Gauhati
University B.Com 5th Sem Solved Question Paper
4
(Sem-5/CBCS) COM HC2 (FOFM)
2021
(Held in 2022)
COMMERCE
(Honours) Paper: COM-HC-5026
(Fundamentals
of Financial Management Solved Question Paper 2021)
Full
Marks: 80
Time:
Three hours
The
figures in the margin indicate full marks for the questions.
1. (A) Choose the correct option of the following: 1x5=5
1. Which of the following is a part of financial
decision-making?
a) Investment
decision.
b) Financing
decision.
c) Dividend
decision.
d) All of the
above.
Ans: All of the
above
2. Capital budgeting is a part of
a) Investment
decision.
b) Working
capital management.
c) Capital
structure.
d) Dividend
decision.
Ans: a)
Investment decision.
3. Cost of capital refers to
a) Floatation
cost.
b) Dividend.
c) Minimum
required rate of return.
d) None of the
above.
Ans: c) Minimum
required rate of return.
4. The working capital ratio is
a) Working
capital/sales.
b) Working
capital/total assets.
c) Current
assets/current liabilities.
d) Current
assets/sales.
Ans: c) Current
assets/current liabilities.
5. The long-term objective of financial management is
to
a) Maximize
earning per share.
b) Maximize the
value of the firm’s common stock.
c) Maximize
return on investment.
d) Maximize
market share.
Ans: b)
Maximize the value of the firm’s common stock.
(B) Write whether the
following statements are True or False:
1x5=5
1. Profit
maximization ignores risk and uncertainty.
Ans: True,
Profit maximization ignores risk, uncertainty and time value of money.
2. The value of
a share is equal to the present value of its expected future dividend.
Ans: True as
per Dividend Discounted model
3. The NPV
method does not consider the time value of money.
Ans: False
4. Retained
earnings do not involve any cost.
Ans: False
5. Gross
working capital means total current assets.
Ans: True
2. Answer the following
questions: 2x5=10
a) What is financial management?
Ans: 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.
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.”
b) What is dividend?
Ans:
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.”
c) What is internal rate of return?
Ans: The internal rate of return method is a modern
technique of capital budgeting that takes into account the time value of money.
It is also known as ‘time adjusted rate of return’ discounted cash flow’
‘discounted rate of return,’ ‘yield method,’ and ‘trial and error yield
method’. In the net present value method, the net present value is determined
by discounting the future cash flows of a project at a predetermined or
specified rate called the cut-off rate.
d) What is marginal cost?
Ans: Marginal Cost: The term Marginal
cost means the additional cost incurred for producing an additional unit of
output. It is the addition made to total cost when the output is increased by
one unit. Marginal cost of nth unit = Total cost of nth unit- total cost of n-1
unit. E.g. When 100 units are produced, the total cost is Rs. 5000.When the
output is increased by one unit, i.e., 101 units, total cost is Rs.5040. Then
marginal cost of 101th unit is Rs. 40[5040-5000]
e) What is leverage?
Ans:
The term leverage refers to an increased means of accomplishing some purpose.
Leverage is used to lifting heavy objects, which may not be otherwise possible.
In the financial point of view, leverage refers to furnish the ability to use
fixed cost assets or funds to increase the return to its shareholders.
James Horne has defined leverage as, “the employment of an asset
or fund for which the firm pays a fixed cost or fixed return.
3.
Answer any four from the following questions: 5x4=20
a) Write
a brief note on valuation of equity shares.
Ans: COMMON STOCK OR EQUITY SHARE
VALUATION
The valuation of common stock or equity shares
is relatively difficult as compared to the bonds or preferred stock. The cash
flows of the latter are certain because the rate of interest on bonds and the
rate of dividend on preference shares are known. The cash flows expected by
investors on common stock are uncertain. The earnings and dividends on equity
shares are expected to grow. However, we can determine the value of equity
shares (1) by developing certain models based on capitalization of dividend,
and (2) Capitalization of earnings. Dividend capitalization models are the
basic valuation models.
The
Basic Valuation and Dividend Capitalization Models
The value of an equity share is a function of
cash inflows expected by the investors and the risk associated with the cash
inflows. The investor expects to receive dividend while holding the shares and
the capital gain on sale of shares. The value of an equity share, in general,
is the present value of its future stream of dividends. Now, let us develop
this idea in the form of valuation of models.
(a)
One-Period Valuation Model: Suppose an investor plans to buy an
equity share to hold it for one year and then sell. The value of the share for
him will be the present value of expected dividend at the end of one year plus
the present value of the expected sale price at the end of the year.
(b) Two-Period Valuation Model
Suppose now that the investor plans to hold
the share for two years and then sell it. The value of the share to the
investor today would be:
(C) n-Period Valuation Model
Similarly, if the investor plans to hold the
share for n years and then sell, the value of the share would be:
If the expected dividend in different periods is (D) constant, we can calculate the value of the share by using annuity discount factor tables, as given below:
DIVIDEND VALUATION MODEL
Dividend valuation model is the generalized
form of common stock valuation. The concept of this model is that many
investors do not contemplate selling their share in the near future. They want
to hold the share for a very long period, say infinity. In their case, the
present value of the share is the capitalized value of an infinite stream of
future dividends.
Some
Variations in the Dividend Valuation Model
(a) No
growth case: If a firm has future dividend pattern with on growth or where
the dividends remain constant over time, the value of the share shall be the
capitalization of perpetual stream of constant dividends:
(b) Constant growth case: It the dividends of a firm are expected to grow at a constant rate forever, the value of the share can be calculated as:
b) Explain various types
of dividend.
Ans:
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.
c) What is optimum capital
structure? Explain.
Ans: Meaning of Optimum 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:
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.
d) State the advantages
and disadvantages of pay-back 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.
c) By stressing earlier cash inflows, liquidity dimension is also
considered in selection criteria. This is important in situations of liquidity
crunch and high cost of capital.
d) Payback period can be compared to break-even point, the point
at which costs are fully recovered but profits are yet to commence.
e) The risk associated with a project arises due to uncertainty
associated with cash inflows. A shorter payback period means that uncertainty
with respect to project is resolved faster.
Limitations
of payback period
a) It stresses capital recovery rather than profitability. It does
not take into account returns from the project after its payback period.
b) This method becomes an inadequate measure of evaluating 2
projects where the cash inflows are uneven.
c) This method does not give any consideration to time value of
money, cash flows occurring at all points of time are simply added.
d) Post-payback period profitability is ignored totally.
e) Explain the main
objective of inventory management.
Ans: Objectives
of inventory control and management:
a)
to make available the right
type of raw material at the right time in order to have smooth and continuous
flow of production;
b)
to ensure effective utilization
of material;
c)
to prevent over stocking of
materials and consequent locking up of working capital;
d)
to procure appropriate quality
of raw materials at reasonable price;
e)
to prevent losses during
storage of materials;
f)
to supply information to the
management regarding the cost of materials and the availability of stock;
f) Explain the main tools
of cash planning and control.
Ans: Tools of Cash Planning and Control:
a) Cash Budget: Cash budget is the most significant
device to plan for and control cash receipts and payments. A cash budget is a
budget or plan of expected cash receipts and disbursements during the period.
These cash inflows and outflows include revenues collected, expenses paid, and
loans receipts and payments. In other words, a cash budget is an estimated
projection of the company's cash position in the future.
Management usually develops the cash budget after the
sales, purchases, and capital expenditures budgets are already made. These
budgets need to be made before the cash budget in order to accurately estimate
how cash will be affected during the period. For example, management needs to
know a sales estimate before it can predict how much cash will be collected
during the period. Management uses the cash budget to manage the cash flows of
a company. In other words, management must make sure the company has enough
cash to pay its bills when they come due.
b) Cash flow statement: A Cash Flow
Statement is similar to the Funds Flow Statement, but while preparing funds
flow statement all the current assets and current liabilities are taken into
consideration. But in a cash flow statement only sources and applications of
cash are taken into consideration, even liquid asset like Debtors and Bills
Receivables are ignored.
A Cash Flow Statement is a statement, which summarises the resources
of cash available to finance the activities of a business enterprise and the
uses for which such resources have been used during a particular period of
time. Any transaction, which increases the amount of cash, is a source of cash
and any transaction, which decreases the amount of cash, is an application of
cash. Projected cash flow statement can be prepared to plan and control cash
receipts and payments.
4.
Explain the characteristics of financial management. Describe the goals of
financial management. 4+6=10
Ans: Nature or Features or Characteristics of
Financial Management
Nature of financial management is concerned with its functions,
its goals, trade-off with conflicting goals, its indispensability, its systems,
its relation with other subsystems in the firm, its environment, its
relationship with other disciplines, the procedural aspects and its equation
with other divisions within the organisation.
1)
Financial Management is an integral
part of overall management. Financial considerations are involved in all
business decisions. So financial management is pervasive throughout the
organisation.
2)
The central focus of financial
management is valuation of the firm. That is financial decisions are directed
at increasing/maximization/ optimizing the value of the firm.
3)
Financial management essentially
involves risk-return trade-off Decisions on investment involve choosing of
types of assets which generate returns accompanied by risks. Generally, higher
the risk, returns might be higher and vice versa. So, the financial manager has
to decide the level of risk the firm can assume and satisfy with the
accompanying return.
4)
Financial management affects the
survival, growth and vitality of the firm. Finance is said to be the life blood
of business. It is to business; what blood is to us. The amount, type, sources,
conditions and cost of finance squarely influence the functioning of the unit.
5)
Finance functions, i.e., investment,
rising of capital, distribution of profit, are performed in all firms -
business or non-business, big or small, proprietary or corporate undertakings.
Yes, financial management is a concern of every concern.
6)
Financial management is a sub-system
of the business system which has other subsystems like production, marketing,
etc. In systems arrangement financial sub-system is to be well-coordinated with
others and other sub-systems well matched with the financial subsystem.
Objectives of Financial Management
The firm’s investment and financing decision are
unavoidable and continuous. In order to make them rational, the firm must have
a goal. Two financial objectives predominate amongst many objectives. These
are:
1. Profit maximization
2. Shareholders’ Wealth Maximization (SWM)
Profit maximization refers to the rupee income
while wealth maximization refers to the maximization of the market value of the
firm’s shares. Although profit
maximization has been traditionally considered as the main objective of the
firm, it has faced criticism. Wealth maximization is regarded as operationally
and managerially the better objective.
1. Profit maximization: Profit maximization
implies that either a firm produces maximum output for a given input or uses
minimum input for a given level of output. Profit maximization causes the
efficient allocation of resources in competitive market condition and profit is
considered as the most important measure of firm performance. The underlying
logic of profit maximization is efficiency.
In a market economy, prices are driven by
competitive forces and firms are expected to produce goods and services desired
by society as efficiently as possible. Demand for goods and services leads
price. Goods and services which are in great demand can command higher prices.
This leads to higher profits for the firm. This in turn attracts other firms to
produce such goods and services. Competition grows and intensifies leading to a
match in demand and supply. Thus, an equilibrium price is reached. On the other
hand, goods and services not in demand fetches low price which forces producers
to stop producing such goods and services and go for goods and services in
demand. This shows that the price system directs the managerial effort towards
more profitable goods and services. Competitive forces direct price movement
and guides the allocation of resources for various productive activities.
2. Shareholders’ Wealth Maximization: Shareholders’ wealth maximization means maximizing the net present
value of a course of action to shareholders. Net Present Value (NPV) of a
course of action is the difference between the present value of its benefits
and the present value of its costs. A financial action that has a positive NPV
creates wealth for shareholders and therefore, is desirable. A financial action
resulting in negative NPV destroys shareholders’ wealth and is, therefore
undesirable. Between mutually exclusive projects, the one with the highest NPV
should be adopted. NPVs of a firm’s projects are additive in nature. That is
NPV(A) + NPV(B) = NPV(A+B)
The objective of Shareholders Wealth Maximization
(SWM) considers timing and risk of expected benefits. Benefits are measured in
terms of cash flows. One should understand that in investment and financing
decisions, it is the flow of cash that is important, not the accounting
profits. SWM as an objective of financial management is appropriate and
operationally feasible criterion to choose among the alternative financial
actions.
Maximizing the shareholders’ economic welfare is
equivalent to maximizing the utility of their consumption over time. The wealth
created by a company through its actions is reflected in the market value of
the company’s shares. Therefore, this principle implies that the fundamental
objective of a firm is to maximize the market value of its shares. The market
price, which represents the value of a company’s shares, reflects shareholders’
perception about the quality of the company’s financial decisions. Thus, the
market price serves as the company’s performance indicator.
In such a case, the financial manager must know
or at least assume the factors that influence the market price of shares.
Innumerable factors influence the price of a share and these factors change
frequently. Moreover, the factors vary across companies. Thus, it is
challenging for the manager to determine these factors.
Or
Discuss the various
factors that affect bond value. Also explain the steps in bond valuation. 5+5=10
Ans:
5.
Define capital budgeting. Discuss the capital budgeting process. 2+8=10
Ans:
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”.
Capital Budgeting Process
The important steps involved in the capital budgeting
process are:
(1) Project generation,
(2) Project evaluation,
(3) project selection and
(4) project execution.
1. Project Generation. Investment proposals of various
types may originate at different levels within a firm. Investment proposals may
be either proposals to add new product to the product line or proposals to expand
capacity in existing product lines. Secondly, proposals designed to reduce
costs in the output of existing products without changing the scale of
operations. The investment proposals of any type can originate at any level. In
a dynamic and progressive firm there is a continuous flow of profitable
investment proposals.
2. Project evaluation. Project evaluation involves two
steps: i) estimation of benefits and costs and ii) selection of an appropriate
criterion to judge the desirability of the projects. The evaluation of projects
should be done by an impartial group. The criterion selected must be consistent
with the firm’s objective of maximizing its market value.
3. Project Selection. There is no uniform selection
procedure for investment proposals. Since capital budgeting decisions are of
crucial importance, the final approval of the projects should rest on top
management.
4. Project Execution. After the final selection of
investment proposals, funds are earmarked for capital expenditures. Funds for
the purpose of project execution should be spent in accordance with
appropriations made in the capital budget.
Or
A company has to select
one of the two alternative projects whose particulars are given below:
|
Particulars |
Project
A (Rs.) |
Project
B (Rs.) |
|
Initial
outlay: |
1,18,720 |
1,00,670 |
|
Net cash flow
at the end of the year: |
|
|
|
1st
year |
1,00,000 |
10,000 |
|
2nd
year |
20,000 |
10,000 |
|
3rd
year |
10,000 |
20,000 |
|
4th
year |
10,000 |
1,00,000 |
The company can arrange necessary fund at 8%. Compute NPV of each project and comment on results. 10
[The PV factor of Re. 1 received at the end of 1st year is 0.926, 2nd year is 0.857, 3rd year is 0.794 and 4th year is 0.735]
Ans:
6.
Explain the concept of cost of capital. Also explain the methods for
calculating cost of capital. 2+8=10
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 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”.
Methods to Calculate
Cost of Capital
The cost of capital is a significant factor in
designing the capital structure of an undertaking, as basic reason of running
of a business undertaking is to earn return at least equal to the cost of
capital. Commercial undertaking has no relevance if, it does not expect to earn
its cost of capital. Thus cost of capital constitutes an important factor in
various business decisions. For example, in analysing financial implications of
capital structure proposals, cost of capital may be taken as the discounting
rate. Obviously, if a particular project gives an internal rate of return
higher than its cost of capital, it should be an attractive opportunity.
Following are the cost of capital acquired from various sources:
1) Cost of debt: The explicit cost of debt is the interest rate as per contract
adjusted for tax and the cost of raising debt.
a) Cost of
irredeemable debentures: Cost of debentures not
redeemable during the life time of the company,
Kd = (I/NP) * (I - T)
Where,
Kd = Cost of debt after tax
I = Annual interest rate
NP = Net proceeds of debentures
T = Tax rate
b) Cost of
redeemable debentures: If the debentures are
redeemable after the expiry of a fixed period the cost of debentures would be:
Kd = I (1 - t) + {[(RV - NP)]/N} / [(RV + NP)/2]
Where,
I = Annual interest payment
NP = Net proceeds of debentures
RV = Redemption value of debentures
t = tax rate
N = Life of debentures
2) Cost of
preference shares: In case of preference shares,
the dividend rate can be taken as its cost, as it is this amount that the
company intends to pay against the preference shares. As, in case of debt, the
issue expenses or discount/premium on issue/redemption is also to be taken into
account.
a) Cost of
irredeemable preference shares: Cost of
irredeemable preference shares = PD/PO
Where,
PD = Annual preference dividend
PO = Net proceeds of an issue of preference shares
b) Cost of
redeemable preference shares: If the preference
shares are redeemable after the expiry of a fixed period, the cost of
preference shares would be:
Kp = PD + {[(RV - NP)]/N} / [(RV + NP)/2]
Where,
PD = Annual preference dividend
NP = Net proceeds of debentures
RV = Redemption value of debentures
N = Life of debentures
3) Cost of
ordinary or equity shares: Calculation of the cost
of ordinary shares involves a complex procedure, because unlike debt and
preference shares there is no fixed rate of interest or dividend against
ordinary shares. Hence, to assign a certain cost to equity share capital is not
a question of mere calculation, it requires an understanding of many factors
basically concerning the behaviour of investors and their expectations. As,
there can be different interpretations of investor's behaviour, there are many
approaches regarding calculation of cost of equity shares. The 4 main
approaches are:
i) D/P ratio
(Dividend/Price) approach: According to this
method, the cost of equity capital is the ‘discount rate that equates the
present value of expected future dividends per share with the net proceeds of a
share. Symbolically:
Ke = D/NP or D/MP
Where,
Ke = Cost of Equity Capital
D = Expected dividend per share
NP = Net proceeds per share
MP = Market Price per share
ii) Earning
yield Method/Earning Price ratio: According to this
method, the cost of equity capital is the discount rate that equates the
present values of expected future earnings per share with the net proceeds of a
share. Symbolically:
Ke = EPS/NP or EPS/MP
Where,
Ke = Cost of Equity Capital
EPS = Earnings per share
NP = Net proceeds per share
MP = Market Price per share
iii) D/P +
growth approach: The dividend/price + growth
approach emphasises what an investor actually expects to receive from his
investment in a particular company's ordinary share in terms of dividend plus
the rate of growth in dividend/earnings. This growth rate in dividend (g) is
taken to be good to the compound growth rate in earnings per share.
Ke = [D1/P0] + g
Where,
Ke = Cost of capital
D1= Dividend for the period 1
P0 = Price for the period 0
g = Growth rate
iv) Realised
yield approach: This approach takes into
consideration the basic factor of the D/P + g approach but, instead of using
the expected values of the dividends and capital appreciation, past yields are
used to denote the cost of capital. This approach is based upon the assumption
that the past behaviour would be repeated in future and thus, they may be used
to measure the cost of ordinary capital.
4) cost of
reserves or retained earnings: The cost of retained
earnings may be considered as the rate of return which the existing
shareholders can obtain by investing the after-tax dividends in alternative
opportunity of equal qualities. It is, thus the opportunity cost of dividends
foregone by the shareholders. Cost of retained earnings can be computed with
the help of following formula:
Kr = [D1/NP] + G
or [D1/MP] + G
Where,
Kr = Cost of retained earnings
D1= Dividend for the period 1
NP = Net proceeds of shares issued
MP = Market prices of share
g = Growth rate
Or
a) A company
plans to issue 1,000 new shares of Rs. 100 each at par. The floatation costs
are expected to be 5% of the share price. The company pays a dividend of Rs. 10
per share initially and the growth in dividends is expected to be 5%. Compute
the cost of new issue of equity shares.
5
Ans:
b) Distinguish between operating leverage and financial
leverage. 5
Ans: Difference
between Operating Leverage and Financial Leverage
1)
Operating Leverage results from the
existence of fixed operating expenses in the firm’s income stream whereas
Financial Leverage results from the presence of fixed financial charges in the
firm’s income stream.
2)
Operating Leverage is determined by
the relationship between a firm’s sales revenues and its earnings before
interest and taxes (EBIT). Financial Leverage is determined by the relationship
between a firm’s earnings before interest and tax and after subtracting the
interest component.
3)
Operating Leverage = Contribution/EBIT
and Financial Leverage = EBIT/EBT
4)
Operational Leverage relates to the
Assets side of the Balance Sheet, whereas Financial Leverage relates to the
Liability side of the Balance Sheet.
5)
Operational Leverage affects profit
before interest and tax, whereas Financial Leverage affects profit after
interest and tax.
7.
State the meaning of dividend policy. Explain the Modigliani and Miller
hypothesis of dividend decision. 2+8=10
Ans: Meaning of Dividend Policy: A policy which
determines the amount of earnings to be distributed to the shareholders and the
amount to be retained in the company as retained earnings, is called dividend
policy. In short, dividend policy determines the division of earnings between
payment to shareholders and retained earnings.
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)
Where,
P0 = Present
market price of the share
Ke = Cost of
equity share capital
D1 = Expected
dividend at the end of year 1
P1 = Expected
market price of the share at the end of year 1
With the help of
this valuation model we will create an 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
an 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.
Or
Explain
the concept and determinants of working capital. 2+8=10
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.
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.
Determinants of Working Capital
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.
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