NCERT Solutions for Class 12 Business Studies Chapter 9 - Financial Management

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Very Short Answer Type Questions

1. What is meant by capital structure?

Ans. Capital structure refers to the mix between owners and borrowed funds. It represents the proportion of equity and debt.

$$\text{Capital Structure }= \frac{\text{Debt}}{\text{Equity}}$$

2. State the two objectives of Financial Planning.

Ans. Financial Planning endeavors to achieve the following two objectives:

(i) To ensure the availability of funds whenever required: Financial planning involves proper evaluation of the funds
required for different purposes, such as, purchase of long term assets or to meet dayto- day expenses of business, etc.

(ii) Avoiding unessential generation of funds: Excess funding is almost as bad as inadequate funding. Efficient financial planning ensures that business does not raise unnecessarily funds in order to avoid unnecessary addition of cost.

3. Name the concept of financial management which increases the return to equity shareholders due to the presence of fixed financial charges.

Ans. Trading on equity is the concept that increases the return to equity shareholders due to the presence of fixed financial charges.

4. 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’.

Ans. There will be a need of more amount of working capital as Amrit is running a business which is operated on a large scale.

5. 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.

Ans. As Ramnath has adopted new policy for his business, it will eventually affect the requirement of working capital. When the working capital will is reduced.

Short Answer Type Questions

1. What is ‘financial risk? Why does it arise?

Ans. Financial risk refers to the risk of a company not being able to cover its fixed financial costs. The higher level of risks are attached to higher degrees of financial leverage with the increase in fixed financial charges, the company also required to raise its operating profit (EBIT) to meet financial charges. If the company can not cover these financial charges, it can be forced into liquidation.

2. Define ‘current assets’. Give four examples of such.

Ans. Current assets are those assets of the business which can be converted into cash or cash equivalents within a period of one year. Cash in hand or at bank, bills receivables, debtors, finished goods inventory are some of the examples of current assets. These assets are used to run day to day business operations.

3. What are the main objectives of financial management? Briefly explain.

Ans. Primary aim of the financial management is to maximise shareholder’s wealth, which is referred as the wealth maximisation concept. The wealth of owners is reflected in the market value of shares. Wealth maximisation refers to
the maximisation of market price of shares. According to the wealth maximisation objective, financial management must select those decisions which result in value addition, that is to say the benefits from a decision exceed the cost involved. Such value addition increase the market value of the company’s share and hence, results in maximisation of the shareholder’s wealth.

4. Financial management is based on three broad financial decisions. What are these?

Ans. Financial management is concerned with the
solution of the three major issues related to the financial operations of a firm corresponding to the three questions of investment, financing and dividend decision. In a financial context, it means the selection of the best financing alternative or best investment alternative.

The finance function deals with three broad decision which are as follows:

(i) Investment Decision: The investment decision focused on the allocation of financial resources and how the firm’s funds are invested in different assets.

(ii) Financing Decision: Financing decision is concerned about the quantum of finance to be raised from various long term sources and short term sources. It considered identification of various available sources of finance.

(iii) Dividend Decision: Dividend decision is related to distribution of dividend. Dividend is that portion of profit which is distributed to shareholders. The decision involved here is how much of the profit earned by company is to be distributed to the shareholders and how much of it should be retained in the business for meeting investment requirements.

5. 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. No, Cost of Debt (10%) is more than ROI which is 8%.

Ans. A company is able to issue debenture to raise fund when the cost of debt is less than the the cost of capital. In the question given, cost of capital of Sunrises Limited is 10% which is ₹8,00,000 as total capital is ₹80,00,000. Now, Return on
investment is calculated as

$$ROI = Return / Investment\\ \text{Capital Structure }= \frac{\text{8,00,000}}{\text{1,00,00,000}}=8\%$$

Let’s assume that the company will be operating with the same efficiency, the additional investment of ₹80,00,000 will have a ROI of 8% which will amount to ₹6,40,000. The cost of debt will be ₹8,00,000 which is more than the ROI of ₹6,40,000. Therefore, it is advised to a company not to issue debenture when cost of debt is higher than the cost of capital.

6. How does working capital affect both the liquidity as well as profitability of a business?

Ans. The working capital should neither be more nor less than required. Both these situations are harmful. If the amount of working capital is more than the requirement, it will undoubtedly increase liquidity but decrease profitability. For instance, if a large amount of cash is kept as working capital, then this excessive cash will remain idle and cause the profitability to fall.
On the contrary, if the amount of cash and other current assets are very little, then a lot of difficulties will have to be faced in meeting daily expenses and making payments to the creditors. Thus, optimum amount of both the current assets and current liabilities should be determined so that the profitability of the business remains intact and there would be no fall in liquidity.

7. Aval Ltd. is engaged in the business of export of canvas goods and bags. In the past, the performance of the company had been up to 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)

Ans. (a) The financial concept discussed in the is capital budgeting. It is a decision related to capital investment which will impact the profitability of the company in the long term. As the company wants to invest in new machinery which requires investment, this will have a direct impact on the operations which will be going to affect the profitability of the organisation.

The following objectives can be achieved:

Cash flow: Investment will bring new machinery which helps to increase the organisation’s profitability.
Company wants to raise funds from both the organisation's (i.e., inside and outside). It will be helpful to examine the return generated from such investment will be more than the cost of capital.
Investment used: If the company is planning to raise funds from both inside and outside. Then it is important to notice that funds from internal and external sources will have different rates of interest.

(b) Companies pay dividend to shareholders which is a part of the company earnings. Payment of dividends is based on following factors:

Legal Constraint: Legal constraints are those constraints that are mentioned in the company laws which impact paying out dividends on certain occasions. It should be followed properly.
Contractual Constraints: Pay out of dividend results in reduction of cash in the company. Money that is raised as loan will lay down certain restrictions on the company for paying dividends, such constraints are called contractual constraints.

Long Answer Type Questions

1. What is working capital? Discuss five important determinants of working capital requirements.

Ans. Working capital is that part of total capital which is required to meet day-to-day expenses, to buy raw materials, to pay wages and other expenses of routine nature in the production process or we can say it refers to an excess of current assets over current liabilities. Working Capital = Current Assets – Current Liabilities

Factors affecting working capital requirement are:

(i) Nature of Business: The basic nature of a business influences the amount of working capital required. A trading organisation usually needs a lower amount of the working capital compared to a manufacturing organisation. This is because, in trading, there is no processing required. In a manufacturing business, however, raw materials need to be converted into finished goods, which increases the expenditure on raw material, labour and other expenses.

(ii) Scale of Operation: The firms operating on a higher scale of operations, the quantum of inventory, debtors required is generally high, therefore, such organisations require large amount of working capital as compared to the organisations which operate on a lower scale.

(iii) Production Cycle: Production cycle is the time between the receipts of raw materials and their conversion into finished goods. Some businesses have a longer production cycle while some have a shorter one. Therefore, working capital requirement is higher in terms of a longer processing cycle and lower in firms with a shorter processing cycle.

(iv) Credit Allowed: Different firms allow different credit terms to their customers. However, a liberal credit policy results in higher amount of debtors, increasing the working capital requirements.

(v) Credit Availed: Just as a firm allows credit to its customers, it also may get credit from its suppliers. Thus, the more credit a firm avails on its purchases, the working capital requirement is reduced.

2. “Capital structure decision is essentially optimisation of risk-return relationship.” Comment.

Ans. Capital structure refers to the combination of owner’s and borrowed funds. It can be calculated as Debit/Equity.
Debt and equity differ significantly in their cost and riskiness for the firm. Cost of debt is lower than the cost of equity for a firm because lender’s risk is lower than the equity shareholder’s risk. Since lenders earn on assured return and repayment of capital and therefore, they should require a lower rate of return. Debt is cheaper but is more risky for a business because payment of interest and the return of principal is obligatory for the business. These commitments may force the business to go into liquidation if there is any default in meeting them. There is no such compulsion in case of equity, that is why, it is considered riskless for the business. Higher use of debt increases the fixed financial charges of a business. As a result increased use of debt increases the financial risk of a business.
Capital structure of a business thus, affects both the profitability and the financial risk. A capital structure will said to be optimal when the proportion of debt and equity results in an increment in the value of the equity share.

3. “A capital budgeting decision is capable of changing the financial fortune of a business.” Do you agree? Give reasons for your answer.

Ans. Investment decision can be long term or short term. A long term investment decision is also called a capital budgeting decision. It involves the commitment of the finance on a long term basis, e.g., making investment in a new machine to replace an existing one or acquiring a new fixed assets or opening a new branch, etc. These decisions turn out to be very crucial for any business. The earning capacity over the long-run assets of a firm, profitability and competitiveness, are all affected by the capital budgeting decisions. Moreover, these decisions normally involve huge amounts of investment and are irreversible except at a huge cost. Therefore, once made, it is futile for a business to wriggle out of such decisions. Therefore, they need to be taken with utmost care. These decisions must be taken by those who understand them comprehensively. A bad capital budgeting decision can severely damage the financial fortune of a business.

4. Explain factors affecting the dividend decision.

Ans. Dividend decision is related to the distribution of profit to the shareholders and its retention in the business for meeting the future investment requirements.
How much of the profit earned by a company will be distributed and how much will be retained in the business is affected by many factors.

Some of the important factors which affect the dividend decision are as follows:

(i) Earnings: Dividends are paid out of current and past year earnings. Therefore, earnings is a major determinant of the decision about dividend.

(ii) Stability of Earnings: Other things remaining the same, a company having stable earning is in a position to declare higher dividends. As against this, a company having unstable earnings is likely to pay smaller dividend.

(iii) Growth Opportunities: Companies having good growth opportunities retain more money out of their earnings so as to finance the required investment. The dividend in growth companies, is therefore, smaller than that in non-growth companies.

(iv) Cash Flow Position: Dividends involve an outflow of cash. A company may be profitable but short on cash. Availability of enough cash in the company is necessary for declaration of dividend by it.

(v) Shareholder Preference: If the shareholders in general, desire that at least a certain amount should be paid as dividend, the companies are likely to declare the same.

(vi) Taxation Policy: If tax on dividend is higher it would be better to pay less by way of dividends. As compared to this, higher dividends may be declared if tax rates are relatively lower.

(vii) Stock Market Reaction: For investors, an increase in dividend is a good news as stock prices react positively to it. Similarly, a decrease in dividend may have a negative impact on the share prices in the stock market.

(viii) Access to Capital Market: Large and reputed companies generally have easy access to the capital market and therefore, depend less on retained earnings to finance their growth. These companies tend to pay higher dividends than the smaller companies which have relatively low access to the market.

(ix) Legal constraints: Certain provisions of the Company’s Act place restriction on payouts as dividend. Such provisions have to be adhered, while declaring dividends.

(x) Contractual Constraints: While granting loans to a company, sometimes the lender may impose certain restrictions on the payment of dividends in future. The companies are required to ensure that the dividends do not violate the terms and conditions of the loan agreement in this regard.

5.Explain the term ”Trading on Equity”. Why, when and how it can be used by a company?

Ans. Trading on equity is a financial process of using debt in order to produce gain for the owners. In this process, new debt is taken to gain new assets with which they can earn greater level of interest which is more than the interest that is paid for debt. This process is followed because the equity shareholders are interested in the income that is being generated from business. It is practiced by a company only when the rate of return on investment is greater than the rate of interest for the fund that is borrowed. There will be an increment in earnings per share when this process is adopted. Trading
on equity is profitable only when the return on investment is greater than the amount of funds borrowed. It is said that trading on equity shall be avoided if the return on investment is less than the rate of interest from the funds that are borrowed.

6. ‘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 percent 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 `5,000 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.

Ans. Role of Financial Management: Financial management is concerned with the proper management of funds. It involves:
(i) Managerial decisions related to procurement of long term and short term funds.
(ii) Keeping the risk associated with respect to procured funds under control.
(iii) Utilisation of funds in the most productive and effective manner.
(iv) Fixed debt equity ratio in capital.
Objective of Financial Management: The objective of financial management is to maximise the shareholder’s wealth. The investment decision, financial decision and dividend decision help an organisation to achieve this objective. In the given situation, S limited visualizes growth prospects of steel industry due to the growing demand. To expand the production capacity, the company needs to invest. However, investment decision will depend on the availability of funds, the financing decision and the dividend decision. However, the company will take those financial decisions which result in value addition, i.e., the benefits are more than the cost. This leads to an increase in the market value of the shares of the company.

(b) Explain the importance of having a financial plan for this company. Give an imaginary plan to support your answer.

Ans. Importance of financial plan for the company are :
(i) Financial Planning ensures allocation of adequate funds to meet the working capital requirements.
(ii) It brings about a balance between in flow and out flow of funds and ensures liquidity throughout the year.
(iii) It helps to solve the problems of shortage and surplus of funds by ensuring proper and optimum utilisation of available resources.
(iv) It ensures to increase profitability through cost benefit analysis and by avoiding wasteful operations.
(v) It seeks to eliminate wastage of funds and provides better financial control.
(vi) It seeks to avail the benefits of trading on equity.

(c) What are the factors which will affect the capital structure of this company?

Ans. Capital structure refers to the proportion in which debt and equity funds are used for financing the operations of a business. A capital structure is considered to be optimum when the proportion of debt and equity results in an increase in the value of shares.

The factors that will affect the capital structure of this company are:

(i) Equity Funds: The composition of equity funds in the capital structure will be governed by the following factors:
(a) The funding requirement of ‘S’ Limited is for long term. Hence, equity funds will be more appropriate.
(b) There are no financial risks involved in this form of funding.
(c) If the stock market is bullish, the company can easily raise funds through issue of equity shares.
(d) If the company already has raised reasonable amount of debt funds, each subsequent borrowing will come at a higher interest rate and will increase the fixed charges.

(ii) Debt Funds: The usage and the ratio of debt funds in the capital structure will be governed by factors like:
(a) The availability of cash flow with the company to meet its fixed financial charges. The purpose is to reduce the financial risk associated with such payments which can further be checked by using ‘debt’ service coverage ratio.
(b) It will provide the benefit of trading on equity and hence, will increase the earning per share of equity shareholders. However, ‘return on investment’ ratio will be the guiding principle behind it. The company should choose trading on equity only when return on investment is more than the fixed charges.
(c) Interest on debt funds is a deductible expense and therefore, will reduce the tax liability.
(d) It does not result in dilution of management control.

(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.

Ans. The working and fixed capital requirement of ‘S’ Limited will be high due to the following reasons:
(i) The business is capital intensive and the scale of operation is large.
(ii) For technological upgradation and to build up production base, heavy investments are required.
(iii) In case of steel industry, the major input is iron ore and coal. The ratio of cost of raw material to total cost is very high. Thus, there will be the higher need for working capital.
(iv) The longer the operating cycle, the larger is the amount of working capital required as the funds get locked up in the production process for a long period of time.
(v) Terms of credit for buying and selling goods, discount allowed by suppliers and to the customers also determine the quantum of working capital.