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Financial Management Solved Question Papers: Nov' 2017

2017
COMMERCE (General / Speciality)
Course: 302
Financial Management
(New course)
Full marks: 80
Pass marks: 24
Time: 3 hours
1. (a) Write True or false:                                                             1x4=4

1)      Increased use of debt increases the financial risk of equity share holders.     True
2)      Corporation finance is a part of public finance.                           False
3)      Composite cost refers to the cost of equity and preference share capital.     False
4)      The fixed proportion of working capital should be generally financed from the fixed capital sources.                        False, Borrowed
(b) Fill in the blanks:                                                                      1x4=4
1)      Payment of dividend involves legal as well as financial considerations.
2)      Capital budgeting is the process of making investment decisions in capital expenditure
3)      Fixed cost bearing securities should be mixed with equity when the rate of earnings is more than the rate of interest of the company.
4)      Working capital is also known as net working capital.
2. Write short notes on any four of the following:                           4x4=16
a)      Aims of finance function
Ans: Objectives of Finance functions: 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: 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. 
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)
b)      Capital gearing
Ans: Capital gearing: Capital gearing means taking decision regarding proportion of various types of securities in capital structure. Every company aims at maintaining proper proportion between various types of securities in capital structure so as to reduce its cost of capital. It can be also described as the ratio between the ordinary share capital and fixed interest bearing securities. If ratio of equity is less than the sum of debt capital and preference shares than the situation is said to be high gearing. Again, if ratio of equity is more than the sum of debt capital and preference share than the situation is said to be low gearing. Capital gearing ratio is calculated by dividing sum of equity shares and retained earnings by the sum of debt and preference shares.
c)       Estimate of working capital requirement
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. For smooth running of a business, it is necessary to estimate the working capital requirement in future. There are broadly three methods of estimating the requirement of working capital of a company viz. percentage of revenue or sales, regression analysis, and operating cycle method. Estimating working capital means calculating future working capital. It should be as accurate as possible because planning of working capital would be based on these estimates and bank and other financial institutes finances the working capital needs based on such estimates only.
Factors Affecting Working Capital Requirement: The level of working capital is influenced by several factors which are given below:
1.       Nature of Business.
2.       Size of Business.
3.       Production Policies.
4.       Terms of Purchase and Sale
5.       Production Process.
6.       Turnover of Circulating Capital.
d)      Optimal payout ratio
Ans: The dividend payout ratio measures the percentage of net income that is distributed to shareholders in the form of dividends during the year. In other words, this ratio shows the portion of profits the company decides to keep to fund operations and the portion of profits that is given to its shareholders. Investors are particularly interested in the dividend payout ratio because they want to know if companies are paying out a reasonable portion of net income to investors. The dividend payout formula is calculated by dividing total dividend by the net income of the company i.e.
Dividend Payout Ratio = Total Dividend/Net income
Optimal Dividend Payout Ratio: Dividend payout ratio maximizes the firm’s value. A payout ratio which maximizes the firm’s value is called optimal dividend payout ratio. A firm achieves this dividend payout-ratio at that point where it minimises the total cost of financing.  The minimization of sum of total cost of financing produces a unique dividend payout ratio for the firm.
e)      Net present value as a technique of capital budgeting
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.
f)       Optimal capital structure
Ans: The optimum capital structure may be defined as “that capital structure or combination of debt and equity that leads to the maximum value of the firm. 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.

3. (a) “Profit maximisation is not the adequate criterion to judge the efficiency of a firm.” Explain the statement. What should be the right criterion and why?  6+8=14
Ans: 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. 
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, 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.
OR
(b) Critically analyze the functions of a financial of a financial manager in a large scale industrial establishment. What are the responsibilities of a financial manager in a modern business organisation?                                8+6=14
Ans: Role and Functions of Finance Manager
In the modern enterprise, a finance manager occupies a key position, he being one of the dynamic member of corporate managerial team. His role, is becoming more and more pervasive and significant in solving complex managerial problems. Traditionally, the role of a finance manager was confined to raising funds from a number of sources, but due to recent developments in the socio-economic and political scenario throughout the world, he is placed in a central position in the organisation. He is responsible for shaping the fortunes of the enterprise and is involved in the most vital decision of allocation of capital like mergers, acquisitions, etc. A finance manager, as other members of the corporate team cannot be averse to the fast developments, around him and has to take note of the changes in order to take relevant steps in view of the dynamic changes in circumstances.
The nature of job of an accountant and finance manager is different, an accountant's job is primarily to record the business transactions, prepare financial statements showing results of the organisation for a given period and its financial condition at a given point of time. He is to record various happenings in monetary terms to ensure that assets, liabilities, incomes and expenses are properly grouped, classified and disclosed in the financial statements. Accountant is not concerned with management of funds that is a specialised task and in modern times a complex one. The finance manager or controller has a task entirely different from that of an accountant, he is to manage funds. Some of the important decisions as regards finance are as follows:
1.       Estimating the requirements of funds: A business requires funds for long term purposes i.e. investment in fixed assets and so on. A careful estimate of such funds is required to be made.  An assessment has to be made regarding requirements of working capital involving, estimation of amount of funds blocked in current assets and that likely to be generated for short periods through current liabilities. Forecasting the requirements of funds is done by use of techniques of budgetary control and long range planning.
2.       Decision regarding capital structure: Once the 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.

4. (a) What are the advantages of adequate working capital? What shall be the repercussions if a firm has (i) redundant working capital and (ii) inadequate working capital?
Ans: Importance of Adequate 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.
e) Smooth Business Operation: Working capital is really a life blood of any business organization which maintains the firm in well condition. Any day to day financial requirement can be met without any shortage of fund. All expenses such as salaries, rent, electricity bills and current liabilities are paid on time.
Excess or inadequate working capital
Every business concern should have adequate working capital to run its business operations. It should have neither redundant or excess working capital nor inadequate or shortage of working capital. Both excess as well as short working capital positions are bad for any business. However, out of the two, it is the inadequacy of working capital which is more dangerous from the point of view of the firm.
Disadvantages of Redundant or Excessive Working Capital
1.       Excessive Working Capital means idle funds which earn no profits for the business and hence the business cannot earn a proper rate of return on its investments.
2.       When there is a redundant working capital, it may lead to unnecessary purchasing and accumulation of inventories causing more chances of theft, waste and losses.
3.       Excessive working capital implies excessive debtors and defective credit policy which may cause higher incidence of bad debts.
4.       It may result into overall inefficiency in the organisation.
5.       When there is excessive working capital, relations with banks and other financial institutions may not be maintained.
6.       Due to low rate of return on investments, the value of shares may also fall.
7.       The redundant working capital gives rise to speculative transactions.
Disadvantages or Dangers of Inadequate Working Capital
1.       A concern which has inadequate working capital cannot pay its short-term liabilities in time. Thus, it will lose its reputation and shall not be able to get good credit facilities.
2.       It cannot buy its requirements in bulk and cannot avail of discounts, etc.
3.       It becomes difficult for the firm to exploit favourable market conditions and undertake profitable projects due to lack of working capital.
4.       The firm cannot pay day-to-day expenses of its operations and it creates inefficiencies, increases costs and reduces the profits of the business.
5.       It becomes impossible to utilise efficiently the fixed assets due to non-availability of liquid funds.
6.       The rate of return on investments also falls with the shortage of working capital.
OR
(b) The following information has been extracted from the Cost sheet of Dot Com Co. Ltd.:
Particulars
Rs. (per unit)
Raw materials
Direct labour
Overhead (including depreciation of Rs. 10)
45
18
40
Total cost
Profit
103
17
Selling price
120
The following further information is available:
a)      Raw materials are in stock on an average of one month
b)      The materials are in progress on an average for half a month (100% complete in regard to material and 50% for labour and overheads)
c)       Credit allowed by suppliers is one month
d)      Time lag in receipts of proceeds from debtors is two months.
e)      Average time lag in payment of overheads is one month.
f)       30 percents of sales are on cash basis
g)      The company expected to keep a cash balance of Rs. 1,00,000.
h)      Time lag in payment of wages is 10 days
i)        Finished goods lie in warehouse for half a month
Prepare the working capital needed to finance a level of activity of 45000 units of output. Production is carried on evenly throughout the year, and wages and overhead accrue similarly.                                               14
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5. (a) (i) Define capital structure. What is optimal capital structure?                                       3+5=8
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.
Optimal capital structure
The optimum capital structure may be defined as “that capital structure or combination of debt and equity that leads to the maximum value of the firm. 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:
6)      Profitability: The most profitable capital structure is one that tends to minimise financing cost and maximise of earnings per equity share.
7)      Flexibility: The capitals structure should be such that the company is able to raise funds whenever needed.
8)      Conservation: Debt content in capital structure should not exceed the limit which the company can bear.
9)      Solvency: Capital structure should be such that the business does not run the risk of insolvency.
10)   Control: Capital structure should be devised in such a manner that it involves minimum risk of loss of control over the company.
(ii) A Company Ltd. Has a share capital of Rs. 1,00,000 divided into shares of Rs. 10 each. It has major expansion programme requiring an investment of another Rs. 50,000. The management is considering the following alternatives for raising this amount:
Issue of 5000 shares of Rs. 10 each.
Issue of 5000, 12 5 preference shares of Rs. 10 each
Issue of 10% debentures of Rs. 50,000
 The company’s present earnings before interest and tax (EBIT) is Rs. 30,000 pa
You are required to calculate the effect of each  of the above modes of financing on the earning per share (EPS) presuming EBIT continues to be the same even after expansion (Assume tax liability at 50%)    6
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Or
(b) What is meant by cost of capital? What are the components of the cost of capital? What is the cost of retained earnings? How is the cost of new equity issues determined?                    3+3+4+4=14
Ans: 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”.
Various components of cost of capital
Capital structure of a company mainly consists of debt and equity. Debt includes debentures, loans and bonds and equity include both equity and preference shares and retained earnings. The individual cost of each source of financing is called component of cost of capital. The component of cost of capital is also known as the specific cost of capital which includes the individual cost of debt, preference shares, ordinary shares and retained earning. Such components of cost of capital have been presented below:
1. Cost of debt
a) Cost of irredeemable debt
b) Cost of redeemable debt (before tax and after tax)
c) Cost of debt redeemable in instalments
d) Cost of existing debt
e) Cost of zero coupon bonds
2. Cost of Preference Share
a) Cost of irredeemable preference Share
b) Cost of redeemable preference Share
3. Cost of ordinary/equity shares or common stock
4. Cost of retained earning

6. (a) (i) What is dividend? Discuss the various forms of dividend.                           2+5=7
Ans: Meaning of Dividend: A dividend is that portion of profits and surplus funds of a company which has actually set aside by a valid act of the company for distribution among its shareholders.
According to ICAI, “Dividend is the distribution to the shareholders of a company from the reserves and profits.”
In the words of S.M. Shah, “Dividend is a part of divisible profits of a business company which is distributed to the shareholders.”
Dividend may be divided into following categories:
1.       Cash Dividend.
2.       Stock Dividend or Bonus Dividend.
3.       Bond Dividend.
4.       Property Dividend.
5.       Composite Dividend.
6.       Interim Dividend.
7.       Special or Extra Dividend.
8.       Optional Dividend.
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 stable dividend policy? Why should it be followed? 2+5=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:
1.       Constant D/P ratio.
2.       Constant dividends per share.
3.       Constant dividend per share plus extra dividends.
Merits of Stable Dividend Policy: Following are some of the advantages of a stable dividend policy due to which every company must follow it:
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.
OR
(b) In Walter’s approach, the dividend policy of a firm depends on availability of investment opportunity and the relationship between the firm’s internal rate of return and its cost of capital. Discuss. What are the shortcomings of this view?                    14
Ans: Walter’s Dividend theory
Professor James E. Walter argues that the choice of dividend policies almost always affects the value of the enterprise. His model shows clearly the importance of the relationship between the firm’s internal rate of return (r) and its cost of capital (k) in determining the dividend policy that will maximise the wealth of shareholders.
Valuation Formula and its Denotations: Walter’s formula to calculate the market price per share (P) is:
P = D/k + {r*(E-D)/k}/k, where
P = market price per share
D = dividend per share
E = earnings per share
r = internal rate of return of the firm
k = cost of capital of the firm
Explanation: The mathematical equation indicates that the market price of the company’s share is the total of the present values of:
a)      An infinite flow of dividends, and
b)      An infinite flow of gains on investments from retained earnings.
The formula can be used to calculate the price of the share if the values of other variables are available.
Walter’s model is based on the following assumptions:
a)      The firm finances all investment through retained earnings; that is debt or new equity is not issued;
b)      The firm’s internal rate of return (r), and its cost of capital (k) are constant;
c)       All earnings are either distributed as dividend or reinvested internally immediately.
d)      Beginning earnings and dividends never change. The values of the earnings per share (E), and the divided per share (D) may be changed in the model to determine results, but any given values of E and D are assumed to remain constant forever in determining a given value.
e)      The firm has a very long or infinite life.
Criticism of Walter’s theory:
Walter’s model is quite useful to show the effects of dividend policy on an all equity firm under different assumptions about the rate of return. However, the simplified nature of the model can lead to conclusions which are net true in general, though true for Walter’s model. The criticisms on the model are as follows:
1. Walter’s model of share valuation mixes dividend policy with investment policy of the firm. The model assumes that the investment opportunities of the firm are financed by retained earnings only and no external financing debt or equity is used for the purpose when such a situation exists either the firm’s investment or its dividend policy or both will be sub-optimum. The wealth of the owners will maximise only when this optimum investment in made.
2. Walter’s model is based on the assumption that r is constant. In fact decreases as more investment occurs. This reflects the assumption that the most profitable investments are made first and then the poorer investments are made. The firm should step at a point where r = k. This is clearly an erroneous policy and fall to optimize the wealth of the owners.
3. A firm’s cost of capital or discount rate, K, does not remain constant; it changes directly with the firm’s risk. Thus, the present value of the firm’s income moves inversely with the cost of capital. By assuming that the discount rate, K is constant, Walter’s model abstracts from the effect of risk on the value of the firm.
(Old course)
Full marks: 80
Pass marks: 32
1. (a) write True or False:                                                             1x4=4
a)      Finance manager has to estimate, procure and utilize financial resources.     True
b)      Capital budgeting and capital rationing mean the same thing.              False
c)       Ownership securities are represented by debentures.           False, Creditorship Securities
d)      Cash dividend is a usual method of paying dividend.                                True
(b) Fill in the blanks:                                                                      1x4=4
a)      It is the duty of a finance manager to arrange, manage and estimate funds.
b)      Cost of capital is not a perfect  rate as such.
c)       Scrip Dividend promises to pay the shareholders at a future date.
d)      Current Assets – Current Liabilities = Working Capital
2. Write short notes on any four of the following:                           4x4=16
a)      Profit maximisation
b)      Net present value method
c)       Lease financing
d)      Retained earnings
e)      Gross and net working capital
3. (a) What is Finance Function? What are the aims of finance function? Discuss its scope. 12
OR
(b) Define Financial Management. Discuss its significance in modern era. State the objectives of financial management.                                                                                3+5+4=12
4. (a) What is cost of capital? Discuss its problems in determination of cost of capital. 3+8=11
OR
(b) What is Financial Leverage? Calculate operating leverage and financial leverage from the following data: 3+4+4=11                                                                   Rs.
Sales (100000 units)                                        2,00,000.00
Variable cost per unit                                     0.70
Fixed cost                                                            65,000.00
Interest charges                                                               15,000.00
SOLUTIONS: LINK OF ALL PRACTICAL PROBLEMS VIDEOS
5. (a) What are the main sources of finance available to industries for meeting long term financial requirements? Discuss                                                                                                                11
OR
(b) What is capital market? What are the main components of a capital market? Distinguish between capital market and money market                                                  2+3+6=11
6. (a) Discuss the MM theory of dividend distribution. What are the criticisms of this theory of irrelevance? 7+4=11
OR
(b) What is Stable Dividend Policy? Do you recommend a stable dividend policy? Explain it with justification. 2+2+7=11
7. (a) What do you mean by Inventory Management? Why is it essential to an enterprise? Mention any four problems of inventory management.                                               2+2+7=11
OR
(b) From the following information, prepare a statement showing the working capital requirements:                      11
Budgeted sales- Rs. 2,60,000 per annum. Analysis of one rupee of sales:
Particulars
Rs. (per unit)
Raw materials
Direct labour
Overhead (including depreciation of Rs. 10)
0.30
0.40
0.20
Total cost
Profit
0.90
0.10
Selling price
1.00
It is estimated that:
a)      Raw materials are carried in stock for 3 weeks and finished goods for 2 weeks.
b)      Factory processing will take 3 weeks and it may be assumed to be consisting of 100 % of raw materials, wages and overheads
c)       Suppliers will give 5 weeks credit
d)      Customers will require 8 weeks credit.
SOLUTIONS: LINK OF ALL PRACTICAL PROBLEMS VIDEOS

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