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NCERT Solutions for Class 12 Business Studies Chapter wise
EXERCISES
Very Short Answer Type:
Q1. What is meant by capital structure?
Answer: Capital structure is the combination of debt and equity which is used by a company to finance its requirements for funds. Debt can be obtained in the form of loans while equity is generated through retained earnings or common stock.
Q2. Discuss the two objectives of Financial Planning
Answer: The twin objectives of financial planning are:
1) To ensure availability of funds whenever these are required: This includes a proper estimation of the funds required for different purposes such as for the purchase of long-term assets or to meet day-to-day expenses of business etc.
2) To see that the firm does not raise resources unnecessarily: Excess fund is almost as bad as inadequate funding. Even if there is some surplus money, good financial planning would put it to the best possible use so that the financial resources are not left idle and don’t unnecessarily add to the cost.
Q3. Name the concept of financial management which increases the return to equity shareholders due to the presence of fixed financial charges.
Answer: The concept of financial management which increases the return to equity shareholders due to the presence of fixed financial charges is called trading on equity. When the rate of earning of the return on investment of a company is higher than the rate of interest on the borrowed funds only then a company should adopt for trading on equity.
Q4. Amrit is running a ‘transport service’ and earning good returns by providing this service to industries. Giving reason, state whether the working capital requirement of the firm will be ‘less’ or ‘more’.
Answer: The type of business conducted by Amrit is transport service which will be operating on a large scale. Hence, there is need of more amount of working capital.
Q5. Ramnath is into the business of assembling and selling of televisions. Recently he has adopted a new policy of purchasing the components on three months credit and selling the complete product in cash. Will it affect the requirement of working capital? Give reason in support of your answer
Answer: As Ramnath has adopted the policy of purchasing components on credit for 3 months and selling the product in cash. Therefore, working capital requirement is reduced.
Short Answer Type:
Q1. What is financial risk? Why does it arise?
Answer: Proportion of debt in the total capital determines the overall financial risk. Financial risk is the situation that the company will not be able to meet its fixed financial charges. With higher degree of debt in the overall capital, i.e. high Debt Equity ratio, the overall cost of capital declines and profitability (EPS) increases. However, due to higher repayment and interest payment obligations, the financial risk increases.
Q2. Define a ‘current asset’. Give four examples of such assets.
Answer: Apart from the investment in fixed assets every business organisation needs to invest in current assets. This investment facilitates smooth day-to-day operation of the business. Current assets are usually more liquid but contribute less to the profits than fixed assets. Examples of current assets, in order of their liquidity, are as under.
- Cash in hand/Cash at Bank
- Marketable securities
- Bills receivable
- Debtors
These assets, are expected to get converted into cash or cash equivalents within a period of one year. These provide liquidity to the business. An asset is more liquid if it can be converted into cash quicker and without reduction in value. Insufficient investment in current assets may make it more difficult for an organisation to meet its payment obligations. However, these assets provide little or low return. Hence, a balance needs to be struck between liquidity and profitability.
Current liabilities are those payment obligations which, when they arise, are due for payment within one year, such as Bills payable, creditors, outstanding expenses, advances received from customers etc. Some part of current assets is usually financed through short term sources i.e; current liabilities. The rest is financed through long-term sources and is called net working capital. Thus NWC=CA-CL.
Q3. What are the main objectives of financial management? Briefly explain
Answer: Primary aim of financial management is to maximise shareholder’s wealth, which is referred to as the wealth maximisation concept. The wealth of owners is reflected in the market value of shares, wealth maximisation means the maximisation of market price of shares.
According to the wealth maximisation objective, financial management must select those decisions which result in value addition, that is to say the benefits from a decision exceed the cost involved. Such value addition I increase the market value of the company’s share and hence result in maximisation of the shareholder’s wealth.
Q4. Financial management is based on three broad financial decisions. What are these?
Answer: Financial management refers to the procurement, allocation and utilisation of funds. It deals with three main decisions :-
a) Procurement decisions :- To decide the source of capital that is from where the capital should be raised so as the overall cost of capital should be at its minimum.
b) Investment decisions (Allocation of funds) :- Where the available funds should be invested so as to ensure maximum return.
c) Dividend decision :- To decide the rate of dividend to be paid to the shareholders
Q5. Sunrises Ltd. dealing in readymade garments, is planning to expand its business operations in order to cater to international market. For this purpose, the company needs additional 80,00,000 for replacing machines with modern machinery of higher production capacity. The company wishes to raise the required funds by issuing debentures. The debt can be issued at an estimated cost of 10%. The EBIT for the previous year of the company was 8,00,000 and total capital investment was 1,00,00,000. Suggest whether issue of debenture would be considered a rational decision by the company. Give reason to justify your answer. (Ans. No, Cost of Debt (10%) is more than ROI which is 8%).
Answer: A company is able to issue debenture for fund raising when the debt cost is less than cost of capital.
In this question. Cost of capital of Sunrises Limited is 10% which is 8,00,000 as total capital is 80,00,000.
Now return on investment is calculated as
ROI = Return / Investment
= 8,00,000/1,00,00,000
= 8 %
On assuming that the company will be operating on the same efficiency, the additional investment of 80,00,000 will have a ROI of 8% which will amount to 6,40,000.
The cost of debt will be 8,00,000 which is more than the ROI of 6,40,000. Therefore, it is advisable for a company not to issue debenture when cost of debt is higher than cost of capital.
Q6. How does working capital affect both the liquidity as well as profitability of a business?
Answer: Working capital is the excess of current assets over current liabilities. It affects both liquidity as well as profitability of a business. Increase in working capital increases the liquidity of the business. But current assets have low returns so this decreases the profitability of the business.
Q7. Aval Ltd. is engaged in the business of export of canvas goods and bags. In the past, the performance of the company had been up to the expectations. In line with the latest demand in the market, the company decided to venture into leather goods for which it required specialised machinery. For this, the Finance Manager Prabhu prepared a financial blueprint of the organisation’s future operations to estimate the amount of funds required and the timings with the objective to ensure that enough funds are available at right time. He also collected the relevant data about the profit estimates in the coming years. By doing this, he wanted to be sure about the availability of funds from the internal sources of the business. For the remaining funds, he is trying to find out alternative sources from outside.
a. Identify the financial concept discussed in the above paragraph. Also, state the objectives to be achieved by the use of financial concept so identified. (Financial Planning).
b. ‘There is no restriction on payment of dividend by a company’. Comment. (Legal & Contractual Constraints)
Answer: (a) The financial concept discussed here is capital budgeting, it is decision regarding capital investment which will be having an impact on the profitability of the company in the long term.
The company wants to invest in new machinery which needs investment, this will have a direct impact on the operations which will result in affecting the profitability of the organisation.
The following objectives can be achieved:
- Cash flow: Investment will bring new machinery which will increase the organisations profitability.
- Company wants to raise funds from both inside and outside organisation, it will be helpful to analyse that return generated from such investment will be more than cost of capital.
- Investment used: The company is planning to raise funds from both inside and outside. It is important to know that funds from internal and external sources will have different rates of interest.
(b) Companies pay dividend to shareholders which is a part of the company earnings. Paying of dividends is based on following factors:
- Legal Constraint: Legal constraints are such constraints that are mentioned in the company laws which impact paying out dividends on certain occasions. It should be followed properly.
- Contractual Constraints: Pay out of dividend reduces cash in the company. Money that is raised as loan will put certain restrictions on the company for paying dividends, such constraints are called contractual constraints
Long Answer Type:
Q1. What is working capital? How is it calculated? Discuss five important determinants of working capital requirement.
Answer: Working capital management is an important aspect of financial management. In business, money is required for fixed assets and working capital. Fixed assets include land and building, plant and machinery, furniture and fittings etc. Fixed assets are acquired to be retained in the business for a long period and yield returns over the life of such assets.
Working capital, on the other hand,, is required for the efficient and effective use of fixed assets. The main objective of working capital management is to determine the optimum amount of working required.
Definition of working capital
There are two concepts of working capital :-
(i) Gross working capital concept
(ii) Net working capital concept
(i) Gross working capital concept:- According to this concept, working capital means gross working capital which is the total of all the current assets of a business.
Gross Working Capital = Total Current Assets
Definitions favouring this concept are .
- “Working capital means total of current Assets” – Mead, Mailott and Field
- “Any acquisition of funds which increases the current Assets increases working capital, for they are one and the same” Bonneville and Dewey .
Persons acknowledging the total of current assets as working capital give the following arguments in their favour.
i) Just as fixed assets are considered as the symbol of fixed capital, current assets must also, be considered as symbol of working capital.
(ii) Any acquisition of funds increases the working capital. This statement proves true according to this concept whereas it does not hold true according to the second concept.
(iii) Most of the managers plan their business operations according to the current assets concept because these are the assets used in day- to-day business operations.
Q2. ”Capital structure decision is essentially optimisation of risk-return relationship”. Comment.
Answer: Capital structure refers to the mix between owners and borrowed funds. It can be calculated as Debit/Equity.
Debt and equity differ significantly in their cost and riskiness for the firm. Cost of debt is lower than cost of equity for a firm because lender’s risk is lower than equity shareholder’s risk, since lenders earn on assured return and repayment of capital and therefore they should require a lower rate of return. Debt is cheaper but is more risky for a business because payment of interest and the return of principal is obligatory for the business. Any default in meeting these commitments may force the business to go into liquidation. There is no such compulsion in case of equity, which is therefore, considered riskless for the business. Higher use of debt increases the fixed financial charges of a business. As a result increased, use of debt increases the financial risk of a business.
Capital structure of a business thus, affects both the profitability and the financial risk. A capital structure will be said to be optimal when the proportion of debt and equity is such that it results in an increase in the value of the equity share.
Q3. ”A capital budgeting decision is capable of changing the financial fortunes of a business”. Do you agree? Why or why not?
Answer: Yes, capital budgeting is a critical decision that must be carefully considered. It has the potential to transform a company’s financial fortunes. Capital budgeting decisions are those concerning the allocation of fixed capital to various projects. Investment decisions involving the acquisition of new assets, expansion, modernization, and replacement are examples of such decisions. Long-term investments include the purchase of plant and machinery, furniture, land, and buildings, as well as expenditures for the launch of a new product, modernization, and advertising, among other things. They have long-term consequences for the business and are irreversible except at a high cost. They have an impact on a company’s long-term growth, profitability, and risk. The following factors highlight the significance of capital budgeting decisions:
(i) Long-Term Implications: Investing in capital assets (long-term assets) yields a future return. As a result, they have an impact on a company’s future prospects. The long-term growth prospects of a company are determined by the capital budgeting decisions it makes.
(ii) Large Amount of Funds: Investing in fixed capital necessitates a large sum of money. This makes capital budgeting decisions even more critical, as large amounts of funds remain blocked for an extended period of time. Once made, these decisions are difficult to reverse. Thus, capital budgeting decisions must be carefully considered after a thorough examination of the total amount of funds required and the sources from which they are to be raised.
(iii) High Risk: Fixed assets involve a large amount of money and, as a result, a large amount of risk. Such decisions are risky because they have an impact on the company’s long-term viability. For example, deciding whether to purchase new machinery involves a risk in terms of whether the return on investment will be greater than the cost of the machinery.
(iv) Irreversible Decisions: Once made, these decisions are final. Reversing a capital budgeting decision comes at a high cost. This is due to the fact that once a large investment has been made in a project, withdrawing it would result in significant losses.
Q4. Explain the factors affecting the dividend decision.
Answer: Dividend decision of a company deals with what portion of the profits is to be distributed as dividends between the shareholders and what portion is to be kept as retained earnings. The following are the factors that affect the dividend decision.
- Amount of Earning :- A firm pays dividends out of its current and the past earnings. This implies that earnings play a key role in the dividend decision. A company having higher earnings will be in a position to pay a higher amount of dividend to its shareholders. In contrast to this, a company having low or limited earnings would distribute low dividends.
- Stable Earnings :- When a company has a stable and a smooth earning, they are in a position to distribute higher dividend as compared to the companies who have an unstable earning. In other words, a company having consistent and stable earnings can distribute higher amount of dividends.
- Stable Dividends :- Companies generally follow the practice of stabilising their dividends. They try to avoid frequent fluctuations in dividend per share and opt for increasing (or decreasing) the value only when there is a consistent rise (or fall) in the earnings of the company.
- Growth Prospects :- Companies aiming for a higher growth level or expansion of operations retain a higher portion of the earnings with itself for re-investment. Thus, dividend of such a company is smaller as compared to the companies with lower growth opportunities.
- Cash Flow Position :- Dividend payments require cash outflow. If a company is low on cash then the dividend will be lower as compared to the company which has more liquidity. Even if a company has higher profits, it will not be able to distribute high dividends if it does not have enough cash.
- Preference of the Shareholders :- A company must keep in mind the preferences of the share holders while distributing the dividends. For instance, if the share holders prefer at least a certain amount of dividend, then the company is likely to declare the same.
- Taxation Policy :- Taxation policy plays an important role in deciding the dividends. If the taxation policy is such that a high rate of tax is levied on dividend distribution, then the companies are likely to distribute lower dividends. On the other, it might prefer to distribute higher dividends if the tax rate is low.
- Stock Market Reactions :- The amount of dividend that a company distributes affects its stock market prices. An increase in dividend by a company is viewed as a good sign by the investors and the stock price of the company goes up. On the other hand, a fall in the dividends adversely affects the stock prices. Thus, while taking the dividend decision, a company must consider the probable stock market reactions.
Q5. Explain the term ”Trading on Equity”. Why, when and how it can be used by a company?
Answer: Trading on equity is a process of using debt in order to produce gain for the owners. In this process new debt is taken in order to gain new assets with which they can earn greater level of interest which is more than the interest that is paid for debt. This process is practiced as the equity shareholders are only interested in the income that is generated from business. It is only practiced by a company when the rate of return on investment is greater than the rate of interest for the fund that is borrowed. This practice is a form of financial leverage that a company exercise. There is an increase in earnings per share when this process is adopted.
Trading on equity is profitable only when the return on investment is greater than amount of funds borrowed. It is said that trading on equity shall be avoided if the return on investment is less than the rate of interest from the funds that are borrowed.
Q6. ‘S’ Limited is manufacturing steel at its plant in India. It is enjoying a buoyant demand for its products as economic growth is about 7%-8% and the demand for steel is growing. It is planning to set up a new steel plant to cash on the increased demand. It is estimated that it will require about Rs 5000 crores to set up and about Rs 500 crores of working capital to start the new plant.
Questions
- Describe the role and objectives of financial management for this company.
- Explain the importance of having a financial plan for this company. Give an imaginary plan to support your answer.
- What are the factors which will affect the capital structure of this company?
- Keeping in mind that it is a highly capital-intensive sector, what factors will affect the fixed and working capital. Give reasons in support of your answer.
Answer: 1) Role of financial management in this company is as follows:
- Financial management will help in taking decisions of purchasing fixed assets which will increase the composition of fixed assets.
- The composition of funds that are used by a company refers to the mix of short- and long-term funds that are used by the company. Fund composition is determined by the company’s decision which is regarding profitability and liquidity. It can be said that if a company is looking to attain higher liquidity it would be looking to opt for long term financing and companies looking for short term liquidity will opt for short term financing.
- The proportion of debt and equity that should be used in long term financing or in other words the distribution of funds that are raised with mix of debt and equity which is taken by financial management.
- The amount of current assets that a company holds is dependent on the financial decision of the company. Higher amount will lead to more working capital but decrease in profits and vice versa.
In this case, the basic objective of financial management will be towards increasing or maximising the shareholders wealth. Decisions that will be beneficial for the shareholders i.e. helps in increasing their market value of shares. This can be achieved if financial management takes a decision that results in increase in value of shares where benefits obtained from making this decision exceeds the cost of taking the financial decision.
2) These points highlight the importance of financial planning for the company
i. It enables the company in forecasting for future requirements.
ii. Financial plan will be helpful in avoiding any kind of shortage that may occur or surplus that can also occur. It ensures that funds are used optimally.
iii. It helps in better coordination between sales and production team.
iv. It helps in avoiding any type of wastages such as time, money and effort.
v. If the targets and policies are well defined then financial planning helps in evaluating the performance in a good way.
Proposed Financial Plan
The company can use the 50% through the issue of shares and the other 50% can be collected using funds that are borrowed from outside in form of debts.
3) Following factors will affect the capital structure choice:
i. Company should be opting for debt capital in case of strong cash flow is present. Debt requires payment of principal as well as interest that is applicable on the principal.
ii. Debt service coverage ratio determines the obligations towards cash payment of a company as against the cash availability. Having a high DSCR can make the company to opt for debt as source of funds.
iii. Equity cost can be directly related with the financial risk that a company faces. A company having a higher financial risk will see the expectations of shareholders to rise which raises the cost of equity. Rising cost of equity makes it difficult to opt for equity.
iv. Good stock market conditions are very much conducive for opting equity capital whereas poor stock market conditions are difficult for opting equity capital.
v. Higher interest coverage ratio which is a measure of the times EBIT is able to meet interest rate obligations. A higher interest coverage ratio translates to lower risk for the company which enables a company to opt for a high portion of debt in the composition of its capital structure.
vi. A high rate of floatation cost leads to reduction of the component in capital structure. A high floatation cost of equity results in a low capital structure.
vii. Higher rate of interest applicable on debt leads to higher debt cost which makes it difficult to choose debt as capital structure.
4) Factors affecting fixed capital requirements are as follows:
i. Fixed capital can be determined by the type of business. As the company mentioned here (S limited) is a company which is into manufacturing it will have a large operating cycle which therefore results in a need for a large amount of fixed capital.
ii. The scale of operations of a company also determines the need for investment in assets such as machinery, land, plants and buildings which requires large sum of fixed capital.
iii. A growing company or a company which is seeking expansion will be needing more amount of fixed capital which is the case with S Limited.
Factors affecting working capital requirements will be as follows:
i. The working capital requirements for a company will vary on the type of business it is conducting. As it is a manufacturing firm will it will have a large operating cycle as goods need to be transformed from raw materials to finished goods. Therefore, the requirement of working capital will be more for this firm.
ii. As this company is conducting large scale operations, there will be requirements of large amount of working capital.
iii. The company is looking to expand its business which requires more working capital as it will lead to higher growth prospects.
iv. As the product that is being manufactured by this company is in high demand the company would need to produce more to meet the requirements. Therefore, there will be need of large amount of working capital.
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