In this post we have Shared Gauhati University Fundamentals of Financial Management solved Question Paper 2023 in Pdf, B.Com 5th Sem GU, Which can be very beneficial for your upcoming exam preparation. So read this post from top to bottom and get familiar with the question paper solution .
4 (Sem-5/CBCS) COM HC 2 (FOFM)
2023
COMMERCE
(Honours Core)
Paper: COM-HC-5026
(Fundamentals of Financial Management)
Full Marks: 70
Time: Three hours
The figures in the margin indicate full marks for the questions.
1. Choose the right answers : 1×10=10
(i) Which of the following is a part of financial decision making?
(a) Financing decision
(b) Dividend decision
(c) Investment decision
(d) All of the above
Answer: (d) All of the above
(ii) Which of the following represents the capital structure of a company?
(a) Debt and equities
(b) Equities and preference share capital
(c) All assets
(d) All liabilities
Answer: (a) Debt and equities
(iii) Which of the following is also known as long-term investment decision?
(a) Dividend decision
(b) Working capital
(c) Capital budgeting decision
(d) All of the above
Answer: (c) Capital budgeting decision
(iv) Current assets are twice the current liabilities. If the working capital is Rs. 2,00,000, current assets would be:
(a) Rs. 2,00,000
(b) Rs. 4,00,000
(c) Rs. 3,00,000
(d) Rs. 1,00,000
Answer: (b) Rs. 4,00,000
(v) The capitalisation of profit is termed as:
(a) Stock dividend
(b) Cash dividend
(c) Property dividend
(d) Bond dividend
Answer: (a) Stock dividend
(vi) Investment decisions are outside the purview of financial decisions.
(a) True
(b) False
Answer: (b) False
(vii) Increased use of debt increases the financial risk of equity shareholders.
(a) True
(b) False
Answer: (a) True
(viii) Capital budgeting decisions are generally of irreversible nature.
(a) True
(b) False
Answer: (a) True
(ix) The rate of return on investment falls with the shortage of working capital.
(a) True
(b) False
Answer: (a) True
(x) Profitability index is also known as benefit/cost ratio.
(a) True
(b) False
Answer: (a) True
2. Answer the following questions in about 50 words each: 2×5=10
(a) What is financial management?
Financial management refers to the efficient and effective planning, organizing, directing, and controlling of financial activities such as procurement, utilization, and allocation of funds in an organization. It involves making crucial decisions related to investment, financing, and dividend distribution, ensuring optimal use of financial resources to achieve organizational objectives and maximize shareholder wealth.
(b) What is leverage?
Leverage refers to the use of borrowed funds (debt) to finance the assets of a company. It is a strategy to amplify returns on equity by using debt in the capital structure. Financial leverage increases the potential for higher returns to shareholders but also increases the financial risk due to fixed interest obligations.
(c) What are the various methods of capital budgeting decisions?
The various methods of capital budgeting decisions include:
Payback period: Time taken to recover the initial investment.
Net present value (NPV): The difference between the present value of cash inflows and outflows.
Internal rate of return (IRR): The discount rate at which the NPV of an investment becomes zero.
Profitability index: The ratio of the present value of cash inflows to the initial investment.
(d) What is dividend?
A dividend is the portion of a company’s earnings that is distributed to its shareholders, usually in the form of cash or additional shares. Dividends represent a return on shareholders' investments and are typically paid periodically, depending on the company’s profitability and dividend policy.
(e) What is permanent working capital?
Permanent working capital refers to the minimum level of current assets required by a business to continue its operations without interruption. This portion of working capital remains constant throughout the year and is needed to maintain the firm's operational cycle, covering essential expenses like raw materials, salaries, and utilities.
3. Answer the following questions within 150- 200 words each: (any four) 5×4=20
(a) State the nature of financial management.
Financial management is an integral part of business management that focuses on managing the financial resources of an organization to achieve its objectives. It involves planning, organizing, controlling, and monitoring financial resources efficiently and effectively. The nature of financial management can be understood through its core functions:
Investment Decisions: Financial management helps in making long-term investment decisions, known as capital budgeting, and short-term investment decisions, like managing working capital.
Financing Decisions: It involves determining the optimal mix of debt and equity to finance the organization’s operations and growth while minimizing the cost of capital and financial risk.
Dividend Decisions: Financial managers decide how much of the profit should be distributed as dividends to shareholders and how much should be retained for reinvestment.
Risk Management: Financial management also involves identifying and managing financial risks, including interest rate fluctuations, exchange rate risk, and liquidity risks.
Overall, financial management aims to maximize shareholder wealth while maintaining liquidity, profitability, and financial stability. It plays a strategic role in the success of a business by ensuring optimal use of financial resources.
(b) Explain the significance of cost of capital.
The cost of capital refers to the minimum rate of return that a business must earn on its investments to satisfy its investors, whether they are equity shareholders or debt holders. It serves as a benchmark for evaluating investment opportunities and making important financial decisions.
Investment Decisions: The cost of capital helps in assessing whether a project will generate sufficient returns. If a project's return is higher than the cost of capital, it is considered viable.
Optimal Capital Structure: The cost of capital plays a key role in determining the proportion of debt and equity in a firm’s capital structure. A lower cost of capital implies a more efficient capital structure.
Performance Evaluation: Companies use the cost of capital to evaluate their performance. A return on investment higher than the cost of capital indicates that the company is adding value to its shareholders.
Dividend Policy: It influences the decision of how much profit should be distributed as dividends. A company with a higher cost of capital may retain more earnings to reinvest in projects.
In essence, the cost of capital is a crucial financial metric that guides investment, financing, and dividend decisions.
(c) Explain the significance and limitations of financial leverage.
Significance of Financial Leverage:
Financial leverage refers to the use of borrowed funds (debt) in a company's capital structure to enhance returns to equity shareholders. Its significance lies in several areas:
Enhanced Returns: When a company uses debt, it can increase its potential returns on equity, as long as the return on investment exceeds the cost of debt. This is because debt typically has a lower cost compared to equity financing.
Tax Benefits: Interest paid on debt is tax-deductible, which provides companies with a tax shield, thereby reducing the overall tax liability.
Capital Availability: Leverage allows companies to access more capital than they could through equity alone, enabling growth and expansion without diluting ownership.
Limitations of Financial Leverage:
While financial leverage has its advantages, it also comes with several limitations:
Increased Financial Risk: Higher leverage increases the company’s fixed financial obligations (interest payments). If the company’s earnings are not sufficient to cover these payments, it can lead to financial distress or even bankruptcy.
Earnings Volatility: Leverage amplifies both gains and losses. If the company’s revenues decline, the fixed debt obligations remain, leading to greater volatility in earnings.
Credit Risk: Excessive debt can damage the company’s credit rating, making it more difficult and expensive to borrow in the future.
In conclusion, while financial leverage can enhance shareholder returns and provide tax benefits, it also increases financial risk, potentially leading to higher earnings volatility and credit risk. Therefore, careful management of debt levels is crucial.
(d) Explain the capital budgeting process.
Ans:- Capital Budgeting Process
Capital budgeting is a process that helps organizations evaluate potential major investments or expenditures, such as new projects, acquisitions, or large equipment purchases. The steps involved in capital budgeting include:
Identification of Investment Opportunities: The first step is to identify potential investment opportunities that align with the company’s strategic goals.
Project Evaluation: This step involves gathering relevant data and analyzing the financial feasibility of the project. Methods such as Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period are commonly used.
Selection of Projects: Based on the evaluation, management decides which projects should be pursued. Projects with positive NPV or higher IRR compared to the cost of capital are typically chosen.
Financing: After the selection, the company determines how to finance the project, whether through internal funds, equity, or debt.
Implementation: Once financing is secured, the project is implemented. It involves allocating resources and managing the timeline.
Performance Review: Post-implementation, the project's performance is monitored to ensure it delivers the expected returns. This step is crucial for future decision-making.
(e) Distinguish between gross working capital and net working capital.
Ans:- Gross Working Capital vs. Net Working Capital
Gross Working Capital refers to the total current assets of a business, such as cash, accounts receivable, and inventory. It measures the firm’s short-term liquidity and its ability to meet operational expenses and obligations.
Net Working Capital (NWC) is calculated as the difference between current assets and current liabilities. NWC shows the firm’s efficiency in using its short-term resources and maintaining liquidity after covering its short-term debts.
Gross Working Capital emphasizes the total funds available for day-to-day operations, while Net Working Capital reflects the financial stability of the company by showing its ability to cover liabilities with assets.
(f) Explain the various forms of dividend.
Ans:- Forms of Dividend
Dividends are the returns given to shareholders from a company’s profits. There are various forms of dividends:
Cash Dividend: The most common type where shareholders receive payments in the form of cash. It provides immediate financial benefit to shareholders.
Stock Dividend: Instead of cash, shareholders receive additional shares of the company. This increases their equity but doesn’t immediately provide cash.
Property Dividend: In rare cases, companies distribute dividends in the form of physical assets, securities of other companies, or real estate.
Scrip Dividend: This is a promise to pay shareholders at a later date, essentially an IOU, often when the company lacks liquidity to pay immediate cash dividends.
Liquidating Dividend: When a company is going out of business, it may pay liquidating dividends from the capital instead of profit, signifying the return of initial capital to shareholders.
Each form has different implications for the company’s cash flow and the shareholders' benefits.
4. Answer the following questions within 500- 600 words each:
(a) Discuss the scope and objectives of financial management. 10
Ans:- Scope and Objectives of Financial Management
Scope of Financial Management:
Financial management plays a pivotal role in the operations and sustainability of a business, focusing on planning, controlling, and overseeing the organization’s financial resources. It extends across various functional areas such as investment, financing, and dividend decisions.
Investment Decision: This involves the allocation of funds into profitable ventures. It requires analyzing long-term and short-term investment opportunities. Long-term investments include capital expenditures in assets, while short-term ones refer to managing current assets like inventories and receivables. Proper investment decisions help in wealth maximization for shareholders.
Financing Decision: This entails decisions on the best financing mix—whether to use debt, equity, or a combination of both. It determines how the business will raise capital to finance its operations and growth. A well-balanced financing structure helps in minimizing the cost of capital and maximizing firm value.
Dividend Decision: These decisions revolve around the distribution of profits to shareholders. A firm must decide the proportion of earnings to be retained for future growth versus distributed as dividends. The dividend policy can affect investor perception, share prices, and long-term capital growth.
Working Capital Management: Efficient management of working capital—current assets and liabilities—is vital to ensure the firm has sufficient liquidity for day-to-day operations. It involves optimizing the levels of cash, receivables, and inventories, while also managing short-term debts.
Risk Management: Financial management also involves identifying and mitigating various financial risks such as market risks, credit risks, and operational risks. This ensures the stability and predictability of cash flows.
Objectives of Financial Management:
The primary objective of financial management is wealth maximization, which translates into maximizing the value of shareholders' investments over time. This is achieved by balancing risk and return, ensuring liquidity, and fostering growth. Here are the main objectives:
Profit Maximization: One of the earlier traditional goals, this focuses on generating the maximum possible profit for the organization. However, it does not consider the risks associated with profit-making or the long-term sustainability of those profits.
Wealth Maximization: Unlike profit maximization, this considers the long-term perspective and risk factors. Wealth maximization focuses on increasing the value of shareholders' equity, ensuring long-term growth and sustainability for the firm.
Ensuring Liquidity: Maintaining adequate liquidity to meet short-term obligations is crucial. A company must strike a balance between maintaining enough liquidity to avoid financial distress while also investing excess funds for profitable returns.
Efficient Resource Allocation: Financial management ensures that resources are allocated efficiently to productive ventures. This involves selecting projects that generate the highest returns at an acceptable risk level.
Financial Discipline: Another objective is to maintain financial discipline, which entails managing resources prudently, avoiding unnecessary debt, and ensuring funds are used efficiently.
Or
Describe the determinants of capital structure of a firm.
Ans:- Determinants of Capital Structure of a Firm
The capital structure of a firm refers to the mix of debt and equity that the firm uses to finance its operations and growth. Determining the right capital structure is critical as it influences the company’s cost of capital, financial risk, and overall value. Several factors affect a firm's capital structure:
Business Risk: This is the risk associated with the firm’s operational environment. Companies with higher business risks, such as fluctuating earnings or an unstable market, tend to rely less on debt financing. This is because debt involves fixed interest payments, which may be difficult to meet if revenues are unpredictable.
Cost of Debt: The interest rate on borrowed funds is a major consideration. If the cost of debt is low, companies may be inclined to borrow more since it increases profitability through leverage. However, if borrowing costs rise due to factors like economic conditions or company-specific risks, firms will reduce debt reliance.
Tax Considerations: Debt financing provides tax benefits since interest payments are tax-deductible. This tax shield makes debt a more attractive option for firms seeking to reduce their taxable income. However, the value of this benefit must be weighed against the increased risk of financial distress.
Company Size and Growth Stage: Larger, well-established companies with stable cash flows can often take on more debt compared to smaller firms or startups, which may find it difficult to service regular debt payments. Companies in growth stages may rely more on equity to avoid the burden of fixed interest costs.
Control Considerations: When a company issues new equity, existing shareholders’ control gets diluted. Owners may prefer debt financing if they want to retain control of the firm. Conversely, some firms might prefer equity to avoid the risks associated with fixed debt obligations.
Flexibility and Financial Stability: Firms must consider the flexibility their capital structure offers in terms of future financing needs. Equity offers more flexibility since it doesn't involve obligatory payments. Debt, on the other hand, limits a company's financial flexibility as it requires regular interest payments.
Market Conditions: Prevailing conditions in the capital market also influence the decision. In bullish markets, firms might issue equity to take advantage of high valuations, while in bearish markets, firms may prefer debt if interest rates are favorable.
Industry Standards: Certain industries have norms regarding capital structures. For example, capital-intensive industries such as utilities and telecommunications often have high debt levels due to the stable and predictable nature of their cash flows.
(b) State the various factors determining the dividend policy of a company. 10
Ans:- Factors Determining the Dividend Policy of a Company
Dividend policy refers to the decision-making process regarding the distribution of profits to shareholders in the form of dividends. The policy chosen by a company is influenced by a combination of internal and external factors, each of which can have a significant impact on the firm’s financial health, growth prospects, and shareholder satisfaction.
1. Profitability:
The most fundamental factor influencing dividend policy is the company's profitability. Firms with high and stable profits are more likely to pay regular dividends. A company with inconsistent or low profits may retain earnings for future stability rather than distributing them.
2. Liquidity Position:
Even if a company is profitable, it needs sufficient liquid assets (cash or equivalents) to pay dividends. A firm with poor liquidity may hold back from paying dividends, even if it is making profits, as it needs to maintain sufficient cash to cover operational expenses and investments.
3. Growth Opportunities:
Companies with strong growth opportunities tend to retain earnings rather than distribute them as dividends. Retaining earnings allows the firm to invest in new projects, research and development, or expansion, which could increase shareholder value in the long run. In contrast, mature companies with fewer growth opportunities might return more profits to shareholders through dividends.
4. Shareholder Preferences:
The preferences of shareholders play a crucial role in dividend policy. Some shareholders prefer regular dividend payments as a steady income source, while others prefer capital gains, valuing retained earnings used for growth. A company must balance these preferences when designing its dividend policy.
5. Tax Considerations:
Tax policies can influence whether a company prefers to distribute dividends or retain earnings. If dividend income is taxed at a higher rate than capital gains, shareholders may prefer companies that retain earnings for reinvestment rather than paying out dividends. Firms often adjust their dividend policies according to the tax preferences of their investors.
6. Debt Obligations and Financial Leverage:
Companies with high levels of debt or financial leverage tend to adopt conservative dividend policies. They prioritize debt repayment and interest obligations over dividends to avoid financial distress. A firm that relies on borrowed funds may also face restrictions from lenders, limiting its ability to declare dividends.
7. Stability of Earnings:
Companies with stable and predictable earnings are more likely to pay consistent dividends. Firms with volatile or unpredictable earnings may adopt a cautious dividend policy, choosing to distribute smaller, more conservative dividends to avoid future financial strain.
8. Legal Constraints:
Legal provisions may restrict a company’s ability to pay dividends. For instance, companies are typically prohibited from paying dividends out of capital, and dividends must come from distributable profits. Some jurisdictions also impose specific regulations on dividend payments that firms must adhere to.
9. Inflation and Economic Conditions:
Macroeconomic factors such as inflation, interest rates, and overall economic conditions can influence dividend policy. During economic downturns or periods of high inflation, firms may reduce dividend payments to preserve cash reserves for operational needs.
10. Market Expectations:
Companies often aim to maintain a consistent dividend policy in line with market expectations. If investors expect regular dividends, the company may feel compelled to maintain these payments to avoid negative market reactions, even during challenging financial periods.
In summary, the dividend policy of a company is shaped by a mix of profitability, liquidity, growth prospects, tax considerations, debt levels, and shareholder expectations. An optimal policy balances these factors to satisfy shareholders while ensuring the firm’s long-term financial health.
Or
State the various factors determining the working capital requirements of a firm.
Ans:- Factors Determining the Working Capital Requirements of a Firm
Working capital refers to the difference between a firm’s current assets and current liabilities. Efficient management of working capital is essential for maintaining smooth day-to-day operations, ensuring liquidity, and avoiding financial distress. Several factors influence a firm’s working capital requirements:
1. Nature of Business:
The type of business greatly impacts its working capital needs. Manufacturing companies, for instance, require more working capital due to the need to maintain inventories of raw materials, work-in-progress, and finished goods. In contrast, service-based firms typically need less working capital, as they don’t hold large inventories.
2. Business Cycle and Seasonality:
Firms operating in industries with seasonal demand (e.g., retail or tourism) experience fluctuating working capital needs. During peak seasons, firms may require more working capital to stock inventory and meet increased demand. Conversely, during off-peak periods, their working capital needs diminish.
3. Production Cycle:
The length of the production cycle affects working capital requirements. Companies with long production cycles require more working capital because funds are tied up in raw materials, labor, and overhead costs until the finished goods are ready for sale. Firms with shorter production cycles need less working capital.
4. Credit Policy:
A firm’s credit policy toward its customers directly affects its working capital. Companies that offer longer credit periods to customers will have more receivables, increasing their working capital requirements. On the other hand, firms that require immediate payments can maintain lower levels of working capital.
5. Inventory Management:
The level of inventory a company maintains has a significant impact on its working capital. Firms that manage their inventory efficiently (e.g., just-in-time inventory systems) can minimize the amount of capital tied up in inventory. Companies with poor inventory management practices will require more working capital.
6. Terms of Purchase (Credit from Suppliers):
The credit terms extended by suppliers influence a company’s working capital needs. Firms that receive favorable credit terms from suppliers can delay payment and thus reduce their immediate working capital requirements. However, companies that must pay suppliers quickly need more cash on hand, increasing their working capital needs.
7. Growth and Expansion:
Companies experiencing rapid growth or expansion generally need more working capital to support increased production, sales, and inventory levels. Expansion into new markets or product lines requires additional resources, thus raising the working capital requirements.
8. Operating Efficiency:
Firms that operate efficiently with shorter cash conversion cycles (the time it takes to turn investments in inventory into cash) will have lower working capital requirements. Inefficient operations, on the other hand, lead to a longer cash conversion cycle, increasing the need for working capital.
9. External Factors:
Macroeconomic factors such as inflation, interest rates, and market conditions also affect working capital requirements. High inflation can increase the cost of goods, leading to higher working capital needs. Additionally, higher interest rates raise the cost of borrowing, making it more expensive to finance working capital needs.
10. Company’s Financial Policy:
A company’s approach to financing working capital also plays a role. Some firms adopt a conservative policy, maintaining high levels of working capital to ensure liquidity. Others may opt for an aggressive policy, keeping working capital levels low and relying on short-term financing.
(c) Discuss the traditional methods of capital budgeting decision. 10
Ans:- Capital budgeting is the process by which firms decide on the long-term investments to undertake. It involves evaluating projects or investments to determine whether they will generate value over time. Traditional methods of capital budgeting focus primarily on cash flows and the time value of money. The key traditional methods include:
1. Payback Period (PBP) Method:
This method measures the time it takes for an investment to generate cash flows sufficient to recover its initial cost. The focus is on the liquidity aspect—how quickly the project pays back the investment.
Advantages:
Simple to calculate and understand.
Emphasizes quick recovery of the investment, reducing risk.
Disadvantages:
Ignores the time value of money.
Does not consider cash flows after the payback period.
Does not measure profitability beyond payback.
2. Average Rate of Return (ARR):
The ARR method measures the average annual profit earned from an investment as a percentage of the initial investment. It’s a profitability measure rather than focusing on cash flows.
Advantages:
Easy to calculate and compare with other investments.
Focuses on accounting profitability.
Disadvantages:
Ignores the time value of money.
Depends on accounting profits, which may not reflect cash flows.
Inconsistent with maximizing shareholder wealth.
3. Net Present Value (NPV) Method:
NPV calculates the present value of all cash flows (both inflows and outflows) related to a project, discounted at the firm's cost of capital. If the NPV is positive, the investment is considered acceptable because it adds value to the firm.
Advantages:
Considers the time value of money.
Directly measures how much value a project will add.
Considers all cash flows throughout the project’s life.
Disadvantages:
More complex to calculate.
Requires an appropriate discount rate, which can be difficult to estimate.
4. Internal Rate of Return (IRR) Method:
IRR is the discount rate at which the NPV of a project becomes zero. In other words, it is the rate of return that the project is expected to generate. A project is accepted if its IRR exceeds the required rate of return.
Advantages:
Considers the time value of money.
Provides a clear percentage return, making it easy to interpret.
Disadvantages:
May give multiple IRRs if there are unconventional cash flows (both inflows and outflows during the project’s life).
Assumes reinvestment of interim cash flows at the same rate, which may not be realistic.
5. Profitability Index (PI):
Also known as the benefit-cost ratio, PI is the ratio of the present value of future cash flows to the initial investment. A PI greater than 1 indicates that the project generates more value than its cost, making it acceptable.
Advantages:
Considers the time value of money.
Useful when comparing mutually exclusive projects with different scales of investment.
Disadvantages:
Can be misleading for projects with unequal lifespans.
Requires accurate estimation of future cash flows.
Or
ABC company is considering to purchase one of the following two machines, the details of which are given below :
you
Cost of Machine X and Machine Y is Rs. 10,00,000 each.
Calculate Net Present Value and Profitability Index. 7+3=10
Ans:-
Given:
Cost of each machine: Rs. 10,00,000
Discount rate: 10%
Cash Inflows and Discount Factors (from the table):
Step-by-Step Calculations:
Machine X:
Present Value (PV) of cash inflows = (3,00,000×0.909)+(4,00,000×0.826)+(5,00,000×0.751)+(3,00,000×0.683)+(2,00,000×0.621)= 13,07,700
NPV = 13,07,700−10,00,000=3,07,700
PI = 13,07,700/10,00,000=1.3077
Machine Y:
Present Value (PV) of cash inflows = (1,00,000×0.909)+(3,00,000×0.826)+(4,00,000×0.751)+(6,00,000×0.683)+(4,00,000×0.621)=12,97,300
NPV = 12,97,300−10,00,000=2,97,300
PI = 12,97,300/10,00,000=1.2973
Final Results:
Machine X: NPV = Rs. 3,07,700, PI = 1.3077
Machine Y: NPV = Rs. 2,97,300, PI = 1.2973
Conclusion:
Machine X is the better investment, with a higher NPV and PI than Machine Y.
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