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Gauhati University BCom 2024 Fundamental of Financial Management Solved Question Paper
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Gauhati University Solved Question Paper
B.Com (Honours) – Semester 5 (CBCS)
COM HC2 (FOFM) – 2024
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 correct answer: (1×10=10)
(i) Market capitalisation is a measure of:
(a) Wealth created by equity
(b) Share price indicator of the equity
(c) Market price indicator of the securities
(d) Cost of equity as compared to market price of the equity
Answer: (c) Market price indicator of the securities
(ii) Cost of preference share is:
(a) Treated for tax
(b) Not treated for tax
(c) Only occasionally treated for tax
(d) None of the above
Answer: (b) Not treated for tax
(iii) Internal rate of return is the discount rate at which:
(a) NPV > 0
(b) NPV < 0
(c) NPV = 0
(d) None of the above
Answer: (c) NPV = 0
(iv) Current assets are twice the current liabilities. If working capital is Rs. 20,000, the current assets would be:
(a) Rs. 10,000
(b) Rs. 40,000
(c) Rs. 80,000
(d) Rs. 20,000
Answer: (b) Rs. 40,000
(v) Profit maximisation ignores:
(a) Wealth
(b) Time value of money
(c) Net value
(d) None of the above
Answer: (b) Time value of money
(vi) Net working capital is the excess of current assets over current liabilities.
(a) True
(b) False
Answer: (a) True
(vii) In respect of raising finance from the new issue market, companies are prohibited from issuing shares at a discount except in the case of sweat equity shares.
(a) True
(b) False
Answer: (a) True
(viii) When the profitability index exceeds one, the proposal is rejected.
(a) True
(b) False
Answer: (b) False
(ix) When a company pays a dividend in the form of bonds, it is called a property dividend.
(a) True
(b) False
Answer: (a) True
(x) The profitability index or benefit-cost ratio is the relation between the present value of future net cash flow and the initial cash outlay.
(a) True
(b) False
Answer: (a) True
2. Answer the following questions in about 50 words each: (2×5=10)
(a) State the objectives of wealth maximisation.
Answer: The main objective of wealth maximisation is to increase the value of a business for its shareholders. It focuses on long-term financial growth, ensuring higher returns, better market value of shares, and overall business sustainability. It considers profits, risks, and the time value of money to make the best financial decisions.
(b) State the meaning of EPS.
Answer: EPS (Earnings Per Share) is a financial ratio that shows the profit a company earns per share of its stock. It is calculated by dividing the net profit by the total number of outstanding shares. A higher EPS indicates better profitability and financial performance of a company.
(c) Define the Internal Rate of Return (IRR).
Answer: Internal Rate of Return (IRR) is the discount rate at which the net present value (NPV) of a project becomes zero. It is used in capital budgeting to evaluate investment opportunities. A higher IRR means the project is more profitable and financially attractive for investors.
(d) What is stock dividend?
Answer: A stock dividend is a payment made by a company to its shareholders in the form of additional shares instead of cash. It increases the number of shares owned by investors but does not change the total value of their investment. Companies issue stock dividends to conserve cash.
(e) What is cash management?
Answer: Cash management refers to the process of handling a company’s cash flow efficiently. It involves collecting, managing, and investing cash to ensure financial stability. Proper cash management helps businesses meet short-term expenses, avoid financial crises, and improve overall profitability.
3. Answer any four of the following questions in 150-200 words each: (5×4=20)
(a) Define opportunity cost of capital. How is it computed?
Answer: Opportunity cost of capital refers to the return that an investor forgoes when choosing one investment over another with a similar risk level. It represents the potential earnings lost from not investing in the best alternative option. In financial decision-making, businesses consider this cost while evaluating investment projects.
It is computed by identifying the expected return from the next best alternative investment. The formula for opportunity cost of capital is:
Opportunity Cost of Capital = Return from Best Alternative Investment – Return from Chosen Investment
For example, if a company has Rs. 1,00,000 and chooses to invest in a project with a 10% return instead of a bank deposit offering 8%, the opportunity cost is 8%. Businesses use the opportunity cost of capital to ensure they invest in the most profitable projects.
(b) Distinguish between financial leverage and operating leverage.
Answer:
Financial leverage and operating leverage are two important concepts in financial management that measure a company's risk and profitability.
Financial Leverage:
It refers to the use of borrowed funds (debt) to increase returns for shareholders.
A company with high financial leverage has more debt compared to equity.
It increases both potential profits and financial risk.
Measured using the Debt-to-Equity Ratio or Earnings Before Interest and Taxes (EBIT) / Earnings Before Taxes (EBT).
Operating Leverage:
It refers to the impact of fixed costs on a company’s operating income.
A company with high operating leverage has more fixed costs and fewer variable costs.
It increases profits when sales rise but also increases risk during low sales.
Measured using the Degree of Operating Leverage (DOL) formula: Contribution Margin / Operating Profit.
Key Difference: Financial leverage depends on debt, while operating leverage depends on fixed costs. High financial leverage increases financial risk, while high operating leverage increases business risk.
(c) State the limitations of financial management.
Answer: Financial management is crucial for any business, but it has some limitations:
Uncertainty in Future Predictions: Financial management involves forecasting revenues, expenses, and investments, but future conditions like market fluctuations and economic changes can affect predictions.
Limited Availability of Data: Proper financial decisions require accurate data. If data is incomplete or misleading, financial management may not be effective.
Risk and Uncertainty: Investments carry risks, and financial management cannot completely eliminate them. Business risks, inflation, and interest rate fluctuations impact financial planning.
Dependence on External Factors: Economic policies, government regulations, and financial market conditions influence financial management decisions, which businesses cannot control.
Conflicts Between Profit and Growth: Financial managers must balance profit-making with long-term business growth, which may create conflicts in decision-making.
Short-Term Focus: Some companies focus too much on short-term financial performance, ignoring long-term sustainability and wealth maximization.
Despite these limitations, financial management is essential for business success and requires continuous adaptation to market conditions.
(d) Discuss the use of the Internal Rate of Return (IRR).
Answer: Internal Rate of Return (IRR) is an important financial metric used in investment decision-making. It helps businesses evaluate the profitability of projects by determining the discount rate at which the net present value (NPV) of cash flows becomes zero.
Uses of IRR:
Investment Decision-Making: IRR is used to compare different investment projects. A project is accepted if its IRR is higher than the required rate of return.
Capital Budgeting: Businesses use IRR to assess long-term investments like purchasing machinery, launching new products, or expanding operations.
Comparing Projects: When multiple projects are available, IRR helps in selecting the most profitable one. Higher IRR means a better return on investment.
Risk Assessment: IRR considers the time value of money, helping businesses understand the potential risks and rewards associated with an investment.
Loan and Financing Decisions: Lenders and investors use IRR to decide whether to finance a project or company based on its expected returns.
While IRR is a useful tool, it has limitations. It assumes that cash flows are reinvested at the IRR rate, which is not always realistic. Therefore, IRR is often used along with other financial metrics like NPV for better decision-making.
(e) State the circumstances under which bonus shares are issued.
Answer: Bonus shares are additional shares issued to existing shareholders without any cost. Companies issue bonus shares under the following circumstances:
High Reserves and Surplus: When a company has accumulated high profits and reserves but does not want to distribute cash dividends, it issues bonus shares to reward shareholders.
Increase Market Liquidity: Issuing bonus shares increases the number of shares in the market, making them more affordable and increasing trading activity.
Attract More Investors: Bonus shares make the stock more attractive to new investors, increasing demand and boosting market confidence.
Enhancing Shareholder Value: By issuing bonus shares, companies increase the number of outstanding shares, which may improve the stock's market perception.
Maintaining Dividend Policy: Instead of paying large cash dividends, companies issue bonus shares while keeping a steady dividend per share.
Compliance with Regulatory Requirements: Sometimes, companies issue bonus shares to comply with stock exchange regulations that require a minimum public holding.
Bonus shares do not impact the company’s total equity but help in restructuring capital and increasing investor confidence.
(f) Examine the importance of accounts receivable management.
Answer: Accounts receivable management refers to the process of tracking and collecting payments from customers for goods or services sold on credit. It is crucial for a company’s financial health.
Importance of Accounts Receivable Management:
Ensures Steady Cash Flow: Proper management helps businesses receive payments on time, maintaining a healthy cash flow for daily operations.
Reduces Bad Debts: Monitoring outstanding payments and following up with customers reduces the risk of bad debts and financial losses.
Improves Customer Relationships: A structured credit policy ensures that customers pay on time without feeling pressured, maintaining good business relationships.
Enhances Profitability: Effective receivables management minimizes outstanding dues and maximizes revenues, leading to increased profitability.
Optimizes Working Capital: By reducing the collection period, businesses can use the funds for investment, expansion, or paying off liabilities.
Minimizes Financial Risk: Late or unpaid receivables can create liquidity issues. A strong receivables policy helps companies maintain financial stability.
Companies use credit policies, payment reminders, discounts for early payments, and strict credit evaluations to ensure effective accounts receivable management.
4. Answer any three of the following questions in about 600 words each: (10×3=30)
(a) Discuss the scope and objectives of financial management.
Answer:
Financial management is the process of planning, organizing, controlling, and monitoring financial resources to achieve business goals efficiently. It involves making decisions about investments, financing, and risk management to maximize a company's value.
Scope of Financial Management: Financial management covers several important areas including:
Investment Decisions: Involves selecting profitable long-term investments like new projects, machinery, or business expansion.
Financing Decisions: Determines the right mix of debt and equity financing to fund business operations at the lowest cost.
Dividend Decisions: Focuses on how much profit should be distributed as dividends and how much should be reinvested for future growth.
Working Capital Management: Ensures the business has enough short-term assets to meet daily operational expenses and liabilities.
Risk Management: Identifies and minimizes financial risks related to market fluctuations, interest rates, and credit.
Objectives of Financial Management:
Profit Maximization: Aims to generate the highest possible profit in the short term.
Wealth Maximization: Focuses on increasing the overall value of the company for shareholders.
Ensuring Liquidity: Maintains adequate cash flow to meet short-term obligations and avoid financial crises.
Efficient Allocation of Funds: Ensures financial resources are used effectively to generate maximum returns.
Maintaining Financial Stability: Balances risk and return to ensure long-term financial health and business sustainability.
In conclusion, financial management plays a critical role in guiding a business toward growth, stability, and profitability by making informed financial decisions.
(b) Discuss modern methods of capital budgeting.
Answer:
Capital budgeting is the process businesses use to evaluate and select long-term investment projects. Modern capital budgeting techniques help companies determine which projects will generate the best returns.
Modern Methods of Capital Budgeting:
Net Present Value (NPV): Measures the difference between the present value of cash inflows and outflows of a project, considering the time value of money. A positive NPV indicates a profitable investment.
Internal Rate of Return (IRR): The discount rate at which the NPV of a project becomes zero. A higher IRR than the required rate of return makes a project acceptable.
Profitability Index (PI): The ratio of the present value of future cash flows to the initial investment. A PI greater than 1 indicates a viable investment.
Discounted Payback Period: The time required to recover the initial investment, considering the time value of money. It helps in assessing risk and liquidity.
Modified Internal Rate of Return (MIRR): A refined version of IRR that assumes cash flows are reinvested at the company’s cost of capital rather than at the IRR.
Real Options Analysis: Evaluates investment projects considering flexibility and future opportunities, such as expanding or delaying investments based on market conditions.
Modern capital budgeting methods help businesses make data-driven investment decisions, minimize risks, and maximize long-term profitability.
(c) Define working capital. What considerations are taken into account in estimating the working capital requirements of a newly started company?
Answer:
Working capital refers to the difference between a company’s current assets and current liabilities. It represents the short-term liquidity available to meet day-to-day operational expenses. A positive working capital ensures smooth business operations, while a negative working capital may lead to financial difficulties.
Considerations for Estimating Working Capital Requirements of a Newly Started Company:
Nature of Business: Businesses with high inventory levels (e.g., manufacturing) require more working capital than service-based businesses.
Business Size and Scale: Larger businesses with higher transaction volumes need more working capital compared to small startups.
Operating Cycle: Companies with longer production and sales cycles require more working capital to sustain operations until revenue is generated.
Credit Policy: If the company offers credit sales, it needs higher working capital to cover delayed payments from customers.
Supplier Credit Terms: If suppliers provide longer credit periods, the need for working capital decreases, while short credit periods increase working capital requirements.
Seasonal Demand: Businesses that experience seasonal demand fluctuations (e.g., retail during festive seasons) require higher working capital to stock inventory and manage expenses.
Market Competition: Highly competitive markets require businesses to maintain sufficient stock and offer flexible payment terms, increasing working capital needs.
Inflation and Economic Conditions: Rising costs due to inflation increase working capital requirements, while economic downturns may reduce the need for excessive stock and expenses.
Growth and Expansion Plans: If the company plans to expand, it needs additional working capital to invest in raw materials, marketing, and new operations.
Emergency Reserves: Keeping a buffer amount for unexpected expenses or market downturns ensures financial stability.
Estimating working capital accurately is crucial for new businesses to maintain financial health, avoid liquidity issues, and ensure smooth operations.
(d) Elaborate on the determinants of a corporate entity’s capital structure and the benefits of a balanced capital structure.
Answer:
Capital structure refers to the mix of debt and equity a company uses to finance its operations and growth. A well-balanced capital structure helps a company minimize risks and maximize profitability.
Determinants of Capital Structure:
Nature and Size of Business: Large and well-established businesses can afford higher debt, while small businesses rely more on equity.
Cost of Debt and Equity: Companies compare the interest cost on debt with the return expected by shareholders before deciding the capital mix.
Profitability: Profitable companies can finance operations with retained earnings, reducing reliance on debt.
Cash Flow Position: A company with stable cash flows can afford more debt, while businesses with irregular income prefer equity financing.
Risk and Leverage: Higher debt increases financial risk, so businesses balance debt and equity to maintain financial stability.
Tax Benefits: Interest on debt is tax-deductible, making debt financing attractive for tax savings.
Market Conditions: If stock market conditions are favorable, companies prefer equity financing, whereas in downturns, they opt for debt.
Control Considerations: Issuing more equity dilutes ownership, so companies balance debt and equity to maintain control.
Regulatory Requirements: Legal restrictions on borrowing influence the debt-equity ratio of a company.
Flexibility: A flexible capital structure allows the company to adjust financing strategies based on changing business needs.
Benefits of a Balanced Capital Structure:
Lower Cost of Capital: An optimal mix of debt and equity reduces the overall cost of financing.
Financial Stability: Balancing debt and equity minimizes financial risk and ensures steady operations.
Higher Profitability: A well-planned capital structure maximizes return on investment for shareholders.
Tax Advantages: Debt financing provides tax benefits through interest deductions, reducing tax liabilities.
Business Growth and Expansion: Proper financing supports business expansion without excessive financial burden.
Enhanced Creditworthiness: A stable capital structure improves credit ratings, making it easier to secure loans at favorable terms.
Maintaining Shareholder Control: Avoiding excessive equity issuance helps existing shareholders retain control over the company.
A well-balanced capital structure helps businesses achieve financial efficiency, reduce risks, and create long-term value for stakeholders.
(e) Elaborate on the Modigliani and Miller hypothesis of dividend decisions. Examine its validity.
Answer:
The Modigliani and Miller (M&M) hypothesis on dividend decisions was introduced by economists Franco Modigliani and Merton Miller in 1961. It suggests that a company's dividend policy does not affect its market value in a perfect capital market.
Modigliani and Miller Hypothesis (Dividend Irrelevance Theory):
Dividend policy does not affect firm value: Investors are indifferent to whether a company pays dividends or retains earnings.
Perfect capital markets assumption: No transaction costs, no taxes, and all investors have equal access to information.
Investment decisions are primary: A company’s value depends on its investment and profitability, not its dividend distribution.
Homemade dividends: Investors can create their own dividends by selling shares if they prefer cash returns.
Validity and Criticism of the M&M Hypothesis:
Market Imperfections: In reality, capital markets are not perfect, and transaction costs and taxes influence dividend preferences.
Tax Considerations: Investors may prefer dividends if capital gains taxes are higher than dividend taxes, making dividend policy relevant.
Investor Preference for Dividends: Some investors, such as retirees, prefer regular dividends as a stable income source.
Information Signaling: Dividend announcements impact stock prices as they signal financial health and future prospects.
Agency Costs: High retained earnings might lead to inefficient spending by management, making dividends a tool to discipline managers.
Although the M&M hypothesis provides a theoretical framework, in practical business scenarios, dividend policy does affect investor behavior and firm valuation due to real-world market imperfections.
(f) ABC Ltd. is considering an investment proposal to install a new industrial mixer at a cost of Rs. 10,00,000. The facility has a life expectancy of 5 years and has no salvage value.
The expected revenue before depreciation and taxes from the investment is as follows:
Year 1: Rs. 2,00,000
Year 2: Rs. 2,20,000
Year 3: Rs. 2,50,000
Year 4: Rs. 2,60,000
Year 5: Rs. 3,00,000
The tax rate is 30% per annum, and the company uses the straight-line method for depreciation.
(i) Determine the cash flows after taxes but before depreciation. (4 marks)
(ii) Calculate the Net Present Value (NPV) of the investment at a 10% discount rate. (5 marks)
(iii) Comment on whether the proposal should be accepted or not. (1 mark)
[Present Value of Re. 1 at 10% discount rate for 5 years: 0.909, 0.826, 0.751, 0.683, 0.621]
Solution:
Step 1: Calculation of Depreciation per Year
Depreciation = Initial Investment / Useful Life
= Rs. 10,00,000 / 5
= Rs. 2,00,000 per year
Step 2: Calculate Taxable Income (RBDT - Depreciation) and Tax Amount
Step 3: Calculation of Cash Flows after Taxes but Before Depreciation
Cash Flow = RBDT - Tax
(ii) Calculate the Net Present Value (NPV)
Step 1: Computation of Present Value of Cash Flows
NPV Formula:
where r=10%r = 10\%r=10%
Total Present Value of Cash Flows = Rs. 8,67,645
Step 2: Calculation of NPV
NPV= Total Present Value - Initial Investment
NPV= 8,67, 645-10,00,000
NPV =-1, 32, 355
(iii) Comment on whether the proposal should be accepted or not.
Answer:- Since the NPV is negative (-Rs. 1,32,355), the investment will result in a financial loss. A negative NPV indicates that the present value of expected cash inflows is less than the initial investment, meaning the project is not financially viable.
Conclusion: ABC Ltd. should not accept the investment proposal as it will not generate sufficient returns at a 10% discount rate.
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