Unit 4 Business Finance PYQ’s 29th Sep 2022 Shift 1

The correct answer is Diversification

Key Points

• Diversification involves spreading investments across different assets or asset classes (such as stocks, bonds, real estate, etc.) to reduce risk.
• By diversifying a portfolio, investors aim to minimize the impact of any single investment’s poor performance on the overall portfolio.
• Diversification is a key principle of the portfolio approach to investing, helping investors manage risk and potentially improve their chances of achieving more consistent returns over the long term.

Key Points

Permanent Working capital – Fixed working capital represents the absolute minimum investment in working capital. This level of net working capital, sometimes referred to as permanent working capital, has never been reached on any day of the fiscal year.

Short term financing – Short-term financing is needed when there is a short-term, or less than a year, financial need.

Important Points

Matching Approach –  

• This strategy states that the maturity of funding sources should correspond to the type of assets being financed.
• As a result, this strategy is also known as the matching strategy.
• According to the hedging method, short-term funds should be used to cover seasonal or temporary working capital needs while long-term funds should be used to cover permanent working capital needs.

Conservative Approach – 

• This strategy proposes that the use of short-term funds should be for urgent needs and that all expected investments in current assets should be supported from long-term sources.
• Only emergencies will be met with the short-term cash.

Aggressive Approach – 

• The aggressive method is a high-risk working capital financing strategy in which temporary working capital and a sizeable portion of permanent working capital are financed with short-term funds.
• The levels of inventories, accounts receivable, and bank balances under this financing strategy are barely adequate without a safety net for uncertainty.
• It states that even a small portion of investments in fixed assets must be supported with short-term funds.

Traditional Approach – 

• When creating a working capital policy for a company, the trade-off between profitability and risk is a crucial factor to take into account.
• In other words, both profitability and risk depend on a company’s Net Working Capital (Current Assets – Current Liabilities) level.

Thus, Aggressive Approach of working capital where a firm finances a part of its permanent working capital with short term financing.

Key PointsCapital structure – A company’s capital structure is the specific mix of debt and equity it uses to finance both its general operations and expansion.

Important PointsNet Income Approach – 

• The Weighted Average Cost of Capital (WACC) and the value of the company are both predicted to fluctuate in response to changes in a firm’s financial leverage by the Net Income Approach.
• According to the Net Income Approach, the WACC lowers, and the firm’s value grows as leverage (the proportion of debt) increases. Conversely, if the leverage is reduced, the WACC rises, and the firm’s value is down.

Net Operating Income Approach – 

• David Durand created the concept of net operating income (NOI). According to the net operating income approach, changes in a company’s or a firm’s debt components have no impact on the value of the company.
• According to the net operating income concept, a company’s value is based on its operational income and any related business risk.

Traditional Approach – 

• The classic theory of capital structure predicts that the ideal capital structure will rise to a certain point, then remain constant, before starting to decline.
• It implies that there is a debt-to-equity ratio that is best, where the WACC is lowest and the firm’s market value is largest.
• When a company exceeds the ideal debt to equity ratio, the cost of equity increases and has a negative impact on WACC. When the WACC rises above the threshold, the market value of the company begins to decline.

Modigliani-Miller Approach- 

• This strategy is quite similar to the NOI strategy.
• This strategy assumes that the firm’s use of leverage has no impact on the cost of capital and, consequently, the value of the company.
• According to Modigliani and Miller, there is no ideal balance of debt and equity financing because any reasonable choice of debt and equity results in the same cost of capital under their assumptions.

Key Points

Perpetual debt – Perpetual debt, often referred to as constant debt, is a type of debt instrument that is bought with the intention of creating a consistent flow of income in the form of interest payments.

Cost of Capital – The minimum rate of return a company must achieve before creating value is known as cost of capital.

Important Points

Cost of Debt – 

K_d =Interest×(1−t)RV×100Interest×(1−t)RV×100

Interest = Rs. 10

RV = Rs.110

t = 35% or 0.35

Kd = 10×(1−0.35)110×10010×(1−0.35)110×100 

Kd = 10×0.65110×10010×0.65110×100

Kd = 5.91% 

Cost of Capital = cost of debt + Cost of equity + cost of retained earning 

Cost of Capital = 5.91% + 0 + 0 

Cost of Capital = 5.91%

Key PointsCurrency Depreciation

• In a floating rate system, the exchange value of a nation’s currency in relation to other currencies is referred to as currency depreciation.
• Based on trade imports and exports for a certain nation, the depreciation rate of a currency is calculated.
• Demand for imported goods drives up imports, which boosts foreign currency investment and weakens home currencies.

Important PointsCauses of Currency Depreciation

1. A fall in the world price of a country’s major export. This leads to a decline in export revenues and a fall in overseas demand for the exporting nation’s currency

1. There is a surge in the value of imports causing a deficit on the current account of the balance of payments which then leads to a net outflow of currency, causing exchange rate weakness.
2. A country’s central bank reduces interest rates, leading to a net outflow of hot money(Portfolio outflow) – this is short term financial capital that searches for the best risk-adjusted rate of return
3. Depreciation might be caused by intervention from the Central Bank e.g. it goes into the market to sell their own currency and buy gold and foreign currencies.
4. The basic trend analysis of the variables show that; for countries that suffers from high original sin, a depreciation in currency is accompanied by rising external indebtedness and/or high debt servicing costs.

Hence, it can be concluded that currency depreciation in the Indian Rupee in recent times has largely been attributed to only option C and E only.

Key Points

MM hypothesis of Dividend theory

• The Miller and Modigliani Hypothesis, often known as the MM Approach, contends that the firm’s investment philosophy, not its dividend policy, determines how much its shares are worth.
• As long as the returns exceed the equity capitalization rate “Ke,” the investors are happy with the firm’s retained earnings.
• What is a rate of equity capitalization? the rate at which profits, dividends, or cash flows are transformed into stock or the company’s worth.
• The shareholders would prefer to get the profits in the form of dividends if the returns fall below “Ke”.
• Miller and Modigliani have provided evidence to support their claim that dividend payments have no impact on a company’s share price.

 Important Points

Critical Assumptions of MM hypothesis of Dividend Theory

1. A perfect capital market exists, if investors are rational and have unrestricted access to all available information. No investor is significant enough to affect the market price, there are no flotation or transaction fees, and the shares are infinitely divisible.
2. Taxes don’t exist. Capital gains and dividends are both taxed at a same rate.

1. It is assumed that a business maintains a consistent investing policy. This suggests that the position of business risk and the rate of return on investments in new projects remain unchanged.
2. Since there is no risk involved, there is no uncertainty regarding the future profits; all investors are confident in their future investments, dividend payments, and business earnings.

Hence, it can be concluded that “All financing is done through retained earnings” is not the critical assumption of MM hypothesis of the irrelevance of dividends.