Biju Patnaik Institute of It & Management Studies Bhubaneswar

BIJU PATNAIK INSTITUTE OF IT & MANAGEMENT STUDIES
BHUBANESWAR
BEHERA’S MUST READ ON FINANCIAL MANAGEMENT

LONG QUESTIONS AND ANSWERS
COMPILED BY BHAGAVAN BEHERA
1.What are the basic objectives of financial management?
Answer: Financial Management means planning, organizing, directing and controlling the
financial activities such as procurement and utilization of funds of the enterprise. It means
applying general management principles to financial resources of the enterprise.
The main objectives of financial management are:-

Profit maximization: The main objective of financial management is profit maximization. The
finance manager tries to earn maximum profits for the company in the short-term and the long-
term. He cannot guarantee profits in the long term because of business uncertainties. However, a
company can earn maximum profits even in the long-term, if:-
The Finance manager takes proper financial decisions.
He uses the finance of the company properly.
Wealth maximization: Wealth maximization (shareholders' value maximization) is also a main
objective of financial management. Wealth maximization means to earn maximum wealth for the
shareholders. So, the finance manager tries to give a maximum dividend to the shareholders. He
also tries to increase the market value of the shares. The market value of the shares is directly
related to the performance of the company. Better the performance, higher is the market value of
shares and vice-versa. So, the finance manager must try to maximize shareholder's value.
Proper estimation of total financial requirements: Proper estimation of total financial
requirements is a very important objective of financial management. The finance manager must
estimate the total financial requirements of the company. He must find out how much finance is
required to start and run the company. He must find out the fixed capital and working capital
requirements of the company.
BHAGAVAN BEHERA
BHUBANESWAR
Proper mobilization: Mobilization (collection) of finance is an important objective of financial

management. After estimating the financial requirements, the finance manager must decide about
the sources of finance. He can collect finance from many sources such as shares, debentures,
bank loans, etc. There must be a proper balance between owned finance and borrowed finance.
Proper utilization of finance: Proper utilization of finance is an important objective of financial
management. The finance manager must make optimum utilization of finance. He must use the
finance profitable. He must not waste the finance of the company. He must not invest the
company's finance in unprofitable projects.
Maintaining proper cash flow: Maintaining proper cash flow is a short-term objective of
financial management. The company must have a proper cash flow to pay the day-to-day
expenses such as purchase of raw materials, payment of wages and salaries, rent, electricity bills,
etc. If the company has a good cash flow, it can take advantage of many opportunities such as
getting cash discounts on purchases, large-scale purchasing, and giving credit to customers, etc.
A healthy cash flow improves the chances of survival and success of the company.
Survival of company: Survival is the most important objective of financial management. The
company must survive in this competitive business world. The finance manager must be very
careful while making financial decisions. One wrong decision can make the company sick, and it
will close down.
Creating reserves: One of the objectives of financial management is to create reserves. The
company must not distribute the full profit as a dividend to the shareholders. It must keep a part
of it profit as reserves. Reserves can be used for future growth and expansion. It can also be used
to face contingencies in the future.
Proper coordination: Financial management must try to have proper coordination between the
finance department and other departments of the company.
Create goodwill: Financial management must try to create goodwill for the company. It must
improve the image and reputation of the company. Goodwill helps the company to survive in the
short-term and succeed in the long-term. It also helps the company during bad times.
Increase efficiency: Financial management also tries to increase the efficiency of all the
departments of the company. Proper distribution of finance to all the departments will increase
the efficiency of the entire company.
Financial discipline: Financial management also tries to create a financial discipline. Financial
discipline means:-
To invest finance only in productive areas. This will bring high returns (profits) to the
company.
To avoid wastage and misuse of finance.
Reduce cost of capital: Financial management tries to reduce the cost of capital. That is, it tries
to borrow money at a low rate of interest. The finance manager must plan the capital structure in
such a way that the cost of capital it minimized.
Reduce operating risks: Financial management also tries to reduce the operating risks. There
are many risks and uncertainties in a business. The finance manager must take steps to reduce
these risks. He must avoid high-risk projects. He must also take proper insurance.
Prepare capital structure: Financial management also prepares the capital structure. It decides
the ratio between owned finance and borrowed finance. It brings a proper balance between the
different sources of Capital. This balance is necessary for liquidity, economy, flexibility and
stability
BHAGAVAN BEHERA
BHUBANESWAR
2. Do you feel that profit maximization objective is no more valid for a modern financial
manager? Why? Explain the alternative before him.
Answer: The aim of any business is to maximize profitability and minimize losses. In order to
meet financial goals, organizations require a financial management plan. There are two
paramount objectives of the Financial Management: Profit Maximization and Wealth
Maximization. Profit Maximization as its name signifies refers that the profit of the firm should
be increased while Wealth Maximization aims at accelerating the worth of the entity.
Profit Maximization: Profit maximization means maximizing the rupee income of a firm. Profit
earning is the main aim of every economic activity. No business can survive without earning
profit. Profit is a measure of efficiency of a business enterprise.
Arguments for profit maximization:

1. When profit earning is the aim of business, the profit maximization should be the main
objective.
2. Profitability is a barometer for measuring efficiency and economic prosperity of a business
enterprise.
3. Profits are the main source of finance for the growth of a business.
4. Profitability is essential for fulfilling social goals.
5. A business will be able to survive under unfavorable situation only if it has some past earnings
Arguments against profit maximization /Criticism of Profit Maximization:
1. It is vague: The price meaning of profit maximization objective is unclear. Whether short
term or long term profit, profits before tax or after tax, total profit or earning per share and so on.
2. Ignores the timing of the return: The profit maximization objective ignores the time value of
money.
3. It ignores risk: The streams of benefit may possess different degree of certainty. Two firms
may have same total expected earnings, but if the earnings of one firm fluctuate considerably as
compared to the other, it will be more risky. Profit maximization objective ignores this factor.
4. The effect of dividend policy on the market price of share is also not considered in the
objective of profit maximization.
5. Profit maximization criteria fail to take into consideration the interest of govt., workers and
other persons in the enterprise.
6. The firm’s goals cannot be to maximize profit but to attain a certain level or rate of profit,
holding a certain shares of the market or a certain level of sales.
Wealth Maximization: It is assumed that the goal of the firm should be to maximize the wealth
of its current shareholders. Wealth maximization is the appropriate objective of an enterprise.
Financial theory asserts that wealth maximization is the single substitute for a stockholder’s
utility. When the firm maximizes the stockholder’s wealth, the individual stockholder can use
this wealth to maximize his individual utility. It means that by maximizing stockholder’s wealth
the firm is operating consistently towards maximizing stockholder’s utility. A stockholder’s
current wealth in the firm is the product of the number of shares owned, multiplied with the
current stock price per share. Current wealth in a firm = (Number of shares owned) x (Current
stock price per share).
BHAGAVAN BEHERA
BHUBANESWAR
Favorable Arguments for Wealth Maximization:
Wealth Maximization serves the interests of suppliers of long term and short-term loaned capital,
employees, management and society.
1. Short – term lenders are primarily interested in liquidity position so that they get
their payments in time.
2. The long –term lenders get a fixed rate of interest from the earnings and also have a
priority over shareholders in return of their funds.
3. The employees may also try to acquire share of company’s wealth through bargaining etc.
4. Management is the elected body of shareholders. The shareholders may not like to change a
management if it is able to increase the value of their holdings. The efficient allocation of
productive resources will be essential for raising the wealth of the company
5. The economic interest of society is served if various resources are put to economical and
efficient use.
6. Wealth maximization is superior to the profit maximization because the main aim of the
business concern under this concept is to improve the value or wealth of the shareholders.
7. Wealth maximization considers both time value of money and risk of the business concern.
Arguments against Wealth Maximization:

1. The objective of wealth maximization is not necessarily socially desirable.
2. The firm should not to increase the shareholders wealth but also to see the interest of
customers, creditors, suppliers, community and others.
3. There is some controversy as to whether the objective is to maximize the shareholders wealth
or the wealth of the firm, which includes other financial claim holders such as debenture holder’s
preference stock holders etc.
4. Wealth maximization is nothing, it is also profit maximization, and it is the indirect name of
the profit maximization.
There is always a contradiction between Profit Maximization and Wealth Maximization. We

cannot say that which one is better, but we can discuss which is more important for a company.
Profit is the basic requirement of any entity otherwise it will lose its capital and cannot be able to
survive in the long run. But, as we all know, risk is always associated with profit or in the simple
language profit is directly proportional to risk and the higher the profit, the higher will be the risk
involved with it. So, for gaining the larger amount of profit a finance manager has to take such
decision which will give a boost to the profitability of the enterprise.
Therefore, it can be said that for day to day decision making, Profit Maximization can be taken
into consideration as a sole parameter but when it comes to decisions which will directly affect
the interest of the shareholders, then Wealth Maximization should be exclusively considered.
Maximizing Profit after Taxes: Let us put aside the first problem mentioned above, and assume
that maximizing profit means maximizing profits after taxes, in the sense of net profit as reported
in the profit and loss account (income statement) of the firm. It can easily be realized that
maximizing this figure will not maximize the economic welfare of the owners.
Maximizing EPS: If we adopt maximizing EPS as the financial objective of the firm, this will
also not ensure the maximization of owners’ economic welfare. It also suffers from the flaws
already mentioned, i.e. it ignores timing and risk of the expected benefits.
BHAGAVAN BEHERA
BHUBANESWAR
3. State the basic financial decisions. How does a financial manager conduct risk return
trade-off?
A financial manager is a person who is responsible, in a significant way, to carry out the
finance functions. It should be noted that, in a modern enterprise, the financial manager occupies
a key position. He or she is one of the members of the top management team, and his or her role,
day-by-day, is becoming more pervasive, intensive and significant in solving the complex funds
management problems. Now his or her function is not confined to that of a scorekeeper
maintaining records, preparing reports and raising funds when needed, nor is he or she a staff
officer–in a passive role of an adviser. The finance manager is now responsible for shaping the
fortunes of the enterprise, and is involved in the most vital decision of the allocation of capital.
Investment Decision (Long-Term Asset-Mix Decision): A firm’s investment decisions involve
capital expenditures. They are, therefore, referred as capital budgeting decisions. A capital
budgeting decision involves the decision of allocation of capital or commitment of funds to
long-term assets that would yield benefits (cash flows) in the future. Two important aspects of
investment decisions are: (a) the evaluation of the prospective profitability of new investments,
and (b) the measurement of a cut-off rate against that the prospective return of new investments
could be compared. Future benefits of investments are difficult to measure and cannot be
predicted with certainty. Risk in investment arises because of the uncertain returns. Investment
proposals should, therefore, be evaluated in terms of both expected return and risk.
Financing Decision (Capital-mix Decision): Financing decision is the second important
function to be performed by the financial manager. The central issue before him or her is to
determine the appropriate proportion of equity and debt. The mix of debt and equity is known as
the firm’s capital structure. The financial manager must strive to obtain the best financing mix
or the optimum capital structure for his or her firm. The firm’s capital structure is considered
optimum when the market value of shares is maximized.
Dividend Decision (Profit Allocation Decision): Dividend decision is the third major financial
decision. The financial manager must decide whether the firm should distribute all profits, or
retain them, or distribute a portion and retain the balance. The proportion of profits distributed as
dividends is called the dividend-pay-out ratio and the retained portion of profits is known as the
retention ratio. Like the debt policy, the dividend policy should be determined in terms of its
impact on the shareholders’ value. The optimum dividend policy is one that maximizes the
market value of the firm’s shares. Thus, if shareholders are not indifferent to the firm’s dividend
policy, the financial manager must determine the optimum dividend-pay-out ratio. Dividends are
generally paid in cash. But a firm may issue bonus shares.
Bonus shares are shares issued to the existing shareholders without any charge. The financial
manager should consider the questions of dividend stability, bonus shares and cash dividends in
practice.
Liquidity Decision (Sort-term Asset-Mix Decision): Investment in current assets affects the
firm’s profitability and liquidity. Current assets management that affects a firm’s liquidity is yet
another important finance function. Current assets should be managed efficiently for
safeguarding the firm against the risk of illiquidity. Lack of liquidity (or illiquidity) in extreme
situations can lead to the firm’s insolvency.
Financial Procedures and Systems: For the effective execution of the finance functions, certain
other functions have to be routinely performed. They concern procedures and systems and
involve a lot of paper work and time. They do not require specialized skills of finance.
Financial Analysis: Financial analysis refers to study of financial health from different
interested groups’ point of view viz. management, employees, government, suppliers, lenders &
investors etc. Ratio Analysis, Cost-Volume-Profit (CVP), Fund Flow/Cash Flow Analysis are
BHAGAVAN BEHERA
BHUBANESWAR
popular tools for financial analysis which in turn further helps in financial planning for
subsequent periods.
Financial Control: Financial control refers to comparison of actual activities related to financial
decisions with planned activities. In other words, it is reviewing financial performances as per
planning schedule in order to meet the set financial objective. Budgetary control system,
variance analyses are some popular tools, which help in controlling activities related to financial
decisions.
RISK-RETURN TRADE-OFF: Financial decisions incur different degree of risk. Your
decision to invest your money in government bonds has less risk as interest rate is known and the
risk of default is very less. On the other hand, you would incur more risk if you decide to invest
your money in shares, as return is not certain. However, you can expect a lower return from
government bond and higher from shares. Risk and expected return move in tandem; the greater
the risk, the greater the expected return. The following figure shows this risk-return relationship.
Financial decisions of the firm are guided by the risk-return trade-off. These decisions are
interrelated and jointly affect the market value of its shares by influencing return and risk of the
firm. The relationship between return and risk can be simply expressed as follows:
Return = Risk-free rate + Risk premium
Risk-free rate is a rate obtainable from a default-risk free government security. An investor
assuming risk from her investment requires a risk premium above the risk-free rate. Risk-free
rate is a compensation for time and risk premium for risk. Higher the risk of an action, higher
will be the risk premium leading to higher required return on that action. A proper balance
between return and risk should be maintained to maximize the market value of a firm’s shares.
Such balance is called risk-return trade-off, and every financial decision involves this trade-off.
The interrelation between market value, financial decisions and risk-return trade-off is depicted
in the above Figure. It also gives an overview of the functions of financial management.
The financial manager, in a bid to maximize shareholders’ wealth, should strive to maximize
returns in relation to the given risk; he or she should seek courses of actions that avoid
unnecessary risks. To ensure maximum return, funds flowing in and out of the firm should be
constantly monitored to assure that they are safeguarded and properly utilized.
BHAGAVAN BEHERA
BHUBANESWAR
4. What are the key functions of a modern finance manager? Discuss the challenges faced
by financial manager.
A financial manager is a person who is responsible, in a significant way, to carry out the
finance functions. It should be noted that, in a modern enterprise, the financial manager occupies
a key position. He or she is one of the members of the top management team, and his or her role,
day-by-day, is becoming more pervasive, intensive and significant in solving the complex funds
management problems. Now his or her function is not confined to that of a scorekeeper
maintaining records, preparing reports and raising funds when needed, nor is he or she a staff
officer–in a passive role of an adviser. The finance manager is now responsible for shaping the
fortunes of the enterprise, and is involved in the most vital decision of the allocation of capital.
Some of the major functions of a financial manager are as follows:
1. Estimating the Amount of Capital Required: This is the foremost function of the financial
manager. Business firms require capital for:
(i) Purchase of fixed assets,
(ii) Meeting working capital requirements, and
(iii) Modernization and expansion of business.
The financial manager makes estimates of funds required for both short-term and long-term.
2. Determining Capital Structure: Once the requirement of capital funds has been determined,
a decision regarding the kind and proportion of various sources of funds has to be taken. For this,
financial manager has to determine the proper mix of equity and debt and short-term and long-
term debt ratio. This is done to achieve minimum cost of capital and maximize shareholders
wealth.
3. Choice of Sources of Funds: Before the actual procurement of funds, the finance manager
has to decide the sources from which the funds are to be raised. The management can raise
finance from various sources like equity shareholders, preference shareholders, debenture-
holders, and banks and other financial institutions, public deposits, etc.
4. Funds Rising (Procurement of Funds): The financial manager takes steps to procure the
funds required for the business. It might require negotiation with creditors and financial
institutions, issue of prospectus, etc. The procurement of funds is dependent not only upon cost
of raising funds but also on other factors like general market conditions, choice of investors,
government policy, etc.
5. Funds Allocation (Utilization of Funds): Once the funds are raised through different
channels the next important function is to allocate the funds. The funds should be allocated in
such a manner that they are optimally used. In order to allocate funds in the best possible manner
the following point must be considered
 The size of the firm and its growth capability
 Status of assets whether they are long term or short tem
 Mode by which the funds are raised.
6. Profit Planning (Disposal of Profits or Surplus): Profit earning is one of the prime functions
of any business organization. Profit earning is important for survival and sustenance of any
organization. Profit planning refers to proper usage of the profit generated by the firm.
7. Management of Cash/ Maintain Proper Liquidity: Every concern is required to maintain
some liquidity for meeting day-to-day needs. Cash is the best source for maintaining liquidity. .
It involves forecasting the cash inflows and outflows to ensure that there is neither shortage nor
surplus of cash with the firm.
8. Financial Control: Evaluation of financial performance is also an important function of
financial manager. The overall measure of evaluation is Return on Investment (ROI).
BHAGAVAN BEHERA
BHUBANESWAR
9. Understanding Capital Markets: Shares of a company are traded on stock exchange and
there is a continuous sale and purchase of securities. Hence a clear understanding of capital
market is an important function of a financial manager.
10. Interrelation with Other Departments: Finance manager deals with various functional
departments such as marketing, production, personnel, system, research, development, etc.
Finance manager should have sound knowledge not only in finance related area but also well
versed in other areas. He must maintain a good relationship with all the functional departments
of the business organization.
CHALLENGES OF A MODERN FINANCIAL MANAGER:
Regulations: The more complex and uncertain the economic environment is, the higher the
speed of regulatory changes, the higher the need to harmonize regulation across borders. This
gives additional roles to the Finance manager in order to comply with all regulations and to have
in the finance departments the professionals that can cope with the regulatory changes.
Globalization: As businesses become global, Finance managers have to have a global
perspective and experience. They have to understand how their business can operate in different
cultures, regions, in different regulatory context in order to provide a valuable input of the
finance function into the overall business while expanding in new markets.
Technology: The finance function has to be in the center of a data revolution. On one hand there
is far more information available that should be collected and processed, on the other hand more
complex software to process the data is available. There is a great opportunity in these turbulent
times in using the huge data and the tools to give insight for the further development of the
business.
Risk: The role of the Finance manager is no more only about cost savings. One of the challenges
for the Finance manager becomes risk management. In a highly volatile environment, Finance
managers have to be able to approach in a proactive way the diverse risks in order to safeguard
the business assets, to prevent poor behavior that can erode value, to ensure the right policies in
what concerns investments, cash availability and shareholder return.
Transformation: The transformation of the finance function is at two levels. First is related to
outsourcing and shared services taking into account the more complex environment and the need
for diversified skills. This brings more risk to the business that has to be carefully managed.
Second is related to the remaining finance function that should more concentrate on more
effective analysis.
Stakeholder Management: The financial manager has not only to prove finance leadership and
controllership but to be a strategic partner to the Finance manager. The financial manager has to
make a step forward from analyzing the past performance and forecasting on the short term to a
long term view on the development of the business.
Reporting: Financial management is no more only about achieving financial goals outside
sustainability parameters. This includes social and environmental objectives in addition to the
traditional economic ones. There is a triple bottom line reporting: measurement and reporting of
performance on social, environmental and financial metrics.
Talent and capability: Many challenges for the Finance manager in a global context – diverse
skills needed in order to respond to a more complex finance function, operations that are
developed abroad imposing working with talents from different cultures, incorporating virtual
teams in the context of advanced technology.
BHAGAVAN BEHERA
BHUBANESWAR
5.What is agency problem? What are the costs involved in it? How do modern corporations
deal with agency problems?
Answer: In large companies, there may be a divorce between management and ownership. The
decision-taking authority in a company lies in the hands of managers. Shareholders as owners of
a company are the principals and managers are their agents. Thus there is a principal-agent
relationship between shareholders and managers. In theory, managers should act in the best
interests of shareholders; that is, their actions and decisions should lead to shareholders’ wealth
Maximization (SWM).
In practice, managers may not necessarily act in the best interest of shareholders, and they may
pursue their own personal goals. Managers may maximize their own wealth (in the form of high
salaries and perks) at the cost of shareholders, or may play safe and create satisfactory wealth for
shareholders than the maximum. They may avoid taking high investment and financing risks that
may otherwise be needed to maximize shareholders’ wealth.
Thus their actions are very likely to be directed towards the goals of survival and self-
sufficiency. Further, a company is a complex organization consisting of multiple stakeholders
such as employees, debt-holders, consumers, suppliers, government and society. Managers in
practice may, thus, perceive their role as reconciling conflicting objectives of stakeholders.
Shareholders continuously monitor modern companies that would help them to restrict
managers’ freedom to act in their own self-interest at the cost of shareholders. Employees,
creditors, customers and government also keep an eye on managers’ activities. Thus the
possibility of managers pursuing exclusively their own personal goals is reduced.
Managers can survive only when they are successful; and they are successful when they manage
the company better than someone else. Every group connected with the company will, however,
evaluate management success from the point of view of the fulfilment of its own objective. The
survival of management will be threatened if the objective of any of these groups remains
unfulfilled. In reality, the wealth of shareholders in the long run could be maximized only when
customers and employees, along with other stakeholders of a firm, are fully satisfied. The wealth
maximization objective may be generally in harmony with the interests of the various groups
such as owners, employees, creditors and society, and thus, it may be consistent with the
management objective of survival. Finance theory prescribes that under such situations,
shareholders wealth maximization goal should have precedent over the goals of other
stakeholders.
The conflict between the interests of shareholders and managers is referred to as agency
problem and it results into agency costs. Agency costs include the less than optimum share
value for shareholders and costs incurred by them to monitor the actions of managers and control
their behavior. The agency problems vanish when managers own the company. Thus one way to
mitigate the agency problems is to give ownership rights through stock options to managers.
Shareholders can also offer attractive monetary and non-monetary incentives to managers to act
in their interests. A close monitoring by other stakeholders, board of directors and outside
analysts also may help in reducing the agency problems. Corporations employ several dynamic
techniques to circumvent static issues resulting from agency problems, including monitoring,
contractual incentives, soliciting the aid of third parties or relying on other price system
mechanisms.
BHAGAVAN BEHERA
BHUBANESWAR
6. What are the techniques/ methods of Methods of Evaluating Capital Investment

Proposals?
Or
Explain the merits and demerits of the time adjusted methods of evaluating the
investment projects.
Answer: There are number of appraisal methods which may be recommended for evaluating the
capital investment proposals. We shall discuss the most widely accepted methods. These
methods can be grouped into the following categories:
I. Time Adjusted Method or Discounted Cash Flow Method

(1) Net Present Value Method.
(2) Internal Rate of Return Method.
(3) Profitability Index Method.
II. Traditional Methods/ Non-Discounted Cash Flow Method:

(1) Pay-back period method or Pay Out method.
(2) Accounting Rate of Return Method.
Discounted Cash Flow Method (or) Time Adjusted Method:
Discount cash flow is a method of capital investment appraisal which takes into account both the
overall profitability of projects and also the timing of return. Discounted cash flow method helps
to measure the cash inflow and outflow of a project as if they occurred at a single point in time
so that they can be compared in an appropriate way. This method recognizes that the use of
money has a cost, i.e., interest foregone. In this method risk can be incorporated into Discounted
Cash Flow computations by adjusting the discount rate or cut off rate.
Disadvantages:
The following are some of the limitations of Discounted Pay-back Period Method:
(1) There may be difficulty in accurately establishing rates of interest over the cash flow period.
(2) Lack of adequate expertise in order to properly apply the techniques and interpret results.
(3) These techniques are based on cash flows, whereas reported earnings are based on profits.
The inclusion of Discounted Cash Flow Analysis may cause projected earnings to fluctuate
considerably and thus have an adverse on share prices.
(1) Net Present Value Method (NPV): This is one of the Discounted Cash Flow techniques
which explicitly recognize the time value of money. In this method all cash inflows and outflows
are converted into present value (i.e., value at the present time) applying an appropriate rate of
interest (usually cost of capital). In other words, Net Present Value Method discount inflows and
outflows to their present value at the appropriate cost of capital and set the present value of cash
inflow against the present value of outflow to calculate Net Present Value. Thus, the Net Present
Value is obtained by subtracting the present value of cash outflows from the present value of
cash inflows.
BHAGAVAN BEHERA
BHUBANESWAR
Equation for Calculating Net Present Value:

(1) In the case of conventional cash flows. i.e., all cash outflows are entirely initial and all cash
inflows are in future years, NPV may be represented as follows:
Where: NPV =Net Present Value

R= Future Cash Inflows at different times
K = Cost of Capital or Cut-off rate or Discounting Rate
I=Cash outflows at different times
Rules of Acceptance:
Where: NPV > Zero Accept the proposal
NPV < Zero Reject the Proposal
Advantages of Net Present Value Method:

(1) It recognizes the time value of money and is thus scientific in its approach.
(2) All the cash flows spread over the entire life of the project are used for calculations.
(3) It is consistent with the objectives of maximizing the welfare of the owners as it depicts the
positive or otherwise present value of the proposals.
Disadvantages:
(1) This method is comparatively difficult to understand or use.
(2) When the projects in consideration involve different amounts of investment, the Net Present
Value Method may not give satisfactory results.
(2) Internal Rate of Return Method (IRR): Internal Rate of Return Method is also called as
"Time Adjusted Rate of Return Method." It is defined as the rate which equates the present value
of each cash inflows with the present value of cash outflows of an investment. In other words, it
is the rate at which the net present value of the investment is zero.
The Internal Rate of Return can be found out by Trial and Error Method. First, compute the
present value of the cash flow from an investment, using an arbitrarily selected interest rate, for
example 10%. Then compare the present value so obtained with the investment cost.
If the present value is higher than the cost of capital, try a higher interest rate and go through the
procedure again. On the other hand if the calculated present value of the expected cash inflows is
lower than the present value of cash outflows, a lower rate should be tried. This process will be
repeated until and unless the Net Present Value becomes zero. The interest rate that brings about
this equality is defined as the Internal Rate of Return.
BHAGAVAN BEHERA
BHUBANESWAR
Evaluation:
A popular discounted cash flow method, the internal rate of return criterion has several virtues:
(1) It takes into account the time value of money.
(2) It considers the cash flows over the entire life of the project.
(3) It makes more meaningful and acceptable to users because it satisfies them in terms of the
rate of return on capital.
Limitations:
(1) The internal rate of return may not be uniquely defined.
(2) The IRR is difficult to understand and involves complicated computational problems.
(3) The internal rate of return figure cannot distinguish between lending and borrowings and
hence high internal rate of return need not necessarily be a desirable feature.
(3) Profitability Index Method:
Profitability Index is also known as Benefit Cost Ratio. It gives the present value of future
benefits, computed at the required rate of return on the initial investment. Profitability Index may
either be Gross Profitability Index or Net Profitability Index. Net Profitability Index is the Gross
Profitability Index minus one. The Profitability Index can be calculated by the following
equation:
Profitability Index = Present Value of Cash Inflows/Initial Cash Outlays
Rule of Acceptance: As per the Benefit Cost Ratio or Profitability Index a project with
Profitability Index greater than one should be accepted as it will have Positive Net Present Value.
Likewise if Profitability Index is less than one the project is not beneficial and should not be
accepted.
Advantages of Profitability Index:

(1) It duly recognizes the time value of money.
(2) For calculations when compared with internal rate of return method it requires less time.
(3) It helps in ranking the project for investment decisions.
(4) As this method is capable of calculating incremental benefit cost ratio, it can be used to
choose between mutually exclusive projects.
Traditional Methods/ Non-Discounted Cash Flow Method :
(1) Pay-back Period Method: Pay-back period is also termed as "Pay-out period" or Pay-off
period. Pay-out Period Method is one of the most popular and widely recognized traditional
methods of evaluating investment proposals. It is defined as the number of years required to
recover the initial investment in full with the help of the stream of annual cash flows generated
by the project.
Calculation of Pay-back Period: Pay-back period can be calculated into the following two
different situations:
(a) In the case of constant annual cash inflows.
(b) In the case of uneven or unequal cash inflows.
(a) In the case of constant annual cash inflows: If the project generates constant cash flow the
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Pay-back period can be computed by dividing cash outlays (original investment) by annual cash
inflows. The following formula can be used to ascertain pay-back period:
Pay-back Period= Cash Outlays (Initial Investment)/Annual Cash Inflows
(b) In the case of Uneven or Unequal Cash Inflows: In the case of uneven or unequal cash
inflows, the Pay-back period is determined with the help of cumulative cash inflow. It can be
calculated by adding up the cash inflows until the total is equal to the initial investment.
Accept or Reject Criterion: Investment decisions based on pay-back period are used by many
firms to accept or reject an investment proposal. Among the mutually exclusive or alternative
projects whose pay-back periods are lower than the cut off period the project would be accepted.
If not it would be rejected.
Advantages of Pay-back Period Method:
(1) It is an important guide to investment policy
(2) It is simple to understand and easy to calculate
(3) It facilitates to determine the liquidity and solvency of a firm
(4) It helps to measure the profitable internal investment opportunities
(5) It enables the firm to select an investment which yields a quick return on cash funds
(6) It used as a method of ranking competitive projects
(7) It ensures reduction of cost of capital expenditure.
Disadvantages of Pay-back Period Method:
(1) It does not measure the profitability of a project
(2) It does not value projects of different economic lives
(3) This method does not consider income beyond the pay-back period
(4) It does not give proper weight to timing of cash flows
(5) It does not indicate how to maximize value and ignores the relative profitability of the project
(6) It does not consider cost of capital and interest factor which are very important factors in
taking sound investment decisions.
(2) Average Rate of Return Method (ARR) or Accounting Rate of Return Method:
Average Rate of Return Method is also termed as Accounting Rate of Return Method. This
method focuses on the average net income generated in a project in relation to the project's
average investment outlay. This method involves accounting profits not cash flows and is similar
to the performance measure of return on capital employed. The average rate of return can be
determined by the following equation: Average Income/ Average Investments X 100
Advantages:
(1) It considers all the years involved in the life of a project rather than only pay-back years.
(2) It applies accounting profit as a criterion of measurement and not cash flow.
Disadvantages:
(1) It applies profit as a measure of yardstick not cash flow.

(2) The time value of money is ignored in this method.
(3) Yearly profit determination may be a difficult task.
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7. What is capital structure? What are the factors that determine the capital structure
of a company?
A capital structure is a mix of a company's long-term debt, specific short-term debt, common
equity and preferred equity. The capital structure is how a firm finances its overall operations
and growth by using different sources of funds.
Debt comes in the form of bond issues or long-term notes payable, while equity is classified as
common stock, preferred stock or retained earnings. Short-term debt such as working capital
requirements is also considered to be part of the capital structure.
A company's proportion of short and long-term debt is considered when analyzing capital
structure. When people refer to capital structure they are most likely referring to a firm's debt-to-
equity ratio, which provides insight into how risky a company is. Usually a company more
heavily financed by debt poses greater risk, as this firm is relatively highly levered.
Factors Determining Capital Structure
Trading on Equity- The word “equity” denotes the ownership of the company. Trading
on equity means taking advantage of equity share capital to borrowed funds on
reasonable basis. It refers to additional profits that equity shareholders earn because of
issuance of debentures and preference shares. It is based on the thought that if the rate of
dividend on preference capital and the rate of interest on borrowed capital is lower than
the general rate of company’s earnings, equity shareholders are at advantage which
means a company should go for a judicious blend of preference shares, equity shares as
well as debentures. Trading on equity becomes more important when expectations of
shareholders are high.
Degree of control- In a company, it is the directors who are so called elected
representatives of equity shareholders. These members have got maximum voting rights
in a concern as compared to the preference shareholders and debenture holders.
Preference shareholders have reasonably less voting rights while debenture holders have
no voting rights. If the company’s management policies are such that they want to retain
their voting rights in their hands, the capital structure consists of debenture holders and
loans rather than equity shares.
Flexibility of financial plan- In an enterprise, the capital structure should be such that
there are both contractions as well as relaxation in plans. Debentures and loans can be
refunded back as the time requires. While equity capital cannot be refunded at any point
which provides rigidity to plans. Therefore, in order to make the capital structure
possible, the company should go for issue of debentures and other loans.
Choice of investors- The Company’s policy generally is to have different categories of
investors for securities. Therefore, a capital structure should give enough choice to all
kind of investors to invest. Bold and adventurous investors generally go for equity shares
and loans and debentures are generally raised keeping into mind conscious investors.
Capital market condition- In the lifetime of the company, the market price of the shares
has got an important influence. During the depression period, the company’s capital
structure generally consists of debentures and loans. While in period of boons and
inflation, the company’s capital should consist of share capital generally equity shares.
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BHUBANESWAR
Period of financing- When company wants to raise finance for short period, it goes for
loans from banks and other institutions; while for long period it goes for issue of shares
and debentures.
Cost of financing- In a capital structure, the company has to look to the factor of cost
when securities are raised. It is seen that debentures at the time of profit earning of
company prove to be a cheaper source of finance as compared to equity shares where
equity shareholders demand an extra share in profits.
Stability of sales- An established business which has a growing market and high sales
turnover, the company is in position to meet fixed commitments. Interest on debentures
has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are
high and company is in better position to meet such fixed commitments like interest on
debentures and dividends on preference shares. If company is having unstable sales, then
the company is not in position to meet fixed obligations. So, equity capital proves to be
safe in such cases.
Sizes of a company- Small size business firms capital structure generally consists of
loans from banks and retained profits. While on the other hand, big companies having
goodwill, stability and an established profit can easily go for issuance of shares and
debentures as well as loans and borrowings from financial institutions. The bigger the
size, the wider is total capitalization.
8. What is Optimal Capital Structure? What are its features? What are the
Constraints in Designing Optimal Capital Structure?
Capital structure means the proportion of debt and equity in the total capital of a firm. The
objective of a firm is to maximize the value of its business.
This is done by maximizing market value of the shares and minimizing the cost of capital of a
firm. An optimal capital structure is that proportion of debt and equity, which fulfils this
objective of a firm. Thus an optimal capital structure tries to optimize two variables at the same
time: cost of capital and market value of shares.
Concept of Optimal Capital Structure:
Every firm should aim at achieving the optimal capital structure and try to maintain it. Optimal
capital structure refers to the combination of debt and equity in total capital that maximizes the
value of the company. An optimal capital structure is designated as one at which the average cost
of capital is the lowest which produces an income that leads to maximization of the market value
of the securities at that income.
Optimal capital structure may be defined as that relationship of debt and equity which maximizes
the value of company’s share in the stock exchange.
According to Prof Ezra Solomon, ‘Optimal capital structure is that mix of debt and equity which
will maximize the market value of a company’. Hence there should be a judicious combination
of the various sources of long-term funds which provides a lower overall cost of capital and so a
higher total market value for the capital structure. Optimal capital structure may thus be defined
BHAGAVAN BEHERA
BHUBANESWAR
as, the mixing of the permanent sources of funds used by the firm in a manner that will maximize
the company’s common stock price by minimizing the firm’s composite cost of capital.
Features of Optimal Capital Structure:
The salient features of an optimal capital structure are described below:
a) The relationship of debt and equity in an optimal capital structure is made in such a manner
that the market value per equity share becomes maximum.
b) Optimal capital structure maintains the financial stability of the firm.
c) Under optimal capital structure the finance manager determines the proportion of debt and
equity in such a manner that the financial risk remains low.
d) The advantage of the leverage offered by corporate taxes is taken into account in achieving the
optimal capital structure.
e) Borrowings help in increasing the value of company leading towards optimal capital structure.
f) The cost of capital reaches at its minimum and market price of share becomes maximum at
optimal capital structure.
Constraints in Designing Optimal Capital Structure:
The capital structure of a firm is designed in such a manner that the cost of capital is kept at its
lowest and the value of the firm reaches its maximum. The firm manoeuvers its debt-equity
proportion to reach the optimum level. However in practice, reaching the level of optimum
capital structure is a difficult task due to several constraints that appear on the way of
implementing that structure.
The main constraints in designing the optimum capital structure are:

1. The optimum debt-equity mix is difficult to ascertain in true sense.
2. The concept of appropriate capital structure is more realistic than the concept of optimum
capital structure.
3. It is difficult to find an optimum capital structure as the extent to which the market value of an
equity share will fall due to increase in risk of high debt content in capital structure, is very
difficult to measure.
4. The market price of equity share rarely changes due to changes in debt-equity mix, so there
cannot be any optimum capital structure.
5. It is impossible to predict exactly the amount of decrease in the market value of an equity
share because market factors that influence market value of equity share are highly complex.
9. Explain the concept of working capital? What are the Factors/ Determinants that Affect
the Working Capital needs of a company?
Working capital is a measure of both a company's efficiency and its short-term financial health.
There are two concepts or senses used for working capital. These are: 1. Gross Working Capital
2. Net working Capital
1. Gross Working Capital: The concept of gross working capital refers to the total value of
current assets. In other words, gross working capital is the total amount available for financing of
current assets. However, it does not reveal the true financial position of an enterprise. How? A
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borrowing will increase current assets and, thus, will increase gross working capital but, at the
same time, it will increase current liabilities also.
As a result, the net working capital will remain the same. This concept is usually supported by
the business community as it raises their assets (current) and is in their advantage to borrow the
funds from external sources such as banks and the financial institutions. In this sense, the
working capital is a financial concept. As per this concept: Gross Working Capital = Total
Current Assets
2. Net Working Capital: The net working capital is an accounting concept which represents the
excess of current assets over current liabilities. Current assets consist of items such as cash, bank
balance, stock, debtors, bills receivables, etc. and current liabilities include items such as bills
payables, creditors, etc. Excess of current assets over current liabilities, thus, indicates the liquid
position of an enterprise.
Factors Affecting Working Capital or Determinants of Working Capital
(1) Nature of Business: Working capital requirements of an enterprise are largely influenced by
the nature of its business. For instance, public utilities such as railways, transport, water,
electricity etc. have a very limited need for working capital because they have invested fairly
large amounts in fixed assets. Their working capital need is minimal because they get immediate
payment for their services and do not have to maintain big inventories. On the other extreme are
the trading and financial enterprises which have to invest fewer amounts in fixed assets and a
large amount in working capital. This is so because the nature of their business is such that they
have to maintain a sufficient amount of cash, inventories and debtors.
(2) Size of Business: Larger the size of the business enterprise, greater would be the need for
working capital. The size of a business may be measured in terms of scale of its business
operations.
(3) Growth and Expansion: As a business enterprise grows, it is logical to expect that a larger
amount of working capital will be required. Growing industries require more working capital
than those that are static.
(4) Production cycle: Production cycle means the time-span between the purchase of raw
materials and its conversion into finished goods. The longer the production cycle, the larger will
be the need for working capital because the funds will be tied up for a longer period in work in
process. If the production cycle is small, the need for working capital will also be small.
(5) Business Fluctuations: Business fluctuations may be in the direction of boom and
depression. During boom period the firm will have to operate at full capacity to meet the
increased demand which in turn, leads to increase in the level of inventories and book debts.
Hence, the need for working capital in boom conditions is bound to increase. The
depression phase of business fluctuations has exactly an opposite effect on the level of working
capital requirement.
(6) Production Policy: The need for working capital is also determined by production policy.
The demand for certain products (such as woolen garments) is seasonal. Two types of production
policies may be adopted for such products. Firstly, the goods may be produced in the months
of demand and secondly, the goods may be produces throughout the year. If the second
alternative is adopted, the stock of finished goods will accumulate progressively upto the
season of demand which requires an increasing amount of working capital that remains tied
up in the stock of finished goods for some months.
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(7) Credit Policy Relating to Sales: If a firm adopts liberal credit policy in respect of sales, the
amount tied up in debtors will also be higher. Obviously, higher book debts mean more working
capital. On the other hand, if the firm follows tight credit policy, the magnitude of working
capital will decrease
(8) Credit Policy Relating to Purchase: If a firm purchases more goods on credit, the
requirement for working capital will be less. In other words, if liberal credit terms are available
from the suppliers of goods (i.e., creditors), the requirement for working capital will be
reduced and vice versa.
(9) Availability of Raw Material: If the raw material required by the firm is available easily on
a continuous basis, there will be no need to keep a large inventory of such materials and hence
the requirement of working capital will be less. On the other hand, if the supply of raw material
is irregular, the firm will be compelled to keep an excessive inventory of such raw materials
which will result in high level of working capital.
(10) Availability of Credit from Banks: If a firm can get easy bank facility in case of need, it
will operate with less working capital. On the other hand, if such facility is not available, it will
have to keep large amount of working capital.
(11) Volume of Profit: The net profit is a source of working capital to the extent it has been
earned in cash. Higher net profit would generate more internal funds thereby contributing the
working capital pool.
(12) Level of Taxes: Full amount of cash profit is not available for working capital purpose.
Taxes have to be paid out of profits. Higher the amount of taxes less will be the profits for
working capital.
(13) Dividend Policy: Dividend policy is a significant element in determining the level of
working capital in an enterprise. The payment of dividend reduces the cash and thereby, affects
the working capital to that extent. On the contrary, if the company does not pay dividend but
retains the profits, more would be the contribution of profits towards capital pool.
(14) Depreciation Policy: Although depreciation does not result in outflow of cash, it affects the
working capital indirectly. In the first place, since depreciation is allowable expenditure in
calculating net profits, it affects the tax liability. In the second place, higher depreciation also
means lower disposable profits and, in turn, a lower dividend payment. Thus, outgo of cash is
restricted to that extent.
(15) Price Level Changes: Changes in price level also affect the working capital
requirements. If the price level is rising, more funds will be required to maintain the existing
level of production. Same level of current assets will need increased investment when prices are
increasing. However, companies that can immediately their product prices with rising price
levels will not face a severe working capital problem. Thus, it is possible that some companies
may not be affected by rising prices while others may be badly hit.
(16) Efficiency of Management: Efficiency of management is also a significant factor to
determine the level of working capital. Management can reduce the need for working capital by
the efficient utilization of resources. It can accelerate the pace of cash cycle and thereby use the
same amount working capital again and again very quickly.
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BHUBANESWAR
10. What is Modigliani-Miller’s dividend irrelevance hypothesis? Critically evaluate its

assumptions.
OR
Discuss the implications and assumptions of the Modigliani-Miller theory.
OR
Under perfect market conditions, stockholders would ultimately be indifferent between
returns from dividends or returns from capital gains – justify this statement.
Modigliani – Miller theory is a major proponent of ‘Dividend Irrelevance’ notion. According to

this concept, investors do not pay any importance to the dividend history of a company and thus,
dividends are irrelevant in calculating the valuation of a company. This theory is in direct
contrast to the ‘Dividend Relevance’ theory which deems dividends to be important in the
valuation of a company.
Modigliani – Miller theory illustrates the practical situations where dividends are not relevant to
investors. Irrespective of whether a company pays a dividend or not, the investors are capable
enough to make their own cash flows from the stocks depending on their need for the cash. If the
investor needs more money than the dividend he received, he can always sell a part of his
investments to make up for the difference. Likewise, if an investor has no present cash
requirement, he can always reinvest the received dividend in the stock. Thus, the Modigliani –
Miller theory firmly states that the dividend policy of a company has no influence on the
investment decisions of the investors.
This theory also believes that dividends are irrelevant by the arbitrage argument. By this logic,
the dividends distribution to shareholders is offset by the external financing. Due to the
distribution of dividends, the price of the stock decreases and will nullify the gain made by the
investors because of the dividends. This theory also implies that the cost of debt is equal to the
cost of equity as the cost of capital is not affected by the leverage.
Assumptions of the Model
Modigliani – Miller theory is based on the following assumptions:
Perfect Capital Markets: This theory believes in the existence of ‘perfect capital markets’. It
assumes that all the investors are rational, they have access to free information, there are no
floatation or transaction costs and no large investor to influence the market price of the share.
No Taxes: there is any existence of taxes. Alternatively, both dividends and capital gains are
taxed at the same rate.
Fixed Investment Policy: The Company does not change its existing investment policy. This
means that new investments that are financed through retained earnings do not change the risk
and the rate of required return of the firm.
No Risk of Uncertainty: All the investors are certain about the future market prices and the
dividends. This means that the same discount rate is applicable for all types of stocks in all time
periods.
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Valuation Formula and its Denotations:
Modigliani – Miller’s valuation model is based on the assumption of same discount rate / rate of
return applicable to all the stocks.
P1 = P0 * (1 + k) – D
Where,
P1 = market price of the share at the end of a period
Po = market price of the share at the beginning of a period
k = cost of capital
D = dividends received at the end of a period
Explanation
Modigliani – Miller’s model can be used to calculate the market price of the share at the end of a
period, if the original share price, dividends received and the cost of capital is known. The
assumption that the same discount rate is applicable to all stocks is important.
The original price of the stock is Rs. 150. The discount rate applicable to the company is 10%.
The company had declared Rs. 10 as dividends in a year. Calculate the market price of the share
at the end of one year using the Modigliani – Miller’s model.
Here, P0 = 150
k = 10%
D = 10
Market price of the stock = P1 = 150 * (1 + .10) – 10 = 150 *1.1 – 10 = 155.
Criticism of Modigliani Miller’s Model
Modigliani – Miller theory on dividend policy suffers from the following limitations:
Perfect capital markets do not exist. Taxes are present in the capital markets.
According to this theory, there is no difference between internal and external financing.
However, if the flotation costs of new issues are considered, it is false.
This theory believes that the shareholder’s wealth is not affected by the dividends.
However, there are transaction costs associated with the selling of shares to make cash
inflows. This makes the investors prefer dividends.
The assumption of no uncertainty is unrealistic. The dividends are relevant under the
certain conditions as well.
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BHUBANESWAR
11. What is dividend policy? What are its types? Explain the nature of the factors which
influence the dividend policy of a firm.
Dividend policy is the set of guidelines a company uses to decide how much of its earnings it will pay out
to shareholders. Some evidence suggests that investors are not concerned with a company's dividend
policy since they can sell a portion of their portfolio of equities if they want cash.
Once a company makes a profit, management must decide on what to do with those profits. They
could continue to retain the profits within the company, or they could pay out the profits to the
owners of the firm in the form of dividends. There are basically 4 types of dividend policy.
1.) Regular dividend policy: In this type of dividend policy the investors get dividend at usual
rate. Here the investors are generally retired persons or weaker section of the society who want
to get regular income. This type of dividend payment can be maintained only if the company has
regular earning.
2) Stable dividend policy: Here the payment of certain sum of money is regularly paid to the
shareholders. It is of three types:
a) Constant dividend per share: Here reserve fund is created to pay fixed amount of dividend
in the year when the earning of the company is not enough. It is suitable for the firms having
stable earning.
b) Constant pay out ratio: It means the payment of fixed percentage of earning as dividend
every year.
c) Stable rupee dividend + extra dividend: It means the payment of low dividend per share
constantly + extra dividend in the year when the company earns high profit.
3) Irregular dividend: As the name suggests here the company does not pay regular dividend to
the shareholders. The company uses this practice due to following reasons:
4) No dividend: The Company may use this type of dividend policy due to requirement of funds
for the growth of the company or for the working capital requirement.
Factors Affecting Dividend Policy
Type of Industry: The nature of the industry to which the company belongs has an important
effect on the dividend policy. Industries, where earnings are stable, may adopt a consistent
dividend policy as opposed to the industries where earnings are uncertain and uneven. They are
better off in having a conservative approach to dividend payout.
Ownership Structure: The ownership structure of a company also impacts the policy. A
company with a higher promoter’ holdings will prefer a low dividend payout as paying out
dividends may cause a decline in the value of the stock. Whereas, a high institutional ownership
will favor a high dividend payout as it helps them to increase the control over the management.
Age of corporation: Newly formed companies will have to retain major part of their earnings
for further growth and expansion. Thus, they have to follow a conservative policy unlike
established companies, which can pay higher dividends from their reserves.
The extent of Share Distribution: A company with a large number of shareholders will have a
difficult time in getting them to agree to a conservative policy. On the other hand, a closely held
company has more chances of succeeding to finalize conservative dividend payouts.
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Different Shareholders’ Expectations: Another factor that impacts the policy is the diversity in
the type of shareholders a company has. A different group of shareholders will have different
expectations. A retired shareholder will have a different requirement vis-a-vis a wealthy investor.
The company needs to clearly understand the different expectations and formulate a successful
dividend policy.
Leverage: A company having more leverage in their financial structure and consequently,
frequent interest payments will have to decide for a low dividend payout whereas a company
utilizing their retained earnings will prefer high dividends.
Future Financial Requirements: Dividend payout will also depend on the future requirements
for the additional capital. A company having profitable investment opportunities is justified in
retaining the earnings. However, a company with no internal or external capital requirements
should opt for a higher dividend.
Business Cycles: When the company experiences a boom, it is prudent to save up and make
reserves for dips. Such reserves will help a company declare high dividends even in depressing
markets to retain and attract more shareholders.
Growth: Companies with a higher rate of growths, as reflected in their annual sales growth, a
ratio of retained earnings to equity and return on net worth, prefer high dividend payouts to keep
their investors happy.
Changes in Government Policies: There could be the change in the dividend policy of a
company due to the imposed changes by the government. The Indian government had put
temporary restrictions on companies to pay dividends during 1974-75.
Profitability: The profitability of a firm is reflected in net profit ratio, current ratio and ratio of
profit to total assets. A highly profitable company generally pays higher dividends and a
company with less or no profits will adopt a conservative dividend policy.
Taxation Policy: The corporate taxes will affect dividend policy, either directly or indirectly.
The taxes directly reduce the residual earnings after tax available for the shareholders. Indirectly,
the dividend distribution is taxable after a certain limit.
Trends of Profits: Even if the company has been profitable over the years, the trend should be
properly analyzed to find the average earnings of the company. This average number should be
then studied in relation to the general economic conditions. This will help in opting for a
conservative policy if a depression is approaching.
Liquidity: Liquidity has a direct relation with the dividend policy. If a firm has a strong liquidity
and enough cash for its working capital, it can afford to pay higher dividends. However, a firm
with less liquidity will choose a conservative dividend policy.
Legal Rules: There are certain legal restrictions on the companies for dividend payments. It is
legal to pay a dividend only if the capital is not reduced post payment. These rules are in place to
protect creditors’ interest.
Inflation: Inflationary environments compel companies to retain major part of their earnings and
indulge in lower dividends. As the prices rise, the companies need to increase their capital
reserves for their purchases and other expenses.
Control Objectives: The firms aiming for more control in the hands of current shareholders
prefer a conservative dividend payout policy. It is imperative to pay fewer dividends to retain
more control and the earnings in the company.
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BHUBANESWAR
SHORT QUESTIONS AND ANSWERS (7 OR 8 MARKS)
Q. What is operating leverage and why is it important?
Answer: Operating leverage is the degree to which fixed costs exist in a company's cost
structure. Generally speaking, operating leverage is fixed costs divided by total costs. Operating
leverage is important to the investment community because it is an indicator of the quality of
earnings of a firm.
A business that makes few sales, with each sale providing a very high gross margin, is said to be
highly leveraged. A business that makes many sales, with each sale contributing a very slight
margin, is said to be less leveraged. As the volume of sales in a business increases, each new sale
contributes less to fixed costs and more to profitability.
A business that has a higher proportion of fixed costs and a lower proportion of variable costs is
said to have used more operating leverage. Those businesses with lower fixed costs and higher
variable costs are said to employ less operating leverage. The more profit you can generate from
the same amount of fixed cost, the higher your degree of operating leverage.
Here’s the formula:
Degree of operating leverage = contribution margin ÷ profit
Profit = contribution margin – fixed costs
The higher the degree of operating leverage, the greater is the potential danger from the
forecasting risk to the firm. That is, if a relatively small error is made in forecasting sales, it can
be magnified into large errors in cash flow projections. The opposite is true for businesses that
are less leveraged. A business that sells millions of products a year, with each contributing
slightly to paying for fixed costs, is not as dependent on each individual sale.
Q. What is financial leverage? Why is it important?
Answer: Financial leverage is the degree to which a company uses fixed-income securities such
as debt and preferred equity. The more debt financing a company uses, the higher its financial
leverage. A high degree of financial leverage means high interest payments, which negatively
affect the company's bottom-line earnings per share. Financial leverage is also known as trading
on equity. In other words, the effect on earnings by the use of fixed cost securities (preference
shares and debentures) is called financial leverage.
It is the ratio of net rate of return on shareholders' equity and the net rate of return on total
capitalization. In the words of J.E. Walter, “Financial leverage may be defined as percentage
return on equity to the percentage return on capitalization.”
The degree of financial leverage may be calculated at any level of operating profit as follows: -
Operating profits or EBIT.
Financial Leverage = --------------------------------------------
EBIT – Interest or PBT.
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EBIT = Earning Before Interest and Taxes.

PBT = Profits Before Tax.
Financial leverage has two primary advantages:
Enhanced Earnings: Financial leverage may allow an entity to earn a disproportionate amount
on its assets.
Favorable Tax Treatment: In many tax jurisdictions, interest expense is tax deductible, which
reduces its net cost to the borrower.
Financial risk is the risk to the stockholders that is caused by an increase in debt and preferred
equities in a company's capital structure. As a company increases debt and preferred equities,
interest payments increase, reducing EPS. As a result, risk to stockholder return is increased. A
company should keep its optimal capital structure in mind when making financing decisions to
ensure any increases in debt and preferred equity increase the value of the company.
Q. What is Combined, or Total, Leverage? How would you measure it?
Answer: The combination of operating leverage and financial leverage is called combined
leverage or total leverage. Operating leverage measures operating or business risk where as
financial leverage measures financial risk. Combined leverage measures total risk of the
business.
Operating leverage is measured by the percentage change in earning before interest and tax due
to percentage change in sales where as financial leverage is measured by percentage change in
earning before tax or earning per share due to percentage change in earning before interest and
tax. Thus, the combined leverage is measured by percentage change in earning per share (EPS)
due to percentage change in sales.
Measuring Degree of Combined Leverage (DCL)
DCL = DOL x DFL = (CM/EBIT) x (EBIT/EBT) = CM/EBT
Where,
DCL = degree of combined leverage
DOL = degree of operating leverage
DFL = degree of financial leverage
CM = contribution margin
EBIT= earning before interest and tax
EBT = earning before tax
Since the degree of combined leverage is calculated by combining both the operational leverage
and the financial leverage, it helps us in ascertaining the total risk involved in the business.
Operating Leverage measures the operating risk or business risk of the company while Financial
Leverage measures the financial risk of the company. Together when combined, both the
financial leverage ratio and the operating leverage ratio can provide you with an idea of how
much risk per share are involved. Operating leverage is determined by the percentage change in
earning before tax or interest is due and similarly financial leverage is determined by the
percentage change in the gross before the tax and interest per share is due.
BHAGAVAN BEHERA
BHUBANESWAR
It is up to the company to maintain the degree of combined leverage so as to minimize the risks
involved in the business. Maintaining the risk and not increasing it from where it is, the business
should try to lower or minimize the financial leverage in order to balance the operating leverage
and by minimizing the operating leverage when the financial leverage is to be balances. The
balanced degree of combined leverage (DCL) provides with an increase in the earnings per share
of the equity holders which is why it is important to calculate the Degree of Combined Leverage
(DCL) for better understanding of the position of the company and minimizing the risks of the
company.
Q. Differentiate between Operating Leverage and Financial Leverage
Answer: Operating leverage refers to the firm’s ability to use fixed operating costs to magnify
the effects of changes in sales on its EBIT while financial leverage is concerned with the firm’s
ability to use fixed financial charges to magnify the effects of changes in EBIT on the firm’s
EPS.
Though both are related to fixed payments either in the form of fixed operating costs or in the
form of fixed financial changes, they are not same. Mentioned in Table 5.2 are the differences
between operating and financial leverages.
Operating Leverage:
Operating leverage is concerned with investment activities of the firm.
It is determined by the cost structure of the firm.
It is the firm’s ability to use fixed operating costs to magnify the effects of changes in sales
on its earnings before interest and taxes.
The higher the proportion of fixed operating costs to the total operating costs in the cost
structure of a firm, the higher is the degree of operating leverage.
Degree of operating leverage enables us to measure the business risk associated with the
firm.
Financial Leverage:
Financial leverage is concerned with financing activities of the firm.
It is determined by the capital structure of the firm.
It is the firm’s ability to use fixed financial charges to magnify the effects of changes in EBIT
on tis earnings per share.
The higher the proportion of fixe charges bearing capital to total financial changes in the
capital structure of a firm, the higher is the degrees of financial leverage.
Degree of financial leverage enables us to measure the degree of financial risk, associated
with the firm.
Q: What is cash management? What are the motives of a company behind holding the
cash?
Answer: Cash management is a broad term that refers to the collection, concentration, and
disbursement of cash. It encompasses a company's level of liquidity, its management of cash
balance, and its short-term investment strategies. In some ways, managing cash flow is the most
important job of business managers. If at any time a company fails to pay an obligation when it
is due because of the lack of cash, the company is insolvent. Insolvency is the primary reason
firms go bankrupt. Obviously, the prospect of such a dire consequence should compel companies
to manage their cash with care. Moreover, efficient cash management means more than just
preventing bankruptcy. It improves the profitability and reduces the risk to which the firm is
exposed.
BHAGAVAN BEHERA
BHUBANESWAR
Objectives of Cash Management:
1) To make Payment According to Payment Schedule:

Firm needs cash to meet its routine expenses including wages, salary, taxes etc. Following are
main advantages of adequate cash-
To prevent firm from being insolvent.
The relation of firm with bank does not deteriorate.
Contingencies can be met easily.
It helps firm to maintain good relation’s with suppliers.
(2) To minimize Cash Balance: The second objective of cash management is to minimize cash
balance. Excessive amount of cash balance helps in quicker payments, but excessive cash may
remain unused & reduces profitability of business. Contrarily, when cash available with firm is
less, firm is unable to pay its liabilities in time. Therefore optimum level of cash should be
maintained.
MOTIVES OF HOLDING THE CASH:
Transaction Motive: Requirement of cash to meet day to day needs is known as transaction
motive. For example: On day to day basis the company is required to make regular payments like
purchases, salaries/wages, taxes, interest, dividends etc. for which company will hold the cash.
Similarly, company receives cash from its sale operations. However, sometimes receipts of the
cash and the cash payments do not match with each other; in such situations the company should
have enough cash to honor the commitments whenever they are due.
Precautionary Motive: Holding up of cash balance in order to take care of contingencies and
unforeseen circumstances is known as precautionary motive. In addition to requirement of cash
for regular transactions, the company may require the cash for such purposes which cannot be
estimated or foreseen. For example: Sudden decline in the collection from the customers or sharp
increase in the prices of raw materials may put the company in such a situation where they need
additional funds to deal with such situation without affecting its regular business.
Speculative Motive: Holding up of some reserve in the form of cash to take the benefit of some
specific nature of favorable market conditions is known speculative motive. For example: If the
company presumes that in near future prices of raw material is going to be low, then it will
preserve that cash for future purchase of raw material. In another case if interest rates are
expected to increase then the company will purchase securities from the reserved cash.
Q. What is a bonus issue or stock dividend? What are its advantages and disadvantages?
Answer: Bonus share means distribution of free shares to the existing shareholders. This is
known as stock dividend in the USA. This has the effect of increasing the number of ordinary
shares of the company by capitalization of retained earnings. In India, bonus shares cannot be
issued in lieu of cash dividend. The earnings per share and market price per share will fall
proportionately to the bonus issue, but the total net worth of the firm is not affected by the bonus
issues.
BHAGAVAN BEHERA
BHUBANESWAR
Advantages of Issue of Bonus Shares:

(A) For Shareholders:
(1) Immediately Realizable: Bonus shares can be sold in the market immediately after a
shareholder gets it.
(2) Not taxable: Bonus shares are not taxable.
(3) Increase in future Income: Shareholders will get dividend on more shares than earlier in
future.
(4) Good Image increases the value in market: Bonus shares create very good image of the
company and the shares. Thereby it results into increase in the value of the share in the market.
(B) For Company: (1) Economical: It is an inexpensive mode of raising capital by which cash
resources of company can be used for some other expansion project.
(2) Wider Marketability: When bonus shares are issued, market price of share is automatically
reduced which increases its wider marketability?
(3) Increase in Credit Worthiness: Issuing bonus shares mean capitalization of profits and
capitalization of profits always increases the credit worthiness of the company to borrow funds.
(4) More realistic Balance Sheet: Balance Sheet of the company will reveal more realistic picture
after the issue of bonus shares.
(5) More Capital Availability: After issuing bonus shares, more capital will be available and
hence more capital can be utilized for more expansion works.
(6) Unaltered Liquidity Position: Liquidity cash position of the company will remain unaltered
with the issue of bonus shares because issue of bonus shares does not result into inflow or
outflow of cash.
Disadvantages of Issue of Bonus Shares:
1. Rate of dividend decline: The rate of dividend in future will decline sharply, which may create
confusion in the minds of the investors.
2. Speculative dealing: It will encourage speculative dealings in the company’s shares.
3. Forgoes Cash equivalent: When partly paid up shares are converted into fully paid-up shares,
the company forgoes cash equivalent to the amount of bonus so applied for this purpose.
4. Lengthy Procedure: Prior approval of central government through SEBI must be obtained
before the bonus share issue. The lengthy procedure, sometime may delay the issue of bonus
shares.
Q. Explain a stock split? Why is it used? How does it differ from a bonus shares?
Answer: A stock (share) split is a method to increase the number of outstanding shares through a
proportional reduction in the par value of the share. A share split affects only the par value and
the number of outstanding shares, the shareholders’ total fund remains unaltered. For example, a
firm’s total share capital of Rs. 10 crore being represented by 1 crore share each having par value
of Rs. 10. The firm can split their shares two-for-one. Then after split off the number of shares
will be 2 crore each having par value of Rs. 5 and total share capital will be Rs. 10 crore only.
Stock split is done with the main purpose to reduce the market price of the share and place it in a
more popular trading range. This helps in marketability and liquidity of the company’s shares.
Generally, when the share is split, the company seldom reduces dividend per share
proportionately, so total dividends of a shareholder increase after a stock split.
The reduction of the number of outstanding shares by increasing per share par value is known as
reverse split. This may be done, when company wants to prop up the market price per share.
BHAGAVAN BEHERA
BHUBANESWAR
In case of both bonus share and stock split, the total net worth of firm does not change, but
number of outstanding shares increases substantially.
In case of bonus shares, the balance of the reserves and surpluses account decreases due to a
transfer to the equity capital and share premium accounts. The par value per share remains
unaffected. With a stock split, the balance of the equity accounts does not change, but the par
value per share changes.
Q. What is meant by the buyback of shares? What are its effects? Is it really beneficial to
the company and shareholders?
Answer: The buyback of shares is the repurchase of its own shares by a company. In India
companies are authorized to buy back their shares. But they cannot do so by raising debt. They
will use their surplus cash for doing so. Also after the buyback, company cannot issue new
shares for next 12 months. There are two methods of the share buyback in India.
A company can buy its shares through authorized brokers on the open market.
The company can make a tender offer, which will specify the purchase price, the total
amount, and the period within which shares will be brought back.
The purpose of the buyback is to provide companies the flexibility of improving their EPS and
share price, to defend themselves from hostile takeovers and adjust their capital structure.
In practice, share prices may fall if the buyback results into slow growth. It may not be effective
in countering the takeover if it does not have enough surplus cash.
Q. Explain the objective of credit policy? What is an optimum credit policy? Discuss.
Answer: The objective of credit policy is to promote sales up to that point where profit is
maximized. To achieve this basic goal, the firm should manage its credit policy in an effective
manner to expand its sales, regulate and control the credit and its management costs, and
maintain debtors at an optimum level.
Optimum credit policy is the policy which maximizes the firm’s value by minimizing total cost
for a given level of revenue. The value of the firm is maximized when the incremental rate of
return (also called marginal rate of return) of an investment is equal to the incremental cost of
funds (also called marginal cost of capital) used to finance the investment in receivables. The
incremental rate of return can be calculated as incremental operating profit divided by the
incremental investment in receivable. The incremental cost of funds is the rate of return required
by the suppliers of funds, given the risk of investment in accounts receivable.
Q. What benefits and costs are associated with the extension of credit? How should they be
combined to obtain an appropriate credit policy?
Answer: The length of time for which credit is extended to customers is called the credit period.
A firm lengthens credit period to increase its operating profit through expected sales. However,
there will be net increase in operating profit only when the cost of extended credit period is less
than the incremental operating profit.
As the firm starts loosening its credit policy, it accepts all or some of those accounts which the
firm had rejected in past. Thus, the firm will recapture lost sales, and thus, lost contribution. In
addition, new accounts may be turned to the firm from competitors resulting into increase
BHAGAVAN BEHERA
BHUBANESWAR
contribution. The opportunity costs of lost sales declines and opportunity benefits of new sales
increases as firm loosens the credit terms.
As the firm loosens its credit policy, the credit investigation costs, credit monitoring costs, bad-
debt losses, and collection costs increases in case of stringent credit policy.
The optimum or appropriate credit policy is such where the firm will obtain the maximum value
for the credit policy when the incremental rate of investment in receivable is equal to the
opportunity cost of capital i.e., the incremental cost of funds.
Q. What is the role of credit terms and credit standards in the credit policy of a firm?
Answer: Credit standards are criteria to decide to whom credit sales can be made and how much.
If the firm has soft standards and sells to almost all customers, its sales may increase but its costs
in the form of bad-debts losses and credit administration will also increase. The firm will have to
consider the impact in terms of increase in profits and increase in costs of a change in credit
standards or any other policy variable.
Credit standards influence the quality of firm’s customers, i.e., the time taken by customers to
repay credit obligation, and the default rate. The time taken by customers to repay debt can be
determined by average collection period (ACP).
Default risk can be measured in terms of bad-debt losses ratio – the proportion of uncollected
receivable. Default risk is the likelihood that a customer will fail to repay the credit obligation.
The estimate of probability of default can be determined by evaluating the character, i.e.,
willingness of customer to pay; customer’s ability to pay and prevailing economic and other
conditions. Based, on above, firm may categorize customers into three kinds, viz., good
accounts, bad accounts and moderate accounts.
The conditions for extending credit sales are called credit terms and they include the credit
period and cash discount. Cash discounts are given for receiving payments before than the
normal credit period. All customers do not pay within the credit period. Therefore, a firm has to
make efforts to collect payments from customers. The length of time for which credit is extended
to customers is called the credit period. A firm’s credit policy may be governed by the industry
norms.
But depending on its objective, the firm can lengthen the credit period. The firm may tighten the
credit period, if customers are defaulting too frequently and bad-debt losses are building up.
Q. What are the objectives of the collection policy? How should it be established?
Answer: The primary objective of collection policy is to cause increase in sales, and to speed up
the collection of dues. The collection policy should ensure prompt and regular collection; keep
down collection costs and bad debts within limits and to maintain collection efficiency. The
collection procedure should be clearly defined in such a manner that the responsibility to collect
and the follow up should be clearly defined. This responsibility may be entrusted to the separate
credit department or accounts or sales department. Besides the general collection policy, firm
should lay-down clear cut collection procedures for past dues or delinquent accounts.
BHAGAVAN BEHERA
BHUBANESWAR
Q. What shall be the effect of the following changes on the level of the firm’s receivables?
a) Interest rate increases
b) Recession
c) Production and selling costs increases
d) The firm changes its credit term from “2/10 net 30” to “3/10 net 30”
Answer: As the interest rate increases, the total cost of production increases resulting into more
investment in receivables.
During the recession, the sales level decreases, so the investment in receivable is supposed to
reduce. But the reduction may not take place on account of delayed recovery of amount due from
customers by firm. So, this may also cause the investment in receivables to increase.
The increases in production and selling costs result to more investment in receivables.
When company changes its terms from ‘2/10 net 30’ to ‘3/10 net 30’, this should normally result
into reduction in level of investments in receivable. But at the same moment, more customers
may be willing to avail cash discount resulting into increase in discount costs.
Q. How would you monitor receivables? Explain the pros and cons of various methods.
Answer: A firm needs to continuously monitor and control its receivables to ensure the success
of collection efforts. Following are the methods to monitor and evaluate the management of
receivables.
Collection Period Method: The average collection period is calculated, and can be
compared with the firm’s stated credit period to judge the collection efficiency. The
average collection period measures the quality of receivable since it indicates the speed
of their collectability. Collection period only provides an aggregate picture. Further, it
does not provide very meaningful information about outstanding receivable when sales
variations are quite high.
Aging Schedule: It breaks down receivables according to the length of the time for which
they have been outstanding. It helps to spot out slow-paying customers. It also suffers
from the problem of aggregation, and does not relate receivables to sales of the same
period.
Collection Experience Matrix: In this method, firm tries to relate receivables to the sales
of the same period. In this method, sales over a period of time are shown horizontally and
associated receivable vertically in a tabular form; thus, a matrix is constructed. This
method indicates which months’ sales receivable are uncollected. It helps to focus efforts
on the collection month wise.
Q. What is factoring? What functions does it perform?

Answer: Factoring involves an outright sale of receivables of an organization to a financial
institution or private agency, called factor. A factor specializes in management of trade credit.
Factors collect receivables and also advance cash against receivables to solve the client firms’
liquidity problem. For providing their services, they charge interest on advance and commission
for other services. The factor performs the following functions:
Factors provide financial assistance to the client by extending advance cash against book
debts.
BHAGAVAN BEHERA
BHUBANESWAR
Sales ledger administration and credit management services to his clients, by maintaining
the ledger of customers of clients, taking all follow-up actions, etc. He also helps the
clients and advises from the stage of credit extension to customers to the final stage of
book debt collection.
Protection against default in payment by debtors, by initializing legal actions at an early
time.
Credit collection: When individual book debts become due from the customer, the factor
undertakes all collection activity that is necessary. He guards the interest of his client, by
developing better strategy against possible defaults by customers of his client; etc.
Q. Explain the importance of trade credit and accruals as sources of working capital. What
is the cost of these sources?
Answer: Trade credit refers to the credit that a customer gets from suppliers of goods in normal
course of business. This deferral of payments is a short term financing, and a major source of
finance. It is mostly granted on an open account basis. It may also take the form of bills payable.
It is a spontaneous source of financing. It appears to be cost free since it does not involve explicit
interest charges. But, in practice, it involves implicit costs, i.e., via the increased price of goods
supplied to customer.
Accrued expenses represent a liability that a firm has to pay for the services which it has already
received. They represent spontaneous, interest free sources of financing. The most important
components of accruals are wages and salaries, taxes and interest. Accrued taxes and interest also
constitute another source of financing.
Q. Define commercial paper. Explain its pros and cons.
Answer: Commercial paper (CP) is a form of unsecured promissory note issued by firms to raise
short term funds. The CP are issued by companies having net worth of Rs. 10 crore or more, and
are financially sound and highest rated companies. In addition to this, companies should have
maximum permissible bank finance of not less than Rs. 25 crore, and are listed on stock
exchange.
The RBI provided that size of issue should be at least Rs. 1 crore and the size of the each CP
should not be less than Rs. 25 lakh. In India, the maturity of CP runs between 91 to 180 days. It
is expected that CP is used for short term financing only, as an alternative to bank credit and
other short term sources. The interest rate of CP will be determined by market.
Advantages:
1) The CP is an alternative source of raising short term finance.
2) It is cheaper source of finance in comparison to bank credit.
Disadvantages or limitations:
1) As it is impersonal method, so it may not be possible to get the maturity of CP extended.
2) It cannot be redeemed until maturity, and will have to incur interest costs.
3) A firm facing temporary liquidity problems may not be able to raise funds by issuing new CP
etc.
BHAGAVAN BEHERA
BHUBANESWAR
Q. Explain the technique that can be used to accelerate the firm’s collections.
Answer: Cash collections can be accelerated by reducing the lag or gap between the time a
customer pays bill and the time the cheque is collected and funds become available for the firm’s
use. For this purpose, a firm can use decentralized collection system and lock-box system to
speed up the collections.
A decentralized collection procedure, called concentration banking, is a system of operating

through a number of collection centres, instead of a single collection centre centralized at the
firm’s head office. The basic purpose of the decentralized collections is to minimize the lag
between the mailing time from customers to the firm and time when the firm can make use of the
firm. Decentralized mailing system saves mailing and processing time, and thus, reduces the
deposit float, and consequently, the financing requirements.
Lock-box system: In a lock-box system, the firm establishes a number of collection centres,
considering customer locations and volume of remittances. At each centre, the firm hires a post
office box and instructs its customers to mail their remittances to the box. The firm’s local bank
is given the authority to pick up the remittances, and deposits the cheque in the firm’s account.
Q. Why should inventory be held? Why is inventory management important?

Explain the objectives of inventory management.
Answer: The manufacturing companies hold inventories in the form of raw materials, work-in-
process and finished goods. There are three motives for holding inventories.
To facilitate smooth production and sales operation (transaction motive).
To guard against the risk of unpredictable changes in usage rate and delivery time
(precautionary motive).
To take advantage of price fluctuations (speculative motive).
Inventory management is important because inventories constitute about 60% of current assets of
public limited companies in India.
The objective of inventory management should:

To ensure a continuous supply of raw materials to facilitate uninterrupted production,
Maintain sufficient stock of raw materials in periods of short supply and anticipate price
changes,
Maintain sufficient finished goods inventory for smooth sales operation, and efficient
customer service,
Minimize the carrying cost and time, and
Control investment in inventories and keep it at an optimum level.
Q. What is the importance of working capital for a manufacturing firm? What shall be the
repercussions if a firm has (a) paucity of working capital, (b) excess working capital?
Answer: A manufacturing firm is required to invest in current assets for a smooth, uninterrupted
production and sales. How much a firm will invest in current assets will depend on its operating
cycle. Operating cycle is defined as the time duration which the firm requires to manufacture and
sell the product and collect cash.
BHAGAVAN BEHERA
BHUBANESWAR
Investment is current assets should be just adequate to the needs of the firm. Excessive
investment in current assets impairs the firm’s profitability, as idle investment earns nothing. On
the other hand, inadequate (i.e. paucity) amount of working capital can threaten solvency of the
firm because of its inability to meet its current obligations.
Q. What is the concept of working capital cycle? What is meant by cash conversion cycle?
Why are these concepts important in working capital management? Give an example to
illustrate.
Answer: Operating cycle or working capital cycle is the time duration required to convert
inventories into production into sales into cash. Thus, working capital cycle refers to the
acquisition of resources, conversion of raw materials into work-in-process into finished goods,
conversion of finished goods into sales and collection of sales. Larger the working capital cycle,
larger the investment in current assets.
The main objective of a firm is to maximize shareholders’ wealth. One of the major ingredients
of achieving it is to maximize profit. The amount of profit largely depends on volume of sales. In
any firm, a major portion of sales is on credit terms. There is always time gap between the day of
sale and day of its realization from customers. Realization of funds from customer will take time
but the firm has to arrange money for purchase of raw materials and components, to pay for
salary, wages and other expenses. Hence, the sufficient working capital is needed so that the flow
of product from raw material stage to its completion to finished goods is not obstructed for want
of working capital. Similarly, working capital is needed to sustain sales activity. The operating
cycle can be said to be reason of the need for working capital. So, working capital funds are
required to finance the amount blocked in the operating cycle.
Q. What are term loans? What are their features?

Answer: Term loans are loans for more than a year maturity. Generally, in India, they are
available for a period of 6 to 10 years. In some cases, the maturity could be as long as 25 years.
Interest on term loans is tax-deductible. Mostly, term loans are secured through an equitable
mortgage on immovable assets. Term loans secured specifically by the assets acquired using the
term loan funds, is called primary security. Term loans are also generally secured by the
company’s current and future assets. This is called secondary or collateral security. In addition to
asset security, lender like financial institutions (FIs), add a number of restrictive covenants (asset
related, liability related, cash flow related and/or control related) to protect itself further. FIs in
India are normally insisting on the option of converting loans into equity, and specify the
repayment schedule at the time of entering into loan agreement (in principle) with borrower.
Q. How does a term loan differ from a non-convertible debenture?

Answer: Non-convertible debentures (NCDs) are pure debenture (a long term promissory note)
without a feature of conversion. They are repayable on maturity. The investor is entitled for
interest and repayment of principal. Term loans are also long term debt with a maturity of more
than one year.
The term loans are obtained from banks and specially created financial institutions (FIs) in India
by private placement rather than public subscription as is the case with NCDs. The purpose of
term loans and NCDs are generally to finance the company’s capital expenditure. Sometimes,
NCDs can be issued to finance mid-term working capital needs also.
BHAGAVAN BEHERA
BHUBANESWAR
In the case of term loans, firms directly negotiate with FIs for terms, while in case of NCDs, the
terms are decided by firms on their own by considering general economic environment. The term
loans and NCDs both can be secured by way of mortgage on assets of the company. Term loans
can be converted into equity shares, while NCDs cannot be convertible into equity shares of
preference shares.
Q. What is a right issue? What are its advantages and disadvantages from the company’s
and shareholder’s point of view?
Answer: A right issue involves selling of ordinary shares to the existing shareholders of the
company. The law in India requires that the new ordinary shares must be first issued to the
existing shareholders’ on a pro-rata basis.
The advantages of right issue are as follows:
1. The existing shareholders control is maintained through the pro-rata issue of shares.
2. Raising of funds through right issue involves less flotation costs as company can avoid
underwriting commission and issue and promotional expenses.
3. In case of profitable and growing company, the issue is more likely to be successful as the
subscription price is set below than current market price.
The limitations or disadvantages are:
1. The wealth of shareholders decline if they fail to exercise their voting rights.
2. Those companies whose shareholding is concentrated in the hands of financial institutions
because of the conversion of loan into equity would prefer public issue of shares rather than the
right issues.
Q. “The contention that dividends have an impact on the share price has been
characterized as the bird-in-the-hand argument.” Explain the essential of this argument.
Why this argument is considered fallacious?
Answer: According to the bird-in-the-hand argument, investors tend to behave rationally, are
risk averse and, therefore, have a preference for near dividends to future dividends. They most
certainly prefer to have their dividend today and let tomorrow take care of itself. Further, given
two companies with identical earnings record, and prospects but one paying a larger dividend
will always command higher share price because investors prefer present to future values.
This argument is fallacious, on the contention that, if the firm does not pay any dividend a
shareholder can create a “homemade dividend” by selling a part of his/her shares at the fair
market price in the capital market for obtaining cash. This will not make any dilution in their
wealth.
_______________________
BHAGAVAN BEHERA

Biju Patnaik Institute of It & Management Studies Bhubaneswar

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BIJU PATNAIK INSTITUTE OF IT & MANAGEMENT STUDIES

BEHERA’S MUST READ ON FINANCIAL MANAGEMENT

The main objectives of financial management are:-

Proper mobilization: Mobilization (collection) of finance is an important objective of financial

Arguments for profit maximization:

Arguments against profit maximization /Criticism of Profit Maximization:

Favorable Arguments for Wealth Maximization:

Arguments against Wealth Maximization:

There is always a contradiction between Profit Maximization and Wealth Maximization. We

CHALLENGES OF A MODERN FINANCIAL MANAGER:

6. What are the techniques/ methods of Methods of Evaluating Capital Investment

I. Time Adjusted Method or Discounted Cash Flow Method

II. Traditional Methods/ Non-Discounted Cash Flow Method:

Discounted Cash Flow Method (or) Time Adjusted Method:

Equation for Calculating Net Present Value:

Where: NPV =Net Present Value

Advantages of Net Present Value Method:

(3) Profitability Index Method:

Advantages of Profitability Index:

Traditional Methods/ Non-Discounted Cash Flow Method :

(1) It applies profit as a measure of yardstick not cash flow.

Factors Determining Capital Structure

Concept of Optimal Capital Structure:

Features of Optimal Capital Structure:

The salient features of an optimal capital structure are described below:

Constraints in Designing Optimal Capital Structure:

The main constraints in designing the optimum capital structure are:

Factors Affecting Working Capital or Determinants of Working Capital

10. What is Modigliani-Miller’s dividend irrelevance hypothesis? Critically evaluate its

Modigliani – Miller theory is a major proponent of ‘Dividend Irrelevance’ notion. According to

Assumptions of the Model

Modigliani – Miller theory is based on the following assumptions:

Valuation Formula and its Denotations:

Criticism of Modigliani Miller’s Model

Factors Affecting Dividend Policy

SHORT QUESTIONS AND ANSWERS (7 OR 8 MARKS)

Q. What is operating leverage and why is it important?

EBIT = Earning Before Interest and Taxes.

Objectives of Cash Management:

1) To make Payment According to Payment Schedule:

MOTIVES OF HOLDING THE CASH:

Advantages of Issue of Bonus Shares:

Q. What is factoring? What functions does it perform?

Q. Define commercial paper. Explain its pros and cons.

A decentralized collection procedure, called concentration banking, is a system of operating

Q. Why should inventory be held? Why is inventory management important?

The objective of inventory management should:

Q. What are term loans? What are their features?

Q. How does a term loan differ from a non-convertible debenture?

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