INDEX

S. NO. CHAPTERS NAME PAGE NO.

1 SCOPE & OBJECTIVES OF FINANCIAL MANAGEMENT 1.1 – 1.8

2 TYPES OF FINANCING 2.1 – 2.15

3 RATIO ANALYSIS 3.1 – 3.7

4 COST OF CAPITAL 4.1 – 4.3

5 FINANCING DECISIONS – CAPITAL STRUCTURE 5.1 – 5.7

6 FINANCING DECISIONS – LEVERAGES 6.1 – 6.4

7 INVESTMENT DECISIONS OR CAPITAL BUDGETING 7.1 – 7.7

8 DIVIDEND DECISIONS 8.1 – 8.6

9 MANAGEMENT OF WORKING CAPITAL 9.1 – 9.11

 CHAPTER 1 SCOPE & OBJECTIVES OF FINANCIAL MANAGEMENT

CHAPTER 1 SCOPE & OBJECTIVES OF FINANCIAL MANAGEMENT

Question 1
Explain two basic functions of Financial Management.

Answer
Two Basic Functions of Financial Management
1. Procurement of Funds:
Funds can be obtained from different sources having different characteristics in terms of risk, cost and
control. The funds raised from the issue of equity shares are the best from the risk point of view since
repayment is required only at the time of liquidation. However, it is also the most costly source of finance
due to dividend expectations of shareholders. On the other hand, debentures are cheaper than equity
shares due to their tax advantage. However, they are usually riskier than equity shares. There are thus
risk, cost and control considerations which a finance manager must consider while procuring funds. The
cost of funds should be at the minimum level for that a proper balancing of risk and control factors must
be carried out.

2. Effective Utilization of Funds:

The Finance Manager has to ensure that funds are not kept idle or there is no improper use of funds. The
funds are to be invested in a manner such that they generate returns higher than the cost of capital to
the firm. Besides this, decisions to invest in fixed assets are to be taken only after sound analysis using
capital budgeting techniques. Similarly, adequate working capital should be maintained so as to avoid
the risk of insolvency.

Question 2
Differentiate between Financial Management and Financial Accounting.

Answer
Differentiation between Financial Management and Financial Accounting:
Though financial management and financial accounting are closely related, still they differ in the
treatment of funds and also with regards to decision - making.

Treatment of Funds: In accounting, the measurement of funds is based on the accrual principle. The
accrual based accounting data do not reflect fully the financial conditions of the organisation. An
organisation which has earned profit (sales less expenses) may said to be profitable in the accounting
sense but it may not be able to meet its current obligations due to shortage of liquidity as a result of say,
uncollectible receivables. Whereas, the treatment of funds, in financial management is based on cash
flows. The revenues are recognised only when cash is actually received (i.e. cash inflow) and expenses
are recognised on actual payment (i.e. cash outflow). Thus, cash flow based returns help financial
managers to avoid insolvency and achieve desired financial goals.

Decision-making: The chief focus of an accountant is to collect data and present the data while the
financial manager’s primary responsibility relates to financial planning, controlling and decision

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 SCOPE & OBJECTIVES OF FINANCIAL MANAGEMENT CHAPTER 1

making.
Thus, in a way it can be stated that financial management begins where financial accounting ends.

Question 3
Write short notes on the following:

1. Inter relationship between investment, financing and dividend decisions.

2. Finance function

Answer
1. Inter-relationship between Investment, Financing and Dividend Decisions:
The finance functions are divided into three major decisions, viz., investment, financing and dividend
decisions. It is correct to say that these decisions are inter-related because the underlying objective of
these three decisions is the same, i.e. maximisation of shareholders’ wealth. Since investment, financing
and dividend decisions are all interrelated, one has to consider the joint impact of these decisions on the
market price of the company’s shares and these decisions should also be solved jointly. The decision to
invest in a new project needs the finance for the investment. The financing decision, in turn, is influenced
by and influences dividend decision because retained earnings used in internal financing deprive
shareholders of their dividends. An efficient financial management can ensure optimal joint decisions.
This is possible by evaluating each decision in relation to its effect on the shareholders’ wealth. The
above three decisions are briefly examined below in the light of their inter-relationship and to see how
they can help in maximising the shareholders’ wealth i.e. market price of the company’s shares.

Investment decision: The investment of long term funds is made after a careful assessment of the
various projects through capital budgeting and uncertainty analysis. However, only that investment
proposal is to be accepted which is expected to yield at least so much return as is adequate to meet its
cost of financing. This have an influence on the profitability of the company and ultimately on its wealth.

Financing decision: Funds can be raised from various sources. Each source of funds involves different
issues. The finance manager has to maintain a proper balance between long-term and short-term funds.
With the total volume of long-term funds, he has to ensure a proper mix of loan funds and owner’s funds.
The optimum financing mix will increase return to equity shareholders and thus maximise their wealth.

Dividend decision: The finance manager is also concerned with the decision to pay or declare dividend.
He assists the top management in deciding as to what portion of the profit should be paid to the
shareholders by way of dividends and what portion should be retained in the business. An optimal
dividend pay-out ratio maximises shareholders’ wealth.

The above discussion makes it clear that investment, financing and dividend decisions are interrelated
and are to be taken jointly keeping in view their joint effect on the shareholders’ wealth.

2. Finance Function:
The finance function is most important for all business enterprises. It remains a focus of all activities. It
starts with the setting up of an enterprise. It is concerned with raising of funds, deciding the cheapest
source of finance, utilization of funds raised, making provision for refund when money is not required

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 CHAPTER 1 SCOPE & OBJECTIVES OF FINANCIAL MANAGEMENT

in the business, deciding the most profitable investment, managing the funds raised and paying returns
to the providers of funds in proportion to the risks undertaken by them. Therefore, it aims at acquiring
sufficient funds, utilizing them properly, increasing the profitability of the organization and maximizing
the value of the organization and ultimately the shareholder’s wealth.

Question 4
What are the important factors considered for deciding the source and quantum of capital?

Answer
Funds procured from different sources have different characteristics in terms of risk, cost and control.
The cost of funds should be at the minimum level for that a proper balancing of risk and control factors
must be carried out. Another key consideration in choosing the source of new business finance is to
strike a balance between equity and debt to ensure the funding structure suits the business.

Question 5
Explain in brief the phases of the evolution of financial management.

Answer
Financial management evolved gradually over the past 50 years. The evolution of financial management
is divided into three phases. Financial Management evolved as a separate field of study at the beginning
of the century. The three stages of its evolution are:

The Traditional Phase: During this phase, financial management was considered necessary only during
occasional events such as takeovers, mergers, expansion, liquidation, etc. Also, when taking financial
decisions in the organisation, the needs of outsiders (investment bankers, people who lend money to
the business and other such people) to the business was kept in mind.

The Transitional Phase: During this phase, the day-to-day problems that financial managers faced were
given importance. The general problems related to funds analysis, planning and control were given more
attention in this phase.

The Modern Phase: Modern phase is still going on. The scope of financial management has greatly
increased now. It is important to carry out financial analysis for a company. This analysis helps in
decision making. During this phase, many theories have been developed regarding efficient markets,
capital budgeting, option pricing, valuation models and also in several other important fields in financial
management.

Question 6
Explain as to how the wealth maximisation objective is superior to the profit maximisation
objective.

Answer
A firm’s financial management may often have the following as their objectives:

A. The maximisation of firm’s profit.

B. The maximisation of firm’s value / wealth.

The maximisation of profit is often considered as an implied objective of a firm. To achieve the aforesaid
objective various type of financing decisions may be taken. Options resulting into maximisation of profit

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 SCOPE & OBJECTIVES OF FINANCIAL MANAGEMENT CHAPTER 1

may be selected by the firm’s decision makers. They even sometime may adopt policies yielding
exorbitant profits in short run which may prove to be unhealthy for the growth, survival and overall
interests of the firm. The profit of the firm in this case is measured in terms of its total accounting profit
available to its shareholders.

The value/wealth of a firm is defined as the market price of the firm’s stock. The market price of a firm’s
stock represents the focal judgment of all market participants as to what the value of the particular firm
is. It takes into account present and prospective future earnings per share, the timing and risk of these
earnings, the dividend policy of the firm and many other factors that bear upon the market price of the
stock.

The value maximisation objective of a firm is superior to its profit maximisation objective due to
following reasons.

1. The value maximisation objective of a firm considers all future cash flows, dividends, earning per
share, risk of a decision etc. whereas profit maximisation objective does not consider the effect of
EPS, dividend paid or any other returns to shareholders or the wealth of the shareholder.
2. A firm that wishes to maximise the shareholders wealth may pay regular dividends whereas a firm
with the objective of profit maximisation may refrain from dividend payment to its shareholders.
3. Shareholders would prefer an increase in the firm’s wealth against its generation of increasing
flow of profits.
4. The market price of a share reflects the shareholders expected return, considering the long-term
prospects of the firm, reflects the differences in timings of the returns, considers risk and
recognizes the importance of distribution of returns.
5. The maximisation of a firm’s value as reflected in the market price of a share is viewed as a proper
goal of a firm. The profit maximisation can be considered as a part of the wealth maximisation
strategy.

Question 7
“The profit maximization is not an operationally feasible criterion.” Comment on it. Or explain the
limitations or profit maximization. Or What are disadvantage of Profit Maximization?

Answer
1. The term profit is vague.
2. Profit maximisation has to be attempted with a realisation of risks involved.
3. Profit maximisation as an objective does not take into account the time pattern of returns.
4. Profit maximisation as an objective is too narrow.

Question 8
State advantage of ‘Wealth Maximization’ goals in Financial Management

Answer
Followings are the advantages of ‘wealth Maximization’:
(a) Emphasizes the long term gains
(b) Recognises risk or uncertainty
(c) Recognises the timing of returns
(d) Considers shareholders’ return.

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 CHAPTER 1 SCOPE & OBJECTIVES OF FINANCIAL MANAGEMENT

Question 9
Explain the role of Finance Manager in the changing scenario of financial management in India.

Answer
Role of Finance Manager in the Changing Scenario of Financial Management in India:
In the modern enterprise, the finance manager occupies a key position and his role is becoming more
and more pervasive and significant in solving the finance problems. The traditional role of the finance
manager was confined just to raising of funds from a number of sources, but the recent development in
the socio-economic and political scenario throughout the world has placed him in a central position in
the business organisation. He is now responsible for shaping the fortunes of the enterprise, and is
involved in the most vital decision of allocation of capital like mergers, acquisitions, etc. He is working
in a challenging environment which changes continuously. Emergence of financial service sector and
development of internet in the field of information technology has also brought new challenges before
the Indian finance managers. Development of new financial tools, techniques, instruments and products
and emphasis on public sector undertaking to be self-supporting and their dependence on capital
market for fund requirements have all changed the role of a finance manager. His role, especially,
assumes significance in the present day context of liberalization, deregulation and globalization.

Question 10
Discuss the functions of a Chief Financial Officer.

Answer
Functions of a Chief Financial Officer: The twin aspects viz procurement and effective utilization of
funds are the crucial tasks, which the CFO faces. The Chief Finance Officer is required to look into
financial implications of any decision in the firm. Thus all decisions involving management of funds
comes under the purview of finance manager. These are namely

1. Estimating requirement of funds

2. Decision regarding capital structure
3. Investment decisions
4. Dividend decision
5. Cash management
6. Evaluating financial performance
7. Financial negotiation
8. Keeping touch with stock exchange quotations & behaviour of share prices.

Question 11
What are the main responsibilities of a Chief Financial Officer of an organisation?

Answer
Responsibilities of Chief Financial Officer (CFO):
The chief financial officer of an organisation plays an important role in the company’s goals, policies,
and financial success. His main responsibilities include:

1. Financial analysis and planning: Determining the proper amount of funds to be employed in the
firm.

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 SCOPE & OBJECTIVES OF FINANCIAL MANAGEMENT CHAPTER 1

2. Investment decisions: Efficient allocation of funds to specific assets.

3. Financial and capital structure decisions: Raising of funds on favourable terms as possible, i.e.,
determining the composition of liabilities.
4. Management of financial resources (such as working capital).
5. Risk Management: Protecting assets.

Question 12
Discuss emerging issues affecting the future role of Chief Financial Officer (CFO).

Answer
Emerging Issues/Priorities Affecting the Future Role of Chief Financial Officer (CFO):

1. Regulation: Regulation requirements are increasing and CFOs have an increasingly personal stake
in regulatory adherence.
2. Globalisation: The challenges of globalisation are creating a need for finance leaders to develop a
finance function that works effectively on the global stage and that embraces diversity.
3. Technology: Technology is evolving very quickly, providing the potential for CFOs to reconfigure
finance processes and drive business insight through ‘big data’ and analytics.
4. Risk: The nature of the risks that organisations face is changing, requiring more effective risk
management approaches and increasingly CFOs have a role to play in ensuring an appropriate
corporate ethos.
5. Transformation: There will be more pressure on CFOs to transform their finance functions to
drive a better service to the business at zero cost impact.
6. Stakeholder Management: Stakeholder management and relationships will become important as
increasingly CFOs become the face of the corporate brand.
7. Strategy: There will be a greater role to play in strategy validation and execution, because the
environment is more complex and quick changing, calling on the analytical skills CFOs can bring.
8. Reporting: Reporting requirements will broaden and continue to be burdensome for CFOs.
9. Talent and Capability: A brighter spotlight will shine on talent, capability and behaviours in the
top finance role.

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 CHAPTER 4 COST OF CAPITAL

CHAPTER 4 COST OF CAPITAL

M
Question 1
What is meant by weighted average cost of capital? Illustrate with an example.

Answer
Meaning of Weighted Average Cost of Capital (WACC) and an Example:

The composite or overall cost of capital of a firm is the weighted average of the costs of the various
sources of funds. Weights are taken to be in the proportion of each source of fund in the capital structure.

While making financial decisions this overall or weighted cost is used. Each investment is financed from
a pool of funds which represents the various sources from which funds have been raised. Any decision
of investment, therefore, has to be made with reference to the overall cost of capital and not with
reference to the cost of a specific source of fund used in the investment decision.

The weighted average cost of capital is calculated by:

1. Calculating the cost of specific source of fund e.g. cost of debt, equity etc;
2. Multiplying the cost of each source by its proportion in capital structure; and
3. Adding the weighted component cost to get the firm’s WACC represented by K0.

K0 = KeWe + Kr Wr + KdWd + KpWp

Question 2
Discuss the dividend-price approach, and earnings price approach to estimate cost of equity
capital.

Answer
In dividend price approach, cost of equity capital is computed by dividing the current dividend by
average market price per share. This ratio expresses the cost of equity capital in relation to what yield
the company should pay to attract investors. It is computed as:

D1
Ke = × 100
P0
Where,
D1 = Dividend per share in period 1
P0 = Market price per share today

Whereas, on the other hand, the advocates of earnings price approach co-relate the earnings of the
company with the market price of its share. Accordingly, the cost of ordinary share capital would be
based upon the expected rate of earnings of a company. This approach is similar to dividend price
approach, only it seeks to nullify the effect of changes in dividend policy.

4.1
 CHAPTER 5 FINANCING DECISIONS – CAPITAL STRUCTURE

CHAPTER 5 FINANCING DECISIONS – CAPITAL STRUCTURE

M
Question 1
Discuss the concept of Debt-Equity or EBIT-EPS indifference point, while determining the capital
structure of a company.

Answer
The determination of optimum level of debt in the capital structure of a company is a formidable task
and is a major policy decision. It ensures that the firm is able to service its debt as well as contain its
interest cost. Determination of optimum level of debt involves equalizing between return and risk.

EBIT – EPS analysis is a widely used tool to determine level of debt in a firm. Through this analysis, a
comparison can be drawn for various methods of financing by obtaining indifference point. It is a point
to the EBIT level at which EPS remains unchanged irrespective of debt-equity mix. The indifference
point for the capital mix (equity share capital and debt) can be determined as follows:

EBIT  I1 (1  T ) EBIT  I2 (1  T )
=
E1 E2

Question 2
Discuss financial break-even.

Answer
Financial Break-even: Financial break-even point is the minimum level of EBIT needed to satisfy all the
fixed financial charges i.e. interest and preference dividend. It denotes the level of EBIT for which firm’s
EPS equals zero. If the EBIT is less than the financial breakeven point, then the EPS will be negative but
if the expected level of EBIT is more than the breakeven point, then more fixed costs financing
instruments can be taken in the capital structure, otherwise, equity would be preferred.

Question 3
Discuss the major considerations in capital structure planning, or List the fundamental principles
governing capital structure.

Answer
Fundamental Principles Governing Capital Structure:

1. Cost Principle:
According to this principle, an ideal pattern or capital structure is one that minimises cost of capital
structure and maximises earnings per share (EPS).

2. Risk Principle:
According to this principle, reliance is placed more on common equity for financing capital
requirements than excessive use of debt. Use of more and more debt means higher commitment in

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 FINANCING DECISIONS – CAPITAL STRUCTURE CHAPTER 5

form of interest payout. This would lead to erosion of shareholders value in unfavourable business
situation.

3. Control Principle:
While designing a capital structure, the finance manager may also keep in mind that existing
management control and ownership remains undisturbed.

4. Flexibility Principle:
It means that the management chooses such a combination of sources of financing which it finds
easier to adjust according to changes in need of funds in future too.

5. Other Considerations:
Besides above principles, other factors such as nature of industry, timing of issue and competition in
the industry should also be considered.

Question 4
What is optimum capital structure? Explain.

Answer
Optimum Capital Structure:
Optimum capital structure deals with the issue of right mix of debt and equity in the long-term capital
structure of a firm. According to this, if a company takes on debt, the value of the firm increases upto a
certain point. Beyond that value of the firm will start to decrease. If the company is unable to pay the
debt within the specified period then it will affect the goodwill of the company in the market. Therefore,
company should select its appropriate capital structure with due consideration of all factors.

Question 5
What is Over-capitalisation? State its causes and consequences.

Answer
Over-capitalization and its Causes and Consequences It is a situation where a firm has more capital than
it needs or in other words assets are worth less than its issued share capital, and earnings are insufficient
to pay dividend and interest.

Causes of Over Capitalization:

1. Raising more money through issue of shares or debentures than company can employ profitably.
2. Borrowing huge amount at higher rate than rate at which company can earn.
3. Excessive payment for the acquisition of fictitious assets such as goodwill etc.
4. Improper provision for depreciation, replacement of assets and distribution of dividends at a higher
rate.
5. Wrong estimation of earnings and capitalization.

Consequences of Over-Capitalisation
1. Considerable reduction in the rate of dividend and interest payments.
2. Reduction in the market price of shares.

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 CHAPTER 5 FINANCING DECISIONS – CAPITAL STRUCTURE

3. Resorting to “window dressing”.

4. Some companies may opt for reorganization. However, sometimes the matter gets worse and the
company may go into liquidation.

Question 6
What is Net Operating Income (NOI) theory of capital structure? Explain the assumptions of Net
Operating Income approach theory of capital structure.

Answer
Net Operating Income (NOI) Theory of Capital Structure:
According to NOI approach, there is no relationship between the cost of capital and value of the firm i.e.
the value of the firm is independent of the capital structure of the firm.

Assumptions
1. The corporate income taxes do not exist.
2. The market capitalizes the value of the firm as whole. Thus the split between debt and equity is not
important.
3. The increase in proportion of debt in capital structure leads to change in risk perception of the
shareholders.
4. The overall cost of capital (Ko) remains constant for all degrees of debt equity mix.

Question 7
Explain, briefly, Modigliani and Miller approach (without tax) on Cost of Capital.

Answer
This approach describes, in a perfect capital market where there is no transaction cost and no taxes, the
value and cost of capital of a company remain unchanged irrespective of change in the capital structure.
The approach is based on further additional assumptions like:

1. Capital markets are perfect. All information is freely available and there are no transaction costs.
2. All investors are rational.
3. Firms can be grouped into ‘Equivalent risk classes’ on the basis of their business risk.
4. Non-existence of corporate taxes.

Based on the above assumptions, Modigliani-Miller derived the following three propositions:

1. Total market value of a firm is equal to its expected net operating income divided by the discount rate
appropriate to its risk class decided by the market.

Value of levered firm (VL) = Value of unlevered firm (VUL)

Value of a firm = Net Operating Income(NOI) ÷ Ko

2. A firm having debt in capital structure has higher cost of equity than an unlevered firm. The cost
equity will be include risk premium for the financial risk. The cost of equity in a levered firm is
determined as under:

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 FINANCING DECISIONS – CAPITAL STRUCTURE CHAPTER 5

Ke = Ko + (Ko – Kd) × Debt/Equity or

Ke = Earning for equity/Equity

3. The structure of the capital (financial leverage) does not affect the overall cost of capital. The cost of
capital is only affected by the business risk.

Question 8
Explain Trade off Theory in Capital Structure.

Answer
The Trade-off Theory: The trade-off theory of capital structure refers to the idea that a company
chooses how much debt finance and how much equity finance to use by balancing the costs and benefits.
Tradeoff theory of capital structure basically entails offsetting the costs of debt against the benefits of
debt.

Trade-off theory of capital structure primarily deals with the two concepts - cost of financial distress
and agency costs. An important purpose of the trade-off theory of capital structure is to explain the fact
that corporations usually are financed partly with debt and partly with equity.

It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost
of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-
bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms,
bondholder/stockholder infighting, etc). The marginal benefit of further increases in debt declines as
debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will
focus on this trade-off when choosing how much debt and equity to use for financing. Modigliani and
Miller in 1963 introduced the tax benefit of debt. Later work led to an optimal capital structure which is
given by the trade-off theory. According to Modigliani and Miller, the attractiveness of debt decreases
with the personal tax on the interest income. A firm experiences financial distress when the firm is
unable to cope with the debt holders’ obligations. If the firm continues to fail in making payments to the
debt holders, the firm can even be insolvent.

The first element of Trade-off theory of capital structure, considered as the cost of debt is usually the
financial distress costs or bankruptcy costs of debt. The direct cost of financial distress refers to the
cost of insolvency of a company. Once the proceedings of insolvency start, the assets of the firm may be
needed to be sold at distress price, which is generally much lower than the current values of the assets.
A huge amount of administrative and legal costs is also associated with the insolvency. Even if the
company is not insolvent, the financial distress of the company may include a number of indirect costs
like - cost of employees, cost of customers, cost of suppliers, cost of investors, cost of managers and cost
of shareholders. The firms may often experience a dispute of interests among the management of the
firm, debt holders and shareholders. These disputes generally give birth to agency problems that in turn
give rise to the agency costs.

The agency costs may affect the capital structure of a firm. There may be two types of conflicts -
shareholders-managers conflict and shareholders-debtholders conflict. The introduction of a dynamic
Trade- off theory of capital structure makes the predictions of this theory a lot more accurate and
reflective of that in practice.

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 CHAPTER 5 FINANCING DECISIONS – CAPITAL STRUCTURE

Question 9
Explain Pecking Order Theory in Capital Structure.

Answer
Pecking order theory: This theory is based on Asymmetric information, which refers to a situation in
which different parties have different information. In a firm, managers will have better information than
investors. This theory states that firms prefer to issue debt when they are positive about future earnings.
Equity is issued when they are doubtful and internal finance is insufficient. The pecking order theory
argues that the capital structure decision is affected by manager’s choice of a source of capital that gives
higher priority to sources that reveal the least amount of information. Myres has given the name
‘PECKING ORDER’ theory as here is no well-defined debt- equity target and there are two kind of equity
internal and external. Now Debt is cheaper than both internal and external equity because of interest.
Further internal equity is less than external equity particularly because of no transaction/issue cost, no
tax etc.

Pecking order theory suggests that managers may use various sources for raising of fund in the
following order:

1. Managers first choice is to use internal finance

2. In absence of internal finance they can use secured debt, unsecured debt, hybrid debt etc.
3. Managers may issue new equity shares as a last option.

So briefly under this theory rules are:

Rule 1: Use internal financing first.

Rule 2: Issue debt next
Rule 3: Issue of new equity shares at last

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 CHAPTER 6 FINANCING DECISIONS – LEVERAGES

CHAPTER 6 FINANCING DECISIONS – LEVERAGES

M
Question 1
Explain the principles of “Trading on equity”.

Answer
Financial leverage indicates the use of funds with fixed cost like long term debts and preference share
capital along with equity share capital which is known as trading on equity. The basic aim of financial
leverage is to increase the earnings available to equity shareholders using fixed cost fund. A firm is
known to have a positive/favourable leverage when its earnings are more than the cost of debt. If
earnings are equal to or less than cost of debt, it will be negative/unfavourable leverage. When the
quantity of fixed cost fund is relatively high in comparison to equity capital it is said that the firm is
‘’trading on equity”.

Question 2
Differentiate between Business risk and Financial risk.

Answer
Business risk refers to the risk associated with the firm’s operations. It is an unavoidable risk because
of the environment in which the firm has to operate and the business risk is represented by the
variability of earnings before interest and tax (EBIT). The variability in turn is influenced by revenues
and expenses. Revenues and expenses are affected by demand of firm’s products, variations in prices
and proportion of fixed cost in total cost.

Whereas, Financial risk refers to the additional risk placed on firm’s shareholders as a result of debt
use in financing. Companies that issue more debt instruments would have higher financial risk than
companies financed mostly by equity. Financial risk can be measured by ratios such as firm’s financial
leverage multiplier, total debt to assets ratio etc.

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 CHAPTER 7 INVESTMENT DECISIONS OR CAPITAL BUDGETING

CHAPTER 7 INVESTMENT DECISIONS OR CAPITAL BUDGETING

Question 1
Write a short note on “Cut - off Rate”.

Answer
Cut - off Rate: It is the minimum rate which the management wishes to have from any project. Usually
this is based upon the cost of capital. The management gains only if a project gives return of more than
the cut – off rate. Therefore, the cut - off rate can be used as the discount rate or the opportunity cost
rate.

Question 2
What do you understand by desirability factor/profitability index?

Answer
Desirability Factor/Profitability Index: In certain cases we have to compare a number of proposals
each involving different amount of cash inflows. One of the methods of comparing such proposals is to
work out what is known as the ‘Desirability factor’ or ‘Profitability index’. In general terms, a project is
acceptable if its profitability index value is greater than 1.

Mathematically, the desirability factor is calculated as below:

Sum of Discounted Cash inflows ÷ Initial Cash outlay or Total Discounted Cash outflow

Question 3
Explain the concept of discounted payback period.

Answer
Concept of Discounted Payback Period: Payback period is time taken to recover the original
investment from project cash flows. It is also termed as break even period. The focus of the analysis is
on liquidity aspect and it suffers from the limitation of ignoring time value of money and profitability.
Discounted payback period considers present value of cash flows, discounted at company’s cost of
capital to estimate breakeven period i.e. it is that period in which future discounted cash flows equal the
initial outflow. The shorter the period, better it is. It also ignores post discounted payback period cash
flows.
M
Question 4
Write a short note on internal rate of return.

Answer
Internal Rate of Return: It is that rate at which discounted cash inflows are equal to the discounted
cash outflows. In other words, it is the rate which discounts the cash flows to zero.

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 INVESTMENT DECISIONS OR CAPITAL BUDGETING CHAPTER 7

This rate is to be found by trial and error method. This rate is used in the evaluation of investment
proposals. In this method, the discount rate is not known but the cash outflows and cash inflows are
known.

In evaluating investment proposals, internal rate of return is compared with a required rate of return,
known as cut-off rate. If it is more than cut-off rate the project is treated as acceptable; otherwise project
is rejected.

Question 5
Identify the limitations of Internal Rate of Return.

Answer
Followings are the limitations of IRR:

(a) The calculation process is tedious if there is more than one cash outflow interspersed between
the cash inflows; there can be multiple IRR, the interpretation of which is difficult.
(b) The IRR approach creates a peculiar situation if we compare two projects with different
inflow/outflow patterns.
(c) It is assumed that under this method all the future cash inflows of a proposal are reinvested at a
rate equal to the IRR. It ignores a firm’s ability to re-invest in portfolio of different rates.
(d) If mutually exclusive projects are considered as investment options which have considerably
different cash outlays. A project with a larger fund commitment but lower IRR contributes more
in terms of absolute NPV and increases the shareholders’ wealth. In such situation decisions
based only on IRR criterion may not be correct.

Question 6
Define Modified Internal Rate of Return method.

Answer
Modified Internal Rate of Return (MIRR): There are several limitations attached with the concept of
the conventional Internal Rate of Return. The MIRR addresses some of these deficiencies. For example,
it eliminates multiple IRR rates; it addresses the reinvestment rate issue and produces results, which
are consistent with the Net Present Value method.

Under this method, all cash flows, apart from the initial investment, are brought to the terminal value
using an appropriate discount rate (usually the cost of capital). This results in a single stream of cash
inflow in the terminal year. The MIRR is obtained by assuming a single outflow in the zeroth year and
the terminal cash inflow as mentioned above. The discount rate which equates the present value of the
terminal cash in flow to the zeroth year outflow is called the MIRR.

Question 7
Do the profitability index and the NPV criterion of evaluating investment proposals lead to the same
acceptance-rejection and ranking decisions? In what situations will they give conflicting results?

Answer

7.2
 CHAPTER 7 INVESTMENT DECISIONS OR CAPITAL BUDGETING

In the most of the situations the Net Present Value Method (NPV) and Profitability Index (PI) yield same
accept or reject decision. In general items, under PI method a project is acceptable if profitability index
value is greater than 1 and rejected if it less than 1. Under NPV method a project is acceptable if Net
present value of a project is positive and rejected if it is negative.

Clearly a project offering a profitability index greater than 1 must also offer a net present value which is
positive. But a conflict may arise between two methods if a choice between mutually exclusive projects
has to be made. Consider the following example:

Project A Project B
PV of Cash inflows 2,00,000 1,00,000
Initial cash outflows 1,00,000 40,000
Net present value 1,00,000 60,000
P.I 2 times 2.5 times

According to NPV method, project A would be preferred, whereas according to profitability index
method project B would be preferred. This is because Net present value gives ranking on the basis of
absolute value of rupees, whereas, profitability index gives ranking on the basis of ratio. Although PI
method is based on NPV, it is a better evaluation technique than NPV in a situation of capital rationing.

Question 8
Distinguish between Net Present Value and Internal Rate of Return.

Answer
NPV versus IRR: NPV and IRR methods differ in the sense that the results regarding the choice of an
asset under certain circumstances are mutually contradictory under two methods. In case of mutually
exclusive investment projects, in certain situations, they may give contradictory results such that if the
NPV method finds one proposal acceptable, IRR favours another. The different rankings given by the
NPV and IRR methods could be due to size disparity problem, time disparity problem and unequal
expected lives.

The net present value is expressed in financial values whereas internal rate of return (IRR) is expressed
in percentage terms.

In the net present value cash flows are assumed to be re-invested at cost of capital rate. In IRR
reinvestment is assumed to be made at IRR rates.

Question 9
Explain the concept of Multiple Internal Rate of Return.

Answer
Multiple Internal Rate of Return (MIRR):
In cases where project cash flows change signs or reverse during the life of a project for example, an
initial cash outflow is followed by cash inflows and subsequently followed by a major cash outflow; there
may be more than one internal rate of return (IRR). The following graph of discount rate versus net
present value (NPV) may be used as an illustration:

7.3
 INVESTMENT DECISIONS OR CAPITAL BUDGETING CHAPTER 7

In such situations if the cost of capital is less than the two IRRs, a decision can be made easily, however,
otherwise the IRR decision rule may turn out to be misleading as the project should only be invested if
the cost of capital is between IRR1 and IRR2. To understand the concept of multiple IRRs it is necessary
to understand the implicit re-investment assumption in both NPV and IRR techniques.

7.4
 CHAPTER 8 DIVIDEND DECISIONS

CHAPTER 8 DIVIDEND DECISIONS

Question 1
Discuss Modigliani and Miller (M.M) Hypothesis of Dividend Decisions.

Answer
Modigliani – Miller theory was proposed by Franco Modigliani and Merton Miller in 1961. MM approach
is in support of the irrelevance of dividends i.e. firm’s dividend policy has no effect on its value of assets.

Assumptions of M.M Hypothesis:

1. Perfect capital markets: The firm operates in a market in which all investors are rational and
information is freely available to all.
2. No taxes or no tax discrimination between dividend income and capital appreciation (capital gain):
This assumption is necessary for the universal applicability of the theory, since, the tax rates or
provisions to tax income may be different in different countries.
3. Fixed investment policy: It is necessary to assume that all investment should be financed through
equity only, since, implication after using debt as a source of finance may be difficult to understand.
Further, the impact will be different in different cases.
4. No floatation or transaction cost: Similarly, these costs may differ country to country or market to
market.
5. Risk of uncertainty does not exist. Investors are able to forecast future prices and dividend with
certainty and one discount rate is appropriate for all securities and all time periods.

According to MM hypothesis:
Market value of equity shares of its firm depends solely on its earning power and is not influence by the
manner in which its earnings are split between dividends and retained earnings.

Market value of equity shares is not affected by dividend size. MM hypothesis is primarily based on the
arbitrage argument.

Advantages of MM Hypothesis:
1. This model is logically consistent.
2. It provides a satisfactory framework on dividend policy with the concept of Arbitrage process.

Limitations of MM Hypothesis
1. Validity of various assumptions is questionable.
2. This model may not be valid under uncertainty.

(n+ △n)P1−I+E
Value of firm (nP0) = 1+Ke

Question 2
Discuss Walter Model.

8.1
 DIVIDEND DECISIONS CHAPTER 8

Answer
Assumptions of Walter Model:
1. All investments proposals of the firm are to be financed through retained earnings only.
2. ‘r’ rate of return & ‘Ke’ cost of capital are constant.
3. Perfect capital markets: The firm operates in a market in which all investors are rational and
information is freely available to all.
4. No taxes or no tax discrimination between dividend income and capital appreciation (capital gain):
This assumption is necessary for the universal applicability of the theory, since, the tax rates or
provisions to tax income may be different in different countries.
5. No floatation or transaction cost: Similarly, these costs may differ country to country or market to
market.
6. The firm has perpetual life.

The relationship between dividend and share price based on Walter’s formula is shown below:

D+(E−D)r/Ke
Market Price (P) = Ke

Market price is dependent upon two factors; firstly, the quantum of dividend and secondly, profitable
opportunities available to the company in investing the earnings retained.

Growth Company (r is higher than Ke): In this condition company is able to invest/utilize the fund in
a better manner. In this case shareholder, can accept low dividend because their value of share would
be higher. Optimum payout is NIL

Constant Company (r = Ke): In this condition each and every payout is optimum payout.

Decline Company(r is lower than Ke): In this case company is not in a position to cover the cost of
capital, in such case shareholders would prefer a higher dividend so that they can utilize their funds
elsewhere in more profitable opportunities. Optimum payout is 100%

Advantages of Walter Model:

1. The formula is simple to understand and easy to compute.
2. It can envisage different possible market prices in different situations and considers internal rate of
return, market capitalisation rate and dividend payout ratio in the determination of market value of
shares.

Limitations of Walter Model:

1. The formula does not consider all the factors affecting dividend policy and share prices. Moreover,
determination of market capitalisation rate is difficult.
2. Further, the formula ignores such factors as taxation, various legal and contractual obligations,
management policy and attitude towards dividend policy and so on.

Question 3
Discuss Gordon Model.

8.2
 CHAPTER 8 DIVIDEND DECISIONS

Answer
Gordon Model (Dividend Discount Model) It is financial model that values shares at the discounted
value of the future dividend payments. Under this model, the price a share will be traded is calculated
by the NPV of all expected future dividend payment discounted by an appropriate risk- adjusted rate.
The dividend discount model price is the intrinsic value of the stock i.e.

Intrinsic value = Sum of PV of Future cash flows Intrinsic value

Assumptions of Gordon Model:

1. Firm is an all equity firm i.e. no debt.
2. IRR will remain constant, because change of IRR will change the growth rate and consequently the
value will be affected. Hence this assumption is necessary.
3. Ke will remains constant, because change in discount rate will affect the present value.
4. Retention ratio (b), once decide upon, is constant i.e. constant dividend payout ratio will be followed.
5. Growth rate (g= br) is also constant, since retention ratio and IRR will remain unchanged and
growth, which is the function of these two variable will remain unaffected.
6. Ke > g, this assumption is necessary and based on the principles of series of sum of geometric
progression for ‘n’ number of years.
7. All investment proposals of the firm are to be financed through retained earnings only.

Advantages of Gordon Model:

1. The dividend discount model is a useful heuristic model that relates the present stock price to the
present value of its future cash flows.
2. This Model is easy to understand.

Limitations of Gordon Model:

1. The dividend discount model, depends on projections about company growth rate and future
capitalization rates of the remaining cash flows, which may be difficult to calculate accurately.
2. The true intrinsic value of a stock is unknowable

Formulae: P0 (with zero growth) = D/Ke

𝐷1
P0 (with constant growth) = 𝐾𝑒−𝑔

𝐷1 𝐷2 𝐷3 𝑃𝑛
P0 (with variable growth) = 1+𝐾𝑒
+ (1+𝐾𝑒)2 + (1+𝐾𝑒)3 + ……+ (1+𝐾𝑒)𝑛+1

Question 4
Discuss Traditional Model (Graham & Dodd Model).

Answer
According to the traditional position expounded by Graham & Dodd, the stock market places
considerably more weight on dividends than on retained earnings. Their view is expressed
quantitatively in the following valuation model:

8.3
 DIVIDEND DECISIONS CHAPTER 8

P = m (D + E/3)

Where, P = Market price per share, D = Dividend per share, E = Earnings per share, m = a multiplier

Question 5
Discuss Linter Model.

Answer
Linter model has two parameters:

1. The target payout ratio,

2. The spread at which current dividends adjust to the target.

John Linter based his model on a series of interviews which he conducted with corporate managers in
the mid 1950’s.While developing the model, he considers the following assumptions:

1. Firm have a long term dividend payout ratio. They maintain a fixed dividend payout over a long
term. Mature companies with stable earnings may have high payouts and growth companies usually
have low payouts.
2. Managers are more concerned with changes in dividends than the absolute amounts of dividends.
3. Dividend changes follow changes in long run sustainable earnings.
4. Managers are reluctant to affect dividend changes that may have to be reversed.

D₁ = D0 + [(EPS ×Target payout) - D0] × Af

Where D₁ = Dividend in year 1, D0 = Dividend in year 0 (last year dividend), EPS = Earnings per share
Af = Adjustment factor

Question 6
Discuss Stock Splits.

Answer
Stock split means splitting one share into many. Stock splits is a tool used by the companies to regulate
the prices of shares i.e. if a share price increases beyond a limit, it may become less tradable, for e.g.
suppose a company’s share price increases from `50 to `1000 over the years, it is possible that it might
goes out of range of many investors.

Advantages of Stock Splits:

1. It makes the share affordable to small investors.
2. Number of shares may increase the number of shareholders; hence the potential of investment may
increase.

Limitations of Stock Splits:

1. Additional expenditure need to be incurred on the process of stock split.
2. Low share price may attract speculators or short term investors, which are generally not preferred
by any company.

8.4
 CHAPTER 9 MANAGEMENT OF WORKING CAPITAL

CHAPTER 9 MANAGEMENT OF WORKING CAPITAL

Question 1
Elucidate the fundamental tasks or functions of treasury department of firm.

Answer
Fundamental tasks of treasury department of firm are:

(1) Cash Management: It involves efficient cash collection process and managing payment of cash
both inside the organisation and to third parties.

(2) Currency Management: The treasury department manages the foreign currency risk exposure
of the company.

(3) Fund Management: Treasury department is responsible for planning and sourcing the
company’s short, medium and long-term cash needs. They also facilitate temporary investment
of surplus funds by mapping the time gap between funds inflow and outflow.

(4) Banking: It is important that a company maintains a good relationship with its bankers. Treasury
department carry out negotiations with bankers with respect to interest rates, foreign exchange
rates etc. and act as the initial point of contact with them. Short-term finance can come in the form
of bank loans or through the sale of commercial paper in the money market.

(5) Corporate Finance: Treasury department is involved with both acquisition and divestment
activities within the group. In addition, it will often have responsibility for investor relations.

Question 2
Discuss Miller-Orr Cash Management model.

Answer
Miller – Orr Cash Management Model:
According to this model the net cash flow is completely stochastic. When changes in cash balance occur
randomly, the application of control theory serves a useful purpose. The Miller – Orr model is one of
such control limit models. This model is designed to determine the time and size of transfers between
an investment account and cash account. In this model control limits are set for cash balances. These
limits may consist of ‘h’ as upper limit, ‘z’ as the return point and zero as the lower limit.

When the cash balance reaches the upper limit, the transfer of cash equal to ‘h – z’ is invested in
marketable securities account. When it touches the lower limit, a transfer from marketable securities
account to cash account is made. During the period when cash balance stays between (h, z) and (z, 0) i.e.
high and low limits, no transactions between cash and marketable securities account is made. The high
and low limits of cash balance are set up on the basis of fixed cost associated with the securities
transaction, the opportunities cost of holding cash and degree of likely fluctuations in cash balances.
These limits satisfy the demands for cash at the lowest possible total costs. The formula for calculation
of the spread between the control limits is:

9.1
 MANAGEMENT OF WORKING CAPITAL CHAPTER 9

Question 3
Explain Baumol’s Model of Cash Management.

Answer
William J. Baumol developed a model for optimum cash balance which is normally used in inventory
management. The optimum cash balance is the trade-off between cost of holding cash (opportunity cost
of cash held) and the transaction cost (i.e. cost of converting marketable securities in to cash). Optimum
cash balance is reached at a point where the two opposing costs are equal and where the total cost is
minimum.

This can be explained with the following diagram:

The optimum cash balance can also be computed algebraically.

2AT
Optimum Cash Balance =
H

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 CHAPTER 9 MANAGEMENT OF WORKING CAPITAL

Where,
A = Annual Cash disbursements
T = Transaction cost (Fixed cost) per transaction
H = Opportunity cost one rupee per annum (Holding cost)

The model is based on the following assumptions:

1. Cash needs of the firm are known with certainty.
2. The cash is used uniformly over a period of time and it is also known with certainty.
3. The holding cost is known and it is constant.
4. The transaction cost also remains constant.

Question 4
State the advantage of Electronic Cash Management System.

Answer
Advantages of Electronic Cash Management System:
1. Significant saving in time.
2. Decrease in interest costs.
3. Less paper work.
4. Greater accounting accuracy.
5. More control over time and funds.
6. Supports electronic payments.
7. Faster transfer of funds from one location to another, where required.
8. Speedy conversion of various instruments into cash.
9. Making available funds wherever required, whenever required.
10. Reduction in the amount of ‘idle float’ to the maximum possible extent.
11. Ensures no idle funds are placed at any place in the organization.
12. It makes inter-bank balancing of funds much easier.
13. It is a true form of centralised ‘Cash Management’.
14. Produces faster electronic reconciliation.
15. Allows for detection of book-keeping errors.
16. Reduces the number of cheques issued.
17. Earns interest income or reduce interest expense.

Question 5
What is Virtual Banking? State its advantages.

Answer
Virtual Banking and its Advantages:
Virtual banking refers to the provision of banking and related services through the use of information
technology without direct recourse to the bank by the customer.

The advantages of virtual banking services are as follows:

1. Lower cost of handling a transaction.
2. The increased speed of response to customer requirements.

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 MANAGEMENT OF WORKING CAPITAL CHAPTER 9

3. The lower cost of operating branch network along with reduced staff costs leads to cost efficiency.
4. Virtual banking allows the possibility of improved and a range of services being made available to
the customer rapidly, accurately and at his convenience.

Question 6
Write short note on Different kinds of float with reference to management of cash.

Answer
Different Kinds of Float with Reference to Management of Cash: The term float is used to refer to the
periods that affect cash as it moves through the different stages of the collection process. Four kinds of
float can be identified:

1. Billing Float: An invoice is the formal document that a seller prepares and sends to the purchaser as
the payment request for goods sold or services provided. The time between the sale and the mailing
of the invoice is the billing float.

2. Mail Float: This is the time when a cheque is being processed by post office, messenger service or
other means of delivery.

3. Cheque processing float: This is the time required for the seller to sort, record and deposit the
cheque after it has been received by the company.

4. Bank processing float: This is the time from the deposit of the cheque to the crediting of funds in the
seller’s account.

Question 7
'Management of marketable securities is an integral part of investment of cash.' Comment.

Answer
“Management of Marketable Securities is an Integral Part of Investment of Cash” Management of
marketable securities is an integral part of investment of cash as it serves both the purposes of liquidity
and cash, provided choice of investment is made correctly. As the working capital needs are fluctuating,
it is possible to invest excess funds in some short term securities, which can be liquidated when need
for cash is felt.
The selection of securities should be guided by three principles namely safety, maturity and
marketability.

Question 8
Describe the three principles relating to selection of marketable securities.

Answer
Three Principles Relating to Selection of Marketable Securities:

1. Safety: Return and risk go hand-in-hand. As the objective in this investment is ensuring liquidity,
minimum risk is the criterion of selection.

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 CHAPTER 9 MANAGEMENT OF WORKING CAPITAL

2. Maturity: Matching of maturity and forecasted cash needs is essential. Prices of long term securities
fluctuate more with changes in interest rates and are, therefore, riskier.

3. Marketability: It refers to the convenience, speed and cost at which a security can be converted into
cash. If the security can be sold quickly without loss of time and price, it is highly liquid or marketable.
ABLES
Question 9
Explain briefly the accounts receivable systems.

Answer
Accounts Receivable Systems: Manual systems of recording the transactions and managing receivables
are cumbersome and costly. The automated receivable management systems automatically update all
the accounting records affected by a transaction. This system allows the application and tracking of
receivables and collections to store important information for an unlimited number of customers and
transactions, and accommodate efficient processing of customer payments and adjustments.

Question 10
Explain the ‘Aging Schedule’ in the context of monitoring of receivables.

Answer
Ageing Schedule: An important means to get an insight into collection pattern of debtors is the
preparation of their ‘Ageing Schedule’. Receivables are classified according to their age from the date of
invoicing e.g. 0 – 30 days, 31 – 60 days, 61 – 90 days, 91 – 120 days and more. The ageing schedule can
be compared with earlier month’s figures or the corresponding month of the earlier year.
This classification helps the firm in its collection efforts and enables management to have a close control
over the quality of individual accounts. The ageing schedule can be compared with other firms also.

Question 11
Enumerate the various forms of bank credit in financing the working capital of a business
organization

Answer
Some of the forms of bank credit are:

1. Short Term Loans: In a loan account, the entire advance is disbursed at one time either in cash or by
transfer to the current account of the borrower. It is a single advance and given against securities like
shares, government securities, life insurance policies and fixed deposit receipts, etc.

2. Overdraft: Under this facility, customers are allowed to withdraw in excess of credit balance standing
in their Current Account. A fixed limit is therefore granted to the borrower within which the borrower
is allowed to overdraw his account.

3. Clean Overdrafts: Request for clean advances are entertained only from parties which are financially
sound and reputed for their integrity. The bank has to rely upon the personal security of the
borrowers.

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 MANAGEMENT OF WORKING CAPITAL CHAPTER 9

4. Cash Credits: Cash Credit is an arrangement under which a customer is allowed an advance up to
certain limit against credit granted by bank. Interest is not charged on the full amount of the advance
but on the amount actually availed of by him.

5. Advances against goods: Goods are charged to the bank either by way of pledge or by way of
hypothecation. Goods include all forms of movables which are offered to the bank as security.

6. Bills Purchased/Discounted: These advances are allowed against the security of bills which may be
clean or documentary. Usance bills maturing at a future date or sight are discounted by the banks for
approved parties. The borrower is paid the present worth and the bank collects the full amount on
maturity.

7. Advance against documents of title to goods: A document becomes a document of title to goods
when its possession is recognised by law or business custom as possession of the goods like bill of
lading, dock warehouse keeper's certificate, railway receipt, etc. An advance against the pledge of
such documents is an advance against the pledge of goods themselves.

8. Advance against supply of bills: Advances against bills for supply of goods to government or semi-
government departments against firm orders after acceptance of tender fall under this category. It is
this debt that is assigned to the bank by endorsement of supply bills and executing irrevocable power
of attorney in favour of the banks for receiving the amount of supply bills from the Government
departments.

Question 12
Discuss the factors to be taken into consideration while determining the requirement of working
capital.

Answer
Factors to be taken into consideration while determining the requirement of working capital:

(i) Production Policies (ii) Nature of the business (iii) Credit policy (iv) Inventory policy (v) Abnormal
factors (vi) Market conditions (vii) Conditions of supply (viii) Business cycle (ix) Growth and expansion
(x) Level of taxes (xi) Dividend policy (xii) Price level changes (xiii) Operating efficiency.

Question 13
Discuss the liquidity vs. profitability issue in management of working capital.

Answer
Liquidity versus Profitability Issue in Management of Working Capital: Working capital management
entails the control and monitoring of all components of working capital i.e. cash, marketable securities,
debtors, creditors etc. Finance manager has to pay particular attention to the levels of current assets
and their financing. To decide the level of financing of current assets, the risk return trade off must be
taken into account. The level of current assets can be measured by creating a relationship between
current assets and fixed assets. A firm may follow a conservative, aggressive or moderate policy. A
conservative policy means lower return and risk while an aggressive policy produces higher return and

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 CHAPTER 9 MANAGEMENT OF WORKING CAPITAL

risk. The two important aims of the working capital management are profitability and solvency. A liquid
firm has less risk of insolvency i.e. it will hardly experience a cash shortage or a stock out situation.
However, there is a cost associated with maintaining a sound liquidity position. So, to have a higher
profitability the firm may have to sacrifice solvency and maintain a relatively low level of current assets.

Question 14
“Permanent working capital and fluctuating (temporary) working capital, both are necessary to
facilitate production and sales through the operating cycle.” – Describe.

Answer
Permanent working capital refers to the base working capital, which is the minimum level of
investment in the current assets that is carried by the entity at all times to carry its day to day activities.
It generally stays invested in the business, unless the operations are scaled up or down permanently
which would also result in increase or decrease in permanent working capital. It is generally financed
by long term sources of finance.

Temporary working capital refers to that part of total working capital, which is required by an entity
in addition to the permanent working capital. It is also called variable or fluctuating working capital
which is used to finance the short-term working capital requirements which arises due to fluctuation in
sales volume. For instance, an organization would maintain increased levels of inventory to meet
increased seasonal demand.

Both kinds of working capital i.e. permanent and fluctuating (temporary) are necessary to facilitate
production and sales through the operating cycle.

Question 15
Discuss the estimation of working capital need based on operating cycle process.

Answer
Estimation of Working Capital Need based on Operating Cycle: One of the methods for forecasting
working capital requirement is based on the concept of operating cycle. The determination of operating
capital cycle helps in the forecast, control and management of working capital. The length of operating
cycle is the indicator of performance of management. The net operating cycle represents the time
interval for which the firm has to negotiate for Working Capital from its Bankers. It enables to determine
accurately the amount of working capital needed for the continuous operation of business activities. The
duration of working capital cycle may vary depending on the nature of the business.
In the form of an equation, the operating cycle process can be expressed as follows:

Operating Cycle = R + W + F +D – C

Where,
R = Raw material storage period.
W = Work-in-progress holding period.
F = Finished goods storage period.
D = Debtors collection period.
C = Credit period availed.

9.7