Commerce Question Bank – 27 Short Questions With Answers on “Financial Management”

1. What do you understand by the cost of capital?

The cost of capital to a company is the rate of return it must earn in order to satisfy the expectation of investors who provide long term funds to the firm. Cost of capital is a concept in financial management linking the investment and financing decisions.

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2. Why is the cost of capital important?

It is important for three reasons:

1. For proper analysis of capital expenditure decisions, which are of prime importance to a firm, an estimate of cost of capital is required. The cost of capital is the discount rate used in NPV calculations and also the financial yardstick against which rate of return is evaluated.

2. Several other decisions like leasing, long ten, financing and working capital policy, require estimates of cost of capital.

3. In order to maximize the value of the firm the costs of all inputs, including capital input, must be minimum and in this context the should be able to measure the cost of capital.

3. Describe some aspects of cost of capital.

A few aspects of cost of capital have been mentioned below:

(a) It is still larger, academic term and the problem of measuring it in operational terms is a recent development. Earlier, the problem was either ignored or bypassed.

(b) Measurement of cost of capital, specifically for equity capital, is very complex subject.

4. Illustrate the concept of average cost of capital with the help of an example?

A firm’s cost of capital is the weighted arithmetic average of the cost of different sources of long term finance used by it. Let us assume a company uses equity costing 16% and debt costing 9%. If the proportions in which debt and equity are used are respectively 40% and 60% the cost capital would work out to:

Cost of capital = Proportion of equity x Cost of equity + Proportion of debt x Cost of debt

= 0.40 x 16% + 0.60 x 9%

= 6.4% + 5.4% = 11.80%

Generalising, if the firm uses different sources of capital then the Average cost of capital would be:

Ka = S Pi Ki

where

Ka = Average cost of capital

Pi = Proportion of the i th sources of finance

Ki = Cost of the i th source of finance.

5. What is cost of debt capital?

The cost of debentures and long term loans is the contractual interest rate adjusted for the tax liability of the company or put simply,

K = (1 – T) R

where, K = Cost of debt capital

T = Tax rate

R = Contractual interest rate

As interest is tax deductible, it is customary to compute the cost of borrowed funds as an after effective rate of tax

6. Write an important condition for the adjustment of the cost of debt.

One can adjust the cost of debt only if the EBIT (Earning Before Interest and Taxes) is equal to or more than the interest rate. If, on the other hand, EBIT is less than the interest rate then the actual interest payable becomes the cost of capital effectively.

7. Illustrate the method of computing cost of preference shares with the help of an example.

The method of computing cost of preference shares is similar to that of debentures. If 11 % preference share is sold at Rs. 100 par value, and the issue expenses incurred by the company amount to Rs. 2 per share then the cost of preference capital would be:

Preference Dividend/ Net Price of Preference shares = D/P

11/100-2 = 11/98 = 11.22%

8. What is the importance of cost of equity capital?

Determining the cost of equity capital enables the corporate management to make decision in the best interests of the equity share holders. In theory, management strives to maximize the returns to the equity share holders and these effort involves many decisions in respect of capital expenditures and financing.

9. What does the cost of equity capital indicate?

The cost of equity capital indicates the minimum rate which must be earned on the projects, before their acceptance and the raising of equity capital to finance them, i.e. it should lead to an increase in the net present value of their wealth.

10. What is meant by ‘to establish the cost of equity capital’?

To establish the cost equity capital is to ascertain what rate of return an investor expects to receive when he puts his money into an equity investment. There is an opportunity cost of investment, in one company or another, and unless the rate offered by the company is comparable to others, the company shall not attract future investment.

11. How many approaches are there for estimating cost of equity?

There are four different approaches for estimating cost of equity:

1. Dividend price ratio

2. Earnings price ratio

3. Dividend price + growth rate of earnings

4. Realised yield approach

12. Describe the correct capital structure of a firm for obtaining the weights to work out the weighted average.

The correct capital structure for obtaining the weights to work out the weighted average, theoretically it is the optimal capital structure of the company. An optimal structure should take into account the following factors:

1. Accounting for the effect of risk

2. Leverage

3. Management control

However, in practice one can never achieve the optimal capital structure, as it can be seldom determined precisely. As a result, what is really sought is a capital structure that can permit the computation of the cost of capital that is not too far from the optimum rate/value.

13. What points should be taken into consideration in order to calculate the cost of capital?

A firm’s cost of capital is the weighted arithmetic average of the cost of various sources of long term finance used by it. Therefore, to calculate the cost of capital we should know (a) the specific cost of each source of capital (b) the proportion of different sources of financing in the capital structure.

14. What is capital budgeting? What steps are involved in the process of capital budgeting?

Evaluation of capital expenditure, which are basically decisions of selecting long term projects proposals for investment, is called budgeting. The process of capital budgeting is quite complex, involving the following:

1. Identifying the potential investment opportunities.

2. Assembling the proposed investments.

3. Making the decision,

4. Capital budget proportion

5. Implementation

6. Performance review.

15. Why are the capital investments important?

Capital investments are important for three reasons:

1. They have long term implications on the company.

2. Capital investment decisions are irreversible. This is owing to the fact that the markets for used capital equipment is not an organized one. Further, the capital equipments ordered and bought may have special tailor made specifications of the customer.

3. Capital investment decisions involve substantial outlays

16. Describe some measures which are relevant for the successful implementation of a project in the process of capital budgeting.

Any delays in implementation can cause cost over-runs. The following points are relevant and should be adopted while implementing a project.

1. For project planning and control one must adopt the Program Evaluation Review Technique or . the Critical Path Method to facilitate monitoring the project on a continuous basis while under implementation.

2. Assigning specific responsibilities to project managers to implement their part of the project within specific time and cost limits is helpful while expediting execution of the project.

17. What is post completion audit in the process of capital budgeting?

Post completion audit is a feedback device. It is a means for comparing the actual performance with the anticipated/planned performance. It should be undertaken once the plant overcomes initial teething problems and stabilizes in operations. Such an audit gives an insight into many aspects.

(a) How realistic were the assumptions at the time the project was taken up for discussion and approval

(b) induces a degree of caution among those who put forth proposals.

18. What is the significance of investment analysis in the capital budgeting process?

The capital budgeting process requires an estimate of future events to be translated into a schedule of cash flows. At a given point of time, a company may be having a number of alternative investment proposals and obviously the objective of the capital budgeting analysis is to obtain an indication of the value each might contribute to the company.

Before applying any method to evaluate the relative acceptability of a project it is necessary to analyse to components which affect cash flows related to the projects over the life of the project. The basic components of investment analysis are: 1 Amount of net capital investment, 2. Operating cash flows, 3. Choice of a horizon.

19. Describe net capital investment as a component of investment analysis

Net capital investment represents the amounts of funds committed to a project. It may include not only the cost of land, building, plant and machinery but also the increase in working capital required to support larger operations.

If a project results in the replacement of an existing capital asset, which has not been fully depreciated, there is a tendency to include the remaining value of the old asset in the amount of the investment.

However, the book value of the replaced asset should be of no consequence to the investment analysis of the new proposal as it pertains to an earlier investment proposal and should be accounted in that proposal. The only relevant factor to be considered is the salvage value of the old asset, which can be reduced from the investment required for the new project.

20. What are initial cash flows?

Initial flows represent the cash outflows associated with investment in various project components These can be: Outlays on plant, machinery, and other fixed assets, tax shields relating to above investments plus outlays on new working capital.

21. What do you understand by operational cash flows?

Operational flows are cash inflows expected during the operational phase of the project. The operational inflow for a particular year is equal to:

Profit after tax + Depreciation and any other non cash changes

22. Define terminal cash flows.

Cash flows expected from the disposal of assets when the project is terminated are referred to as terminal flows. Terminal flows are defined as:

Post tax salvage value of fixed assets + Post tax salvage value of working capital

23. Write the formula for determining payback period of a cash flow project.

Payback period represents the length of time required for the stream of cash proceeds generated by the investment, to be equal to the original investment. In other words this is the time required for the project to pay itself. The formula is

Payback period = Original investment/Annual cash flow

24. What is the relation between the pay back period and the quality of project?

According to the payback criteria the shorter the pay back period the more desirable the project. Firms using this method specify the maximum payback period acceptable. If the specified payback is n years then projects with payback of n years or less than n years are accepted.

25. What are the merits of payback period method?

Payback method has the following merits:

1. It is very simple—both in concept and application. It has no dubious assumptions nor any cumbersome calculations.

2. It favours projects which generate substantial cash flows in the initial years and discriminates against projects which bring substantial cash flows in the later years. Thus the payback method can be used to weed out risky propositions

3. As it emphasizes faster/earlier cash flows it is desirable for a company with a liquidity crunch.

26. What are the demerits of the payback period?

1. It fails to take into account the time value of money. Cash inflows are added without any discounting. This violates the most basic principle of financial accounting which stipulates cash flows accruing at different points of time can be added or subtracted after suitable discounting/compounding.

2. It does not take into account the cash flows after the payback period This leads to discrimination against projects which generate cash flows in later years

27. Define average rate of return.

The average rate of return, also called the accounting rate of return, is defined as

Average rate of return = Profit after tax/Book value of fixed assets

In the ratio, the numerator is the annual average post tax profit over the life of the investment and the denominator, the average book value of the fixed assets committed to the project.

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