Program BBA

Semester II

Course Financial Management

Unit 1 :

PART (A) - (10 MCQ = 10*1M)

1. What is the primary goal of financial management?

a) Maximizing profits

b) Maximizing shareholder wealth

c) Maximizing market share

d) Minimizing costs

Answer: b) Maximizing shareholder wealth

2. Which of the following is not a financial decision?

a) Investment decision

b) Financing decision

c) Marketing decision

d) Dividend decision

Answer: c) Marketing decision

3. What does the term 'scope' in financial management refer to?

a) The range of activities involved in managing finances

b) The profitability of the firm

c) The size of the finance department

d) The cost of capital

Answer: a) The range of activities involved in managing finances

4. Which financial function involves the determination of the firm's optimal capital structure?

a) Investment decision

b) Financing decision

c) Dividend decision

d) Liquidity decision

Answer: b) Financing decision

5. Which of the following is not an objective of financial management?

a) Maximizing shareholder wealth

b) Minimizing risk

c) Increasing market share

d) Maximizing firm's value

Answer: c) Increasing market share

6. What does the term 'nature' in financial management refer to?

a) The natural resources utilized by the firm

b) The characteristics or features of financial management

c) The environmental impact of financial decisions

d) The seasonal variations in financial data

Answer: b) The characteristics or features of financial management

7. Which of the following is not a financial asset?

a) Stocks

b) Bonds

c) Real estate

d) Treasury bills

Answer: c) Real estate

8. What is the key function of financial markets?

a) Allocating resources efficiently

b) Maximizing profits for investors

c) Regulating financial institutions

d) Providing loans to governments

Answer: a) Allocating resources efficiently

9. What is the main focus of working capital management?

a) Managing short-term assets and liabilities

b) Managing long-term investments

c) Managing shareholders' equity

d) Managing fixed assets

Answer: a) Managing short-term assets and liabilities

10. Which of the following statements about financial management is false?

a) Financial management is concerned with the acquisition and allocation of funds.

b) Financial management involves making decisions about the long-term investments of a firm.

c) Financial management is only relevant for large corporations.

d) Financial management aims to maximize shareholder wealth.

Answer: c) Financial management is only relevant for large corporations.

PART (B) - ( 5 Short Answer Questions =5*5 M)

1. Define financial management and explain its importance in modern businesses.

Answer: Financial management involves planning, organizing, directing, and controlling financial

activities such as procurement and utilization of funds of the enterprise. Its importance lies in ensuring

efficient utilization of funds, maximizing profitability, and ensuring long-term sustainability and

growth of the business.

2. Discuss the significance of the investment decision in financial management.

Answer: The investment decision involves allocating funds to long-term assets or projects that will

generate returns in the future. It is significant because it determines the firm's growth, profitability,

and future competitiveness. Making sound investment decisions is crucial for maximizing shareholder

wealth and achieving the firm's objectives.

3. Explain the concept of financial markets and their role in financial management.
Answer: Financial markets are platforms where buyers and sellers trade financial securities,

commodities, and other fungible items at prices determined by supply and demand. They facilitate the

efficient allocation of resources by providing liquidity, price discovery, and a mechanism for risk

transfer. Financial managers utilize these markets to raise capital, manage risk, and invest surplus

funds.

4. Differentiate between long-term financing and short-term financing options available to businesses.

Answer: Long-term financing involves raising funds for periods exceeding one year, typically through

equity or debt instruments like bonds or loans. Short-term financing, on the other hand, involves

obtaining funds for periods less than one year, often through sources like trade credit, bank loans, or

commercial paper. Long-term financing is used for capital expenditures, while short-term financing is

used to meet working capital needs.

5. Discuss the role of financial management in maximizing shareholder wealth.

Answer: The primary goal of financial management is to maximize shareholder wealth, which is

achieved by making decisions that increase the firm's value over time. Financial managers strive to

generate positive returns on investment, manage risks effectively, and distribute profits to

shareholders in the form of dividends or share buybacks. By focusing on shareholder wealth

maximization, financial management aligns the interests of shareholders with those of the firm,

leading to sustainable growth and prosperity.

PART (C) - (2 Long Answer Questions = 2*10 M)

1. Explain the concept of capital budgeting and discuss its significance in financial decision-making.

Answer: Capital budgeting involves evaluating and selecting long-term investment projects that are

expected to generate positive cash flows and enhance the value of the firm. It is a critical aspect of

financial decision-making because it determines how the firm allocates its scarce resources among

competing investment opportunities. By using techniques such as net present value (NPV), internal

rate of return (IRR), and payback period, financial managers assess the feasibility and profitability of

investment projects and prioritize them based on their contribution to shareholder wealth

maximization.
2. Discuss the factors influencing the dividend decision of a firm and explain the various dividend

policies adopted by companies.

Answer: The dividend decision involves determining the portion of earnings that should be distributed

to shareholders as dividends and the portion that should be retained for reinvestment in the business.

Several factors influence this decision, including the firm's profitability, growth prospects, liquidity

needs, shareholder preferences, and tax considerations. Companies may adopt various dividend

policies, such as a stable dividend policy, where dividends are paid regularly regardless of earnings,

or a residual dividend policy, where dividends are paid from residual earnings after financing

investment opportunities. Other policies include a constant payout ratio policy, where a fixed

percentage of earnings is paid as dividends, and a no-dividend policy, where all earnings are retained

for reinvestment. Each policy has its advantages and disadvantages, and the choice depends on the

firm's specific circumstances and objectives.

Unit 2 :

PART (A) - (10 MCQ = 10*1M)

1. What is the primary objective of capital budgeting?

a) Maximizing shareholder wealth

b) Maximizing market share

c) Minimizing fixed costs

d) Minimizing variable costs

Answer: a) Maximizing shareholder wealth

2. Which capital budgeting technique considers the time value of money?

a) Payback period
b) Accounting rate of return

c) Net present value (NPV)

d) Internal rate of return (IRR)

Answer: c) Net present value (NPV)

3. Which of the following is not a key consideration in capital budgeting decisions?

a) Initial investment

b) Expected future cash flows

c) Risk-free rate

d) Cost of capital

Answer: c) Risk-free rate

4. Which capital budgeting technique is based on accounting profits rather than cash flows?

a) Payback period

b) Net present value (NPV)

c) Internal rate of return (IRR)

d) Accounting rate of return

Answer: d) Accounting rate of return

5. In capital budgeting, the term 'discount rate' refers to:

a) The rate at which the project's cash flows are discounted

b) The rate at which the firm borrows money

c) The rate at which the project's payback period is calculated

d) The rate of inflation

Answer: b) The rate at which the firm borrows money

6. Which capital budgeting technique emphasizes the recovery of initial investment?

a) Payback period

b) Net present value (NPV)

c) Internal rate of return (IRR)

d) Profitability index

Answer: a) Payback period

7. What does the profitability index (PI) indicate in capital budgeting?

a) The profitability of the project relative to its initial investment

b) The average rate of return on the project's cash flows

c) The project's sensitivity to changes in discount rates

d) The project's payback period

Answer: a) The profitability of the project relative to its initial investment

8. Which of the following is a limitation of the payback period method?

a) Ignores the time value of money

b) Considers cash flows over the entire project's life

c) Provides a measure of liquidity

d) Considers all cash flows equally

Answer: a) Ignores the time value of money

9. Which capital budgeting technique is preferred when evaluating mutually exclusive projects?

a) Payback period

b) Net present value (NPV)

c) Internal rate of return (IRR)

d) Profitability index

Answer: b) Net present value (NPV)

10. What does the internal rate of return (IRR) represent?

a) The rate of return that equates the present value of cash inflows to the initial investment

b) The average rate of return on the project's cash flows

c) The project's sensitivity to changes in discount rates

d) The project's payback period

Answer: a) The rate of return that equates the present value of cash inflows to the initial investment

PART (B) - ( 5 Short Answer Questions =5*5 M)

1. Explain the concept of Net Present Value (NPV) and its significance in capital budgeting.

Answer: Net Present Value (NPV) is the difference between the present value of cash inflows and the

present value of cash outflows over a specified period, discounted at a certain rate. It is a measure of

the project's profitability and indicates whether an investment will increase shareholder wealth. A

positive NPV signifies that the project is expected to generate more cash inflows than outflows,
adding value to the firm. Therefore, NPV is a critical tool in capital budgeting for evaluating

investment opportunities and making informed decisions.

2. What are the key advantages of using the Internal Rate of Return (IRR) method in capital

budgeting?

Answer: The Internal Rate of Return (IRR) method offers several advantages, including simplicity in

understanding and calculation. It considers the time value of money and provides a single rate of

return, making it easy to compare projects. Additionally, IRR accounts for the entire cash flow stream

and is less affected by changes in the discount rate, making it useful for sensitivity analysis.

Furthermore, IRR helps identify the maximum cost of capital a project can bear while still generating

a positive NPV, aiding in decision-making regarding financing options.

3. Discuss the concept of risk in capital budgeting decisions and how it can be addressed.

Answer: Risk refers to the uncertainty associated with future cash flows and the potential deviation

from expected returns in capital budgeting decisions. It can arise from various sources such as

economic, market, technical, and project-specific factors. To address risk, financial managers employ

techniques such as sensitivity analysis, scenario analysis, and simulation to assess the impact of

different risk factors on project outcomes. Additionally, risk-adjusted discount rates or incorporating

risk premiums into cash flow projections can help account for uncertainty and make more informed

investment decisions.

4. Explain the concept of the payback period and its limitations in capital budgeting.

Answer: The payback period is the time required for an investment to recover its initial cost from the

cash flows it generates. It is a simple and intuitive measure of liquidity and risk but has several

limitations. Firstly, it ignores the time value of money by treating cash flows equally regardless of

when they occur. Secondly, it disregards cash flows beyond the payback period, leading to incomplete

analysis of the project's profitability. Lastly, it does not consider the project's overall impact on

shareholder wealth, making it less suitable for long-term investment decisions.

5. Discuss the role of the profitability index (PI) in capital budgeting and how it complements other

evaluation methods.

Answer: The profitability index (PI) is a ratio of the present value of future cash flows to the initial

investment, providing a measure of the project's value per unit of investment. It helps financial

managers assess the efficiency of investment opportunities and prioritize projects based on their

profitability relative to costs. The PI complements other evaluation methods such as NPV and IRR by

considering the size of investment and providing insights into the relative attractiveness of projects.

Additionally, it accounts for the time value of money and can guide decision-making in situations

where capital is constrained, maximizing shareholder wealth.

PART (C) - (2 Long Answer Questions = 2*10 M)

1. Discuss the concept of risk in capital budgeting decisions and how it can be addressed.

Answer: Risk in capital budgeting refers to the uncertainty surrounding future cash flows of an

investment project. It can arise from various sources including market fluctuations, economic

conditions, technological changes, and project-specific factors. Addressing risk is crucial in making

informed investment decisions. One approach is sensitivity analysis, which involves assessing the

impact of changes in key variables (such as sales volume, cost of capital, and inflation rate) on project

outcomes. Another method is scenario analysis, where different scenarios are constructed based on

varying assumptions about future conditions to evaluate the project's performance under different

circumstances. Additionally, Monte Carlo simulation can be used to generate multiple possible

outcomes and their probabilities, providing a more comprehensive understanding of risk.

Furthermore, risk-adjusted discount rates can be employed to reflect the project's riskiness in the

discounting process. By considering and mitigating risk, financial managers can make more robust

capital budgeting decisions that align with the firm's objectives and enhance shareholder wealth.

2. Explain the concept of the payback period and its limitations in capital budgeting.

Answer: The payback period is the time required for an investment to recover its initial cost from the

cash flows it generates. It is a simple and intuitive measure of liquidity and risk as it indicates how

quickly the initial investment can be recouped. However, the payback period has several limitations.
Firstly, it ignores the time value of money by treating cash flows equally regardless of when they

occur. This means that it does not consider the present value of future cash flows, leading to an

incomplete analysis of the project's profitability. Secondly, it disregards cash flows beyond the

payback period, which can result in overlooking the long-term benefits of an investment. Thirdly, it

does not consider the project's overall impact on shareholder wealth, making it less suitable for

evaluating projects with different lifespans or cash flow patterns. Despite its simplicity, the payback

period should be used in conjunction with other capital budgeting techniques such as net present value

(NPV) and internal rate of return (IRR) to provide a more comprehensive evaluation of investment

opportunities.

Unit 3 :

PART (A) - (10 MCQ = 10*1M)

1. What does the term 'cost of capital' refer to?

a) The cost of running a company's operations

b) The cost a company incurs to obtain funds

c) The cost of producing goods and services

d) The cost of acquiring fixed assets

Answer: b) The cost a company incurs to obtain funds

2. Which of the following is considered a component of the cost of capital?

a) Cost of debt

b) Cost of equity

c) Cost of preferred stock

d) All of the above

Answer: d) All of the above

3. What is the formula for the Weighted Average Cost of Capital (WACC)?

a)WACC=(Cost of Equity+Cost of Debt)/2

b)WACC=Cost of Debt×Weight of Debt+Cost of Equity×Weight of Equity

c)WACC=(Cost of Equity×Market Value of Equity+Cost of Debt×Market Value of Debt)/Total

Market Value of Equity and Debt

d)WACC=Total Cost/Total Funds

Answer: c) (WACC=Cost of Equity×Market Value of Equity+Cost of Debt×Market Value of

Debt)/Total Market Value of Equity and Debt

4. Which of the following is a common method for estimating the cost of equity?

a) Dividend Discount Model (DDM)

b) Net Present Value (NPV)

c) Internal Rate of Return (IRR)

d) Payback Period

Answer: a) Dividend Discount Model (DDM)

5. What does the cost of debt typically include?

a) Interest expenses and tax savings

b) Dividend payments and capital gains

c) Operating expenses and fixed costs

d) Marketing and administrative costs

Answer: a) Interest expenses and tax savings

6. How does the tax shield affect the cost of debt?

a) It increases the cost of debt

b) It decreases the cost of debt

c) It has no effect on the cost of debt

d) It only affects the cost of equity

Answer: b) It decreases the cost of debt

7. The Capital Asset Pricing Model (CAPM) is used to calculate:

a) Cost of debt

b) Cost of preferred stock

c) Cost of equity

d) Cost of capital

Answer: c) Cost of equity

8. In the context of WACC, what does the 'weight' refer to?

a) The total cost of each component of capital

b) The proportion of each component in the total capital structure

c) The average return expected from each component

d) The risk associated with each component

Answer: b) The proportion of each component in the total capital structure

9. If a company has a higher proportion of debt in its capital structure, the WACC will generally:

a) Increase

b) Decrease

c) Stay the same

d) Become negative

Answer: b) Decrease

10. Which of the following best describes the cost of preferred stock?

a) The annual dividend divided by the market price of preferred shares

b) The interest expense divided by the total debt

c) The retained earnings divided by the number of preferred shares

d) The net income divided by the total equity

Answer: a) The annual dividend divided by the market price of preferred shares

PART (B) - ( 5 Short Answer Questions =5*5 M)

1. Define the cost of capital and explain its importance in financial management.

Answer: The cost of capital refers to the rate of return that a company must earn on its investments to

maintain its market value and attract funds. It is important in financial management because it serves
as a benchmark for evaluating investment projects. Projects that yield returns above the cost of capital

are considered value-adding, while those below it may decrease shareholder value.

2. What is the formula for calculating the cost of equity using the Dividend Discount Model (DDM)?

Answer: The cost of equity (Ke) using the Dividend Discount Model (DDM) is calculated as follows:

Ke= (P0/D1)+g

where D1 is the expected dividend per share one year from now, P0 is the current market price of the

stock, and g is the growth rate of dividends.

3. How is the after-tax cost of debt calculated, and why is it important?

Answer: The after-tax cost of debt is calculated by adjusting the interest expense for the tax savings

due to interest being tax-deductible. The formula is:

After-tax cost of debt=Interest rate×(1Tax rate)

It is important because it provides a more accurate measure of the cost of debt financing after

accounting for the tax benefits, impacting the overall cost of capital.

4. Explain the significance of the Weighted Average Cost of Capital (WACC) in investment

decisions.

Answer: WACC represents the average rate of return a company is expected to pay to its security

holders to finance its assets. It is significant in investment decisions as it serves as a hurdle rate for

evaluating project profitability. Projects with returns above WACC are expected to add value to the

firm, while those below may diminish it.

5. What factors can influence a company's cost of capital?

Answer: Factors influencing a company's cost of capital include market conditions, the firm's capital

structure, its creditworthiness, interest rates, tax rates, and the risk profile of its investments. Changes

in any of these factors can affect the components of WACC and thus the overall cost of capital.
PART (C) - (2 Long Answer Questions = 2*10 M)

1. Discuss the various methods for calculating the cost of equity and their respective advantages and

disadvantages.

2. Explain the concept of the Weighted Average Cost of Capital (WACC) and its application in

financial decision-making. Include a detailed example calculation.

Answer: The Weighted Average Cost of Capital (WACC) is the average rate of return a company is

expected to pay to its security holders to finance its assets. It is calculated by weighting the cost of

each component of the capital structure (equity, debt, preferred stock) by its proportion in the total

capital.
Unit 4 :

PART (A) - (10 MCQ = 10*1M)

1. Which of the following best describes capital structure?

a) The mix of a firm’s short-term and long-term assets

b) The mix of a firm’s debt and equity financing

c) The mix of a firm’s operating and non-operating income

d) The mix of a firm’s retained earnings and dividends

Answer: b) The mix of a firm’s debt and equity financing

2. What is the Modigliani-Miller Proposition I (without taxes) about?

a) Capital structure is irrelevant to firm value

b) Capital structure affects firm value

c) Dividends are irrelevant to firm value

d) Dividends affect firm value

Answer: a) Capital structure is irrelevant to firm value

3. Which of the following is a benefit of using debt in the capital structure?

a) Increased equity dilution

b) Tax shield on interest payments

c) Increased financial risk

d) Decreased earnings per share

Answer: b) Tax shield on interest payments

4. A company has a debt-to-equity ratio of 1.5. What does this mean?

a) The company has more equity than debt

b) The company has equal amounts of debt and equity

c) The company has more debt than equity

d) The company is financed solely by equity

Answer: c) The company has more debt than equity

5. Which of the following is NOT a factor influencing a company’s capital structure?

a) Market conditions
b) Company’s risk profile

c) Competitor’s capital structure

d) Company’s historical earnings

Answer: c) Competitor’s capital structure

6. What is financial leverage?

a) The use of retained earnings in financing

b) The use of fixed assets in operations

c) The use of debt in the capital structure

d) The use of equity in the capital structure

Answer: c) The use of debt in the capital structure

7. The trade-off theory of capital structure suggests that firms balance:

a) Equity and retained earnings

b) Operating and financial leverage

c) The tax benefits of debt against bankruptcy costs

d) Fixed and variable costs

Answer: c) The tax benefits of debt against bankruptcy costs

8. Which of the following is an implication of a high debt ratio?

a) Higher financial flexibility

b) Lower financial risk

c) Higher interest obligations

d) Higher retained earnings

Answer: c) Higher interest obligations

9. According to the Pecking Order Theory, which type of financing do firms prefer first?

a) Debt

b) Equity

c) Internal funds (retained earnings)

d) Convertible bonds

Answer: c) Internal funds (retained earnings)

10. What does the term ‘leveraged buyout’ (LBO) refer to?

a) Buying out shareholders using the company's own equity

b) Acquiring a company using a significant amount of borrowed money

c) Issuing new equity to purchase another company

d) A merger between two companies with no debt

Answer: b) Acquiring a company using a significant amount of borrowed money

PART (B) - ( 5 Short Answer Questions =5*5 M)

1. Explain the concept of the capital structure.

Answer: Capital structure refers to the mix of debt and equity that a firm uses to finance its operations

and growth. It reflects the proportion of financing that comes from creditors (debt) and from

shareholders (equity).

2. What is the importance of the debt-to-equity ratio?

Answer: The debt-to-equity ratio is a measure of a company's financial leverage. It indicates the

relative proportion of shareholders' equity and debt used to finance the company's assets. A higher

ratio suggests more debt relative to equity, which can imply higher financial risk.

3. Describe the Modigliani-Miller theorem with taxes.

Answer: The Modigliani-Miller theorem with taxes states that the value of a leveraged firm (one with

debt) is higher than an unleveraged firm (one without debt) due to the tax shield provided by interest

payments. This theorem suggests that capital structure can affect a firm's value in the presence of

taxes.

4. What is financial leverage and how does it impact a company?

Answer: Financial leverage is the use of debt to acquire additional assets. It impacts a company by

amplifying both potential returns and potential losses. High leverage can increase earnings per share

in good times, but it also increases the risk of financial distress and bankruptcy.

5. Discuss the trade-off theory of capital structure.

Answer: The trade-off theory of capital structure posits that firms seek to balance the tax advantages

of debt financing (interest tax shields) with the costs of potential financial distress and bankruptcy.

Firms strive to find an optimal capital structure that maximizes their overall value.

PART (C) - (2 Long Answer Questions = 2*10 M)

1. Discuss the Pecking Order Theory of capital structure and its implications for financial decision-

making within a firm.

Answer: The Pecking Order Theory, proposed by Myers and Majluf, suggests that firms have a

preferred hierarchy for financing decisions. First, they prefer to use internal funds (retained earnings)

because they do not incur flotation costs and do not send negative signals to the market. If internal

funds are insufficient, firms will issue debt due to its lower adverse selection costs compared to

equity. Equity is considered a last resort due to its higher flotation costs and the potential negative

signal it sends to the market about the firm’s valuation. This theory implies that firms with ample

retained earnings are less likely to issue new debt or equity, while firms with insufficient internal

funds may prefer debt over equity. This affects financial decision-making by emphasizing the

importance of maintaining sufficient internal reserves and careful consideration of the market’s

perception when issuing new securities.

2. Analyze the impact of capital structure on a company's cost of capital and its overall valuation.

Include in your discussion the Modigliani-Miller Proposition I and II.

Answer: The capital structure of a company significantly influences its cost of capital and overall

valuation. According to the Modigliani-Miller Proposition I (without taxes), in a perfect market, the

capital structure is irrelevant to the firm’s value. The firm's value is determined by its operating

income and risk, not by its mix of debt and equity. However, when taxes are introduced (Modigliani-

Miller Proposition II), the use of debt can create a tax shield, reducing the company's taxable income

and thus its overall tax liability. This increases the value of the firm.

Proposition II (with taxes) also states that as a firm increases its debt ratio, its cost of equity rises

because equity holders demand higher returns to compensate for the increased financial risk.

However, the overall weighted average cost of capital (WACC) decreases initially due to the tax

benefits of debt. Beyond a certain point, the costs of financial distress and bankruptcy outweigh the

tax benefits, leading to an optimal capital structure where WACC is minimized, and firm value is

maximized. Thus, a company must carefully balance the benefits of debt (tax shields) against the

potential costs (financial distress) to determine its optimal capital structure, which in turn affects its

overall valuation.

Unit 5 :

PART (A) - (10 MCQ = 10*1M)

1. What does working capital management primarily focus on?

a) Long-term financing

b) Short-term assets and liabilities

c) Equity financing

d) Investment in fixed assets

Answer: b) Short-term assets and liabilities

2. Which of the following is included in the calculation of net working capital?

a) Fixed assets

b) Long-term debt

c) Accounts receivable

d) Common stock

Answer: c) Accounts receivable

3. What is the formula for calculating net working capital?

a) Current assets - Current liabilities

b) Total assets - Total liabilities

c) Fixed assets - Long-term liabilities

d) Equity + Long-term debt

Answer: a) Current assets - Current liabilities

4. Which of the following ratios is used to assess a company's short-term liquidity?

a) Debt-to-equity ratio

b) Current ratio

c) Return on equity

d) Price-to-earnings ratio

Answer: b) Current ratio

5. Which of the following is a component of working capital?

a) Land

b) Buildings

c) Inventory

d) Patents

Answer: c) Inventory

6. What does a current ratio of less than 1 indicate?

a) The company has more current assets than current liabilities

b) The company is likely to be highly profitable

c) The company has more current liabilities than current assets

d) The company has high long-term debt

Answer: c) The company has more current liabilities than current assets

7. Which of the following would improve a company's working capital position?

a) Increasing long-term debt

b) Reducing accounts receivable collection period

c) Purchasing fixed assets

d) Increasing dividend payments

Answer: b) Reducing accounts receivable collection period

8. Which of the following best describes the cash conversion cycle?

a) Time taken to convert cash into inventory

b) Time taken to convert investments into cash

c) Time taken to convert inventory into cash

d) Time taken to convert cash into sales revenue

Answer: c) Time taken to convert inventory into cash

9. What is the effect of a high inventory turnover ratio on working capital?

a) It indicates that more cash is tied up in inventory

b) It suggests efficient inventory management

c) It means the company is not selling products quickly

d) It indicates poor working capital management

Answer: b) It suggests efficient inventory management

10. Why is managing accounts payable important in working capital management?

a) To maximize interest earned on cash reserves

b) To minimize long-term debt

c) To maintain good relationships with suppliers and optimize cash flow

d) To increase equity financing

Answer: c) To maintain good relationships with suppliers and optimize cash flow

PART (B) - ( 5 Short Answer Questions =5*5 M)

1. What is working capital and why is it important?

Answer: Working capital is the difference between current assets and current liabilities. It is important

because it measures a company's short-term liquidity and operational efficiency. Sufficient working

capital ensures that a company can meet its short-term obligations and continue its operations without

disruptions.

2. Explain the concept of the cash conversion cycle.

Answer: The cash conversion cycle (CCC) is the time period between the outlay of cash for the

purchase of inventory and the collection of cash from sales. It includes three components: the

inventory conversion period, the receivables collection period, and the payables deferral period. The

CCC measures the efficiency of a company’s working capital management.

3. What is the difference between gross working capital and net working capital?

Answer: Gross working capital refers to the total of a company’s current assets, whereas net working

capital is the difference between current assets and current liabilities. Gross working capital focuses

on the amount invested in current assets, while net working capital indicates the liquidity position and

short-term financial health of the company.

4. Why is inventory management critical in working capital management?

Answer: Inventory management is critical because it helps maintain the optimal level of inventory,

reducing holding costs and avoiding stockouts. Efficient inventory management ensures that capital is

not unnecessarily tied up in unsold goods, thereby improving liquidity and cash flow.
5. How can a company improve its receivables collection period?

Answer: A company can improve its receivables collection period by implementing stricter credit

policies, offering early payment discounts, using efficient invoicing and follow-up processes, and

employing collection agencies if necessary. Faster collection of receivables improves cash flow and

working capital.

PART (C) - (2 Long Answer Questions = 2*10 M)

1. Discuss the impact of working capital management on a company’s profitability and liquidity.

Provide examples to illustrate your points.

Answer: Effective working capital management significantly impacts a company's profitability and

liquidity. By optimizing the levels of inventory, accounts receivable, and accounts payable, a

company can reduce costs and improve cash flow. For example, efficient inventory management

reduces holding costs and minimizes stockouts, directly contributing to profitability. On the other

hand, timely collection of receivables ensures that cash is available for operations, improving

liquidity. Conversely, poor working capital management, such as excessive inventory or delayed

receivables collection, can lead to cash shortages, increased borrowing costs, and ultimately, lower

profitability. Companies like Dell and Walmart, known for their efficient inventory management,

demonstrate how effective working capital management contributes to higher profitability and strong

liquidity positions.

2. Analyze the strategies a firm can employ to manage its working capital effectively. Discuss the

potential risks associated with each strategy.

Answer:

Firms can employ several strategies to manage working capital effectively:

Inventory Management: Just-in-time (JIT) inventory systems minimize inventory levels, reducing

holding costs. However, this strategy risks stockouts and potential supply chain disruptions.
Receivables Management: Offering early payment discounts and using efficient invoicing systems can

speed up receivables collection. The risk is that offering discounts may reduce overall revenue.

Payables Management: Extending payment terms with suppliers can improve cash flow. The

downside is that it might strain supplier relationships and lead to less favorable terms in the future.

Cash Management: Maintaining optimal cash reserves to meet short-term obligations without holding

excessive cash that could be invested elsewhere. The risk is that too little cash can lead to liquidity

issues, while too much cash may result in missed investment opportunities.

Financing Strategies: Using short-term financing options like lines of credit to manage cash flow

needs. The risk is that reliance on short-term debt increases financial risk and interest costs.

Each strategy needs to be balanced with the associated risks to ensure the company maintains liquidity

while optimizing profitability. For instance, while JIT inventory systems are cost-efficient, they

require robust supply chain management to mitigate the risk of stockouts. Similarly, extending

payables can improve cash flow but should be done carefully to avoid damaging supplier

relationships.