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FINANCIAL MANAGEMENT
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1- What is Financial Management?
The procedure of managing the financial resources, as well as accounting and financial
reporting, budgeting, collecting accounts receivable, risk management, and insurance for
a business.
5- Define Financing?
The way in which a proposed purchaser intends to make up the difference between cash
on hand and the purchase price.
6- What is Investment?
Money put in property or other projects with the hope of making a profit, with enough
security to return and protect the capital; not speculation.
Current Ratio
Current Assets
Current Ratio = ------------------------
Current Liabilities
Quick Ratio
Quick Assets
Quick Ratio = ----------------------
Current Liabilities
Net Income
Return on Assets (ROA) = ----------------------------------
Average Total Assets
Net Income
Return on Equity (ROE) = --------------------------------------------
Average Stockholders' Equity
Net Income
Return on Common Equity (ROCE) = --------------------------------------------
Average Common Stockholders' Equity
Profit Margin
Net Income
Profit Margin = -----------------
Sales
Net Income
Earnings Per Share (EPS) = ---------------------------------------------
Number of Common Shares Outstanding
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Activity Analysis Ratios
Assets Turnover Ratio
Sales
Assets Turnover Ratio = ----------------------------
Average Total Assets
Sales
Accounts Receivable Turnover Ratio = -----------------------------------
Average Accounts Receivable
Total Liabilities
Debt to Equity Ratio = ----------------------------------
Total Stockholders' Equity
Dividend Yield
Cash Dividends
Dividend Payout Ratio = --------------------
Net Income
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ROA = Profit Margin X Assets Turnover Ratio
ROA = Profit Margin X Assets Turnover Ratio
31- Annuities:
Annuities are sums of money payable each year.
35- Securities:
Document certificates (definitive securities) or electronic records (book-entry securities)
evidencing ownership of equity (stocks) or debt obligations (bonds).
36- Debentures:
Debentures are the most general corporate bonds. They're backed by the credit of the
issuer, rather than by any specific assets.
39- Accruals:
Amounts owed to or owed by a business that have not yet been recorded in the books of
the business.
40- Amortization:
The reduction in the value of an intangible asset (a copyright, a patent, an address list, or
other similar property) taken as an expense (written off) in each accounting period.
42- Depletion:
The book entry reduction in the value of a natural resource asset due to “using up” the
natural resource. For example, the using up (depletion) of gravel deposits, petroleum
reserves, or other natural resource property.
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43- Loan amortization:
The schedule of payments to be made in repaying a debt. With level-payment
amortization, the payment amount is constant through out the repayment period. With
constant-principal payment amortization, the amount of principal repaid in each payment
is constant but the interest amount and the total payment amount decline as the principal
balance of the loan is reduced.
Short term financing is normally used to provide money that has to be paid back within a
year. The period may be shorter than one year as well.
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53- Need of Long Term Financing
Long term financing is essential for all types of business entities irrespective of their sizes
or stature. These companies need to take advantage the long term financing resources
from the lenders when they have to pay off a debt.
Following are some other requirements that could be met by availing long term
financing:
· Increasing Facilities
· Expansion of Companies
· Buying Fixed Assets
· Buying Machinery
· Construction Projects on a big Scale
· Provide Capital for funding the Operations. This helps in adjusting the cash flow.
54- PROBLEM :
Mr. Naveed has Rs. 70,000 that he can deposit in savings accounts of any of three banks
A, B or C for a three year period.
· Bank A compounds interest on an annual basis;
· Bank B compounds interest semi-annually (twice each year); and
· Bank C compounds interest quarterly (four times each year).
· All three banks have a stated annual interest rate of 12%.
REQUIRED :
· How much Mr. Naveed will have in his account after three years if he deposits his
money in Bank A ?
· How much he will have in his account after three years if he deposits his money in
Bank B ?
· How much he will have in his account after three years if he deposits his money in
Bank C ?
· On the basis of your findings in above parts, describe in which bank should Mr.
Naveed invest his money and why ?
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SOLUTION:
How much Mr. Naveed will have in his account after three years if he
deposits his money in Bank A.
M=P(1+i)n
Where
M = Final amount including the principal
P = Principal amount.
I = Rate of interest per year.
N = No. of year invested.
Where
P = 70000
I = 12% or 0.12
N=3
M = 70000(1+0.12)3
= 70000(1.12)3
= 70000 * 1.404928
= 98344.96 98345
How much he will have in his account after three years if he deposits his
money in Bank B ?
For this Formula is
A = P (1+ r/n)nt
Where
P = Principal amount.
R = Annual rate of interest.
T = number of years amount deposited or borrowed for.
A = amount of money accumulated after n years, including interest.
N = number of times the interest compounded per year.
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Where
P = 70000
R = 12%
T=3
A = 70000 (1 + 012/2)2*3
= 70000 (1+0.06)6
= 70000 (1.06)6
= 70000 * 1.418519112
= 99296.337 99296
How much he will have in his account after three years if he deposits his
money in Bank C ?
A = P (1+ r/n)nt
A = 70000 (1 + 012/3)3*3
= 70000 (1+0.04)9
= 70000 (1.04)9
= 70000 * 1.423311812
= 99631.82 99632
On the basis of your findings in above parts, describe in which bank should Mr.
Naveed invest his money and why ?
Mr. Naveed should invest his money in BANK C because it gives more interest than
other banks.
The reason is that in case of annual basis the principal does not change for whole year but
in case of semi-annually or quarterly basis the principal amount increases after every six
months respectively. So that interest also increases accordingly and it is more than the
interest of annual basis.
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55- PROBLEM # 1:
Assume two firms, A and B, produce and sell widgets. Firm A uses a highly automated
production process with robotic machines, whereas firm B assembles the widgets using
primarily semi-skilled labor. Highly automated firm A has fixed costs of Rs. 35,000 per
year and variable costs of only Rs. 1.00 per unit, whereas labor- intensive firm B has fixed
costs of only Rs. 15,000 per year, but its variable cost per unit is much higher at Rs. 3.00
per unit. Both firms produce and sell 10,000 widgets per year at a price of Rs. 5.00 per
widget.
(i) Which firm has a higher amount of operating leverage and why?
Firm Name Fixed Cost Variable Cost Total Cost Operating Leverage
A 35000 10000 45000 77.78%
B 15000 30000 45000 33.33%
Workings:
Variable Cost Calculation for Firm A:
Variable Cost = 1.0
1.0 * 10000 = 10000
Total Cost Calculation for Firm A:
Total Cost = Fixed Cost + Variable Cost
= 35000 +10000 = 45000
Operating Leverage for Firm A:
Operating Leverage = (Fixed Cost / Total Cost)*100
= (35000/45000)*100 = 77.78%
Variable Cost Calculation for Firm B:
Variable Cost = 3.0
3.0 * 10000 = 30000
Total Cost Calculation for Firm B:
Total Cost = Fixed Cost + Variable Cost
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= 15000+ 30000 = 45000
Variable Cost Calculation for Firm B:
Operating Leverage = (Fixed Cost / Total Cost)*100
= (15000/45000)*100 = 33.33%
Although the total cost for both the firm are same but Firm A is maintaining higher
operating leverage, As Firm A using highly automated production process with
robotic machines, because of this the variable cost reduced to Rs. 1/- per unit.
(ii) How will you interpret the breakeven point of the firm with high operating
leverage?
Firm A (BEP) Firm B (BEP)
Fixed Cost = 35000 Fixed Cost = 15000
Variable Cost = 1 Variable Cost = 3
Price = 5 Price = 5
Break even Point (Q) = fc/ (P-VC) Break even Point (Q) = fc/ (P-VC)
Where fc = Fixed Cost Where fc = Fixed Cost
P = Price per unit P = Price per unit
VC = Variable cost per unit VC = Variable cost per unit
= 35000 / (5-1) = 15000 / (5-3)
= 8750 = 7500
56- PROBLEM # 2:
Assume the same two firms, A and B. At production levels of 10,000 widgets, they both
had operating earnings (EBIT) of Rs. 5,000. In addition, assume that both firms have total
assets of Rs. 40,000. Firm A is financed with Rs.10,000 of debt which carries an annual
interest cost of 8 percent, and Rs. 30,000 of stockholders' equity (3,000 shares), firm B is
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financed entirely with Rs. 40,000 of stockholders' equity (4,000 shares). Tax bracket for
both firms is 40%.
REQUIRED : ( 10 )
Show the results of financial leverage on the both firm's earnings with your
interpretations.
Firms EBIT Interest EBT Tax Net ROE
40% Income =(NI/Equity)
A 5000 8% = 800 4200 1680 2520 8.4%
B 5000 - 5000 2000 3000 7.5%
Working:
EBT for Firm A:
8% of Debt i.e. 10000* 8 / 100 = 800
Tax Calculations:
Firm A = 4200 / 40*100 = 1680
Firm B = 5000 / 40*100 = 2000
Net Income Calculation:
Net Income = EBT – Tax
Firm A = 4200 – 1680 = 2520
Firm B = 5000 – 2000 = 3000
ROE Calculation:
ROE = Net Income / Equity
Firm A = 2520 / 30000 * 100 = 8.4%
Firm B = 3000 / 40000 * 100 = 7.5%
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57- PROBLEM :
Under the prevailing market conditions, financial analysts have estimated a risk
free rate of return of 10% and a market rate of return of 14%. The corporation’s
common stocks have a beta ( b ) of 1.5. Bonds carry an interest rate of 9.5%.
Preferred stocks have a return of 10% p.a. and corporate tax rate is 40%.
REQUIRED :
Compute the present Weighted Average Cost of Capital (WACC) for Sumi
Corporation.
[ Hint: Use CAPM to find out the cost of common shares. ]
Ans:
CAPM = Rf + Beta of Stock x (Rm – RF)
Where
Rf = Risk free rate
Rm = Return on the Market
Rf = Risk free rate
Working:
Calculation of Weighted
= 3,000,000,000 / 10,000,000,000 = 0.30
= 480,000,000 / 10,000,000,000 = 0.048
= 6,520,000,000 / 10,000,000,000 = 0.652
WACC
Debenture = 0.3 * 5.7% = 1.71
Preferred Shares = 0.048 * 10% = 0.48
Common Shares = 0.625 * 16% = 10.432
Total 12.622%
Where
Rf = Risk free rate
Rm = Return on the Market
Rf = Risk free rate
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