Dibrugarh University Financial Management Solved Question Papers
2015 (November)
COMMERCE (Speciality)
Course: 302 (Financial
Management)
The figures in
the margin indicate full marks for the questions
1. (a) Write ‘True’ or
‘False’: 1x4=4
a)
Cash management is an important task of the
finance manager. True
b)
Every business concern should have excessive
working capital. False,
optimum w.c.
c)
The cost of capital is the maximum rate of
return expected by its investors. False
d)
Dividend is the reward of the shareholders for
investment made by them in the shares of the company. True
(b)
Fill in the blanks: 1x4=4
a)
Finance
is the life blood and nerve centre of a business concern.
b)
Capital budgeting means planning for Long term or permanent assets.
c)
The redundant working capital gives rise to Speculative transactions.
d)
Dividends paid in the ordinary course of
business are known as profits
dividends.
2.
Write short notes on any four of the following: 4x4=16
a)
Wealth
maximization.
Ans: Shareholders’ wealth maximization means
maximizing the net present value of a course of action to shareholders. Net
Present Value (NPV) of a course of action is the difference between the present
value of its benefits and the present value of its costs. A financial action
that has a positive NPV creates wealth for shareholders and therefore, is
desirable. A financial action resulting in negative NPV destroys shareholders’
wealth and is, therefore undesirable. Between mutually exclusive projects, the
one with the highest NPV should be adopted. NPVs of a firm’s projects are
additive in nature. That is
NPV(A) + NPV(B) = NPV(A+B)
The objective of Shareholders
Wealth Maximization (SWM) considers timing and risk of expected benefits.
Benefits are measured in terms of cash flows. One should understand that in
investment and financing decisions, it is the flow of cash that is important,
not the accounting profits. SWM as an objective of financial management is
appropriate and operationally feasible criterion to choose among the
alternative financial actions.
Maximizing the shareholders’
economic welfare is equivalent to maximizing the utility of their consumption
over time. The wealth created by a company through its actions is reflected in
the market value of the company’s shares. Therefore, this principle implies
that the fundamental objective of a firm is to maximize the market value of its
shares. The market price, which represents the value of a company’s shares,
reflects shareholders’ perception about the quality of the company’s financial
decisions. Thus, the market price serves as the company’s performance
indicator.
b)
Net
present value method.
Ans: Net
present value (NPV) method: The best method for evaluation of investment
proposal is net present value method or discounted cash flow technique. This
method takes into account the time value of money. The net present value of
investment proposal may be defined as sum of the present values of all cash
inflows as reduced by the present values of all cash outflows associated
with the proposal. Each project involves certain investments and commitment of
cash at certain point of time. This is known as cash outflows. Cash inflows can
be calculated by adding depreciation to profit after tax arising out of that
particular project.
Merits of
NPV method:
1) NPV method takes into account the time
value of money.
2) The whole stream of cash flows is
considered.
3) NPV can be seen as addition to the wealth
of shareholders. The criterion of NPV is thus in conformity with basic
financial objectives.
4) NPV uses discounted cash flows i.e. expresses
cash flows in terms of current rupees. NPV's of different projects therefore
can be compared. It implies that each project can be evaluated independent of
others on its own merits.
Limitations
of NPV method:
1) It involves different calculations.
2) The application of this method necessitates
forecasting cash flows and the discount rate. Thus accuracy of NPV depends on
accurate estimation of these 2 factors that may be quite difficult in reality.
3) The ranking of projects depends on the
discount rate.
c)
Weighted
average cost of capital.
Ans: Weighted
average cost of capital (WACC) is the average of the minimum after-tax required
rate of return which a company must earn for all of its security holders (i.e.
common stock-holders, preferred stock-holders and debt-holders). It is
calculated by finding out cost of each component of a company’s capital
structure, multiplying it with the relevant proportion of the component to
total capital and then summing up the proportionate cost of components. WACC is
a very useful tool because it tells whether a particular project is increasing
shareholders’ wealth or just compensating the cost.
Formula: For a company which has two sources
of finance, namely equity and debt, WACC is calculated using the following
formula: WACC = r(E) × w(E) + r(D) × (1 – t) × w(D)
Cost of equity: In the
formula for WACC, r(E) is the cost of equity i.e. the required rate of return
on common stock of the company. It is the minimum rate of return which a
company must earn to keep its common stock price from falling. Cost of equity
is estimated using different models, such as dividend discount model (DDM) and
capital asset pricing model (CAPM).
Weights: w(E) is the weight of equity in the company’s
total capital. It is calculated by dividing the market value of the company’s
equity by sum of the market values of equity and debt. w(D) is
the weight of debt component in the company’s capital structure. It is
calculated by dividing the market value of the company’s debt by sum of the
market values of equity and debt.
d)
Management
of working capital.
Ans: The capital required for a business is of two types. These are
fixed capital and working capital. Fixed capital
is required for the purchase of fixed assets like building, land, machinery,
furniture etc. Fixed capital is invested for long period, therefore it is known
as long-term capital. Similarly, the capital, which is needed for investing in
current assets, is called working capital. The
capital which is needed for the regular operation of business is called working
capital. Working capital is also called circulating capital or revolving
capital or short-term capital.
Working capital management involves
the relationship between a firm's short-term assets and its short-term
liabilities. The goal of working capital management is to ensure that a firm is
able to continue its operations and that it has sufficient ability to satisfy
both maturing short-term debt and upcoming operational expenses. The management
of working capital involves managing inventories, accounts receivable and
payable, and cash.
e)
Regular
dividend policy.
Ans: Regular dividend
policy: Under this type of dividend policy a company has the policy of paying
dividends to its shareholders every year. When the company makes abnormal profits
then the company will not pay that extra profits to its shareholders completely
rather it will distribute lower profit in the form of the dividend to the
shareholders and keep the excess profits with it and suppose a company makes
loss then also it will pay dividend to its shareholders under regular dividend
policy. This type of dividend policy is suitable for those companies which have
constant cash flows and have stable earnings. Investors like retired person and
conservative investors who prefer safe investment and constant income will
invest in constant dividend paying companies.
3.
(a) “Maximization of profits is regarded as the proper objective of investment
decision, but it is not as exclusive as maximizing shareholders’ wealth.”
Comment. 14
Ans: Objectives of Financial
Management
The firm’s investment and
financing decision are unavoidable and continuous. In order to make them
rational, the firm must have a goal. Two financial objectives predominate
amongst many objectives. These are:
1. Profit maximization
2. Shareholders’ Wealth
Maximization (SWM)
Profit maximization refers to
the rupee income while wealth maximization refers to the maximization of the
market value of the firm’s shares. Although profit maximization has been
traditionally considered as the main objective of the firm, it has faced
criticism. Wealth maximization is regarded as operationally and managerially
the better objective.
1. Profit maximization:
Profit maximization implies that either a firm produces maximum output for a
given input or uses minimum input for a given level of output. Profit
maximization causes the efficient allocation of resources in competitive market
condition and profit is considered as the most important measure of firm
performance. The underlying logic of profit maximization is efficiency.
In a market economy, prices
are driven by competitive forces and firms are expected to produce goods and
services desired by society as efficiently as possible. Demand for goods and
services leads price. Goods and services which are in great demand can command
higher prices. This leads to higher profits for the firm. This in turn attracts
other firms to produce such goods and services. Competition grows and
intensifies leading to a match in demand and supply. Thus, an equilibrium price
is reached. On the other hand, goods and services not in demand fetches low
price which forces producers to stop producing such goods and services and go
for goods and services in demand. This shows that the price system directs the
managerial effort towards more profitable goods and services. Competitive
forces direct price movement and guides the allocation of resources for various
productive activities.
Objections to Profit Maximization:
Certain objections have been raised against
the goal of profit maximization which strengthens the case for wealth
maximization as the goal of business enterprise. The objections are:
(a) Profit cannot be ascertained well in
advance to express the probability of return as future is uncertain. It is not
at all possible to maximize what cannot be known. Moreover, the return profit
vague and has not been explained clearly what it means. It may be total profit
before tax and after tax of profitability tax. Profitability rate, again is
ambiguous as it may be in relation to capital employed, share capital, owner’s
fund or sales. This vagueness is not present in wealth maximisation goal as the
concept of wealth is very clear. It represents value of benefits minus the cost
of investment.
(b) The executive or the decision maker may
not have enough confidence in the estimates or future returns so that he does
not attempt further to maximize. It is argued that firm’s goal cannot be to
maximize profits but to attain a certain level or rate of profit holding certain
share of the market or certain level of sales. Firms should try to ‘satisfy’
rather than to ‘maximise’.
(c)There must be a balance between expected
return and risk. The possibility of higher expected yields are associated with
greater risk to recognize such a balance and wealth maximisation is brought in
to the analysis. In such cases, higher capitalization rate involves. Such
combination of expected returns with risk variations and related capitalization
rate cannot be considered in the concept of profit maximisation.
(d) The goal of maximisation of profits is
considered to be a narrow outlook. Evidently when profit maximisation becomes
the basis of financial decision of the concern, it ignores the interests of the
community on the one hand and that of the government, workers and other
concerned persons in the enterprise on the other hand.
(e) The criterion of profit maximisation
ignores time value factor. It considers the total benefits or profits in to
account while considering a project where as the length of time in earning that
profit is not considered at all. Whereas the wealth maximization concept fully
endorses the time value factor in evaluating cash flows. Keeping the above
objection in view, most of the thinkers on the subject have come to the
conclusion that the aim of an enterprise should be wealth maximisation and not
the profit maximisation.
(f) To make a distinction between profits and
profitability. Maximisation of profits with a view to maximizing the wealth of
share holders is clearly an unreal motive. On the other hand, profitability
maximisation with a view to using resources to yield economic values higher
than the joint values of inputs required is a useful goal. Thus, the proper
goal of financial management is wealth maximisation.
2. Shareholders’ Wealth
Maximization: Shareholders’ wealth maximization means maximizing the net
present value of a course of action to shareholders. Net Present Value (NPV) of
a course of action is the difference between the present value of its benefits
and the present value of its costs. A financial action that has a positive NPV
creates wealth for shareholders and therefore, is desirable. A financial action
resulting in negative NPV destroys shareholders’ wealth and is, therefore
undesirable. Between mutually exclusive projects, the one with the highest NPV
should be adopted. NPVs of a firm’s projects are additive in nature. That is
NPV(A) + NPV(B) = NPV(A+B)
The objective of Shareholders
Wealth Maximization (SWM) considers timing and risk of expected benefits.
Benefits are measured in terms of cash flows. One should understand that in
investment and financing decisions, it is the flow of cash that is important,
not the accounting profits. SWM as an objective of financial management is
appropriate and operationally feasible criterion to choose among the
alternative financial actions.
Maximizing the shareholders’
economic welfare is equivalent to maximizing the utility of their consumption
over time. The wealth created by a company through its actions is reflected in
the market value of the company’s shares. Therefore, this principle implies
that the fundamental objective of a firm is to maximize the market value of its
shares. The market price, which represents the value of a company’s shares,
reflects shareholders’ perception about the quality of the company’s financial
decisions. Thus, the market price serves as the company’s performance
indicator.
In such a case, the financial
manager must know or at least assume the factors that influence the market price
of shares. Innumerable factors influence the price of a share and these factors
change frequently. Moreover, the factors vary across companies. Thus, it is
challenging for the manager to determine these factors.
WEALTH
MAXIMIZATION AS PRIMARY OBJECTIVE OF FINANCIAL MANAGEMENT
The primary objective of financial management
is wealth maximization. The concept of wealth in the context of wealth
maximization objective refers to the shareholders’ wealth as reflected by the
price of their shares in the share market. Therefore, wealth maximization means
maximization of the market price of the equity shares of the company. However,
this maximization of the price of company’s equity shares should be in the long
run by making efficient decisions which are desirable for the growth of a
company and are valued positively by the investors at large and not by
manipulating the share prices in the short run. The long run implies a period
which is long enough to reflect the normal market price of the shares
irrespective of short-term fluctuations. The long run price of an equity share
is a function of two basic factors:
1)
The likely rate of earnings or earnings per
share (EPS) of the company; and
2)
The capitalization rate reflecting the
liking of the investors of a company.
The financial manager must identify those
avenues of investment; modes of financing, ways of handling various components
of working capital which ultimately will lead to an increase in the price of
equity share. If shareholders are gaining, it implies that all other claimants
are also gaining because the equity share holders are paid only after the
claims of all other claimants (such as creditors, employees, lenders) have been
duly paid.
The
following arguments are advanced in favour of wealth maximization as the goal
of financial management:
a) It
serves the interests of owners, (shareholders) as well as other stakeholders in
the firm; i.e. suppliers of loaned capital, employees, creditors and society.
b) It
is consistent with the objective of owners’ economic welfare.
c) The
objective of wealth maximization implies long-run survival and growth of the
firm.
d) It
takes into consideration the risk factor and the time value of money as the
current present value of any particular course of action is measured.
e) The
effect of dividend policy on market price of shares is also considered as the
decisions are taken to increase the market value of the shares.
f) The
goal of wealth maximization leads towards maximizing stockholder’s utility or
value maximization of equity shareholders through increase in stock price per
share.
Criticism
of Wealth Maximization: The wealth maximization objective has been
criticized by certain financial theorists mainly on following accounts:
a) It
is prescriptive idea. The objective is not descriptive of what the firms
actually do.
b) The
objective of wealth maximization is not necessarily socially desirable.
c) There
is some controversy as to whether the objective is to maximize the stockholders
wealth or the wealth of the firm which includes other financial claimholders
such as debenture holders, preferred stockholders, etc.
d) The
objective of wealth maximization may also face difficulties when ownership and
management are separated as is the case in most of the large corporate form of
organization. When managers act as agents of the real owners (equity
shareholders), there is a possibility for a conflict of interest between
shareholders and the managerial interests. The managers may act in such a
manner which maximizes the managerial utility but not the wealth of
stockholders or the firm.
Or
(b)
Define ‘financial management’. Explain the objectives of financial management.
Why is maximizing wealth a better goal than maximizing profits? 3+7+4=14
Ans: Meaning and Definitions of Financial
Management/Business Finance/ Finance Functions
Financial management is management principles and
practices applied to finance. General management functions include planning,
execution and control. Financial decision making includes decisions as to size
of investment, sources of capital, extent of use of different sources of
capital and extent of retention of profit or dividend payout ratio. Financial
management, is therefore, planning, execution and control of investment of
money resources, raising of such resources and retention of profit/payment of
dividend.
Howard and Upton define financial management as
"that administrative area or set of administrative functions in an
organisation which have to do with the management of the flow of cash so that
the organisation will have the means to carry out its objectives as
satisfactorily as possible and at the same time meets its obligations as they
become due.”
According to Guthamann and Dougall,” Business finance
can be broadly defined as the activity concerned with the planning, raising,
controlling and administering the funds used in the business.”
Bonneville and Dewey interpret that financing consists
in the raising, providing and managing all the money, capital or funds of any
kind to be used in connection with the business.
Osbon defines financial management as the
"process of acquiring and utilizing funds by a business”.
Considering all these views, financial management may
be defined as that part of management which is concerned mainly with raising
funds in the most economic and suitable manner, using these funds as profitably
as possible.
Objectives of Financial
Management
The firm’s investment and
financing decision are unavoidable and continuous. In order to make them
rational, the firm must have a goal. Two financial objectives predominate
amongst many objectives. These are:
1. Profit maximization
2. Shareholders’ Wealth
Maximization (SWM)
Profit maximization refers to
the rupee income while wealth maximization refers to the maximization of the
market value of the firm’s shares. Although profit maximization has been
traditionally considered as the main objective of the firm, it has faced
criticism. Wealth maximization is regarded as operationally and managerially
the better objective.
1. Profit maximization:
Profit maximization implies that either a firm produces maximum output for a
given input or uses minimum input for a given level of output. Profit
maximization causes the efficient allocation of resources in competitive market
condition and profit is considered as the most important measure of firm
performance. The underlying logic of profit maximization is efficiency.
In a market economy, prices
are driven by competitive forces and firms are expected to produce goods and
services desired by society as efficiently as possible. Demand for goods and
services leads price. Goods and services which are in great demand can command
higher prices. This leads to higher profits for the firm. This in turn attracts
other firms to produce such goods and services. Competition grows and
intensifies leading to a match in demand and supply. Thus, an equilibrium price
is reached. On the other hand, goods and services not in demand fetches low
price which forces producers to stop producing such goods and services and go
for goods and services in demand. This shows that the price system directs the
managerial effort towards more profitable goods and services. Competitive
forces direct price movement and guides the allocation of resources for various
productive activities.
2. Shareholders’ Wealth
Maximization: Shareholders’ wealth maximization means maximizing the net
present value of a course of action to shareholders. Net Present Value (NPV) of
a course of action is the difference between the present value of its benefits
and the present value of its costs. A financial action that has a positive NPV
creates wealth for shareholders and therefore, is desirable. A financial action
resulting in negative NPV destroys shareholders’ wealth and is, therefore
undesirable. Between mutually exclusive projects, the one with the highest NPV
should be adopted. NPVs of a firm’s projects are additive in nature. That is
NPV(A) + NPV(B) = NPV(A+B)
The objective of Shareholders
Wealth Maximization (SWM) considers timing and risk of expected benefits. Benefits
are measured in terms of cash flows. One should understand that in investment
and financing decisions, it is the flow of cash that is important, not the
accounting profits. SWM as an objective of financial management is appropriate
and operationally feasible criterion to choose among the alternative financial
actions.
WEALTH
MAXIMIZATION AS PRIMARY OBJECTIVE OF FINANCIAL MANAGEMENT
The primary objective of financial management
is wealth maximization. The concept of wealth in the context of wealth
maximization objective refers to the shareholders’ wealth as reflected by the
price of their shares in the share market. Therefore, wealth maximization means
maximization of the market price of the equity shares of the company. However,
this maximization of the price of company’s equity shares should be in the long
run by making efficient decisions which are desirable for the growth of a company
and are valued positively by the investors at large and not by manipulating the
share prices in the short run. The long run implies a period which is long
enough to reflect the normal market price of the shares irrespective of
short-term fluctuations. The long run price of an equity share is a function of
two basic factors:
a)
The likely rate of earnings or earnings per
share (EPS) of the company; and
b)
The capitalization rate reflecting the
liking of the investors of a company.
The financial manager must identify those
avenues of investment; modes of financing, ways of handling various components
of working capital which ultimately will lead to an increase in the price of
equity share. If shareholders are gaining, it implies that all other claimants
are also gaining because the equity share holders are paid only after the
claims of all other claimants (such as creditors, employees, lenders) have been
duly paid.
The
following arguments are advanced in favour of wealth maximization as the goal
of financial management:
a) It
serves the interests of owners, (shareholders) as well as other stakeholders in
the firm; i.e. suppliers of loaned capital, employees, creditors and society.
b) It
is consistent with the objective of owners’ economic welfare.
c) The
objective of wealth maximization implies long-run survival and growth of the
firm.
d) It
takes into consideration the risk factor and the time value of money as the
current present value of any particular course of action is measured.
e) The
effect of dividend policy on market price of shares is also considered as the
decisions are taken to increase the market value of the shares.
f) The
goal of wealth maximization leads towards maximizing stockholder’s utility or
value maximization of equity shareholders through increase in stock price per
share.
4.
(a) Define the term ‘working capital’. What factors you have to take into
consideration in estimating the working capital needs of a concern? 3+11=14
Ans: Meaning and definition of Working
Capital
The capital required for a business is of two
types. These are fixed capital and working capital. Fixed capital is required for the purchase of fixed assets like
building, land, machinery, furniture etc. Fixed capital is invested for long
period, therefore it is known as long-term capital. Similarly, the capital,
which is needed for investing in current assets, is called working capital.
The capital which is needed for the regular
operation of business is called working capital. Working capital is also called
circulating capital or revolving capital or short-term capital.
In the words of John. J
Harpton “Working capital may be defined as all the shot term assets used in
daily operation”.
According to “Hoagland”, “Working
Capital is descriptive of that capital which is not fixed. But, the more common
use of Working Capital is to consider it as the difference between the book
value of the current assets and the current liabilities.
From the above definitions, Working Capital
means the excess of Current Assets over Current Liabilities. Working Capital is
the amount of net Current Assets. It is the investments made by a business
organisation in short term Current Assets like Cash, Debtors, Bills receivable
etc.
Factors
Affecting Working Capital Requirement
The level of working capital is influenced by several
factors which are given below:
a) Nature of
Business: Nature of business is one of
the factors. Usually in trading businesses the working capital needs are higher
as most of their investment is found concentrated in stock. On the other hand,
manufacturing/processing business needs a relatively lower level of working
capital.
b) Size of
Business: Size of business is also an
influencing factor. As size increases, an absolute increase in working capital
is imminent and vice versa.
c) Production
Policies: Production policies of a business organisation exert considerable
influence on the requirement of Working Capital. But production policies depend
on the nature of product. The level of production, decides the investment in
current assets which in turn decides the quantum of working capital required.
d) Terms of
Purchase and Sale: A business organisation making purchases of
goods on credit and selling the goods on cash terms would require less Working
Capital whereas an organisation selling the goods on credit basis would require
more Working Capital. If the payment is to be made in advance to suppliers,
then large amount of Working Capital would be required. 286
e) Production
Process: If the production process requires a long period of
time, greater amount of Working Capital will be required. But, simple and short
production process requires less amount of Working Capital. If production
process in an industry entails high cost because of its complex nature, more
Working Capital will be required to finance that process and also for other
expenses which very with the cost of production whereas if production process
is simple requiring less cost, less Working Capital will be required.
f) Turnover
of Circulating Capital: Turnover of circulating capital
plays an important and decisive role in judging the adequacy of Working
Capital. The speed with which circulating capital completes its cycle i.e.
conversion of cash into inventory of raw materials, raw materials into finished
goods, finished goods into debts and debts into cash decides the Working
Capital requirements of an organization. Slow movement of Working Capital cycle
requires large provision of Working Capital.
g) Dividend
Policies: Dividend policies of a business organisation also influence
the requirement of Working Capital. If a business is following a liberal
dividend policy, it requires high Working Capital to pay cash dividends where
as a firm following a conservative dividend policy will require less amount of
Working Capital.
h) Seasonal
Variations: In case of seasonal industries like Sugar, Oil mills
etc. More Working Capital is required during peak seasons as compared to slack
seasons.
i)
Business Cycle: Business
expands during the period of prosperity and declines during the period of
depression. More Working Capital is required during the period of prosperity
and less Working Capital is required during the period of depression.
j)
Change in Technology: Changes
in Technology as regards production have impact on the need of Working Capital.
A firm using labour oriented technology will require more Working Capital to
pay labour wages regularly.
k) Inflation:
During inflation a business concern requires more Working Capital
to pay for raw materials, labour and other expenses. This may be compensated to
some extent later due to possible rise in the selling price. 287
l)
Turnover of Inventories: A
business organisation having low inventory turnover would require more Working
Capital where as a business having high inventory turnover would require
limited or less Working Capital.
m) Taxation
Policies: Government taxation policy affects the quantum of
Working Capital requirements. High tax rate demands more amount of Working
Capital.
n) Degree
of Co-ordination: Co-ordination between production
and distribution policies is important in determining Working Capital
requirements. In the absence of co-ordination between production and
distribution policies more Working Capital may be required.
Or
(b)
The following information has been extracted from the Cost Sheet of a company:
|
|
Rs. (per unit)
|
|
Raw Materials
Direct Labour
Overheads
|
45
20
40
|
|
Profit
|
105
15
|
|
Selling Price
|
120
|
The
following further information is available:
a)
Raw
Materials are in stock on an average of two months.
b)
The
materials are in process on an average for 4 weeks. The degree of completion is
50% in all respects.
c)
Finished
goods are in stock on an average of one month.
d)
Time
lag in payment of wages and overheads is 1 ½ weeks.
e)
Time
lag in receipts of proceeds from debtors is 2 months.
f)
Credit
allowed by suppliers is one month.
g)
20%
of output is sold against cash.
h)
The
company expects to keep a cash balance of Rs. 1,00,000.
i)
Take
52 weeks per annum.
j)
Calculation
of debtors may be made at selling price.
k)
The
company is poised for a manufacture of 14400 units in the year.
You are
required to prepare a statement showing the working capital requirements of the
company. 14
SOLUTIONS:
LINK OF ALL PRACTICAL PROBLEMS VIDEOS
5. (a) Explain briefly the following methods
of capital budgeting bringing out the advantages and disadvantages of each:
7+7=14
a)
Payback period method.
b)
Accounting rate of return method.
Ans: Payback
period Method: It is one of the simplest methods to calculate period within
which entire cost of project would be completely recovered. It is the period
within which total cash inflows from project would be equal to total cash
outflow of project. Here, cash inflow means profit after tax but before
depreciation.
Merits of
Payback period Method
a) This method of evaluating proposals for
capital budgeting is simple and easy to understand, it has an advantage of
making clear that it has no profit on any project until the payback period is
over i.e. until capital invested is recovered. This method is particularly
suitable in the case of industries where risk of technological services is very
high.
b) In case of routine projects also, use of
payback period method favours projects that generates cash inflows in earlier
years, thereby eliminating projects bringing cash inflows in later years that
generally are conceived to be risky as this tends to increase with futurity.
c) By stressing earlier cash inflows,
liquidity dimension is also considered in selection criteria. This is important
in situations of liquidity crunch and high cost of capital.
d) Payback period can be compared to
break-even point, the point at which costs are fully recovered but profits are
yet to commence.
e) The risk associated with a project arises
due to uncertainty associated with cash inflows. A shorter payback period means
that uncertainty with respect to project is resolved faster.
Limitations
of payback period
a) It stresses capital recovery rather than
profitability. It does not take into account returns from the project after its
payback period.
b) This method becomes an inadequate measure
of evaluating 2 projects where the cash inflows are uneven.
c) This method does not give any consideration
to time value of money, cash flows occurring at all points of time are simply
added.
d) Post-payback period profitability is
ignored totally.
Accounting
rate of return (Average rate of return – ARR): ARR is a
financial ratio used in capital budgeting. The ratio does not take into account
the concept of time value of money. ARR calculates the return, generated from
net income of the proposed capital investment. The ARR is a percentage return.
Say, if ARR = 7%, then it means that the project is expected to earn seven
cents out of each dollar invested. If the ARR is equal to or greater than the
required rate of return, the project is acceptable. If it is less than the
desired rate, it should be rejected. When comparing investments, the higher the
ARR, the more attractive the investment. Over one-half of large firms calculate
ARR when appraising projects. It is calculated with the help of the following
formula:
ARR=Average Profit / Investment
Merits of ARR
a) It is
simple, common sense oriented method.
b) Profits of
all years taken into account.
c) It
considers actual net profit of the project.
Demerits
of ARR
a) Time value
of-money is not considered
b) Risk
involved in the project is not considered
c) Annual
average profits might be same for different projects but accrual of profits
might differ having significant implications on risk and liquidity
d) The ARR
has several variants and that it lacks uniform understanding.
Or
(b) (i)
X Ltd. issues Rs. 50,000, 8% debentures at par. The tax rate applicable to the
company is 50%.
(ii) Y Ltd. issues Rs.
50,000, 8% debentures at a premium of 10%. The tax rate applicable to the
company is 60%. Compute the cost of debt capital.
(iii) A Ltd. issues Rs.
50,000, 8% debentures at a discount of 5%. The tax rate is 50%. Compute the
cost of debt capital.
(iv) B Ltd. issues Rs.
1,00,000, 9% debentures at a premium of 10%. The costs of floatation are 2%.
The tax rate applicable is 60%. Compute the cost of debt capital. 3
½ x4=14
SOLUTIONS:
LINK OF ALL PRACTICAL PROBLEMS VIDEOS
6.
(a) There is strong view prevalent among financial experts that the irrelevant
hypothesis underlying the MM theory of dividend distribution is out-dated and
unsuited to present conditions. Do you agree with this view? Discuss. 14
Ans: Modigliani and Miller approach (M & M Hypothesis)
The residuals theory of
dividends tends to imply that the dividends are irrelevant and the value of the
firm is independent of its dividend policy. The irrelevance of dividend policy
for a valuation of the firm has been most comprehensively presented by Modigliani
and Miller. They have argued that the market price of a share is affected by
the earnings of the firm and not influenced by the pattern of income
distribution. What matters, on the other hand, is the investment decisions
which determine the earnings of the firm and thus affect the value of the firm.
They argue that subject to a number of assumptions, the way a firm splits its
earnings between dividends and retained earnings has no effect on the value of
the firm.
Like several financial theories, M&M
hypothesis is based on the argument of efficient capital markets. In addition,
there are two options:
(a) It retains earnings and finances its new
investment plans with such retained earnings;
(b) It distributes dividends, and finances its
new investment plans by issuing new shares.
The intuitive background of the M&M
approach is extremely simple, and in fact, almost self explanatory. It is based
on the following assumptions:
a) The capital markets are perfect and the
investors behave rationally.
b) All information is freely available to all the
investors.
c) There is no transaction cost.
d) Securities are divisible and can be split into
any fraction. No investor can affect the market price.
e) There are no taxes and no flotation cost.
f) The firm has a defined investment policy and
the future profits are known with certainty. The implication is that the
investment decisions are unaffected by the dividend decision and the operating
cash flows are same no matter which dividend policy is adopted.
Their conclusion is that, the shareholders get
the same benefit from dividend as from capital gain through retained earnings.
So, the division of earnings into dividend and retained earnings does not
influence shareholders' perceptions. So whether dividend is declared or not,
and whether high or low payout ratio is follows, it makes no difference on the
value of the share. In order to satisfy their model, MM has started with the
following valuation model.
P0= 1* (D1+P1)/
(1+ke)
Where,
P0 = Present
market price of the share
Ke = Cost of
equity share capital
D1 = Expected
dividend at the end of year 1
P1 = Expected
market price of the share at the end of year 1
With the help of
this valuation model we will create a arbitrage process, i.e., replacement of
amount paid as dividend by the issue of fresh capital. The arbitrage process
involves two simultaneous actions. With reference to dividend policy the two
actions are:
a) Payment of dividend by the firm
b) Rising of fresh capital.
With the help of
arbitrage process, MM have shown that the dividend payment will not have any
effect on the value of the firm. Even if the firm pays dividends, resulting in
a increase in market value of the share, the effect on the value of the firm
will be neutralised by the decrease in terminal value of the share.
Criticisms on MM Dividend theory: MM theory is criticized on
the invalidity of most of its assumptions. Some of the criticisms are presented
below:
a) First,
perfect capital market is not a reality.
b) Second,
transaction and floatation costs do exist.
c) Third,
Dividend has a signaling effect. Dividend decision signals financial standing
of the business, earnings position of the business, and so on. All these are
taken as uncertainty reducers and that these influence share value. So, the
stand of MM is not tenable.
d) Fourth,
MM assumed that additional shares are issued at the prevailing market price. It
is not so. Fresh issues - whether rights or otherwise, are made at prices below
the ruling market price.
e) Fifth,
taxation of dividend income is not the same as that of capital gain. Dividend
income upto Rs. 10000 is fully exempt, whereas capital gain attracts a flat 20%
tax in the case of individual assesses. So, investor preferences between
dividend and capital gain differ.
f) Sixth,
investment decisions are not always rational. Some, sub-marginal projects may
be taken up by firms if internally generated funds are available in plenty.
This would deflate ROI sooner than later reducing share price.
g) Seventh,
investment decisions are tied up with financing decisions. Availability of
funds and external constrains might affect investment decisions and rationing
of capital, then becomes a relevant issue as it affects the availability of
funds.
Or
(b)
(i) What is ‘dividend’? Discuss the various forms of dividend. 2+5=7
Ans: Meaning of Dividend: Meaning of
Dividend: A dividend is that portion of profits and surplus funds of a company
which has actually set aside by a valid act of the company for distribution
among its shareholders.
According to ICAI, “Dividend is the distribution
to the shareholders of a company from the reserves and profits.”
In the words of S.M. Shah, “Dividend is a part
of divisible profits of a business company which is distributed to the
shareholders.”
Dividend may be divided into following
categories:
a) Cash
Dividend.
b) Stock
Dividend or Bonus Dividend.
c) Bond
Dividend.
d) Property
Dividend.
e) Composite
Dividend.
f) Interim
Dividend.
g) Script
Dividend
h) Liquidating
Dividend.
Some of these are explained below:
CASH DIVIDEND: A Cash dividend is the most
common form of the dividend. The shareholders are paid in cash per share. The
board of directors announces the dividend payment on the date of declaration.
The dividends are assigned to the shareholders on the date of record. The
dividends are issued on the date of payment. But for distributing cash
dividend, the company needs to have positive retained earnings and enough cash
for the payment of dividends.
BONUS SHARE: Bonus share is also called as the
stock dividend. Bonus shares are issued by the
company when they have low operating cash, but still want to keep the investors
happy. Each equity shareholder receives a certain number of additional shares
depending on the number of shares originally owned by the shareholder. For
example, if a person possesses 10 shares of Company A, and the company declares
bonus share issue of 1 for every 2 shares, the person will get 5 additional
shares in his account. From company’s angle, the no. of shares and issued
capital in the company will increase by 50% (1/2 shares). The market price, EPS,
DPS etc will be adjusted accordingly.
INTERIM DIVIDEND: This dividend is issued
between two accounting year on the basis of expected profit. This dividend is
declared before the preparation of final accounts.
PROPERTY DIVIDEND: The
company makes the payment in the form of assets in the property dividend. The
asset could be any of this equipment, inventory, vehicle or
any other asset. The value of the asset has to be restated at the fair value
while issuing a property dividend.
SCRIP DIVIDEND: Scrip dividend is a promissory note
to pay the shareholders later. This type of dividend is used when the company
does not have sufficient funds for the issuance of dividends.
LIQUIDATING DIVIDEND: When the
company returns the original capital contributed by the equity shareholders as
a dividend, it is termed as liquidating dividend. It is often seen as a sign of
closing down the company.
(ii)
What do you understand by a stable dividend policy? Why should it be followed? 4+3=7
Ans: Stable
Dividend Policy: Stability of dividends means regularity in
payment of dividends. It refers to the consistency in stream of dividends. In
short, we can say that a stable dividend policy is a long term policy which is
not affected by the variations in the earnings during different periods. The
stability of dividends can take any one of the three forms:
a)
Constant D/P ratio.
b)
Constant dividends per share.
c)
Constant dividend per share plus extra
dividends.
a) Constant
D/P Ratio: The ratio of dividends to earnings is known as payout ratio. With
this policy the amount of dividends varies directly with the earnings.
b) Constant
Dividend Per share: According to this form, a company follows as policy of
paying a constant dividend irrespective of its level of earnings.
c) Stable
Dividend plus Extra Dividends: Under this policy a firm usually pays a small
fixed dividend to the shareholders and in years of prosperity additional
dividend is paid over and above the fixed dividend.
Merits of Stable Dividend Policy: Following
are some of the advantages of a stable dividend policy:
a) This
policy contributes to stablise market value of company’s equity shares at a
high level.
b) This
policy helps the company is mobilizing additional funds in the form of
additional equity shares.
c) Regular
earnings in the form of dividend satisfy investors.
d) This
policy encourages shareholders to hold company’s share for longer time and
simultaneously other investors are also attracted for the purchase of shares.
e) This
policy is helpful for expansion and growth prospects of a company.
f) This
policy encourages the institutional investors because they like to invest in
those companies which make uninterrupted payment of dividends.
(OLD COURSE)
Full
Marks: 80
Pass
Marks: 32
Time:
3 hours
1. (a) Write ‘True’ or ‘False’: 1x4=4
a) The
main aim of finance function is to maximize the profits. False
b) Capital
budgeting is the process of making investment decisions in capital
expenditures. True
c) Ownership
securities are represented by debentures. False,
Shares
d) New
issue market represents the primary market. True
(b)
Fill in the blanks: 1x4=4
a)
Financial decisions involve investment,
financing and dividend
decisions.
b)
Combined Leverage = Operating Leverage x financial Leverage.
c)
The value of the firm can be maximized, if the
shareholders’ wealth is
maximized.
d)
Adequacy of working
capital is a must for maintaining solvency and continuing production.
2. Write short notes on any four of the
following: 4x4=16
a) Profit
maximization.
Ans: Profit maximization: Profit maximization implies
that either a firm produces maximum output for a given input or uses minimum
input for a given level of output. Profit maximization causes the efficient
allocation of resources in competitive market condition and profit is
considered as the most important measure of firm performance. The underlying
logic of profit maximization is efficiency.
In a market economy, prices
are driven by competitive forces and firms are expected to produce goods and
services desired by society as efficiently as possible. Demand for goods and
services leads price. Goods and services which are in great demand can command
higher prices. This leads to higher profits for the firm. This in turn attracts
other firms to produce such goods and services. Competition grows and
intensifies leading to a match in demand and supply. Thus, an equilibrium price
is reached. On the other hand, goods and services not in demand fetches low
price which forces producers to stop producing such goods and services and go
for goods and services in demand. This shows that the price system directs the
managerial effort towards more profitable goods and services. Competitive
forces direct price movement and guides the allocation of resources for various
productive activities.
b) Optimal
capital structure.
Ans: The capital structure is said to be optimum, when the company has
selected such a combination of equity and debt, so that the company's wealth is
maximum. At this, capital structure, the cost of capital is minimum and market
price per share is maximum. But, it is difficult to measure a fall in the
market value of an equity share on account of increase in risk due to high debt
content in the capital structure. In reality, however, instead of optimum, an
appropriate capital structure is more realistic.
Features of an appropriate capital structure
are as below:
1) Profitability:
The most profitable capital structure is one that tends to minimise financing
cost and maximise of earnings per equity share.
2) Flexibility:
The capitals structure should be such that the company is able to raise funds
whenever needed.
3) Conservation:
Debt content in capital structure should not exceed the limit which the company
can bear.
4) Solvency:
Capital structure should be such that the business does not run the risk of
insolvency.
5) Control:
Capital structure should be devised in such a manner that it involves minimum
risk of loss of control over the company.
c) Capital market
instruments.
d)
Retained earnings.
Ans: Retained earnings are an internal sources of finance for any
company. Actually is not a method of raising finance, but it is called as
accumulation of profits by a company for its expansion and diversification
activities. Retained earnings are called under different names such as self finance,
inter finance, and plugging back of profits. As prescribed by the central government, a
part (not exceeding 10%) of the net profits after tax of a financial year have
to be compulsorily transferred to reserve by a company before declaring dividends
for the year.
Under the retained earnings sources of
finance, a reasonable part of the total profits is transferred to various
reserves such as general reserve, replacement fund, reserve for repairs and renewals,
reserve funds and secrete reserves, etc.
Retained earnings or profits are ploughed
back for the following purposes.
1) Purchasing
new assets required for betterment, development and expansion of the company.
2) Replacing
the old assets which have become obsolete.
3) Meeting
the working capital needs of the company.
4) Repayment
of the old debts of the company.
e) Receivable management.
3. (a)
What is financial management? Discuss the objectives of financial management. 4+8=12
Ans: Meaning and Definitions of Financial
Management/Business Finance/ Finance Functions
Financial management is management principles and
practices applied to finance. General management functions include planning,
execution and control. Financial decision making includes decisions as to size
of investment, sources of capital, extent of use of different sources of
capital and extent of retention of profit or dividend payout ratio. Financial
management, is therefore, planning, execution and control of investment of
money resources, raising of such resources and retention of profit/payment of
dividend.
Howard and Upton define financial management as
"that administrative area or set of administrative functions in an
organisation which have to do with the management of the flow of cash so that
the organisation will have the means to carry out its objectives as
satisfactorily as possible and at the same time meets its obligations as they
become due.”
According to Guthamann and Dougall,” Business finance
can be broadly defined as the activity concerned with the planning, raising,
controlling and administering the funds used in the business.”
Bonneville and Dewey interpret that financing consists
in the raising, providing and managing all the money, capital or funds of any
kind to be used in connection with the business.
Osbon defines financial management as the
"process of acquiring and utilizing funds by a business”.
Considering all these views, financial management may
be defined as that part of management which is concerned mainly with raising
funds in the most economic and suitable manner, using these funds as profitably
as possible.
Objectives of Financial
Management
The firm’s investment and
financing decision are unavoidable and continuous. In order to make them
rational, the firm must have a goal. Two financial objectives predominate amongst
many objectives. These are:
1. Profit maximization
2. Shareholders’ Wealth
Maximization (SWM)
Profit maximization refers to
the rupee income while wealth maximization refers to the maximization of the
market value of the firm’s shares. Although profit maximization has been
traditionally considered as the main objective of the firm, it has faced
criticism. Wealth maximization is regarded as operationally and managerially
the better objective.
1. Profit maximization:
Profit maximization implies that either a firm produces maximum output for a
given input or uses minimum input for a given level of output. Profit
maximization causes the efficient allocation of resources in competitive market
condition and profit is considered as the most important measure of firm
performance. The underlying logic of profit maximization is efficiency.
In a market economy, prices
are driven by competitive forces and firms are expected to produce goods and
services desired by society as efficiently as possible. Demand for goods and
services leads price. Goods and services which are in great demand can command
higher prices. This leads to higher profits for the firm. This in turn attracts
other firms to produce such goods and services. Competition grows and
intensifies leading to a match in demand and supply. Thus, an equilibrium price
is reached. On the other hand, goods and services not in demand fetches low
price which forces producers to stop producing such goods and services and go
for goods and services in demand. This shows that the price system directs the
managerial effort towards more profitable goods and services. Competitive
forces direct price movement and guides the allocation of resources for various
productive activities.
2. Shareholders’ Wealth
Maximization: Shareholders’ wealth maximization means maximizing the net
present value of a course of action to shareholders. Net Present Value (NPV) of
a course of action is the difference between the present value of its benefits
and the present value of its costs. A financial action that has a positive NPV
creates wealth for shareholders and therefore, is desirable. A financial action
resulting in negative NPV destroys shareholders’ wealth and is, therefore
undesirable. Between mutually exclusive projects, the one with the highest NPV
should be adopted. NPVs of a firm’s projects are additive in nature. That is
NPV(A) + NPV(B) = NPV(A+B)
The objective of Shareholders
Wealth Maximization (SWM) considers timing and risk of expected benefits.
Benefits are measured in terms of cash flows. One should understand that in
investment and financing decisions, it is the flow of cash that is important,
not the accounting profits. SWM as an objective of financial management is
appropriate and operationally feasible criterion to choose among the
alternative financial actions.
Maximizing the shareholders’
economic welfare is equivalent to maximizing the utility of their consumption
over time. The wealth created by a company through its actions is reflected in
the market value of the company’s shares. Therefore, this principle implies
that the fundamental objective of a firm is to maximize the market value of its
shares. The market price, which represents the value of a company’s shares,
reflects shareholders’ perception about the quality of the company’s financial
decisions. Thus, the market price serves as the company’s performance
indicator.
In such a case, the financial
manager must know or at least assume the factors that influence the market
price of shares. Innumerable factors influence the price of a share and these
factors change frequently. Moreover, the factors vary across companies. Thus,
it is challenging for the manager to determine these factors.
Or
(b) Discuss the profit
maximization and wealth maximization concept of financial management. 6+6=12
Ans: Objectives of Financial
Management
The firm’s investment and
financing decision are unavoidable and continuous. In order to make them
rational, the firm must have a goal. Two financial objectives predominate
amongst many objectives. These are:
1. Profit maximization
2. Shareholders’ Wealth
Maximization (SWM)
Profit maximization refers to
the rupee income while wealth maximization refers to the maximization of the
market value of the firm’s shares. Although profit maximization has been
traditionally considered as the main objective of the firm, it has faced
criticism. Wealth maximization is regarded as operationally and managerially
the better objective.
1. Profit maximization:
Profit maximization implies that either a firm produces maximum output for a
given input or uses minimum input for a given level of output. Profit
maximization causes the efficient allocation of resources in competitive market
condition and profit is considered as the most important measure of firm
performance. The underlying logic of profit maximization is efficiency.
In a market economy, prices
are driven by competitive forces and firms are expected to produce goods and
services desired by society as efficiently as possible. Demand for goods and
services leads price. Goods and services which are in great demand can command
higher prices. This leads to higher profits for the firm. This in turn attracts
other firms to produce such goods and services. Competition grows and
intensifies leading to a match in demand and supply. Thus, an equilibrium price
is reached. On the other hand, goods and services not in demand fetches low
price which forces producers to stop producing such goods and services and go
for goods and services in demand. This shows that the price system directs the
managerial effort towards more profitable goods and services. Competitive
forces direct price movement and guides the allocation of resources for various
productive activities.
Objections to Profit Maximization:
Certain objections have been raised against
the goal of profit maximization which strengthens the case for wealth
maximization as the goal of business enterprise. The objections are:
(a) Profit cannot be ascertained well in
advance to express the probability of return as future is uncertain. It is not
at all possible to maximize what cannot be known. Moreover, the return profit
vague and has not been explained clearly what it means. It may be total profit
before tax and after tax of profitability tax. Profitability rate, again is
ambiguous as it may be in relation to capital employed, share capital, owner’s
fund or sales. This vagueness is not present in wealth maximisation goal as the
concept of wealth is very clear. It represents value of benefits minus the cost
of investment.
(b) The executive or the decision maker may
not have enough confidence in the estimates or future returns so that he does
not attempt further to maximize. It is argued that firm’s goal cannot be to
maximize profits but to attain a certain level or rate of profit holding
certain share of the market or certain level of sales. Firms should try to
‘satisfy’ rather than to ‘maximise’.
(c)There must be a balance between expected return
and risk. The possibility of higher expected yields are associated with greater
risk to recognize such a balance and wealth maximisation is brought in to the
analysis. In such cases, higher capitalization rate involves. Such combination
of expected returns with risk variations and related capitalization rate cannot
be considered in the concept of profit maximisation.
(d) The goal of maximisation of profits is
considered to be a narrow outlook. Evidently when profit maximisation becomes
the basis of financial decision of the concern, it ignores the interests of the
community on the one hand and that of the government, workers and other
concerned persons in the enterprise on the other hand.
(e) The criterion of profit maximisation
ignores time value factor. It considers the total benefits or profits in to
account while considering a project where as the length of time in earning that
profit is not considered at all. Whereas the wealth maximization concept fully
endorses the time value factor in evaluating cash flows. Keeping the above
objection in view, most of the thinkers on the subject have come to the
conclusion that the aim of an enterprise should be wealth maximisation and not
the profit maximisation.
(f) To make a distinction between profits and
profitability. Maximisation of profits with a view to maximizing the wealth of
share holders is clearly an unreal motive. On the other hand, profitability
maximisation with a view to using resources to yield economic values higher
than the joint values of inputs required is a useful goal. Thus, the proper
goal of financial management is wealth maximisation.
2. Shareholders’ Wealth
Maximization: Shareholders’ wealth maximization means maximizing the net
present value of a course of action to shareholders. Net Present Value (NPV) of
a course of action is the difference between the present value of its benefits
and the present value of its costs. A financial action that has a positive NPV
creates wealth for shareholders and therefore, is desirable. A financial action
resulting in negative NPV destroys shareholders’ wealth and is, therefore
undesirable. Between mutually exclusive projects, the one with the highest NPV
should be adopted. NPVs of a firm’s projects are additive in nature. That is
NPV(A) + NPV(B) = NPV(A+B)
The objective of Shareholders
Wealth Maximization (SWM) considers timing and risk of expected benefits.
Benefits are measured in terms of cash flows. One should understand that in
investment and financing decisions, it is the flow of cash that is important,
not the accounting profits. SWM as an objective of financial management is
appropriate and operationally feasible criterion to choose among the
alternative financial actions.
Maximizing the shareholders’
economic welfare is equivalent to maximizing the utility of their consumption
over time. The wealth created by a company through its actions is reflected in
the market value of the company’s shares. Therefore, this principle implies
that the fundamental objective of a firm is to maximize the market value of its
shares. The market price, which represents the value of a company’s shares,
reflects shareholders’ perception about the quality of the company’s financial
decisions. Thus, the market price serves as the company’s performance
indicator.
In such a case, the financial
manager must know or at least assume the factors that influence the market
price of shares. Innumerable factors influence the price of a share and these
factors change frequently. Moreover, the factors vary across companies. Thus, it
is challenging for the manager to determine these factors.
WEALTH
MAXIMIZATION AS PRIMARY OBJECTIVE OF FINANCIAL MANAGEMENT
The primary objective of financial management
is wealth maximization. The concept of wealth in the context of wealth
maximization objective refers to the shareholders’ wealth as reflected by the
price of their shares in the share market. Therefore, wealth maximization means
maximization of the market price of the equity shares of the company. However,
this maximization of the price of company’s equity shares should be in the long
run by making efficient decisions which are desirable for the growth of a
company and are valued positively by the investors at large and not by
manipulating the share prices in the short run. The long run implies a period
which is long enough to reflect the normal market price of the shares
irrespective of short-term fluctuations. The long run price of an equity share
is a function of two basic factors:
a)
The likely rate of earnings or earnings per
share (EPS) of the company; and
b)
The capitalization rate reflecting the
liking of the investors of a company.
The financial manager must identify those
avenues of investment; modes of financing, ways of handling various components
of working capital which ultimately will lead to an increase in the price of
equity share. If shareholders are gaining, it implies that all other claimants
are also gaining because the equity share holders are paid only after the claims
of all other claimants (such as creditors, employees, lenders) have been duly
paid.
The
following arguments are advanced in favour of wealth maximization as the goal
of financial management:
a) It
serves the interests of owners, (shareholders) as well as other stakeholders in
the firm; i.e. suppliers of loaned capital, employees, creditors and society.
b) It
is consistent with the objective of owners’ economic welfare.
c) The
objective of wealth maximization implies long-run survival and growth of the
firm.
d) It
takes into consideration the risk factor and the time value of money as the
current present value of any particular course of action is measured.
e) The
effect of dividend policy on market price of shares is also considered as the
decisions are taken to increase the market value of the shares.
f) The
goal of wealth maximization leads towards maximizing stockholder’s utility or
value maximization of equity shareholders through increase in stock price per
share.
Criticism
of Wealth Maximization: The wealth maximization objective has been
criticized by certain financial theorists mainly on following accounts:
a) It
is prescriptive idea. The objective is not descriptive of what the firms
actually do.
b) The
objective of wealth maximization is not necessarily socially desirable.
c) There
is some controversy as to whether the objective is to maximize the stockholders
wealth or the wealth of the firm which includes other financial claimholders
such as debenture holders, preferred stockholders, etc.
d) The
objective of wealth maximization may also face difficulties when ownership and
management are separated as is the case in most of the large corporate form of
organization. When managers act as agents of the real owners (equity
shareholders), there is a possibility for a conflict of interest between
shareholders and the managerial interests. The managers may act in such a
manner which maximizes the managerial utility but not the wealth of
stockholders or the firm.
4. (a)
What is cost of capital? How are cost of debt and cost of equity capital
computed? Write in brief about weighted average cost of capital. 2+3+3+3=11
Ans: Meaning and Definition of Cost of
Capital
Cost of capital is the rate of return that a firm
must earn on its project investments to maintain its market value and attract
funds. Cost of capital is the required rate of return on its investments which
belongs to equity, debt and retained earnings. If a firm fails to earn return
at the expected rate, the market value of the shares will fall and it will
result in the reduction of overall wealth of the shareholders.
According to the definition of John J. Hampton
“ Cost of capital is the rate of return the firm required from investment in
order to increase the value of the firm in the market place”.
According to the definition of Solomon Ezra,
“Cost of capital is the minimum required rate of earnings or the cut-off rate
of capital expenditure”.
Cost of
Equity: Cost of equity capital is the rate at which investors discount the
expected dividends of the firm to determine its share value. Conceptually the cost of equity
capital (Ke) defined as the “Minimum rate of return that a firm must earn on the equity financed portion of an
investment project in order to leave
unchanged the market price of the shares”.
Cost of equity can be calculated from the following approach:
• Dividend price (D/P) approach
• Dividend price plus growth (D/P + g)
approach
• Earning price (E/P) approach
a) Dividend Price Approach: The cost of equity capital will be that rate of expected dividend
which will maintain the present
market price of equity shares. Dividend
price approach can be measured with the help of the following formula:
Ke = D/Np
Where,
Ke = Cost of equity capital
D = Dividend per equity share
Np = Net proceeds of an equity share
b) Dividend Price Plus Growth Approach: The cost of equity is calculated on
the basis of the expected dividend rate per share plus growth in dividend. It can be measured with the help of the following
formula:
Ke = D/Np + g
Where,
Ke = Cost of equity capital
D = Dividend per equity share
g = Growth in expected dividend
Np = Net proceeds of an equity share
c) Earning Price Approach: Cost of equity determines the market price of the shares. It is
based on the future earning prospects
of the equity. The formula for calculating the cost of equity according to this approach is as follows.
Ke = E/Np
Where,
Ke = Cost of equity capital
E = Earning per share
Np = Net proceeds of an equity share
Cost of Debt: Cost of debt is the after tax cost of long-term funds through
borrowing. Debt may be issued at
par, at premium or at discount and also it may be perpetual or redeemable.
Debt Issued at Par: Debt issued at par means, debt is issued at the face value of the
debt. It may be calculated with the
help of the following formula:
Kd = I/Np*(1 – t)
Where,
Kd = Cost of debt capital
I = Annual interest payable
Np = Net proceeds of debenture
t = Tax rate
Weighted average cost of capital (WACC) is the
average of the minimum after-tax required rate of return which a company must
earn for all of its security holders (i.e. common stock-holders, preferred
stock-holders and debt-holders). It is calculated by finding out cost of each
component of a company’s capital structure, multiplying it with the relevant
proportion of the component to total capital and then summing up the
proportionate cost of components. WACC is a very useful tool because it tells
whether a particular project is increasing shareholders’ wealth or just
compensating the cost.
Formula: For a company which has two sources
of finance, namely equity and debt, WACC is calculated using the following
formula: WACC = r(E) × w(E) + r(D) × (1 – t) × w(D)
Cost of equity: In the
formula for WACC, r(E) is the cost of equity i.e. the required rate of return
on common stock of the company. It is the minimum rate of return which a
company must earn to keep its common stock price from falling. Cost of equity
is estimated using different models, such as dividend discount model (DDM) and
capital asset pricing model (CAPM).
Weights: w(E) is the weight of equity in the company’s
total capital. It is calculated by dividing the market value of the company’s
equity by sum of the market values of equity and debt. w(D) is
the weight of debt component in the company’s capital structure. It is
calculated by dividing the market value of the company’s debt by sum of the
market values of equity and debt.
Or
(b) Following information is
taken from the records of a hypothetical company:
|
Installed capacity
Operating capacity
Selling price per unit
Variable cost per unit
|
1000 units
800 units
Rs. 10
Rs. 7
|
Calculate operating leverage from the
following situations:
|
Fixed
Cost
|
Rs.
|
|
Situation
A
Situation
B
Situation
C
|
800
1,200
1,500
|
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5. (a) Discuss in detail the sources of
long-term finance of a company form of business organization. 11
Or
(b)
What is ‘capital market’? What are the functions of a capital market?
Distinguish between capital market and money market. 2+5+4=11
6. (a)
Discuss the various types of dividend policies. State the various forms of
dividends on the basis of payments. 6+5=11
Ans: Ans: Every
company which is listed and is making profits has to take the decision
regarding the distribution of profits to its shareholders as they are the ones
who have invested their money into the company. This distribution of profits by
the company to its shareholders is called dividend in finance parlance, every
company has different objectives and methods and dividend is no different and
that is the reason why different companies follow different dividend policies,
let’s look at various types of dividend policies:
1) Regular
dividend policy: Under this type of dividend policy a company has the policy of
paying dividends to its shareholders every year. When the company makes
abnormal profits then the company will not pay that extra profits to its
shareholders completely rather it will distribute lower profit in the form of
the dividend to the shareholders and keep the excess profits with it and
suppose a company makes loss then also it will pay dividend to its shareholders
under regular dividend policy. This type of dividend policy is suitable for
those companies which have constant cash flows and have stable earnings.
Investors like retired person and conservative investors who prefer safe
investment and constant income will invest in constant dividend paying
companies.
2) Stable Dividend Policy: Stability
of dividends means regularity in payment of dividends. It refers to the
consistency in stream of dividends. In short, we can say that a stable dividend
policy is a long term policy which is not affected by the variations in the
earnings during different periods. The stability of dividends can take any one
of the three forms:
a) Constant
D/P ratio.
b) Constant
dividends per share.
c) Constant
dividend per share plus extra dividends.
Merits of
Stable Dividend Policy: Following are some of the advantages of a
stable dividend policy:
a) This
policy contributes to stablise market value of company’s equity shares at a
high level.
b) This policy
helps the company is mobilizing additional funds in the form of additional
equity shares.
c) Regular
earnings in the form of dividend satisfy investors.
d) This
policy encourages shareholders to hold company’s share for longer time and
simultaneously other investors are also attracted for the purchase of shares.
e) This
policy is helpful for expansion and growth prospects of a company.
f) This
policy encourages the institutional investors because they like to invest in
those companies which make uninterrupted payment of dividends.
Demerits
of Stable Dividend Policy: Following are some of the disadvantages of a
stable dividend policy:
a) Sometime
despite of large earnings, management decides not to declare dividends.
b) In this
policy, instead of paying dividend in cash, bonus share are issued to the
shareholders.
c) This
policy is used to capitalise reinvested earnings of the firm.
3) Irregular
dividend policy: Under this type of policy there is no mandate to give dividends
to shareholders of the company and top management gives it according to its own
free will, so suppose company has some abnormal profits then management may
decide to pass it fully to its shareholders by giving interim dividend or
management may decide to use it for future business expansion. Companies which
have irregular earnings, lack of liquidity and are afraid of committing itself
for paying regular dividends adopt irregular dividend policy.
4) No dividend
policy: Under this policy company pays no dividend to its shareholders, the
reason for following this type of policy is that company retains the profit and
invest in the growth of the business. Companies which have ample growth
opportunities follow this type of policy and shareholders who are looking for
growth invest in these types of companies because there is plenty of scope of
capital appreciation in these stocks and if the company is successful then
capital appreciation will outdo regular dividend income as far as shareholders
are concerned.
Meaning of Dividend: A dividend is that
portion of profits and surplus funds of a company which has actually set aside
by a valid act of the company for distribution among its shareholders.
According to ICAI, “Dividend is the
distribution to the shareholders of a company from the reserves and profits.”
In the words of S.M. Shah, “Dividend is a part
of divisible profits of a business company which is distributed to the
shareholders.”
Dividend may be divided into following
categories:
a) Cash
Dividend.
b) Stock
Dividend or Bonus Dividend.
c) Bond
Dividend.
d) Property
Dividend.
e) Composite
Dividend.
f) Interim
Dividend.
g) Script
Dividend
h) Liquidating
Dividend.
Some of these are explained below:
CASH DIVIDEND: A Cash dividend is the most
common form of the dividend. The shareholders are paid in cash per share. The
board of directors announces the dividend payment on the date of declaration.
The dividends are assigned to the shareholders on the date of record. The
dividends are issued on the date of payment. But for distributing cash dividend,
the company needs to have positive retained earnings and enough cash for the
payment of dividends.
BONUS SHARE: Bonus share is also called as the
stock dividend. Bonus shares are issued by the
company when they have low operating cash, but still want to keep the investors
happy. Each equity shareholder receives a certain number of additional shares
depending on the number of shares originally owned by the shareholder. For
example, if a person possesses 10 shares of Company A, and the company declares
bonus share issue of 1 for every 2 shares, the person will get 5 additional
shares in his account. From company’s angle, the no. of shares and issued
capital in the company will increase by 50% (1/2 shares). The market price,
EPS, DPS etc will be adjusted accordingly.
INTERIM DIVIDEND: This dividend is issued
between two accounting year on the basis of expected profit.
PROPERTY DIVIDEND: The
company makes the payment in the form of assets in the property dividend. The
asset could be any of this equipment, inventory, vehicle or
any other asset. The value of the asset has to be restated at the fair value
while issuing a property dividend.
SCRIP DIVIDEND: Scrip dividend is a promissory note
to pay the shareholders later. This type of dividend is used when the company
does not have sufficient funds for the issuance of dividends.
LIQUIDATING DIVIDEND: When the
company returns the original capital contributed by the equity shareholders as
a dividend, it is termed as liquidating dividend. It is often seen as a sign of
closing down the company.
Or
(b) There is a strong
view prevalent among financial experts that irrelevant hypothesis underlying
the M & M approach of dividend distribution is out-dated and unsuited to
present condition. Do you agree with this view? Discuss. 11
Ans: Modigliani and Miller approach (M & M Hypothesis)
The residuals theory of
dividends tends to imply that the dividends are irrelevant and the value of the
firm is independent of its dividend policy. The irrelevance of dividend policy
for a valuation of the firm has been most comprehensively presented by
Modigliani and Miller. They have argued that the market price of a share is
affected by the earnings of the firm and not influenced by the pattern of
income distribution. What matters, on the other hand, is the investment
decisions which determine the earnings of the firm and thus affect the value of
the firm. They argue that subject to a number of assumptions, the way a firm
splits its earnings between dividends and retained earnings has no effect on
the value of the firm.
Like several financial theories, M&M
hypothesis is based on the argument of efficient capital markets. In addition,
there are two options:
(a) It retains earnings and finances its new
investment plans with such retained earnings;
(b) It distributes dividends, and finances its
new investment plans by issuing new shares.
The intuitive background of the M&M
approach is extremely simple, and in fact, almost self explanatory. It is based
on the following assumptions:
a) The capital markets are perfect and the
investors behave rationally.
b) All information is freely available to all the
investors.
c) There is no transaction cost.
d) Securities are divisible and can be split into
any fraction. No investor can affect the market price.
e) There are no taxes and no flotation cost.
f) The firm has a defined investment policy and
the future profits are known with certainty. The implication is that the
investment decisions are unaffected by the dividend decision and the operating
cash flows are same no matter which dividend policy is adopted.
Their conclusion is that, the shareholders get
the same benefit from dividend as from capital gain through retained earnings.
So, the division of earnings into dividend and retained earnings does not
influence shareholders' perceptions. So whether dividend is declared or not,
and whether high or low payout ratio is follows, it makes no difference on the
value of the share. In order to satisfy their model, MM has started with the
following valuation model.
P0= 1* (D1+P1)/
(1+ke)
Where,
P0 = Present
market price of the share
Ke = Cost of
equity share capital
D1 = Expected
dividend at the end of year 1
P1 = Expected
market price of the share at the end of year 1
With the help of
this valuation model we will create a arbitrage process, i.e., replacement of
amount paid as dividend by the issue of fresh capital. The arbitrage process
involves two simultaneous actions. With reference to dividend policy the two
actions are:
a) Payment of dividend by the firm
b) Rising of fresh capital.
With the help of
arbitrage process, MM have shown that the dividend payment will not have any
effect on the value of the firm. Even if the firm pays dividends, resulting in
a increase in market value of the share, the effect on the value of the firm
will be neutralised by the decrease in terminal value of the share.
Criticisms on MM Dividend theory: MM theory is criticized on
the invalidity of most of its assumptions. Some of the criticisms are presented
below:
a) First,
perfect capital market is not a reality.
b) Second,
transaction and floatation costs do exist.
c) Third,
Dividend has a signaling effect. Dividend decision signals financial standing
of the business, earnings position of the business, and so on. All these are
taken as uncertainty reducers and that these influence share value. So, the
stand of MM is not tenable.
d) Fourth,
MM assumed that additional shares are issued at the prevailing market price. It
is not so. Fresh issues - whether rights or otherwise, are made at prices below
the ruling market price.
e) Fifth,
taxation of dividend income is not the same as that of capital gain. Dividend
income upto Rs. 10000 is fully exempt, whereas capital gain attracts a flat 20%
tax in the case of individual assesses. So, investor preferences between
dividend and capital gain differ.
f) Sixth,
investment decisions are not always rational. Some, sub-marginal projects may
be taken up by firms if internally generated funds are available in plenty.
This would deflate ROI sooner than later reducing share price.
g) Seventh,
investment decisions are tied up with financing decisions. Availability of
funds and external constrains might affect investment decisions and rationing
of capital, then becomes a relevant issue as it affects the availability of
funds.
7. (a) What is meant by ‘inventory management’? Discuss
various techniques used for inventory control. 3+8=11
Or
(b) A pro forma cost sheet of a company provides the following
particulars:
|
Direct material
Direct labour
Overheads
|
40%
20%
20%
|
The
following further particulars are available:
a)
It is
proposed to maintain a level of activity of 200000 units.
b)
Selling
price is Rs. 12 per unit.
c)
Raw
materials are expected to remain in stores for an average period of one month.
d)
Finished
goods are required to be in stock for an average period of one month.
e)
Materials
will be in process for an average period of half month.
f)
Credit
allowed to debtors is two months.
g)
Credit
allowed by supplier is one month.
From
the above information, you are required to prepare a statement of working capital
requirements. 11
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