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Financial Management – Class 12 Business Studies notes, important questions and MCQs

NCERT Class 12 Business Studies, chapter 9. Notes, key terms, important questions with answers and MCQs.

Chapter overview

Financial management is concerned with the optimal procurement and use of finance. It involves three major decisions: investment (where to invest), financing (how to raise funds) and dividend (how much profit to distribute). Its main objective is wealth maximisation of shareholders. Financial planning, capital structure and working capital management are key areas.

Objectives and decisions

Objective: maximising shareholders' wealth, reflected in the market price of shares.
Investment decision: long-term (capital budgeting, such as buying machinery) and short-term (working capital); factors include cash flows, rate of return and investment criteria.
Financing decision: choosing the mix of debt and equity; factors include cost, risk, floatation costs, cash flow position, control, and state of the capital market.
Dividend decision: how much of profit to distribute and how much to retain; factors include earnings, stability of dividends, growth opportunities, cash flow, shareholders' preference, taxation, access to capital market and legal constraints.

Financial planning and capital structure

Financial planning estimates fund requirements and their timing, ensuring funds are available when needed and not wasted.
Capital structure is the mix of owners' funds and borrowed funds; using cheaper debt to increase return on equity is trading on equity (financial leverage).
Trading on equity is beneficial only when the return on investment is higher than the cost of debt.

Fixed and working capital

Fixed capital requirements depend on the nature of business, scale of operations, choice of technique, technology upgradation, growth prospects, diversification and financing alternatives such as leasing.
Working capital (current assets − current liabilities) depends on the nature of business, scale, business cycle, seasonal factors, production cycle, credit allowed and availed, and operating efficiency.

Key terms

Financial management: planning, procuring and using funds efficiently to maximise shareholders' wealth
Capital budgeting: long-term investment decisions about fixed assets
Capital structure: the mix of owners' funds and borrowed funds used by a business
Trading on equity: using fixed-cost debt to increase the return to equity shareholders
Working capital: the excess of current assets over current liabilities

Important questions with answers

What is meant by trading on equity?2 marks

Trading on equity means using borrowed funds carrying a fixed rate of interest to increase the return to equity shareholders. If the company earns a rate of return on investment higher than the rate of interest on debt, the surplus increases earnings per share. It is favourable only when the return on investment exceeds the cost of debt.

State any four factors affecting the dividend decision.3 marks

The dividend decision is affected by the amount of current earnings, the need for stability of dividends, growth opportunities that require retaining profits, the cash flow position, shareholders' preference for dividends, taxation policy, access to the capital market, and legal and contractual constraints such as loan agreements.

Explain the three financial decisions and the factors affecting them.5 marks

Financial management involves three major decisions. The investment decision concerns how a firm's funds are invested in different assets. Long-term investment, called capital budgeting, involves buying fixed assets such as machinery or starting a new project, and it affects the firm's earning capacity over many years. It depends on the cash flows of the project, the rate of return, and investment criteria such as payback period and net present value. Short-term investment relates to working capital. The financing decision concerns the quantum of funds to be raised from various sources, especially the mix of debt and equity. It depends on the cost of each source, financial risk, floatation costs, the firm's cash flow position, the fixed operating cost, the effect on control, and the state of the capital market. Using debt can raise returns through trading on equity but increases risk. The dividend decision concerns how much of the profit is to be distributed as dividend and how much retained for reinvestment. It depends on earnings, stability of earnings and dividends, growth opportunities, cash flow position, shareholders' preference, taxation, access to the capital market and legal and contractual constraints. All three decisions together aim at maximising shareholders' wealth.

Quick revision

Objective: wealth maximisation.
Decisions: investment, financing, dividend.
Capital structure; trading on equity when ROI > cost of debt.
Factors affecting fixed and working capital.

Exam tips

For each financial decision, learn at least four affecting factors.
Explain trading on equity with a simple numerical example comparing ROI and interest rate.

Practice MCQs

The main objective of financial management is
1. maximising shareholders' wealth
2. maximising sales
3. minimising taxes
4. maximising expenses
Show answer
Answer: (a) maximising shareholders' wealth. It is reflected in share price.
Deciding to buy new machinery is a
1. investment decision
2. financing decision
3. dividend decision
4. marketing decision
Show answer
Answer: (a) investment decision. It is capital budgeting.
The mix of debt and equity in a company is its
1. working capital
2. budget
3. dividend policy
4. capital structure
Show answer
Answer: (d) capital structure. It is decided by the financing decision.
Deciding how much profit to distribute to shareholders is the
1. dividend decision
2. financing decision
3. investment decision
4. pricing decision
Show answer
Answer: (a) dividend decision. The rest is retained.
Trading on equity is beneficial when
1. ROI is lower than the interest rate
2. profits are negative
3. there is no debt
4. ROI is higher than the interest rate on debt
Show answer
Answer: (d) ROI is higher than the interest rate on debt. Shareholders gain from the difference.
A business with a long production cycle needs
1. less working capital
2. more working capital
3. no working capital
4. no fixed capital
Show answer
Answer: (b) more working capital. Funds remain tied up longer.
A trading firm usually needs
1. more fixed capital and less working capital
2. no working capital
3. less fixed capital and more working capital
4. equal amounts always
Show answer
Answer: (c) less fixed capital and more working capital. It holds stock rather than plant.
A company with stable earnings and good growth opportunities is likely to
1. pay all profits as dividend
2. retain more earnings to finance growth
3. stop all dividends forever
4. borrow to pay dividends
Show answer
Answer: (b) retain more earnings to finance growth. Retained earnings are a cheap source.

All chapters of Class 12 Business Studies

Written by Kundali IQ from standard, well-established facts to help with revision. This is not an official NCERT publication; always read your textbook too.