(^326) Financial Management
- Determination of the tolerance limit on the probability of cash insolvency.
- Specification of the probability distribution of cash flows under adverse conditions
(recessionary conditions). - Calculation of the fixed charges associated with various levels of debt,
- Estimation of the debt capacity of the firm as the highest level of debt which is
acceptable, given the tolerance limit, the probability distribution, and the fixed
charges defined above,
This kind of analysis may be illustrated with the help of information for Phoenix Limited
which is given below:
Tolerance Limit The management of the company does not want the likelihood of cash
insolvency to exceed 5 per cent even in adverse (recessionry) conditions.
Probability Distribution Under adverse (recessionry) conditions the company would
have an expected cash inflow of Rs. 50 million with a standard deviation of Rs, 30
million. The cash inflow would be normally distributed. The initial cash balance of the
company is Rs. 1.26 million.
Fixed Charges The annual fixed charges associated with various levels of debt would
be as follows:
Level of Debt Annual Fixed Charges
Up to Rs. 5 million Rs 0.25 million for every Rs 1 million of debt
Between Rs. 5 million and Rs 0.26 million for every Rs. 1 million debt
Rs. 10 million
Between Rs. 10 million and Rs 0.27 million for every Rs. 1 million of debt.
Rs. 15 million
Debt Capacity Given the above information the debt capacity may be established as
follows: - Since the cash inflow is normally distributed the following variable has a standard
normal distribution (Z distribution):
(^) Standard deviation of cash inflow
Cash inflow-Mean value of cash inflow
- The Z value corresponding to 5 per cent cumulative probability (which reflects
the risk tolerance of the management) is - 1.653 - Since m = Rs. 50 million, s = Rs. 30 million, and the Z value corresponding to the
risk tolerance limit is --1.645, the cash available from the operations of the firm to
service the debt is equal to X: which is defined as: