1) What is risk analysis?

Risk analysis is the study of the uncertainly of a given course of action and refers to computation of
the statement.

An estimation of the present value of the cash for high risk investments. Is known as risk analysis.

2) What is sensitivity analysis?

Sensitivity analysis is used to understand the effect of a set of independent variables on same
dependent variable under certain specific conditions.

3) Define capital structure.

Capital structure is the particular combination of debt and equity used by a company to finance its
overall operations and growth. Debt comes in the form of bond issues or loans, while equity may
come in the form of common stock, preferred stock, or retained earnings.

4)Explain the different techniques of measuring risks.

 Risk adjusted cut off rate method

 Certainty equivalent method
 Sensitivity technique
 Probability technique
 Standard deviation method
 Co-efficient of variation method
 Decision tree analysis
 Beak even analysis

o Risk adjusted cut off rate Method: the present value of cash for high risk investments is
known as risk adjusted discount rate. it represents required periodical returns by investors
for pulling funds to the company.
o Certainty equivalent method: it is a method in which uncertain cashflows are converted into
certain cashflows by multiplying with probability of occurrence such cashflows. Certainty
co-efficient assumes value between 0 & 1. In this method risk free rate are used instead of
risk. Adjusted discount rate.
o Sensitivity technique: it is used to study the impact of the changes on the variables on the
outcome of the project. The changes in these variables impact the outcome of the project.
o The more sensitive is the NPV. the more critical is that variable.
o Probability technique: A probability is the relative frequency with which an event may occur
in the future. the future estimates of cash inflows. have different probabilities the expected
monetary value may be computed.
o Standard deviation method: SD is a degree of variation of individual items of a set of data
from its average. The square root of variance is called SD. The helps in calculating the risk
associated with estimated CI from an investment.
o Co-efficient of variance: the co-efficient of variation calculates the risk borne for every.
Select a project which has a lower co-efficient of variation. The project having a higher SD is
said to be more risky as compared to the other.
o Decision tree techniques: in modern business there are complex investment decision which
involve a sequence of decisions over time. Such sequential decisions can be handles by
plotting decisions trees.
 o Break even analysis: useful tool for determining at what point your company, or a new
product or service. Will be profitable. Put another way. It’s a financial calculation used to
determine. The number of products or services you need to sell.

5) Write the assumptions and arguments of MM Model.

Assumptions

Perfect capital market

No taxes do not exit

Fix investment policy

No transaction cost

Risk of uncertainly does not exit

Arguments

The assumption that taxes do not exit far from exit

MM argument that internal and external. The cost of following

Information about the company may not be available for all the members

The firm do not follow a rigid investment policy

Share holder may prefer current income as future income.

6) Write the importance of capital structure.

 Return Maximisation: A well-designed capital structure provides a scope of increasing

the earnings per share, which ultimately maximizes the return for equity shareholders
and recover the cost of borrowings.
 Flexibility: It also facilitates the expansion or contraction of the debt capital to suit
the business strategies and conditions.
 Solvency: A sound capital structure helps to maintain liquidity in the firm because an
unplanned debt capital leads to the burden of interest payments, ultimately reducing
the cash in hand.
 Increases Firm’s Value: Investors prefer to put in their money in the company, which
has a sound capital structure. Thus, leading to a rise in the market value of the firm’s
shares and securities.
 Reduces Financial Risk: Balancing the proportion of debt and equity in the business
through capital structure assist the business firms in managing and minimizing risk.
 Minimizes Cost of Capital: It provides for planning the long term debt capital of the
company strategically and thus reducing the cost of capital.
 Tax Planning Tool: For the company opting for debt funds, the capital structure
provides them with a benefit tax deduction and saving, decreasing the cost of
borrowing.
 Optimum Utilization of Funds: A well planned, strategically designed and
systematically arranged capital structure assists the companies in generating
maximum output from the available funds.
7) What is working capital? Explain the factors determining working capital.

Working capital, also known as net working capital (NWC), is the difference between a company's
current assets, such as cash, accounts receivable (customers' unpaid bills) and inventories of raw
materials and finished goods, and its current liabilities, such as accounts payable.

Factors determining working capital

NATURE OF THE INDUSTRY / BUSINESS

The management of working capital is completely different from industry to industry. A simple
comparison of the service industry and manufacturing industry can clarify the point. In the service
industry, there is no inventory and therefore, one big component of working capital is already
avoided. So, the nature of the industry is a factor in determining the working capital requirement.

SEASONALITY OF INDUSTRY AND PRODUCTION POLICY

Businesses based on seasons like manufacturing of ACs whose demand peaks in summer and dips in
winter. The requirement of working capital will be more in summer compared to winter if they are
produced in the fashion of their demand. The policy of producing throughout the year can smoothen
the fluctuation of the working capital requirement.

COMPETITION
If the industry is competitive, quick response to customer needs is compulsory and therefore a
higher level of inventory is maintained. Liberal credit terms are also mandatory with good service to
survive in the market. So, higher the competition, higher would be the requirement of working
capital.

PRODUCTION CYCLE TIME

The production cycle time refers to the time required for converting the raw materials into finished
goods. Higher, this time, higher would be the time of blocking funds in the working capital.

CREDIT POLICY
summer compared to winter if they are produced in the fashion of their demand. The policy of
producing throughout the year can smoothen the fluctuation of the working capital requirement.

COMPETITION
If the industry is competitive, quick response to customer needs is compulsory and therefore a
higher level of inventory is maintained. Liberal credit terms are also mandatory with good service to
survive in the market. So, higher the competition, higher would be the requirement of working
capital.

PRODUCTION CYCLE TIME

The production cycle time refers to the time required for converting the raw materials into finished
goods. Higher, this time, higher would be the time of blocking funds in the working capital.

CREDIT POLICY
Liberal credit policy demands a higher level of working capital and tight credit policy reduces it.
GROWTH AND EXPANSION
Some industries are static and others are growing. Obviously, growing industry grows the
requirement of working capital also as compared to static industry.

SHORTAGE OF SUPPLY OF RAW MATERIAL

If the raw material supply is not smooth for any reason, companies tend to store more of raw
materials than needed and that increased requirement of working capital.

TAXES
Taxes are often paid in advance. This also blocks a part of working capital. Depending on the tax
environment of the industry, working capital needs are also affected.

DIVIDEND POLICY
Dividend policy determines the level of retained profits with the business and retained profits are
also used for working capital. This is how; dividend policy affects the need for working capital.

PRICE LEVELS
The price levels of inventory and other expenses such as labour rates etc increase the working
capital requirement. If the company also is able to increase the price of their finished goods, it
reduces this impact.

8) ‘A’ Company limited is considering the purchase of a new investment. Two alternative
investments are available A and B, both costing RS 1,00,000.

year Cashflow of project A (RS) Cashflow of project B (RS)

1 40,000 50,000
2 35,000 40,000
3 25,000 30,000
4 20,000 30,000

sol

Computation of NPV

Years Discount factor (10%+2%)= CI PV

(1/1+12%)
1 0.8928 40000 35680
2 0.7971 35000 27895
3 0.7117 25000 17800
4 0.6355 20000 12720
total 94095

-II 1,00,000
 Total NPV -5905

Computation of NPV

The profitability of the two investment can be compared on this basis of NPV for investment A and B
(RADR)

Years Discount factor (10% CI PV

+8%)= (1/1+18%)
1 0.847 50,000 42350
2 0.718 40,000 28720
3 0.608 30,000 18240
4 0.515 30,000 15450

total 104760
- II 1,00,000
4760

9) The company has a target return on capital of 10%. Risk premium rate is 2% and 8% Respectively
for investments A and B. which project should be preferred for investment?

Types of capital Book value Market value Specific cost (%)

Debentures 40,000 38,000 5
Preference capital 10,000 11,000 8
Equity capital 60,000 1,20,000 13
Retained earnings 20,000 --- 9

You are required to determine the weighted average cost of capital using:

1 book value as weights

2 market value as weights

Computation of WACC using book value

sol

sources Book value X W WX

Debentures 40,000 5 153.8
40,000/1,30,000*100
 30.76
Preference 10,000 8 7.69 61.52
capital
Equity capital 60,000 13 46.15 599.95
Retained 20,000 9 15.38 138.42
earnings
Total 1,30,000 99.98 953.69

WX/W = 953.69/99.98= 9.54%

Computation of WACC using market value

sources market value X W WX

Debentures 38,000 5 112.45
38,000/1,69,000*100
22.49
Preference 11,000 8 6.51 52.08
capital
Equity capital 1,20,000 13 71.00 923
Retained ----- 9 ------ ------
earnings
Total 1,69,000 100 1087.53

WX/W = 1087.53/100 = 10.87%

10) Find out the relationship of dividend policy and the value of share according to Gordon’s model

Particulars A B C
r= 0.30 0.20 0.15
Ke= 0.20 0.20 0.20
E= 5 5 5
Effect of dividend policy on market value of shares according to Gordon’s model when retention
ratio is 40% and 60% . comment on the results.

sol

Dividend payout ratio (1-b) Retention ratio

A 60% 40%
B 40% 60%
C 100% 0%
Calculate the price the share using Gordon’s model

When dividend payout ratio is 60%

P=E(1-b)/ke -br

=5(1-40%)/0.20-(0.40*0.30)

=3/0.08

= RS 37.5

When dividend payout ratio is 40%

P=E(1-b)/ke -br

= 5(1-60%)/0.20-(0.60*0.20)

=2/0.08

= RS 25

When dividend payout ratio is 100%

P=E(1-b)/ke -br

=5(1-0%)/0.20-(0.00*0.15)

= 5/0.2

=RS 25