporation. Value maximization represents the interest of all
    these stakeholders. It represents the interest of society at large by allocating scare resources
    efficiently in the areas that are the most promising. Similarly, value maximization requires lowcost and high quality of a business that benefits the customers. It also focuses on fair
    compensation to employees.
  8. What is the meaning of financing decision?
    Financing decision is the most important function of financial management. Financial decision
    concerns the procurement of fund. Under this function financial manager must decide about
    when, from where and how to acquire funds to meet the financial needs for investment. To
    specific, it is required to determine the appropriate proportion of equity and debt, the mix of
    which is understood as capital structure

Unit -2. Financial Statement and Analysis

  1. Write the meaning and uses of free cash flows.
    Free cash flow is the cash flow available to all investors in a company including common
    stakeholders. Free cash flow provides a useful valuation technique that can derive the value of a
    firm or the value of a firm common equity. It is a measure of how much cash a business
    generates after accounting for capital expenditures. This cash flow can be used for expansion,
    payment of dividends, repayment of debt, and for other purpose.
  2. How does net cash flow differ from net income?
    Net cash flow is the difference between cash inflow and cash outflows. We deduct all cash
    expenses from all cash income to calculate net cash flow. It differs from net income in a way that
    net income is the difference between revenues and expenditure that includes all cash and noncash items. For example, depreciation is a non-cash expense. We deduct depreciation in
    calculating net income. However, depreciation is not deducted while calculating net cash flow.
    Therefore, if only non-cash item of a firm is depreciation then net cash flow is always equal to
    net income plus depreciation.
  3. Limitation of ratio analysis.
    Limitation of ratio analysis as follows:
     Lack of suitable standard for comparison
     Difficulty in comparison
     Conceptual diversity
     Ignores qualitative aspects
     Based on the historical information
     Ignore the change in price level
  4. Uses of ratio analysis.
     Knowledge of liquidity position
     Knowledge of operating efficiency
     Knowledge of overall profitability
     Trend analysis
     Inter-firm comparison
  5. Role of financial statements.
    The roles of financial statements are as given by:
     Provide information for decision making
     Depict the financial position
     Reflect the prospective cash flows of the firm
     Helpful in inter-firm comparison
  6. What is Du-Pont system?
    Du-Pont system is a comprehensive method of financial analysis first used and popularized by
    Du-Pont Corporation. It is used to make classified assessment of the link between firm’s
    profitability, Operating efficiency, assets management and debt management. A simple Du-Pont
    system links return on firm’s as a function of operating efficiency measured by net profit margin
    and the assets productivity measured by total assets turnover. It is stated as:
    Simple Du- Pont equation:
    ROA = profit margin × assets turnover
    Extended Du-Pont equation:
    ROE = profit margin ×assets turnover ×equity multiplier
  7. Suppose a firm uses a part of cash collected on accounts receivable to buy inventory and
    leaves the rest in its bank accounts. What effect does it make on the firm’s current ratio?

    It does not make any effect on the firm‟s current ratio because decrease in current assets due to
    collection of accounts receivable will exactly fulfilled by increase in inventory and bank account.
  8. Types of financial statements?
    There are four basic financial statements are as follows:
     The balance sheet
     The income statements
     The statements of stockholder’s equity
     The statements of cash flow
  9. Short list out the importance of financial statements.
    The basic importance of financial statements as follows:
     Financial statements can be used for the purpose of reporting to shareholders, creditors,
    creditors, and other stakeholders about financial affairs of the firm.
     Financial statements such as statements of cash flow are prepared to know about
    comparative cash flow position of a firm between two periods.
     The pro-forma financial statements can be prepared to provide a future forecast of
    revenues, expenses, investment and financial need of the firm.
  10. Why cash flow statement is needed to be prepaid?
    Cash flow statement is a statement showing the changes in financial position or cash position of
    a firm during two balance sheet dates. This statement shows cash inflow and outflow of the firm
    during a period. Cash flow statement is basically prepared to analyze the causes of changes in
    cash position of the firm during two regular balance sheet dates. The basic needs for preparing
    cash flow statement are as follow:
     To identify the cash flow from operating activities
     To analyze the cash flow from investing activities
     To identify the changes in cash brought about by financing activities
     To analyze the changes in net cash position.
  11. What difference between assets management ratio and debt management ratios?
    Assets management ratios are used to evaluate the productive power of firm’s investment in
    different assets. It show whether the firm has held adequate investment in productive asset. It
    Show the qualitative liquidity position of firm’s investment in inventories and receivables.
    Debt management ratios are used to assess the use of debt capital by firm. It shows the extent
    of use of debt capital to finance the total assets and the long term solvency position of the firm.
    Debt management ratios show the firm’s debt serving and fixed charge coverage capacity.

Unit- 3 Time Value of Money

  1. How does effective rate differ from nominal rate?
    Nominal rate is also called stated interest rate. This rate works according to the simple interest
    and does not take into account the compounding effects. However, effective rate is the one which
    caters the compounding periods during a payment plan. It is used to compare the annual interest
    between loans with different compounding periods like week, month, year etc. in general,
    nominal rate is less than the effective one. The effective rate shows the true picture of financial
    payments.
  2. How is perpetuity different from annuity?
    A perpetuity refer to the equal payment to each interval of time until the indefinite time period
    while an annuity refers to the equal payment at each equal interval of time until the definite time
    period. In other words, there are fixed number of equal payments in an annuity.
  3. Differentiate annuity from annuity due.
    An annuity is a series of equal payment that occurs at equal interval of time over a definite
    period. An annuity can be an ordinary annuity or an annuity due.in case of an ordinary annuity,
    each payment is made at the end of equal interval of time while in case of an ordinary annuity
    due each payment occurs at the beginning of equal interval of time. In other word, in case of an
    annuity due each payment occurs one period earlier than ordinary annuity. Due to this reason, the
    present value and future value of the annuity due is always greater than the ordinary annuity over
    the same.
  4. Differentiate between future value and present value.
    Present value is the today value of a future sum of money where as future value is the value of a
    present sum of money in some future date, given a certain interest rate. For example, if we
    deposit rs1000 today in a bank account paying 10% annual interest we will have rs1100 at the
    end of year. In this example, rs1000 today is the present value of rs1100 in year 1 given 10%
    interest rate. Similarly, rs1100 at the end of year 1 is the future value of rs1000 today given the
    interest rate of 10 percent.
  5. Explain what is meant by the following statement. “A rupee in hand today is worth more
    than a rupee to be received next year.”

    Every sum of money received earlier commands higher value than the equal sum of money
    received later. This statement is well explained by the concept of time value of money. The time
    value of money is the concept to understand value of cash flows occurred at different period of
    time. A rupee in hand today is valued more than a rupee next year due to the following three
    reasons:
    a) Investment opportunity: money received earlier can be invested to generate further
    sum of money. For example, if we receive rs100 today and deposit in a bank account
    paying 5% interest. We will have rs105 at the end of the year. Therefore, given this
    investment opportunity rs100 today is equivalent to rs105 at the end of year.
    b) Preference toward current consumption: most of the people prefer current
    consumption than the future consumption. Money in hand today makes current
    consumption possible. Therefore, current sum of the money is more valuable.
    c) Inflation: A sum of money today is worth more than the equal sum of money a year
    later due to inflation. Inflation kills purchasing power of money. if the rate of inflation is
    5%, we need rs105 to buy a basket of commodity a year later what we could buy with
    rs100 today.
  6. Short note of Amortization schedule (loans).
    Amortization loans are those loans that are repaid in equal period installment over a loan contract
    period. The equal periodic installments contain a part of principal repayment and the interest
    payment on outstanding loan. This type of loan is more common hire purchase financing of autos
    and home appliances in Nepal. Besides, commercial banks in Nepal also extends housing loan
    for a longer period of time which is repaid in equal monthly installment. In amortization loans,
    the equal periodic installment is called payment. It is determined on the basis of the concept of
    time value of money. A payment is a series of equal future payments on the loan that has a total
    present value equal to the amount of loan at a given interest rate. It is worked out as follows:
    Payment (PMT) = Amount of loan / PVIFA i%, n year
  7. Why time vale of money concept so important in financial analysis?
     Application in investment decision
     Application in financing decision
     Application in security analysis
     Application in leasing versus buying decision
     Other uses:

    Unit- 4
    Risk and return
  8. Explain the concept of portfolio risk?
    A portfolio is a combination of wealth in to two or more assets. The portfolio theory deals with
    forming an efficient portfolio of assets that offers higher return and minimizes the risk. It is
    possible for an investor that a single asset might be very risky when held in isolation but not as
    much risky when held in combination with other assets in the portfolio. Thus, first the portfolio
    risk depends on the riskiness of individual assets in the portfolio other things remaining the same
    higher the level of risk associated with individual assets higher will be the portfolio risk.
  9. Capital asset pricing model (CAPM).
    Capital asset pricing model shows the relationship between risk and return of an asset. The
    capital asset pricing model postulates that required rate of return on any assets is the total of risk
    free rate plus the risk premium. The capital assets pricing model equation is stated as follows:
    E(Rj) = Rf + [Rm-Rf]βj
  10. Systematic and unsystematic risk.
    Systematic risk refers to the risk which affects the whole market and therefore it cannot be
    reduce or diversified away.it refers to the variability in security‟s return with respect to overall
    market. This arises due to imbalance in the political situation or fluctuation in the market etc. In
    other hand, unsystematic risk is the extent of variability in security‟s return on account of factors
    which are unique to a firm. In other words, it is the variability in security‟s return with respect to
    unique factors associated with individual firm. It can be diversified away. This risk arises from
    management inefficiency unsuccessful planning etc.
  11. Define the term of coefficient of variation?
    Coefficient of variation is an investor has to choose one investment between two investment that
    have the same expected returns but different standard deviations, he/she would choose the one
    with the lower standard deviation and therefore the lower risk. The investor is given a choice
    between two investments with the risk but different expected return, he/she would generally
    prefer the investment with the higher expected return. Coefficient of variation is a measure to
    relative dispersion that is useful in comparing the risk of assets with differing expected return.
    The CV as a measure of risk in this case neutralizes the influence of size of the investment.
    Unit-5
    Financial assets valuation
    A. Bond valuation
  12. Define premium bond and gives an example of premium bond.
    A bond is said to be a premium bond if it sells at price higher than the par value. For example,
    suppose par value of bond is re1000. If the bond currently sells at 1050, it is called a premium
    bond. The bond sells at premium when the market interest rate is lower than the coupon rate.
  13. How do you determine value of coupon bond with finite maturity?
    Value of coupon bond with finite maturity is the total present value of periodic steam of interest
    payments plus the present value of maturity value all discounted at bondholders required rate of
    return. It is determined as using following model:
    Vo= I×[PVIFA i%, n] + M×[PVIF i%, n]
  14. Define the discount bond and gives an example of discount bond.
    Or, how does value of a discount bond change over the time if all other things remain the
    same?
    A discount bond is the bond that sells at a price below par value. The bond sells at discount when
    the market rate exceeds the coupon rate. For example, any bond issued by a corporation usually
    has a par value of rs1000 and it has a stated coupon rate. If the coupon rate of the bond is less
    than the prevailing market interest rate on similar risk class bond, then it sell at a price less than
    rs1000. The value of such bond increase as it approaches to the maturity.
  15. What are the key features of the bond?
    A bond is a long term promissory note-issued by corporation. It is called a promissory note
    because the issuer promises to pay stated amount of interest regularly and repay the maturity
    value at the expiry of maturity period. While issuing bond, the issuer prepares a legal documents
    called indenture which is duly signed by the issuer and the trustee on behalf of the bondholders.
    The specific features are as follows:
     Par value
     Coupon rate
     Maturity period
     Call provision
     Conversion feature
  16. Yield to maturity.
    The yield to maturity is the annualized rate of return that a bondholder can realize from bond
    investment if the bond is held until the maturity period. Technically speaking, YTM is the
    discount rate at which the present value of all future cash flows associated with bond investment
    remains equal to the current selling price of the bond. The YTM is the total annualized yield that
    contains both capital gain yield and the current yield from the bond.
    B. Stock valuation
  17. Discuss features of common stock.
    Common stock is securities issued by corporation to raised ownership capital. Capital raised by
    issuing share of common stock is used to finance major portion of the firm‟s fixed assets.
    Common stock certificate represents the evidence of ownership right of the holders in the
    corporation. Some of the basic features of common stock are as follows:
     Par value
     Limited liability
     No maturity
     Voting rights
     Residual claim
  18. How do you calculate the value of irredeemable preferred stock?
    Irredeemable preferred stock has no specified maturity. Therefore, value of an irredeemable
    preferred stock is the total of the present value of indefinite steam of preferred stock dividend
    discounted at preferred stockholders required rate of return. For example, if an irredeemable
    preferred stock has rs100 par value and that pays a 12% preferred stock dividend and preferred
    stockholder required rate of return is 10%, we calculate the value of irredeemable preferred stock
    as follows:
    VPS = DPS / KP
  19. What are the features of preferred stock?
    Preferred stock has an immediately position between long term debt and common stock in term
    of claim on assets and dividend payment. In the event of liquidation, a preferred stockholders
    claim on assets comes after that of creditors but before that of common stockholders. Similarly,
    preferred stock dividend is distributed after payment of interest but before distribution of
    common stock dividend. It is called the hybrid form of financing because it has combined
    features of both debt and common stock. Its features are as follows:
     Par value
     Fixed dividend
     Cumulative feature
     Maturity
     Participating features
  20. If stock is not in equilibrium, explain how financial markets adjust to bring it into
    equilibrium.
    If stock is not in equilibrium but over or under priced then financial markets adjust to bring it
    into equilibrium. If the stock is overpriced, selling pressure increase in the market. This leads to
    increase in supply of the stock, which ultimately causes stock price to decline to adjust towards
    equilibrium. In opposite case, when stock is under-priced buying pressure increase in the market.
    This will cause the demand for stock to increase and the price of stock also to increase to adjust
    towards equilibrium.

Unit-6
Cost of capital

  1. What are the key factors affecting cost of capital?
    The key factors affecting cost of capital are as follows:
     General economic condition
     Marketability of the security
     Amount of financing need of the firm
     Operating and financing decision associated with the firm
     Tax rate
     Capital structure and dividend policy
  2. Describe the uses of weighted average cost of capital.
    The WACC is the minimum required rate of return on firm‟s investment. It represents the
    weighted average cost of all components of capital employed by the firm to finance its project. If
    the project return is higher than the WACC, the project is considered profitable. Therefore, it is
    considered an appropriate acceptance criterion for evaluating the project investment. However,
    in this calculation the WACC has been computed for existing capital employed by the firm. If
    the firm plans to invest in new project, it has to raise additional capital.
  3. What is weighted cost of capital?
    Weighted average cost of capital is the overall cost of capital applicable to the firm. It is the
    weighted average of the cost of each components of capital employed by a firm, where the
    weight corresponds to the proportion of each components of capital employed by the firm in its
    overall capitalization.
  4. What are the assumptions of cost of capital?
    In calculating cost of capital, we assume that risk to the firm being unable to cover operating
    and financing costs are assumed to be constant, the cost of capital are measured on an after tax
    basis and the corporate marginal tax rate is assumed to be constant and the firm‟s dividend policy
    doesn‟t change.
  5. What is the significance of marginal cost of capital in decision making?
     Use in investment decision
     Use in financing decision
     Use in dividend decision
    Unit- 8
    The basics of capital budgeting
  6. State the limitation of pay back method.
    Some limitations of payback period are as follows:
     It does not take into account all cash flows over the life of the project
     It does not recognized the timing and riskiness of cash flows
     It is not consistent of the value maximization objective
  7. Why NPV method is preferred over IRR?
    IRR method has certain shortcoming such as it gives the multiple IRR when cash flows are nonnormal; IRR assumes that all cash flows from the project are reinvested at IRR. This is not valid
    assumption because cash flows should be reinvested at cost of capital which reflects the level of
    risk associate with the project. Similarly, the NPV method does not have all these shortcoming of
    IRR.
  8. Define NPV with merits and demerits.
    Net present value is one of the widely used discounted cash flow techniques of evaluating capital
    budgeting projects. NPV is the difference between present value of cash inflows and outflows
    from the projects. According to this method, benefits of the project measured in term of cash
    flow is discounted and sum up, and then initial cash outlay of the project is deducted. The
    remaining value is known as net present value.
    Merits:
     It recognizes the concept of time value of money
     It takes into account all cash flows over the life of the project
     This method is based on the cash flows rather accounting profits
     It is consistent with the shareholder‟s wealth maximization objective.
    Demerits:
     This method is based on the expected cash flows of the project. However, in real life, it is
    very difficult to forecast the cash flows with accuracy.
     Lack of simplicity
     Sensitive to cost of capital
     Difficulty in selection of discount factor
  9. Define IRR with merits and demerits.
    Internal rate of return is the discount rate at which present value of future cash flows is equal to
    the present value of cost. In other words, IRR is the discount rate at which the net present value
    is zero.
    Merits:
     It considered the time value of money and all cash flow of the project
     It is based on the cash flows of the project.
     Useful to achieve the firm‟s goal
     Consider to total cash flow
     Suitable for comparison
    Demerits:
     Difficulty in calculation
     Possibility of multiple IRR
     Misleading assumptions
  10. Cross over rate.
    Crossover rate is the discount rate at which two mutually exclusive projects have equal net
    present value. In case of two mutually exclusive projects, NPV of one project may be higher than
    that of other at lower cost of capital, while the net present value of the same project may be
    lower than that of other at higher cost of capital. In this situation there exists a crossover rate at
    which NPVs of two projects remain equal. If NPV of one project remains always higher than that
    of other at any level of cost of capital then there exists no cross over rate.
  11. Meaning of Payback period.
    The payback period is the expected number of years required to recover the initial investment of
    the project. According to this method, the project with lower payback period is selected. For
    decision making purpose, the maximum cost recovery time is established, and payback period of
    the project is compared with this time. Shorter payback period means earlier recovery of
    investment.
  12. Define the meaning of mutually exclusive project?
    A mutually exclusive project is one where acceptance of such a project will have an effect on the
    acceptance of another project. In mutually exclusive projects, the cash flows of one project can
    have an impact on the cash flows of another. For example, if you are planning to install the
    window frame in your new building, you have three options: wooden frame, metal frame, and
    metal frame. You can install one among the available in the market. Installing one option is
    rejection to another option.
    Unit-7
    Capital structure and leverage
  13. How does financial structure differ from capital structure? Describe the factors that
    affect capital structure of a firm. Or what are the factors affecting target capital structure?
    Financial structure refers to the composition of entire components of liabilities in equity in a
    firm‟s balance sheet. It refers to the proportionate mix of current liabilities, long term debt,
    preferred stock, and equity in the balance sheet of the firm. On the other hand, capital structure
    only refers to the proportionate mix of long term and permanent capital such as long term debt,
    preferred stock, and equity. It does not include the short term liabilities. Thus, capital structure is
    only a part of financial structure of a firm.
    The capital structure of a firm is affected by various factors as follows:
    a) Business risk: the level of business risk is determined by the use of fixed operating cost
    or operating leverage. The chance of business failure is higher for the firm with higher
    level of business risk. Thus, they tend to use lower debt.
    b) Cash flow stability: a firm with relatively stable cash flows finds no difficulties in
    meeting its fixed charge obligation. Thus such firm tends to use more debt.
    c) Firm size: the larger firms have easy access to the capital market as they have higher
    credit rating for debt issues. Therefore they tend to use more debt capital than smaller
    firms.
    d) Sales growth: the firms with significant growth in sales have high market price per
    share. Thus they prefer to use more equity.
    e) Control and risk: management‟s attitude towards control and risk also affect capital
    structure decision, if management wants to maintain control in the firm, they prefer to use
    more debt financing. Similarly, if the management of a firm is more risk seeker, they
    attempt to use more debt to take the advantage of financial leverage.
    f) Debt service capacity: debt service capacity of the firm is indicated by interest coverage
    ratio. The firms with higher interest coverage ratio tend to use more debt.
    g) Assets structure: maturity structure of assets to be financed also affects the capital
    structure. A firm with relatively higher longer-term assets and stable demand of products
    tends to use more long term debt.
  14. What is meant by the term leverage? With which type of risk leverage generally
    associated?

    Leverage is a more popular term used in physics, which refers to the use of a lever to raise a
    heavy object with relatively small forces, in finance leverage refers to the potential use of fixed
    costs to magnify the earnings. There are three types of leverage:
    Operating leverage: operating leverage shows the responsiveness of change in operating profit
    to the change in sales. A given change in sales usually brings more than proportionate change in
    operating profit because of the use of fixed operating costs. Thus operating leverage refers to the
    potential use of fixed cost by a firm. The numerical measure of operating leverage is called the
    degree of operating leverage.
    Financial leverage: financial leverage explains how a given change in operating income of the
    firm affects its earnings per share and earning to common stockholders. It is the responsiveness
    of change in firm‟s EPS to the change in operating profit. Financial leverage exists because of
    the use of fixed charge bearing securities, such as bond and preferred stock. In fact the financial
    leverage refers to the use of debt in firm.
    Total leverage: total leverage is the combination of operating and financial leverage. Degree of
    operating leverage measures the degree of business risk associated with a firm. The operating
    leverage results from the existence of fixed operating cost. On the other hand, the degree of
    financial leverage measures the financial risk associated with a firm. It results from the existence
    of fixed financing cost. The combined use of operating and financial leverage causes
    considerable change in net income and EPS even there is only a small change in sales.
  15. What is business risk? What are the some determinants of business risk?
    Business risk is the riskiness on a firm‟s stock provided that the firm has used no debt capital. It
    is the risk inherent in operation of the business. A firm‟s business risk arises because of
    uncertainty associated with projections of return on invested capital. Return on investment varies
    due to the number of factors such as variability in demand price of the product and general
    economic condition, competition and so on. Business risk also called operating risk. Some
    determinants are as follows:
     Demand volatility
     Selling price volatility
     Technological changes
     Level of fixed operating costs
     Input costs volatility
     Efficiency of price adjustment
    Unit-10
    Distribution of shareholder’s
  16. What is repurchases of stock?
    Stock repurchases refers to the repurchasing own outstanding shares of common stock by the
    firm itself in the market place. There may be several motives for share repurchases. Some of the
    motives may be to obtain shares to be used in acquisitions, to have shares available for employee
    stock option plans, to achieve a gain in the book value of equity when shares are selling below
    their book value, to retire outstanding share and so on.
  17. In what situations should a firm declare stock dividend?
    A firm usually issues a stock dividend when it does not have the cash available to issue a normal
    cash dividend, but still wants to give the appearance of having issued a payment to stockholders.
    The firm should declare stock dividend instead of a cash dividend when it happens to increase
    the number of outstanding shares or to capitalize its retained earnings as paid in capital, or to
    conserve the firm‟s cash for other purpose.
  18. In what situations should a firm consider the repurchase of the stock?
    Repurchase of stock is buying back outstanding share of common stock of a firm by itself from
    open market. The basic motive of repurchase of stock is to retire the share and reduce the number
    of outstanding shares. Similarly, a firm should consider the repurchase of the stock to make the
    shares available for employee stock option. Repurchase of stock for retirement of outstanding
    share is considered similar to the payment of cash dividend. If earning remain constant
    repurchase of shares reduce the number of outstanding shares thereby increasing the earnings per
    share and market price per share.
  19. What are the factors influencing dividend policy? Also explain the types of dividend
    payout schemes.
    Dividend policy of a firm is influenced by many factors. Some major factors are explained
    below:
    1) Legal requirements: certain conditions imposed by law restrict the dividend payment.
    For example, dividend should not exceed the sum of current earnings and past
    accumulated earnings; accumulated loss must be set off out of the current earnings before
    paying out any dividends; firm cannot pay dividend out of its paid up capital because it
    adversely affects the firm‟s equity base; it is strictly prohibited by law to pay dividends.
    2) Repayments need: a firm uses debt financing for investment is assets. These debts must
    be repaid at the maturity. The firm has to retain certain proportion of the profits every
    year to meet the repayment need of debt at maturity. This reduces the dividend payment
    capacity of the firm.
    3) Expected rate of return: if a firm expects higher rate of return from new investment, the
    firm prefers to retain the earnings for reinvestment rather than distributing cash
    dividends.
    4) Earnings stability: firms with relatively stable earnings tend to pay higher dividend. A
    firm with unstable earnings is relatively uncertain about its future earnings prospects.
    Such firm prefers to retain more out of current earnings.
    5) Desire for control: the management with high desire for control in the company does not
    prefer to issue additional common stock even the need for additional capital arises.
    Issuing additional common stock may dilute their control authority. Instead of paying
    dividend, the management prefers to retain the profits for reinvestment in such case.
    6) Liquidity position:
    7) Restrictions by creditors:
    8) Personal tax bracket of shareholders:
    9) Access to the capital market:
    Types of dividend payout schemes:
    Dividend payout schemes can be of two types: residual dividend policy and stability in
    dividends. They are discussed below:
    a) Residual dividend policy: under this policy, a firm pays dividend only after meeting its
    investment need at desired debt-assets ratio. This policy assumes that the firm wises to
    minimize the need of external equity, and attempts to maintain current capital structure.
    Thus under this policy, the firm uses internally generated equity more to finance the new
    projects that have positive NPV. Dividends are paid out of residual income left after
    meeting equity financing need of new investment. Under this policy, net income is first
    set aside to meet the equity requirement of new investment. If net income is left this,
    dividend is paid otherwise not. The amount of dividend under this policy is worked out as
    follows:
    Dividend = net income – equity requirement of new investment
    b) Stable dividend policy: under stable dividend policy, firm attempts to maintain stability
    in dividend payment behavior. The stability in dividend is maintained according to the
    following dividend payment schemes.
     Constant rupee per share dividend: under this scheme, a constant rupee per share
    dividend is paid. The fixed amount of dividend per share is paid on an annual basis
    irrespective of earnings for the year. The earnings may fluctuate from year to year but
    dividends per share remain constant.
     Constant payout ratio: under this scheme the firm maintains constant dividend payout
    ratio over the years. For example, if the dividend payout ratio is 30% maintain, it implies
    that the firm pay 30% of its earnings in dividend every year. Dividend per share under
    this policy fluctuates with earnings in the exact proportion.
     Minimum regular plus extra: under this policy, the firm always pay minimum regular
    dividend per share and also pay extra dividend over the minimum regular dividend if
    earnings increase as targeted. For example, with a minimum re2 per share regular
    dividend plus extra 30% on the EPS exceeding rs10 policy, firm regular pays rs2 per
    share in dividend and pays extra 30% dividend on the earnings exceeding rs10 per share
    in any year.
  20. What are Advantages of stock dividends?
     Stock dividend conserves the cash in the firm, so that it can be used in new projects
     Paying stock dividend does not result into cash outflows from the firm
     It simply involves a book keeping transfer from retained earnings to the capital stock
    account
     Stock dividend is a way of recapitalization of earnings
  21. In what situations should a firm consider the use of stock dividend?
    Stock dividend is simply a book keeping transfer of equity account from retained earnings to
    common stock and additional paid up capital account. It simply results into increase in number of
    outstanding share with no change in total value of shareholder‟s equity. Stock dividend is a way
    to recapitalize earnings. Thus a firm should consider paying stock dividend when it happens to
    recapitalize earnings for reinvesting into profitable opportunities.
    .
    Unit-9
    Working capital management
  22. What is working capital management? Discuss the importance of working capital
    management in a manufacturing firm.
    Working capital management is concerned with managing firm‟s current assets and current
    liabilities to maintain a proper trade of between profitability and liquidity. The working capital
    management is important for the financial health of the firm due to the following reason:
    A. It requires significant managerial consideration: for most manufacturing concerns, the
    current assets represent significant part of total assets. The size and volatility of current
    assets make working capital management a major managerial concern. Financial manager
    spends much of their time in day-to-day internal operation of the firm, which revolves
    around working capital management.
    B. It is helpful to maintaining desired scale of operation: the relation between growth in
    sales and working capital used in direct and close. So far as the firm is more concerned
    about maximizing sales revenue, must involve in working capital management. For
    example, as sales increase, firms must increase inventory and accounts payable to meet
    the increasing sales requirement.
    C. It assists in maintaining continuous cash flow: working capital management is also
    important from the viewpoint of maintain continuous cash flow. A good working capital
    management reflects in terms of adequate level of accounts receivable, inventory and
    cash flow in and out of the firm. A firm doing better in working capital management can
    maintain control over its accounts receivable and inventory and ensure the regular flow of
    cash.
    D. It is more significant to small firm: working capital management is particularly
    significant for smaller firms, since they carry a higher percentage of current assets and
    current liabilities. They survival of these firm largely depends on the effective working
    capital management. Due to their limited approach to the long term capital market, they
    have to rely heavily on the short term borrowing, trade credit and so on.
    Importance of working capital management in a manufacturing firm:
    Firm‟s liquidity has two major aspects: ongoing liquidity and protective liquidity. Ongoing
    liquidity refers to the inflow and outflow of cash through the firm as the product acquisition,
    production, sales, payment and collection takes place over time. Protective liquidity refers to the
    ability to adjust rapidly to unforeseen cash demands and to have backup means available to raise
    cash. The firm‟s ongoing liquidity is a function of its working capital cash flow cycle or cash
    conversion cycle.
    One important model to look at the working capital cash flows cycle is to analyze firm‟s cash
    conversion cycle. This represents the net time interval in days between actual cash expenditure
    of the firm and the ultimate recovery of cash. The cash conversion cycle model focuses on the
    length of time between the company makes payments and when it receives cash flows. It
    calculated as:
    CCC= operating cycle – payable deferral period
    A firm‟s operating cycle has two components: inventory conversion period and receivables
    collection period.
    Inventory conversion period (ICP) reefers to the length of time required for converting raw
    materials in to finished goods and then into sales. It calculated as
    ICP = inventory / sales per day
    Receivable collection period (RCP), also called days sale outstanding or average collection
    period, is the average length of time required to collect accounts receivable after credit sales has
    taken place. It is calculated as:
    RCP = receivable / credit sales per day
    Payables deferral period (PDP), is defined as the average length of time between purchase of
    materials and labor and the payment of cash for them. It is calculated as:
    PDP = payables / credit purchase per day
    Having determined all these three components, the cash conversion cycle (CCC) is given by:
    CCC ICP RCP PDP
    The calculation of cash conversion cycle is meaningful in a sense that it represents the average
    length of time that the firm must hold investment in working capital. This discussion explores
    one important point that the length of working capital investment depends on the length of cash
    conversion cycle. If the firm is able to shorten its cash conversion cycle, the working capital
    requirement also could be reduced. However, the length cash conversion cycle is positively
    related with inventory conversion period and receivable collection period, whereas it is
    negatively related with payables deferral period.
  23. Explain the elements of credit policy of a firm with examples.
    A firm‟s credit policy provides guidelines for determining whether to extend credit to a customer
    and how much credit to extend. A firm‟s credit policy included three elements: credit standard,
    credit terms, and collection policy as described below:
    a) Credit standard: credit standards are minimum criteria for the extension of credit to a
    customer. Credit standards refer to the financial strength and creditworthiness a customer must
    exhibit in order to the quality for credit. Therefore setting a credit standard is the job of assessing
    the credit quality of the customer. However assessment of credit quality of the customer on the
    basis of given credit standard is totally based on the subjective judgment of credit manager. Firm
    can use five Cs scoring factors, which includes character, capacity, capital, collateral and
    conditions, to evaluate the credit standard.
    Character is the moral state of customer determining the possibility of timely repayment of credit
    granted. For evaluating moral character of customers, the credit manager may rely on past
    background of customers regarding the behavior and intention of repayment effort. Capital refers
    to the indicator of general financial condition of the credit customer as depicted by financial
    statement. Collateral refers to the assets that a credit customer can present as security against
    credit going to be granted to him. Capacity refers to the ability of customer to generate sufficient
    cash required for serving credit granted to him. Finally, condition refers to the general economic
    condition of the business with which the credit firm belongs.
    b) Credit term: the credit term refers to the condition under which a firm sells its goods and
    services for credit. After the creditworthiness of customers has been evaluated, the terms and
    conditions on which credits are granted must be determined. Therefore, a firms credit terms
    specify the repayment terms required of its entire credit customer.
    A typical credit terms may be “ 2/10 net 30” which means that the customer gets a 2% cash
    discount if the amount is paid within 10 days from the billing date. If customer fails to accept
    discount offer the full amount of credit must be paid within 30 days from the billing date. Such
    credit terms cover three components: cash discount, cash discount period and credit period.
    A firm may offer cash discount to its credit customer for early payment of dues, when a firm
    increase a cash discount, this increase the sales volume and reduce the investment in accounts
    receivable, bad debt expenses and ultimately may put positive or negative impact on profit
    figure. Therefore, the use of cash discounted for early payment is evaluated on the basis of
    relative costs and benefits associated with cash discount offer.
    c) Collection policy: collection policy refers to the procedure for collecting accounts receivable
    when they are due. The basic aim of any collection policy is to speed up the collection of dues. If
    collections are delayed, the firm should have to make alternative arrangements for financing the
    production and sales. The effectiveness of collection policies can be evaluated by looking at the
    level of bad debt expenses. Assuming the level of bad debts attributable to credit policies
    constant, increasing collection expenditures is expected to reduce bad debts. In other words
    greater the relative amount expended for credit collection, the lower the proportion of bad debts
    and shorter the average collection period, assuming all other things remained constant.
  24. Explain the various determinants of working capital for an enterprise.
    The working capital requirement for a firm is influenced by a larger number of factors. They are
    as follows:
    a) Nature and size of business: the nature and business affects the working capital. If a firm
    involve in trading or financial sector.it required very less investment in fixed assets than a
    manufacturing firm. Thus, the working capital requirement for such firms is relatively larger. It
    is more common to maintain larger working capital.
    b) Cash conversion cycle: cash conversion cycle represent the length of period lag between the
    time cash flow occurs in the form of purchase and investment in inventories and receivables and
    the time cash inflows realize in the form of cash sales or collection of credit sales. Longer the
    cash conversion cycle larger will be the working capital requirement.
    c) Seasonal fluctuation: most firms have seasonal nature of business. For such firms, the
    working capital need is relatively larger during the peak season because of increase temporary
    working capital over and above the permanent working capital.
    d) Production policy: if a firm adopts steady production policy, the investment in inventories
    will build up during off seasons. As a result the working capital need of the firm increases.
    e) Terms of purchase: if the term of credit purchase is relatively longer, the firm will have
    larger spontaneous source of financing in the form of accounts payable, which results into
    decline in working capital need.
    f) Access to money market: the level of working capital to be maintained by a firm is also
    determined by capacity of the firm to borrow on short notice. If the firm has good approach with
    bank and finance companies, it can raise short term loans at very short notice so that working
    capital requirement is reduced
    g) Credit policy:
    h) Growth and expansion:
  25. What is the working capital management? Why is the management of working capital
    important in a business? Explain the role of cash budget in the management of working
    capital.
    Working capital management is concerned with managing firm‟s current assets and current
    liabilities to maintain a proper trade of between profitability and liquidity. The working capital
    management is important for the financial health of the firm due to the following reason:
     It requires significant managerial consideration
     It is helpful to maintaining desired scale of operation
     It assists in maintaining continuous cash flows
     It is more significant to small firm
    The extent of firm‟s efficiency of cash management depends on its ability to forecast cash inflow
    and outflow, more accurately. If cash inflow and outflow were perfectly predicted, no cash
    management would be required. But cash outflows are almost certain whereas cash inflows are
    uncertain and fluctuating. Therefore first of all, the firm should determine the extent to which
    cash flows are non-synchronized. This required the preparation of a schedule forecasting the cash
    receipts and payments during the month of a year. Cash budget, perhaps, serves as the most
    important technique of planning and controlling the use of cash. Cash budget is simply defined
    as the statement that depicts the firms estimate cash receipt and estimated cash disbursement
    during the plan period. It serves the following purpose:
     It shows the amount of cash received from different sources each period
     It shows the cash payment need of the firm for given period
     It suggest on the surplus of deficit cash for the forecasted period
     The firm can plan for investment of surplus cash and financing of deficit cash
    Thus, preparation of cash budget can ensure that the firm has sufficient cash during peak times
    for purchasing and for other purpose. The firm can meet obligatory cash outflows when they fall
    due. It can plan properly for capital expenditure to be incurred.
  26. Short note of Re-order level
    In real life situation, it is not possible to get the replenishment of inventory as immediately as
    required. The basic problem associated with the inventory management is to determine when a
    reorder should be placed. EOQ solves the problem of how much to order. Once order is placed it
    will take sometimes to receive the delivery as per order placed. Thus, a reorder has to be placed
    in advance before previous inventories are completely used. Hence a reorder level refers to the
    level of inventory at which a reorder should be placed to receive the inventory at the time when
    previous stocks exactly finish. It is worked out as follows:
    ROP = (lead time × average usage) + safety stock
  27. Economic order quantity.
    Economic order quantity refers to the order size of inventory at which total inventory costs
    remain at the minimum. EOQ is one of the most commonly used tools for determining the
    optimal order quantity for an item of inventory. It takes into considerations the carrying and
    ordering costs. Carrying cost is the cost per unit of holding an item of inventory for a specified
    time period. Carrying cost includes cost of storage, insurance, and taxes, cost of deterioration and
    obsolescence. Ordering cost includes the fixed clerical costs of placing and receiving an order.
    They are cost of writing a purchase order cost of processing the paperwork; cost of receiving an
    order and checking it against the invoice.
    Thus, ordering cost and carrying cost oppositely react to each other in response to the order
    quantity. Due to this fact, EOQ is determined at the order size where these two costs are equal
    producing the minimum total cost of inventory. It is determined as follows:
  28. What do you understand by inventory management? How do you exercise control over
    inventories?
    Inventory constitutes one of the important items of current assets, which permits the production
    and sale process of a firm to operate smoothly. Inventories involve significant investment of
    funds. In this sense, inventory is an investment that the firm ties up its money in it, thereby
    forgoing certain other opportunities of investment. As the firm goes on investing more and more
    in inventories, the cost of funds being tied up will increase. Therefore inventory management is a
    significant part of firm‟s financial management function. So far as it is concerned to financial
    management, investment in inventories must be minimized to the extent it is unnecessary. Here
    inventory management of a firm attempts to meet two basic and conflicting requirements:
    maintaining adequate size of inventory for smooth flow of production and selling activities;
    minimizing investment in inventory to enhance firm‟s profitability. The following inventories
    control system has close relationship to the determinants of inventory size.
    a) ABC system: as inventories from one category to another differ in their value and
    significance to the firm, it is not desirable to maintain the same degree of control upon all types
    of inventories. The firm should be careful enough to maintain the best and effective control on
    those inventories, which have the highest value. ABC system allows selective control on
    inventories. It classifies all the inventories into three categories- A, B, and C on the basis of their
    value. Category „A‟ consists of those items, which have very high percent of investment value
    and category „C‟ include those, which have nominal value. The firm should direct most of its
    inventory control efforts to the items included in category „A‟. Inventories in category „B‟
    require less attention than those in „A‟ but more than those in „C‟.
    b) Just- in- time (JIT) system: JIT is a system of inventory control in which a manufacturer
    coordinates production with suppliers so that raw materials or components arrive just as they are
    needed in the production process. This system helps to minimize carrying cost of inventory.
    c) Red line method: under this system a red line is drawn around the inside of the bin used for
    stocking inventories. This red line represents the re-order point of inventories. A re-order is
    placed, when the level of inventories reaches down to red line drawn in the bin.
    d) Two bin system: under two bins system, inventories are shocked in two separated bins. When
    the stock is one bin completely used, the firm places a reorder to fill the bin and inventories are
    drawn for use from the second bin.
    e) Computerized system: larger firms design a specific computer programming to count the
    stock of inventories. It is a system in which a computer is used to determine the reorder point and
    adjust inventory balances. The computer starts with the level of inventory counted in memory.
    When inventories are drawn the computer records them and balance of inventories is revised.
    Determinants of inventories:
     Level of safety stock: if a firm has to maintain high level of safety stock because of
    relatively larger degree of uncertainty associated to production and sales, the size of
    investment in inventories is also larger.
     Economy in purchase: if the firm likely to receive certain benefits in the form of cash
    discount for purchase made currently, the size of investment in inventories is also likely
    to be larger because of longer larger quantity purchase.
     Possibility of price rise: if the price of materials is likely to rise in near future, the firm
    makes larger quantity purchase at present.
     Cost and availability of funds: if the cost of funds to be invested in inventories is
    relatively cheaper and they are conveniently available at present, the firm makes larger
    purchase of inventories.
     Length of production cycle: if the length of production cycle is relatively longer the
    firm has to maintain investment in work in progress inventories for longer duration of
    time, which increase the size investment in inventories.
     Availability of materials: if certain kinds of materials are only available in particulars
    season only, the firm has to increase the investment in inventories to keep the larger
    stocks in a season.
     Carrying cost: if the cost of holding inventories in stock is relatively lower, the firm
    keeps larger stocks of inventories.
     Size of the firm:
     Nature of business:
     Possibility of raise in demand:
  29. State the motives for holding cash.
    There are several motives for holding cash. They are as follows:
     Transaction motive for holding cash, that is holding cash to satisfy day to day transaction
    need
     Precautionary motive for holding cash, that is holding cash to act as financial reserve
    against contingencies
     Speculative motive for holding cash, that is holding cash to take the advantage of
    profitable opportunities
     Compensating balance motive for holding cash that is holding cash to satisfy the
    compensating balance requirement imposed by commercial banks.
  30. What are the motives of holding cash? Explain in brief.
    There are following motives for holding cash by firm.
    a) Transaction motive: transaction motive refers to the need to hold cash to satisfy normal
    disbursement collection activities associated with a firm‟s ongoing operation, in its ordinary
    course of action, a firm frequently involves in purchase and sales of good or services. A firm
    should make payment for the purchase of goods, payment of wages, salary, interest, commission,
    brokerage, rent, taxes, insurance, dividends, and so on. In the likewise manner a firm receives
    cash in terms of sales revenue, interest on loan given to outsider, return on investment made
    outside the firm and so on.
    b) Precautionary motives: precautionary motive refers to hold some cash as a safety margin to
    act as a financial reserve. A firm should also hold some cash for the payment against unanticipated events. A firm may have to face different emergencies such as strikes and lockup
    from employees, increase in cost of raw materials funds and labor, fall in market demand and so
    on. These emergencies also bound a firm to hold certain level of cash but how much cash is held
    against these emergencies depends on the degree of predictability associated with future cash
    flow. If there is high degree of predictability, less cash is needed against these.
    c) Speculative motives: the speculative motive refers to the need to hold cash in order to be able
    to take advantage of bargain purchase that might arise, attractive interest rates, and favorable
    exchange rate fluctuations. Some firms hold cash in excess than transaction and precautionary
    needs to involve in speculation. Speculation need for holding cash required that a firm possibly
    may have some profitable opportunities to exploit, which are out of the normal course of
    business.
    Besides, a firm sometimes should also hold cash to meet the compensating balance requirement
    demanded by commercial banks for providing short term loan, specially, commercial banks
    demand a regular borrower to maintain an average checking account balance equal to some
    percentage of the outstanding loan. The cash kept as compensating balance is not allowable for
    the borrower to use. Bank provides different services to the firm. Compensating balance also
    represents an indirect charge to bank for providing services by them. Hence, this also represents
    the reason why a firm should hold cash.
  31. What is the purpose of cash budget? What are the three major sections of a cash
    budget?
    The extent of firm‟s efficiency on the cash management depends on its ability to forecast cash
    inflow and outflow, more accurately. If cash inflow and outflow were perfectly predicated, no
    cash management would be required. But cash outflows are almost certain cash inflows and
    uncertain and fluctuating. Therefore first of all, the firm should determine the extent to which
    cash flows are non-synchronized. This requires the preparation of a schedule forecasting the cash
    receipt and payment during the months of a year. The purpose of preparing cash budget is to
    determine whether at a given point of time there is surplus or shortage of cash. It serves the
    following purpose:
     It shows the amount of cash received from different sources each period
     It shows the cash payment need of the firm for given period
     It suggest on the surplus or deficit cash for the forecasted period,
    Preparation of cash budget as a cash flow synchronization model requires several considerations.
    The first and foremost consideration is to determine time period for which cash budget is to be
    prepared and then determining the cash flow position. The three sections of cash budget are as
    follows:
    Cash receipt: in this section the forecast of cash receipt are shown. Cash receipt includes cash
    sales, collection of credit sales, proceeds realized from the sale of fixed assets, borrowing,
    interest and dividend received, and cash receipt from issue of the new share, bonds, debentures,
    sale of securities etc.
    Cash payment: this section provides the forecast of cash payment of the period. Cash payment
    includes cash purchase, payment of credit purchase, payment of wages, salaries, factory, office
    and selling & distribution expenses, purchase of fixed assets, payment of interest, tax, dividends,
    redemption of shares and debentures and repssurchase of shares and debentures etc.
    Cash balance: this section of the cash budget shows the forecast of cash surplus and deficit in
    any period. If receipt of cash is higher there will be cash surplus. If payment is higher there will
    be cash deficit. Accordingly, firm should plan for investing surplus cash and financing deficit
    cash.
  32. How does the days sales outstanding (DSO) affect the investment in accounts
    receivables?
    The investment in accounts receivable is positively related to the length of day sales outstanding.
    Longer days sales outstanding refers that the firm is slower in collecting receivables, which
    increase the size of investment in accounts receivable.
  33. What are the factors that affect receivable policies? Explain.
    A firm‟s receivable policies are concerned with determining whether to extend credit to a
    customer and how much and how long credit to extend. It is affected by several factors as
    discussed below:
    a) Competition: a firm‟s receivable policy is largely affected by the terms of credit offered by
    the competitors. The competitors may be very aggressive to capture the market by offering more
    liberal policy to the customers. Thus, considerations should be given to the terms of credit the
    competitors are offering.
    b) Financing cost: the cost of granting credit is an important factor in determining the degree to
    which a firm is prepared to extend payment terms, credit terms and period should always be
    concerned with the cost of running an overdraft or any other loans obtained to finance credit.
    c) Attitude to risk and bad debts: comparative cost-benefit associated with receivable policy is
    an important matter to affect the receivable policy. A firm should be able to measure the risk
    associated with receivable policy in comparison to the inherent benefits.
    d) The nature of the product: receivable policy is also affected by the nature of the product the
    firm deals with. It basically affects the credit period offered. For example, the credit period is
    shorter in food industry while it is longer in heavy industries such as plant industries.
    e) Size of the order: the bigger the order the more the profits and this would warrant a longer
    credit as the cost of credit is supported by the profits.
    f) General condition of the economy: receivable policy is also dictated by the position of the
    underlying domestic economy. For example, if the general condition of economy is in recession,
    granting liberal credit may expose the firm toward higher degree of default risk

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