NCERT Solutions for Class 12th: Ch 9 Financial Management (Long Answer Questions)
Exercises
Page No. 263
Long Answer Type Questions
1. What is meant by working capital? How is it calculated? Discuss five important determinants of working capital requirements.
Answer
Working capital is that part of total capital which is required to meet day to day expenses and to pay wages and other activities of the organisation and also help to run our business smooth.
It is calculated by
Working capital = Current assets – Current liabilities.
Five important determinants of working capital requirements-
1. Nature of business: The nature of business influences the amount of working capital required. For example trading organisation usually needs a smaller amount of working capital as compared to manufacturing organisation. because in trading organisation there is no need of processing, no need of any raw material, and no long procedure for sales and marketing where as in manufacturing business raw material converted in to finished goods before any sales become possible.
2. scales of operations : Those organisations which operate on higher scale of operation , needs a more working capital because the quantum of inventory and debtors required is generally high ,where as those organisation which operate on a lower scale needs less working capital.
3. Business cycle: Working capital is depends on phase of a business cycle. In case of a boom, the sales as a well as production are likely to be larger so, large amount of working capital required. And the period of depression, the sales as well as production will be small, so lower amount of working capital required.
4. Seasonal factors: working capital depends on a seasonal factor because in peak season higher level of activity, larger amount of working capital is required and in during the lean season requirement of working capital and activities are low.
5. Production cycle: some businesses have a longer production cycle and some have a shorter production cycle. Duration of production affect the working capital because length of production cycle, affect the amount of funds required for raw material and expenses. So, working capital requirement is higher in firm with longer processing cycle and lower in firms with a shorter processing cycle.
6. Credit allowed: Different firms allow different credit terms to their customers. A liberal credit policy results in higher amount of debtors, increasing the requirements of working capital.
7. Credit Availed: Just as a firm allows credit to its customers it also may get credit from its suppliers. The more credit a firm avails on its purchases, the working capital requirement is reduced.
2."Capital structure decision is essentially optimisation of risk- return relationship." Comment.
Answer
Capital Structure refers to the combination of different financial sources used by a company for raising funds. The sources of raising funds can be classified on the basis of ownership into two categories as borrowed funds and owners’ fund. Borrowed funds are in the form of loans, debentures, borrowings from banks, public deposits, etc. On the other hand, owners’ funds are in the form of reserves, preference share capital, equity share capital, retained earnings, etc. Thus, capital structure refers to the combination of borrowed funds and owners’ fund. For simplicity, all borrowed funds are referred as debt and all owners’ funds are referred as equity. Thus, capital structure refers to the combination of debt and equity to be used by the company. The capital structure used by the company depends on the risks and returns of the various alternative sources.
Both debt and equity involve their respective risk and profitability considerations. While on one hand, debt is a cheaper source of finance but involves greater risk, on the other hand, although equity is comparatively expensive, they are relatively safe.
The cost of debt is less because it involves low risk for lenders as they earn an assured amount of return. Thereby, they require a low rate of return which lowers the costs to the firm. In addition to this, the interest on debt is deductible from the taxable income (i.e. interest that is to be paid to the debt security holders is deducted from the total income before paying the tax). Thus, higher return can be achieved through debt at a lower cost. In contrast, raising funds through equity is expensive as it involves certain floatation cost as well. Also, the dividends are paid to the shareholder out of after tax profits.
Though debt is cheaper, higher debt raises financial risk. This is due to the fact that debt involves obligatory payments to lenders. Any default in payment of the interest can lead to the liquidation of the firm. As against this, there is no such compulsion in case of dividend payment to shareholders. Thus, high debt is related to high risk.
Another factor that affects the choice of capital structure is the return offered by various sources. The return offered by each source determines the value of earning per share. High use of debt increases the earning per share of a company (this situation is called Trading on Equity). This is because as debt increases the difference between Return on Investment and the cost of debt increases and so does the EPS. Thus, there is a high return on debt. However, even though higher debt leads to higher returns but it also increases the risk to the company.
Therefore, the decision regarding the capital structure should be taken very carefully, taking into consideration the return and risk involved.
3. A capital budgeting decision is capable of changing the financial fortune of a business. Do you agree? Why or why not?
Answer
Yes, I agree a capital budgeting is capable of changing the financial fortune of a business because a long term investment decision is called a capital budgeting decision and long term investment affect our business.
There are certain factors which affect our capital budgeting decisions –
Cash flows of the project- when a company takes an investment decision involving huge amount to generate some cash flows over a period. These cash flows are in the form of a series of a cash receipt and payment over the life of an investment. The amount of these cash flows analysed before considering capital budgeting decisions.
The rate of return: The most important criterion is the rate of return of the project. These calculations are based on the expected returns from each proposal and assessment of the risk involved.
The investment criteria involved: the decision to invest in a particular project involves a number of calculations regarding the amount of investment, interest rate, cash flow and rate of return.
Above discussed decision are very important for any business. They affect its earning capacity over the long-run, assets of a firm, profitability and competitiveness, are all affected by the capital budgeting decisions. Moreover, these decisions normally involve huge amounts of investment and are irreversible except at a huge cost. Therefore, once made, it is almost impossible for a business to wriggle out of such decisions. Therefore, they need to be taken with utmost care. These decisions must be taken by those who understand them comprehensively. A bad capital budgeting decision normally has the capacity to severely damage the financial fortune of a business.
4. Explain the factors affecting the dividend decision.
Answer
Dividend decision of a company deals with what portion of the profit is to be distributed as dividend between the shareholder and what portion is to be kept as retained earnings.
The factors affecting the dividend decision
• Amount of earnings: dividends are paid out of current and past earning. So earning s of amount will affect our dividend decision because a company having higher earnings will be in a position to pay a higher amount of dividend to its shareholders. In contrast to this, a company having low or limited earnings would distribute low dividends among shareholder.
• Stability earning: when a company having a stable earning is in a better position to declare higher dividends and when a company having unstable earning position they declare smaller dividend.
• Stability of dividend: Companies generally follow the practice of stabilising their dividend per share. They try to avoid frequent fluctuations in dividend per share and opt for increasing (or decreasing) the value only when there is a consistent rise (or fall) in the earnings of the company.
• Growth opportunities: companies having good growth opportunities retain more money out of their earnings so as to finance the required investment.so, dividend in growth companies is smaller than non-growth companies.
• Cash flow position: if a company is low on cash then the dividend will be lower as compared to the company which has more liquidity. So dividend totally depends on cash flow even a company has high profit, it will not be able to distribute high dividends if it does not have enough cash.
• Shareholders’ preference: while declaring a dividend, companies must keep in mind the preference of the shareholders. If the shareholder in general desires that at least a certain amount should be paid as dividend because there are always some shareholders who depend upon a regular income from their investment.
• Taxation policy: if tax on dividend is higher than company pay less dividend and when the company pay lower tax than they pays a higher dividend to the shareholders.
• Stock Market Reaction: if an increase in dividend and stock prices is good and taken positively. Similarly, a decrease in dividend may have negative impact on the share price in the stock market. So, it is important factors considered by the management while taking a decision about a dividend decision.
• Access to Capital Market: Large and reputed companies generally have easy access to the capital market and therefore, depend less on retained earnings to finance their growth. These companies tend to pay higher dividends than the smaller companies which have relatively low access to the market.
• Legal constraints: some rules and regulation of the company act which restrict to pay as dividend. Such provisions must be kept in mind while declaring the dividend.
• Contractual constraints: while granting a loan to a company. Sometimes, the lender may impose certain restrictions on the payment of dividend in the future. On that time companies may ensure that dividend does not violate the terms of the loan agreement.
5. Explain the term ‘Trading on Equity’. Why, when and how it can be used by a company?
Answer
Page No. 263
Long Answer Type Questions
1. What is meant by working capital? How is it calculated? Discuss five important determinants of working capital requirements.
Answer
Working capital is that part of total capital which is required to meet day to day expenses and to pay wages and other activities of the organisation and also help to run our business smooth.
It is calculated by
Working capital = Current assets – Current liabilities.
Five important determinants of working capital requirements-
1. Nature of business: The nature of business influences the amount of working capital required. For example trading organisation usually needs a smaller amount of working capital as compared to manufacturing organisation. because in trading organisation there is no need of processing, no need of any raw material, and no long procedure for sales and marketing where as in manufacturing business raw material converted in to finished goods before any sales become possible.
2. scales of operations : Those organisations which operate on higher scale of operation , needs a more working capital because the quantum of inventory and debtors required is generally high ,where as those organisation which operate on a lower scale needs less working capital.
3. Business cycle: Working capital is depends on phase of a business cycle. In case of a boom, the sales as a well as production are likely to be larger so, large amount of working capital required. And the period of depression, the sales as well as production will be small, so lower amount of working capital required.
4. Seasonal factors: working capital depends on a seasonal factor because in peak season higher level of activity, larger amount of working capital is required and in during the lean season requirement of working capital and activities are low.
5. Production cycle: some businesses have a longer production cycle and some have a shorter production cycle. Duration of production affect the working capital because length of production cycle, affect the amount of funds required for raw material and expenses. So, working capital requirement is higher in firm with longer processing cycle and lower in firms with a shorter processing cycle.
6. Credit allowed: Different firms allow different credit terms to their customers. A liberal credit policy results in higher amount of debtors, increasing the requirements of working capital.
7. Credit Availed: Just as a firm allows credit to its customers it also may get credit from its suppliers. The more credit a firm avails on its purchases, the working capital requirement is reduced.
2."Capital structure decision is essentially optimisation of risk- return relationship." Comment.
Answer
Capital Structure refers to the combination of different financial sources used by a company for raising funds. The sources of raising funds can be classified on the basis of ownership into two categories as borrowed funds and owners’ fund. Borrowed funds are in the form of loans, debentures, borrowings from banks, public deposits, etc. On the other hand, owners’ funds are in the form of reserves, preference share capital, equity share capital, retained earnings, etc. Thus, capital structure refers to the combination of borrowed funds and owners’ fund. For simplicity, all borrowed funds are referred as debt and all owners’ funds are referred as equity. Thus, capital structure refers to the combination of debt and equity to be used by the company. The capital structure used by the company depends on the risks and returns of the various alternative sources.
Both debt and equity involve their respective risk and profitability considerations. While on one hand, debt is a cheaper source of finance but involves greater risk, on the other hand, although equity is comparatively expensive, they are relatively safe.
The cost of debt is less because it involves low risk for lenders as they earn an assured amount of return. Thereby, they require a low rate of return which lowers the costs to the firm. In addition to this, the interest on debt is deductible from the taxable income (i.e. interest that is to be paid to the debt security holders is deducted from the total income before paying the tax). Thus, higher return can be achieved through debt at a lower cost. In contrast, raising funds through equity is expensive as it involves certain floatation cost as well. Also, the dividends are paid to the shareholder out of after tax profits.
Though debt is cheaper, higher debt raises financial risk. This is due to the fact that debt involves obligatory payments to lenders. Any default in payment of the interest can lead to the liquidation of the firm. As against this, there is no such compulsion in case of dividend payment to shareholders. Thus, high debt is related to high risk.
Another factor that affects the choice of capital structure is the return offered by various sources. The return offered by each source determines the value of earning per share. High use of debt increases the earning per share of a company (this situation is called Trading on Equity). This is because as debt increases the difference between Return on Investment and the cost of debt increases and so does the EPS. Thus, there is a high return on debt. However, even though higher debt leads to higher returns but it also increases the risk to the company.
Therefore, the decision regarding the capital structure should be taken very carefully, taking into consideration the return and risk involved.
3. A capital budgeting decision is capable of changing the financial fortune of a business. Do you agree? Why or why not?
Answer
Yes, I agree a capital budgeting is capable of changing the financial fortune of a business because a long term investment decision is called a capital budgeting decision and long term investment affect our business.
There are certain factors which affect our capital budgeting decisions –
Cash flows of the project- when a company takes an investment decision involving huge amount to generate some cash flows over a period. These cash flows are in the form of a series of a cash receipt and payment over the life of an investment. The amount of these cash flows analysed before considering capital budgeting decisions.
The rate of return: The most important criterion is the rate of return of the project. These calculations are based on the expected returns from each proposal and assessment of the risk involved.
The investment criteria involved: the decision to invest in a particular project involves a number of calculations regarding the amount of investment, interest rate, cash flow and rate of return.
Above discussed decision are very important for any business. They affect its earning capacity over the long-run, assets of a firm, profitability and competitiveness, are all affected by the capital budgeting decisions. Moreover, these decisions normally involve huge amounts of investment and are irreversible except at a huge cost. Therefore, once made, it is almost impossible for a business to wriggle out of such decisions. Therefore, they need to be taken with utmost care. These decisions must be taken by those who understand them comprehensively. A bad capital budgeting decision normally has the capacity to severely damage the financial fortune of a business.
4. Explain the factors affecting the dividend decision.
Answer
Dividend decision of a company deals with what portion of the profit is to be distributed as dividend between the shareholder and what portion is to be kept as retained earnings.
The factors affecting the dividend decision
• Amount of earnings: dividends are paid out of current and past earning. So earning s of amount will affect our dividend decision because a company having higher earnings will be in a position to pay a higher amount of dividend to its shareholders. In contrast to this, a company having low or limited earnings would distribute low dividends among shareholder.
• Stability earning: when a company having a stable earning is in a better position to declare higher dividends and when a company having unstable earning position they declare smaller dividend.
• Stability of dividend: Companies generally follow the practice of stabilising their dividend per share. They try to avoid frequent fluctuations in dividend per share and opt for increasing (or decreasing) the value only when there is a consistent rise (or fall) in the earnings of the company.
• Growth opportunities: companies having good growth opportunities retain more money out of their earnings so as to finance the required investment.so, dividend in growth companies is smaller than non-growth companies.
• Cash flow position: if a company is low on cash then the dividend will be lower as compared to the company which has more liquidity. So dividend totally depends on cash flow even a company has high profit, it will not be able to distribute high dividends if it does not have enough cash.
• Shareholders’ preference: while declaring a dividend, companies must keep in mind the preference of the shareholders. If the shareholder in general desires that at least a certain amount should be paid as dividend because there are always some shareholders who depend upon a regular income from their investment.
• Taxation policy: if tax on dividend is higher than company pay less dividend and when the company pay lower tax than they pays a higher dividend to the shareholders.
• Stock Market Reaction: if an increase in dividend and stock prices is good and taken positively. Similarly, a decrease in dividend may have negative impact on the share price in the stock market. So, it is important factors considered by the management while taking a decision about a dividend decision.
• Access to Capital Market: Large and reputed companies generally have easy access to the capital market and therefore, depend less on retained earnings to finance their growth. These companies tend to pay higher dividends than the smaller companies which have relatively low access to the market.
• Legal constraints: some rules and regulation of the company act which restrict to pay as dividend. Such provisions must be kept in mind while declaring the dividend.
• Contractual constraints: while granting a loan to a company. Sometimes, the lender may impose certain restrictions on the payment of dividend in the future. On that time companies may ensure that dividend does not violate the terms of the loan agreement.
5. Explain the term ‘Trading on Equity’. Why, when and how it can be used by a company?
Answer
Trading on equity refers to a practice of raising the proportion of debt in the capital structure Such that the earning per share increases. A company resorts to trading on equity when the rate of return on investment is greater than the rate of interest on the borrowed fund. Trading on equity occurs when a corporation uses bonds and other debt.
| Company 'X' | Company 'Y' | |
| Share Capital | ₹10 lakhs | ₹ 6 lakhs |
| Loan@15%pa |
-
|
₹ 4 lakhs |
| ₹ 10 lakhs | ₹ 10 lakhs | |
| Profit before Interest + Tax | ₹ 3 lakhs | ₹ 3 lakhs |
| Interest |
Nil
|
₹ 0.09 lakhs |
| Profit before tax | ₹ 3 lakhs | ₹ 2.01 lakhs |
| Tax@50% | ₹ 1.5 lakhs | ₹ 1.05 lakhs |
| Profit after tax | ₹ 1.5 lakhs | ₹ 1.05 lakhs |
| No. Of equity shares | ₹ 10 lakhs | ₹ 4 lakhs |
| Rate of return on share |
15%
|
26.25%
|
It should be clear from the above example that shareholders of the company ‘X’ have a higher rate of return than company ‘Y’ due to loan component in the total capital of the company.
Case problem
‘S’ limited is manufacturing steel at its plant in India. It is enjoying a buoyant demand for its product 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 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. Describe the role and objective of financial management for this company.
Answer
The role and objective of the financial management for this company is:
(i) Managerial decisions relating to procurement of long term and short term funds
(ii) Keeping the risk associated with respect to procured funds under control.
(iii) Utilisation of funds in the most productive and effective manner
(iv) Fixed debt equity ratio in capital.
The main objective of the financial management is to maximize shareholders’ wealth which is
referred to as the wealth maximisation concept, and management also ensure that all the decision is efficient and adds some value. The investment decision, financial decision and dividend decision help an organisation to achieve this objective. In the given situation, S limited envisages growth prospects of steel industry due to the growing demand. To expand the production capacity, the company needs to invest. However, investment decision will depend on the availability of funds, the financing decision and the dividend decision. However, the company will take those financial decisions which result in value addition examples the benefits are more than the cost. This leads to an increase in the market value of the shares of the company.
2. Explain the importance of having a financial plan for this company. Give an imaginary plan to support your answer.
Answer
Financial planning is an important part of overall planning of any business organisation.
The importance of financial planning
• It helps in forecasting what may happen in future under different business situation.
• It helps in avoiding business shocks and surprises and helps the company in preparing for the future.
• It helps in co-ordinating various business functions, by providing clear policies and procedure.
• Detailed plans of action prepared under financial planning reduce waste, duplication of efforts, and gaps in planning.
• It tries to link the present with the future.
• It provides a link between investment and financing decisions on a continuous basis.
3. What are the factors which will affect the capital structure of this company?
Answer
Capital structure refers to the mix between owners fund and borrowed fund. Deciding about the capital structure of a firm involves determining the relative proportion of various types of fund. This depends on various factors which are cash flow position, interest coverage ratio, debt service coverage ratio.
The factor affecting the choice of capital structure:
1. cash flow position.
2. Interest coverage ratio.
3. Debt service coverage Ratio.
4. Return on investment.
5. Cost of debt.
6. Tax rate.
7. Cost of equity.
8. Floatation costs.
9. Risk consideration.
10. Flexibility.
11. Control.
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.
Answer
The working and fixed capital requirement of ‘S’ Limited will be high due to the following reasons
(i) Working capital depends on nature of business.
(ii) Higher scale of operation need higher level of working capital whereas operation is lower level need low working capital.
(iii) In case of steel industry, the major input is iron ore and coal. The ratio of cost of raw material to total cost is very high. Hence, higher will be the need for working capital.
(iv) The longer the operating cycle, the larger is the amount of working capital required as the funds get locked up in the production process for a long period of time.
(v) Terms of credit for buying and selling goods, discount allowed by suppliers and to the customers also determines the quantum of working capital.
Notes of Chapter 9 Financial Management