11. Discuss conflict in profit versus wealth maximization objective?
Profit maximization is a short–term objective and cannot be the sole objective of a company. It is at best a limited objective. If profit is given undue importance, a number of problems can arise like the term profit is vague, profit maximization has to be attempted with a realization of risks involved, it does not take into account the time pattern of returns and as an objective it is too narrow.
Whereas, on the other hand, wealth maximization, is a long-term objective and means that the company is using its resources in a good manner. If the share value is to stay high, the company has to reduce its costs and use the resources properly. If the company follows the goal of wealth maximization, it means that the company will promote only those policies that will lead to an efficient allocation of resources.
12. Differentiate between Financial Management and Financial Accounting?
Though financial management and financial accounting are closely related, still they differ in the treatment of funds and also with regards to decision - making.
Treatment of Funds: In accounting, the measurement of funds is based on the accrual principle.
The accrual based accounting data do not reflect fully the financial conditions of the organization. An organization which has earned profit (sales less expenses) may said to be profitable in the accounting sense but it may not be able to meet its current obligations due to shortage of liquidity as a result of say, uncollectible receivables. Whereas, the treatment of funds, in financial management is based on cash flows. The revenues are recognized only when cash is actually received (i.e. cash inflow) and expenses are recognized on actual payment (i.e. cash outflow).
Thus, cash flow based returns help financial managers to avoid insolvency and achieve desired financial goals.
Decision-making: The chief focus of an accountant is to collect data and present the data while the financial manager’s primary responsibility relates to financial planning, controlling and decision- making. Thus, in a way it can be stated that financial management begins where financial accounting ends.
13. Explain the relevance of time value of money in financial decisions?
Time value of money means that worth of a rupee received today is different from the worth of a rupee to be received in future. The preference of money now as compared to future money is known as time preference for money.
A rupee today is more valuable than rupee after a year due to several reasons:
• Risk: there is uncertainty about the receipt of money in future.
• Preference for present consumption
• Most of the persons and companies in general, prefer current consumption over future consumption.
• Inflation: In an inflationary period a rupee today represents a greater real purchasing power than a rupee a year hence.
• Investment opportunities: Most of the persons and companies have a preference for present money because of availabilities of opportunities of investment for earning additional cash flow.
Many financial problems involve cash flow accruing at different points of time for evaluating such cash flow an explicit consideration of time value of money is required.
14. Discuss the composition of Return on Equity (ROE) using the DuPont model ?
Composition of Return on Equity using the DuPont Model:
There are three components in the calculation of return on equity using the traditional DuPont model- the net profit margin, asset turnover, and the equity multiplier. By examining each input individually, the sources of a company's return on equity can be discovered and compared to its competitors.
(a) Net Profit Margin: The net profit margin is simply the after-tax profit a company generates for each rupee of revenue.
Net profit margin = Net Income ÷ Revenue
Net profit margin is a safety cushion; the lower the margin, lesser the room for error.
(b) Asset Turnover: The asset turnover ratio is a measure of how effectively a company converts its assets into sales. It is calculated as follows:
Asset Turnover = Revenue ÷ Assets
The asset turnover ratio tends to be inversely related to the net profit margin; i.e., the higher the net profit margin, the lower the asset turnover.
(c) Equity Multiplier: It is possible for a company with terrible sales and margins to take on excessive debt and artificially increase its return on equity. The equity multiplier, a measure of financial leverage, allows the investor to see what portion of the return on equity is the result of debt. The equity multiplier is calculated as follows:
Equity Multiplier = Assets ÷ Shareholders’ Equity.
Calculation of Return on Equity
To calculate the return on equity using the DuPont model, simply multiply the three components (net profit margin, asset turnover, and equity multiplier.)
Return on Equity = Net profit margin× Asset turnover × Equity multiplier
15. Explain briefly the limitations of financial ratios?
The limitations of financial ratios are listed below:
(a) Diversified product lines: Many businesses operate a large number of divisions in quite different industries. In such cases, ratios calculated on the basis of aggregate data cannot be used for inter-firm comparisons.
(b) Financial data are badly distorted by inflation: Historical cost values may be substantially different from true values. Such distortions of financial data are also carried in the financial ratios.
(c) Seasonal factors may also influence financial data.
(d) To give a good shape to the popularly used financial ratios (like current ratio, debt- equity ratios, etc.): The business may make some year-end adjustments. Such window dressing can change the character of financial ratios which would be different had there been no such change.
(e) Differences in accounting policies and accounting period: It can make the accounting data of two firms non-comparable as also the accounting ratios.
(f) There is no standard set of ratios against which a firm’s ratios can be compared: Sometimes a firm’s ratios are compared with the industry average. But if a firm desires to be above the average, then
industry average becomes a low standard. On the other hand, for a below average firm, industry averages become too high a standard to achieve.
16. What do you understand by Weighted Average Cost of Capital?
Weighted Average Cost of Capital
The composite or overall cost of capital of a firm is the weighted average of the costs of various sources of funds. Weights are taken in proportion of each source of funds in capital structure while making financial decisions. The weighted average cost of capital is calculated by calculating the cost of specific source of fund and multiplying the cost of each source by its proportion in capital structure. Thus, weighted average cost of capital is the weighted average after tax costs of the individual components of firm’s capital structure. That is, the after tax cost of each debt and equity is calculated separately and added together to a single overall cost of capital.
17. Explain in brief the assumptions of Modigliani-Miller Theory?
Assumptions of Modigliani – Miller Theory
(a) Capital markets are perfect. All information is freely available and there is no transaction cost.
(b) All investors are rational.
(c) No existence of corporate taxes.
(d) Firms can be grouped into “Equivalent risk classes” on the basis of their business risk.
18. What is optimum capital structure? Explain.
Optimum Capital Structure: Optimum capital structure deals with the issue of right mix of debt and equity in the long-term capital structure of a firm. According to this, if a company takes on debt, the value of the firm increases up to a certain point. Beyond that value of the firm will start to decrease. If the company is unable to pay the debt within the specified period then it will affect the goodwill of the company in the market. Therefore, company should select its appropriate capital structure with due consideration of all factors.
19. Explain the assumptions of Net Operating Income approach (NOI) theory of capital structure.
Assumptions of Net Operating Income (NOI) Theory of Capital Structure
According to NOI approach, there is no relationship between the cost of capital and value of the firm i.e. the value of the firm is independent of the capital structure of the firm.
Assumptions
(a) The corporate income taxes do not exist.
(b) The market capitalizes the value of the firm as whole. Thus the split between debt and equity is not important.
(c) The increase in proportion of debt in capital structure leads to change in risk perception of the shareholders.
(d) The overall cost of capital (Ko) remains constant for all degrees of debt equity mix.
20. Explain the principles of “Trading on equity”?
Ans.11. The term trading on equity means debts are contracted and loans are raised mainly on the basis of equity capital. Those who provide debt have a limited share in the firm’s earning and hence want to be protected in terms of earnings and values represented by equity capital.
Since fixed charges do not vary with firms earnings before interest and tax, a magnified effect is produced on earning per share. Whether the leverage is favorable, in the sense, increase in earnings per share more proportionately to the increased earnings before interest and tax, depends on the profitability of investment proposal. If the rate of returns on investment exceeds their explicit cost, financial leverage is said to be positive.
More Questions & Answers :-
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Profit maximization is a short–term objective and cannot be the sole objective of a company. It is at best a limited objective. If profit is given undue importance, a number of problems can arise like the term profit is vague, profit maximization has to be attempted with a realization of risks involved, it does not take into account the time pattern of returns and as an objective it is too narrow.
Whereas, on the other hand, wealth maximization, is a long-term objective and means that the company is using its resources in a good manner. If the share value is to stay high, the company has to reduce its costs and use the resources properly. If the company follows the goal of wealth maximization, it means that the company will promote only those policies that will lead to an efficient allocation of resources.
12. Differentiate between Financial Management and Financial Accounting?
Though financial management and financial accounting are closely related, still they differ in the treatment of funds and also with regards to decision - making.
Treatment of Funds: In accounting, the measurement of funds is based on the accrual principle.
The accrual based accounting data do not reflect fully the financial conditions of the organization. An organization which has earned profit (sales less expenses) may said to be profitable in the accounting sense but it may not be able to meet its current obligations due to shortage of liquidity as a result of say, uncollectible receivables. Whereas, the treatment of funds, in financial management is based on cash flows. The revenues are recognized only when cash is actually received (i.e. cash inflow) and expenses are recognized on actual payment (i.e. cash outflow).
Thus, cash flow based returns help financial managers to avoid insolvency and achieve desired financial goals.
Decision-making: The chief focus of an accountant is to collect data and present the data while the financial manager’s primary responsibility relates to financial planning, controlling and decision- making. Thus, in a way it can be stated that financial management begins where financial accounting ends.
13. Explain the relevance of time value of money in financial decisions?
Time value of money means that worth of a rupee received today is different from the worth of a rupee to be received in future. The preference of money now as compared to future money is known as time preference for money.
A rupee today is more valuable than rupee after a year due to several reasons:
• Risk: there is uncertainty about the receipt of money in future.
• Preference for present consumption
• Most of the persons and companies in general, prefer current consumption over future consumption.
• Inflation: In an inflationary period a rupee today represents a greater real purchasing power than a rupee a year hence.
• Investment opportunities: Most of the persons and companies have a preference for present money because of availabilities of opportunities of investment for earning additional cash flow.
Many financial problems involve cash flow accruing at different points of time for evaluating such cash flow an explicit consideration of time value of money is required.
14. Discuss the composition of Return on Equity (ROE) using the DuPont model ?
Composition of Return on Equity using the DuPont Model:
There are three components in the calculation of return on equity using the traditional DuPont model- the net profit margin, asset turnover, and the equity multiplier. By examining each input individually, the sources of a company's return on equity can be discovered and compared to its competitors.
(a) Net Profit Margin: The net profit margin is simply the after-tax profit a company generates for each rupee of revenue.
Net profit margin = Net Income ÷ Revenue
Net profit margin is a safety cushion; the lower the margin, lesser the room for error.
(b) Asset Turnover: The asset turnover ratio is a measure of how effectively a company converts its assets into sales. It is calculated as follows:
Asset Turnover = Revenue ÷ Assets
The asset turnover ratio tends to be inversely related to the net profit margin; i.e., the higher the net profit margin, the lower the asset turnover.
(c) Equity Multiplier: It is possible for a company with terrible sales and margins to take on excessive debt and artificially increase its return on equity. The equity multiplier, a measure of financial leverage, allows the investor to see what portion of the return on equity is the result of debt. The equity multiplier is calculated as follows:
Equity Multiplier = Assets ÷ Shareholders’ Equity.
Calculation of Return on Equity
To calculate the return on equity using the DuPont model, simply multiply the three components (net profit margin, asset turnover, and equity multiplier.)
Return on Equity = Net profit margin× Asset turnover × Equity multiplier
15. Explain briefly the limitations of financial ratios?
The limitations of financial ratios are listed below:
(a) Diversified product lines: Many businesses operate a large number of divisions in quite different industries. In such cases, ratios calculated on the basis of aggregate data cannot be used for inter-firm comparisons.
(b) Financial data are badly distorted by inflation: Historical cost values may be substantially different from true values. Such distortions of financial data are also carried in the financial ratios.
(c) Seasonal factors may also influence financial data.
(d) To give a good shape to the popularly used financial ratios (like current ratio, debt- equity ratios, etc.): The business may make some year-end adjustments. Such window dressing can change the character of financial ratios which would be different had there been no such change.
(e) Differences in accounting policies and accounting period: It can make the accounting data of two firms non-comparable as also the accounting ratios.
(f) There is no standard set of ratios against which a firm’s ratios can be compared: Sometimes a firm’s ratios are compared with the industry average. But if a firm desires to be above the average, then
industry average becomes a low standard. On the other hand, for a below average firm, industry averages become too high a standard to achieve.
16. What do you understand by Weighted Average Cost of Capital?
Weighted Average Cost of Capital
The composite or overall cost of capital of a firm is the weighted average of the costs of various sources of funds. Weights are taken in proportion of each source of funds in capital structure while making financial decisions. The weighted average cost of capital is calculated by calculating the cost of specific source of fund and multiplying the cost of each source by its proportion in capital structure. Thus, weighted average cost of capital is the weighted average after tax costs of the individual components of firm’s capital structure. That is, the after tax cost of each debt and equity is calculated separately and added together to a single overall cost of capital.
17. Explain in brief the assumptions of Modigliani-Miller Theory?
Assumptions of Modigliani – Miller Theory
(a) Capital markets are perfect. All information is freely available and there is no transaction cost.
(b) All investors are rational.
(c) No existence of corporate taxes.
(d) Firms can be grouped into “Equivalent risk classes” on the basis of their business risk.
18. What is optimum capital structure? Explain.
Optimum Capital Structure: Optimum capital structure deals with the issue of right mix of debt and equity in the long-term capital structure of a firm. According to this, if a company takes on debt, the value of the firm increases up to a certain point. Beyond that value of the firm will start to decrease. If the company is unable to pay the debt within the specified period then it will affect the goodwill of the company in the market. Therefore, company should select its appropriate capital structure with due consideration of all factors.
19. Explain the assumptions of Net Operating Income approach (NOI) theory of capital structure.
Assumptions of Net Operating Income (NOI) Theory of Capital Structure
According to NOI approach, there is no relationship between the cost of capital and value of the firm i.e. the value of the firm is independent of the capital structure of the firm.
Assumptions
(a) The corporate income taxes do not exist.
(b) The market capitalizes the value of the firm as whole. Thus the split between debt and equity is not important.
(c) The increase in proportion of debt in capital structure leads to change in risk perception of the shareholders.
(d) The overall cost of capital (Ko) remains constant for all degrees of debt equity mix.
20. Explain the principles of “Trading on equity”?
Ans.11. The term trading on equity means debts are contracted and loans are raised mainly on the basis of equity capital. Those who provide debt have a limited share in the firm’s earning and hence want to be protected in terms of earnings and values represented by equity capital.
Since fixed charges do not vary with firms earnings before interest and tax, a magnified effect is produced on earning per share. Whether the leverage is favorable, in the sense, increase in earnings per share more proportionately to the increased earnings before interest and tax, depends on the profitability of investment proposal. If the rate of returns on investment exceeds their explicit cost, financial leverage is said to be positive.
More Questions & Answers :-
Part1 Part2 Part3 Part4
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