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FM Important Theory Questions (PAST YEAR TREND)

FM IMPORTANT Theory Questions

BASICS

Q 1. List the emerging issues (any four) affecting the future role of CFO 
ANS. Emerging Issues/Priorities Affecting the Future Role of Chief Financial Officer (CFO)
 (i) Regulation: Regulation requirements are increasing and CFOs have an increasingly personal stake in regulatory adherence.
(ii) Globalisation: The challenges of globalisation are creating a need for finance leaders to develop a finance function that works effectively on the global stage and that embraces diversity.
(iii) Technology: Technology is evolving very quickly, providing the potential for CFOs to reconfigure finance processes and drive business insight through ‘big data’ and analytics.
 (iv) Risk: The nature of the risks that organisations face are changing, requiring more effective risk management approaches and increasingly CFOs have a role to play in ensuring an appropriate corporate ethos.
 (v) Transformation: There will be more pressure on CFOs to transform their finance functions to drive a better service to the business at zero cost impact.
 (vi) Stakeholder Management: Stakeholder management and relationships will become important as increasingly CFOs become the face of the corporate brand.
(vii) Strategy: There will be a greater role to play in strategy validation and execution, because the environment is more complex and quick changing, calling on the analytical skills CFOs can bring.
 (viii) Reporting: Reporting requirements will broaden and continue to be burdensome for CFOs.

(ix) Talent and Capability: A brighter spotlight will shine on talent, capability and behaviours in the top finance role.

Q 2.Discuss the functions of a Chief Financial Officer.
ANS.Functions of a Chief Financial Officer
    The twin aspects viz procurement and effective utilization of funds are the crucial tasks, which the CFO faces. The Chief Finance Officer is required to look into financial implications of any decision in the firm. Thus all decisions involving management of funds comes under the purview of finance manager. These are namely:
 Estimating requirement of funds
 Decision regarding capital structure
 Investment decisions
 Dividend decision
 Cash management
 Evaluating financial performance
 Financial negotiation
 Keeping touch with stock exchange quotations and behaviour of share prices.

Q 3.What are the main responsibilities of a Chief Financial Officer of an organisation?
ANS. Responsibilities of Chief Financial Officer (CFO): The chief financial officer of an organisation plays an important role in the company’s goals, policies, and financial success.
     His main responsibilities include:
     (a) Financial analysis and planning: Determining the proper amount of funds to be employed in the firm.
     (b) Investment decisions: Efficient allocation of funds to specific assets.
     (c) Financial and capital structure decisions: Raising of funds on favourable terms as possible, i.e., determining the composition of liabilities.
     (d) Management of financial resources (such as working capital).
     (e) Risk Management: Protecting assets.
Q 4.Explain the limitations of profit maximization objective of Financial Management.
ANS. (a) Time factor is ignored.
          (b) It is vague because it is not clear whether the term relates to economic profit, accounting profit, profit after tax or before tax.
          (c) The term maximization is also ambiguous.
          (d) It ignores the risk factor.

Q 5.Discuss the conflicts in Profit versus Wealth maximization principle of the firm.
ANS. Conflict in Profit versus Wealth Maximization Principle of the Firm: Profit maximisation is a short-term objective and cannot be the sole objective of a company. It is at best a limited objective. If profit is given undue importance, a number of problems can arise like the term profit is vague, profit maximisation has to be attempted with a realisation of risks involved, it does not take into account the time pattern of returns and as an objective it is too narrow.

Whereas, on the other hand, wealth maximisation, as an objective, means that the company is using its resources in a good manner. If the share value is to stay high, the company has to reduce its costs and use the resources properly. If the company follows the goal of wealth maximisation, it means that the company will promote only those policies that will lead to an efficient allocation of resources.

Q 6.Differentiate between Financial Management and Financial Accounting.
ANS.Though financial management and financial accounting are closely related, still they differ in the treatment of funds and also with regards to decision – making.
    Treatment of Funds: In accounting, the measurement of funds is based on the accrual principle. The accrual based accounting data do not reflect fully the financial conditions of the organisation. An organisation which has earned profit (sales less expenses) may said to be profitable in the accounting sense but it may not be able to meet its current obligations due to shortage of liquidity as a result of say, uncollectible receivables. Whereas, the treatment of funds, in financial management is based on cash flows. The revenues are recognised only when cash is actually received (i.e. cash inflow) and expenses are recognised on actual payment (i.e. cash outflow). Thus, cash flow based returns help financial managers to avoid insolvency and achieve desired financial goals.
    Decision-making: The chief focus of an accountant is to collect data and present the data while the financial manager’s primary responsibility relates to financial planning, controlling and decisionmaking. Thus, in a way it can be stated that financial management begins where financial accounting ends.
Q 7.Distinguish between ‘Profit Maximization’ and ‘Wealth Maximization’ objective of a firm .
ANS. Distinguish between ‘Profit Maximization’ and ‘Wealth Maximization’:
          Profit maximisation is a short-term objective and cannot be the sole objective of a company. It is at best a limited objective. If profit is given undue importance, a number of problems can arise like the term profit is vague, profit maximisation has to be attempted with a realisation of risks involved, it does not take into account the time pattern of returns and as an objective it is too narrow.
         Whereas, on the other hand, wealth maximisation, as an objective, means that the company is using its resources in a good manner. If the share value is to stay high, the company has to reduce its costs and use the resources properly. If the company follows the goal of wealth maximisation, it means that the company will promote only those policies that will lead to an efficient allocation of resources.
Q 8.Explain the two basic functions of Financial Management.
ANS. Two Basic Functions of Financial Management
     Procurement of Funds: Funds can be obtained from different sources having different characteristics in terms of risk, cost and control. The funds raised from the issue of equity shares are the best from the risk point of view since repayment is required only at the time of liquidation. However, it is also the most costly source of finance due to dividend expectations of shareholders. On the other hand, debentures are cheaper than equity shares due to their tax advantage. However, they are usually riskier than equity shares. There are thus risk, cost and control considerations which a finance manager must consider while procuring funds. The cost of funds should be at the minimum level for that a proper balancing of risk and control factors must be carried out.
     Effective Utilization of Funds: The Finance Manager has to ensure that funds are not kept idle or there is no improper use of funds. The funds are to be invested in a manner such that they generate returns higher than the cost of capital to the firm. Besides this, decisions to invest in fixed assets are to be taken only after sound analysis using capital budgeting techniques. Similarly, adequate working capital should be maintained so as to avoid the risk of insolvency.
Q 9.“The profit maximization is not an operationally feasible criterion.” Comment on it.
ANS. “The profit maximisation is not an operationally feasible criterion.” This statement is true because Profit maximisation can be a short-term objective for any organisation and cannot be its sole objective. Profit maximization fails to serve as an operational criterion for maximizing the owner’s economic welfare. It fails to provide an operationally feasible measure for ranking alternative courses of action in terms of their economic efficiency. It suffers from the following limitations:
     (i) Vague term: The definition of the term profit is ambiguous. Does it mean short term or long term profit? Does it refer to profit before or after tax? Total profit or profit per share?
     (ii) Timing of Return: The profit maximization objective does not make distinction between returns received in different time periods. It gives no consideration to the time value of money, and values benefits received today and benefits received after a period as the same.
     (iii) It ignores the risk factor.

     (iv) The term maximization is also vague.

TIME VALUE OF MONEY

Q 10.Explain the relevance of time value of money
ANS. Time value of money means that worth of a rupee received today is different from the worth of a rupee to be received in future. The preference of money now as compared to future money is known as time preference for money.
A rupee today is more valuable than rupee after a year due to several reasons:
♦ Risk − There is uncertainty about the receipt of money in future.
♦ Preference for present consumption − Most of the persons and companies in general, prefer current consumption over future consumption.
♦ Inflation − In an inflationary period a rupee today represents a greater real purchasing power than a rupee a year hence.
♦ Investment opportunities − Most of the persons and companies have a preference for present money because of availabilities of opportunities of investment for earning additional cash flow.
♦ Many financial problems involve cash flow accruing at different points of time for evaluating such cash flow an explicit consideration of time value of money is required.

Q 12. Explain – Time Value of Money
ANS. Time Value of Money: It means money has time value. A rupee today is more valuable than a rupee after a year. Similarly, a rupee received in future is less valuable than it is today. Time value of money can be of two types, present value of money and future value of money. Concept of discounting is applicable to present value of money and compounding is applicable to future value of money. In a nutshell, time value of money represents monetary value arising out of difference of time.

Q 13.Define ‘Present Value’ and ‘Perpetuity’.
ANS. Present Value: Present Value” is the current value of a “Future Amount”. It can also be defined as the amount to be invested today (Present Value) at a given rate over specified period to equal the “Future Amount”.

Perpetuity: Perpetuity is an annuity in which the periodic payments or receipts begin on a fixed date and continue indefinitely or perpetually. Fixed coupon payments on permanently invested (irredeemable) sums of money are prime examples of perpetuities.

Q 13.Why money in the future is worth less than similar money today? Give the reasons and explain.
ANS. Money in the Future is worth less than the Similar Money Today due to several reasons:
 Risk − There is uncertainty about the receipt of money in future.
 Preference For Present Consumption − Most of the persons and companies in general, prefer current consumption over future consumption.
 Inflation − In an inflationary period a rupee today represents a greater real purchasing power than a rupee a year hence.
 Investment Opportunities − Most of the persons and companies have a preference for present money because of availabilities of opportunities of investment for earning additional cash flow.

RATIO ANALYSIS

Q 14.Discuss any three ratios computed for investment analysis.
ANS.Three ratios computed for investment analysis are as follows;

(i) Earnings per share = Profit after tax/Number of equity shares outstanding

(ii) Dividend yield ratio = (Equity dividend per share/Market price per share) x 100

(iii) Return on capital employed = (Net profit before interest and tax/Capital employed) x 100

Q 15.Discuss the financial ratios for evaluating company performance on operating efficiency and liquidity position aspects.
ANS. Financial ratios for evaluating performance on operational efficiency and liquidity position aspects are discussed as:

Operating Efficiency: Ratio analysis throws light on the degree of efficiency in the management and utilization of its assets. The various activity ratios (such as turnover ratios) measure this kind of operational efficiency. These ratios are employed to evaluate the efficiency with which the firm manages and utilises its assets. These ratios usually indicate the frequency of sales with respect to its assets. These assets may be capital assets or working capital or average inventory. In fact, the solvency of a firm is, in the ultimate analysis, dependent upon the sales revenues generated by use of its assets – total as well as its components.

 Liquidity Position: With the help of ratio analysis, one can draw conclusions regarding liquidity position of a firm. The liquidity position of a firm would be satisfactory, if it is able to meet its current obligations when they become due. Inability to pay-off short-term liabilities affects its credibility as well as its credit rating. Continuous default on the part of the business leads to commercial bankruptcy. Eventually such commercial bankruptcy may lead to its sickness and dissolution. Liquidity ratios are current ratio, liquid ratio and cash to current liability ratio. These ratios are particularly useful in credit analysis by banks and other suppliers of short-term loans.

Q 16.Comment on the Debt Service Coverage Ratio.
ANS. Debt service coverage ratio indicates the capacity of a firm to service a particular level of debt i.e. repayment of principal and interest. High credit rating firms target DSCR to be greater than 2 in its entire loan life. High DSCR facilitates the firm to borrow at the most competitive rates. Lenders are interested in this ratio to judge the firm’s ability to pay off current interest and installments.

The debt service coverage ratio can be calculated as under:
Debt Service Coverage Ratio =(Earnings available for debt service)/(Interest + Installments)

OR

Debt Service Coverage Ratio = (EBITDA)/(Interest+{Principal Repayment Due/ 1 – Tc}

Q 17.Explain the important ratios that would be used in each of the following situations:
(i) A bank is approached by a company for a loan of ` 50 lakhs for working capital purposes.
(ii) A long term creditor interested in determining whether his claim is adequately secured.
(iii) A shareholder who is examining his portfolio and who is to decide whether he should hold or sell his holding in the company.
(iv) A finance manager interested to know the effectiveness with which a firm uses its available resources.

ANS. (i) Liquidity Ratios- Here Liquidity or short-term solvency ratios would be used by the bank to check the ability of the company to pay its short-term liabilities. A bank may use Current ratio and Quick ratio to judge short terms solvency of the firm.

(ii) Capital Structure/Leverage Ratios- Here the long-term creditor would use the capital structure/leverage ratios to ensure the long term stability and structure of the firm. A long term creditors interested in the determining whether his claim is adequately secured mayuse Debt-service coverage and interest coverage ratio.

(iii) Profitability Ratios- The shareholder would use the profitability ratios to measure the profitability or the operational efficiency of the firm to see the final results of business operations. A shareholder may use return on equity, earning per share and dividend per share.

(iv) Activity Ratios- The finance manager would use these ratios to evaluate the efficiency with which the firm manages and utilises its assets. Some important ratios are (a) Capital turnover ratio (b) Current and fixed assets turnover ratio (c) Stock, Debtors and Creditors turnover ratio.

Q 18.Explain the following ratios:
(i) Operating ratio
(ii) Price earnings ratio
ANS. (i) Concept of Operating Ratio
        Operating ratio = (Cost of goods sold + operating expenses)/NET SALES x 100
        This is the test of the operational efficiency with which the business is being carried; the operating ratio should be low enough to leave a portion of sales to give a fair return to the investors.
     (ii) Concept of Price-Earnings ratio
          Price Earnings Ratio = Market price per equity share/Earning per share

          This ratio indicates the number of times the earnings per share is covered by its market price. It indicates the expectation of equity investors about the earnings of the firm.

Q 20.Explain briefly the limitations of Financial ratios.
ANS. The limitations of financial ratios are listed below:
(a) Diversified product lines: Many businesses operate a large number of divisions in quite different industries. In such cases, ratios calculated on the basis of aggregate data cannot be used for inter-firm comparisons.

(b) Financial data are badly distorted by inflation: Historical cost values may be substantially different from true values. Such distortions of financial data are also carried in the financial ratios.

(c) Seasonal factors may also influence financial data.

(d) To give a good shape to the popularly used financial ratios (like current ratio, debt- equity ratios, etc.): The business may make some year-end adjustments. Such window dressing can change the character of financial ratios which would be different had there been no such change.

(e) Differences in accounting policies and accounting period: It can make the accounting data of two firms non-comparable as also the accounting ratios.

(f) There is no standard set of ratios against which a firm’s ratios can be compared: Sometimes a firm’s ratios are compared with the industry average. But if a firm desires to be above the average, then industry average becomes a low standard. On the other hand, for a below average firm, industry averages become too high a standard to achieve.

Q 21.Diagrammatically present the DU PONT CHART to calculate return on equity.
ANS. There are three components in the calculation of return on equity using the traditional DuPont model- the net profit margin, asset turnover, and the equity multiplier. By examining each input individually, the sources of a company’s return on equity can be discovered and compared to its competitors.

Return on Equity = (Net Profit Margin) (Asset Turnover) (Equity Multiplier)

Q 22.How return on capital employed is calculated? What is its significance?
ANS. Return on Capital Employed (ROCE): It is the most important ratio of all. It is the percentage of return on funds invested in the business by its owners. In short, it indicates what returns management has made on the resources made available to them before making any distribution of those returns.

Return on Capital Employed = (EBIT / Capital Employed) X 100
Where,
Capital Employed = Equity Share Capital
+ Reserve and Surplus
+ Pref. Share Capital
+ Debentures and other long term loan
– Misc. expenditure and losses
– Non-trade Investments.

Intangible assets (assets which have no physical existence like goodwill, patents and trademarks) should be included in the capital employed. But no fictitious asset should be included within capital employed.

Q 23.What do you mean by Stock Turnover ratio and Gearing ratio?
ANS. Stock Turnover Ratio helps to find out if there is too much inventory build-up. An increasing stock turnover figure or one which is much larger than the “average” for an industry may indicate poor stock management. The formula for the Stock Turnover Ratio is as follows:

Stock Turnover ratio = Cost of Sales/Average inventory OR Turnover/Average inventory

Gearing Ratio indicates how much of the business is funded by borrowing. In theory, the higher the level of borrowing (gearing), the higher are the risks to a business, since the payment of interest and repayment of debts are not “optional” in the same way as dividends. However, gearing can be a financially sound part of a business’s capital structure particularly if the business has strong, predictable cash flows. The formula for the Gearing Ratio is as follows:
Gearing Ratio = Borrowings (all long term debts including normal overdraft)/Net Assets or Shareholders’ funds

Q 24.What is quick ratio? What does it signify?
ANS. Quick Ratio: It is a much more exacting measure than the current ratio. It adjusts the current ratio to eliminate all assets that are not already in cash (or near cash form). A ratio less than one indicates low liquidity and hence is a danger sign.

Quick Ratio = Quick Assets/Current Liabilities
Where,
Quick Assets = Current Assets – Inventory

Q 25.Discuss the composition of Return on Equity (ROE) using the DuPont model.
ANS. There are three components in the calculation of return on equity using the traditional DuPont model- the net profit margin, asset turnover, and the equity multiplier. By examining each input individually, the sources of a company’s return on equity can be discovered and compared to its competitors.

(a) Net Profit Margin: The net profit margin is simply the after-tax profit a company generates for each rupee of revenue.
Net profit margin = Net Income ÷ Revenue

(b) Asset Turnover: The asset turnover ratio is a measure of how effectively a company converts its assets into sales. It is calculated as follows:
Asset Turnover = Revenue ÷ Assets
The asset turnover ratio tends to be inversely related to the net profit margin; i.e., the higher the net profit margin, the lower the asset turnover.

(c) Equity Multiplier: It is possible for a company with terrible sales and margins to take on excessive debt and artificially increase its return on equity. The equity multiplier, a measure of financial leverage, allows the investor to see what portion of the return on equity is the result of debt. The equity multiplier is calculated as follows:
Equity Multiplier = Assets ÷ Shareholders’ Equity.

Calculation of Return on Equity
To calculate the return on equity using the DuPont model, simply multiply the three components (net profit margin, asset turnover, and equity multiplier.)
Return on Equity = Net profit margin× Asset turnover × Equity multiplier

FUND FLOW

Q26. Distinguish between ‘Funds Flow’ and ‘Cash Flow’.
ANS. The points of distinction between Funds flow and Cash flow are as below:

FUND FLOW CASH FLOW
(i) It ascertains the changes in financial position between two accounting periods. (i) It ascertains the changes in balance of cash in hand and bank.
(ii) It analyses the reasons for change in financial position between two balance sheets (ii) It analyses the reasons for changes in balance of cash in hand and bank
(iii) It reveals the sources and application of finds. (iii) It shows the inflows and outflows of cash.
(iv) It helps to test whether working capital has been effectively used or not. (iv) It is an important tool for short term analysis.

Q 27. State, which of the following would result in inflow/outflow of funds, if the funds were defined as working capital.
(i) Purchase of a fixed asset on credit of two months.
(ii) Sale of a fixed asset (book value ` 8,000) at a loss of `7,000.
(iii) Payment of final dividend already declared.
(iv) Writing off Bad debts against a provision for doubtful debts.
ANS .  

Result in inflow/ outflow of funds
1 outflow, Total current liabilities are increased but total current assets
remain unchanged.
2 Inflow, current assets are increased but total current liabilities remain
unchanged.
3 No effect, Both the total current assets and current liabilities remain
unchanged.
OR
assume proposed dividend as Non- current liability then
payment of final dividend is considered as out flow of fund.
4 No effect, Neither the total current assets nor the total current liabilities are
affected.

COST OF CAPITAL 

Q28. Write short notes on: Opportunity Cost
ANS. Opportunity Cost: This cost refers to the value of sacrifice made or benefit of opportunity foregone in accepting an alternative course of action. For example, a firm financing its expansion plan by withdrawing money from its bank deposits. In such a case the loss of interest on the bank deposit is the opportunity cost for carrying out the expansion plan.

Q 29.Distinguish between Preference Shares and Debentures.
ANS. 

Basis of difference Preference shares Debentures
Ownership Preference Share Capital is a special kind of share Debenture is a type of loan which can be raised from the public
Payment of Dividend/ Interest its holders enjoy priority both as regard to the payment of a fixed amount of dividend and also towards repayment of capital in case of winding up of a company It carries fixed percentage of interest.
Nature Preference shares are a hybrid form of financing with some characteristic of equity shares and some attributes of Debt Capital. Debentures are instrument for raising long term capital with a period of maturity.

Q 30.What do you understand by Weighted Average Cost of Capital?
ANS. Weighted Average Cost of Capital
The composite or overall cost of capital of a firm is the weighted average of the costs of various sources of funds. Weights are taken in proportion of each source of funds in capital structure while making financial decisions. The weighted average cost of capital is calculated by calculating the cost of specific source of fund and multiplying the cost of each source by its proportion in capital structure. Thus, weighted average cost of capital is the weighted average after tax costs of the individual components of firm’s capital structure. That is, the after tax cost of each debt and equity is calculated separately and added together to a single overall cost of capital.

Q 31.Discuss the dividend-price approach, and earnings price approach to estimate cost of equity capital.
ANS. In dividend price approach, cost of equity capital is computed by dividing the current dividend by average market price per share. This ratio expresses the cost of equity capital in relation to what yield the company should pay to attract investors. It is computed as:

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

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

CAPITAL STRUCTURE DECISIONS

Q 32. State the principles that should be followed while designing the capital structure of a company.
ANS. The fundamental principles are:
(i) Cost Principle: According to this principle, an ideal pattern or capital structure is one that minimises cost of capital structure and maximises earnings per share (EPS).
(ii) Risk Principle: According to this principle, reliance is placed more on common equity for financing capital requirements than excessive use of debt. Use of more and more debt means higher commitment in form of interest payout. This would lead to erosion of shareholders value in unfavourable business situation.
(iii) Control Principle: While designing a capital structure, the finance manager may also keep in mind that existing management control and ownership remains undisturbed.
(iv) Flexibility Principle: It means that the management chooses such a combination of sources of financing which it finds easier to adjust according to changes in need of funds in future too.
(v) Other Considerations: Besides above principles, other factors such as nature of industry, timing of issue and competition in the industry should also be considered.

Q.33  What do you mean by capital structure? State its significance in financing decision.
ANS. Capital structure refers to the mix of a firm’s capitalisation i.e. mix of long-term sources of funds such as debentures, preference share capital, equity share capital and retained earnings for meeting its total capital requirement.

Significance in Financing Decision
The capital structure decisions are very important in financial management as they influence debt – equity mix which ultimately affects shareholders return and risk. These decisions help in deciding the forms of financing (which sources to be tapped), their actual requirements (amount to be funded) and their relative proportions (mix) in total capitalisation. Therefore, such a pattern of capital structure must be chosen which minimises cost of capital and maximises the owners’ return.

Q 34.What is optimum capital structure? Explain.
ANS. Optimum capital structure deals with the issue of right mix of debt and equity in the long-term capital structure of a firm. According to this, if a company takes on debt, the value of the firm increases upto a certain point. Beyond that value of the firm will start to decrease. If the company is unable to pay the debt within the specified period then it will affect the goodwill of the company in the market. Therefore, company should select its appropriate capital structure with due consideration of all factors.

Q 35.What is Over capitalisation? State its causes and consequences.
ANS. Overcapitalization and its Causes and Consequences

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

Causes of Over Capitalization
Over-capitalisation arises due to following reasons:
(i) Raising more money through issue of shares or debentures than company can employ profitably.
(ii) Borrowing huge amount at higher rate than rate at which company can earn.
(iii) Excessive payment for the acquisition of fictitious assets such as goodwill etc.
(iv) Improper provision for depreciation, replacement of assets and distribution of dividends at a higher rate.
(v) Wrong estimation of earnings and capitalization.

Consequences of Over-Capitalisation
Over-capitalisation results in the following consequences:
(i) Considerable reduction in the rate of dividend and interest payments.
(ii) Reduction in the market price of shares.
(iii) Resorting to “window dressing”.
(iv) Some companies may opt for reorganization. However, sometimes the matter gets worse and the company may go into liquidation.

Q 36.Explain the principles of “Trading on equity”.
ANS. The term trading on equity means debts are contracted and loans are raised mainly on the basis of equity capital. Those who provide debt have a limited share in the firm’s earning and hence want to be protected in terms of earnings and values represented by equity capital. Since fixed charges do not vary with firms earnings before interest and tax, a magnified effect is produced on earning per share. Whether the leverage is favourable, in the sense, increase in earnings per share more proportionately to the increased earnings before interest and tax, depends on the profitability of investment proposal. If the rate of returns on investment exceeds their explicit cost, financial leverage is said to be positive.

Q 37.Discuss the major considerations in capital structure planning.
ANS . There are three major considerations, i.e. risk, cost of capital and control, which help the finance manager in determining the proportion in which he can raise funds from various sources.
      Although, three factors, i.e., risk, cost and control determine the capital structure of a particular business undertaking at a given point of time.
      Risk: The finance manager attempts to design the capital structure in such a manner, so that risk and cost are the least and the control of the existing management is diluted to the least extent. However, there are also subsidiary factors also like  marketability of the issue, manoeuvrability and flexibility of the capital structure, timing of raising the funds. Risk is of two kinds, i.e., Financial risk and Business risk. Here we are concerned primarily with the financial risk. Financial risk also is of two types:
         Risk of cash insolvency
         Risk of variation in the expected earnings available to equity share-holders
       Cost of Capital: Cost is an important consideration in capital structure decisions. It is obvious that a business should be at least capable of earning enough revenue to meet its cost of capital and finance its growth. Hence, along with a risk as a factor, the finance manager has to consider the cost aspect carefully while determining the capital structure.
       Control: Along with cost and risk factors, the control aspect is also an important consideration in planning the capital structure. When a company issues further equity shares, it automatically dilutes the controlling interest of the present owners. Similarly, preference shareholders can have voting rights and thereby affect the composition of the Board of Directors, in case dividends on such shares are not paid for two consecutive years. Financial institutions normally stipulate that they shall have one or more directors on the Boards. Hence, when the management agrees to raise loans from financial institutions, by implication it agrees to forego a part of its control over the company. It is obvious, therefore, that decisions concerning capital structure are taken after keeping the control factor in mind.

Q 38.What is Net Operating Income (NOI) theory of capital structure? Explain the assumptions of Net Operating Income approach theory of capital structure.
ANS Net Operating Income (NOI) Theory of Capital Structure According to NOI approach, there is no relationship between the cost of capital and value of the firm i.e. the value of the firm is independent of the capital structure of the firm.
Assumptions
(a) The corporate income taxes do not exist.
(b) The market capitalizes the value of the firm as whole. Thus the split between debt and equity is not important.
(c) The increase in proportion of debt in capital structure leads to change in risk perception of the shareholders.
(d) The overall cost of capital (Ko) remains constant for all degrees of debt equity mix.

Q 39.Discuss the concept of Debt-Equity or EBIT-EPS indifference point, while determining the capital structure of a company.
ANS. The determination of optimum level of debt in the capital structure of a company is a formidable task and is a major policy decision. It ensures that the firm is able to service its debt as well as contain its interest cost. Determination of optimum level of debt involves equalizing between return and risk.
EBIT – EPS analysis is a widely used tool to determine level of debt in a firm. Through this analysis, a comparison can be drawn for various methods of financing by obtaining indifference point. It is a point to the EBIT level at which EPS remains unchanged irrespective of debt-equity mix. The indifference point for the capital mix (equity share capital and debt) can be determined as follows:

Q 40.Discuss financial break-even and EBIT-EPS indifference analysis.
ANS. Financial Break-even and EBIT-EPS Indifference Analysis

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

EBIT-EPS analysis is a vital tool for designing the optimal capital structure of a firm. The objective of this analysis is to find the EBIT level that will equate EPS regardless of the financing plan chosen.

Where,
EBIT = Indifference point
E1 = Number of equity shares in Alternative 1
E2 = Number of equity shares in Alternative 2
I1 = Interest charges in Alternative 1
12 = Interest charges in Alternative 2
T = Tax-rate
Alternative 1= All equity finance
Alternative 2= Debt-equity finance.

BUSINESS RISK AND FINANCIAL RISK

Q 41.“Operating risk is associated with cost structure, whereas financial risk is associated with capital structure of a business concern.” Critically examine this statement.
ANS. Operating risk refers to the risk associated with the firm’s operations. It is represented by the variability of earnings before interest and tax (EBIT). The variability in turn is influenced by revenues and expenses, which are affected by demand of firm’s products, variations in prices and proportion of fixed cost in total cost. If there is no fixed cost, there would be no operating risk. Whereas financial risk refers to the additional risk placed on firm’s shareholders as a result of debt and preference shares used in the capital structure of the concern. Companies that issue more debt instruments would have higher financial risk than companies financed mostly by equity.

Q 42.Distinguish between ‘Business Risk’ and ‘Financial Risk’.
ANS. Business Risk and Financial Risk: Business risk refers to the risk associated with the firm’s operations. It is an unavoidable risk because of the environment in which the firm has to operate and the business risk is represented by the variability of earnings before interest and tax (EBIT). The variability in turn is influenced by revenues and expenses. Revenues and expenses are affected by demand of firm’s products, variations in prices and proportion of fixed cost in total cost.

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

Q 43.Discuss the impact of financial leverage on shareholders wealth by using return-on-assets (ROA) and return-on-equity (ROE) analytic framework
ANS. The impact of financial leverage on ROE is positive, if cost of debt (after-tax) is less than ROA. But it is a double-edged sword.

Where
NOPAT = EBIT * ( 1 – Tc)
Capital employed = Shareholders funds + Loan funds
D = Debt amount in capital structure
E = Equity capital amount in capital structure
Kd = Interest rate * ( 1 – Tc) in case of fresh loans of a company.
Kd = Yield to maturity *(1-Tc) in case of existing loans of a company.

Q 44.State the main elements of leveraged lease.
ANS. Under this lease, a third party is involved beside lessor and lessee. The lessor borrows a part of the purchase cost (say 80%) of the asset from the third party i.e., lender. The asset so purchased is held as security against the loan. The lender is paid off from the lease rentals directly by the lessee and the surplus after meeting the claims of the lender goes to the lessor. The lessor is entitled to claim depreciation allowance.

Q 45. Explain Leveraged Lease
ANS Leveraged Lease: Under this lease, a third party is involved beside lessor and lessee. The lessor borrows a part of the purchase cost (say 80%) of the asset from the third party i.e., lender and asset so purchased is held as security against the loan. The lender is paid off from the lease rentals directly by the lessee and the surplus after meeting the claims of the lender goes to the lessor. The lessor is entitled to claim depreciation allowance.

Q 46.What is the meaning of Margin of Safety (MOS)? State the relationship between Operating Leverage and Margin of Safety Ratio.
ANS. Margin of Safety (MoS) is the excess of total sales over the Break even sales. MoS defines the amount upto which level sales can decline before occurring loss.
Therefore MoS = Total Sales – Break even sales ;
MoS ratio = (Sales- Breakeven sales)/Sales

Break even sales (BE sales) will depend on contribution margin (BE sales = Fixed Cost ÷ Contribution margin). Contribution margin is related to operating leverage also. Operating leverage is calculated as Contribution ÷ Operating profit and contribution margin plays an important role in it. If sales are expected to increase, higher operating leverage will result in higher profit. When sales are expected to decrease, lower operating leverage will result in higher profit. Higher variable cost and lower fixed cost will result into higher MoS and risk will be lower and vice versa.
So like Operating leverage, MoS is a measure of risk as to what extent an organisation is exposed to change in sales volume.

 

TYPE OF FINANCING 

Q 47.”Financing a business through borrowing is cheaper than using equity.” Briefly explain.
ANS. “Financing a business through borrowing is cheaper than using equity”
(i) Debt capital is cheaper than equity capital from the point of its cost and interest being deductible for income tax purpose, whereas no such deduction is allowed for dividends.
(ii) Issue of new equity dilutes existing control pattern while borrowing does not result in dilution of control.
(iii) In a period of rising prices, borrowing is advantageous. The fixed monetary outgo decreases in real terms as the price level increases.

Q 48.What is venture capital financing? State the factors which are to be considered in financing any risky project.
ANS.Venture Capital Financing and Factors to be considered in financing any Risky Project

Under venture capital financing, venture capitalist makes investment to purchase debt or equity from inexperienced entrepreneurs who undertake highly risky ventures with potential of success.

The factors to be considered in financing any risky project are:
(i) Quality of the management team is a very important factor to be considered. They are required to show a high level of commitment to the project.
(ii) The technical ability of the team is also vital. They should be able to develop and produce a new product / service.
(iii) Technical feasibility of the new product / service should be considered.
(iv) Since the risk involved in investing in the company is quite high, venture capitalists should ensure that the prospects for future profits compensate for the risk.
(v) A research must be carried out to ensure that there is a market for the new product.
(vi) The venture capitalist himself should have the capacity to bear risk or loss, if the project fails.
(vii) The venture capitalist should try to establish a number of exit routes.
(viii) In case of companies, venture capitalist can seek for a place on the Board of Directors to have a say on all significant matters affecting the business.

Q 49.What is meant by venture capital financing? State its various methods.
ANS. Meaning of Venture Capital: The venture capital financing refers to financing and funding of the small scale enterprises, high technology and risky ventures.

Methods of Venture Capital financing: Some common methods of venture capital financing are as follows:
(i) Equity financing: The venture capital undertakings generally requires funds for a longer period but may not be able to provide returns to the investors during the initial stages. Therefore, the venture capital finance is generally provided by way of equity share capital..
(ii) Conditional Loan: A conditional loan is repayable in the form of a royalty after the venture is able to generate sales. No interest is paid on such loans. In India Venture Capital Financers charge royalty ranging between 2 to 15 per cent; actual rate depends on other factors of the venture such as gestation period, cash flow patterns, riskiness and other factors of the enterprise.
 (iii) Income Note: It is a hybrid security which combines the features of both conventional loan and conditional loan. The entrepreneur has to pay both interest and royalty on sales but at substantially low rates
 (iv) Participating Debenture: Such security carries charges in three phases- in the start- up phase, no interest is charged, next stage a low rate of interest is charged upto a particular level of operations, after that, a high rate of interest is required to be paid.

Q 50.Discuss the risk-return considerations in financing current assets.
ANS. The financing of current assets involves a trade off between risk and return. A firm can choose from short or long term sources of finance. Short term financing is less expensive than long term financing but at the same time, short term financing involves greater risk than long term financing.

Depending on the mix of short term and long term financing, the approach followed by a company may be referred as matching approach, conservative approach and aggressive approach.

In matching approach, long-term finance is used to finance fixed assets and permanent current assets and short term financing to finance temporary or variable current assets. Under the conservative plan, the firm finances its permanent assets and also a part of temporary current assets with long term financing and hence less risk of facing the problem of shortage of funds.

An aggressive policy is said to be followed by the firm when it uses more short term financing than warranted by the matching plan and finances a part of its permanent current assets with short term financing.

Q 51.Explain the meaning and advantages of Factoring .
ANS.Meaning of Factoring: Factoring is a specialised service related with receivable management which involves credit investigation, sales ledger management, purchase and collection of debts, credit protection as well as provision of finance against receivables. In factoring, accounts receivables are generally sold to a financial institution, known as factor, who charges commission and bears the credit risks associated with the accounts receivables purchased by it.
The factor takes the responsibility of monitoring, follow-up, collection and risk management related with receivables (debts).
Advantages of Factoring:
(1)The firm can convert accounts receivables into cash without bothering about repayment.
(2)Factoring ensures a definite pattern of cash inflows.
(3)Continuous factoring virtually eliminates the need for the credit department. That is why receivables financing through factoring is gaining popularly as useful source of financing short-term funds requirements of business enterprises because of the inherent advantage of flexibility it affords to the borrowing firm. The seller firm may continue to finance its receivables on a more or less automatic basis. If sales expand or contract it can vary the financing proportionally.
(4)Unlike an unsecured loan, compensating balances are not required in this case. Another advantage consists of relieving the borrowing firm of substantially credit and collection costs and to a degree from a considerable part of cash management.

Q 52.What are the forms of bank credit?
ANS. Some of the forms of bank credit are:
(i) Short Term Loans: In a loan account, the entire advance is disbursed at one time either in cash or by transfer to the current account of the borrower. It is a single advance and given against securities like shares, government securities, life insurance policies and fixed deposit receipts, etc.
 (ii) Overdraft: Under this facility, customers are allowed to withdraw in excess of credit balance standing in their Current Account. A fixed limit is therefore granted to the borrower within which the borrower is allowed to overdraw his account.
 (iii) Clean Overdrafts: Request for clean advances are entertained only from parties which are financially sound and reputed for their integrity. The bank has to rely upon the personal security of the borrowers.
 (iv) Cash Credits: Cash Credit is an arrangement under which a customer is allowed an advance up to certain limit against credit granted by bank. Interest is not charged on the full amount of the advance but on the amount actually availed of by him.
 (v) Advances against goods: Goods are charged to the bank either by way of pledge or by way of hypothecation. Goods include all forms of movables which are offered to the bank as security.
(vi) Bills Purchased/Discounted: These advances are allowed against the security of bills which may be clean or documentary.
Usance bills maturing at a future date or sight are discounted by the banks for approved parties. The borrower is paid the present worth and the bank collects the full amount on maturity.
(vii) Advance against documents of title to goods: A document becomes a document of title to goods when its possession is recognised by law or business custom as possession of the goods like bill of lading, dock warehouse keeper’s certificate, railway receipt, etc. An advance against the pledge of such documents is an advance against the pledge of goods themselves.
(viii) Advance against supply of bills: Advances against bills for supply of goods to government or semi-government departments against firm orders after acceptance of tender fall under this category. It is this debt that is assigned to the bank by endorsement of supply bills and executing irrevocable power of attorney in favour of the banks for receiving the amount of supply bills from the Government departments.

Q 53. Explain GDR and ADR.
ANS. Global Depository Receipts (GDRs): It is a negotiable certificate denominated in US dollars which represents a Non-US company’s publically traded local currency equity shares. GDRs are created when the local currency shares of an Indian company are delivered to Depository’s local custodian Bank against which the Depository bank issues depository receipts in US dollars. The GDRs may be traded freely in the overseas market like any other dollar-expressed security either on a foreign stock exchange or in the over-the-counter market or among qualified institutional buyers.

American Depository Receipts (ADRs): American Depository Receipts (ADRs) are securities offered by non- US companies who want to list on any of the US exchanges. It is a derivative instrument. It represents a certain number of company’s shares. These are used by depository bank against a fee income. ADRs allow US investors to buy shares of these companies without the cost of investing directly in a foreign stock exchange. ADRs are listed on either NYSE or NASDAQ. It facilitates integration of global capital markets. The company can use the ADR route either to get international listing or to raise money in international capital market.

Q 54.State advantages of Debt. Securitisation
ANS Debt securitisation is a method of recycling of funds and is especially beneficial to financial intermediaries to support lending volumes.

    The advantages of debt securitisation are as follows:

    (a) To the originator: 
(i) The asset is shifted off the Balance Sheet, thus giving the originator recourse to off balance sheet funding.
(ii) It converts illiquid assets to liquid portfolio.
(iii) It facilitates better balance sheet management; assets are transferred off balance sheet facilitating satisfaction of capital adequacy norms.
(iv) The originator’s credit rating enhances.

    (b) For the investors: Securitisation opens up new investment avenues. Though the investor bears the credit risk, the securities are tied up to definite assets

Q 55.Name any four financial instruments, which are related to international financial market.
ANS.
Some of the various financial instruments dealt with in the international market are:
(a) Euro Bonds
(b) Foreign Bonds
(c) Fully Hedged Bonds
(d) Medium Term Notes
(e) Floating Rate Notes
(f) External Commercial Borrowings
(g) Foreign Currency Futures
(h) Foreign Currency Option
(i) Euro Commercial Papers.

Q 56.Explain  Bridge finance
ANS. Bridge Finance: Bridge finance refers, normally, to loans taken by the business, usually from commercial banks for a short period, pending disbursement of term loans by financial institutions, normally it takes time for the financial institution to finalise procedures for creation of security, tie-up participation with other institutions etc. even though a positive appraisal of the project has been made. However, once the loans are approved in principle, firms in order not to lose further time in starting their projects arrange for bridge finance. Generally, rate of interest on bridge finance is higher as compared with that on term loans

Q 57.Explain ‘Sales and Lease Back’.
ANS. Sales and Lease Back: Under this type of lease, the owner of an asset sells the asset to a party (the buyer), who in turn leases back the same asset to the owner in consideration of a lease rentals. Under this arrangement, the asset is not physically exchanged but it all happen in records only. The main advantage of this method is that the lessee can satisfy himself completely regarding the quality of an asset and after possession of the asset convert the sale into a lease agreement.

Q. 58 Distinguish between operating lease and finance lease.
ANS.

Point Operating Lease Finance Lease
1 Ownership The lessee is only provided the use of the asset for a certain time. Risk incident to ownership belongs only to the lessor. The risk and reward incidental to ownership are passed on to the lessee. The lessor only remains the legal owner of the asset.
2 Bearing risk The lessor bears the risk of obsolescence. The lessee bears the risk of obsolescence.
3 Purchase option The lessee does not have any option to buy the asset during the lease period. It allows the lessee to have a purchase option during the lease period.
4 Expenses borne Usually, the lessor bears the cost of repairs, maintenance or operations. The lessor does not bear the cost of repairs, maintenance or operations.
5 Treatment Lease payment is treated like operating expenses like rent. Finance lease is generally treated like a loan.

Q 13.Describe the three principles relating to selection of marketable securities.
ANS. Three principles relating to selection of marketable securities are as follows
Safety: Return and risks go hand in hand. As the objective in this investment is ensuring liquidity, minimum risk is the criterion of selection.
Maturity: Matching of maturity and forecasted cash needs is essential. Prices of long term securities fluctuate more with changes in interest rates and are therefore, more risky.
Marketability: It refers to the convenience, speed and cost at which a security can be converted into cash. If the security can be sold quickly without loss of time and price it is highly liquid or marketable.

Q 59.EXPLAIN Deep Discount Bonds vs. Zero Coupon Bonds
ANS.Deep Discount Bonds (DDBs) are in the form of zero interest bonds. These bonds are sold at a discounted value and on maturity face value is paid to the investors. In such bonds, there is no interest payout during lock-in period.
IDBI was first to issue a Deep Discount Bonds (DDBs) in India in January 1992. The bond of a face value of Rs.1 lakh was sold for `2,700 with a maturity period of 25 years.

    A zero coupon bond (ZCB) does not carry any interest but it is sold by the issuing company at a discount. The difference between discounted value and maturing or face value represents the interest to be earned by the investor on such bonds.

Q 60.Seed Capital Assistance:
ANS. The seed capital assistance has been designed by IDBI for professionally or technically qualified entrepreneurs. All the projects eligible for financial assistance from IDBI, directly or indirectly through refinance are eligible under the scheme. The project cost should not exceed `2 crores and the maximum assistance under the project will be restricted to 50% of the required promoters contribution or Rs 15 lacs whichever is lower.

The seed capital Assistance is interest free but carries a security charge of one percent per annum for the first five years and an increasing rate thereafter.

Q 61.Differentiate between ‘Factoring’ and ‘Bill discounting’.
ANS. Differentiation between Factoring and Bills Discounting
The differences between Factoring and Bills discounting are:
(a) Factoring is called as “Invoice Factoring’ whereas Bills discounting is known as ‘Invoice discounting.”
(b) In Factoring, the parties are known as the client, factor and debtor whereas in Bills discounting, they are known as drawer, drawee and payee.
(c) Factoring is a sort of management of book debts whereas bills discounting is a sort of borrowing from commercial banks.
(d) For factoring there is no specific Act, whereas in the case of bills discounting, the Negotiable Instruments Act is applicable.

Q 62.Explain the term ‘Ploughing back of Profits’.
ANS. Ploughing back of Profits: 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 its profits each 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.

Q 63.Explain the concept of Indian depository receipts.
ANS. Concept of Indian Depository Receipts: The concept of the depository receipt mechanism which is used to raise funds in foreign currency has been applied in the Indian capital market through the issue of Indian Depository Receipts (IDRs). Foreign companies can issue IDRs to raise funds from Indian market on the same lines as an Indian company uses ADRs/GDRs to raise foreign capital. The IDRs are listed and traded in India in the same way as other Indian securities are traded.

Q 64.Explain briefly the features of External Commercial Borrowings (ECBs)
ANS. External Commercial Borrowings are loans taken from non-resident lenders in accordance with exchange control regulations. These loans can be taken from:
 International banks
 Capital markets
 Multilateral financial institutions like IFC, ADB, IBRD etc.
 Export Credit Agencies
 Foreign collaborators
 Foreign Equity Holders.
ECBs can be accessed under automatic and approval routes depending upon the purpose and volume.

In automatic there is no need for any approval from RBI / Government while approval is required for areas such as textiles and steel sectors restructuring packages.

INVESTMENT DECISIONS

Q 65.Define Modified Internal Rate of Return method.
ANS. Modified Internal Rate of Return (MIRR): There are several limitations attached with the concept of the conventional Internal Rate of Return. The MIRR addresses some of these deficiencies. For example, it eliminates multiple IRR rates; it addresses the reinvestment rate issue and produces results, which are consistent with the Net Present Value method.
Under this method, all cash flows, apart from the initial investment, are brought to the terminal value using an appropriate discount rate(usually the cost of capital). This results in a single stream of cash inflow in the terminal year. The MIRR is obtained by assuming a single outflow in the zeroth year and the terminal cash inflow as mentioned above. The discount rate which equates the present value of the terminal cash in flow to the zeroth year outflow is called the MIRR.
Q 66.Explain the concept of Multiple Internal Rate of Return.
ANS . Multiple Internal Rate of Return (MIRR)
      In cases where project cash flows change signs or reverse during the life of a project for example, an initial cash outflow is followed by cash inflows and subsequently followed by a major cash outflow; there may be more than one internal rate of return (IRR). The following graph of discount rate versus net present value (NPV) may be used as an illustration:
 
In such situations if the cost of capital is less than the two IR`, a decision can be made easily, however, otherwise the IRR decision rule may turn out to be misleading as the project should only be invested if the cost of capital is between IRR1 and IRR2. To understand the concept of multiple IR` it is necessary to understand the implicit re-investment assumption in both NPV and IRR techniques.      
Q 67.Explain the concept of discounted payback period.
ANS. Concept of Discounted Payback Period Payback period is time taken to recover the original investment from project cash flows. It is also termed as break even period. The focus of the analysis is on liquidity aspect and it suffers from the limitation of ignoring time value of money and profitability. Discounted payback period considers present value of cash flows, discounted at company’s cost of capital to estimate breakeven period i.e. it is that period in which future discounted cashflows equal the initial outflow. The shorter the period, better it is. It also ignores post discounted payback period cash flows.
 
Q 68.Explain the term “Desirability factor”.
ANS . Desirability Factor: In certain cases we have to compare a number of proposals each involving different amount of cash inflows. One of the methods of comparing such proposals is to work out, what is known as the ‘Desirability Factor’ or ‘Profitability Index’. In general terms, a project is acceptable if the Profitability Index is greater than 1.
 
 

Q 70.What is ‘Internal Rate of Return’? Explain.
ANS Internal Rate of Return: It is that rate at which discounted cash inflows are equal to the discounted cash outflows. It can be stated in the form of a ratio as follows:
Cash inflows / Cash Outflows = 1

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

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

    

Q 71.Distinguish between Net Present Value (NPV) and Internal Rate of Return (IRR) methods for evaluating projects.
ANS. Distinguish between Net Present Value (NPV) and Internal Rate of Return (IRR)

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

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

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

WORKING CAPITAL MANAGEMENT

Q 72.Discuss the liquidity vs. profitability issue in management of working capital.
ANS. Liquidity versus Profitability Issue in Management of Working Capital Working capital management entails the control and monitoring of all components of working capital i.e. cash, marketable securities, debtors, creditors etc. Finance manager has to pay particular attention to the levels of current assets and their financing. To decide the level of financing of current assets, the risk return trade off must be taken into account. The level of current assets can be measured by creating a relationship between current assets and fixed assets. A firm may follow a conservative, aggressive or moderate policy.

A conservative policy means lower return and risk while an aggressive policy produces higher return and risk. The two important aims of the working capital management are profitability and solvency. A liquid firm has less risk of insolvency i.e. it will hardly experience a cash shortage or a stock out situation. However, there is a cost associated with maintaining a sound liquidity position. So, to have a higher profitability the firm may have to sacrifice solvency and maintain a relatively low level of current assets.
Q 73.Discuss the estimation of working capital need based on operating cycle process.
ANS. One of the methods for forecasting working capital requirement is based on the concept of operating cycle. The determination of operating capital cycle helps in the forecast, control and management of working capital. The length of operating cycle is the indicator of performance of management. The net operating cycle represents the time interval for which the firm has to negotiate for Working Capital from its Bankers. It enables to determine accurately the amount of working capital needed for the continuous operation of business activities. The duration of working capital cycle may vary depending on the nature of the business.
     In the form of an equation, the operating cycle process can be expressed as follows:
     Operating Cycle = R + W + F +D – C
     Where,
         R = Raw material storage period.
         W = Work-in-progress holding period.
         F = Finished goods storage period.
         D = Debtors collection period.
         C = Credit period availed.

TREASURY AND CASH MANAGEMENT

Q 74.’Management of marketable securities is an integral part of investment of cash.’ Comment.
ANS. Management of marketable securities is an integral part of investment of cash as it serves both the purposes of liquidity and cash, provided choice of investment is made correctly. As the working capital needs are fluctuating, it is possible to invest excess funds in some short term securities, which can be liquidated when need for cash is felt. The selection of securities should be guided by three principles namely safety, maturity and marketability.

Q75 .Evaluate the role of cash budget in effective cash management system.
ANS. Cash Budget is the most significant device to plan for and control cash receipts and payments. It plays a very significant role in effective Cash Management System. This represents cash requirements of business during the budget period.

The various role of cash budgets in Cash Management System are:-
(i) Coordinate the timings of cash needs. It identifies the period(s) when there might either be a shortage of cash or an abnormally large cash requirement;
(ii) It also helps to pinpoint period(s) when there is likely to be excess cash;
(iii) It enables firm which has sufficient cash to take advantage like cash discounts on its accounts payable; and
(iv) Lastly it helps to plan/arrange adequately needed funds (avoiding excess/shortage of cash) on favorable terms.

Q 76.Explain briefly the functions of Treasury Department.
ANS  The functions of treasury department management are to ensure proper usage, storage and risk management of liquid funds so as to ensure that the organisation is able to meet its obligations, collect its receivables and also maximize the return on its investments. Towards this end the treasury function may be divided into the following:
 (i) Cash Management: The efficient collection and payment of cash both inside the organisation and to third parties is the function of treasury department. Treasury normally manages surplus funds in an investment portfolio.
(ii) Currency Management: The treasury department manages the foreign currency risk exposure of the company. It advises on the currency to be used when invoicing overseas sales. It also manages any net exchange exposures in accordance with the company policy.
(iii) Fund Management: Treasury department is responsible for planning and sourcing the company’s short, medium and long-term cash needs. It also participates in the decision on capital structure and forecasts future interest and foreign currency rates.
(iv) Banking: Since short-term finance can come in the form of bank loans or through the sale of commercial paper in the money market, therefore, treasury department carries out negotiations with bankers and acts as the initial point of contact with them.
(v) Corporate Finance: Treasury department is involved with both acquisition and disinvestment activities within the group. In addition, it is often responsible for investor relations.

Q 77.What is Virtual Banking? State its advantages.
ANS.Virtual Banking and its Advantages

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

    The advantages of virtual banking services are as follows:
 Lower cost of handling a transaction.
 The increased speed of response to customer requirements.
 The lower cost of operating branch network along with reduced staff costs leads to cost efficiency.
 Virtual banking allows the possibility of improved and a range of services being made available to the customer rapidly, accurately and at his convenience.

Q 78.Explain four kinds of float with reference to management of cash.
ANS. Four Kinds of Float with reference to Management of Cash
The four kinds of float are:
(i) Billing Float: The time between the sale and the mailing of the invoice is the billing float.
(ii) Mail Float: This is the time when a cheque is being processed by post office, messenger service or other means of delivery.
(iii) Cheque processing float: This is the time required for the seller to sort, record and deposit the cheque after it has been received by the company.
(iv) Bank processing float: This is the time from the deposit of the cheque to the crediting of funds in the seller’s account.

Q 79.Explain the following:
(i) Concentration Banking
(ii) Lock Box System
ANS. (i) Concentration Banking: In concentration banking the company establishes a number of strategic collection centres in different regions instead of a single collection centre at the head office. This system reduces the period between the time a customer mails in his remittances and the time when they become spendable funds with the company. Payments received by the different collection centers are deposited with their respective local banks which in turn transfer all surplus funds to the concentration bank of head office.

     (ii) Lock Box System: Another means to accelerate the flow of funds is a lock box system. The purpose of lock box system is to eliminate the time between the receipts of remittances by the company and deposited in the bank. A lock box arrangement usually is on regional basis which a company chooses according to its billing patterns.

Q 80.State the advantage of Electronic Cash Management System.
ANS. Advantages of Electronic Cash Management System
(i) Significant saving in time.
(ii) Decrease in interest costs.
(iii) Less paper work.
(iv) Greater accounting accuracy.
(v) More control over time and funds.
(vi) Supports electronic payments.
(vii) Faster transfer of funds from one location to another, where required.
(viii) Speedy conversion of various instruments into cash.
(ix) Making available funds wherever required, whenever required.
(x) Reduction in the amount of ‘idle float’ to the maximum possible extent.
(xi) Ensures no idle funds are placed at any place in the organization.
(xii) It makes inter-bank balancing of funds much easier.
(xiii) It is a true form of centralised ‘Cash Management’.
(xiv) Produces faster electronic reconciliation.
(xv) Allows for detection of book-keeping errors.
(xvi) Reduces the number of cheques issued.
(xvii)Earns interest income or reduce interest expense.

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