FFM 2022

(A) Choose the correct option (any five):

(a) Long term investment decision is also known as

✅(iii) Capital budgeting

(b) The overall cost of capital is also known as

✅(iii) Weighted average cost of capital

(c) Capital structure represents

✅(i) Ratio between different forms of capital

(d) The capitalization of profit is termed as

✅(iii) Stock dividend

(e) Key financial function of a firm includes the following, except

✅(iv) Make or buy decision

(f) According to which model dividend policy has no effect on the market price of the shares and
value of the firm?
✅(ii) M M model

(g) Capital budgeting deals with

✅(iii) Managing fixed assets

(h) Which is not payback method?

✅(iv) None of the above

(i) When should a project be accepted under profitability index (PI)?

✅(i) When PI > 1.0

(B) True or False

(a) Cost of retained earnings is less than cost of equity.

✅True

(b) Stable dividend does not mean a fixed dividend payout ratio.
✅True

(c) Every financial decision should be based on cost-benefit analysis.

✅True
(d) Working capital is also known as excess of current assets over current liabilities.
✅True

(e) Profitability index is the relationship between present value of cash inflows and the present
value of cash outflows.
✅True

(f) The cost of capital is the minimum rate of return expected by its investors.
✅True

(g) Stock dividend affects liquidity position of the company.

✅False

(h) Receivables constitute a significant portion of the fixed assets.

✅False

(i) Capital structure is the mix of preference and equity share capital.
✅False (It includes debt too)

(2) Short Answers (50 words each):

(a) Financing Decision:

It involves selecting the appropriate sources of funds (debt, equity, or hybrid instruments) and
determining the capital structure. The goal is to minimize the cost of capital and maximize
shareholder wealth.

(b) Permanent Working Capital:

This refers to the minimum level of current assets required to ensure uninterrupted operations. It
remains invested in current assets throughout the business cycle.

(c) Capital Structure:

It represents the mix of debt and equity used by a company to finance its operations and growth.
An optimal structure balances risk and cost of capital.

(d) Bond Dividend:

This refers to the payment of dividends in the form of bonds instead of cash. It is rare and usually
done to preserve cash while rewarding shareholders.

(e) Importance of Capital Budgeting:

 Helps evaluate long-term investment projects.

 Facilitates effective resource allocation to maximize profitability.
(f) Cash Management:
It involves planning and controlling cash inflows and outflows to ensure sufficient liquidity for
day-to-day operations and to avoid cash shortages or surpluses.

(g) Payback Period:

It is the time required to recover the initial investment in a project from the net cash inflows. It is
a simple and widely used method for project appraisal.

(h) Cost of Capital:

It is the minimum rate of return required by investors to compensate for the risk of investing
capital. It acts as a benchmark for evaluating investment projects.

(i) Accounting Rate of Return (ARR):

ARR is the ratio of average annual accounting profit to initial investment. It reflects the
profitability of an investment based on accounting data.

(j) Objectives of Receivable Management:

 To reduce bad debts and ensure timely collections.

 To maintain an optimal level of trade credit for improving sales and liquidity.

3. Answer any four of the following questions in about 150 words each:

(a) Briefly explain the sources of long-term financing.

Long-term financing provides funds for more than one year and is crucial for capital
expenditures and business expansion. Major sources include:

1. Equity Shares: Permanent capital raised from shareholders. It involves no repayment

obligation but dilutes ownership.
2. Preference Shares: Hybrid securities offering fixed dividends and preferential claims
over equity in liquidation.
3. Debentures/Bonds: Debt instruments with fixed interest, used widely due to tax benefits
on interest.
4. Term Loans: Loans from banks/financial institutions repayable over a fixed term, often
with collateral.
5. Retained Earnings: Internal source generated from business profits, involves no cost or
dilution of control.
6. Leasing and Hire Purchase: Asset financing methods where ownership may or may not
transfer.
7. Public Deposits: Funds from the public for a fixed term, used by established companies.

Each source has different implications on cost, control, and risk, and should be chosen based on
the company’s needs and financial structure.
(b) Write a brief note on valuation of securities.

Valuation of securities is the process of determining the fair value of financial instruments like
shares, debentures, and bonds. It is essential for investment decisions, mergers, acquisitions, and
financial reporting.

 Equity Shares: Valued using Dividend Discount Model (DDM), Price-Earnings Ratio, or
Net Asset Value. DDM considers future dividends discounted to present value.
 Preference Shares: Valued based on fixed dividend payments using present value of
perpetuity or annuity.
 Debentures/Bonds: Valued using Net Present Value of future interest payments and
redemption value, discounted at the required rate of return.

Valuation helps assess risk and return, compare investment opportunities, and support fair
market pricing. Market conditions, investor expectations, and company fundamentals influence
valuations.

(c) Discuss five factors determining working capital requirements.

1. Nature of Business: Manufacturing firms need more working capital than service firms
due to higher inventory needs.
2. Production Cycle: Longer cycles require higher investment in raw materials and WIP,
increasing working capital needs.
3. Credit Policy: Liberal credit increases receivables, thereby increasing working capital
requirements.
4. Seasonal Requirements: Businesses with seasonal sales require additional working
capital during peak seasons.
5. Operating Efficiency: Efficient inventory and receivables management reduces working
capital needs.

Other factors include growth plans, availability of credit, inflation, and market competition. An
optimal level ensures liquidity without locking excessive funds.

(d) Write the different types of dividend policies.

1. Stable Dividend Policy: Company pays a fixed or gradually increasing dividend. Builds
investor confidence.
2. Constant Payout Ratio: Dividends are a fixed percentage of earnings. Varies with
profits.
 3. Residual Dividend Policy: Dividends are paid from residual profits after all investment
needs are met.
4. Irregular Dividend Policy: Dividends are paid only when the company has sufficient
earnings or cash.
5. No Dividend Policy: Retains all profits for growth, common in early-stage or high-
growth companies.

The choice depends on earnings stability, cash flow, investment opportunities, and shareholder
expectations.

(e) What is IRR method of capital budgeting? Mention two advantages and two
limitations of this method.

IRR (Internal Rate of Return) is the discount rate at which the Net Present Value (NPV) of a
project becomes zero. It reflects the expected rate of return from a project.

Advantages:

1. Considers time value of money.

2. Helps in ranking projects based on profitability.

Limitations:

1. May give multiple IRRs for non-conventional cash flows.

2. Assumes reinvestment at IRR, which may not be realistic.

Despite limitations, IRR is a popular method for comparing investment projects.

(f) Why is wealth maximization objective considered superior to profit

maximization? Write five reasons.

1. Focus on Long-Term Growth: Wealth maximization considers the future value of cash
flows, unlike short-term profits.
2. Time Value of Money: It recognizes that money today is more valuable than in the
future.
3. Risk Consideration: Adjusts for risk in investment and financing decisions.
4. Shareholder Interest: Aligns with shareholder value creation, not just accounting profit.
5. Comprehensive Approach: Considers cash flows, investment decisions, and cost of
capital.

Profit maximization ignores these aspects, potentially leading to poor financial decisions.
(g) State the limitation of financial management.

1. Dependence on Estimates: Many decisions rely on future estimates that may be

uncertain.
2. Lack of Coordination: Poor integration with other departments may hinder financial
effectiveness.
3. Changing Market Conditions: Fluctuating interest rates, policies, and competition
affect decisions.
4. Time-Consuming: Financial analysis and planning can be complex and slow down
decision-making.
5. Conflict of Objectives: Balancing shareholder, management, and other stakeholder
interests can be challenging.

(h) Explain the significance of cost of capital.

Cost of capital represents the minimum return a firm must earn on investments to satisfy its
investors. It serves as a benchmark for:

1. Investment Decisions: Helps evaluate whether projects add value.

2. Capital Structure Decisions: Influences the mix of debt and equity financing.
3. Valuation: Used to discount future cash flows to calculate enterprise value.
4. Performance Appraisal: Acts as a hurdle rate for comparing returns.
5. Shareholder Value Maximization: Ensures only value-adding projects are undertaken.

A lower cost of capital improves profitability and competitive advantage.

(a) What is Capital Asset Pricing Model (CAPM)? Discuss the various
assumptions and elements of CAPM.

Definition of CAPM (2 marks):

The Capital Asset Pricing Model (CAPM) is a financial model that determines the expected
return on an investment based on its systematic risk. It establishes a relationship between
expected return and beta (β), which measures the asset’s sensitivity to market movements. The
CAPM formula is:

Expected Return (R)=Rf+β(Rm−Rf)\text{Expected Return (R)} = R_f + \beta (R_m -

R_f)Expected Return (R)=Rf+β(Rm−Rf)
Where:

 RfR_fRf = Risk-free rate

 RmR_mRm = Expected market return
 Rm−RfR_m - R_fRm−Rf = Market risk premium
 β\betaβ = Beta of the security

The CAPM helps investors assess whether an investment is fairly valued given its risk relative to
the market.

Assumptions of CAPM (4 marks):

1. Efficient Market: All investors have equal access to information and securities are fairly
priced. There are no undervalued or overvalued stocks in the long run.
2. Risk-averse Investors: Investors prefer less risk and require higher returns for taking
additional risk.
3. Single-period Transaction Horizon: All investors make decisions for the same time
horizon (usually one period).
4. No Taxes or Transaction Costs: There are no personal income taxes or brokerage costs;
hence, capital gains and income returns are treated equally.
5. Homogeneous Expectations: All investors have the same expectations regarding returns,
variance, and correlation of all assets.
6. Unlimited Lending and Borrowing at Risk-free Rate: Investors can borrow or lend
unlimited amounts at a constant risk-free rate.
7. Perfect Divisibility of Assets: Securities can be bought or sold in any fraction, making
portfolio customization easier.

These assumptions help create a simplified model but also highlight the limitations of CAPM in
real-world applications.

Elements of CAPM (4 marks):

1. Risk-free Rate (RfR_fRf):

This is the return expected from an absolutely risk-free investment, typically government
securities like treasury bills. It acts as a baseline return for all investments.
2. Beta Coefficient (β):
Beta measures a security’s volatility compared to the market. A beta of 1 means the asset
moves with the market, while:
o β > 1 = More volatile (e.g., aggressive stocks)
o β < 1 = Less volatile (e.g., defensive stocks)
o β = 0 = No market risk (e.g., treasury bills)
 3. Market Risk Premium (Rm−RfR_m - R_fRm−Rf):
This is the excess return the market is expected to provide over the risk-free rate. It
reflects the additional return investors demand for taking on market risk.
4. Expected Return (R):
The main output of the CAPM. It tells the investor whether an asset is underpriced or
overpriced. If an asset’s actual return is greater than CAPM’s expected return, it is
considered undervalued and worth investing in.

Significance of CAPM:

 Helps in pricing risky securities.

 Assists investors in decision-making related to asset allocation.
 Useful in portfolio management and performance appraisal.
 Widely applied in calculating the cost of equity in capital budgeting and project
appraisal.

Criticisms of CAPM:

 Based on unrealistic assumptions like perfect markets and unlimited borrowing at a risk-
free rate.
 Beta is not a perfect measure of risk; it only considers systematic risk, ignoring firm-
specific risks.
 Empirical studies show that CAPM predictions sometimes deviate from actual returns.

Conclusion:
Despite its limitations, CAPM remains a foundational concept in modern finance. It provides a
systematic approach to link risk with return, helping both investors and financial managers in
evaluating investment opportunities and making rational decisions.

b) Discuss the Role and Responsibilities of a Finance Manager in Modern

Business Organization.

(10 marks)

The role of a finance manager in a modern business organization is critical for ensuring
financial health, stability, and growth. With increasing complexities in the global business
environment, the finance manager’s role has evolved from mere record-keeping to strategic
decision-making.
1. Financial Planning and Forecasting:

A finance manager is responsible for preparing the financial roadmap of the company. This
includes forecasting revenue, estimating costs, determining capital needs, and ensuring that the
firm has enough funds to meet both short-term and long-term obligations. Accurate financial
planning helps avoid liquidity crises and ensures smooth business operations.

2. Investment Decision-Making:

One of the core functions of a finance manager is to allocate capital to projects that maximize
shareholder value. This involves evaluating investment opportunities using capital budgeting
techniques like Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period.
The manager must ensure that resources are deployed in a way that ensures optimal returns with
acceptable levels of risk.

3. Financing Decisions:

The finance manager decides the best mix of debt and equity to finance the company's operations
(capital structure). The decision must balance the cost of capital, risk, and return. Choosing
between internal financing (retained earnings), debt (loans, debentures), and equity (issuing
shares) is a strategic responsibility requiring deep financial acumen.

4. Dividend Policy Decisions:

Determining how much profit should be distributed as dividends and how much should be
retained for reinvestment is another key function. The finance manager must design a dividend
policy that satisfies shareholders while ensuring sufficient reinvestment for future growth. This
includes considering factors such as earnings stability, growth prospects, liquidity, and
shareholder expectations.

5. Working Capital Management:

Effective management of working capital—current assets and current liabilities—is crucial for
day-to-day operations. A finance manager ensures adequate liquidity by managing inventory,
receivables, and payables efficiently. Poor working capital management can disrupt business
activities and increase borrowing costs.
6. Cost Control and Profitability Monitoring:

The finance manager plays an important role in budgeting and controlling costs. By tracking
expenses and comparing them with budgets, the manager helps maintain profitability. They also
analyze cost behavior and profitability margins to guide the management in price setting and
expense control.

7. Risk Management:

Modern financial environments are exposed to various types of risks—market risk, credit risk,
interest rate risk, and operational risk. A finance manager is expected to identify these risks and
formulate strategies to mitigate them through insurance, diversification, hedging, and proper
internal controls.

8. Financial Reporting and Compliance:

The finance manager ensures that all financial statements are accurate, timely, and comply with
legal and regulatory requirements. They must ensure adherence to accounting standards, tax
laws, and corporate governance norms. This includes interaction with auditors, regulators, and
tax authorities.

9. Strategic Decision Support:

Today, finance managers are strategic partners in the organization. They provide data-driven
insights for strategic decisions like mergers and acquisitions, business expansion, cost reduction
strategies, and financial restructuring. Their analytical input helps top management in making
informed, goal-aligned decisions.

10. Technological Integration:

With the emergence of financial technologies, automation, and data analytics, finance managers
must be adept at using ERP systems, financial modeling software, and business intelligence
tools. These tools improve the accuracy of financial decisions and provide real-time insights.

Conclusion:
The finance manager is no longer just a custodian of funds, but a strategic leader in the
business. Their multidimensional role spans planning, decision-making, compliance, risk
management, and strategic growth. In today’s dynamic environment, their expertise is critical
for navigating financial complexities and achieving sustainable organizational success.

(c) Sunrise Enterprise is considering two mutually exclusive projects.

Cash Flows (Rs.):

Year Project A Project B

1 40,000 10,000

2 30,000 20,000

3 20,000 30,000

4 10,000 40,000

Cost of capital = 12%

PV factors @ 12%:
Year 1: 0.892, Year 2: 0.797, Year 3: 0.711, Year 4: 0.635

(i) Payback Period

The payback period is the time taken to recover the original investment.

Let’s assume the initial investment is ₹1,00,000 for both projects.

Project A:
Year Cash Inflow Cumulative Inflow

1 40,000 40,000

2 30,000 70,000

3 20,000 90,000

4 10,000 1,00,000
→ Payback period = 4 years (Investment recovered exactly by the end of year 4)

Project B:
Year Cash Inflow Cumulative Inflow

1 10,000 10,000

2 20,000 30,000

3 30,000 60,000

4 40,000 1,00,000

→ Payback period = 4 years

(ii) Net Present Value (NPV)

NPV=∑(Cash Inflow(1+r)t)−Initial Investment\text{NPV} = \sum \left( \frac{\text{Cash Inflow}}{(1 + r)^t}

\right) - \text{Initial Investment}NPV=∑((1+r)tCash Inflow)−Initial Investment

Where r = 12%, initial investment = ₹1,00,000

Project A:
NPVA=(40,000×0.892)+(30,000×0.797)+(20,000×0.711)+(10,000×0.635)−1,00,000\text{NPV}_A = (40,000
\times 0.892) + (30,000 \times 0.797) + (20,000 \times 0.711) + (10,000 \times 0.635) - 1,00,000NPVA
=(40,000×0.892)+(30,000×0.797)+(20,000×0.711)+(10,000×0.635)−1,00,000
=35,680+23,910+14,220+6,350−1,00,000=80,160−1,00,000=−₹19,840= 35,680 + 23,910 + 14,220 + 6,350
- 1,00,000 = 80,160 - 1,00,000 = \mathbf{-
₹19,840}=35,680+23,910+14,220+6,350−1,00,000=80,160−1,00,000=−₹19,840

Project B:
NPVB=(10,000×0.892)+(20,000×0.797)+(30,000×0.711)+(40,000×0.635)−1,00,000\text{NPV}_B = (10,000
\times 0.892) + (20,000 \times 0.797) + (30,000 \times 0.711) + (40,000 \times 0.635) - 1,00,000NPVB
=(10,000×0.892)+(20,000×0.797)+(30,000×0.711)+(40,000×0.635)−1,00,000
=8,920+15,940+21,330+25,400−1,00,000=71,590−1,00,000=−₹28,410= 8,920 + 15,940 + 21,330 + 25,400
- 1,00,000 = 71,590 - 1,00,000 = \mathbf{-
₹28,410}=8,920+15,940+21,330+25,400−1,00,000=71,590−1,00,000=−₹28,410

Ranking of Projects:

Criteria Project A Project B Better

Payback Period 4 years 4 years Same

NPV -₹19,840 -₹28,410 A

Conclusion:

 Both projects have the same payback period (4 years), but payback does not consider
time value of money.
 Project A has a higher NPV (less negative), making it the better financial choice.
 Recommendation: Even though both projects yield a negative NPV (suggesting rejection
if independent), if the company must choose one, Project A is preferred due to the
lower loss in value.

(d) Radha & Company issues 10,000 preference shares at 10% and face value of
the share is Rs. 100 each. The cost of issue is Rs. 2 per share.

We need to calculate the cost of preference share capital (Kp) under two situations:

 (i) Issued at a premium of 10%

 (ii) Issued at a discount of 5%

Formula:

Kp=DP0−FK_p = \frac{D}{P_0 - F}Kp=P0−FD

Where:

 KpK_pKp = Cost of preference share capital

 DDD = Annual dividend
 P0P_0P0 = Issue price of share (after premium/discount)
 FFF = Floatation cost per share
Given:

 Face value of preference share = ₹100

 Dividend rate = 10% → Annual Dividend (D) = ₹10 per share
 Number of shares = 10,000
 Floatation cost = ₹2 per share

(i) When issued at a premium of 10%

 Premium = 10% of ₹100 = ₹10

 Issue price (P₀) = ₹100 + ₹10 = ₹110
 Net proceeds = P₀ − F = ₹110 − ₹2 = ₹108

Kp=10108=0.0926 or 9.26%K_p = \frac{10}{108} = 0.0926 \text{ or } \boxed{9.26\%}Kp

=10810=0.0926 or 9.26%

(ii) When issued at a discount of 5%

 Discount = 5% of ₹100 = ₹5
 Issue price (P₀) = ₹100 − ₹5 = ₹95
 Net proceeds = P₀ − F = ₹95 − ₹2 = ₹93

Kp=1093=0.1075 or 10.75%K_p = \frac{10}{93} = 0.1075 \text{ or } \boxed{10.75\%}Kp

=9310=0.1075 or 10.75%

Conclusion:

Scenario Cost of Preference Capital (Kp)

Issued at 10% Premium 9.26%
Issued at 5% Discount 10.75%

 Issuing shares at a premium reduces the cost of capital.

 Issuing shares at a discount increases the cost of capital.
 This is because investors require the same dividend while the company receives a lower
or higher net amount depending on issue price.

(e) What is a Dividend? Discuss the important factors which determine the
dividend policy of a company.
What is a Dividend?

A dividend is the portion of a company's earnings that is distributed to shareholders as a return

on their investment. It is usually paid in the form of cash or additional shares (stock dividend).
Dividends are typically declared by the board of directors and can be paid periodically
(quarterly, semi-annually, or annually).

Dividends serve as a source of income for investors and reflect the company’s profitability and
financial health. However, not all profits are distributed—some are retained for reinvestment and
future growth.

Factors Determining Dividend Policy

The dividend policy refers to the strategy a company uses to decide how much profit it will
return to shareholders versus how much it will retain. Several internal and external factors
influence this policy:

1. Stability of Earnings

Companies with stable and predictable earnings are more likely to offer regular dividends.
Firms in cyclical industries (e.g., automobiles, construction) may avoid high or consistent
dividends due to fluctuating profits.

2. Liquidity Position of the Company

Even if a firm is profitable, it may not be able to pay dividends unless it has sufficient liquid
cash. Dividends are paid in cash, so strong cash flows are essential for consistent dividend
payments.

3. Growth and Expansion Plans

Firms with aggressive expansion strategies often prefer to retain earnings to finance new
projects instead of paying dividends. Such firms typically offer lower or no dividends.
4. Access to Capital Markets

If a firm has easy access to external financing (like issuing shares or bonds), it can afford to
pay higher dividends. However, firms with limited access may retain profits to meet future
capital needs.

5. Legal and Contractual Constraints

Legal provisions under the Companies Act or loan agreements with financial institutions may
restrict dividend payments. For instance, some lenders impose conditions like maintaining
certain reserves before paying dividends.

6. Tax Considerations

Dividend income is often taxable in the hands of shareholders. In contrast, capital gains
(resulting from retained earnings leading to share price appreciation) may be taxed differently or
at lower rates. These tax implications can influence the company's decision to retain or distribute
profits.

7. Shareholder Preferences

If a majority of shareholders prefer regular income, the firm may adopt a stable dividend
policy. However, growth-oriented shareholders may prefer capital appreciation, leading the
firm to retain more earnings.

8. Past Dividend Policy

Companies generally follow a consistent dividend policy to build investor trust. Sudden
changes (especially reduction) may negatively affect share prices. Firms hesitate to increase
dividends unless they are confident in maintaining the level.

9. Control Considerations

Retaining earnings avoids issuing new equity and diluting existing ownership. Promoters often
prefer retained earnings to maintain control of the business.
10. Inflation

In an inflationary environment, companies may need to retain more earnings to maintain the
real value of capital. This reduces the funds available for dividend distribution.

Conclusion

Dividend policy is a strategic financial decision that balances the expectations of shareholders
and the long-term interests of the company. An optimal dividend policy considers profitability,
liquidity, growth opportunities, shareholder expectations, and market conditions. A well-
formulated and consistent policy enhances shareholder satisfaction and builds investor
confidence in the company.

(f) Discuss the disadvantages of excessive working capital and dangers of

inadequate working capital.

(5 marks + 5 marks = 10 marks)

Meaning of Working Capital

Working capital refers to the difference between current assets and current liabilities. It is the
capital used in day-to-day business operations to finance activities such as purchasing raw
materials, paying wages, and managing inventories.

Working Capital=Current Assets−Current Liabilities\text{Working Capital} = \text{Current Assets} -

\text{Current Liabilities}Working Capital=Current Assets−Current Liabilities

An optimal level of working capital is essential for smooth business functioning. Both
excessive and inadequate working capital can cause serious financial problems.

A. Disadvantages of Excessive Working Capital

Excessive working capital means a very high amount of current assets, especially in cash,
inventory, or receivables. Though it might seem like a good position, it leads to inefficiency and
loss of profitability. The key disadvantages include:

1. Inefficient Utilization of Funds

Excess funds tied up in current assets do not earn a proper return. Idle cash, overstocked
inventory, or delayed receivables reduce the return on investment.

2. Lower Profitability

When a company holds excess inventory or gives extended credit to customers, the carrying
cost of inventory increases and interest income is lost, resulting in lower overall profits.

3. Increased Operating Costs

Higher working capital often leads to increased storage costs, insurance, and administrative
expenses. This increases the overall cost of operations without contributing to productivity.

4. Increased Risk of Wastage and Obsolescence

Overstocking of raw materials or finished goods may result in spoilage, damage, or

obsolescence, especially in industries with short product life cycles.

5. Reduced Financial Discipline

Too much working capital may result in laxity in credit control, overstaffing, and inefficient
management, as there’s no pressure to control costs and maintain efficiency.

B. Dangers of Inadequate Working Capital

Inadequate working capital means current liabilities exceed current assets, and the company
struggles to meet its short-term obligations. This situation is far more dangerous than having
excessive working capital. Key dangers include:

1. Difficulty in Meeting Day-to-Day Expenses

Without adequate cash or liquid assets, the company may fail to pay salaries, creditors, and
utility bills, which disrupts day-to-day operations.
2. Loss of Business Reputation

Inability to pay suppliers on time may damage the firm’s credit rating, leading to loss of trust
and higher credit costs or refusal of further credit.

3. Interrupted Production

Lack of funds may delay the purchase of raw materials and payment of wages, which can halt
production, leading to loss of revenue and customers.

4. Inability to Avail Discounts

Firms with cash shortages cannot take advantage of cash discounts on early payments, resulting
in higher operating costs.

5. Higher Dependence on Costly Borrowings

To manage short-term obligations, the firm may depend on costly bank overdrafts or loans,
increasing interest expenses and reducing net profit.

6. Risk of Insolvency and Bankruptcy

Persistent working capital deficiency can lead to a liquidity crisis, making the firm insolvent or
bankrupt, especially if it cannot raise emergency funds.

Conclusion

Maintaining an optimal level of working capital is crucial for the financial health of a company.
While excessive working capital leads to inefficiency and low returns, inadequate working
capital results in operational difficulties and increased risk of insolvency. A balanced working
capital policy ensures profitability, liquidity, and sustainability.
(g) Explain the relationship between operating leverage and financial leverage.

1. Introduction to Leverage

Leverage refers to the use of fixed costs to magnify the returns or losses of a business. It helps in
assessing how sensitive a company's earnings are to changes in sales or financing structure.
There are two main types of leverage:

 Operating Leverage
 Financial Leverage

Both forms of leverage affect a company’s earnings per share (EPS) and risk profile, but in
different ways.

2. Operating Leverage

Operating leverage arises from the presence of fixed operating costs (like rent, depreciation,
and salaries) in the cost structure of a business. It measures how a change in sales will affect
operating profit (EBIT).

Formula:
Degree of Operating Leverage (DOL)=% change in EBIT% change in Sales\text{Degree of Operating
Leverage (DOL)} = \frac{\% \text{ change in EBIT}}{\% \text{ change in
Sales}}Degree of Operating Leverage (DOL)=% change in Sales% change in EBIT

High Operating Leverage:

 Indicates a high proportion of fixed costs.

 A small change in sales results in a large change in EBIT.
 Suitable for firms with predictable and growing sales.

Low Operating Leverage:

 Indicates a high proportion of variable costs.

 Business is less risky but also less responsive to sales growth.

3. Financial Leverage
Financial leverage arises from the use of fixed financial costs such as interest on debt or
preference dividends. It measures how a change in operating profit (EBIT) affects the earnings
per share (EPS).

Formula:
Degree of Financial Leverage (DFL)=% change in EPS% change in EBIT\text{Degree of Financial Leverage
(DFL)} = \frac{\% \text{ change in EPS}}{\% \text{ change in
EBIT}}Degree of Financial Leverage (DFL)=% change in EBIT% change in EPS

High Financial Leverage:

 Indicates higher debt and fixed financial obligations.

 Enhances returns during good times but increases the risk of loss during downturns.

Low Financial Leverage:

 Indicates less dependence on debt.

 Lower financial risk, but also lower enhancement of returns.

4. Combined or Total Leverage

This refers to the combined effect of operating and financial leverage on EPS due to a change
in sales.

Formula:
Degree of Combined Leverage (DCL)=DOL×DFL\text{Degree of Combined Leverage (DCL)} = DOL \times
DFLDegree of Combined Leverage (DCL)=DOL×DFL

It shows how a percentage change in sales affects EPS.

5. Relationship Between Operating and Financial Leverage

Basis Operating Leverage Financial Leverage

Nature of Cost Fixed operating costs Fixed financial costs

Affects EBIT (Operating Income) EPS (Earnings per Share)

Production and sales

Decision Area Capital structure/financing decisions
management
 Basis Operating Leverage Financial Leverage

Risk Type Business risk Financial risk

High Level
Sensitive EBIT to changes in sales Sensitive EPS to changes in EBIT
Implication

Suitable when firm has stable and predictable

Strategy Suitable when sales are stable
EBIT

6. Strategic Implications

 A firm with high operating leverage should use low financial leverage, and vice versa,
to manage total risk.
 A balanced combination ensures higher profitability while keeping overall risk
manageable.
 Both levers can be used to maximize shareholder wealth, but excessive use can lead to
financial distress.

7. Example:

Suppose two companies, A and B, both have the same sales and variable cost. But:

 Company A has higher fixed operating costs (high OL) and low debt (low FL).
 Company B has low OL but uses more debt (high FL).

A small dip in sales would hurt Company A’s EBIT more, while a dip in EBIT would hurt
Company B’s EPS more. Hence, companies must analyze their cost and capital structures to
balance these two types of leverage.

Conclusion

Operating and financial leverage are powerful tools that can amplify profits as well as risks.
Their interrelationship is crucial in financial planning, particularly in determining the optimal
capital structure and managing overall business risk. An ideal mix of both helps a firm
maximize returns without exposing it to excessive risk.
(h) Discuss the modern methods of capital budgeting.

1. Introduction

Capital budgeting is the process of evaluating and selecting long-term investments that are
consistent with the firm’s goal of maximizing shareholder wealth. Modern methods of capital
budgeting use time value of money to assess the profitability and risk of investment projects.

These methods are considered more accurate and reliable than traditional ones, such as
payback period or accounting rate of return, because they factor in the timing and risk of future
cash flows.

2. Key Modern Methods of Capital Budgeting

(i) Net Present Value (NPV)

Definition:
NPV is the difference between the present value (PV) of cash inflows and the initial
investment (cash outflow). It shows the net value created by the investment in today’s terms.

Formula:

NPV=∑Ct(1+r)t−C0\text{NPV} = \sum \frac{C_t}{(1+r)^t} - C_0NPV=∑(1+r)tCt−C0

Where:

 CtC_tCt = cash inflow in time ttt

 rrr = discount rate (cost of capital)
 C0C_0C0 = initial investment

Decision Rule:

 Accept if NPV > 0 (project adds value)

 Reject if NPV < 0 (project destroys value)

Advantages:

 Considers time value of money

 Considers all cash flows
 Aligned with shareholder wealth maximization
Limitations:

 Requires accurate estimation of discount rate

 Complex for non-financial users

(ii) Internal Rate of Return (IRR)

Definition:
IRR is the discount rate at which NPV becomes zero. It represents the expected rate of return
from the investment.

Formula:
Solve for rrr in:

0=∑Ct(1+r)t−C00 = \sum \frac{C_t}{(1+r)^t} - C_00=∑(1+r)tCt−C0

Decision Rule:

 Accept if IRR > cost of capital

 Reject if IRR < cost of capital

Advantages:

 Considers time value of money

 Expressed as a percentage, easy to compare
 Uses all cash flows

Limitations:

 May result in multiple IRRs for non-conventional cash flows

 Can be misleading for mutually exclusive projects

(iii) Profitability Index (PI)

Definition:
PI is the ratio of the present value of future cash inflows to the initial investment. It shows the
return per rupee invested.

Formula:

PI=Present Value of InflowsInitial Investment\text{PI} = \frac{\text{Present Value of Inflows}}{\text{Initial

Investment}}PI=Initial InvestmentPresent Value of Inflows
Decision Rule:

 Accept if PI > 1
 Reject if PI < 1

Advantages:

 Useful in capital rationing

 Considers time value of money
 Easy to rank multiple projects

Limitations:

 May not give accurate decision if project sizes differ significantly

(iv) Discounted Payback Period

Definition:
It is the time period required to recover the initial investment using discounted cash flows (i.e.,
PV of cash inflows).

Advantages:

 Incorporates time value of money

 Measures liquidity and risk
 Better than simple payback method

Limitations:

 Ignores cash flows after payback period

 Does not measure profitability

(v) Modified Internal Rate of Return (MIRR)

Definition:
MIRR addresses IRR’s limitations by assuming positive cash flows are reinvested at the
firm’s cost of capital (or reinvestment rate), not at IRR itself.

Advantages:

 Eliminates multiple IRR problem

 Provides a more realistic reinvestment assumption
Limitations:

 Slightly more complex to calculate

3. Conclusion

Modern capital budgeting techniques provide better decision-making tools than traditional
methods, primarily because they account for the time value of money, risk, and comprehensive
cash flow analysis. Among these, NPV is considered the most reliable method because it
directly measures the increase in firm value. However, in practice, a combination of techniques
is often used to make well-informed investment decisions.