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BCOE 143 Question Paper June 2024
BCOE 143 Solved Question Paper June 2024
1.
(a) Explain the concept of Risk and Return. (10 Marks)
(b) Explain time value of money with examples. (10 Marks)
Ans. (A) Risk and return are two fundamental concepts in financial management that go hand in hand. Whenever someone invests money—whether in stocks, mutual funds, or a business—there is a certain level of uncertainty about what they will get back in the future. This uncertainty is known as risk. It refers to the possibility that the actual return on an investment may be different from the expected return, and in some cases, it could mean losing part or all of the original investment. For example, if you invest in the stock market, the value of shares may go up or down due to various factors like market trends, economic conditions, company performance, or political events. All these create risk.
On the other hand, return is the gain or profit that an investor expects or actually receives from an investment. It can come in different forms such as interest, dividends, or capital gains (the increase in the value of the investment). In general, the higher the risk, the higher the expected return, because investors need to be compensated for taking more risk. For instance, government bonds are considered low-risk investments and usually offer lower returns, while investing in stocks or new businesses is riskier but offers a chance for higher returns.
Understanding the relationship between risk and return helps investors make better decisions. It allows them to compare different investment options based on how much risk they are willing to take and what return they expect in return. A careful balance of risk and return is essential for successful financial planning. In short, risk is about uncertainty and potential loss, while return is the reward or profit expected from taking that risk.
(B) The time value of money is a basic concept in financial management that means money today is worth more than the same amount of money in the future. This happens because money has the potential to earn over time. If you have ₹1,000 today and you keep it in a bank or invest it, it can earn interest or profit. For example, if you invest ₹1,000 at a 10% interest rate per year, after one year you will have ₹1,100. So, ₹1,000 today is not the same as ₹1,000 one year from now because of the interest or return you could have earned in that time.
This concept is important in making financial decisions, especially when comparing the value of money received or spent at different times. For example, if someone offers you ₹10,000 today or ₹10,000 after two years, it is better to take the money today because you can use it now to earn more. In reverse, if you have to pay ₹10,000 today or the same amount after two years, it is better to pay later because you can use the money in the meantime.
Another example is in loan repayments or investments. When companies or individuals plan long-term projects, they need to calculate whether future profits will be enough to cover the present investment. They do this using methods like present value and future value. Present value tells us how much a future amount of money is worth today, while future value tells us how much money today will grow to in the future.
Overall, the time value of money helps in understanding that the timing of cash flows matters. It encourages people to use their money wisely and make choices that give them better value in the long run.
2.
XY Ltd. is considering investment in Machine Y for replacement of existing Machine X having a remaining life of 5 years, book value of ₹5,00,000 at present, salvage value NIL.
However, Machine X can be sold presently at ₹2,00,000. The Machine Y has a useful life of 5 years, cost ₹10,00,000 and has NIL salvage value.
The purchase of Machine Y to replace Machine X will generate an annual cost savings of ₹5,00,000 per annum over its useful life of 5 years.
The company uses Straight Line Method (SLM) of depreciation and is subject to a tax rate of 30%.
Using NPV method, suggest whether XY Ltd. should replace Machine X with Machine Y, if the discount rate is 12%. (20 Marks)
Ans. To determine whether XY Ltd. should replace Machine X with Machine Y, we will use the Net Present Value (NPV) method. NPV compares the present value of cash inflows (savings) with the present value of cash outflows (costs). If NPV is positive, the investment is profitable and should be accepted.
Given Data:
Cost of Machine Y = ₹10,00,000
Salvage value = NIL
Machine Y life = 5 years
Annual cost savings = ₹5,00,000
Tax rate = 30%
Depreciation method = Straight Line (SLM)
Machine X can be sold now for = ₹2,00,000
Discount rate = 12%
Step 1: Initial Investment
Since Machine X can be sold for ₹2,00,000, this amount will reduce the investment needed for Machine Y:
Net Initial Investment=₹10,00,000−₹2,00,000=₹8,00,000
Step 2: Calculate Annual Depreciation
Depreciation per year=₹10,00,000−05=₹2,00,000\text{Depreciation per year} = \frac{₹10,00,000 - 0}{5} = ₹2,00,000Depreciation per year=5₹10,00,000−0=₹2,00,000
Step 3: Calculate Annual Net Cash Flow
Annual cost savings = ₹5,00,000
Depreciation is non-cash but reduces taxable income. So we calculate tax savings and adjust:
Taxable savings = ₹5,00,000 – ₹2,00,000 = ₹3,00,000
Tax = 30% of ₹3,00,000 = ₹90,000
Net Profit after tax = ₹3,00,000 – ₹90,000 = ₹2,10,000
Now add back depreciation (non-cash):
Cash flow = ₹2,10,000 + ₹2,00,000 = ₹4,10,000
Step 4: Calculate Present Value of Cash Flows for 5 years
We use Present Value of Annuity formula:
PV=Cash flow×PVAF(r
Where,
r = 12%
n = 5 years
PVAF (12%, 5 years) ≈ 3.605
PV=₹4,10,000×3.605≈₹14,77,050
Step 5: Calculate NPV
NPV=Present Value of inflows–Initial Investment NPV=₹14,77,050–₹8,00,000=₹6,77,050NPV = ₹14,77,050 – ₹8,00,000 = ₹6,77,050NPV=₹14,77,050–₹8,00,000=₹6,77,050
Conclusion:
Since NPV is positive (₹6,77,050), XY Ltd. should replace Machine X with Machine Y. It is a profitable decision based on cost savings and tax benefits over 5 years.
3.
Define working capital. Explain the bases on which it can be classified. (5+15 Marks)
Ans. Working capital is a key concept in financial management and refers to the capital required for the day-to-day operations of a business. It represents the short-term financial health and operational efficiency of a company. In simple terms, working capital is the difference between a company’s current assets and current liabilities.
Working Capital=Current Assets–Current Liabilities
Current assets include cash, accounts receivable, inventory, and other short-term assets expected to be converted into cash within a year. Current liabilities include obligations like accounts payable, short-term loans, and other debts due within the same period.
Working capital is essential for maintaining business operations such as purchasing raw materials, paying wages, and managing short-term obligations. Without sufficient working capital, a company may face liquidity problems, struggle to meet its short-term liabilities, and risk business failure—even if it is profitable on paper.
Classification of Working Capital
Working capital can be classified on the basis of concept, time, and need. Each classification helps businesses analyze and manage working capital according to their operational and financial needs.
1. On the Basis of Concept
Working capital can be divided into two types based on concept: Gross Working Capital and Net Working Capital.
Gross Working Capital: This refers to the total investment in current assets. It includes cash, inventory, receivables, marketable securities, and prepaid expenses. Gross working capital focuses only on the asset side and is useful for assessing the amount invested in short-term assets.
Net Working Capital: This is the difference between current assets and current liabilities. It provides a more realistic view of a company’s liquidity and its ability to meet short-term obligations. A positive net working capital means the company has more current assets than liabilities, indicating financial stability.
2. On the Basis of Time or Duration
Working capital can also be classified into Permanent Working Capital and Temporary Working Capital based on how long it is required.
Permanent Working Capital: This is the minimum amount of working capital a business needs to operate continuously. It is also called fixed working capital. It does not change with the level of production or sales and is required throughout the life of the business to ensure smooth operations.
Temporary Working Capital: Also called variable or fluctuating working capital, this refers to the additional working capital needed during peak seasons or periods of high demand. It varies based on business activity levels, such as during festivals, sales promotions, or expansion periods.
3. On the Basis of Need or Purpose
Working capital can be further divided into Regular Working Capital, Reserve Working Capital, Seasonal Working Capital, and Special Working Capital.
Regular Working Capital: This is the core working capital needed to meet the routine operating expenses of the business such as payment for raw materials, wages, and electricity bills.
Reserve Working Capital: This is the extra working capital kept aside to meet unforeseen expenses or emergencies like strikes, natural disasters, or unexpected breakdowns.
Seasonal Working Capital: Businesses that experience seasonal fluctuations in demand require additional working capital during peak seasons. For example, a company selling woollen clothes will need more working capital during winter.
Special Working Capital: Sometimes, businesses need extra funds for special purposes like launching a new product, running a marketing campaign, or fulfilling a bulk order. This is known as special working capital.
4.
Define cost of capital with examples. Explain its relevance in decision-making. (10+10 Marks)
Ans. Cost of capital refers to the minimum rate of return that a company must earn on its investments or projects to maintain the market value of its shares and satisfy its investors or creditors. It represents the cost of using funds from various sources like equity, debt, or preference shares. In simple terms, it is the expected return that providers of capital (like shareholders and lenders) require for investing in the business.
For a business, capital can come from different sources—owners (equity shareholders), preference shareholders, banks, or bondholders. Each source has a cost associated with it. For example, if a company borrows money from a bank at 10% interest, this 10% becomes the cost of debt. Similarly, if the company issues shares and investors expect a 15% return, then 15% becomes the cost of equity.
The overall cost of capital or Weighted Average Cost of Capital (WACC) is calculated by combining the cost of all sources, each weighted by its proportion in the capital structure.
Formula for WACC:
WACC=(E/V)×Re+(D/V)×Rd×(1−T)
Where:
E = Market value of equity
D = Market value of debt
V = Total value (E + D)
Re = Cost of equity
Rd = Cost of debt
T = Tax rate
Examples:
Cost of Debt:
If a company issues ₹1,00,000 worth of bonds at 10% interest, and the tax rate is 30%, the after-tax cost of debt is:
10%×(1−0.30)=7%
Cost of Equity:
Suppose investors expect a 14% return on the company’s shares. This 14% is the cost of equity.WACC Example:
Let’s say a company has ₹60,000 equity at 14% and ₹40,000 debt at 7%:
WACC=(60/100)×14%+(40/100)×7%=8.4%+2.8%=11.2%
So, the company must earn at least 11.2% on its investments to satisfy investors and lenders.
Relevance of Cost of Capital in Decision-Making (500 Words)
The cost of capital plays a vital role in various financial decisions. It acts as a benchmark or cut-off rate for evaluating investment projects. If the expected return from a project is greater than the cost of capital, the project adds value to the business and should be accepted. If it is lower, the project may reduce the firm’s value and should be rejected.
Here are key areas where cost of capital is important in decision-making:
1. Capital Budgeting Decisions
When a company evaluates long-term projects (e.g., opening a new factory or launching a new product), it uses the cost of capital to calculate Net Present Value (NPV) or Internal Rate of Return (IRR). If the IRR of the project is higher than the cost of capital, the project is profitable. For example, if a project returns 13% and the cost of capital is 11%, the project is acceptable.
2. Capital Structure Decisions
Cost of capital helps in deciding the optimal mix of debt and equity in the company’s capital structure. A company may try to lower its WACC by choosing a suitable combination of financing. Since debt is usually cheaper due to tax benefits, companies might prefer a certain level of debt, but too much debt increases financial risk.
3. Performance Evaluation
The cost of capital serves as a tool to measure whether the firm is generating enough returns for its stakeholders. If a company's return on investment (ROI) is consistently above its cost of capital, it indicates efficient use of resources. If not, corrective actions are needed.
4. Dividend Decisions
Companies use cost of equity to decide whether to retain profits for reinvestment or distribute them as dividends. If the expected return on reinvested earnings is more than the cost of equity, retaining profits is better. Otherwise, paying dividends might be more favorable.
5. Valuation of Business
In business valuation, especially during mergers and acquisitions, the cost of capital is used as a discount rate to find the present value of future cash flows. An accurate WACC ensures the correct valuation of the company.
5.
Calculate operating leverage, financial leverage, and combined leverage using the following information: (20 Marks)
Sales: 80,000 units
Selling price per unit: ₹12.50
Variable cost: 60%
Fixed costs: ₹2,40,000
12% Debentures: ₹5,00,000
Tax Rate: 40%
Ans. Given Information:
Sales = 80,000 units
Selling price per unit = ₹12.50
Variable cost = 60% of selling price
Fixed costs = ₹2,40,000
Debentures = ₹5,00,000 @ 12% interest
Tax rate = 40%
Step 1: Calculate Contribution
Selling Price per Unit = ₹12.50
Variable Cost per Unit = 60% of ₹12.50 = ₹7.50
Contribution per Unit = ₹12.50 – ₹7.50 = ₹5.00
Total Sales = 80,000 units × ₹12.50 = ₹10,00,000
Total Variable Cost = 80,000 × ₹7.50 = ₹6,00,000
Total Contribution = ₹10,00,000 – ₹6,00,000 = ₹4,00,000
Step 2: Calculate EBIT (Earnings Before Interest and Taxes)
EBIT = Contribution – Fixed Costs
EBIT=₹4,00,000–₹2,40,000=₹1,60,000
✅ Step 3: Calculate Interest on Debentures
Debentures = ₹5,00,000 @ 12%
Interest=₹5,00,000×12%=₹60,000
✅ Step 4: Calculate EBT (Earnings Before Tax)
EBT=EBIT–Interest=₹1,60,000–₹60,000=₹1,00,000
✅ Step 5: Calculate Net Profit (EAT or Earnings After Tax)
Tax Rate = 40%
Tax=₹1,00,000×40%=₹40,000
Net Profit (EAT)=₹1,00,000–₹40,000=₹60,000
✅ Now, Leverage Calculations
1. Operating Leverage (OL)
Operating Leverage=Contribution / EBIT= ₹4,00,000 / ₹1,60,000 = 2.5
2. Financial Leverage (FL)
Financial Leverage=EBIT / EBT = ₹1,60,000 / ₹1,00,000 = 1.6
3. Combined Leverage (CL)
Combined Leverage=Operating Leverage×Financial Leverage=2.5×1.6=4.0
✅ Final Answer Summary:
Operating Leverage = 2.5
Financial Leverage = 1.6
Combined Leverage = 4.0
6.
Explain with examples the Net Income and Net Operating Income approach to Capital Structure. (20 Marks)
Ans. Capital structure refers to the mix of debt and equity a company uses to finance its operations and investments. There are different theories in financial management that explain the impact of capital structure on the value of a firm and its cost of capital. Two such important theories are the Net Income (NI) Approach and the Net Operating Income (NOI) Approach. These two are part of the traditional debate on whether capital structure decisions affect the value of the firm and cost of capital.
1. Net Income (NI) Approach
The Net Income (NI) approach, developed by David Durand, suggests that capital structure is relevant to the value of the firm. According to this approach, the value of the firm increases and the overall cost of capital decreases as the proportion of cheaper debt increases in the capital structure.
Assumptions of NI Approach:
Cost of debt (Kd) is less than cost of equity (Ke).
The use of debt does not change the risk perception of investors.
Taxes are ignored (in simple models, though real-world applications may include tax benefits).
Cost of debt and cost of equity remain constant with changes in capital structure.
Explanation:
Since debt is a cheaper source of finance compared to equity, increasing debt will reduce the overall weighted average cost of capital (WACC), thus increasing the total value of the firm. The more debt the company uses, the cheaper its capital becomes, resulting in higher firm value.
Formula:
Value of the Firm (V) = Equity (E) + Debt (D)
WACC = (E/V) × Ke + (D/V) × Kd
As D increases, and if Ke and Kd are constant, the overall WACC decreases, increasing the value of the firm.
Example of NI Approach:
Suppose a company has an operating income (EBIT) of ₹1,00,000. The cost of debt (Kd) is 10%, and cost of equity (Ke) is 15%. The firm is evaluating two capital structures:
Case 1 – All Equity:
Equity = ₹5,00,000
No Debt
Net Income = ₹1,00,000 (no interest)
Cost of equity = 15%
Value of the firm = ₹1,00,000 / 0.15 = ₹6,66,667
Case 2 – Mix of Debt and Equity:
Debt = ₹2,00,000 at 10% = Interest = ₹20,000
EBIT = ₹1,00,000 – Interest = ₹80,000
Ke = 15%
Equity = ₹80,000 / 0.15 = ₹5,33,333
Value of the firm = Equity + Debt = ₹5,33,333 + ₹2,00,000 = ₹7,33,333
2. Net Operating Income (NOI) Approach
The Net Operating Income (NOI) approach, also developed by David Durand, takes the opposite view. It suggests that capital structure is irrelevant to the value of the firm. According to this approach, the value of the firm remains constant regardless of the mix of debt and equity.
Assumptions of NOI Approach:
The overall cost of capital (Ko) remains constant.
The cost of debt (Kd) is lower than the cost of equity (Ke).
As debt increases, the risk to equity holders increases, so Ke also increases.
There is no tax advantage of debt.
Explanation:
According to this approach, although debt is cheaper than equity, increasing debt increases the financial risk of the firm. As a result, investors demand higher returns on equity (Ke). This increase in Ke offsets the benefit of using cheaper debt, and hence the overall cost of capital (Ko) remains unchanged. Therefore, the value of the firm does not change with capital structure.
Formula:
Value of the Firm (V) = EBIT / Ko
Equity Value (E) = V – D
Where:
Ko is constant regardless of debt-equity mix
Example of NOI Approach:
Let’s use the same EBIT of ₹1,00,000 and assume the overall cost of capital (Ko) is 12.5%.
Case 1 – All Equity:
V = ₹1,00,000 / 0.125 = ₹8,00,000
Debt = ₹0
Equity = ₹8,00,000
Case 2 – With Debt:
Debt = ₹2,00,000 at 10% → Interest = ₹20,000
Net Income = ₹1,00,000 – ₹20,000 = ₹80,000
Value of the firm remains: ₹8,00,000 (as Ko is constant)
Equity = ₹8,00,000 – ₹2,00,000 = ₹6,00,000
Cost of equity = ₹80,000 / ₹6,00,000 = 13.33%
Key Differences Between NI and NOI Approach
7.
Write short notes on the following: (10+10 Marks)
(a) Motives of Cash Management
(b) Different sources of short-term finance
Ans. (a) Motives of Cash Management
Cash management refers to the process of collecting, managing, and using cash effectively in an organization. Proper cash management ensures that a business has enough liquidity to meet its day-to-day expenses, pay off short-term liabilities, and handle any emergencies. There are several motives behind maintaining and managing cash in a business. These motives explain why companies prefer to hold a certain amount of cash rather than investing all of it in long-term projects or assets. The four primary motives of cash management are the transaction motive, precautionary motive, speculative motive, and compensating motive.
1. Transaction Motive:
The transaction motive refers to the need to hold cash for carrying out regular business transactions. Companies need cash to pay for routine expenses such as payments to suppliers, salaries to employees, rent, electricity bills, and taxes. Since there is a time gap between cash inflows (from customers) and outflows (to vendors), businesses need to maintain a minimum cash balance to ensure smooth operations. This motive is the most basic and essential purpose of holding cash.
2. Precautionary Motive:
This motive involves holding cash as a safeguard against unexpected events or emergencies. Businesses face uncertainties such as sudden increases in raw material prices, machine breakdowns, delays in receiving payments, or economic downturns. By maintaining a reserve of cash, companies can manage these unforeseen expenses without affecting their operations. The amount held under this motive depends on the risk perception of the business and the stability of its cash flows.
3. Speculative Motive:
Cash is sometimes held to take advantage of unexpected business opportunities. For instance, a company might get a chance to buy raw materials at a discounted price or invest in a profitable short-term venture. In such cases, having ready cash allows the company to act quickly and earn extra income. This is known as the speculative motive, where cash is maintained not just for expenses but to benefit from favorable market conditions.
4. Compensating Motive:
This motive arises due to banking arrangements. Banks often require companies to maintain a minimum cash balance in their accounts as compensation for providing various services such as processing payments, offering overdrafts, or granting loans. This balance is known as a compensating balance. It is not available for immediate use but is part of the cash management strategy.
(b) Different Sources of Short-Term Finance
Short-term finance refers to funds required by a business for a period of less than one year. These funds are generally used to meet day-to-day operating expenses like buying raw materials, paying wages, or covering utility bills. Since the need for short-term finance arises frequently and sometimes unexpectedly, businesses must be aware of the various sources available to them. Some common sources of short-term finance include trade credit, bank loans, commercial paper, factoring, and bill discounting.
1. Trade Credit:
Trade credit is the most common and informal source of short-term finance. It is the credit extended by suppliers to the business. Instead of paying immediately for goods and services, companies are allowed a credit period (usually 30 to 90 days). This helps in maintaining cash flow. For example, a textile company might buy fabric on credit and pay the supplier after a month, by which time it might have sold the finished goods.
2. Bank Overdraft:
In a bank overdraft facility, a company is allowed to withdraw more money from its current account than what is available. The bank sets a limit for the overdraft, and interest is charged only on the overdrawn amount. It is a flexible and convenient source of short-term funds for handling temporary cash shortages.
3. Cash Credit:
Cash credit is a short-term loan provided by banks against collateral like inventory or receivables. The borrower can withdraw funds up to a certain limit, and interest is charged on the amount actually used, not on the total limit. It is suitable for businesses with regular working capital needs.
4. Commercial Paper:
Commercial paper is an unsecured promissory note issued by large and financially strong companies to raise funds from the market. It has a fixed maturity period, usually between 15 days and one year. Since it is not backed by collateral, only companies with high credit ratings can issue commercial paper. It is a low-cost option for short-term financing.
5. Factoring:
Factoring involves selling the company’s accounts receivable (invoices) to a financial institution (called a factor) at a discount. The factor pays a percentage of the invoice amount upfront and the rest (minus a fee) when the customer pays. This helps companies get immediate cash instead of waiting for customers to pay.
6. Bill Discounting:
In bill discounting, a company sells its bills of exchange (receivables) to a bank at a discount before the maturity date. The bank pays the company the discounted amount and collects the full amount from the customer on the due date. This helps convert credit sales into cash quickly.
8.
(a) Explain the concepts of Factoring and Forfaiting. (10 Marks)
(b) Describe the Baumol’s Model of Cash Management. (10 Marks)
Ans. (A) Factoring and forfaiting are two financial services that help businesses convert their receivables (money owed by customers) into immediate cash. These services are commonly used in trade finance, especially by companies involved in domestic and international trade. Both aim to improve liquidity, reduce credit risk, and manage working capital efficiently, but they differ in scope, duration, and structure.
Factoring
Factoring is a financial arrangement where a business sells its accounts receivable (invoices) to a financial institution known as a factor. The factor pays a large percentage of the invoice amount immediately (usually 80%–90%) and the balance (after deducting fees and interest) is paid when the customer settles the invoice.
There are two main types of factoring:
Recourse factoring: The business remains responsible if the customer fails to pay.
Non-recourse factoring: The factor takes the risk of customer default.
Factoring is typically used for short-term receivables and is common in domestic and small-scale international trade.
Example: A textile manufacturer sells goods worth ₹10,00,000 to a retailer on 60 days credit. To get instant cash, the manufacturer sells the invoice to a factor and receives ₹8,50,000 immediately. After 60 days, the factor collects ₹10,00,000 from the retailer and pays the remaining balance (minus fees) to the manufacturer.
Forfaiting
Forfaiting is the purchase of medium- to long-term international trade receivables by a financial institution (called a forfaiter) without recourse to the exporter. It is used mainly in export financing, especially for capital goods or large contracts with extended payment terms, typically ranging from 6 months to 5 years.
In forfaiting, the receivables are usually backed by bills of exchange or promissory notes and guaranteed by the importer's bank. The exporter sells these receivables to the forfaiter at a discount, and the forfaiter takes full responsibility for collecting payments, bearing all credit and political risks.
Example: An Indian company exports machinery worth ₹1 crore to a buyer in Europe, payable over 3 years. Instead of waiting, the exporter sells the payment obligation (secured by the buyer’s bank) to a forfaiter at a discount and receives ₹90 lakhs immediately. The forfaiter now assumes the risk and collects payment over 3 years.
Key Differences
Factoring deals with short-term receivables; forfaiting handles medium- to long-term export receivables.
In factoring, the buyer may or may not be liable in case of default; in forfaiting, there is no recourse to the exporter.
Factoring is used in both domestic and international trade; forfaiting is mainly for international trade.
Both services improve cash flow, reduce risk, and support business growth, especially in competitive markets.
(B) The Baumol’s Model of Cash Management, developed by William J. Baumol, is an economic model that helps a firm determine the optimal amount of cash to hold. The model is similar to the Economic Order Quantity (EOQ) model used in inventory management. It aims to minimize the total cost associated with holding and obtaining cash.
Baumol's model is based on the trade-off between two types of costs:
Transaction Costs – The cost incurred each time the firm converts securities or investments into cash. These are fixed costs per transaction.
Opportunity Costs – The interest or return lost by holding cash instead of investing it.
Assumptions of the Model:
The firm spends cash at a steady, predictable rate.
Cash is replenished by selling investments or marketable securities.
The opportunity cost of holding cash is known and constant.
The firm aims to minimize the sum of transaction and holding costs.
Cash is used only for payments, not for speculative purposes.
Formula:
C∗=2bTiC^* = \sqrt{\frac{2bT}{i}}C∗=i2bT
Where:
C∗C^*C∗ = Optimal cash balance
bbb = Fixed cost per transaction (e.g., brokerage)
TTT = Total cash requirement for a period
iii = Opportunity cost of holding cash (interest rate)
This formula tells the firm how much cash to withdraw each time it needs funds.
Explanation:
According to the model, a firm should not keep too much idle cash because it loses potential interest income. At the same time, withdrawing cash frequently from investments increases transaction costs. The model helps find a balance between these two costs.
When cash balance reaches zero, the firm should withdraw the optimal amount C∗C^*C∗ from its investments to restore the cash balance. This cycle continues regularly.
Example:
Suppose a company needs ₹12,00,000 for operations over a year, the transaction cost to convert securities is ₹500, and the interest rate is 10%.
Using Baumol’s formula:
C∗=2×500×12,00,0000.10=1,20,00,000≈₹10,954C^* = \sqrt{\frac{2 × 500 × 12,00,000}{0.10}} = \sqrt{1,20,00,000} ≈ ₹10,954C∗=0.102×500×12,00,000=1,20,00,000≈₹10,954
So, the firm should withdraw ₹10,954 each time it needs cash. The number of transactions per year = ₹12,00,000 / ₹10,954 ≈ 110
9.
Prepare an estimate of Net Working Capital requirement for ABC Ltd., adding 10% for contingencies from the following information: (20 Marks)
Estimated cost per unit: ₹170, including:
Raw Materials: ₹80
Direct Labor: ₹30
Overheads: ₹60 (exclusive of depreciation)
Selling Price: ₹200 per unit
Level of activity per annum: 1,04,000 units
Raw material in stock: 4 weeks
WIP (50% completion stage): 2 weeks
Finished goods in stock: 4 weeks
Credit allowed by suppliers: 4 weeks
Credit allowed to debtors: 8 weeks
Lag in payment of wages: 1.5 weeks
Cash at bank expected: ₹25,000
Assume:
Production is carried on evenly throughout the year (52 weeks)
Wages and overheads accrue evenly
All sales are on credit
Ans. Uploading Soon
10.
Write explanatory notes on any two of the following: (10+10 Marks)
(a) MM–Irrelevance Approach of Dividend Policy
(b) Optimal Capital Structure
(c) Methods of Valuation of Shares
(d) Business Risk vs. Financial Risk
Ans. (a) MM–Irrelevance Approach of Dividend Policy
The MM Irrelevance Approach, proposed by Modigliani and Miller in 1961, states that dividend policy has no effect on the value of a firm or its cost of capital under certain ideal conditions. According to this theory, whether a firm pays high dividends or retains earnings, it does not impact shareholders’ wealth or the market price of its shares.
Core Idea:
Modigliani and Miller argued that the value of a firm is determined only by its earning power and investment decisions, not by the way profits are distributed between dividends and retained earnings. Investors can create their own “dividend policy” by selling a portion of their shares if they want cash or reinvesting dividends if they don’t.
Assumptions of the MM Approach:
No taxes
No transaction or flotation costs
Perfect capital markets (information is free and equally available to all)
Investors behave rationally
Investment decisions are not affected by dividend policy
Example:
Suppose a firm earns ₹10 per share and has the choice of paying a ₹4 dividend or reinvesting it. If the return on reinvestment is the same as the shareholders' required return, the investor’s total wealth will be the same whether the dividend is paid or not.
Criticism:
In reality, the assumptions are not practical. Taxes exist, and dividends are often taxed differently than capital gains. Transaction costs also affect investors' ability to “create their own dividend.” Additionally, in imperfect markets, dividend announcements may signal financial health, affecting stock prices.
Conclusion:
The MM approach provides a theoretical foundation to challenge the belief that dividends always impact firm value. However, due to unrealistic assumptions, the theory serves more as a benchmark than a real-world rule. In practice, many investors do value steady dividend income, and firms consider dividend policy important.
(b) Optimal Capital Structure
Optimal Capital Structure refers to the best mix of debt and equity financing that minimizes a company’s cost of capital and maximizes its market value. It balances the benefits and risks of debt and equity in a way that enhances shareholder value.
Why It Matters:
Using debt in capital structure brings tax benefits (since interest is tax-deductible), making it a cheaper source of finance than equity. However, too much debt increases financial risk and may lead to bankruptcy. The optimal capital structure lies where the marginal benefit of debt equals its marginal cost.
Key Theories Related to It:
Net Income Approach: Suggests more debt increases value due to lower cost.
Net Operating Income Approach: Claims capital structure doesn't affect firm value.
Traditional Approach: Believes an optimal structure exists that minimizes WACC.
Modigliani & Miller (With Taxes): Suggests 100% debt is ideal, but practically limited by risk.
Example:
If a company finances its assets with 70% equity and 30% debt and finds that increasing debt to 40% lowers the overall cost of capital, its value increases. But increasing debt to 70% may raise the cost due to rising interest rates and credit risk, reducing firm value.
Factors Influencing Optimal Capital Structure:
Business risk
Cost of capital
Market conditions
Tax considerations
Company size and credit rating
Conclusion:
There is no one-size-fits-all capital structure. Each firm must consider its financial health, industry standards, and risk profile. The goal is to find a financing mix that supports growth while keeping financial risks under control.
(c) Methods of Valuation of Shares
Valuation of shares is the process of determining the fair value or market price of a company’s shares. It is essential for investors, financial analysts, and companies during mergers, acquisitions, IPOs, or investment decisions.
There are several methods used to value shares, depending on the purpose, availability of data, and type of business.
1. Net Asset Value Method:
Also known as the book value method, it values the share based on the company's net assets. It is calculated as:
Net Asset Value per Share=Total Assets – Total LiabilitiesNumber of Equity Shares\text{Net Asset Value per Share} = \frac{\text{Total Assets – Total Liabilities}}{\text{Number of Equity Shares}}Net Asset Value per Share=Number of Equity SharesTotal Assets – Total Liabilities
This method is useful for asset-rich companies but ignores future earnings.
2. Earning-Based Methods:
a. Earnings Per Share (EPS) Method:
It values shares based on the company’s profitability.
Value per Share=EPS×P/E Ratio\text{Value per Share} = \text{EPS} \times \text{P/E Ratio}Value per Share=EPS×P/E Ratio
Where EPS is earnings per share, and P/E is the price-to-earnings ratio.
b. Dividend Discount Model (DDM):
It assumes the value of a share is the present value of all future dividends.
Value per Share=Dr–g\text{Value per Share} = \frac{D}{r – g}Value per Share=r–gD
Where D = dividend, r = required rate of return, g = growth rate of dividend.
3. Market Price Method:
This method uses the current market price of shares listed on a stock exchange. It reflects demand and supply but can be affected by market speculation.
4. Discounted Cash Flow (DCF) Method:
This approach estimates future cash flows and discounts them to present value using a discount rate. It’s commonly used for valuing startups or firms with irregular earnings.
Conclusion:
Each method has its own relevance. A combination of methods is often used for accuracy. The chosen method depends on the nature of the company, purpose of valuation, and availability of data.
(d) Business Risk vs. Financial Risk
Business Risk and Financial Risk are two important types of risks faced by a company, and both affect the stability of its earnings and financial health. Understanding the difference between them is key for making investment and financing decisions.
Business Risk:
Business risk refers to the risk associated with the operations of the company, which affects its ability to generate profits from its regular activities. This type of risk is influenced by internal and external factors, such as:
Changes in consumer demand
Economic conditions
Input cost fluctuations
Competition
Operational inefficiencies
Example: A manufacturing company may face business risk if raw material prices increase or if demand for its product declines due to new competitors.
Business risk exists regardless of how the company is financed (debt or equity). It is directly related to the firm's cost structure—especially fixed operating costs. Companies with higher fixed costs have higher operating leverage, and therefore more business risk.
Financial Risk:
Financial risk is the risk that arises from the use of debt financing. It is related to the company's ability to meet its fixed financial obligations like interest payments and loan repayments.
The more debt a company takes, the higher its financial risk, because failure to meet these obligations can lead to bankruptcy. Financial risk is influenced by the company's capital structure and leverage.
Example: If a company has borrowed a large amount and its earnings fall, it may not be able to pay interest, increasing the chance of financial distress.
Unlike business risk, financial risk can be controlled by adjusting the debt-equity ratio. Companies with high debt levels have high financial leverage and therefore face more financial risk.
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