NCERT Class 12 Business Studies Chapter 9 Financial Management

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NCERT Class 12 Business Studies Chapter 9 Financial Management

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Financial Management

Chapter: 9

PART – ⅠⅠ – BUSINESS FINANCE AND MARKETING

EXERCISE

VERY SHORT ANSWER TYPE

1. What is meant by capital structure?

Ans: Capital structure refers to the mix between owners and borrowed funds. These shall be referred to as equity and debt in the subsequent text. 

2. State the two objectives of financial planning. 

Ans: Financial planning strives to achieve the following twin objectives. 

(a) To ensure availability of funds whenever required: 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.

(b) To see that the firm does not raise resources unnecessarily: Excess funding is almost as bad as inadequate funding. Even if there is some surplus money, good financial planning would put it to the best possible use so that the financial resources are not left idle and don’t unnecessarily add to the cost.

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

Ans: The concept is called Financial Leverage (or Trading on Equity).

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: Amrit’s transport service will likely have a lesser working capital requirement. This is because it’s a service-oriented business with minimal inventory needs.

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: Yes, Ramnath’s new policy will significantly affect his working capital requirement, specifically reducing it. His working capital requirement is reduced to the extent of credit availed by him.

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

Ans: Financial risk is the possibility that a company may not be able to meet its fixed financial obligations, such as interest payments and debt repayments, leading to potential financial distress or insolvency. It arises due to the use of debt (leverage) in the capital structure.

2. Define current assets? Give four examples of such assets. 

Ans: Current assets are those assets which, in the normal routine of the business, get converted into cash or cash equivalents within one year, e.g., inventories, debtors, bills receivables, Prepaid Expenses etc.

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

Ans: The primary aim of financial management is to maximise shareholders’ wealth, which is referred to as the wealth-maximisation concept. The objective of financial management is to maximise the current price of equity shares of the company or to maximise the wealth of owners of the company, that is, the shareholders.

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

Ans: The finance function, therefore, is concerned with three broad decisions which are explained below: 

(i) Investment Decision: A firm’s resources are scarce in comparison to the uses to which they can be put. A firm, therefore, has to choose where to invest these resources, so that they are able to earn the highest possible return for their investors. The investment decision, therefore, 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. Short-term sources are studied under the ‘working capital management’.

(iii) Dividend Decision: The third important decision that every financial manager has to take relates to the distribution of dividend. Dividend is that portion of profit which is distributed to shareholders. 

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 Rs. 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 Rs. 8,00,000 and total capital investment was Rs. 1,00,00,000. Suggest whether issue of debenture would be considered a rational decision by the company. Give reason to justify your answer. (Ans. No, Cost of Debt (10%) is more than ROI which is 8%).

Ans: Calculation of ROI (Return on investment)

ROI = (EBIT/Total capital Investment) × 100

= 8,00,000 / 1,00,00,000 × 100

= 8%

No, issuing debentures is not a rational decision as the cost of debt (10%) is higher than the ROI (8%), leading to financial burden.

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

Ans: Working capital plays a crucial role in maintaining both liquidity and profitability in a business. Current assets are more liquid compared to fixed assets, but they generally contribute less to profitability.

Examples of current assets, in order of their liquidity, are as under:

(i) Cash in hand/Cash at Bank.

(ii) Marketable securities.

(iii) Bills receivable.

(iv) Debtors.

(v) Finished goods inventory.

(vi) Work in progress.

(vii) Raw materials.

(viii) Prepaid expenses.

These assets, as noted earlier, are expected to get converted into cash or cash equivalents within a period of one year. These provide liquidity to the business. An asset is more liquid if it can be converted into cash quicker and without reduction in value. Insufficient investment in current assets may make it more difficult for an organisation to meet its payment obligations. However, these assets provide little or low return. Hence, a balance needs to be struck between liquidity and profitability.

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 concepts so identified. (Financial Planning).

Ans: The objective of financial planning is to ensure that enough funds are available at right time. If adequate funds are not available the firm will not be able to honour its commitments and carry out its plans. On the other hand, if excess funds are available, it will unnecessarily add to the cost and may encourage wasteful expenditure. Financial planning on the other hand aims at smooth operations by focusing on fund requirements and their availability in the light of financial decisions.

Financial planning strives to achieve the following twin objectives:

(i) To ensure availability of funds whenever required: This include 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. Apart from this, there is a need to estimate the time at which these funds are to be made available. 

(ii) To see that the firm does not raise resources unnecessarily: Excess funding is almost as bad as inadequate funding. Even if there is some surplus money, good financial planning would put it to the best possible use so that the financial resources are not left idle and don’t unnecessarily add to the cost. 

Thus, a proper matching of funds requirements and their availability is sought to be achieved by financial planning. 

(b) ‘There is no restriction on payment of dividend by a company’. Comment. (Legal & Contractual Constraints).

Ans: The statement “there is no restriction on the payment of dividends by a company” is not entirely true, as there are legal and other restrictions on dividend payments. Legally, dividends must come from profits and cannot jeopardize solvency, while contractually, loan agreements and preferred stock terms may impose further limitations. 

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

Ans: Working capital is a crucial financial metric that represents the difference between a company’s current assets and its current liabilities. Some part of current assets is usually financed through short-term sources, i.e., current liabilities. The rest is financed through long-term sources and is called net working capital.

Factors affecting the working capital requirements / important determinants of 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 smaller amount of working capital compared to a manufacturing organisation. This is because there is usually no processing. 

(ii) Scale of Operations: For organisations which operate on a higher scale of operation, the quantum of inventory and debtors required is generally high. Such organisations, therefore, require large amount of working capital as compared to the organisations which operate on a lower scale. 

(iii) Business Cycle: Different phases of business cycles affect the requirement of working capital by a firm. In case of a boom, the sales as well as production are likely to be larger and, therefore, larger amount of working capital is required. 

(iv) Seasonal Factors: Most business have some seasonality in their operations. In peak season, because of higher level of activity, larger amount of working capital is required. As against this, the level of activity as well as the requirement for working capital will be lower during the lean season.

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

Ans: Capital structure of a company, thus, affects both the profitability and the financial risk. A capital structure 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. In other words, all decisions relating to capital structure should emphasise on increasing the shareholders’ wealth. Capital structure of a firm involves determining the relative proportion of various types of funds. This depends on various factors. A useful guideline in capital structure planning is to analyze the debt-equity ratios of other companies in the same industry. 

(i) Equity is a safer source of funding; however, it does not offer the tax advantage of interest deductibility, as dividends are distributed from after-tax profits.

(ii) In contrast, debentures carry a fixed interest rate, and the interest payments are tax-deductible, reducing taxable income. This, in turn, enhances the return for equity shareholders.

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

Ans: A firm’s resources are scarce in comparison to the uses to which they can be put. A firm, therefore, has to choose where to invest these resources, so that they are able to earn the highest possible return for their investors. The investment decision, therefore, relates to how the firm’s funds are invested in different assets. 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. The size of assets, profitability and competitiveness are all affected by 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 often almost impossible for a business to wriggle out of such decisions.

A bad capital budgeting decision normally has the capacity to severely damage the financial fortune of a business. Short-term investment decisions (also called working capital decisions) are concerned with the decisions about the levels of cash, inventory and receivables. These decisions affect the day-to-day working of a business. These affect the liquidity as well as profitability of a business. Efficient cash management, inventory management and receivables management are essential ingredients of sound working capital management.

4. Explain the factors affecting dividend decision? 

Ans: Some of the important factors affecting dividend decision are discussed as follows: 

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

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

(c) Stability of Dividends: Companies generally follow a policy of stabilising dividend per share. The increase in dividends is generally made when there is confidence that  their earning potential has gone up and not just the earnings of the current year. In other words, dividend per share is not altered if the change in earnings is small or seen to be temporary in nature. 

(d) 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 the non-growth companies. 

(e) Cash Flow Position: The payment of dividend involves an outflow of cash. A company may be earning profit but may be short on cash. Availability of enough cash in the company is necessary for declaration of dividend. 

(f) Shareholders’ Preference: While declaring dividends, managements must keep in mind the preferences of the shareholders in this regard. If the shareholders in general desire that at least a certain amount is paid as dividend, the companies are likely to declare the same. There are always some shareholders who depend upon a regular income from their investments. 

(g) Taxation Policy: The choice between the payment of dividend and retaining the earnings is, to some extent, affected by the difference in the tax treatment of dividends and capital gains.

(h) Stock Market Reaction: Investors, in general, view an increase in dividend as a good news and stock prices react positively to it. Similarly, a decrease in dividend may have a negative impact on the share prices in the stock market. Thus, the possible impact of dividend policy on the equity share price is one of the important factors considered by the management while taking a decision about it. 

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

(j) Legal Constraints: Certain provisions of the Companies Act place restrictions on payouts as dividend. Such provisions must be adhered to while declaring the dividend. 

(k) Contractual Constraints: While granting loans to a company, sometimes the lender may impose certain restrictions on the payment of dividends in future. 

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

Ans: Trading on Equity refers to the increase in profit earned by the equity shareholders due to the presence of fixed financial charges like interest.

When it use:

(i) When the company’s return on investment is higher than the interest rate on the debt.

(ii) When the company is already making high profits.

(iii) Market conditions are favorable, and borrowing is available at reasonable interest rates.

Effect of RoI on Trading on Equity:

(i) If RoI is higher than the cost of debt, trading on equity is beneficial as it increases EPS.

(ii) If RoI is lower than the cost of debt, using more debt reduces EPS, making trading on equity unprofitable.

Trading on equity is used by companies to leverage borrowed funds to potentially increase their return on equity, allowing them to generate higher profits by investing in growth opportunities while maintaining control over ownership. The company uses this strategy to ensure that control over the company remains the same. A company might also use the trading on equity strategy to increase the company’s market share price.

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 per cent 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 Rs. 5000 crores to set up and about Rs. 500 crores of working capital to start the new plant.

(a) Describe the role and objectives of financial management for this company. 

Ans: Financial Management is concerned with optimal procurement as well as the usage of finance. For optimal procurement, different available sources of finance are identified and compared in terms of their costs and associated risks. The role of financial management cannot be over emphasised, since it has a direct bearing on the financial health of a business. The financial statements, such as Balance Sheet and Profit and Loss Account, reflect a firm’s financial position and its financial health. Almost all items in the financial statements of a business are affected directly or indirectly through some financial management decisions. When an investment decision is made, the objective of financial management is to ensure that the benefits exceed the costs, leading to value addition. Similarly, when finance is procured, the aim is to reduce the cost so that the value addition is even higher. 

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

Ans: Financial Management aims at reducing the cost of funds procured, keeping the risk under control and achieving effective deployment of such funds. It also aims at ensuring availability of enough funds whenever required as well as avoiding idle finance. Needless to emphasise, the future of a business depends a great deal on the quality of its financial management. Financial management, among others, involves decision about the proportion of long-term and short-term funds. An organisation wanting to have more liquid assets would raise relatively more amount on a long-term basis. There is a choice between liquidity and profitability. 

Imaginary Plan:

(i) Equity Financing: Rs. 2500 crores.

(ii) Debt Financing: Rs. 2500 crores.

(iii) Working Capital: Rs. 500 crores.

(iv) Projected Revenue: Expected growth of 15% annually based on rising steel demand.

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

Ans: On the basis of ownership, the sources of business finance can be broadly classified into two categories viz., ‘owners’ funds’ and ‘borrowed funds’. Owners’ funds consist of equity share capital, preference share capital and reserves and surpluses or retained earnings. Borrowed funds can be in the form of loans, debentures, public deposits etc. These may be borrowed from banks, other financial institutions, debentureholders and the public. A capital structure 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. In other words, all decisions relating to capital structure should emphasise on increasing the shareholders’ wealth.

(i) Cost of Debt and Equity: The company should balance between cheaper debt and riskier equity.

(ii) Business Risk: Higher business risk means lower debt capacity.

(iii) Cash Flow Position: Stable cash flows allow more debt financing.

(iv) Market Conditions: Favorable conditions allow easier equity issuance.

(v) Growth Opportunities: Expansion plans impact the capital mix.

(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 Ltd will be high due to following reasons:

(i) Large-scale, capital-intensive operations: This demands significant investment in fixed assets.

(ii) Production base and technology: Building and upgrading these require heavy capital expenditure.

(iii) High raw material costs: The steel industry’s reliance on costly inputs like iron ore and coal necessitates a large working capital reserve.

Parimal

Hi! my Name is Parimal Roy. I have completed my Bachelor’s degree in Philosophy (B.A.) from Silapathar General College. Currently, I am working as an HR Manager at Dev Library. It is a website that provides study materials for students from Class 3 to 12, including SCERT and NCERT notes. It also offers resources for BA, B.Com, B.Sc, and Computer Science, along with postgraduate notes. Besides study materials, the website has novels, eBooks, health and finance articles, biographies, quotes, and more.