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.

Investment Appraisal Very Short Answer Type Questions

Investment Appraisal Very Short Answer Type Questions

Question 1.
What is investment appraisal?
Answer:
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

Question 2.
What is inflation?
Answer:
Inflation is the rate at which the general level of prices for goods and services is rises and subsequently, purchasing power falls.

Question 3.
What are the different types of inflation?
Answer:
The different types of inflation are:

  • Demand pull inflation
  • Cost push inflation
  • Built-in inflation

Question 4.
What is 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 5.
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 6.
What is systematic risk?
Answer:
Systematic risks are associated with external environment, these are non diversifiable and is associated with securities market as well as economic, sociological, political considerations of the prices of-a.ll securities in the market.

Question 7.
What is unsystematic risk?
Answer:
Unsystematic risk is also Called unique risk and it is unique to firm or industry. It is caused by factors like labour strike, irregular disorganised management policies and consumer preferences.

Question 8.
What is business risk?
Answer:
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. The Internal Business Risk leads to fair in revenues and in profit of the company, but can be corrected by certain changes in the company’s policies.

Question 9.
What is financial risk?
Answer:
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.

Question 10.
What is insolvency risk?
Answer:
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.

Question 11.
Distinguish between risk and uncertainty.
Answer:
Risk and uncertainty go together. Risk suggests that the decision-maker knows that there is some possible consequence of an investment decision, but uncertainty involves a situation, where the outcome is not known to the decision-maker. But basically, whether the outcome is known or not, the investments involve both risk and uncertainty.

Question 12.
How is the risk measured or technique of measuring risk?
Answer:
The risk. associated with the capital budgeting decisions is measured through the following methods:

  • Risk adjusted rate of return
  • Certainty equivalent co-efficient
  • Probabilistic method
  • Sensitivity analysis
  • Co-efficient of variation method or Standard deviation
  • Decision tree analysis.

Question 13.
What is lease or buy?
Answer:
Lease or buy decision involves applying capital budgeting principles to determine if leasing as asset is a better option than buying it. Leasing in a contractual arrangement in which a company (the lessee) obtains an asset from another company (the lessor) against periodic payments of lease rentals.

Question 14.
What is replacement assets value?
Answer:
The monetary value that would be required to replace the production capability of the, present assets in the plant. Includes production or process equipment, as well as utilities, support and related assets. It should not be based on the insured value or depreciated value of the assets. It includes the replacement value of the buildings and the grounds if these assets are maintainted by the maintenance expenditures.

Question 15.
What is replacement decision?
Answer:
Decision regarding replacement of an existing asset with another is based on the net present value and internal rate of return of the incremental cash flows, i.e. the difference between periodic net cash flows if the existing asset is kept and the periodic net cash flows if the asset is replaced.

In capital budgeting and engineering economics, the existing asset is called the defender and the asset which is proposed to replace the defender is called the challenger. Estimation of incremental cash flows for such replacement analysis involves calculation of net cash flows of the defender, net cash flows of the challenger and then finding the difference in cash flows for both the assets.

Question 16.
What do you mean by capital rationing?
Answer:
Capital rationing is the act of placing restrictions on the amount of new investments or projects undertaken by a company. This is accomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on specific portions of a budget.

Working Capital Management Long Answer Type Questions

Working Capital Management Long Answer Type Questions

Question 1.
Explain the determinants of working capital.
Answer:
Many factors have to be considered while deciding on the working capital requirements. Following are some of the important factors influencing the working capital.
(1) Operational efficiency: If a firm is very efficient in the operations it will utilise the available resources to the maximum extent eliminating wastages this will inturn increase the profitability and help the firm to reduce its costs. The pressure on working capital will be less when the firm is efficient in its operation whereas the firms that are not efficient will consume more working capital.

(2) Growth and Expansion: If the firm is desirous to expand its operations and aims at growth accordingly, the requirement of working capital will also be more, hence the growth and expansion programmes of a firm is an important factor influencing the requirement of working capital.

(3) Profit Appropriation: The earnings available to the firm through its operations are not available for working capital purposes. Only a certain proportion of the earning is available for working capital requirements. Because the company has to apportion its earnings in the form of depreciation, taxes, dividend and retained earnings. Whatever the amount left out after apportionment is available for working capital purposes.

(4) Capital structure of the company: If the policy of the company is such that the shareholders provide some funds towards the working capital needs then it will be easy for the management because it need not arrange from outside sources whereas if no such policy is followed then, the company has to raise money from outside sources and with an additional obligation of interest payment.

(5) Policies of RBI: If RBI follows stringent credit policies it will affect the companies intending to raise funds from outside sources for working capital requirements it may have to pay more interest. But if RBI follows liberal credit policies raising money in the capital or money market will not be a problem.

(6) Changes in prices: If the firm experiences fluctuations in the prices it has to keep more amount of working capital to meet the changes in the prices but if the prices are stable the working capital to be arranged is considerably less than in the previous case. Therefore the changes in the prices are one of the important factors influencing the working capital requirements.

(7) Profitability: There are concerns earning more profit because of good quality products, customer’s preference brand loyalty, less competition, monopoly power etc. Therefore a portion of the profit can be used as working capital. Whereas the other concerns are earning less profit because of more competition, inferior quality of product, more substitute etc. profit may not be sufficient to meet the working capital purposes as a result of which they may. have to borrow from other sources.

(8) Nature and size of the firm: If the nature and size of the firm is small then the requirement of working capital is less when compared to that of the firms which are bigger in size and with larger operations.

(9) Sales volume: The sales volume and the size or requirement of working capital are directly related to each other. As the volume of sales increases, there is an increase in the investment of working capital.

(10) Business terms: A firm which allows liberal credits to its customers may enjoy higher sales but will need more working capital as compared to a firm following stringent credit terms.

Conclusion:
Finance manager has to consider all these factors at the time of deciding the amount of working capital. His/Her main aim should be to reduce the cost to the maximum possible extent and makes funds available as and when required.

Question 2.
Explain the different sources of finance for funding working capital or short term finance requirements.
Answer:
The main sources of finance for short term working capital are as follows:
1. Trade Credit: It refers to the credit extended by the suppliers of goods in the normal course of business. This is an important source of short term finance. The credit worthiness of a firm and the confidence of its suppliers are the main basis of securing trade credit. It is most granted on open account basis whereby supplier sends goods to the buyer for the payment to be received in future as per terms of the sales invoice. It may also take the form of bills payable whereby the buyer signs a bill of exchange payable on a specified future date.

Accrued Expenses and Deferred Income are other spontaneous sources for short term financing. Accrued expenses are the expenses which have been incurred but not yet due and hence not yet paid also. These simply represent a liability that a firm has to pay for the services already received by it. Wages, salaries, interest and taxes are the most important components of accrued expenses.

Deferred incomes are incomes received in advance before supplying goods or services. They represent funds received by a firm and constitute an important source of short term finance. However, firms having great demand for its products and services, and those having good reputation in the market can demand deferred incomes.

2. Bank Borrowing: Commercial banks are the most important source of short term capital. The major portion of working capital loans are provided by commercial banks. They provide a wide variety of loans tailored to meet the specific requirements of a concern. The different forms in which banks normally provide loans and advances are as follows:

(a) Loans: When a bank makes an advance in lump-sum against some security it is called a loan. The entire loan amount is paid to the borrower either in cash or by credit to his account. The borrower is required to pay interest on the entire amount of loan from the date of sanction.

(b) Cash Credit: It is an arrangement by which a bank allows his customer to borrow money upto a certain limit against some tangible security or guarantee. The customer can withdraw from his cash credit limit according to his needs and he can also deposit .any surplus amount with him. The interest is charged on daily balance.

(c) Overdrafts: It is an agreement with a bank by which a current account holder is allowed to withdraw more than the balance to his credit upto a certain limit. There are no restrictions for operation of overdraft limits. The interest is charged on daily overdrawn balances. However it is allowed for. a short period and to a temporary accommodation.

(d) Purchasing and Discounting of bills: This is the most important form in which a bank lends without any collateral security. The seller draws a bill of exchange on the buyer of goods on credit. Such a bill may either be a clean bill or a documentary bill which is accompanied by documents of title to goods such as a railway receipt. The bank purchases the bills payable on demand and credits the customers’ account with the amount of bill less discount. On maturity, bank presents the bill to its acceptor for payment.

In addition to the above, banks help their customers in obtaining credit from their suppliers through the arrangement of Letter of credit. This is an undertaking by a bank, to honour the obligations of its customers upto a specified amount.

Question 3.
Explain Cash Management.
Answer:
Cash Management is concerned with the managing of:
(i) Cash flows into and out of the firm
(ii) Cash flows within the firm and
(iii) Cash balances held by the firm at a point of time by financing deficit or investing surplus cash. Cash management seeks to accomplish this cycle at a minimum cost. At the same time, it also seeks to achieve liquidity and control.’ Following are some of the facts of cash management.
(1) Cash Planning:
Cash Planning is a technique to plan and control the use of cash. A projected cash flow statement may be prepared based on the present business operations and anticipated future activities. The cash inflows from various sources may be anticipated and cash outflows will determine the possible uses of cash. Cash inflows and outflows should be planned to project cash surplus or deficit for each period of the planning period. The cash inflows International Financial Management should be accelerated while as far as possible, the cash out lows should be decelerated. Cash budget should be prepared for this purpose.

(2) Cash Forecasts and Budgeting:
A Cash budget is the most important device for the control of receipts and payments of cash. A cash budget is an estimate of cash receipts and disbursements during a future period of time. It is an analysis of flow of cash in a business over a future, short or long period of time. It is a forecast of expected cash intake and outlay. The short term forecasts can be made with the help of cash flow projections.

The finance manager will make estimates of likely receipts in the near future and the expected disbursements in that period. Though it is not possible to make exact forecasts even then estimates of cash flows will enable the planners to make arrangement for cash needs. The long term cash forecasts are also essential for proper cash planning. Long term forecasts indicate company’s future financial needs for working capital, capital projects etc.

(3) Investment of Surplus Funds:
The surplus cash balances should be properly invested to earn profits. The firm should decide about the division of such cash balance between alternative short term investment opportunities such as bank deposits, marketable securities, or intercorporate lending. As the firm invests its temporary cash balance, its primary criteria in selecting a security or investment opportunity will be its quickest convertibility into cash, when the need for cash arises. Besides this, the firm would also be interested in the fact that when it selis the security or liquidates investment, it atleast gets the amount of cash equal to the investment outlay. Thus, in choosing among alternative investment, the firm should examine three basic features of security: safety, maturity and marketability.

Question 4.
Discuss various Cash Management Techniques.
Answer:
Cash Management is concerned with the managing of:
(i) Cash flows into and out of the firm
(ii) Cash flows within the firm and
(iii) Cash balances held by the firm at a point of time by financing deficit or investing surplus cash. Cash management seeks to accomplish this cycle at a minimum cost. At the same time, it also seeks to achieve liquidity and control. .Following are some of the facts of cash management.
(1) Cash Planning:
Cash Planning is a technique to plan and control the use of cash. A projected cash flow statement may be prepared based on the present business operations and anticipated future activities. The cash inflows from various sources may be anticipated and cash outflows will determine the possible uses of cash. Cash inflows and outflows should be planned to project cash surplus or deficit for each period of the planning period. The cash inflows should be accelerated while as far as possible, the cash outlows should be decelerated. Cash budget should be prepared for this purpose.

(2) Cash Forecasts and Budgeting:
A Cash budget is the most important device for the control of receipts and payments of cash. A cash budget is an estimate of cash receipts and disbursements during a future period of time. It is an analysis of flow of cash in a business over a future, short or long period of time. It is a forecast of expected cash intake and outlay. The short term forecasts can be made with the help of cash flow projections.

The finance manager will make estimates of likely receipts in the near future and the expected disbursements in that period. Though it is not possible to make exact forecasts even then estimates of cash flows will enable the planners to make arrangement for cash needs. The long term cash forecasts are also essential for proper cash planning. Long term forecasts indicate company’s future financial needs for working capital, capital projects etc.

(3) Investment of Surplus Funds:
The surplus cash balances should be properly invested to earn profits. The firm should decide about the division of such cash balance between alternative short term investment opportunities such as bank deposits, marketable securities, or intercorporate lending. As the firm invests its temporary cash balance, its primary criteria in selecting a security or investment opportunity will be its quickest convertibility into cash, when the need for cash arises. Besides this, the firm would also be interested in the fact that when it sells the security or liquidates investment, it atleast gets the amount of cash equal to the investment outlay. Thus, in choosing among alternative investment, the firm should examine three basic features of security: safety, maturity and marketability.

Question 5.
Explain the Management of Accounts Receivable.
Answer:
Accounts Receivables Management is the process of making decisions relating to investment in trade debtors. The objective is to take a sound decision as regards investment in debtors as this involves cost consideration and a risk of bad debts too.

Dimensions of Accounts Receivables Management: Accounts Receivables Management involves the careful consideration of the following aspects:
(1) Forming of Credit Policy: A credit policy is related to decisions such as credit standards, credit, terms and collection efforts. Credit standards are criteria to decide the types of customers to whom goods could be sold on credit. If a firm has more slow paying customers, its investment in accounts receivable will increase. The firm will also be exposed to higher risk of default.

Credit terms specify duration of credit and terms of payment by customers. Investment in accounts receivable will be high if customers are allowed extended time period for making payments. Collection efforts determine the actual collection period. The lower the collection period, the lower the investment in accounts receivable and vice versa.

(2) Credit Evaluation of Individual Accounts: The firm need not follow the policy for treating all customers equal for the purpose of extending credit. Each case may be fully examined before granting any credit terms. Similarly, collection procedure will differ from customer to customer.The credit evaluation procedure of the individual accounts should involve the following steps:
(i) Credit Information:
The first step will be to gather credit information about the customers. This information should be adequate enough so that proper evaluation about the financial position of the customers is possible. This type of investigation can be undertaken only upto a certain limit because it will involve cost. The cost incurred and the benefit from reduced bad debt losses will be compared. The cost of collecting information should, therefore, be less than the potential -profitability. The information may be available from financial statements credit rating agencies, reports from banks, firms records etc.

(ii) Credit Investigation:
After having obtained the credit information, the firm will get an idea regarding matters which should be further investigated. The factors that affect the extent and nature of credit investigation of an individual customer are:

  • The type of customer, whether new of existing
  • The Customer’s business line background and the related trade risks
  • The nature of the product perishable or seasonal
  • Size of customer’s order and expected further volumes of business with him
  • Company’s credit policies and practices.

(iii) Credit Limit: A credit limit is a maximum amount of credit which the firm will extend at any point of time. The finance manager will match the creditworthiness of the customers with the credit standards of the company. The decision on the magnitude of credit will depend upon the amount of contemplated sale and the customer’s financial strength. The credit limit must be reviewed periodically.

(iv) Collection Procedure: The concern should follow a well laid down collection policy and procedure to collect dues from its customers. The concern should devise procedures to be followed when accounts become due after the expiry of credit period. The collection policy be termed as strict and lenient. A strict policy of collection will involve more efforts on collection. Such a policy will enable early collection of dues and will reduce bad debt losses. A rigorous collection policy will involve increased collection costs. A linient policy may increase the debt collection period and more bad debt losses.

(3) Control of Receivables: A firm needs to continuously monitor and control its receivable to ensure the success of collection efforts. Two traditional methods of evaluating the management of receivable are:

  • Average collection period
  • Aging schedule.

The average collection Period = The average collection period so calculated is compared with the firm’s stated credit period to judge the collection efficiency. The aging schedule breaks down receivables according to the length of time for which they have been outstanding. The aging schedule provides more information about the collection experience.

Question 6.
Discuss the preparation of Ageing Schedule and Debtors Turnover Ratio.
Answer:
Ageing Schedule:
Ageing schedule is a table that classifies accounts receivable and payables according to their dates. It helps in managing cash and analyzing payments. An aging schedule is a way of finding out if customers are paying their bills within the credit period prescribed in the company’s credit terms.

The typical accounts receivable aging schedule consists of 6 columns:

  • Column 1 lists the name of each customer with an accounts receivable balance.
  • Column 2 lists the total amount due from the customers listed in Column 1.
  • Column 3 is the “current column.” Listed in this column are the amounts due from customers for sales made during the current month.
  • Column 4 shows the unpaid amount due from customers for sales made in the previous month. These are the customers with accounts 1 to 30 days past due.
  • Column 5 lists the amounts due from customers for sales made two months prior. These are customers with accounts 31 to 60 days past due.
  • Column 6 lists the amount due from customers with accounts over 60 days past due.

Debtors Turnover Ratio:
A concern may sell goods on cash as well as on credit. Credit is one of the important elements of sales promotion. The volume of sales can be increased by following a liberal credit policy.
Debtors/Receivables Turnover = \(\frac{\text { Net Credit Annual Sales }}{\text { Average Trade Debtors }}\)
= No. of times
Trade Debtors = Sundry debtors + Bills Receivables
Debtors should always be taken to gross value. No provision for bad and doubtful debts be deducted from them. Generally, the higher the value of debtors turnover the more efficient is the management of debtors/sales or more liquid are the debtors.

Practical Problems

Question 1.
From the following information, calculate the operating cycle in days and the amount of working capital required.
Period covered – 365 days
Total cost of production – ₹ 22,000
Total cost of sales – ₹ 24,000
Raw materials consumption – ₹ 9,200
Average debtors outstanding – ₹ 1,000
Credit sales for the year – ₹ 30,000
Value of average stock maintained:
Raw materials – ₹ 680
“Work in progress – ₹ 760
Finished goods – ₹ 560
Note: Amount given represent lakhs.

Question 2.
Prepare an estimate of working capital requirement from the following date of a trading concern.
(a) Projected annual sales – 80,000 units
(b) Selling price – ₹ 8 per unit
(c) Percentage of profit – 20%
(d) Average credit period allowed to debtors – 10 weeks
(e) Average credit period allowed by suppliers – 8 weeks
(f) Average stock holding in terms of sales requirement – 10 weeks
(g) Allow 20% for contingencies.

Question 3.
Calculate the working capital requirement from the following information.

Question 4.
A proforma a cost sheet of a company provides the following particulars.
Elements of cost – Amount per Unit
Materials – 50%
Direct labour – 15%
Overheads – 15%
The following further particulars are available
(a) It is proposed to maintain a level of activity of 6,00,000 units.
(b) Selling price is 20 per unit
(c) Raw materials are expected to be in stores for an average of 2 months
(d) Materials will be in process, an average of one month
(e) Finished goods are required to be in stock for an average of 2 months
(f) Credit allowed to debtors is three months
(g) Credit allowed to supplier is two months.

Question 5.
A cost sheet of a company provides you the following information.
Elements of cost – Amount per Unit
Materials – 80
Direct labour – 30
Overheads – 60
Total cost – 170
Profit – 30
Selling price – 200
The following further particulars are available.
(a) Raw materials are in stock for one month (avg)
(b) Raw materials are in process on an average for half a month.
(c) Finished goods are in stock on an average for one month
(d) Credit allowed by supplier one month.
(e) Lag in payment of overheads is one month
(f) Lag in payment of wages is 1 1/2 weeks.
(g) 1/4th output is sold against cash.
(h) Cash in hand and at bank is expected to be ₹ 1,25,000.
(i) Credit allowed to customers 2 months.
You are required to prepare a statement showing the working capital needed to finance level of activity of 2,08,000 units of production.

Question 6.
What are the different methods of calculating EOQ?

Question 7.
Find out the EOQ from the following.

Question 8.
Give the meaning of EOQ and claculate EOQ from the following:
Monthly consumption 1,500 units
Ordering cost ₹ 50 per order
Inventory carrying cost per month per units ₹ 0.60.

Question 9.
Find out E.O.Q. from the following Annual usage 4000 units, cost of material per units ₹ 2, cost of placing and receiving one order ₹ 5 Annual carrying cost of one unit : 8% inventory value.

Working Capital Management Short Answer Type Questions

Working Capital Management Short Answer Type Questions

Question 1.
Explain the different principles of Working Capital.
Answer:
The different principles of working capital are:
(i) Principle of Risk Variation: Risk refers to the inability of a firm to maintain sufficient current assets to pay for its obligations. There is a definite relationship between the degree of risk and the rate of return. As a firm assumes more risk, the opportunity for gain or loss increases.

As the level of working capital relative to sales decreases, the degree of risk increases. When the degree of risk increases, the opportunity for gain and loss also increases. Thus, if the level of working capital goes up, the amount of risk goes down, the opportunity for gain or loss is likewise adversely affected. Depending upon their attitudes, the managements change the size of their working capital.

(ii) Principle of Cost of Capital: This principle emphasises the different sources of finance, for each source has a different cost of capital. It should be remembered that the cost of capital moves inversely with risk. Thus, additional risk capital results in the decline in the cost of capital.

(iii) Principle of Equity Position: According to this principle, the amount of working capital invested in each component should be adequately justified by a firm’s equity position. Every rupee invested in the working capital should contribute to the new worth of the firm.

(iv) Principle of Maturity of Payment: A company should make every effort to relate maturities of payment to its flow of internally generated funds. There should be the least disparity between the maturities of a firm’s short-term debt instruments and its flow of internally generated funds because a greater risk is generated with greater disparity. A margin of safety should, however, be provided for short-term debt payments.

Question 2.
Explain the characteristics of working capital.
Answer:
The features of working capital are:
1) Short term Needs: Working capital is used to acquire current assets which get converted into cash in a short period. In this respect it differs from fixed capital which represents funds locked in long term assets. The duration of the working capital depends on the length of production process, the time that elapses in the sale and the waiting period of the cash receipt.

2) Circular Movement: Working capital is constantly converted into cash which again turns into working capital. This process of conversion goes on continuously. The cash is used to purchase current assets and when the goods are produced and sold out; those current assets are transformed into cash. Thus it moves in a circular away. That is why working capital is also described as circulating capital.

3) An Element of Permanency: Though working capital is a short term capital it is necessary to continue the productive activity of the enterprise. Hence so long as production continues, the enterprise will constantly remain in need of working capital. The working capital that is required permanently is called permanent or regular working capital.

4) An Element of Fluctuation: Though the requirement of working capital is felt permanently, its requirement fluctuates more widely than that of fixed capital. The requirement of working capital varies directly with the level of production. It varies with, the variation of the purchase and sale policy; price level and the level of demand also. The portion of working capital that changes with production, sale, price etc. is called variable working capital.

5) Liquidity: Working capital is more liquid than fixed capital. If need arises, working capital can be converted into cash within a short period and without much loss. A company in need of cash can get it through the conversion of its working capital by insisting on quick recovery of its bills receivable and by expediting sales of its product. It is due to this trait of working capital that the companies with a larger amount of working capital feel more secure.

6) Less Risky: Funds invested in fixed assets get locked up for a long period of time and cannot be recovered easily. There is also a danger of fixed assets like machinery getting obsolete due to technological innovations. Hence investment in fixed capital is comparatively more risky. As against this, investment in current assets is less risky as it is a short term investment. Working capital involves more of physical risk only, and that too is limited. Working capital involves financial or economic risk to a much less extent because the variations of product , prices are less severe generally.

7) Special Accounting System not needed: Since fixed capital is invested in long term assets, it becomes necessary to adopt various systems of estimating depreciation. On the other hand working capital is invested in short term assets which last for one year only. Hence it is not necessary to adopt special accounting system for them.

Question 3.
Explain various types of working capital.
Answer:
The various types of working capital are as follows:
1. Permanent working capital: It is the minimum amount of current assets which is needed to conduct a business even during the off season of the year. It is maintained to carry out operations at any time. It varies from year to year and organisation to organisation, depending upon the growth of fund required to produce the goods, necessary to satisfy demand at a particular point.

2. Temporary working capital: It represents the additional assets which is required from time to time during a year as per market fluctuations. It is also called as variable or seasonal working capital. It is required during the more active business seasons of the year.

3. Gross working capital: It refers to the amount of funds invest in current assets. It provides the correct amount of working capital at right time.

4. Net working capital: The net working capital is the difference between current liabilities. It enables the firm to determine how much amount is left for operational requirements.

Question 4.
Explain the Importance of adequate working capital. OR Describe the need of working capital in a firm.
Answer:
Adequate working capital is important for an organisation because of the following reasons:

  • To protect a business from the adverse effects of reduction in the value of current assets.
  • To permit a sufficient level of inventories for continuous production.
  • To enable the management to overcome depression period
  • To pay current liabilities on time promptly and avail discounts on payment.
  • Acts as a cushion in emergencies like strikes, flood etc.
  • Have favourable credit terms with customers.
  • Helpful in providing funds for expansion.
  • Working capital if possible can be invested in non-current assets.
  • Necessary funds can be accumulated for meeting future expenses.
  • It enables the company to operate its business more efficiently
  • To overcome excessive non operating losses.
  • To meet higher inventories and fixed assets requirements.

Question 5.
What are the disadvantages of excess working capital in the company.
Answer:
Excess working capital is a threat to a company. The following are disadvantages of excess working capital:

  • Leads to low profitability even though sufficient cash is available.
  • Outstanding and losses may be faced.
  • One of the root causes over overcapitalisation
  • It leads to greater production level but not having a matching demand in market.
  • High level of inventories and its maintenance and storage cost increases.
  • It may lead to carelessness about costs and therefore inefficiency of operations.
  • Creates an imbalance between liquidity and profitability
  • Unwise dividend policies.

Excessive working capital is not a good indicator for future growth and profitability for the organisation. The management should avoid such a condition and maintain a level of adequate working capital in the organisation.

Question 6.
What are the disadvantages of inadequate working capital in the company?
Answer:
Inadequate working capital is also not a favourable position for an organisation. There are several disadvantages of it.
These are as follows:

  • May not be able to take bulk orders.
  • It leads to adverse effects on solvency of the firm
  • Cash discount facilities cannot be availed properly or efficiently.
  • Leads to low liquidity which ultimately leads to decrease in profitability.
  • The organisation will not be able to pay dividends because of non availability of funds.
  • The credit worthiness of the company is adversely effected due to insufficient funds and untimely payment to creditors.
  • The upgradation of machines and even its repairs cannot be done properly due to lack of funds with the company.
  • Leads to borrowing at higher rates many times.
  • May not be able to take up profitable business opportunities.
  • Cash sales of the company mostly stagnate or even reduce and it may restrict its activities.

Question 7.
Explain the methods of estimating working capital requirements.
Answer:
There are two methods usually followed in determining working capital requirements:
(i) Conventional Method or Cash Cycle Method:
According to the conventional method, cash inflows and outflows are matched with each other. Greater emphasis is laid on liquidity and greater importance is attached to current ratio, liquidity ratio etc. which pertain to the liquidity of a business.

(ii) Operating Cycle Method:
The term operating cycle or cash cycle refers to the time duration required to convert the cash to raw materials, raw materials to work-in-progress, work in progress to finished goods, finished goods to debtors and debtors back to cash. We should know the operating cycle of an enterprise. There are four major components of the operating cycle of a manufacturing company.
(a) The cycle starts with free capital in the form of cash and credit, followed by investment in materials, manpower and the services

(b) Production phase

(c) Storage of the finished products terminating at the time-finished product is sold

(d) Cash or accounts receivable collection period, which results in, and ends at the point of dis-investment of the free capital originally committed. New free capital then becomes available for productive reinvestment. When new liquid capital becomes available for recommitment to productive activity, a new operating cycle begins.

Question 8.
What are the different motives of holding cash? OR What are the objectives of cash management?
Answer:
a. Transactionary motive:
A firm requires cash to meet the transactions in the ordinary course of the business like making payments towards dividends taxes, purchases wages etc. As there is no synchronisation between the cash inflows and the cash outflows the firms has to keep aside a certain portion of the amount to meet its day to day transactions.

b. Precautionary motive:
Cash under this motive is held as a precautionary measure. Firms are exposed to unforeseen events or contingencies like calamities, competition, strike, lockouts, consumer behaviour, changing government policies. As such so to meet these additional formalities firms have to set aside a certain portion of the amount to meet these unforeseen events.

c. Speculative motive:
The speculative motive relates to holding cash for investing in profitable investments as and when they arise. As such investments does not occur on a regular basis so the firm can keep a certain portion of the amount aside to reap the benefits of taking up the profitable investments as and when they occur. Ex. Prices of raw materials may fall temporarily so the firm may utilise the portion kept aside for speculative purpose and purchase the materials when they are available at lesser prices.

Question 9.
How to prepare Cash Budget? Explain.
Answer:
The cash budget is prepared after operating budgets and the capital expenditure budgets are prepared.
(i) The cash budget starts with the beginning cash balance to which is added the cash inflows to get cash available.

(ii) Cash outflows for the period are then subtracted to calculate the cash balance before financing.

(iii) If this balance is below the company’s required balance, the financing section shows the borrowings needed.

(iv) The financing section also includes debt repayments, including interest payments.

(v) The cash balance before financing is adjusted by the financing activity to calculate the ending cash balance.

(vi) The ending cash balance is the cash balance in the budgeted or pro forma balance sheet.

(vii) The format of this budget is:
Beginning cash balance
+ cash receipts
= cash available
? cash disbursements
= excess/deficiency of cash
+/- financing
= Ending cash balance

Question 10.
What are the factors influencing size of receivables?
Answer:
A number of factors influence the size of receivables, following are some of the factors:
1) Volume of credit sales: A firm has to be very competitive to ensure that it faces the competition in the market. It has to attract customers which is possible by offering credit sales to the customers. Hence, the volume of credit sales is one of the factor that influences the size of the receivables. More the credit sales more will be the accounts receivables.

2) New products: A firm to promote its new products will have to offer attractive terms like discounts, Sale on credit basis etc. If the firm is selling its new products on credit basis it will result in accounts receivables or debtors. Hence, promotion of the new product is one of the factor affecting the account receivable.

3) Location: If the firm is operating from a distant place from the market area, location becomes a demerit. So the firm to promote its product and attract the customers offers the products on credit basis which will in turn result in debtors.

4) Credit policy: If the firm is rigid on selling goods on credit basis the size of the accounts receivable is almost nil. But if the firm is liberal in offering its goods on credit basis then the size of the accounts receivable will be more.

5) Credit worthiness of the customers: The paying habits of the customers affects the size of the accounts receivables, if the customers delay the payments it will adversely affect the size of the accounts receivables.

6) Credit collection efforts: The firm should give due concern in collecting the credit given to the customers. The firm has to send periodical reminders reminding the customers to pay the money due to the firm. If the firm is liberal in collecting the credit, the customers also will delay their payments. This will effect the size of the accounts receivables.

Question 11.
Explain various Inventory Management Techniques.
Answer:
Inventory management refers to managing the stores to ensure that there is neither over stocking nor under stocking of materials. An efficient system of inventory management will determine what to purchase, from where to purchase, how much to purchase, and where to store. Following are, the tools of inventory management.
a. Fixation of levels: It is a tool through by which materials are maintained in the store houses by fixing different levels namely Maximum level, Re-order level, Minimum level and Danger level. Levels are fixed taking into consideration the factors like cost and nature of raw materials, lead time, storage spare etc.

b. ABC analysis: Materials are controlled giving importance to its value. Materials are graded as A, B & C wherein materials with ‘A’ grade are costlier in value but less in number where as materials with ‘C” grade are cheaper in value and more in number. Grade ‘B’ materials are moderate in value and moderate number of such items are maintained.

c. VED analysis: Materials are categorised as vital, essential and desirable components. Much importance is given to the materials categorised as vital than to the desirable components.

d. FSN analysis: Under this type, materials are grouped according to their movements. Fast moving items are stored in large quantities to meet the requirements. Slow moving items are moderately stored. Non moving items are rarely required therefore the quantity stored is very less.

e. Economic order quantity: Economic order quantity is the size of the lot to be purchased which is economically viable. EOQ is a point at which the ordering cost and the carrying cost are minimum.

f. Perpetual inventory system: A record is kept on a continuous basis as and when the materials are received and issued and hence, it is called perpetual inventory system.

Working Capital Management Very Short Answer Type Questions

Working Capital Management Very Short Answer Type Questions

Question 1.
What is Working Capital?
Answer:
Working capital is that part of the firms total capital which is required for financing short term assets or current assets.such as cash, debtors, inventories, marketable securities. It is also known as circulating capital.

Question 2.
Explain the concept of working capital.
Answer:
Working capital is the amount of funds necessary to cover the cost of Operating the enterprise. There are two concepts of working capital: (i) Gross working capital (ii) Net working capital Gross working capital is the capital invested in total current assets of the enterprise. Net working capital is the excess of current assets over current liabilities.

Question 3.
Mention the different types of working capital.
Answer:
The different types of working capital are:

  • Permanent working capital
  • Temporary working capital
  • Gross working capital
  • Net working capital

Question 4.
What do you mean by working capital management?
Answer:
Working capital management refers to the administration of all aspects of current assets namely cash, debtors, inventories and marketable securities and current liabilities. This basically determines the levels and compositions of current assets to ensure that right sources are tapped to finance current assets and current liabilities are paid in time.

Question 5.
Differentiate between Gross and Net Working Capital.
Answer:
Gross working capital is a broader concept which includes all the current assets of the company whereas net working capital is the difference between current assets and current liabilities.

Question 6.
What is conservative approach to working capital financing?
Answer:
Conservative approach to working capital financing depends on long-term funds for financing needs. The firm finances the permanent current assets and a part of the temporary current assets with long-term funds. If the temporary assets are not needed then the long-term funds are invested in the marketable securities. A firm following this approach will face less risk but along with Sow returns.

Question 7.
State any two determinants of working capital.
Answer:
The two determinants of working capital are:

  • Opersational efficiency
  • Growth and Expansion

Question 8.
What is operating cycle?
Answer:
The term operating cycle or cash cycle refers to the time duration required to convert the cash to raw materials, raw materials to work-in-progress, work in progress to finished goods, finished goods to debtors and debtors back to cash.

Question 9.
What is cash management?
Answer:
Cash management refers to the process of managing cash i.e. its inflow and outflow in an organisation for cash demanding activities and minimising funds committed to cash balances.

Question 10.
What is cash cycle?
Answer:
It is the net time interval between cash collections from sale of the product and cash payment for resources acquired by the firm. It also represents the time interval over which additional funds called working capital, should be obtained in order to carry out the firm’s operations.

Question 11.
Name the various floats which necessitates management of cash.
Answer:
Float refers to the amount of money tied up between the time a payment is initiated and cleared funds become available in the company’s bank account. The different types of float are:

Question 12.
Mention various Cash Management Techniques.
Answer:
The various cash management techniques include the following:

  • Budgeting
  • Investing
  • Credit
  • Generating income

Question 13.
Give the meaning of receivables.
Answer:
Receivables are also known as accounts receivables or Book debts. Receivables are the claims against its customers for the goods sold to the customers in the ordinary course of business on credit basis. The purpose of lending goods on credit basis is to attract more customers, meet competition and to increase sales and profits.

Question 14.
What is receivable management?
Answer:
Receivables management is a decision making process which takes into account the creation of debtors turnover and minimising the cost of borrowing of working capital due to lacking of funds in receivables.

Question 15.
What is Ageing Schedule?
Answer:
Ageing schedule is a table that classifies accounts receivable and payables according, to their dates. It helps in managing cash and analyzing payments.

Question 16.
What do you mean by Debtors Turnover Ratio?
Answer:
A concern may sell goods on cash as well as on credit. Credit is one of the important elements of sales promotion. The volume of sales can be increased by following a liberal credit policy.
Debtors/Receivables Turnover = \(\frac{\text { Net Credit Annual Sales }}{\text { Average Trade Debtors }}\)
= No. of times
Trade Debtors = Sundry debtors + Bills Receivables
Debtors should always be taken to gross value. No provision for bad and doubtful debts be deducted from them. Generally, the higher the value of debtors turnover the more efficient is the management of debtors/sales or more liquid are the debtors.

Question 17.
What is Inventory Management?
Answer:
Inventory Management refers to the purchase of raw materials from the right source at the right time and at the -right price and supplying the materials to the production department as and when required. The main objective of inventory management is to reduce the order placing, receiving and inventory carrying cost

Question 18.
State the objectives of inventory management.
Answer:
The basic objectives of inventory management are:

  • Availability of materials
  • Best services to consumers
  • Wastage minimisation
  • Optimum Investment

Question 19.
Give the meaning of EOQ.
Answer:
Economic Order Quantity is a point at which the carrying cost and the ordering cost are equal. Economic order Quantity is that size of the lot to be purchased which is economically viable. This is the quantity of material which can be purchased at minimum costs.

Question 20.
Mention two benefits of holding inventories.
Answer:
Various benefits of holding inventories are:

  • Avoiding Lost Sales
  • Gaining Quantity Discounts
  • Reducing Order Cost

Question 21.
Mention the techniques of inventory management.
Answer:
The techniques of inventory management are:

  • Fixation of levels
  • ABC Analysis
  • VED analysis
  • FSN analysis
  • Economic order quantity
  • Perpetual inventory system.

Question 22.
What is ABC analysis OR Pareto analysis?
Answer:
ABC analysis is a method of material control wherein the materials are divided into a number of categories. Materials are controlled giving importance to its value. Materials are graded as A, B & C where in materials with ‘A’ grade are costly in value but less in number where as materials with ‘C” grade are cheap in value and more in number. Grade ‘B’ materials are moderate in value and moderate number of such items are maintained.

Question 23.
What is Just-In-Time Management?
Answer:
Just-In-Time (JIT) is a broad philosophy of seeking excellence and eliminating waste in the manufacturing process. A major objective of JIT is to have items only at the right place at the right time i.e. to purchase and produce items only before they are needed so that work-in-process inventory is keet low. As a concept, JIT means that virtually no inventories are held at any stage of production and that exact number of units is brought to each successive stages of production at the right time.

Question 24.
What do you mean by safety stock?
Answer:
The receipt of inventory from the suppliers may be delayed beyond the expected lead time. The delay may be because of strikes, floods, transportation and communication barriers, and also because of seasonal nature of the raw materials. This inturn would disrupt the production schedule. To prevent this situation the firm maintains additional inventory which is known as “safety stock”.

The Finance Function Long Answer Type Questions

The Finance Function Long Answer Type Questions

Question 1.
Explain the scope of financial management.
Answer:
The primary objective of a finance Manager is to arrange sufficient finances in order to meet the short term long, term needs. The funds are procured at minimum costs so that the profitability of the business is maximised.

The finance manager should basically concentrate on the following areas:
(1) Financial Estimation: As stated earlier, the prime task of a finance executive is to estimate the short term and long term financial requirement of the business. The estimation of finance should be such that there should neither be inadequate nor excess funds with the concern because both the situations would be uangerous for the concern. If there is inadequacy of funds, the day-to-day functioning of the organisation gets affected whereas excess funds results in misuse of funds are unprofitable investment.

(2) Planning of the capital structure: The process of planning of the capital structure includes selection of right proportion of securities for raising funds. The process involves deciding about the quantum of funds and also the type of securities to raise the funds. The organisation should choose long term debts for financing fixed assets and overdrafts and cash credits should be selected for financing working capital requirements.

(3) Selecting right source of funds: In market, finance is available in different forms like shares, debentures, financial institutions, commercial banks public deposits etc. Selecting a right source at the right time at right cost is the challenge for the finance executive. Before making any commitment about the funds, the finance executor should decide and be clear about the period for which funds are required. It funds are needed for short period then he should choose banks, financial institutions etc. If funds are needed for long periods then equity or debentures should be selected.

(4) Investment of funds: After the mobilisation of funds, it is the responsibility of the finance manager to allocate or invest the funds towards capital expenditure and revenue expenditure. Before making a final decision the profitability of each project has to be evaluated by the finance manager. The proposal is selected based on the fair returns it promises.

(5) Analysing the financial performance: After the investment of funds in different investment proposals, the performance of each proposal has to be measured. In other words the profit generating capacity of each proposal has to be analyzed.

(6) Planning of profit: Profit earning capacity of an organisation speaks about the efficiency level Of the organisation. Profit earning capacity enables future expansion and diversification programs of the company. It is the prime responsibility of the finance manager to plan the profits before hand as he has to protect the interest of the stakeholders and shareholders.

(7) Ensuring liquidity: Another responsibility of a finance manager is to ensure the liquidity of the organisation as it is directly by related to the borrowing capacity of the company.

Question 2.
Give a brief note on sources of business finance.
Answer:
There are two major sources of finance for meeting the financial requirements of any business enterprises, which are as under

Owners Fund:
Owners fund is also called as Owners Capital or owned capital. It consists of the funds contributed by the owners of business as well as profits reinvested in business. A company cans raise owner’s funds in the following ways:

  • Issue of equity shares,
  • Ploughed back profits

Borrow Fund:
The second source of funding to a business is the borrowed fund. Borrowed fund consists of the amount raised by way of loans or credit. It is also known as borrowed capital.
The borrowed fund is procured from the following sources:

  • Debentures
  • Bank Loans
  • Loans from specialized financial institutions.
  • Other long term financial institutions

All businesses require an adequate finance. They need money for investment in fixed asset such as land, building, machinery etc. Once business is in operation, money is needed for Working Capital, such as purchase of raw material, payment of wages, utility bills etc. A going concern also requires extra capital to cover a temporary cash flow crisis, or purchase new improved machinery or simply to expand the business. The financial requirements of a business, on the basis of time duration, are usually classified under three heads which are as follow

1. Short Term Finance:
Short term Sources of finance is defined as money raises for investment in business for a period of less than one year, it is also named as working capital or circulating capital or revolving capital.

The purpose and amount of obtaining short term capital varies with the nature and size of the business. Generally the short term capital is required for meeting the day to day expenses of business such as payment of utility bills, wages to the workers, unforeseen expenses, seasonal upswings in business, increasing inventories raw material, work in progress and finished goods etc.

The various sources of short term finance are as under –

  • Trade creditor open book account
  • Advance from customers
  • Installment credit
  • Bank Overdraft
  • Gash credit
  • Discounting bills
  • Against bill of lading

2. Medium Term Finance:
Medium term sources of finance are required for investment in business for a medium period which normally ranges from one to five years. The medium term funds are required generally for the repair and modernization of machinery, renovation of the building, adoption of new methods of production, carrying advertisement campaign on large scale, in newspapers, television etc. The various sources of medium term finance are as under:

  • Commercial Banks
  • Debentures
  • Loans from Specialized Credit Institutions

3. Long Term Finance:
Long term sources of finance refer to the funds, which are required for investment in business for a period exceeding up’ to five years. It is also named as long term capital or fixed capital. Long term sources’of finance are mostly required for the purchased of fixed assets, such as land, building, machinery etc. modernization and expansion of business. The amount of long term finance varies with the nature of business, size of business, nature of the product manufactured, the number of goods produced, and the method of production etc. The various sources of long term finance are as under

  • Equity shares
  • Issue of right shares
  • Debentures
  • Loans from industrial and financial institutions –
  • Leasing
  • Ploughing back of profits

Question 3.
What are the aims/goals/objectives of financial management?
Answer:
Financial Management of any business firm has to set goals for and to interpret them in relation to the objectives of the firm. Broadly there are only two alternative goals/objectives of financial management.
1. Specific Objectives:
(a) Profit Maximisation: It is considered as an important goal in financial decision making in an organisation. Maximisation is the condition of achieving the maximum target profit with available resources .in an economic and efficient manner. Profit ensures maximum welfare to the share holders, employees and creditors and increases confidence of the management of the company.

(b) Wealth Maximisation: It refers to the maximisation of wealth through maximisation in the market value of shares of a company. The efficient management of an organisation maximises the present value not only for shareholders but for all including employees, customers, suppliers and community at large. It Is the ultimate objective of every organisation.

2. General Objectives:
(a) Balanced asset structure: A proper balance between the fixed and current assets is an important factor for efficient management of funds. This is one of the objectives of financial management that the size of current asset must permit the company, to exploit the investments on fixed assets.

(b) Liquidity: Liquidity refers to available cash and it is an indication of positive growth of a company. It is an important factor for meeting the short and long term obligations of a firm.

(c) Proper planning of funds: Proper planning of funds include acquisition and allocation of funds in the best possible manner i.e. minimum cost of acquisition of funds but maximum returns through wise decisions.

(d) Efficiency: Efficiency and effectiveness are very much necessary in controlling the flow of funds. The efficiency level should continuously increase for betterment of
the organisation.

(e) Financial discipline: There shouldn’t be any bulk handling of funds, mis-use etc. Proper discipline should be practiced in matters relating to finance, its flow and control. This can be done through various techniques like budgeting, fund flow statements etc.

Question 4.
Evaluate Wealth Maxmisation and Profit Maximisation as primary objectives of a concern?
Answer:
Profit maximisation: It is the primary motive of any business concern to earn profit. Profit is the means through which the efficiency level of an organisation can be measured. Profits reduce the risk of companies. The ultimate survival of the firm depends upon the profit generating capacity.

Wealth Maximisation: Wealth Maxmisation refers to creation of wealth of the concern. In other words, it refers to the increase in the market value of shares. By taking care of the interest of shareholders and stakeholders, the company in the long run can ensure the increase in the value of its shares.

Profit maximisation:
Advantages:

  • The efficiency level of an organisation can be ensured only through profits.
  • The interest of shareholders, creditors, employees, banks, financial institutions etc., can be protected and
  • their welfare can be ensured only through profits.
  • The profits enable a concern to take up expansion and diversification programs.
  • Profits increase the demand for the shares of the company.
  • Profits ensure the survival of the concern

Disadvantages:

  • Profit maximisation objective does not consider the element of risk.
  • Profit maximisation unnecessarily invites competition for the concern
  • There is unnecessary government intervention because of profit maximisation
  • Huge profits invite problems from workers.
  • Huge profits unnecessarily create doubts in the minds of customers that they are cheated

Wealth Maximisation:
Advantages:
1. Wealth maximisation is a clear term. The present values of cash flows are taken into consideration. The effect of investment and benefits can be measured clearly.

2. Wealth Maximisation includes the concept of time value of money. This concept includes the usage of present value of cash inflows and cash outflows which helps in achieving the overall objectives of the company.

3. Wealth Maximisation guides the management in framing consistent strong dividend policy to give maximum returns to the equity shareholders.

Disadvantages:
The objective of wealth maximisation is not descriptive. The wealth maximisation concept differs from one entity to another entity.

Question 5.
Write short note economic environment for business.
Answer:
Economic environment influences the business to a great extent. It refers to all those economic factors which affect the functioning of a business unit. Dependence of business on economic environment is total i.e. for input and also to sell the finished goods. Trained economists supplying the Macro economic forecast and. research are found in major companies in manufacturing, commerce and finance which prove the importance of economic environment in business.

The following factors constitute economic environment of business:

  • Economic system
  • Economic planning
  • Industry
  • Agriculture
  • Infrastructure
  • Financial & fiscal sectors
  • Removal of regional imbalances
  • Price and distribution controls
  • Economic reforms
  • Human resource and
  • Per capita income and national income

Question 6.
Explain various functions of financial markets.
Answer:
The various functions of financial markets are:
Functions of a financial market can be classified into two categories: Economic Functions, and Financial Functions. The various functions of financial markets are as follows:
(a) Economic Functions:

  • It facilitates the transfer of real economic resources from lenders to ultimate borrowers in financial system
  • Lenders earn interest/dividend on their surplus invisible funds, thereby increasing their earnings, and as a result, enhancing national income of the country.
  • Borrowers will have’ to use borrowed funds productively if invested in new assets, hence increasing their income, spending and standard of living.
  • By facilitating transfer of real resources, it serves the economy and finally the welfare of the general public in the country.
  • It provides a channel through which new savings flow into capital market which facilitates smooth capital formation in the economy.
  • Interaction of buyers and sellers in the financial market helps in price discovery of financial assets.
  • Financial markets provide a mechanism for an investor to sell a financial asset and liquidate the funds invested. In the absence of liquidity, the owner will be forced to hold a debt instrument till its maturity.
  • Financial market reduces the search and information costs of transacting financial instrument. Search costs include money spent to advertise the desire to sell purchase a financial asset.

(b) Financial Functions:

  • It provides the borrowers with funds which they will invest in some productive purpose.
  • It provides the lenders with productive assets so that they can invest it in productive usage without the necessity of direct ownership of assets.
  • 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 7.
Give the classification of financial markets. OR Discuss the types o of financial markets.
Answer:
Financial markets can be classified into:
a. Money market and capital market: Money market is a market for short term financial assets, which are near substitutes for money. Money market instruments are highly liquid in nature and can be easily converted into cash without major losses. The instruments of money market are for shortest duration usually for a period less than one year. The dealings of money market can. be conducted with the involvement of brokers and middlemen.

Money market consists of a number of sub markets such as treasury bills market, call money market, inter bank transactions market, commercial paper market and commercial bill market etc. Capital market is the market for developmental finance. This market deals with instruments such as shares, debentures etc. Capital market instruments are for long term duration. It is a market for long term finance.

b. Primary market and secondary market: Primary (or new issue) market basically consists of all people, institutions, services and practices involved in raising fresh capital for both new and existing companies. Primary markets is a market for new securities, which acquire capital for the first time.

Secondary market basically consists of securities which are already issued. Secondary market also known as stock market which deals with purchases and sales of securities issued by government, semi government or public sector undertakings and shares and debentures by Joint stock companies.

c. Organised, and Unorganised market: The operators of organised market are non-bank financial institutions such as LIC, and GIC, State Co-operative Banks etc. At the top, there are state co-operative banks, at the district level there are central co-operative banks and at local level, there are primary credit societies and urban co-operative banks. This is called as organised market because they are governed by RBI.

The Unorganised market structure comprises of Money lenders, indigenous bankers etc. It is said as unorganised market because the activities of these market are not governed by RBI or any other authority. The principal operators of unorganised market are money lenders, indigenous banks, nidhis and chit funds etc.

d. Foreign Exchange market: It is a market where foreign currency are bought and sold. The major operators of this market are central bank and its authorised dealers. The foreign exchange market plays the part of a clearing house through which purchases and sales of foreign exchange whether originating outside the market or within the market itself are offset against each other.

e. Broad, deep and shallow market: Broad market is a market that basically attracts funds from national and international investors in greater volume. Deep market is a market where there are good opportunities for swap dealings. Shallow market is an under developed financial market. This underdevelopment exists due to unnecessary regulations and control imposed by government.

Question 8.
What are functions of financial intermediaries?
Answer:
The various functions performed by these intermediaries are broadly classified into two:
(а) Traditional functions:

  • Underwriting of investments in shares/debentures etc
  • Dealing in secondary market activities
  • Participating in money market instruments
  • Involving in leasing, hire purchase, venture capital, seed capital etc.
  • Dealing in foreign exchange market activities
  • Managing the capital issues
  • Making arrangements for the placement of capital and debt instruments with investing institutions
  • Arrangement of funds from financial institutions for the clients project
  • Assisting in the process of getting all Government and other clearances.

b. Modern Functions:

  • Rendering project advisory services
  • Planning for mergers and acquisitions and assisting for their smooth carry out
  • Guiding corporate customers in capital restructuring
  • Acting as trustees’to the debenture holders .
  • Structuring the financial collaboration joint venture by identifying suitable partner and preparing joint venture agreement
  • Rehabilitating and reconstructing sick companies
  • Hedging of risks by using swaps and derivatives –
  • Managing portfolio of large public sector corporations .
  • Undertaking risk management services like insurance service, buy back options etc
  • Advising the clients on best source of funding overall
  • Guiding the clients in the minimisation of the cost of debt
  • Capital market .services such as clearing, registration and transfers, safe custody of securities, collection of income on securities
  • Promoting credit rating agencies.
  • Recommending suitable changes in the management structure and management style with a view of achieving better result.

Question 9.
Explain the different instruments traded in money market.
Answer:
The instruments traded in Money market are:

  • Treasury bills
  • Commercial bills
  • Certificates of deposits
  • Inter-bank participation certificates
  • Commercial papers
  • Money at call or call money

(a) Treasury bills: Treasury bills are purely finance bills, which are for short term not exceeding one year, issued by RBI on behalf of the government. The primary objectives behind the issue of treasury bills is to meeting temporary financial deficits of government.

(b) Commercial bills: There are situations of credit sale, the seller draws a bill on behalf of the buyer, the buyer accepts the bill by promising him to pay the bill amount later Usually bills are drawn for 3 months and 6 months.

(c) Certificates of deposits: These are short term instruments issued by banks, financial institutions to raise large sums of money. The Certificates of deposits are issued for period ranging from 3 months to one year. These are issued to individuals, corporation, companies, trust, funds, associations etc. r in the form of promissory notes payable on a particular fixed date without days of grace.

(d) Inter bank participation: With the permission of RBI, the banks are authorised to raise short term finance by issuing Inter bank participation certificate. This scheme of inter banks participation is restricted to scheduled commercial banks only and the participation is for a minimum period ranging from 91 days to 180 days. Participation is permitted in two types a. With risk participation b. Without risk participation.

(e) Commercial papers: These refers to promissory notes issued by i companies, basically approved by RBI. These are negotiable by endorsement and delivery. These are usually issued with a fixed maturity and at a discount usually determined by the company issuing it.

(f) Money at call: This is basically a market for short term loans say one day to fourteen days. These are payable on demand at the option of the lender or borrower.

Question 11.
Briefly explain the components of money market.
Answer:
The Indian Money Market is divided into two parts, namely, the unorganised sector and the organised sector. This has been depicted below:
The Finance Function Long Answer Type Questions 1
I. Unorganized Sector:
The unorganized sector is more predominant in small towns and villages where modern banking facilities are not available. Farmers, labourers, craftsman, artisans and other small scale producers and traders who do not have access to modern band, rely on the unorganized sector.

A. Unregulated Non banking financial intermediaries:
These include – i) Finance companies, ii) Chit fund, and iii) Nidhis Finance companies are found all over the country and generally give loans to retailers, wholesalers, traders, artisans and other self-employed persons. They charge high rates of interest from 36% to 48% Chit funds have no standardised form. It has regular members who make fixed periodic subscriptions to it.

The total fund collected from this periodic subscription is given to some member of the chit fund selected on the basis of previously agreed criterion. The RBI has absolutely no control over the lending activities of the chit funds. The nidhis are predominant in South India they are like some kind of mutual benefit funds as their dealings are restricted only to members. Since the nidhis operate in the unregulated credit market, there is hardly any information available about the amount of lending business done by them.

B. Indigenous bankers: are individuals or private firms which receive deposits and give loans and thereby operate as bands. Indigenous bankers do not constitute a homogenous groups. They can be classified under four subgroups. Namely equjarati shroffs, Muitane shroffs, Chettiars and Marwari kayas Amongst these four, the Gujarati indigenous bankers are the most important in terms of volume of business. Indigenous bankers are facing stiff competition from the commercial and co-operative banks.

C. Moneylenders : are of three types:

  • professional money enders whose main activity is money lending;
  • itinerant money lenders like pathans and Kabouli’s and
  • non professional money lenders whose main source of income is not money lendings, the activities of money lenders are generally lacalised.

II. Organized Sector:
Mumbai, Delhi, Chennai, Kolkatta, Ahmedabad and Bangalore are the principal centres of the organized money market in India, Mumbai being the most prominent, the organized sector of the Indian money market comprises the RBI, commercial banks, foreign banks, cooperative banks, finance corporations, Mutual Funds and Discount and Finance House of India limited (DFHI) the principal constituents of the Indian money market are:

  • The call money market
  • The treasury Billmarket
  • The Repo market
  • the commercial Bill market
  • The certificate of Deposits Market
  • The commercial paper market and
  • Money Market Mutual Funds.

A. The Call Money Market: The call money market refers to the market for extremely short period loans, say one day to fourteen days. These loans are repayable on demand at the option of either the lender or the borrower.

B. Treasury Bill Market: Treasury bills are short term promissory notes issued by RBI on behalf of Central Government for raising fund to meet revenue expenditure. These are issued at discount to face value.

C. The Repo Market: Repo is a money market instrument which helps in collateralised short term borrowing and lending through sale purchase operations in debt instruments.. Under a repo transaction, securities are sold by their holder to an investor with an agreement to repurchase them at a predetermined rate and date. Under reverse repo transactions, securities are purchased with a simultaneous commitment to resll as a predetermined rate and date.

D. The Commercial Bill Market: The Commercial Bill Market is the Submarket in which the trade bills or commercial bills are handled. The Commercial bill is a bill drawn by one merchant firm on the other. The legitimate purpose of a commercial bill is to reimburse the seller while the buyer delays payment. In India, the commercial bill market is highly undeveloped Commercial bills as instruments of credit are useful to both business firms and banks

E. The Certificate of Deposit Market: Certificate of deposits are short term deposit instruments issued by banks and financial institutions to raise large sums of money.

F. Commercial Paper: A Commercial Paper is an unsecured promissory note issued with a fixed maturity, short-term debt instrument issued by a corporation approved by RBI, typically for the financing of accounts receivable, inventories and meeting short-term liabilities. Maturities on commercial paper rarely range any longer than 270 days. The debt is usually issued at a discount, reflecting prevailing market interest rates. Commercial paper is not usually backed by any form of collateral, so only firms with high-quality debt ratings will easily find buyers without having to offer a substantial discount (higher cost) for the debt issue.

G. Money Market Mutual funds: A Scheme of money market mutual funds was introduced by the RBI in April 1992. The objective of the scheme was to provide an additional short term avenue to the individual investors. As the initial guidelines were not attractive, the scheme did not receive a favourable response. The new guidelines allow banks, public financial institutions and also the institutions in the private sector to set up MMMFs. MMMFS have been brought under the purview of-the SEBI regulations since March 2000.