NCERT Solutions for Class 12 Business Studies Chapter 9 Financial Management

Q. 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.

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

Q. What is the main objective of financial management? Explain briefly.

Ans. Primary aim of financial management is to maximise shareholders’ wealth, which is the wealth maximisation concept. The owners’ wealth is reflected by the market value of shares, and wealth maximisation means maximizing the 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 increases the market value of the company’s share and maximizes the shareholder’s wealth.

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

Ans. Financial management is concerned with the solution of three major issues relating to the financial operations corresponding to the three questions of investment, financing and dividend decision. In an economic context, it means the selection of the best financing alternative or best investment alternative. The finance function, therefore, is concerned with three broad decisions, which are as follows:

  • (i) Investment decision: The investment decision relates to how the firm’s funds are invested in different assets.
  • (ii) Financing decision: This decision is about the quantum of finance to be raised from various long term sources and short term sources. Therefore, it involves the identification of various available sources of finance.
  • (iii) Dividend decision: This decision relates to the distribution of dividends. The dividend is that portion of the profit that is distributed to shareholders. The decision involved here is how much of the company’s profit is to be distributed to the shareholders and how much of it should be retained in the business for meeting investment requirements.

Q. Explain the following as factors affecting dividend decision.

  • (a) Stability of earnings
  • (b) Growth opportunities
  • (c) Cash flow position
  • (d) Taxation policy

Explain the factors affecting dividend decision ?

Ans.  Factors affecting dividend decision are:

  • (a) Stability of earnings: The stability of earnings of a business unit affects the dividend decision. Stability of earnings is when the company can earn a reasonable amount of profits every year. A company with stable earnings can declare a higher dividend whereas a company with unstable earnings is likely to pay a less dividend.
  • (b) Growth opportunities: Companies intended to grow and diversify their operations in new lines of business generally pay less dividend and retain more money out of profits to invest in profitable projects. On the contrary, companies that are not intended to grow and continue with the same line of business having enough earnings and cash can pay higher dividends.
  • (c) Cash flow position: Dividend involves an outflow of cash. Therefore, the availability of enough cash is necessary for the payment of dividends. If the cash flow position is strong, dividends can be paid. If the cash flow position is weak, it is difficult to pay dividends.
  • (d) Taxation policy: The decision is affected by the tax treatment of dividends and capital gains. For a company, it is better to pay less dividends when the tax rate on the dividend is higher and pay more as dividends when the tax rate is lower. This is because dividends are tax-free in the hands of shareholders and dividends distribution tax is levied on the company. Therefore, the payment of tax on the dividend is an added expense for the company to be paid apart from the distributed dividends.

Q. Discuss how working capital affect both the liquidity as well as the profitability of a business?

Ans. The working capital should neither be more nor less than; required. Both these situations are harmful. If working capital is more than required, it will undoubtedly increase liquidity but decrease profitability. For instance, if a large amount of cash is kept as working capital, then this excess 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, the optimum amount of both current assets and current liabilities should be determined so that the business’s profitability remains intact and there is no fall in liquidity.

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

Ans. Capital structure refers to the mix between owners and borrowed funds. It can be calculated as Debt/Equity.

Debt and equity differ significantly in their cost and riskiness for the firm. The cost of debt is lower than the cost of equity for a firm because the lender’s risk is lower than the equity shareholder’s risk since lenders earn on assured return and repayment of capital. Therefore they should require a lower rate of return. Debt is cheaper but is riskier for a business because payment of interest and the return of principal is obligatory for the business. Any default in meeting these commitments may force the business to go into liquidation. There is no such compulsion in the case of equity, which is, therefore, 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. The capital structure of a business thus affects both the profitability and the financial risk. Therefore, a capital structure will be said to be optimal when the proportion of debt and equity is such that it increases the value of the equity share.

Q. “A capital budgeting decision is capable of changing the financial fortune of a business.” Do you agree? Why or why not?

Ans. Investment decisions can be long term or short term. A long term investment decision is also called a capital budgeting decision. It involves committing the finance on a long term basis, e.g., investing in a new machine to replace an existing one or acquiring new fixed assets or opening a new branch etc. These decisions are very crucial for any business. They affect its 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 almost impossible 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.