The Institute of Chartered Financial Analysts of India University 2010 C.A Chartered Accountant Integrated Professional Competence (IPCC) Revision Test s- 3 (II)-Financial Management - Question P

Rs.

1,72,500

37,500

Increase in Retained Earnings [4,10,500 - 2,38,000]

Add: Dividend Paid Add: Depreciation on Plant

Less: Gain on Sale of Equipment

Statement of Sources and Uses of Fund

37,500

4,97,500

4,97,500

12. (a) William J. Baumal and Miller- Orr Cash Management Model

According to William J. Baumal's Economic order quantity model optimum cash level is that level of cash where the carrying costs and transaction costs are the minimum. The carrying costs refer to the cost of holding cash, namely, the interest foregone on marketable securities. The transaction cost refers to the cost involved in getting the marketable securities converted into cash. This happens when the firm falls short of cash and has to sell the securities resulting in clerical, brokerage, registration and other costs.

The optimim cash balance according to this model will be that point where these two costs are equal. The formula for determining optimum cash balance is:

Where,

C =    Optimum cash balance

U =    Annual (monthly) cash disbursements

P =    Fixed cost per transaction

S =    Opportunity cost of one rupee p.a. (or p.m.)

Miller-Orr cash management model is a net cash flow stochastic model. This model is designed to determine the time and size of transfers between an investment account and cash account. In this model control limits are set for cash balances. These limits may consist of h as upper limit, z as the return point, and zero as the lower limit.

When the cash balances reaches the upper limit, the transfer of cash equal to h-z is invested in marketable securities account. When it touches the lower limit, a transfer from marketable securities account to cash account is made. During the period when cash balance stays between (h, z) and (z, o ) i.e high and low limits no transactions between cash and marketable securities account is made. The high and low limits of cash balance are set up on the basis of fixed cost associated with the securities transactions, the opportunity cost of holding cash and the degree of likely fluctuations in cash balances. These limits satisfy the demands for cash at the lowest possible total costs. The diagram given below illustrates the Miller- Orr model.

MILLER-ORR CASH MANAGEMENT MODEL

(b) Global Depository Receipts (GDRs) and American Depository Receipts (ADRs)

Global Depository Receipt is a negotiable certificate denominated in US dollars, which represents a non-US company's publicly, traded local currency equity.

GDRs are created when the local currency shares of an Indian company are delivered to the depository's local custodian bank, against which depository bank issues depository receipts in US dollar.

The GDRs may be freely traded in the overseas market like any other dollar denominated security either on a foreign stock exchange or in the over-the-counter market of qualified institutional buyers (QIBs). By issue of GDRs, Indian companies are able to tap global equity market to raise foreign currency funds by way of equity. It has distinct advantage over debt as there is no repayment of the principal and service costs are lower. Rule 144A of SEC of USA permits companies from outside USA to offer their GDRs to QIBs.

Whereas, American Depository Receipts (ADRs) are depository receipts issued by a company in the USA and are governed by the provisions of Security and Exchange Commission of USA. As the regulations are severe, Indian Companies tap the American market through private debt placements of GDRs listed in London Luxemburg Stock Exchanges.

Apart from legal impediments, ADRs are costlier than GDRs. Legal fees are considerably high for US listing. Registration fee in USA is also substantial. Hence, ADRs are less popular than GDR's.

The two most important objectives of financial management are as follows:

1.    Profit maximization

2.    Value maximization

Objective of profit maximization: Under this objective the financial manager's sole objective is to maximize profits. The objective could be short-term or longterm. Under the short-term objective the manager would intend to show profitability in a short run say one year. When profit maximization becomes a long-term objective the concern of the financial manager is to manage finances in such a way so as to maximize the EPS of the company.

Objective of value maximization: Under this objective the financial manager strives to manage finances in such a way so as to continuously increase the market price of the company's shares.

Under the short-term profit maximization objective a manager could continue to show profit increased by merely issuing stock and using the proceeds to invest in risk-free or near to risk-free securities. He may also opt for increasing profit through other non-operational activities like disposal of fixed assets etc. This would result in a consistent decrease in the shareholders profit - that is earning per share would fall. Hence it is commonly thought that maximizing profits in the long run is a better objective. This would increase the Earning Per Share on a consistent basis. However, even this objective has its own shortcomings, which are as follows:

   It does not specify the timing of duration of expected returns, hence one cannot be sure whether an investment fetching a Rs. 10 lakhs return after a period of five years is more or less valuable than an investment fetching a return of Rs. 1.5 lakhs per year for the next five years.

   It does not consider the risk factor of projects to be undertaken; in many cases a highly levered firm may have the same earning per share as a firm having a lesser percentage of debt in the capital structure. In spite of the EPS being the same the market price per share of the two companies shall be different.

   This objective does not allow the effect of dividend policy on the market price per share; in order to maximize the earning per share the companies may not pay any dividend. In such cases the earning per share shall certainly increase, however the market price per share could as well go down.

   For the reasons just given, an objective of maximizing profits may not be the same as maximizing the market price of share and hence the firm's value. The market price of a firm's share represents the focal judgment of all market participants as to the value of the particular firm. It takes into account present

as well as futuristic earnings per share; the timing, duration and risk of these earnings; the dividend policy of the firm; and other factors that bear upon the market price of the share. The market price serves as a barometer of the company's performance; it indicates how well management is doing on behalf of its shareholders. Management is under continuous watch. Shareholders who are not satisfied may sell their shares and invest in some other company. This action, if taken, will put downward pressure on the market price per share and hence reduce the company's value.

(d) Operating Leverage and Financial Leverage

Operating leverage is defined as the "firm's ability to use fixed operating costs to magnify effects of changes in sales on its earnings before interest and taxes. When there is an increase or decrease in sales level the EBIT also changes. The effect of change in sales on the level of EBIT is measured by operating leverage. Operating leverage occurs when a firm has fixed costs which must be met regardless of volume of sales. When the firm has fixed costs, the percentage change in profits due to change in sales level is greater than the percentage change in sales.

Whereas, Financial leverage is defined as "the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT/Operating profits, on the firm's earnings per share. The financial leverage occurs when a firm's capital structure contains obligation of fixed financial charges e.g. interest on debentures, dividend on preference shares etc. along with owner's equity to enhance earnings of equity shareholders. The fixed financial charges do not vary with the operating profits or EBIT. They are fixed and are to be paid irrespective of level of operating profits or EBIT.

13. (a) Debt Securitisation

It is a method of recycling of funds. It is especially beneficial to financial intermediaries to support the lending volumes. Assets generating steady cash flows are packaged together and against this asset pool, market securities can be issued, e.g. housing finance, auto loans, and credit card receivables.

Process of Debt Securitisation

(i)    The origination function - A borrower seeks a loan from a finance company or a bank. The credit worthiness of borrower is evaluated and contract is entered into with repayment schedule structured over the life of the loan.

(ii)    The pooling function - Similar loans on receivables are clubbed together to create an underlying pool of assets. The pool is transferred in favour of Special Purpose Vehicle (SPV), which acts as a trustee for investors.

(iii) The securitisation function - SPV will structure and issue securities on the basis of asset pool. The securities carry a coupon and expected maturity which can be asset-based/mortgage-based. These are generally sold to investors through merchant bankers. Investors are - pension funds, mutual funds, insurance funds.

The process of securitisation is without recourse i.e. investor bears the credit risk or risk of default. Credit enhancement facilities like insurance, letter of credit (LOC) and guarantees are also provided.

(b) Venture Capital Financing

It refers to financing of new high risky venture promoted by qualified entrepreneurs who lack experience and funds, to give shape to their ideas. In other words, under venture capital financing venture capitalist make investment to purchase equity or debt securities from inexperienced entrepreneurs who undertake highly risky ventures with a potential of success.

Some common methods of venture capital financing are as follows:

(i)    Equity financing: When funds are required for a longer period but the firm fails to provide returns to the investors during the initial stages, the venture capital finance is provided by way of equity share capital.

(ii)    Conditional loan: A conditional loan is repayable in the form of a royalty after the venture is able to generate sales'. Here royalty ranges between 2 to 15 per cent. No interest is paid on such loans.

(iii)    Income note: It combines the features of both conventional and conditional loans. The concern has to pay viz., interest and royalty on sales but at substantially low rates.

(iv)    Participating debenture: Such a security carries charges in three phases - in the start - up phase no interest is charged, next stage a low rate of interest is charged up to a particular level of operation, after that, a high rate of interest is required to be paid.

(b) Factoring

It is a new financial service that is presently being developed in India. It is not just a single service, rather a portfolio of complimentary financial services available to clients i.e., sellers. The sellers are free to avail of any combination of services offered by the factoring organizations according to their individual requirements.

Factoring involves provision of specialized services relating to credit investigation, sales ledger management, purchase and collection of debts, credit protection as well as provisions of finance against receivables and risk-bearing. In factoring, accounts receivables are generally sold to a financial institution (a subsidiary of commercial bank called "Factor) that charges commission and bears the credit risks associated with the accounts receivable purchased by it.

Its operation is very simple. Clients enter into an agreement with the "Factor working out a factoring arrangement according to his requirements. The Factor then takes the responsibility of monitoring; follow - up, collection and risk - taking and provision of advance. The factor generally fixes up a limit customer-wise for the client (seller).

The seller selects various combinations of these functions by changing provision in the factoring agreements. The seller may utilize the factor to perform the credit checking and risk-taking functions but not the lending functions. Under this arrangement the factor checks and approves the invoices.

(d) Merits of Payback Period

(i)    This method of evaluating proposals for capital budgeting is quite simple and easy to understand. It has the advantage of making it clear that there is no profit on any project unless the payback period is over. Further, when funds are limited, they may be made to do more by selecting projects having shorter payback periods. This method is particularly suitable in the case of industries where the risk of technological obsolescence is very high. In such industries, only those projects which have a shorter payback period should be financed since the change in technology would make the projects totally obsolete before their costs are recovered.

(ii)    In the case of routine projects also use of payback period method favours projects which generate cash inflows in earlier years, thereby eliminating projects bringing cash inflows in later years which generally are conceived to be risky as risk tends to increase with futurity.

(iii)    By stressing earlier cash inflows, liquidity dimension is also considered in the selection criterion. This is important in situations of liquidity crunch and high cost of capital.

(iv)    The pay back period can be compared to a break-even point, the point at which the costs are fully recovered but profits are yet to commence.

(v)    The risk associated with a project arises due to uncertainty associated with the cash inflows. A shorter payback period means that the uncertainty with respect to the project is resolved faster.

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