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Financial Management
Chapter: 9
PART – B
VERY SHORT TYPE QUESTIONS ANSWERS (1 MARK EACH)
1. How is working capital determined ?
Ans: Working capital = Current ― assets Current liabilities.
2. What are the two types of capital ?
Ans: Debt capital and equity capital.
3. Give the second name for fixed asset management.
Ans: Capital budgeting.
4. Mention two components of ownership funds.
Ans: (i) Equity share capital.
(ii) Retained earnings.
5. Give any two factors affecting working capital requirement of a company.
Ans: (i) Nature of business.
(ii) Sale of operations.
6. A decision is taken to raise money for long-term capital needs of the business from certain sources. What is this decision called ?
Ans: Financing decision
7. Name the concept which increases the return on equity. shares with a change in the capital structure of a company.
Ans: Trading on Equity or Financial Leverage.
8. State why working capital needs for a ‘service industry’ are different from that of a manufacturing industry ?
Ans: Service industries keep very high stock of finished goods and which sell goods on cash basis can manage with less working capital. But trading and manufacturing concerns which are required to keep huge stocks have to arrange for higher amount of working capital.
9. Capital structure refers to what ?
Ans: Capital structure refers to the ratio between owner’s funds and borrowed funds.
10. A decision is taken to distribute a certain portion of the profit after tax among the shareholders. What is this decision called ?
Ans: Dividend decision.
11. Name the financial decision which affects the liquidity as well as profitability of a business.
Ans: Capital budgeting decisions.
12. “Fixed capital decisions involve more risk”. How ?
Ans: Fixed capital decisions involve huge funds and also big risk because the return comes in long run and company has to bear the risk for a long period of time till the returns start coming.
13. Why is working capital needed? Give any one reason.
Ans: Working capital is needed for holding convertible assets like stock of raw materials and finished goods, bills receivable, cash for meeting day-to-day expenditure on salaries, wages etc.
14. Which is the most costly capital for a company ?
Ans: Fixed capital.
15. State one objective of financial management.
Ans: To procure sufficient funds for the business.
16. A decision is taken to raise money for long-term capital needs of the business from certain sources. What is this decision called ?
Ans: Financial decision.
17. Give the second name for fixed assets management.
Ans: Capital budgeting.
18. Mention two components of ownership fund.
Ans: (i) Equity share capital.
(ii) Retained earnings.
SHORT TYPE QUESTIONS ANSWERS TYPE – I (2 MARKS EACH)
19. Briefly explain any three functions of a financial manager.
Ans: The functions of financial manager include the following:
(i) Estimating the Amount of Capital Required: The financial manager makes estimates of funds required for both short-term and long-term.
(ii) Determining Capital Structure: The financial manager determines the proper mix of equity and debt and short-term and long-term debt ratio. This is done to achieve minimum cost of capital maximise shareholders’ wealth.
(iii) Procurement of Funds: The financial manager takes steps to procure the funds required for the business.
C. SHORT TYPE QUESTIONS ANSWERS TYPE 11(3/4 MARKS EACH)
20. Explain the importance of financial planning.
Ans: The importance of financial planning are described below:
(i) Foresighting Financial Requirements: Financial planning forecasts needs for finances in future. Both current and future needs are estimated and then sources are planned to meet them.
(ii) Optimum Utilisation of Funds: The plans for raising funds must be commensurate with requirements. A good plan facilitates maximum utilisation of funds. There should not be either more or less funds as compared to financial needs.
(iii) Cost Effective: Financial planning should be in such a way that cost of using the funds is lower. Equity and loans should be planned in such a way that the use of funds is cost effective.
21. State the three decisions involved in financial management.
Ans: The three decisions involved in financial management are given below:
(i) Investment decisions.
(ii) Financial decisions.
(iii) Dividend decisions.
(i) Investment decisions: The financial manager has to decide about the investment of funds in various business activities. Funds have to be invested in fixed assets such as machines and equipments etc. and also in current assets such as raw materials, stocks of finished goods etc.
(ii) Financial decisions: The finance manager must decide when, where and how to procure funds to meet the requirements of the company. Choice of the sources of funds must be based on the comparison of merits and demerits of the available sources of finance.
(iii) Dividend decisions: Such decisions refer to dividend policy of the company. The financial manager has to decide whether the company. should distribute all its profits or retain them or distribute a portion and retain the balance.
22. How does ‘Trading on Equity’ affect the choice of capital structure of a company ? Explain with the help of a suitable example.
Ans: Trading on equity is an arrangement under which the financial management raises funds by issuing securities which carry a fixed rate of interest (or dividend) which is less than the average earnings of the company. This is done to increase the return on equity shares.
Let us suppose that a company requires an investment of Rs. 10 lakhs to earn Rs. 2.5 lakhs @ 25% p.a. In order to raise this amount, we may consider two proposals, namely (a) to issue 1 lakh equity shares of 10 each and (b) to issue equity shares worth 5 lakhs (i.e. 50,000 shares of 10 each) and 10% debentures worth 5 lakhs. The rate of tax is assumed to be 40%. The earnings per share under proposal ‘B’ will be higher because of application of ‘trading on equity. The earning per share, (EPS) under proposal B are Rs. 2.40 as compared to Rs. 1.50 under proposal A because of the impact of financial leverage.
23. Explain three objectives of financial planning.
Ans: The objectives of financial planning are as follows:
(i) To ensure availability of adequate funds at the right time: This includes a proper estimation of the funds required for different purposes such as for the purchase of long term assets or to meet day to day expenses of business etc.
(ii) To check excess funding: Excess funding is almost as bad as inadequate funding. So the financial manager must see to it that the company does not raise more capital than is required for the business.
(iii) Liquidity: The liquidity of funds should always be kept in mind while preparing a financial plan. During periods of depression it is the liquidity which can keep a concern going.
24. State the objectives of financial management.
Ans: The objectives of financial management are as follows:
(i) To procure sufficient funds for the business: Adequate and regular supply of funds is to be maintained for the smooth operation of the business. The funds must be raised at a reasonable cost.
(ii) To ensure effective utilisation of funds: It is also the objective of financial management to ensure optimum utilisation of funds. To ensure safety of funds: Funds should be invested in business in such a way that safety of funds is ensured. The chances of risk in investments should be the minimum possible.
25. “Sound Financial Management is the key to the prosperity of business.” Explain.
Ans: Sound Financial Management is essential for the success of any business enterprise. It deals with planning, organising, directing and controlling financial activities like procurement and utilisation of funds of an enterprise. It is concerned with maximising the wealth of owners of business through wise and rational investment of funds. The major goal of financial management is to maximise market price of equity shares of the company. So, sound financial management is the key to the prosperity of business.
26. What is meant by “Financial Management” ? State any two financial decisions taken by a Financial Manager.
Ans: Financial management is concerned with assessing need of funds, raising required funds, capital budgeting, distribution to surplus or profits etc. Financial management deals with planning, organising, directing and controlling financial activities like procurement and utilisation of funds of an enterprise.. For
The two financial decisions taken by a financial management are:
(i) Investment decisions: The financial manager has to decide about the investment of funds in various business activities. Funds have to be invested in fixed assets such as machines and equipments etc. and also in current assets such as raw materials, stocks of finished goods etc.
(ii) Financial decisions: The finance manager must decide when, where and how to procure funds to meet the requirements of the company. Choice of the sources of funds must be based on the comparison of merits and demerits of the available sources of finance.
27. Explain three factors affecting the requirements of working capital.
Ans: Three factors affecting the requirements of working capital are given below:
(i) Nature of Business: The business units which do not keep very high stock of finished goods and which sell goods on cash basis can manage with less working capital. But trading and manufacturing concerns which are required to keep huge stocks have to arrange for higher amount of working capital.
(ii) Scale of Operations : Generally, the size of the concern has a direct relation with the working capital requirements. Big enterprises have to keep higher working capital for investment in current assets and for investment in current assets and for paying current liabilities.
(iii) Operating Expenses: Requirement of cash for meeting the operating expenses like salaries, rents, taxes, transport charges, www. etc. and meeting the obligations of the creditors favour a larger amount of working capital.
28. Enumerate three factors affecting the capital structure of a business.
Ans: Three factors affecting the capital structure of a business are given below:
(i) Stability of Sales: Stability of sale 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.
(ii) Trading on Equity: It refers to the additional profits that equity shares earn because of funds raised by issuing other forms of securities. 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.
(iii) 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 etc. are the various factors which affect the cost of financing.
29. Describe briefly the significance of finance function.
Ans: Every enterprise, whether big, medium or small, needs finance to carry on its operations and achieve it targets. Without adequate finance, no enterprise can possible accomplish its objectives. In order to establish an enterprise, there is a need for finance. The main source of funds is the capital raised from shareholders. The finance function of the business is put under the charge of a senior executive known as financial manager. The financial manager is concerned with investment decisions, financing decisions and dividend decisions of the business.
30. Explain four. factors which affect the capital structure of a company.
Ans: Four factors which affect the capital structure of a company are as follows:
(i) Stability of Sales: Stability of sale 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.
(ii) Trading on Equity: It refers to the additional profits that equity shares earn because of funds raised by issuing other forms of securities. 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.
(iii) 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 etc. are the various factors which affect the cost of financing.
(iv) Cost of Debt: A company’s ability to borrow at a lower rate of interest increases its capacity to employ higher debt.
31. Explain any four factors which affect the working capital requirements of a company.
Ans: Four factors which affect the working capital requirements of a company are discussed below :
(i) Nature of Business: The business units which do not keep very high stock of finished goods and which sell goods on cash basis. can manage with less working capital. But trading and manufacturing concerns which are required to keep huge stocks have to arrange for higher amount of working capital.
(ii) Scale of Operations: Generally, the size of the concern has a direct relation with the working capital requirements. Big enterprises have to keep higher working capital for investment in current assets and for investment in current assets and for paying current liabilities.
(iii) Operating Expenses: Requirement of cash for meeting the operating expenses like salaries, rents, taxes, transport charges, etc. and meeting the obligations of the creditors favour a larger amount of working capital.
(iv) Seasonal Nature of Production: Industries which are engaged in producing and selling seasonal goods such as woollen garments require large amount of working capital during off-seasons than those industries which carry on regular production and sales.
32. Explain any four factors affecting the requirements of fixed capital.
Ans: Factors affecting requirements of fixed capital (or Capital Budgeting Decisions) are as follows:
(i) Nature of Business: Industrial units using complex production processes would require more fixed capital than units using simple production processes which are labour capital.
(ii) Scale of operations: A large scale enterprise generally requires more fixed capital than a small scale enterprise. For instance, public utility concerns like railways and electric supply companies require huge investments in fixed assets.
(iii) Type of Techniques: Service and assembly industries require a much smaller amount of fixed capital than what is required in analytical processing or synthetical processing industries.
(iv) Growth Opportunities: Where a company wants to exploit growth opportunities it might decide to diversify into new products and new markets. It would require greater amount of fixed capital.
33. Briefly explain any four factors that affect dividend decision of a company.
Ans: The factors affecting the requirement or dividend decision of a company are given below:
(i) Current Earnings: The most important determinant of dividend decision is the earnings of the company during the year under consideration. Generally, companies distribute higher rates of dividend when the earnings are substantially higher as compared to the previous years.
(ii) Past Earnings: Under the provisions of the Companies Act, a company can also distribute dividend out of its past profits after providing for depreciation. However, all past earnings or retained. profits can’t be distributed as dividend.
(iii) Stock Market Considerations: It the share price of a company is falling at the stock exchange, it may distribute most of its current earnings among the shareholders to check the fall in price. The higher dividend declared by a company has a psychological impact on many shareholders and investors.
(iv) Legal Constraints: All earnings can’t be distributed as dividend. Under the provision of the Companies Act, the company has to provide for depreciation on assets and create statutory reserves. This limits the capacity of the company to declare dividend.
34. Explain the meaning of Financial Planning. Why is it important ? Give any two reasons.
Ans: Financial planning is the process of determining the objectives policies, procedures, programmes, and budgets to deal with the financial activities of an enterprise. It involves preparation of a financial blue print of an organisation’s future operations. Financial planning is important for the following reasons.
(i) Foresighting Financial Requirements: Financial planning forecasts needs for finances in future. Both current and future needs are estimated and then sources are planned to meet them.
(ii) Optimum Utilisation of Funds: The plans for raising funds must be commensurate with requirements. A good plan facilitate maximum utilisation of funds. There should not be either more on less funds as compared to financial needs.
35. Explain the meaning and the objective of Financial Management.
Ans: Financial management is concerned with assessing need of funds raising required funds, capital budgeting, distribution to surplus or profits etc. Financial management deals with planning, organising directing and controlling financial activities like procurement and utilisation of funds of an enterprise.
The objectives of financial management are as follows:
(i) To procure sufficient funds for the business: Adequate and regular supply of funds is to be maintained for the smooth operation of the business. The funds must be raised at a reasonable cost.
(ii) To ensure effective utilisation of funds: It is also the objectives of financial management to ensure optimum utilisation of funds.
(iii) To ensure safety of funds: Funds should be invested in business in such a way that safety of funds is ensured. The chances of risk in investments should be the minimum possible.
36. To avoid the problem of shortage and surplus of funds what is required in financial management ? Name the concept and explain any three points of importance.
Ans: Financial planning is required to avoid the problem of shortages and surplus of funds in an organisation. Sound financial planning is essential for the success of any business enterprise. It will provide policies and procedures to achieve close coordination between the various functional areas of business. This will lead to minimisation of resources.
The importance of financial planning are given below:
(i) Foresighting Financial Requirements: Financial planning forecasts needs for finances in future. Both current and future needs are estimated and then sources are planned to meet them.
(ii) Optimum Utilisation of Funds: The plans for raising funds must be commensurate with requirements. A good plan facilitates maximum utilisation of funds. There should not be either more or less funds as compared to financial needs.
(iii) Cost Effective: Financial planning should be in such a way that cost of using the funds is lower. Equity and loans should be planned in such a way that the use of funds is cost effective.
37. Explain four importance of capital budgeting decision.
Ans: The importance of capital budgeting decision arises because of the following factors:
(i) Long-term effects: Capital budgeting decisions have long-term implications. Since fixed assets account for a sizable proportion of the total assets and their life extends over a good number of years, any investment in fixed assets must be made very carefully.
(ii) Commitment of funds: Capital investment decisions involve blocking up of large amount of funds in fixed assets. Capita! budgeting helps the management in estimating the amount of funds to be invested in long-term assets and the probable schedule of their recovery.
(iii) Risk factor: Investment in fixed assets is a risky proposition as it involves huge funds getting blocked in long term assets. It affects the revenue of the firm in the long-run. Any mistake in capital budgeting decisions might prove to be very costly.
(iv) Irreversible decision: Capital investment decisions involved commitment of large funds for a long-term. Such decisions are no reversible without incurring heavy losses. If a project is abandoned it will lead to huge wastage of funds. That is why, such decision should be taken with great care.
38. Describe in brief any four features of sound capital structure.
Ans: A sound capital structure should possess the following feature:
(i) Maximum return: The financial structure of a company should be guided by clear-cut objective. Its objective can be maximisation of the wealth of the shareholders or maximisation of return to the shareholders.
(ii) Less risky: The capital structure should represent a balance between different types of ownership and debt securities. This essential to reduce risk on the use of debt capital.
(iii) Safety: A sound capital structure should ensure safety on investment. It should be so determined that fluctuations in the earnings of the company do not have heavy strain on its financial structure.
(iv) Economy: The capital structure should ensure the minimum costs of capital which in turn would increase its ability to generate more wealth for the company.
39. “Financing decision of a company is affected by a number of factors.” Explain in brief any four factors.
Ans: The financial decisions of a company are affected by th following factors :
(i) Cost of raising funds: Capital for a company can be raised from different sources and cost of raising funds may differ with the source tapped (e.g. equity shares, debentures, commercial banks etc.)
(ii) Cost of Floatation: Floatation costs of raising funds through equity, debentures and other sources are different. If the costs of floatation alongwith cost of raising funds are lower for a particular source, it is to be selected.
(ii) Risk involved: Different sources of finance may be associated with different kinds of risks. Adequate analysis of each risk must be done before taking any financing decision.
(iv) Cash flow or liquidity position: If a company has enough liquidity, it may opt. for debt financing. Debt could be paid off when funds are not needed.
D. LONG TYPE QUESTIONS ANSWERS TYPE – 1 (5 MARKS EACH)
40. Explain any five factors which affect capital structure of a company.
Ans: The factors which affect the capital structure of a company are given below:
(i) Stability of Sales: Stability of sale 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.
(ii) Trading on Equity: It refers to the additional profits that equity shares earn because of funds raised by issuing other forms of securities. 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.
(iii) 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 etc. are the various factors which affect the cost of financing.
(iv) Cost of Debt: A company’s ability to borrow at a lower rate of interest increases its capacity to employ higher debt.
(v) 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 type of securities except equity shares.
41. Explain in brief, any five factors that should be taken into consideration while determining capital structure of a business enterprise.
Ans: See Answer to Question No. 51.
42. Define working capital and distinguish between fixed capital and working capital.
Ans: In the words of Shubin, “working capital is the amount of funds necessary to cover the cost of operating the enterprises.”
The differences between working capital and fixed capital are listed below:
| Fixed Capital | Working Capital |
| 1. Fixed capital is invested in fixed assets like land and building, plant and machinery, furniture etc. | Working capital is invested in current assets like raw materials debtors, bills receivable etc. |
| 2. It remains sunk/fixed in the business. | It fluctuates from time to time. |
| 3. It is required for meeting the permanent long-term needs of the business. | It is required for meeting the short term needs of the business. |
| 4. It is needed for financing fixed assets, provision of initial working capital and for financing expansion and modernisation. | It is used for meeting the day to day expenditure on wages, materials rent, freight etc. |
| 5. Fixed capital is blocked in fixed assets permanently. | Working capital is realised a re-invested again and again. |
43. “The dividend decision of a company is determined by a number of factors.” Explain this statement.
Ans: The dividend decision of a company is determined by a number of factors. Such factors are discussed below:
(i) Current Earnings: The most important determinant of dividend decision is the earnings of the company during the year under consideration. Generally, companies distribute higher rates of dividend when the earnings are substantially higher as compared to the previous years.
(ii) Past Earnings: Under the provisions of the companies act, a company can also distribute dividend out of its past profits after providing for depreciation. However, all past earnings or retained profits can’t be distributed as dividend.
(iii) Stock Market Considerations: It the share price of a company is falling at the stock exchange, it may distribute most of its current earnings among the shareholders to check the fall in price. The higher dividend declared by a company has a psychological impact on many shareholders and investors.
(iv) Legal Constraints: All earnings can’t be distributed as dividend. Under the provision of the Companies Act, the company has to provide for depreciation on assets and create statutory reserves. This limits the capacity of the company to declare dividend.
(v) Issue of Bonus Shares: Dividend can be distributed in the form of cash and also in the form of bonus shares. Generally, dividends are paid in cash by most of the companies, But companies with huge reserves may also distribute bonus shares to increase their capital base. Issue of bonus share signifies growth of the company. It enhances the reputation of the company in the capital market.
44. Explain any five factors which might influence the amount of working capital needed by a business enterprise.
Ans: The factors, which might influence the amount of working capital needed by a business enterprise are as follows:
(i) Nature of Business: The business units which do not keep very high stock of finished goods and which sell goods on cash basis can manage with less working capital. But trading and manufacturing concerns which are required to keep huge stocks have to arrange for higher amount of working capital.
(ii) Scale of Operations: Generally, the size of the concern has a direct relation with the working capital requirements. Big enterprises have to keep higher working capital for investment in current assets and for investment in current assets and for paying current liabilities.
(iii) Operating Expenses: Requirement of cash for meeting the operating expenses like salaries, rents, taxes, transport charges, etc. and meeting the obligations of the creditors favour a larger amount of working capital.
(iv) Seasonal Nature of Production: Industries which are engaged in producing and selling seasonal goods such woollen garments require large amount of working capital during off-seasons than those industries which carry on regular production and sales.
(v) Turnover of Working Capital: Turnover means the speed with which the working capital is converted into cash by the sale of goods. If the turnover is speedier, the amount of working capital required will be smaller as compared to other concerns.
45. Discuss the role of a Financial Manager in a corporate enterprise.
Ans: Financial Manager is the executive who manages the financial matters of a business.
The role of a financial manager in a corporate enterprise are given below:
(i) Determining Capital Structure: The financial manager determines the proper mix of equity and debt and short-term and long-term debt ratio. This is done to achieve minimum cost of capital and maximise shareholder’s wealth.
(ii) Estimating the Amount of Capital Required: The financial manager makes estimates of funds required for both short-term and long-term.
(iii) Utilisation of Funds: The funds procured by the financial manager are to be prudently invested in various assets so as to maximise the return on investment.
(iv) Procurement of Funds: The financial manager takes steps to procure the funds required for the business.
(v) Disposal of Profits or Surplus: The financial manager has to decide how much to retain for ploughing back and how much to distribute as dividend to shareholders out of the profits of the company.
E. LONG TYPE QUESTIONS ANSWERS TYPE II (6/8 MARKS EACH)
46. 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.
Ans: Financial planning is an integral part of the financial management of a company. It involves the determination of objectives, policies and procedures relating to the finance function. Financial policy and procedures are the broad guides in the procurement, administration and disbursement of funds.
Financial planning involves, both short-term and long-term planning. Financial planning covers plan for a comparatively short period, i.e., upto one year and it is called budgeting. Long-term planning relates to long-term investment plans of a company ranging from three to five years. It focuses on capital expenditure programme of the company.
Financial planning reflects the needs of the business and is integrated with the overall business planning. Proper financial planning is necessary to enable the business enterprise to have right amount of capital to continue its operations efficiently. Financial planning involves taking certain important decisions so that funds are continuously available to the company and are used efficiently.
The important benefits of financial planning to a business are discussed below:
(i) Financial planning ensures required funds from various sources for the smooth conduct of business.
(ii) Uncertainty about the availability of funds is reduced. It ensures stability of business operations.
(iii) Financial planning attempts to achieve a balance between the inflow and outflow of funds. Adequate liquidity is ensured throughout the year. This will increase the reputation of the company.
47. A company wants to design its capital structure. What factors should be considered by it ?
Ans: Same as Q.No 51.
48. Explain the meaning of fixed capital. Briefly explain any four functions that determine the fixed capital of a company.
Ans: “Fixed capital denotes the portion of capital that is invested in fixed assets such as land and buildings, plant and machinery, tools, furniture, etc.” The importance of fixed investment decisions arises because of the following factors:
(i) Long-term Effects: Capital budgeting decisions have long-term implications. Since fixed assets account for a sizable proportion of the total assets and their life extends over a good number of years, any investment in fixed assets must be made very carefully.
(ii) Commitment of Funds: Capital investment decisions involve blocking up of large amount of funds in fixed assets. Capital budgeting helps the management in estimating the amount of funds to be invested in long-term assets and the probable schedule of their recovery.
(iii) Risk Factor: Investment in fixed assets is a risky proposition as it involves huge funds getting blocked in long-term assets. It affects the revenues of the firm in the long-run. Any mistake in capital budgeting decisions might prove to be very costly.
(iv) Irreversible Decision: Capital investment decisions commitment of large funds for a long-term. Such decisions are reversible without incurring heavy losses. If a project is abandoned, it will lead to huge wastage of funds. That is why, such decisions should be taken with great care.
19. What is meant by capital structure? What are the factors to be kept in mind while determining the capital structure of a company ?
Ans: Capital structure implies the composition of different types of capital such as ownership and borrowed capital. It refers to the ratio between owner’s funds and borrowed funds.
Thus capital structure denotes:
(i) the types of securities issued (equity shares, preference shares and debentures).
(ii) the relative proportion of each type of security.
2nd Part: See Answer to Question No. 51.
50. You are the financial manager of a company. The Board of Directors have asked you to determine the working capital requirements of the company. State the factors that you would take into consideration while determining the requirements of working capital of the company.
Ans: See Answer to Question No. 35.
51. “Determination of capital structure of a company is influenced by a number of factors.” Explain any six such factors.
Ans: Determination of capital structure of a company is influenced by a number of factors.
Such factors are given below:
The factors which affect the capital structure of a company are given below:
(i) Stability of Sales: Stability of sale 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.
(ii) Trading on Equity: It refers to the additional profits that equity shares earn because of funds raised by issuing other forms of securities. 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.
(iii) 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 etc. are the various factors which affect the cost of financing.
(iv) Cost of Debt: A company’s ability to borrow at a lower rate of interest increases its capacity to employ higher debt.
(v) 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 type of securities except equity shares.
(vi) Capital Market Conditions: The conditions prevailing in the capital market influence the determination of the securities to be issued. Therefore, debentures and preference shares which carry a fixed rate of return may be marketed more easily during the periods of low activity.
52. What is working capital ? Explain any four factors affecting do the working capital requirements.
Ans: Working capital is relatively liquid (which can be converted into cash) portion of the total capital of the business. It is required for investment in current assets like cash, stock of materials and finished goods, debtors etc. Working capital is that portion of capital which is required for holding current assets like stock of materials and finished goods, taxes, rent etc.
Four factors which affect the working capital requirements a company are discussed below:
(i) Nature of Business: The business units which do not keep very high stock of finished goods and which sell goods on cash basis can manage with less working capital. But trading and manufacturing concerns which are required to keep huge stocks have to arrange for higher amount of working capital.
(ii) Scale of Operations: Generally, the size of the concern has a direct relation with the working capital requirements. Big enterprises have to keep higher working capital for investment in current assets and for investment in current assets and for paying current liabilities.
(ii) Operating Expenses: Requirement of cash for meeting the operating expenses like salaries, rents, taxes, transport charges, etc. and meeting the obligations of the creditors favour a larger amount of working capital.
(iv) Seasonal Nature of Production: Industries which are engaged in producing and selling seasonal goods such as woollen garments require large amount of working capital during off-seasons than those industries which carry on regular production and sales.
53. What is fixed capital? Explain any four factors affecting the fixed capital requirements.
Ans: Fixed capital denotes the portion of capital that is invested in fixed assets such as land and building, plant and machinery, tools, furniture etc. It is required for acquisition of fixed assets that are to be used repeatedly over a long period of time. Fixed capital is also used for, meeting the permanent needs of the company.
Factors affecting requirements of fixed capital (or Capital Budgeting Decisions) are as follows:
(i) Nature of Business: Industrial units using complex production processes would require more fixed capital than units using simple production processes which are labour capital.
(ii) Scale of operations: A large scale enterprise generally requires more fixed capital than a small scale enterprise. For instance, public utility concerns like railways and electric supply companies require huge investments in fixed assets.
(iii) Type of Techniques: Service and assembly industries require a much smaller amount of fixed capital than what is required in analytical processing or synthetical processing industries.
(iv) Growth Opportunities: Where a company wants to exploit growth opportunities it might decide to diversify into new products and new markets. It would require greater amount of fixed capital.
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