FINANCIAL

MANAGEMENT
CUEXAMS
2025
THEORY
SUGGESTIONS
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 GOBIND KUMAR JHA
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B.Com.(Semester – VI) Financial Management Theory

Suggested Questions & Answers for Cu Exams 2025

1. Interrelationship Between Financing Decision, Investment Decision, and

Dividend Decision

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Introduction:​
In financial management, a firm’s success largely depends on three fundamental decisions:
investment decision, financing decision, and dividend decision. These decisions are closely
linked and together determine the firm’s financial strategy and overall value.

Importance:​
Each decision influences the firm’s profitability, risk, and growth. Coordinating these decisions
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properly ensures efficient use of resources and maximizes shareholder wealth.

Main Points:

●​ Investment Decision:​
This decision, also called capital budgeting, involves choosing where to allocate funds
among various long-term assets or projects. The goal is to select investments that yield the
highest returns relative to risk. It shapes the firm’s future by deciding what assets to acquire
for generating profits.​

●​ Financing Decision:​
Once the investment needs are identified, the firm must decide the best way to finance
these investments. The financing decision involves selecting the optimal mix of debt, equity,
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or internal funds to fund the investments. This decision affects the firm’s capital structure,
cost of capital, and financial risk.​

●​ Dividend Decision:​
After generating profits, the firm decides how much of those earnings to distribute as
dividends to shareholders and how much to retain for reinvestment. The dividend decision
affects the company’s retained earnings, growth potential, and investor satisfaction.​

Interrelationship:​
The three decisions are interdependent and affect each other directly:

●​ The investment decision determines the amount of funds required, influencing the
financing decision on how to raise these funds.​
 ●​ The financing decision impacts the cost of capital and availability of funds, which can limit
or expand investment opportunities.​

●​ The dividend decision affects retained earnings, which is an internal source of finance
impacting future investments and financing needs.

2. Value Maximization Objective of a Firm and Its Difference from Profit

Maximization Objective

Introduction:​
Firms have different objectives guiding their decision making. Two major financial objectives are
value maximization and profit maximization. Understanding the difference is crucial for effective
financial management.

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Importance:​
The value maximization objective is considered more comprehensive and realistic because it
focuses on long-term growth and shareholder wealth, unlike profit maximization, which may
overlook key factors.

Main Points:
K ●​ Value Maximization Objective:​
This objective aims to increase the market value of the firm’s shares by maximizing the
wealth of shareholders. It considers the present value of expected future cash flows
generated by the firm’s projects, adjusted for risk and time value of money. This objective
emphasizes sustainable growth, risk management, and long-term financial health.​

●​ Profit Maximization Objective:​

Profit maximization aims to increase the firm’s accounting profits over a short period,
often focusing on maximizing earnings in the current period without considering the timing
or risk of returns. It ignores factors like cash flow timing, capital investment needs, and
shareholder wealth.​

●​ Differences Between Value Maximization and Profit Maximization:​

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○​ Time Frame: Value maximization focuses on long-term shareholder wealth, while
profit maximization often targets short-term earnings.​

○​ Risk and Uncertainty: Value maximization incorporates risk assessment and

discounting of future cash flows; profit maximization ignores risk and timing.​

○​ Measure of Success: Value maximization uses market value and cash flows; profit
maximization uses accounting profits which can be manipulated or misleading.​

○​ Shareholder Focus: Value maximization aligns with shareholders’ interests by

maximizing their wealth; profit maximization may not always benefit shareholders,
especially if profits are achieved by sacrificing long-term value.
3. Role of Chief Financial Executive in Policy Formulation and Decision
Making

Introduction:​
The Chief Financial Executive (CFO) is a vital member of the top management team responsible
for overseeing the financial activities of a firm. The CFO plays a crucial role in shaping financial
policies and guiding decision making to achieve the company’s strategic goals.

Importance:​
The CFO ensures the firm maintains financial stability, manages risks effectively, and uses
resources efficiently, which is critical for long-term success.

Main Points:

●​ Policy Formulation:​
The CFO actively participates in developing financial policies related to investment,

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financing, dividend distribution, budgeting, and working capital management. These policies
create a framework for consistent and disciplined financial operations.​

●​ Financial Planning and Forecasting:​

The CFO prepares detailed financial plans and forecasts that guide management in setting
realistic targets and allocating resources effectively. This helps the company anticipate
K future financial needs and challenges.​

●​ Decision Making Support:​

As a financial expert, the CFO provides critical insights and analysis to top management,
enabling informed decisions on major financial issues. This includes evaluating investment
proposals, financing options, and dividend policies.​

●​ Risk Management:​
The CFO identifies and manages financial risks through appropriate strategies, such as
hedging, insurance, or diversification. This protects the company’s assets and earnings.​

●​ Coordination and Communication:​

The CFO coordinates with other departments and communicates financial information
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clearly to stakeholders, ensuring transparency and alignment with the company’s
objectives.​

●​ Monitoring and Control:​

The CFO sets up financial controls and monitors performance against budgets and
policies. This helps detect deviations early and take corrective actions to maintain financial
health.​

4. Playback Period Method of Project Evaluation is Conceptually Unsound:

Critical Discussion

Introduction:​
The payback period method measures how long it takes to recover the initial investment of a
project from its cash inflows. It is a simple and popular technique for project evaluation.
Importance:​
Despite its popularity, this method has significant conceptual flaws that limit its usefulness for
making sound investment decisions.

Main Points:

●​ Advantages:​
The payback method is easy to understand and apply. It helps assess liquidity by showing
how quickly a project recovers the invested funds, which can be important for firms with
cash flow constraints.​

●​ Conceptual Weaknesses:​

○​ Ignores Time Value of Money: The method does not discount future cash flows. It
treats all cash inflows as equal regardless of when they occur, ignoring the
fundamental finance principle that money today is worth more than the same

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amount in the future.​

○​ Ignores Cash Flows After Payback: Once the initial investment is recovered, the
method ignores any additional cash inflows, which may be significant and affect
overall profitability.​
K ○​ No Consideration of Risk: The payback period method does not consider the risk
or uncertainty of future cash flows, which is essential for investment decisions.​

●​ Critical Evaluation:​
Because of these limitations, the payback period method is considered conceptually
unsound as a primary criterion for project evaluation. It can lead to rejecting profitable
long-term projects or accepting short-term projects with lower overall returns. However, it
remains useful as a supplementary tool for quick screening or liquidity analysis.​

●​ Better Alternatives:​
More comprehensive methods like Net Present Value (NPV) and Internal Rate of Return
(IRR) consider the time value of money, risk, and total profitability, making them preferable
for evaluating investment projects.​
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5. Aggressive and Conservative Current Asset Financing Policies

Introduction:​
Current asset financing policies refer to how a firm arranges funds to finance its current assets
such as inventory, accounts receivable, and cash. Choosing the right financing policy is important
for balancing cost and risk. Two main types of policies are aggressive and conservative financing
policies.

Aggressive Current Asset Financing Policy:​

In an aggressive policy, a firm finances most of its current assets using short-term funds like
bank loans or commercial paper. The firm relies heavily on short-term financing because it is
cheaper compared to long-term financing. Here, only a small portion of fixed assets and permanent
current assets are financed through long-term funds. The key characteristics of this policy are:
 ●​ Lower financing costs because short-term debt usually has lower interest rates.​

●​ Higher risk due to the uncertainty of renewing short-term funds when needed. If market
conditions change, short-term funds may not be available or may become expensive.​

●​ The firm has higher liquidity risk since it depends on continuously rolling over short-term
loans.​

Conservative Current Asset Financing Policy:​

In a conservative policy, a firm finances all its current assets and some portion of fixed assets with
long-term funds such as equity or long-term debt. This approach emphasizes safety and stability.
The features include:

●​ Higher financing costs since long-term funds carry higher interest rates or cost of equity.​

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●​ Lower risk because funds are secured for a longer period, reducing the risk of refinancing.​

●​ Greater liquidity and financial stability as the firm is not pressured by short-term funding
demands.​

Preference and Reasons:​

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Generally, firms prefer a conservative financing policy due to the following reasons:

●​ It provides financial stability by securing funds for longer periods, which is crucial during
economic uncertainty.​

●​ It lowers the risk of liquidity crises that could arise if short-term funds dry up suddenly.​

●​ It helps maintain the firm's creditworthiness and reputation by reducing dependence on

short-term borrowing.​

●​ Though more expensive, the conservative approach ensures smoother operations without
the stress of frequent refinancing
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6. Detailed Note on the Recommendations of Chore Committee

Introduction:​
The Chore Committee, appointed by the Government of India in 1949, was tasked with
examining the financial administration and control mechanisms in government-owned enterprises
and making recommendations for improvement.

Main Recommendations:

●​ Improvement of Financial Management:​

The committee emphasized the need for government enterprises to have sound financial
management practices. This included proper budgeting, cost control, and efficient use of
funds to avoid wastage.​
 ●​ Establishment of Financial Discipline:​
It recommended strict financial discipline within government undertakings to ensure that
expenditures were controlled, and resources were used economically and efficiently.​

●​ Regular Financial Reporting:​

The Chore Committee suggested that enterprises should maintain transparency by
preparing regular financial statements and submitting reports to government authorities.
This would help in monitoring performance and ensuring accountability.​

●​ Audit and Control Systems:​

It highlighted the importance of independent and thorough audits. Government
undertakings were advised to strengthen their internal control systems and be subject to
periodic audits to detect irregularities and improve financial integrity.​

●​ Autonomy in Financial Decisions:​

The committee encouraged enterprises to have some degree of financial autonomy to

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make timely and efficient decisions while being accountable for their financial performance.​

●​ Training and Development:​

It recommended the training of personnel involved in financial management to improve
their competence and ensure the implementation of recommended financial controls.
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7. Explain the Term ‘Dividend’ and ‘Dividend Policy’

Dividend:​
A dividend is the portion of a company’s profits that is distributed to its shareholders as a reward
for investing in the company. It represents a return on investment and is usually paid in the form of
cash, but sometimes it may be given as additional shares (called stock dividend) or other assets.
Dividends are declared by the company’s board of directors based on the company’s profitability,
liquidity, and future needs.

Dividend Policy:​
Dividend policy refers to the company’s strategy or guidelines for deciding the amount and timing
of dividend payments to shareholders. It determines how the profits earned by the company are
divided between distributing as dividends and retaining for business growth and expansion. The
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dividend policy reflects the company’s approach to balancing the interests of shareholders who
want returns and the company’s need to reinvest funds.

Importance of Dividend Policy:

●​ It impacts the company’s financial health by deciding how much profit is retained versus
paid out. Retained earnings help finance new projects and expansion, while dividends
provide income to shareholders.​

●​ A clear dividend policy helps build investor confidence because consistent or

well-explained dividend payments attract investors and enhance the company’s reputation.​

●​ It affects the company’s stock price; stable or increasing dividends often lead to a positive
market perception and higher stock value.​
 ●​ Dividend policy also influences the company’s liquidity management, ensuring that
dividend payments do not negatively affect day-to-day operations.​

Types of Dividend Policy:​

Some common types include:

●​ Stable Dividend Policy: The company pays a fixed dividend regularly, providing certainty
to shareholders.​

●​ Residual Dividend Policy: Dividends are paid from leftover earnings after financing all
profitable projects.​

●​ Hybrid Dividend Policy: Combines stable and residual policies to balance stability and
flexibility.​

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8. Long-Term Capital Investment Decisions of a Firm are Concerned with:
Capital Budgeting

Capital Budgeting:​
Capital budgeting is the process by which a firm plans and evaluates its long-term investment
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projects. These projects involve large expenditures on assets like machinery, buildings, or new
product development that will generate cash flows and returns over several years.

Key Aspects of Capital Budgeting:

●​ It involves identifying investment opportunities that align with the company’s strategic
goals.​

●​ The firm estimates the future cash inflows and outflows related to each project to assess
profitability.​

●​ Different financial techniques like Net Present Value (NPV), Internal Rate of Return (IRR),
and Payback Period are used to evaluate projects.​
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●​ Capital budgeting helps in resource allocation to projects that maximize shareholder
wealth.​

●​ These decisions are critical because they involve significant amounts of capital and impact
the company’s growth and financial health for many years.​

Why Capital Budgeting?​

Because long-term investments are usually irreversible or costly to reverse, careful analysis is
required to avoid bad investments that can harm the firm financially.

Clarification of Other Terms:

●​ Working Capital Management: Focuses on managing current assets and liabilities to

maintain liquidity and smooth operations. It deals with short-term financial decisions, not
 long-term investments.​

●​ Capital Structure: Refers to how a firm finances its overall operations and growth using
debt and equity, not investment decisions.​

●​ Dividend: Relates to profit distribution to shareholders, not investment in assets.

9. State Two Defects of Profit Maximization Objective of a Firm

Definition:​
Profit maximization refers to the goal of a business to earn the highest possible profit within a
given period. It is one of the oldest and most traditional objectives of a firm.

However, this objective has several limitations. Two major defects are:

1. Ignores the Time Value of Money

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Profit maximization treats all profits as equal, regardless of when they are earned. It does not
consider the time value of money, which means that a rupee earned today is more valuable than
a rupee earned in the future. This makes the objective unsuitable for evaluating long-term projects
where timing of cash flows is important.

2. Ignores Risk and Uncertainty

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Profit maximization focuses only on increasing earnings, without considering the risk involved. In
reality, different investment decisions carry different levels of risk. A firm may earn more profit
through risky investments, but this could also lead to losses. Therefore, ignoring risk makes the
objective unrealistic and potentially harmful in uncertain conditions.

10. Define ‘Financial Management’

Definition:​
Financial Management refers to the strategic planning, organizing, directing, and controlling
of financial activities in an organization. It focuses on the acquisition, allocation, and
management of funds to ensure financial stability and support the overall goals of the firm.
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Importance of Financial Management:

●​ Ensures adequate availability of funds for smooth business operations.​

●​ Helps in optimal use of financial resources by investing in the right projects.​

●​ Aims at maximizing shareholder value through proper decision-making.​

●​ Maintains financial discipline by controlling costs and monitoring performance.​

●​ Assists in managing business risks by making informed financial decisions.​

Main Functions of Financial Management:

1. Investment Decision

It involves deciding where to invest the company’s funds to earn maximum returns. This includes
long-term investment (capital budgeting) and short-term investment (working capital management).

2. Financing Decision

It determines the sources of finance, such as equity, debt, or internal funds. The goal is to choose
the best mix of financing to minimize the cost of capital.

3. Dividend Decision

This relates to the portion of profit to be distributed among shareholders and how much to retain in
the business. A proper balance supports both investor satisfaction and future growth.

4. Liquidity Management

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It ensures the firm has enough cash to meet day-to-day expenses and short-term obligations,
avoiding insolvency.

13. What is ‘Term Loan’?

Definition:​
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A term loan is a type of loan that a company borrows from a bank or financial institution for a
specific period, usually to finance long-term capital needs. The borrower agrees to repay the loan
amount in fixed instalments (monthly, quarterly, or yearly) over a set loan tenure, along with
interest.

Key Features of Term Loan:

●​ Time Period: Generally medium to long-term, ranging from 1 year to 10 years or more.​

●​ Repayment: Paid back in regular instalments that include both principal and interest.​

●​ Interest Rate: Can be fixed or floating, depending on the agreement with the lender.​

●​ Purpose: Used for purchasing fixed assets like machinery, land, building, etc., or for
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business expansion.​

●​ Security: Often secured by collateral, such as company assets or property.

Importance:

Term loans are crucial for financing large projects or asset purchases, and they provide financial
stability by spreading repayments over time. This helps companies manage cash flow and plan for
future operations efficiently.

14. What is ‘Explicit Cost of Capital’?

Definition:​
The explicit cost of capital refers to the actual cost of obtaining capital from a specific source,
such as debt, equity, or preference shares. It is the rate of return that a company must pay to the
providers of capital in exchange for the funds.

In simple terms, it is the known and measurable cost of raising capital, often expressed as a
percentage.

Key Characteristics of Explicit Cost of Capital:

●​ Measurable: It is a clearly defined cost, such as the interest rate on a loan or dividend on
preference shares.​

●​ Cash Outflow: It involves actual payment of interest, dividends, or returns to investors or

lenders.​

●​ Used in Capital Budgeting: Helps in evaluating the cost-effectiveness of financing a

project from a particular source.​

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●​ Example: If a company borrows ₹10 lakhs at 10% interest per year, the explicit cost of debt
is 10%.​

Importance:​
Knowing the explicit cost helps the company to compare different sources of finance and choose
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the most cost-effective option. It also plays a vital role in calculating the Weighted Average Cost
of Capital (WACC), which is essential for investment decisions.

15. State Two Assumptions of Net Operating Income (NOI) Approach of

Capital Structure Theory

Definition:​
The Net Operating Income (NOI) Approach is a theory under capital structure that suggests the
value of a firm and its overall cost of capital (Ko) remain constant regardless of the capital
structure. This approach believes that the method of financing (more debt or more equity) does not
affect the firm’s total market value.

According to NOI Approach, changes in debt-equity mix do not influence the total cost of
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capital or value of the firm.

Two Main Assumptions of NOI Approach:

1. Overall Capitalization Rate (Ko) Remains Constant

It is assumed that the overall cost of capital (Ko) of the firm does not change with a change in
the capital structure. Even if the firm increases debt (which has lower cost), the cost of equity
(Ke) rises due to increased financial risk. This adjustment keeps Ko constant. So, the benefit of
cheaper debt is exactly offset by the increased cost of equity.

2. The Market Capitalizes the Firm as a Whole Based on NOI

Under the NOI approach, it is assumed that the market values the firm based on its Net
Operating Income (NOI) and not on the capital structure. The firm's overall value is calculated
by dividing its net operating income by the overall capitalization rate. Therefore, the total market
value remains unaffected by whether the firm is financed more by debt or equity.

16. What is Capital Structure of a Firm?

Definition:​
The capital structure of a firm refers to the mix or proportion of long-term sources of finance
used by a company to fund its operations and growth. It shows how a firm finances its overall
assets and activities through a combination of equity, debt, preference shares, and retained
earnings.

It is an important part of financial planning and management, as the right capital structure helps
the firm manage risk and cost of capital efficiently.

Main Components of Capital Structure:

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●​ Equity Capital: Funds raised by issuing ordinary shares. Equity shareholders are the
actual owners of the company and bear the highest risk.​

●​ Debt Capital: Funds raised through loans or debentures. Debt carries a fixed interest
burden and must be repaid after a certain period.​

●​ Preference Capital: Hybrid securities that have fixed dividend payments and priority over
K equity in case of liquidation.​

●​ Retained Earnings: Profits reinvested into the business instead of being distributed to
shareholders.​

Importance of Capital Structure:

●​ It affects the firm’s financial stability and flexibility.​

●​ It helps in minimizing the cost of capital, thereby maximizing the value of the firm.​

●​ A balanced structure maintains a healthy debt-equity ratio, reducing financial risk.​

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●​ It supports the firm in raising future funds easily by showing a strong financial base.​

●​ It plays a crucial role in maximizing shareholders’ wealth in the long run.

17. What Do You Mean by Conservative Working Capital Policy?

Definition:​
A conservative working capital policy is a financial strategy where a firm maintains a high level
of current assets (like cash, inventory, receivables) compared to its current liabilities. The aim is
to reduce the risk of liquidity problems by ensuring there is enough working capital available at all
times.

In this policy, the firm relies more on long-term funds (like equity or long-term loans) rather than
short-term borrowings to finance both fixed assets and current assets.
Key Characteristics:

●​ High Level of Current Assets: The company maintains more cash, inventory, and
receivables to avoid shortage.​

●​ Low Risk of Liquidity Issues: There is less chance of failing to meet short-term
obligations.​

●​ Higher Financing Cost: Since the firm uses long-term funds (which are costlier than
short-term), the overall cost of capital is higher.​

●​ Lower Profitability: Due to idle current assets and higher cost of funds, profits may be
lower compared to other policies.

18. Mention Any Two Sources of Working Capital Finance from Bank

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Definition:​
Working capital finance refers to the short-term funds a firm requires to meet its day-to-day
operational expenses, such as purchasing raw materials, paying wages, or managing inventory.
Banks provide several types of working capital loans to help businesses meet these needs.

Two Main Sources of Working Capital Finance from Banks:

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1. Cash Credit

Cash credit is a popular facility where the bank allows the business to borrow up to a certain
limit, usually against the security of inventory or receivables. The borrower can withdraw funds as
needed and only pays interest on the amount actually used.

2. Overdraft Facility

An overdraft allows the company to withdraw more money than is available in its current
account, up to a specified limit. This facility is granted for a short term and interest is charged on
the overdrawn amount only. It helps in managing short-term cash shortages.

19. State Four Advantages of Value Maximization Objective of the Firm. Who
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is a Chief Financial Officer (CFO)?

Value Maximization Objective – Meaning:

The value maximization objective means the main goal of a firm is to maximize the wealth of
its shareholders. It focuses on increasing the market value of the company’s shares over the
long term. This approach looks beyond short-term profits and considers long-term financial growth
and stability.

Four Advantages of Value Maximization Objective:

1.​ Long-Term Growth Focus:​

It encourages the firm to invest in projects that provide long-term returns rather than just
short-term profits. This helps in sustainable growth and strong business development.​
 2.​ Improves Shareholder Wealth:​
Since the aim is to increase the market price of shares, it leads to better returns for
shareholders, which increases their confidence and loyalty.​

3.​ Efficient Use of Resources:​

Resources are used more effectively because only those projects or investments are
selected which have a positive impact on the firm's value.​

4.​ Better Decision-Making:​

It provides a clear goal for financial decision-making. All decisions—investment, financing,
and dividend—are evaluated based on their impact on firm value.​

Who is a Chief Financial Officer (CFO)?

A Chief Financial Officer (CFO) is the senior-most executive in the finance department of a

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company. The CFO is responsible for managing the financial activities of the firm, including
financial planning, risk management, record keeping, and financial reporting.

Main Roles of a CFO:

●​ Preparing and analyzing financial statements​

K ●​ Making key financial decisions and policies​

●​ Managing budgets and capital structure​

●​ Ensuring legal and regulatory compliance in financial matters​

●​ Advising top management on financial strategy

20. Explain the Advantages of Preference Shares

Meaning of Preference Shares:

Preference shares are a type of share capital that gives shareholders a fixed rate of dividend
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and priority over equity shareholders in the payment of dividends and repayment of capital in case
of liquidation. However, they usually do not have voting rights.

Advantages of Preference Shares:

1.​ Fixed Rate of Dividend:​

Preference shareholders receive a fixed and regular dividend, making it a stable source
of income, similar to interest on loans.​

2.​ Priority in Dividend and Capital Repayment:​

In case of liquidation, preference shareholders are paid before equity shareholders,
which makes them more secure than equity investors.​

3.​ No Dilution of Control:​

Since preference shares generally do not carry voting rights, issuing them does not affect
 the control of existing equity shareholders.​

4.​ Useful for Raising Long-Term Capital:​

Companies can raise long-term funds without increasing debt or giving up control, which is
especially useful during expansion.​

5.​ Flexibility in Payment:​

For cumulative preference shares, if a company cannot pay dividends in one year, it can
carry forward the obligation to the next year, providing flexibility to the company.

21. What Are the Features of Institutional Financing? (H)

Meaning:

Institutional financing refers to the financial assistance provided by specialized financial

institutions to businesses for their growth and development. These institutions include banks,

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development finance institutions (DFIs), insurance companies, and mutual funds.

They offer medium- and long-term funds in the form of loans, debentures, underwriting, and
equity participation to support industrial and infrastructure development.

Key Features of Institutional Financing:

K 1.​ Long-Term Funding Support:​
Institutions provide medium to long-term financial assistance, which helps companies in
financing fixed assets like land, building, and machinery.​

2.​ Focused on Industrial Development:​

These institutions are mainly aimed at promoting industrial and economic
development, especially in backward or priority sectors.​

3.​ Lower Interest Rates and Flexible Terms:​

Compared to commercial banks, institutional finance often comes with lower interest
rates and customized repayment terms suited to the nature of the project.​

4.​ Technical and Managerial Support:​

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Many institutions also offer technical, managerial, and project advisory services to
ensure that the funded projects are successful.​

5.​ Promotion of Balanced Regional Development:​

They support projects in economically weaker or underdeveloped regions, helping to
reduce regional imbalances.​

6.​ Strict Project Appraisal:​

Institutions conduct detailed project evaluations before financing to ensure feasibility,
which promotes responsible borrowing and efficient project execution.

22. Explain the Term ‘Systematic Risk’ with Example (G)

Meaning of Systematic Risk:

Systematic risk refers to the type of risk that arises from factors affecting the entire economy
or financial market as a whole. It is also known as market risk or non-diversifiable risk,
because it cannot be avoided or eliminated through diversification of investments.

This type of risk is linked to macro-economic variables such as inflation, interest rates, political
instability, economic recession, changes in government policy, natural disasters, or global crises. It
affects all businesses, industries, and investments regardless of their individual
performance.KJ

Key Characteristics of Systematic Risk:

●​ Economy-Wide Impact:​
It affects the entire market or economy at the same time and cannot be restricted to a
single industry or company.​

●​ Uncontrollable in Nature:​

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Since it arises due to external economic or political conditions, investors or companies
cannot control or avoid it.​

●​ Not Reduced by Diversification:​

Even if a portfolio contains a mix of different industries or asset classes, systematic risk
still remains. Diversification helps reduce unsystematic risk only.​
K ●​ Relevant to All Investors and Firms:​
Both small and large investors, as well as all types of firms, are exposed to systematic risk
in equal proportion.​

●​ Measured by Beta (β):​

In finance, systematic risk of a security is measured by Beta. A higher beta indicates
greater sensitivity to market movements.​

23. What are the Functions of Financial Management?

Financial management refers to the strategic planning, organizing, directing, and controlling of
financial activities within an organization. It ensures efficient financial decision-making, which is
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crucial for the company's stability, profitability, and growth.

1. Investment Decisions

●​ Capital Budgeting: Selecting long-term assets or projects that maximize profits, such as
buying new machinery, expanding operations, or investing in research.
●​ Risk Evaluation: Analyzing potential financial risks associated with investments to
minimize losses and ensure stable returns.
●​ Portfolio Management: Managing a mix of investments (stocks, bonds, real estate) to
optimize returns and reduce risk.

2. Financing Decisions

●​ Capital Structure Optimization: Determining the right mix of debt and equity to finance
the company while minimizing financial risk.
 ●​ Fundraising Strategies: Identifying sources of funding, such as issuing shares, borrowing
from banks, or reinvesting profits.
●​ Cost of Capital Management: Ensuring the company secures funds at the lowest possible
cost to maximize profitability.

3. Dividend Decisions

●​ Profit Distribution Strategy: Deciding how much of the profit should be distributed to
shareholders and how much should be retained for reinvestment.
●​ Investor Relations: Maintaining a balance between rewarding shareholders and keeping
funds available for company growth.
●​ Impact on Market Value: Ensuring dividend policies enhance stock prices and maintain
investor confidence.

4. Liquidity Management

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●​ Cash Flow Optimization: Ensuring the company has enough cash to cover short-term
expenses such as salaries, rent, and supplier payments.
●​ Working Capital Management: Managing inventories, receivables, and payables
efficiently to prevent financial strain.
●​ Avoiding Idle Funds: Preventing excessive cash accumulation, which reduces profitability
by limiting investment opportunities.
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5. Risk Management

●​ Financial Risk Assessment: Identifying risks such as market fluctuations, credit defaults,
and operational inefficiencies.
●​ Hedging and Insurance Strategies: Using financial instruments like futures and insurance
policies to mitigate risks.
●​ Economic Stability Measures: Preparing for external uncertainties like inflation,
recession, or regulatory changes.

24. Discuss the Role of Retained Earnings as a Source of Corporate Finance.

Retained earnings refer to the portion of net income that a company keeps instead of distributing
as dividends. It serves as a crucial internal source of financing for business expansion and
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financial stability.

1. Business Growth and Expansion

●​ Funding Expansion Projects: Used for opening new branches, entering new markets, or
acquiring assets.
●​ Supporting Innovation: Helps finance research and development (R&D) for new products,
technology, or business improvements.
●​ Enhancing Competitive Advantage: Allows companies to improve production processes
or marketing strategies to stay ahead in the market.

2. Financial Stability

●​ Building Reserves: Acts as a financial cushion for emergencies, economic downturns, or

unexpected losses.
 ●​ Reducing Dependence on External Funds: Lowers reliance on loans or external
investments, minimizing interest costs and debt obligations.
●​ Strengthening Creditworthiness: A strong retained earnings balance improves financial
stability and makes it easier to secure loans.

3. Shareholder Value

●​ Stock Price Appreciation: A strong retained earnings balance enhances company

valuation, increasing share prices.
●​ Long-Term Wealth Creation: Reinvesting earnings leads to higher future profits, benefiting
shareholders indirectly.
●​ Reinvestment for Growth: Instead of paying large dividends, companies use retained
earnings to expand operations, boosting shareholder wealth.

4. Debt Reduction

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●​ Loan Repayment: Used to pay off debts, reducing interest burden and improving financial
health.
●​ Lowering Financial Risk: Reduces the overall financial risk by maintaining a low
debt-to-equity ratio.
●​ Improving Borrowing Capacity: Companies with strong retained earnings and low debt
can secure additional funding easily.
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5. Internal Funding Source

●​ Cost-Effective Financing: Eliminates the need for external fundraising through loans or
issuing new shares.
●​ Flexible Resource Allocation: Can be reinvested as needed, without restrictions from
external financiers.
●​ Maintaining Financial Independence: Reduces reliance on investors or lenders, giving
the company more control over its operations.

25. What is Trading on Equity?

Trading on Equity refers to the practice of using borrowed funds (debt) to increase a company's
returns on equity capital. This strategy helps businesses maximize their earnings by leveraging
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financial resources.

Key Features of Trading on Equity

●​ Use of Debt Financing: Companies issue bonds, take loans, or borrow funds instead of
using only shareholder equity.
●​ Increased Earnings Per Share (EPS): If the return on investments made using debt is
higher than the cost of borrowing, shareholders benefit from increased profits.
●​ Higher Financial Risk: Excessive reliance on debt may lead to financial instability,
especially during economic downturns.
●​ Optimal Capital Structure: Businesses aim to balance debt and equity to achieve financial
efficiency while minimizing risk.
●​ Investor Attraction: When managed properly, trading on equity enhances shareholder
wealth, making the company attractive to investors.
26. What do you mean by working capital? Why is working capital necessary for a
business?

Meaning of Working Capital

Working capital refers to the difference between a company’s current assets (cash, inventory,
receivables) and current liabilities (short-term debts, payables). It represents the funds needed
for day-to-day business operations.

Formula:​

Importance of Working Capital in a Business

1.​ Ensures Smooth Operations

○​ Provides the necessary funds to cover short-term expenses like salaries, rent, and

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utility bills.
2.​ Maintains Liquidity
○​ Ensures a company has sufficient cash flow to manage unexpected financial needs
or emergencies.
3.​ Supports Business Growth
○​ Helps invest in inventory, marketing, and product development, ensuring sustainable
expansion.
K 4.​ Enhances Creditworthiness
○​ A strong working capital position improves the company’s ability to secure loans and
negotiate favorable credit terms.
5.​ Reduces Financial Risk
○​ Prevents the risk of insolvency by ensuring the company can meet its short-term
debt obligations.
6.​ Strengthens Supplier Relationships
○​ Enables timely payments to suppliers, avoiding penalties and ensuring smooth
procurement of raw materials.
7.​ Improves Profitability
●​ Efficient working capital management helps reduce unnecessary expenses, optimizing
overall profitability.
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27. Financial Policy of Current Assets in a Conservative Approach

A firm that follows a conservative policy in maintaining current assets adopts a low-risk
strategy, ensuring high liquidity and financial stability. This policy focuses on maintaining more
current assets than needed, even at the cost of lower profitability.

Key Features of a Conservative Financial Policy for Current Assets

1.​ High Level of Current Assets

○​ The firm maintains excess cash, inventories, and receivables, ensuring smooth
business operations.
○​ The focus is on financial security, even if it means lower returns.
2.​ Minimal Dependence on Short-Term Borrowings
○​ The company avoids excessive short-term loans and relies on internal funds for
working capital needs.
 ○​ This reduces the risk of liquidity crises.
3.​ Higher Working Capital Requirement
○​ A conservative firm maintains large working capital, ensuring enough funds to
cover day-to-day expenses.
○​ This prevents financial strain but might result in idle cash.
4.​ Reduced Financial Risk
○​ By maintaining more liquid assets, the firm minimizes solvency risks during
uncertain economic conditions.
○​ This approach prioritizes stability over aggressive expansion.
5.​ Lower Profitability
●​ Since the company keeps excess liquid assets, fewer funds are invested in high-return
opportunities.
●​ This results in lower earnings compared to firms with aggressive financial policies.

28. Short Note on Accounting Rate of Return (ARR)

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Accounting Rate of Return (ARR) is a financial metric used to evaluate the profitability of an
investment. It measures the expected return on an asset relative to its initial investment cost,
using accounting profits instead of cash flows.

Formula:
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Key Points about ARR:

1.​ Uses Net Operating Income

○​ ARR is calculated using the average profit generated by the investment, excluding
interest and taxes.
2.​ Expressed as a Percentage
○​ ARR is shown in percentage form, making it easy to compare different projects.
3.​ Ignores Time Value of Money
○​ Unlike discounted cash flow methods (NPV, IRR), ARR does not consider future
cash value depreciation.
4.​ Helps in Capital Budgeting Decisions
○​ Businesses use ARR to assess whether an investment is financially worth
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pursuing based on expected profits.
5.​ Simple and Easy to Calculate
●​ ARR is straightforward, making it a quick tool for estimating returns, but it may lack
precision due to ignoring cash flows.

29. Distinguishing Features of Capital Budgeting Decisions

Capital budgeting refers to the process of evaluating and selecting long-term investments that
require substantial financial resources. These decisions significantly impact a company's future
financial performance and growth.

Key Features of Capital Budgeting Decisions

1.​ Long-Term Investment Decisions

○​ Involves selecting assets or projects that will generate benefits over multiple years.
 ○​ Examples include expanding facilities, acquiring machinery, and launching new
products.
2.​ High Financial Commitment
○​ Requires large capital investment, making accurate evaluation essential.
○​ Poor decisions can lead to financial instability for the firm.
3.​ Irreversible Decisions
○​ Once funds are invested, reversing the decision is difficult and costly.
○​ Requires careful assessment before committing resources.
4.​ Risk and Uncertainty
○​ Long-term investments carry significant risks due to changing market conditions,
competition, and economic fluctuations.
○​ Requires thorough risk analysis and financial forecasting.
5.​ Impact on Profitability
○​ Capital budgeting decisions influence a firm's future earnings and financial
stability.
○​ Wrong decisions can reduce profitability or lead to financial losses.

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6.​ Evaluation Methods
○​ Companies use techniques such as Net Present Value (NPV), Internal Rate of
Return (IRR), Payback Period, and Profitability Index to assess investment
viability.
○​ These methods help in comparing projects and selecting the most profitable ones.
7.​ Influence on Business Strategy
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●​
Decisions align with the company's long-term goals and strategic vision.
Determines growth opportunities, market expansion, and competitiveness.

30. What do you mean by EBIT-EPS Analysis? Discuss its importance in financing decision.

Meaning of EBIT-EPS Analysis

EBIT-EPS Analysis refers to the evaluation of different financing options to determine their
impact on a company's earnings per share (EPS) at various levels of Earnings Before Interest
and Taxes (EBIT). It helps businesses decide whether to finance their operations using debt,
equity, or a mix of both.

●​ EBIT (Earnings Before Interest and Taxes): Represents the company's operating profit
before deducting interest and taxes.
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●​ EPS (Earnings Per Share): Measures the company's profitability per share, calculated as:​

Importance of EBIT-EPS Analysis in Financing Decision

1.​ Capital Structure Selection

○​ Helps companies compare debt financing vs. equity financing, choosing the
option that maximizes EPS.
○​ Higher debt increases financial risk, but also boosts EPS if the return on
investment is higher than the cost of borrowing.
2.​ Impact of Interest Costs
○​ Debt financing reduces net income due to interest payments, affecting EPS.
○​ Companies analyze different levels of EBIT to determine if debt is sustainable and
profitable.
 3.​ Risk Assessment
○​ EBIT-EPS analysis helps evaluate the trade-off between risk and return, ensuring
companies do not over-leverage.
○​ Provides insights into financial stability and profitability under different economic
conditions.
4.​ Decision on Expansion and Growth
○​ Determines whether additional debt or equity should be raised to fund expansion.
○​ Higher EPS signals financial strength, making the company more attractive to
investors.
5.​ Investor Confidence
●​ Investors prefer companies with strong EPS growth, as it indicates profitability.
●​ Companies aim for higher EPS while maintaining financial stability.

31. Discuss the significance of operating leverage and financial leverage.

1. Operating Leverage

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Operating leverage measures the impact of fixed costs on a company's profitability. Higher
operating leverage means a significant portion of expenses are fixed, which magnifies the
effect of changes in sales on profits.

Importance of Operating Leverage

K ●​ Higher Profitability: When sales increase, companies with high operating leverage
experience larger profit growth, as fixed costs remain constant.
●​ Break-Even Analysis: Helps determine the minimum sales level required to cover fixed
costs.
●​ Risk Assessment: High fixed costs increase risk during downturns, as profits decline
sharply if sales decrease.
●​ Cost Efficiency: Encourages businesses to optimize operations to reduce unnecessary
fixed costs.

Formula:​

2. Financial Leverage
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Financial leverage measures the impact of debt financing on a company's returns. Higher
financial leverage means the company uses more borrowed funds, which can magnify profits
but also increase financial risk.

Importance of Financial Leverage

●​ Boosts Shareholder Returns: If the return on assets is higher than interest costs,
financial leverage increases EPS.
●​ Affects Creditworthiness: Excessive debt can harm financial stability, making it difficult
to secure further loans.
●​ Risk vs. Reward Trade-Off: Companies must balance profitability and financial risk,
ensuring optimal debt levels.
●​ Enhances Capital Efficiency: Allows businesses to finance expansion without issuing
new shares, preserving ownership control.
Formula:​

32. What do you mean by Discounted Payback Period Method?

The discounted payback period method is a capital budgeting technique used to determine the
time required to recover the initial investment in a project, considering the time value of money.
Unlike the simple payback period, this method discounts future cash flows to their present
values before calculating the recovery time.

Key Features of the Discounted Payback Period Method

1.​ Time Value of Money Considered

○​ Future cash flows are discounted using a predetermined rate to reflect their
actual worth today.

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2.​ Measures Investment Recovery
○​ Determines the period within which the present value of cash inflows equals the
initial investment.
3.​ More Accurate than Traditional Payback Period
○​ Since it accounts for the declining value of money over time, it provides a better
assessment of investment risk.
4.​ Helps in Project Evaluation
K ●​ Useful in comparing different investment opportunities, prioritizing those with quicker
discounted payback periods.

Formula:

33. Features of Optimum Capital Structure

An optimum capital structure refers to the ideal combination of debt and equity financing that
minimizes the cost of capital while maximizing shareholder value and financial stability.

Key Features of an Optimum Capital Structure

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1.​ Balanced Debt and Equity Mix
○​ The company maintains a proper ratio of borrowed funds (debts) and owner’s
funds (equity) to achieve stability.
2.​ Minimized Cost of Capital
○​ The structure ensures minimum financing costs, leading to higher profitability
and lower financial burden.
3.​ Financial Flexibility
○​ Enables the company to raise funds easily for future expansion without excessive
risk.
4.​ Maintains Liquidity and Solvency
○​ A well-structured capital mix ensures enough liquidity to meet short-term
obligations while avoiding insolvency.
5.​ Enhances Shareholder Returns
 ○​ The firm selects financing options that maximize earnings per share (EPS),
making it attractive to investors.
6.​ Risk Management
○​ Keeps financial risk at an optimal level by preventing excessive debt that may
lead to financial distress.
7.​ Adaptability to Economic Changes
●​ An effective capital structure adjusts to market fluctuations, maintaining financial stability
in economic downturns.

34. Role of Debenture in Company Financing

A debenture is a long-term debt instrument used by companies to raise funds from investors,
without offering ownership stakes. It serves as a key financing tool, allowing businesses to meet
their capital and expansion needs efficiently.

Importance of Debenture in Company Financing

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1.​ Reliable Source of Long-Term Funds
○​ Companies issue debentures to finance large projects, avoiding dependence on
short-term loans.
2.​ Fixed Interest Payments
○​ Investors receive a fixed interest rate, making debentures attractive for stable
financing options.
K 3.​ Non-Dilution of Ownership
○​ Since debentures do not provide voting rights, companies retain full control over
management decisions.
4.​ Enhances Financial Stability
○​ Serves as a secured or unsecured loan, helping firms meet liquidity needs without
immediate repayment pressure.
5.​ Tax Benefits
○​ Interest paid on debentures is considered a tax-deductible expense, reducing the
company’s taxable income.
6.​ Flexible Terms
○​ Companies can issue convertible debentures, allowing investors to convert them
into shares later.
7.​ Diversifies Financing Options
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●​ Acts as an alternative funding mechanism alongside bank loans and equity financing.

35. What do you mean by Internal Rate of Return? Discuss its Accept and Reject Rule.

Meaning of Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is a capital budgeting metric used to evaluate the profitability of
an investment or project. It represents the discount rate at which the net present value (NPV) of
future cash flows equals zero. In simpler terms, IRR is the rate of return that makes an
investment break even over time.

Formula for IRR

The IRR is found by solving the following equation:​

Where:

●​ C_t = Cash inflow in time period t

●​ t = Time period
●​ IRR = Internal Rate of Return

Accept and Reject Rule for IRR

Companies use IRR to decide whether to accept or reject investment proposals:

1.​ Accept the Project (IRR > Cost of Capital)

○​ If IRR is greater than the required rate of return (cost of capital), the project is
considered profitable and accepted.

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○​ Higher IRR means better returns compared to the company’s financing costs.
2.​ Reject the Project (IRR < Cost of Capital)
○​ If IRR is lower than the cost of capital, the project is not financially viable and
rejected.
○​ A lower IRR indicates that the project’s returns do not justify the investment.
3.​ Indifference (IRR = Cost of Capital)
●​ If IRR equals the required rate of return, the company may consider other factors like
K risk, market conditions, and strategic benefits before deciding.

Limitations of IRR

●​ Does not always provide reliable results when comparing mutually exclusive projects.
●​ Assumes cash inflows are reinvested at the IRR, which may not be realistic.
●​ Can give multiple IRRs in case of irregular cash flows.

36. Short Note on: Dividend Policy and Retained Earnings

Dividend Policy

A dividend policy refers to a company’s approach to distributing profits to shareholders in the

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form of dividends. It determines how much of the earnings are paid and how much is retained
for reinvestment.

Types of Dividend Policies:

1.​ Stable Dividend Policy: Fixed or gradually increasing dividend payments regardless of
fluctuations in earnings.
2.​ Constant Payout Ratio: Dividends are paid as a fixed percentage of profits, leading to
variable payouts.
3.​ Residual Dividend Policy: Dividends are paid after meeting all reinvestment needs,
prioritizing business growth.

A well-defined dividend policy maintains investor confidence and influences stock market
performance.

Retained Earnings
Retained earnings refer to the portion of net income that a company keeps instead of
distributing as dividends. It serves as an internal source of funding for future expansion, debt
repayment, and financial stability.

Importance of Retained Earnings:

1.​ Supports Business Growth: Used for new investments, acquisitions, and modernization.
2.​ Improves Financial Strength: Acts as a financial cushion during economic downturns or
unexpected losses.
3.​ Enhances Shareholder Value: Boosts company valuation by reinvesting profits into
productive activities.
4.​ Reduces Dependence on Debt: Helps minimize borrowing costs, reducing financial risk.

A balance between dividend payouts and retained earnings is essential for ensuring long-term
financial health and business expansion.

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37. What do you mean by Profitability Index?

Meaning of Profitability Index (PI)

The Profitability Index (PI) is a capital budgeting tool that measures the profitability of an
investment relative to its cost. It helps companies rank investment projects by evaluating their
return potential.
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Formula for Profitability Index

Interpretation of Profitability Index

●​ PI > 1: The project is profitable and acceptable because its present value of cash flows
exceeds the initial investment.
●​ PI = 1: The project is break-even, meaning no profit or loss, requiring further analysis.
●​ PI < 1: The project should be rejected as it generates less value than the cost incurred.

Importance of Profitability Index in Decision Making

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1.​ Efficient Resource Allocation: Helps prioritize projects with higher profitability.
2.​ Considers Time Value of Money: Takes into account discounted cash flows, making it
more accurate than simple ROI calculations.
3.​ Useful for Comparing Projects: Helps businesses select the best investment option
when evaluating multiple projects.
4.​ Aligns with NPV Method: Both PI and Net Present Value (NPV) offer insights into
investment viability.