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Tuesday, November 07, 2017

Financial Management Solved Question Papers: November' 2012

2012 (November)
Commerce (Speciality)
1. Write ‘True’ or ‘False’:
  1. Financial decision includes financial planning and capital structure decisions.
  2. Profit maximization is a capitalistic approach. True
  3. Debentures do not carry any voting right. True
  4. A firm should always keep a large balance of cash so as to meet the contingencies True
2. Fill in the blanks:
(a) The time required to process and execute an order is called Fixed time.
(b) Payment of dividend involves legal as well as financial  considerations.
(c) ‘Ploughing back of profit’ is also known as retained earnings.
(d) Leasing benefits both the lessee as well as the lessor.
3. Write short notes on:
(a) Trading on Equity
(b) Lease Financing
(c) Stable Dividend Policy
(d) Inventory Management

Ans: Financial leverage is also known as Trading on Equity. Trading on Equity refers to the practice of using borrowed funds, carrying a fixed charge, to obtain a higher return to the Equity Shareholders. With a larger proportion of the debt in the financial structure, the earnings, available to the owners would increase more than the proportionately with an increase in the operating profits of the firm.  This is because the debt carries a fixed rate of return and if the firm is able to earn, on the borrowed funds, a rate higher than the fixed charges on loans, the benefit will go the shareholders. This is referred to as “Trading on Equity”
The concept of trading on equity is the financial process of using debt to produce gain for the residual owners or the equity shareholders. The term owes its name also to the fact that the equity supplied by the owners, when the amount of borrowing is relatively large in relation to capital stock, a company is said to be trading on equity, but where borrowing is comparatively small in relation to capital stock, the company is said to be trading on thick equity. Capital gearing ration can be used to judge as to whether the company is trading on thin or thick equity.
Degree of Financial Leverage: Degree of financial leverage may be defined as the percentage change in taxable profit as a result of percentage change in earning before interest and tax (EBIT). This can be calculated by the following formula:  DFL= Percentage change in taxable Income / Precentage change in EBIT 
Stable Dividend Policy: Stability of dividends means regularity in payment of dividends. It refers to the consistency in stream of dividends. In short, we can say that a stable dividend policy is a long term policy which is not affected by the variations in the earnings during different periods. The stability of dividends can take any one of the three forms:
  1. Constant D/P ratio.
  2. Constant dividends per share.
  3. Constant dividend per share plus extra dividends.
Merits of Stable Dividend Policy: Following are some of the advantages of a stable dividend policy:
  1. This policy contributes to stablise market value of company’s equity shares at a high level.
  2. This policy helps the company is mobilizing additional funds in the form of additional equity shares.
  3. Regular earnings in the form of dividend satisfy investors.
  4. This policy encourages shareholders to hold company’s share for longer time and simultaneously other investors are also attracted for the purchase of shares.
  5. This policy is helpful for expansion and growth prospects of a company.
  6. This policy encourages the institutional investors because they like to invest in those companies which make uninterrupted payment of dividends.
Demerits of Stable Dividend Policy: Following are some of the disadvantages of a stable dividend policy:
  1. Sometime despite of large earnings, management decides not to declare dividends.
  2. In this policy, instead of paying dividend in cash, bonus share are issued to the shareholders.
  3. This policy is used to capitalise reinvested earnings of the firm.

4. (a) “Finance is lifeblood of an organization and financial management is the network which facilitates its flow and availability to all organs of an organization.” Explain.
(b) What is financial management? What are the objectives of financial management? Discuss its scope.
Ans: Ans: Financial management is management principles and practices applied to finance. General management functions include planning, execution and control. Financial decision making includes decisions as to size of investment, sources of capital, extent of use of different sources of capital and extent of retention of profit or dividend payout ratio. Financial management, is therefore, planning, execution and control of investment of money resources, raising of such resources and retention of profit/payment of dividend.
Howard and Upton define financial management as "that administrative area or set of administrative functions in an organisation which have to do with the management of the flow of cash so that the organisation will have the means to carry out its objectives as satisfactorily as possible and at the same time meets its obligations as they become due.”
According to Guthamann and Dougall,” Business finance can be broadly defined as the activity concerned with the planning, raising, controlling and administering the funds used in the business.”
Bonneville and Dewey interpret that financing consists in the raising, providing and managing all the money, capital or funds of any kind to be used in connection with the business.
Osbon defines financial management as the "process of acquiring and utilizing funds by a business”.
Considering all these views, financial management may be defined as that part of management which is concerned mainly with raising funds in the most economic and suitable manner, using these funds as profitably as possible.
Objectives of Financial Management
The firm’s investment and financing decision are unavoidable and continuous. In order to make them rational, the firm must have a goal. Two financial objectives predominate amongst many objectives. These are:
1. Profit maximization
2. Shareholders’ Wealth Maximization (SWM)
Profit maximization refers to the rupee income while wealth maximization refers to the maximization of the market value of the firm’s shares. Although profit maximization has been traditionally considered as the main objective of the firm, it has faced criticism. Wealth maximization is regarded as operationally and managerially the better objective. 
1. Profit maximization: Profit maximization implies that either a firm produces maximum output for a given input or uses minimum input for a given level of output. Profit maximization causes the efficient allocation of resources in competitive market condition and profit is considered as the most important measure of firm performance. The underlying logic of profit maximization is efficiency.
In a market economy, prices are driven by competitive forces and firms are expected to produce goods and services desired by society as efficiently as possible. Demand for goods and services leads price. Goods and services which are in great demand can command higher prices. This leads to higher profits for the firm. This in turn attracts other firms to produce such goods and services. Competition grows and intensifies leading to a match in demand and supply. Thus, an equilibrium price is reached. On the other hand, goods and services not in demand fetches low price which forces producers to stop producing such goods and services and go for goods and services in demand. This shows that the price system directs the managerial effort towards more profitable goods and services. Competitive forces direct price movement and guides the allocation of resources for various productive activities. 
2. Shareholders’ Wealth Maximization: Shareholders’ wealth maximization means maximizing the net present value of a course of action to shareholders. Net Present Value (NPV) of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action that has a positive NPV creates wealth for shareholders and therefore, is desirable. A financial action resulting in negative NPV destroys shareholders’ wealth and is, therefore undesirable. Between mutually exclusive projects, the one with the highest NPV should be adopted. NPVs of a firm’s projects are additive in nature. That is
NPV(A) + NPV(B) = NPV(A+B)
The objective of Shareholders Wealth Maximization (SWM) considers timing and risk of expected benefits. Benefits are measured in terms of cash flows. One should understand that in investment and financing decisions, it is the flow of cash that is important, not the accounting profits. SWM as an objective of financial management is appropriate and operationally feasible criterion to choose among the alternative financial actions. 

Finance Functions (Scope of Financial Management)/ Types of Decisions to be taken under financial management
The finance function encompasses the activities of raising funds, investing them in assets and distributing returns earned from assets to shareholders. While doing these activities, a firm attempts to balance cash inflow and outflow. It is evident that the finance function involves the four decisions viz., financing decision, investment decision, dividend decision and liquidity decision. Thus the finance function includes:
  1. Investment decision
  2. Financing decision
  3. Dividend decision
  4. Liquidity decision
1. Investment Decision: The investment decision, also known as capital budgeting, is concerned with the selection of an investment proposal/ proposals and the investment of funds in the selected proposal. A capital budgeting decision involves the decision of allocation of funds to long-term assets that would yield cash flows in the future. Two important aspects of investment decisions are:
(a) The evaluation of the prospective profitability of new investments, and
(b) The measurement of a cut-off rate against that the prospective return of new investments could be compared.
Future benefits of investments are difficult to measure and cannot be predicted with certainty. Risk in investment arises because of the uncertain returns. Investment proposals should, therefore, be evaluated in terms of both expected return and risk. Besides the decision to commit funds in new investment proposals, capital budgeting also involves replacement decision, that is decision of recommitting funds when an asset become less productive or non-profitable. The computation of the risk-adjusted return and the required rate of return, selection of the project on these bases, form the subject-matter of the investment decision.
Long-term investment decisions may be both internal and external. In the former, the finance manager has to determine which capital expenditure projects have to be undertaken, the amount of funds to be committed and the ways in which the funds are to be allocated among different investment outlets. In the latter case, the finance manager is concerned with the investment of funds outside the business for merger with, or acquisition of, another firm.
2.Financing Decision: Financing decision is the second important function to be performed by the financial manager. Broadly, he or she must decide when, from where and how to acquire funds to meet the firm’s investment needs. The central issue before him or her is to determine the appropriate proportion of equity and debt. The mix of debt and equity is known as the firm’s capital structure. The financial manager must strive to obtain the best financing mix or the optimum capital structure for his or her firm. The firm’s capital structure is considered optimum when the market value of shares is maximized.
The use of debt affects the return and risk of shareholders; it may increase the return on equity funds, but it always increases risk as well. The change in the shareholders’ return caused by the change in the profit is called the financial leverage. A proper balance will have to be struck between return and risk. When the shareholders’ return is maximized with given risk, the market value per share will be maximized and the firm’s capital structure would be considered optimum. Once the financial manager is able to determine the best combination of debt and equity, he or she must raise the appropriate amount through the best available sources. In practice, a firm considers many other factors such as control, flexibility, loan covenants, legal aspects etc. in deciding its capital structure. 
3. Dividend Decision: Dividend decision is the third major financial decision. The financial manager must decide whether the firm should distribute all profits, or retain them, or distribute a portion and return the balance. The proportion of profits distributed as dividends is called the dividend-payout ratio and the retained portion of profits is known as the retention ratio. Like the debt policy, the dividend policy should be determined in terms of its impact on the shareholders’ value. The optimum dividend policy is one that maximizes the market value of the firm’s shares. Thus, if shareholders are not indifferent to the firm’s dividend policy, the financial manager must determine the optimum dividend-payout ratio. Dividends are generally paid in cash. But a firm may issue bonus shares. Bonus shares are shares issued to the existing shareholders without any charge. The financial manager should consider the questions of dividend stability, bonus shares and cash dividends in practice. 
4. Liquidity Decision: Investment in current assets affects the firm’s profitability and liquidity. Current assets should be managed efficiently for safeguarding the firm against the risk of illiquidity. Lack of liquidity in extreme situations can lead to the firm’s insolvency. A conflict exists between profitability and liquidity while managing current assets. If the firm does not invest sufficient funds in current assets, it may become illiquid and therefore, risky. But if the firm invests heavily in the current assets, then it would loose interest as idle current assets would not earn anything. Thus, a proper trade-off must be achieved between profitability and liquidity. The profitability-liquidity trade-off requires that the financial manager should develop sound techniques of managing current assets and make sure that funds would be made available when needed. 
5. (a) What do you mean by Investment Decisions? What are its characteristics? Discuss any one technique of investment decisions.
Ans: Meaning of Capital Budgeting or Investment Decision
The term capital budgeting or investment decision means planning for capital assets. Capital budgeting decision means the decision as to whether or not to invest in long-term projects such as setting up of a factory or installing a machinery or creating additional capacities to manufacture a part which at present may be purchased from outside and so on. It includes the financial analysis of the various proposals regarding capital expenditure to evaluate their impact on the financial condition of the company for the purpose to choose the best out of the various alternatives.
According to Milton “Capital budgeting involves planning of expenditure for assets and return from them which will be realized in future time period”.
According to I.M Pandey “Capital budgeting refers to the total process of generating, evaluating, selecting, and follow up of capital expenditure alternative”
Capital budgeting decision is thus, evaluation of expenditure decisions that involve current outlays but are likely to produce benefits over a period of time longer than one year. The benefit that arises from capital budgeting decision may be either in the form of increased revenues or reduced costs. Such decision requires evaluation of the proposed project to forecast likely or expected return from the project and determine whether return from the project is adequate.
Nature / Features of Capital budgeting decisions
  1. Long term effect: Such decisions have long term effect on future profitability and influence pace of firms growth. A good decision may bring amazing returns and wrong decision may endanger very survival of firm. Hence capital budgeting decisions determine future destiny of firm.
  2. High degree of risk: Decision is based on estimated return. Changes in taste, fashion, research and technological advancement leads to greater risk in such decisions.
  3. Huge funds: Large funds are required and sparing huge funds is problem and hence decision to be taken after proper care .
  4. Irreversible decision: Reverting back from a decision is very difficult as sale of high value asset would be a problem.
  5. Most difficult decision: Decision is based on future estimates/uncertainty. Future events are affected by economic, political and technological changes taking place.
  6. Impact on firms future competitive strengths: These decisions determine future profit or cost and hence affect the competitive strengths of firm.
  7. Impact on cost structure – Due to this vital decision, firm commits itself to fixed costs such as supervision, insurance, rent, interest etc. If investment does not generate anticipated profit, future profitability would be affected.
Payback period Method: It is one of the simplest methods to calculate period within which entire cost of project would be completely recovered. It is the period within which total cash inflows from project would be equal to total cash outflow of project. Here, cash inflow means profit after tax but before depreciation.
Merits of Payback period Method
a) This method of evaluating proposals for capital budgeting is simple and easy to understand, it has an advantage of making clear that it has no profit on any project until the payback period is over i.e. until capital invested is recovered. This method is particularly suitable in the case of industries where risk of technological services is very high.
b) In case of routine projects also, use of payback period method favours projects that generates cash inflows in earlier years, thereby eliminating projects bringing cash inflows in later years that generally are conceived to be risky as this tends to increase with futurity.
c) By stressing earlier cash inflows, liquidity dimension is also considered in selection criteria. This is important in situations of liquidity crunch and high cost of capital.
d) Payback period can be compared to break-even point, the point at which costs are fully recovered but profits are yet to commence.
e) The risk associated with a project arises due to uncertainty associated with cash inflows. A shorter payback period means that uncertainty with respect to project is resolved faster.
Limitations of payback period
a) It stresses capital recovery rather than profitability. It does not take into account returns from the project after its payback period.
b) This method becomes an inadequate measure of evaluating 2 projects where the cash inflows are uneven.
c) This method does not give any consideration to time value of money, cash flows occurring at all points of time are simply added.
d) Post-payback period profitability is ignored totally.
(b) What is financial Leverage? What are its important features? Calculate the degree of financial leverage from the following capital structure of a company:
Equity Share Capital:                                      1000000
10% preference Share Capital:                     1000000
8% Debentures:                                               1250000
The Earning Before Interest and Tax (EBIT) are Rs. 500000. The rate of income tax is 50%
6. (a) What are the main sources of finance available to industries for meeting long-term financial requirements? Discuss these sources.
(b) What is Capital Market? What are the main components of a capital market? Distinguish between Capital Market and Money Market.
7. (a) Discuss the M-M Theory of dividend distribution. What are the major criticisms of this theory of irrelevance?
Ans: Modigliani and Miller approach (M & M Hypothesis)
The residuals theory of dividends tends to imply that the dividends are irrelevant and the value of the firm is independent of its dividend policy. The irrelevance of dividend policy for a valuation of the firm has been most comprehensively presented by Modigliani and Miller. They have argued that the market price of a share is affected by the earnings of the firm and not influenced by the pattern of income distribution. What matters, on the other hand, is the investment decisions which determine the earnings of the firm and thus affect the value of the firm. They argue that subject to a number of assumptions, the way a firm splits its earnings between dividends and retained earnings has no effect on the value of the firm.
Like several financial theories, M&M hypothesis is based on the argument of efficient capital markets. In addition, there are two options:
(a) It retains earnings and finances its new investment plans with such retained earnings;
(b) It distributes dividends, and finances its new investment plans by issuing new shares.
The intuitive background of the M&M approach is extremely simple, and in fact, almost self explanatory. It is based on the following assumptions:
  1. The capital markets are perfect and the investors behave rationally.
  2. All information is freely available to all the investors.
  3. There is no transaction cost.
  4. Securities are divisible and can be split into any fraction. No investor can affect the market price.
  5. There are no taxes and no flotation cost.
  6. The firm has a defined investment policy and the future profits are known with certainty. The implication is that the investment decisions are unaffected by the dividend decision and the operating cash flows are same no matter which dividend policy is adopted.
Their conclusion is that, the shareholders get the same benefit from dividend as from capital gain through retained earnings. So, the division of earnings into dividend and retained earnings does not influence shareholders' perceptions. So whether dividend is declared or not, and whether high or low payout ratio is follows, it makes no difference on the value of the share. In order to satisfy their model, MM has started with the following valuation model.
P0= 1* (D1+P1)/ (1+ke)
P0 = Present market price of the share
Ke = Cost of equity share capital
D1 = Expected dividend at the end of year 1
P1 = Expected market price of the share at the end of year 1
With the help of this valuation model we will create a arbitrage process, i.e., replacement of amount paid as dividend by the issue of fresh capital. The arbitrage process involves two simultaneous actions. With reference to dividend policy the two actions are:
  1. Payment of dividend by the firm
  2. Rising of fresh capital.
With the help of arbitrage process, MM have shown that the dividend payment will not have any effect on the value of the firm. Even if the firm pays dividends, resulting in a increase in market value of the share, the effect on the value of the firm will be neutralised by the decrease in terminal value of the share.
Criticisms on MM Dividend theory: MM theory is criticized on the invalidity of most of its assumptions. Some of the criticisms are presented below:
  1. First, perfect capital market is not a reality.
  2. Second, transaction and floatation costs do exist.
  3. Third, Dividend has a signaling effect. Dividend decision signals financial standing of the business, earnings position of the business, and so on. All these are taken as uncertainty reducers and that these influence share value. So, the stand of MM is not tenable.
  4. Fourth, MM assumed that additional shares are issued at the prevailing market price. It is not so. Fresh issues - whether rights or otherwise, are made at prices below the ruling market price.
  5. Fifth, taxation of dividend income is not the same as that of capital gain. Dividend income upto Rs. 10000 is fully exempt, whereas capital gain attracts a flat 20% tax in the case of individual assesses. So, investor preferences between dividend and capital gain differ.
  6. Sixth, investment decisions are not always rational. Some, sub-marginal projects may be taken up by firms if internally generated funds are available in plenty. This would deflate ROI sooner than later reducing share price.
  7. Seventh, investment decisions are tied up with financing decisions. Availability of funds and external constrains might affect investment decisions and rationing of capital, then becomes a relevant issue as it affects the availability of funds.
(b) What do you mean by Ploughing Back of profit? What are the purposes of Ploughing back? Discuss different factors that influence the Ploughing back of profits.
Ans: Retained Earnings or Ploughing Back of Profit
Retained earnings are an internal sources of finance for any company. Actually is not a method of raising finance, but it is called as accumulation of profits by a company for its expansion and diversification activities. Retained earnings are called under different names such as self finance, inter finance, and plugging back of profits.  As prescribed by the central government, a part (not exceeding 10%) of the net profits after tax of a financial year have to be compulsorily transferred to reserve by a company before declaring dividends for the year.
Under the retained earnings sources of finance, a reasonable part of the total profits is transferred to various reserves such as general reserve, replacement fund, reserve for repairs and renewals, reserve funds and secrete reserves, etc.
Retained earnings or profits are ploughed back for the following purposes.
    1. Purchasing new assets required for betterment, development and expansion of the company.
    2. Replacing the old assets which have become obsolete.
    3. Meeting the working capital needs of the company.
    4. Repayment of the old debts of the company.
Determinants or Factors of Ploughing Back of Profits or Retained Earnings
    1. Total Earnings of the Enterprise: The question of saving can arise only when there are sufficient profits. So larger the earnings larger the savings, it is a common principle of financial management.
    2. Taxation Policy of the Government: The report submitted by Taxation Enquiry Commission has brought into light that taxation policy of the Government tells upon it the taxes are levied at high rates. Hence, it is also an important determinant of corporate savings.
    3. Dividend Policy: It is policy adapted by the top management (board of directors) in regards to distribution of profits. A conservative dividend policy is essential for having good accumulation of corporate savings. But, dividend policy is highly influenced by the income expectation of shareholders and by general environment prevailing in the country.
    4. Government Attitudes and Control: Govt. is not only a silent spectator but a regulatory body of economic system of the country. Its policies, control order and regulatory instructions-all compel the organizations to work in that very direction for example compulsory Deposit Scheme which had been in force.
    5. Other Factors : Other factors affecting the retained earnings are:
    1. Tradition of industry.
    2. General economic and social environment prevailing in the country.
    3. Managerial attitudes and philosophy, etc.
8. (a) What is Receivable Management? Discuss the factors which influence the size of receivables.
(b) A proforma Cost Sheet of a company provided the following particulars:
Elements of Cost:
Raw Material                      40%
Direct Labour                     10%
Overheads                          30%
Following further particulars are also available:
  1. Raw materials are to remain in stores on an average of 6 weeks
  2. Processing time is 4 weeks
  3. Finished goods are required to be in stock on an average period of 8 weeks
  4. Credit period  allowed to debtors on an average of 10 weeks
  5. Credit period  allowed by creditors is 4 weeks
  6. Lag-in payment of wages is 2 weeks
  7. Selling price per unit is Rs. 50
You are required to be preparing an Estimate of Working Capital Requirements adding 10% margin for contingencies for a level of activity of 130000 unites of production.
Estimation of Working Capital

(a) Current Assets:
(i) Raw Material
(ii) W – I – P
Ram Material





(iii) Finished goods
(iv) Sundry Debtors



(b) Current Liabilities:
(i) Sundry Creditors
(ii) Outstanding Wages




Add: 10%