Financial Management — NCERT Solutions

To judge whether debt is suitable, compare cost of debt with Return on Investment (RoI).

• EBIT = ₹8,00,000
• Total capital investment = ₹1,00,00,000

So,
$$RoI = \frac{EBIT}{Total\ Investment} \times 100 = \frac{8,00,000}{1,00,00,000} \times 100 = 8\%$$

Cost of debentures = 10%

Since 10% > 8%, the company will pay more on debt than it earns on the funds invested. This is an unfavourable financial leverage situation, so issuing debentures is not rational.

Working capital has a direct effect on both liquidity and profitability:

• If a business keeps more working capital, it can pay its short-term obligations easily, so liquidity increases.
• But too much working capital means more money remains idle in current assets, which gives low return, so profitability decreases.
• If a business keeps too little working capital, funds are tightly used and profitability may improve, but the firm may face difficulty in paying bills, salaries, and creditors, so liquidity falls.

Therefore, the business must maintain a proper balance between liquidity and profitability.

a. Financial concept: Financial planning.

It is the preparation of a financial blueprint for the organisation’s future operations. In this case, Prabhu is estimating the amount of funds required, the time when they will be needed, expected profits, the funds available from internal sources, and the additional funds needed from outside sources.

Objectives of financial planning:

1. To ensure availability of funds whenever required — so that the firm can meet its future commitments and expansion plans on time.
2. To see that the firm does not raise resources unnecessarily — so that excess funds are not kept idle and cost is not increased.

b. Comment on dividend restriction:
The statement is false. There are restrictions on payment of dividend.

Dividends can be paid only if:

• there are sufficient profits,
• cash is available,
• and the company does not violate legal constraints or contractual constraints.

For example, the Companies Act places restrictions on dividend payout, and sometimes lenders also impose conditions in loan agreements. So a company cannot pay dividend freely without such limits.

Working capital is the amount invested in current assets for day-to-day operations of the business. It is calculated as:
$$NWC = Current\ Assets - Current\ Liabilities$$

Five important determinants of working capital requirement are:

1. Nature of business — manufacturing firms usually need more working capital than trading or service firms.
2. Scale of operations — larger operations need more inventory and debtors.
3. Business cycle — boom periods need more working capital than depression.
4. Seasonal factors — peak season needs more working capital than lean season.
5. Production cycle — longer production cycles require more funds tied up in raw materials and work-in-progress.

Other factors like credit policy, operating efficiency, and inflation also matter.

Capital structure decision is indeed an optimisation of the risk-return relationship.

• Debt is cheaper than equity, so using more debt may raise EPS and reduce overall cost of capital.
• But too much debt increases financial risk because interest and repayment become compulsory.
• Equity is safer but usually costlier.

Therefore, a firm must choose a balance between debt and equity that gives the best return with acceptable risk. The best combination is called the optimum capital structure, and it should maximise shareholders’ wealth.

Yes, I agree.

A capital budgeting decision can change the financial fortunes of a business because:

• it involves large sums of money,
• it is taken for the long term,
• it affects the firm’s earning capacity, profitability, and competitiveness,
• and once made, it is often irreversible except at a huge cost.

A wrong decision can severely damage the business, while a good one can improve future profits and growth. Hence, such decisions must be taken with great care.

The dividend decision is influenced by many factors:

1. Amount of earnings — dividends are paid from profits.
2. Stability of earnings — stable earnings allow higher dividends.
3. Stability of dividends — firms try to keep dividend per share steady.
4. Growth opportunities — growing firms retain more earnings.
5. Cash flow position — dividend needs cash, not just profit.
6. Shareholders’ preference — some shareholders prefer regular income.
7. Taxation policy — tax treatment of dividends and capital gains affects the choice.
8. Stock market reaction — higher dividends may raise share prices.
9. Access to capital market — firms with easy access may pay higher dividends.
10. Legal constraints — Companies Act restrictions must be followed.
11. Contractual constraints — loan agreements may limit dividend payment.

These factors guide how much profit is distributed and how much is retained.

Trading on Equity refers to the increase in profit earned by equity shareholders due to the presence of fixed financial charges like interest.

It is used:

• when the company’s RoI is higher than the cost of debt,
• so that using more debt increases EPS,
• and the extra earnings go to equity shareholders.

How it works:

• Debt is cheaper than equity.
• If the firm earns more on its investments than it pays as interest, the difference increases the return to equity holders.
• This is called favourable financial leverage.

But it should be used carefully, because too much debt increases financial risk.

a. Role and objectives of financial management for this company:
Financial management will help mobilise funds at the lowest possible cost and deploy them in the most profitable way. For this steel company, it is important because it has to decide:

• how much money to invest in the new plant,
• how to arrange the required funds,
• what proportion should come from debt and equity,
• and how to manage the large working capital requirement.

Its main objective is to maximise shareholders’ wealth by ensuring that the investment and financing decisions add value to the company. It should also keep the financial risk under control and ensure that enough funds are available whenever needed.

b. Importance of financial plan:
A financial plan is important because it gives a blueprint of future funds requirement. It helps the company to:

• ensure funds are available at the right time,
• avoid shortages or excess funds,
• forecast future sales, costs, profits and cash flows,
• and arrange internal and external sources in time.

Imaginary plan:
For example, if the plant requires ₹5000 crores and working capital of ₹500 crores, the company may prepare a plan like:

• ₹2500 crores from equity shares,
• ₹2000 crores from debentures/long-term loans,
• ₹500 crores from internal accruals,
• and ₹500 crores as working capital from short-term bank finance and current liabilities.

This helps the company match the timing and amount of funds with its expansion programme.

c. Factors affecting capital structure:
The company’s capital structure will depend on:

1. Cash flow position — it must have enough cash to service debt.
2. Interest coverage ratio (ICR) — higher EBIT can support more debt.
3. Debt service coverage ratio (DSCR) — ability to meet interest and repayment obligations.
4. Return on investment (RoI) — if RoI is higher than cost of debt, debt can be used more.
5. Cost of debt — cheaper debt is more attractive.
6. Tax rate — interest is tax-deductible, so higher tax makes debt cheaper.
7. Cost of equity — too much debt may raise equity shareholders’ expected return.
8. Floatation costs — higher issue costs make a source less attractive.
9. Risk consideration — higher debt increases financial risk.
10. Flexibility — some borrowing power should be kept for future needs.
11. Control — equity may dilute management control; debt does not.
12. Regulatory framework — legal requirements for raising funds.
13. Stock market conditions — equity is easier in a bullish market.
14. Capital structure of other companies — industry norms can guide the choice.

d. Factors affecting fixed and working capital:

Fixed capital factors:

1. Nature of business — steel production is capital-intensive, so heavy investment in plant and machinery is needed.
2. Scale of operations — a large steel plant requires more fixed assets.
3. Choice of technique — modern steel plants use capital-intensive techniques, increasing fixed capital needs.
4. Technology upgradation — machinery may become obsolete, so more investment is needed.
5. Growth prospects — expansion for future demand requires larger fixed capital.
6. Financing alternatives — leasing or similar options may reduce purchase cost.

Working capital factors:

1. Nature of business — manufacturing requires more working capital than trading.
2. Scale of operations — large output means more raw material, stock and debtors.
3. Business cycle — boom conditions increase production and sales, raising working capital needs.
4. Production cycle — steel has a long production cycle, so more funds remain blocked.
5. Credit allowed — if credit is given to customers, debtors increase.
6. Credit availed — credit from suppliers reduces working capital need.
7. Operating efficiency — efficient inventory and receivables management lowers need.
8. Availability of raw material — if supply is uncertain, higher stock is needed.
9. Growth prospects — expansion requires more current assets.
10. Level of competition — competition may force higher stocks and liberal credit.
11. Inflation — rising prices increase the amount needed for current assets.

Thus, because steel is a highly capital-intensive industry, it will need a large amount of fixed capital and substantial working capital to run the new plant smoothly.