Dibrugarh University Financial
Management Solved Question Papers 2021
5th SEM TDC
FIMT (CBCS) C 512
2021 (Held in
January/February, 2022)
COMMERCE (Core)
Paper: C-512 (Financial
Management)
Full Marks: 80
Pass Marks: 32
Time: 3 hours.
The figures in the margin
indicate full marks for the questions.
1. (a) Write True or False: 1x4=4
a) Wealth maximization is a socialistic approach. True
b) Cash management is an important task of the finance manager. True
c) Temporary investments of surplus funds are not current assets. False
d) Dividend means ratio of profit to capital. False
(b)
Fill in the blanks: 1x4=4
a) The cost of capital is the expected
rate of return expected by its investors.
b) Payment of dividend involves legal as well as financial considerations.
c) Corporation finance deals with the CAPITAL STRUCTURE of organization.
d) The volume of sales is influenced by the credit policy of a firm.
2.
Write short notes on (any four): 4x4=16
a) Profit
maximization.
Ans: Profit maximization:
Profit maximization implies that either a firm
produces maximum output for a given input or uses minimum input for a given
level of output. Profit maximization causes the efficient allocation of resources
in competitive market condition and profit is considered as the most important
measure of firm performance. The underlying logic of profit maximization is
efficiency.
In a market economy, prices are driven by
competitive forces and firms are expected to produce goods and services desired
by society as efficiently as possible. Demand for goods and services leads
price. Goods and services which are in great demand can command higher prices.
This leads to higher profits for the firm. This in turn attracts other firms to
produce such goods and services. Competition grows and intensifies leading to a
match in demand and supply. Thus, an equilibrium price is reached. On the other
hand, goods and services not in demand fetches low price which forces producers
to stop producing such goods and services and go for goods and services in
demand. This shows that the price system directs the managerial effort towards
more profitable goods and services. Competitive forces direct price movement
and guides the allocation of resources for various productive activities.
Arguments in favour of profit maximisation
a) When profit earning is the aim of business
then profit maximisation should be the obvious objective.
b) Profit is the barometer for measuring
efficiency and economic prosperity of a business.
c) In adverse situation such recession,
depression etc., a business can survive only when if it has past reserves to
rely upon. Therefore, every business should try to earn more and more profit
when situation is favourable.
Objections to Profit Maximization:
Certain objections have been raised against the goal of profit
maximization which strengthens the case for wealth maximization as the goal of
business enterprise. The objections are:
(a) Profit cannot be ascertained well in advance to express the
probability of return as future is uncertain. It is not at all possible to
maximize what cannot be known. Moreover, the return profit vague and has not
been explained clearly what it means. It may be total profit before tax and
after tax of profitability tax. Profitability rate, again is ambiguous as it
may be in relation to capital employed, share capital, owner’s fund or sales.
This vagueness is not present in wealth maximisation goal as the concept of
wealth is very clear. It represents value of benefits minus the cost of
investment.
(b) The executive or the decision maker may not have enough
confidence in the estimates of future returns so that he does not attempt
further to maximize. It is argued that firm’s goal cannot be to maximize
profits but to attain a certain level or rate of profit holding certain share
of the market or certain level of sales. Firms should try to ‘satisfy’ rather
than to ‘maximise’.
b) 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.
c) Financial
leverage.
Ans: Financial Leverage: A
Leverage activity 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.
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 earnings before interest and tax (EBIT). This
can be calculated by the following formula: DFL= Percentage change in
taxable Income / Percentage change in EBIT
d) Payback
period method.
Ans: Payback period Method:
It is one of the simplest methods to calculate period within which entire cost
of project would be completely recovered. It is the period within which total
cash inflows from project would be equal to total cash outflow of project. It
is calculated by dividing initial investments in project by annual cash
inflows. Here, cash inflow means profit after tax but before depreciation.
Merits of
Payback Period Method
a) This method of evaluating proposals for capital budgeting is
simple and easy to understand, it has an advantage of making clear that it has
no profit on any project until the payback period is over i.e. until capital
invested is recovered. This method is particularly suitable in the case of
industries where risk of technological services is very high.
b) In case of routine projects also, use of payback period method
favours projects that generates cash inflows in earlier years, thereby
eliminating projects bringing cash inflows in later years that generally are
conceived to be risky as this tends to increase with futurity.
Limitations
of payback period
a) It stresses capital recovery rather than profitability. It does
not take into account returns from the project after its payback period.
b) This method becomes an inadequate measure of evaluating 2
projects where the cash inflows are uneven.
e) Dividend
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
3.
(a) “The responsibilities 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: 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.
Or
(b)
What is financial management? Discuss its significance in modern era. State the
objectives of financial management. 4+5+5=14
Ans:
Meaning
and Definitions of Financial Management
Financial management is management principles and practices
applied to finance. General management functions include planning, execution
and control. Financial decision making includes decisions as to size of
investment, sources of capital, extent of use of different sources of capital
and extent of retention of profit or dividend payout ratio. Financial
management, is therefore, planning, execution and control of investment of
money resources, raising of such resources and retention of profit/payment of
dividend.
Howard and Upton define financial management as "that
administrative area or set of administrative functions in an organisation which
have to do with the management of the flow of cash so that the organisation
will have the means to carry out its objectives as satisfactorily as possible
and at the same time meets its obligations as they become due.”
According to Guthamann and Dougall,” Business finance can be
broadly defined as the activity concerned with the planning, raising,
controlling and administering the funds used in the business.”
Considering all these views, financial management may be defined
as that part of management which is concerned mainly with raising funds in the
most economic and suitable manner, using these funds as profitably as possible.
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.
2)
Importance to all Stake holders
a) Shareholders: Shareholders 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 aspects 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.
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.
Objectives of Financial Management
The firm’s investment and financing decision are
unavoidable and continuous. In order to make them rational, the firm must have
a goal. Two financial objectives predominate amongst many objectives. These
are:
1. Profit maximization
2. Shareholders’ Wealth Maximization (SWM)
Profit maximization refers to the rupee income
while wealth maximization refers to the maximization of the market value of the
firm’s shares. Although profit
maximization has been traditionally considered as the main objective of the
firm, it has faced criticism. Wealth maximization is regarded as operationally
and managerially the better objective.
1. Profit maximization: Profit maximization
implies that either a firm produces maximum output for a given input or uses
minimum input for a given level of output. Profit maximization causes the
efficient allocation of resources in competitive market condition and profit is
considered as the most important measure of firm performance. The underlying
logic of profit maximization is efficiency.
In a market economy, prices are driven by
competitive forces and firms are expected to produce goods and services desired
by society as efficiently as possible. Demand for goods and services leads
price. Goods and services which are in great demand can command higher prices.
This leads to higher profits for the firm. This in turn attracts other firms to
produce such goods and services. Competition grows and intensifies leading to a
match in demand and supply. Thus, an equilibrium price is reached. On the other
hand, goods and services not in demand fetches low price which forces producers
to stop producing such goods and services and go for goods and services in
demand. This shows that the price system directs the managerial effort towards
more profitable goods and services. Competitive forces direct price movement
and guides the allocation of resources for various productive activities.
2. Shareholders’ Wealth Maximization: Shareholders’ wealth maximization means maximizing the net present
value of a course of action to shareholders. Net Present Value (NPV) of a
course of action is the difference between the present value of its benefits
and the present value of its costs. A financial action that has a positive NPV
creates wealth for shareholders and therefore, is desirable. A financial action
resulting in negative NPV destroys shareholders’ wealth and is, therefore
undesirable. Between mutually exclusive projects, the one with the highest NPV
should be adopted. NPVs of a firm’s projects are additive in nature. That is
NPV(A) + NPV(B) = NPV(A+B)
The objective of Shareholders Wealth Maximization
(SWM) considers timing and risk of expected benefits. Benefits are measured in
terms of cash flows. One should understand that in investment and financing
decisions, it is the flow of cash that is important, not the accounting
profits. SWM as an objective of financial management is appropriate and
operationally feasible criterion to choose among the alternative financial
actions.
4.
(a) What do you understand by working capital? Discuss the various sources of
working capital funds. 4+10=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.
Various Sources of Working Capital
Sources of working capital are many. There are both external and
internal sources. The external sources are both short-term and long-term. Trade
credit, commercial banks, finance companies, indigenous bankers, public
deposits, advances from customers, accrual accounts, loans and advances from
directors and group companies etc. are external short-term sources. Companies
can also issue debentures and invite public deposits for working capital which
are external long term sources. Equity funds may also be used for working
capital. A brief discussion of each source is attempted below.
1) Trade credit is
a short term credit facility extended by suppliers of raw materials and other
suppliers. It is a common source. It is an important source. Trade credit is an
informal and readily available credit facility. It is unsecured. It is flexible
too; that is advance retirement or extension of credit period can be
negotiated. Trade credit might be costlier as the supplier may inflate the
price to account for the loss of interest for delayed payment.
2) Commercial banks are the next important source of
working capital finance commercial banking system in the country is broad based
and fairly developed. Straight loans, cash credits, hypothecation loans, pledge
loans, overdrafts and bill purchase and discounting are the principal forms of
working capital finance provided by commercial banks. They provide loan in the following form:
a)
Straight loans are
given with or without security. A onetime lump-sum payment is made, while repayments
may be periodical or one time.
b)
Cash credit is
an arrangement by which the customers (business concerns) are given borrowing
facility upto certain limit, the limit being subjected to examination and
revision year after year. Interest is charged on actual borrowings, though a
commitment charge for utilization may be charged.
c)
Hypothecation advance is
granted on the hypothecation of stock or other asset. It is a secured loan. The
borrower can deal with the goods.
d)
Pledge loans are
made against physical deposit of security in the bank's custody. Here the
borrower cannot deal with the goods until the loan is settled.
e)
Overdraft facility is
given to current account holding customers t^ overdraw the account upto certain
limit. It is a very common form of extending working capital assistance.
f)
Bill financing by
purchasing or discounting bills of exchange is another common form of
financing. Here, the seller of goods on credit draws a bill on the buyer and
the latter accepts the same. The bill is discounted per cash will the banker.
This is a popular form.
3) Finance companies abound in the country. About 50000
companies exist at present. They provide services almost similar to banks,
though not they are banks. They provide need based loans and sometimes arrange
loans from others for customers. Interest rate is higher. But timely assistance
may be obtained.
4) Indigenous bankers also
abound and provide financial assistance to small business and trades. They
change exorbitant rates of interest by very much understanding.
5) Public deposits
are unsecured deposits raised by businesses for periods exceeding a year but
not more than 3 years by manufacturing concerns and not more than 5 years by
non-banking finance companies. The RBI is regulating deposit taking by these
companies in order to protect the depositors. Quantity restriction is placed at
25% of paid up capital + free services for deposits solicited from public is
prescribed for non-banking manufacturing concerns. The rate of interest ceiling
is also fixed. This form of working capital financing is resorted to by well
established companies.
6) Advances
from customers are normally demanded by producers of costly goods at the
time of accepting orders for supply of goods. Contractors might also demand
advance from customers. Where sellers* market prevail advances from customers
may be insisted. In certain cases to ensure performance of contract in advance
may be insisted.
7) Accrual accounts are simply outstanding dues to
workers, suppliers of overhead service requirements and the like. Outstanding
wages, taxes due, dividend provision, etc. are accrual accounts providing
working capital finance for short period on a regular basis.
8) Loans from directors, loans from group companies
etc. constitute another source of working capital. Cash rich companies lend to
liquidity crunch companies of the group.
9) Commercial papers can
be used to raise funds. It is a promissory note carrying the undertaking to
repay the amount on or after a particular date. Normally it is an unsecured
means of borrowing and the companies are allowed to issue commercial papers as
per the regulations issued by SEBI and Company’s Act.
10) Debentures and equity fund can be
issued to finance working capital so that the permanent working capital can be
matchingly financed through long term funds.
Or
(b) Mohan Manufacturing
Co. Ltd. is to start production on 1st Jan, 2021. The prime cost of
a unit is expected to be Rs. 40 out of
which Rs. 16 is for materials and Rs. 24 for labour. In addition, variable
expenses per unit are expected to be Rs. 8 and fixed expenses per month Rs.
30,000. Payment for materials is to be made in the month following the
purchase. One-third of sales will be for cash and the rest on credit for
settlement in the following month. Expenses are payable in the month in which
they are incurred. The selling price is fixed at Rs. 80 per unit. The numbers
of units manufactured and sold are expected to be as under:- 14
|
January February March April May June |
900 1,200 1,800 2,100 2,100 2,400 |
Draw up a statement
showing requirements of working capital from month to month, ignoring the
questions of stocks.
Ans:
Will be available very soon on our Youtube channel
5.
(a) “Capital budgeting is long-term planning for making and financing proposed
capital outlay.” Explain. What are the limitations of capital budgeting? 6+8=14
Ans: Concept of Capital Budgeting: The term
capital budgeting or investment decision means planning for capital assets.
Capital budgeting decision means the decision as to whether or not to invest in
long-term projects such as setting up of a factory or installing a machinery or
creating additional capacities to manufacture a part which at present may be
purchased from outside and so on. It includes the financial analysis of the
various proposals regarding capital expenditure to evaluate their impact on the
financial condition of the company for the purpose to choose the best out of
the various alternatives.
According to Milton “Capital budgeting involves planning of
expenditure for assets and return from them which will be realized in future
time period”.
According to I.M Pandey “Capital budgeting refers to the total
process of generating, evaluating, selecting, and follow up of capital
expenditure alternative”
Capital budgeting decision is thus, evaluation of expenditure
decisions that involve current outlays but are likely to produce benefits over
a period of time longer than one year. The benefit that arises from capital
budgeting decision may be either in the form of increased revenues or reduced
costs. Such decision requires evaluation of the proposed project to forecast
likely or expected return from the project and determine whether return from
the project is adequate.
NEED AND
IMPORTANCE OF CAPITAL BUDGETING
Capital budgeting means planning for capital assets. Capital
budgeting decisions are vital to any organization as they include the decisions
as to:
a)
Whether or not funds should be
invested in long term projects such as setting of an industry, purchase of plant
and machinery etc.
b)
Analyze the proposal for expansion or
creating additional capacities.
c)
To decide the replacement of permanent
assets such as building and equipments.
d)
To make financial analysis of various
proposals regarding capital investments so as to choose the best out of many
alternative proposals.
Limitations of
Capital Budgeting:
Capital budgeting techniques suffer from the following
limitations:
1) The techniques of capital budgeting require
estimation of future cash inflows and outflows. The future is always uncertain
and the data collected for future may not be exact. Obliviously the results
based upon wrong data may not be good.
2) The economic life of the project and annual cash
inflows are only estimation. The actual economic life of the project is either
increased or decreased. Likewise, the actual annual cash inflows may be either
more or less than the estimation. Hence, control over capital
expenditure cannot be exercised.
3) Capital budgeting process does not take into
consideration of various non-financial aspects of the projects while they play
an important role in successful and profitable implementation of them. Hence,
true profitability of the project cannot be highlighted.
4) All the techniques of capital budgeting presume that
various investment proposals under consideration are mutually exclusive which
may not be practically true in some particular circumstances.
5) There are certain factors like morale of the
employees, goodwill of the firm, etc., which cannot be correctly quantified but
which otherwise substantially influence the capital decision.
6) It is also not correct to assume that mathematically
exact techniques always produce highly accurate results.
Or
(b)
(1) What is meant by cost of capital? What are the components of cost of
capital? 3+3=6
Ans:
Meaning
and Definition of Cost of Capital
Cost of capital is the rate of return that a firm must earn on its
project investments to maintain its market value and attract funds. Cost of
capital is the required rate of return on its investments which belongs to
equity, debt and retained earnings. If a firm fail 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
earnings. 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 installments
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
(2)
What is the cost of retained earnings? How is cost of new equity issues
determined? 4+4=8
Ans: Cost
of Retained Earnings: Generally, retained
earnings are considered as cost free source of financing. It is because neither
dividend nor interest is payable on retained profit. However, this statement is
not true. A shareholder of the company that retains more profit expects more
income in future than the shareholders of the company that pay more dividends
and retains less profit. Therefore, there is an opportunity cost of retained
earnings. In other words, retained earnings are not a cost free source of
financing. The cost of retained earning must be at least equal to shareholder’s
rate of return on re-investment of dividend paid by the company.
Determination of Cost
of Retained Earning
In the absence of any
information relating to addition of cost of re-investment and extra burden of
personal tax, the cost of retained earnings is considered to be equal to the
cost of equity. However, the cost of retained earnings differs from the cost of
equity when there is flotation cost to be paid by the shareholders on
re-investment and personal tax rate of shareholders exists.
i) Cost of retained earnings
when there is no flotation cost and personal tax rate applicable for shareholders:
Cost of retained earnings (kr) = Cost of equity (ke) = (D1/NP) +g where,
D1= expected dividend per
share
NP= current selling price or
net proceed
ii) Cost of retained earnings
when there is flotation cost and personal tax rate applicable for shareholders:
Cost of retained earnings (kr) = Cost of equity (ke) x 1-fp)
(1-tp)
Where,
Fp = flotation cost on
re-investment (in fraction) by shareholders
Tp = Shareholders' personal tax
rate.
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 (MM Approach): According to this approach, the total
cost of capital of particular firm is independent of its method and level of
financing. Modigliani and Miller argued that the weighted average cost of
capital of a firm is completely independent of its capital structure. In other
words, a change in the debt equity mix does not affect the cost of capital.
They argued, in support of their approach, that as per the traditional
approach, cost of capital is the weighted average of cost of debt and cost of
equity, etc. The cost of equity, is determined from the level of shareholder's
expectations. That is if, shareholders expect a particular rate of return, say
15 % from a particular company, they do not take into account the debt equity
ratio and they expect 15 % as they find that it covers the particular risk
which this company entails. Thus, the shareholders would now, expect a higher
rate of return from the shares of the company. Thus, each change in the debt
equity mix is automatically set-off by a change in the expectations of the
shareholders from the equity share capital. Modigliani and Miller, thus, argue
that financial leverage has nothing to do with the overall cost of capital and
the overall cost of capital is equal to the capitalisation rate of pure equity
stream of its class of risk. Thus, financial leverage has no impact on share
market prices nor on the cost of capital.
Assumptions:
i)
The capital markets are assumed to be perfect. This means that investors are
free to buy and sell securities.
a)
They are well-informed about the
risk-return on all type of securities.
b)
There are no transaction costs.
c)
They behave rationally.
d)
They can borrow without restrictions
on the same terms as the firms do.
ii) The firms can be
classified into 'homogenous risk class'. They belong to this class, if their
expected earnings have identical risk characteristics.
iii) All investors have the same expectations from a firms' EBIT
that is necessary to evaluate the value of a firm.
iv) The dividend payment ratio is 100 %. i.e. there are no
retained earnings.
v) There are no corporate taxes, but, this assumption has been
removed.
Modigliani and Miller agree
that while companies in different industries face different risks resulting in
their earnings being capitalised at different rates, it is not possible for
these companies to affect their market values, and thus, their overall
capitalisation rate by use of leverage. That is, for a company in a particular
risk class, the total market value must be same irrespective of proportion of
debt in company's capital structure. The support for this hypothesis lies in
the presence of arbitrage in the capital market. They contend that arbitrage
will substitute personal leverage for corporate leverage.
Or
(b)
What do you understand by retained earnings? Discuss the merits and demerits
ploughing back of profits. 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.
Advantages
of Retained Earnings
Retained earnings consist of the following important advantages:
From company
point of view
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. Avoid excessive tax: Retained earnings provide opportunities
for evasion of excessive tax in a
company when it has small number of shareholders.
From shareholders’
point of view
6. 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.
7. Increase earning capacity and high dividend: Retained earnings
consist of least cost of capital and also
it is most suitable to those companies which go for diversification and
expansion. Low cost of capital increases profitability of the company which in
turn results into higher EPS and high dividend payout.
8. Bonus shares to shareholders: A company with high retained
earnings can give bonus shares to existing shareholders.
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.
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