1.

From the following information, prepare a statement showing the estimated working capital
requirements:
Budgeted sales – Rs. 2, 60,000 p.a.Cost and profit of each units:
Particulars Rs.
Raw materials 3
Labour 4
Overheads 2
Profit 1
Selling price 10
It is estimated that
a) Raw materials carried in stock for three weeks and finishedgoods for two weeks.
b) Factory process will take three weeks.
c) Suppliers will give five weeks and customers will require eight-week credit.
Assumed that production and overheads accrue evenlythroughout the year.
2. From the following capital structure of a company, calculate the overall cost of capital using a)
book value weights and b) market value weights.
Book Value Market
Source
(Rs.) Value (Rs.)
Equity Share Capital @ Rs. 10 each 45,000 90,000
Retained Earnings 15,000 Nil
Preference Capital 10,000 10,000
Debentures 30,000 30,000
Total 1,00,000 1,30,000
The after tax cost of different source of finance is as follows:
Equity Share Capital: 14%, Retained Earnings: 13%, Preference Share Capital; 10% and
Debentures: 5%.
3. Calculate the amount of working capital requirements for Jolly &Co. Ltd., from the following
information:
Rs. (Per unit)
Raw Materials 160
Direct Labour 60
Overheads 120

Total Cost 340

Profit 60

Selling Price 400

Raw materials are held in stock on an average for one month. Materials are in process on an average for a half-a–
month. Finishedgoods are in stock on an average for one month. Credit allowed bysuppliers is one month on credit
allowed to debtors is two months.Time lag in payment of wages is 1½ weeks.
Time lag in payment of overhead expenses is one month. One fourth of the finished goods are sold against cash.
Cash in hand andat bank is expected to be Rs.50, 000; and expected level of production amount to 1, 04,000 units.
Assume that production is carried on evenly throughout the year, wages and overheads accrue similarly and a
time of four weeks is equivalent to a month.
4. From the following, prepare income statement for company J and K Ltd
J Ltd K Ltd
Financial Leverage 3:1 4:1
Interest (Rs.) 30,000 90,000
Operating Leverage 4:1 5:1
Variable cost as a percentage of
Sales 70% 60%
Income Tax 50% 50%
5. Payoff Ltd is producing articles mostly on hand labour and is considering to replace it by a new machine.
There are two alternative models M and N of the new machine. Prepare a statement of profitability showing
the pay-back period from the following info:
Machine M Machine N
Estimated life of Machine 4 years 5 years
Cost of Machine (Rs.) 9,000 18,000
Estimated Saving in scrap (Rs.) 500 800
Estimated Saving in Direct Wages (Rs.) 6,000 8,000
Additional Cost of Maintenance (Rs) 800 1,000
Additional Cost of Supervision (Rs) 1,200 1,800
Ignore Tax.
6. Sakthi Ltd issued 20,000 8% debentures of Rs.100 each on April 2018. The cost of issue was Rs.50,
000. The company’s tax rate is 35%. Determine the cost of debentures (before as well as after tax)
if they were issued (a) at par; (b) at a premium of 10% and (c) at adiscount of 10%.
7. X Corporation has a net operating income of Rs.50 million. X Ltd employs Rs.200 million of debt
capital carrying 12 percent interestcharge. The equity capitalisation rate applicable to X Ltd is 14
percent. What is the market value of X Ltd under the net income method? Assume there is no tax.
8. X Ltd. has an EBIT of Rs.4, 50,000. The cost of debt is 10% and the outstanding debt is
Rs.12, 00,000. The overall capitalisation (k0)is 15%. Calculate the total value of the firm and equity
capitalisation rate under the net income approach.
9. Details regarding two companies are given below:
A Ltd: r =15%; Ke = 10%; E =Rs.10 B Ltd: r = 8%; Ke = 10%; E = Rs.10
By using Walter’s model, you are required to calculate the value ofan equity share of each of these
companies when dividend payout ratio is (a) 0%; (b) 100%.
10. From the following information relating to Prakash Ltd., calculate
(a) operating cycle (b) number of operating cycles; (c) average working capital required, if annual
cash operating expenses are Rs.150 Lakh. Stock holding: Raw materials 2 months, W.I.P 15 days,
Finished goods 1 month, Average collection period 2 months,Average payment period 45 days.
11. R Ltd., is carrying on business of purchase and sale of an item. Selling price is Rs.80 and purchase
price is Rs.60. During Dec. 2007, Jan 2008, Feb.2008 and Mar.2008, its sales were 300 units,
400 units, 500 units and 600 units respectively.
10% of sales are on cash basis and the balance on one month’s credit basis. Its office expenses are
Rs.3000 per month. Cash balance on 1.1.2008 Rs.10, 000. At the end of each month, the stock was
nil. Prepare a cash budget for the months of Jan, Feb, and March 2008.
12. The annual demand for a product is 6,400 units. The unit cost is Rs.6 and inventory carrying cost
per annum is 25% of the average inventory value. If the cost of procurement is Rs.75, determine
a) EOQ; b) Number of orders per annum; and c) Time between two consecutive orders.
13. The following data is available in respect of two mutually exclusive projects to be considered by the
management for investment.
Cash flows before depreciation
Year Project X Project Y
Rs. Rs.
1 60,000 90,000
2 75,000 1,50,000
3 1,20,000 1,75,000
4 1,80,000 1,25,000
5 2,50,000 50,000
Project X costs Rs. 2, 75,000 and Project Y cost Rs. 3, 00,000. Aninvestment of this type is expected
to earn a discounted rate of return of at least 12%. You are required to determine the more desirable
project by 1) Pay Back Period Methods. 2) NPV Method.
14. Mr. X invested Rs. 2, 00,000 at 12% p.a. for 2 years. What will bethe value of investment if interest
is compounded:
a) Annually, b) Semi-Annually, c) Quarterly and d) Monthly.
15. Details regarding three companies are given below:
A Ltd. B Ltd. C Ltd.
r=15% r=10% r=8%
Ke=10% Ke=10% Ke=10%
E= Rs. 10 E= Rs. 10 E= Rs. 10
By using Walter’s model, you are required to calculate the value ofequity share of each of these
companies when dividend pay-out ratio is a) 20%, b) 50%, c) 0% and d) 100%
16. Project Y has an initial investment of Rs. 5, 00,000. Its cash flows for 5 years are Rs. 1,50,000, Rs.
1,80,000, Rs. 1,50,000, Rs.1,32,000 and Rs. 1,20,000. Calculate the Pay Back Period.
17. Vignesh deposits Rs. 75,000 today at 9% interest. H wants to knowin how many years the deposit
will grow to Rs. 6, 00,000. Calculatethe period by using the rule 72.
18. Modern Corporation requires 2000 units of a certain item per year.Purchase price per unit is Rs 30.
Carrying cost of the inventory is 25% of the inventory value. Fixed cost per order is Rs 1,000.
i)Determine the Economic Order Quantity ii) What will be the totalcost of carrying and ordering
inventories when 4 orders of equal size are placed?
19. Calculate the operating, financial and combined leverages from thefollowing:
Particulars Rs.
Sales 50,000
Variable expenses 25,000
Fixed Cost 15,000
Interest charges 5,000
20. A company expects a net operating income of Rs.1, 00,000. It has Rs.5, 00,000-6% debentures. The
overall capitalisation rate is 10%.Calculate the value of the firm according to NOI Approach.
21. Draw up a flexible budget for production at 75% capacity on thebasis of the following data for 50%
activity
Materials Rs 100 per unit
Labour Rs 50 per unit
Direct variable expenses Rs 10 per unit
Administrative expenses (50% fixed) Rs 40,000
Selling and distribution expenses (60% fixed) Rs 50,000
Present production (50% activity) 1,000 units
22. In considering the most desirable capital structure for a company, the following estimates of the
cost of debt and equity capital (aftertax) has been making at various levels of debt-equity mix:
Debt as % of total Cost of Debt Cost of Equity
capital employed (%) (%)
0 5.0 12.0
10 5.0 12.0
20 5.0 12.5
30 5.5 13.0
40 6.0 14.0
50 6.5 16.0
60 7.0 20.0
Suggest the best debt - equity mix for the company. Show workings.
23. Your company’s share is quoted in the market at Rs. 20 currently. The company pays a dividend of
Re. 1 per share and the investors expect a growth rate of 5% per year.
i) Compute the company is cost of capital.
ii) If the anticipated growth rate is 6% p.a., calculate the indicated market price per share.
iii) If the company’s cost of capital is 8% and the anticipated growthrate is 5% p.a., calculate the
indicated market price, if the dividendof Re. 1 per share is to be maintained?
24. Illakkiyaa Limited is expecting an annual EBIT of Rs. 2, 00,000. The company has Rs.2, 00,000 in
10% debentures. The equity capitalisation rate is 12%. You are required to ascertain the total value
of the firm and overall cost of capital. What happens if the company borrows Rs. 2, 00,000 at 10%
to repay equity capital?
25. Calculate the operating, financial and the combined leverage for thefollowing firms.
P Q R
Output (Units) 3,00,000 75,000 5,00,000
Fixed cost (Rs.) 3,50,000 7,00,000 75,000
Variable cost per unit (Rs.) 1 7.50 0.10
Interest Expenses (Rs.) 25,000 40,000 Nil
Unit selling price (Rs.) 3 25 0.50
26. It is proposed to introduce a new machine to increase the productioncapacity of Department X. Two
machines of available Type “A” and Type “B”. The following information is available:
Details A B
(Rs.) (Rs.)
Cost of Machine 3,50,000 6,30,000
Estimated Life ( Years) 7 10
Estimated savings in scrap p.a. 20,000 32,000
Additional cost of indirect materials p.a. 10,000 16,000
Estimated savings in wages:
Employees not required 15 20
Wages per employees per annum 10,000 16,000
Additional cost of maintenance p.a. 7,200 12,000
Additional cost of supervision p.a. 24,000 36,000

The rate of taxation can be regarded as 50% of profits. Whichmachine can be recommended for
purchase?
27. Calculate the future value of the following series of payment at theend of a year.
P1 = Rs. 1,500 at the end of first year
P2 = Rs. 3,000 at the end of second year
P3 = Rs. 4,500 at the end of third year
P4 = Rs .6, 000 at the end of fourth year
Rate of interest is 9%.
28. ABC Company has the following capital structure on 30th June 2012.
Rs.
Ordinary Shares (2, 00,000 shares) 40, 00,000
10% Preference shares 10, 00,000
14% Debentures 30, 00,000
Total 80, 00,000
The shares of the company sell for Rs. 20. It is expected that thecompany will pay next year a
dividend of Rs. 2 per share, whichwill grow at 7 % forever. Assume a 50 % tax rate.
(i) Compute a WACC based on the existing capital structure.
(ii) Compute the new WACC if the company raises an additional Rs. 20, 00,000 debt by
issuing 15 % Debentures. This would result in increasing the expected dividend to Rs.
3 and leave the growth rate unchanged, but the price of the share will fall to Rs. 15 per
share.
29. As per the pro forma cost sheet of the company provides the
following data:
Cost per unit: Rs.
Raw Materials 60.00
Direct Labour 20.00
Overheads 40.00
Total Costs (per unit) 120.00
Profit 30.00
Selling price 150.00
The following is the additional information available:
Average raw material in stock is one month; average material in progress is in half a month. Credit allowed by
suppliers one month,Credit allowed to debtors two months. Time lag in payment of wages is two weeks and for
overhead one month. Half of the sales are on cash basis. Cash balance is expected to be Rs. 2, 00,000.
You are required to prepare a statement showing the working capital needed to finance a level of activity of
50,000 units of output. You may assume that production is carried out on evenly throughout the year and wages
and overheads accrue similarly.
30. ABC Company is considering two machines, only one of which canbe purchased. The available data
on the two machines is given below:
Machine - A Machine- B
Cost (Rs.) 48,000 85,000
Life of the Machine 5 Years 7 Years
Annual savings after Taxation
Years Rs. Rs.
1 8,000 18,000
2 10,000 25,000
3 15,000 30,000
4 22,000 40,000
5 30,000 20,000
Neither machine will have any salvage value. The cost of capital is 10%. Compute the profitability
index for each machine. Based on theprofitability index, which machine should be purchased?
31. A Limited company is considering investing in a project requiring a capital outlay of Rs.2, 00,000.
Forecast for annual income after depreciation but before tax is as follows:
Year Rs.
1 1,0,0000
2 1,00,000
3 80,000
4 80,000
5 40,000
Depreciation may be taken as 20% on original cost and taxation at50% of net income.
You are required to evaluate the project according to each of thefollowing methods.
a) Payback method.
b) Rate of return on original investment method.
c) Rate of return on average investment method.
d) Discounted cash flow method taking cost of capital as 10%.
e) Net present value index method.
f) Internal rate of return method.
32. A firm needs Rs 50 lakh ad is considering two options. Plan 1 withall equity and Plan 2 with half
equity and half debt @15%. Equity shares can be currently issued at Rs 100 per share. If the
expected EBIT is Rs 5 lakh, what is the EPS under the two financial mix if tax rate is 40%.
33. Anand makes a fixed deposit of Rs. 10,000 in a Bank which pays 10% interest. What is the effective rate of
interest if compounding is done a) Semi-annually, b) Quarterly, and c) Monthly?
34. Determine the weighted average cost of capital of Krishna Ltd., using (i) Book value weights and (ii) Market
value weights. The following information is available for your perusal:
Krishna Ltd.’s present book value of capital structure is Debentures [Rs. 100 per debentures] Rs
8, 00,000
Preference shares [Rs. 100 per share] Rs 2, 00,000
Equity Shares [Rs. 10 per share] Rs 10, 00,000
All these securities are traded in the capital markets. Recent pricesare, Debentures @ Rs. 110, Preference shares
@ Rs. 120 and Equityshares @ Rs. 22.
Anticipated external financial opportunities are:
a) Rs. 100 per debentures redeemable at par, 20 years maturity,8% coupon rate, 4% floatation cost, sale price
Rs. 100.
b) Rs. 100 preference shares redeemable at par, 15 years maturity,10% dividend rate, 5% floatation cost and sale
price Rs. 100.
c) Equity shares: Rs. 2 per share floatation costs, sale price Rs.100.
In addition, the dividend expected on the equity share at the end ofthe year in Rs 2 per share, the anticipated
growth rate in dividendsis 5% and the company has the practice of paying all its earnings inthe form of dividends.
The corporate tax rate is 50%.
35. A choice is to be made between two competing proposals which require an equal investment of
Rs.50,000 and are expected togenerate net cash flows as under:
End of year 1 2 3 4 5 6
Project A Rs.50,000 30,000 20,000 NIL 24,000 12,000
Project B Rs.20,000 24,000 36,000 50,000 16,000 8,000
The cost of capital of the company is 10%.Evaluate the project proposals
under:
(a) Pay-back period
(b) Discounted cash flow method (NPV)
(c) Internal Rate of Return (IRR)
(d) Which proposal should be chosen and why?
 Theory Questions

1. Define Financial Management and describe its functions and objectives

Financial Management – Financial Management means planning, organizing, directing and controlling the
financial activities such as procurement and utilization of funds of the enterprise. It means applying
general management principles to financial resources of the enterprise.
Objectives of Financial Management
The financial management is generally concerned with procurement, allocation and control of financial
resources of a concern. The objectives can be-
a. To ensure regular and adequate supply of funds to the concern.
b. To ensure safety on investment, i.e, funds should be invested in safe ventures so that adequate rate
of return can be achieved.
c. To ensure adequate returns to the shareholders which will depend upon the earning capacity,
market price of the share, expectations of the shareholders.
d. To plan a sound capital structure-There should be sound and fair composition of capital so that a
balance is maintained between debt and equity capital.
e. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in
maximum possible way at least cost.

Functions of Financial Management

(i) Estimation of capital requirements: A finance manager has to make estimation with regards to
capital requirements of the company. This will depend upon expected costs and profits and future
programmes and policies of a concern. Estimations have to be made in an adequate manner which
increases earning capacity of enterprise.
(ii) Management of cash: Finance manager has to make decisions with regards to cash management.
Cash is required for many purposes like payment of wages and salaries, payment of electricity and
water bills, payment to creditors, meeting current liabilities, maintenance of enough stock, purchase
of raw materials, etc.
(iii)Choice of sources of funds: For additional funds to be procured, a company has many choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and demerits of each source and period of financing.
(iv) Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so
that there is safety on investment and regular returns is possible.
(v) Determination of capital composition: Once the estimation have been made, the capital structure
have to be decided. This involves short- term and long- term debt equity analysis. This will depend
upon the proportion of equity capital a company is possessing and additional funds which have to be
raised from outside parties.
(vi) Disposal of surplus: The net profits decision have to be made by the finance manager. This can be
done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other benefits like
bonus.
b. Retained profits - The volume has to be decided which will depend upon expansional,
innovational, diversification plans of the company.
(vii) Financial Controls:The finance manager has not only to plan, procure and utilize the funds but he
also has to exercise control over finances. This can be done through many techniques like ratio
analysis, financial forecasting, cost and profit control, etc.

2. Under what circumstances do the net present value and internal rate of return methods differ?
Which method would you prefer and why?
 BASIS FOR
NPV IRR
COMPARISON

Meaning The total of all the present values IRR is described as a rate at
of cash flows (both positive and which the sum of discounted
negative) of a project is known as cash inflows equates
Net Present Value or NPV. discounted cash outflows.

Expressed in Absolute terms Percentage terms

What it represents? Surplus from the project Point of no profit no loss

(Break even point)

Decision Making It makes decision making easy. It does not help in decision
making

Rate for reinvestment of Cost of capital rate Internal rate of return

intermediate cash flows

Variation in the cash Will not affect NPV Will show negative or multiple
outflow timing IRR

The basic differences between NPV and IRR are presented below:

1. The aggregate of all present value of the cash flows of an asset, immaterial of positive or negative is
known as Net Present Value. Internal Rate of Return is the discount rate at which NPV = 0.
2. The calculation of NPV is made in absolute terms as compared to IRR which is computed in percentage
terms.
3. The purpose of calculation of NPV is to determine the surplus from the project, whereas IRR represents
the state of no profit no loss.
4. Decision making is easy in NPV but not in the IRR. An example can explain this, In the case of positive
NPV, the project is recommended. However, IRR = 15%, Cost of Capital < 15%, the project can be
accepted, but if the Cost of Capital is equal to 19%, which is higher than 15%, the project will be
subject to rejection.
5. Intermediate cash flows are reinvested at cut off rate in NPV whereas in IRR such an investment is
made at the rate of IRR.
6. When the timing of cash flows differs, the IRR will be negative, or it will show multiple IRR which
will cause confusion. This is not in the case of NPV.
7. When the amount of initial investment is high, the NPV will always show large cash inflows while
IRR will represent the profitability of the project irrespective of the initial invest. So, the IRR will
show better results.

Using NPV
The advantage to using the NPV method over IRR using the example above is that NPV can handle multiple
discount rates without any problems. Each year's cash flow can be discounted separately from the others
making NPV the better method.
 The NPV can be used to determine whether an investment such as a project, merger or acquisition will add
value to a company. Positive net values mean they shareholders will be happy, while negative values are not
so beneficial.

The Bottom Line

Both IRR and NPV can be used to determine how desirable a project will be and whether it will add value to
the company. While one uses a percentage, the other is expressed as a dollar figure. While some prefer using
IRR as a measure of capital budgeting, it does come with problems because it doesn't take into account
changing factors such as different discount rates. In these cases, using the net present value would be more
beneficial.

3. Explain the factors influencing working capital management decisions.

Main factors affecting the working capital are as follows:

(1) Nature of Business:
The requirement of working capital depends on the nature of business. The nature of business is usually of
two types: Manufacturing Business and Trading Business. In the case of manufacturing business it takes a lot
of time in converting raw material into finished goods. Therefore, capital remains invested for a long time in
raw material, semi-finished goods and the stocking of the finished goods.
Consequently, more working capital is required. On the contrary, in case of trading business the goods are
sold immediately after purchasing or sometimes the sale is affected even before the purchase itself. Therefore,
very little working capital is required. Moreover, in case of service businesses, the working capital is almost
nil since there is nothing in stock.

(2) Scale of Operations:

There is a direct link between the working capital and the scale of operations. In other words, more working
capital is required in case of big organisations while less working capital is needed in case of small
organisations.
(3) Business Cycle:
The need for the working capital is affected by various stages of the business cycle. During the boom period,
the demand of a product increases and sales also increase. Therefore, more working capital is needed. On the
contrary, during the period of depression, the demand declines and it affects both the production and sales of
goods. Therefore, in such a situation less working capital is required.

(4) Seasonal Factors:

Some goods are demanded throughout the year while others have seasonal demand. Goods which have
uniform demand the whole year their production and sale are continuous. Consequently, such enterprises need
little working capital.
On the other hand, some goods have seasonal demand but the same are produced almost the whole year so
that their supply is available readily when demanded.
Such enterprises have to maintain large stocks of raw material and finished products and so they need large
amount of working capital for this purpose. Woolen mills are a good example of it.

(5) Production Cycle:

Production cycle means the time involved in converting raw material into finished product. The longer this
period, the more will be the time for which the capital remains blocked in raw material and semi-manufactured
products.
Thus, more working capital will be needed. On the contrary, where period of production cycle is little, less
working capital will be needed.

(6) Credit Allowed:

Those enterprises which sell goods on cash payment basis need little working capital but those who provide
credit facilities to the customers need more working capital.

(7) Credit Availed:

 If raw material and other inputs are easily available on credit, less working capital is needed. On the contrary,
if these things are not available on credit then to make cash payment quickly large amount of working capital
will be needed.

(8) Operating Efficiency:

Operating efficiency means efficiently completing the various business operations. Operating efficiency of
every organisation happens to be different.
Some such examples are: (i) converting raw material into finished goods at the earliest, (ii) selling the finished
goods quickly, and (iii) quickly getting payments from the debtors. A company which has a better operating
efficiency has to invest less in stock and the debtors.
Therefore, it requires less working capital, while the case is different in respect of companies with less
operating efficiency.

(9) Availability of Raw Material:

Availability of raw material also influences the amount of working capital. If the enterprise makes use of such
raw material which is available easily throughout the year, then less working capital will be required, because
there will be no need to stock it in large quantity.
On the contrary, if the enterprise makes use of such raw material which is available only in some particular
months of the year whereas for continuous production it is needed all the year round, then large quantity of it
will be stocked. Under the circumstances, more working capital will be required.
(10) Growth Prospects:
Growth means the development of the scale of business operations (production, sales, etc.). The organisations
which have sufficient possibilities of growth require more working capital, while the case is different in respect
of companies with less growth prospects.

(11) Level of Competition:

High level of competition increases the need for more working capital. In order to face competition, more
stock is required for quick delivery and credit facility for a long period has to be made available.

(12) Inflation:
Inflation means rise in prices. In such a situation more capital is required than before in order to maintain the
previous scale of production and sales. Therefore, with the increasing rate of inflation, there is a corresponding
increase in the working capital.

4. Compare Profit Maximization Vs Wealth Maximization.

Basis Wealth Maximization Profit Maximization

It is defined as the management of financial It is defined as the management of financial

Definition resources aimed at increasing the value of the resources aimed at increasing the profit of
stakeholders of the company. the company.

Focuses on increasing the value of the stakeholders Focuses on increasing the profit of the
Focus
of the company in the long term. company in the short term.

It does not consider the risks and

It considers the risks and uncertainty inherent in
Risk uncertainty inherent in the business model
the business model of the company.
of the company.

It helps in achieving a larger value of a company’s It helps in achieving efficiency in the

Usage worth, which may reflect in the increased market company’s day-to-day operations to make
share of the company. the business profitable.
 BASIS FOR
PROFIT MAXIMIZATION WEALTH MAXIMIZATION
COMPARISON

Concept The main objective of a concern The ultimate goal of the concern
is to earn a larger amount of is to improve the market value of
profit. its shares.

Emphasizes on Achieving short term objectives. Achieving long term objectives.

Consideration of No Yes
Risks and
Uncertainty

Advantage Acts as a yardstick for Gaining a large market share.

computing the operational
efficiency of the entity.

Recognition of Time No Yes

Pattern of Returns

Comparing Profit Maximization and Wealth Maximization

The essential difference between the maximization of profits and the maximization of wealth is that the profits
focus is on short-term earnings, while the wealth focus is on increasing the overall value of the business entity
over time. These differences are substantial, as noted below.

Planning Duration
Under profit maximization, the immediate increase of profits is paramount, so management may elect not to
pay for discretionary expenses, such as advertising, research, and maintenance. Under wealth maximization,
management always pays for these discretionary expenditures.

Risk Management
Under profit maximization, management minimizes expenditures, so it is less likely to pay for hedges that
could reduce the organization's risk profile. A wealth-focused company would work on risk mitigation, so its
risk of loss is reduced.

Pricing Strategy
When management wants to maximize profits, it prices products as high as possible in order to increase
margins. A wealth-oriented company could do the reverse, electing to reduce prices in order to build market
share over the long term.

Capacity Planning
A profit-oriented business will spend just enough on its productive capacity to handle the existing sales level
and perhaps the short-term sales forecast. A wealth-oriented business will spend more heavily on capacity in
order to meet its long-term sales projections.
It should be apparent from the preceding discussion that profit maximization is a strictly short-term approach
to managing a business, which could be damaging over the long term. Wealth maximization focuses attention
on the long term, requiring a larger investment and lower short-term profits, but with a long-term payoff that
increases the value of the business.
 5. Compare Debt Vs Equity Financing.

Basis of Debt Financing Equity Financing

Comparison

Meaning Debt financing means where the lender Equity financing is a source of raising capital
provides loans to the borrower and charge through selling shares.
interest on the sanctioned amount.

Capital of Cost Under this, Interest is charged on the No scheduled fixed cost is involved in equity
amount, and the rate is fixed or pre- share.
defined.

Dividends Payment There is no dividend that needs to be paid. The company pays a dividend, as decided by the
company.

Voting rights Lenders have no voting rights in the Equity shareholders enjoy voting rights as they
company, as they are the creditors of the have ownership.
company.

Participation Lenders have no participation in business Equity shareholder has involvement in the entity,
activity, as there is no ownership. as they have the ownership of the entity to the
extent share held.

Settlement Creditors need to be paid first. They are the last who will receive the payment.

Profit-Sharing The company doesn’t share profit with the The company shares profit through dividends.
creditors

Repayment Creditors need to be paid irrespective of The company needs to make a profit to pay off
generating profits or loss by the company. the shareholders, or shareholders can also sell the
shares as well.

6. What is capital budgeting? Why is it significant for a firm?

Capital budgeting is a managerial technique of planning capital expenditure in consonance with the overall
goals of the firm. By capital expenditures we mean those expenditures whose benefits are expected to
extend beyond one year and include expenditures on acquisition of new buildings and the enlargement and
improvement of existing buildings, replacement of machinery and equipment, acquisition of new facilities
having higher productive or labour saving capacities than do existing facilities, acquisition of additional
machines and other facilities of the kinds already owned in anticipation of increased sales of present
product lines and acquisition of new kinds of facilities needed for new product lines to be taken on.

Significance of Capital Budgeting

1. Indirect Forecast of Sales. The investment in fixed assets is related to future sales of the firm during
the life time of the assets purchased. It shows the possibility of expanding the production facilities to
cover additional sales shown in the sales budget. Any failure to make the sales forecast accurately
would result in over investment or under investment in fixed assets and any erroneous forecast of asset
needs may lead the firm to serious economic results.
2. Comparative Study of Alternative Projects. Capital budgeting makes a comparative study of the
alternative projects for the replacement of assets which are wearing out or are in danger of becoming
 obsolete so as to make the best possible investment in the replacement of assets. For this purpose, the
profitability of each projects is estimated.

3. Timing of Assets-Acquisition. Proper capital budgeting leads to proper timing of assets-acquisition

and improvement in quality of assets purchased. It is due to ht nature of demand and supply of capital
goods. The demand of capital goods does not arise until sales impinge on productive capacity and such
situation occur only intermittently. On the other hand, supply of capital goods with their availability is
one of the functions of capital budgeting.

4. Cash Forecast. Capital investment requires substantial funds which can only be arranged by making
determined efforts to ensure their availability at the right time. Thus it facilitates cash forecast.

5. Worth-Maximization of Shareholders. The impact of long-term capital investment decisions is far

reaching. It protects the interests of the shareholders and of the enterprise because it avoids over-investment
and under-investment in fixed assets. By selecting the most profitable projects, the management facilitates
the wealth maximization of equity share-holders.

6. Other Factors. The following other factors can also be considered for the significance of capital
budgeting decisions:

5. It assist in formulating a sound depreciation and assets replacement policy.

6. It may be useful n considering methods of cost reduction. A reduction campaign may necessitate the
consideration of purchasing most up-to–date and modern equipment.
7. The feasibility of replacing manual work by machinery may be seen from the capital forecast be
comparing the manual cost an the capital cost.
8. The capital cost of improving working conditions or safety can be obtained through capital expenditure
forecasting.
9. It facilitates the management in making of the long-term plans an assists in the formulation of general
policy.
10. It studies the impact of capital investment on the revenue expenditure of the firm such as depreciation,
insure and there fixed assets.

7. Assumptions: Gordon’s Model on Dividend decision and Firm’s value.

Myron Gordon developed a popular Model relating dividend policy and the firm’s value, based on the
following assumptions:
a. The firm has only equity capital, and no debt.
b. Only retained earnings will be used for financing expansion. This assumption mixes dividend
and investment policy, similar to Walter’s model.
c. Firm’s internal rate of return is constant, which is not correct in practice.
d. Firm’s discount rate is constant. Even this assumption is also incorrect, as is the case with
Walter’s model.
e. The firm and its stream of earnings are perpetual.
f. The corporate taxes are nil.
g. The retention ratio, once decided, remains constant, leading to a constant growth rate of
earnings.
h. The discount rate is higher than growth rate.
i. According to the Gordon’s model, the market value of a firm’s share will be equal to the
present value of future stream of dividends payable for that

8. Explain the different types of working capital.

1) Permanent Working Capital
It is that portion of the working capital that remains permanently tied up in current assets to undertake
business activity uninterruptedly. In other words, permanent working capital is the least amount of current
assets needed to carry out business effortlessly. Thus, it is also known as fixed working capital.
 The amount of fixed working capital required by a business depends upon the size and the growth of the
business. For instance, minimum cash or stock required by a firm to undertake the operational activities of
the business.Now, permanent working capital can be further subdivided into two categories:

2) Regular Working Capital

This is defined as the least amount of capital required by a business to fund its day-to-day operations of a
business. Examples include payment of salaries and wages and overhead expenses for the processing of raw
materials.
3) Reserve Margin Working Capital
Apart from day-to-day activities, a business may need some amount of capital for unforeseen circumstances.
Reserve Margin Working Capital is nothing but the amount of capital kept aside apart from the regular
working capital. These pools of funds are kept separately for unforeseen circumstances such as strikes,
natural calamities, etc
4) Variable Working Capital
This can be defined as the working capital invested for a temporary period of time in the business. For this
reason, it is also called as fluctuating working capital. Such a capital varies with respect to the change in the
size of the business or changes in the assets of the business. Further, variable working capital is subdivided
into two categories

5) Seasonal Variable Working Capital

This refers to the increased amount of working capital a business needs during the peak season of the year.
A business may even have to borrow funds to meet its working capital needs. Such a working capital
specifically meets the demands of business having a seasonal nature.

6) Special Variable Working Capital

Supplementary working capital may also be required by a business to undertake exceptional operations or
unforeseen circumstances. The capital required for such circumstances is termed as special variable working
capital. Funds needed to finance marketing campaigns, unforeseen events like accidental fires, floods, etc

7) Gross Working Capital

This refers to the aggregate amount of funds invested in the current assets of the business. In other words,
Gross Working Capital is the total of the current assets of the business. These include:
• Cash
• Accounts Receivable
• Inventory
• Marketable Securities and
• Short-Term Investments
Gross Working Capital used alone neither shows the complete picture of the short-term financial soundness.
Nor does it showcase the operational efficiency of the business. Current assets should be compared with the
current liabilities to get a better understanding of a business’s operational efficiency. That is, how efficiently
a business utilizes its short term assets to meet its day-to-day cash requirements.

8) Net Working Capital

Net Working Capital is the amount by which current assets exceed the current liabilities of a business. Thus,
the working capital equation is defined as the difference between current assets and current liabilities. Where
current assets refer to the sum of cash, accounts receivable, raw material and finished goods inventory.
Whereas, current liabilities include accounts payable.

The amount of working capital in a business is the indicator of liquidity, operational efficiency and short-
term financial soundness of the business. Businesses having adequate working capital typically have the
ability to invest and grow.
On the other hand, businesses having insufficient working capital have higher odds of going bankrupt. This
is because of their inability to pay for their short-term obligations, thus making it difficult for them to grow

9. What are the different forms of dividend?

1. Cash Dividend:
Generally, many companies pay dividends in the form of cash. But payment of dividend in the form of cash
requires enough cash in its bank or in hand. In other words, there should not be any shortage of cash for
payment of dividends. Sufficient cash is available only when a company prepares cash budget to estimate
the required amount for the period for which the budget is prepared.
If the company finds any shortage of cash, it should make arrangements to borrow funds. But it may be
difficult to prepare cash budget with the expected amount needed for payment of dividends.
2. Scrip Dividend:
In this form of dividends, the equity shareholders are issued transferable promissory notes for a shorter
maturity period that may or may not be interest bearing. Stated simply it means payment of dividends in the
form of promissory notes. Payment of dividend in this form takes place only when the firm is suffering from
shortage of cash or weak liquidity position.
Payment of dividends in the form of cash is justifiable only when the company has earned profits and it will
take some time to convert current assets into cash.
3. Bond Dividend:
Both scrip dividend and bond dividend are same, but they differ in terms of maturity. Bond dividends carry
longer maturity whereas scrip dividend carries shorter maturity. Effect of both forms of dividends on the
company is the same. Bond dividend bears interest.
4. Property Dividend:
The name itself suggests that payment of dividend takes place in the form of property. This form of
dividends takes place only when a firm has assets that are no longer necessary in the operation of business
and shareholders are ready to accept dividend in the form of assets. This form of dividend payment is not
popular in India.
5. Stock Dividend (Bonus Shares):
Stock dividend is the payment of additional shares of common stocks to the ordinary shareholders. It is
known as stock dividend in the USA to the existing shareholder. Bonus shares are shares issued to the
existing shareholders as a result of capitalisation of resources.
The declaration of bonus shares will increase the paid- up share capital and reduce retention of earnings. But
there would not be any change in the net worth. Issue of bonus shares increases the number of outstanding
shares. Distribution of bonus shares is done proportionately.
Payment of dividend in the form of bonus shares does not affect the wealth of owners’, since earnings per
share and market price per share will fall proportionately.

10. What are the various motives for holding cash?

The firm’s needs for cash may be attributed to the following needs: Transactions motive, Precautionary
motive and Speculative motive.
1. Transaction Motive:
A firm needs cash for making transactions in the day to day operations. The cash is needed to make
purchases, pay expenses, taxes, dividend, etc. The cash needs arise due to the fact that there is no complete
synchronization between cash receipts and payments. Sometimes cash receipts exceed cash payments or
vice-versa.

The transaction needs of cash can be anticipated because the expected payments in near future can be
estimated. The receipts in future may also be anticipated but the things do not happen as desired. If more
cash is needed for payments than receipts, it may be raised through bank overdraft.

On the other hand if there are more cash receipts than payments, it may be spent on marketable securities.
The maturity of securities may be adjusted to the payments in future such as interest payment, dividend
payment, etc.

2. Precautionary Motive:
A firm is required to keep cash for meeting various contingencies. Though cash inflows and cash outflows
are anticipated but there may be variations in these estimates. For example, a debtor who was to pay after 7
days may inform of his inability to pay; on the other hand a supplier who used to give credit for 15 days may
not have the stock to supply or he may not be in a position to give credit at present.

In these situations cash receipts will be less than expected and cash payments will be more as purchases may
have to be made for cash instead of credit. Such contingencies often arise in a business. A firm should keep
some cash for such contingencies or it should be in a position to raise finances at a short period.

The cash maintained for contingency needs is not productive or it remains ideal. However, such cash may be
invested in short-period or low-risk marketable securities which may provide cash as and when necessary.

3. Speculative Motive:
The speculative motive relates to holding of cash for investing in profitable opportunities as and when they
arise. Such opportunities do not come in a regular manner. These opportunities cannot be scientifically
predicted but only conjectures can be made about their occurrence.

For example, the prices of shares and securities may be low at a time with an expectation that these will go
up shortly. The prices of raw materials may fall temporarily and a firm may like to make purchases at these
prices.

11. How the financial decision-making involves risk-return trade off?

The risk-return tradeoff states that the potential return rises with an increase in risk. Using this principle,
individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty
or risk with high potential returns. According to the risk-return tradeoff, invested money can render higher
profits only if the investor will accept a higher possibility of losses.

The risk-return tradeoff is the trading principle that links high risk with high reward. The appropriate risk-
return tradeoff depends on a variety of factors including an investor’s risk tolerance, the investor’s years
 to retirement and the potential to replace lost funds. Time also plays an essential role in determining a
portfolio with the appropriate levels of risk and reward. For example, if an investor has the ability to
invest in equities over the long term, that provides the investor with the potential to recover from the risks
of bear markets and participate in bull markets, while if an investor can only invest in a short time frame,
the same equities have a higher risk proposition.

Investors use the risk-return tradeoff as one of the essential components of each investment decision, as
well as to assess their portfolios as a whole. At the portfolio level, the risk-return tradeoff can include
assessments of the concentration or the diversity of holdings and whether the mix presents too much risk
or a lower-than-desired potential for returns.

Risk Return tradeoff in single context :

When an investor considers high-risk-high-return investments, the investor can apply the risk-return tradeoff
to the vehicle on a singular basis as well as within the context of the portfolio as a whole. Examples of
high-risk-high return investments include options, penny stocks and leveraged exchange-traded funds
(ETFs). Generally speaking, a diversified portfolio reduces the risks presented by individual investment
positions. For example, a penny stock position may have a high risk on a singular basis, but if it is the
only position of its kind in a larger portfolio, the risk incurred by holding the stock is minimal.

Risk return tradeoff at the port folio level:

the risk-return tradeoff also exists at the portfolio level. For example, a portfolio composed of
all equities presents both higher risk and higher potential returns. Within an all-equity portfolio, risk and
reward can be increased by concentrating investments in specific sectors or by taking on single positions
that represent a large percentage of holdings. For investors, assessing the cumulative risk-return tradeoff
of all positions can provide insight on whether a portfolio assumes enough risk to achieve long-term return
objectives or if the risk levels are too high with the existing mix of holdings.

12. What are the objectives, significance and limitations of financial planning?

Objectives of Financial Plan:

The principal objectives of the overall financial plan are as follows:

(1) To ensure supply of sufficient funds to the firm so that it may employ its resources up to the optimal point.
(2) To minimize cost of funds by procuring funds under the most favourable circumstances commensurate
with the risks, owners are willing to assume.
(3) To match costs with risks so as to protect owners against the loss of control of business.
(4) To provide flexibility in the plan so that the financial structure of the company may be adjusted in the light
of changed circumstances.
(5) To keep the financial plan as simple as is consistent with other objectives of the plan.
The above objectives serve as standards with which the financial decisions of the company can be evaluated.
Which of these objectives is more important than the other is dependent upon the existing circumstances.
A particular objective may be more important than others under particular set of situations and accordingly it
may be assigned greater weight while evaluating the financial decisions. Continuous evaluation of the
financial plan is inevitable so that a proper balance among the major objectives of the plan may be ensured.

Types of Financial Plan:

On the basis of duration, financial plan can be categorized as short-term, medium-term and long-term financial
plan.
i. Short-term Financial Plan:
Financial plan prepared for a maximum period of one year is termed as short-term financial plan. Usually
assessment of working capital needs of the enterprise and planning for financing these requirements are done
in short-term financial plan.
Preparation of different types of budgets including sales and cash budgets, proforma income statement,
sources and uses of funds and balance sheet are planning exercises and are part of short-term financial plan.

ii. Medium-Term Financial Plan:

This plan is prepared for a period of less than five years and incorporates plans for replacement and
maintenance of assets, research and development activities and financing of increased working capital needs
of the enterprise.
iii. Long-Term Financial Plan:
Financial plan prepared for a period of five years or more is designated as long-term financial plan. This kind
of plan is made keeping in view long-term financial objectives of the enterprise. It incorporates policies and
programmes concerning capitalisation, capital structure, replacement of permanent assets and financing of
growth and expansion activities of the enterprise.

Significance of Financial Plan:

1. Financial plan is an intellectual arm of organized growth. It is prologue to tomorrow. It supplies a powerful
tool to management to deal with distance which is uncertain and hazy in all respects.

2. Effective financial planning enables the management to prevent impending financial crises emerging out of
rapid technological, economic and other changes.

3. The very complexity and haziness of the future environment make financial planning more necessary than
ever before. Organization, which does not keep a breast of environmental changes, will underutilize and waste
their resources, miss opportunities and will fail to withstand inexorable events.

4. Financial planning system leads to better decisions because it focuses on all factors that have bearing on
decision making and insists on identification of myriad of product market options and their evaluation and
selection of the best alternative for achievement of corporate objective.

5. It provides the criteria for making sound decisions on acquisition of resources and their commitment.

6. It aids the management to utilise the resources to the optimal level and avoid wastage. The more prudent a
financial plan is, the less would be the problems of redundance or shortage of capital in the business. Many
business undertakings have failed in the past mainly because of their defective financial plan.

7. Faulty financial plan fails to assess the financial requirements of the business correctly with the result that
either the firm encounters the problem of inadequacy or redundance of capital. Both these situations must be
avoided as they adversely affect the profitability of the firm. Likewise, financial plan acts as guide in deciding
about optimal capital structure of the firm.
While determining the composition of funds a finance manager must ensure that the firm pays minimum cost
and incurs less risk. Slight careless on the part of the finance manager is likely to impair the financial health
of the firm for a long period of time.

8. Financial plan also ensures successful production and distribution functions of the firm by helping
avoidance of wastage resulting from complexity of operation. This it seeks to achieve by providing suitable
policies and procedures that make possible a closer coordination between various functions of the enterprise.

9. Financial plan serves as a means for communications among all levels of management about objectives,
strategies and policies. Within the parameters of these strategies and major policies, the lower echelons of
management develop the operational plans. In the absence of such plan, there is every possibility that different
levels of management formulate their own policies and procedures, which would produce confusion and
waste.

10. Financial planning provides an objective basis for measuring performance. Clearly defined objectives with
established targets provide the framework for measurement. An effective system of financial planning readily
identifies areas, units or individuals within the organization which fail to meet desired goals. To prevent this
failure, it is necessary for management at all levels to control the performance of their subordinates and
improve their performance.

11. In view of the above it is essential to prepare financial plan for the firm. A prudent plan is one which is
developed in the light of certain cardinal economic and financial principles, important among them are as
under:

Limitations of Financial Plan:

Financial plan suffers from the following limitations:

1. Financial plan is based on forecasts which are themselves founded on certain assumptions. Due to
uncertainty associated with future, financial plan may not be of considerable use to the management. This is
more true of long-term financial plans because reliability of forecasting decreases with time.
In contrast, short-term plans are relatively more dependable because predictions about changes in internal and
external conditions during short span of time can be made more confidently.

2. However, by improving techniques of forecasting magnitude of risk associated with financial plan can be
minimized. Further, revision of plans periodically, say, every six months would go a long way in offsetting
limitations of financial plan. Preparation of variable budgets is burning example of variable plans.

3. In real world [the management adopts an attitude of rigidity about financial plan. They are reluctant to bring
about alternatives in plans in the light of changed situations. This may be due to several reasons. First, plans
relating to capital expenditures involve huge investments and commitments are made in advance.

4. Such investments cannot be changed readily. Second, arrangements are also made in advance for acquisition
of raw materials and equipment. Any change in this arrangement may land the organisation in trouble. Third,
psychologically management personnel are loath to any change in the plan prepared and finalized by them.

5. Absence of coordination and indecision among management personnel render financial plan ineffective.
For effective planning each business function should be coordinated because this will ensure consistency of
action. Indecision on the part of the management may result in poor implementation of the financial plan.

6. In order to obviate poor coordination and indecision, it is necessary that the management should avoid
complex organisation structure, synthesize objectives, policies and procedures and develop well designed
communication process and impart necessary training to executives in respect of the fundamentals of the
administration.

13. Explain various factors influencing Capital structure.

1. Financial Leverage or Trading on Equity:
The word ‘equity’ denotes the ownership of the company. Trading on equity means taking advantage of
equity share capital to borrowed funds on reasonable basis. It refers to the additional profits that equity
shares earn because of funds raised by issuing other forms of securities, viz., preference shares and
debentures.
It is based on the premise that if the rate of interest on borrowed capital and the rate of dividend on preference
capital are lower than the general rate of company’s earnings, the equity shareholders will get advantage
in the form of additional profits. Thus, by adopting a judicious mix of long-term loans (debentures) and
preference shares with equity shares, return on equity shares can be maximized.

2. Expected Cash Flows:

Debentures and preference shares are often redeemable, i.e., they are to be paid back after their maturity. The
expected cash flows over the years must be sufficient to meet the interest liability on debentures every
year and also to return the maturity amount at the end of the term of debentures. Thus, debentures are not
suitable for those companies which are likely to have irregular cash flows in future.
 3. Stability of Sales:
Stability of sales turnover enhances the company’s ability to pay interest on debentures. If sales are rising,
the company can use more of debt capital as it would be in a position to pay interest. But if sales are
unstable or declining, it would not be advisable to employ additional debt capital.

4. Control over the Company:

The control of a company is entrusted to the Board of Directors elected by the equity shareholders. If the
board of directors and shareholders of a company wish to retain control over the company in their hands,
they may not allow to issue further equity shares to the public. In such a case, more funds can be raised
by issuing preference shares and debentures.

5. Flexibility of Financial Structure:

A good financial structure should be flexible enough to have scope for expansion or contraction of
capitalisation whenever the need arises. In order to bring flexibility, those securities should be issued
which can be paid off after a number of years.
Equity shares cannot be paid off during the life time of a company. But redeemable preference shares and
debentures can be paid off whenever the company feels necessary. They provide elasticity in the financial
plan.

6. Cost of Floating the Capital:

Cost of raising finance by tapping various sources of finance should be estimated carefully to decide which
of the alternatives is the cheapest. Prevailing rate of interest, rate of return expected by the prospective
investors, and administrative expenses are the various factors which affect the cost of financing

7. Period of Financing:
When funds are required for permanent investment in a company, equity share capital is preferred. But when
funds are required to finance expansion programme and the management of the company feels that it will
be able to redeem the funds within the life-time of the company, it may issue redeemable preference
shares and debentures.

8. Market Conditions:
The conditions prevailing in the capital market influence the determination of the securities to be issued. For
instance, during depression, people do not like to take risk and so are not interested in equity shares. But
during boom, investors are ready to take risk and invest in equity shares. Therefore, debentures and
preference shares which carry a fixed rate of return may be marketed more easily during the periods of
low activity.

9. Types of Investors:
The capital structure is influenced by the likings of the potential investors. Therefore, securities of different
kinds and varying denominations are issued to meet the requirements of the prospective investors. Equity
shares are issued to attract the people who can take the risk of investment in the company. Debentures
and preference shares are issued to attract those people who prefer safety of investment and certainty of
return on investment.

10. Legal Requirements:

The structure of capital of a company is also influenced by the statutory requirements. For instance,
banking companies have been prohibited by the Banking Regulation Act to issue any type of securities
except equity shares

14. Explain various factors influencing working capital.

1. Nature of Business:
The requirement of working capital depends on the nature of business. The nature of business is usually of two
types: Manufacturing Business and Trading Business.In the case of manufacturing business more working
 capital is required as capital remains invested for a long time in raw materials and semi-finished goods. In
case of trading business the goods are sold immediately after purchasing. Therefore, very little working
capital is required.

2. Scale of operations:
There is a direct link between the working capital and the scale of operations. In other words, more working
capital is required in case of big organisations while less working capital is needed in case of small
organisations.

3. Business Cycle:
The need for the working capital is affected by various stages of the business cycle. During the boom period,
the demand of a product increases and sales also increase. Therefore, more working capital is needed. On
the contrary, during the period of depression, the demand declines and it affects both the production and
sales of goods. Therefore, in such a situation less working capital is required

4. Seasonal factors:
Some goods are demanded throughout the year while others have seasonal demand. Goods which have uniform
demand the whole year are produced throughout the year and sales are continuous. Consequently, such
enterprises need little working capital.
On the other hand, some goods have seasonal demand but the same are produced almost the whole year so that
their supply is available readily when demanded.
Such enterprises have to maintain large stocks of raw material and finished products and so they need large
amount of working capital for this purpose. Woolen mills are a good example of it.

5. Production cycle:
Production cycle means the time involved in converting raw material into finished product. The longer this
period, the more working capital will be needed.

6. Credit Allowed:
Those enterprises which sell goods on cash payment basis need little working capital but those who provide
credit facilities to the customers need more working capital

7. Credit Availed:
If raw material and other inputs are easily available on credit, less working capital is needed. On the contrary,
if these things are not available on credit then to make cash payment quickly large amount of working
capital will be needed.

8. Operating Efficiency:
Operating efficiency means efficiently completing the various business operations.
A company which has a better operating efficiency has to invest less in stock and the debtors. Therefore, it
requires less working capital, while the case is different in respect of companies with less operating
efficiency.

9. Availability of Raw Material:

Availability of raw material also influences the amount of working capital. If the enterprise makes use of such
raw material which is available easily throughout the year, then less working capital will be required and
it is vice versa otherwise.

10. Growth Prospects:

Growth means the development of the scale of business operations (production, sales, etc.). The organisations
which have sufficient possibilities of growth require more working capital, while the case is different in
respect of companies with less growth prospects.

11. Level of Competition:

High level of competition increases the need for more working capital. In order to face competition, more stock
 is required for quick delivery and credit facility for a long period has to be made available

11. Inflation means rise in prices. In such a situation more capital is required than before in order to
maintain the previous scale of production and sales. Therefore, with the increasing rate of inflation,
there is a corresponding increase in the working capital

15. Explain various factors influencing dividend policy.

1. Type of Industry:
The nature of the industry to which the company belongs has an important effect on the dividend policy.
Industries, where earnings are stable, may adopt a consistent dividend policy as opposed to the industries
where earnings are uncertain and uneven.

2. Ownership Structure:
The ownership structure of a company also impacts the policy. A company with a higher promoter’ holdings
will prefer a low dividend payout as paying out dividends may cause a decline in the value of the stock.
Whereas, a high institutional ownership will favor a high dividend payout as it helps them to increase the
control over the management.

3. Age of corporation:
Newly formed companies will have to retain major part of their earnings for further growth and expansion.
Thus, they have to follow a conservative policy unlike established companies, which can pay higher
dividends from their reserves.

4. The extent of Share Distribution:

A company with a large number of shareholders will have a difficult time in getting them to agree to a
conservative policy. On the other hand, a closely held company has more chances of succeeding to finalize
conservative dividend payouts.

5. Different Shareholders’ Expectations

Another factor that impacts the policy is the diversity in the type of shareholders a company has. A different
group of shareholders will have different expectations. The company needs to clearly understand the
different expectations and formulate a successful dividend policy.

6. Leverage:
A company having more leverage in their financial structure and consequently, more interest payments have
to decide for a low dividend payout, so as to increase their net worth and to make sure that it can make
payment of financial charges even in case of earning of the company is falling. Whereas a company utilizing
more of own financing will prefer high dividends.

7. Future Financial Requirements / Reinvestment opportunity:

Dividend payout will also depend on the future requirements for the additional capital. A company having
profitable investment opportunities is justified in retaining the earnings.

8. Business Cycles
When the company experiences a boom, it is prudent to save up and make reserves for dips. Such reserves will
help a company to maintain dividend even in depressing markets to retain and attract more shareholders.

9. Changes in Government Policies

There could be the change in the dividend policy of a company due to the imposed changes by the government.

10. Profitability:
The profitability of a firm is reflected in net profit ratio and ratio of profit to total assets. A highly profitable
company have a capacity to pays higher dividends and a company with less profits will adopt a conservative
dividend policy.
11. Taxation Policy:
The corporate taxes will affect dividend policy, either directly or indirectly. The taxes directly reduce the
residual earnings after tax available for the shareholders. If dividend income is taxable in the hands of
investor and capital gain is exempt, then company may retain its earning so as to increase price per share,
which ultimately gives higher return to investors’ and vice versa.

12. Trends of Profits

Even if the company has been profitable over the years, the trend should be properly analyzed to find the
average earnings of the company. This average number should be then studied in relation to the general
economic conditions. This will help in opting for a conservative policy if a depression is approaching.

13. Liquidity:
Liquidity has a direct relation with the dividend policy. Many a times, company having high profit, may have
majority of profit blocked in working capital or it may acquired assets. In that case its liquidity is poor. In
that case company should pay less dividend. High dividend payment is possible only if company has good
earning and sound liquidity.

14. Legal Rules:

There are certain legal restrictions on the companies for dividend payments. It is legal to pay a dividend only
if the capital is not reduced post payment. These rules are in place to protect creditors’ interest. .

15. Inflation:
Inflationary environments compel companies to retain major part of their earnings and indulge in lower
dividends. As the prices rise, the companies need to increase their capital reserves for their purchases of
fixed assets.

16. Control Objectives:

The firms aiming for more control in the hands of current shareholders prefer a conservative dividend payout
policy. It is imperative to pay fewer dividends to retain more control and the earnings in the company.

17. Repayment of debt:

If a substantial amount of debt is required to paid, in that case even though the company has high amount of
earning, it may pay less dividend.

In a nutshell, the management of a company is completely free to frame the required dividend policy. There
are no obligations to be adhered to. So, the company needs to judiciously weight all the above-mentioned
factors and formulate a balanced dividend policy. A dividend policy can also be revised in the wake of
changes in any of the factors.

16. Discuss Modigliani and Miller approach on dividend policy.

Modigliani – Miller’s theory is a major proponent of the ‘Dividend Irrelevance’ notion. According to this
concept, investors do not pay any importance to the dividend history of a company and thus, dividends
are irrelevant in calculating the valuation of a company. This theory is in direct contrast to the ‘Dividend
Relevance’ theory which deems dividends to be important in the valuation of a company.

Crux of Modigliani-Miller Model

Modigliani – Miller theory was proposed by Franco Modigliani and Merton Miller in 1961. They were the
pioneers in suggesting that dividends and capital gains are equivalent when an investor considers returns
on investment. The only thing that impacts the valuation of a company is its earnings, which is a direct
result of the company’s investment policy and future prospects. So, according to this theory, once the
investment policy is known to the investor, he will not need any additional input on the dividend history
of the company. The investment decision is, thus, dependent on the investment policy of the company
and not on the dividend policy.
Assumptions of the Model
Modigliani – Miller theory is based on the following assumptions:

• Perfect Capital Markets

• This theory believes in the existence of “perfect capital markets”. It assumes that all the
investors are rational, they have access to free information, there are no flotation or transaction
costs, and no large investor to influence the market price of the share.

• No Taxes
• There is no existence of taxes. Alternatively, both dividends and capital gains are taxed at the
same rate.

• Fixed Investment Policy

• The company does not change its existing investment policy. It means whatever may be the
dividend payment, the company will make the investment as it has already decided upon. If the
company is going to pay more amount of dividends, then it will have more equity shares and
vice versa.

• No Risk of Uncertainty
• All the investors are certain about the future market prices and the dividends. This means that
the same discount rate is applicable for all types of stocks in all time periods.

• Investor is indifferent between dividend income and capital gain income

• It is assumed that investor is indifferent between dividend income and capital gain income. It
means if he requires the total return of Rs. 500, he may get Rs. 200 dividend income and Rs.
300 as capital gain income or reverse, in either of the case he gets equal satisfaction.
Criticism of Modigliani Miller’s Model
Modigliani – Miller theory on dividend policy suffers from the following limitations:

Perfect capital markets do not exist. Taxes are present in the capital markets.
According to this theory, there is no difference between internal and external financing. However,
if the flotation costs of new issues are considered, it is false.
This theory believes that the shareholder’s wealth is not affected by the dividends. However, there
are transaction costs associated with the selling of shares to make cash inflows. This makes the
investors prefer dividends.
The assumption of no uncertainty is unrealistic. The dividends are relevant under the certain
conditions as well.

17. State the advantages and limitations of stable dividend policy

Stability or regularity of dividends is considered as a desirable policy by the management of most

companies. Shareholders also generally favour this policy and value stable dividends higher than the
fluctuating ones. All other things being the same, stable dividends have a positive impact on the market
price of the share.

Stability of dividends sometimes means regularity in paying some dividend annually, even though the
amount of dividend may fluctuate from year to year and may not be related with earnings. There are a
number of companies which have records of paying dividend for a long unbroken period. More precisely
stability of dividends refers to the amounts out regularly. Three distinct forms of such stability may be
distinguished.

1. Constant dividend per share:

A number of companies follow the policy of paying a fixed amount per share as dividend every year,
irrespective of the fluctuations in the earnings. This policy does not imply that the dividend per share will
never be increased.

When the company reaches new levels of earnings and expects to maintain it, the annual dividend per
share may be increased.

The dividend policy of paying a constant amount of dividend per year treats common shareholders
somewhat like preference shareholders without giving any consideration to investment opportunities
within the firm and the opportunities available to shareholders.

This policy is generally preferred by those persons and institutions that depend upon the dividend income
to meet their living and operating expenses, increases and decreases in market values may even be of little
concern to these investors, and this condition tends to produce a steady long-run demand that automatically
stabilizes the market value of the share.

2. Constant percentage of net earnings:

The ratio of dividend to earnings is known as payout ratio. Some companies follow a policy of constant
payout ratio, i.e., paying a fixed percentage of net earnings every year. With this policy the amount of
dividend will fluctuate in direct proportion to earnings. If a company adopts a 40 per cent payout ratio,
then 40 percent of every rupee of net earnings will be paid out.

This type of a policy may be supported by management because it is related to the company’s ability to
pay dividends. Internal financing with retained earnings is automatic when this policy is followed.

At any given payout ratio, the amount of dividends and the additions to retained earnings increase with
increasing earnings and decrease with decreasing earnings. One of the most appealing features of this
policy is its conservatism and its guarantee against over or under payment, since it does not allow
management to pay dividends if profits are not earned in the current year, and it does not allow
management to forego a dividend if profits are earned.

3. Small constant dividend per share plus extra dividend:

Under this policy a small amount of dividend is fixed to reduce the possibility of ever missing a dividend
payment and extra dividend is paid in periods of prosperity.

This type of a policy enables a company to pay constant amount of dividend regularly without a default
and allows a great deal of flexibility for supplementing the income of shareholders only when the
company’s earnings are higher than the usual.

Though we have discussed three forms of stability of dividends, generally a stable dividend policy refers
to the first form of paying constant dividend per share.

B. Advantages:
From the point of view of shareholders as well as company the stability of dividends has various
advantages.

1. Resolution of investor’s uncertainty:

When a company follows a policy of stable dividends, it will not change the amount of dividend if there
are temporary changes in the earnings, Thus, when the earnings of a company fail and it continues to pay
same amount of dividend as in the past, it conveys to investors that the future of the company is bright
than suggested by drop in earnings.

2. Investor’s desire for current income:

The investors who desire (old and retired persons, women, children etc.) to receive a regular dividend
income, will prefer a company with stable dividends to one with fluctuating dividends.
 3. Institutional investors’ requirements:
The financial institutions like IFC, IDBI, LIC and UTI Generally invest in the shares of those companies
which have a record of paying regular dividends.

4. Raising additional finances:

A stable dividend policy is also advantageous to the company in its efforts to raise external finances. Stable
and regular dividend policy tends to make the shares of a company and investment rather than a
speculation.

The loyalty finds goodwill of shareholders towards the company increases with a stable dividend policy.

C. Disadvantages of stability of dividends:

Stability of dividends has the following dangers, once the stable dividend policy is adopted, it cannot be
changed without seriously affecting investors’ attitude and the financial standing of the company. A cut
in dividend is considered as a cut in ‘Salary’. Because of the serious depressing effect on investors due to
a dividend cut, the directors have to maintain stability of dividends during lean years even though financial
prudence would indicate elimination of dividends or a cut in it.

Consequently, to be on the safe side, the dividend rate should be fixed at a conservative figure so that it
may be possible to maintain it even in a lean period of several years. To give the benefit of the company’s
prosperity, extra dividend can be declared, when a company fails to pay extra dividend, it does not have a
depressing an effect on investors as the failure to pay a regular dividend.

18. State the motives of holding cash by a business.

For some persons, cash means only money in the form of currency (cash in hand). For other persons, cash
means both cash in hand and cash at bank. Some even include near cash assets in it. They take marketable
securities too as part of cash.

These are the securities which can easily be converted into cash. These viewpoints reflect the degree of
freedom of the persons using the cash. Whether a person’s wants to use it immediately or can wait for a
time to use it depends upon the needs of the concerned person.

Cash itself does not produce goods or services. It is used as a medium to acquire other assets. It is the other
assets which are used in manufacturing goods or providing services. The idle cash can be deposited in
bank to earn interest.

A business has to keep required cash for meeting various needs. The assets acquired by cash again help the
business in producing cash. The goods manufactured or services produced are sold to acquire cash. A
firm will have to maintain a critical level of cash. If at a time it does not have sufficient cash with it, it
will have to borrow from the market for reaching the required level.

There remains a gap between cash inflows and cash outflows. Sometimes cash receipts are more than the
payments or it may be vice-versa at another time. A financial manager tries to synchronize the cash
inflows and cash outflows. But this situation is seldom found in the real world. Perfect synchronization
of receipts and payments of cash is only an ideal situation.

Motives for Holding Cash:

The firm’s needs for cash may be attributed to the following needs: Transactions motive, Precautionary
motive and Speculative motive. Some people are of the view that a business requires cash only for the
first two motives while others feel that speculative motive also remains.

These motives are discussed as follows:

 1. Transaction Motive:
A firm needs cash for making transactions in the day to day operations. The cash is needed to make purchases,
pay expenses, taxes, dividend, etc. The cash needs arise due to the fact that there is no complete
synchronization between cash receipts and payments. Sometimes cash receipts exceed cash payments or
vice-versa.

The transaction needs of cash can be anticipated because the expected payments in near future can be
estimated. The receipts in future may also be anticipated but the things do not happen as desired. If more
cash is needed for payments than receipts, it may be raised through bank overdraft.

On the other hand if there are more cash receipts than payments, it may be spent on marketable securities.
The maturity of securities may be adjusted to the payments in future such as interest payment, dividend
payment, etc.

2. Precautionary Motive:
A firm is required to keep cash for meeting various contingencies. Though cash inflows and cash outflows
are anticipated but there may be variations in these estimates. For example, a debtor who was to pay after
7 days may inform of his inability to pay; on the other hand a supplier who used to give credit for 15 days
may not have the stock to supply or he may not be in a position to give credit at present.

In these situations cash receipts will be less than expected and cash payments will be more as purchases may
have to be made for cash instead of credit. Such contingencies often arise in a business. A firm should
keep some cash for such contingencies or it should be in a position to raise finances at a short period.

The cash maintained for contingency needs is not productive or it remains ideal. However, such cash may be
invested in short-period or low-risk marketable securities which may provide cash as and when necessary.

3. Speculative Motive:
The speculative motive relates to holding of cash for investing in profitable opportunities as and when they
arise. Such opportunities do not come in a regular manner. These opportunities cannot be scientifically
predicted but only conjectures can be made about their occurrence.

For example, the prices of shares and securities may be low at a time with an expectation that these will go
up shortly. The prices of raw materials may fall temporarily and a firm may like to make purchases at
these prices.

Such opportunities can be availed of if a firm has cash balance with it. These transactions are speculative
because prices may not move in a direction in which we suppose them to move. The primary motive of
a firm is not to indulge in speculative transactions but such investments may be made at times.

19. Explain the cost of maintaining receivables.

Costs Of Maintaining Receivables And Their Calculation
Maintaining receivables bears cost. It includes cost of investment in receivables, bad debt losses, collection
expenses and cash discount. Costs related with receivables and their calculation are as follows:

1. Cost Of Investment In Receivables

This is the opportunity cost of funds being tied up in receivables, which would otherwise have not been
incurred if all sales were in cash. The cost of investment in receivable is calculated as:

Cost of receivables = Investment in receivables X Opportunity costs

Here,
investment in receivables = (FC+ VC)/Days in year) X DSO
Where, FC = Fixed Cost, VC = Variable Cost and DSO = Days sales outstanding.

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2. Bad Debt Losses

This is the loss due to default customers. Extension of credit to low quality-rate customers results into increase
in bad debt losses. Bad debt losses are calculated as a percentage on sales as shown in equation below:

Bad debt losses = Annual credit sales X Percentage default customer

3. Collection Expenses

This is the cost incurred for operating and managing the collection and credit department of a firm. This
includes the administrative cost of credit department, salary and commission paid to collection staff, cost paid
for telephone and communication and so on.

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4. Cash Discount

It is the cost incurred to induce the customer for early payments of their accounts. A firm can offer cash
discount to its customers to reduce the average collection period, bad debt losses, and the cost of investment
in receivables. The discount cost is calculated as cash discount percentage multiplied by sales to discount
customers as given below:

Discount Cost = Annual credit sales X Percentage discount customer X Percentage cash discount

20. Compare NPV and IRR methods to highlight their merits and demerits.
What is Net Present Value?
Net present value (NPV) discounts the stream of expected cash flows associated with a proposed project to
their current value, which presents a cash surplus or loss for the project. It is used to evaluate a proposed
capital expenditure.

What is Internal Rate of Return?

The internal rate of return (IRR) calculates the percentage rate of return at which the cash flows associated
with a project will result in a net present value of zero. It is used to evaluate a proposed capital
expenditure.

Comparing NPV and IRR

The two capital budgeting methods have the following differences:

Outcome. The NPV method results in a dollar value that a project will produce, while IRR generates the
percentage return that the project is expected to create.

Purpose. The NPV method focuses on project surpluses, while IRR is focused on the breakeven cash flow
level of a project.

Decision support. The NPV method presents an outcome that forms the foundation for an investment
decision, since it presents a dollar return. The IRR method does not help in making this decision, since
its percentage return does not tell the investor how much money will be made.

Reinvestment rate. The presumed rate of return for the reinvestment of intermediate cash flows is the firm's
cost of capital when NPV is used, while it is the internal rate of return under the IRR method.
 Discount rate issues. The NPV method requires the use of a discount rate, which can be difficult to derive,
since management might want to adjust it based on perceived risk levels. The IRR method does not have
this difficulty, since the rate of return is simply derived from the underlying cash flows.

Generally, NPV is the more heavily-used method. IRR tends to be calculated as part of the capital budgeting
process and supplied as additional information.

21. How the financial decision-making involves risk-return trade off?

The risk-return tradeoff states that the potential return rises with an increase in risk. Using this principle,
individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty or
risk with high potential returns. According to the risk-return tradeoff, invested money can render higher profits
only if the investor will accept a higher possibility of losses.

1:29
Risk-Return Tradeoff
Understanding Risk-Return Tradeoff
The risk-return tradeoff is the trading principle that links high risk with high reward. The appropriate risk-
return tradeoff depends on a variety of factors including an investor’s risk tolerance, the investor’s years to
retirement and the potential to replace lost funds. Time also plays an essential role in determining a portfolio
with the appropriate levels of risk and reward. For example, if an investor has the ability to invest in equities
over the long term, that provides the investor with the potential to recover from the risks of bear markets and
participate in bull markets, while if an investor can only invest in a short time frame, the same equities have a
higher risk proposition.

Investors use the risk-return tradeoff as one of the essential components of each investment decision, as well
as to assess their portfolios as a whole. At the portfolio level, the risk-return tradeoff can include assessments
of the concentration or the diversity of holdings and whether the mix presents too much risk or a lower-than-
desired potential for returns.

KEY TAKEAWAYS
The risk-return tradeoff is an investment principle that indicates that the higher the risk, the higher the potential
reward.
To calculate an appropriate risk-return tradeoff, investors must consider many factors, including overall risk
tolerance, the potential to replace lost funds and more.
Investors consider the risk-return tradeoff on individual investments and across portfolios when making
investment decisions.
Special Considerations
Measuring Singular Risk in Context
When an investor considers high-risk-high-return investments, the investor can apply the risk-return tradeoff
to the vehicle on a singular basis as well as within the context of the portfolio as a whole. Examples of high-
risk-high return investments include options, penny stocks and leveraged exchange-traded funds (ETFs).
Generally speaking, a diversified portfolio reduces the risks presented by individual investment positions. For
example, a penny stock position may have a high risk on a singular basis, but if it is the only position of its
kind in a larger portfolio, the risk incurred by holding the stock is minimal.

Risk-Return Tradeoff at the Portfolio Level

That said, the risk-return tradeoff also exists at the portfolio level. For example, a portfolio composed of all
equities presents both higher risk and higher potential returns. Within an all-equity portfolio, risk and reward
can be increased by concentrating investments in specific sectors or by taking on single positions that represent
a large percentage of holdings. For investors, assessing the cumulative risk-return tradeoff of all positions can
provide insight on whether a portfolio assumes enough risk to achieve long-term return objectives or if the
risk levels are too high with the existing mix of holdings.