Address: Near Jivan Jyoti Hospital, Tinsukia College Road; Contact Person: Naveen Mahato, 8876720920

Tuesday, November 07, 2017

Financial Management Solved Question Papers: November' 2014

2014 (November)
Course: 302
(Financial Management)
The figures in the margin indicate full marks for the questions.
1. (a) Write ‘True’ or ‘False’:    1x4=4
  1. The cost of capital is minimum rate of return expected by its investors. True
  2. Financial leverage is also known as composite leverage. False
  3. Leasing benefits both the lessee as well as the lessor. True
(b) Choose the appropriate answer from the given alternatives:                               1x2=2
(i) The prime objective of an enterprise is
  1. maximization of sales
  2. maximization of owner’s equity
  3. maximization of profit
(ii) Non-members can trade in securities at stock exchanges with the help of
  1. jobbers
  2. brokers
  3. authorized clerk
(c) Fill in the blanks:        1x3=3

  1. Corporation finance is a wider term than business Finance finance.
  2. Degree of financial leverage = Percentage Change in EPS/Percentage change in EBIT.
  3. The volume of sales is influenced by fund policy of a firm.
2.    Write short notes on (any four):                       4x4=16
    1. Profit maximization
    2. Trading on equity
    3. Sweat equity shares
    4. Dividend payout ratio
    5. Working capital
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. 
Trading on Equity: 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 
Dividend Payout Ratio: The dividend payout ratio measures the percentage of net income that is distributed to shareholders in the form of dividends during the year. In other words, this ratio shows the portion of profits the company decides to keep to fund operations and the portion of profits that is given to its shareholders. Investors are particularly interested in the dividend payout ratio because they want to know if companies are paying out a reasonable portion of net income to investors. The dividend payout formula is calculated by dividing total dividend by the net income of the company i.e.  Dividend Payout Ratio = Total Dividend/Net income
Sweat equity shares: Sweat equity shares refers to equity shares given to the company’s employees on favourable terms, in recognition of their work. It is one of the modes of making share based payments to employees of the company. The issue of sweat equity allows the company to retain the employees by rewarding them for their services. Sweat equity rewards the beneficiaries by giving them incentives in lieu of their contribution towards the development of the company. Further, it enables greater employee stake and interest in the growth of an organization as it encourages the employees to contribute more towards the company in which they feel they have a stake.
Working Capital: The capital required for a business is of two types. These are fixed capital and working capital. Fixed capital is required for the purchase of fixed assets like building, land, machinery, furniture etc. Fixed capital is invested for long period, therefore it is known as long-term capital. Similarly, the capital, which is needed for investing in current assets, is called working capital. The capital which is needed for the regular operation of business is called working capital. Working capital is also called circulating capital or revolving capital or short-term capital.
In the words of John. J Harpton “Working capital may be defined as all the shot term assets used in daily operation”.
According to “Hoagland”, “Working Capital is descriptive of that capital which is not fixed. But, the more common use of Working Capital is to consider it as the difference between the book value of the current assets and the current liabilities.
From the above definitions, Working Capital means the excess of Current Assets over Current Liabilities. Working Capital is the amount of net Current Assets. It is the investments made by a business organisation in short term Current Assets like Cash, Debtors, Bills receivable etc.
3.    (a) Define ‘finance function’. Explain its role in a business firm. Discuss some of the crucial financial problems that a decision maker faces today.                        2+4+6=12
Ans: Finance function is the most important of all business functions. It means a focus of all activities. It is not possible to substitute or eliminate this function because the business will close down in the absence of finance. The need for money is continuous. It starts with the setting up of an enterprise and remains at all times. The development and expansion of business rather needs more commitment for funds. The funds will have to be raised from various sources. The sources will be selected in relation to the implications attached with them. The receiving of money is not enough, its utilization is more important. The money once received will have to be returned also. It its use is proper then its return will be easy otherwise it will create difficulties for repayment. The management should have an idea of using the money profitably. It may be easy to raise funds but it may be difficult to repay them. The inflows and outflows of funds should be properly matched.
Significance of financial management in the present day business world
The scope and significance of financial management can be discussed from the following angles:
1) Importance to Organizations
  1. Business organizations: Financial management is important to all types of business organization i.e. Small size, medium size or a large size organization. As the size grows, financial decisions become more and more complex as the amount involves also is large.
  2. Charitable organization / Non-profit organization / Trust: In all those organizations, finance is a crucial aspect to be managed. A finance manager has to concentrate more on collection of donations/ revenues etc and has to ensure that every rupee spent is justified and is towards achieving Goals of organization.
  3. Government / Govt. or public sector undertaking: In central/ state Govt, finance is a key/ important portfolio generally given to most capable or competent person. Preparation of budget, monitoring capital /revenue receipt and expenditure are key functions to be performed by the person in charge of finance. Similarly, in a Govt or public sector organization, financial controller or Chief finance officer has to play a key role in performing/ taking all three financial decisions i.e. raising of funds, investment of funds and distributing funds.
  4. Other organizations: In all other organizations or even in a family finance is a key area to be looked in to seriously by a competent person so that things do not go out of gear.
2) Importance to all Stake holders
a) Share holders: Share holders are interested in getting optimum dividend and maximizing their wealth which is basic objective of financial management.
b) Investors / creditors: these stake holders are interested in safety of their funds, timely repayment of the principal amount as well as interest on the same. All these aspect are to be ensured by the person managing funds/ finance.
c) Employees: They are interested in getting timely payment of their salary/ wages, bonus, incentives and their retirement benefits which are possible only if funds are managed properly and organization is working in profit.
d) Customers: They are interested in quality products at reasonable rates which is possible only through efficient management of organization including management of funds.
e) Public: Public at large is interested in general public welfare activities under corporate social responsibility and this aspect is possible only when organization earns adequate profit.
f) Government: Govt is interested in timely payment of taxes and other revenues from business world where again efficient finance manager has a definite role to play.
g) Management: Management is interested in overall image building, increase in the market share, optimizing share holders wealth and profit and all these aspect greatly depends upon efficient management of financial resources.
3) Importance to other departments of an organization
A large size company, besides finance dept., has many departments like
  1. Production Dept
  2. Marketing Dept
  3. Personnel Dept
  4. Material/ Inventory Dept
All these departments look for availability of adequate funds so that they could manage their individual responsibilities in an efficient manner. Lot of funds are required in production/manufacturing dept for ongoing / completing the production process as well as maintaining adequate stock to make available goods for the marketing dept for sale. Hence, finance department through efficient management of funds has to ensure that adequate funds are made available to all department and these departments at no stage starve for want of funds. Hence, efficient financial management is of utmost importance to all other department of the organization.
Major consideration by managers before taking financial decisions:
While taking financing decisions the finance manager keeps in mind the following factors:
1. Cost: The cost of raising finance from various sources is different and finance managers always prefer the source with minimum cost.
2. Risk: More risk is associated with borrowed fund as compared to owner’s fund securities. Finance manager compares the risk with the cost involved and prefers securities with moderate risk factor.
3. Cash Flow Position: The cash flow position of the company also helps in selecting the securities. With smooth and steady cash flow companies can easily afford borrowed fund securities but when companies have shortage of cash flow, then they must go for owner’s fund securities only.
4. Control Considerations: If existing shareholders want to retain the complete control of business then they prefer borrowed fund securities to raise further fund. On the other hand if they do not mind to lose the control then they may go for owner’s fund securities.
5. Floatation Cost: It refers to cost involved in issue of securities such as broker’s commission, underwriters fees, expenses on prospectus, etc. Firm prefers securities which involve least floatation cost.
6. Fixed Operating Cost: If a company is having high fixed operating cost then they must prefer owner’s fund because due to high fixed operational cost, the company may not be able to pay interest on debt securities which can cause serious troubles for company.
7. State of Capital Market: The conditions in capital market also help in deciding the type of securities to be raised. During boom period it is easy to sell equity shares as people are ready to take risk whereas during depression period there is more demand for debt securities in capital market.
(b) “Finance function of a business is closely related to its other functions.” Discuss.        12
Ans: The relationship between financial management and other functional areas can be defined as follows:
1. Financial Management and Production Department: The financial management and the production department are interrelated. The production department of any firm is concerned with the production cycle, skilled and unskilled labour, storage of finished goods, capacity utilisation, etc. and the cost of production assumes a substantial portion of the total cost. The production department has to take various decisions like replacing machinery, installation of safety devices, etc. and all the decisions have financial implications.
2. Financial Management and Material Department: The financial management and the material department are also interrelated. Material department covers the areas such as storage, maintenance and supply of materials and stores, procurement etc. The finance manager and material manager in a firm may come together while determining Economic Order Quantity, safety level, storing place requirement, stores personnel requirement, etc. The costs of all these aspects are to be evaluated so the finance manager may come forward to help the material manager.
3. Financial Management and Personnel Department: The personnel department is entrusted with the responsibility of recruitment, training and placement of the staff. This department is also concerned with the welfare of the employees and their families. This department works with finance manager to evaluate employees’ welfare, revision of their pay scale, incentive schemes, etc.
4. Financial Management and Marketing Department: The marketing department is concerned with the selling of goods and services to the customers. It is entrusted with framing marketing, selling, advertising and other related policies to achieve the sales target. It is also required to frame policies to maintain and increase the market share, to create a brand name etc. For all this finance is required, so the finance manager has to play an active role for interacting with the marketing department.
4. (a) A company is considering an investment proposal to purchase a machine costing Rs. 2,50,000. The machine has a life expectancy of 5 years and no salvage value. The company’s tax rate is 40%. The firm uses straight-line method for providing depreciation. The estimated cash flows before tax after depreciation (CFBT) from the machine are as follows.

a) payback period;
b) average rate of return;
c)  net present value at 10% discount rate.                         3+4+4=11
You may use the following table:
PV Factor at 10%

Calculation of Cash Inflows
(After dep.)
`Tax (40%)
(After dep.)
Cash flows After Tax and before Depreciation Cash Inflows

(a) Calculation of Pay-back period

Cash outlay of the project
Total Cash inflows for the first 2 years
Balance of cash outlay left to be paid-back in the 3rd year
Cash inflow for the 3rd year
So, the pay-back period is between 2nd and 3rd year, i.e.:

(b) Calculation of Average Rate or Return
(c) Calculation of Net Present Value at 10% Discount Rate
Cash Inflows
P.V. Factor at 10%
Present Value

Calculation of Profitability Index
(b) What is ‘financial leverage’? How does it magnify the revenue available for equity shareholders? Discuss the relationships between financial leverage and debt financing.                      2+41/2+41/2=11
Ans: Financial Leverage: Leverage activities with financing activities is called financial leverage. Financial leverage represents the relationship between the company’s earnings before interest and taxes (EBIT) or operating profit and the earning available to equity shareholders. Financial leverage is defined as “the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share”. It involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders. Financial leverage can be calculated with the help of the following formula:
FL = Financial leverage
OP = Operating profit (EBIT)
PBT = Profit before tax.
Impact of Financial leverage on profitability:
  1. Financial leverage helps to examine the relationship between EBIT and EPS.
  2. Financial leverage measures the percentage of change in taxable income to the percentage change in EBIT.
  3. Financial leverage locates the correct profitable financial decision regarding capital structure of the company.
  4. Financial leverage is one of the important devices which is used to measure the fixed cost proportion with the total capital of the company.
  5. If the firm acquires fixed cost funds at a higher cost, then the earnings from those assets, the earning per share and return on equity capital will decrease.
Relationship between financial leverage and debt financing:
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 
5.    (a) What are the main sources of finance available to industries for meeting long-term financial requirements? Discuss.        11
(b) Comment on accounting policies and disclosures in relation to finance leases and operating leases prescribed in AS-19.                                11
6.    (a) Explain the various factors which influence the dividend decision of a firm.                      11
Ans: Factors Influencing Dividend Decision: There are various factors which affect dividend decision. These are enumerated below with brief explanation.
  1. Legal position: Section 205 of the Companies Act, 1956 which lays down the sources from which dividend can be paid, provides for payment of dividend (i) out of past profits and (ii) out of moneys provided by the Central/State Government, apart from current profits. Thus, by law itself, a company may be allowed to declare a dividend even in a year when the profits are inadequate or when there is absence of profit.
  2. Magnitude and Trend in EPS: EPS is the basis for dividend. The size of the EPS and the trend in EPS in recent years set how much can be paid as dividend a high and steadily increasing EPS enables a high and steadily increasing DPS. When EPS fluctuates a different dividend policy has to be adopted.
  3. Taxability: According to Section 205(3) of the Companies Act, 1956 'no dividend shall be payable except in cash'. However, the Income-Tax Act defines the term dividend so as to include any distribution of property or rights having monetary value. Therefore liberal dividend policy becomes unattractive from the point of view of the shareholders/investors in high income brackets. Thus a company which considers the taxability of its shareholders, may not declare liberal dividend though there may be huge profit, but may alternatively go for issuing bonus shares later.
  4. Liquidity and Working Capital Position: Apparently, distribution of dividend results in outflow of cash and as such a reduction in working capital position. Even in a year when a company has earned adequate profit to warrant a dividend declaration, it may confront with a week liquidity position. Under the circumstance, while one company may prefer not to pay dividend since the payment may impair liquidity, another company following a stable dividend policy, may wish to declare dividends even by resorting to borrowings for dividend payment in cash.
  5. Impact on share price: The impact of dividends on market price of shares, though cannot be precisely measured, still one could consider the influence of dividend on the market price of shares. The dividend policy pursued by a company naturally depends on how far the management is concerned about the market price of shares. Generally, an increase in dividend payout results in a hike in the market price of shares. This is significant as it has a bearing on new issues.
  6. Control consideration: Where the directors wish to retain control, they may desire to finance growth programmes by retained earnings, since issue of fresh equity shares for financing growth plan may lead to dilution of control of the dominating group. So, low dividend payout is favoured by Board.
  7. Type of Shareholders: When the shareholders of the company prefer current dividend rather man capital gain a high payment is desirable. This happens so, when the shareholders are in low tax brackets, they are less moneyed and require periodical income or they have better investment avenues than the company. Retired persons, economically weaker sections and similarly placed investors prefer current income i.e. dividend. If, on the other hand, majority of the shareholders are moneyed people, and want capital gain, then low payout ratio is desirable. This is known as clientele effect on dividend decision.
  8. Industry Norms: The industry norms have to be adhered to the extent possible. It most firms in me industry adopt a high payout policy, perhaps others also have to adopt such a policy.
  9. Age of the company: Newly formed companies adopt a conservative dividend policy so that they can get stabilized and think of growth and expansion.
  10. Investment opportunities for the company: If the company has better investment opportunities, and it is difficult to raise fresh capital quickly and at cheap costs, it is better to adopt a conservative dividend policy. By better investment opportunities we mean those with higher 'r' relative to the 'k'. So, if r>k, low payout is good. And vice versa.
  11. Restrictive covenants imposed by debt financiers: Debt financiers, especially term lending financial institutions, may impose restrictive conditions on the rate, timing and form of dividends declared. So, that consideration is also significant.
  12. Floatation cost, cost of fresh equity and access capital market: When floatation costs and cost of fresh equity are high and capital market conditions are not congenial for a fresh issue, a low payout ratio is adopted.
  13. Financial signaling: Dividends are the best medium to tell shareholder of better days ahead of the company. When a company enhances the target dividend rate, it overwhelmingly signals the shareholders that their company is on stable growth path. Share prices immediately react positively.
(b) What do you mean by ploughing back of profit? What are the purposes of ploughing back? Discuss the different factors that influence the ploughing back of profits.       2+4+5=11
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.
7.    (a) What do you understand by receivable management? Discuss the factors which influence the size of receivables. 3+8=11
Per unit (Rs.)
Raw materials
Direct labour
Selling Price
(b)The Board of Directors, Jonaki Engineering Co. Pvt. Ltd., requests you to prepare a statement showing the working capital requirements for a level of activity of 156000 units of production. The following information are available for your calculations: 11
  1. Raw materials are in stock on an average one month.
  2. Materials are in process on an average two weeks.
  3. Finished goods are in stock on an average one month.
  4. Credit allowed by suppliers- one month.
  5. Credit allowed to debtors- two months.
  6. Lag in payment of wages- 11/2 weeks.
  7. Lag in payment of overheads- one month.
20% of the output is sold against cash. Cash in had and at bank is expected to be Rs. 60,000. It is to be assumed that production is carried on evenly throughout the year, wages and overheads accrue similarly and a time period of 4 weeks is equivalent to a month.
Estimation Working Capital Requirement
Current Assets:

(iii) Stock of Finished goods:
(iv) Sundry Debtors
(v) Balance of Cash
Current Liabilities:

(ii) Outstanding Wages
(iii) Overheads