Class XII – Financial Management – PYQs

Ans. Role of financial management can be explained as follows

(i) The Size and the Composition of Fixed Assets of the Business Financial management plays a significant role in determining the size and composition of fixed assets of the business. Decision to invest a sum of ` 500 crore in fixed assets would raise the size of fixed assets blocked by this amount.

(ii) Quantum of Current Assets The quantum of current assets is also influenced by financial management decisions. With an increase in the investment in fixed assets, there is a commensurate increase in the working capital requirement.

(iii) Break-up of Long-term Financing into Debt and Equity Financing decision involves decision regarding procurement of finance from debt as well as equity. Thus, it affects the proportion of equity and debt to make up the capital structure.

(iv) All Items of Profit and Loss Account Capital budgeting decisions, i.e., investment in fixed assets affect the profit and loss statement, e.g. more debt requires more interest payment. Thus, we can see the impact of financial decisions on various items of financial statement such as interest, profit, tax, etc.

Ans. The main objectives of financial management are

(i) Effective utilisation of funds, by ensuring that benefits of an investment exceed its cost.

(ii) To raise funds at minimum cost and minimum risk, through effective financing decision.

(iii) To ensure safety of funds by creating reserves, reinvesting profits, etc.

(iv) To maintain financial liquidity and profitability through working capital decision.

Ans. (i) Financial decision taken by Ashish Jain is investment (Long-term/Capital budgeting) decision.

(ii) The factors affecting investment decision are given below

(a) Cash Flow of the Project When a firm takes an investment decision involving huge amount, it expects to generate some cash flows (inflow or outflow) over a period. Thus, the inflows and outflows of cash in the business should be considered before making capital budgeting decisions.

(b) Rate of Return Each project is selected after comparing expected returns of different projects and the degree of risk involved in them.

(c) The Investment Criteria Involved The decision to invest in a particular project involves a number of calculations regarding the amount of investment, interest rate, cash flows and rate of return.

Ans. The company should use ‘Option A’ as in this case the return on investment (10-12%) will be more than the cost of debt (9%). The concept being used in the above case is Trading on Equity. The use of debt along with equity increases Earnings Per Share (EPS). This use of fixed financial charge, i.e., interest, increases the profit earned by shareholders. This concept is known as trading on equity.

If the company opts for Option A, it will lead to favourable trading on equity as in this case RoI > CoD, where

RoI—Return on Investment (10-12%)

CoD—Cost of Debt (9%)

Ans. (i) The company will be available to take advantage of trading on equity in alternative III. This is because of higher earnings per share in Alternative III as calculated below

(ii) No, Earning Per Shares (EPSs) only rises with increase in debt when the rate of interest on debt is lower than the return on investment.

Ans. In the transportation business, lower amount of working capital is required as it is a service industry. Working capital requirement of Neelabh would include payment of salaries, fuel charges, maintenance of vehicles, etc. Factors affecting the fixed capital requirements are

(i) Growth Prospects: Businessman wants to expand his business, in such situation company requires higher investment to meet the anticipated demand in future. Thus, the requirement of fixed capital will be higher.

(ii) Diversification: If the businessman diversifies his business, this means larger amount of fixed capital is required.

Ans. Two factor affecting the working capital requirement of Steelone Enterprises are

(i) Credit Allowed: Different firms allow different credit terms to their customers. These depend upon the level of competition that a firm face, as well as the credit worthiness of their clientele. A liberal credit policy results in higher amount of debtors, increasing the requirement of working capital.

(ii) 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. As against this, the requirement for working capital will be lower during the period of depression, since the sales as well as production will be less.

Ans. Financial management is concerned with optimal procurement as well as usage of finance. It aims at reducing the cost of funds procured, keeping the risk under control and achieving effective deployment of such funds. Financial management is an area of financial decision-making harmonising individual motives and enterprise goals.

Objectives of Financial Management

The primary aim of financial management is to maximise shareholders’ wealth, which is referred to as the wealth-maximisation concept. The market price of equity shares increases, if the benefit from a financial management decision exceeds the cost involved. Therefore, those financial decisions are taken which ultimately prove to be gainful and maximise the current price of equity shares of the company.

With the primary objective of wealth maximisation, following objectives are also achieved

(i) Funds should be deployed in such a way that returns from an investment exceeds its cost.

(ii) To raise funds at minimum cost and minimum risk, through effective financing decision.

(iii) To maintain financial liquidity and profitability, through working capital decision.

(iv) To ensure safety of funds by creating reserves, reinvestment of profits, etc.

Ans. (i) Two financial decisions being discussed are

(a) Investment Decisions: It involves careful selection of assets in which funds are to be invested.

Decisions relating to investment in fixed assets are known as capital budgeting, whereas those concerning investment in current assets are called working capital decisions.

A business needs to invest funds for setting up new business, for expansion and modernisation. Investment decision is taken after careful scrutiny of available alternatives in terms of costs involved and expected return.

(b) Financing Decisions: It is concerned with the decisions of how much funds are to be raised from which long-term source, i.e., by means of shareholders’ funds or borrowed funds. Shareholders’ funds include share capital, reserves and surplus and retained earnings, whereas borrowed funds includes debentures, long-term loans and public deposits.

(ii) Two factors which affect capital budgeting/ investment decisions and needs to be considered are

(a) Cash Flows of the Project: When a business invests huge amount of money in a certain project, then it expects regular and reasonable cash inflows from such an investment. Cash generated from operations are analysed in selecting the desired project.

(b) The Rate of Return: Each project is selected after comparing expected returns of different projects and the degree of risk involved in them.

Two factors affecting financing decisions and needs to be considered are

(a) Fixed Operating Cost: If a firm is having a higher fixed operating burden like payment of interests, premiums, salaries, rent, etc., then it should avoid financing through debt. This is because it will further increase the interest payment burden and the firm can reach an unfavourable position.

(b) Control Considerations: Issue of more equity may dilute shareholder’s control over the business. Therefore, a company afraid of a takeover bid may prefer debt to equity.

Ans. The factors identified in the above lines are given below

(i) Stability in Earnings: A company having higher and stable earnings can declare higher dividends than a company with lower and unstable earnings. The line ‘‘It has been consistently ……….. many years.’’

(ii) Amount of Earnings: Dividends are paid out of current and past earnings. Thus, earnings are a major determinant of dividend decision. The line “This year too ………… enough profits.”

(iii) Growth Opportunities: Companies having good growth opportunities retain more money out of their earnings so as to finance the required investment. Therefore, the dividend declared in growth companies is smaller than that in the non-growth companies. The line “There is availability ……… in future.”

(iv) Shareholders Preference: While declaring dividends, management must keep in mind the preferences of the shareholders. Some shareholders in general desire that atleast a certain amount is paid as dividend. The companies should consider the preferences of such shareholders. The line “It has many share ……… in an investment”.

Ans. ‘‘Sound financial planning is essential for the success of any enterprise.’’ The following points explain the importance of financial planning

(i) It helps in forecasting what may happen in future under different business situations. By doing so, it helps the firms to face the eventual situation in a better way. In other words, it makes the firm better prepared to face the future. By preparing a blueprint of these situations, the management may decide what must be done in each of these situations. This preparation of alternative financial plans to meet different situations is clearly of immense help in running the business smoothly.

(ii) It helps in avoiding business shocks and surprises and helps the company in preparing for the future.

(iii) It helps in coordinating various business functions, e.g. sales and production functions, by providing clear policies and procedures.

(iv) It provides a link between investment and financing decisions on a continuous basis.

(v) Detailed plans of action prepared under financial planning reduce waste, duplication of efforts and gaps in planning.

(vi) By spelling out detailed objectives for various business segments, it makes the evaluation of actual performance easier.

Ans. Adequate working capital is essential for smooth and efficient working of every business enterprise. Adequate working capital provides the following advantages to a business enterprise

(i) A firm with adequate working capital can meet its liabilities promptly. Prompt payment helps to raise the credit-standing or reputation of the enterprise.

(ii) Adequacy of working capital enables the firm to take advantage of any favourable business opportunity, e.g. to purchase raw materials at a discount or to execute a special order.

(iii) Financial soundness of business boosts the morale of employees.

(iv) Lack of adequate working capital may result in interruptions in operations and underutilisation of plant capacity.

(v) Adequate working capital permits timely and regular payment of cash dividends. This helps to maintain cordial relations with shareholders.