FFM 2023

1. Choose the right answers: 1×10=10

1. (d) All of the above

2. (a) Debt and equities
3. (c) Capital budgeting decision
4. (b) Rs. 4,00,000
o Explanation: Let current liabilities be ₹X, so current assets = 2X
Working capital = Current assets - Current liabilities = 2X - X = X = ₹2,00,000 ⇒
Current assets = ₹4,00,000
5. (a) Stock dividend
6. (b) False
7. (a) True
8. (a) True
9. (a) True
10. (a) True

2. Answer the following questions in about 50 words each:

(a) What is financial management?

Financial management refers to the efficient planning, organizing, directing, and controlling of
financial activities such as procurement and utilization of funds. It aims to maximize the firm’s
value by ensuring optimal investment, financing, and dividend decisions.

(b) What is leverage?

Leverage refers to the use of various financial instruments or borrowed capital (debt) to increase
the potential return of an investment. It measures the impact of fixed costs (financial or
operating) on the profitability of the firm.

(c) What are the various methods of capital budgeting decisions?

The common methods of capital budgeting include:

1. Payback Period
2. Net Present Value (NPV)
3. Internal Rate of Return (IRR)
4. Profitability Index (PI)
5. Accounting Rate of Return (ARR)

(d) What is dividend?

A dividend is a portion of a company’s earnings that is distributed to its shareholders. It can be
paid in cash or in the form of additional shares and reflects the company’s profitability and
policy regarding return to shareholders.

(e) What is permanent working capital?

Permanent working capital is the minimum amount of capital required to ensure the day-to-day
operations of a business. It remains constantly invested in current assets and is not affected by
seasonal fluctuations in business activity.

3. Answer the following questions within 150-200 words each:

(a) State the nature of financial management.

Financial management is both an art and a science. It involves decision-making related to the
procurement, allocation, and control of financial resources of an organization. Its scope includes
three major decisions: investment decisions, financing decisions, and dividend decisions. It
ensures that funds are utilized efficiently to maximize shareholders' wealth. The nature of
financial management includes:

 Analytical Nature: Requires quantitative analysis of cost, risk, and return.

 Dynamic Function: Adapts with changes in the economic and financial environment.
 Integral to Management: A core part of overall business management.
 Goal-Oriented: Focused on value maximization and wealth creation.

(b) Explain the significance of cost of capital.

Cost of capital represents the minimum rate of return a firm must earn to satisfy its investors and
maintain the value of its securities. It acts as a benchmark for evaluating investment proposals. A
lower cost of capital enhances firm value, while a higher cost discourages investment. It helps in
optimal capital budgeting, determining capital structure, and setting financial strategy. It also
aids in comparing various financing options like debt, equity, and preference capital. The cost of
capital ensures that only projects with a return higher than the cost are undertaken, promoting
profitability and efficient resource allocation.

(c) Explain the significance and limitations of financial leverage.

Significance: Financial leverage arises from the use of debt in the capital structure. It magnifies
the return on equity when the return on investment exceeds the cost of debt. It is beneficial for
companies aiming to enhance earnings per share and achieve tax benefits due to interest
deductibility.
Limitations: However, excessive leverage increases financial risk and may lead to insolvency
during downturns. It limits the firm’s borrowing capacity and increases the burden of fixed
interest payments. Thus, an optimal level of leverage is crucial for balancing risk and return.

(d) Explain the capital budgeting process.

Capital budgeting is the process of evaluating and selecting long-term investments that are
consistent with the firm’s goal of wealth maximization. The steps include:
 1. Identification of Investment Opportunities
2. Assembling Investment Proposals
3. Evaluation of Proposals (using NPV, IRR, PI, etc.)
4. Capital Rationing and Selection
5. Implementation
6. Monitoring and Post-Audit
This process ensures that only profitable projects are selected, supporting long-term
growth and efficient resource allocation.

(e) Distinguish between gross working capital and net working capital.

Basis Gross Working Capital Net Working Capital

Definition Total current assets Current assets minus current liabilities
Focus Emphasizes on investment in current assets Focuses on liquidity position
Objective To optimize investment in current assets To ensure firm’s short-term solvency
Useful in managing individual current Helpful in assessing overall financial
Use
assets health

(f) Explain the various forms of dividend.

Dividends can be distributed in several forms:

1. Cash Dividend: Regular payment of profit in cash to shareholders.

2. Stock Dividend (Bonus Shares): Issuance of additional shares instead of cash.
3. Property Dividend: Distribution of assets or goods instead of cash.
4. Interim Dividend: Dividend paid before finalization of annual profits.
5. Scrip Dividend: Promissory note issued when cash is not available immediately.
6. Liquidating Dividend: Paid from capital, not profits, usually when winding up.
Each type reflects the firm’s financial position and its dividend policy.

(a) Discuss the scope and objectives of financial management.

(Or Option A1: Describe the determinants of capital structure of a firm.)

Scope of Financial Management:

Financial management is primarily concerned with the effective procurement, allocation, and
control of financial resources. Its scope covers the following key areas:

1. Investment Decision:
Deals with capital budgeting decisions and investment in fixed assets and current assets.
The aim is to select projects that maximize returns.
2. Financing Decision:
Involves determining the optimal capital structure (mix of debt and equity) and choosing
appropriate sources of finance like equity, debentures, loans, etc.
 3. Dividend Decision:
Concerns the distribution of profit to shareholders in the form of dividends while
retaining sufficient earnings for future growth.
4. Liquidity Decision (Working Capital Management):
Ensures that the firm has sufficient liquidity to meet its short-term obligations.
5. Financial Planning and Control:
Budgeting, forecasting, financial analysis, and internal control are also key components
of financial management.

Objectives of Financial Management:

1. Wealth Maximization:
The primary objective is to maximize shareholders’ wealth by enhancing the market
value of the firm.
2. Profit Maximization:
While short-term, this objective ensures efficient use of resources to generate profit.
3. Ensuring Liquidity:
Maintaining adequate liquidity ensures smooth business operations.
4. Optimum Utilization of Funds:
Funds must be used effectively and efficiently to avoid waste and idle resources.
5. Ensuring Financial Discipline and Planning:
Financial management ensures systematic financial planning and adherence to budgets.

Option A1: Determinants of Capital Structure of a Firm

Capital structure refers to the mix of debt and equity in a firm’s financing. Its determinants
include:

1. Cost of Capital:
Firms prefer cheaper sources of finance. Debt is usually cheaper due to tax benefits but
increases financial risk.
2. Risk Factor:
Higher debt increases financial risk. Companies with stable earnings can afford more
debt.
3. Control Considerations:
Issuing equity may dilute ownership. Firms reluctant to lose control may prefer debt.
4. Cash Flow Position:
Strong, stable cash flows encourage debt usage as firms can meet interest obligations
easily.
5. Flexibility:
Firms prefer a flexible capital structure that allows them to adjust debt-equity ratios as
per need.
6. Tax Considerations:
Interest on debt is tax-deductible, providing a tax shield, thus making debt attractive.
 7. Market Conditions:
In bullish markets, equity financing is easier; during recessions, debt might be preferred.

(b) State the various factors determining the dividend policy of a company.

(Or Option B1: State the various factors determining the working capital requirements of a
firm.)

Dividend Policy:

Dividend policy refers to the decision regarding the amount of profit to be distributed as
dividends and the amount to be retained.

Factors Affecting Dividend Policy:

1. Profitability of the Company:

Higher profits generally lead to higher dividends.
2. Liquidity Position:
Even with high profits, a lack of cash may limit dividend payments.
3. Stability of Earnings:
Companies with stable earnings tend to follow a consistent dividend policy.
4. Growth Opportunities:
Firms with high growth potential retain more earnings, thus paying lower dividends.
5. Shareholder Preference:
Some shareholders may prefer regular dividends over capital gains.
6. Taxation Policy:
Dividend tax and capital gains tax rates may affect the company’s dividend policy.
7. Legal Restrictions:
Companies can’t pay dividends out of capital and must comply with legal provisions.
8. Inflation:
During inflation, more funds are required for working capital, reducing dividend payouts.
9. Access to Capital Markets:
Firms with easy access to markets may pay higher dividends, as they can raise funds
externally.

Option B1: Working Capital Determinants

1. Nature of Business:
Manufacturing firms need more working capital than service-based firms.
2. Business Cycle:
During boom periods, firms need more working capital due to increased production and
sales.
 3. Production Cycle:
Longer production cycles require more funds to sustain operations.
4. Credit Policy:
Liberal credit to customers increases receivables and working capital needs.
5. Inventory Policy:
High inventory levels increase working capital requirements.
6. Operating Efficiency:
Efficient operations reduce cycle time and need less working capital.
7. Availability of Credit:
Suppliers offering credit reduce the need for working capital.

(c) Discuss the traditional methods of capital budgeting decision.

(Or Option C1: NPV and PI Calculation – see below)

Traditional Methods of Capital Budgeting:

1. Payback Period:
Time required to recover the initial investment. Simple but ignores time value of money.
2. Accounting Rate of Return (ARR):
Average annual accounting profit divided by initial investment. Focuses on accounting
data, not cash flows.

Limitations of Traditional Methods:

 Ignores time value of money

 Doesn’t consider profitability beyond the payback period
 Less effective for long-term projects

Modern techniques like NPV and IRR overcome these limitations.

Option C1: ABC Company – NPV & PI Calculation

Given:

Year Machine X (₹) Machine Y (₹) DF @10%

1 3,00,000 1,00,000 0.909

2 4,00,000 3,00,000 0.826

Year Machine X (₹) Machine Y (₹) DF @10%

3 5,00,000 4,00,000 0.751

4 3,00,000 6,00,000 0.683

5 2,00,000 4,00,000 0.621

Cost of both machines: ₹10,00,000

NPV Calculation

Machine X:

NPVX=(3,00,000×0.909)+(4,00,000×0.826)+(5,00,000×0.751)+(3,00,000×0.683)+(2,00,000×0.621)−10,00,
000NPV_X = (3,00,000 \times 0.909) + (4,00,000 \times 0.826) + (5,00,000 \times 0.751) + (3,00,000
\times 0.683) + (2,00,000 \times 0.621) - 10,00,000NPVX
=(3,00,000×0.909)+(4,00,000×0.826)+(5,00,000×0.751)+(3,00,000×0.683)+(2,00,000×0.621)−10,00,000
=2,72,700+3,30,400+3,75,500+2,04,900+1,24,200=13,07,700= 2,72,700 + 3,30,400 + 3,75,500 + 2,04,900
+ 1,24,200 = 13,07,700=2,72,700+3,30,400+3,75,500+2,04,900+1,24,200=13,07,700
NPVX=13,07,700−10,00,000=₹3,07,700NPV_X = 13,07,700 - 10,00,000 = ₹3,07,700NPVX
=13,07,700−10,00,000=₹3,07,700

PI = PV of inflows / Initial investment = 13,07,700 / 10,00,000 = 1.31

Machine Y:

NPVY=(1,00,000×0.909)+(3,00,000×0.826)+(4,00,000×0.751)+(6,00,000×0.683)+(4,00,000×0.621)−10,00,
000NPV_Y = (1,00,000 \times 0.909) + (3,00,000 \times 0.826) + (4,00,000 \times 0.751) + (6,00,000
\times 0.683) + (4,00,000 \times 0.621) - 10,00,000NPVY
=(1,00,000×0.909)+(3,00,000×0.826)+(4,00,000×0.751)+(6,00,000×0.683)+(4,00,000×0.621)−10,00,000
=90,900+2,47,800+3,00,400+4,09,800+2,48,400=12,97,300= 90,900 + 2,47,800 + 3,00,400 + 4,09,800 +
2,48,400 = 12,97,300=90,900+2,47,800+3,00,400+4,09,800+2,48,400=12,97,300
NPVY=12,97,300−10,00,000=₹2,97,300NPV_Y = 12,97,300 - 10,00,000 = ₹2,97,300NPVY
=12,97,300−10,00,000=₹2,97,300

PI = 12,97,300 / 10,00,000 = 1.30

Conclusion:
 Machine X NPV: ₹3,07,700, PI: 1.31
 Machine Y NPV: ₹2,97,300, PI: 1.30
✅Choose Machine X (higher NPV and PI)