Master of Business Administration- MBA Semester 2 MB0045 – Financial Management - 4 Credits (Book ID: B1134) Assignment Set- 1 (60 Marks) Note: Each question carries 10 Marks. Answer all the questions. Q.1 Write the short notes on 5X2= (10 Marks) 1.

Financial ManagementFinancial Management is planning, directing, monitoring, organizing, and controlling ofthe monetary resources of an organization. The management of the finances of a business/ organization in order to achieve financial objectives. Financial Management is theefficient and effective planning and controlling of financial resources so as to maximizeprofitability and ensuring liquidity for an individual(called personal finance),government(called public finance) and for profit and non-profit organization/firm (calledcorporate or managerial finance). Generally, it involves balancing risks and profitability.The decision function of financial management can be divided into the following 3 majorareas:Investment Decision1.Determine the total amount of assets needed by a firm hence closely tied to theallocation of funds2.Two type of investment decisions namely:• Capital Investment decisions re: large sums, non routine, longer term, critical to thebusiness like purchase of plant and machinery or factory• Working Capital Investment decisions re: more routine in nature, short term but arealso very critical decisions like how much and how long to invest in inventories orreceivablesFinancing Decision1.After deciding on the amount and type of assets to buy, the financial managerneeds to decide on HOW TO FINANCE these assets with the sources of fund2.Financing decisions for example:• Whether to use external borrowings/debts or share capital or retained earnings• Whether to borrow short, medium or long term• What sort of mix – all borrowings or part debts part share capital or 100% sharecapital• The needs to determine how much dividend to pay out as this will directly affects thefinancial decision.- 1 -

MB0045-Financial Management2.Financial PlanningFinancial Planning is an exercise aimed to ensure availability of right amount of money atthe right time to meet the individual’s financial goalsConcept of Financial PlanningFinancial Goals refer to the dreams of the investor articulated in financial terms. Each

dream implies a purpose, and a schedule of funds requirements for realising the purposeAsset Allocation refers to the distribution of the investor’s wealth between different assetclasses (gold, property, equity, debt etc.)Portfolio Re-balancing is the process of changing the investor’s asset allocationRisk Tolerance / Risk Preference refers to the appetite of the investor for investment riskviz. risk of lossFinancial Plan Is a road map, a blue print that lists the investors’ financial goals andoutlines a strategy for realising themQuality of the Financial Plan is a function of how much information the prospect shares,which in turn depends on comfort that the planner inspires3.Capital StructureCapital structure of a firm is a reflection of the overall investment and financing strategyof the firm.Capital structure can be of various kinds as described below:• Horizontal capital structure: the firm has zero debt component in the structure mix.Expansion of the firm takes through equity or retained earnings only.• Vertical capital structure: the base of the structure is formed by a small amount ofequity share capital. This base serves as the foundation on which the super structureof preference share capital and debt is built.• Pyramid shaped capital structure: this has a large proportion consisting of equitycapita; and retained earnings.• Inverted pyramid shaped capital structure: this has a small component of equitycapital, reasonable level of retained earnings but an ever-increasing component ofdebt.- 2 -

MB0045-Financial ManagementSignificance Of Capital Structure:• Reflects the firm’s strategy• Indicator of the risk profile of the firm• Acts as a tax management tool• Helps to brighten the image of the firm.Factors Influencing Capital Structure:• Corporate strategy• Nature of the industry• Current and past capital structure4.Cost of CapitalCost of capital is the rate of return the firm requires from investment in order to increasethe value of the firm in the market place. In economic sense, it is the cost of raising fundsrequired to finance the proposed project, the borrowing rate of the firm. Thus undereconomic terms, the cost of capital may be defined as the weighted average cost of eachtype of capital.There are three basic aspects about the concept of cost1. It is not a cost as such: The cost of capital of a firm is the rate of return which itrequires on the projects. That is why; it is a ‘hurdle’ rate.

2. It is the minimum rate of return: A firm’s cost of capital represents the minimum rateof return which is required to maintain at least the market value of equity shares.3. It consists of three components. A firm’s cost of capital includes three componentsa. Return at Zero Risk Level: It relates to the expected rate of return when a projectinvolves no financial or business risks.b. Business Risk Premium: Business risk relates to the variability in operating profit(earnings before interest and taxes) by virtue of changes in sales. Business risk premiumis determined by the capital budgeting decisions for investment proposals.c. Financial Risk Premium: Financial risk relates to the pattern of capital structure (i.e.,debt-equity mix) of the firm, In general, a firm which has higher debt content in itscapital structure should have more risk than a firm which has comparatively low debtcontent. This is because the former should have a greater operating profit with a view tocovering the periodic interest payment and repayment of principal at the time of maturitythan the latter.- 3 -

MB0045-Financial Management5.Trading on EquityWhen a co. uses fixed interest bearing capital along with owned capital in raising finance,is said “Trading on Equity”.(Owned Capital = Equity Share Capital + Free Reserves )Trading on equity represents an arrangement under which a company uses funds carryingfixed interest or dividend in such a way as to increase the rate of return on equity shares.It is possible to raise the rate of dividend on equity capital only when the rate of intereston fixed – interest – bearing – security is less than the rate of return earned in business.Two other terms:• Trading on Thick Equity :- When borrowed capital is less than owned capital• Trading on Thin Equity :- When borrowed capital is more than owned capital, it iscalled Trading on thin Equity

Q.2 a. Write the features of interim divined and also write the factors (08 Marks) Influencing divined policy? 

Answer: a. Interim Dividend : A dividend which is declared anddistributed before the company's annual earnings have been calculated; often distributed quarterly. 

Usually, board of directors of company declares dividend in annual general meeting after finding the real net profit position. If boards of directors givedividend for current year before closing of that year, then it is called interimdividend. This dividend is declared between two annual general meetings. Before declaring interim dividend, board of directors should estimate the net profit which will be in future. They should also estimate the amount of reserves which will deduct from net profit in profit and loss appropriation account. If they think that it is sufficient for operating of business after declaring such dividend. They can issue but after completing the year, if profits are less than estimates, then they have to pay the amount of declared dividend. For this, they will have to take

loan. Therefore, it is the duty of directors to deliberate with financial consultant before taking this decision. Accounting treatment of interim dividend in final accounts of company :# First Case : Interim dividend is shown both in profit and loss appropriation account and balance sheet , if it is outside the trial balance in given question. ( a) It will go to debit side of profit and loss appropriation account (b) It will also go to current liabilities head in liabilities side. # Second Case: Interim dividend is shown only in profit and loss appropriation account, if it is shown in trial balance. 

( a) It will go only to debit side of profit and loss appropriation account. If in final declaration is given outside of trial balance and this will be proposeddividend and interim dividend in trial balance will be deducted for writingproposed dividend in profit and loss appropriation account and balance sheet of company, because if we will not deducted interim dividend, then it will be double deducted from net profit that is wrong and error shows when we will match balance sheets assets with liabilities. Usually, board of directors of company declares dividend in annual general meeting after finding the real net profit position. If boards of directors givedividend for current year before closing of that year, then it is called interimdividend. This dividend is declared between two annual general meetings. Before declaring interim dividend, board of directors should estimate the net profit which will be in future. They should also estimate the amount of reserves which will deduct from net profit in profit and loss appropriation account. If they think that it is sufficient for operating of business after declaring such dividend. They can issue but after completing the year, if profits are less than estimates, then they have to pay the amount of declared dividend. For this, they will have to take loan. Therefore, it is the duty of directors to deliberate with financial consultant before taking this decision. A number of considerations affect the dividend policy of company. The major factors are 1. Stability of Earnings. The nature of business has an important bearing on the dividend policy. Industrial units having stability of earnings may formulate a more consistent dividend policy than those having an uneven flow of incomes because they can predict easily their savings and earnings. Usually, enterprises dealing in necessities suffer less from oscillating earnings than those dealing in luxuries or fancy goods. 2. Age of corporation. Age of the corporation counts much in deciding thedividend policy. A newly established company may require much of its earnings for expansion and plant improvement and may adopt a rigiddividend policy while, on the other hand, an older company can formulate a clear cut and more consistent policy regarding dividend. 3. Liquidity of Funds. Availability of cash and sound financial position is also an important factor in dividend decisions. A dividend represents a cash outflow, the greater the funds and the liquidity of the firm the better the ability to pay dividend. The liquidity of a firm depends very much on the investment and financial decisions of the firm which in turn determines the rate of expansion and the manner of financing. If cash position is weak, stock dividend will be distributed and if cash position is good, company can distribute the cash dividend. 4. Extent of share Distribution. Nature of ownership also affects thedividend decisions. A closely held company is likely to get the assent of the shareholders for the suspension of dividend or for following a conservativedividend policy. On the other hand, a company having a good number of shareholders widely distributed and forming low or medium income group, would face a great difficulty in securing such assent because they will emphasise to distribute higher dividend. 5. Needs for Additional Capital. Companies retain a part of their profits for strengthening their financial position. The income may be conserved for meeting the increased requirements of working capital or of future expansion. Small companies usually find difficulties in raising finance for their needs of increased working capital for expansion programmes. They having no other alternative, use their ploughed back profits. Thus, such Companies distribute dividend at low rates and retain a big part of profits. 

6. Trade Cycles. Business cycles also exercise influence upon dividendPolicy. Dividend policy is adjusted according to the business oscillations. During the boom, prudent management creates food reserves for contingencies which follow the inflationary period. Higher rates of dividendcan be used as a tool for marketing the securities in an otherwisedepressed market. The financial solvency can be proved and maintained by the companies in dull years if the adequate reserves have been built up.7. Government Policies. The earnings capacity of the enterprise is widely affected by the change in fiscal, industrial, labour, control and othergovernment policies. Sometimes government restricts the distribution ofdividend beyond a certain percentage in a particular industry or in all spheres of business activity as was done in emergency. The dividend policy has to be modified or formulated accordingly in those enterprises. 8. Taxation Policy. High taxation reduces the earnings of he companies and consequently the rate of dividend is lowered down. Sometimes governmentlevies dividend-tax of distribution of dividend beyond a certain limit. It also affects the capital formation. N India, dividends beyond 10 % of paid-up capital are subject to dividend tax at 7.5 %. 9. Legal Requirements. In deciding on the dividend, the directors take the legal requirements too into consideration. In order to protect the interests of creditors an outsiders, the companies Act 1956 prescribes certain guidelines in respect of the distribution and payment of dividend. Moreover, a company is required to provide for depreciation on its fixed and tangible assets before declaring dividend on shares. It proposes that Dividend should not be distributed out of capita, in any case. Likewise, contractual obligation should also be fulfilled, for example, payment of dividend on preference shares in priority over ordinary dividend. 10. Past dividend Rates. While formulating the Dividend Policy, the directors must keep in mind the dividend paid in past years. The current rate should be around the average past rat. If it has been abnormally increased the shares will be subjected to speculation. In a new concern, the company should consider the dividend policy of the rival organisation. 11. Ability to Borrow. Well established and large firms have better access to the capital market than the new Companies and may borrow funds from the external sources if there arises any need. Such Companies may have a better dividend pay-out ratio. Whereas smaller firms have to depend on their internal sources and therefore they will have to built up good reserves by reducing the dividend pay out ratio for meeting any obligation requiring heavy funds. 12. Policy of Control. Policy of control is another determining factor is so far as dividends are concerned. If the directors want to have control on company, they would not like to add new shareholders and therefore, declare a dividend at low rate. Because by adding new shareholders they fear dilution of control and diversion of policies and programmes of the existing management. So they prefer to meet the needs through retained earing. If the directors do not bother about the control of affairs they will follow a liberal dividend policy. Thus control is an influencing factor in framing the dividend policy. 13. Repayments of Loan. A company having loan indebtedness are vowed to a high rate of retention earnings, unless one other arrangements are made for the redemption of debt on maturity. It will naturally lower down the rate of dividend. Sometimes, the lenders (mostly institutional lenders) put restrictions on the dividend distribution still such time their loan is outstanding. Formal loan contracts generally provide a certain standard of liquidity and solvency to be maintained. Management is bound to hour such restrictions and to limit the rate of dividend payout. 14. Time for Payment of Dividend. When should the dividend be paid is another consideration. Payment of dividend means outflow of cash. It is, therefore, desirable to distribute dividend at a time when is least needed by the company because there are peak times as well as lean periods of expenditure. Wise management should plan the payment of dividend in such a manner that there is no cash outflow at a time when the undertaking is already in need of urgent finances. 15. Regularity and stability in Dividend Payment. Dividends should be paid regularly because each investor is interested in the regular payment of dividend. The management should, inspite of regular payment of dividend, consider that the rate of dividend should be all the most constant. For this purpose sometimes companies maintain dividend equalization Fund.

b. What is reorder level ?

b. What is reorder level? (02Marks) 

Reorder Level

This is that level of materials at which a new order for supply of materials is to be placed.

In other words, at this level a purchase requisition is made out. This level is fixed

somewhere between maximum and minimum levels. Order points are based on usage

during time necessary to requisition order, and receive materials, plus an allowance for

protection against stock out.

The order point is reached when inventory on hand and quantities due in are equal to the

lead time usage quantity plus the safety stock quantity.

Formula of Re-order Level or Ordering Point:

The following two formulas are used for the calculation of reorder level or point.

Ordering point or re-order level = Maximum daily or weekly or monthly usage ×

Lead time

The above formula is used when usage and lead time are known with certainty; therefore,

no safety stock is provided. When safety stock is provided then the following formula

will be applicable:

Ordering point or re-order level = Maximum daily or weekly or monthly usage ×

Lead time + Safety stock

Q.3 Sales Rs.400, 000 less returns Rs 10, 000, Cost of Goods Sold Rs 300,000, Administration and selling expenses Rs.20, 000, Interest on loans Rs.5000, (10 Marks) Income tax Rs.10000, preference dividend Rs. 15,000, Equity Share Capital Rs.100, 000 @Rs. 10 per share. Find EPS. 

Q.3 Sales Rs.400, 000 less returns Rs 10, 000, Cost of Goods Sold Rs 300,000,

Administration and selling expenses Rs.20, 000, Interest on loans Rs.5000,

Income tax Rs.10000, preference dividend Rs. 15,000, Equity Share Capital

Rs.100, 000 @Rs. 10 per share. Find EPS.

Ans 3.

Sales

400,0

00

Less Returns

10,00

0

390,0

00

Less

COGS

30,00

0

S&A

20,00

0

Int on

Loan

5,000

IT

10,00

0

325,0

00

Div

15,00

0

ESC

100,0

00 @ 10/-

NPAT - Pref

Share Div

No of Shares

NPAT

55,00

0

less Pref Share

Div

15,00

0

40,00

0

EPS

40,00

0

=

Rs.4/-

10,00

0

Answer:Sales = Rs 400000 – 10000 = 390000Cost of goods = 300000+ 20000 + 5000 + 10000 + 15000 = 350000

Earning = 390000 – 350000 = 40000

Total share = 100000/10 = 10000

EPS = Earning / share = 40000/10000 = Rs4

Q.4 What are the techniques of evaluation of investment? (10 Marks) 

Answer:Steps involved in the evaluation of any investment proposal are: • Estimation of cash flows both inflows and outflows occurring at different stages of project life cycle • Examination of the risk profile of the project to be taken up and arriving at the required rate of return • Formulation of the decision criteria 

Estimation of cash flows Estimating the cash flows associated with the project under consideration is the most difficult and crucial step in the evaluation of an investment proposal. Estimation is the result of the team work of many professionals in an organisation. • Capital outlays are estimated by engineering departments after examining all aspects of production process • Marketing department on the basis of market survey forecasts the expected sales revenue during the period of accrual of benefits from project executions • Operating costs are estimated by cost accountants and production engineers • Incremental cash flows and cash out flow statement is prepared by the cost accountant on the basis of the details generated in the above steps 

The ability of the firm to forecast the cash flows with reasonable accuracy lies at the root of the success of the implementation of any capital expenditure decision. 

Estimation of incremental cash flows Investment (capital budgeting) decision requires the estimation of incremental cash flow stream over the life of the investment. Incremental cash flows are estimated on tax basis. Incremental cash flows stream of a capital expenditure decision has three components. Initial cash outlay (Initial investment) Initial cash outlay to be incurred is determined after considering any post tax cash inflows. In

replacement decisions existing old machinery is disposed of and a new machinery incorporating the latest technology is installed in its place. On disposal of existing old machinery the firm has a cash inflow. This cash inflow has to be computed on post tax basis. The net cash out flow (total cash required for investment in capital assets minus post tax cash inflow on disposal of the old machinery being replaced by a new one) therefore is the incremental cash outflow. Additional net working capital required on implementation of new project is to be added to initial investment. Operating cash inflows Operating cash inflows are estimated for the entire economic life of investment (project). Operating cash inflows constitute a stream of inflows and outflows over the life of the project. Here also incremental inflows and outflows attributable to operating activities are considered. Any savings in cost on installation of a new machinery in the place of the old machinery will have to be accounted on post tax basis. In this connection incremental cash flows refer to the change in cash flows on implementation of a new proposal over the existing positions. Terminal cash inflows At the end of the economic life of the project, the operating assets installed will be disposed off. It is normally known as salvage value of equipments. This terminal cash inflows are computed on post tax basis. Prof. Prasanna Chandra in his book Financial Management (Tata McGraw Hill, published in 2007) has identified certain basic principles of cash flow estimation. The knowledge of these principles will help a student in understanding the basics of computing incremental cash flows. 

The basic principles of cash flow estimation, by Prof. Prasanna Chandra, are (see figure) – Separation principle, Increment principle, Post-tax principle and Consistency principle. Principles of Prof. Prasanna Chandra Separation principle The essence of this principle is the necessity to treat investment element of the project separately (i.e. independently) from that of financing element. The financing cost is computed by the cost of capital. Cost of capital is the cut off rate and rate of return expected on implementation of the project. Therefore, we compute separately cost of funds for execution of project through the financing mode. The rate of return expected on implementation if the project is arrived at by the investment profile of the projects. Therefore, interest on debt is ignored while arriving at operating cash inflows. The following formula is used to calculate profit after tax Incremental PAT = Incremental EBIT ( 1-t ) (Incremental) (Incremental) EBIT = earnings (profit) before interest and taxes t = tax rate Incremental principle Incremental principle says that the cash flows of a project are to be considered in incremental terms. Incremental cash flows are the changes in the firms total cash flows arising directly from the implementation of the project. Keep the following in mind while determining incremental cash flows. Ignore sunk costs Sunk costs are costs that cannot be recovered once they have been incurred. Therefore, sunk costs are ignored when the decisions on project under consideration is to be taken. Opportunity costs If the firm already owns an asset or a resource which could be used in the execution of the project under consideration, the asset or resource has anopportunity cost. The opportunity cost of such resources will have to be taken into account in the evaluation of the project for acceptance or rejection. Need to take into account all incident effect Effects of a project on the working of other parts of a firm also known as externalities must be taken into account. Need to take into account all incident effect Effects of a project on the working of other parts of a firm also known as externalities must be taken into account. 

Cannibalisation Another problem that a firm faces on introduction of a new product is the reduction in the sale of an existing product. This is called cannibalisation. The most challenging task is the handling the problems of cannibalisation. Depending on the company’s position with that of the competitors in the market, appropriate strategy has to be followed. Correspondingly the cost of cannibalisation will have to be treated either as relevant cost of the decision or ignored. Depending on the company’s position with that of the competitors in the market, appropriate strategy has to be followed. Correspondingly the cost of cannibalisation will have to be treated either as relevant cost of the decision or ignored. Product cannibalisation will affect the company’s sales if the firm is marketing its products in a market characterised by severe competition, without any entry barriers. In this case costs are not relevant for decision. However, if the firm’s sales are not affected by competitor’s activities due to certain unique protection that it enjoys on account of brand positioning orpatent protection, the costs of cannibalisation cannot be ignored in taking decisions. Post tax principle All cash flows should be computed on post tax basis Consistency principle Cash flows and discount rates used in project evaluation need to be consistent with the investor group and inflation.

Q.5 What are the problems associated with inadequate working capital? (10 Marks) 

.5 What are the problems associated with inadequate working capital?Ans:Problems associated with inadequate working capitalWorking capital may be regarded as the life blood of business. Working capital is ofmajor importance to internal and external analysis because of its close relationship withthe current day-to-day operations of a business. Every business needs funds for twopurposes.• Long term funds are required to create production facilities through purchase of fixedassets such as plants, machineries, lands, buildings & etc• Short term funds are required for the purchase of raw materials, payment of wages,and other day-to-day expenses. . It is other wise known as revolving or circulatingcapitalIt is nothing but the difference between current assets and current liabilities. i.e.Workin gCapital = Current Asset – Current Liability.Businesses use capital for construction, renovation, furniture, software, equipment, ormachinery. It is also commonly used to purchase inventory, or to make payroll. Capital isalso used often by businesses to put a down payment down on a piece of commercial realestate. Working capital is essential for any business to succeed. It is becomingincreasingly important to have access to more working capital when we need it.Importance of Adequate Working CapitalA business firm must maintain an adequate level of working capital in order to run itsbusiness smoothly. It is worthy to note that both excessive and inadequate workingcapital positions are harmful. Working capital is just like the heart of business. If itbecomes weak, the business can hardly prosper and survive. No business can runsuccessfully without an adequate amount of working capital.Danger of inadequate working capitalWhen working capital is inadequate, a firm faces the following problems.- 11 -

Fixed Assets cannot efficiently and effectively be utilized on account of lack of sufficientworking capital. Low liquidity position may lead to liquidation of firm. When a firm isunable to meets its debts at maturity, there is an unsound position. Credit worthiness ofthe firm may be damaged because of lack of liquidity. Thus it will lose its reputation.There by, a firm may not be able to get credit facilities. It may not be able to takeadvantages of cash discount.Disadvantages of Redundant or Excessive Working Capital1. Excessive Working Capital means ideal funds which earn no profits for the businessand hence the business cannot earn a proper rate of return on its investments.2. When there is a redundant working capital, it may lead to unnecessary purchasing andAccumulation of inventories causing more chances of theft, waste and losses.3. Excessive working capital implies excessive debtors and defective credit policy whichMay cause higher incidence of bad debts.4. It may result into overall inefficiency in the organization.5. When there is excessive working capital, relations with banks and other financialinstitutions may not be maintained.6. Due to low rate of return on investments, the value of shares may also fall.7. The redundant working capital gives rise to speculative transactions.Disadvantages or Dangers of Inadequate Working Capital1. A concern which has inadequate working capital cannot pay its short-term liabilitiesin time. Thus, it will lose its reputation and shall not be able to get good credit facilities.2. It cannot buy its requirements in bulk and cannot avail of discounts, etc.3. It becomes difficult for the firm to exploit favorable market conditions and undertakeprofitable projects due to lack of working capital.4. The firm cannot pay day-to-day expenses of its operations and its createsinefficiencies, increases costs and reduces the profits of the business.5. It becomes impossible to utilize efficiently the fixed assets due to non-availability ofliquid funds.6. The rate of return on investments also falls with the shortage of working capital.Disadvantages or Dangers of Inadequate or Short Working Capital1.Can’t pay off its short-term liabilities in time.2.Economies of scale are not possible.3.Difficult for the firm to exploit favorable market situations4.Day-to-day liquidity worsens5.Improper utilization the fixed assets and ROA/ROI falls sharply

Q.6 What is leverage? Compare and Contrast between operating (10 Marks) Leverage and financial leverage 

Answer: Leverage is the influence of power to achieve something. The use of an asset or source of funds for which the company has to pay a fixed cost or fixed return is termed as leverage. Leverage is the influence of an independent financial variable on a dependent variable. It studies how the dependent variable responds to a particular change in independent variable. Operating leverage arises due to the presence of fixed operating expensesin the firm’s income flows. A company’s operating costs can be categorised into three main sections as shown in figure fixed costs, variable costs and semi-variable costs. 

Classification of operating costs • Fixed costs Fixed costs are those which do not vary with an increase in production or sales activities for a particular period of time. These are incurred irrespective of the income and value of sales and generally cannot be reduced. For example, consider that a firm named XYZ enterprises is planning tostart a new business. The main aspects that the firm should concentrate at are salaries to the employees, rents, insurance of the firm and the accountancy costs. All these aspects relate to or are referred to as ―fixed costs. • Variable costs Variable costs are those which vary in direct proportion to output and sales. An increase or decrease in production or sales activities will have a direct effect on such types of costs incurred. For example, we have discussed about fixed costs in the above context. Now, the firm has to concentrate on some other features like cost of labour, amount of raw material and the administrative expenses. All these features relate to or are referred to as ―Variable costs, as these costs are not fixed and keep changing depending upon the conditions. • Semi-variable costs Semi-variable costs are those which are partly fixed and partly variable in nature. These costs are typically of fixed nature up to a certain level beyond which they vary with the firm’s activities. For example, after considering both the fixed costs and the variable costs, the firm should concentrate on some-other features like production cost and the wages paid to the workers which act at some point of time as fixed costs and can also shift to variable costs. These features relate to or are referred to as ―Semi-variable costs. The operating leverage is the firm’s ability to use fixed operating costs to increase the effects of changes in sales on its earnings before interest and taxes (EBIT). Operating leverage occurs any time a firm has fixed costs. The percentage change in profits with a change in volume of sales is more than the percentage change in volume. As operating leverage can be favourable or unfavourable, high risks are attached to higher degrees of leverage. As DOL considers fixed expenses, a larger amount of these expenses increases the operating risks of the company and hence a higher degree of operating leverage. Higher operating risks can be taken when income levels of companies are rising and should not be ventured into when revenues move southwards. 

Financial Leverage Financial leverage as opposed to operating leverage relates to the financing activities of a firm and measures the effect of earnings before interest and tax (EBIT) on earnings per share (EPS) of the company. A company’s sources of funds fall under two categories – • Those which carry a fixed financial charges like debentures, bonds and preference shares and • Those which do not carry any fixed charges like equity shares Debentures and bonds carry a fixed rate of interest and have to be paid off irrespective of the firm’s revenues. Though dividends are not contractual obligations, dividend on preference shares is a fixed charge and should be paid off before equity shareholders are paid any. The equity holders are entitled to only the residual income of the firm after all prior obligations are met. Financial leverage refers to the mix of debt and equity in the capitalstructure of the firm. This results from the presence of fixed financial charges in the company’s income stream. Such expenses have

nothing to do with the firm’s performance and earnings and should be paid off regardless of the amount of earnings before income and tax (EBIT). It is the firm’s ability to use fixed financial charges to increase the effects of changes in EBIT on the EPS. It is the use of funds obtained at fixed costswhich increase the returns on shareholders. A company earning more by the use of assets funded by fixed sources is said to be having a favourable or positive leverage. Unfavourable leverage occurs when the firm is not earning sufficiently to cover the cost of funds. Financial leverage is also referred to as “Trading on Equity”. 

Q6. What is Leverage? Compare and contrast Financial and operating leverage.Ans:-‘Leverage’ is the action of a lever or the mechanical advantage gained by it; it alsomeans ‘effectiveness’ or ‘power’. The common interpretation of leverage is derived fromthe use or manipulation of a tool or device termed as lever, which provides a substantiveclue to the meaning and nature of financial leverage.When an organization is planning to raise its capital requirements (funds), these may beraised either by issuing debentures and securing long term loan 0r by issuing share-capital. Normally, a company is raising fund from both sources. When funds are raisedfrom debts, the Co. investors will pay interest, which is a definite liability of thecompany. Whether the company is earning profits or not, it has to pay interest on debts.But one benefit of raising funds from debt is that interest paid on debts is allowed asdeduction for income tax. ‘When funds are raised by issue of shares (equity) , theinvestor are paid dividend on their investment. Dividends are paid only when theCompany is having sufficient amount of profit. In case of loss, dividends are not paid.But dividend is not allowed as deduction while computing tax on the income of theCompany. In this way both way of raising funds are having some advantages anddisadvantages. A Company has to decide that what will be its mix of Debt and Equity,considering the liability, cost of funds and expected rate of return on investment of fund.A Company should take a proper decision about such mix, otherwise it will face manyfinancial problems. For the purpose of determination of mix of debt and equity, leveragesare calculated and analyzed.Concept of Financial LeverageLeverage may be defined as the employment of an asset or funds for which the firm paysa fixed cost or fixed return. The fixed cost or return may, therefore be thought of as thefull annum of a lever. Financial leverage implies the use of funds carrying fixedcommitment charge with the objective of increasing returns to equity shareholders.Financial leverage or leverage factor is defined, as the ratio of total value of debt to totalassets or the total value of the firm. For example, a firm having a total value of Rs.2,00,000 and a total debt of Rs. 1,00,000 would have a leverage factor of 50 percent.There are difficult measures of leverage such as.- 13 -

MB0045-Financial Managementi.The ratio of debt to total capitalii.The ratio of debt to equityiii.The ratio of net operating income (earning before interest and taxes) to fixed’

charges) The first two measures of leverage can be expressed either in book v8lue ormarket value the debt of equity ratio as a measure of financial leverage is more popular inpractice.“Risk & Financial Leverage:Effects of financial Leverage: The use of leverage results in two obvious effects:i.Increasing the shareholders earning under favorable economic conditions, andii.Increasing the financial risk of the firm. Suppose there are two companies eachhaving a Rs. 1,00,000 capital structure. One company has borrowed half of itsinvestment while the other company has only equity capital: Both earn Rs. 2,00,000profit. The ratio of interest on the borrowed capital is 10%and the rate of corporatetax 50%. Let us calculate the effect of financial leverage, both in the shareholdersearnings and the Company’s financial risk in these two companies.(a) Effect of Leverage on Shareholders Earnings:CompanyARs.CompanyBRs.Profit before Interest andTaxes2,00,000 2,00,000Equity10,00,0005,00,000Debt—-5,00,000Interest (10%)—-50,000Profit after interest butbefore Tax2,00,000 1,50,000Taxes @ 50%1,00,000 75,000Rate of return on Equity of Company A Rs. 1,00,000/Rs. 10,00,000 = 10%Rate of return on Equity of Company B Rs. 75,000/Rs. 5,00,000 = 15%The above illustration points to the favorable effect of the leverage factor on earnings ofshareholders. The concept of leverage is 5 if one can earn more on the borrowed moneythat it costs but detrimental to the man who fails to do so far there is such a thing as aMB0045-Financial Managementnegative leverage i.e. borrowing money at 10% to find that, it can earn 5%. The

difference comes out of the shareholders equity so leverage can be a double-edged sword.(b) Effect of Leverage on the financial risk of the company: Financial risk broadlydefined includes both the risk of possible insolvency and the changes in the earningsavailable to equity shareholders. How the leverage factor leads to the risk possibleinsolvency does is self-explanatory. As defined earlier the inclusion of more and moredebt in capital structure leads to increased fixed commitment charges on the part of thefirm as the firm continues to lever itself, the changes of cash insolvency leading’ to legalbankruptcy increase because the financial ‘charges incurred, by the firm exceed theexpected earnings. Obviously this leads to fluctuations in earnings’ available to the equityshareholders.Relationship: Financial and Operating leverage:Relationship between financial and operating leverage: In business terminology,leverage is used in two senses: Financial leverage & Operating LeverageFinancial leverage: The effect which the use of debt funds produces on returns is calledfinancial leverage.Operating leverage: Operating leverage refers to the use of fixed costs in the operationof the firm. A firm has a high degree of operating leverage if it employs a greater amountof fixed costs. The degree of operating leverage may be defined as the percentage changein profit resulting from a percentage change in sales. This can be expressed as:= Percent Change in Profit/Percent Change in SalesThe degree of financial leverage is defined as the percent change in earnings available tocommon shareholders that is associated with a given percentage change in EBIT. Thus,operating leverage affects EBIT while financial leverage affects earnings after interestand taxes the earnings available to equity shareholders. For this reason operating leverageis sometimes referred to as first stage leverage and financial leverage as second stageleverage. Therefore, if a firm uses a considerable amount of both operating leverage andfinancial leverage even small changes in the level of sales will produce wide fluctuationsin earnings per share (EPS). The combined effect of both these types of leverages is aftercalled total leverage which, is closely tied to the firm’s total risk

Master of Business Administration- MBA Semester 2 MB0045 – Financial Management - 4 Credits (Book ID: B1134) Assignment Set- 2 (60 Marks) Note: Each question carries 10 Marks. Answer all the questions. Q. 1 Discuss the three broad areas of Financial Decision Making (10 Marks) 

Q.2 What is the future value of an annuity and state the formulae for (10 Marks) future value of an annuity 

Q.3 The equity stock of ABC Ltd is currently selling for Rs 30 per share. The dividend expected next year is Rs 2.00. the investors required rate of return on this stock is 15 per cent. If the constant growth model applies to ABC Ltd, What is the expected growth rate? (10 Marks) 

Q.4 State the assumptions underlying the CAPM model and MM model (10 Marks) Q.5 Write the cash flow analysis? (10 Marks) 

Q.6 The following two projects A and B requires an investment of Rs 2, 00,000 each. The income returns after tax for these projects are as follows: (10 Marks) Year 

Project A  Project B 

1  Rs. 80,000  Rs. 20,000 

2  Rs. 80,000  Rs. 40,000 

3  Rs. 40,000  Rs. 40,000 

4  Rs. 20,000  Rs. 40,000 

5  Rs. 60,000 

6  Rs. 60,000