Unit-9 notess

Q1. What is meant by capital structure?

Capital structure is the combination of debt and equity, which is
used by a company to finance its requirements for funds. Debt
can be obtained in the form of loans, while equity is generated
through retained earnings or common stock.

Q2. Discuss the two objectives of Financial Planning.

Financial planning is the process of framing financial policies,
procedures, programs and budgets that are necessary for the
financial activities of the enterprise. Objectives of financial
planning are:
1. To ensure proper utilisation of funds available for the
organisational activities.
2. To determine the capital structure, which is the composition
of debt and equity that is necessary for a business.

Q3. Name the concept of financial management, which

increases the return to equity shareholders due to the
presence of fixed financial charges.
Trading on equity concept increases returns to equity
shareholders due to the presence of fixed financial charges.

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’.
The type of business conducted by Amrit is transport service
which will be operating on a large scale. Hence, there is a need
for more amount of working capital.
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 for working capital? Give reasons
in support of your answer
As Ramnath has adopted the policy of purchasing components
on credit for 3 months and selling the product in cash, the
working capital requirement is reduced
Short Answer Questions
Q1. What is financial risk? Why does it arise?
Financial risk is said to be the situation when a company is
unable to meet its set of fixed expenses such as interest
payment, loan repayment and preference dividend pay-out. It is
a situation where a company is unable to meet its financial
obligations. Financial risk arises due to the high level of debt in
the capital structure. A high level of debt leads to a high
amount of interest which increases the chances of defaulting on
payment.
Q2. Define a ‘current asset’. Give four examples of such
assets.
The current assets of a firm are those assets that have the
potential to be converted into cash or cash equivalents within
the current accounting period. Current assets provide liquidity
to the company. Examples of current assets are cash, short-
term investment, marketable securities and debtors.
Q3. What are the main objectives of financial
management? Briefly explain.
The main objective of financial management is the
maximisation of shareholders’ wealth. Therefore, financial
management is all about making those decisions that will bring
gains for the shareholders. Gains can be said to be achieved
when the market value of shares rises. Once the primary
objective of wealth maximisation is achieved, the other
objectives, such as maintaining liquidity and proper utilisation
of funds, are fulfilled along with it.
Q4. Financial management is based on three broad
financial decisions. What are these?
Financial management is the technique of proper allocation,
acquisition and use of funds by the company. The three broad
financial decisions on which financial management is based are
investment decisions, financial decisions and dividend
decisions.
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 to replace
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 the total capital
investment was 1,00,00,000. Suggest whether the issue
of debenture would be considered a rational decision by
the company. Give reasons to justify your answer. (Ans.
No, the Cost of Debt (10%) is more than ROI which is
8%).
A company is able to issue debentures for fundraising when the
debt cost is less than the cost of capital.
In this question, the cost of capital of Sunrises Limited is 10%
which is 8,00,000, as the total capital is 80,00,000.
Now, the return on investment is calculated as
ROI = Return / Investment = 8,00,000/1,00,00,000 = 8 %
Assuming that the company will be operating with the same
efficiency, the additional investment of 80,00,000 will have an
ROI of 8%, which will amount to 6,40,000.
The cost of debt will be 8,00,000, which is more than the ROI
of 6,40,000. Therefore, it is advisable for a company not to
issue a debenture when the cost of debt is higher than the cost
of capital.
Q6. How does working capital affect both the liquidity as
well as the profitability of a business?
Working capital in a business is the surplus that is determined
by subtracting current liabilities from the current assets of the
organisation. By increasing the working capital, the liquidity of
an organisation increases. But more current assets present in
business results in a fall in profitability of the organisation, as
current assets offer low returns, which cause a decline in the
profit of a business.
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 up to 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 number
of funds required and the timings with the objective of
ensuring that enough funds are available at the right
time. He also collected relevant data about the profit
estimates for 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 the financial concept so identified. (Financial
Planning)
b. ‘There is no restriction on payment of dividends by a
company.’ Comment. (Legal & Contractual Constraints)
a. The financial concept discussed here is capital budgeting; it
is the decision regarding capital investment which will have an
impact on the profitability of the company in the long term. The
company wants to invest in new machinery, which needs
investment, this will have a direct impact on the operations,
which will result in affecting the profitability of the organisation.
The following objectives can be achieved:
1. Cash flow: Investment will bring new machinery, which will
increase organisations’ profitability. 2. When a company wants
to raise funds from both inside and outside the organisation, it
will be helpful to analyse that return generated from such
investment will be more than the cost of capital.
3. Investment used: The company is planning to raise funds
from both inside and outside. It is important to know that funds
from internal and external sources will have different rates of
interest.
b. Companies pay dividends to shareholders, which are part of
the company earnings. Paying of dividends is based on the
following factors:
1. Legal Constraint: Legal constraints are such constraints that
are mentioned in the company laws which impact paying out
dividends on certain occasions. It should be followed properly.
2. Contractual Constraints: Paying out of dividends reduces
cash in the company. Money that is raised as a loan will put
certain restrictions on the company for paying dividends, such
constraints are called contractual constraints.
Long Answer Questions
Q1. What is working capital? How is it calculated?
Discuss five important determinants of working capital
requirement.
Working capital in a business is the surplus that is determined
by subtracting current liabilities from the current assets of the
organisation. Current assets are those assets that can be
converted into cash or cash equivalent within the current
accounting period. Two broad categories of working capital can
be classified
1. Gross Working Capital 2. Net Working Capital
Gross Working Capital is referred to as the current assets
that are present in the balance sheet of a company. Net
Working Capital is the difference between current assets
and current liabilities present in the balance sheet of an
organisation. Net working capital is more relevant for
capital financing and management.
Working capital is calculated as
Working Capital = Current Assets – Current Liabilities
The following are the determinants of the working capital
requirement:
1. Business Type: The nature of the business of a firm
determines its working capital requirement. The size and
type of operations of an organisation will affect the extent
of working capital required. For example, firms that offer
services will have low working capital requirements,
whereas a manufacturing plant will have a large working
capital requirement. The operating cycle of such a firm is
more.
2. Scale of operations: The extent of the scale of
operations is a determining factor for working capital. A
firm having a large scale of operation will see an increase
in working capital requirement as firms have a high
requirement of maintaining inventory. Similarly, a firm
having a small scale of operations will have a low working
capital requirement.
3. Fluctuations of Business Cycle: The working capital will
also vary with the different phases in which a business is
running. During high demand in the market, there will be a
high requirement for production; so, working capital will be
more, whereas in terms of low demand.
4. Production Cycle: Every industry will have a different
production cycle depending on the type of industry. A firm
having a longer production cycle will have a higher
requirement of working capital, and firms having a short
production cycle will have a low working capital
requirement.
5. Growth Prospects: Companies that have higher growth
prospects and are looking for expansion have a higher
working capital requirement.

Q2. “Capital structure decision is essentially

optimisation of risk-return relationship.” Comment.
Capital structure is the combination of debt and equity,
which is used by a company to finance its requirements
for funds. Debt can be obtained in the form of loans, while
equity is generated through retained earnings or common
stock. Borrowed funds can be in the form of loans,
debentures, bank loans, etc. While in the case of an
owner’s fund, it can be in the form of preference share
capital, reserves, retained earnings, equity share capital,
etc.
Debt and equity both have their risk and profitability. Debt
is a relatively cheap source while the greater risk is there,
and equity is comparatively expensive but is of lower risk
for the firm. Fundraising through debt is cheaper, while
same with equity is expensive. Debt, though cheaper, has
more risks, as it has an obligation towards lenders. For
equity, there is no such compulsion to pay dividends. Also,
the return offered by the sources leads to an increase in
value per share. Debt gives higher returns per share but
increases the risk comparatively many times. Therefore,
capital structure decisions should be taken into
consideration with return and the amount of risk involved.

Q3. “A capital budgeting decision is capable of

changing the financial fortunes of a business.” Do
you agree? Why or why not?
Capital budgeting decision needs to be taken very
carefully, as the fortunes of a business can be changed
with such a decision. The decision of capital budgeting is
the allocation of fixed capital to different projects. Capital
budgeting involves purchasing new assets, or it can be
regarding the replacement or modernisation of the assets.
All these decisions have a long-term impact on the
business and can affect profitability and risk. The following
points highlight the importance of capital budgeting
decisions:
1. Investment in long-term assets will yield returns in
future and, by doing so, affect the future prospects of a
business. Therefore, the kind of decision taken by a
company will reflect on its long-term growth.
2. A large amount of funds is required to acquire assets.
Therefore, the money that is invested will be blocked for a
certain period, which makes it all the more important to
plan capital budgeting decisions.
3. Acquiring assets is of high risk because it has a long-
term impact on the business. If the return on the asset is
less than the investment, the business will be impacted.
4. Decisions, once made, are irreversible as reversing
leads to a great amount of loss.

Q4. Explain the factors affecting the dividend

decision.
A dividend decision is a decision to share a portion of
profit which is to be shared between shareholders and
what should be kept as retained earnings. The following
factors affect dividend decisions:
1. Businesses can pay dividends from current and past
earnings. A company which is having higher earnings will
be in a better position to pay dividends in comparison to a
company having limited earnings.
2. Companies having stable earning are in a good position
to provide dividends as compared to companies which are
inconsistent in earnings.
3. Companies follow a stable dividend-sharing policy. It will
only be changed when there is a rise in earning.
4. Companies that are looking for higher growth may keep
a certain portion of earning as dividends while investing
the majority in expansion. Therefore, such companies offer
lesser dividends.
5. If the company does not have a good cash flow, it will
impact the dividends paid out.
6. Company must also check the shareholder preferences
while paying dividends, as shareholders may require a
certain amount of dividend.
7. Taxation policies play a major role in deciding the
dividends. A policy levying high tax on dividend
distribution leads to companies offering lower dividends
and vice versa.
8. Stock market prices will fluctuate depending on the
dividend that is declared. It can rise with a high dividend
payout while declining with a low dividend payout.
 9. There can be contractual constraints at the time of
offering loans that are imposed by the lender in the form
of an agreement. Such agreements need to be checked
before issuing dividend payouts.
10. Companies having greater access to capital markets
can pay a higher dividend and vice versa.
11. Companies have to follow the rules, regulations and
restrictions of the Companies Act while declaring dividend
pay-out.

Q5. Explain the term” Trading on Equity.” Why,

when, and how it can be used by a company?
Trading on equity is a process of using debt in order to
produce a gain for the owners. In this process, new debt is
taken in order to gain new assets with which they can earn
a greater level of interest, which is more than the interest
that is paid for the debt. This process is practised as the
equity shareholders are only interested in the income that
is generated from the business. It is only practised by a
company when the rate of return on investment is greater
than the rate of interest for the fund that is borrowed. This
practice is a form of financial leverage that a company
exercises. There is an increase in earnings per share when
this process is adopted. Trading on equity is profitable only
when the return on investment is greater than the amount
of funds borrowed. It is said that trading on equity shall be
avoided if the return on investment is less than the rate of
interest from the funds that are borrowed

Q6. ‘S’ Limited manufactures steel at its plant in

India. It is enjoying a buoyant demand for its
products as economic growth is about 7%-8%, 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 Rs
5000 crores to set up and about Rs 500 crores of
working capital to start the new plant.
Questions
 1. Describe the role and objectives of financial
management for this company.
2. Explain the importance of having a financial plan
for this company. Give an imaginary plan to support
your answer.
3. What are the factors which will affect the capital
structure of this company?
4. 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.

1 Role of financial management in this company is

as follows:
1. Financial management will help in taking decisions to
purchase fixed assets which will increase the composition
of fixed assets.
2. The composition of funds that are used by a company
refers to the mix of short and long-term funds that are
used by the company. Fund composition is determined by
the company’s decision which is regarding profitability and
liquidity. It can be said that if a company is looking to
attain higher liquidity, it would be looking to opt for long-
term financing and companies looking for short-term
liquidity will opt for short-term financing. 3. The proportion
of debt and equity that should be used in long-term
financing or, in other words, the distribution of funds that
are raised with a mix of debt and equity, which is taken by
financial management.
4. The amount of current assets that a company holds is
dependent on the financial decision of the company. A
higher amount will lead to more working capital but a
decrease in profits and vice versa. In this case, the basic
objective of financial management will be towards
increasing or maximising shareholders’ wealth. Decisions
that will be beneficial for the shareholders, i.e., help in
increasing their market value of shares. This can be
achieved if financial management takes a decision that
results in an increase in the value of shares where benefits
obtained from making this decision exceed the cost of
taking the financial decision.

2. These points highlight the importance of financial

planning for the company:
i. It enables the company to forecast future requirements.
ii. Financial plan will be helpful in avoiding any kind of
shortage that may occur or surplus that can also occur. It
ensures that funds are used optimally.
iii. It helps in better coordination between the sales and
production teams. iv. It helps in avoiding any type of waste
such as time, money and effort.
v. If the targets and policies are well defined, then
financial planning helps in evaluating the performance in a
good way.
v. If the targets and policies are well defined, then
financial planning helps in evaluating the performance in a
good way.

Proposed Financial Plan The company can use the 50%

through the issue of shares, and the other 50% can be
collected using funds that are borrowed from outside in
the form of debts

3. Following factors will affect the capital structure

choice:

i. Company should be opting for debt capital in case of

strong cash flow is present. Debt requires payment of
principal as well as interest that is applicable to the
principal.
ii. ii. Debt service coverage ratio determines the
obligations towards cash payment of a company as
against the cash availability. Having a high DSCR can
make the company opt for debt as a source of funds.
iii. iii. Equity cost can be directly related to the financial
risk that a company faces. A company having a
higher financial risk will see the expectations of
shareholders rise, which raises the cost of equity. The
 rising cost of equity makes it difficult to opt for
equity.
iv. iv. Good stock market conditions are very much
conducive to for opting equity capital, whereas poor
stock market conditions are difficult for opting for
equity capital.
v. v. Higher interest coverage ratio, which is a measure
of the times EBIT is able to meet interest rate
obligations. A higher interest coverage ratio
translates to lower risk for the company, which
enables a company to opt for a high portion of debt
in the composition of its capital structure.
vi. A high rate of floatation cost leads to a reduction of
the component in capital structure. A high floatation
cost of equity results in a low capital structure.
vii. Higher rate of interest applicable on debt leads to
higher debt cost, which makes it difficult to choose
debt as capital structure.

4. Factors affecting fixed capital requirements

are as follows:

i. Fixed capital can be determined by the type of

business. As the company mentioned here (S
Limited) is a company which is into manufacturing, it
will have a large operating cycle which therefore
results in a need for a large amount of fixed capital.
ii. The scale of operations of a company also
determines the need for investment in assets such as
machinery, land, plants and buildings, which requires
a large sum of fixed capital.
iii. A growing company or a company which is
seeking expansion will need more amount of fixed
capital which is the case with S Limited.

Factors affecting working capital requirements

will be as follows:
i. The working capital requirements for a
company will vary on the type of business it is
 conducting. As it is a manufacturing firm will, it
will have a large operating cycle as goods need
to be transformed from raw materials to
finished goods. Therefore, the requirement for
working capital will be more for this firm.
ii. ii. As this company is conducting large-scale
operations, there will be requirements for a
large amount of working capital.
iii. iii. The company is looking to expand its
business which requires more working capital as
it will lead to higher growth prospects.
iv. iv. As the product that is being manufactured by
this company is in high demand, the company
would need to produce more to meet the
requirements. Therefore, there will be a need
for a large amount of working capital