fm mba study material

7/31/2019 FM MBA Study Material

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The ultimate objective of a business concern is to fulfill the desires of equity

shareholder such asa. high percentage of dividendb. maximum returns to shareholders in the form of capital gain.

This decision is also influenced by the amount of retained earnings and dividend

Payout ratio.

Section C

Explain Objectives / Goals of Financial Management

Financial management deals with procurement and use of funds. Its main purpose is to utilize

business funds in such a way that the firms value/earnings are maximized. The objectives offinancial management are broadly classified as below :

1. Profit Maximization2. Wealth Maximization

1. Profit maximizationProfit earning is the main aim of every economic activity. No business can survive

with earning profit. profit is a measure of efficiency of a business enterprise. Profits

also serve as a protection against risks which can not be ensured. The ale

accumulation profits enable a business to face risks like fall in prices, competition

from other units, adverse government policies etc. Thus profit maximization is

considered as the main objective of business.

Merits of profit maximization

1. Best criterion of Decision MakingThe goal of profit maximization is regarded as the best criterion of the decision

making as it provides a yard stick to judge the economic performance of the

enterprise.

2. Efficient allocation of resourcesIt leads to efficient allocation of scarce resources as they tend to be diverted to

those uses which, in terms of profitability, are the most desirable.

3. Optimum utilizationOptimum utilization of available resources is possible.

4. Maximum social welfareIt ensures maximum social welfare in the form of maximum dividend to

shareholders, timely payments to creditors, higher wages, better quality and lower


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prices, more employment opportunities to the society and maximization of capital

to the owners.

Drawbacks of profit maximization.

1. Time factor ignoredThe term profit does not speak anything about the period of profit whether

it is short term profit or long term profit.

2. It is vagueThe term profit is very vague. It is not clear in what exact sense the term

profit is used. Whether it is accounting profit or economic profit or profit

after tax or profit before tax.

3. It ignores time valueThe profit maximization objective fails to provide any idea regarding the

timing of expected cash earnings. It ignores the fact that the rupee earnedtoday is more valuable than a rupee earned later.

4. It ignores the risk factorAccording to economists, profit is a reward for risk and uncertainty bearing.

It is also a dynamic surplus or profit is a reward for innovation. But when can

the organization maximize profits ? profit maximization objective does not

make this clear.

2. Wealth MaximizationWealth maximization is the appropriate objective of an enterprise. Wealth maximizationis also called value-maximization. In simple wealth maximization means maximizing the present

value of a course of action that is Net Present Value (NPV) which means GPV (Gross Present

Value)Investment.

Any financial action results in positive NPV, creates and adds to the existing wealth of theorganization and the course of action which has a negative NPV reduces the existing wealth and

hence be given up.

Maximum utility refers to Maximum shareholders wealth which refers to Maximum currentstock price per share.

Implications of Wealth Maximization

1. It serves the interests of suppliers of loan capital, employees, management and society.Short term lenders are primarily interested in liquidity position so that they get their

payments in time. The long term lenders get a fixed rate of interest from the earnings

and also have a priority over shareholders in return of their funds. Wealth objective

maximization objective not only serves shareholders interests by increasing the value of

holdings but ensures security to lenders also.


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2. The survival of management for a longer period will be served if the interests of variousgroups are served properly. Management is the elected body of shareholders. The

shareholders may not like to change a management if it is able to increase the value of

their holdings. The efficient allocation of productive resources will be essential for

raising the wealth of the company.

Criticism of Wealth Maximization

1. The objective of wealth maximization is not necessarily socially desirable.2. The objective of wealth maximization may also face difficulties when ownership and

management are separated. When managers act as agents of real owners (equity

shareholders) there is a possibility for conflict of interest between shareholders and the

managerial interests.

3. There is controversy as to whether the objective is to maximize the stockholders wealthor the wealth of the firm which includes other financial claimholders such as debenture

holders, preference shareholders etc.

Explain Scope and Significance of Financial Management

Scope of Financial Management

The main objective of financial management is to arrange sufficient finances for meeting short

term and long term needs. Financial management covers the following areas :

1. Estimating financial requirementsThe first task of a financial manager is to estimate short term and long term financialrequirements of his business. For this purpose he will prepare a financial plan for present

as well as for future. The amount needed for purchasing fixed assets and funds for

working capital will have to be ascertained.

2. Deciding Capital StructureThe capital structure refers to the kind and proportion of different securities for raising

funds. After deciding about the quantum of funds required it should be decided which

type of securities should be raised. It may be wise to finance fixed assets through long

term debts. A decision about various sources for funds should be linked to the cost of

raising funds. If the cost of raising funds is very high then such sources may not be useful

for long.

3. Selecting a source of financeAfter deciding capital structure an appropriate source finance is selected. Various sources

from which finance may be raised include : Share capital, debentures, financial


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institutions, commercial banks, public deposits etc. If funds are required for short period

banks, public deposits and financial institutions may be appropriate. On other

hand if long term funds are required share capital and debentures may be useful.

4. Selecting a pattern of investmentWhen funds have been procured a decision about investment pattern is to be taken. The

selection of an investment pattern is related to the use of funds. A decision will have to

be taken as to which assets are to be purchased ? Even in various categories of assets a

decision the about the type of fixed or other assets will be essential. The decision

making techniques such as capital budgeting, opportunity cost etc may be applied in

making decisions about capital expenditures.

5. Proper cash managementCash management is also an important task of finance manager. He has to assess various

cash needs at different times and then make arrangements for arranging cash. The cash

management should be such that neither there is a shortage of it and nor it is idle. Any

shortage of cash will damage the creditworthiness of the enterprise. The idle cash withthe business will mean that it is not properly used.

6. Implementing financial controlsAn efficient system of financial management necessitates the use of various control

devices. Financial controls include ROI(Return on Investment), Budgetary Control, Break

Even Analysis, Ratio Analysis and Cost and Internal Audit. The use of various control techniques

helps to evaluate the performance in various areas.

7. Proper use of surplusesThe utilization of profits or surpluses is also an important factor in financial management.

A judicious use of surpluses is essential for expansion and diversification plans and also

in protecting the interests of shareholders.

Significance or importance of Financial Management

Financial management is indeed the key to successful business operations. Without properadministration and effective use of funds no business enterprise can utilize its potentials for

growth and expansion.

1. Successful promotionSuccessful promotion of a business concern depends upon efficient financial

management. If the plan adopted fails to provide adequate capital to meet the

requirements of fixed and working capital the firm can not carry on its business

successfully.

2. Smooth runningSince funds is required at each stage of the business such as promotion, development,

expansion and management of day to day expenses, proper financial administration

becomes necessary for smooth running of a business enterprise.

3. Decision making


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Financial management provides scientific analysis of all facts and figures through various

financial tools such as ration analysis, variance analysis, budgets etc. Such an analysis

helps the management to evaluate the profitability of the plan.

4. Solutions to financial problemsThe efficient financial management helps the top management by providing solutions to

the various financial problems faced by it.

5. Measure of performanceFinancial management is considered as a yard stick to measure the performance of the

firm.

CHAPTER II

Cost of Capital

Section A

What is Opportunity Cost ?Opportunity Cost or Implicit cost refers to the cost of investment which a company

avails due to investment in some other opportunities.

The cost of retained earnings is an opportunity cost, for a shareholder is deprived of

the opportunity to invest retained earnings elsewhere.

What is explicit cost ?

Explicit cost the discount rate which equates the present value of cash inflows withthe present value of cash outflows. It is the internal rate of return on cash flows.

What do you mean by Time value of Money?Time value of money means that the value of a unit of money is different in

different time periods.

Rational investors prefer current receipt of money to future receipt because the

value of a sum of money received today is more than its value received aftersometime. This phenomena is also known as investors time preference of money.

What is present value of future money?

The present value formula is the core formula for the time value of money; each of the other

formulae is derived from this formula.PV = 1

(1+r)n

WherePV = Present Valuer = rate of interest /discount rate

n = no of years.


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What is Weighted Average Cost of capital?

Weighted average cost of capital is the average cost of the costs of various sources offinancing. The weightage assigned to each cost is according to book value or market value .

It is also known as Composite or Overall or Average cost of capital

Define Cost of capitalCost of capital is the minimum required rate of earnings expected by the

investors or the cut off rate of capital expenditures. It is also known as Hurdle rate

or Discount rate.

SECTION B

Explain the significance of cost of capital

Cost of capital can be used as a basis for evaluating the performance of a firm

and helps management in taking other financial decision.

a. Acceptance criteria for capital budgetingCapital budgeting decisions are carried by considering the cost of capital. The presentvalue for expected returns is calculated by discounting the expected cash inflows at cut-

off rate.

b. Determinant of Capital mix in Capital structure decisionWhile designing an optimal capital structure , the management tries to maximize the

value of the firm and minimize cost of capital.

Thus measurement of cost of capital from various sources is very essentialIn planning the capital structure of the firm

c. Basis for evaluating the financial performanceThe actual profitability of the project is compared with projected cost of capital of eachsource If actual profitability is more than actual cost of capital the performance is

satisfactory

d Basis for taking other financial decisions

For other financial decisions such as

Dividend policy Capitalization of profits Making Rights issue Working capital


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CHAPTER III

Capital Budgeting

Section A

Define Capital Budgeting .

Capital Budgeting is defined as

it is long term planning for making and financing proposed capital

outlays. Capital budgeting is the process of making investment decisions incapital expenditures.

What is Internal rate of return ?

Internal rate of return is that rate at which the sum of discounted cash

inflow equals the sum of discounted cash outflows .At IRR, NPV = 0.

Section B

Explain the factors to be considered while taking capital budgeting decisions.

1. Creative search for profitable opportunities : Profitable investment opportunitiesshould be sought to supplement existing proposals.

2. Long range capital planning : A flexible programme of a companys expectedfuture development over a long period of time should be prepared.

3. Short range capital planning : It indicates its sectoral demand for funds tostimulate alternative proposals before the aggregate demand for funds is finalized.

4. Measurement of project work : Here the project is ranked with other projects.5. Screening and selection : The project is examined on the basis of selection criteria

such as supply and cost of capital, expected returns, alternative investment

opportunities etc.

6. Retirement and disposal : The expiry of the cycle in the life of a project ismarked at this stage.

7. Forms and procedures : These involve the preparation of reports necessary for anycapital expenditure programme.

Section C

Explain the capital budgeting process and its significance.

Capital Budgeting process


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Capital budgeting involves the following steps.

1. Project Generation2. Project Evaluation3. Project Selection4. Project Execution

1. Project GenerationThe investment proposals may fall into one of the following categories :

a) 1) Proposals to add new product to the product line.2) Proposal to expand capacity in existing product lines.

b) Proposal to reduce the costs of the output of the existing products without

altering the scale of operation.

2. Project Evaluation

It involves two steps :a) Evaluation of benefits and costs. The benefits and costs must be measured in terms ofcash flows.

b) Selection of an appropriate criterion to judge the desirability of the project3.Project Selection

Since capital budgeting decisions are of considerable significance the final approval of the

project may generally rest on top management. However projects are screened at multiple levels.

4.Project Execution

The project execution committee or the top management must ensure that the funds are

spent in accordance with appropriations made in the capital budget.

Importance / Significance of Capital Budgeting

Capital budgeting is significant for the following reasons

1. Large investmentsCapital budgeting decisions involve large investment of funds. But the funds

available with the firm are always limited. Hence it is very important for a firm to

plan and control its capital expenditure.

2. Long term commitment of fundsThe long term commitment of funds increases the financial risk involved in the

investment decision. Greater the risk involved, greater is the need for careful

planning of capital expenditure that is capital budgeting.

3. Irreversible nature


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Once the decision for acquiring a permanent asset is taken it becomes very difficult to

dispose of these assets with incurring heavy losses.

4. Long term effect on profitabilityThe present earnings of the firm not only are affected by the investment in capital

assets but also the future growth and profitability of the firm depends upon the

investment decision taken today.

5. Difficulties of investment decisionThe long term investment decision are difficult to be taken because a) decision

extends to a series of years beyond the current accounting period b) uncertainties of

future and c) higher degree of risk.

6. National Importance : Investment decision though taken by individual concern is ofnational importance because it determines employment, economic activities and

economic growth.

What are the various methods of capital budgeting ? Explain its merits and demerits.

1. Payback Period Method

The term payback (or payout or pay-off) is defined as the length of time required for the

stream of cash proceeds produced by an investment equal to the original cash outlay required bythe investment. In other words the time required to recover the initial investment is known as

pay back period. This method is also known as the payout method.

If the project generates constant annual cash inflows ,the payback period can be computed by

the following formula :

Payback period= Initial investment ( cash outlay)---------------------------------------

Annual cash inflow

Accept or Reject Criterion :

The decision rule is accepted if the computed pay-back period is less than the standard;otherwise reject it.

Merits:

1. It is an important guide to investment policy.

2 . It lays a great emphasis on liquidity.

3.The rate which capital is recouped has a positive significance.4.The method enables a firm to choose an investment which yields a quick return on

cash funds.

5.It is easy to understand ,calculate and communicate to others.


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6.Other than its simplicity, the main advantage claimed for the payback method is that it is

built-in safeguard against risk.7.It enables a firm to determine the period required to recover the original investment with

some percentage return and thus arriving at the degree of risk associated with the investment.

Demerits:

1.It does not measure the profitability of a project.

2.The time value of money is ignored.3.It does not value projects of different economic lives.

4.It is only a rule-of-thumb method. It is often difficult to judge objectively whether one

proposed project is superior to another and ,if so ,by how much.5.No allowance is made for taxation nor is any capital allowance made.

2. Accounting Rate of Return Method or Average Rate of Return Method

(ARR)

The accounting rate of return is found out by dividing the average income after taxes by the

average investment. This method is based on conventional accounting concepts.

The rate of return is expressed as a percentage of the earnings of the invest in a particular project.Following formula can be used to know the ARR.

ARR=Average profit after tax

------------------------- ------- x 100

Average Investment

Average Investment =Original investmentscrap value / 2

Or Average Investment = opening investment + closing investment / 2

Accept or Reject Criterion:

This method will accept all those projects whose accounting rate of return is higher than the

minimum rate established by management. This will reject those projects which have accounting

rate of return less than the minimum rate.

Merits:

1.It is very simple to understand and use.2.It provides a better means of comparison of projects than the payback method.

Demerits:1.It ignores the time value of money.


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2.It ignores the fact that the profits earned can be reinvested.

3.Net Present Value Method

The NPV method is one of the Discounted Cash Flow [DSF]techniques explicitly

Recognizing the time value of money. It is considered to be the best method for evaluating thecapital investment projects.The NPV is the difference between the total Present value of future cash flows and cash

outflows.

NPV = PV of future cash inflow - PV of cash outflow

Accept or Reject Criterion

If NPV is positive accept the project. If the NPV is negative the project should be rejected.

Merits

1. The most significant advantage of the NPV method is that it recognizes the time value ofmoney.

2. It considers all cash flows over the entire life of the project in its calculation.3. It is consistent with the objective of maximizing the welfare of the shareholders

Demerits

1. The NPV method assumes that the discount rate that is firms cost of capital is known.But the cost of capital is difficult to understand and measure in practice.

2. Decisions arrived at may not be satisfactory when the projects being compared involvedifferent amounts of investment.

4.Internal Rate of Return (IRR)

IRR is that rate at which the sum of discounted cash equals the sum of the discounted cash flow.

It is the rate at which the net present value of the investment is zero.

In other words at IRR , NPV = 0.


Accept the project if the IRR is higher than or equal to minimum required rate of return. Aproject shall be rejected if its IRR is lower than the cut off rate.

Merits1. It considers time value of money.2. It considers cash flows throughout the life of the project.3. It is not in conflict with the concept of maximizing the welfare of the shareholders.

Demerits


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1. Calculation of IRR is quite tedious and it is difficult to understand.2. It may give results inconsistent with NPV method.

5.Profitability Index ( PI )

PI is the ratio of present value of future cash inflow and cash outflow.

PI = PV of cash inflows / Initial cash outflow


Accept if PI is greater than one.

Reject if PI is less than one.

CHAPTER IV

Corporate Financial Structure

Section AWhat is Capital Structure?Capital Structure of the company refers to the composition or make-up of its

capitalization and includes long term capital resources ie loans, reserves, shares and

bonds.

What is Optimum capital Structure ?

The capital structure which maximizes the value of the firm or the structure that

increases wealth of the shareholders is known as optimum capital structure.

What is meant by financial risk ?

Financial risk is the additional risk a shareholder bears when a company uses debt

in addition toequity financing.Companies that issue more debt instruments would

have higher financial risk than companies financed mostly or entirely by equity.

Give the meaning of leverage.

Leverage has been defined as the employment of an asset or sources of funds of which the firm

has to pay a fixed cost or fixed return, . It generally refers to usingborrowed funds, ordebt, soas to attempt to increase the returns toequity.

What is Trading on Equity? Or What is financial leverage ?

Trading on Equity or Financial Leverage refers to the use of long-term fixed

interest bearing debt and preference capital along with equity share capital.
http://en.wikipedia.org/w/index.php?title=Equity_financing&action=edit&redlink=1http://en.wikipedia.org/w/index.php?title=Equity_financing&action=edit&redlink=1http://en.wikipedia.org/wiki/Borrowinghttp://en.wikipedia.org/wiki/Borrowinghttp://en.wikipedia.org/wiki/Borrowinghttp://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Borrowinghttp://en.wikipedia.org/w/index.php?title=Equity_financing&action=edit&redlink=1


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It refers to the leverage or force applied on debt and the benefit is reflected in the

form of higher returns to equity shareholders.Financial Leverage = EBIT / EBT

What is Operating leverage ?

The fixed cost remaining the same , the percentage change in operating income will be morethan the percentage change in sales. This occurrence is called operating leverage. Operating

Leverage = contribution / EBIT.

What is Combined leverage or Composite leverage?

This leverage shows the relationship between change in sales and the corresponding

change in taxable income.Combined Leverage = Financial leverage X Operating leverage.

Section B

What is trading on equity ? Explain the significance and limitations of financial leverage.

Trading on Equity or Financial Leverage refers to the use of long-term fixedinterest bearing debt and preference capital along with equity share capital.

It refers to the leverage or force applied on debt and the benefit is reflected in the

form of higher returns to equity shareholders.

Financial Leverage = EBIT / EBT

Significance

Financial leverage is employed to plan the ratio between debt and equity so that per share is

improved

a. Planning of Capital structureCapital structure refers to raising the long-term funds both for shareholders and

long-term creditors. So decide about the ratio of fixed cost funds ie debt and equity sharecapital providing less cost of capital and financial risk , financial leverage are considered

b. Profit planningThe earnings available to each shareholder is affected by the degree of financial leverage

. if the profit increases availability to equity shareholder also increases. So leverages are

helpful for proper planning by the use of break even analysis.

Limitations

a. Double edged weapon.Financial leverage can be employed to increase the earnings to shareholders when

the earnings of shareholders are more than fixed rate of interest / dividend on shares and

debentures


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b. Beneficial for companies having stability of earningsTrading on equity is beneficial due to regular burden of interest on debentures which

company can pay only when it has regular income.

c.

Increases risk and rate of interest.Every rupee of debt increases the risk of the firm and also the rate of

SECTION C

Explain factors determining the capital structure

1. Financial leverage or Trading on equityThe use of long term debt and preference share capital along with equity share capital

is called financial leverage or trading on equity. The use of long term debt increases,

magnifies the earnings per share if the firm yields a return higher than the cost of

debt. The earnings per share also increase with the use of preference share capital.

However leverage can operate adversely also if the rate of interest on long term loan

is more than the expected rate of earnings of the firm. Therefore it needs caution to

plan the capital structure of a firm.

2. Growth and stability of salesIf the sales of a firm are expected to remain fairly stable it can raise a higher level of

debt. Higher the rate of growth of sales greater can be the use of debt in the financing

of firm. On the other hand if firms sales are declining it should not employ debt

financing.3. Nature and size of a firm

Public utility concerns may employ more debt because of stability and regularity of

their earnings. The firms which do not have stable earnings have to depend mainly

upon equity capital. Small companies have to depend upon mainly owned capital.

4. Retaining controlThe capital structure of a company is also affected by the extent to which the existing

management of the company desires to maintain control over the affairs of the

company. If the company issues debt capital or preference capital there is no risk of

dilution of control. The company can also buy back the shares to increase the control

of the promoters over the company.5. Purpose of financing

If funds are required for a productive purpose debt financing is suitable. If funds are

required for unproductive use the firm should prefer equity capital.

6. Period of finance


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If the fund is required for a very long time equity shares should be issued because it is

a permanent source. If the funds are required only for the short period short term debt

may be increased.

7. Requirement of investorsIt is necessary to meet the requirement of both institutional as well as private

investors. Investors can be of three types : Bold investors, cautious investors and less

cautious investors. Bold investors are willing to take all types of risk and thus prefer

equity shares. Over cautious investors prefer safety and stability in returns and hence

they prefer debentures. Less cautious investors prefer preference share capital.

8. Market sentimentsWhen there is boom in the capital market it is very easy to issue equity capital. But

when in the market bear conditions prevail people will look for the safety. So only

debt instruments with good credit ratings can be used for such periods.

9. Floatation costsFloatation costs are incurred when the funds are raised externally. Floatation costs forthe issue of shares is more than that of debentures and bonds. Further the floatation

costs are lesser when the company issues securities on private placements basis

instead of public issue.

10.Corporate tax rateHigh rate of corporate taxes on profits compel the companies to prefer debt financing

because interest is allowed to be deducted while computing taxable profits. On the

other hand dividend on shares is not an allowable expense for that purpose.

11.Legal requirementsThe legal restrictions are very significant as these lay down framework within which

capital structure decisions has to be made. The capital structure of the companyshould satisfy the following legal restrictions :

a) The debtequity ratio does not exceed 2:1b) The ratio of preference capital to equity does not exceed 1:3c) Promoters hold at least 25% of the equity capital.

12.Assets structureIf fixed assets constitute a major proportion of the total assets of the company it may

be possible for the company to raise more of long term debts.


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CHAPTER V

Dividend Policy

Section A

Define Dividend

According to ICAI ( Institute of Chartered Accountants of India )

Dividend is a distribution to shareholders out of profits or reserves

available for this purpose.

Section B

What are the different forms of dividend ?The different forms of dividend are as follows

1. Cash DividendCash dividend is the most commonly used term for the payment of dividend.

Generally the company which has enough cash balance is likely to pay dividend in cash.

Payment of dividend in cash causes outflows of funds. If the company does not havesufficient cash balance it has to take loan from outside.

2. Bond DividendSometimes during shortage of cash company may not have any idea abouthow much time it would take to generate cash. In such cases company may issue the

bonds to its shareholders for the longer periods. The issue of bond dividend increases the

long term liability of the firm.

3. Scrip DividendDuring shortage of cash , for short time, the company may issue promissory note or scrip

to shareholders promising to pay them dividend at a certain date in near future. The mainreason for scrip dividend is to postpone due payment of cash for short time. Scrip

dividend increases the current liability of the company.

4. Property Dividend.Under exceptional circumstances property dividend is paid to its shareholders in some

thing rather than cash. In such cases company may give its own asset or product instead

of cash dividend. This form of dividend is not prevalent in India.

5. Composite Dividend.It means a part of dividend paid in cash and another part paid in the form of property orany other type dividend.

6. Interim Dividend


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Regular dividend s are paid at the end of each financial year but sometimes directors of

the company may declare dividend between two annual general meetings . It is calledinterim dividend.

7. Stock dividend or bonus sharesDuring the financial year company may issue shares to its existing shareholders. Theseshares are called bonus shares. Issue of bonus shares increases the total number of shares

of the existing shareholders. A company issues such shares in a fixed proportion over the

existing share holding.

8. Extra dividend.

Sometimes in any year if a company earns supernormal profits and decided to give someextra dividend to its shareholders along with regular dividend . This type of dividend is

temporary in character and has is directly related with extra earnings of the company.

Write a note on Stable Dividend policy.

The term stability of dividend means lack of variability in the stream of dividend payments.

In other words it means payment of certain minimum amount of dividend regularly .The following are the different forms of stable dividend policy

a. Constant Dividend per shareUnder this form companies follow a policy of paying fixed dividend per share

irrespective of the level of earnings year after year. Such firms usually create a dividendequalization fund to enable them to pay fixed dividend even in the year when the earnings are

not good or when there are losses.

b. Constant Payout ratioConstant payout ratio means payment of a fixed percentage of net earnings as dividend per

year. The amount of dividend changes according to the earnings of the company.

c. Stable rupee dividend plus extra dividend.Some companies follow a policy of paying constant dividend per share plus an extra

dividend in the years of high profit.

Advantages of Stable dividend policy.

It stabilizes the market value of the shares. It creates confidence among the investors It is a sign of profitable organisations Jt improves the creditworthiness of the company which helps in easy financing It results in continuous flow of the national income and thus stabilizes the economy.Demerits of Stable dividend policy

If the company follows stable dividend policy and withdraws it in between itadversely affects the market price of shares


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When the company pays stable dividend in spite of its incapacity it adversely affectsin long run.

Section C

Explain factors influencing dividend policy

The payment of dividend involves some legal as well as financial considerations. The

following are the important factors which determine the dividend policy of a firm

1. Legal restrictionsLegal provisions relating to dividends as laid down in sections 93, 205, 205A, 206

and 207 of the Companies Act, 1956 are important because they lay down a

framework within which dividend policy is formulated. These provisions requirethat dividend can be paid only out of current profits or past profits after providing

for depreciation. Moreover the Companies Rule 1975 require a company

providing more than 10% dividend to transfer certain % of current years profit to

reserves. Further it provides that dividends can not be paid out of capital.

2. Magnitude and trend of earningsThe amount and trend of earnings is an important aspect of dividend policy. It is

rather the starting point of the dividend policy. The past trend of the companys

earnings should also be kept in mind while making the dividend decision.

3. Desire and Type of shareholdersDesires of shareholders for dividends depend upon their economic status.Investors such as retired persons, widows and other economically weaker persons

view dividend as a source of funds to meet their day to day operations. Such

investors may prefer regular dividends. On the other hand a wealthy investor in a

high income tax bracket may not benefit by high current dividend incomes. Such

investor may be interested in lower current dividend and high capital gains.

4. Nature of industryNature of industry to which the company is engaged also considerably affects the

dividend policy. Certain industries have a comparatively steady and stable

demand irrespective of the prevailing economic conditions. Such firms expect

regular earnings and hence can follow a consistent dividend policy. If earnings

are uncertain conservative policy should be followed.

5. Age of the companyA newly established concern has to limit payment of dividend and retain

substantial part of earnings for financing its future growth and development.

Older companies may have sufficient reserves can afford to pay liberal dividends.

6. Future financial requirements


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If a company has highly profitable investment opportunities it can convince the

shareholders of the need for limitation of dividend to increase the future earnings

and stabilize its financial position. When the companies do not have profitable

opportunities the company can follow liberal dividend policy.

7. Taxation policyA high or low rate of business taxation affects the net earnings of company and

thereby its dividend policy. If the dividend income of shareholders is heavily

taxed being in high income bracket the shareholders may forego cash dividend

and prefer bonus shares and capital gains.

8. Control objectivesWhen a company pays high dividend out of its earnings it may result in the

dilution of both control and earnings for the existing shareholders. Issue of new

shares shall cause increase in the number of equity shares and ultimately cause a

lower earnings per share and their price in the market.

9.

Requirement of institutional investorsDividend policy of a company can be affected by the requirement of institutional

investors such as financial institutions, banks, insurance corporations etc. These

investors usually favour a policy of regular payment of cash dividends.

10.Stability of dividendsStability of dividend refers to the payment of dividend regularly and shareholders

prefer payment of such regular dividends. A policy of constant dividend per share

is most suitable to concerns whose earnings are expected to remain stable over a

number of years. The policy of constant low dividend per share plus some extra

dividend in years of high profits is suitable to firms having fluctuating earnings

year to year.11.Liquid resources

Although a firm may have sufficient available profits to declare dividends,

sometimes, it may not have sufficient liquid resources. In such cases it may not

be position to declare dividends.

CHAPTER VI

Working Capital Management

Section A

.What is receivable management ?

Receivable management is decision making process which takes into account the

creation of debtors, debtors turnover and minimizing cost of burrowing of working capital.


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Define Working Capital

Working Capital is the amount of funds necessary to cover the cost of operating the

enterprise. It is the difference between Current assets and Current liabilities.

Working capital = CACL.

Section B

Write a note on the significance of Inventory management.

Inventory management

It refers to stocks, raw materials, components, spares or working progress maintainedin the organisation to have continuous production and sales. It is one of the component of

working capital management.

An efficient system directly contributes to the growth and profitability of the concern

by keeping stocks in such a way that there is no overstocking and under stocking and reduction

in cost of production.

Significance /Objects of inventory management To provide continuous supply of raw materials to carry out uninterrupted production To reduce wastage To exploit the opportunities available and to reduce cost of purchase To introduce scientific inventory management techniques To provide right materials at right time.Tools of Inventory management

The various tools of inventory management are as follows

1. Fixation of levels.Inventories are maintained by fixing them at different levels with the help

of different factors

a. Maximum levelIt is the level beyond which stocks should not exceed. If it exceeds it is

overstocking

b. Minimum level.or Safety stockIt represents the quantity which must be maintained at all times. If it is

less than this level it is understocking

c. Reorder level.This level indicates that the material should be procured . it is fixed inbetween maximum and minimum level.

2. ABC analysisUnder this technique the materials are graded as A,B,C on the basis of value the

material has in cost, numbers used and part of consumption. The main purpose ofadopting this technique is to maintain scientific and proper investment in inventory.


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3. Economic Order QuantityEconomic order quantity is that quantity of materials to be ordered where it will

have least or minimum order placing and carrying cost. It is also called as the size of

materials to be purchased most economically.

4.

Perpetual Inventory systemUnder this system the stocks are continuously checked using different types of

registers for materials and entries are made on issuing and receiving. It is a costly

technique of inventory management.

Explain the scope, objectives and importance of cash management

Cash management

Cash is one of the current assets of a business. It includes money and instruments such as

cheques, money orders and bank drafts. Cash is just a medium to acquire other resources.

Cash management deals with the following:a. Cash inflows and outflowsb. Cash flows within the firmc. Cash balances held by the firm at a point of time.

Objectives/Importance of Cash management

1. Adequate Requirement of Cash:Cash is very vital asset to meet every type of expenditure so adequate cash resources

are required otherwise it indicates insolvency of the organisation.

2. To make Cash payment

Cash is required to make payment for various types of expenditures for smooth

business operations.

3. Maintain Minimum Cash reserve

Along with liquidity a firm should also maintain minimum reserve for meeting futureobligations. The cash inflow and outflow should be properly controlled to conserve cash

resources

4. Image of the Organisation

Cash management helps to maintain the image of the organisation by making prompt

payment to creditors and to avail cash discounts.

These are some of the objectives of cash management

What are motives of holding cash?


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----- Introduction of Cash management-----

Cash is held by the firm for the following motives

1. Transaction motive2. Precautionary motive3.

Speculative motive4. Compensatory motive

1. Transaction motiveA firm needs cash for making transactions in the day to day operations. Cash is needed

to make payment for purchases, expenses, taxes and dividend etc.

Cash need arises when there is no balance between cash receipts and payments. This can be

achieved by investing marketable securities which mature on the day a payment has to be made.

2. Precautionary motive

A firm is required to keep cash for meeting various contingencies such as change in

government policies, competitions, accidents and consumer behaviour.

To meet these unforeseen situations a firm should always invest in securities with readyliquidity.

3. Speculative motive

To take advantage of unexpected opportunities a firm holds cash for investing in profit

making opportunities . Such opportunities do not come in a regular manner.

4. Compensatory motive

This refers to compulsory balance to be maintained in savings and current accounts to getseveral facilities from the bank

Explain the concepts of working capital.

Working capital is the amount of funds necessary to cover the cost of operating the

enterprises.It is defined as the difference between the inflow and outflow of funds. Ie the excess of currentassets and current liabilities.

Working capital is also known as revolving or circulating capital.

Concepts of Working capital

There are two concepts of working capital


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A. Balance sheet conceptB. Operating Cycle or Circular flow concept.A. Balance sheet concept

There are interpretations of working capital

a. Gross Working Capitalb. Net Working Capitala. Gross Working Capital

Gross working capital is the amount of funds invested in various componentsof current assets. It is most acceptable concept in financial management.

Advantages

Provides correct amount of working capital at the right time Helps in determining correct rate of return on investments in working capital

b. Net Working CapitalNet working capital is the excess of current assets over current liabilities

Net working capital = Current assetsCurrent liabilities.

Advantages

Enables a firm to determine how much amount is left for operationalrequirements.

Indicates financial soundness of firm.B. Operating Concept

Working Capital is required to finance short term requirements such as cash, debtors

and stocks. So capital circulates constantly from inflow to outflow and vice versa.

This concept is based on working capital cycle of the firm where the cycle starts with thepurchase of raw material and other resources and ends with realization of cash from the sale

of finished goods

Cash

Debtors Raw materials

Sales Work in process


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Finished goods.

Differentiate between Temporary and Permanent Working Capital

Temporary Working Capital Permanent Working Capital

Meaning It is the amount of workingcapital which is required to

meet seasonal demand and

special conditions

It is the minimum amountwhich is required to ensure

effective utilization of facilities

and circulating current assets

Types Seasonal and Special are two

types of variable capital

Regular and reserve are two

types of fixed capital

Period of

Usage

It is required for a shorter

period

It is permanently employed in

business

Amount of

WorkingCapital

It fluctuates and increases and

decreases according torequirement

It is stable or fixed over time

and increases due to expansionof business

Section C

Explain briefly the importance and advantages of Working Capital

Advantage of having adequate working capital

Working capital is very important for the smooth functioning of the business. The

importance of maintaining adequate working capital are as follows.

1. Solvency of businessIt maintains solvency by providing constant flow of working capital.

2. GoodwillWorking capital helps in making prompt payment and creates goodwill of the

firm

3. Cash discountsOn payment of cash on time firms get cash discounts on the purchase made.

4. Regular supply of raw-materialsEnsures regular supply and hence continuous productions

5. Ability to face crisis.


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Enables a business to face crisis such as depression in the market which requires

more working capital.

6. High moraleAdequate working capital ensures security, high morale and overall efficiency of

the firm.

Need and importance of Working capital

The basic objective of financial management is to maximize shareholders wealth. This

is possible only when the company earns sufficient profit. The amount of such profits

largely depends upon the magnitude of sales. Working capital is needed because of

following reasons :

1. Sales do not convert into cash instantly. There is invariably a time lag between thesale of goods and the receipt of cash. Therefore there is a need for working capital in

the form of current assets to deal with the problem arising out of the lack ofimmediate realization of cash against goods sold.

2. Sufficient working capital is necessary to sustain sales activity.3. Working capital is required to have uninterrupted business operations.4. The operating cycle can be said to be at the heart of the need for working capital. The

operating cycle includes a ) conversion of cash into inventory b) conversion of

inventory into receivables c) conversion of receivables into cash

5. Since cash inflows and outflows do not match firms have to necessarily keep cash orinvest in short term liquid securities so that they will be in a position to meet

obligations when they become due.

6. The working capital is required by the firm to guard against the possibility of notbeing able to meet demand for their products. Hence adequate inventory provides a

cushion against being out of stock.

7. If firms have to be competitive they must sell goods to their customers on credit. itnecessitates the holding of accounts receivable. So firms needs working capital.

Explain factors Determining Working capital (WC) requirements

1. Nature of BusinessThe working capital requirements of a firm basically depend upon the nature of its business.

Public utility undertakings like Electricity, water supply and Railways need very limitedworking capital because they offer cash sales only and supply services. On the other hand

trading and financial firms require less investment in fixed assets but to have invest large

amount of working capital (WC). The manufacturing concerns also require sizable

working capital along with fixed assets.

2. Size of business


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The working capital requirements of a concern are directly influenced by the size of its

business which may be measured in terms of scale of operations. Generally greater the

size of a business unit, larger will be the requirements of working capital.

3. Production policyThe production policy could be kept either steady by accumulating inventories during

slack period in order to meet high demand during the peak season OR the production can

be reduced during the slack season. If the policy is steady the firm will require larger

WC.

4. Credit PolicyA firm that buys its goods on credit and sells its products/services on cash requires LESS

WC. On the other hand a concern buys its requirements for cash and sells on credit needs

LARGER WC.

5. Seasonal VariationGenerally during the busy season a firm needs LARGER WC than in the slack season.

Because the firm has to purchase raw materials in bulk during the season to ensure anuninterrupted flow of production.

6. WC CycleThe speed with which the WC completes one cycle determines the requirements of WC

longer the period of the cycle larger is the requirement of WC.

7. Business CycleIn a period of boom that is when the business is prosperous there is a need for LARGER

amount of WC due to increase in sales, rise in prices etc. on the other hand in the times of

depression the business declines, sales decline and firms may have a LARGER amount of

WC.

8. Rate of Growth of businessThe WC requirements of a concern increase with the growth and expansion of its

business activities. The fast growing concerns require larger amount of WC.

9. Dividend policyA firm that maintains a steady high rate of cash dividend irrespective of its generation of

profits needs more WC. Hence the dividend policy of a firm influences the requirements

of its working capital.


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10.Operating efficiency of firmOperating efficiency of the firm results in optimum use of resources at minimum cost. If

firm successfully controls operating costs, it will need LESS WC.

11.Price Level ChangesGenerally the rising prices will require the firm to maintain larger amount of WC as more

funds will be required to maintain the same current assets.

12.Taxation policyIn the event of regressive taxation policy of the Govt. as it exists today the firm may have

little profits for distribution and retention, consequently, the firm may require MORE

WC.

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