Financial Management
Chapter 1
Very Short Answer Type
1. What is meant by capital structure?
Ans: Capital structure refers to the combination of debt and equity financing used by a company to fund its operations and growth. Think of it as the mix of "loans" (debt) and "ownership shares" (equity) used to build and run the business. A healthy capital structure balances the benefits and risks of each to maximize shareholder value and long-term sustainability.
2. Sate the two objectives of financial planning.
Ans: There are two primary objectives of financial planning:
1. Maximize Wealth: This involves allocating resources (income, investments, etc.) effectively to achieve your financial goals in the short and long term. It could mean accumulating wealth for retirement, building a dream home, or providing for your children's education.
2. Minimize Risk: Financial planning also aims to manage financial risks like unexpected expenses, job loss, or market downturns. This might involve building emergency funds, diversifying investments, and obtaining adequate insurance coverage.
3. Name the concept of financial management which increases the return to equity shareholders due to the presence of fixed financial charges.
Ans: The concept of financial management that increases the return to equity shareholders due to the presence of fixed financial charges is called trading on equity.
This strategy involves using debt to finance a portion of the company's assets, generating interest expenses that are tax-deductible. This reduces the company's taxable income and allows for a higher proportion of profits to be distributed to shareholders as dividends.
However, trading on equity also comes with risks, such as increased financial leverage and vulnerability to rising interest rates. It's important to carefully consider the company's financial situation and risk tolerance before implementing this strategy.
4. Amrit is running a ‘transport service’ and earning good returns by providing this service to industries. Giving reason, state whether the working capital requirement of the firm will be ‘less’ or ‘more’.
Ans: Amrit's transport service business will likely have a higher working capital requirement compared to businesses in other sectors. Here's why:
High Operating Costs:
*Fuel: Transportation heavily relies on fuel, a significant ongoing expense requiring immediate payment.
*Vehicle Maintenance: Regular upkeep and repairs for trucks and other vehicles add to the constant need for cash.
*Driver Salaries and Wages: Wages often need to be paid out weekly or bi-weekly, leading to frequent cash disbursement.
Long Operating Cycle:
*Credit Terms: Clients might have extended payment terms, creating a gap between service delivery and receiving payment. This extends the cash conversion cycle.
*Inventory Fluctuations: Depending on the type of goods transported, there might be temporary storage needs, requiring investment in inventory management.
Additional Factors:
*Scale of Operations: Larger fleets and broader service areas lead to a higher overall requirement for working capital.
*Seasonality: Businesses catering to seasonal industries might experience fluctuating cash flow, impacting working capital needs.
While transport services can be profitable, their inherent operational costs and operating cycle contribute to a higher working capital requirement. Amrit needs to ensure adequate cash flow and consider financing options to maintain smooth operations and avoid liquidity issues.
5. Ramnath is into the business of assembling and selling of televisions. Recently he has adopted a new policy of purchasing the components on three months credit and selling the complete product in cash. Will it affect the requirement of working capital? Give reason in support of your answer.
Ans: Yes, Ramnath's new policy will affect his working capital requirement, reducing it. Here's why:
Reduced Inventory Levels: By purchasing components on credit, Ramnath delays the payment for them, which effectively frees up cash that would otherwise be tied up in inventory. This translates to lower immediate cash outflow and a reduced need for initial working capital.
Faster Cash Conversion Cycle: Selling the finished product in cash significantly shortens the cash conversion cycle. This means the time it takes for cash to flow back into the business after an investment is reduced. Faster conversions contribute to improved liquidity and reduced dependence on additional working capital.
Offsetting Credit Terms: Since Ramnath receives three months of credit on components, it indirectly provides him with a buffer to manage potential delays in selling televisions. This buffer can mitigate the need for additional working capital to bridge any temporary cash flow gaps.
However, it's important to consider any potential drawbacks:
*Interest on Credit: If Ramnath incurs any interest charges on the three-month credit, it would partially offset the benefit of reduced working capital.
*Dependence on Suppliers: Relying on extended credit from suppliers creates a certain dependence and might limit flexibility in sourcing components.
Short Answer Type
1. What is financial risk? Why does it arise?
Ans: Financial risk is the chance of losing money on investments or business decisions. It arises from uncertainty and unexpected changes in markets, interest rates, currencies, or economic conditions. These shifts can impact your income, expenses, or the value of your assets, leading to potential losses.
Think of it like walking a tightrope - every step carries the risk of a wobble or a fall. Managing financial risk involves balancing potential threats with the rewards you seek.
2. Define current assets? Give four examples of such assets.
Ans: Sure, here is a definition of current assets and four examples:
Current assets are assets that a company expects to convert to cash or use within one year of the balance sheet date. They are listed on the current assets section of the company's balance sheet. Current assets are important because they provide a measure of a company's liquidity, or its ability to meet its short-term obligations.
Here are four examples of current assets:
*Cash and cash equivalents: This includes cash on hand, money in checking and savings accounts, and short-term investments that can be easily converted to cash, such as certificates of deposit and marketable securities.
*Accounts receivable: This is money that customers owe the company for goods or services that have been purchased on credit.
3. What are the main objectives of financial management? Briefly explain.
Ans: Financial management aims to achieve various objectives for a company, but the main ones can be summarized as follows:
1. Profit Maximization:
*Generating the highest possible return on investment (ROI) while considering ethical and sustainable practices.
4. Financial management is based on three broad financial decisions. What are these?
Ans: Financial management is indeed based on three crucial financial decisions, often referred to as the "investment triangle":
1. Investment Decisions:
*This involves allocating resources to different assets or projects, aiming to maximize returns while managing risks.
*Think of it like choosing where to plant your seeds – you consider soil quality, sunlight, and potential yield to make the most of your resources.
2. Financing Decisions:
*This concerns determining how to raise capital to finance investments and operations. It involves choosing between debt, equity, or a combination of both, considering factors like cost, control, and risk tolerance.
*Imagine building a house – you decide whether to use your savings, take out a loan, or find investors, balancing affordability with ownership and potential interest payments.
3. Dividend Decisions:
*This relates to how much of the company's profits to distribute to shareholders as dividends and how much to retain for reinvestment. It involves balancing shareholder satisfaction with the company's growth potential.
*Think of it like dividing your harvest – you decide how much to eat now and how much to save for future plantings, ensuring both immediate needs and long-term sustainability.
5. Sunrises Ltd. dealing in readymade garments, is planning to expand its business operations in order to cater to international market. For this purpose the company needs additional `80,00,000 for replacing machines with modern machinery of higher production capacity. The company wishes to raise the required funds by issuing debentures. The debt can be issued at an estimated cost of 10%. The EBIT for the previous year of the company was `8,00,000 and total capital investment was 1,00,00,000. Suggest whether issue of debenture would be considered a rational decision by the company. Give reason to justify your answer. (Ans. No, Cost of Debt (10%) is more than ROI which is 8%).
Ans: You're absolutely right! Issuing debentures in this scenario wouldn't be a rational decision for Sunrises Ltd. Here's why:
1. Cost of Debt vs. Return on Investment (ROI):
*The cost of issuing debentures is estimated at 10%, which means the company will incur an annual interest expense of Rs. 80,000 (10% of Rs. 80,00,000).
*The company's previous year's EBIT was Rs. 8,00,000, which translates to an ROI of 8% (Rs. 8,00,000 / Rs. 1,00,00,000).
Clearly, the cost of debt (10%) is higher than the company's ROI (8%). This implies that borrowing money through debentures would lead to financial strain as the interest expense would exceed the profit generated from the borrowed funds.
2. Alternative Financing Options:
Sunrises Ltd. should explore alternative financing options with a lower cost of capital. Here are some possibilities:
*Bank loans: Negotiating a loan with a lower interest rate compared to debentures.
*Equity financing: Issuing new shares to raise capital, although this might dilute existing shareholders' ownership.
*Internal accruals: Reinvesting a portion of the company's profits for expansion.
3. Impact on Profitability:
Using debentures with a higher cost of debt would ultimately reduce the company's profitability. This could negatively impact investor confidence and future growth prospects.
6. How does working capital affect both the liquidity as well as profitability of a business?
Ans: Working capital plays a key role in balancing both liquidity and profitability of a business:
Increased Working Capital:
*Pros for Liquidity: Higher working capital leads to more cash, inventory, and receivables, enhancing a business's ability to meet short-term obligations and cope with unexpected expenses. This improves their financial solvency and flexibility in the short run.
*Cons for Profitability: Conversely, excess working capital implies idle resources like excess inventory or extended credit terms to customers. These resources are not generating immediate returns, potentially lowering the Return on Assets (ROA) and overall profitability.
Decreased Working Capital:
*Pros for Profitability: Lower working capital means efficient resource utilization, minimizing inventory holding costs and credit risks. This can lead to improved efficiency and potentially higher profit margins.
*Cons for Liquidity: However, insufficient working capital can hinder smooth operations. Limited inventory might lead to stockouts, impacting sales and customer satisfaction. Tight credit terms might deter customers and slow down cash flow, potentially leading to liquidity issues and difficulty in meeting short-term debts.
Finding the Optimum Level:
Therefore, managing working capital effectively involves finding the right balance between liquidity and profitability. This ensures sufficient resources for smooth operations without sacrificing profitability from idle resources. Techniques like inventory management, efficient receivables collection, and optimizing credit terms can help achieve this balance.
7. Aval Ltd. is engaged in the business of export of canvas goods and bags. In the past, the performance of the company had been upto the expectations. In line with the latest demand in the market, the company decided to venture into leather goods for which it required specialised machinery. For this, the Finance Manager Prabhu prepared a financial blueprint of the organisation’s future operations to estimate the amount of funds required and the timings with the objective to ensure that enough funds are available at right time. He also collected the relevant data about the profit estimates in the coming years. By doing this, he wanted to be sure about the availability of funds from the internal sources of the business. For the remaining funds, he is trying to find out alternative sources from outside.
a. Identify the financial concept discussed in the above paragraph. Also, state the objectives to be achieved by the use of financial concept so identified. ( Financial Planning).
Ans: Financial Planning:
The financial concept discussed in the paragraph is financial planning. Prabhu, the Finance Manager of Aval Ltd., is conducting a comprehensive analysis of the company's financial future to ensure they have enough funds to:
*Expand into leather goods: This requires acquiring specialized machinery, which involves a significant investment.
*Maintain operational liquidity: Sufficient funds need to be available at the right time to support ongoing operations and avoid any cash flow disruptions.
*Achieve profitability: Prabhu is analyzing profit estimates for the coming years to understand the potential internal cash generation capability of the business.
Objectives of Financial Planning:
*Secure adequate funding: The plan aims to identify the total funds required for expansion and determine the best sources of capital, both internal and external.
*Optimize resource allocation: By forecasting future profits and expenses, the plan helps efficiently allocate resources to ensure long-term financial sustainability.
*Manage financial risks: Anticipating potential financial challenges allows the company to take proactive measures to mitigate risks and maintain stability.
*Achieve strategic goals: The financial plan supports the company's overall strategic objectives, in this case, venturing into a new product line.
b. ‘There is no restriction on payment of dividend by a company’. Comment. ( Legal & Contractual Constraints)
Ans: Legal & Contractual Constraints on Dividend Payments:
While the statement "There is no restriction on payment of dividend by a company" might seem true on the surface, it needs additional clarification due to legal and contractual constraints that can limit dividend payments:
*Company Law: Specific regulations within company law might impose restrictions on dividend distributions based on factors like minimum net asset value or profitability ratios.
*Loan Covenants: Loan agreements with banks or other creditors may include covenants that restrict dividend payments until certain financial conditions are met.
*Contractual Agreements: Contracts with investors or stakeholders might stipulate certain conditions for dividend distribution, such as achieving specific milestones or maintaining particular financial ratios.
Therefore, even though companies have some flexibility in dividend payments, they are not entirely unrestricted. They must adhere to legal, contractual, and financial considerations to ensure responsible and sustainable dividend policies.
Long Answer Type
1. What is working capital? Discuss five important determinants of working capital requirement?
Ans: Working capital: the difference between a company's current assets (cash, inventory, receivables) and current liabilities (payables, short-term debts). It represents the cash and resources readily available to run daily operations.
Five important determinants of working capital requirement:
1. Nature of Business: Manufacturing needs more inventory than service-based businesses, impacting their working capital needs.
2. Business Cycle: Seasonal businesses require higher working capital during peak seasons to meet increased demand.
3. Credit Policy: Offering longer credit terms to customers increases receivables and working capital needs.
4. Operating Cycle: The time it takes to convert inventory into cash (production + sales + collection) directly impacts working capital requirements.
5. Scale of Operations: Larger businesses generally have higher overall expenses and inventory, leading to higher working capital needs.
2. “Capital structure decision is essentially optimisation of risk-return relationship.” Comment.
Ans: The statement "Capital structure decision is essentially optimization of risk-return relationship" is largely accurate. It captures the core challenge of choosing a mix of debt and equity financing that balances potential returns for shareholders with the overall financial risk of the company.
Here's why:
*Different Financing Sources, Different Risks and Returns: Equity entails higher risk but unlimited potential returns for shareholders. Debt offers fixed returns but also fixed obligations, increasing financial risk if profits can't cover them.
*Finding the Sweet Spot: Choosing the right capital structure involves finding the point where increasing debt's leverage boosts returns without pushing risk to an unsustainable level (potential bankruptcy).
*Optimization, Not Maximization: It's not just about maximizing returns. Companies seek a balance that suits their risk tolerance, industry, growth prospects, and other factors.
However, consider these nuances:
*Not just risk-return: Other factors like control rights, tax implications, and signaling to investors also play a role.
*Not static: Optimal capital structure evolves with a company's age, industry conditions, and business strategy.
*Difficult in practice: Predicting future risks and returns is never perfect, making finding the "sweet spot" challenging.
3. “A capital budgeting decision is capable of changing the financial fortunes of a business.” Do you agree? Give reasons for your answer?
Ans: I strongly agree that capital budgeting decisions can transform a business's financial fortunes. Here's why:
1. High-stakes allocation: These decisions determine where significant resources flow, shaping the company's future growth and profitability. Choosing the right project can unlock immense potential.
2. Long-term impact: The effects of capital budgeting can ripple for years, influencing revenue, market share, and overall financial stability.
3. Leverage potential: By investing in the right assets, businesses can amplify their earning power, creating a snowball effect of financial success.
4. Turning points: Capital budgeting can mark pivotal moments in a company's journey. A well-timed investment in innovation or market expansion can propel it to a new level, while a missed opportunity can leave it lagging behind.
5. Risk of decline: Conversely, poor decisions can result in wasted resources, missed opportunities, and even financial distress. Choosing the wrong project can be a costly misstep.
Ultimately, capital budgeting decisions are like forks in the road, leading to paths of either prosperity or decline. The potential for both makes them some of the most impactful choices a business can make.
4. Explain the factors affecting dividend decision?
Ans: Dividend decisions are complex, and several factors influence them. Here are some key ones:
Internal factors:
*Profitability and cash flow: Companies with strong earnings and healthy cash flow are more likely to pay dividends. Low profits or tight cash flow may lead to lower dividends or none at all.
*Growth opportunities: If a company has promising growth prospects, it may want to retain earnings for reinvestment rather than distributing them as dividends.
*Stability of earnings: Stable earnings make it easier to predict future cash flow and therefore maintain a consistent dividend policy.
*Debt levels: High debt levels can limit a company's ability to pay dividends due to debt repayment obligations.
External factors:
*Market expectations: Shareholders may have different expectations for dividends depending on their investment goals and risk tolerance. Companies may consider these expectations when setting their dividend policy.
*Industry norms: Dividend practices vary across industries. Some industries traditionally pay high dividends, while others prioritize reinvestment.
*Legal and regulatory constraints: Certain regulations may restrict how much a company can distribute as dividends.
Other considerations:
*Tax implications: Both the company and shareholders may face different tax consequences depending on the dividend payout.
*Signaling effect: Dividend payments can signal investor confidence in the company's future prospects.
5. Explain the term ‘Trading on Equity’? Why, when and how it can be used by company.
Ans: Trading on Equity Explained: Leverage for Boosting Returns
Trading on equity refers to a financial strategy where a company uses debt capital (loans, bonds, etc.) to finance investments or projects with the aim of generating returns higher than the cost of the borrowed funds. Essentially, it's about amplifying shareholder returns through financial leverage.
Why Use Trading on Equity?
*Increase Earnings per Share (EPS): When successful, the gains from investments financed by debt exceed the interest expense, boosting EPS and potentially attracting more investors.
*Improve Return on Equity (ROE): Leverage can magnify ROE, making the company appear more efficient and attractive to investors.
*Accelerate Growth: Companies can quickly fund expansion or acquisitions by taking on debt, propelling growth faster than relying solely on equity.
When to Use Trading on Equity:
*Confidently high return projects: The expected returns from the financed investments must comfortably exceed the borrowing cost for the strategy to be successful.
*Strong financial position: Companies with stable cash flow and manageable debt levels can handle the additional financial risk associated with leverage.
*Growth opportunities: When rapid growth is the primary objective, using debt to fuel expansion can be effective.
How to Use Trading on Equity:
*Careful debt-to-equity ratio: Maintaining a healthy balance between debt and equity is crucial to avoid excessive financial risk and potential insolvency.
*Matching debt maturity to project durations: Long-term projects should be financed with long-term debt to avoid mismatched maturities and potential refinancing constraints.
*Continuous monitoring and adjustment: Monitoring financial performance and adjusting the debt levels as needed is vital to mitigate risks and ensure the strategy remains sustainable.
Remember, trading on equity is a double-edged sword. While it can significantly boost returns, it also amplifies losses if investments underperform. Careful analysis, proper implementation, and continuous monitoring are key to using this strategy effectively.
6. ‘S’ Limited is manufacturing steel at its plant in India. It is enjoying a buoyant demand for its products as economic growth is about 7–8 per cent and the demand for steel is growing. It is planning to set up a new steel plant to cash on the increased demand. It is estimated that it will require about `5000 crores to set up and about `500 crores of working capital to start the new plant.
a. Describe the role and objectives of financial management for this company.
Ans: Financial Management for 'S' Limited: Expansion on the Horizon
a. Role and Objectives of Financial Management:
*Resource Allocation: Ensure optimal allocation of funds to support expansion plans, balancing needs for current operations and future growth.
*Profitability Maximization: Maintain and enhance profitability through cost control, efficient utilization of resources, and strategic pricing.
*Solvency and Liquidity: Manage debt financing and cash flow effectively to maintain solvency and avoid liquidity crunches.
*Risk Management: Mitigate financial risks associated with market fluctuations, raw material prices, and financing decisions.
*Long-Term Value Creation: Implement strategies to maximize shareholder value through sustainable growth and return on investments.
b. Explain the importance of having a financial plan for this company. Give an imaginary plan to support your answer.
Ans: Importance of a Financial Plan:
*Roadmap for Expansion: Define the scope of the new plant, projected costs, financing options, and operational timelines.
*Investment Justification: Provide quantitative evidence (NPV, IRR, payback period) to assess the feasibility and profitability of the project.
*Funding Strategy: Determine the mix of debt and equity financing, considering cost, risks, and long-term financial stability.
*Budgeting and Forecasting: Allocate resources efficiently for construction, working capital, and operational expenses.
Performance Monitoring: Track progress against budgeted targets, identify deviations, and implement corrective measures.
Imaginary Financial Plan:
.Project Cost: `5000 crores
.Funding Breakdown:
*Debt: `3000 crores (60%) - long-term loans with competitive interest rates and flexible repayment terms.
*Equity: `2000 crores (40%) - combination of retained earnings and issuance of new shares to raise capital.
.Working Capital Management:
*Inventory Optimization: Implement Just-in-Time (JIT) inventory management to minimize raw material and finished goods inventory.
*Receivables Management: Offer discounts for early payments and implement stricter credit control measures.
*Payables Management: Negotiate extended payment terms with suppliers to improve cash flow.
.Projected Revenue and Profitability: Develop comprehensive sales forecasts and cost estimates to project earnings and assess ROI.
.Capital Expenditure Plan: Outline future investments in technology upgrades, capacity expansion, and environmental initiatives.
c. What are the factors which will affect the capital structure of this company?
Ans: Factors affecting Capital Structure:
*Profitability and Growth: Highly profitable companies with strong growth potential can utilize more debt than companies with lower profitability.
*Debt Capacity: Analyze debt servicing ratios to ensure the company can comfortably manage its debt obligations.
*Cost of Capital: Compare the cost of debt and equity financing to optimize the capital mix.
*Investor Confidence: Strong credit rating and stable financial performance attract investors, providing access to favorable terms for raising equity.
*Industry Risks: Volatility in the steel industry necessitates a cautious approach to debt financing to maintain financial stability.
d. Keeping in mind that it is a highly capital-intensive sector, what factors will affect the fixed and working capital. Give reasons in support of your answer.
