Financial Management Solved Question Paper 2018, Dibrugarh University B.Com 5th Sem Non-CBCS Pattern

Dibrugarh University Financial Management Solved Question Papers

2018 (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) Write True or False:                            1x4=4
1)         Retained earnings do not involve any cost.                                False
2)         The main aim of financial function is to maximize profit.       False
3)         Gross working capital refers to the capital invested in the total assets of an enterprise.        False, CA
4)         Payment of dividend at the usual rate is termed as regular dividend.             True
(b) Fill in the blanks:                                  1x4=4
1)         It is better for a company to remain in low gear during the period of depression.
2)         According to M&M approach, the total value of a firm is absolutely unaffected by capital structure. 
3)         Corporation finance deals with the company form of organization.
4)         The rate of return on investments does not related with the shortage of working capital.
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. 
b)      Significance of cost of capital.
Ans: 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.
c)       Profitability index method of capital budgeting.
Ans: It is also a time-adjusted method of evaluating the investment proposals. Profitability index also called as Benefit-Cost Ratio (B/C) or ‘Desirability factor’ is the relationship between present value of cash inflows and the present value of cash outflows.
Merits of PI
1.       It considers the time value of money.
2.       It considers entire cash flows over entire life of the project.
3.       It is a relative measure of profitability since the ratio of cash inflows to cash outflows is considered.
4.       It guides in resolving capital rationing where projects are divisible.
5.       It guides the selection of Mutually Exclusive Projects having same Net Present Value.
Demerits of PI
1.       It requires the estimation of cash inflows and cash outflows, which is a difficult task.
2.       It requires the computation of the cost of capital to be used as discount rate.
3.       The ranking of projects depends upon the discount rate.
4.       It ignores the difference in initial cash outflows, size of different projects, etc. while evaluating mutually exclusive projects.
5.       It fails to guide in resolving capital rationing where projects are indivisible.
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:
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.
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.

e)      Importance of working capital management.
Ans: Importance of working capital: Working Capital means excess of current assets over current liabilities. Such Working Capital is required to smooth conduct of business activities. It is as important as blood to body. An organisation’s profitability depends on the quantum of Working Capital available to it. Adequate Working Capital is a source of energy to any business organisation. It is the life blood of an organisation. The following points will highlight the need of adequate working capital:
a) Enables a company to meet its obligations: Working capital helps to operate the business smoothly without any financial problem for making the payment of short-term liabilities. Purchase of raw materials and payment of salary, wages and overhead can be made without any delay. Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production.
b) Enhance Goodwill:  Sufficient working capital enables a business concern to make prompt payments and hence helps in creating and maintaining goodwill. Goodwill is enhanced because all current liabilities and operating expenses are paid on time.
c) Facilitates obtaining Credit from banks without any difficulty: A firm having adequate working capital, high solvency and good credit rating can arrange loans from banks and financial institutions in easy and favorable terms.
d) Regular Supply of Raw Material: Quick payment of credit purchase of raw materials ensures the regular supply of raw materials for suppliers. Suppliers are satisfied by the payment on time. It ensures regular supply of raw materials and continuous production. Prompt payments to its creditors also enable a company to take advantage of cash and quantity discounts offered by them.
3. (a) The responsibility of a finance manager is now regarded as much more than mere procurement of funds. What do you think are other responsibilities of a finance manager?                         14
Ans: Responsibility of a 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 requirement 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 is 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.
(b) What do you mean by Finance Function? Discuss about the scope of finance function in a business enterprise. Should the goal of financial decision making be profit maximization or wealth maximization?                 4+6+4=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.
Scope of Finance Function
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 lose 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. 
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, and 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) Define the term ‘working capital’. On the formation of a 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 short 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 vary 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.
(b) The following information has been extracted from the cost sheet of a company:
Rs. (Per Unit)
Raw materials
Direct labour
Selling Price
The following further information is available:
1)         Raw materials are in stock on an average two months.
2)         The materials are in process of an average for 4 weeks. The degree of completion is 50% in all respects.
3)         Finished goods are in stock on an average for one month.
4)         Time lag in payment of wages and overheads is 1 and half weeks.
5)         Time lag in respect of proceeds from debtors is 2 months.
6)         Credit allowed by suppliers is one month.
7)         20% of output is sold against cash.
8)         The company expects to keep a cash balance of Rs. 50,000.
9)         Take 52 weeks per annum.
10)      Calculation of debtors may be made at selling price.
11)      The company is planned to manufacture 15,000 units in the year.
You are required to prepare a statement showing the working capital requirements of the company.                   14
5. (a) Define capital structure. Using imaginary figures, show how to determine the value of firm under (1) the net income (NI) approach and (2) the net operating income (NOI) approach.                                             4+5+5=14
Ans: Meaning of Capital Structure
Capital structure refers to the mix of sources from where long term funds required by a business may be raised i.e. what should be the proportion of equity share capital, preference share capital, internal sources, debentures and other sources of funds in total amount of capital which an undertaking may raise for establishing its business.
In the words of Robert H. Wessel “The term capital structure is frequently used to indicate the long-term sources of funds employed in a business enterprise”.
In the words of John J. Hampton “Capital structure is the combination of debt and equity securities that comprise a firm’s financing of its assets”.
In simple words, Capital structure of a company is the composition of long-term sources of funds, such as ordinary shares, preference shares, debentures, bonds, long-term funds.
Various theories on Capital Structure
A firm's objective should be directed towards the maximisation of the firm's value; the capital structure or leverage decisions are to be examined from the view point of their impact on the value of the firm. If the value of the firm can be affected by capital structure or financing decision, a firm would like to have a capital structure that maximises the market value of the firm. There are broadly 4 approaches in the regard, which analyses relationship between leverage, cost of capital and the value of the firm in different ways, under the following assumptions:
1)      There are only 2 sources of funds viz. debt and equity.
2)      The total assets of the firm are given and the degree of leverage can be altered by selling debt to repurchase shares or selling shares to retire debt.
3)      There are no retained earnings implying that entire profits are distributed among shareholders.
4)      The operating profit of firm is given and expected to grow.
5)      The business risk is assumed to be constant and is not affected by the financing mix decision.
6)      There are no corporate or personal taxes.
7)      The investors have the same subjective probability distribution of expected earnings.
The approaches are as below:
1) Net Income Approach (NI Approach): The approach is suggested by Durand. According to it, a firm can increase its value or lower the overall cost of capital by increasing the proportion of debt in the capital structure. In other words, if the degree of financial leverage increases, the weighted average cost of capital would decline with every increase in the debt content in total funds employed, while the value of the firm will increase. Reverse would happen in a converse situation. It is based on the following assumptions:
 i) There are no corporate taxes.
 ii) The cost of debt is less than cost of equity or equity capitalisation rate.
 iii) The use of debt content does not change the risk perception of investors as a result of both the Kd (Debt capitalisation rate) and Ke (equity capitalisation rate) remains constant.
The value of the firm on the basis of Net Income Approach may be ascertained as follows: V = S + D
V = Value of the firm
S = Market value of equity (S = NI/Ke)
D = Market value of debt
NI = Earnings available for equity shareholders
Ke = Equity Capitalisation rate
Under, NI approach, the value of a firm will be maximum at a point where weighted average cost of capital is minimum. Thus, the theory suggests total or maximum possible debt financing for minimising cost of capital. Overall cost of capital = EBIT/Value of the firm
2) Net Operating Income Approach (NOI): This approach is also suggested by Durand, according to it, the market value of the firm is not affected by the capital structure changes. The market value of the firm is ascertained by capitalising the net  operating income at the overall cost of capital, which is constant. The market value of the firm is determined as:
V = EBIT/Overall cost of capital
V = Market value of the firm
EBIT = Earnings before interest and tax
S = V – D Where,
S = Value of equity
D = Market value of debt
V = Market value of firm
It is based on the following assumptions:
 i) The overall cost of capital remains constant for all degree of debt equity mix.
 ii) The market capitalises value of the firm as a whole. Thus, the split between debt and equity is not important.
 iii) The use of less costly debt funds increases the risk of shareholders. This causes the equity capialisation rate to increase. Thus, the advantage of debt is set off exactly by increase in equity capitalisation rate.
iv) There are no corporate taxes.
v) The cost of debt is constant.
               Under, NOI approach since overall cost of capital is constant, thus, there is no optimal capital structure rather every capital structure is as good as any other and so every capital structure is optimal.
(b) A chemical company is considering investment in a project that costs Rs. 5,00,000. The life of the project is 5 years and estimated salvage value is zero. Tax rate is 55%. The company uses straight-line depreciation and proposed project has estimated earnings before depreciation and before tax as follows:                                                        14
Earnings before
Depreciation and Tax (Rs.)
Determine the following:
1)         Payback period.
2)         Average rate of return.
3)         Net present value at 15%.
4)         Gross profitability index at 15%.
The following are the present value factors at 15% p.a.:
PV Factor:
6. (a) What is the Modigliani-Miller approach of irrelevance concept of dividends? Under what assumptions do the conclusions hold good?                                10+4=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, are 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)
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 neutralized 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.
(b) What do you understand by retained earnings? Discuss the merits and limitations of ploughing back of profit. 4+5+5=14
Ans: Retained Earnings or Ploughing Back of Profit: Retained earnings are 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.
Advantages of Retained Earnings
Retained earnings consist of the following important advantages:
1. Useful for expansion and diversification: Retained earnings are most useful to expansion and diversification of the business activities.
2. Economical sources of finance: Retained earnings are one of the least costly sources of finance since it does not involve any floatation cost as in the case of raising of funds by issuing different types of securities.
3. No fixed obligation: If the companies use equity finance they have to pay dividend and if the companies use debt finance, they have to pay interest. But if the company uses retained earnings as sources of finance, they need not pay any fixed obligation regarding the payment of dividend or interest.
4. Flexible sources: Retained earnings allow the financial structure to remain completely flexible. The company need not raise loans for further requirements, if it has retained earnings.
5. Increase the share value: When the company uses the retained earnings as the sources of finance for their financial requirements, the cost of capital is very cheaper than the other sources of finance; hence the value of the share will increase.
6. Avoid excessive tax: Retained earnings provide opportunities for evasion of excessive tax in a company when it has small number of shareholders.
7. Increase earning capacity: Retained earnings consist of least cost of capital and also it is most suitable to those companies which go for diversification and expansion.
Disadvantages of Retained Earnings
Retained earnings also have certain disadvantages:
1. Misuses: The management by manipulating the value of the shares in the stock market can misuse the retained earnings.
2. Leads to monopolies: Excessive use of retained earnings leads to monopolistic attitude of the company.
3. Over capitalization: Retained earnings lead to over capitalization, because if the company uses more and more retained earnings, it leads to insufficient source of finance.
4. Tax evasion: Retained earnings lead to tax evasion. Since, the company reduces tax burden through the retained earnings.
5. Dissatisfaction: If the company uses retained earnings as sources of finance, the shareholder can’t get more dividends. So, the shareholder does not like to use the retained earnings as source of finance in all situations.
Full Marks: 80
Pass Marks: 32
Time: 3 hours
1. (a) Fill in the blanks:               1x4=4
1)         Financial leverage is also known as ‘Trading on Equity’.
2)         Payment of dividend involved legal as well as financial consideration.
3)         Finance is the life blood and nerve centre of a business concern.
4)         Financial decisions involved investment, financing and dividend decisions.
(b) Write True or False:     1x4=4
1)         Debentures do not carry any voting right.   True
2)         The value of the firm can be maximized, if the shareholders’ wealth is maximized.   True
3)         According to Walter’s model, the dividend decision is irrelevant.    False, MM Approach
4)         Corporation finance is a wider term than business finance.   False, Similar
2. Write short notes on any four of the following:      4x4=16
a)      Capital market.
b)      Trading on equity.
c)       Retained earnings.
d)      Dividend payout ratio.
e)      Aims of finance function.
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
(b) Discuss the profit maximization and wealth maximization concept of financial management.                          6+6=12
4. (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
(b) What is ‘capital market’? Why is it considered as a prerequisite for the economic development of a country like India? Discuss.                                                   3+8=11
5. (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
(b) (1) Define capital budgeting. State its limitations.                                                 2+3=5
(2) The following data are available for ABC Ltd:

Selling price per unit
Variable cost per unit
Fixed cost 
1)         What is the operating leverage, when ABC Ltd. produces and sells 6,000 units?
2)         What is the percentage change that will occur in the EBIT of ABC Ltd., if output increases by 5%?     3+3=6
6. (a) What do you mean by ploughing back of profit? What are the purposes of ploughing back? Discuss different factors that influence the ploughing back of profit.                                         2+4+5=11
(b) Explain the various factors which influence the dividend decision of a firm.                   11
7. (a) Define receivable management. Discuss the various dimensions of receivable management.  3+8=11
(b) The following information has been submitted by the borrower:
1)         Expected level of production – 120000 units.
2)         Raw materials to remain in stock on an average – 2 months.
3)         Processing period for each unit of product (costing of 100% of raw material, wages and overheads) – 1 month.
4)         Finished goods remain in stock on an average – 3 months.
5)         Credit allowed to the customers from the date of dispatch – 3 months.
6)         Expected ratios of cost to selling price:
a)         Raw material – 60%
b)         Direct wages – 10%
c)          Overheads – 20%
7)         Selling price per unit – Rs. 10.
8)         Expected margin on sale – 10%.
You are required to estimate the working capital requirements of the borrower.    11

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