Financial Management Objective questions

Financial Management

Question 1. What Is The Financial Management Reform?

Answer :The Financial Management Reform is the new policy framework that had been adopted by the Fiji Government to improve performance and accountability.

Question 2. What Are The Main Responsibilities Of A Chief Financial Officer Of An Organization?

Answer :Responsibilities of Chief Financial Officer (CFO):

The chief financial officer of an organization plays an important role in the company’s goals, policies, and financial success. His main responsibilities include:

 Financial analysis and planning: Determining the proper amount of funds to be employed in the firm.

 Investment decisions: Efficient allocation of funds to specific assets.

 Financial and capital structure decisions: Rising of funds on favorable terms as possible, i.e., determining the composition of liabilities.

Risk Management: Protecting assets.

Question 3. Discuss Conflict In Profit Versus Wealth Maximization Objective?

Answer :Profit maximization is a short–term objective and cannot be the sole objective of a company. It is at best a limited objective. If profit is given undue importance, a number of problems can arise like the term profit is vague, profit maximization has to be attempted with a realization of risks involved, it does not take into account the time pattern of returns and as an objective it is too narrow. Whereas, on the other hand, wealth maximization, is a long-term objective and means that the company is using its resources in a good manner.

If the share value is to stay high, the company has to reduce its costs and use the resources properly. If the company follows the goal of wealth maximization, it means that the company will promote only those policies that will lead to an efficient allocation of resources.

Question 4. Differentiate Between Financial Management And Financial Accounting?

Answer :Though financial management and financial accounting are closely related, still they differ in the treatment of funds and also with regards to decision - making.

Treatment of Funds: In accounting, the measurement of funds is based on the accrual principle. The accrual based accounting data do not reflect fully the financial conditions of the organization. An organization which has earned profit (sales less expenses) may said to be profitable in the accounting sense but it may not be able to meet its current obligations due to shortage of liquidity as a result of say, uncollectble receivables. Whereas, the treatment of funds, in financial management is based on cash flows. The revenues are recognized only when cash is actually received (i.e. cash inflow) and expenses are recognized on actual payment (i.e. cash outflow).

Thus, cash flow based returns help financial managers to avoid insolvency and achieve desired financial goals.

Decision-making: The chief focus of an accountant is to collect data and present the data while the financial manager’s primary responsibility relates to financial planning, controlling and decision- making. Thus, in a way it can be stated that financial management begins where financial accounting ends.

 Question 5. Explain The Relevance Of Time Value Of Money In Financial Decisions?

Answer :Time value of money means that worth of a rupee received today is different from the worth of a rupee to be received in future. The preference of money now as compared to future money is known as time preference for money.

A rupee today is more valuable than rupee after a year due to several reasons:

 Risk: there is uncertainty about the receipt of money in future.

 Preference for present consumption

 Most of the persons and companies in general, prefer current consumption over future consumption.

 Inflation: In an inflationary period a rupee today represents a greater real purchasing power than a rupee a year hence.

 Investment opportunities: Most of the persons and companies have a preference for present money because of availabilities of opportunities of investment for earning additional cash flow.

Many financial problems involve cash flow accruing at different points of time for evaluating such cash flow an explicit consideration of time value of money is required.

Question 6. Explain Briefly The Limitations Of Financial Ratios?

Answer :The limitations of financial ratios are listed below:

Diversified product lines: Many businesses operate a large number of divisions in quite different industries. In such cases, ratios calculated on the basis of aggregate data cannot be used for inter-firm comparisons.

Financial data are badly distorted by inflation: Historical cost values may be substantially different from true values. Such distortions of financial data are also carried in the financial ratios.

Seasonal factors may also influence financial data.

To give a good shape to the popularly used financial ratios (like current ratio, debt- equity ratios, etc.): The business may make some year-end adjustments. Such window dressing can change the character of financial ratios which would be different had there been no such change.

Differences in accounting policies and accounting period: It can make the accounting data of two firms non-comparable as also the accounting ratios.

There is no standard set of ratios against which a firm’s ratios can be compared: Sometimes a firm’s ratios are compared with the industry average. But if a firm desires to be above the average, then industry average becomes a low standard. On the other hand, for a below average firm, industry averages become too high a standard to achieve.

Question 7. What Do You Understand By Weighted Average Cost Of Capital?

Answer :Weighted Average Cost of Capital:

The composite or overall cost of capital of a firm is the weighted average of the costs of various sources of funds. Weights are taken in proportion of each source of funds in capital structure while making financial decisions. The weighted average cost of capital is calculated by calculating the cost of specific source of fund and multiplying the cost of each source by its proportion in capital structure. Thus, weighted average cost of capital is the weighted average after tax costs of the individual components of firm’s capital structure. That is, the after tax cost of each debt and equity is calculated separately and added together to a single overall cost of capital.

Question 8. Explain In Brief The Assumptions Of Modigliani-miller Theory?

Answer : Assumptions of Modigliani – Miller Theory:

Capital markets are perfect. All information is freely available and there is no transaction cost.

All investors are rational.

No existence of corporate taxes.

Firms can be grouped into “Equivalent risk classes” on the basis of their business risk.

Question 9. What Is Optimum Capital Structure? Explain.

Answer : Optimum Capital Structure: Optimum capital structure deals with the issue of right mix of debt and equity in the long-term capital structure of a firm. According to this, if a company takes on debt, the value of the firm increases up to a certain point. Beyond that value of the firm will start to decrease. If the company is unable to pay the debt within the specified period then it will affect the goodwill of the company in the market. Therefore, company should select its appropriate capital structure with due consideration of all factors.

Question 10. Explain The Assumptions Of Net Operating Income Approach (noi) Theory Of Capital Structure?

Answer :Assumptions of Net Operating Income (NOI) Theory of Capital Structure According to NOI approach, there is no relationship between the cost of capital and value of the firm i.e. the value of the firm is independent of the capital structure of the firm.

Assumptions:

The corporate income taxes do not exist.

The market capitalizes the value of the firm as whole. Thus the split between debt and equity is not important.

The increase in proportion of debt in capital structure leads to change in risk perception of the shareholders.

The overall cost of capital (Ko) remains constant for all degrees of debt equity mix.

Question 11. Explain The Principles Of "trading On Equity"?

Answer : The term trading on equity means debts are contracted and loans are raised mainly on the basis of equity capital. Those who provide debt have a limited share in the firm’s earning and hence want to be protected in terms of earnings and values represented by equity capital.

Since fixed charges do not vary with firms earnings before interest and tax, a magnified effect is produced on earning per share. Whether the leverage is favorable, in the sense, increase in earnings per share more proportionately to the increased earnings before interest and tax, depends on the profitability of investment proposal. If the rate of returns on investment exceeds their explicit cost, financial leverage is said to be positive.

Question 12. Differentiate Between Business Risk And Financial Risk?

Answer : Business Risk and Financial Risk:

Business risk refers to the risk associated with the firm’s operations. It is an unavoidable risk because of the environment in which the firm has to operate and the business risk is represented by the variability of earnings before interest and tax (EBIT). The variability in turn is influenced by revenues and expenses. Revenues and expenses are affected by demand of firm’s products, variations in prices and proportion of fixed cost in total cost.

Whereas, financial risk refers to the additional risk placed on firm’s shareholders as a result of debt use in financing. Companies that issue more debt instruments would have higher financial risk than companies financed mostly by equity. Financial risk can be measured by ratios such as firm’s financial leverage multiplier, total debt to assets ratio etc.

 Question 13. Explain The Term 'ploughing Back Of Profits'?

Answer : Ploughing back of Profits:

Long-term funds may also be provided by accumulating the profits of the company and by ploughing them back into business. Such funds belong to the ordinary shareholders and increase the net worth of the company. A public limited company must plough back a reasonable amount of its profits each year keeping in view the legal requirements in this regard and its own expansion plans. Such funds also entail almost no risk. Further, control of present owners is also not diluted by retaining profits.

Question 13. Discuss The Features Of Deep Discount Bonds?

Answer : Features of Deep Discount Bonds:

Deep discount bonds are a form of zero-interest bonds. These bonds are sold at discounted value and on maturity; face value is paid to the investors. In such bonds, there is no interest payout during the lock- in period. The investors can sell the bonds in stock market and realize the difference between face value and market price as capital gain.

IDBI was the first to issue deep discount bonds in India in January 1993. The bond of a face value of Rs. 1 lack was sold for Rs. 2700 with a maturity period of 25 years.

 Question 14. Explain The Methods Of Venture Capital Financing?

Answer : Some Common Methods of Venture Capital Financing:

Equity financing: The venture capital undertaking requires long-term funds but is unable to provide returns in initial stage so equity capital is the best option.

Conditional Loan: A conditional loan is repayable in the form of a royalty after the venture is able to generate sales. No interest is paid on such loans.

Income note: It is hybrid security; the entrepreneur has to pay both interest and royalty on sales but at substantially low rates.

Participating debenture: Such security carries charges in three phases - in the start-up phase, no interest is charged, next stage a low rate of interest up to a particular level of operation is charged, after that, high rate of interest is required to be paid.

Question 15. Explain The Concept Of Multiple Internal Rate Of Return?

Answer : In cases where project cash flows change signs or reverse during the life of a project for example, an initial cash outflow is followed by cash inflows and subsequently followed by a major cash out-flow, there may be more than one internal rate of return (IRR).

Question 16. Explain The Concept Of Discounted Payback Period?

Answer : Concept of Discounted Payback Period

Payback period is time taken to recover the original investment from project cash flows. It is also termed as break even period. The focus of the analysis is on liquidity aspect and it suffers from the limitation of ignoring time value of money and profitability. Discounted payback period considers present value of cash flows, discounted at company’s cost of capital to estimate breakeven period i.e. it is that period in which future discounted cash flows equal the initial outflow. The shorter the period, better it is. It also ignores post discounted payback period cash flows.

Question 17. Explain Briefly The Functions Of Treasury Department?

Answer : The functions of treasury department management is to ensure proper usage, storage and risk management of liquid funds so as to ensure that the organization is able to meet its obligations, collect its receivables and also maximize the return on its investments. Towards this end the treasury function may be divided into the following:

Cash Management: The efficient collection and payment of cash both inside the organization and to third parties is the function of treasury department. Treasury normally manages surplus funds in an investment portfolio.

Currency Management: The treasury department manages the foreign currency risk exposure of the company. It advises on the currency to be used when invoicing overseas sales. It also manages any net exchange exposures in accordance with the company policy.

Fund Management: Treasury department is responsible for planning and sourcing the company’s short, medium and long-term cash needs. It also participates in the decision on capital structure and forecasts future interest and foreign currency rates.

Banking: Since short-term finance can come in the form of bank loans or through the sale of commercial paper in the money market, therefore, treasury department carries out negotiations with bankers and acts as the initial point of contact with them.

Corporate Finance: Treasury department is involved with both acquisition and disinvestment activities within the group. In addition, it is often responsible for investor relations.

Question 18. Define Modified Internal Rate Of Return Method?

Answer : Modified Internal Rate of Return (MIRR): There are several limitations attached with the concept of the conventional Internal Rate of Return. The MIRR addresses some of these defiencies. For example, it eliminates multiple IRR rates; it addresses the reinvestment rate issue and produces results, which are consistent with the Net Present Value method.

Under this method, all cash flows, apart from the initial investment, are brought to the terminal value using an appropriate discount rate(usually the cost of capital). This results in a single stream of cash inflow in the terminal year. The MIRR is obtained by assuming a single outflow in the zeroth year and the terminal cash inflow as mentioned above. The discount rate which equates the present value of the terminal cash in flow to the zeroth year outflow is called the MIRR.

Question 19. What Is Free Cash Flow?

Answer : Free cash flow is the cash flow that exists for distribution. It is available for all the securities holders of the organization. They include debt holders, preferred stock holders, equity holders, convertible holders etc.

Question 20. Which is cheaper, debt or equity?

Answer : Debt is cheaper because it is paid before equity and has collateral backing it. Debt ranks ahead of equity on liquidation of the business. There are pros and cons to financing with debt vs equity that a business needs to consider. It is not automatically better to use debt financing simply because it’s cheaper.  A good answer to the question may highlight the tradeoffs if there is any followup required. Learn more about the cost of debt and cost of equity.

Question 21. What is working capital?

Answer : Working capital is typically defined as current assets minus current liabilities.  In banking, working capital is normally defined more narrowly as current assets (excluding cash) less current liabilities (excluding interest-bearing debt). Sometimes it’s even more narrowly defined as accounts receivable plus inventory minus accounts payable. By knowing all three of these definitions you can provide a very thorough answer.

Question 22. What does negative working capital mean?

Answer : Negative working capital is common in some industries such as grocery retail and the restaurant business.  For a grocery store, customers pay upfront, inventory moves relatively quickly, but suppliers often give 30 days (or more) credit.  This means that the company receives cash from customers before it needs the cash to pay suppliers.  Negative working capital is a sign of efficiency in businesses with low inventory and accounts receivable.  In other situations, negative working capital may signal a company is facing financial trouble if it doesn’t have enough cash to pay its current liabilities.

Question 23. When do you capitalize rather than expense a purchase?

Answer : If the purchase will be used in the business for more than one year, it is capitalized and depreciated according to the company’s accounting policies.

Question 24. What is the scope of finance function?

Answer : The finance function is concerned with three types of decisions:
- Financing decisions are the decisions regarding the process of raising funds.
- Investment decisions are the decisions regarding the investment of funds.
- Dividend Policy decisions are strategic financial decisions and they are based on the profits earned by the organization. As the shareholders are the owners of the organization thus they are entitled to receive profits in the form of dividend.

Question 25. What are the goals of finance function?

Answer :
- Profit Maximisation
- Wealth Maximisation

Question 26 . What is the relation of finance function to other functions of a business enterprise?

Answer : A business enterprise has many functions apart from finance function such as production, marketing and personnel. All these functions are related to the finance function as they all require funds for their execution.

For example: In production function, to produce good quality of goods and proper functioning of various operations involved in the production function involves investment either in terms of fixed capital or working capital, which is a finance function. The personnel function deals with the availability of proper kinds of laborers at proper time, their training etc. All theses activities need funds. All the activities or functions are finally related to the finance function. The success of a business depends on the coordination between these functions.

Question 27. What are the main duties and responsibilities of a finance executive?

Answer :
Recurring Duties:
- Deciding the financial needs
- Raising the funds required
- Allocation of funds
• Fixed assets management
• Working capital management
- Allocation of Income
- Control of Funds
- Evaluation of Performance
- Corporate Taxation
- Other duties : to prepare annual accounts, carrying out internal audit, safeguarding securities, present financial reports to top management. Etc.
Non recurring Duties :
- Preparation of financial plan at the time of company promotion
- Financial adjustments in times of liquidity crisis
- Valuation of the firm at the time of acquisition and merger etc.

Question 28 . What are the various sources through which a company can meets its fund requirements?

Answer :The various sources through which a company can meet its fund requirements are:
- Shares
- Debentures
- Term Deposits
- Public Deposits
- Retained Earnings
- Lease and Hire Purchase

Question 29. What are shares? What are nominal value/ free value of shares?

Answer :Share is a smaller unit into which the total capital of the company is subdivided. For example: if a company requires a capital of Rs. 500000, it can be sub divided into fifty thousand smaller units called as shares, each unit having the value of Rs. 10 each. The value of each share is known as Face value or Nominal value. In the example Rs. 10 is the face value of the share. Face value or the nominal value of the shares can be decided by the company.

Question 30. What types of shares can a company issue to raise long term funds?

Answer :- A company can issue two types of shares to raise long term funds:
Equity Shares are also known as ordinary shares as they are ordinary in the course of company’s business. Equity shareholders get dividend out of the profits earned by the company. Higher the profits, higher will be dividend vice-versa. But they don’t get first preference regarding payment of dividend and repayment of capital in the case of winding up of the company.
- Preference Shares are the shares which get first preference over equity shares as regards to payment of dividend and repayment of capital. Capital of preference shareholders is paid before equity shareholders in case of winding up of the company. Preference share holders don’t have voting powers. They can only vote when matters affect their own interest

Question 31. What are the advantages of equity shares to following parties?

Answer :i.) Company: The Company does not accept any obligation while issuing equity shares. The funds raised by equity shares are available to the company on unsecured and permanent basis. Company is required to repay the amount only in the event of company’s winding up and not before that. The return on equity shares is paid in the form of dividend, which has no fixed rate i.e. it depends on the profit earnings of the company. Thus, the company is not obliged to pay dividend on equity shares. Equity share capital strengthens the credit worthiness and borrowing or debt capacity of the company. This is a free source of capital for the company.

ii.) Investors: Investors in the equity shares are the owners of the company. In equity shares, there is always a possibility of getting higher returns. The investors gain in two forms: Firstly, regular dividend in the form of cash or by way of bonus shares. Secondly, they get capital appreciation on equity shares by selling them in secondary market. It is a risky investment to invest in equity shares thus the investors get voting rights. They enjoy the right to maintain the proportionate interest in profits, assets and control of the company. They have pre-emptive Right which means if a company issues any additional shares then company is under obligation to pay the additional shares to the existing shareholders first before offering it general public. Investors’ liability is restricted only to the extent of face value of the shares purchased by the investors. The personal properties of the investors are not at stake.

Question 32. What are the disadvantages of equity shares?

Answer : Following are the disadvantages of equity shares:
1) Cost of issue of equity shares is high.
2) The excessive use of equity shares is likely to result in over capitalization of the company
3) The issuing of equity capital causes dilution of control of the equity holders. In times of depression, dividends on equity shares reach low which leads to drastic fall in their market values.

Question 33. What are preference shares? What are their features?

Answer : Preference shares are those shares which are given preferential treatment as compared to equity shares.
Features of Preference Shares:
1) Return on Investment : It is in the form of dividend and rate of dividend is prefixed and pre communicated to the investors.
2) Not Owners : Investors in preference shares are not the owners of the company.
3) Return of Capital : Capital raised by the company by way of preference shares are required to be repaid during the existence of the company.

Question 34. What are the various types of preference shares?

Answer : Types of Preference Shares:
- Cumulative Preference Shares
- Non cumulative Preference Shares
- Participating preference shares
- Non-participating preference shares
- Convertible preference shares
- Non-convertible preference shares
- Redeemable preference shares
- Irredeemable preference shares
- Cumulative convertible preference shares

Question 35. Compare Convertible & Non-convertible shares

Answer : Convertible Shares are those shares which can be converted in the equity shares whereas non convertible shares are those which cannot be converted in the form of equity shares. They are issued as preference shares and they remain the preference shares.

Compare Cumulative & Non-cumulative shares

Answer : Cumulative Shares are those preference shares in which the arrears of dividend go on accumulating if the company is unable to pay the dividend in a certain year due to non-availability of profits. Whereas Non-cumulative shares are those preference shares in which the arrears of dividend do not accumulate if the company is unable to pay the dividend in a certain year due to non-availability of profits

Question 36. What are debentures? What are their features?

Answer : Debenture means a document issued by the company as an acknowledgement of indebtedness to its debenture-holders and giving an undertaking to repay the debt at a specified date or at the option of the company. These are the instruments for raising long term debt capital. Debenture holders are the creditors of the company to which company pays the interest at a fixed rate and at the intervals stated in the debenture. No voting rights are given to the debenture holders. Usually debentures are secured by charge on the assets of the company. Following are the features of debentures:
1) Debenture holders of the company are the creditors of the company and not the owners of the company.
2) Capital raised by way of debentures is required to be repaid during the life time of the company at the time stipulated by the company. Thus, it is not a source of permanent capital.
3) Debentures are generally secured.

Question 37. What are the advantages of issuing debentures to following parties?

Answer : i.) Company : Controlling position of the existing equity shareholders does not get affected as debentures do not carry any voting rights. The post tax cost associated with debentures is less. Debentures provide funds for a specific period. During the period of inflation the company may be compelled to issue debentures as a source of raising long term capital.
ii.) Investors : Investment in debentures is a good option for conservative investors as well as institutional investors as fixed rate of interest is payable by the company and security available for the investment.

Question 38. What are the disadvantages of debentures?

Answer : The disadvantages of debentures are as follows:
1) Interest on debentures and capital repayment are obligatory payments.
2) Debentures are a secured source of raising the long term requirements of funds and usually the security offered to the investors is the fixed assets of the company.
3) Debenture financing enhances the financial risk.

Question 39. What is working capital cycle?

Answer : The working capital cycle measures the amount of time that elapses between the moment when the organization commences its business with a certain amount of cash, and the moment when the organization receives payment for its goods or services. Thus, in this cycle cash available to the organization is converted back in the form of cash. Good working capital cycle balances incoming and outgoing payments to maximize working capital. A short working capital gives an idea to the organization that the business has good cash flow.

Question 40. What factors affect working capital requirement?

Answer : Factors affecting working capital requirement:
1) Nature of business
2) Size of the organization
3) Phase of trade cycles
4) Production policies
5) Turnover of inventories
6) Dividend Policies
7) Trading terms
8) Length of production cycle
9) Profitability
10) Seasonal Variations.

Question 41. Define a.) Fixed working capital b.) Variable working capital

Answer : a.) Fixed working capital is that portion of the total capital that is required to be maintained in the business on the permanent basis or uninterrupted basis. This working capital is required to invest in fixed assets. The requirement of this type of working capital is unaffected due to the changes in the level of activity.
b.) Variable working capital is that portion of the total capital that is required over and above the fixed working capital. This working capital is required to meet the seasonal needs and some contingencies. The requirement of this type of working capital changes with the changes in the level of activity.

Question 42. What are the sources used for financing temporary requirement of working capital?

Answer : The sources used for financing temporary requirement of working capital are:
1) Spontaneous Sources
a. Trade Credit
b. Outstanding Expenses
2) Inter Corporate Deposits
3) Commercial Papers
4) Banks
5) Advances received form customers
6) Various short term provisions
7) Fixed deposits for a period of 1 year or less

Question 43. Explain spontaneous source of financing variable working capital.

Answer : Spontaneous source of financing variable working arises in the normal course of business operations. It is also known as current liabilities. This source of financing is unsecured in nature and varies with the level of sales. They do not have any explicit cost attached to the same.

Question 44. What current liabilities can be used as spontaneous sources for financing the working capital?

Answer :Following current liabilities can be used as spontaneous source of financing the working capital:
1) Trade Credit
2) Outstanding Expenses
Trade credit is an arrangement in which a company buy goods or services without making immediate cash payment. If a company buys raw materials from the suppliers on credit basis, it gets the raw material for utilization immediately with the facility to make the payment at the delayed time. By accepting the delayed payment, the suppliers of raw material finance the requirement of working capital. It is an essential element of capitalization in an operating business because it can reduce the capital investment required to operate the business if it is managed properly.
Outstanding expenses are the expenses that are unpaid at the end of the accounting period, which means they are payable but not yet paid. This may apply to salaries, wages, telephone expenses, electricity expenses, water charges etc. All the outstanding expenses come under nominal accounts and must be credited.

Question 45. What is management of receivables? What are its objects?

Answer : Receivables are amounts owed to the company by the customers to who company sell goods or services in the normal course of business. The main purpose of managing receivables is to meet competition and to increase sales and profits.
Following are the objectives of receivables management which will help us to understand the purpose of receivables:
1. To optimize the amount of sales
2. To minimize cost of credit
3. To optimize investment in receivables.
4. To increase credit sales.
Therefore, the main objective of receivable management is to create a balance between profitability and cost.

Question 46. What are the areas covered by receivables management?

Answer : Following are the areas covered by receivables management:
- Credit Analysis
- Credit Terms
- Financing of Receivables
- Credit Collection
- Monitoring of Receivables

Question 47. What is float in receivables management?

Answer : Float is the time gap in the receivables management and these can be in the following forms:
1. The frequency with which the bills or invoices are raised in favour of the customers.
2. Delay at the administrative end for raising the bills or invoices in favour of customers.
3. Period of credit offered to customers.
For an effective receivable management all the important measures need to be taken to reduce the time gaps between receivable management. From this point, the following measures can be taken into consideration:
1. Attempts should be made to reduce the time gap between the payment of the invoice and the time when bills or invoices are raised.
2. Bills or invoices should be raised immediately after the dispatch of material or rendering the service.
3. Credit period offered to the customers should be kept as low as possible.

Question 48.What do you mean by credit terms? What are its various aspects?

Answer : Credit terms are the conditions under which the company extends the credit given to the customer. This involves various aspects which are as follows:
Credit Period : It is the time allowed by the company to the customers to pay their dues. At the end of this period the customer is supposed to pay for all goods and services which he has purchased. Duration of credit period depends on various factors such as:
- In case of products having inelastic demand, the credit period may be small.
- Nature of industry also affects credit period.
- Credit period may also be affected by attitude of management.
- Credit period may also depend on the amount of funds available and possible bad debts.
Credit Limit : The maximum amount of money one is allowed to borrow. A bank or another financial services company may extend a credit line to a client, which is essentially approval for a loan or series of loans to be given on demand from the borrower. The borrower is under no obligation to actually take out a loan at any particular time. The maximum amount for which a particular borrower is approved is known as the credit limit. Banks and financial services company do not extend loans past the credit limit. For example, one may have a credit card with a credit limit of RS 2,000; if one attempts to put RS 2,100 on the card, the bank will decline payment. A good credit report and a regular history of loan payments may result in the credit limit being raised.
Discount Policy: In this policy discounts are given to speed up the collection process by inducing the customers to pay the dues as early as possible.

Question 49. What can a company do with the profits it earns?

Answer : Company earns profits and that money is put for the following use:-
1) The profit can either be re-invested in the business which is also called as retained earnings
2) The profit can also be paid to the shareholders as a dividend.
In many companies the retained portion of the earning and pay work as the remainder as a dividend.

Question 50. What are the various choices available for a company to choose its dividend policy?

Answer :  Dividend policy is an element of the financial management. It helps the company in capital markets and establishing a good corporate image in development of company's long term financial decision making.
The choices that are available to the user are as follows:-
1) Dividend payout ratio policy - it is to determine the actual distribution of earnings per share and the ratio of earnings available for distribution of high and low
2) Dividend distribution policy - refers to steady growth in dividend policy
3) Dividend payout policy - it is a dividend in the form of cash dividends, stock dividends, dividends and share repurchase allotment.

Question 51.What external factors determine the dividend policy?

Answer : The external factors which determine the dividend policy are as follows:-
1) Dividend payout rate- defined as the ratio of dividends per share and earnings per share.
2) Regulated firms
3) Unregulated firms in this result are compared with earlier studies

Question 52. What external factors affect the dividend policy?

Answer : The external factors which affect the dividend policy are as follows:-

1) Economy in general state:
In uncertain economic conditions, management might retain large part of earnings to build reservoir to absorb future hurdles.
Period of recession or inflation or beginning stages of it company may also retain large part of earning to maintain the liquidity.
2) State of Capital Market:
Favourable Market: This is also called as liberal dividend policy.
Unfavourable market: This is also called as conservative dividend policy.

Question 53. Define a.) Stable dividend policy b.) No immediate dividend policy c.) Regular and extra dividend policy d.) Regular stock dividend policy e.) Irregular dividend policy

a.) Stable dividend policy

This is also called Regular policy in this company pays dividend at fixed rate, and maintains it for long time even the profit fluctuates. It pays minimum amount of dividend every year regularly. A firm paying this can satisfy the shareholders and can enhance the credit in market. In this the dividend must be stable and also helps in raising long term finance.
b.) No immediate dividend policy
Company pays no dividend in the beginning when it starts as it might be requiring credit for growth and expansion. This happens in the case of outside funds are costlier and the market is also very difficult to handle. This kind of policy can be used in short term period only and not good for long term.
c.) Regular and extra dividend policy
In this Pay out ratio is used which a firm pays continuously. But when sometimes the earnings exceed the normal level, management pays extra dividend in addition to the regular dividend. It doesn’t mean that the company is earning extra profit that it is paying extra dividend.
d.) Regular stock dividend policy
In this a particular firm pays dividend in the form of shares not in the form of cash continuously for some years. Stock dividends are used as bonus shares and when company is short of cash or a crunch then this policy is used. It is not used for long time because number of shares will go on increasing, which would result in fall in earnings per share.
e.) Irregular dividend policy
In this firm doesn’t pay the fix dividend regularly and it changes from year to year according to changes in earnings level. This is followed by the company which have unstable earning.

Question 54. What are the various forms in which dividends can be paid?

Answer: 1) Cash dividends are the first form in which dividends are paid out in currency, usually by check or electronic cash. These dividends are the form of investment income and are taxable to the recipient in the year they are paid. This is used to share the corporate profit with the shareholders of the company.
2) Stock dividends are the second form in which dividends are paid out in form of additional stock shares of the issuing corporation. They differ in the issuing of the shares owned by people around. If payment involves issue of new shares then it increases total number of shares while lowering the price of each share without changing market value.
3) Property dividends are the third form in which dividends are paid out in the form of assets from the issuing corporation or another corporation, such as a subsidiary corporation. They are rare and mostly used in securities of companies owned by issuer

Question 55. What are bonus shares? What advantages does the company get by issuing them?

Answer: Bonus shares are the shares which are allotted to the existing shareholders without receiving any additional payment from them. Issue of bonus share has advantages in increasing the company’s profits into share market. It also helps the shareholders to retain their proportionate ownership of the company. It doesn’t affect the total capital structure and total earning of the shareholders. It actually keeps the morale high of the employees who are associated with the company. It also increases the outstanding shares and share capital base.

Question 56. What are the disadvantages of issuing bonus shares?

Answer:  The disadvantages of issuing bonus shares are:

1) To the company - as issue of this may lead to increase in capital of the company.
2) Shareholder expect existing rate dividend per share to continue.
3) It also prevents the new investors from becoming the shareholders of the company.
4) Shareholder preferring cash to stock dividend may be disappointed.

Question 57. What are the advantages of issuing bonus shares to the shareholders and creditors?

Answer:  The advantages of issuing bonus shares to the shareholders and creditors are as follows:-
1. Tax benefits : Bonus shares increase the wealth of shareholder when they receive dividend in cash.
2. Indication of higher future profits : company gives bonus only when its earning are expected to increase.
3. Increase in future dividend : more dividends in future to the shareholder will be given.
4. High psychological value: it tends to create greater demand for the company’s share in the market.

Question 58. What is capital structure? What are the principles of capital structure management?

Answer:  Capital structure is a term which is referred to be the mix of sources from which the long term funds are required for business purposes which are raised to improve the capital of the company. To fund an organization plan this capital structure is required which is the combination of debt and equity. The management ensures the capital structure accesses which are needed to fund future growth and enhance financial performance. The principles of capital structure management which are essentially required are as follows:-

1) Cost Principle
2) Risk Principle
3) Control Principle
4) Flexibility Principle
5) Timing Principle

Question 59. What are the internal factors affecting capital structure?

Answer:  The internal factors which are affecting capital structure are as follows:-

1) Cost of capital : - it is a process of raising the funds which involves the cost in planning the capital structure, the use of capital should be capable of earning revenue to meet the cost of capital. There are changes in this because of two reasons:
(i) Interest rates are less than dividend rates.
(ii) Interest paid on borrowed capital is an allowable for income tax purposes.
2) Risk factor : Company raising the capital by borrowed capital, as it accepts the risk in two ways:
(i) Company maintains the payment of interest as well as installments of borrowed capital at predecided rate and time without being concerned about the profits and losses.
(ii) Borrowed capital is secured capital in the case where the company fails to meet the contract done with the lenders of the money.
3) Control Factor: These factors have been considered by the private companies while raising additional funds and planning the capital structure. In this company plans to raise long term funds by issue the equity and preference shares. It doesn't have relation with the borrowed capital.

Question 60. What are the external factors affecting capital structure?

Answer: The external factors which are affecting the capital structure are as follows:-
1) Economic Conditions: If the economy is in state of depression, preference is given to equity form of capital which involves less amount of risk but it is avoided in some cases where the investor is not ready to take the risk. In this case company go on with the borrowed capital.
2) Interest Rates level : Form of borrowed capital will be delayed if the funds are available in high rates of interest but raising is not favourable.
3) Lending Policy : If policy is hard to understand and not flexible then it is good to go with the borrowed capital.
4) Taxation Policy: This policy should be viewed from both the sides from individual as well as corporate perspective. From the individual point of view both interest as well as dividend will be taxable in hands of lender.

Question 61. What are the general factors affecting capital structure?

Answer: The general factors which are affecting the capital structure are as follows:-
1) Company constitution : In companies capital structure is very important as many companies treat it as a different entity. Private companies considers control factor as important whereas public company finds cost factor more important.
2) Company characteristics : Characteristic of the company which describe its infrastructure as size, age and credit plays pivotal role in deciding the capital structure. Smaller or newly started companies depend more on equity capital as they can do limited bargaining. Large companies or having good credit companies are in the position to get funds from the source of their choice.
3) Stability of Earnings : Fluctuations occurs if the sales and earnings of the company are not stable enough over a period of time. Stable company can take the risk.

Question 62. Compare Component cost and Composite cost.

Answer: The component cost is the one which comes under the cost of capital and it has three levels:-
(i) Return at zero risk level: which tells about the expected rate of return when there is no risk involved in the project
(ii) Premium for business risk: This tells about the variance in operating profit due to change in sales.
(iii) Premium for financial risk: This tells about the captital structure risk.
It is the decision whether to buy components or services from an outsider or not. It requires understanding the cost associated with building and buying the components.

Composite Capital is also called the weighted average of component cost of common stock, preference shares and debt. In this each of the components is given an importance on its interest rate, risk analysis and management loss of control which is used to compute the composite capital.

Question 63. Explain cost of capital and its importance.

Answer: Cost of the capital is the rate of return which is minimum which has to be earned on investments in order to satisfy the investors of various types who are making investments in the company in the form of shares, debentures and loans. It is used in financial investment which refers to the cost of a company's funds or the shareholders return on the company's existing deals. It is the required rate that a company must achieve to cover the cost of generating funds in the market. By seeing this only the investor invests the money in the company if the company is giving the required rate of return. It is a guideline to measure the profitability of different investments.
The importance of cost of capital is that it is used to evaluate new project of company and allows the calculations to be easy so that it has minimum return that investor expect for providing investment to the company. It has such an importance in financial decision making. It actually used in managerial decision making in certain field such as-
1) Decision on capital budgeting- It is used to measure the investment proposal to choose a project which satisfies return on investment.
2) Used in designing corporate financial structure- it is used to design the market fluctuations and try to achieve the economical capital structure for firm.
3) Top management performance- It evaluates the financial performance of top executives. It involves the comparison of actual profit of the projects and taken projects overall cost.

Question 64. How is the cost of capital measured?

Answer:  Cost of capital is measured in terms of weighted average cost of capital. In this the total capital value of a firm without any outstanding warrants and the cost of its debt are included together to calculate the cost of capital.
To calculate the company's weighted cost of capital, first the calculation of the costs of the individual financing sources:
Cost of Debt Cost of Preference Capital, Cost of Equity Capital, and cost of stock capital take place and the formula is given as:-
WACC= Wd (cost of debt) + ws (cost of stock/RE) + wp (cost of pf. Stock)
where WACC= weighted average cost of capital

Question 65. Explain Traditional approach of capital structure.

Answer:  Traditional approach is also known as Net income approach but it is the simplest form. It is in between the other two theories named as Net income theory and Net operating income theory. This approach has been formulated by Ezta Solomon and Fred Weston. This theory gives the right and correct combination of debt and equity shares and always lead to enhanced market value of the firm. This approach tells about the financial risk which will be undertaken by the equity shareholders. This approach focuses mainly on increasing the cost of equity capital which will be done after a level of debt in the capital structure.

Question 66. What is Modigliani- Miller (M and M) approach?

Answer:  Modigilani-Miller approach is also known as MM approach which looks similar to Net operating income approach. It is in synchronization with the Net operating income approach and states in acceptance with the approach that cost of capital is independent of degree of leverage. It provides justification for operational and behavioural for constant cost of capital at any degree of leverage as this is not being provided by the Net operating Income approach. It is been assumed in this approach that capital markets are perfect and the investors are investing in the company from the same expectation of the company's net operating income in search of evaluating the value of the firm.

Question 67. Explain Cost of debt ,

Answer:  Cost of debt
It is used to measure the cost of capital. This is the first thing which should be calculated in the beginning to find out the cost of capital. It includes both contractual cost and imputed cost. It is defined as the required rate of return that an investment which is debt has to yield to protect the shareholder's interest.

Question 68. Explain Cost of preference shares

Answer:  Cost of preference shares
Costs of preference share are also used to calculate the cost of capital and are the fixed cost bearing securities. In this the rate of dividend is fixed in advance when they are issued. It is equal to the ratio of annual dividend income per shares to net proceed. It is not used for taxes and it should not be adjusted for the same. Basically it is larger than the cost of debt.

Question 69. Explain Cost of equity shares

Answer: Cost of equity shares
Cost of equity shares is the hardest job to calculate and it also raises lots of problem while working on its calculations. Its main motive is to enable the management which is to make the decisions in the best interest of the equity holders. There is a certain amount of equity capital which must be earned on projects before raising any equity funds or acceptance of finance for other projects.

Question 70. Explain Cost of retained earnings

Answer: Cost of retained earnings
Cost of retained earnings have the opportunity cost associated with it and it can be computed as well without any difficulty. The opportunity cost in this is same as the rate of return of the shareholders which determine the cut off point for the deals. It is also the rate of return which shareholders can get by investing after tax dividends in alternative opportunity.

Question 71. Explain Earnings Per Share (EPS)

Answer: Earning per share (EPS) is the amount of earning per each share of a company's stock. Companies require the EPS for their each income statement which shows about the continuing operations, discontinued operations, net income and outstanding items. EPS doesn't depend on the increase or decrease of the earning power of the company and gets calculated over number of years.

Question 72. How is EPS calculated?

Answer: Earnings per share ratio (EPS Ratio) is calculated by dividing the net profit after taxes and preference dividend by the total number of equity shares. It is a small variance of return on equity capital ratio. The formula of Earning per share ratio is given as:-

“[Earnings per share (EPS) Ratio = (Net profit after tax - Preference dividend) / No. of equity shares (common shares)]”

Question 73. What is its significance of EPS?

Answer: Earnings per share is a measure of profitability and it is viewed as the comparative earnings or the earning power of the respected firms. It is used from last four quarters but it can also be used to estimates the expected earnings of the next quarters as well.

Question 74. What is Price Earning Ratio (P/E Ratio)

Answer:  Price earnings ratio (P/E Ratio) is the ratio which is between the market price per equity and earning per share. High Price Ratio is used to give suggestion to the investors about their higher earning expected growth in future. It is usually used to compare the two P/E Ratio of different companies which are from the same industry. Investors should carefully note problems that arises with P/E Ratio measure to avoid biasing decision on many company's measure.

Question 75. How is PE calculated?

Answer: The P/E Ratio is calculated by dividing Market price per equity share to Earnings per share. This allows the company to estimate the appreciation in value of share of company and is used by investors for decision making on whether or not to buy shares in a particular company.

Following formula is used to calculate price earnings ratio:

“[Price Earnings Ratio = Market price per equity share / Earnings per share]”

For example:

The market price of share is Rs. 30 and earning per share is Rs. 5

Price Earning Ratio = 30/5 = Rs. 6

This shows that market value of every one Rs. of earning is Rs. 6. It is useful in calculation of financial forecasting and also helps in knowing whether or not the share of company are under or over valued.

Question 76. What is PE significance?

Answer: The significance of Price earning Ratio is it helps investor in deciding whether or not to buy the shares of particular company at a particular market price. Higher the P/E better is it for the company. If P/E ratio is low then the management should be more particular in knowing the cause of the fall as it can affect the company's position in the market.

Question 77. Explain leverages.

Answer: Leverage is a general term which is used in financial management and it is used as a technique to multiply the gains and losses. It refers of attainment of more benefits on comparative lower level of investment or lower sales. There are many ways to attain leverage the most common of them all is borrowing money, buying the fixed assets and use of derivatives. Examples of these are as follows:-
1) Public corporation may leverage its equity by borrowing money. The more a company borrows less equity capital it needs so the profits and losses are shared among small group of people.
2) Business Corporation may leverage its revenue by buying fixed assets. This will get more fixed proportion to the company rather than variable cost as change in revenue will result in larger change in operating income.

Question 78. What are the different types of leverages computed for financial analysis?

Answer: Different types of leverage computed for financial analysis and they are as follows:-
1) Operating Leverage : - it is a leverage which refers to the enhancement of profits because there is a fixed operating cost which is involved with each and every component. When the sales increases fixed cost doesn't increase and it results in higher profits. Higher fixed expenses results in higher operating leverage which leads to higher business risk.
2.) Financial Leverage : - It is a leverage which refers to high level of profitability because of high fixed financial expenses. It includes interest on loan and preference dividend. Higher financial leverage indicates higher financial risk as well as higher break points. In this kind the managers have flexibility in choice of capital structure.
3.) Combined Leverage: - it is a leverage which refers to high profits due to fixed costs. It includes fixed operating expenses with fixed financial expenses. It indicates leverage benefits and risks which are in fixed quantity. Competitive firms choose high level of degree of combined leverage whereas cooperative firms choose lower level of degree of combined leverage.

Question 79. Explain Operating Leverage.

Answer: Operating leverage works on fixed cost as well as variable costs. It analyzes both of the costs and it remains in the company which has the highest proportion of fixed operating cost in relation to variable operating costs. The company uses fixed assets in operation of the company or vice versa. The company which is dealing in high operating leverage makes more money from additional sales if the company's cost doesn’t increase to produce more sales. For example the software developing company's cost structure remains fixed and limited to the development and marketing cost. It doesn't matter how many components they sell the cost remain fixed. It helps the investor in dealing with the information on the risk analysis of the company. High operating leverage sometimes helps benefiting companies and sometimes remain vulnerable to sharp economic and business cycle swings.

Question 80. How is Operating Leverage  computed?

Answer: Operating leverage is highest in companies which got fixed operating cost in relation to variable operating cost. It tells investor about the companies position and the risk profile of the company. It is measured when a company has fixed costs that are regardless the sales volume. When company has fixed cost then the percentage change in profits due to changes in sales volume is greater than the percentage change in sales. The computation of this is known as degree of operating leverage (DOL) which gives the extent to which operating profits change as sales volume changes. It is given as:-

DOL (Degree of operating leverage) = %age change in income / %age change in sale

Question 81. What does high/low operating leverage indicate?

Answer: Operating leverage indicate about the company and its future profitability. It also help in assessing the level of risk which has been offered to the investors. Through this investors can estimate the profitability under certain conditions. High operating leverage indicates profits and it tells about the company's more money making policies from each additional sale if the increase cost doesn't increase to produce more sales whereas low operating leverage indicate the declining of profit margins and decreasing in earnings.

Question 82. Explain Financial Leverage.

Answer: Financial leverage is the leverage in which a company decides to finance majority of its assets by taking on debt. The leverages have been applied by investors and companies to generate more returns on their assets. This employment of leverage doesn't guarantee success and increases the possibility of excessive losses which becomes more great in high leverage positions. Firms use this leverage when they are unable to raise enough capital by issuing shares in the market and unable to meet their business needs. When firm takes on debt it sees that at that time how is the return on assets and for a firm it should be higher than the interest on the loan.

Question 83. How is Financial Leverage calculated?

Answer: The calculation of financial leverage takes place in following steps:-
1) Calculation of total debt is carried out by the company which includes short term debt as well as long term debt.
2) Calculation of total equity takes place in the company by shareholders to find out the equity they multiply number of outstanding shares by stock price. This amount is represented as shareholder equity.
3) To calculate financial leverage ratio divide total debt with total equity.
4) If company has high financial leverage ratio than it could be a sign of financial weakness. This can also lead to bankruptcy if the company is highly leveraged.

Question 84. What does high/ low financial leverage indicate?

Answer:  High financial leverage indicates the risky investment made by the company's shareholders. Low financial leverage indicates that management has adopted a very good approach towards the debt capital. This decreases the management decision making on earning per share.

Question 85. What does financial leverage indicate? What are its limitations?

Answer: Financial leverage indicates borrow of funds to raise the capital by issuing shares in the market to meet their business requirements. This also indicates the profitability and return on equity of the company which has taken significant amounts of debt. The financial leverage has many advantages but it possess some limitations as well which has been shown as follows:-
1) When a company borrows funds using financial leverage then this money develops an environment that can either creates lots of profits or a small amount of it.
2) Borrowing constantly creates an image that the company might be on high risk. Which in turn increases the interest rates and some restrictions could be handed over to the borrowing organization.
3) Value of stock also gets affected as it can drop substantially if the stockholders intervene in between.

Question 86. What is combined leverage

Answer: Combined leverage is a leverage which refers to high profits due to fixed costs. It includes fixed operating expenses with fixed financial expenses. It indicates leverage benefits and risks which are in fixed quantity. Competitive firms choose high level of degree of combined leverage whereas conservative firms choose lower level of degree of combined leverage. Degree of combined leverage indicates benefits and risks involved in this particular leverage.

Question 87. How is it calculated?

Answer: The formula which is used to calculate this is as follows-
Degree of combined leverage = Degree of operating leverage * Degree of financial leverage.

c.) Low operating leverage, high financial leverage.
d.) Low operating leverage, low financial leverage.

Question 88. What do High operating leverage, high financial leverage indicate?

Answer:  High operating leverage, high financial leverage.
High operating leverage and high financial leverage indicates the risky investment made by the company's shareholders. This also indicates that company is making few sales but with high margins. This shows the risk if a firm incorrectly forecasts future sales. If the future sales have been manipulative forecasted then it create a difference between actual and budgeted cash flow, which affects the company's future operating ability. The financial leverage poses high risk when a company's return on assets doesn't exceed interest on loan, which lowers down company's return on equity and profitability.

Question 89. What do High Operating leverage, low financial leverage indicate

Answer: High Operating leverage, low financial leverage.
High operating leverage indicates that company is making few sales but with high margins. This shows the risk if a firm incorrectly forecasts future sales. If the future sales have been manipulative forecasted then it create a difference between actual and budgeted cash flow, which affects the company's future operating ability. Low financial leverage indicates that management has adopted a very good approach towards the debt capital. This decreases the management decision making on earning per share. This is the optimum situation.

Question 90. What do Low operating leverage, high financial leverage indicate

Answer: Low operating leverage, high financial leverage.
If financial leverage is high than the funds are obtained mainly through preference shares, debentures and debts. This makes the base solid by keeping the operating leverage low on scale. The financial decision can be maximized as the management's concern can be earning per share which will favour the debt capital only. This will increase when the rate of interest on debentures is lower than rate of return in business. The decision is based on earning per share without any indication of the risks involved.

Question 91. What do Low operating leverage, low financial leverage indicate?
 

Answer: Low operating leverage, low financial leverage.
This is also a worst situation where both operating leverage and financial leverage are low which results in undesirable consequences. Low degree of these leverages shows that the amount of fixed costs is very small and proportion of debts in capital is also low. The management in this situation might loose number of profitable opportunities and investments.

Question 92. Explain the theories of capital structure.

Answer:  Capital structure is a term which is referred to be the mix of sources from which the long term funds are required for business purposes which are raised to improve the capital of the company. The theories which are involved in these are as follows:-
1) Net operating income (NOI):- this is an approach in which both value of the firm and weighted average cost are independent of capital structure. Individual holding the debt and equity receives the same cash flows without worrying about the taxes as they are not involved in it.
2) Traditional approach and Net income (NI) approach :- this is an approach in which both cost of debt, and equity are independent of capital structure. The components which are involved in it are constant and don’t depend on how much debt the firm is using.
3) MM hypothesis with and without corporate tax : This approach tells that firm's value is independent of capital structure. The same return can be received by shareholders with the same risk.
4) Miller’s hypothesis with corporate and personal taxes : This approach gives important advantage over equity. This ignores bankruptcy and agency costs.

5) Trade-off theory: costs and benefits of leverage.

Question 93. Explain Net income approach. Who proposed this theory?

Answer: Net income (NI) approach as this is also called as traditional approach. This is an approach in which both cost of debt, and equity are independent of capital structure. The components which are involved in it are constant and doesn't depend on how much debt the firm is using. This theory was proposed by David Durand. In this change in financial leverage leads to change in overall cost of capital as well as total value of firm. If financial leverage increases, weighted average cost decreases and value of firm and market price of equity increases. If this decreases then weighted average cost of capital increases and value of firm and market price of equity decreases. The assumptions which can be made according to this approach is that there are no taxes involved in this and the use of debt doesn't change the risk factor for the investors and will remain the same throughout.

Question 94. Explain Operating income approach. Who proposed this theory?

Answer: Operating income approach is the approach which suggests the decision of capital structure towards a firm is irrelevant and change in leverage or debt doesn't result in change of total and market price of the firm. It tells that overall cost of capital is independent of degree of leverage. This approach was also proposed by David Durand.

Question 95. What is management of cash?

Answer: Management of cash is a process of collecting, managing and investing cash. Cash is the most liquid form of current assets which ensures a company’s financial stability and solvency thus management of cash is the most important areas of overall working capital. It is the responsibility of the finance department to see that various functional areas of business have sufficient cash for their various operations. On the other hand it needs to be ensured that funds are not blocked in the form of ideal cash. Hence, successful cash management not only involves avoiding insolvency, but also speeding up the collection of receivables, delay in payment of liabilities, investment of ideal cash, keeping inventory levels low and create a cash budget in order to improve a company’s overall financial profitability.

Question 96. What is Transaction Motive of holding cash ?

Answer: Transaction Motive : Requirement of cash to meet day to day needs is known as transaction motive. For example: On day to day basis the company is required to make regular payments like purchases, salaries/wages, taxes, interest, dividends etc. for which company will hold the cash. Similarly, company receives cash from its sale operations. However, sometimes receipts of the cash and the cash payments do not match with each other; in such situations the company should have enough cash to honour the commitments whenever they are due.

Question 97. What is Precautionary Motive of holding cash ?

Answer: Precautionary Motive : Holding up of cash balance in order to take care of contingencies and unforeseen circumstances is known as precautionary motive. In addition to requirement of cash for regular transactions, the company may require the cash for such purposes which cannot be estimated or foreseen. For example: Sudden decline in the collection from the customers or sharp increase in the prices of raw materials may put the company in such a situation where they need additional funds to deal with such situation without affecting its regular business.

Question 98. What is Speculative Motive of holding cash ?

Answer: Speculative Motive: Holding up of some reserve in the form of cash to take the benefit of some specific nature of favorable market conditions is known speculative motive. For example: If the company presumes that in near future prices of raw material is going to be low, then it will preserve that cash for future purchase of raw material. In another case if interest rates are expected to increase then the company will purchase securities from the reserved cash.

Question 99. What are the principles of cash management?

Answer: Following are the principles of Cash management:
1. Speed up collection of Receivables
2. Keep Inventory levels low
3. Delay payment of Liabilities
4. Invest Ideal Cash
5. Prepare Cash Budget.

Question 100. What are delay cash payments? What techniques are used for this?

Answer: Following are the techniques used to delay cash payments:
1. Payments made from bank which is distant from the bank of the company to which payment is to be made. This increase the postal float and bank float.
2. Attempts made by the company to get the maximum credit for the goods and services supplied to it.
3. Avoid early payments: According to the credit terms available to the company, it is required to make payment within the stipulated period of time. The company should not make the payment before the specified date unless the company is entitled to cash discounts.
4. Centralised Disbursements: Under this method, the payments of the company are made from the central bank account of the head office of the company. This method benefits the company in three respects: Firstly, it increases transit time. Secondly, it becomes easy to maintain minimum cash balance in the central bank account and thirdly, it becomes administratively easy to maintain bank account.

Question 101. How is the cash requirement estimated?

Answer: The best tool available with the company to estimate the cash requirement is Cash Budget. It is a statement showing the various sources of cash receipts and various applications of cash. Thus, by preparing cash budget the company can get a glance over the excess or shortage of cash. If shortage of cash is estimated then the company has to arrange for it from other sources. On the other hand if excess of cash is estimated then the company can explore more investment opportunities. The cash budget is prepared while keeping few points in mind and these are:

- Cash budget period should be selected very carefully. As the period covered by the cash budget should neither be too long nor too short.
- The items appearing in the cash budget should be carefully decided.
- Various items appeared in the cash budget should be classified under two categories : Operating cash flows and Non operating cash flows.

Question 102. What is concept of float?

Answer: Float is the difference between the bank balance as per the cash book and as per the bank pass book or bank statement. This difference arises due to delay occurring between the time a cheque is written by the company and the money actually deducted from the company’s account.

Question 103. Explain Accelerated Cash Collection.

Answer: This is another arrangement made by the company to accelerate cash collection. Under this arrangement the company hires a post office box at important collection centers. The customers are directed to make the payment directly to the lock box. The local bankers collect cheques from the lock box and deposit in the bank account. Bank informs the company about the details after crediting the cheques to the company’s account. This system reduces the postal float as well as bank float but at the same time it involves cost.

Question 104. How is optimum cash balance maintained?

Answer: One of the important objectives of cash management is to maintain an optimum level of cash balance and the tools available with the company to ensure the maintenance of optimum level of cash balance is to prepare cash budget. Cash balance either in excess or shortage of it has its own consequences. Thus by preparing the cash budget, the company can have an idea in advance the requirement and the amount of cash which will be required by the company at any given point of time. On the basis of which company can further take its decision of investing excess cash or to meet the shortfall

Question 105. What factors are considered for final selection of avenue for investing cash balance?

Answer: As the company cannot afford to keep the excess cash balance idle as it involves the opportunity cost. Thus the objective of cash management requires the company to think about the possibility of investing the excess cash balance on short term basis. Various avenues are available to the company to invest the excess cash balance on short term basis. However for the final selection of the avenue for investing the cash balance may depend on various factors:

1. Return: Higher the return, better the investment.
2. Risk : High return investments involve high risk.
3. Liquidity : Liquidity associated with the investment opportunity becomes an important criteria.
4. Legal Requirements: Sometimes organizations need to fulfill some legal formalities before considering any investment portfolio.

Question 106. What are the objectives of inventory management?

Answer: The main objective of inventory management is to maintain inventory at appropriate level to avoid excessive or shortage of inventory because both the cases are undesirable for business. Thus, management is faced with the following conflicting objectives:
1. To keep inventory at sufficiently high level to perform production and sales activities smoothly.
2. To minimize investment in inventory at minimum level to maximize profitability

Question 107. What are the consequences of over investment & under investment in inventory?

Answer: Both over investment and under investment in inventory is undesirable as both have consequences.
Following are the consequences of over investment:
- Unnecessary blockage of funds in inventory
- Excessive storage is required to store the inventory.
- Excessive insurance cost.
- Risk of liquidity: Value of the inventory reduces due to the long holding period as the inventories once purchased are difficult to dispose off at the same value.
Following are the consequences of under investment:
- Under investment in the inventory may cause frequent interruptions in production process.
- Insufficient stock of finished goods may create problems in meeting customers’ demands and they may shift to the competitors.

Question 108. Explain ABC analysis

Answer: A.B.C. analysis is an analytical technique of controlling different items of inventory. This technique assumes the basic principle of ‘Vital Few Trivial Many’ which means in a business there are thousands items not equally important. According to this technique only those items are considered and given more attention which are significant from business point of view. In this technique, all items are classified under 3 categories A, B and C. In ‘A’ category those items are taken which are very important and small in quantity, ’B’ category includes relatively less costly and important items as compared to ‘A’ category and ‘C’ category includes those items which are large in number and are low priced. The importance of various items is decided on the basis of following factors:

- Amount of investment in inventory,
- Value of material consumption and
- Critical nature of inventory items.

Question 109. What are  the Advantages of ABC Analysis?

Answer: 1. Close and strict control is facilitated on the most important items which help in overall inventory valuation or overall material consumption.
2. Proper regulation of investment in inventory which will ensure optimum utilization of available funds.
3. Helps in maintaining a high inventory turnover rates.

Question 110. What external factors determine the dividend policy?

Answer: The external factors which determine the dividend policy are as follows:-

1) Dividend payout rate- defined as the ratio of dividends per share and earnings per share.
2) Regulated firms
3) Unregulated firms in this result are compared with earlier studies.