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Sunday, November 05, 2017

Financial Management Solved Question Papers: Nov' 2015 (Both New Course and Old Course)

2015 (November)
COMMERCE
(Speciality)
Course: 302
(Financial Management)
The figures in the margin indicate full marks for the questions
1. (a) Write ‘True’ or ‘False’:                                                       1x4=4

a)      Cash management is an important task of the finance manager.                        True
b)      Every business concern should have excessive working capital.                          False, optimum w.c.
c)       The cost of capital is the maximum rate of return expected by its investors.                 False
d)      Dividend is the reward of the shareholders for investment made by them in the shares of the company.      True
(b) Fill in the blanks:                                                                      1x4=4
a)      Finance is the life blood and nerve centre of a business concern.
b)      Capital budgeting means planning for Long term or permanent assets.
c)       The redundant working capital gives rise to Speculative transactions.
d)      Dividends paid in the ordinary course of business are known as profits dividends.
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)      Net present value method.
Ans: Net present value (NPV) method: The best method for evaluation of investment proposal is net present value method or discounted cash flow technique. This method takes into account the time value of money. The net present value of investment proposal may be defined as sum of the present values of all cash inflows as reduced by the  present values of all cash outflows associated with the proposal. Each project involves certain investments and commitment of cash at certain point of time. This is known as cash outflows. Cash inflows can be calculated by adding depreciation to profit after tax arising out of that particular project.
Merits of NPV method:
1) NPV method takes into account the time value of money.
2) The whole stream of cash flows is considered.
3) NPV can be seen as addition to the wealth of shareholders. The criterion of NPV is thus in conformity with basic financial objectives.
4) NPV uses discounted cash flows i.e. expresses cash flows in terms of current rupees. NPV's of different projects therefore can be compared. It implies that each project can be evaluated independent of others on its own merits.
Limitations of NPV method:
1) It involves different calculations.
2) The application of this method necessitates forecasting cash flows and the discount rate. Thus accuracy of NPV depends on accurate estimation of these 2 factors that may be quite difficult in reality.
3) The ranking of projects depends on the discount rate.
c)       Weighted average cost of capital.
Ans: Weighted average cost of capital (WACC) is the average of the minimum after-tax required rate of return which a company must earn for all of its security holders (i.e. common stock-holders, preferred stock-holders and debt-holders). It is calculated by finding out cost of each component of a company’s capital structure, multiplying it with the relevant proportion of the component to total capital and then summing up the proportionate cost of components. WACC is a very useful tool because it tells whether a particular project is increasing shareholders’ wealth or just compensating the cost.
Formula: For a company which has two sources of finance, namely equity and debt, WACC is calculated using the following formula: WACC = r(E) × w(E) + r(D) × (1 – t) × w(D)
Cost of equity: In the formula for WACC, r(E) is the cost of equity i.e. the required rate of return on common stock of the company. It is the minimum rate of return which a company must earn to keep its common stock price from falling. Cost of equity is estimated using different models, such as dividend discount model (DDM) and capital asset pricing model (CAPM).
Weights: w(E) is the weight of equity in the company’s total capital. It is calculated by dividing the market value of the company’s equity by sum of the market values of equity and debt. w(D) is the weight of debt component in the company’s capital structure. It is calculated by dividing the market value of the company’s debt by sum of the market values of equity and debt.
d)      Management of working capital.
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.
e)      Regular dividend policy.
Ans: 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.
3. (a) “Maximization of profits is regarded as the proper objective of investment decision, 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:
1)      The likely rate of earnings or earnings per share (EPS) of the company; and
2)      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) Define ‘financial management’. Explain the objectives of financial management. Why is maximizing wealth a better goal than maximizing profits?                                                                                                   3+7+4=14
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.
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. 
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. 
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.
4. (a) Define the term ‘working capital’. What factors you have to take into consideration in estimating the working capital needs of a concern?                                                                                                                        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) The following information has been extracted from the Cost Sheet of a company:

Rs.  (per unit)
Raw Materials
Direct Labour
Overheads
45
20
40

Profit
105
15
Selling Price
120
The following further information is available:
a)      Raw Materials are in stock on an average of two months.
b)      The materials are in process on an average for 4 weeks. The degree of completion is 50% in all respects.
c)       Finished goods are in stock on an average of one month.
d)      Time lag in payment of wages and overheads is 1 ½ weeks.
e)      Time lag in receipts of proceeds from debtors is 2 months.
f)       Credit allowed by suppliers is one month.
g)      20% of output is sold against cash.
h)      The company expects to keep a cash balance of Rs. 1,00,000.
i)        Take 52 weeks per annum.
j)        Calculation of debtors may be made at selling price.
k)      The company is poised for a manufacture of 14400 units in the year.
You are required to prepare a statement showing the working capital requirements of the company.                   14
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5. (a) Explain briefly the following methods of capital budgeting bringing out the advantages and disadvantages of each: 7+7=14
a)      Payback period method.
b)      Accounting rate of return 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.
Accounting rate of return (Average rate of return – ARR): ARR is a financial ratio used in capital budgeting. The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested. If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. Over one-half of large firms calculate ARR when appraising projects. It is calculated with the help of the following formula:
ARR=Average Profit / Investment
Merits of ARR
a)      It is simple, common sense oriented method.
b)      Profits of all years taken into account.
c)       It considers actual net profit of the project.
Demerits of ARR
a)      Time value of-money is not considered
b)      Risk involved in the project is not considered
c)       Annual average profits might be same for different projects but accrual of profits might differ having significant implications on risk and liquidity
d)      The ARR has several variants and that it lacks uniform understanding.
Or
(b) (i) X Ltd. issues Rs. 50,000, 8% debentures at par. The tax rate applicable to the company is 50%.
(ii) Y Ltd. issues Rs. 50,000, 8% debentures at a premium of 10%. The tax rate applicable to the company is 60%. Compute the cost of debt capital.
(iii) A Ltd. issues Rs. 50,000, 8% debentures at a discount of 5%. The tax rate is 50%. Compute the cost of debt capital.
(iv) B Ltd. issues Rs. 1,00,000, 9% debentures at a premium of 10%. The costs of floatation are 2%. The tax rate applicable is 60%. Compute the cost of debt capital.                                                             3 ½ x4=14
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6. (a) There is strong view prevalent among financial experts that the irrelevant hypothesis underlying the MM theory of dividend distribution is out-dated and unsuited to present conditions. Do you agree with this view? Discuss.  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.
Or
(b) (i) What is ‘dividend’? Discuss the various forms of dividend.                                                                            2+5=7
Ans: Meaning of Dividend: 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:
a)      Cash Dividend.
b)      Stock Dividend or Bonus Dividend.
c)       Bond Dividend.
d)      Property Dividend.
e)      Composite Dividend.
f)       Interim Dividend.
g)      Script Dividend
h)      Liquidating Dividend.
Some of these are explained below:
CASH DIVIDEND: A Cash dividend is the most common form of the dividend. The shareholders are paid in cash per share. The board of directors announces the dividend payment on the date of declaration. The dividends are assigned to the shareholders on the date of record. The dividends are issued on the date of payment. But for distributing cash dividend, the company needs to have positive retained earnings and enough cash for the payment of dividends.
BONUS SHARE: Bonus share is also called as the stock dividend. Bonus shares are issued by the company when they have low operating cash, but still want to keep the investors happy. Each equity shareholder receives a certain number of additional shares depending on the number of shares originally owned by the shareholder. For example, if a person possesses 10 shares of Company A, and the company declares bonus share issue of 1 for every 2 shares, the person will get 5 additional shares in his account. From company’s angle, the no. of shares and issued capital in the company will increase by 50% (1/2 shares). The market price, EPS, DPS etc will be adjusted accordingly.
INTERIM DIVIDEND: This dividend is issued between two accounting year on the basis of expected profit. This dividend is declared before the preparation of final accounts.
PROPERTY DIVIDEND: The company makes the payment in the form of assets in the property dividend. The asset could be any of this equipment, inventory, vehicle or any other asset. The value of the asset has to be restated at the fair value while issuing a property dividend.
SCRIP DIVIDEND: Scrip dividend is a promissory note to pay the shareholders later. This type of dividend is used when the company does not have sufficient funds for the issuance of dividends.
LIQUIDATING DIVIDEND: When the company returns the original capital contributed by the equity shareholders as a dividend, it is termed as liquidating dividend. It is often seen as a sign of closing down the company.
(ii) What do you understand by a stable dividend policy? Why should it be followed?                  4+3=7
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.
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:
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.
(OLD COURSE)
Full Marks: 80
Pass Marks: 32
Time: 3 hours
1. (a) Write ‘True’ or ‘False’:                                                                                                                        1x4=4
a)      The main aim of finance function is to maximize the profits.                                                                                False
b)      Capital budgeting is the process of making investment decisions in capital expenditures.       True      
c)       Ownership securities are represented by debentures.                                                                           False, Shares
d)      New issue market represents the primary market.                                                                                  True
    (b) Fill in the blanks:                                                                                                                                    1x4=4
a)      Financial decisions involve investment, financing and dividend decisions.
b)      Combined Leverage = Operating Leverage x financial Leverage.
c)       The value of the firm can be maximized, if the shareholders’ wealth is maximized.
d)      Adequacy of working capital is a must for maintaining solvency and continuing production.
2. Write short notes on any four of the following:                                                                             4x4=16
a)      Profit maximization.
Ans: 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. 
b)      Optimal capital structure.
Ans: The capital structure is said to be optimum, when the company has selected such a combination of equity and debt, so that the company's wealth is maximum. At this, capital structure, the cost of capital is minimum and market price per share is maximum. But, it is difficult to measure a fall in the market value of an equity share on account of increase in risk due to high debt content in the capital structure. In reality, however, instead of optimum, an appropriate capital structure is more realistic.
Features of an appropriate capital structure are as below:
1)      Profitability: The most profitable capital structure is one that tends to minimise financing cost and maximise of earnings per equity share.
2)      Flexibility: The capitals structure should be such that the company is able to raise funds whenever needed.
3)      Conservation: Debt content in capital structure should not exceed the limit which the company can bear.
4)      Solvency: Capital structure should be such that the business does not run the risk of insolvency.
5)      Control: Capital structure should be devised in such a manner that it involves minimum risk of loss of control over the company.
c)       Capital market instruments.
d)      Retained earnings.
Ans: Retained earnings are an internal sources of finance for any company. Actually is not a method of raising finance, but it is called as accumulation of profits by a company for its expansion and diversification activities. Retained earnings are called under different names such as self finance, inter finance, and plugging back of profits.  As prescribed by the central government, a part (not exceeding 10%) of the net profits after tax of a financial year have to be compulsorily transferred to reserve by a company before declaring dividends for the year.
Under the retained earnings sources of finance, a reasonable part of the total profits is transferred to various reserves such as general reserve, replacement fund, reserve for repairs and renewals, reserve funds and secrete reserves, etc.
Retained earnings or profits are ploughed back for the following purposes.
1)      Purchasing new assets required for betterment, development and expansion of the company.
2)      Replacing the old assets which have become obsolete.
3)      Meeting the working capital needs of the company.
4)      Repayment of the old debts of the company.

e)      Receivable management.
3. (a) What is financial management? Discuss the objectives of financial management.                                                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.
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. 
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. 
Or
(b) Discuss the profit maximization and wealth maximization concept of financial management.            6+6=12
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.
4. (a) What is cost of capital? How are cost of debt and cost of equity capital computed? Write in brief about weighted average cost of capital.                                                                                                 2+3+3+3=11
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”.
Cost of Equity: Cost of equity capital is the rate at which investors discount the expected dividends of the firm to determine its share value. Conceptually the cost of equity capital (Ke) defined as the “Minimum rate of return that a firm must earn on the equity financed portion of an investment project in order to leave unchanged the market price of the shares”. Cost of equity can be calculated from the following approach:
• Dividend price (D/P) approach
• Dividend price plus growth (D/P + g) approach
• Earning price (E/P) approach
a) Dividend Price Approach: The cost of equity capital will be that rate of expected dividend which will maintain the present market price of equity shares. Dividend price approach can be measured with the help of the following formula:
Ke = D/Np
Where,
Ke = Cost of equity capital
D = Dividend per equity share
Np = Net proceeds of an equity share
b) Dividend Price Plus Growth Approach: The cost of equity is calculated on the basis of the expected dividend rate per share plus growth in dividend. It can be measured with the help of the following formula:
Ke = D/Np + g
Where,
Ke = Cost of equity capital
D = Dividend per equity share
g = Growth in expected dividend
Np = Net proceeds of an equity share
c) Earning Price Approach: Cost of equity determines the market price of the shares. It is based on the future earning prospects of the equity. The formula for calculating the cost of equity according to this approach is as follows.
Ke = E/Np
Where,
Ke = Cost of equity capital
E = Earning per share
Np = Net proceeds of an equity share
Cost of Debt: Cost of debt is the after tax cost of long-term funds through borrowing. Debt may be issued at par, at premium or at discount and also it may be perpetual or redeemable.
Debt Issued at Par: Debt issued at par means, debt is issued at the face value of the debt. It may be calculated with the help of the following formula:
Kd = I/Np*(1 – t)
Where,
Kd = Cost of debt capital
I = Annual interest payable
Np = Net proceeds of debenture
t = Tax rate
Weighted average cost of capital (WACC) is the average of the minimum after-tax required rate of return which a company must earn for all of its security holders (i.e. common stock-holders, preferred stock-holders and debt-holders). It is calculated by finding out cost of each component of a company’s capital structure, multiplying it with the relevant proportion of the component to total capital and then summing up the proportionate cost of components. WACC is a very useful tool because it tells whether a particular project is increasing shareholders’ wealth or just compensating the cost.
Formula: For a company which has two sources of finance, namely equity and debt, WACC is calculated using the following formula: WACC = r(E) × w(E) + r(D) × (1 – t) × w(D)
Cost of equity: In the formula for WACC, r(E) is the cost of equity i.e. the required rate of return on common stock of the company. It is the minimum rate of return which a company must earn to keep its common stock price from falling. Cost of equity is estimated using different models, such as dividend discount model (DDM) and capital asset pricing model (CAPM).
Weights: w(E) is the weight of equity in the company’s total capital. It is calculated by dividing the market value of the company’s equity by sum of the market values of equity and debt. w(D) is the weight of debt component in the company’s capital structure. It is calculated by dividing the market value of the company’s debt by sum of the market values of equity and debt.
Or
(b) Following information is taken from the records of a hypothetical company:
Installed capacity
Operating capacity
Selling price per unit
Variable cost per unit
1000 units
800 units
Rs. 10
Rs. 7
Calculate operating leverage from the following situations:
Fixed Cost
Rs.
Situation A
Situation B
Situation C
800
1,200
1,500
SOLUTIONS: LINK OF ALL PRACTICAL PROBLEMS VIDEOS
5. (a) Discuss in detail the sources of long-term finance of a company form of business organization.                       11
Or
(b) What is ‘capital market’? What are the functions of a capital market? Distinguish between capital market and money market.                                                                                2+5+4=11
6. (a) Discuss the various types of dividend policies. State the various forms of dividends on the basis of payments. 6+5=11
Ans: 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:
a)      Cash Dividend.
b)      Stock Dividend or Bonus Dividend.
c)       Bond Dividend.
d)      Property Dividend.
e)      Composite Dividend.
f)       Interim Dividend.
g)      Script Dividend
h)      Liquidating Dividend.
Some of these are explained below:
CASH DIVIDEND: A Cash dividend is the most common form of the dividend. The shareholders are paid in cash per share. The board of directors announces the dividend payment on the date of declaration. The dividends are assigned to the shareholders on the date of record. The dividends are issued on the date of payment. But for distributing cash dividend, the company needs to have positive retained earnings and enough cash for the payment of dividends.
BONUS SHARE: Bonus share is also called as the stock dividend. Bonus shares are issued by the company when they have low operating cash, but still want to keep the investors happy. Each equity shareholder receives a certain number of additional shares depending on the number of shares originally owned by the shareholder. For example, if a person possesses 10 shares of Company A, and the company declares bonus share issue of 1 for every 2 shares, the person will get 5 additional shares in his account. From company’s angle, the no. of shares and issued capital in the company will increase by 50% (1/2 shares). The market price, EPS, DPS etc will be adjusted accordingly.
INTERIM DIVIDEND: This dividend is issued between two accounting year on the basis of expected profit.
PROPERTY DIVIDEND: The company makes the payment in the form of assets in the property dividend. The asset could be any of this equipment, inventory, vehicle or any other asset. The value of the asset has to be restated at the fair value while issuing a property dividend.
SCRIP DIVIDEND: Scrip dividend is a promissory note to pay the shareholders later. This type of dividend is used when the company does not have sufficient funds for the issuance of dividends.
LIQUIDATING DIVIDEND: When the company returns the original capital contributed by the equity shareholders as a dividend, it is termed as liquidating dividend. It is often seen as a sign of closing down the company.
Or
(b) There is a strong view prevalent among financial experts that irrelevant hypothesis underlying the M & M approach of dividend distribution is out-dated and unsuited to present condition. Do you agree with this 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 meant by ‘inventory management’? Discuss various techniques used for inventory control.                  3+8=11
Or
(b) A pro forma cost sheet of a company provides the following particulars:
Direct material
Direct labour
Overheads
40%
20%
20%
The following further particulars are available:
a)      It is proposed to maintain a level of activity of 200000 units.
b)      Selling price is Rs. 12 per unit.
c)       Raw materials are expected to remain in stores for an average period of one month.
d)      Finished goods are required to be in stock for an average period of one month.
e)      Materials will be in process for an average period of half month.
f)       Credit allowed to debtors is two months.
g)      Credit allowed by supplier is one month.
From the above information, you are required to prepare a statement of working capital requirements.  11
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