27 Short Questions with Answers on “Financial Management” for Commerce Students:
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1. What are the merits and demerits of average rate of returns?
Merits:
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1. It is simple to compute.
2. It is based on accounting information which is readily available and familiar to business men.
3. It considers the benefits over the entire life of the project.
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Demerits:
1. It is based on accounting profit, not cash flow.
2. Does not take into account the time value of money.
3. The average rate of return is inconsistent The numerator of the ratio represents profit belonging to equity and preference stock holders whereas, the denominator represents fixed investments which is rarely equal to contribution of equity and preference stock holders.
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2. What is the net present value method of a cash flow project?
The net present value of a project is equal to the sum of the present value of all the cash flows associated with the project. Introduction of compound interest in the calculation gives the earlier receipts more weight age than the later ones. Under the present value method a minimum required rate of return is assumed and the calculation is made to use a present value amount which is compared with original investment to determine prospective profitability An investment is accepted if the present value of its cash inflows, discounted at a predetermined rate of return, equals or exceeds the amount of investment planned. The discounting factor is also referred to as the required earning rate.
3. Define benefit cost ratio
Benefit cost ratio can be defined in two ways:
Benefit cost ratio (BCR) = PVR/I
or Net benefit cost ratio = NBCR = PVB — I/I
where, PVB = Present value of benefits
I = Initial investment
B/C ratios are also called profitability indices.
4. A project which is being evaluated, has a cost of capital of 12%.
Initial investment = 100,000
Benefits: Year 1 =25,000
Year 2 = 40,000
Year 3 = 40,000
Year A =50,000
Find out the benefit cost ratio measures for the project and comment if the project should be accepted or not.
NBCR = BCR – 1 =0 145 The two ratio give the same signals, as the difference between them is unity.
When BCR When NBCR Thumb rule is
>1 >0 Accept
=1 =0 Indifferent
<1 <0 Reject
Since BCR is > 1 and NBCR is > 0, the project should be accepted.
5. What are the constituents of gross working capital?
Gross working capital is the total of all current assets. The constituents of current assets are:
Inventories
Raw materials and components
Work in progress
Finished goods
Trade debtors
Loans and advances
Investments
Cash and bank balances. Others
6. What is net working capital?
Net working capital is the difference between current assets and current liabilities. The current liabilities items are:
Sundry creditors Trade advances Borrowings Commercial banks Provisions Others
The constituents of current assets have been given in above question.
Hence, net working capital = current assets – current liabilities
7. What type of questions has to be answered while formulating the working capital?
While formulating the working capital one has to two questions:
1. What should be the ratio of current asset to sales?
2. What should be relationship between short term financing and long term financing?
8. What do you understand by a conservative and an aggressive current asset policy?
A conservative current asset policy is that in which the risk factor is reduced. The surplus current assets can easily absorb the variations in sales, production plans and procurement time However, lower risk factor results in lower profitability too.
An aggressive current asset policy, on the other hand, seeks to reduce investments in current assets. However, this exposes the firm to greater risk. It will be difficult for the company to absorb any favourable variations in sales and unfavourable changes in procurement and production operations. The compensation for higher risk is higher expected profitability.
9. On what factor does a conservative policy rely?
A conservative policy relies on short term bank financing and also on long term sources like debentures. A very highly conservative current asset financing policy would seek to replace even long term debt by equity.
10. On what factors does an aggressive policy rely?
Aggressive current asset financing policy relies heavily on short term bank finance and reduces dependence on long term finance.
An aggressive current asset financing policy which relies more on short term bank credit exposes the firm to higher degree of risk at the same time reducing the average cost of financing.
11. What do you mean by conservative, moderate and aggressive working capital policies?
A conservative overall working capital policy means that the firm chooses a conservative current asset policy and a conservative current asset financing policy. A moderate working capital policy reflects a combination of conservative and aggressive policies of current assets and current asset financing. An aggressive overall working capital policy consists of an aggressive current assets policy and an aggressive current asset financing policy.
12. Divide the operating cycle of firm into its several stages.
The operating cycle of a firm begins with the acquisition of raw materials and ends with the collection of receivables. It can be divided into four stages.
1. Raw materials and stores storage stage.
2. Work in process stage.
3. Finished goods inventory stage.
4. Collections of accounts receivables stage.
13. Write down the formula for calculating the duration of an operating cycle.
The duration of an operating cycle is equal to the sum of the duration of each of its stages less the credit period allowed by the suppliers of materials
0 = R +W+F +D-C
where, O = Duration of Operating Cycle
R = Raw Material and stores storage period
W = Work-in-progress period
F = Finished goods storage period
D = Debtors (Accounts receivables) collection period
C = Creditors Credit Period.
14. Write formula for calculating all the components of the duration of an operating cycle.
The components of the duration of an operating cycle (O = R + W + F + D – C) are calculated as follows:
Raw material and stores storage period (R) = Average stock of raw materials and stores/Average raw material and stores consumption per day
Work in progress period (W) = Average work in progress inventory/Average cost of production per day
Finished goods storage period (F) = Average finish goods inventory/Average cost of goods sold per day
Debtors collection period (D) = Average accounts receivable/Average credit sales per day
Creditors credit period (C) = Average trade accounts payable/Average credit purchases per day
15. On what factor do the working capital requirements depend in order to ensure proper working capital control?
Working capital requirement depends on the level of operations and the length of the operating cycle to ensure proper working capital control.
16. On what factors does the duration of the raw material stage depend?
The duration of the raw material stage depends on
(a) Regularity of supply
(b) Transportation time,
(c) Perishable nature of the material
(d) Economies of bulk purchases.
It can vary from a few days in the case of highly perishable materials to six months or more for imported raw materials.
17. On what factors does the duration of WIP stage and finished goods stage depend?
The duration of the WIP stage depends a great deal on the manufacturing process/cycle, balanced capacities at different stages, and efficient coordination in obtaining inputs
The duration at the finished goods stage depends on the pattern of production and sales. If production during the whole year is uniform, sales are seasonal or vice versa, the duration at the finished goods stage will naturally be long
18. Briefly describe the concept of working capital. What factors should be considered while deciding working capital policy?
There are two concepts of working capital—gross working capital and net working capital. Gross working capital is the total of all current assets. Net working capital is the difference between current assets and current liabilities. There are two important factors to be considered while deciding working capital policy:
(i) Ratio of current assets to sales
(ii) Ratio of short term financing to long term financing.
19. What should be the characteristics of current assets while managing working capital? What are the factors that influence the working capital needs of a firm?
While managing working capital there should be two characteristics of current assets
(i) Short life span
(ii) Swift transferability into other asset forms.
The working capital needs of a firm are influenced by:
(i) Nature of business
(ii) Seasonality of operations
(iii) Production policy
(iv) Market conditions
(v) Supply conditions.
20. What do you mean by the term ‘dividend’?
The term dividend refers to that part of profits of a company which is distributed by the company among its shareholders. It is the reward of the shareholders for investments made by them in the shares of the company.
21. How do legal restrictions work as determinants of dividend policy?
Legal provisions relating to dividends are significant because they lay down a framework within which dividend policy is formulated. These provisions require that dividend can be paid only out of current profits or past profits after providing for depreciation or out of the moneys provided by the Government for the payment of dividends in pursuance of a guarantee given by the Government.
The Companies (Transfer of Profits to Reserves) Rules, 1975 require a company providing more than ten percent dividend to transfer certain percentage of the current year’s profits to reserves. Companies Act, further, provides that dividends cannot be paid out of capital, because it will amount to reduction of capital adversely affecting the security of its creditors.
22. Describe magnitude and trend of earnings as determinants of dividend policy.
As dividends can be paid only out of present or past year’s profits, earnings of a company fix the upper limits on dividends. The dividends should, generally be paid out of current year’s earnings only as the retained earnings of the previous years become more or less a part of permanent investment in the business to earn current profits. The past trend of the company’s earnings should also be kept in consideration while making the dividend decision.
23. What is the net income approach of capital structure? When is a company said to be in high- gear and low-gear?
According to net income approach of capital structure, a firm can minimise the weighted average cost of capital and increase the value of the firm as well as market price of equity shares by using debt financing to the maximum possible extent.
A company is said to be in high-gear, when it has a proportionately higher issue of debentures and preference shares for raising the long-term resources whereas, low-gear stands for a proportionately large issue of equity shares.
24. (a) What is the difference between operating and financial leverage? (b) What do you mean by average cost of capital?
(a) The leverage associated with the employment of fixed cost assets is referred to as operating leverage, while the leverage resulting from the use of fixed cost source of funds is known as financial leverage.
(b) An average cost refers to the combined cost of various sources of capital such as debentures, preference shares and equity shares. It is the weighted average cost of the various sources of finance.
25. (a) Give few examples of capital expenditure. (b) On what principle pay-back method is based?
(a) (i) Cost of addition, expansion, improvement or alteration in the fixed assets, (ii) Cost of acquisition of permanent assets as land and building, plant and machinery, goodwill, etc. (iii) Research and development project cost, etc.
(b) It is based on the principle that every capital expenditure pays itself back within a certain period out of the additional earnings generated from the capital assets.
26. (a) For what reasons the net working capital concept is important? (b) What do you mean by receivables?
(a) (i) It is a qualitative concept which indicates the firm’s ability to meet its operating expenses and short-term liabilities, (ii) It is an indicator of the financial soundness of an enterprise.
(b) Receivables represent amounts owed to the firm as a result of sale of goods or services in the ordinary course of business. These are claims of the firm against the customers and form part of its current assets.
27. What is the Modigliani and Miller approach for dividend policy?
According to Modigliani and Miller approach, dividend policy has no effect on the market price of the shares and the value of the firm is determined by the earning capacity of the firm or its investment policy.