MBA FINANCIAL MANAGEMENT QUESTION AND ANSWERS ANDHRA UNIVERSITYFinancial Leverage: Financial leverageis the degree to which a company uses fixed-income securities such as debt and preferred equity. The more debt financing a company uses, the higher itsfinancial leverage.Financial leverage refers to the use of debt to acquire additional assets. Financial leverage is also known astrading on equity. Example : Maryuses Rs. 400,000 of her cash to purchase 40 acres of land with a total cost of Rs.400,000. Mary is not using financial leverage.

John uses Rs.400,000 of her cash and borrows Rs.800,000 to purchase 120 acres of land having a total cost of Rs.1,200,000. He is using financial leverage. He is controlling Rs.1,200,000 of land with only Rs.400,000 of her own money.Financial Leverage DefinitionFinancial leverage is the amount of debt that an entity uses to buy more assets. Leverage is employed to avoid using too much equity to fund operations. An excessive amount of financial leverage increases the risk of failure, since it becomes more difficult to repay debt.

The financial leverage formula is measured as the ratio of total debt to total assets. As the proportion of debt to assets increases, so too does the amount of financial leverage. Financial leverage is favourable when the uses to which debt can be put generate returns greater than theinterest expense associated with the debt. Many companies use financial leverage rather than acquiring more equity capital, which could reduce the earnings per share of existing shareholders.Financial leverage has two primary advantages:Enhanced earnings. Financial leverage may allow an entity to earn a disproportionate amount on its assets.Favorable tax treatment. In many tax jurisdictions, interest expense is tax deductible, which reduces its net cost to the borrower.However, financial leverage also presents the possibility of disproportionate losses, since the related amount of interest expense may overwhelm the borrower if it does not earn sufficient returns to offset the interest expense. This is a particular problem when interest rates rise or the returns from assets decline.The unusually large swings in profits caused by a large amount of leverage increase the volatility of a company's stock price. This can be a problem when accounting for stock options issued to employees, since highly volatile stocks are considered to be more valuable, and so create a higher compensation expense than would less volatile shares.Financial leverage is an especially risky approach in a cyclical business, or one in which there are low barriers to entry, since sales and profits are more likely to fluctuate considerably from year to year, increasing the risk of bankruptcy over time. Conversely, financial leverage may be an acceptable alternative when a company is located in an industry with steady revenue levels, large cash reserves, and high barriers to entry, since operating conditions are sufficiently steady to support a large amount of leverage with little downside.There is usually a natural limitation on the amount of financial leverage, since lenders are less likely to forward additional funds to a borrower that has already borrowed a large amount of debt.Debt/equity Ratio : The debt to equity ratio is a financial, liquidity ratio that compares a company's total debt to total equity. The debt to equity ratio shows the percentage of company financing that comes from creditors and investors. A higher debt to equity ratio indicates that more creditor financing (bank loans) is used than investor financing (shareholders).

FormulaThe debt to equity ratio is calculated by dividing total liabilities by total equity. The debt to equity ratio is considered a balance sheet ratio because all of the elements are reported on the balance sheet.

AnalysisEach industry has different debt to equity ratio benchmarks, as some industries tend to use more debt financing than others. A debt ratio of .5 means that there are half as many liabilities than there is equity. In other words, the assets of the company are funded 2-to-1 by investors to creditors. This means that investors own 66.6 cents of every dollar of company assets while creditors only own 33.3 cents on the dollar.A debt to equity ratio of 1 would mean that investors and creditors have an equal stake in the business assets.A lower debt to equity ratio usually implies a more financially stable business. Companies with a higher debt to equity ratio are considered more risky to creditors and investors than companies with a lower ratio. Unlike equity financing, debt must be repaid to the lender. Since debt financing also requires debt servicing or regular interest payments, debt can be a far more expensive form of financing than equity financing. Companies leveraging large amounts of debt might not be able to make the payments.Creditors view a higherdebtto equity ratio as risky because it shows that the investors haven't funded the operations as much as creditors have. In other words, investors don't have as much skin in the game as the creditors do. This could mean that investors don't want to fund the business operations because the company isn't performing well. Lack of performance might also be the reason why the company is seeking out extra debt financing.ExampleAssume a company has $100,000 of bank lines of credit and a $500,000 mortgage on its property. The shareholders of the company have invested $1.2 million. Here is how you calculate the debt to equity ratio.

Weighted average Cost of Capital : Weighted average cost of capital (WACC) is the average after-tax cost of a companys various capital sources, including common stock, preferred stock, bonds and any other long-term debt. A company has two primary sources of financing - debt and equity - and, in simple terms, WACC is the average cost of raising that money.WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight, and then adding the products together to determine the WACC value:

WACC =* Re +* Rd * (1 Tc)Where:Re = cost of equityRd = cost of debtE = market value of the firms equityD = market value of the firms debtV = E + DE/V = percentage of financing that is equityD/V = percentage of financing that is debtTc = corporate tax rateWhen calculating a firm's WACC, the first step is to determine what proportion of a firm is financed by equity and what proportion is financed by debt by entering the appropriate values into theandcomponents of the equation. Next, the proportion of equity () is multiplied by the cost of equity (Re); and the proportion of debt () is multiplied by the cost of debt (Rd).The debt side of the equation (* Rd) is then multiplied by (1 - Tc) to get the after-tax cost of debt (there is atax shieldassociated with interest). The final step is to add the equity side of the equation to the debt side of the equation to determine WACC.

For example, a firm's financial data shows the following:Equity = $8,000Debt = $2,000Re = 12.5%Rd = 6%Tax rate = 30%To find WACC, enter the values into the equation and solve:WACC =[(* 0.125)] + [(* 0.06 * (1 - 0.3)]WACC = 0.1 + .0084 = 0.1084 or 10.84%; the WACC for this firm then is 10.84%.Because the calculation takes time, most investors use online stock analysis tools to find a company's WACC.

Current Ratio : The current ratio is a financial ratio that investors and analysts use to examine the liquidity of a company and its ability to pay short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables).The current ratio is calculated by dividing current assets by current liabilities:Current ratio = current assets / current liabilitiesAs of March 31, 2014, for example, Microsofts (MSFT) balance sheet listed the following:Current Assets:Cash and cash equivalents$11,572,000

Short-term investments$76,853,000

Net receivables$14,921,000

Inventory$1,920,000

Other current assets$3,740,000

Total current assets$109,006,000

Current Liabilities:Accounts payable$9,958,000

Short-term debt$2,000,000

Other current liabilities$21,945,000

Total current liabilities$33,903,000

To determine MSFTs current ratio, we divide current assets by current liabilities:MSFT current ratio = $109,006,000 / $33,903,000 = 3.22

The current ratio can provide investors and analysts withclues about the efficiency of a companys operating cycleor its ability to monetize its products. The higher the ratio, the more able a company is to pay off its obligations. While acceptable ratios vary depending on the specific industry, a ratio between 1.5 and 3 is generally considered healthy. Investors and analysts would consider MSFT, with a current ratio of 3.22, financially healthy and capable of paying off its obligations.Liquidity problems can arise for companies that have difficulty getting paid on their receivables or that have slow inventory turnover because they cant satisfy their obligations. A ratio under 1 implies that a company would be unable to pay off its obligations if they become due at that point in time. A ratio under 1 does not necessarily mean that a company will go bankrupt since it may be able to secure other forms of financing; however, it does indicate the company is not in good financial health. A ratio that is too high may indicate that the company is not efficiently using its current assets or short-term financing.As with other financial ratios, it is more useful to compare various companies within the same industry than to look at only one company, or to attempt to compare companies from different industries. In addition, investors should consider more than one ratio (or number) when making investment decisions since one cannot provide a comprehensive view of the company.Internal rate of Return: internal rate of return (IRR) methodalso takes into account the time value of money. It analyzes an investment project by comparing the internal rate of return to theminimum required rate of returnof the company.Theinternal rate of returnis the rate at which an investment project promises to generate a return during its useful life. Theminimum required rate of returnis set by management. Most of the time, it is the cost of capital of the company.Under this method, If the internal rate of return promised by the investment project is greater than or equal to the minimum required rate of return, the project is considered acceptable otherwise the project is rejected. Internal rate of return method is also known astime-adjusted rate of return method.

To understand how computations are made and how a proposed investment is accepted or rejected under this method, consider the following example:Example:The management of VGA Textile Company is considering to replace an old machine with a new one. The new machine will be capable of performing some tasks much faster than the old one. The installation of machine will cost $8,475 and will reduce the annual labor cost by $1,500. The useful life of the machine will be 10 years with no salvage value. The minimum required rate of return is 15%.Required:Should VGATextile Company purchase the machine? Use internal rate of return (IRR) method for your conclusion.Solution:To conclude whether the proposal should be accepted or not, the internal rate of return promised by machine would be found out first and then compared to the companys minimum required rate of return.The first step in finding out the internal rate of return is to compute a discount factor calledinternal rate of return factor. It is computed by dividing theinvestment required for the projectbynet annual cash inflowto be generated by the project. The formula is given below:Formula of internal rate of return factor:

In our example, the required investment is $8,475 and the net annual cost saving is $1,500. The cost saving is equivalent to revenue and would, therefore, be treated as net cash inflow. Using this information, the internal rate of return factor can be computed as follows:Internal rate of return factor = $8,475 /$1,500 =5.650

After computing the internal rate of return factor, the next step is to locate this discount factor in present value of an annuityof $1 in arrears table. Since the useful life of the machine is 10 years, the factor would be found in 10-period line or row. After finding this factor, see the rate of return written at the top of the column in which factor 5.650 is written. It is 12%. It means the internal rate of return promised by the project is 12%. The final step is to compare it with the minimum required rate of return of the VGA Textile Company. That is 15%.Conclusion:According to internal rate of return method, the proposal is not acceptable because the internal rate of return promised by the proposal (12%) is less than the minimum required rate of return (15%).Notice that the internal rate of return promised by the proposal is a discount rate that equates the present value of cash inflows with the present value of cash out flows as proved by the following computation:Present value of cash outflowNow$8,475 1.000 = $8,475

Present value of cash inflow1-10 year-period @ 12%$1,500 5.650 = $8,475

Cash Flow analysis: In financial accounting, acash flow statement, also known asstatementofcash flows, is a financialstatementthat shows how changes in balance sheet accounts and income affectcashand cashequivalents, and breaks the analysis down to operating, investing and financing activities.The statement of cash flows is part of the financial statements issued by a business, and describes the cash flows into and out of the organization. Its particular focus is on the types of activities that create and use cash, which are operations, investments, and financing. Though the statement of cash flows is generally considered less critical than the income statement and balance sheet, it can be used to discern trends in business performance that are not readily apparent in the rest of the financial statements. It is especially useful when there is a divergence between the amount of profits reported and the amount of net cash flow generated by operations.

There can be significant differences between the results shown in the income statement and the cash flows in this statement, for the following reasons:There are timing differences between the recordation of a transaction and when the related cash is actually expended or received.Management may be using aggressive revenue recognition to report revenue for which cash receipts are still some time in the future.The business may be asset intensive, and so requires large capital investments that do not appear in the income statement, except on a delayed basis as depreciation.Many investors feel that the statement of cash flows is the most transparent of the financial statements (i.e., most difficult to fudge), and so they tend to rely upon it more than the other financial statements to discern the true performance of a business.

Cash flows in the statement are divided into the following three areas:Operating activities. These constitute the revenue-generating activities of a business. Examples of operating activities are cash received and disbursed for product sales, royalties, commissions, fines, lawsuits, supplier and lender invoices, and payroll.Investing activities. These constitute payments made to acquire long-term assets, as well as cash received from their sale. Examples of investing activities are the purchase of fixed assets and the purchase or sale of securities issued by other entities.Financing activities. These constitute activities that will alter the equity or borrowings of a business. Examples are the sale of company shares, the repurchase of shares, and dividend payments.There are two ways in which to present the statement of cash flows, which are the direct method and the indirect method. The direct method requires you to present cash flow information that is directly associated with the items triggering cash flows, such as:1. Cash collected from customers2. Interest and dividends received3. Cash paid to employees4. Cash paid to suppliers5. Interest paid6. Income taxes paidFew organization collect information as required for the direct method, so they instead use the indirect method. Under the indirect approach, the statement begins with the net income or loss reported on the company's income statement, and then makes a series of adjustments to this figure to arrive at the amount of net cash provided by operating activities.

Methods of Cash Flow Statement: - There are two ways in which to present the statement of cash flows, which are the direct method and the indirect method. Direct Method: The direct method of presenting the statement of cash flows presents the specific cash flows associated with items that affect cash flow. Items that typically do so include:1. Cash collected from customers2. Interest and dividends received3. Cash paid to employees4. Cash paid to suppliers5. Interest paid6. Income taxes paidThe advantage of the direct method over theindirect methodis that it reveals operating cash receipts and payments.The standard-setting bodies encourage the use of the direct method, but it is rarely used, for the excellent reason that the information in it is difficult to assemble; companies simply do not collect and store information in the manner required for this format. Using the direct method may require that the chart of accounts be restructured in order to collect different types of information. Instead, they use the indirect method, which can be more easily derived from existing accounting reports.

Statement of Cash Flows Direct Method ExampleLowry Locomotion constructs the following statement of cash flows using the direct method:Lowry Locomotion -- Statement of Cash Flows -- for the year ended 12/31/x1Cash flows from operating activities

Cash receipts from customers$45,800,000

Cash paid to suppliers(29,800,000)

Cash paid to employees(11,200,000)

Cash generated from operations4,800,000

Interest paid(310,000)

Income taxes paid(1,700,000)

Net cash from operating activities$2,790,000

Cash flows from investing activities

Purchase of property, plant, and equipment(580,000)

Proceeds from sale of equipment110,000

Net cash used in investing activities(470,000)

Cash flows from financing activities

Proceeds from issuance of common stock1,000,000

Proceeds from issuance of long-term debt500,000

Principal payments under capital lease obligation(10,000)

Dividends paid(450,000)

Net cash used in financing activities1,040,000

Net increase in cash and cash equivalents3,360,000

Cash and cash equivalents at beginning of period1,640,000

Cash and cash equivalents at end of period$5,000,000

Reconciliation of net income to net cash provided by operating activities:Net income$2,665,000

Adjustments to reconcile net income to net cash provided by operating activities:

Depreciation and amortization$125,000

Provision for losses on accounts receivable15,000

Gain on sale of equipment(155,000)

Increase in interest and income taxes payable32,000

Increase in deferred taxes90,000

Increase in other liabilities18,000

Total adjustments125,000

Net cash provided by operating activities$2,790,000

Cash Flow statement Indirect method: The statement of cash flows is one of the components of a company's set of financial statements, and is used to reveal the sources and uses of cash by a business. It presents information about cash generated from operations and the effects of various changes in the balance sheet on a company's cash position.Under the indirect method of presenting the statement of cash flows, the presentation of this statement begins with net income or loss, with subsequent additions to or deductions from that amount for non-cash revenue and expense items, resulting in net income provided by operating activities.The format of the indirect method appears in the following example.In the presentation format, cash flows are divided into the following general classifications: Cash flows from operating activities Cash flows from investing activities Cash flows from financing activitiesThe indirect method of presentation is very popular, because the information required for it is relatively easily assembled from the accounts that a business normally maintains in its chart of accounts.The indirect method is less favored by the standard-setting bodies, since it does not give a clear view of how cash flows through a business (as is shown under thedirect methodof presentation).Statement of Cash Flows Indirect Method ExampleFor example, Lowry Locomotion constructs the following statement of cash flows using the indirect method:Lowry Locomotion - Statement of Cash Flows -- for the year ended 12/31x1Cash flows from operating activities

Net income$3,000,000

Adjustments for:

Depreciation and amortization$125,000

Provision for losses on accounts receivable20,000

Gain on sale of facility(65,000)

80,000

Increase in trade receivables(250,000)

Decrease in inventories325,000

Decrease in trade payables(50,000)

25,000

Cash generated from operations3,105,000

Cash flows from investing activities

Purchase of property, plant, and equipment(500,000)

Proceeds from sale of equipment35,000

Net cash used in investing activities(465,000)

Cash flows from financing activities

Proceeds from issue of common stock150,000

Proceeds from issuance of long-term debt175,000

Dividends paid(45,000)

Net cash used in financing activities280,000

Net increase in cash and cash equivalents2,920,000

Cash and cash equivalents at beginning of period2,080,000

Cash and cash equivalents at end of period$5,000,000

Objectives of financial ratios: Objectives offinancial statement analysis are as follows

1.Assessment Of Past Performance : Past performance is a good indicator of future performance. Investors or creditors are interested in the trend of past sales, cost of goods sold, operating expenses, net income, cash flows and return oninvestment. These trends offer a means for judging management's past performance and are possible indicators of future performance.2.Assessment of current position : Financial statement analysisshows the current position of the firm in terms of the types of assets owned by abusiness firmand the different liabilities due against the enterprise.3.Prediction of profitability and growth prospects : Financial statement analysishelps in assessing and predicting the earning prospects andgrowth ratesin earning which are used by investors while comparinginvestmentalternatives and other users in judgingearning potentialofbusiness enterprise.4.Prediction ofbankruptcyand failure : Financial statement analysisis an important tool in assessing and predictingbankruptcyandprobabilityofbusiness failure.5. Assessment of the operational efficiency : Financial statement analysishelps toassessthe operational efficiency of the management of a company. The actual performance of the firm which are revealed in the financial statements can be compared with some standards set earlier and the deviation of any between standards and actual performance can be used as the indicator of efficiency of the management.

Finance Function:

Functions of Financial Management : Financial management performs different function for the effective management of funds of any organization. Financial management is concerned with the supervision of the capital invested in the business enterprise, allocation of finance to resources and overall increase in the value of business.The function of financial management include the following- Resource mobilization from the economy Resource development Resource generation and distribution for growth and risk comparisonBasically these decisions are divided under three broad categories. These are financial decision, investment decision and dividend decisions. Financial Decision-Financing decision of an enterprise includes decision for short term capital and long term capital requirement. Financing decision include decision upon the needs and source of new outside financing and caring on negotiations for new outside financing. Financing means procurement of finance at most convenient and economic rates.Investment Decisions- Funds acquired from different sources are to be invested in profitable projects so that maximum profit can be earned and the value of the wealth becomes maximum. Long term funds are invested for the acquisition of fixed assets and current assets also. The investment of funds in different projects should be made carefully so that the funds can be utilized in the maximum possible ways. Capital budgeting techniques is used or making investment decisions. Investment decision considers the management of current assets such as cash, marketable securities, etc. Capital budgeting which includes identification, selection, implementation of capital projects, etc. and management of mergers, reorganization, disinvestment, etc.Dividend Decisions-The financial managers takes dividend decisions. For taking decision in respect of dividend, the factor to be consider include- availability of cash, tax position of the shareholders, trend of earnings, requirements of funds for the future, etc. Dividend decision considers the allocation of net profit.Dividend decision gives emphasis on the checking on financial performance. The financial manager takes initiatives to take proper dividend decisions as to the amount of dividend to be paid and the time of payment of dividend. He tries to set balance between dividend retention and distribution. Dividend decisions are taken considering the overall liquidity and profitability of the enterprise. Dividend decisions are taken taking into account the disposition of profits between dividend and retained earnings.Rights Issue: Newstock(share)issueoffered to existingstockholders(shareholders) inproportionto theircurrentstock/shareholding, for a specifiedperiodand at a specified (usually discounted)price. Itsobjectiveis to afford them theopportunitytomaintaintheir percentage ofownershipof the firm. See alsoscrip issue. Alsocalledrightsoffering

Bonus issue: Fullypaid-upnewcommon stock(ordinary shares) issuedfreeto existingstockholders(shareholders) inproportionto theircurrentstock/shareholdings. Abookkeepingtransaction(because nocashchangeshands), itcapitalizesa part ofreserves(retained earnings) to bring(1)share capitalmore in line with theassetsemployed; and (2) ahighsharepriceback to a more manageableamount, thus enhancing itsmarketability. Although the number ofsharesheldby each shareholder increases, thevalueof the total shareholding remains the same as before thebonusissue. Also called as scrip issue, bonus shares, capitalisation issue.

stock splits: Stock split is done to infuse liquidity and to make shares affordable for various investors who could not buy the shares of that company before due to high prices.Definition: When a company declares a stock split, the number of shares of that company increases, but the market cap remains the same. Existing shares split, but the underlying value remains the same. As the number of shares increases, price per share goes down.Description:Stock split is done to infuse liquidity and to make shares affordable for various investors who could not buy the shares of that company before due to high prices.People often confuse bonus shares with stock split. Distribution of bonus shares only changes its issued share capital whereas stock split splits the company's authorized share capital.Stable Dividend Policy : Types of Dividend Policis: (1) Strict or Conservative dividend Policy which envisages the retention of profits on the cost of dividend pay-out. It helps in strengthening the financial position of the company; (2) Lenient Dividend Policy which views the payment of dividend at the maximum rate possible taking in view the current earing of the company. Under such policy company retains the minimum possible earnings; (3) Stable Dividend Policy suggests a mid-way of the above two views. Under this policy, stable or almost stable rate ofdividend is maintained. Company maintains reserves in the years of prosperity and uses them in paying dividend in lean year. If company follows stable dividend policy, the market price of tis shares shall be higher. There are reasons why investors prefer stable dividend policy. Main reasons are:-1. Confidence Among Shareholders.A regular and stable dividend payment may serve to resolve uncertainty in the minds of shareholders. The company resorts not to cut the dividend rate even if its profits are lower. It maintains the rate of dividends by appropriating the funds from its reserves. Stable dividend presents a bright future of the company and thus gains the confidence of the shareholders an the goodwill of the company increases in the eyes of the general investors.2. Income Conscious Investors.The second factor favouring stable dividend policy is that some investors are income conscious and favour a stable rate of dividend. They too, never favour an unstable rte of dividend. A Stable dividend policy may also satisfy such investors.3. Stability in Market Price of Shares.Other things beings equal, the market price very with the rate of dividend the company declares on its equity shares. The value of shares of a company having a stable dividend policy fluctuates not widely even if the earnings of the company turn down. Thus, this policy buffer the market price of the stock.4. Encouragement to Institutional Investors.A stable dividend policy attracts investments from institutional investors such institutional investors generally prepare a list of securities, mainly incorporating the securities of the companies having stable dividend policy in which they invest their surpluses or their long term funds such as pensions or provident funds etc.In this way, stability and regularity of dividends not only affects the market price of shares but also increases the general credit of the company that pays the company in the long run.-----------------------------------------------------------------------------------------------------------------------------Financial risk :

Financial Risk is one of the major concerns of every business across fields and geographies. Risk can be referred as the chances of having an unexpected or negative outcome. Any action or activity that leads to loss of any type can be termed as risk. There are different types of risks that a firm might face and needs to overcome. Widely, risks can be classified into three types:Business Risk, Non-Business Risk and Financial Risk.Business Risk: These types of risks are taken by business enterprises themselves in order to maximize shareholder value and profits. As for example: Companies undertake high cost risks in marketing to launch new product in order to gain higher sales.Non- Business Risk: These types of risks are not under the control of firms. Risks that arise out of political and economic imbalances can be termed as non-business risk.Financial Risk:Financial Riskas the term suggests is the risk that involves financial loss to firms. Financial risk generally arises due to instability and losses in the financial market caused by movements in stock prices, currencies, interest rates and more.Types of Financial Risks:Financial risk is one of the high-priority risk types for every business. Financial risk is caused due to market movements and market movements can include host of factors. Based on this, financial risk can be classified into various types such as Market Risk, Credit Risk, Liquidity Risk, Operational Risk and Legal Risk.Market Risk: This type of risk arises due to movement in prices of financial instrument. Market risk can be classified asDirectional RiskandNon - Directional Risk. Directional risk is caused due to movement in stock price, interest rates and more. Non- Directional risk on the other hand can be volatility risks.Credit Risk: This type of risk arises when one fails to fulfil their obligations towards their counter parties.Credit riskcan be classified intoSovereign RiskandSettlement Risk. Sovereign risk usually arises due to difficult foreign exchange policies. Settlement risk on the other hand arises when one party makes the payment while the other party fails to fulfil the obligations.Liquidity Risk: This type of risk arises out of inability to execute transactions. Liquidity risk can be classified intoAsset Liquidity RiskandFunding Liquidity Risk. Asset Liquidity risk arises either due to insufficient buyers or insufficient sellers against sell orders and buy orders respectively.Capitl Gearing : DEFINITION of 'Capital Gearing' The degree to which a company acquires assets or to which it funds its ongoing operations with long- or short-term debt. Capital gearingwill differ between companies and industries, and will often change over time.Capital gearingis also known as "financial leverage".Capital gearing ratiois a useful tool to analyze the capital structure of a company and is computed by dividing the common stockholders equity by fixed interest or dividend bearing funds.Analysing capital structure means measuring the relationship between the funds provided by common stockholders and the funds provided by those who receive a periodic interest or dividend at a fixed rate.A company is said to be low geared if the larger portion of the capital is composed of common stockholders equity. On the other hand, the company is said to be highly geared if the larger portion of the capital is composed of fixed interest/dividend bearing funds.Formula:

In the above formula, the numerator consists of common stockholders equity that is equal to total stockholders equity less preferred stock and the denominator consists of fixed interest or dividend bearing funds that usually include long term loans, bonds, debentures and preferred stock etc.All the information required to compute capital gearing ratio is available from the balance sheet.Example: The following information have been taken from the balance sheet of PQR limited:20112012

Common stockholders equity3,500,0002,800,000

Preferred stock 9%1,400,0001,800,000

Bonds payable 6%1,600,0001,400,000

We can compute the capital gearing ratio for the years 2011 and 2012 from the above information as follows: For the year 2011: Capital gearing ratio = 3,500,000 / 3,000,000 = 7 : 6 (Low geared)For the year 2012: Capital gearing ratio = 2,800,000 / 3,200,000 = 7 : 8 (Highly geared)The company has a low geared capital structure in 2011 and highly geared capital structure in 2012.Notice that the gearing is inverse to the common stockholders equity.Highly geared>>>Less common stockholders equity

Low geared>>>More common stockholders equity

Significance and interpretation: Capital gearing ratio is the measure of capital structure analysis and financial strength of the company and is of great importance for actual and potential investors.Borrowing is a cheap source of funds for many companies but a highly geared company is considered a risky investment by the potential investors because such a company has to pay more interest on loans and dividend on preferred stock and, therefore, may have to face problems in maintaining a good level of dividend for common stockholders during the period of low profits.Banks and other financial institutions reluctant to give loans to companies that are already highly geared.Funds from Operations: Funds from operations is the cash flows generated by the operations of a business. The term is most commonly used in relation to the cash flows from real estate investment trusts (REITs). This measure is commonly used to judge the operational performance of REITs, especially in regard to investing in them.Funds from operations does not include any financing-related cash flows, such as interest income or expense. It also does not include any gains or losses from the disposition of assets, or any depreciation or amortization of fixed assets.Thus, the calculation of funds from operations is:Net income - Interest income + Interest expense + Depreciation ( -) Gains on asset sales + Losses on asset sales = Funds from operationsFor example, the ABC REIT reports net income of $5,000,000, depreciation of $1,500,000, and a gain of $300,000 on the sale of a property. This results in funds from operations of $6,200,000.

A variation on the funds from operations concept is to compare it to the stock price of a company (usually an REIT). This is can be used in place of the price-earnings ratio, which includes the additional accounting factors just noted.The funds from operations concept is needed, especially for the analysis of an REIT, because depreciation should not be factored into the results of operations when the underlying assets are appreciating in value, rather than depreciating; this is a common situation when dealing with real estate assets.The funds from operations concept is considered to be a better indicator of the operational results of a business than net income, but keep in mind that accounting chicanery can impact a variety of aspects of the financial statements. Thus, it is always better to rely upon a mix of measurements, rather than a single measure that can potentially be twisted.Adjusted Funds from Operations : It is possible to adjust the formula even further for some types of capital expenditures that are recurring in nature; depreciation related to recurring expenditures to maintain a property (such as carpet replacements, interior painting, or parking lot resurfacing) should be included in the FFO calculation. This altered format results in lower profitability figures. This revised version of the concept is called adjusted funds from operations.--------------------------------------------------------------------------------------------------------------------------------Pay back Period: -

Payback periodin capital budgeting refers to theperiodof time required to recoup the funds expended in an investment, or to reach the break-even point.For example, a Rs.1000 investment which returned Rs.500 per year would have a two-yearpayback period. The time value of money is not taken into account.

The formula for the payback method is simplistic: Divide the cash outlay (which is assumed to occur entirely at the beginning of the project) by the amount of net cash flow generated by the project per year (which is assumed to be the same in every year).Payback Period ExampleAlaskan Lumber is considering the purchase of a band saw that costs Rs.50,000 and which will generate Rs.10,000 per year of net cash flow. The payback period for this capital investment is 5.0 years. Alaskan is also considering the purchase of a conveyor system for Rs.36,000, which will reduce saw mill transport costs by Rs.12,000 per year. The payback period for this capital investment is 3.0 years. If Alaskan only has sufficient funds to invest in one of these projects, and if it were only using the payback method as the basis for its investment decision, it would buy the conveyor system, since it has a shorter payback period.Payback Method Advantages and DisadvantagesThe payback period is useful from a risk analysis perspective, since it gives a quick picture of the amount of time that the initial investment will be at risk. If you were to analyze a prospective investment using the payback method, you would tend to accept those investments having rapid payback periods, and reject those having longer ones. It tends to be more useful in industries where investments become obsolete very quickly, and where a full return of the initial investment is therefore a serious concern. Though the payback method is widely used due to its simplicity, it suffers from the following problems:Asset life span. If an assets useful life expires immediately after it pays back the initial investment, then there is no opportunity to generate additional cash flows. The payback method does not incorporate any assumption regarding asset life span.Additional cash flows. The concept does not consider the presence of any additional cash flows that may arise from an investment in the periods after full payback has been achieved.Cash flow complexity. The formula is too simplistic to account for the multitude of cash flows that actually arise with a capital investment. For example, cash investments may be required at several stages, such as cash outlays for periodic upgrades. Also, cash outflows may change significantly over time, varying with customer demand and the amount of competition.Profitability. The payback method focuses solely upon the time required to pay back the initial investment; it does not track the ultimate profitability of a project at all. Thus, the method may indicate that a project having a short payback but with no overall profitability is a better investment than a project requiring a long-term payback but having substantial long-term profitability.Time value of money. The method does not take into account the time value of money, where cash generated in later periods is work less than cash earned in the current period. A variation on the payback period formula, known as the discounted payback formula, eliminates this concern by incorporating the time value of money into the calculation.Individual asset orientation. Many fixed asset purchases are designed to improve the efficiency of a single operation, which is completely useless if there is a process bottleneck located downstream from that operation that restricts the ability of the business to generate more output. The payback period formula does not account for the output of the entire system, only a specific operation. Thus, its use is more at the tactical level than at the strategic level.Incorrect averaging. The denominator of the calculation is based on the average cash flows from the project over several years - but if the forecasted cash flows are mostly in the part of the forecast furthest in the future, the calculation will incorrectly yield a payback period that is too soon. The following example illustrates the problem.Payback Method Example #2ABC International has received a proposal from a manager, asking to spend $1,500,000 on equipment that will result in cash inflows in accordance with the following table:YearCash Flow

1+$150,000

2+150,000

3+200,000

4+600,000

5+900,000

The total cash flows over the five-year period are projected to be $2,000,000, which is an average of $400,000 per year. When divided into the $1,500,000 original investment, this results in a payback period of 3.75 years. However, the briefest perusal of the projected cash flows reveals that the flows are heavily weighted toward the far end of the time period, so the results of this calculation cannot be correct.Instead, the company's financial analyst runs the calculation year by year, deducting the cash flows in each successive year from the remaining investment. The results of this calculation are:YearCash FlowNet Invested Cash

0-$1,500,000

1+$150,000-1,350,000

2+150,000-1,200,000

3+200,000-1,000,000

4+600,000-400,000

5+900,0000

The table indicates that the real payback period is located somewhere between Year 4 and Year 5. There is $400,000 of investment yet to be paid back at the end of Year 4, and there is $900,000 of cash flow projected for Year 5. The analyst assumes the same monthly amount of cash flow in Year 5, which means that he can estimate final payback as being just short of 4.5 years.Operating Leverage : operating leverage measures a companys fixed costs as a percentage of its total costs. It is used to evaluate the break even point of a business, as well as the likely profit levels on individual sales. The following two scenarios describe an organization having high operating leverage and low operating leverage.High operating leverage. A large proportion of the companys costs are fixed costs. In this case, the firm earns a large profit on each incremental sale, but must attain sufficient sales volume to cover its substantial fixed costs. If it can do so, then the entity will earn a major profit on all sales after it has paid for its fixed costs.Low operating leverage. A large proportion of the companys sales are variable costs, so it only incurs these costs if there is a sale. In this case, the firm earns a smaller profit on each incremental sale, but does not have to generate much sales volume in order to cover its lower fixed costs. It is easier for this type of company to earn a profit at low sales levels, but it does not earn outsized profits if it can generate additional sales.

For example, a software company has substantial fixed costs in the form of developer salaries, but has almost no variable costs associated with each incremental software sale; this firm has high operating leverage. Conversely, a consulting firm bills its clients by the hour, and incurs variable costs in the form of consultant wages. This firm has low operating leverage.

To calculate operating leverage, divide an entityscontribution marginby its net operating income. The contribution margin is sales minus variable expenses.For example, the Alaskan Barrel Company (ABC) has the following financial results:Revenues$100,000

Variable expenses 30,000

Fixed expenses 60,000

Net operating income$10,000

ABC has a contribution margin of 70% and net operating income of $10,000, which gives it a degree of operating leverage of 7. ABCs sales then increase by 20%, resulting in the following financial results:Revenues$120,000

Variable expenses 36,000

Fixed expenses 60,000

Net operating income$24,000

The contribution margin of 70% has stayed the same, and fixed costs have not changed. Because of ABCs high degree of operating leverage, the 20% increase in sales translates into a greater than doubling of its net operating income.When using the operating leverage measurement, constant monitoring of operating leverage is more important for a firm having high operating leverage, since a small percentage change in sales can result in a dramatic increase (or decrease) in profits. A firm must be especially careful to forecast its revenues carefully in such situations, since a small forecasting error translates into much larger errors in both net income and cash flows.Knowledge of the level of operating leverage can have a profound impact on pricing policy, since a company with a large amount of operating leverage must be careful not to set its prices so low that it can never generate enough contribution margin to fully offset its fixed costs.

Explicit Cost/ implicit cost : Animplicit costis a cost that has occurred but it is not initially shown or reported as a separate cost. On the other hand, anexplicit costis one that has occurred and is clearly reported as a separate cost. Below are some examples to illustrate the difference between an implicit cost and an explicit cost.Let's assume that a company gives apromissory notefor Rs.10,000 to someone in exchange for a unique used machine for which the fair value is not known. The note will come due in three years and it does not specify any interest. Due to the company's weak financial position it will have to pay a high interest rate if it were to borrow money. In this example, there is no explicit interest cost. However, due to the issuer's financial difficulty and the seller having to wait three years to collect the money, there has to be some interest cost. In other words, there is some interest and it is implicit. To properly record the note and the machine, theaccountantmust determine the amount of the interest, which is known as imputing the interest. In effect the accountant must convert the implicit interest to explicit interest. This is done by discounting the $10,000 by using the interest rate that the issuer of the note would have to pay to another lender. If the rate is 12% per year, the interest that was implicit in the note is $2,880 and the principal portion of the note is the remaining $7,120.

If another company with the same financial condition purchased this unique machine by issuing a $7,120 note with a stated interest rate of 12% per year, the interest cost of $2,880 would be explicit. In this situation, there is no need to impute the interest.

Another example of an implicit cost is theopportunity costof a sole proprietor working in her own business. For example, Gina works as a sole proprietor and her business reported anet incomeof $30,000 for the year. Since a sole proprietor does not receive a salary or wages, there is no explicit cost reported for Gina's work in her business. However, if Gina is foregoing a salary of $40,000 from another company, that is an implicit cost for her business. After considering this implicit cost, Gina is losing $10,000 by working in her proprietorship.

If Gina operates her business as a corporation, Gina will be an employee of the corporation. If her annual salary is $40,000 the corporation'sincome statementwould report the $40,000 salary as anexplicitcost for Gina's work.

Leveraged buyouts: A leveraged buyout (LBO) is an acquisition of a company or a segment of a company funded mostly with debt. A financial buyer (e.g. private equity fund) invests a small amount of equity (relative to the total purchase price) and uses leverage (debt or other non-equity sources of financing) to fund the remainder of the consideration paid to the seller. The LBO analysis generally provides a "floor" valuation for the company, and is useful in determining what a financial sponsor can afford to pay for the target and still realize an adequate return on its investment.Transaction StructureBelow is a simple diagram of an LBO structure. The new investors (e.g. and LBO firm or management of the target) form a new corporation for the purpose of acquiring the target. The target becomes a subsidiary of NewCo, or NewCo and the target can merge.

Applications of the LBO AnalysisDetermine the maximum purchase price for a business that can be paid based on certain leverage (debt) levels and equity return parameters.Develop a view of the leverage and equity characteristics of a leveraged transaction at a given price.Calculate the minimum valuation for a company since, in the absence of strategic buyers, an LBO firm should be a willing buyer at a price that delivers an expected equity return that meets the firm'shurdle rate.Steps in the LBO AnalysisDevelop operating assumptions and projections for the standalone company to arrive at EBITDA and cash flow available for debt repayment over the investment horizon (typically 3 to 7 years).Determine key leverage levels and capital structure (senior and subordinated debt, mezzanine financing, etc.) that result in realistic financial coverage and credit statistics.Estimate the multiple at which the sponsor is expected to exit the investment (should generally be similar to the entry multiple).Calculate equity returns (IRRs) to the financial sponsor and sensitize the results to a range of leverage and exit multiples, as well as investment horizons.Solve for the price that can be paid to meet the above parameters (alternatively, if the price is fixed, solve for achievable returns).ReturnsIn LBO transactions, financial buyers seek to generate high returns on the equity investments and use financial leverage (debt) to increase these potential returns. Financial buyers evaluate investment opportunities with by analyzing expectedinternal rates of return(IRRs), which measure returns on invested equity. IRRs represent the discount rate at which the net present value of cash flows equals zero. Historically, financial sponsors' hurdle rates (minimum required IRRs) have been in excess of 30%, but may be as low as 15-20% for particular deals under adverse economic conditions. Hurdle rates for larger deals tend to be a bit lower than hurdle rates for smaller deals.Advantaes: De-levering (paying down debt) Operational improvement (e.g. margin expansion, revenue growth) Multiple expansion (buying low and selling high)RiskEquity holders In addition to the operating risk assumed risk arises due to significant financial leverage. Interest costs resulting from substantial amounts of debt are "fixed costs" that can force a company into default if not paid. Furthermore, small changes in the enterprise value (EV) of a company can have a magnified effect on the equity value when the company is highly levered and the value of the debt remains constant.Debt holders The debt holders bear the risk of default equated with higher leverage as well, but since they have the most senior claims on the assets of the company, they are likely to realize a partial, if not full, return on their investments, even in bankruptcy.Exit StrategiesIdeally, an exit strategy enables financial buyers to realize gains on their investments. Exit strategies most commonly include an outright sale of the company to a strategic buyer or another financial sponsor, an IPO, or a recapitalization. A financial buyer typically expects to realize a return on its LBO investment within 3 to 7 years via one of these strategies.

Q: Financial management is nothing but managerial decision making on asset mix, capital mix, and profit allocation. Explain.Q: Discuss the role of Finance manager in modern business firm.Q: Discuss the major types of Financial management Decisions that business firms make.Q: Wealth Maximisation objective provides an operationally appropriate decisions criterion. Comment.Q; Discuss the scope and objectives of financial management in the context of changing business environment.Q; Outline the factors behind Indian companies according greater importance to the goal of shareholders wealth maximization.

Meaning of Financial ManagementFinancial Management means planning, organizing, directing and controlling the financial activities such as procurement and utilization of funds of the enterprise. It means applying general management principles to financial resources of the enterprise.Scope/ElementsInvestment decisions includes investment in fixed assets (called as capital budgeting). Investment in current assets are also a part of investment decisions called as working capital decisions.Financial decisions - They relate to the raising of finance from various resources which will depend upon decision on type of source, period of financing, cost of financing and the returns thereby.Dividend decision - The finance manager has to take decision with regards to the net profit distribution. Net profits are generally divided into two:Dividend for shareholders- Dividend and the rate of it has to be decided.Retained profits- Amount of retained profits has to be finalized which will depend upon expansion and diversification plans of the enterprise.Objectives of Financial ManagementThe financial management is generally concerned with procurement, allocation and control of financial resources of a concern. The objectives can be- To ensure regular and adequate supply of funds to the concern. To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price of the share, expectations of the shareholders. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way at least cost. To ensure safety on investment, i.e, funds should be invested in safe ventures so that adequate rate of return can be achieved. To plan a sound capital structure-There should be sound and fair composition of capital so that a balance is maintained between debt and equity capital.Functions of Financial ManagementEstimation of capital requirements:A finance manager has to make estimation with regards to capital requirements of the company. This will depend upon expected costs and profits and future programmes and policies of a concern. Estimations have to be made in an adequate manner which increases earning capacity of enterprise.Determination of capital composition:Once the estimation have been made, the capital structure have to be decided. This involves short- term and long- term debt equity analysis. This will depend upon the proportion of equity capital a company is possessing and additional funds which have to be raised from outside parties.Choice of sources of funds:For additional funds to be procured, a company has many choices like-Issue of shares and debenturesLoans to be taken from banks and financial institutionsPublic deposits to be drawn like in form of bonds.Choice of factor will depend on relative merits and demerits of each source and period of financing.Investment of funds:The finance manager has to decide to allocate funds into profitable ventures so that there is safety on investment and regular returns is possible.Disposal of surplus:The net profits decision have to be made by the finance manager. This can be done in two ways:Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus.Retained profits - The volume has to be decided which will depend upon expansional, innovational, diversification plans of the company.Management of cash:Finance manager has to make decisions with regards to cash management. Cash is required for many purposes like payment of wages and salaries, payment of electricity and water bills, payment to creditors, meeting current liabilities, maintainance of enough stock, purchase of raw materials, etc.Financial controls:The finance manager has not only to plan, procure and utilize the funds but he also has to exercise control over finances. This can be done through many techniques like ratio analysis, financial forecasting, cost and profit control, etc.

Some of the important functions which every finance manager has to take are as follows:i. Investment decisionii. Financing decisioniii. Dividend decisionA. Investment Decision (Capital Budgeting Decision):This decision relates to careful selection of assets in which funds will be invested by the firms. A firm has many options to invest their funds but firm has to select the most appropriate investment which will bring maximum benefit for the firm and deciding or selecting most appropriate proposal is investment decision.The firm invests its funds in acquiring fixed assets as well as current assets. When decision regarding fixed assets is taken it is also called capital budgeting decision.

Factors Affecting Investment/Capital Budgeting Decisions1. Cash Flow of the Project:Whenever a company is investing huge funds in an investment proposal it expects some regular amount of cash flow to meet day to day requirement. The amount of cash flow an investment proposal will be able to generate must be assessed properly before investing in the proposal.2. Return on Investment:The most important criteria to decide the investment proposal is rate of return it will be able to bring back for the company in the form of income for, e.g., if project A is bringing 10% return and project is bringing 15% return then we should prefer project B.3.Risk Involved:With every investment proposal, there is some degree of risk is also involved. The company must try to calculate the risk involved in every proposal and should prefer the investment proposal with moderate degree of risk only.4.Investment Criteria:Along with return, risk, cash flow there are various other criteria which help in selecting an investment proposal such as availability of labour, technologies, input, machinery, etc.The finance manager must compare all the available alternatives very carefully and then only decide where to invest the most scarce resources of the firm, i.e., finance.Investment decisions are considered very important decisions because of following reasons:(i) They are long term decisions and therefore are irreversible; means once taken cannot be changed.(ii) Involve huge amount of funds.(iii) Affect the future earning capacity of the company.

B. Importance or Scope of Capital Budgeting Decision:Capital budgeting decisions can turn the fortune of a company. The capital budgeting decisions are considered very important because of the following reasons:1.Long Term Growth:The capital budgeting decisions affect the long term growth of the company. As funds invested in long term assets bring return in future and future prospects and growth of the company depends upon these decisions only.2.Large Amount of Funds Involved:Investment in long term projects or buying of fixed assets involves huge amount of funds and if wrong proposal is selected it may result in wastage of huge amount of funds that is why capital budgeting decisions are taken after considering various factors and planning.3.Risk Involved:The fixed capital decisions involve huge funds and also big risk because the return comes in long run and company has to bear the risk for a long period of time till the returns start coming.4.Irreversible Decision:Capital budgeting decisions cannot be reversed or changed overnight. As these decisions involve huge funds and heavy cost and going back or reversing the decision may result in heavy loss and wastage of funds. So these decisions must be taken after careful planning and evaluation of all the effects of that decision because adverse consequences may be very heavy.

C. Financing Decision:The second important decision which finance manager has to take is deciding source of finance. A company can raise finance from various sources such as by issue of shares, debentures or by taking loan and advances. Deciding how much to raise from which source is concern of financing decision. Mainly sources of finance can be divided into two categories:1. Owners fund.2. Borrowed fund.Share capital and retained earnings constitute owners fund and debentures, loans, bonds, etc. constitute borrowed fund.The main concern of finance manager is to decide how much to raise from owners fund and how much to raise from borrowed fund.While taking this decision the finance manager compares the advantages and disadvantages of different sources of finance. The borrowed funds have to be paid back and involve some degree of risk whereas in owners fund there is no fix commitment of repayment and there is no risk involved. But finance manager prefers a mix of both types. Under financing decision finance manager fixes a ratio of owner fund and borrowed fund in the capital structure of the company.

Factors Affecting Financing Decisions:While taking financing decisions the finance manager keeps in mind the following factors:1.Cost: The cost of raising finance from various sources is different and finance managers always prefer the source with minimum cost.2.Risk: More risk is associated with borrowed fund as compared to owners fund securities. Finance manager compares the risk with the cost involved and prefers securities with moderate risk factor.3.Cash Flow Position: The cash flow position of the company also helps in selecting the securities. With smooth and steady cash flow companies can easily afford borrowed fund securities but when companies have shortage of cash flow, then they must go for owners fund securities only.4.Control Considerations: If existing shareholders want to retain the complete control of business then they prefer borrowed fund securities to raise further fund. On the other hand if they do not mind to lose the control then they may go for owners fund securities.5.Floatation Cost: It refers to cost involved in issue of securities such as brokers commission, underwriters fees, expenses on prospectus, etc. Firm prefers securities which involve least floatation cost.6.Fixed Operating Cost: If a company is having high fixed operating cost then they must prefer owners fund because due to high fixed operational cost, the company may not be able to pay interest on debt securities which can cause serious troubles for company.7.State of Capital Market: The conditions in capital market also help in deciding the type of securities to be raised. During boom period it is easy to sell equity shares as people are ready to take risk whereas during depression period there is more demand for debt securities in capital market.

D. Dividend Decision: This decision is concerned with distribution of surplus funds. The profit of the firm is distributed among various parties such as creditors, employees, debenture holders, shareholders, etc.Payment of interest to creditors, debenture holders, etc. is a fixed liability of the company, so what company or finance manager has to decide is what to do with the residual or left over profit of the company.The surplus profit is either distributed to equity shareholders in the form of dividend or kept aside in the form of retained earnings. Under dividend decision the finance manager decides how much to be distributed in the form of dividend and how much to keep aside as retained earnings.To take this decision finance manager keeps in mind the growth plans and investment opportunities.If more investment opportunities are available and company has growth plans then more is kept aside as retained earnings and less is given in the form of dividend, but if company wants to satisfy its shareholders and has less growth plans, then more is given in the form of dividend and less is kept aside as retained earnings.This decision is also called residual decision because it is concerned with distribution of residual or left over income. Generally new and upcoming companies keep aside more of retain earning and distribute less dividend whereas established companies prefer to give more dividend and keep aside less profit.

Factors Affecting Dividend Decision:The finance manager analyses following factors before dividing the net earnings between dividend and retained earnings:1.Earning:Dividends are paid out of current and previous years earnings. If there are more earnings then company declares high rate of dividend whereas during low earning period the rate of dividend is also low.2.Stability of Earnings:Companies having stable or smooth earnings prefer to give high rate of dividend whereas companies with unstable earnings prefer to give low rate of earnings.3.Cash Flow Position:Paying dividend means outflow of cash. Companies declare high rate of dividend only when they have surplus cash. In situation of shortage of cash companies declare no or very low dividend.4.Growth Opportunities:If a company has a number of investment plans then it should reinvest the earnings of the company. As to invest in investment projects, company has two options: one to raise additional capital or invest its retained earnings. The retained earnings are cheaper source as they do not involve floatation cost and any legal formalities.If companies have no investment or growth plans then it would be better to distribute more in the form of dividend. Generally mature companies declare more dividends whereas growing companies keep aside more retained earnings.5.Stability of Dividend:Some companies follow a stable dividend policy as it has better impact on shareholder and improves the reputation of company in the share market. The stable dividend policy satisfies the investor. Even big companies and financial institutions prefer to invest in a company with regular and stable dividend policy.There are three types of stable dividend policies which a company may follow:(i) Constant dividend per share:In this case, the company decides a fixed rate of dividend and declares the same rate every year, e.g., 10% dividend on investment.(ii) Constant payout ratio:Under this system the company fixes up a fixed percentage of dividends on profit and not on investment, e.g., 10% on profit so dividend keeps on changing with change in profit rate.(iii) Constant dividend per share and extra dividend:Under this scheme a fixed rate of dividend on investment is given and if profit or earnings increase then some extra dividend in the form of bonus or interim dividend is also given.6.Preference of Shareholders:Another important factor affecting dividend policy is expectation and preference of shareholders as their expectations cannot be ignored by the company. Generally it is observed that retired shareholders expect regular and stable amount of dividend whereas young shareholders prefer capital gain by reinvesting the income of the company.They are ready to sacrifice present day income of dividend for future gain which they will get with growth and expansion of the company.Secondly poor and middle class investors also prefer regular and stable amount of dividend whereas wealthy and rich class prefers capital gains.So if a company is having large number of retired and middle class shareholders then it will declare more dividend and keep aside less in the form of retained earnings whereas if company is having large number of young and wealthy shareholders then it will prefer to keep aside more in the form of retained earnings and declare low rate of dividend.7.Taxation Policy:The rate of dividend also depends upon the taxation policy of government. Under present taxation system dividend income is tax free income for shareholders whereas company has to pay tax on dividend given to shareholders. If tax rate is higher, then company prefers to pay less in the form of dividend whereas if tax rate is low then company may declare higher dividend.8.Access to Capital Market Consideration:Whenever company requires more capital it can either arrange it by issue of shares or debentures in the stock market or by using its retained earnings. Rising of funds from the capital market depends upon the reputation of the company.If capital market can easily be accessed or approached and there is enough demand for securities of the company then company can give more dividend and raise capital by approaching capital market, but if it is difficult for company to approach and access capital market then companies declare low rate of dividend and use reserves or retained earnings for reinvestment.9.Legal Restrictions:Companies Act has given certain provisions regarding the payment of dividends that can be paid only out of current year profit or past year profit after providing depreciation fund. In case company is not earning profit then it cannot declare dividend.Apart from the Companies Act there are certain internal provisions of the company that is whether the company has enough flow of cash to pay dividend. The payment of dividend should not affect the liquidity of the company.10.Contractual Constraints:When companies take long term loan then financier may put some restrictions or constraints on distribution of dividend and companies have to abide by these constraints.11.Stock Market Reaction:The declaration of dividend has impact on stock market as increase in dividend is taken as a good news in the stock market and prices of security rise. Whereas a decrease in dividend may have negative impact on the share price in the stock market. So possible impact of dividend policy in the equity share price also affects dividend decision.

Q: what are the distinction between fund flow and cash flow statement?Q: what do you mean by Funds Flow Analysis? Explain the mechanics involved in the preparation of funds flow statement.Q: How does a funds flow statement differ from balance sheet? Expain the managerial uses of funds flow statement.

Cash flow refers to the current format for reporting the inflows and outflows of cash, while funds flow refers to an outmoded format for reporting a subset of the same information.Cash flow is derived from the statement of cash flows. This statement is required under Generally Accepted Accounting Principles (GAAP), and shows the inflows and outflows of cash generated by a business during a reporting period.

The information in a statement of cash flows is aggregated into the following three areas: Operating activities. Comprised of the main revenue-generating activities of a business, such as receipts from the sale of goods and payments to suppliers and employees. Investing activities. Involves the acquisition and disposal of long-term assets, such as cash received from the sale of property. Financing activities. Involves changes in cash from selling or paying off financing instruments, such as from the issuance or repayment of debt.

The statement of cash flows is part of the main group of financial statements that a business issues, though it is commonly considered to be third in importance after the income statement and balance sheet. The statement can be of considerable use in detecting movements of cash that are not readily apparent by perusing the income statement. For example, the income statement may reveal that a business earned a large profit, while the statement of cash flows shows that the same business actually lost cash while doing so (probably due to large investments in fixed assets or working capital). Thus, cash flow analysis is useful for determining the underlying health of a business.

The funds flow statement. The statement primarily reported changes in an entity's networking capitalposition between the beginning and end of an accounting period. Net working capital is an entity'scurrent assetsminus itscurrent liabilities. The statement of cash flows is a more comprehensive document than the earlier funds flow statement, with a focus on multiple types of cash flows.Importance Of Funds Flow Statement : Funds flowstatementis an importantfinancialtool, which analyze the changes infinancialpositionof a firm showing the sources and applications of its funds. It provides useful information about the firm'soperating,financingand investing activities during aparticularperiod. T he following points highlightthe importance of funds flowstatement.1. Funds flowstatementhelps in identifying the change inlevelofcurrent assetsinvestmentand current liabilities financing.2. Funds flowstatementhelps in analyzing the changes in working capital level of a firm.3. Funds flowstatementshows the relationship of net income to the changes in funds from business operation.

4. Funds flowstatementreports about past fund flow as an aid to predict future funds flow.5. Funds flowstatementhelps in determining the firms' ability to pay interest and dividend, and pay debt when they become due.6. Funds flowstatementshows the firms' ability to generate long-term financing to satisfy the investmentin long-term assets.7. Funds flow statements helps in identifying the factorresponsiblefor changes in assets, liabilities and owners' equity at two balance sheet date.Difference Between Balance Sheet And Funds Flow StatementThe main differences between balancesheetand fund flow statementare as below:1. Meaning : BalanceSheet:Balancesheetis a statement of assets, liabilities and capital.FundsFlow Statement:Fundsflow statement is a statement if changes in assets, liabilities andcapital accounts.2. Objective : BalanceSheet:Balancesheetis prepared to ascertain thefinancial positionof a firm.FundsFlow Statement:It is prepared to ascertain the sources and application offunds.3. Preparation: BalanceSheet:It is prepared with the help of trial balance. FundsFlow Statement:It is prepared with the help of balance sheets of two subsequent dates.4. Information: BalanceSheet: It provides static view of financial affairs. FundsFlow Statement:It provides the changes in assets, liabilities andcapital accounts.Steps for Preparing Funds Flow Statement: Determine the change (increase or decrease) in working capital. Determine the adjustments account to be made to net income. For each non-current account on the balance sheet, establish the increase or decrease in that account. Analyze the change to decide whether it is a source (increase) or use (decrease) of working capital. Be sure the total of all sources including those from operations minus the total of all uses equals the change found in working capital in Step 1.General Rules for Preparing Funds Flow Statement: The following general rules should be observed while preparing funds flow statement: Increase in a current asset means increase (plus) in working capital. Decrease in a current asset means decrease (minus) in working capital. Increase in a current liability means decrease (minus) in working capital. Decrease in a current liability means increase (plus) in working capital. Increase in current asset and increase in current liability does not affect working capital. Decrease in current asset and decrease in current liability does not affect working capital. Changes in fixed (non-current) assets and fixed (non-current) liabilities affects working capital. Format of Funds Flow Statement:A funds flow statement can be prepared in statement form or T form. Both the formats are givenbelow:

Schedule of Changes in Working Capital:Many business enterprises prefer to prepare another statement, known as schedule of changes in working capital, while preparing a funds flow statement, on a working capital basis. This schedule of changes in working capital provides information concerning the changes in each individual current assets and current liabilities accounts (items).This schedule is a part of the funds flow statement and increase (decrease) in working capital indicated by the schedule of changes in working capital will be equal to the amount of changes in working capital as found by funds flow statement. The schedule of changes in working capital can be prepared by comparing the current assets and current liabilities at two periods.The format of schedule of changes in working capital is as follows:Illustration:The following are the balance sheet of a company for the years 2012 and 2013 and income statement for the year 2013:

The above statement presentation is a two parts statement; the sources are first detailed and then totalled, followed by the detail information and total for uses. The difference between the sources and uses must equal the change in working capital.It can be noticed that sources of funds (working capital is sub-divided into two parts; the first part is concerned with sources from operations, and the second part deals with other sources. Uses of working capital in the above statement do not include any uses for operations, such as salaries and rent, because these have been included automatically by starting the funds flow statement with the net income rather than with revenue. Generally, the most common uses of funds shown are for the firms investment activities such as the purchase of the new equipment, declaration of dividends, or payment of long-term liabilities.Using the figures given in the Illustration, the Schedule of Changes in Working capital can be prepared as follows:

Q: What is capital budgeting? Explain the assumptions and decision rules of the discounted flow techniques of capital budgeting.Q: Briefly explain the various techniques of Capital Budgeting.Q: What do you mean by Discounted Cash Flow Techniques of capital budgeting? Discuss the merits and limitations of Net Present value and Internal Rate of Return methods.

What is capital budgeting? Capital budgeting is a process used by companies for evaluating and ranking potential expenditures or investments that are significant in amount. The large expenditures could include the purchase of new equipment, rebuilding existing equipment, purchasing delivery vehicles, constructing additions to buildings, etc. The large amounts spent for these types of projects are known ascapital expenditures.Capital budgeting usually involves the calculation of each project's future accounting profit by period, the cash flow by period, the present value of the cash flows after considering thetime value of money, the number of years it takes for a project's cash flow to pay back the initial cash investment, an assessment of risk, and other factors.Capital budgeting is a tool for maximizing a company's future profits since most companies are able to manage only a limited number of large projects at any one time.Some of the major techniques used in capital budgeting are as follows: Payback period Accounting Rate of Return method Net present value method Internal Rate of Return Method Profitability index.

1. Payback period: The payback (or pay out) period is one of the most popular and widely recognized traditional methods of evaluating investment proposals, it is defined as the number of years required to recover the original cash outlay invested in a project, if the project generates constant annual cash inflows, the payback period can be computed dividing cash outlay by the annual cash inflow.Payback period = Cash outlay (investment) / Annual cash inflow = C / A

Advantages:1. A company can have more favourable short-run effects on earnings per share by setting up a shorter payback period.2. The riskiness of the project can be tackled by having a shorter payback period as it may ensure guarantee against loss.3. As the emphasis in pay back is on the early recovery of investment, it gives an insight to the liquidity of the project.

Limitations:1. It fails to take account of the cash inflows earned after the payback period.2. It is not an appropriate method of measuring the profitability of an investment project, as it does not consider the entire cash inflows yielded by the project.3. It fails to consider the pattern of cash inflows, i.e., magnitude and timing of cash inflows.4. Administrative difficulties may be faced in determining the maximum acceptable payback period.

2. Accounting Rate of Returnmethod:The Accounting rate of return (ARR) method uses accounting information, as revealed by financial statements, to measure the profit abilities of the investment proposals. The accounting rate of return is found out by dividing the average income after taxes by the average investment.ARR= Average income/Average Investment

Advantages:1. It is very simple to understand and use.2. It can be readily calculated using the accounting data.3. It uses the entire stream of incomes in calculating the accounting rate.

Limitations:1. It uses accounting, profits, not cash flows in appraising the projects.2. It ignores the time value of money; profits occurring in different periods are valued equally.3. It does not consider the lengths of projects lives.4. It does not allow for the fact that the profit can be reinvested.

3. Net present value method:The net present value (NPV) method is a process of calculating the present value of cash flows (inflows and outflows) of an investment proposal, using the cost of capital as the appropriate discounting rate, and finding out the net profit value, by subtracting the present value of cash outflows from the present value of cash inflows.The equation for the net present value, assuming that all cash outflows are made in the initial year (tg), will be:

Where A1, A2. represent cash inflows, K is the firms cost of capital, C is the cost of the investment proposal and n is the expected life of the proposal. It should be noted that the cost of capital, K, is assumed to be known, otherwise the net present, value cannot be known.

Advantages:1. It recognizes the time value of money2. It considers all cash flows over the entire life of the project in its calculations.3. It is consistent with the objective of maximizing the welfare of the owners.

Limitations:1. It is difficult to use2. It presupposes that the discount rate which is usually the firms cost of capital is known. But in practice, to understand cost of capital is quite a difficult concept.3. It may not give satisfactory answer when the projects being compared involve different amounts of investment.

4. Internal Rate of Return Method:The internal rate of return (IRR) equates the present value cash inflows with the present value of cash outflows of an investment. It is called internal rate because it depends solely on the outlay and proceeds associated with the project and not any rate determined outside the investment, it can be determined by solving the following equation:

Advantages:1. Like the NPV method, it considers the time value of money.2. It considers cash flows over the entire life of the project.3. It satisfies the users in terms of the rate of return on capital.4. Unlike the NPV method, the calculation of the cost of capital is not a precondition.5. It is compatible with the firms maximising owners welfare.

Limitations:1. It involves complicated computation problems.2. It may not give unique answer in all situations. It may yield negative rate or multiple rates under certain circumstances.3. It implies that the intermediate cash inflows generated by the project are reinvested at the internal rate unlike at the firms cost of capital under NPV method. The latter assumption seems to be more appropriate.

5. Profitability index:It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment. It may be gross or net, net being simply gross minus one. The formula to calculate profitability index (PI) or benefit cost (BC) ratio is as follows.PI = PV cash inflows/Initial cash outlay A,

1. It gives due consideration to the time value of money.2. It requires more computation than the traditional method but less than the IRR method.3. It can also be used to choose between mutually exclusive projects by calculating the incremental benefit cost ratio.

Capital budgeting with discounted cash flows (DCF)allows you to value a project, based on the time value of money. In essence, you are discounting the value of future cash flows to determine if the value today makes the project worthwhile.Equation BasicsThe DCF equation is:Discounted Present Value (DPV) = Future Value / (1 + interest rate)^ time periodThe equation is used to allow you to determine the value today of a future cash flows. For example, if investing $100,000 today will result in a cash flow of $125,000 in two years. In order to make a fair judgment of whether the return is a good one, you will need to consider the cost of capital. If it will cost you 8% per year to borrow the money, the return is less attractive. Using the equation, you get $125,000 / (1 + 0.08) ^ 2 = 107,167.40. After you return the original $100,000, you will only earn $7,167.40. While this is not a great return, it is positive, so the project may worth consideration.DrawbackThe drawback to this method is that it assumes that the cost of capital, or the interest rate used will not vary. Another problem is that it assumes cash flow can be accurately projected. While you can make both of these factors variable, it makes the calculation cumbersome and increases the chances of error.

Q: What are the factors influencing planning of Capital structure?Q:what is optimum capital structure? explain the factors influencing the capital sturcture decision of a corporate firm.

The following are the factors influencing planning of capital structure:

(1) Cash Flow Position: While making a choice of the capital structure the future cash flow position should be kept in mind. Debt capital should be used only if the cash flow position is really good because a lot of cash is needed in order to make payment of interest and refund of capital.(2) Interest Coverage Ratio-ICR: With the help of this ratio an effort is made to find out how many times the EBIT (Earnings Before Interest and Taxes) is available to the payment of interest. The capacity of the company to use debt capital will be in direct proportion to this ratio.It is possible that in spite of better ICR the cash flow position of the company may be weak. Therefore, this ratio is not a proper or appropriate measure of the capacity of the company to pay interest. It is equally important to take into consideration the cash flow position.(3) Debt Service Coverage Ratio-DSCR: This ratio removes the weakness of ICR. This shows the cash flow position of the company.This ratio tells us about the cash payments to be made (e.g., preference dividend, interest and debt capital repayment) and the amount of cash available. Better ratio means the better capacity of the company for debt payment. Consequently, more debt can be utilised in the capital structure.(4) Return on Investment-ROI: The greater return on investment of a company increases its capacity to utilise more debt capital.(5) Cost of Debt: The capacity of a company to take debt depends on the cost of debt. In case the rate of interest on the debt capital is less, more debt capital can be utilised and vice versa.(6) Tax Rate: The rate of tax affects the cost of debt. If the rate of tax is high, the cost of debt decreases. The reason is the deduction of interest on the debt capital from the profits considering it a part of expenses and a saving in taxes.For example, suppose a company takes a loan of Rs 100 and the rate of interest on this debt is 10% and the rate of tax i