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IGNOU MBA MS-04 Solved Assignment

December 2012
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Ans.1A)
'Capitalization Of Earnings'
A method of determining the value of an organization by calculating the net present
value (NPV) of expected future profits or cash flows. The capitalization of earnings
estimate is done by taking the entity's future earnings and dividing them by the
capitalization rate (cap rate). This will take into account the risk that earnings will stop
or be lower than the estimate.
Where:
d = discount rate
g = growth rate
This is an income-valuation approach that determines the value of a business by looking
at the current benefit of realizing a cash flow now, rather than in the future. The
capitalization of earnings is particularly useful when the future earnings can be
predicted easily and accurately.

For example, if a company had a business that made $1.2 million last year and that was
expected to grow at a 4% rate (plus a 3.25% inflation rate), the annual rate of return
needed by a purchaser given the level of risk would be 26%. Expected value using the
capitalization of earnings method would be $6.4 million, calculated as:

-$1,200,000/ (0.26 - (.04+.0325))

-$1,200,000/0.1875
-$6.4 million

Ans 1 B)
'Net Worth'
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The amount by which assets exceed liabilities. Net worth is a concept applicable to
individuals and businesses as a key measure of how much an entity is worth. A
consistent increase in net worth indicates good financial health; conversely, net worth
may be depleted by annual operating losses or a substantial decrease in asset values
relative to liabilities. In the business context, net worth is also known as book value or
shareholders' equity.
For a company, total assets minus total liabilities. Net worth is an important
determinant of the value of a company, considering it is composed primarily of all the
money that has been invested since its inception, as well as the retained earnings for the
duration of its operation. Net worth can be used to determine creditworthiness because
it gives a snapshot of the company'sinvestment history. also called owner's equity,
shareholders' equity, or net assets
The net worth of a company (sometimes referred to as its net assets) is measured by
subtracting the total assets of the company from its total liabilities. Thus, net worth
represents the liquidation proceeds a company would fetch if its operations were to
cease immediately and the firm were sold off.
OWNER’S EQUITY
Total assets minus total liabilities of an individual or company. For a company, also
called net worth or shareholders' equity or net assets.Owner’s equity is one of the three
main components of a sole proprietorship’s balance sheet and accounting equation.
Owner’s equity represents the owner’s investment in the business minus the owner’s
draws or withdrawals from the business plus the net income (or minus the net loss)
since the business began.
Mathematically, the amount of owner’s equity is the amount of assets minus the amount
of liabilities. Since the amounts must follow the cost principle (and others) the amount
of owner’s equity does not represent the current fair market value of the business.
DIVIDEND POLICY NOT CONNECTED DIRECTLY WITH THE NET WORTH.•
Dividend Policy refers to the explicit or implicit decision of the Board of Directors
regarding the amount of residual earnings (past or present) that should be distributed to
the shareholders of the corporation.
o This decision is considered a financing decision because the profits of the corporation
are an important source of financing available to the firm.
Types of Dividends
Dividend Policy
Types of Dividends
• Dividends are a permanent distribution of residual earnings/property of the
corporation to its owners.
• Dividends can be in the form of:
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o Cash
o Additional Shares of Stock (stock dividend)
o Property

Ans 2.
Determinants of Working Capital:
- Nature of Business/Industry;
-Size of Business/Scale of Operations;
-Growth prospects
- Business Cycle;
-Manufacturing Cycle;
-Operating Cycle &
-Rapidity of Turnover;
- Operating Efficiency;
-Profit Margin;
-Profit Appropriation
- Depreciation Policy;
-Taxation Policy;
-Dividend Policy and
-Government Regulations

1. Nature of Business
This is one of the main factors. Usually in trading businesses the working capital needs
are higher as most of their investment is concentrated in stock or inventory.
Manufacturing businesses also need a good amount of working capital to meet their
production requirements.
2. Size of Business
Size of business is another influencing factor. As size increases, the working capital
requirement is also more and vice versa.
3. Credit Terms / Credit Policy
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Credit terms greatly influence working capital needs. If terms are:

i. buy on credit and sell by cash, working capital is lower
ii. buy on credit and sell on credit, working capital is medium
Prevailing trade practices and changing economic condition do generally exert greater
influence on the credit policy of concern.
e. A liberal credit policy if adopted more trade debtors would result and when the same
is tightened, size of debtors gets slim.
4. Seasonality
. Seasonality of Production
Agriculture and food processing and preservation industries have a seasonal production.
During seasons, when production activities are in their peak, working capital need is
high. it pays to buy in bulk during the seasons. Hence the high level of working capital
needed when season exists for raw materials.
5. Trade Cycle
Trade cycle refers to the periodic turns in business opportunities from extremely peak
levels, via a slackening to extremely tough levels and from there, via a recovery phase to
peak levels, thus completing a business cycle. There are 4 phases of trade cycle.
a. Boom Period.
a. Depression period
b. Recession period –
d. Recovery period
6. Inflation
Under inflationary conditions generally working capital increases, since with rising
prices demand reduces resulting in stock pile-up and consequent increase in working
capital.
7. Production cycle
The time lapse between feeding of raw material into the machine and obtaining the
finished goods out from the machine is what is described as the length of manufacturing
process. It is otherwise known as conversion time.
8. System of Production process
If capital intensive, high-technology automated system is adopted for production, more
investment in fixed assets and less investment in current assets are involved
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9. Growth and expansion plans

Growth and expansion industries need more working capital than those that are static.
10.. Small or Large Demand
Nature of demand also absolutely affects the working capital need. Some product can be
easily sold by businessman, in that business; you need small amount of working capital
because your earned money from sale can easy fulfill the shortage of working capital.
11. Production Policy
Production policy is also main determinant of working capital requirement. Different
company may different production policy. Some companies stop or decrease the
production level in off seasons, in that time.
12. Dividend Policy
Dividend policy also effect working capital requirement. Company can distribute major
part of net profit. But, if there is no reserve, we have to invest large amount in working
capital because, lacking of reserve will effect on adversely on fulfill our liabilities
 TWO FIRMS WITH DIFFERENT WORKING CAPITAL
CAN ACHIEVE THE SAME SALES VOLUME , PROVIDED THEY MANAGE THE
FOLLOWING FACTORS EFFECTIVELY.
1.WORKING CAPITAL CYCLE
Cash flows in a cycle into, around and out of a business. It is the business's life blood
and every manager's primary task is to help keep it flowing and to use the cashflow to
generate profits. If a business is operating profitably, then it should, in theory, generate
cash surpluses. If it doesn't generate surpluses, the business will eventually run out of
cash and expire.
2.SOURCES OF ADDITIONAL WORKING CAPITAL.
Sources of additional working capital include the following:
• Existing cash reserves
• Profits (when you secure it as cash !)
• Payables (credit from suppliers)
• New equity or loans from shareholders
• Bank overdrafts or lines of credit
• Long-term loans
3. HANDLING RECEIVABLES [ DEBTORS]
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Cashflow can be significantly enhanced if the amounts owing to a business are collected
faster. Every business needs to know.... who owes them money.... how much is owed....
how long it is owing.... for what it is owed.you may need to look for the following
possible defects:
• weak credit judgement
• poor collection procedures
• lax enforcement of credit terms

4. MANAGING PAYABLES [ CREDITORS]

Creditors are a vital part of effective cash management and should be managed carefully
to enhance the cash position.
Purchasing initiates cash outflows and an over-zealous purchasing function can create
liquidity problems.
5. INVENTORY MANAGEMENT
Managing inventory is a juggling act. Excessive stocks can place a heavy burden on the
cash resources of a business. Insufficient stocks can result in lost sales, delays for
customers etc.

Ans 3.
Importance of Cash Flows statement :-
Paradoxically a situation arises when profits are reported but negative cash flows are
experienced by the business entities. Therefore, it is of the essence that the changes in
cash position be depicted; to know the cash concepts that the statement of cash flows is
based upon; to get the information about the cash receipts and the cash payments
during a period. Also, it is necessary to assess the ability of a business entity to generate
cash so that it can be used as and when it is needed. Moreover, it is required to assess
the liquidity and solvency position of a business. Thus, the preparation of cash flow
statement is very much useful to management. It is one of the three main financial
statements (Balance Sheet, Income Statement and the cash flow statement).
The cash flow statement is an important tool as it explains the changes in cash and gives
the information related to the business operating, investing and financing activities in a
way to bring advantage to short term analysis and cash planning of the business.
Cash flows are inflows and outflows of cash and cash equivalents. The cash activities are
classified into three main categories of cash inflows and cash outflows. The tree
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categories are:-
1- Operating activities- They are revenue generating activities of the business entity.
They include cash effects of transactions by which Net profit or loss is determined. 

2- Investing Activities- Investing activities are those that involve the acquisition and
selling fixed assets.(Land, building and equipments) not held for resale.
3- Financing Activities- These activities are the activities by which the size and the
composition of owners’ capital is changed.
 Soources of cash flows are :-
The (total) net cash flow of a company over a period (typically a quarter or a full year) is
equal to the change in cash balance over this period: positive if the cash balance
increases (more cash becomes available), negative if the cash balance decreases. The
total net cash flow is the sum of cash flows that are classified in three areas:
1. Operational cash flows: Cash received or expended as a result of the company's
internal business activities. It includes cash earnings plus changes to working capital.
Over the medium term this must be net positive if the company is to remain solvent.
2. Investment cash flows: Cash received from the sale of long-life assets, or spent on
capital expenditure (investments, acquisitions and long-life assets).
3. Financing cash flows: Cash received from the issue of debt and equity, or paid out as
dividends, share repurchases or debt repayments.
 CONCEPT OF CASH CYCLE
The length of time between the purchase of raw materials and the collection of accounts
receivable generated in the sale of the final product.also called cash conversion cycle
A metric that expresses the length of time, in days, that it takes for a company to convert
resource inputs into cash flows. The cash conversion cycle attempts to measure the
amount of time each net input dollar is tied up in the production and sales process
before it is converted into cash through sales to customers. This metric looks at the
amount of time needed to sell inventory, the amount of time needed to collect
receivables and the length of time the company is afforded to pay its bills without
incurring penalties.

Ans 4.
Capital structure planning is very important to survive the business in long run. After
simple watching the balance sheet of company, you see two sides of balance sheet. One
side is liability side and other side is asset side. Liability side is the mixture of finance of
company which company has collected from internal and external sources and it has
been used or will be used for development of company.
Liability side of balance sheet is made under perfect capital structure planning. Finance
manager and other promoters decides which source of fund or funds should be selected
after monitoring the factors affecting capital structures. So, capital structure planning
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makes strong balance sheet. The right capital structure planning also increases the
power of company to face the losses and changes in financial markets. Following points
shows the importance of capital structure and its planning.

 factors to be considered whenever a capital structure decision is taken are below. Let
it’s briefly explain these factors.
1. Leverage or Trading on Equity
The use of sources of finance with a fixed cost, such as debt and preference share capital,
to finance the assets of the company is known as financial leverage or trading on equity.
If the assets financed by debt yield a return greater than the cost of the debt, the
earnings per share will increase without an increase in the owners ‘investment.
Similarly, the earnings per share will also increase if preference share capital is used to
acquire assets.
2. Cost of Capital
Measuring the costs of various sources of funds is a complex subject and needs a
separate treatment. Needless to say that it is desirable to minimize the cost of capital.
Hence, cheaper sources should be preferred, other things remaining the same. The cost
of a source of finance is the minimum return expected by its suppliers. The expected
return depends on the degree of risk assumed by investors. A high degree of risk is
assumed by shareholders than debt-holders.
3. Cash Flow
One of the features of a sound capital structure is conservation. Conservation does not
mean employing no debt or a small amount of debt. Conservatism is related to the
assessment of the liability for fixed, charges, created by the use of debt or preference
capital in the capital structure in the context of the firm's ability to generate cash to meet
these fixed charges.
4. Control
In designing the capital structure, sometimes the existing management is governed by
its desire to continue control over the company. The existing management team may not
only what to be elected to the Board of Directors but may also desire to manage the
company without any outside interference.
5. Flexibility
Flexibility means the firm's ability to adapt its capital structure to the needs of the
changing conditions. The capital structure of a firm is flexible if it has no difficulty in
changing its capitalisation or sources of funds. Whenever needed the company should
be able to raise funds without undue delay and cost to finance the profitable
investments.
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6. Size of the Company

The size of a company greatly influences the availability of funds from different
sources. A small company may often find it difficult to raise long-term loans. If
somehow it manages to obtain a long-term loan, it is available at a high rate of
interest and on inconvenient terms. The highly restrictive covenants in loans
agreements of small companies make their capital structure quite inflexible. The
management thus cannot run business freely.
7. Marketability
Marketability here means the ability of the company to sell or market particular type of
security in a particular period of time which in turn depends upon -the readiness of the
investors to buy that security.
8. Floatation Costs
Floatation costs are incurred when the funds are raised. Generally, the cost of floating a
debt is less than the cost of floating an equity issue. This may encourage a company to
use debt rather than issue ordinary shares.

Ans. 5.

Budgetary control:

Budgetary Control is defined as "the establishment of budgets, relating the

responsibilities of executives to the requirements of a policy, and the continuous
comparison of actual with budgeted results either to secure by individual action the
objective of that policy or to provide a base for its revision. A control technique whereby
actual results are compared with budgets. Any differences (variances) are made the
responsibility of key individuals who can either exercise control action or revise the
original budgets. A budgetary control also ensures that corporate cash outflows
(payments) and inflows (receipts) remain at adequate levels. A statement of cash flows
indicates cash flows from operating activities, investing activities and financing
activities.

Advantages of budgeting and budgetary control

 Compels management to think about the future, which is probably the most
important feature of a budgetary planning and control system
 Promotes coordination and communication.
 Clearly defines areas of responsibility. Requires managers of budget centres to be
made responsible for the achievement of budget targets for the operations under
their personal control.
 Provides a basis for performance appraisal (variance analysis).
 Enables remedial action to be taken as variances emerge.
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 Motivates employees by participating in the setting of budgets.

 Improves the allocation of scarce resources.
 Economies management time by using the management by exception principle.
Different types of budgets help the organisation monitor and control different aspects of
the business.

 Sales/Revenue budget- It shows the amount of money that flows into the business at
any point in time, then number of units (products or services) that would be sold and
at what price they would be sold at. This information could help the organisation e.g.
in hiring more staff to handle the expected rise in sales.
 Production budget- It shows the current levels of stock and rate of production. It
would also take note in the seasonal fluctuations in the sales budget to meet current
demand. This could help the organisationmaximise their storage and logistics and
lower costs associated in these areas.
 Cash budgets- This budget monitors the cash flows in the business, and the cash
reserves. The main reason for monitoring this budget could be to make sure that the
organisation is always at a position to pay its current liabilities and ensure there is no
shortage of cash for operational expenses and day to day running of the organisation.
 Purchases budget- A purchases budget records and controls the raw materials the
organisation buys. It takes into account the production budget and matches the raw
materials that would be required to keep inline with the rate of production.
 Expenses budget- An expense budget is sub divied into 3 boroad
catogeries,i.e.:Marketing,Sales and Financial. As sales grow or there is a new
marketing campaign this is the budget that would monitor and controll the expenses
that relates to these activities.This would simplify the cost ratio analisis.
 Capital budget- A capital budget would accommodate the expense in buying a captal
intensive asset, and example of an item that belongs to the capital budget could be a
new delivert truck or an additional wharehouse.
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