This page contains the NCERT Business Studies class 12 chapter 9 Financial Management from Part 2 Business Finance and Marketing. You can find the solutions for the chapter 9 of NCERT class 12 Business Studies, for the Short Answer Questions, Long Answer Questions and Projects/Assignments Questions in this page. So is the case if you are looking for NCERT class 12 Business Studies related topic Financial Management question and answers.
Very Short Answer Type
1. What is meant by capital structure?
Capital structure refers to the mix between owners and borrowed funds, encompassing both ‘owners’ funds’ like equity and preference share capital, and ‘borrowed funds’ such as loans and debentures.
2. Sate the two objectives of financial planning.
The two objectives of financial planning are:
1.
To ensure availability of funds whenever required: This includes estimating the funds required for different purposes and specifying possible sources of these funds.
2.
To see that the firm does not raise resources unnecessarily: Excess funding should not lead to unnecessary costs, and any surplus money should be put to the best possible use.
3. Name the concept of financial management which increases the return to equity shareholders due to the presence of fixed financial charges.
The concept of financial management that increases the return to equity shareholders due to the presence of fixed financial charges is “Trading on Equity.”
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’.
Amrit’s ‘transport service’ primarily involves providing services rather than selling tangible goods. Therefore, the working capital requirement of the firm will be ‘less’ because there’s no need to maintain inventory and the receivables cycle might be shorter compared to manufacturing businesses.
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.
Yes, Ramnath’s new policy will affect the requirement of working capital. By purchasing components on three months credit and selling the product in cash, he will reduce the need for working capital. This is because he can use the cash from sales to pay for components after three months without needing to maintain a large cash balance in the interim. The extended credit period for purchases and immediate cash inflow from sales enhances liquidity and reduces the working capital requirement.
Short Answer Type
1. What is financial risk? Why does it arise?
Financial risk refers to the possibility of a company defaulting on its obligations to pay fixed charges, which include interest on borrowed funds or repayment of the principal amount.
It arises when a company takes on debt or borrows funds and may face challenges in generating enough revenue or profits to meet these fixed obligations. The risk increases with the proportion of debt in the company’s capital structure. The inability to meet these obligations can lead to financial distress or bankruptcy for the company.
2. Define current assets? Give four examples of such assets.
Current assets are those assets which, in the normal routine of the business, get converted into cash or cash equivalents within one year. These assets facilitate smooth day-to-day operations of the business and provide liquidity to the enterprise. Examples of current assets include:
1.
Cash in hand/Cash at Bank
2.
Marketable securities
3.
Bills receivable
4.
Debtors.
3. What are the main objectives of financial management? Briefly explain.
The primary objectives of financial management are to maximize shareholders’ wealth, which is reflected in the market value of a company’s equity shares. This involves ensuring that all financial decisions, whether related to investments, financing, or working capital, lead to value addition for the company. The aim is to procure finance at the lowest possible cost and deploy it in lucrative activities, ensuring that the benefits exceed the costs. All decisions should ultimately contribute to increasing the share price, signifying the overall financial health of the business.
4. Financial management is based on three broad financial decisions. What are these?
Financial management revolves around three major decisions:
1.
Investment Decision: This relates to how the firm’s funds are invested in different assets. It can be long-term (Capital Budgeting decision) or short-term (working capital decisions).
2.
Financing Decision: Concerned with the quantum of finance to be raised from various sources, it determines the mix of debt and equity, considering the overall cost of capital and the financial risk.
3.
Dividend Decision: This involves deciding how much profit earned by the company (after tax) is to be distributed to the shareholders and how much should be retained in the business.
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%).
No, the issue of debentures by Sunrises Ltd. would not be considered a rational decision. The reason is that the estimated cost of the debt, which is 10%, is higher than the company’s Return on Investment (ROI) from the previous year, which stands at 8% (The calculation is as below).
ROI
{= \dfrac{\text{EBIT}}{\text{Investment}}}
{= \dfrac{80,000}{1,00,000}}
= 8%
Issuing debentures at a higher cost than the ROI means the company would be paying more on the debt than what it’s earning from the invested capital.
6. How does working capital affect both the liquidity as well as profitability of a business?
Working capital facilitates smooth day-to-day operations of a business by investing in current assets, ensuring liquidity. Current assets, being more liquid, provide the necessary funds to meet short-term payment obligations, preventing potential financial crises. However, these assets often yield low returns, so a balance must be struck between liquidity and profitability. An inadequate investment in current assets can affect liquidity, whereas an over-investment might hinder profitability.
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).
b.
‘There is no restriction on payment of dividend by a company’. Comment. ( Legal & Contractual Constraints)
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.
The financial concept discussed in the above paragraph is “Financial Planning”.
The objectives to be achieved by the use of financial planning are:
1.
To ensure the availability of funds whenever required: It includes proper estimation of funds needed for various purposes and specifying possible sources of these funds.
2.
To see that the firm does not raise resources unnecessarily: Good financial planning ensures that surplus money is utilized effectively so that the resources are not left idle and don’t add unnecessary costs.
b. ‘There is no restriction on payment of dividend by a company’. Comment.
In general, while companies have the flexibility to decide on dividend payments, they are subject to legal, contractual, and financial constraints. The company must ensure that dividends are paid out of genuine profits and not at the expense of the company’s financial health or legal obligations.
Long Answer Type
1. What is working capital? Discuss five important determinants of working capital requirement?
Working Capital: Working capital refers to the investment made in current assets, which facilitates the day-to-day operations of a business. These current assets are expected to get converted into cash or cash equivalents within a period of one year and provide liquidity to the business. The net working capital can be defined as the excess of current assets over current liabilities, i.e., NWC = CA – CL.
Determinants of Working Capital Requirement
1.
Nature of Business: The type of business influences its working capital requirement. For instance, trading organizations generally need less working capital compared to manufacturing entities because trading businesses can effect sales immediately upon the receipt of materials.
2.
Scale of Operations: Organizations operating on a grander scale typically require a larger amount of working capital due to a higher quantum of inventory and debtors. Conversely, entities with smaller operations have a lesser need for working capital.
3.
Business Cycle: The phase of the business cycle a firm is in can significantly affect its working capital needs. During boom periods, both sales and production increase, necessitating a larger working capital. However, during times of depression, the requirement decreases.
4.
Seasonal Factors: The seasonality in operations impacts working capital needs. In peak seasons, the activity level rises, demanding more working capital, while the requirement drops during off-peak times.
5.
Production Cycle: The time span between acquiring raw materials and converting them into finished goods is known as the production cycle. Firms with longer production cycles require more working capital than those with shorter cycles due to the time funds are tied up in raw materials and processing.
2. “Capital structure decision is essentially optimisation of risk-return relationship.” Comment.
Capital structure refers to the mix of debt and equity that a company uses to finance its long-term operations and growth. An optimal capital structure aims to strike a balance between risk and return.
Risk-Return Trade-off
1.
Risk Perspective:
–
Fixed Capital: As the passage mentions, investment decisions in fixed assets (long-term assets) are vital because they are irreversible and involve huge amounts of money. The use of debt (like long-term loans or debentures) increases the financial risk as the company becomes obligated to pay interest and repay the principal amount. The higher the proportion of debt, the higher the financial risk.
–
Working Capital: While dealing with current assets and liabilities, a company faces liquidity risks. Insufficient investment in current assets can make it challenging for the company to meet its short-term obligations.
2.
Return Perspective:
–
Fixed Capital: Investing in fixed assets, like plant and machinery or launching a new product line, promises potential returns in the future. However, the expected returns come with the associated risks mentioned earlier.
–
Working Capital: Proper management of working capital ensures smooth day-to-day operations, allowing the company to generate steady revenues and, consequently, returns.
Factors Influencing the Capital Structure Decision
There are several factors affect the fixed and working capital requirements, which indirectly influence the capital structure decision:
1.
Nature of Business: Manufacturing organizations, due to their need for plant, machinery, and raw materials, might have a different capital structure compared to trading organizations.
2.
Scale of Operations: Larger organizations might require more significant investments in fixed and current assets, leading them to opt for a different mix of debt and equity.
3.
Business Cycle: During a boom, companies might opt for more debt to capitalize on growth opportunities, while during a downturn, they might be more conservative.
4.
Growth Prospects: Companies expecting higher growth might require more funds, affecting their capital structure.
5.
Level of Competition: Higher competition might force companies to invest more in fixed assets or maintain higher inventory levels, leading to changes in their financing decisions.
6.
Inflation: Rising prices can increase the need for working capital, which might lead companies to revisit their capital structure.
Capital structure decisions aim to maximize shareholder wealth by optimizing the risk-return relationship. While equity might be expensive due to dividend expectations, it doesn’t carry fixed obligations, making it less risky than debt. On the other hand, debt provides tax benefits (interest is tax-deductible) but increases financial risk. Therefore, the decision regarding the mix of debt and equity should be based on striking a balance between risk and return, considering the various factors influencing fixed and working capital requirements.
3. “A capital budgeting decision is capable of changing the financial fortunes of a business.” Do you agree? Give reasons for your answer?
Yes, I agree that a capital budgeting decision is capable of changing the financial fortunes of a business. The reasons for this are:
1.
Long-term growth:
–
Capital budgeting decisions have a bearing on the long-term growth of a business.
–
The funds invested in long-term assets are expected to yield returns in the future, affecting the future prospects of the business.
2.
Large amount of funds involved:
–
These decisions result in a significant portion of capital funds being blocked in long-term projects.
–
Investments are planned after a detailed analysis, which may involve decisions like sourcing funds and determining interest rates.
3.
Risk involved:
–
Fixed capital involves the investment of substantial amounts.
–
It affects the returns of the firm as a whole in the long-term, influencing the overall business risk complexion of the firm.
4.
Irreversible decisions: Capital budgeting decisions, once made, are not easily reversible without incurring substantial losses.
5.
Impact on Financial Statements:
–
Decisions like capital budgeting can influence virtually all items in the profit and loss account of the business.
–
The overall financial health of a business is determined by the quality of its financial management, and capital budgeting is a crucial aspect of this.
6.
Impact on Earning Capacity: Capital budgeting decisions, such as investing in a new machine or opening a new branch, affect the earning capacity of a business in the long run.
7.
Irreversibility: These decisions often involve significant investments and are irreversible except at a considerable cost. A poor capital budgeting decision can severely damage the financial fortune of a business.
4. Explain the factors affecting dividend decision?
The decision regarding the distribution of dividends is influenced by various factors. Some of the significant factors affecting the dividend decision are:
1.
Amount of Earnings: Dividends are paid out of current and past earnings. Therefore, the amount of earnings is a major determinant of the decision about dividend.
2.
Stability of Earnings: Companies with stable earnings are in a better position to declare higher dividends. In contrast, companies with unstable earnings are likely to pay smaller dividends.
3.
Stability of Dividends: Companies generally follow a policy of stabilizing dividend per share. An increase in dividends is usually made when there’s confidence in the increased earning potential, not just the current year’s earnings.
4.
Growth Opportunities: Companies with good growth opportunities tend to retain more of their earnings to finance the required investment. Consequently, dividends in growth companies are typically smaller than in non-growth companies.
5.
Cash Flow Position: The payment of dividends involves an outflow of cash. Even if a company is earning a profit, it might be short on cash. Sufficient cash availability is essential for the declaration of dividends.
6.
Shareholders’ Preference: Managements must consider the preferences of shareholders regarding dividends. Some shareholders might depend on a regular income from their investments.
7.
Taxation Policy: The choice between dividend payment and retaining earnings can be influenced by the tax treatment of dividends and capital gains. The current tax policy can influence shareholders’ preferences regarding dividends.
8.
Stock Market Reaction: Investors often view an increase in dividends positively, leading to a positive reaction in stock prices. Conversely, a decrease in dividends might negatively impact share prices in the stock market.
5. Explain the term ‘Trading on Equity’? Why, when and how it can be used by company.
Trading on Equity:
Trading on Equity refers to the practice of using borrowed funds to finance the purchase of a company’s assets. It involves the increase in profit earned by the equity shareholders due to the presence of fixed financial charges like interest. The main idea behind this strategy is to use external funds at a fixed cost (like interest on debt) to earn a higher rate of return for the equity shareholders.
Why it is used:
1.
Enhance Returns: When a company can earn a higher return on its investments than the interest it pays on its debt, it results in increased earnings per share (EPS) for the equity shareholders.
2.
Leverage Benefits: Trading on equity allows companies to benefit from the leverage effect, where the use of borrowed funds can amplify the returns on equity.
3.
Tax Benefits: Interest expenses on debt are tax-deductible, which can reduce the overall tax liability of a company.
When it should be used:
1.
Higher Return on Investment (RoI) than Cost of Debt: Trading on equity is beneficial when the company’s RoI is higher than the cost of debt. For instance, if a company’s RoI is 13.33% and the interest rate on debt is 10%, the company can benefit from trading on equity.
2.
Stable Earnings: Companies with stable and predictable earnings are in a better position to use trading on equity, as they can reliably meet their interest obligations.
3.
Favorable Market Conditions: In bullish stock market conditions, companies might prefer to use more equity financing. However, in bearish conditions, debt might be more favorable.
How it can be used:
1.
Issuing Debt: Companies can issue bonds or take loans to raise debt capital.
2.
Investing in Profitable Ventures: The borrowed funds should be invested in projects or assets that yield a return higher than the cost of debt.
3.
Regular Monitoring: Companies should continuously monitor the difference between their RoI and the cost of debt to ensure that trading on equity remains beneficial.
4.
Maintaining a Balance: While trading on equity can enhance returns, excessive debt can increase the financial risk. Hence, companies should strike a balance between debt and equity in their capital structure.
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.
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.
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.
a. Describe the role and objectives of financial management for this company.
Role and Objectives of Financial Management:
Financial management plays a pivotal role in the smooth functioning and success of an organization. For ‘S’ Limited, the objectives of financial management would be:
1.
Wealth Maximization: Ensuring that the market value of the company’s shares is maximized.
2.
Profit Maximization: Ensuring that the company earns maximum profits, leading to a higher dividend for shareholders and retained profits for future growth.
3.
Optimal Investment Decisions: Allocating funds in projects that yield the highest return.
4.
Optimal Financing Decisions: Deciding the best mix of debt and equity to finance the company’s operations.
5.
Liquidity Management: Ensuring that the company always has enough funds to meet its short-term liabilities.
b. Explain the importance of having a financial plan for this company. Give an imaginary plan to support your answer.
Importance of Financial Plan:
1.
Forecasting Financial Needs: A financial plan will help ‘S’ Limited estimate its financial needs for setting up the new plant and its working capital requirements.
2.
Optimal Allocation of Funds: It ensures that funds are allocated where they are needed the most and yield the best return.
3.
Risk Management: Helps in identifying potential financial risks and ways to mitigate them.
4.
Ensuring Liquidity: Ensures that the company has enough funds to meet its short-term liabilities.
Imaginary Financial Plan:
–
Capital Requirement: ₹ 5500 crores (₹ 5000 crores for setting up the plant and ₹ 500 crores as working capital).
–
Financing Mix: 70% Debt and 30% Equity.
–
Projected Revenue: ₹ 8000 crores in the first year with a 10% increase annually.
–
Projected Profit: ₹ 1000 crores in the first year with a 10% increase annually.
c. What are the factors which will affect the capital structure of this company?
Factors Affecting Capital Structure:
1.
Business Risk: The inherent risk associated with the steel industry.
2.
Growth Rate: The company’s growth rate in terms of revenue and profit.
3.
Operational Efficiency: The efficiency with which the company utilizes its assets.
4.
Market Conditions: The prevailing conditions in the stock market.
5.
Regulatory Framework: The regulations related to raising funds from the market.
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.
Factors Affecting Fixed and Working Capital and the corresponding reason:
1.
Nature of Business: Being in the steel industry, which is capital-intensive, ‘S’ Limited will require a higher fixed capital for machinery, plant, etc.
2.
Production Cycle: The time taken from procuring raw materials to producing the final product will determine the working capital needs.
3.
Market Demand: A buoyant demand for steel products will require higher working capital to meet the production needs.
4.
Operational Efficiency: Efficient operations can reduce the need for high working capital as inventory turnover will be faster.
5.
Credit Terms: The credit terms offered to customers and availed from suppliers will impact the working capital.
