Scope, Objectives and Types of Financing — Practice

Question 1

State the three core decisions of financial management and briefly explain how the financing decision affects the investment decision.

Accepted Answer

The three core decisions are the investment decision, concerning which assets or projects the firm commits funds to; the financing decision, concerning from which sources and in what mix funds are raised; and the dividend decision, concerning how much of earnings is distributed versus retained. The financing decision affects the investment decision because the mix and cost of financing sources chosen determines the firm's overall cost of capital, and this cost of capital is then used as the discount rate to evaluate whether a prospective investment or project should be accepted, so a change in the financing mix that changes the cost of capital can change which investment decisions appear worthwhile.

Question 2

State three specific objections to profit maximisation as the objective of financial management, and explain how wealth maximisation resolves each.

Accepted Answer

First, profit maximisation ignores the time value of money, treating a rupee of profit earned now as equivalent to a rupee earned years later, whereas wealth maximisation, based on the present value of expected future benefits, correctly values earlier profit more highly than later profit of the same amount. Second, profit maximisation ignores risk, being indifferent between a safe and a volatile route to the same expected profit, whereas wealth maximisation, since market value reflects cash flows discounted at a rate that rises with risk, correctly values the riskier path lower. Third, profit maximisation is an ambiguous measure, since profit can mean several different accounting figures and can be inflated in the short term at the expense of long-term value, whereas wealth maximisation is unambiguous, resting on the single, market-determined value of the firm's equity, which cannot be manipulated by a short-term accounting choice without that manipulation eventually being reflected in a lower valuation once discovered.

Question 3

Wealth maximisation is often defined as the maximisation of market value of equity shares. How does this objective apply to a company whose shares are not listed and do not trade in an observable market?

Accepted Answer

For an unlisted company, wealth maximisation is understood as the maximisation of the firm's intrinsic or fundamental value, meaning the value the firm's equity would command if it were valued using the same underlying logic that a market would apply, namely the present value of the stream of future benefits the firm is expected to generate for its shareholders, discounted at a rate appropriate to the risk involved. The absence of a traded market price does not change the underlying objective; it only means that value must be estimated through valuation techniques rather than observed directly from a share price.

Question 4

Compare equity share capital, preference share capital and debentures on three dimensions: nature of return, obligation to pay, and tax treatment.

Accepted Answer

On nature of return, equity shareholders receive a dividend only when declared by the board out of profit, with no fixed rate and full participation in residual profit and control; preference shareholders receive a dividend at a fixed rate, ranking ahead of equity but still payable only out of profits; debenture holders receive interest at a fixed rate as creditors of the company, not as owners. On obligation to pay, equity carries no obligation at all in a year of no profit or no declaration; preference dividend, if cumulative, accumulates as arrears to be paid before any future equity dividend, though it is not a legal debt until declared, while non-cumulative preference dividend is simply lost for that year; debenture interest is a legal obligation payable irrespective of whether the company has earned any profit at all, and default can lead to legal consequences including winding up proceedings. On tax treatment, dividend paid on both equity and preference capital is an appropriation of profit and is not tax-deductible to the company, while interest on debentures is a charge against profit and is fully tax-deductible, which is the central reason debt is typically the cheaper source of finance on an after-tax basis.

Question 5

A manufacturing company finances the construction of a new factory building, a fixed asset with a useful life of thirty years, entirely through a one-year renewable bank overdraft. Identify the principle this violates and explain the risk it creates.

Accepted Answer

This violates the maturity-matching principle, which holds that the duration of a financing source should be matched to the duration of the need it funds, so that long-term assets are financed by long-term sources and short-term, self-liquidating needs are financed by short-term sources. Financing a thirty-year fixed asset with a one-year renewable overdraft creates renewal risk, since the company must seek the bank's agreement to renew the facility every single year for the asset's entire useful life, and if the bank declines to renew at any point, whether due to the bank's own liquidity constraints, a change in the company's credit standing, or a general tightening of credit conditions in the market, the company could face a funding crisis for an asset that generates cash flow only gradually over decades and cannot be quickly liquidated to repay a suddenly-called facility. It also creates interest rate risk, since a short-term facility's rate typically resets far more frequently than a long-term loan's rate would, exposing the company to fluctuating financing costs on what is fundamentally a long-term commitment.

Question 6

A supplier offers terms of 2/10 net 40, meaning a 2% discount if paid within 10 days, or the full amount due within 40 days. Explain why a firm that pays on day 40 has not obtained free financing, even though no explicit interest is charged.

Accepted Answer

A firm paying on day 40 has forgone the 2% discount it could have claimed by paying on day 10, and this forgone discount is the real, implicit cost of using the additional 30 days of credit between day 10 and day 40, even though no invoice ever states an explicit interest rate. Expressed as an annualised cost, forgoing a 2% discount to delay payment by 30 days is a materially expensive form of financing when annualised over a 365-day year, often working out to an implicit annual rate well above what a bank would charge for a formal short-term loan, which is why trade credit taken beyond the discount period is not free financing but simply an uncosted one unless the firm deliberately calculates and compares this implicit rate against its alternatives.

Question 7

Explain why retained earnings, though described as an 'internal' source of finance with no explicit interest or dividend attached to them, are not a cost-free source of capital under the wealth maximisation objective.

Accepted Answer

Retained earnings belong to the equity shareholders, since they represent profit that could have been distributed as dividend but was instead reinvested in the business on the shareholders' behalf, and shareholders forgoing that dividend expect the retained funds to earn at least the return they could have earned themselves by receiving the dividend and investing it elsewhere at a comparable level of risk, which is the opportunity cost of retained earnings. Under wealth maximisation, if the firm reinvests retained earnings in projects earning less than this opportunity cost, shareholder wealth is actually reduced compared to a scenario where the earnings had simply been distributed and shareholders invested the money themselves, even though no explicit interest or dividend was ever paid on the retained amount. This is why retained earnings, despite appearing free of any stated cost, are assigned a cost of capital in valuation and capital budgeting work, generally taken as approximately the cost of equity, since they are ultimately equity shareholders' funds retained rather than distributed.

Question 8

Name three sources of short-term finance and explain what distinguishes them from the long-term sources discussed for financing fixed assets.

Accepted Answer

Three sources of short-term finance are trade credit, extended by suppliers allowing deferred payment for goods purchased; bank credit in forms such as cash credit and overdraft, providing working capital funding typically secured against inventory or receivables; and commercial paper, an unsecured short-term promissory note issued directly to investors by financially strong companies. These are distinguished from long-term sources such as equity, debentures and term loans by their purpose and duration: short-term sources are intended to fund the recurring, self-liquidating operating cycle of purchasing inventory, converting it to finished goods, selling and collecting from debtors, a cycle that typically completes within a year, whereas long-term sources fund fixed assets and long-term expansion whose benefits are realised over many years and whose financing should not need to be renewed or repaid within a single operating cycle.

Question 9

Explain how factoring converts a firm's receivables into immediate cash, and identify one way it differs from simply borrowing against receivables as collateral for a bank loan.

Accepted Answer

Under factoring, a firm sells its book debts, that is, amounts owed to it by its debtors, to a specialised financial institution called a factor, at a discount to their face value, and receives immediate cash from the factor rather than waiting for debtors to pay according to their original credit terms; the factor then collects the amounts directly from the debtors when due. This differs from simply borrowing against receivables as loan collateral because in a true sale factoring arrangement, particularly non-recourse factoring, the receivables and the risk of debtor default are actually transferred to the factor, meaning the firm has genuinely sold an asset off its books rather than merely pledged it as security for a separate loan obligation that the firm itself must still repay regardless of whether its debtors eventually pay; a collateralised loan, by contrast, leaves the receivables on the firm's own books and leaves the firm fully liable to the lender irrespective of debtor payment behaviour.

Question 10

A firm needs a piece of specialised machinery costing a large sum but expects its need for the machinery to last only five years, after which newer technology is expected to make it obsolete. Explain why lease financing might be preferred over outright purchase funded by a term loan in this situation.

Accepted Answer

Lease financing allows the firm to obtain the use of the machinery in exchange for periodic lease rentals without committing the large upfront capital outlay that outright purchase would require, which preserves the firm's cash and borrowing capacity for other uses. Given that the firm's need for this specific machinery is expected to last only five years due to anticipated obsolescence, leasing is particularly attractive because it avoids the risk of the firm being left owning an asset whose economic usefulness has expired but which it must still dispose of, potentially at a loss, whereas a lease can often simply be allowed to end or be renegotiated for updated equipment at the end of its term, transferring the obsolescence risk substantially to the lessor rather than leaving it entirely with the firm.

Question 11

Explain why commercial paper is typically only accessible to large, financially strong companies, and what advantage it offers those companies over conventional bank borrowing.

Accepted Answer

Commercial paper is an unsecured promissory note, meaning investors who buy it have no specific asset pledged as security and rely purely on the issuing company's general creditworthiness and reputation for repayment, which is why only companies with a strong credit rating and an established reputation in the financial markets are able to issue it successfully, since investors would not otherwise be willing to lend unsecured to a lesser-known or weaker credit. The advantage such companies gain is typically a lower cost of borrowing than a conventional bank loan, because commercial paper allows the company to borrow directly from investors in the money market, bypassing the bank as an intermediary and the margin the bank would otherwise charge for bearing the credit risk and administering the loan, effectively letting the company's own strong credit standing substitute for the credit-enhancement role a bank would normally play.

Question 12

Explain how the scope of the finance manager's role has broadened from a traditional, custodial function to a modern, strategic one, giving two specific examples of activities now considered part of the finance function that were not traditionally included.

Accepted Answer

Traditionally, the finance function was viewed narrowly as a custodial and record-keeping role, primarily concerned with arranging funds when needed and maintaining accurate financial records, with relatively little involvement in the firm's broader strategic and operating decisions. The modern view treats the finance function as genuinely strategic, deeply embedded in decisions about which investments to undertake, how to structure financing, what dividend policy to follow, and how to manage the risks the firm is exposed to. Two specific examples of activities now considered part of the finance function that were not traditionally included are investment appraisal and capital budgeting, where the finance function actively evaluates and recommends which projects the firm should undertake rather than merely funding decisions made elsewhere, and financial risk management, where the finance function actively manages the firm's exposure to interest rate, currency and market risk through appropriate instruments and policies, rather than simply absorbing whatever risk the firm's operations happen to generate.

Question 13

A firm's board decides to sharply increase the dividend payout ratio this year, distributing a much larger share of profit than usual. Trace how this single dividend decision could affect both the financing decision and the investment decision the firm faces going forward.

Accepted Answer

Increasing the dividend payout ratio means a smaller portion of the year's profit is retained within the business as retained earnings, which reduces the amount of internally generated funds available to finance future investment. If the firm still wishes to pursue the same set of investment opportunities it would otherwise have funded partly from retained earnings, it must now raise a larger amount of external financing, whether through additional equity issuance or additional borrowing, to make up the shortfall left by the reduced retention, which directly affects the financing decision by changing both how much external capital is needed and potentially the mix between debt and equity chosen to raise it. This altered financing mix can in turn change the firm's overall cost of capital, since more external financing, particularly if the firm leans towards additional debt, can shift the weighted average cost of capital, and a changed cost of capital is the discount rate applied to evaluate the investment decision, meaning projects that looked acceptable at the firm's original cost of capital could now appear marginal or even unacceptable at the new one. In this way, a decision framed purely as a dividend decision cascades through the financing decision and ultimately constrains or reshapes the investment decision, illustrating precisely the interdependence the chapter opens with.

Question 14

Explain, with reference to voting rights and risk, why preference shares are described as sitting 'between' equity and debt rather than being classified as a form of either.

Accepted Answer

Preference shares sit between equity and debt because they share features with both without being identical to either. Like debt, preference shares carry a fixed rate of return, the preference dividend rate, and a preferential claim ahead of equity both in annual dividend payment and in repayment of capital on winding up, giving preference shareholders materially lower risk than equity shareholders. Like equity, however, preference dividend is payable only out of profits and only when declared by the board, unlike debt interest which is a legal obligation payable regardless of profit, meaning preference shareholders bear more risk than debt holders in a year of poor or no profit. On voting rights, preference shareholders ordinarily have only limited voting rights, restricted to matters directly affecting their own class of shares such as a proposed variation of their rights, or to situations where their dividend has remained unpaid for a specified period, in clear contrast to equity shareholders who ordinarily have full voting rights on all company matters, and in equally clear contrast to debt holders who as creditors have no voting rights in company management at all. This combination of a fixed, preferential but profit-contingent return, and near-absent ordinary voting rights, is precisely why preference shares cannot be neatly filed under either equity or debt.

Question 15

Critics sometimes argue that market value of equity, the basis of wealth maximisation, can itself be volatile and influenced by factors outside the firm's control, such as general market sentiment, making it an imperfect measure of managerial performance. Explain why financial management still treats it as preferable to profit-based measures, despite this limitation.

Accepted Answer

It is true that market value can move for reasons unrelated to a specific firm's own decisions, such as broad market sentiment, interest rate changes, or macroeconomic news, and in that narrow sense market value is not a perfectly clean, isolated measure of managerial performance on any single day. Financial management nonetheless treats wealth maximisation, understood over a reasonable time horizon rather than on any single day's price movement, as preferable to profit-based measures because the objections to profit maximisation are structural rather than incidental: profit ignores the time value of money and risk by construction, no matter how carefully it is measured or over what period, whereas market value, precisely because it reflects the market's own discounting of expected future cash flows for both timing and risk, incorporates exactly the considerations profit leaves out. The volatility critics point to is, in this framework, not a flaw unique to wealth maximisation but a reflection of genuine uncertainty about the future that a profit-based measure simply hides rather than resolves, since a single year's profit figure gives no direct information at all about how the market perceives the firm's future prospects or the risk attached to them. In other words, market value can be a noisy measure in the short run, but it is noisy about the right thing, expected future risk-adjusted performance, whereas profit is clean but silent about exactly that.

Practice — Scope, Objectives and Types of Financing

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