Class 12 business studies chapter 9 ncert solutions: Financial Management class 12 questions and answers
| Textbook | Ncert |
| Class | Class 12 |
| Subject | Business Studies |
| Chapter | Chapter 9 |
| Chapter Name | Financial Management class 12 ncert solutions |
| Category | Ncert Solutions |
| Medium | English |
Are you looking for business studies class 12 chapter 9 questions and answers? Now you can download Financial Management class 12 questions and answers pdf from here.
Very Short Answer Type:
Question 1: What is meant by capital structure?
Answer 1: Capital structure refers to the mix of debt and equity that a company uses to finance its operations and growth. It represents the proportion of different sources of funds, including common equity, preferred equity, long-term debt, and short-term debt.
A well-balanced capital structure helps a company minimize its cost of capital while maximizing shareholder value. The choice between debt and equity financing depends on factors such as financial stability, market conditions, and business strategy. An optimal capital structure ensures financial flexibility and sustainability in the long run.
Question 2: Sate the two objectives of financial planning.
Answer 2: The two main objectives of financial planning are:
- Minimizing Cost of Finance – To optimize the cost of capital by balancing debt and equity, ensuring financial stability and profitability.
- Ensuring Adequate Funds – To ensure that sufficient funds are available for business operations, expansion, and unforeseen expenses.
Question 3: Name the concept of financial management which increases the return to equity shareholders due to the presence of fixed financial charges.
Answer 3: Trading on equity concept increases returns to equity shareholders due to the presence of fixed financial charges.
Question 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’.
Answer 4: Working capital is the amount of capital required for meeting the day-to-day operations of the business. In this case, Amrit runs a Transport Service. This business operates on a large scale of operation, with a higher amount of inventory. He would require a large amount to working capital.
Question 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.
Answer 5: As Ramnath has adopted new policy for his business, it will eventually affect the requirement of working capital. When the working capital will is reduced.
Short Answer Type:
Question 1: What is financial risk? Why does it arise?
Answer 1: Financial risk refers to the possibility of a company or individual facing financial loss due to factors like market fluctuations, credit defaults, liquidity shortages, or changes in interest rates.
It arises when a business relies heavily on debt financing, as higher debt obligations increase the risk of default. Other factors, such as economic downturns, poor financial management, or unexpected expenses, can also contribute to financial risk. Managing financial risk involves careful planning, diversification, and maintaining a balanced capital structure to ensure financial stability and long-term sustainability.
Question 2: Define current assets? Give four examples of such assets.
Answer 2: Current assets are short-term assets that a company expects to convert into cash or use up within one year or an operating cycle, whichever is longer. These assets are essential for daily business operations and liquidity management.
Examples of current assets include cash and cash equivalents, which provide immediate liquidity; accounts receivable, representing money owed by customers; inventory, consisting of goods available for sale; and marketable securities, which are short-term investments that can be quickly converted into cash. Managing current assets effectively is crucial for maintaining smooth business operations and financial stability.
Question 3: What are the main objectives of financial management? Briefly explain.
Answer 3: The main objective of financial management is the maximisation of shareholders’ wealth. Therefore, financial management is all about making those decisions that will bring gains for the shareholders. Gains can be said to be achieved when the market value of shares rises. Once the primary objective of wealth maximisation is achieved, the other objectives, such as maintaining liquidity and proper utilisation of funds, are fulfilled along with it.
Question 4: Financial management is based on three broad financial decisions. What are these?
Answer 4: Financial management refers to the procurement, allocation and utilisation of funds. It deals with three main decisions:
- a) Procurement decisions :- To decide the source of capital that is from where the capital should be raised so as the overall cost of capital should be at its minimum.
- b) Investment decisions (Allocation of funds) :- Where the available funds should be invested so as to ensure maximum return.
- c) Dividend decision :- To decide the rate of dividend to be paid to the shareholders
Question 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%).
Answer 5: 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 ₹8,00,000 as total capital is ₹80,00,000. Now, Return on
investment is calculated as
ROI = Return/Investment
Capital Structure = 8,00,000/1,00,00,000 = 8%
Let’s assume that the company will be operating with the same efficiency, the additional investment of ₹80,00,000 will have a ROI of 8% which will amount to ₹6,40,000. The cost of debt will be ₹8,00,000 which is more than the ROI of ₹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.
Question 6: How does working capital affect both the liquidity as well as profitability of a business?
Answer 6: Working capital in a business is the surplus that is determined by subtracting current liabilities from the current assets of the organisation. By increasing the working capital, the liquidity of an organisation increases. But more current assets present in business results in a fall in profitability of the organisation, as current assets offer low returns, which cause a decline in the profit of a business.
Question 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).
b. ‘There is no restriction on payment of dividend by a company’. Comment. ( Legal & Contractual Constraints)
Answer 7: (a) The financial concept discussed in the is capital budgeting. It is a decision related to capital investment which will impact the profitability of the company in the long term. As the company wants to invest in new machinery which requires investment, this will have a direct impact on the operations which will be going to affect the profitability of the organisation.
The following objectives can be achieved:
- Cash flow: Investment will bring new machinery which helps to increase the organisation’s profitability.
- Company wants to raise funds from both the organisation’s (i.e., inside and outside). It will be helpful to examine the return generated from such investment will be more than the cost of capital.
- Investment used: If the company is planning to raise funds from both inside and outside. Then it is important to notice that funds from internal and external sources will have different rates of interest.
(b) Companies pay dividend to shareholders which is a part of the company earnings. Payment of dividends is based on following factors:
1. Contractual Constraints: Pay out of dividend results in reduction of cash in the company. Money that is raised as loan will lay down certain restrictions on the company for paying dividends, such constraints are called contractual constraints.
2. Legal Constraint: Legal constraints are those constraints that are mentioned in the company laws which impact paying out dividends on certain occasions. It should be followed properly.
Long Answer Type:
Question 1: What is working capital? Discuss five important determinants of working capital requirement?
Answer 1: Working capital refers to the difference between a company’s current assets and current liabilities. It represents the liquidity available to meet short-term obligations and is essential for day-to-day operations. A sufficient amount of working capital ensures that a company can cover its short-term debts and invest in its operations.
Five important determinants of working capital requirement are:
- Nature of Business – Companies in industries with long production cycles or seasonal fluctuations, like manufacturing or agriculture, require more working capital to maintain operations.
- Size of the Business – Larger businesses typically have higher working capital requirements due to the increased volume of transactions and inventory needs.
- Production Cycle – The length of time between raw material procurement and the sale of finished goods affects working capital needs. Longer cycles demand more capital for financing production.
- Sales Volume – Higher sales volume generally requires more working capital to finance the increased inventory and accounts receivable.
- Credit Policy – A company’s approach to extending credit to customers influences its working capital. More liberal credit policies increase accounts receivable, thus raising working capital needs.
Question 2: “Capital structure decision is essentially optimisation of risk-return relationship.” Comment.
Answer 2: Capital structure is the combination of debt and equity, which is used by a company to finance its requirements for funds. Debt can be obtained in the form of loans, while equity is generated through retained earnings or common stock. Borrowed funds can be in the form of loans, debentures, bank loans, etc. While in the case of an owner’s fund, it can be in the form of preference share capital, reserves, retained earnings, equity share capital, etc.
Debt and equity both have their risk and profitability. Debt is a relatively cheap source while the greater risk is there, and equity is comparatively expensive but is of lower risk for the firm. Fundraising through debt is cheaper, while same with equity is expensive. Debt, though cheaper, has more risks, as it has an obligation towards lenders. For equity, there is no such compulsion to pay dividends.
Also, the return offered by the sources leads to an increase in value per share. Debt gives higher returns per share but increases the risk comparatively many times. Therefore, capital structure decisions should be taken into consideration with return and the amount of risk involved.
Question 3: “A capital budgeting decision is capable of changing the financial fortunes of a business.” Do you agree? Give reasons for your answer?
Answer 3: Investment decision can be long term or short term. A long term investment decision is also called a capital budgeting decision. It involves commiting the finance on a long term basis, e.g., making investment in a new machine to replace an existing one or acquiring a new fixed assets or opening a new branch etc. These decisions are very crucial for any business. They affect its earning capacity over the long-run, assets of a firm, profitability and competitiveness, are all affected by the capital budgeting decisions.
Moreover, these decisions normally involve huge amounts of investment and are irreversible except at a huge cost. Therefore, once made, it is almost impossible for a business to wriggle out of such decisions. Therefore, they need to be taken with utmost care. These decisions must be taken by those who understand them comprehensively A bad capital budgeting decision normally has the capacity to severely damage the financial fortune of a business.
Question 4: Explain the factors affecting dividend decision?
Answer 4: The dividend decision refers to a company’s choice regarding the distribution of profits to shareholders in the form of dividends. Several factors affect this decision, including:
- Profitability – A company’s ability to generate consistent profits directly influences its capacity to pay dividends. Higher profitability increases the likelihood of higher dividends.
- Liquidity – Even if a company is profitable, it must have sufficient cash flow to meet its dividend obligations. If liquidity is low, the company may retain earnings rather than pay dividends.
- Growth Opportunities – Companies with significant growth opportunities may prefer to reinvest profits into business expansion rather than distribute them as dividends.
- Taxation Policy – The tax treatment of dividends affects both the company and shareholders. If dividends are heavily taxed, companies may opt for retaining earnings or repurchasing shares.
- Debt Obligations – A company with high debt may prioritize paying off its liabilities over paying dividends to avoid financial strain.
- Shareholder Expectations – The preferences of shareholders, such as whether they prioritize income from dividends or capital appreciation, can influence the company’s dividend policy.
- Economic and Market Conditions – During periods of economic uncertainty or recession, companies may choose to retain earnings to safeguard against future financial challenges rather than pay dividends.
Question 5: Explain the term ‘Trading on Equity’? Why, when and how it can be used by company.
Answer 5: 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.
Question 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 to 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 Rs. 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 6: a. The role of financial management in this company is to ascertain:-
1. The amount and structure of fixed assets :- A decision to invest more in a particular type of fixed asset would increase its share in the overall composition of fixed assets. For instance, a financial management decision to invest more in fixed assets would directly increase the size of the fixed assets held by the business.
2. The composition of funds used :- The composition of funds used by a company refers to the short-term and long-term financing sources used by that company. It is determined by the company’s decisions regarding liquidity and profitability. For instance, a company aiming at higher liquidity would rely more on long-term financing and vice versa.
3. The proportion of debt, equity, etc. in long-term financing :- What proportion of the long-term finance is to be raised by the way of debt or equity is a financial decision, which in itself is a part of financial management.
4. The quantum and composition of current assets :- The amount of current assets (i.e. working capital) that the organisation holds depends on the financial decisions pertaining to the amount of fixed assets to be held. A decision to increase the quantum of fixed assets directly increases the working capital requirements of the business and vice versa.
The basic objective of the financial management in this company would be to maximise the shareholders’ wealth. The company must opt for those financial decisions that prove gainful from the point of view of the shareholders (i.e. increase in the market value of the shares). The market value of shares increase when the benefits from a financial decision exceed the cost involved in taking them.
b. The following points highlight the importance of financial planning for the company.
i. Financial plan would enable the company to forecast the future in a better manner. For instance, it would be able to forecast the sales return that it would be able to earn through the expansion.
ii. Proper planning would help to avoid any shortage or surplus of funds, thereby ensuring optimum utilisation of funds.
iii. Planning would help in better coordination of the production and sales activities.
iv. Financial planning would help in avoiding wastages of time, effort and money.
v. With a clear definition of targets and policies, financial planning helps in evaluating current performance in a better way.
Financial Plan: It is given that the company requires Rs 5000 crore fixed capital and Rs 500 crore working capital. Of this the company can collect 50 % through issue of shares and the remaining 50% can be collected through borrowed funds.
c. The following are the factors affecting the choice of capital structure.
1. Cash flow :- The company should opt for debt capital only in case of strong cash flow position. This is because debt cash is required to pay the principle as well as the interest on the debt.
2. Debt-service coverage ratio (DSCR) :- This ratio shows the cash payment obligations of a company as against the availability of cash. In case of high DSCR, the company can opt for debt.
3. Equity cost :- Cost of equity is directly related to the financial risk faced by the company. With higher financial risk, shareholders expectations of return increases. This in turn implies that the cost of equity rises. With high cost of equity it becomes difficult for the company to opt for equity.
4. Condition of stock market :- It is easy to opt for equity capital in case of good stock market conditions. On the other hand, in case of poor stock market conditions it becomes difficult to opt for equity capital.
5. Interest coverage Ratio :- This ratio refers to the number of times ‘earnings before interest and tax’ is able to meet the interest rate obligations. Higher interest coverage ratio implies lower risk for the company, thereby the company can opt for higher portion of debt in the capital structure.
6. Floatation cost :- Higher the floatation cost of a particular source (in terms of broker’s commission, underwriting commission), lower is its component in the capital structure. For instance, if the floatation cost involved in equity is high, its component in the capital structure would be low.
7. Rate of interest on debt :- High rate of interest on debt implies higher cost of debt, thereby, it becomes difficult to opt for debt in the capital structure.
d. The factors that will affect the fixed capital requirements of the company are as follows:
1. Type of business :- The amount of fixed capital required by a company depends, to a large extent, on the type of business that it deals in. Since ‘S’ Limited is a manufacturing firm (having a large operating cycle), thus it requires large fixed capital.
2. Scale of operations :- The scale of operations of the company is high implying that a larger amount needs to be invested in plants, land, building, etc. Thus, it requires large fixed capital.
3. Growth prospects :- Since the company is growing and expanding, thus it requires higher amount of fixed capital.
The factors that will affect the working capital requirements of the company are as follows:
1. Type of business :- The company would require large working capital as it is a manufacturing firm and involves a large operating cycle. That is, in this company the raw materials need to be converted into finished goods before they are finally sold. Therefore, it requires large working capital.
2. Scale of operations :- Since the company is operating on a large scale, thus it requires large working capital. This is because it need to maintain high stock of inventory and debtors.
3. Growth Prospects :- The company would require higher amount of working capital as it has higher growth prospects.
4. Seasonal factors related to operation :- The company would require high working capital as the demand for its product (i.e steel) is growing.