Q1.

Scope /approaches of financial management

Ans Financial Management broadly refers to the efficient and effective management of money (funds)
in such a manner as to accomplish the objectives of the organization. The scope defines the areas or
activities covered under financial management. The main areas included in the scope are:
Financial Planning and Forecasting
• Estimating the capital requirements of the firm.
• Planning how to raise funds and use them efficiently.
• Forecasting future financial needs.
Capital Structure Decision
• Determining the right mix of debt and equity.
• Balancing risk and return.
• Deciding the optimal leverage.
Investment Decisions (Capital Budgeting)
• Evaluating and selecting profitable investment projects.
• Assessing risk and return for each investment.
• Long-term decision making.
Financing Decisions
• Raising funds from different sources.
• Choosing between short-term and long-term sources.
• Cost of capital considerations.
Dividend Decisions
• Deciding the amount of profits to distribute as dividends.
• Retained earnings management.
• Balancing between rewarding shareholders and reinvesting in the business.
Approaches of Financial Management
Financial management can be understood and practiced through different approaches, mainly based
on the firm’s objective and perspective:
Traditional Approach
• Focus on procurement of funds at minimum cost.
• Emphasis on safeguarding funds and ensuring liquidity.
• Concerned mostly with financing decisions.
• Profit maximization was considered important, but the primary goal was to avoid financial
distress.
• Short-term orientation.
Modern Approach
• Financial management as a broader concept encompassing investment, financing, and dividend
decisions.
• Objective is to maximize shareholder wealth or maximize the market value of the firm’s shares.
• Emphasis on profit maximization with risk consideration.
• Long-term perspective on financial planning.
• Integration of financial management with overall business strategy.
Profit Maximization Approach
• Focus on maximizing profits.
• Ignores risk and timing of returns.
• It is a simple and traditional concept but inadequate as it ignores wealth maximization.
Wealth Maximization Approach (Value Maximization)
• Maximizing the net present value of the firm.
• Considers risk and time value of money.
• Reflects the goal of financial management in contemporary businesses.
Q2 Role of finance manager
• Ans Financial Planning – Plans short-term and long-term financial needs of the organization.
• Raising Funds – Arranges funds through equity, debt, or other financial instruments.
• Investment Decisions – Allocates capital in profitable projects (also called capital budgeting).
• Dividend Decisions – Decides how much profit to distribute as dividends and how much to retain.
• Working Capital Management – Manages day-to-day finances like cash, inventory, receivables, and
payables.
• Cost Control and Profit Maximization – Controls costs to maximize profits efficiently.
• Financial Reporting and Analysis – Prepares financial reports and analyzes performance.
• Risk Management – Identifies and manages financial risks using tools like insurance or hedging.

Q2 Objectives of financial management

Ans Objectives of Financial Management
• Profit Maximization - Maximize short-term profits.
• Wealth Maximization -Maximize shareholders’ wealth by increasing share value, considering risk
and time.
• Liquidity Management - Maintain enough cash to meet short-term needs.
• Risk Management - Minimize financial risks.
• Efficient Use of Funds - Use financial resources optimally to avoid waste.
• Financial Flexibility - Keep the ability to raise funds easily when needed.

Q3. Diff between Profit Maximization and Wealth Maximization

Ans Profit Maximization:
• Focuses on maximizing current profits.
Wealth Maximization:
• Focuses on maximizing shareholders’
• Short-term perspective.
• Ignores risk.
wealth (share price).
• Long-term perspective.
• Does not consider time value of money.
• Considers risk.
• May ignore cash flow and timing issues.
• Takes time value of money into account.
• More comprehensive and realistic
Q3 what is time value of money (TVM)
Time Value of Money (TVM) is a core concept in
financial management that refers to the idea that a sum of money has greater value now than the
same sum in the future due to its potential earning capacity. This principle recognizes the opportunity
cost of tying up money over time.

Q4. Function of CFO as a treasurer and as a As a Controller

controllerAs a Treasurer • Financial Accounting: Maintain accurate
• Financial Planning: Prepare long-term and financial records and books.
short-term financial plans. • Budgeting: Prepare and control budgets.
• Fund Raising: Arrange funds from various
• Cost Control: Monitor and control costs
sources (equity, debt, etc.).
and expenses.
• Cash Management: Ensure adequate liquidity
• Financial Reporting: Prepare financial
and manage cash flows.
statements and reports for stakeholders.
• Investment Decisions: Decide on investment
• Internal Controls: Implement controls to
of surplus funds.
safeguard assets and prevent fraud.
• Risk Management: Manage financial risks
through hedging, insurance, etc.
Q5. Concept of capital structure. And what is Optimal Capital Structure
optimal capital structure • The optimal capital structure is the best mix of
Ans Concept of Capital Structure debt and equity that minimizes the company’s
• Capital structure refers to the mix of different overall cost of capital and maximizes the
sources of long-term funds used by a company company’s market value.
to finance its operations and growth. • It balances risk and return — too much debt
• It typically includes debt (loans, bonds) and increases financial risk, while too much equity
equity (share capital, retained earnings). can be expensive.
• The capital structure determines how a • The goal is to achieve the highest possible return
company funds its assets and operations. for shareholders with the least financial risk.

Q6. Factors influencing capital structure

• Ans Business Risk - Higher business risk means less debt to avoid financial distress.
• Financial Risk - The risk associated with debt; higher debt means higher financial risk.
• Cost of Debt and Equity - Cheaper sources of funds are preferred.
• Tax Considerations - Interest on debt is tax-deductible, making debt financing attractive.
• Company’s Growth Rate - High-growth companies may prefer equity to avoid fixed obligations.
• Profitability - Profitable firms can take more debt since they can meet interest payments.
• Asset Structure - Companies with more tangible assets can borrow more as collateral.
• Control Considerations - Issuing new equity may dilute control; firms may prefer debt to retain
control.
• Market Conditions - Market interest rates and investor sentiment affect financing choices.
• Flexibility - Companies prefer capital structures that allow flexibility in future financing.

Q7. Net income (NI) approach

• Ans The Net Income Approach is a theory of capital structure that assumes the firm’s overall cost
of capital (WACC) decreases as more debt is used because debt is cheaper than equity.
• According to this approach, increasing debt in the capital structure increases the firm's value due to
the tax benefits of debt (interest is tax-deductible).
• It assumes that both cost of debt and cost of equity remain constant regardless of the level of debt.
• As debt increases, the weighted average cost of capital (WACC) decreases, which increases the
firm’s value.

Q7. Discounted pay back period

Ans The Discounted Payback Period (DPP) is the time it takes for a project to recover its initial
investment in present value (discounted) terms of cash flows. Unlike the regular payback period, DPP
accounts for the time value of money by discounting future cash flows.

Q7. Wigheted average or composite cost of capital

WACC is the average cost of all sources of capital (equity, debt, preference shares), weighted by their
proportion in the total capital structure. It reflects the overall cost of financing a company’s operations
and investments.
Why WACC is Important:
• Used in Capital Budgeting: Acts as a discount rate in NPV and IRR methods.
• Guides Investment Decisions: A project is accepted only if its return is greater than WACC.
• Affects Company Valuation: Lower WACC increases firm value in DCF models.
• Used for Optimal Capital Structure: Helps in balancing debt and equity to achieve lowest possible
cost
Q8. Net operating income (NOI) approach and its assumptions
• Ans The NOI Approach suggests that a firm’s value and overall cost of capital (WACC) remain
constant, regardless of its capital structure.
• It assumes that increasing debt increases financial risk, which leads to an increase in the cost of
equity, thus offsetting the benefit of cheaper debt.
• Therefore, changing the debt-equity mix has no effect on the firm’s value.
Key Assumptions of NOI Approach
• Overall Cost of Capital (Ko) is Constant
– Ko does not change with changes in capital structure.
• Cost of Debt (Kd) is Less Than Cost of Equity (Ke)
– Debt is cheaper, but using more debt increases equity risk.
• Increase in Debt Increases Ke
– As financial risk increases, shareholders demand higher returns.
• No Taxes
– The model assumes no corporate taxes.
• Operating Income (EBIT) is Constant
– Earnings before interest and taxes do not change.

Q9. MM (Modigliani and miller) approach and assumptions

The Modigliani and Miller (MM) approach is a modern theory of capital structure that states:Under
certain assumptions, the value of a firm is independent of its capital structure This means that it does
not matter whether a firm finances itself with debt or equity — the total value of the firm remains the
same.
There are Two Propositions:
Proposition I (Without Taxes):
• The value of the firm is unaffected by the capital structure.
• V = EBIT / Ko
• Debt or equity mix does not change the total value of the firm.
Proposition II (Without Taxes):
• Cost of equity (Ke) increases linearly with increase in debt.
• As financial leverage increases, so does the risk to equity holders.
With Taxes (Revised MM Theory):
• With corporate taxes, interest on debt is tax-deductible, so debt financing provides a tax shield.
• More debt → higher firm value due to tax savings.
• So, optimal capital structure = 100% debt (in theory).
Assumptions of MM Approach (Without Taxes)
• No Taxes – No corporate or personal taxes.
• No Transaction Costs – No flotation or bankruptcy costs.
• Perfect Capital Market – Information is freely available; investors behave rationally.
• Equal Borrowing Costs – Firms and investors can borrow at the same rate.
• EBIT is Constant – The firm’s operating income doesn’t change.
• No Risk of Bankruptcy – Debt does not lead to financial distress.

Q10 Arbitrage process

Ans The arbitrage process refers to the method by which investors exploit price differences between
similar firms with different capital structures to earn risk-free profits, thereby bringing the value of
firms in line with MM’s proposition that capital structure is irrelevant (in a perfect market).
How It Works:
• Two firms with same earnings (EBIT) but different capital structures are valued differently.
• Investors identify the overvalued firm (usually more debt-heavy) and sell its shares.
• They then buy shares of the undervalued firm (less debt or all-equity) and replicate the same
returns through personal leverage.
• This buying and selling continues until both firms are valued equally, restoring equilibrium.

Q11 MM hypothesis with corporate taxation

Ans According to Modigliani and Miller, when corporate taxes are considered, the value of a firm
increases with more debt because interest payments are tax-deductible. This creates a tax shield,
reducing tax liability and increasing firm value. The formula is VL = VU + (Tax Rate × Debt). Hence, in
theory, the more debt a firm uses, the higher its value. However, this ignores bankruptcy risk, which
limits debt in practice.

Q12 Criticism of MM theory

• Ans Unrealistic Assumptions • Constant EBIT
– Assumes perfect capital markets, which – Assumes earnings before interest and tax
don’t exist in reality. remain constant, which is impractical.
• Ignores Taxes (Original Model) • Equal Borrowing Rates
– The original MM theory ignored corporate – Assumes investors and firms can borrow at
and personal taxes. the same interest rate, which is not true.
• No Bankruptcy Risk • No Transaction Costs
– Assumes firms can borrow unlimited debt – Ignores flotation, legal, and administrative
without risk of bankruptcy. costs of financing.

Q13 Defination of leverage and financial leverage and operating leverage

Ans Leverage
Leverage refers to the use of fixed costs (either operating or financial) to increase the potential returns
to shareholders. It helps in magnifying profits (or losses) based on changes in sales or financing.
Financial Leverage
Financial leverage refers to the use of debt (borrowed funds) in a company’s capital structure. It shows
how sensitive the firm’s earnings per share (EPS) are to changes in operating income (EBIT). Higher
financial leverage means higher potential returns, but also higher risk.
Operating Leverage
Operating leverage refers to the use of fixed operating costs (like rent, salaries, depreciation) in a firm’s
cost structure. It shows how a change in sales leads to a change in operating profit (EBIT). Higher
operating leverage means profits are more sensitive to changes in sales.

Q14 implication and advantages of financial leverage

Ans Implications of Financial Leverage
• Increases Risk: Using debt increases the financial risk because interest payments are fixed and
must be paid regardless of profit levels.
• Magnifies Profits and Losses: Financial leverage amplifies the effect of changes in EBIT on EPS,
leading to higher profits in good times and larger losses in bad times.
• Impact on Cost of Capital: Moderate leverage can lower the overall cost of capital, but excessive
debt increases risk and cost.
Advantages of Financial Leverage
• Tax Benefits: Interest on debt is tax-deductible, reducing taxable income and increasing firm
value.
• Increases EPS: If the firm earns more on borrowed funds than the cost of debt, EPS increases.
• Retain Ownership Control: Debt financing does not dilute ownership, unlike issuing new equity.
• Access to Additional Funds: Enables firms to raise capital without selling shares.
Q15 diff between operating leverage and financial leverage
Operating Leverage
• Involves fixed operating costs like rent, salaries, and depreciation.
• Measures how a change in sales affects operating profit (EBIT).
• Related to business risk because fixed operating costs must be paid regardless of sales.
• Shows how sensitive the firm’s operating income is to changes in sales volume.
• Higher operating leverage means greater fluctuations in EBIT with sales changes.
• Does not involve borrowing or financial expenses.
Financial Leverage
• Involves fixed financial costs such as interest on debt.
• Measures how a change in EBIT affects earnings per share (EPS).
• Related to financial risk because interest payments must be made regardless of profits.
• Shows how sensitive shareholders’ earnings are to changes in operating income.
• Higher financial leverage means greater fluctuations in EPS with changes in EBIT.
• Involves borrowing and use of debt in the capital structure.

Q16. Combined / composite leverage

Ans Combined leverage refers to the total impact of both operating leverage and financial leverage
on a firm's earnings per share (EPS) due to a change in sales.
It shows how a change in sales affects the firm’s EPS, by considering both fixed operating costs and
fixed financial costs. Formula: DCL=Contribution /EBT

Q18 Meaning of agency problem / conflicts

Ans The agency problem arises when there is a conflict of interest between the owners (shareholders)
and the managers (agents) of a company.
Managers are hired to run the company on behalf of shareholders, but they may act in their own
personal interest (like higher salary, perks, or less effort) instead of maximizing shareholder wealth.
This misalignment creates the agency conflict.
Examples of Agency Problems:
• Managers investing in unprofitable projects for personal benefit.
• Avoiding risky but profitable ventures to protect their position.
• Misusing company resources (e.g., luxury travel or office perks).

Q19. What is Agency cost

Ans Agency cost is the cost incurred due to conflicts of interest between the owners (shareholders)
and the managers (agents) of a company.
These costs arise when managers do not act in the best interest of shareholders and resources are
used inefficiently
Direct Agency Costs:
These are measurable and identifiable costs that a firm incurs to monitor and control managerial
behavior or due to managerial misuse of resources.
Indirect Agency Costs:
These are opportunity costs or losses in value that occur when managers avoid risky but profitable
decisions to protect their own interests.

Q20 Resolving The Agency Problem

Ans 1. Incentive-Based Compensation
• Offer performance-linked rewards like bonuses, profit sharing, or stock options.
• Aligns managers’ interests with shareholder wealth maximization.
2. Strong Corporate Governance
 • Establish an independent board of directors to monitor management.
• Ensures accountability and transparency in decision-making.
3. Regular Audits and Reporting
• Conduct internal and external audits.
• Enhances trust through transparency and accurate financial reporting.
4. Threat of Takeover
• Poorly managed firms are at risk of being taken over.
• The fear of losing control motivates managers to act in shareholders' best interests.

Q21 Meaning and definition of Investment Decision / capital Budgeting

Ans. Investment decision, also known as capital budgeting, refers to the process of planning and
managing a firm’s long-term investments. It involves deciding whether to invest in specific projects or
assets that will generate future returns. Capital budgeting is the process of evaluating and selecting
long-term investment projects that are expected to generate returns over a period of time.

Q22. Purpose / Process of capital budgeting

purpose
• Ans Long-Term Investment Planning– Helps decide where to invest funds for long-term growth.
• Maximize Shareholder Wealth – Selects projects that offer the best return, increasing firm value.
• Efficient Resource Allocation – Ensures funds are invested in the most profitable and productive
areas.
• Risk Management– Evaluates risks and returns of different investment options.
• Cost Control – Avoids unprofitable investments and reduces wastage of capital.
• Improves Strategic Decision-Making – Supports informed decisions that align with company goals.
process
• Identification of Investment Opportunities – Find potential long-term investment projects (e.g.,
expansion, equipment, new products).
• Screening and Preliminary Evaluation – Eliminate unsuitable proposals and do a quick feasibility
check.
• Project Evaluation – Analyze costs and benefits using techniques like Payback Period, NPV, IRR, etc.
• Project Selection – Choose the most profitable and strategically aligned projects.
• Capital Budgeting and Approval – Prepare detailed capital budget and get necessary approvals from
top management.
• Implementation – Acquire assets and start the project execution.
• Performance Review and Post-Completion Audit – Compare actual performance with estimates to
evaluate the decision and improve future planning.

Q24. What is payback period method and its advantage

Ans The payback period method is a capital budgeting technique that calculates the time required to
recover the initial investment from the cash inflows generated by a project.
Formula: Payback Period= Initial Investment/ Annual Cash Inflow
Advantages of Payback Period Method
• Simple and Easy to Understand – Requires basic calculations and is straightforward to apply.
• Focus on Liquidity – Helps in assessing how quickly invested money can be recovered.
• Useful for Risk Assessment
– Shorter payback periods imply less risk, especially in uncertain environments.
• Helpful for Small Businesses
– Ideal for firms with limited resources that need quick returns.

Q25 what is ARR method

The ARR method is a capital budgeting technique that measures the average accounting profit
expected from an investment as a percentage of the initial or average investment.
It focuses on the profitability of a project based on accounting data rather than cash flows.
ARR=( Average Annual Profit / Initial or Average Investment )×100

Q26. NPV as investment decision criteria and it advantages / disadvantage

Ans. Net Present Value (NPV) is a capital budgeting method that calculates the difference between the
present value of cash inflows and outflows of a project using a discount rate (usually the cost of
capital).
Why NPV is Preferred:
• Considers time value of money.
• Accounts for all cash flows during the project’s life.
• Aligns with the goal of maximizing shareholder wealth.
• Provides a direct measure of the increase in firm value.
Advantages of NPV
• Considers Time Value of Money – Discounts future cash flows to their present value.
• Considers All Cash Flows – Takes into account every cash inflow and outflow during the project’s
life.
• Objective Decision Criterion – Provides a clear accept/reject rule based on value addition.
• Aligns with Wealth Maximization – Focuses on maximizing shareholders’ wealth.
• Accounts for Risk through Discount Rate – Riskier projects can use higher discount rates.
Disadvantages of NPV
• Requires Accurate Estimation of Cash Flows – Difficult to predict future cash inflows and outflows
accurately.
• Sensitive to Discount Rate – Small changes in the discount rate can significantly affect the NPV
result.
• Ignores Project Size – May favor smaller projects with high NPV over larger projects with bigger
overall returns.
• Complex Calculations – More complicated compared to simpler methods like payback period,
requiring understanding of present value concepts.
• Doesn’t Reflect Timing of Cash Flows Beyond Discounting – Two projects with same NPV but
different cash flow patterns may have different risk profiles.

Q27. What is IRR

Ans IRR is the discount rate that makes the Net Present Value (NPV) of all cash flows from a project
equal to zero. In other words, it is the rate of return at which the present value of inflows equals the
initial investment. Key Points:
• Represents the expected rate of return from a project.
• Helps compare and rank projects by profitability.
• Used widely in capital budgeting decisions.
Q28. Mutually Exclusive project / decisions
Ans Mutually exclusive projects are investment options where the acceptance of one project excludes
the possibility of accepting the other(s).
In other words, if a company chooses one project, it cannot undertake the other competing projects
due to limited resources or conflicting [Link]:
• A company can either buy Machine A or Machine B to produce the same product, but not both.
• Choosing to expand production in one location excludes expanding in another location.
Implication in Decision Making:
• The project with the highest Net Present Value (NPV) or better profitability measure is usually
selected.
• Requires careful analysis to choose the most beneficial option.

Q29. Profitability index (PI) method

Ans. Profitability Index (PI), also called the Benefit-Cost Ratio, is a capital budgeting technique that
measures the ratio of the present value of future cash inflows to the initial investment.
Advantages:
• Considers time value of money.
• Useful when capital is limited (helps in ranking projects).
• Simple to calculate and interpret.

Q30. Meaning and types of capital rationing

Ans Capital rationing occurs when a company has limited funds available for investment and must
prioritize and select among various projects to invest in.
It involves restricting capital expenditures despite the availability of profitable projects, usually due to
budget limits or financial constraints.
Types of Capital Rationing
Hard Capital Rationing
• Imposed by external factors like lack of funds, borrowing limits, or market conditions.
• The company physically cannot raise more capital.
Soft Capital Rationing
• Imposed internally by management due to policies or strategic decisions.
• For example, limiting investment to control risk or maintain credit rating

Q31. Definition of cash flow / component/difficulties determining cash flow

Definition of Cash Flow
Cash flow refers to the movement of cash in and out of a business during a specific period. It shows the
actual cash generated or used by the company.
Components of Cash Flow
• Operating Cash Flow (OCF)
– Cash generated from the core business operations.
• Investing Cash Flow
– Cash used for or received from buying/selling long-term assets like equipment or investments.
• Financing Cash Flow
– Cash inflows or outflows from borrowing, repaying debt, issuing shares, or paying dividends.
Difficulties in Determining Cash Flow
• Estimating Future Cash Inflows and Outflows can be uncertain.
 • Non-cash expenses (like depreciation) complicate profit-to-cash adjustments.
• Timing differences between revenue recognition and actual cash receipt.
• Inflation and changing economic conditions affect cash flow projections.
• Allocation of shared costs in multi-product firms.

Q32. Company and project cost of capital

Company Cost of Capital
• This is the average cost a company pays to use money from both debt (like loans) and equity (like
shares). Think of it like the overall interest rate a company pays for using other people’s money.
It shows how much return the company needs to earn to keep investors and lenders happy.
• Example: If a company uses 50% debt at 5% interest and 50% equity at 10% return, the cost of
capital is around 7.5%.
Project Cost of Capital:
• This is the rate of return a specific project must earn to be worth investing [Link], we use the
company’s cost of capital as a starting [Link] if the project is riskier or safer than the company’s
usual business, we adjust the rate.
• Example: If a company is trying a new risky product, it might use a higher rate (like 12%) to decide
if the project is good enough.

Q33. speecific cost vs composite cost

Specific Cost of Capital
• Specific cost is the cost of using only one source of capital
• It is calculated separately for each type of capital.
• It helps in choosing the cheapest individual financing option.
• There is no weighting involved in its calculation.
• Example: If debt costs 8%, then the specific cost of debt is 8%.
Composite Cost of Capital
• Composite cost is the average cost of all sources of capital used by a company.
• It is also called Weighted Average Cost of Capital (WACC).
• It helps evaluate the overall cost of capital for investment or project decisions.
• It is calculated using weights, based on the proportion of each capital source.
• Example: If a company uses 60% debt (6%) and 40% equity (12%), the WACC might be around 8.4%

Q34. average cost vs marginal cost

Average cost
• Definition: Average Cost is the total cost divided by the number of units produced.
• Formula: average cost = total cost/ total output
• It shows the cost per unit of output.
• Used for pricing decisions and understanding efficiency over time.
• Example: If total cost is ₹1000 for producing 100 units, then Average Cost = ₹1000 / 100 = ₹10 per
unit
Marginal Cost
• Definition: Marginal Cost is the additional cost of producing one more unit of output.
• Formula: marginal cost= total cost/output
• It shows the extra cost for each additional unit.
• Used in decision-making, such as whether to increase production.
• Example: If producing 101 units costs ₹1015 and 100 units cost ₹1000, then Marginal Cost = ₹1015 -
₹1000 = ₹15.

Q35. implicit cost vs explicit cost

Implicit Cost
• Definition: Implicit cost is the opportunity cost of using resources that the business already owns,
not paid in cash.
• These are hidden costs — they don’t involve actual payment but still represent a loss of potential
income.
• It includes things like the owner’s time, self-owned buildings, or capital used in the business.
• Used mainly in economic profit calculations, not in accounting.
• Example: If a business owner could earn ₹50,000 elsewhere but chooses to work in their own
business for free, ₹50,000 is the implicit cost.
Explicit Cost
• Definition: Explicit cost is the actual cash expense a business pays for resources or services.
• These are visible, recorded costs that appear in the books of accounts.
• Includes rent, salaries, utilities, raw materials, etc.
• Used in both accounting profit and economic profit calculations.
• Example: Paying ₹20,000 as rent and ₹30,000 as salaries are explicit costs

Q36 .Significance of cost of capital

• Capital Budgeting Decisions: 'Cost of Capital' may be considered as one of the most important basis
on which capital budgeting is done. It is used as a rate for discounting cash inflows to assess the
profitability of a project.
• Capital Structure Decisions: The objective of minimising cost of capital need to be kept in mind
while planning an appropriate capital structure of a company. This would ensure a better market
value of the company.
• 3)Evaluating Profitability: Profitability of a project depends upon the projected cost of the capital
funds and the actual cost of the capital fund raised to finance the project. The performance of a
project may be considered satisfactory, if the profitability of the project is more than the projected
and actual cost of capital.
• Other Decisions: Decisions with regard to the level of dividend distribution, working capital
requirements, etc. are directly affected by the cost of capital. Moreover, the profitability of a
project depends upon the cost of capital.

Q37. Measuring cost of preference capital

Ans Preference shareholders are entitled to have a fixed rate of dividend. Although there is no statutory
compulsion regarding the payment of dividends to the preference shareholders, in case a company
decides to pay dividend to its shareholders, then preference shareholders would be given priority over
other shareholders. Non-payment of dividend to its preference shareholders impacts negatively on the
company's reputation and its capacity to mobilise funds at an appropriate rate. Further, dividend
expected by preference shareholders has a direct relationship with the cost of preference capital.
Q38. what is Sensitivity analysis
sensitivity analysis is a technique used in decision-making and financial modeling to test how changes
in one or more input variables affect the outcome (like NPV, IRR, or profit). It shows how sensitive a
result is to changes in assumptions.
Steps of Sensitivity Analysis
• Identify the Objective: Decide what output you want to analyze (e.g., NPV, profit).
• Identify Key Variables: Select the input variables that affect the result — like sales volume, cost,
price, discount rate.
• Set Base Case Values: Use the most likely (expected) values for all inputs.
• Change One Variable at a Time:
Increase or decrease one input while keeping others constant.
• Record and Analyze Impact: Note how changes affect the outcome. This shows which variables
have the most impact (high sensitivity).
• Repeat for Other Variables: Test all key variables one by one.
Advantages of Sensitivity Analysis
• Identifies Critical Variables: Shows which inputs have the greatest effect on results.
• Improves Decision-Making: Helps managers prepare for risks and uncertainty.
• Simple and Easy to Use: Requires basic calculations and is easy to understand.
• Supports Strategic Planning: Assists in evaluating best case and worst-case scenarios.
• Enhances Risk Management: Allows businesses to test assumptions before committing resources.
Disadvantages of Sensitivity Analysis
• One Variable at a Time: Changing only one input at a time ignores real-world complexity (where
many inputs change together).
• No Probabilities Assigned: It doesn’t show how likely a change is to occur.
• Time-Consuming: Repeating calculations for many variables takes time.
• Can Be Misleading: If the base case or assumptions are wrong, results may be inaccurate.
• Lacks Decision Guidance: It tells you "what if," but not what to do in response.

Q39. Decision tree approach

A decision tree is a graphical tool used for decision-making under uncertainty. It helps evaluate
different choices by showing possible outcomes, risks, costs, and returns step-by-step.
Structure of a Decision Tree:
1. Decision Nodes (Squares): Points where a decision must be made (e.g., invest or not invest).
2. Chance Nodes (Circles): Points where an outcome depends on probability (e.g., high demand or
low demand).
3. Branches: Lines that represent each possible decision or outcome.
4. Payoffs: The result (profit, loss, NPV, etc.) from following a branch to the end.
5. Probabilities: Assigned to each chance outcome to calculate Expected Value (EV).
Steps in the Decision Tree Approach
1. Define the Problem: Identify the decision to be made and alternatives available.
2. Draw the Tree: Use square for decisions, circle for uncertain outcomes. Add branches for each
option.
3. Assign Probabilities: Estimate the probability for each possible outcome.
4. Estimate Payoffs: Calculate the financial result (e.g., NPV, profit) for each path.
5. Calculate Expected Values: Multiply each payoff by its probability and sum them to find the EV
of each decision.
6. Choose the Best Option: Select the decision path with the highest expected value.
Advantages of Decision Tree Approach
• Visual and Easy to Understand
• Helps in evaluating complex decisions
• Considers both risk and reward
• Useful in capital budgeting, project evaluation, and strategic planning
Disadvantages
• Becomes complicated with too many branches
• Depends on accurate probability and payoff estimates
• Doesn’t always include non-financial factors

Q40. Capital Investment Process

Capital investment refers to the process of planning and deciding on long-term investments in assets
like land, machinery, buildings, or new projects. These decisions affect the future profitability and
direction of a business.
Steps in Capital Investment Process
• Identify Opportunities: Find potential investment ideas that align with business goals, like new
projects, expansion, or asset upgrades.
• Evaluate Options: Analyze options using tools like NPV, IRR, and Payback Period to assess
profitability and feasibility.
• Estimate Costs & Benefits: Forecast all cash inflows and outflows over the life of the project to
understand financial impact.
• Analyze Risk: Use methods like sensitivity or scenario analysis to evaluate uncertainty and risk
factors.
• Decide Financing: Choose how to fund the project—through debt, equity, or internal funds—based
on cost and availability.
• Get Approval: Obtain final permission from top management or board after financial and strategic
evaluation.
Factors Considered in Capital Investment (Short Form)
• Expected Returns: The profit or financial benefit expected from the investment.
• Cost of Capital: The minimum return required to cover financing costs.
• Risk and Uncertainty: Possibility of adverse outcomes due to market or operational factors.
• Project Duration: Length of time before returns are realized and total project life.
• Strategic Fit: How well the investment supports long-term business goals.

Q43. Meaning of Economic Value Added (EVA)

Economic Value Added (EVA) is a financial performance measure that shows the true economic profit
of a company. It calculates the value created over and above the required return of the company’s
shareholders. Simple Definition: EVA = Net Operating Profit After Taxes (NOPAT) − Cost of Capital ×
Capital Invested
Pros of EVM:
• Tracks Cost and Schedule Together: EVM integrates cost, time, and scope, giving a clear view of
overall project performance.
• Early Warning System: It helps detect problems early so corrective actions can be taken before
delays or overspending occur.
• Forecasting Ability: EVM can predict future project performance, helping in better planning and
budgeting.
• Objective Measurement: Provides quantifiable data for measuring progress, making reporting and
decisions more accurate.
Cons of EVM:
• Complexity: EVM requires detailed planning, data collection, and analysis, which can be difficult
and time-consuming.
• High Setup Cost: Implementing EVM systems and training staff can be expensive, especially for
small projects.
• Data Dependency: Inaccurate or incomplete data can lead to misleading results.
• Focus on Cost & Schedule, Not Quality: EVM doesn’t directly measure the quality of work or
customer satisfaction.

Q44. Concept of Market Efficiency (MBA-Level, Simple Explanation)

Market efficiency refers to how well financial markets reflect all available information in the prices of
securities. If a market is efficient, it means that stock prices always incorporate and reflect all relevant
information, so investors cannot consistently earn above-average returns using that information.
Types of Market Efficiency:(form)
• Weak Form Efficiency: Prices reflect all past trading information (like historical prices and volumes).
Technical analysis won’t work.
• Semi-Strong Form Efficiency: Prices reflect all publicly available information (financial reports,
news, etc.). Neither technical nor fundamental analysis can give an edge.
• Strong Form Efficiency: Prices reflect all information, both public and private (including insider
info). No one can consistently outperform the market.

Q45. Meaning of efficient marketing hypothesis

The Efficient Market Hypothesis (EMH) is a financial theory that states financial markets are
"informationally efficient," meaning that stock prices always reflect all available information at any
given time.
Assumptions
• Investors are deemed to be rational.
• Markets act rationally.
• There are no taxes applicable to the transactions.
• The transactions do not incur any costs.
• An investor does not differentiate between the dividend and capital gains income.
• A company and its investors are indifferent between additional equity and additional debt.

Q46. Random walk hypothesis/theory

Ans The Random Walk Theory is a financial concept that suggests stock prices move in a completely
random and unpredictable manner, just like a "random walk." According to this theory, past
movements or trends in stock prices cannot be used to predict future movements.

Implications of Random Walk Theory:

• No Predictability: Price patterns, trends, and historical data cannot reliably predict future stock
prices.
• Ineffectiveness of Technical Analysis: Since prices are random, using charts or patterns to forecast
prices is not useful.
• Support for Efficient Market Hypothesis (EMH): The theory supports the idea that markets are
efficient and reflect all known information.
• Advantage of Passive Investing: Since consistent outperformance is unlikely, passive strategies like
investing in index funds are recommended.
• Market Prices Are Fair: Stocks are usually fairly priced, and it's hard to find undervalued or
overvalued stocks for profit.
Q47. What is Financing Choice?
Financing choice refers to the strategic decision a company makes regarding the source of funds to
finance its operations, expansion, or investments. This choice typically involves selecting between
equity financing, debt financing, or a mix of both (hybrid). The goal is to optimize the capital structure
to minimize the cost of capital and maximize shareholder value.
Sources of equity financing
• Friends and Family: Often the first source of capital for startups. This can be easier to secure but
may involve personal relationships.
• Angel Investors: Wealthy individuals who invest their own money in early-stage companies with
high growth potential. They often bring valuable experience, skills, and connections.
• Venture Capital (VC) Firms: Professional investors who manage funds from institutions (like
pension funds) and high-net-worth individuals. They invest larger sums in startups and high-growth
companies in exchange for a significant equity stake and often a board seat. Venture capital is
typically raised in stages (Seed, Series A, B, C, etc.) as the company grows.
• Corporate Venture Capital (CVC): Venture capital funds that are part of large corporations. They
invest for strategic reasons, such as gaining access to new technologies or markets, as well as for
financial returns.
• Initial Public Offering (IPO): The first time a private company offers its shares to the public on a
stock exchange to raise capital. This is a significant milestone and allows for much larger amounts
of funding.

Advantages of Equity Financing:

• No Repayment Obligation: Unlike debt, equity financing doesn't require you to pay back the
money.
• Improved Cash Flow: Without the burden of loan payments, you can reinvest more capital into the
business.
• Access to Expertise and Networks: Investors, especially angel investors and VCs, often bring
valuable experience, industry knowledge, and connections.
• Risk Sharing: Investors share the financial risks of the business.
• Increased Credibility: Securing investment from reputable investors can enhance your company's
image.
Disadvantages of Equity Financing:

• Dilution of Ownership: Selling shares means giving up a portion of your company's ownership and
control.
• Profit Sharing: Investors will expect a share of future profits through dividends or capital
appreciation.
• Loss of Control: Depending on their stake, investors may have a say in business decisions.
• Potential Conflicts: Differences in vision or strategy between founders and investors can lead to
disagreements.
• Cost of Equity: In the long run, equity financing can be more expensive than debt because
dividends are not tax-deductible.

Q48. Differences between debt and equity financing

Debt Financing
• Involves borrowing money that must be repaid over time.
• Requires regular payments of principal and interest regardless of business performance.
• Does not give the lender any ownership or control in the company.
• Interest payments are often tax-deductible.
• Increases the company’s liabilities on the balance sheet.
Equity Financing
• Involves raising money by selling shares or ownership stakes in the company.
• No obligation to repay the invested amount like a loan.
• Investors become partial owners and may receive dividends.
• Investors may have voting rights and influence company decisions.
• Does not create debt or liabilities on the balance sheet; instead, it increases shareholders’
equity.

Q49. Factors affecting financing decision

• Cost of Financing:Companies choose the option (debt or equity) that is most cost-effective. Debt is
often cheaper due to tax-deductible interest, but risky if not managed well.
• Control and Ownership:Equity financing reduces ownership and control, as shareholders get voting
rights. Companies that want to retain control often prefer debt.
• Cash Flow Position: A strong and steady cash flow supports debt repayment. If cash flow is
uncertain, companies may avoid debt and go for equity instead.
• Financial Risk: Taking on too much debt increases financial risk. Companies assess their risk
tolerance before deciding how much debt to use.
• Market Conditions: Favorable market conditions (like high investor interest or low interest rates)
influence the choice—equity is preferred in a booming market; debt in a low-interest environment.

Q50. What is Walter’s Model?

Walter’s Model is a dividend relevance theory proposed by Prof. James E. Walter. It suggests that a
company’s dividend policy (i.e., how much profit it pays out vs. retains) directly affects its value and
share [Link] model is based on the idea that if a company retains profits and reinvests them at a
rate higher than its cost of capital, it increases shareholder value. If not, it should pay dividends.
Assumptions of Walter’s Model
• Internal Financing: Investment is made by the company out of the retained earnings.
exclusively; issue of fresh equity or debt instruments are not involved.
• Constant Return and Cost of Capital: The rate of return on the investment is made by the
company (r) and the cost of capital (K) remains unchanged.
• Cent Per cent Payout or Retention: The entire earning is either used for distribution of
dividends amongst the shareholders or reinvested internally in a prompt manner.
• Constant EPS and DPS: Under the Walter's Model, the value of Earning Per Share (EPS) and
Dividend Per Share (DPS) may be changed in order to establish results, but there is a
presumption that the value of EPS or DPS would remain unchanged.
• Infinite Time: The life of the company is very long or infinite

Q51. Buyback of shares

Ans. Buyback of shares refers to a company repurchasing its own shares from existing shareholders.
This reduces the number of outstanding shares in the market. Companies usually buy back shares at a
premium price and it can be done through open market purchases, tender offers, or negotiated deals.
Advantages of Share Buyback:
• Increase in Earnings Per Share (EPS): Reducing the number of shares increases the EPS, which can
boost investor confidence and share price.
• Improves Return Ratios:Ratios like Return on Equity (ROE) and Return on Assets (ROA) often
improve due to reduced equity base.
• Sign of Confidence: A buyback signals that the company believes its shares are undervalued and
that it has confidence in its financial strength.
• Efficient Use of Surplus Cash: Companies with excess cash can return value to shareholders without
committing to regular dividends.
• Reduces Dilution: It can offset the dilution caused by employee stock options or convertible
securities.
Disadvantages of Share Buyback:

• Reduces Available Cash: Using cash for buyback reduces funds available for investment, R&D, or
debt repayment.
• May Signal Lack of Growth Opportunities: Regular buybacks can suggest the company lacks
profitable investment options.
• Short-Term Focus: Sometimes done to inflate EPS and stock price in the short term rather than
improve long-term value.
• Can Mislead Investors: If done when shares are overvalued, it can destroy shareholder value.
• Regulatory and Legal Risks: Buybacks are subject to rules and disclosures. Improper practices may
invite penalties or investor criticism.

Q51. Spin-off/ Demerger

A spin-off is a type of corporate restructuring in which a company creates a new independent
company by separating a portion of its operations, assets, or business unit. The shares of the new
entity are typically distributed to existing shareholders on a pro-rata basis.A demerger is a broader
term that refers to splitting a company into two or more separate entities. It can be done through
various ways, including spin-offs, sell-offs, or transferring part of the business to a new or existing
company.
Advantages of Spin-offs/Demergers
• Improved Focus: Each company can focus on its core business and management goals.
• Unlock Shareholder Value: The market can value each business independently, potentially
increasing total shareholder wealth.
• Operational Efficiency: Independent units often become more agile and efficient.
• Attract Targeted Investors: Investors can choose to invest in specific segments they prefer (e.g.,
tech vs. manufacturing).
• Regulatory or Strategic Reasons: May help comply with regulations or simplify organizational
structure.
Disadvantages
• High Cost of Restructuring: Legal, tax, and administrative expenses can be significant.
• Duplication of Efforts: Separate entities may duplicate functions like HR or IT, increasing costs.
• Loss of Synergy: Some benefits of operating as one company (e.g., cross-selling, economies of
scale) may be lost.
• Market Uncertainty: May create temporary confusion or uncertainty among investors and
employees.