FINANCIAL MANAGEMENT For M.Com /B.Com Part A Question & Answers INTRODUCTION TO FINANCIAL MANAGEMENT 1. What is financial management?

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1 FINANCIAL MANAGEMENT For M.Com /B.Com Part A Question & Answers INTRODUCTION TO FINANCIAL MANAGEMENT 1. What is financial management? It is the application of planning and control functions of the finance function. 2. What do you mean by profit maximization? It means maximization of income or earnings of the firm. 3. What is wealth maximization? It refers to maximization of the wealth of the share holders. 4. Define financing decision. It is concerned with deciding the source of finance for financing the investment. 5. Explain the concept of wealth. Total of all assets of an economic unit that generate current income or have the potential to generate future income. 6. Explain the concept of profit. Profits are the difference between revenues and costs. Profit is the money a business makes after accounting for all the expenses. 7. State the limitations of profit maximization? The concept is very vague. Ignores time value of returns, risk and uncertainty factors. 8. What are the aims of finance functions? Acquiring Sufficient and Suitable Funds: Proper Utilization of Funds: Increasing Profitability: Maximizing Firm s Value: 9. What is investment decision? Investment decision it is concerned with deciding the total amount of asset to be held in the firm and their composition.

2 10. What is risk return trade off? High risks are associated with the high potential returns and low risks are associated with low potential returns. Invested money can render high profit only if it is subject to the possibility of being lost. TIME VALUE OF MONEY 1. Define time value of money? The value of money received today is greater than the value of the same amount receivable in future years. 2. What is compound value? It is the future value of a present value using a compound interest rate. 3. What is present value? Value on a given date of payment or series of payment at other times. 4. What is NPV? It is the excess of present value of project cash inflows over that of outflows. 5. What is discounting? It is reducing the value of future cash flows or returns to make it directly comparable to the values at present. 6. What are the reasons for time preference of money? Risk, Preference of Consumption and Investment opportunities. 7. What is capital asset pricing model in security risk? The Capital Asset Pricing Model (CAPM) is a linear model that describes the relationship between risk and expected return of a risky asset. Or It is the risk of a security and its expected return,

3 8. How will you value equity shares? Average (Fair Value) Method Earning Capacity (Capitalization) Method Dividend Yield Method Net Assets Value (NAV) Method 9. What is financial risk? It is the variability in EPS caused by the use of financial leverage. 10. What are market / systematic risk? factors. It is that part of the total risk which arises due to general economy wide 11. What is unique / unsystematic risk? It is that part of risk which arises due to factors specific to a company or security 12. What is total risk? It is the sum of market risk and unique risk. 13. What is portfolio? Combination of securities is called portfolio. 14. What is portfolio return? It is the weighted average of the returns of the individual securities. 15. Define doubling period? It is the time taken for doubling the investment. 16. Define annuity? It refers to a series of equal annual payment made at the end of each year for a particular period

4 17. What is yield? Yield refers to the return earned on the investment. 18. What is risk? It refers to the degree of variability of actual return from the expected return. 19. What is yield on debentures? It is the rate of return on earned on debentures. 20. What is holding period return? HPR is the sum of income and capital gains divided by the asset value at the beginning of the period, often expressed as a percentage. 21. What is yield to maturity? maturity. It is the rate of return earned by an investor who purchases a bond and holds it till CAPITAL STRUCTURE 1. What do you mean by capital structure? It means the proportion of long term sources of finance in the capitalization of the firm. 2. Explain net income approach? Capital structure is relevant to the valuation of the firm. A firm can minimize the overall cost of capital by maximizing the use of debt in the capital structure. 3. Explain net operating income approach? According to this theory capital structure does not affect the overall cost of capital and the value of the firm.

5 4. Explain MM approach under capital structure? This theory states that the market value of the firm and its overall cost of capital are independent of its capital structure. 5. What is traditional approach? It is a compromise between the net income and net operating income approach. Capital structure will be optimum at that level of debt equity mix. (Cost of debt is favorable up to a point and beyond that point will adversely affect the value of firm) 6. What is financial structure? It is the composition of the entire liability of the balance sheet 7. What do you mean by capitalization? It means the total amount of long term funds employed by the firm 8. What is overall capitalization? It refers to actual capitalization is higher than that is warranted by its earning or capitalization is higher than standard capitalization. 9. What is under capitalization? It means actual capitalization is less than the standard capitalization. 10. What is financial planning? It is an estimate of the amount of capital and composition. 11. What are the different patterns of capital structure? Equity shares Preference shares Debentures / bonds Long term loans

6 12. What is contribution? The difference between sales and variable cost is called contribution. 13. What is EBIT? It is the difference between contribution and fixed cost. It is earnings before interest and tax. 14. What do you mean by EPS? It represents earnings per share which shows the relationship between equity earnings and number of equity shares. 15. Explain any two factors affecting capital structure Business risk Management style Growth rate Market conditions COST OF CAPITAL 1. What is cost of capital? It is the minimum rate of returns expected by the investors. 2. What is real cost of capital? The Real Cost of Capital describes the key issues in understanding and using the cost of capital today, taking principles from the world of managerial finance and putting them into the context of major investment decisions. 3. What are the components of cost of capital? Cost of Debt Cost of Preference Share Cost of equity shares Cost of retained earnings

7 4. What do you mean by cost of preference capital? It s a function of the dividend expected by investors. 5. What is cost of equity capital? It is the rate of return which the equity shareholders expect from the shares of the company. 6. Define cost of debt capital? It is the rate of interest payable on debt debentures. 7. What is the cost of retained earnings? It is the earnings forgone by the shareholders. 8. What do you mean by weighted average cost of capital? It is the weighted average of the costs of different source of finance. 9. Explain any two factors affecting cost of capital? General economic conditions Market conditions Operating & financial decisions. Amount of financing 10. What is specific cost? It is the cost of each source of capital. 10. a. What is explicit cost? It is the direct payment made to others in the course of running a business. 11. What is composite cost? It is the combined or weighted average cost of capital of the firm.

8 12. What is historical cost? It is an expected cost which has already been incurred for financing an investment proposal. 13. What is future cost? It is an expected cost of funds which may be incurred for raising funds in future. LEVERAGES 1. What is leverage? It is employment of an asset or funds for which the firm pays a fixed cost or fixed return. 2. Explain the types of leverage? Operating leverage Financial leverage Combined leverage 3. What is operating leverage? It refers to use of fixed cost in the operation of the firm. 4. What is financial leverage / trading on equity? It refers to use of long term debt and preference share capital along with the owners equity in the capital structure (trading on equity is using debt capital in the capital structure). 5. What is combined leverage? It measures the combine effect of operating leverage and financial leverage it shows the effect of the change in sales on EPS

9 6. What is arbitrage process? When two firms are identical in all aspect except their capital structure cannot have different market values. If market value differ arbitrage process will takes place and make them equal. 7. What is indifference point? It refers to the EBIT at which EPS or return share capital is equal for different combination of debt and equity. 8. What is EBIT-EPS Analysis? It is used to analyze the behavior of EPS with varying levels of EBIT under alternative financial plans. DIVIDEND 1. Define the term dividend. Distribution of profit to shareholders are called dividend. 2. What do you mean by dividend policy? It refers to that policy which is considered with the quantity of profits to be distributed as dividend or it is the policy of the firm distributing let earnings to equity shareholders. 3. Explain the different types of dividend? Cash dividend dividend is paid to shareholders in cash. Bond dividend issue of bonds in levy of dividend. Stock dividend issue of bonus shares to shareholders. Property dividend payment of dividend in the form of sum assets other than cash. Stock split reduction in the par value of a share and proportionate increase in the number of shares. 4. What is reverse split? It is the opposite of stock split it involves increase in par value of shares and a proportional decrease in number of shares.

10 5. What are growth firms? They have good profitable investment opportunities conditions are r >k Optimum layout ratio is zero. 6. What are normal firms? Normal firms do not have good investment opportunities and conditions are, r=k no optimum payout ratio 7. What are declining firms? Declining firms do not have profitable investment opportunities and conditions are, r<k optimum payout ratio is Explain Walters approach in dividend policy? Dividend policy is a critical factor and it affects the value of the firm. 9. Explain MM theory under dividend policy? Value of the firm depends on its earnings. The dividend decision is irrelevant as it does not affect the wealth of the shareholders. 10. What is relevant theory? This theory says that dividend decision is an active variable and it influences the value of the firm. 11. What do you mean by irrelevant theory? This theory considers dividend decision as irrelevant and it has no effect on the value of the firm.

11 12. What are the legal restrictions of payment of dividend? If the firm s liabilities are greater than its assets If the dividend amount exceeds retain earning If the dividend is being paid from capital invested in the firm. 13. Why companies dividend policy is important? Customer Service Buffering against Uncertainty 14. What is stability of dividends? It means regular payment of the minimum dividend although there may be fluctuation in earnings. 15. Mention any two factors affecting dividend policy. Amount of earnings. Cash inflows. Taxation. Financial needs of the firm WORKING CAPITAL 1. Define working capital. Capital required to meet the day to day expenditure and purchase of raw materials is called working capital. It is the part of capital that is directly involved in the profitability in the business. 2. What is zero working capital? When current assets are equal to current liabilities, working capital is zero. 3. What are current assets? Current assets are those assets which are converted into cash within one account year.

12 4. What are current liabilities? These are liabilities which are likely to mature for payment within an accounting year. 5. What do you mean by gross working capital? Firm investment in current assets is called gross working capital. 6. What is net working capital? The difference between current assets and current liabilities are called as net working capital. 7. What is fixed working capital / permanent Working.Capital? It is the minimum amount of working capital required to ensure are carry out normal business operations. 8. What do you mean by fluctuating temporary working capital? It is also called temporary working capital. It is the amount of working capital which is required by the business over and above the permanent working capital. 9. Explain operating cycle / working capital cycle? It is the series of activities involved from converting of cash into raw materials till cash is received back from accounts receivable and this cycle continues. 10. What are the sources of working capital? Financing permanent working capital issue of shares, issue of debentures, public deposits, ploughing back of profits and loans from financial institution. Financial temporary working capital trade credit, commercial paper, bank credit, loans from directors, installment credit, depreciation funds, provision for taxes and accrued expenses.

13 11. Explain any two factors affecting working capital Nature of business Size of business Seasonal fluctuations Terms of sales 1. What is cash management? CASH MANAGEMENT It is minimizing idle cash without impairing liquidity of the firm. 2. What is cash planning? It is forecasting of cash needs well in advance for a given period. 3. What is cash budget? It is the summary of expected cash inflows and outflows over projected periods. 4. Explain transaction motive? Firm needs cash to meet routine business payments. 5. Explain precautionary motive. Firm needs cash to meet unexpected contingencies 6. Explain speculative motives Firm needs cash for investing in profitable investment opportunities as and when they arise. 7. What do you mean by concentration banking? It is the system of operating through a number of collection centers.

14 8. What do you mean by lock box system? Firms hire post office box at important collection centers. The customers are required to remit payments to the lockbox directly. The local bank of the firm are authorize to open the box and pick up the cheques several times a day and deposit them in firms account. 9. What is short cost? It is the cost that arises with the short fall of cash. 10. Explain Cash cycle. Cash cycle is the time lag between the point of time of cash outflow and the point of time of cash inflow 11. What does Cash turnover means? Cash turnover means the number of times the average cash is turned over during an operating period usually 360 days. It indicates the velocity or the speed of average cash. 12. What are rights issues? It is offer of new shares of the company to the existing shareholders. 13. What are bonus shares? Shares issued free of cost to existing shareholders. 14. What do you mean by commercial paper? Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. INVENTORY MANAGEMENT 1. What is inventory management? It is the activities employed in maintaining the optimum number or amount of each inventory item.

15 2. What do you mean by maximum level? time. This is the level above which the stock should not be allowed to exceed at any 3. What is minimum level? It is the level below which the stock should not be allowed to fall at anytime. 4. What is reorder level? It is the level at which new order for materials are to be replaced by the store keeper. 5. What is danger level? This level is fixed below the minimum level then stock reach this level action for immediate purchase necessary. 6. What is safety level? It is the minimum stock maintained as a cushion against possible increase in usage/delay in delivery time. 7. What is average level? It is the average of minimum and maximum level. 8. What is EOQ? It is the size of order that will result in the lowest total of ordering costs and carrying cost for an item of inventory (the optimum size of an order of an item of inventory is called EOQ). 9. What do you mean by JIT? It is just in time. It is the strategy used to increase efficiency and decrease waste by receiving goods only as they are needed in production process.

16 10. What do you mean by ABC analysis? It is always better controlled system based on the principle that management should concentrate more on costlier items than others. 11. What is VED analysis? It is Vital Essential and Desirable analysis used primarily for control of spare parts. 12. What are perpetual inventory systems? It is the method of recording stores balance after each receipt and issue to facilitate regular checking and obviate closing down for stock taking. 13. What are objectives of inventory control? To provide information on the availability of stocked items and the status of stocked requisitions To facilitate timely requisition processing To automatically record and service backorders RECEIVABLES MANAGEMENT 1. What is receivables management? The tradeoff between costs (interest and bad debts) and benefits (increase in profit) as a result of credit sales is known as receivable management 2. What are the costs relating to maintaining of accounts receivable? Capital cost the cost that is incurred to make arrangement for additional funds to meet its own obligation is called capital cost Collection cost it is the cost that is incurred for collecting the amounts from the customer to whom credit sales have been made Administration cost the cost that is incurred for maintaining accounts receivable is called administration cost

17 Default cost sometimes the firm may not be able to recover the dues by the customers called bad debts and has to be written off since they have not been realized 3. What is lead time? It is the time required to get fresh supplies. It is the period from the date of placing the order to the date of actual delivery.

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