Multiple Choice Questions
1. The cheapest source of finance is
(b) equity share capital
(c) preference share
(d) retained earning
Answer (d) Retained earning is the cheapest source of finance.
2. A decision to acquire a new and modem plant to upgrade an old one is a
(a) financing decision
(b) working capital decision
(c) investment decision
(d) dividend decision
Answer (c) Investment decision is related to careful selection of assets in which funds
will be Invested by firms. Thus, the above case comes under the investment decision.
3. Other things remaining the same, an increase in the tax rate on corporate profits will
(a) make debt relatively cheaper
(b) make debt relatively less cheap home
(c) no impact on the cost of debt
(d) we can’t say
Answer (a) If the tax rate on corporate, profit will increase it makes debt relatively
4. Companies with higher growth paternal are likely to
(a) pay lower dividends
(b) pay higher dividends
(c) dividends are not affected by growth considerations
(d) None of the above
Answer (a) Companies who are having the higher growth pattern are likely to pay lower
5. Financial leverage is called favourable if
(a) return on investment is lower than cost of debt
(b) return on investment is higher than cost of debt
(c) debt is nearly available
(d) if the degree of existing financial leverage is low
Answer (b) If ROI is higher than cost of debt financial leverage in this case called
6. Higher debt equity ratio ( Debt/Equity ) results in Equity
(a) lower financial risk
(b) higher degree of operating risk
(c) higher degree of financial risk
(d) higher EPS
Answer (c) Higher debt equity ratio results in higher degree of financial risk.
7. Higher working capital usually results in
(a) higher current ratio, higher risk and higher profits
(b) lower current ratio, higher risk and profits
(b) higher equitably, lower risk and lower profits
(d) lower equitably, lower risk and higher profits
Answer (a) If the working capital is higher it results in higher current ratio, higher risk
and higher profits.
8. Current assets are those assets which get converted into cash
(a) within six month
(b) within one year
(c) between one and three year
(d) between three and five year
Answer (b) Current assets are those assets which are converted in cash in one year.
9. Financial planning arrives at
(a) minimising the external borrowing by resorting to equity issues
(b) entering that the firm always have significantly more fund than required so that there
is no paucity of funds
(c) ensuring that the firm paces neither a shortage nor a glut of unusable funds
(d) doing only what is possible with the funds that the firm has at its disposal
Answer (c) Financial planning means deciding how much to spend and on what to
spend it ensuring that the firm paces neither a shortage nor a glut of unusable funds.
10. Higher dividends per share is associated with
(a) high earnings, high cash flows, unusable earnings and higher growth opportunities
(b) high earnings, high cash flows, stable earnings and high growth opportunities
(c) high earnings, high cash flows, stable earnings and lower growth opportunities
(d) high earnings, low cash flows, stable earnings and lower growth opportunities
Answer (c) Higher dividend per share includes higher earnings. high cash flows, stable
earning and lower growth opportunities.
11. A fixed asset should be financed through
(a) a long term liability
(b) a short term liability
(c) a mix of long and short term liabilities
(d) None of the above
Answer (a) Fixed assets financed through long term liability.
12. Current assets of a business firm should be financed through
(a) current liability only
(b) long term liability only
(c) partly from both types i.e., long and short term liabilities
(d) None of the above
Answer (c) Current assets are financed through long and short term liabilities.
Short Answer Type Questions
Question 1. What is meant by capital structure?
Answer Capital structure refers to the mix between owners and borrowed funds. It
represents the proportion of equity and debt.
Capital Structure = (Debt/Equity)
Question 2. Discuss the two objectives of Financial Planning.
Answer Financial Planning strives to achieve the following two objectives
1. To Ensure Availability of Funds whenever These are Required This includes a
proper estimation of the funds required for different purposes such as for the
purchase of long term assets or to meet day-to-day expenses of business etc.
2. To See That the Firm Does Not Raise Resources Unnecessarily Excess
funding is almost as bad as Inadequate funding. Efficient financial planning
ensures that funds are not raised unnecessarily in order to avoid unnecessary
addition of cost.
Question 3. What is ‘financial risk’? Why does it arise?
Answer It refers to the risk of company not being able to cover its fixed financial costs.
The higher level of risks are attached to higher degrees of financial leverage with the
Increase in fixed financial costs, the company its also required to raise its operating
profit (EBIT) to meet financial charges. If the company can not cover these financial
charges, it can be forced into liquidation.
Question 4. Define a ‘current assets’ and give four examples.
Answer Current assets are those assets of the business which can be converted into
cash within a period of one year. Cash in hand or at bank, bills receivables, debtors,
finished goods inventory are some of the examples of current assets.
Question 5. Financial management is based on three broad financial decisions. What
Answer Financial management is concerned with the solution of three major issues
relating to the financial operations of a firm corresponding to the three questions of
Investment, financing and dividend decision. In a fmancial context, it means the
selection of best financing alternative or best investment alternative. The finance
function therefore, is concerned with three broad decision which are as follows
1. Decision The investment decision relates to how the firm’s funds are invested in
2. Financing Decision This decision is about the quantum of finance to be raised
from various long term sources and short term sources. It Involves identification of
various available sources of finance.
3. Dividend Decision This decision relates to distribution of dividend.
Dividend is that portion of profit which is distributed to shareholders the decision
involved here is how much of the profit earned by company is to be distributed to the
shareholders and how much of it should be retained in the business for meeting
Question 6. What is the main objective of financial management? Explain briefly.
Answer Primary aim of financial management is to maximise shareholder’s wealth,
which is referred to as the wealth maximisation concept. The wealth of owners is
reflected in the market value of shares, wealth maximisation means the maximisation of
market price of shares.
According to the wealth maximisation objective, financial management must select
those decisions which result in value addition, that is to say the benefits from a decision
exceed the cost involved. Such value addition increase the market value of the
company’s share and hence result in maximisation of the shareholder’s wealth.
Question 7. Discuss about working capital affecting both the liquidity as well as
profitability of a business.
Answer The working capital should neither be more nor less than required. Both these
situations are harmful. If the amount of working capital is more than required, it will no
doubt increase liquidity but decrease profitability. For instance, if large amount of cash
is kept as working capital. then this excessive cash will remain idle and cause the
profitability to fall. On the contrary, if the amount of cash and other current assets are
very little, then lot of difficulties will have to be faced in meeting daily expenses and
making payment to the creditors. Thus, optimum amount of both current assets and
current liabilities should be determined so that profitability of the business remains intact
and there is no fall in liquidity.
Long Answer Type Questions
Question 1. What is meant by working capital? How is it calculated? Discuss five
important determinants of working capital requirements.
Answer Working capital IS that part of total capital which is required to meet day-to-day
expenses. to buy raw materials, to pay wages and other expenses of routine nature in
the production process or we can say it refers to excess of current assets over current
Working Capital = Current Assets – Current Liabilities
Factors affecting working capital requirement are
(i) Nature of Business The basic nature of a business influences the amount of
working capital required. A trading organisation usually needs a lower amount of
working capital compared to a manufacturing organisation. This IS because in trading.
there is no processing required. In a manufacturing business, however. raw materials
need to be converted into finished goods. which increases the expenditure on raw
material, labour and other expenses.
(ii) Scale of Operation The firms which are operating on a higher scale of operations,
the quantum of inventory. debtors required is generally high. Such organisations.
therefore, require large amount of working capital as compared to the organisations
which operate on a lower scale.
(iii) Production Cycle Production cycle is the time span between the receipts of raw
materials and their conversion into finished goods. Some businesses have a longer
production cycle while some have a shorter one. Working capital requirement is higher
in ferms with longer processing cycle and lower in firms with shorter processing cycle.
(iv) Credit Allowed Different firms allow different credit terms to their customers. A
liberal credit policy results in higher amount of debtors, increasing the requirements of
(v) Credit Availed Just as a firm allows credit to its customers it also may get credit
from its suppliers. The more credit a firm avails on its purchases, the working capital
requirement is reduced.
Question 2. Capital structure decision is essentially optimisation of risk-return
Answer Capital structure refers to the mix between owners and borrowed funds. It can
be calculated as(Debt/Equity).
Debt and equity differ significantly in their cost and riskiness for the firm. Cost of debt is
lower than cost of equity for a firm because lender’s risk is lower than equity
shareholder’s risk, since lenders earn on assured return and repayment of capital and
therefore they should require a lower rate of return. Debt is cheaper but is more risky for
a business because payment of interest and the return of principal is obligatory for the
business. Any default in meeting these commitments may force the business to go into
liquidation. There is no such compulsion in case of equity, which is therefore,
considered riskless for the business. Higher use of debt increases the fixed financial
charges of a business. As a result increased. use of debt increases the financial risk of
Capital structure of a business thus, affects both the profitability and the financial risk. A
capital structure will be said to be optimal when the proportion of debt and equity is such
that it results in an increase in the value of the equity share.
Question 3. A capital budgeting decision is capable of changing the financial fortune of
a business. Do you agree? Why or why not?
Answer Investment decision can be long term or short term. A long term Investment
decision is also called a capital budgeting decision. It involves committing the finance on
a long term basis. e.g., making investment in a new machine to replace an existing one
or acquiring a new fixed assets or opening a new branch etc. These decisions are very
crucial for any business. They affect its earning capacity over the long-run, assets of a
firm, profitability and competitiveness, are all affected by the capital budgeting
decisions. Moreover, these decisions normally involve huge amounts of investment and
are irreversible except at a huge cost. Therefore, once made, it Is almost impossible for
a business to wriggle out of such decisions. Therefore, they need to be taken with
utmost care. These decisions must be taken by those who understand them
A bad capital budgettng decision normally has the capacity to severely damage the
financial fortune of a business.
Question 4. Explain factors affecting the dividend decision.
Answer Dividend decision relates to distribution of profit to the shareholders and its
retention in the business for meeting the future investment requirements.
How much of the profits earned by a company will be distributed as profit and how much
will be retained in the business is affected by many factors. Some of the important
factors are discussed as follows
(i) Earnings Dividends are paid out of current and past year earnings. Therefore,
earnings is a major determinant of the decision about dividend.
(ii) Stability of Earnings Other things remaining the same, a company having stable
earning is in a position to declare higher dividends As against this, a company having
unstable earnings is likely to pay
(iii) Growth Opportunities Companies having good growth opportunities retain more
money out of their earnings so as to finance the required investment. The dividend in
growth companies. is therefore, smaller than that in non-growth companies.
(iv) Cash Flow Position Dividends Involve an outflow of cash. A company may be
profitable but short on cash. Availability of enough cash in the company is necessary for
declaration of dividend by it.
(v) Shareholder Preference If the shareholder in general, desire that at least a certain
amount should be paid as dividend, the companies are likely to declare the same.
(vi) Taxation Policy If tax on dividend is higher It would be better to pay less by way of
dividends. As compared to this, higher dividends may be declared if tax rates are
(vii) Stock Market Reaction For investors. an increase in dividend is a good news and
stock prices react positively to It. Similarly a decrease in dividend may have a negative
impact on the share prices in the stock market.
(viii) Access to Capital Market Large and reputed companies generally have easy
access to the capital market and therefore. depend less on retained earnings to finance
their growth These companies tend to pay higher dividends than the smaller companies
which have relatively low access to the market.
(ix) Legal constraints Certain provisions of the Company’s Act place restriction on
payouts as dividend. Such provisions have to be adhered, while declaring dividends.
(x) Contractual Constraints While granting loans to a company, sometimes the lender
may impose certain restrictions on the payment of dividends in future The companies
are required to ensure that the dividends does not violate the terms and conditions of
the loan agreement in this regard
Explain the term ‘trading on equity’. Why,when and how it can used by a business
Answer Trading on equity refers to the Increase in profit earned by the equity
shareholders due to presence of fixed financial charges. When the rate of earning or
Return on Investment (ROt) of a company is higher than the rate of interest on
borrowed funds only then a company should opt for trading on equity. Let us consider
the following example
It should be clear from the above example that shareholders of the company ‘X have a
higher rate of return than company ‘Y’ due to loan component In the total capital of the
‘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% 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
facing. It is estimated that it will require about ₹ 5,000 crores to set up and about ₹ 500
crores of working capital to start the new plant.
Question 1. What is the role and objectives of financial management for this company?
Answer Role of Financial Management Financial management is concerned with the
proper management of funds it involves
1. Managerial decisions relating to procurement of long term and short term funds
2. Keeping the risk associated with respect to procured funds under control.
3. Utilisation of funds in the most productive and effective manner
4. Fixed debt equity ratio ‘n capital.
Objective of Financial Management
The objective of financial management is maximisation of shareholder’s wealth The
investment decision. financial decision and dividend decision help an organisation to
achieve trus objective In the given situation S limited envisages growth prospects of
steel Industry due to the growing demand. To expand the production capacity. the
company needs to invest However, investment decision will depend on the availability of
funds. the financing decision and the dividend decision. However. the company win take
those financial decisions which result In value addition I e the benefits are more than the
cost This leads to an increase in the market value of the shares of the company.
Question 2. Explain the importance of having a financial plan for this company. Give an
imaginary plan to support your answer.
Answer Importance of financial plan for the company
1. Financial Planning ensures provision of adequate funds to meet working capital
2. It brings about a balance between in flow and out flow of funds and ensures
liquidity throughout the year.
3. It solves the problems of shortage and surplus of funds and ensures proper and
optimum utilisation of available resources
4. It ensures increased profitability through cost benefit analyses and by avoiding
5. It seeks to eliminate waste of funds and provides better financial control.
6. It seeks to avail the benefits of trad n9 on equity.
Financial Plan of S Ltd
Total finance required; Fixed capital = ₹ 1,000 crores
Working capital = ₹ 100 crores
Source of finance : 2:1 Ratio i.e..
50% finance collected by issue of shares and 50% by borrowed funds.
Question 3. What are the factors which will affect the capital structure of this company?
Answer Capital structure refers to the proportion In which debt and equity funds are
used for financing the operations of a business. A capital structure is said to be optimum
when the proportion of debt and equity is such that it results in an increase in the value
of shares. The factors that will affect the capital structure of this company are
(i) Equity Funds The composition of equity funds in the capital structure will be
governed by the following factors
(a) The requirement of funds of’S Limited is for long term. Hence, equity funds will be
(b) There are no financial risks attached to this form of funding
(c) If the stock market is bullish, the company can easily raise funds through issue of
(d) If the company already has raised reasonable amount of debt funds, each
subsequent borrowing will come at a higher interest rate and will Increase the fixed
(ii) Debt Funds The usage and the ratio of debt funds in the capital structure will be
governed by factors like
(a) The availability of cash flow with the company to meet its fixed financial charges.
The purpose IS to reduce the financial risk associated with such payments which can
further be checked by using ‘debt’ service coverage ratio
(b) It will provide the benefit of trading on equity and hence Will Increase the earning per
share of equity shareholders However, return on Investment’ ratio will be the gUiding
principle behind it. The company should opt for trading on equity only when return on
investment is more than the fixed charges.
(c) Interest on debt funds is a deductible expense and therefore, will reduce the tax
(d) It does not result in dilution of management control.
Question 4. Keeping in mind that it is a highly capital intensive sector what factors will
affect the fixed and working capital. Give reasons with regard to both in support of your
Answer The work.nq and fixed capital requirement of ‘S’ Limited Will be high due to the
1. The business is capital intensive and the scale of operation is large.
2. Heavy Investments are required for building up the production base and for
3. In case of steel industry. the major Input is iron are and coal. The ratiO of cost of
raw material to total cost is very high. Hence, higher will be the need for working
4. The longer the operating cycle, the larger is the amount of working capital required
as the funds get locked up in the production proceSS for a tong penod of lime
5. Terms of credit for buying and selting goods, discount allowed suppliers and to the
customers also determines the quantum working capital.