Capital Structure:

(a) Major Determinants:

​ Business Risk: The nature and volatility of the business's operations affect the
capital structure. Riskier businesses may opt for lower debt to reduce financial
risk.
​ Tax Considerations: Tax benefits associated with debt interest make it an
attractive option compared to equity financing.
​ Cost of Capital: The cost of debt vs. equity influences the optimal capital
structure. Higher costs of equity might lead to a preference for debt financing.
​ Flexibility: The company's need for flexibility in financial operations and its ability
to adapt to changing market conditions.

Dividend Policy:
(b) Major Determinants:

​ Earnings Stability: Consistent earnings often lead to stable dividend policies.

​ Investment Opportunities: Companies retaining earnings for growth may offer
lower dividends.
​ Tax Considerations: Dividend taxation impacts the decision to distribute profits as
dividends.
​ Shareholder Preferences: Some shareholders prefer dividends for income, while
others prefer capital appreciation.

Working Capital:
(c) Major Determinants:

​ Nature of Business: Different industries have varying working capital needs. For
instance, manufacturing may require higher working capital than service-based
businesses.
​ Sales Volume and Growth: Increased sales volume and rapid growth might
necessitate higher working capital.
​ Seasonality: Businesses with seasonal sales may experience fluctuating working
capital requirements.
​ Efficiency of Operations: Efficient inventory management and receivables
collection can impact working capital needs.
M-M Approach Assumptions and Criticisms:
2(a) Assumptions:

● Perfect capital markets

● No taxes
● No transaction costs

Investors and firms have access to the same information

● Criticisms:
● Unrealistic assumptions
● Tax effects and bankruptcy costs are significant in real-world scenarios
● Ignores market imperfections and frictions

NI Approach vs. NOI Approach:

2(b) NI Approach: Considers the impact of capital structure on Net Income.
NOI Approach: Focuses on the impact of capital structure on Net Operating Income.

The NI approach assumes a constant tax rate, while the NOI approach assumes that
the cost of debt remains constant. The key difference lies in the consideration of interest
tax shields.

NPV vs. IRR:

3(a) Similarities:

● Both are capital budgeting techniques used to evaluate investment projects.

● Aim to determine the profitability of projects based on cash flows and time value
of money.

Differences:

● NPV (Net Present Value): Measures the absolute dollar value of a project by
discounting cash flows to the present value using a predetermined discount rate.
● IRR (Internal Rate of Return): Represents the discount rate that makes the
present value of cash inflows equal to the initial investment. It measures the
percentage return on a project.
Differences:
3(b) (i) Weighted Average (After Tax) Cost vs. Marginal Cost of Capital:

● WACC: Represents the average cost of funds (both debt and equity) weighted by
their proportions in the capital structure.
● Marginal Cost of Capital: Refers to the cost of obtaining one more unit of capital.
It considers the cost of the last unit of financing.

(ii) Book Value Weights vs. Market Value Weights:

● Book Value Weights: Proportions based on the accounting/book values of debt

and equity.
● Market Value Weights: Proportions based on the market values of debt and
equity.

(iii) Systematic Risk vs. Unsystematic Risk:

● Systematic Risk: Market-related risk that cannot be diversified away (e.g., market
crashes, interest rate changes).
● Unsystematic Risk: Specific to a company or industry and can be mitigated
through diversification (e.g., company-specific management issues).

Understanding these concepts is crucial in financial decision-making within a firm.

Capital Asset Pricing Model (CAPM):

CAPM is a financial model used to determine an expected return on an investment
based on its risk and cost of capital. It's based on the following formula:

Expected Return=Risk-Free Rate+Beta×(Market Return−Risk-Free Rate)

Expected Return=Risk-Free Rate+Beta×(Market Return−Risk-Free Rate)

● Risk-Free Rate: The return on a risk-free investment, often approximated by

government bond yields.
● Beta: Measures the sensitivity of an asset's returns to market movements.
● Market Return: Expected return from the market as a whole.
CAPM is widely used in finance to estimate the appropriate return an investor should
expect for taking on additional risk. It helps in evaluating an investment's potential by
comparing its risk-adjusted return to the market's expected return.

Trading on Equity:
This concept involves using debt (in addition to equity) to finance operations or
investments in order to magnify returns to shareholders. By borrowing funds at a lower
cost than the return on investment, a company can amplify shareholders' returns.
However, it also increases the financial risk due to fixed interest payments on debt.

Weighted Average Cost of Capital (WACC):

WACC is the average rate of return a company is expected to pay to its investors (both
debt and equity) for funding its assets. It's calculated by weighting the cost of equity
and the after-tax cost of debt based on their proportions in the company's capital
structure.

The rationale behind using WACC is that it represents the average cost of funds
employed by the company. It's used as a discount rate in discounted cash flow analysis
to evaluate potential investments. Projects or investments with returns above the WACC
are generally considered worthwhile, as they theoretically create value for the company.

EBIT-EPS Analysis:
EBIT-EPS analysis (Earnings Before Interest and Taxes - Earnings Per Share) is a tool
used to evaluate the impact of financial leverage (using debt) on a company's earnings
per share.

● EBIT: Earnings before interest and taxes.

● EPS: Earnings per share.

This analysis assesses the effect of different capital structures on EPS by comparing
the earnings available for equity shareholders. It helps in determining the optimal capital
structure by evaluating the impact of varying levels of debt on EPS at different levels of
EBIT.

Companies use this analysis to find the ideal mix of debt and equity financing that
maximizes EPS and shareholder value while managing financial risk.
These financial tools and analyses are critical for firms to make informed decisions
regarding investments, capital structure, and financing choices.

Walter's Dividend Model:

Assumptions:

​ Infinite Dividend Payout: Firms can retain or distribute earnings indefinitely.

​ Constant Rate of Return: The rate of return and the cost of capital remain
constant.
​ No External Financing: The company can finance all investment opportunities
using retained earnings or dividends.
​ Investment Opportunities: Companies have profitable investment opportunities.

Criticisms:

● Unrealistic Assumptions: The model assumes a constant rate of return and

infinite dividend payout, which rarely occurs in real-world scenarios.
● Ignores Tax Effects: It doesn't consider the impact of taxes on dividend policies.
● Doesn't Address Market Reactions: It doesn't account for the market's response
to dividend decisions.

Gordon Dividend Model (or Gordon Growth Model):

Assumptions:

​ Constant Growth Rate: Dividends grow at a constant rate indefinitely.

​ No External Financing: Similar to Walter's model, it assumes no external
financing for investments.
​ Stable Dividend Policy: The dividend payout ratio remains constant.

Criticisms:

● Unrealistic Growth Assumption: Assumes a constant growth rate perpetually,

which doesn't align with market fluctuations.
● Ignores Variations in Dividend Policy: Doesn't consider changes in dividend policy
or market reactions to such changes.
 ● Limited Applicability: Works well for companies with stable growth rates, but not
for companies experiencing fluctuating growth rates.

M-M (Modigliani-Miller) Approach as to Dividend:

Assumptions:

​ Perfect Capital Markets: Assumes no taxes, transaction costs, or information

asymmetry.
​ Irrelevance of Dividend Policy: Argues that in perfect markets, dividend policy
doesn't affect the firm's value.
​ Investors' Preferences: Assumes investors can create their desired cash flows
from dividends or selling shares.

Criticisms:

● Unrealistic Market Assumptions: The model's assumptions of perfect markets

don't reflect real-world scenarios with taxes, costs, and imperfect information.
● Contradicts Real-World Evidence: Empirical evidence often shows that dividend
policies do affect stock prices and investor behavior.
● Limited Practical Applicability: While it provides theoretical insights, in practice,
dividend policies impact investor sentiment and firm value.

These models offer theoretical frameworks for understanding dividend policies, but
their assumptions often oversimplify real-world complexities and may not fully capture
the dynamics of dividend decisions in practical business settings.

5 (a) Wealth Maximisation as the Objective of Financial

Management:
Wealth Maximization: This objective aims to increase the overall value of the firm for its
shareholders over time. It considers not just immediate profits but also the long-term
impact of decisions on the firm's value.

Profit Maximization vs. Wealth Maximization:

 ● Profit Maximization: Focuses solely on earning maximum profits in the short
term. However, it doesn't consider risk, time value of money, or the impact of
decisions on the firm's long-term value.
● Operational Feasibility: Profit maximization is challenging due to varied factors
such as uncertainty, risk, competition, and changing market conditions. It also
doesn't consider the timing and risk associated with future cash flows.

5 (b) Wealth Maximization vs. Profit Maximization:

Agree or Disagree: The preference for wealth maximization over profit maximization is
subjective and context-dependent.

● Wealth Maximization: It considers long-term value creation, incorporating risk

and time value of money.
● Profit Maximization: It's limited in scope, focusing on immediate profits without
considering long-term consequences.

Which is Better?: Wealth maximization is generally considered superior as it aligns with

the goal of shareholders' wealth maximization, taking into account risk, timing, and
sustainability of returns.

6 (a) Stable Dividend Policy:

Stable Dividend Policy: Refers to a consistent or steadily increasing dividend payout by a
company over time. It aims to provide predictability to shareholders regarding dividend
income.

Relevance: Stability in dividend payments:

● Enhances investor confidence and trust in the company.

● Attracts long-term investors seeking consistent income streams.
● Signals financial health and sustainability of the company's operations.

6 (b) Informational Content of Dividend Payment:

Effect on Share Value: Dividend payment provides information to investors about a
company's financial health and future prospects.
 ● High Dividend Payment: Often interpreted as a sign of strong financial
performance and stability, positively impacting share value.
● Change in Dividend Policy: Alterations in dividend policies can influence investor
sentiment and affect share prices, indicating management's confidence in future
cash flows.

7) Basic Differences:
(i) Gross Operating Cycle vs. Net Operating Cycle:

● Gross Operating Cycle: It's the total time taken from the purchase of raw
materials to the collection of cash from the sale of goods.
● Net Operating Cycle: It deducts the credit period received from suppliers from the
gross operating cycle, giving the net time for which capital is tied up in the
operating cycle.

(ii) Gross Working Capital vs. Net Working Capital:

● Gross Working Capital: Represents the total current assets of a company.

● Net Working Capital: It's the difference between a company's current assets and
current liabilities, indicating the liquidity and short-term financial health of the
company.