Financial ManagementClass 12 Business Studies Part 2 NCERT Solutions
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Q1Long Answer Type
What is working capital? Discuss five important determinants of working capital requirement?
Solution
Working capital refers to the capital invested in current assets of a business, which facilitates smooth day-to-day operations. Current assets are those that are expected to be converted into cash within one year. Net working capital is the excess of current assets over current liabilities (NWC = CA - CL).
Five important determinants of working capital requirement are:
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Nature of Business: The type of business significantly influences working capital needs. A manufacturing organization requires a higher amount of working capital because it needs to maintain inventory of raw materials, work-in-progress, and finished goods. In contrast, a trading concern needs less working capital as there is no processing involved, and a service industry requires even less as it typically does not maintain any inventory.
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Scale of Operations: The size of the business directly impacts working capital needs. A larger organization operating at a higher scale will require a larger quantum of inventory and debtors to support its operations. Therefore, it will need a large amount of working capital compared to a small-scale organization.
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Production Cycle: The production cycle is the time taken to convert raw materials into finished goods. Firms with a longer production cycle need to hold raw materials and work-in-progress for a longer duration, which ties up more funds. Consequently, working capital requirement is higher in firms with a longer processing cycle and lower in firms with a shorter one.
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Credit Allowed: A firm's credit policy towards its customers affects its working capital. A liberal credit policy (allowing customers more time to pay) results in a higher amount of debtors. This increases the amount of funds locked in receivables, thereby increasing the requirement of working capital.
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Credit Availed: Just as a firm allows credit, it also avails credit from its suppliers. If a firm can get liberal credit terms from its suppliers, it can finance its inventory and other current assets with trade credit. To the extent it avails credit on purchases, the need for its own working capital is reduced.
Q2Long Answer Type
"Capital structure decision is essentially optimisation of risk-return relationship." Comment.
Solution
The statement "Capital structure decision is essentially optimisation of risk-return relationship" is correct. The capital structure decision involves determining the proportion of debt and equity in a firm's total capital, and this mix directly affects its profitability (return) and financial risk.
Return: The use of debt in the capital structure can increase the return for equity shareholders. Debt is generally a cheaper source of finance than equity because interest paid on debt is tax-deductible, and lenders demand a lower return as they bear less risk. When the firm's Return on Investment (RoI) is higher than the cost of debt, the use of debt magnifies the earnings available to equity shareholders (a concept known as Trading on Equity). This increases the Earnings Per Share (EPS).
Risk: However, debt is a riskier source of finance for the firm. The payment of interest and repayment of principal are legal obligations that must be met regardless of the firm's earnings. Failure to meet these commitments can force the business into liquidation. This risk of default is known as financial risk. As the proportion of debt increases, the firm's financial risk also increases.
Optimisation: The goal of the capital structure decision is not just to maximize return or minimize risk, but to find an optimal balance between them. While increasing debt can boost EPS, it also increases financial risk. After a certain point, the increased risk perceived by shareholders will cause the cost of equity to rise sharply, which can decrease the market value of the share despite a higher EPS. An optimal capital structure is one where the mix of debt and equity is such that it maximizes the market price of the equity share, thereby maximising shareholders' wealth. This requires a careful trade-off between the return generated by using cheaper debt and the financial risk it introduces.
Q3Long Answer Type
"A capital budgeting decision is capable of changing the financial fortunes of a business." Do you agree? Give reasons for your answer?
Solution
Yes, I agree with the statement that "A capital budgeting decision is capable of changing the financial fortunes of a business." Capital budgeting decisions involve investment in long-term assets and are crucial for a firm's success and survival.
The following reasons support this view:
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Long-term Growth and Effects: These decisions affect the firm's earning capacity and growth in the long run. An investment in a new plant or technology can open up new markets and increase future profits significantly. Conversely, a poor investment can drain resources and hamper future prospects for years.
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Large Amount of Funds Involved: Capital budgeting decisions typically involve huge amounts of investment. A substantial portion of a firm's capital is blocked in these long-term projects. If a decision goes wrong, the financial loss can be massive and may even threaten the company's solvency.
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Irreversible Decisions: Once a decision to invest in a fixed asset is made and funds are committed, it is often irreversible except at a huge cost. Abandoning a project midway or selling a specialized plant can lead to heavy losses. The inflexibility of these decisions means that they must be taken with utmost care and detailed analysis.
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Risk Involved: These decisions influence the overall business risk of the firm. A decision to diversify into a new, riskier line of business or invest in an unproven technology can significantly alter the risk profile of the company. A wrong capital budgeting decision has the capacity to severely damage the financial fortune of a business.
Therefore, because of their long-term impact, the large funds involved, their irreversibility, and the inherent risk, capital budgeting decisions are critical and have the power to make or break a company.
Q4Long Answer Type
Explain the factors affecting dividend decision?
Solution
The dividend decision involves determining how much of a company's after-tax profit should be distributed to shareholders and how much should be retained for reinvestment. Key factors affecting this decision include:
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Amount of Earnings: Dividends are paid out of current and past earnings. Therefore, the level of earnings is a major determinant. A company with higher earnings can afford to pay higher dividends.
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Stability of Earnings: A company with stable and consistent earnings is in a better position to declare higher and regular dividends. In contrast, a company with unstable earnings is likely to follow a more conservative dividend policy and pay smaller dividends.
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Growth Opportunities: Companies with significant growth opportunities need funds for investment. They tend to retain a larger portion of their earnings to finance these growth projects. Consequently, the dividend payout in growth companies is generally smaller than in mature, non-growth companies.
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Cash Flow Position: The payment of dividends results in an outflow of cash. A company may be profitable on paper but short on cash. Therefore, the availability of adequate cash is a necessary condition for the declaration and payment of dividends.
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Shareholders' Preference: The management must consider the expectations of its shareholders. If shareholders, particularly retired individuals or those relying on regular income, prefer a certain level of dividend, the company is likely to declare it to keep them satisfied.
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Taxation Policy: Tax policies regarding dividends and capital gains can influence the decision. If the tax on dividends is higher than on capital gains, companies may prefer to pay less in dividends and retain more earnings, which increases the share value (leading to capital gains).
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Access to Capital Market: Large, reputable companies with easy access to the capital market can raise funds easily when needed. They may depend less on retained earnings and thus can afford to pay higher dividends. Smaller companies with limited access to the market may need to rely more on internal funds and pay lower dividends.
Q5Long Answer Type
Explain the term 'Trading on Equity'? Why, when and how it can be used by company.
Solution
Meaning of Trading on Equity
'Trading on Equity' refers to the practice of using borrowed funds, which carry a fixed financial charge like interest, to increase the profit earned by the equity shareholders. It involves using the leverage provided by debt to magnify the returns on equity capital.
Why it is used:
The primary purpose of using Trading on Equity is to increase the Earnings Per Share (EPS) of the equity shareholders. By borrowing funds and investing them profitably, the company can generate a surplus that belongs to the equity shareholders, thereby enhancing their wealth.
When it can be used:
A company can and should use Trading on Equity only when its Return on Investment (RoI) is higher than the rate of interest on borrowed funds. This situation is known as favourable financial leverage. If the RoI is lower than the cost of debt, using more debt will decrease the EPS, creating an unfavourable financial leverage, and Trading on Equity would be unadvisable.
How it can be used:
A company uses Trading on Equity by including a significant proportion of debt in its capital structure. The process works as follows:
- The company borrows funds (e.g., by issuing debentures or taking loans) at a fixed rate of interest, say 10%.
- It invests these funds in its business operations to generate a Return on Investment (RoI), say 15%.
- The company pays the fixed interest of 10% on the borrowed funds.
- The difference between the RoI earned (15%) and the interest paid (10%) is a surplus of 5%. This surplus profit is added to the earnings available to the equity shareholders, thus increasing their overall return and the EPS.
Q6Long Answer Type
' S ' Limited is manufacturing steel at its plant in India. It is enjoying a buoyant demand for its products as economic growth is about 7-8 per cent and the demand for steel is growing. It is planning to set up a new steel plant to cash on the increased demand. It is estimated that it will require about ₹5000 crores to set up and about ₹500 crores of working capital to start the new plant. a. Describe the role and objectives of financial management for this company. b. Explain the importance of having a financial plan for this company. Give an imaginary plan to support your answer. c. What are the factors which will affect the capital structure of this company? d. Keeping in mind that it is a highly capital-intensive sector, what factors will affect the fixed and working capital. Give reasons in support of your answer.
Solution
a. Role and Objectives of Financial Management
- Role: The role of financial management for 'S' Limited is crucial. It involves the optimal procurement and usage of the ₹5500 crores required for the new plant. This includes identifying different sources of finance (debt, equity, retained earnings), comparing their costs and risks, and raising the funds. It also involves making the capital budgeting decision to invest in the new plant in a manner that ensures the returns exceed the cost of financing.
- Objectives: The primary objective is wealth maximization for its shareholders. This means the decision to set up the new steel plant must add value to the company. Financial management must ensure that this massive investment leads to an increase in the market price of 'S' Limited's equity shares.
b. Importance and an Imaginary Financial Plan
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Importance: A financial plan is vital for 'S' Limited because it provides a blueprint for its future operations. It will help in:
- Forecasting fund requirements accurately (₹5500 crores) and ensuring their availability at the right time.
- Avoiding business shocks by preparing for different scenarios (e.g., if demand growth slows down).
- Coordinating the production and sales functions of the new plant.
- Linking the investment decision (new plant) with the financing decision (how to raise funds).
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Imaginary Plan:
- Sales Forecast: Project sales for the next 5 years based on the 7-8% economic growth and growing steel demand.
- Fund Requirement: Estimate total fund requirement at ₹5500 crores (₹5000 crores for fixed capital and ₹500 crores for working capital).
- Internal Sources: Estimate profits and retained earnings over the next few years to see how much can be financed internally.
- External Sources: Plan to raise the remaining funds. For example, raise ₹2000 crores through long-term debt from financial institutions and ₹2500 crores by issuing new equity shares, considering market conditions.
c. Factors Affecting Capital Structure
- Cash Flow Position: A steel plant has a long gestation period but generates strong, stable cash flows once operational. This strong future cash flow position may make debt financing more viable.
- Cost of Debt: As a large, established company, 'S' Limited can likely borrow at a lower interest rate, making debt an attractive option.
- Risk Consideration: The steel industry has high fixed operating costs, leading to high business risk. Therefore, the company must be cautious not to take on excessive debt, which would increase financial risk to a very high level.
- Control: If the existing management wants to retain control and avoid dilution, it might prefer debt over a large public issue of equity.
- Stock Market Conditions: If the stock market is bullish, raising funds through equity might be easier and more preferable.
d. Factors Affecting Fixed and Working Capital
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Factors Affecting Fixed Capital (₹5000 crores):
- Nature of Business: Steel manufacturing is a heavy industry and is highly capital-intensive, requiring massive investment in plant and machinery.
- Scale of Operations: Setting up a new plant is a large-scale operation, necessitating a huge investment in fixed assets.
- Choice of Technique: Steel production is a capital-intensive process that relies on advanced machinery and technology rather than labour, thus requiring higher fixed capital.
- Technology Upgradation: The steel industry requires continuous technological upgrades to remain competitive, which involves high fixed capital expenditure.
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Factors Affecting Working Capital (₹500 crores):
- Scale of Operations: A large plant will require a high volume of raw materials (iron ore, coal) and will have a large amount of work-in-progress and finished goods, leading to high working capital needs.
- Production Cycle: The process of converting iron ore into finished steel is long. This long production cycle means more funds are tied up in raw materials and work-in-progress.
- Growth Prospects: The company is expanding to meet growing demand. Higher growth requires a larger amount of working capital to support higher production and sales targets.
- Availability of Raw Material: To ensure continuous production, the company will need to maintain a large inventory of raw materials, increasing its working capital requirement.
Q1Short Answer Type
What is financial risk? Why does it arise?
Solution
Financial risk is the chance that a firm will fail to meet its payment obligations, such as the payment of interest on debt and the repayment of principal.
It arises due to the use of borrowed funds (debt) in the capital structure. When a company uses debt, it is legally obligated to pay fixed financial charges (interest) and repay the principal amount at a specified time, regardless of whether it earns a profit. The higher the proportion of debt in a company's capital, the higher its fixed commitments and, consequently, the higher its financial risk.
Q2Short Answer Type
Define current assets? Give four examples of such assets.
Solution
Current assets are those assets which, in the normal course of business, are expected to be converted into cash or cash equivalents within one year. They are essential for the smooth day-to-day operations of a business and provide liquidity.
Four examples of current assets are:
- Inventories (including raw materials, work-in-progress, and finished goods)
- Debtors (or accounts receivable)
- Bills receivable
- Cash in hand/Cash at Bank
Q3Short Answer Type
What are the main objectives of financial management? Briefly explain.
Solution
The primary objective of financial management is the maximisation of shareholders' wealth, also known as the wealth-maximisation concept.
This objective is achieved by maximising the market price of the company's equity shares. When a financial decision is made, such as investing in a new project, the goal is to ensure that the benefits from the decision exceed its costs. This creates value for the company. Such value additions lead to an increase in the market price of the shares, thereby increasing the wealth of the shareholders, who are the owners of the company. All financial decisions—investment, financing, and dividend—should ultimately aim to be efficient and contribute to this primary objective.
Q4Short Answer Type
Financial management is based on three broad financial decisions. What are these?
Solution
Financial management is based on the following three broad financial decisions:
- Investment Decision: This relates to how the firm's funds are invested in different assets. It includes long-term decisions, known as capital budgeting (e.g., buying new machinery), and short-term decisions, known as working capital management (e.g., managing cash and inventory levels).
- Financing Decision: This decision is about the quantum of finance to be raised from various long-term sources. It involves deciding the optimal mix of debt and equity in the capital structure to minimize the cost of capital and financial risk.
- Dividend Decision: This decision relates to the distribution of profit. It involves deciding how much of the after-tax profit should be distributed to the shareholders as dividends and how much should be retained in the business for future investment.
Q5Short Answer Type
Sunrises Ltd. dealing in readymade garments, is planning to expand its business operations in order to cater to international market. For this purpose the company needs additional ₹80,00,000 for replacing machines with modern machinery of higher production capacity. The company wishes to raise the required funds by issuing debentures. The debt can be issued at an estimated cost of 10%. The EBIT for the previous year of the company was ₹ 8,00,000 and total capital investment was ₹ 1,00,00,000. Suggest whether issue of debenture would be considered a rational decision by the company. Give reason to justify your answer. (Ans. No, Cost of Debt ( 10% ) is more than ROI which is 8% ).
Solution
No, the issue of debentures would not be considered a rational decision for Sunrises Ltd.
Reason:
A company should use debt financing only when its Return on Investment (RoI) is higher than the cost of debt. This practice, known as 'Trading on Equity', increases the Earnings Per Share (EPS) for shareholders. In this case, we need to calculate the company's RoI.
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Return on Investment (RoI) = (EBIT / Total Capital Investment) x 100
- EBIT = ₹ 8,00,000
- Total Capital Investment = ₹ 1,00,00,000
- RoI = (₹ 8,00,000 / ₹ 1,00,00,000) x 100 = 8%
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Cost of Debt = 10%
Here, the company's RoI (8%) is lower than the cost of debt (10%). This represents a situation of unfavourable financial leverage. If the company issues more debt, the interest payments will be higher than the returns generated from the borrowed funds, which will lead to a decrease in the EPS. Therefore, issuing debentures is not advisable.
Q6Short Answer Type
How does working capital affect both the liquidity as well as profitability of a business?
Solution
Working capital, which is the investment in current assets, affects both the liquidity and profitability of a business in opposing ways:
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Effect on Liquidity: A higher level of investment in current assets (i.e., more working capital) improves a company's liquidity. With more cash, inventory, and receivables, the firm is in a better position to meet its short-term payment obligations as they become due. Insufficient working capital can threaten solvency and make it difficult to pay creditors on time.
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Effect on Profitability: Current assets generally provide little or no return. Funds tied up in cash or inventory do not earn profits like investments in fixed assets (e.g., machinery) do. Therefore, a higher level of working capital means that more funds are locked in low-return assets, which reduces the overall profitability of the business. Conversely, a lower level of working capital frees up funds to be invested in more profitable long-term assets, potentially increasing profitability.
Thus, a financial manager must strike a balance between liquidity and profitability. While high working capital ensures safety (liquidity), it compromises profitability, and while low working capital may boost profits, it increases the risk of illiquidity.
Q7Short Answer Type
Aval Ltd. is engaged in the business of export of canvas goods and bags. In the past, the performance of the company had been upto the expectations. In line with the latest demand in the market, the company decided to venture into leather goods for which it required specialised machinery. For this, the Finance Manager Prabhu prepared a financial blueprint of the organisation's future operations to estimate the amount of funds required and the timings with the objective to ensure that enough funds are available at right time. He also collected the relevant data about the profit estimates in the coming years. By doing this, he wanted to be sure about the availability of funds from the internal sources of the business. For the remaining funds, he is trying to find out alternative sources from outside. a. Identify the financial concept discussed in the above paragraph. Also, state the objectives to be achieved by the use of financial concept so identified. ( Financial Planning). b. 'There is no restriction on payment of dividend by a company'. Comment. ( Legal & Contractual Constraints)
Solution
a. Identification of Concept and Objectives
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Financial Concept: The concept discussed is Financial Planning. The paragraph describes the preparation of a "financial blueprint of the organisation's future operations to estimate the amount of funds required and the timings," which is the essence of financial planning.
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Objectives: The objectives of financial planning, as highlighted in the case, are:
- To ensure availability of funds whenever required: Prabhu is estimating the amount and timing of funds needed for the new machinery to ensure they are available at the right time.
- To see that the firm does not raise resources unnecessarily: By first estimating the availability of internal funds (profits), he is planning to raise only the 'remaining funds' from outside, thus avoiding excess financing and its associated costs.
b. Comment on the Statement
The statement 'There is no restriction on payment of dividend by a company' is incorrect.
There are several restrictions that a company must adhere to while declaring dividends. The source material highlights two key constraints:
- Legal Constraints: The Companies Act contains specific provisions that place restrictions on dividend payouts. Companies must comply with these legal requirements.
- Contractual Constraints: When a company takes a loan, the lender (like a bank or financial institution) may impose certain restrictions on the payment of dividends in the future as part of the loan agreement. The company is required to ensure that its dividend policy does not violate these contractual terms.
Q1Very Short Answer Type
What is meant by capital structure?
Solution
Capital structure refers to the mix between owners' funds (equity) and borrowed funds (debt) used by a business to finance its assets. It represents the proportion of debt and equity in the total capital of a firm.
Q2Very Short Answer Type
Sate the two objectives of financial planning.
Solution
The two primary objectives of financial planning are:
- To ensure availability of funds whenever required: This involves estimating the funds needed for different purposes and the timing of these requirements, ensuring the business can meet its commitments.
- To see that the firm does not raise resources unnecessarily: This aims to avoid excess funding, which adds to costs and may lead to wasteful expenditure, by ensuring that funds are used optimally.
Q3Very Short Answer Type
Name the concept of financial management which increases the return to equity shareholders due to the presence of fixed financial charges.
Solution
The concept is known as Trading on Equity. It refers to the increase in profit earned by the equity shareholders that results from using borrowed funds with fixed financial charges, like interest.
Q4Very Short Answer Type
Amrit is running a 'transport service' and earning good returns by providing this service to industries. Giving reason, state whether the working capital requirement of the firm will be 'less' or 'more'.
Solution
The working capital requirement for Amrit's 'transport service' will be less.
Reason: A transport service is a service industry. As mentioned in the text, service industries usually do not have to maintain inventory of raw materials or finished goods. Since inventory is a major component of current assets, the need for working capital is lower compared to a manufacturing or trading business.
Q5Very Short Answer Type
Ramnath is into the business of assembling and selling of televisions. Recently he has adopted a new policy of purchasing the components on three months credit and selling the complete product in cash. Will it affect the requirement of working capital? Give reason in support of your answer.
Solution
Yes, this new policy will affect the requirement of working capital; it will reduce the working capital requirement.
Reason: The text states that the extent to which a firm avails credit on its purchases, its working capital requirement is reduced. By purchasing components on three months credit, Ramnath is getting credit from his suppliers (creditors), which is a source of short-term finance. Simultaneously, by selling the televisions for cash, he is ensuring a quick conversion of inventory into cash. This combination reduces the amount of his own funds that need to be tied up in the operating cycle.