Fundamentals of Financial Management Solved Question Paper 2021 [Gauhati University B.Com 5th Sem CBCS Pattern]

1. (A) Choose the correct option of the following:  1x5=5

1. Which of the following is a part of financial decision-making?

a) Investment decision.

b) Financing decision.

c) Dividend decision.

d) All of the above.

Ans: All of the above

2. Capital budgeting is a part of

a) Investment decision.

b) Working capital management.

c) Capital structure.

d) Dividend decision.

Ans: a) Investment decision.

3. Cost of capital refers to

a) Floatation cost.

b) Dividend.

c) Minimum required rate of return.

d) None of the above.

Ans: c) Minimum required rate of return.

4. The working capital ratio is

a) Working capital/sales.

b) Working capital/total assets.

c) Current assets/current liabilities.

d) Current assets/sales.

Ans: c) Current assets/current liabilities.

5. The long-term objective of financial management is to

a) Maximize earning per share.

b) Maximize the value of the firm’s common stock.

c) Maximize return on investment.

d) Maximize market share.

Ans: b) Maximize the value of the firm’s common stock.

(B) Write whether the following statements are True or False:  1x5=5

1. Profit maximization ignores risk and uncertainty.

Ans: True, Profit maximization ignores risk, uncertainty and time value of money.

2. The value of a share is equal to the present value of its expected future dividend.

Ans: True as per Dividend Discounted model

3. The NPV method does not consider the time value of money.

Ans: False

4. Retained earnings do not involve any cost.

Ans: False

5. Gross working capital means total current assets.

Ans: True

2. Answer the following questions:         2x5=10

a) What is financial management?

Ans: 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.

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.”

b) What is dividend?

Ans: 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.”

c) What is internal rate of return?

Ans: The internal rate of return method is a modern technique of capital budgeting that takes into account the time value of money. It is also known as ‘time adjusted rate of return’ discounted cash flow’ ‘discounted rate of return,’ ‘yield method,’ and ‘trial and error yield method’. In the net present value method, the net present value is determined by discounting the future cash flows of a project at a predetermined or specified rate called the cut-off rate.

d) What is marginal cost?

Ans: Marginal Cost: The term Marginal cost means the additional cost incurred for producing an additional unit of output. It is the addition made to total cost when the output is increased by one unit. Marginal cost of nth unit = Total cost of nth unit- total cost of n-1 unit. E.g. When 100 units are produced, the total cost is Rs. 5000.When the output is increased by one unit, i.e., 101 units, total cost is Rs.5040. Then marginal cost of 101th unit is Rs. 40[5040-5000]

e) What is leverage?

Ans: The term leverage refers to an increased means of accomplishing some purpose. Leverage is used to lifting heavy objects, which may not be otherwise possible. In the financial point of view, leverage refers to furnish the ability to use fixed cost assets or funds to increase the return to its shareholders.

James Horne has defined leverage as, “the employment of an asset or fund for which the firm pays a fixed cost or fixed return.

3. Answer any four from the following questions:            5x4=20

a) Write a brief note on valuation of equity shares.

Ans: COMMON STOCK OR EQUITY SHARE VALUATION

The valuation of common stock or equity shares is relatively difficult as compared to the bonds or preferred stock. The cash flows of the latter are certain because the rate of interest on bonds and the rate of dividend on preference shares are known. The cash flows expected by investors on common stock are uncertain. The earnings and dividends on equity shares are expected to grow. However, we can determine the value of equity shares (1) by developing certain models based on capitalization of dividend, and (2) Capitalization of earnings. Dividend capitalization models are the basic valuation models.

The Basic Valuation and Dividend Capitalization Models

The value of an equity share is a function of cash inflows expected by the investors and the risk associated with the cash inflows. The investor expects to receive dividend while holding the shares and the capital gain on sale of shares. The value of an equity share, in general, is the present value of its future stream of dividends. Now, let us develop this idea in the form of valuation of models.

(a) One-Period Valuation Model: Suppose an investor plans to buy an equity share to hold it for one year and then sell. The value of the share for him will be the present value of expected dividend at the end of one year plus the present value of the expected sale price at the end of the year.

(b) Two-Period Valuation Model

Suppose now that the investor plans to hold the share for two years and then sell it. The value of the share to the investor today would be:

(C) n-Period Valuation Model

Similarly, if the investor plans to hold the share for n years and then sell, the value of the share would be:

If the expected dividend in different periods is (D) constant, we can calculate the value of the share by using annuity discount factor tables, as given below:

DIVIDEND VALUATION MODEL

Dividend valuation model is the generalized form of common stock valuation. The concept of this model is that many investors do not contemplate selling their share in the near future. They want to hold the share for a very long period, say infinity. In their case, the present value of the share is the capitalized value of an infinite stream of future dividends.

Some Variations in the Dividend Valuation Model

(a) No growth case: If a firm has future dividend pattern with on growth or where the dividends remain constant over time, the value of the share shall be the capitalization of perpetual stream of constant dividends:

(b) Constant growth case: It the dividends of a firm are expected to grow at a constant rate forever, the value of the share can be calculated as:

b) Explain various types of dividend.

Ans: 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.

c) What is optimum capital structure? Explain.

Ans: Meaning of Optimum 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:

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.

d) State the advantages and disadvantages of pay-back 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.

c) By stressing earlier cash inflows, liquidity dimension is also considered in selection criteria. This is important in situations of liquidity crunch and high cost of capital.

d) Payback period can be compared to break-even point, the point at which costs are fully recovered but profits are yet to commence.

e) The risk associated with a project arises due to uncertainty associated with cash inflows. A shorter payback period means that uncertainty with respect to project is resolved faster.

Limitations of payback period

a) It stresses capital recovery rather than profitability. It does not take into account returns from the project after its payback period.

b) This method becomes an inadequate measure of evaluating 2 projects where the cash inflows are uneven.

c) This method does not give any consideration to time value of money, cash flows occurring at all points of time are simply added.

d) Post-payback period profitability is ignored totally.

e) Explain the main objective of inventory management.

Ans: Objectives of inventory control and management:

a)       to make available the right type of raw material at the right time in order to have smooth and continuous flow of production;

b)      to ensure effective utilization of material;

c)       to prevent over stocking of materials and consequent locking up of working capital;

d)      to procure appropriate quality of raw materials at reasonable price;

e)      to prevent losses during storage of materials;

f)        to supply information to the management regarding the cost of materials and the availability of stock;

f) Explain the main tools of cash planning and control.

Ans: Tools of Cash Planning and Control:

a) Cash Budget: Cash budget is the most significant device to plan for and control cash receipts and payments. A cash budget is a budget or plan of expected cash receipts and disbursements during the period. These cash inflows and outflows include revenues collected, expenses paid, and loans receipts and payments. In other words, a cash budget is an estimated projection of the company's cash position in the future.

Management usually develops the cash budget after the sales, purchases, and capital expenditures budgets are already made. These budgets need to be made before the cash budget in order to accurately estimate how cash will be affected during the period. For example, management needs to know a sales estimate before it can predict how much cash will be collected during the period. Management uses the cash budget to manage the cash flows of a company. In other words, management must make sure the company has enough cash to pay its bills when they come due.

b) Cash flow statement: A Cash Flow Statement is similar to the Funds Flow Statement, but while preparing funds flow statement all the current assets and current liabilities are taken into consideration. But in a cash flow statement only sources and applications of cash are taken into consideration, even liquid asset like Debtors and Bills Receivables are ignored.

A Cash Flow Statement is a statement, which summarises the resources of cash available to finance the activities of a business enterprise and the uses for which such resources have been used during a particular period of time. Any transaction, which increases the amount of cash, is a source of cash and any transaction, which decreases the amount of cash, is an application of cash. Projected cash flow statement can be prepared to plan and control cash receipts and payments.

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Also Read: Fundamentals of Financial Management Important Questions (GU)

4. Explain the characteristics of financial management. Describe the goals of financial management. 4+6=10

Ans: Nature or Features or Characteristics of Financial Management

Nature of financial management is concerned with its functions, its goals, trade-off with conflicting goals, its indispensability, its systems, its relation with other subsystems in the firm, its environment, its relationship with other disciplines, the procedural aspects and its equation with other divisions within the organisation.

1)      Financial Management is an integral part of overall management. Financial considerations are involved in all business decisions. So financial management is pervasive throughout the organisation.

2)      The central focus of financial management is valuation of the firm. That is financial decisions are directed at increasing/maximization/ optimizing the value of the firm.

3)      Financial management essentially involves risk-return trade-off Decisions on investment involve choosing of types of assets which generate returns accompanied by risks. Generally, higher the risk, returns might be higher and vice versa. So, the financial manager has to decide the level of risk the firm can assume and satisfy with the accompanying return.

4)      Financial management affects the survival, growth and vitality of the firm. Finance is said to be the life blood of business. It is to business; what blood is to us. The amount, type, sources, conditions and cost of finance squarely influence the functioning of the unit.

5)      Finance functions, i.e., investment, rising of capital, distribution of profit, are performed in all firms - business or non-business, big or small, proprietary or corporate undertakings. Yes, financial management is a concern of every concern.

6)      Financial management is a sub-system of the business system which has other subsystems like production, marketing, etc. In systems arrangement financial sub-system is to be well-coordinated with others and other sub-systems well matched with the financial sub­system.

Objectives of Financial Management

The firm’s investment and financing decision are unavoidable and continuous. In order to make them rational, the firm must have a goal. Two financial objectives predominate amongst many objectives. These are:

1. Profit maximization

2. Shareholders’ Wealth Maximization (SWM)

Profit maximization refers to the rupee income while wealth maximization refers to the maximization of the market value of the firm’s shares. Although profit maximization has been traditionally considered as the main objective of the firm, it has faced criticism. Wealth maximization is regarded as operationally and managerially the better objective. 

1. Profit maximization: Profit maximization implies that either a firm produces maximum output for a given input or uses minimum input for a given level of output. Profit maximization causes the efficient allocation of resources in competitive market condition and profit is considered as the most important measure of firm performance. The underlying logic of profit maximization is efficiency.

In a market economy, prices are driven by competitive forces and firms are expected to produce goods and services desired by society as efficiently as possible. Demand for goods and services leads price. Goods and services which are in great demand can command higher prices. This leads to higher profits for the firm. This in turn attracts other firms to produce such goods and services. Competition grows and intensifies leading to a match in demand and supply. Thus, an equilibrium price is reached. On the other hand, goods and services not in demand fetches low price which forces producers to stop producing such goods and services and go for goods and services in demand. This shows that the price system directs the managerial effort towards more profitable goods and services. Competitive forces direct price movement and guides the allocation of resources for various productive activities. 

2. Shareholders’ Wealth Maximization: Shareholders’ wealth maximization means maximizing the net present value of a course of action to shareholders. Net Present Value (NPV) of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action that has a positive NPV creates wealth for shareholders and therefore, is desirable. A financial action resulting in negative NPV destroys shareholders’ wealth and is, therefore undesirable. Between mutually exclusive projects, the one with the highest NPV should be adopted. NPVs of a firm’s projects are additive in nature. That is

NPV(A) + NPV(B) = NPV(A+B)

The objective of Shareholders Wealth Maximization (SWM) considers timing and risk of expected benefits. Benefits are measured in terms of cash flows. One should understand that in investment and financing decisions, it is the flow of cash that is important, not the accounting profits. SWM as an objective of financial management is appropriate and operationally feasible criterion to choose among the alternative financial actions. 

Maximizing the shareholders’ economic welfare is equivalent to maximizing the utility of their consumption over time. The wealth created by a company through its actions is reflected in the market value of the company’s shares. Therefore, this principle implies that the fundamental objective of a firm is to maximize the market value of its shares. The market price, which represents the value of a company’s shares, reflects shareholders’ perception about the quality of the company’s financial decisions. Thus, the market price serves as the company’s performance indicator.

In such a case, the financial manager must know or at least assume the factors that influence the market price of shares. Innumerable factors influence the price of a share and these factors change frequently. Moreover, the factors vary across companies. Thus, it is challenging for the manager to determine these factors. 

Or

Discuss the various factors that affect bond value. Also explain the steps in bond valuation.       5+5=10

Ans:

5. Define capital budgeting. Discuss the capital budgeting process.         2+8=10

Ans: 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”.

Capital Budgeting Process

The important steps involved in the capital budgeting process are:

(1) Project generation,

(2) Project evaluation,

(3) project selection and

(4) project execution.

1. Project Generation. Investment proposals of various types may originate at different levels within a firm. Investment proposals may be either proposals to add new product to the product line or proposals to expand capacity in existing product lines. Secondly, proposals designed to reduce costs in the output of existing products without changing the scale of operations. The investment proposals of any type can originate at any level. In a dynamic and progressive firm there is a continuous flow of profitable investment proposals.

2. Project evaluation. Project evaluation involves two steps: i) estimation of benefits and costs and ii) selection of an appropriate criterion to judge the desirability of the projects. The evaluation of projects should be done by an impartial group. The criterion selected must be consistent with the firm’s objective of maximizing its market value.

3. Project Selection. There is no uniform selection procedure for investment proposals. Since capital budgeting decisions are of crucial importance, the final approval of the projects should rest on top management.

4. Project Execution. After the final selection of investment proposals, funds are earmarked for capital expenditures. Funds for the purpose of project execution should be spent in accordance with appropriations made in the capital budget.

Or

A company has to select one of the two alternative projects whose particulars are given below:

Particulars	Project A (Rs.)	Project B (Rs.)
Initial outlay:	1,18,720	1,00,670
Net cash flow at the end of the year:
1st year	1,00,000	10,000
2nd year	20,000	10,000
3rd year	10,000	20,000
4th year	10,000	1,00,000

The company can arrange necessary fund at 8%. Compute NPV of each project and comment on results.   10 

[The PV factor of Re. 1 received at the end of 1^st year is 0.926, 2^nd year is 0.857, 3^rd year is 0.794 and 4^th year is 0.735]

Ans: I have not solved this practical question yet, but from my past video you can learn how to solve this questions

6. Explain the concept of cost of capital. Also explain the methods for calculating cost of capital.  2+8=10

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 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”.

Methods to Calculate Cost of Capital

The cost of capital is a significant factor in designing the capital structure of an undertaking, as basic reason of running of a business undertaking is to earn return at least equal to the cost of capital. Commercial undertaking has no relevance if, it does not expect to earn its cost of capital. Thus cost of capital constitutes an important factor in various business decisions. For example, in analysing financial implications of capital structure proposals, cost of capital may be taken as the discounting rate. Obviously, if a particular project gives an internal rate of return higher than its cost of capital, it should be an attractive opportunity. Following are the cost of capital acquired from various sources:

1) Cost of debt: The explicit cost of debt is the interest rate as per contract adjusted for tax and the cost of raising debt.

a) Cost of irredeemable debentures: Cost of debentures not redeemable during the life time of the company,

Kd = (I/NP) * (I - T)

Where,

Kd = Cost of debt after tax

I = Annual interest rate

NP = Net proceeds of debentures

T = Tax rate

b) Cost of redeemable debentures: If the debentures are redeemable after the expiry of a fixed period the cost of debentures would be:

Kd = I (1 - t) + {[(RV - NP)]/N} / [(RV + NP)/2]

Where,

I = Annual interest payment

NP = Net proceeds of debentures

RV = Redemption value of debentures

t = tax rate

N = Life of debentures

2) Cost of preference shares: In case of preference shares, the dividend rate can be taken as its cost, as it is this amount that the company intends to pay against the preference shares. As, in case of debt, the issue expenses or discount/premium on issue/redemption is also to be taken into account.

a) Cost of irredeemable preference shares: Cost of irredeemable preference shares = PD/PO

Where,

PD = Annual preference dividend

PO = Net proceeds of an issue of preference shares  

b) Cost of redeemable preference shares: If the preference shares are redeemable after the expiry of a fixed period, the cost of preference shares would be:

Kp = PD + {[(RV - NP)]/N} / [(RV + NP)/2]

Where,

PD = Annual preference dividend

NP = Net proceeds of debentures

RV = Redemption value of debentures

N = Life of debentures

3) Cost of ordinary or equity shares: Calculation of the cost of ordinary shares involves a complex procedure, because unlike debt and preference shares there is no fixed rate of interest or dividend against ordinary shares. Hence, to assign a certain cost to equity share capital is not a question of mere calculation, it requires an understanding of many factors basically concerning the behaviour of investors and their expectations. As, there can be different interpretations of investor's behaviour, there are many approaches regarding calculation of cost of equity shares. The 4 main approaches are:

i) D/P ratio (Dividend/Price) approach: According to this method, the cost of equity capital is the ‘discount rate that equates the present value of expected future dividends per share with the net proceeds of a share. Symbolically:

K_e = D/NP or D/MP

Where,

K_e = Cost of Equity Capital

D = Expected dividend per share

NP = Net proceeds per share

MP = Market Price per share

ii) Earning yield Method/Earning Price ratio: According to this method, the cost of equity capital is the discount rate that equates the present values of expected future earnings per share with the net proceeds of a share. Symbolically:

K_e = EPS/NP or EPS/MP

Where,

K_e = Cost of Equity Capital

EPS = Earnings per share

NP = Net proceeds per share

MP = Market Price per share

iii) D/P + growth approach: The dividend/price + growth approach emphasises what an investor actually expects to receive from his investment in a particular company's ordinary share in terms of dividend plus the rate of growth in dividend/earnings. This growth rate in dividend (g) is taken to be good to the compound growth rate in earnings per share.

Ke = [D1/P0] + g

Where,

Ke = Cost of capital

D1= Dividend for the period 1

P0 = Price for the period 0

g = Growth rate

iv) Realised yield approach: This approach takes into consideration the basic factor of the D/P + g approach but, instead of using the expected values of the dividends and capital appreciation, past yields are used to denote the cost of capital. This approach is based upon the assumption that the past behaviour would be repeated in future and thus, they may be used to measure the cost of ordinary capital.

4) cost of reserves or retained earnings: The cost of retained earnings may be considered as the rate of return which the existing shareholders can obtain by investing the after-tax dividends in alternative opportunity of equal qualities. It is, thus the opportunity cost of dividends foregone by the shareholders. Cost of retained earnings can be computed with the help of following formula:

Kr = [D1/NP] + G  or  [D1/MP] + G

Where,

Kr = Cost of retained earnings

D1= Dividend for the period 1

NP = Net proceeds of shares issued

MP = Market prices of share

g = Growth rate

Or

a) A company plans to issue 1,000 new shares of Rs. 100 each at par. The floatation costs are expected to be 5% of the share price. The company pays a dividend of Rs. 10 per share initially and the growth in dividends is expected to be 5%. Compute the cost of new issue of equity shares.  5

Ans:

b) Distinguish between operating leverage and financial leverage.           5

Ans: Difference between Operating Leverage and Financial Leverage

1)      Operating Leverage results from the existence of fixed operating expenses in the firm’s income stream whereas Financial Leverage results from the presence of fixed financial charges in the firm’s income stream.

2)      Operating Leverage is determined by the relationship between a firm’s sales revenues and its earnings before interest and taxes (EBIT). Financial Leverage is determined by the relationship between a firm’s earnings before interest and tax and after subtracting the interest component.

3)      Operating Leverage = Contribution/EBIT and Financial Leverage = EBIT/EBT

4)      Operational Leverage relates to the Assets side of the Balance Sheet, whereas Financial Leverage relates to the Liability side of the Balance Sheet.

5)      Operational Leverage affects profit before interest and tax, whereas Financial Leverage affects profit after interest and tax.

7. State the meaning of dividend policy. Explain the Modigliani and Miller hypothesis of dividend decision.  2+8=10

Ans: Meaning of Dividend Policy: A policy which determines the amount of earnings to be distributed to the shareholders and the amount to be retained in the company as retained earnings, is called dividend policy. In short, dividend policy determines the division of earnings between payment to shareholders and retained earnings.

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 an 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 an 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

Explain the concept and determinants of working capital.            2+8=10

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.

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.

Determinants of Working Capital

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.

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