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UNIT 9
FINANCIAL MANAGEMENT
Quick Revision Notes and Practice Questions
A. Business Finance
Concept: Money required to carry out business activities is called Business Finance. Finance is
required to establish, run, modernise, expand and diversify a business.
B. Concept and Objectives of Financial Management
1. Concept: Financial Management is concerned with the proper management of funds. It involves
managerial decisions relating to procurement of long-term and short-term funds, keeping the risk
associated with it under control and their proper utilisation in the most productive and effective
manner. In other words, Financial Management deals with planning, organising, directing and
controlling financial activities like procurement and utilisation of funds of an enterprise.
2. Objective of Financial Management
The objective of financial management is maximisation of shareholders' wealth. It means
maximisation of the market value of equity shares. This is because funds of a company belong to its
shareholders. Thus, all financial decisions aim at ensuring that each decision is efficient and adds
some value to increase the market price of shares.
C. Financial Decisions
For achieving the objective of financial management, three important financial decisions are taken:
1. Investment Decision: Investment Decision involves deciding how the firm's funds are invested in
various assets. It is allocation of resources to different proposals. Investment decision can be of two
types:
• Long-term Investment Decision or Capital Budgeting Decision, and
• Short-term Investment Decision or Working Capital Decision.
• Capital Budgeting Decision: It pertains to that part of capital which is invested in acquiring
fixed assets—machinery, building, furniture, etc. Fixed capital decisions are also known as fixed
assets decisions.
Factors Affecting Fixed Assets!Capital Budgeting Decisions
330K+
Fam
Cash flow of the project ^ Rate of return Investment criteria
• Working Capital Decision: It pertains to that part of capital which is related to current assets and
current liabilities. While taking such a decision, there should be a proper balance between
liquidity and profitability.
2. Financing Decision: This decision is about how to raise or procure necessary capital funds. The main
sources of funds are shares, debentures, public deposits or loans, loans from financial institutions, etc.
This decision determines the overall cost of capital and the financial risk for the enterprise.
Factors Affecting Financing Decisions
o Cash flow position o Cost o Risk
o Floatation cost o Fixed operating cost o Control considerations
o State of the capital market o Return on investment o Tax rate
o Flexibility o Regulatory framework
3. Dividend Decision: It involves deciding how much of the net profit of the firm will be distributed as
dividend and the extent to which it will be retained in the business to meet the future requirements. Dividend
is that portion of profit which is distributed to shareholders. Dividend can be paid as cash dividend-when
dividend paid tr-cash or bonus dividend-when dividend is allowed to shareholders by allotting shares
without asking them to pay for such shares.
Determinants of Dividend Decisions-factors affecting dividend decisions are:
o Amount of earnings o Legal constraints Preferences of shareholders
o Contractual constraints o Growth opportunities o Stock market reaction
o Cash flow position o Taxation policy o Stability of dividends
o Access to capital market o Stability of earnings
D. Financial Planning: Concept, Process and Importance
1. Concept: It refers to planning regarding financial needs of an enterprise, various sources of raising
funds and their optimum utilisation.
2. Process of Financial Planning
o Estimating financial requirement for present and future needs.
o Determining capital structure and various sources of raising funds.
3. Importance of Financial Planning
o Financial planning ensures provision of adequate funds to meet day-to-day requirements of business as
well as its future expansion.
o It brings about a balance between inflow and outflow of funds and ensures liquidity throughout the
year.
o It solves the problems of shortage and surplus of funds and ensures proper and optimum utilisation of
available resources.
o It ensures increased profitability through cost-benefit analysis and by avoiding wasteful operations.
o It seeks to eliminate waste of funds and provide better financial control.
o It seeks to avail the benefits of trading on equity.
o It aims at efficient and optimum utilisation of surplus funds for the benefit of business.
E. Capital Structure: Concept
1. Concept: Capital structure refers to the make-up or composition of the total funds raised by the
company, also known as Capital Mix.
In other words, it refers to the mix between owners and borrowed funds.
o Owners' fund is known as equity and borrowed fund is known as debt.
o It involves deciding the type of securities to be raised and the relative proportion of debt and equity
used for financing the business operations.
Capital structure can be calculated by debt-equity ratio, i.e.,
Debt Debt
------ or --------
Equity Debt + Equity
2. Factors Affecting Capital Structure
o Position of cash flow o Return on Investment (ROI) o Interest coverage ratio (ICR)
o Debt-service coverage ratio (DSCR) o Cost of debt funds o Tax rate
o Cost of equity o Floatation costs o Risk consideration
o Flexibility o Retaining control o Regulatory Framework
o Conditions of capital market o Capital structure of other companies
(Stock market)
F. Cost and Risk Analysis-Debt Vs Equity
1. Cost of debt is lower than cost of equity as lender's risk is lower than risk of equity holders. This is
because
o Returns and repayment of capital is assured for lenders so they are willing to accept lower rate of return
(i.e., low rate of interest) as compared to rate of return earned by equity holders.
o Interest paid on debt is deductible expense for computation of tax liability, whereas dividend to
shareholder is not.
Therefore, increased use of debt lowers the overall cost of capital if cost of equity remains unaffected.
2. Debt is more risky than equity as payment of interest and repayment of the principal amount is
obligatory for a business in case of debt. Any default in meeting these commitments may force the
business to go into liquidation. Higher use of debt, therefore, increases the financial risk of a business.
Equity is considered riskless as there is no such compulsion.
o Capital structure of a company affects both the profitability and the financial risk.
o Optimum Capital is that combination of debt and equity which maximises the market value of the
shares of the company.
o Financial Risk is the chance that a firm would fail to meet its payment obligations.
o The proportion of debt in the overall capital is called financial leverage. It is computed as:
Debt or Debt
------ ---------
Equity Debt + Equity
o Trading on Equity refers to the increase in profit earned by the equity shareholders due to the presence
of fixed financial charges like interest.
o The impact of financial leverage on the profitability of the business can be seen through EBIT - EPS
(Earning before interest and tax - Earning per share) analysis.
G. Fixed Capital and Working Capital: Concept and Factors Affecting their Requirements
1. Fixed Capital: That part of capital which is invested in permanent or lasting assets used in business
such as building, machinery, etc.
o Factors Determining Fixed Capital
o Nature of business o Financial alternatives
o Growth prospects o Scale of operation o Diversification
o Scale of operation o Choice of technique
o Technology upgradation o Level of collaboration
2. Working Capital: That part of total capital which is needed to meet day-to-day requirements-to buy raw
materials, pay wages and other expenses, also called circulating or floating capital.
o Factors Determining Working Capital
- Nature of business - Operating efficiency - Production cycle
- Scale of operations - Availability of raw materials - Credit availed
- Business cycle - Credit allowed - Seasonal factor
o Difference between Fixed Capital and Working Capital
- Fixed capital represents fixed assets; working capital represents capital required for meeting routine
needs, consisting of floating assets.
- Fixed assets are not meant for resale, working capital changes into cash again and again.
- Fixed capital is permanent and long-term investment. Working capital is short-term investment.
CBSE AND OTHER MODEL QUESTIONS WITH ANSWERS
Financial Management: Concept and Objectives
1. Define Business Finance.
Ans. Business finance refers to money required to carry out activities pertaining to business.
2. What is meant by Financial Management? (1) (2017)
Ans. Financial management is concerned with the proper management of funds and involves decisions
relating to procurement of funds, investment of funds and distribution of earnings to the owners.
3. "Sound Financial Management is the key to the prosperity of business." Explain. (3) (2009)
Or
"Financial management is concerned with optimal procurement as well as usage of finance." Explain.
(3)
Or
"The future of a business depends on the quality of its financial management." Explain. (3)
Ans. Financial management involves:
1. decisions pertaining to procurement of long-term and short-term funds and identifying the different
sources of finance.
2. procuring such funds at minimum cost and at the same time keeping the risk associated with such
procurement under check.
3. ensuring availability of enough funds whenever required as well as avoiding idle funds.
4. utilisation of funds in such a manner that the return from such investment exceeds the cost of
procurement.
Thus, it can be said that the future of a business depends on the quality of its financial management.
In other words, sound financial management is the key to prosperity of business.
4. What is the primary objective of 'Financial Management'? (1) (2013)
Or
State the objective of 'Financial Management'. (1) (2014 OD)
Ans. The primary objective of financial management is to maximise the shareholders' wealth. The wealth of
the shareholders is reflected in the market value of shares and, therefore, it means maximisation of
market price of shares.
5. What is meant by Financial Management? State the primary objective of Financial Management. (3)
(2012)
Or
Define Financial Management. What is the objective of Financial Management?
Or
Explain the concept and the objectives of Financial Management.
Or
State the objective of Financial Management and how it is achieved.
Ans. The term financial management refers to management of flow of funds. It involves decisions relating to
procurement of funds, investment of funds and distribution of earnings among the owners.
The primary objective of financial management is to maximise shareholders' wealth. The wealth of the
shareholders is reflected in the market value of shares and, therefore, it means maximisation of market
price of shares. This objective is achieved by ensuring:
1. availability of funds at reasonable cost.
2. effective utilisation of funds by selecting those projects or by taking such decisions which result in
value addition. That is to say benefits from a decision exceed the cost involved.
Financial Decisions: Investment, Financing and Dividend
6. Explain the three important decisions taken in Financial Management. (6) (2009 C)
Or
State the meaning of 'Investment' and 'Financing' decisions of Financial Management. (4) (2014
OD)
Or
"Financial Management is based on three broad financial decisions." Explain these decisions. (6) (2010
C)
Ans. Financial management takes financial decisions relating to three main categories, namely, investment
decisions, financing decisions and dividend decisions. These decisions are explained below:
1. Investment Decision: This decision is about how much fixed and working capital will be needed to
acquire fixed assets and to meet day-to-day requirements of funds.
2. Financing Decision: This decision is about how to raise or procure necessary capital funds. The main
sources of funds are shares, debentures, public deposits or loans, loans from financial institutions, etc.
3. Dividend Decision: It involves deciding how much of the net profit of the firm will be distributed as
dividend and the extent to which it will be retained in the business to meet the future requirements.
7. What is meant by Financial Management? State any two financial decisions taken by a Financial
Manager. (3) (2009)
Ans. Financial Management is concerned with the proper management of funds. It involves managerial
decisions relating to procurement and utilisation of funds in the most productive and effective manner.
The two financial decisions taken by a Financial Manager are:
1. Investment Decision: This decision is about how much fixed and working capital will be needed to
acquire fixed assets and to meet day-to-day requirements of funds.
2. Financing Decision: This decision is about how to raise or procure necessary capital funds. The main
sources of funds are shares, debentures, public deposits or loans, loans from financial institutions, etc.
8. How are financial decisions interrelated? How do these contribute to the primary objective of wealth
maximisation? (3)
Ans. Financial decisions are of three types, viz. investment decision, financing decision and dividend
decision. These decisions are interrelated in the sense that underlying objective of these decisions is
maximisation of wealth. For example, investment decision will depend on the availability of funds.
The financing decision in turn is influenced by and also influences the dividend decision. In case the
profits are retained for financing the investments, the dividends are reduced. Thus, all financial
decisions are interrelated.
Investment Decision and Influencing Factors
9. What is meant by investment decisions? Give two examples of investment decisions. (3) (2012
c)
Ans. Investment decisions are those decisions which are related to how the firm's funds are invested in
different assets. These decisions are of two types:
1. Long-term Investment Decisions or Capital Budgeting Decisions: Such decisions involve committing
funds for a long span of time. These decisions affect the growth, profitability and competitiveness of
the business in the long run.
Example: A company wants to purchase machinery worth Rs.30 lakh.
2. Short-term Investment Decisions of Working Capital Decisions: These decisions relate to the level of
cash in hand, inventories and debtors. These affect day-to-day working of a business. Example: A
manufacturing company will require more working capital compared to a trading organisation, as it
has to engage in the process of converting raw material into finished products.
10. Name the financial decision which helps a businessman in opening a new branch of his business. (1)
(2010)
Or
A Pharmaceutical company has invested a huge sum of money on a Research and Development
project. Name the type of financial decision undertaken by the company. (1) (2010)
Ans. Investment Decision
11. How are Long-term Investment Decisions crucial for the business? (3)
Ans. Capital Budgeting Decisions are crucial for the business as:
1. These are irreversible in nature.
2. These involve heavy capital outlay.
3. These affect the profitability of the company.
4. These decisions have a bearing on the long-term growth as the amount invested in fixed assets is likely
to yield returns in future.
12. Identify the decision taken in financial management which affects the liquidity as well as the
profitability of the business. (1) (2008)
Or
Name the type of investment decision which relates to short-term and affects day-to-day operations of a
company. (Sample Paper 2010)
Ans. Working Capital Decision
13. Name any two essential ingredients of sound working capital management. (1) (2010)
Ans. The essential ingredients of sound working capital management are:
1. Efficient cash management,
2. Inventory management, and
3. Receivable management.
14. What are Short-term Investment Decisions? (1)
Ans. Short-term Investment Decisions are also known as Working Capital Decisions. These decisions relate
to the level of cash in hand, inventories and debtors. They affect the day-to-day working of a business.
15. How are Short-term Investment Decisions important for a business?
Ans. Short-term Investment Decisions are important for a business enterprise because:
1. They affect the liquidity and profits earned in the short run.
2. Efficient decisions help maintain optimum level of working capital.
16. What is meant by 'Long-term Investment Decision'? State any three factors which affect the long-term
investment decisions. (4) (2013)
Or
What is meant by 'Investment Decision'? State any three factors which affect the Investment Decision.
any two factors affecting this decision. (3) (2012 OD)
Or
What are 'capital budgeting decisions'? Explain briefly the factors affecting capital budgeting decisions. (5)
Ans. Long-term Investment Decisions are also known as Capital Budgeting Decisions or Investment
Decisions as these affect the growth, profitability and competitiveness of the business in the long run.
Acquiring a fixed asset, opening a new branch, making investment in building, machinery, etc., are
examples of Long-term Investment Decisions.
Factors Affecting Long-term Investment Decisions or Capital Budgeting Decisions
1. Cash Flow of the Project: Capital budgeting decisions are influenced by the amount of cash flow which
a project is going to yield over the life of a project. A cash flow is a receipt or payment of money over
a period of time. Each project may result in different amount of inflows over different time intervals.
Investment should be done only if the net cash inflows are more than the fund invested. Thus, amount
of cash flow should be carefully analysed before taking a decision.
2. The Rate of Return: The most important criterion is the rate of return of the project. Different projects
have different risk and return perceptions. The investment should be done in the projects which earn a
higher rate of return, provided the level of risk is same.
3. The Investment Criteria: Calculations regarding the amount of investment, interest rate, cash flow and
rate of return influence the decision to go for a particular investment or not. For this purpose, capital
budgeting techniques are applied to each of the project and accordingly decisions are taken.
Financing Decision and Influencing Factors
17. What do you mean by shareholders' funds?
Ans. Shareholders' funds refer to equity share capital, preference share capital and reserves and surplus or
retained earnings.
18. What are borrowed funds?
Ans. Borrowed funds refer to the funds raised through issue of debentures, public deposits or loans. These
funds are to be repaid after scheduled time interval. Such funds bring liability to the firm in the form
of interest payment
19. "Determining the overall cost of capital and the financial risk of the enterprise depends upon various
factors." (5) (2011)
Or
Explain the following as factors affecting 'Financing decision':
1. Cash flow position of the business; 2. Level of fixed operating cost;
3. Control consideration; and 4. State of capital markets. (6) (2014) (4) (2012)
Or
What is meant by financing decision? State any four factors affecting the financing decision. (6) (2010)
Ans. Financing decision is the decision about the quantum of funds to be raised from various long-term
sources.
The main sources of funds for a firm are shareholders' funds and borrowed funds.
Factors Affecting Financing Decision
The financing decisions of a firm are influenced by the following factors:
1. Cost: The cost of raising funds from different sources influences a financing decision. A prudent
financial manager selects the cheapest sources of finance.
2. Financial Risk: The risk associated with different sources is different. Risk associated with various
sources of finance is to be compared before taking financing decision. For example, borrowed funds
have higher risk as compared to equity capital.
3. Cash Flow Position of Business: A company with strong cash-flow position may prefer debt to equity
financing as it will not be difficult to meet the fixed commitments and vice versa.
4. Control Considerations: Further raising of funds through equity may lead to dilution of management
control. Thus, in order to protect their interest sometimes companies prefer to procure debt funds.
5. Level of Fixed Operating Costs: Higher the fixed operating costs like building rent, insurance,
premium, salaries, etc., for a company, lesser would be the preference for debt funds as it will add up
to their obligations.
6. State of Capital Market: Prevailing capital market sentiments significantly influence the financing
decisions. During the period of correction (or bear run) in the stock market, there are a few takers for
equity shares and the company may have to resort to debt funds.
7. Floatation Costs: Floatation costs are costs associated with issuing a new security like underwriting
commission, brokerage, printing cost of prospectus, etc. A finance manager estimates the floatation
cost of various sources and selects the source with least floatation cost. Lower the cost of floatation,
more attractive the source of finance.
(Dividend Decision and Influencing Factors)
20. What is dividend? (1)
Ans. Dividend is that portion of divisible profits that is distributed among the owners, i.e., the shareholders.
21. When is the dividend decision treated as a residual decision? (1)
Ans. Dividend decision is treated as a residual decision because it is concerned with the distribution of
residual or leftover income. (More investment opportunities lead to more retained earnings and less
dividend and vice versa.)
22. What is dividend decision?
Ans. Dividend decision relates to the decision as to how much profit should be distributed to the
shareholders as dividend or how much should be retained in the business to finance long-term needs of
the firm.
23. What is meant by dividend decision? State any four factors affecting the dividend decision. (6) (2013,
2010)
Or
Explain the following as factors affecting dividend decision:
1. Stability of earnings; 2. Growth opportunities;
3. Cash flow position; and 4. Taxation policy. (6) (2014, 2014 OD)
Ans. The dividend decision involves deciding how much of the net profit earned by the company will be
distributed as dividend or, alternatively, how much of the profit will be retained in the business to meet
the future requirements.
Dividend decisions depend on a number of factors which are as follows:
Factors Affecting Dividend Decision
1. Earnings: Dividends are paid out of current and past earnings. Thus, earning is one of the major factors
affecting dividend policy of a company.
2. Stability of Earnings: A company registering a stable growth in earnings is more likely to pay regular
dividends than a company with unstable earnings.
3. Preferences of Shareholders: Before declaration and distribution of dividend the company management
must bear in mind the preferences of the shareholders-whether shareholders want dividend income or
capital gain. Preferences of the shareholders for dividend depend upon their economic status.
4. Growth Opportunities: Companies having good growth prospects prefer to retain more earnings to
finance their investment. Therefore, amount of dividend paid by non-growth companies is generally
more than that of growth companies.
5. Cash Flow Position: If a company is short of liquid assets (mainly cash) it would certainly retain all or
a major part of its earnings to improve its cash flow position. On the other hand, if a company has
enough surplus funds, it may decide to distribute dividends.
6. Stability of Dividends: There should not be much fluctuations in the rate of dividend. Stable rate of
dividend raises the value of shares in the market.
7. Legal Provisions: There are certain provisions regarding payment of dividend in the Indian Companies
Act, which must be followed by the company. Listed companies have to follow SEBI guidelines also
regarding payment of dividend.
8. Contractual Constraints: Dividend cannot violate the terms and conditions of the loan agreement with a
financial institution.
9. Stock Market Reaction: Declaring higher dividend by a company is normally considered as good news
in the stock market and it influences the share price of that company positively and vice versa.
Therefore, the stock market reaction is one of the important factors influencing the dividend decision.
10. Taxation Policy: Dividend decision is also affected by taxation policy of the government regarding
corporate profits and dividend.
11. Access to Capital Market: Companies having easy access to capital markets may not depend on
retained earnings to finance their projects and thus, may distribute high dividends.
24. Identify the financial decision which determines the amount of profit earned to be distributed and to be
retained in the business. Explain any four factors affecting this decision. (Foreign 2012)
Ans. Dividend decision.
Factors Affecting Dividend Decision: Refer to Q. 23 on Page 9.8.
Financial Planning: Concept and Importance
25. What do you mean by Financial Planning? (1)
Ans. Financial Planning refers to the process and functions of determining capital requirements of a business
and deciding the various sources from which it can be procured.
26. What is required to tackle the uncertainty in respect of availability and timings of funds? (1) (2008)
Ans. Financial Planning is required to tackle the uncertainty in respect of availability and timings of funds.
27. To avoid the problem of shortage and surplus of funds, what is required in Financial Management?
Name the concept and explain any three points of its importance. (1) (2008)
Ans. To avoid the problem of shortage and surplus of funds, 'financial planning' is required in financial
management.
28. Explain the objectives of Financial Planning. (3) (2009)
Ans. The objectives of Financial Planning are:
1. To ensure availability of funds when they are required. It involves:
(a) estimating the amount of capital required for carrying out the business operations.
(b) estimating the time at which these funds are required.
(c) deciding the sources of raising finance and the proportion in which each of the sources can be utilised.
2. To ensure that the firm does not raise funds unnecessarily and surplus funds, if any, are put to best
possible use.
29. Explain any four points that highlight the importance of Financial Planning. (4) (2014)
Or
What is meant by 'Financial Planning'? Explain any five points which highlight its importance. (6)
(2013 OD, 2013, 2012 OD, 2010)
Or
"Sound Financial Planning is essential for the success of any business enterprise." Explain this
statement by giving any six reasons. (6) (2011)
Or
"Financial Planning tries to link the present with the future." Explain the importance of Financial
Planning in the light of this statement. (3) (2010 C)
Or
What is meant by Financial Planning? State any two points of its importance. (Foreign 2012)
Ans. Financial Planning is a process of estimating the fund requirement of a business and specifying the
sources of such funds.
Importance of Financial Planning
1. It tries to forecast the future under different business situations. It helps in preparing alternative
financial plans so that an action can be taken according to the need of the situation.
2. It helps in preparing an organisation for the future by eliminating business surprises and shocks.
3. It solves the problem of shortage and surplus of funds and ensures proper and optimum utilisation of
available resources.
4. It helps in coordinating various business functions by providing clear policies and budgets.
5. It seeks to eliminate waste of funds and provide better financial control by preparing detailed plan of
action.
6. It provides a link between investment and financial decisions. In other words, it ensures adequate
provision of funds by balancing between inflows and outflows.
7. It helps in evaluation of actual performance by spelling out objectives for every business segment.
Capital Structure: Concept and Influencing Factors
30. Define Capital Structure. (1) (2014)
Or
What is meant by capital structure in financial management? (1) (2017)
Ans. Capital Structure means the proportion in which debt and equity funds are used for financing the
operations of a business. It is also known as Capital Composition or Capital Mix.
31. When is a Capital Structure said to be optimum? (1)
Ans. A Capital Structure is said to be optimum when the proportion of debt and equity is such that it results
in an increase in the value of the equity shares or shareholders' wealth.
32. Explain the term Trading on Equity or Financial Leverage. (1)
Ans. Trading on Equity refers to the increase in profit earned by the equity shareholders due to the presence
of fixed financial charges like interest.
33. Explain the term Fixed Financial Charges. (1)
Ans. Fixed financial charges include interest on long-term debts.
34. What is the effect of higher use of debt for a business?
Ans. Higher use of debt increases the fixed financial charges of a business. As a result, increased used of
debt increases the financial risk of a business.
35. What is financial leverage? How is it computed?
Ans. The proportion of debt in the overall capital is called financial leverage. It is computed as
Debt Debt
-------------- or ---------
Debt + Equity Equity
36. Explain when a company should opt for trading on equity. (1)
Ans. When the rate of earning or Return on Investment (ROI) of a company is higher than the rate of
interest on borrowed funds, only then a company should opt for trading on equity.
37. Why is 'trading on equity' used by a company? (1)
Ans. Trading on equity is used because debts carry fixed charges (i.e., interest) which are tax-deductible.
Thus, they reduce the cost of capital and increase earning of shareholders.
38. How can 'trading on equity' be used by a business organisation? (1)
Ans. Trading on equity can be used by having higher level of debts as compared to equity so that Earning
per Share (EPS) increases.
39. Name the concept which increases the return on equity shares with a change in the capital
structure of a
company. (1) (2008)
Ans. 'Trading on Equity'.
40. What is meant by 'Financial Risk'? (1) (2014 OD)
Ans. Financial risk is the risk which arises due to inability of a firm to meet its fixed financial commitments,
for example, interest on debt funds.
41. How does trading on equity increase the return on equity shares? Explain with an example. (5)
Ans. Trading on equity raises the return, i.e., Earning per share (EPS) of equity shareholders by making use
of fixed cost securities (Debt) in the capital structure. It happens because:
1. Cost of debt is lower than cost for equity for a firm as lender's risk is lower than the shareholders'
risk.
2. Interest paid on debt is a deductible expense while computing tax liability whereas dividends are
paid out of after-tax profits.
Example: Let us consider two public companies: ABC Ltd. and XYZ Ltd.
Each company has a total investment of Rs.50 lakh. ABC Ltd. has its entire capital in the form of
equity shares and XYZ Ltd. has 70% of its capital in equity shares with debentures forming the
balance 30%. The rate of interest on debentures is 10% per annum. Both companies earned a profit of
Rs.10 lakh in the previous year. Tax rate is 50% on profit. Face value of each equity share is Rs.10.
The following example will show how trading on equity increased the return on equity shares:
Particulars ABC Ltd. (?)
(Company with no
financial leverage)
XYZ Ltd. (?) (Company
with financial leverage)
Capital:
Equity Share Capital 50,00,000 35,00,000
10% Debentures — 15,00,000
50,00,000 50,00,000
Profit (Earning) before Interest and Tax (PBIT/EBIT) 10,00,000 10,00,000
Less: Interest on Debentures (10% of ? 15,00,000) — 1,50,000
Profit (Earning) before Tax (PBT/EBT) 10,00,000 8,50,000
Less: Tax @ 50% 5,00,000 4,25,000
Earning after Tax (EAT) 5,00,000 4,25,000
Calculation for Earning Per Share (EPS)
Particulars ABC Ltd. (Rs.)
(Company with no financial
leverage)
XYZ Ltd. (Rs.)
(Company with financial leverage)
Equity Share Capital Rs. 50,00,000 Rs. 35,00,000
No. of Equity shares @ Rs.
10 each
5,00,000 3,50,000
Earnings after Tax (EAT) Rs. 5,00,000 Rs. 4,25,000
Earnings per share (EPS =
Earnings after Tax
(EAT)/No. of Equity Shares
Rs. 1 Rs. 1.21
Thus, it can be concluded that a company that uses fixed financial charges earns a relatively higher rate
of return on equity capital and it will be at an advantage as compared to a company that uses only
equity capital.
42. How are the shareholders likely to gain with a loan component in the capital employed? Explain with
suitable example. (5) (2011 0D)
Ans. When the rate of earning (or Return on Investment or ROI) of a company is higher than the rate of
interest on borrowed funds, equity shareholders can get a higher rate of dividend. By issuing
preference shares and debentures, the rate of dividend to equity shareholders can be increased by a
company. Moreover, interest on debentures is exempted from income tax and is allowed as deductible
expense. Hence, this also leads to saving in income tax and equity shareholders can increase their
share of dividend to the extent of interest on debentures.
Example: Suppose total capital requirement of a company is Rs50,00,000 and it is expected to earn a
profit of 16%. In this case, earnings before tax would be Rs.8,00,000. Assuming tax rate of 30%, the
earnings available to equity shareholders will be Rs.5,60,000. If whole of the capital was subscribed
by equity shareholders the earning per share of equity shareholders will be 11.2%.
But if the capital structure has the following composition
2nd Alternative: Capital Structure Rs.
(1) Equity Share Capital 20,00,000
(2) 8% Debentures 20,00,000
(3) 10% Preference Share Capital 10,00,000
Earnings before interest and tax 8,00,000
Less: Interest on 8% debentures 1,60,000
Less: Tax @ 30% on earnings (after interest) of Rs.6,40,000 1,92,000
Earnings after interest and tax 4,48,000
Less: Dividend on 10% preference shares 1,00,000
Earnings after interest, tax and preference dividend 3,48,000
Percentage Return to Equity Shareholders: Earning after Interest, Tax and Dividend Total
equity Capital
3,48,000 xlQ0
20,00,000
=17.4%
The rate of dividend to equity shareholders has increased by 6.2% (i.e., 17.4% - 11.2%).
43. How can we judge the impact of financial leverage on the profitability of a business? Explain with an
example.
Ans. We can judge the impact of financial leverage on the basis of: (i) Earnings Before Interest and Tax
(EBIT), and (ii) Earning Per Share (EPS), commonly known as EBIT-EPS analysis. This will be very
clear from the following example:
Capital Structure Situation I Situation II Situation III
Equity Share Capital Rs. 60 lakh Rs. 40 lakh Rs. 20 lakh
10% Debt Nil Rs. 20 lakh Rs. 40 lakh
Note: Rate of Tax 30%, and EBIT is Rs. 8 lakhs.
EPS Analysis of XYZ Ltd.
Particulars Situation I Situation II Situation III
(0 EBIT Rs. 8,00,000 Rs. 8,00,000 Rs. 8,00,000
(ii) Interest NIL Rs. 2,00,000* Rs. 4,00,000**
(in’) EBT (Earnings before Tax) (i - ii) Rs. 8,00,000 Rs. 6,00,000 Rs. 4,00,000
(iv) Tax @ 30% Rs. 2,40,000 Rs. 1,80,000 Rs. 1,20,000
(v) EAT (Earnings after Tax) (in - iv) Rs. 5,60,000 Rs. 4,20,000 Rs. 2,80,000
(vi) No. of Shares of Rs.10 each (Total Funds “ Debt)
Rs.10
6,00,000 4,00,000 2,00,000
(vii) EPS (v 4- vi) Rs. 0.93 Rs. 1.05 Rs. 1.40
It is clear from the above EBIT and EPS analysis:
o The company earns Rs.0.93 per share if it is unlevered (Situation I).
o With debt of Rs.20 lakh (Situation II) its EPS is Rs.1.05.
o With a still higher debt of Rs.40 lakh, its EPS rises to Rs.1.40.
The EPS is rising with higher debt: It is because the cost of debt is lower than the return that company
is earning on funds employed.
The company is earning a return on investment (ROI) of 13.33%, i.e.,
EBIT (Rs. 8,00,000) x
Total Investment (Rs. 60,00,000)
ROI is higher than the 10% interest paying on debt by company. With higher use of debt, this
difference between ROI and cost of debt increases the EPS. This is a situation of favourable financial
leverage. In such situation, companies often employ more of cheaper debt to enhance the EPS. Such
practice is called Trading on equity.
44. When is financial leverage considered unfavourable? Explain with an example. (5)
Ans. When the rate of return on investment (ROI) is less than the cost of debt, use of debt reduces the EPS.
This is a situation of unfavourable financial leverage. Trading on equity should be avoided in such a
situation.
Example:
Total fund employed: Rs. 60 lakh by XYZ Ltd. as follows:
Particulars Equity 10% Debentures
Situation I Rs. 60 lakh NIL
Situation II Rs. 40 lakh Rs. 20 lakh
Situation III Rs. 20 lakh Rs. 40 lakh
Note: Rate of Tax: 30% and EBIT is Rs. 4,00,000.
* Rs. 20,00,000 x 10/100 = Rs. 2,00,000;
**Rs. 40,00,000 x 10/100 = Rs. 4,00,000.
In the above example, the EPS of the company is falling with increased use of debt. It is because the
company's rate of return on investment (ROI) is less than the cost of debt.
ROI = Rs. 4 lakh
---------------- x 6.67%
Rs. 60 lakh
ROI (6.67%) < Cost of Debt (10%).
Particulars Situation I Situation II Situation III
(0 EBIT Rs. 4,00,000 Rs. 4,00,000 Rs. 4,00,000
(if) Interest NIL Rs. 2,00,000* Rs. 4,00,000**
(Hi) EBT (Earnings before Tax) Rs. 4,00,000 Rs. 2,00,000 NIL
(iv) Tax (30% of EBT) Rs. 1,20,000 Rs. 60,000 NIL
(v) EAT (Earnings after Tax) Rs. 2,80,000 Rs. 1,40,000 NIL
(vi) No. of Equity Shares of Rs.10 each 6,00,000 4,00,000 2,00,000
(vii) EPS Rs. 0.47 Rs. 0.35 NIL
45. Explain any four factors which affect the choice of capital structure of a company. (6) (2017, 2010,
2008)
Or
What is meant by 'capital structure'? State any two factors, which affect the capital structure of a
company. (3) (2012 OD, Foreign)
Or
"Determining the relative proportion of various types of funds depends upon various factors." Explain
any five such factors.
Or
Explain the following factors which affect the choice of capital structure of a company:
(i) Cash Flow Position, and (ii) Tax Rate.
Or
Explain how the (i) Cost of Debt, and (ii) Cost of Equity affect the choice of capital structure?
Or
Explain how the (/) Risk consideration, and {//) Tax rate affect the choice of capital structure?
Or
Explain the impact of 'Stock Market Conditions' and 'Regulatory Framework' on the capital structure of
a company, (Al 2012 c)
The capital structure of a company refers to the composition or make-up of its long-term funds. The
following factors affect the capital structure of a company:
1. Position of Cash Flow: The decision relating to composition of capital structure depends upon the
ability of the business to generate enough cash flow. The expected cash inflows must be adequate to
pay interest and repay the loan, apart from meeting other requirements of the business. A company can
employ more of debt securities in its capital structure if it is sure of generating enough cash inflows.
2. Return on Investment (ROI): ROI refers to the earnings expected from the investment. If ROI of a
company is higher than interest rate on debt, it can opt for trading on equity to increase the earning per
share.
3. Interest Coverage Ratio (ICR): The purpose of calculating this ratio is to determine the composition of
debt funds in the capital structure of a company. It is a ratio between earnings before interest and taxes
(EBIT) and interest obligations.
ICR = EBIT
--------
Interest
Higher ICR means that the company can have more of borrowed funds or debt securities whereas lower
ICR means less of debt securities. The limitation of this ratio is that it does not take into account the
availability of funds or cash with the firm and repayment of loan.
4. Debt Service Coverage Ratio (DSCR): This ratio takes care of the limitation of ICR. It is calculated as
follows:
Net Profit after Tax + Depreciation + Interest on borrowings
Repayment of borrowings + Interest on borrowings
A DSCR of 2:1 is considered satisfactory.
A high debt service coverage ratio indicates better ability to meet debt service commitments and
thereby increases the potential of the company to increase debt component.
5. Cost of Debt Funds: If debt funds are available in the market at lower rate of interest, the firm can opt
for debt financing. However, caution should be exercised while using more of debt capital as it
increases the fixed obligations of the company and thus increases the risk for equity shareholders.
6. Tax Rate: A higher tax rate makes the debt cheaper because interest on debt is a deductible expense
from the profit to arrive at earning after tax. For example, cost of debt is 10% and tax rate is 30%, then
after tax, the cost of debt will be 10% - (30% x 10%) = 7%.
7. Cost of Equity: It is the return expected by equity shareholders on their investment commensurate to
the risk assumed by them. The risk for the equity shareholders increases when firm makes excessive
use of debt funds. Thus, a firm should use a proper mix of debt and equity.
8. Floatation Costs: Floatation costs are costs associated with issuing a new security like underwriting
commission, brokerage, printing cost of prospectus, etc. Floatation cost is generally less for debt.
9. Risk Consideration: A company has to decide upon the right proportion of debt and equity after taking
into account its ability to meet its interest, obligations and the amount of risk involved. If a firm's
business risk is lower, its capacity to use debt is high and vice versa.
10. Flexibility: Capital structure should be flexible in nature. It should not only meet the present capital
needs but must have a provision for future as well.
11. Retaining Control: If a company wants to protect itself from the dilution of control or takeover, it will
be prompted to issue less of equity shares and more of preference shares and debentures.
12. Regulatory Framework: Every company operates within a regulatory framework provided by law. For
example, the Securities and Exchange Board of India (SEBI) has issued certain guidelines for the issue
of shares and debenture. The relative ease with which legal norms can be fulfilled also significantly
influence the choice of source of finance.
13. Conditions of Capital Market (Stock Market): The conditions prevailing in the capital market influence
the determination of the securities to be issued. For instance, during boom period, investors are ready
to take risk and invest is equity shares. But during depression, markets are bearish and investors do not
want to take risk and so prefer debt with fixed returns. Therefore, the company may find raising of
equity capital more difficult and have to resort to debt.
14. Capital Structure of Other Companies: Debt-equity ratio of other companies in the industry can also act
as guiding force before deciding an appropriate capital structure.
46. What is meant by Floatation Cost? (1) (2009 C)
Ans. Floatation cost is the cost incurred for garnering funds from the public by issuing shares and
debentures.
47. What is meant by Cost of Equity? (1) (2009 C)
Ans. The return expected by equity shareholders on their investments commensurate with the risk assumed
by them is known as cost of equity.
48. How does 'cost of equity' affect the choice of capital structure? (1) (2015 OD)
Ans. A high cost of equity implies excessive use of debt by the company while a low cost of equity allows a
company to use more debts in its capital structure.
49. Why does cost of equity increase when a firm makes use of excessive debts? (1)
Ans. Higher cost of equity arises when equity shareholders demand higher returns to compensate them for
higher financial risk assumed by them, i.e., when firm makes excessive uses of debt.
50. What is meant by Cost of Debt? (1) (2009 C)
Ans. Cost of debt refers to the rate of interest at which debt funds can be acquired.
51. Explain how 'cost of debt' affects the choice of capital structure of a company. (1) (2015)
Ans. There is an inverse relationship between cost of debt and their usage in capital structure of a company.
Debt raised at higher rate limits its usage in capital structure of a company while more debts can be
used when it can be obtained at lower interest rate.
52. What does a high debt service coverage ratio indicate? (1) (Sample Paper, 2018)
Ans. A high debt service coverage ratio indicates better ability to meet debt service commitment and thereby
increases the potential of the company to increase debt in its capital structure.
53. What does a firm's lower business risk indicate? (1) (2009 C)
Ans. A lower business risk indicates the higher capacity to use debt.
54. What does a firm's higher business risk indicate? (1) (2009 C)
Ans. A higher business risk indicates the lower capacity to use debt.
Fixed Capital and Working Capital-Concept and Influencing Factors
55. What do you mean by working capital? (1)
Ans. Working capital is that part of total capital of a business which is invested in current assets. It is
required to meet day-to-day expenses to finance production and inventory.
56. What is 'gross working capital' or 'total working capital'? (1)
Ans. Gross or total working capital refers to the investment in all the current assets. It includes cash,
inventories, bills receivables and prepaid expenses.
57. What is 'net working capital'? (1)
Ans. Net working capital is the difference between current assets and current liabilities.
58. State why the working capital needs for the 'service industry' are different from that of the
'manufacturing industry'. (1) (2008)
Ans. The working capital needs of the service industry are generally less than that of the manufacturing
industry because in service industry no inventories of raw materials, work-in-process and finished
products are required to be maintained.
59. Discuss about working capital affecting both the liquidity as well as profitability of a business. (1)
Ans. Working capital is that part of total capital of a business which is invested in current assets. It is
required to meet day-to-day expenses to finance production and inventory. These assets are expected
to be converted into cash within a period of one year. Hence, it provides liquidity to the business.
However, such assets are equivalent to holding cash and attract very nominal earnings. Thus, it can be
said that though working capital provides liquidity to a business, contributes very little to the profits.
60. Define current assets and give four examples. (1)
Ans. Current assets are those assets of the business which can be converted into cash within a period of one
year. Cash in hand or at bank, bills receivables, debtors, finished goods inventory are some examples of
current assets.
61. What do you mean by current liabilities? (1)
Ans. Current liabilities are those obligations which are to be paid within one year, e.g., creditors, bills
payable, outstanding expenses, etc.
62. When is an asset more liquid? (1)
Ans. An asset is more liquid when it can be converted into cash quickly and without any reduction in its
value.
63. Explain any four factors which affect the working capital requirements of a company. (6) (2018, 2017,
2013 OD, 2010 C, 2009, 2008)
Or
Explain the following as factors affecting the requirements of working capital:
1. Business cycle; 2. Availability of raw material;
3. Nature of business; 4. Scale of operations;
5. Seasonal factors; and 6. Production cycle. (6) (Delhi and OD, 2014)
Ans. Working or circulating capital is that part of total capital which is required to meet day-to-day
expenses, to buy raw materials, to pay wages and other expenses of routine nature in the production
process. It represents floating assets such as stocks, debtors, cash, tools, receivables, short-term
investments, etc.
The factors determining the working capital needs of an enterprise are stated below:
1. Nature of Business: A trading organisation usually requires lower amount of working capital as
compared to a manufacturing organisation because it does not engage in manufacturing activities and
its sales are quickly converted into cash.
Similarly, the working capital requirements of service industries are also usually low as they do not
have to maintain inventories.
2. Scale of Operation: The higher the scale of operations, the higher will be the quantum of inventories
and debtors. Thus, organisations operating at higher scale of operations would require large amount of
working capital as compared to organisations operating at lower scale of operations.
3. Business Cycle: Business cycle refers to alternate expansion and contraction in general business
activity. During boom, sale and production tend to be high and, therefore, higher amount of working
capital is required. On the other hand, less working capital is needed during depression because
production and sales are slow.
4. Seasonal Factor: Most of the industries are influenced by seasonal variations. During the peak season,
the level of operations is higher and hence higher is the need of working capital and vice versa.
5. Production Cycle: Production cycle is the time span between the receipt of raw material and their
conversion into finished goods. Business units having longer production cycle will require more
working capital as their funds get locked up in the production process for a longer period of time.
6. Credit Allowed: Credit policy of a firm depends upon market tradition, level of competition and
creditworthiness of the clientele. A liberal credit policy results in higher amount of debtors and hence
increasing the requirement of the working capital.
7. Credit Availed: The working capital needs will be low if raw materials and supplies are available on
credit to a firm.
8. Availability of Raw Materials: If raw material and other supplies can be obtained from the market
quickly and without any disruption, then the firms can even maintain lower stock levels. However,
non-availability or seasonal availability and higher lead time (the time between placing an order and
receipt of material) may force a firm to maintain high stock levels, thereby pushing up its working
capital requirements.
9. Operating Efficiency: The operating efficiency refers to optimum utilisation of resources at minimum
costs. Efficiency of operation accelerates the pace of cash cycle and improves the use of working
capital. This can be reflected in:
(a) Inventory Turnover Ratio: It indicates the velocity with which stock is converted into sales. A firm
having higher stock turnover will require lower amount of working capital as compared to a firm
having a low rate of turnover.
(b) Debtor Turnover Ratio: A high debtor turnover ratio indicates faster realisation of cash from
receivables. Hence, reduces the working capital requirement.
(c) Better Sales Efforts: It also reduces the average time for which finished goods inventory is held by a
firm and thereby reducing the working capital requirement.
10. Growth Prospects: If the growth potential of a firm is perceived to be higher, it will require amount of
working capital so that it can meet higher production and sales target.
11. Eevel of Competition: The greater the level of competition, more will be the working capital
requirements as a firm would like to capture a significant share of market. To achieve it may offer
liberal terms of credit, and supply higher stock of finished goods to meet the orders of the customers.
12. Inflation: Changes in the price level also affect the working capital requirements. In case of rising
prices a firm requires more working capital to maintain the same level of operations. However, the
effect of inflation will be different for different concerns.
65. Distinguish between fixed capital and working capital. (3)
Ans. The basic points of difference are:
Fixed Capital Working Capital
1. Fixed capital is invested in fixed
assets such as building,
machinery, etc.
It is invested in floating assets, i.e.,
stock, debtors, etc. 2. Fixed assets have a long life and
are not meant for resale.
Floating assets are for short-term
and these can be converted into
cash quickly.
3. Basic objective is to provide
infrastructure or production
capacity for the manufacture of
finished goods.
Its aim is to meet day-to-day
expenses of production process. 65. Explain any four factors which affect the requirements of fixed capital of a company. (6) (2017, 2010
C, 2009, 2008)
Or
Explain the following as factors affecting the requirements of fixed capital:
1. Scale of operations; 2. Choice of technique;
3. Technology upgradation; and 4. Financing alternatives. (6) (2014, 2014 OD)
Or
Explain the following as factors affecting the requirements of fixed capital:
1. Nature of business; 2. Growth prospects;
3. Diversification; and 4. Level of collaboration. (6) (2014)
Or
How do 'Choice of Technique' and 'Nature of Business' affect the 'Fixed Capital' requirements of a
company? Explain. (2012 Foreign)
Ans. Fixed capital is the money invested in fixed or long-term assets such as building, machinery, etc. Such
investment decisions are generally irreversible in nature and involve heavy capital outlay.
Following are the factors that affect fixed capital requirements of an enterprise:
1. Nature of Business: The fixed capital requirement of an enterprise is influenced by the nature of the
business, i.e., whether it is a manufacturing or trading or service organisation. Manufacturing
enterprises require a larger amount of fixed capital as compared to trading or service concerns.
2. Scale of Operation: A company operating at a higher scale of operation will require huge investment in
building the infrastructure as compared to an organisation operating at smaller scale of operation.
3. Choice of Technique: An organisation can either adopt capital-intensive or labour-intensive technique.
Capital-intensive technique of production implies that production takes place through machines with
no or less human intervention. Therefore, such organisations require higher investments in plant and
machinery.
4. Technology Upgradation: Due to rapid technological changes, it becomes essential for some industries
to continuously upgrade themselves. This requires heavy outlay of funds in new technologies and
innovations. Hence, such industries require an increased amount of fixed capital.
5. Groivth Prospects: A company with higher growth prospects requires funds for growth and expansion
of business, hence greater is the need for fixed capital.
6. Diversification: A company which intends to or diversifies into new product lines requires higher
amount of fixed capital for research and development and building infrastructure and capacities.
7. Financial Altematives/Mode of Acquiring Fixed Assets: In a developed financial market, fixed assets
can be acquired either on cash-down basis or on lease basis. When an asset is taken on lease, the firm
only pays the lease rentals. This lowers the requirement for fixed capital.
8. Level of Collaboration: The level of collaboration influences the fixed capital requirements of a
business. In case of a joint venture, every collaborating partner contributes its share of capital, thereby,
lowering the requirement of fixed capital.
HOTS AND APPLICATION-BASED QUESTIONS
1. In the paint industry, various raw materials are mixed in different proportions with petroleum for
manufacturing different kinds of paints. One specific raw material is not readily and regularly
available to the paint manufacturing companies. Bonier Paints Company is also facing this problem
and because of this there is a time lag between placing the order and the actual receipt of the material.
But, once it receives the raw materials, it takes less time in converting it into finished goods.
Identify the factor affecting the working capital requirements of this industry. (1) (2018)
Ans. The factor affecting working capital requirement is availability of raw material/production cycle/
nature of business, (give any one)
2. The size of assets, the profitability and competitiveness are affected by one of the financial decisions.
Name and state the decision. (1) (2016)
Ans. Investment Decision or Capital Budgeting Decision: It pertains to allocation of the firm's funds in
different assets so as to maximise the returns of the investors.
3. Name and state the aspect of financial management that enables to foresee the fund requirements both
in terms of 'the quantum' and 'the timings'. (1) (2016 OD)
Ans. Financial Planning: It refers to the process and functions of determining the capital requirements of a
business and deciding the various sources from which it can be procured.
4. Rizul Bhattacharya after leaving his job wanted to start a Private Limited Company with his son. His
son was keen that the company may start manufacturing of mobile phones with some unique features.
Rizul Bhattacharya felt that the mobile phones are prone to quick obsolescence and a heavy fixed
capital investment would be required regularly in this business. Therefore, he convinced his son to
start a furniture business.
Identify the factor affecting fixed capital requirements, which made Rizul Bhattacharya to choose
furniture business over mobile phones. (1) (2016 OD)
Ans. Technology Upgradation
5. Radhika and Vani who are young fashion designers left their job with a famous fashion designer chain
to set up a company 'Fashionate Pvt. Ltd.' They decided to run a boutique during the day and coaching
classes for entrance examination of National Institute of Fashion Designing in the evening. For the
coaching centre they hired the first floor of a nearby building. Their major expense was money spent
on photocopying of notes for their students. They thought of buying a photocopier knowing fully that
their scale of operations was not sufficient to make full use of the photocopier.
In the basement of the building of 'Fashionate Pvt. Ltd.' Praveen and Ramesh were carrying on a
printing and stationery business in the name of 'Neo Prints Pvt. Ltd.' Radhika approached Praveen with
the proposal to buy a photocopier jointly which could be used by both of them without making
separate investment, Praveen agreed to this.
Identify the factor affecting fixed capital requirements of 'Fashionate Pvt. Ltd.' (1) (2016)
Ans. The factor influencing the fixed capital requirement of 'Fashionate Pvt. Ltd.' is the Level of
Collaboration. In the given case it will be low.
6. Aarohan Ltd. an automobile manufacturer was diversifying into manufacturing two-wheelers. They
knew that India is on a growth path and a new breed of consumer is eager for a first vehicle. The
market responded very well to the new product. The company did not have to allow credit, as it had
advance orders from four to six months with deposits paid. Also, due to efficiency in managing their
operations as soon as a vehicle was off the assembly line, it was out to the dealers. Give any one
reason discussed above which helped the firm in managing its working capital efficiently. (1)
(Sample Paper, 2018)
Ans. Credit Allowed/Operating Efficiency (give any one)
7. 'Indian Logistics' has its own warehousing arrangements at key locations across the country. Its
warehousing services help business firms to reduce their overheads, increase efficiency and cut down
distribution time. (1) (2015)
State with reason whether the working capital requirements of 'Indian Logistics' will be high or low.
Ans. The working capital requirements of 'Indian Logistics' will be low as they do not have to maintain
inventory.
8. 'Bharat Express' specialises in Courier Service. Its 'wide range of express package and parcel services'
helps business firms to make sure that the goods are made available to the customers at the right place
and at the right time. (1) (2015 OD)
State with reason whether the working capital requirements of 'Bharat Express' will be high or low.
Ans. The working capital requirements of 'Bharat Express' will be low as they do not have to maintain
inventory.
9. Reliable Transport Services Ltd. specialises in transporting fruits and vegetables. It has a good
reputation in the market as it delivers the fruits and vegetables at the right time and at the right place.
State with reason whether the working capital requirements of Reliable Transport Services will be high
or low. (1) (Foreign 2015)
Ans. The working capital requirements of 'Reliable Transport Services Ltd.' will be low as they do not have
to maintain inventory.
10. Amit is running an 'Advertising agency' and earning a lot by providing this service to big industries.
State whether the working capital requirement of the firm will be 'less' or 'more'. Give reason in
support of your answer. (1) (Sample Paper 2015)
Ans. The working capital requirement of the advertising agency will be less as no or very less amounts of
inventories are required to be maintained.
11. A company wants to establish a new unit in which machinery worth Rs.10 lakh is involved. Identify the
type of decision involved in financial management. (2008)
Or
A company wants to upgrade its existing plant by investing Rs.20 crore. Identify the type of decision
involved in financial management. (1)
Ans. The given situation pertains to investment in fixed assets of the business hence it is 'Capital Budgeting
Decision' or 'Investment Decision'.
12. Name the concept which increases the return on equity shares with a change in the capital structure of a
company. (1) (Delhi 2008)
Ans. 'Trading on Equity' or Financial Leverage
13. Name the type of industry which requires maximum fixed capital. (1)
Ans. Manufacturing Industry
14. What is required to tackle the uncertainty in respect of availability and timings of funds? Name the
concept involved.
Or
To avoid the problem of shortage and surplus of funds what is required in financial management?
Name the concept. (!)
Ans. Financial Planning
15. Give an example of capital budgeting decision. (D
Ans. Making investment in a new machine to replace the existing obsolete machine.
16. With which form of capital structure 'Floatation Costs' are associated? (1)
Ans. Public issue of shares and debentures.
17. Which component of capital structure determines the overall financial risk in an organisation? (1)
(2009 C) Ans. Debt component of capital structure determines the overall financial risk in an
organisation.
18. What kind of decision is known as 'irreversible decision'? (1)
Ans. Fixed Capital or Investment or Capital Budgeting Decision is known as irreversible decision.
19. Somnath Ltd. is engaged in the business of export of garments. In the past, the performance of the
company had been up to the expectations. In line with the latest technology, the company decided to
upgrade its machinery. For this, the Finance Manager, Dalmia estimated the amount of funds required
and the timings. This will help the company in linking the investment and the financing decisions on a
continuous basis. Dalmia therefore, began with the preparation of a sales forecast for the next four
years. He also collected the relevant data about the profit estimates in the coming years. By doing this,
he wanted to be sure about the availability of funds from the internal sources of the business. For the
remaining funds he is trying to find out alternative sources from outside.
Identify the financial concept discussed in the above para. Also state the objectives to be achieved by
the use of financial concept, so identified. (3) (2017)
Ans. Financial Planning is the concept discussed in the above para. For objectives of financial planning refer
to Q. 28, Page 9.9.
20. Shyam wanted to start a business of selling handicraft by getting in touch with the craftsmen in the
rural areas of Bengal. He wants to make a low investment in fixed capital. Advise him in taking
suitable decisions regarding the Nature of Business, Scale of Operations and Financing Alternatives
(in a developed financial market) that he needs to take for the purpose. (3) (Sample Paper, 2018)
Ans. In order to keep fixed capital requirement low, Shyam should take these decisions:
1. Nature of Business: He should set up a trading concern instead of a manufacturing unit.
2. Scale of Operations: Shyam should keep scale of his business operations small. Large scale of
operation equires large investment.
3. Financing Alternatives: He should not invest in fixed assets rather he can take it on rent/lease. This will
lower his fixed capital requirement.
21. Yogesh, a businessman, is engaged in purchasing and selling of ice creams. Identify his working
capital requirements giving reason in support of your answer. Now he is willing to start his own ice
cream factory.
Explain any two factors that will affect his fixed capital requirements. (5) (Al 2012 C)
Ans. Working capital requirement of Yogesh would be low as it is a trading concern.
Two factors which will affect his fixed capital requirements: Refer to Q. 65 on Page 9.18.
22. State whether the working capital requirements of the business manufacturing the following items are
big or small. Justify your statement:
1. Coolers, 2. Bread, 3. Sugar, 4. Locomotives, 5. Furniture Manufactured against Orders, and 6.
Motorcars. (5)
Ans. 1. Coolers: It requires large amount of working capital as it is a seasonal product.
2. Bread: A small amount of working capital is needed as there is a quick cash turnover.
3. Sugar: A large amount of working capital is needed because the ratio of raw material cost to the total
cost is quite high.
4. Locomotives: A large amount of working capital is needed because the gestation period is long.
5. Furniture Manufactured against Orders: It requires small working capital as it is quickly converted into
cash sale.
6. Motorcars: A large amount of working capital is needed as the gestation period, i.e., time to convert
cars into cash sales, is long.
23. Shalini, after acquiring a degree in Hotel Management and Business Administation took over her
family food processing company of manufacturing pickles, jams and squashes. The business was
established by her great grandmother and was doing reasonably well. However the fixed operating
costs of the business were high and the cash flow position was weak. She wanted to undertake
modernisation of the existing business to introduce the latest manufacturing processes and diversify
into the market of chocolates and candies. She was very enthusiastic and approached a finance
consultant, who told her that approximately Rs.50 lakh would be required for undertaking the
modernisation and expansion programme. He also informed her that the stock market was going
through a bullish phase.
(a) Keeping the above considerations in mind, name the source of finance Shalini should not choose for
financing the modernisation and expansion of her food processing business. Give one reason in
support of your answer.
(b) Explain any two other factors, apart from those stated in the above situation, which Shalini should keep
in mind while taking this decision. (6) (Sample Paper 2016)
Ans. (a) Shalini should not choose debt for financing the modernisation and expansion of her food
processing business. The reason is: (Any one)
(i) The fixed operating cost of the business is high, as it will add up to the fixed financial obligations.
(ii) Cash flow position is weak. This company may find it difficult to honour fixed cash payment
obligations on debt.
(iii) Stock market is going through bullish phase. It means the company will be able to easily raise funds
through equity shares.
(b) Other factors, which Shalini should keep in mind are: (Any two)
(i) Flexibility: Capital structure should be flexible in nature. It should not only meet the present capital
needs but must have a provision for future as well.
(ii) Control Consideration: If a company wants to protect itself from the dilution of control, it will be
prompted to issue less of equity shares and more of debentures.
(iii) Tax Rate: A higher tax rate makes the debt funds attractive because interest on debt is a deductible
expense from the profit to arrive at earning after tax.
(iv) Floatation Cost: Debt fund is a relatively cheaper source of raising funds as low floatation costs are
involved.
(v) Return on Investment: If Return on Investment (ROI) of a company is higher than rate of interest on
debt, the company can opt for debt funds. In this way, it can take advantage of trading on equity.
(vi) Cost of Debt: Lower is the cost of debt higher is the ability of a company to employ debt funds.
(vii) Cost of Equity: It is the return expected by the equity shareholders on their investment commensurate
with the risk assumed by them. When a company uses more debt, the desired rate of return expected
by the equity shareholders also increases.
(viii) Debt Service Coverage Ratio: It indicates better ability of the company to meet its debt service
(repayment) commitments and thereby increase its potential to use debt funds in its capital structure.
(ix) Interest Coverage Ratio: Higher interest coverage ratio indicates that company can have more debt
funds in its capital structure and vice versa.
(x) Regulatory Frameivork: The relative ease with which legal norms can be fulfilled also significantly
influences the choice of source of finance.
(xi) Capital Structure of Other Companies: Debt-equity ratio of other companies in the industry can also act
as a guiding force.
24. Tata International Ltd. earned a net profit of Rs.50 crores. Ankit the Finance Manager of Tata
International Ltd. wants to decide how to appropriate these profits. Identify the decision that Ankit will
have to take and also discuss any five factors which help him in taking this decision. (6)
(Sample Paper 2015)
Ans. Dividend Decision involves deciding how much of net profit earned by the company will be distributed
as dividend or alternatively, how much of profit will be retained in the business to meet the future
requirements.
Dividend decisions depend on a number of factors which are as follows:
1. Earnings: Dividends are paid out of current and past earnings. Thus, earning is one of the major factors
affecting dividend policy of a company.
2. Stability of Dividends: There should not be much fluctuations in the rate of dividend. Stable rate of
dividend raises the value of shares in the market.
3. Preferences of Shareholders: While declaring dividend, the company management must bear in mind
the preferences of the shareholders-whether shareholders want dividend income or capital gain.
Preferences of the shareholders for dividend depend upon their economic status.
4. Growth Opportunities: Companies having good growth prospects prefer to retain more earnings to
finance their investment. Therefore, the amount of dividend paid by non-growth companies is
generally more than that of growth companies.
5. Cash Flow Position: A comfortable cash position is necessary to declare dividend by a company.
25. Manish is engaged in the business of garment manufacturing. Generally he used to sell his garments in
Delhi, identify the working capital requirements of Manish giving reasons in support of your answer.
Further, Manish wants to expand and diversify his garment business.
Explain any two factors that will affect his fixed capital requirements. (6) (2012 C)
Ans. The working capital requirement of Manish would be more as he is engaged in manufacturing industry.
The reasons are:
1. He is engaged in the process of converting raw material into finished product. His running expenses
will be more in the form of payment of wages to the workers, purchase of raw material, etc.
2. There is long time gap between purchase of raw material and converting finished product into sales.
3. Since he is selling his garments only in Delhi, which is affected by seasonality of weather, he will
require more working capital.
Factors which will affect Manish's fixed capital requirement are: (Any two)
1. Scale of Operation: The scale of operation at which Manish wants to operate will influence his fixed
capital requirements. A higher scale of operation will require huge investment in building the
infrastructure as compared to a smaller scale of operation.
2. Growth Prospects: If garment business has higher growth prospects then greater will be the need for
fixed capital.
3. Choice of Technique: To expand the business, if Manish opts for capital-intensive garment
manufacturing unit; his fixed capital requirement will be more.
4. Diversification: Manish intends to diversify his garment business. With diversification his fixed capital
requirement will increase.
26. Neeiabh is engaged in 'transport business' and transports fruits and vegetables to different states.
Stating the reason in support of your answer, identify the working capital requirements of Neeiabh.
Neeiabh also wants to expand and diversify his transport business.
Explain any two factors that will affect his fixed capital requirements. (5) (2012)
Amar is doing his transport business in Delhi. His buses are generally used for the tourists going to
Jaipur and Agra. Identify the working capital requirements of Amar giving reason in support of your
answer. Further Amar wants to expand and diversify his transport business.
Explain any two factors that will affect his fixed capital requirements. (At 2012 C)
Ans. The working capital requirement of Neelabh/Amar would be less as he is engaged in 'Service Industry'.
A service firm needs less working capital as it sells more on cash basis and doesn't have to maintain an
inventory.
Factors which will affect his fixed capital requirement are: (Any two)
1. Scale of Operation: The scale of operation at which he wants to operate will influence his fixed capital
requirements. A higher scale of operation will require huge investment in building the infrastructure as
compared to a smaller scale of operation.
2. Growth Prospects: If transport business has higher growth prospects then greater will be the need for
fixed capital.
3. Financial Alternatives: He can acquire trucks either on cash-down basis or on lease basis. If he intends
to take the trucks on lease, he is required to pay only lease rents. This can lower his requirement for
fixed capital.
4. Diversification: Since he intends to diversify his transport business, the requirement of fixed capital
will be high for building infrastructure and capacities and research and development.
27. "A business that doesn't grow dies", says Mr. Shah, the owner of Shah Marble Ltd. with glorious 36
months of its grand success having a capital base of Rs.80 crores. Within a short span of time, the
company could generate cash flow which not only covered fixed cash payment obligations but also
create sufficient buffer. The company is on the growth path and a new breed of consumers is eager to
buy the Italian marble sold by Shah Marble Ltd.
To meet the increasing demand, Mr. Shah decided to expand his business by acquiring a mine. This
required an investment of X 120 crore. To seek advice in this matter, he called his financial advisor
Mr. Seth who advised him about the judicious mix of equity (40%) and Debt (60%). Mr. Seth also
suggested him to take loan from a financial institution, as the cost of raising funds from financial
institutions is low. Though this will increase the financial risk but will also raise the return to equity
shareholders. He also apprised him that issue of debt will not dilute the control of equity shareholders.
At the same time, the interest on loan is a tax deductible expense for computation of tax liability.
After due deliberations with Mr. Seth, Mr. Shah decided to raise funds from a financial institution.
(a) Identify and explain the concept of Financial Management as advised by Mr. Seth in the above
situation.
(b) State the four factors affecting the concept as identified in part 'a' above which have been discussed
between Mr. Shah and Mr. Seth. (6) (Sample Paper, 2017)
Ans. (a) Capital Structure/Capital Composition/Capital Mix: It means the proportion in which debt and
equity funds are used for financing the operations of a business.
(b) The factors affecting capital structure are: (Any four)
(i) Position of Cash flow: The company can employ more of debt funds in its capital structure if it is sure
of generating enough cash flow.
(ii) Floatation cost: Floatation cost of debt funds is generally less.
(iii) Risk consideration: The company with lower business risk can use more of debt funds.
(iv) Tax rate: A higher tax rate makes the debt fund cheaper as it is deductible expenses from the profit.
(v) Control: The company can protect itself from dilution of control by using more of debt fund.
Or
EVALUATION AND VALUE-BASED QUESTIONS
1. The Return on Investment (ROI) of a company ranges between 10 - 12% for the past three years. To
finance its future fixed capital needs, it has the following options for borrowing debt:
Option 'A': Rate of interest 9%
Option 'B': Rate of interest 13%
Which source of debt, 'Option A' or 'Option B', is better? Give reason in support of your answer. Also
state the concept being used in taking the decision. (3) (2018)
Ans. (a) Option 'A' is better.
(b) The reason being Return on Investment is greater than Rate of Interest.
(c) The concept used here is 'Trading on Equity'. It refers to the use of fixed cost source of finance,
i. e., Preference shares + Debentures + Long-Term Loans, in the capital structure so as to increase the
return on equity shares.
2. North East Ltd. needs to raise funds of Rs. 75,00,000. Its expected earning before interest and tax
(EBIT) are Rs. 7,50,000. The company wishes to use more of debt content as compared to equity to
raise earning per share (EPS). The debt is available at an interest of 12%. As a finance manager, advise
whether the company should prefer more of debt or more of equity to have higher EPS. (3)
Give reason in support of your answer.
Ans. North East Ltd. should not use debt because the current return on investment (ROI) is less than the cost
of debt. The current ROI is only 10%
Rs. 7,50,000
------------------ x 100 against the interest rate of 12%. When
Rs.75,00,000
ROI < interest rate on debt, then EPS falls with rise in use of debt. So, the company should prefer use of
equity to have higher EPS.
3. A company XYZ Ltd. has Rs.
Equity Capital 10,00,000
Earnings before interest and taxes 50,000
The company is in need of Rs.5,00,000 for expansion of business. It has decided to go for debt funds
which are available in the market @ 7%. The prevailing tax rate is 30% of the earnings. Should the
company proceed with its plans? Give reasons. (4)
Ans. The XYZ Ltd. should not opt for debt funding due to:
1. The current return on investment is lower than the interest rate of debt funds. The prevailing
return on investments is only 5%
i.e. Rs. 50,000
---------------- x 100 while market rate of interest is 7%. It will
Rs. 10,00,000
adversely affect the financial leverage of the company.
2. It will reduce the earning per share of equity shareholders as shown below:
Particulars Before After
Earnings before interest and taxes (EBIT) Rs. 50,000 Rs. 50,000
Less: Interest on debt funds 0 Rs. 35,000
Earnings before tax (EBT) Rs. 50,000 Rs. 15,000
Less: Tax at 30% Rs. 15,000 Rs. 4,500
1. Earnings after tax (EAT) Rs. 35,000 Rs. 10,500
2. Share capital Rs. 10,00,000 Rs. 10,00,000
Earning per share (EPS) (1 -f- 2) .035 or 3.5% .0105 or 1.05%
3. It will also be reflected in market price of the shares and hence will not lead to maximisation of
shareholders' wealth.
4. The Directors of a manufacturing company are thinking of issuing Rs.20 lakh additional debentures for
expansion of their production capacity. This will lead to an increase in debt-equity ratio from 2:1 to
3:1.
(a) What is the risk involved in it?
(b) What factors do you think the Directors should keep in view before taking the decision?
Ans. (a) Financial risk is involved in it.
(b) Factors which the Directors should consider before taking the decision are:
(i) The issuance of additional debentures will bring with it an additional fixed liability in the form of
interest and return of principal amount on maturity. Any default in meeting these commitments may
force the business to go into liquidation.
(ii) Since the company requires funds for expansion of its production capacity, it is a long-term investment
decision. Therefore, the firm has to decide how to meet its fixed charges.
(iii) If funds are obtained from financial institutions, the terms and conditions of debt funds may affect the
company's decision in dealing with financial matters like distribution of cash dividend, investing in
new projects, etc.
(iv) The Directors Should consider the floatation cost involved with issuance of additional debenture. The
floatation costs include the cost of advertisement, cost of underwriting, statutory fees, etc.
5. The Directors of Gama Ltd. have decided to modernise the plant and machinery at an estimated cost of
Rs. 1 crore, but are in a fix whether to issue equity shares or debentures for this purpose. As a Finance
Manager of the company, advise the Directors whether to issue equity shares or debentures in the
interest of the company and why? (5)
Ans. Being the Finance Manager of the company, I will suggest the Directors to issue equity shares to raise
Rs. 1 crore for modernisation of plant and machinery. Following are the merits of equity share capital
over the debenture capital:
1. Unlike debenture, by issuing equity share capital funds can be raised without creating any charge or
mortgage on fixed assets.
2. There is no fixed liability to pay dividend on equity share. The rule is 'No Profit, No Dividend'.
It is in the interest of the company when modernisation process has a long gestation period.
3. Besides, there is no obligation of refunding equity share capital during the lifetime of the company. It is
a permanent capital of the company.
4. It attracts venturesome investors who want participation in management.
'Viyo Ltd.' is a company manufacturing textiles. It has a share capital of Rs.60 lakh. The earning per
share in the previous year was Rs.0.50. For diversification, the company requires additional capital of
Rs. 40 lakh. The company raised funds by issuing 10% debentures for the same. During the current
year the company earned profit of Rs. 8 lakh on capital employed. It paid tax @ 40%.
(a) State whether the shareholders gained or lost, in respect of earning per share on diversification. Show
your calculations clearly.
(b) Also, state any three factors that favour the issue of debentures by the company as part of its capital
structure.
Ans. (a) Calculations showing earning per share on diversification: (6) (2016)
Equity Share Capital Rs. 60,00,000 10% Debentures Rs. 40,00,000 Total Investment Rs. 1,00,00,000 Profit before interest and tax (EBIT) Rs. 8,00,000 Less: 10% Interest on Debentures Rs. 4,00,000 Profit before tax Rs. 4,00,000 Less: Tax @ 40% Rs. 1,60,000 Profit after interest and tax or Profit available to shareholders (EAT) Rs. 2,40,000
Earnings After Tax (EAT)
Earning Per Share (EPS) = --------- -----------------------
No. of Equity Shares
Note: In the absence of information about the face value of share, we cannot compute
EPS. Although, students can make assumption about it, we are showing different
alternatives:
Alternative I: Using Return on Investment (ROI) method to determine
shareholders' gain/loss.
EBIT x 100 Rs.8,00,000x100 Total Investment Rs.1,00,00,000
Here, ROI < Interest on debts, hence equity shareholders are worse off in the
given scenario. Their EPS will decline.
= 8%
Alternative II: Face value of shares is assumed to be Rs.10, then EPS will be (Rs.
2,40,000/6,00,000).
This is a loss situation for equity shareholders.
Rs.0.40
Alternative III: If Rs.100 is assumed to be the face value of shares, the EPS will be
(Rs. 2,40,000/60,000). In this situation shareholders will gain.
Rs.
4
(b) Three factors that favour the issue of debentures by the company as part of its capital structure are:
(Any three)
1. A good cash flow makes it viable for the company to use debt funding.
2. If Return on Investment (ROI) of a company is higher than rate of interest on debt, it can opt for debt
funds. In this way, it can take advantage of trading on equity.
3. A high Interest Coverage Ratio indicates the company's ability to pay interest charges without failing.
The companies with high interest coverage ratio can use more of the debt funds.
4. A high debt service coverage ratio indicates better ability of the company to meet its debt service
(repayment) commitments and thereby increase its potential to use debt funds in its capital structure.
5. Lower is the cost of debt higher is the ability to employ debt funds.
6. Higher tax rate makes debt relatively cheaper source of fund, as interest on debt is a deductible
expense.
7. Debt fund is a relatively cheaper source of raising funds as low floatation costs are involved.
8. If company does not want dilution of control, debt funding is a better alternative.
9. If a company's business risk is lower, its capacity to use debt is high.
10. During bearish phase in the stock market, the company may find raising of equity capital difficult and
hence normally opt for debt funds.
7. Abhishek Ltd. is manufacturing cotton clothes. It has been consistently earning good profits for many
years. This year too, it has been able to generate enough profits. There is availability of enough cash in
the company and good prospects for growth in future. It is a well-managed company and believes in
quality, equal employment opportunities and good remuneration practices. It has many shareholders
who prefer to receive a regular income from their investments.
It has taken a loan of Rs.50 lakh from ICICI bank and is bound by certain restrictions on the payment
of dividend according to the terms of the loan agreement.
The above discussion about the company leads to various factors, which decide how much of the
profits should be retained and how much has to be distributed by the company.
Quoting the lines from the above discussion, identify and explain any four such factors. (6) (2015
OD)
Ans. The dividend decision of Abhishek Ltd. will be governed by the following factors:
1. Earnings: Dividends are paid out of current and past earnings. Thus, earning is one of the major factors
affecting dividend policy of a company. Since the company is having stable earnings, it can declare
higher dividends.
Quote: "It has been consistently earning good profits for many years. This year too, it has been able to
generate enough profits."
2. Cash Flow Position: Since dividend involves an outflow of cash, the availability of enough cash is
necessary to declare dividend. In the above case, Abhishek Ltd. will not find any difficulty in paying
dividend.
Quote: "There is availability of enough cash in the company and good prospects for growth in future. "
3. Shareholders' Preference: The company keeps in mind the preference of shareholders-whether they
want regular income or capital gain. In the given situation, many shareholders want regular income in
the form of dividend.
Quote: "It has many shareholders who prefer to receive a regular income from their investments."
4. Contractual Constraints: Sometimes, lenders may put restrictions on dividend payments to protect their
interests. Therefore, while declaring dividend, Abhishek Ltd. must ensure that the terms of loan
agreement are not violated.
Quote: "It has taken a loan of Rs.50 lakh from ICICI bank and is bound by certain restrictions on the
payment of dividend according to the terms of the loan agreement."
8. 'Sarah Ltd.' is a company manufacturing cotton yarn. It has been consistently earning good profits for
many years. It has been able to generate enough profits this year too. There is availability of enough
cash in the company and good prospects for growth in future. It is a well-managed organisation and
believes in quality, equal employment opportunities and good remuneration practices. It has many
shareholders who prefer to receive a regular income from their investments.
It has taken a loan of T 40 lakh from IDBI and is bound by certain restrictions on the payment of
dividend according to the terms of loan agreement.
The above discussion about the company leads to various factors which decide how much of the profits
should be retained and how much has to be distributed by the company.
Quoting the lines from the above discussion, identify and explain any four such factors. (6) (2015)
Ans. The dividend decision of Sarah Ltd. will be governed by the following factors:
1. Earnings: Dividends are paid out of current and past earnings. Thus, earning is one of the major factors
affecting dividend policy of a company. Since the company is having stable earnings, it can declare
higher dividends.
Quote: "It has been consistently earning good profits for many years. This year too, it has been able to
generate enough profits."
2. Cash Flow Position: Since dividend involves an outflow of cash, the availability of enough cash is
necessary to declare dividend. In the above case, Sarah Ltd. will not find any difficulty in paying
dividend.
Quote: "There is availability of enough cash in the company and good prospects for growth in future."
3. Shareholders' Preference: The company keeps in mind the preference of the shareholders- whether they
want regular income or capital gain. In the given situation, many shareholders want regular income in
the form of dividend.
Quote: "It has many shareholders who prefer to receive a regular income from their investments."
4. Contractual Constraints: Sometimes, lenders may put restrictions on dividend payments to protect their
interests. Therefore, while declaring dividend, Sarah Ltd. must ensure that the terms of loan agreement
are not violated.
Quote: "It has taken a loan of X 40 lakh from IDBI and is bound by certain restrictions on the payment
of dividend according to the terms of loan agreement."
REVIEW EXERCISE
1. State the objective of Financial Management.
Ans. Wealth maximisation is the primary objective of financial management, which means maximising the
market value of investment in the shares of the company.
2. Financial management is based on three broad financial decisions. What are these?
Ans. Three broad financial decisions are: (a) Investment decision, (b) Financing decision, and (c) Dividend
decision.
3. What are the twin objectives financial planning strives to achieve?
Ans. The objectives of financial planning are:
(a) To ensure availability of funds, whenever required, and
(b) To see that the firm does not raise resources unnecessarily.
4. Identify the decision taken in financial management which affects the liquidity as well as the
profitability of the business.
Ans. 'Short-term Investment Decision or Working Capital Decision' affects the liquidity as well as the
profitability of the business.
5. What does financial planning aim at?
Ans. The objective of financial planning is to ensure that enough funds are available at the right time.
6. What is the other name of a Long-term Investment Decision?
Ans. Capital Budgeting Decision is the other name of Long-term Investment Decision.
7. Despite volatile market conditions, a company is paying above average dividend this year. What could
be the possible reason?
Ans. The possible reason could be that the company is finding it difficult to identify fruitful investment
opportunities and hence the company's profits are lying idle.
8. State why the working capital needs for a 'service industry' are different from that of a 'manufacturing
industry'.
Ans. The working capital needs of service industry are generally less than that of manufacturing industry
because in service industry no inventories of raw materials, work-in-process and finished products are
required to be maintained.
9. What is 'capital structure'?
Ans. Capital structure refers to the mix between owner (equity) and borrowed (debt) funds.
10. State when a trading company should opt for trading on equity.
Ans. When return on investment (ROI) is higher than the rate of interest on borrowed funds. (ROI > Rate of
interest on borrowed funds)
11. Name the financial decision that affects the growth, profitability and risk of the business in the long
run.
Ans. Capital budgeting decision/Investment decision
12. What is 'production cycle'?
Ans. Production cycle is the time span between the receipt of raw materials and their conversion into
finished goods.
13. Name the financial decision which relates to how the firm's funds are invested in different assets.
Ans. Investment Decision.
14. What is the effect of higher growth opportunities on 'dividend decision'?
Ans. Higher growth prospects mean lesser dividend and more retained earnings for funding business
activities.
15. Which type of financial decision decides how much of corporate profits will be distributed and how
much will be retained in the business?
Ans. Dividend Decision
16. What is the alternative name for proportion of debt to equity?
Ans. Financial Leverage
17. State the most important criterion which influences investment decision.
Ans. Rate of return from the investment.
18. A project may be rejected despite high ROI. Why?
Ans. A very high risk may be involved in the project.
19. Name the decision which affects the amount and proportion of debt in the capital structure of a
company.
Ans. Financing Decision
20. What is meant by 'Gross Working Capital' and 'Net Working Capital'?
Ans. Gross Working Capital refers to aggregate value of current assets. Net Working Capital is calculated by
deducting current liabilities from current assets.
21. Explain the term 'Cost of Equity'.
Ans. The return expected by the equity shareholders on their investment is known as Cost of Equity. It
normally varies in direct proportion to Risk.
22. What effect does excessive use of debt have on cost of equity?
Ans. Excessive use of debt increases the cost of equity.
23. Cost of Debt is lower than the Cost of Equity Share Capital. Give reason why even then a company
cannot work only with the debt. (Delhi 2010)
Ans. A company cannot work only with debt because equity share capital is necessary to bring a company
into existence. It provides the capital base to the company.
24. What is 'financial risk'? (Al 2014)
Ans. Financial risk is the risk which arises due to inability of a firm to meet its fixed financial commitments,
for example, interest on debt funds.
25. What is 'Operating Risk' or 'Business Risk'?
Ans. Operating Risk or Business Risk is the risk associated with fixed operating costs, like rent on plant and
machinery. FFigher the fixed Operating Cost, higher will be the Operating Risk and vice versa.
26. Which source of funds dilutes management's control?
Ans. Raising of capital from equity sources dilutes management control.
27. Which source of finance is considered riskless? Give reason.
Ans. Equity as a source of finance is considered riskless because it has no obligation related to payment of
dividend or repayment of investment.
28. Explain the relationship between financial leverage, EPS, cost of capital and financial risk.
Ans. Higher financial leverage increases EPS, reduces cost of capital but increases financial risk.
