Roll No. :
Date :
Time MM - 160
How does ‘Inflation’ affect the working capital requirements of a company? State.
Ans :
3
With the rising prices, larger amount of funds is required to maintain a constant volume
of production and sales. The working capital requirement of a business is higher with
higher rate of inflation.
2. What is meant by ‘Financial Management’? State the primary objective of Financial 6
Management.
Or
Explain the concept and the objective of Financial Management.
Ans :
Financial management may be defined as planning, organising, directing and controlling
the financial activities of the organisation. It is concerned with management of flow of
funds and involves decisions relating to procurement of funds, investment of funds in
long-term and short-term and distribution of earnings to the owners.
The objectives of financial management are:
(a) To estimate the amount of capital to be required accurately.
(b) To determine the form and proportionate amount of securities to be issued.
(c) To raise funds at minimum cost and at the most advantageous terms.
(d) To maintain financial liquidity and flexibility.
(e) To ensure the efficient administration of capital.
3. What is capital budgeting?
Ans :
Capital budgeting is the technique of making long-term planning decisions for investment
and their finance. Decision on capital expenditure is difficult as future is uncertain. It
includes current cash outlay or a series of cash outlays in return for an anticipated flow of
future benefits. Capital budgeting is employed to evaluate long-term expenditure
decisions which involves current outlays and the benefits that occur in the future years.
4. State any three advantages of debenture issue as a source of finance.
Ans :
3
3
The advantages of issuing debentures as a source of finance are:
(a) The interest paid on debentures is lower than the dividend paid on preference or
equity capital. Therefore, the cost is, lower.
(b) The interest on debenture is a tax deductible expense.
(c) Since debentureholders are not entitled to vote, there is no risk of loss of control.
5. When is the dividend decision treated as a residual decision?
3
Ans :
A company’s net earnings are divided into two parts, i.e., retained earnings and
dividends. If the company has profitable investment opportunities, it would like to retain
the earnings and reinvest rather than distribute them as dividends.
To finance investment projects, the company has two alternatives either to raise external
equity or to internally finance from the retained earnings available. Retained earnings are
preferred as a source as they do not involve floatation costs and legal formalities. Thus,
the company will pay dividends only when it cannot profitably reinvest the earnings. In
this case, the dividend decision is treated as a residual or passive decision.
6. What are the various aspects of financial planning?
Ans :
3
The three aspects/elements of financial planning are:
(a) Estimating the amount of capital to be raised.
(b) Determining the form and proportionate amount of securities to be issued.
(c) Laying down policies for the administration of funds.
7. What is meant by ‘Capital Structure’? State any two factors which affect the capital structure of a 3
company.
Ans :
Capital structure means the proportion in which debt and equity funds are used for
financing the operations of a business.
The following factors decide a company’s capital structure:
(a) Cash flow position. A company must have enough cash in hand or liquidity if it has to
raise capital through debentures to pay interest in time. If cash inflows are not enough,
then it should issue shares.
(b) Cost of debt. A firm’s ability to borrow at a lower rate increases its capacity to employ
higher debt. Thus, more debt can be used if debt can be raised at a lower rate.
8. Which process prepares a blue print of an organisation’s future preparations relating to finance? 3
Give any two reasons why this process is needed?
Ans :
The process of ‘Financial Planning’ prepares a blue print of an organisation’s future
preparations relating to finance. This process is needed to:
(a) to ensure availability of funds whenever required.
(b) to see that the firm does not raise resources unnecessarily
9. “Sound Financial Management is the key to the prosperity of business.” Explain.
Ans :
Financial management plays an important role in overall financial position of the
organisation. Decisions taken during financial managements are the main cause behind
items appearing in financial statements, Profit and Loss Account and Balance Sheet. Its
role can be understood through the following points:
(a) It determines what amount will be invested in various types of fixed and current
assets. Composition of current assets is also affected by it.
(b) It determines the requirement of long-term and short-term finance for the
organisation. Various factors are taken into consideration before reaching the conclusion.
(c) It determines the composition of capital structure, i.e., the ratio of debt and equity
after considering all the factors.
(d) Use of debt and equity as a source of financing will involve the payments in terms of
interest and dividends respectively which are the items of Profit and Loss Account.
Thus, the overall financial health of a business is determined by the quality of its financial
management.
5
10. Give the meaning of ‘Investment’ and ‘Financing’ decisions of financial management.
Or
Give the meaning of ‘Investment’ and ‘Dividend’ decisions of financial management.
Ans :
6
Financial Management may be defined as planning, organising, directing and controlling
the financial activities of the organisation. It is concerned with management of flow of
funds and involves decisions relating to procurement of funds, investment of funds in
long-term and short-term and distribution of earnings to the owners.
There are three major decisions which an organisation has to take in respect of finance.
All these decisions are interrelated and interdependent. These are:
(a) Investment decision. The first and foremost decision which a business must take is to
allocate resources or capital to different investment proposals. The benefit of these
investments may not be realised immediately since the value of future benefits is not
known. These investments involve risks. Therefore, the risk factor also has to be
considered. Different investment proposals are evaluated on the basis of their expected
returns and risks involved. Investment in long-term assets is known as capital budgeting
decision and those relating to short-term assets are known as working capital decisions.
(b) Financing decision. The second decision which concerns a company is how to
finance the activities of the business. There are different sources of finance like shares,
debentures and loans. But a proper mix of all these types of securities is essential. The
combination of shares, loans and debentures constitute the capital structure of a
company. The best financing mix or capital structure has to be decided which involves
determining the proportion or ratio of shares and debentures in the capital structure.
(c) Dividend decision. The third decision to be taken is the disposal of profits. Profits are
required for a number of purposes. Some amount of profit has to be recycled in the
business for reinvestment and expansion of business activities. This part of the profit is
retained in the business and is called retained earnings. The rest of the profit then has to
be distributed to shareholders in the form of dividends. How much to retain for
reinvestment and expansion and how much to pay out as dividends to the shareholders,
are another crucial decisions to be taken by the company.
11. What is meant by ‘Long-term Investment Decision’? State any three factors which affect the long 6
term investment decisions.
Or
Investment decision can be long-term or short-term. Explain long-term investment decision and
state any two factors affecting this decision.
Ans :
Long term investment decisions are also called as Capital Budgeting Decisions. It
involves committing the finance on a long-term basis on fixed assets or various projects
of an organisation.
The factors affecting capital budgeting decisions are:
(a) Cash flows of the project. When a company takes an investment decision involving
huge amount, it expects to generate some cash flows over a period. These cash flows
are in the form of a series of cash receipts and payments over the life of an investment.
The amount of these cash flows should be carefully analysed before considering a
capital budgeting decision.
(b) The rate of return. The most important criterion is the rate of return of the project.
These calculations are based on the expected returns from each proposal and the
assessment of risk involved.
(c) The investment criteria involved. The decision to invest in a particular project involves
a number of calculations regarding the amount of investment proposals which are known
as capital budgeting techniques. These techniques are applied to each proposal before
selecting a particular project.
12. Explain the objectives of Financial Planning.
5
Ans :
Following are the objectives of financial planning:
(a) To estimate accurately the amount of funds to be required.
(b) To determine the form and proportionate amount of securities to be issued.
(c) To raise funds at minimum cost and at most advantageous terms and to avoid excess
funding or inadequate funding.
(d) To maintain financial liquidity and flexibility.
(e) To ensure the efficient administration of capital.
13. What do you mean by management of fixed capital? Why is it important?
Ans :
Management of fixed capital involves allocation of firm’s capital to different projects or
assets with long-term implications for the business. These decisions are called
investment decisions or capital budgeting decisions and affect the growth, profitability
and risk of the business in the long run.
The management of fixed capital is important for the following reasons:
(a) Long-term growth and effects. These decisions have bearing on the longterm growth.
The funds invested in long-term assets are likely to yield returns in the future. These
affect future possibilities and prospects of the business.
(b) Large amount of funds involved. These decisions result in a substantial portion of
capital funds being blocked in long-term projects. Therefore, these investment
programmes are planned after a detailed analysis is undertaken. This may involve
decisions like where to procure funds from and at what rate of interest.
(c) Risk involved. Fixed capital involves investment of huge amounts. It affects the
returns of the firm as whole in the long-term. Therefore, investment decisions involving
fixed capital influence the overall business risk complexion of the firm.
14. Explain the link between operating cycle and working capital.
Ans :
5
4
Operating cycle is the duration of time between acquisition of supplies and the collection
of cash from receivables. In a trading concern, operating cycle begins with procuring
goods to be sold in the market and ends with realising cash from creditors after the sale
of these goods. In a manufacturing concern, there are some more activities to be
performed, like procurement of raw materials, putting the raw materials into work in
progress and converting these ultimately into finished goods, sale of finished goods on
credit or cash and realising cash from creditors. In both the cases, there is a time gap
between the first stage of procuring goods or raw materials and the last stage of realising
cash. This time duration is called operating cycle and working capital is required to
finance operations during operating cycle for the business to run smoothly. Working
capital requirement is higher in firms with longer operating cycle and lower in firms with
shorter processing cycle.
15. The directors of Bajaj Ltd. have decided to modernise the plant and machinery at an estimated 5
cost of
1 crore, but could not decide whether to issue equity shares or debentures for this
purpose. As finance manager of the company, advise the directors whether to issue equity shares
or debentures in the interest of the company and why?
Ans :
The company should issue equity shares because:
(a) The share capital is not required to be repaid like debentures, it is like permanent
capital.
(b) Dividends are paid to equity shareholders only out of profits. No fixed obligation like
interest on debentures is there. Non-payment of interest and capital in case of
debentures may lead to insolvency.
(c) The company enjoys a better reputation as it has more equity capital.
(d) The company is able to obtain credit on the basis of its equity capital.
(e) Financial risk of the company is increased by debentures since they have to be
secured over the assets of the company which is not the case in respect of equity
shares.
16. What is meant by ‘Financing Decision’? State any four factors affecting the financing decision.
Ans :
5
Financing decision relate to the quantum of finance to be raised from various long-term
sources. This decision determines the overall cost of capital and financial risk of
enterprise. Factors affecting financing decisions are:
(a) Cost. The cost of raising the funds from different sources is compared and the one
which is cheapest is opted for.
(b) Cash flow position of the business. A strong cash flow position of the company makes
debt financing better than funding through equity because it can generate enough cash
inflows to pay interest on debt. On the contrary, it would be quite risky to use more debt if
cash inflows are unstable.
(c) Level of fixed operating cost. A business can have fixed operating cost like rent,
insurance premium, salaries etc. Issuing debt increases this fixed cost as it involves fixed
financing cost. Hence, if the fixed operating cost is less, more of the debt financing can
be preferred.
(d) Control consideration. Shares carry the voting right and thus may lead to dilution of
management’s control over the business. If the company is afraid of takeover bid, it
would prefer debt to equity.
(e) State of capital markets. When the market is bullish, the company can easily raise
funds through equity shares. But in case, the phase is bearish, raising funds through
debentures is easier.
17. What is meant by Dividend decision? State any four factors affecting the dividend decision.
5
Ans :
A dividend decision means whether to distribute profits as dividend to shareholders or
retain profits and reinvest into the business.
Factors affecting the dividend policy/decision of a company are:
(a) Growth opportunities/Financial requirements of the company. If a company has a
number of projects to invest in, then it should reinvest the earnings of the company. In
this case, the company would prefer to pay low dividends to shareholders and invest the
remaining profits in the business. But if the company has no investment/growth avenues
open, then it would be better to distribute earnings as dividends to shareholders.
(b) Stability of dividends. Most companies follow a stable dividend policy. This policy has
a favourable impact on the market value of shares and shareholders also prefer stable
dividends than fluctuating ones. Stable dividends have certain advantages as they
resolve uncertainty in the minds of investors and satisfies their desire for current income.
Even financial institutions like IFCI, IDBI, UTI also prefer investing in those companies,
which follow a policy of paying regular dividends.
(c) Access to Capital Market/Capital market consideration. When a company requires
funds for investments, it can either tap the capital market and raise additional equity or
retain its earnings by declaring low dividends. If the capital market is easily accessible to
the company, then it can afford to follow a liberal dividend policy. However, if a company
has limited access to capital markets then, it will pay low dividends to shareholders and
rely more on retained earnings to finance their long-term projects.
(d) Shareholders’ preference. Small and retired shareholders who invest their savings in
shares in the hope of getting a regular income are interested in a stable and regular
dividend. The management may follow a policy which serves the purpose of the majority
group. Wealthy investors usually invest in shares for earning capital gains. They are in
high income tax brackets and therefore, may not prefer current dividends, as their taxes
would increase.
18. How are shareholders likely to gain with a loan component in the capital employed? Explain with 5
a suitable example.
Or
How does ‘trading on equity’ increase the return on equity shares ? Illustrate with a suitable
example.
Ans :
With a loan component in the total capital, shareholders are likely to have the benefit of a
higher rate of return on share capital.
This is because loans carry a fixed charge and the amount of interest paid is deductible
from earnings before tax payment. The benefit to shareholders will be realised only if the
average rate of return on total capital invested is more than the rate of interest payable
on loan.
Let us see the given example:
A Ltd.
Share Capital
Loan (Rate of Interest at 15%)
Profit before interest and tax
Interest
10 lakhs
—
B Ltd.
4 lakhs
6 lakhs
10 lakhs
10 lakhs
3 lakhs
3 lakhs
Nil
0.9 lakhs
Profit before tax
3 lakhs
2.1 lakhs
Tax @ 50%
1.5 lakhs
1.05 lakhs
Profit after tax
1.5 lakhs
1.05 lakhs
Rate of return on share capital
× 100 = 15%
× 100 = 26.25%
19. Explain the meaning of Fixed Capital. Briefly explain any four factors that determine the fixed 5
capital of a company.
Or
Explain any four factors which affect the ‘Fixed Capital’ requirements of a company.
Or
How do ‘Choice of Technique’ and ‘Nature of Business’ affect the ‘Fixed Capital’ requirements of a
company? Explain.
Ans :
Fixed capital refers to investment in fixed assets which remains in the business for more
than one year, usually for much longer, e.g., plant and machinery, furniture and fixtures,
land and building, vehicles, etc.
Factors affecting fixed capital are:
(a) Nature of business. A manufacturing enterprise needs a huge investment in fixed
assets (plant and machinery) as compared to a trading firm.
(b) Scale of operations/size of business. Higher investment in fixed assets is required in
a large scale enterprise as compared to a small firm.
(c) Choice of technique. Higher investments in fixed assets is required for a company
which employs capital intensive technique of production as compared to firms which use
labour intensive techniques of production.
(d) Technology upgradation. Companies which use assets which are likely to become
obsolete in the near future require high investment in fixed assets.
(e) Growth prospects. If an organisation aims for higher growth and expansion of the
company in the near future, then huge investment in fixed assets is always required.
(f) Financing alternative. Requirement of investment in fixed assets can be reduced if
leasing facilities are available in the financial market.
(g) Diversification. If an organisation has future plans of diversification into different
projects other than the existing one, then it will require huge investment in fixed assets.
(h) Level of collaboration. Some business organisations share its experience and skills
with others and use their fixed assets for the same, e.g, Mother’s Pride, a some reputed
play school give their franchises to others and also employ their fixed assets. This
reduces the requirement of huge investment in fixed assets of the organisations and their
franchises.
(i) Method of sale. A manufacturing firm will require more fixed capital if it sells its
products directly to consumers through its own retail stores, e.g., Bata.
(j) Types of goods produced. A firm producing light goods like aggarbatties, ball pens,
etc. will require less amount of fixed capital than the firm producing heavy goods like air
conditioners, computers etc.
20. Explain any four factors which affect the working capital requirements of a business.
5
Ans :
The factors determining working capital requirements are:
(a) Business cycle. During boom period, when sales are high, higher amount of working
capital is required as compared to depression period.
(b) Operating efficiency. Less requirement of working capital will be there in a firm in the
presence of best sales effort, ideal debtors turnover ratio and higher inventory turnover
ratio.
(c) Availability of raw material. Higher lead time (i.e. time lag between the placement of
order and actual receipt of the materials) and interrupted availability of raw materials will
raise the requirement of working capital.
(d) Level of competition. Working capital requirements will be more if level of competition
is high and vice-versa.
(e) Nature of business. Manufacturing firm requires high amount of working capital as
compared to a trading organisation, to convert raw materials into finished goods.
(f) Scale of operations. Large amount of working capital is required by firms operating on
a large scale of operations in terms of debtors, inventory etc.
(g) Seasonal factors. Higher amount of working capital is required by the organisation
during its peak season and less during lean season.
(h) Production cycle/Length of operating cycle. Operating cycle refers to the length of the
manufacturing cycle, i.e., the periods taken to convert raw materials to finished products.
Longer period means more working capital is required and vice-versa.
(i) Credit allowed. If liberal credit terms are given and a liberal policy is followed, then the
company would require more working capital as there is less cash inflow and vice-versa.
(j) Growth prospects. If an organisation has planned for higher growth prospects then its
requirement for working capital will also be higher.
(k) Inflation. At a higher rate of inflation, working capital requirement will also be higher
and vice-versa.
(l) Inventory policies. If the business has a policy of keeping a large stock of inventory,
working capital requirement will be more and vice-versa.
(m) Sales level. Higher sales level means ready convertibility into cash and thus, there is
not much investment required in working capital as there is inflow of cash. Similarly, a
lower sales level requires more investment in working capital.
(n) Type of products manufactured. Certain products which require heavy initial
investment in plant and machinery do not require much working capital. Labour intensive
activities require large stocks of raw materials, inventories, etc. They require more
working capital.
(o) Credit availed. If it is difficult to avail credit by the firm on its purchases from suppliers
then, higher amount of working capital is required.
(any four)
21. A businessman who wants to start a manufacturing concern approaches you to suggest him
whether the following manufacturing concerns would require large or small working capital:
(a) Bread
(b) Sugar
(c) Coole
(d) Furniture manufacturing against specific orders, and
(e) Motor Car
Give your view point with reasons in each of the above cases.
5
Ans :
Requirements of working capital for the mentioned business would be:
(a) Bread. Requirement of working capital will be less because it has quick cash
turnover.
(b) Sugar. Working capital required for manufacturers will be more as ratio of raw
material cost to total cost is more.
(c) Coolers. Working capital required for manufacturers of cooler will be more because it
is a seasonal product.
(d) Furniture. Requirement of working capital for a manufacturer of furniture against
specific orders is less as it doesn’t require large stock.
(e) Motor Car. Requirement of working capital for a manufacturer of locomotives will be
less because gestation period is more.
22. State the three merits and demerits each of issuing equity shares for the company.
Ans :
6
Merits of issuing equity share capital:
(a) Equity share capital does not have to be repaid (except at the time of liquidation), so,
it is like permanent capital.
(b) Dividends have to be paid only out of profits. Hence, there is no fixed obligation.
(c) The company enjoys a better reputation as it has more equity capital and it is able to
obtain credit on the basis of its equity capital.
Demerits of issuing equity share capital:
(a) Equity shareholders expect a higher rate of return than others since the risk involved
is also high. Hence, the cost of capital to the company is highest.
(b) Dividends to be paid are not allowed to be deducted from the profits for calculating
taxes, i.e., they are not tax deductible.
(c) The floatation costs of equity capital is higher than other types of capital. Underwriting
and brokerage commissions are high for equity capital.
(d) Sale of equity shares to others will result in changing the existing control and
ownership. The remaining shareholders may not be able to control the company.
(any three)
23. The directors of Lavanya Ltd. have decided to expand the business activities by increasing the 6
stock of raw materials and finished goods at an estimated cost of 50 lakhs. As a finance manager
of the company, advise the directors about the methods open to the company to raise necessary
finance for this purpose.
Ans :
Finance could be raised through following methods:
(a) Issue of shares. A share is a unit of measure of a shareholder’s interest in the
company. The share of a company is a movable property transferrable in the manner
provided by the Companies Act. A shareholder is entitled to the dividend. Shares may be
either equity or preference. Share capital of a company is regarded as owned capital. It
is a permanent source of finance and is non-returnable. Shareholders are the owners of
the company and therefore, bear the risk of loss and profit.
(b) Issue of debentures. Debentures are creditorship securities which provide funds to
the company on loan basis. Debenture capital is a loan capital, usually repayable during
the lifetime of the company. A debentureholder is a creditor of the company. He gets
interest at a fixed rate irrespective of annual profit or loss. Debentures are liked by the
investors who give weightage to safety of principle and continuous fixed rate of income
on the principle.
(c) Loans from banks and financial institutions. Banks and financial institutions like IFCI,
ICICI, UTI, etc. also provide term loans to various business concerns.
(d) Retained earnings. Sometimes companies retain some profits to finance their
requirements. It is an internal source of finance. Normally, companies do not distribute its
entire earnings in the form of dividend. Such a practice helps the company to build up
reserves which can be used for financing long-term requirements.
24. Explain the following as factors affecting financing decision:
(a) Cost
(b) Cash flow position of business
(c) Level of fixed operating cost and
(d) Control considerations
Or
Explain the following as factors affecting ‘financing decision.’
(a) Cash flow position of the business;
(b) Level of fixed operating cost;
(c) Control consideration and
(d) State of capital markets.
Ans :
6
Financing decision relate to the quantum of finance to be raised from various long-term
sources. This decision determines the overall cost of capital and financial risk of
enterprise. Factors affecting financing decisions are:
(a) Cost. The cost of raising the funds from different sources is compared and the one
which is cheapest is opted for.
(b) Cash flow position of the business. A strong cash flow position of the company makes
debt financing better than funding through equity because it can generate enough cash
inflows to pay interest on debt. On the contrary, it would be quite risky to use more debt if
cash inflows are unstable.
(c) Level of fixed operating cost. A business can have fixed operating cost like rent,
insurance premium, salaries etc. Issuing debt increases this fixed cost as it involves fixed
financing cost. Hence, if the fixed operating cost is less, more of the debt financing can
be preferred.
(d) Control consideration. Shares carry the voting right and thus may lead to dilution of
management’s control over the business. If the company is afraid of takeover bid, it
would prefer debt to equity.
(e) State of capital markets. When the market is bullish, the company can easily raise
funds through equity shares. But in case, the phase is bearish, raising funds through
debentures is easier.
25. Explain the following as factors affecting dividend decision:
(i) Stability of earnings;
(ii) Growth opportunities;
(iii) Cash flow position and
6
(iv) Taxation policy.
Or
Explain the following as factors affecting dividend decision:
(a) Stability of dividends
(b) Shareholder’s preferences
(c) Access to capital market and
(d) Legal constraints
Or
Tata International Ltd. earned a net profit of 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.
Or
What is meant by ‘Dividend Decision’ ? Explain any four factors which affect the dividend decision
of a company.
Or
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.
Ans :
A dividend decision means whether to distribute profits as dividend to shareholders or
retain profits and reinvest into the business.
Factors affecting the dividend policy/decision of a company are:
(a) Growth opportunities/Financial requirements of the company. If a company has a
number of projects to invest in, then it should reinvest the earnings of the company. In
this case, the company would prefer to pay low dividends to shareholders and invest the
remaining profits in the business. But if the company has no investment/growth avenues
open, then it would be better to distribute earnings as dividends to shareholders.
(b) Stability of dividends. Most companies follow a stable dividend policy. This policy has
a favourable impact on the market value of shares and shareholders also prefer stable
dividends than fluctuating ones. Stable dividends have certain advantages as they
resolve uncertainty in the minds of investors and satisfies their desire for current income.
Even financial institutions like IFCI, IDBI, UTI also prefer investing in those companies,
which follow a policy of paying regular dividends.
(c) Access to Capital Market/Capital market consideration. When a company requires
funds for investments, it can either tap the capital market and raise additional equity or
retain its earnings by declaring low dividends. If the capital market is easily accessible to
the company, then it can afford to follow a liberal dividend policy. However, if a company
has limited access to capital markets then, it will pay low dividends to shareholders and
rely more on retained earnings to finance their long-term projects.
(d) Shareholders’ preference. Small and retired shareholders who invest their savings in
shares in the hope of getting a regular income are interested in a stable and regular
dividend. The management may follow a policy which serves the purpose of the majority
group. Wealthy investors usually invest in shares for earning capital gains. They are in
high income tax brackets and therefore, may not prefer current dividends, as their taxes
would increase.
(e) Legal restrictions. Companies Act has certain provisions regarding payment of
dividends. Dividends can be paid only out of current profits or past profits after providing
for depreciation. Companies are not allowed to pay dividends out of the paid up capital
as this amounts to reduction in capital. Then, there are certain internal constraints in the
company like whether there is enough cash to pay dividends and what is the company’s
liquidity position. Financial institutions also provide certain conditions in their loan
agreements. Thus, the dividend decision depends upon these legal and internal
constraints.
(f) Amount of earnings. How much dividend will be paid to shareholders will depend on
the earnings of the company.
(g) Stability of earnings. If unstable earnings are there, lower dividend will be declared
and if stable earnings are there, company will declare higher dividends.
(h) Cash flow position. If company is short of cash then, declaration of higher dividend
will be difficult for the company.
(i) Taxation policy. If tax rates on dividends are lower, then higher rates of dividends can
be declared by the company.
(j) Stock market reaction. Declaration of higher dividends have a favourable influence on
the price of equity shares of the company.
(k) Contractual constraints. Sometimes company has to take care of the terms of loan
agreements if it is relating to condition on declaration of dividend amount to the
shareholders.
(l) Bonus shares. At times, company may also issue bonus shares, which we call stock
dividends. Bonus shares have the effect of increasing the number of shares and the
capital base of the company. At the same time, it keeps investors happy as it signifies
higher and growing earnings.
(m) Inflation. Because of rising prices, companies may need more funds to internally
finance assets as the depreciation provided may not be enough to replace them. In that
case, the companies are not able to declare high dividends as they have to rely on
retained earnings as a source of long-term financing.
26. What is meant by ‘Financial Planning’ ? Explain any five points which highlight its importance.
6
Or
“Sound Financial Planning is essential for the success of any business enterprise.” Explain this
statement by giving any six reasons.
Ans :
Financial planning is the act of deciding in advance the financial activities necessary to
achieve the goals and objectives of an organisation.
Importance of financial planning is as follows:
(a) It helps in forecasting what may happen in future under different business situations.
Preparation of alternative financial plans to meet different situations is clearly of
immense help in running the business smoothly.
(b) It helps in avoiding business shocks and surprises and thus, helps the company in
preparing for the future.
(c) It helps in coordinating various business functions by providing clear policies and
procedures.
(d) It helps in reducing waste, duplication of efforts and gaps in planning through detailed
plans of action.
(e) It helps in linking the present with the future.
(f) It helps as providing a link between investment and financing decisions on a
continuous basis.
(g) It helps in better evaluation of actual performance through listing detailed objectives
for various business segments.
27. What is meant by capital structure? What are the factors to be kept in mind while determining the 6
capital structure of a company?
Or
The directors of a company, of which you are the finance manager, have to design the capital
structure for the company and have asked you about the factors that affect the capital structure of a
company. Give your view points with reasons.
Or
‘Determination of capital structure of a company is influenced by a number of factors.’ Explain any
five such factors.
Or
Explain the following as factors affecting the choice of capital structure:
(i) Cash flow position
(ii) Cost of equity
(iii) Floatation costs
(iv) Stock market conditions
Or
Explain the following as factors affecting the choice of capital structure:
(i) Return on Investment
(ii) Flexibility
(iii) Risk consideration
(iv) Control
Ans :
The following factors decide a company’s capital structure:
(a) Cash flow position. A company must have enough cash in hand or liquidity if it has to
raise capital through debentures to pay interest in time. If cash inflows are not enough,
then it should issue shares.
(b) Cost of debt. A firm’s ability to borrow at a lower rate increases its capacity to employ
higher debt. Thus, more debt can be used if debt can be raised at a lower rate.
(c) Control. To retain control over the management of the company, debentures and
preference shares should be issued to raise capital.
(d) Flexibility. Equity allows more flexibility to change its capital structure according to
market conditions while debt restricts this freedom.
(e) Size of the company. Large companies are able to raise capital through shares more
easily while smaller companies have to depend on their own sources or retained
earnings as they do not get loans easily.
(f) Tax rate. It will be beneficial for the company to raise funds through debt if tax rates
are high. Tax rate influences cost of debt as interest is a tax deductible item.
(g) Stock market conditions. If there is a boom period, then company will be in a better
position to issue shares and that also at a premium. On the other hand, if there is
depression in the market then investors may not be in a mood to take risk and therefore
it is advisable for the company to issue debentures.
(h) Risk consideration. More risk is attached to debt as compare to shares such as
interest payment, repayment etc. If level of fixed operating costs (like rent of the building)
are high, then business should go in favour of issuing more of equity instead of debt.
(i) Cost of equity. More debt means more risk for the equity holders which increases their
desired rate of return. To control cost of equity, limit should be imposed on the use of
debt.
(j) Return on investment. Trading on equity/financial leverage can be used to increase
earnings per share if ROI is higher.
(k) Floatation costs. It refers to costs involved in the issue of shares or debentures.
These costs are high in case of equity as compared to debt.
(l) Interest coverage ratio. Risk of company is lower if ICR is higher. But it is not a full
proof measure.
(m) Debt service coverage ratio. Company can use more debt, if DSCR is higher.
(n) Regulatory framework. The Companies Act and SEBI provide guidelines from time to
time regarding the raising of funds from the public. All these rules and regulations should
be considered before taking a decision that whether company would like to issue shares
or debentures or take loan from a financial institution.
(o) Capital structure of other companies. A company, before taking decision on the
capital structure, should observe/study the relative proportion of various sources of funds
in the capital structure of other companies in the same industry.
28. Explain the following as factors affecting the requirements of working capital:
(a) Business cycle;
(b) Operating efficiency;
(c) Availability of raw material and
(d) Level of competition.
Or
Explain the following as factors affecting the requirements of working capital:
(i) Nature of business
(ii) Scale of operations
6
(iii) Seasonal factors
(iv) Production cycle
Or
Explain the following as factors affecting the requirements of working capital:
(i) Business cycle
(ii) Credit allowed and availed
(iii) Operating efficiency
(iv) Availability of raw material
Or
You are the Financial Manager of a newly established company. The Directors have asked you to
determine the amount of working capital requirement for the company. Explain any four factors that
you will consider while determining the working capital requirement for the company.
Ans :
The factors determining working capital requirements are:
(a) Business cycle. During boom period, when sales are high, higher amount of working
capital is required as compared to depression period.
(b) Operating efficiency. Less requirement of working capital will be there in a firm in the
presence of best sales effort, ideal debtors turnover ratio and higher inventory turnover
ratio.
(c) Availability of raw material. Higher lead time (i.e. time lag between the placement of
order and actual receipt of the materials) and interrupted availability of raw materials will
raise the requirement of working capital.
(d) Level of competition. Working capital requirements will be more if level of competition
is high and vice-versa.
(e) Nature of business. Manufacturing firm requires high amount of working capital as
compared to a trading organisation, to convert raw materials into finished goods.
(f) Scale of operations. Large amount of working capital is required by firms operating on
a large scale of operations in terms of debtors, inventory etc.
(g) Seasonal factors. Higher amount of working capital is required by the organisation
during its peak season and less during lean season.
(h) Production cycle/Length of operating cycle. Operating cycle refers to the length of the
manufacturing cycle, i.e., the periods taken to convert raw materials to finished products.
Longer period means more working capital is required and vice-versa.
(i) Credit allowed. If liberal credit terms are given and a liberal policy is followed, then the
company would require more working capital as there is less cash inflow and vice-versa.
(j) Growth prospects. If an organisation has planned for higher growth prospects then its
requirement for working capital will also be higher.
(k) Inflation. At a higher rate of inflation, working capital requirement will also be higher
and vice-versa.
(l) Inventory policies. If the business has a policy of keeping a large stock of inventory,
working capital requirement will be more and vice-versa.
(m) Sales level. Higher sales level means ready convertibility into cash and thus, there is
not much investment required in working capital as there is inflow of cash. Similarly, a
lower sales level requires more investment in working capital.
(n) Type of products manufactured. Certain products which require heavy initial
investment in plant and machinery do not require much working capital. Labour intensive
activities require large stocks of raw materials, inventories, etc. They require more
working capital.
(o) Credit availed. If it is difficult to avail credit by the firm on its purchases from suppliers
then, higher amount of working capital is required.
29. Shalini, after acquiring a degree in Hotel Management and Business Administation took over her 5
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 modernization 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 modernization 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.
Ans :
(a) Shalini should not finance the modernisation and expansion programme through debt
because:
(i) as the business already has high fixed operating costs, further issue of debt will
increase the financial risk of business.
(ii) as the business has weak cash flow position, it may not be able to honour the fixed
cash payment obligations.
(any one)
(b) The two factors Shalini should keep in mind while taking this financing decision are:
(i) Cost of equity. The stock owners assume more risk as compared to the borrowers of
the business, so they expect more rate of return from their investments. When a
company increases debt, the financial risk faced by equityholders increases and
consequently their desired rate of return also increased. For this reason, a company can
not use debt recklessly. The cost of equity may go up sharply with the use of debt.
(ii) Floatation cost. The floatation cost is the cost of raising funds from the market, be it
equity or debt. This cost is to be considered before choosing the source of fund. Getting
a loan from a financial institution may not cost so much, so these considerations affect
the capital structure.
(or any other relevant point)
30. Puneet, the finance manager of Sahara Ltd., is involved in preparation of the financial blueprint 4
for future operations. He is directed by the seniors to ensure that enough funds are available at
right time. Because if surplus/excess funds are available, it will add to the cost and may encourage
wasteful expenditure. On the other hand, if funds are short, then firms will not be able to honour
their commitments and carry out plans.
He is taking into consideration the growth, performance, investments and requirement of funds for a
given period. He is working on both short-term and long-term plans. After completing the process of
estimating the funds requirement of the company, he specifies the source of funds also. Last year
also, he got lot of appreciation for his successful effort.
(a) In which process, Puneet is currently involved?
(b) Is the above concept equivalent to or substitute for financial management? Why?
(c) Mention two importance of the concept in which Puneet is involved.
Ans :
(a) Puneet is involved in Financial Planning.
(b) No, Financial Planning is not equivalent to or a substitute for Financial Management
because Financial Management aims at choosing the best investment and financing
alternatives by focussing on their costs and benefits, whereas Financial Planning, on the
other hand, aims at smooth operations by focussing on funds requirement and their
availability in the light of financial decisions.
(c) Importance of financial planning is as follows:
(i) It helps in avoiding business shocks and surprises and, thus, helps in preparing for the
future.
(ii) It helps in coordinating various business functions.
31. Bakers Mart is catering to corporate clients. It is facing a lot of competition. What impact will this 4
have on its working capital requirements? Also, explain three other factors which could affect its
working capital requirements.
Ans :
Working capital requirements would be high as higher inventories may have to be
stocked to meet orders from customers or liberal credit terms may have to be given to
customers to face the competition.
Other Factors affecting the working capital requirement are:
(a) Nature of business. Manufacturing firm requires high amount of working capital as
compared to a trading organisation, to convert raw materials into finished goods.
(b) Scale of operations. Large amount of working capital is required by firms operating on
a large scale of operations in terms of debtors, inventory etc.
(c) Business cycle. During boom period, when sales are high, higher amount of working
capital is required as compared to depression period.
32. ABC Ltd. is thinking to modernize its Plant and Machinery. It would require a huge expenditure. 4
Mr. Beniwal, Finance Manager of the company has to estimate how much funds would be required
and also from where to raise these funds. Mr. Beniwal wants that the funds should be available at
just the right time. The profits of the company are high and cash flows of the company were very
stable despite the fact that the economy is in a bearish phase. The management has asked Mr.
Beniwal to decide the source of raising the funds however they want to retain control over the
business.
(a) Name the process which will help in estimating the fund requirements at the right time.
(b) Which source should the company opt for, debt or equity. Justify your answer by giving two
reasons in support of your answer.
Ans :
(a) The process of Financial Planning will help in estimating the fund requirement at the
right time.
(b) The company should raise funds through debt as:
(i) Cash flows of the company were very stable.
(ii) The economy is in a bearish phase.
(iii) The management wants to retain control over the business.
33. ‘Sarah Ltd.’ is a company manufacturing cotton yarn. It has been consistently earning good 5
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 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 40 lakhs 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.
Ans :
Dividend decision. Factors affecting dividend decision are:
(a) Cash flow position. ‘There is enough cash in the company’. Here company can
declare higher dividends.
(b) Stability of earnings. ‘Consistently earning good profits for many years’. Here
company can declare higher dividends.
(c) Shareholder’s preference. ‘It has many shareholders who prefer to receive a regular
income from their investments’. Here company may follow the policy of declaring higher
dividends to serve their purpose.
(d) Contractual constraints. ‘Taken a loan of 40 lakhs from IDBI Bank and is bound by
certain restrictions on the payment of dividend according to the terms of loan
agreement’. Here company has to take care of the terms of the loan agreements if it is
relating to condition on declaration of dividend amount to the shareholders.
34. Manak Chand and Co., dealing in copper and other metals, has earned a profit of 1,200 crores. 3
Manak Chand and Co. is a renowned name in the market and investors like to invest in the
company. Company has explored its potential fully and is on the top, thus, it has no plans for growth
or expansion in the next few years. Also, earnings of the company are consistent and stable over
the years. Tax on dividends is also levied at a low rate by the government on the company. Guide
the company on the decision of distribution of dividend to shareholders.
Ans :
The company should declare higher dividends due to the given reasons:
(a) As company has no growth/expansion plans in next few years.
(b) Earnings of the company are stable.
(c) Company can afford to give higher dividends due to lower rate of taxes on dividend.