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Financial Management
Some Questions and Answers for the Final Examination
Financial Management
Section A: Objective Type

PART ONE:
Multiple choices:
1
...
Ignored Non-Corporate Enterprise
b
...
External Approach
d
...
These are those shares, which can be redeemed or repaid to the holders after a lapse of the
stipulated period
a
...
Non-Cumulative Preference Shares
c
...
Perpetual Shares
Answer: b (Redeemable Preference Shares)
3
...
Political Risk
b
...
International Risk
d
...
It is the cost of capital that is expected to raise funds to finance a capital budget or
investment proposal
a
...
Specific cost
c
...
Book cost
Answer: a (Future Cost)

5
...
Financial Performance Appraisal
b
...
Designing Optimal Corporate Capital Structure
d
...
It is the minimum required rate of return needed to justify the use of capital
a
...
Firms Point
c
...
Cost Of Capital
Answer: b (Firms Point)
7
...
Seasonal Variation
b
...
Industry Life Cycle
d
...
Some guidelines on shares & debentures issued by the government that are very
important for the constitution of the capital structure are
a
...
Purpose Of Finance
c
...
Requirement Of Investors
Answer: a (Legal Requirement)
9
...
Bull-bear market risk
b
...
International risk
d
...
–––––– measure the systematic risk of a security that cannot be avoided through
diversification
a
...
Gamma
c
...
Alpha
Answer: a (Beta)

PART TWO:

Short Notes type Questions:
1
...

Ordinary annuity: A series of equal payments or receipts occurring over a specified number
of periods with the payments or receipts occurring at the end of each period
...

Annuities are a special type of cash flow where each year you get a specified amount of
money
...



Normal annuity: This type of cash flow is received at the end of each period
(typically a year)



Annuity due: When you get a cash flow periodically at the beginning of each period
...
The following two types of annuities can also be either
normal, or annuity due
...
A very typical example is life annuity
(or life rent)
...
In other words, each period the growth is the same rate
...

Normal Annuity – Present and future value
If you have read the article on Present and future value, you know by now how to calculate
them
...
Of course that would be quite long for an annuity which has a lifespan of
50 years
...
Lets look at a short example and calculate future value
with the long and the short way
...
One particular bond will pay you $1000 for five years at the

end of each year
...
If you look at the tables in the Value
of money article you will find PVIF10,1 to be 0,909 ; PVIF10,2 to be 0,826 and so on
...
If we add these values up, we would get 3791
...
This is the basis for the short cut
...
These are called Present Value Interest Factors
Annuity, or PVIFA
...

Future value for annuities needs no more explanation because it works in exactly the same
way
...
The sum of these would give
you the FVIFA amount
...
The calculation matches the one before, but a methodical difference
is very important to remember
...
To understand this we (again) look at some
timelines and seek the help of present value
...
So when
calculating present value for normal annuities we multiply each amount by a value that is less
than one
...
This may not seem like a big
difference, because instead of 3,791 we multiply with 4,169 ; this almost 0,4 difference can
be huge if your cash-flow is $1000000!
The future value for annuity due is smaller for the same reason
...

Please do not be mislead by the number of years on the timelines
...


Of course there is a short cut for calculating annuity due also
...
These equations are a direct result of what we have
discussed
...
This amount is 1, so that is why you add one at the end
...

Perpetuity
Perpetuity is a term for unlimited amounts of cash-flow
...
We use a very simple

equation, but I will not explain it because the mathematics behind it is quite complicated
...
What is the total worth of your prize if

the interest rate is

15%?

We can say that the prize is worth $133333,34 today
...
Again we will not discuss the
equation because the mathematical derivation is long and unimportant for our purpose
...

2
...
This risk is generally unavoidable because there is a
modicum of risk involved in any type of investment, even if it is extremely small
...
There are some
risks which cannot be solved through diversification, and these risks, known as market risks,
can only be lessened by hedging with contrasting investments
...
In reality though,
investment of any kind carries the risk that the capital at stake will either be lessened or lost

completely
...

Investors use many different means to attempt to lessen the portfolio risk that they must
incur
...
By doing this, the risk
that one or even a few securities will underperform is mitigated by the fact that there are
plenty of others in the portfolio to balance them out
...

Some risks are resistant to diversification tactics and they represent a different challenge for
an investor managing portfolio risk
...
For example, an
economy in recession will likely cause a broad range of securities to suffer, thus harming
even a diversified portfolio
...

It should be noted that a savvy investor is willing to accept a certain amount of portfolio risk
as a trade-off for the potential for high investment rewards
...
Investors seeking growth must be able to take on a little risk to get the kind of
returns they're seeking for their portfolio
...
Investors attempt to reduce this risk through diversification or
hedging (taking an offsetting position in a related security)
...
Systematic risk is risk that
impacts the overall market; for example, inflation, interest rate changes, or economic
conditions
...

Measuring Risk
Investors use standard deviation to measure the amount by which realized returns differ from
expected, or average, returns
...


Managing Risk
Systematic risk cannot be eliminated but can be managed by hedging with derivatives or
short selling
...

Diversification
Diversification entails investing in different asset classes, such as stocks, bonds, real estate,
and cash, and selecting securities with different characteristics, such as company size,
industry, country, or dividend policy
...
According to Brinson, Hood, and Beebower, asset allocation
explains 93
...

3
...
This is the system
used to calculate the amount of the home loan’s monthly payment will go towards the
principal balance of the loan and the amount that is going towards the interest
...
For the first few years of the
loan terms, it will be applied mostly towards the interest and later, when reaching the end of
the repayment period, it will go more towards the principal
...
Anybody wanting to get a
loan should understand how it is figured and how the process works so that there will be no
surprises later on
...
When you use this to help you
compare all the different loan options, you will see what your best option would be for you
...
e
...
Secondly, you
also pay down some of the loan that you took, i
...
, the repayment of the principal amount of
the loan
...
e
...
This process of paying down the loan is
referred to as Loan Amortization
...
As you amortize the loan, the total principal amount outstanding reduces with
every progressive EMI payment
...
The EMI amount stays the same but the mixture of
principal repayment and interest cost comprising the EMI changes
...
Krishna has took a home loan in 2010 with the
following details:


Principal loan amount: Rs 10 lakhs



Term period: 10 years



Rate of interest: 9%



EMI: Rs 12,668

During the early life of the loan, for his EMI payments, Krishna would pay more towards the
interest component, and a relatively smaller amount towards the principal repayment
...

The EMI payments are monthly, and so for a 10-year loan there will be 120 payments
...

Timing of
Interest
Principal (in
EMI (in
Loan Amt
+
=
Payment
(in Rs)
Rs)
Rs)
Outstanding (in Rs)
December 2010 7,057
+
5,611
= 12,668
9,34,180
December 2011 6,531
+
6,137
= 12,668
8,62,436
December 2012 5,955
+
6,713
= 12,668
7,84,235
December 2013 5,326
+
7,342
= 12,668
6,98,996
December 2014 4,637
+
8,031
= 12,668
6,06,086
December 2015 3,884
+
8,784
= 12,668
5,04,813
December 2016 3,060
+
9,608
= 12,668
3,94,427
December 2017 2,159
+
10,509
= 12,668
2,74,105
December 2018 1,173
+
11,495
= 12,668
1,42,954
December 2019
94
+
12,574
= 12,668
Nil
Note: The EMI shown are for the particular month, but the loan outstanding is the
balance at that point in time
...
At
the end of the 10-year tenure, the loan extinguishes itself because you have paid back your
entire debt through your recurring EMI
...


Fortunately, this is a calculation that almost any loan advisor can do for you
...

Why is this important?
The natural question for you to ask when you see the above table and graph is "its too
complicated, why do I need to know this?"
It's important for you to know this for three reasons:
1
...
Your ability to take on additional loans
depends upon what is the existing debt that you have outstanding and its only through
a loan amortization schedule that you can get this info
...
Decide when to pre-pay or refinance your loan: You might consider refinancing
your loan with another lender if you find your existing interest rate on the loan to be
high relative to what current interest rates might be
...
Also, once you factor in the
hidden costs, in the form of any refinancing penalty you might be charged, it probably
won't make economic sense to refinance
...

3
...
If you have your amortization schedule handy, you can
easily do some financial planning to efficiently plan your taxes for the coming years
...

How to Amortize a Loan
Amortization: Literally to "kill off" (root: mort) the outstanding balance of a loan by
making equal payments on a regular schedule (usually monthly)
...

A payments and amortization calculator is available (no charge, no registration) to help you
make quick calculations
...

To begin, here are the definitions of each of the variables used in the formula
...

J = monthly interest in decimal form = I / (12 x 100)
N = number of months over which loan is amortized = L x 12
The following assumes a typical conventional loan where the interest is compounded
monthly
...
Now take the inverse of that (if you have a 1/X button on
your calculator push that)
...


The formula above allows you to calculate the monthly payment, M
...


Step 1: Calculate H = P x J, this is your current monthly interest
Step 2: Calculate C = M - H, this is your monthly payment minus your monthly interest, so it
is the amount of principal you pay for that month
Step 3: Calculate Q = P - C, this is the new balance of your principal of your loan
...

4
...

Given an investment opportunity, a firm needs to decide whether undertaking the investment
will generate net economic profits or losses for the company
...
Next, all of the investment's future positive cash flows are reduced into one present
value number
...

When the exercise of capital budgeting is undertaken to calculate the cost of a project and its
estimated returns, two tool are most commonly used
...
When evaluating a project, it is generally assumed that higher
the value of these two parameters, the more profitable the investment is going to be
...
Net
present value goes down well with those who are laymen as it is expressed in units of
currency and as such preferred method for such purposes
...

IRR
To know whether a project is feasible in terms of returns on investment, a firm needs to
evaluate it with a process called capital budgeting and the tool which is commonly used for
the purpose is called IRR
...
As it is a rate that is in terms of percentage,

unless its value is positive any company should not proceed ahead with a project
...
This means that IRR is a parameter that can
be used to rank several projects that a company is envisaging
...
While it is only estimation, and the real
rates of return might be different, in general if a project has a higher IRR, it presents a chance
of higher growth for a company
...
It is the difference
between the values of cash inflow and cash outflow of any company at present
...
If this value is positive, the
project can be undertaken, but if it is negative, it is better to discard the project
...
For the same reason, NPV is the preferred choice to real estate dealers and
also for brokers in a stock market
...




While NPV is expressed in terms of a value in units of a currency, IRR is a rate that is
expressed in percentage which tells how much a company can expect to get in
percentage terms from a project down the years
...


Section B

Case let 1
This case provides the opportunity to match financing alternatives with the needs of
different companies
...
George Thomas was finishing some weekend reports on a Friday afternoon in the
downtown office of Wishart and Associates, an investment-banking firm
...
He was on a trip through
Pennsylvania, visiting five potential clients, who were considering the flotation of securities
with the assistance of Wishart and Associates
...

George was waiting for the cable
...
He
also knew Meenda wanted him to call each of the clients to consider the recommendations
over the weekend
...
At
4:00 p
...
a secretary handed George the following telegram
...
See you Wednesday STOP
Meenda
...
In the front of each folder
were some handwritten notes that Meenda had made on Monday before he left
...
APT, Inc needs $8 million now and $4 million in four years
...
Common stock trades over the
counter
...
Willing to accept any type
of security
...
Expects moderate growth
...
Recently retired $7 million in debt
...

Sandford Enterprises
Needs $16 million
...
Stock price depressed but expected to improve
...
Low debt-equity ratio, as the
firm has record of retiring debt prior to maturity
...
Management not interested in surrendering voting control to outsiders
...

Sharma Brothers
...


Needs $20 million to expand cabinet and woodworking business
...
Seeks
additional shareholder but not willing to stock at discount
...
Fair management
...
Very good earnings
...
Banks could be willing to lend money for long-term needs
...
Sound
growth company
...
Management would like to sell common
stock at $21 or more willing to use debt to raise $ 28 million, but this is second choice
...

Ranbaxy Industry
Needs $25 million
...

Needs long-term money
...
Cannot issue
debt without permission of bondholders and First National Bank of Philadelphia
...
Relatively high profits
...
As George was looking
over the folders, Meenda's secretary entered the office
...
Meenda called early this morning and said that he
verified the facts in the folders
...
George pondered over the situation
...
If he could
determine which firm matched each recommendation, he could still call the firms by 6:00
P
...
and meet the original deadline
...

Question:
1
...
What types of securities must be issued by a firm which is on the growing stage in order
to meet the financial requirements?

Case Let 1

Solution
1
...
It is not as if a firm must choose only one of the two type of sources of
finance
...

Also, usually every firm starts with financing from equity, and uses debt to supplement
equity, rather than replace equity
...

Then it is important to note that within the broad classification of equity and debt financing
many different alternative form of finance exist
...

The issue of equity shares also presents different choices such as form of company (private
limited, public limited, cooperative,, etc
...

Similarly debt financing can also take many forms such as supplier credit, short term bank
loans, long term loans from banks or other institutions, fixed deposits from the public, and
debentures
...
can go in for debt with warrants since it is nearly a zero debt company and is also
willing to accept any form of security
...
Its
future cash flows also suggest a strong capability to service future debt
...

can go in for issue of preferred stock considering that its fund requirements of $20 million
cannot be met by debt issue
...
Ranbaxy Industries can issue convertible bonds or
debt with warrant considering that it is averse to divesting management control
...
What types of securities must be issued by a firm which is on the growing stage in
order to meet the financial requirements?
Any firm can issue bonds, debentures or shares of it stock for accessing the funds it requires
...

In the case of bonds the company will have to pay a regular interest every year to its bond
holders and after a number of years specified when the bond is created will pay the bond
holders and buy back the bonds
...
Directly selling shares of its stock will dilute ownership but the company
does not have any further financial obligations
...
This would also be in line with the
potential risk appetite of the organization to sustain its growth and earn incremental returns
...
This would however
depend on the management philosophy of retaining or divesting management control
...
Cost of raising debt or equity
would be an important consideration in deciding the option
...
Perluence International is large manufacturer of petroleum and
rubber-based products used in a variety of commercial applications in the fields of
transportation, electronics, and heavy manufacturing
...
Operating from a headquarters and warehouse facility in San
Antonio, Strand Electronics has 950 employees and handles a volume of $85 million in
sales annually
...

Gupta is the credit manager at Bajaj electronics
...
The accounts range in size from $120
to $85,000
...
Sales fluctuate
seasonally and the average collection period tends to run 40 days
...
6 per cent of sales
...
, a
wholesale supply dealer serving the oil industry
...
Booth and has grown steadily since that time
...
Bajaj
Electronics purchased goods from Perluence International under the same terms and
conditions as Perluence used when it sold to independent customers
...
The
Perluence's cost-accounting department estimated a 24 per cent markup as the average for
items sold to Pucca Electronics
...
It appeared that these percentages would hold on any sales to Booth
Plastics
...
For example, the contact with Booth
Plastics had been made by James, the salesman who handled the Glaveston area
...
James would,
of course, be willing to assist in collecting any accounts that he had sold
...
As a general guideline, warehousing and other
administrative variable costs would run 3 per cent sales
...
First of all, he considered the potential
profit from the account
...

Assuming that Neck Booth took the, 3 per cent discount
...
If Neck Booth did not take the discount, the markup
would be slightly higher, as would the cost of financing the receivable for the additional
period of time
...
He knew that weak customers could become bad debts at
any time and therefore, required a vigorous collection effort whenever their accounts were
overdue
...
He also figured that overdue and
uncollected funds had to be financed by Bajaj Electronics at a rate of 18 per cent
...
With these
considerations in mind, Gupta began to review the credit application for Booth Plastics
...
How would you judge the potential profit of Bajaj Electronics on the first year of sales
to Booth Plastics and give your views to increase the profit
...
Suggestion regarding Credit limit
...

Case Let 2
Solution
1
...

This case has been framed in order to test the skills in evaluating a credit request and
reaching a correct decision
...
In the northwestern United States,
many of the Perluence products are marketed by a wholly-owned subsidiary, Bajaj
Electronics Company
...
About $6 million of the sales represents items manufactured by Perluence
...
He supervises five employees who handle credit
application and collections on 4,600 accounts
...
The firm sells on varied terms, with 2/10, net 30 mostly
...
Bad-debt losses are less than 0
...
Gupta is evaluating a credit application from Booth Plastics, Inc
...
The company was founded in 1977 by Neck A
...
Bajaj Electronics is not selling any products to Booth
Plastics and had no previous contact with Neck Booth
...
Although Bajaj Electronics generally followed Perluence in
setting its prices, the subsidiary operated independently and could adjust price levels to meet
its own marketing strategies
...
Bajaj Electronics, in turn,
resold the items to yield a 17 per cent markup
...
In addition to the
potential profit from the account, Gupta was concerned about his company's exposure
...
Suggestion regarding Credit limit
...

Every concept offers a leeway that people can take advantage of
...
This phenomenon gives rise to the biggest problem
associated with credit cards – bad debts
...
Although they gain financial flexibility through the credit concept, they lose the
flexibility of managing one's funds
...
A lot of people have experienced this the hard way
...
To ensure that you do not grapple with an incessantly climbing
credit card debt, you must follow a systematic credit management plan
...
It will, of course, lead to a handicap in terms of possessing a payment
alternative
...
Although an ‘only-cash' option can be a frightening thought, you must take this step
to ensure that you do not accumulate debts further
...
Prepare a table that
includes the owed amount, interest rate, minimum payment and the due date for each of your
credit cards
...
Once you have your
payment plan ready, develop strategies to reduce your debts methodically
...
High interest
can eat into your monthly payments by way of finance charges
...
Another alternative to
this is paying off the debts on cards with the least balances
...
Honey Well Company is contemplating to liberalize its collection effort
...
10 lakh, its average collection period is 30 days, its expected variable
cost to sales ratio is 85 percent and its bad debt ratio is 5 percent
...
He proposed liberalization in
collection effort increase sales to Rs
...
Determine the Change in net
profit
...

From this contribution of 15 percent all other expenses except the bad debt and cost of capital
tied up in receivable will change
...

Description
1
...
Contribution [15% 0f (1)]

Original Amount

Changed Amount

1,000,000

1,200,000

150,000

180,000

3
...
Cost of receivables [(3)*0
...
Cost of bad debts [(1)*%]

50,000

84,000

6
...
Balance Contribution (2) - (6)

91,781

81,206

We can see from above table that that the balance contribution available will decrease by Rs
...
91,781 to Rs
...
The profit before tax will also reduce by the same
amount
...
6345
2
...
What are the factors which influence the
working capital?
Answer
Introduction
Concept of Working Capital Management
There are two concepts of working capital viz
...
Some people also
define the two concepts as gross concept and net concept
...
What we call current assets?
Smith called, ‘circulating capital’
...

The qualitative concept gives an idea regarding source of financing capital
...
” L
...
Guthmann defined working capital as “the portion of a firm’s current
assets which are financed from long–term funds
...
In this
concept “Net working capital” represents the amount of current assets which would remain if
all current liabilities were paid
...
“If the objectives is to measure the size and extent to which current assets are
being used, ‘Gross concept’ is useful; whereas in evaluating the liquidity position of an
undertaking ‘Net concept’ becomes pertinent and preferable
...


Current assets
It is rightly observed that “Current assets have a short life span
...
e
...
The two important
characteristics of such assets are, (i) short life span, and (ii) swift transformation into other
form of assets
...
”
Fitzgerald defined current assets as, “cash and other assets which are expected to be
converted in to cash in the ordinary course of business within one year or within such longer
period as constitutes the normal operating cycle of a business
...
This liability is also known as accounts payable and shown in the
balance sheet till the payment has been made to the creditors
...
These can be defined as “those liabilities
where liquidation is reasonably expected to require the use of existing resources properly
classifiable as current assets, or the creation of other current assets, or the creation of other
current liabilities
...
’ “The use of the term
circulating capital instead of working capital indicates that its flow is circular in nature
...
“Working capital management is concerned with
problems that arise in attempting to manage the current assets, the current liabilities and the
inter-relationship that exist between them
...
”

Working Capital Meaning
Working capital is how much in liquid assets that a company has on hand
...

A lack of working capital makes it hard to attract investors or to get business loans or obtain
credit
...

Where Does Working Capital Come From?
From an accounting standpoint, working capital comes from:


Net income;



Long-term loans (non-current liabilities);



Sale of capital (non-current) assets; and



Funds contributed by the owners and investors (stockholders)
...
So no set
rule or formula can be framed
...
The data and
problem of each company should be analysed to determine the amount of working capital
...

Nature of business
Trading and industrial concerns require more funds for working capital
...
For example, if a concern is engaged in
electric supply, it will need less current assets, firstly due to cash nature of the transactions
and secondly due to sale of services
...
In addition
to it, the investment varies concern to concern, depending upon the size of business, the
nature of the product, and the production technique
...
But, if the
supply is seasonal or unpredictable, more funds will be invested in inventory
...

Production policy
In case of seasonal fluctuations in sales, production will fluctuate accordingly and ultimately
requirement of working capital will also fluctuate
...

Seasonal Operations
It is not always possible to shift the burden of production and sale to slack period
...

Credit Availability
If credit facility is available from banks and suppliers on favourable terms and conditions,
less working capital will be needed
...

Credit policy of enterprises
In some enterprises most of the sale is at cash and even it is received in advance while, in
other sales is at credit and payments are received only after a month or two
...
The credit terms depend largely on norms of
industry but enterprise some flexibility and discretion
...

Growth and expansion
The need of working capital is increasing with the growth and expansion of an enterprise
...
The critical fact, however, is that the need for increased working capital funds
does not follow growth in business activities but precedes it
...

Price level change
With the increase in price level more and more working capital will be needed for the same
magnitude of current assets
...


Circulation of working capital
Less working capital will be needed with the increase in circulation of working capital and
vice-versa
...
e
...

Volume of sale
This is directly indicated with working capital requirement, with the increase in sales more
working capital is needed for finished goods and debtors, its vice versa is also true
...
When working capital in
relation to sales is increased it will reduce risk and profitability on one side and will increase
liquidity on the other side
...

External Environment
With development of financial institutions, means of communication, transport facility, etc
...

*********



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