NCERT Solutions for Class 12 Business Studies Business Studies II Chapter 1: Financial Management

Chapter at a glance

Exercises – Very Short Answer Type

Question VSA – Q1

What is meant by capital structure?

Answer

Capital structure refers to the mix between owners’ funds (equity shares, reserves) and borrowed funds (debentures, loans) used to finance a business. It is expressed as the debt–equity ratio.

Capital structure is the proportion of owners’ funds and borrowed funds in the long-term finance of a business.

Question VSA – Q2

State the two objectives of financial planning.

Answer

1. To ensure availability of funds whenever required – estimating the funds needed and their timing.
2. To see that the firm does not raise resources unnecessarily – avoiding excess funds, which add to cost.

To ensure funds are available when needed, and to avoid raising funds unnecessarily.

Question VSA – Q3

Name the concept of financial management which increases the return to equity shareholders due to the presence of fixed financial charges.

Answer

Trading on equity (financial leverage).

Trading on equity.

Question VSA – Q4

Amrit is running a ‘transport service’ and earning good returns by providing this service to industries. Giving reason, state whether the working capital requirement of the firm will be ‘less’ or ‘more’.

Answer

Less. A transport service is a service business – it does not hold inventory of goods (raw materials, finished goods), and the operating cycle is short. Hence it needs less working capital.

Less – a service business holds no inventory and has a short operating cycle.

Question VSA – Q5

Ramnath is into the business of assembling and selling of televisions. Recently he has adopted a new policy of purchasing the components on three months credit and selling the complete product in cash. Will it affect the requirement of working capital? Give reason in support of your answer.

Answer

Yes – the working capital requirement will decrease. Buying on credit (credit availed) means payment is postponed, and selling for cash means no funds are locked up in debtors. Both reduce the funds needed for day-to-day operations.

Yes – it reduces working capital requirement, since purchases on credit delay payment and cash sales avoid funds being blocked in debtors.

Exercises – Short Answer Type

Question SA – Q1

What is financial risk? Why does it arise?

Answer

Financial risk is the risk of the firm being unable to meet its fixed financial charges – interest on debt and repayment of loans – on time.

Why it arises: it arises from the use of debt in the capital structure. Interest and repayment are compulsory, whatever the firm’s profits. The higher the proportion of debt, the higher the fixed charges and the higher the risk of default (and possibly insolvency).

Financial risk is the chance of failing to meet fixed financial obligations (interest and repayment); it arises from using debt, and rises as the proportion of debt increases.

Question SA – Q2

Define current assets. Give four examples of such assets.

Answer

Current assets are assets which, in the normal course of business, can be converted into cash within a short period – one year (or the operating cycle). They provide liquidity to the business.

Examples: cash in hand/bank, inventories (raw materials, work-in-progress, finished goods), debtors (trade receivables), bills receivable, marketable securities, prepaid expenses.

Assets convertible into cash within one year – e.g. cash, inventories, debtors and bills receivable (also marketable securities, prepaid expenses).

Question SA – Q3

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

Answer

The primary objective of financial management is maximisation of shareholders’ wealth – i.e. maximising the market price of equity shares. A decision is good if it increases the value of the shares.

To achieve this, it aims to:

1. Ensure availability of sufficient funds at reasonable cost.
2. Ensure effective utilisation of funds – investment in profitable projects.
3. Ensure safety of funds and a proper balance between risk and return.
4. Maintain liquidity to meet obligations.
5. Ensure a suitable capital structure and dividend policy.

The main objective is to maximise shareholders’ wealth (market price of equity shares), through adequate funds at low cost, their efficient use, safety, liquidity and a sound capital structure and dividend policy.

Question SA – Q4

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

Answer

1. Investment decision – how the firm’s funds are invested in different assets: long-term (capital budgeting – e.g. new machinery, new plant) and short-term (working capital – cash, inventory, debtors).
2. Financing decision – how much finance to raise from which long-term sources (equity, debt), i.e. deciding the capital structure.
3. Dividend decision – how much of the profit is distributed to shareholders as dividend and how much is retained in the business.

Investment decision (capital budgeting and working capital), financing decision (capital structure) and dividend decision.

Question SA – Q5

Sunrises Ltd. dealing in readymade garments, is planning to expand its business operations in order to cater to international market. For this purpose the company needs additional ₹ 80,00,000 for replacing machines with modern machinery of higher production capacity. The company wishes to raise the required funds by issuing debentures. The debt can be issued at an estimated cost of 10%. The EBIT for the previous year of the company was ₹ 8,00,000 and total capital investment was ₹ 1,00,00,000. Suggest whether issue of debenture would be considered a rational decision by the company. Give reason to justify your answer.

Answer

ROI = EBIT ÷ Total investment × 100 = 8,00,000 ÷ 1,00,00,000 × 100 = 8 %. Cost of debt = 10 %.

No, issuing debentures is not rational. Trading on equity is profitable only when ROI > cost of debt. Here ROI (8 %) is less than the cost of debt (10 %), so using debt will reduce the earnings per share of equity shareholders and add financial risk. The company should raise funds through equity (or retained earnings) instead.

No – ROI (8 %) is lower than the cost of debt (10 %), so debt would reduce returns to equity shareholders; trading on equity is not favourable.

Question SA – Q6

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

Answer

• More working capital → higher liquidity, lower profitability. Large current assets (cash, stock, debtors) ensure the firm can pay its obligations on time, but the funds are idle and earn little or nothing; there is also a cost of holding inventory.
• Less working capital → higher profitability, lower liquidity. Funds are used in profitable long-term investments, but the firm may be unable to meet short-term obligations, affecting its credit and operations.

So there is a trade-off between liquidity and profitability; the financial manager must maintain an optimum level of working capital that balances both.

High working capital improves liquidity but lowers profitability (idle funds); low working capital raises profitability but risks liquidity – so an optimum balance is needed.

Question SA – Q7

Aval Ltd. is engaged in the business of export of canvas goods and bags. In the past, the performance of the company had been up to the expectations. In line with the latest demand in the market, the company decided to venture into leather goods for which it required specialised machinery. For this, the Finance Manager Prabhu prepared a financial blueprint of the organisation’s future operations to estimate the amount of funds required and the timings with the objective to ensure that enough funds are available at right time. 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 of the business. For the remaining funds, he is trying to find out alternative sources from outside. a. Identify the financial concept discussed in the above paragraph. Also, state the objectives to be achieved by the use of financial concept so identified. b. ‘There is no restriction on payment of dividend by a company’. Comment.

Answer

a. The concept is financial planning – preparing a financial blueprint of future operations.

Objectives

1. To ensure availability of funds whenever required – estimating the amount and timing of funds needed and their sources.
2. To see that the firm does not raise resources unnecessarily – excess funds add to cost.

b. The statement is incorrect. There are legal and contractual constraints on payment of dividend:

• Legal: under the Companies Act, 2013 dividend can be paid only out of current or past profits (after providing depreciation), not out of capital. Past losses must be set off; transfer to reserves as per rules.
• Contractual: loan agreements may restrict the payment of dividend until the loan is repaid, or until certain ratios are maintained.

Besides, factors such as cash flow, earnings, growth opportunities and stability of dividends also affect the dividend decision.

1. Financial planning – to ensure funds are available when required and that funds are not raised unnecessarily. b. Incorrect – dividend can be paid only out of profits under the Companies Act, and loan agreements may restrict it (legal and contractual constraints).

Exercises – Long Answer Type

Question LA – Q1

What is working capital? Discuss five important determinants of working capital requirement?

Answer

Working capital refers to investment in current assets. Gross working capital = total current assets; net working capital = current assets – current liabilities. It is needed for day-to-day operations.

Determinants

1. Nature of business – a trading firm needs less than a manufacturing firm; service firms need the least.
2. Scale of operations – larger operations need more inventory and debtors, hence more working capital.
3. Business cycle – in a boom, more working capital is needed (higher sales and production); in a depression, less.
4. Seasonal factors – peak season needs more working capital.
5. Production cycle – a longer production cycle (time to convert raw materials into finished goods) needs more working capital.
6. Credit allowed – liberal credit to customers increases debtors and working capital needs.
7. Credit availed – credit from suppliers reduces working capital needs.
8. Operating efficiency – efficient firms need less working capital.
9. Availability of raw material – if supply is irregular, more stock must be kept.
10. Growth prospects, level of competition and inflation – each increases working capital needs.

Working capital is investment in current assets (net = current assets – current liabilities); it depends on the nature of business, scale of operations, business cycle, seasonal factors, production cycle, credit allowed and availed, operating efficiency, raw material availability, growth, competition and inflation.

Question LA – Q2

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

Answer

Capital structure is the mix of debt and equity.

• Debt is cheaper (interest is tax-deductible and lenders expect a lower return), so it can increase returns to equity shareholders through trading on equity. But it carries fixed obligations of interest and repayment, raising financial risk.
• Equity is safer (no compulsory payment), but costlier, and over-reliance on it dilutes control and may lower EPS.

So increasing debt raises return (EPS) but also risk. Beyond a point, higher risk raises the cost of both debt and equity and lowers the value of the firm. The financial manager must find the optimal capital structure – the mix at which the value of the firm (market price of shares) is maximum and the overall cost of capital is minimum.

Factors considered include cash flow position, interest and debt-service coverage ratios, ROI vs cost of debt, tax rate, cost of equity, flexibility, control and regulatory framework.

True – debt raises returns to shareholders (cheaper, tax-deductible) but increases financial risk; the capital structure decision seeks the optimal debt–equity mix that balances risk and return to maximise shareholders’ wealth.

Question LA – Q3

“A capital budgeting decision is capable of changing the financial fortunes of a business.” Do you agree? Give reasons for your answer?

Answer

Yes. Capital budgeting decisions are long-term investment decisions (e.g. buying new machinery, new plant, expansion, new product line). They are important because:

1. Long-term growth and effects – they affect the earning capacity of the business over a long period.
2. Large amount of funds involved – substantial funds are committed; a wrong decision is very costly.
3. Risk involved – they affect the returns and risk of the business for years.
4. Irreversible decisions – once made, they cannot be reversed without heavy loss.

A good capital budgeting decision can increase the firm’s profitability and value; a bad one can lead to heavy losses or even failure. Hence it can change the financial fortunes of a business.

Yes – capital budgeting decisions have long-term effects on growth, involve large funds and risk, and are irreversible, so a good decision can transform profitability while a bad one can ruin the business.

Question LA – Q4

Explain the factors affecting dividend decision?

Answer

1. Amount of earnings – dividends are paid out of current and past earnings.
2. Stability of earnings – firms with stable earnings can pay higher dividends.
3. Stability of dividends – companies try to keep dividend per share stable.
4. Growth opportunities – firms with good growth prospects retain more earnings.
5. Cash flow position – dividend requires cash; profit alone is not enough.
6. Shareholders’ preference – some shareholders want regular income.
7. Taxation policy – higher tax on dividends means lower payout.
8. Stock market reaction – an increase in dividend has a positive impact on share price.
9. Access to capital market – large, reputed firms with easy access can pay more dividends.
10. Legal constraints – Companies Act provisions on payment of dividend.
11. Contractual constraints – loan agreements may restrict dividend.

Earnings and their stability, stability of dividends, growth opportunities, cash flow, shareholders’ preference, taxation, stock market reaction, access to capital market, and legal and contractual constraints.

Question LA – Q5

Explain the term ‘Trading on Equity’? Why, when and how it can be used by company.

Answer

Trading on equity refers to the increase in profit per equity share (EPS) due to the use of fixed-cost funds (debt, preference shares) in the capital structure.

Why: to increase the return to equity shareholders – debt is cheaper (interest is tax-deductible) and lenders do not share surplus profits.

When: it is favourable only when the rate of return on investment (ROI) is higher than the rate of interest on debt. If ROI is lower than the cost of debt, EPS falls.

How: by raising part of the required funds through debt instead of equity. Illustration – total funds ₹ 30 lakh, EBIT ₹ 4 lakh (ROI 13.33 %), interest 10 %, tax 30 %:

EPS rises as debt increases because ROI (13.33 %) > interest (10 %). The company must also consider its ability to bear the extra financial risk (interest coverage, cash flows).

Trading on equity is raising EPS by using fixed-cost debt; it is used to boost shareholders’ returns, only when ROI exceeds the cost of debt, by financing part of the investment with debt (e.g. EPS rises from ₹ 0.93 to ₹ 1.40 as debt rises when ROI 13.33 % > interest 10 %).

Question LA – Q6

‘S’ Limited is manufacturing steel at its plant in India. It is enjoying a buoyant demand for its products as economic growth is about 7–8 per cent and the demand for steel is growing. It is planning to set up a new steel plant to cash on the increased demand. It is estimated that it will require about ₹ 5000 crores to set up and about ₹ 500 crores of working capital to start the new plant. a. Describe the role and objectives of financial management for this company. b. Explain the importance of having a financial plan for this company. Give an imaginary plan to support your answer. c. What are the factors which will affect the capital structure of this company? d. Keeping in mind that it is a highly capital-intensive sector, what factors will affect the fixed and working capital. Give reasons in support of your answer.

Answer

a. Role and objectives of financial management

• Objective: maximise shareholders’ wealth (market value of shares) by ensuring the new plant earns returns above its cost of capital.
• Role:
  • estimate total funds needed (₹ 5,500 crore);
  • decide the investment in fixed and current assets (capital budgeting – evaluate the project’s viability);
  • decide the mix of debt and equity (financing decision);
  • plan the dividend policy, since retained earnings can finance part of the project;
  • ensure liquidity and the safety of funds, and control costs.

b. Importance of a financial plan

• ensures funds are available on time, which avoids delays in construction;
• prevents raising excess funds;
• facilitates coordination between construction, production and finance;
• reduces uncertainty about future cash needs;
• provides a basis for control.

Imaginary financial plan (₹ crore):

c. Factors affecting capital structure

• cash flow position;
• interest coverage and debt service coverage ratios;
• return on investment versus cost of debt (trading on equity);
• tax rate (interest is deductible);
• cost of equity;
• floatation costs;
• risk (steel is cyclical, so business risk is high);
• flexibility for future borrowing;
• control (equity dilutes control);
• regulatory framework (SEBI, RBI norms);
• stock market conditions;
• capital structure of other steel companies.

d. Factors affecting fixed and working capital (capital-intensive sector)

Fixed capital – large requirement because:

• nature of business – manufacturing steel needs heavy plant and machinery;
• scale of operations – a large new plant;
• choice of technique – capital-intensive technology;
• technology upgradation;
• growth prospects – demand is growing, so capacity is built for the future;
• financing alternatives (leasing) and level of collaboration (sharing facilities) may reduce the requirement.

Working capital – substantial because:

• long production cycle;
• large inventories of raw materials (iron ore, coal);
• scale of operations;
• credit allowed to buyers;
• business cycle – a boom phase needs more;
• availability of raw material;
• inflation.

Credit availed from suppliers and operating efficiency can reduce the requirement.

1. Maximise shareholders’ wealth by evaluating, financing and controlling the ₹ 5,500 crore project. b. A financial plan ensures timely funds, avoids excess funds and aids coordination and control – illustrated by a three-year sources-and-uses plan. c. Cash flows, coverage ratios, ROI vs cost of debt, tax, cost of equity, risk, flexibility, control, regulation and market conditions. d. Fixed capital is high due to the nature of business, scale, technique, technology and growth; working capital is high due to the long production cycle, raw-material stocks, scale, credit allowed, the business cycle and inflation.

Topic checklist

• ☒ Meaning, objectives and financial decisions (SA 3, 4; LA 3, 6a)
• ☒ Financial planning (VSA 2; SA 7a; LA 6b)
• ☒ Capital structure, financial risk and trading on equity (VSA 1, 3; SA 1, 5; LA 2, 5, 6c)
• ☒ Fixed and working capital (VSA 4, 5; SA 2, 6; LA 1, 6d)
• ☒ Dividend decision (SA 7b; LA 4)

Total questions answered: 18 of 18