“ Finance Management”

In partial fulfilment of the requirement of the subject in

SSMBA-I, MBA PROGRAMME

MBA PROGRAMME,
FACULTY OF MANAGEMENT STUDIES,
THE MAHARAJA SAYAJIRAO UNIVERSITY, VADODARA
Academic Year (2022-2024)

Submitted to
Dr. Bhargav Pandya Sir
ASSISTANT PROFESSOR

Submitted by
Salil A. Thosar
MBA SEMESTER II
PRN NO.: 8022053356
Question 1: Describe the dividend relevance and irrelevance theories with
suitable examples along with their implications

Solution:
The dividend theories relates with the impact of dividend on the value of the firm. According
to one school of thought, the dividends are irrelevant and the amount of dividends paid does
not affect the value of the firm while the other theory considers that the dividend decision is
relevant to the value of the firm.
Thus, there are conflicting theories on dividends.
1. Relevance Theory of Dividend.
2. Irrelevance Theory of Dividend.

(1) Relevance of Dividend:

Walter and Gordon suggested that shareholders prefer current dividends and hence a positive
relationship exists between dividend and market value. The logic put behind this argument is
that investors are generally risk-averse and that they prefer current dividend, attaching lesser
importance to future dividends or capital gains.

(1.1) Walter Valuation Model:

Prof James E. Walter developed the model on the assumption that dividend policy has
significant impact on the value of the firm.
Example:

(1.2) The Gordon Growth Model

The most common DDM is the Gordon growth model, which uses the dividend for the next
year (D1), the required return (r), and the estimated future dividend growth rate (g) to arrive
at a final price or value of the stock. The formula for the Gordon growth model is as follows:
Stock Value=D1/(r – g)
This calculation values the stock entirely on expected future dividends. You can then
compare the calculated price to the actual market price in order to determine whether
purchasing the stock at market will meet your requirements.

Example:
Let us consider the data in Table 17.3. The implications of dividend policy, according to
Gordon’s model, are shown respectively for the growth, the normal and the declining firms.
It is revealed that under Gordon’s model:
 The market value of the share, P0, increases with the retention ratio, b, for firms with
growth opportunities, i.e., when r > k.
 The market value of the share, P0, increases with the payout ratio, (1 – b), for
declining firms with r < k.
 The market value of the share is not affected by dividend policy when r = k.
Gordon’s model’s conclusions about dividend policy are similar to that of Walter’s model.
This similarity is due to the resemblance of assumptions that underlie both the models. Thus
the Gordon model suffers from the same limitations as the Walter model.

Irrelevance of Dividend:
As per Irrelevance Theory of Dividend, the market price of shares is not affected by dividend
policy. Payment of dividend does not change the wealth of the existing shareholders because
payment of dividend decreases cash balance and their share price falls by that amount. Franco
Modigliani and Merton Miller, two Nobel-laureates developed this model in the year 1961.

Modigliani-Miller (M-M) Hypothesis:

Modigliani and Miller argued that the value of firm is solely determined by the earning
capacity of a firm’s assets and split of earnings between dividend and retained earnings does
not affect the shareholders’ wealth. They suggested that in perfect financial market, the value
of a firm is unaffected by the distribution of dividends. They also argued that values of shares
are affected by the future earnings and the risk of its investment.
Mathematical Explanation of M-M Hypothesis:
The rate of return (r) as per M-M Hypothesis is

If m Number of shares is to be issued at the end of the year at Price P1 to finance new
investment, then the Value of the firm at the beginning of the year will be:
Example:
X Ltd., belongs to a risk class having cost of capital 12%. It has 25,000 shares outstanding
selling at Rs 10 each. The company is planning to declare a dividend of Rs 2 per share at the
end of the current year.What will be the market price of share if dividend is declared and
dividend is not declared, assuming the M-M Hypothesis.
Solution:
We know,
P0 = D1 + P1 / 1 + k
Where, P0 = Current market price = Rs 10
D1 = Dividend at the end of the year
k = Cost of capital
Question 2: Explain the capital structure theories with suitable illustrations

Solution:
Theories of capital structure
A business requires the most beneficial capital structure. Therefore, many capital structure
theories are available to take as a reference; amongst them, we will discuss the four most
essential ones:

1) The Net Income Approach

1. Net Income Approach: According to Durand, this theory states that there is a relationship
between Capital structure and the value of the Firm and therefore the firm Can affects its
value
by increasing or decreasing the Debt proportion in the overall financing mix. This approach is
based on the following assumptions.
1. The total Capital requirement of the firm is given and remains constant.
2. The cost of debt is less than cost of Equity.
3. Both Kd and Ke remain constant and increase in financial leverage i.e. use of more and
debt financing in the capital structure does not affect the risk perception of the investors.
The line of argument in favor of Net Income approach is that as the proportion of Debt
financing
in capital structure increases, the proportion of an expensive source of fund increases. This
results in the decrease in overall cost of capital leading to an increase in the value of the firm.
The reason for assuming Kd less than Ke are that interest rates are usually lower than the
dividend rates due to the element of risk and the benefit of tax as the interest is a deductible
expense. The total market value of the firm on the basis of Net Income approach can be
ascertained as below:

V=E+D
Overall cost of Capital can be calculated as below:
Ko = EBIT/V

Illustration : The expected EBIT of a firm is Rs. 80,000. It has Rs. 2, 00,000 8% debentures.
The equity capitalization rate of the company is 10%. Calculate the value of the firm and over
all Capitalization rate according to Net Income Approach.
Solution:
2. Net Operating Income Approach: The NOI approach is opposite to the NI approach.
According to NOI approach, the market value of the firm depends upon the net operating
profit
or EBIT and the overall cost of Capital. The financing mix or the capital structure is
irrelevant
and does not affect the value of the firm. The NOI approach makes the following
assumptions:
1. The Kd is taken as constant.
2. The K0 of the firm is also taken as constant.
3. The firm capitalizes the total earnings of the firm to find the value of the firm as a whole.
4. The use of more and more debt in capital structure increase the risk of the shareholders
and thus results in the increase in cost of equity capital i.e. Ke. The increase in Ke is such
as to completely offset the benefits of employing cheaper debts.

The value of a firm on the basis of NOI approach can be determined as below:
V = EBIT
Ko
Where, V = Value of the firm
EBIT = Earning before interest and tax
Ko = Overall cost of Capital
The market value of equity is residual value, calculated as
E=V–D
And the Cost of Equity is, Ke = EBIT – Interest/V-D
Thus financing Mix is irrelevant and does not affects the value of the firm.. The value of the
firm remains for all types of debt – equity mix. Since there will be change in the risk of the
shareholders as a result of change in Debt-Equity mix, therefore the Ke will be changing
linearly with change in debt proportion.

Illustration : A firm has an EBIT of Rs. 2, 00,000 and belongs to a risk class of 10%. What
is the value of equity capital if it employees 6% debt to the extent of 30%, 40%, 50% of the
total capital fund of Rs. 10, 00,000.

Solution:
3. Traditional Approach: The traditional approach also known as Intermediate approach is a
compromise between the two extremes of Net income approach and Net operating income
approach. According to this theory, the value of the firm can be increased initially or the cost
of capital can be decreased by using more debt as the debt is the cheaper source if finance
then equity. Thus the optimum capital structure can be reached by a proper Debt Equity mix.
Beyond
a particular point, the cost of equity increases because increased debt increases the financial
risk of the equity shareholders. The advantage of cheaper debt at this point of capital structure
is offset by increased cost of equity. After this there comes a stage, when the increased cost
of
equity cannot be offset by the advantage of low cost debt. Thus the overall cost of debt
decrease
up to a certain point, remains more or less unchanged for l\moderate increase in debt
thereafter
and increases or rises beyond a certain point. Thus as per the traditional approach, a firm can
be benefited from a moderate level of leverage when then advantages of using debt
outweighed the disadvantages of increasing Ke. The overall cost of capital is a function of
financial leverage. The value of the firm can be affected, by the judicious use of debt and
equity in capital structure.

Illustration: Compute the market value of the firm, value of shares and average cost of capital
from the following information:

Assume that Rs.4, 00,000 debentures can be raised at 5% rate of interest whereas Rs. 6,
00,000 Debentures can be raised at 6% rate of interest
Solution:
Computation of market value of firm, value of shares & the average cost of capital.

4. Modigliani and Miller Approach: M&M Model, which was presented in 1958 on the
relationship between the leverage, cost of capital and the value of the firm. The model
emphasis that under a given set of assumptions the capital structure and its composition has
no effect on the value of the firm. There is nothing which may be called the optimal capital
structure, the model is based ob the following assumptions:
1. The capital markets are perfect and the complete information is available to all the
investors free of cost.
2. The securities are infinitely divisible.
3. Investors are rational and well informed about the risk return of all the securities.
4. The personal leverage and the corporate leverage are perfect substitute.

On the basis of the above assumptions, the M&M Model derived that:
1. The total value of the firm is equal to the capitalized value of the operating earnings of
the firm.
2. The total value of the firm is independent of the financial mix.
3. The cut off rate of the investment decision of the firm depends upon the risk class to
which the firm belongs, and thus is not affected by the financing pattern of this
investment.

The M&M model argues that if two firms are alike in all respects except that they differ in
respect of their financing patter and their market value, then the investors will develop a
tendency to sell the shares of the overvalued firm and to buy the shares of the undervalued
firm. This, buying and selling pressure will continue till the two firms have same market
value.
Illustration:
Suppose there are two firms, LEV & Co. and ULE & Co.. These are alike and identical in all
respect except that the LEV & Co. is a leveraged firm and has 10% debt of Rs. 30, 00,000 in
its capital structure. O the other hand, the ULE & Co. is an unleveled firm and has raised
funds only by the issue of the equity share capital. Both these firms have an EBIT of Rs. 10,
00,000 and the equity capitalization rate, Ke of 20%. The total value and WACC of both the
firms may be
ascertained as follows:

Though both the firm has same EBIT still the Levered firm has a lower Ko and higher value
as against the Unleveled firm. MM argues that this position cannot exist for a long and there
will be equality in the value of the two firms through the Arbitrage process.

Question 3: Describe the techniques of risk analysis in capital budgeting with relevant
examples

Solution:

All the techniques of capital budgeting require the estimation of future cash inflows and cash
outflows. But due to uncertainties about the future, the estimates if demand, production, sales
cannot be exact. All these elements of uncertainty have to be taken into account in the form
of forcible risk while taking a decision on investment proposals. The following two methods
are suggested for accounting for risk in capital budgeting.

1. Risk adjusted cut off rate or method of varying discount rate.

2. Certainty equivalent method.

Risk adjusted cut off rate or method of varying discount rate: The simplest method for
accounting for risk in capital budgeting is to increase the cut-off rate or the discount factor by
certain % on account of risk. The projects which are more risky and which have greater
variability in expected returns should discounted at higher rate as compared to the projects
which are less risky and are expected to have lesser variability in returns. The greater
drawback of this method is that it is not possible to determine the risk premium rate
appropriately and moreover it is the future cash flow, which is uncertain and requires the
adjustment and not the discount rate.
Illustration: The Beta Company Is considering the purchase of new investment. Two
alternatives investments are available (A and B) Rs.1, 00,000. Cash flows are expected to be
as follows:

The company has a target return on capital at 10%. Risk premium rates are 2% and 8%. For
investments A and B. which investments should be preferred?

Solution:

The profitability of the investments can be compared on the basis of net present values cash
inflows adjusted for risk premiums rate as follows:

As even at a higher discount rate investment B gives a higher present value, investment B
Should be preferred.

Certainty Equivalent Method: Another simple method of accounting foe risk n capital
budgeting is to reduce the expected cash flows by certain amounts. It can be employed by
multiplying the expected cash flows by certainty equivalent co-efficient as to convert the cash
floe to certain cash flows.
Illustration 5. There are two projects X and Y. each involves an investment of Rs40,000. The
expected cash flows and the certainty co-efficient are as under:

Risk free cut off rate is 10%. Suggest which of the two projects should be preferred?

Solution:
 Question 4: Describe in detail the Baumol and Miller-Orr models with
illustrations.

Solution:

Cash Management Model # 1. William J. Baumol’s Model:

William J. Baumol developed a model (The Transactions Demand for Cash: An Inventory
Theoretic Approach) which is usually used in inventory management but has its application
in determining the optimal cash balance also. Baumol found similarities between inventory
management and cash management.

As Economic Order Quantity (EOQ) in inventory management involves tradeoff between

carrying costs and ordering cost, the optimal cash balance is the tradeoff between opportunity
cost or cost of borrowing or holding cash and the transaction cost (i.e. the cost of converting
marketable securities into cash etc.) The optimal cash balance is reached at a point where the
total cost is the minimum. The figure below shows the optimum cash balance.
Illustration:

The annual cash requirement of A Ltd. is Rs 10 lakhs. The company has marketable
securities in lot sizes of Rs 50,000, Rs 1, 00,000, Rs 2, 00,000, Rs 2, 50,000 and Rs 5, 00,000.
Cost of conversion of marketable securities per lot is Rs 1,000. The company can earn 5%
annual yield on its securities. You are required to prepare a table indicating which lot size
will have to be sold by the company. Also show that the economic lot size can be obtained by
the Baumol Model.
Cash Management Model # 2. Miller and Orr Model:
Baumol’s model is based on the basic assumption that the size and timing of cash flows are
known with certainty. This usually does not happen in practice. The cash flows of a firm are
neither uniform nor certain. The Miller and Orr model overcomes the shortcomings of
Baumol model.

M.H. Miller and Daniel Orr (A Model of the Demand for Money) expanded on the Baumol
model and developed Stochastic Model for firms with uncertain cash inflows and cash
outflows.

The Miller and Orr (MO) model provides two control limits-the upper control limit and the
lower control limit along-with a return point as shown in the figure below:

When the cash balance touches the upper control limit (h), markable securities are purchased
to the extent of hz to return back to the normal cash balance of z. In the same manner when
the cash balance touches lower control limit (o), the firm will sell the marketable securities to
the extent of oz to again return to the normal cash balance.

The spread between the upper and lower cash balance limits (called z) can be
computed using Miller-Orr model as below:

Illustration:

A company has a policy of maintaining a minimum cash balance of Rs 1, 00,000. The

standard deviation in daily cash balances is Rs 10,000. The interest rate on a daily
basis is 0.01%. The transaction cost for each sale or purchase of securities is Rs 50. Compute
the upper control limit and the return point as per the Miller-Orr model.

Question 5: Explain the techniques of inventory management with illustrations

Solution:

Effective inventory management requires an effective control, system for inventories. A

proper inventory control not only helps in solving the acute problem of liquidity but also
increases the profits and causes substantial reduction in the working capital of the concern.
The following are the important tools and techniques in inventory management and control:
1. Determination of stock level
2. Determination of safety stock
3. Determination of economic order quantity
4. A.B.C. analysis
5. V E D analysis
6. Inventory turnover ratio
7. JIT Control system
Determination of stock level: Carrying too much and too little inventories is detrimental to
the firm. If the inventory level is too little, the firm will face frequent stock outs involving
heavy ordering costs and if the inventory if too high it will be unnecessary tie up of capital.
Therefore an efficient inventory management requires that a firm should maintain an
optimum level of inventory where inventory costs are minimum. Various stock levels are as
follow:

a) Minimum level: This represents the quantity, which must be maintained in hand at all,
times. If stocks are less than the minimum level than the work will stop due to shortage of
material. Following factors are undertaken while fixing minimum stock level.

b) Lead time: The time taken in processing the order and then executing is known as lead
time

c) Rate of consumption: It is the average consumption of material in the factory. Minimum

stock Level = Re order level – (Normal consumption x Normal reorder period)

d) Reorder level: Re order level is fixed between minimum and maximum level. Reorder
level = Maximum Consumption x Maximum reorder period

e) Maximum Level: It is the quantity of the material beyond which a firm should not
exceeds its stocks. If the quantity exceed maximum level limit then it will be
overstocking. Maximum Level = Reorder level + reorder quantity – (Minimum
Consumption x Minimum reorder period)

f) Average stock level: Average Stock level = Minimum stock level + ½ of reorder
quantity

Determination of the safety stock: Safety stock is a buffer to meet some unanticipated
increase
in usage. The usage of inventory cannot be perfectly forecasted. It fluctuates over a period of
time. Two costs are involved in the determination of this stock.
• Opportunity cost of stock out
• Carrying costs
The stock out of Raw Material would cause production disruption. The stock out of finished
goods result into the failure of the firm in competition as the form cannot provide proper
customer service.

Economic order of quantity: A decision about how much to order has a great gignifi8cance in
inventory management. The quantity to be purchased should be neither small nor big. EOQ is
the size of lot to be purchased which is economically viable. This is the quantity of the
material,
which can be purchased at minimum cost. Cost of managing the inventory is made up of two
parts:-

Ordering Costs: This cost includes:

a) Cost of staff posted for ordering of goods
b) Expenses incurred on transportation of goods purchased.
c) Inspection costs of incoming material
d) Cost of stationery, postage, telephone charges.

Carrying costs: These are the costs for holding the inventories. It includes:
a) The cost of capital invested in inventories.
b) Cost of storage
c) Insurance cost
d) Cost of spoilage on handling of materials
e) The loss of material due to deterioration.

The ordering and carrying costs of material being high, an effort should be made to minimize
these costs. The quantity to be ordered should be large so that economy may be made in
transport cost and discounts may also be earned.

Assumptions of EOQ
a) The supply of goods is satisfactory.
b) The quantity to be purchased by the concern is certain
c) The prices of the goods are stable.

Illustration: A firm buys casting equipment from outside [email protected]/unit. Total annual
needs are 800 units. You have with you following further data:
a) Annual return on investment, 10%
b) Rent, insurance, taxes per unit per year, Re.1
c) Cost of placing an order, Rs.100
d) How will you determine the economic order quantity?

Solution:
Annual consumption (A) = 800 units
Ordering cost (S) = Rs.100.
Annual consumtion in Rs. = 800 unit x Rs. 30 per unit = Rs. 24,000
Total interest cost = 10% of 24000 = Rs.2400
Interest cost per unit = 2400 / 800 = Rs.3
Inventory Carrying cost (I) = Interest cost + Rent, insurance, Taxes cost = 3 + 1 = Rs.4 per
unit
A-B-C Analysis: The materials divided into a number of categories for adopting a selective
approach for material control. Under ABC analysis, the materials are divided into 3
categories viz, a B and C. Past experience has shown that almost 10% of the items contribute
to 70% of the value of the consumption and this category is called ‘a’ category. About 20%
of the items contribute 20% of the value of the consumption and is known as category ‘B’
materials. Category ‘C’ covers about 70% of the items of the material, which contribute only
10% of the value of the consumption.

A B C ANALYSIS helps to concentrate more efforts on category A. since greatest monetary

advantage will come by controlling these items. An attention should be paid in estimating the
requirements, purchasing, maintaining the safety stocks and properly storing of ‘A’ Category,
material. These items are kept under a constant review so that a substantial material cost may
be controlled. The control of ‘C’ items may be relaxed and these stocks may be purchased for
the year. A little more attention should be given toward ‘B’ category items and their purchase
should be undertaken at quarterly or half yearly intervals.

V E D Analysis: The VED analysis is generally used for spare parts. The requirement and
urgency of spares parts is different from that of the material. Spare parts are classified as
Vital (V), essential (E), and Desirable (D). The vital spares are must for running the concern
smoothly and these must be stored adequately. The non-availability of spare parts will cause
havoc on the concern. The E type of spares is also necessary but their stock may be kept at
low figures. The stocking of D type of spares may be avoided at times. If the lead time of
these spares is less, then stocking of these spares can be avoided. The classification of spares
under these three categories is an important decision. A wrong classification of any spare will
create difficulties for production department. The classification should be left to the technical
staff because they know the need urgency and use of these spares.

Inventory Turnover Ratio: This ratio is calculated to indicate whether the inventories have
been used efficiently or not. The purpose is to ensure the blocking of only required minimum
funds in inventory. This ratio is also known as Stock velocity.

Just In Time (JIT) Inventory Control System: Just in time philosophy, which aims at
eliminating waste from every aspect of manufacturing and its related activities, was first
developed in Japan. Toyota introduced this technique in 1950's in Japan, how U.S. companies
started using this technique in 1980's. The term JIT refers to a management tool that helps
produce only the needed quantities at the needed time. Just in time inventory control system
involves the purchase of materials in such a way that delivery of purchased material is
assured just before their use or demand. The philosophy of JlT control system implies that the
firm should maintain a minimum (zero level) of inventory and rely on suppliers to provide
materials just in time to meet the requirements.

Objectives of JIT
1. Minimum (zero) inventory and its associated costs.
2. Elimination of non-value added activities and all wastes.
3. Minimum batch/lot size.
4. Zero breakdowns and continuous flow of production.
5. Ensure timely delivery schedules both inside and outside the firm.
6. Manufacturing the right product at right time. –

Features of JIT
1. It emphasises that firms following traditional inventory control system overestimate
ordering cost and underestimate carrying costs associated with holding of inventories.
2. It advocates maintaining good relations with suppliers so as to enable purchases of right
quantity of materials at right time.
3. It involves frequent production/order runs because of smaller batch/lot sizes.
4. It requires reduction in set up time as well as processing time.
5. The major focus of JlT approach is to purchase or produce in response to need rather than
as per the plans and forecasts.