Business Finance Short Answer Type Questions

Question 1.
What are the advantages and disadvantages of equity, shares?
Answer:
The following are the advantages of equity shares:

It is a good source of long – term finance.
It serves as a permanent source of capital.
They suppose no fixed burden on the company’s resources, because the dividend on these shares are subject to availability of profits.
Issuance of equity share capital creates no charge on the assets of the company.
Equity shareholders have voting rights and elect competent persons as directors to control and manage the affairs of the company.

The following are the disadvantages of equity shares:

Ordinary shares are transferable and may bring about centralization of power in few hands.
Trading on equity is not possible.
Excessive issue of equity shares may result in over-capitalization.
The cost of issuance of equity shares is high.
ordinary shares cannot be paid back during the lifetime of the company. This characteristic creates inflexibility in capital structure of the company.
The dividend on equity shares is subject to availability of profits and intention of the Board of Directors and hence the income is quite irregular and uncertain.

Question 2.
What are the advantanges and disadvantages of preference shares?
Answer:
Advantages of Preference Shares are:
(i) Fixed return: The dividends to be paid to the preference shareholders are fixed as compared to the equity shareholders. The company can thus maximize the profits that are available on the part of preference shareholders.

(ii) Absence of charge on assets: Because preference shares have no payment of dividends, no charges are levied on the assets of the company unlike in the case of debentures.

(iii) Capital structure flexibility: By means of issuing redeemable preference shares, flexibility in the company’s capital structure can be maintained because redeemable preference shares can be redeemed under the terms of issue.

(iv) Widening of the capital market: The scope of a company’s capital market is widened as a result of the issuance of preference shares. Preference shares provide not only a fixed rate of return but also safety to the investors.

(v) Less capital losses: The preference shareholders possess the preference rights of the repayment of their capital as a result of which there are less capital losses.

Disadvantages of Preference Shares are:
(i) Dilution of claim over assets: Because of the very reason that preference shareholders have preferential rights over the company assets in case of winding up of the company, dilution of equity shareholders claim over the assets take place.

(ii) Tax disadvantages: In case of preference shareholders, the taxable income of the company is not reduced while in case of common shareholders, the taxable income of the company is reduced.

(iii) Increase in financial burden: Because most of the preference shares issued are culminate, the financial burden on the part of the company increases vehemently. The company also reduces the dividends of the equity shareholders because of the reason that it is essential on the part of the company to pay the dividends to the preference shareholders.

Question 3.
What are the advantanges and disadvantages of debentures?
Answer:
Advantages of debentures:

Less costly: as compared to equity shares
Tax deduction: Interest payable on debentures is allowed as deduction for tax purpose.
No ownership dilution: Debenture holders do not carry any interest in the payment.
Fixed interest: Interest rate does not increase with increase in profits of organizatin.
Reduced real obligation: Although interest payable is fixed, with the change in inflation rate, the real obligation the part of the company reduces.

Limitations of debentures:

Obligatory payment: If the company fails to pay the interest on debentures the investors can ask for declaring the company as bankrupt. Interest payment on debenture is obligatory.
Financial risk associated with debenture is higher than equity shares.
Cash out flow on maturity is very high.
The investors may put various restrictions while investing in the debentures.

Question 4.
Explain any six types of debentures.
Answer:
The types of debentures are:
1. Redeemable and irredeemable (perpetual) debentures:
Redeemable debentures carry a specific date of redemption on the certificate. The company is legally bound to repay the principal amount to the debenture holders on that date. On the other hand, irredeemable debentures, also known as perpetual debentures, do not carry any date of redemption. This means that there is no specific time of redemption of these debentures. They are redeemed either on the liquidation of the company or when the company chooses to pay them off to reduce their liability by issues a due notice to the debenture holders beforehand.

2. Convertible and non-convertible debentures:
Convertible debenture holders have an option of converting their holdings into equity shares. The rate of conversion and the- period after which the conversion will take effect are declared in the terms and conditions of the agreement of debentures at the time of issue. On the contrary, non-convertible debentures are simple debentures with no such option of getting converted into equity. Their state will always remain of a debt and will not become equity at any point of time.

3. Fully and partly convertible debentures:
Convertible Debentures are further classified into two – Fully and Partly Convertible. Fully convertible debentures are completely converted into equity whereas the partly convertible debentures have two parts. Convertible part is converted into equity as per agreed rate of exchange based on an agreement. Non-convertible part becomes as good as redeemable debenture which is repaid after the expiry of the agreed period.

4. Secured (mortgage) and unsecured (naked) debentures:
Debentures are secured in two ways. One when the debenture is secured by the charge on some asset or set of assets which is known as secured or mortgage debenture and another when it is issued solely on the credibility of the issuer is known as the naked or unsecured debenture. A trustee is appointed for holding the secured asset which is quite obvious as the title cannot be assigned to each and every debenture holder.

5. First mortgaged and second mortgaged debentures:
Secured / Mortgaged debentures are further classified into two types- first and second mortgaged debentures. There is no restriction on issuing different types of debentures provided there is clarity on claims of those debenture holders on the profits and assets of the company at the time of liquidation. First mortgaged debentures have the first. charge over the assets of the company whereas the second mortgage has . the secondary charge which means the realization of the assets will first fulfill the obligation of first mortgage debentures and then will do for second ones.

6. Registered unregistered debentures (bearer) debenture:
In the case of registered debentures, the name, address and other holding details are registered with the issuing company and whenever such debenture is transferred by the holder; it has to be informed to the issuing company for updating in its records. Otherwise, the interest and principal will go the previous holder because the company will pay to the one who is registered. Whereas, the unregistered commonly known as bearer debenture. It can be transferred by mere delivery to the new holder. They are considered as good as currency notes due to their easy transferability. The interest and principal are paid to the person who produces the coupons, which are attached to the debenture certificate and the certificate respectively.

7. Fixed and floating rate debentures:
Fixed rate debentures have fixed interest rate over the life of the debentures. Contrarily, the floating rate debentures have the floating rate of interest which is dependent on some benchmark rate say LIBOR etc.

Question 5.
Write note on: Retained Earnings.
Answer:
Retained Earnings is a technique of financial management under which all profits of a company are not distributed amongst the shareholders as dividend but a part of the profits is retained in the company. This is also known as ploughing back of profits.

A part of the profits is ploughed back or re-employed into the business and is regarded as an ideal source of financing expansion and modernisation schemes as there is no immediate pressure to pay a return on this portion of stockholders’ equity. A part of total profits is transferred to reserves such as General Reserve, Reserve Fund, Replacement Fund etc.

Some of the main characteristics of retained earnings are as follows:

The retained earnings plus the common stock value equal the shareholders equity in the company.
They are the profits generated by a company that are not distributed as dividends to the shareholders.
They are the sum of profits that have been retained by a company since its inception.
They are reduced by the losses.
Retained earnings are also known as accumulated surplus, accumulated profits, accumulated earnings, undivided profits and earned surplus.
Retained earnings do not represent surplus cash left after payment of dividends. Instead, the retained earnings show how the company has treated its profits.
They represent the amount of profits a company has reinvested since it was incorporated.
Retained earnings represent the dividend policy of a company because they reflect a decision of a company to either reinvest the profits or to distribute profits.

Question 6.
Briefly explain the merits and demerits of long term loan from financial institutions.
Answer:
The various merits of long – term loan from financial institutions are as follows:
i. Cash Flow: Capital is a limited resource and investing large amounts into any asset or project limits the availability of capital for other investments.

ii. Save time: Long term loans minimize time spent saving for investments and investors are able to realize potential earnings sooner to help offset the cost.

iii. Increase flexibility: Although keeping some cash on hand is important to mitigate unexpected expenses, saving large lump sums is inefficient. Long term loans increase the flexibility of an investor’s limited capital by allowing for its distribution over multiple investments, and minimizing the immediate impact on operational cash flow.

iv. Lower interest rates: Lending institutions assume a high degree of risk on long terms loans, which usually requires the borrower to offer collateral. Often, the asset for which the funds are being borrowed can act as that collateral. If the borrower defaults on their payments, that asset can then be seized, or repossessed, by the lender.

v. Build credit: Generally, long term loans have a very structured payment process that has been designed to meet the payment capability of the borrower, notwithstanding unforeseen events. Therefore, making regular payments on a long term loan will allow an individual or a business to build their credit worthiness.

The various disadvantages of long – term loans from financial institutions are as follows:

Liquidation: Creditors/ Financial institutions can liquidate the business if the business cannot meet its debt obligations.
Risk: Business’s risk increases in proportion to the amount of debt it takes on.
Collateral: A financial institution wants its loan to be protected and requires a security called collateral before lending. This requires additional cost.
Contract contents: Contract contents of these loans create financial limitations for economic unit.

Question 7.
Define cost of capital. What is cost of debt? Give the meaning of cost of equity and reserves. What is weighted average cost of capital (WACC)?
Answer:
Cost of capital is defined as the minimum rate of return that a firm must earn on its investments so that market value per share remains unchanged.

Cost of debt refers to the minimum rate of return expected by the suppliers of debt capital.
It is instrument that yields to protect the shareholdeer’s interest.
kd = \(\frac{\text { Interest }}{\text { Net proceeds }}\) x (1 – Tax)
Cost of equity and reserves. It refers to the minimum rate of return that a company must earn on the equity share capital financed portion of an investment project so that the market price of share does not change.

Weighted average cost of capital is nothing but overall cost of capital. In other words in case of WACC proper weightage is given to the cost of each and every source of funds i.e. proper assessment of relative proportion of source of funds, to the total, is ascertained by considering either the book value or the market value of each source of funds.

Question 8.
How will you compute the cost of equity Capital?
Answer:
The cost of equity is not the out-of-pocket cost of using these funds, that is, the cost of floatation and dividends. It is rather the cost of the estimated stream of enterprise capital outlays derived from equity sources. The cost of obtaining funds through the sale of common stock may be determined in one of three ways- The first method uses the accepted earnings price ratio, the second method is to find a rate that will equate the present value to all future dividends per share to the current market price. The third way is to substitute earnings for dividends. This is known as the earnings model.
1st Method ⇒ Ke = \(\frac { Ea }{ Po }\) where,
Ke – Cost of equity capital
Ea – Expected average earning per share
Po – Price of share of equity stock, is sold

2nd Method ⇒ Ke = \(\frac { Ea }{ Po }\) = + g
where, Ke – Cost of equity capital,
Do – beginning dividend
Po – Price of share of stock is sold
g – Growth rate of dividend

3rd Method ⇒ Ke = \(\frac { E }{ Po }\) + g
where Ke – Cost of equity capital
E- Earning per share, Po – Price of share of Stock if sold
g – growth rate of dividend

Question 9.
What is meant by optimum capital structure? Discuss the basic qualities which a sound capital structure should possess.
Answer:
“OCS refers to that capital structure or combination of debt and equity that leads to the maximum value of the firm”. Hence thereby the wealth of its owners also increases with the minimisation of cost of capital.
The basic qualities which a sound capital structure should possess are as follows:
1. Profitability: The capital structure of the company should be most advantageous, within the constraints. Maximum use of leverage at a minimum cost should be made.

2. Solvency: The use of excessive debt threatens the solvency of the company. Debt should be used judiciously.

3. Flexibility: The capital structure should be flexible to meet the changing conditions. It should be possible for a company to adapt its capital structure with minimum cost and delay if warranted by a changed situation. It should also be possible for the company to provide funds whenever needed to finance its profitable activities.

Question 10.
Explain the traditional approach of capital structure.
Answer:
The traditional approach of capital structure states that when the Weighted Average Cost of Capital (WACC) is minimized, and the market value of assets are maximized, an optimal structure of capital exists.
The important points of the Traditional approach of capital structure are as follows:
(i) Traditional approach to capital structure advocates that there is a right combination of equity and debt in the capital structure, at which the market value of a firm is maximum.

(ii) As per this approach, debt should exist in the capital structure only up to a specific point, beyond which, any increase in leverage would result in reduction in value of the firm.

(iii) It means that there exists an optimum value of debt to equity ratio at which the WACC is the lowest and the market value of the firm is the highest.

(iv) Once the firm crosses that optimum value of debt to equity ratio, the cost of equity rises to give a detrimental effect to the WACC. Above the threshold, the WACC increases and market value of the firm starts a downward movement.

Assumptions of the Traditional approach:

The rate of interest on debt remains constant for a certain period and thereafter increases with increase in leverage.
The expected rate by equity shareholders remains constant or increase gradually.
As a result of activity of rate of interest and expected rate of return, the WACC first decreases and then increases.
The lowest point on. the curve is the optimal capital structure.

Question 11.
Discuss the MM approach of capital structure.
Answer:
Modigliani, and Miller, approach stated that the total market value of a firm and the cost of capital are independent (exclusive of tax considerations) of the capital structure. According to Modigliani and Miller (MM), under the situation of perfect market, the dividend policy of a firm is irrelevant as it does not affect the value of the firm.

MM argue that dividend policies and decision basically depend on the investment policies of the firm. If the investment policies go wrong, firm is unable to generate earnings. If investment policies and decisions are right then firm is able to get good returns which ultimately results in to a split between dividend to shareholders and retained earnings.

In situations of perfect competition, companies experience any of the following three situations.

Company has sufficient cash to payout dividend
Company does not have sufficient cash and thereby issues new shares to finance payment of dividend.
Company is not ready to pay dividend as cash position is very weak but shareholders want cash immediately.

Assumptions of MM Hypothesis:

There are perfect capital markets
Investors behave rationally
Information about the company is available to all without any cost
There are no floatation and transaction costs
No investor is large enough to effect the market price of shares
There are either no taxes or there are no differences in the tax rates applicable to dividends and capital gains
The firm has a rigid investment policy
There is no risk or uncertainty in regard to the future of the firm.