Sunday, November 05, 2017

Financial Management Solved Papers: Nov' 2016

2016 (November)
COMMERCE
(Speciality)
Course: 302
(Financial Management)
The figures in the margin indicate full marks for the questions
(New Course)
Full Marks: 80
Pass Marks: 24
Time: 3 hours
1. (a) Fill in the blanks:                                  1x4=4

a)      Financial function is the most important of all management functions.
b)      Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production.
c)       Cost of capital is the minimum rate of return expected by its investors.
d)      The value of the firm can be maximized, if the shareholders’ wealth is maximised.
(b) Write ‘True’ or ‘False’:                            1x4=4
a)      ‘Finance’ has been rightly termed as universal lubricant which keeps the enterprise dynamic.             True
b)      Working capital is also known as revolving or circulating capital.                          True
c)       Operating Leverage x Composite Leverage = Financial Leverage.                       False
d)      Payment of dividend at the usual rate is termed as regular dividend.                               True
2. Write short notes on any four of the following:                           4x4=16
a)      Financial forecasting and planning.
Ans: Financial Forecasting uses a set of techniques to determine the amount of additional financing a company will, or may, require in the future. It can also be a useful approach for assessing a new venture's profitability. Methods employed include, but are not limited to, assumptions, expectations, scenarios, sales percentage, and in addition there are more mathematical analytic methodologies, such as financial ratio based or regression analysis based forecasting. The concept explains the structured methodology that allows organisations to evaluate future financial needs. It also reviews how this technique is used to assess the amount of cash the company requires if a project develops more quickly or slowly than expected.
b)      Working capital management.
Ans: The capital required for a business is of two types. These are fixed capital and working capital. Fixed capital is required for the purchase of fixed assets like building, land, machinery, furniture etc. Fixed capital is invested for long period, therefore it is known as long-term capital. Similarly, the capital, which is needed for investing in current assets, is called working capital. The capital which is needed for the regular operation of business is called working capital. Working capital is also called circulating capital or revolving capital or short-term capital.
Working capital management involves the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.
c)       Capital budgeting decisions.
Ans: The investment decision, also known as capital budgeting, is concerned with the selection of an investment proposal/ proposals and the investment of funds in the selected proposal. A capital budgeting decision involves the decision of allocation of funds to long-term assets that would yield cash flows in the future. Two important aspects of investment decisions are:
(a) The evaluation of the prospective profitability of new investments, and
(b) The measurement of a cut-off rate against that the prospective return of new investments could be compared.
Future benefits of investments are difficult to measure and cannot be predicted with certainty. Risk in investment arises because of the uncertain returns. Investment proposals should, therefore, be evaluated in terms of both expected return and risk. Besides the decision to commit funds in new investment proposals, capital budgeting also involves replacement decision, that is decision of recommitting funds when an asset become less productive or non-profitable. The computation of the risk-adjusted return and the required rate of return, selection of the project on these bases, form the subject-matter of the investment decision.
Long-term investment decisions may be both internal and external. In the former, the finance manager has to determine which capital expenditure projects have to be undertaken, the amount of funds to be committed and the ways in which the funds are to be allocated among different investment outlets. In the latter case, the finance manager is concerned with the investment of funds outside the business for merger with, or acquisition of, another firm.
d)      Payback period method.
Ans: Payback period Method: It is one of the simplest methods to calculate period within which entire cost of project would be completely recovered. It is the period within which total cash inflows from project would be equal to total cash outflow of project. Here, cash inflow means profit after tax but before depreciation.
Merits of Payback period Method
a) This method of evaluating proposals for capital budgeting is simple and easy to understand, it has an advantage of making clear that it has no profit on any project until the payback period is over i.e. until capital invested is recovered. This method is particularly suitable in the case of industries where risk of technological services is very high.
b) In case of routine projects also, use of payback period method favours projects that generates cash inflows in earlier years, thereby eliminating projects bringing cash inflows in later years that generally are conceived to be risky as this tends to increase with futurity.
c) By stressing earlier cash inflows, liquidity dimension is also considered in selection criteria. This is important in situations of liquidity crunch and high cost of capital.
d) Payback period can be compared to break-even point, the point at which costs are fully recovered but profits are yet to commence.
e) The risk associated with a project arises due to uncertainty associated with cash inflows. A shorter payback period means that uncertainty with respect to project is resolved faster.
Limitations of payback period
a) It stresses capital recovery rather than profitability. It does not take into account returns from the project after its payback period.
b) This method becomes an inadequate measure of evaluating 2 projects where the cash inflows are uneven.
c) This method does not give any consideration to time value of money, cash flows occurring at all points of time are simply added.
d) Post-payback period profitability is ignored totally.
e)      Stable dividend policy.
Ans: Stable Dividend Policy: Stability of dividends means regularity in payment of dividends. It refers to the consistency in stream of dividends. In short, we can say that a stable dividend policy is a long term policy which is not affected by the variations in the earnings during different periods. The stability of dividends can take any one of the three forms:
a)      Constant D/P ratio.
b)      Constant dividends per share.
c)       Constant dividend per share plus extra dividends.
Merits of Stable Dividend Policy: Following are some of the advantages of a stable dividend policy:
a)      This policy contributes to stablise market value of company’s equity shares at a high level.
b)      This policy helps the company is mobilizing additional funds in the form of additional equity shares.
c)       Regular earnings in the form of dividend satisfy investors.
d)      This policy encourages shareholders to hold company’s share for longer time and simultaneously other investors are also attracted for the purchase of shares.
e)      This policy is helpful for expansion and growth prospects of a company.
f)       This policy encourages the institutional investors because they like to invest in those companies which make uninterrupted payment of dividends.
Demerits of Stable Dividend Policy: Following are some of the disadvantages of a stable dividend policy:
a)      Sometime despite of large earnings, management decides not to declare dividends.
b)      In this policy, instead of paying dividend in cash, bonus share are issued to the shareholders.
c)       This policy is used to capitalise reinvested earnings of the firm.

3. (a) “Maximization of profit is regarded as the proper objective of investment decisions, but it is not as exclusive as maximizing shareholders’ wealth” Comment.   14
Ans: Objectives of Financial Management
The firm’s investment and financing decision are unavoidable and continuous. In order to make them rational, the firm must have a goal. Two financial objectives predominate amongst many objectives. These are:
1. Profit maximization
2. Shareholders’ Wealth Maximization (SWM)
Profit maximization refers to the rupee income while wealth maximization refers to the maximization of the market value of the firm’s shares. Although profit maximization has been traditionally considered as the main objective of the firm, it has faced criticism. Wealth maximization is regarded as operationally and managerially the better objective. 
1. Profit maximization: Profit maximization implies that either a firm produces maximum output for a given input or uses minimum input for a given level of output. Profit maximization causes the efficient allocation of resources in competitive market condition and profit is considered as the most important measure of firm performance. The underlying logic of profit maximization is efficiency.
In a market economy, prices are driven by competitive forces and firms are expected to produce goods and services desired by society as efficiently as possible. Demand for goods and services leads price. Goods and services which are in great demand can command higher prices. This leads to higher profits for the firm. This in turn attracts other firms to produce such goods and services. Competition grows and intensifies leading to a match in demand and supply. Thus, an equilibrium price is reached. On the other hand, goods and services not in demand fetches low price which forces producers to stop producing such goods and services and go for goods and services in demand. This shows that the price system directs the managerial effort towards more profitable goods and services. Competitive forces direct price movement and guides the allocation of resources for various productive activities. 
Objections to Profit Maximization:
Certain objections have been raised against the goal of profit maximization which strengthens the case for wealth maximization as the goal of business enterprise. The objections are:
(a) Profit cannot be ascertained well in advance to express the probability of return as future is uncertain. It is not at all possible to maximize what cannot be known. Moreover, the return profit vague and has not been explained clearly what it means. It may be total profit before tax and after tax of profitability tax. Profitability rate, again is ambiguous as it may be in relation to capital employed, share capital, owner’s fund or sales. This vagueness is not present in wealth maximisation goal as the concept of wealth is very clear. It represents value of benefits minus the cost of investment.
(b) The executive or the decision maker may not have enough confidence in the estimates or future returns so that he does not attempt further to maximize. It is argued that firm’s goal cannot be to maximize profits but to attain a certain level or rate of profit holding certain share of the market or certain level of sales. Firms should try to ‘satisfy’ rather than to ‘maximise’.
(c)There must be a balance between expected return and risk. The possibility of higher expected yields are associated with greater risk to recognize such a balance and wealth maximisation is brought in to the analysis. In such cases, higher capitalization rate involves. Such combination of expected returns with risk variations and related capitalization rate cannot be considered in the concept of profit maximisation.
(d) The goal of maximisation of profits is considered to be a narrow outlook. Evidently when profit maximisation becomes the basis of financial decision of the concern, it ignores the interests of the community on the one hand and that of the government, workers and other concerned persons in the enterprise on the other hand.
(e) The criterion of profit maximisation ignores time value factor. It considers the total benefits or profits in to account while considering a project where as the length of time in earning that profit is not considered at all. Whereas the wealth maximization concept fully endorses the time value factor in evaluating cash flows. Keeping the above objection in view, most of the thinkers on the subject have come to the conclusion that the aim of an enterprise should be wealth maximisation and not the profit maximisation.
(f) To make a distinction between profits and profitability. Maximisation of profits with a view to maximizing the wealth of share holders is clearly an unreal motive. On the other hand, profitability maximisation with a view to using resources to yield economic values higher than the joint values of inputs required is a useful goal. Thus, the proper goal of financial management is wealth maximisation.
2. Shareholders’ Wealth Maximization: Shareholders’ wealth maximization means maximizing the net present value of a course of action to shareholders. Net Present Value (NPV) of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action that has a positive NPV creates wealth for shareholders and therefore, is desirable. A financial action resulting in negative NPV destroys shareholders’ wealth and is, therefore undesirable. Between mutually exclusive projects, the one with the highest NPV should be adopted. NPVs of a firm’s projects are additive in nature. That is
NPV(A) + NPV(B) = NPV(A+B)
The objective of Shareholders Wealth Maximization (SWM) considers timing and risk of expected benefits. Benefits are measured in terms of cash flows. One should understand that in investment and financing decisions, it is the flow of cash that is important, not the accounting profits. SWM as an objective of financial management is appropriate and operationally feasible criterion to choose among the alternative financial actions. 
Maximizing the shareholders’ economic welfare is equivalent to maximizing the utility of their consumption over time. The wealth created by a company through its actions is reflected in the market value of the company’s shares. Therefore, this principle implies that the fundamental objective of a firm is to maximize the market value of its shares. The market price, which represents the value of a company’s shares, reflects shareholders’ perception about the quality of the company’s financial decisions. Thus, the market price serves as the company’s performance indicator.
In such a case, the financial manager must know or at least assume the factors that influence the market price of shares. Innumerable factors influence the price of a share and these factors change frequently. Moreover, the factors vary across companies. Thus, it is challenging for the manager to determine these factors. 
WEALTH MAXIMIZATION AS PRIMARY OBJECTIVE OF FINANCIAL MANAGEMENT
The primary objective of financial management is wealth maximization. The concept of wealth in the context of wealth maximization objective refers to the shareholders’ wealth as reflected by the price of their shares in the share market. Therefore, wealth maximization means maximization of the market price of the equity shares of the company. However, this maximization of the price of company’s equity shares should be in the long run by making efficient decisions which are desirable for the growth of a company and are valued positively by the investors at large and not by manipulating the share prices in the short run. The long run implies a period which is long enough to reflect the normal market price of the shares irrespective of short-term fluctuations. The long run price of an equity share is a function of two basic factors:
a)      The likely rate of earnings or earnings per share (EPS) of the company; and
b)      The capitalization rate reflecting the liking of the investors of a company.
The financial manager must identify those avenues of investment; modes of financing, ways of handling various components of working capital which ultimately will lead to an increase in the price of equity share. If shareholders are gaining, it implies that all other claimants are also gaining because the equity share holders are paid only after the claims of all other claimants (such as creditors, employees, lenders) have been duly paid.
The following arguments are advanced in favour of wealth maximization as the goal of financial management:
a)      It serves the interests of owners, (shareholders) as well as other stakeholders in the firm; i.e. suppliers of loaned capital, employees, creditors and society.
b)      It is consistent with the objective of owners’ economic welfare.
c)       The objective of wealth maximization implies long-run survival and growth of the firm.
d)      It takes into consideration the risk factor and the time value of money as the current present value of any particular course of action is measured.
e)      The effect of dividend policy on market price of shares is also considered as the decisions are taken to increase the market value of the shares.
f)       The goal of wealth maximization leads towards maximizing stockholder’s utility or value maximization of equity shareholders through increase in stock price per share.
Criticism of Wealth Maximization: The wealth maximization objective has been criticized by certain financial theorists mainly on following accounts:
a)      It is prescriptive idea. The objective is not descriptive of what the firms actually do.
b)      The objective of wealth maximization is not necessarily socially desirable.
c)       There is some controversy as to whether the objective is to maximize the stockholders wealth or the wealth of the firm which includes other financial claimholders such as debenture holders, preferred stockholders, etc.
d)      The objective of wealth maximization may also face difficulties when ownership and management are separated as is the case in most of the large corporate form of organization. When managers act as agents of the real owners (equity shareholders), there is a possibility for a conflict of interest between shareholders and the managerial interests. The managers may act in such a manner which maximizes the managerial utility but not the wealth of stockholders or the firm.
Or
(b) What is finance function? Critically analyze the functions of financial manager in a large-scale industrial establishment.                                                                 2+12=14
Ans: MEANING OF FINANCE FUNCTION
Finance function is the most important of all business functions. It means a focus of all activities. It is not possible to substitute or eliminate this function because the business will close down in the absence of finance. The need for money is continuous. It starts with the setting up of an enterprise and remains at all times. The development and expansion of business rather needs more commitment for funds. The funds will have to be raised from various sources. The sources will be selected in relation to the implications attached with them. The receiving of money is not enough, its utilization is more important. The money once received will have to be returned also. It its use is proper then its return will be easy otherwise it will create difficulties for repayment. The management should have an idea of using the money profitably. It may be easy to raise funds but it may be difficult to repay them. The inflows and outflows of funds should be properly matched.
Role and Functions of Finance Manager
In the modern enterprise, a finance manager occupies a key position, he being one of the dynamic member of corporate managerial team. His role, is becoming more and more pervasive and significant in solving complex managerial problems. Traditionally, the role of a finance manager was confined to raising funds from a number of sources, but due to recent developments in the socio-economic and political scenario throughout the world, he is placed in a central position in the organisation. He is responsible for shaping the fortunes of the enterprise and is involved in the most vital decision of allocation of capital like mergers, acquisitions, etc. A finance manager, as other members of the corporate team cannot be averse to the fast developments, around him and has to take note of the changes in order to take relevant steps in view of the dynamic changes in circumstances.
The nature of job of an accountant and finance manager is different, an accountant's job is primarily to record the business transactions, prepare financial statements showing results of the organisation for a given period and its financial condition at a given point of time. He is to record various happenings in monetary terms to ensure that assets, liabilities, incomes and expenses are properly grouped, classified and disclosed in the financial statements. Accountant is not concerned with management of funds that is a specialised task and in modern times a complex one. The finance manager or controller has a task entirely different from that of an accountant, he is to manage funds. Some of the important decisions as regards finance are as follows:
1)      Estimating the requirements of funds: A business requires funds for long term purposes i.e. investment in fixed assets and so on. A careful estimate of such funds is required to be made.  An assessment has to be made regarding requirements of working capital involving, estimation of amount of funds blocked in current assets and that likely to be generated for short periods through current liabilities. Forecasting the requirements of funds is done by use of techniques of budgetary control and long range planning.
2)      Decision regarding capital structure: Once the requirements of funds is estimated, a decision regarding various sources from where the funds would be raised is to be taken. A proper mix of the various sources is to be worked out, each source of funds involves different issues for consideration. The finance manager has to carefully look into the existing capital structure and see how the various proposals of raising funds will affect it. He is to maintain a proper balance between long and short term funds. 
3)      Investment decision: Funds procured from different sources have to be invested in various kinds of assets. Long term funds are used in a project for fixed and also current assets. The investment of funds in a project is to be made after careful assessment of various projects through capital budgeting. A part of long term funds is also to be kept for financing working capital requirements. Asset management policies are to be laid down regarding various items of current assets, inventory policy is to be determined by the production and finance manager, while keeping in mind the requirement of production and future price estimates of raw materials and availability of funds.
4)      Dividend decision: The finance manager is concerned with the decision to pay or declare dividend. He is to assist the top management in deciding as to what amount of dividend should be paid to the shareholders and what amount be retained by the company, it involves a large number of considerations. The principal function of a finance manager relates to decisions regarding procurement, investment and dividends. 
5)      Maintain Proper Liquidity: Every concern is required to maintain some liquidity for meeting day-to-day needs. Cash is the best source for maintaining liquidity. It is required to purchase raw materials, pay workers, meet other expenses, etc. A finance manager is required to determine the need for liquid assets and then arrange liquid assets in such a way that there is no scarcity of funds.
6)      Management of Cash, Receivables and Inventory: Finance manager is required to determine the quantum and manage the various components of working capital such as cash, receivables and inventories. On the one hand, he has to ensure sufficient availability of such assets as and when required, and on the other there should be no surplus or idle investment.
7)      Disposal of Surplus: A finance manager is also expected to make proper utilization of surplus funds. He has to make a decision as to how much earnings are to be retained for future expansion and growth and how much to be distributed among the shareholders.
8)      Evaluating financial performance: Management control systems are usually based on financial analysis, e.g. ROI (return on investment) system of divisional control. A finance manager has to constantly review the financial performance of various units of the organisation. Analysis of the financial performance helps the management for assessing how the funds are utilised in various divisions and what can be done to improve it.
9)      Financial negotiations: Finance manager's major time is utilised in carrying out negotiations with financial institutions, banks and public depositors. He has to furnish a lot of information to these institutions and persons in order to ensure that raising of funds is within the statutes. Negotiations for outside financing often require specialised skills.
10)   Helping in Valuation Decisions: A number of mergers and consolidations take place in the present competitive industrial world. A finance manager is supposed to assist management in making valuation etc. For this purpose, he should understand various methods of valuing shares and other assets so that correct values are arrived at.
4. (a) Define the term ‘Working capital’. On the formation of new business, what considerations are taken into account in estimating the amount of working capital needed?                                                        3+11=14
Ans: Meaning and definition of Working Capital
The capital required for a business is of two types. These are fixed capital and working capital. Fixed capital is required for the purchase of fixed assets like building, land, machinery, furniture etc. Fixed capital is invested for long period, therefore it is known as long-term capital. Similarly, the capital, which is needed for investing in current assets, is called working capital. The capital which is needed for the regular operation of business is called working capital. Working capital is also called circulating capital or revolving capital or short-term capital.
In the words of John. J Harpton “Working capital may be defined as all the shot term assets used in daily operation”.
According to “Hoagland”, “Working Capital is descriptive of that capital which is not fixed. But, the more common use of Working Capital is to consider it as the difference between the book value of the current assets and the current liabilities.
From the above definitions, Working Capital means the excess of Current Assets over Current Liabilities. Working Capital is the amount of net Current Assets. It is the investments made by a business organisation in short term Current Assets like Cash, Debtors, Bills receivable etc.
Factors Affecting Working Capital Requirement
The level of working capital is influenced by several factors which are given below:
a)      Nature of Business: Nature of business is one of the factors. Usually in trading businesses the working capital needs are higher as most of their investment is found concentrated in stock. On the other hand, manufacturing/processing business needs a relatively lower level of working capital.
b)      Size of Business: Size of business is also an influencing factor. As size increases, an absolute increase in working capital is imminent and vice versa.
c)       Production Policies: Production policies of a business organisation exert considerable influence on the requirement of Working Capital. But production policies depend on the nature of product. The level of production, decides the investment in current assets which in turn decides the quantum of working capital required.
d)      Terms of Purchase and Sale: A business organisation making purchases of goods on credit and selling the goods on cash terms would require less Working Capital whereas an organisation selling the goods on credit basis would require more Working Capital. If the payment is to be made in advance to suppliers, then large amount of Working Capital would be required. 286
e)      Production Process: If the production process requires a long period of time, greater amount of Working Capital will be required. But, simple and short production process requires less amount of Working Capital. If production process in an industry entails high cost because of its complex nature, more Working Capital will be required to finance that process and also for other expenses which very with the cost of production whereas if production process is simple requiring less cost, less Working Capital will be required.
f)       Turnover of Circulating Capital: Turnover of circulating capital plays an important and decisive role in judging the adequacy of Working Capital. The speed with which circulating capital completes its cycle i.e. conversion of cash into inventory of raw materials, raw materials into finished goods, finished goods into debts and debts into cash decides the Working Capital requirements of an organization. Slow movement of Working Capital cycle requires large provision of Working Capital.
g)      Dividend Policies: Dividend policies of a business organisation also influence the requirement of Working Capital. If a business is following a liberal dividend policy, it requires high Working Capital to pay cash dividends where as a firm following a conservative dividend policy will require less amount of Working Capital.
h)      Seasonal Variations: In case of seasonal industries like Sugar, Oil mills etc. More Working Capital is required during peak seasons as compared to slack seasons.
i)        Business Cycle: Business expands during the period of prosperity and declines during the period of depression. More Working Capital is required during the period of prosperity and less Working Capital is required during the period of depression.
j)        Change in Technology: Changes in Technology as regards production have impact on the need of Working Capital. A firm using labour oriented technology will require more Working Capital to pay labour wages regularly.
k)      Inflation: During inflation a business concern requires more Working Capital to pay for raw materials, labour and other expenses. This may be compensated to some extent later due to possible rise in the selling price. 287
l)        Turnover of Inventories: A business organisation having low inventory turnover would require more Working Capital where as a business having high inventory turnover would require limited or less Working Capital.
m)    Taxation Policies: Government taxation policy affects the quantum of Working Capital requirements. High tax rate demands more amount of Working Capital.
n)      Degree of Co-ordination: Co-ordination between production and distribution policies is important in determining Working Capital requirements. In the absence of co-ordination between production and distribution policies more Working Capital may be required.
Or
(b) J.K. Ltd. requests you to prepare a statement showing the working capital requirements for a level of activity of 156000 units of production. The following information is available for you calculations:               14

Rs.  (per unit)
Raw Materials
Direct Labour
Overheads
90
40
75

Profit
205
60
Selling Price
265
a)      Raw materials are in stock, on average one month.
b)      Materials are in process, on average 2 weeks.
c)       Finished goods are in stock, on average one month.
d)      Credit allowed by suppliers’ one month.
e)      Time lag in payment from debtors, 2 months.
f)       Lag in payment of wages, 1½ weeks.
g)      Lag in payment of overheads is one month.
20% of the output is sold against cash. Cash in hand and at bank is expected to be Rs. 60,000. It is to be assumed that production is carried on evenly throughout the year, wages and overheads accrue similarly and a time period of 4 weeks is equivalent to a month.
SOLUTIONS: LINK OF ALL PRACTICAL PROBLEMS VIDEOS
5. (a) What is cost of capital? Explain its significance. A firm has the following capital structure and after tax costs for the different sources of funds used:
Sources of funds
Amount
(Rs.)
Proportion
After-tax cost
(%)
Debt
Preference shares
Equity shares
Retained earnings
15,00,000
12,00,000
18,00,000
15,00,000
25
20
30
25
5
10
12
11

60,00,000
100

You are required to compute weighted average cost of capital.                                  2+4+8=14
SOLUTIONS: LINK OF ALL PRACTICAL PROBLEMS VIDEOS
Ans: Meaning and Definition of Cost of Capital
Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. Cost of capital is the required rate of return on its investments which belongs to equity, debt and retained earnings. If a firm fails to earn return at the expected rate, the market value of the shares will fall and it will result in the reduction of overall wealth of the shareholders.
According to the definition of John J. Hampton “ Cost of capital is the rate of return the firm required from investment in order to increase the value of the firm in the market place”.
According to the definition of Solomon Ezra, “Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditure”.
Significance of Cost of Capital
Computation of cost of capital is a very important part of the financial management to decide the capital structure of the business concern.
a)      Importance to Capital Budgeting Decision: Capital budget decision largely depends on the cost of capital of each source. According to net present value method, present value of cash inflow must be more than the present value of cash outflow. Hence, cost of capital is used to capital budgeting decision.
b)      Importance to Structure Decision: Capital structure is the mix or proportion of the different kinds of long term securities. A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital helps to take decision regarding structure.
c)       Importance to Evolution of Financial Performance: Cost of capital is one of the important determine which affects the capital budgeting, capital structure and value of the firm. Hence, it helps to evaluate the financial performance of the firm.
d)      Importance to Other Financial Decisions: Apart from the above points, cost of capital is also used in some other areas such as, market value of share, earning capacity of securities etc. hence, it plays a major part in the financial management.
Calculation of weighted average cost of capital
Sources of funds
Amount  (Rs.)
Proportion
After-tax cost (%)
Weighted average cost of capital (%)
Debt
Preference shares
Equity shares
Retained earnings
15,00,000
12,00,000
18,00,000
15,00,000
25
20
30
25
5
10
12
11
1.25
2.00
3.60
2.75

60,00,000
100
WACC
9.60
Or
(b) What do you mean by ‘financial leverage’? Distinguish between financial leverage and operating leverage. Do you think that they are related to capital structure?                                                                3+6+5=14
Ans: Financial Leverage: Leverage activities with financing activities is called financial leverage. Financial leverage represents the relationship between the company’s earnings before interest and taxes (EBIT) or operating profit and the earning available to equity shareholders. Financial leverage is defined as “the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share”. It involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders. Financial leverage can be calculated with the help of the following formula:
FL = OP/PBT
Where,
FL = Financial leverage
OP = Operating profit (EBIT)
PBT = Profit before tax.
Financial leverage is also known as Trading on Equity. Trading on Equity refers to the practice of using borrowed funds, carrying a fixed charge, to obtain a higher return to the Equity Shareholders. With a larger proportion of the debt in the financial structure, the earnings, available to the owners would increase more than the proportionately with an increase in the operating profits of the firm.  This is because the debt carries a fixed rate of return and if the firm is able to earn, on the borrowed funds, a rate higher than the fixed charges on loans, the benefit will go the shareholders. This is referred to as “Trading on Equity”
Difference between Operating Leverage and Financial Leverage
1)      Operating Leverage results from the existence of fixed operating expenses in the firm’s income stream whereas Financial Leverage results from the presence of fixed financial charges in the firm’s income stream.
2)      Operating Leverage is determined by the relationship between a firm’s sales revenues and its earnings before interest and taxes (EBIT). Financial Leverage is determined by the relationship between a firm’s earnings before interest and tax and after subtracting the interest component.
3)      Operating Leverage = Contribution/EBIT and Financial Leverage = EBIT/EBT
4)      Operational Leverage relates to the Assets side of the Balance Sheet, whereas Financial Leverage relates to the Liability side of the Balance Sheet.
5)      Operational Leverage affects profit before interest and tax, whereas Financial Leverage affects profit after interest and tax.
6)      Operational Leverage involves operating risk of being unable to cover fixed operating cost, whereas Financial Leverage involves financial risk of being unable to cover fixed financial cost.
7)      Operational Leverage is concerned with investment decisions, whereas Financial Leverage is concerned with financing decisions.
8)      Operating Leverage is described as a first stage leverage, whereas Financial Leverage is described as a second stage leverage.
Effect of Financial Leverage on Capital Structure
The use of long term fixed interest bearing debt and preference share capital along with equity share capital is called financial leverage or trading on equity. The use of long-term debt increases, magnifies the earnings per share if the firm yields a return higher than the cost of debt. The earnings per share also increase with the use of preference share capital but due to the fact that interest is allowed to be deducted while computing tax, the leverage impact of debt is much more. However, leverage can operate adversely also if the rate of interest on long-term loan is more than the expected rate of earnings of the firm. Therefore, it needs caution to plan the capital structure of a firm.
6. (a) Discuss the various types of dividend policies. State the various forms of dividends on the basis of payments. 8+6=14
Ans: Every company which is listed and is making profits has to take the decision regarding the distribution of profits to its shareholders as they are the ones who have invested their money into the company. This distribution of profits by the company to its shareholders is called dividend in finance parlance, every company has different objectives and methods and dividend is no different and that is the reason why different companies follow different dividend policies, let’s look at various types of dividend policies:
1) Regular dividend policy: Under this type of dividend policy a company has the policy of paying dividends to its shareholders every year. When the company makes abnormal profits then the company will not pay that extra profits to its shareholders completely rather it will distribute lower profit in the form of the dividend to the shareholders and keep the excess profits with it and suppose a company makes loss then also it will pay dividend to its shareholders under regular dividend policy. This type of dividend policy is suitable for those companies which have constant cash flows and have stable earnings. Investors like retired person and conservative investors who prefer safe investment and constant income will invest in constant dividend paying companies.
2) Stable Dividend Policy: Stability of dividends means regularity in payment of dividends. It refers to the consistency in stream of dividends. In short, we can say that a stable dividend policy is a long term policy which is not affected by the variations in the earnings during different periods. The stability of dividends can take any one of the three forms:
a)      Constant D/P ratio.
b)      Constant dividends per share.
c)       Constant dividend per share plus extra dividends.
Merits of Stable Dividend Policy: Following are some of the advantages of a stable dividend policy:
a)      This policy contributes to stablise market value of company’s equity shares at a high level.
b)      This policy helps the company is mobilizing additional funds in the form of additional equity shares.
c)       Regular earnings in the form of dividend satisfy investors.
d)      This policy encourages shareholders to hold company’s share for longer time and simultaneously other investors are also attracted for the purchase of shares.
e)      This policy is helpful for expansion and growth prospects of a company.
f)       This policy encourages the institutional investors because they like to invest in those companies which make uninterrupted payment of dividends.
Demerits of Stable Dividend Policy: Following are some of the disadvantages of a stable dividend policy:
a)      Sometime despite of large earnings, management decides not to declare dividends.
b)      In this policy, instead of paying dividend in cash, bonus share are issued to the shareholders.
c)       This policy is used to capitalise reinvested earnings of the firm.
3) Irregular dividend policy: Under this type of policy there is no mandate to give dividends to shareholders of the company and top management gives it according to its own free will, so suppose company has some abnormal profits then management may decide to pass it fully to its shareholders by giving interim dividend or management may decide to use it for future business expansion. Companies which have irregular earnings, lack of liquidity and are afraid of committing itself for paying regular dividends adopt irregular dividend policy.
4) No dividend policy: Under this policy company pays no dividend to its shareholders, the reason for following this type of policy is that company retains the profit and invest in the growth of the business. Companies which have ample growth opportunities follow this type of policy and shareholders who are looking for growth invest in these types of companies because there is plenty of scope of capital appreciation in these stocks and if the company is successful then capital appreciation will outdo regular dividend income as far as shareholders are concerned.
Meaning of Dividend: A dividend is that portion of profits and surplus funds of a company which has actually set aside by a valid act of the company for distribution among its shareholders.
According to ICAI, “Dividend is the distribution to the shareholders of a company from the reserves and profits.”
In the words of S.M. Shah, “Dividend is a part of divisible profits of a business company which is distributed to the shareholders.”
Dividend may be divided into following categories:
1.       Cash Dividend.
2.       Stock Dividend or Bonus Dividend.
3.       Bond Dividend.
4.       Property Dividend.
5.       Composite Dividend.
6.       Interim Dividend.
7.       Special or Extra Dividend.
8.       Optional Dividend.
Or
(b) Discuss the MM theory of dividend distribution. What are the criticisms of this theory of irrelevance?         8+6=14
Ans: Modigliani and Miller approach (M & M Hypothesis)
The residuals theory of dividends tends to imply that the dividends are irrelevant and the value of the firm is independent of its dividend policy. The irrelevance of dividend policy for a valuation of the firm has been most comprehensively presented by Modigliani and Miller. They have argued that the market price of a share is affected by the earnings of the firm and not influenced by the pattern of income distribution. What matters, on the other hand, is the investment decisions which determine the earnings of the firm and thus affect the value of the firm. They argue that subject to a number of assumptions, the way a firm splits its earnings between dividends and retained earnings has no effect on the value of the firm.
Like several financial theories, M&M hypothesis is based on the argument of efficient capital markets. In addition, there are two options:
(a) It retains earnings and finances its new investment plans with such retained earnings;
(b) It distributes dividends, and finances its new investment plans by issuing new shares.
The intuitive background of the M&M approach is extremely simple, and in fact, almost self explanatory. It is based on the following assumptions:
a)      The capital markets are perfect and the investors behave rationally.
b)      All information is freely available to all the investors.
c)       There is no transaction cost.
d)      Securities are divisible and can be split into any fraction. No investor can affect the market price.
e)      There are no taxes and no flotation cost.
f)       The firm has a defined investment policy and the future profits are known with certainty. The implication is that the investment decisions are unaffected by the dividend decision and the operating cash flows are same no matter which dividend policy is adopted.
Their conclusion is that, the shareholders get the same benefit from dividend as from capital gain through retained earnings. So, the division of earnings into dividend and retained earnings does not influence shareholders' perceptions. So whether dividend is declared or not, and whether high or low payout ratio is follows, it makes no difference on the value of the share. In order to satisfy their model, MM has started with the following valuation model.
P0= 1* (D1+P1)/ (1+ke)
Where,
P0 = Present market price of the share
Ke = Cost of equity share capital
D1 = Expected dividend at the end of year 1
P1 = Expected market price of the share at the end of year 1
With the help of this valuation model we will create a arbitrage process, i.e., replacement of amount paid as dividend by the issue of fresh capital. The arbitrage process involves two simultaneous actions. With reference to dividend policy the two actions are:
a)      Payment of dividend by the firm
b)      Rising of fresh capital.
With the help of arbitrage process, MM have shown that the dividend payment will not have any effect on the value of the firm. Even if the firm pays dividends, resulting in a increase in market value of the share, the effect on the value of the firm will be neutralised by the decrease in terminal value of the share.
Criticisms on MM Dividend theory: MM theory is criticized on the invalidity of most of its assumptions. Some of the criticisms are presented below:
a)      First, perfect capital market is not a reality.
b)      Second, transaction and floatation costs do exist.
c)       Third, Dividend has a signaling effect. Dividend decision signals financial standing of the business, earnings position of the business, and so on. All these are taken as uncertainty reducers and that these influence share value. So, the stand of MM is not tenable.
d)      Fourth, MM assumed that additional shares are issued at the prevailing market price. It is not so. Fresh issues - whether rights or otherwise, are made at prices below the ruling market price.
e)      Fifth, taxation of dividend income is not the same as that of capital gain. Dividend income upto Rs. 10000 is fully exempt, whereas capital gain attracts a flat 20% tax in the case of individual assesses. So, investor preferences between dividend and capital gain differ.
f)       Sixth, investment decisions are not always rational. Some, sub-marginal projects may be taken up by firms if internally generated funds are available in plenty. This would deflate ROI sooner than later reducing share price.
g)      Seventh, investment decisions are tied up with financing decisions. Availability of funds and external constrains might affect investment decisions and rationing of capital, then becomes a relevant issue as it affects the availability of funds.
(Old Course)
Full Marks: 80
Pass Marks: 32
Time: 3 hours
1. (a) Write ‘True’ or ‘False’:                                        1x4=4
a)      Corporation finance is a wider term than business finance.                                                                  False
b)      Net working capital is the excess of current liabilities over current assets.                                     False
c)       Dividend policy of a firm affects both the long-term financing and shareholders’ wealth.       True
d)      Equity shareholders have a residual claim on the assets of the company.                                       True
    (b) Fill in the blanks:                                                    1x4=4
a)      It is better for a company to remain in low gear during the period of depression.
b)      The rate of return on investments also falls with the shortage of working capital.
c)       Capital investment decisions are generally of non-recurring nature.
d)      A firm will have favourable leverage if its operating profits/EBIT are more than the debt cost.
2. Write short notes on any four of the following:                                           4x4=16
a)      Wealth maximization.
Ans: Shareholders’ wealth maximization means maximizing the net present value of a course of action to shareholders. Net Present Value (NPV) of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action that has a positive NPV creates wealth for shareholders and therefore, is desirable. A financial action resulting in negative NPV destroys shareholders’ wealth and is, therefore undesirable. Between mutually exclusive projects, the one with the highest NPV should be adopted. NPVs of a firm’s projects are additive in nature. That is
NPV(A) + NPV(B) = NPV(A+B)
The objective of Shareholders Wealth Maximization (SWM) considers timing and risk of expected benefits. Benefits are measured in terms of cash flows. One should understand that in investment and financing decisions, it is the flow of cash that is important, not the accounting profits. SWM as an objective of financial management is appropriate and operationally feasible criterion to choose among the alternative financial actions. 
Maximizing the shareholders’ economic welfare is equivalent to maximizing the utility of their consumption over time. The wealth created by a company through its actions is reflected in the market value of the company’s shares. Therefore, this principle implies that the fundamental objective of a firm is to maximize the market value of its shares. The market price, which represents the value of a company’s shares, reflects shareholders’ perception about the quality of the company’s financial decisions. Thus, the market price serves as the company’s performance indicator.
b)      Capital market.
c)       Management of receivables.
d)      Stable dividend policy.
Ans: Stable Dividend Policy: Stability of dividends means regularity in payment of dividends. It refers to the consistency in stream of dividends. In short, we can say that a stable dividend policy is a long term policy which is not affected by the variations in the earnings during different periods. The stability of dividends can take any one of the three forms:
d)      Constant D/P ratio.
e)      Constant dividends per share.
f)       Constant dividend per share plus extra dividends.

a)      Constant D/P Ratio: The ratio of dividends to earnings is known as payout ratio. With this policy the amount of dividends varies directly with the earnings.
b)      Constant Dividend Per share: According to this form, a company follows as policy of paying a constant dividend irrespective of its level of earnings.
c)       Stable Dividend plus Extra Dividends: Under this policy a firm usually pays a small fixed dividend to the shareholders and in years of prosperity additional dividend is paid over and above the fixed dividend.
Merits of Stable Dividend Policy: Following are some of the advantages of a stable dividend policy:
g)      This policy contributes to stablise market value of company’s equity shares at a high level.
h)      This policy helps the company is mobilizing additional funds in the form of additional equity shares.
i)        Regular earnings in the form of dividend satisfy investors.
j)        This policy encourages shareholders to hold company’s share for longer time and simultaneously other investors are also attracted for the purchase of shares.
k)      This policy is helpful for expansion and growth prospects of a company.
l)        This policy encourages the institutional investors because they like to invest in those companies which make uninterrupted payment of dividends.
Demerits of Stable Dividend Policy: Following are some of the disadvantages of a stable dividend policy:
d)      Sometime despite of large earnings, management decides not to declare dividends.
e)      In this policy, instead of paying dividend in cash, bonus share are issued to the shareholders.
f)       This policy is used to capitalise reinvested earnings of the firm.

e)      Trading on equity.
Ans: Financial leverage is also known as Trading on Equity. Trading on Equity refers to the practice of using borrowed funds, carrying a fixed charge, to obtain a higher return to the Equity Shareholders. With a larger proportion of the debt in the financial structure, the earnings, available to the owners would increase more than the proportionately with an increase in the operating profits of the firm.  This is because the debt carries a fixed rate of return and if the firm is able to earn, on the borrowed funds, a rate higher than the fixed charges on loans, the benefit will go the shareholders. This is referred to as “Trading on Equity”
The concept of trading on equity is the financial process of using debt to produce gain for the residual owners or the equity shareholders. The term owes its name also to the fact that the equity supplied by the owners, when the amount of borrowing is relatively large in relation to capital stock, a company is said to be trading on equity, but where borrowing is comparatively small in relation to capital stock, the company is said to be trading on thick equity. Capital gearing ration can be used to judge as to whether the company is trading on thin or thick equity.
Degree of Financial Leverage: Degree of financial leverage may be defined as the percentage change in taxable profit as a result of percentage change in earning before interest and tax (EBIT). This can be calculated by the following formula:  DFL= Percentage change in taxable Income / Precentage change in EBIT 
3. (a) What do you mean by business finance? What is the scope of finance function in a business enterprise? Should the goal of financial decision-making be profit maximization or wealth maximization?                                        2+4+6=12
 Ans: Meaning and Definitions of Financial Management/Business Finance/ Finance Functions
Financial management is management principles and practices applied to finance. General management functions include planning, execution and control. Financial decision making includes decisions as to size of investment, sources of capital, extent of use of different sources of capital and extent of retention of profit or dividend payout ratio. Financial management, is therefore, planning, execution and control of investment of money resources, raising of such resources and retention of profit/payment of dividend.
Howard and Upton define financial management as "that administrative area or set of administrative functions in an organisation which have to do with the management of the flow of cash so that the organisation will have the means to carry out its objectives as satisfactorily as possible and at the same time meets its obligations as they become due.”
According to Guthamann and Dougall,” Business finance can be broadly defined as the activity concerned with the planning, raising, controlling and administering the funds used in the business.”
Bonneville and Dewey interpret that financing consists in the raising, providing and managing all the money, capital or funds of any kind to be used in connection with the business.
Osbon defines financial management as the "process of acquiring and utilizing funds by a business”.
Considering all these views, financial management may be defined as that part of management which is concerned mainly with raising funds in the most economic and suitable manner, using these funds as profitably as possible.
Finance Functions (Scope of Financial Management)/ Types of Decisions to be taken under financial management
The finance function encompasses the activities of raising funds, investing them in assets and distributing returns earned from assets to shareholders. While doing these activities, a firm attempts to balance cash inflow and outflow. It is evident that the finance function involves the four decisions viz., financing decision, investment decision, dividend decision and liquidity decision. Thus the finance function includes:
a)      Investment decision
b)      Financing decision
c)       Dividend decision
d)      Liquidity decision
1. Investment Decision: The investment decision, also known as capital budgeting, is concerned with the selection of an investment proposal/ proposals and the investment of funds in the selected proposal. A capital budgeting decision involves the decision of allocation of funds to long-term assets that would yield cash flows in the future. Two important aspects of investment decisions are:
(a) The evaluation of the prospective profitability of new investments, and
(b) The measurement of a cut-off rate against that the prospective return of new investments could be compared.
Future benefits of investments are difficult to measure and cannot be predicted with certainty. Risk in investment arises because of the uncertain returns. Investment proposals should, therefore, be evaluated in terms of both expected return and risk. Besides the decision to commit funds in new investment proposals, capital budgeting also involves replacement decision, that is decision of recommitting funds when an asset become less productive or non-profitable. The computation of the risk-adjusted return and the required rate of return, selection of the project on these bases, form the subject-matter of the investment decision.
Long-term investment decisions may be both internal and external. In the former, the finance manager has to determine which capital expenditure projects have to be undertaken, the amount of funds to be committed and the ways in which the funds are to be allocated among different investment outlets. In the latter case, the finance manager is concerned with the investment of funds outside the business for merger with, or acquisition of, another firm.
2.Financing Decision: Financing decision is the second important function to be performed by the financial manager. Broadly, he or she must decide when, from where and how to acquire funds to meet the firm’s investment needs. The central issue before him or her is to determine the appropriate proportion of equity and debt. The mix of debt and equity is known as the firm’s capital structure. The financial manager must strive to obtain the best financing mix or the optimum capital structure for his or her firm. The firm’s capital structure is considered optimum when the market value of shares is maximized.
The use of debt affects the return and risk of shareholders; it may increase the return on equity funds, but it always increases risk as well. The change in the shareholders’ return caused by the change in the profit is called the financial leverage. A proper balance will have to be struck between return and risk. When the shareholders’ return is maximized with given risk, the market value per share will be maximized and the firm’s capital structure would be considered optimum. Once the financial manager is able to determine the best combination of debt and equity, he or she must raise the appropriate amount through the best available sources. In practice, a firm considers many other factors such as control, flexibility, loan covenants, legal aspects etc. in deciding its capital structure. 
3. Dividend Decision: Dividend decision is the third major financial decision. The financial manager must decide whether the firm should distribute all profits, or retain them, or distribute a portion and return the balance. The proportion of profits distributed as dividends is called the dividend-payout ratio and the retained portion of profits is known as the retention ratio. Like the debt policy, the dividend policy should be determined in terms of its impact on the shareholders’ value. The optimum dividend policy is one that maximizes the market value of the firm’s shares. Thus, if shareholders are not indifferent to the firm’s dividend policy, the financial manager must determine the optimum dividend-payout ratio. Dividends are generally paid in cash. But a firm may issue bonus shares. Bonus shares are shares issued to the existing shareholders without any charge. The financial manager should consider the questions of dividend stability, bonus shares and cash dividends in practice. 
4. Liquidity Decision: Investment in current assets affects the firm’s profitability and liquidity. Current assets should be managed efficiently for safeguarding the firm against the risk of illiquidity. Lack of liquidity in extreme situations can lead to the firm’s insolvency. A conflict exists between profitability and liquidity while managing current assets. If the firm does not invest sufficient funds in current assets, it may become illiquid and therefore, risky. But if the firm invests heavily in the current assets, then it would loose interest as idle current assets would not earn anything. Thus, a proper trade-off must be achieved between profitability and liquidity. The profitability-liquidity trade-off requires that the financial manager should develop sound techniques of managing current assets and make sure that funds would be made available when needed. 
WEALTH MAXIMIZATION AS PRIMARY OBJECTIVE OF FINANCIAL MANAGEMENT
The primary objective of financial management is wealth maximization. The concept of wealth in the context of wealth maximization objective refers to the shareholders’ wealth as reflected by the price of their shares in the share market. Therefore, wealth maximization means maximization of the market price of the equity shares of the company. However, this maximization of the price of company’s equity shares should be in the long run by making efficient decisions which are desirable for the growth of a company and are valued positively by the investors at large and not by manipulating the share prices in the short run. The long run implies a period which is long enough to reflect the normal market price of the shares irrespective of short-term fluctuations. The long run price of an equity share is a function of two basic factors:
a)      The likely rate of earnings or earnings per share (EPS) of the company; and
b)      The capitalization rate reflecting the liking of the investors of a company.
The financial manager must identify those avenues of investment; modes of financing, ways of handling various components of working capital which ultimately will lead to an increase in the price of equity share. If shareholders are gaining, it implies that all other claimants are also gaining because the equity share holders are paid only after the claims of all other claimants (such as creditors, employees, lenders) have been duly paid.
The following arguments are advanced in favour of wealth maximization as the goal of financial management:
a)      It serves the interests of owners, (shareholders) as well as other stakeholders in the firm; i.e. suppliers of loaned capital, employees, creditors and society.
b)      It is consistent with the objective of owners’ economic welfare.
c)       The objective of wealth maximization implies long-run survival and growth of the firm.
d)      It takes into consideration the risk factor and the time value of money as the current present value of any particular course of action is measured.
e)      The effect of dividend policy on market price of shares is also considered as the decisions are taken to increase the market value of the shares.
f)       The goal of wealth maximization leads towards maximizing stockholder’s utility or value maximization of equity shareholders through increase in stock price per share.
Or
(b) What is financial management? What major decisions are required to be taken in finance?                                4+8=12
Ans: Meaning and Definitions of Financial Management/Business Finance/ Finance Functions
Financial management is management principles and practices applied to finance. General management functions include planning, execution and control. Financial decision making includes decisions as to size of investment, sources of capital, extent of use of different sources of capital and extent of retention of profit or dividend payout ratio. Financial management, is therefore, planning, execution and control of investment of money resources, raising of such resources and retention of profit/payment of dividend.
Howard and Upton define financial management as "that administrative area or set of administrative functions in an organisation which have to do with the management of the flow of cash so that the organisation will have the means to carry out its objectives as satisfactorily as possible and at the same time meets its obligations as they become due.”
According to Guthamann and Dougall,” Business finance can be broadly defined as the activity concerned with the planning, raising, controlling and administering the funds used in the business.”
Bonneville and Dewey interpret that financing consists in the raising, providing and managing all the money, capital or funds of any kind to be used in connection with the business.
Osbon defines financial management as the "process of acquiring and utilizing funds by a business”.
Considering all these views, financial management may be defined as that part of management which is concerned mainly with raising funds in the most economic and suitable manner, using these funds as profitably as possible.
Finance Functions (Scope of Financial Management)/ Types of Decisions to be taken under financial management
The finance function encompasses the activities of raising funds, investing them in assets and distributing returns earned from assets to shareholders. While doing these activities, a firm attempts to balance cash inflow and outflow. It is evident that the finance function involves the four decisions viz., financing decision, investment decision, dividend decision and liquidity decision. Thus the finance function includes:
e)      Investment decision
f)       Financing decision
g)      Dividend decision
h)      Liquidity decision
1. Investment Decision: The investment decision, also known as capital budgeting, is concerned with the selection of an investment proposal/ proposals and the investment of funds in the selected proposal. A capital budgeting decision involves the decision of allocation of funds to long-term assets that would yield cash flows in the future. Two important aspects of investment decisions are:
(a) The evaluation of the prospective profitability of new investments, and
(b) The measurement of a cut-off rate against that the prospective return of new investments could be compared.
Future benefits of investments are difficult to measure and cannot be predicted with certainty. Risk in investment arises because of the uncertain returns. Investment proposals should, therefore, be evaluated in terms of both expected return and risk. Besides the decision to commit funds in new investment proposals, capital budgeting also involves replacement decision, that is decision of recommitting funds when an asset become less productive or non-profitable. The computation of the risk-adjusted return and the required rate of return, selection of the project on these bases, form the subject-matter of the investment decision.
Long-term investment decisions may be both internal and external. In the former, the finance manager has to determine which capital expenditure projects have to be undertaken, the amount of funds to be committed and the ways in which the funds are to be allocated among different investment outlets. In the latter case, the finance manager is concerned with the investment of funds outside the business for merger with, or acquisition of, another firm.
2.Financing Decision: Financing decision is the second important function to be performed by the financial manager. Broadly, he or she must decide when, from where and how to acquire funds to meet the firm’s investment needs. The central issue before him or her is to determine the appropriate proportion of equity and debt. The mix of debt and equity is known as the firm’s capital structure. The financial manager must strive to obtain the best financing mix or the optimum capital structure for his or her firm. The firm’s capital structure is considered optimum when the market value of shares is maximized.
The use of debt affects the return and risk of shareholders; it may increase the return on equity funds, but it always increases risk as well. The change in the shareholders’ return caused by the change in the profit is called the financial leverage. A proper balance will have to be struck between return and risk. When the shareholders’ return is maximized with given risk, the market value per share will be maximized and the firm’s capital structure would be considered optimum. Once the financial manager is able to determine the best combination of debt and equity, he or she must raise the appropriate amount through the best available sources. In practice, a firm considers many other factors such as control, flexibility, loan covenants, legal aspects etc. in deciding its capital structure. 
3. Dividend Decision: Dividend decision is the third major financial decision. The financial manager must decide whether the firm should distribute all profits, or retain them, or distribute a portion and return the balance. The proportion of profits distributed as dividends is called the dividend-payout ratio and the retained portion of profits is known as the retention ratio. Like the debt policy, the dividend policy should be determined in terms of its impact on the shareholders’ value. The optimum dividend policy is one that maximizes the market value of the firm’s shares. Thus, if shareholders are not indifferent to the firm’s dividend policy, the financial manager must determine the optimum dividend-payout ratio. Dividends are generally paid in cash. But a firm may issue bonus shares. Bonus shares are shares issued to the existing shareholders without any charge. The financial manager should consider the questions of dividend stability, bonus shares and cash dividends in practice. 
4. Liquidity Decision: Investment in current assets affects the firm’s profitability and liquidity. Current assets should be managed efficiently for safeguarding the firm against the risk of illiquidity. Lack of liquidity in extreme situations can lead to the firm’s insolvency. A conflict exists between profitability and liquidity while managing current assets. If the firm does not invest sufficient funds in current assets, it may become illiquid and therefore, risky. But if the firm invests heavily in the current assets, then it would loose interest as idle current assets would not earn anything. Thus, a proper trade-off must be achieved between profitability and liquidity. The profitability-liquidity trade-off requires that the financial manager should develop sound techniques of managing current assets and make sure that funds would be made available when needed. 
4. (a) Distinguish between operating leverage and financial leverage. Do you think that they are related to capital structure?                                           7+4=11
Ans: Difference between Operating Leverage and Financial Leverage
1)      Operating Leverage results from the existence of fixed operating expenses in the firm’s income stream whereas Financial Leverage results from the presence of fixed financial charges in the firm’s income stream.
2)      Operating Leverage is determined by the relationship between a firm’s sales revenues and its earnings before interest and taxes (EBIT). Financial Leverage is determined by the relationship between a firm’s earnings before interest and tax and after subtracting the interest component.
3)      Operating Leverage = Contribution/EBIT and Financial Leverage = EBIT/EBT
4)      Operational Leverage relates to the Assets side of the Balance Sheet, whereas Financial Leverage relates to the Liability side of the Balance Sheet.
5)      Operational Leverage affects profit before interest and tax, whereas Financial Leverage affects profit after interest and tax.
6)      Operational Leverage involves operating risk of being unable to cover fixed operating cost, whereas Financial Leverage involves financial risk of being unable to cover fixed financial cost.
7)      Operational Leverage is concerned with investment decisions, whereas Financial Leverage is concerned with financing decisions.
8)      Operating Leverage is described as a first stage leverage, whereas Financial Leverage is described as a second stage leverage.
Effect of Financial Leverage on Capital Structure
The use of long term fixed interest bearing debt and preference share capital along with equity share capital is called financial leverage or trading on equity. The use of long-term debt increases, magnifies the earnings per share if the firm yields a return higher than the cost of debt. The earnings per share also increase with the use of preference share capital but due to the fact that interest is allowed to be deducted while computing tax, the leverage impact of debt is much more. However, leverage can operate adversely also if the rate of interest on long-term loan is more than the expected rate of earnings of the firm. Therefore, it needs caution to plan the capital structure of a firm.
Or
(b) (i) A company issues 10000, 10% preference shares of Rs. 100 each. Cost of issue is Rs. 2 per share. These shares are redeemable after 10 years at a premium of 5%. Calculate the cost of preference capital.
(ii) A company issues 1000, 10% preference shares of Rs. 100 each at a discount of 5%. Costs of raising capital are Rs. 2,000. Compute the cost of preference capital.
(iii) A company raises Rs. 90,000 be the issue of 1000, 10% debentures of Rs. 100 each at a discount of 10% repayable at par after 10 years. If the rate of the company’s tax is 50%, what is the cost of debt capital to the firm?          3+4+4=11
SOLUTIONS: LINK OF ALL PRACTICAL PROBLEMS VIDEOS
     
5. (a) Describe the various natures of short-term and long-term requirement of finance in a business and sources from which those can be arranged.                                    5+6=11
Or
(b) What do you understand by leasing? State its advantages and limitations.                                     3+4+4=11
6. (a) Explain the various factors which influence the dividend decision of a firm.                                           11
Ans: Factors Influencing Dividend Decision
There are various factors which affect dividend decision. These are enumerated below with brief explanation.
a)      Legal position: Section 205 of the Companies Act, 1956 which lays down the sources from which dividend can be paid, provides for payment of dividend (i) out of past profits and (ii) out of moneys provided by the Central/State Government, apart from current profits. Thus, by law itself, a company may be allowed to declare a dividend even in a year when the profits are inadequate or when there is absence of profit.
b)      Magnitude and Trend in EPS: EPS is the basis for dividend. The size of the EPS and the trend in EPS in recent years set how much can be paid as dividend a high and steadily increasing EPS enables a high and steadily increasing DPS. When EPS fluctuates a different dividend policy has to be adopted.
c)       Taxability: According to Section 205(3) of the Companies Act, 1956 'no dividend shall be payable except in cash'. However, the Income-Tax Act defines the term dividend so as to include any distribution of property or rights having monetary value. Therefore liberal dividend policy becomes unattractive from the point of view of the shareholders/investors in high income brackets. Thus a company which considers the taxability of its shareholders, may not declare liberal dividend though there may be huge profit, but may alternatively go for issuing bonus shares later.
d)      Liquidity and Working Capital Position: Apparently, distribution of dividend results in outflow of cash and as such a reduction in working capital position. Even in a year when a company has earned adequate profit to warrant a dividend declaration, it may confront with a week liquidity position. Under the circumstance, while one company may prefer not to pay dividend since the payment may impair liquidity, another company following a stable dividend policy, may wish to declare dividends even by resorting to borrowings for dividend payment in cash.
e)      Impact on share price: The impact of dividends on market price of shares, though cannot be precisely measured, still one could consider the influence of dividend on the market price of shares. The dividend policy pursued by a company naturally depends on how far the management is concerned about the market price of shares. Generally, an increase in dividend payout results in a hike in the market price of shares. This is significant as it has a bearing on new issues.
f)       Control consideration: Where the directors wish to retain control, they may desire to finance growth programmes by retained earnings, since issue of fresh equity shares for financing growth plan may lead to dilution of control of the dominating group. So, low dividend payout is favoured by Board.
g)      Type of Shareholders: When the shareholders of the company prefer current dividend rather man capital gain a high payment is desirable. This happens so, when the shareholders are in low tax brackets, they are less moneyed and require periodical income or they have better investment avenues than the company. Retired persons, economically weaker sections and similarly placed investors prefer current income i.e. dividend. If, on the other hand, majority of the shareholders are moneyed people, and want capital gain, then low payout ratio is desirable. This is known as clientele effect on dividend decision.
h)      Industry Norms: The industry norms have to be adhered to the extent possible. It most firms in me industry adopt a high payout policy, perhaps others also have to adopt such a policy.
i)        Age of the company: Newly formed companies adopt a conservative dividend policy so that they can get stabilized and think of growth and expansion.
j)        Investment opportunities for the company: If the company has better investment opportunities, and it is difficult to raise fresh capital quickly and at cheap costs, it is better to adopt a conservative dividend policy. By better investment opportunities we mean those with higher 'r' relative to the 'k'. So, if r>k, low payout is good. And vice versa.
k)      Restrictive covenants imposed by debt financiers: Debt financiers, especially term lending financial institutions, may impose restrictive conditions on the rate, timing and form of dividends declared. So, that consideration is also significant.
l)        Floatation cost, cost of fresh equity and access capital market: When floatation costs and cost of fresh equity are high and capital market conditions are not congenial for a fresh issue, a low payout ratio is adopted.
m)    Financial signaling: Dividends are the best medium to tell shareholder of better days ahead of the company. When a company enhances the target dividend rate, it overwhelmingly signals the shareholders that their company is on stable growth path. Share prices immediately react positively.
Or
(b) There is a strong view prevalent among financial experts that the irrelevant hypothesis underlying the MM theory of dividend distribution is outdated and unsuited to present conditions. Do you agree with the view? Discuss.     11
Ans: Modigliani and Miller approach (M & M Hypothesis)
The residuals theory of dividends tends to imply that the dividends are irrelevant and the value of the firm is independent of its dividend policy. The irrelevance of dividend policy for a valuation of the firm has been most comprehensively presented by Modigliani and Miller. They have argued that the market price of a share is affected by the earnings of the firm and not influenced by the pattern of income distribution. What matters, on the other hand, is the investment decisions which determine the earnings of the firm and thus affect the value of the firm. They argue that subject to a number of assumptions, the way a firm splits its earnings between dividends and retained earnings has no effect on the value of the firm.
Like several financial theories, M&M hypothesis is based on the argument of efficient capital markets. In addition, there are two options:
(a) It retains earnings and finances its new investment plans with such retained earnings;
(b) It distributes dividends, and finances its new investment plans by issuing new shares.
The intuitive background of the M&M approach is extremely simple, and in fact, almost self explanatory. It is based on the following assumptions:
a)      The capital markets are perfect and the investors behave rationally.
b)      All information is freely available to all the investors.
c)       There is no transaction cost.
d)      Securities are divisible and can be split into any fraction. No investor can affect the market price.
e)      There are no taxes and no flotation cost.
f)       The firm has a defined investment policy and the future profits are known with certainty. The implication is that the investment decisions are unaffected by the dividend decision and the operating cash flows are same no matter which dividend policy is adopted.
Their conclusion is that, the shareholders get the same benefit from dividend as from capital gain through retained earnings. So, the division of earnings into dividend and retained earnings does not influence shareholders' perceptions. So whether dividend is declared or not, and whether high or low payout ratio is follows, it makes no difference on the value of the share. In order to satisfy their model, MM has started with the following valuation model.
P0= 1* (D1+P1)/ (1+ke)
Where,
P0 = Present market price of the share
Ke = Cost of equity share capital
D1 = Expected dividend at the end of year 1
P1 = Expected market price of the share at the end of year 1
With the help of this valuation model we will create a arbitrage process, i.e., replacement of amount paid as dividend by the issue of fresh capital. The arbitrage process involves two simultaneous actions. With reference to dividend policy the two actions are:
a)      Payment of dividend by the firm
b)      Rising of fresh capital.
With the help of arbitrage process, MM have shown that the dividend payment will not have any effect on the value of the firm. Even if the firm pays dividends, resulting in a increase in market value of the share, the effect on the value of the firm will be neutralised by the decrease in terminal value of the share.
Criticisms on MM Dividend theory: MM theory is criticized on the invalidity of most of its assumptions. Some of the criticisms are presented below:
a)      First, perfect capital market is not a reality.
b)      Second, transaction and floatation costs do exist.
c)       Third, Dividend has a signaling effect. Dividend decision signals financial standing of the business, earnings position of the business, and so on. All these are taken as uncertainty reducers and that these influence share value. So, the stand of MM is not tenable.
d)      Fourth, MM assumed that additional shares are issued at the prevailing market price. It is not so. Fresh issues - whether rights or otherwise, are made at prices below the ruling market price.
e)      Fifth, taxation of dividend income is not the same as that of capital gain. Dividend income upto Rs. 10000 is fully exempt, whereas capital gain attracts a flat 20% tax in the case of individual assesses. So, investor preferences between dividend and capital gain differ.
f)       Sixth, investment decisions are not always rational. Some, sub-marginal projects may be taken up by firms if internally generated funds are available in plenty. This would deflate ROI sooner than later reducing share price.
g)      Seventh, investment decisions are tied up with financing decisions. Availability of funds and external constrains might affect investment decisions and rationing of capital, then becomes a relevant issue as it affects the availability of funds.
7. (a) What is cash management? Explain various methods of investing surplus cash. What criteria should a firm use for investing idle cash in marketable securities?                                                        2+6+3=11
Or
(b) The management of Vishal Ltd. has called for statement showing the working capital needed to finance a level of activity of 300000 units of output for the year. The cost structure for the company’s product, for the above-mentioned activity level is detailed below:

Rs.  (per unit)
Raw Materials
Direct Labour
Overheads
20
5
15

Profit
40
10
Selling Price
50
a)      Past experience indicates that raw materials are held in stock on an average for two months.
b)      Work-in-process (100% complete in regard to materials and 50% for labour and overheads) will approximately be half a month’s production.
c)       Finished goods remain in warehouse, on an average for a month
d)      Suppliers of raw materials extend a month’s credit.
e)      Two months credit is allowed to debtors, calculation of debtors may be made at selling price.
f)       A minimum cash balance of Rs. 25,000 is expected to be maintained.
g)      The production pattern is assumed to be even during the year.
Prepare the statement of working capital requirements.                                                                             11
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