FM/U2 Some Important Questions And Answer Of Financial Management
Question No. 1 What role does a finance manager play in a modern firm?
“FM is nothing but managerial decision making on asset mix, capital mix and profit allocation” Elucidate the statement.
Investment, financing and dividend decisions are all inter-related.Comment.
Finance Manager has to perform three main functions in a modern firm which are-
- Investment Decision: The investment decision relates to the selection of asset in which funds will be invested by a firm.
- The assets which can be acquired fall into two broad group:
- Long term assets: long term asset which yield a return over a period of time in future. it is popularly known in financial literature as capital budgeting.
- Short term or current assets: short term assets, defined as those assets which in the normal course of business are convertible into cash without diminution in value, usually within a year. It is popularly termed as working capital management.
- Investment decisions determine both the mix and the type of assets held by a firm. The mix refers to the amount of current assets and fixed assets. Consistent with the mix, the financial manager must determine and maintain certain optimal levels of each type of current assets.
- Finance manager should also decide the best fixed assets to acquire and when existing fixed assets need to be modified/replaced/liquidated. The success of a firm in achieving its goals depends on these decisions.
2. Financing decision:
- The second major decision involved in financial management is the financing decision. The investment decision is broadly concerned with the asset-mix or the composition of the assets of a firm.
- The concern of the financing decision is with the financing-mix or capital structure or leverage.
- The term capital structure refers to the proportion of debt (fixed-interest source of finance) and equity capital (variable-dividend securities/source of funds).
- A capital structure with a reasonable proportion of debt and equity capital is called the optimum capital structure.
- The financing decision covers two interrelated aspects:
- the capital structure theory
- the capital structure decision.
- Financing decision involve two major areas-
- The most appropriate mix of short term and long term financing.
- The best individual short term or long term sources of financing at a given point of time.
- Many of these decisions are dictated by necessasity, but some require an in-depth analysis or the available financing alternatives, their costs and their long term implications.
- Dividend policy decision: The dividend decision should be analysed in relation to the financing decision of a firm.
- Two alternatives are available in dealing with the profile of a firm:
- They can be distributed to the shareholders in the form of dividends.
- They can be retained in the business itself.
- Dividend decision is an important decision, which a financial manager has to take. it refers to that profits of a company which is distributed by company among its shareholders
- Dividend-payout ratio: what proportion of net profits should be paid out to the shareholders.
- The final decision will depend upon the preference of the shareholders and investment opportunities available within the firm
- There has been a difference of opinion on the effect of dividend policy on value of firm. Two school of thought have emerged on relationship between dividend policy and value of firm. On one hand walter’s model and Gordon’s model consider dividend as relevant for value of the firm as investors prefer current dividend over future dividend. On other hand MM model consider dividend as irrelevant for valuation of firm. The detention of profit for reinvestment is important. MM model have introduced arbitrage process to prove that value of firm remain same whether firm pays dividend or not.
Question No 2. ‘Profit Maximization is not an operationally feasible criterion for financial decision making’. Comment
“Wealth maximisation is only a decision criterion and not a goal” Explain.
“Wealth maximization is a better criterion than profit maximization”. Do you agree? Explain
Definition of Profit Maximization-:
Profit Maximisation is the capability of the firm in producing maximum output with the limited input, or it uses minimum input for producing stated output. It is termed as the foremost objective of the company.
It has been traditionally recommended that the apparent motive of any business organisation is to earn a profit, it is essential for the success, survival, and growth of the company. Profit is a long term objective, but it has a short-term perspective i.e. one financial year.
Profit can be calculated by deducting total cost from total revenue. Through profit maximization, a firm can be able to ascertain the input-output levels, which gives the highest amount of profit. Therefore, the finance officer of an organisation should take his decision in the direction of maximizing profit although it is not the only objective of the company.
Definition of Wealth Maximisation-:
Wealth Maximisation is the ability of a company to increase the market value of its common stock over time. The market value of the firm is based on many factors like their goodwill, sales, services, quality of products, etc.
It is the versatile goal of the company and highly recommended criterion for evaluating the performance of a business organisation. This will help the firm to increase their share in the market, attain leadership, and maintain consumer satisfaction and many other benefits are also there.
It has been universally accepted that the fundamental goal of the business enterprise is to increase the wealth of its shareholders, as they are the owners of the undertaking, and they buy the shares of the company with the expectation that it will give some return after a period. This states that the financial decisions of the firm should be taken in such a manner that will increase the Net Present Worth of the company’s profit.
Key Differences between Profit Maximization and Wealth Maximization-:
- The process through which the company is capable of increasing earning capacity known as Profit Maximization. On the other hand, the ability of the company in increasing the value of its stock in the market is known as wealth maximization.
- Profit maximization is a short term objective of the firm while the long-term objective is Wealth Maximization.
- Profit Maximization ignores risk and uncertainty. Unlike Wealth Maximization, which considers both.
- Profit Maximization avoids time value of money, but Wealth Maximization recognises it.
- Profit Maximization is necessary for the survival and growth of the enterprise. Conversely, Wealth Maximization accelerates the growth rate of the enterprise and aims at attaining the maximum market share of the economy.
From the above points, we can conclude that wealth maximisation is superior to profit maximisation as it ignores the risk factor and time value of money in the business.
Moreover, Profit Maximisation is not helpful for the business in the long run as compared to wealth maximisation.
Question No. 3: Discuss the five technique of capital budgeting?
Capital budgeting (or investment appraisal) is the process of determining the viability to long-term investments on purchase or replacement of property plant and equipment, new product line or other projects.
CAPITAL BUDGETING TECHNIQUES / METHODS
There are different methods adopted for capital budgeting.
The traditional methods or non discount methods include: Payback period and Accounting rate of return method.
The discounted cash flow method includes the NPV method, profitability index method and IRR.
Accounting rate of return method (ARR):
It works on the criteria that any project having ARR higher than the minimum rate established by the management will be considered and those below the predetermined rate are rejected.
This method takes into account the entire economic life of a project providing a better means of comparison. It also ensures compensation of expected profitability of projects through the concept of net earnings. However, this method ignores time value of money and doesn’t consider the length of life of the projects. Also it is not consistent with the firm’s objective of maximizing the market value of shares.
ARR= Average income/Average Investment
Payback period method:
As the name suggests, this method refers to the period in which the proposal will generate cash to recover the initial investment made. It purely emphasizes on the cash inflows, economic life of the project and the investment made in the project, with no consideration to time value of money. Through this method selection of a proposal is based on the earning capacity of the project. With simple calculations, selection or rejection of the project can be done, with results that will help gauge the risks involved. However, as the method is based on thumb rule, it does not consider the importance of time value of money and so the relevant dimensions of profitability.
Payback period = Cash outlay (investment) / Annual cash inflow
Discounted cash flow method:
The discounted cash flow technique calculates the cash inflow and outflow through the life of an asset. These are then discounted through a discounting factor. The discounted cash inflows and outflows are then compared. This technique takes into account the interest factor and the return after the payback period.
Net present Value (NPV) Method:
This is one of the widely used methods for evaluating capital investment proposals. In this technique the cash inflow that is expected at different periods of time is discounted at a particular rate. The present values of the cash inflow are compared to the original investment. If the difference between them is positive (+) then it is accepted or otherwise rejected. This method considers the time value of money and is consistent with the objective of maximizing profits for the owners. However, understanding the concept of cost of capital is not an easy task.
The equation for the net present value, assuming that all cash outflows are made in the initial year (tg), will be:
Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost of the investment proposal and n is the expected life of the proposal. It should be noted that the cost of capital, K, is assumed to be known, otherwise the net present, value cannot be known.
NPV = PVCI – PVOF
PVCI = Present value of cash inflows
PVCO = Present value of cash outflows
Internal Rate of Return (IRR):
This is defined as the rate at which the net present value of the investment is zero. The discounted cash inflow is equal to the discounted cash outflow. This method also considers time value of money. It tries to arrive to a rate of interest at which funds invested in the project could be repaid out of the cash inflows. However, computation of IRR is a tedious task.
It is called internal rate because it depends solely on the outlay and proceeds associated with the project and not any rate determined outside the investment.
It can be determined by solving the following equation:
If IRR > WACC then the project is profitable.
If IRR > k = accept
If IR < k = reject
Profitability Index (PI):
It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment. It may be gross or net, net being simply gross minus one. The formula to calculate profitability index (PI) or benefit cost (BC) ratio is as follows.
PI = PV cash inflows/Initial cash outlay A,
PI = PVCI /PVCO
All projects with PI > 1.0 is accepted.
IMPORTANCE OF CAPITAL BUDGETING
1) Long term investments involve risks: Capital expenditures are long term investments which involve more financial risks. That is why proper planning through capital budgeting is needed.
2) Huge investments and irreversible ones: As the investments are huge but the funds are limited, proper planning through capital expenditure is a pre-requisite. Also, the capital investment decisions are irreversible in nature, i.e. once a permanent asset is purchased its disposal shall incur losses.
3) Long run in the business: Capital budgeting reduces the costs as well as brings changes in the profitability of the company. It helps avoid over or under investments. Proper planning and analysis of the projects helps in the long run.
SIGNIFICANCE OF CAPITAL BUDGETING
Capital budgeting is an essential tool in financial management
Capital budgeting provides a wide scope for financial managers to evaluate different projects in terms of their viability to be taken up for investments
It helps in exposing the risk and uncertainty of different projects
It helps in keeping a check on over or under investments
The management is provided with an effective control on cost of capital expenditure projects
Ultimately the fate of a business is decided on how optimally the available resources are used
Question No. 4 : Discuss cost of capital and its various components?
The term cost of capital refers to the minimum rate of return a firm must earn on its investment so that the market value of company’s equity shares does not fall. This is a consonance with the overall firm’s objective of wealth maximization. This is possible only when the firm earns a return on the projects financed by equity shareholders funds at a rate which is at least equal to the rate of return expected by them. If a firm fails to earn return at the expected rate, the market value of the shares would fall and thus result in reduction of overall wealth of the shareholders.
Thus, a firm’s cost of capital may be defined as “the rate of return the firm requires from investment in order to increase the value of the firm in the market place”.
The three components of cost of capital are:
- Cost of Debt
Debt may be issued at par, at premium or discount. It may be perpetual or redeemable. The technique of computation of cost in each case has been explained later.
The computation of cost of debt is an easy task. It is the explicit interest rate adjusted further for the tax liability of the company.
- Cost of Preference Capital
The computation of the cost of preference capital however poses some conceptual problems. In case of borrowings, there is legal obligation on the firm to pay interest at fixed rates while in case of preference shares, there is no such legal obligation. Hence, some people argue that dividends payable on preference share capital do not constitute cost. However, this is not true. This is because, though it is not legally binding on the company to pay dividends on preference shares, it is generally paid whenever the company makes sufficient profits. The failure to pay dividend may be better of serious concern from the point of view of equity shareholders. They may even lose control of the company because of the preference shareholders getting the legal right to participate in the general meetings of the company with equity shareholders under certain conditions in the event of failure of the company to pay them their dividend.
3. Cost of Equity Capital
The computation of the cost of equity capital is a difficult task. Some people argue, as observed in case of preference shares, that the equity capital does not involve any cost. The argument put forward by them is that it is not legally binding on the company to pay dividends to the equity shareholders. This does not seem to be a correct approach because the equity shareholders invest money in shares with the expectation of getting dividend from the company. The company also does not issue equity shares without having any intention to pay them dividends. The market price of the equity shares, therefore, depends upon the return expected by the shareholders.
Conceptually cost of equity share capital may be defined as the minimum rate of return that a firm must earn on the equity financed portion of an investment in a project in order to leave unchanged the market price of such shares.
In order to determine the cost of equity capital, it may be divided into new equity and existing equity. The following are some of the appropriate according to which the cost of equity capital can be worked out:
(a) Dividend price (D/P) approach
The cost of equity capital will be that rate of expected dividends which will maintain the present market price of equity shares.
This approach rightly emphasizes the importance of dividends, but it ignores the fact that the retained earnings have also an impact on the market price of the equity shares. The approach therefore does not seem to be very logical.
Ke = D/MP
- Ke= Cost of equity capital;
- D= Dividend per equity share;
- MP = Market price of an equity share.
(b) Dividend price plus growth (D/P + g) approach
According to this approach, the cost of equity capital is determined on the basis on the expected dividend rate plus the rate of growth in dividend. The rate of growth in dividend is determined on the basis of the amount of dividends paid by the company for the last few years. The computation of cost of capital according to this approach can be done by using the following formula:
Ke = (D/NP) + g
- Ke = Cost of equity capital;
- D= Expected dividend per share;
- NP = Net proceeds of per share;
- g= Growth in expected dividend.
Question No 5. Discuss capital structure theories.
Capital structure is the proportion of debt, preference shares and equity shares on a firm’s balance sheet. In theory, capital structure can affect the value of a company by affecting either its expected earnings or the cost of capital , or both. While it is true that financing mix cannot affect the total operating earnings of a firm.
- Net Income Approach
- Net Operating Income Approach
- Modigliani-Miller Approach
- Traditional Approach
NET INCOME APPROACH
This approach was suggested by Durand. According to the Net Income Approach, the capital structure decision is relevant to the valuation of the firm. In other words, a change in the financial leverage will lead to a corresponding change in the overall cost of capital as well as the total value of the firm. If therefore the degree of financial leverage as measured by the ratio of debt to equity is increased, the weighted average cost of capital will decline, while the value of the firm as well as the market price of ordinary shares will increase.
The NI Approach is based on three assumptions:
- There are no taxes
- The cost of debt is less than the equity capitalization rate
- The use of debt does not change the risk perception of investors.
Value of the firm (as per Net Income Approach)
Earnings available for equity share holders ****
Equity capitalization rate (ke) ****
Market value of equity(S) ****
Market value of Debt (B) ****
Total value of the firm(V), (S+B=V) ****
Overall cost of capital(KO),KO=EBIT/V ****
NET OPERATING INCOME (NOI) APPROACH
This approach was also propunded by Durand, it says that capital structure is not relevant with regard to valuation of the firm. This approach is opposite to the NI Approach. The essence of this approach is that the capital structure decision of a firm is irrelevant. Any change in leverage in leverage will not lead to any change in the total value of the firm and the market price of shares as well as the overall cost of capital is independent of the degree of leverage.
With the cost of debt and the cost of capital constant, we can say that the cost of equity capital changes.
Value of the firm (as per Net Operating Income Approach)
Operating Income (EBIT)
Overall Capitalization rate(KO)
Total value of firm(V),V=EBIT/KO
Market value of debt(B)
Market value of equity(S),(S=V-B)
Equity Capitalization rate(Ke)
MODIGILANI AND MILLER APPROACH
It is similar to NOI Approach, according to this the value of the firm is independent of its capital structure.
The basic difference between NOI and MM Approach is that NOI is purely definitional whereas MM Approach provides behavioural justification for the independence of valuation and cost of capital of the firm from its capital structure.
Assumptions of MM Approach
- Capital markets are perfect; investors are free to buy and sell well informed.
- Homogenous firm shall have same degree of business risk.
- Dividend payout ratio is 100%.
- The Net Income Approach as well as Net Operating Income Approach represents two extremes as regards the theoretical relationship between financing decisions as determined by the capital structure, the weighted average cost of capital and total value of the firm.
- Therefore, traditional approach is mid way of two approaches.
- It agrees with NI approach to the extent that capital structure affects the overall cost of capital and value of the firm but does not agree that the value of the firm will increase with all degree of leverages.
Question No. 6. Discuss the different approaches of financing of working capital requirements.
Answer – Working capital is a measure of the company’s efficiency and short term financial health. It refers to that part of the company’s capital, which is required for financing short-term or current assets such a cash marketable securities, debtors and inventories. It is a company’s surplus of current assets over current liabilities, which measures the extent to which it can finance any increase in turnover from other fund sources. Funds thus, invested in current assets keep revolving and are constantly converted into cash and this cash flow is again used in exchange for other current assets.
Formula for Working Capital: “Current Assets – Current Liabilities”
Working capital Approaches:
- Hedging or Matching Approach
- Conservative Approach
- Aggressive Approach
This approach matches assets and liabilities to maturities. Basically, a company uses long term sources to finance fixed assets and permanent current assets and short term financing to finance temporary current assets
It is conservative because the company prefers to have more cash on hand. That is why, fixed and part of current assets are financed by long-term or permanent funds. As permanent or long-term sources are more expensive, this leads to “lower risk lower return”.
Under this approach long term sources are used to finance fixed assets requirement and permanent working capital requirement. Fluctuating working capital is financed from short term sources.
Question No. 7. Explain the factors affecting investment in working capital.
Following are the factors:-
1.Nature of business-The working capital requirement is closely related to the nature of the business of the firm. In case of the retail shop or a trading firm, the amount of working capital is required is small enough as most of the transactions are undertaken in cash. In case of financial concerns there may not be stock of goods but these firms do have to maintain sufficient liquidity all the times. In case of manufacturing concerns, different types of production processes are performed, therefore there is substantial requirement of working capital.
2. Price level changes:-Changes in price level also effect the requirement of working capital. Rising prices necessitate the use of more funds for maintaining an existing level of activity. The implications of changing price levels on working capital position vary from company to company depending on the nature of its operations, its standing in the market and other relevant considerations.
3.Operating efficiency:- the management can contribute to a sound working capital position through operating efficiency. Although the management cannot control the rise in prices, it can ensure the efficient utilization of resources and so on. Efficiency of operations accelerates the pace of cash cycle and improves the working capital turnover. It releases the pressure on working capital by improving the internal generation of funds.
4.Level of taxes:-the amount of taxes to be paid is determined by the prevailing tax regulation. The management has no discretion in this respect. An adequate provision for taxes payments is therefore, an important aspect of working capital planning. If tax liability increases, it leads to an increase in the requirement of working capital and vice –versa. However tax liability can be reduced through proper tax planning, incentives, concessions etc.
5. Growth and Expansion:- As a company grows, it is logical to expect that a larger amount of working capital is required. Its therefore difficult to determine precisely the relationship between the growth in the volume of business of a company and the increase in its working capital. The composition of working capital in a growing company also shifts with economic circumstances and corporate practices. Other thing being equal, growth industries require more working capital than those that are static.
6. Seasonal operations:- if a firm is operating in goods and services having seasonal fluctuations in demand ,then the working capital requirement will also fluctuate with every change . In a cold drink factory, the demand will certainly be higher during summer season and therefore, more capital is required to maintain higher production in the form of larger inventories and bigger receivables. On the other hand, if the operations are smooth and even throughout the year then the working capital retirement will be constant and will not be affected by the seasonal factors.
Question No. 8: Discuss Cash Flow Statement.
Answer : In financial accounting, a cash flow statement, also known as statement of cash flows, is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and break the analysis down to operating, investing and financing activities.
Cash flow statement is a statement which indicates sources of cash inflows and transactions of cash outflows of a firm during an accounting period. The activities/transactions which generate cash inflows are known as sources of cash and activities which cause cash outflows are known as uses of cash.
Objectives of cash flow statement
- Measurement of cash
- Generating inflow of cash
- Prediction of future
- Assessing liquidity and solvency position
- Supply necessary information to the users
Cash Flow Statement is prepared according to Accounting Standard-3(Revised). It requires cash flow should be classified and shown in the cash flow under the following three activities
- Operating activities
- Investing activities
- Financing activities
Operating Activities are the principal revenue-producing activities of the enterprise. It indicates the amount of money a company brings in from ongoing, regular business activities. Operating activities are directly related to production and sale of the firm’s products/services.
The examples are:
*Cash receipts from the sale of goods and rendering of services.
*Cash receipts from royalties, fees, commission and other revenue.
*Cash payments to suppliers of goods and services
Investing activities are the acquisition and disposal of long term assets and other investments not included in cash equivalents. These activities include transactions involving the purchase and sale of long term assets like machinery, land and building, long term investments, etc.
The examples are: *Payments for purchase of fixed assets.
*Receipts from disposal of fixed assets.
*Payments for purchase of shares, warrants or debt instruments of other enterprises.
Financing activities are the activities which result in change in the size and composition of the owner’s capital and borrowings of the enterprise from other sources. Thus, increase in share capital, redemption of preference shares, increase in borrowing and repayment of loan etc.
The examples are:
*Proceeds from issue of shares or other similar instruments.
*Proceeds from issue of debentures, loan notes, bonds and other short term borrowings.
*Repayments of the amounts borrowed including redemption of debentures.
Importance of cash flow statement
- Helps to make cash forecast
- Helps in understanding liquidity and solvency
- Efficient cash management
- Helps to the internal management
- Reveals the cash position
Limitations of cash flow statement
- Non-cash transactions are ignored
- Not a substitute for income statement
- Historical in nature
- It ignores basic accounting concept.