Ch 9 Financial management

1.What is meant by capital structure?

Ans: Capital structure refers to the mix between owners and borrowed funds. It represents the
proportion of equity and debt.

2. Discuss the two objectives of Financial Planning.

Ans: Financial Planning strives to achieve the following two objectives
(i) To Ensure Availability of Funds whenever These are 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.
(ii) To See That the Firm Does Not Raise Resources Unnecessarily
Excess funding is almost as bad as inadequate funding. Efficient financial planning ensures that
funds are not raised unnecessarily in order to avoid unnecessary addition of cost.

3. What is ‘financial risk? Why does it arise?

Ans: It refers to the risk of company not being able to cover its fixed
financial costs. The higher level of risks are attached to higher degrees of
financial leverage with the increase in fixed financial costs, the company its
also required to raise its operating profit (EBIT) to meet financial charges. If
the company can not cover these financial charges, it can be forced into liquidation.

4. Define a ‘current assets’ and give four examples.

Ans: Current assets are those assets of the business which can be converted into cash within a
period of one year. Cash in hand or at bank,
bills receivables, debtors, finished goods inventory are some of the examples of current assets.

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

Ans: Primary aim of financial management is to maximise shareholder’s wealth, which is
referred to as the wealth maximisation concept. The wealth of owners is reflected in the market
value of shares, wealth maximisation means the maximisation of market price of shares.
According to the wealth maximisation objective, financial management must select those
decisions which result in value addition, that is to say the benefits from a decision exceed the
cost involved. Such value addition I increase the market value of the company’s share and
hence result in maximisation of the shareholder’s wealth.

6. Discuss about working capital affecting both the liquidity as well as profitability of a business.
Ans: The working capital should neither be more nor less than ; required. Both these situations
are harmful. If the amount of working capital
is more than required, it will no doubt increase liquidity but decrease profitability. For instance, if
large amount of cash is kept as working capital, i then this excessive cash will remain idle and
cause the profitability to fall.
On the contrary, if the amount of cash and other current assets are very ‘ little, then lot of
difficulties will have to be faced in meeting daily expenses
and making payment to the creditors. Thus, optimum amount of both current assets and current
liabilities should be determined so that profitability of the business remains intact and there is no
fall in liquidity.

7.How does inflation affect the working capital requirements of a company? State.
Answer:
With rising prices, larger amounts are required even to maintain a constant volume of
production and sales. The working capital requirement of a business thus, become higher with
higher rate of inflation.

8.How do ‘growing opportunities’ as a factor affect dividend decision? State.

A firm having higher growth opportunities may decide to retain more earnings and declare less
dividends.

9.What is ‘financial risk? Why does it arise?

Ans. Financial risk refers to the risk of a company not being able to cover its fixed financial
costs. The higher level of risks are attached to higher degrees of financial leverage with the
increase in fixed financial charges, the company also required to raise its operating profit (EBIT)
to meet financial charges. If the company can not cover these financial charges, it can be forced
into liquidation.

10.How does working capital affect both the liquidity as well as profitability of a business?
Ans. The working capital should neither be more nor less than required. Both these situations
are harmful. If the amount of working capital is more than the requirement, it will undoubtedly
increase liquidity but decrease profitability. For instance, if a large amount of cash is kept as
working capital, then this excessive cash will remain idle and cause the profitability to fall.
On the contrary, if the amount of cash and other current assets are very little, then a lot of
difficulties will have to be faced in meeting daily expenses and making payments to the
creditors. Thus, optimum amount of both the current assets and current liabilities should be
determined so that the profitability of the business remains intact and there would be no fall in
liquidity.

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

Ans. Capital structure refers to the combination of owner’s and borrowed funds. It can be
calculated as Debit/Equity.
Debt and equity differ significantly in their cost and riskiness for the firm. Cost of debt is lower
than the cost of equity for a firm because lender’s risk is lower than the equity shareholder’s
risk. Since lenders earn on assured return and repayment of capital and therefore, they should
require a lower rate of return. Debt is cheaper but is more risky for a business because payment
of interest and the return of principal is obligatory for the business. These commitments may
force the business to go into liquidation if there is any default in meeting them. There is no such
compulsion in case of equity, that is why, it is considered riskless for the business. Higher use of
debt increases the fixed financial charges of a business. As a result increased use of debt
increases the financial risk of a business.
Capital structure of a business thus, affects both the profitability and the financial risk. A capital
structure will said to be optimal when the proportion of debt and equity results in an increment in
the value of the equity share.

12.A capital budgeting decision is capable of changing the financial fortune of a business.” Do
you agree? Give reasons for your answer.
Ans. Investment decision can be long term or short term. A long term investment decision is
also called a capital budgeting decision. It involves the commitment of the finance on a long
term basis, e.g., making investment in a new machine to replace an existing one or acquiring a
new fixed assets or opening a new branch, etc. These decisions turn out to be very crucial for
any business. The earning capacity over the long-run assets of a firm, profitability and
competitiveness, are all affected by the capital budgeting decisions. Moreover, these decisions
normally involve huge amounts of investment and are irreversible except at a huge cost.
Therefore, once made, it is futile for a business to wriggle out of such decisions. Therefore, they
need to be taken with utmost care. These decisions must be taken by those who understand
them comprehensively. A bad capital budgeting decision can severely damage the financial
fortune of a business.

13.Explain the term ”Trading on Equity”. Why, when and how it can be used by a company?
Ans. Trading on equity is a financial process of using debt in order to produce gain for the
owners. In this process, new debt is taken to gain new assets with which they can earn greater
level of interest which is more than the interest that is paid for debt. This process is followed
because the equity shareholders are interested in the income that is being generated from
business. It is practiced by a company only when the rate of return on investment is greater than
the rate of interest for the fund that is borrowed. There will be an increment in earnings per
share when this process is adopted. Trading
on equity is profitable only when the return on investment is greater than the amount of funds
borrowed. It is said that trading on equity shall be avoided if the return on investment is less
than the rate of interest from the funds that are borrowed.

14.The Return on Investment (ROI) of a company ranges between 10%-12% for the past three
years. To finance in future fixed capital needs, it has the following option for borrowing debts.
Option A: Rate of Interest 9%
Option B: Rate of Interest 13%
Which source of debts, Option A or Option B is better? Give reason in support of your answer.
Also state the concept used in taking the decision.
Out of the two available sources of debt according to me Option A is better as the cost of debt is
less than return on Investment which is the prerequisite to maximising returns to the
shareholders/trading on equity. Since, the rate of Interest is 9%. Whereas the Return on
Investment (ROI) of a company ranges between 10%- 12% for the past three years.
This decision is based on the concept of Trading on Equity. Trading on Equity refers to the
increase in the earnings per share by employing the sources of finance carrying a fixed financial
charges like debentures (interest is paid at a fixed rate or preference shares (dividend is paid at
fixed rate).
The two conditions necessary for taking advantage of trading on equity are:
(a) The rate of return on investment should be more than the rate of interest.
(b) The amount of interest paid should be tax deductible.

15. Sunrises Ltd., dealing in readymade garments, is planning to expand its business operations
in order to cater to the international market. For this purpose, the company needs an additional
80,00,000 to replace 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 8,00,000, and
the total capital investment was 1,00,00,000. Suggest whether the issue of debenture would be
considered a rational decision by the company. Give reasons to justify your answer