Dibrugarh University Financial Management Solved Question Papers
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
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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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