UNIT-1

1. What do you mean by Financial Management? Discuss the objectives of

Financial Management.
Answer: Financial management means applying management principles to
manage the financial resources of an organization. It simply involves planning,
organizing, directing, and controlling financial operations to manage the finance
of an organization efficiently. It deals with finding out various sources for
raising funds for the firm, procurement of funds and their optimum utilization.
According to J.L. Massie, “Financial management is the operational activity of
a business that is responsible for obtaining and effectively utilizing the funds
necessary for efficient operations.”
OBJECTIVES:
Following are the objectives of financial management:
i.Profit maximization: Profit earning is the main aim of every economic
activity. A business being an economic institution must earn profit to
cover its cost and provide funds for growth. No business can survive
without earning profit. Profit is a measure of efficiency of a business
enterprise. Profits also serve as a protection against risks which cannot
be ensured.
ii.Wealth maximization: Wealth maximization is another important
objectives of financial management. Wealth maximization means to
generate maximum wealth for the shareholders. The wealth created by
a company is reflected in the market value of the company’s shares.
The market value of the shares is directly related to the performance of
the company. Better the performance higher is the market value of
shares and vice versa.
iii.Forecasting financial requirement: Proper forecasting of financial
requirement is a very important objective from financial management
point of view. It is the duty of financial manager to plan and estimate
financial needs of the business.
iv.Procurement and investment of funds: After estimating financial
requirements the finance manager has to take necessary steps to
procure the funds and make optimum investment of funds. He must
use the funds in a profitable project and should not waste funds of the
company.
v.Ensure proper liquidity: Another objective of financial management is
to ensure proper liquidity. The company must have adequate cash in
order to meet day to day expenses such as purchase of raw materials,
payment of direct and indirect expenses etc.
vi.Survival of company: The financial manager must be very aware
while taking financial decisions as one wrong decision can make the
company sick and it may shut down. So,survival is one of the
important objectives of financial management.
 vii.Financial control: The finance manager should have a proper control
of inflow and outflow of funds with a view to ensure safety of the
concern. Financial control can be done by using many techniques like
ratio analysis, cost volume profit analysis etc.

2. Explain the nature of Financial Management.

Answer: The nature of financial management is concerned with its functions,
objectives, goals and scope. Following are the main characteristics of financial
management:
i.Specialized Branch of General Management: Financial management is
a specialized branch of general management like production,
marketing, human resource etc. It is concerned with planning and
controlling of firm’s financial resources.
ii.Integral Part of Management: Financial management is an integral part
of overall management. It is pervasive throughout the organization as
all activities of a firm need finance. Thus, it occupies the central
position in the organisation.
iii.Both an Art as well as Science: Financial management is neither a
pure art nor a pure science. It is both an art as well as science. It has
certain well-defined principles and uses various methods and
techniques like capital budgeting, statistical and mathematical models
and computer applications.
iv.Growing as a Profession: Financial management has emerged as a
separate discipline of study and is fast growing as a profession. It
provides a variety of financial services like planning, acquisition and
effective utilization of financial resources for long-term as well as
short term financial needs of a firm.
v.Multidisciplinary Approach: Financial management is multi-
disciplinary in approach. It depends upon other disciplines like
economics, accounting etc.
vi.Involves Risk-Return Trade off: Financial management is concerned
with investment, financing and dividend decisions of a firm. All these
decisions are interrelated and involve trade-off between risk and
return.
vii.Focus on Valuation of the Firm: The main focus of financial
management is towards maximizing the value of the firm. It includes
the maximization of stockholder’s wealth as well as other financial
claimholders such as debenture holders, preferred stockholders, etc.

3. Discuss the scope of Financial Management.

Answer: Financial management is one of the important parts of overall
management. It has a wide scope over the years. The following are the
important scope of financial management:
 i.Estimating Financial Requirements: The first task of a financial
manger is to estimate short-term and long-term financial requirements
of his business. Depending on the size of the business, the finance
manager has to forecast the amount of fixed capital and working
capital required in a specified period of time. Apart from that, the
finance manager also has to forecast period when further funds from
outside sources will be required for operations.
ii.Deciding Capital Structure: The capital structure refers to the kind and
proportion of different securities for raising funds. After deciding
about the quantum of funds required it should be decided which type
of securities should be raised.
iii.Selecting a source of finance: After preparing a capital structure, an
appropriate source of finance is selected. Various sources from which
finance may be raised, include: share capital, debentures financial
institution, commercial banks, public deposits, etc. If finances are
needed for short periods, then banks, public deposits and financial
institutions may be appropriate; on the other hand, if long term
finances are required then share capital and debentures may be
useful.
iv.Selecting a Pattern of investment: When funds have been procured
then a decision about investment pattern is to be taken. The selection
of an investment pattern is related to the use of funds. The decision-
making techniques such as Capital Budgeting, Opportunity Cost
Analysis etc. may be applied in making decisions about capital
expenditures.
v.Proper cash management: Cash management is also an important task
of finance manager. He has to assess various cash needs at different
times and then make arrangements for arranging cash. Cash may be
required to (a)purchase raw materials, (b) make payments to creditors,
(c) meet wage bills, (d)meet day to day expenses. The usuals sources
of cash may be: (a) cash sales, (b)collection of debts, (c) short term
arrangement with banks etc.
vi.Implementing financial controls: An efficient system of financial
management necessitates the use of various control devices. Financial
control devices generally used are: (a) return on investment, (b)
budgetary control, (c) break even analysis, (d) cost control, (e) ratio
analysis, (f)cost and internal audit.
vii.Proper use of surpluses: The utilization of profits or surpluses is also
an important factor in financial management. A judicious use of
surpluses is essential for expansion and diversification plans and also
in protecting the interests of shareholders. The ploughing back of
profits is the best policy of further financing but it clashes with the
interest of shareholders.
4. Discuss the significance of financial management in business
management.
Answer: Finance is the life blood and nerve centre of a business and is very
essential for smooth running of the business. The importance of financial
management has arisen some importances of the financial management are as
follows :
i.Financial planning: With the help of financial management, financial
requirement of the business can be determined which leads to make
financial planning of the concern. Financial planning plays an
important role for the promotion of the business concern.
ii.Acquisition of funds: After assessing the financial requirement of the
business, financial management helps to acquire the finance from
suitable sources of finance at minimum cost.
iii.Proper use of funds: Financial management uses the funds in such a
way which leads to improve the operational efficiency of the concern.
Moreover, when the funds are used properly by the finance manager;
they can minimize the cost of capital and maximize the value of the
firm.
iv.Helpful for investors: If the investors are well acquainted about the
principles of financial management, they will be in a position to
decide whether a company's securities should be acquired or not.
Hence, investors need not depend upon the advice of brokers.
v.Financial Decision: Financial management helps to take sound
financial decision in the business concern. Financial decision will
affect the entire business operation of the concern because there is a
direct relationship with various department functions such as
marketing, production personnel etc.
vi.Improve profitability: With the help of financial control devices such
as ratio analysis, cost volume profit analysis etc. financial
management helps to improve the profitability of the concern.
vii.Maximization of wealth: All the three important decisions such as
investment decision, financing decision and dividend decisions are
taken by the financial management in such a way that it leads to
maximize the wealth of the concern.

5. “The profit maximization is not an operating feasible criterion”. Do you

agree? Illustrate your view.
Answer: Profit earning is the main aim of every economic activity. A business
being an economic institution must earn profit to cover its cost and provide
funds for growth. No business can survive without earning profit. Profit is a
measure of efficiency of a business enterprise. Profits also serve as a protection
against risks which cannot be ensured. The accumulated profits enable a
business to face risks like fall in prices, competition from other units, adverse
government policies etc. Thus, profit maximization is considered as the main
objectives of business.
The following arguments are advanced in favour of profit maximation as the
objectives of business:
i.When profit earning is the aim of business then profit maximization
should be the obvious objectives.
ii.Profitability is a barometer for measuring efficiency and economic
prosperity of a business enterprise; thus, profit maximization is
justified on the grounds of rationality.
iii.Economic and business condition do not remain same at all the time.
There may be adverse business conditions like recession, depression
severe competition etc. A business will be able to survive under
unfavourable situation, only if it has some past earning to rely upon.
Therefore, a business should try to earn more and more when situation
is favourable.
iv.Profits are the main sources of finance for the growth of a business.
So, a business should aim at maximization of profits for enabling its
growth and development.
v.Profitability is an essential for fulfilling social goals also. A firm by
pursuing the objective of profit maximization also maximizes socio-
economic welfare.
The disadvantages of Profit Maximization are as follows: –
i. Ambiguity of Benefit Concept: – The concept of profit is uncertain
as different people may have a different idea about profit, such as
profit may be EPS, gross profit, net profit, profit before interest and
tax, profit ratio etc. In particular, no fixed profit-maximizing rule
or method actually exists.
ii. Does Not Consider Time Value of Money: – The profit
maximization principle simply states that the higher the profit, the
better the performance of the business. The theory considers only
profit without considering the time value of money.
iii. Does Not Consider the Risk: – Any business decision considering
only the profit maximization model ignores the risk factor involved
which may be detrimental to the survival of the business in the
long run. Because if the business is unable to handle the high risk,
its existence will be in question.
iv. Dividend policy: The effect of dividend policy on the market price
of shares is also not considered in the objective of profit
maximization. In case, earnings per share is the only objective then
an enterprise may not think of paying dividend at all because
retaining profits in the business or investing them in the market
may satisfy this aim .
6. Critically explain the wealth maximization as an objective of financial
management.
Answer: Wealth maximization is another important objective of financial
management. Wealth maximization means to generate maximum wealth for the
shareholders. The wealth created by a company is reflected in the market value
of the company’s shares. The market value of the shares is directly related to the
performance of the company. Better the performance higher is the market value
of shares and vice versa. The financial management should assure its
shareholders that the value of their shares will be increased in the long run.
The following arguments are advanced in favour of wealth maximization as the
goal of financial management:
i.It serves the interest of owners, (shareholder) as well as other
stakeholders in the firm; i.e., Suppliers of loaned capital, employees,
creditors and society.
ii.It is consistent with the objective of owner’s economic welfare.
iii.The objective of wealth maximization implies long run survival and
growth of the firm.
iv.It takes into consideration the risk factor and the time value of money
as the current present value of any particular course of action is
measured.
v.The effect of dividend policy on market price of shares is also
considered as the decisions are taken to increase the market value of
the shares.
Arguments against wealth maximization: -
i.The utmost aim of wealth maximization objectives is to maximize the
profit. But wealth maximization objective ultimately depends upon the
profitable position of the business.
ii.The firm may not increase the shareholders wealth in some cases
rather it may consider the interest of customers, creditors, suppliers,
community and others.
iii.Some controversy may arise, i.e., whether the objective is to maximize
the shareholders wealth or the wealth of the firm, which includes other
financial claim holders such as debenture holders, preference
shareholders etc.
iv.The objective is not descriptive of what the firm actually do to
maximize the wealth.
7. Discuss the functions performed by a financial manager.
Answer: Following are the functions performed by the financial manager:
i. Estimating the requirements of funds : A business requires funds
for long term purposes i.e. investment in fixed assets and so on. A
careful estimate of such funds is required to be made. An
assessment has to be made regarding requirements of working
capital involving, estimation of amount of funds blocked in current
 assets and that likely to be generated for short periods through
current liabilities. Forecasting the requirements of funds is done by
use of techniques of budgetary control and long range planning.
ii. Decision regarding capital structure: Once the requirements of
funds is estimated, a decision regarding various sources from
where the funds would be raised is to be taken. A proper mix of the
various sources is to be worked out, each source of funds involves
different issues for consideration. The finance manager has to
carefully look into the existing capital structure and see how the
various proposals of raising funds will affect it.
iii. Acquisition of funds: After making financial planning and deciding
the capital structure the next step will be to acquire funds. There
are a number of sources available for supplying funds these sources
may be shares or debentures, financial institutions, commercial
banks etc. The selection of an appropriate source is an important
task. The pros and cons of various sources should be analyzed
before making a final decision.
iv. Investment decision: Funds procured from different sources have
to be invested in various kinds of assets. Long term funds are used
in a project for fixed and also current assets. The investment of
funds in a project is to be made after careful assessment of various
projects through capital budgeting. A part of long term funds is
also to be kept for financing working capital requirements.
v. Disposal of Profits or Surplus: The financial manager has to decide
how much to retain for ploughing back and how much to distribute
as dividend to shareholders out of the profits of the company. The
factors which influence these decisions include the trend of
earnings of the company, the trend of the market price of its shares,
the requirements of funds for self- financing the future programmes
and so on.
vi. Helping in valuation decisions: Number of mergers and
consolidations take place in the present competitive industrial
world. A finance manager is supposed to assist management in
making valuation. For this purpose, he should understand various
methods of valuing shares and other assets so that correct values
are arrived at.
vii. Maintain proper liquidity: Every concern is required to maintain
some liquidity formatting day-to-day needs. Cash is the best source
for maintaining liquidity. It is required to purchase raw materials
be workers, meet other expense etcetera. A finance manager is
required to determine the need for liquid assets and then arranged
liquid assets in such a way that there is no scarcity of funds.
8. Discuss the traditional approach and modern approach of finance
function.
Answer: Financial management is evolutionary concept not a revolutionary
concept. The approaches are divided into 2 broad categories:
A. Traditional approach and
B. Modern approach.

A. Traditional Approach: Traditional approach is the initial stage of financial

management; it was evolved during 1920s and 1930s and was very
popular up to the beginning of 1950s. Traditional approach was only
confined to arrangement of funds for the enterprise. This funds were
needed to meet their financial needs such as expansion, merger,
reconstitution etc. The traditional view on financial management is based
on the assumption that the financial manager has no concern about the
application of firm’s fund. He is required to raise the needed funds from
right sources, at the right time and right terms and conditions. As per this
approach, the following aspects are included:
i. Estimation of financial requirements;
ii. Raising of funds from financial institutions;
iii. Raising of funds through financial instruments such as shares,
debentures, bonds etc.
iv. Consider the accounting and legal work related with the raising of
funds.
B. Modern approach: On account of new trends and changes, modern
approach came in the picture. Modern approach considers the term
‘ Financial management’ in a broad sense. Financial management has
become an integral part of overall management. The focus of financial
management has been transferred from acquisition of funds to their
effective and judicious utilization of funds. In other words, it's not only
confined to raising of funds but increased it's limit for efficient allocation
and effective administration of funds.
As per this approach, the financial management is concerned with the
solution of three pertinent problems regarding finance:
i. What is the total amount of funds an enterprise should possess?
ii. How should the funds be acquired?
iii. In what specific assets the enterprise should invest its funds?
The three aforesaid problems covered the major financial problems of an
enterprise. As such, in the modern approach, the financial management
takes three decisions: (a) financing decision (b) investment decision and
(c) dividend decision. The financial manager helps in making this
decision in the most rational way so that the funds of the firm are used
optimally.
9. Explain the four important decisions involved in financial management.
Answer: Financial decisions refer to decisions concerning financial matters of a
business form. There are many kinds of financial management decisions that the
firm makes in pursuit of maximizing shareholders wealth. We can classify this
decisions into the following three major groups:
i. Investment Decision: The investment decision relates to the selection of
assets in which funds will be invested by a firm. The assets as per their
duration of benefits, can be categorized into two groups: (i) long-term
assets which yield a return over a period of time in future (ii) short-term
or current assents which in the normal course of business are convertible
into cash usually within a year. Accordingly, the asset selection decision
of a firm is of two types. The investment in long-term assets is popularly
known as capital budgeting and in short-term assets, working capital
management.
ii. Financing Decision: The second major decision involved in financial
management is the financing decision, which is concerned with the
financing mix or capital structure of leverage. The term capital
structure refers to the combination of debt and equity capital. The
financing decision of a firm relates to the choice of the proportion of
these sources to finance the investment requirements. A higher proportion
of debt implies a higher return to the shareholders and also the higher
financial risk and vice versa. A proper balance between debt and equity is
a must to ensure a tradeoff between risk and return to the shareholders.
iii. Dividend Decision: The third major decision of financial management is
relating to dividend policy. The firm has two alternatives with regard
to management of profits of a firm. They can be either distributed to the
shareholder in the form of dividends or they can be retained in the
business or even distribute some portion and retain the remaining. The
course of action to be followed is a significant element in the dividend
decision. The dividend payout ratio i.e., the proportion of net profits to be
paid out to the shareholders should be in tune with the investment
opportunities available within the firm. The second major aspect of the
dividend decision is the study of factors determining dividend policy of a
firm in practice.
10.What is meant by finance function? Discuss the various contents of
modern finance function.
Answer: The finance function refers to practices and activities directed to
manage business finances. The functions are oriented toward acquiring and
managing financial resources to generate profit. The financial resources and
information optimized by these functions contribute to the productivity of other
business functions, planning, and decision-making activities.
Finance is the lifeblood of any business; without proper financial resources, no
business can run smoothly; the finance processes can be related to planning,
execution, control, and maintenance of financial resources.
Contents of Finance Function: Same as scope of financial management.

11.Discuss the significance of financial management in business

management.
Answer: The importance of financial management has arisen because of the
fact that present day business activities are predominantly carried on by
company or corporate form of organization. Following are the importance of
financial management in business management:
i. Financial Planning: With the help of financial management, financial
requirement of the business can be determined which leads to make
financial planning of the concern. Financial planning plays an important
role for the promotion of the business concern.
ii. Acquisition of funds: After assessing the financial requirements of the
business, financial management helps to acquire the finance from suitable
sources of finance at minimum cost.
iii. Proper use of funds: Financial management uses the funds in such a way
which leads to improve the operational efficiency of the concern.
Moreover, when the funds are used properly by the finance manager, they
can minimize the cost of capital and maximize the value of the firm.
iv. Helpful for investors: If the investors are well acquainted about the
principles of the financial management, they will be in a position to
decide whether a company’s securities should be acquired or not. Hence,
investors need not depend upon the advice of brokers.
v. Financial decision: Financial management helps to take sound financial
decision in the business concern. Financial decision will affect the entire
business operation of the concern. Because there is a direct relationship
with various department functions such as marketing, production
personnel, etc.
vi. Improve profitability: With the help of financial control devices such as
ratio analysis, cost volume profit analysis, etc. financial management
helps to improve the profitability of the concern.
vii. Maximization of wealth: All the three important decisions such as
investment decision, financing decisions and dividend decisions are taken
by the financial management in such a way that it leads to maximize the
wealth of the concern.

12.Distinguish between Profit Maximization and Wealth Maximization.

Answer:
Basis Profit Maximization Wealth Maximization
 Motive The main motive of a The main objective of the
concern is to earn profit. concern is to increase the
market value of its shares.
Focus Profit maximization Wealth maximization
emphasizes on short term emphasizes on long term
objectives. objectives.
Pricing When profit maximization A wealth-oriented company
Strategy is the ultimate objective, do the reverse, decides to
management tries to reduce prices in order to build
increase the price of the market share over the long
product as higher as term.
possible.
Time value of It ignores the time value of It considers the time value of
money money. money.
Risk It does not consider risk It takes into account the
connected with cash flows. riskiness of cash flows.
Acceptability It is not broadly accepted as It is broadly accepted as
objective of financial objective of financial
management. management.

13.What is Time value of Money? Discuss the various reasons for time
preference of money.
Answer: Time value of money is a fundamental financial concept stating that
the value of money received today is more than the value of the same amount of
money received after a certain period. In other words, money received in the
future is not as valuable as money received today. For instance, if an individual
is given an option to receive rupees 10,000 today or to receive the same amount
after one year, he would obviously select to receive today then after one year
because the value of that money is going to decrease to less than rupees 10,000.
This preference for current money as against future money is called as a time
preference for money or simply time value of money.
Reasons for time preference of money:
In the financial decisions, the time value of money holds a very important place.
Time preference for many arises because of the following reasons:
a. Inflation: Under inflationary condition, the rupee today has a
higher purchasing power to buy rather than the same of rupee can buy
in future. Therefore, those who want to receive the money always
prefer to receive the same as early as possible, while those would pay
the money try to delay the payment.
b. Risk:Due to uncertain future an individual prefers to receive
current money rather than receiving the same in future as he may be in
a confusion that probably the person from whom the payment is to be
received may become insolvent.
 c. Preference for present consumption: Because of inflationary and
uncertain situations, an individual generally prefers present
consumption to future consumption. They do not like to save for
future by sacrificing present consumption.
d. investment opportunities: An individual, in general, takes interest
to invest whenever he finds favorable opportunity and earn some
return on it.

14.Discuss the various techniques for adjusting time value of money.

Answer: There are two techniques for adjusting time value of money:
A. Compounding technique
B. Discounting technique
A. Compounding technique: The compounding technique is used to
ascertain the future value of present money. A future value implies
that value of money received today has more worth than what will be
received at point of time in future. In other words, compounding
technique is the process of ascertaining the future value of an
investment made today and/ or series of equal payments made each
period. Simply, it can be expressed as
Future Value (FV) = Present Value (PV) + Interest (r)
The compounding technique to find out future value of present money
can be discussed with the help of the following :
i.Future value of a single Present cash flow: The future value of
single cash flow is the determination of the amount of money at
a certain point of time in future. Under the compounding
technique interest earns interest. In fact, it depends on the rate
of compound interest incurred on the amount of money
invested. It can be calculated by adopting the following
formula:
𝑉𝑛 = 𝑉0 (1 + 𝑖)𝑛

𝑉𝑛 =Future value of money after n years.

𝑉0= Value of money at time.
i = Interest rate .
n= Number of Payment Period.
ii.Future value of a series of Equal cash flow or Annuity of cash
flow: A fixed amount of cash receipts or payments made at a
regular interval of time is termed as annuity. When the cash
flow occurs at the end of each year the annuity is said to be a
regular annuity or deferred annuity. The future value of annuity
is calculated with the help of following formula :
Future Value= Annuity Amount x CVAF(r, n)
Where, CVAF=Compound value of Annuity Factor.
 B. Discounting technique: This technique is the reverse technique of
compounding technique. Discounting is the process of determining
present value of a series of future cash flows. Present value of a future
cash flow is the current value of a future sum of money given a
specified rate of return. The present value of cash flow is always lesser
than the future value of cash flow .
The discounting technique to find out the present value is analyzed
with the help of the following:
i. Present value of a single future cash flow: The present value of
a future sum can be computed by multiplying the future value
by a present value factor that can be derived from “present
value factor table.”
ii. Present value of a series of Equal future cash flows or Annuity:
The present value of a series of equal future cash flow can be
calculated by multiplying the annuity amount by a present value
annuity factor that can be derived from present value annuity
factor table.
iii. Present value of a series of unequal future cash flows: We can
calculate the present value even when future cash flows of a
series is unequal. It can be calculated by finding out the present
values of each individual payment by applying present value
factor table and then adding these present values.
iv. Present value of a perpetuity: The stream of regular cash flows
for an infinite period is called perpetuity. It may be compared to
an annuity but it does not have any time limit. In perpetuity time
is not finite.

15.What is Risk?
Answer: Risk is the variability in the actual returns in relation to the estimated
returns.
In other words, the term ‘risk is defined as the variability in the actual returns
emanating from a project over its working life, in relation to the estimated
return as forecast at the time of the initial capital budgeting decision.’
The decision situations with reference to risk analysis in capital budgeting
decisions can be broken up into three types:

a. Uncertainty
b. Risk and
c. Certainty
Risk situation is one in which the probabilities of occurrence of a
particular event are known, these probabilities are not known under the
uncertainty situation. The difference between risk and uncertainty therefore lies
in the fact that variability is less in risk than in uncertainty.
16.What are the different types of risk? Discuss the various techniques of
measuring risk.
Answer: Types of risk: Risk can be classified under two main groups, viz,
Systematic risk and Unsystematic risk.
A. Systematic Risk: Systematic risk refers to that variability of returns which
moves with the market. The effect in systematic return causes the price of
all individual securities to move in the same direction. This movement is
generally due to the response to economic, social, legal and political
changes. Such risk is non-diversifiable and firm cannot ignore such risk
and hence this is a matter of concern to investors. It arises due to the
influence of external factors on an organisation.

The different types of systematic risk are listed below:

a. Interest Rate Risk: Interest Rate Risk refers to the variability in a
security’s return resulting from fluctuations in the market interest
rates. Generally, security prices move in an opposite direction with
changes in the rate of interest. In fact, interest rate risk affects the
prices of bonds, debentures and shares. The fluctuations in interest
rates arise due to changes in government’s monetary policy, interest
rates of treasury bills or government bonds.

b. Market Risk: It refers to the variability of returns which occurs due

to fluctuations in the securities market. Such fluctuations may take
place on account of increase or decrease in the trading prices of listed
shares or securities in the share market.

c. Purchasing Power Risk: It is also called as inflation risk because

with the increase in prices there is reduction in purchasing power of
money. In fact, inflation risk is the probable loss in the purchasing
power of returns/income to be received. The increase in price
penalizes the returns to the investor and each potential increase in
price is a risk to the investor.

B. Non-Systematic Risk: Non-Systematic Risk refers to that portion of the

risk which occurs due to firm-specific factors like managerial
inefficiency, changes in customer’s preferences, labour unrest, shortage
of power, failure to get an overseas contract, etc. The nature and
magnitude of all such factors differ from one company to another
company. This type of risk is a company specific risk and can be
controlled if proper measures are taken. It is micro in nature as it affects
 only a particular organisation.
The types of non-systematic risk are as follows:
a. Business Risk: Business Risk can be internal as well as external.
Internal risk is caused due to improper product mix, non-availability
of raw materials, incompetence to face competition, absence of
strategic management, etc. External business risk arises due to change
in operating conditions caused by conditions thrust upon the firm
which are beyond its control.
b. Financial risk: Financial risk is associated with the capital structure
of a company. A company with no debt financing has no financial
risks. The extent of financial risk depends on the leverage of firm’s
capital structure.
c. Credit or Default Risk: The credit risk deals with the probability of
meeting with a default. It is primarily the probability that a buyer will
default. The chances that the borrower will not pay up can stem from a
variety of factors. The borrower’s credit rating might have fallen
suddenly and he became default prone and in its extreme form it lead
to insolvency.
Measurement of Risk:
Risk is associated with the variability in the likelihood of its outcome. If the
returns of an asset have no variabilities, it has no risk. There are different ways to
measure variability of returns or the risk associated with an asset.
Methods of Risk Measurement:
The different methods of risk measurement are as follows:
i. Sensitivity or Range Analysis: Where different returns from an asset are
possible under different circumstances, more than one forecast of the future
returns may be made. These returns may be regarded as ‘optimistic’, ‘most
likely’, and ‘pessimistic’. The range of the returns is the difference between
the highest possible rate of return and the lowest possible rate of return.
According to this measure, an asset having greater range is said to be more
risky than the one having less range.
ii. Probability Distribution: The risk associated with an asset can be measured
more accurately by the use of probability distribution than the range
analysis as the range is based on only two extreme values. The probability
of an event represents the chances of its occurrence. While assigning
probability, the following rules should be kept in mind:
a. The possible outcomes must be mutually exclusive and collectively
exhaustive.
b. The probability assigned to an outcome may vary between 0 and 1.
c. The sum total of probabilities must be equal to 1.
d. If an outcome is certain to occur, it is assigned a possibility of 1,
while an impossible outcome is assigned a probability of 0. Thus, a
 probability can never be greater than 1 or lower than 0, it can never
be a negative number.
iii. Standard Deviation: Standard Deviation, most widely used statistical
technique, is employed in order to measure the dispersion of the probability
distribution. In other words, it represents the variability of forecast returns
when such returns approximate a normal probability distribution. In fact,
the greater the value of standard deviation, the higher is the risk and vice-
versa.
iv. Co-efficient of Variation: Co-efficient of variation is a relative measure of
dispersion which measures the risk per unit of return. Generally, the larger
the co-efficient of variation, the greater will be the risk and vice-versa.
While the expected returns on two alternative proposals are not same, co-
efficient of variation is regarded to be the best measure of variability.
v. Beta Co-efficient: The amount of systematic risk present in particular
security is measured by beta co-efficient. Beta co-efficient measures the
sensitivity of the price of a security in relation to the market movements.
vi. Decision Trees: Decision tree analysis is also another important technique
for measuring risk investment proposals. A decision tree is a graphic
representation of the relationship between a present decision and possible
future events, future decisions and their consequences. The sequence of
events is mapped out over time in a format looking like branches of a tree.
All probabilities estimates of potential outcomes and their effects are taken
into account under this approach.

17.What is Return?
Answer: Return may be defined as the total gain or loss expected on the
investment made in a particular project. Returns are the stream of benefits
expected from an investment decision over a given future period. Future being
uncertain, actual return may vary from the expected return. This variation of
actual return from expected return is known as risk.

18.What do you mean by Bond? State the features of bond.

Answer: A bond is an instrument of debt issued by a business house or a
government unit. Bonds are a form of long term debt. Bonds are generally
issued by organizations for a period of more than one year to raise money by
borrowing. With the view to raise capital; organizations issue bond to investors
which is nothing but a long term contract under which the organizations agreed
to pay periodical interest at a specified rate and the principal amount to the
bondholders.
Features of bonds:
i. A bond is a form of debt under which the investors pay to the issuers for a
specified time. In other words, bondholders offers credit to the company
in the form of bonds.
ii. Bonds usually have a fixed maturity date .
iii. All bonds repay the principal amount after the maturity date; however in
some cases bonds do pay the interest along with the principal to the
bondholders.

19.Discuss briefly the advantages and disadvantages of Bond.

Answer: Advantages of bonds:
i. Bonds have a clear advantages over other securities. The volatility of
bonds [especially short and medium dated bonds] is lower than that of
equities. Thus bonds are generally viewed as safer investments than
stocks. In addition, bonds do suffer from less day-to-day volatility than
stocks, and the interest payment of bonds are sometimes higher than the
general level of dividend payments.
ii. Bonds are often liquid. It is often fairly easy for an institution to sell a
large quantity of bonds without affecting the price much, which may be
more difficult for equities. In effect, bonds are attractive because of the
comparative certainty of a fixed interest payment twice a year and a fixed
lump sum at maturity.
iii. Bondholders also enjoy a measure of legal protection. Under the law of
most countries, if a company goes bankrupt, its bond holders will often
receive some money back, whereas the companies equity stocks often
ends up valueless. Furthermore, bonds come with indentures and
covenants.
iv. There are also a variety of bonds to fit different types of investors
including fixed rate bonds, floating rate bonds, zero coupon bonds,
convertible bonds and inflation linked bonds.

Disadvantages of bonds:
i. Bonds are also subject to various other risks such as call and prepayment
risks, credit risk, reinvestment risk, liquidity risk, event risk , exchange
rate risk, volatility risk, inflation risk, sovereign risk and yield curve risk.
ii. Price changes in a bond will immediately affect mutual funds that hold
these bonds. If the value of the bonds in a trading portfolio falls the value
of the portfolio also falls. This can be damaging for professional investors
such as banks, insurance companies, pension funds and asset managers. If
there is any chance a holder of individual bonds may need to sell his
bonds and cash out the interest rate risk could become a real problem.
iii. Bond prices can become volatile depending on the credit rating of the
issuer. An unanticipated downgrade will cause the market price of the
 bond to fall. As with interest rate risk, this risk does not affect the bonds
interest payments, but put at risk the market price, which affects mutual
funds holding these bonds, and the holders of individual bonds who may
have to sell them.
iv. A company’s bond holders may lose much or all their money if the
company goes bankrupt. Under the laws of many countries, bondholders
are in line to receive the proceeds of the sale of the assets of liquidated
company ahead of some other creditors. Bank lenders, deposit holders
and trade creditors may take precedence.
v. Some bonds are callable, meaning that even though the company has
agreed to make payments plus interest towards the debts for a certain
period of time, the company can choose to pay off the bonds early.This
creates reinvestment risk, meaning the investor is forced to find a new
place for his money. As a consequence, the investor might not be able to
find as good a deal, especially because this usually happens when interest
rates are falling.

20.State the various types of Bonds.

Answer: Following are the various types of bonds:
i. Treasury or Government Bonds: Treasury or govt. bonds are issued by
the Govt. of India, Reserve Bank of India, any State Govt. and any other
government organisation. For example, Govt. of India 8.5% Relief
Bonds, 2001, 8% Relief Bonds, National Savings Certificates and Kisan
Vikas Patra issued by the Indian Postal Department. Fixed rate of interest
is given to holders after the specified period without any default.
ii. Foreign Bonds: Foreign Bonds are issued by foreign companies or
financial institutions or foreign governments in foreign currency. Beyond
default risk, the bond involves another risk, i.e., exchange risk which
occurs due to fluctuations in the exchange rate of the currency of the
bondholders and the exchange rate of the currency of the issuing
company or government.
iii. Municipal Bonds: Municipalities corporations and other semi-
government organizations invite public for the issue of such bonds. By
considering the financial background of municipalities and corporations
in our country, such bonds, unless guaranteed by a state government may
have a high default risk and consequently, the interest rate is likely to be
high.
iv. Fixed Rate Bonds: In fixed rate bonds, the interest remains fixed
throughout the tenure of the bond.
v. Bearer Bonds: Bearer bonds do not carry the name of the bond holder and
anyone who possesses the bond certificate can claim the amount. If the
bond certificate gets stolen or misplaced by the bond holder, anyone else
with the paper can claim the bond amount.
vi. Corporate Bonds: Corporate bonds are issued by corporations to raise
capital. They are safer than equities. The bond holders usually get a
specified return every period. These are highly risky bonds since the
maturity depends on the track record of the company. Before investing in
such bonds, one must go through complete study into the company and its
performance.

21.What is Valuation of Equity? Discuss the various approaches of

valuation of equity shares.
Answer: Every company should have equity share capital because it represents
the real owner of the company. The decision making process of the finance
manager is directed towards the maximization of market price of the equity
share. Therefore, a financial manager as well as an investor is often concerned
with finding out the value of equity shares.
The valuation of equity share is most difficult due to residual ownership
character. Also, the rate of dividend in the case of equity share is not
predetermined and the rate of dividend on equity share may vary over the
years.
Approaches to the valuation of equity shares:
A. Valuation based on dividends [dividend valuation model]
B. Valuation based on earnings [praise earning approach]
C. Accounting concept of valuation [asset valuation approach]

A. Valuation based on dividends:

There are two types of this model:
i. Single valuation model: Returns from equity share may be in
two forms. It may be in the form of dividends or capital
gain/losses. In other words, equity shareholders may receive
dividends and/or may realize capital gain or loss. This model is
suitable where an equity share is bought and sold by an investor
within a period of one year.
ii. Multi-period valuation model: Under this model, there is no
redeemable period for equity shares and the value of an equity
share of infinite duration is equal to discounted / present value
of stream of dividends of infinite period. Through this model,
investor won't be able to forecast all infinite future dividends. In
order to overcome this difficulty, some assumptions are made
with regard to future growth of dividend and these assumptions
are:
a. Valuation with constant dividend [case of zero growth
rate]: Under this, dividend value of an equity shares
remains constant as it is expected that there is no growth
rate. In other words, dividend will remain safe at all time.
 The value can be calculated by using the following
formula:
𝐷1
𝑃0 =
𝑟

b. Valuation with constant growth and dividends [case of

constant growth rate]: It is a fact that dividend increases
over a period of time because concerns generally expand
over a period of time. It is assumed that if dividends grow
in all future periods at constant rate ‘g’ then we get the
value of equity share by applying the following formula:
𝐷𝑡 = 𝐷0 (1 + 𝑔)𝑡

B. Valuation based on Earnings (or Yield Basis): Yield refers to the

earning of a firm relating to its investment. From the valuation of
equity shares point of view, yield means the profit available to
equity shareholders. The earning basis of share valuation maybe
any of the following method:
i. Valuation based on Rate of Return: The term ‘Rate of
Return’ implies a return which a shareholder earns on his
investment. The rate of return can be classified as (a)Rate of
Dividend and (b)Rate of Earning.
a) Valuation based on Rate of Dividend (or Dividend
Capitalization Method): The investors of equity shares
take less interest in the amount of profit earned by the
company rather they are interested in the amount of
dividend declared by the company. Because of that,
sometimes, shares are valued on the basis of dividend.
The value of a share can be calculated according to
this method as follows:
Value of share
Expected Rate of Dividend
= x Paid up value of share
Normal Rate of Dividend

Expected Rate of
Total profit available for Dividend
Dividend= x 100
Total paid up equity share capital

b) Valuation based on Rate of Earning(or Earning

Yield): Earning yield implies the profit attributable to
each equity share. It is generally applicable for
valuing large block of company’s shares/large
investors. Under this method the value of a share can
be determined as follows:
 Expected Rate of Earnings
Value of each equity share= x Paid up value of share
Normal Rate of Return

Profit available to Equity shareholders

Expected Rate= 𝑥 100
Total paid up equity share capital

ii. Valuation based on Price Earnings Ratio: This method is

applicable for ascertaining the market value of shares which
are quoted on a recognised Stock Exchange. Under this
method the shares are valued on the basis of earning per
share multiplied by the price earnings ratio.
iii. Valuation based on Productivity Factor: Productivity factor
is concerned with the earning’s capacity of the company in
relation to the net worth of the company. It is calculated as
follows:
Productivity Factor
Average Weighted Adjusted Taxed Profit
= x 100
Average Weighted Net Worth

C. Accounting Concept of Valuation:

i. Net Asset Method: On the basis of circumstances the method
relating to net asset basis may take the following form:
a. Book or Break-up Value: The net worth available to
equity shareholders divided by the number of equity
shares represents the value of each equity share. An
estimate of worth of the net assets is made by deducting
the total liabilities and preference share capital from the
total realisable assets. Thus,
Net Assets
Book Value =
Number of Equity Shares

ii. Realisation or Liquidation Value: This is the amount of

money that would be received from the company if all its
assets are sold at the time of liquidation. The value realized
from liquidating all the assets minus amount payable to all
the creditors shall be taken the liquidation value of the firm.
Hence,
Liquidation Value=
𝐴𝑚𝑜𝑢𝑛𝑡 𝑟𝑒𝑎𝑙𝑖𝑧𝑒𝑑 𝑓𝑟𝑜𝑚 𝐴𝑠𝑠𝑒𝑡𝑠−𝐴𝑚𝑜𝑢𝑛𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑡𝑜 𝑎𝑙𝑙 𝑐𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑆ℎ𝑎𝑟𝑒𝑠

iii. Replacement Value: Under this method, assets should be

valued on the basis of replacement cost rather component
units with the intention of detailed analysis.
22. State the merits and demerits of Earning basis or Yield basis.
Answer: Following are the merits of Earning basis or Yield basis:
i. The value of each equity share can be easily calculated under
this method as compared to net assets method.
ii. The value of share depends upon what the investor will earn
i.e., a fact on which balance sheet throws little light.
iii. It is a fact that risk factor plays a significant role in any
investment decision while computing the normal rate of
return, the risk factor is taken into consideration at the same
time the value that is finally reached reflects the
consequences of risk.
Demerits of Earning basis or Yield Basis:
i. It becomes difficult to select normal rate of earnings as it
represents the element of risk involved in a particular
business.
ii. The market quotation may not represent the true earnings
power of the company.
iii. This is not an applicable method of valuation when the
company has been suffering losses for a number of years.

23.Discuss Capital Asset Pricing Model (CAPM). Point out its implications.
Does it suffer from limitations?
Answer: Capital Asset Pricing Model:
The Capital Asset Pricing Model(CAPM) is a model which provides a
framework for determining the required rate of return on an asset and helps in
explaining the relationship between risk and return of the asset. This model also
explains how the pricing of an asset or portfolio is determined in the capital
market.
The model: The Capital Asset Pricing Model assumes that total risk of a
portfolio or an asset can be divided into two parts- systematic risk and
unsystematic risk. Systematic risk is the risk which cannot be eliminated
through investing in very diversified market portfolio. Systematic risk is
represented by beta(𝛽). On the other hand, unsystematic risk is that type of risk
which can be eliminated through diversification. Since the unsystematic risk can
be eliminated there is no reward for it and hence it has no impact on the return
of securities. Market will pay premium only for systematic risk as it cannot be
avoided. However, CAPM can be expressed as follows:
R s = If + (R m − If )β
R s =The expected return from a security or market.
If = The risk free interest rate.
R m =The estimated rate of return on market portfolio.
β =Market sensitivity index of individual security on portfolio of securities.
Assumptions of CAPM:
CAPM is based on the following assumptions:
a. Large number of investors: All investors are price takers. Their
number is so large that no single investor can affect prices of
securities.
b. Risk averse: All investors are risk averse in nature all the investors
participating in the capital market measured the risk and return before
investment decision.
c. No transaction cost: There are no transaction costs and income
taxes.
d. Risk free rate: All investors can borrow or lend at a risk free rate of
interest.
Implications and relevance of CAPM:
CAPM is based on a number of assumptions. Based on those assumptions it
gives a logical basis for measuring risk and return however, CAPM has the
following implications:
a. Investors will always combine a risk free asset with the market
portfolio of risky assets. They will invest in risky assets in proportion
to their market value.
b. Investors can expect returns from their investment according to
their risk. This implies a linear relationship between the assets
estimated return and its beta.
c. It assists in identification of undervalued and overvalued assets
traded in the market.
Limitations of CAPM:
CAPM is one of the best models to establish equilibrium between their risk and
return of an asset or portfolio however, it suffers from some limitations, which
are as follows:
a. The value of beta is not easy to calculate and it charges overtime
with the changes in market risk. It does not remain static overtime.
However, weak diversified investors would be concerned with not
only systematic risk but also total risk.
b. Investors do not seem to follow the assumptions of CAPM as these
are far away from reality and non feasible for apply in practical
purpose.
c. CAPM model does not provide any suggestion on the suitable
choice for the risk free rate.
d. Estimates of beta can fluctuate wildly depending upon the market
index and time period considered.
e. It is not easy task to predict the values for risk free rate, market
return and systematic risk for the future.
24.Explain in brief Security Market Line (SLM) and Capital Market Line
(CML).
Answer: Security Market Line (SML):

The graphical representation of CAPM is called security market line (SML).

Security market line describes the expected return of all assets and portfolios of
assets in the economy, the risk of any stock be divided into systematic risk and
unsystematic risk. Beta is the index of systematic risk. In case of portfolios
involving complete diversification, where the unsystematic risk tends to zero
there is only systematic risk measured by beta. Thus, the dimensions of the
security which concern us are expected return and Beta. The expected return on
any asset or portfolio, whether it is efficient or not can be determined by SML
by focusing on Beta of securities.

Capital Market Line (CML):

The capital market line (CML) defines the relationship between total risk and
expected return for portfolios consisting of the risk free asset in the market
portfolio. If all the investors hold the same risky portfolio, then in equilibrium it
must be the market portfolio. CML generates a line on which efficient portfolio
can lie. Those which are not efficient will however lie below the line.

25.Explain the concept of risk-return trade off.

Answer: Every decision taken by financial management affects both risk and
return of the firm. The projects having a higher return are generally
accompanied by higher risk and vice versa. In order to maximize the firm's
value a proper balance will have to be maintained between risk and return
which is called risk return trade off. At this level of risk return, the market value
of the firm will be maximized.
 Suppose,ABC is planning to establish a plant which have two options such as
the capacity of 10,000 tons and a capacity of 5000 tons. The plant having
10,000 tons capacity will have a higher return accompanied by a higher risk. As
such the plant having 5000 tonnes capacity will have a lower return along with a
lower risk. Hence, a capital investment project involving higher return has a
higher risk where as a capital investment project involving lower return has a
lower risk. However, the relationship between risk and return has been depicted
below:

50%

40%

30%

20%

10%

Low Medium Medium Medium High

Expected Return high
Level of Risk

Figure: Relationship between Risk and Return

It has been observed from the above figure that hired the return greater service
than vice versa. However, the risk return trade off analysis expresses the
relationship between rates of return to be achieved on an investment and the
degree of risk assumed in that investment. In other words, the risk return trade
off represents that the return the r rises with an increase in risk. It is of great
importance for investor to strike a point between the intention for the lowest
possible risk and highest possible return.