Financial Management Test - 2

Among the given alternatives, a decision with regard to installation of new machinery is the odd one out. This is because it is a long-term investment decision (capital budgeting decision), while the remaining are short-term investment decisions (working capital decisions).

Only Statement 1 is correct, while Statement 2 is incorrect.

Various factors affect the financing decisions of a firm. One of the factors is cash flow position of the firm. Stronger the cash flow position of the firm, more would be the suitability of debt over equity financing.

Another factor is fixed operating cost. If a firm has high fixed operating cost, then the fixed financing cost must be lowered. For this, debt must be lowered.

Financial risk refers to the risk that borrowed funds would not be repaid. Debt involves large financial risk. On the other hand, equity and retained capital do not involve any such risk.

If the required raw material is easily available, then the firm need not maintain high stocks. In other words, the requirement of working capital would be low.

A long-term investment decision is called a capital budgeting decision, and it is irreversible.

Such investment decisions which are long term are known as capital budgeting decisions. For example, investment in a new fixed asset, new machinery etc. Such investment involves a huge amount of money. Accordingly, it is very difficult to reverse such decisions. Reversing such decisions would involve a huge cost.

Capital structure refers to the ratio of debt and equity. Capital structure is said to be optimal when the ratio of debt and equity is such that the value of equity share increases, or in other words, the shareholder’s wealth increases.

The first step in the process of financial planning is to estimate the sales of the firm. Based on this, it would be estimated how much funds would be required for the firm in the financial year. Next, the expected profits are estimated. Accordingly, it is estimated that what proportion of the fund requirement can be met internally and how much external funding would be required. Further, the sources from which the funds can be obtained are identified.

In the given situation, a capital budgeting decision is being made. Such investment decisions are long term. For example, investment in a new fixed asset, new machinery etc. Such investment involves a huge amount of money. Accordingly, it is very difficult to reverse such decisions.

The basic objective of financial management is to maximise the wealth of shareholders. Such financial decisions are taken wherein the anticipated benefits exceed the cost incurred, which in turn implies an improvement in the market value of shares. An increase in the market value of shares, in turn, is gainful for the shareholders. In other words, decisions taken prove to be beneficial for shareholders.

Financial planning involves identifying the sources from where the funds can be obtained and ensuring that the required funds are available to the firm as and when needed. However, it discourages surplus or excess funding because such a practice unnecessarily adds to the cost of the firm.