Q.1 Discuss the objective of profit maximization vs wealth maximization.

The financial management come a long way by shifting its focus from traditional
approach to modernapproach. The modern approach focuses on wealth maximization rather
thanprofit maximization.Thisgives a longer term horizon for assessment, making way for
sustainable performance by businesses.A myopic person or business is mostly concerned about
short term benefits. A short term horizon canfulfill objective of earning profit but may not help
in creating wealth. It is because wealth creation needsa longer term horizon Therefore, Finance
Management or Financial Management emphasizes on wealthmaximization rather than profit
maximization.For a business, it is not necessary that profit should be the only objective; it may
concentrate on various other aspects like increasing sales, capturing more marketshare etc, which
will take care of profitability. So, we can say that profit maximizationis a subset of  wealth and
being a subset, it will facilitate wealth creationGiving priority to value creation, managers have
now shifted from traditional approach to modernapproach of financial management that focuses
on wealth maximization. This leads to better and trueevaluation of business. For e.g., under
wealth maximization, more importance is given to cash flowsrather than profitability. As it is
said that profit is a relative term, it can be a figure in some currency, itcan be in percentage etc.
For e.g. a profit of say $10,000 cannot be judged as good or bad for a business,till it is compared
with investment, sales etc. Similarly, duration of earning the profit is also importanti.e. whether
it is earned in short term or long term.In wealth maximization, major emphasizes is on cash
flows rather than profit. So, to evaluate variousalternatives for decision making, cash flows are
taken under consideration. For e.g. to measure theworthof a project, criteria like: ― 
 
present value of its cash inflow – present value of cash outflows (netpresent value) is taken. This
approach considers cash flows rather than profits into consideration andalso use discounting
technique to find out worth of a project. Thus, maximization of wealth approachbelieves that
money has time value.An obvious question that arises now is that how can we measure wealth.
Well, a basic principle is thatultimately wealth maximization should be discovered in increased
net worth or value of business. So, tomeasure the same, value of business is said to be a function
of two factors - earnings per share andcapitalization rate. And it can be measured by adopting
following relation:Value of business = EPS / Capitalization rateAt times, wealth maximization
may create conflict, known as agency problem. This describes conflictbetween the owners and
managers of firm. As, managers are the agents appointed by owners, a strategicinvestor or the
owner of the firm would be majorly concerned about the longer term performance of thebusiness
that can lead to maximization of shareholder‘s wealth. Whereas, a manager might focus ontaking
such decisions that can bring quick result, so that he/she can get credit for good performance.
However, in course of fulfilling the same, a manager might opt for risky decisions which can
puton stake the owner‘s objectives.Hence, a manager should align his/her objective to broad
objective of organization and achieve atradeoff between risk and return while making decision;
keeping in mind the ultimate goal of financial management i.e. to maximize the wealth of its
current shareholdershe objections are:-(i) Profit cannot be ascertained well in advance to express
the probability of return as future isuncertain. It is not at possible to maximize what cannot be
known.(ii) The executive or the decision maker may not have enough confidence in the estimates
of future returns so that he does not attempt future to maximize. It is argued that firm's goal
cannotbe to maximize profits but to attain a certain level or rate of profit holding certain share of
themarket or certain level of sales. Firms should try to 'satisfy' rather than to 'maximize'(iii)
There must be a balance between expected return and risk. The possibility of higher
expectedyields are associated with greater risk to recognise such a balance and wealth
Maximization isbrought in to the analysis. In such cases, higher capitalisation rate involves. Such
combination of expected returns with risk variations and related capitalisation rate cannot be
considered in theconcept of profit maximization.(iv) The goal of Maximization of profits is
considered to be a narrow outlook. Evidentlywhen profit maximization becomes the basis of
financial decisions of the concern, it ignoresthe interests of the community on the one hand and
that of the government, workers andother concerned persons in the enterprise on the other
hand.Keeping the above objections in view, most of the thinkers on the subject have come to
theconclusion that the aim of an enterprise should be wealth Maximization and not the
profitMaximization. Prof. Soloman of Stanford University has handled the issued very logically.
Heargues that it is useful to make a distinction between profit and 'profitability'. Maximization
of profits with a vie to maximising the wealth of shareholders is clearly an unreal motive. On
theother hand, profitability Maximization with a view to using resources to yield economic
valueshigher than the joint values of inputs required is a useful goal. Thus the proper goal of
financialmanagement is wealth maximization.

Q2. Explain the Net operating approach to capital structure.

Ans. net operating income approach examines the effects of changes in capital structure in terms
of net operating income. In the net income approach discussed above net income available to
shareholders is obtained by deducting interest on debentures form net operating income. Then
overall value of the firm is calculated through capitalization rate of equities obtained on the basis
of net operating income, it is called net income approach. In the second approach, on the other
hand overall value of the firm is assessed on the basis of net operating income not on the basis of
net income. Hence this second approach is known as net operating income approach.

The NOI approach implies that (i) whatever may be the change in capital structure the overall
value of the firm is not affected. Thus the overall value of the firm is independent of the degree
of leverage in capital structure. (ii) Similarly the overall cost of capital is not affected by any
change in the degree of leverage in capital structure. The overall cost of capital is independent of
leverage.

If the cost of debt is less than that of equity capital the overall cost of capital must decrease with
the increase in debts whereas it is assumed under this method that overall cost of capital is
unaffected and hence it remains constant irrespective of the change in the ratio of debts to equity
capital. How can this assumption be justified? The advocates of this method are of the opinion
that the degree of risk of business increases with the increase in the amount of debts.
Consequently the rate of equity over investment in equity shares thus on the one hand cost of
capital decreases with the increase in the volume of debts; on the other hand cost of equity
capital increases to the same extent. Hence the benefit of leverage is wiped out and overall cost
of capital remains at the same level as before. Let us illustrate this point.
If follows that with the increase in debts rate of equity capitalization also increases and
consequently the overall cost of capital remains constant; it does not decline.

To put the same in other words there are two parts of the cost of capital. One is the explicit cost
which is expressed in terms of interest charges on debentures. The other is implicit cost which
refers to the increase in the rate of equity capitalization resulting from the increase in risk of
business due to higher level of debts.

Optimum capital structure

This approach suggests that whatever may be the degree of leverage the market value of the firm
remains constant. In spite of the change in the ratio of debts to equity the market value of its
equity shares remains constant. This means there does not exist a optimum capital structure.
Every capital structure is optimum according to net operating income approach.

Q.3 What do you understand by operating cycle.

Ans.  An operating cycle is the length of time between the acquisition of inventory and the sale
of that inventory and subsequent generation of a profit. The shorter the operating cycle, the faster
a business gets a return on investment (ROI) for the inventory it stocks. As a general rule,
companies want to keep their operating cycles short for a number of reasons, but in certain
industries, a long operating cycle is actually the norm. Operating cycles are not tied to
accounting periods, but are rather calculated in terms of how long goods sit in inventory before
sale.

When a business buys inventory, it ties up money in the inventory until it can be sold. This
money may be borrowed or paid up front, but in either case, once the business has purchased
inventory, those funds are not available for other uses. The business views this as an acceptable
tradeoff because the inventory is an investment that will hopefully generate returns, but keeping
the operating cycle short is still a goal for most businesses so they can keep their liquidity high.

Keeping inventory during a long operating cycle does not just tie up funds. Inventory must be
stored and this can become costly, especially with items that require special handling, such as
humidity controls or security. Furthermore, inventory can depreciate if it is kept in a store too
long. In the case of perishable goods, it can even be rendered unsalable. Inventory must also be
insured and managed by staff members who need to be paid, and this adds to overall operating
expenses.

There are cases where a long operating cycle in unavoidable. Wineries and distilleries, for
example, keep inventory on hand for years before it is sold, because of the nature of the business.
In these industries, the return on investment happens in the long term, rather than the short term.
Such companies are usually structured in a way that allows them to borrow against existing
inventory or land if funds are needed to finance short-term operations.

Operating cycles can fluctuate. During periods of economic stagnation, inventory tends to sit
around longer, while periods of growth may be marked by more rapid turnover. Certain products
can be consistent sellers that move in and out of inventory quickly. Others, like big ticket items,
may be purchased less frequently. All of these issues must be accounted for when making
decisions about ordering and pricing items for inventory.

Q.4 What is the implication of operating leverage for a firm.

Ans.   

Operating leverage: Operating leverage is the extent to which a firm uses fixed costs in
producing its goods or offering its services. Fixed costs include advertising expenses,
administrative costs, equipment and technology, depreciation, and taxes, but not interest on debt,
which is part of financial leverage. By using fixed production costs, a company can increase its
profits. If a company has a large percentage of fixed costs, it has a high degree of operating
leverage. Automated and high-tech companies, utility companies, and airlines generally have
high degrees of operating leverage.

As an illustration of operating leverage, 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 semiskilled labor. Table 1 shows both firm’s operating
cost structures.

Highly automated firm A has fixed costs of $35,000 per year and variable costs of only $1.00 per
unit, whereas labor-intensive firm B has fixed costs of only $15,000 per year, but its variable
cost per unit is much higher at $3.00 per unit. Both firms produce and sell 10,000 widgets per
year at a price of $5.00 per widget.

Firm A has a higher amount of operating leverage because of its higher fixed costs, but firm A
also has a higher breakeven point—the point at which total costs equal total sales. Nevertheless,
a change of I percent in sales causes more than a I percent change in operating profits for firm A,
but not for firm B. The “degree of operating leverage” measures this effect. The following
simplified equation demonstrates the type of equation used to compute the degree of operating
leverage, although to calculate this figure the equation would require several additional factors
such as the quantity produced, variable cost per unit, and the price per unit, which are used to
determine changes in profits and sales:

Operating leverage is a double-edged sword, however. If firm A’s sales decrease by I percent, its
profits will decrease by more than I percent, too. Hence, the degree of operating leverage shows
the responsiveness of profits to a given change in sales.

Implications: Total risk can be divided into two parts: business risk and financial risk. Business
risk refers to the stability of a company’s assets if it uses no debt or preferred stock financing.
Business risk stems from the unpredictable nature of doing business, i.e., the unpredictability of
consumer demand for products and services. As a result, it also involves the uncertainty of long-
term profitability. When a company uses debt or preferred stock financing, additional risk—
financial risk—is placed on the company’s common shareholders. They demand a higher
expected return for assuming this additional risk, which in turn, raises a company’s costs.
Consequently, companies with high degrees of business risk tend to be financed with relatively
low amounts of debt. The opposite also holds: companies with low amounts of business risk can
afford to use more debt financing while keeping total risk at tolerable levels. Moreover, using
debt as leverage is a successful tool during periods of inflation. Debt fails, however, to provide
leverage during periods of deflation, such as the period during the late 1990s brought on by the
Asian financial crisis.