I. Multiple Choice Questions
Tick (✓) the correct answer out of the given alternatives:
Question 1. Equity shareholders are called:
(a) Owners of the company (b) Partners of the company
(c) Executives of the company (d) Guardian of the company
Question 2.The term ‘redeemable’ is used for
(a) Preference shares (b) Commercial paper
(c) Equity shares (d) Public deposits
Question 3. Funds required for purchasing current assets is an example of
(a) Fixed capital requirement (b) Ploughing back of profits
(c) Working capital requirement (d) Lease financing
Question 4. ADRs are issued in
(a) Canada (b) China
(c) India (d) USA
Question 5. Public deposits are the deposits that are raised directly from
(a) The public (b) The directors
(c) The auditors (d) The owners
Question 6. Under the lease agreement, the lessee gets the right to
(a) Share profits earned by the lessor
(b) Participate in the management of the organization
(c) Use the asset for a specified period
(d) Sell the assets
Question 7. Debentures represent
(a) Fixed capital of the company (b) Permanent capital of the company
(c) Fluctuating capital of the company (d) Loan capital of the company
Question 8. Under the factoring arrangement, the factor
(a) Produces and distributes the goods or services
(b) Makes the payment on behalf of the client
(c) Collects the client’s debt or account receivables
(d) Transfer the goods from one place to another
Question 9. The maturity period of a commercial paper usually ranges from
(a) 20 to 40 days (b) 60 to 90 days
(c) 120 to 365 days (d) 90 to 364 days
Question 10. Internal sources of capital are those that are
(а) Generated through outsiders such as suppliers
(b) Generated through loans from commercial banks
(c) Generated through issue of shares
(d) Generated within the business
1. (a) 2. (a) 3. (c) 4.(d) 5.(a)
6. (c) 7. (d) 8. (c) 9. (d) 10. (d)
II. Short Answer Type Questions
Question 1. What is business finance? Why do businesses need funds? Explain.
Answer:Business is concerned with production and distribution of goods and services for the satisfaction of need of society. A business cannot function unless adequate funds are made available to it. The need of fund arises from the stage when an entrepreneur makes a decision to start a business. Some funds are needed immediately. The financial need of a business can be categorized in the following ways:
Fixed Capital Requirements:In order to start business, funds are required to purchase fixed assets like land and building, plant and machinery, and furniture and fixures. This is known as fixed capital requirement of an enterprise.
Working Capital Requirements:The financial requirements of an enterprise do not end with the procurement of fixed assets. No matter how small or large business, it need funds for its day-to-day operations. This is known as working capital of an enterprise which is used for holding current assets like stock, bill receivable, current expenses etc. Therefore, a business needs funds to meet its fixed as well as working capital requirements.
Question 2. List sources of raising long-term and short term finance.
Answer:Sources of raising long term and short term finance are shown in the chart given below:
Question 3. What is the difference between internal and external sources of raising funds? Explain.
Answer:The differences between interned and external sources of raising funds are summarized in the table given as follows:
Question 4. What preferential rights are enjoyed by preference shareholders? Explain.
Answer:Following preferential rights are enjoyed by the preference shareholders:
They get dividend at a fixed rate and dividend is given on these shares before any dividend on equity shares.
When company winds up, preference shares are paid before equity shares.
Preference shares also have a right to participate in excess profits left after payment being made to equity shares.
They also have a right to participate in the premium at the time of redemption. In lieu of these preferential rights, their voting rights are taken i.e. they are not eligible for voting.
Question 5. Name any three special financial institutions and state their objectives.
Answer:Given below are three financial institutions along with their objectives:
1. Industrial Credit and Investment Corporation of India (ICICI):It came into existence in 1955 as a public limited company under the Companies Act, 1956.Objective:ICICI assists the expansion and modernisation of industrial enterprises exclusively in the private sector. The corporation has also encouraged the participation of foreign capital in the country.
2. Industrial Development Bank of India (IDBI):It came into existence in 1964 under the Industrial Development Bank of India Act, 1964.
Objective:Its objective was to coordinate the activities of other financial institutions including commercial banks. The bank performed three types of functions namely, assistance to other financial institutions, direct assistance to industrial concerns and promotion and coordination of financial technique service.
3. Life Insurance Corporation of India (LIC): It came into existence in 1956 under the LIC Act 1956 after nationalising 245 existing insurance companies.
Objective:It mobilises the community saving in the form of insurance premia and makes it available to industrial concerns. Both public as well as private, in the form of direct loan and underwriting of an subscription to shares and debentures.
Question 6. What is the difference between GDR and ADR? Explain.
Answer:Global Depository Receipts (GDRs): GDR is an instrument issued by a company to raise funds in some foreign currency and is listed and traded on a foreign stock
exchange. American Depository Receipts (ADRs): The depository receipts issued by the company in the USA are called American Depository Receipts.
GDR and ADR are similar to each other except:
GDR can be issued to anyone but ADRs can be issued only to an American citizen.
GDR can be listed and traded in stock exchange of any country but ADRs can be listed and traded only in the stock exchange of USA.
III. Long Answer Type Questions
Question 1. Explain trade credit and bank credit as sources of short term finance for business enterprises.
Answer:Trade Credit: Trade credit is the credit extended by the trader to another to purchase goods and services. It facilitates the purchase of supplies without immediate payment. In books of accounts they are shown as “creditors’ or ‘ills payable’.
Merits of Trade Credit
It is a convenient and continuous source of finance.
It is readily available.
It helps in promoting sales of an organization.
If an organization wants to expand its inventory level so as to meet expected rise in demand, it may use trade credit.
It does not demand any security.
Demerits of Trade Credit
When easy and flexible trade credit is available, it may induce the firm to indulge in over trading.
Trade credit can meet only limited financial needs. Funds required for inventory can be met through it but not others like plant and machinery, land and building or salaries of employees etc.
Bank Credit:Borrowings from banks are an important source of finance to companies. Bank lending is still mainly short term, although medium-term lending is quite common these days.
Short term lending may be in the form of:
An overdraft, which a company should keep within a limit set by the bank. Interest is charged (at a variable rate) on the amount by which the company is overdrawn from day to day.
A short-term loan, for up to three years.
Medium-term loans are loans for a period of three to ten years.
The rate of interest charged on medium-term bank lending to large companies will be a set margin, with the size of the margin depending on the credit standing and risk of the borrower. A loan may have a fixed rate of interest or a variable interest rate, so that the rate of interest charged will be adjusted every three, six, nine or twelve months in line with recent movements in the Base Lending Rate.
Merits of Bank Credit
Economical:Rate of interest charged by banks is quite nominal and is therefore economical.
Maintains business secrecy:Banks maintain secrecy of the business. They do not disclose the information shared to any third party.
Less formalities:As compared to issue of shares, debentures or accepting public deposits, it has less legal formalities..
Flexible source:It can be increased or decreased as per the requirements of the business. It is not so that once a loan is taken it can’t be reduced.
Limitations of Bank Credit
Short-term financing: It does not provide loans for long term as shares and debentures do.
Difficult procedure: As compared to commercial papers and trade credit, it involves many legal and paper formalities. It makes its procedure difficult.
Restrictive clauses: Bank credit has many restrictive clauses which includes mortgage on company’s assets or ineligibility to raise funds from specific sources.
Question 2. Discuss the sources from which a large industrial enterprise can raise capital for financing modernisation and expansion.
Answer:A large industrial enterprise can raise capital from the following sources.
1. Equity Shares:Equity shares are the most important source of raising long term capital by a company. They represent the ownership of a company and therefore, the capital raised by issue of these shares is called owner’s funds. These shareholders do not get a fixed dividend. They get according to the earnings of the company. They receive what is left after all other claims on the company’s income and assets have been settled. They enjoy the reward and also bear the risk of ownership. They have voting rights. Using their voting rights, they get participation in management of the company.
2. Preference Shares:Preference shareholders are called so because they enjoy some preferential rights over equity shares. They get dividend at a fixed rate and dividend is given on these shares before any dividend on equity shares. When company winds up, preference shares are paid before equity shares. Preference shares also have a right to participate in excess profits left after payment being made to equity shares. They also have a right to participate in the premium at the time of redemption. In lieu of these preferential rights, their voting rights are taken i.e. they are not eligible for voting. Preference shares have some characteristics of equity shares as well as debentures. They are safer investment with stable return from investor’s point of view and free from control from owner’s point of view.
3. Debentures:Debenture is an acknowledgement by a company that the company has borrowed certain amount from the debenture holder which it promises to pay on a specific date. It is an important source for raising long term debt capital. Debentures bear a fixed rate of interest. In recent times, issue of zero interest debentures has also become popular which do not carry any explicit rate of interest. But they are issued at discount and redeemed at a premium or at par. It is the return on the debenture. Public issue of debentures requires that issue of debentures should be rated by a credit rating agency like CRISIL (Creditrating and Information Services of India Limited).
4. Loans from Financial Institutions:The government has established many financial institutions like LIC, IDBI, ICICI etc all over the country to provide finance to these organizations. These institutions are established by central and state government both. These institutions provide owned capital as well as borrowed capital for long term and short term requirements. They provide financial and technical advice and consultancy to business firms. Obtaining loan from a financial institution increases goodwill of a company. These sources are available even during depression. Loans can be repaid in easy instalments.
5. Loans from Commercial Banks:Borrowings from banks are an important source of finance to companies. Bank lending is still mainly short term, although medium- term lending is quite common these days. The rate of interest charged on medium- term bank lending to large companies will be a set margin, with the size of the margin depending on the credit standing and risk of the borrower. A loan may have a fixed rate of interest or a variable interest rate, so that the rate of interest charged will be adjusted every three, six, nine or twelve months in line with recent movements in the Base Lending Rate. Short term lending may be in the form of:
(i) An overdraft, which a company should keep within a limit set by the bank. Interest is charged (at a variable rate) on the amount by which the company is overdrawn from day to day.
(ii) A short-term loan, for up to three years.
(iii) Medium-term loans are loans for a period of three to ten years.
6. Retained Earnings:For any company, the amount of earnings retained within the business has a direct impact on the amount of dividends. Profit re-invested as retained earnings is profit that could have been paid as a dividend. The management of many companies believes that retained earnings are funds which do not cost anything, although this is not true. However, it is true that the use of retained earnings as a source of funds does not lead to a payment of cash. In practice, the dividend policy of the company is determined by the directors. From their standpoint, retained earnings are an attractive source of finance because investment projects can be undertaken without involving either the shareholders or any outsiders. The use of retained earnings as opposed to new shares or debentures avoids issue costs. The use of retained earnings avoids the possibility of a change in control resulting from an issue of new shares. Another factor that may be of importance is the financial and taxation position of the company’s shareholders. For example, because of taxation considerations, they would rather make a capital profit (which will only be taxed when shares are sold) than receive current income, then finance through retained earnings would be preferred to other methods.
Question 3. What advantage does issue of debentures provide over the issue of equity shares?
Answer:Debentures provide following advantages over issue of equity shares.
1. Voting Rights:Voting rights are not given to debentures while equity shareholders have voting rights.
2. Dilution of Controlling Power:Since voting power is not given, therefore, if funds are raised by issue of debentures then controlling power does not get diluted.
3. Redeemable:Debentures are redeemable. Therefore, funds become flexible. When funds are not required permanently but for 5 or 10 years, debentures are more suitable.
4. Fixed Rate of Interest:Debentures are to be paid at fixed rate of interest. However, we need to share profits with equity shareholders.
5. Creditor versus Owner:Debenture holder is a creditor of the company and cannot take part in the management of the company while a shareholder is the owner of the company. It is the basic distinction between a debenture and a share.
6. Convertibility:Shares cannot be converted into debentures whereas debentures can be converted into shares.
Question 4. State the merits and demerits of public deposits and retained earnings as methods of business finance.
Answer:Public Deposits: Deposits accepted from public directly by the companies are called public deposits. These deposits generally carry a rate of interest higher than the deposits in commercial banks.
Merits of Public Deposits
The procedure of obtaining deposits is simple and does not contain restrictive conditions.
Cost of public deposits is generally lower than the cost of borrowings from banks and financial institutions.
Public company usually does not create a charge on the assets of the company.
As the depositors do not have voting rights, it does not dilute control in the company.
Demerits of Public Deposits
It is difficult for a newly established company to be able to get funds from public deposits.
It is dependent on public response and can’t be relied on if financial needs are urgent.
It is difficult especially when size of deposits is large.
Retained Earnings:For any company, the amount of earnings retained within the business has a direct impact on the amount of dividends. Profit re-invested as retained earnings is profit that could have been paid as a dividend.
Merits of Retained Earnings:
The management of many companies believes that retained earnings are funds which do not cost anything, although this is not true. However, it is true that the use of retained earnings as a source of funds does not lead to the payment of cash.
The dividend policy of the company is in practice determined by the directors. From their standpoint, retained earnings are an attractive source of finance because investment projects can be undertaken without involving either the shareholders or any outsiders.
The use of retained earnings as opposed to new shares or debentures avoids issue costs.
The use of retained earnings avoids the possibility of a change in control resulting from an issue of new shares.
Another factor that may be of importance is the financial and taxation position of the company’s shareholders. For example, because of taxation considerations, they would rather make a capital profit (which will only be taxed when shares are sold) than receive current income, then finance through retained earnings would be preferred to other methods.
Demerits of Retained Earnings:
A company must restrict its self-financing through retained profits because shareholders should be paid a reasonable dividend, in line with realistic expectations, even if the directors would rather keep the funds for re-investing.
At the same time, a company that is looking for extra funds will not be expected by investors (such as banks) to pay generous dividends, nor over-generous salaries to owner-directors.
Scope of retained earnings is limited by amount of profits. A loss incurring firm has no source called retained earnings.
Question 5. Discuss the financial instruments used in international financing.
Answer:Following financial instruments are used in international financing:
1. Global Depository Receipts (GDRs):The local currency shares of a company are delivered to the depository bank. The depository bank issues depository receipts against these shares. When these depository receipts are denominated in US $, they are called GDR. It is a bank certificate issued in more than one country for shares in a foreign company. The shares are held by a foreign branch of an international bank. The shares trade as domestic shares, but are offered for sale globally through the various bank branches. A financial instrument used by private markets to raise capital denominated in either U.S. dollars or Euros. These instruments are called EDRs when private markets are attempting to obtain Euros. It is a negotiable instrument and can be traded freely like any other security. A holder of GDR can convert it into any other security at any time. Holders of GDR are eligible only for capital appreciation and dividend but no voting rights.
2. American Depository Receipts (ADRs):When a company in the USA issues depository receipts, they are termed as American Depository Receipts (ADRs). These are bought and sold in stock markets of the USA. They are similar to GDR except that these can be issued only to American citizens and these can be listed and traded on a stock exchange of USA.
3. Foreign Currency Convertible Bonds (FCCBs): Foreign Currency Convertible Bonds are equity linked debt securities that are to be converted into equity or depository receipts after a specific period. Foreign Currency Convertible Bonds are listed and traded in Foreign Stock Exchanges. A holder of Foreign Currency Convertible Bonds has the option of converting them into equity shares at a pre-determined price. Foreign Currency Convertible Bonds are issued in foreign currency. Their rate of interest is lower than rate of any other similar non convertible debt instrument.
Question 6. What is commercial paper? What are its advantages and limitations?
Commercial paper is an unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities.
Maturities on commercial paper can range up to 365 days. The debt is usually issued at a discount, reflecting prevailing market interest rates.
Commercial paper is not usually backed by any form of collateral, so only firms with high-quality debt ratings will easily find buyers without having to offer a substantial discount (higher cost) for the debt issue.
Advantages and Limitations of Commercial Paper Advantages:
For the most part, commercial paper is a very safe investment because the financial situation of a company can easily be predicted over a few months.
Typically only companies with high credit ratings and creditworthiness issue commercial paper. Hence the companies issuing them enjoy (a) the prestige associated
with such issuance and (b) the ability to issue large quantum without much hassles like other types of financing which requires restrictions from regulatory bodies.
Interest rate is generally lower compared to others like bank loans and other types of short term financing
It does not have any flexibility with regard to repayments.
MORE QUESTIONS SOLVED
I. VeryShort Answer Type Questions
Question 1. Give the full form of GDR and ADR.
Answer:Global Depository Receipts and American Depository Receipts
Question 2. State various sources of long term funds.
Answer:Various sources of long term funds include: Equity shares, preference shares, debentures, retained earnings, loans from financial institutions, loans from commercial banks etc.
Question 3. State various sources of short and medium term funds.
Answer:Short term sources include trade credit, factoring, banks and commercial papers. Middle term credit sources include loans from banks, public deposits, loans from financial institutions and lease financing.
Question 4. What are the preferences given to preference shareholders?
1. They get dividend at a fixed rate and dividend is given on these shares before any dividend on equity shares.
2. When company winds up, preference shares are paid before equity shares.
3. Preference shares also have a right to participate in excess profits left after payment being made to equity shares.
4. They also have a right to participate in the premium at the time of redemption.
Question 5. Name two sources of funds under owner’s fund.
Answer:Equity shares and retained earnings
Question 6. Who are called the owners of a company?
Answer:Equity shareholders are called the owners of the company.
Question 7. Which deposits are directly raised from the public?
Question 8. What are the two important functions of factors?
Answer:(a) Discounting of bills and collection of the client’s receivables.
(b) Providing information to the client on credit worthiness of prospective client.
Question 9. What is the status of debenture holders?
Answer:Debenture holders are creditors of the company.
Question 10. In leasing agreement what right is given to lessee?
Answer:The right to use the asset in lieu of specific prepayment for a specific time period.
Question 11. Preference shares are not suitable for which kind of investors?
Answer:It is not suitable for those investors who want to get a fixed return without failure.
Question 12. What are Indian depository receipts (IDRs)?
Answer:IDR is an instrument in the form of a depository receipt created by the Indian depository in India against the underlying equity shares of the issuing company.
Question 13. Name the two Indian companies which have raised money through issue of GDRs.
Answer:WIPRO and ICICI
Question 14. Who regulates the acceptance of public deposits?
Answer:Reserve Bank of India
Question 15. What is factoring?
Answer:Factoring is a financial service under which the factor of discounting of the bills of exchange of the clients and collects his debts and also provides him information on credit worthiness of perspective client. He charges fees for the services rendered.
Question 16. What are retained earnings?
Answer:A company generally does not distribute all its earnings amongst shareholders in the form of dividend. A portion of the net earnings may be retained in the business of ruse in future. These are called retained earnings.
Question 17. What are public deposits?
Answer:Public deposits are the deposits raised by organizations directly from the public.
Question 18. Specify the objective of I.D.B.I.
Answer:Its objective was to coordinate the activities of other financial institutions including commercial banks. The bank performs three types of functions namely, assistance to other financial institutions, direct assistance to industrial concerns and promotion and coordination of financial technique service.
Question 19. What do you mean by discounting of bills of exchange?
Answer:Discounting of bills of exchange means that the bank pays the person beforehand at less than face value and receives the payment on maturity equivalent to maturity value. The difference between the amount paid and face value is the return for discounting bills of exchange.
Question 20. What is a trade credit?
Answer:Trade credit is the credit extended by one trader to another for the purchase of goods and services.
Question 21. What is debenture?
Answer:A debenture is a document or certificate, which is issued under the common seal of the company, acknowledging its debt to the holders at given terms and conditions.
Question 22. Why preferences are given to preferential shares?
Answer:They are given some preferences because they are not given voting rights.
Question 23. State two factors affecting the fixed capital requirement of a firm.
Answer:Size of business and nature of business.
Question 24. Why is equity share capital called ‘Risk Capital’?
Answer:Equity shareholders get return only when profits is left after paying interest on debentures and fixed return on preference shares. Therefore, it is called risk capital as it bears maximum risk.
Question 25. State two factors affecting the working capital requirement of a firm.
Answer:Nature of business and speed of sales turnover.
II. Short Answer Type Questions
Question 1. State the meaning of finance. What factors determine working capital and fixed capital requirements of a business?
Answer:No business can be started, run or expanded without finance. There are many sources of finance. Each source has its own merits and demerits. Business needs to choose right source of finance to make the best use of it.
Business finance refers to the money required for carrying out business activities. Factors determining working capital requirements of a business:
Whether firm is selling goods on credit or cash:If the firm is selling goods on credit or cash, then its working capital requirements will be more. On the other hand, if it is selling in cash, its working capital requirements will be less.
Speed of sales turnover:A firm whose sales process gets converted into cash soon will have lesser working capital requirements and a firm whose sales process gets converted into cash in delay will have more working capital requirements.
Size and scale of business:If business is operating at a larger scale then working capital requirements will be more. On the other hand, if size and scale of operations is small, its working capital requirements will be less.
Factors determining Fixed Capital Requirements
Size and scale of business:If business is operating at a larger scale then fixed capital requirements will be more. On the other hand, if size and scale of operations is small, its fixed capital requirements will be less.
Technology:A firm using labour intensive method needs lesser fixed capital and a firm using capital intensive methods needs more fixed capital.
Question 2. Why does business enterprise need finance?
Answer:A business needs finance because:
1. Business is concerned with production and distribution of goods and services for the satisfaction of needs of society. There are four factors required for any production: land, labour, capital and entrepreneur. All these factors need to be paid for their services.
2. No business can be carried without availability of adequate funds.
3. As soon as a decision is taken to start a business, requirement of funds initiates.
4. Finance is called ‘life blood of a business’.
5. It is very important to assess financial needs of the organization and the identification of various sources of finance.
Question 3. List different types of finance.
Question 4. Differentiate between:
(a) Fixed Capital and Working Capital
(b) Short Term Finance and Long Term finance
(c) Owner’s Funds and Borrowed Funds
(d) Internal Sources and External Sources
Answer:(a) Fixed Capital and Working Capital
(b) Short Term Finance and Long Term Finance
(c) Owner’s Funds and Borrowed Funds
(d) Internal and External Sources
Question 5. Preference shares are preferred by company but not by investors. Why?
Answer:Preference shares have a filed percentage dividend before any dividend is paid to the ordinary shareholders. As with ordinary shares a preference dividend can only be paid if sufficient distributable profits are available, although with ‘cumulative’ preference shares the right to an unpaid dividend is carried forward to later years. The arrears of dividend on cumulative preference shares must be paid before any dividend is paid to the ordinary shareholders.
From the company’s point of view, preference shares are advantageous in the following ways:
1. Dividends do not have to be paid in a year in which profits are poor, while this is not the case with interest payments on long term debt (loans or debentures).
2. Since they do not carry voting rights, preference shares avoid diluting the control of existing shareholders while an issue of equity shares would not.
3. Unless they are redeemable, issuing preference shares will lower the company’s gearing. Redeemable preference shares are normally treated as debt when gearing is calculated.
4. The issue of preference shares does not restrict the company’s borrowing power, at least in the sense that preference share capital is not secured against assets in the business.
5. The non-payment of dividend does not give the preference shareholders the right to appoint a receiver, a right which is normally given to debenture holders.
However, dividend payments on preference shares are not tax deductible in the way that interest payments on debt are. Furthermore, for preference shares to be attractive to investors, the level of payment needs to be higher than for interest on debt to compensate for the additional risks.
For the investor, preference shares are less attractive than loan stock because:
1. They cannot be secured on the company’s assets.
2. The dividend yield traditionally offered on preference dividends has been too low to provide an attractive investment compared with the interest yields on loan stock in view of the additional risk involved.
Question 6. What are the differences between Equity Shares and Preference Shares?
Answer:Differences between Equity shares and Preference shares are as follows:
Question 7. Write a short note on the features of GDRs.
Answer:GDRs have the following features:
A bank certificate issued in more than one country for shares in a foreign company.
The shares are held by a foreign branch of an international bank. The shares trade as domestic shares, but are offered for sale globally through the various bank branches. ‘
A financial instrument used by private markets to raise capital denominated in either U.S. dollars or Euros.
Holders of GDR are eligible only for capital appreciation and dividend but no voting rights.
These instruments are called EDRs when private markets are attempting to obtain Euros.
It is a negotiable instrument and can be traded freely like any other security.
A holder of GDR can convert it into any other security at any time.
Question 8. Name zones of the Lessors and Lessees in India.
Specialised Leasing Companies’
Banks and Bank Subsidiaries
Specialised Financial Institutions
Manufacturer Lessors The Lessees
Public Sector Undertakings
Mid Market Companies
Government Departments and Authorities
Question 9. Classify internal and external sources on the basis of time.