Question 1

Financial statement analysis is mainly done to assess:

Accepted Answer

Analysis focuses on performance and financial position: profitability, liquidity, solvency, efficiency.

Question 2

MM theory (without taxes) states that capital structure is:

Accepted Answer

MM (no tax) proposition: firm value is independent of leverage in perfect markets.

Question 3

Higher financial leverage generally implies:

Accepted Answer

Debt increases fixed charges, increasing EPS variability and financial risk.

Question 4

The modern objective of financial management is:

Accepted Answer

Wealth maximisation considers cash flows, risk and time value of money.

Question 5

CAPM is used to compute:

Accepted Answer

CAPM estimates required return on equity using beta and risk premium.

Question 6

Debt–equity ratio indicates:

Accepted Answer

Debt-equity reflects the leverage and long-term solvency risk.

Question 7

According to Walter model, if r > k, the firm should prefer:

Accepted Answer

If r exceeds k, retention/reinvestment adds value.

Question 8

The cost of retained earnings is generally considered equal to:

Accepted Answer

Retained earnings belong to equity holders; opportunity cost approximates Ke (basic).

Question 9

Interest coverage ratio is:

Accepted Answer

Interest coverage measures ability to pay interest from EBIT.

Question 10

Payback period method ignores:

Accepted Answer

PB ignores TVM and post-payback cash flows.

Question 11

In NOI approach, as leverage increases, Ke:

Accepted Answer

Ke rises with leverage to offset benefits of debt, keeping Ko constant.

Question 12

Receivables management primarily aims to:

Accepted Answer

Receivables policy balances sales growth with collection and credit risk.

Question 13

Degree of Financial Leverage (DFL) is commonly computed as:

Accepted Answer

DFL = EBIT/(EBIT − Interest) (basic, ignoring taxes/pref).

Question 14

Beta (β) measures:

Accepted Answer

Beta measures systematic/market risk relative to the market portfolio.

Question 15

Which approach is also called 'irrelevance theory' (basic view)?

Accepted Answer

MM without taxes is known for irrelevance proposition.

Question 16

Financial leverage arises mainly due to:

Accepted Answer

Financial leverage is due to fixed financing costs (interest, pref dividend).

Question 17

The CFO of a company is primarily responsible for:

Accepted Answer

CFO is the top finance executive handling strategy, funding, control and risk.

Question 18

After-tax cost of debt is lower than before-tax cost because:

Accepted Answer

Tax shield reduces effective cost of debt: Kd(after) = i(1−t).

Question 19

If WACC increases, then for NPV calculations the discount rate:

Accepted Answer

WACC is used as discount rate; higher WACC means higher discount rate.

Question 20

Diversification primarily helps to reduce:

Accepted Answer

Diversification reduces company-specific risk.

Question 21

Define financial management.

Accepted Answer

Financial management is the process of **planning, raising, investing and controlling funds** to achieve organisational objectives and maximise firm value.

Question 22

Financial management is future-oriented.

Accepted Answer

True. Financial management focuses on future **cash flows** and decisions, whereas accounting is mainly past-oriented reporting.

Question 23

What does beta (β) represent in CAPM?

Accepted Answer

Beta (β) represents **systematic (market) risk**—the sensitivity of a stock’s return to market movements.

Question 24

What is beta (β)?

Accepted Answer

Beta (β) measures **systematic risk** as the sensitivity of a security’s return to market return.

Question 25

Write the basic formula of DFL.

Accepted Answer

Basic formula: **DFL = EBIT / (EBIT − Interest)** (ignoring preference dividend and taxes in basic form).

Question 26

Define operating cycle.

Accepted Answer

Operating cycle is the time gap between **cash payment** for purchases/expenses and **cash collection** from sales.

Question 27

Define operating leverage.

Accepted Answer

Operating leverage is the use of **fixed operating costs** that causes a larger change in **EBIT** for a given change in sales.

Question 28

Define dividend policy.

Accepted Answer

Dividend policy is the firm’s long-term decision regarding **payout** of earnings as dividend versus **retention** for reinvestment.

Question 29

What is initial outlay in a project?

Accepted Answer

Initial outlay is the cash investment at **time 0** (cost of asset + installation + working capital, if any).

Question 30

State one objective of financial management.

Accepted Answer

One objective is **wealth maximisation** (maximising the market value of the firm/shareholders’ wealth).

Question 31

Differentiate between systematic and unsystematic risk (any three points) using a table.

Accepted Answer

Systematic vs unsystematic risk:

| Basis | **Systematic risk** | **Unsystematic risk** |
|---|---|---|
| Source | economy/market factors | firm/industry factors |
| Diversification | **not reducible** | reducible |
| Example | interest rate, recession | strike, product failure |

Hence, only unsystematic risk can be diversified away.

Question 32

Write CAPM formula and explain how beta affects required return (brief) with a flow.

Accepted Answer

CAPM: **Ke = Rf + β(Rm − Rf)**

Beta effect: higher **β** increases the risk premium β(Rm−Rf), so required return rises.

Flow: β ↑ → risk premium ↑ → **Ke ↑**

Question 33

Explain dividend payout ratio and retention ratio relationship with a small table/flow.

Accepted Answer

Payout ratio and retention ratio are complementary:

Retention ratio = 1 − **payout ratio** (in percentage terms).

Flow: Earnings → Dividend (payout) + Retained earnings (retention)

| Item | Formula |
|---|---|
| **Payout ratio** | Dividend / Earnings |
| **Retention ratio** | Retained earnings / Earnings = 1 − payout |

Thus, higher payout implies lower retention for growth funding.

Question 34

Explain liquidity vs profitability trade-off in working capital management (brief) with a table.

Accepted Answer

Trade-off:

- More **liquidity** (higher CA) reduces risk of default/stock-out but increases idle funds → profitability falls.
- More **profitability** focus reduces CA but increases risk of cash crunch.

| Policy | Liquidity | Profitability |
|---|---|---|
| Conservative (more CA) | **high** | lower |
| Aggressive (less CA) | lower | **higher** |

Hence, aim for **optimum working capital**.

Question 35

Compute contribution and EBIT, then DOL: Sales ₹8,00,000; variable cost ₹5,00,000; fixed cost ₹2,00,000.

Accepted Answer

Contribution = Sales − Variable cost = 8,00,000 − 5,00,000 = **₹3,00,000**.

EBIT = Contribution − Fixed cost = 3,00,000 − 2,00,000 = **₹1,00,000**.

DOL = **Contribution/EBIT** = 3,00,000/1,00,000 = **3**.

| Item | Amount (₹) |
|---|---:|
| Contribution | **3,00,000** |
| EBIT | **1,00,000** |
| **DOL** | **3** |

Question 36

Explain how to avoid unit mismatch errors in TVM problems (exam-style) with a short flow.

Accepted Answer

### Core rule
Always match the **rate per period** with the **number of periods**.

### Steps (flow)
Given data → identify compounding/discounting frequency → convert rate to **periodic rate** (r/m) → convert time to **number of periods** (n×m) → apply correct formula → write answer with units

| Given | Convert to |
|---|---|
| 12% p.a. monthly compounding | 1% per month |
| 3 years monthly | 36 months |

### Conclusion
Following this flow prevents the most common TVM mistakes and ensures correct PV/FV results.

Question 37

Differentiate between NPV and IRR (exam-style) and state which is preferred when they conflict (use a table).

Accepted Answer

### Difference

| Basis | **NPV** | **IRR** |
|---|---|---|
| Output | ₹ value added | % return |
| Reinvestment assumption (basic) | at cost of capital | at IRR |
| Use | accept/reject; ranking | accept/reject; ranking |

### Preference in conflict
For **mutually exclusive** projects with conflicting rankings, **NPV is generally preferred** because it measures absolute value addition and aligns with **wealth maximisation**.

### Conclusion
Use NPV as primary criterion; IRR can be used as a supporting indicator.

Question 38

Explain MM dividend irrelevance theory: assumptions and conclusion (exam-style) with a table/flow.

Accepted Answer

### MM irrelevance proposition
MM argues dividend policy does not affect firm value under **perfect market** assumptions.

### Assumptions (basic)
- no taxes and no transaction costs
- perfect information
- fixed investment policy
- investors can create homemade dividends (sell/buy shares)

Flow: Investment policy तय → Earnings/cash flows तय → **Firm value** तय (dividend split doesn’t change value)

| Item | MM view |
|---|---|
| Dividend policy | **irrelevant** |
| Driver of value | **investment policy + earnings** |

### Conclusion
Thus, in ideal conditions dividend is just a distribution decision; value comes from investment returns.

Question 39

Explain inventory management and EOQ concept (exam-style) with a flow/table.

Accepted Answer

### Meaning
Inventory management ensures that inventory is available for smooth production/sales at minimum total cost.

### EOQ concept
EOQ is the order quantity that minimises total inventory cost, balancing:
- **ordering cost** (cost of placing orders)
- **carrying cost** (storage, insurance, obsolescence)

Flow: Ordering cost ↓ with larger orders, Carrying cost ↑ with larger orders → **EOQ at minimum total cost**

| Cost type | Behavior with order size |
|---|---|
| **Ordering cost** | decreases |
| **Carrying cost** | increases |

### Conclusion
By ordering near EOQ, a firm reduces total inventory cost and lowers funds blocked in inventory.

Question 40

Explain agency problem and list measures to reduce it (exam-style) with a small table.

Accepted Answer

### Meaning
Agency problem arises due to separation of **ownership and management**. Managers may pursue personal goals instead of **wealth maximisation**.

### Effects
- unnecessary perks/empire building
- short-term profit focus
- risk choices not aligned with owners

### Measures to reduce agency conflict
| Measure | How it helps |
|---|---|
| **Performance-linked pay** | aligns manager incentives |
| **Board/audit committee** | monitoring and control |
| **Disclosure & audit** | transparency and accountability |

### Conclusion
Strong **corporate governance** reduces agency costs and supports shareholder wealth maximisation.

Financial Management — Question Paper

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