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Tuesday, November 07, 2017

Financial Management Solved Question Papers: November' 2013

2013 (November)

Commerce (Speciality)

  1. Write true or false:
  1. Wealth maximization is a socialistic approach. True
  2. Cash management is an important task of finance manager. True
  3. Capital expenditure involves non-flexible short term commitment of funds. False
  4. Financial leverage is also known as Trading on Equity. True
  1. Choose the appropriate answer from the given alternatives:
  1. Financial decisions involve with
  1. Investment, financing and dividend decisions
  2. Investment, financing and sales decisions
  3. Financing, dividend and cash decisions
  1. Factoring is a method of raising
  1. Long term finance
  2. Medium term finance
  3. Short term finance
  1. Financing leverage =
  1. Contribution/Earnings before interest and tax
  2. Earnings before interest and tax/Earnings before tax
  3. Earning after interest and tax/Earnings after tax
  1. Debenture securities carry
  1. Voting rights and dividend
  2. Interest and voting rights
  3. Interest and dividend
  4. Interest only

  1. Write short notes on (any four)
  1. Wealth maximization
  2. Payback period method
  3. Financial leverage
  4. Optimal payout ratio
  5. Management of cash

  1. (a) The finance manager is responsible for shaping the fortunes of the enterprise and is involved in the most vital decision of the allocation of capital. Explain.  
(b) What is financial management? Discuss its significance in modern era. State the objectives of financial management.
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.
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.
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. 

  1. (a) “Capital budgeting is long term planning for making and financing proposed capital outlays.” Explain. What are the limitations of capital budgeting?
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.
Capital budgeting means planning for capital assets. Capital budgeting decisions are vital to any organization as they include the decisions as to:

  1. Whether or not funds should be invested in long term projects such as setting of an industry, purchase of plant and machinery etc.
  2. Analyze the proposal for expansion or creating additional capacities.
  3. To decide the replacement of permanent assets such as building and equipments.
  4. To make financial analysis of various proposals regarding capital investments so as to choose the best out of many alternative proposals.
The importance of capital budgeting can be well understood from the fact that an unsound investment decision may prove to be fatal to the very existence of the concern. The need, significance or importance of capital budgeting arises mainly due to the following:
  1. Large Investments: Capital budgeting decisions, generally, involve large investment of funds. But the funds available with the firm are always limited and the demand for funds far exceeds the resources. Hence it is very important for a firm to plan and control its capital expenditure.
  2. Long-term Commitment of Funds: Capital expenditure involves not only large amount of funds but also funds for long-term or more or less on permanent basis. The long-term commitment of funds increases the financial risk involved in the investment decision. Grater the risk involved, greater is the need for careful planning of capital expenditure, i.e. Capital budgeting.
  3. Irreversible Nature: The capital expenditure decisions are on irreversible nature. Once the decision for acquiring a permanent asset is taken, it becomes very difficult to dispose of these assets without incurring heavy losses.
  4. Long-term Effect on Profitability: Capital budgeting decisions have a long-term and significant effect on the profitability of a concern. Not only the present earnings of the firm are affected by the investments in capital assets but also the future growth and profitability of the firm depends upon the investment decision taken today. An unwise decision may prove disastrous and fatal to the very existence of the concern. Capital budgeting is of utmost importance to avoid over investment or under investment in fixed assets.
  5. Difficulties of Investment Decisions: The long term investment decisions are difficult to be taken because (i) decision extends to a series of years beyond the current accounting period, (ii) uncertainties of future and (iii) higher degree of risk.
  6. National Importance: Investment decisions though taken by individual concern is of national importance because it determines employment, economic activities and economic growth.
This, we may say that without using capital budgeting techniques a firm may involve itself in a losing project. Proper timing of purchase, replacement, expansion and alternation of assets is essential.
  1. Capital budgeting decisions are for long term and are majorly irreversible in nature.
  2. Most of the times, these techniques are based on the estimations and assumptions as the future would always remain uncertain.
  3. Capital budgeting still remains introspective as the risk factor and the discounting factor remains subjective to the manager’s perception.
  4. A wrong capital budgeting decision taken can affect the long term durability of the company and hence it needs to be done judiciously by professionals who understands the project well.
(b) XYZ company has currently an equity shares capital of Rs. 40 lakhs consisting of 40000 equity shares of Rs. 100 each. The management is planning to raise another Rs. 30 lakhs to finance a major programme of expansion through one of the four possible financing plans. The options are:
    1. Entirely through equity shares
    2. 15 lakhs in equity shares of Rs. 100 each and the balance in 8% debentures
    3. Rs. 10 lakhs in equity shares of Rs. 100 each and the balance through long-term borrowing at 9% interest p.a.
    4. Rs. 15 lakhs in equity shares of 100 each and the balance through preference shares with 5% dividend
The company’s expected earnings before interest and taxes (EBIT) will be Rs. 50%, you are required to determine the EPS and comment on the financial leverage that will be authorized under each of the above scheme of financing.
Calculation of EPS and Financial Leverage

Financial Plan
Financial Plan
Financial Plan
Financial Plan
Equity Shares (Rs. in lakhs)
Equity Shares (Number)
8% Debentures (Rs. in lakhs)
9% Long-term Borrowings (Rs. in lakhs)
5% Preference Shares (Rs. in lakhs)
Earnings before interest and tax
40 + 30 = 70
40 + 15 = 55
40 + 10 = 50

40 + 15 = 55
Less: Interest on debentures
Interest on long term borrowing
Rs. 15,00,000
Rs. 15,00,000
Rs. 15,00,000
Rs. 15,00,000
Earnings before tax
Less: Tax @ 50%
Earnings after tax (EAT)
Less: Preference dividend
Earnings for equity shareholders
Number of equity shares
Earnings per shares (EPS)
Rs. 10.71
Rs. 12.55
Rs. 13.20
Rs. 12.27
Degree of Financial Leverage (DFL)

  1. (a) What do you mean by long term finance? Explain the importance of debentures as a source of long term finance.  
(b) What is capital market? Why is it consideration as a prerequisite for the economic development of a country like India? Discuss.
  1. (a) What is Modigliani Miller approach of irrelevance concept of dividends?  Under what assumptions do the conclusions hold good?  
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 understand by retained earning? How and in what ways ploughing back of profits can short out the financial problems of a business unit?
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.
Retained earnings can sort out the financial problems of a concern in the following ways:
1. Useful for expansion and diversification: Retained earnings are most useful to expansion and diversification of the business activities.
2. Economical sources of finance: Retained earnings are one of the least costly sources of finance since it does not involve any floatation cost as in the case of raising of funds by issuing different types of securities.
3. No fixed obligation: If the companies use equity finance they have to pay dividend and if the companies use debt finance, they have to pay interest. But if the company uses retained earnings as sources of finance, they need not pay any fixed obligation regarding the payment of dividend or interest.
4. Flexible sources: Retained earnings allow the financial structure to remain completely flexible. The company need not raise loans for further requirements, if it has retained earnings.
5. Increase the share value: When the company uses the retained earnings as the sources of finance for their financial requirements, the cost of capital is very cheaper than the other sources of finance; Hence the value of the share will increase.
6. Avoid excessive tax: Retained earnings provide opportunities for evasion of excessive tax in a company when it has small number of shareholders.
7. Increase earning capacity: Retained earnings consist of least cost of capital and also it is most suitable to those companies which go for diversification and expansion.
  1. (a) What is inventory management? Discuss its objectives. How is ABC analysis useful as a tool of inventory management?  
(b) From the information given below you are required to prepare a statement of working capital requirements:
  1. Issued shares capital  200000
8% Bonds                      75000
Fixed assets at cost      200000
  1. The expected ratio of cost to selling price are:
Raw materials       40%
Labour                    30%
Overheads              20%
Profit                       10%

  1. Raw materials are kept in store for an average of two months
  2. Finished goods remain in store for an average period of one months
  3. Work in process (100% complete in regard to materials and 50% for labour and overheads) will approximately be to half a month’s production
  4. Credit allowed to customers is two months and given by suppliers is one month
  5. Production during the previous year was 40000 units and it is planned to maintain the same in current year also
  6. Selling price is Rs. 9 per units
  7. Calculation of debtors may be made at selling price