Question

NCERT Solutions Class 12, Business Studies, Chapter- 9, Financial Management

The NCERT Solutions for Class 12 Business Studies offer a thorough and organized method for mastering the subject. Created by specialists, these solutions deliver an in-depth exploration of key concepts from every chapter. Designed to align with the latest CBSE syllabus, they aim to enhance your comprehension and boost your readiness for exams.

In these NCERT Solutions for Class 12 Business Studies, we have discussed all types of NCERT intext questions and exercise questions.

Concepts covered in Class 12 Business Studies chapter- 6 Financial Management, are :

• Introduction of Financial Management
• Meaning of Busines Finance
• Financial Decision
• Investment Decision
• Dividend Decision
• Financial Planning
• Fixed and Working Capital

The NCERT Solutions for Class 12 Business Studies are an essential tool for students striving to excel in their business studies. They offer clear explanations, practice questions, and simple examples to clarify challenging business concepts. By utilizing these solutions, students can achieve a thorough grasp of business principles and improve their exam performance, setting the stage for academic success.

You can now conveniently access all the solutions and practice questions to start your preparation.

Answer 1

NCERT Solutions Class 12, Business Studies, Chapter- 9, Financial Management

Very Short Answer Type

1. What is meant by capital structure?

Solution:

The mix between two sources of business finance, owner’s funds and borrowed funds is called capital structure. They are referred to as debt and equity.

2. Sate the two objectives of financial planning.

Solution:

Two objectives of financial planning are:

1. To ensure availability of funds whenever required
2. To see that the firm does not raise resources unnecessarily

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

Solution:

The concept of financial management which increases the return to equity shareholders due to the presence of fixed financial charges is called trading on equity. When the rate of earning of the return on investment of a company is higher than the rate of interest on the borrowed funds only then a company should adopt for trading on equity.

4. 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’.

Solution:

The working capital of a firm is the capital required to run the daily operations of the business. Since transport service is an exhaustive area that requires a lot of operations, its working capital will be more.

5. 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.

Solution:

Yes, purchasing three months of credit will affect his working capital since it will increase to the amount of credit taken to him. But, selling the complete product in cash wouldn’t affect the working capital of the firm.

Short Answer Type

1. What is financial risk? Why does it arise?

Solution:

Financial risk refers to the financial situation of a company when it would not be able to meet its fixed financial obligations. Such a situation occurs when the debt of a company increases. When a company takes a huge amount of debt, the higher becomes its obligations to repay it with an interest rate are equally high. Thus, such a situation arises when there is a higher debt in the capital structure.

2. Define current assets? Give four examples of such assets.

Solution:

The assets that are convertible into cash after one year are called current assets. Four examples of such assets:

• Cash and cash equivalents
• Accounts receivable
• Stocks Inventory
• Pre-paid liabilities

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

Solution:

The main objectives of financial management are:

• To maximize shareholders’ wealth.
• All financial decisions aim to ensure that each decision is efficient and adds some value.
• To maximize the current price of equity shares of the company or to maximize the wealth of owners of the company, that is, the shareholders.
• To ensure that benefits from the investment exceed the cost so that some value addition takes place.

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

Solution:

Three broad financial decisions of financial management are:

1. Investment Decision- It relates to how the firm’s funds are invested in different assets. They can be short-term or long-term. A long-term investment decision is also called a Capital Budgeting decision. These decisions are very crucial for any business since they affect its earning capacity in the long run.

2. Financing Decision- This decision is about the quantum of finance to be raised from various long-term sources. It is concerned with the decisions about how much to be raised from which source. This decision determines the overall cost of capital and the financial risk of the enterprise.

3. Dividend Decision- It relates to the distribution of dividends. The decision is mainly about how much of the profit earned by the company (after paying tax) is to be distributed to the shareholders and how much of it should be retained in the business.

5. 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 Rs. 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 Rs. 8,00,000 and total capital investment was Rs. 1,00,00,000. Suggest whether issue of debenture would be considered a rational decision by the company. Give reason to justify your answer. (Ans. No, Cost of Debt (10%) is more than ROI which is 8%).

Solution:

A company is able to issue debenture to raise fund when the cost of debt is less than the the cost of capital. In the question given, cost of capital of Sunrises Limited is 10% which is Rs.8,00,000 as total capital is Rs. 80,00,000. Now, Return on investment is calculated as

ROI = Return / Investment

Capital Structure = 1,00,00,000 / 8,00,000 = 8%

Let’s assume that the company will be operating with the same efficiency, the additional investment of Rs. 80,00,000 will have a ROI of 8% which will amount to Rs. 6,40,000. The cost of debt will be Rs. 8,00,000 which is more than the ROI of Rs. 6,40,000. Therefore, it is advised to a company not to issue debenture when cost of debt is higher than the cost of capital.

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

Solution:

Working capital is directly proportional to the liquidity of the business and indirectly proportional to the profitability of the business. As the working capital increases, the liquidity of the business increases whereas as the working capital increases, the profitability of the business decreases. This is so because the increase in working capital indicates that the capital required for running the daily operations of the business has increased, which means more investment and less return.

7. Aval Ltd. is engaged in the business of export of canvas goods and bags. In the past, the performance of the company had been upto 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. ( Financial Planning).

Solution:

Financial planning is discussed in the above paragraph. The preparation of a financial blueprint for an organisation’s future operations is called financial planning. Objectives of financial planning are:

• To ensure that enough funds are available at the right time
• It focuses on smooth operations by focusing on fund requirements and their availability in the light of financial decisions
• It forecasts all the items that are likely to undergo changes
• To ensure availability of funds whenever required
• To see that the firm does not raise resources unnecessarily

b. ‘There is no restriction on payment of dividend by a company’. Comment. ( Legal & Contractual Constraints)

Solution:

There is no restriction on the payment of dividends by a company. This can be understood through legal constraints and contractual constraints. Legal constraints deal with the restrictions put on the company while paying the dividends to its shareholders. Contractual constraints- When a company pays its dividend using cash, then the company’s cash gets reduced. As a consequence, the company has to take loans from banks and other credit institutions. Thus, they can put restrictions on a bank to pay its dividends.

Answer 2

Long Answer Type

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

Solution:

Working capital is that part of total capital which is required to meet day-to-day expenses, to buy raw materials, to pay wages and other expenses of routine nature in the production process or we can say it refers to an excess of current assets over current liabilities. Working Capital = Current Assets – Current Liabilities

Factors affecting working capital requirement are:

(i) Nature of Business: The basic nature of a business influences the amount of working capital required. A trading organisation usually needs a lower amount of the working capital compared to a manufacturing organisation. This is because, in trading, there is no processing required. In a manufacturing business, however, raw materials need to be converted into finished goods, which increases the expenditure on raw material, labour and other expenses.

(ii) Scale of Operation: The firms operating on a higher scale of operations, the quantum of inventory, debtors required is generally high, therefore, such organisations require large amount of working capital as compared to the organisations which operate on a lower scale.

(iii) Production Cycle: Production cycle is the time between the receipts of raw materials and their conversion into finished goods. Some businesses have a longer production cycle while some have a shorter one. Therefore, working capital requirement is higher in terms of a longer processing cycle and lower in firms with a shorter processing cycle.

(iv) Credit Allowed: Different firms allow different credit terms to their customers. However, a liberal credit policy results in higher amount of debtors, increasing the working capital requirements.

(v) Credit Availed: Just as a firm allows credit to its customers, it also may get credit from its suppliers. Thus, the more credit a firm avails on its purchases, the working capital requirement is reduced.

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

Solution:

Capital structure refers to the combination of owner’s and borrowed funds. It can be calculated as Debit/Equity.

Debt and equity differ significantly in their cost and riskiness for the firm. Cost of debt is lower than the cost of equity for a firm because lender’s risk is lower than the equity shareholder’s risk. Since lenders earn on assured return and repayment of capital and therefore, they should require a lower rate of return. Debt is cheaper but is more risky for a business because payment of interest and the return of principal is obligatory for the business. These commitments may force the business to go into liquidation if there is any default in meeting them. There is no such compulsion in case of equity, that is why, it is considered riskless for the business. Higher use of debt increases the fixed financial charges of a business. As a result increased use of debt increases the financial risk of a business.

Capital structure of a business thus, affects both the profitability and the financial risk. A capital structure will said to be optimal when the proportion of debt and equity results in an increment in the value of the equity share.

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

Solution:

Yes, I agree that a capital budgeting decision is capable of changing the financial fortunes of a business. This is because capital budgeting is done for future operations, keeping in mind the needs and requirements of the future. It has long-term implications and thought processes behind it. Strong capital budgeting can help a company grow in various ways. But, the financial situation keeps on changing. And it is an irreversible decision. Once the decision has been made and capital invested, there’s no going back. The entire money can go in vain. Thus, capital budgeting decisions are capable of changing the financial fortune of a company.

4. Explain the factors affecting dividend decision?

Solution:

Dividend decision is related to the distribution of profit to the shareholders and its retention in the business for meeting the future investment requirements. How much of the profit earned by a company will be distributed and how much will be retained in the business is affected by many factors.

Some of the important factors which affect the dividend decision are as follows:

(i) Earnings: Dividends are paid out of current and past year earnings. Therefore, earnings is a major determinant of the decision about dividend.

(ii) Stability of Earnings: Other things remaining the same, a company having stable earning is in a position to declare higher dividends. As against this, a company having unstable earnings is likely to pay smaller dividend.

(iii) Growth Opportunities: Companies having good growth opportunities retain more money out of their earnings so as to finance the required investment. The dividend in growth companies, is therefore, smaller than that in non-growth companies.

(iv) Cash Flow Position: Dividends involve an outflow of cash. A company may be profitable but short on cash. Availability of enough cash in the company is necessary for declaration of dividend by it.

(v) Shareholder Preference: If the shareholders in general, desire that at least a certain amount should be paid as dividend, the companies are likely to declare the same.

(vi) Taxation Policy: If tax on dividend is higher it would be better to pay less by way of dividends. As compared to this, higher dividends may be declared if tax rates are relatively lower.

(vii) Stock Market Reaction: For investors, an increase in dividend is a good news as stock prices react positively to it. Similarly, a decrease in dividend may have a negative impact on the share prices in the stock market.

(viii) Access to Capital Market: Large and reputed companies generally have easy access to the capital market and therefore, depend less on retained earnings to finance their growth. These companies tend to pay higher dividends than the smaller companies which have relatively low access to the market.

(ix) Legal constraints: Certain provisions of the Company’s Act place restriction on payouts as dividend. Such provisions have to be adhered, while declaring dividends.

(x) Contractual Constraints: While granting loans to a company, sometimes the lender may impose certain restrictions on the payment of dividends in future. The companies are required to ensure that the dividends do not violate the terms and conditions of the loan agreement in this regard.

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

Solution:

Trading on equity is a financial process of using debt in order to produce gain for the owners. In this process, new debt is taken to gain new assets with which they can earn greater level of interest which is more than the interest that is paid for debt. This process is followed because the equity shareholders are interested in the income that is being generated from business. It is practiced by a company only when the rate of return on investment is greater than the rate of interest for the fund that is borrowed. There will be an increment in earnings per share when this process is adopted. Trading on equity is profitable only when the return on investment is greater than the amount of funds borrowed. It is said that trading on equity shall be avoided if the return on investment is less than the rate of interest from the funds that are borrowed.

Answer 3

6. ‘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.

Solution:

Role of Financial Management: Financial management is concerned with the proper management of funds.

It involves:-

(i) Managerial decisions related to procurement of long term and short term funds.
(ii) Keeping the risk associated with respect to procured funds under control.
(iii) Utilisation of funds in the most productive and effective manner.
(iv) Fixed debt equity ratio in capital.

Objective of Financial Management: The objective of financial management is to maximise the shareholder’s wealth. The investment decision, financial decision and dividend decision help an organisation to achieve this objective. In the given situation, S limited visualizes growth prospects of steel industry due to the growing demand. To expand the production capacity, the company needs to invest. However, investment decision will depend on the availability of funds, the financing decision and the dividend decision. However, the company will take those financial decisions which result in value addition, i.e., the benefits are more than the cost. This leads to an increase in the market value of the shares of the company.

b. Explain the importance of having a financial plan for this company. Give an imaginary plan to support your answer.

Solution:

Importance of financial plan for the company are :

(i) Financial Planning ensures allocation of adequate funds to meet the working capital requirements.
(ii) It brings about a balance between in flow and out flow of funds and ensures liquidity throughout the year.
(iii) It helps to solve the problems of shortage and surplus of funds by ensuring proper and optimum utilisation of available resources.
(iv) It ensures to increase profitability through cost benefit analysis and by avoiding wasteful operations.
(v) It seeks to eliminate wastage of funds and provides better financial control.
(vi) It seeks to avail the benefits of trading on equity.

c. What are the factors which will affect the capital structure of this company?

Solution:

Capital structure refers to the proportion in which debt and equity funds are used for financing the operations of a business. A capital structure is considered to be optimum when the proportion of debt and equity results in an increase in the value of shares.

The factors that will affect the capital structure of this company are:

(i) Equity Funds: The composition of equity funds in the capital structure will be governed by the following factors:

(a) The funding requirement of ‘S’ Limited is for long term. Hence, equity funds will be more appropriate.

(b) There are no financial risks involved in this form of funding.

(c) If the stock market is bullish, the company can easily raise funds through issue of equity shares.

(d) If the company already has raised reasonable amount of debt funds, each subsequent borrowing will come at a higher interest rate and will increase the fixed charges.

(ii) Debt Funds: The usage and the ratio of debt funds in the capital structure will be governed by factors like:

(a) The availability of cash flow with the company to meet its fixed financial charges. The purpose is to reduce the financial risk associated with such payments which can further be checked by using ‘debt’ service coverage ratio.

(b) It will provide the benefit of trading on equity and hence, will increase the earning per share of equity shareholders. However, ‘return on investment’ ratio will be the guiding principle behind it. The company should choose trading on equity only when return on investment is more than the fixed charges.

(c) Interest on debt funds is a deductible expense and therefore, will reduce the tax liability.

(d) It does not result in dilution of management control.

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.

Solution:

The working and fixed capital requirement of ‘S’ Limited will be high due to the following reasons:

(i) The business is capital intensive and the scale of operation is large.
(ii) For technological upgradation and to build up production base, heavy investments are required.
(iii) In case of steel industry, the major input is iron ore and coal. The ratio of cost of raw material to total cost is very high. Thus, there will be the higher need for working capital.
(iv) The longer the operating cycle, the larger is the amount of working capital required as the funds get locked up in the production process for a long period of time.
(v) Terms of credit for buying and selling goods, discount allowed by suppliers and to the customers also determine the quantum of working capital.