Two-mark answers for your Financial Management (1st chapter )

1. Define Financial Management:

Financial Management refers to the strategic planning, organising, directing, and controlling
of financial activities such as procurement and utilisation of funds in an organization.

2. What is Financial Management?

Financial Management involves managing a company’s financial resources to achieve its

business objectives, maximise profits, and ensure financial stability.

3. What is Investment Management?

Investment Management is the process of managing financial assets and investments,

including buying, selling, and monitoring assets to meet specific investment goals.

4. Mention Two Significances of Financial Management:

i) It helps in effective utilisation of funds.

ii) It aids in financial planning and decision-making.

5. What is Agency Theory?

Agency Theory explains the relationship between principals (owners) and agents (managers),
where agents are expected to act in the best interest of principals.

6. What is Risk-Return Trade-off?

Risk-return trade-off means the higher the risk, the higher the potential return, and vice versa.
Investors must balance risk with desired returns.

7. Write Any Four Finance Functions:

i) Investment decision
ii) Financing decision

iii) Dividend decision

iv) Working capital management

8. What is Agency Problem?

Agency Problem arises when the goals of the principals and agents diverge, leading to
conflicts of interest in decision-making.

9. What Do You Mean by Agency Cost?

Agency cost refers to the expenses incurred to resolve conflicts between principals and
agents, including monitoring and incentive costs.

10. What is the Relationship of Financial Management with Accounting Department?

Financial Management uses accounting data to make financial decisions, while the
accounting department provides the necessary financial information and records.

II :- CAPITAL STRUCTURE THEORIES AND DETERMINANTS

1. What is Capital Structure?

• Capital structure refers to the mix of debt and equity a firm uses to finance its
operations.
• It shows how a firm finances its overall activities and growth.

2. Define Capital Structure:

• Capital structure is the ratio of different sources of long-term financing such as equity,
preference shares, and debt.
• It represents the firm’s financial leverage.

3. What is Financial Structure?

 • Financial structure includes all sources of financing – both long-term and short-term.
• It consists of capital structure plus current liabilities.

4. Differentiate Capitalisation & Capital Structure:

• Capitalisation: Total amount of capital used by a firm.

• Capital Structure: Proportion of different types of securities in capital.

5. What is NOI Approach?

• Meaning: Net Operating Income (NOI) approach suggests that capital structure is
irrelevant to the firm’s value.
• Assumptions:
o Cost of debt is constant.
o Overall cost of capital (Ko) remains constant.
• Formula:
o Value of Firm (V) = EBIT / Ko
o Ko = EBIT / V

6. What is NI Approach?

• Meaning: Net Income (NI) approach states that increasing debt reduces overall cost of
capital and increases firm value.
• Assumptions:
o Cost of debt is less than cost of equity.
o No taxes.
• Formula:
o NI = EBIT – Interest
o Ko = Ke(E) + Kd(D)

7. What is Traditional Approach?

• Meaning: It suggests an optimal capital structure exists where WACC is minimised

and firm value maximised.
• Assumptions:
o Initially, using debt reduces WACC.
o Excessive debt increases financial risk.
• Formula:
o V = EBIT / Ko (Ko changes with capital structure)
8. What is MM Approach?

• Meaning: Modigliani-Miller (MM) approach states that capital structure is irrelevant

in a perfect market.
• Assumptions:
o No taxes, transaction costs, or bankruptcy costs.
o Perfect capital markets.
• Formula:
o V = EBIT / Ko
o Ko = Ke(E/V) + Kd(D/V)

9. What is Cost of Capital?

• Cost of capital is the minimum return required to justify an investment.

• It represents the firm’s cost of financing from debt and equity.

10. Define WACC?

• Meaning: Weighted Average Cost of Capital (WACC) is the average rate of return a
firm is expected to pay its investors.
• Assumptions:
o Capital structure is known and constant.
o Cost of each component is known.
• Formula:
o WACC = (E/V) × Ke + (D/V) × Kd × (1 – T)

o III :- CAPITAL BUDGETING

1. What do you mean by Capital Budgeting?

• Capital budgeting is the process of planning and evaluating investments in long-term

assets.
• It involves decision-making on projects that require large capital outlay and affect
future earnings.

2. Mention the Types of Capital Budgeting:

• Traditional Methods:
o Payback Period
o Accounting Rate of Return (ARR)
 • Discounted Cash Flow Methods:
o Net Present Value (NPV)
o Internal Rate of Return (IRR)
o Profitability Index (PI)

3. What is ARR and How is it Calculated? (Give Formula)

• ARR (Accounting Rate of Return) measures the return on investment based on

accounting profit.
• Formula:
o ARR = (Average Annual Profit / Initial Investment) × 100

4. What is NPV and How is it Calculated? (Give Formula)

• NPV (Net Present Value) is the difference between present value of cash inflows and
outflows.
• Formula:
o NPV = ∑ [Ct / (1 + r)^t] – C₀
o Where, Ct = Cash inflow, r = discount rate, t = time, C₀ = initial investment

5. What is IRR and How is it Calculated? (Give Formula)

• IRR (Internal Rate of Return) is the discount rate that makes NPV = 0.
• Formula (by interpolation):
o IRR = R1 + [(NPV1 × (R2 – R1)) / (NPV1 – NPV2)]
o Where, R1 & R2 = two discount rates, NPV1 & NPV2 = NPVs at those rates

6. What is PI and How is it Calculated? (Give Formula)

• PI (Profitability Index) is the ratio of present value of inflows to initial investment.

• Formula:
o PI = Present Value of Cash Inflows / Initial Investment

7. Differentiate Between NPV and IRR:

• NPV: Gives absolute value; decision based on whether NPV is positive or not.
• IRR: Gives percentage return; decision based on comparing IRR with required rate of
return.
8. Define Risk and Uncertainty:

• Risk: Situation where outcomes are unknown but probabilities are known.
• Uncertainty: Situation where outcomes and their probabilities are both unknown.

IV :- DIVIDEND DECISIONS

1. What Do You Mean by Dividend?

• A dividend is the portion of a company’s profit distributed to its shareholders.

• It is a reward to investors for investing in the company’s equity.

2. What is Cash and Stock Dividend?

• Cash Dividend: Payment made in cash to shareholders out of the company’s profits.
• Stock Dividend: Payment made in the form of additional shares instead of cash.

3. State the Assumptions of MM Approach:

• No taxes and transaction costs.

• Perfect capital markets.
• Investment decisions are not affected by dividend decisions.
• Investors are indifferent between dividends and capital gains.

4. What is Walter’s Model? State the Formula.

• Walter’s model suggests that dividend policy affects the value of the firm.
• Formula:
o P = (D + (r/E)(E – D)) / Ke
o Where:
▪ P = Market price per share
▪ D = Dividend per share
▪ E = Earnings per share
▪ r = Internal rate of return
▪ Ke = Cost of equity

V :- WORKING CAPITAL MANAGEMENT

1. What is Working Capital Management?

• Working capital management involves overseeing a company’s short-term assets and

liabilities to ensure efficient operations and maintain sufficient liquidity to meet short-
term obligations.
2. Mention the Factors Determining Working Capital:

• Nature of Business: Manufacturing firms typically require more working capital than
service-oriented businesses.
• Scale of Operations: Larger companies may need more working capital to support
extensive operations.
• Business Cycle Fluctuations: During boom periods, increased production and sales
can raise working capital needs.
• Seasonal Factors: Businesses with seasonal demand may experience fluctuating
working capital requirements.
• Technology and Production Cycle: Companies with longer production cycles may tie
up funds longer, affecting working capital.

3. What is Operating Cycle?

• The operating cycle is the time duration between the acquisition of inventory and the
collection of cash from receivables after the sale of the inventory. It measures how
quickly a company can convert its investments in inventory and other resources into
cash flows from sales.

4. What is Payable Management?

• Payable management refers to the process of managing a company’s obligations to

pay off short-term debts to its creditors or suppliers. It involves ensuring timely
payments, maintaining good supplier relationships, and optimising cash flow.

5-mark answers for your Financial Management subject, focusing on the

chapter Introduction to Financial Management:

1. Explain the Significance of Financial Management

Financial management is crucial for the success and sustainability of any organization. Its
significance includes:

• Efficient Resource Utilisation: Ensures optimal use of financial resources, minimising

waste and maximising returns.
 • Profit Maximisation: Aims to achieve the highest possible profits through careful
planning and control of financial activities.
• Liquidity Maintenance: Maintains adequate cash flow to meet short-term obligations,
ensuring smooth operations.
• Investment Decisions: Assists in evaluating and selecting investment opportunities
that yield the best returns.
• Financial Planning and Control: Facilitates strategic planning and monitoring of
financial performance to align with organisational goals.

2. What Are the Objectives of Financial Management?

The primary objectives of financial management are:

• Profit Maximisation: Focuses on increasing the company’s earnings to enhance

shareholder value.
• Wealth Maximisation: Aims to maximise the market value of the company’s shares,
reflecting the true worth of the business.
• Ensuring Liquidity: Maintains sufficient funds to meet day-to-day expenses and
unforeseen obligations.
• Risk Management: Identifies and mitigates financial risks to protect the company’s
assets and earnings.
• Optimal Capital Structure: Determines the best mix of debt and equity financing to
minimise the cost of capital.

3. Write a Note on Agency Theory

Agency theory explores the relationship between principals (owners) and agents (managers)
in a business context. Key points include:

• Principal-Agent Relationship: Owners delegate decision-making authority to

managers to run the company on their behalf.
• Conflict of Interest: Managers may pursue personal goals that conflict with the
owners’ objective of wealth maximisation.
• Agency Costs: Expenses incurred to monitor and align managers’ actions with
owners’ interests, such as performance-based incentives.
• Mitigation Strategies: Implementing corporate governance mechanisms, like audits
and performance evaluations, to reduce agency problems.
• Importance: Understanding agency theory helps in designing effective management
structures and compensation plans to align interests.
4. Write a Note on Risk-Return Trade-Off

The risk-return trade-off is a fundamental concept in finance, highlighting the balance

between the desire for the lowest possible risk and the highest possible return. Key aspects
include:

• Definition: The principle that potential return rises with an increase in risk. Low
levels of uncertainty (low risk) are associated with low potential returns, whereas high
levels of uncertainty (high risk) are associated with high potential returns.
• Investor Behaviour: Investors must assess their risk tolerance and investment goals to
choose appropriate investment options.
• Portfolio Diversification: Spreading investments across various assets to manage risk
while aiming for acceptable returns.
• Financial Decision-Making: Businesses evaluate the risk-return profile of projects to
make informed investment decisions.
• Importance: Understanding this trade-off assists in achieving a balance between risk
and return, aligning with financial objectives.

II:- Capital Structure and theories

1. Explain the Net Income Approach to Capital Structure Planning

The Net Income (NI) Approach, proposed by David Durand, posits that a firm’s capital
structure directly influences its overall value. According to this theory, increasing the
proportion of debt in the capital structure can lead to a decrease in the firm’s overall cost of
capital (WACC) and, consequently, an increase in the firm’s total value.

Key Assumptions:

• Cost of Debt < Cost of Equity: Debt is considered a cheaper source of financing
compared to equity.
• Constant Cost of Debt and Equity: The costs remain unchanged regardless of the
capital structure.
• No Taxes: The model assumes a tax-free environment.
• Unchanged Risk Perception: Increasing debt does not alter the risk perception of
investors.

Implications:
 • As debt increases, the WACC decreases, leading to a higher firm value.
• The optimal capital structure, under this approach, is one with maximum debt.

Formula:

• Value of the Firm (V) = Value of Equity (E) + Value of Debt (D)
• WACC = EBIT / V

Where:

• EBIT: Earnings Before Interest and Taxes

• V: Total value of the firm

This approach suggests that leveraging debt can enhance shareholder value by reducing the
overall cost of capital.

2. Explain the Determinants of Capital Structure

Capital structure decisions are influenced by various internal and external factors. Key
determinants include:

1. Business Risk: Firms with stable earnings can afford higher debt levels, while those
with volatile earnings should limit debt to reduce financial risk.
2. Company Size: Larger firms often have better access to capital markets and can
secure debt at favourable terms due to their established reputation.
3. Asset Structure: Companies with substantial tangible assets can use them as collateral,
making it easier to obtain debt financing.
4. Profitability: Highly profitable firms may rely more on retained earnings, reducing the
need for external financing.
5. Growth Opportunities: Firms with significant growth prospects might prefer equity to
avoid the obligations associated with debt.
6. Tax Considerations: Interest payments on debt are tax-deductible, making debt
financing more attractive in jurisdictions with higher tax rates.
7. Market Conditions: Prevailing economic conditions and investor sentiment can
influence the choice between debt and equity.
8. Control Considerations: Issuing new equity may dilute existing ownership, so firms
concerned about control may prefer debt.
9. Flexibility: Maintaining a balance between debt and equity ensures financial
flexibility to adapt to changing business needs.
Understanding these determinants helps firms in crafting a capital structure that aligns with
their strategic objectives and risk appetite.

IV:- DIVIDEND DECISIONS

1. Mention the Determinants of Dividend Decision

Dividend decisions are influenced by various internal and external factors that a company
must consider to balance shareholder expectations and financial stability. Key determinants
include:

1. Earnings Stability: Companies with consistent and predictable earnings are more
likely to distribute regular dividends.
2. Liquidity Position: Adequate cash flow is essential to pay dividends. Even profitable
companies may withhold dividends if they face liquidity constraints.
3. Access to Capital Markets: Firms with easy access to external financing might
distribute higher dividends, relying on external funds for investment needs.
4. Shareholder Preferences: Companies may tailor their dividend policies based on the
preferences of their shareholder base, such as favouring regular income or capital
gains.
5. Legal and Contractual Constraints: Legal provisions and debt covenants can restrict
the amount and timing of dividend payments.
6. Tax Considerations: Tax policies affecting dividends can influence a company’s
decision on dividend payouts.
7. Investment Opportunities: Firms with profitable investment opportunities may retain
earnings to finance growth rather than paying out dividends.
8. Inflation: In high inflation environments, companies might retain more earnings to
maintain their capital’s purchasing power.
9. Control Considerations: To avoid diluting control, companies may prefer retained
earnings over issuing new equity, affecting dividend decisions.
10. Market Expectations: Maintaining a stable or gradually increasing dividend can
positively influence investor perception and stock price stability.

2. Write the Legal Provisions Relating to Dividend

Legal frameworks govern how and when companies can declare and distribute dividends to
ensure financial prudence and protect stakeholders’ interests. Key legal provisions include:

1. Declaration from Profits: Dividends can only be declared out of current profits or
accumulated profits after providing for depreciation as per statutory requirements.
 2. Provision for Depreciation: Before declaring dividends, companies must account for
depreciation on all assets, ensuring that capital is not eroded.
3. Transfer to Reserves: Companies may be required to transfer a certain percentage of
profits to reserves before declaring dividends, enhancing financial stability.
4. Payment Timeline: Once declared, dividends must be paid within a specified period
(e.g., 30 days in some jurisdictions) to avoid penalties.
5. Unpaid Dividend Account: Dividends not claimed within a certain period must be
transferred to an Unpaid Dividend Account, and if unclaimed for a further period, to
the Investor Education and Protection Fund.
6. Restrictions on Defaulting Companies: Companies that have defaulted on repayment
of deposits, debentures, or interest payments may be restricted from declaring
dividends until defaults are rectified.
7. Interim Dividends: Boards may declare interim dividends between annual general
meetings, provided the company has sufficient profits and complies with relevant
provisions.

These legal provisions ensure that dividend distributions do not compromise a company’s
financial health and that shareholders are treated equitably

10 Marks Questions and Answers from introducing to financial

management .

1. Elaborate the Functions of Financial Management

Financial management encompasses various functions that are crucial for the effective
operation and sustainability of an organization. These functions include:

1. Financial Planning and Forecasting: This involves estimating the capital requirements
of the organization and determining its competition. It ensures that the company has
adequate funds to meet its objectives.
2. Investment Decision-Making: Also known as capital budgeting, this function involves
allocating funds to long-term assets that will yield the highest returns over time. It
requires analyzing potential investment opportunities and selecting the most profitable
ones.
3. Financing Decisions: Determining the optimal capital structure of the company by
deciding the right mix of debt and equity financing. This function aims to minimize
the cost of capital and maximize shareholder value.
4. Dividend Decisions: Deciding how much profit should be distributed to shareholders
in the form of dividends and how much should be retained for reinvestment. This
decision affects the company’s retained earnings and overall financial strategy.
5. Working Capital Management: Managing the company’s short-term assets and
liabilities to ensure operational efficiency and financial stability. It involves
overseeing cash, inventories, receivables, and payables.
6. Risk Management: Identifying, analysing, and mitigating financial risks that could
adversely affect the company’s assets and earning capacity. This includes managing
market risk, credit risk, and operational risk.
 7. Financial Reporting and Analysis: Preparing financial statements and analyzing them
to assess the company’s financial performance and make informed decisions.
8. Budgeting and Control: Developing budgets to guide the company’s financial
activities and implementing control measures to ensure adherence to these budgets.

These functions are interrelated and collectively contribute to the financial health and
strategic goals of the organization.

2. Relationship of Financial Management with Other Disciplines

Financial management does not operate in isolation; it is closely linked with various other
disciplines, each contributing to and drawing from financial principles:

1. Accounting: Accounting provides the financial data necessary for financial

management decisions. Financial managers use accounting information to analyse
performance, plan budgets, and make investment decisions.
2. Economics: Economic theories and principles, such as supply and demand, inflation,
and interest rates, influence financial decision-making. Financial managers use
economic indicators to forecast market trends and make strategic decisions.
3. Marketing: Marketing strategies impact sales and revenue, which in turn affect
financial planning. Financial managers work with marketing teams to allocate budgets
and assess the financial viability of marketing campaigns.
4. Operations Management: Efficient operations can lead to cost savings and improved
profitability. Financial managers collaborate with operations to optimise resource
allocation and manage operational budgets.
5. Human Resources Management: Compensation, benefits, and training programs have
financial implications. Financial managers assist HR in budgeting for these expenses
and analysing their return on investment.
6. Information Technology: IT systems support financial data processing and reporting.
Financial managers rely on IT for accurate and timely information to make informed
decisions.

The integration of financial management with these disciplines ensures a holistic approach to
organisational strategy and performance.

3. Elaborate Organisation of Financial Functions

The organization of financial functions within a company is structured to ensure effective
financial planning, control, and decision-making. The typical organisational setup includes:

1. Chief Financial Officer (CFO): The CFO oversees all financial activities, including
planning, risk management, record-keeping, and financial reporting.
2. Treasurer: Responsible for managing the company’s finances, including capital
structure, investments, and cash management. The treasurer ensures that the company
has sufficient liquidity to meet its obligations.
3. Controller: Handles accounting functions, such as financial reporting, budgeting, and
internal controls. The controller ensures the accuracy and integrity of financial
information.
4. Finance Manager: Assists in financial planning, analysis, and decision-making
processes. The finance manager evaluates financial performance and identifies areas
for improvement.
5. Internal Auditor: Evaluates the effectiveness of internal controls and compliance with
financial regulations. The internal auditor helps prevent fraud and ensures the
reliability of financial reporting.

The organization of financial functions may vary depending on the size and complexity of the
company. In smaller firms, roles may be combined, while larger organisations may have
more specialised positions.

Effective organization of financial functions facilitates efficient financial management,

supports strategic objectives, and ensures regulatory compliance.

II:- CAPITAL STRUCTURE AND THEORIES

Capital Structure Practices Followed by Indian

Companies

Capital structure refers to the mix of debt and equity that a company uses to finance its
operations and growth. In India, companies adopt diverse capital structure strategies
influenced by industry norms, regulatory frameworks, and market conditions.

1. Predominance of Equity Financing

Many Indian companies, especially in sectors like Information Technology (IT) and Fast-
Moving Consumer Goods (FMCG), prefer equity financing over debt. This preference is due
to factors such as:

• Risk Aversion: Equity financing reduces financial risk associated with fixed interest
obligations.
• Cash Flow Considerations: Companies with volatile cash flows avoid debt to prevent
default risks.
• Regulatory Environment: Equity financing is often encouraged by regulatory policies
that aim to maintain financial stability.

A study analyzing companies listed on the National Stock Exchange (NSE) from 2006-07 to
2015-16 found that a significant number maintained a debt-equity ratio below one, indicating
a strong inclination towards equity financing.

2. Industry-Specific Capital Structure Trends

Capital structure practices vary across industries:

• IT and Personal Care Sectors: These industries rely heavily on internal funds and
equity due to their asset-light models and consistent cash flows.
• Energy, Pharmaceutical, and Engineering Sectors: Companies in these sectors often
use a balanced mix of debt and equity to finance capital-intensive projects.
• Finance and Investment Sector: Firms in this sector tend to have higher debt levels,
leveraging borrowed capital to fund their operations.

An analysis of various industries revealed that 60% of sample companies had a debt-equity
ratio below one, highlighting a general preference for equity financing across sectors.

3. Regulatory Influences and Financial Instruments

Regulatory bodies like the Securities and Exchange Board of India (SEBI) influence capital
structure decisions through policies and instruments such as:

• Qualified Institutional Placements (QIPs): Introduced to facilitate quicker and more

efficient capital raising from institutional investors.
• Debenture Redemption Reserve (DRR): Mandated reserves to ensure the repayment
of debentures, impacting companies’ decisions on issuing debt instruments.
These regulatory measures aim to balance the interests of investors and companies,
promoting financial stability and investor protection.

4. Impact of Economic Factors

Economic conditions significantly affect capital structure choices:

• Interest Rate Fluctuations: High-interest rates may deter companies from taking on
debt, leading to a preference for equity financing.
• Market Volatility: During periods of market instability, companies might opt for
internal financing to avoid the risks associated with external capital.
• Tax Policies: Tax incentives on interest payments can make debt financing more
attractive, influencing companies to adjust their capital structures accordingly.

5. Strategic Capital Structure Adjustments

Indian companies often adjust their capital structures strategically to align with growth
objectives:

• Expansion Plans: Firms may increase debt to finance expansion projects, taking
advantage of tax benefits associated with interest payments.
• Mergers and Acquisitions: Companies might alter their capital structures to facilitate
acquisitions, balancing debt and equity to optimize financial performance.
• Restructuring Initiatives: In response to financial distress or changing market
conditions, firms may restructure their capital to improve liquidity and solvency.

In summary, Indian companies exhibit diverse capital structure practices influenced by

industry characteristics, regulatory frameworks, economic conditions, and strategic
objectives. While there is a general preference for equity financing, especially in less capital-
intensive sectors, companies strategically utilise debt to leverage growth opportunities and
optimize their financial performance.