FM Sem-6 GKJ

Commerce Eed - Vision
By,
Gobind Kumar Jha

CA (F), L.L.B(H), M.COM,
B.COM(H)
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GOBIND KUMAR JHA | 9874411552
Financial Management
Chapter-1
Introduction & Basic Concept
1. Define Financial Management.
Introduction:
One needs money to make money. Finance is the life-blood of business and there must be a
continuous flow of funds in and out of a business enterprise. Money makes the wheels of business run
smoothly. Sound plans, efficient production system and excellent marketing network are all hampered in
the absenceof an adequate and timely supply of funds.
Sound financial management is as important in business as production and marketing. A business firm
requires finance to commence its operations, to continue operations and for expansion or growth.
Financeis, therefore, an important operative function of business.
Definition of Financial Management:
Financial management may be defined as planning, organising, directing and controlling the financial
activities of an organisation.
According to Guthman and Dougal, financial management means, “the activity concerned with the
planning, raising, controlling and administering of funds used in the business.” It is concerned with the
procurement and utilisation of funds in the proper manner.
Ezra Solomon has described the nature of financial management as follows: “Financial management is
properly viewed as an integral part of overall management rather than as a staff specially concerned
withfunds raising operations."
In addition to raising funds, financial management is directly concerned with production, marketing
and other functions within an enterprise whenever decisions are made about the acquisition or
distribution offunds.
2. Discuss the importance of Financial Management.

Finance is the lifeblood of business organization. It needs to meet the requirement of the business
concern. Each and every business concern must maintain adequate amount of finance for their smooth
running of the business concern and also maintain the business carefully to achieve the goal of the
business concern. The business goal can be achieved only with the help of effective management of
finance. We can’t neglect the importance of finance at any time at and at any situation.
Some of the importance of the financial management is as follows:
(a) Financial Planning: Financial management helps to determine the financial requirement of the
business concern and leads to take financial planning of the concern. Financial planning is an
important part of the business concern, which helps to promotion of an enterprise
(b) Acquisition of Funds: Financial management involves the acquisition of required finance to the
business concern. Acquiring needed funds play a major part of the financial management, which
involve possible source of finance at minimum cost.
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(c) Proper Use of Funds: Proper use and allocation of funds leads to improve the operational
efficiency of the business concern. When the finance manager uses the funds properly, they can
reduce the cost of capital and increase the value of the firm.
(d) Financial Decision: Financial management helps to take sound financial decision in the business
concern. Financial decision will affect the entire business operation of the concern. Because
there is a direct relationship with various department functions such as marketing, production
personnel,etc.
(e) Improve Profitability: Profitability of the concern purely depends on the effectiveness and proper
utilization of funds by the business concern. Financial management helps to improve the
profitability position of the concern with the help of strong financial control devices such as
budgetary control, ratio analysis and cost volume profit analysis.
(f) Increase the Value of the Firm: Financial management is very important in the field of increasing
the wealth of the investors and the business concern. Ultimate aim of any business concern will
achieve the maximum profit and higher profitability leads to maximize the wealth of the
investorsas well as the nation.
(g) Promoting Savings: Savings are possible only when the business concern earns higher profitability
and maximizing wealth. Effective financial management helps to promoting and mobilizing
individual and corporate savings.
Now days financial management is also popularly known as business finance or corporate finances.
The business concern or corporate sectors cannot function without the importance of the financial
management.
3. What are the functions of financial manager/Financial Management?
Financial Management means planning, organizing, directing and controlling the financial activities such
as procurement and utilization of funds of the enterprise. It means applying general management
principles to financial resources of the enterprise.
(a) Estimation of capital requirements: A finance manager has to make estimation with regards to
capital requirements of the company. This will depend upon expected costs and profits and
future programmes and policies of a concern. Estimations have to be made in an adequate
manner whichincreases earning capacity of enterprise.
(b) Determination of capital composition: Once the estimation have been made, the capital
structure have to be decided. This involves short- term and long- term debt equity analysis.
This will depend upon the proportion of equity capital a company is possessing and additional
funds which have to be raised from outside parties.
(c) Choice of sources of funds: For additional funds to be procured, a company has many choices
like-
 Issue of shares and debentures
 Loans to be taken from banks and financial institutions
 Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and demerits of each source and period of
financing.
(d) Investment of funds: The finance manager has to decide to allocate funds into profitable
venturesso that there is safety on investment and regular returns is possible.
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(e) Disposal of surplus: The net profits decision have to be made by the finance manager. This can
be done in two ways:
(f) Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus.
(g) Retained profits - The volume has to be decided which will depend upon expansional,
innovational, diversification plans of the company.
(h) Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries, payment
of electricity and water bills, payment to creditors, meeting current liabilities, maintenance of
enough stock, purchase of raw materials, etc.
(i) Financial controls: The finance manager has not only to plan, procure and utilize the funds but
he also has to exercise control over finances. This can be done through many techniques like
ratioanalysis, financial forecasting, cost and profit control, etc.
4. The activities of financial managers involve taking three important decisions.

Briefly explain these decisions?
The modern approach to the Financial Management is concerned with the solution of major problems
like investment financing and dividend decisions of the financial operations of a business enterprise.
Thus, the functions of Financial Management can be broadly classified into three major decisions,
namely:
(a) Investment decisions.
(b) Financing decisions.
(c) Dividend decisions.
The functions of Financial Management are briefly discussed as under:
1. Investment Decision:
Investment Decision relates to the determination of total amount of assets to be held in the firm,
the composition of these assets and the business risk complexions of the firm as perceived by its
investors. It is the most important financial decision. Since funds involve cost and are available in a
limited quantity, its proper utilisation is very necessary to achieve the goal of wealth maximisation.
The investment decisions can be classified under two broad groups:
(i) Long-term investment decision and
(ii) Short-term investment decision.
The long-term investment decision is referred to as the capital budgeting and the short-term
investmentdecision as working capital management.
2. Financing Decision
Once the firm has taken the investment decision and committed itself to new investment, it must
decide the best means of financing these commitments. Since, firms regularly make new
investments; the needs for financing and financial decisions are ongoing.
Hence, a firm will be continuously planning for new financial needs. The financing decision is not
only concerned with how best to finance new assets, but also concerned with the best overall mix
of financing for the firm.
A finance manager has to select such sources of funds which will make optimum capital structure.
The important thing to be decided here is the proportion of various sources in the overall capital mix
of the firm. The debt-equity ratio should be fixed in such a way that it helps in maximising the
profitability of the concern.
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The raising of more debts will involve fixed interest liability and dependence upon outsiders. It may
help in increasing the return on equity but will also enhance the risk.
The raising of funds through equity will bring permanent funds to the business but the shareholders
will expect higher rates of earnings. The financial manager has to strike a balance between various
sources so that the overall profitability of the concern improves.
If the capital structure is able to minimise the risk and raise the profitability then the market prices
ofthe shares will go up maximising the wealth of shareholders.
3. Dividend Decision
The third major financial decision relates to the disbursement of profits back to investors who
supplied capital to the firm. The term dividend refers to that part of profits of a company which is
distributed by it among its shareholders.
It is the reward of shareholders for investments made by them in the share capital of the company.
The dividend decision is concerned with the quantum of profits to be distributed among
shareholders.
A decision has to be taken whether all the profits are to be distributed, to retain all the profits in
business or to keep a part of profits in the business and distribute others among shareholders. The
higher rate of dividend may raise the market price of shares and thus, maximise the wealth of
shareholders. The firm should also consider the question of dividend stability, stock dividend
(bonus shares) and cash dividend.
5. Discuss the nature of financial management.
Nature of financial management could be spotlighted with reference to the following aspects of this
discipline:
(a) Financial management is a specialized branch of general management, in the present-day-
times. Long back, in traditional times, the finance function was coupled, either with production
or withmarketing, without being assigned a separate status.
(b) Financial management is growing as a profession. Young educated persons, aspiring for a
career in management, undergo specialized courses in Financial Management, offered by
universities, management institutes etc.; and take up the profession of financial management.
(c) Despite a separate status financial management, is intermingled with other aspects of
management. To some extent, financial management is the responsibility of every functional
manager. For example, the production manager proposing the installation of a new plant to be
operated with modern technology; is also involved in a financial decision.
(d) Financial management is multi-disciplinary in approach. It depends on other disciplines, like
Economics, Accounting etc., for a better procurement and utilisation of finances.
(e) The finance manager is often called the Controller; and the financial management function is
given name of controllership function; in as much as the basic guideline for the formulation
and implementation of plans-throughout the enterprise-come from this quarter.
(f) Despite a hue and cry about decentralisation of authority; finance is a matter to be found still
centralised, even in enterprises which are so called highly decentralised. The reason for
authority being centralised, in financial matters is simple; as every Tom, Dick and Harry
manager cannot
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be allowed to play with finances, the way he/she likes. Finance is both-a crucial and limited
asset-of any enterprise.
(g) Financial management is not simply a basic business function along with production and
marketing; it is more significantly, the backbone of commerce and industry. It turns the sand of
dreams into the gold of reality.
No production, purchases or marketing are possible without being duly supported by requisite
finances. Hence, Financial Management commands a higher status vis-a-vis all other functional areas
of general management.
6. What are the objectives of financial Management?
Objectives of financial management may be multiple; as this branch of general management

encompassesthe entire organizational functioning.
For sake of analysis and better comprehension, the objectives of financial management might be
classifiedinto certain categories-as depicted in form of the following chart:
Following is a brief account of each one of the above objectives of financial management:
(1) Basic Objectives:
(i) Profit-Maximisation:
Since time immemorial, the primary objective of financial management has been held to be profit-
maximisation. That is to say, that financial management ought to take financial decisions and
implement them in a way so as to lead the enterprise along lines of profit maximization. The support
for these objectives could be derived from the philosophy, that ‘profit is a test of economic efficiency’.
(ii) Wealth-Maximisation:
Discarding the profit-maximisation objective; the real basic objective of financial management, now-a-
days, is considered to be wealth maximisation. Wealth maximisation is also known as value-
maximisationor the net present worth maximisation.
Since wealth of owners is reflected in the market-value of shares; wealth maximisation means the
maximisation of the market price of shares. Accordingly, wealth maximisation is measured, by the
marketvalue of shares.
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According to wealth maximisation objective, financial management must select those decisions, which
create most wealth for the owners. If two or more financial courses of action are mutually exclusive
(i.e. only one can be undertaken at a time); then that decision-which creates most wealth, must be
selected.
The wealth arising from a financial course of action could be stated as follows:
Wealth = Gross present worth of a financial course of action minus amount of capital invested which is
required to achieve the benefits i.e. cash flows.
(2) Operational Objectives:
(i) Timely Availability of Requisite Finances:
A very important operational objective of financial management is to ensure that requisite funds are
made available to all the departments, sections or units of the enterprise at the needed time; so that
the operational life of the enterprise goes smoothly.
(ii) Most Effective Utilization of Finances:
Throughout the enterprise, the finances must be utilized most effectively. This is yet, another
important operational objective of the financial, management.
To ensure the attainment of this objective, the financial management must:
– Formulate plans for the most effective utilisation of funds, among channels of investment, which
createmost wealth for the company.
– Exercise and enforce ‘financial discipline’ to prevent wasteful expenditure, by any department, or
branch or section of the enterprise.
(iii) Safety of Investment:
The financial management must primarily look to the safety of investment i.e. the channels of
investment might bring in less returns; but investment must be safe. Loss of investment, in any one
line, might lead to capital depletion; and ultimately tell upon the financial health of the enterprise.
(iv) Growth of the Enterprise:
The financial management must plan for the long-term stability and growth of the enterprise. The
limitedfinances of the enterprise must be so utilized that not only short run benefits are available; but
the enterprise grows slow and steady, in the long run also.
(3) Social Objectives:
(i) Timely Payment of Interest:
The financial management must see to it that interest on bonds, debentures or other loans of the
company is paid in time. This will not only keep the creditors satisfied with the company adding to its
goodwill; but also prevent any untoward consequences of the non-payment of interest, in time.
(ii) Payment of Reasonable Dividends:
An important social objective of financial management is that shareholders i.e. the equity members of
thecompany must get at least some regular dividends.
This objective is important for two reasons: –
– It helps the company maintain its competitive image, in the market. The members on whose funds the
company is running profitable operations must be duly compensated,as a matter of natural justice.
(iii) Timely Payment of Wages:
The financial management must make a provision for a timely payment of wages to workers. This is
necessary to keep the labour force satisfied and motivated. Further, if wages are paid on time; the
legal consequences of non-payment of wages, under the ‘ Payment of Wages Act’, need not frighten
management.
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(iv) Fair-Settlement with Suppliers:

The financial management must make it a point to settle accounts with suppliers and fellow-
businessmen in time, in a fair way; otherwise the commercial reputation of the enterprise will get a
setback.
(v) Timely Payment of Taxes:
An important objective of financial management would be to make timely payment of taxes to the
Government – so as to avoid legal consequences; and also fulfill its social obligations towards the State.
(vi) Maintaining Relations with Financiers:
The financial management must develop and maintain friendly relations with financiers i.e. banks,
financial institutions and various segments of the money market and capital market. When good
relations are maintained with financiers; they might come to the rescue of the enterprise, in situations
of financial crisis.
(4) Research Objectives:
The successful attainment of various objectives by the financial management requires it to follow a
research approach. It must research into new and better sources of finances; and also into new and
betterchannels for the investment of finances.
This research objective of financial management requires it to:
– Collect financial data about the progress of its competitive counterparts.
– Make a study of money market and capital market operations, through a study of latest financial
magazines and other literature on financial management.
7. Why it is inappropriate to seek profit maximisation as the goal of

financial decision making?
Though, there could be little controversy over profit maximisation, as the basic objective of financial
management – yet, in the modern times, several authorities on financial management criticise this
objectives, on the following grounds:
(i) Profit is a vague concept, in that; it is not clear whether profit means
–short-run or long-run profits.
OR
– Profit before tax or profits after tax or
– Rate of profits or the amount of profits.
(ii) The profit maximisation objective ignores, what financial experts call the time value of money’. To
illustrate, this concept, let us assume that two financial courses of action provide equal benefits (i.e.
profits) over a certain period of time. However, one alternative gives more profits in earlier years;
while the other one gives more profits in later years.
Based on profit maximization criterion, both alternatives are equally well. However, the first
alternative
i.e. the one which gives more profits in earlier years is better; as some part of the profits received
earlier could be reinvested also.
Modern financial experts call this philosophy, ‘the earlier the better principle’. The second alternative
which gives more profits only in later years is inferior; as the time-value of profits is more in the case of
the first alternative.
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(iii) The profit maximization objective ignores the quality of benefits (i.e. profits). The factor implicit
here, is the risk element associated with profits. Quality of benefits (profits) is the most when risk
associated with their occurrence is the least. According to modern financial experts, less profit with
less risk are superior to more profits with more risk.
(iv) Profit-maximisation objective is lop-sided. This objective considers or rather over-emphasizes only
on the interests of owners. Interests of other parties like, workers, consumers, the Government and
the society as a whole are ignored, under this concept of profit-maximisation.
8. Why value maximisation (wealth maximisation) objective is called better than profit
maximisation objectives?
The wealth maximisation objective is held to be superior to the profit maximisation objective, because
ofthe following reasons:
(a) It is based on the concept of cash flows; which is more definite than the concept of profits.
Moreover, management is more interested in immediate cash flows than the profits a large
part of which might be hidden in credit sales- still to be realized.
(b) Through discounting the cash flows arising from a financial course of action over a period of
time at an appropriate discount rate; the wealth maximisation approach considers both- the
time valueof money and the quality of benefits.
(c) Wealth maximisation objective is consistent with the long term profitability of the company.
9. Give an idea about ‘wealth maximisation’ & Profit Maximisation objective of

financial management?
Wealth Maximization
Wealth Maximization is considered as the appropriate objective of an enterprise. When the firms
maximizes the stock holder’s wealth, the individual stockholder can use this wealth to maximize his
individual utility. Wealth Maximization is the single substitute for a stock holder’s utility.
A Stock holder’s wealth is shown by:
Stock holder’s wealth = No. of shares owned x Current stock price per share
Higher the stock price per share, the greater will be the stock holder’s wealth.
Arguments in favour of Wealth Maximization:
(i) Due to wealth maximization, the short term money lenders get their payments in time.
(ii) The long time lenders too get a fixed rate of interest on their investments.
(iii) The employees share in the wealth gets increased.
(iv) The various resources are put to economical and efficient use.
Argument against Wealth Maximization:
(i) It is socially undesirable.

(ii) It is not a descriptive idea.
(iii) Only stock holders wealth maximization does not lead to firm’s wealth maximization.
(iv) The objective of wealth maximization is endangered when ownership and management are
separated.Inspite of the arguments against wealth maximization, it is the most appropriative objective
of a firm
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‘Profit Maximization’
Profit Maximization is the main objective of business because:
(i) Profit acts as a measure of efficiency and
(ii) It serves as a protection against risk.
Agreements in favour of Profit Maximization:
(a) When profit earning is the main aim of business the ultimate objective should be profit maximization.
(b) Future is uncertain. A firm should earn more and more profit to meet the future contingencies.
(c) The main source of finance for growth of a business is profit. Hence, profit maximization is required.
(d) Profit maximization is justified on the grounds of rationality as profits act as a measure of
efficiencyand economic prosperity.
Arguments against Profit Maximization:
(a) It leads to exploitation of workers and consumers.
(b) It Ignores the risk factors associated with profit.
(c) Profit in itself is a vague concept and means differently to different prople.
(d) It is narrow concept at the cost of social and moral obligations.
Thus, profit maximization as an objective of Financial Management has been considered inadequate.
10.What are Limitations of ‘Maximisation of Profit’ as the objective of a firm.
Profit maximization is criticized for some of its limitations which are discussed below:
The haziness of the concept “profit”
The term “Profit” is a vague term. It is because different mindset will have a different perception of
profit. For e.g. profits can be the net profit, gross profit, before tax profit, or the rate of profit etc.
There is no clearly defined profit maximization rule about the profits.
Ignores time value of money
The profit maximization formula simply suggests “higher the profit better is the proposal”. In essence,
itis considering the naked profits without considering the timing of them. Another important dictum of
finance says “a dollar today is not equal to a dollar a year later”. So, the time value of money is
completelyignored.
Ignores the risk
A decision solely based on profit maximization model would take a decision in favor of profits. In the
pursuit of profits, the risk involved is ignored which may prove unaffordable at times simply because
higher risks directly questions the survival of a business.
Ignores quality
The most problematic aspect of profit maximization as an objective is that it ignores the intangible
benefitssuch as quality, image, technological advancements etc. The contribution of intangible assets
in generating value for a business is not worth ignoring. They indirectly create assets for the
organization. Profit maximization ruled the traditional business mindset which has gone through
drastic changes. Inthe modern approach of business and financial management, much higher
importance is assigned to wealth maximization in comparison of Profit Maximization vs. Wealth
Maximization. The losingimportance of profit maximization is not baseless and it is not only because
it ignores certain importantareas such as risk, quality, and the time value of money but also because
of the superiority of wealthmaximization as an objective of the business or financial management.
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11.Distinguish Between Profit maximization & wealth maximization
Profit Maximisation Wealth Maximisation

It is traditional approach of the financial It is modern approach of the financial
management. management.
According to this criterion, the financial activities of a According to this criterion, the financial
firm are conducted in such a way so that the activities of a firm are conducted in such a way
amountof profit of the firm is maximum. so that the net wealth of the firm is
maximum.
The concept of profit is not clear in the The concept of wealth is clear in the wealth
profitmaximisation criterion. maximisation criterion. In this case wealth
refers to the net present value of a project.
The aspects of risk and uncertainty are ignored The aspects of risk and uncertainty are
inprofit maximisation criterion. considered in wealth maximisation criterion,
In this case, it is not necessary to know the rate In this case, it is necessary to know the rate of
ofdiscount for determining the profit. discount for determining the net wealth.
Time value of money is not considered in this Time value of money is considered in this
criterion. criterion
It measures the performance of a business firm It measures the performance of a business firm
onlyon the basis of its profit. on the basis of the shareholders’ wealth (or the
current market price of the equity shares).
It is based on the assumption of perfect competition in It assumes an efficient capital market.
the product market.
It does not also consider the impacts of earnings per It takes into account the present value of the
share, dividend payments and other returns to the future cash inflows, dividend payments,
shareholders on shareholder’s wealth or on the earnings per share and their influence on
value of the firm. shareholders’ wealth.
A firm may not pay regular dividends to its A firm pays regular dividends to its
shareholders and reinvest its retained earning shareholders to achieve this goal.
toachieve this goal.
There remains some ambiguity in the definition of There remains some ambiguity in the
profits of a firm (e.g., profit before tax or profits definition of ‘wealth’, i.e., whether it should
aftertax) be shareholders’ wealth of the ‘wealth of a
firm’ (which includes other financial
claimholders such as bondholders,
preferenceshareholders etc.)
The conflict among the goals of owners and The divorce between management and owners
management may stand in the way of achieving in any corporate firm can also frustrate
thisgoal thegoal of wealth maximization.
The role of the CFO (Chief Financial Officer) has been changing over the past twenty years. Originally,
the role of the CFO revolved around producing and analyzing the financial statements. However,
because of the computerization of the accounting function the need for accounting skills in
performing the roles and responsibilities of a CFO diminished. Though the job description of a CFO
(Chief FinancialOfficer) remains broad the tasks comprising that function fall into four distinct roles.
The Strategist CFO
The first role of the CFO is to be a strategist to the CEO. The traditional definition of success for a chief
financial officer was reporting the numbers, managing the financial function, and being reactive to
events as they unfold. But in today’s fast paced business environment, producing financial reports and
information is no longer enough.
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CFO’s in the twenty-first century must be able to “peak around corners”. Therefore, they must be able
toapply critical thinking skills, along with financial acumen, to the long term goals of the organization.
The CFO as a Leader
The second role of the CFO hand in hand with the first one. That is one of a leader
implementing the strategies of the company. As a result, it is no longer sufficient for a CFO to sit back
and analyze the effort of others. The chief financial officer (CFO) of today must take ownership of the
financial results ofboth the organization and senior management team.
The chief financial officer of today must be responsible for providing leadership to other senior
management team members, including the CEO. The CFO’s role can sometimes force them to make
the tough calls that others in the organization don’t or can’t make. Occasionally, this can mean the
differencebetween success and failure.
The CFO as a Team Leader
The third role of the CFO is that of a team leader to other employees – both inside and outside of the
financial function. Not only will a coach call plays for a team, but they are also responsible for getting
thehighest results out of the talent on their team.
An aspiring and successful coach will produce superior results by finding the strengths of their team
members and obtaining a higher level of performance than the individuals might achieve on their own.
The role of the CFO (Chief Financial Officer) is to bring together a diverse group of talented individuals
to achieve superior financial performance.
The CFO with Third Parties
Last, but not least, the role of the CFO is that of a diplomat to third parties. People outside of
the company look to senior management team for inspiration and confidence in the company’s ability
toperform. In almost every case the financial viability of the company is vouched for by the CFO.
The CFO’s role becomes that of the “face” of the company’s sustainability to customers, vendors
and bankers. Often these third parties look to the CFO for the unvarnished truth regarding the financial
viability of the company to deliver on it’s brand promise.
Today’s Role of the CFO
In today’s fast paced environment the role of the CFO is extremely fluid. One day the CFO might be
developing a compensation plan for employees. Then the next day taking their bankers on a tour of
the facilities. Consequently, to be a successful CFO in the future you must be a more multi-functional
executive with financial skills.
13.What is time value of money? What is its importance in long termfinancial decision
making?
What is time value of money can be easily understand from the following example:
If we are offered the choice between having ₹ 100 today and having ₹ 100 at a future date, we will
usually prefer to have ₹ 100 now. If the choice is between paying ₹ 100 now or paying the same ₹
100 at a future date, we will usually prefer to pay ₹ 100 later. But why is this? ₹ 100 has the same
value one year from now also. Actually, although the value is the same, we can do much more with the
money if you have it now; over the time we can earn some interest on our money.
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The time value of money (TVM) is one of the basic concepts of finance. We know that if we deposit
money in a bank account we will receive interest. Because of this, we prefer to receive money today
rather than the same amount in the future. Money we receive today is more valuable to us than money
received in the future by the amount of interest we can earn with the money. This is referred to as the
time value of money.
The term time value of money can be defined as “The value derived from the use of money over
timeas a result of investment and reinvestment.
The reason why there is time value of money is as follows:
(a) Inflation: Under inflationary conditions the value of money expressed in terms of its purchasing
power over goods and services declines.
(b) Risk: Having one rupee now is certain where as one rupee receivable tomorrow is less certain.
That is a bird-in-the-hand principle is most important in the investment decisions.
(c) Personal Consumption Preference: Many individuals have a strong preference for immediate rather
than delayed consumption. The promise of a bowl of rice next week counts for little to the starving
man.
(d) Investment Opportunities: Money like any other commodity has a price. Given the choice of `
1000/- now or the same account in one year time, it is always preferable to take ` 1000/- now,
because it could be invested over the next year @ 12% interest, to produce ` 1,120/- at the end of
year. If the risk-free rate of return in 12%, then you would be indifferent in receiving ` 1000/- now
or `1120/- in ones year’s time. In other words, the present value of `1120/- receivable one year
hence is `1000/-.
14.Explain the compounding & discounting technique in relation to time value of

money?
Technique of discounting:
The present value of a sum of money to be received at a future date is determined by discounting the
future value at the interest rate that the money could earn over the period. This process is known as
Discounting. The present value interest factor declines as the interest rate rises and as the length of
time increases.
Techniques of compounding
The "time value of money" describes the effects of compounding. An amount invested today has more
value than the same amount invested at a later date because it can utilize the power of compounding.
Compounding is the process by which interest is earned on interest. When a principal amount is
invested, interest is earned on the principal during the first period or year. In the second period or year,
interest is earned on the original principal plus the interest earned in the first period. Over time, this
reinvestment process can help an account grow significantly.
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15. In which techniques time is adjusted with the value of money?

Present value is the exact opposite of compound or future value. While future value shows how much
a sum of money becomes at some future period, present value shows what the value is today of some
future sum of money. In compound or future value approach the money invested today appreciates
because the compound interest is added to the principal.
The present value of money to be received on future date will be less because we have lost the
opportunity of investing it at some interest. Thus, the present value of money to be received in future
will always be less. It is for this reason that the present value technique is called discounting.
16. Define risk. Classify risks associated with financial management.
Risk and Types of Risks:

Risk can be referred as the chances of having an unexpected or negative outcome. Any action or activity
that leads to loss of any type can be termed as risk. There are different types of risks that a firm might
face and needs to overcome. Widely, risks can be classified into three types: Business Risk, Non-
Business Risk and Financial Risk.
(a) Business Risk: These types of risks are taken by business enterprises themselves in order to
maximize shareholder value and profits. As for example: Companies undertake high cost risks in
marketing to launch new product in order to gain higher sales.
(b) Non- Business Risk: These types of risks are not under the control of firms. Risks that arise out
of political and economic imbalances can be termed as non-business risk.
(c) Financial Risk: Financial Risk as the term suggests is the risk that involves financial loss to firms.
Financial risk generally arises due to instability and losses in the financial market caused by
movements in stock prices, currencies, interest rates and more.
Types of Financial Risks:
Financial risk is one of the high-priority risk types for every business. Financial risk is caused due to
market movements and market movements can include host of factors. Based on this, financial risk
can be classified into various types such as Market Risk, Credit Risk, Liquidity Risk, Operational Risk and
Legal Risk.
Market Risk:
This type of risk arises due to movement in prices of financial instrument. Market risk can be classified
as Directional Risk and Non - Directional Risk. Directional risk is caused due to movement in stockprice,
interest rates and more. Non- Directional risk on the other hand can be volatility risks.
Credit Risk:
This type of risk arises when one fails to fulfill their obligations towards their counter parties. Credit
risk can be classified into Sovereign Risk and Settlement Risk. Sovereign risk usually arises due to
difficult foreign exchange policies. Settlement risk on the other hand arises when one party makes the
payment while the other party fails to fulfill the obligations.
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Liquidity Risk:
This type of risk arises out of inability to execute transactions. Liquidity risk can be classified
into Asset Liquidity Risk and Funding Liquidity Risk. Asset Liquidity risk arises either due to insufficient
buyers or insufficient sellers against sell orders and buy orders respectively.
Operational Risk:
This type of risk arises out of operational failures such as mismanagement or technical failures.
Operational risk can be classified into Fraud Risk and Model Risk. Fraud risk arises due to lack of
controls and Model risk arises due to incorrect model application.
Legal Risk:
This type of financial risk arises out of legal constraints such as lawsuits. Whenever a company
needsto face financial loses out of legal proceedings, it is legal risk.
17. Discuss the relationship between Risk and Return.
The risk and return constitute the framework for taking investment decision. It has generally been
found that there is a direct relationship between risk and return. An investment proposal involving
low risk has low return while a proposal involving higher risk has higher return.
Relationship between risk and return means to study the effect of both elements on each other. We
measures the effect of increase or decrease risk on return of investment. Following is the main type
of relationship of risk and return.
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1. Direct Relationship between Risk and Return

(A) High Risk - High Return
According to this type of relationship, if investor will take more risk, he will get more reward. So, he
invested million, it means his risk of loss is million dollar. Suppose, he is earning 10% return. It means,
his return is Lakh but he invests more million, it means his risk of loss of money is million. Now, he
will get Lakh return.
(B) Low Risk - Low Return
It is also direct relationship between risk and return. If investor decreases investment. It means, he is
decreasing his risk of loss, at that time, his return will also decrease.
2. Negative Relationship between Risk and Return
(A) High Risk Low Return :
Sometime, investor increases investment amount for getting high return but with increasing return, he
faces low return because it is nature of that project. There is no benefit to increase investment in such
project. Suppose, there are 1,00,000 lotteries in which you will earn the prize of You have bought
50% of total lotteries. But, if you buy 75% of lotteries. Prize will same but at increasing of risk, your
return will decrease.
(B) Low Risk High Return
There are some projects, if you invest low amount, you can earn high return. For example, Govt. of
India need money. Because, govt. needs this money in emergency and Govt. is giving high return on
small investment. If you get this opportunity and invest your money, you will get high return on your
small risk of loss of money.
18.Write in brief about the financial environment of the business.
Introduction Financial deals bring two different identities together; wherein one side has party that has
shortage of funds and on other side there is a party who has surplus funds. Fund seekers want to get
liquid funds and are willing to pay cost for it. Whereas fund investors have wish to channelize their
savings in most optimal way so as that they may earn maximum return on it. Financial markets
have an important role to play in this financial environment. Financial market introduces borrower and
suppliers together so that investment objectives of both can be met.
Financial environment emerges when different individual and institutional investors enter in this
market with different investment objectives. Investors are generally categorized in three different types
depending on their willingness to assume risk. Aggressive investors are the one who wish to take
maximum risk with objective to earn above average return. On the other extreme are conservative
investors who wish to take lowest degree of risk and are satisfied with minimum assured return. Within
these two extremes lie balanced investors who will prefer to take calculated risk and will like to get
return higher than risk free return.
Investors are an important building block of financial environment. However, this is most diversified
component as investors plan to invest with different investment objectives. Investment objective of
investors may include tax planning, capital appreciation, enhanced liquidity, assured return, long term
return etc. These investors prefer to select different financial products (Financial instruments) based on
these varied investment objectives. Selection of these financial products is also affected by investors’
decision to select a particular combination os assumed risk level and preferred return.
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19.Discuss the basic components of the financial environment under which a firm
has to operate.
The complete system of financial environment comprises of four important components. These include
(1) financial managers (2) investors (3) financial markets and 4) Financial instruments.
(1) Financial Managers:
Decision of investing funds lies with financial managers. Financial managers are responsible for taking
decision on acquiring the funds for business and appropriately investing those funds. Finance manager
is accountable on the issue of how to obtain funds (financing) and where to invest a company’s funds
to expand its business. The actions taken by financial managers to make financial decisions for their
respective firms are referred to as financial management (or managerial finance). Financial managers
are expected to make financial decisions in such a way to optimize risk return trade off so as to ensure
maximum value of the firm and ultimately maximize the value of the firm’s stock price. Hence, the final
focus of finance manager is to take financial decisions in a way that may ensure maximum wealth to
the shareholders.
(2) Investors :
Investors may be individuals or institutions who have surplus funds and are willing to provide these
funds to borrowers such as firms, government agencies, individuals or other institutions. This section
provides a brief insight on investors and how do they create provision of funds? Individual investors
are generally small investors who commonly provide funds to firms by purchasing their securities
(equity shares or debt securities). Second category of investors includes institutional investors. The
financial institutions that provide funds are referred to as institutional investors. Some of these
institutions focus on providing loans, whereas others commonly purchase securities that are issued by
firms.
(3) The Financial Markets:
Financial markets represent place/ market that facilitate the flow of funds among investors and
borrowers. In financial markets investors and borrowers trade financial securities, commodities and
other fungible items at a price determined by demand and supply. Financial markets are typically
defined by having transparent pricing, basic regulations on trading, costs and fees and market forces
determining the prices of securities that trade. Hence, financial markets refer to an organized
institutional structure or mechanism for creating and exchanging financial assets. An important
component of these financial markets is financial institutions that act as intermediaries. Financial
markets can be a) Capital markets b) Money market
(4) Financial Instruments:
Financial instruments refer to tradable securities of financial markets. These financial instruments may
represent cash, ownership interest or contractual right to pay/receive money. Broadly, financial
instruments can be of two types: a) Cash instruments b) Derivative instruments Cash instruments are
the one whose value is directly determined by the market e.g. deposits and loans. Whereas value of
derivativeinstrument is derived from underlying asset e.g. forward, options, swap etc.
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Chapter-2
Sources of Capital:
1.What are the various sources of long term finance of limited company?
Explain merits and demerits of any three of them.
Sources of Long-term Finance of a Business

(A) Share capital or Equity share
(B) Preference shares
(C) Retained earnings
(D) Debentures/Bonds of different types
(E) Loans from financial institutions
(A) Share capital or Equity share
Equity Share Capital is a basic source of finance for any firm. It represents the ownership interest in
the company. The characteristics of equity Share Capital are a direct consequence of its position in the
company’s control, income and assets. Equity Share Capital does not have any maturity and there is no
compulsion to pay dividend. The Equity Share Capital provides funds, more or less, on a permanent
basis. It also works as a base for creating the debt and loan capacity of the firm. The advantages and
limitations of Equity Share Capital may be summarized as follows:
Advantages of Equity Share Financing:
(a) It is a permanent source of funds.
(b) The new Equity Share Capital increases the corporate flexibility for the point of view of capital
structure planning.
(c) Equity Share Capital does not involve any mandatory payments to shareholde₹
(d) It may be possible to make further issue of share capital by using a right offering. In
general,selling right shares involves no change in the relationship between ownership and
control.
Limitations of Equity Share Financing:
(a) Cost of capital is the highest of all sources.
(b) Equity Share Capital has a burden of Corporate Dividend Tax on the company.
(c) New issue of Equity Capital may reduce the EPS.
(B) Preference shares
The Preference Share Capital is also owner’s capital but has a maturity period. In India, the preference
shares must be redeemed within a maximum period of 20 years from the date of issue. The rate of
dividend payable on preference shares is also fixed. As against the equity share capital, the preference
shares have two references: (i) Preference with respect to payment of div
Advantages
(a) The preference shares carry limited voting right though they are a part of the capital.
(b) The cost of capital of preference shares is less than that of equity shares.
(c) The preference share financing may also provide a hedge against inflation.
(d) A company does not face liquidation or other legal proceedings if it fails to pay the
preferencedividends
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Disadvantages
(a) The cost of capital of preference shares is higher than cost of debt.
(b) Non-payment of dividend may adversely affect the value of the firm.
(c) The compulsory redemption of preference shares after 20 years will entail a substantial cash
outflow from the company.
(C) Retained earnings
Long-term funds may also be provided by accumulating the profits of the company and by ploughing
them back into business. Such funds belong to the ordinary shareholders and increase the net worth of
the company. A public limited company must plough back a reasonable amount of profit every year
keeping in view the legal requirements in this regard and its own expansion plans. Such funds also
entail almost no risk. Further, control of present owners is also not diluted by retaining profits.
(D) Debentures or Bonds:
As compared with preference shares, debentures provide a more convenient mode of long- term funds.
The cost of capital raised through debentures is quite low since the interest payable on debentures
can be charged as an expense before tax. From the investors' point of view, debentures offer a more
attractive prospect than the preference shares since interest on debentures is payable whether or not
the company makes profits.
Advantages
(a) The cost of debentures is much lower than the cost of preference or equity capital as the
interest is tax-deductible. Also, investors consider debenture investment safer than equity or
preferredinvestment and, hence, may require a lower return on debenture investment.
(b) Debenture financing does not result in dilution of control.
(c) In a period of rising prices, debenture issue is advantageous. The fixed monetary outgo
decreasesin real terms as the price level increases.
Disadvantages
(a) Debenture interest and capital repayment are obligatory payments.
(b) The protective covenants associated with a debenture issue may be restrictive.
(c) Debenture financing enhances the financial risk associated with the firm.
(d) Since debentures need to be paid during maturity, a large amount of cash outflow is needed at
that time.
(E) Loans from Financial Institutions:
In India specialised institutions provide long- term financial assistance to industry. Thus, the Industrial
Finance Corporation of India, the State Financial Corporations, the Life Insurance Corporation of India,
the National Small Industries Corporation Limited, the Industrial Credit and Investment Corporation,
the Industrial Development Bank of India, and the Industrial Reconstruction Corporation of India
provide term loans to companies.
2. What are the various sources of short term finance of limited company?
Discuss*
Sources of Short-term Finance of a Business
(A) Trade credit
It represents credit granted by suppliers of goods, etc., as an incident of sale. The usual duration of
such credit is 15 to 90 days. It generates automatically in the course of business and is common to
almost all business operations. It can be in the form of an 'open account' or 'bills payable'. Trade
credit is preferred as a source of finance because it is without any explicit cost and till a business is a
going concern it keeps on rotating. Another very important characteristic of trade credit is that it
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enhances automatically with the increase in the volume of business.
(B) Accrued Expenses and Deferred Income:

Accrued expenses represent liabilities which a company has to pay for the services which it has already
received. Such expenses arise out of the day to day activities of the company and hence represent a
spontaneous source of finance.
Deferred income, on the other hand, reflects the amount of funds received by a company in lieu of
goods and services to be provided in the future. Since these receipts increase a company’s liquidity,
they are also considered to be an important source of spontaneous finance.
(C) Advances from Customers:
Manufacturers and contractors engaged in producing or constructing costly goods involving
considerable length of manufacturing or construction time usually demand advance money from their
customers at the time of accepting their orders for executing their contracts or supplying the goods.
This is a cost free source of finance and really useful.
(D) Commercial Paper:
A Commercial Paper is an unsecured money market instrument issued in the form of a promissory note.
The Reserve Bank of India introduced the commercial paper scheme in the year 1989 with a view to
enabling highly rated corporate borrowers to diversify their sources of short term borrowings and to
provide an additional instrument to investo₹ Subsequently, in addition to the Corporate, Primary
Dealers and All India Financial Institutions have also been allowed to issue Commercial Pape₹
Commercial Papers can be issued for maturities between 15 days and a maximum up to one year from
the date of issue. These can be issued in denominations of Rs 5 lakh or multiples thereof. All eligible
issuers are required to get the credit rating
(E) Bank Advances:
Bank advances are in the form of loan, overdraft, cash credit and bills purchased/discounted etc.
Banks do not sanction advances on a long term basis beyond a small proportion of their demand and
time liabilities. Advances are granted against tangible securities such as goods, shares, government
promissory notes, Bills etc. In very rare cases, clean advances may also be allowed.
3.What do you mean by Finance Lease? Write its features.

Meaning and definition of Financial Lease
A financial lease is a method used by a business for acquisition of equipment with payment structured
over time. To give proper definition, it can be expressed as an agreement wherein the lessor receives
lease payments for the covering of ownership costs. Moreover, the lessor holds the responsibility of
maintenance, taxes, and insurance.
A financial lease is similar to an out-and-out purchase transaction which has been financed through
a term loan, in that the payments are made on a monthly basis. However, unlike an out-and-out
purchase transaction in that the lessee doesn’t present the obligated balance as debt, shows
payments as expensed, and retains the equipment title. During the lease period, the finance
company is considered as the legal owner of the asset.
Main features of a Financial Lease
(a) Ownership: In a financial lease, ownership is transferred to the lessee at the end of the lease
period. It may be transferred with or without a merger or residual amount as mentioned in the
agreementof finance lease.
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(b) The term of lease: The term of a financial lease extends over the economic life of an asset.
(c) Monthly lease rentals: Monthly lease rentals or payments are the equated monthly payments
which are paid by the lessee to the lessor. In the lease rental, lessor covers the investment made,
interest thereon, repairs and maintenance and profit
(d) Asset: The lessor has nothing to do with the asset. As he is mere a financier to the asset, the
assetis purchased by the choice of the lessee who is the ultimate economic user of it.
(E) Processing time and fee: Unlike a loan, there is no processing fee for the lease and time for
processing is also quite less compared to a loan.
(F) Margin money: In a loan, margin money has to be invested by the equipment buyer but in the case
of the lease, the lessee does not have to pay any margin money and a full amount of the equipment
can be financed here.
(G) Collateral security: There is no such requirement of collateral security in the case of a lease which
is a must when a big loan is taken from any bank or institution.
4.Write short notes on Operating Lease.

Definition:
Operating lease is a contract wherein the owner, called the Lessor, permits the user, called the
Lessee, to use of an asset for a particular period which is shorter than the economic life of the asset
without any transfer of ownership rights. The Lessor gives the right to the Lessee in return for regular
payments for an agreed period of time.
An operating lease is a contract that allows for the use of an asset but does not convey rights of
ownership of the asset. An operating lease represents an off-balance sheet financing of assets, where a
leased asset and associated liabilities of future rent payments are not included on the balance sheet
ofa company.
An operating lease is the rental of an asset from a lessor, but not under terms that transfer
ownership of the asset to the lessee. During the rental period, the lessee typically has unrestricted use
of the asset, but is responsible for the condition of the asset at the end of the lease, when it is
returned to the lessor. An operating lease is especially useful in situations where a business needs to
replace its assets on a recurring basis, and so has a need to swap out old assets for new ones at regular
intervals. For example, the lessee may have decided to replace the office photocopier once every three
years, and so enters into a series of operating leases to continually refresh this equipment. Automobiles
are also commonly leased under operating lease arrangements.
Unlike a finance lease, at the end of the operating lease the title to the asset does not pass to the
lessee, but remains with the lessor. Accordingly, at the end of an operating lease, the lessee has several
options:
 Return of the equipment
 Renewal of the lease
 Purchase of the equipment
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Chapter-4
Capital Structure
1. What do you mean by capital structure? Discuss the pattern of capital structure.
A firm needs funds for long term requirements and working capital. These funds are raised through
different sources both short term and long term. The long term funds required by a firm are mobilized
through owners funds (equity share, preference shares and retained earnings) and long term debt
(debentures and bonds). A mix of various long term sources of funds employed by a firm is called
capitalstructure.
According to Gerestenberg, “Capital structure of a company refers to the composition or make-up of
its capitalization and it includes all long term capital resources, viz, loans, bonds, shares and reserves”.
Thus capital structure is made up of debt and equity securities and refers to permanent financing of a
firm.
Financial Manager has to plan the appropriate mix of different securities in total capitalization in such
a way as to minimize the cost of capital and maximize the earnings per share to the equity shareholde₹
There may be four fundamental patterns of capital structure as follows:
(a) Equity capital only(including Reserves and Surplus)
(b) Equity and preference capital
(c) Equity, preference and long term debt i.e. debentures, bonds and loans from financial
institutionsetc.
(d) Equity and long term debt.
2.What do you mean by Optimum Capital Structure? Discuss the features of an

optimum capital structure.
The theory of optimal capital structure deals with the issue of the right mix of debt and equity in the
long term capital structure of a firm. This theory states that if a company takes on debt, the value of
the firm increases up to a point. Beyond that point if debt continues to increase then the value of the
firm will start to decrease. Similarly if the company is unable to repay the debt within the specified
period then it will affect the goodwill of the company in the market and may create problems for
collecting further debt. Therefore, the company should select its optimum capital structure.
The main features of an optimum capital structure are:
(a) Profitability: The capital structure of the company should be most profitable. The most profitable
capital structure is one that tends to minimize cost of financing and maximize earnings per equity
share.
(b) Solvency: The pattern of capital structure should be so devised as to ensure that the firm does not
run the risk of becoming insolvent. Excess use of debt threatens the solvency of the company. The
debt content should not, therefore, be such that which increases risk beyond manageable limits.
(c) Flexibility: The capital structure should be flexible to meet the requirements of changing
conditions. Moreover, it should also be possible for the company to provide funds whenever
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(d) Conservatism: The capital structure should be conservative in the sense that the debt content in
the total capital structure does not exceed the limit which the company can bear. In other words, it
shouldbe such as is commensurate with the company’s ability to generate future cash flows.
(e) Control: The capital structure should be so devised that it involves minimum risk of loss of control
of the company.
3.Mention the factors that ate to be considered in determining capital structure?
(a) Trading on equity or financial leverage: Through this device, the capital is highly-geared. In this
case, the company issues more debentures and preference shares with fixed rate of interest and
dividend. As a result, the dividend rate of equity shares can be substantially raised.
(b) Risk, income and control of the enterprise: Risk, income and control move together, Greater
income and control may cover greater risk. Equity shareholders undertake greater risk than the
fixed interest-bearing securities. The control is also concentrated in their hands. So this aspect
should be considered in capital structure.
(c) Operating leverage: It indicates the vulnerability of operating profit of change in volume of sales
and depends on operating fixed cost of the company. It reflects the operating risk. If operating
leverageis high, the company should introduce relatively small amount of debt capital.
(d) EBIT-EPS analysis: To maximise earnings per share (EPS) of equity shareholders, while planning capital
structure the behaviour of EPS at varying levels of earnings before interest and tax (EBIT) under
alternative financial plans should be studied.
(e) Cost of capital: Lower cost of capital increases the value of the firm. Cost of capital is influenced by
capital structure. Debt capital is usually cheaper because of lower risk and tax deductibility. So debt-
equitymix has to be made in such a way that overall cost of capital becomes minimum.
(f) Control: Capital structure is affected by the extent to which the promoters desire to maintain
control over the affairs of the company. If the company issues more equity shares, there will be dilution of
control. To avoid loss of control, the company should use more debt capital and preference capital.
(g) Cash flow analysis: The Company should prepare a projected cash flow statement for the next 5-6 years
toget an idea of cash inflows. If future cash inflows position is steady or stable, more debt capital can
beemployed. But if future cash inflows position is unstable, debt capital should be avoided.
(h) Stability of sales: If the company's sales are stable, it can employ more debt capital because there will
beno difficulty in meeting fixed obligations.
(i) Size of the company: If the size of the company is large, it can raise fund easily from different sources.
So its capital structure can be suitably designed.
(j) Legal requirements or restrictions: The finance manager has to comply with the legal
requirements or restrictions while deciding about the capital structure.
(k) Corporate taxation: Corporate taxation is an important factor in determining the choice between
different sources of financing, e.g., dividend on shares is not deductible but interest on borrowed
capital and cost of raising finance are allowed as deduction for taxation purpose. So capital structure
planningneeds to consider corporate taxation factor.
(l) Government policies: Lending policies of financial institutions, SEBI rules and regulations,
government's monetary and fiscal policies affect capital structure decisions.
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(m) Purpose of financing: If the funds are required for manufacturing or productive purposes, funds
should be raised from long-term sources. If the funds are needed for welfare facilities to
employees of the company, internal sources should be tapped.
(n) Period of finance: When permanent funds are needed, equity shares should be issued but
whenfinance is required for 8-10 years, it is appropriate to raise borrowed funds.
4.Discuss the Net Income (NI) Approach of capital structure. What are itscriticisms.
According to the Net Income Approach, a suggested by David Durand, the capital structure decisions
have an important bearing upon the valuation of the firm. Alternatively speaking, a change in the
capital structure results in a corresponding change in the overall cost of capital as well as the value of
the firm. Thus, the firm can influence its value by changing the proportion of debt capital in the debt
equity mix of its capital structure.
According to this approach, higher financial leverage or the higher debt content in the capital structure
leads to a reduction in the weighted average cost of capital of the firm. As a result, the returns
available to the shareholders will increase. The increased returns to the shareholders would, in turn,
increase the total value of the equity and hence, it would lead to an increase in the value of the firm.
This approachis based on the following assumptions:
a. There are no corporate taxes (as we have already stated),
b. The cost of debt capital is less than the cost of equity capital i.e., Kd<Ke
c. Any change in the financial leverage or the debt content in the capital structure does not
alterthe risk perception of the investors, and
d. The cost of debt capital and the cost of equity capital will remain unchanged irrespective of
any change in the debt-equity mix of the firm.
The value of the firm, on the basis of this approach, can be ascertained as follows
V= S+D
Where, V= Value of the firm
S = Market value of the equity
D = Market value of the Debt.
Criticisms of Net Income (NI) Approach.
The principal drawback of the Net Income approach is that it assumes constancy of cost of debt capital
and the cost of equity capital. Empirical observations indicate that with the introduction of debt
capital, the cost of equity tends to rise and, after a certain stage of leverage, the cost of debt capital
also starts rising. Moreover, the general assumption of the distribution of entire earnings of a firm as
dividend or the similarity of risk perception among all investors have no practical feasibility.
5.Discuss the Net Operating Income (NOI) Approach of capital structure. What are its
criticisms.
According to this approach, the value of a firm is not at all affected by the changes in its capital
structure. This theory indicates that the market price of shares and the overall cost of capital would be
independent of the degree of finacial leverage of a firm. Hence, this theory suggests that the capital
structure decision in any firm are irrelevant and hence, there remains no such thing as optimum capital
structure. Any capital structure can be considered as an optimum capital structure for a firm.
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This theory is based on the following assumptions:

a. The overall cost of capital (Ko) remains constant for all degrees of financial leverage.
b. The investors see the firm as a whole and thus capitalises the total earnings of the firm to
determine the value of the firm as a whole (i.e. the split between the debt and equity capital is
not relevant here).
c. The value of equity (S) is a residual value and it is determined by deducting the total value of debt
(D) from the value of the firm (V). ∴S=V- D.
d. The cost of debt capital (Kd) also remains constant at all degrees of financial leverage, and K d <
Ke.
e. The cost of equity capital (Ke) or the equity capitalisation rate increases with an increase in
thedegree of financial leverage.
f. There are no corporate taxes.
According to this approach the value of a firm can be determined by capitalisation the EBIT/
OperatingIncome at Overall Cost of Capital (Ko) as follows:
EBIT
V=
ko
Criticisms of Net Operating Income (NOI) Approach.
This theory has been criticised on the following grounds:
(b) This approach presumes that the benefits from the use of cheaper debt capital will be just off
set by the increase in the cost of equity. Therefore, the value of the firm will remain unchanged.
But this seems to be an absurd proposition and is unlikely to happen in reality.
(c) Under this approach, change in the capital structure of a firm does not affect the market value
of the firm and every capital structure is the optimum capital structure, provided there are no
corporate tax. However, when the existence of taxes are assumed, the optimum capital
structurecan be achieved by maximising the debt mix in the capital structure of a firm.
(d) According to this approach, there will be no optimum capital structure of any firms. If this is true,
there will be no need of any financial plan for any firm.
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Chapter-7
Capital Budgeting
1.What is capital Budgeting? What are the Purposes of CapitalExpenditure
Decisions:
Capital budgeting decision may be defined as “Firms decisions to invest its current funds most
efficiently in long term activities in anticipation of an expected flow of future benefits over a series of
year. The firm’s capital budgeting decisions will include addition, disposition, modification and
replacement of fixed assets”.
Definitions:
Charles. T. Horngreen defined capital budgeting as “Long term planning for making and financing
proposed capital out lay”.
According to Keller and Ferrara, “Capital Budgeting represents the plans for the appropriation and
expenditure for fixed asset during the budget period”.
Robert N. Anthony defined as “Capital Budget is essentially a list of what management believes to be
worthwhile projects for the acquisition of new capital assets together with the estimated cost of each
product”.
Need of capital budgeting decision
The selection of the most profitable project of capital investment is the key function of Financial
Manager. The decisions taken by the management in this area affect the operations of the firm for
many years Capital budgeting decisions may be generally needed for the following purposes:
Hence, following may be considered as major or specific objectives in respect of investment in fixed
assets under long-term basis:
(a) Modification and Replacement of existing facilities.
(b) Quality improvement in the present projects.
(c) Expansion of business through creating additional facilities.
(d) Creation of new product and improving the quality of existing products.
(e) Product diversification for survival under the competitive market scenario.
(f) Cost reduction initiatives which may require the purchase of most sophisticated and
modernequipment.
(g) Exploration of new ideas through Research and Development.
(h) Replacement of manual work by automation process.
(i) Maximization of wealth of the shareholder
(j) Achievement of various social objectives complying with statutory obligations. (say, setting
upof waste treatment plant to reduce environmental pollution).
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2.What do you mean by capital budgeting? Discuss its importance.
Financing and investment of funds are two crucial financial functions. The investment of funds also
termed as capital budgeting requires a number of decisions to be taken in a situation in which
fundsare invested and benefits are expected over a long period. The term capital budgeting means
planning for capital assets. It involves proper project planning and commercial evaluation of
projects to knowin advance technical feasibility and financial viability of the project.
Importance of Capital Budgeting

Capital Budgeting decisions are considered important for a variety of reasons. Some of them are the
following:
(a) Crucial decisions: Capital budgeting decisions are crucial, affecting all the departments of the
firm. So the capital budgeting decisions should be taken very carefully.
(b) Long-run decisions: The implications of capital budgeting decisions extend to a longer period in
the future. The consequences of a wrong decision will be disastrous for the survival of the firm.
(c) Large amount of funds: Capital budgeting decisions involve spending large amount of funds. As
such proper care should be exercised to see that these funds are invested in productive
purchases.
(d) Rigid: Capital budgeting decision can not be altered easily to suit the purpose. Because of this
reason, when once funds are committed in a project, they are to be coutinued till the end, loss or
profit no matter.
3. What are the process (Steps) of capital budgeting?
The major steps in the capital budgeting process are given below. They are a) Generation of project;
b) Evaluation of the project; c) Selection of the project and d) Execution of the project. The capital
budgeting process may include a few more steps. As each step is significant they are usually taken bytop
management
(a) Generation of Project:
Depending upon the nature of the firm, investment proposals can emanate from a variety of
sources.Projects may be classified into five categories.
(i) New products or expansion of existing products.
(ii) Replacement of equipment or buildings.
(iii) Research and development.
(iv) Exploration.
(v) Others like acquisition of a pollution control device etc.
Investment proposals should be generated for the productive employment of firm’s funds.
However, asystematic procedure must be evolved for generating profitable proposals to keep the
firm healthy.
(b) Evaluation of the project:
The evaluation of the project may be done in two steps. First the costs and benefits of the project are
estimated in terms of cash flows and secondly the desirability of the project is judged by an
appropriate criterion. It is important that the project must be evaluated without any prejudice on the
part of the individual. While selecting a criterion to judge the desirability of the project, due
consideration mustbe given to the market value of the firm.
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(c) Selection of the project:

After evaluation of the project, the project with highest return should be selected. There is no hard
and fast rule set for the purpose of selecting a project from many alternative projects. Normally the
projects are screened at various levels. However, the final selection of the project vests with the top
level management.
(d) Execution of project:
After selection of a project, the next step in capital budgeting process is to implement the project.
Thus the funds are appropriated for capital expenditures. The funds are spent in accordance with
appropriations made in the capital budget funds for the purpose of project execution should be
spent only after seeking format permission for the controller. The follow – up comparison of actual
performance with original estimates ensure better control.
Thus the top management should follow the above procedure before taking actual expenditure
decision.
4.Discuss the different Types of Investment Projects
Firms generally classify their investment project into the project into the following categories for
carrying out the screening process as stated in our earlier section:
(a) Replacement for the maintenance of business: This involves expenditure for replacing worn-
out or damaged capital and equipment used to produce some profitable products.
(b) Replacement for cost reduction: Investment required to replace working but obsolete
equipment with modern equipment, which are supposed to reduce the average cost of
production (say, by reducing the labour costs, material costs, electricity and fuel costs, etc.), fall
into this category.
(c) Expansion of output of some traditional products and their markets: Investment needed to
expand the production of some traditional products of a firm in their existing or traditional
markets, are included in this category. These investment projects may be taken up in response to
increase demand for such products, say, in the domestic market.
(d) Search for new markets and increase in the production of non-traditional products: In a fast
changing business world, the efficient operation of a firm also requires investment in developing
new products and expanding the market for such products, both in the domestic and external
fronts.
(e) Complying with statutory obligations: These investment projects include such investments
which are required by any firm to fulfill some statutory obligations like population control, health
and safety regulations, etc. imposed by the Government.
5. Discuss briefly the NPV method of evaluation of projects.
NPV method
The net present value method is a classic method of evaluating the investment proposals. It is one
of the methods of discounted cash flow techniques, which recognizes the importance of time value of
money. It correctly postulates that cash flows arising at time periods differ in value and are
comparable only with their equivalents i.e. present values.
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It is a method of calculating the present value of cash flows (inflows and outflows) of an investment
proposal using the cost of capital as an appropriate discounting rate. The net present value will be
arrived at by subtracting the present value of cash outflows from the present value of cash inflows.
According to Ezra Soloman, “it is a present value of the cast of the investment.”
Acceptance Rule:
If the NPV is positive or at-least equal to zero, the project can be accepted. If it is negative, the
proposal can be rejected. Among the various alternatives, the project which gives the highest positive
NPV should be selected.
NPV is positive = Cash inflows are generated at a rate higher than the minimum required by the firm.
NPV is zero = Cash inflows are generated at a rate equal to the minimum required.
NPV is negative = Cash inflows are generated at a rate lower than the minimum required by the firm.
The market value per share will increase if the project with positive NPV is selected.
The accept/reject criterion under the NPV method can also be put as:
Merits:
The following are the merits of the net present value (NPV) methods:
(a) Consideration to total Cash Inflows: The NPV methods considers the total cash inflows of
investment opportunities over the entire life-time of the projects unlike the payback period
methods.
(b) Recognition to the Time Value of Money: This methods explicitly recognizes the time value of
money, which is investable for making meaningful financial decisions.
(c) Changing Discount Rate: Due to change in the risk pattern of the investor different discount rates
can be used.
(d) Best decision criteria for Mutually Exclusive Projects: This Method is particularly useful for
the selection of mutually exclusive projects. It serves as the best decision criteria for mutually
exclusive choice proposals.
(e) Maximisation of the Shareholders Wealth: Finally, the NPV method is instrumental in achieving
the objective of the maximization of the shareholders’ wealth. This method is logically consistent
with the company’s objective of maximizing shareholders’ wealth in terms of maximizing market
value of shares, and theoretically correct for the selections of investmentproposals.
Demerits:
The following are the demerits of the net present value method:
(a) It is difficult to understand and use.
(b) The NPV is calculated by using the cost of capital as a discount rate. But the concept of cost of
capital itself is difficult to understand and determine.
(c) It does not give solutions when the comparable projects are involved in different amounts
ofinvestment.
(d) It does not give correct answer to a question when alternative projects of limited funds
areavailable, with unequal lives.
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6.Discuss briefly IRR method of evaluation of projects.
IRR method follows discounted cash flow technique which takes into account the time value of
money. The internal rate of return is the interest rate which equates the present value of expected
future cash inflows with the initial capital outlay. In other words, it is the rate at which NPV is equal
zero.
Whenever a project report is prepared, IRR is to be worked out in order to ascertain the viability of
the project. This is also an important guiding factor to financial institutions and investor.
Acceptance Rule
If the internal rate of return exceeds the required rate of return, then the project will be accepted.
If the project’s IRR is less than the required rate of return, it should be rejected. In case of ranking the
proposals the technique of IRR is significantly used. The projects with highest rate of return will be
ranked as first compared to the lowest rate of return projects.
Thus, the IRR acceptance rules are
Accept if IRR > k
Reject if IRR < k
May accept or reject if IRR = k
Where
K is the cost of capital
MERITS
The following are the merits of the IRR method:
(i) Consideration of Time of Money: It considers the time value of money.
(ii) Consideration of total Cash Flows: It taken into account the cash flows over the entire useful life of
the asset.
(iii) Maximising of shareholders’ wealth: It is in conformity with the firm’s objective of maximizing
owner welfare.
(iv) Provision for risk and uncertainty: This method automatically gives weight to money values which
are nearer to the present period than those which are distant from it. Conversely, in case of
other methods like ‘Payback Period’ and ‘Accounting Rate of Return’, all money units are given
the same weight which is unrealistic. Thus the IRR is more realistic method of project valuation.
This methodimproves the quality of estimates reducing the uncertainty to minimum.
(v) Elimination of pre-determined discount rate: Unlike the NPV method, the IRR method eliminates
the use of the required rate of return which is usually a pre-determined rate of cost of capital for
discounting the cash flow consistent with the cost of capital. Therefore, the IRR is more reliable
measure of the profitability of the investment proposals.
DEMERITS
The following are the demerits of the IRR:
(i) It is very difficult to understand and use
(ii) It involves a very complicated computational work
(iii) It may not give unique answer in all situations.
(iv) The assumption of re-investment of cash flows may not be possible in practice.
(v) In evaluating the mutually exclusive proposals, this method fails to select the most
profitableproject which is consistent with the objective of maximization of shareholders wealthy.
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7. Compare between Internal Rate of Return & Net Present Value.
Comparison of both the techniques

(i) Both techniques use Discounted Cash Flow (DCF) method.
(ii) Both recognize the time value of money.
(iii) Both take into account the cash flows over the entire life of the project.
(iv) Both are consistent with the objective of maximizing the wealth of shareholde₹
(v) Both are difficult to calculate.
(vi) Both techniques may often give contradictory result in the case of alternative proposals which
aremutually exclusive.
Contrast, i.e. Points of difference

(i) Interest Rate: NPV uses the firm’s cost of capital as Interest Rate. Unless the cost of capital is
known, NPV method cannot be used. Calculating cost of capital is not required for computing IRR.
(ii) NPV may mislead when dealing with alternative projects or limited funds under the conditions of
unequal lives. IRR allows a sound comparison of the project having different lives and different
timings of cash inflows.
(iii) NPV may give different ranking in case of complicated projects as compared to IRR method.
(iv) NPV assumes that intermediate cash flows are re-invested at firm’s cost of capital whereas
IRRassumes that intermediate cash inflows are reinvested at the internal rate of the project.
(v) The results of IRR method may be inconsistent compared to NPV method, if the projects differ
intheir (a) expected lives or (b) investment or (c) timing of cash inflow.
(vi) IRR method favours short-lived project so long as it promises return in excess of cut-off
ratewhereas NPV method favours long-lived projects.
(vii) Some times IRR may give negative rate or multiple rates. NPV does not suffer from the
limitationof multiple rates.
Recommendation
The NPV method is generally considered to be superior theoretically because:
It is simple to calculate as compared to IRR.
(i) It does not suffer from the limitation of multiple rates.
(ii) NPV assumes that intermediate cash flows are reinvested at firm’s cost of capital.
Thereinvestment assumption of NPV is more realistic than IRR method.
But IRR method is favoured by some scholars because:
(i) It is easier to visualize and to interpret as compared to NPV.
(ii) Even in the absence of cost of capital, IRR gives an idea of project’s profitability.
(iii) Unless the cost of capital is known, NPV cannot be used.
(iv) IRR method is preferable to NPV in the evaluation of risky projects.
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8.Examine the rationality of the Payback Period Method in the context of capital
expenditure decisions.
Payback Period
It is the most popular and widely recognized traditional methods of evaluating the investment
proposals. It can be defined as “the number of years to recover the original capital invested in a
project”. According to Weston and Brigham, “the pay back period is the number of years it takes for
the firm to recover its original investment by net returns before depreciation, but after taxes:
When cash flows are uniform:
If the proposed project’s cash inflows are uniform the following formula can be used to calculate the
payback period.
Payback period = Annual Cash inflows/Initial Investment
When cash flows are not uniform
When the project’s cash inflows are not uniform, but vary from year to year pay back period is
calculated by the process of cumulating cash inflows till the time when cumulative cash flows become
equal to the original investment outlay.
Discounted payback period’
Some Accountants calculate payback period after discounting the cash flows by a predetermined rate
and the payback period so calculated is called, ‘Discounted payback period’.
Advantages of Payback period:

Merits: The following are the merits of the pay back period method:
(a) Easy to calculate: It is one of the easiest methods of evaluating the investment projects. It is
simpleto understand and easy to compute.
(b) Knowledge: The knowledge of payback period is useful in decision-making, the shorter the period
better the project.
(c) Protection from loss due to obsolescence: This method is very suitable to such industries where
mechanical and technical changes are routine practice and hence, shorter payback period practice
avoids such losses.
(d) Easily availability of information: It can be computed on the basis of accounting information, what
is available from the books
Limitations of Payback period:
However, the payback period method has certain demerits:
(a) Failure in taking cash flows after payback period: This method is not taking into account the
cash flows received by the company after the payback period.
(b) Not considering the time value of money: It does not take into account the time value of
money.
(c) Non-considering of interest factor: It does not take into account the interest factor involved
inthe capital outlay.
(d) Maximisation of market value not possible: It is not consistent with the objective of maximizing
the market value of share.
(e) Failure in taking magnitude and timing of cash inflows: It fails to consider the pattern of cash
inflows i.e. the magnitude and timing of cash inflows.
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9.Write short note on Accounting Rate of Return Method.
Accounting Rate of Return

This technique uses the accounting information revealed by the financial statements to measure the
profitability of an investment proposal. It can be determined by dividing the average income after
taxes by the average investment. According to Soloman, Accounting Rate of Return can be calculated
as the ratio, of average net income to the initial investment.
On the basis of this method, the company can select all those projects whose ARR is higher than the
minimum rate established by the company. It can reject the projects with an ARR lower than the
expected rate of return. This method also helps the management to rank the proposal on the basis of
ARR.
Accounting Rate of Return (ARR) = Original Investment/Average Net Income
Acceptance Rule:
The project which gives the highest rate of return over the minimum required rate of return is
acceptable
Merits:
The following are the merits of ARR method:
(i) It is very simple to understand and calculate;
(ii) It can be readily computed with the help of the available accounting data;
(iii) It uses the entire stream of earnings to calculate the ARR.
Demerits:
This method has the following demerits:
(i) It is not based on cash flows generated by a project;
(ii) This method does not consider the objective of wealth maximization;
(iii) It ignore the length of the projects useful life;
(iv) If does not take into account the fact that the profile can be re-invested; and
(v) It ignores the time value of money.
10.Write short note on Profitability Index Method.
This method is also known as ‘Benefit Cost Ratio’. According to Van Horne, the profitability Index
of a project is “the ratio of the present value of future net cash inflows to the present value of cash
outflows”.
Profitability Index = Present value of cash inflows/Present value of cash outflows
Advantages
Decision criteria: If the Profitability Index is greater than or equal to one, the project should
beaccepted otherwise reject.
Merits:
The merits of this method are:
(i) It takes into account the time value of money
(ii) It helps to accept / reject investment proposal on the basis of value of the index.
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(iii) It is useful to rank the proposals on the basis of the highest /lowest value of the index.
(iv) It takes into consideration the entire stream of cash flows generated during the life of the asset.
Demerits:
However, this technique suffers from the following limitations:
(i) It is some what difficult to compute.
(ii) It is difficult to understand the analytical of the decision on the basis of profitability index.
11. Modified Internal Rate of Returns (MIRR)
IRR assumes that interim positives cash flows are reinvested at the rate of returns as that of the
project that generated them. This is usually an unrealistic scenario.. To overcome this draw back a
new technique emerges. Under MIRR the earlier cash flows are reinvested at firm’s rate of
return and finding out the terminal value. MIRR is the rate at which present value of terminal values
equal to outflow (Investment).
The procedure for calculating MIRR is as follows:
Step I: Calculate the present value of the costs (PVC) associated with the project, using cost of capital
(r) as the discount rate.
Step 2: Calculate the future value (FV) of the cash inflows expected from the project:
Step 3: Obtain MIRR
MIRR= ∑ CV of all CIAT - 1.
√
∑ PV of all CO
Merits of MIRR method:

(a) It takes into account the time value of money.
(b) This method also considers the net cash flow stream over the life-span of the investment project.
(c) The approach of this method is very straight forward, simple, quick and easy to understand.
(d) MIRR assumes that positive cash flows are reinvested at the rate equivalent to firm’s cost capital,
and hence gives a more realistic evaluation of the project.
(e) Any series of cash flows has a single MIRR.
Demerits of the MIRR method:
The MIRR does suffer from some of the drawbacks of IRR. Relying on it can lead to an incorrect
choice between mutually exclusive investments. The MIRR cannot be validly used to rank-order
projects of different sizes because a larger project with a smaller MIRR may have a higher present
value.
12.Write Short Notes on Capital Rationing
Capital Rationing means distribution of limited Capital in favour of more acceptable proposals. It
refers to a situation where a firm is not in a position to invest in all profitable projects due to the
limited financial resources in the form of capital. In other words, under this situation, a firm is
compelled to reject some of the firm of the viable projects having positive net present value because
of shortage of funds. Therefore, the firm has to select a feasible combination of proposals that will
give the maximum return to the wealth of shareholders by maximising the total net present value
from the available projects.
In this section we shall discuss the methods of solving the capital budgeting problems under the
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situation of capital rationing. This can be studied under the following two situations:
1. When projects are Divisible:
It means projects can be taken up (i.e., accepted or rejected) in parts.
2. When project are Indivisible:
It means projects can be taken up in totality and the part acceptance or rejection is not possible.
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Commerce Eed - Vision

Gobind Kumar Jha

2. Discuss the importance of Financial Management.

3. What are the functions of financial manager/Financial Management?

4. The activities of financial managers involve taking three important decisions.

5. Discuss the nature of financial management.

6. What are the objectives of financial Management?

Objectives of financial management may be multiple; as this branch of general management

(iv) Fair-Settlement with Suppliers:

7. Why it is inappropriate to seek profit maximisation as the goal of

9. Give an idea about ‘wealth maximisation’ & Profit Maximisation objective of

(i) It is socially undesirable.

10.What are Limitations of ‘Maximisation of Profit’ as the objective of a firm.

11.Distinguish Between Profit maximization & wealth maximization

Profit Maximisation Wealth Maximisation

14.Explain the compounding & discounting technique in relation to time value of

15. In which techniques time is adjusted with the value of money?

16. Define risk. Classify risks associated with financial management.

Risk and Types of Risks:

17. Discuss the relationship between Risk and Return.

1. Direct Relationship between Risk and Return

18.Write in brief about the financial environment of the business.

Sources of Long-term Finance of a Business

enhances automatically with the increase in the volume of business.

(B) Accrued Expenses and Deferred Income:

3.What do you mean by Finance Lease? Write its features.

4.Write short notes on Operating Lease.

2.What do you mean by Optimum Capital Structure? Discuss the features of an

3.Mention the factors that ate to be considered in determining capital structure?

This theory is based on the following assumptions:

2.What do you mean by capital budgeting? Discuss its importance.

Importance of Capital Budgeting

3. What are the process (Steps) of capital budgeting?

(c) Selection of the project:

4.Discuss the different Types of Investment Projects

5. Discuss briefly the NPV method of evaluation of projects.

6.Discuss briefly IRR method of evaluation of projects.

7. Compare between Internal Rate of Return & Net Present Value.

Comparison of both the techniques

Contrast, i.e. Points of difference

Advantages of Payback period:

9.Write short note on Accounting Rate of Return Method.

Accounting Rate of Return

10.Write short note on Profitability Index Method.

11. Modified Internal Rate of Returns (MIRR)

Merits of MIRR method:

12.Write Short Notes on Capital Rationing

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