Financial Management Solved Question
Paper 2022
Dibrugarh University Financial
Management Question Papers (CBCS Pattern)
5 SEM TDC FIMT (CBCS) C
512
2022 (Nov / Dec)
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
(1) Profit maximization objectives consider
the risk and time value of money.
Ans: False
(2) Capital budgeting and capital rationing
are alternative to each other.
Ans: False
(3) Cost of capital refers to required rate
of return.
Ans: True
(4) Capital profits can never be
distributed as dividends to the shareholders.
Ans: False
(b) Fill in the blanks: 1x4=4
(1) A sound capital budgeting technique is
based on _______.
Ans: Cash flows
(2) EBIT is also known as _______ profits.
Ans: Operating
(3) Working capital is also known as
_______ of _______ capital.
Ans:
(4) Dividend payout ratio is _______.
Ans: the proportion of earnings
paid out as dividends.
2.
Write short notes on (any four): 4x4=16
(a)
Operating leverage.
Ans:
The leverage associated with investment activities is called as
operating leverage. It is caused due to fixed operating expenses in the
company. Operating leverage may be defined as the company’s ability to use
fixed operating costs to magnify the effects of changes in sales on its
earnings before interest and taxes. Operating leverage consists of two
important costs viz., fixed cost and variable cost. When the company is said to
have a high degree of operating leverage if it employs a great amount of fixed
cost and smaller amount of variable cost. Thus, the degree of operating
leverage depends upon the amount of various cost structure. Operating leverage
can be determined with the help of a break even analysis. Operating leverage
can be calculated with the help of the following formula:
OL = C/OP
Where,
OL = Operating Leverage
C = Contribution
OP = Operating Profits
Degree of Operating Leverage: The degree of operating leverage may
be defined as percentage change in the profits resulting from a percentage change
in the sales. It can be calculated with the help of the following formula:
DOL = Percentage change in profits/Percentage change in sales
Features
of operating leverage
a) It is related to the assets side of balance sheet.
b) It is calculated to measure business risk of the company.
c) It is directly related to break-even point.
d) It is related to selling price and variable cost.
e) It is concerned with investment decision.
(b)
Weighted average cost of capital.
Ans: Weighted average cost of capital (WACC)
is the average of the minimum after-tax required rate of return which a company
must earn for all of its security holders (i.e. common stock-holders, preferred
stock-holders and debt-holders). It is calculated by finding out cost of each
component of a company’s capital structure, multiplying it with the relevant
proportion of the component to total capital and then summing up the
proportionate cost of components. WACC is a very useful tool because it tells
whether a particular project is increasing shareholders’ wealth or just
compensating the cost.
Formula: For a company which has two sources
of finance, namely equity and debt, WACC is calculated using the following
formula: WACC = r(E) × w(E) + r(D) × (1 – t) × w(D)
Cost of equity: In the formula for WACC, r(E) is the
cost of equity i.e. the required rate of return on common stock of the company.
It is the minimum rate of return which a company must earn to keep its common
stock price from falling. Cost of equity is estimated using different models,
such as dividend discount model (DDM) and capital asset pricing model (CAPM).
Weights: w(E) is the weight of equity in the company’s
total capital. It is calculated by dividing the market value of the company’s
equity by sum of the market values of equity and debt. w(D) is
the weight of debt component in the company’s capital structure. It is
calculated by dividing the market value of the company’s debt by sum of the
market values of equity and debt.
(c)
Operating cycle concept.
Ans:
Operating cycle is the time duration required to convert sales,
after the conversion of resources into inventories and cash.
The operating cycle of a manufacturing co involves 3 segments:
i) Acquisition of resources like raw labor, material,
fuel and power
ii) Manufacture of the product that includes conversion of raw
material into work in process and into finished goods,
and
iii) Sales of the product either for cash or credit. Credit
sales create book debts for collection (debtors).
The length of the operating cycle of
a manufacturing co is the sum of - i)
inventory conversion period (ICP) and ii) Book debts conversion
period (BDCP) collectively, they are sometimes called as gross operating cycle
(GOC).
GOC = ICP + DCP
The Inventory conversion period is the entire time needed for
producing and selling the product and includes:
(a) Raw material conversion time (RMCP)
(b) Work in process conversion period (WIPCP) and
(C) Finished good conversion period (FGCP).
ICP = RMCP + WIPCP + FGCP
The payables deferral period (PDP) is the length of time the firm
is capable to defer payments on various resource purchases. The variation
between the gross operating cycle and payables deferrals period is the net
operating cycle (NOC).
NOC = GOC- Payables deferral period.
(d)
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.
(e)
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.
3.
(a) Define ‘financial management’. Explain the objectives of financial
management. Why is maximizing wealth a better goal than maximizing profits?
Discuss. 3+7+4=14
Ans: Meaning and Definitions of
Financial Management/Business Finance/ Corporation Finance
Financial management is management principles and practices
applied to finance. General management functions include planning, execution
and control. Financial decision making includes decisions as to size of
investment, sources of capital, extent of use of different sources of capital
and extent of retention of profit or dividend payout ratio. Financial
management, is therefore, planning, execution and control of investment of money
resources, raising of such resources and retention of profit/payment of
dividend.
Howard and Upton define financial management as "that
administrative area or set of administrative functions in an organisation which
have to do with the management of the flow of cash so that the organisation
will have the means to carry out its objectives as satisfactorily as possible
and at the same time meets its obligations as they become due.”
According to Guthamann and Dougall,” Business finance can be
broadly defined as the activity concerned with the planning, raising,
controlling and administering the funds used in the business.”
Bonneville and Dewey interpret that financing consists in the
raising, providing and managing all the money, capital or funds of any kind to
be used in connection with the business.
Osbon defines financial management as the "process of
acquiring and utilizing funds by a business”.
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.
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.
d) The profits are the main source of finance for
the growth of a business. So, a business should aim at maximisation of profits
for enabling its growth and development.
e) Profitability is essential for fulfilling
social goals also. A firm by pursuing the objective of profit maximisation also
maximises socio-economic welfare.
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’.
(c)There must be a balance between expected return and risk. The
possibility of higher expected yields are associated with greater risk to
recognize such a balance and wealth maximisation is brought in to the analysis.
In such cases, higher capitalization rate involves. Such combination of
expected returns with risk variations and related capitalization rate cannot be
considered in the concept of profit maximisation.
(d) The goal of maximisation of profits is considered to be a
narrow outlook. Evidently when profit maximisation becomes the basis of
financial decision of the concern, it ignores the interests of the community on
the one hand and that of the government, workers and other concerned persons in
the enterprise on the other hand.
(e) The criterion of profit maximisation ignores time value
factor. It considers the total benefits or profits in to account while
considering a project whereas the length of time in earning that profit is not
considered at all. Whereas the wealth maximization concept fully endorses the
time value factor in evaluating cash flows. Keeping the above objection in
view, most of the thinkers on the subject have come to the conclusion that the
aim of an enterprise should be wealth maximisation and not the profit
maximisation.
(f) To make a distinction between profits and profitability.
Maximisation of profits with a view to maximizing the wealth of shareholders is
clearly an unreal motive. On the other hand, profitability maximisation with a
view to using resources to yield economic values higher than the joint values
of inputs required is a useful goal. Thus, the proper goal of financial
management is wealth maximisation.
2. Shareholders’ Wealth Maximization: Shareholders’ wealth maximization means maximizing the net present
value of a course of action to shareholders. Net Present Value (NPV) of a
course of action is the difference between the present value of its benefits
and the present value of its costs. A financial action that has a positive NPV
creates wealth for shareholders and therefore, is desirable. A financial action
resulting in negative NPV destroys shareholders’ wealth and is, therefore
undesirable. Between mutually exclusive projects, the one with the highest NPV
should be adopted.NPVs of a firm’s projects are additive in nature. That is
NPV(A) + NPV(B) = NPV(A+B)
The objective of Shareholders Wealth Maximization
(SWM) considers timing and risk of expected benefits. Benefits are measured in
terms of cash flows. One should understand that in investment and financing
decisions, it is the flow of cash that is important, not the accounting
profits. SWM as an objective of financial management is appropriate and
operationally feasible criterion to choose among the alternative financial
actions.
Maximizing the shareholders’ economic welfare is
equivalent to maximizing the utility of their consumption over time. The wealth
created by a company through its actions is reflected in the market value of
the company’s shares. Therefore, this principle implies that the fundamental
objective of a firm is to maximize the market value of its shares. The market
price, which represents the value of a company’s shares, reflects shareholders’
perception about the quality of the company’s financial decisions. Thus, the
market price serves as the company’s performance indicator.
In such a case, the financial manager must know
or at least assume the factors that influence the market price of shares.
Innumerable factors influence the price of a share and these factors change
frequently. Moreover, the factors vary across companies. Thus, it is
challenging for the manager to determine these factors.
WEALTH
MAXIMIZATION AS PRIMARY OBJECTIVE OF FINANCIAL MANAGEMENT
The primary objective of financial management is wealth
maximization. The concept of wealth in the context of wealth maximization
objective refers to the shareholders’ wealth as reflected by the price of their
shares in the share market. Therefore, wealth maximization means maximization
of the market price of the equity shares of the company. However, this
maximization of the price of company’s equity shares should be in the long run
by making efficient decisions which are desirable for the growth of a company
and are valued positively by the investors at large and not by manipulating the
share prices in the short run. The long run implies a period which is long
enough to reflect the normal market price of the shares irrespective of
short-term fluctuations. The long run price of an equity share is a function of
two basic factors:
a) The
likely rate of earnings or earnings per share (EPS) of the company; and
b) The
capitalization rate reflecting the liking of the investors of a company.
The financial manager must identify those avenues of investment;
modes of financing, ways of handling various components of working capital
which ultimately will lead to an increase in the price of equity share. If
shareholders are gaining, it implies that all other claimants are also gaining
because the equity share holders are paid only after the claims of all other
claimants (such as creditors, employees, 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 stockholder’s 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)
“Financial management is more than procurement of funds.” In the context of the
above statement, what is your thinking about the 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.
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) Define the term ‘working capital’. What factors you have to take into
consideration in estimating the working capital needs of a concern? 3+11=14
Ans: Meaning and definition of Working
Capital: The capital required for a business is of two
types. These are fixed capital and working capital. Fixed capital is required for the purchase of fixed assets like
building, land, machinery, furniture etc. Fixed capital is invested for long
period, therefore it is known as long-term capital. Similarly, the capital,
which is needed for investing in current assets, is called working capital. The
capital which is needed for the regular operation of business is called working
capital. Working capital is also called circulating capital or revolving
capital or short-term capital.
In the words of John. J
Harpton “Working capital may be defined as all the short term assets used in
daily operation”.
According to “Hoagland”, “Working
Capital is descriptive of that capital which is not fixed. But, the more common
use of Working Capital is to consider it as the difference between the book
value of the current assets and the current liabilities.
From the above definitions, Working Capital means the excess of
Current Assets over Current Liabilities. Working Capital is the amount of net
Current Assets. It is the investments made by a business organisation in short
term Current Assets like Cash, Debtors, Bills receivable etc.
Factors
Affecting Working Capital Requirement
The level of working capital is influenced by several factors
which are given below:
a)
Nature of Business: Nature of businessis 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 lowerlevel of working
capital.
b)
Size of Business: Size of businessis 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.
l)
Turnover of Inventories: A
business organisation having low inventory turnover would require more Working
Capital where as a business having high inventory turnover would require
limited or less Working Capital.
Or
(b) Prepare an estimate of
net working capital requirement of Wimco Ltd. adding 10% of computed figure for
contingencies.
|
Estimated
cost per unit of production: Raw materials Direct labour Overhead (including depreciation Rs. 5) |
Rs.
80 Rs.
30 Rs.
65 |
Additional
information:
(1) Selling
price Rs. 200 per unit.
(2) Level of
activity 1,04,000 units of production p.a.
(3) Raw
materials in stock average 4 weeks.
(4)
Work-in-progress (assume full unit of raw materials required in the beginning
of manufacturing; other conversion costs are 50%) average 2 weeks.
(5) Finished
goods in stock average 4 weeks.
(6) Credit
allowed by supplier’s average 4 weeks.
(7) Credit
allowed to debtor’s average 8 weeks.
(8) Lag in
payment of wages average 1.5 weeks.
(9) Cash at
bank (desired to be maintained) Rs. 25,000.
You may assume
that the production is carried on evenly throughout the year (52 weeks) and
wages and overheads accrue similarly. All sales are on credit basis only. 14
5.
(a) What is meant by cost of capital and what relevance it has in financial
management decision making? 4+10=14
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”.
Relevance
of Cost of capital in financial management
Cost of capital is a very important tool in the hand of finance
management. It has both advantages and limitations which a finance manager must
take into consideration while taking financial decisions.
Significance
of Cost of Capital
Computation of cost of capital is a very important part of the
financial management to decide the capital structure of the business concern.
a)
Importance to Capital Budgeting
Decision: Capital budget decision largely depends on the cost of capital of
each source. According to net present value method, present value of cash
inflow must be more than the present value of cash outflow. Hence, cost of
capital is used to capital budgeting decision.
b)
Importance to Structure Decision:
Capital structure is the mix or proportion of the different kinds of long term
securities. A firm uses particular type of sources if the cost of capital is
suitable. Hence, cost of capital helps to take decision regarding structure.
c)
Importance to Evolution of Financial
Performance: Cost of capital is one of the important determine which affects
the capital budgeting, capital structure and value of the firm. Hence, it helps
to evaluate the financial performance of the firm.
d)
Importance to Other Financial
Decisions: Apart from the above points, cost of capital is also used in some
other areas such as, market value of share, earning capacity of securities etc.
hence, it plays a major part in the financial management.
Problems
in Determination of the cost of capital
The determination of the cost of capital of a firm is not an easy task. The
finance manager is confronted with a large number of problems, both conceptual
and practical, while determining the cost of capital of a firm. These problems in
determination of cost of capital can briefly be summarized
as follows:
1.
Controversy regarding the dependence of cost of capital upon the method
and level of financing: There is a, major controversy
whether or not the cost of capital dependent
upon the method and level of financing by the company. According to the traditional
authors, the cost
of capital of a firm depends upon the method and level of financing. On
the other hand, the modern authors such as Modigliani and Miller the firm’s total cost of capital argue that is independent of the
method and level of financing. An important assumption underlying MM approach is that there is perfect capital
market. Since perfect capital market does
not exist in practice, hence the approach is not of much practical utility.
2.
Computation of cost of equity: The
determination of the cost of equity capital is
another problem. In theory, the cost of equity capital may be defined as the
minimum rate of return that accompany must earn on that portion of its capital
employed, which is financed by equity capital so that the market price of the shares
of the company remains unchanged. This means that determination of the cost of
equity capital will
require quantification of the expectations of the equity shareholders. This is
a difficult task because the equity shareholders value the equity shares on the basis of a large number of
factors, financial as well as psychological.
3.
Computation of cost of retained earnings and depreciation funds: The cost of capital raised through retained earnings and depreciation funds will
depend upon the approach adopted for computing the cost of equity capital. Since there are
different views, therefore, a finance manager has to face difficult task in
subscribing and selecting an appropriate approach.
4.
Future costs versus historical costs: It is
argued that for decision-making purposes, the historical cost is
not relevant. The future costs should be considered. It, therefore, creates
another problem whether to consider marginal cost of capital, i.e., cost of additional funds or the average cost of capital,
i.e., the cost of total funds.
5.
Problem of weights: The assignment of weights to each
type of funds is a complex issue. The finance manager has to make a choice
between the risk value of each source of funds and the market value of each
source of funds. The results would be different in each case.
Or
(b) A company has an investment opportunity costing Rs. 50,000 with
the following expected net cash flow (i.e., after taxes and before
depreciation):
|
Year |
Net Cash Flow |
|
1 2 3 4 5 6 7 8 |
8,000 8,000 8,000 15,000 20,000 10,000 6,000 5,000 |
Using 10% as the cost of capital, determine the
following: 14
(1) Payback period.
(2) Net present value at 10% discount factor.
Present value of Rs. 1 at 10% discount factor:
|
Year |
1 |
2 |
3 |
4 |
5 |
6 |
7 |
8 |
|
|
0.909 |
0.826 |
0.751 |
0.683 |
0.621 |
0.564 |
0.513 |
0.467 |
6. (a)
Explain the Walter’s approach to the theory of dividend decisions. What are the
shortcomings of this theory? 10+4=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.
Or
(b)
“Retained earnings do not involve any cost.” Do you agree? Justify your answer.
10+4=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.
Though retained earning do not involve any cost but it is
beneficial for both company and shareholders. It indirectly creates value for
both company and the shareholders. 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 shareholder’s
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.
Calculation of 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) +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.
***
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