TERMINAL QUESTION AND ANSWERS

FINANCIAL MANAGEMENT [DBB2104]

UNIT1:

Short Answer Questions

Q1. Define financial management.

ANS: Financial management refers to the strategic planning, organizing, directing, and
controlling of financial resources within an organization to achieve its objectives and
maximize value. It involves managing financial activities such as budgeting, forecasting,
investing, managing risks, and overseeing cash flow to ensure the business's financial health
and growth.

The primary goals of financial management are to maximize profits, minimize financial risks,
and ensure liquidity to meet the organization’s short-term and long-term obligations. It also
focuses on the efficient use of resources to optimize returns on investments, while balancing
financial risks and ensuring compliance with regulations.

Key areas within financial management include financial planning, where organizations
assess future financial needs and develop budgets, and financial analysis, which involves
evaluating financial performance through financial statements, ratios, and other tools.
Investment management is another crucial area, which includes decisions about allocating
resources for growth and profitability.

Risk management is essential to financial management, as it identifies potential financial

risks and develops strategies to mitigate them, such as insurance, hedging, or diversifying
investments. Finally, financial management involves capital structure decisions, ensuring that
the business has the right mix of debt and equity to support operations and expansion while
minimizing the cost of capital.

Q2. Explain the goal of financial management.

ANS: The primary goal of financial management is to maximize the value of the organization
for its stakeholders, particularly shareholders, while ensuring long-term financial stability and
sustainability. This overarching objective can be broken down into several key goals, which
are interrelated and contribute to the overall financial success of a business.

One central goal is to maximize profits, which directly enhances the financial performance
and value of the organization. Financial management seeks to achieve this by optimizing
revenue generation, controlling costs, and improving operational efficiency.

Another critical goal is liquidity management, ensuring the organization has enough cash
flow to meet its short-term obligations and avoid financial crises. This involves managing
working capital, including inventory, accounts receivable, and accounts payable, to maintain
a balance between growth and operational needs.
Minimizing financial risk is also a significant goal. Financial managers aim to identify,
assess, and mitigate risks that could negatively impact the organization, such as market
fluctuations, interest rate changes, or credit risks. By doing so, they protect the organization’s
assets and ensure its ability to weather economic uncertainties.

Furthermore, financial management involves making sound investment decisions that

generate optimal returns while balancing risk. This includes evaluating opportunities, such as
expansion projects or acquisitions, and ensuring capital allocation is efficient.

Q3. Explain the two sources of finance.

ANS: Two primary sources of finance for businesses are equity finance and debt finance,
each serving distinct purposes and offering different advantages and risks.

1. Equity Finance: This refers to raising capital by selling shares of the company to
investors, typically through private placements or public stock offerings. When a
company opts for equity financing, it allows investors (shareholders) to become
partial owners of the business in exchange for capital. Equity finance does not require
repayment, making it an attractive option for businesses that need long-term funding
without the burden of interest payments. Additionally, shareholders may provide
strategic support and resources to the business. However, equity financing dilutes
ownership, meaning existing owners may lose some control over business decisions,
and shareholders expect a return on their investment, often in the form of dividends or
capital appreciation.
2. Debt Finance: Debt financing involves borrowing money from external sources, such
as banks, financial institutions, or bond markets, with the agreement to repay the
principal along with interest over a specified period. Common forms of debt finance
include bank loans, bonds, and lines of credit. The key advantage of debt finance is
that it does not involve giving up ownership or control of the business. Additionally,
interest payments on debt are tax-deductible, which can provide tax benefits.
However, debt financing comes with the obligation of regular repayments, which can
put pressure on the company’s cash flow and increase financial risk, especially if the
business faces economic challenges.

Q4. How is profit planning one of the important functions of a finance manager?
ANS: Profit planning is one of the most crucial functions of a finance manager as it directly
impacts an organization's ability to achieve its financial objectives and ensure sustainable
growth. The finance manager plays a pivotal role in formulating strategies that drive
profitability, manage costs, and maximize returns. Here's how profit planning is integral to
their role:

1. Setting Profit Targets: A finance manager is responsible for setting realistic profit
goals based on historical performance, market conditions, and business strategies.
These targets guide the organization and align its operations with financial
expectations, ensuring focus on maximizing revenue while managing costs.
2. Cost Control and Budgeting: Effective profit planning involves creating a
comprehensive budget that forecasts expenses and ensures resources are allocated
 efficiently. The finance manager monitors operational costs, identifies areas of
wastage, and implements cost-control measures. By keeping costs under control while
maximizing revenues, profit margins improve, directly contributing to higher profits.
3. Investment Decisions: The finance manager also assesses potential investment
opportunities that can enhance the company’s profitability. By analyzing return on
investment (ROI) and conducting cost-benefit analyses, they can direct funds toward
projects that will generate higher returns, ensuring optimal use of financial resources.
4. Risk Management: A critical aspect of profit planning is identifying and mitigating
financial risks that could negatively affect profitability. The finance manager
evaluates various risks such as market volatility, interest rate fluctuations, or
unforeseen costs, and formulates strategies to manage these challenges effectively.

Q5. What is the risk and return trade-off?

ANS: The risk and return trade-off is a fundamental concept in finance that refers to the
relationship between the potential risk an investment carries and the potential return it can
generate. Essentially, it suggests that higher potential returns are typically associated with
higher risk, and conversely, lower-risk investments generally offer lower returns. This trade-
off is central to investment decision-making, as investors must balance the desire for higher
returns with their tolerance for risk.

1. Risk: In the context of investments, risk refers to the uncertainty or potential for loss.
It can manifest in various forms, such as market volatility, economic downturns,
interest rate fluctuations, or specific business risks. Risk is measured using metrics
such as standard deviation or beta, which assess the extent to which an investment’s
returns fluctuate relative to the overall market or its own historical performance.
2. Return: Return is the profit or income generated by an investment over time,
typically expressed as a percentage of the initial investment. Returns can come from
capital gains (increases in the asset’s value) or income, such as dividends or interest
payments. Higher returns are generally sought by investors looking to maximize
wealth, but these often come at the cost of increased risk.

Investors must determine their risk tolerance based on factors like time horizon, financial
goals, and personal preferences. Risk-averse investors typically seek lower-risk investments,
such as bonds or blue-chip stocks, which offer steady but modest returns. On the other hand,
risk-tolerant investors may pursue higher-risk opportunities, like startups or volatile stocks, to
potentially achieve greater returns.

Long Answer Questions

Q1. Discuss different types of finances with a diagram.

ANS: Finance is the study of managing monetary resources, and it is crucial for both
individuals and organizations. There are various types of finance, and they can be broadly
categorized into two main groups: personal finance and business finance. These categories
can be further divided into more specialized areas. Let’s explore each type in detail:
1. Personal Finance: Personal finance refers to the financial management of an
individual or household. It involves budgeting, saving, investing, insurance, and
retirement planning. The goal of personal finance is to help individuals manage their
money effectively to achieve financial security and meet their long-term goals. Key
components of personal finance include:
o Budgeting: Planning income and expenses to ensure savings and avoid debt.
o Saving and Investing: Building wealth through savings accounts, stocks,
bonds, and other investments.
o Insurance: Protecting against financial risks such as illness, accidents, or
death.
o Retirement Planning: Saving for retirement through pensions, 401(k) plans,
or other retirement vehicles.
2. Business Finance: Business finance is concerned with managing the financial
activities of an organization. It involves making decisions on how to raise capital,
invest in projects, and manage financial resources efficiently. Business finance can be
further broken down into specific areas:
o Corporate Finance: Deals with managing a company's funding, financial
decisions, and maximizing shareholder value. Key activities include capital
budgeting (choosing investment projects), capital structure management
(balancing debt and equity), and dividend policies.
o Public Finance: Involves managing the finances of government entities,
including tax collection, government spending, and budgeting for public
services.
o International Finance: Deals with financial activities across borders, such as
exchange rates, international investments, and managing risks associated with
global markets.

Finance

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Personal Finance Business Finance

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Corporate Finance Public Finance

International Finance
Q2. Explain the scope of financial management.
ANS: The scope of financial management is vast and encompasses several critical activities
that ensure an organization’s financial health. Financial management involves planning,
organizing, directing, and controlling an organization’s financial resources to achieve its
objectives. The main areas within the scope of financial management are:

1. Financial Planning: Financial planning involves forecasting future financial needs

and formulating strategies to meet them. This process ensures the company can meet
both its short-term and long-term financial objectives. Financial managers develop
budgets, cash flow projections, and financial forecasts to guide the company in
making sound financial decisions.
2. Investment Decisions: This is a key area of financial management, involving the
allocation of resources into projects or investments that will generate the highest
returns. Investment decisions may involve purchasing assets, expanding the business,
or investing in research and development. These decisions are typically evaluated
using techniques like Net Present Value (NPV), Internal Rate of Return (IRR),
and Payback Period to determine their financial feasibility.
3. Financing Decisions: Financing decisions relate to how a company will fund its
operations and investments. The finance manager decides the best mix of debt
(borrowed capital) and equity (ownership capital) to raise funds. A sound financing
decision considers factors like cost of capital, financial risk, and the company’s
capital structure.
4. Dividend Decisions: Dividend decisions revolve around determining how much
profit should be distributed to shareholders as dividends versus how much should be
retained within the company for reinvestment. The dividend policy must align with
the company’s financial goals and growth objectives.
5. Risk Management: Financial management includes identifying and managing
various financial risks, such as credit risk, market risk, operational risk, and liquidity
risk. Risk management involves hedging strategies, diversification of investments,
and maintaining appropriate insurance coverage to safeguard the company’s financial
interests.
6. Liquidity Management: Liquidity management is critical for ensuring that the
organization has enough cash or liquid assets to meet its short-term obligations. This
includes managing working capital components like accounts receivable, accounts
payable, and inventory levels.

Q3. Explain the functions of a financial manager.

ANS: A financial manager plays a vital role in overseeing an organization’s financial health,
ensuring resources are allocated efficiently, and guiding the organization toward profitability.
The key functions of a financial manager include:

1. Capital Budgeting: Capital budgeting involves evaluating potential investment

opportunities and deciding which projects or assets the company should invest in. The
financial manager uses tools like NPV, IRR, and Payback Period to assess whether
an investment is viable and profitable. The goal is to invest in projects that will
generate positive cash flows and align with the company’s strategic goals.
 2. Capital Structure Management: A financial manager is responsible for deciding
how to raise capital—through equity (issuing shares) or debt (loans or bonds). The
manager must strike the right balance between debt and equity, considering factors
like the cost of capital, financial risk, and the company’s overall growth strategy. This
decision is crucial because it impacts the company’s financial stability, leverage, and
profitability.
3. Cash Flow Management: Efficient cash flow management ensures that the company
has enough liquidity to meet its day-to-day operational needs. The financial manager
monitors cash inflows and outflows, ensuring that the company can pay its bills,
employees, and suppliers on time, while also maintaining sufficient reserves for
unforeseen expenses. This involves managing working capital components like
receivables, payables, and inventory.
4. Financial Reporting: Financial managers are responsible for preparing financial
reports, such as the income statement, balance sheet, and cash flow statement,
which reflect the company’s financial performance. These reports provide critical
information to management, investors, and other stakeholders for making informed
business decisions.
5. Risk Management: Financial managers identify and manage financial risks that
could adversely affect the company. They assess market risks, credit risks, and
operational risks and employ strategies like diversification, hedging, and insurance to
mitigate potential threats to the company’s financial stability.
6. Profit Planning: Profit planning involves setting financial goals and developing
strategies to achieve those targets. The financial manager oversees budgeting
processes, cost control measures, and profitability analysis to ensure the company
meets its financial objectives and enhances shareholder value.

Q4. Evaluate the interface of the finance department with other areas.
ANS: The finance department does not operate in isolation; it plays a central role in
coordinating with other functional departments within the organization. Effective
collaboration with other departments ensures that financial resources are used efficiently and
aligned with organizational goals. The key interfaces between the finance department and
other areas include:

1. Marketing: Finance collaborates with marketing to determine how much budget

should be allocated for marketing campaigns, product development, and promotional
activities. The finance team evaluates the potential return on investment (ROI) of
marketing strategies and ensures that marketing expenditures are aligned with the
company’s financial objectives.
2. Human Resources (HR): The finance department works closely with HR to manage
payroll, employee benefits, and compensation packages. It is responsible for
budgeting HR expenses, determining the financial feasibility of employee
development programs, and ensuring that labor costs are controlled within budget.
3. Operations: Finance works with the operations department to ensure efficient use of
resources and to monitor production costs. It supports decisions related to
procurement, inventory management, and production planning, ensuring that
operational activities are carried out within the allocated budget and that cost control
measures are followed.
 4. Sales: The finance department interacts with the sales team to set sales targets,
monitor sales performance, and forecast revenues. The finance manager also ensures
that the sales targets are aligned with the overall financial goals of the company and
that cash flows from sales are appropriately managed.
5. Information Technology (IT): Finance collaborates with IT to ensure that financial
systems, such as accounting software and enterprise resource planning (ERP) systems,
are up-to-date and secure. The IT department also helps in automating financial
processes, improving data analysis, and streamlining reporting mechanisms, which
enhances the efficiency of financial management.

UNIT2:

Short Answer Questions

Q1. Explain the concept of wealth maximization.

ANS: Wealth maximization refers to the financial management goal of increasing the value
of the shareholders' equity, which ultimately leads to maximizing the overall wealth of the
company. This is done by enhancing the market value of the firm’s shares over time, ensuring
long-term profitability and growth. Wealth maximization focuses not only on increasing
profits but also on considering the timing, risk, and sustainability of returns.

The main objective of wealth maximization is to increase the present value of the expected
future cash flows of the company. This involves decisions that increase the firm's long-term
value while considering the risks involved. Unlike profit maximization, which only focuses
on short-term gains, wealth maximization takes a holistic approach, incorporating factors like
risk, market conditions, and shareholder expectations.

For example, a firm that pursues wealth maximization will carefully evaluate investment
opportunities and financing options to ensure that the choices made will enhance the
company’s long-term value, rather than focusing on immediate profits that may not be
sustainable.

The wealth maximization concept also accounts for shareholder wealth, as it aims to increase
the value of their investments through dividends and appreciation of stock prices. This
approach ensures that the interests of shareholders are aligned with the company’s long-term
goals.

Q2. Explain the assumptions of profit maximization.

ANS: Profit maximization is a traditional financial management objective that aims to
maximize the company’s profits, usually in the short term. However, this goal is based on
certain assumptions:

1. Rational Decision-Making: The company assumes that all decisions made will be
rational and aimed at maximizing profits without considering other factors like risk or
market fluctuations.
 2. Profit is the Sole Objective: It assumes that the company’s primary focus is on
maximizing profits, without taking into account the long-term growth, ethical
considerations, or stakeholder interests.
3. Certainty in Returns: The concept assumes that returns on investments or business
activities can be predicted with certainty, ignoring the volatility and risks in the
business environment.
4. No Consideration of Time: Profit maximization does not differentiate between short-
term and long-term profits, focusing solely on immediate gains, often ignoring future
consequences of present decisions.
5. Market Efficiency: Profit maximization assumes that the market functions efficiently
and that the company will always be able to achieve its maximum possible profits
without significant external interference.

While profit maximization provides clear financial targets, it has limitations in terms of long-
term sustainability, risk management, and the broader interests of stakeholders.

Q3. Explain the advantages of shareholders’ wealth maximization objective.

ANS: The objective of shareholders’ wealth maximization aims to increase the value of
shareholders’ investments by focusing on both profitability and risk management. The
advantages of this objective include:

1. Long-Term Focus: Unlike profit maximization, which is short-term oriented, wealth

maximization takes into account the long-term sustainability and growth of the
company. This ensures that the company’s value continues to grow over time.
2. Risk Consideration: Shareholder wealth maximization considers the risk involved in
generating returns. It ensures that decisions made by the company balance both the
returns and the risks associated with those returns, providing a more realistic and
sustainable financial strategy.
3. Alignment of Interests: Wealth maximization aligns the interests of management and
shareholders. When management focuses on maximizing the value of shareholders’
wealth, it encourages decisions that lead to increasing stock prices and dividend
payouts, which directly benefit shareholders.
4. Better Resource Allocation: By focusing on wealth maximization, the company is
more likely to allocate resources to projects and investments that provide the highest
returns, as these will lead to an increase in shareholder value. This ensures efficient
and effective use of capital.
5. Market Value Growth: Shareholders benefit from wealth maximization as it
increases the value of their investment in the company, reflected through rising stock
prices and higher dividends, which are both indicators of the company’s success.

UNIT3:

Short Answer Questions

Q1. Mention any five advantages of budget.

ANS: A budget is a detailed financial plan that estimates the revenue and expenses for a
specific period, usually a year. The process of budgeting offers numerous advantages to
organizations. Here are five key advantages:

1. Financial Control: Budgeting allows management to set financial goals and allocate
resources effectively. It acts as a tool to monitor and control expenditures, ensuring
that the organization doesn’t overspend or exceed its financial limits.

2. Performance Evaluation: Budgets provide benchmarks against which actual

financial performance can be measured. By comparing actual performance to
budgeted figures, organizations can assess their financial health, identify variances,
and take corrective actions.

3. Resource Allocation: A well-prepared budget helps in the effective allocation of

resources. By setting clear priorities, organizations can allocate funds to departments
or projects that are most aligned with strategic goals, improving operational
efficiency.

4. Motivation for Employees: Budgeting encourages employees to work towards

achieving financial targets. It provides clear goals and expectations, motivating staff
to improve their performance and contribute to the organization’s financial success.
5. Facilitates Decision-Making: Budgets provide managers with relevant financial
information that helps in making informed decisions. Whether it’s deciding on new
investments, cost-cutting measures, or pricing strategies, a budget helps ensure that
decisions are aligned with the financial capabilities of the organization.

Q2. Mention any three principles of responsibility accounting.

ANS: Responsibility accounting is a system that helps in assigning accountability for
financial results to individuals or departments within an organization. Three key principles of
responsibility accounting are:

1. Clearly Defined Responsibility Centers: Responsibility accounting involves

breaking down the organization into smaller, manageable units or responsibility
centers. Each center, whether it’s a department, division, or individual, is assigned
specific financial goals, budgets, and performance metrics.
2. Accountability for Results: Managers or department heads are held accountable for
the results of their responsibility centers. They are responsible for revenues, expenses,
and any variances from the budget. This ensures that each unit’s performance is
evaluated based on factors they can control.
3. Separation of Costs: In responsibility accounting, costs are classified into
controllable and uncontrollable categories. Managers are held accountable only for
those costs they can control. This principle ensures fairness in performance
evaluation, as it considers external factors that may impact certain costs beyond the
control of a department or individual.
Long Answer Questions

Q1. Explain responsibility accounting along with definition.

ANS: Definition:
Responsibility accounting is a system that involves assigning specific financial and
performance responsibilities to individual managers or departments within an organization.
Each manager or unit is held accountable for the results of their decisions, specifically
focusing on controllable revenues, expenses, and financial outcomes. The primary goal of
responsibility accounting is to evaluate performance, encourage efficient use of resources,
and ensure that managers are responsible for financial outcomes within their areas of control.

Concept:
In responsibility accounting, an organization is divided into smaller units or "responsibility
centers," and each center is responsible for its own financial performance. These
responsibility centers can be categorized into:

• Cost Centers: Responsible for controlling costs but not for generating revenue. The
performance of cost centers is evaluated based on how well they adhere to their
budgeted costs.
• Revenue Centers: Accountable for generating revenue but not for controlling costs.
Performance is evaluated based on revenue targets.
• Profit Centers: Responsible for both generating revenue and controlling costs. Profit
centers are evaluated based on their ability to generate profit.
• Investment Centers: These centers are responsible for managing both revenue and
costs and are also accountable for the returns on investments made by the unit.
Performance is evaluated based on profitability and return on investment (ROI).

Principles of Responsibility Accounting:

1. Define Responsibility Centers: The first step is to identify responsibility centers

within the organization and assign specific duties to managers or departments.
2. Accountability for Performance: Each center is held accountable for its specific
performance—revenues, costs, or profits—based on the center’s area of control.
3. Controllable vs. Uncontrollable Factors: Managers are only held accountable for
factors they can control. For example, a manager in a cost center is accountable for
costs but not for changes in external prices.

Benefits:

• Performance Measurement: Helps organizations evaluate the effectiveness of

individual managers and departments.
• Encourages Accountability: Managers are incentivized to make decisions that align
with the company’s financial goals.
• Improves Decision-Making: Responsibility accounting provides clear financial data,
helping managers make more informed and accurate decisions.
Q2. Explain any eight types of budgets.
ANS: Budgets are financial plans that help organizations manage their resources effectively
by forecasting revenues, expenses, and financial goals. There are various types of budgets,
each designed for different aspects of an organization’s operations. Below are eight common
types of budgets:

1. Sales Budget: A sales budget is a forecast of the expected sales for a specific period,
usually broken down by product, region, or salesperson. This budget is critical
because it influences all other budgets (such as production, inventory, and cash
budgets). Sales forecasts guide production schedules and the procurement of
materials.

Purpose: To estimate sales and plan the resources necessary for production and
inventory management.

2. Production Budget: This budget outlines the number of units that must be produced
to meet sales goals, taking into account inventory levels at the beginning and end of
the period. It includes direct labor, materials, and overhead costs for production.

Purpose: To ensure that adequate resources are available for manufacturing without
overproducing or underproducing.

3. Cash Budget: The cash budget forecasts the cash inflows and outflows over a
specific period, typically on a monthly or quarterly basis. It helps in ensuring that the
company has sufficient liquidity to meet its obligations, such as payroll, bills, and
debt payments.

Purpose: To manage cash flow and avoid liquidity problems by forecasting when to
expect surplus cash or cash shortages.

4. Operating Budget: An operating budget is a comprehensive financial plan that

includes both revenues and expenses related to the day-to-day operations of the
business. This includes costs like wages, rent, materials, and utilities.

Purpose: To allocate funds for regular operations and ensure that expenses do not
exceed available revenues.

5. Capital Expenditure (CapEx) Budget: This budget focuses on the acquisition of

long-term assets, such as machinery, equipment, or property. Capital expenditures are
usually large, infrequent, and require detailed planning.

Purpose: To ensure that long-term investments align with the company’s strategic
goals and financial capacity.

6. Flexible Budget: A flexible budget adjusts the original budget for variations in
activity levels, such as changes in sales or production volume. It is often used for
performance evaluation as it accounts for changes in real-time operations.

Purpose: To provide a more adaptable budgeting process that allows for adjustments
based on actual performance, rather than fixed assumptions.
 7. Master Budget: A master budget is a comprehensive financial plan that consolidates
all other individual budgets, including sales, production, cash, and capital expenditure
budgets. It provides a complete picture of the organization’s financial health and
future projections.

Purpose: To integrate all financial plans and help senior management align the
various departmental goals with the overall organizational objectives.

8. Static Budget: A static budget is a fixed budget created at the beginning of the period
based on predetermined assumptions. It does not change, even if actual performance
or activities differ. This type of budget is useful for long-term planning but may not
be flexible for short-term adjustments.

Purpose: To establish a clear target based on initial projections, with limited

flexibility for unforeseen changes.

UNIT4:

Short Answer Questions

Q1. Explain the concept of time value of money.

ANS: The Time Value of Money (TVM) is a financial concept that emphasizes the value of
money changing over time. Essentially, a sum of money available today is worth more than
the same sum in the future due to its potential earning capacity. This principle is based on the
idea that money can earn interest or generate returns over time, which is not possible for
money received in the future.

TVM is often represented using the following concepts:

• Present Value (PV): The current value of a sum of money that you will receive or
pay in the future, discounted at an appropriate rate.
• Future Value (FV): The value of a sum of money at a specific point in the future,
based on an assumed interest rate.
• Interest Rates: The rate at which money grows over time, reflecting the opportunity
cost of tying up funds.
• Compounding: The process of earning interest on both the initial amount of money
and the interest accumulated over time.

For example, if you receive ₹10,000 today, you can invest it and earn interest, meaning that
₹10,000 today is worth more than ₹10,000 in a year. The future value of the money will be
greater if invested, reflecting the time value of money.

This concept is crucial in making investment decisions, pricing financial products, and
assessing the viability of projects. Financial models and valuation techniques such as
discounted cash flow (DCF) rely on TVM to assess the value of future cash flows in today's
terms.
Q2. Elaborate the importance of time value of money.
ANS: The Time Value of Money (TVM) is of paramount importance in financial decision-
making and plays a key role in various areas:

1. Investment Decision-Making: When deciding on an investment, it’s essential to

consider how much money today is worth compared to how much it will be worth in
the future. TVM helps investors choose between different investment options by
evaluating their future returns in present terms. If an investment’s future cash inflows,
discounted to present value, exceed its initial investment, it is likely a good
investment.
2. Loan and Mortgage Calculations: TVM is a fundamental concept in calculating the
present and future value of loans. It helps borrowers understand the cost of loans by
showing the present value of all future payments. Lenders also use TVM to determine
the fair interest rate to charge and assess the profitability of loans.
3. Capital Budgeting: TVM is a crucial tool for businesses in capital budgeting. Capital
budgeting involves making decisions about large investments, like acquiring new
equipment or starting new projects. TVM ensures that future cash flows from these
investments are properly discounted to assess their value in today's terms, helping
firms decide which projects will maximize shareholder value.
4. Retirement Planning: TVM is critical in retirement planning. To calculate how much
to save for retirement, individuals need to understand how much their savings will
grow over time due to interest compounding. By applying TVM, they can calculate
the amount of savings required today to meet future retirement needs.
5. Risk and Return Evaluation: TVM is essential when evaluating risk and return. It
helps in understanding that returns are not the same over time and that risk can reduce
the value of future cash flows. By using TVM, investors can adjust their investment
strategies to account for various levels of risk and return over time.
6. Inflation Adjustment: Since inflation erodes the purchasing power of money, TVM
helps adjust future amounts of money to reflect the inflation-adjusted present value.
This adjustment allows individuals and businesses to plan more effectively for future
expenditures and ensure that future amounts of money retain their purchasing power.

Q3. Explain the reasons for time preference of money.

ANS: Time preference of money refers to the notion that people generally prefer receiving
money today rather than in the future. Several psychological, financial, and economic factors
drive this preference:

1. Opportunity to Earn Interest or Returns: One of the primary reasons for preferring
money today is the opportunity to invest or save it and earn returns in the form of
interest, dividends, or capital gains. People recognize that money has the potential to
grow when it is available today, which is why they value it more in the present.
2. Inflation: Inflation reduces the purchasing power of money over time. A sum of
money that can buy more goods or services today will be able to buy less in the future
due to rising prices. This leads individuals to prefer receiving money now so that they
can purchase goods and services before prices rise.
3. Uncertainty and Risk: There is inherent uncertainty in the future, and people
generally prefer to have control over their finances now rather than risking that the
money they will receive in the future may not materialize. Economic, political, or
 personal factors can affect future income streams or the value of money, making it
more attractive to receive money immediately.
4. Consumption Preferences: Many people have an innate desire to consume goods
and services sooner rather than later. This preference for immediate consumption is
influenced by behavioral factors, such as present bias or impatience, which often leads
individuals to value money today more than in the future.
5. Liquidity Needs: People may have immediate financial needs that require access to
cash. Whether it is for medical expenses, emergencies, or fulfilling lifestyle desires,
individuals often value money today because they may have urgent obligations that
must be met.
6. Investment Opportunities: People may prefer to receive money today because it
allows them to take advantage of opportunities that might not be available in the
future. For example, one might wish to purchase a property or invest in stocks or
bonds with favorable terms that are only available now.

Q4. Calculate the future value of Rs50,000 at the end of 3 years at 12% per annum rate of

interest.
ANS: To calculate the Future Value (FV) of an amount of money after a certain number of
years, we use the formula:

FV = PV x (1+r) n

Where:

• PV is the present value (₹50,000)

• r is the annual interest rate (12% or 0.12)
• n is the number of years (3 years)

Substituting the given values:

FV=50,000×(1+0.12)3
FV=50,000×1.404928
FV=70,246.40

Thus, the Future Value (FV) of ₹50,000 after 3 years at a 12% annual interest rate is
₹70,246.40.

Q5. Calculate the present value of the following cash flows assuming a discount rate of 8%

p.a.

Year Cash flows [₹]

1 20,000

2 40,000
3 20,000

4 10,000
ANS: To calculate the Present Value (PV) of a series of future cash flows, we use the
Present Value formula for each cash flow:

PV = CF / (1+r) n

Where:

• CF is the cash flow in each year

• r is the discount rate (8% or 0.08)
• n is the year in which the cash flow occurs

Let's calculate the present value of each cash flow:

Year 1 (₹20,000):

PV1=20,000/(1+0.08)1=20,000/1.08=18,518.52

Year 2 (₹40,000):

PV2=40,000/(1+0.08)2=40,000/1.1664=34,292.28

Year 3 (₹20,000):

PV3=20,000/(1+0.08)3=20,000/1.2597=15,867.60

Year 4 (₹10,000):

PV4=10,000/(1+0.08)4=10,000/1.3605=7,353.12

Now, summing these present values:

Total PV=18,518.52+34,292.28+15,867.60+7,353.12=75,031.52

Thus, the Present Value (PV) of the given cash flows at an 8% discount rate is ₹75,031.52.

Long Answer Questions

1. Explain the meaning of time value of money along with its importance.
ANS: Meaning of Time Value of Money (TVM)

The Time Value of Money (TVM) is a fundamental financial concept that asserts that the
value of money is affected by the passage of time. The basic principle behind TVM is that
money received today is worth more than the same amount of money received in the future,
due to its potential earning capacity. This idea rests on the concept of opportunity cost,
which means that if you have money today, you can invest it and generate returns.
Conversely, money received in the future means you miss out on the potential to earn returns
during the waiting period.

The TVM is typically explained in two terms:

• Present Value (PV): The current value of a sum of money to be received in the
future, discounted at a specific interest rate.
• Future Value (FV): The value of a sum of money in the future, based on an assumed
rate of interest and the number of periods it will be invested.

Mathematically, the relationship is given by:

• Present Value (PV) Formula:

PV=FV/(1+r) n

Where:

• FV = Future Value
• r= Interest rate (or discount rate)
• n = Number of periods (years, months, etc.)
• Future Value (FV) Formula:

FV=PV×(1+r) n

Importance of Time Value of Money

TVM is essential because it provides the foundation for all financial decision-making. Some
of its most important applications are:

1. Investment Decisions: TVM is crucial for assessing the value of investment

opportunities. Investors can compare the present value of expected future returns to
determine whether an investment is worth pursuing. It helps in understanding the
long-term impact of investing today and how the value of money appreciates over
time through interest or returns.
2. Loan Management: TVM is central in determining the costs of loans, mortgages, and
credit. By understanding how money grows over time due to interest, both borrowers
and lenders can better evaluate the financial implications of borrowing or lending
money over extended periods.
3. Capital Budgeting: Businesses use TVM to evaluate long-term projects. When
making capital budgeting decisions, companies calculate the present value of
expected future cash flows from a project to determine if it is financially feasible.
TVM helps businesses avoid making poor investments by ensuring the expected
returns exceed the initial investment.
4. Retirement Planning: TVM is important in retirement planning. It helps individuals
calculate how much they need to save today to accumulate sufficient funds for
retirement, considering interest compounding and inflation. By applying TVM, one
can determine the future value of savings based on how long they can invest and what
rate of return they expect.
 5. Pricing of Financial Instruments: The valuation of financial products like bonds,
stocks, and annuities relies heavily on TVM. For example, the present value of a
bond’s future coupon payments is a key determinant in its market price.
6. Risk Assessment: TVM helps in assessing the risk and return associated with future
cash flows. It gives investors a tool to adjust future values to reflect the uncertainties
and potential risks they face over time.
7. Inflation and Purchasing Power: TVM accounts for inflation, which erodes the
purchasing power of money over time. Thus, understanding TVM allows businesses
and individuals to adjust their financial plans in order to protect their future
purchasing power.

2. Explain the techniques for estimating time value of money.

ANS: There are various techniques used to estimate and apply the Time Value of Money in
financial decision-making. The most common techniques include:

1. Present Value (PV) and Future Value (FV) Formulas

The most fundamental techniques for estimating TVM are the Present Value (PV) and
Future Value (FV) formulas, as discussed earlier. These formulas are used to discount future
cash flows to the present (PV) or to calculate the value of current cash flows at a future date
(FV).

• Future Value helps estimate what a sum of money today will be worth at a future
date, given a specific interest rate.
• Present Value helps determine what a future sum of money is worth today, based on
the current interest rate or discount rate.

Example:

• If you invest ₹10,000 today at 5% interest for 3 years, you can calculate the future
value of that investment using the FV formula:

FV=10,000×(1+0.05)3=₹11,576.25FV = 10,000 \times (1 + 0.05)^3 =

₹11,576.25FV=10,000×(1+0.05)3=₹11,576.25

Similarly, the present value technique helps in evaluating what a sum to be received in the
future is worth today, considering a given discount rate.

2. Discounted Cash Flow (DCF) Analysis

Discounted Cash Flow (DCF) is a comprehensive technique used to estimate the present
value of a series of future cash flows. The cash flows could be from an investment, business
project, or any other financial asset.

In DCF, future cash flows are adjusted using a discount rate (interest rate, required rate of
return, etc.), which accounts for the time value of money. The formula for DCF is:

DCF=∑CFt(1+r)tDCF = \sum \frac{CF_t}{(1 + r)^t}DCF=∑(1+r)tCFt

Where:

• CFtCF_tCFt = Cash flow at time ttt

• rrr = Discount rate
• ttt = Time period (year, month, etc.)

This technique is crucial in valuing projects, companies, and investments. For instance, a
company may use DCF to evaluate the net present value (NPV) of a project, considering all
expected inflows and outflows over its lifetime.

3. Annuities and Perpetuities

An annuity refers to a series of equal cash flows or payments made at regular intervals over a
specific time period. An annuity due means payments are made at the beginning of each
period, whereas a regular annuity involves payments at the end of each period.

• Present Value of an Annuity:

The formula for the present value of an annuity is:

PV=P×(1−(1+r)−nr)PV = P \times \left( \frac{1 - (1 + r)^{-n}}{r} \right)PV=P×(r1−(1+r)−n)

Where:

• PPP = Payment per period

• rrr = Interest rate per period
• nnn = Number of periods
• Future Value of an Annuity:
The formula for the future value of an annuity is:

FV=P×((1+r)n−1r)FV = P \times \left( \frac{(1 + r)^n - 1}{r} \right)FV=P×(r(1+r)n−1)

• Perpetuity:
A perpetuity is an annuity that continues forever, with constant payments at regular
intervals. The formula for the present value of a perpetuity is:

PV=PrPV = \frac{P}{r}PV=rP

Where PPP is the payment and rrr is the interest rate.

These techniques are often used to value pensions, retirement plans, or investment products
that provide regular income.

4. Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is another powerful technique used to estimate the time
value of money. It is the discount rate that makes the Net Present Value (NPV) of all future
cash flows from an investment or project equal to zero. IRR is widely used in capital
budgeting to evaluate whether an investment is worthwhile.
The formula for IRR involves finding the discount rate rrr where the following equation
holds:

NPV=∑CFt(1+r)t=0NPV = \sum \frac{CF_t}{(1 + r)^t} = 0NPV=∑(1+r)tCFt=0

Where:

• CFtCF_tCFt = Cash flow at time ttt

• rrr = Internal rate of return (the discount rate that sets NPV to 0)

The IRR represents the expected annual rate of return an investment would generate over its
life, making it an essential decision-making tool for investors and companies.

UNIT5:

Short Answer Questions

Q1. How is cost of equity calculated?

Q2. What is the significance of cost of capital for credit policy design?
ANS: The cost of capital is crucial for designing a company's credit policy as it impacts the
company’s ability to set terms for financing, borrowing, and lending decisions. Here's why
the cost of capital is significant:

1. Setting Credit Terms: The cost of capital helps a company decide on the appropriate
credit terms to offer to customers. If a company’s cost of capital is high, it may need
to adjust its credit policy to ensure that it can generate sufficient returns to cover its
financing costs. This could include adjusting the interest rates or offering shorter
repayment terms.
2. Risk Management: Companies assess the risk associated with lending to customers.
If the cost of capital is high, the business will want to limit credit exposure to riskier
customers, adjusting its credit policy to ensure profitability. The cost of capital
reflects the company’s overall risk profile, which is factored into decisions about
creditworthiness and terms.
3. Cash Flow Management: By analyzing the cost of capital, a company can ensure
that its credit policy is in line with its working capital requirements. Offering long
credit periods or high levels of credit can strain cash flow. A company with a high
cost of capital may be more conservative in offering credit to avoid liquidity issues.
4. Investment Decisions: The cost of capital influences a company’s investment
decisions and its ability to fund credit. For instance, if the company borrows at a
higher rate, the cost of borrowing is considered when extending credit to customers. If
financing is costly, the company may limit the amount of credit offered to maintain its
financial stability.
Q3. What is the use of β in calculating the cost of equity shares?
ANS: The beta (β) in the Capital Asset Pricing Model (CAPM) is a measure of a
company's stock volatility relative to the broader market. It helps determine the cost of
equity by quantifying the stock's risk in relation to the market's risk. A beta value is used in
the following way:

1. Risk Measurement:
Beta represents the systematic risk of a stock. A beta greater than 1 indicates that the
stock is more volatile than the market, implying higher risk. A beta less than 1 means
the stock is less volatile than the market.
2. Cost of Equity Calculation:
In the CAPM formula, beta is multiplied by the market risk premium (the difference
between the expected market return and the risk-free rate). This allows investors to
determine the extra return required for holding a risky asset. A higher beta implies a
higher cost of equity because investors expect higher returns for taking on more risk.
Conversely, a lower beta implies a lower cost of equity.

The formula in CAPM, where beta is used, is:

Cost of Equity=Rf+β×(Rm−Rf)

Here, the value of beta directly impacts the cost of equity by adjusting it based on the
company’s sensitivity to market movements.

Q4. Define floatation cost?

ANS: Floatation costs refer to the expenses a company incurs when issuing new securities,
such as stocks or bonds. These costs are associated with the process of bringing a new
security to the market and can include:

1. Underwriting Fees: The fees paid to investment banks for their role in marketing and
selling the securities.
2. Legal Fees: Costs for legal services related to regulatory compliance and document
preparation.
3. Registration Fees: Fees paid to regulatory bodies for registering the securities.
4. Accounting and Auditing Fees: Costs of auditing financial statements and other
necessary reports.
5. Printing and Advertising: The costs of producing and distributing prospectuses or
marketing materials.

Floatation costs reduce the net proceeds a company can raise from issuing securities. For
example, if a company issues new shares worth ₹10 million but incurs ₹500,000 in floatation
costs, the net amount raised is ₹9.5 million. These costs are typically factored into the cost of
capital because they impact the total funds a company can utilize for expansion or other
purposes.
Q5. How will you calculate the cost of preferences share?
ANS: The cost of preference shares is the return required by investors who hold preference
shares. It is calculated using the following formula:

Cost of Preference Shares=Dp/Pp

Where:

• Dp = The dividend paid on the preference share

• Pp = The price of the preference share

The cost of preference shares reflects the dividend yield on the preference stock. The
preferred dividends are generally fixed, and investors expect regular payments. The cost of
preference shares is similar to the yield on bonds, as it reflects the fixed return that investors
will receive for holding these shares.

For example, if a company pays an annual dividend of ₹10 on each preference share, and the
current price of the preference share is ₹100, the cost of preference shares would be:

Cost of Preference Shares=10/100=0.10 or 10%

This means the company must pay a 10% return on the preference shares. This return must be
factored into the company’s cost of capital when making investment and financing decisions.

Long Answer Questions

Q1. Calculate the cost of capital for the following. You may assume the tax rate to be 40%.

i. Rs 100, 10% Debentures issued at Rs 90 redeemable after five years.

ii. A preference share pays 7% dividend. The Par value of this share is Rs. 100 per share

and its current market price is Rs. 80.

Q2. Explain the significance of the concept of cost of capital.

ANS: The cost of capital is a critical concept in finance, as it reflects the return required by
all of a company's investors (debt holders, equity holders, and preference shareholders) for
providing capital to the business. The significance of the cost of capital includes:

1. Investment Decision Making: The cost of capital is the minimum rate of return that a
company must earn on its investments to satisfy its investors. When making
investment decisions, companies use the cost of capital as a benchmark to evaluate
whether an investment project will generate sufficient returns to cover the cost of
financing (both debt and equity). If the return on investment (ROI) exceeds the cost of
capital, the project adds value to the company.
2. Capital Budgeting: Companies often use the cost of capital to evaluate the net
present value (NPV) of future cash flows. If the NPV is positive, the project is likely
to create value, and the company should proceed with the investment. Conversely, if
 the NPV is negative, it suggests the company will not generate sufficient returns, and
the investment should be avoided.
3. Valuation of Business: The cost of capital is used in determining the value of a
company. In valuation models like Discounted Cash Flow (DCF), the cost of capital
serves as the discount rate to calculate the present value of expected future cash flows.
This helps investors and analysts determine the fair value of the business.
4. Optimal Capital Structure: Understanding the cost of capital is essential for
determining the optimal capital structure (the mix of debt, equity, and preference
shares). A company aims to minimize the cost of capital by selecting the right
combination of debt and equity. By doing so, it can lower its financing costs and
increase its profitability.
5. Risk and Return Analysis: The cost of capital also reflects the risk associated with
raising capital. Higher risk leads to a higher required return, which increases the cost
of capital. This is particularly important when assessing the risk profiles of different
funding sources (e.g., debt is typically cheaper than equity, but more risky).
6. Setting Dividends and Growth Strategy: Companies consider the cost of capital
when deciding on dividend payouts and the reinvestment of earnings. If the cost of
capital is high, the company might prioritize paying down debt or investing in high-
return opportunities rather than distributing dividends.
7. Credit Policy: The cost of capital affects a company's credit policy and lending
practices. Companies with a higher cost of capital are generally more conservative
with their credit policies, offering credit only to customers who are likely to generate
sufficient profits to cover the cost of capital.

In essence, the cost of capital serves as a key decision-making tool for businesses to make
informed choices about investments, financing, and growth strategies.

Q3. With the help of following information calculate the weighted average cost of capital.

UNIT6:

Short Answer Questions

Q1. Define the term operating leverage.

ANS: Operating leverage refers to the extent to which a company's operating income (EBIT)
is affected by changes in sales. It is a measure of how fixed costs in a business influence the
profitability. High operating leverage means that a small change in sales will result in a
significant change in EBIT. This is because companies with high operating leverage have a
higher proportion of fixed costs compared to variable costs, so their profits increase more
rapidly as sales grow.

Mathematically, the Degree of Operating Leverage (DOL) can be expressed as:

DOL=% Change in EBIT/% Change in Sales

When operating leverage is high, companies benefit more from increases in sales but face
greater losses when sales decline.
Q2. Define the term financial leverage.
ANS: Financial leverage refers to the use of debt to finance a company's operations and
investments. It measures the impact of fixed financial costs (such as interest expenses) on
the company’s earnings per share (EPS) and the overall risk to equity holders.

When a company uses debt financing, it magnifies the potential returns to equity
shareholders, but it also increases the financial risk. A higher level of debt relative to equity
leads to higher financial leverage, and the company’s EPS can become more sensitive to
changes in operating income (EBIT).

Mathematically, Degree of Financial Leverage (DFL) at a given level of EBIT is expressed as:

𝐷𝐹𝐿=% Change in EPS/% Change in EBIT

Financial leverage magnifies the effect of changes in EBIT on the company’s net income and
thus on EPS.

Q3. A company A ltd has 10000, Rs 10 equity share and EBIT of Rs 30,000 and interest

expenses of Rs 10,000. Assuming the rate of tax as 30%, calculate the EPS.

Q4. A firm X ltd has an EPS of Rs 5. Assuming the DFL is 2 times if sales is raised by 5%, what

will be the new EPS?

Q5. A company A ltd has EPS of Rs 3. The total outstanding equity shares are 10000 of Rs 10

each. As on date the company has 15000 in its reserves and 5000 as accumulated losses.

Calculate the ROE.

Long Answer Questions

Q1. Define the term leverage. How useful is it for maximizing the wealth of the
shareholders?
ANS: Leverage refers to the use of various financial instruments or borrowed capital (such as
debt) to increase the potential return on investment. In business, leverage is often associated
with the use of debt to finance operations, allowing companies to increase their potential
earnings without having to raise additional equity capital.

Leverage can be broadly categorized into two types:

 1. Operating Leverage: The use of fixed costs in the company’s operations to magnify
the impact of sales on earnings before interest and taxes (EBIT).
2. Financial Leverage: The use of debt to finance the company’s operations, increasing
the potential return on equity for shareholders.

Leverage and Wealth Maximization for Shareholders: Leverage can be useful for
maximizing the wealth of shareholders when used judiciously. It allows companies to
amplify their returns and increase the profitability from operations. However, excessive
leverage can also increase the financial risk, particularly when the cost of debt is higher than
the returns on the investments made.

• Positive Impact: When a company uses leverage effectively, it can generate higher
returns on equity. If the return on assets (ROA) is greater than the interest rate on
debt, then leveraging increases the wealth of shareholders by boosting earnings and
overall company value.
• Negative Impact: On the flip side, if the company takes on excessive debt, the
interest payments could become a burden, reducing profitability and increasing the
risk of financial distress. This risk may overshadow the benefits of leverage, leading
to a decrease in shareholder wealth.

Thus, leveraging can be a powerful tool for wealth maximization, but only when it is used
with caution and within limits that the company can manage effectively.

Q2. Differentiate between operating leverage and financial leverage.

ANS: • Definition:

• Operating Leverage: The use of fixed costs in the company’s operations to magnify
the effect of sales on EBIT (Earnings Before Interest and Taxes).
• Financial Leverage: The use of debt (borrowed capital) to finance the company’s
operations, magnifying the effect of EBIT on earnings per share (EPS).

• Focus:

• Operating Leverage: Focuses on the impact of fixed operational costs (such as rent,
salaries, etc.) on the company’s earnings.
• Financial Leverage: Focuses on the impact of debt financing (interest expense) on
the company’s profitability and equity holder returns.

• Leverage Effect:

• Operating Leverage: Amplifies the effect of sales changes on EBIT due to fixed
operational costs.
• Financial Leverage: Amplifies the effect of EBIT changes on EPS due to fixed
financial costs (interest on debt).

• Risk:
 • Operating Leverage: Higher operating leverage increases risk by making the
company more sensitive to changes in sales, either positively or negatively.
• Financial Leverage: Higher financial leverage increases financial risk due to the
fixed obligation of debt repayment, especially if EBIT is insufficient to cover interest.

• Impact of Sales:

• Operating Leverage: A small change in sales leads to a significant change in EBIT

because of high fixed costs.
• Financial Leverage: A small change in EBIT leads to a larger change in EPS, as
interest expenses are fixed.

• Examples:

• Operating Leverage: Companies with high fixed costs (e.g., manufacturing firms
with heavy machinery and plant infrastructure).
• Financial Leverage: Companies with a significant amount of debt financing in their
capital structure (e.g., firms that issue bonds or have long-term loans).

Q3. Consider the following information for XYZ ltd.

Detail Amount in lakh rupees

EBIT 1100

PBT 300

Fixed cost 700

Calculate the percentage change in EPS if sales are increased by 5 percent.

UNIT7:

SHORT ANSWER QUESTIONS

Q1. Define the term capital budgeting.

ANS: • Capital budgeting is the process through which a company evaluates and selects
long-term investment projects that are expected to generate future cash flows. The primary
purpose of capital budgeting is to determine whether an investment will be profitable in the
long run and will contribute positively to the company’s value.

• It involves assessing projects like purchasing new machinery, expanding facilities, or

developing new products. These decisions usually require large amounts of capital and have
long-term implications.
• The goal of capital budgeting is to maximize shareholder wealth by choosing investments
that increase the firm's value. This process is crucial because it involves decisions that affect
the company’s financial health and overall strategic direction.
• The methods used for capital budgeting analysis include tools like Net Present Value
(NPV), Internal Rate of Return (IRR), Payback Period, Profitability Index (PI), and
Discounted Payback Period.

Q2. Differentiate between discounted and non-discounted methods of capital budgeting?

ANS: • Discounted Methods:

• These methods take into account the time value of money, meaning that future cash
flows are adjusted for their value today using a discount rate.
• The Net Present Value (NPV) method calculates the difference between the present
value of cash inflows and the present value of cash outflows.
• The Internal Rate of Return (IRR) is the discount rate that makes the NPV of a
project zero, indicating the project’s rate of return.
• Discounted Payback Period measures the time it takes to recover the initial
investment in present value terms, considering the time value of money.

• Non-Discounted Methods:

• These methods ignore the time value of money, treating all cash flows as equally
valuable, regardless of when they occur.
• The Payback Period method measures the time needed to recover the initial
investment but does not consider the time value of cash flows.
• Average Accounting Return (ARR) evaluates the profitability of a project based on
accounting data (average profit divided by initial investment) without considering
when profits occur.

Q3. What do you understand by the term capital rationing?

ANS: • Capital rationing is a situation where a company has limited financial resources
available to invest in all the projects it wants to undertake. In such a case, the company needs
to prioritize projects that offer the best potential returns while adhering to the financial
constraints.

• This typically happens when there is either:

• Hard Capital Rationing: External limitations like difficulty in accessing capital

markets or a lack of investor confidence.
• Soft Capital Rationing: Internal policies where management deliberately imposes
limits on the funds available for investments, such as setting a budget cap for all
capital expenditures.

• Companies implement capital rationing by ranking projects based on their return

potential, using methods like Net Present Value (NPV) or Profitability Index (PI), to
ensure that only the most financially viable projects are selected.
• It helps companies optimize their investment in the face of limited resources, but it may
also lead to missed opportunities if valuable projects are overlooked.

Q4. X Ltd is expecting an initial investment of Rs 10 lakhs in the project and an annual cash
flow of Rs 3,00,000 for next five years; calculate the discounted payback period at a

discounting rate of 10%.

Q5. If the EBIT for a project is expected to be Rs 2,00,000 with an initial investment of

8,00,000 which will have a value of Rs 1,00,000 at the end of 5 years; calculate the ARR.

Assume the rate of tax as 30%.

UNIT8:

SHORT ANSWER QUESTIONS

• Q1. What is a firm’s capital structure? How is it different from financial structure?
ANS: Capital Structure refers to the specific mix of debt and equity that a company
uses to finance its overall operations and growth. It indicates how much debt and
equity the company has employed in its balance sheet to fund its assets. Capital
structure is typically represented by the proportion of debt (borrowed funds) and
equity (shareholder funds) in the company. The capital structure decision is crucial
because it determines the risk and return profile of the firm, as well as its cost of
capital.
o Debt: This consists of borrowed money, such as bonds, loans, or debentures
that the company must repay with interest. Debt financing provides leverage,
which can amplify profits, but it also increases the risk, as fixed interest
payments must be made irrespective of the company’s performance.
o Equity: This refers to funds raised by issuing shares or retained earnings.
Equity holders (shareholders) are the owners of the firm, and they have a
claim on the company’s profits in the form of dividends, as well as any
remaining assets after debt obligations are met. Equity financing is less risky
than debt but can be more expensive due to the higher required returns by
investors.
• Financial Structure is a broader term that includes not only the capital structure
(debt and equity) but also other forms of financing, such as long-term and short-term
liabilities, provisions, and other financial instruments. While the capital structure
focuses solely on the financing sources that are permanent in nature (i.e., equity and
long-term debt), financial structure encompasses the entire liability and equity side of
the balance sheet, including short-term debts and other non-permanent sources of
financing.
o Key Difference:
▪ Capital Structure deals with the long-term sources of funding, i.e., the
mix of equity and long-term debt.
▪ Financial Structure includes both short-term and long-term debt, as
well as equity.

Example: If a company has a mix of equity, long-term loans, and short-term debts, its
capital structure would only focus on equity and long-term loans, while its financial
structure would include all debts (both short and long term) and equity.
Q2. Under the traditional approach to capital structure, what happens to the cost of debt and
cost of equity as the firm’s financial leverage increases?
ANS: The traditional approach to capital structure suggests that there is an optimal capital
structure for a firm that minimizes the cost of capital and maximizes the value of the firm.
This approach assumes that a firm can reduce its overall cost of capital by increasing its debt
(financial leverage) up to a certain point. However, beyond a certain level of debt, the cost of
debt and cost of equity start to increase.

• Cost of Debt:
o Initially, as a firm increases its leverage (i.e., takes on more debt), the cost of
debt (interest rate) remains relatively constant or slightly decreases because
debt financing is cheaper than equity financing. Lenders view a company with
a reasonable amount of debt as less risky than one with too much equity, as
debt payments are fixed.
o However, as leverage increases further, the risk of default also increases
because the firm has to make fixed interest payments regardless of its
earnings. As a result, lenders may demand a higher interest rate to compensate
for the increased risk. Therefore, beyond a certain threshold, the cost of debt
begins to rise.
• Cost of Equity:
o As financial leverage increases, the cost of equity rises. This is due to the
increased financial risk borne by equity shareholders. The more debt a
company uses, the greater the risk of financial distress, as debt must be repaid
regardless of profitability. Equity holders expect higher returns to compensate
for the increased risk associated with higher leverage.
o According to the traditional approach, cost of equity increases in a
nonlinear manner with leverage, as equity holders demand a risk premium for
the higher potential of financial distress and the possibility of a lower return
on their investment.
• Combined Impact:
o When leverage is low, the firm's total cost of capital is dominated by the cost
of equity, which is higher than debt. As debt increases, the overall weighted
average cost of capital (WACC) decreases because debt is cheaper than equity.
o However, once leverage exceeds an optimal level, both the cost of debt and
cost of equity start rising, causing the WACC to increase. The optimal
capital structure occurs at the point where the WACC is minimized,
providing the most cost-effective balance between debt and equity.

LONG ANSWER QUESTIONS

Q1. Mehta company Limited is expecting an annual EBIT of Rs. 2,00,000. The company has

Rs. 5,00,000 in 10% debentures. The cost of equity capital or capitalization rate is 12.5%.

Compute the value of the firm.

UNIT9:

SHORT ANSWER QUESTIONS

Q1. What are equity shares?
ANS: • Equity shares, also known as ordinary shares or common stock, represent
ownership in a company. Shareholders who hold equity shares are the owners of the company
and have voting rights in the annual general meeting (AGM) or special resolutions.

• Characteristics:

• Ownership: Equity shareholders are the ultimate owners of the company.

• Dividends: They receive dividends based on the company’s profit, which is not fixed
but depends on the company’s performance.
• Risk: Equity shares are considered high-risk investments because their value depends
on the company’s performance. If the company performs well, shareholders can
expect dividends and an increase in share value; if the company underperforms, they
may not receive dividends and the share value may decrease.
• Rights: Equity shareholders have the right to vote on matters such as elections of
directors and major company decisions. They also have a claim on the company’s
residual assets after all liabilities have been settled in case of liquidation.

Q2. What is a preference share?

ANS: • Preference shares are a type of stock that has preferential treatment over common
equity shares regarding dividend payments and, in some cases, the repayment of capital in
case of liquidation.

• Characteristics:

• Fixed Dividend: Preference shareholders receive a fixed dividend before equity

shareholders. This dividend is usually expressed as a percentage of the par value.
• No Voting Rights: Typically, preference shareholders do not have voting rights,
except in cases where dividends are not paid for a certain period.
• Priority in Liquidation: In case of liquidation, preference shareholders are paid
before equity shareholders, though after debt holders.
• Cumulative vs. Non-Cumulative: Cumulative preference shares ensure that any
missed dividend payments are carried forward and paid in the future before common
shareholders receive any dividends.

Q3. Differentiate between a debenture and a share.

ANS: • Debenture:

• A debenture is a long-term debt instrument issued by a company to raise funds.

• It represents a loan made by the investor to the company, and the company promises
to repay the principal along with interest at a predetermined rate.
• Debenture holders receive a fixed interest income regardless of the company's
performance.
• They do not have voting rights in company matters.
 • Debenture holders have a priority claim over shareholders in case of liquidation,
meaning they get paid before equity shareholders.
• Debentures are usually issued with a fixed tenure, after which the principal amount is
repaid.
• Debentures are considered less risky than shares because they provide fixed interest
payments.

• Share:

• A share represents ownership in a company.

• Shareholders are part-owners and have a claim on the company's profits (in the form
of dividends) and a residual claim on assets in case of liquidation.
• Shareholders receive dividends, but the amount is not fixed and depends on the
company’s profitability.
• Shareholders typically have voting rights, enabling them to participate in decisions
like electing directors and other key issues.
• Shareholders are paid last in the event of liquidation, after all liabilities, including
debentures, are settled.
• Shares do not have a fixed tenure and continue to exist as long as the company exists
or until sold.
• Shares are considered riskier than debentures since dividends and capital appreciation
depend on the company's performance.

Q4. What are commercial papers?

ANS: • Commercial papers are short-term, unsecured debt instruments issued by
corporations to raise funds for working capital and other short-term liabilities. They usually
have maturities ranging from a few days to one year.

• Characteristics:

• Issuer: Typically issued by large corporations with high credit ratings.

• Unsecured: They are not backed by any collateral, and investors rely on the issuer’s
creditworthiness.
• Discounted: Commercial papers are issued at a discount to face value and do not pay
periodic interest. The return to the investor is the difference between the purchase
price and the face value.
• Market: These papers are usually traded in the money market.

Q5. What do you understand by discounting of bill?

ANS: • Discounting of a bill refers to the process of selling a bill of exchange (such as a
promissory note or a trade bill) to a bank or financial institution at a price lower than its face
value. This is done in exchange for immediate cash, rather than waiting until the bill matures.

• Process:
 • The seller (drawer) presents the bill to the bank before its maturity date.
• The bank deducts a discount fee based on the time left until maturity and the
prevailing interest rates.
• The remaining amount is given to the drawer as immediate payment.

• Purpose: Discounting helps businesses meet their immediate cash flow needs without
waiting for the maturity of the bill. The discount rate is typically based on the market interest
rate and the creditworthiness of the drawer.

LONG ANSWER QUESTIONS

Q1. What is are the various sources of long-term finance for a firm?
ANS: Long-term finance refers to capital that is raised for a longer duration (more than a
year) to fund long-term assets or support the growth and expansion of a business. Several
sources of long-term finance are available to firms, each with its own characteristics,
advantages, and disadvantages. Some of the main sources are:

1. Equity Capital:
o Equity shares or common stock represent ownership in the company.
Shareholders are the owners of the firm and are entitled to the residual profits
(dividends) and a claim on assets in case of liquidation.
o Equity capital does not require repayment, but dividends are paid at the
discretion of the company.
o It is a permanent source of capital, providing financial stability.
2. Preference Capital:
o Preference shares represent ownership, but unlike common equity, preference
shareholders have a fixed dividend and are given priority over equity
shareholders in case of liquidation.
o Preference shares do not carry voting rights but have preferential treatment
when it comes to dividend payments.
3. Debentures/Bonds:
o Debentures or bonds are long-term debt instruments issued by a company to
raise funds. Debenture holders receive fixed interest (debenture interest) and
the principal is repaid at maturity.
o These instruments are attractive to investors due to their fixed returns and
lower risk compared to equity.
o Debentures may be secured (backed by assets) or unsecured.
4. Term Loans from Banks/Financial Institutions:
o Banks and financial institutions provide loans for specific periods (usually
more than a year) to finance capital expenditure or working capital
requirements.
o These loans are often used for purchasing assets like machinery, equipment, or
expanding infrastructure.
5. Venture Capital:
o Venture capital is funding provided to start-ups or small businesses with high
growth potential. It is typically provided by venture capital firms or angel
investors in exchange for equity.
 o It is used in high-risk, high-return businesses where traditional forms of
financing are not readily available.
6. Public Deposits:
o Firms can raise funds by inviting the public to deposit money with them for a
fixed term at an agreed interest rate.
o Public deposits are attractive as they offer flexibility in terms of interest rates
and repayment schedules.
7. Retained Earnings:
o Retained earnings refer to the portion of the company's profits that are not
distributed as dividends but are reinvested back into the business for
expansion or development.
o This is an internal source of finance that does not involve any external
liability.

Q2. What is trade credit? What are their features?

ANS: Trade credit is a type of short-term financing provided by suppliers to businesses for
the purchase of goods and services. In this arrangement, a supplier allows a business to
purchase goods or services on credit and pay for them later, usually within a specified period
(30, 60, or 90 days).

Features of Trade Credit:

1. Unsecured Credit:
o Trade credit is usually unsecured, meaning no collateral is required. The
business is expected to pay for the goods/services as per the agreed terms.
2. Short-Term Nature:
o Trade credit is generally a short-term financing arrangement, with repayment
periods typically ranging from 30 to 90 days, depending on the agreement
between the buyer and the supplier.
3. No Interest (if Paid on Time):
o Most trade credit agreements do not carry an interest charge as long as the
buyer makes payment within the stipulated time frame. However, if the
payment is delayed, late fees or interest may be charged.
4. Facilitates Cash Flow Management:
o Trade credit helps businesses manage their cash flow by providing the
flexibility to pay for goods/services after using them in production or resale.
This allows businesses to operate without immediate cash outflows.
5. Improves Liquidity:
o Since businesses do not have to pay immediately, trade credit helps improve
short-term liquidity, allowing companies to utilize funds for other operations.
6. Supplier Relationship:
o The supplier typically provides trade credit to businesses that have an
established relationship and a history of timely payments. Trust and reliability
are key factors in determining creditworthiness.
7. Limits:
o Trade credit is generally granted based on the creditworthiness of the business
and the volume of business transacted. There is often a limit to the amount of
credit that can be extended.
 8. Impact on Credit Rating:
o Consistently paying trade credit on time helps improve a company’s credit
rating, while delayed payments can harm the company’s financial reputation
and ability to obtain future credit.

Q3. Explain the term debenture and state the features of debentures.
ANS: A debenture is a long-term debt instrument issued by a company to raise funds for
various purposes, such as capital expenditure, expansion, or debt refinancing. It is a form of
loan where the company borrows money from investors and agrees to repay the principal
amount at a specific maturity date with periodic interest payments.

Features of Debentures:

1. Interest Payments:
o Debenture holders receive a fixed rate of interest (called the coupon rate) over
the life of the debenture, regardless of the company’s financial performance.
Interest payments are made annually, semi-annually, or as per the terms of the
issue.
2. Maturity:
o Debentures have a defined maturity date, at which point the principal amount
(face value) must be repaid to the debenture holders. This is usually a long-
term period (e.g., 5, 10, or 20 years).
3. Secured vs. Unsecured:
o Secured Debentures: These are backed by specific assets (e.g., property or
equipment) of the company. In case of liquidation, debenture holders have a
claim on the assets.
o Unsecured Debentures: These are not backed by any collateral and are
riskier, but they offer higher interest rates to compensate for the increased risk.
4. Convertibility:
o Convertible Debentures: These can be converted into equity shares of the
company after a certain period.
o Non-Convertible Debentures: These cannot be converted into shares and are
redeemed in cash at maturity.
5. Priority in Liquidation:
o Debenture holders have priority over equity shareholders in case of the
company’s liquidation. However, they are subordinated to secured creditors
(banks, etc.).
6. Redemption:
o Companies may redeem debentures before maturity if they choose to. This
process is known as early redemption, and it can be done at a premium or at
face value.
7. Marketability:
o Debentures are typically traded in secondary markets, allowing investors to
buy and sell them before the maturity date.
8. Tax Deductibility:
o The interest paid on debentures is tax-deductible, which makes it an attractive
financing option for companies looking to reduce their taxable income.
Q4. Explain the spontaneous source of short-term financing?
ANS: Spontaneous sources of short-term financing refer to the funds that automatically
arise during the normal course of business without requiring a formal borrowing agreement.
These sources are usually generated from trade credit and other current liabilities that
increase in response to the business's operational needs.

Examples of Spontaneous Sources:

1. Trade Credit:
o Trade credit, as discussed earlier, is the most common spontaneous source.
When a company purchases goods on credit from suppliers, it effectively
obtains short-term financing. The business can delay payments, usually within
30 to 90 days, which gives it more time to convert its inventories into cash.
2. Accrued Expenses:
o Accrued expenses refer to expenses that have been incurred but not yet paid,
such as wages, salaries, taxes, and utilities. These liabilities arise automatically
as the business operates, and they do not require any formal financing
arrangements.
3. Accounts Payable:
o Accounts payable is the amount a business owes to its suppliers for goods and
services received. Like trade credit, it represents an obligation to pay in the
near term but does not require the business to raise external funds.
4. Deferred Revenue:
o Deferred revenue is money received by the company in advance for goods or
services that will be delivered or performed later. This short-term liability
increases as the company receives payments ahead of delivery.
5. Short-Term Bank Borrowings:
o Some firms may also use short-term loans or lines of credit with their bank.
These facilities are often available automatically and can be drawn upon as
needed.

Advantages:

• Flexible and Low-Cost: Spontaneous financing is generally cheaper and more

flexible because it arises naturally from business operations.
• Quick Access to Funds: Since these sources are built into the company’s operations,
funds can be accessed quickly without formal approval or paperwork.

Disadvantages:

• Limited Control: The company has less control over the amount and timing of these
funds.
• Dependence on Supplier or Service Provider: Over-reliance on trade credit or other
spontaneous sources may affect relationships with suppliers if payments are delayed.

UNIT10:
SHORT ANSWER QUESTIONS

Q1. Define the term finance lease.

ANS: A finance lease, also known as a capital lease, is a lease agreement in which the lessee
(the party using the asset) essentially assumes the majority of the risks and rewards of owning
the leased asset, even though the legal ownership remains with the lessor. In a finance lease,
the lessee typically takes responsibility for the maintenance, insurance, and any risks
associated with the asset’s depreciation, while the lease payments are structured to cover both
the cost of the asset and the interest on the financing. These leases are generally long-term
agreements, and often, at the end of the lease period, the lessee is given the option to buy the
asset for its residual value or at a nominal price.

Finance leases are often used by businesses when they need to acquire high-value assets like
machinery or vehicles but do not wish to make a large upfront capital investment. This
arrangement allows them to conserve capital while still having access to the asset. The terms
of the lease are designed to recover the cost of the asset over its useful life, and the lessee has
an obligation to make regular lease payments for the duration of the agreement.

Q2. Differentiate between an operating lease and a finance lease.

ANS: • Operating Lease:

• Lease Term: Typically short-term, often shorter than the useful life of the asset.
• Ownership Risks and Rewards: The lessor retains most of the risks and rewards
associated with ownership of the asset.
• Payment Structure: Lease payments tend to be lower compared to finance leases, as
they usually cover only the asset's depreciation and operating expenses.
• Purchase Option: The lessee does not usually have the option to purchase the asset at
the end of the lease period.
• Accounting Treatment: Operating leases are generally treated as operating expenses
and do not appear on the lessee's balance sheet.
• Example: Leasing office equipment for a short period or renting a car for a few
months.

• Finance Lease:

• Lease Term: Longer-term, usually lasting for most or all of the asset's useful life.
• Ownership Risks and Rewards: The lessee assumes the majority of the risks and
rewards of ownership, such as the risk of asset obsolescence or the responsibility for
maintenance.
• Payment Structure: Lease payments tend to be higher as they cover the cost of the
asset and the interest charges.
• Purchase Option: The lessee usually has the option to purchase the asset at the end
of the lease term, often at a bargain price or for its residual value.
• Accounting Treatment: Finance leases are recorded as both an asset and a liability
on the lessee's balance sheet under accounting standards like IFRS or GAAP.
• Example: Leasing industrial machinery or a fleet of vehicles for long-term use with
the option to purchase them later.
Q3. Define the term BOOT.
ANS: BOOT stands for Build-Own-Operate-Transfer. It is a type of project financing
model, commonly used in large infrastructure projects, where a private sector entity (often a
consortium of companies) is contracted to build, own, and operate a project for a specified
period, after which the ownership of the project is transferred to the government or the public
authority. In this model, the private entity is responsible for the capital investment and risk
during the project’s development phase. It generates revenue during the operational phase
(usually through user fees, tariffs, or subsidies) to recover the costs of investment and earn a
return. After the contract period, the asset is handed over to the government or another public
authority, typically free of charge.

The BOOT model is frequently used in public-private partnerships (PPPs) for infrastructure
projects like toll roads, bridges, and power plants, as it enables governments to get the benefit
of improved infrastructure without needing to invest heavily upfront.

Q4. Define the term SPV.

ANS: SPV stands for Special Purpose Vehicle. It is a separate legal entity created for a
specific, narrow purpose. SPVs are commonly used in project financing to isolate the
financial risk of a particular project. An SPV is often formed to undertake a particular
infrastructure project, such as constructing a power plant, road, or port. By isolating the
project within the SPV, the sponsors (typically companies or financial institutions) ensure
that any financial risks or liabilities incurred by the project do not affect the parent
companies.

The SPV holds the assets and liabilities related to the project, and typically, it will be the
entity that raises the capital for the project through debt or equity. This structure helps to
protect the sponsors from the financial risks of the project, as lenders will have recourse only
to the assets and cash flows of the SPV. SPVs are also used for securitization transactions,
where specific assets are grouped and sold off in the form of securities, further protecting the
parent company’s balance sheet from the risks associated with those assets.

LONG ANSWER QUESTIONS

Q1. Mention the key stakeholders in project financing.

ANS: Project financing involves multiple parties that have specific roles and responsibilities
in ensuring the successful completion and operation of the project. The key stakeholders are:

1. Project Sponsors:
o These are the companies or entities that initiate and fund the project. They are
typically responsible for the equity investment and assume the risks associated
with the project. Sponsors may include multinational corporations,
consortiums, or private investors.
2. Lenders/Financial Institutions:
o Lenders such as banks, financial institutions, and development banks provide
debt capital to finance the project. They assess the financial viability of the
 project and typically require a fixed rate of return (interest). Lenders are repaid
based on the cash flows generated by the project.
3. Equity Investors:
o These investors contribute equity capital in exchange for ownership or shares
in the project. Equity investors share in the risks and profits generated by the
project. They provide funds to bridge the gap between the debt financing and
the total capital required for the project.
4. Government and Regulatory Authorities:
o Governments may play a key role in providing necessary approvals, licenses,
and permits for the project. Regulatory authorities ensure that the project
adheres to local laws, environmental regulations, and safety standards. They
may also offer financial incentives like tax exemptions or subsidies for certain
projects.
5. Contractors and Suppliers:
o Contractors are responsible for constructing and building the infrastructure,
while suppliers provide the necessary materials, equipment, and services for
the project. These stakeholders are crucial for the timely and quality execution
of the project.
6. End Users/Consumers:
o The customers or clients who will ultimately use or consume the services or
goods produced by the project. For example, in infrastructure projects, the end
users could be the citizens using a toll road or receiving power from a new
power plant.
7. Advisors and Consultants:
o Legal, financial, and technical advisors offer expertise in structuring the
project financing, managing risks, and ensuring compliance with relevant
laws. These professionals provide advice on project valuation, risk assessment,
and contract negotiations.
8. Insurance Companies:
o Insurance firms help mitigate various risks associated with the project,
including property damage, delay in construction, or operational risks. They
provide coverage to ensure that potential financial losses are minimized.

Q2. What are the advantages of hire purchase financing?

ANS: Hire purchase financing is a form of acquiring assets through installment payments.
The key advantages include:

1. Ownership Option:
o At the end of the agreement, the buyer has the option to own the asset by
paying a nominal price. This is particularly beneficial for individuals or
businesses who need the asset long-term but cannot afford the upfront cost.
2. Fixed Payment Structure:
o The buyer agrees to make fixed, regular payments, which helps in budgeting
and financial planning. This predictability makes it easier to manage cash
flow, especially for small businesses or individuals.
3. Conservation of Capital:
 o One of the main advantages is that businesses or individuals can conserve
capital. They do not need to invest a large sum upfront for purchasing assets,
allowing them to focus on other priorities.
4. Tax Benefits:
o In many jurisdictions, hire purchase payments are considered an operating
expense and may be tax-deductible, helping businesses reduce their taxable
income and, in turn, their tax burden.
5. Flexibility:
o Hire purchase agreements can often be customized to suit the buyer's needs,
such as the length of the repayment period or the amount of the installment,
offering flexibility in terms of payment terms.
6. Access to New Equipment:
o Businesses can acquire modern or high-quality equipment without needing to
pay the full purchase price upfront. This helps businesses stay competitive,
especially when the latest technology is crucial for operations.

Q3. What are the different models of project financing?

ANS: Project financing can be structured in various ways depending on the nature of the
project, risk profile, and participants involved. The major models include:

1. Non-recourse Financing:
o This type of financing ensures that lenders can only claim the project’s assets
and cash flows if the project fails. The lenders cannot pursue the personal
assets of the sponsors, offering a limited risk exposure to the sponsors.
2. Limited Recourse Financing:
o Limited recourse financing provides that lenders have recourse to specific
parties, typically only the project’s assets and cash flows. It may also allow for
the recovery of a portion of the debt from sponsors under certain conditions.
3. Non-recourse Project Financing:
o Similar to non-recourse financing, this type isolates the financial risk to the
project itself, and the lenders cannot seek compensation from the sponsors in
case of default, thus offering greater protection to the sponsors.
4. BOOT Model (Build-Own-Operate-Transfer):
o In the BOOT model, the private sector develops, owns, and operates an
infrastructure project for a fixed period. After the specified period, the
ownership of the project is transferred to the public sector. The private sector
typically recoups its investment through revenues generated during the
operating phase.
5. BOLT Model (Build-Operate-Lease-Transfer):
o In the BOLT model, the private entity builds and operates the project for a set
period and leases the asset to the government or another public authority.
After the lease period, the asset is transferred to the public sector.
6. BOT Model (Build-Operate-Transfer):
o A public-private partnership model where the private company builds and
operates the project for a specific period before transferring ownership to the
government.
7. Project Finance with Equity Participation:
 o In this model, equity investors provide capital for the project in exchange for
ownership or shares. The equity holders share both the risks and the rewards
of the project, including profits and potential losses.

Q4. Explain the advantages of lease financing.

ANS: Lease financing provides a variety of benefits to businesses, making it an attractive
option for acquiring assets:

1. Conservation of Capital:
o Leasing allows a company to acquire necessary assets without making a large
upfront payment. This frees up capital for other business needs or investments.
2. Flexibility:
o Leasing offers flexibility in terms of asset usage. It allows businesses to
upgrade equipment regularly as technology improves without the need to
purchase new assets every time.
3. Tax Benefits:
o Lease payments are often tax-deductible, which can help businesses lower
their taxable income and reduce their tax liabilities. This makes leasing a
financially advantageous option.
4. Off-Balance Sheet Financing:
o Operating leases, in particular, may not be recorded on the balance sheet,
allowing the business to maintain favorable financial ratios, which is
beneficial when seeking loans or credit.
5. Risk Mitigation:
o In leasing agreements, the lessor typically assumes the risks associated with
asset ownership, such as obsolescence or maintenance costs, offering
businesses protection from these liabilities.
6. Improved Cash Flow:
o Leasing can provide improved cash flow management, as businesses only
need to make periodic payments instead of a large upfront capital expenditure.
This regular cost structure helps businesses manage their finances more
effectively.
7. Access to Modern Equipment:
o Leasing enables businesses to acquire state-of-the-art equipment or technology
without the need for a huge capital investment. This is particularly
advantageous for businesses in industries where technological advancements
occur frequently.

UNIT11:

SHORT ANSWER QUESTIONS

Q1. What are the broad categories of financial decision making?

ANS: Financial decision-making in a firm can be broadly classified into three main
categories:
 1. Investment Decisions (Capital Budgeting):
o Investment decisions are concerned with the allocation of the firm’s capital to
long-term assets or projects.
o The goal is to evaluate different investment opportunities and decide which
ones will yield the highest returns or strategic value.
o These decisions involve analyzing the potential costs, returns, risks, and
impacts of investing in long-term assets such as property, machinery, or new
business projects.
o Common techniques for evaluating investment decisions include Net Present
Value (NPV), Internal Rate of Return (IRR), and Payback Period.
2. Financing Decisions:
o Financing decisions focus on how a company will fund its operations and
growth, whether through debt, equity, or a combination of both.
o It involves determining the appropriate capital structure, which is the mix of
debt and equity financing a firm uses to fund its assets.
o The goal is to strike a balance between risk and return, ensuring the firm can
meet its obligations while maximizing shareholder value.
o Decisions around the issuance of stocks, bonds, loans, and managing short-
term and long-term financing needs are included in this category.
3. Dividend Decisions:
o Dividend decisions are concerned with how a company will distribute its
profits to shareholders.
o The decision involves determining the amount of profit to be retained for
reinvestment in the business (retained earnings) and the portion to be
distributed to shareholders as dividends.
o The firm must also consider the preferences of shareholders, the firm's
investment opportunities, and its need for cash to fund future growth.
o Key concepts in dividend decisions include the dividend payout ratio and the
dividend policy.

Q2. What are the main areas of concern under dividend decisions?
ANS: The main areas of concern under dividend decisions include:

1. Dividend Policy:
o The company must determine a consistent and sustainable dividend policy.
The policy defines how much profit will be distributed as dividends versus
how much will be retained for reinvestment.
o Common types of dividend policies include stable dividend policy, constant
payout ratio policy, and residual dividend policy.
2. Dividend Payout Ratio:
o This is the proportion of net income that is paid out to shareholders as
dividends. The firm must assess the optimal payout ratio, which is influenced
by factors like profitability, cash flow, and future investment needs.
3. Retained Earnings:
o Companies often retain a portion of their earnings for reinvestment in the
business rather than distributing them as dividends. The decision about the
amount to retain or distribute is crucial as it impacts the company’s growth
opportunities and financial stability.
 4. Liquidity Position:
o The firm needs to ensure that it has sufficient liquid assets to pay dividends
without compromising its operational needs or strategic investments.
o Dividend payments should not strain the company’s cash flows or financial
flexibility.
5. Legal and Contractual Restrictions:
o Companies are often subject to legal restrictions that limit their ability to pay
dividends. For example, a firm may be prohibited from paying dividends if it
doesn’t meet certain profitability or capital adequacy ratios as per regulatory
requirements.
o Some debt covenants may also restrict the amount of dividends a company can
pay.
6. Shareholder Expectations:
o Shareholders, particularly income-focused investors, may have expectations
regarding the frequency and consistency of dividend payments.
o The company must balance the need for dividend payments with the
requirement for reinvestment in business growth.
7. Tax Considerations:
o Dividends are often subject to taxation at the shareholder level. The tax
implications of paying or not paying dividends can influence the dividend
policy.
o Some firms may prefer to retain earnings and reinvest them to avoid higher tax
burdens on dividends.
8. Market Conditions:
o The overall economic and market conditions may influence a firm’s ability to
pay dividends. In times of economic downturns or financial stress, a company
might reduce or omit dividends to conserve cash.

Q3. Briefly explain investment decisions.

ANS: Investment decisions, also known as capital budgeting decisions, are the decisions
regarding the allocation of capital to long-term projects or assets that will generate future
returns for the firm. These decisions are critical because they influence the growth and
profitability of the company.

Key aspects of investment decisions include:

1. Identifying Investment Opportunities:

o The company identifies potential investment opportunities such as purchasing
new equipment, launching new products, expanding operations, or entering
new markets. These investments are aimed at generating long-term benefits
for the firm.
2. Evaluating Projects:
o After identifying investment opportunities, the firm evaluates each one using
financial analysis techniques such as Net Present Value (NPV), Internal
Rate of Return (IRR), Payback Period, and Profitability Index. These
methods help in assessing the expected returns and risks associated with each
investment.
3. Risk and Return Considerations:
 oInvestment decisions also involve analyzing the risks associated with each
project. Firms must assess how much risk they are willing to take on and
ensure that the expected return justifies that risk.
o Risk analysis can involve sensitivity analysis, scenario analysis, and other risk
evaluation techniques.
4. Capital Allocation:
o Once projects are evaluated, the company must decide how to allocate its
available capital among competing projects. This is often constrained by the
firm’s budget or financial resources, leading to the need for capital rationing
in some cases.
5. Long-term Impact:
o Investment decisions must consider the long-term effects on the company,
including growth, profitability, market position, and strategic objectives.
6. Monitoring and Adjustment:
o After an investment is made, firms continue to monitor its performance to
ensure that it is delivering the expected results. If necessary, adjustments can
be made to the investment strategy to enhance returns.

UNIT12:

SHORT ANSWER QUESTIONS

Q1. Explain the term working capital. What is the primary objective of working capital

management?
ANS: Working Capital refers to the difference between a company’s current assets and
current liabilities. It represents the funds that are available for day-to-day operations and is a
measure of a company’s short-term financial health and operational efficiency. Working
capital is necessary for the smooth functioning of business operations, ensuring that the
company has enough cash flow to meet its short-term obligations and invest in its daily
activities, such as inventory management, paying suppliers, and meeting payroll expenses.

The formula for working capital is:

Working Capital = Current Assets - Current Liabilities

• Current Assets include cash, accounts receivable, and inventory that are expected to
be converted into cash or used up within one year.
• Current Liabilities include short-term debts, accounts payable, and other obligations
due within one year.

Primary Objective of Working Capital Management:

The primary objective of working capital management is to ensure that the company
maintains an optimal balance between its current assets and current liabilities. The aim is to:
 1. Ensure Liquidity:
o The primary objective is to ensure that the company has sufficient cash and
liquid assets to meet its short-term obligations as they become due. Efficient
working capital management prevents liquidity crises and helps maintain
smooth operations without disruptions.
2. Maximize Profitability:
o By managing the levels of current assets such as inventory, receivables, and
cash, a company can reduce its cost of capital and avoid unnecessary interest
expenses. Effective management ensures that resources are used efficiently,
which contributes to higher profitability.
3. Minimize Costs:
o Excessive working capital can lead to inefficient use of resources, such as
holding too much inventory or granting too much credit to customers.
Conversely, inadequate working capital can result in cash shortages, leading to
missed opportunities or the need for expensive short-term borrowing.
4. Balance Risk and Efficiency:
o The goal is to strike a balance between too much and too little working capital.
Too much working capital might indicate inefficiency in using resources,
while too little working capital could signal financial distress.

Q2. Explain the working capital cycle?

ANS: The working capital cycle (also known as the cash conversion cycle) refers to the time
taken for a company to convert its current assets into cash. It is the process through which a
company manages its short-term assets and liabilities to ensure it has enough cash to meet its
immediate operational needs. The cycle illustrates how quickly a company can turn its
investments in inventory and receivables into cash flow from sales.
The working capital cycle is composed of the following stages:

1. Inventory Conversion Period:

o This is the time taken to convert raw materials into finished goods and then
sell them as inventory. It represents how long the company holds inventory
before selling it.
o The shorter the inventory conversion period, the quicker the company can
convert its inventory into cash, reducing the capital tied up in inventory.
Formula:
Inventory Conversion Period=Average InventoryCost of Goods Sold per Day\text{Inventory
Conversion Period} = \frac{\text{Average Inventory}}{\text{Cost of Goods Sold per
Day}}Inventory Conversion Period=Cost of Goods Sold per DayAverage Inventory

2. Receivables Collection Period:

o This represents the time taken to collect cash from customers after a sale has
been made on credit. The longer the receivables period, the longer it takes for
the company to convert sales into cash.
 o Companies need to effectively manage their receivables to minimize
outstanding payments and reduce the risk of bad debts.

Formula:
Receivables Collection Period=Average Accounts ReceivableSales per Day\text{Receivables
Collection Period} = \frac{\text{Average Accounts Receivable}}{\text{Sales per
Day}}Receivables Collection Period=Sales per DayAverage Accounts Receivable

3. Payables Deferral Period:

o This is the time taken by the company to pay its suppliers after receiving
goods or services. A longer payables deferral period allows the company to
hold on to cash for a longer period, improving liquidity.

o However, if the payables period is too long, the company may damage its
relationships with suppliers and face the risk of delayed deliveries or even
supply chain disruptions.

Formula:
Payables Deferral Period=Average Accounts PayableCost of Goods Sold per Day\text{Payabl
es Deferral Period} = \frac{\text{Average Accounts Payable}}{\text{Cost of Goods Sold per
Day}}Payables Deferral Period=Cost of Goods Sold per DayAverage Accounts Payable

4. Cash Conversion Cycle:

o The overall working capital cycle is the combination of these periods:

inventory conversion period, receivables collection period, and payables
deferral period. The cash conversion cycle (CCC) represents the net time
taken for cash to flow from the company’s operations.

Formula:
Cash Conversion Cycle=Inventory Conversion Period+Receivables Collection Period−Payabl
es Deferral Period

The shorter the working capital cycle, the less time a company takes to convert its
investments in inventory and receivables into cash, which is beneficial for liquidity and
operational efficiency. An effective working capital management strategy aims to minimize
the working capital cycle to ensure that the company can quickly turn over its working capital
without straining its liquidity.

LONG ANSWER QUESTIONS

Q1. Discuss the objectives of working capital management.

ANS: Working Capital Management (WCM) is a vital component of financial
management aimed at ensuring a company has sufficient liquidity to meet its short-term
obligations. The objectives of WCM revolve around maintaining an optimal level of working
capital to ensure smooth operations, profitability, and financial stability. The key objectives
are as follows:

1. Ensuring Liquidity and Solvency:

o The primary objective of working capital management is to maintain liquidity
so that the company can meet its day-to-day operational needs and financial
obligations (short-term debts, salaries, taxes, etc.) as they arise.
o Adequate working capital ensures that the company does not face cash flow
problems, which could lead to operational disruptions or even insolvency.
2. Maximizing Profitability:
o Efficient working capital management helps minimize unnecessary costs
associated with holding excessive inventory or offering long credit periods to
customers.
o By optimizing the use of current assets, companies can reduce financing costs,
such as interest on short-term borrowings, and improve profitability.
3. Minimizing the Cost of Capital:
o A company with excessive working capital may incur unnecessary costs in the
form of idle inventory or non-earning cash balances. On the other hand,
inadequate working capital may lead to the company having to resort to
expensive short-term borrowing.
o The goal is to minimize the capital tied up in working capital while ensuring
that there is enough to fund operational needs, thus reducing the overall cost of
capital.
4. Optimizing Cash Flow:
o The company aims to optimize its cash conversion cycle by reducing the time
taken to convert inventory into sales and sales into cash. This results in a
shorter cash conversion cycle, improving cash flow.
o Efficient working capital management helps businesses generate more cash
from operations, reducing reliance on external financing.
5. Balancing Risk and Return:
o An important objective is to strike the right balance between holding too much
and too little working capital. Excessive working capital can indicate
inefficiency, whereas too little working capital increases financial risk and can
disrupt operations.
o The key is to ensure the availability of enough working capital to fund growth,
yet avoid holding excessive amounts that can result in idle resources.
6. Maintaining Business Continuity:
o Working capital management helps a firm maintain business continuity by
ensuring that all operational activities, including procurement, production, and
distribution, continue smoothly without delays or interruptions due to lack of
funds.
7. Supporting Growth and Expansion:
o An efficient working capital management system provides a business with the
financial flexibility to take advantage of growth opportunities, such as
expansion into new markets or product development, without compromising
operational stability.
Q2. Discuss the two concepts of working capital.
ANS: Working capital is commonly defined in two ways: Gross Working Capital and Net
Working Capital. These two concepts provide different perspectives on the firm's short-term
financial health and operational efficiency.
1. Gross Working Capital:

o Gross working capital refers to the total investment in current assets, which
are assets that are expected to be converted into cash or used up within one
year.

o It includes items such as cash, accounts receivable, inventory, and marketable

securities.

o Gross working capital focuses on the total amount of resources tied up in

current assets, which are essential for day-to-day business operations.

o Formula: Gross Working Capital=Total Current Assets\text{Gross Working

Capital} = \text{Total Current
Assets}Gross Working Capital=Total Current Assets

o Gross working capital is primarily concerned with the resources available for
meeting the business's immediate operational requirements.

2. Net Working Capital:

o Net working capital is defined as the difference between a company’s current

assets and current liabilities.

o It reflects the company’s ability to pay off its short-term obligations with its
short-term assets.
o A positive net working capital indicates that the company has more current
assets than current liabilities and is in a good position to cover its short-term
debts. A negative net working capital indicates that the company may struggle
to meet its obligations.
o Formula: Net Working Capital=Current Assets−Current Liabilities
Liabilities}Net Working Capital=Current Assets−Current Liabilities

o Net working capital is a critical measure of a company’s short-term financial

health and operational efficiency, as it reflects the liquidity available to fund
day-to-day operations.

Q3. What factors that affect working capital requirement?

ANS: The working capital requirement of a firm is influenced by various factors that
determine how much capital needs to be tied up in its day-to-day operations. These factors
include both internal and external conditions that impact the operational needs of the
company:

1. Nature of Business:
o Different types of businesses have varying working capital needs based on the
industry they operate in.
o For example, manufacturing companies generally need more working capital
due to the requirement for inventory and raw materials, while service
companies may require less working capital since they often do not hold
significant inventory.
2. Business Cycle:
o The stage of the business cycle significantly affects working capital
requirements. During periods of growth, firms typically need more working
capital to support expansion, while during recession or downturns, the need
for working capital may decrease.
o Additionally, seasonal businesses often experience fluctuating working capital
requirements based on demand cycles.
3. Production Cycle:
o The length of the production cycle (the time taken from raw materials to
finished goods) can directly affect working capital needs. Longer production
cycles require more working capital to cover inventory and other production-
related costs.
4. Credit Policy:
o A company's credit policy (terms of credit offered to customers) has a
significant impact on the working capital requirement. If the company offers
extended credit periods to customers, the amount of accounts receivable will
increase, leading to higher working capital needs.
o Tightening credit terms can reduce working capital requirements by speeding
up cash flow and reducing outstanding receivables.
5. Inventory Management:
o The size and nature of inventory held by a firm also influence its working
capital. Companies with larger inventories or slow-moving inventory tend to
need more working capital to fund these assets.
o Efficient inventory management, such as using Just-in-Time (JIT) systems,
can reduce inventory levels and, consequently, working capital needs.
6. Operating Efficiency:
o Firms that operate more efficiently and have a better turnover of current assets
generally require less working capital. High asset turnover and faster
receivables collection reduce the amount of capital needed for operations.
7. Profitability:
o A highly profitable firm generates more internal funds and can finance its
working capital requirements with retained earnings. Conversely, a less
profitable company may need to rely on external financing or increase its
working capital reserves.
8. Taxation and Legal Environment:
o Government policies, taxes, and legal requirements can impact a firm’s
working capital. Changes in taxation laws or regulations around working
capital management can influence the amount of capital needed for daily
operations.
9. Market Conditions:
 o Economic conditions, interest rates, and inflation affect the cost of financing
working capital. During times of inflation, the firm may need more working
capital to maintain the same purchasing power.
10. Technological Changes:
o Advances in technology, such as automation and digitalization, can improve
operational efficiency and reduce the need for working capital by reducing
reliance on inventory and improving cash flow management.

UNIT13:

SHORT ANSWER QUESTIONS

Q1. What is the transaction motive of holding cash? ANS: The transaction motive for
holding cash refers to the need for cash to meet the day-to-day operational requirements of a
business. It arises from the necessity of having sufficient liquidity to carry out routine
transactions such as paying for raw materials, wages, utilities, and other operating expenses.

• Purpose: The transaction motive ensures that a business can operate smoothly
without facing cash shortages or liquidity issues.
• Factors Influencing Transaction Motive:
o Volume of Transactions: The more frequent the business transactions, the
higher the cash balance needed.
o Credit Sales: If a business offers credit to customers, it may need to hold
more cash to cover the time gap between sales and the actual collection of
payments.
o Operating Cycle: The length of the company’s operating cycle (time taken
from purchasing inventory to receiving cash from customers) affects the cash
balance needed for transactions.

Q2. Define cash management.

ANS: Cash management refers to the process of managing a company’s cash inflows and
outflows efficiently to ensure that there is enough liquidity for day-to-day operations while
maximizing the return on any surplus cash. It involves the planning, monitoring, and
controlling of cash in the business to meet both short-term obligations and long-term goals.

Objectives of Cash Management:

• Ensure Liquidity: Ensure that the company has enough cash to meet its short-term
obligations and operational requirements.
• Minimize Idle Cash: Avoid holding excessive cash that does not earn returns.
Surplus cash should be invested to earn interest or returns.
• Optimize Cash Flow: Ensure that cash flow is sufficient to maintain smooth business
operations without interruption.
• Improve Working Capital Efficiency: Effective cash management contributes to the
optimal utilization of working capital.
Q3. What is payment float?
ANS: Payment float refers to the period of time between when a payment is initiated by a
company and when the cash is actually deducted from its bank account. In other words, it is
the delay between the time the company writes a check or initiates a payment and when the
recipient deposits the check and the funds are cleared from the company’s bank account.

• Importance: Companies can use payment float to manage their cash flow by taking
advantage of the delay in clearing payments.
• Types of Payment Float:
o Mail Float: The time it takes for a check to be mailed to the payee.
o Processing Float: The time it takes for the payee to deposit the check into
their bank account.
o Clearing Float: The time it takes for the payee's bank to clear the check and
transfer the funds to the recipient.

While payment float can help a company temporarily hold on to cash, it is important to
manage it carefully to avoid potential late payments and associated penalties.

Q4. Give two criteria of investing surplus cash.

ANS: When a company has surplus cash, it must decide how to invest it efficiently. Two key
criteria for investing surplus cash are:

1. Safety of the Investment:

o The primary criterion for investing surplus cash is ensuring that the investment
is safe and does not expose the company to significant risk of losing the
principal amount. Conservative investments such as government bonds,
treasury bills, or money market funds are commonly used to maintain safety.
o The goal is to protect the company’s liquidity and ensure that the cash is
available when needed.
2. Liquidity of the Investment:
o The investment should be liquid, meaning the company can easily convert the
investment into cash without significant loss of value or delay. Investments
like short-term certificates of deposit (CDs), money market instruments, or
other near-cash assets are suitable as they offer high liquidity.
o This ensures that if the company needs to use the cash for operations or
emergencies, it can do so without significant hurdles.

Both safety and liquidity are critical to ensure that surplus cash is efficiently invested without
jeopardizing the company’s ability to meet its immediate obligations.

LONG ANSWER QUESTIONS

Q1. How is the optimum balance of working cash balance determined?

ANS: The optimum working cash balance is the ideal level of cash that a business should
maintain to meet its operational needs while minimizing opportunity costs. It is determined
using several approaches, including theoretical models and practical considerations:
1. Baumol’s Model (Inventory Model)

Developed by William Baumol, this model is based on the Economic Order Quantity
(EOQ) principle, where cash is treated like inventory. It suggests that firms should replenish
cash when it reaches a certain level to minimize total costs, which include:

• Transaction Costs (costs of converting securities into cash)

• Holding Costs (opportunity cost of keeping idle cash)

The optimum cash balance (C) can be determined using the formula:

C= sqr root (2Bt/i )

Where:

• b = Fixed cost per transaction

• T = Total cash requirement for a period
• i = Opportunity cost of holding cash

2. Miller-Orr Model (Stochastic Model)

This model is more practical as it accounts for cash flow fluctuations. It establishes an upper
limit, a lower limit, and a return point:

• When cash reaches the upper limit, the excess is invested.

• When it hits the lower limit, securities are liquidated to bring cash back to the return
point.

The model is ideal for firms with uncertain cash flows and helps in reducing the risk of cash
shortages or excessive idle cash.

3. Practical Considerations

Apart from models, firms consider:

• Nature of Business: Seasonal businesses require higher cash reserves.

• Payment Cycle: Companies with frequent outflows (e.g., wages, rent) need more
liquidity.
• Market Conditions: In uncertain times, firms hold extra cash as a buffer.
• Banking Facilities: If borrowing is easy, lower cash reserves are required.

By balancing these factors, companies ensure they neither run out of cash nor hold
excessive idle cash, which could otherwise be invested profitably.

Q2. Write a short note on investment of idle cash in readily marketable securities.
ANS: When businesses accumulate idle cash beyond their working capital needs, it is
prudent to invest it in readily marketable securities to earn a return. Readily marketable
securities are short-term, low-risk financial instruments that can be quickly converted into
cash without significant loss.

Types of Marketable Securities

1. Treasury Bills (T-Bills):

o Issued by the government, offering high liquidity and low risk.
o Short maturity (e.g., 91, 182, or 364 days).
2. Commercial Paper:
o Unsecured, short-term promissory notes issued by corporations.
o Higher return than T-Bills but slightly riskier.
3. Certificates of Deposit (CDs):
o Issued by banks with a fixed term and interest rate.
o Low-risk, higher yield than a savings account.
4. Money Market Funds:
o A diversified investment in short-term, high-quality debt instruments.
o Offers liquidity and stable returns.
5. Repurchase Agreements (Repos):
o Agreements where securities are sold with a commitment to repurchase later.
o Used by businesses to park surplus funds temporarily.

Benefits of Investing Idle Cash in Marketable Securities

• Earns Interest/Returns: Prevents idle cash from depreciating due to inflation.

• Maintains Liquidity: Easily converted into cash when needed.
• Reduces Risk: Safer than investing in stocks or long-term assets.
• Ensures Financial Stability: Provides a financial cushion for emergencies.

Firms adopt a balanced investment strategy to ensure that sufficient cash is available for
operational needs while maximizing returns on idle funds.

Q3. Explain the objectives of holding cash.

ANS: Businesses hold cash for various strategic and operational reasons. The main objectives
include:

1. Transaction Motive

• Cash is needed for day-to-day operations like purchasing raw materials, paying
wages, and covering other routine expenses.
• Without adequate cash, firms may struggle to meet short-term obligations.

2. Precautionary Motive

• Companies hold extra cash as a buffer against unexpected events such as sudden
expenses, economic downturns, or supplier delays.
• This is crucial for businesses with irregular cash flows.

3. Speculative Motive
 • Firms hold cash to take advantage of unexpected opportunities, such as:
o Purchasing discounted raw materials.
o Investing in profitable ventures.
o Benefiting from favorable exchange rate fluctuations.

4. Compensating Balance Motive

• Some businesses maintain a minimum balance in their bank accounts to:

o Avoid bank charges or penalties for falling below the required balance.
o Maintain good banking relationships for easier loan approvals.

5. Investment Motive

• Companies often hold cash temporarily before investing in growth opportunities

such as:
o Expanding operations.
o Mergers and acquisitions.
o Research and development (R&D).

UNIT14:

SHORT ANSWER QUESTIONS

Q1. What do you mean by “Receivables”?

ANS: Receivables refer to the amount of money owed to a business by its customers for
goods sold or services rendered on credit. They are also known as accounts receivable (AR)
and represent a company’s right to collect payment in the future.

Key Features of Receivables

• Arise when a company sells goods or services on credit instead of immediate cash
payment.
• Recorded as a current asset on the balance sheet.
• Include trade receivables (from customers) and non-trade receivables (loans,
advances, etc.).
• Have a credit period within which payment must be made (e.g., 30, 60, or 90 days).

Importance of Receivables

• Help increase sales volume by offering customers flexible payment options.

• Can be converted into cash through collection efforts or factoring.
• Require effective management to reduce the risk of bad debts and improve cash
flow.

Q2. Define Inventory Management.

ANS: Inventory Management refers to the process of planning, controlling, and
optimizing the storage, movement, and use of goods to ensure smooth business operations
while minimizing costs.

Objectives of Inventory Management

• Maintain adequate stock levels to meet customer demand.

• Minimize holding costs such as storage, insurance, and depreciation.
• Prevent stockouts (shortages) and overstocking.
• Optimize order quantity using models like Economic Order Quantity (EOQ).
• Ensure product quality by avoiding obsolete or expired inventory.

Techniques of Inventory Management

1. Economic Order Quantity (EOQ): Helps determine the optimal order size.
2. Just-in-Time (JIT): Reduces excess inventory by receiving stock only when needed.
3. ABC Analysis: Categorizes inventory into A (high value), B (moderate value), and
C (low value) items.
4. FIFO & LIFO: First-In-First-Out (FIFO) ensures older stock is sold first, while Last-
In-First-Out (LIFO) values newer stock higher.

Effective inventory management enhances profitability by reducing costs and ensuring a

smooth supply chain.

Q3. What are Credit Standards?

ANS: Credit Standards are the criteria or guidelines a company uses to determine whether
to extend credit to customers. These standards help businesses assess the creditworthiness
of customers and minimize the risk of bad debts.

Key Components of Credit Standards

1. Creditworthiness of Customers:
o Based on financial position, credit history, and repayment ability.
2. Credit Period:
o The number of days given to customers for repayment (e.g., 30, 60, 90 days).
3. Collection Policies:
o Defines how overdue payments are handled, including follow-ups and
penalties.
4. Risk Tolerance:
o Some businesses are more flexible with credit terms, while others are strict.

Factors Influencing Credit Standards

• Industry Practices: Some industries have standard credit terms.

• Company’s Financial Strength: Stronger companies can afford lenient credit terms.
• Market Competition: Businesses may offer more credit to attract customers.

Strict credit standards reduce bad debts but may limit sales, while lenient standards boost
sales but increase the risk of defaults.
Q4. Why cash discount is offered by business firms?
ANS: A cash discount is a price reduction offered by businesses to customers who make
early payments on their credit purchases. It is an incentive to encourage prompt payments
and improve cash flow.

Reasons for Offering Cash Discounts

1. Encourages Early Payment:

o Helps businesses receive cash faster and reduce reliance on credit.
2. Reduces Bad Debt Risk:
o Customers who pay early are less likely to default.
3. Improves Cash Flow:
o More liquidity means the business can reinvest in operations and expansion.
4. Reduces Collection Costs:
o Less effort is needed for follow-ups and legal actions for late payments.
5. Competitive Advantage:
o Attracts customers who seek cost savings.

Example of Cash Discount Terms

• "2/10, Net 30" → This means:

o The customer gets a 2% discount if they pay within 10 days.
o Otherwise, the full amount is due in 30 days.

By offering cash discounts, businesses balance profitability with liquidity while

maintaining strong customer relationships.

LONG ANSWER QUESTIONS

Q1. Explain the two types of Credit Policy.

ANS: A credit policy refers to the set of guidelines that a business follows when extending
credit to customers. It defines who qualifies for credit, how much credit is given, the
repayment terms, and how overdue accounts are handled. Businesses choose between
two main types of credit policies based on their objectives and risk appetite:

1. Lenient Credit Policy

A lenient credit policy is a flexible approach where a company offers liberal credit terms
to customers. This means:

• Easier approval for credit sales.

• Longer credit periods (e.g., 60 or 90 days instead of 30 days).
• Lower creditworthiness requirements (more customers can qualify).
• Fewer restrictions on overdue payments before penalties or collections begin.

Advantages of a Lenient Credit Policy

 Increases sales volume: More customers can buy on credit, boosting revenue.
Expands market share: Attracts new customers who prefer flexible payment options.
Enhances customer relationships: Builds goodwill by offering convenience.

Disadvantages of a Lenient Credit Policy

Higher risk of bad debts: Some customers may default on payments.

Delayed cash inflows: More funds get tied up in receivables.
Increased collection costs: More effort required to follow up on overdue accounts.

2. Strict Credit Policy

A strict credit policy means the company follows tighter credit control measures. This
includes:

• Careful evaluation of customers' creditworthiness.

• Shorter credit periods (e.g., 15–30 days).
• Higher credit standards, approving only financially stable customers.
• Immediate penalties for late payments.

Advantages of a Strict Credit Policy

Reduces bad debts: Only financially sound customers receive credit.

Improves cash flow: Faster payments mean more liquidity.
Minimizes collection costs: Fewer overdue accounts to chase.

Disadvantages of a Strict Credit Policy

Limits sales growth: Some customers may prefer competitors with flexible terms.
Restricts market expansion: Businesses may lose potential buyers who need credit.
May strain customer relationships: Some clients may find strict terms inconvenient.

Which Policy is Better?

• Lenient credit policies are best for growing businesses looking to attract more
customers.
• Strict credit policies work well for companies that prioritize financial stability and
cash flow.
• Many businesses adopt a balanced approach, offering flexible terms to reliable
customers while being strict with high-risk clients.

Q2. Write a short note on “EOQ”.