MADHAV INSTITUTE OF TECHNOLOGY & SCIENCE

ASSIGNMENT-
FINANCIAL MANAGEMENT

SUBMITTED BY-
ANCHAL GOYAL
0901MB211004

SUBMITTED TO-
DHARMENDRA CHAHAR SIR
Question 1- what do you understand by cost of capital?

Answer- Cost of Capital  is the minimum rate of return or profit a

company must earn before generating value. It’s calculated by a business’s
accounting department to determine financial risk and whether an
investment is justified.

Company leaders use cost of capital to gauge how much money new
endeavors need to generate to offset upfront costs and achieve profit. They
also use it to analyze the potential risk of future business decisions.

Cost of capital is extremely important to investors and analysts. These

groups use it to determine stock prices and potential returns from acquired
shares. For example, if a company’s financial statements or cost of capital
are volatile, cost of shares may plummet; as a result, investors may not
provide financial backing.

HOW TO CALCULATE COST OF CAPITAL

To determine cost of capital, business leaders, accounting departments,

and investors must consider three factors: cost of debt, cost of equity, and
weighted average cost of capital (WACC)

1. Cost of Debt

While debt can be detrimental to a business’s success, it’s essential to its

capital structure. Cost of debt refers to the pre-tax interest rate a company
pays on its debts, such as loans, credit cards, or invoice financing. When
this kind of debt is kept at a manageable level, a company can retain more
of its profits through additional tax savings.

Companies typically calculate cost of debt to better understand cost of

capital. This information is crucial in helping investors determine if a
business is too risky. Cost of debt also helps identify the overall rate being
paid to use funds acquired from financial strategies, such as debt financing,
which is selling a company’s debt to individuals or institutions who, in turn,
become creditors of that debt.

There are many ways to calculate cost of debt. One common method is
adding your company’s total interest expense for each debt for the year,
then dividing it by the total amount of debt.

formula that businesses and investors can use to calculate co st of debt is:

Cost of Debt = (Risk-Free Rate of Return + Credit Spread) × (1 – Tax

Rate)

Here’s a breakdown of this formula’s components:

1. Risk-free return: Determined from the return on US government

security
2. Credit spread: Difference in yield between US Treasury bonds and
other debt securities
3. Tax rate: Percentage at which a corporation is taxed.

2. Cost of Equity

Equity is the amount of cash available to shareholders as a result of asset

liquidation and paying off outstanding debts, and it’s crucial to a company’s
long-term success.

Cost of equity is the rate of return a company must pay out to equity
investors. It represents the compensation that the market demands in
exchange for owning an asset and bearing the risk associated with owning
it.

This number helps financial leaders assess how attractive investments are
—both internally and externally. It’s difficult to pinpoint cost of equity,
however, because it’s determined by stakeholders and based on a
company’s estimates, historical information, cash flow, and comparisons to
similar firms.

Cost of equity is calculated using the Capital Asset Pricing Model (CAPM),
which considers an investment’s riskiness relative to the current market.

To calculate CAPM, investors use the following formula

Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of

Return - Risk-Free Rate of Return

Here’s a breakdown of this formula’s components:

 Dividends: Amount of money a company pays regularly to its

shareholders
 Market value stocks: Fractional ownership of equity in an
organization that’s value is determined by financial markets
 Dividend growth rate: Annual percentage rate of growth of a
dividend over a period.

3. Weighted Average Cost of Capital (WACC)

Weighted average cost of capital is the most common method for

calculating cost of capital. It equally averages a company’s debt and equity
from all sources.

Companies use this method to determine rate of return, which indicates the
return that shareholders demand to provide capital. It also helps investors
gauge the risk of cash flows and desirability for company shares, projects,
and potential acquisitions. In addition, it establishes the discount rate for
future cash flows to obtain value for a business.

WACC is calculated by multiplying the cost of each capital source (both

equity and debt) by its relevant weight by market value, then adding the
products together to determine the total. The formula is:
 WACC = (E/V x Re) + ((D/V x Rd) x (1 – T)

Here’s a breakdown of this formula’s components:

 E: Market value of firm’s equity

 D: Market value of firm’s debt
 V: Total value of capital (equity + debt)
 E/V: Percentage of capital that’s equity
 D/V: Percentage of capital that’s debt
 Re: Required rate of return
 Rd: Cost of debt
 T: Tax rate
A high WACC calculation indicates that a company’s stock is volatile
or its debt is too risky, meaning investors will demand greater returns.

Question-2- what is time value of money how to

calculate it?

Answer-
The Time Value of Money is a core principle of valuation that states that
money as of the present date carries more value than the same amount
received in the future.

The time value of money is the widely accepted conjecture that there is

greater benefit to receiving a sum of money now rather than an identical
sum later. It may be seen as an implication of the later-developed concept
of time preference.
The present value of $1,000, 100 years into the future. Curves represent
constant discount rates of 2%, 3%, 5%, and 7%.
The time value of money is among the factors considered when weighing
the costs of spending rather than saving or investing money. As such, it is
among the reasons why interest is paid or earned: interest, whether it is on
a bank deposit or debt, compensates the depositor or lender for the loss of
their use of their money. Investors are willing to forgo spending their money
now only if they expect a favorable net return on their investment in the
future, such that the increased value to be available later is sufficiently high
to offset both the preference to spending money now and inflation if
present required rate of return.

How to Calculate the Time Value of Money

In short, receiving money today is preferable (i.e. more valuable) than
receiving the same amount of money on a later date.

Under the time value of money concept, a dollar received today is worth
more than a dollar received at a later date — which is one of the most
fundamental concepts in corporate finance.

There are two main reasons backing this theory:

1. Opportunity Cost: If you have capital on hand currently, the

funds could be used to invest into other projects to achieve a
higher return — i.e. the “opportunity cost” of the money.
2. Inflation: There are risks to consider such as inflation or the
probability that the company in question might go bankrupt in the
 future — i.e. future uncertainty should be costlier than the lower
risks identified on the present date.
Since money tends to decline in value across time due to factors such as
inflation, the purchasing power of money also decreases.

With that said, cash flows received in the future (and with increased
uncertainty) are worth less than the present value (PV) of the cash flows.
If you risk one dollar in an investment, you should reasonably expect gains
of more than solely your initial one-dollar contribution as a return.

For each incremental unit of risk you take on, you should expect a
proportionally higher return in exchange.

Present Value (PV) Formula

The formula for the time value of money, from the perspective of the
current date, is as follows:

PV = FV / [1 +( i / n) ^(n * t)
PV = Present Value

FV = Future Value

i = Annual Rate of Return (Interest Rate)

n = Number of Compounding Periods Each Year

t = Number of Years
Future Value (FV) Formula
Alternatively, to calculate the future value given the present value, the
formula used is:

FV = PV * [ 1 + (i / n) ] ^ (n * t)
In both formulas, “i” represents the rate of interest on comparable
investments

QUESTION-3- Define financial leverage and

operations leverage with example.

Answer-
Financial leverage refers to the utilization of borrowed funds to acquire
new assets which are assumed to generate a higher capital gain or income
as compared to the cost of borrowing. It is a liability for the borrowing
business organization whereas, makes a source of income for the lender.

Financial leverage refers to the utilization of borrowed funds to acquire

new assets which are assumed to generate a higher capital gain or income
as compared to the cost of borrowing. It is a liability for the borrowing
business organization whereas, makes a source of income for the lender.

The three ways in which the company can obtain funds are as follows:

 Debt: Debts are the funds borrowed in the form of

bonds, commercial papers and debentures to be paid back to
the lender with interest.
 Equity: Equity is the issuing of shares to the public for gathering
funds by giving ownership.
 Leases: Lease refers to a legal agreement abiding to which the
lessor provides a property to be used by the lessee for the
defined period in exchange for money.
Measures of Financial Leverage
After employing additional capital into the business, the management uses
various financial ratios to the performance of the company. The four most
crucial financial leverage ratios or measures are given below:

Debt-Equity Ratio

The debt-equity ratio is the proportion of the funds which the company has
borrowed to the fund raised from shareholders. In short, it is the ratio of the

borrowings to the owner’s fund.

Analysis: The higher the debt-equity ratio is, the weaker is the financial
position of the company. Therefore, this ratio should always be less to
avoid the risk of bankruptcy and insolvency.

Debt Ratio

The debt ratio determines the company’s asset position or strength to meet

its liabilities.

Analysis: Lower is the debt ratio of the company; the sounder is its financial
position, indicating that the company has sufficient assets to pay of the
liabilities at the time of downfall.

Interest Coverage Ratio

The interest coverage ratio emphasizes the company’s ability to pay off the
interest with the profits earned.

Analysis: If the ratio is high, it signifies that the company can make enough
profit to pay the interest due and vice-versa.
Degree of Financial Leverage (DFL)

The degree of financial leverage (DFL) signifies the level of volatility in the
earning per share (EPS) with the change in operating income as a result of
the capital restructuring, i.e., acquisition of debts, issuing of shares and
debentures and leasing out assets.

Operating Leverage-
Operating leverage is a cost-accounting formula that measures the degree
to which a firm or project can increase operating income by increasing
revenue. A business that generates sales with a high gross margin and
low variable costs has high operating leverage.
The higher the , the greater the potential danger from forecasting risk, in
which a relatively small error in forecasting sales can be magnified into
large errors in cash flow projections.
The Operating Leverage Formula Is:
Degree of operating leverage=Profit Contribution margin

Degree of operating leverage=Q∗CM−Fixed operating costs
where :Q=unit quantityCM=contribution margin (price - variable cost per u
nit)

where:
Q=unit quantityCM=contribution margin (price - variable cost per unit)

High and Low Operating Leverage

It is important to compare operating leverage between companies in the
same industry, as some industries have higher fixed costs than others.
The concept of a high or low ratio is then more clearly defined.
Most of a company’s costs are fixed costs that recur each month, such as
rent, regardless of sales volume. As long as a business earns a substantial
profit on each sale and sustains adequate sales volume, fixed costs are
covered and profits are earned.

QUESTION-3- what is the scope of financial

management?

Answer- Scope of Financial Management Financial

management helps a particular organisation to utilize their finances most
profitably. This is achieved via the following two conducts.
The scope of financial management is divided into two
categories: 1. Traditional Approach 2. Modern Approach
Let us discuss the two approaches in brief.

Traditional Approach According to this approach, the scope of

financial function is restricted to procurement of funds by the corporate
organizations to meet their financial needs. The term procurement here
refers to raising of funds externally as well as the interdependent aspects
of raising funds.
Institutional source of finance
Issuance of financial instruments to collect funds from the capital market.
Legal and accounting relationship between the business and the source of
finance.
According to this approach, finance is not required for the routine events
but for the sporadic events like promotion, reorganization, liquidation,
expansion, etc. Managing funds for these things is considered as the most
important feature of financial management. The financial manager in this
approach is not concerned with internal financing rather he has to maintain
relationships with outside parties and financial institutions. According to
this approach, the financial manager is not responsible for the efficient use
of funds whereas he is responsible to get necessary funds on fair terms
from the outside parties. The traditional approach continued till the fifth
decade of the 20th century
What are the Limitation of Traditional Approach The traditional approach of
finance can be considered somewhat narrow because of several reasons.
Following are the primary drawbacks and this approach. One-sided
Approach This traditional approach gives more attention to the system of
procurement and the problems that might arise during that scenario. It
does not offer a system for efficient utilization of procured funds. This
approach considers the viewpoint of outside parties (like banks, financial
institutions, investors) who provide funds to the business but ignores the
internal parties who are responsible to take financing decisions. Therefore,
a one-sided approach is also termed as an outsider-looking approach
More Focus On the Financial Issues of Corporate Enterprise: This
approach focuses only on the financial problem of corporate enterprises
but the financial problems of non corporate entities like partnership firms,
and sole trade are ignored.
More Emphasis On Sporadic Events: Traditional approach considers
fund allocation as on the contingencies for sporadic incidents like business
reorganization, incorporations, mergers, consolidation, etc. ignoring This
approach ignores everyday financial problems that a business enterprise
might face. Working capital financing decisions are also kept outside the
scope of a traditional approach.

Modern Approach
By the end of the 1950 technology up-gradation, development of strong
corporate structure and increasing competition made it necessary for the
management to make optimum use of available natural resources.
According to this approach, the financial manager considers the broader
and analytical point of view. According to the modern approach, financial
management is concerned with both acquisition of funds and optimum use
of available resources. The arrangement of funds is an important
component of the whole finance function.
In this approach, not only sporadic events are considered but also the long
term and short term financial problems are considered. The main
components of financial management include financial planning,
evaluation of alternative use of funds, capital budgeting, determination of
cost of capital, determination of the financial standard for the success of
the business, management of income, etc. Therefore, according to this
approach, three important decisions are taken by the finance manager.

The three decisions are: Investment Decision

Financing Decision
Dividend Decision