Dibrugarh University Financial Management Solved Question Papers
2018 (November)
COMMERCE (Speciality)
Course: 302 (Financial Management)
The figures in the margin indicate full marks for the questions
(New Course)
Full Marks: 80
Pass Marks: 24
Time: 3 hours
1. (a) Write True or False: 1x4=4
1)
Retained earnings do not involve any cost. False
2)
The main aim of financial function is to
maximize profit. False
3)
Gross working capital refers to the capital
invested in the total assets of an enterprise. False, CA
4)
Payment of dividend at the usual rate is termed
as regular dividend. True
(b) Fill in the blanks: 1x4=4
1)
It is better for a company to remain in low gear during the period of
depression.
2)
According to M&M approach, the total value
of a firm is absolutely unaffected by
capital structure.
3)
Corporation finance deals with the company form of organization.
4)
The rate of return on investments does not related with the
shortage of working capital.
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.
b)
Significance of
cost of capital.
Ans: Computation
of cost of capital is a very important part of the financial management to
decide the capital structure of the business concern.
a) Importance
to Capital Budgeting Decision: Capital budget decision largely depends on the
cost of capital of each source. According to net present value method, present
value of cash inflow must be more than the present value of cash outflow.
Hence, cost of capital is used to capital budgeting decision.
b) Importance
to Structure Decision: Capital structure is the mix or proportion of the
different kinds of long term securities. A firm uses particular type of sources
if the cost of capital is suitable. Hence, cost of capital helps to take
decision regarding structure.
c) Importance
to Evolution of Financial Performance: Cost of capital is one of the important
determine which affects the capital budgeting, capital structure and value of
the firm. Hence, it helps to evaluate the financial performance of the firm.
d) Importance
to Other Financial Decisions: Apart from the above points, cost of capital is
also used in some other areas such as, market value of share, earning capacity
of securities etc. hence, it plays a major part in the financial management.
c) Profitability index method of capital budgeting.
Ans: It is also a
time-adjusted method of evaluating the investment proposals. Profitability
index also called as Benefit-Cost Ratio (B/C) or ‘Desirability factor’ is the
relationship between present value of cash inflows and the present value of
cash outflows.
Merits
of PI
1.
It considers the time value of money.
2.
It considers entire cash flows over entire life
of the project.
3.
It is a relative measure of profitability since
the ratio of cash inflows to cash outflows is considered.
4.
It guides in resolving capital rationing where
projects are divisible.
5.
It guides the selection of Mutually Exclusive
Projects having same Net Present Value.
Demerits of PI
1.
It requires the estimation of cash inflows and
cash outflows, which is a difficult task.
2.
It requires the computation of the cost of
capital to be used as discount rate.
3.
The ranking of projects depends upon the
discount rate.
4.
It ignores the difference in initial cash
outflows, size of different projects, etc. while evaluating mutually exclusive
projects.
5.
It fails to guide in resolving capital rationing
where projects are indivisible.
d) Stable dividend policy.
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.
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.
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.
e) Importance of working capital management.
Ans: Importance of working capital: Working
Capital means excess of current assets over current liabilities. Such Working
Capital is required to smooth conduct of business activities. It is as
important as blood to body. An organisation’s profitability depends on the
quantum of Working Capital available to it. Adequate Working Capital is a
source of energy to any business organisation. It is the life blood of an
organisation. The following points will highlight the need of adequate working
capital:
a) Enables
a company to meet its obligations: Working
capital helps to operate the business smoothly without any financial problem
for making the payment of short-term liabilities. Purchase of raw materials and
payment of salary, wages and overhead can be made without any delay. Adequate
working capital helps in maintaining solvency of the business by providing
uninterrupted flow of production.
b)
Enhance Goodwill: Sufficient working capital enables a business concern
to make prompt payments and hence helps in creating and maintaining goodwill.
Goodwill is enhanced because all current liabilities and operating expenses are
paid on time.
c)
Facilitates obtaining Credit from banks without any difficulty: A firm having adequate working capital, high solvency
and good credit rating can arrange loans from banks and financial institutions
in easy and favorable terms.
d)
Regular Supply of Raw Material: Quick payment of
credit purchase of raw materials ensures the regular supply of raw materials for
suppliers. Suppliers are satisfied by the payment on time. It ensures regular
supply of raw materials and continuous production. Prompt
payments to its creditors also enable a company to take advantage of cash and
quantity discounts offered by them.
3. (a) The responsibility of a
finance manager is now regarded as much more than mere procurement of funds.
What do you think are other responsibilities of a finance manager? 14
Ans: Responsibility of
a finance manager: In the modern enterprise, a finance manager occupies a key
position, he being one of the dynamic member of corporate managerial team. His
role, is becoming more and more pervasive and significant in solving complex
managerial problems. Traditionally, the role of a finance manager was confined
to raising funds from a number of sources, but due to recent developments in
the socio-economic and political scenario throughout the world, he is placed in
a central position in the organisation. He is responsible for shaping the
fortunes of the enterprise and is involved in the most vital decision of
allocation of capital like mergers, acquisitions, etc. A finance manager, as
other members of the corporate team cannot be averse to the fast developments,
around him and has to take note of the changes in order to take relevant steps
in view of the dynamic changes in circumstances.
The nature of job of an accountant and finance
manager is different, an accountant's job is primarily to record the business
transactions, prepare financial statements showing results of the organisation
for a given period and its financial condition at a given point of time. He is to
record various happenings in monetary terms to ensure that assets, liabilities,
incomes and expenses are properly grouped, classified and disclosed in the
financial statements. Accountant is not concerned with management of funds that
is a specialised task and in modern times a complex one. The finance manager or
controller has a task entirely different from that of an accountant, he is to
manage funds. Some of the important decisions as regards finance are as
follows:
1)
Estimating the requirements of funds: A
business requires funds for long term purposes i.e. investment in fixed assets
and so on. A careful estimate of such funds is required to be made. An
assessment has to be made regarding requirements of working capital involving,
estimation of amount of funds blocked in current assets and that likely to be
generated for short periods through current liabilities. Forecasting the
requirements of funds is done by use of techniques of budgetary control and
long range planning.
2)
Decision regarding capital structure: Once
the requirement of funds is estimated, a decision regarding various sources
from where the funds would be raised is to be taken. A proper mix of the
various sources is to be worked out, each source of funds involves different
issues for consideration. The finance manager has to carefully look into the
existing capital structure and see how the various proposals of raising funds
will affect it. He is to maintain a proper balance between long and short term
funds.
3)
Investment decision: Funds procured
from different sources have to be invested in various kinds of assets. Long
term funds are used in a project for fixed and also current assets. The
investment of funds in a project is to be made after careful assessment of
various projects through capital budgeting. A part of long term funds is also
to be kept for financing working capital requirements. Asset management
policies are to be laid down regarding various items of current assets,
inventory policy is to be determined by the production and finance manager,
while keeping in mind the requirement of production and future price estimates
of raw materials and availability of funds.
4)
Dividend decision: The finance
manager is concerned with the decision to pay or declare dividend. He is to
assist the top management in deciding as to what amount of dividend should be
paid to the shareholders and what amount is retained by the company, it
involves a large number of considerations. The principal function of a finance
manager relates to decisions regarding procurement, investment and
dividends.
5) Maintain Proper Liquidity: Every
concern is required to maintain some liquidity for meeting day-to-day needs.
Cash is the best source for maintaining liquidity. It is required to purchase
raw materials, pay workers, meet other expenses, etc. A finance manager is
required to determine the need for liquid assets and then arrange liquid assets
in such a way that there is no scarcity of funds.
6)
Management
of Cash, Receivables and Inventory: Finance manager is required to determine
the quantum and manage the various components of working capital such as cash,
receivables and inventories. On the one hand, he has to ensure sufficient
availability of such assets as and when required, and on the other there should
be no surplus or idle investment.
7)
Disposal
of Surplus: A finance manager is also expected to make proper utilization
of surplus funds. He has to make a decision as to how much earnings are to be
retained for future expansion and growth and how much to be distributed among
the shareholders.
8)
Evaluating financial performance: Management
control systems are usually based on financial analysis, e.g. ROI (return
on investment) system of divisional control. A finance manager has to
constantly review the financial performance of various units of the
organisation. Analysis of the financial performance helps the management for
assessing how the funds are utilised in various divisions and what can be done
to improve it.
9)
Financial negotiations: Finance
manager's major time is utilised in carrying out negotiations with financial
institutions, banks and public depositors. He has to furnish a lot of
information to these institutions and persons in order to ensure that raising
of funds is within the statutes. Negotiations for outside financing often
require specialised skills.
10)
Helping
in Valuation Decisions: A number of mergers and consolidations take place
in the present competitive industrial world. A finance manager is supposed to
assist management in making valuation etc. For this purpose, he should
understand various methods of valuing shares and other assets so that correct
values are arrived at.
Or
(b) What do you mean by Finance
Function? Discuss about the scope of finance function in a business enterprise.
Should the goal of financial decision making be profit maximization or wealth
maximization? 4+6+4=14
Ans: MEANING OF FINANCE FUNCTION: 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.
Scope of Finance Function
The finance function encompasses the
activities of raising funds, investing them in assets and distributing returns
earned from assets to shareholders. While doing these activities, a firm
attempts to balance cash inflow and outflow. It is evident that the finance
function involves the four decisions viz., financing decision, investment
decision, dividend decision and liquidity decision. Thus the finance function
includes:
a) Investment
decision
b) Financing
decision
c) Dividend
decision
d) Liquidity
decision
1. Investment Decision: The investment
decision, also known as capital budgeting, is concerned with the selection of
an investment proposal/ proposals and the investment of funds in the selected
proposal. A capital budgeting decision involves the decision of allocation of
funds to long-term assets that would yield cash flows in the future. Two
important aspects of investment decisions are:
(a) The evaluation of the prospective
profitability of new investments, and
(b) The measurement of a cut-off rate against
that the prospective return of new investments could be compared.
Future benefits of investments are difficult
to measure and cannot be predicted with certainty. Risk in investment arises
because of the uncertain returns. Investment proposals should, therefore, be
evaluated in terms of both expected return and risk. Besides the decision to
commit funds in new investment proposals, capital budgeting also involves
replacement decision, that is decision of recommitting funds when an asset
become less productive or non-profitable. The
computation of the risk-adjusted return and the required rate of return,
selection of the project on these bases, form the subject-matter of the
investment decision.
Long-term investment decisions may be both
internal and external. In the former, the finance manager has to determine
which capital expenditure projects have to be undertaken, the amount of funds
to be committed and the ways in which the funds are to be allocated among
different investment outlets. In the latter case, the finance manager is
concerned with the investment of funds outside the business for merger with, or
acquisition of, another firm.
2. Financing Decision: Financing decision is
the second important function to be performed by the financial manager. Broadly,
he or she must decide when, from where and how to acquire funds to meet the
firm’s investment needs. The central issue before him or her is to determine
the appropriate proportion of equity and debt. The mix of debt and equity is
known as the firm’s capital structure. The financial manager must strive to
obtain the best financing mix or the optimum capital structure for his or her
firm. The firm’s capital structure is considered optimum when the market value
of shares is maximized.
The use of debt affects the return and risk of
shareholders; it may increase the return on equity funds, but it always
increases risk as well. The change in the shareholders’ return caused by the
change in the profit is called the financial leverage. A proper balance will have
to be struck between return and risk. When the shareholders’ return is
maximized with given risk, the market value per share will be maximized and the
firm’s capital structure would be considered optimum. Once the financial
manager is able to determine the best combination of debt and equity, he or she
must raise the appropriate amount through the best available sources. In
practice, a firm considers many other factors such as control, flexibility,
loan covenants, legal aspects etc. in deciding its capital structure.
3. Dividend Decision: Dividend decision is the
third major financial decision. The financial manager must decide whether the
firm should distribute all profits, or retain them, or distribute a portion and
return the balance. The proportion of profits distributed as dividends is
called the dividend-payout ratio and the retained portion of profits is known
as the retention ratio. Like the debt policy, the dividend policy should be
determined in terms of its impact on the shareholders’ value. The optimum
dividend policy is one that maximizes the market value of the firm’s shares.
Thus, if shareholders are not indifferent to the firm’s dividend policy, the
financial manager must determine the optimum dividend-payout ratio. Dividends
are generally paid in cash. But a firm may issue bonus shares. Bonus shares are
shares issued to the existing shareholders without any charge. The financial
manager should consider the questions of dividend stability, bonus shares and
cash dividends in practice.
4. Liquidity Decision: Investment in current
assets affects the firm’s profitability and liquidity. Current assets should be
managed efficiently for safeguarding the firm against the risk of illiquidity.
Lack of liquidity in extreme situations can lead to the firm’s insolvency. A
conflict exists between profitability and liquidity while managing current
assets. If the firm does not invest sufficient funds in current assets, it may
become illiquid and therefore, risky. But if the firm invests heavily in the current
assets, then it would lose interest as idle current assets would not earn
anything. Thus, a proper trade-off must be achieved between profitability and
liquidity. The profitability-liquidity trade-off requires that the financial
manager should develop sound techniques of managing current assets and make
sure that funds would be made available when needed.
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, and 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) Define the term ‘working
capital’. On the formation of a new business, what considerations are taken
into account in estimating the amount of working capital needed? 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 short 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 vary 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:
|
Particulars
|
Rs.
(Per Unit)
|
|
Raw
materials
Direct
labour
Overheads
|
40
30
35
|
|
Total
Profits
|
105
15
|
|
Selling
Price
|
120
|
The
following further information is available:
1)
Raw
materials are in stock on an average two months.
2)
The
materials are in process of an average for 4 weeks. The degree of completion is
50% in all respects.
3)
Finished
goods are in stock on an average for one month.
4)
Time
lag in payment of wages and overheads is 1 and half weeks.
5)
Time
lag in respect of proceeds from debtors is 2 months.
6)
Credit
allowed by suppliers is one month.
7)
20%
of output is sold against cash.
8)
The
company expects to keep a cash balance of Rs. 50,000.
9)
Take
52 weeks per annum.
10)
Calculation
of debtors may be made at selling price.
11)
The
company is planned to manufacture 15,000 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) Define capital
structure. Using imaginary figures, show how to determine the value of firm
under (1) the net income (NI) approach and (2) the net operating income (NOI)
approach. 4+5+5=14
Ans: Meaning of Capital Structure
Capital structure refers to the mix of sources
from where long term funds required by a business may be raised i.e. what
should be the proportion of equity share capital, preference share capital,
internal sources, debentures and other sources of funds in total amount of
capital which an undertaking may raise for establishing its business.
In the words of Robert H. Wessel “The term capital structure is frequently used to
indicate the long-term sources of funds employed in a business enterprise”.
In the words of John J. Hampton “Capital structure is the combination of debt and
equity securities that comprise a firm’s financing of its assets”.
In simple words, Capital structure
of a company is the composition of long-term sources of funds, such as
ordinary shares, preference shares, debentures, bonds, long-term funds.
Various theories on
Capital Structure
A firm's objective should be directed towards
the maximisation of the firm's value; the capital structure or leverage
decisions are to be examined from the view point of their impact on the value
of the firm. If the value of the firm can be affected by capital structure or
financing decision, a firm would like to have a capital structure that
maximises the market value of the firm. There are broadly 4 approaches in the
regard, which analyses relationship between leverage, cost of capital and the
value of the firm in different ways, under the following assumptions:
1)
There are only 2 sources of funds viz. debt and
equity.
2)
The total assets of the firm are given and the
degree of leverage can be altered by selling debt to repurchase shares or selling
shares to retire debt.
3)
There are no retained earnings implying that
entire profits are distributed among shareholders.
4)
The operating profit of firm is given and
expected to grow.
5)
The business risk is assumed to be constant and
is not affected by the financing mix decision.
6)
There are no corporate or personal taxes.
7)
The investors have the same subjective
probability distribution of expected earnings.
The approaches are as below:
1) Net
Income Approach (NI Approach): The approach is suggested by Durand.
According to it, a firm can increase its value or lower the overall cost of
capital by increasing the proportion of debt in the capital structure. In other
words, if the degree of financial leverage increases, the weighted average cost
of capital would decline with every increase in the debt content in total funds
employed, while the value of the firm will increase. Reverse would happen in a
converse situation. It is based on the following assumptions:
i) There are no corporate taxes.
ii) The cost of debt is less than cost of
equity or equity capitalisation rate.
iii)
The use of debt content does not change the risk perception of investors as a
result of both the Kd (Debt capitalisation rate) and Ke (equity capitalisation
rate) remains constant.
The value of the firm on the basis of Net
Income Approach may be ascertained as follows: V = S + D
Where,
V = Value of the firm
S = Market value of equity (S = NI/Ke)
D = Market value of debt
NI = Earnings available for equity
shareholders
Ke = Equity Capitalisation rate
Under, NI approach, the value of a firm will
be maximum at a point where weighted average cost of capital is minimum. Thus,
the theory suggests total or maximum possible debt financing for minimising
cost of capital. Overall cost of capital = EBIT/Value of the firm
2) Net
Operating Income Approach (NOI): This approach is also suggested by Durand,
according to it, the market value of the firm is not affected by the capital
structure changes. The market value of the firm is ascertained by capitalising
the net operating income at the overall
cost of capital, which is constant. The market value of the firm is determined
as:
V = EBIT/Overall cost of capital
Where,
V = Market value of the firm
EBIT = Earnings before interest and tax
S = V – D Where,
S = Value of equity
D = Market value of debt
V = Market value of firm
It is based on the following assumptions:
i) The overall cost of capital remains
constant for all degree of debt equity mix.
ii) The market capitalises value of the firm
as a whole. Thus, the split between debt and equity is not important.
iii)
The use of less costly debt funds increases the risk of shareholders. This
causes the equity capialisation rate to increase. Thus, the advantage of debt
is set off exactly by increase in equity capitalisation rate.
iv) There are
no corporate taxes.
v) The cost of
debt is constant.
Under, NOI approach since
overall cost of capital is constant, thus, there is no optimal capital
structure rather every capital structure is as good as any other and so every
capital structure is optimal.
Or
(b) A chemical company
is considering investment in a project that costs Rs. 5,00,000. The life of the
project is 5 years and estimated salvage value is zero. Tax rate is 55%. The
company uses straight-line depreciation and proposed project has estimated
earnings before depreciation and before tax as follows: 14
|
Year
|
Earnings
before
Depreciation
and Tax (Rs.)
|
|
1
2
3
4
5
|
1,00,000
1,00,000
1,50,000
1,50,000
2,50,000
|
Determine
the following:
1)
Payback
period.
2)
Average
rate of return.
3)
Net
present value at 15%.
4)
Gross
profitability index at 15%.
The following are the
present value factors at 15% p.a.:
|
Year:
|
1
|
2
|
3
|
4
|
5
|
|
PV
Factor:
|
0.870
|
0.756
|
0.658
|
0.572
|
0.497
|
SOLUTIONS:
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6. (a) What is the
Modigliani-Miller approach of irrelevance concept of dividends? Under what
assumptions do the conclusions hold good? 10+4=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, are 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 neutralized 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) What do you understand by
retained earnings? Discuss the merits and limitations of ploughing back of
profit. 4+5+5=14
Ans: Retained Earnings or Ploughing Back of Profit: Retained
earnings are 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.
Advantages of Retained Earnings
Retained earnings consist of the following
important advantages:
1. Useful for expansion and diversification:
Retained earnings are most useful to
expansion and diversification of the business activities.
2. Economical sources of finance: Retained
earnings are one of the least costly sources
of finance since it does not involve any floatation cost as in the case of raising of funds by issuing different
types of securities.
3. No fixed obligation: If the companies use
equity finance they have to pay dividend and if the companies use debt finance,
they have to pay interest. But if
the company uses retained earnings as sources of finance, they need not pay any fixed obligation regarding the
payment of dividend or interest.
4. Flexible sources: Retained earnings allow
the financial structure to remain completely
flexible. The company need not raise loans for further requirements, if it has retained earnings.
5. Increase the share value: When the company
uses the retained earnings as the sources
of finance for their financial requirements, the cost of capital is very
cheaper than the other sources of
finance; hence the value of the share will increase.
6. Avoid excessive tax: Retained earnings
provide opportunities for evasion of excessive
tax in a company when it has small number of shareholders.
7. Increase earning capacity: Retained
earnings consist of least cost of capital and also it is most suitable to those companies which go for
diversification and expansion.
Disadvantages of Retained Earnings
Retained earnings also have certain
disadvantages:
1. Misuses: The management by manipulating the
value of the shares in the stock market
can misuse the retained earnings.
2. Leads to monopolies: Excessive use of
retained earnings leads to monopolistic attitude
of the company.
3. Over capitalization: Retained earnings lead
to over capitalization, because if the company
uses more and more retained earnings, it leads to insufficient source of finance.
4. Tax evasion: Retained earnings lead to tax
evasion. Since, the company reduces tax
burden through the retained earnings.
5. Dissatisfaction: If the company uses
retained earnings as sources of finance, the shareholder can’t get more dividends. So, the shareholder does not
like to use the retained earnings as
source of finance in all situations.
(OLD COURSE)
Full Marks: 80
Pass Marks: 32
Time: 3 hours
1. (a) Fill in the
blanks: 1x4=4
1)
Financial
leverage is also known as ‘Trading on Equity’.
2)
Payment of dividend involved legal as well as financial consideration.
3)
Finance
is the life blood and nerve centre of a business concern.
4)
Financial decisions involved investment,
financing and dividend
decisions.
(b) Write True or
False: 1x4=4
1)
Debentures do not carry any voting right. True
2)
The value of the firm can be maximized, if the
shareholders’ wealth is maximized. True
3)
According to Walter’s model, the dividend
decision is irrelevant. False, MM Approach
4)
Corporation finance is a wider term than
business finance. False, Similar
2. Write short notes on
any four of the following: 4x4=16
a)
Capital
market.
b)
Trading
on equity.
c)
Retained
earnings.
d)
Dividend
payout ratio.
e)
Aims
of finance function.
3. (a) What do you mean by business finance? What is the scope
of finance function in a business enterprise? Should the goal of financial
decision making be profit maximization or wealth maximization? 2+4+6=12
Or
(b) Discuss the profit maximization and
wealth maximization concept of financial management. 6+6=12
4. (a) Describe the various natures of short-term and
long-term requirement of finance in a business and sources from which those can
be arranged. 5+6=11
Or
(b) What is ‘capital market’? Why is it
considered as a prerequisite for the economic development of a country like
India? Discuss. 3+8=11
5. (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
Or
(b) (1) Define capital budgeting. State its
limitations. 2+3=5
(2) The following data are available for
ABC Ltd:
|
|
Rs.
|
|
Selling price per unit
Variable cost per unit
Fixed cost
|
120
70
2,00,000
|
1)
What is the operating leverage, when ABC Ltd.
produces and sells 6,000 units?
2)
What is the percentage change that will occur in
the EBIT of ABC Ltd., if output increases by 5%? 3+3=6
SOLUTIONS:
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6. (a) What do you mean by ploughing back of profit? What are
the purposes of ploughing back? Discuss different factors that influence the
ploughing back of profit. 2+4+5=11
Or
(b) Explain the various factors which influence the dividend
decision of a firm. 11
7. (a) Define receivable management. Discuss the various
dimensions of receivable management.
3+8=11
Or
(b) The following information has been submitted by the
borrower:
1)
Expected level of production – 120000 units.
2)
Raw materials to remain in stock on an average –
2 months.
3)
Processing period for each unit of product
(costing of 100% of raw material, wages and overheads) – 1 month.
4)
Finished goods remain in stock on an average – 3
months.
5)
Credit allowed to the customers from the date of
dispatch – 3 months.
6)
Expected ratios of cost to selling price:
a)
Raw material – 60%
b)
Direct wages – 10%
c)
Overheads – 20%
7)
Selling price per unit – Rs. 10.
8)
Expected margin on sale – 10%.
You are required to estimate the working
capital requirements of the borrower. 11
SOLUTIONS:
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