# NCERT Solutions for Class 12 Business Studies Chapter 9 Financial Management

Detailed, Step-by-Step NCERT Solutions for 12 Business Studies Chapter 9 Financial Management Questions and Answers were solved by Expert Teachers as per NCERT (CBSE) Book guidelines covering each topic in chapter to ensure complete preparation.

## Financial Management NCERT Solutions for Class 12 Business Studies Chapter 9

### Financial Management Questions and Answers Class 12 Business Studies Chapter 9

Question 1.
The cheapest sources of finance is ………….
(a) debentures
(b) equity share capital
(c) preference share
(d) reterised earning
(a) Debentures.

Question 2.
A decision to acquire a new and modern plant to upgrade an old one is a ……..
(a) financing decision
(b) working capital decision
(c) investment decision
(d) dividend decision
(c) Investment Decision.

Question 3.
Other things remaining the same, as increase in the tax rate on corporate profits will
(a) make debt relatively cheaper
(b) make debt relatively less cheap home
(c) No impact on the cost of debt
(d) We can’t say
(a) Make debt relatively cheaper.

Question 4.
Companies with higher growth paternal are likely to ………..
(a) pay lower dividends
(b) pay higher dividends
(c) dividends are not affected by growth considerations
(d) none of the above
(b) Pay higher dividends.

Question 5.
Financial leverage is called favorable if ………..
(a) Return of Investment is lower than cost of debt
(b) ROI is higher than cost of debt
(c) Debt is nearly available
(d) If the degree of existing financial leverage is low
(b) ROI is higher than cost of debt.

Question 6.
Higher debt equity ratio Equity results in
(a) lower financial risk
(b) higher degree of operating risk
(c) higher degree of financial risk
(d) higher EPS
(a) Lower financial risk.

Question 7.
Higher working capital usually results in
(a) higher current ratio, higher risk and higher profits
(b) lower current ratio, higher risk and profits
(c) higher equitably, lower risk and lower profits
(d) lower equitably, lower risk and higher profits
(a) Higher current ratio, higher risk and higher profits.

Question 8.
Current assets are those assets which get converted into cash
(a) within six month
(b) within one year
(c) between one and three year
(d) between three and five year
(b) Within one year.

Question 9.
Financial planning arrives at
(a) minimising the external borrowing by resorting the equity issues
(b) entering that the firm always have sinthicicanlty more fund than required so that there is no pugnacity of funds
(c) ensuring that the firm paces neither a shortage nor a glut of unusable funds
(d) doing only what is possible with the funds that the firms has at its disposal
(c) Ensuring that the firm paces neither a shortage nor a glut of unusable funds.

Question 10.
Higher dividends per share is associated with
(a) high earnings, high cash flows, unusable earnings and higher growth opportunities
(b) high earnings, high cash flows, stable earnings and lower high growth opportunities.
(c) high earnings, high cash flows, stable earnings and lower growth opportunities.
(d) high earnings, low cash flows, stable earnings and lower growth opportunities.
(b) high earnings, high cash flows, stable earnings and lower high growth opportunities.

Question 11.
A fixed asset should be financed through
(a) a long term liability
(b) a short term liability
(c) a mix of long and short term liabilities
(a) A long term liability.

Question 12.
Current assets of a business firm should’be finance through
(a) Current liability only
(b) long term liability only .
(c) party from both types i.e. long and short term liabilities
(c) Party from both types i.e. long and short term liabilities.

Question 1.
What is meant by capital structure ?
Meaning of capital structure : The term’capital structure’refers to the proportion between the various long term sources of finance in the total capital of the firm.

The major sources of long term finance include ‘Proprietor’s Funds’ and ‘Borrowed Funds’. Proprietors Funds include equity capital, preference capital, and reserves and surpluses (i.e., retained earnings) and Borrowed funds include long term debts such as loans from financial institutions, debentures etc. In the capital structure decisions, it is determined as to what should be the proportion of each of the above sources of finance in the total capital of the firm.

In other words, how much finance is to be raised from each of these sources. These sources differ from each other in term of risk and their Cost to the enterprise. Some sources are less costly but more risky wheres others are more costly but less risky. To illustrate, debentures are least costly source of finance (because rate of interest is usually lower than the rate of dividend and interest paid on debentures is deducted from profits while calculating the tax) but these are most risky

(because it involves a burden to pay the interest irrespective of the profits earned by the company and the debenture ’ holders can move to the court to recover the interest and the principal amount. On the other hand, equity share capital is the most costlier ” source of finance (as return expected by equity share holders is greater than the interest on debentures and the dividend on preference share) but these are least risky (as there is no fixed commitment to i, pay dividend and the return of equity capital).

Preference share capital lies between debentures and equity capital in terms of risk and cost.
While choosing the source of finance a financial manager makes f an attempt to ensure that risk as well as cost of capital is minimum. For this purpose he has to answer the following questions.

• How much amount should be raised through issue of equity?
• How much amount should be raised through issue of perference share capital?
• How much amount should be raised through debentures and, other long term debts?

While deciding the proportion of finance raised from’various sources, the financial manager weighs the pros and cons of various sources of finance and select the most advantageous source. The selection also depends on various internal and external factors and hence the pattern of capital structure can be different among different businesses and also among the different companies in the same business.

Question 2.
Discuss the two objectives of financial planning.
Financial planning is an important function of plan financial management. This function has to be performed whether the business is big or small. Similarly, a new as well as an existing business must perform this’function very carefully because it is concerned with the procurement and effective utilisation of funds. A carefully prepared financial plan will not only ensure the economical and sufficient procurement of funds but their proper utilisation also.

Meaning of Financial Planning.

Different authors have different views about the meaning of financial planning. These views can be classified into two groups.
(i) Narrow concept of financial planning and
(ii) Broader concept of financial planning
(i) Narrow concept of Financial Planning
In the narrow concept, there are two views : According to first view, some authors are of the opinion that financial planning means estimating or forecasting the financial requirements of the business. According to second view, some other authors are of the opinion that financial planning means determining the capital structure of the business.

According to the supporters of second view, financial planning is related to capital structure, i.e. determining the proportion in which the funds are to be raised by various sources such as equity shares, preference shares, debentures etc.

Both of these views are considered faulty because the first view emphasises only the estimation of financial requirements but ignores the determination of capital structure whereas the second view ignores the estimation of financial requirements.

(ii) Broader concept of Financial Planning : In the broader concept, financial planning means estimation of financial requirements and the determination of capital structure. According to this concept, the following activities may be induded in the term financial planning.

• Estimating the financial requirements of the business.
• Determination of capital structure, i.e. the determination of the proportion in which finance will be raised from various sources of finance.
• To establish the policies to be pursued for the flotation of various securities.
• To-establish and maintain a system of financial control governing the allocation and utilisation of funds.

Walker and Baughn also view the financial planning in a broader concept, According to them :
“Financial planning pertains to the function of finance and includes the determination of the firms’ financial objectives, financial policies and financial procedures.” – Walker and Baughn

Objective of Financial Planning
Following are the main objectives of financial planning :

• To provide adequate funds to the business. Neither the funds should be short nor, in excess of the needs of business.
• To raise the funds in a manner that the cost of capital is minimum.
• To ensure flexibility in capital structure so that changes in the sources of funds may be made according to the changing conditions.
• To ensure simplicity in the capital structure.
• To ensure sufficient liquidity of funds.

All of these objectives should be kept in mind while preparing a financial plan. However, which objective is to be given more importance and which objective is to be considered less important depends upon the actual circumstances prevailing at the time of preparing the financial plan. Also, necessary changes are made in the financial plan according to the change in circumstances.

Question 3.
What is ‘Financial Risk?’ Why does it arise?
Risk consideration : Financial risk refers to a position when a company is unable to meet its fixed financial charges namely interest payment, preference dividend and repayment obligation. Apart from the financial risk, every business has some operating risk, (also called business risk).

Business risk depends upon fixed operating costs. Higher fixed operating costs result in higher business risk and vice- versa. The total risk depends upon both the business risk and the financial risk. If firm’s business risk is lower, its capacity to use debt is higher and vice-versa.

Question 4.
Define a ‘Current Assets’ and give four examples?
Apart from the investment in fixed assets every business organisation needs to invest in current assets. This investment facilitates smooth day-to-day operation of the business. Current assets are usually more liquid but contribute less to the profits than fixed assets. Examples of current assets, in order of their liquidity, are as under.

• Cash in hand/Cash at Bank
• Marketable securities
• Bills receivable
• Debtors
• Finished goods inventory
• Work in progress
• Raw materials
• Prepaid expenses

These assets, are expected to get converted into cash or cash equivalents within a period of one year. These provide liquidity to the business. An asset is more liquid if it can be converted into cash quicker and without reduction in value. Insufficient investment in current assets may make it more difficult for an organisation to meet its payment obligations. However, these assets provide little or low return. Hence, a balance needs to be struck between liquidity and profitability.

Current liabilities are those payment obligations which, when they arise, are due for payment within one year, such as Bills payable, creditors, outstanding expenses, advances received from customers etc. Some part of current assets is usually financed through short term sources i.e; current liabilities. The rest is financed through long-term sources and is called net working capital. Thus NWC=CA-CL.

Question 5.
Financial management is based on three broad financial decisions, what are these ?
There are three basic functions of financial management. These are

• raising finance
• investing in assets and
• distributing returns earned from assets to shareholders.

These three functions are respectively known as financing decision, investment decision and dividend policy decision. While performing these functions, various other functions have also to be performed such as taking working capital decisions and planning and controlling the finance.

Certain routine functions are also performed for the effective execution of all these finance functions. Hence, the functions of finance are:

(i) Determining the financial Needs
(ii) Financing Decision
(iii) Investment Decision
(iv) Working Capital Decision
(v) Dividend policy Decision

(i) Determining the financial Needs : The first task of the financial management is to estimate and determine the financial requirements of the business. For this purpose, the short tern) and long-term needs of the business are estimated separately.

Financial needs are estimated with a long-term view so that necessary funds will be available for expansion and renewal of plant and machinery in future. While determining the financial needs the financial management should take into consideration the nature of the business, possibilities for future expansion, attitutde of the management towards risk, general economic circumstances, etc.

(ii) Financing Decision : This function is related to raising of finance from different sources. For this purpose the financial manager is to determine the proportion L of debt and equity. In other words, what proportion of total funds will 1 be raised from loans and what proportion will be provided by share J. holders. The mixing of debt and equity is known as the firm’s capital structure or leverage.

Raising of funds through debts results in a higher return to the share holders but it also increases risk. Hense, a proper balance will have to be ensured-between debt and equity. A capital [ structure with a reasonable proportion of debt and equity capital is ‘ termed the ‘optimum capital structure’.

When the return to share-holders is maximized with minimum risk, the per-share market value of company’s shares will be maximized and the firm’s capital structure will be considered optimum. In order to raise the capital, a prospectus is issued and services of underwriters are used.

(iii) Investment Decision : Investment Decision also known as ‘Capital Budgeting’ as related to the selection of long-term assets or projects in which investments will be made by the business. Long-term assets are the assets which would yield benefits over a period of time in future.

Since the future benefits are difficult to measure and cannot be predicted with certainty, investment decision involve risk. Investment decision should, therefore, be evaluated in terms of both expected return and risk. Further, a minimum required rate of return also known-as cut-off rate l is also determined against which the expected return from new I investment can be compared.

(iv) Working Capital Decision : It is concerned with the management of current assets. It is an | important function of financial management since short-term survival of the firm is a pre-requisite for its long-term sucess. Current assets should be managed in such a way that the investment in current assets is neither inadequate nor unnecessary funds are locked up in current assets.

If a firm does not have adequate working, capital, that is its investment in current assets is inadequate, it may become illiquid and as a result may not be able to meet its current obligations and,thus, invite the risk of bankruptcy. On the other hand, if the investment in current assets is too large, the profitability of the firm will be adversely affected because idle current assets will not earn anything.

Thus the financial management must develop a sound technique of managing current assets. It should properly estimate the current assets requirements of the firm and make sure that funds would be made available when needed.

(v) Dividend policy Decision : The financial management has to decide as to which portion of the profits is to be distributed as dividend among shareholders and which portion is to be retained in the business.

For this purpose the financial management should take into consideration the factors of dividend stability, bonus shares and cash dividends in practice. Usually, tHe profitable companies pay cash dividends regularly. Periodically, the bonus shares are also issued to the existing equity shareholders.

Question 6.
What is the main objectives of financial management? Briefly explain.
Objective or Goals of financial Management : It is the duty of the top management to lay down the objectives or goals which are to be achieved by the business. In order to make wise financial decisions a clear understanding of the objectives of the business is necessary. Objectives provide a framework within which various decisions relating to investment, financial and dividend are to be taken.

In other words, objectives lay down a criterion by which the efficiency and profitability of a particular decision is evaluated. The choice of such a criterion lies between profit maximization and wealth maximization. Hence, there are two approaches in this regard :
(1) Profit Maximization and
(2) Wealth Maximization

(1) Profit Maximization : According to this approach, all activities which increase profits should be undertaken and which decrease profits should be avoided. Profit maximization implies that the financial decision making should be guided by only one test, which is, select those assets, projects and decisions which are profitable and reject those which are not. The following arguments are advanced in favour of this approach :

(i) Profit is a test of economic efficiency of a business. It is a yard stick by which the economic performance of a business can be judged.

(ii) This approach leads to efficient allocation and utilisation of scare resources of the business because sources tend to be directed to uses which are most profitable.

(iii) Profitability is essential for fulfilling the goal of social welfare also. Maximization of profits leads fo the maximization of social welfare.

(iv) Profit acts as motivator or incentive which induces a business organisation to work more efficiently. If profit motive is wilthdrawn the pace of development will be reduced.

(v) Economic and business conditions go on changing from time to time. There may be adverse business conditions like recession, competition etc. Under adverse circumstances a business will be able to survive only if it has some past earnings to rely upon. Hence, a business should maximize its profits when the circumstances are favourable.

(vi) Profits are the major source of finance for the growth of a – firm.However, the profit maximization approach has been criticised on several grounds :

(i) Ambiguous : One practical difficulty with this approach is that the term profit is vague and ambiguous. Different people take different meaning of term  profit. For example, profit may be short term or long-term, it may be ‘ before tax or after tax, and it may be total profit or rate of profit.

‘Similarly, it may be return on total capital employed or total assets or ‘ share holders funds and so on. Further, it is possible that total profits may increase but earnings per share may decrease. To illustrate, if a company has 1,00,000 shares and earns a profit of Rs. 10,00,000,earning per share is Rs. 10.

Now, if the company further issues 50,000 shares and earns a total profit of Rs. 12,00,000; the total profits have increased by Rs. 2,0, 000; but the earning per share declined to Rs. 8
$$\left\{\text { i.e. } \frac{\text { Rs. } 12,00,000}{1,50,000}\right\}$$

Hence, the question aries, which of these profits should a firm try to maximize? .

(ii) Ignores the Time Value of money : This approach ignores the time value of money, i.e. it does not make a distinction between profits earned over the different years. It ignores the fact that the value of one rupee at present is greater than the value of same rupee received after one year.

Similarly, the value of profit earned in first year will be more in comparison to the equivalent profits earned in later years. To illustrate, the profits of two different projects are

 Year Project A Project B 1. 1,50,000 ……………. 2. 4,50,000 4,00,000 3. 2.00,000 4,00,000 Total 8.00,000 8,00,000

The total profits of both the projects are Rs. 8,00,000 in 3 years and hence, if the profit maximization approach is adopted both the projects will be considered equally profitable. But it can be seen that project A earns higher profits in ealier years and hence is more profitable in terms of time value of money. The profits earned in earlier years can be reinvested to earn more profits.

(iii) Ignores Risk factor : This approach ignores the risk associated with the earnings. If the two firms have the same total expected earning, but if earnings of one firm fluctuate considerably as compared to the other, it will be more risky. Investor in general, have a preference for a less income with less risk in comparison to high income  greater risk. But this approach does not pay any attention to these factor.

It is, thus, clear that profit maximizariterion is inappropriate and unsuitable. It is not only ambiguous kuf\$gnis to solve the problems of time value of money and the risk. An alternative to profit maximization, which solves these problems* is the criterion of wealth maximization.

2. Wealth Maximization : This approach is now universally accepted as an appropriate criterion for making’financial decision as it removes all the limitations of profit maximization approach. It is also known as net present value (NPV) maximization approach. According to this approach the worth of an asset is measured in terms of benefits received from its use less the cost of its acquisition.

Benefits are measured in terms of cash flows received from its use rather than accounting profit which was the basis of measurement of benefits in profit maximization approach. Measuring benefits in terms of cash flow avoids the ambiguity in respect of the meaning of the term profit.

Another important feature of this approach is that it also incorporates the time value of money. While measuring the value of future cash flows an allowance is made for time and risk factors by discounting or reducing the cash flows by a certain percentage. This percentage is known as discount rate.

The difference between the present value of future cash inflows generated by an asset and its cost is known as net present value (NPV). A financial action (or an asset or a project) which has a positive NPV creates wealth for shareholders and therefore is undertaken.

On the other hand, a financial action resulting in negative NPV 1 should be rejected since it would reduce shareholder’s wealth. If one out of various projects is to be choosen, the one with the highers NPV is adopted. Hence, the shareholder’s wealth will be maximized if this criterion is followed in making financial decisions.

The NPV can be calculated with the help of the following Formula:-
$$\mathrm{W}=\frac{\mathrm{A}_{1}}{(1+\mathrm{K})}+\frac{\mathrm{A}_{2}}{(1+\mathrm{K})^{2}}+—-\frac{\mathrm{A}_{\mathrm{n}}}{(1+\mathrm{K})^{\mathrm{n}}}-\mathrm{C}$$
Where W = Net Percent worth
A1 , A2 — An = Stream of cash flows expected to occur from a course of action over a period of time.
K = Apporopriate discount rate to measure risk and time factors.
C = Initial outlay to acquire an asset or pursure a course of action.

If W or NPV is positive, the firm should acquire the asset or pursure a particular course of action. On the contrary, If W is negative the asset should not be acquired or that particular course of action should not be taken.

The wealth maximization approach is superior then the profit maximization approach. Firstly, because it uses cash flows instead of accounting profits which avoids the ambiguity regarding the exact meaning of the term profit. Secondly it gives due importance to the time value of money by reducing the future cash flows by an appropriate discount or interest rate.

If higher risk and longer time period are involved, higher rate of discount or interest will be used to find out the present value of future cash benefits. The discount or interest rate will be lower for the projects which involve low risk.

Question 7.
Discuss about working capital affecting both the liquidity as well as profitability of a business.
Management of working capital : The goal of working capital management is to manage the current assets and current liabilities of a firm in such a way that working capital is maintained at a satisfactory level. The current assets should be large enough to pay the current liabilities in time while not keeping too high a level of anyone of them.

The interation between, current assets and current liabilities is, therefore, the main objective of management of working capital. According to Smith, K.V., “Working capital management is concerned with the problems that arise in attempting to manage the current assets, current liabilities and the after relationship that exists between them?’
Following are the main objectives or aspects of working capital management:

(1) To determine the adequate or optimum quantum of investment in working capital.
(2) To determine the composition or structure of current assets.
(3) To maintain a proper balance between liquidity and profitability.
(4) To determine the policy or means of finance for current assets.

(1) To determine the adequate or optimum quantum of investment in working capital : As discussed, a firm should maintain adequate or reasonable investment in working capital. Investment in working capital should neither be excessive nor inadequate.

(2) To determine the composition or structure of current assets : The financial management is required to determine the , composition of current assets. It should decide how much amount 1 should be invested in each individual current assets. For this purpose, it should fix the average amount invested in Stock, debtors, marketable securities and the level of cash balance.

(3) To maintain a proper balance between liquidity and profitability : While managing working capital, management will have to reconcile two conflicting aspects. The confliciting aspects are liquidity A I and profitability. If the quantum of working capital is relatively large, -it will increase the liquidity but decrease the profitability.

The reason is that a considerable amount of firm’s funds will be tied up in current assets, and to the extent this investment is idle, the firm will have to forego profits. On the other hand, if the quantum of Working capital is relatively small, it will decrease liquidity but will result in increase in V the profitability. This is because the less funds are tied up in idle current assets.

(4) To determine the policy or means of finance for current assets : Another important aspect of working capital management is determining the financing mix i.e. what will be the sources of financing the current assets. There are mainly two sources from which funds can be raised for current assets financing

• Short-term sources Such as short-term bank loan and other current liabilities such as creditors, bills payable etc.
• Long-term sources :- Such as share capital, long-term borrowings, retained earnings etc.

Question 1.
What is meant by working capital. How is it calculated? Discuss five important determinants of working capital requirements.
Working capital management is an important aspect of financial management. In business, money is required for fixed assets and working capital. Fixed assets include land and building, plant and machinery, furniture and fittings etc. Fixed assets are acquired to be retained in the business for a long period and yield returns over the life of such assets.

Working capital, on the other hand,, is required for the efficient and effective use of fixed assets. The main objective of working capital management is to determine the optimum amount of working required.

Definition of working capital
There are two concepts of working capital :-
(i) Gross working capital concept
(ii) Net working capital concept

(i) Gross working capital concept:- According to this concept, working capital means gross working capital which is the total of all the current assets of a business.
Gross Working Capital = Total Current Assets
Definitions favouring this concept are .

1. “Working capital means total of current Assets” – Mead, Mailott and Field
2. “Any acquisition of funds which increases the current Assets increases working capital, for they are one and the same” Bonneville and Dewey .

Persons acknowledging the total of current assets as working capital give the following arguments in their favour.

(i) Just as fixed assets are considered as the symbol of fixed capital, current assets must also, be considered as symbol of working capital.

(ii) Any acquisition of funds increases the working capital. This statement proves true according to this concept whereas it does not hold true according to the second concept.

(iii) Most of the managers plan their business operations according to the current assets concept because these are the assets used in day- to-day business operations.

(iv) Utility of current assets remains the same whether financed from long-term loans or short-term loAnswer:Hence, the total amount of current assets must be treated as working capital.

2. Net working capital concept According to this concept, working capital means net working capital which is the excess of current assets over current liabilities.
Net working Capital = Current Assets – Current liabilities Definitions favouring this concept are :-

• “It has ordinarily been defined as the excess of current assets over current liabilities.” – C.W. Gestenbergh.
• The most common definition of net working capital is the difference of firm’s current assets and current liabilities” – Lawrence . J, Gitmen

Persons favouring this concept give the following arguments in their favour:
(i) This concept gives the true information about the liquidity of a concern. According to first concept, the working capital appears to be increased merely by taking a short-term loan whereas in the second concept working capital remains unchanged by doing so. Thus, the second concept looks more logical. In actual sense, working capital increases only by ploughing back of profits or when a long-term loan is obtained.

(ii) Exess, of current assets over current liabilities will indicate whether or not the concern will be able to meet its current liabilities when they fall due. First concept does not disclose this fact.

(iii) It is on the basis of this concept that the short-term lenders, bankers etc. calculate the safety margin regarding the timely payment of their debt.

(iv) Excess of current assets over current liabilities will determine whether or not the concern will be able to face the depression or any other contingent need of the business.

(v) According to this concept a comparison can be made between the financial position of two firms whose current assets are equal. As discussed, net working capital is the excess of current assets over current liabilities. If current assets are equal to current liabilities, net working capital will be zero and if current liabilities are more than current assets, net working capital will be negative.

Current assets mean those assets which are converted into cash within a short period of time not exceeding one year, eg. cash, bank balance debtors, bills receivable, stock, accured income etc.

Current liabilities mean those liabilities which have to be paid within a short period of time in no Case exceeding one year, e.g. creditors, bills payable, outstanding expenses, short-term loans etc.

Factors affecting Working Capital
or
Determinants of Working Capital
A firm should have neither too much nor too little working capital. The working capital requirement is determined by a large number of factors but, in general, the following factors influence the working capital needs of an enterprise :-

1. Nature of Business : Working capital requirements of an enterprise are largely influenced by the nature of its business. For instance, public utilities such as railways, transport, water, electricity etc. have a very limited need for working capital because they have to invest fairly large amounts in fixed assets.

Their working capital need is minimal because they get immediate payment for their services and do act have to maintain big inventories. On the other extreme are the trading and financial enterprise which have to invest less amount in fixed assets and a large amount in working capital.

This is so because the nature of their business is such that they have to maintain a sufficient amount of cash, inventories and debtors. Working capital needs of most of the manufacturing enterprises fall between these two extremes, that is, between public utilities and trading concerns.

2. Size of Business : Larger the size of the business enterprise, greater would be the need for working capital, The size of a business may be measured in terms of scale of its business operations.

3. Growth and Expansion : As a business enterprise grows, it is logical to expect that a larger amount of working capital will be required. Growing industries require f more working capital than those that are static.

4. Production Cycle : Production cycle means the time span between the purchase of raw materials and its conversion into finished goods. The longer the production cycle, the larger will be the need for working capital because the funds will be tied up for a longer period in work in process. If the production cycle is small, the need for working capital will also be small.

5. Business Fluctuations : Business fluctuations may be in the direction of boom and depression. During boom period the firm will have to operate at full capacity to meet the increased Remand which in turn, leads to increase in the level of inventories and book debts. Hence, the need for working capital in boom conditions is bound to increase. The depression phase of business fluctuations has exactly a opposite effect on the level of working capital requirement.

6. Production Policy : The need for working capital is also determined by production . policy. The demand for certain products (such as woolen garments) is seasonal. Two types of production policies may be adopted for such products. Firstly, the goods may be produced in the months of demand and secondly, the goods may be produced throughout the year.

If the second alternative is adopted, the stock of finished goods will accumulate progressively upto the season of demand which requires an increasing amount of working capital that remains tied up in the stock of finished goods for some months.”

7. Credit Policy Relating to Sales : If a firm adopts liberal credit policy in respect of sales, the amount tied up in debtors will also be higher. Obviously, higher book debts mean more working capital. On the other hand, if the firms follows tight credit policy, the magnitude of working capital will decrease.

8. Credit Policy Relating to Purchase : If a firm purchases more goods on credit, the requirement for working capital will be.less. In the other words, if liberal credit terms are available from the suppliers of goods (i.e. creditors) the requirement for working capital will be reduced and vice versa.

9. Availability of Raw Material : If the raw material required by the firm is available easily on a continuous basis, there will be no need to keep a large inventory of such material and hence the requirement of working capital will be less. On the other hand, if the supply of raw material is irregular, the firm will be compelled to keep an excessive inventory of such materials which will result in high level of working capital.

Also, some raw materials are available only during a particular season such as oil seeds, cotton, etc. They would have to be necessarily purchased in the season and have to be kept in stock for a period when supplies are lean. This will require more working capital.

Question 2.
Capital structure decision is essentially optimisation of risk-return relationship. Comment.
Importance of Capital Structure Capital structure decision is one of the strategic decisions taken by the financial management. Considerable attention is required to decide the mix up of various sources of finance.

A judicious and right capital structure decision reduces the cost of capital and increases the value of a firm while a wrong decision can adversely affect the value of the firm. As discussed earlier, various sources of finance differ in terms of risk and cost. Hence, there is utmost need of designing an appropriate capital structure.

Capital structure decisions are of great significance due to the following reasons
(i) Capital structure determines the risk assumed by the firm.
(ii) Capital structure determines the cost of capital of the firm.
(iii) If affects the flexibility and liquidity of the firm.
(iv) It affects the control of owners on the firm.

Optimum Capital Structure : The capital structure which maximises the value of the firm is called optimum capital structure. In other words, the capital structure is said to be optimum when cost of capital is minimum and total value of the firm is maximum. Hence, in the order to achieve the objective of maximisation of shareholder’s wealth, the financial manager should determine an optimum capital structure for the firm. Following are the benefits of capital structure

1. Minimum Risk : Capital structure should ensure minimum risk. The use of excessive debt threatens the solvency of the firm because it involves a fixed commitment to pay the interest irrespective of the profits. Debt should be used to the extent it does not add significant risk. Beyond this, the use of debt should be avoided.

2. Minimum cost of Capital : Cost of capital means interest on debts or divident on shares. Debt is a cheaper source of finance in comparison to equity capital because rate of interest is lower than the return expected by equity shareholders and the tax deductibility of interest further reduces the cost of debts. The preference share capital is also cheaper than equity capital, but not as cheap as debt. Thus, optimum capital structure should include sufficient amount of debt since it is the cheapest source of finance.

3. Sufficient liquidity : Liquidity means the ability of the firm to pay interest as well as principal in time. A firm is considered liquid if it is able to pay the interest and principal under reasonably predicted adverse conditions. Hence, while determining the optimum amount of debt it should be carefully analysed as to how a firm’s liquid Will be maintained under recession conditions.

4. Maximum Profitability : Capital structure of the company must provide maximum return to equity’ shareholders. If there is a probability of earning higher return on company’s assets in comparison to the cost of debt, a large amount of debt can be used by the firm to maximise its profitability, otherwise the firm should refrain frc n employing debt capital. .

5. Retaining control : Capital structure should help the present management in retaining the control the company. For this purpose debt should be preferred in comparison to issue of equity capital while raising further funds. Debt . holders do not possess voting rights in company’s meetings and hence cannot elect the directors of the company whereas equity shareholders possess voting rights.

6. Avoidance of Unnecessary Restrictions : Capital structure should avoid unnecessary restrictions on the firm. For instance, term loans from financial institutions should be avoided because these institutions impose a number of restriction on further borrowing of the company.

Question 3.
A capital budgeting decisions is capable of changing the financial fortune of a business. Do you agree? Why or why not?
The most important function of financial management is not only the procurement of external funds for the business but also to make efficient and wise allocation of these funds. The allocation of funds means the investment of funds in various assets and other activities. It is also known as ‘Investment Decision’, because a choice is to be made regarding the assets in which funds will be invested.

The assets which can be acquired fall into two broad categories
(i) Short-term or Current Assets
(ii) Long-term or Fixed Assets

Accordingly, we have to take two types of investment decisions.
First type of investment decisions related to the short-term assets are ‘ called short-term investment decisions or current assets management. These are popularly termed as working capital management.

Second type of investment decisions related to long-term assets are called long-term investment decisions. These are widely known as capital budgeting or capital expenditure decisions.

Nature of Capital Budgeting
Nature includes meaning and feature of capital budgeting.

Meaning of Capital Budgeting
Capital budgeting is the technique of making decisions for investment in long-term assets. It is a process of deciding whether or not to invest the funds in a particular asset, the benefit of „which will be available over a period of time longer than one year.

“Capital budgeting consists in planning the deployment of available capital for the purpose of maximizing the long-term profitability of the firm.” – R. M. Lynch

“Capital budgeting involves the planning of expenditure for assets, the returns from which will be realized in future time periods. – Milton H. Spencer

Thus, a capital budgeting decision may be defined as the firm’s decision to invest its funds in the long-term assets in anticipation of an expected flow of benefits over the lifetime of the asset. These benefits may be either in the form of increased sales or reduced costs. Capital budgeting decisions generally include decisions regarding expansion, acquisition, modernisation and replacement of the long term assets.

Features of Capital Budgeting Decisions

The main features of the capital budgeting may be summarised as follows :-
1. Funds are invested in long-term assets.
2. Funds are invested in present times anticipation of future profits.
3. The future profits will occur to the firm over a series of year.
4. Capital budgeting decisions involve a high degree of risk because future benefits are not certain.

Importance of Capital Budgeting

Capital budgeting decisions are of paramount importance in financial decision making. The following reasons make such decisions very important:

1. Such Decisions Affect the Profitability of the Firm: Capital budgeting decisions affect the long-term Profitability of a
firm because of the fact that they relate to fixed assets.

The fixed assets, in a sense, reflect the true earning capacity of the firm. They enable a firm to produce finished goods which is ultimately sold for profit. Hence, a correct investment decision can yield spactacular profits, whereas, an ill-advised and incorrect decision can endanger the very survival of the firm.

2. Long Time Periods: The effect of a capital budgeting decision will be felt by the firm over a long time span, and thu%-affects the future cost structure of the firm. To illustrate, if a compa% purchase a new plant to manufacture a new product, the company  have to incur a sizable amount of fixed costs, in terms of labour, supervisor’s salary, insurance, rent of building etc.

If, in future, the products turns out to be unsuccessful or if it yields (ess profit than anticipated, the company will have to bear the burden of heavy fixed costs. Hence, the future costs, sales and profits will all be determined by the capital budgeting decisions.

3. Irreversible Decisions : Capital budgeting decisions, once taken, are not easily reversible without heavy financial loss to the firm. This is because it is very difficult to sell the second hand plant.

4. Involvement of large Amount of Funds : Capital budgeting decisions require large amount of funds and most of the firms have limited .financial, resources. Hence, it is absolutely necessary to take thoughtful and correct investment decisions because an incorrect decision would not only result in losses but also prevent the firm from earning profits from the alternative investments which had to be dropped because of thq paucity of funds.

5. Risk: Investment in fixed assets may change the risk complexion of the firm. This is because different capital investment proposals have different degree of risk. If thev adoption of an investment proposal increases average gain, but causes frequent fluctuations in the profits of the firm, the firm will become more risky. As such, investment decisions shape the basic character of a firm

6. Most difficult to make : These decisions are among the most difficult decisions to be taken by a firm. This is, because they ire an assessment of future events which are uncertain and difficult to predict. For example, estimating the future cash inflows and life of the project is really a complex problem.

Kinds of Capital Budgeting Decisions : A firm may have various investment proposals for its consideration, it may select all of them, one of them or some of them depending upon the various types of proposals

(i) Accept-Reject Decisions : This is a fundamental decision in capital budgeting. Proposal (or project) is accepted, the firm would invest in it and if the proposal is rejected, the firm would not invest in it. In general, all those proposals (or projects) which yield a rate of return higher than a certain required rate of return are accepted and the rest are rejected.

By applying this criterion, all independent proposals are either accepted or rejected. Independent proposals are those which do not compete with one another and all proposals can be accepted simultaneously. Hence, all independent proposals which satisfy the minimum investment criterion should be implemented.

(ii) Mutually Competitive Decisions : These are related to the proposals which compete with other projects in such a way that the acceptance of one will automatically result in the rejection of others. For example, a company is considering two sites X and Y for the construction of its plant. It site X is selected, site Y will be automatically rejected.

(iii) Priority Order Decisions In case where a firm has unlimited funds, all those independent projects are accepted which yield a higher cate of return as against some predetermined rate. However, in actual practice most of the firms have limited funds. The firm, therefore, must fix a priority order for investing these funds.

The firm allocates funds to various x projects in a manner that the long term profits are maximised. The priority of projects will be determined on the basis of a pre¬determined criterion such as the rate of return. In this way, the projects yielding the maximum return will be selected and all other projects will be rejected.

Question 4.
Explain factors affecting the dividend decision.
The following are the factors which generally affect the dividend policy of a firm

1. Financial Needs of the Firm : Financial needs of a firm are directly related to the investment opportunities available to it. If a firm has abundand profitable investment opportunities, it will adopt a policy of distributing lower dividends. It would like to retain a large part of its earnings because it can reinvest them at a higher rate than the shareholder can.

Other reason for retaining the earnings is, that, issuing new share capital is inconvenient as well as involves flotation costs. On the other hand, if the firm has little or no investment opportunities, it should retain only a small portion of its earnings and should distribute the rest as dividends.

2. Stability’ of Dividends : Investors always prefer a stable dividend policy. They expect that they should get a fixed amount as dividends which should increase gradually over the years. Hence while determining the dividend policy, the merits of stability of dividends like investor’s desire for current income, resolution of investor’s uncertainly, requirement of institutional investors etc. should be given due consideration.

3. Legal Restrictions : The firm’s dividend policy has to be formulated within the legal provisions and restrictions. For instance, section 205 of the Indian Companies Act provides that dividend shall be paid only out of the current profits or past profits after providing for depreciation.

Like wise, if there are past accumulated losses, they must be first set off against current year’s profits before the declaration of any dividend. , Similarly, a firm is prohibited from declaring any dividends if its ‘ libilities exceed its assets.

4. Restrictions in Loan Agreements : Lenders, mostly the financial institutions, put certain restrictions on the payment of dividend to safeguard their interests. For instance, a loan agreement may prohibit the payment of any dividend as long as the firm’s current ratio is less than, say, 2:1 or debt equity ratio is more than, say 1.5:1.

They may allow the payment of dividend only when some minimum amount has been transferred to a sinking fund established for the redemption of their debt. Likewise they may prohibit the payment of dividends in excess of a certain percentage, say, 10%. Alternatively, they may fix the maximum limit of profits that may be used for dividend, say not more than 40% of the net profits can be paid as dividends. When such restrictions are put, the company will have to keep a low dividend payout ratio.

5. Liquidity : Payment of dividend causes sufficient outflow of cash. Although a firm may have adequate profits, it may not have enough cash to pay the dividends. It may happen when most of the sales are on credit and firm’s cash resources have been utilized in the expansion of assets or payment of its liabilities.

This situation is common for growing firms which need funds for their expanding activities and permanent working capital. Thus, the cash position is a significant factor in determining the size of dividends. Higher the cash and overall liquidity position of a firm, higher will be its ability to pay dividends.

6. Access to Capital Market : A company which is not sufficiently liquid can still pay dividends if it has easy acessibility to the capital market. In other Words, if a company is able to raise debt or equity in the capital market, it will be able to pay dividends even if its liquidity position is not good.

While evaluating the ability to raise funds in the capital market, the cost of funds and the promptness with which funds can be raised must be considered. Usually, mature firms have greater acess to capital market than the new firms.

7. Stability of Earnings : Stability of earnings also has a significant effect on the dividend policy of a firm. Normally, the greater the stability of earnings, greater will be the dividend payout ratio.

The reason is, that such firms are more confident of maintaining the higher dividends from year to year. For instance, the earnings of public utility companies are relatively stable and hence their dividend payout ratio is usually high.

8. Objective of Maintaining Control : Sometimes the present management employs dividend policy to retain control of the company in its own hands. When a company pays larger dividends, its liquidity position is adversely affected and it may have to issue new shareto raise funds to finance its investment opportunities.

If the existing shareholders do not want or cannot purchase the new shares, their control over the company will be diluted. Under such circumstances, the management will declare lower dividends and earnings will be retained to finance the investment opportunities.

9. Effect on Earning Per Share : As discussed above, high dividend payout ratio affects the liquidity posi tion adversely and may necessitate the issue of new equity shares in the near future, causing an increase in the number of equity shares and ultimately the earning per share may reduce. On the other hand, by keeping a low dividend payout ratio the firm can retain and plough back larger portion of its earnings resulting in increase in future and thereby an increase in earning per share.

10. Firm’s Expected Rate of Return : If the firm’s expected rate of return would be less than the rate which could be earned by the shareholders themselves from external investment of their funds, the firm should retain smaller part of its earnings and should opt for a higher dividend payout ratio.

11. Inflation : Inflation may also act as a constraint on paying larger dividends. Depreciation is charged on the original cost of the asset and as a result, when there is an increase in price level, funds generated from depreciation’ become inadequate to replace the obsolete assets.-

Consequently, companies will have to retain more of its earnings to provide funds to replace the assets and hence their dividend payout ratio will be low during periods of inflation.

12. General State of Economy : Earnings of a firm are subject to general economic conditions of the country. If the future economic conditions are uncertain, it may lead to retention of larger part of the earnings of a firm to absorb any eventuality. Likewise, in the event of depression, when the level of business activity is very low,’the management may reduce the dividend payout ratio to preserve its liquidity position. All the above factors must be carefully considered before formulating a dividend policy.

Question 5.
Explain the term ’Trading on Equity’. Why, when and how it can be used by a business organisation?
Trading on Equity : The use of fixed cost sources of finance, such as debts and preference share capital is termed as trading on equity or financial leverage. In case the assets acquired from the debt funds yield a return greater than the cost of debts, the profits available to equity shareholders or the earning per share (EPS) will increase.

EPS will also increase by the use of preference share capital but it will increase more in case of use of debt because the interest paid oil debt is deductible from profits while calculating the tax. Hence, the alternative methods of financing must be analysed by the management to examine their effect on E.P.S. To Illustrate :

Suppose that a firm has an all-equity capital structure consisting of 2,00,000 equity shares of Rs. 10 each. The firm now desire to raise Rs. .5,00,000 to acquire additional and is considering three alternative methods of financing :

(i) to issue 50,000 equity shares of Rs. 10 each, or

(ii) to raise a debt of Rs. 5,00,000 at 12% rate of interest, or

(iii) to issue 5,000 preference shares of Rs. 100 each at 12% rate of dividend . If the firm’s earnings before interest and taxes after additional assets acquire are Rs. 8,00,000 and the tax rate is 40% the effect on the earning per share under the three alternatives will be as follows

It is clear from the above example that the firm will be able to maximise its EPS when it uses debt financing. But the debt financing will have an adverse effect on EPS if the company is not able to earn a rate of return on its assets greater than the interest rate on debt.

Case Problems

1.’S’ Limited is manufacturing steel at its plant in India. It is enjoying a buoyant demand for its products as economic growth is about 7%-8% and the demand for steel is growing. It is planning to set up a new steel plant to cash on the increased demand it is facing. It is estimated that it will require about Rs. 5000 crores to set up and about Rs. 500 crores of working capital to start the new plant.

Question 1.
What is the role and objectives of financial management for this company?
As we know that Financial Management is concerned with optimal procurement as well as usage of finance. The financial management of this company, for optimal procurement, identify the different available sources of finance and compare them in terms ; of their costs and associated risks.

It aims at reducing the cost of funds procured, keeping the risk under control and achieving effective deployment of such funds. It also aims at ensuring availability of enough funds whenever required as well as avoiding idle finance. It is very much clear that the overall financial health of a business is determined by the quality of company’s financial management.

The main objective of financial management of this company is to maximise share holder’s wealth. In fact, in all financial decisions, major or minor, the ultimate objective that guides the decision-maker is that some value addition should take place so that the market price of equity shares is maximised. It should select best financing alternative to collect Rs. 5000 crores to set up and 500 crores as F working capital.

Question 2.
What is the importance of having a financial plan for this company? Give an imaginary plan to support your answer.
Financial planning is essentially preparation of a financial blue print of an organisation’s future operations. The objective of financial planning is to ensure that enough funds are available at right time’Financial plan is an important part of overall planning of any business enterprise. It aims at enabling the company to tackle the uncertainty in respect of the availability and timing of the funds and helps in smooth functioning of an organisation.

The financial plan for this company tries to forecast what may happen in future under different business situation, so that company face the eventual situation in a better way. It makes the firm better prepared to face the future. It also helps company in avoiding business shocks and surprise.

By providing cleat policies and procedures, it helps company in coordinating various functions. It reduces waste, duplications of efforts and gaps in planning. It also provides continuous line between investment and financing decisions.

Question 3.
What are the factors, which will affect capital structure of this company?
One of the important decisions under financial management of this company is to relates to the financing pattern or the proportion of the use of different sources in raising funds. On the basis of  ownership the sources of business finance can be broadly classified into two categories viz ‘owner funds’ and ‘borrowed funds’.

Capital structure refers to the mix between owners and borrowed funds. Deciding about the capital structure of a company involves determining the relative proportion of various types of funds. This depends upon various factors, which are following :

• Cash Flow Statement
• Interest Coverage Ratio (ICR)
• Debt Service Coverage Ratio (DSCR)
• Return on Investment (ROl)
• Cost of debt
• Tax Rate
• Cost of Equity
• Floatation Costs
• Risk Consideration
• Flexibility
• Control
• Regulatory Framework
• Stock Market Conditions
• Capital structure of other Companies.

Question 4.
Keeping in mind that it is a highly capital intensive sector what factors will affect the fixed and working capital. Give reasons with regard to both in support of your answer.
As it is a highly capital intensive sector, there are so many factors that will affect the fixed and working capital of this company which are following:

Factors affecting the Fixed Capital :

1. Nature of Business As, it is a manufacturing company of steel, it needs huge fixed capital as compared to trading.concern.

2. Scale of Operations It is a large organisation operating at a higher scale needs bigger plant, more space etc. and therefore, requires higher investment in fixed assets when compared with the small organisations. ,

3. Technique of Operations It is a highly capital intensive organisation, so it requires higher investment in plant and machinery, which require high fixed capital.

4. Growth Prospects Higher growth of an organisation generally requires higher investment in fixed assets. ‘S’ Limited is growing fast and expected to grow more so it requires huge fixed capital.

5. Financing Alternative If a company’s management arranged some fixed assets on lease or rent, then it requires less fixed capital otherwise it requires large sum of fixed capital.

Factors affecting the working capital

1. Nature of Business The requirement of working capital of
this type of large manufacturing concern is very big.

2. Scale of Operations For organisations which operate on a higher scale of operation, the quantum of inventory, debtors required is generally high. Such organisations, therefore requires large amount of working capital. ‘

3. Production cycle Steel plant at this large scale has-a long production cycle, so it requires the large sum of working capital.

4. Credit Policy The credit policy of these industries, very much affects the working capital of the company. It takes long period to receive their due, so it requires large sum of working capital to run day to day operations.

5. Availability of Raw Material If the raw materials and other required materials are available freely and continuously, lower stock levels may suffice. Higher the read time, higher the quantity of material to be stored and higher is the amount of working capital requirement.

6. Growth Prospects The growth potentials of this steel plant of’S’ Ltd. is perceived to be higher, it will require higher amount of working capital so that is able to meet higher production and sales , target whenever required.

Project Work

Question 1.
Pick up annual reports of 2 or more companies engaged . in the same line of business. You can access this data on the respective web sites of the companies and other sources. Compare their capital structures. Analyse the reasons for the difference. You can also use ratio analysis for this. Prepare a report of your findings and discuss it in the class with the help of your teacher.