[_Bhalotia Classes (9883034569): FM important theory for Hons 2024] 4. Define Financial Management. [B.com 2018 Pass] [10%] Financial management is that managerial activity which is concemed with planning and controlling of the firm’s financial resources. In other words it is concemed with acquiring, financing and managing assets to accomplish the overall goal ofa business enterprise (mainly to maximise the shareholder's wealth), Financial Management comprises of forceasting. planning, organising, directing. coordinating and controlling, of all activities relating to acquisition and application of the financial resources of an undertaking in keeping with its financial objective. Financial Management is concerned with the managerial decisions that result in the acqui short term and long term credits for the firm. Howard and Uptron define Financial Management “as an application of general managerial principles to the area of financial decision-making Weston and Brighem define Financial Management “as an area of financial decision making, harmonizing individual motives and enterprise goal”, ion and financing of 2. Discuss the importance of | Management. [15 P] [30%] ‘Some of the importance of the financial management is as follow (a) Financial Planning: Financial management helps to determine the financial requirement of the business concern and leads to take financial planning of the concem. Financial planning is an important part of the business concem, which helps to promotion ofan enterprise (b) Acquisition of Funds: Financial managsment involves the aequistion of required finance tothe business concern, Acquiring needed funds play a major part of the financial management, which involve possible souree of finanee at minimum cost. (6) Proper Use of Funds: Proper use and allocation of funds leads to improve the operational efficiency of the business concem. When the finanee manager uses the funds properly, they can reduce the cost of capital and increase the value of the (@) Financial Decision: inagement helps to take sound financial decision in the business concern. Financial decision will affect the entire business operation of the concern. Because there is a direct relationship with various department functions such as marketing, production personnel, ete. (©) Improve Profitability: Profitability of the concem purely depends on the effectiveness and proper utilization of funds by the business concem. Financial management helps to improve the profitability position of the concer with the help of strong financial control devices such as budgetary control, ratio analysis and. cost volume profit analys (® Increase the Value of the Firm: {agement is very important inthe field ofnereasing the wealth ofthe investors and the business concer. Uitimate aim of any business concern will achieve the maximum profit and higher profitability leads to maximize the wealth ofthe investors as wel a the nation (g) Promoting Savings: Savings are possible only when the business concer earns higher profitability and maximizing wealth, Effective financial management helps to promoting and mobilizing individual and corporate savings anci mn, ancial n FinancialBhalotia Classes (9883034569): FM important theory for Hons 2024 3. What are the functions of Financial Management/Financial Manager? [2014 H, 2016 H] [BHALOTIA] [97%]******* Function of financial management means functional activities that an enterprise undertakes in achieving its desired objectives. These fimetions may be classified on the basis of its operational activities, 1. Purchase Function In this fimetion Finance Manager plays a key role in providing finance. In order to minimize cost and exercise ‘maximum control, various material management technique: sonomie order quantity (EOQ), determination of stock level, perpetual inventory system ete. are applied. The task of the Finance Manager is to arrange the availability of cash when the bills for purchase become dut. such as 2. Production Function Production function involves heavy investment in fixed assets and in working capital. Naturally, a tighter control by the Finance Manager on the investment in product neither over-capitalisation nor under-capitalisation, sary. It must be seen that there is 3 ribution Function ‘The objective of distribution function is making available the goods to the end customer, As every aspect of distributor function involves cash outflow and every distributing activity is aimed at bringing about inflow of cash both the functions are closely inter-related and henee should be carried out in close union. 4. Accounting Function ‘The efficiency of the whole organization.can.be greatly improved with correct recording of financial data, All the accounting tools and control devices, necessary for appraisal of finance poliey ean be correctly formulated if the accounting data areipropetly recorded. 5, Human ree Function A sound HR poliey ificludes propef wage striéiure-fiiceffives schemes, promotional opportunity, human resource developimerit and other fringe bereits provided f6.the eftploy¥8s. All these matters affect finance, But the finance manager should KGW that organization can afford Yopa only’Wwhat it can bear. It means that expenditure incurred on HR Managentent and the expected return on such investifient through labour productivity should be considered in framing a sound HR polieyiiherefore, the relation between the finance and HR department should be intimate, 6. Research and Development Function In the world of innovations a constant endeavour for improvement and sophistication of an existing product and introduction of newer varieties, the firm is bound to be gradually out marketed and out of existenc - 2~Admission Going on for B.com, M.com, CA, CMA, CS XI, XII. Contact.4. The activities of financial managers involve taking three important decisions. Briefly explain these decisions? [60%] OR Describe the three broad areas of financial deci [2018 Hons] [60%] OR the inter-relationship between finan: investment de: ‘Value of a firm will depend on various finance finetions decisions. It decisions, namely L.Investment Decision: Those d different sources have to be invested in various kinds of assets. Long term funds are used in a projeet for various fixed assets and also for current assets, The investment of funds in a project has to be made after carefil assessment of the various projects through capital budgeting. A part of long term funds is also to be kept for financing the Working capital requirements. Asset management policies are to be laid down regarding various items of eurrent 9 deci ion and dividend decision. [2022 H] [60%] in be broadly classified into three major jons relate to the selection of assets in which funds will be invested by a firm. Funds procured from assets. The inventory poliey would be determined by the production manager and the finance manager keeping in view the requirement of production and the future price estimates of raw materials and the availability of funds. ‘ing Deci ese decisions relate to acquifing the optimum finance to meet financial objectives and seeing that fixed and working capital areeffeetively managed. The financial manager needs to possess a good knowledge of the sources of available funds and their respective COsts and tleeds fo ensure that the company has a sound capital structure, i. clear understanding as to the difference between profit and cash flow, bearing in mind that profit is of little avail unless the organisation is 4 proper balance between equity capital and debt, Such managers also need to have a v jons also call adequately supported by cash to pay for assets and sustain the working capital cyele. Financing deci for a good knowledge of evaluation of risk:e.g. excessive debt éarried high risk for an organization's equity because hts of the lenders, of the priority ividend decision thus has two elements ~ the amount to be paid out and the amount to be: ctained to support the growth of the organisation, the latter being also a financing decision: the level and regular growth of dividends csent a significant factor in determining a profit-making company’s by the market value, ic. the value placed on its jock market. All three types of decisions are interrelated, the first two pertaining to any kind of organisation while the third relates only to profit-making organisations, thus it can be seen that financial management is of vital importance at every level of business activity, rom a sole trader to the largest multinational corporation.5. What are the objectives of financial Management? [2017] [20%] Efficient financial management requires the existence of some objectives or goals because judgment as to whether cr nota financial decision is efficient must be made in the light of seme objective. Although Various objectives are possible but we assume two objectives of financial management for elaborate discussion. These are 4. Profit Maximisation It has traditionally been argued that the primary objective of a company is to earn profit; hence the objective of financial management is also profit maximisation. ‘This implies thatthe finance manager has to make his decisions in a manner so that the profits of the concern are maximised, Each altemative, therefore, isto be seen as to whether oF not it gives maximum profit Limitations of ‘Maximisation of Profit’ as the objective of the firm. However, profit maximisation cannot be the sole objective of a company. Itis at best a limited objective. If profit is given undue importance, a number of problems can arise, Some of these have been discussed below (a) The term profit is vague It does not clarify what exactly it means (b) Profit maximisation has to be attempted with a realisation of risks involved (©) Profit maximisation as an objective does not take into account the time pattem of returns (@) Profit maximisation as an objective is too narrow Arguments in favour of Profit Maximization (a) When profit eaming is the main aim of business the ultimate objective should be profit maximization (b) Future is uncertain. A firm should cam more and more profit to meet the future contingencies. (6) The main source of finance for growth of a business is profit. Hence, profit maximization is required. (@) Profit maximization is justified on the grounds of rationality as profits act as a measure of efficieney and conomic prosperity Arguments against Pr: ization (a) It leads to exploitation of workers and consumers. (©) It Ignores the risk factors associated with profit (c) Profit in itself a vague concept and means differently to different people. (@) Itisnarrow concept atthe eost of social and moral obligations ‘Thus, profit maximization as an objective of Financial Management has been considered inadequate. 2. Wealth / Value Maximisation I will first like to define what is Wealth / Value Maximization Model. Shareholders wealth are the result of cost benefit analysis adjusted with their timing and risk i.e. time value of money So, Wealth = Present value of benefits ~ Present Value of Costs Itis important that benefits measured by the finance manager are in terms of cash flow. Finance manager should emphasis on Cash flow for investment or financing decisions not on Accounting profit. The shareholder value ‘maximization model holds that the primary goal of the firm is to maximize its market value and implies that business decisions should seck to increase the net present value of the economic profits of the firm. So for measuring and ‘maximising shareholders wealth finance manager should follow. (a) Cash Flow approach not Accounting Profit () Cost benefit analysis (©) Application of time value of money.Arguments in favour of Wealth Maximization (a Due to wealth maximization, the short term money lenders get their payments in time. (b) The long time lenders too get a fixed rate of interest on their investments (©) The employees share in the wealth gets increased. (The various resources are put to economical and efficient use. Argument against Wealth Maximization (a) Itis socially undesirable, (b) _Itisnot a deseriptive idea (©) Only stock holders wealth maximization does not lead to firm’s wealth maximization, (&) The objective of wealth maximization is endangered when ownership and management are separated. 6. Distinguish Between Profit maximization & wealth n [BHALOTIA] [9883034569/9330960172] [67%] Profit Maximisation ‘Wealth Maximisation Itis traditional approach of the financial management. It is modem approach of the financial ‘management According to this eriterion, the financial activities of a firm, are conducted in such a way so that the amount of profit of the firm is maximum, According to this criterion, the financial activities of a firm are conducted in such a ‘way so that the net wealth of the firm is ‘maximum, Tho concept of profit is not clear in the profit maximisation criterion ‘The concept of wealth is clear in the wealth maximisation criterion, In this ease wealth refers to the net present value of a project. The aspects of risk and uncertainty are ignored in profit maximisation criterion, The aspects of risk and uncertainty are lered in wealth maximisation criterion, In this case, itis not necessary to know the rate of discount {or determining the profit. case, itis necessary to know the rate of discount for determining the net wealth, Time value of money is not considered in this etiterion, It measures the performance of a business firm only on the basis ofits profit Tt measures the performance of a business firm on the basis of the shareholders’ wealth (or the current market price of the equity It is based on the assumption of perfect competition in the product market Itassumes an efficient capital market, 1 does not also consider the impacts of earnings per share, dividend payments and other retums to the shareholders on shareholder's Wealth or on the value of the firm, It takes into account the present value of the future cash inflows, dividend payments, camings per share and their ifluenee on shareholders” Wealth A firm may not pay regular dividends to its shareholders and reinvest its retained earning to achieve this goal ‘A firm pays regular dividends to its shareholders to achieve this goalBhalotia Classes (9883034569): FM important theory for Hons 2024 7. Why value maximisation (wealth maximisation) objective is called better than profit maximisation objectives? [2017 H, 2024H] [BHALOTIA] [9883034569/9330960172] [98%]****** Although Profit and Wealth Maximization sound pretty similar, there are some major differences between them While profit maximization aims at increasing the profit of firm, wealth maximization has a larger role to play and it deals with the wellbeing of the stakeholders as a whole, Profit and wealth maximization deal in different subjects and hence they are defined differently, Profit maximization refers to the management of a firm's resources and utilities to maximize pro On the other hand, wealth maximization refers to managing the financial and managerial resources for the wellbeing of the stakeholder community as a whole, However wealth maximisation objective is held to be superior to the profit maximisation objective, because of the following reasons: (a) Wealth maximization plays a larger role in busi than profit maximization (b) The main focus of profit maximization is on increasing the profit of the company while wealth maximization deals in raising the value of stakeholders in the company. The profit maximization theory is centered around the profit motive while wealth maximization looks at the wellbei 12 of all stakeholders. (©) ‘The risk and its effects on financials ofthe company are a core part ofthe wealth maximization process, while there is no focus on risk in the profitmaximization theory. Therefore, in practice, profit maximization is not a complete theoryinfifS€IPWhile wealth maximization is much more cohesive and inclusive in nature. (@ Profit inaimniZAtIOn is actually @oncepf that is basieaily related to day-to-day business profits, Wealth maxiniiZation i’ mor the inreased pir complex prétesSf increase the overall wealth of the company that is reflected in c of sires the markt (©) Profit WARZAtion does not covethe ri&k.ABtors sociated with finance and operations but wealth maximization 08, (O Profit maximization GWTBlder theory. and hence it lacks the modem approaches towards business and profitability. Wealth maximization isa new concept that deals with a larger subject area and includes as many factors as possible. Therefore, wealth maximization is a better approach than pr maximization, (@) Profit maximization was a very relevant theory during the early 19th century, while the wealth maximization concept is a newer concept in business. So, wealth maximization is more complex and inclusive in practice in general (h) Profit maximization is a theory of the past, while wealth maximization is a modem theory - 6-Admission Going on for B.com, M.com, CA, CMA, CS XI, XII. Contact.8. Specify the limitations of ‘Maximisation of Profit’ as the objective of the firm. [2016 H, 2020H old, 2023 H] [1%] As the term suggests, Profit Maximization is a philosophy to maximize the profits from a business concern. In the free economy, there is always profitability if the goods and/or services are good. So, firms selling good products, and services increase the prices of goods to generate more revenues and profits, After the market competition for such service providers, however, a point is reached where the maximum profit halts. This is the point of profit ‘maximization, Profit maximization was considered an ideal concept in the early 1900s when businesses were owned by one person ‘who usually paid for everything and asked all the staff to work so that the firms could eam as much as possible, ‘The structure of the firms allowed the owners to do so Profit maximization may seem to be a good idea but it does not fit the modem ideas of entrepreneurship and doing business. Li Profit maximization is criticized for some of its limitations which are discussed below: 1. The haziness of the concept “profit” ‘The term “Profit” is a vague term, Itis because different mindset will have a different perception of profit, For e.g. profits can be the net profit, gross profit, before tax profit, or the rate of profit ete. There iso clearly defined profit ‘maximization rule about the profits 2. Ignores time value of money ‘The profit maximization formula simply suggests “higher the profit better is the proposal”. In essence, it is considering the naked profits without considering the timing of them. Another important dictum of finance says “a dollar today is not equal fo a dollar a_year lat the time value of money is completely ignored. 3. Tgnores the risk A decision solely based on profit maximization model would take a decision in favor of profits. In the pursuit of profi Ge the risk involved is ignored which may prove unaffordable at times simply because higher risks directly jons the survival of a business. A. Ignores quality ‘The most problematic aspect of profit maximization that it ignores the intangible benefits such as quality, image, 1 nts ete. The contribution of intangible asset business is not worth ignoring, They indirectly create assets for the organization. in objectiv in generating value for a hnological advanc Profit maximization ruled the traditional business mindset which has gone through drastic changes. In the modern approach of business and financial management, much higher importance is assigned to wealth maximization in comparison of Profit Maximization vs. Wealth Maximization. The losing importance of profit maximization is not baseless and it is not only because it ignores certain important areas such as risk, quality, and the time value of money but also because of the superiority of wealth maximization as an objective of the business or financial management,9. Discuss the Role of Chief financial officer (CFO) [2021 P] [1%] ‘The role of the CFO (Chief Financial Officer) has been changing over the past twenty years. Originally, the role of the CFO revolved around producing and analyzing the financial statements. However, because of the computerization of the accounting fimetion the need foraccounting skills in performing the roles and responsibilities of a CFO diminished. Though the job description of a CFO (Chief Financial Officer) remains broad the tasks comprising that function fall into four distinet roles, the Strategist CKO ‘The first role of the CFO is to be a strategist to the CEO. The traditional definition of success for a chief financial officer was reporting the numbers, managing the financial function, and being reactive to events as they unfold. But in today’s fast paced business environment, producing financial reports and information is no longer enough CFO's in the twenty-first century must be able to “peak around comers”, Therefore, they must be able to apply citical thinking skills, along with financial acumen, to the long term goals of the organization 2. ‘The CFO asa Leader ‘The second role of the CFO hand in hand with the first one, That is one of a leader implementing the strategies of the company. As. result, it is no longer sufficient for a CFO to sit back and analyze the effort of others. The chief financial officer (CFO) of today must fake ownership of the financial results of both the organization and senior ‘management team. ‘The chief financial officer of today must be responsible for providing leadership to other senior management team members, including the CEO. The CFO’s role can sometimes force them to make the tough calls that others in the organization don’t or can’t make, Occasionally, this can mean the difference between success and failure 3. The CFO 3 ‘The third role of the CFOs that ofa team leader to other employees ~ both inside and outside of the financial fanetion. Not only will a coach call plays fora team. but they are also responsible for getting the highest results out of the talent on their team, An aspiring and successful coach will produce superior results by finding the strengths of their team members and obtaining a higher level of performance than the individuals might achieve on their own. The role of the CFO (Chief Financial Officer) is to bring together a diverse group of talented individuals to achieve superior financial performance. a Team Leader 4. The CEO with Third Parties Last, but not least, the role of the CFO is that of diplomat to third parties. People outside of the company look to senior management team for inspiration and confidence in the company’s ability to perform. In almost every ease the financial viability of the company is vouched for by the CFO ‘The CFO's role becomes that of the “face” of the company’s sustainability to customers, vendors and bankers. Often these third parties look to the CFO for the unvamished truth regarding the financial viability of the company to deliver on it’s brand promise ‘Today's Role of the CKO In today’s fast paced environment the role of the CFO is extremely fluid. One day the CFO might be developing 4 compensation plan for employees. Then the next day taking their bankers on a tour of the facilities. Consequently to be a successful CFO in the future you must be a more multi-functional executive with financial skills.Bhalotia Classes (9883034569): FM important theory for Hons 2024 10. Discuss the basic components of the financial environment under which a firm has to operate. [2015 H] [RKB] [99%]******* Definition of financial environment, Financial environment of a company refers to all the financial institutions and financial market around the company that affects the working of the company as a whole. A financial environment is a part of an economy with the major players being firms, investors, and markets, Essentially, this sector can represent a large part of a well-developed economy as individuals who retain private property have the ability to grow their capital. Firms are any business that offer goods or services to consumers. Investors are individuals or businesses that place capital into businesses for financial returns, Markets represent the fi fonment that makes this all possible. ieial en The financial environment has a number of factors, It includes the financial institutions, government, individuals and firms around the business. Firms use their financial markets to keep their savings as property. It is extremely important for the monetary markets Components of financial environment ‘The financial environment is composed of three key components: (1) financial managers, (2) financial markets, and (3) investors (including creditors). (1) Financial Managers Financial managers are responsible for deciding how to invest a company’s funds to expand its business and how to obtain funds (financing). The actions taken by financial managers to make financial decisions for their respective firms are referred.tovastfinanciat-menagement (or managerial finance). Financial managers are expected to make finanéialld8eisions that will maximize the firm’s value and therefore maximize the value of the firm’s stock pfFiGBl TREY are usually-compensat&@in a manner that encourages them to achieve this, objective (2) The Financial M Financial markets represent plac®!- mare hat Facilitat® the How of financial markets investors and borrowers trade fiflanéial sedtrities, commodities and other fungible items at a price determined by demand and supply. Financial market® are typically defined by having transparent pricing, basic regulations on trading, €osts and fees and market forces determining the prices of securities that trade, Hence, financial markets refer to an Organized institutional structure or mechanism for creating and exchanging, financial assets, An important component of these financial markets is financial institutions that act as intermediaries. Financial markets can be a) Capital markets b) Money market ds among investors and borrowers. In 3) Investors are individuals or financial institutions that provide funds to firms, government agenci who need funds. In this book, our focus regarding investors is on their provision of funds to firms. Individual investors commonly provide funds to firms by purchasing their securities (stocks and debt securities). The financial institutions that provide funds are referred to as institutional investors, Some of these institutions focus on providing loans, whereas others commonly purchase securities that are issued by firms, or individuals - 9~Admission Going on for B.com, M.com, CA, CMA, CS XI, XII. Contact.44. What do you mean by time value of money? What are its reasons? [2021H] [BHALOTIA] [9883034569] [80%] ¢ value of money (TVM) Money has time value. In simpler terms, the value of a certain amount of money today is more valuable than its value tomorrow. It is not because of the uncertainty involved with time but purely on account of timing. The difference in the value of money today and tomorrow is referred to as the time value of money. The term time value of money can be defined as “The value derived from the use of money over time as a result of investment and reinvestment. The time value of money (TVM) is one of the basic concepts of finance. We know that if we deposit money in a bank account, we will receive interest. Because of this. we prefer to receive money today rather than the same amount in the future. Money, we receive today is more valuable to us than money ri amount of interest we can eam with the money. This is referred to as the time value of money. ved in the future by the Reasons of ¢ value of money (TVM) The reason why there is time value of money is as follows 1, Risk and Uncertainty Future is always uncertain and risky. Outflow of cash is in our control as payments fo parties are made by us. ‘There is no certainty for future cash inflows. Cash inflows are dependent on our Creditor, Bank ot individual or As an im is not certai bout future cash receipts, it prefers receiving cash now. 2. Inflation: In an inflationary economy. the money feeeived foday, has more purcha: ng power than the money to be received in future. In other words, a rupee today represents a greatér real purchasing power than a rupee a year after. 3. Consumption: Individuals generally prefer current consumption fo future consumption 4. Investment opportunities: ‘An investor can profitably employ @ rupee reveived today, to give him a higher value to be received tomorrow or after a certain period of time. Thus, the fundamental principle behind the concept of time value of money is that, a sum of money received today, is worth more than if the same is received after a certain period of time For example, if an individual is given an alternative either to receive Rs.10,000 now or after one year, he will prefer Rs, 10,000 now. This is because, today, he may’be in @ position to purchase more goods with this money than what he is going to get for the same amount afler one year12. Explain the significance of time value of money (TVM) in financial decision making. [2022 H] [BHALOTIA] [70%] Since the money is worth more now than the same money in the future, TVM is therefore important for financial management. You can always use the funds to make an investment and receive interest. Following are the significance of time value of money (TVM) in financial decision making 1. Opportunity costs_& Time value of money Opportunity costs exist wherever options are available, Opportunity costs are, therefore, the benefit or interest that one forgoes when one prefers one investment over another, Or, to put it simply, opportunity costs are the next best available and preferred investment, Therefore, when deciding on an investment, one should consider its opportunity costs. Opportunity costs are a TVM concept and help in decision-making 2. Capital Budgeting And Time Value of Money TVM is very useful in capital budgeting as it helps management get an idea of their cash flows. In capital budgeting, we discount the future cash flows to their present value to determine whether the project is worthy of investment or not. When a company plans to make investments, for example, in machinery, to take over another company, etc, it ‘wants to get an idea of whether that investment will pay off or not, Or companies need to know whether the cash flows from the investment are sufficient to recoup at least the initial outlay. The TVM helps a business in deciding and analyzing this aspect with the use of a discount rate 3. Finance Decisions And Time Value of Money ‘The importance of the timé value of money is not only for corporate decision-making but also on a personal level. Knowing the TVM eoncept will help you see:the financial impact of every financial decision we make. It ‘would help you plan our financial goals afd help us to meet financial challenges. It would also help us to compare and evaluate two or more investment options, 4. Investing and Time Value of Money Because of inflation, prices will rise over time. And the value of the available money will decrease over time. Therefore, the money you have is worth more today than‘in the future, Therefore, itis very important that you invest the money instead of Keeping it in yourself or in a normal bank account, And the TVM helps you make the better investment decision based of the following factors: (a) Inflation It is the continuous rise of the price level. The money in your pocket has more purchasing power foday than in five years after that. Therefore, an appropriate investment can only maintain or increase the value of your money over time. (b) Risk ~the future is uncertain so you may lose some or all of your money in the future, but you ean reduce your risk by investing it right now. (©) Investment Opportunity ~ There are many ways and options in which you can invest your money However, you lose the opportunity if you wait to invest your money Any delay will lose the value of13. Explain the compounding & discounting technique in relation to time value of money? [BHALOTIA] [9883034569] [40%] Time Value of Money says that the worth of a unit of money is going to be changed in future. Put simply, the value of one rupee today will be decreased in future. value of money. There are two methods used for ascertaining the worth of money at different points of time, namely, compounding and discounting. Compounding method is used to know the future value of present money, Conversely, discounting is a way to compute the present value of future money. The whole concept is about the present value and future Compounding is helpful to know the future values, of the cash flow, at the end of the particular period, at a definite rate, Contrary to this, Discounting is used to determine the present value of the future cash flow, at a certain interest rate, Here, inthis article, we've described the differences between compounding and discounting. Techniques of compounding The "time value of money” deseribes the effects of compounding, An amount invested today has more value than the same amount invested at a later date because it can utilize the power of compounding, Compounding is the process by which interest is earned on interest. When a principal amount is invested, interest is earned on the principal during the first period or year. In the second period or year, interest is earned on the original principal plus the interest eamed in the first period. Over time, this reinvestment process can help an account grow significantly Technique of discounting: The present value of a sum of money to be received at a future date is determined by discounting the future value at the interest rate that the moftey could earn over the period. This process is known as Discounting. The present value interest factor declines as the interest rate rises and as the length of time increases Difference between compounding & Discounting: BASIS FOR comPareon COMPOUNDING DISCOUNTING Meaning The method used to determine the | The method used to determine the future value of present investment is _| present value of future cash flows is known as Compounding known as Discounting, [Concept If we invest some money today, what_| What should be the amount we will be the amount we get at afuture | need to invest today, to get a specific date, amount in future. [Use of Compound interest rate. Discount rate known Present Value Future Value Factor Future Value Factor or Compounding _| Present Value Factor or Discounting Factor Factor [Formula FV=PV (tee PV=FV/(1 +0)"14, Briefly explain how the risk-return trade off play a significant role in the financial decision making. [2022 H] [RKB] [50%] OR Discuss the relationship between Risk and Return. [2024H old] The risk and retum constitute the framework for taking investment decision. It has generally been found that there is a direct relationship between risk and return. An investment proposal involving low risk has low return while a proposal involving higher risk has higher return. risk-return relationship model RELATIVE lek COMFORT ZONE High Risk | Low Risk | High Risk | Low Risk Low Retum | Low Retum | High Retum | High Return x g e ~~ 4 é le é SpE ze : tow HIGH RETURN > Following is the main type of relationship of risk and retum, 1. Direct Relationship between Risk and Return (4) High Risk High Return According to this type of relationship, if investor will take more risk, he will get more reward. So, he invested million, it means his risk of loss is million dotlar (B) Low Risk - Low Return Itis also direct relationship between risk and return. If investor decreases investment. It means, he is decreasing his risk of loss, at that time, his return will also decrease. 2. Negative Relationship between Risk and Return (A) High Risk Low Return : Sometime, investor increases investment amount for getting high return but with increasing return, he faces low retum because it is nature of that project. There is no benefit to increase investment in such project. Suppose. there are 1,00,000 lotteries in which you will earn the prize of You have bought 50% of total lotteries. But, if you buy 75% of lotteries. Prize will same but at increasing of risk, your ret (B) Low Risk High Return ‘There are some projects, if you invest low amount, you ean eam high return, For example, Govt, of India need money, Because, govt, needs this money in emergency and Govt. is giving high return on small investment, If you get this opportunity and invest your money, you will get high return on your small risk of loss of money. n will decrease,Unit 2: Sources of Capital & Cost of Capital: [Optional theory or No theory] 45. What are the various sources of long term finance of limited company? Explain merits and demerits of any three of them. [2013 Pass] [BHALOTIA] [9883034569] [10%] ss of Long-term Finance of a Business ‘Soure (A) Share capital or Equity share (B) Preference shares (©) Retained earnings (D) Debentures’Bonds of different types (E) Loans from financial institutions {A) Share capital or Equity share Equity Share Capital is a basic source of nance for any hip interest in the company ‘The characteristics of equity Share Capital are a dir n in the company’s control, income and assets. Equity Share Capital does not have any maturity and the The Equi is no compulsion to pay dividend, Share Capital provides funds, more or less, on a permanent basis. IL also works as a base for creating the debt and loan capacity of the firm. The advantages and limitations of Equity Share Capital may be summarized as follows Advantages of Equity Share Financ (a) Iisa permanent souree of funds (b) The new Equity Share Capital increases the corporate flexibility for the point of view of capital structure planning, (©) Equity Share Capital does not involve any mandatory payments to shareholders. (@) It may be possible to make further issue of share capital by usin shares involves no change in the relationship between ownership and control. Limitations of Equity Share Financing: a right offering. In general, selling right (a) Cost of capital is the highest of all sources. (b) Equity Share Capital has @ burden of Corporate Dividend Tax on the company (©) New issue of Equity Capital may reduce the EPS. {B) Preference shares The Preference Share Capital is also owner's capital but has a maturity period. In India, the preference shares must be redeemed within a maximum period of 20 years from the date of issue. The rate of dividend payable on preference shares is also fixed. As against the equity share capital, the preference shares have two references: (i) Preference with respect to payment of div Advantages (a) The preference shares carry limited voting right though they are a part of the capital, (b) The cost of capital of preference shares is less than that of equity shares. (©) The preferens (@ A company does not face liquidation or other legal proceedings if it fails to pay the preference dividends share financing may also provide a hedge against inflation.Disadvantages (a) The cost of capital of preference shares is higher than cost of debt, (b) Non-payment of dividend may adversely affect the value of the firm (©) The compulsory redemption of preference shares after 20 years will entail a substantial cash outflow from the company {C) Retained earninas Long-term funds may also be provided by accumulating the profits of the company and by ploughing them back into business. Such funds belong to the ordinary shareholders and inerease the net worth of the company. A public limited company must plough back a reasonable amount of profit every year keeping in view the legal requirements in this regard and its own expansion plans. Such funds also entail almost no risk. Further, control of present owners is also not diluted by retaining profits (0) Debentures or Bonds: As compared with preference shares, debentures provide a more convenient mode of long-term funds. The cost of capital raised through debentures is quite low since the interest payable on debentures ean be charged as an expense before tax. From the investors’ point of view, debentures offer a more attractive prospect than the preference shares since interest on debentures is payable whether or not the company makes profits. Advantages (a) The cost of debentures is much lower than the cost of preference or equity capital as the interest is tax- deductible, Also, investors consider debenture investment safer than equity or preferred investment and, hence, may require a lower return on debenture investment, (b) Debenture financing does not result in ditution of control (©) In a period of rising prices, debenture issue is advantageous. The fixed monetary outgo decrease terms as the prige level increases. Disadvantages (a) Debenture interest and capital repayment are obligatory payments, (b) ‘The protective covenants associated with a debenture issue may be restrictive. (e) Debenture financing enhanees the financial risk associated with the firm. (@) Since debentures need to be paid during maturity, a large amount of cash outflow is needed at that time. in real In India specialised institutions provide long- term financial assistance to industry. Thus, the Industrial Finance Corporation of India, the State Financial Corporations, the Life Insurance Corporation of India, the National Stnall Industries Corporation Limited, the Industrial Credit and Investment Corporation, the Industrial Development Bank of India, and the Industrial Reconstruction Corporation of India provide term loans to companies.46. What are the various sources of short term finance of limited company? Discuss [BHALOTIA] [9883034569] [20%] Sources of Short-term Finance ofa Business (A) Trade. It represents credit granted by suppliers of goods, etc, as an incident of sale, The usual duration of such ereit is 15 to 90 days. It generates automatically in the course of business and is common to almost all business. operations, It can be in the form of an ‘open account’ or ‘bills payable’. Trade credit is preferred as a source of finance because itis without any explicit cost and fill a business i a going concer it keeps on rotating, Another very important characteristic of trade red is that it enhances automatically with the increase inthe volume of mF (B) Accrued Expenses and Deferred Income: Acerued expenses represent liabilities which a company has fo pay for the services which it has already received Such expenses arise out of the day to day activities of the company finance. Deferred income, on the other hand, reflects the amount of funds received by a company in lieu of goods and services to be provided in the future. Since these receipts increase a company’s liquidity, they are also considered to be an important source of spontaneous finance. and hence represent a spontaneous source of © Ady Manufacturers and contractors engaged in producing or constructing costly goods involving considerable length of manufacturing or construction time usually demand advance mon ces from Customer from their customers at the time of iheir orders for executing their contracts or supplying the goods. This is a cost free source of finance and really useful accepti () Gommereial Paper: A Commercial Paper is an unsecured money market instrument issued in the form of @ promissory note. The Reserve Bank of India introduced the commercial paper Scheme in the year 1989 with a view to enabling highly rated corporate borrowers to diversifY their sourees of short term borrowings and to provide an additional instrument fo investors, Subsequently, in addition to the Corporate, Primary Dealers and All India Financial Institutions have also been allowed to issue Commercial Pape® Commercial Papers can be issued for maturities between 15 days and a maximum up to-one year from the date of issue. These can be issued in denominations of Rs 5 lakh or multiples thereof. All eligible issuers are required to get the credit rating. (£) Bank Advances: Bank advances are in the form of loan, overdraft, cash eredit and bills purchased/discounted ete. Banks do not sanetion advances on a long term basis beyond a small proportion of their demand and time liabilit are granted against tangible securities such as goods, shares, government promissory notes, Bills ete. In very rare cases, clean advances may also be allowed. es. Advances17. What is the weighted average cost of capital? What weights do you take into consideration for computation of weighted average cost of capital? Which of them do you recommend most? Why? [BHALOTIA] [9883034569] [20%] The weighted Average Cost of Capital can be computed by using the “Book Value” or the “Market value” as weights. If there is a difference between market value and book value weights, the weighted average cost of capital would also differ, The market value weighted average cost is usually higher than it would be if the book value is used Merits and Demerits of market value weights: The Market values weights are sometimes preferred to the book value weights due to following reasons 4. Market value represents the true expectations of the investors as they presumably reflect economic values, Market value weights are not influenced by the arbitrary accounting policy of the firm. It considers price level changes and, therefore, reflects current cost of capital. Because of this market, value weights for calculating the cost of capital is theoretically more appealing But it suffers from the following limitations: a. Market value weights are operationally inconvenient as market values undergo frequent fluctuations, This will affect the overall cost of capital and, in tur decision eriterion for investment, b. Market values of all sources of capital are not readily available ©. Use of market values tends to shift @ greater importance towards the larger amounts of equity funds, particularly when additional financing is undertaken d. When the shares are not listed in any stock exchange, the use of market value weights is impossible. of market value and book value wei Due to above limitations, it is desirable to use the book value weights. This method has the following advantages: a Book value weights are easily or readily available from published accounts. b. The capital structure targets are usually set in terms of book values. c. To evaluate the riskiness of the company. the book value debt-equity ratios are analyzed by the investors. 4. It is easier to evaluate the performance of a financial manager in producing funds comparing on the basis of book values ©. When the shares of the company are not listed in any stock exchange the use of book value weights is the only alternative. However, the book value weights system suffers from the following limitations: a. It does not truly reflect the econom b. Book values weights may be based on arbitrary accoun carnings and value of assets, ©. The book value weights system is not consistent with the definition of the overall cost of capital, which is defined as the minimum rate of return required to maintain the company’s market value. 4. Theoretically, itis very difficult to justify the use of book value weights. Selection of appropriate weights by using both the alternatives - book value and market values is an important aspect to calculate weighted average cost of capital. Both have their own commendable features. Market value weights are operationally inconvenient as compared to book value weights. However, market values weights are theoretically consistent and sound, and therefore a better indicator of firm’s cost of capital, provided market value of various sources of capital are readily available and they seems to be stable, policies followed to caleulate retainedBhalotia Classes (9883034569): FM important theory for Hons 2024 Unit 3: Leverage & Capital structure theories [10 marks Optional theory] 48. What do you mean by capital structure? Discuss the pattern of capital structure. [BHALOTIA] [9883034569] [1%] A firm needs funds for long term requirements and working capital. These funds are raised through different sources both short term and long term. The long term funds required by a firm are mobilized through owners funds (equity share, preference shares and retained eamings) and long term debt (debentures and bonds). A mix of various long term sources of funds employed by a firm is called capital structure. According to Gerestenberg. “Capital structure of a company ref capitalization and it includes all long term capital resoures structure is made up of debt and equity and refers to permanent financing of a firm. Financial Manager has to plan the appropriate mix of different securities in total capitalization in such a way as to minimize the cost of capital and maximize the earnings per share to the equity shareholders. There may be four fundamental pattems of capital structure as follows (a) Equity capital only( including Reserves and Surplus) (b)_ Equity and preference capital (6) Equity, preference and long term debt i (a) Equity and long term debt to the composition or make-up of its viz, loans, bonds, shares and reserves”. Thus capital crit debentures, bonds and loans from financial institutions et 49. What do you mean by Optimum Capital Structure? Discuss the features of an optimum capital structure. [RKB] [99%]***** The theory Of Optiinalleapital structure deals with the issue ofthe right mix of debt and equity in the long term capital structiifé Of firm. This thetry stéfes that if company takes on debt, the value of the fitm increases up to a point. BeVond that poinPir debt contifies to"IncfEascatlen the value of the firm will start to dec Similarly ifthe Company is unable to Rpaglthe debt within ti€ specified period then it will affect the goodwill of the compSRVlifl He market and may Gfeate pRObIgms fuF/collecting further debt. Therefore, the company should select its optimumn.capital structure (@) Profitability: The capital structure:of the-company should be most profitable. The most profitable capital structure is one that tends to minimize cost of financing and maximize earnings per equity share. (b) Solvency: The pattem of capital structure should be so devised as to ensure that the firm does not run the risk of becoming insolvent. Excess use of debt threatens the solvency of the company. The debt content should not, therefore, be such that which increases risk beyond manageable limits, (©) Flexibility: The capital structure should be flexible to meet the requirements of changing conditions, Moreover it should also be possible for the company to provide funds whenever needed to finance its profitable activities, (@ Conservatism: The capital structure should be conservative in the sense that the debt content inthe total capital structure does not exceed the limit which the company can bear. In other words, it should be such as is commensurate with the company’s ability to generate future cash flows, (©) Contr company The capital structure should be so devised that it involves minimum risk of loss of control of the - 18—Admission Going on for B.com, M.com, CA, CMA, CS XI, XI. Contact.20. Mention the factors that are to be considered in determining capital structure? [BHALOTIA] [9883034569] [60%] (a) Trading on equity or financial leverage: Through this deviee, the capital is highly-geared. In this ease, the company issues more debentures and preference shares with fixed rate of interest and dividend. As a result, the dividend rate of equity shares can be substantially raised. (b) Risk, income and control of the enterprise: Risk, income and control move together, Greater income and control may cover greater risk. Equity shareholders undertake greater risk than the fixed interest-bearing securities, The control is also concentrated in their hands, So this aspect should be considered in capital structure, (©) Operating leverage: It indicates the vulnerability of operating profit of change in volume of sales and depends, on operating fixed cost of the company, It reflects the operating risk, If operating leverage is high, the company should introduce relatively small amount of debt capital (@ EBIT-EPS analysis: To maximise eamings per share (EPS) of equity shareholders, while planning capital structure the behaviour of EPS at varying levels of earnings before interest and tax (EBIT) under altemative financial plans should be studied. (©) Cost of capital: Lower cost of capital increases the value of the firm, Cost of capital is influenced by capital structure, Debt capital is usually cheaper because of lower risk and tax deductibility. So debt-equity mi has to be made in such a way that overall cos of capital becomes minimum, () Controk: Capital structure is affected by the extent to which the promoters desire to maintain control over the affairs of the company. Ifthe company issues more equity shares there will be dilution of contol, To avoid loss of contro, the company should use more debt eapital and preference capital (@) Cash flow analysis: The Company should prepare @ projected cash flow statement for the next 5-6 years to get an idea of cash inflows, If fture cash inflows position is steady or stable, more debt capital ean be employed. Butif future cash inflows position is usable, debt capital should be avoided. (hy Stability of sales: Ifthe company’s sales are stable, itcan employ more debt capital because there will beno difficulty in meeting fixed obligations (@ Size of the company: If the size'6F the gompany is large, it can raise fund easity from different sources, So its capital strcture can be suitably designed. (@ Legal requirements or restrictions: The finanee manager has to comply with the legal requirements or restrictions while deciding about the capital structire (&) Corporate taxation: Corporate taxation is an important factor in determining the choice between different sources of financing, ¢ 2, dividend on shares is not deductible but interest on borrowed capital and cost of raising inance are allowed as deduction for taxation purpose. So capital structure planning needs to consider corporate taxation fietor @ Government policies: Lending policies of financial institutions, SEBI rules and regulations, government's ‘monetary and fiscal policies affect capital structure decisions. (im) Purpose of financing: If the finds are required for manufacturing or productive purposes, funds should be raised from long-term sources. If the funds are needed for welfare facilities to employees of the company. internal sources should be tapped. (1) Period of finance: When permanent finds are needed, equity shares should be issued but when finance is required for 8-10 years it is appropriate to raise borrowed funds.21. Write a short note on EBIT-EPS analysis [BHALOTIA] [80%] ‘The EBIT-EPS analysis is one of the most widely used techniques employed in financial management to design an appropriate capital structure which ensures the highest EPS under firm’s expected ran words, this analysis is very usefull to examine the effect of financial leverages on the altemati ial plans with varying levels of EBIT. This technique is applicd within this framework as because, EPS is considered as one of the most important yardstick or tool of financial management fo evaluate the firm’s performance for the investor. Limitation of PS analvsis (1) Ifissues of new equity shares is not taken into considerations under the alternatives financi there will be no EBIT indifference point (2) When we consider a set of altematives plans that may give negative EBIT, which is imaginary and hence provide negative EPS. (3) The EBIT-EPS analysis does not take cognizance of the implicit cost associated with the debt. (4) This technique sometimes ignores the risk factor associated with the inerease of debt financing. of EBIT. In others iavior of EPS under s finan 1g plans, then 22. Write a short note on Trading on Equity [BHALOTIA] [30%] ‘Trading on Equity Meaning—Trading on equity means using the borrowed capital to generate revenue that boosts the profits of equity shareholders, ic. to make the profits by investing in the debt higher than the loan’s interest costs Financial leverage also refers to trading on equity. ‘Trading on equity in financial management involves a strategy where a company takes debt as bonds, debentures, loans, of preferred stocks. A company applies this strategy to increase the equity shareholder's retum on investment, ‘What is The Purpose of Trading on Equity? (a) The primary purpose is to inerease the wealth of the shareholders. (b) Trading on equity is employed when the company wants more finance from debt sources rather than equity (©) The company uses this strategy to ensure that eontrol over the company remains the same (@) A company might also use the trading on equity strategy to increase the company’s market share price Advantages of Trading on Equity It gives the company access to extra capital, which makes it possible to invest in assets that will generate a profit, As the interest on a loan is tax deductible, the company pays less amount in taxes overall. Disadvantages of Trading on Equit (a) Trading on equity involves disadvantages as well. The inability of the company to pay back the interest for any reason is one of the primary disadvantages it faces (b) Similarly, the company’s liabilities may grow if interest rates rise. (©) The borrowed debt finds may not fulfill the purpose for which itis borrowed. (@) In the worst scenario, the company can also become bankrupt.23. What do you mean by wo! | Management? [1%] ‘Working Capital is a part of the capital which is needed for meeting day to day requirement of the business concern. For example, payment to creditors, salary paid to workers, purchase of raw materials ete., normally it consists of recurring in nature, It can be easily converted into cash, Hence, itis also known as short-term capital. Working capital management is also ot with short-term finance of the business concem which is a closely related trade betw liquidity. Efficient working capital management leads to improve the operating performan concern and it helps to meet the short- term liquidity. Henes an important part of financial management but also are overall management of the business concern. of the important parts of the financial management. It is concemed sn profitability and 2 of the business , study of working capital management is not only 24, Concept of Working Capital [BHALOTIA] [9883034569] [1%] Working capital can be classified or understood with the help of the following two important concepts. A: Gross Working Capital Gross Wor ing capital concept. Thus the gross ‘working capital is the capital invested total cent assets ofthe business concern Gross Working Capital is simply called asthe total current assets of the eoncem 1g Capital is the general mncept which determines the wo Gross Working Capital = Current Assets B: Net Working Capital Net Working Capital is the specific concept, whieh, considers both current assets and current lability of the concer, Net Working Capital i the excess of period rent assets over the current liability of the concem during a particular If the current assets exe surrent liabilities it is said to be positive working itis said pital; it is reverse, Current Liabilities 25. Importance/Significance of Working Capital [RKB] [30%] ‘Working capital is a vital part of a business and ean provide the following advantages to a business (a) Higher return on capital: Firms with lower working capital will post a higher return on capital ‘Therefore, shareholders will benefit from a higher return for every dollar invested in the business.(b) Improved credit profile and solvency: The ability to meet short-term obligations is a pre- requisite to long-term solvency. And it is often a good indication of counterparty’s credit risk. Adequate working capital management will allow a business to pay on time its short-term obligations. This could include payment for a purchase of raw materials, payment of salaries, and other operating expenses (©) Higher profitability: According to some researchers, the management of account payables and receivables is an important driver of small businesses’ profitability (@) Higher liquidity: A large amount of cash can be tied up in working capital, so a company managing it efficiently could benefit from additional liquidity and be less dependent on external financing. This is especially important for smaller businesses as they typically have limited access to external funding sources, Also, small businesses often pay their bills in cash from earnings so efficient working capital management will alow a business to better allocate its resources and improve their cash management. (e) Increased business value: Firms with more efficient working capital management will generate more fiee cash flows which will result in higher business valuation and enterprise value. (0) Favorable financing conditions: A firm with a good relationship with its trade partners and paying its suppliers on time will benefit fiom favorable financing terms such as discount payments from its suppliers and banking partners (g) Uninterrupted production: A firm paying its suppliers on time will also benefit from a regular flow of raw materials, ensuring that the production remains uninterrupted and clients receive their goods on time (h) Ability to face shocks and peak demand: Efficient working capital management will help a firm to survive through a crisis or ramp up production in case of an unexpectedly large order 26. Classification of Working Capital [BHALOTIA] [40%] ‘Working capital may be of diffrent types as follows {a} Gross Working Capital; Gross working capital refers tothe amount of funds invested in various components ‘of current assets. Iteonsists of raw materials, workin progress, debtors, finished goods, et. (©) Net Working Capital: The excess of current assets over current liabilities is known as Net working capital ‘The principal objective here isto learn the composition and magnitude of current assets required to meet current liabilities (6) Positive Working Capit his refers to the surplus of current assets over current liabilities, (a) Negative Working Capital: Negative working capital refers to the excess of current liabilities over current assets, (e) Permanent Working Capital: The minimum amount of working capital which even required during the dullest season of the year is known as Permanent working capital ( Temporary or Variable Working Capital: It represents the additional current assets required at different times during the operating year to meet additional inventory, extra cash, et27. Explain the concept of working capital cycle (operating cycle) [BHALOTIA] [9883034569] [30%] Operating Cycle Approach / Working Capital Cycle organisation needs adequate working capital because the conversion of cash into finished goods to debtors and back to cash is not instantaneous. It takes some time. For example, in a manufacturing firm, cash is used to purchase raw materials. They are not consumed immediately. They remain some time in stores in order to ensure smooth production and to protect the firm against the risk of non-availability of raw materials in future. Then they are issued from stores to production centre for conversion. This conversion also generally takes some time, When certain expenses such as wages and overheads are incurred on it, it gets itself converted into semi-finished goods or work-in-progress and, finally, into finished goods. These finished goods will have to be stored for some time before sale. Next, finished goods are sold to customers which may take the form of cash or receivables/debtors. Rec able! debtors, when realised, again take the form of cash and the eyele starts Raw Materials Wages. Overhead Finiched Goss ‘The continuing flow from cash to suppliers, to inventory, t6 accounts receivable and back into working capital cycle or operating eycle. In other words, the term operating eye! which begins with the acquisition of raw materials ofa firm and ends with the final realisation of cash from debtors, Measurement of Operating C Strictly speaking, the volume of working capital depends upon the length of working capital cycle. So, it is important to measure working capital cycle for management of working capital. The Profit and Loss Account and Balance Sheet, can guide us fo measure Working capital eyele. ‘The steps involved in the determination of the operating cycle are shown below: Particulars D ish is called the refers to the le th of time aneial statements i [Raw materials holding period Work-in-progress period Finished goods holding period Debtors collection period Sross Operating Cyele woditors payment period 0 ing CycleBhalotia Classes (9883034569): FM important theory for Hons 2024 28. What factors are to be considered in determining the working capital need of a firm? [2014 H, 2016 H] [RKB] [99%] Following are the factors to be considered while determining the working capital requirement 1, Nature of business: A company’s working capital requirements are basically related to the kinds of business it conducts. Generally speaking, trading and financial firms require relatively large amounts of working capital, public utilities comparatively small amounts, whereas manufacturing concems stand between th ‘their needs depending upon the character of industry of which they are a part 2, Production policies: Depending upon the kind of items manufactured, a company is able to offset the effeet off: seasonal fluctuations upon working capital by adjusting its production schedules. The choice rests between ‘varying output in order to adjust inventories to seasonal requirements and maintaining a steady rate of production and permitting stocks of inventories to build up during off-season periods. It will thus be obvious that a level production plan would involve a higher investment in working capital 3. Manufacturing process: If the manufacturing process in an industry entails a longer period because of its complex character, more working, capital is required to finance that process. The longer it takes to make an approach and the greater its cost, the larger the Inventory tied up In Its manufacture and, therefore, higher the amount of working capital 4. Turnover of circulating capital: The speed with which the circulating capital completes its round Le conversion of cash into inventory of raw material Into Inventory of finished goods, Inventory of finished goods into book debts or accounts receivables and book debt into cash account, plays an Important and decisive role in Judging the adequacy of working capital ‘5. Growth and expanisiof(@f business: Asa company erovs, itis logical to expeet tha larger amount of working capital will besféqifed though It Is difficult toxdFaW up firm.rules for the relationship between the growth in the ‘Volume of a company’s business aff the growth ofits working capital ness variation. 6. BusindS VEE Muctuations: Ata time when the price level Comes upiafé bodim coddition pifevail, the psychology of the management isto pile upabig stockofrawmaterial and other goods likefitdbe used in the business operations as there isan expectation flationary conditions ereates (eqiiremeitsof Working pital of a company vary with the b 10 take advantage Of lower prices. The expansion of Busfhess units caused by the demand for more and MOF Capital, 7. Terms of purchase and sales: A business unit, making purchases on eredit basis and selling its finished products on cash basis, will require lower amount of working capital, on the contrary, a concern having no credit, facilities and at the same time forced to grant credit to its customers may find itself in a tight position 8. Dividend policy: A desire to maintain an established dividend policy may affect working capital, often changes in working capital bring about an adjustment of dividend policy. ‘The relationship between dividend policy and working capital is well established and very few companies declare a dividend without giving due consideration to: is for eash. A shortage of working capital often acts as a powerful reason for reducing or skipping a cash dividend. On the other hand, a strong position may justify continuing dividend payment. fleets on cash and their no - 24—Admission Going on for B.com, M.com, CA, CMA, CS XI, XI. Contact.Bhalotia Classes (9883034569): FM important theory for Hons 2024 29. Various sources of finance to meet working capital requirements [BHALOTIA] [9883034569] [90%] ‘Working Capital requirement can be normalized from short-term and long-term sourees. Each source will have both merits and limitations up to certain extract. Uses of Working Capital may be differing from stage to stage Short-Term Sources of Working Capital L Indigenous Bankers: Private money-lenders and other country bankers used to be the only source of finance prior to the establishment of commercial banks. They used to charge very high rates of interest and exploited the customers to the largest extent possible 2. Trade Credit ‘Trade credit represents the credit extended by the supplier of goods and services. It is a spontaneous source of finance in the sense that it arises in the normal transactions of the firm without specific negotiations, provided the firm is considered creditworthy by its supplier. It is an important source of finance representing 25% to 50% of | short-term financing. 3. Working capital advance by commercial banks ‘Working capital advance by commercial banks represents the most important source for financing current assets. Forms of Bank Finance: Working capital advance is provided by commercial banks in three primary ways: (i) cash credits / overdrafts, (ii) loans, and (iii) purchase / discount of bills. In addition to these forms of direct finance, commercials banks help their customers in obtaining credit from other sources through the letter of credit arrangement A. Cash Cre ‘Under a cash ¢redit or 6verdraft-arrangeifient, a/pre-determinedblimit for borrowing is specified by the bank. The borrower ean drawas Often ay requiféd provide the out standings do not exeeed the cash Lov fi ¢/ overdraft limit & Loans ‘These are AdVGHEBOF Fixed amounts whiclire erelitedo the!Wurrent account of he borrower or released fo him in cash, The borroWerig Ghiitged with interest on the enlifé loaf amount, irrespective of how much he draws. 6 Purchase / Discount of Bills A bill arises out of a trade transaction. The seller of goods draws the bill on the purchaser. The bill may be either clean or documentary (a documentary bill is supported by a document of ttle to goods like a railway receipt or a bill of lading) and may be payable on demand or after a usance period which does not exceed 90 days. of! A letter of eredit is an arrangement whereby bank helps its customer fo obtain eredit from its (customer's) suppliers. When a bank opens a letter of credit in favour of its customer for some specific purchases, the bank undertakes the responsibility to honour the obligation ofits customer, should the customer fil t0 do so, - 25—Admission Going on for B.com, M.com, CA, CMA, CS XI, XI. Contact.ig Cay Investment Policies / Approaches/ s to Financing Current Assets. [BHALOTIA] [30%] ‘Working capital financing policy basically deals with the sources and the amount of working capital that a company should maintain. A firm isnot only concemed about the amount of current assets but also about the proportions of short-term and long-term sources for financing the current assets. There are several working capital investment policies a firm may adopt after taking into account the variability of its eash inflows and outflows and the level of risk. As the name suggests, this policy tries to avoid the risk involved in financing of current assets. Here, relatively high proportions of long-term sources are to be used for financing current assets. The firm not only matches the current assets with current liabilities but also keeps some excess amount fo meet any uncertainty ‘This is the lowest risk working capital policy and fails to ensure optimum utilization of funds. Hence it cuts down the expected retums of the shareholders. This policy is illustrated below. Line A denotes the fixed assets and Line B denotes the permar is financed through long-term sources. Certain portion of fluctuating current assets, which is shown by dashed Line C. is also financed by long-term sources. Under this, policy through short-term sources. int working capital, whi ome part of fluctuating current assets is FinancFctuting Curent Asset, > aguny and Long Tenn be af 2. Aggressive Policy: ‘Ageressive working capital financing policy is a risky policy that requires maximum amount of investment in current assets, Fluctuating as well as permanent current assets under this policy will be financed through short-term debt, In this policy debt is collected on time and payments to the ereditors are made as late as possible. This poliey has been illustrated below, According to this approach long-term sources are used to finance the fixed assets, which are shown by Line A: but portion of permanent current assets, shown by the dotted Line B, is also financed through long-term sources. The remaining part of permanent current assets, depicted by Line C, and the entire amount of fluctuating current assets, shown by the curved Line D, ate financed by short-term debt. Equity and Long Tem Debt3. Hedging Policy (Balanced Policy) (Matching Policy) (Moderate Policy) ‘One ofthe policies by which a firm finances its Working eapital nods isthe hedging policy. also known as matching policy. This policy works in an arrangement where the current asses of the business are used perfectly to match the current liabilities. As por this approach, fixed and permanent current asses are financed through long-term sources and fluctuating current assets are financed throtgh short-term sources. This policy is a medium risk proposition and requires @ good amount of attention, For example, ifa bank loan is due to be pad after six months, the company ‘will ensure that sufficient amount of cash will be available to repay the loan on the date of maturity even though it may or may not currently have sufficient cash. In case of a growth firm, the amount of fixed assets and permanent current asset go on increasing with the passage of time but the volume of Nuctuating current assets change with the change in production level. In the following figure, Line A and Line B is upward stopped indicating that they go on increasing with the passage of time and as pet hedging principle they are financed through long-term sources like equity’ and long-term debt, Fluctuating current assets, which are shown by the curved Line C, should be financed through short term sources, ctatng Current Assets >> Sto Term Dete Ss guy and Con Ter ety Permanent Caste Aste / Fino Asst 34. Length of operating cycle is the major determinant of the working capital needs of a business firm — Explain. [3" yr old 2021] [BHALOTIA] ‘One of the methods for forecasting working capital requirement is based on the concept of operating eyele. ‘The various constituents of current assets and current liabilil es have a direct bearing on the computation of ‘working capital and the operating cycle, The holding period of various constituents of Current Assets and Current Liabilities eyele may either contract or expand the net operating eyele period. Shorter the operating cycle period, lower will be the requirement of working capital and vice-versa.32. What is capital Budgeting? What are the Purposes of Capital Expenditure Decisions [BHALOTIA] [30%] Capital budgeting decision may be defined as “Firms decisions to invest its eurrent funds most efficiently in long term activities in anticipation of an expected flow of future benefits over a series of year. The firm's capital budgeting decisions will include addition, disposition, modification and replacement of fixed assets Definitions: ‘Charles. T. Homgreen defined capital budgeting as “Long term planning for making and financing proposed capital out lay According o Keller and Ferrara,“ fixed asset during the budget period” [Need of capital budgeting decision The selection of the most profitable project of capital investment is the key function of Financial Manager. The decisions taken by the management in this are affect the operations ofthe firm for many years Capital budgeting decisions may be generally needed for the following purposes: Hence, following may be considered as major or specific objectives in respect of investment in fixed assets “apital Budgeting represents the plans for the appropriation and expenditure for under long-term basis: (a) Modification and Replacement of existi (b) Quality improvement in the present projects. (©) Expansion of business through creating additional facilities. (4) Creation of new product and improving the quality of existing products (©) Product diversification for survival under the competitive market scenario. (£) Cost reduction initiatives which may require the purchase of most sophisticated and modern equipments. (g) Exploration of new ideas through Research and Development (h) Replacement of manual work by automation process (i) Maximization of wealth of the shareholders, (i) Achievement of various social objectives complying with statutory obligations. (say, setting up of waste facilities. treatment plant to reduce environmental pollution) 33. What do you mean by capital budgeting? Discuss its importance. [BHALOTIA] [10%] Financing and investment of funds are two crucial financial functions. The investment of funds also termed as capital budgeting requires a number of decisions to be taken in a situation in which funds are invested and benefits are expected over a long period. The term capital budgeting means planning for capital assets. It involves and financial viability of the project. proper project planning and commercial evaluation of projects to know in advance technicalImportance of Capital Budgeting Capital Budgeting decisions are considered important for a variety of reasons. Some of them are the following (a) Crucial decisions: Capital budgeting decisions are crucial, affecting all the departments of the firm, So the capital budgeting decisions should be taken very carefully (b) Long-run decisions: The implications of capital budgeting decisions extend to a longer period in the future, The consequences of a wrong decision will be disastrous for the survival of the firm, (©) Large amount of funds: Capital budgeting decisions involve spending large amount of finds, As such proper care should be exercised to see that these finds are invested in productive purchases, (4) Rigid: Capital budgeting decision can not be altered easily to suit the purpose, Because of this reason, when once funds are committed in a project, they are to be continued till the end, loss or profit no matter 34, What are the process (Steps) of capital budgeting? [10 %] ] ‘The major steps in the capital budgeting process are given below. They are a) Generation of project: b) Evaluation of the project; ¢) Selection of the project and d) Execution of the project. The capital budgeting process may include a few more steps. As each step is significant they are usually taken by top management (a) Generation of Project: Depending upon the nature of the firm, investment proposals ean emanate from a variety of sources, Projects may be classified into five categories (i) New products or expansion of existing products Gi) Replacement of equipment or buildings. (iii) Research and development, Gv) Exploration (v) Others like acquisition of a pollution control device ete Investment proposals should be generated for the productive employment of firm’s funds. However, a systematic procedure must be evolved for generating profitable proposals to keep the firm healthy. (b) Evaluation of the project: ‘The evaluation of the project may be done in two steps, First the costs and benefits of the project are estimated in terms of eash flows and secondly the desirability of the project is judged by an appropriate criterion. It is important that the project must be evaluated without any prejudice on the part of the individual, While selecting, a criterion to judge the desirability of the project, de consideration must be given to the market value of the firm, (©) Selection of the project: After evaluation of the project, the project with hig set for the purpose of selecting a project from many altemative projects. Normally the projects are screened at various levels. However, the final selection of the project vests with the top level management. (@ Execution of project: After selection of a project, the next step in capital budgeting process is to implement the project. Thus the funds are appropriated for capital expenditures. The funds are spent in accordance with appropriations made in the capital budget funds for the purpose of project execution should be spent only after secking format permission for the controller. The follow ~ up comparison of actual performance with original estimates ensure better control ‘Thus the fop management should follow the above procedure before taking actual expenditure decision est return should be scted. There is no hard and fast ruleBhalotia Classes (9883034569): FM important theory for Hons 2024 35. Discuss the different Types of Investment Projects [30 %] Firms generally classify their investment project into the project into the following categories for carrying out the screening process as stated in our earlier s (a) Replacement for the maintenance of business: This involves expenditure for replacing worn-out or damaged capital and equipment used to produce some profitable products. (b) Replacement for cost reduction: Investment required to replace working but obsolete equipment with ‘modern equipment, which are supposed to reduce the average cost of production (say, by reducing the labour costs, material costs, electricity and fuel costs, ete), fall into this category (© Expansion of output of some traditional products and their markets: Investment needed to expand the production of some traditional products of a firm in their existing or traditional markets, are included in this category. These investment projects may be taken up in response to increase demand for such products, say, in the domestic market. (@)_ Search for new markets and increase in the production of non-traditional products: In a fast changing business world, the efficient operation of a firm also requires investment in developing new products and expanding the market for such products, both in the domestic and external fronts, (©) Complying with statutory obligations: These investment projects include such investments which are required by any firm to fulfill some statutory obligations like population control, health and safety regulations, etc. imposed by the Government 36. Discuss briefly the NPV method of evaluation of projects [99%] 'V_ method ‘The net present valued Wa classic method of evaluating the investment proposals, Its one of the methods of discounted cash MOW techniques. which reeod¥Zes the importance of time value of money. It correctly postulates tha Gash f6Ws avisitig atime Perids differ inV@IUE and are comparable only with their equivalents ice. present Wales Itis a method! GF Giléulating the ffesSht valllewot Gash flow€|Ginflows and outflows) of an investment proposal using the Gof OF apital as an sppropriat@ difcouit the present vill@ Of A8h outflows from the preseiftluc offCash inflows. According to Ezra Soloman, “itis a present value of {RE ASO the investment Acceplance Rule: Ifthe NPV is positive or a-Ieast equal to zero, the project can be accepted. Ifit is negative, the proposal ean be rejected, Among the various alternatives, the project which gives the highest positive NPV should be selected. NPV is positive = Cash inflows are generated at a rate higher than the minimum required by the firm. NPV is zero ~ Cash inflows are generated ata rate equal to the minimum required. NPV is negative ~ Cash inflows are generated ata rate lower than the minimum required by the firm ‘The market value per share will increase if the project with positive NPV is selected. ‘The acceptireject criterion under the NPV method can also be put as Merits: ‘The following are the merits of the net present value (NPV) methods: (a) Consideration to total Cash Inflows: The NPV methods considers the total eash inflows of investment opportunities over the entire life-time of the projects unlike the payback period methods. dite. Th€net present value will be arrived at by subtracting - 31—Admission Going on for B.com, M.com, CA, CMA, CS XI, XI. Contact.37. Discuss briefly IRR method of evaluation of projects. [10 %] IRR method follows discounted cash flow technique which takes into account the time value of money. The intemal rate of return is the interest rate which equates the present value of expected future cash inflows with, the initial capital outlay. In other Words; iis the rate at which NPV is equal zero. ‘Whenever a project report is prepared, IRR is to be worked out in order to ascertain the viability of the project ‘Thisis also an important guiding factor to finaneial institutions and investors, Acceptance Rule If the internal rate of return exceeds the required rate of retum, then the project will be accepted. If the project's IRR is less than the required rate of return, it should be rejected. In case of ranking the proposals the technique of IRR is significantly used. The projects with highest rate of return will be ranked as first compared to the lowest rate of retum projects. ‘Thus, the IRR acceptance rules are Accept if IRR > k Reject if RR K. (In case of determining the value of the shares, no other factor is considered in Gordon's model except dividend payout ratio44. Critically discuss the assumptions of Walter’s dividend Model. To what extents are the shortcomings of this model are justified to you. [BHALOTIA] [9883034569] [10%] Walter model: According to this model founded by Jame Walter, the dividend policy of a company has an impact on the share valuation, ie., dividends are relevant, The key argument is support of the relevance proposition of Walter’s model is the relationship between the retum on a firm's investment (its intemal rate of return) ‘r° and its cost of capital (ie. the required rate of return) ‘k’, Ifthe return on investments exceeds the cost of capital, the firm should retain the earnings, ‘whereas it should distribute the earings to the shareholders in cash the required rate of retum exceeds the expected retum on the firm’s investments. The rationale is that if =k, the firm is able to eam more than what the shareholders could by reinvesting, if the eamings are paid to them. The implication of rk is that shareholders can eam a higher return by reinvesting elsewhere. Assumptions: All financing is done through retained eamings; extemal sources of funds like debt or new equity capital are not used, b. With addition investments undertaken, the firm’s business risk does not change. It implies that ‘r° and ‘k’ are constant. There is no charge in the key variable namely EPS & DPS. The values D and E may be changed in the model to determine results, but, any given value of E and D are assumed to remain constant in determining a given value. 4. The firm has a perpetual (very long) life. of the Mod Prof. Walter postulated some unrealistic assumption in this model. So, the mode is criticized from various points of view for his unrealistic assumptions. These are — (a) It is assumed in this model that the firm does not isstie any new share or debenture, it meets the requirement of ‘he additional capital only out of retainéd earings. This assumption is not correct, because itis found in most of the cases that when a firm requires additional fd, it meets the requirement of that additional fimd by issuing new shares or debentures. (b) Itisassumed in this model that the internal rate of return of the firm will alway’ remain fixed, Even this assumption is not correct, because if profit is ploughed back, then the amount of capital employed tothe firm is increased and as a result, the intemal rate of retum decreases. (©) Itis assumed in this model that the cost of capital of the firm will alway’ remain fixed. It is not eorreet, Because, if the degree of risk changes, the cost of capital is also changed. As the degree of risk of a firm does not always remain fixed, the cost of capital (K) can not remain fixed (@ It is assumed in this model, that the firm either distributes its entire earnings as dividend or ploughs back immediately as additional capital into the business, This assumption is not correct, Because, according to section 205 (2A) of the Indian Companies Act, a portion of the profits is to be transferred to reserve fund compulsorily before declaring dividend (©) Walter's Model has assumed that the market price of equity shares depend only on the present value of expected future dividend. Butit isnot so, Bull phase and bear phase, ic., upward swings and downward swings in business also affect the market prices of equity shares45. What factors determine the dividend policy of a firm/Discuss the determinants of dividend policies. [BHALOTIA] [67%] ‘The dividend poliey is affected by the following factors: 1. Availabi source. The reason being the saving of floatation cost and pre in case of new issue of equity shares to public. of funds: If the business is in requirement of funds, then retained eamings could be a good sntion of dilution of control which happens 2. Cost of capital: Ifthe financing requirements are to be executed through debt (relatively cheaper source of finance). then it would be preferable to distribute more dividend. On the other hand. if the financing is to be done through fresh issue of equity shares, then itis better to use retained camings as much as possible. Capital structure: An optimum Debt Equity ratio should also be considered for the dividend decision, 4. Stock price: Stock price here means market price of the shares. Generally, higher dividends increase market value of shares and low dividends decrease the value. Investment opportunities in hand: ‘The dividend decision is also affected if there are investment ‘opportunities in hand. In that situation, the company may prefer to retain more eamings. 6. Internal rate of return (IRR): If the intemal rate of return (IRR) is more than the cost of retained earnings (Ko) itis better to distribute the eamings as much as possible. 7. Trend of industry: The investors depend on some industries for t in such cases, the firms have to pay dividend in order to survive in the market. 8. Expectation of shareholders: The shareholders can be categorised into two categories: (i) those who invests for regular income, & (ji) those who invests for growth, Generally, the investor prefers current dividend over the future growth: 9. Legal constraints: Section 123 of the Companies Act, 2013 which provides for declaration of dividend sates that Dividend shall be declared or paid by a company for any financial year only (a) out of the profits of the company-for that year arrived at after providing for depreciation in accordance With the relevant provisions , or (b) out of the profits of the company for any previous financial year or years arrived at afler providing for depreciation in accordance with the relevant provisions and remaining undistributed, or (©) out of both, o (@ _ outof money provided by the Central Government or a State Government for the payment of dividend by the company in pursuance of a guarantee given by that Government, It may be noted that, while computing the profits for payment of dividends any amount representing unrealised gains, notional gains or revaluation of assets and any change in carrying amount of an asset orof a liability on measurement of the asset or the liability at fair value shall be excluded. 10. Taxation: Before 1" April 2020, as per Section 115-O of Income Tax Act, 1961, dividend was subject to dividend distribution tax (DDT) in the hands of the company. Dividend on which DDT was paid, was to be exempted in the hands of the shareholder u/s 10(34). However. as per amendment made by the Finance Act 2020, the exemption u's 10(34) shall not apply to dividend received on or after 1 April 2020 and the dividend income from shares held as investment shall be taxable under the head of “Other income” at the applicable slab rateBhalotia Classes (9883034569): FM important theory for Hons 2024 Capital Budgeting (New Question) 46. Distinguishing features of Capital Budgeting [95%]**** Features of Capital Budgeting Capital Budgeting is characterized by the following features: (a) There is a long duration between the initial investments and the expected returns (b) The organizations usually estimate large profits (©) The process involves high risks. (4) _Itisa fixed investment over the long run. (©) Investments made in a project determine the future financial condition of an organization. (8) All projects require significant amounts of funding. (g) The amount of investment made in the project determines the profi bility of a company 47. Distinguishing features of Capital Budgeting (Another Ans] 195%]*** Features of Capital Budgeting Long-term outcome Such choices affect the rate of a company’s growth and have long-term effects on future profitability Significant risk A decision is made on the expected return, The risk involved in making such judgments ine style, expertise, and technology change. IseS as tastes, Huge amount of money Large sums of money are needed, vet sparing such sums is a challenge. Therefore, individuals must make dceisions after careful consideration and study, Unchangeable choice Reversing a choice is extremely dit t since doing so would involve selling a valuable item. Extremely challenging choice A choice is made based on projected outcomes and unpredictability. Finank advancements now have an influence on future events, social, and technical Effect on cost structure: Due to this important choice, the organization is dedicated to fixed expenses like monitoring, coverage, rental, tax, ete, An investment not providing the expected profit would impact potential income. - 40—Admission Going on for B.com, M.com, CA, CMA, CS XI, XI. Contact.BHALOMACEASSES | ADMISSION GOING ON VE RYANOMINAIE EES ALEVE UMTS a HAVING FINANCIAL ISSUES