Financial System Short Answer Type Questions

Financial System Short Answer Type Questions

Question 1.
Distinguish between capital and money market.
Answer:
→ The subject matter of capital market comprises long-term financial instruments having maturity of more than one year, on the other hand, the thrust of money market is on short-term instruments only.

→ Money market is a wholesale market and the participants in money market are large institutional investors, commercial banks, mutual funds, and corporate bodies. However, in case of capital market even a small individual investor can deal by sale/purchase of shares, debentures or mutual fund units.

→ In capital market, the two common segments are primary market and secondary market. Both these segments are interrelated. Securities emerge in primary segment and their subsequent dealings take place in secondary market. However, in case of money market, there is no such sub-division in general. In efficient money market, secondary market transactions may also take place.

→ Total volume of trade occur per day in money market is many fold that of the volume per day taking place in capital market.

→ In capital market, the financial instruments being dealt with are shares (equity as well as preference),debentures (a large variety), public sector bonds and units of mutual funds. On the other hand, money market has different financial instruments such as treasury bills, commercial papers, call money, certificate of deposits, etc.

Question 2.
State the functions of financial system.
Answer:
Following are the functions of financial system:

  • The main function of financial system is the channelization of the individuals saving and making it available for various borrowers. The borrowers are companies and industries which take loan in order to increase their overall growth of the economy
  • It helps in liquidating one’s savings whenever required
  • It help to pass financial information
  • It Creates an environment for one to invest their funds which involves good return on investment
  • It helps to select best investment based on the pre-determined risk and return.
  • It acts as a regulatory body and monitors the action performed by financial institutions and financial market.
  • It plays vital role to control risks and uncertainties
  • It increases the habit of savings
  • It helps in Mobilizing huge financial resources for the economic growth.
  • It gives some innovative services like smart cards, debit cards, credit cards enable the user to make easy payment and transfer of money.

Question 3.
State the.features of primary market.
Answer:
The various features of primary markets are:
→ This is the market for new long term equity capital. The primary market is the market where the securities are sold for the first time. Therefore it is also called the new issue market (NIM).

→ In a primary issue, the securities are issued by the company directly to investors.

→ The company receives the money and issues new security certificates to the investors.

→ Primary issues are used by companies for the purpose of setting up new business or for expanding or modernizing the existing business.

→ The primary market performs the crucial function of facilitating capital formation in the economy.

→ The new issue market does not include certain other sources of new long term external finance, such as loans from financial institutions. Borrowers in the new issue market may be raising capital for converting private capital into public capital; this is known as “going public.”

Question 4.
Explain the components of financial system.
Answer:
The financial system consists four components. These are financial markets, financial services, financial instruments and financial institutions.
(a) Financial Institution:
Financial Institution can be classified as banking and nonbanking institutions. Banking Institutions are creators and purveyors of credit while non banking financial institutions are purveyors of credit.

(b) Financial Markets:
Financial Markets can be classified, as primary and secondary markets. A Primary Market deals with new issues and secondary markets is meant for trading in existing securities.

(c) Financial Instruments:
A financial instrument is a claim against an institution or a person for payment at a future date of a sum of money in the form of dividend.

(d) Financial Services:
Financial services are those , which help with borrowing and funding, buying and selling securities, lending and investing, making and enabling payments and settlements and managing risk exposures in financial markets.

Question 5.
Write a note on financial assets.
Answer:
A financial asset is an intangiable asset representing the monetary value of paper’ securities. It obtains its monetary value from a contractual agreement. Financial asset is a document that has no fundamental value in itself until it is converted into cash. Financial assets are usually more.liquid than tangible assets types of financial assets include certificates, bonds stocks and bank deposits. – Classification of financial assets:
(a) Stock asset:
Stock includes equity shares and preference shares. These stock assets are issued by companies to raise long term capital. Equity share holders are considered to be the owners of the company but preference share holders are not the owners of the company but they have preferential right over equity in receiving dividend and during the time of liquidation of the company.

(b) Debt Asset:
It is an instrument whereby the business enterprises will enter into a contractual agreement with the debenture holder for a predetermined period and during the period it promises to pay a fixed percentage of invest to investors.

(c) Bonds:
Bonds are sold by government and corporations to raise funds for short term projects bonds are legal documents contains how much interest is guaranteed to be returned to the investor along with the original loan amount

Question 6.
Explain the importance and functions of developed money market. Importance of a developed money market and its various functions are discussed below:
(i) Financing Trade:
Money Market plays crucial role in financing both internal as well as international trade. Commercial finance is made available to the traders through bills of exchange, which are discounted by the bill market. The acceptance houses and discount markets help in financing foreign trade.

(ii) Financing Industry:
Money market contributes to the growth of industries in two ways:
(a) Money market helps the industries in securing short-term loans to meet their working capital requirements through the system of finance bills, commercial papers, etc.

(b) Industries generally need long-term loans, which are provided in the capital market. However, capital market depends upon the nature of and the conditions in the money market. The short-term interest rates of the money market influence the long-term interest rates of the capital market. Thus, money market indirectly helps the industries through its link with and influence on long-term capital market.

(iii) Profitable Investment:
Money market enables the commercial banks to use their excess reserves in profitable investment. The main objective of the commercial banks is to earn income from its reserves as well as maintain liquidity to meet the uncertain cash demand of the depositors. In the money market, the excess reserves of the commercial banks are invested in near-money assets (e.g. short-term bills of exchange) which are highly liquid and can be easily converted into cash. Thus, the commercial banks earn profits without losing liquidity.

(iv) Self-Sufficiency of Commercial Bank:
Developed money market helps the commercial banks to become self¬sufficient. In the situation of emergency, when the commercial banks have scarcity of funds, they need not approach the central bank and borrow at a higher interest rate. On the other hand, they can meet their requirements by recalling their old short-run loans from the money market.

(v) Help to Central Bank:
Though the central bank can function and influence the banking system in the absence of a money market, the existence of a developed money market smoothens the functioning and increases the efficiency of the central bank.

Money market helps the central batik in two ways:
(a) The short-run interest rates of the money market serves as an indicator of the monetary and banking conditions in the country and, in this way, guide the central bank to adopt an appropriate banking policy.

(b) The sensitive and integrated money market helps the central bank to secure quick and widespread influence on the sub-markets, and thus achieve effective implementation of its policy.

Question 7.
Explain the functions of money market.
Answer:

  • It facilitates economic development through provision of short term funds to industrial and other sectors
  • It provides a mechanism to achieve equilibrium between demand and supply of short term funds
  • It facilitates effective implementation of RBIs monetary policy
  • It provides ample avenues for short term funds with fair returns to investors
  • It instills financial discipline in commercial banks
  • It provides funds to meet short term needs
  • It helps in employment generation
  • It provides funds to government to meet its deficit
  • It helps to control inflation

Question 8.
What is financial system? Explain its features.
Answer:
Financial system is a set of inter – related activities or services working together to achieve some predetermined purpose or goal. It includes different markets, institutions, instruments and services and mechanism which influence the generation of savings investment capital formation and economic growth.

Features:

  • It is a set of inter- related activities or services
  • Services are working together to achieve pre-determined goals.
  • It connects the link between savers and borrowers
  • It includes financial institutions, markets, instruments services, practices and transactions
  • Its main objective is to formulate capital investment and profit generation
  • It provides services that are essential in a modern economy.

Question 9.
What is certificate of deposits? Explain the characteristics of certificate of deposits.
Certificate of deposits are those deposits which are issued by banks and it is like a promissory note. The term of a CD generally ranges from One month to five years. Following are the important features of certificate of deposits –

  • Certificate of deposits is considered as risk-less because default risk in them is almost negligible and hence its safe bet for investors.
  • Certificate of deposits is highly liquid and marketable and hence investors can buy or sell it whenever they desire to do so.
  • They are transferable from one party to another which cannot be done with term deposits and hence it is an added advantage for investors who are willing to invest in it.
  • It is a time deposit that restricts holders from withdrawing funds on demand, however if an investor wants to withdraw the money, this action will often incur a penalty.
  • A certificate of deposits may be payable to the bearer or registered in the name of the investor. Most certificates of deposits are issued in bearer form because investors can resell bearer CD’s more easily than registered CD’s.

Question 10.
State the features of a developed money market.
Answer:
The features of developed money market are:
(i) Highly organised Banking System:
The commercial banks are the nerve centre of the whole money market. They are the principal suppliers of short-term funds. Their policies regarding loans
and advances have impact on the entire money market. The commercial banks serve as vital link between the central bank and various segments of the money market, consequently, a well developed money market and a highly organised banking system co-exist.

(ii) Presence of a Central Bank:
Central Bank acts as the banker’s bank. It keeps their cash Reserves and provides them financial accommodation in difficulties by discounting their eligible securities. In other words, it enables the commercial banks and other institutions to convert their assets into cash in times of financial crisis. Through its open market operations the central banks absorbs surplus cash during off¬season and provides additional liquidity in the busy seasons. Thus, the central bank is the leader, guide and controller of the money market.

(iii) Availibility of proper credit Instruments:
It is necessary for the existence of a developed money market a continuous availibility of readily acceptable negotiable securities such as bills of exchange, treasury bills etc., in the market. There should Tie a number of dealers in the money maket to transact in these securities. Availibility of negotiable securities and the presence of dealer and brokers in large numbers to transact in these securities are needed for the existence of a developed money market.

(iv) Existance of Sub-markets:
The number of sub-markets determines the development of a money market. The larger the number of sub- markets, the broader and more developed will be the structure of money market. The several sub -markets together make a Cohernt money market. In an underdeveloped money market, the various sub- markes particularly the bill market, are absent.

(v) Ample Resources;
There must be availibility of sufficient funds to finance transactions in the sub-markets. These funds may come from within the country and also from foriegn countries.

(vi) Existence of secondary market:
There should be an active secondary market in these instruments.

(vii) Demand and supply of funds:
There should be a large demand and supply of short-term funds. It presupposes the existance of a large domestic and foreign trade. Besides it should have adequate amount of liquidity in the form of large amounts maturing with in a short period.

(viii) Other factors:
Other factors also contribute to the development of a money market, Rapid industrial development leading to the emergence of stock exchanges, large volume of international trade leading to the system of bills of exchange, political stability, favourable conditions for foreign investment, price stabilisation etc.

Question 11.
Discuss the primary market for industrial securities.
Answer:
Primary market is a market for new issues or new financial claims. Hence, it is also called new issue market. The primary market deals with those securities which are issued to the public for the first time. In the primary market, borrowers exchange new financial securities for log term funds. Thus, primary market facilitates capital formation.
There are three ways by which a company may raise capital in a primary market. They are –
(i) Public Issue:
In this case, the securities are offered to the public. It means, capital is raised through the sale of securities to the public.

(ii) Rights Issue:
It is the sale of securities first to the existing shareholders on a priority basis.

(iii) Private placements:
It is the sale of securities privately to a small group of investors.

Question 12.
What are the objectives of financial system.
Answer:
Following are the objectives of financial system:
(a) To mobilize the savings:
The financial system mobilizes saving from the small saving community. It collects the fund by offering different schemes which attract the investor to invest their savings in different institutions, services securities etc.

(b) To distribute the savings for the industrial investment:
It collects the funds from small investors and invest the amount in different industries. There by it meets the fund requirement of industrial sector therefore it helps in the growth of industrial sector

(c) To stipulate capital formation:
This is also one of the main object of financial system financial system is supporting the industries by sanctioning the fund needed to them. It also makes the industries to formulate the capital out of their earnings for further capital requirement and industrial investment.

(d) To accelerate the process of economic growth:
The ultimate aim of financial institutions is to support the process of economic growth of a nation. Directing the saving fund to the industrial capital need motivating them for the capital formation support the acceleration of the process of economic growth.

Question 13.
What’s financial market? What are its importance?
Answer:
Financial markets are a the market for purchase and sale of stocks shares bonds bills of exchange commodities, futures and options, foreign currency etc. Financial markets are the market for exchange of credit and capital. It is on essential player in the economic development of a nation. It facilitates the organization in the savings and investment process.

Importance of financial market:

  • It provides facilities for interaction between investors and borrowers
  • It provides Information resulting from buyers and sellers interaction in the market
  • It provides security to deal in financial assets
  • It helps investor to sell their financial assets.
  • It gives financial information to select best investment available among the various alternatives.

Question 14.
What is financial market? State its role.
Answer:
Financial market refers to as those centres and arrangements which facilitate ‘buying and selling of financial assets and claims.
(a) Helpful to Business: Financial markets helpful to the business developments and provide short term financial facilities to such business.

(b) Helpful to commercial banks: It not only provide financial facilities to business but also to commercial banks.

(c) Facilities effective implementation of monetary policy: It helps the central banks for effective implementation of monetary policy. So, central banks can achive its goals.

(d) Helpful to the development of capital market: Financial markets were also helpful to the development of capital markets.

(e) Helpful to the formulation of monetary policy ; It also helpful to the government to the formulation of monetary policy.

(f) Helpful to the government to mobilize finance: Finance markets helpful to the Government to mobilize finance. Finance markets provide funds to govt, in case of shortage of funds.

(g) Opportunity to exchange financial assets ; Financial markets provides an opporutunity to exchange financial assets.

Question 15.
Write a note on Treasury Bill or T- Bills.
Answer:
Treasury Bills are short term financial instruments issued by RBI on behalf of govt departments to over-come short term liquidity short falls. Treasury Bills are borrowing instruments of the Govt of India which enable investors to invest their funds in short term funds while reducing their market risks treasury bills are repaid at par on maturity

Features of Treasury Bills are:

  • Treasury bills are negotiable securities
  • These securities are highly liquid
  • There is absence of default risk
  • These securities have an assured yield on its investment
  • Treasury bills are issued in the form of subsidiary general ledger (SGL) entries in the books of RBI to hold the securities on behalf of the holder
  • Treasury bills are also issued under the market stabilization scheme (MSS)
  • There are two types of treasury bills viz, (a) Regular treasury bills and (b) Adhoc treasury bills
  • These bills are short term investment generally up to one.year.
  • There is no tax deducted at sources
  • Treasury bills are liquid money market instruments

Question 16.
Write a note on role of money market in economic development of the nation.
Answer:
The money market is integral part of a country’s economy will developed money market help in the economic development of a country. A developed money market enables the smooth functioning of the financial system in any economy in the following ways.
(a) Financing the industries: A well developed money market helps the industries to secure short term loans for meeting their working capital requirements.

(b) Financing the trade: Money market plays important role in financing the domestic as well as international trade. Traders can get short term finance from banks by discounting bills of exchange

(c) Development of capital market: The short term rates of interest and the conditions prevail in the money market influence the long term rates of interest as well as mobilization of resources in the capital market.

(d) Profitable investment: The money market helps the commercial banks to earn profit by investing their surplus funds in the purchase of treasury bills and bills of exchange etc. these instrument are sale highly liquid.

(e) Smooth functioning of commercial banks : The money market provides the facilities for temporarily employing their funds in easily realizable assets. Banks can get back the funds easily.

(f) Effective implementation of monetary policy: The well developed money market helps the central bank in shaping and controlling the flow of money in the country.

(g) Encourages economic growth

(h) Well organized money market safeguards the liquidity and safety of financial assets and this encourages for economic growth savings and investments.

(i) Proper allocation of resources: the saving of the community are converted into investment which leads to proper allocation of resources in the country.

Question 17.
What is capital market? Explain its functions.
Answer:
Capital market is a market dealing in medium and long term funds. It provides facilities for marketing and trading of securities. It constitutes all long term borrowings from banks and financial institutions borrowings from foreign markets and raising of capital by issuing various securities such as shares, debentures, bonds etc capital market includes primary market and secondary market.

Functions of capital market –

  • It mobilizes savings and acceleration of capital formation
  • It promotes industrial growth
  • It raises long term capital
  • It facilitates for proper channelization of funds
  • It provides insurance against market risk
  • It enables quick valuation of financial instruments.
  • It provides operation efficiency like lowering settlement time lower transaction cost and simplified transaction procedure.

Question 18.
What are the objectives of capital market.
Answer:
Following are the objectives of capital market:
(a) To connect link between savers and investors: The main objective of capital market is to connect link between savers and investors. It plays an important role in mobilizing the savings and diverting them in productive investment. Therefore capital market plays an important role in transferring the financial resources from surplus areas to productive and deficit areas.

(b) To encourage savings: Capital market encourage people to save more in banking and non- banking financial institutions

(c) To encourage for investment: Capital market provides facilities to business and Govt by lending the money and there by it helps the banks and non banking institution to invest their amount in right investment areas.

(d) To promote economic growth: Capital market connects the link between savers and investors. There fore it facilities the growth of economic conditions of the country various institutions of capital market allocate the resources rationally in accordance with the development needs of the country.

(e) To stabilize security prices: The capital market tends to stabilize the values of stocks and securities and reduce the fluctuations in the prices to the minimum. The process of stabilization is facilitated by providing capital reducing the speculative and unproductive activities.

(f) To give benefits to investors: Capital market helps the investor to invest in long term financial assets

(g) To regulate the market ; Capital market implement policies laws and regulations related to the activities of securities.

(h) To reduce risk; Capital market gives protection to the activities of securities and stock and there by it reduces the risks and uncertainties

Question 19.
Write a note on Organizational structure of Indian capital market.
Answer:
Financial System Short Answer Type Questions 1
(a) Government securities : It also knows as gilt edged market. This refers to the market for government and semi – government securities backed by Reserve Bank of India.

(b) Industrial securities Market: This is a market for industrial securities like shares and debentures of the existing and new corporate firms Industrial securities market helps for buying and selling of such financial instruments. This market is divided into two types. They are primary market for New issues of shares and debentures and secondary market for old and existing issue of shares and debentures. In primary market fresh capital is raised by the companies by issuing new shares bonds, mutual funds units and debentures and in secondary market old shares and debentures are traded.

(c) Development Financial Institutions (DFIs): It is another part of Indian capital market It includes various financial institutions like IFCI, ICICI, SFC, IDBI, IIBI, UIT etc. these financial institutions provide long term finance for the establishment of new industries.

(d) Financial intermediaries: It is last segment of Indian capital market this comprises various merchant banking institutions, mutual funds, leasing finance companies, venture, capital companies and other financial institutions.

Question 20.
Write the role of capital market in economic development?
Answer:
The role of capital market in economic growth of the nation is outlined as follows

  • It increases long term savings for long term investment
  • It enables large scale industries to establish its business without any problems by providing long term capital
  • It enables corporations to raise capital to finance their investment in real assets
  • Capital market helps to increase the productivity and employment
  • It helps to connect link between banking system with industrial investment
  • It Increases the domestic savings and investment ratio and that are essential for rapid industrialization
  • It provides equity capital and infrastructure development capital for the socio economic benefits of the nations.
  • It promotes public – private sector partnerships to encourage participation of private sector in productive investments
  • It assist the public sector to close resourse gap and complement its efforts in financing essential socio-economic development through raising long term project based capital
  • It also attracts foreign portfolio investors who are critical in supplementing the domestic savings level.

Financial System Very Short Answer Type Questions

Financial System Very Short Answer Type Questions

Question 1.
What is a financial system?
Answer:
Financial system is a set of inter-related activities or services working together . to achieve some predetermined purpose or goal.

Question 2.
State the components of Indian financial systems.
Answer:
The components of Indian financial system includes the following:

  • Financial market
  • Financial instruments
  • Financial intermediation
  • Financial service

Question 3.
What is a financial market?
Answer:
A Financial Market can be defined as the market in which financial assets are created or transferred. It is a place or mechanism where funds or savings are transferred from one section to another section of financial system.

Question 4.
What is financial asset?
Answer:
Financial Assets or Financial Instruments represents a claim to the payment of a sum of money sometime in the future and /or periodic payment in the form of interest or dividend.

Question 5.
What is a money market?
Answer:
The money market is a wholesale debt market for low-risk, highly-liquid, short term instrument. Funds are available in this market for periods ranging from a single day up to a year. This market is dominated mostly by government, banks and financial institutions.

Question 6.
What is a capital market?
Answer:
A capital market is a market for securities (debt or equity), where business enterprises (companies) and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year, as the raising of short-term funds takes place on other markets (e.g., the money market). The capital market includes the stock market (equity securities) and the bond market (debt). The capital market is designed to finance the long-term investments. The ransactions taking place in this market will be for periods over a year

Question 7.
Define financial system.
Answer:
According to Robinson the primary function of the system is “to provide a link between savings and investment for the creation of new wealth and to permit portfolio adjustment in the composition of existing wealth.

Question 8.
What is forex market?
Answer:
The Forex market deals with the multicurrency requirements, which are met by the exchange of currencies. Depending on the exchange rate that is applicable, the transfer of funds takes place in this market. This is one of the most developed and integrated market across the globe.

Question 9.
What is credit market?
Answer:
Credit market is a place where banks, FIs and NBFCs provide short, medium and long-term loans to corporate and individuals

Question 10.
What is a commercial paper?
Answer:
CP is a note in evidence of the debt obligation of the issuer. On issuing commercial paper the debt obligation is transformed into an instrument. CP is thus an unsecured promissory note privately placed with investors at a discount rate to face value determined by market forces. CP is freely negotiable by endorsement and delivery.

Question 11.
What is a call money?
Answer:
Call/Notice money is the money borrowed or lent on demand for a very short period. When money is borrowed or lent for a day, it is known as Call (Overnight) Money. Intervening holidays and/or Sunday are excluded for this purpose. Thus money, borrowed on a day and repaid on the next working day, (irrespective of the number of intervening holidays) is “Call Money”.

Question 12.
Define money market.
Answer:
According to Geottery Crowther money market is defined as “The market is a i collective name given to the various firms and institutions that deal in the various grader of near money”.

Question 13.
What is treasury bill?
Answer:
Treasury Bills are short term (up to one year) borrowing instruments of the union government. It is an IOU of the Government. It is a promise by the Government to pay a stated sum after expiry of the stated period from the date of issue (14/91/182/364 days i.e. less than one year). They are issued at a discount to the face value, and on maturity the face value is paid to the holder.

Question 14.
What are hybrid instruments?
Answer:
Hybrid instruments have both the features of equity and debenture. This kind of instruments is called as hybrid instruments. Examples are convertible debentures, warrants etc.

Question 15.
State the various money market instruments.
Answer:
The various money market instruments are:

  • Call/Notice Money
  • Treasury Bills
  • Term Money
  • Certificate of Deposit
  • Commercial Papers

Question 16.
What do you mean by inter bank term money?
Answer:
Inter-bank market for deposits of maturity beyond 14 days is referred to as the term money market. The entry restrictions are the same as those for Call/Notice Money except that, as per existing regulations, the specified entities are not allowed to lend beyond 14 days.

Question 17.
What is primary market?
Answer:
The primary market is that part of the capital markets that deals with the issuance of new securities Companies, governments or public sector institutions can obtain funding through the sale of a new stock or bond issue.

Question 18.
Distinguish between primary and secondary market.
Answer:
In the primary market, securities are offered to public for subscription for the purpose of raising capital or fund. Secondary market is an equity trading venue in which already existing/pre-issued securities are traded among investors: Secondary market could be either auction or dealer market. While stock exchange is the part of an auction market, Over-the-Counter (OTC) is a part of the dealer market.

Question 19.
Name any two objectives of money market.
Answer:
Objectives of money market are:

  • To provide an equilibrium mechanism for solving problems relating to short term surplus and deficits.
  • To provide access to users of short term money to meet their requirements at a reasonable price.

Question 20.
Name any four features of Indian money market.
Answer:
Features of Indian money market are:

  • Highly organized banking system
  • Presence of a central bank
  • Availability of proper credit instruments
  • Existence of sub markets
  • Demand and supply of funds
  • Ample resources

Question 21.
What is secondary market?
Answer:
Secondary market, also called aftermarket, is the financial market in which previously issued financial instruments such as stock, bonds,options, and futures are bought and sold.

Question 22.
What is a repo market?
Answer:
The repo market is one in which two participants agree that one will sell securities to another and make a commitment to repurchase equivalent securities on a future specified date, or on call, at a specified price. In effect, it is a way of borrowing or lending stock for cash, with the stock serving as collateral.

Question 23.
State any two functions of financial market?
Answer:

  • It provides a channel through which new savings flow into capital market which facilitates smooth capital formation in the economy.
  • It facilitates the transfer of real economic resources from lenders to ultimate borrowers in financial system.
  • It provides the borrowers with funds which they will invest in some productive purpose.
  • It provides liquidity in the market through which the claims against money can be resold by investors at any time and there by assets can be converted in to cash.

Question 24.
State the components of Indian financial system.
Answer:
The components of Indian financial system are:

  • Financial institutions
  • Financial instruments
  • Financial markets
  • Financial services

Question 25.
State the characteristics of treasury bills.
Answer:

  • These are issued as a promissory note at discount over their face value.
  • It is used to raise short term funds to bridge seasonal/temporary gaps between receipt and expenditure of the Govt.
  • It is a negotiable instrument.
  • Assured yield and low transaction cost.
  • Eligibility for inclusion in SLR.

Question 26.
What is acceptance market?
Answer:
Investment market based on short-term credit instruments is termed as acceptance market. An acceptance is a time draft or bill of exchange that is accepted as payment for goods. A banker’s acceptance, for example, is a time draft drawn on and accepted by a bank, which is a common method of financing short-term debts in international trade including import-export transaction.

Question 27.
What is a financial asset?
Answer:
Financial Assets of Financial Instruments represents a claim to the payment of a sum of money sometime in the future and /or periodic payment in the form of interest or dividend.

Question 28.
What is a discount market?
Answer:
A discount market is the part of the money market consisting of banks, discount houses and brokers on which bills are discounted.

Question 29.
Explain the components of unorganized money market.
Answer:
The components of unorganized money market comprises of indigenous bankers, money lenders, chit funds, nidhis, loan companies and finance brokers.

Question 30.
Write two differences between money market and capital market.
Answer:
Money Market:

  • It is market for short – term loanable funds for a period of not exceeding one year.
  • This market supplies funds for financing current business operation, working capital requirements of industries and short – period requirements of the government.

Capital Market:

  • It is a market for long-term funds exceeding a period one year.
  • This market supplies funds for financing the fixed capital requirements of trade and commerce as well as the long-term requirements of the Government.

Question 31.
What is call money market?
Answer:
Call money market refers to market for very short term funds not exceeding 7 days.

Question 32.
What do you mean by “ Financial Dualism”?
Answer:
The process which helps in economic development and encourages investment and savings by establishing continuous effective relationship between savings and investment Of the people is called financial dualism.

Question 33.
What do you mean by the malpractice, “Insider Trading”?
Answer:
The process of creating fraud in capital market by some executives in organizations by making use of unpublished information. They make assumption about these information and misuse their positions in the organization.

Question 34.
Expand Repo.
Answer:
Repurchase Agreement.

Question 35.
Who are the important players or participant of money market.
Answer:
Govt, RBI, Banks, Discount and Finance House of India, Financial Institutions, Mutual Funds etc.

Question 36.
What are capital market instruments?
Answer:
Capital market instruments are broadly divided into two types:

  • Equity instruments
  • Debt instruments

Question 37.
Give the meaning of equity instruments.
Answer:
Equity instruments are also called as ownership funds comprises equity shares, preference shares and deferred shares.

Question 38.
What is debt instruments?
Answer:
Debt instruments are also called as creditor ship securities comprises of all interest bearing securities like debentures, bonds, public deposits, bank loans, etc.

Risk Management Long Answer Type Questions

Risk Management Long Answer Type Questions

Question 1.
Explain nature and importance of risk management.
Answer:
In today’s world, managing corporate risks is a daunting task. The last few decades have seen a substantial increase in the average rate, as well as the volatility, of inflation. The increased uncertainty about inflation has been followed by greater volatility in interest rates, exchange rates, and commodity prices. Global competition has intensified in the wake of reduced tariff barriers.

The entire process of identifying, evaluating, controlling and reviewing risks, to make sure that the organisation is exposed to only those risks that it needs to take to achieve its primary objectives, is known as ‘risk management.’ Risk management is a proactive process, not reactive. In different markets or sectors there are different types of risks and so, the risk management procedures and techniques vary in their application ways but the target is same; putting the risks under control and accomplishing the mission as expected.

Risk cannot be eliminated. However, it can be:

  • Transferred to another party, who is willing to take risk, say by buying an insurance policy or entering into a forward contract.
  • Reduced, by having good internal controls.
  • Avoided, by not entering into risky businesses.
  • Retained, to either avoid the cost of trying to reduce risk or in anticipation of higher profits by taking on more risk.
  • Shared, by following a middle path between regaining and transferring risk.

There are various tools available to the management to manage risks. Some of them being, derivative products like Forwards, Futures, Options and Swaps. The others involve having better internal controls in place, due diligence exercises, compliance with rules and regulations, etc.

In coping with the challenge of risk management, the following interrelated guidelines should be considered:

  • Understanding the firm’s strategic exposure
  • Employing a mix of real and financial tools
  • Proactively managing uncertainty
  • Aligning risk management with corporate strategy
  • Learning when it is worth reducing risk

Managing risk is considered important; it comes next only to minimizing borrowing costs and maintaining / improving the firm’s, credit. Firms often reduce some exposures, leaving others unhedged, the principal emphasis being on hedging transaction exposures.

Question 2.
Discuss classification of risk.
Answer:
Risks are Classified into Major Categories
(1) Systematic Risks are out of external and uncontrollable factors, arising out of the market, nature of the industry and the state of the economy and a host of other factors.

(2) Unsystematic Risks emerge out of the known and controllable factors, internal to the issuer of the securities or companies.

Examples of Systematic Risks:
(i) Market Risk: This arises out of changes in Demand and Supply pressures in the markets, following the changing flow of information or expectations. The totality of investor perception and subjective factors influence the events in the Market which are unpredictable and give rise to risk, which is not controllable.

(ii) Interest Rate Risk: The return on an investment depends on the interest rate promised on it and changes in market rates of interest from time to time. The cost of funds borrowed by companies or stockbrokers depend oh interest rates. The market activity and investor perceptions change with the changes in interest rates.

(iii) Purchasing Power Risk: Purchasing power risk is also known as inflation risk. This risk arises out of change in the prices of goods and services and technically it covers both inflation and deflation periods. During the last two decades, it has been seen that inflationary pressures have been continuously affecting the Indian economy.

Examples of Unsystematic Risks:
(i) Business Risk:
This relates to the variability of the business,-sales, income, profits etc. which in turn depend on the market conditions for the product . mix, input supplies, strength of competitors, etc. This business Risk is sometimes external to the company due to changes in govt, policy or strategies of competitors or unforeseen market conditions. They may be internal due to fall in production, labour problems, raw material problems or inadequate supply of electricity etc. The Internal Business Risk leads to fall in revenues and in profit of the company, but can be corrected by certain changes in the company’s policies.

(ii) Financial Risk:
This relates to the method of financing, adopted by the company, high leverage leading to larger debt servicing problems or short¬term liquidity problems due to bad debts, delayed receivables and fall in current assets or rise in current liabilities. These Problems could no doubt be solved, but they may lead to fluctuations in earnings, profits and dividends to shareholders. Sometimes, if the company runs into losses or reduced profits, these may lead to fall in returns to investors or negative returns. Proper financial planning and other financial adjustments can be used to correct this risk and as such it is controllable.

(iii) Default or Insolvency Risk:
The borrower or issuer of securities may become insolvent or may default, or delay the payments due, such as interest instalments or principal repayments. The borrower’s credit rating might have fallen suddenly and he became’default prone and in its extreme form it may take to insolvency or bankruptcies. In such cases, the investor may get no return or negative returns. An investment in a healthy company’s share might turn out to be a waste paper, if within a short span, by the deliberate mistakes of Management or acts of God, the Company became sick and its share price tumbled below its face value.

Other Risks:
(i) Industry risk: Changes in the environment of a particular industry may introduce a great deal of risk and cause securities connected to that industry to decline. Diversification can help to counter this risk because industries don’t usually all underperform simultaneously.

(ii) Stock-specific risk: Events that impact a particular company can have a monumental effect on the company’s stock. The potential problems that can arise at-a given company can infuse a great deal of risk into a particular stock. Again, this type of risk can be combated by diversification because not all companies experience problems at the same time.

(iii) Liquidity risk: An investment may need to be sold before its maturity in order to extract the invested funds. Unfortunately, an insufficient secondary market may prevent the liquidation or limit the funds that can be generated from it. There can also be significant fees associated with liquidating some investments before a certain time. By the same token, the need to liquidate will eliminate the possibility of earning returns that would have been expected if the investment were held as long as expected.

(iv) Principal risk: There is always the possibility that through some set of circumstances, invested money will decrease or completely disappear. In this case, principal is lost in addition to returns and expected returns. If the invested money is essential, it will have to be replaced in some way.

(v) Currency risk: If money must be exchanged to make a certain investment, changes in the value of the currency relative to the American dollar will affect the total loss or gain on the investment when the money is converted back. This risk usually affects businesses, but it can also affect individual investors who make international investments.

(vi) Inflation risk: Although all investing decisions involve risk, simply not investing is not the answer. Inflation causes money to decrease in value at some rate. So inflation risk occurs whether you invest or not. It is up to you to choose investments that outpace inflation; otherwise, invested money will gradually lose value even if the principal invested is increasing at some rate. Thus theoritically risk can be minimised and eliminated but practically risk can be minimised but not totally eliminated in investment.

Question 3.
Explain the techniques of risk analysis.
Answer:
Three modern methods of risk analysis:

  • Sensitivity Analysis
  • Probability Analysis
  • Expected Values

1. Sensitivity Analysis:
Sensitivity analysis is a simulation technique in which key variables are changed and the resulting change in the rate of return or [the NPV] is observed. Some of the key variables are cost, prices, project life, market share, etc. The most practical way to do this is to select those variables whose estimated values may contain some significant errors or an element of uncertainty and then to calculate the effect of errors of different sizes on the present value of the project.

The common operating mechanism would be to vary each strategic variable by certain fixed percentages in both positive as well as negative directions in turn, say plus or minus 10% or plus or minus 5% etc. and study the effect of change on the rate of return [or on NPV].
It is an effective tool to handle risk in project appraisal. However, there are certain limitations in using this tool.
(a) Unless the combined effect of change in a set of Inter-correlated variables is examined, single variable sensitivity testing could be worse than useless. It may lead to wrong conclusions. Hence, it is a very difficult task.

(b) The second limitation lies in the fact that the values of the variables are generally changed in an arbitrary manner by say 5% or 10% to examine the effect on the returns. Unless it is done in a meaningful manner, it might mislead the investor.

(c) The third one is that it ignores the chances associated with the different possible values of the components.

2. Probability Analysis:
Probability may be defined as a measure of some one’s opinion about the likelihood that an event (cash flow) will occur. The likelihood of occurrence normally ranges from 1 to 0 i.e., 100 per cent certainty to 100 per cent uncertainty. In this analysis, in the place of one single estimate a range of estimates and their associated probabilities are calculated. A probability distribution in its simplest form could be with a few estimates such as “optimistic”, “pessimistic” and “most likely”.

The real problem; however, is how this probability distribution can be obtained. Two types of probabilities which include objective and subjective are normally used for decision-making under uncertainty.

The objective probability is the probability estimate, which is based on a very large number of observations. Subjective probabilities are those probability measures, which are based on the state of belief of a person rather than the objective evidence of a large number of trials. As the capital expenditure decisions are mostly non-repetitive and not made under identical situations, only.subjective probabilities are useful.

3. Expected Values [EV]:
EV is the sum of products of estimated outcomes and their respective probabilities. In advance, while uncertainty refers to a situation where such probability distribution cannot be objectively known, but only guessed. However, in the case of investment decisions, such a theoretical distinction is hypothetical and may not serve much useful purpose in practice. Even the best estimates of the project manager regarding the probability of the expected cash flows materializing and their magnitude are only subjective guesses. Hence, both risk and uncertainty are used interchangeably to mean the same thing.

Some of the factors, which add to the degree of risk or uncertainty of an investment, are the possibilities of –

  • The process or product becoming obsolete
  • Declining demand for the product
  • Change in government policy on business
  • Price fluctuations
  • Foreign exchange restrictions
  • Inflationary tendencies

Question 4.
Explain briefly exchange rate fluctuations.
Answer:
Exchange rate fluctuations are the increases or decreases in the value of a currency as against the other currency at international levels. These fluctuations are a part of international financial markets. The exchange rate regime is the way a country manages its currency in respect to foreign currencies and the foreign exchange market. The changes in the value of one currency against another country’s currencies is termed to be exchange rate fluctuations.

In India, RBI acts as the Exchange Control Authority. Its one of the important functions is maintenance of external value of the rupee. The dealings in foreign exchange and foreign securities in India, payments to person resident outside and export and import of currency notes, bullion or precious stones etc. are subject to general or special permissions of RBI or are prohibited. The types of transactions that are controlled by the RBI and the government of India are in general and include the following important items :

  • Purchase and sale and other dealings in foreign exchange and maintenance of balances at foreign centres by residents.
  • Procedure for realisation of proceeds of exports of goods and services.
  • Payments to non-residents or to their accounts in India for imports and others.
  • Transfer of securities as between residents and non-residents and acquisition and holding of foreign securities.
  • Foreign travel
  • Export and import of currency, cheques, drafts, travellers cheques and other financial instruments, securities, gold, jewelleries etc.
  • Trading commercial and industrial activities in India of. foreign companies, employment etc.
  • Acquisition, holding and disposal of immovable property in Or outside India by foreigners or Indian residents.

Question 5.
What is foreign exchange exposure? Discuss the three kinds of exposures.
Answer:
Foreign exchange Exposure is sensitivity of real value of an undertaking’s, assets, liabilities, or operating incomes, expenses in its functional currency to unanticipated changes in Exchange rates.

The three kinds of exposures are explained as follows:
(i) Economic exposure: Economic exposure can be defined as the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. Any anticipated changes in. exchange rates would have been already discounted and reflected in the firm’s value.. The changes’ in exchange rates can have a profound effect on the firm’s competitive position* in the world market and thus on its cash flows and market value.

(ii) Transaction exposure: Transaction exposure can be defined as the sensitivity of realized domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Transaction exposure arises from fixed price contracting in a world where exchange rates are changing randomly.

(iii) Translation exposure: Translation exposure refers to the potential that the firm’s consolidated financial statements can be affected by changes in exchange rates. Consolidation involves translation of subsidiaries’ financial statements from local currencies to the home currency.

Question 6.
Explain the various tools and techniques of foreign exchange risk management.
Answer:
Foreign exchange risk management is linked with unexpected fluctuations in the value of currency. It consists of spot, forward and future market. The various tools and techniques of foreign exchange risk management are as follows:
(i) Managing transaction exposures: A transaction exposure arises, when even a company is committed to a foreign currency denominated transaction entered into before the change “in exchange rate. So it basically refers to the extent to which the future value of firm’s domestic cash flow is affected by exchange rate fluctuation.

The various methods of managing transaction exposures are:

  • Forward market hedge
  • Money market hedge
  • Options market hedge
  • Exposure netting.

In a forward market hedge, a company that is long in a foreign currency will sell the foreign currency forward, where as a company that is short in a foreign currency will levy the currency forward. In this way the company can fix the dollar value of future foreign currency cash flow.

A money market hedge involves simultaneous borrowing and lending activities in two different currencies to lock in the home currency- value of a foreign currency cash flow. Currency option nullify the uncertainty which the firms faces, whether they should yo for hedging of foreign currency cash inflows or outflows.

Lastly, exposure netting involves off-setting exposures in one currency with exposures in the same or other currency, where exchange rates are expected to move in such a way that losses (gains) on the first exposed position should be offset by gains (losses) on the second currency exposure.

(ii) Exchange exposures: There are various methods available by which a firm can hedge exchange exposures if it wishes.
There is no thumb rule that firm should hedge. But at the corporate level there are various resource available in favour of exposure management:

  • Information asymmetry: Management is aware about the firm’s exposure position much better than share holders, so management should manage exchange exposure.
  • Transaction cost: The firm is in a better position to acquire low cost hedges and hence transaction costs can be significantly reduced.
  • Default cost: In corporate hedging, profitability of default is significantly lower. This in turn, can lead to a better credit rating and lower financing costs.

(iii) Managing economic exposures: Economic exposure refers to the extent to which the economic value of a company can decline due to changes in exchange rate. It is basically the overall impact of exchange rate changes due to changes in exchange rate.

Managing economic exposure is very important in the long run health of an for the organisation than managing transaction or translation exposure. The following are some proactive marketing and production strategies which a firm can pursue in response to anticipate or real exchange rate changes

Marketing Initiatives:
(i) Marketing selection: Market selection is the main important factor for an exporter. Foreign currency devaluation and home currency depreciation should be taken care of.

(ii) Pricing strategy: Pricing strategy is another very crucial aspect of managing economic exposure. A firm selling overseas should follow a standard economic proposition of setting the price that maximizes dollar profit.

(iii) Product strategy: Exchange rate changes can also be responded by using the new product development strategy which consists of two major components –

  • Product line decisions
  • Product innovations

(iv) Promotional strategy: Promotional strategy should be taken into consideration for anticipated exchange rate changes. A key issue in any marketing programme is the size of the promotional budget.

Production Initiatives:
(i) Product sourcing: MNC’s with worldwide production systems can allocate production among their several plans in line with the changing home currency cost of production, increasing production in a notion whose currency has devaluated and -decreasing production in a country where there has been a revaluation.

(ii) Plant location: A firm whose currency has devaluated and who exports to other countries find suitable to establish in the third country.

(iii) Input mix: Out sourcing is one of the solutions for devaluing currency and it gives flexibility to shift purchases of intermediate inputs towards suppliers which is least affected by exchange rate changes.

(iv) Raising productivity: Raising productivity through closing inefficient plants, automating heavily and negotiating wage and work rule concession is another alternative to manage economic exposure.

Question 7.
Explain the nature of country risk analysis. OR Discuss the various country risk indicators.
Answer:
Country risk is an indispensable tool for asset management as it requires the assessment of economic opportunity against political odds.
The factors that affect the country risk can be divided into two parts:

  • Political Factors
  • Economic factors

The various indicators of political and economic factors are discussed below:
I. Political risk Indicators : Political risk indicators are very difficult to measure for a particular country. Some of the common forms of political risk indicators include:
(i) Stability of local political environment: The political risk of each of the nations are analysed here. Measures like cognizance of changes in the government, levels of violence, internal and external conflict etc. are used.

(ii) Consensus regarding priorities: This measures the degree of agreement and unity on fundamental objectives of government policy and the extent to which this consensus cuts across party lines.

(iii) Attitude of host government: A variation will be when the MNC’s satisfy the needs, wants and demands of the local people, but faces the hostile attitude of the host government.

(iv) War: If war is possible, then the safety of hired people/employees would be affected and at the same time the cash inflows will be uncertain in nature.

(v) Mechanisms for expression of discontent: This is related to the ability of effecting peaceful change, providing internal continuity to alter direction of policy without major changes of political system.

II. Economic Risk Indicators: Economic factors also should be considered while assessing country risk: Some of the economic factors can be as follows –
(i) Inflation rate: Inflation rate is used to measure the economic instability, disruption and government mismanagement and also affects the purchasing power of consumers.

(ii) Current and potential state of country’s economy: The company, which is having a subsidiary to another country and/or exports is highly concerned, with the country’s demand for the product, as this demand is strongly influenced by country’s economy.

(iii) Resource Base: The resource base of a country consists of its natural, human and financial resources. Effective and efficient use of these resources will have less economic risk and vice versa.

(iii) Resource Base: The resource base of a country consists of its natural, human and financial resources. Effective and efficient use of these resources will have less economic risk and vice versa.

(iv) Adjustment of external shocks: The ability of a country to handle external shocks is another important factor in economic analysis.

Question 8.
Explain the risk return trade-off for current asset financing.
Answer:
A firm can adopt different financing policies in relation to current assets. Three types of financing may be distinguished.
Long Term Financing – The sources of long term financing include ordinary share capital, preference share capital, debentures, long term borrowings from financial institutions and retained earnings.

Short Term financing: It is obtained for a period less than one year. It is arranged in advance from banks and other suppliers of short term finance in the money market.

Spontaneous financing: It refers to the automatic sources of short term funds arising in the normal course of a business. Trade credit and outstanding expenses are examples of this type.

Short Term Vs Long Term Financing: A Risk – Return Trade – off. A firm should decide whether or not it should use short term financing. If short term financing has to be used, the firm must determine its portion in total financing. This decision of the firm will be guided by the risk-return trade – off. Short term financing may be preferred over long term financing for the reasons: (i) the cost advantage and (ii) flexibility. But short term financing is more risky than long term financing.

Cost: The justification for the higher cost of long term financing can be found in liquidity preference theory. This theory state that since lenders are risk averse, and risk generally increases with the length of lending time, most lenders would prefer to make short term loans. The only way to induce these lenders to lend for longer periods is to offer them higher rates of interest. Both short term and long term financing have a leveraging effect on shareholder’s return. But the short term financing ought to cost less than the long term financing; therefore it gives relatively higher return to shareholders.

Flexibility: It is relatively easy to refund short term funds when the need for funds diminishes. Long term funds such as debentures cannot be refunded before time.

Risk: Although short term financing may involve less cost, it is more risky than long term financing. If the firm uses short term financing to finance its current assets, it runs the risk of renewing, borrowings again and again.

It may be difficult for the firm to borrow during stringent credit periods. At times, the firm may be unable to raise any funds and consequently, its operating activities may be disrupted. In order to avoid failure/the firm may have to borrow at most inconvenient terms. These problems are much less with long term funds.

Risk-Return Trade-off: Thus, there is a conflict between long term and short term financing. Short term financing is less expensive but at the same time involves greater risk than long term financing. The choice between long term and short-term financing involves a trade off between risk and return.

Risk Management Short Answer Type Questions

Risk Management Short Answer Type Questions

Question 1.
Explain the process of risk management.
Answer:
The process used to systematically manage pure risk exposures is known as risk management. The risk management process consists of four steps:
(i) Identify risk: There are many potential risks that confront individuals and businesses. The risk management process is concerned primarily with the identification of the relevant exposures to pure risks.

(ii) Evaluating risks: For each source of pure risks that is identified, an evaluation should be performed. In this stage, risk can be categorized as to how often associated loses are likely to occur.

(iii) Select risk management techniques: The results of the analysis in step 2 are used as the basis of making decision regarding ways to handle risks.

(iv) Implement and review decisions: The business or individual must implement the techniques selected.

Question 2.
Explain foreign exchange risk.
Answer:
International business can reduce the international risk exposure to its home market but increases its exposure in following:
(i) Exchange rate movements: Most international business results in the exchange of one currency for another to make payment. Exchange rate fluctuates and due to that, the cash outflow also changes.

(ii) Foreign Economic condition: When multinational companies enter into the foreign markets to sell their product, the demand for these products will depend on the economic conditions in those markets.

(iii) Political risk: When MNC’s establish subsidiaries in foreign countries, they are, exposed to political risk.
It actually represents political actions taken by the host government or the public that affect the MNC’s cash flows.

Question 3.
What are the features of foreign exchange risk management?
Answer:
The foreign exchange risk management consists of spot market, forward and future market. The spot market deals with foreign exchange, delivered within 2 days or less. On the other hand, forward market deals with foreign exchange which is delivered in 3 days or more.

Exchange rate is one of the crucial factor, considered by MNC’s because rate fluctuation directly affect the sales revenue of firm’s exporting goods and services. Foreign exchange risk is the possibility of a gain or loss to a firm that occurs due to anticipated changes in the exchange rate.

The salient features of foreign exchange risk management are as follows:

  • It consists of spot, forward and future market
  • There can be a possible gain or loss because of exchange rate fluctuation.
  • It directly affects the sales revenue of MNC’s
  • It has more importance because MNC’s operate in multiple currencies.

Question 4.
Why do companies involved in international.trade hqve te hedge their foreign exchange exposure.
Answer:
Companies involved in international trade have to hedge their foreign exchange exposure for various reasons. In deciding whether to hedge foreign exchange exposure, Merck focused on the objective of maximizing long term cash flows and on the potential effect of exchange rate movements on the firms ability to meet its strategic objectives. This focus is ultimately intended to maximize shareholders wealth. The company has a large portion of earning generated overseas. While a disproportionate share of costs is incurred in dollars.

Volatile cash flows can adversely affect the firm’s ability to implement the strategic plan, especially investments in RBD that form the basis for future growth. To succeed in a highly competitive industry, the company needs to make a long term commitment’to a high level of research funding. Having selected currency options as the key hedging vehicle, the company still had to formulate an implementation strategy regarding the term of the hedge, the strike price of the currency options of income to be converted.

Question 5.
Discuss Hedging of Transaction Exposure.
Answer:
Transaction Exposure is typically defined as the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. Such exposure includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies.

A transaction exposure arises, when even a company is committed to a foreign currency denominated transaction entered into before the change in exchange rate. So it basically refers to the extent to which the future value of firm’s domestic cash flow is affected by exchange rate fluctuation.
The various methods of managing transaction exposures are:

  • Forward market hedge
  • Money market hedge
  • Options market hedge
  • Exposure netting.

In a forward market hedge, a company that is long in a foreign currency will sell the foreign currency forward, where as a company that is short in a foreign currency will levy the currency forward. In this way the company can fix the dollar value of future foreign currency cash flow.

A money market hedge involves simultaneous borrowing and lending activities in two different currencies to lock in the home currency value of a foreign currency cash flow. Currency option nullify the uncertainty which the firms faces, whether they should go for hedging of foreign currency cash inflows or outflows.

Lastly, exposure netting involves off-setting exposures in one currency with exposures in the same or other currency, where exchange rates are expected to move in such a way that losses (gains) on the first exposed position should be offset by gains (losses) on the second currency exposure.

Risk Management Very Short Answer Type Questions

Risk Management Very Short Answer Type Questions

Question 1.
What is risk? What are types of risk?
Answer:
The quantifiable likelihood of loss or less-than-expected returns. Examples: currency risk, inflation risk, principal risk, country risk, economic risk, mortgage risk, liquidity risk, market risk, opportunity risk, income risk, interest rate risk, prepayment risk, credit risk, unsystematic risk, call risk, business risk, counterparty risk, purchasing-power risk, event risk.

Question 2.
What is internal risk?
Answer:
Internal Risks are those risks which arise from the events taking place within the business enterprise. Such risks arise during the ordinary course of a business. These risks can be forecasted and the probability of their occurrence can be determined.

Question 3.
What is external risk?
Answer:
External risks are those risks which arise due to the events occurring outside the business organisation. Such events are generally beyond the control of an entrepreneur. Hence, the resulting risks cannot be forecasted and the probability of their occurrence cannot be determined with accuracy.

Question 4.
State various sources of risk.
Answer:
The various sources of business risk are as follows:

  • Customer risk
  • Technical risk
  • Delivery risk

Question 5.
What is risk Management?
Answer:
Risk management can be defined as a process used to manage systematically pure risk exposures. It is a procedure to minimize the adverse effect of a possible financial loss by –

  • identifying potential sources of loss
  • measuring the financial consequences of a loss occurring
  • using controls to minimize, actual losses or their financial consequences.

Question 6.
What do you mean by Risk analysis?
Answer:
Risk analysis is the process of defining and analyzing the dangers to individuals, businesses and government agencies posed by potential natural and human-caused adverse events.

Question 7.
What is risk management planning?
Answer:
Risk management planning is the process of developing the risk management plan through the process of identifying risks, assessing risks and developing strategies to manage risks.

Question 8.
What do you mean by Risk control?
Answer:
Risk control is a method by which firms evaluate potential losses and take action to reduce or eliminate such threats. Risk control is a technique that utilizes findings from risk assessments and implementing changes to reduce risk in these areas.

Question 9.
What is transfer of risk?
Answer:
Risk transfer is a risk management and control strategy that involves the contractual shifting of a pure risk from one party to another. One example, is the purchase of an insurance policy, by which a specified risk of loss is passed from the policyholder to the insurer.

Question 10.
What is hedging?
Answer:
Hedging is an investment made in order to reduce the risk of adverse price movements in a security, by taking an offsetting position in a related security, such as an option or a -short sale.

Question 11.
What are Hedging instruments?.
Answer:
A hedging instrument is a designated financial instrument whose fair value or related cash flows should offset changes in the fair value or cash flows of a designated hedged item.

Question 12.
Why do foreign exchange rates fluctuate?
Answer:
The foreign exchange rate fluctuates because of the changes in the demand and supply position of foreign currency in the world market.

Business Valuation Questions and Answers

Business Valuation Questions and Answers

SECTION – A

Question 1.
What is valuation/business valuation?
Answer:
Valuation is the process, of determining the current worth of an asset or a company; there are many techniques used to determine value. An analyst placing a value on a company looks at the company’s management, the composition of its capital structure, the prospect of future earnings and market value of assets.

Question 2.
What is Share?
Answer:
Shares are units of ownership interest in a corporation or financial asset that provide for an equal distribution in any profits, if any are declared, in the form of dividends. The two main types of shares are common shares and preferred shares.

Question 3.
What is the efficient market hypothesis?
Answer:
The efficient market hypothesis is the hypothesis that the stock, market reacts immediately to all the information that is available. Three forms of the efficient market hypothesis can explain the theory behind share price movements.

SECTION – B

Question 1.
Explain the Nature and purpose of the valuation of business.
Answer:
The Nature and Purpose of Business Valuations:
(A) When valuations are required – A share valuation will be necessary:
(a) For quoted companies, when there is a takeover bid and the offer price is an estimated fair value in excess of the current market price of the shares.

(b) For unquoted companies, when:

  • the company wishes to go public and must fix an issue price for its shares.
  • there is a scheme of merger.
  • shares are sold.
  • shares need to be valued for the purposes of taxation.
  • shares are pledged as collateral for a loan.

(c) For subsidiary companies, when the group’s holding company is negotiating the sale of the subsidiary to a management buyout or to an external buyer.

(d) For any company, where a shareholder wishes to dispose of his or her holding.

(e) For any company, when the company is being broken up in a liquidation situation or the company needs to obtain finance, or re-finance current debt.

(B) Information requirements for valuation: There is wide range of information that will be needed in order to value a business.

  • Financial statements: statement of financial positions, income statements, statements of shareholders equity for the past five years.
  • Summary of non-current assets list and depreciation schedule.
  • Aged accounts receivable summary.
  • Aged accounts payable summary.
  • List of marketable, securities.
  • Inventory summary.
  • Details of any existing contracts, e.g. leases, supplier agreements.
  • List of shareholders with number of shares owned by each.
  • Budgets or projections, for a minimum of five years.

Question 2.
Explain the Net Assets Method of valuation of Share.
Answer:
Net assets method of valuation of share:
Under this method, the net value of assets of the company are divided by the number of shares to arrive at the value of each share. For the determination of net value of assets, it is necessary to estimate the worth of the assets and liabilities. The goodwill as well as non-trading assets should also be included in total assets. The following points should be considered while valuing of shares according to this method:

  • Goodwill must be properly valued.
  • The fictitious assets such as preliminary expenses, discount on issue of shares and debentures, accumulated losses etc. should be eliminated.
  • The fixed assets should be taken at their realizable value.
  • Provision for bad debts, depreciation etc. must be considered.
  • All unrecorded assets and liabilities ( if any) should be considered.
  • Floating assets should be taken at market value.
  • The external liabilities such as sundry creditors, bills payable, loan, debentures etc. should be deducted from the value of assets for the determination of net value.

The net value of assets, determined so has to be divided by number of equity shares for finding out the value of share. Thus the value per share can be determined by using the following formula: Value Per Share=(Net Assets- Preference Share Capital)/Number Of Equity Shares.

Question 3.
Explain the Market Value Method of valuation of Share.
Answer:
Market value method of valuation of shares:
The expected rate of return in investment is denoted by yield. The term “rate of return” refers to the return which a shareholder earns on his investment. Further it can be classified as (a) Rate of earning and (b) Rate of dividend. In other words, yield may be earning yield and dividend yield.
(a) Earning Yield:
Under this method, shares are valued on the basis of expected earning and normal rate of return. The value per share is calculated by applying following formula:
Value Per Share = (Expected rate of earning/Normal rate of return) x Paid up value of equity share
Expected rate of earning – (Profit after tax/paid up value of equity share) x 100

(b) Dividend Yield:
Under this method, shares are valued on the basis of expected dividend and normal rate of return. The value per share is calculated by applying following formula:
Expected rate of dividend – (profit available for dividend/paid up equity share capital) x 100
Value per share = (Expected rate of dividend/normal rate of return) x 100

Question 4.
Explain the Earning Capacity Method of valuation of Share.
Answer:
Earning capacity method of valuation of shares:
Under this method, the value per share is calculated on the basis of disposable profit of the company. The disposable profit is found out by deducting reserves and taxes from net profit. The following steps are applied for the determination of value per share under earning capacity:
Step 1: To find out the profit available for dividend

Step 2: To find out the capitalized value
Capitalized Value =( Profit available for equity dividend/Normal rate of return) x 100

Step 3: To find out value per share
Value per share = Capitalized Value/Number of Shares
The valuation of debt and other financial assets

Question 5.
Write short note on efficient market hypothesis.
Answer:
The efficient market hypothesis is the hypothesis that the stock market reacts immediately to all the information that is available. Three forms of the efficient market hypothesis can explain the theory behind share price movements. These are:

Weak form efficiency:
Weak form efficiency implies that prices reflect all relevant information about past price movements and their implications. Share prices reflect all available information about past changes in the share price. Since new information arrives unexpectedly, changes in share prices should occur in a random fashion. Technical analysis to study past share price movements will not give anyone an advantage, because the information they use to predict share prices is already reflected in the share price.

Semi-strong form efficiency:
Semi-strong form implies that share prices reflect all relevant information about past price movement and their implications, and all knowledge that is available publicly. Therefore, an individual cannot beat the market by reading the newspaper or annual reports since the information contained in these will be reflected in the share price.

Strong form efficiency:
This implies that prices reflect past price movements, publicly available knowledge and inside knowledge.

What are the different types of efficiencies in the context of the operation of financial markets?
1. Allocative efficiency: Allocative efficiency can be achieved if financial markets allow funds to be directed towards firms that make the. most productive use of them.

2. Operational efficiency: Operational efficiency can be achieved if there is open competition between brokers and other market participants so that transaction costs are kept as low as possible.

3. Informational processing efficiency: Information processing efficiency of a stock market can be achieved if the stock market is able to price stocks and shares fairly and quickly because market prices of all securities reflect all the available information.

Question 6.
State the features of efficient market.
Answer:
Features of an efficient market:

  • The prices of securities bought and sold reflect all the relevant information that is available to buyers and sellers.
  • No individual dominates the market.
  • Transaction costs of buying and selling are not so high as to discourage trading significantly.
  • Investors are rational.
  • There are low to no costs of acquiring information.

Business Finance Long Answer Type Questions

Business Finance Long Answer Type Questions

Question 1.
Explain various Long Term Sources of Finance.
OR
Explain in detail long term sources of raising capital.
Answer:
The various sources of finance have been classified as follows:
(A) Security/External Financing: Corporate securities can be classified under two categories:

  • Ownership Securities or Capital Stock
  • Creditorship securities or Debt Capital

(i) The term Ownership securities represents shares. Shares are the most universal form of raising long term funds from the market. The capital of a company is’ divided into a number of equal parts known as shares. Companies issue different types of shares to mop up funds from investors. The various kinds of shares are discussed as follows:
(a) Equity Shares: Equity shares are also known as ordinary shares or common shares and represent the owners capital in a company. The holders of these shares are the real owners of the company. They control the working of the company. The rate of dividend on these shares depends upon the profits of the company. Equity capital is paid after meeting all other claims including that of preference shareholders. Equity share capital cannot be redeemed during the lifetime of the company.

Public Issue of Equity means raising of share capital directly from the public. As per the existing norms, a company with a track record is free to determine the issue price for its shares. Thus, it can issue shares at a premium. However, a new company has to issue its shares at par.

Private Placement involves sale of shares by a company to few selected investors, particularly the institutional investors like UTI, LIC and IDBI.

Rights issue involves selling of ordinary shares to the existing shareholders of the company. Law in India requires that new ordinary shares must be first issued to existing shareholders on a pro-rata basis. This pre-emptive right can be forfeited by shareholders through a special resolution.

(b) Preference Shares: These shares have certain preferences as compared to other types of shares. There is a preference for payment of dividend and there is a preference for repayment of capital at the time of liquidation of the company. A fixed rate of dividend is paid on preference share capital. Preference shareholders do not have any voting rights and hence they have no say in the management of the company. However, they can vote if their own interests are affected.

(c) Deferred Shares: Also known as Founders Shares, these shares were earlier issued to promoters or founders for services rendered to the company. These shares rank last so far as payment of dividend and repayment of capital is concerned. These shares are generally of a small denomination.

(ii) Creditorship Securities, also known as ‘debt capital’, represents debentures and bonds. A debenture is an acknowledgement of a debt. It is a long-term promissory note for raising loan capital. A debenture or bondholder is a creditor of the company. A fixed rate of interest is paid on debentures. The debentures are generally given a floating Charge over the assets of the company. They are paid on priority in comparison to all other creditors.

(B) Internal Financing
(i) 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.

(ii) Depreciation as a source of funds Depreciation may be regarded as the capital cost of assets allocated over the life of the asset. It is a gradual decrease in the value of asset due to wear and tear, use and passage of time. In reality depreciation is simply a book entry having the effect of reducing the book value of the asset and profits of the current year for the same amount.

It is a non fund item. Hence, although depreciation is an operating cost there is no actual outflow of cash and so the amount of depreciation charged during the year is added back to profits while finding funds from operations. It is an indirect source of fund as it helps a concern to effect savings in taxes and dividends. However this is true only if the concern is making profits.

Question 2.
Explain the factors influencing the determination of the capital structure of a company.
Answer:
The following factors have practical implications for-capital structure of a business enterprise.
Control: The management control over the firm is one of the major determinants of capital structure decisions. The equity shareholders are considered as the real owners of the company, since they can participate in the decision making through the BOD. Preference shareholders and debentures holders cannot participate in decision making.

Risk: Risk and return always go hand in hand. Business risks are influenced by demand price, input costs, fixed costs, business cycles, competition etc. The business risk of a firm is determined by the accumulated investments the firm makes over time. A firm with high business risk prefer to have low levels of debt, since the volatility of its earnings is-more. A firm with low level of business risk can have higher debt component in capital structure, since the risk of variations in expected earnings is lower.

Income: Increase of return on equity shareholders depends on the method of financing and its impact on EPS and ROE. If the levels of EBIT is low from EPS point of view, equity is preferable to debt. If the EBIT is high from EPS point of view, debt financing is preferable. IF the ROI is less than the cost’ of debt, financial leverage depress ROE. When the ROI is more than cost of debt, financial leverage enhances ROE.

Tax Consideration: Under the provisions of the IT Act,, the dividend payable on equity capital and preference capital is not tax deductible, causing the high cost of such funds. Interest paid on debt is deductible from income and reduces a firm’s tax liabilities. The tax saving on interest charges reduces the cost of debt funds, Debt, thus, has tax advantage over equity.

Cost of capital: Cost of different components of capital will influence the capital structuring decisions. A firm should possess earning power to generate revenues to meet its cost of capital and finance its future growth. The cost of debt funds are cheaper as compared to cost of equity funds due to tax advantage. . But increased gearing causes the increase in expectations of debt providers for accepting more risk.

Trading on Equity: The basic objective of financial management is to enhance the wealth of the firm by increasing the market value of the share. The firm’s wealth is increased, if after tax earnings are increased. A company raises debt at low cost with a view to enhance the earnings of the equity shareholders.

Investors attitude: In a segmented market, different sets of investors measure risk differently or by simply charging different rates on the capital that they invest. By. choosing the instrument that taps the cheapest market, firms lower their cost of capital.

Flexibility: Debt capital has got the characteristic of greater flexibility than equity capital and this influences the capital structure decisions. As and when required, debt may be raised and it can be paid off as and when desired.

But in case of equity, once the funds are raised through the issue of equity shares, it cannot ordinarily be reduced except with the permission of the court and compliance with a lot of legal obligations.

Market conditions: In times of boom, it is easier to raise equity, but in times of recession, the equity investors will not show much interest and the firm has to rely on debt funds.

Legal Provisions: Raising of equity capital is mote complicated than raising debt.

Profitability: A company with higher profitability will have low reliance on outside debt and it will meet its additional requirements through internal, generation.

Growth Rate:Fast growing companies reply more on debt than on equity.

Government policy: Monetary and fiscal policies of the government also affect capital structure decisions.

marketability: The company’s ability to market its securities will affect the capital structure decisions.

Company size: Companies with small capital base rely more on owner’s funds and internal earnings.

Purpose of financing: Long term projects are financed through long term sources and in the form of equity. Short term projects are financed by issue of debt instruments and by raising of term loans from banks and financial institutions.

Question 3.
Explain two different theories or approaches of capital structure.
Answer:
As far as the concept of capital structure is concerned a number of eminent scholars have made th^ir respective contributions. Few among them are David Durand, Ezra Solomon, Modigliani and Miller etc.

According to David Durand who has rightly said that there cannot be an optimal capital structure. He classifies the theory of capital structure into two extreme views. They are: (a) Net income approach (b) Net operating income approach

(a) Net income approach (NIA): Under this approach, the cost of equity capital and cost of debt capital are assumed to be independent to the capital structure. The value of the firm rises by the use of more and more leverage and the weighted average cost of capital declines.

The crucial assumptions of this approach are:

  • The use of debt does not change the risk perception of investors, as a result, the equity capitalisation rate and the debt capitalisation rate remain constant with changes in leverage.
  • The debt capitalisation rate is less than the equity capitalisation rate
  • Corporate income taxes do not exist

(b) Net operating income approach (NOIA): Under this approach, the cost of equity increases in accordance with leverage. Due to which the weighted average cost of capital remains constant and the value of the firm also remains constant as leverage is changed.

The critical assumptions of the NOIA approach are:

  • The market capitalises the value of the firm as a whole. Thus the split between debt and equity is not important.
  • The market uses an overall capitalisation rate to capitalise the net operating income. This rate depends on the business risk. If business risk is assumed to remain unchanged, the capitalisation rate is a constant.
  • The use of the costly debt funds increases the risk of shareholders. This causes the equity capitalisation rate to increase. There the advantage of debt is offset exactly by the increase in equity capitalisation rate.
  • The debt capitalisation rate is a constant
  • Corporate income taxes do not exist.

Practical Problems

Problems on Cost of Capital:

Question 1.
AB Ltd. issues ₹ 1,00,000 9% debentures at a premium of 10%.
Solution:
Cost of Debt = Ki = \(\frac { I }{ Np }\) x (1 – T)
Np = 1,00,000 + 10% premium – Floatation cost
= 1,00,000 + 10,000 – 2,500 = 1,07,500
Ki = 9,000/1,07,500 (1 – 0.5) x 100 = 4.18 %

Question 2.
What is the net benefit cost ratio when benefit cost ratio is 1.40:1?
Solution:
Benefit cost ratio = 1.40:1
Total revenue = 1.40
Cost = 1
Therefore Net benefit = 1.40 – 1
= 40
Therefore Net benefit cost ratio = 0.4 : 1

Question 3.
The Market price of the equity of a Ltd. Co. is ₹ 160. The dividend expected after a year is ₹ 12 per Share. The dividend is expected to grow at a constant rate of 4 percent per annum. Find the rate of return required by shareholders.
Solution:
γe = \(\frac{\mathrm{D} 1 \mathrm{~V}_{1}}{\mathrm{P}_{0}}\)
Where γe = Rate of return required by shareholders
D1V1 = Expected dividend
P0 = Current market price
g = Growth rate of dividends.
∴ ye = \(\frac { 12 }{ 160 }\) + 0.04 = 0.075 + 0.04
ye = 0.115 or 11.5%
Hence the rate of return required by shareholders is 11.5%

Question 4.
The expected average earnings per share of a company are ₹ 16 and the current market price of the shares is ? 160. Find out the cost of equity.

Question 5.
The market price of a share is ₹ 255. A company anticipated earnings of ₹ 3,00,000 to be distributable among 30000 shareholders. The tax rate is 30 per cent. Find out the cost of internally generated retained earnings.

Question 6.
The shares of a leather Company are selling at 60 per shares. The firm has paid dividend at the rate of ₹ 3 per share. The growth rate is 9%. Compute cost of equity capital of the company.
Kc = \(\frac { D }{ P }\) + g
= \(\frac { 3 }{ 60 }\) + 0.09
= 0.05 + 0.09
= 0.14 x 100
= 14%

Question 7.
20 years 20% debentures of a firm are sold at a rate of ₹ 180. The face value of the debenture is 200, 50% tax is assumed. Find the cost of debt.

Question 8.
A Ltd, company with net operating earnings ₹ 6,00,000 you want to evaluate possible capital structures, shown below, Which capital structure you will select? Why?

Question 9.
XYZ Ltd. Co; has the following securities In its capital structure.
Source – Amount(₹)
Debt – 6,00,000
Preference capital – 4,00,000
Equity capital – 10,00,000
Total – 20,00,000
The after tax cost of capital is as follows
After tax cost
Cost of debt – 8%
Cost of preference shares – 14%
Cost of equity capital – 17%
From the above information compute weighted average cost of capital by using the book value weights.

Question 10.
Mr. Kiran is considering to purchase 20% ₹ 2,000 preference share redeemable after 6 years at par. What should he be willing to pay now to purchase the share assuming that the required rate of return is 14%.

Question 11.
A company issues a new 15% debentures of ₹ 1,000 face value to be redeemed after 10 years. The debentures are expected to be sold at 5% discount. It will also involve flotation cost of 5%. The company’s tax rate is 30%. What would be the cost of debt?

Question 12.
XYZ Company has debentures outstanding with 5 years left before maturity. The debentures are currently selling for ₹ 90 (face value is 100 ₹) The debentures are to be redeemed at 5% premium. The interest is paid annually at a rate of interest of 12%. The firm’s tax rate is 35%. Calculate Kd.

Question 13.
Alfa Ltd., with net operating earnings of ₹ 3 lakhs is attempting to evaluate a ,number of capital structures given below. Which of the capital structure will you recommend and why?

Question 14.
Kishan Limited wishes to raise additional finance of ₹ 20 Lakh for meeting its investment plans. It has ₹ 4,20,000 in the form of retained earnings available for Investment purposes. The following details are available.
1. Debt /equity mix 30% : 70%
2. Cost of debt upto ₹ 3,60,000 – 10% (Before tax)
Cost of debt beyond ₹ 3,60,000 – 16% (Before tax)
3. Earnings per share: 4
4. Dividend payout : 50% of earnings
5. Expected growth rate of dividend: 10%
6. Current market price: 44
7. Tax rate: 50%
You are required:
a. To determine the pattern for raising the additional finance.
b. To determine the post-tax average cost of additional cost.
c. To determine the cost of retained earnings and cost of equity.
d. Compute the overall weighted average after tax cost of additional finance.

Question 15.
Varsha Ltd. wishes to raise additional finance of ₹ 10 lakhs for meeting its investment plans. It has ₹ 2,10,000 in the form of retained earnings available for investment purposes. The following are the further details.
(a) Debt / Equity mix – 30% 70%
(b) Cost of debt
up to 1,80,000 – 10% (before tax)
beyond ₹ 1,80,000 – 16% (before tax)
(c) Earnings per share – ₹ 4
(d) Dividend payout – 50%
(e) Expected growth rate in dividend – 10%
(f) Current market price per share – ₹ 44
(g) Tax rate – 50%
You are required.
(a) To determine the pattern for raising additional finance.
(b) Compute the weighted average cost of capital.

Question 16.
Thee companies A,B, and C are in the same business and hence have similar operating risks. However, the capital structure of each firm is different.

Problems On Capital Structure

Question 1.
It is proposed to start a business requiring capital of ₹ 10 lakhs and expected return is 15%. Calculate EPS if
(a) Total capital required is financed by was of ₹ 100 equity.
(b) Is financed by way of 50% equity and 50% debt (10% Interest)
Note Tax rate 50%

Question 2.
The P Ltd, has equity share capital of ₹ 10,00,000 in shares of ₹ 10 each and debt capital of ₹ 10,00,000 at 20% interest rate. The output of the company is increased by 50% from 1,00,000 units to 1,50,000 units. Selling price per unit – ₹ 20, Variable cost per unit – ₹ 10, Fixed cost – ₹ 5,00,000, Tax rate – 40%.
You are required to calculate: (a) Percentage increase in EPS (b) Degree of operating leverage at 1,00,000 units and 1,50,000 units (c) Degree of financial leverage at 1,00,000 units and 1,50,000 units.

Question 3.
Determine the earnings per share of a company which has operating profit of ₹ 4,80,000. Its capital structure consists of the following securities.
Securities – Amount
10% debentures – 15,00,000
12% preference shares – 3,00,000
Equity shares of 100 ₹ each
The company is in the 55% tax bracket.
(1) Determine the company’s EPS (2) Determine the percentage change in EPS, associated with 30% increase and 30% decrease in EBIT. (3) Determine the degree of financial leverage.

Question 4.
A company needs ₹ 10,00,000 for construction of a new plant.
The following three financial plans are feasible.
(1) The company may issue 1,00,000 ordinary shares at ₹ 10 per share.
(2) The company may issue 50,000 ordinary shares at ₹ 10 per share and 5,000 debentures of ₹ 100 denomination bearing 8% rate of interest.
(3) The company may issue 50,000 ordinary shares at ₹ 10 per share and 5,000 preference shares at ₹ 100 per share bearing a 8% rate of dividend.
If the company’s earnings before interest and taxes are ₹ 20,000, ₹ 40,000, ₹ 80,000, ₹ 1,20,000 and ₹ 2,00,000 share. What are the earnings per share under each of the three financial plans? Which alternative would be recommended and why. Assume a corporate tax @ 50%.

Question 5.
The following information of a business concern is available who close their books of accounts on Dec 31st of every year. Calculate EPS and return on equity capital.
(a) 10,000 equity shares of 10 each and ₹ 8 paid up Rs 80,000
(b) 10% 12,000 preference shares of 10 each ₹ 1,20,000
(c) Profit before tax ₹ 80,000
(d) Rate of tax applicable 50%

Question 6.
The capital structure of ABC Ltd. consists of the following securities.
10% Debenture ₹ 5,00,000
12% Preference shares ₹ 1,00,000
Equity shares of ₹ 100 each ₹ 4,00,000
Operating profit (EBIT) of ₹ 1,60,000 and the company is in 50% tax bracket.
(1) Determine the company’s EPS.
(2) Determine the percentage change in EPS associated with 30% increse and 30% decrease in EBIT.
(3) Determine the financial leverage.

Question 7.
The Balance sheet of ABC company Ltd as on 31-12-2003 gives the following details.

Question 8.
A company has a capital of ₹ 2,00,000 divided into shares of ₹ 10 each It has major expansion programme requiring an investment of another ₹ 1,00,000. The management is considering the following alternatives for raising this amount.
(1) Issue of 10,000 shares of ₹ 10 each
(2) Issue of 10,000 12% preference shares of ₹ 10 each
(3) Issue of 10% debentures of ₹ 1,00,000
The, company’s present earnings before interest tax (EBIT) is ₹ 60,000 p.a. You are required to calculate the effect of each of the above modes of financing on the earnings per share (EPS) presuming:
(a) EBIT continues to be the same even after expansion
(b) EBIT increases by 20,000
(c) Assume tax liability as 50%

Question 9.
The Balance sheet of key Ltd on 31/12/2002
Balance Sheet

Liabilities Assets
Equity capital ₹ 10 per share 10% Debenture Retained earnings 1,20,000
1,60,000
1,20,000
Net fixed assets Current Assets 3,00,000
1,00,000
4,00,000 4,00,000

The company’s total turnover ratio is 3. Its fixed operating cost are ₹ 2,00,000 and the variable cost ratio is 40% The income tax rate is 50% a) Calculate for the company all the there types of leverages b) Determine the likely level of EBIT if EPS is ₹ 5.

Question 10.
The Balance Sheet of a company is as follows:

Liabilities Amount Assets Amount
Equity shares ₹ 10 each 10% Debenture P & L A/c Creditors 6,00,000
8,00,000
2,20,000
4,00,000
Fixed assets
Current Assets
15,00,000
5,00,000
20,00,000 20,00,000

The company’s total assets turnover ratio is 5 times. Its fixed operating expenses are ₹ 10,00,000 and variable cost is 30%. Income Tax 50%.
1) Calculate all the leverages
2) Show the likely level of EBIT if EPS is a) 5 b) 3 c) 2

Question 11.
Compare two companies in terms of its financial, operating leverages and combined leverage.

Question 12.
The Capital Structure of the Progressive Corporation Ltd. Consist of an Equity Share capital of ₹ 10,00,000 (shares of ₹ 10 par value) and ₹ 10,00,000 of 20% Debentures. Sales increased by 25% from 2,0, 000 units to 2,50,000, the selling price is ₹ 10 per unit, variable cost amount to ₹ 6 per unit and fixed expenses amount to ₹ 2,50,000. Income tax rate is assumed to be 50%.
You are required to calculate the following:
i) The percentage increase in EPS
ii) The DFL at 2,00,000 units and 2,50,000 units.
iii) The DOL at 2,00,000 units and 2,50,000 units.

Question 13.
A company has EBIT of 4,80,000 and its capital structure consists of the following securities.

Equity Share Capital (₹ 10 each) – 4,00,000
12% preference shares – 6,00,000
14.5% debentures – 10,00,000
The company is facing fluctuations in its sales. What would be the change in EPS.
(a) If EBIT of the company incresed by 25% and
(b) If EBIT of the company decreased by 25%. The corporate tax is 35%.

Question 14.
Omax Auto Ltd. has an equity share capital of ₹ 5,00,000 divided into shares of ₹ 1oo each. It wishes to raise further ₹ 3,00,000 for modernization. The company plans the following financing schemes:
(a) All equity shares
(b) ₹ 1,00,000 in equity shares and ₹ 2,00,000 in 10% debentures
(c) All in 10% debentures
(d) ₹ 1,00,000 in equity shares and ₹ 2,00,000 in 10% preference shares. The company’s EBIT is ₹ 2,00,000. The corporate tax is 50%. Calculate EPS in each case. Give a comment as to which capital structure is suitable.

Question 15.
A companys capital structure consists of the following:
Equity shares of ₹ 100 each ₹ 10,00,000
Retained earnings ₹ 5,00,000
9% Pref. shares ₹ 6,00,000
7% debentures ₹ 4,00,000
Total ₹ 25,00,000
The company earns 12% on its capital, the income tax rate is 50%. The company requires a sum of ?12,50,000 to finance its expansion programme for which the following alternatives are available.
(i) Issue of 10,000 equity shares at a premium of ₹ 25 per share.
(ii) Issue of 10% preference shares
(iii) Issue of 8% debentures.
It is estimated that the P/E ratios for equity, preference and debenture financing would be 21.4,17 and 15.7 respectively. Which of the three financing alternatives would you recommend and why?

Business Finance Short Answer Type Questions

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.

Business Finance Very Short Answer Type Questions

Business Finance Very Short Answer Type Questions

Question 1.
What, are sources of long term financing?
Answer:
The sources of long term financing include ordinary share capital, preference share capital, debentures, long term borrowings form financial institutions and retained earnings.

Question 2.
What are equity Shares?
Answer:
Equity shares are also known as ordinary shares or common shares and represent the owners’ capital in a company. The holders of these shares are the real owners of the company.

Question 3.
What are Preference Shares?
Answer:
Preference shares have a preference over the equity shares in the event of liquidation of company. The preference dividend rate is fixed and known. A‘ company may issue preference shares with a maturity period (redeemable preference shares). A preference share may also provide for the accumulation of dividend. It is called cumulative preference share.

Question 4.
What is trading on equity?
Answer:
Trading on equity means to raise fixed cost capital such as borrowed capita! and preference share capital on the basis of equity share capital so as to increasing the income of equity shareholders.

Question 5.
Define a debenture.
Answer:
According to Section 2(12) of the companies act of 1956. “Debenture is an instrument issued by a company under its common seal, acknowledging the debt to the holder, and containing an undertaking to repay the debt on or after a specified period and to pay interest on the debt at a fixed rate at regular intervals usually, half yearly etc. until the debt is paid.”

Question 6.
What is retained earning?
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.

Question 7.
What do you mean by term loan?
Answer:
Term loan refers to loan given for a particular period of time. It may be short or long period. Short term, which is less than a year. Medium term, which lies between two to five years. Long term, which is more than 5 years upto 20 years.

Question 8.
What is cost of capital?
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.

Question 9.
What do you mean by cost of equity capital?
Answer:
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.

Question 10.
What is cost of preferred capital?
Answer:
Cost of preference share capital is the rate of return that must be earned on preference capital financed investments, to keep unchanged the earnings available to the equity shareholders.

Question 11.
What is cost of debt capital?
Answer:
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.

Question 12.
What is weighted average cost of capital?
Answer:
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 each source of funds, to the total, is ascertained by considering either the book value or the market value of each source of funds.

Question 13.
What is capital structure?
Answer:
Capital structure is basically focussed towards the objective of profit maximisation. Capital structure is nothing but the financial structure of a firm, which consists of different combinations of securities. In other words it represents the relationship between the various long term forms of financing such as debentures, preference shares capital on equity etc.

Question 14.
What is optimal capital structure?
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.

Question 15.
What do you mean by flexible capital structure?
Answer:
Flexible capital structure means the capital structure of the firm should be flexible, so that without much practical difficulties, a firm can change the securities in capital structure.

Question 16.
What is capital expenditure?
Answer:
Capital expenditure refers to investment that involves huge amount, associated with high risk and the benefits from such investment are derived over a longer period of time.

Question 17.
What is leverage?
Answer:
Leverage is the employment of fixed assets or funds for which a firm has to meet fixed costs or fixed rate of interest obligation irrespective of the level of activities attained or profit earned.

Question 18.
What are the different types of leverages?
Answer:
There are three types of leverages.

  • Operating leverage
  • Financial leverage
  • Combined leverage

Question 19.
What do you mean by personal leverage?
Answer:
Personal leverage refers to an individual replicating the advantages of corporate debt by borrowing on personal account and subscribing for an equivalent amount of shares in an unlevered company.

Question 20.
What is a financial leverage?
Answer:
The use of long term fixed interest and dividend bearing securities like debentures a«d preference shares along with equity is called financial leverage or trading on equity.

Question 21.
What is Operating Leverage?
Answer:
The operating leverage occurs when a firm has fixed costs which must be recovered irrespective of sales volume. The fixed costs remaining same the percentage change in operating revenue will be more than the percentage change in sales. This occurrence is known as operating leverage.

Question 22.
Expand EAT,EBIT and PAT?
Answer:
EAT = Earnings after Tax
FBIT = Earnings Before Interest and Tax
PAT – Profit after tax

Question 23.
What is EPS?
Answer:
EPS = Earnings per share.
The formula for computing EPS: \(\frac{\text { Earnings available for equity Shareholders }}{\text { number of equity shares }}\)

Question 24.
What is Net Income Approach?
Answer:
Net income approach (NIA): Under this approach, the cost of equity capital and cost of debt capital are assumed to be independent to the capital structure.

Question 25.
Give the meaning of Net Operating Income Approach.
Answer:
Net operating income approach (NOIA): Under this approach, the cost of equity increases in accordance with leverage. Due to which the weighted average cost of capital remains constant and the value of the firm also remains constant as leverage is changed.

Question 26.
What is capital budgeting?
Answer:
Capital budgeting is the planning process used to determine whether an organization’s long term investments such as new machinery, replacement of machinery, new plants, new products and research development projects are worth the funding of cash through the firm’s capitalization structure.

Question 27.
What is 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.

Question 28.
State the MM approach of capital structure.
Answer:
The Modigliani – Miller (MM) hypothesis is identical to the net operating income approach. MM argue, that in the absence of taxes, a firm’s market value and the cost of capital remain invariant to the capital structure changes.

Investment Appraisal Long Answer Type Questions

Investment Appraisal Long Answer Type Questions

Question 1.
Explain risk and uncertainty.
Answer:
Profit is the reward for the entrepreneur and it is the balance left with the entrepreneur – after he makes the payment for all factor services. Profits are residual income left after the payment of the contractual records to other factors of production. According to Prof. Knight, profit is the reward for uncertainty bearing and taking risks. He distinguished between risk and uncertainty on one hand and predictable and unpredictable changes on the other. According to him only unforeseen changes can give rise to profits.

Risks are classified as insurable risks and non insurable risks. Examples of insurable risks are theft, fire and death by accident. Examples of non insurable risks are changes in price, demand, supply etc. According to Knight, profit is the reward for bearing non insurable risks and uncertainty.

The entrepreneur has to undertake production under uncertain condition. There is uncertainty regarding demand, price and cost. As there is a time gap between the period of producing and selling, many changes may take place during that period. If the entrepreneur enters into contractual agrement with the factor owners predicting rightly the uncertainty, he earns good profits.

If the predictions are wrong, he gets losses. Thus profit is a reward for uncertainty. Thus profit is a residual and non contractual income which accrues to the entrepreneur because of the fact of uncertainty. The entrepreneur is an unhired factor and he hires other factors for production. It is therefore, entrepreneur who .bears uncertainty and earns profit as a reward for it.

There are two types of changes which take place and are responsible for conditions of uncertainty. First type of changes refer to. the innovations (for e.g,. introducing of a new product or a new and cheaper method of production etc.) which are introduced by the entrepreneurs themselves. These innovations not only create uncertainty for the rivals or competitors who are affected by them but they also involve uncertainty for the entrepreneur who introduces ‘them, for one cannot be certain whether a particular innovation will be definitely successful.

The second type of changes which cause uncertainty are those which are external to the firms and industries. These changes are; changes in taste and fashions of the people, changes in government policies and Jaws especially taxation, wage and labour policies and laws, movements of prices as a result of inflation and depression, changes in production technology etc. All these changes cause uncertainty and bring profits, positive or negative into existence.

Only those risks can be insured against, the probability of whose occurrence can be calculated. An insurance company knows by calculation on the basis of past statistics, that how much percentage of factories will catch fire in a year. On the basis of this information, it will fix the rate of premium and is able to insure the factories against the risk. But there are risks which cannot be insured and therefore they have to be borne by the entrepreneurs. These non insurable risks relate to the outcomes of price output decisions to be taken by the entrepreneurs.

Whether it will pay him to increase output, reduce output and what will be the outcome in terms of profits or losses as a result of his particular output decision. Similarly, he has to face risks as a result of his decisions regarding mode of advertisement and outlay to be made on it, product variation etc. for taking all these decisions he has to guess about demand and cost conditions and always these is a risk of suffering losses as a result of decisions.

No insurance company can insure the entrepreneurs against commercial losses which may emerge out of decisions regarding price, output, product variation and also against losses which may fall upon the entrepreneurs due to the structural, cyclical and other exogenous changes which take place in the economy, It is, therefore clear that it is non insurable risks that involve uncertainty and give rise to profits.

To quote Knight, ” It is ‘uncertainty’ distinguished from insurable risk that effectively gives rise to entrepreneurial form of organisation and to the much condemned ‘profit’, as an income form’. However this theory is unrealistic as it fails to separate owner and salaried manager.

Question 2.
Discuss measurement of risk.
Answer:
Accurate measurement of derivative-related risks is necessary for proper monitoring and control. All significant risks should be measured and integrated into a entity-wide risk management system. The risk of loss can be most directly quantified in relation to market risk and credit risk (though other risks may have an equally or even greater adverse impact on earnings or. capital if not properly controlled). These two types of risks are dearly related since the extent to which a derivatives contract is “in the money” as a result of market price movements will determine the degree of credit risk. This illustrates the need for an integrated approach to the”risk management of derivatives. The methods used to measure market and credit risk should be related to:

  • the nature, scale and complexity of the derivatives operation
  • the capability of the data collection systems and
  • the ability of management to understand the nature limitations and meaning of the results produced by the measurement system.

Mark-to-market:
The measurement process starts with marking to market of risk positions. This is necessary to establish the current value of risk positions and to recognize profits and losses in the books of account. It is essential that the revaluation process is carried out by an independent risk control’unit or by back office staff who are independent of the risk-takers in the front office, and that the pricing factors used for revaluation are obtained from a source which is independently verifiable.

Measuring market risk:
The risk measurement system should assess the probability of future loss in derivative positions. In order to achieve this objective, it is necessary to estimate:
(a) the sensitivity of the instruments in the portfolio to changes in the„ market factors which affect their value (e.g. interest rates, exchange rates and volatilities); and

(b) the tendency of the relevant market factors to change based on past volatilities and correlations.

The assumptions and variables used in the risk management method should be fully documented and reviewed regularly by the senior management, the independent risk management unit and internal audit.

Question 3.
Explain different tax system of international risk management.
Answer:
A tax (also known as a “duty”) is a financial charge or other levy imposed on an individual or a legal entity by a state or a functional equivalent of a state (e.g. tribes, secession istmovements or revolutionary movements). Taxes could also be imposed by a subnational entity.

Taxes consist of direct tax or indirect tax, and may be paid in money or as corvee labor. In modern, capitalist taxation systems, taxes are levied in money, but in-kind and corvee taxation are characteristic of traditional or pre-capitalist states and their functional equivalents

Risk management is the process of measuring, or assessing, developing strategies to manage it. Strategies include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, and accepting some or all of the consequences of a particular risk. Traditional risk management focuses on risks stemming from physical or legal causes (e.g. natural disasters or fires, accidents, death, and lawsuits). Financial risk management, on the other hand, focuses on risks that can be managed using traded financial instruments
(1) Establishing the context: It includes planning the remainder of the process and mapping out the scope of the exercise, the identity and objectives of stakeholders, the basis upon which risks will be evaluated and defining a framework for the process, and agenda for identification and analysis of risk involved in the process.

(2) Identification: After establishing the context, the next step in the process of managing risk is to identify potential risks. Risks are about events that, when triggered, cause problems. Hence, risk identification can start with the source of problems, or with the problem itself.

(3) Assessment: Once risks have been identified, they must then be assessed as to their potential severity of loss and to the probability of occurrence. These quantities can be either simple to measure, in the case of the value of a lost building, or impossible to know for sure in the case of the probability of an unlikely event occurring.

Therefore, in the assessment process it is critical to make the best educated guesses possible in order to properly prioritize the implementation of the risk management plan. Numerous different risk formulae exist, but perhaps the most widely accepted formula for risk quantification is Rate of occurrence multiplied by the impact of the event equals risk

(4) Potential risk treatments: Once risks have been identified and assessed, all techniques to manage the risk fall into one or more of these four major categories: (Dorfman, 1997) (remember as 4 T’s)

  • Tolerate (aka retention)
  • Treat (aka mitigation)
  • Terminate (aka elimination)
  • Transfer (aka buying insurance)

Ideal use of these strategies may not be possible. Some of them may involve trade-offs that are not acceptable to the organization or person making the risk management decisions.

(5) Risk avoidance: Includes not performing an activity that could carry risk. Avoidance may seem the answer to all risks, but avoiding risks also means losing out on the potential gain that accepting (retaining) the risk may have allowed. Not entering a business to avoid the risk of loss also avoids the possibility of earning profits.

(6) Risk reduction: Involves methods that reduce the severity of the loss. Examples include sprinklersdesigned to put out a fire to reduce the risk of loss by fire. This method may cause a greater loss by water damage and therefore may not be suitable.

(7) Risk retention: Involves accepting the loss when it occurs. True self insurance falls in this category. Risk retention is a viable strategy for small risks where the cost of insuring against the risk would be greater over time than the total losses sustained. All risks that are not avoided or transferred are retained by default. This includes risks that are so large or catastrophic that they either cannot be insured against or the premiums would be infeasible.

War is an example since most property and risks are not insured against war, so the loss attributed by . war is retained by the insured. Also any amounts of potential loss (risk) over the amount insured is retained risk. This may also be acceptable if the chance of a very large loss is small or if the cost to insure for greater coverage amounts is so great it would hinder the goals of the organization too much.

(8) Risk transfer: Means causing another party to accept the risk, typically by contract or by hedgingInsuranceis one type of risk transfer that uses contracts. Other times it may involve contract language that transfers a risk to another party without the payment of an insurance premium. Liability among construction or other contractors is very often transferred this way. On the other hand, taking offsetting positions in derivatives is typically how firms use hedging to financially manage risk.

Investment Appraisal Short Answer Type Questions

Investment Appraisal Short Answer Type Questions

Question 1.
What is investment appraisal? List the various capital investment appraisal techniques.
Answer:
An evaluation of the attractiveness of an investment proposal, using methods such as average rate of return, internal rate of return (IRR), net present value (NPV), or payback period. Investment appraisal is an integral part of capital budgeting (see capital budget), and is applicable to areas even where the returns may not be easily quantifiable such as personnel, marketing, and training. The capital investment appraisal techniques used to measure capital investment appraisal of a business project include:

  • Net present value.
  • Accounting rate of return.
  • Internal rate of return.
  • Modified internal rate of return.
  • Adjected present value.
  • Profitability index.
  • Equivalent annuity.
  • Pay back period

Question 2.
How allowing for inflation and Taxation in investment appraisal?
Answer:
Inflation in investment:
It is important that whichever technique is used, inflation is considered in a consistent manner. For instance, in both the internal rate of return and the net present value techniques, present and future cash flows will be identified as nominal amounts and will use a nominal interest rate to discount them to a present value. The impact of future inflation is ignored, except to the extent it is reflected in the interest rate used.

However, sometimes a company will want to compare the return on a potential future- project with a completed or ongoing one. Alternatively, the company will want to compare the returns from two countries with different rates of inflation. In these cases, real rates of return, which account for inflation, should be calculated for the completed projects. Real rates of return, even when inflation is low, will always be lower than a nominal return for the same period.

When discounting cash flows, they must be discounted using the appropriate rate of return. So, if real cash flows are used, then they must be discounted using a real rate of return. Similarly, a nominal rate of return must be used to discount nominal cash flows. The conventional method is to use nominal values.

Taxation in investment:
Tax will also have an impact on the discount rate used. Again, the issue is consistency. In most cases, the cash flows identified will be after-tax flows. To give a fairer reflection of the relative returns from prospective projects, companies should use an after-tax rate of return to discount any after-tax cash flows.

The after-tax discount rate can be calculated using the following formula:
R = r x 1 – trn where R equals the after-tax discount rate, r is the pre-tax discount rate and tm is the marginal tax rate.
The marginal tax rate is important as it reflects, as close as possible, the tax which will be payable on additional positive cash flows. As can be seen, the after-tax discount rate will be lower than the pre-tax equivalent.
Applying the correct discount rate is important when projects in different tax regimens are being assessed. For example, tax-is often an important consideration when a company is deciding to develop a new production facility. Using a pre-tax discount rate would distort the potential return from a project based in a low tax regimen when compared with one based in a location where a higher rate applies.

Question 3.
Explain the technique of assets replacement.
Answer:
Calculating periodic cash flows of existing asset is straight forward. Since the existing asset is already purchased, the initial investment outlay is zero and the periodic net cash flows are calculated based on the following formula:
Net cash flows = (revenue – operating expenses – depreciation) * (1 – tax rate) + depreciation
If the asset is replaced, it involves investment is the new asset and sale or disposal of the existing asset. Disposal of exiting asset has some income tax implications which need to be reflected in the calculation of initial investment as follows:
Initial investment after replacement = cost of new asset – sale proceeds of old asset +/- tax on disposal
Tax on disposed asset = (sale proceeds of old assets – book value of old asset) * tax rate
As evident from the equation above, if the old asset is sold at an amount higher than its book value, the company bears a related tax cost which is added to the initial investment. Similarly, if the sale proceeds are lower than the book value of the asset sold, there is a resulting tax shield which is subtracted from sum of cost of new asset and sale proceeds of the old asset.

Question 4.
Explain the various types of Capital rationing.
Answer:
1. Soft Rationing:
Soft rationing is when the firm itself limits the amount of capital that is going to be used for investment decisions in a given time period. This could happen because of a variety of reasons:
(a) The promoters may be of the opinion that if they raise too much capital too soon, they may lose control of the firm’s operations. Rather, they may want to raise capital slowly over a longer period of time and retain control. Besides if the firm is constantly demonstrating a high level of proficiency in generating returns it may get a better valuation when it raises capital in the future.

(b) Also, the management may be worried that if too much debt is raised it may exponentially increase the risk raising the opportunity cost of capital. Most firms have written guidelines regarding the amount of debt and capital that they plan to raise to keep their liquidity and solvency ratios intact and these guidelines are usually adhered to.

(c) Thirdly, many managers believe that they are taking decisions under imperfect market conditions i.e. they do not know about the opportunities available in the future. Maybe a project with a better rate of return can be found in the future or maybe the cost of capital may decline in the future. Either way, the firm must conserve some capital for the opportunities that may arise in the future. After all raising capital takes time and this may lead to a missed opportunity.

2. Hard Rationing:
Hard rationing, on the other hand, is the limitation on capital that is forced by factors external to the firm. This could also be due to a variety of reasons:
(a) For instance, a young startup firm may not be able to raise capital no matter how lucrative their project looks on paper and how high the projected returns may be.

(b) Even medium sized companies are dependent on banks and institutional investors for their capital as many of them are not listed on the stock exchange or do not have enough credibility to sell debt to the common people.

(c) Lastly, large sized companies may face restrictions by existing investors such as banks who place an upper limit on the amount of debt that can be issued before they make a loan. Such covenants are laid down to ensure that the company does not borrow excessively increasing risk, and jeopardizing the investments of old lenders.