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Important Questions in Corporate Finance

1. Define Financial Management?

Ans: financial management is that specialized activity which is responsible for obtaining and

affectively utilizing the funds for the efficient functioning of the business and, therefore, it

includes financial planning, financial administration and financial control.

2 State the primary objective of financial management?

Ans. To maximize the shareholders wealth.

3 State the decisions involved in financial management?

Ans..

a) Investment decision

b) Financing decision

c) Dividend decision

4 What is meant by Financial Planning?

Ans.. Financial planning means deciding in advance, the financial activities to be carried on

to achieve the basic objective of the firm. The basic objective of the firm is to get maximum

profits out of minimum efforts.

5 What are the objectives of financial planning?

Ans..
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a) to ensure availability of fund whenever required.

b) to see that the firm does not raise funds unnecessarily.

6 What is Working Capital?

Ans.. The capital required for day to day operations of the business is called Working capital.

7 State the difference between gross working capital and net working capital?

Ans.. Gross working capital is the sum/ aggregate of the current assets,

Whereas

Net working capital = Current assets – current liabilities.

8 What is meant by capital budgeting decision?

Ans.. A long term Investment decision is called capital budgeting decision.

9. When is financial leverage considered favorable?

Ans) Financial leverage is considered favorable when return on investment is higher than the

cost of debt.

10. How does production cycle effect working capital?

Ans) working capital requirement is higher with longer production cycle.

11. What do you mean by floatation cost?

Ans) Cost incurred for raising funds.

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12. What is capital structure of a company?

Ans.. Capital structure is the relative proportion of different sources of long term finance. In

other words Capital structure of a company refers to the make up of its capitalization

SHORT ANSWER QUESTIONS (2 Marks)

1. Are the share holders of a company likely to gain with a debt component in the

capital employed ? Explain with the help of an example?

Ans) The shareholders of a company are very likely to gain with debt component in the

capital employed by way of trading On equity as it increases the earning per share(EPS) of

the share holders.

2 Define current assets and Give four examples.

Ans. Current assets also called as floating assets or fluctuating assets are short term assets

whose value fluctuates in the short period. These assets are required to pay off the current

liabilities. For e.g. cash in hand/Bank, Inventory, Debtors. Bills receivable, Marketable

securities etc.

3 “To avoid the problem of shortage and surplus of funds, what is required in Financial

management? Name the concept and explain four points of importance.

[Link] Planning is required to avoid shortage or surplus of finance.

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Importance of financial planning is:

a) By planning utilization of finance, it reduces waste, duplication of efforts and gaps in the

planning.

b) It helps in coordinating the various business activities such as sales, purchases, production,

finance etc.

c) It is a technique of control. It helps in setting up standard and compare with the actual

performance. The deviations, if any are then analysed. Causes found out and corrective

measures are taken.

(d)It helps in avoiding shocks and surprises as proper provision regarding Shortage or surplus

is made in advance by anticipating future receipts and Payments.

4 Explain the role of ‘Operational efficiency’ in the determination of working capital

requirement.

Ans. The firm with a better operational efficiency has to invest less in working capital

because they convert raw materials quickly into finished goods, and sell them at their earliest.

i.e. converts stock into sales quickly.

b) Promptly collects debts from debtors and bills receivable.

5 Discuss how Working capital affects both the liquidity and profitability of a business.

Ans.

• Short term Investment decisions are concerned with the decisions about the level of

cash, inventory and debtors etc. (working capital)

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• Efficient cash management, Inventory management and receivable management are

essential ingredients of sound working capital management.

• The working capital should be neither more or less than required. Both the situations

are harmful. If the amount of working capital is more than required, it will no doubt

increase the liquidity but decrease the profitability. Similarly if there is a shortage of

working capital, it will face the problem of meeting day to day requirements.

• Thus optimum amount of current assets and current liabilities should be determined so

that the profitability of the business remains intact and there is no fall in the liquidity.

6 Why Capital budgeting decisions are more important?.

Ans. The long term Investment decision is called capital budgeting. It is more important due

to the following reasons:

a) Long term growth and affects: As capital budgeting decisions involve investment in long

term fixed assets, it affects the long term growth.

b) Large amount of funds involved: As huge amount of fund is blocked for a long period, the

decision should be taken rationally.

c) Risk involved: As such a decision affects the returns of the firm as a whole, it involves

more risk.

d) Irreversible decisions: These long term decisions taken once cannot be reversed back,

without incurring heavy losses. It will lead to waste of fund, if reversed.

Thus capital budgeting decisions should be taken after careful study and deep analysis.
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7 What is Financial risk? How does it arise?

Ans. It refers to the risk of the company not being able to cover its fixed financial cost. Fixed

financial cost includes payment of interest that is to be paid irrespective of profit.

The higher levels of risk are attached to higher degrees of financial leverage. If EBIT

(Earnings before interest and tax) decreases, financial risk increases as the firm is not in a

position to pay its interest obligations. Thus the risk of default is called Financial risk. The

firm should overcome the situation accordingly or will be forced towards liquidation.

LONG QUESTIONS ( 5/6 MKS)

[Link] are the determinant of capital structure of a company?

OR

‘Determination of capital structure of a company is influenced by a number of factors’

explain six such factors.

Ans. Capital structure refers to the relative proportion of different sources of long term

finance. Following factors are to be considered before determining capital structure.

a) Cash flow position: The cash available with the company should be enough to meet the

fixed interest liabilities. Interest on debt is to paid irrespective of profits. A company has

to meet working capital requirements, invest in fixed assets and also pay the interest and

principal amount of debt after a particular stipulated period. If cash position is sound, debt

van be raised, and if not sound debt should be avoided.

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b) Interest coverage ratio: it is the ratio that expresses the number of times the Net profit

before interest and tax covers the interest liabilities. Higher the ratio, better is the position of

the firm to raise debt.

c) Control: Issue of Equity shares dilutes the control of the existing shareholders , whereas

issue of debt does not as the debenture holders do not participate in the management decisions

as they are not the owners of the fir. Thus if control is to be retained, equity should be

avoided.

d) Stock market conditions: If the stock market is bullish, the investors are adventurous

and are ready to invest in risky securities, equity can be issued even at a premium whereas

in the Bearish phase, when the investors become cautious, debt should be issued as there is a

demand for fixed cost security.

e) Regulatory framework: Before determining the capital structure of a company , the

guidelines of SEBI and concerned regulatory authority is to be considered. For e.g companies

Act, Banking regulation Act etc are to considered.

f) Tax rate: As interest on debt is treated as an expense, it is tax deductable. Dividend on

equity is the distribution of profit so is not tax deductable. Thus if the tax rates are high, issue

of debt is an attractive means as it is economical in nature.

2. Explain briefly five factors determining the amount of fixed capital.

Ans. Fixed capital refers to the capital which is used for the purchase of fixed assets, such as

land, building, machinery etc.

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Following factors are to be considered before determining its requirement.

a) Nature of Business: If a firm is a manufacturing fir, it requires to purchase fixed assets

for the production process. It needs investment in fixed assets, so require more fixed capital.

Similarly if it is a Trading firm where the finished goods are only traded i.e purchased and

sold, it needs less fixed capital.

b) Scale of operations: larger the size and scale of operations larger is the requirement of the

fixed capital and vice versa.

c) Choice of technique: The Manufacturing firm using the modern, latest technology

machines has to invest more funds in the fixed assets, so they require more fixed capital. On

the other hand, firms using the traditional method of production where the task is performed

manually by the labourers, it requires less fixed capital.

d) Diversification: There are few firms and organizations who deal in a single product.

This investment in fixed assets is low, whereas the firms dealing in number of products

(Diversification) requires more investment in purchasing different fixed assets, it requires

more fixed capital.

e) Financing alternatives: If the manufacturing firm actually buys the assets and blocks

huge funds in the fixed assets, it requires more fixed capital. The companies who acquire the

fixed asset and use them by obtaining leasing facilities, it requires less fixed capital. Leasing

is suitable in high risk lines of business where huge funds should not be blocked in the fixed

assets.
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3. What is meant by Working capital? How is it calculated? Explain the determinants of

working capital requirements.

Ans. Working capital is the capital required for meeting day to day requirements/operations

of the business.

Net working capital= current assets – current liabilities

Following factors are to be considered before determining the requirement of working capital.

a) Scale of operations: There is a direct link between the scale of business and working

capital. Larger business needs more working capital as compared to the small organizations.

b) Nature of Business: The manufacturing organizations are required to purchase raw

materials, convert them into finished goods, maintain the stock of raw materials, semi

finished goods and finished goods before they are offered for sale. They have to block their

capital for labour cost, material cost etc, so they need more working capital. In the trading

firm processing is not performed. Sales are affected immediately after receiving goods for

sale. Thus they do not block their capital and so needs less working capital.

c) Credit allowed: If the inventory is sold only for cash, it requires less working capital as

money is not blocked in debtors and bills receivable. But due to increased competition, credit

is usually allowed. A liberal credit policy results in higher amount of debtors, so needs more

working capital.
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d) Credit availed: If goods are purchased only for cash, it requires more working capital.

Similarly if credit is received from the creditors, the requirement of working capital

decreases.

e) Availability of Raw materials: If the raw materials are easily available in the market and

there is no shortage, huge amount need not be blocked in inventories, so it needs less working

capital. But if there is shortage of materials, huge inventory is to be maintained leading

to larger amount of working capital. Similarly if the lead time is higher, higher amount of

working capital is required.

4. ‘Every Manager has to take three major decisions while performing the finance

function’ briefly explain them.

Ans. The three important decisions taken by the finance manager are as follows

1. Investment decision: It refers to the selection of the assets in which investment is to be made

by the company. Investment can be made in Long term fixed assets and short term current

assets. Thus Investment decision is divided in two parts:

(a) Long term Investment decisions: Such decisions are also called Capital Budgeting

decisions. It relates to the investment in long term fixed assets. As such decisions affects the

growth of the firm, it involves huge fund to be blocked for a long period, and such decisions

are irreversible in nature, they should be taken carefully after making a comparative study of

various alternatives available.

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(b) Short term Investment decision (Working capital decision): It refers to investment

in short term assets such as cash, inventory, debtors etc. Finance manager has to ensure that

enough working capital is available to meet the day to day requirements. It should also ensure

that unnecessarily high reserve of working capital should not be retains as it decreases the

profitability. Thus profitability and Liquidity are to be compared and appropriate amount kept

as working capital.

2. Financing decision: There are various sources of obtaining long term finance such as Equity

shares, preference shares, term loans, Debentures etc. For taking financing decision and

deciding the capital structure various factors are to be considered and an analysis of cost and

benefit is made.

3. Dividend decision: It refers to the decision related to the distribution of profit. The finance

manager has to decide as to how much amount of profit is to be distributed as Dividend

and how much to be retained in the business. If too much retained earnings are maintained,

it dissatisfies the shareholders as they receive less dividend. Similarly if a liberal dividend

policy is followed, though the shareholders are satisfies, but the firm does not have enough

reserve for future growth, expression, meeting contingency etc.

5. What is meant by ‘Financial management’ Explain its importance?

Ans. Financial management refers to that part of the management which is concerned

with the efficient planning and controlling the financial affairs of the enterprise. Financial

management plays the following role.-

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a) Determination of fixed assets: Fixed assets have an important contribution in increasing

the earning capacity of the business. Long term investment decisions also called capital

budgeting decision raise the size of fixed assets.

b) Determination of current assets: Current assets are needed to meet the day to day

transactions of the business. The total investment in current assets is to be determined and the

split up into its elements is required. For e.g. if it is decided to maintain current assets of Rs

10 lakh, further decision is to be made as to how much cash is required, how much amount to

be invested in debtors, stock etc.

c) Determination of long term and short term finance: Under this a Finance manager has

to maintain a proper ratio of short term and long term sources of finance after estimating its

requirement.

d) Determination of Capital Structure: A balanced decision related to capital structure is to

be made. The proportion of debt and equity is to be determined.

e) Determination of various items in the Profit and loss account-The financial decisions

affect the various items to appear in the profit and loss account. For e.g depreciation on fixed

assets, interest on debt etc.

6. Why Debt is cheaper source of finance?

Ans: Debt is always cheaper source of finance because of following reasons.

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a) Tax benefit: The firm gets an income tax benefit on the interest component that is

paid to the lender. Dividends to equity holders are not tax deductable.

b) Limited obligation to lenders: In the event of a firm going bankrupt, which is what

happened with Lehman Brothers, equity holders lose everything. But, debt holders

have the first claim on company assets (collateral), increasing their security. So since

debt has limited risk, it is usually cheaper. Equity holders are taking on more risk,

hence they need to be compensated for it with higher returns.

c) Limited upside: Since the equity holder has a stake in the business; he can

actually participate in the potential upside in earnings. PE, Venture Capital funds

usually buy stakes in high potential companies at cheap valuations, and since they

have a minority stake in the company, they are entitled to a share of the profits. Plus

they can exit after a few years at a fantastic premium. On the other hand debt holders

have an upside limited to the fixed rate of interest they receive every year.

Source: Collected by author, from very web sources like [Link]