💰 Financial Management

Capital Budgeting · Working Capital · Capital Structure · Dividend Decisions

20 Questions · All Answers Verified
Q1 Assertion–Reason
Assertion: Higher the lead time, the lower is amount of working capital requirement.
Reasoning: If the raw material is available freely and continuously, then less working capital is needed as less inventory has to be maintained.
a. Both assertion and reason are true and reason is the correct explanation of assertion.
b. Both assertion and reason are true and reason is not the correct explanation of assertion.
c. Assertion is true but reason is false.
d. Assertion is false but reason is true.
✔ Answer d. Assertion is false but reason is true.  ·  (Higher lead time means higher working capital requirement)
Q2 MCQ
If a firm has growth opportunities, it should prefer giving
a. Low dividend
b. High dividend
c. Does not affect dividend decision
d. None of the above
✔ Answer a. Low dividend
Q3 MCQ
If ICR is high, firm prefers
a. Debt
b. Equity
c. Both a and b
d. None of the above
✔ Answer a. Debt
Q4 MCQ
Positive leverage effect brings
a. Gain for equity shareholders
b. Loss for equity shareholders
c. Both a and b
d. None of the above
✔ Answer a. Gain for equity shareholders
Q5 MCQ
A decision to acquire a new and modern plant to upgrade an old-one is a
a. Financing decision
b. Investment decision
c. Working capital decision
d. Dividend decision
✔ Answer b. Investment decision
Q6 Assertion–Reason
Assertion (A): Capital budgeting decisions are very crucial and must be taken with utmost care.
Reasoning (R): Investment decisions affect the earning capacity of the firm over the long run and are irreversible except at a huge cost.
a. Both assertion and reasoning are true and reason is the correct explanation of assertion.
b. Both assertion and reason are true and reason is not the correct explanation of assertion.
c. Assertion is true but reason is false.
d. Assertion is false but reason is true.
✔ Answer a. Both assertion and reasoning are true and reason is the correct explanation of assertion.
Q7 MCQ
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 equitably, lower risk and lower profits
d. Lower equitably, lower risk and higher profits
✔ Answer a. Higher current ratio, higher risk and higher profits
Q8 MCQ
Megha is planning to enter in the business of Herbal Shampoo. In the beginning she was thinking there are very few companies making Herbal Shampoo, but when she started selling her product, she realized that many companies are already in the business of selling herbal shampoo. Identify the factor affecting working capital in the above para
a. Growth prospects
b. Nature of business
c. Level of competition
d. Business cycle fluctuation
✔ Answer c. Level of competition
Q9 MCQ
Financial planning arrives at
a. Minimizing 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 firm has its disposal
✔ Answer c. Ensuring that the firm faces neither a shortage nor a glut of unusable funds.
Q10 MCQ
Higher dividends per share is associated with
a. High earning, high cash flows, unstable earnings and higher growth opportunities
b. High earning, high cash flows, stable earnings and high growth opportunities
c. High earning, high cash flows, stable earnings and lower growth opportunities
d. High earning, low cash flows, stable earnings and lower growth opportunities
✔ Answer c. High earning, high cash flows, stable earnings and lower growth opportunities
Q11 3 marks · Descriptive
Explain three factors affecting capital budgeting decision of a company.
✔ Answer
  • Cash flow of the project – The expected cash inflows and outflows over the project's life.
  • Return on investment – The profitability of the project compared to the cost of capital.
  • Investment criteria – The evaluation methods like payback period, NPV, IRR, etc.
Q12 3 marks · Descriptive
Steel one enterprise is manufacturing high quality steel utensils. The demand for steel is rising as people are getting aware that plastic is not good for health. This has led to increase in the production of steel utensils. To encourage sales, Steel one Enterprises declared a liberal credit policy, which allows three months credit to its wholesale buyers.

In the light of the above, identify the two factors affecting capital requirements of steel one enterprise. State with reason, whether the factors as identified above, will result in high or low working capital requirement.
✔ Answer
  • Nature of business – Manufacturing business requires higher working capital.
  • Credit allowed – Liberal credit policy of 3 months results in higher working capital requirement.
  • Scale of operations – Increased production due to rising demand leads to higher working capital requirement.
Q13 3 marks · Descriptive
Explain any three factors which affect the choice of capital structure of a company.
✔ Answer
  • Cash flow position – Strong cash flows allow more debt financing.
  • Interest coverage ratio – Higher ICR indicates better ability to service debt.
  • Debt service coverage ratio – Higher DSCF indicates ability to meet debt obligations.
Q14 3 marks · Descriptive
Ramnath Ltd. is dealing in import of organic food items in bulk. The company sells the items in smaller quantities in attractive packages. Performance of the company has been up to the expectations in the past. Keeping up with the latest packaging technology, the company decided to upgrade its machinery. For this, the finance manager of the company, Mr. Vikrant Dhull, estimated the amount of funds required and the timings. This will help the company in linking the investment and the financing decisions on a continuous basis. Therefore, Mr. Vikrant Dhull began with the preparation of sales forecast for the next four years. He also collected the relevant data about the profit estimates in the coming years. By doing this, he wanted to be sure about the availability of funds from the internal sources. For the remaining funds he is trying to find out alternative sources.

Identify the financial concept discussed in the above paragraph. Also, state any two points of importance of the financial concept, so identified.
✔ Answer
Financial planning

Importance of financial planning:
  • It helps the company to prepare for the future by forecasting what may happen in the future under different business situations.
  • It provides a link between investment and financing decisions.
Q15 4 marks · Descriptive
A company's earnings before interest and tax is 10 lac. It pays 10% interest on its debt. Total investment of company is 50 lac.

a. Advise company whether it should include debt or equity to raise its capital.
b. Name the concept related to this and explain.
c. Will the company's decision to raise funds from debt or equity will change if company's EBIT becomes 4 lac.
✔ Answer
a. Company should prefer debt to raise fund as debt is gainful for equity shareholders till ROI > rate of interest.
ROI = (EBIT / Total investment) × 100 = (10 / 50) × 100 = 20%
Interest = 10%
20% > 10% → Prefer Debt

b. Financial leverage or trading on equity – The use of fixed cost sources of finance (debt) to increase the return on equity shareholders.

c. Yes, company's decision will change if EBIT becomes 4 Lakhs, because ROI will become less than interest.
ROI = (EBIT / Total investment) × 100 = (4 / 50) × 100 = 8%
Interest = 10%
8% < 10% → Prefer Equity
Q16 4 marks · Case-based
Computer tech Ltd., is one of the leading information technology outsourcing services providers in India. The company provides business consultancy and outsourcing services to its clients. Over the past five years the company has been paying dividends at high rate to its shareholders. However, this year, although the earnings of the company are high, its liquidity position is not so good. Moreover, the company plans to undertake new ventures in order to expand its business.

In context of the above case:
a. Give any three reasons because of which you think Computer tech Ltd. has been paying dividends at high rate to its shareholders over the past five years.
b. Comment upon the dividend policy of the company this year by stating any two reasons in support of your answer.
✔ Answer
a. Computer Tech Ltd. has been paying dividends at high rate to its shareholders over the past five years because of the following reasons:
  • Earnings
  • Cash flow position
  • Access to capital market
b. This year company is likely to follow a conservative dividend policy because of the following reasons:
  • Cash flow position of the company is not good, and dividends are paid in cash.
  • Company may like to retain profits to finance its projects.
Q17 4 marks · Descriptive
"Smart stationery Ltd." wants to raise funds of Rs. 40,00,000 for its new project. The management is considering the following mix of debt and equity to raise this amount:

Capital structure Alternative 1 Alternative 2 Alternative 3
Equity 40,00,000 30,00,000 10,00,000
Debt 0 10,00,000 30,00,000
Other details are as follows:
Interest rate on debt = 9%
Face value of equity shares = Rs. 100 each
Tax rate = 30%
Earnings before interest and tax (EBIT) = Rs. 8,00,000

a. Under which of the three alternatives will the company be able to take advantage of trading on equity?
b. Does earning per share always rise with increase in debt?
✔ Answer
a. Alternative 3 – Highest debt (Rs. 30,00,000) will give the maximum advantage of trading on equity as ROI > interest rate.

b. No, earning per share does not always rise with increase in debt. It depends on the relationship between ROI and cost of debt. If ROI > cost of debt, EPS rises; if ROI < cost of debt, EPS falls.
Q18 6 marks · Case-based
Krishna Ltd. is manufacturing steel at its plant at Noida. Due to economic growth, the demand for steel is also growing. The company is planning to set up a new steel plant at Gurgaon. It needs Rs. 800 crore to start the new plant. It decides to raise Rs. 300 crore through debentures, Rs. 200 crore through long-term loan from banks and Rs. 200 crore by issue of equity share to the public. It decided to finance the remaining amount by utilizing its reserves and surplus.

a. State the importance of financial planning for this company.
b. What is the capital structure of this company? Explain.
c. Identify the financial decision involved when the company decides to raise Rs. 800 crore from different sources of funds.
d. How will the dividend decision of Krishna Ltd. be affected? Explain.
✔ Answer
a. Financial planning will help the company in avoiding business shocks and surprises. It will reduce waste and duplication of efforts.

b. Capital structure refers to the mix between owners' funds and borrowed funds. It is calculated as debt equity ratio.

c. Financing decision – The decision about the sources of funds (debentures, loans, equity, reserves).

d. Since the company has growth opportunities of setting up a new steel plant at Gurgaon, it retains Rs. 100 crores out of profits to finance the required investment. So, it is likely to pay less dividend. However, since the company makes more debt financing than funding through equity, it implies that cash flow position of the company is strong. Therefore, it can pay higher dividend.
Q19 6 marks · Descriptive
Explain any six factors affecting the decision that determines the amount of profit earned to be distributed and to be retained in the business.
✔ Answer
  • Earnings – Higher earnings allow higher dividends.
  • Stability of earnings – Stable earnings support consistent dividend policy.
  • Cash flow position – Dividends are paid in cash; strong cash flow supports higher dividends.
  • Growth opportunities – Companies with growth opportunities retain more profits.
  • Preference of shareholders – Some shareholders prefer current dividends, others prefer capital gains.
  • Taxation policy – Tax treatment of dividends vs capital gains affects payout decisions.
Q20 6 marks · Case-based
"Viyo Ltd. is a company manufacturing textiles. It has a share capital of rupees 60 lakhs. The earning per share in the previous year was rupees 0.50. For diversification, the company requires additional capital of rupees 40 lakhs. The company raised funds by issuing 10% debentures for the same. During the current year the company earned profit of rupees 8 lakh on capital employed. It paid tax @40%.

a. State whether the shareholders gained or lost, in respect of earning per share on diversification. Show your calculation clearly.
b. Also, state any three factors that favor the issue of debentures by the company as part of its capital structure.
✔ Answer
a. Shareholders have gained after the issue of debentures since the earning per share has increased from Rs. 0.50 to Rs. 4.

Calculation:
Share Capital = Rs. 60,00,000 (Face value assumed Rs. 10 each → 6,00,000 shares)
Additional capital = Rs. 40,00,000 through 10% debentures
Interest on debentures = 10% of 40,00,000 = Rs. 4,00,000
EBIT = Rs. 8,00,000
EBT = EBIT − Interest = 8,00,000 − 4,00,000 = Rs. 4,00,000
Tax @ 40% = 1,60,000
PAT = 4,00,000 − 1,60,000 = Rs. 2,40,000
EPS = PAT / Number of shares = 2,40,000 / 6,00,000 = Rs. 4
Previous EPS = Rs. 0.50
Gain = Rs. 4 − Rs. 0.50 = Rs. 3.50
b. Factors that favor issue of debentures by the company:
  • A good cash flow position makes debt funding more valuable.
  • High interest coverage ratio indicates better ability to meet the debt service obligations.
  • Lower the cost of debt, higher is the ability to employ debt.