Dibrugarh University Financial Management Solved Question Papers
2017 (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) Increased
use of debt increases the financial risk of equity share holders. True
2) Corporation
finance is a part of public finance. False
3) Composite
cost refers to the cost of equity and preference share capital. False
4) The fixed
proportion of working capital should be generally financed from the fixed
capital sources. False, Borrowed
(b)
Fill in the blanks: 1x4=4
1) Payment of
dividend involves legal as well as financial
considerations.
2) Capital
budgeting is the process of making investment decisions in capital expenditure
3) Fixed cost
bearing securities should be mixed with equity when the rate of earnings is more than the rate of interest
of the company.
4) Working
capital is also known as net working
capital.
2. Write short notes on any four of the following: 4x4=16
a)
Aims of finance function
Ans:
Objectives of Finance functions: 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: 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.
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)
b)
Capital gearing
Ans: Capital gearing:
Capital gearing means taking decision regarding proportion of various types of
securities in capital structure. Every company aims at maintaining proper
proportion between various types of securities in capital structure so as to
reduce its cost of capital. It can be also described as the ratio between the
ordinary share capital and fixed interest bearing securities. If ratio of
equity is less than the sum of debt capital and preference shares than the
situation is said to be high gearing. Again, if ratio of equity is more than
the sum of debt capital and preference share than the situation is said to be
low gearing. Capital gearing ratio is calculated by dividing sum of equity
shares and retained earnings by the sum of debt and preference shares.
c)
Estimate of working capital requirement
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. For
smooth running of a business, it is necessary to estimate the working capital
requirement in future. There are broadly
three methods of estimating the requirement of working capital of a company
viz. percentage of revenue or sales, regression analysis, and operating cycle
method. Estimating working capital means calculating future working capital. It
should be as accurate as possible because planning of working capital would be
based on these estimates and bank and other financial institutes finances the
working capital needs based on such estimates only.
Factors Affecting Working Capital
Requirement: The level of working capital is influenced by several factors
which are given below:
1. Nature of Business.
2. Size of Business.
3. Production Policies.
4. Terms of Purchase and Sale
5. Production Process.
6. Turnover of Circulating Capital.
d)
Optimal payout ratio
Ans: 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
Optimal
Dividend Payout Ratio: Dividend payout ratio maximizes the firm’s
value. A payout ratio which maximizes the firm’s value is called optimal
dividend payout ratio. A firm achieves this dividend payout-ratio at that point
where it minimises the total cost of financing.
The minimization of sum of total cost of financing produces a unique
dividend payout ratio for the firm.
e)
Net present value as a technique of
capital budgeting
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.
f)
Optimal capital structure
Ans:
The
optimum capital structure may be defined as “that capital structure or
combination of debt and equity that leads to the maximum value of the firm. 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.
3. (a) “Profit maximisation is not the adequate criterion
to judge the efficiency of a firm.” Explain the statement. What should be the
right criterion and why? 6+8=14
Ans: 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.
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.
OR
(b) Critically analyze the functions of a financial of a
financial manager in a large scale industrial establishment. What are the
responsibilities of a financial manager in a modern business organisation? 8+6=14
Ans: Role and Functions of 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.
4. (a) What are the advantages of adequate working
capital? What shall be the repercussions if a firm has (i) redundant working
capital and (ii) inadequate working capital?
Ans: Importance
of Adequate 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.
e)
Smooth Business Operation: Working capital is really a
life blood of any business organization which maintains the firm in well
condition. Any day to day financial requirement can be met without any shortage
of fund. All expenses such as salaries, rent, electricity bills and current
liabilities are paid on time.
Excess or
inadequate working capital
Every business
concern should have adequate working capital to run its business operations. It
should have neither redundant or excess working capital nor inadequate or
shortage of working capital. Both excess as well as short working capital
positions are bad for any business. However, out of the two, it is the
inadequacy of working capital which is more dangerous from the point of view of
the firm.
Disadvantages of Redundant or Excessive
Working Capital
1.
Excessive Working Capital means idle funds which
earn no profits for the business and hence the business cannot earn a proper
rate of return on its investments.
2.
When there is a redundant working capital, it
may lead to unnecessary purchasing and accumulation of inventories causing more
chances of theft, waste and losses.
3.
Excessive working capital implies excessive
debtors and defective credit policy which may cause higher incidence of bad
debts.
4.
It may result into overall inefficiency in the
organisation.
5.
When there is excessive working capital,
relations with banks and other financial institutions may not be maintained.
6.
Due to low rate of return on investments, the
value of shares may also fall.
7.
The redundant working capital gives rise to
speculative transactions.
Disadvantages or Dangers of Inadequate
Working Capital
1.
A concern which has inadequate working capital
cannot pay its short-term liabilities in time. Thus, it will lose its
reputation and shall not be able to get good credit facilities.
2.
It cannot buy its requirements in bulk and
cannot avail of discounts, etc.
3.
It becomes difficult for the firm to exploit
favourable market conditions and undertake profitable projects due to lack of
working capital.
4.
The firm cannot pay day-to-day expenses of its
operations and it creates inefficiencies, increases costs and reduces the
profits of the business.
5.
It becomes impossible to utilise efficiently the
fixed assets due to non-availability of liquid funds.
6.
The rate of return on investments also falls
with the shortage of working capital.
OR
(b) The following information has been
extracted from the Cost sheet of Dot Com Co. Ltd.:
|
Particulars
|
Rs. (per unit)
|
|
Raw materials
Direct labour
Overhead
(including depreciation of Rs. 10)
|
45
18
40
|
|
Total cost
Profit
|
103
17
|
|
Selling price
|
120
|
The following further information is
available:
a)
Raw
materials are in stock on an average of one month
b)
The
materials are in progress on an average for half a month (100% complete in
regard to material and 50% for labour and overheads)
c)
Credit
allowed by suppliers is one month
d)
Time lag
in receipts of proceeds from debtors is two months.
e)
Average
time lag in payment of overheads is one month.
f)
30
percents of sales are on cash basis
g)
The
company expected to keep a cash balance of Rs. 1,00,000.
h)
Time lag
in payment of wages is 10 days
i)
Finished
goods lie in warehouse for half a month
Prepare the working capital needed to
finance a level of activity of 45000 units of output. Production is carried on
evenly throughout the year, and wages and overhead accrue similarly. 14
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5. (a) (i) Define capital structure. What is optimal
capital structure? 3+5=8
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.
Optimal capital structure
The optimum capital structure may be defined
as “that capital structure or combination of debt and equity that leads to the
maximum value of the firm. 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:
6) Profitability:
The most profitable capital structure is one that tends to minimise financing
cost and maximise of earnings per equity share.
7) Flexibility:
The capitals structure should be such that the company is able to raise funds
whenever needed.
8) Conservation:
Debt content in capital structure should not exceed the limit which the company
can bear.
9) Solvency:
Capital structure should be such that the business does not run the risk of
insolvency.
10) Control:
Capital structure should be devised in such a manner that it involves minimum
risk of loss of control over the company.
(ii) A Company Ltd. Has a share
capital of Rs. 1,00,000 divided into shares of Rs. 10 each. It has major
expansion programme requiring an investment of another Rs. 50,000. The
management is considering the following alternatives for raising this amount:
Issue of
5000 shares of Rs. 10 each.
Issue of
5000, 12 5 preference shares of Rs. 10 each
Issue of
10% debentures of Rs. 50,000
The company’s present earnings before interest
and tax (EBIT) is Rs. 30,000 pa
You are required to calculate the effect
of each of the above modes of financing
on the earning per share (EPS) presuming EBIT continues to be the same even
after expansion (Assume tax liability at 50%) 6
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Or
(b) What is meant by cost of capital? What are the
components of the cost of capital? What is the cost of retained earnings? How
is the cost of new equity issues determined? 3+3+4+4=14
Ans: 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”.
Various components of cost of capital
Capital
structure of a company mainly consists of debt and equity. Debt includes
debentures, loans and bonds and equity include both equity and preference
shares and retained earnings. The individual cost of each source of financing
is called component of cost of capital. The component of cost of capital is
also known as the specific cost of capital which includes the individual cost
of debt, preference shares, ordinary shares and retained earning. Such
components of cost of capital have been presented below:
1. Cost of
debt
a) Cost of
irredeemable debt
b) Cost of redeemable
debt (before tax and after tax)
c) Cost of
debt redeemable in instalments
d) Cost of
existing debt
e) Cost of
zero coupon bonds
2. Cost of Preference
Share
a) Cost of
irredeemable preference Share
b) Cost of
redeemable preference Share
3. Cost of
ordinary/equity shares or common stock
4. Cost of
retained earning
6. (a) (i) What is dividend? Discuss the various forms of
dividend. 2+5=7
Ans: 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:
1. Cash
Dividend.
2. Stock
Dividend or Bonus Dividend.
3. Bond
Dividend.
4. Property
Dividend.
5. Composite
Dividend.
6. Interim
Dividend.
7. Special or
Extra Dividend.
8. Optional
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 stable dividend policy?
Why should it be followed? 2+5=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:
1. Constant
D/P ratio.
2. Constant
dividends per share.
3. Constant
dividend per share plus extra dividends.
Merits of
Stable Dividend Policy: Following are some of the advantages of a
stable dividend policy due to which every company must follow it:
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.
OR
(b) In Walter’s approach, the dividend policy of a firm
depends on availability of investment opportunity and the relationship between
the firm’s internal rate of return and its cost of capital. Discuss. What are
the shortcomings of this view? 14
Ans: Walter’s Dividend theory
Professor James E. Walter
argues that the choice of dividend policies almost always affects the value of
the enterprise. His model shows clearly the importance of the relationship
between the firm’s internal rate of return (r) and its cost of capital (k) in
determining the dividend policy that will maximise the wealth of shareholders.
Valuation Formula and its Denotations: Walter’s formula to calculate the market price
per share (P) is:
P = D/k +
{r*(E-D)/k}/k, where
P = market price
per share
D = dividend per
share
E = earnings per
share
r = internal rate
of return of the firm
k = cost of
capital of the firm
Explanation: The mathematical
equation indicates that the market price of the company’s share is the total of
the present values of:
a) An infinite flow of dividends, and
b) An infinite flow of gains on investments from
retained earnings.
The formula can
be used to calculate the price of the share if the values of other variables
are available.
Walter’s model is based on the
following assumptions:
a) The firm
finances all investment through retained earnings; that is debt or new equity
is not issued;
b) The firm’s
internal rate of return (r), and its cost of capital (k) are constant;
c) All
earnings are either distributed as dividend or reinvested internally
immediately.
d) Beginning
earnings and dividends never change. The values of the earnings per share (E),
and the divided per share (D) may be changed in the model to determine results,
but any given values of E and D are assumed to remain constant forever in
determining a given value.
e) The firm
has a very long or infinite life.
Criticism of Walter’s theory:
Walter’s model is quite useful to show the
effects of dividend policy on an all equity firm under different assumptions
about the rate of return. However, the simplified nature of the model can lead
to conclusions which are net true in general, though true for Walter’s model. The criticisms on the model are as
follows:
1. Walter’s model of share valuation mixes
dividend policy with investment policy of the firm. The model assumes that the
investment opportunities of the firm are financed by retained earnings only and
no external financing debt or equity is used for the purpose when such a
situation exists either the firm’s investment or its dividend policy or both
will be sub-optimum. The wealth of the owners will maximise only when this
optimum investment in made.
2. Walter’s model is based on the assumption
that r is constant. In fact decreases as more investment occurs. This reflects
the assumption that the most profitable investments are made first and then the
poorer investments are made. The firm should step at a point
where r = k. This is clearly an erroneous policy and fall to optimize the
wealth of the owners.
3. A firm’s cost of capital or discount rate, K,
does not remain constant; it changes directly with the firm’s risk. Thus, the
present value of the firm’s income moves inversely with the cost of capital. By
assuming that the discount rate, K is constant, Walter’s model abstracts from
the effect of risk on the value of the firm.
(Old course)
Full marks: 80
Pass marks: 32
1. (a) write True or False: 1x4=4
a) Finance
manager has to estimate, procure and utilize financial resources. True
b) Capital
budgeting and capital rationing mean the same thing. False
c)
Ownership securities are represented by
debentures. False, Creditorship Securities
d) Cash
dividend is a usual method of paying dividend. True
(b) Fill in the blanks: 1x4=4
a) It is the
duty of a finance manager to arrange,
manage and estimate funds.
b) Cost of
capital is not a perfect rate as such.
c) Scrip Dividend promises to pay the
shareholders at a future date.
d) Current
Assets – Current Liabilities = Working
Capital
2. Write short notes on any four of
the following: 4x4=16
a) Profit
maximisation
b) Net present
value method
c) Lease
financing
d) Retained
earnings
e) Gross and
net working capital
3. (a) What is Finance Function? What are the aims of finance
function? Discuss its scope. 12
OR
(b) Define Financial Management. Discuss its significance in
modern era. State the objectives of financial management. 3+5+4=12
4. (a) What is cost of capital? Discuss its problems in
determination of cost of capital. 3+8=11
OR
(b) What is Financial Leverage? Calculate operating leverage and
financial leverage from the following data: 3+4+4=11 Rs.
Sales (100000 units) 2,00,000.00
Variable cost per unit 0.70
Fixed cost 65,000.00
Interest charges 15,000.00
SOLUTIONS:
LINK OF ALL PRACTICAL PROBLEMS VIDEOS
5. (a) What are the main sources of finance available to
industries for meeting long term financial requirements? Discuss 11
OR
(b) What is capital market? What are the main components of a
capital market? Distinguish between capital market and money market 2+3+6=11
6. (a) Discuss the MM theory of dividend distribution. What are
the criticisms of this theory of irrelevance? 7+4=11
OR
(b) What is Stable Dividend Policy? Do you recommend a stable
dividend policy? Explain it with justification. 2+2+7=11
7. (a) What do you mean by Inventory Management? Why is it
essential to an enterprise? Mention any four problems of inventory management. 2+2+7=11
OR
(b) From the following information, prepare a statement showing
the working capital requirements: 11
Budgeted sales- Rs. 2,60,000 per annum. Analysis of one rupee of
sales:
|
Particulars
|
Rs.
(per unit)
|
|
Raw materials
Direct labour
Overhead (including depreciation of Rs. 10)
|
0.30
0.40
0.20
|
|
Total
cost
Profit
|
0.90
0.10
|
|
Selling
price
|
1.00
|
It is estimated that:
a) Raw
materials are carried in stock for 3 weeks and finished goods for 2 weeks.
b) Factory
processing will take 3 weeks and it may be assumed to be consisting of 100 % of
raw materials, wages and overheads
c) Suppliers
will give 5 weeks credit
d) Customers
will require 8 weeks credit.
SOLUTIONS:
LINK OF ALL PRACTICAL PROBLEMS VIDEOS
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