FFM 2019

1. (A) Choose the appropriate answer: (1×5=5)

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

✅d) All of the above
2. Internal rate of return is the discount rate, at which
✅c) NPV = 0
3. The overall cost of capital is also known as
✅c) Weighted cost of capital
4. Stable dividend means
✅c) Both (a) or (b)
5. Earnings per share of a firm is calculated by
✅c) PAT minus preference dividend divided by number of equity shares

1. (B) Write True or False: (1×5=5)

1. Investment decision is not related to working capital management decision.

✅False
2. If the market value of shares is higher than their book value, it may be taken as a
symptom of under-capitalisation.
✅True
3. When the Profitability Index exceeds one, the proposal for investment is accepted.
✅True
4. When the company pays dividend in the form of bond, it is called property dividend.
✅False (It is called bond dividend or debenture dividend; property dividend is usually
non-cash assets like stock of another company.)
5. Over-capitalisation may be corrected by ploughing back of profit.
✅True

2. Answer the following questions (30 words each):

a) What is capital structure?

Capital structure refers to the mix of debt and equity that a company uses to finance its overall
operations and growth.

b) What is net present value?

NPV is the difference between the present value of cash inflows and outflows over time. A
positive NPV indicates profitability.
c) Define Operating Leverage.
Operating leverage measures the sensitivity of a firm's operating income (EBIT) to changes in
sales due to fixed operating costs.

d) What is permanent working capital?

Permanent working capital is the minimum amount of capital always required to meet the firm’s
basic day-to-day operational needs.

e) State the meaning of EPS.

EPS (Earnings Per Share) represents the portion of a company’s profit allocated to each
outstanding equity share.

3. Answer the following questions (100–150 words each):

1) Limitations of Financial Management:

 Forecasting Errors: Financial decisions are based on forecasts which may not always be
accurate due to economic fluctuations.
 Complexity: Requires technical knowledge and understanding of financial instruments
and markets.
 Uncertainty: Market conditions, interest rates, and government policies can
unpredictably affect outcomes.
 Risk Factor Ignored: Traditional financial management often emphasizes profitability
over risk.
 Overemphasis on Quantitative Aspects: Qualitative aspects like employee morale or
reputation are often overlooked.
 Costly Implementation: Advanced financial strategies may require expensive
technology and expertise.

2) Difference between Financial Leverage and Operating Leverage:

Basis Operating Leverage Financial Leverage

Use of fixed operating costs in
Definition Use of fixed financial costs (like debt)
production
Impact Area Affects EBIT Affects EPS
Risk Business risk Financial risk
Indicator DOL = % Change in EBIT / % Change DFL = % Change in EPS / % Change
Formula in Sales in EBIT
Maximize returns from financing
Objective Maximize returns from operations
decisions
3) Working Capital Requirement Calculation:

Given:

 Cost of Goods Sold (COGS) = Rs. 125 crores

 Operating Cycle = 52 days
 Desired cash balance = Rs. 125 crores

Step 1: Calculate Daily Operating Cost:

Daily COGS=125365=0.3425 crores/day\text{Daily COGS} = \frac{125}{365} = 0.3425 \text{

crores/day}Daily COGS=365125=0.3425 crores/day

Step 2: Multiply with Operating Cycle:

Working Capital Requirement (excluding buffer)=0.3425×52=17.81 crores\text{Working Capital

Requirement (excluding buffer)} = 0.3425 × 52 = 17.81 \text{
crores}Working Capital Requirement (excluding buffer)=0.3425×52=17.81 crores

Step 3: Add Desired Cash Balance:

Total Working Capital Requirement=17.81+125=Rs.142.81crores\text{Total Working Capital

Requirement} = 17.81 + 125 = \boxed{Rs. 142.81
crores}Total Working Capital Requirement=17.81+125=Rs.142.81crores

4) What is stock dividend? Why is it issued?

Stock Dividend:
A stock dividend is a dividend payment made in the form of additional shares rather than cash.
Instead of receiving cash, shareholders get more shares of the company, in proportion to their
existing holdings.

Why It Is Issued:

1. To Conserve Cash: When a company wants to reward shareholders but conserve cash
for reinvestment or liquidity.
2. To Signal Confidence: Indicates the company expects good future earnings.
3. To Make Shares More Affordable: By increasing the number of shares, the price per
share may reduce, making it more attractive to investors.
4. To Capitalize Retained Earnings: It converts retained earnings into share capital,
thereby strengthening the equity base.

5) State the consequences of overcapitalisation.

Overcapitalisation occurs when a company’s capital exceeds its actual needs or earning
capacity. This leads to inefficiency and low returns.

Consequences:

1. Low Rate of Return: Earnings are insufficient to justify the capital employed, leading to
a lower return on investment.
2. Reduced Share Price: Investors may lose confidence, causing a fall in market price of
shares.
3. Difficulty in Raising Funds: Investors may hesitate to invest further due to poor
financial performance.
4. Poor Creditworthiness: Creditors may see the firm as financially weak, making
borrowing difficult or expensive.
5. Employee Dissatisfaction: Low profits may lead to wage cuts or lack of bonuses,
causing unrest.
6. Loss of Reputation: Market reputation suffers, making long-term growth difficult.

4(a) Explain the inter-relationship among financing, investment, and dividend

distribution decisions.

(Marks: 10)

Financial management revolves around three core decisions:

1. Investment Decision

 Concerned with selecting the best assets or projects in which the firm should invest its
funds.
 Affects the size and composition of assets.

2. Financing Decision

 Related to the procurement of funds.

 Involves deciding the capital structure – the mix of debt and equity.
 Impacts the cost of capital and financial risk.

3. Dividend Decision

 Deals with how much profit should be distributed as dividends and how much should be
retained.
 Influences shareholder satisfaction and future growth.

Interrelationship:

 These three decisions are interlinked and impact each other:

 o The investment decision determines the amount of funds required, influencing
the financing decision.
o The financing decision affects the cost of capital, which in turn influences the
viability of investment projects (through NPV or IRR).
o The amount of profit retained versus distributed as dividends affects the internal
funds available for future investments, influencing the need for external financing.
 The goal is to maximize shareholders' wealth, and this is only possible when all three
decisions are aligned.

OPTION A1: Explain the factors affecting capital structure of a firm.

Capital structure refers to the mix of debt and equity used by a firm to finance its operations.
Key factors:

1. Cost of Capital: Firms aim to minimize the weighted average cost of capital (WACC).
2. Risk: High debt increases financial risk. Firms must balance between return and risk.
3. Cash Flow Position: Firms with stable and strong cash flows can afford more debt.
4. Control: Equity dilutes control; debt does not. Owners may prefer debt to retain control.
5. Tax Benefits: Interest on debt is tax-deductible, making debt financing attractive.
6. Market Conditions: Favorable equity markets might prompt equity financing.
7. Flexibility: Firms may want flexibility in raising funds and managing obligations.
8. Nature of Business: Capital-intensive industries may prefer debt due to asset base.
9. Regulatory Framework: Government rules regarding debt-equity ratios may influence
structure.

4(b) NPV Analysis for Computer A and B

Given:

Year A (Rs.) B (Rs.) PV Factor @10%

1 20,000 22,000 0.909
2 24,000 40,000 0.826
3 26,000 8,000 0.751
4 18,000 20,000 0.683
5 12,000 10,000 0.621
Cost 55,000 55,000

Computer A:

 20,000 × 0.909 = 18,180

  24,000 × 0.826 = 19,824
 26,000 × 0.751 = 19,526
 18,000 × 0.683 = 12,294
 12,000 × 0.621 = 7,452
 Total PV = ₹77,276
 NPV = 77,276 – 55,000 = ₹22,276

Computer B:

 22,000 × 0.909 = 19,998

 40,000 × 0.826 = 33,040
 8,000 × 0.751 = 6,008
 20,000 × 0.683 = 13,660
 10,000 × 0.621 = 6,210
 Total PV = ₹78,916
 NPV = 78,916 – 55,000 = ₹23,916

Conclusion:

Since Computer B has a higher NPV, it is more profitable.

Recommendation: Purchase Computer B.

4(c) “Profit maximisation is not the adequate criteria to judge the efficiency of a
firm.”

(Marks: 10)

Explanation:

While profit maximization is an important goal, it is not a comprehensive measure of a firm's

efficiency or long-term success.

Limitations of Profit Maximization:

1. Ignores Time Value of Money: Future profits are not valued properly.
2. Short-Term Focus: Firms may cut essential costs (like R&D) for short-term gains.
3. Risk Factor Ignored: It doesn't account for the uncertainty in achieving profits.
4. No Consideration for Stakeholders: Focuses only on shareholders, ignoring employees,
customers, society, etc.
5. No Standard Definition: Profit can be defined in different ways – gross, net, operating.
6. Ethical and Environmental Neglect: Firms might adopt unethical practices to boost
profits.

Better Alternative – Wealth Maximization:

  Focuses on long-term value.
 Considers time value of money.
 Incorporates risk.
 Aims at increasing the market value of shares.

Conclusion: Profit is important but not sufficient. Wealth maximization is a more holistic and
appropriate goal for financial management.

4(d) Basic strategies of efficient cash management and importance of cash budget

Basic Strategies for Efficient Cash Management (5 marks)

1. Cash Flow Forecasting: Predict inflows and outflows to avoid shortages or surpluses.
2. Speedy Collections: Use of electronic payments, lock-box systems to accelerate
collections.
3. Delayed Payments: Delay outflows (without penalties) to optimize cash retention.
4. Investment of Idle Funds: Temporary surplus cash should be invested in marketable
securities.
5. Cash Concentration Systems: Centralizing cash from different branches for better
control.

Importance of Cash Budget (5 marks)

A cash budget is a plan showing expected cash inflows and outflows during a specific period.

 Liquidity Planning: Helps ensure the firm has enough cash to meet obligations.
 Avoid Overdrafts/Idle Cash: Manages cash balance efficiently.
 Informs Borrowing Decisions: Indicates when and how much to borrow.
 Controls Expenditures: Prevents overspending and enforces financial discipline.
 Planning for Investment: Guides when surplus cash can be invested profitably.

Conclusion: Effective cash management and budgeting are essential for liquidity, profitability,
and solvency of a firm.

✅OPTION B1: Discuss the modern methods of capital budgeting.

(Marks: 10)

Modern methods of capital budgeting incorporate the time value of money, providing a better
evaluation of investment projects:

1. Net Present Value (NPV)

  Calculates the present value of future cash inflows minus initial investment.
 Accept if NPV > 0.
 Advantage: Considers time value of money and risk-adjusted rate.
 Formula:

NPV=∑Cash inflow(1+r)t−Initial Investment\text{NPV} = \sum \frac{\text{Cash

inflow}}{(1 + r)^t} - \text{Initial Investment}NPV=∑(1+r)tCash inflow
−Initial Investment

2. Internal Rate of Return (IRR)

 The discount rate at which NPV = 0.

 Accept if IRR > cost of capital.
 Indicates project profitability in percentage terms.

3. Profitability Index (PI)

 Ratio of PV of inflows to PV of outflows.

 PI=Present value of cash inflowsInitial investment\text{PI} = \frac{\text{Present value of
cash inflows}}{\text{Initial
investment}}PI=Initial investmentPresent value of cash inflows
 Accept if PI > 1.

4. Discounted Payback Period

 Time period required to recover initial investment, considering discounting.

 Better than traditional payback, but ignores returns after payback.

5. Modified Internal Rate of Return (MIRR)

 Overcomes the limitations of IRR (multiple IRRs, reinvestment assumption).

 Assumes reinvestment at cost of capital.

Conclusion:
Modern techniques like NPV and IRR are more reliable because they account for the time
value of money, risk, and cash flows, giving a more realistic view of a project’s viability.

✅OPTION C1: Factors determining the dividend policy of a corporate entity

(Marks: 10)

Dividend policy refers to the decision regarding the distribution of profits as dividends vs.
retention in the business.

Key Factors:

1. Profitability of the Company

o Firms with stable and high profits are more likely to pay higher dividends.
2. Liquidity Position
o Even if profits exist, cash must be available to pay dividends.
3. Stability of Earnings
o Companies with consistent earnings prefer stable dividend policies.
4. Growth Opportunities
o Firms with expansion plans retain more profits and pay lower dividends.
5. Shareholder Preferences
o If shareholders prefer regular income, firms may follow stable payout policies.
6. Taxation Policy
o Higher dividend tax may reduce dividends to favor capital appreciation.
7. Access to Capital Market
o Companies with easy access to capital markets may pay more dividends.
8. Legal Restrictions
o Dividends can only be paid out of distributable profits as per the Companies Act.
9. Inflation
o Firms may retain more during inflation to maintain capital purchasing power.
10. Cost of Alternative Financing

 Higher cost of external funds leads to lower dividends and higher retention.

✅OPTION D1: Forecasting Techniques of Working Capital Requirement

(Marks: 10)

Working capital forecasting is essential for ensuring smooth business operations. Major
techniques:
1. Percentage of Sales Method

 Assumes working capital requirements are a fixed percentage of projected sales.

 Simple and widely used for short-term forecasting.

2. Operating Cycle Method

 Based on time taken from purchase of raw materials to realization of cash from sales.
 More accurate as it considers inventory, receivables, and payables.

3. Cash Budgeting Method

 Involves forecasting cash inflows and outflows for a given period.

 Helps maintain desired cash balance.
 Suitable for seasonal businesses and short-term planning.

4. Regression Analysis

 Uses historical data to forecast working capital using statistical methods.

 Helpful for medium to large firms with sufficient data.

5. Average Collection Period & Inventory Turnover Analysis

 Helps in estimating receivables and inventory holding levels based on past trends.

6. Projected Balance Sheet Method

 Estimates current assets and liabilities based on projected financial statements.

 The difference gives working capital requirement.

Conclusion:

Choice of technique depends on business size, nature, data availability, and forecasting
purpose. A combination is often used for better accuracy.