www.youtube.com/commercebaba /Commercebaba 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
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
www.youtube.com/commercebaba
/Commercebaba
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
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.