Commerce ePathshala NOTES
(IGNOU)
Important Questions & Answers
IGNOU
: BCOM
BCOE
143 – FUNDAMENTALS OF FINANCIAL MANAGEMENT
Q – State the objectives of Financial Management.
Ans.
OBJECTIVES OF FINANCIAL MANAGEMENT
The objectives of financial management provide a
framework for making optimum decisions. There are two objectives of Financial
Management which are as follows:
i)
Profit Maximization
ii)
Wealth Maximization
The objectives are means to reach to a goal of a
business. Let us discuss these.
Profit
Maximization: In general terms it means maximizing the
income of the firm. When we discuss this concept it is quite vague as it does
not clearly spell out the following:
a)
What are the profits?
b)
What is the absolute value of earnings per
share?
c)
Does the profits have return on investment?
d)
Are the profits calculated before tax or
after tax?
Initially this objective was the main aim of the firm
and there are many arguments in favour of this. In case a firm adopts the
concept of profit maximization then the returns are achieved at a later stage
which may not be good for the financial health of the firm. In present times
profit maximization is also not socially responsible decision on part of the
firm. Let us see some pros and cons of this approach.
Wealth
Maximization: This approach tries to overcome the
limitations of profit maximization. This is the ultimate goal of the financial
management. In operational terms it means maximization of profit, maximization
of return on capital employed, growth in earning per share or market value of a
share or dividends, optimum level of leverage and minimization of cost of
capital. This is universally accepted in the modern approach to financial
management. We can say that this approach takes into consideration the risk,
appropriateness and the time value of money. This concept refers to the wealth
of the shareholders as shown by the price of their shares in the market. So it
means maximization of the market price of the shares of the firm.
Q – State the Long-Term Source of Funds.
Ans.
LONG-TERM SOURCES OF FINANCE
Let us now discuss the most common long-term sources of
financing. These are
· Equity
Shares
· Preference
Shares
· Debentures
· Venture
Capital
· Lease
Financing
· Warrant
Equity
Shares : Equity share can be defined as the share which does
not have two major preferential rights. What are these rights? These are
a)
Right to receive dividend
b)
Right to receive payment of capital
When the capital is raised through equity shares this
is known as equity share capital and the contributors towards such capital are
known as equity shareholders.
The company’s article of association states the amount
authorised as share capital. A company issues shares of equal values amounting
to the value of authorised capital. However it may not issue all shares up-to
the authorised amount. Any amount of authorised capital not issued is known as
unissued capital. It is classified as long term of source of finance as it does
not have any maturity.
Preference
Shares : Unlike equity shares, the preference shares have the
following two rights as per Section 85 of the Companies Act.
a.
Right to receive dividend
b.
Right to receive payment of capital
Preference shares also have the features of equity
shares and the debt capital. It is like equity shares as the dividend like
equity is non-taxable and like debt-capital as the rate of preference dividend
is fixed.
Debentures
:
Debenture is a written instrument which acknowledges a debt and contains
provisions as regards to the repayment of principal and payment of a fixed
interest rate. Debt is represented by a debenture. As per Section 2 (30) of the
Companies Act 2013, “debenture includes debenture stocks, bonds or any other
instrument of a company evidencing a debt, whether constituting a charge on the
assets of company or not”. The main characteristics of debenture are:
1)
Fixed interest is payable on debenture
2)
It is not have voting rights
3)
It can be redeemed during the life of the
Company.
Venture
Capital
This is a form of financing which has grown in the past
two decades. With the start-ups coming up the concept of venture capital has
taken a leap. It is a form of financing for new and highly likely ventures. The
ventures are usually promoted by qualified entrepreneurs who do not have much
experience and funds to implement their ideas.
Lease
Financing
Lease financing is an important source of long term as
well as medium term source of financing. It is a form of financing where the
owner of a particular asset gives the right to another person to use that
particular asset in lieu of the payments periodically. In other words, “a lease
is a contract whereby the owner of the asset grants the other party the
exclusive right to use the asset, usually for a specified period in return for
the payment of rent. “The ownership remains with the owner only. There are
certain terms related which are important to understand the concept of lease
financing.
Warrants
Stock warrants are the derivatives which give the right
to the investors but not the obligation to buy or sell the security before its
expiry. The price is specific at which the warrant can be bought or sold. The
price at which the underlying security is bought or sold is known as the
„exercise price‟ or „strike price‟.
There are two types of warrants. These are:
· Call
warrant
· Put
Warrant
Call warrants give the right to buy a security and Put
warrants give the right to sell the security.
Q – State the Advantages & Disadvantages of Lease Financing.
Ans.
Advantages of Lease Financing:
i.
Whenever an asset is acquired, there
is always the risk of obsolescence, and that said asset might become obsolete
before the completion of its service life. In case the firm acquires the asset
on lease, the risk of obsolescence lies on the owner of the asset. However
firms also need to be cognizant of the fact that the owner in fact knows the
true value of the equipment that is leased, so they may charge in accordance to
the risk involved.
ii.
The firm enjoys the convenience of not
having to pay for the
asset immediately, and can further acquire other assets by methods of lease
financing .In-case the firm had acquired the asset through debt financing, it
would have to comply to different terms and conditions which are stipulated in
the bond agreement. In case of lease financing the restrictions are far lesser
than a loan.
iii.
When a firm takes a loan to purchase
an asset, both asset and the loan are part of the debt. However in case of
lease financing, the obligation does not appear as debt on the balance sheet.
Thereby strengthening the borrowing capacity of the firm.
iv.
Lease financing works as a tax shield
for the firm since it reduces tax liability. When an asset is acquired on
lease, the full amount of Lease payment is deductible for tax purposes, when if
the company had brought the asset, it would entitle to deduct depreciation and
interest expenses. The former method is much more beneficial for the company.
Disadvantages
of Lease Financing
i.
In the long run, all benefits and
limitations of debt financing apply to lease financing as well because some
believe it to be another form of it.
ii.
There is deprivation of profits on
account of appreciation in the value of assets. This is because the ownership
lies at the hands of the lessee
iii.
It is costlier than buying on credit.
iv.
This form of lease financing has long
term legal obligation as the firm will still have to pay for the asset even if
it ceases its operations.
Q – State the Sources of Short Term Finance.
Ans.
SHORT-TERM SOURCES OF FINANCE
As we know this type of finance is used to finance the
temporary working capital. We will discuss few of the sources.
Trade
Credit
This is a kind of arrangement whereby the suppliers of
raw materials, components, finished goods etc. allow the customers to pay the
outstanding balances within a specified credit period. Usually this period
ranges between 3 to 6 months. The trade credit is given to the firms based on
their nature and size credit worthiness, policy of trade credit etc. There are
certain advantages and disadvantages associated with the trade credit.
Discounting
Bills of Exchange
Bills of exchange are generally drawn by the suppliers
when they sell the goods to the customers who accept it. The time period of
these bills ranges from 3-6 months. Usually the firms prefer to get such bills
discounted than holding it till maturity. Discounting bills of exchange is an
act of selling the bill to get the payment before the maturity. The bank
charges discount in terms of interest for the period from the date of discounting
to the date of the maturity of the bills. When the maturity is attained then
the bank presents the bills to the acceptor to get full payment and in case
bank does not receive the bill then it is known as dishonour of the bill. The
cost associated with this type of source is the discount charged by the bank.
Bank
Overdraft
It is a kind of arrangement whereby the bank allows the
customer to withdraw money over and above the deposited amount from current
account but within a specified limit. This facility is given against a security
of assets or personal security. The bank charges the interest only on the
actual amount overdrawn. In this case also the cost is the interest charged by
the bank.
Cash
Credit
It is a facility provided by the bank to the borrower
to draw money from time to time within a specified limit and this is known as
cash credit limit. This facility is also granted against a security. It can be
a pledge or hypothecation of stock etc. In this case also the cost is the
discount charged by the bank only on the actual amount withdrawn for actual
period of use.
Public
deposits
These are the funds which are raised by the companies
by inviting their shareholders, employees and public at large to deposit their
savings with the company. It is important to note that the general public
cannot deposit savings in the private company. These funds are raised by the
companies to meet their short and medium term financing need. The minimum
period for the deposit of fund is 6 months and maximum is 3 years. This type of
funds do not have any security attached with them and can be easily invited by
offering higher rate of interest than the banks.
Advances
from customers
This is the payment the firm has received from
customers for the goods and services not yet delivered.
Pre
shipment finance
It is before the shipment of goods. It is the credit
which is extended to the exporter for purchase, processing, and manufacturing
of goods before the shipments of goods. It can be granted in the form of loan,
cash credit or overdraft facilities.
Post
shipment
finance It is after the shipment of goods. It is the
credit granted to the exporter after the shipment of goods. This is granted to
meet the working capital requirements and insurance of goods. It can be received
from banks, EXIM bank, non-banking financial companies.
Inter
Corporate deposit (IC)
The business firms can borrow funds from other firms
which have good liquidity. It can also be borrowed for a single day. The rate
of interest on inter-corporate deposits depends upon the amount and the time
for which it is taken. These are some of the major types of short term sources
of finance.
Q – State the Process of Capital Budgeting.
Ans.
PROCESS OF CAPITAL BUDGETING
The capital budgeting process requires you to take the
various steps such as investment proposals identification, preliminary
screening, evaluation, prioritizing, final approval, implementation and review
as explained below:
i)
Identification: First of all you need to identify the
investment proposals taking into consideration the various changes taking place
in business environment. For instance, you may require to replace an existing
machine with a modern machine which is technically better and cost efficient.
ii)
Preliminary Screening: After identification of investment
proposals, you need to do the preliminary screening of these proposals to find
out their feasibility taking into consideration the resource requirements, risk
return involved, technical feasibility and compatibility with the existing
projects of the company.
iii)
Evaluation: You need to do the detailed evaluation of
the investment proposals which successfully pass the preliminary screening
stage. The detailed evaluation requires their market, demand, technical and
financial analysis. The cash flows are found and the investment proposals are
appraised using the various capital budgeting techniques.
iv)
Prioritizing: After evaluation of investment proposals,
you need to prioritize the acceptable proposals depending on their urgency,
funds required and expected returns.
v)
Final Approval: After prioritizing the investment
proposals, you need to present the detailed report of acceptable investment
proposals to the top management along with the funds requirement and sources of
financing these proposals. The top management then approves the most desirable
proposals consistent with wealth maximization of shareholders and allocates
funds for such projects.
vi)
Implementation: The investment proposals approved by the
top management are then implemented by raising funds, purchase of required
assets, and deployment of assets so purchased, fixing of responsibilities for
timely completion and determining the cost limits. You can use the network
techniques for monitoring the implementation of investment proposals.
vii)
Review: After implementation of the projects, you need to
review its performance by comparing the funds spent with the funds allocated
and the actual returns with the anticipated returns. The purpose of project
review is to find out unfavorable variances if any and taking timely corrective
measures required for successful completion of the project.
Q – State the Merits & Demerits of Accounting Rate of Return
Method.
Ans.
ACCOUNTING RATE OF RETURN
The accounting rate of return (ARR) is based on
accounting profit instead of cash flows from an investment project and is used
to measure profitability of investment project. The ARR is the annualized
return you earn on funds invested in project.
The
following is the acceptance criteria of ARR Method:
While taking capital budgeting decisions, you must
accept a project having higher ARR as compared to some predetermined minimum
acceptable rate. If you want to choose among mutually exclusive projects then
you must accept the one having highest ARR among projects having ARR higher
than predetermined minimum acceptable rate.
MERITS
AND DEMERITS OF ACCOUNTING RATE OF RETURN METHOD
The
ARR method has the following merits:
i) It is easy to understand and use.
ii) The information required in this method is easily
available from the accounting records.
iii) It considers the economic benefit arising from a
project during its lifetime.
The
ARR method suffers from the following demerits:
i) It is based on accounting profit which may be
affected by the changes in accounting policies related to charging
depreciation, valuation of inventory etc.
ii) It gives equal ranks to mutually exclusive projects
that have same ARR although they require different initial investment. In such
a case, among such projects, the company should accept the project requiring
lesser initial investment.
iii) It gives equal ranks to mutually exclusive
projects that have same ARR but different useful life. In such a case, among
such projects, the company should accept the project that generates economic
benefit over longer period of time.
iv) It does not consider time value of money and gives
same ranks to mutually exclusive projects with same ARR although they are
different in terms of timing of economic benefit. In such a case, among such
projects, the company should accept the project that generates more economic
benefit during early years of project life.
Q – Merits & Demerits of Net Present Value Method.
Ans.
NET PRESENT VALUE
The Net Present Value refers to the surplus of total
present values of cash inflows estimated to be generated from the project over
total present values of cash outflows spent or expected to be spent on the
project.
The
following is the acceptance criteria of NPV Method:
While making capital budgeting decisions, you must
accept a project having positive NPV as its acceptance implies addition to
shareholders wealth. If you want to choose among mutually exclusive projects
then you must accept the one having largest NPV among the projects having
positive NPV.
MERITS
AND DEMERITS OF NET PRESENT VALUE METHOD
The
following are the merits of NPV method:
i) It uses the cash flows instead of accounting profit
of a project.
ii) It considers all cash inflows and cash outflows of
a project.
iii) It considers time value of money as it recognizes
timing of the cash flows by making them comparable through finding their PV at
a given discount rate.
iv) It is consistent with the wealth maximization
objective of financial management as acceptance of a project having positive
NPV clearly implies addition to the wealth of shareholders as it will generate
returns more than the minimum returns required on the funds committed to the project.
The
NPV method suffers from the following demerits:
i) It is difficult as compared to PB Period or ARR
method.
ii) It may not give reliable results because of the
errors in the estimation of cost of money or discount rate. H. Bier Jr. and S.
Smidt suggest the rate should be closer to a default free interest rate than to
that rate required by shareholder the firm should not use single discount rate
for two problems (time and risk).
iii) It gives equal ranks to mutually exclusive
projects having same NPV but different economic life. However, the project
having shorter economic life should be preferred in such case.
iv) It gives equal ranks to mutually exclusive projects
having same NPV but different cash outflows required. However, the project
generating higher returns per rupee invested should be preferred in such case.
This limitation of NPV method can be overcome using Profitability Index which
is computed by dividing PV of cash inflows by PV of cash outflows.
Q – What are the Types of Risks ? explain.
Ans.
TYPES OF RISK
The various types of risk in capital budgeting
decisions are as follows:
i)
Project Specific Risk: The variability of cash flows due to
factors specific to that project only is referred as project specific risk. The
project specific risk occurs due to wrong assumptions about the cash flows of
an investment project. For instance, discontinuation of Tata Nano car is an
example of project specific risk as Tata Motors was not able to properly
estimate the cash flows associated with it.
ii)
Competition Risk: The variability of cash flows due to
actions of competitors different from estimated is known as competition risk.
For instance, due to popularity of various e-commerce companies the traditional
retail stores are facing significant competition risk.
iii)
Industry Specific Risk: The variability of the cash flows due
to factors such as innovations, changes in technology and material cost etc.
that are specific to the industry to which the project relates is known as
industry specific risk. For example, presently automobile industry in India is
facing significant fall in demand of the products and hence project that
relates to investment for introducing a new car is presently subject to
industry specific risk.
iv)
Market Risk: The variability of cash flows due to
factors such as domestic political instability, changes in monetary and fiscal
policies etc. that affect all the projects and all the companies is known as
market risk. For instance, increase in interest rate affect all the projects
and all the companies and make many projects unviable which were selected prior
to increase in interest rate.
v)
International Risk: The variability of the cash flows due to
international factors such as changes in the foreign currency rates or foreign
policy changes is known as international risk. For instance, project that
significantly earns its revenue from exports is subject to international risk
due to depreciating Indian currency at present.
Q – State the Significance of Cost of Capital.
Ans.
SIGNIFICANCE OF COST OF CAPITAL
The significance of cost of capital can be studied is
as follows:
·
Capital budgeting decisions: The acceptance or
rejection of the project is decided taking into consideration the cost of
capital. Here the present values for the estimated benefits from the available
investment opportunities are calculated by discounting them using a relevant
cost of capital.
· Capital structure
decisions: Different sources of funds have distinct features, few are cheaper
in comparison to others, some are easily available. A firm uses both debt and
equity mix for designing its capital structure. Thus, for determining optimum capital
structure we choose the debt and equity capital mix for which the cost of
capital is minimum.
· Evaluating
financial performance: A firm having a high cost of capital is exposed to high
risk and it also adversely impacts the profitability. The profitability of the
project is compared to the overall cost of capital and if it is more than
performance is said to be satisfactory.
· Other financial
decisions: Cost of capital is also seen to have role in other fields such as to
find the value of shares, earning power of shares, for taking other financial
decisions such as dividend policy decisions, working capital decisions etc. The
cost of capital, thus, form the basis for various decisions and as a result, it
plays a crucial role in financial accounting.
Q – State the Types of Cost of Capital.
Ans.
TYPES OF COST OF CAPITAL
Cost of capital may be broadly classified into the
following:
·
Explicit cost and Implicit cost: Explicit cost of any
source of capital is one which is stated and firm has to pay it for procuring
the finance. The Interest payment on debt and dividend payment on equity
capital are examples of explicit cost of capital for raising funds through
equity and debt. On the other hand, the implicit cost of any source of fund is
like the opportunity cost. An example of implicit cost is retained earnings
where its cost is the opportunity cost which is equal to the earnings forgone
by shareholders.
·
Future cost and Historical cost: Future cost may be
defined as the expected cost of financing a project. These costs are an
important consideration while deciding any future financial investments and
hence, are relevant for financial decision making On the other hand, historical
cost in the cost which have already been incurred. These costs are also very
useful for calculating the projected future cost and are also used for making
comparison between actual and projected costs.
·
Specific cost and Combined cost: Cost of individual or
each source of finance is called specific cost like cost of equity, cost of
preference shares, cost of debentures or cost of retained earnings. When we
combine all the individual and specific cost of finance together, we get
combined cost. It is used to calculate the overall cost incurred for financing
a project when more than one source of finance is used to raise the capital.
·
Average cost and Marginal costs: The average cost is
calculated as the weighted average of the costs of each source of funds
employed by the firm. The weights are the proportions of the share of each
component of capital to the total capital structure the capital structure
comprises of different sources of borrowed funds and owned funds such as
debentures, preference shares capital, equity share capital and retained
earnings.
Marginal cost, on the other hand, in an incremental
cost. It is the incremental or differential cost of capital of the additional
finance raised by a firm. It is an important concept in financial management
for making capital budgeting decisions.
Q – State the Factors Affecting Cost of Capital.
Ans.
FACTORS AFFECTING COST OF CAPITAL
1)
Risk free interest rate: Risk free interest rate is the
interest rate which is on risk free securities, for example securities of
government of India which are default and risk free. The risk free interest
rate depends on supply and demand consideration in financial market for long
term funds, the market sources of demand and supply consists of two components:
a) Real interest rate: The interest rate payable to
lender for surrendering the funds for a period.
b) Purchasing power risk premium: when an investor
commits his funds for investment, he sacrifices his present purchasing power.
When the investor receives back his money, it is possible that during that
period prices have increased and his purchasing power has reduced.
An investor likes to maintain his purchasing power and want
to get compensation for the loss in purchasing power for the period in which he
supplies funds, so with real interest rate, purchasing power risk premium is
added in analyzing the risk free interest rate. Purchasing power risk premium
is directly related with rate of inflation and hence, when rate of inflation
increases, the purchasing power risk premium also increase and risk-free rate
of interest goes high.
2)
Business Risk: It can be defined as chances of occurrence
of any unfavorable event that has ability to minimize gain and maximize loss in
the business. No business can completely avoid risk although the degree of risk
may differ from are business to another depending upon the type and nature of
business. The various factors influencing the business risk may include
economics climate, government regulations, per unit pricing, sales volumes,
input cost, completion, environmental factors etc.
3)
Financial Risk: The financial risk is associated with
composition and mixing of different sources of finance. It can affect the
returns available to the investors, higher proportion of fixed cost securities
in capital structure, greater would be financial risk. Investors want to be
compensated for the increased risk, so they seek financial risk premium. Thus,
risk due to addition of fixed interest bearing securities is financial risk.
Q – Describe CAPM.
Ans.
Capital Asset Pricing Model (CAPM)
Under this method, return on any security depends on
the risk level that is attached to the security. The expected return of a
security is directly proportional to the risk attached to the security. Hence,
the relationship between risk and return is linear. Risk in relation to
security investment may be bifurcated into –
·
Unsystematic Risk: It is diversifiable and is caused due to
company specific factors such as management of the company, staff unrest,
strikes, level of operating and financial leverage of the firm. This part of
the total risk is diversifiable
·
Systematic Risk: It is non-diversifiable and is caused due
to macro– environment factors such as changes in demand and supply, government
policy, change in trade policy, inflation, purchasing power etc.
In CAPM (developed by Sharpe in 1965), the cost equity
is determined based on the risk –free rate, market return and β which is the
symbol of systematic risk.
Ke
=Rf+ β (Rm–Rf)
Ke
= cost of equity
Rf=
risk –free return
β
= coefficient of systematic risk
Rm=
expected Market return
Q – State the features of an Appropriate Capital Structure.
Ans.
FEATURES OF AN APPROPRIATE CAPITAL STRUCTURE
Every firm wants to have an appropriate
capital structure. Each firm strives to have that level of debt-equity proportion
which helps to maximize the market value of share and minimize the cost of
capital.
Following
are the features of an appropriate capital structure:
1) Profitability
A sound capital structure can allow for the most
effective use of leverage at the lowest possible expense in order to improve
performance and thereby maximise earnings per share.
2) Flexible
A financial manager should be able to modify the firm’s
capital structure with a minimal expense if required. It should therefore be
necessary for the corporation to supply funding whenever required to support
its productive operations.
3) Solvency
Excessive debt jeopardizes the company's solvency and
credit scores. Debt financing can be limited to the degree that it can be
properly repaid.
4) Conservatism
A company's debt capability can never be exceeded to
the extent that it becomes difficult to service its debt. Both the interest and
the principal balance must be paid on the debt. Future cash flows are expected
to make these payments. Cash insolvency will lead to legal insolvency if
potential cash flows are inadequate.
5) Control
The capital structure should not be changed so much
that it leads to loss of control in the company. The proportion of debt and
equity thus be kept in such a manner that there is no loss of control.
Q – State the factors affecting Structure of Capital.
Ans.
FACTORS AFFECTING CAPITAL STRUCTURE
Capital structure is affected by various factors that
are either internal or external to the organization. Various factors affecting
the capital structure are as follows:
1)
Nature and Size of business: The capital structure of a
corporation is strongly determined by its scale. Since trading companies need
more operating capital, they collect capital by issuing equity and preference
shares. Small businesses have a restricted ability to collect capital from
outside investors. Large firms have a lot of money to spend, so they will issue
debentures by selling fixed asset securities like property, buildings, and so
on. Small businesses usually have to rely on the owner’s funds, but as they
expand, they may be able to obtain long-term funding and larger businesses are
seen as less risky by investors.
2)
Stage of business: Since a company will not be able to get
finance by issuing variety of securities in the early stages of operation due
to the high risk involved, it is better to collect capital by equity shares.
The firm may later issue other forms of shares and fixed interest bearing
debentures and so on, for expansion or modernization. Companies with volatile
profits (unpredictable cash flow) should avoid using leverage in their financial
structure so they can struggle to cover the fixed interest rate.
3)
Period of funding: The ‘period for which funding is needed'
must also be addressed when designing capital structure. If money is needed on
a regular basis, the company can issue equity shares to collect the funds.
Funds may be obtained over a shorter period of time by issuing debentures or
preference shares.
4)
Management’s desire for control: The mind set of those in
management has an effect on capital structure. If management wants to have
complete leverage, it will raise money by preference shares and debt. Since the
owners of those shares has no voting powers. They are unable to influence the
company's executives.
5)
Taxation: Dividends are not considered a tax free cost for the
corporation, whereas interest charged on debt is. As a result, issuing debt
capital is preferred to issuing share capital. Debt capital is used by
businesses with higher taxes because it is a tax deductible expense.
Q – State the Conditions under which dividends cannot be declared.
Ans.
Conditions under which dividends cannot be declared:
A company is prohibited from declaring dividends on its
equity shares in case of non compliance of the provisions of section 73 and 74
relating to the acceptance of deposits under the Companies Act, 2013 till such
time the deposits accepted have been repaid along with the interest. In
addition a company shall also not declare any dividend, in case it has
defaulted in:
i) Redemption of debentures or payment of interest
thereon or creation of debenture redemption reserves.
ii) Redemption of preference shares or creation of
capital redemption reserves.
iii) Payment of dividends declared in the current or
previous financial year(s) or
iv) Repayment of any term loan to a bank or financial
institution or interest thereon.
The bar on declaration of dividends shall persist till
such time the defaults mentioned above is subsisting. The above bar is also
applicable on declaring dividends on preference shares also.
Q – Explain Gordon’s Model.
Ans.
GORDON’S MODEL
Myron Gordon developed a stock valuation model using
the dividend capitalization approach. This model tries to relate the market
value of the firm to its dividend policy.
This model is also based on certain assumptions just
like Walter’s model which are as follows:
1)
All equity firm: The capital requirement of the firm is
fulfilled through equity and it has no debt.
2)
No external financing: The firm cannot raise capital from
external sources, therefore only retained earnings can be used for expansion
purpose.
3)
Constant return: The rate of return for the firm remains
constant throughout the life of the firm. This assumption ignores the marginal
efficiency of investment.
4)
Constant cost of Capital: The cost of capital for the firm
remains constant throughout the life of the firm. This assumption ignores the
effect of change in the firm’s risk class and its consecutive effect on firm’s
cost of capital.
5)
The growth rate of firm is function of retention ratio and
rate of return of the firm. It is product of retention ration and rate of
return. This assumption follows from assumption 2&3.
6)
Constant retention: The retention ratio (fraction of earnings
that the firms plough back) once decided is never changed i.e. it is constant
through the life of the firm. From this we can further derive that the growth
rate is constant forever.
7)
No taxes : Corporate taxes do not exist.
8)
Perpetual earnings: The firm and its stream of earnings are
perpetual.
9)
Cost of capital is greater that the growth rate:
The dividend per share is expected to grow as result of retained earnings.
Q – State the Practical Consideration in Dividend Policy.
Ans.
PRACTICAL CONSIDERATIONS IN DIVIDEND POLICY
The conclusion that dividends are irrelevant is based
on certain set of the simplistic assumptions; but when these assumptions are
relaxed to incorporate the realities we come across a situation where the
dividend policy of a firm does have a relevance and do have an impact on all
the stake holders. In practice all companies do follow some kind of dividend
policy. In India most of the companies retain up to one third to one half of
their income and distribute the rest as dividends. In India companies specify
dividends in term of dividend rate which is a percentage of the paid up capital
per share. Example: Suppose a company XYZ had issued shares of Rs. 10 face
value at a premium of Rs. 150. All the shares are full paid up. Next year
company announces a dividend of 100%. What is the amount of dividend will it be
Rs. 160 or 10. Since the dividend rate is percentage of the paid up capital per
share and in this case the paid up capital is Rs. 10 therefore the amount of
dividend would be Rs. 10.
The firm while designing its dividend policy, keep in
consideration the following factors.
1)
Firms financial needs in context of its
growth plan and investment opportunities.
2) The
composition of shareholders and their expectations regarding dividends.
3) Firms
business and Financial risks.
4) Legal
and Financial constraints in paying dividends.
5) Control
considerations viz. is the firm a target of takeover or acquisition.
6) Firms
dividend policy;
7) Form
of dividend whether in the form of cash dividend, bonus shares or shares
buyback.
Q – Explain “ Dividends as a residual Payment.
Ans.
DIVIDENDS AS A RESIDUAL PAYMENT
Dividend decisions are not taken in isolation; they are
depended on many variables which may be internal or external to the firms.
While deciding on dividend decision the firm shall look and analyze the
following consideration.
1) Value creation potential of the firms is contingent
on investment decisions which in turn is dependent to some extent on dividend
decisions
2) External finance is difficult to raise and is
generally more expensive than the internal finance (retained earnings) because
of issue cost, compliance cost and under pricing.
3) Raising funds through additional equity finance will
reduce the proportionate holding of promoters leading to loss of control of
promoters on the firm.
4) Beyond a certain point the firm may find it
difficult to raise finance through debt issuance. A higher amount of debt in
the capital structure would raise the cost of capital and any incremental debt
financing would entail higher cost.
5) The dividend decision is an important communication
tool through which management conveys the future prospect of the firm not only
to the shareholders but also to other stakeholders.
Q – What are the forms of dividend ? Explain.
Ans.
Firm’s
usually pay dividend in cash, but under certain circumstances they may opt to
pay dividends in some other way in the form of bonus shares, share repurchase,
and dividend reinvestment plans (DRIPS). In this section we are also going to
discuss about stock split which is not exactly a form of dividend but has a
similar effect to that of issue of bonus shares. Now let us briefly discuss
each of these forms.
Cash
Dividend: Firms pay dividend in cash as paying dividend in kind
or others form is expressing prohibited under law. A Firm should have enough
liquidity when dividend is declared. In case of absence of liquidity firm
should borrow funds to meet its commitment of paying dividend after they are
declared. In case of stable dividend policy pursued by firms, it is easy to
make precise provisions for payment of dividend in the cash budget. The same is
relatively difficult to make when firm pursues erratic or unstable dividend
policy.
When cash dividend is paid the cash account and the
reserved account will reduce. The total assets and the net worth of the firm
are reduced when cash dividend is paid. Post payment of dividend or when the
share becomes ex dividend the price of the share drop by the amount of the cash
dividend distributed.
Bonus
Shares : An issue of bonus share implies distribution of
shares free of cost to existing shareholders in proportion of their existing
holdings.
Suppose a firm started with Rs. 1000 cr. Capital in the
form of 100cr. Equity shares each priced at Rs. 10 at par. During the course of
operations for next several years the firm has enjoyed a healthy growth in
sales and profits. A small part of the profit was distributed as dividend and
rest of the profits were ploughed back in the firms operation. As a result of
this the earnings per share and the share price has increased. Now these shares
have very high EPS and DPS. When a normal P/E ratio is applied for valuation it
results in valuation where share prices are so high that very few investors are
able to buy a round of the 100 shares. This situation results into limited
demand for these shares there by keeping the firms market value below what it
would have been if more shares with lower price would have been outstanding. To
correct this situation management has two options viz. issue of bonus shares or
to go for stock split. Now let us analyze the impact of each of these actions.
Dividend
Reinvestment Plans (DRIPs) : Dividend Reinvestment Plans are
schemes that enable shareholders to automatically reinvest the dividend
received back into the shares of the firm paying dividends.
This kind of plan is not operational in India, but is
quite popular in America and Europe. This plan gained popularity in the early
70’s. Even today many multinational corporations offer these plans but the
participation varies from company to company. There are basically two types of
DRIPs.
1) Plans that involve already issued outstanding shares
(old shares)
2) Plans that involve issuing new shares
Buyback
of Shares : Buyback of shares is the repurchase of a
part of the outstanding shares of the company by the company itself. Till 1999
Indian companies were prohibited from buying their own shares but with amendments
in the companies act the companies can now repurchase their own shares subject
to the following conditions:
1)
Company opting for buyback of shares will
not issue fresh capital for next 12 months except for issuance of bonus shares.
2)
Prior approval of the shareholders shall be
obtained and the funds to be used for buyback shall be explicitly stated.
3)
Buyback can only be done by utilizing free
reserves viz. reserves not earmarked for any other purpose.
4)
Companies are prohibited from using debt
funds/borrowings to effect buyback.
5)
The shares bought through buyback are to be
extinguished and can’t be reissued.
Q – State the Factors of Affecting Working Capital.
Ans.
FACTORS AFFECTING WORKING CAPITAL
The level of working capital required for smooth business
operations depends upon multiple factors; some of them are listed below:
1) Nature of Business
The requirement of working capital depends on the
nature of business. In the case of manufacturing businesses it takes more time
in converting raw material into finished goods. Therefore, capital remains
invested for a long time in raw material, semi-finished goods and the stock of
the finished goods. Thus, more working capital is required. On the contrary, in
case of trading business the goods are sold immediately after purchasing or
sometimes the sale is effected even before the purchase itself. Therefore, very
little working capital is required.
2.
Competition
High level of competition increases the need for more
working capital. In order to face competition, more stock is required for quick
delivery and credit facility for a long period has to be offered. If the level
of competition is low or the business is a monopoly, the requirement of working
capital will be less as the business controls the terms of services.
3.
Scale of Operation
There is a direct link between the working capital and
the scale of operations. In other words, more working capital is required in
case of big organisations while less working capital is needed in case of small
organisations.
4.
The Status of the Economy
The conditions of the market, global economy, political
status, environmental conditions and the status of the domestic economy affect
working capital. These factors, however, affect large scale businesses more
often than small scale businesses.
5.
Supply of Raw Materials
If there is ready supply of raw materials in the firm,
the amount of working capital will be lesser than if there is shortage of raw
materials in the firm. Unsteady supply of raw materials also threatens the
financial status and the overall status of a business. If the firm uses rare
raw materials like mineral ores or imported raw materials, the requirement of
working capital will be higher. It is because the firm will have to procure
such raw materials well in advance to avoid any bottlenecks in the production
process.
6.
Operating Efficiency
Businesses with high degree of operating efficiency
require less working capital as compared to those with low degree of operating
efficiency. Businesses with high operating efficiency have lower wastage and
they also incur lesser expenses.
7.
Inflation
Inflation refers to a sustained rise in prices of
goods. In such a situation, more working capital is required in order to
maintain the previous scale of production and sales. Therefore, with the
increasing rate of inflation, there is a corresponding increase in the working
capital.
8.
Availability of Credit from Suppliers
If the suppliers extend liberal credit policy terms to
the company, less working capital will be required to run the business. If the
terms are unfavorable, that is, credit is not easily available, then larger
amount of working capital will be required to run the business.
9.
Production Policy of the Firm
Production policy can either be seasonal or uniform. If
the production cycle is shorter less working capital is required to manage the
firm. On the other hand, if the production cycle is longer, larger amount of
working capital is required to carry out daily business activities especially
during the peak season.
10.
Growth and Expansion of a Business
Rapidly growing firms need additional funds to
continuously cope up with the changes in the business environment, implying
larger working capital requirements. On the other hand businesses that
experience slow growth have lower working capital requirements.
Q – State the importance of Adequate Working Capital.
Ans.
IMPORTANCE OF ADEQUATE WORKING CAPITAL
For a business to prosper, it is important to maintain a
satisfactory amount of working capital. Working capital is important for the
following reasons:
1)
Business Goodwill
Adequate working capital helps in creating and
maintaining business goodwill as it facilitates prompt payments for suppliers‘
goods. Timely payment of raw materials, salary and other overheads helps to
maintain the goodwill of the company.
2)
Regular Supply of Raw Materials
When businesses settle their debts on time, suppliers
ensure regular supply of raw materials which in turn increases productivity in
a firm. Firms with adequate working capital, therefore, enjoy steady supply of
raw materials from their suppliers.
3)
Smooth Business Operations
Adequate working capital enables smooth running of
business operations as it helps in meeting day to day business requirements
without the firm experiencing shortage of funds.
4)
Strengthening the Solvency
Adequate working capital in business helps in
maintaining the solvency of the business by providing adequate flow of cash,
which in turns helps in paying the debts on time and thus helps in maintaining
and strengthening solvency of business.
5)
Helps to Face
Contingencies Adequate working capital enables
businesses to face business crisis. A crisis occurs in a business when an
unexpected situation puts the stability of the business at risk. Business
crises that can be experienced by firms include financial crisis, technological
crisis, personnel crisis, natural crisis and organisational crisis.
6)
Taking Advantage of Opportunities
Favorable market conditions make it easier for
businesses to purchase raw materials in bulk when the prices are lower, borrow
money from banks at low interest rates and hold their current stock for future
sales at higher prices. Firms with adequate working capital are able to take
advantage of such opportunities.
7)
Cash Discounts
Adequate working capital helps firms to make payments
on time. This in turn enables firms to access cash discounts on purchases
thereby reducing their operational cost.
8)
Steady and Timely Dividends
Sufficient working capital enables firms to make
regular and timely dividends to their investors. This enhances the confidence
of investors in the enterprise.
Q – State the Comparison between Long-term & short-term
financing
Ans.
LONG TERM FINANCING VS. SHORT TERM FINANCING: RISK RETURN TRADEOFF
While deciding the sources of acquiring funds, the firm
faces a trade-off between risk and return - whether to use long-term sources or
short-term sources. Generally, as maturity of a debt increases, the rate of
interest also increases. This implies that a firm which uses long term sources
incurs more financing cost than a firm resorting to short term sources. Risk
and return increase with an increase in short term sources. Therefore, an
adequate balance needs to be maintained between risk and return while selecting
a source of finance.
In considering liquidity (risk) and profitability
(return) two important points are to be considered : (a) costs and (b) risks.
In aggressive policy, the investment in current assets is low. That will
involve shortage of cash form of fall in production and sales and loss of
customer‘s goodwill. In conservative approach the investment in current assets
in higher. That involves carrying costs in the form of financing a higher level
of current assets like granting liberal credit to customers. The second element
risk increases if there is lower level of liquidity. The firm may become
technically insolvent by not paying current liabilities as they occur. So there
should be a trade off between profitability and liquidity.
Q – State the functions of cash management.
Ans.
FUNCTIONS OF CASH MANAGEMENT
a)
Estimation of Required Capital: Finance Managers work to
ensure the right calculation of the required capital depending on the costs
they plan to incur, the expected profits and the future policies and programs
of the firm.
b)
Allocation of Funds: It is the job of the cash manager to decide
how funds are to be allocated, to whom they are to be allocated and for what
purposes.
c)
Control over Business Funds: Cash management has full
control over cash available in the organisation. It plans on how funds are
utilized on organisational projects.
d)
Handling Unexpected Costs: Cash management handles costs that
may arise as a result of unexpected situations, for instance-breakdown of
machinery.
e)
Initiates Investments: Cash management ensures that extra
funds in the business are invested in the best market opportunities.
Q – State the methods of preparing the cash budget
Ans.
METHODS OF PREPARING THE CASH BUDGET
A cash budget can be prepared in the following ways:
a)
Receipts and Payments Method: This method is the most
popular and is universally used for preparation of the cash budget. This method
considers all the expected receipts and payments for the budget period. All the
cash inflow and outflow of all functional budgets including capital expenditure
budgets are considered. Accruals and adjustments in accounts will not affect
the cash flow budget. Anticipated cash inflow is added to the opening balance
of cash and all cash payments are deducted from this to arrive at the closing
balance of cash.
b)
Adjusted Net Income Method (Adjust Profit and Loss Method):
In this method the annual cash flows are calculated by adjusting the sales
revenue and cost figures for delays in receipts and payments (change in debtors
and creditors) and eliminating non-cash items such as depreciation.
c)
Balance Sheet Method: In this method, the budgeted balance
sheet is predicted by expressing each type of asset (except cash & bank)
and short-term liabilities as percentage of the expected sales. The profit is
also calculated as a percentage of sales, so that the increase in owner’s
equity can be forecasted. Known adjustments, may be made to long-term
liabilities and the balance sheet will then show if additional finance is
needed (if budgeted assets exceed budgeted liabilities) or if there will be a
positive cash balance (if budgeted liabilities exceed budgeted assets).
CONCEPT
OF FACTORING AND FORFAITING
Factoring:
Factoring is a new concept in the area of financing of
accounts receivables which refers to outright sale of accounts receivables to a
factor or a financial agency. A factor is a firm that acquires the receivables
of other firm(s). The factoring lays down the conditions of the sale in a
factoring agreement. The factoring agency bears the risk of collection and
services the accounts for a fee.
Factoring
arrangement can be either on a recourse basis or on a non-recoursebasis:
·
Recourse: In case factor is unable to collect the amount from
receivables then, factor can turn back the same to the organization for
resolution (which generally is by replacing those receivables with new
receivables)
·
Non-Recourse: The factor bears the ultimate risk of loss
in case of default and hence in such cases they charge higher commission.
A large number of financial institutions like
commercial banks and other financial agencies are currently involved in
providing factoring services in India. The biggest advantages of factoring are
the immediate conversion of receivables into cash and predicted pattern of cash
flows. Financing receivables with the help of factoring can help a company
having liquidity without creating a net liability on its financial condition
and hence no impact on debt equity ratio. Besides, factoring is a flexible
financial tool providing timely funds, efficient record keepings and effective
management of the collection process. This is not considered as a loan. There
is no debt repayment and hence no compromise to balance sheet, no long-term
agreements or delays associated with other methods of raising capital.
Factoring allows the firm to use cash for the growth needs of business.
Forfaiting
“Forfait” is a French term meaning “relinquish a
right”. Forfaiting is an arrangement of bill discounting in which a financial
institution or bank buys the trade bills (invoices) or trade receivables from
exporters of goods or services, where the exporter relinquish his right to
receive payment from importer. Financial Institutions or banks provides
immediate finance to exporter „without recourse‟
basis in which risk and rewards related with the bills/ receivables transferred
to the financial institutions/ banks. It is a unique credit facility
arrangement where an overseas buyer (importer) can open a "letter of
credit" (or other negotiable instruments) in favour of the exporter and
can import goods and services on deferred payment terms.
Functions
of Forfaiting
The functionality can be understood in the following
manner:
i) Exporter sells goods or services to an overseas
buyer.
ii) The overseas buyers i.e. the importer on the basis
trade bills and import documents draws a letter of credit (or other negotiable
instruments) through its bank (known as importer‟s
bank).
iii) The exporter on receiving the letter of credit (or
other negotiable instruments) approaches to its bank (known as exporter‟s
bank).
iv) The exporter‟s
bank buys the letter of credit (or other negotiable instruments) „without
recourse basis‟ and provides the exporter the payment
for the bill.
Q – State the Factors Influencing Inventory Management.
Ans.
FACTORS INFLUENCING INVENTORY MANAGEMENT
a)
Economic Stability: Unstable economy results into high costs
of purchasing inventory. This situation can stress the management if it
persists for a long period of time.
b)
Availability of Working Capital: Adequate working capital
makes it easier to manage the inventory. Alternatively, inadequate working
capital might bring down the management efficiency as a result of less finance
to fund the cost of inventory.
c)
Suppliers: Suppliers can have influence on the control of
inventory. This is because suppliers impact production rates of a company. It
is important to find reliable suppliers to ensure steady supply of business
inventory and avoid shortages.
d)
Lead Time: Lead time describes the length of time a product takes
from the time it is ordered to the point of time it finally arrives. Lead time,
however, varies widely subject to the type of product and manufacturing
processes involved in producing the final product. Longer lead time affects
inventory management negatively since it makes controlling production rates
difficult.
e)
Type of Product: Inventory management must consider the
type of products in the inventory. For instance, some products are more
perishable than others so they may have different expiry dates. It is important
to ensure that these products are rotated in line with their expiration dates.
Q – State the benefits of Inventory Management.
Ans.
BENEFITS OF INVENTORY MANAGEMENT
a)
Level of Stock: Effective Management of inventory helps to
eliminate overstocking, shortages and stock obsolescence. Inventory management
aids the managers to find an equilibrium between carrying excessive and
insufficient inventory.
b)
Ease of Access: Tracking of inventory helps in identifying
items that are utilized most frequently. By organizing warehouse on the basis
of usage frequency, the time spent retrieving these items will be minimized and
is readily accessible.
c)
Improved Efficiency: Inventory management systems help in eliminating
many time consuming and error producing processes associated with manual
systems. Software systems can help make the entire inventory system more
efficient and reduce errors.
d)
Lower Costs: Effective and efficient inventory
management practices result in decreasing inventory write-offs and lowering
inventory holding costs. Carrying additional inventory is generally costly for
an organisation.
e)
Better Inventory Turnover: The longer an item is stored in the
warehouse, the greater the chances of its obsolescence. A managed system will
identify items that no longer need to be carried as well as additional items
that should be added to the inventory.
Q – Define JIT. State it’s advantages & Dis-advantages.
Ans.
Just-In-Time Inventory Management
Just-in-time (JIT) is a management strategy that aligns
raw-material orders from suppliers directly with production schedules in order
to be able to meet consumer demands with minimum delays. It was first developed
and applied in the Toyota manufacturing plants. In this method, labour,
material and goods (to be used in manufacturing) are re-filled or scheduled to
arrive exactly when needed in the manufacturing process. Thus, this inventory
strategy allows companies to increase efficiency (by reducing inventory costs
and increasing inventory turnover) and decrease wastage by receiving goods only
when they need them for the production process.
Advantages:
i)
It results in the elimination of
overproduction.
ii)
It helps in keeping the stock holding
costs to a minimum level.
iii)
Less working capital is required.
iv)
It results in less dead stock because
there’s less risk of unwanted stock left as the inventories are maintained on
basis of customer demand.
v)
It emphasizes the ‘right-first-time’
concept, so that rework costs and the cost of inspection is minimized.
Disadvantages:
i.
This approach states zero tolerance
for mistakes. As the inventory is kept at minimum levels, re-work in case of
any production error is difficult.
ii.
Successful application of JIT requires
high reliance on suppliers, whose performances are out of control of the
manufacturer.
iii.
There are chances of occurrence of
production line idling and downtime due to no buffers in JIT and that can have
unfavorable effect on the production process and finances.
iv.
In case of an unexpected increase in
demand, companies following JIT would not be able to fulfil the new orders as
there would be no excess inventory of finished goods.
v.
Transaction costs would be generally
high depending upon the frequency of transactions
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