Dibrugarh University Financial Management Solved Question Papers
2014 (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)
The
cost of capital is minimum rate of return expected by its investors. True
b)
Financial
leverage is also known as composite leverage. False
c)
Leasing
benefits both the lessee as well as the lessor. True
(b) Choose the appropriate answer from
the given
alternatives: 1x2=2
(i)
The prime objective of an enterprise is
1)
maximization
of sales
2)
maximization
of owner’s equity
3)
maximization
of profit
(ii) Non-members can trade
in securities at stock exchanges with the help of
1)
jobbers
2)
brokers
3)
authorized
clerk
(c)
Fill in the blanks: 1x3=3
a)
Corporation
finance is a wider term than business
Finance finance.
b)
Degree
of financial leverage = Percentage
Change in EPS/Percentage
change in EBIT.
c)
The
volume of sales is influenced by fund
policy of a firm.
2. Write short notes
on (any four):
4x4=16
a) 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) Trading on Equity: Financial
leverage is also known as Trading on Equity. Trading
on Equity refers to the practice of using borrowed funds, carrying a fixed
charge, to obtain a higher return to the Equity Shareholders. With a larger
proportion of the debt in the financial structure, the earnings, available to
the owners would increase more than the proportionately with an increase in the
operating profits of the firm. This is
because the debt carries a fixed rate of return and if the firm is able to
earn, on the borrowed funds, a rate higher than the fixed charges on loans, the
benefit will go the shareholders. This is referred to as “Trading on Equity”
The concept of
trading on equity is the financial process of using debt to produce gain for
the residual owners or the equity shareholders. The term owes its name also to
the fact that the equity supplied by the owners, when the amount of borrowing
is relatively large in relation to capital stock, a company is said to be
trading on equity, but where borrowing is comparatively small in relation to
capital stock, the company is said to be trading on thick equity. Capital
gearing ration can be used to judge as to whether the company is trading on
thin or thick equity.
Degree of Financial Leverage: Degree of
financial leverage may be defined as the percentage change in taxable profit as
a result of percentage change in earning before interest and tax (EBIT). This
can be calculated by the following formula: DFL= Percentage change in
taxable Income / Precentage change in EBIT
c)
Dividend Payout Ratio: The dividend payout ratio measures the
percentage of net income that is distributed to shareholders in the form of
dividends during the year. In other words, this ratio shows the portion of
profits the company decides to keep to fund operations and the portion of
profits that is given to its shareholders. Investors are particularly
interested in the dividend payout ratio because they want to know if companies
are paying out a reasonable portion of net income to investors. The dividend
payout formula is calculated by dividing total dividend by the net income of
the company i.e. Dividend Payout Ratio =
Total Dividend/Net income
d) Sweat equity shares: Sweat equity
shares refers to equity shares given to the company’s employees on favourable
terms, in recognition of their work. It is one of the modes of making share
based payments to employees of the company. The issue of sweat equity allows
the company to retain the employees by rewarding them for their services. Sweat
equity rewards the beneficiaries by giving them incentives in lieu of their
contribution towards the development of the company. Further, it enables
greater employee stake and interest in the growth of an organization as it
encourages the employees to contribute more towards the company in which they
feel they have a stake.
e)
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.
3. (a) Define ‘finance function’. Explain its role in
a business firm. Discuss some of the crucial financial problems that a decision
maker faces today.
2+4+6=12
Ans: Finance
function is the most important of all business functions. It means a focus of
all activities. It is not possible to substitute or eliminate this function
because the business will close down in the absence of finance. The need for
money is continuous. It starts with the setting up of an enterprise and remains
at all times. The development and expansion of business rather needs more
commitment for funds. The funds will have to be raised from various sources.
The sources will be selected in relation to the implications attached with
them. The receiving of money is not enough, its utilization is more important.
The money once received will have to be returned also. It its use is proper
then its return will be easy otherwise it will create difficulties for
repayment. The management should have an idea of using the money profitably. It
may be easy to raise funds but it may be difficult to repay them. The inflows
and outflows of funds should be properly matched.
Significance of financial management in the present day
business world
The scope and significance of financial
management can be discussed from the following angles:
1)
Importance to Organizations
a) Business
organizations: Financial management is important to all types of business
organization i.e. Small size, medium size or a large size organization. As the
size grows, financial decisions become more and more complex as the amount
involves also is large.
b) Charitable
organization / Non-profit organization / Trust: In all those organizations,
finance is a crucial aspect to be managed. A finance manager has to concentrate
more on collection of donations/ revenues etc and has to ensure that every
rupee spent is justified and is towards achieving Goals of organization.
c) Government
/ Govt. or public sector undertaking: In central/ state Govt, finance is a key/
important portfolio generally given to most capable or competent person.
Preparation of budget, monitoring capital /revenue receipt and expenditure are
key functions to be performed by the person in charge of finance. Similarly, in
a Govt or public sector organization, financial controller or Chief finance
officer has to play a key role in performing/ taking all three financial
decisions i.e. raising of funds, investment of funds and distributing funds.
d) Other
organizations: In all other organizations or even in a family finance is a key
area to be looked in to seriously by a competent person so that things do not
go out of gear.
2)
Importance to all Stake holders
a) Share holders: Share holders are interested
in getting optimum dividend and maximizing their wealth which is basic
objective of financial management.
b) Investors / creditors: these stake holders
are interested in safety of their funds, timely repayment of the principal
amount as well as interest on the same. All these aspect are to be ensured by
the person managing funds/ finance.
c) Employees: They are interested in getting
timely payment of their salary/ wages, bonus, incentives and their retirement
benefits which are possible only if funds are managed properly and organization
is working in profit.
d) Customers: They are interested in quality
products at reasonable rates which is possible only through efficient
management of organization including management of funds.
e) Public: Public at large is interested in
general public welfare activities under corporate social responsibility and
this aspect is possible only when organization earns adequate profit.
f) Government: Govt is interested in timely
payment of taxes and other revenues from business world where again efficient
finance manager has a definite role to play.
g) Management: Management is interested in
overall image building, increase in the market share, optimizing share holders
wealth and profit and all these aspect greatly depends upon efficient
management of financial resources.
3)
Importance to other departments of an organization
A large size company, besides finance dept.,
has many departments like
a) Production
Dept
b) Marketing
Dept
c) Personnel
Dept
d) Material/
Inventory Dept
All these departments look for availability of
adequate funds so that they could manage their individual responsibilities in
an efficient manner. Lot of funds are required in production/manufacturing dept
for ongoing / completing the production process as well as maintaining adequate
stock to make available goods for the marketing dept for sale. Hence, finance
department through efficient management of funds has to ensure that adequate
funds are made available to all department and these departments at no stage
starve for want of funds. Hence, efficient financial management is of utmost
importance to all other department of the organization.
Major consideration by managers before taking
financial decisions:
While taking financing decisions the finance
manager keeps in mind the following factors:
1. Cost: The
cost of raising finance from various sources is different and finance managers
always prefer the source with minimum cost.
2. Risk: More
risk is associated with borrowed fund as compared to owner’s fund securities.
Finance manager compares the risk with the cost involved and prefers securities
with moderate risk factor.
3. Cash Flow
Position: The cash flow position of the company also helps in selecting
the securities. With smooth and steady cash flow companies can easily afford
borrowed fund securities but when companies have shortage of cash flow, then
they must go for owner’s fund securities only.
4. Control
Considerations: If existing shareholders want to retain the complete
control of business then they prefer borrowed fund securities to raise further
fund. On the other hand if they do not mind to lose the control then they may
go for owner’s fund securities.
5. Floatation
Cost: It refers to cost involved in issue of securities such as broker’s
commission, underwriters fees, expenses on prospectus, etc. Firm prefers
securities which involve least floatation cost.
6. Fixed
Operating Cost: If a company is having high fixed operating cost then
they must prefer owner’s fund because due to high fixed operational cost, the
company may not be able to pay interest on debt securities which can cause
serious troubles for company.
7. State of
Capital Market: The conditions in capital market also help in deciding
the type of securities to be raised. During boom period it is easy to sell
equity shares as people are ready to take risk whereas during depression period
there is more demand for debt securities in capital market.
Or
(b) “Finance function of a business is closely related to its other
functions.” Discuss. 12
Ans: Financial management is one of the important parts of overall
management, which is directly related with various functional departments like personnel,
marketing and production. Financial management covers wide area with multidimensional
approaches. The relationship between financial management and other functional
areas can be defined as follows:
1. Financial Management and Economics: Economic
concepts like micro and macroeconomics are directly applied with the financial
management approaches. Investment decisions, micro and macro environmental
factors are closely associated with the functions of financial manager. Financial
management also uses the economic equations like money value discount factor,
economic order quantity etc. Financial economics is one of the emerging area,
which provides immense opportunities to finance, and economical areas.
2. Financial Management and Accounting: Accounting
records includes the financial information of the business concern. Hence, we
can easily understand the relationship between the financial management and
accounting. In the olden periods, both financial management and accounting are
treated as a same discipline and then it has been merged as Management Accounting
because this part is very much helpful to finance manager to take decisions.
But now a day’s financial management and accounting discipline are separate and
interrelated.
3. Financial Management or Mathematics: Modern
approaches of the financial management applied large number of mathematical and
statistical tools and techniques. They are also called as econometrics.
Economic order quantity, discount factor, time value of money, present value of
money, cost of capital, capital structure theories, dividend theories, ratio
analysis and working capital analysis are used as mathematical and statistical tools
and techniques in the field of financial management.
4. Financial Management and Production Management:
Production management is the operational part of the business concern, which helps
to multiple the money into profit. Profit of the concern depends upon the production
performance. Production performance needs finance, because production department
requires raw material, machinery, wages, operating expenses etc. These
expenditures are decided and estimated by the financial department and the
finance manager allocates the appropriate finance to production department. The
financial manager must be aware of the operational process and finance required
for each process of production activities.
5. Financial Management and Marketing: Produced
goods are sold in the market with innovative and modern approaches. For this,
the marketing department needs finance to meet their requirements. The
financial manager or finance department is responsible to allocate the adequate
finance to the marketing department. Hence, marketing and financial management are
interrelated and depends on each other.
6. Financial Management and Human Resource: Financial
management is also related with human resource department, which provides
manpower to all the functional areas of the management. Financial manager
should carefully evaluate the requirement of manpower to each department and
allocate the finance to the human resource department as wages, salary,
remuneration, commission, bonus, pension and other monetary benefits to the
human resource department. Hence, financial management is directly related with
human resource management.
4. (a) A company is considering an
investment proposal to purchase a machine costing Rs. 2,50,000. The machine has
a life expectancy of 5 years and no salvage value. The company’s tax rate is
40%. The firm uses straight-line method for providing depreciation. The
estimated cash flows before tax after depreciation (CFBT) from the machine are
as follows.
|
Year
|
CFBT Rs.
|
|
1
|
60,000
|
|
2
|
70,000
|
|
3
|
90,000
|
|
4
|
1,00,000
|
|
5
|
1,50,000
|
Calculate:
a) payback period;
b) average rate of return;
c) net present value at
10% discount rate.
3+4+4=11
You
may use the following table:
|
Year
|
1
|
2
|
3
|
4
|
5
|
|
PV
Factor at 10%
|
0.909
|
0.826
|
0.751
|
0.683
|
0.621
|
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Or
(b) What is ‘financial leverage’?
How does it magnify the revenue available for equity shareholders? Discuss the
relationships between financial leverage and debt financing. 2+41/2+41/2=11
Ans: Financial
Leverage: Leverage activities with financing activities is called financial
leverage. Financial leverage represents the relationship between the company’s
earnings before interest and taxes (EBIT) or operating profit and the earning
available to equity shareholders. Financial leverage is defined as “the ability
of a firm to use fixed financial charges to magnify the effects of changes in
EBIT on the earnings per share”. It involves the use of funds obtained at a fixed
cost in the hope of increasing the return to the shareholders. Financial
leverage can be calculated with the help of the following formula:
FL = OP/PBT
Where,
FL = Financial leverage
OP = Operating profit (EBIT)
PBT = Profit before tax.
Impact of Financial leverage on
profitability:
a) Financial
leverage helps to examine the relationship between EBIT and EPS.
b) Financial
leverage measures the percentage of change in taxable income to the percentage
change in EBIT.
c) Financial
leverage locates the correct profitable financial decision regarding capital
structure of the company.
d) Financial
leverage is one of the important devices which is used to measure the fixed
cost proportion with the total capital of the company.
e) If the
firm acquires fixed cost funds at a higher cost, then the earnings from those
assets, the earning per share and return on equity capital will decrease.
Relationship between financial
leverage and debt financing:
Financial leverage is also known as
Trading on Equity. Trading on Equity
refers to the practice of using borrowed funds, carrying a fixed charge, to
obtain a higher return to the Equity Shareholders. With a larger proportion of
the debt in the financial structure, the earnings, available to the owners
would increase more than the proportionately with an increase in the operating
profits of the firm. This is because the
debt carries a fixed rate of return and if the firm is able to earn, on the
borrowed funds, a rate higher than the fixed charges on loans, the benefit will
go the shareholders. This is referred to as “Trading on Equity”
The concept of
trading on equity is the financial process of using debt to produce gain for
the residual owners or the equity shareholders. The term owes its name also to
the fact that the equity supplied by the owners, when the amount of borrowing
is relatively large in relation to capital stock, a company is said to be
trading on equity, but where borrowing is comparatively small in relation to
capital stock, the company is said to be trading on thick equity. Capital
gearing ration can be used to judge as to whether the company is trading on
thin or thick equity.
Degree of Financial Leverage: Degree of
financial leverage may be defined as the percentage change in taxable profit as
a result of percentage change in earning before interest and tax (EBIT). This
can be calculated by the following formula: DFL= Percentage change in
taxable Income / Precentage change in EBIT
5. (a) What are the
main sources of finance available to industries for meeting long-term financial
requirements? Discuss. 11
Or
(b) Comment on accounting policies and
disclosures in relation to finance leases and operating leases prescribed in
AS-19.
11
6.
(a) Explain the various factors which influence the dividend decision of a
firm. 11
Ans: Factors Influencing Dividend Decision: There are various factors which affect
dividend decision. These are enumerated below with brief explanation.
a) Legal
position: Section 205 of the Companies Act, 1956 which lays down the sources
from which dividend can be paid, provides for payment of dividend (i) out of
past profits and (ii) out of moneys provided by the Central/State Government,
apart from current profits. Thus, by law itself, a company may be allowed to
declare a dividend even in a year when the profits are inadequate or when there
is absence of profit.
b) Magnitude
and Trend in EPS: EPS is the basis for dividend. The size of the EPS and the
trend in EPS in recent years set how much can be paid as dividend a high and
steadily increasing EPS enables a high and steadily increasing DPS. When EPS
fluctuates a different dividend policy has to be adopted.
c) Taxability:
According to Section 205(3) of the Companies Act, 1956 'no dividend shall be
payable except in cash'. However, the Income-Tax Act defines the term dividend
so as to include any distribution of property or rights having monetary value.
Therefore liberal dividend policy becomes unattractive from the point of view
of the shareholders/investors in high income brackets. Thus a company which
considers the taxability of its shareholders, may not declare liberal dividend
though there may be huge profit, but may alternatively go for issuing bonus
shares later.
d) Liquidity
and Working Capital Position: Apparently, distribution of dividend results in
outflow of cash and as such a reduction in working capital position. Even in a
year when a company has earned adequate profit to warrant a dividend
declaration, it may confront with a week liquidity position. Under the
circumstance, while one company may prefer not to pay dividend since the
payment may impair liquidity, another company following a stable dividend
policy, may wish to declare dividends even by resorting to borrowings for
dividend payment in cash.
e) Impact on
share price: The impact of dividends on market price of shares, though cannot
be precisely measured, still one could consider the influence of dividend on
the market price of shares. The dividend policy pursued by a company naturally
depends on how far the management is concerned about the market price of
shares. Generally, an increase in dividend payout results in a hike in the
market price of shares. This is significant as it has a bearing on new issues.
f) Control
consideration: Where the directors wish to retain control, they may desire to
finance growth programmes by retained earnings, since issue of fresh equity
shares for financing growth plan may lead to dilution of control of the
dominating group. So, low dividend payout is favoured by Board.
g) Type of
Shareholders: When the shareholders of the company prefer current dividend
rather man capital gain a high payment is desirable. This happens so, when the
shareholders are in low tax brackets, they are less moneyed and require
periodical income or they have better investment avenues than the company.
Retired persons, economically weaker sections and similarly placed investors
prefer current income i.e. dividend. If, on the other hand, majority of the
shareholders are moneyed people, and want capital gain, then low payout ratio
is desirable. This is known as clientele effect on dividend decision.
h) Industry Norms:
The industry norms have to be adhered to the extent possible. It most firms in
me industry adopt a high payout policy, perhaps others also have to adopt such
a policy.
i)
Age of the company: Newly formed companies
adopt a conservative dividend policy so that they can get stabilized and think
of growth and expansion.
j)
Investment opportunities for the company: If
the company has better investment opportunities, and it is difficult to raise
fresh capital quickly and at cheap costs, it is better to adopt a conservative
dividend policy. By better investment opportunities we mean those with higher
'r' relative to the 'k'. So, if r>k, low payout is good. And vice versa.
k) Restrictive
covenants imposed by debt financiers: Debt financiers, especially term lending
financial institutions, may impose restrictive conditions on the rate, timing
and form of dividends declared. So, that consideration is also significant.
l)
Floatation cost, cost of fresh equity and
access capital market: When floatation costs and cost of fresh equity are high
and capital market conditions are not congenial for a fresh issue, a low payout
ratio is adopted.
m) Financial
signaling: Dividends are the best medium to tell shareholder of better days
ahead of the company. When a company enhances the target dividend rate, it
overwhelmingly signals the shareholders that their company is on stable growth
path. Share prices immediately react positively.
Or
(b) What do you mean by ploughing
back of profit? What are the purposes of ploughing back? Discuss the different
factors that influence the ploughing back of
profits. 2+4+5=11
Ans: Retained Earnings or Ploughing Back of Profit
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.
a) Purchasing
new assets required for betterment, development and expansion of the company.
b) Replacing
the old assets which have become obsolete.
c) Meeting
the working capital needs of the company.
d) Repayment
of the old debts of the company.
Determinants or Factors of Ploughing Back of Profits or Retained
Earnings
(a) Total
Earnings of the Enterprise: The question of saving can arise only when there
are sufficient profits. So larger the earnings larger the savings, it is a
common principle of financial management.
(b) Taxation
Policy of the Government: The report submitted by Taxation Enquiry Commission
has brought into light that taxation policy of the Government tells upon it the
taxes are levied at high rates. Hence, it is also an important determinant of
corporate savings.
(c) Dividend Policy:
It is policy adapted by the top management (board of directors) in regards to
distribution of profits. A conservative dividend policy is essential for having
good accumulation of corporate savings. But, dividend policy is highly
influenced by the income expectation of shareholders and by general environment
prevailing in the country.
(d) Government
Attitudes and Control: Govt. is not only a silent spectator but a regulatory
body of economic system of the country. Its policies, control order and
regulatory instructions-all compel the organizations to work in that very
direction for example compulsory Deposit Scheme which had been in force.
(e) Other
Factors : Other factors affecting the retained earnings are:
(a) Tradition
of industry.
(b) General
economic and social environment prevailing in the country.
(c) Managerial
attitudes and philosophy, etc.
7.
(a) What do you understand by receivable management? Discuss the factors which
influence the size of receivables. 3+8=11
Or
(b)The
Board of Directors, Jonaki Engineering Co. Pvt. Ltd., requests you to prepare a
statement showing the working capital requirements for a level of activity of
156000 units of production. The following information are available for your
calculations: 11
|
Particulars
|
Per unit (Rs.)
|
|
Raw materials
Direct labour
Overheads
|
90
40
75
|
|
Total
Profit
|
205
60
|
|
Selling Price
|
265
|
a)
Raw
materials are in stock on an average one month.
b)
Materials
are in process on an average two weeks.
c)
Finished
goods are in stock on an average one month.
d)
Credit
allowed by suppliers- one month.
e)
Credit
allowed to debtors- two months.
f)
Lag
in payment of wages- 11/2 weeks.
g)
Lag
in payment of overheads- one month.
20%
of the output is sold against cash. Cash in had and at bank is expected to be
Rs. 60,000. It is to be assumed that production is carried on evenly throughout
the year, wages and overheads accrue similarly and a time period of 4 weeks is
equivalent to a month.
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