Indirect, Short and Long Questions And Answers - Financial management

1. Ans:
Yes, I agree. Capital budgeting decisions involve large, long-term and irreversible investments. They affect the earning capacity, growth and risk of a business. A wrong decision can damage financial position, while a correct one can increase shareholders' wealth.

2. Ans:
EPS falls when the return on investment (ROI) is less than the cost of debt (interest rate). In such a case, the company pays more interest than it earns, leading to lower profits and EPS. This is called unfavourable financial leverage.

3. Ans:
Loans or debentures act as a lever because interest is fixed. If the company earns more than the cost of debt, the extra profit goes to equity shareholders, increasing their return. This is known as trading on equity.

4. Ans:
Shareholders gain when the return on investment is higher than the cost of debt. The excess profit after paying interest increases earnings available to equity shareholders, thereby increasing EPS.

5. Ans:
Financial leverage means the use of debt in capital structure. It increases profitability (EPS) when ROI is greater than interest but also increases financial risk due to fixed interest obligations.

6. Ans:
Yes, capital structure is the optimization of risk and return. More debt increases returns but also increases risk. An optimum capital structure balances both to maximize shareholders' wealth.

7. Ans:
Increasing debt-equity ratio increases financial risk due to higher interest obligations and chances of default. Directors should also consider cash flow position, ROI, cost of debt, control, market conditions and tax benefits before taking the decision.

8. Ans:
Factors to be considered while determining working capital include nature of business, scale of operations, production cycle, credit policy, inventory turnover, business cycle and seasonal factors.

9. Ans:
The primary objective of financial management is maximization of shareholders' wealth, which is reflected in the market price of shares.

10. Ans:
Yes, financial planning is not a substitute for financial management. Financial planning focuses on estimating funds, while financial management focuses on taking decisions to maximize wealth.

11. Ans:
Financial blueprint means a plan showing future financial requirements and sources of funds. It is important because it ensures availability of funds, avoids shortage or excess, reduces uncertainty and improves coordination.

12. Ans:
Working capital affects both liquidity and profitability. Higher working capital increases liquidity but reduces profitability, while lower working capital increases profitability but increases risk.

13. Ans:
(a) Bread - Small
(b) Coolers - Large
(c) Sugar - Medium
(d) Motorcar - Large
(e) Furniture (custom order) - Small
(f) Locomotives - Very large

14. Ans:
Debt has lower cost due to tax benefits but higher risk due to fixed interest obligations. Equity has higher cost but lower risk as there is no fixed obligation to pay returns.