Chapter financial-management: Financial Management Application Questions | business studies Class 12 CBSE

Chapter financial-management: Financial Management Application Questions | business studies Class 12 CBSE | ByteNotes.in

Application Question

Medium difficulty • Concept in a practical situation

Medium

Question 1

Applied Concept

Ramesh runs a small garment manufacturing unit and is considering expanding production by purchasing new machinery worth Rs. 50 lakh. He is unsure whether to finance it through a bank loan at 12% per annum or by issuing equity shares. His current RoI is 15%. Advise Ramesh on the financing decision and explain the concept involved.

Since Ramesh's RoI (15%) is higher than the cost of debt (12%), using a bank loan would be favourable. This is a case of favourable financial leverage or Trading on Equity — using cheaper debt increases the earnings per share (EPS) of equity shareholders.
By taking a bank loan, Ramesh benefits from the tax deductibility of interest, effectively reducing the cost of debt further. The interest acts as a fixed financial charge, and since the return on the new machinery exceeds this cost, equity holders gain more than if equity were issued.
However, Ramesh must also consider the financial risk involved: bank loan repayment is obligatory. He should assess whether his projected cash flows are sufficient to service the debt (interest + principal) comfortably, alongside normal business operations. Reckless use of debt beyond his debt capacity is inadvisable.

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Application Question

Medium difficulty • Concept in a practical situation

Medium

Question 2

Applied Concept

Sunayna Ltd. is a software services company with no physical inventory. It sells services immediately after delivery and collects payment within 15 days. A competing manufacturing firm in the same city employs 500 workers and holds 2 months of raw material stock. Compare the working capital requirements of these two firms and justify your answer.

Sunayna Ltd. (service company) will have significantly lower working capital requirements. Service industries do not maintain inventory (no raw materials or finished goods), and with a 15-day collection cycle, debtors are also limited. The primary current asset would be cash and short-term receivables.
The manufacturing firm will require substantially higher working capital. It must hold 2 months of raw material stock, maintain work-in-progress during the production cycle, hold finished goods until sold, and extend credit to customers. All these increase the investment in current assets.
The key factors explaining the difference are: (a) Nature of Business — manufacturing requires raw material conversion, creating multiple stages of working capital need; (b) Production Cycle — the manufacturing firm has a longer cycle tying up funds; (c) Inventory — manufacturing firms must stock raw materials, WIP, and finished goods, whereas service firms hold none.

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Application Question

Medium difficulty • Concept in a practical situation

Medium

Question 3

Applied Concept

Priya is the CFO of a growing FMCG company. She is preparing the financial plan for the next five years. Describe the steps she would follow in preparing this financial plan and identify its key objectives.

Priya would begin with a sales forecast for the next five years — estimating the level of sales likely to be achieved annually. Based on this, she would prepare projected financial statements (Balance Sheet and Profit and Loss Account) to estimate funds required for fixed capital (new plant, equipment) and working capital (inventory, debtors, cash).
She would then estimate expected profits to determine how much of the fund requirement can be met through internal sources (retained earnings after dividend payouts). This tells her the residual external funds requirement. She would identify and evaluate potential external sources — debt, equity, or a mix — and prepare cash budgets incorporating these factors.
The twin objectives of this financial plan are: (a) To ensure availability of funds whenever required — estimating both quantum and timing of fund needs so that operations are never starved of finance; and (b) To ensure the company does not raise resources unnecessarily — avoiding excess funding that adds to cost and may encourage wasteful expenditure.

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Application Question

Hard difficulty • Concept in a practical situation

Hard

Question 4

Applied Concept

With reference to the concept of capital structure, explain why a company with high and stable cash flows might prefer higher debt financing compared to a company with volatile and unpredictable cash flows.

A company with high and stable cash flows can confidently meet its fixed financial obligations — interest payment and principal repayment — because its revenue is predictable and consistent. This reduces financial risk even with a high proportion of debt, making debt financing more viable.
For such a company, higher debt is attractive because debt is cheaper than equity (interest is tax-deductible) and does not dilute management control. As long as cash flows comfortably cover debt service commitments (reflected in a high DSCR), using more debt enhances EPS through Trading on Equity.
A company with volatile cash flows faces the risk of being unable to meet debt obligations during periods of low revenue — creating financial risk and potential default. Such a company should prefer equity financing (which has no fixed obligation) and maintain a conservative capital structure with less debt and higher equity to ensure financial stability.

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Application Question

Medium difficulty • Concept in a practical situation

Medium

Question 5

Applied Concept

Aval Ltd., an exporter of canvas goods, decided to diversify into leather goods requiring specialised machinery. The Finance Manager prepared a detailed financial blueprint estimating fund requirements and timing, and identified internal and external sources. Identify the financial concept and state its importance for Aval Ltd.

The financial concept described is Financial Planning. The Finance Manager prepared a financial blueprint of the organisation's future operations, estimated fund requirements (quantum and timing), assessed internal fund generation (profits/retained earnings), and identified external sources for additional funds — all characteristic elements of financial planning.
For Aval Ltd., financial planning is important because diversifying into leather goods with specialised machinery involves significant capital expenditure and changes in operational scale. Without a proper plan, the company may face fund shortages at critical moments, delaying machinery procurement and disrupting the new venture's launch.
Financial planning helps Aval Ltd. ensure that funds are available at the right time from the right sources at the right cost. It also prevents over-borrowing, coordinates the expansion with existing operations, reduces the risk of business shocks, and provides a benchmark against which actual performance in the new leather goods segment can be evaluated.

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Application Question

Medium difficulty • Concept in a practical situation

Medium

Question 6

Applied Concept

Ramnath assembles and sells televisions. He recently adopted a policy of purchasing components on three months credit and selling finished products only in cash. Will this policy affect his working capital requirement? Give reasons.

Yes, this policy will reduce Ramnath's working capital requirement significantly. By purchasing components on three months' credit, Ramnath avails credit from his suppliers, which means he does not immediately need cash for raw material purchases — this reduces the current assets needed.
Simultaneously, by selling televisions for cash, Ramnath eliminates debtors entirely from his current assets. There is no credit period extended to customers, so no funds are tied up in receivables. This further reduces his working capital needs.
The net effect of credit availed (delaying cash outflows) combined with cash sales (immediate cash inflows with zero debtors) means Ramnath's net working capital requirement is substantially lower. This reflects two key working capital factors: Credit Availed (reduces working capital) and Credit Allowed (cash sales eliminate debtors and reduce working capital).

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Application Question

Hard difficulty • Concept in a practical situation

Hard

Question 7

Applied Concept

Sunrises Ltd., a readymade garment company, plans to expand for international markets and needs Rs. 80 lakh. It plans to issue debentures at 10% cost. Its previous year EBIT was Rs. 8 lakh on total capital investment of Rs. 1 crore. Should it issue debentures? Justify your answer.

No, Sunrises Ltd. should not issue debentures. The current Return on Investment (RoI) = (EBIT / Total Capital) × 100 = (8,00,000 / 1,00,00,000) × 100 = 8%. The cost of debt (debentures) is 10%, which is higher than the RoI of 8%.
This is a situation of unfavourable financial leverage. When the cost of debt exceeds RoI, using more debt reduces the Earnings Per Share (EPS) of equity shareholders. Trading on Equity in this case would be counterproductive and would harm equity shareholders' wealth.
The company should explore alternative financing options — such as issuing equity shares or using retained earnings — or focus on improving its RoI above 10% before considering debt financing. Borrowing at a cost higher than the return earned leads to a reduction in value for equity shareholders and works against the wealth-maximisation objective.

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Application Question

Easy difficulty • Concept in a practical situation

Easy

Question 8

Applied Concept

Amrit runs a transport service providing vehicles to industries and earning good returns. State whether his working capital requirement will be less or more compared to a manufacturing firm, giving reasons.

Amrit's working capital requirement will be less compared to a manufacturing firm. A transport service is a service-sector business that does not maintain physical inventory of goods. There are no raw materials, work-in-progress, or finished goods stock — the largest components of working capital in a manufacturing firm.
Service industries primarily need cash and debtors (receivables from clients) as current assets, which are relatively smaller in quantum. Since there is no processing or production cycle involved, funds are not tied up over an extended period.
In contrast, a manufacturing firm must purchase and stock raw materials, process them into finished goods (involving a production cycle), and often extend credit to customers. All of these create significant working capital needs. The nature of business factor is the primary reason why Amrit's transport service needs less working capital.

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Application Question

Medium difficulty • Concept in a practical situation

Medium

Question 9

Applied Concept

A textile company has decided to set up a new cement manufacturing plant. Explain how this decision will affect its fixed capital requirements and working capital requirements.

Fixed Capital Impact: Setting up a new cement manufacturing plant is an act of diversification. The company must invest in entirely new plant, machinery, kilns, storage facilities, and land for the cement plant — substantially increasing its fixed capital requirements. The nature of cement manufacturing (capital-intensive, large-scale equipment) ensures fixed capital needs are very high.
Working Capital Impact: The cement plant will add new operational requirements: raw material stocks (limestone, gypsum), work-in-progress, finished goods (cement bags), and debtors if credit is extended to dealers and builders. The scale of operations and production cycle of the cement plant will increase the company's total working capital requirement significantly.
Additionally, the diversification into a new industry may expose the company to different credit terms and competition norms in the cement sector, potentially requiring higher inventory to meet urgent orders. The company must plan both fixed and working capital requirements for the new business alongside its existing textile operations.

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Application Question

Hard difficulty • Concept in a practical situation

Hard

Question 10

Applied Concept

A pharmaceutical company's management is debating whether to pay a large dividend this year or retain profits to fund a new drug research project. Using relevant factors, advise the management on this dividend decision.

The management should consider Growth Opportunities: pharmaceutical R&D is a long-gestation, high-return activity. If the new drug research project promises high returns, retaining profits to finance it would add more value to shareholders in the long run than distributing a large immediate dividend. Companies with good growth opportunities typically retain more and pay less dividend.
Cash Flow Position is also critical: even if profits are high, the company needs sufficient cash to fund ongoing R&D, which is capital-intensive and has a long development cycle. A large dividend payout could reduce cash availability needed for research continuity.
However, shareholders' preference and stock market reaction must also be weighed. A sudden reduction in expected dividends may signal financial difficulty, causing share prices to fall. The company should communicate clearly about the R&D investment opportunity to reassure shareholders that profit retention is for value-creating purposes, not distress. A moderate dividend combined with retained earnings for R&D may be the balanced approach.

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Chapter sections

Chapter financial-management: Financial Management | Application Questions

Priya is the CFO of a growing FMCG company. She is preparing the financial plan for the next five years. Describe the steps she would follow in preparing this financial plan and identify its key objectives.

With reference to the concept of capital structure, explain why a company with high and stable cash flows might prefer higher debt financing compared to a company with volatile and unpredictable cash flows.

Ramnath assembles and sells televisions. He recently adopted a policy of purchasing components on three months credit and selling finished products only in cash. Will this policy affect his working capital requirement? Give reasons.

Sunrises Ltd., a readymade garment company, plans to expand for international markets and needs Rs. 80 lakh. It plans to issue debentures at 10% cost. Its previous year EBIT was Rs. 8 lakh on total capital investment of Rs. 1 crore. Should it issue debentures? Justify your answer.

Amrit runs a transport service providing vehicles to industries and earning good returns. State whether his working capital requirement will be less or more compared to a manufacturing firm, giving reasons.

A textile company has decided to set up a new cement manufacturing plant. Explain how this decision will affect its fixed capital requirements and working capital requirements.

A pharmaceutical company's management is debating whether to pay a large dividend this year or retain profits to fund a new drug research project. Using relevant factors, advise the management on this dividend decision.

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