NCERT Solution For Class 12 Business Studies Financial Management Chapter 9

NCERT Books Solutions For Class 12 Business Studies Financial Management

Takshila Learning’s NCERT Solutions for Business Studies are an advanced and next stage of Class 11 NCERT Solutions in business studies. We provide the basic fundamentals of the subject in Class 11 and then move on to an advanced degree of concepts in Class 12. The business studies topics are related to our practical life and dealt with in an easy way for understanding.

NCERT Solutions For Class 12 Business Studies Financial Management Chapter 9 provides us with all-inclusive information on all concepts. As students would have to learn the basics about the subject in class 12, this curriculum for class 12 is a comprehensive study material, which explains the concepts in a great way.

Questions Covered In Class 12 Business Studies Financial Management

Multiple Choice:

1. The cheapest source of finance is

• (a) debenture
• (b) equity share capital
• (c) preference share
• (d) retained earning

Ans: (d) The cheapest source of finance has been retained. Retired income refers to the net income or portion of an organization’s profits that it holds after paying dividends. An organization can reorganize its projected earnings or profits for purpose expansion, modernization, and more. There is neither any fund raising cost nor any risk involved. Also, unlike other sources of finance, it does not include any obligation in terms of repayment.

2. A decision to acquire a new and modern plant to upgrade an old one is a

• (a) financing decision
• (b) working capital decision
• (c) investment decision
• (d) None of the above

Ans: (c) The decision to acquire a new and modern plant to upgrade an old one is an investment decision. Investment decision refers to the decision in which to invest, so as to earn the highest possible return. The decision to acquire a new plant is a long-term investment decision and it affects long-term working and earning potential of the business. On the other hand, working capital decisions refer to investment decisions that affect the day-to-day functioning of the business. Whereas, financing decisions refer to decisions in relation to the sources from which the funds can be raised.

3. Other things remaining the same, an increase in the tax rate on corporate profit will

• (a) make the debt relatively cheaper
• (b) make the debt relatively the dearer
• (c) have no impact on the cost of debt
• (d) we can’t say

Ans: (a) When the tax on corporate profits increases, debt becomes relatively cheaper. The reason for this is that the interest that is to be paid to the debtors is deducted from the total income before calculating the value of the tax. Thus, as the value of tax increases, debt becomes relatively cheaper.

4. Companies with a higher growth potential are likely to

• (a) pay lower dividends
• (b) pay higher dividends
• (c) dividends are not affected
• (d) none of the above

Ans (a) Companies with higher growth potential are likely to pay lower dividends. This is because companies with high growth potential have higher investment plans and require larger funds to invest. Thus, they keep a large portion of their earnings to finance the required investment and, thus, pay a lower dividend.

5. Financial leverage is called favourable if

• (a) Return on investment is lower than the cost of debt
• (b) ROI is higher than the cost of debt
• (c) Debt is easily available
• (d) If the degree of existing financial leverage is low

Ans: (b) Financial uplift refers to the ratio of debt to overall capital. This is called a favorable situation when the return on investment exceeds the cost of the loan. In other words, as the return on investment increases, earnings per share also increase and financial leverage is said to be favorable.

6. Higher debt-equity ratio results in

• (a) lower financial risk
• (b) higher degree of operating risk
• (c) higher degree of financial risk
• (d) higher EPS

Ans: (c) A high debt-equity ratio refers to a situation where the ratio of debt to total capital is high. This means a high level of financial risk. This is because in the case of debt, it is mandatory for the business to make interest payments and return the principal to the debtors. Thus, high lending increases the financial risk to the business.

7. Higher working capital usually results in

• (a) higher current ratio, higher risk and higher profits
• (b) lower current ratio, higher risk and profits
• (c) higher equity, lower risk and lower profits
• (d) lower equity, lower risk and higher profits

Ans: (a) The working capital of a firm refers to the amount of current assets that exceed current liabilities. If a company has a high working capital then there will be a higher current ratio (ie assets more than current liabilities), higher risk and higher profits.

8. Current assets are those assets which get converted into cash

• (a) within six months
• (b) within one year
• (c) between one year and three years
• (d) between three and five years

Ans: (b) Current assets are those assets that can be converted into cash or used to pay off liabilities within a time period of 12 months, i.e. within a year. Some examples of current assets are cash, cash equivalents, inventions, debtors, bill receipts, etc.

9. Financial planning arrives at

• (a) minimising the external borrowing by resorting to equity issues
• (b) entering that the firm always have significantly more fund than required so that there is no paucity of funds
• (c) ensuring that the firm faces neither a shortage nor a glut of unusable funds
• (d) doing only what is possible with the funds that the firms has at its disposal

Ans: (c) The objective of financial planning is to ensure that the firm suffers neither shortage nor any shortage (excess) of unusable funds. If there is a shortage of funds, the firm will not be able to fulfill its planned activities and commitments. On the other hand, if additional funds are available it increases the cost of business and also encourages wastage of money. Thus, financial planning focuses on ensuring the availability of sufficient funds at just the right time.

10. Higher dividend per share is associated with

• (a) high earnings, high cash flows, unstable earnings and higher growth opportunities
• (b) high earnings, high cash flows, stable earnings and high growth opportunities
• (c) high earnings, high cash flows, stable earnings and lower growth opportunities
• (d) high earnings, low cash flows, stable earnings and lower growth opportunities

Ans: (d) If a company pays a high dividend per share, it is associated with higher earnings because if they earn a higher income, they will be able to pay a higher dividend; High cash flow in the form of payment of dividends includes cash outflows; Stable income in the form of fixed income means that the company is confident of its future earnings prospects; And lower growth opportunities because it requires less of the paid income and their earning potential while reducing the amount of dividends paid.

11. A fixed asset should be financed through

• (a) a long term liability
• (b) a short term liability
• (c) a mix of long and short term liabilities

Ans : (a) Fixed assets are those assets that are invested in the company for a long period, typically over a year. Since these assets have a long-term impact on the business in terms of growth and profitability, they should be financed through long-term liabilities such as long-term debt, preference shares, retained earnings, and more.

12. Current assets of a business firm should be financed through

• (a) current liability only
• (b) long-term liability only
• (c) both types (i.e. Long and short liabilities)

Ans: (c) Current assets are those assets that convert to cash or cash equivalents within a short period of time and provide liquidity to a business. To finance the current assets of a business, both types of liabilities (short and long) can be used.

Short Answer Type:

1. What is meant by capital structure?

Ans: Capital structure refers to a combination of borrowing funds and owner funds that a firm uses to finance its fund requirements. Thus, the money borrowed consists of loans, public deposits, debentures etc. and owners’ funds include preference share capital, equity share capital, acquisition earnings etc. Commonly, capital structure is referred to as the combination of debt and equity that a firm uses to finance its funds. It is calculated as the ratio of debt and equity or debt to total capital used by the firm.

Capital Structure is

Or,

The ratio of debt and equity used by the firm affects its financial risk and profitability. While on the one hand, debt is a cheaper source of finance than equity and reduces the overall cost of capital, but greater use of debt, on the other hand, increases financial risk for the firm. Thus, decisions regarding capital structure should be taken with utmost care. Capital structure is said to be optimal when the ratio of debt and equity is such that earnings per share increase.

2. Discuss the two objective of Financial Planning.

Ans: Financial planning involves designing a firm’s financial operations. This ensures that the right funds are available at the right time for organizational operations. This ensures that it functions smoothly. Through financial planning, keeping growth and performance in mind, companies estimate how much fund will be required at what time. The following are the two main objectives of financial planning.(i) Ensuring availability of funds: One of the main objectives of financial planning is to ensure that the right amount of funds is available at the right time. This involves estimating the correct amount of fund that is required for various business functions over the long term as well as day to day operations. In addition, it also involves estimating the time at which the money will be required.

(ii) Proper utilization of funds: The objective of financial planning is to make full use of funds. This ensures that both insufficient funds and excess funds are avoided. Insufficient funds impede smooth operations and the firm is unable to meet its commitments. On the other hand, the additional funds add to the cost of business and encourage unnecessary wasted expenditure. Thus, financial planning ensures that the funds are properly and optimally utilized.

3. What is financial risk? Why does it arise?

Ans: Financial risk refers to a situation when a company is not able to meet its fixed financial charges such as interest payments, preference dividends and repayment obligations. In other words, it refers to the possibility that the company will not be able to meet its prescribed financial obligations. It arises when the ratio of debt to capital structure increases. This is because it is mandatory for the company to pay interest charges on the loan along with the principle amount. Thus, the higher the loan, the higher will be its payment obligations and thus the possibility of default on higher payment. Therefore, greater use of debt leads to higher financial risk for the company.

4. Define a ‘current asset’. Give four examples of such assets.

Ans: A firm’s current assets refer to assets that can be converted to cash or cash equivalents in a short period of time, that is, less than one year. Such assets are used for day to day business operations. Since they can be easily converted into cash or cash equivalents, these assets provide liquidity to the company. Firms acquire such assets to meet their various payment obligations. However, such assets provide very low returns and, thus, are less profitable. Current assets can be financed through short-term and long-term sources.Some examples of current assets are short-term investments, debtors, stock and cash equivalents.

5. Financial management is based on three broad financial decisions. What are these?

Ans: Financial management refers to the efficient acquisition, allocation and utilization of company funds. It invests in three main dimensions of financial decisions, investment decisions, financial decisions and dividend decisions.Investment decisions: Investment decisions refer to decisions where to invest so as to earn the highest possible return on investment. Investment decisions can be made for long term as well as short term.Long-term investment decisions are also known as capital budgeting decisions that affect the long-term earning potential and profitability of a business. For example, investing in a new machine, purchasing a new building, etc. are long-term investment decisions.Short-term investment decisions are also known as working capital decisions that affect the day-to-day operations of a business. For example, decisions regarding cash or bill receipts are short-term investment decisions. Financial decisions: Such decisions involve identifying different sources of funds and deciding the best combination to raise funds. The main sources for fund raising are shareholders’ funds (referred to as equity) and borrowing funds (referred to as debt). A company should judiciously decide the combination of debt and equity to be used, based on the cost, risk and profitability involved. For example, while debt is considered the cheapest source of finance, high debt increases financial risk. Financial decisions taken by a company affect its overall cost of capital and financial risk. Dividend decision:The decision includes the decision about the distribution of the company’s profit or surplus. A company can distribute its profit in the form of dividends to its shareholders or keep it to itself. Under the dividend decision, a company decides what proportion of surplus is to be distributed as dividends and to be retained as retained earnings. The aim is to maximize shareholders’ wealth while maintaining the income required for repurchases.

6. What are the main objectives of financial management? Briefly explain

Ans: The paramount objective of financial management is to maximize shareholders’ wealth. That is, the basic objective of financial management for a company is to select the financial decisions that prove profitable from the point of view of shareholders. Shareholders are asked when the market value of their shares increases. The market value of shares increases when the profit from financial decisions exceeds the costs involved in taking them. Thus, financial decisions should be made such that there is some value addition and eventually the equity share price increases. When a financial decision is able to fulfill the primary objective of wealth maximization, other objectives such as proper utilization of funds, maintenance of liquidity, etc. are automatically accomplished.

7. How does working capital affect both the liquidity as well as profitability of a business?

Ans: The working capital of a business refers to the excess of current assets (such as cash in hand, debtors, stocks, etc.) over current liabilities. Working capital affects both liquidity as well as profitability of a business. As the amount of working capital increases, the liquidity of the business increases. However, as current assets offer lower returns, the profitability of the business falls with an increase in working capital. For example, an increase in the inventory of a business increases its liquidity but since the stock is kept idle, profitability falls. Low working capital, on the other hand, hinders the operation of day trading. Thus, working capital should be such that maintains a balance between profitability and liquidity.

Long Answer Type:

1. What is working capital? How is it calculated? Discuss five important determinants of working capital requirement.

Ans: Every business needs to make decisions regarding investment in existing assets i.e. working capital. Current assets refer to assets that are converted into cash or cash equivalents in a short period of time (less than or equal to one year). There are two broad concepts of working capital, gross working capital and net working capital.Gross working capital (or, working capital only) refers to investments made in current assets. Net working capital, on the other hand, refers to the amount of current assets that exceed current liabilities. Thus, current liabilities are those compulsory payments due for payment such as bills due, outstanding expenses, creditors, etc. Net working capital is calculated as the difference of current assets over current liabilities. meaning.NWC = Current Assets – Current Liabilities

The following are the five determinants of working capital requirement:(i) Type of business: The working capital requirement of a firm depends on the nature of its business. An organization that works in services or business will not require much working capital. This is because such organizations involve shorter operational cycles and no processing is done. In this, the raw materials are similar to the output and the sales transaction takes place immediately. In contrast, a construction firm involves large operating cycles and has to convert raw materials into finished goods before the final sales transaction takes place. Thus, such companies require large working capital. (ii) Scale of operation:Another factor determining the need for working capital is the scale of operations in which the firm deals. If a firm is running on a large scale, the need for working capital increases. This is because such firms would be required to maintain a high stock of inventory and debtors. Conversely, if the scale of operation is small, the working capital requirement will be less. (iii) Business Cycle Fluctuations: The working capital requirements are changed by a firm at different stages of the business cycle. During the boom period, the market flourishes and thus, leads to higher sales, higher output, higher stock and debtors. Thus, the need for working capital increases during this period. As opposed to this, in the depression period there is less demand, less production and sales, etc. Thus, the need for working capital is reduced.(iv) Production cycle: The period between the conversion of raw materials to finished goods is called production cycle. The duration of the production cycle varies for different firms, based on which the working capital requirement is determined. If a firm has a long period of production cycle, That is, if there is a long time gap between the receipt of raw materials and their conversion to final finished goods, there will be a high need for working capital due to inventions and related expenses. On the other hand, if the production cycle is short the working capital requirement will be less. (v) Growth prospects: Higher growth and expansion is related to higher production, more sales, more inputs etc. Thus, companies with high growth potential require high amounts of working capital and vice versa.

2. ”Capital structure decision is essentially optimisation of risk-return relationship”. Comment.

Ans: Capital structure refers to the combination of different financial sources used by a company to raise funds. The sources of raising funds can be classified into two categories on the basis of ownership, borrowed funds and owners’ funds. The money borrowed is in the form of loans, debentures, borrowings from banks, public deposits, etc. On the other hand, the wealth of the owners is in the form of reserves, preference share capital, equity share capital, retained earnings, etc. Capital structure refers to the combination of borrowed funds and owners’ funds. For simplicity, all borrowed money is referred to as debt and all owners’ money as equity. Thus, capital structure refers to the combination of debt and equity used by the company. The capital structure used by the company depends on the risk and returns of various alternative sources.

Both debt and equity include their respective risk and profitability considerations. While on one hand, debt is a cheaper source of finance, but on the other hand involves more risk, although equities are comparatively expensive, they are relatively safe.The cost of the loan is low as it involves less risk for the lenders as they earn an assured amount of return. Whereby they require a lower rate of return which reduces costs to the firm. Additionally, the interest on the loan is subtracted from the taxable income (i.e. the interest that is to be paid to the debt security holders is deducted from the total income before paying the tax). Thus, higher returns can be achieved through low cost loans. Conversely, fund raising through equity is expensive because it also involves some flotation costs. In addition, dividends are paid after tax benefits to shareholders. Although debt is cheaper, higher debt increases financial risk. This is due to the fact that the loan involves a mandatory payment to the lenders. Any default in payment of interest can lead to liquidation of the firm. As opposed to this, there is no such obligation in case of dividend payment to shareholders. Thus, higher debt is related to higher risk.Another factor that affects the choice of capital structure is the returns given by various sources. The return given by each source determines the value of earnings per share. A higher use of debt leads to an increase in earnings per share of the company (this situation is called trading on equity). This is because as the difference between the return on debt investment increases and the cost of debt increases, EPS also increases. Thus, there is a high return on debt. However, even though higher debt leads to higher returns but it also increases risk for the company.Therefore, decisions about capital structure must be taken very carefully, which includes return and risk.

3. ”A capital budgeting decision is capable of changing the financial fortunes of a business”. Do you agree? Why or why not?

Ans: Yes, a capital budget decision is a very necessary decision, which must be taken carefully. It has the potential to change the financial fortunes of a business. Capital budgeting decisions refer to decisions related to the allocation of fixed capital for various projects. Such decisions include investment decisions regarding the acquisition, expansion, modernization and replacement of new assets. Such long-term investments include purchasing plants and machinery, furniture, land, buildings, etc., and also expenses such as the launch, modernization and advertising of a new product. They have long-term effects on business and are irreversible except for one giant. Cost. They affect the long-term growth, profitability and risk of the business.The following are the factors that highlight the importance of capital budgeting decisions:(i) Long Term Implications: Returns investment on future capital assets (long term assets). By which they affect the future prospects of the company. The company’s long-term growth prospects depend on the capital budget decisions it takes.(ii) Huge funds: Fixed capital consists of large amount for investment. This makes capital budgeting decisions all the more important because large amounts of money remain blocked for a long time. It is difficult to change these decisions once made. Thus, capital budgeting decisions need to be taken cautiously after detailed study from the total requirement of funds and the sources from which they are to be raised.(iii) High Risk:Fixed assets involve large amounts of money and with it huge risks. Such decisions are risky because they have an impact on the long-term survival of the company. For example, a decision about the purchase of new machinery involves the risk of whether the return from the machinery will exceed the cost incurred on it.(iv) Immutable Decisions: These decisions once made are irreversible. Reversing capital budget decisions involves huge costs. This is because once a project is heavily invested, withdrawing it will mean huge losses.

4. Explain the factors affecting the dividend decision.

Ans: The dividend decision of a company relates to which part of the profit is to be distributed among the shareholders as dividend and which portion is to be retained as retained income. The following are the factors that influence the dividend decision.(i) Amount of earnings: A firm pays dividends from its current and past earnings. This implies that income plays a major role in the dividend decision. A company with a higher income would be in a position to pay a greater amount of dividends to its shareholders. Conversely, a company with low or limited income will distribute less dividends.

(ii) Stable income: When a company has stable and smooth earnings, they are in a position to distribute higher dividends than companies that have unstable earnings. In other words, a company with a consistent and stable income can distribute a large amount of dividends.(iii) Stable dividends: Companies usually follow the practice of stabilizing their dividends. They try to avoid constant fluctuations in dividends per share and choose to increase (or decrease) the value only when there is a steady increase (or decline) in the company’s earnings.(iv) Growth Prospects: Companies aiming for higher growth levels or expanding operations carry a larger share of earnings for reinvestment. Thus, the dividend of such a company is smaller than that of companies with low growth opportunities.(v) Cash flow position: Cash outflow is required for dividend payment. If a company is low on cash, the dividend will be lower than a company that has more liquidity. Even if a company has more profit, it will not be able to distribute enough dividends, if it does not have enough cash.  vi) Shareholders’ preference:A company should take shareholders’ preferences into consideration when distributing dividends. For example, if shareholders prefer at least a fixed dividend amount, the company is likely to declare the same.(vii) Taxation policy: Taxation policy plays an important role in deciding dividends. If the taxation policy is such that a higher rate of tax is levied on dividend distribution, then companies are likely to distribute less dividends. On the other hand, it may prefer to distribute higher dividends when the tax rate is low.(viii) Stock Market Reactions: The amount of dividend distributed by a company affects its stock market prices. An increase in dividend by a company is seen by investors as a good sign and the stock price of the company increases. On the other hand, declining dividends adversely affect stock prices. Thus, when making a dividend decision, a company must consider potential stock market reactions.(ix) Contractual Constraints: Sometimes when lending to a company, the lender may impose some restrictions in the form of agreement. These restrictions may be related to dividends paid in the future. In such cases, the company will have to take such agreements into consideration when distributing dividends.  (x) Access to capital market:Companies that have greater access to capital markets pay higher dividends. The reason for this is that they can earn less due to market access and rely more on other sources. Smaller companies that have less access to capital markets pay lower dividends.(xi) Legal bottlenecks: Companies have to follow the rules and policies laid down by the Companies Act. Thus, any company should take care of such restrictions and policies before declaring a dividend.

5. Explain the term ”Trading on Equity”. Why, when and how it can be used by a company?

Ans: Trading on equity refers to the practice of increasing the ratio of debt to capital structure as earnings per share increase. A company favors trading on equity when the rate of return on investment is higher than the rate of interest on the borrowed fund. That is, the company resolves to trade on equity in the event of favorable financial gain. As the difference between the rate of return on investment and the rate of interest on debt increases, the earnings per share increase. The use of trading on equity is explained in detail with the following example.Suppose that there are two conditions for a company. In such a situation I raise a fund of Rs.5,00,000 through equity capital and in another situation, it raises the same amount through two sources – Rs.2,00,000 through equity capital and the remaining Rs through borrowing. . 3,00,000.Also assume that the tax rate is 30% and interest on borrowings is 10%. Earnings per share (EPS) in two situations are calculated as follows.

Clearly, in the second situation the EPS is greater than in the first situation. In the second situation the company takes advantage of the Trading on Equity and raises the EPS. Here, the return on investment calculated as is 20% while the interest on the borrowings is 10%. Thus, the Trading on Equity is profitable.

However, it should be noted that Trading on Equity is profitable and should be used only when the return on investment is greater than the interest on borrowed funds. In case the return on investment is less than the rate of interest to be paid, the Trading on Equity should be avoided.

Suppose instead of Rs 1,00,000 the company earns just Rs 25,000. In such a case the EPS are calculated as follows.

Clearly in this case, the EPS in Situation II falls. Here the return on investment is only 8% while the interest on the borrowings is 10%.

Thus, in this situation the Trading on Equity is not favourable and should be discouraged. Hence, it can be said that a firm can use Trading on Equity if it is earning high profits and can increase the EPS by raising more funds through borrowings.