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NIOS Class 12 Business Studies Chapter 17 Financial Management
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Financial Management
Chapter: 17
Module – 6 : BUSINESS FINANCE
INTEXT QUESTIONS 17.1
Q. 1. A company plans to buy a latest machine which operates on new technology in order to replace an old and outdated machine. Identify the type of decision involved:
(a) Investment decision.
(b) Financial decision.
(c) Dividend decision.
(d) All of the above.
Ans: (a) Investment decision.
Q. 2. A company decided to distribute a portion of the profits earned in the previous years among its shareholders. Identity the type of decision involved:
(a) Financial decision.
(b) Investment decision.
(c) Dividend decision.
(d) All of the above.
Ans: (c) Dividend decision.
Q. 3. A company assured the funds required to execute an expansion programme. Identify the decision made by the company:
(a) Financial decision.
(b) Investment decision.
(c) Dividend decision.
(d) None of the above.
Ans: (a) Financial decision.
INTEXT QUESTIONS 17.2
Q. 1. Define ‘Financial Planning’ in your own words.
Ans: The process of estimating the financial requirement, determining the pattern of financing and formulating financial policies and procedures is termed as Financial planning’.
Q. 2. Which of the following are not the essential characteristics of financial planning?
(a) Simplicity.
(b) Liquidity.
(c) Abundant availability of funds.
(d) Flexibility.
(e) Concentration on long term needs only.
(f) Economy.
Ans: (c) Abundant availability of funds. and
(e) Concentration on long term needs only.
Q. 3. State whether the following are objectives of financial planning, by writing ‘Yes’or ‘No’:
(a) Determining the requirement of fixed and working capital. ()
Ans: Yes.
(b) Determining the sales output. ()
Ans: No.
(c) To ensure the timely availability of funds. ()
Ans: Yes.
(d) To determine the quantity of production. ()
Ans: No.
(e) To raise funds at the lowest possible cost. ()
Ans: Yes.
INTEXT QUESTIONS 17.3
Q. 1. Mention any two factors that determine Fixed Capital requirement.
Ans: Following are the Factors that determine Fixed Capital requirement:
(i) Nature of business.
(ii) Size of business.
(iii) Process of production.
(iv) Type of products.
Q. 2. State whether we require ‘more’ or ‘less’ working capital in the following cases:
(a) A company manufacturing Iron & steel.
Ans: More.
(b) A bread manufacturing company having high inventory turnover.
Ans: Less.
(c) A large size business enterprise making toys.
Ans: More.
(d) A company manufacturing furnitures against orders only.
Ans: Less.
(e) A company manufacturing of coolers/refrigerators.
Ans: More.
Q. 3. Match the items in column A with column B.
| Column A | Column B |
| (a) Fixed capital | (i) Short term finance |
| (b) Public utilities | (ii) Working capital requirement |
| (c) Permanent working capital | (iii) Long-term finance |
| (d) Goodwill | (iv) Telephone company |
| (e) Fluctuating working capital | (v) Intangible fixed asset |
| (f) Length of production cycle | (vi) Fixed working capital |
Ans:
| Column A | Column B |
| (a) Fixed capital | (iii) Long-term finance |
| (b) Public utilities | (iv) Telephone company |
| (c) Permanent working capital | (vi) Fixed working capital |
| (d) Goodwill | (v) Intangible fixed asset |
| (e) Fluctuating working capital | (i) Short term finance |
| (f) Length of production cycle | (ii) Working capital requirement |
INTEXT QUESTIONS 17.4
Q. 1. Why do you need flexibility in capital structure?
Ans: The planned capital structure should be flexible enough to raise additional funds without much difficulty. The company should be able to raise additional capital in the form of debt or equity whenever required. But if the company’s capital structure has too much debt, then the lenders may not be able to give more loan to the company. In a such a situation it may be forced to raise the funds only through shares for which the capital market condition may not be conducive. Similarly, when on account of declining business and lack of other investment opportunities the funds need to be refunded, it may not be possible to do so if the company has heavily relied on equity shares which cannot be redeemed easily. Hence, to ensure an element of flexibility, it is better if the firm relies more on redeemable securities that can be paid off if necessary and, at the same time, have some unused debt raising capacity so that future financial needs can be fully taken care of without much difficulty.
Q. 2. Which of the following are characteristics of an appropriate capital structure? Indicate, by writing YES or NO in the space provided. Rewrite the statements where your answers is NO.
(a) It involves a judicious mix of different types of securities.
Ans: Yes.
(b) It involves dilution of control of existing shareholders.
Ans: No- It involves minimum risk of dilution in control by existing shareholders.
(c) It caters to exclusively to the wealthy investors.
Ans: No-It caters to all types of investors.
(d) It ensures minimum return on equity.
Ans: No – It ensures maximum return on equity.
(e) It keeps in view the legal constraints.
Ans: Yes.
(f) It has rigidity and firmness and does not change with changed conditions.
Ans: No – It has the necessary flexibility to make required reduction or addition to funds, according to changed conditions.
INTEXT QUESTIONS 17.5
Q. 1. Give the full form of the following abbreviations:
(a) PAT
Ans: Profit After Tax.
(b) PBT
Ans: Profits Before Tax.
(c) PBIT
Ans: Profit Before Interest and Tax.
Q. 2. List any five factors affecting the dividend decision of a company.
Ans: (a) Financial needs of the company.
(b) Liquidity.
(c) Access to capital market.
(d) Tax policy.
(e) Legal constraints.
Q. 3. State the meaning of the following terms in the space provided:
(a) Dividend.
Ans: Amount of profit distributed to shareholders.
(b) Retained Earnings.
Ans: The part of profit retained in the company to meet the company’s future financial needs.
(c) Preference Dividend.
Ans: Dividend paid to preference shareholders.
(d) Equity Dividend.
Ans: Dividend paid to equity shareholders.
TERMINAL EXERCISE
Very Short Answer Type Questions:
Q. 1. Define the term ‘Dividend’.
Ans: Dividend refers to the amount of profits distributed by a company to its shareholders. The amount of profit to be distributed as dividend and the amount of profit to be retained by the company for meeting its future financial requirement is determined by factors like future financial needs of the company. liquidity requirement, company’s access to capital market, expectations of the shareholders, tax policy. investment opportunity and growth prospects and legal constraints, if any.
Q. 2. What is meant by ‘Optimal Capital Structure’?
Ans: The most judicious capital structure is one that minimises the cost of funds and maximises the shareholders wealth. In financial management terminology, such a capital structure is called optimal capital structure.
Q. 3. State the meaning of Financial Management.
Ans: Adequate and proper financing is quite important for success in any business. While the overall managerial activity of handling finance is called ‘Financial management”.
Q. 4. What is meant by Financial Planning?
Ans: The process of estimating the financial requirement, determining the pattern of financing and formulating financial policies and procedures is termed as ‘Financial planning’.
Short Answer Type Questions:
Q. 5. State any four objectives of financial planning.
Ans: The main objectives of financial planning are:
(a) To ascertain the amount of fixed capital as well as the working capital required in a given period.
(b) To determine the amount to be raised through various sources using a judicious debt-equity mix.
(c) To ensure that the required amount is raised on time at the lowest possible cost.
(d) To ensure adequate liquidity so that there are no defaults in payments and all contingencies (any unforseen expenditure) are met without difficulty.
(e) To ensure optimal use of funds so that the business is neither starved of funds nor has unnecessary surplus funds at any point of time.
Q. 6. Explain any two factors that are taken into consideration while determining the fixed capital requirement of a company.
Ans: In order to assess the fixed capital requirement for any business enterprise, one must be fully conversant with the factors that influence such requirement.
These factors are summarised as follows:
(a) Nature of business: The amount of fixed capital requirement is determined primarily by the nature of business the firm is engaged in. Such requirement, for example, is very large in case of industrial establishments, shipping companies, public utilities, etc. which involve heavy investment in plant and machinery The trading concerns (wholesalers and retailers) do not require much investment in the fixed assets.
(b) Type of products: It is not only the nature of business which determines the requirement of fixed capital but also the type of product involved. A firm manufacturing simple products like soap, toothpaste, stationery, etc. requires small amount of fixed capital as against the firms producing items like steel, cement, automobiles, etc.
Q. 7. Do you advocate distribution of whole amount of profits earned by a company as dividends? Support your view with reasons.
Ans: No, we do not advocate distribution of whole amount of profits earned by a company as dividends. We would advocate that substantial part of profit should be retained for meeting compnay’s future financial needs. Further payment of dividend requires cash to be distributed.
Q. 8. Describe any two determinants of capital structure.
Ans: Following are the factors that should be kept in view while deciding on the choice of an appropriate capital structure.
1. Expected earnings and their stability: If the expected earnings, in terms of rate of return on the amount to be invested are sufficiently large, use of debt is considered quite desirable. Not only that, the stability of earnings should also be taken into account because if the firm is engaged is business activities in which sales and profits are subject to wide fluctuations, it will be risky to use higher proportion of debt. In other words, if there is an element of uncertainty about the expected earnings it is considered better to rely more on equity share capital. However, with assured prospects of rising earnings, there should be greater reliance on debt so as to take advantage of leverage effect.
2. Cost of debt: If the rate of interest on borrowings is lower than the expected rate of return on capital employed, then debt may be preferred. With lower cost of debt financing, the overall cost of financing is reduced and the return on equity capital will be higher, as explained earlier.
Q. 9. What is meant by “Trading on Equity’?
Ans: Owners get higher return when a part of Capital required is funded by borrowings. This is called ‘Trading on Equity or Leverage Effect’. But, there is also an element of risk in using borrowed funds because when the profits decline, interest being a fixed charge, the return on owners’ funds is likely to decline. This implies that dependence on borrowings should be kept within reasonable limits. Therefore, most companies generally plan to raise the required amount of long-term funds by using a judicious mix of ownership capital (called equity) and borrowed capital (called debt). The mix of equity and debt actually used by a company for meeting its requirement of capital is known as its capital structure. Thus, the term capital structure refers to the make up of a firm’s capital in terms of the planned mix of different kinds of long-term funds like equity shares, preference shares, debentures and long term funds.
Q. 10. Briefly describe the objectives of Financial Management.
Ans: The main objective of financial management is to maximize the wealth of shareholders.
The other important objectives of financial management are:
1. To provide maximum returns to the owners on their investment.
2. To ensure continuous availability of sufficient funds at reasonable cost.
3. To ensure effective utilisation of funds.
4. To ensure safety of funds.
Q. 11. What do you mean by Investment Decision?
Ans: Investment decision involves careful selection of assets in which funds have to be invested. Decision relating to investment in fixed assets (capital budgeting) and decision relating to investment in current asset (working capital) are considered here. Investment decisions are influenced by cash flow, risk involved, technological changes etc.
Long Answer Type Questions:
Q. 12. What is meant by ‘Financial Planning’? Explain any four requisites of a sound financial plan.
Ans: The process of estimating the financial requirement, determining the pattern of financing and formulating financial policies and procedures is termed as ‘Financial planning’.
Following are the requisites of a sound financial plan:
(a) The plan must be simple: Now-a-days you have a large variety of securities that can be issued to raise capital from the market. But it is considered better to confine to equity shares and simple fixed interest debentures.
(b) It must take a long term view: While estimating the capital needs of a firm and raising the required funds, a long-term view is necessary. It ensures that the plan fully provides for meeting the capital requirement on long term basis and takes care of the changes in capital requirement from year to year.
(c) It must be flexible: While the financial plan is based on long term view, one may not be able to properly visualise the possible developments in future. Not only that, the firm may also change its plans of expansion for various reasons. Hence, it is very necessary that the financial plan is capable of being adjusted and revised without any difficulty and delay so as to meet the requirements of the changed circumstances.
(d) It must ensure optimal use of funds: The plan should provide for raising reasonable amount of funds. As stated earlier, the business should neither be starved of funds nor have surplus funds. It must be strictly need based and every rupee raised should be effectively utilised. There should be no idle funds.
Q. 13. How does raising of long term funds through debt affect the return on shareholders funds? Explain with an example.
Ans: Borrowed capital, on the other hand, refers to the amount of funds raised through long term loans and debentures on which its contributors are entitled to a fixed rate of interest which has to be paid at regular intervals (half-yearly or yearly) irrespective of the profits earned. There is also a commitment that the principal amount shall be repaid on maturity. However, it is still considered advantageous to finance business activities through borrowed capital because if the rate of earnings from the planned business investment is expected to be better than the rate of interest on the borrowed funds, it shall ensure higher returns on owners’ funds.
Suppose the total investment in a business is Rs 50 lakh, to which owners contribute Rs 20 lakh and the remaining amount of Rs 30 lakh is funded through loans at 10% interest per annum. Assuming expected annual earnings before interest and tax are Rs 10 lakh (20% on total investment) the profit after payment of interest but before tax will be Rs 7 lakh (Rs 10 lakh-Rs3 lakh). Let us assume that the tax is payable on profits at the rate of 40%, the profit after tax will be Rs 4.20 lakh (Rs 7 lakh-Rs 2.80 lakh tax) and the return on owner’s funds will be 21%. Now, suppose the whole amount of required investment of Rs 50 lakh is contributed by the owners and no loan is taken. Since no interest is payable, the amount of tax will be Rs 4 lakh (40% on Rs 10 lakh) and the profit after tax Rs 6 lakh (Rs 10 lakh-Rs 4 lakh tax). This shall result in 12% return on owner’s funds.
Q. 14. What is meant by ‘dividend’? State the factors that affect dividend decision.
Ans: Dividend refers to the amount of profits distributed by a company to its shareholders. The amount of profit to be distributed as dividend and the amount of profit to be retained by the company for meeting its future financial requirement is determined by factors like future financial needs of the company, liquidity requirement, company’s access to capital market, expectations of the shareholders, tax policy, investment opportunity and growth prospects and legal constraints, if any.
Factors Affecting Dividend Decisions: The dividend to preference shareholders is paid at fixed rate and paid on priority basis i.c., before making payment to equity shareholders. The dividend to be paid to equity shareholders is the real issue involved in dividend decision by the management of any company.
Such a decision is guided by the following factors:
1. Financial needs of the company: While deciding the amount of dividend to be paid, the management must take into account the financial needs for normal growth of its business, the expansion activities, the repayment of long term debt, etc. Even otherwise, the company must retain a part of profits for long term solvency and meeting future contingencies.
2. Liquidity requirement: The payment of dividend involves out flow of cash. At times, a company may have high profits but not much cash. In such a situation, it may not declare high rate of dividend. Even otherwise, liquidity requirement for ensuring timely payment of all dues and debts has to be kept in view while determining the rate of dividend. Such a consideration is of greater importance in case of a growing concern whose liquidity needs may be large on account of its expansion activities and growing working capital requirement, and therefore, they would prefer low payout.
3. Access to capital market: A company which, by virtue of its record of profitability and timely repayment of debt, has better access to capital market i.e., it can successfully raise funds by issuing shares. and debentures through the capital market, may pay higher dividends. But, if a company does not have easy access to capital markets because of its weak financial position or low profitability record, it can not afford to pay high dividends. However, when capital market condition is unfavourable most companies shall adopt a conservative dividend policy.
4. Expectations of shareholders: The equity shareholders normally look forward to appreciation to their capital rather than higher rate of dividend. But, some shareholders like retired persons or employees do look forward to dividend as a source of their regular income. So, the companies cannot ignore such segment and pay low dividend or skip it even when there are high profits. A reasonable payout is always welcome. In fact, the companies which skip payment of dividend or pay too low rate of dividend as a matter of practice, are rated low in the capital market as the shareholders suspect their management’s intentions.
5. Tax policy: In our country, dividends have been taxable in the hands of shareholders. Hence, the companies prefer to pay low amount of dividend and issue bonus shares to the shareholders from time to time as these are not taxable until these are sold. If these are sold after 12 months, the sale proceeds are regarded as long term capital gain and taxed at a lower rate. However, of late, the government has changed its policy of taxation of dividends. The dividends are not taxable in the hands of shareholders. But the company has to pay some additional tax (12.5%) on the distributed part of its profits. So, the companies have now become liberal in the matter of dividend distribution.
6. Investment opportunities and growth prospects: When a company has adequate profitable investment opportunities and growth prospects, it may prefer to retain more profits and pay low rate of dividends so as to serve the shareholders in a better way in long run. Of course, in the absence of such possibilities, companies prefer payment of higher dividend and avoid idle cash with them.
7. Legal constraints: Sometimes, the government prescribes certain limits on the dividend payout which has to be kept in view while deciding on the rate of dividend to be paid. Similarly, at times the long term fund providers may put some restrictions on the dividend payout as part of their agreement. The companies have to adhere to such limits. In any case, the Company Law has provided certain rules to be followed while deciding on the amount to be distributed as dividend. For example, capital profits are not to be used for distribution of dividend normally; a banking company has to transfer certain percentage of profit to a statutory reserve which is not available for payment of dividend, and so on. These have to be duly abided while determining the amount to be distributed as dividend.
