NCERT Solutions Class 12 Business Studies Chapter 9 Financial Management
NCERT Solutions Class 12 Business Studies Chapter 9 Financial Management: National Council of Educational Research and Training (NCERT) Class 12 Business Studies Chapter 9 Solutions – Financial Management.
Board |
NCERT |
Class |
12 |
Subject |
Business Studies |
Chapter |
9 |
Chapter Name |
Financial Management |
Topic |
Exercise Solutions |
Very Short Answer Type
1.) What is meant by capital structure?
Ans-Capital Structure refers to the mix between owner’s and borrowed funds.
2.) Sate the two objectives of financial planning.
Ans – The two objectives of financial planning are –
(a) To ensure availability of funds whenever required and
(b) To see that firm does not raise funds or resources unnecessarily.
3.) Name the concept of financial management which increases the return to equity shareholders due to the presence of fixed financial charges.
Ans- The concept of financial management which increases the return to equity shareholders due to the presence of fixed financial charges is Increasing shareholder’s wealth or Profit maximization.
4.) Amrit is running a ‘transport service’ and earning good returns by providing this service to industries. Giving reason, state whether the working capital requirement of the firm will be ‘less’ or ‘more’.
Ans – The Working Capital requirement of the firm will be more because it has to maintain its operating expenses on a regular basis.
5.) Ramnath is into the business of assembling and selling of televisions. Recently he has adopted a new policy of purchasing the components on three months credit and selling the complete product in cash. Will it affect the requirement of working capital? Give reason in support of your answer.
Ans- Yes, the decision to adopt the policy of purchasing components on credit will affect the requirement of working capital as it will increase the Interest coverage Ratio due to payment of interest on loan.
Short Answer Type
1.) What is financial risk? Why does it arise?
Ans- Financial risk refers to the risk of covering the expenses incurred in the acquisition of funds and other financial resources.
Financial risk arises due to following reasons:
i) Non availability of funds – This refers to the situation when funds are not available for purchasing of assets or meeting day to day expenses of business.
ii) High Debt Equity Ratio – This happens when the capital structure of the firm has a more amount of debt than equity.
iii) Cash flow position : If the firm has unsteady or insufficient amount of cash
flow in the business then it increases the chances of financial risk of the business.
2.) Define current assets? Give four examples of such assets.
Ans – Current assets refers to those assets which can be converted into cash within a year or within a short period of time .
Four examples of such assets – Stock , Debtors , Cash in Hand and Bills Receivable.
3.) What are the main objectives of financial management? Briefly explain.
Ans – The main objectives of financial management are as follows:
i) Financial Management aims at reducing the cost of funds procured, keeping the risk under control and achieving effective deployment of such funds. It also aims at ensuring availability of enough funds whenever required as well as avoiding idle finance. Needless to emphasize, the future of a business depends a great deal on the quality of its financial management.
ii) The primary objective of financial management is to maximize shareholder’s wealth that is refered as wealth maximization concept. It is essential because it is assumed that company’s funds belongs to shareholders and the return on investment on shares determines the prices if the shares.
4.) Financial management is based on three broad financial decisions. What are these?
Ans – The three broad financial decisions are as follows:
i) Investment Decision : A firm’s resources are scarce in comparison to the uses to which they can be put. The Investment Decision relates to how the firm’s assets are invested . investment Decision can be of 2 types – Long time or Capital Budgeting Decision and Short term or Working capital decision . capital Budgeting decision involves committing the finance for long term basis and working capital decision are concerned with level of cash , inventory and stock etc.
ii) Financing Decision : It is related with quantity of finance to be raised from various long term sources . It involves identification of various available sources like – borrowed fund or shareholder’s funds. A firm has to decide the proportion of funds to be raised from either sources.
iii) Dividend Decision: This decision relates to the distribution of Dividend . Dividend is that part of profit which is distributed to the shareholders. The decision involved here is how much of the profit is to be distributed to shareholders and how much of it is to be retained in the business.
5.) Sunrises Ltd. dealing in readymade garments, is planning to expand its business operations in order to cater to international market. For this purpose the company needs additional `80,00,000 for replacing machines with modern machinery of higher production capacity. The company wishes to raise the required funds by issuing debentures. The debt can be issued at an estimated cost of 10%. The EBIT for the previous year of the company was `8,00,000 and total capital investment was `1,00,00,000. Suggest whether issue of debenture would be considered a rational decision by the company.
Ans- In this case issue of debentures is not considered a suitable or rational decision by the company as it would increase more debt in the capital structure of the company and it is an additional cost for the company.
6.) How does working capital affect both the liquidity as well as profitability of a business?
Ans – Working capital provides liquidity to business as current assets like – cash ,marketable securities , Debtors etc can be converted into cash or cash equivalents within a period of one year that proves the liquidity of the business.
On the other hand , it affects the profitability position of business with the help of accurate proportion of Stock turnover ratio.
7.) Aval Ltd. is engaged in the business of export of canvas goods and bags. In the past, the performance of the company had been upto the expectations. In line with the latest demand in the market, the company decided to venture into leather goods for which it required specialised machinery.
For this, the Finance Manager Prabhu prepared a financial blueprint of the organisation’s future operations to estimate the amount of funds required and the timings with the objective to ensure that enough funds are available at right time. He also collected the relevant data about the profit estimates in the coming years. By doing this, he wanted to be sure about the availability of funds from the internal sources of the business.
For the remaining funds, he is trying to find out alternative sources from outside.
a.) Identify the financial concept discussed in the above paragraph. Also, state the objectives to be achieved by the use of financial concept so identified.
b.) ‘There is no restriction on payment of dividend by a company’. Comment.
Ans- a ) The Financial concept discussed above is Financial planning . The objective of Financial Panning are as follows:
i) To ensure availability of funds – This includes proper estimation of funds required for different purposes.
ii) To see that firm does not raise resources unnecessarily: excess funding is almost as bad as inadequate funding . With a surplus money available a good financial planning will put it to best possible use so that financial resources are not left idle.
b) The statement explains the following constraint in payment of dividend .
i) Legal constraint :Certain provisions of the Companies Act lay some restrictions on payment of dividend , hence those should be adhered to while payment of dividend.
ii) Contractual constraint : this means while granting loan to the company , the lender may put some contracts or restrictions in case of payment of dividend .
Long Answer Type
1.) What is working capital? Discuss five important determinants of working capital requirement?
Ans- Working Capital refers to the fund required for carrying out day to day expenses of the business.
The determinants of Working capital requirement are as follows:
i) Nature of Business: The basic nature of a business determines its requirement of working capital , like a trading concern will need a less amount of working capital than a manufacturing unit.
ii) Scale of operation: A Business unit operating on a large scale requires high amount of working capital for maintaining its inventory whereas a business unit operating in small scale requires less amount of it.
iii) Production cycle: This is defined as the time period between receipt of raw materials and converting them into finished goods. A Firm with longer processing or production cycle needs more amount of working capital than a firm with short production cycle.
iv) Availability of Raw Materials : If the raw materials are easily and freely available then the requirement of working capital is less and vice versa.
v) Inflation: With increase in prices of materials and other things a firm needs to maintain a large amount of working capital .
2.) “Capital structure decision is essentially optimisation of risk-return relationship.” Comment
Ans- One of the important decisions under financial management relates to the financing pattern or the proportion of the use of different sources in raising funds. On the basis of ownership, the sources of business finance can be broadly classified into two categories viz., ‘owners’ funds’ and ‘borrowed funds’. Owners’ funds consist of equity share capital, preference share capital and reserves and surpluses or retained earnings. Borrowed funds can be in the form of loans, debentures etc.
Capital structure refers to the mix between owners and borrowed funds. These shall be referred as equity and debt in the subsequent text. It can be calculated as debt-equity ratio i.e – Debt/ Equity.
Debt and equity differ significantly in their cost and riskiness for the firm. The cost of debt is lower than the cost of equity for a firm because the lender’s risk is lower than the equity shareholder’s risk, since the lender earns an assured return and repayment of capital and, therefore, they should require a lower rate of return.
3.) “A capital budgeting decision is capable of changing the financial fortunes of a business.” Do you agree? Give reasons for your answer?
Ans – Yes , I agree with the above statement and the reason for this are as follows:
Investment decision can be long-term or short-term. A long-term investment decision is also called a Capital Budgeting decision. It involves committing the finance on a long- term basis. For example, making investment in a new machine to replace an existing one or acquiring a new fixed asset or opening a new branch, etc. These decisions are very crucial for any business since they affect its earning capacity in the long run. The size of assets, profitability and competitiveness are all affected by capital budgeting decisions. Moreover, these decisions normally involve huge amounts of investment and are irreversible except at a huge cost. Therefore, once made, it is often almost impossible for a business to wriggle out of such decisions. Therefore, they need to be taken with utmost care. A bad capital budgeting decision normally has the capacity to severely damage the financial fortune of a business.
4.) Explain the factors affecting dividend decision.
Ans- The factors affecting Dividend decisions of a firm are as follows:
i) Amount of Earnings: Dividends are paid out of current and past earning. Therefore, earnings is a major determinant of the decision about dividend.
ii) Stability Earnings: Other things remaining the same, a company having stable earning is in a better position to declare higher dividends. As against this, a company having unstable earnings is likely to pay smaller dividend.
iii) Stability of Dividends: Companies generally follow a policy of stabilising dividend per share. The increase in dividends is generally made when there is confidence that their earning potential has gone up and not just the earnings of the current year.
iv) Growth Opportunities: Companies having good growth opportunities retain more money out of their earnings so as to finance the required investment. The dividend in growth companies is, therefore, smaller, than that in the non– growth companies.
v) Cash Flow Position: The payment of dividend involves an outflow of cash. A company may be earning profit but may be short on cash. Availability of enough cash in the company is necessary for declaration of dividend.
5.) Explain the term ‘Trading on Equity’. Why ,when and how it can be used by company?
Ans- Trading on Equity refers to the process of utilizing long term funds in the capital structure of the business.Capital structure of a company, thus, affects both the profitability and the financial risk. A capital structure will be said to be optimal when the proportion of debt and equity is such that it results in an increase in the value of the equity share. In other words, all decisions relating to capital structure should emphasise on increasing the shareholders’ wealth. The proportion of debt in the overall capital is also called financial leverage.
Financial leverage is computed as Debt equity ,or D + E when D is the Debt and E is the Equity. As the financial leverage increases, the cost of funds declines because of increased use of cheaper debt but the financial risk increases. The impact of financial leverage on the profitability of a business can be seen through EBIT-EPS (Earning before Interest and Taxes-Earning per Share).
6.) ‘S’ Limited is manufacturing steel at its plant in India. It is enjoying a buoyant demand for its products as economic growth is about 7–8 per cent and the demand for steel is growing. It is planning to set up a new steel plant to cash on the increased demand. It is estimated that it will require about `5000 crores to set up and about `500 crores of working capital to start the new plant.
a.) Describe the role and objectives of financial management for this company.
b.) Explain the importance of having a financial plan for this company.
Give an imaginary plan to support your answer.
a.) What are the factors which will affect the capital structure of this company?
b.) Keeping in mind that it is a highly capital-intensive sector, what factors will affect the fixed and working capital. Give reasons in support of your answer.
Ans- a) The Role and Objectives of Financial Management are as Follows:
i) The role of financial management cannot be over – emphasized, since it has a direct bearing on the financial health of a business. The financial statements, such as Balance Sheet and Profit and Loss Account, reflect a firm’s financial position and its financial health. Almost all items in the financial statements of a business are affected directly or indirectly through some financial management decisions.
ii) With an increase in the investment in fixed assets, there is a commensurate increase in the working capital requirement. The quantum of current assets is also influenced by financial management decisions. In addition, decisions about credit and inventory management affect the amount of debtors and inventory which in turn affect the total current assets as well as their composition.
b) The importance of having a Financial plan for this company are as follows:
i) To determine the best sources of raising funds.
ii) To know the Cash Flow position of the business to finance the project.
iii) To estimate and calculate the risk involved in the project.
a) The factors affecting Capital Structure of this company are as follows:
i) Interest Coverage Ratio (ICR): The interest coverage ratio refers to the number of times earnings before interest and taxes of a company covers the interest obligation. This may be calculated as follows:
ICR = EBIT/Interest
The higher the ratio, lower shall be the risk of company failing to meet its interest payment obligation.
ii) Cash Flow Position: Size of projected cash flows must be considered before borrowing. Cash flows must not only cover fixed cash payment obligations but there must be sufficient buffer also. It must be kept in mind that a company has cash payment obligations for
(i) normal business operations;
ii)for investment in fixed assets; and
(iii) for meeting the debt service commitments i.e., payment of interest and repayment of principal.
b) Factors affecting Fixed capital requirement are as follows:
i) Growth Prospects: Higher growth of an organisation generally requires higher investment in fixed assets. Even when such growth is expected, a company may choose to create higher capacity in order to meet the anticipated higher demand quicker.
ii) Diversification: A firm may choose to diversify its operations for various reasons, with diversification, fixed capital requirements increases.
Factors affecting Working capital requirement are as follows:
i) Nature of Business: The basic nature of a business determines its requirement of working capital , like a trading concern will need a less amount of working capital than a manufacturing unit.
ii) Scale of operation: A Business unit operating on a large scale requires high amount of working capital for maintaining its inventory whereas a business unit operating in small scale requires less amount of it.