Question

1. A) Define the following terms/concepts used in financial management:

1. Capital
2. Financial Leverage
3. Perpetuity
4. Dupont Analysis
5. Dividend payout ratio
6. Investment
7. Beta factor
8. Management
9. Indenture
10. Capital market
11. Capital structure
12. Portfolio theory
13. Goodwill
14. Bearer bonds

Answer 1

Hello. As per our Honor Code, we will answer the first four parts of this question.

1. CAPITAL

In finance, Capital can be defined as the amount that a business enterprise uses to fund its operations and expenditures. Capital is considered as the most important part in any business since without it, the business cannot run. Firms usually raise capital either in the form of Equity capital or Debt capital or even a mix of both which decides the optimal capital structure. In return, the firm also bears the cost of capital by paying interest or dividend. While long term expenditure is financed through Debt and equity capital, short term expenditure is financed through Working capital of the firm which is the excess of Current Assets over Current Liabilities which means how much is the firm capable to meet its current liabilities.

2. FINANCIAL LEVERAGE

Financial leverage refers to using borrowed funds, specifically Debt to finance a firm's projects or assets. When financing a project, a firm has either an option of raising equity capital or a mixture of equity and debt. The firms that use a mix of it in their capital structure are known as the levered firms. Individual Investors also use financial leverage to magnify their returns. It is also known as trading in equity.

Concept

If the return on investment(ROI) is greater than the cost of borrowing(debt)(Kd), then a firm that uses financial leverage can magnify its returns thereby maximising the shareholder's wealth as compared to the firms that only issues equity capital. Therefore, financial leverage is an integral part in deciding a firm's capital structure. There are various measures of financial leverage, the most common ratio being the Debt-Equity ratio.

Debt Equity Ratio = Debt/Equity

Though financial leverage can help firms and individual investors maximise their wealth, it must be used carefully since raising debts have a cost with them in the form of interest. Too much of debt may increase the cost of borrowing and the risk as well.

3. PERPETUITY

Perpetual in general terms means something that is never ending. Perpetuity in financial management refers to a stream of cash flows that are never ending. When investors invest in a perpetuity, this means that the project is generating cash flows for an infinite period. Perpetuity formula is used while calculating the present value of such cash flows so that the investor gets to know how beneficial the project is. For calculating Perpetuity, the cash flows are divided by the discounting rate which is usually the minimum required rate of return from a project to determine the present value of that project.

PV= CF/ r

Where PV is the present value of perpetuity

CF is the cash flow

r is the discounting rate

4. DUPONT ANALYSIS

DuPont analysis is the analysis of a firm's Profitability. Profitability refers to a firm's ability to generate income in order to cover its expenses. The Du Pont analysis breaks the Return on Equity(ROE) of a firm into different components so that the analysis becomes easy.

The formula for ROE is Net Income/ Common Equity

The DuPont analysis model breaks this formula into three components i.e. Net profit margin, Total assets turnover and Financial leverage. All the three together constitute the Return on Equity.

The formula for DuPont model is given as:

ROE= Net profit margin * Total Asset Turnover * Financial leverage

or ROE = Net Income/ sales * Sales/ Total Assets * Total Assets/ Common Equity