Financial Management Solved Question Paper 2021, Dibrugarh University B.Com 5th Sem CBCS Pattern

Dibrugarh University Financial Management Solved Question Papers 2021
5th SEM TDC FIMT (CBCS) C 512
2021 (Held in January/February, 2022)
COMMERCE (Core)
Paper: C-512 (Financial Management)
Full Marks: 80
Pass Marks: 32
Time: 3 hours.
The figures in the margin indicate full marks for the questions.

1. (a) Write True or False:            1x4=4

a) Wealth maximization is a socialistic approach.                True                      

b) Cash management is an important task of the finance manager.            True

c) Temporary investments of surplus funds are not current assets.             False

d) Dividend means ratio of profit to capital.          False

(b) Fill in the blanks:       1x4=4

a) The cost of capital is the expected rate of return expected by its investors.

b) Payment of dividend involves legal as well as financial considerations.

c) Corporation finance deals with the CAPITAL STRUCTURE of organization.

d) The volume of sales is influenced by the credit policy of a firm.

2. Write short notes on (any four):                          4x4=16

a) Profit maximization.

Ans: Profit maximization: Profit maximization implies that either a firm produces maximum output for a given input or uses minimum input for a given level of output. Profit maximization causes the efficient allocation of resources in competitive market condition and profit is considered as the most important measure of firm performance. The underlying logic of profit maximization is efficiency.

In a market economy, prices are driven by competitive forces and firms are expected to produce goods and services desired by society as efficiently as possible. Demand for goods and services leads price. Goods and services which are in great demand can command higher prices. This leads to higher profits for the firm. This in turn attracts other firms to produce such goods and services. Competition grows and intensifies leading to a match in demand and supply. Thus, an equilibrium price is reached. On the other hand, goods and services not in demand fetches low price which forces producers to stop producing such goods and services and go for goods and services in demand. This shows that the price system directs the managerial effort towards more profitable goods and services. Competitive forces direct price movement and guides the allocation of resources for various productive activities. 

Arguments in favour of profit maximisation

a) When profit earning is the aim of business then profit maximisation should be the obvious objective.

b) Profit is the barometer for measuring efficiency and economic prosperity of a business.

c) In adverse situation such recession, depression etc., a business can survive only when if it has past reserves to rely upon. Therefore, every business should try to earn more and more profit when situation is favourable.

Objections to Profit Maximization:

Certain objections have been raised against the goal of profit maximization which strengthens the case for wealth maximization as the goal of business enterprise. The objections are:

(a) Profit cannot be ascertained well in advance to express the probability of return as future is uncertain. It is not at all possible to maximize what cannot be known. Moreover, the return profit vague and has not been explained clearly what it means. It may be total profit before tax and after tax of profitability tax. Profitability rate, again is ambiguous as it may be in relation to capital employed, share capital, owner’s fund or sales. This vagueness is not present in wealth maximisation goal as the concept of wealth is very clear. It represents value of benefits minus the cost of investment.

(b) The executive or the decision maker may not have enough confidence in the estimates of future returns so that he does not attempt further to maximize. It is argued that firm’s goal cannot be to maximize profits but to attain a certain level or rate of profit holding certain share of the market or certain level of sales. Firms should try to ‘satisfy’ rather than to ‘maximise’.

b) 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.

c) Financial leverage.

Ans: Financial Leverage: A Leverage activity with financing activities is called financial leverage. Financial leverage represents the relationship between the company’s earnings before interest and taxes (EBIT) or operating profit and the earning available to equity shareholders. Financial leverage is defined as “the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share”. It involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders. Financial leverage can be calculated with the help of the following formula:

FL = OP/PBT

Where,

FL = Financial leverage

OP = Operating profit (EBIT)

PBT = Profit before tax.

Degree of Financial Leverage: Degree of financial leverage may be defined as the percentage change in taxable profit as a result of percentage change in earnings before interest and tax (EBIT). This can be calculated by the following formula:  DFL= Percentage change in taxable Income / Percentage change in EBIT 

d) Payback period method.

Ans: Payback period Method: It is one of the simplest methods to calculate period within which entire cost of project would be completely recovered. It is the period within which total cash inflows from project would be equal to total cash outflow of project. It is calculated by dividing initial investments in project by annual cash inflows. Here, cash inflow means profit after tax but before depreciation.

Merits of Payback Period Method

a) This method of evaluating proposals for capital budgeting is simple and easy to understand, it has an advantage of making clear that it has no profit on any project until the payback period is over i.e. until capital invested is recovered. This method is particularly suitable in the case of industries where risk of technological services is very high.

b) In case of routine projects also, use of payback period method favours projects that generates cash inflows in earlier years, thereby eliminating projects bringing cash inflows in later years that generally are conceived to be risky as this tends to increase with futurity.

Limitations of payback period

a) It stresses capital recovery rather than profitability. It does not take into account returns from the project after its payback period.

b) This method becomes an inadequate measure of evaluating 2 projects where the cash inflows are uneven.

e) Dividend 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

3. (a) “The responsibilities 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: 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.

Or

(b) What is financial management? Discuss its significance in modern era. State the objectives of financial management. 4+5+5=14

Ans: Meaning and Definitions of Financial Management

Financial management is management principles and practices applied to finance. General management functions include planning, execution and control. Financial decision making includes decisions as to size of investment, sources of capital, extent of use of different sources of capital and extent of retention of profit or dividend payout ratio. Financial management, is therefore, planning, execution and control of investment of money resources, raising of such resources and retention of profit/payment of dividend.

Howard and Upton define financial management as "that administrative area or set of administrative functions in an organisation which have to do with the management of the flow of cash so that the organisation will have the means to carry out its objectives as satisfactorily as possible and at the same time meets its obligations as they become due.”

According to Guthamann and Dougall,” Business finance can be broadly defined as the activity concerned with the planning, raising, controlling and administering the funds used in the business.”

Considering all these views, financial management may be defined as that part of management which is concerned mainly with raising funds in the most economic and suitable manner, using these funds as profitably as possible.

Significance of financial management in the present day business world

The scope and significance of financial management can be discussed from the following angles:

1) Importance to Organizations

a)       Business organizations: Financial management is important to all types of business organization i.e. Small size, medium size or a large size organization. As the size grows, financial decisions become more and more complex as the amount involves also is large.

b)      Charitable organization / Non-profit organization / Trust: In all those organizations, finance is a crucial aspect to be managed. A finance manager has to concentrate more on collection of donations/ revenues etc. and has to ensure that every rupee spent is justified and is towards achieving Goals of organization.

2) Importance to all Stake holders

a) Shareholders: Shareholders are interested in getting optimum dividend and maximizing their wealth which is basic objective of financial management.

b) Investors / creditors: these stake holders are interested in safety of their funds, timely repayment of the principal amount as well as interest on the same. All these aspects are to be ensured by the person managing funds/ finance.

c) Employees: They are interested in getting timely payment of their salary/ wages, bonus, incentives and their retirement benefits which are possible only if funds are managed properly and organization is working in profit.

3) Importance to other departments of an organization

A large size company, besides finance dept., has many departments like

a)       Production Dept.

b)      Marketing Dept.

c)       Personnel Dept.

d)      Material/ Inventory Dept.

All these departments look for availability of adequate funds so that they could manage their individual responsibilities in an efficient manner. Lot of funds are required in production/manufacturing dept. for ongoing / completing the production process as well as maintaining adequate stock to make available goods for the marketing dept. for sale. Hence, finance department through efficient management of funds has to ensure that adequate funds are made available to all department and these departments at no stage starve for want of funds. Hence, efficient financial management is of utmost importance to all other department of the organization.

Objectives of Financial Management

The firm’s investment and financing decision are unavoidable and continuous. In order to make them rational, the firm must have a goal. Two financial objectives predominate amongst many objectives. These are:

1. Profit maximization

2. Shareholders’ Wealth Maximization (SWM)

Profit maximization refers to the rupee income while wealth maximization refers to the maximization of the market value of the firm’s shares. Although profit maximization has been traditionally considered as the main objective of the firm, it has faced criticism. Wealth maximization is regarded as operationally and managerially the better objective. 

1. Profit maximization: Profit maximization implies that either a firm produces maximum output for a given input or uses minimum input for a given level of output. Profit maximization causes the efficient allocation of resources in competitive market condition and profit is considered as the most important measure of firm performance. The underlying logic of profit maximization is efficiency.

In a market economy, prices are driven by competitive forces and firms are expected to produce goods and services desired by society as efficiently as possible. Demand for goods and services leads price. Goods and services which are in great demand can command higher prices. This leads to higher profits for the firm. This in turn attracts other firms to produce such goods and services. Competition grows and intensifies leading to a match in demand and supply. Thus, an equilibrium price is reached. On the other hand, goods and services not in demand fetches low price which forces producers to stop producing such goods and services and go for goods and services in demand. This shows that the price system directs the managerial effort towards more profitable goods and services. Competitive forces direct price movement and guides the allocation of resources for various productive activities. 

2. Shareholders’ Wealth Maximization: Shareholders’ wealth maximization means maximizing the net present value of a course of action to shareholders. Net Present Value (NPV) of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action that has a positive NPV creates wealth for shareholders and therefore, is desirable. A financial action resulting in negative NPV destroys shareholders’ wealth and is, therefore undesirable. Between mutually exclusive projects, the one with the highest NPV should be adopted. NPVs of a firm’s projects are additive in nature. That is

NPV(A) + NPV(B) = NPV(A+B)

The objective of Shareholders Wealth Maximization (SWM) considers timing and risk of expected benefits. Benefits are measured in terms of cash flows. One should understand that in investment and financing decisions, it is the flow of cash that is important, not the accounting profits. SWM as an objective of financial management is appropriate and operationally feasible criterion to choose among the alternative financial actions. 

4. (a) What do you understand by working capital? Discuss the various sources of working capital funds. 4+10=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.

Various Sources of Working Capital

Sources of working capital are many. There are both external and internal sources. The external sources are both short-term and long-term. Trade credit, commercial banks, finance companies, indigenous bankers, public deposits, advances from customers, accrual accounts, loans and advances from directors and group companies etc. are external short-term sources. Companies can also issue debentures and invite public deposits for working capital which are external long term sources. Equity funds may also be used for working capital. A brief discussion of each source is attempted below.

1) Trade credit is a short term credit facility extended by suppliers of raw materials and other suppliers. It is a common source. It is an important source. Trade credit is an informal and readily available credit facility. It is unsecured. It is flexible too; that is advance retirement or extension of credit period can be negotiated. Trade credit might be costlier as the supplier may inflate the price to account for the loss of interest for delayed payment.

2) Commercial banks are the next important source of working capital finance commercial banking system in the country is broad based and fairly developed. Straight loans, cash credits, hypothecation loans, pledge loans, overdrafts and bill purchase and discounting are the principal forms of working capital finance provided by commercial banks.  They provide loan in the following form:

a)       Straight loans are given with or without security. A onetime lump-sum payment is made, while repayments may be periodical or one time.

b)      Cash credit is an arrangement by which the customers (business concerns) are given borrowing facility upto certain limit, the limit being subjected to examination and revision year after year. Interest is charged on actual borrowings, though a commitment charge for utilization may be charged.

c)       Hypothecation advance is granted on the hypothecation of stock or other asset. It is a secured loan. The borrower can deal with the goods.

d)      Pledge loans are made against physical deposit of security in the bank's custody. Here the borrower cannot deal with the goods until the loan is settled.

e)      Overdraft facility is given to current account holding customers t^ overdraw the account upto certain limit. It is a very common form of extending working capital assistance.

f)        Bill financing by purchasing or discounting bills of exchange is another common form of financing. Here, the seller of goods on credit draws a bill on the buyer and the latter accepts the same. The bill is discounted per cash will the banker. This is a popular form.

3) Finance companies abound in the country. About 50000 companies exist at present. They provide services almost similar to banks, though not they are banks. They provide need based loans and sometimes arrange loans from others for customers. Interest rate is higher. But timely assistance may be obtained.

4) Indigenous bankers also abound and provide financial assistance to small business and trades. They change exorbitant rates of interest by very much understanding.

5) Public deposits are unsecured deposits raised by businesses for periods exceeding a year but not more than 3 years by manufacturing concerns and not more than 5 years by non-banking finance companies. The RBI is regulating deposit taking by these companies in order to protect the depositors. Quantity restriction is placed at 25% of paid up capital + free services for deposits solicited from public is prescribed for non-banking manufacturing concerns. The rate of interest ceiling is also fixed. This form of working capital financing is resorted to by well established companies.

6) Advances from customers are normally demanded by producers of costly goods at the time of accepting orders for supply of goods. Contractors might also demand advance from customers. Where sellers* market prevail advances from customers may be insisted. In certain cases to ensure performance of contract in advance may be insisted.

7) Accrual accounts are simply outstanding dues to workers, suppliers of overhead service requirements and the like. Outstanding wages, taxes due, dividend provision, etc. are accrual accounts providing working capital finance for short period on a regular basis.

8) Loans from directors, loans from group companies etc. constitute another source of working capital. Cash rich companies lend to liquidity crunch companies of the group.

9) Commercial papers can be used to raise funds. It is a promissory note carrying the undertaking to repay the amount on or after a particular date. Normally it is an unsecured means of borrowing and the companies are allowed to issue commercial papers as per the regulations issued by SEBI and Company’s Act.

10) Debentures and equity fund can be issued to finance working capital so that the permanent working capital can be matchingly financed through long term funds.

Or

(b) Mohan Manufacturing Co. Ltd. is to start production on 1st Jan, 2021. The prime cost of a unit is expected to be    Rs. 40 out of which Rs. 16 is for materials and Rs. 24 for labour. In addition, variable expenses per unit are expected to be Rs. 8 and fixed expenses per month Rs. 30,000. Payment for materials is to be made in the month following the purchase. One-third of sales will be for cash and the rest on credit for settlement in the following month. Expenses are payable in the month in which they are incurred. The selling price is fixed at Rs. 80 per unit. The numbers of units manufactured and sold are expected to be as under:-    14

January

February

March

April

May

June

900

1,200

1,800

2,100

2,100

2,400

Draw up a statement showing requirements of working capital from month to month, ignoring the questions of stocks.

Ans: Will be available very soon on our Youtube channel

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5. (a) “Capital budgeting is long-term planning for making and financing proposed capital outlay.” Explain. What are the limitations of capital budgeting?   6+8=14

Ans: Concept of Capital Budgeting: The term capital budgeting or investment decision means planning for capital assets. Capital budgeting decision means the decision as to whether or not to invest in long-term projects such as setting up of a factory or installing a machinery or creating additional capacities to manufacture a part which at present may be purchased from outside and so on. It includes the financial analysis of the various proposals regarding capital expenditure to evaluate their impact on the financial condition of the company for the purpose to choose the best out of the various alternatives.

According to Milton “Capital budgeting involves planning of expenditure for assets and return from them which will be realized in future time period”.

According to I.M Pandey “Capital budgeting refers to the total process of generating, evaluating, selecting, and follow up of capital expenditure alternative”

Capital budgeting decision is thus, evaluation of expenditure decisions that involve current outlays but are likely to produce benefits over a period of time longer than one year. The benefit that arises from capital budgeting decision may be either in the form of increased revenues or reduced costs. Such decision requires evaluation of the proposed project to forecast likely or expected return from the project and determine whether return from the project is adequate.

NEED AND IMPORTANCE OF CAPITAL BUDGETING

Capital budgeting means planning for capital assets. Capital budgeting decisions are vital to any organization as they include the decisions as to:

a)       Whether or not funds should be invested in long term projects such as setting of an industry, purchase of plant and machinery etc.

b)      Analyze the proposal for expansion or creating additional capacities.

c)       To decide the replacement of permanent assets such as building and equipments.

d)      To make financial analysis of various proposals regarding capital investments so as to choose the best out of many alternative proposals.

Limitations of Capital Budgeting:

Capital budgeting techniques suffer from the following limitations:

1) The techniques of capital budgeting require estimation of future cash inflows and outflows. The future is always uncertain and the data collected for future may not be exact. Obliviously the results based upon wrong data may not be good.

2) The economic life of the project and annual cash inflows are only estimation. The actual economic life of the project is either increased or decreased. Likewise, the actual annual cash inflows may be either more or less than the estimation. Hence, control over capital expenditure cannot be exercised.

3) Capital budgeting process does not take into consideration of various non-financial aspects of the projects while they play an important role in successful and profitable implementation of them. Hence, true profitability of the project cannot be highlighted.

4) All the techniques of capital budgeting presume that various investment proposals under consideration are mutually exclusive which may not be practically true in some particular circumstances.

5) There are certain factors like morale of the employees, goodwill of the firm, etc., which cannot be correctly quantified but which otherwise substantially influence the capital decision.

6) It is also not correct to assume that mathematically exact techniques always produce highly accurate results.

Or

(b) (1) What is meant by cost of capital? What are the components of cost of capital?    3+3=6

Ans: Meaning and Definition of Cost of Capital

Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. Cost of capital is the required rate of return on its investments which belongs to equity, debt and retained earnings. If a firm fail 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 earnings. 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 installments

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

(2) What is the cost of retained earnings? How is cost of new equity issues determined?              4+4=8

Ans: Cost of Retained Earnings: Generally, retained earnings are considered as cost free source of financing. It is because neither dividend nor interest is payable on retained profit. However, this statement is not true. A shareholder of the company that retains more profit expects more income in future than the shareholders of the company that pay more dividends and retains less profit. Therefore, there is an opportunity cost of retained earnings. In other words, retained earnings are not a cost free source of financing. The cost of retained earning must be at least equal to shareholder’s rate of return on re-investment of dividend paid by the company.

Determination of Cost of Retained Earning

In the absence of any information relating to addition of cost of re-investment and extra burden of personal tax, the cost of retained earnings is considered to be equal to the cost of equity. However, the cost of retained earnings differs from the cost of equity when there is flotation cost to be paid by the shareholders on re-investment and personal tax rate of shareholders exists.

i) Cost of retained earnings when there is no flotation cost and personal tax rate applicable for shareholders:

Cost of retained earnings (kr) = Cost of equity (ke) = (D1/NP) +g where,

D1= expected dividend per share

NP= current selling price or net proceed

ii) Cost of retained earnings when there is flotation cost and personal tax rate applicable for shareholders:

Cost of retained earnings (kr) = Cost of equity (ke) x 1-fp) (1-tp)

Where,

Fp = flotation cost on re-investment (in fraction) by shareholders

Tp = Shareholders' personal tax rate.

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 (MM Approach): According to this approach, the total cost of capital of particular firm is independent of its method and level of financing. Modigliani and Miller argued that the weighted average cost of capital of a firm is completely independent of its capital structure. In other words, a change in the debt equity mix does not affect the cost of capital. They argued, in support of their approach, that as per the traditional approach, cost of capital is the weighted average of cost of debt and cost of equity, etc. The cost of equity, is determined from the level of shareholder's expectations. That is if, shareholders expect a particular rate of return, say 15 % from a particular company, they do not take into account the debt equity ratio and they expect 15 % as they find that it covers the particular risk which this company entails. Thus, the shareholders would now, expect a higher rate of return from the shares of the company. Thus, each change in the debt equity mix is automatically set-off by a change in the expectations of the shareholders from the equity share capital. Modigliani and Miller, thus, argue that financial leverage has nothing to do with the overall cost of capital and the overall cost of capital is equal to the capitalisation rate of pure equity stream of its class of risk. Thus, financial leverage has no impact on share market prices nor on the cost of capital.

Assumptions:

i) The capital markets are assumed to be perfect. This means that investors are free to buy and sell securities.

a)       They are well-informed about the risk-return on all type of securities.

b)      There are no transaction costs. 

c)       They behave rationally.

d)      They can borrow without restrictions on the same terms as the firms do.

 ii) The firms can be classified into 'homogenous risk class'. They belong to this class, if their expected earnings have identical risk characteristics.

iii) All investors have the same expectations from a firms' EBIT that is necessary to evaluate the value of a firm.

iv) The dividend payment ratio is 100 %. i.e. there are no retained earnings.

v) There are no corporate taxes, but, this assumption has been removed.

 Modigliani and Miller agree that while companies in different industries face different risks resulting in their earnings being capitalised at different rates, it is not possible for these companies to affect their market values, and thus, their overall capitalisation rate by use of leverage. That is, for a company in a particular risk class, the total market value must be same irrespective of proportion of debt in company's capital structure. The support for this hypothesis lies in the presence of arbitrage in the capital market. They contend that arbitrage will substitute personal leverage for corporate leverage.

Or

(b) What do you understand by retained earnings? Discuss the merits and demerits ploughing back of profits.  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.

Advantages of Retained Earnings

Retained earnings consist of the following important advantages:

From company point of view

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. Avoid excessive tax: Retained earnings provide opportunities for evasion of excessive tax in a company when it has small number of shareholders.

From shareholders’ point of view

6. 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.

7. Increase earning capacity and high dividend: Retained earnings consist of least cost of capital and also it is most suitable to those companies which go for diversification and expansion. Low cost of capital increases profitability of the company which in turn results into higher EPS and high dividend payout.

8. Bonus shares to shareholders: A company with high retained earnings can give bonus shares to existing shareholders.

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.

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