BHARATA MATA COLLEGE OF COMMERCE AND ARTS

FINANCIAL MANAGEMENT-QUESTION BANK

MODULE 1
PARTA- 2 MARKS
1. Define Financial Management?
Financial Management is a vital activity in any organization. It is the process of
planning, organizing, controlling and monitoring financial resources with a view
to achieve organizational goals and objectives
2. Define public finance?
Public finance is the study of the role of the government in the economy. It is the
branch of economics that assesses the government revenue and government
expenditure of the public authorities and the adjustment of one or the other to
achieve desirable effects and avoid undesirable ones.

3. What is time value of money?

The value of money, then, is the quantity of goods in general that will be
exchanged for one unit of money. The value of money is its purchasing power,
i.e., the quantity of goods and services it can purchase. What money can buy
depends on the level of prices.
4. Explain compounding?
Compounding is the process whereby interest is credited to an existing principal
amount as well as to interest already paid. Compounding can thus be construed
as interest on interest—the effect of which is to magnify returns to interest over
time, the so-called "miracle of compounding."
5. What is private finance?
Private finance is the study of income and expenditure,
borrowings, etc. of individuals, households and business firms. Public finance is
concerned with the revenue/incomes and expenditure, borrowings, etc. of the
economy or government. Adjustments
Part-B – 5 marks
6. Explain the scope of financial mgt?
1. Financial Management is an integral part of overall management. Financial
considerations are involved in all business decisions. So financial management is
pervasive throughout the organization.

2. The central focus of financial management is valuation of the firm. That is financial
decisions are directed at increasing/maximization/ optimizing the value of the firm.

3. Financial management essentially involves risk-return trade-off Decisions on

investment involve choosing of types of assets which generate returns accompanied by
risks. Generally higher the risk returns might be higher and vice versa. So, the financial
manager has to decide the level of risk the firm can assume and satisfy with the
accompanying return.

4. Financial management affects the survival, growth and vitality of the firm. Finance is
said to be the life blood of business. It is to business, what blood is to us. The amount,
type, sources, conditions and cost of finance squarely influence the functioning of the
unit.

5. Finance functions, i.e., investment, rising of capital, distribution of profit, are

performed in all firms - business or non-business, big or small, proprietary or corporate
undertakings. Yes, financial management is a concern of every concern.

6. Financial management is a sub-system of the business system which has other

subsystems like production, marketing, etc. In systems arrangement financial sub-
system is to be well-coordinated with others and other sub-systems well matched with
the financial subsystem.

7. What is profit maximization? What are criticisms against profit maximization?

A firm maximizes profit by operating where marginal revenue equals marginal
cost. In the short run, a change in fixed costs has no effect on the profit
maximizing output or price. The firm merely treats short term fixed costs as sunk
costs and continues to operate as before.

i) The profit maximization objective ignores the timing of returns. It equates a rupee
received today with a rupee received in the future. In fact, Rs 100 today is valued more
than Rs 100 received after one year. It is because the money received in an earlier
period may be reinvestable to earn more.

(ii) It leads to proper and efficient channelization and utilization of surplus funds for
productive business operations and other economic activities.

(iii) The critics of profit maximization objective argue that it ignores the risk associated
with a stream of the cash flow of the project. For example, the total profit from the two
projects may be the same but the profit from one project may be fluctuating widely than
the profit from the other project. The firm with wider fluctuation in profit is riskier. This
fact is ignored by the profit maximization objective.

(iv) It’s impossible to always accurately forecast demand, so you may end up with a glut
of items that nobody really wants, reducing the profits that you were trying to maximize.

(v) The profit maximization objective has greater relevance to a perfectly competitive
firm than to a monopoly firm. Critics argue that a monopoly firm would be earning
supernormal profit more or less automatically.
(vi) Today large-scale corporate type of organizations exists. Different stakeholders
such as owners, managers, customers, creditors, and employees are directly connected
with the organization. The interest of each member in this organizational collusion
cannot be achieved with the sole objective of profit maximization.

(vii) If you outfit a facility quickly and cheaply to meet an immediate demand, you may
lose out on the opportunity to build a larger facility that takes longer to build, but will
yield better earnings in the future.

8.What is wealth maximization? What are criticisms against wealth maximization

It simply means maximization of shareholder’s wealth. It is a combination of

two words viz. wealth and maximization. A wealth of a shareholder maximizes
when the net worth of a company maximizes. To be even more meticulous, a
shareholder holds share in the company/business and his wealth will improve if
the share price in the market increases which in turn is a function of net worth.
This is because wealth maximization is also known as net worth maximization.

1. It is a prescriptive idea. The objective is not descriptive of what the firm actually does.

2. The objective of wealth maximization is not necessarily socially desirable.

3. There is some controversy as to whether the objective is to maximize the stockholder

“wealth or the wealth of the firm, which includes other Finance claim holder’s such as
debenture holders, preference shareholder

4. The objective of wealth maximization may also face difficulties when ownership and
management are separated, as is the case in most of the corporate form of
organizations. When managers act as the agents of the real owner, there is the
possibility for a conflict of interest between shareholders and the managerial interests

Part-C -15 marks

9.What are the functions of FM?

Finance Functions (Scope of Financial Management)

The finance function encompasses the activities of raising funds, investing them in
assets and distributing returns earned from assets to shareholders. While doing these
activities, a firm attempts to balance cash inflow and outflow.
It is evident that the finance function involves the four decisions viz., financing decision,
investment decision, dividend decision and liquidity decision. Thus the finance function
includes:

1. Investment decision
2. Financing decision
3. Dividend decision

1. Investment Decision: The investment decision, also known as capital budgeting, is

concerned with the selection of an investment proposal/ proposals and the investment
of funds in the selected proposal. A capital budgeting decision involves the decision of
allocation of funds to long-term assets that would yield cash flows in the future. Two
important aspects of investment decisions are:

i. The evaluation of the prospective profitability of new investments, and

ii. The measurement of a cut-off rate against that the prospective return of new
investments could be compared.

Future benefits of investments are difficult to measure and cannot be predicted with
certainty. Risk in investment arises because of the uncertain returns. Investment
proposals should, therefore, be evaluated in terms of both expected return and risk.
Besides the decision to commit funds in new investment proposals, capital budgeting
also involves replacement decision, that is decision of recommitting funds when an
asset become less productive or non-profitable. The computation of the risk-adjusted
return and the required rate of return, selection of the project on these bases, form the
subject-matter of the investment decision.

Long-term investment decisions may be both internal and external. In the former, the
finance manager has to determine which capital expenditure projects have to be
undertaken, the amount of funds to be committed and the ways in which the funds are
to be allocated among different investment outlets. In the latter case, the finance
manager is concerned with the investment of funds outside the business for merger
with, or acquisition of, another firm.

2. Financing Decision: Financing decision is the second important function to be

performed by the financial manager. Broadly, he or she must decide when, from where
and how to acquire funds to meet the firm’s investment needs. The central issue before
him or her is to determine the appropriate proportion of equity and debt. The mix of debt
and equity is known as the firm’s capital structure. The financial manager must strive to
obtain the best financing mix or the optimum capital structure for his or her firm. The
firm’s capital structure is considered optimum when the market value of shares is
maximized.

3. Dividend Decision: Dividend decision is the third major financial decision. The
financial manager must decide whether the firm should distribute all profits, or retain
them, or distribute a portion and return the balance. The proportion of profits distributed
as dividends is called the dividend-payout ratio and the retained portion of profits is
known as the retention ratio. Like the debt policy, the dividend policy should be
determined in terms of its impact on the shareholders’ value. The optimum dividend
policy is one that maximizes the market value of the firm’s shares. Thus, if shareholders
are not indifferent to the firm’s dividend policy, the financial manager must determine
the optimum dividend-payout ratio. Dividends are generally paid in cash. But a firm may
issue bonus shares. Bonus shares are shares issued to the existing shareholders
without any charge. The financial manager should consider the questions of dividend
stability, bonus shares and cash dividends in practice.
10. What are the arguments infovour and against wealth maximisation
Wealth maximazation is a long-term goal of a company and it is
concerned with multiple factors such as gaining market share in
order to gain industry leadership and innovation in new products
and services which drive sales. Wealth is generated when the
present value of all future cash flows are higher than the cost of
operations. In essence, wealth maximization is evaluated in terms
of net present value (NPV).
 MODULE 2
Part A – 2 marks
1, what is equity share?
Equity shares are long-term financing sources for any company.
These shares are issued to the general public and are non-redeemable in nature.
Investors in such shares hold the right to vote, share profits and claim assets of
a company.

2. What is Preference share?

Preference shares, more commonly referred to as preferred stock, are shares of
a company's stock with dividends that are paid out to shareholders before
common stock dividends are issued. If the company enters
bankruptcy, preferred stockholders are entitled to be paid from company assets
before common stockholders

3. What is Debenture?
Debentures are a debt instrument used by companies and government to issue
the loan. The loan is issued to corporate based on their reputation at a fixed rate
of interest. Debentures are also known as a bond which serves as an IOU
between issuers and purchaser.

4. What is Retained Earnings?

retained earnings (RE) is the amount of net income left over for the business
after it has paid out dividends to its shareholders.Often this profit is paid out to
shareholders, but it can also be re-invested back into the company for growth
purposes. The money not paid to shareholders counts as retained earnings

5. What is Secured premium notes ?

Secured premium notes (SPNs) are financial instruments which are issued with
detachable warrants and are redeemable after certain period. SPN is a kind of
non-convertible debenture (NCD) attached with warrant. It can be issued by the
companies with the lock-in-period of say four to seven years.

6. What is Second mortgage Debentures?

Second mortgage debentures are those debentures on which the holders have
the claim on the asset charged after the claim of first mortgage debentures is
settled. Mortgage debentures have been gaining popularity among investors in
recent times.
.

PART B -5 marks
7.A ltd issued Rs.50,000,8% debentures @par. The tax rate is
 50%.Compute cost of capital.
Kd=I/P(1-t)
I=50,000*8/100
=4000
P=50,000
T=50%
Kd=4000/50,000*(1-.50)
=4000/50,000*.50
=4%

8.What are the Features of equity shares.

• Equity shareholders have the right to vote on various matters of the company.
• The management of the company is elected by equity shareholders.
• The equity share capital is held permanently by the company and returned only upon
winding up.
• Equity shares give the right to the holders to claim dividend on the surplus profits of
the company. The rate of dividend on the equity capital is determined by the
management of the company.
• Equity shares are transferable in nature. They can be transferred from one person to
another with or without consideration.
9. List out the advantages of Equity Shares

From the Shareholder’s Point of View:

• Equity shares are liquid in nature and can be sold easily in the capital market.
• The dividend rate is higher for the equity shareholders when the company
earns high profits.
• The equity shareholders have the right to control the company’s management.
• The equity shareholders not only get the benefit of dividend but they also get
the benefit of price appreciation in the value of their investment.

From the Company’s Point of View:

• Equity shares are the permanent source of capital for a company.
• There is no requirement of creating a charge over the assets of the company
when equity shares are issued.
• The liability of the equity shares is not required to be paid.
• The company does not have any obligation to pay dividend to the
shareholders.
• The credit worthiness of the company increases among the investors and
creditors when the company has a larger equity capital base.
The above mentioned are the advantages of equity shares to both the
shareholders and the company
10. FINANCIAL LEVERAGE
PLAN1 PLAN2
DEBT 10% 800000 200000

Equity of rs 10 200000 800000

Total finance required 1000000 1000000

EBIT 10000.tax 50%

Ans
Plan 1 Plan2

EBIT 100000 100000

LESS INTEREST 80000 20000

EBT 20000 80000

LESS TAX 10000 10000

EARNING AFTER Interest 10000 40000

and tax

No.of equity share 20000 20000

EPS .50 .50

11. COMPOSITE LEVERAGE

A company has sale of rs 100000.V.C Rs500000, F.C Rs200000 and long term loans of
Rs 400000@5%rate of interest

Ans

OP LEVERAGE=contribution/EBIT
CONTRIBUTION=SALES-V.C
EBIT=1000000-500000-200000=300000
O.L=500000/300000=1.67
F.L=EBIT/EBIT-I
=300000/300000-40000=1.15
COPOSITE LEVERAGE=O.L*F.L
1.67*1.15=1.92

PART – C 15 marks
12.What do you mean by debentures? What are the various types of debentures?
1. From the Point of view of Security

● Secured Debentures: Secured debentures are that kind of debentures where a

charge is being established on the properties or assets of the enterprise for the
purpose of any payment. The charge might be either floating or fixed. The fixed
charge is established against those assets which come under the enterprise’s
possession for the purpose to use in activities not meant for sale whereas
floating charge comprises of all assets excluding those accredited to the
secured creditors. A fixed charge is established on a particular asset whereas a
floating charge is on the general assets of the enterprise.
● Unsecured Debentures: They do not have a particular charge on the assets of the
enterprise. However, a floating charge may be established on these debentures
by default. Usually, these types of debentures are not circulated.

2. From the Point of view of Tenure

● Redeemable Debentures: These debentures are those debentures that are due on
the cessation of the time frame either in a lump-sum or in installments during the
lifetime of the enterprise. Debentures can be reclaimed either at a premium or at
par.
● Irredeemable Debentures: These debentures are also called as Perpetual
Debentures as the company doesn’t give any attempt for the repayment of
money acquired or borrowed by circulating such debentures. These debentures
are repayable on the closing up of an enterprise or on the expiry (cessation) of a
long period.

3. From the Point of view of Convertibility

● Convertible Debentures: Debentures which are changeable to equity shares or in

any other security either at the choice of the enterprise or the debenture holders
are called convertible debentures. These debentures are either entirely
convertible or partly changeable.
● Non-Convertible Debentures: The debentures which can’t be changed into shares
or in other securities are called Non-Convertible Debentures. Most debentures
circulated by enterprises fall in this class.

4. From Coupon Rate Point of view

● Specific Coupon Rate Debentures: Such debentures are circulated with a

mentioned rate of interest, and it is known as the coupon rate.
● Zero-Coupon Rate Debentures: These debentures don’t normally carry a
particular rate of interest. In order to restore the investors, such type of
debentures are circulated at a considerable discount and the difference between
the nominal value and the circulated price is treated as the amount of interest
associated to the duration of the debentures.
5. from the view Point of Registration

● Registered Debentures: These debentures are such debentures within which all
details comprising addresses, names and particulars of holding of the debenture
holders are filed in a register kept by the enterprise. Such debentures can be
moved only by performing a normal transfer deed.
● Bearer Debentures: These debentures are debentures which can be transferred
by way of delivery and the company does not keep any record of the debenture
holders Interest on debentures is paid to a person who produces the interest
coupon attached to such debentures
13.What are the types of preference shares?
1. Cumulative Preference Shares
A preference share is called cumulative when the outstanding payment of
a dividend is cumulative. If a company does not have the financial
capability to pay a dividend to the owners of its preference shares at any
point of time, then it will not pay a dividend to its common shareholders, as
long as the preference shareholders are not paid. The dividend amount
gets carried on to the next year.

2. Non-Cumulative Preference Shares

A non-cumulative preference shareholder is only payable from each year’s
net profit. A non-cumulative preference shareholder will not be paid from
future profits.So, if a company undergoes a loss in that year, then the
outstanding payment of dividend cannot be claimed in subsequent years
like in the case of cumulative preference shares.

3. Redeemable Preference Shares

Preference shares which can be redeemed after a fixed period or after
giving a certain notice are called a redeemable preference shareA
redeemable preference share is good for the company. These act as a
hedge against future inflation and when the monetary rate declines in the
country.

4. Irredeemable Preference Shares

Irredeemable preference shares are a perpetual liability, which cannot be
redeemed during the lifetime of the company.

According to the Companies Amendment Act, 1988, no company can issue

any preference share which is irredeemable or redeemable after 20 years
from the date of the issue.

5. Participating Preference Shares

 Participating preference share is where the issuing company is entitled to
pay an increased dividend to the owners, in addition to preference dividend
at a fixed rate,

Also, the holders of participating preference shares may have the right to
share the surplus asset of the company, when it’s winding up.

6. Non-Participating Preference Shares

The holders of non-participating preference shares are entitled only to a

fixed rate of dividend and do not have any share in the surplus profit.

The surplus profit of the company will thus go to the common

shareholders.

Preference shares are non-participating in nature unless and until

expressly provided in the memorandum of the article.

7. Convertible Preference Shares

Convertible preference shares are the type of preference shares where the
holder has the option to convert into the common/equity share of the
company.

This kind of preference share is useful for the investors who want to
receive a preferred share dividend and also participate in any kind of
upward change in the price of the issuer’s common shares.So, an investor
has the benefit and security of a fixed return along with a chance to earn a
higher return on his/her investment.

But the convertible preference shareholders can convert into common

shares within a certain period as agreed in the memorandum.

8. Non-Convertible Preference Shares

Non-convertible preference shares do not carry the right of conversion into the
company’s common shares.
 MODULE 3
PART A-2 MARKS
1. What is Capital budgeting?
Capital budgeting, and investment appraisal, is the planning process used to determine
whether an organization's long term investments such as new machinery, replacement
of machinery, new plants, new products, and research development projects are worth
the funding of cash through the firm's capitalization structure
2. What is Capital rationing?
Capital rationing is the act of placing restrictions on the amount of new investments or
projects undertaken by a company. This is accomplished by imposing a higher cost
of capital for investment consideration or by setting a ceiling on specific portions of a
budge
3. What you mean by ARR?
Accounting rate of return, also known as the Average rate of return, or ARR is a financial
ratio used in capital budgeting. The ratio does not take into account the concept of time
value of money. ARR calculates the return, generated from net income of the proposed
capital investment. The ARR is a percentage return
4, What is OPERATIONS RESEARCH?
The application of scientific and especially mathematical methods to the study and
analysis of problems involving complex systems
5. What is payback period?
The payback period refers to the amount of time it takes to recover the cost of an
investment. Simply put, the payback period is the length of time an investment reaches
a break-even point. The desirability of an investment is directly related to its payback
period. Shorter paybacks mean more attractive investments.
6.what is NPV?
In finance, the net present value or net present worth applies to a series of cash flows
occurring at different times. The present value of a cash flow depends on the interval of
time between now and the cash flow. It also depends on the discount rate. NPV
accounts for the time value of money

PART B -5 MARKS
7. What are the merits and demerits of payback method?
Merits of Pay-Back Method:
The merits or advantages of Pay-back methods!
(1) This method is Easy and Simple:
Pay-back method is easy to calculate and simple to understand. Its quick computation
makes it a favorable among executives who prefer snap answers.

(2) Ranking of Projects:

This method is preferred by executives who like snap answers for the selection of the
proposal. The projects are ranked in terms of their eco (4) Useful in Case of Uncertainty:
Pay-back method is useful in the industries which are subject to uncertainty, instability
or rapid technological changes because the future uncertainty does not permit
projection of annual cash inflows beyond a limited period. It reduces the possibility of
loss through obsolescence.

(5) Handy Device or Method:

This method is handy device for evaluating investment proposals where procession in
estimates of profitability is not important.

Demerits or Limitations of Pay-Back Method:

Important de-merits of Pay Back Methods are as follows:
(a) It ignores annual cash flow:
Pay-back method totally ignores the annual cash inflow after the pay-back period.

(b) It considers only the period of pay-back:

Pay-back method does not consider the pattern of cash inflows or the magnitude and
timing of cash inflows.

(c) It overlooks capital cost:

Pay-back method overlook the costs of capital i.e., interest factor which is an important
consideration in making sound investment decisions.

(d) No rational basis of decision:

There is no rational basis for determining the minimum acceptable pay-back period. It is
generally subjective decision of the management which creates so many administrative
difficulties.

(e) It is delicate and rigid:

A slight change in operation cost may affect the cash inflow and as such pay-back
period shall not be affected.

(f) This method over emphasizes the importance of liquidity as a goal of capital
expenditure decisions:
8. Explain steps in capital budgeting?
1. Identify and evaluate potential opportunities

The process begins by exploring available opportunities. For any given initiative, a
company will probably have multiple options to consider. For example, if a company is
seeking to expand its warehousing facilities, it might choose between adding on to its
current building or purchasing a larger space in a new location. As such, each option
must be evaluated to see what makes the most financial and logistical sense. Once the
most feasible opportunity is identified, a company should determine the right time to
pursue it, keeping in mind factors such as business need and upfront costs.
2. Estimate operating and implementation costs

The next step involves estimating how much it will cost to bring the project to fruition.
This process may require both internal and external research. If a company is looking to
upgrade its computer equipment, for instance, it might ask its IT department how much
it would cost to buy new memory for its existing machines while simultaneously pricing
out the cost of new computers from an outside source. The company should then
attempt to further narrow down the cost of implementing whichever option it chooses.
3. Estimate cash flow or benefit
Now we determine how much cash flow the project in question is expected to generate.
One way to arrive at this figure is to review data on similar projects that have proved
successful in the past. If the project won't directly generate cash flow, such as the
upgrading of computer equipment for more efficient operations, the company must do
its best to assign an estimated cost savings or benefit to see if the initiative makes
sense financially.
4. Assess risk
This step involves estimating the risk associated with the project, including the amount
of money the company stands to lose if the project fails or can't produce its previously
anticipated results. Once a degree of risk is determined, the company can evaluate it
against its estimated cash flow or benefit to see if it makes sense to pursue
implementation.
5. Implement
if a company chooses to move forward with a project, it will need an implementation
plan. The plan should include a means of paying for the project at hand, a method for
tracking costs, and a process for recording cash flows or benefits the project generates.
The implementation plan should also include a timeline with key project milestones,
including an end date if applicable.

9. Explain IRR?
The internal rate of return is a metric used in financial analysis to estimate the
profitability of potential investments. The internal rate of return is a discount rate that
makes the net present value (NPV) of all cash flows equal to zero in a discounted cash
flow analysis. IRR calculations rely on the same formula as NPV does.

KEY TAKEAWAYS

● IRR is the annual rate of growth an investment is expected to generate.

● IRR is calculated using the same concept as NPV, except it sets the NPV equal to
zero.
● IRR is ideal for analyzing capital budgeting projects to understand and compare
potential rates of annual return over time.
10. Explain NPV?
NPV analysis is used to help determine how much an investment, project, or any series
of cash flows is worth. It is an all-encompassing metric, as it takes into account
all revenues, expenses, and capital costs associated with an investment in its Free Cash
Flow (FCF).In addition to factoring all revenues and costs, it also takes into account the
timing of each cash flow that can result in a large impact on the present value of an
investment. For example, it’s better to see cash inflows sooner and cash outflows later,
compared to the opposite.
Why Are Cash Flows Discounted? The cash flows in net present value analysis are
discounted for two main reasons, (1) to adjust for the risk of an investment opportunity,
and (2) to account for the time value of money (TVM).
The first point (to adjust for risk) is necessary because not all businesses, projects, or
investment opportunities have the same level of risk. Put another way, the probability of
receiving cash flow from a US Treasury bill is much higher than the probability of
receiving cash flow from a young technology startup.

PART C -15 MARKS

11. Project A and project B requires an investment of Rs 50000 and 80000 respectively
calculate NPV

YEARS PROJECT A PROJECT B

1 25000 20000

2 15000 22000

3 12500 23000

4 NIL 25000

5 12000 18000

6 6000 8500
Discount rate 10%
ANS

PROJECT A PROJECT B

Year PV CASH PV CASH PV

INFLOW INFLOW

1 .909 25000 22725 20000 18180

2 .826 15000 12390 22000 18172

3 .751 12500 9388 23000 17273

4 .683 NIL NIL 25000 17075

5 .621 12000 7452 18000 11178

6 .564 6000 3384 8500 4794

TOTAL PV 55339 86672

LESS COST OF PROJECT 50000 50000

NPV 5339 6672

NPV of project B is higher than that project of A .project B should be selected

12. A company has an investment opportunity costing Rs 40000with the following
expected net cash flow (After tax and before depreciation)
year 1 2 3 4 5 6 7 8 9 10

Cash 700 700 7000 7000 7000 8000 1000 15000 1000 4000
flow 0 0 0 0

Using 10% as the cost of capital. Find

1.payback period,2.NPV10% discounting factor,3.profitability index 10% discounting
factor,4.IRR 10% discounting factor and 15% discounting factor
ANS;
YEAR NET CASH INFLOW CUMULATIVE NET CASH FLOW

1 7000 7000

2 7000 14000

3 7000 21000
4 7000 28000

5 7000 35000

6 7000 43000

Pay back period=5 years +5ooo/8000=5.62 years

B. NPV
YEAR NET CASH FLOW DISCOUNT FACTOR PV

1 7000 .909 6363

2 7000 .826 5782

3 7000 .751 5257

4 7000 .683 4781

5 7000 .621 4347

6 8000 .564 4512

7 10000 .513 5130

8 15000 .467 7005

9 10000 .424 4240

10 4000 .386 1544

Total present value of cash inflow =48961

Less Initial investment = 40000

NPV = 8961
C.Profitability Index
Present value of cash inflow =48961 =1.224
Present value of cash out flow 40000
D. IRR
YEAR NET CASH INFLOW DISCOUNT FACTOR PV
10%

1 7000 .870 6090

2 7000 .756 5292

3 7000 .658 4606

4 7000 .572 4004

5 7000 .497 3479

6 8000 .432 3456

7 10000 .376 3760

8 15000 .327 4905

9 10000 .284 2840

10 4000 .247 988

Total present value of cash inflow

39420
Less Initial investment
40000
NPV ( -)580
IRR=L1+P1-1 *D
P2-P1
L1=LOWER RATE=10%
L2=HIGHER RATE=15%
P1=PV LOWER RATE=Rs48961
I=COST OF INVESTMENT=Rs 40000
P2=PV AT HIGHER RATE=39420
D=L2-L1=15-10=5
IRR=10+ 48961-40000 *5
48961-39420
=10+4.696=14.696
 MODULE 4
PART A- 2marks
1. Define working capital?
Working capital, also known as net working capital (NWC), is the difference between a
company's current assets, such as cash, accounts receivable (customers' unpaid bills)
and inventories of raw materials and finished goods, and its current liabilities, such as
accounts payable

2. What is Gross working capital?

Gross working capital is the sum of a company's current assets (assets that are
convertible to cash within a year or less). Gross working capital includes assets such as
cash, accounts receivable, inventory, short-term investments, and marketable securities.

3. What is Net working capital?

Net working capital (NWC) is the difference between a company's current assets and
current liabilities. A positive net working capital indicates a company has sufficient
funds to meet its current financial obligations and invest in other activities
4. What is operating cycle?
An operating cycle refers to the time it takes a company to buy goods, sell them and
receive cash from the sale of said goods. In other words, it's how long it takes a
company to turn its inventories into cash. The length of an operating cycle is dependent
upon the industry
5. What is working capital gap?
Working capital gap = Current Assets (excluding cash & bank balance) - Current
Liabilities. So, high working capital entails a cost to the firm in the form of short term
loan interest payments. The greater the working capital gap, the larger is the amount to
be borrowed and so higher is the servicing cost
6. What is Hard core working capital?
The term Hard-Core Working Capital was first used by Tandon Committee in its report.
It means the minimum amount of working capital required to invest in raw materials,
stores and spares, work in progress etc to keep the firm running

PARTB-5 MARKS
7. What is operating cycle method of estimating working capital?

Operating Cycle Approach’ or ‘Cash Working Capital Approach’ to Working Capital

requirement.

Unlike the conventional approach, consistent with the definition, this approach views
working capital as a function of the volume of operating expenses. This approach
suggests that actual level of working capital requirement of a firm in a period can be
appropriately determined with reference to the length of Net Operating Cycle and the
operating expenses needed for the period.
The net duration of operating cycle is equal to the number of days involved in the
different stages of operation commencing from purchase of raw materials and ending
up with collection of sale proceeds from Debtors against which the number of days
credit allowed by suppliers are to be adjusted.
The number of operating cycles in a period is determined by dividing the number of
days in the same by the length of Net Operating Cycle. Once the number of operating
cycle has been determined, the actual working capital requirement is then arrived at by
dividing the total operating expenses for the period by the number of operating cycles in
that period.

8. What are the sources of working capital?

1. Loans from Commercial Banks:

Small-scale enterprises can raise loans from the commercial banks with or without
security. This method of financing does not require any legal formality except that of
creating a mortgage on the assets. Loan can be paid in lump sum or in parts. The short-
term loans can also be obtained from banks on the personal security of the directors of
a country.

2. Public Deposits:

Often companies find it easy and convenient to raise short- term funds by inviting
shareholders, employees and the general public to deposit their savings with the
company. It is a simple method of raising funds from public for which the company has
only to advertise and inform the public that it is authorised by the Companies Act 1956,
to accept public deposits.

Public deposits can be invited by offering a higher rate of interest than the interest
allowed on bank deposits. However, the companies can raise funds through public
deposits subject to a maximum of 25% of their paid up capital and free reserves.

But, the small-scale enterprises are exempted from the restrictions of the maximum
limit of public deposits if they satisfy the following conditions:
The amount of deposit does not exceed Rs. 8 lakhs or the amount of paid up capital
whichever is less.

The main merit of this source of raising funds is that it is simple as well as cheaper. But,
the biggest disadvantage associated with this source is that it is not available to the
entrepreneurs during depression and financial stringency.

3. Trade Credit:

Just as the companies sell goods on credit, they also buy raw materials, components
and other goods on credit from their suppliers. Thus, outstanding amounts payable to
the suppliers i.e., trade creditors for credit purchases are regarded as sources of
finance. Generally, suppliers grant credit to their clients for a period of 3 to 6 months.

4. Factoring:

Factoring is a financial service designed to help firms in managing their book debts and
receivables in a better manner. The book debts and receivables are assigned to a bank
called the ‘factor’ and cash is realised in advance from the bank. For rendering these
services, the fee or commission charged is usually a percentage of the value of the
book debts/receivables factored.

5. Discounting Bills of Exchange:

When goods are sold on credit, bills of exchange are generally drawn for acceptance by
the buyers of goods. The bills are generally drawn for a period of 3 to 6 months. In
practice, the writer of the bill, instead of holding the bill till the date of maturity, prefers
to discount them with commercial banks on payment of a charge known as discount.

6. Bank Overdraft and Cash Credit:

Overdraft is a facility extended by the banks to their current account holders for a short-
period generally a week. A current account holder is allowed to withdraw from its
current deposit account upto a certain limit over the balance with the bank. The interest
is charged only on the amount actually overdrawn. The overdraft facility is also granted
against securities.

7. Advances from Customers:

One way of raising funds for short-term requirement is to demand for advance from
one’s own customers. Examples of advances from the customers are advance paid at
the time of booking a car, a telephone connection, a flat, etc. This has become an
increasingly popular source of short-term finance among the small business enterprises
mainly due to two reasons.

8. Accrual Accounts:

Generally, there is a certain amount of time gap between incomes is earned and is
actually received or expenditure becomes due and is actually paid. Salaries, wages and
taxes, for example, become due at the end of the month but are usually paid in the first
week of the next month. Thus, the outstanding salaries and wages as expenses for a
week help the enterprise in meeting their working capital requirements. This source of
raising funds does not involve any cost.
 9.Different types of working capital?

Types of Working Capital

1. On the basis of Value

▪ Gross Working Capital: It denotes the company’s overall investment in the current
assets.
▪ Net Working Capital: It implies the surplus of current assets over current liabilities. A
positive net working capital shows the company’s ability to cover short-term
liabilities, whereas a negative net working capital indicates the company’s inability in
fulfilling short-term obligations.
On the basis of Time
▪ Temporary working Capital: Otherwise known as variable working capital, it is that
portion of capital which is needed by the firm along with the permanent working
capital, to fulfil short-term working capital needs that emerge out of fluctuation in the
sales volume.
▪ Permanent Working Capital: The minimum amount of working capital that a company
holds to carry on the operations without any interruption, is called permanent
working capital.
Other types of working capital include Initial working capital and Regular working capital.
The capital required by the promoters to initiate the business is known as initial working
capital. On the other hand, regular working capital is one that is required by the firm to
carry on its operations effectively.
Working Capital Cycle

Working Capital Cycle or popularly known as operating cycle, is the length of time
between the outflow and inflow of cash during the business operation. It is the time
taken by the firm, for the payment of materials, wages and other expenses, entering into
stock and realizing cash from the sale of the finished good.

In short, the working capital cycle is the average time required to invest cash in assets
and reconverting it into cash by selling the assets produced.

The working capital cycle may vary from enterprise to enterprise depending on various
factors, such as nature and size of business, production policies, manufacturing
process, fluctuations in trade cycle, credit policy, terms and conditions for purchase and
sales, etc

10.what is working capital management?

A company’s working capital essentially consists of current assets and current
liabilities. Current assets refer to those assets that can be converted into cash within
one year, like debtors, and stock and prepaid expenses- expenses that have already
been paid for. Current liabilities are the day-to-day debts incurred by a business in its
operation. These could be credit purchases made from vendors (creditors) and
outstanding expenses (expenses that are yet to be paid).

Thus, working capital management refers to monitoring these two components or the
short-term liquidity of your firm.
Three fundamental parameters that help you manage working capital
requirements better and indicate your liquidity standing of your firm are:

1. Working Capital Ratio:

A ratio between the current assets and current liabilities, it signifies the current ability of
an organization to pay off its short-time financial obligations.

2. Collection Period Ratio:

Also known as the debtors or accounts receivables turnover ratio, this ratio is indicative
of a company’s ability to convert its debts into cash. The lesser number of days it takes
to realise its payments from its debtors, the better.

3. Inventory Turnover Ratio:

Also known as the stock turnover ratio, this ratio monitors the time a company takes to
converts its goods into cash. Lower the time taken, higher is the company’s stock
efficiency.

Strong working capital management aids a company in having a higher operational

efficiency and hence, higher profitability.

11. What is the importance of working capital?

Working capital is just what it says – it is the money you have to work with to meet your
short-term needs. It is important because it is a measure of a company’s ability to pay
off short-term expenses or debts.

But on the other hand, too much working capital means that some assets are not being
invested for the long-term, so they are not being put to good use in helping the company
grow as much as possible.

The most important positions for effective working capital management are inventory,
accounts receivable, and accounts payable. Depending on the industry and business,
prepayments received from customers and prepayments paid to suppliers may also
play an important role in the company’s cash flow. Excess cash and nonoperational
items may be excluded from the calculation for better comparison.

Working capital is the difference between a business’ current assets and current
liabilities or debts. Working capital serves as a metric for how efficiently a company is
operating and how financially stable it is in the short-term. The working capital ratio,
which divides current assets by current liabilities, indicates whether a company has
adequate cash flow to cover short-term debts and expenses. A healthy company should
have a positive ratio.

Current assets are assets which are expected to be sold or otherwise used within one
fiscal year. Typically, current assets include cash, cash-equivalents, accounts receivable,
inventory, and prepaid accounts which will be used within a year, and short-term
investments.

Current liabilities are considered to be the debts of the business that are to be settled in
cash within the fiscal year. Current liabilities include accounts payables for goods,
services, or supplies, short term loans, long-term loans with maturity within one year,
dividends and interest payable, or accrued liabilities such as accrued taxes.

But one of the measures shortcomings is that current assets often cannot be liquidated
in the short term. High working capital positions often indicate that there is too much
money tied up in accounts receivable or inventory, rather than short-term liquidity. In
those cases, it is best to work to collect payments from your customers and sell down
inventory to increase your working capital.

PART C -15 MARKS

12. Define working capital? what are the factors determining working capital
requirements?
1. Sales:
Among the various factors, size of the sales is one of the important factors in
determining the amount of working capital. In order to increase sales volume, the
enterprise needs to maintain its current assets. In the course of period, the enterprise
becomes in the position to keep a steady ratio of its current assets to annual sales. As a
result, the turnover ratio, i.e., current assets to turnover increases reducing the length of
operating cycle. Thus, less the operating cycle period, less will be requirements for
working capital and vice versa.

2. Length of Operating Cycle:

Conversion of cash through various stages viz., raw material, semi-processed goods,
finished goods, sales, debtors and bills receivables into cash takes a certain period of
time that is known as ‘length of operating cycle’. Longer the operating cycle time, the
more is the working capital required.

For example, heavy engineering needs relatively more working capital than a rice mill or
cotton spinning mill or a steel rolling mill. Thus, it follows that depending upon the
length of working cycle, the requirement for working capital varies from enterprise to
enterprise.

3. Nature of Business:
The requirement of working capital also varies among the enterprises depending upon
the nature of the business. For instance, trading companies require more working
capital than manufacturing companies. This is because that the trading business
requires large quantities of goods to be held in stock and also carry large amounts of
working capital than manufacturing concerns.

In both these types of businesses, the value of current assets is 80% to 90% of the value
of total assets. The investment in current assets is relatively smaller in the case of
hotels and restaurants because they mostly have cash sales, and only small amounts of
debtors’ balances.

4. Terms of Credit:
Another important factor that determines the amount of working capital requirements
relates to the terms of credit allowed to the customers. For instance, an enterprise may
allow only 15 days credit, while another may allow 90 days credit to its customers.
Besides, an enterprise may extend credit facilities to its all customers, while another
enterprise in the same business may extend credit only to select and those too reliable
customers only

Then, the requirements for working capital will naturally be more if the credit period is
longer and credit facilities are extended to all customers, no matter reliable or non-
reliable they are. This is because there will be longer balance of debtors and that too for
a relatively longer period which will obviously demand for more capital.

On the contrary, if supplies of raw materials are available on favourable conditions or

terms of credit i.e., the payment will be made after a relatively longer period of time, the
requirement for working capital will be correspondingly smaller.

5. Seasonal Variations:
The seasonal enterprises, i.e., the enterprise whose operations pick up seasonally may
require more working capital to meet their increased operations during the particular
season. A popular example of seasonal enterprise may be sugar factory whose
operations are highly seasonal.

6. Turnover of Inventories
If inventories are large in size but turnover is slow, the small-scale enterprise will need
more working capital. On the contrary, if inventories are small but their turnover is quick,
the enterprise will need a small amount of working capital.

7. Nature of Production Technology:

In case of labour intensive technology, the unit will need more amount to pay the wages
and, therefore, will require more working capital. On the other hand, if the production
technology is capital- intensive, the enterprise will have to make less payment for
expenses like wages. As a result, enterprise will require less working capital.

8. Contingencies:
If the demand for and price of the products of small- scale enterprises are subject to
wide variations or fluctuations, the contingency provisions will have to be made for
meeting the fluctuations. This will obviously increase the requirements for working
capital of the small enterprises. While one can add certain other factors to this list, the
said factors appear to be the major ones in determining the requirement of working
capital of a small-scale enterprise

13.percentage sales method

RS RS

Share capital 400 Fixed Asset 400

Reserve & surplus 200 Inventories 300

Debenture 100 Receivable 200

S.cr 200 Cash 100

Bills payable 100

1000 1000

The turnover of the company for 2016-17 was Rs 1000lakhs.it is anticipates a sales
turnover Rs 1500lakhs in 2017-18.estimate thwe working capital requirement for 2017-
18

ANS;

% current asset & 2016-17 2017-18

C.liablity

SALES 100 1000 1500

Current asst

30 300 450
Inventories
20 200 300

10 100 150
Receivable
cash

total 60 600 900

C.liability

S.CR 20 200
300
Bills payable 10 100
150
Total 30 300
450

Working capital =60-30=30, 600-300=300, 900-450=450

 MODULE 5
PART A -2 MARKS
1. What is dividend?
A dividend is a distribution of profits by a corporation to its shareholders. When a
corporation earns a profit or surplus, it is able to pay a proportion of the profit as
a dividend to shareholders. Any amount not distributed is taken to be re-invested in the
business (called retained earnings).

2. What is Dividend policy?

A dividend policy is the policy a company uses to structure its dividend payout to
shareholders. Some researchers suggest the dividend policy is irrelevant, in theory,
because investors can sell a portion of their shares or portfolio if they need funds.
3. What is stock dividend?
A stock dividend is a dividend payment to shareholders that is made in shares rather
than as cash. ... For example, a company might issue a stock dividend of 5%, which will
require it to issue 0.05 shares for every share owned by existing shareholders, so the
owner of 100 shares would receive 5 additional shares

4. What is scrip dividend?

A scrip dividend is new shares of an issuer's stock that are issued to shareholders
instead of a dividend. Scrip dividends may be used when issuers have too little cash
available to issue a cash dividend, but still want to pay their shareholders in some
manner

5. What is stock split?

A stock split is a decision by a company's board of directors to increase the number
of shares that are outstanding by issuing more shares to current shareholders. For
example, in a 2-for-1 stock split, an additional share is given for each share held by a
shareholder

6 What is.Reverse split?

In finance, a reverse stock split or reverse split is a process by which shares of
corporate stock are effectively merged to form a smaller number of proportionally more
valuable shares. A reverse stock split is also called a stock merge.

7. What is Bones issue?

Bonus Shares are shares distributed by a company to its current shareholders as fully
paid shares free of charge. to capitalise a part of the company's retained earnings for
conversion of its share premium account, or distribution of treasury shares. An issue of
bonus shares is referred to as a bonus share issue?

8. What is optimum dividend policy?

The optimal dividend policy is simple: only distribute dividends when cash holdings
exceed threshold, which depends on the state of the economy. This is done exactly as
in the deterministic interest rate case. Namely, if the initial cash holdings exceed , then
an initial dividend of x − x ( i ) is distributed.

9. What is Dividend payout ratio?

The dividend payout ratio is the fraction of net income a firm pays to its stockholders in
dividends: The part of earnings not paid to investors is left for investment to provide for
future earnings growth.

PART B -5 MARKS
10. What are the Various sources of bonus issue?

Source of bonus shares

The bonus shares can be issued out of profit or reserve which have been earned by the
company profit or reserve should be free for the purpose of dividend and as specified in
company act . The reserves cannot be used for issue of bonus which are not earned by
company .

The following is the list of reserves which can be used for issuing bonus shares by
passing the journal entries under its accounting treatment .

● Profit and loss account

● general reserve
● revenue reserve
● free reserves
● dividend equalization fund
● capital reserve
● sinking fund
● debenture redemption reserve only after redemption
● development rebate reserve
● allowance after expiry of 8 years
● capital redemption reserve
● share premium or security premium if received in cash

11.Types of Dividend Policy:

The various types of dividend policies are discussed as follows:
(a) Regular Dividend Policy:
Payment of dividend at the usual rate is termed as regular dividend. The investors such
as retired persons, widows and other economically weaker persons prefer to get regular
dividends.

A regular dividend policy offers the following advantages:

(a) It establishes a profitable record of the company.

(b) It creates confidence amongst the shareholders.

(c) It aids in long-term financing and renders financing easier.

(d) It stabilises the market value of shares.

(e) The ordinary shareholders view dividends as a source of funds to meet their day-to-
day living expenses.

(f) If profits are not distributed regularly and are retained, the shareholders may have to
pay a higher rate of tax in the year when accumulated profits are distribute

However, it must be remembered that regular dividends can be maintained only by

companies of long standing and stable earnings, A company should establish the
regular dividend at a lower rate as compared to the average earnings of the company.

(b) Stable Dividend Policy:

The term ‘stability of dividends’ means consistency or lack of variability in the stream of
dividend payments. In more precise terms, it means payment of certain minimum
amount of dividend regularly.

A stable dividend policy may be established in any of the following three forms:
(i) Constant dividend per share:
Some companies follow a policy of paying fixed dividend per share irrespective of the
level of earnings year after year. Such firms, usually, create a ‘Reserve for Dividend
Equalisation’ to enable them pay the fixed dividend even in the year when the earnings
are not sufficient or when there are losses.

A policy of constant dividend per share is most suitable to concerns whose earnings are
expected to remain stable over a number of years.

(ii) Constant payout ratio:

Constant pay-out ratio means payment of a fixed percentage of net earnings as
dividends every year. The amount of dividend in such a policy fluctuates in direct
proportion to the earnings of the company. The policy of constant pay-out is preferred
by the firms because it is related to their ability to pay dividends.

(iii) Stable rupee dividend plus extra dividend:

Some companies follow a policy of paying constant low dividend per share plus an extra
dividend in the years of high profits. Such a policy is most suitable to the firm having
fluctuating earnings from year to year.

13. Explain SEBI guidelines for bonus issue?

The shares so reserved may be issued at the time of conversion(s) of such debentures
on the same terms on which the bonus issues were made.
1 .The bonus issue shall be made out of free reserves built out of the genuine profits or
share premium collected in cash only.
2 Reserves created by revaluation of fixed assets are not capitalised.
.3 The declaration of bonus issue, in lieu of dividend, is not made.
.4 The bonus issue is not made unless the partly-paid shares, if any existing, are made
fully paid-up.
5 The Company -
(a) has not defaulted in payment of interest or principal in respect of fixed deposits and
interest on existing debentures or principal on redemption thereof and
(b) has sufficient reason to believe that it has not defaulted in respect of the payment of
statutory dues of the employees such as contribution to provident fund, gratuity, bonus
etc.
6 A company which announces its bonus issue after the approval of the Board of
Directors must implement the proposal within a period of six months from the date of
such approval and shall not have the option of changing the decision.
7 (i) The Articles of Association of the company shall contain a provision for
capitalisation of reserves, etc.
(ii) If there is no such provision in the Articles the company shall pass a Resolution at its
general body meeting making provisions in the Articles of Associations for
capitalisation.
8 Consequent to the issue of Bonus shares if the subscribed and paid-up capital
exceeds the authorised share capital, a Resolution shall be passed by the company at
its general body meeting for increasing the authorised Capital.
PART C -15 MARKS
14,Determinants of dividend policy?

Some of the most important determinants of dividend policy are: (i) Type of Industry (ii)
Age of Corporation (iii) Extent of share distribution (iv) Need for additional Capital (v)
Business Cycles (vi) Changes in Government Policies (vii) Trends of profits (vii) Trends
of profits (viii) Taxation policy (ix) Future Requirements and (x) Cash Balance.

The declaration of dividends involves some legal as well as financial considerations.

From the point of legal considerations, the basic rule is that dividend can only be paid
out profits without the impairment of capital in any way. But the various financial
considerations present a difficult situation to the management for coming to a decision
regarding dividend distribution

These considerations are discussed below:

(i) Type of Industry:

Industries that are characterised by stability of earnings may formulate a more
consistent policy as to dividends than those having an uneven flow of income. For
example, public utilities concerns are in a much better position to adopt a relatively
fixed dividend rate than the industrial concerns.

(ii) Age of Corporation:

Newly established enterprises require most of their earning for plant improvement and
expansion, while old companies which have attained a longer earning experience, can
formulate clear cut dividend policies and may even be liberal in the distribution of
dividends.

(iii) Extent of share distribution:

A closely held company is likely to get consent of the shareholders for the suspension
of dividends or for following a conservative dividend policy. But a company with a large
number of shareholders widely scattered would face a great difficulty in securing such
assent. Reduction in dividends can be affected but not without the co-operation of
shareholders.

(iv) Need for additional Capital:

The extent to which the profits are ploughed back into the business has got a
considerable influence on the dividend policy. The income may be conserved for
meeting the increased requirements of working capital or future expansion.

(v) Business Cycles:

During the boom, prudent corporate management creates good reserves for facing the
crisis which follows the inflationary period. Higher rates of dividend are used as a tool
for marketing the securities in an otherwise depressed market.

(vi) Changes in Government Policies:

Sometimes government limits the rate of dividend declared by companies in a particular
industry or in all spheres of business activity. The Government put temporary
restrictions on payment of dividends by companies in July 1974 by making amendment
in the Indian Companies Act, 1956. The restrictions were removed in 1975.

(vii) Trends of profits:

The past trend of the company’s profit should be thoroughly examined to find out the
average earning position of the company. The average earnings should be subjected to
the trends of general economic conditions. If depression is approaching, only a
conservative dividend policy can be regarded as prudent.

(viii) Taxation policy:

Corporate taxes affect dividends directly and indirectly— directly, in as much as they
reduce the residual profits after tax available for shareholders and indirectly, as the
distribution of dividends beyond a certain limit is itself subject to tax. At present, the
amount of dividend declared is tax free in the hands of shareholders.

(ix) Future Requirements:

Accumulation of profits becomes necessary to provide against contingencies (or
hazards) of the business, to finance future- expansion of the business and to modernise
or replace equipments of the enterprise. The conflicting claims of dividends and
accumulations should be equitably settled by the management.

(x) Cash Balance:

If the working capital of the company is small liberal policy of cash dividend cannot be
adopted. Dividend has to take the form of bonus shares issued to the members in lieu
of cash payment.

The regularity of dividend payment and the stability of its rate are the two main
objectives aimed at by the corporate management. They are accepted as desirable for
the corporation’s credit standing and for the welfare of shareholders.

High earnings may be used to pay extra dividends but such dividend distributions
should be designed as “Extra” and care should be taken to avoid the impression that the
regular dividend is being increased.
A stable dividend policy should not be taken to mean an inflexible or rigid policy. On the
other hand, it entails the payment of a fair rate of return, taking into account the normal
growth of business and the gradual impact of external events.

A stable dividend record makes future financing easier. It not only enhances the credit-
standing of the company but also stabilises market values of the securities outstanding.
The confidence of shareholders in the corporate management is also strengthened.

Legal rules governing payment of dividends:

It is illegal to pay a dividend, if after its payment; the capital would be impaired
(reduced). This requirement might be met if only capital surplus existed. An upward
revaluation of assets, however, would create a capital surplus, but at the same time
might operate as a fraud on creditors and for that reason is illegal.

Basically the dividend laws were intended to protect creditors and therefore prohibit
payment of a dividend if a corporation is insolvent or if the dividend payment will cause
insolvency.

The corporate laws must be taken into consideration by the directors before they
declare a dividend. The company can postpone the distribution of dividend in cash,
which may be conserved for strengthening the financial condition of the company by
declaring stock dividend or bonus shares.

To sum up, the decision with regard to dividend policy rests on the judgement of the
management, since it is not a contractual obligation like interest. The formulation of
dividend policy requires a balanced financial judgement by judiciously weighting the
different factors affecting the policy.

Stock dividend or bonus shares:

A stock dividend is a distribution of additional shares of stock to existing shareholders
on a pro-rata basis i.e. so much stock for each share of stock held. Thus, a 10% stock
dividend would give a holder of ICQ shares, as additional 10 shares, whereas a 250%
stock dividend would give him 250 additional shares. A stock dividend has no
immediate effect upon assets.

It results in a transfer of an amount from the accumulated earnings or surplus account

to the share capital account. In other words, the reserves are capitalised and their
ownership is formally transferred to the shareholders.

The equity of the shareholders in the corporation increases. Stock dividends do not alter
the cash position of the company. They serve to commit the retained earnings to the
business as a part of its fixed capitalisation.

Reasons for declaring a stock dividend:

Two principal reasons which usually actuate the directors to declare a stock dividend
are:
(1) They consider it advisable to reduce the market value of the stock and thereby
facilitate a broader distribution of ownership.

(2) The corporation may have earnings but may find it inadvisable to pay cash dividends.
The declaration of a stock dividend will give the stock holders evidence of the increase
in their investment without interfering with the company’s cash position. If the stock
holders prefer cash to additional stock in the company, they can sell the stock received
as dividend.

Sometimes, a stock dividend is declared to protect the interests of old stock holders
when a company is about to sell a new issue of stock (so that new shareholders should
not share the accumulated surplus).

Limitations of stock dividends:

The bonus shares entail an increase in the capitalisation of the corporation and this can
only be justified by a proportionate increase in the earning capacity of the corporation.
Young companies with uncertain earnings or companies with fluctuating income are
likely to take great risk by distribution stock dividends.

Every stock dividend carries an implied promise that future cash dividends will be
maintained at a steady level because of the permanent capitalisation of reserves.
Unless the corporate management has reasonable grounds of entertaining this hope,
the wisdom of large stock dividend is always subject to grave suspicion.

The existence of legal sanction for distributing the accumulated earnings or reserves
does not warrant the issue of stock dividends from the point of view of sound financial
practice. There should be other conditioning factors also for the issue of stock dividend.