SHORT QUESTIONS ANSWERS FINANCIAL MANAGEMENT MGT201 By

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1 SHORT QUESTIONS ANSWERS FINANCIAL MANAGEMENT MGT201 By 1- What is Financial Management? The procedure of managing the financial resources, as well as accounting and financial reporting, budgeting, collecting accounts receivable, risk management, and insurance for a business. 2- What is Profit Maximization? In economics, profit maximization is the procedure by which a firm determines the price and output level that returns the maximum profit. 3- Who are Shareholders? Shareholder is any possessor of one or more shares in a corporation. A shareholder usually has proof that they are a shareholder; this evidence is represented by a stock certificate. 4- Who are Stakeholders? Stakeholders are the particular people or groups who have a stake, or an interest, in the conclusion of the project. Usually stakeholders are from within the company, and could include internal clients, management, employees, administrators... etc 5- Define Financing? The way in which a proposed purchaser intends to make up the difference between cash on hand and the purchase price. 6- What is Investment? Money put in property or other projects with the hope of making a profit, with enough security to return and protect the capital; not speculation. 7- What is Capital budgeting? The procedure of managing capital assets by means of a capital budget. This may cover an yearly or longer period. 8- Define Chief Financial Officer (CFO)? The person liable for management of an organization's overall financial plans and policies and the management of accounting practices. The job usually includes directing the treasury, budgeting, auditing, and tax accounting and purchasing real state. 9- Define Asset Management? Careful administration of investable (liquid) assets, aimed at achieving an optimum risk-

2 reward ratio. 10- Who are Creditors? These are your suppliers. This includes people and companies who have given you credit or terms, and they would have to be repaid by you or the company at a future date. 11- What is Capital Structure? The capital structure of a company is the particular mixture of debt, equity and other sources of finance that it uses to fund its long term financing. The key division in capital structure is between debt and equity. The amount of debt funding is measured by gearing. 12: Define Following: Income Statement Balance Sheet Cash Flow Statement A document generated A statement of the financial A financial statement that monthly and/or annually position of a business which reflects the inflow of that reports the earnings of states the assets, liabilities, revenue vs. the outflow of a company by stating all and owners' equity at a expenses resulting from relevant income and all particular point in time. In operating, investing and expenses that have been other words, the Balance financing activities during a incurred to generate that Sheet illustrates your specific time period income. Also referred to as business's net value. a profit and loss statement. 13- What is Liquidity? Liquidity refers to the ability of people to get into and out of investments. A "liquid" stock is a stock with a lot of volume that is easy to buy and sell. 14- What is Solvency? The ability of a company to meet all its obligations and it is calculated as the existing capital divided by the required capital. 15- Define Capital Structure? A mix of a company's long-term debt, detailed short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds. 16- What is Book Keeping? Bookkeeping is the recording of all financial transactions undertaken by an individual or organization.

3 17- Define Return on Investment (ROI): A performance measure used to assess the effectiveness of an investment or to evaluate the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio. 18- Define Return on Assets (ROA) An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to produce earnings. Calculated by dividing a company's yearly earnings by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as "return on investment". 19- What is Bond? A certificate of debt (usually interest-bearing or discounted) that is issued by a government or company in order to raise money; the issuer is required to pay a fixed sum yearly until maturity and then a fixed sum to repay the principal. 20- A little about bonds Face Value: Printed on the bond, never changes, and the amount you get at maturity. Maturity: Printed on the bond, never changes, the date at which you get the face value paid Coupon rate: Printed on the bond, never changes, the percentage of Face Value that is paid as interest each year [actually one half of the interest is paid every six months] Yield or market yield: Not on the bond, changes every day, determined by supply and demand of bonds in the bond market Market value or price of the bond: not on the bond, changes every day, calculated by figuring the present value of the coupon payments and the present value of the face value at maturity at the discount rate set equal to the market yield. 21- Define Valuation: It is the act or procedure that determines the value of a business or a security or an asset.

4 22- Types of Bonds Corporate bonds: which are sold by the representative bank. Junk bonds or high yield bonds: which are bonds from risky companies, so therefore they offer higher interest rates to compensate for the risk. Municipal bonds: which are issued by various cities. These are tax free, but have slightly lower interest rates. Savings bonds: which are issued by the Treasury Department and are in low enough amounts to make them affordable for individuals. I Bonds: which are like Savings Bonds, except they are adjusted for inflation every six months. 23- Type of Financial Markets: Capital Market The capital market is the market for securities, w h e r e companies a n d governments can liftup longterm funds. Capital market includes the stock market and the bond market. Money Market In finance, the money market is the worldwide financial market for short-term borrowing and lending. It provides short-term liquid funding for the global financial system. 24- Share vs Bonds The main difference between shares and bonds is that Shares are representation of ownership in a company while bonds are not representative of ownership. The second difference is that shares last as long as the company lasts where as bonds have limited life. Another difference is that the return on a bond is predetermined, i.e., the investor knows in advance how much return he would get from a bond. However, a stockholder cannot be certain about the return on a stock investment, since the dividends may or may not be paid in a certain year or the percentage of dividends announced may vary. 25- Types of Stocks Common stock represents the basic equity ownership in a corporation Preferred stock is an equity which has characteristics of both bonds and common stock. Because it is not debt, on the other hand, it still carries more risk than bonds. Blue chip stocks are stocks of well-established companies that have stable earnings and no extensive liabilities. Penny stocks are low-priced, speculative and risky securities which are traded overthe-counter (OTC); i.e. outside of one of the major exchanges.

5 Income stocks offer a higher dividend in relation to their market price. They are especially attractive to investors who are looking for current income that will gradually grow over the years as a way to offset inflation. Growth stocks are securities which appreciate in value and yield a high return. Their profits are typically re-invested to expand the business. Investors gain because the stock prices increase as the business grows, thus increasing the value of the investment. Value stocks are securities which investors consider to be undervalued. They feel that the stock is being traded below market value, and they believe in the long-term growth of the issuing company. 26- Accounting Ratios: Liquidity Analysis Ratios Current Ratio Current Assets Current Ratio = Current Liabilities Quick Ratio Quick Assets Quick Ratio = Current Liabilities Quick Assets = Current Assets - Inventories Net Working Capital Ratio Net Working Capital Net Working Capital Ratio = Total Assets Net Working Capital = Current Assets - Current Liabilities

6 Profitability Analysis Ratios Return on Assets (ROA) Net Income Return on Assets (ROA) = Average Total Assets Average Total Assets = (Beginning Total Assets + Ending Total Assets) / 2 Return on Equity (ROE) Net Income Return on Equity (ROE) = Average Stockholders' Equity Average Stockholders' Equity = (Beginning Stockholders' Equity + Ending Stockholders' Equity) / 2 Return on Common Equity (ROCE) Net Income Return on Common Equity (ROCE) = Average Common Stockholders' Equity Average Common Stockholders' Equity = (Beginning Common Stockholders' Equity + Ending Common Stockholders' Equity) / 2 Profit Margin Net Income Profit Margin = Sales Earnings Per Share (EPS) Net Income Earnings Per Share (EPS) = Number of Common Shares Outstanding

7 Activity Analysis Ratios Assets Turnover Ratio Sales Assets Turnover Ratio = Average Total Assets Average Total Assets = (Beginning Total Assets + Ending Total Assets) / 2 Accounts Receivable Turnover Ratio Sales Accounts Receivable Turnover Ratio = Average Accounts Receivable Average Accounts Receivable = (Beginning Accounts Receivable + Ending Accounts Receivable) / 2 Inventory Turnover Ratio Cost of Goods Sold Inventory Turnover Ratio = Average Inventories Average Inventories = (Beginning Inventories + Ending Inventories) / 2 Capital Structure Analysis Ratios Debt to Equity Ratio Total Liabilities Debt to Equity Ratio = Total Stockholders' Equity Interest Coverage Ratio Income Before Interest and Income Tax Expenses Interest Coverage Ratio = Interest Expense

8 Income Before Interest and Income Tax Expenses = Income Before Income Taxes + Interest Expense Capital Market Analysis Ratios Price Earnings (PE) Ratio Market Price of Common Stock Per Share Price Earnings (PE) Ratio = Earnings Per Share Market to Book Ratio Market Price of Common Stock Per Share Market to Book Ratio = Book Value of Equity Per Common Share Book Value of Equity Per Common Share = Book Value of Equity for Common Stock / Number of Common Shares Dividend Yield Annual Dividends Per Common Share Dividend Yield = Market Price of Common Stock Per Share Book Value of Equity Per Common Share = Book Value of Equity for Common Stock / Number of Common Shares Dividend Payout Ratio Cash Dividends Dividend Payout Ratio = Net Income

9 ROA = Profit Margin X Assets Turnover Ratio ROA = Profit Margin X Assets Turnover Ratio Net Income Net Income Sales ROA = = X Average Total Assets Sales Average Total Assets Profit Margin = Net Income / Sales Assets Turnover Ratio = Sales / Averages Total Assets 27- Time Value of Money: Money received sooner rather than later allows one to use the funds for investment of consumption purposes. This concept is referred as to Time Value of Money. 28- Net Present Value (NPV): The current value of a series of future net cash flows that will result from an investment, minus the amount of the original investment. 29- Present Value: The present equivalent of payments or a flow of payments to be received at various times in the future. 30- Discounted Cash Flow: A method or procedure for valuing a financial instrument by applying a discount rate (or a series of discount rates) to compute a present value of each future interest and principal cash flow expected from a financial instrument. The sum of the market values of the cash flows is considered to be the value of the instrument. For financial instruments with readily available, current trade prices, this value is called the fair value and is used in lieu of a trade- or transaction-based market value. 31- Annuities: Annuities are sums of money payable each year. 32- Capital Budgeting Capital budgeting (or investment appraisal) is the planning process used to establish a firm's long term investments such as new machinery. 33- Pay Back Period: The length of time or we can say number of years it takes for the accumulated net returns earned from an investment to equal the original investment.

10 34- Internal Rate of Return. The discount or interest rate at which the net present worth of an investment is equal to zero. 35- Securities: Document certificates (definitive securities) or electronic records (book-entry securities) evidencing ownership of equity (stocks) or debt obligations (bonds). 36- Debentures: Debentures are the most general corporate bonds. They're backed by the credit of the issuer, rather than by any specific assets. 37- Bond Valuation: Bond valuation is the process of determining the fair price of a bond. 38- Accounting Period: The period between successive closings of the books of a business. An accounting period typically is a month, three months (a quarter), or a year (a fiscal year or a calendar year) corresponding to the tax year used by the business. 39- Accruals: Amounts owed to or owed by a business that have not yet been recorded in the books of the business. 40- Amortization: The reduction in the value of an intangible asset (a copyright, a patent, an address list, or other similar property) taken as an expense (written off) in each accounting period. 41- Business net worth or business equity: The owners interest in a business. Equity is calculated as the value of all business assets minus all business liabilities. (Often called owners equity or owners net worth.). 42- Depletion: The book entry reduction in the value of a natural resource asset due to using up the natural resource. For example, the using up (depletion) of gravel deposits, petroleum reserves, or other natural resource property.

11 43- Loan amortization: The schedule of payments to be made in repaying a debt. With level-payment amortization, the payment amount is constant through out the repayment period. With constant-principal payment amortization, the amount of principal repaid in each payment is constant but the interest amount and the total payment amount decline as the principal balance of the loan is reduced. 44- Operating revenues: Inflows of funds from sales of goods or services offered for sale through the principal business activities of a business. 45- Non operating revenues: Inflows of funds from all sources other than operating revenues. 46- Intermediate-term assets: Assets that normally will be sold or used up during a period of one to five years. Categories include: vehicles, machinery, and equipment (may be placed impersonal property category); breeding live stock; securities not readily marketable; and other similar assets. The cash surrender value of life insurance policies sometimes is included. 47- Capital Improvement Plan: A plan listing priorities for major capital improvement projects anticipated over a fixed number of years, their costs, and methods of financing the expenditures. (Among small to medium size units of government, a capital improvement program will typically span three to seven years.) 48- Cash Flow Plan: A projection of the cash receipts and disbursements anticipated during each week or month of the fiscal year. Usually requiring a cooperative effort by the clerk and treasurer, the plan helps determine the most opportune time to expend funds, helps avoid unnecessary short term borrowing, and earns the highest return on idle funds.

12 49- Types of Business Risk: 1. Project risk (when your next big plan fails). 2.Customer risk (when customers abandon you). 3. Transition risk (when unforeseen changes in technology or business design undermine your company) 4. Unique competitor risk (when a giant likes Pepsi, Walls etc rides over your industry). 5. Brand risk (when your brand becomes irrelevant or unattractive). 6. Industry risk (when your industry becomes a no-profit zone). 7.Stagnation risk (when growth grinds to a halt). 50- What is Short Term Finance? Short term finance allows businesses and investors to take advantage of opportunities which require transactions to be completed rapidly. The focus on this type of finance is speed. Its about getting the deal done as quickly as required. 51- Example of Short Term financing sources There are many ways for which a firm can look for short terms financing some of these include: Overdrafts Short-term loans Bills of exchange Promissory notes/commercial paper Inventory loan Letters of credit Short term Eurocurrency advances Factoring 52- Long Term Finance: It is a type of financing that is provided for a period of more than a year. Long term financing services are provided to those business entities that face a shortage of capital. It is different from short term financing. Short term financing is normally used to provide money that has to be paid back within a year. The period may be shorter than one year as well.

13 53- Need of Long Term Financing Long term financing is essential for all types of business entities irrespective of their sizes or stature. These companies need to take advantage the long term financing resources from the lenders when they have to pay off a debt. Following are some other requirements that could be met by availing long term financing: Increasing Facilities Expansion of Companies Buying Fixed Assets Buying Machinery Construction Projects on a big Scale Provide Capital for funding the Operations. This helps in adjusting the cash flow. 54- PROBLEM : Mr. Naveed has Rs. 70,000 that he can deposit in savings accounts of any of three banks A, B or C for a three year period. Bank A compounds interest on an annual basis; Bank B compounds interest semi-annually (twice each year); and Bank C compounds interest quarterly (four times each year). All three banks have a stated annual interest rate of 12%. REQUIRED : How much Mr. Naveed will have in his account after three years if he deposits his money in Bank A? How much he will have in his account after three years if he deposits his money in Bank B? How much he will have in his account after three years if he deposits his money in Bank C? On the basis of your findings in above parts, describe in which bank should Mr. Naveed invest his money and why?

14 SOLUTION: How much Mr. Naveed will have in his account after three years if he deposits his money in Bank A. The Formula for the calculation of compound interest is: M=P(1+i) n Where M = Final amount including the principal P = Principal amount. I = Rate of interest per year. N = No. of year invested. Where P = I = 12% or 0.12 N = 3 M = 70000(1+0.12) 3 = 70000(1.12) 3 = * = How much he will have in his account after three years if he deposits his money in Bank B? For this Formula is A = P (1+ r/n) nt Where P = Principal amount. R = Annual rate of interest. T = number of years amount deposited or borrowed for. A = amount of money accumulated after n years, including interest. N = number of times the interest compounded per year.

15 Where P = R = 12% T = 3 A = ( /2) 2*3 = (1+0.06) 6 = (1.06) 6 = * = How much he will have in his account after three years if he deposits his money in Bank C? A = P (1+ r/n) nt A = ( /3) 3*3 = (1+0.04) 9 = (1.04) 9 = * = On the basis of your findings in above parts, describe in which bank should Mr. Naveed invest his money and why? Mr. Naveed should invest his money in BANK C because it gives more interest than other banks. The reason is that in case of annual basis the principal does not change for whole year but in case of semi-annually or quarterly basis the principal amount increases after every six months respectively. So that interest also increases accordingly and it is more than the interest of annual basis.

16 55- PROBLEM # 1: Assume two firms, A and B, produce and sell widgets. Firm A uses a highly automated production process with robotic machines, whereas firm B assembles the widgets using primarily semi-skilled labor. Highly automated firm A has fixed costs of Rs. 35,000 per year and variable costs of only Rs per unit, whereas labor- intensive firm B has fixed costs of only Rs. 15,000 per year, but its variable cost per unit is much higher at Rs per unit. Both firms produce and sell 10,000 widgets per year at a price of Rs per widget. (i) Which firm has a higher amount of operating leverage and why? Firm Name Fixed Cost Variable Cost Total Cost Operating Leverage A % B % Workings: Variable Cost Calculation for Firm A: Variable Cost = * = Total Cost Calculation for Firm A: Total Cost = Fixed Cost + Variable Cost = = Operating Leverage for Firm A: Operating Leverage = (Fixed Cost / Total Cost)*100 = (35000/45000)*100 = 77.78% Variable Cost Calculation for Firm B: Variable Cost = * = Total Cost Calculation for Firm B: Total Cost = Fixed Cost + Variable Cost

17 = = Variable Cost Calculation for Firm B: Operating Leverage = (Fixed Cost / Total Cost)*100 = (15000/45000)*100 = 33.33% Although the total cost for both the firm are same but Firm A is maintaining higher operating leverage, As Firm A using highly automated production process with robotic machines, because of this the variable cost reduced to Rs. 1/- per unit. (ii) How will you interpret the breakeven point of the firm with high operating leverage? Firm A (BEP) Firm B (BEP) Fixed Cost = Fixed Cost = Variable Cost = 1 Variable Cost = 3 Price = 5 Price = 5 Break even Point (Q) = fc/ (P-VC) Break even Point (Q) = fc/ (P-VC) Where fc = Fixed Cost Where fc = Fixed Cost P = Price per unit P = Price per unit VC = Variable cost per unit VC = Variable cost per unit = / (5-1) = / (5-3) = 8750 = PROBLEM # 2: Assume the same two firms, A and B. At production levels of 10,000 widgets, they both had operating earnings (EBIT) of Rs. 5,000. In addition, assume that both firms have total assets of Rs. 40,000. Firm A is financed with Rs.10,000 of debt which carries an annual interest cost of 8 percent, and Rs. 30,000 of stockholders' equity (3,000 shares), firm B is

18 financed entirely with Rs. 40,000 of stockholders' equity (4,000 shares). Tax bracket for both firms is 40%. REQUIRED : ( 10 ) Show the results of financial leverage on the both firm's earnings with your interpretations. Firms EBIT Interest EBT Tax 40% Net Income ROE =(NI/Equity) A % = % B % Working: EBT for Firm A: 8% of Debt i.e * 8 / 100 = 800 Tax Calculations: Firm A = 4200 / 40*100 = 1680 Firm B = 5000 / 40*100 = 2000 Net Income Calculation: Net Income = EBT Tax Firm A = = 2520 Firm B = = 3000 ROE Calculation: ROE = Net Income / Equity Firm A = 2520 / * 100 = 8.4% Firm B = 3000 / * 100 = 7.5%

19 57- PROBLEM : 1. Sumi Corporation has the following Target capital structure: Debentures = Rs. 3 Billion Preferred shares = Rs Billion Common shares = Rs Billion Total = Rs.10 Billion Under the prevailing market conditions, financial analysts have estimated a risk free rate of return of 10% and a market rate of return of 14%. The corporation s common stocks have a beta ( β ) of 1.5. Bonds carry an interest rate of 9.5%. Preferred stocks have a return of 10% p.a. and corporate tax rate is 40%. REQUIRED : Compute the present Weighted Average Cost of Capital (WACC) for Sumi Corporation. [ Hint: Use CAPM to find out the cost of common shares. ] Ans: CAPM = Rf + Beta of Stock x (Rm RF) Where Rf = Risk free rate Rm = Return on the Market Rf = Risk free rate CAPM = (14-10) = (4) = = 16%

20 WACC Principal Weighted Financial Tax Effective WACC Cost Debenture 3,000,000, % 40% 5.7% 1.71 Preferred 480,000, % - 10% 0.48 Shares Common 6,520,000, % - 16% Shares Total 10,000,000, % Working: Calculation of Weighted = 3,000,000,000 / 10,000,000,000 = 0.30 = 480,000,000 / 10,000,000,000 = = 6,520,000,000 / 10,000,000,000 = There is 40% tax on Debenture so rest is 60% so effective is = 9.5 * 60/100 = 5.7% WACC Debenture = 0.3 * 5.7% = 1.71 Preferred Shares = * 10% = 0.48 Common Shares = * 16% = Total % 58- Operating & Financial Leverage: Operating leverage is the name given to the impact on operating income of a change in the level of output. Financial leverage is the name given to the impact on returns of a change in the extent to which the firm s assets are financed with borrowed money. 59- Break Even Point: A business can work out how what quantity of sales it needs to attain to cover its costs. This is known as the break even point.

21 60- Capital Asset Pricing Model (CAPM): A model that allows investors to price securities, such as stocks, based on the risk- free rate, market returns, and the security's volatility. CAPM = Rf + Beta of Stock x (Rm RF) Where Rf = Risk free rate Rm = Return on the Market Rf = Risk free rate 61- Weighted Average Cost of Capital (WACC) The weighted average cost of capital is the cost linked with a firm's capital structure. BEST OF LUCK