SHORT QUESTIONS: 2 Marks
Q) The main point of financial management in a firm is:
Answer:
Creation of value for shareholders.
Q) The term ‘capital structure’ refers to:
Answer:
Long-term debt, preference shares and equity shares.
Q) Gross Working Capital means:
Answer:
Total current assets.
Q) What is Business Finance?
Answer:
Business finance refers to funds required for carrying out business activities effectively.
Q) Enlist financial statements of listed company.
Answer:
1. Balance Sheet
2. Profit & Loss Account
3. Cash Flow Statement
4. Statement of Changes in Equity
5. Notes to Accounts
Q) Formula for Interest Coverage Ratio.
Answer:
𝐸𝐵𝐼𝑇
Interest Coverage Ratio =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
Q) Define Cost of Capital.
Answer:
Cost of capital is the minimum rate of return expected by investors for providing funds to the
company.
Q) What do you mean by Leverage?
Answer:
Leverage refers to the use of fixed costs to magnify returns to shareholders.
Q) Maximisation of wealth of shareholders is reflected in:
Answer:
Market price of equity shares.
Q) Which ratio measures debt servicing capacity?
Answer:
Interest Coverage Ratio.
Q) In case of all-equity financing, WACC equals:
Answer:
Cost of Equity.
Q) Which is not part of investment decision?
Answer:
Dividend payout decision.
Q) Financial statements converted into percentages are called:
Answer:
Common Size Statements.
Q) How is shareholder wealth calculated?
Answer:
Shareholder wealth is calculated through market value of shares held by shareholders.
Q) Define Fund Flow Statement.
Answer:
Fund flow statement shows movement of funds between two balance sheet dates.
Q) Funds are financial resources in the form of:
a) Corporate Capital
b) Business Funds
c) Cash Equivalents
Answer:
All of these.
Q) Sum of short-term and long-term sources of finance is known as:
Answer:
Financial Structure.
Q) Long-term investment decisions based on risk-return analysis are:
Answer:
Capital Budgeting Decisions.
Q) Decisions relating to use of profits are:
Answer:
Dividend Decisions.
Q) Value of future rupee being less than present rupee is:
Answer:
Time Value of Money.
Q) Method of converting future cash flows into present value:
Answer:
Discounting.
Q) Allocation of funds to short-term proposals refers to:
Answer:
Working Capital Decisions.
Q) Leverage analysis measures relationship between:
Answer:
Cost, sales revenue and earnings.
Q) “Wealth maximisation is better than profit maximisation.” Justify.
Answer:
Wealth maximisation is superior because:
1. It considers time value of money.
2. It considers risk and uncertainty.
3. It focuses on long-term growth.
4. It increases market value of shares.
5. It satisfies shareholders’ interests.
Profit maximisation ignores risk and timing of returns and focuses only on accounting profits.
Q) Explain Wealth Maximisation and Profit Maximisation.
Answer:
Profit Maximisation
• Focuses on increasing profits.
• Short-term objective.
• Ignores risk and timing.
Wealth Maximisation
• Focuses on shareholder value.
• Long-term objective.
• Considers risk and time value of money.
5 MARKS QUESTIONS:
1) Wealth Maximisation vs Profit Maximisation
Profit Maximisation
Profit maximisation means increasing the profits of the business.
Features
• Focuses on short-term profits
• Ignores risk and uncertainty
• Does not consider time value of money
• Concentrates only on earning capacity
Limitations
• Ambiguous concept
• Ignores timing of returns
• Ignores shareholder value
• May encourage unethical practices
Wealth Maximisation
Wealth maximisation means maximising the market value of shareholders’ wealth.
Features
• Focuses on long-term growth
• Considers risk and return
• Considers time value of money
• Improves market price of shares
Why Wealth Maximisation is Better
1. Considers future cash flows
2. Considers risk and uncertainty
3. Focuses on shareholder satisfaction
4. Helps in sustainable business growth
5. Enhances company valuation
2. Modern Approaches of Financial Management
Modern financial management focuses on efficient utilisation of funds and shareholder wealth
creation.
Main Features
• Wealth maximisation objective
• Scientific decision-making
• Risk-return analysis
• Capital budgeting decisions
• Working capital management
• Dividend decisions
• Financial planning and control
Scope
1. Investment Decision
2. Financing Decision
3. Dividend Decision
Importance
• Improves profitability
• Helps in value creation
• Ensures financial stability
• Supports strategic business decisions
3. Functions of Finance Manager
The finance manager is responsible for planning, procurement and utilisation of funds.
Functions
a) Financial Planning
Estimating future financial requirements.
b) Procurement of Funds
Raising funds through shares, debentures, loans etc.
c) Investment Decision
Selecting profitable investment opportunities.
d) Working Capital Management
Managing current assets and current liabilities.
e) Dividend Decision
Deciding distribution of profits.
f) Financial Control
Monitoring proper utilisation of funds.
g) Risk Management
Managing financial and business risks.
4. Comparative Financial Statements
Comparative statements compare financial data of two or more years.
Objectives
• Compare performance
• Identify trends
• Evaluate financial progress
Advantages
• Easy comparison
• Helps management decisions
• Useful for investors and creditors
Limitations
• Inflation affects comparison
• Accounting policy changes may distort results
5. Trend Analysis
Trend analysis studies changes in financial performance over several years.
Trend analysis uses a base year (or period) as a benchmark against which subsequent years are
compared. The changes are evaluated both in absolute amounts and relative percentages to
spot uptrends, downtrends, or periods of stagnation.
Formula
Current Year Figure - Base Year Figure
Trend Percentage = × 100
Base Year Figure
Advantages
• Shows growth trend
• Helps forecasting
• Assists planning
Limitations
• Ignores qualitative factors
• May give misleading conclusions during inflation
6. Trading on Equity
Trading on equity means using debt capital to increase returns to equity shareholders.
Favourable Trading on Equity
Occurs when:
Return on Investment > Cost of Debt
Advantages Disadvantages
• Increases EPS • Reduces cost of capital
• Improves return on equity • Increases financial risk
• Improves return on equity • Fixed interest burden
7. Financial Forecasting
Financial forecasting means estimating future financial needs of business. Financial forecasting
is a financial planning process that involves estimating future revenue, expenses, and monetary
flow of a company, based on its historical financial data, statistical models, and market research.
Advantages
• Reduces uncertainty
• Helps budgeting
• Assists financial planning
8. Operating Cycle
Operating cycle is the time between purchase of raw materials and collection of cash from sales.
Components
1. Raw Material Storage Period
2. Work-in-progress Period
3. Finished Goods Storage Period
4. Debtors Collection Period
5. Less: Creditors Payment Period
Importance
• Helps determine working capital requirement
• Improves liquidity management
9. Factoring
Factoring is a financial service in which receivables are sold to a factor for immediate cash.
Functions of Factor
• Collection of debts
• Financing
• Sales ledger management
• Credit protection
Advantages
• Improves liquidity
• Reduces bad debts
• Saves administrative costs
10. Leverages
a) A leverage ratio measures how much debt a company uses relative to assets, equity, or
earnings.
b) Leverage ratios help assess financial risk and a company’s ability to meet its obligations.
c) Common leverage ratios include debt-to-equity, debt-to-capital, debt-to-EBITDA, and
interest coverage ratios.
d) Higher leverage can increase returns but also increases financial risk.
Operating Leverage (DOL)
Operating leverage measures the relationship between Sales and EBIT (Earnings Before Interest
and Tax).
IMPORTANCE:
It arises because of fixed operating costs such as:
❖ Measures business risk
• Rent
❖ Helps in profit planning
• Salaries ❖ Assists cost control
• Depreciation ❖ Useful in break-even analysis
❖ Helps management decision-making
• Factory expenses
When a company has high fixed operating costs, even a small increase in sales can lead to a
large increase in profits.
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛(𝑆𝑎𝑙𝑒𝑠 − 𝑉𝐶)
𝐷𝑂𝐿 =
𝐸𝐵𝐼𝑇
Financial Leverage (DFL)
Measures relationship between EBIT and EPS. Formula
It arises due to fixed financial charges such as: 𝐸𝐵𝐼𝑇
𝐷𝐹𝐿 =
𝐸𝐵𝑇
• Interest on debentures
• Interest on loans Type equation here.
• Preference dividend Where:
A company using more debt has higher financial leverage. 𝐸𝐵𝑇 = 𝐸𝐵𝐼𝑇 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝐻𝐼𝐺𝐻 𝐷𝐹𝐿 = HIGH FINANCIAL RISK; 𝐿𝑂𝑊 𝐷𝐹𝐿 = LOW FINANCIAL RISK
Combined Leverage:
Combined leverage shows the combined effect of:
• Operating leverage
• Financial leverage
It measures relationship between Sales and EPS.
Formula
𝐷𝐶𝐿 = 𝐷𝑂𝐿 × 𝐷𝐹𝐿
OR
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
𝐷𝐶𝐿 =
𝐸𝐵𝑇
11. Cost of Capital and WACC
Cost of capital is the minimum return expected by investors.
WACC Formula
𝑊𝐴𝐶𝐶 = (𝑊𝑒 × 𝐾𝑒 ) + (𝑊𝑝 × 𝐾𝑝 ) + (𝑊𝑑 × 𝐾𝑑 )
Where:
• 𝑊𝑒 = Weight of Equity
• 𝐾𝑒 = Cost of Equity
• 𝑊𝑝 = Weight of Preference Shares
• 𝐾𝑝 = Cost of Preference Shares
• 𝑊𝑑 = Weight of Debt
• 𝐾𝑑 = Cost of Debt
Importance
• Capital budgeting decisions
• Business valuation
• Optimum capital structure decisions
12. Capital Structure
Capital structure means the mix of debt and equity used by a company.
Factors Affecting Capital Structure
1. Cost of capital
2. Business risk IMPORTANCE:
3. Tax benefits • Affects profitability
4. Control considerations • Influences company value
5. Market conditions • Balances risk and return
6. Flexibility
7. Profitability
13. Fund Flow Statement
Fund flow statement shows movement of funds between two balance sheet dates.
Uses
• Analyses financial position
• Shows sources and application of funds
• Helps management control
Limitations
• Does not show exact cash position
• Based on historical data
14) “Wealth maximising objective is superior to profit maximisation objective.” Explain.
Answer:
Wealth maximisation is superior because it:
• Considers shareholders’ wealth.
• Focuses on long-term growth.
• Considers risk and uncertainty.
• Includes time value of money.
• Enhances market value of shares.
Profit maximisation ignores these important aspects.
15) Describe finance functions divided into three broad categories.
Answer:
The finance functions are:
1. Investment Decisions
2. Financing Decisions
3. Dividend Decisions
16) Explain financial management.
Answer:
Financial management is the planning, organising, directing and controlling of financial activities
such as procurement and utilisation of funds.
Objectives:
• Wealth maximisation
• Proper utilisation of funds
• Financial stability
• Profitability
17) Explain modern approaches to financial management.
Answer:
Modern financial management focuses on:
• Wealth maximisation
• Risk-return analysis
• Investment decisions
• Financing decisions
• Dividend decisions
• Financial planning and control
18) Explain relationship of financial management with other functional areas.
Answer:
Financial management is related to:
1. Production Management
2. Marketing Management
3. Human Resource Management
4. Accounting
5. Economics
19) Explain factors affecting capital structure.
Answer:
Factors affecting capital structure:
1. Cost of capital
2. Business risk
3. Tax benefits
4. Flexibility
5. Control considerations
6. Market conditions
7. Profitability
20) Explain factors affecting capital structure.
Answer:
1. Cost of financing
2. Risk level
3. Tax advantages
4. Control of ownership
5. Market conditions
6. Stability of earnings
7. Flexibility of finance
21) How is wealth maximisation a better operative criterion than profit maximisation?
Answer:
Wealth Maximisation
Wealth maximisation means maximising the market value of shareholders’ wealth.
Advantages over Profit Maximisation
1. Considers time value of money.
2. Considers risk and uncertainty.
3. Focuses on long-term growth.
4. Enhances market value of shares.
5. Protects shareholders’ interests.
Profit Maximisation Limitations
• Ignores timing of returns.
• Ignores risk.
• Short-term oriented.
• Does not focus on shareholder wealth.
Conclusion
Wealth maximisation is the primary objective of modern financial management because it
creates sustainable shareholder value.
22) Write a note on Comparative Financial Statements.
Answer:
Comparative financial statements compare financial data of different years side by side.
Objectives
1. Compare financial performance.
2. Identify growth trends.
3. Evaluate operational efficiency.
Advantages
• Simplifies analysis.
• Helps decision making.
• Useful for investors and creditors.
Limitations
• Inflation affects comparison.
• Different accounting methods may distort results.
23) Explain in brief Modern Approaches of Financial Management.
Answer:
Modern financial management focuses on efficient utilisation of funds and shareholder wealth
maximisation.
Features
1. Wealth maximisation objective
2. Risk-return analysis
3. Investment decisions
4. Financing decisions
5. Dividend decisions
6. Financial planning and control
Importance
• Improves profitability
• Supports strategic decisions
• Enhances company value
24) Critically examine the steps involved in Capital Budgeting Process.
Answer:
Capital budgeting refers to decision-making relating to long-term investments.
Steps in Capital Budgeting
1. Identification of investment opportunities
2. Estimation of cash flows
3. Evaluation of proposals
4. Selection of projects
5. Implementation
6. Performance review
Importance
• Efficient allocation of resources
• Long-term profitability
• Wealth maximisation
25) What are the factors affecting Capital Structure?
Answer:
Factors affecting capital structure:
5. Flexibility
1. Cost of capital 6. Market conditions
2. Business risk 7. Stability of earnings
3. Tax benefits
4. Control considerations
26) Calculate Cost of Equity.
Formula
𝐷1
𝐾𝑒 = +𝑔
𝑃0
Where:
• 𝐷1 = Expected Dividend
• 𝑃0 = Market Price
• 𝑔= Growth Rate
27) Different Sources of Finance in Present Scenario.
Answer:
Short-term Sources Long-term Sources
1. Bank credit 1. Equity shares
2. Trade credit 2. Preference shares
3. Factoring 3. Debentures
4. Term loans
5. Venture capital
28) Calculate WACC using Book Value and Market Value Weights.
1. Calculate proportions of each capital component.
2. Multiply by respective costs.
3. Add weighted costs.
29) Write note on importance of Capital Structure.
Answer:
Capital structure is important because:
1. Affects profitability.
2. Influences risk.
3. Determines cost of capital.
4. Helps wealth maximisation.
5. Balances debt and equity.