Financial Management

Financial management is concerned with the optimal procurement as well as the usage of finance, and its primary objective is wealth maximisation, that is, increasing the market price of equity shares. In this chapter you will study the three financial decisions: the investment decision, including long-term capital budgeting decisions affected by cash flows, rate of return and investment criteria; the financing decision, choosing between debt and equity after weighing cost, risk, floatation costs, cash flow position, fixed operating costs, control and the state of the capital market; and the dividend decision, influenced by earnings, stability, growth opportunities, cash flow, shareholders' preferences, taxation, legal and contractual constraints. You will then learn about financial planning and its objectives and importance, and about capital structure, the mix of debt and equity, including financial risk, trading on equity and factors such as interest coverage ratio, debt service coverage ratio, return on investment and tax rate. Finally, the chapter explains the factors affecting the requirements of fixed capital and working capital, such as the nature of business and the production cycle.

Detailed Worksheet: Financial Management Section A - Definitions (10 marks) 1. Define financial management. State its primary objective. (2 marks) 2. What is capital budgeting? Why are capital budgeting decisions important? (2 marks) 3. What is trading on equity? When is it favourable? (2 marks) 4. Define capital structure. What is meant by an optimal capital structure? (2 marks) 5. Distinguish between fixed capital and working capital. (2 marks) Section B - Calculations and Applications (15 marks) 6. A company needs Rs 30 lakh. It can raise the full amount by issuing equity shares of Rs 10 each, or raise Rs 20 lakh through equity shares of Rs 10 each and Rs 10 lakh through 10% debentures. EBIT is Rs 4 lakh and the tax rate is 30%. Calculate EPS under both options, and state whether trading on equity is favourable. (3 marks) 7. Using the data in Question 6, calculate the return on investment (EBIT divided by total investment) and explain why the EPS rises when debt is used. What would happen to EPS under the debt option if EBIT fell to Rs 2 lakh? Calculate. (3 marks) 8. A company has EBIT of Rs 6 lakh and pays interest of Rs 1.5 lakh. Calculate the interest coverage ratio. In another year, profit after tax is Rs 3 lakh, depreciation Rs 1 lakh, interest Rs 1.5 lakh and repayment of loan instalment Rs 2 lakh (no preference dividend). Calculate the debt service coverage ratio. (3 marks) 9. A company's current assets are Rs 18 lakh and current liabilities Rs 11 lakh. Calculate its net working capital. If it is a sugar mill whose production depends on the seasonal supply of sugarcane, explain two factors that make its working capital requirement high. (3 marks) 10. Identify the financial decision involved in each case: (i) buying a new machine worth Rs 50 lakh (ii) issuing debentures instead of shares (iii) retaining profits for expansion instead of paying dividend (iv) opening a new branch (v) choosing between a bank loan and public deposits (vi) paying a stable dividend of 20% every year. (3 marks) Section C - Diagrams (10 marks) 11. Draw a chart showing the three financial decisions with three factors affecting each. (4 marks) 12. Draw a chart showing the factors affecting the choice of capital structure, grouping them into cash flow and coverage factors, cost factors, risk and control factors, and market factors. (3 marks) 13. Draw a flowchart of the operating cycle of a manufacturing firm: cash -> raw materials -> work in progress -> finished goods -> debtors -> cash, and explain its effect on working capital. (3 marks) Section D - Analysis and Higher-order Thinking (15 marks) 14. A software company and a cement company are both planning to raise funds. Analyse how differences in their fixed operating costs, cash flows, stability of earnings and asset structure should influence their choice between debt and equity. (5 marks) 15. A company with high growth opportunities has been paying 40% of its profits as dividend, while shareholders mostly prefer capital gains. Analyse the factors affecting dividend decision in this case and recommend a suitable dividend policy, giving reasons. (5 marks) 16. Explain the factors affecting fixed capital requirements. Analyse why a trading concern needs less fixed capital than a manufacturing concern, and why a public utility like a railway needs very large fixed capital but little working capital. (5 marks) Instructions: Time allowed 2 hours. Attempt all sections. Show all calculations clearly with formulae, and quote relevant lines from cases while identifying concepts.