NCERT Solutions - Financial Management

Very Short Answer Type Questions

Q1: What is meant by capital structure?
Ans: Capital structure refers to the mix between owners' funds (equity) and borrowed funds (debt) used to finance a company's operations. It determines the proportion of debt and equity in the company's total capital and affects both risk and return for the firm.

Q2: State the two objectives of financial planning.
Ans:

1. To ensure the availability of funds whenever required.
2. To avoid raising resources unnecessarily and to ensure funds are used optimally.

Q3: Name the concept of financial management which increases the return to equity shareholders due to the presence of fixed financial charges.
Ans: Trading on Equity.

Q4: 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: The working capital requirement of the firm will be less because a transport business typically requires minimal investment in current assets such as inventory or receivables. Lower holdings of such current assets reduce the need for working capital.

Q5: Ramnath is into the business of assembling and selling 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: The requirement for working capital will be less because purchasing components on credit delays cash outflow while selling the finished products in cash ensures immediate cash inflow. This combination reduces the firm's need to maintain a large amount of working capital.

Short Answer Type Questions

Q1: What is financial risk? Why does it arise?
Ans: It refers to the risk of a company not being able to cover its fixed financial costs, such as interest and principal repayments. Financial risk arises when a firm uses debt financing because higher fixed financial charges increase the company's obligation to generate sufficient operating profit (EBIT). If the firm cannot meet these obligations, it may face financial distress or liquidation.

Q2: Define current assets? Give four examples of such assets.
Ans: Current assets are those assets of the business which can be converted into cash within a period of one year. Examples include cash in hand or at bank, bills receivable, debtors (accounts receivable), and finished goods inventory.

Q3: What are the main objectives of financial management? Briefly explain.
Ans: The main objectives of financial management are:

1. Profit Maximization: Ensuring the business earns adequate returns on its investments.
2. Wealth Maximization: Enhancing shareholders' value by increasing the company's market value.
3. Maintaining Liquidity: Ensuring sufficient funds are available for day-to-day operations.
4. Optimal Utilisation of Funds: Efficiently allocating resources to achieve maximum output from available funds.

Q4: Financial management is based on three broad financial decisions. What are these?
Ans: 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 financial context, it means the selection of best financing alternative or best investment alternative. The finance function therefore is concerned with three broad decisions which are as follows

1. Investment Decision: The investment decision relates to how the firm's funds are invested in different assets.
2. Financing Decision: This decision is about the quantum of finance to be raised from various long-term and short-term sources. It involves identification of available sources of finance.
3. Dividend Decision: This decision relates to distribution of profit. It determines how much of the profit earned by the company is to be distributed to shareholders and how much should be retained for meeting future investment requirements.

Q5: 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 ₹,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: No, the issue of debentures would not be a rational decision.
Reason: The cost of debt is 10%, which is higher than the return on investment (ROI) of 8%. Raising funds through debt at a higher cost than the expected return on the investment would reduce shareholder returns and lower overall profitability.

Q6: How does working capital affect both the liquidity as well as profitability of a business?
Ans: Working capital should neither be excessive nor insufficient. Both extremes are harmful:

• If working capital is more than required, liquidity increases but profitability falls because excess funds (for example idle cash or excessive inventory) earn little or no return.
• If working capital is insufficient, the firm may face difficulty in meeting day-to-day expenses and paying creditors, harming operations and possibly damaging creditworthiness.

Therefore, an optimum level of current assets and current liabilities should be maintained so that liquidity is adequate while profitability is preserved.

Q7: Aval Ltd. is engaged in the business of export of canvas goods and bags. In the past, the performance of the company had been up to 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. 
Questions:
(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). 
(b) 'There is no restriction on payment of dividend by a company'. Comment. ( Legal & Contractual Constraints) 
Answers:
(a) Identify the financial concept discussed in the above paragraph. Also, state the objectives to be achieved by the use of the financial concept so identified.
Ans:
Financial Concept: Financial Planning.
Objectives:

1. To estimate the amount of funds required for the proposed venture.
2. To ensure the availability of funds at the right time.
3. To ensure optimal utilisation of funds and avoid wasteful expenditure.

(b) 'There is no restriction on payment of dividend by a company'. Comment.
Ans: This statement is not entirely correct. There are legal and contractual constraints on the payment of dividends, such as:

1. Legal Constraints: Companies must comply with statutory provisions which generally permit dividend payment only out of current or accumulated profits and subject to certain reserves and solvency tests.
2. Contractual Constraints: Loan agreements, debenture covenants or other contracts may restrict dividend payouts to protect lenders' interests and maintain financial stability.

Long Answer Type Questions

Q1: What is working capital? Discuss five important determinants of working capital requirement?
Ans: Working capital generally refers to the net working capital, which is the difference between current assets and current liabilities. This can be expressed as:
Net Working Capital (NWC) = Current Assets (CA) - Current Liabilities (CL)
Factors Influencing Working Capital:

• Nature of Business: Service firms and trading companies typically need less working capital than manufacturing firms, which hold larger inventories and receivables.
• Scale of Operations: Larger firms and larger scale of operations generally require more working capital because of higher volumes of inventory and receivables.
• Business Cycle: During economic booms, sales and production rise, increasing working capital needs; during recessions, working capital requirements fall.
• Seasonal Factors: Seasonal industries need more working capital during peak seasons to fund higher production and sales activity, and less during off-seasons.
• Production Cycle: A longer production cycle requires funds to be tied up in raw materials, work-in-progress and finished goods for longer periods, increasing working capital needs.
• Credit Allowed: More generous credit terms to customers raise accounts receivable and increase working capital requirements.
• Credit Availed: Greater credit from suppliers reduces the need for working capital, since payables act as a source of short-term finance.
• Availability of Raw Materials: Ready availability allows lower stock levels and hence lower working capital; scarcity forces higher inventory holdings and increases working capital needs.
• Time Lag (Lead Time): Longer lead times between ordering and receipt of materials raise the need for larger inventories, increasing working capital requirements.

Q2: "Capital structure decision is essentially optimisation of risk-return relationship." Comment.
Ans: Capital structure refers to the mix between owners' funds (equity) and borrowed funds (debt). It can be expressed as (Debt/Equity). Debt and equity differ significantly in cost and risk. Cost of debt is generally lower than cost of equity because lenders have a prior claim and receive fixed returns, making lending less risky than equity investment. However, debt carries obligatory interest and principal repayments; failure to meet these obligations increases financial risk and may lead to liquidation. Equity does not impose such obligatory payments, so it carries less risk for the firm but is costlier. Therefore, a firm must balance the lower cost of debt against the increased financial risk it brings. A capital structure is considered optimal when the chosen mix of debt and equity maximises the value of equity shareholders - that is, when the risk-return trade-off is best balanced.

Q3: "A capital budgeting decision is capable of changing the financial fortunes of a business." Do you agree? Give reasons for your answer? 
Ans: I agree. Capital budgeting (long-term investment) decisions involve committing funds for long periods to projects such as new plants, machinery, or expansion. These decisions are crucial because:

• They affect the firm's earning capacity and profitability over the long run.
• They change the firm's asset base and competitive position.
• They usually involve large sums and are often irreversible or costly to reverse.

Because of their long-term impact and large scale, poor capital budgeting decisions can severely damage a firm's financial health, while good decisions can substantially improve its profitability and market value.

Q4: Explain the factors affecting dividend decision? 
Ans: Dividend decision relates to the distribution of profit to shareholders and the retention of earnings for financing future investments. Important factors affecting this decision include:

• Earnings: Dividends are paid out of current and past earnings. Higher earnings allow for higher dividends.
• Stability of Earnings: Firms with stable earnings can declare higher and more consistent dividends than firms with volatile earnings.
• Growth Opportunities: Companies with significant growth opportunities retain more earnings to finance expansion and therefore typically pay lower dividends.
• Cash Flow Position: Dividend payment requires cash. A profitable company with poor cash flow may not be able to pay dividends.
• Shareholder Preference: If shareholders prefer current income, firms may adopt higher payout policies to meet investor expectations.
• Taxation Policy: The tax treatment of dividends affects payout decisions; higher taxes on dividends may encourage retention rather than distribution.
• Stock Market Reaction: Market often views dividend increases positively and dividend cuts negatively, which influences management decisions.
• Access to Capital Markets: Firms with easy access to external finance may retain less and pay higher dividends; those with limited access will retain more.
• Legal Constraints: Statutory provisions may restrict dividend payments to protect creditors and ensure solvency.
• Contractual Constraints: Loan covenants or debenture terms may restrict dividend payments as a condition of borrowing.

Q5: Explain the term 'Trading on Equity'? Why, when and how it can be used by company. 
Ans: Trading on Equity: It refers to using borrowed funds (debt) to enhance returns to equity shareholders by taking advantage of the lower cost of debt compared with equity.

• Why: To maximise shareholder returns when borrowing can increase earnings available to equity holders.
• When: It is appropriate when the firm's return on investment (ROI) exceeds the cost of debt; in that case, debt financing increases earnings for shareholders.
• How: By issuing debentures, taking loans, or using other debt instruments to fund projects while keeping the equity component relatively lower, thereby leveraging returns to equity.

Q6: '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.
Questions:

(a) Describe the role and objectives of financial management for this company.
(b) Explain the importance of having a financial plan for this company. Give an imaginary plan to support your answer.
(c) What are the factors which will affect the capital structure of this company? 
(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.
Answers:
(a) Describe the role and objectives of financial management for this company.
Ans:
Role of Financial Management:

1. Ensure timely availability of funds for setting up the plant and for operations.
2. Optimise the overall cost of capital to enhance shareholder wealth.
3. Manage cash flows to ensure smooth day-to-day operations and debt servicing.

Objectives:

1. Maximise return on investment by selecting profitable projects.
2. Maintain financial stability and adequate liquidity.
3. Ensure optimal utilisation of financial resources and control costs.

(b) Explain the importance of having a financial plan for this company. Give an imaginary plan to support your answer.
Ans:
Importance of Financial Planning:

1. Ensures timely availability of funds for capital expenditure and working capital needs.
2. Helps minimise wastage and avoid unnecessary borrowing by planning expenditures and cash flows.

Imaginary Financial Plan:

• Capital Expenditure: ₹5,000 crores for plant setup financed through a mix of equity and long-term debt.
• Working Capital: ₹500 crores to meet initial operational requirements such as raw material purchases and inventory build-up.
• Debt-Equity Policy: Maintain a target debt-equity ratio of 2:1 to balance cost and financial risk, subject to market conditions and lender covenants.

(c) What are the factors which will affect the capital structure of this company?
Ans:

1. Cost of Debt: Prevailing interest rates and borrowing costs will affect the attractiveness of debt.
2. Business Risk: High operating risk in the steel sector may necessitate a higher equity cushion to avoid distress.
3. Cash Flow Position: Stable and predictable cash flows make it easier to service debt and support higher leverage.
4. Tax Considerations: Interest tax shields make debt attractive, but other tax rules and incentives will influence the choice.
5. Market Conditions and Access to Capital: Ability to raise equity or debt in the capital markets and investor sentiment will affect the mix.

(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.
Ans:

Factors Affecting Fixed Capital:

1. Nature of Business: Steel manufacturing requires heavy investment in plant, machinery and infrastructure, raising fixed capital needs.
2. Technology: Adoption of modern, efficient technology increases initial fixed capital but may lower operating costs over time.
3. Scale and Capacity: Larger capacity and higher automation increase fixed capital requirements.

Factors Affecting Working Capital:

1. Production Cycle: A long production cycle requires funds to be tied up in raw materials and work-in-progress for longer periods, increasing working capital needs.
2. Inventory Management: Maintaining large stocks of raw material and finished goods to meet demand increases working capital; efficient inventory control reduces it.
3. Credit Policy: Liberal credit to customers raises receivables and working capital requirements; credit from suppliers reduces the need for working capital.
4. Seasonality and Demand Fluctuations: Fluctuations in demand require buffer inventories and cash, increasing working capital needs during peak periods.