Course Code : MBA-203

Course Title : Financial Management

Assignment No. : MBA-203/ 2022
Maximum Marks : 30

Q2. What is financial leverage? What cause it? How is the degree of financial leverage measured?

Ans. Financial leverage is a main source of financial risk. By issuing more debt, a company incurs the fixed costs
associated with the debt (interest payments). The company’s inability to meet the obligations may result in financial
distress or even bankruptcy.

Highly leveraged companies may face significant financial problems during a recession because their operating
income will rapidly decline and, thus, so will their overall profitability. Note that taxes do not affect the degree of
financial leverage.

A high degree of financial leverage indicates that even a small change in the company’s leverage may result in a
significant fluctuation in the company’s profitability. Also, a high degree of leverage may translate to a more volatile
stock price because of the higher volatility of the company’s earnings. Increased stock price volatility means the
company is forced to record a higher expense for outstanding stock options, which represents a higher cost of debt.
Therefore, companies with extremely volatile operating incomes should not take on substantial leverage because
there is a high probability of financial distress for the business.

Formula for Degree of Financial Leverage

There are several ways to calculate the degree of financial leverage. The choice of the calculation method depends
on the goals and context of the analysis. For example, a company’s management often wants to decide whether it
should or should not issue more debt. In such a case, net income would be an appropriate measure of the company’s
profitability:

However, if an investor wants to determine the effects of the company’s decision to incur additional leverage,
the earnings per share (EPS) is a more appropriate figure because of the metric’s strong relationship with the
company’s share price.

Finally, there is a formula that allows calculating the degree of financial leverage in a particular time period:

Example of Degree of Financial Leverage

ABC Corp. is preparing to launch a new project that will require substantial external financing. The company’s
management wants to determine whether it can safely issue a significant amount of debt to finance the new project.
Currently, the company’s EBIT is $500,000, and interest payments are $100,000.

In order to make the decision, the company’s management wants to examine its degree of financial leverage ratio:
It shows that a 1% change in the company’s leverage will change the company’s operating income by 1.25%.

Q3. Explain gross working capital concept.

Ans. Gross working capital is a quantitative concept that indicates the total current assets a company or a business
firm holds in an accounting year. These total current assets are totally convertible in cash. So, we can say that the
Gross working capital represents the total assets accrued by a business firm or company in one year period that can
be converted into liquidity wherever the company or business firm requires it.

Subsequently, the Gross working capital includes the total current assets such as cash, accounts receivables,
inventory, marketable securities, short-term investments, and commercial papers.

Gross working capital is a company's net working capital before deducting current liabilities.

Gross working capital gives a glimpse of the short-term financial status of a firm or company. Hence, Gross working
capital is not portrayed as a real financial status of a business firm. It may happen that a firm is in big financial
distress but denotes a good Gross working capital on paper. So one should not blindly believe in this popular concept
of financial management. He/she should evaluate the Net Working Capital of a firm before making any decision.

Gross working capital = Total current assets a business firm holds in a 12-month period

Or

Gross working capital = current investments + cash + trade receivables + short-term assets + inventory + commercial
papers + other current assets

The firm or company should also evaluate the Current liabilities acquired in a 12-month period for better financial
analysis.

An Example of Gross Working Capital

For instance, let’s understand the calculation of the Gross working capital by the following example:

Cash = Rs. 55,000

Trade receivables = Rs. 10,000
Current investments = Rs. 80,000
Commercial papers = Rs. 25,000
Other current assets = Rs. 5,000
Gross working capital = Rs. 55,000 + Rs. 10,000 + Rs. 80,000 + Rs. 25,000 + Rs. 5,000
Gross working capital = Rs. 1,75,000
Q4. Explain the objects of capital structure planning and the factors affecting it?

Ans. The following are the objects of capital structure planning:

1) Avail or Tax advantage of Debt

Interest on debt finance is a tax-deductible expense. Hence, finance scholars and practitioners agree that debt
financing gives rise to tax shelter which enhances the value of the firm. What is the impact of this tax shelter on the
value of the firm? In this 1963 paper Modigilani and Miller argued that the present value of the interest tax shield is
– tcD where, tc = corporate tax rate on a unit of marginal earnings and D = Debt financing.

2) Preserve Flexibility

The tax advantage of debt should not persuade one to believe that a company should exploit its debt capacity fully.
By doing so, it loses flexibility. And loss of flexibility can erode shareholder value. Flexibility implies that the firm
maintains reserve borrowing power to enable it to raise debt capital to respond to unforeseen changes in
government policies, recessionary conditions in the market place, disruption in supplies, decline in production
caused by power shortage or labour market, intensification in competition, and, perhaps most importantly,
emergence of profitable investment opportunities. Flexibility is a powerful defense against financial distress and its
consequences which may include bankruptcy.

3) Ensure that the Total Risk Exposure is Reasonable

While examining risk from the point of view of the investor, a distinction is made between systematic risk (also
referred to as the market risk or non-diversifiable risk) and unsystematic risk (also referred to as the non-market risk
or diversifiable risk).

Business Risk refers to the variability of earnings before interest and taxes. It is influenced by the following factors:

 Demand Variability- Other things being equal, the higher the variability of demand for the products
manufactured by the firm, the higher is its business risk.

 Price Variability- A firm which is exposed to a higher degree of volatility in the prices of its products is, in
general, characterized by a higher degree of business risk in comparison with similar firms which are exposed
to a lesser degree of volatility in the prices of their products.

 Variability in Input Prices- When input prices are highly variable, business risk tends to be high.

4) Subordinate Financial Policy to Corporate Strategy

Financial Policy and Corporate Strategy are often not integrated well. This may be because financial policy originates
in the capital market and corporate strategy in the product market.

5) Mitigate Potential agency Costs

Due to separation of ownership and control in modern corporations, agency problems arise. Shareholders scattered
and dispersed as they are not able to organize themselves effectively. Since agency costs are borne by shareholders
and the management, the financial strategy of a firm should seek to minimize these costs. One way to minimize
agency costs is to employ an external agent who specializes in low cost monitoring. Such an agent may be a lending
organization like a commercial bank (or a term-lending institution).

Several factors affect a company’s capital structure, and it also determines the composition of debt and equity
portions within this structure. Some of these factors are as follows:

 Business Size – The size and scale of a business affect its ability to raise finance. Small-sized companies face
difficulty in raising long-term borrowings. Creditors are hesitant to give them loans because of the scale of
their business operations. Even if they do get these loans, they have to accept high-interest rates and
stringent repayment conditions. It limits their ability to grow their business.

 Earnings – Firms with relatively stable revenues can afford a more significant amount of debt in their capital
structure. Since debt repayment is periodical with fixed interest rates, businesses with higher income
 prospects can bear these fixed financial charges? On the other hand, companies that face higher fluctuations
in their sales, like consumer goods, rely more on equity shares to finance their operations.

 Competition: If a company operates in a business environment with more competition, it should have more
equity shares in its capital structure. Their earnings are prone to more fluctuation compared to businesses
facing lesser competition.

 Stage of the life cycle: A business in the early stage of its life cycle is more susceptible to failure. In that case,
they should use a more significant proportion of ordinary share capital to finance their operations. Debt
comes with a fixed interest rate, and it is more suitable for companies with stable growth prospects.

 Creditworthiness: Any company that has a reputation for paying back its loans on time will be able to raise
funds on less stringent terms and at lower interest rates. It allows them to pay back their loans on time. The
opposite is true for firms that don’t have a good credit standing in the market.

 Risk Aptitude of the Management: The attitude of a company’s management also affects the proportion of
debt and equity in the capital structure. Some managers prefer to follow a low-risk strategy and opt for
equity shares to raise finances. Other managers are confident of the company’s ability to repay big loans,
and they prefer to undertake a higher proportion of long term debt instruments.

 Control: A management that wants outside interference in its operations may not raise funds through equity
shares. Equity shareholders have the right to appoint directors, and they also dilute the stake of owners in
the company. Some companies may prefer debt instruments to raise funds. If the creditors get their
instalments on loans and interest on time, they will not be able to interfere in the workings of the business.
But if the company defaults on their credit, the creditors can remove the present management and take
control of the business.

 State of Capital Market: The tendencies of investors and creditors determine whether a company uses more
debt or equity to finance their operations. Sometimes a company wants to issue ordinary shares, but no one
is willing to invest due to the high-risk nature of their business. In that case, the management has to raise
funds from other sources like debt markets.

 Taxation Policy: The government’s monetary policies in terms of taxation on debt and equity instruments
are also crucial. If a government levies more tax on gains from investing in the share market, investors may
move out of equities. Similarly, if the interest rate on bonds and other long-term instruments is affected due
to the government’s policy, it will also influence companies’ decisions.

 Cost of Capital: The cost of raising funds depends on the expected rate of return for the suppliers. This rate
depends on the risk borne by investors. Ordinary shareholders face the maximum risk as they don’t get a
fixed rate of dividend. They get paid after preference shareholders receive their dividends. The company has
to pay interest on debentures under all circumstances. It attracts more investors to opt for debentures and
bonds.
Q7. Define Demand? What factors determine the demand of commodity?

Ans. Demand simply means a consumer’s desire to buy goods and services without any hesitation and pay the price
for it. In simple words, demand is the number of goods that the customers are ready and willing to buy at several
prices during a given time frame. Preferences and choices are the basics of demand, and can be described in terms
of the cost, benefits, profit, and other variables.

The amount of goods that the customers pick, modestly relies on the cost of the commodity, the cost of other
commodities, the customer’s earnings, and his or her tastes and proclivity. The amount of a commodity that a
customer is ready to purchase, is able to manage and afford at provided prices of goods, and customer’s tastes and
preferences are known as demand for the commodity.

The demand curve is a graphical depiction of the association between the price of a commodity or the service and
the number demanded for a given time frame. In a typical depiction, the cost will appear on the left vertical axis. The
number (quantity) demanded on the horizontal axis is known as a demand curve.

The quantity demanded of a commodity by a consumer depends mainly on price of the commodity itself, prices of
other related goods, income of consumer and tastes and preferences of the consumer.

The above statement can also be expressed by symbols as:

DA=F (PA: PB, PC, PD……. I, T)

Where DA shows the consumer’s demand for commodity A; PA stands for the price of the commodity itself; PB, PC,
PD . . . show the prices of other related goods, 1 denotes consumer’s income and T denotes tastes and preferences of
the consumer; F denotes functional relationship.

We shall now discuss each factor influencing the demand in detail:

(i) Price of the commodity itself:

When a commodity is selling at a very high price, only rich people are able to buy it. So the demand of that
commodity will be less. But when the price is low more and more people will be able to buy it and the demand of the
commodity would be more. Thus, the demand of the commodity is greatly influenced by its price.

(ii) Prices of other related goods:

The demand for a commodity is also influenced by prices of other related goods as substitutes. Tea and coffee are
substitutes to each other. A change in the prices of such commodities affects the changes in the consumption of its
substitutes. For example, a change in the price of tea will change the consumption of coffee.

(iii) Level of income of the consumer:

Consumer’s demand is also influenced by the size of his income. This is but natural that with increase in the level of
income, there is increase in the demand of goods and services. Increased level of real incomes creates more
purchasing power in the country. As the level of income increases, the demand for goods and services also increases.

(iv) Tastes and Preferences of the Consumer:

Tastes and preferences of the consumer also influence his demand. A taste, fashions, preferences of the consumer
keep on changing and is his demand.

(v) Population:

The change in the population in a country changes the demand. This change in population is in terms of change in
the size and composition of population. Increase in the size of population will definitely increase the demand of
commodities and services.

Again increase in the size of population also affects the composition of population. By consumption of population is
meant the distribution of population in terms of the age-group, sex- ratio, and skilled or unskilled population. In a
country where the majority of population is composed of minors, naturally demand for such goods will be more
which interest more to minor-toys, sports goods, etc.
(vi) Income Distribution:

It is only the size or level of income which affects the demand but also the nature of income distribution in the
country. In countries where income distribution is equal, the demand pattern will also be even. This can be
illustrated from the example of socialist countries like Russia and China. In capitalist countries where there is
inequality of income, the demand pattern is different.

(vii) State of trade:

During a period of boom—a period in which there is higher circulation of money and the production level is at a
peak, the employment of resources reaches the optimum level. Consequently there is more purchasing power in the
hands of the people.

The demand for goods and services is also high. But during the depression, economic conditions are different and
opposite to the boom period. The level of purchasing power is now because of lower level of employment or
resources. So the demand for goods and services is low.

(viii) Climate and weather:

Cold countries have more demand for woolen clothes, heaters, etc. Whereas the demand in the tropical countries
for cotton textiles, umbrellas, rain coats, etc., is more. Even in the same country demand for umbrellas and rain coats
will not be as high in the winter as during the rains. Thus, change in weather also influences the demand.

Q8. Explain income effect and substitution effect on demand of a commodity?

Ans. Definition of Income Effect

When there is a decrease in the price of a good or service, the consumer will be able to buy the more quantity with
the same amount or same quantity with less amount of money. In this way, the overall purchasing power of the
consumer increases, which induces him to buy more of that commodity whose price has decreased, increases. The
inverse is also true, i.e. any increase in the price of a good or service will result in the fall in consumption, due to
income effect.
Suppose Mr. Ramesh spends half of his income on purchasing grocery and a decline of 10% in the price of grocery
will increase his free money available to him which he can spend on buying additional grocery or something else of
his choice.

Definition of Substitution Effect

When the price of a commodity falls, it becomes comparatively cheaper than another commodity, which instigates
customers to replace commodity whose price has been decreased for other commodities that are relatively
expensive now. As a result of this, the aggregate demand of the commodity whose price has been reduced, increases
and vice versa. This is known as substitution effect, which arises due to the inherent tendency of consumer’s to
substitute cheaper goods for relatively expensive ones, after eliminating real income effect of price change.

Comparison Chart

BASIS FOR
INCOME EFFECT SUBSTITUTION EFFECT
COMPARISON

Meaning Income effect refers to the change in Substitution effect means an effect due to the
the demand of a commodity caused by change in price of a good or service, leading
the change in consumer's real income. consumer to replace higher priced items with
lower prices ones.

Reflected by Movement along income-consumption Movement along price-consumption curve

curve

Effect of Income being freed up. Relative price changes.

BASIS FOR
INCOME EFFECT SUBSTITUTION EFFECT
COMPARISON

Expresses Impact of rise or fall in purchasing Change in quantity demanded of a good due to
power on consumption. change in prices.

Rise in price of a Reduces disposable income, which in As alternative goods are comparatively cheaper
good turn decrease quantity demanded. and so customers will switch to other goods.

Fall in price of a Increases real spending power of a Will make it cheaper than its substitutes, which
good consumer that allows customers to will attract more customers and result in higher
buy more, with the given budget. demand.