Case Study Based HOTs Class 12 Business Studies
Read the following text and answer the following questions on the basis of the same:
Mr. A. Bose is running a successful business. Mr. Bose is the owner of R. K. Cement Ltd.
Mr. Bose decided to expand his business by acquiring a Steel Factory. This required an investment of Rs. 60 crores.
To seek advice in this matter, he called his financial advisor Mr. T. Ghosh who advised him about the judicious mix of equity (40%) and Debt (60%). Employ more of cheaper debt may enhance the EPS. Mr. Ghosh also suggested him to take loan from a financial institution as the cost of raising funds from financial institutions is low. Though this will increase the financial risk but will also raise the return to equity shareholders. He also apprised him that issue of debt will not dilute the control of equity shareholders. At the same time, the interest on loan is a tax deductible expense for computation of tax liability. After due deliberations with Mr. Ghosh, Mr. Bose decided to raise funds from a financial institution.
Question. Identify the concept of Financial Management as advised by Mr. Ghosh in the above situation.
A) Capital Budgeting
B) Capital Structure
C) Dividend Decision
D) Working Capital Decision
Answer : B
Question. In the above case Mr. Ghosh suggested to raised more fund from debt.
Higher debt-equity ratio results in:
A) Lower financial risk
B) Higher degree of operating risk
C) Higher degree of financial risk
D) Higher Earning of profit.
Answer : C
Question. “Mr. T. Ghosh who advised him about the judicious mix of equity (40%) and Debt (60%)” The proportion of debt in the overall capital is called___________.
A) Working Capital
B) Financial Leverage
C) Total Assets
D) None of these
Answer : B
Question. Employ more of cheaper debt may enhance the EPS. Such practice is called:
A) Equity Trading
B) Financial Leverage
C) Investment Decision
D) Trading on Equity
Answer : D
Read the following text and answer the following questions on the basis of the same:
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 Rs.80,00,000 for replacing machines with modern machinery of higher production capacity. It involves committing the finance on a long term basis. These decisions are very crucial for any business since they affect its earning capacity in the long run. 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 Rs. 8,00,000 and total capital investment was Rs. 1,00,00,000. Instead of issuing 10% Debenture the Company can issue Equity Shares for raising the fund. The financial manager of the company would normally opt for a source which is the cheapest.
Question. What is the other name of long term decision?
A) Capital Budgeting
B) Gross working capital
C) Financial management
D) Working Capital
Answer : A
Question. A decision for replacing machines with modern machinery of higher production capacity is a:
A) Financing decision
B) Working capital decision
C) Investment decision
D) None of the above
Answer : C
Question. A decision for raising fund of Rs. 80,00,000 either from 10% Debenture or Equity Shares is a:
A) Financing decision
B) Dividend decision
C) Investment decision
D) None of the above
Answer : A
Question. The financing decisions are affected by various factors. Which one of the following factor is discussed in the above case?
Choose the correct option.
A) Cash Flow Position of the Company
B) Cost
C) Amount of Earnings
D) Taxation Policy
Answer : B
Very Short Answer type Chapter Financial Management Class 12 Business Studies
Question. A company wants to establish a new unit in which a machinery worth Rs.10 lakhs is involved. Identify the type of decision involved in financial management.
Answer: Investment decision
Question. A decision is taken to raise money for long term capital needs of the business from certain sources. What is this decision called ?
Answer: Financing decision
Question. A decision is taken to distribute certain parts of the profit to shareholders after paying tax. What is this decision called?
Answer: Dividend decision
Question. Name the source of finance carrying two fixed obligations viz., interest and redemption.
Answer: Debentures
Question. Incase of inflation, does an enterprise need more or less of the working capital?
Answer: More working capital
Question. Identify the decision taken in financial management which affects the liquidity as well as the profitability of business.
Answer: Capital budgeting decision
Question. State why the working capital needs for a service industry are different from that of a manufacturing industry.
Answer: Nature of business determines the working capital needs . Service industries which usually do not have to maintain inventory require less working capital whereas manufacturing industries have to maintain inventory in the form of R/M to finished goods there require more working capital.
Question. To avoid the problem of shortage and surplus of funds what is required in financial management? Name the concept and explain its any three points of importance.
Answer: Financial Planning. Sound financial planning is essential for success of any business enterprise. It is important because-
(i) It facilitates collection ;of optimum funds.
(ii) It helps in fixing the most appropriate capital structure.
(iii) It helps in investing finance in right projects.
Question. State the factors which affect the capital structure of a company.
Answer: (i) Cash flow ability
(ii) Control
(iii) Floatation cost
(iv) Flexibility
(v) Market condition
Question. Why is Financial Planning done?
Answer: It is done to achieve following two objectives–
(i) To ensure availability of funds whenever these are required.
(ii) To see that firm does not raise resources unnecessarily.
Question. Length of Production cycle affects the working capital requirements of an organization. Explain how?
Answer: Production cycle is the time span between the receipt of raw material and their conversion into finished goods. Duration and length of production cycle affects the amount of funds required of R/M and expenses. Consequently the working capital requirement is higher in firms with longer processing cycle and lower in firms with shorter processing cycle.
Question. ‘Primary objective of financial management is to maximize the wealth of shareholders’. Explain.
Answer: Maximization of shareholders wealth depends upon the market price of shares . Market price of equity share increase if the benefits from a decision exceeds the cost involvcd.
Question. The directors of a manufacturing company are thinking of issuing Rs. 20 lacs additional debentures for expansion of their production capacity. This will lead to an increase in debt-equity ratio from 2:1 to 3:1. What are the risks involved in it?
Answer: The increase in debt-equity ratio from 2:1to 3:1 is subject to following risks-
(a) Interest on debt has to be paid even when the company is not making sufficient profits.
(b) The debebtureholders have charge over the assets of the company so there is threat of solvency.
Question. A businessman who wants to start a manufacturing cocern, approaches you tosuggest him whether the following manufacturing cocern would require large or small working capital: (a) Bread, (b) Coolers, (C) motor Car.
Answer: (a) Bread – Requirement of working capital will be less because it has quick cash turnover.
(b) Coolers – Require of working capital will be more because it is a seasonal product.
(c) Motor car – Working capital requirement will be more.
Question. You are the finance manager of a newly established company. The directors of the company have asked you to plan the capital structure of the company. State any four factors that you would consider while planning the capital structure.
Answer: Following factors would be considered for the purpose –
(i) Cash Flow Position
(ii) Interest Coverage Ratio
(iii) Return on Investment
(iv) Cost of debt
(v) Tax rate
Question. How Stock market conditions affect the capital struceture specially when company is planning to raise additonal capital?
Answer: There are two main conditions of stock market i.e., Boom condition and Recession condition.
During recession market is slow and investors also hesitate to take risk so at this time it is advisable to issue borrowed funds as they are less risky and ensure fixed repayment and regular interest. But during boom period, business flourishes and investors also take risk and prefer to invest in equity shares to earn more in the form of dividend.
Question. How is Interest Coverage Ratio computed? What does it indicate?
Answer: Interest Coverage Ratio= Earnings before interest and tax/Interest Higher ICR means companies can have more of borrowed fund securities whereas lower ICR means less borrowed fund securities.
Question. How is Return on Investment computed?
Answer: Return on Investment= Earnings before Interest and tax/ Total investment.
Question. When is financial leverage considered favorable?
Answer: Financial leverage is considered favorable when return on investment is higher than the cost of debt.
Question. why does financial risk arise?
Answer: Interest on borrowed fund have to be paid regardless of whether or not you firm has made a profit. Moreover borrowed fund have to be repaid after a fixed time and it carries a charge on assets. This gives rise to financial risk.
Question. How does production cycle effect working capital?
Answer: working capital requirement is higher with longer production cycle.
Question. Enumerate two objectives of financial management?
Answer: (a)To ensure availability of required funds. (b) to see that the firm does not raise resources unnecessarily.
Question. What is the primary objectives of financial management?
Answer: Wealth Maximization.
Question. The board of Directors has asked you to design the capital structure of the company. Explain any sin factors that you would consider while doing so.
Answer: For design the capital structure of the company six factors are as following:- 1) Cash Flow Position. 2) Interest coverage ration(ICR) 3) Debt Service coverage ratio(DSCR) 4) Return on investment (ROI) 5) Cost of debt 6) Tax rate.
Question. Every manager has to take three major decisions while performing the finance function. Explain them.
Answer: A manager take three following major decisions:- 1) financing Decision. 2) Investment Decision. 3) Dividend Decision.
Question. What do you call the capital needed for day to day operations? Explain any 5 factors affecting such capital needs.
Answer: Capital needed for day to day operations is called working capital.{explain any 5 factors affecting such capital needs]. 1) Nature of business 2) Scale of operations 3) Seasonal Factors 4) Production cycle 5) Credit allowed
Question. The directors of a company have decided to expand their business activities by increasing the stock of raw materials and finished goods at an estimated cost of Rs. 50 lakhs, Describe the various ways open to the company to raise necessary finance for the purpose.
Answer: the company can raise necessary finance for the purpose of expansion through the following function. (a) Issue of shares (b) Issue of debentures (c) Loans from banks and financial institutions. (d) Retained earnings.
Question. A capital budgeting decisions is capable of changing the financial fortune of a business. Do you agree? Why or why not?
Answer: hint Yes, I agree to this statement because of the following importance of capitals budgeting decisions. (a) long term growth and effects. (b) Large amt of funds involved (c) Risk involved (d) Irreversible decisions.
Question. Are the share holders of a company likely to gain with a debt component in the capital employed ? Explain with the help of an example?
Answer: The shareholders of a company are very likely to gain with debt component in the capital employed by way of trading On equity as it increases the earning per share(EPS) of the share holders[( Explain trade on equity with one example)].
Question. state whether the working capital requirements of business manufacturing the following items are big or small. Justify your statement. (a) Coolers (c) Sugar (b)bread (d) Locomotives (e) Furniture manufacturing against orders.
Answer: Requirements of working capital for the mentioned business will be: (a) Bread Requirements of working capital will be less because it has quick cash turnover. (b) Sugar;- working capital required for manufacturers will be more as ration of raw material cost to total cost is more. (c) Coolers:- working capital required for manufacturers of cooler will be more because it is a seasonal product. (d) Furniture:- Requirements of working capital for a manufacturer of furniture manufactured against specific order is less as it doesn’t requires large stock. (e) Motor car;- Requirements of working capital for a manufacturer of locomotives will be more because gestation period is more.
Question. What do you mean by flotation cost?
Answer: Cost uncured for raising funds.
Question. Name any 2 sources of long term fund?
Answer: (a) Debt. (b) Equity
Question. What is Business Finance?
Answer: Money required for carrying out business activities is called business finance.
Important Exam Questions for NCERT Class 12 Business Financial Management
Meaning of Financial Management
Financial management is the activity concerned with the planning, raising, controlling and administering of funds used in the business. It is concerned with optimal procurement as well as usage of finance. It aims to reduce the cost of funds. It also aims at ensuring availability of enough funds whenever required as well as avoiding idle finance.
Objectives of Financial Management
(A) Primary Objective:
• Wealth Maximisation: The main objective of Financial management is to maximise shareholder’s wealth. The market price of a company shares is linked to three basic financial decisions and shareholder’s wealth maximisation.
Wealth of shareholders = number of shares x market price per share.
(B) Other objectives:
1. To procure sufficient funds for the organisation:Adequate and regular supply of funds is to be maintained for smooth operations of the business.
2. To ensure effective utilisation of funds.
3. To ensure safety of funds : The chances of risk in investments should be minimum possible.
Deciding how much amount is to be arranged from which source.
FIRST STAGE: FINANCIAL PLANNING
The process of estimating the fund requirement of a business and specifying the sources of funds is called financial planning. It ensures that enough funds are available at right time so that a firm could honour its commitments and carry out its plans. STEPS
(i) Determination of Financial Objectives.
(ii) Formulation of Financial Policies and Rules.
(iii) Forecasting the Needs of Finance.
(iv) Developing Alternative sources of Finance.
(v) Selection of Best Alternative.
(vi) Implementing Financial Plans and Policies.
Importance of Financial Planning
1. To ensure availability of adequate funds at right time.
2. To see that the firm does not raise funds unnecessarily.
3. It results in preparation of plans for future. Thus new projects can be under taken smoothly.
4. It serves as the basis of financial control. The management attempts to ensure utilization of funds in tune with the financial plans.
SECOND STAGE: CAPITAL STRUCTURE
Capital structure refers to the optimal mix between owner’s funds and borrowed funds. It will be said to be optimal when the proportion of debt and equity is such that it results in an increase in the value of the equity share. The proportion of debt in the overall capital of a firm is called Financial Leverage or Capital Gearing. When the proportion of debt in the total capital is high then the firm will be called highly levered firm but when the proportion of debts in the total capital is less, then the firm will be called low levered firm
Factors affecting Capital structure or financing decision.
1. Trading on Equity: It refers to the increase in profit earned by the equity shareholders due to the presence of fixed financial charges like interest. Trading on equity happens when the rate of earning of an organisation is higher than the cost at which funds have been borrowed and as a result equity shareholders get higher rate of dividend per share.
2. Cash Flow Position: In case a company has strong cash flow position then it may raise finance by issuing debts, as they are to be paid back after some time and interest has to be paid on debt.
3. Interest Coverage Ratio: It refers to the number of times earning before interest and taxes of a company covers the interest obligation. High interest coverage ratio indicates that company can have more of borrowed funds. Formula for calculating ICR = EBIT/interest.
4. Return on Investment: If return on investment is higher than the rate of interest on debt then it will be beneficial for a firm to raise finance through borrowed funds.
5. Floatation Cost: The cost involved in issuing securities such as brokers commission, under writer’s fees, cost of prospectus etc. is called floatation cost..
6. Risk: The risk associated with different sources is different. More risk is associated with borrowed funds as compared to owner’s fund as interest is paid on it and it is to be repaid also, after a fixed period of time or on expiry of its tenure.
INVESTMENT DECISION
It relates to how the firm’s funds are invested in different assets. Investment decision can be long-term or short-term. Long term investment decision is called capitaL
budgeting decision as they involve huge amounts of funds and are irreversible except at a huge cost.
Factors affecting Investment Decisions
1. Cash flows of the project : The series of cash receipts and payments over the life of an investment proposal should be considered and analysed for selecting the best proposal.
2. Rate of Return : The expected returns from each proposal and risk involved in them should be taken into account to select the best proposal.
3. Investment Criteria Involved : The various investment proposals are evaluated on the basis of capital budgeting techniques. These involve calculations regarding investment amount, interest rate, cash flows, rate of return, risk involved in project etc.
INVESTMENT: 1. FIXED CAPITAL 2. WORKING CAPITAL
Fixed Capital
Fixed capital refers to investment in long-term assets. Investment in fixed assets like land, plant and machinery for longer duration and they must be financed through long-term sources of capital.
Factors Affecting Requirement of Fixed Capital
1. Nature of Business : Manufacturing concerns require huge investment in fixed assets & thus huge fixed capital is required for them but trading concerns need less fixed capital as they are not required to purchase plant and machinery etc.
2. Scale of Operations : An organisation operating on large scale requires more fixed capital as compared to an organisation operating on small scale.
3. Choice of Technique : An organisation using capital intensive techniques requires more investment in plant & machinery as compared to an organisation using labour intensive techniques.
4. Technology upgradation : Organisations using assets which become obsolete faster require more fixed capital as compared to other organisations.
5. Growth Prospects : Companies having more growth plans require more fixed capital. In order to expand production capacity more plant & machinery are required.
Working Capital
Working Capital refers to the capital required for day to day working of an organisation. Every business organisation needs to invest in current assets, which can be converted into cash or cash equivalents within a period of one year. They provide liquidity to the business. Working capital is of two types - Gross working capital and Net working capital. Investment in all the current assets is called Gross Working Capital whereas the excess of current assets over current liabilities is called Net Working Capital.
MCQs for NCERT Class 12 Business Studies Financial Management
Question. ROI of a company is 12%. To finance its project, it has two borrowing options.
(a) Rate of interest 9%
(b) Rate of interest 13%
Which option is better. Give reason.
Answer: A
Question. Higher debt equity ratio results in
(a) Lower financial risk
(b) higher operating risk
(c) higher financial risk
(d) higher EPS
Answer: C
Fill in the blanks :
Question. If there is only one project, its viability in terms of ______________ and its comparability with the industry average is seen.
Answer: Rate of return on investment.
Question. _____________ involves committing the finance on a long-term basis.
Answer: Capital Budgeting Decision.
Question. _____________ aims at reducing the cost of funds procured, keeping the risk under control and achieving effective deployment of such funds. (Financial management/Financial planning).
Answer: Financial management.
Question. _____________ aims at mobilisation of financial resources at a lower cost and deployment of these in most lucrative activities.
Answer: Financial management.
Question. Making investment in a new machine to replace an existing one or acquiring a new fixed asset or opening a new branch, etc. are __________________
Answer: Capital Budgeting Decision.
Question. A decision is taken in financial management to distribute certain parts of the profit to shareholders after paying tax. This decision is called ________.
Answer: Dividend decision
Question. The size of assets, profitability and competitiveness are all affected by _________________.
Answer: Capital Budgeting Decisions.
Question. Decision to invest in fixed assets must be taken very carefully as the investment usually quite large. Such decisions once taken are irrevocable except at a huge loss. Such decision are called __________.
Answer: capital budgeting decisions
Question. The overall financial risk depends upon __________________.
Answer: The proportion of debt in the total capital.
Question. The fund raising cost is called_____________.
Answer: Flotation cost.
Question. A stronger cash flow position may make ____________ financing more viable than funding through ___________.
Answer: Debt; Equity.
Question. ___________________ decisions involve allocation of firm’s capital to different projects or assets with long-term implications for the business. These decisions affect the growth profitability and risk of the business in the long run.
Answer: capital budgeting decisions
Question. The statement of Profit and Loss of Govinda Ltd. shows huge profits but the company is short on cash. So, it can pay less dividend. The factor affecting dividend decision highlighted here is _____________.
Answer: Cash Flow Position
Question. If a business has high fixed operating costs (e.g. building rent, insurance premium, salaries, etc)__________ debt financing is better.
Answer: Lower.
True/False :
Question. Companies with higher growth potential pay lower dividends.
Answer: True
Question. An ‘Advertising agency’ needs to have large fixed capital.
Answer: False
Question. Trading on equity takes place when ROI is less than the rate of interest.
Answer: False
Question. Capital budgeting decisions are very crucial for any business.
Answer: True
Question. If cash flow position of a company is weak more debt financing is not recommended.
Answer: True
Short Answer type Chapter Financial Management Class 12 Business Studies
Question. Write the full form of the terms :-
a) EBIT b) ROI
Answer: EBIT refers to earnings before interest & taxes. ROI refers to return on investment.
Question. State which type of capital structure (more equity based or debt based) would a company adopt when.
a) The stock market is bullish b) The stock market is bearish.
Answer: a) When the stock market is bullish equity based capital structure can be easily raised .
b) When the stock market is bearish a company must go in for more of loans or debt in its capital structure.
Question. Seema is a manufacture who deals in bakery products. Reena also a manufacturer deals in stainless steel ware. Based on length of operating cycle state who would require more working capital?
Answer: The length of operating cycle of Reena’s firm stainless steel ware is longer i.e. The conversion time for raw material to stainless steel product may require more time in case of Reena’s firms. Hence Reena would require more
working capital as compared to Seema.
Question. State the foremost objective of financial management.
Answer: The foremost objective of financial management is “maximization of share holder’s wealth.
Question. “Ploughing back of profits holds the key to success of a business enterprises”. Do you agree. Give two reasons.
Answer: Yes, agree. (1) This is because (i) the company need not raise finance from other sources hence cost of financing of the Co. is kept at minimum.
ii) When retained earnings are ploughed back business this greatly enhances prestige of Co. in the eyes of shareholder and the general public.
Question. Give reasons why fixed capital requirement of the electronic and computer industry are different from those of furniture industry.
Answer: Electronic & computer industry are industries which require constant technological up gradation . The assets in such industries become obsolete very quickly and require constant replacement hence they require greates fixed capital investment. Furniture industry does not face danger of technological upgradation and hence they require less investment in fixed assets.
Question. A decision in financial management is basically concerned about now much to raise and from which source.
Name the type of decision. Also explain two vital factors to be kept in mind while taking such decisions.
Answer: The types decision is financing decision. Two vital factors to be kept in mind white taking such decision are :-
• The cost of raising such funds.
• Risk associated with deferent course – debt capital are generally considered more riskily.
Question. You are the finance manager of DO WELL INDUSTRIES LTD.. The firm has earned a profit of 100 crores. Management wants to retain the profit fully in the business without paying any dividend Advise the management on the negative impact of doing so. (Any two reasons).
Answer: Negative impact of not paying dividend to share holder despite earning good profits.
• It may adversely affect the share prices, stock market reacts adversely to non payment of dividend.
• Chase holder will feel dissatisfied and this may lead to heavy seeling of shares which would in turn affect reputation of the firm.
Question. Name the activity which essentially involves “preparation” of financial blue of an enterprise’s future operations. “Also state any two advantages of this activity.
Answer: The activity which involves preparation of financial blue print of an enterprises future operation is financial planning Advantages :-
• It ensures availability of funds to a firm whenever it requires it.
• To ensure that the firm does not raise resources unnecessarily or waste financial resources.
Question. Explain giving reasons why firms with :-
a) High debtors turnover ratio and
b) High inventory turnover ratio require lesser amount of working capital.
Answer: a) High debtors turnover ratio signifies firm’s efficiency in realizing value of credit sales from debtors . Therefore such firms need relatively less amount of working capital.
b) High inventory resources ratio also indicates operational efficiency e.i. the firm’s stock is quickly converted into sales. Hence these firms also require less investment in working capital.
Question. Explain with the suitable example how ‘lead time’ affects working capital requirements of a business?
Answer: Lead time refers to the time lag between placing an order and obtaining delivery of raw materials. Firms which have longer lead time therefore require maintenance of high levels of stock and therefore more investments in working capital. For example :-
Firm x dealing in tyre and tube has a lead time of one week and firm y dealing in computer spare parts has a lead time of three weeks. Firm would need to maintain more inventory and therefore require more working capital.
Question. Apollo Ltd, has earned a profit which is very high,. However the firm faces a short term liquidity crunch .Explain how it will affect the dividend decision which are to be taken.
Answer: Dividend decision are taken on the basis of several factors most important of which is cash flow position of a company. Company’s which face liquidity Creech or shortage of cash generally do not declare high percentage of
dividend as it involves hige outflow of cash as payment of dividend to share holders.
Question. What are the condition that a company must consider before it tardes on equity?
Answer: Trading on equity involves usage of highel percentage of debt in capitalstructure to ensure better return to equity share holders. The two conditions to be kept mind while trading on equity are :-
i) Rate of return must be greater that interest payable on fixed interest securities.
ii) Interest must be tax deductible.
Question. “Capital budgeting decisions can make or break a firms fortunes? Do you agree. Give reasons why? (four reasons)
Answer: Yes,
Reasons
i) Huge amount of funds are involved.
ii) Such decisions have long term implication.
They are irreversible decisions.
There are associated cause with capital budgeting decisions
Question. Swaja, the finance manager of OPTIMA LTD. A firm dealing in telecommunication equipment chose a capital structure which was Lighly geared :-
i) What do you understand by a highly geared capital structure?
ii) What are the implications of choosing such a structure?
Answer: i) A highly geared capital structure is one in which mole debt is employed to ensure return to equity share holders. Implications of such a structure are
• EPS will increase
• But the higative impact is that as more debt is used it is more risky for the business enterprise.
Question. Rama Enterprises a small business concern wants to expand its capital base. However the firm faces a major threat of takeover by a bigger concern in the same line of operations.
a) Advice the firm on what type of capital it should raise?
b) Give reasons also.
Answer: a) Firm should choose a capital structure which is more based on debt.
b) As the firm faces threat of takeover equity Bhares are totally unsuitable as they will dilute the owner’s inter in the business. Further where equity shares are issued the bigger concern right purchase its share and acquire greater stake in the business and ultimately take over the enterprise.
Question. i) What is interest coverage ratio?
ii) How does it affect capital structure?
iii) Illustrate effect of interest coverage ratio on capital structure with a suitable example.
Answer: i) Interest coverage ratio refers to no. of times EBIT covers interest obligation of a business. Formula for calculation is EBIT Interest
ii) Interest coverage ratio determines the maximum amount the company can raise by way of debt keeping the mind the return on investment and interest obligations to be met .
iii) lllustration of interest coverage ratio – If a company has EBIT at RS 10,00,000. If Co. had issued 10% debentures of Rs. 50,00,000. The interest coverage ratio is 10 00 000 / 50 000 = 20 times
The Co. is at a lower risk of failing to meet its interest obligation as compared to a Co. with a lower interest coverage ratio.
Question. State whether the following require huge or low fixed capital give reason also
i) The manufacturing concern.
ii) The cottage/small scale industry.
iii) A petrochemical Co. which is going to diversify operations and enter the textile business also.
Answer: I) Manufacturing concern converse requires higher investment in fixed assets and therefore requires more working capital.
ii) Cottage/small scale industries are generally labour intensive. So their fix capital requirement are not very high.
iii) A petro chemical Co. diversify in activities into textile sector requires high initial investment for purchase of fixed assets for purpose of manufacture of textiles.
Question. Inflation has affected working capital requirement of all firms”.
a) What do you think is impact of inflation on working capital?
b) Give reasons for your answer.
c) Also explain how credit allowed and credit availed affects working capital requirements of a business.
Answer: i) When there is inflation in the economy more working capital is required.
ii) This is because under inflationary conditions cost of raw materials, labour inputs etc. Also increase leading to higher requirements of working capital.
iii) When credit is allowed by a firm it needs to maintain higher working capital as sometime is required before credit sales are realized from. Credit availed help a firm to operate with less working capital as credit purchases of raw
material, spare parts etc. can be made. (2+2+2=6)
Question. Comment on the fixed capital requirement of the following industries giving suitable reasons :-
a) A construction firm? Which has provisions to tease earthmoving equipment and bulldozers.
b) A electronic goods manufacture who has entered into a collaboration with a giant firm in South East Asia.
Answer: a) Construction firm with provisions for leasing need not invest heavily in fixed capital as these assets which involve huge cost can be leased or hired based on need.
b) The electronic goods manufactures who entered in collaboration of South West Asia also requires lesser fixed capital as this joint venture enables pooling of resoures such as machinery equipment and therefore and also joint investment for purchase of certain fixed assets hence there fixed capital need tends to be lower.
Question. When is the dividend decision treated as a residual decision ?
Answer: To finance investment projects the firm has two alternatives either to raise external equity or to internally finance from the retained earnings available. thus, the company will pay dividends only when it cannot profitably invest the earnings. In this case, the dividend is treated as a residual or passive decision.
Question. What is ‘stock dividend’ ? How does it affect a company ?
Answer: When a co. instead of paying dividend in cash issues shares to its shareholders it is known as bonus shares or stock dividend. The effect of issuing bonus shares is that it increases the capital base of the Co.
Question. When is a capital structure said to be optimum ?
Answer: A capital structure is said to be optimum when the proportion of debt and equity is such that it results in an increase in the value of the shares.
Question. State the concept of financial leverage ? How is it computed ?
Answer: The proportion of the debt in the overall capital is called financial leverage. It is computed as debt /debt+equity.
Question. Explain the term financial risk.
Answer: Financial risk is risk which arises due to inability of a firm to meet its fixed financial commitments, for eg. interest on debentures.
Question. Define business finance.
Answer: Business Finance refers to money required to carry out activities pertaining to business.
Question. Give the full form of
• ROI
• ICR
Answer: ROI – Return on Investment.
ICR – Interest Coverage Ratio
Question. When an asset said to be more liquid ?
Answer: An asset is more liquid when it can be converted into cash quickly and without any reduction in its value.
Question. To avoid the problem of shortage and surplus of funds what is required in financial management ? Name the concept involved.
Answer: To avoid the problem of storage and surplus of funds financial planning is required in management.
Question. Depict the effect of a higher debtor turnover ratio on working capital needs of a firm.
Answer: A high debtor turnover ratio indicates faster realization of cash receivables. It will be reduce the working capital requirement of a firm.
Question. Distinguish between fixed and working capital.
Answer: Fixed Capital :
i) Capital invested in fixed assets such as building, machinery etc.
ii) Fixed assets have a long life and are not meant for resale.
iii) Basic objective is to provide infrastructure or production capacity for the manufacture of furnished goods.
Working capital :
i) It is invested in floating assets i.e. stock debtors.
ii) Floating assets are for short term and these can be converted into cash quickly.
iii) It’s aim is to meet day to day expenses of production process.
Question. What are the three possible situations of capitalisation ?
Answer: Three possible situations of capitalization are : Fair and normal Capitalisation – Business employs correct amount of capital.
Once Capitalistaion – Business employs more capital than warranted.
Under Capitalisattion – Business employs less capital than warranted.
Question. Capital structure and capitalisation way consist of the same components and yet they may differ”. Explain briefly.
Answer: Capitalisation is a quantitative aspect of financial planning of an enterprise, while capital structure is concerned with qualitative aspect. Capitalisation refers to total amount of securities issued by a company while capital structure refers to the kind of securities and their compositions in total funds raised by a Co
Question. Explain any four factors which affect the capital structure of a business enterprises.
Answer: The capital structure of a company refers to the composition of its long term funds. The following factors effect the capital structure of a company –
I) Position of cash Flow :- The decision relating to composition of capital structure depends upon the ability of the business to generate enough cash flow. Funds are required to meet its day to day requirements. long term investments & to pay fixed commitments.
II) Return on investment (ROI) :- It refers to the earnings expected from the investment. If ROI is high a Co. can opt for trading on equity to increase the earning per share. Thus, it is an important determinant of the extent of trading on equity and hence, capital structure.
III) Interest Coverage Ratio :- The purpose of calculating this ratio is to determine the composition of debt funds in the capital structure of a Co. It is a ratio between earning before interest and taxes (EBIT) and interest obligation
ICR = EBIT/Interest
IV) Debt Service Coverage ratio (DSCR) :- This ratio takes care of the limitation of ICR. It is calculated as follow
Net profit after tax + depreciation + Int. on term borrowings / Repayment of term berrowings Int. on term borrowings
Question. What are capital budgeting decisions ? Explain factors affecting such decisions.
Answer: Capital Budgeting decision refers to investment decision to which are to be taken by a finance manager for investment in long term projects. The basic criteria involved for taking such decisions are :-
(a) Rate of return and (b) risk involve. Firms try to invest in projects with maximum rate of return and minimum risk. The other factors to be considered are
(i) Cash flow of project :- A project must be able to generate reasonable cash flow.
(ii) Investment Criteria involved :- Calculations regarding amount of investment, interest rate and purpose have to be carefully analysed before making such decision.
Question. State and explain whether the following have small or large working capital requirements.
(i) A firm trading in biscuits
(ii) A manufacturer of steel pipes
(iii) A firm selling ice-creams.
(iv) A firm following a liberal credit policy.
Explain why management of fixed capital is considered critical to an enterprises success.
Answer: (a) A firm trading in biscuits need relatively less working capital as it requires the processing time for sales can be effected immediately and hence less working capital need be maintained.
(b) Steel pipes have a long manufacturing process is conversion time from raw materials to furnished products is long. Hence more working capital is required. 4
(c) Ice-creams are seasonal products . They are demanded more during summer season. Hence more working capital is required in such firm only during summer months.
(d) A firm following a liberal credit policy has higher investment in debtors and hence requires more working capital.
Question. Clearly state the role of a financial manager in a business.
Answer: Role of finance manager in a business :-
a) The finance manager determines size and composition of fixed assets in the business.
b) The finance manager determines the quantum of current assets as well as its break up into cash inventories.
c) He must also determine the long term and short term financing to be used.
d) The finance manager determines break up of long term finances into debt and equity.
Question. Explain any five factors affecting financing decisions.
Answer: The five major factors affecting financing decisions are :
a) Cost of raising funds through various sources analysed and cheapest source is determined.
b) Risk-funds with least risk associated are selected.
c) Floatation Cost :- Higher floatation costs makes a source less attractive.
d) Cash Flow position of business :- When cast flow position is good debt financing may be more reliable.
e) Level of fixed operating costs : If fixed operating costs like rent insurance premium of a business are high then low debt financing must be resorted to.
f) Control Consideration : Equity leads to dilution of control. Hence firm facing takeover bide generally go for debt financing.
g) State of Capital Markets : If capital markets are in a state of boom raising finds through equity becomes easy.
Question. (a) Which decision determines the amount of profit to be retained in the business ? Explain any two factors affected this decision.
(b) Name the other two important decision taken by a financial manager.
Answer: Dividend decision determines amount of profits to be retained in the business factors affecting dividend decisions are :
(a) Growth opportunities : Companies with growth opportunities retain dividend for expansions and distribute lesser amount as dividend.
(b) Earnings : It earnings are high more dividend can be distributed and vice versa. The other two types of decisions taken by a finance manager are :
(i) Investment decisions and
(ii) Financing decisions.
