2 MARKS

2024
a) What is zero-growth dividend model?
Answer:
The zero-growth dividend model assumes that a company pays a fixed dividend
every year, indefinitely. The value of the stock is calculated using the formula:
P0=DrP_0 = \frac{D}{r}
Where:
 P0P_0 = Current price of the stock
 DD = Constant annual dividend
 rr = Required rate of return

b) Mention the two approaches to relevance theory of capital structure.

Answer:
The two main approaches to the relevance theory of capital structure are:
1. Net Income (NI) Approach – suggests that capital structure affects the
value of the firm.
2. Traditional Approach – proposes that there is an optimal capital
structure that maximizes firm value and minimizes the cost of capital.

c) What do you mean by "investment decision"?

Answer:
An investment decision refers to the process of allocating funds to long-term
assets or projects with the objective of generating returns. It includes capital
budgeting decisions like acquiring new equipment, launching new products, or
expanding operations.

d) State any two disadvantages of the RADR (Risk-Adjusted Discount Rate)

method.
Answer:
1. Subjectivity in risk estimation – Determining the correct risk premium is
difficult and subjective.
2. Same discount rate for all cash flows – It does not differentiate the risk
among various cash flows over time.

e) Bring out any two differences between growth and normal firms.
Answer:
1. Earnings Growth: Growth firms experience rapid increase in earnings,
whereas normal firms have stable or slow earnings growth.
2. Investment Opportunities: Growth firms have more high-return
investment opportunities compared to normal firms.

2024 TT
a) What is Transaction Cost?
Answer:
Transaction cost refers to the expenses incurred while buying or selling
securities or assets. These include brokerage fees, bank charges, taxes, legal
fees, and other costs associated with a financial transaction.

b) Define Dividend.
Answer:
A dividend is the portion of a company's earnings that is distributed to
shareholders, usually in the form of cash or additional shares. It represents a
reward to investors for investing in the company.

c) What is Horizontal Merger? State with example.

Answer:
A horizontal merger occurs when two companies operating in the same
industry and at the same stage of production combine.
Example: The merger of Vodafone and Idea, both telecom service providers in
India.

d) What is Purchasing Power Risk?

Answer:
Purchasing power risk is the risk that inflation will erode the real value of
returns from an investment. It means that the money received in the future
may buy fewer goods and services than today.

e) State any 2 differences between Merger and Acquisition.

Answer:
1. Control: In a merger, two firms combine and form a new entity; in an
acquisition, one firm takes over another.
2. Identity: Merged companies often lose their individual identities, while
in acquisitions, the acquired company may retain its name or become a
subsidiary.

f) What do you mean by Capitalization?

Answer:
Capitalization refers to the total amount of a company's long-term funds,
including equity, preference capital, retained earnings, and long-term debt. It
shows how a company finances its operations and growth.

g) What is Sunk Capital?

Answer:
Sunk capital is the amount already invested in a project or asset that cannot be
recovered. It is a past cost that should not affect future investment decisions.

h) A company issues 1000, 10% preference shares of ₹100 each at a discount

of 5%. Cost of raising capital is ₹2,000. Compute cost of preference capital
(Kp).
Answer:
 Face value = ₹100
 Issue price = ₹100 - 5% = ₹95
 Net proceeds per share = ₹95 - ₹2 (cost of raising capital per share) = ₹93
 Dividend = 10% of ₹100 = ₹10
Kp=DividendNetProceeds=1093≈10.75%K_p = \frac{Dividend}{Net Proceeds}
= \frac{10}{93} \approx 10.75\%
Answer: Cost of preference capital (Kp) is approximately 10.75%

2023
a) What is Business Risk?
Answer:
Business risk is the uncertainty a firm faces in earning adequate profits due to
factors like market demand fluctuations, production issues, or competition. It
arises from the core operations of the business and is independent of financial
leverage.

b) Give the meaning of Cost of Equity.

Answer:
Cost of equity is the return expected by equity shareholders for investing in a
company. It reflects the compensation for bearing the risk of ownership and
can be calculated using the Dividend Discount Model or CAPM.

c) What do you understand by Optimal Capital Structure?

Answer:
Optimal capital structure refers to the ideal mix of debt and equity financing
that minimizes a firm’s overall cost of capital while maximizing its value. It
balances the risk of debt with the return expectations of equity holders.
d) State any two objectives of Stock Dividend.
Answer:
1. To conserve cash while rewarding shareholders in the form of additional
shares.
2. To signal confidence in the company’s future earnings and stability

2022
1. What do you understand by Coefficient of Variation (CV)?
The Coefficient of Variation (CV) is a statistical measure that shows the extent
of variability in relation to the mean of the data. It is expressed as a percentage
and calculated as:
CV=Standard DeviationMean×100\text{CV} = \frac{\text{Standard Deviation}}{\
text{Mean}} \times 100
It is used to compare the relative risk or volatility of different investments or
data sets, even if their means are different. A higher CV indicates greater risk or
variability relative to the average.

2. Write a short note on Financial Risk

Financial risk refers to the possibility of losing money on an investment or
business operation due to factors such as changes in interest rates, credit
defaults, liquidity issues, or leverage. In corporate finance, it specifically relates
to the risk that a company will not be able to meet its financial obligations
because of debt. Higher financial risk is associated with higher levels of
borrowing (debt), which can amplify both profits and losses.

3. Mention any four classifications of Cost of Capital

1. Debt Capital Cost - Cost of borrowing funds through loans or bonds.
2. Preference Capital Cost - Cost of raising funds through preference
shares.
 3. Equity Capital Cost - Cost of issuing ordinary shares.
4. Retained Earnings Cost - Opportunity cost of reinvesting earnings
instead of distributing dividends.

4. Give the meaning of Net Income Approach

The Net Income Approach to capital structure suggests that changes in the
capital structure affect the value of the firm and its overall cost of capital.
According to this approach, by increasing debt (which is cheaper than equity), a
firm can reduce its overall cost of capital and thus increase the firm's value. It
assumes that the cost of debt is constant and does not increase with more
borrowing.

5. State any two factors influencing Dividend Decisions

1. Profitability – Firms with higher profits are more likely to pay dividends.
2. Liquidity – Availability of cash or liquid assets affects a company’s ability
to pay dividends.

6. Differentiate between Gross and Net Working Capital

Aspect Gross Working Capital Net Working Capital

Total current assets of a Difference between current assets

Definition
company and current liabilities

Formula Sum of all current assets Current Assets - Current Liabilities

Indicates total investment in Indicates short-term financial health

Focus
current assets and liquidity

Measures size of current Measures availability of working

Purpose
assets funds

7. Write any four salient characteristics of Debentures

 1. Fixed Interest – Debentures carry a fixed rate of interest payable to
holders.
2. No Ownership Rights – Debenture holders do not have voting rights in
the company.
3. Repayment Priority – Debenture holders are paid before equity
shareholders in case of liquidation.
4. Transferability – Debentures can be transferred or sold to other
investors.

2021
a) What is Co-efficient of Variation?
The Coefficient of Variation (CV) is a statistical measure that shows the relative
variability of data compared to its mean. It is calculated as:
CV=Standard DeviationMean×100\text{CV} = \frac{\text{Standard Deviation}}{\
text{Mean}} \times 100
It helps compare the risk or volatility of different investments, regardless of
their average returns. A higher CV means greater risk per unit of return.

b) Give the meaning of Composite Cost of Capital

Composite Cost of Capital (also called Weighted Average Cost of Capital -
WACC) is the overall cost of capital for a company, calculated by weighting the
cost of each source of capital (debt, equity, preference shares) according to its
proportion in the total capital structure.
c) What is Dividend?
A Dividend is a portion of a company’s profit distributed to its shareholders as
a return on their investment.
d) State any two internal sources of finance
1. Retained Earnings – Profits kept in the business instead of being
distributed as dividends.
 2. Depreciation Fund – Funds generated through charging depreciation to
reduce taxable income.
e) What is Working Capital?
Working Capital is the capital used in day-to-day operations of a business,
calculated as:
Working Capital=Current Assets−Current Liabilities\text{Working Capital} = \
text{Current Assets} - \text{Current Liabilities}
It represents the liquidity available to meet short-term obligations.
f) State any two benefits of holding inventories
1. Ensures smooth production by avoiding delays due to lack of raw
materials.
2. Helps meet unexpected demand from customers quickly.

g) Give the meaning of Corporate Valuation

Corporate Valuation is the process of determining the overall value or worth of
a company, considering its assets, liabilities, earnings, and market position.

2019
a) What is Risk Analysis?
Risk analysis is the process of identifying, assessing, and evaluating potential
risks that could negatively impact a project, investment, or business decision. It
helps in understanding the likelihood and consequences of uncertain events.

b) What is Sensitivity Analysis?

Sensitivity analysis studies how the variation in key input variables affects the
outcome of a financial model or decision. It shows which variables have the
most impact on results, helping in risk assessment.
c) Define Capital Structure
Capital structure refers to the mix of debt, equity, and other securities that a
company uses to finance its operations and growth.

d) What do you mean by Bonus Issue?

A bonus issue is when a company issues additional shares to existing
shareholders for free, usually as a way to distribute retained earnings without
paying cash dividends.

e) What is a Stock Dividend?

A stock dividend is a dividend paid to shareholders in the form of additional
shares rather than cash.

f) What is Factoring?
Factoring is a financial service where a business sells its accounts receivable
(invoices) to a third party (factor) at a discount to get immediate cash.

g) What is Aging Schedule?

An aging schedule is a table that categorizes accounts receivable based on the
length of time they have been outstanding, helping businesses manage credit
risk and collections.

2018
1. a) What is meant by Unsystematic Risk? Give an example.
Unsystematic risk is the risk specific to a particular company or industry, which
can be reduced or eliminated through diversification.
Example: A strike in a company’s factory or a sudden failure of a product
launch.
b) Distinguish between Risk and Uncertainty

Aspect Risk Uncertainty

Situation where probabilities of

Situation where outcomes and
Definition outcomes are known or can be
probabilities are unknown
estimated

Nature Measurable and quantifiable Not measurable

Impact of a new technology on

Example Stock price fluctuation
industry

c) What is Specific Cost of Capital?

Specific cost of capital is the cost of a particular source of finance, such as the
cost of debt, cost of equity, or cost of preference shares.

d) What is a Stock Dividend?

A stock dividend is a dividend paid to shareholders in the form of additional
shares instead of cash.

e) What do you mean by Dividend Policy?

Dividend policy is a company’s approach to distributing profits to shareholders,
deciding the amount and timing of dividend payments.

f) What is an Ageing Schedule?

An aging schedule is a report that categorizes a company’s accounts receivable
based on the length of time invoices have been outstanding, helping to assess
credit risk.

g) Annual requirement is 1,00,000 units, cost of placing order is ₹10, carrying

cost per annum is 6% of inventory. Calculate Economic Order Quantity (EOQ).
Given:
 Annual demand (D) = 1,00,000 units
 Ordering cost (S) = ₹10 per order
 Carrying cost rate (C%) = 6% per annum
 Cost per unit (assumed as ₹1 for calculation, since carrying cost is % of
inventory cost)
Carrying cost per unit per year (H) = 6% of cost per unit = 0.06 × ₹1 = ₹0.06
EOQ formula:

4 MARKS
1. Explain the forms of dividend.
 Cash Dividend: This is the most common form where the company
distributes profits directly as cash to shareholders. It provides immediate
liquidity and is often seen as a sign of a financially healthy company.
 Stock Dividend: Instead of cash, shareholders receive additional shares.
This increases the number of shares owned but does not change the
total value immediately. Useful when the company wants to conserve
cash.
 Property Dividend: Sometimes, companies distribute physical assets or
property to shareholders. This is less common and usually involves assets
not needed by the business.
  Scrip Dividend: This is a promissory note issued to shareholders that
promises payment at a future date. Useful when the company faces
temporary cash flow issues.
 Liquidating Dividend: This is a return of capital to shareholders when a
company is winding up or selling part of its assets. It reduces the
company’s capital base.
 Interim Dividend: Paid before the final financial results are announced,
typically during the financial year to provide early returns.
 Final Dividend: Declared after the company’s annual accounts are
finalized, based on actual profits earned.

2. State any four importance of ethics and governance in corporate finance.

 Ensures Transparency: Ethical governance requires that financial
information is presented honestly and clearly, preventing
misinformation.
 Builds Trust: Investors and stakeholders rely on ethical conduct to make
decisions, fostering confidence in the company’s management.
 Prevents Fraud: A strong ethical framework reduces the risk of
fraudulent activities that can harm the company’s reputation and
finances.
 Enhances Reputation: Companies known for ethical governance attract
better investors, customers, and employees, helping long-term success.
 Promotes Accountability: Ethical standards hold management
responsible for their actions, ensuring decisions benefit the company as
a whole.
 Supports Compliance: Ethical governance aligns company practices with
legal requirements, reducing risks of penalties and litigation.
 Encourages Responsible Decision-making: It helps prioritize social and
environmental concerns alongside profit, leading to sustainable growth.
3. Explain the ethical issues in financial management.
 Insider Trading: Using confidential company information to trade
securities is illegal and unethical as it creates unfair advantages.
 Misrepresentation of Financial Data: Altering financial statements to
appear more profitable misleads investors and creditors.
 Conflict of Interest: When managers prioritize personal gains over
company interests, it undermines trust and can harm company value.
 Bribery and Corruption: Paying or receiving bribes compromises fair
business practices and can lead to legal consequences.
 Disclosure Issues: Failure to provide complete and timely information to
stakeholders leads to poor decision-making and loss of confidence.
 Fair Treatment of Shareholders: Ensuring all shareholders have equal
access to information and benefits avoids favoritism.
 Social Responsibility: Ethical financial management balances profit-
making with environmental protection and social welfare.

4. Briefly explain the motives of Merger.

 Synergy: Combining companies often creates value greater than the sum
of individual firms by sharing resources and eliminating redundancies.
 Diversification: Mergers enable companies to spread risk by entering
new markets or industries, reducing dependency on one sector.
 Growth: Merging can be faster than organic expansion, allowing firms to
increase their scale and market presence rapidly.
 Market Power: Mergers can increase bargaining power with suppliers
and customers and reduce competition.
 Economies of Scale: Larger operations lower per-unit costs by spreading
fixed costs over more output.
 Tax Benefits: Firms can use losses or deductions from one entity to
reduce overall tax liability.
  Financial Leverage: A combined entity may access financing more easily
or on better terms, improving capital structure.

5. What is sensitivity analysis? Explain the relevance in project appraisal.

 Sensitivity analysis examines how the variation in key input variables
(like sales volume, costs, or discount rates) affects project outcomes such
as Net Present Value (NPV) or Internal Rate of Return (IRR).
 It helps identify the most critical variables influencing the success of a
project, showing which assumptions need careful monitoring.
 The method aids in assessing the risk and uncertainty inherent in project
forecasts, guiding managers to prepare contingency plans.
 Sensitivity analysis improves decision-making by illustrating the
robustness of the project under different scenarios, making it easier to
reject or accept projects based on risk tolerance.
 It also helps communicate project risks clearly to stakeholders, ensuring
better alignment of expectations.

6. Describe the different types of costs.

 Fixed Costs: These costs remain constant regardless of output levels,
such as rent, salaries, or insurance. They provide stability but can be
burdensome if sales drop.
 Variable Costs: Costs that vary directly with production, such as raw
materials or direct labor. They fluctuate with sales and affect profit
margins directly.
 Semi-variable Costs: Costs with both fixed and variable components, like
electricity bills that have a base charge plus usage fees.
 Direct Costs: Easily traceable to a specific product or service, for
example, the raw materials used in manufacturing.
 Indirect Costs: Expenses that cannot be directly linked to production,
such as administrative overheads or utilities.
  Sunk Costs: Past expenditures that cannot be recovered and should not
influence future decisions.
 Opportunity Costs: The value of the next best alternative foregone when
making a decision, important for evaluating true cost.

7. Explain any five types of risks.

 Business Risk: The possibility that operating income will fluctuate due to
market demand, competition, or operational inefficiencies.
 Financial Risk: Risk arising from the use of debt financing; higher
leverage means greater risk of bankruptcy if obligations are not met.
 Market Risk: Risks due to fluctuations in market variables like stock
prices, interest rates, or exchange rates affecting asset values.
 Credit Risk: The chance that borrowers or counterparties fail to meet
their financial obligations, leading to losses.
 Liquidity Risk: The risk that a company cannot quickly convert assets to
cash without significant loss, potentially impairing operations.
 Inflation Risk: The erosion of purchasing power of money over time,
impacting real returns on investments.
 Political Risk: Uncertainty due to changes in government policies,
political instability, or expropriation affecting business operations.

8. Explain the importance of risk management.

 Effective risk management helps protect a company’s assets and
earnings from unexpected adverse events, reducing potential losses.
 It ensures business continuity by identifying risks early and putting
mitigation plans in place.
 Helps maintain stable cash flows and profits, which is crucial for
valuation and attracting investors.
  Enables management to make informed decisions by quantifying and
prioritizing risks.
 Enhances stakeholder confidence as shareholders and creditors see the
firm as responsibly managed.
 Supports compliance with regulatory requirements, avoiding legal
penalties.
 Facilitates strategic planning, allowing firms to take calculated risks that
lead to growth and competitive advantage.

9. Describe what is weighted average cost of capital (WACC).

 WACC is the average cost a firm pays to finance its operations through
debt, equity, and preference shares, weighted by their respective
proportions in the firm’s capital structure.
 It reflects the minimum return a company must earn on its investments
to satisfy its investors and lenders.
 Cost of debt is adjusted for tax benefits since interest expenses are tax-
deductible, lowering the effective cost.
 Cost of equity reflects the return expected by shareholders, typically
estimated through models like CAPM or dividend growth.
 WACC is widely used as a discount rate in capital budgeting to evaluate
project feasibility.
 A lower WACC implies cheaper financing, increasing the firm’s valuation
and competitive edge.
 Formula:
WACC=EV×Ke+DV×Kd×(1−T)WACC = \frac{E}{V} \times K_e + \frac{D}{V} \times
K_d \times (1-T)WACC=VE×Ke+VD×Kd×(1−T)
Where E = market value of equity, D = market value of debt, V = total capital,
KeK_eKe = cost of equity, KdK_dKd = cost of debt, T = tax rate.
10. Analyse the significance of dividend policy.
 Dividend policy sends signals to the market about a company’s financial
health; stable or increasing dividends often indicate confidence in future
earnings.
 It influences the company’s stock price and investor satisfaction,
affecting liquidity and market perception.
 Balances between distributing profits to shareholders and retaining
earnings for reinvestment and growth.
 A stable dividend policy reduces uncertainty, attracting long-term
investors who seek steady income.
 Dividend decisions impact the cost of capital; high dividends might
reduce funds available internally, increasing reliance on external
financing.
 Helps in maintaining financial flexibility, ensuring the company can
meet future investment needs without financial distress.
 Good dividend policy supports shareholder value maximization by
aligning management decisions with shareholder interests.
11. What is EOQ of materials? Write any four assumptions of EOQ model.
 EOQ (Economic Order Quantity) is the optimal order size that minimizes
the total inventory costs, which include ordering costs and holding costs.
It balances the cost of ordering frequently against the cost of holding
large inventories.
 EOQ helps companies avoid both excess inventory and stockouts,
ensuring smooth production and sales operations.
Four assumptions of EOQ model:
1. Constant demand: The demand for the inventory item is known and
remains constant over time.
2. Constant lead time: The time between placing an order and receiving it
is fixed and does not vary.
 3. No stockouts: The model assumes inventory is replenished before it runs
out, so shortages or backorders are not allowed.
4. Constant ordering and holding costs: The costs of ordering and carrying
inventory per unit are constant and do not change with order size or
time.
5. Instantaneous replenishment: The entire order quantity is received at
once, not in parts or over time.

12. Briefly explain the guidelines for Corporate valuation.

 Assess Financial Performance: Review historical financial statements for
profitability, cash flow stability, and growth trends to understand the
firm’s earning capacity.
 Analyze Market Conditions: Consider industry trends, competitor
performance, and economic factors that affect the company’s future
outlook.
 Choose Valuation Approach: Decide between asset-based, income-
based (discounted cash flow), or market-based (comparable companies)
approaches depending on the company and available data.
 Adjust for Risks: Incorporate risk factors like business, financial, and
market risks into valuation models by adjusting discount rates or
projections.
 Consider Intangibles: Include brand value, intellectual property,
customer loyalty, and management quality, which impact the company’s
long-term value.
 Use Multiple Methods: Cross-verify valuation results from different
methods to arrive at a reasonable and defendable estimate.
 Transparency: Clearly document assumptions, methods, and sources
used to ensure valuation credibility.

13. Explain the different techniques of measuring risks.

  Sensitivity Analysis: Tests how changes in key variables affect project
outcomes, identifying which factors are most influential.
 Risk-Adjusted Discount Rate: Adjusts the discount rate to reflect the risk
level, higher risk projects use higher rates to reduce present value.
 Certainty Equivalent Approach: Converts uncertain cash flows into
certain equivalents by discounting the risk premium separately, allowing
risk-free discounting.
 Probability Analysis: Assigns probabilities to different outcomes and
calculates expected values to account for uncertainty in decision-making.
 Standard Deviation and Coefficient of Variation: Measures the
variability and relative risk of returns, with higher values indicating
greater risk.
 Decision Tree Analysis: A graphical method that maps out possible
decisions and outcomes, including probabilities, to evaluate complex
choices under uncertainty.

14. Write the assumptions and arguments of MM Model.

 Assumptions:
1. No taxes or bankruptcy costs exist.
2. Capital markets are perfect with no transaction costs.
3. Investors and firms can borrow at the same risk-free rate.
4. Firms’ investment decisions are not affected by capital structure.
5. All investors have homogeneous expectations.
 Arguments:
o MM Proposition I (without taxes) states that the value of a firm is
independent of its capital structure — debt or equity mix does
not affect firm value.
 o MM Proposition II argues that the cost of equity increases linearly
with leverage due to higher financial risk, but the weighted
average cost of capital (WACC) remains constant.
o With corporate taxes, MM suggests that debt financing provides a
tax shield, increasing firm value by the present value of tax
savings.
o The model emphasizes that leverage increases financial risk but
the overall cost of capital is unaffected without taxes.

15. Write the importance of capital structure.

 Capital structure affects a firm’s financial flexibility, determining its
ability to raise funds during expansion or downturns.
 Influences the cost of capital, impacting the firm’s investment decisions
and valuation. An optimal capital structure minimizes WACC.
 Affects risk and return for both shareholders and creditors, balancing
between debt and equity to achieve desired financial stability.
 Impacts the control of ownership, as issuing equity dilutes existing
shareholders, whereas debt does not.
 Determines the company’s ability to weather economic cycles; higher
debt means higher fixed obligations increasing default risk in downturns.
 Helps in tax planning, as interest payments on debt are tax-deductible,
providing tax benefits.
 Influences market perception and credit ratings, affecting future
borrowing costs and investor confidence.

16. What is working capital? Explain the factors determining working capital.
 Working capital is the difference between a company’s current assets
and current liabilities. It represents the funds available for day-to-day
operations.
  Positive working capital ensures smooth business operations and
liquidity to meet short-term obligations.
Factors determining working capital:
 Nature of Business: Manufacturing firms require more working capital
than trading companies due to inventory needs.
 Business Cycle: During peak seasons, working capital needs increase to
support higher sales.
 Production Cycle: Longer production times require more working capital
to finance raw materials and work-in-progress.
 Credit Policy: Liberal credit terms to customers increase receivables,
raising working capital requirements.
 Operating Efficiency: Efficient management reduces inventory and
receivables, lowering working capital needs.
 Growth and Expansion: Rapid growth demands more working capital to
support increased operations.
 Availability of Raw Materials: Supply reliability affects inventory levels
and working capital.
 Profitability: Profitable firms can generate internal funds reducing the
need for external working capital.

17. What do you mean by business valuation? Explain the elements of

business valuation.
 Business valuation is the process of determining the economic value of a
company or business unit. It is used for mergers, acquisitions, sale, or
investment decisions.
Elements of business valuation:
 Assets: Includes tangible (property, machinery) and intangible assets
(patents, brand value) that contribute to value.
  Earnings: Past and projected profits or cash flows indicating the firm’s
ability to generate returns.
 Growth Potential: Expected future growth rates impacting future
earnings and valuation.
 Market Conditions: Economic and industry factors that influence
demand and competition.
 Risk: Business and financial risks that affect the reliability of earnings and
cash flows.
 Capital Structure: The mix of debt and equity impacts cost of capital and
risk profile.
 Management Quality: The capability and experience of the management
team to execute strategies and create value.

18. Explain net operating income approach.

 The Net Operating Income (NOI) Approach states that the value of the
firm is independent of its capital structure (debt vs equity mix).
 It assumes that the cost of debt is constant and debt increases financial
risk, which raises the cost of equity proportionally.
 As a result, the weighted average cost of capital (WACC) remains
constant, so the total firm value does not change with leverage.
 This approach contrasts with the net income approach, which suggests
that increasing debt lowers WACC and increases firm value.
 The NOI model emphasizes that leverage only redistributes risk between
debt and equity holders, without affecting overall value.

19. What are the assumptions of Walter's dividend model? Explain its
shortcomings.
 Assumptions:
 1. The firm’s rate of return on investment (r) and cost of equity (ke)
are constant and known.
2. The firm finances all investments through retained earnings (no
new equity or debt).
3. Dividends paid do not affect the firm’s cost of capital.
4. Investors are indifferent between dividends and capital gains.
5. The firm operates in a perfect capital market without taxes or
transaction costs.
 Shortcomings:
o Unrealistic assumption that retained earnings are the only source
of finance, ignoring debt or new equity.
o Assumes constant and known rates of return and cost of equity,
which may vary in reality.
o Does not consider taxes or market imperfections.

o Assumes dividends do not affect the firm’s value or cost of capital,

which may not hold in practice.
o Ignores investor preferences for dividends versus capital gains,
which can vary.

20. What is EOQ? What are the different methods of EOQ? Discuss the
importance of relative valuation approach.
 EOQ is the Economic Order Quantity, the order size minimizing the total
cost of inventory—ordering plus holding costs.
Different methods to calculate EOQ:
 Basic EOQ Formula: Uses annual demand, ordering cost per order, and
holding cost per unit to compute the optimal order size.
 Quantity Discount EOQ: Adjusts EOQ for price breaks on bulk purchases,
balancing cost savings with holding costs.
  Probabilistic EOQ: Considers uncertainty in demand or lead time,
incorporating safety stock into calculations.
Importance of relative valuation approach:
 Relative valuation compares a business’s value to similar companies
using multiples like P/E, P/B, or EV/EBITDA.
 It provides a market benchmark reflecting investor sentiment and
industry trends.
 Useful for quick valuations when detailed financial data is limited.
 Helps identify undervalued or overvalued companies relative to peers.
 Assists in pricing mergers, acquisitions, and investment decisions based
on comparable transactions.
 Easy to understand and apply, making it popular in practical scenarios.
21. What are the pros and cons of using dividend growth model approach to
calculate the cost of equity?
Pros:
 Simple and intuitive: The model is easy to understand and apply as it
uses dividend payments and expected growth rates.
 Based on actual cash flows: Uses expected dividends, which represent
real returns to shareholders.
 Widely used: Commonly accepted in finance, especially for companies
with stable dividend policies.
Cons:
 Assumes constant growth: The model requires a constant dividend
growth rate, which is unrealistic for many firms.
 Not suitable for non-dividend-paying firms: Firms that do not pay
dividends cannot be valued using this method.
 Sensitive to growth rate estimation: Small errors in estimating the
growth rate can significantly affect the cost of equity.
  Ignores capital gains explicitly: Although growth is implied, it doesn't
separately consider changes in stock price due to other factors.
 Less useful in volatile markets: Dividend policies may change frequently,
reducing model reliability.

22. Write note on sensitivity analysis as a method of measuring risk.

 Sensitivity analysis evaluates how changes in key input variables affect
the outcome of a financial model or project appraisal.
 It identifies the most critical variables by testing one variable at a time,
keeping others constant, to see its impact on project returns or net
present value.
 Helps managers understand which assumptions are risky and require
careful monitoring or control.
 Supports decision-making by highlighting potential areas of vulnerability.
 Limitations include ignoring interactions between variables and focusing
only on one variable at a time.
 Despite limitations, it is a simple, widely used tool to assess project risk
qualitatively.

23. Write note on concept of working capital.

 Working capital refers to the funds a company uses to manage its short-
term day-to-day operations. It is calculated as current assets minus
current liabilities.
 It ensures liquidity, allowing the firm to meet its short-term obligations
such as paying suppliers, employees, and creditors.
 Adequate working capital prevents business interruptions caused by cash
shortages.
 Working capital management involves balancing inventory levels,
receivables, and payables to optimize operational efficiency.
  Too much working capital leads to unnecessary investment and reduced
profitability, while too little increases liquidity risk.
 Proper management is crucial for sustaining business growth and
solvency.
24. Explain the different techniques of measuring risks.
 Sensitivity Analysis: Measures how the variation in one input variable
affects the output of a project or investment, keeping other variables
constant. Helps identify the most sensitive variables.
 Scenario Analysis: Examines the impact of different combined sets of
variables or scenarios (best case, worst case, most likely) on project
outcomes. Provides a broader view of risk.
 Probability Analysis: Uses statistical probabilities assigned to different
outcomes or events to assess expected returns and risks.
 Standard Deviation: Measures the variability or dispersion of returns
from the mean; higher values indicate higher risk.
 Coefficient of Variation (CV): Standard deviation divided by the mean;
useful to compare risk across projects with different expected returns.
 Decision Tree Analysis: Uses a tree-like model to represent decisions,
chance events, and outcomes; helps analyze complex risk scenarios with
multiple stages.

25. Write the assumptions and arguments of MM Model.

 Assumptions:
o No taxes, bankruptcy costs, or transaction costs.
o Investors and firms can borrow/lend at the same risk-free rate.
o Symmetric information: all investors have the same information.
o Firms’ investment decisions are fixed and independent of capital
structure.
 Arguments:
 o The value of a firm is independent of its capital structure (debt vs
equity mix).
o Capital structure does not affect the overall cost of capital.
o Leverage increases the risk and return to equity holders but does
not affect firm value.
o Changes in debt and equity proportions only redistribute risk
among investors.

26. Write the importance of capital structure.

 Optimizes Cost of Capital: Proper capital structure minimizes the overall
cost of capital, improving firm value.
 Risk Management: Balances the use of debt and equity to manage
financial risk and solvency.
 Financial Flexibility: Provides options for raising funds in the future as
per business needs.
 Tax Benefits: Debt interest is tax-deductible, reducing taxable income
and enhancing value.
 Control Considerations: Equity financing may dilute control; debt may
help owners retain control.
 Market Perception: Capital structure signals financial health and affects
investor confidence.

27. What is working capital? Explain the factors determining working capital.
 Working Capital: The difference between current assets and current
liabilities; funds available for daily operations.
 Factors Determining Working Capital:
o Nature of Business: Manufacturing firms need more working
capital than trading firms.
 o Business Cycle: Seasonal industries require more during peak
seasons.
o Production Cycle: Longer production cycles need higher working
capital.
o Credit Policy: Liberal credit to customers increases receivables and
working capital needs.
o Operating Efficiency: Efficient management reduces inventory and
receivables, lowering working capital.
o Growth and Expansion: Growing firms require more working
capital to support increased operations.

28. What do you mean by business valuation? Explain the elements of

business valuation.
 Business Valuation: The process of determining the economic value of a
business or company. It helps in mergers, acquisitions, sale, or
investment decisions.
 Elements of Business Valuation:
o Asset Valuation: Value of tangible and intangible assets owned by
the business.
o Earnings Valuation: Future earning capacity or profitability of the
business.
o Market Value: Value based on comparable companies or market
transactions.
o Discount Rate: Rate used to discount future cash flows to present
value, reflecting risk.
o Liabilities: Obligations that reduce the overall value of the
business.
o Growth Prospects: Expected growth rates influencing future
income and value.
29. Explain net operating income approach.
 The Net Operating Income (NOI) Approach assumes that the value of
the firm is independent of its capital structure.
 Changes in leverage do not affect the overall cost of capital or the firm’s
value.
 The cost of equity rises linearly with increased debt to compensate for
higher risk.
 The weighted average cost of capital (WACC) remains constant regardless
of debt-equity mix.
 This theory contrasts with the net income approach and MM theory and
considers the risk associated with both debt and equity.

30. What are the assumptions of Walter's dividend model? Explain its
shortcomings.
 Assumptions:
o The firm’s internal rate of return (r) and cost of equity (ke) are
constant.
o The firm finances all investments through retained earnings.
o Dividend payments and reinvestments are the only factors
affecting share price.
o Investors have homogeneous expectations regarding returns.
 Shortcomings:
o Unrealistic constant rate assumptions.
o Ignores external financing and other capital market imperfections.
o Assumes dividends are the only source of value to shareholders.
o Not suitable for firms that pay no or irregular dividends.
o Overly simplistic in ignoring risk and market factors.
31. What is EOQ? Write any four assumptions of EOQ model.
 Economic Order Quantity (EOQ): The optimal order quantity that
minimizes total inventory costs, including ordering and carrying costs.
 Assumptions:
o Demand is constant and known.
o Ordering cost per order is fixed.
o Carrying cost is proportional to inventory held.
o Lead time is constant and known.
o No stockouts or shortages allowed.

12 MARKS
1. Explain briefly about the Merger process.
1. Identification of Target Company: The acquiring company identifies a
suitable firm for merger based on strategic fit, financial health, and
market position.
2. Preliminary Negotiations: Initial talks take place between the two
companies to explore interest and compatibility.
3. Due Diligence: A thorough investigation of the target company’s
financials, operations, legal matters, and liabilities to assess risks and
benefits.
4. Valuation of Companies: Both companies are valued using various
methods to determine a fair exchange ratio.
5. Agreement on Terms: Parties negotiate the terms of the merger,
including share exchange ratio, management structure, and financial
arrangements.
6. Approval from Board of Directors: Both companies’ boards must
approve the merger agreement.
 7. Regulatory Approvals: Required permissions from government and
regulatory authorities like SEBI or competition commission are obtained.
8. Shareholder Approval: Shareholders of both companies vote to approve
the merger proposal.
9. Merger Scheme Drafting: Legal documents detailing the terms,
conditions, and modalities of the merger are prepared.
[Link] of Merger: Execution of the merger as per approved
scheme, combining assets, liabilities, and operations.
[Link]-Merger Integration: Combining the organizational culture, systems,
and processes of the merged entities.
[Link] to Stakeholders: Informing employees, customers,
suppliers, and market about the merger.
[Link] and Evaluation: Continuous assessment of merger success
and resolving integration issues.

2. Explain briefly the Relationship Theory. Explain briefly its components.

1. Introduction: Relationship Theory explains the capital structure as a
function of the relationship between the firm's operating income and its
capital cost.
2. Core Idea: The theory suggests an optimal capital structure exists where
the cost of capital is minimized, and firm value is maximized.
3. Cost of Debt: As debt increases, the cost of debt rises due to higher
financial risk.
4. Cost of Equity: With more debt, equity holders demand higher returns
due to increased risk.
5. Weighted Average Cost of Capital (WACC): Initially decreases with debt
but after a point starts rising.
6. Indifference Point: The point where changes in capital structure do not
affect the firm's value.
 7. Business Risk and Financial Risk: Differentiates operating (business) risk
and financial risk impacting capital structure.
8. Components of Relationship Theory:
o Cost of Debt (Kd)
o Cost of Equity (Ke)
o Weighted Average Cost of Capital (WACC)
o Total Risk (Operating + Financial)
9. Optimal Capital Structure: Exists at minimum WACC.
[Link] Relevance: Helps firms plan debt and equity mix strategically.
[Link]: No taxes, efficient markets.
[Link]: Ignores taxes and bankruptcy costs.
[Link]: It bridges Net Income and Net Operating Income approaches
by considering changing costs of capital.

3. Briefly explain the following capital structure theories:

a) Net Income (NI) Approach
1. Basic Idea: Capital structure affects firm value; lower cost of debt
reduces overall cost.
2. Assumptions: Cost of debt is constant, cost of equity rises with leverage.
3. Implication: Increasing debt increases firm value due to cheaper debt
cost.
4. Optimal Capital Structure: Maximum debt with minimum cost.
5. Criticism: Unrealistic assumption of constant cost of debt.
b) Modigliani and Miller (MM) Approach
1. Proposition I (Without Taxes): Value of the firm is independent of capital
structure.
 2. Proposition II (Without Taxes): Cost of equity increases linearly with
debt to compensate risk.
3. With Taxes: Interest is tax-deductible, so debt increases firm value.
4. Assumptions: No bankruptcy costs, perfect markets.
5. Significance: Shows leverage effects and irrelevance of capital structure
under perfect conditions.
6. Criticism: Real markets have taxes, bankruptcy costs, and asymmetric
information.
7. Application: Provides base for modern capital structure theories.

4. What is working capital? Explain briefly the various factors affecting

working capital.
1. Definition: Working Capital = Current Assets - Current Liabilities;
represents liquidity available for day-to-day operations.
2. Importance: Ensures smooth business operations, meets short-term
obligations.
3. Factors affecting Working Capital:
o Nature of Business: Manufacturing firms require more working
capital than trading firms.
o Business Cycle: Expansion requires more working capital.
o Production Cycle: Longer production processes increase working
capital needs.
o Credit Policy: Lenient credit to customers increases receivables
and working capital.
o Inventory Policy: High inventory levels increase working capital.
o Growth and Expansion: Growing firms need more working capital.
o Operating Efficiency: Efficient management reduces working
capital requirements.
 o Seasonal Factors: Seasonal businesses need higher working capital
in peak periods.
o Terms of Purchase and Sales: Longer credit period from suppliers
reduces working capital needs.
o Inflation: Inflation increases costs and working capital.
o Technology: Automation reduces working capital needs.
o Financial Policies: Aggressive or conservative financing impacts
working capital.

5. What is dividend policy? Explain the various factors affecting dividend

policy.
1. Definition: Dividend policy refers to a company’s approach to
distributing profits to shareholders as dividends.
2. Importance: Balances between reinvestment and shareholder returns.
3. Factors Affecting Dividend Policy:
o Profitability: Higher profits lead to higher dividends.
o Stability of Earnings: Firms with stable earnings pay regular
dividends.
o Growth Opportunities: Firms with high growth retain earnings for
reinvestment.
o Cash Flow Position: Dividends depend on availability of cash.
o Taxation Policy: Tax rates on dividends influence payout decisions.
o Access to Capital Markets: Firms with easy access to funds may
pay higher dividends.
o Legal Constraints: Laws regulating minimum reserves and dividend
payments.
o Market Expectations: Companies maintain dividend stability to
meet market expectations.
 o Inflation: High inflation may reduce dividends to retain capital.
o Debt Obligations: Debt covenants may restrict dividend payments.
o Control Considerations: Retaining earnings can reduce dilution of
ownership.
o Industry Practices: Norms within industries influence dividend
behavior.

6. Elucidate the valuation of debentures in detail.

1. Definition: Valuation of debentures means determining the present
worth of future cash flows from debentures.
2. Cash Flows: Interest payments (coupons) and principal repayment.
3. Types of Debentures: Convertible, Non-convertible, Redeemable,
Irredeemable.
4. Valuation Formula: Present value of interest + Present value of principal
discounted at required rate of return.
5. Factors Influencing Valuation:
o Coupon rate vs market rate
o Time to maturity
o Creditworthiness of issuer
o Interest rate fluctuations
o Tax implications
6. Methods of Valuation:
o Yield to Maturity Method
o Present Value Method
o Current Yield Method
7. Impact of Market Interest Rates: If market rates rise, debenture prices
fall, and vice versa.
 8. Call and Put Provisions: Affect valuation by allowing early redemption or
sale.
9. Risk Factors: Default risk and liquidity risk affect valuation.
[Link]: Helps investors decide on purchase or sale and assess
investment value.
[Link] Calculation: Using discounting techniques.
[Link]: Assumes fixed cash flows and market efficiency.

7. Explain the factors which influence the dividend decision of a firm.

(Repeated from dividend policy question)

8. Explain various situations which may call for a formal business valuation.
1. Mergers and Acquisitions: To determine fair value of target companies.
2. Raising Capital: To set share prices for issuing new equity or debt.
3. Sale or Purchase of Business: To negotiate price.
4. Legal and Taxation Purposes: For inheritance tax, divorce settlements, or
litigation.
5. Financial Reporting: For impairment testing and goodwill valuation.
6. Management Buyouts: To assess value of firm’s shares.
7. Strategic Planning: To evaluate business worth for growth decisions.
8. Shareholder Disputes: For buyout or settlement.
9. Bankruptcy or Liquidation: To estimate liquidation value.
[Link] Requirements: For disclosures and compliance.
[Link] Stock Option Plans: To set option exercise prices.
[Link] Planning: To plan transfer of ownership.
9. Describe different methods of valuation of intangible assets at the time of
merger.
1. Cost Method: Based on historical or replacement cost of intangible
assets.
2. Market Method: Comparing with similar intangible assets sold in the
market.
3. Income Method: Based on present value of expected future earnings
from intangible assets.
4. Relief from Royalty Method: Valuation based on royalties saved by
owning the asset.
5. Excess Earnings Method: Earnings attributable to intangible assets after
deducting returns on tangible assets.
6. Option Pricing Method: Treats intangible as an option on future
earnings.
7. Benefits: Helps determine goodwill and fair value in mergers.
8. Challenges: Intangibles are subjective, hard to quantify.
9. Importance in Merger: Accurate valuation affects purchase price and
goodwill.
[Link]: Patents, trademarks, copyrights, brand names.
[Link]: Required for legal and accounting compliance.
[Link]: Estimates vary due to assumptions and market conditions.

10. What factors have an important bearing on working capital needs?

Explain.
(Repeated from working capital factors question)

11. Explain the factors stimulating interest in value-based management.

1. Maximizing Shareholder Wealth: Focus on long-term value creation over
short-term profits.
2. Competitive Markets: Pressure to improve operational efficiency and
profitability.
3. Globalization: Need to compete internationally with value-driven
strategies.
4. Corporate Governance: Emphasis on transparency and accountability.
5. Investor Expectations: Demand for sustainable growth and risk
management.
6. Technological Changes: Adoption of value-based performance
measurement tools.
7. Mergers and Acquisitions: Use of value metrics for deal evaluation.
8. Capital Market Pressures: Need for better disclosure and market
valuation.
9. Risk Management: Integration of risk with value creation.
[Link] Decision Making: Aligning projects with value maximization.
[Link] Measurement: Moving beyond traditional accounting
profits.
[Link] Environment: Compliance with value-based reporting
standards.