NCERT Solutions for Class 12 Business Studies Chapter 9 Financial Management

NCERT
SOLUTIONS
CLASS - 12th

aglase .co

Class : 12th

Subject : Business Studies

Chapter : 9

Chapter Name : Financial Management

Q1 What is meant by capital structure?

Answer. Capital structure means the proportion of debts and equity used for financing the
operations of business.

Capital structure= Debt/Equity

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Q2 State the two objectives of financial planning.

Answer. Two objectives of financial planning are as follows -

→ To ensure availability of funds whenever these are required.

→ To see that firm does not raise resources unnecessarily.

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Q3 Name the concept of financial management which increases the return to equity
shareholders due to the presence of fixed financial charges.

Answer. Financial leverage increases the return to equity shareholders due to the presence of
fixed financial charges.

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Q4 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’.

Answer. Requirements of working capital will be less since service sectors like transport service
require no inventory and manufacturing overheads.

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Q5 Ramnath is into the business of assembling and selling 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.

Answer. It will affect the working capital. Requirement of working capital will be less since the
current liabilities are getting reduced.

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Q1 What is financial risk? Why does it arise?

Answer. Financial risk refers to the risk of a company not being able to cover its fixed financial
costs. The fixed costs of an enterprise may include interest obligations, preference dividend or
repayment obligations. Financial risk is directly associated with the debt capital in the capital
structure. If the debts will be more than the financial risk will also increase.

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Q2 Define current assets? Give four examples of such assets.

Answer. Current assets of a company are those assets which can be converted into cash or
cash equivalents within one year. These may include cash in hand, cash at bank, trade
receivables, inventory, prepaid expenses etc. These assets are used to provide liquidity and to
meet the current liabilities of the company.

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Q3 What are the main objectives of financial management? Briefly explain.

Answer. The main objective of financial management is to maximise shareholders wealth. The
shareholders wealth comprises the shares. Thus their wealth is maximised when the market
value of shares of the company is maximised. Thus financial management aims at those
activities which will increase more benefits to the firm than the costs in order to increase the
market value of the shares. It also aims to achieve the objective of profit maximisation and
maintaining adequate liquidity in the company.

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Q4 Financial management is based on three broad financial decisions. What are these?

Answer. Financial management is based on three broad financial decisions which are explained
below -

→ Investment Decision: Investment decision mainly relates to how the firm is going to invest its
funds in different assets. It determines the proportion of current assets and fixed assets in the
company.

→ Financing Decision: Financing decision aims at determining how the company is going to
raise its capital through various sources. It determines the proportion of the debt and equity
capital in the total capital of the company.

→ Dividend Decision: Dividend is the amount of profits which is paid to the shareholders on the
shares purchased by them. Thus this decision pertains to the amount of dividend to be paid to
the shareholders and the amount of retained earnings in the business for meeting investment
requirements.

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Q5 Sunrises Ltd. dealing in readymade garments, is planning to expand its business operations
in order to cater to the international market. For this purpose the company needs an 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 the issue of debenture would be
considered a rational decision by the company. give reason to justify your answer.

Answer. No, the issue of debenture would not be considered a rational decision by the
company.

Reason: Cost of debt: 10%

ROI: \( \frac{8,00,000}{1,00,00,000}\times 100 = 8 \% \)

Cost of debt is greater than ROI.

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Q6 How does working capital affect both the liquidity as well as profitability of a business?

Answer. Working capital of a business enterprise is the amount of funds available at its disposal
for the day to day administration and management of the organisation. It is the difference
between the current assets and current liabilities. If more working capital will be employed by
the business then it will increase its liquidity. However it yields less return as compared to fixed
assets, thus it will decrease profitability. Thus proper balance must be maintained between the
liquidity and profitability by using adequate amount of working capital.

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Q7 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 the 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 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 concepts so identified.

a. ‘There is no restriction on payment of dividend by a company’. Comment

Answer. a. The financial concept discussed in the above paragraph is known as Financial
planning. Objectives to be achieved by the use of financial concept so identified are:

a (1) Requirement of specialized machinery in order to venture into leather goods.

a (2) Availability of enough funds.

a (3) Finding alternative sources from outside sources

b. ‘There is no restriction on payment of dividend by a company’- this statement is incorrect. The
law has imposed certain legal restrictions on the payment of dividend along with the contractual
restrictions.

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Q1 What is working capital? Discuss five important determinants of working capital
requirement?

Answer. Working capital of a business enterprise is the amount of funds available at its
disposal for the day to day administration and management of the organisation. It is the
difference between the current assets and current liabilities.

Working Capital = Current Assets – Current Liabilities

Factors affecting working capital requirement are as follows:

→ Nature of Business: The business enterprise may deal in manufacturing or in trading
activities. A trading business requires less working capital as it doesn't have a long processing
cycle. However a manufacturing business requires more working capital.

→ Scale of Operation : A large sized organisation has more working capital requirements than a
small sized organisation. It is so because a large sized organisation has more requirements to
maintain inventory and has more expenses in the day to day activities.

→ Production Cycle : If the production cycle of a business enterprise is long, i.e. It requires
more time to convert raw materials into finished products, then it has to maintain more working
capital in order to meet its expenses.

→ Credit Allowed Different firms allow different credit terms to their customers. A liberal credit
policy results in a higher amount of debtors, increasing the requirements of working capital.

(v) Credit Availed Just as a firm allows credit to its customers it also may get credit from its
suppliers. The more credit a firm avails on its purchases, the working capital requirement is
reduced.

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Q2 “Capital structure decision is essentially optimisation of risk-return relationship.” Comment.

Answer. Capital structure refers to the mix between owners and borrowed funds. It can be
calculated as Debit/Equity.

Debt and equity differ significantly in their cost and riskiness for the firm. 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 lenders earn on assured return and repayment of capital and therefore they should
require a lower rate of return. Debt is cheaper but is more risky for a business because payment
of interest and the return of principal is obligatory for the business. Any default in meeting these
commitments may force the business to go into liquidation. There is no such compulsion in case
of equity, which is therefore, considered riskless for the business. Higher use of debt increases
the fixed financial charges of a business. As a result increased, use of debt increases the
financial risk of a business.

Capital structure of a business 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.

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Q3 “A capital budgeting decision is capable of changing the financial fortunes of a business.” Do
you agree? give reasons for your answer?

Answer. Investment decisions can be long term or short term. A long term investment decision
is also called a capital budgeting decision. It involves commiting the finance on a long term
basis, e.g., making investment in a new machine to replace an existing one or acquiring new
fixed assets or opening a new branch etc. These decisions are very crucial for any business.
They affect its earning capacity over the long-run, assets of a firm, profitability and
competitiveness, are all affected by the 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 almost impossible for a business to wriggle out of such decisions.
Therefore, they need to be taken with utmost care. These decisions must be taken by those
who understand them comprehensively. A bad capital budgeting decision normally has the
capacity to severely damage the financial fortune of a business.

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Q4 Explain the factors affecting dividend decision?

Answer. Dividend decision relates to distribution of profit to the shareholders and its retention in
the business for meeting the future investment requirements.

Factors affecting dividend decision are as follows:

→ Earnings Dividends are paid out of current and past year earnings. Therefore, earnings is a
major determinant of the decision about dividend.

→ Stability of Earnings Other things remaining the same, a company having stable earnings is
in a position to declare higher dividends. As against this, a company having unstable earnings is
likely to pay a smaller dividend.

→ 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 non-growth companies.

→ Cash Flow Position Dividends involve an outflow of cash. A company may be profitable but
short on cash. Availability of enough cash in the company is necessary for declaration of
dividend by it.

→ Shareholder Preference If the shareholder in general, desire that at least a certain amount
should be paid as dividend, the companies are likely to declare the same.

→ Taxation Policy If tax on dividend is higher it would be better to pay less by way of dividends.
As compared to this, higher dividends may be declared if tax rates are relatively lower.

→ Stock Market Reaction For investors, an increase in dividend is a good news and stock
prices react positively to it. Similarly, a decrease in dividend may have a negative impact on the
share prices in the stock market.

→ Access to Capital Market Large and reputed companies generally have easy access to the
capital market and therefore, depend less on retained earnings to finance their growth. These
companies tend to pay higher dividends than the smaller companies which have relatively low
access to the market.

→ Legal constraints Certain provisions of the Company’s Act place restriction on payouts as
dividend. Such provisions have to be adhered, while declaring dividends.

→ Contractual Constraints While granting loans to a company, sometimes the lender may
impose certain restrictions on the payment of dividends in future. The companies are required to
ensure that the dividends does not violate the terms and conditions of the loan agreement in this
regard.

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Q5 Explain the term ‘Trading on equity’? Why, when and how it can be used by company.

Answer. Trading on equity refers to the increase in profit earned by the equity shareholders due
to presence of fixed financial charges. When the rate of earning or Return on Investment (ROI)
of a company is higher than the rate of interest on borrowed funds only then a company should
opt for trading on equity.

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Q6 ‘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.

c. What are the factors which will affect the capital structure of this company?

d. 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.

Answer. a) Role of Financial Management Financial management is concerned with the proper
management of funds. It involves

→ Managerial decisions relating to procurement of long term and short term funds.

→ Keeping the risk associated with respect to procured funds under control.

→ Utilisation of funds in the most productive and effective manner

→ Fixed debt equity ratio in capital.

b) Importance of financial plan for the company:

→ Financial Planning ensures provision of adequate funds to meet working capital
requirements.

→ It brings about a balance between in flow and out flow of funds and ensures liquidity
throughout the year.

→ It solves the problems of shortage and surplus of funds and ensures proper and optimum
utilisation of available resources.

→ It ensures increased profitability through cost benefit analysis and by avoiding wasteful
operations.

→ It seeks to eliminate waste of funds and provides better financial control.

→ It seeks to avail the benefits of trading on equity

c) Capital structure refers to the proportion in which debt and equity funds are used for financing
the operations of a business. A capital structure is said to be optimum when the proportion of
debt and equity is such that it results in an increase in the value of shares. The factors that will
affect the capital structure of this company are:

→ Equity Funds: The composition of equity funds in the capital structure will be governed by the
following factors

The requirement of funds of ‘S’ Limited is for long term. Hence, equity funds will be more
appropriate.

→ There are no financial risks attached to this form of funding.

→ If the stock market is bullish, the company can easily raise funds through issue of equity
shares.

→ If the company already has raised a reasonable amount of debt funds, each subsequent
borrowing will come at a higher interest rate and will increase the fixed charges.

→ Debt Funds: The usage and the ratio of debt funds in the capital structure will be governed
by factors like

→ The availability of cash flow with the company to meet its fixed financial charges. The
purpose is to reduce the financial risk associated with such payments which can further be
checked by using ‘debt’ service coverage ratio.

→ It will provide the benefit of trading on equity and hence will increase the earning per share of
equity shareholders. However, ‘return on investment’ ratio will be the guiding principle behind it.
The company should opt for trading on equity only when return on investment is more than the
fixed charges.

→ Interest on debt funds is a deductible expense and therefore, will reduce the tax liability.

→ It does not result in dilution of management control.

d) The working and fixed capital requirement of ‘S’ Limited will be high due to the following
reasons:

→ The business is capital intensive and the scale of operation is large.

→ Heavy investments are required for building up the production base and for technological
upgrade.

→ In the case of the steel industry, the major input is iron ore and coal. The ratio of cost of raw
material to total cost is very high. Hence, higher will be the need for working capital.

→ The longer the operating cycle, the larger is the amount of working capital required as the
funds get locked up in the production process for a long period of time.

→ Terms of credit for buying and selling goods, discount allowed by suppliers and to the
customers also determines the quantum of working capital.

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