Hello Students. Are you Searching for Class 12 Business Studies NCERT Solutions of Chapter 9? If yes then you are in the right place. Here we have provided you with the Question and Answers of Chapter 9: Financial Management. These solutions are written by expert teachers and are so accurate to rely on. These solutions can eliminate any lingering doubts you may have regarding the concepts.
|Chapter||9. Financial Management|
|Category||NCERT Solutions for Class 12|
NCERT Solutions for Class 12 Business Studies can be a great tool for the students who have taken Business Studies stream for higher studies. These NCERT Class 12 Business Studies solutions are written by expert teachers and faculties to make your practice and revision easier. On this page, we have provided you with the complete solutions of Chapter 9: Financial Management.
NCERT Solutions for Class 12 Business Studies Chapter 9
Financial Management Solutions
Multiple Choice Questions
Q1) The cheapest source of finance is
(b) equity share capital
(c) preference share
(d) retained earning
Answer) (d) Retained earnings
Q2) A decision to acquire a new and modern plant to upgrade an old one is a
(a) financing decision
(b) working capital decision
(c) investment decision
(d) None of the above
Answer) (c) investment decision
Q3) Other things remaining the same, an increase in the tax rate on corporate profit will
(a) make the debt relatively cheaper
(b) make the debt relatively the dearer
(c) have no impact on the cost of debt
(d) we can’t say
Answer) (a) make the debt relatively cheaper
Q4) Companies with a higher growth potential are likely to
(a) pay lower dividends
(b) pay higher dividends
(c) dividends are not affected
(d) none of the above
Answer) (a) pay lower dividends
Q5) Financial leverage is called favourable if
(a) Return on investment is lower than the cost of debt
(b) ROI is higher than the cost of debt
(c) Debt is easily available
(d) If the degree of existing financial leverage is low
Answer) (b) ROI is higher than the cost of debt
Q6) Higher debt-equity ratio results in
(a) lower financial risk
(b) higher degree of operating risk
(c) higher degree of financial risk
(d) higher EPS
Answer) (c) higher degree of financial risk
Q7) Higher working capital usually results in
(a) higher current ratio, higher risk and higher profits
(b) lower current ratio, higher risk and profits
(c) higher equity, lower risk and lower profits
(d) lower equity, lower risk and higher profits
Answer) (a) higher current ratio, higher risk and higher profits
Q8) Current assets are those assets which get converted into cash
(a) within six months
(b) within one year
(c) between one year and three years
(d) between three and five years
Answer) (b) within one year
Q9) Financial planning arrives at
(a) minimising the external borrowing by resorting to equity issues
(b) entering that the firm always have significantly more fund than required so that there is no paucity of funds
(c) ensuring that the firm faces neither a shortage nor a glut of unusable funds
(d) doing only what is possible with the funds that the firms has at its disposal
Answer) (c) ensuring that the firm faces neither a shortage nor a glut of unusable funds
Q10) Higher dividend per share is associated with
(a) high earnings, high cash flows, unstable earnings and higher growth opportunities
(b) high earnings, high cash flows, stable earnings and high growth opportunities
(c) high earnings, high cash flows, stable earnings and lower growth opportunities
(d) high earnings, low cash flows, stable earnings and lower growth opportunities
Answer) (d) high earnings, low cash flows, stable earnings and lower growth opportunities
Q11) A fixed asset should be financed through
(a) a long term liability
(b) a short term liability
(c) a mix of long and short term liabilities
Answer) (a) a long term liability
Q12) Current assets of a business firm should be financed through
(a) current liability only
(b) long-term liability only
(c) both types (i.e. Long and short liabilities)
Answer) (c) both types (i.e. Long and short liabilities)
Short Answer Questions
Q1) What is meant by capital structure?
Answer) Capital structure is the combination of debt and equity which is used by a company to finance its requirements for funds. Debt can be obtained in the form of loans while equity is generated through retained earnings or common stock.
Q2) Discuss the two objectives of Financial Planning
Answer) Financial planning is the process of framing of financial policies, procedures, programs and budgets that are necessary for financial activities of the enterprise.
Objectives of financial planning are:
- To ensure proper utilisation funds are available for the organisational activities.
- To determine the capital structure which is the composition of debt and equity that is necessary for a business.
Q3) What is financial risk? Why does it arise?
Answer) Financial risk refers to a situation when a company is not able to meet its fixed financial charges such as interest payment, preference dividend and repayment obligations. In other words, it refers to the probability that the company would not be able to meet its fixed financial obligations. It arises when the proportion of debt in the capital structure increases. This is because it is obligatory for the company to pay the interest charges on debt along with the principle amount. Thus, higher the debt, higher will be its payment obligations and thereby higher would be the chances of default on payment. Hence, higher use of debt leads to higher financial risk for the company.
Q4) Define a ‘current asset’. Give four examples of such assets.
Answer) Current asset of a firm refers to those assets which can be converted into cash or cash equivalents in a short period of time, i.e. less than one year. Such assets are used to facilitate the day to day business operations. As they can be easily converted into cash or cash equivalents, these assets provide liquidity to the company. Firms acquire such assets to meet its various payment obligations. However, such assets provide very little return and are thereby, less profitable. Current assets can be financed through short-term as well as long term sources.
Some of the examples of current assets are short term investment, debtors, stocks and cash equivalents.
Q5) Financial management is based on three broad financial decisions. What are these?
Answer) Financial management refers to the efficient acquisition, allocation and usage of funds of the company. It deals in three main dimensions of financial decisions namely, Investment decisions, Financial decisions and Dividend decisions.
Investment decisions refer to the decisions regarding where to invest so as to earn the highest possible returns on investment. Investment decisions can be taken for both long term as well as short term.
Long term investment decisions also known as Capital Budgeting decisions affect a business’ long term earning capacity and profitability. For example, investment in a new machine, purchase of a new building, etc. are long term investment decisions.
Short term investment decisions also known as working capital decisions affect a business’ day to day working operations. For example, decisions regarding cash or bill receivables are short term investment decisions.
Such decisions involve identifying various sources of funds and deciding the best combination for raising the funds. The main sources for raising funds are shareholders’ funds (referred as equity) and borrowed funds (referred as debt). Based on the cost involved, risk and profitability a company must judiciously decide the combination of debt and equity to be used. For example, while debt is considered to be the cheapest source of finance, higher debt increases the financial risk. Financial decisions taken by a company affects its overall cost of capital and the financial risk.
The decision involves the decision regarding the distribution of profit or surplus of the company. A company can distribute its profit to the equity share holders in the form of dividends or retain it with itself. Under dividend decision, a company decides what proportion of the surplus to distribute as dividends and what proportion to keep as retained earnings. It is aimed at maximising the shareholders’ wealth while keeping in view the requirement of retained earnings that are needed for re-investment.
Q6) What are the main objectives of financial management? Briefly explain
Answer) The paramount objective of the financial management is maximising the shareholders’ wealth. That is, the basic objective of financial management for a company is to opt for those financial decisions that prove gainful from the point of view of the shareholders. The share holders are said to gain when the market value of their shares rise. The market value of shares increase when the benefits from a financial decision exceed the cost involved in taking them. In other words, a financial decision raises the market value of share if it results in some value addition. Thus, financial decisions should be taken such that some value addition takes place and ultimately the price of the equity share increases. When a financial decision is able to fulfil the primary objective of wealth maximisation, other objectives such as proper utilisation of funds, maintenance of liquidity etc. are automatically fulfilled.
Q7) How does working capital affect both the liquidity as well as profitability of a business?
Answer) Working capital of a business refers to the excess of current assets (such as cash in hand, debtors, stock, etc.) over current liabilities. Working capital affects both the liquidity as well as profitability of a business. As the amount of working capital increases, the liquidity of the business increases. However, since current assets offer low return, with the increase in working capital the profitability of the business falls. For example, an increase in the inventory of the business increases its liquidity but since the stock is kept idle, the profitability falls. On the other hand, low working capital, hinders the day to day operations of the business. Thus, the working capital should be such that a balance is maintained between the profitability and liquidity.
Long Answer Questions
Q1) What is working capital? How is it calculated? Discuss five important determinants of working capital requirement.
Answer) Working capital in a business is the surplus that is determined by subtracting current liabilities from current assets of the organisation. Current assets are those assets that can be converted into cash or cash equivalent within the current accounting period. Two broad categories of working capital can be classified:
- Gross Working Capital: Gross Working Capital is referred to as the current assets that are present in the balance sheet of a company.
- Net Working Capital: Net Working Capital is the difference between current assets and current liabilities present in the balance sheet of an organisation. Net working capital is considered to be more relevant for capital financing and management.
Working capital is calculated as-
Working Capital = Current Assets – Current Liabilities
The following are the determinants of the working capital requirement:
- Business Type: The nature of business of a firm determines its working capital requirement. The size and type of operations of an organisation will the extent of working capital required. For example, firms that offer services will have low working capital requirement whereas a manufacturing plant will have a large working capital requirement. The operating cycle of such a firm is more.
- Scale of operations: The extent of scale of operations is a determining factor for working capital. A firm having a large scale of operation will see an increase in working capital requirement as firms have a high requirement of maintaining inventory. Similarly, a firm having small scale of operations will have a low working capital requirement.
- Fluctuations of Business Cycle: The working capital will also vary with the different phases in which a business is running. During high demand in market there will be high requirement for production, so working capital will be more whereas in terms of low demand.
- Production Cycle: Every industry will have a different production cycle depending on the type of industry. A firm having a longer production cycle will have a higher requirement of working capital and firms having short production cycle will have low working capital requirement.
- Growth Prospects: Companies that have higher growth prospects and look for expansion have a higher working capital requirement.
Q2) “Capital structure decision is essentially optimisation of risk-return relationship”. Comment.
Answer) Capital structure is the combination of debt and equity which is used by a company to finance its requirements for funds. Debt can be obtained in the form of loans while equity is generated through retained earnings or common stock. Borrowed funds can be in the form of loans, debentures, bank loans etc. While in case of owner’s fund it can be in the form of preference share capital, reserves, retained earnings, equity share capital etc.
Debt and equity both have their risk and profitability. Debt is a relatively cheap source while greater risk is there and equity is comparatively expensive but is of lower risk for the firm. Fund raising through debt is cheaper while the same with equity is expensive. Debt though cheaper is having more risks as it has an obligation towards lenders. For equity there is no such compulsion of paying dividend.
Also, the return offered by the sources leads to increase in value per share. Debt gives higher returns per share but increases the risk comparatively many times.
Therefore, capital structure decisions should be taken into consideration with return and the amount of risk involved.
Q3) ”A capital budgeting decision is capable of changing the financial fortunes of a business”. Do you agree? Why or why not?
Answer) Yes, capital budgeting decision is a very essential decision which needs to be taken carefully. It has the capability of changing the financial fortunes of a business. Capital budgeting decision refers to the decisions regarding the allocation of fixed capital to different projects. Such decisions involve investment decisions regarding attainment of new assets, expansion, modernisation and replacement. Such long term investments include purchasing plant and machinery, furniture, land, building, etc. and also expenditure as on launch of a new product, modernisation and advertising, etc. They have long term implications on the business and are irrevocable except at a huge cost. They affect a business’ long term growth, profitability and risk.
The following are the factors that highlight the importance of capital budgeting decisions.
- Long Term Implications: Investment on capital assets (long term assets) yield return in the future. Thereby, they affect the future prospects of a company. A company’s long term growth prospects depend on the capital budgeting decisions taken by it.
- Huge Amount of Funds: Investing in fixed capital involves a large amount of funds. This makes the capital budgeting decisions all the more important as huge amount of funds remain blocked for a longer period of time. These decisions once made are difficult to change. Thus, capital budgeting decisions need to be taken carefully after a detailed study of the total requirement of funds and the sources from which they are to be raised.
- High Risk: Fixed assets involve huge amount of money and thereby, involve huge risk as well. Such decisions are risky as they have an impact on the long term existence of the company. For example, decision about the purchase of new machinery involves a risk in terms of whether the return from the machinery would be greater than the cost incurred on it.
- Irreversible Decisions: These decisions once made are irrevocable. Reversing a capital budgeting decision involves huge cost. This is because once huge investment is made on a project, withdrawing it would mean huge losses.
Q4) Explain the factors affecting the dividend decision.
Answer) Dividend decision is the decision to share a portion of profit which is to be shared between shareholders and what should be kept as retained earnings. Following factors affect dividend decision:
- Businesses are able to pay dividends from the current and past earnings. A company which is having higher earnings will be in a better position to pay dividend in comparison to company having limited earnings.
- Companies having stable earning are in a good position to provide dividends as compared to companies which are inconsistent in earnings.
- Companies follow stable dividend sharing policy. It will only be changed when there is a rise in earning.
- Companies that are looking for higher growth may keep certain portion of earning as dividend while investing majority in expansion. Therefore, such companies offer lesser dividend.
- If the company is not having a good cash flow, it will impact the dividends paid out.
- Company must also check the shareholder preferences while paying dividend as shareholders may require a certain amount of dividend.
- Taxation policies play a major role in deciding the dividends. A policy levying high tax on dividend distribution leads to companies offering lower dividends and vice versa.
- Stock market prices will fluctuate depending on the dividend that is declared. It can rise with high dividend pay-out while decline with low dividend pay-out.
- There can be contractual constraints at the time of offering loans that is imposed by the lender in form of an agreement. Such agreements need to be checked before issuing dividend pay-outs.
- Companies having greater access in capital markets can pay higher dividend and vice versa.
- Companies have to follow rules, regulations and restrictions of Companies Act while declaring dividend pay-out.
Q5) Explain the term ”Trading on Equity”. Why, when and how it can be used by a company?
Answer) Trading on equity is a process of using debt in order to produce gain for the owners. In this process new debt is taken in order to gain new assets with which they can earn greater level of interest which is more than the interest that is paid for debt. This process is practiced as the equity shareholders are only interested in the income that is generated from business. It is only practiced by a company when the rate of return on investment is greater than the rate of interest for the fund that is borrowed. This practice is a form of financial leverage that a company exercise. There is an increase in earnings per share when this process is adopted.
Trading on equity is profitable only when the return on investment is greater than amount of funds borrowed. It is said that trading on equity shall be avoided if the return on investment is less than the rate of interest from the funds that are borrowed.
‘S’ Limited is manufacturing steel at its plant in India. It is enjoying a buoyant demand for its products as economic growth is about 7%-8% and the demand for steel is growing. It is planning to set up a new steel plant to cash on the increased demand. It is estimated that it will require about Rs 5000 crores to set up and about Rs 500 crores of working capital to start the new plant.
- Describe the role and objectives of financial management for this company.
- Explain the importance of having a financial plan for this company. Give an imaginary plan to support your answer.
- What are the factors which will affect the capital structure of this company?
- Keeping in mind that it is a highly capital-intensive sector, what factors will affect the fixed and working capital. Give reasons in support of your answer.
Answer 1) Role of financial management in this company is as follows:
- Financial management will help in taking decisions of purchasing fixed assets which will increase the composition of fixed assets.
- The composition of funds that are used by a company refers to the mix of short- and long-term funds that are used by the company. Fund composition is determined by the company’s decision which is regarding profitability and liquidity. It can be said that if a company is looking to attain higher liquidity it would be looking to opt for long term financing and companies looking for short term liquidity will opt for short term financing.
- The proportion of debt and equity that should be used in long term financing or in other words the distribution of funds that are raised with mix of debt and equity which is taken by financial management.
- The amount of current assets that a company holds is dependent on the financial decision of the company. Higher amount will lead to more working capital but decrease in profits and vice versa.
In this case, the basic objective of financial management will be towards increasing or maximising the shareholders wealth. Decisions that will be beneficial for the shareholders i.e. helps in increasing their market value of shares. This can be achieved if financial management takes a decision that results in increase in value of shares where benefits obtained from making this decision exceeds the cost of taking the financial decision.
Answer 2) These points highlight the importance of financial planning for the company
- It enables the company in forecasting for future requirements.
- Financial plan will be helpful in avoiding any kind of shortage that may occur or surplus that can also occur. It ensures that funds are used optimally.
- It helps in better coordination between sales and production team.
- It helps in avoiding any type of wastages such as time, money and effort.
- If the targets and policies are well defined then financial planning helps in evaluating the performance in a good way.
Proposed Financial Plan
The company can use the 50% through the issue of shares and the other 50% can be collected using funds that are borrowed from outside in form of debts.
Answer 3) Following factors will affect the capital structure choice:
- Company should be opting for debt capital in case of strong cash flow is present. Debt requires payment of principal as well as interest that is applicable on the principal.
- Debt service coverage ratio determines the obligations towards cash payment of a company as against the cash availability. Having a high DSCR can make the company to opt for debt as source of funds.
- Equity cost can be directly related with the financial risk that a company faces. A company having a higher financial risk will see the expectations of shareholders to rise which raises the cost of equity. Rising cost of equity makes it difficult to opt for equity.
- Good stock market conditions are very much conducive for opting equity capital whereas poor stock market conditions are difficult for opting equity capital.
- Higher interest coverage ratio which is a measure of the times EBIT is able to meet interest rate obligations. A higher interest coverage ratio translates to lower risk for the company which enables a company to opt for a high portion of debt in the composition of its capital structure.
- A high rate of floatation cost leads to reduction of the component in capital structure. A high floatation cost of equity results in a low capital structure.
- Higher rate of interest applicable on debt leads to higher debt cost which makes it difficult to choose debt as capital structure.
Answer 4) Factors affecting fixed capital requirements are as follows:
- Fixed capital can be determined by the type of business. As the company mentioned here (S limited) is a company which is into manufacturing it will have a large operating cycle which therefore results in a need for a large amount of fixed capital.
- The scale of operations of a company also determines the need for investment in assets such as machinery, land, plants and buildings which requires large sum of fixed capital.
- A growing company or a company which is seeking expansion will be needing more amount of fixed capital which is the case with S Limited.
Factors affecting working capital requirements will be as follows:
- The working capital requirements for a company will vary on the type of business it is conducting. As it is a manufacturing firm will it will have a large operating cycle as goods need to be transformed from raw materials to finished goods. Therefore, the requirement of working capital will be more for this firm.
- As this company is conducting large scale operations, there will be requirements of large amount of working capital.
- The company is looking to expand its business which requires more working capital as it will lead to higher growth prospects.
- As the product that is being manufactured by this company is in high demand the company would need to produce more to meet the requirements. Therefore, there will be need of large amount of working capital.
That’s it. These were the solutions of NCERT Class 12 Business Studies Chapter 9 – Financial Management. Our team hopes that you have found these solutions helpful for you. If you have any doubt related to this chapter then feel free to comment your doubts below. Our team will try their best to help you with your doubts.