Internal Assessments

Program – MBA Program

Subject – Financial Management

Semester - 3

Assessment Type – (Subjective Assignment)

Questions & Answers:

1. What is Capital Structure Substitution Theory? Explain in detail.

The Capital Structure Substitution Theory, also known as the Capital Structure
Irrelevance Theory or the Modigliani-Miller Theorem, is an economic theory that
suggests that in a perfect market with no taxes, transaction costs, or bankruptcy
costs, the capital structure of a firm is irrelevant in determining its market value and
cost of capital. This theory was developed by economists Franco Modigliani and
Merton Miller in the 1950s and 1960s.

The central idea behind the Capital Structure Substitution Theory is that the
value of a firm is determined by its underlying productive assets and the expected
future cash flows generated by those assets, rather than the specific mix of debt and
equity used to finance those assets. According to this theory, investors can replicate
the effects of a firm's capital structure by creating their own personal leverage or
diversifying their portfolios.

Key Assumptions:

Perfect Capital Markets: The theory assumes the existence of perfect capital
markets, where there are no barriers to buying and selling securities, no transaction
costs, no taxes, and no information asymmetry. This implies that all investors have
the same information and can trade assets at fair prices without any restrictions.

No Bankruptcy Costs: The theory assumes that bankruptcy costs, such as financial
distress costs and agency costs associated with financial distress, are nonexistent.
Financial distress and bankruptcy can lead to real costs for a firm, such as legal fees,
loss of reputation, and disruptions to business operations.

Rational Behavior: The theory assumes that all investors and market participants are
rational and make decisions based on maximizing their wealth. It also assumes that
investors can borrow or lend at the same interest rate as the firm, without any risk
premium.

Implications of the Theory:

Capital Structure Irrelevance: According to the theory, in a perfect market, the
capital structure decision of a firm does not affect its market value. The overall
market value of a firm remains the same regardless of whether it is financed with all
equity, all debt, or any combination of debt and equity.

Cost of Capital: The theory suggests that the cost of capital is independent of the
capital structure. The required rate of return for a firm's equity increases as the use
of debt increases, but the lower cost of debt offsets the higher cost of equity.
Consequently, the weighted average cost of capital (WACC) remains constant.

Homemade Leverage: The theory proposes that investors can create leverage or
adjust their personal leverage to replicate the capital structure of a firm. By
borrowing or lending on their own, investors can achieve the same risk-return profile
as a leveraged or unleveraged firm.

Critiques and Real-World Limitations: While the Capital Structure Substitution

Theory provides valuable insights, it has been subject to several critiques and is
considered to have limitations in real-world scenarios. Some of these limitations
include:

Taxes and bankruptcy costs: In reality, taxes and bankruptcy costs do exist, and they
can significantly impact a firm's capital structure decisions and value.

Information asymmetry: Perfect information assumptions do not hold in practice,

and information asymmetry can affect the availability and cost of capital.

Market imperfections: Market frictions, such as agency costs, transaction costs, and
imperfect competition, can influence capital structure decisions and market values.

Signaling and pecking order theory: The theory does not consider the signaling
effects of capital structure decisions or the pecking order theory, which suggests that
firms prefer internal financing over external financing.

Market dynamics and investor behavior: The theory assumes static market
conditions and rational behavior, which may not hold in dynamic and uncertain
market environments.

Overall, while the Capital Structure Substitution Theory provides a useful

framework for understanding the fundamental principles of capital structure, it is
important to consider its limitations and incorporate other factors that influence
real-world capital structure decisions.

2. What are the assumptions of Gordon’s Model?

Gordon's model, also known as the Gordon growth model or the Gordon
dividend model, is a method used to value the stock price of a company based on its
dividends and expected dividend growth rate. The model makes several key
assumptions, including Constant Dividend Growth, Required Rate of Return,
Dividends as the Only Cash Flow, Infinite Time Horizon, Dividend Reinvestment.

Constant Dividend Growth: The model assumes that dividends will grow at a
constant rate indefinitely. This assumption implies that the company has a stable
and predictable dividend policy and that the dividend growth rate remains
consistent over time.

Required Rate of Return: The model assumes that investors require a minimum rate
of return, often referred to as the discount rate or the required rate of return. This
rate is used to discount future dividends to their present value. The required rate of
return is typically based on the risk associated with the company's stock and the
overall market conditions.

Dividends as the Only Cash Flow: The model assumes that the only cash flow
received by investors is in the form of dividends. It does not consider other sources
of cash flow, such as capital gains or share repurchases.

Infinite Time Horizon: The model assumes that the dividend growth rate and the
required rate of return will remain constant indefinitely. This assumption implies an
infinite time horizon, which may not be realistic in practice. In reality, factors such as
changes in the company's financial performance, industry dynamics, or
macroeconomic conditions can influence the growth rate and required rate of return
over time.

Dividend Reinvestment: The model assumes that investors reinvest their dividends
back into the stock at the same rate as the dividend growth rate. This assumption
implies that shareholders have a constant dividend reinvestment policy.

It's important to note that while the Gordon growth model provides a simplified
framework for valuing stocks, it relies on these assumptions, which may not hold
true in all cases. Therefore, it's crucial to consider the specific characteristics of the
company and the market conditions when using this model for stock valuation.
3. What are risk diversification and its types?

Risk diversification, also known as portfolio diversification, is an investment

strategy that involves spreading investments across different assets or asset classes
to reduce risk. The principle behind diversification is that by investing in a variety of
assets that are not perfectly correlated with each other, the potential losses from
any one investment can be offset by gains from others. This helps to mitigate the
impact of individual investment risks and create a more balanced portfolio. Here are
some common types of risk diversification: Asset Class Diversification, Industry or
Sector Diversification, Geographic Diversification, Company-Specific Diversification.

Asset Class Diversification: This type of diversification involves allocating

investments across different asset classes, such as stocks, bonds, cash, real estate,
and commodities. Each asset class has its own risk and return characteristics, and by
holding a mix of assets, investors can potentially reduce the overall risk of their
portfolio. Different asset classes tend to perform differently under various market
conditions, so diversifying across them can help capture potential gains and cushion
against losses.

Industry or Sector Diversification: Within a particular asset class, such as stocks,

diversifying across different industries or sectors is another form of risk
diversification. Different industries may be affected by specific factors that impact
their performance, such as technological advancements, regulatory changes, or
economic trends. By investing in a variety of industries, investors can reduce the risk
associated with a single industry or sector experiencing a downturn.

Geographic Diversification: Geographic diversification involves investing in different

regions or countries. Economic and political factors can vary across different regions,
and by spreading investments globally, investors can reduce the risk associated with
exposure to a single country or region. A geographically diversified portfolio can help
mitigate risks associated with localized economic shocks, political instability, or
currency fluctuations.

Company-Specific Diversification: Investing in a diverse range of individual

companies within an asset class is another way to diversify risk. Company-specific
risks can include factors such as poor management, competitive pressures, or legal
issues. By holding a portfolio of different companies, investors can reduce the impact
of a single company's negative performance on the overall portfolio.

It's important to note that diversification does not eliminate risk entirely, as all
investments carry some level of risk. However, by diversifying across different types
of risk, investors can potentially reduce their exposure to any one particular risk and
improve the risk-return tradeoff of their portfolio. The specific diversification
strategy will depend on an individual's investment goals, risk tolerance, and time
horizon.

4. What are the techniques of calculation of operating cycle period?

The operating cycle period, also known as the cash conversion cycle, is a
measure of the time it takes for a company to convert its investments in inventory
and other resources into cash inflows from sales. It reflects the efficiency of a
company's working capital management. There are two main techniques for
calculating the operating cycle period:

Traditional Technique: The traditional technique calculates the operating cycle

period by considering three key components: the average age of inventory, the
average collection period, and the average payment period.
Operating Cycle Period = Average Age of Inventory + Average Collection Period

Average Age of Inventory: This represents the average number of days it takes for
inventory to be sold. It is calculated by dividing the average inventory by the cost of
goods sold (COGS) per day.

Average Collection Period: This represents the average number of days it takes for a
company to collect its receivables from customers. It is calculated by dividing the
average accounts receivable by the sales per day.

Average Payment Period: This represents the average number of days it takes for a
company to pay its suppliers. It is calculated by dividing the average accounts
payable by the cost of goods sold (COGS) per day.

Cash-Based Technique: The cash-based technique calculates the operating cycle

period by considering the average collection period and the average payment
period, excluding the inventory holding period.
Operating Cycle Period = Average Collection Period - Average Payment Period

This technique focuses on the cash flow aspects of the operating cycle and does
not take inventory into account. Both techniques provide insights into the efficiency
of a company's operations and working capital management. The choice of
technique depends on the specific needs and preferences of the analyst or company
using the calculation.

5. What are the types of financing approaches/policies?

There are several types of financing approaches and policies that can be
employed by individuals, businesses, or governments. Here are some common ones:

 Debt Financing: This involves borrowing money from external sources such
as banks, financial institutions, or bond markets. The borrowed funds are
repaid over time with interest.

 Equity Financing: In this approach, ownership in a company is sold in

exchange for capital. Investors become shareholders and share in the profits
and losses of the business.
  Venture Capital: Venture capitalists provide financing to start-ups and early-
stage companies in exchange for equity. They typically take on higher risks
and expect higher returns on their investments.

 Angel Investment: Angel investors are individuals who provide capital to

start-ups or small businesses in exchange for ownership equity or convertible
debt. They often provide mentorship and expertise in addition to funding.

 Grants and Subsidies: Governments, non-profit organizations, or foundations

may offer grants or subsidies to support specific projects, research, or social
initiatives. These funds do not need to be repaid.

 Crowdfunding: This method involves raising funds from a large number of

individuals, typically through online platforms. Contributors may receive
rewards, products, or a stake in the project in return for their financial
support.

 Leasing: Instead of purchasing assets outright, leasing allows businesses or

individuals to use assets (such as equipment, vehicles, or property) by making
regular lease payments.

 Trade Credit: Suppliers may extend credit to businesses, allowing them to

receive goods or services upfront and defer payment for a specified period.

 Public-Private Partnerships (PPPs): These involve collaboration between the

public and private sectors to finance and manage projects such as
infrastructure development, where both parties share risks and benefits.

 Internal Financing: This involves using retained earnings or profits generated

from the business itself to fund operations, expansion, or investments.

It's important to note that the suitability of each financing approach or policy
depends on various factors, including the nature of the project, the financial
situation of the entity seeking funds, and the associated risks and returns.