Chapter

Financial Management 9
NCERT Question

Very Short Answer Type Questions Ans. As Ramnath has adopted new policy for
1. What is meant by capital structure? his business, it will eventually affect the
requirement of working capital. When the
Ans. Capital structure refers to the combination of
working capital will is reduced.
owner’s and borrowed funds. It represents the
proportion of equity and debt. Short Answer Type Questions
Debt 1. What is ‘financial risk? Why does it arise?
Capital Structure = Ans. Financial risk refers to the risk of a company
Equity not being able to cover its fixed financial costs.
2. State the two objectives of Financial Planning. The higher level of risks are attached to higher
Ans. Financial Planning endeavors to achieve the degrees of financial leverage with the increase
following two objectives: in fixed financial charges, the company also
(i) To ensure the availability of funds required to raise its operating profit (EBIT) to
whenever required: Financial planning meet financial charges. If the company can not
involves proper evaluation of the funds cover these financial charges, it can be forced
required for different purposes, such as, into liquidation.
purchase of long term assets or to meet day- 2. Define ‘current assets’. Give four examples of
to-day expenses of business, etc. such.
(ii) Avoiding unessential generation of Ans. Current assets are those assets of the business
funds: Excess funding is almost as bad which can be converted into cash or cash
as inadequate funding. Efficient financial equivalents within a period of one year. Cash
planning ensures that business does not
in hand or at bank, bills receivables, debtors,
raise unnecessarily funds in order to avoid
finished goods inventory are some of the
unnecessary addition of cost.
examples of current assets. These assets are used
3. Name the concept of financial management to run day to day business operations.
which increases the return to equity
3. What are the main objectives of financial
shareholders due to the presence of fixed
management? Briefly explain.
financial charges.
Ans. Primary aim of the financial management is
Ans. Trading on equity is the concept that increases
to maximise shareholder’s wealth, which is
the return to equity shareholders due to the
presence of fixed financial charges. referred as the wealth maximisation concept.
The wealth of owners is reflected in the market
4. Amrit is running a ‘transport service’ and
value of shares. Wealth maximisation refers to
earning good returns by providing this service
the maximisation of market price of shares.
to industries. Giving reason, state whether the
working capital requirement of the firm will According to the wealth maximisation objective,
be ‘less’ or ‘more’. financial management must select those
Ans. There will be a need of more amount of working decisions which result in value addition, that
capital as Amrit is running a business which is is to say the benefits from a decision exceed the
operated on a large scale. cost involved. Such value addition increase the
5. Ramnath is into the business of assembling and market value of the company’s share and hence,
selling of televisions. Recently he has adopted results in maximisation of the shareholder’s
a new policy of purchasing the components on wealth.
three months credit and selling the complete 4. Financial management is based on three broad
product in cash. Will it affect the requirement financial decisions. What are these?
of working capital? Give reason in support of Ans. Financial management is concerned with the
your answer. solution of the three major issues related to the

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financial operations of a firm corresponding The cost of debt will be `8,00,000 which is more
to the three questions of investment, financing than the ROI of `6,40,000. Therefore, it is advised
and dividend decision. In a financial context, to a company not to issue debenture when cost
it means the selection of the best financing of debt is higher than the cost of capital.
alternative or best investment alternative. 6. How does working capital affect both the
The finance function deals with three broad liquidity as well as profitability of a business?
decision which are as follows: Ans. The working capital should neither be more
(i) Investment Decision: The investment nor less than required. Both these situations
decision focused on the allocation of are harmful. If the amount of working capital is
financial resources and how the firm’s funds more than the requirement, it will undoubtedly
are invested in different assets. increase liquidity but decrease profitability.
(ii) Financing Decision: Financing decision is For instance, if a large amount of cash is kept
concerned about the quantum of finance to as working capital, then this excessive cash will
be raised from various long term sources remain idle and cause the profitability to fall.
and short term sources. It considered On the contrary, if the amount of cash and
identification of various available sources of other current assets are very little, then a lot
finance. of difficulties will have to be faced in meeting
(iii) Dividend Decision: Dividend decision daily expenses and making payments to the
is related to distribution of dividend. creditors. Thus, optimum amount of both the
Dividend is that portion of profit which is current assets and current liabilities should
distributed to shareholders. The decision be determined so that the profitability of the
involved here is how much of the profit business remains intact and there would be no
earned by company is to be distributed to fall in liquidity.
the shareholders and how much of it should 7. Aval Ltd. is engaged in the business of export
be retained in the business for meeting of canvas goods and bags. In the past, the
investment requirements. performance of the company had been up
5. Sunrises Ltd. dealing in readymade garments, to the expectations. In line with the latest
is planning to expand its business operations demand in the market, the company decided
in order to cater to international market. For to venture into leather goods for which it
this purpose, the company needs additional required specialised machinery. For this,
`80,00,000 for replacing machines with modern the Finance Manager Prabhu prepared a
machinery of higher production capacity. The financial blueprint of the organisation’s future
company wishes to raise the required funds operations to estimate the amount of funds
by issuing debentures. The debt can be issued required and the timings with the objective
at an estimated cost of 10%. The EBIT for the to ensure that enough funds are available at
previous year of the company was `8,00,000 right time. He also collected the relevant data
and total capital investment was `1,00,00,000. about the profit estimates in the coming years.
Suggest whether issue of debenture would be By doing this, he wanted to be sure about the
considered a rational decision by the company. availability of funds from the internal sources
Give reason to justify your answer. No, Cost of
of the business. For the remaining funds, he
Debt (10%) is more than ROI which is 8%.
is trying to find out alternative sources from
Ans. A company is able to issue debenture to raise outside.
fund when the cost of debt is less than the the
(a) Identify the financial concept discussed
cost of capital.
in the above paragraph. Also, state the
In the question given, cost of capital of Sunrises
objectives to be achieved by the use of
Limited is 10% which is `8,00,000 as total capital
financial concept so identified. (Financial
is `80,00,000.
Planning).
Now, Return on investment is calculated as
(b) ‘There is no restriction on payment of
ROI = Return / Investment dividend by a company’. Comment. (Legal
8,00,000
= =8% & Contractual Constraints)
1, 00, 00, 000 Ans. (a) The financial concept discussed in the is
Let’s assume that the company will be operating capital budgeting. It is a decision related
with the same efficiency, the additional to capital investment which will impact
investment of `80,00,000 will have a ROI of 8% the profitability of the company in the long
which will amount to `6,40,000. term.

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As the company wants to invest in new In a manufacturing business, however, raw
machinery which requires investment, this will materials need to be converted into finished
have a direct impact on the operations which goods, which increases the expenditure on
will be going to affect the profitability of the raw material, labour and other expenses.
organisation. (ii) Scale of Operation: The firms operating on
The following objectives can be achieved: a higher scale of operations, the quantum
of inventory, debtors required is generally
1. Cash flow: Investment will bring new
high, therefore, such organisations
machinery which helps to increase the
require large amount of working capital
organisation’s profitability.
as compared to the organisations which
2. Company wants to raise funds from both operate on a lower scale.
the organisation's (i.e., inside and outside).
(iii) Production Cycle: Production cycle is the
It will be helpful to examine the return
time between the receipts of raw materials
generated from such investment will be
and their conversion into finished goods.
more than the cost of capital.
Some businesses have a longer production
3. Investment used: If the company is planning cycle while some have a shorter one.
to raise funds from both inside and outside. Therefore, working capital requirement is
Then it is important to notice that funds higher in terms of a longer processing cycle
from internal and external sources will have and lower in firms with a shorter processing
different rates of interest. cycle.
(b) Companies pay dividend to shareholders which (iv) Credit Allowed: Different firms allow
is a part of the company earnings. Payment of different credit terms to their customers.
dividends is based on following factors: However, a liberal credit policy results in
1. Legal Constraint: Legal constraints are higher amount of debtors, increasing the
those constraints that are mentioned in the working capital requirements.
company laws which impact paying out (v) Credit Availed: Just as a firm allows credit
dividends on certain occasions. It should be to its customers, it also may get credit from
followed properly. its suppliers. Thus, the more credit a firm
2. Contractual Constraints: Pay out of avails on its purchases, the working capital
dividend results in reduction of cash in the requirement is reduced.
company. Money that is raised as loan will 2. “Capital structure decision is essentially
lay down certain restrictions on the company optimisation of risk-return relationship.”
for paying dividends, such constraints are Comment.
called contractual constraints. Ans. Capital structure refers to the combination of
Long Answer Type Questions owner’s and borrowed funds. It can be calculated
1. What is working capital? Discuss five as Debit/Equity.
important determinants of working capital Debt and equity differ significantly in their cost
requirements. and riskiness for the firm. Cost of debt is lower
Ans. Working capital is that part of total capital which than the cost of equity for a firm because lender’s
is required to meet day-to-day expenses, to buy risk is lower than the equity shareholder’s
raw materials, to pay wages and other expenses risk. Since lenders earn on assured return
of routine nature in the production process or and repayment of capital and therefore, they
we can say it refers to an excess of current assets should require a lower rate of return. Debt is
over current liabilities. cheaper but is more risky for a business because
Working Capital = Current Assets – Current payment of interest and the return of principal is
Liabilities obligatory for the business. These commitments
may force the business to go into liquidation if
Factors affecting working capital requirement
there is any default in meeting them. There is no
are:
such compulsion in case of equity, that is why,
(i) Nature of Business: The basic nature
it is considered riskless for the business. Higher
of a business influences the amount of
use of debt increases the fixed financial charges
working capital required. A trading of a business. As a result increased use of debt
organisation usually needs a lower amount increases the financial risk of a business.
of the working capital compared to a
Capital structure of a business thus, affects
manufacturing organisation. This is because,
both the profitability and the financial risk. A
in trading, there is no processing required.

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capital structure will said to be optimal when Cash Flow Position: Dividends involve
the proportion of debt and equity results in an an outflow of cash. A company may be
increment in the value of the equity share. profitable but short on cash. Availability of
enough cash in the company is necessary for
3. “A capital budgeting decision is capable of
declaration of dividend by it.
changing the financial fortune of a business.”
Do you agree? Give reasons for your answer. (v) Shareholder Preference: If the shareholders
in general, desire that at least a certain
Ans. Investment decision can be long term or
amount should be paid as dividend, the
short term. A long term investment decision
companies are likely to declare the same.
is also called a capital budgeting decision. It
involves the commitment of the finance on (vi) Taxation Policy: If tax on dividend is higher
a long term basis, e.g., making investment in it would be better to pay less by way of
a new machine to replace an existing one or dividends. As compared to this, higher
acquiring a new fixed assets or opening a new dividends may be declared if tax rates are
branch, etc. These decisions turn out to be very relatively lower.
crucial for any business. The earning capacity (vii) Stock Market Reaction: For investors, an
over the long-run assets of a firm, profitability increase in dividend is a good news as
and competitiveness, are all affected by the stock prices react positively to it. Similarly,
capital budgeting decisions. Moreover, these a decrease in dividend may have a negative
decisions normally involve huge amounts of impact on the share prices in the stock
investment and are irreversible except at a market.
huge cost. Therefore, once made, it is futile for (viii) Access to Capital Market: Large and
a business to wriggle out of such decisions. reputed companies generally have easy
Therefore, they need to be taken with utmost access to the capital market and therefore,
care. These decisions must be taken by those depend less on retained earnings to
who understand them comprehensively. A bad finance their growth. These companies
capital budgeting decision can severely damage tend to pay higher dividends than the
the financial fortune of a business. smaller companies which have relatively
4. Explain factors affecting the dividend decision. low access to the market.
Ans. Dividend decision is related to the distribution (ix) Legal constraints: Certain provisions of the
of profit to the shareholders and its retention in Company’s Act place restriction on payouts
the business for meeting the future investment as dividend. Such provisions have to be
adhered, while declaring dividends.
requirements.
(x) Contractual Constraints: While granting
How much of the profit earned by a company
loans to a company, sometimes the lender
will be distributed and how much will be
may impose certain restrictions on the
retained in the business is affected by many
payment of dividends in future. The
factors.
companies are required to ensure that the
Some of the important factors which affect the
dividends do not violate the terms and
dividend decision are as follows:
conditions of the loan agreement in this
(i) Earnings: Dividends are paid out of current regard.
and past year earnings. Therefore, earnings 5. Explain the term ”Trading on Equity”. Why,
is a major determinant of the decision about
when and how it can be used by a company?
dividend.
Ans. Trading on equity is a financial process of using
(ii) Stability of Earnings: Other things debt in order to produce gain for the owners.
remaining the same, a company having In this process, new debt is taken to gain new
stable earning is in a position to declare assets with which they can earn greater level of
higher dividends. As against this, a interest which is more than the interest that is
company having unstable earnings is likely paid for debt. This process is followed because
to pay smaller dividend. the equity shareholders are interested in the
(iii) Growth Opportunities: Companies having income that is being generated from business. It
good growth opportunities retain more is practiced by a company only when the rate of
money out of their earnings so as to finance return on investment is greater than the rate of
the required investment. The dividend in interest for the fund that is borrowed. There will
growth companies, is therefore, smaller be an increment in earnings per share when this
than that in non-growth companies. process is adopted.
(iv)

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Trading on equity is profitable only when the It helps to solve the problems of shortage
return on investment is greater than the amount and surplus of funds by ensuring proper and
of funds borrowed. It is said that trading optimum utilisation of available resources.
on equity shall be avoided if the return on (iv) It ensures to increase profitability through
investment is less than the rate of interest from cost benefit analysis and by avoiding
the funds that are borrowed. wasteful operations.
6. ‘S’ Limited is manufacturing steel at its plant (v) It seeks to eliminate wastage of funds and
in India. It is enjoying a buoyant demand for provides better financial control.
its products as economic growth is about 7-8 (vi) It seeks to avail the benefits of trading on
percent and the demand for steel is growing. It equity.
is planning to set up a new steel plant to cash (c) What are the factors which will affect the
on the increased demand. It is estimated that it capital structure of this company?
will require about `5,000 crores to set up and
Ans. Capital structure refers to the proportion in
about `500 crores of working capital to start the
which debt and equity funds are used for
new plant.
financing the operations of a business. A capital
(a) Describe the role and objectives of financial
structure is considered to be optimum when
management for this company.
the proportion of debt and equity results in an
Ans. Role of Financial Management: Financial increase in the value of shares.
management is concerned with the proper
The factors that will affect the capital structure
management of funds. It involves:
of this company are:
(i) Managerial decisions related to procurement
(i) Equity Funds: The composition of equity
of long term and short term funds.
funds in the capital structure will be
(ii) Keeping the risk associated with respect to
governed by the following factors:
procured funds under control.
(a) The funding requirement of ‘S’ Limited
(iii) Utilisation of funds in the most productive
and effective manner. is for long term. Hence, equity funds
will be more appropriate.
(iv) Fixed debt equity ratio in capital.
(b) There are no financial risks involved in
Objective of Financial Management: The
objective of financial management is to this form of funding.
maximise the shareholder’s wealth. The (c) If the stock market is bullish, the
investment decision, financial decision and company can easily raise funds through
dividend decision help an organisation to issue of equity shares.
achieve this objective. In the given situation, (d) If the company already has raised
S limited visualizes growth prospects of steel reasonable amount of debt funds, each
industry due to the growing demand. To subsequent borrowing will come at a
expand the production capacity, the company higher interest rate and will increase the
needs to invest. However, investment decision fixed charges.
will depend on the availability of funds, the (ii) Debt Funds: The usage and the ratio of
financing decision and the dividend decision. debt funds in the capital structure will be
However, the company will take those financial governed by factors like:
decisions which result in value addition, i.e., the
(a) The availability of cash flow with the
benefits are more than the cost. This leads to an
company to meet its fixed financial
increase in the market value of the shares of the
charges. The purpose is to reduce the
company.
financial risk associated with such
(b) Explain the importance of having a financial
payments which can further be checked
plan for this company. Give an imaginary plan
by using ‘debt’ service coverage ratio.
to support your answer.
(b) It will provide the benefit of trading
Ans. Importance of financial plan for the company
on equity and hence, will increase the
are :
earning per share of equity shareholders.
(i) Financial Planning ensures allocation of
However, ‘return on investment’ ratio
adequate funds to meet the working capital
will be the guiding principle behind it.
requirements.
The company should choose trading on
(ii) It brings about a balance between in flow
equity only when return on investment
and out flow of funds and ensures liquidity
is more than the fixed charges.
throughout the year.
(iii)

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(c) Interest on debt funds is a deductible up production base, heavy investments are
expense and therefore, will reduce the required.
tax liability. (iii) In case of steel industry, the major input is
(d) It does not result in dilution of iron ore and coal. The ratio of cost of raw
management control. material to total cost is very high. Thus,
(d) Keeping in mind that it is a highly capital- there will be the higher need for working
intensive sector what factors will affect the capital.
fixed and working capital. Give reasons in (iv) The longer the operating cycle, the larger is
support of your answer. the amount of working capital required as
Ans. The working and fixed capital requirement of the funds get locked up in the production
‘S’ Limited will be high due to the following process for a long period of time.
reasons: (v) Terms of credit for buying and selling
(i) The business is capital intensive and the goods, discount allowed by suppliers and to
scale of operation is large. the customers also determine the quantum
(ii) For technological upgradation and to build of working capital.
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