Question 5 OR

Short notes: net income approach, types of leverage, risk-return trade-off in working capital

15 marks

Time to write
About 30 minutes

From an older CBCS paper

Question

Question 5 OR · 15 marks

Write short notes on any three of these:

  1. The Net Income Approach to Capital Structure

  2. The Types of Leverage

  3. The Economic Order Quantity

  4. The Risk-Return Trade Off in Working Capital Management

  5. The Cash Budget

Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.

Before you write

Read off the question and its marks

30 minfor 15 marks

Read from the question

  • any threeAnswer any 3 of the 5, 5 marks each. Only 3 are marked: a fourth earns nothing.
  • short notesA note opens with the meaning, then two or three key points. No long introduction.

What the paper leaves open

Any three of the five. Option (iii), EOQ, is outside the current syllabus; the answer writes notes on (i), (ii) and (iv); the cash-budget note follows the reading recorded in the subject log.

Write it in this order

The parts stand alone: start with the one you are surest of.

  1. Read; underline the asks; jot your points 2 min
  2. 1 (i) The Net Income Approach to Capital Structure 5 marks 9 min
  3. 2 (ii) The Types of Leverage 5 marks 9 min
  4. 3 (iv) The Risk-Return Trade-Off in Working Capital Management 5 marks 8 min
  5. Check: every ask answered, key terms underlined 2 min

Easy marks

  • Choose the ones you know best: each carries the same marks.

Short on time? A few lines on every part beat a full answer to one: each part is capped at its own marks.

Try it first. About 30 minutes for 15 marks. Write it out, then open the solution.

Solution

Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.

Option (iii), the EOQ, is outside the current syllabus (paper note); notes are written on (i), (ii) and (iv).

Picture itShort notes: net income approach, types of leverage, risk-return trade-off in working capital

1The baker signs for the bank's money at a fixed interest.

Financial leverageThe use of fixed-charge funds (debt, preference shares) in the capital structure.

2The ovens run full, the queue is long—the loan earns more than it costs, and the owner's share swells.

FavourableThe fixed-charge funds earn more than they cost, so EPS rises.

3The same counter empty: the interest envelope still goes out, from a thinner cash box.

UnfavourableWhen ROI is below the cost of debt: EPS falls.

(i) The Net Income Approach to Capital Structure

According to the net income (NI) approach, a firm can lower its weighted average cost of capital and raise its value, and the market price of its shares, by using debt to the maximum possible extent.

  • Assumptions: the cost of debt is less than the cost of equity; there are no taxes; the use of debt does not change investors' perception of risk, so kd and ke stay constant at every level of leverage.
  • Reasoning: as cheap debt replaces equity, the overall cost ko = EBIT ÷ V falls and V = S + D rises; ko approaches kd but never reaches it, since some equity must remain.
  • Example: EBIT ₹2,00,000, ke 16%, kd 10%. With ₹5,00,000 of debt, S = 1,50,000 ÷ 0.16 = ₹9,37,500 and V = ₹14,37,500 (ko 13.91%); with ₹8,00,000 of debt, V = ₹15,50,000 (ko 12.90%).
  • Criticism: the constancy of ke is unrealistic, since more debt raises the shareholders' financial risk; the approach ignores this and would imply an almost all-debt firm.

(ii) The Types of Leverage

Leverage is the magnifying effect of fixed costs: a given percentage change in one variable produces a larger percentage change in another.

  1. Operating leverage: arises from fixed operating costs; it magnifies the effect of a change in sales on EBIT. DOL = contribution ÷ EBIT. It exists only when there are fixed costs: with none, a 20% rise in sales gives just a 20% rise in EBIT. It reflects business risk.
  2. Financial leverage: the use of funds with a fixed cost in order to increase earnings per share; DFL = EBIT ÷ EBT. It reflects financial risk and is favourable when the return on assets exceeds the cost of debt (trading on equity).
  3. Combined leverage: DOL × DFL = contribution ÷ EBT, the % change in EPS for a 1% change in sales. A firm normally balances a high operating leverage with a low financial leverage, or the reverse.

(iv) The Risk-Return Trade-Off in Working Capital Management

Risk here is the firm's inability to meet its obligations as they fall due.

  • Conservative policy: a larger investment in current assets and less dependence on short-term borrowing increase liquidity and reduce risk, but lower profitability, because funds lie idle in cash and stocks and long-term finance costs more.
  • Aggressive policy: less investment in current assets and more short-term borrowing increase profitability but also risk, and reduce liquidity: the firm may run out of cash or stock.

There is a direct relationship between risk and profitability; the goal of management should be a suitable trade-off between them. It applies to each decision: the level of current assets (how much cash, stock and credit), and the financing of current assets (the matching, conservative or aggressive approach). Because cheaper sources of finance are generally riskier, sound working capital management balances cost against risk as well.

Where the 15 marks sit

#ComponentMarks
1(i) The Net Income Approach to Capital Structure5
2(ii) The Types of Leverage5
3(iv) The Risk-Return Trade-Off in Working Capital Management5
Total15
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