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Q) Give the meaning of ‘capital structure’.
Ans: The mix of equity and debt actually used by a company for meeting its requirement of capital is known as its capital structure.
Q) State any three objectives of financial planning.
Ans: Three objectives of financial planning are:
To ascertain the amount of fixed capital(land, machinery) as well as the working capital(rent, salary, raw materials) required in a given period.
To determine the amount to be raised through various sources using a judicious debt-equity mix.
To ensure that the required amount is raised on time at the lowest possible cost.
State the meaning of Financial Management.
Ans: Adequate and proper financing is quite important for success in any business. While the overall managerial activity of handling finance is called ‘Financial management’
What is meant by Financial Planning?
Ans: It refers to the process of estimating a firm’s financial requirements and determining pattern of financing. It includes determining the objectives, policies, procedures and programmes to deal with financial activities.
Q) 'While preparing financial plan for a business unit, some aspects should be kept in view so as to ensure the success of the enterprise in meeting the organisational objectives'. Briefly describe these aspects.
Ans: To ensure the success of the enterprise in meeting the organisational objectives, some essentials of a sound financial plan are:
The plan must be simple: Now-a-days you have a large variety of securities that can be issued to raise capital from the market. But it is considered better to confine to equity shares and simple fixed interest debentures.
It must take a long term view: This ensures that the planfully provides for meeting the capital requirement on long term basis and takes care of the changes in capital requirement from year to year.
It must be flexible: While the financial plan is based on long term view, one may not be able to properly visualise the possible developments in future. Hence, it is very necessary that the financial plan is capable of being adjusted and revised without any difficulty and delay so as to meet the requirements of the changed circumstances.
It must ensure optimal use of funds: The plan should provide for raising reasonable amount of funds. As stated earlier, the business should neither be starved of funds nor have surplus funds.
The cost of funds raised should be fully taken into account and kept at the lowest possible level: It must be ensured that the cost of funds raised is reasonable. The plan should provide for a financial mix (combination of debt and equity) that is most economical in terms of cost of capital, otherwise it will adversely affect the return on shareholders’ funds.
Adequate liquidity must be ensured: Liquidity refers to the ability of a firm to make available the necessary amount of cash as and when required.
Q) Define ‘fixed capital.’ What are the factors determining the fixed capital requirements of a manufacturing organisation? Explain them in brief.
Ans:
Fixed capital represents the requirement of capital for meeting the permanent or long-term financial needs of the business.
It is primarily used for acquiring the fixed assets like land and buildings, plant and machinery, office equipment, furniture and fixtures etc.
Fixed capital is required not only while establishing a new enterprise but also for meeting expansion requirement in the existing enterprises.
Factors Determining Fixed Capital Requirement are:
Nature of business: The amount of fixed capital requirement is determined primarily by the nature of business the firm is engaged in. Such requirement, for example, is very large in case of industrial establishments, shipping companies, public utilities, etc. which involve heavy investment in plant and machinery.
Type of products: A firm manufacturing simple products like soap, toothpaste, stationery, etc. requires small amount of fixed capital as against the firms producing items like steel, cement, automobiles, etc.
Size of business: A firm working on a large scale requires heavy investment in fixed assets as it has to establish large production capacity. Hence, its fixed capital requirement is larger.
Process of Production: A firm which goes in for an automatic plant requires larger amount of fixed capital as compared to the firm which selects semi-automatic plant or depends more on manual labour for production of goods.
Method of acquiring fixed assets: The fixed assets, specially machinery and equipment, can be acquired either on cash basis (instant payment) or on installments or leasing basis.
Briefly describe the objectives of Financial Management.
Ans: The main objective of financial management is to maximize the wealth of shareholders. The other important objectives of financial management are:
1. To provide maximum returns to the owners on their investment.
2. To ensure continuous availability of sufficient funds at reasonable cost.
3. To ensure effective utilisation of funds.
4. To ensure safety of funds.
State any four objectives of financial planning.
Ans: The main objectives of financial planning are:
(a) To ascertain the amount of fixed capital as well as the working capital required in a given period.
(b) To determine the amount to be raised through various sources using a judicious debt-equity mix.
(c) To ensure that the required amount is raised on time at the lowest possible cost.
(d) To ensure adequate liquidity so that there are no defaults in payments and all contingencies (any unforeseen expenditure) are met without difficulty.
(e) To ensure optimal use of funds so that the business is neither starved of funds nor has unnecessary surplus funds at any point of time.
Q) “The amount of working capital required varies from business to business and from period to period.” In the light of this statement, briefly explain the various factors that influence working capital requirement of a business.
Ans: The various factors that influence working capital requirement of a business are:
Nature of Business: The working capital requirement of the manufacturing companies is usually high as they require huge stock-in-trade (inventories) and the amount of their debtors is also expected to be large because of the credit sales involved.
Size of Business: Larger the volume of business, larger would be the amount of working capital need.
Length of Production Cycle: Length of production cycle refers to the time period involved in converting raw-material into finished goods. Longer the length of such period, larger will be the requirement of working capital and vice versa.
Inventory Turnover Rate: Inventory turnover rate refers to the speed at, or the time period within which finished stock is converted into sales. A firm having high inventory turnover rate needs less working capital as against a firm which has low inventory turnover rate. It is so because the firm with high rate can manage with less investment in stock.
Credit Policy: The firms which provide liberal credit facility to their customers need more working capital as compared to those firms which observe strict credit terms and are efficient in realisation of their debts. Because when customers enjoy longer period of credit, a larger amount of firm’s funds get tied up with debtors.
Seasonal Fluctuations: The firms that are engaged in manufacturing products like woollen garments, the demand of which is limited to a specific period of the year, require higher amount of working capital not only during the peak period but also during off season. Because they may be left with a good amount of unsold goods which is kept in stock for sale during the next season
Q) “Money market does not deal in cash or money as such but simply provides a market for credit instrument.” Explain any three such instruments.
Ans: Three money market instruments or securities are:
Call Money : Call money is mainly used by the banks to meet their temporary requirement of cash. They borrow and lend money from each other normally on a daily basis. It is repayable on demand and its maturity period varies between oneday to a fortnight.
Certificate of Deposit: Certificate of Deposit (CDs) are short-term instruments issued by Commercial Banks and Special Financial Institutions (SFIs), which are freely transferable from one party to another. The maturity period of CDs ranges from 91 days to one year. These can be issued to individuals, cooperatives and companies.
Commercial Paper: Commercial paper (CP) is a popular instrument for financing working capital requirements of companies. The CP is an unsecured instrument issued in the form of promissory note. It can be issued for period ranging from 15 days to one year.
Explain the decisions involved in financial management.
Ans: Decisions Relating to Investment, Financing and Dividend
1. Investment Decision :This decision involves careful selection of assets in which funds have to be invested. Decisions relating to investment in fixed assets [capital budgeting] and decision relating to investment in current assets [working capital] are considered here. Investment decisions are influenced by cash flow, risk involved, technological changes etc.
2. Financing Decision : This decision relates to the proportion in which funds are raised from various sources. Factors like cost of fund, risk involved, control, cash flow etc. are considered before taking a financial decision. In financing decisions the firm has to decide the ratio of owned funds and borrowed funds. Owned funds consist of equity share capital, preference share capital and retained earnings. Borrowed funds include debentures, loans and public deposits etc.
3. Divided Decision : This decision is concerned with appropriation of earned profits. This profit of the firm can be retained in the business or can be distributed to the shareholders as dividend. A company has to decide how much profits should be distributed as dividend and how much should be retained for future business growth. Factors affecting dividend decisions are cash flow position, stability of earnings, growth opportunities etc.
What is meant by ‘Optimal Capital Structure’?
Ans: The most judicious capital structure is one that minimises the cost of funds and maximises the shareholders wealth. In financial management terminology, such a capital structure is called optimal capital structure.
Q) 'The dividend to be paid to equity shareholders is the real issue involved in dividend decision by the management of any company.' Briefly explain any six factors that guide such decision.
Ans: Six factors that guide the dividend decision are:
Financial needs of the company: While deciding the amount of dividend to be paid, the management must take into account the financial needs for normal growth of its business, the expansion activities, the repayment of long term debt, etc.
Liquidity requirement: The payment of dividend involves outflow of cash. At times, a company may have high profits but not much cash. In such a situation, it may not declare high rate of dividend.
Access to capital market: A company which, by virtue of its record of profitability and timely repayment of debt, has better access to capital market i.e., it can successfully raise funds by issuing shares and debentures through the capital market, may pay higher dividends.
Expectations of shareholders: The equity shareholders normally look forward to appreciation to their capital rather than higher rate of dividend. But, some shareholders like retired persons or employees do look forward to dividend as a source of their regular income.
Tax policy: In our country, dividends have been taxable in the hands of shareholders. Hence, the companies prefer to pay low amount of dividend and issue bonus shares to the shareholders from time to time as these are not taxable until these are sold.
Investment opportunities and growth prospects: When a company has adequate profitable investment opportunities and growth prospects, it may prefer to retain more profits and pay low rate of dividends so as to serve the shareholders in a better way in long run.
Give the meaning of ‘capital structure’.
Ans: The mix of equity (shares) and debt (loans) actually used by a company for meeting its requirement of capital is known as its capital structure.
Describe any two determinants of capital structure.
Ans: Cost of debt :If the rate of interest on borrowings is lower than the expected rate of return on capital employed, then debt may be preferred. With lower cost of debt financing, the overall cost of financing is reduced and the return on equity capital will be higher.
Regulatory norms :While deciding on the capital structure, the legal constraints like the limit on debt-equity ratio should also be kept in view. At present, such a limit is 2:1 in most cases. This implies that at any point of time, the debt should not be more than twice the amount of share capital. This limit keeps on changing with the changing economic environment and varies from industry to industry.