GSEB Class 12 Organization of Commerce and Management Solutions Chapter 8 Financial Management

1. Select The Correct Alternative And Write Answers To The Following Questions:

 

Question 1. By which other name is the objective of wealth maximization known?
(A) Social welfare
(B) Capital investment
(C) Net present value
(D) Trading on equity
Answer: (C) Net present value
In simple words: The goal of making the most money or value for owners is also called 'Net Present Value'. This method helps decide which projects add the most worth over time.

Exam Tip: For wealth maximization, always focus on the future value of cash flows, which Net Present Value (NPV) accounts for, unlike mere profit maximization.

 

Question 2. On which concept is the approach to the wealth maximization based?
(A) Profitability
(B) Social responsibility
(C) Present value of wealth
(D) Cash flow
Answer: (C) Present value of wealth
In simple words: The idea of maximizing wealth is built upon the concept of how much a company's future wealth is worth right now. It considers the current worth of all future benefits.

Exam Tip: Understand that wealth maximization prioritizes long-term value creation for shareholders, often measured by the present value of future cash flows, rather than short-term profits.

 

Question 3. With what is financial management related?
(A) Finance function
(B) Finance market
(C) Capital market
(D) Stock exchange
Answer: (A) Finance function
In simple words: Financial management is linked to the overall role of finance within a company. It involves all tasks related to getting, spending, and handling money effectively.

Exam Tip: Financial management covers planning, organizing, directing, and controlling financial activities. The core of this is the finance function, which handles all money-related operations in a business.

 

Question 4. Decisions of investment means
(A) Capital cost
(B) Capital budgeting
(C) Capital structure
(D) Ploughing back of profit
Answer: (B) Capital budgeting
In simple words: Investment decisions are essentially about capital budgeting. This means choosing which long-term projects a company should invest in to get the best returns.

Exam Tip: Capital budgeting involves evaluating investment opportunities. Key techniques include Net Present Value (NPV), Internal Rate of Return (IRR), and payback period.

 

Question 5. Capital structure having proper ratio of equity and debts means
(A) Optimum capital structure
(B) Simple capital structure
(C) Working capital structure
(D) Equilibrium capital structure
Answer: (A) Optimum capital structure
In simple words: An optimum capital structure refers to the perfect blend of equity and debt. This mixture aims to lower the company's cost of capital and increase the value for shareholders.

Exam Tip: An optimum capital structure maximizes the company's market value by finding the right balance between debt (cheaper but riskier) and equity (costlier but less risky).

 

Question 6. Which of the following statements is not true with reference to the concept of net working capital?
(A) Excess of current assets over current liabilities
(B) Does not show the liquidity position of the company
(C) Provides proper measurement for working capital
(D) Increase in current liability does not increase net working capital
Answer: (A) Excess of current assets over current liabilities
In simple words: The statement "Excess of current assets over current liabilities" is actually the definition of net working capital, not something untrue about it. Therefore, this option is the one that is NOT true in the context of being a false statement.

Exam Tip: Net working capital (current assets - current liabilities) is a key indicator of a company's short-term liquidity, so any statement denying this is incorrect. Option (A) is the definition itself, making the question tricky.

 

Question 7. How many types of capital structure are there?
(A) Two
(B) Three
(C) Four
(D) Five
Answer: (C) Four
In simple words: There are four main ways a company can structure its capital. These different structures combine debt and equity in various forms to raise funds.

Exam Tip: The four primary types of capital structure are: (1) equity share capital only, (2) equity and preference share capital, (3) equity share capital and debentures, and (4) equity, preference shares, and debentures.

 

Question 8. From which capital is dividend paid?
(A) Paid up capital
(B) Authorized capital
(C) Called up capital
(D) Working capital
Answer: (A) Paid up capital
In simple words: Dividends, which are payments to shareholders, are always paid out of the company's 'paid-up capital'. This is the portion of capital that shareholders have actually given to the company.

Exam Tip: Dividends are usually paid from a company's profits, but legally they are declared on the paid-up capital of the shares, not the authorized or working capital.

 

Question 9. Which statement is true with reference to fixed capital?
(A) Invested upto 5 years in business
(B) Components are debtors, bill receivable, bank balance, etc.
(C) Ratio of liquidity is less
(D) Investment can be withdrawn easily
Answer: (C) Ratio of liquidity is less
In simple words: Fixed capital, used for long-term assets like buildings, is not easily turned into cash. This means its liquidity level is low compared to other types of capital.

Exam Tip: Fixed capital is tied up in long-term assets, making it less liquid. Options (A), (B), and (D) describe working capital or current assets, not fixed capital.

 

Question 10. With whom has the foreign institution investor need to registered?
(A) Company registrar
(B) Court
(C) Stock exchange
(D) SEBI
Answer: (D) SEBI
In simple words: Foreign institutional investors must register with SEBI, which is the Securities and Exchange Board of India. This registration helps regulate their activities in the Indian stock market.

Exam Tip: SEBI is the regulatory body for the securities market in India. All foreign institutional investors (FIIs) must register with SEBI to operate in the Indian capital markets.

 

Question 11. Excess of current assets over current liabilities means
(A) Positive working capital
(B) Negative working capital
(C) Equilibrium working capital
(D) Gross working capital
Answer: (A) Positive working capital
In simple words: When a company has more current assets than current liabilities, it indicates that it has 'positive working capital'. This shows a healthy short-term financial position.

Exam Tip: A positive working capital is crucial for a company's day-to-day operations, indicating its ability to cover short-term debts. Gross working capital refers to total current assets, not the excess.

 

2. Answer The Following Questions In One Sentence Each:

 

Question 1. Financial management is related with which type of financial decision making?
Answer: Financial management is connected with decisions about new investments, the capital structure of a company, and its dividend policy.
In simple words: Financial management involves choices about where to invest money, how to raise capital, and how to distribute profits.

Exam Tip: Remember the three key financial decisions: investment (capital budgeting), financing (capital structure), and dividend policy. Briefly explaining each can help secure marks.

 

Question 2. Which approaches does financial management adopt to achieve maximum economic welfare of the owner?
Answer: Financial management utilizes both profit maximization and wealth maximization approaches to achieve the maximum economic welfare for the owner.
In simple words: To make the owner's financial situation as good as possible, financial management uses strategies that aim for high profits and increasing overall wealth.

Exam Tip: Be sure to differentiate between profit maximization (short-term) and wealth maximization (long-term, shareholder value). Both are valid approaches, but wealth maximization is generally preferred.

 

Question 3. Which objective is acceptable for financial management?
Answer: The acceptable goal for financial management is to increase the current worth of the net wealth for the company.
In simple words: Financial management aims to raise the present value of the company's net assets.

Exam Tip: Emphasize "wealth maximization" or "current value of net wealth" as the most accepted objective, as it considers long-term value and risk, unlike simple profit maximization.

 

Question 4. What does capital structure consist of?
Answer: Capital structure is made up of various securities that a company issues, including equity shares, preference shares, and debentures.
In simple words: A company's capital structure includes different types of funds like regular shares, special shares, and loans (debentures).

Exam Tip: When defining capital structure, always mention both ownership funds (equity, preference shares) and borrowed funds (debentures, long-term loans) as its key components.

 

Question 5. In which form dividend can be paid to the shareholders?
Answer: Dividends can be paid to shareholders either in cash or by cheque, based on the paid-up capital of their shares.
In simple words: Shareholders can get their dividends as money or a check, which is calculated on the money they already paid for their shares.

Exam Tip: Dividends are a distribution of profits. Mentioning "cash or cheque" and linking it to "paid-up capital" are important keywords for this answer.

 

Question 6. Which type of shares must be issued by a company procuring capital fund by issuing securities?
Answer: A company that raises capital by issuing securities must always issue equity shares.
In simple words: Companies that get money by selling shares are required to issue equity shares.

Exam Tip: Equity shares represent ownership and carry voting rights, forming the primary capital for any company raising funds via securities.

 

Question 7. For which type of security issue the expense is comparatively less?
Answer: The expense involved in issuing debentures is usually lower compared to other types of securities.
In simple words: It costs less to sell debentures than other company shares or bonds.

Exam Tip: Debentures often involve lower issuance costs because they are debt instruments, carrying fixed interest payments and a maturity date, making them less risky for investors and therefore easier to market.

 

Question 8. With whom foreign investment institution has to register itself?
Answer: A foreign investment institution must register itself with SEBI (Securities and Exchange Board of India).
In simple words: Foreign companies that want to invest need to sign up with SEBI.

Exam Tip: Recall that SEBI is the regulatory authority for capital markets in India. Any entity, foreign or domestic, involved in securities investment must comply with its regulations, including registration.

 

Question 9. What are the components of fixed capital?
Answer: The components of fixed capital include land, machinery, plant, vehicles, furniture, computers, and printers.
In simple words: Fixed capital means assets like land, machines, buildings, cars, and office items.

Exam Tip: Fixed capital consists of long-term assets that a business uses over many years to generate revenue, not for immediate sale. Listing several distinct examples is good.

 

Question 10. Why depreciation is not charged on the assets in which working capital is invested?
Answer: Depreciation is not charged on assets where working capital is invested because these are current assets that constantly circulate within the business. Their form keeps changing quickly, meaning they are not long-term fixed assets that lose value over time.
In simple words: Working capital is in short-term assets that change fast, so we don't count depreciation on them.

Exam Tip: Depreciation applies only to fixed assets, which have a definite useful life and wear out over time. Working capital is by nature short-term and continuously consumed or converted, hence not depreciated.

 

3. Answer The Following Questions In Short:

 

Question 1. What does the objective of owner's maximum economic welfare mean?
Answer: The objective of focusing on both maximum profit and maximum wealth for the owner is known as wealth maximization. This goal aims to increase the overall value of the business for its owners over the long term.
In simple words: Making the owner as financially well-off as possible means trying to get the most profit and the most wealth, which we call wealth maximization.

Exam Tip: Explain that economic welfare combines maximizing current profits with maximizing the long-term value of the owner's investment, making wealth maximization the more comprehensive goal.

 

Question 2. What are the factors affecting investment decision?
Answer: Several important factors influence investment decisions, including the total capital needed, the expected rate of return and how profitable the investment might be, and the estimated net cash flow received from it. Other considerations are the level of risk involved, the amount of working capital required after the investment, the estimated useful economic life of the investment, its overall importance, and any capital rationing limits. Lastly, the certainty or uncertainty of future earnings also plays a role.

• Need of total capital
• Estimated rate of return and profitability from investment
• Estimated net cash receivable from investment
• Element of risk involved in investment
• Requirement of working capital after investment
• Useful economic life of investment and its estimated life
• Significance of investment
• Capital rationing
• Certainty or uncertainty of earning in future

In simple words: When deciding where to invest, companies look at how much money is needed, how much profit they might make, the cash they'll get back, the risks, and if they'll need more working capital. They also check how long the investment will last and if future earnings are sure or unsure.

Exam Tip: For factors affecting investment decisions, ensure you cover both quantitative aspects (return, cash flow, capital) and qualitative aspects (risk, economic life, certainty) to provide a complete answer.

 

Question 3. "Capital structure is a mixture of owner's capital and debt.” – Explain.
Answer: Capital structure represents the blend of funds from owners (equity) and borrowed money (debt) that a company uses to finance its operations. When building this structure, the finance manager needs to decide the ideal proportion of equity and debt to include. Achieving a good balance between equity capital and debt is crucial for ensuring the company earns the best possible returns. If the capital structure has an optimal mix of these two, many risks can be prevented, and the company can achieve its highest returns.

• While setting up the capital structure, the finance manager has to take a decision regarding the portion to be maintained between equity and debt in capital structure.
• A fine balance between equity capital and debt is necessary so as to maximize the returns of the company.
• If the structure maintains an optimum balance between the two, several risks can be avoided and maximum returns can be ensured.

In simple words: Capital structure mixes the money from owners and loans. The finance manager chooses the right amount of each to get the best company profits, avoid risks, and ensure the highest returns.

Exam Tip: Define capital structure as the mix of equity and debt. Emphasize the importance of balancing these two components to minimize risk and maximize shareholder value, as an optimal mix directly impacts a firm's profitability.

 

Question 4. What is meant by optimum capital structure?
Answer: An optimum capital structure refers to a capital structure that has the right proportion of equity share capital and debt. This ideal mix helps a company achieve the lowest possible cost of capital while maximizing its market value.
In simple words: An optimum capital structure means having the best amount of owner's money and borrowed money. This mix helps the company save money and grow its value.

Exam Tip: An optimum capital structure is key for maximizing shareholder wealth and minimizing the weighted average cost of capital (WACC). It balances the financial risk associated with debt and the cost of equity.

 

Question 5. "Working capital means circulating capital in business.” – Explain.
Answer: Working capital is indeed known as circulating capital because it constantly moves through a business, much like blood flows in a human body. Just as an organ functions abnormally without enough blood, a business suffers if it lacks sufficient working capital. This continuous flow of capital ensures all departments and functions operate smoothly; without it, the business cannot survive. Therefore, working capital is accurately called the life-blood of a business.

• A human being remains alive as long as blood keeps circulating his body. Moreover, if any part of the body is devoid of sufficient quantity of blood then that part or organ may start functioning abnormally.
• Capital does the same job for the business. If the business lacks blood, it will start functioning abnormally and eventually die.
• Capital must be provided in order to see that all the department and functions of the business work smoothly. Absence of capital means death of business.
• Hence it is rightly said that working capital is the life-blood of business.

In simple words: Working capital is like the blood of a business; it moves around constantly. If a business doesn't have enough, it can't work well and might even fail.

Exam Tip: Use the analogy of "life-blood" to explain how working capital facilitates daily operations, such as purchasing raw materials, paying wages, and managing inventory, emphasizing its constant movement and critical role.

 

Question 6. What is production cycle?
Answer: The production cycle is the duration that passes between obtaining raw materials and completing the manufacturing of finished goods.
In simple words: The production cycle is the total time it takes from getting materials to making a finished product.

Exam Tip: Define the production cycle clearly as the time from raw material acquisition to finished product creation. Mentioning its impact on working capital needs can add value to the answer.

 

4. Answer The Following Questions In Brief:

 

Question 1. Explain the concept of financial management through various definitions.
Answer: Financial management involves the efficient handling of a company's financial resources to ensure its smooth operation and growth. Finance: In simple terms, managing money is known as financial management. Finance is crucial for any business, serving as its lifeblood. A business cannot begin or continue without funds, making finance its fundamental base. Financial management: This involves managerial activities related to planning and controlling financial resources for a business organization. Under financial management, managers aim to manage these resources in the best possible way so the company achieves a good return. Various definitions of financial management:

• According to F. W. Paish, "In the modern economy, based on utilization of funds, financial management means acquiring of required funds at the required time."
• According to Raymond J. Chambers, "Financial management means to take decisions about financial matters to implement then smoothly and to review, them."
• According to Prof. M. Kimbal, "Financial management means acquisition of fund, its optimum utilization and its appropriate allocation."

From these definitions, we can conclude that the scope of financial management is very broad, encompassing all financial decisions of a business from its very beginning.In simple words: Financial management means smart money handling for a business. It's like the business's blood, needed to start and keep it running well. Experts define it as getting money, using it best, and making sure it's placed correctly to earn good profits and cover all financial choices.

Exam Tip: When explaining financial management, start with a simple definition, use analogies (like "blood of business"), and include at least two recognized definitions to showcase comprehensive knowledge.

 

Question 2. Explain the objectives of financial management.
Answer: The main goal of financial management is to maximize the economic well-being of the owner. To achieve this, financial management typically uses two primary strategies: profit maximization and wealth maximization.

• The objective of financial management is maximization of the owner's economic welfare.
• To achieve this objective, financial management adopts following two approaches:
(A) Objective of profit maximization and
(B) Objective of wealth maximization

(A) Objective of profit maximization: This objective aims to maximize the company's income. Investors usually buy shares hoping for maximum dividends, so companies should strive to earn the highest profit from their available resources. Dividend policies should also be based on maximizing profit. This approach suggests that a company should only undertake projects that can generate good profits, which means those targeting profit maximization. Ultimately, this strategy helps increase the company's share price and its earnings per share.

• The objective of maximizing income of the company is called profit maximization.
• In the market, investors purchase shares of a company with the hope of earning maximum dividend. As a result, a company should earn maximum profit out of its available resources. Moreover, its dividend policy should be based on maximization of profit.
• In addition, this approach suggests that a company should take up only those business projects which can earn good profits, i.e., which aims at profit maximization.
• This approach increases the share price of the company. This in turn increases company's per-share earning.

(B) Objective of wealth maximization: This concept focuses on increasing the total value of the business to boost the value of shares held by shareholders. Net Present Value (NPV) is a term used to assess a company's profitability. Profit under NPV is calculated by subtracting the necessary investment over a period from the present value of wealth. Wealth maximization strives to build a profitable NPV, which creates value for shareholders. Because of this calculation, an organization should only choose decisions that increase net present value and, consequently, wealth. One drawback of the wealth maximization approach is its sole reliance on cash flow, ignoring actual recorded business profit. Only cash flow is used as a measure, and accounting profit is overlooked. The net present value of wealth represents the difference between the present value of wealth and the required investment.
Net present value of wealth = Present value of wealth - Investment required
Financial management should make decisions that maximize the company's wealth. When a company's wealth is maximized, it will be reflected in its share price on the stock exchange. The market price of the share will rise, leading to greater shareholder wealth. The objective of wealth maximization is considered suitable and broadly accepted; it is seen as superior to profit maximization, and Prof. Solomon has supported it.

• The concept of increasing the value of the business in order to increase the value of the shares held by the shareholders is called wealth maximization.
• A term called Net Present Value (NPV) is used to measure the profit of the company. Profit under NPV is obtained by subtracting the present value of wealth from the investment required over a period of time.
• Wealth maximization focuses on building a profitable NPV. The net present value creates wealth for the shareholders.
• Owing to this calculation, the organization should take up only such decisions which increase the net present value and hence the wealth.
• A drawback of wealth maximization approach is that it is based only on the concept of cash flow. It does not consider actual profit booked by the business.
• Only cash flow is considered as a measurement and the accounting profit is ignored.
• The net present value of wealth is the difference between present value of wealth and investment required.
• Financial management should take such financial decisions by which wealth of the company is maximized. If the wealth of the company is maximized, it will be reflected in the price of the share of the company in the stock exchange.
• Market price of the share will increase in the share market. This will result in maximization of the wealth of shareholders.
• The objective of wealth maximization is appropriate and universally accepted. Moreover, it is considered superior to profit maximization. Prof. Solomon has favoured the objective of wealth maximization.

In simple words: Financial management aims to make the owner's finances as good as possible. It does this through two ways: making the most profit and increasing overall wealth. Profit maximization means getting the highest income and dividends. Wealth maximization means increasing the business's value and share price, often using Net Present Value calculations, and it's generally seen as the better long-term goal.

Exam Tip: Clearly distinguish between profit maximization (short-term, ignores risk and time value of money) and wealth maximization (long-term, considers risk and time value, preferred goal). Provide a brief explanation for each and why wealth maximization is considered superior.

 

5. Answer The Following Questions In Detail:

 

Question 1. Explain the importance of financial management.
Answer: Financial management is essential for any business as it guides crucial decisions regarding funds, ensuring efficient operation and sustained growth. Its importance spans several key areas, from estimating financial needs to boosting the company's creditworthiness in the market. Importance of financial management: 1. Estimation of financial needs: Financial management helps determine the necessary amounts of long-term and short-term capital a business will require. 2. Acquiring finance: It ensures that the finance needed for the business is obtained at the lowest possible cost. 3. Planning and controlling: Financial management combines planning with effective control to ensure the economical use of financial resources. 4. Distribution of finance: It allocates funds among different departments in such a way that each department receives sufficient finance. 5. Maintaining liquidity: Financial management prepares cash flow statements and cash budgets to ensure a specific cash balance is always available. 6. Distribution of income: It decides how much profit will be distributed as dividends to shareholders and how much will be reinvested back into the business. 7. Management of current assets: Current assets such as cash, debtors, inventory, marketable securities, and bank balances are managed by financial management, which creates investment policies for their proper handling. 8. Financial decisions: Financial management makes vital decisions related to capital budgeting, dividend policy, and profit reinvestment. It also coordinates different financial decisions, like aligning dividend policy with profit reinvestment. 9. Raising credit of business: Financial management significantly helps in the advancement and growth of a business. Effective financial management builds a strong financial structure, which helps in paying employee salaries and creditors on time. Consequently, the business's credit standing in the market improves.In simple words: Financial management is vital because it figures out how much money a business needs, gets funds cheaply, plans and controls their use, gives enough money to all departments, and keeps enough cash ready. It also decides how to share profits, manages daily assets, makes big money decisions, and helps the business earn trust and credit in the market.

Exam Tip: When explaining importance, structure your answer with clear points, starting with identifying needs and ending with broader impacts like credit rating. Use simple language to elaborate on each point.

 

Question 2. Discuss the factors affecting the capital structure.
Answer: A company's capital structure is influenced by several factors, both internal and external, which guide decisions on the mix of debt and equity. These factors help determine the optimal way to raise funds while managing costs and risks. External factors that affect the capital structure of the company: 1. Condition of boom-depression in capital market: During a depressed market, investors typically prefer the safety of debentures over risky equity, as debentures offer steady returns. Conversely, in a booming market, investors are more inclined to invest in equity shares to earn higher dividends and profits. Therefore, the prevailing market trends significantly impact how the capital structure is formed. 2. Current rate of interest in capital market: If interest rates are high in the capital market, companies prefer to raise capital by issuing equity shares rather than borrowing, as high-interest borrowing becomes expensive. However, if interest rates are low, companies often favor issuing debentures. 3. Cost of capital expenses of issuing securities: When a company issues securities to raise capital, it incurs various expenses, such as prospectus release, underwriting commission, and brokerage, which increase the overall cost of capital. The cost associated with issuing debentures is usually less than that for issuing equity securities. 4. Legal restrictions: Companies must comply with various legal restrictions that influence their capital structure. For example, under the Companies Act, a company raising capital through securities must mandatorily issue equity shares. Regulations from SEBI and RBI, along with provisions of the Companies Act, are also considered when designing the capital structure. 5. Taxation policy: When tax rates are high, companies often prefer to issue debentures to acquire capital. This is because interest paid on debentures is tax-deductible, reducing the company's tax burden. Additionally, equity shares become more appealing if dividend income is tax-exempt or taxed at a lower rate. 6. Institutional investors: Entities such as insurance companies, banks, and state and central government financial institutions invest in company shares and debentures according to their established rules and criteria. The investment trends and conditions set by these institutions are vital considerations when forming or modifying a company's capital structure. 7. Foreign institutional investor: A Foreign Institutional Investor (FII) is a financial institution established and registered outside India, with the goal of investing in specific Indian securities within primary and secondary markets. These investors must register with SEBI, which then permits them to purchase shares and debentures of Indian companies. The involvement of FIIs in India's capital market significantly influences the capital structure of companies.In simple words: A company's capital structure depends on many things outside its control. Market conditions (boom or bust) change what investors want. High interest rates make companies prefer selling shares, while low rates make loans (debentures) attractive. The cost to issue shares or debentures, legal rules, tax policies, how big financial institutions invest, and foreign investors all play a big part in how a company chooses to get its money.

Exam Tip: Classify factors into internal and external, even if the question focuses on one. For external factors, discuss market conditions (boom/depression), interest rates, regulatory framework, and institutional investor behavior. Provide specific examples for clarity.

 

Question 4. Distinguish between :
(i) Gross working capital and net working capital.
Answer:

In simple words: Gross working capital includes all current assets, while net working capital is current assets after subtracting current liabilities. Gross capital does not show a company's liquidity, but net capital reveals the true amount of liquid funds a company possesses.

Exam Tip: Remember that gross working capital focuses on current assets, while net working capital considers both current assets and liabilities, providing a clearer picture of financial health.

 

Question 4. (ii) Fixed capital and working capital.
Answer:

In simple words: Working capital is money used for daily operations and is short-term, while fixed capital is for buying long-term assets like property. Working capital is liquid and has less risk, but fixed capital is less liquid and carries more risk.

Exam Tip: Understand that working capital helps with everyday operations, while fixed capital forms the foundation of a business by providing essential long-term assets.

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