Business Finance Questions and Answers AP Inter 1st Year Commerce Chapter 8

Andhra Pradesh BIEAP AP Inter 1st Year Commerce Study Material 8thLesson Business Finance Class 11 Questions and Answers.

Business Finance Class 11 Questions and Answers AP Inter 1st Year Commerce 8th Lesson

I. Fill in the Blanks (1 Mark)

Question 1.
The requirement of funds by a business firm to accomplish its various activities is called …………… .
Answer:
Business finance

Question 2.
Funds required to purchase fixed assets in a business are called ………………. .
Answer:
Fixed capital

Question 3.
Funds required for day-to-day operations and for holding current assets are called …………….. .
Answer:
working capital

Question 4.
Funds required for more than one year but less than five years are called ………… source of finance.
Answer:
medium term

Question 5.
Funds required for more than five years are called ……………. source of finance.
Answer:
long term

Question 6.
Funds required for a period not exceeding one year are called …………… source of finance.
Answer:
short term

Question 7.
…………. and …………. are two important sources of owners funds.
Answer:
equity shares, retained earnings

Question 8.
The capital obtained by the issue of shares is known as ……………. capital.
Answer:
share

Question 9.
The person holding the share is known as ……………. .
Answer:
share holder

Question 10.
The two types of shares normally issued by a company are …………. and ……………. shares.
Answer:
equity and preference

Question 11.
Retained earnings can also be called as ……………. .
Answer:
ploughing back of profits

Question 12.
Debenture holders are also termed as ……………. of the company.
Answer:
creditors

Question 13.
ZID full form ……………….. .
Answer:
Zero Interest Debentures

Question 14.
The acceptance of public deposits is regulated by ……………. .
Answer:
Reserve Bank of India

Question 15.
………….. is an unsecured promissory note issued by a firm to raise funds for a short period.
Answer:
Commercial paper

Question 16.
CRISIL full form …………….. .
Answer:
Credit Rating and Information Services of India limited.)

Question 17.
………….. shareholders are also referred to as residual pwners.
Answer:
Equity

II. Very Short Answer Type Questions (2 Marks)

Question 1.
Business finance
Answer:

1. The requirement of funds by a business firm to accomplish its various activities is called ‘business finance’. Finance is considered the lifeblood of any organi-zation.
2. The success of an industry depends on the availability of adequate finance.
3. To promote and operate a proposed enterprise economically and efficiently, adequate finance is necessary. Finance is a vital functional area of a business.

Question 2.
Fixed Capital
Answer:
The capital which is used to acquire fixed assets such as land and buildings, plant and machinery, etc., is called “Fixed Capital”. These assets remain with the business for a long period. These items are not purchased for sale. In other words, capital required by the business concern to meet its long term needs is known as ‘Fixed capital’. It is permanently kept in the business. It cannot be easily realised.

Question 3.
Working Capital .
Answer:

1. The capital required by a business organisation to run its day- to day operation such as payment of wages, salaries, electricity bills, purchase of raw-material, etc., is called “Working Capital”. The capital used in current assets is also called “Working capital”.
2. Current assets are those which can be converted into cash within a period of one year. Therefore it is also called circulating or revolving capital.
3. The working capital of the business concern depends on the nature of the business, size of the business, production policy, etc.

Question 4.
Long-term finance
Answer:

1. The capital required for long period are termed as long term finance. This is usually required for period between 7 years to 20 years.
2. This type of capital is used to acquire fixed assets such as land and buildings, plant and machinery, for working capital and also for expansion and modern-ization of the business.
3. Long term finance can be raised through issue of shares, issues of debentures, loan from banks and other financial institutions, retained earnings, etc.

Question 5.
Short term finance
Answer:

1. Funds raised for a period not exceeding one year is called short-term capital or short-term finance. This type of finance is used to meet day-to-day operating expenses of business such as purchase of raw materials, wages, salaries, etc.
2. The amount of funds required depends upon nature of business, time gap be-tween order and delivery of stocks, operating cycle and the volume of business.
3. It can be raised through Trade Credit, Bank Credit, Advances from Customers, Bank Loans, Retained earnings and Bills of Exchange.

Question 6.
Debenture
Answer:

1. Debentures’ are an important instrument for raising long term debt capital. A company can raise funds through issue of debentures.
2. It bears a fixed rate of interest. The debenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money, which it promises to repay on a future date. ‘Debenture holders’ are, therefore, termed as ‘creditors of the company’.
3. Debenture holders receive fixed stated amount of interest at specified intervals such as every six months or once a year.

Question 7.
Equity shares
Answer:

1. Equity shares are the most important source of raising long term capital for a company. Equity shares, also known as ordinary shares represent the ownership of a company and thus the capital raised by issue of such shares is known as ownership capital or owner’s funds.
2. Equity share capital is a prerequisite to the creation of a company. Equity shareholders do not get a fixed dividend but are paid on the basis of earnings by the company.
3. They are referred to as ‘residual owners’ since they receive what is left after all other claims on the company’s income and assets have been settled. They enjoy the reward as well as bear the risk of ownership.
4. Their liability, however, is limited to the extent of capital contributed by them to the company.
5. These shareholders have a right to participate in the management of a company.

Question 8.
Retained earnings
Answer:

1. A company generally does not distribute all its earnings to the shareholders as dividends. A portion of the net earnings may be retained in the business for use in the future. This is known as ‘Retained earnings’.
2. It is a source of internal financing or self financing or ‘ploughing back of profits’. However, the profit available for ploughing back of profits in an organisation depends on many factors like net profits, dividend policy and age of the organization.

Question 9.
Preference shares
Answer:
1. The capital raised by issue of preference shares is called ‘preference share capital’. The preference shareholders enjoy a preferential position over equity shareholders in two ways :

• Receiving a fixed rate of ‘dividend’, out of the net profits of the company, before any dividend is declared for equity shareholders; and
• Receiving their capital after the claims of the company’s creditors have been settled, at the time of liquidation.

2. In other words, as compared to the equity shareholders, the preference share-holders have a preferential claim over dividends and repayment of capital. Preference shares resemble debentures as they carry a fixed rate of return.

3. Thus, preference shares have some characteristics of both equity shares and debentures. Preference shareholders generally do not enjoy any voting rights.

Question 10.
Lease Financing
Answer:

1. A lease is a contractual agreement whereby one party i.e., the owner of an asset grants the other party the right to use the asset in return for periodic payments.
2. In other words it is the rental of an asset for a specified period. The owner of the assets is called the ‘lessor’ while the party that uses the assets is known as the ‘lessee’ The lessee pays a fixed periodic amount called lease rental to the lessor for the use of the asset.
3. Lease finance provides an important means of modernisation and diversi-fication to the firm.

Question 11.
Overdraft
Answer:

1. Under an overdraft financing facility, bank allows the business firm to withdraw the amount even more than the customer’s balance in the bank account.
2. The limit of extra withdrawal is also fixed by the bank. This limit is decided on the basis of creditworthiness of the borrower. Interest is charged on the overdrawn money.

Question 12.
Cash credit
Answer:
Bank grants the cash credit up to a specified limit. Business firms can withdraw any amount within that limit. Interest is charged on the actual amount drawn.

Question 13.
Internal sdurces of Finance
Answer:
Internal sources of funds are those which are generated from within the business. E.g.: Ploughing back of profits, retained earnings, collection of receivables disposing of surplus inventories, and depreciation of funds, etc.

Question 14.
External sources of finance
Answer:
External sources of funds include those sources that lie outside an organisation, such as shares, debentures, public deposits, borrowing from commercial banks and financial institutions, suppliers, lenders, and investors.

Question 15.
Public deposits
Answer:

1. The deposits that are raised by organisations directly from the public are known as ‘public deposits’.
2. Any person who is interested in depositing money in an organisation can do so by filling up a prescribed form. The organisation in return issues a deposit receipt as an acknowledgment of the debt.
3. Public deposits can take care of both medium and short-term financial requirements of a business. The deposits are beneficial to both the depositor as well as to the organisation.

Question 16.
Trade credit
Answer:

1. Trade credit is the credit extended by one trader to another for the purchase of goods and services. Trade credit facilitates the purchase of supplies without,, immediate payment. Such credit appears in the records of the buyer of goods as ‘sundry creditors’ or ‘accounts payable’.
2. Trade credit is commonly used by business organizations as a source of short-term financing. It is granted to those customers who have reasonable amount of financial standing and goodwill.

Question 17.
Commercial paper
Answer:
1. Commercial Paper emerged as a source of short term finance in our country in the early nineties. Commercial paper is an unsecured promissory note issued by a firm to raise funds for a short period, varying from 90 days to 364 days.

2. It is issued by one firm to other business firms, insurance companies, pension funds and banks. The amount raised by CP is generally very large. As the debt is completely unsecured, only firms having good credit rating can issue CP. Its regulation falls under the purview of the Reserve Bank of India.

Question 18.
Commercial Banks
Answer:
1. Commercial banks occupy a vital position as they provide funds for different purposes as well as for different time periods. Banks extend loans to firms of all sizes and in many ways, like, cash credits, overdrafts, term loans, purchase / discounting of bills, and issue of letter of credit.

2. The loan is repaid either in a lump sum or in installments. Bank credit is not a permanent source of funds. Though banks have started extending loans for longer periods, generally such loans are used for medium to short periods. The borrower is required to provide some security or create a charge on the assets of the firm before a loan is sanctioned by a commercial bank.

3. Banks extend loans to firms of all sizes and in many ways, like, cash credits, overdrafts, term loans, purchase / discounting of bills, and issue of letter of credit.

III. Short Answer Type Questions (4 Marks)

Question 1.
What are the sources of short term finance ?
Answer:
Short-term Sources of Finance
The short-term loans and credits are raised by a firm to meet its working capital requirements. These are generally for a short period not exceeding accounting period, i.e., one year.
The main sources of short term funds are as follows.
1. Bank credit
Commercial banks extend the short-term financial assistance to business firms by means of bank credit. Bank credit may be provided in the following forms:
a) Loans Bank: loans are provided for a specific short period. The amount of loan depends upon the size and goodwill of the firm. Such advance is credited to a separate loan account and the borrower must pay interest on the entire amount of loan irrespective of the amount of loan granted. Bank Loans are usually granted against the security of assets.

b) Cash Credit: Bank grants the cash credit up to a specified limit. Business firms can withdraw any amount within that limit. Interest is charged on the actual amount drawn.

c) Overdraft: Under an overdraft financing facility, bank allows the business firm to withdraw the amount even more than the customer’s balance in the bank account. The limit of extra withdrawal is also fixed by the bank. This limit is decided on the basis of creditworthiness of the borrower. Interest is charged on the overdrawn money.

2. Trade Credit:
Trade credit is the credit extended by one trader to another for the purchase of goods and services. Trade credit facilitates the purchase of supplies without immediate payment. Such credit appears in the records of the buyer of goods as ‘sundry creditors’ or ‘accounts payable’. Trade credit is commonly used by business organizations as a source of short-term financing. It is granted to those customers who have reasonable amount of financial standing and goodwill.

3. Installment Credit ;This is another method by which the assets are purchased and possession of goods is taken immediately but the payment is made in installment over a pre- determined period. Generally, interest is charged on the unpaid price or it may be adjusted in the price. In any case, it provides finance for some time and is used as a source of short-term working capital by many business organizations that have difficult funds positions.

4. Advances : Some business organizations get advances from their customers and agents against orders and this source is short term source of finance for them. It is a cheap source of finance and in order to minimize their investments in working capital, some firms having long production cycles, especially the firms manufacturing industrial products prefer to take advance from their customers.

5. Commercial Paper: Commercial Paper emerged as a source of short term finance in our country in the early nineties. Commercial paper is an unsecured promissory note issued by a firm to raise funds for a short p’eriod, varying from 90 days to 364 days. It is issued by one firm to other business firms, insurance companies, pension funds and banks. The amount raised by CP is generally very large. As the debt is completely unsecured, only firms having good credit rating can issue CP. Its regulation falls under the purview of the Reserve Bank of India.

Question 2.
What are the sources of long-term finance ?
Answer:
1. Ipsue of Shares:
The capital obtained by issue of shares is known as ‘share capital’. The capital of a company is divided into small units called shares. There are two types of shares normally issued by a company. These are ‘equity shares’ and ‘preference shares. The money raised by issue of equity shares is called ‘equity share capital’, while the money raised by issue of preference shares is called ‘preference share capital’.

a) Equity Shares:
Equity shares are the most important source of raising long term capital for a company. Equity shares, also known as ordinary shares represent the ownership of a company and thus the capital raised by issue of such shares is known as ownership capital or owner’s funds. Equity share capital is a prerequisite to the creation of a company.

Equity shareholders do not get a fixed dividend but are paid on the basis of earnings by the company. They are referred to as ‘residual owners’ since they receive what is left after all other claims on the company’s income and assets have been settled. They enjoy the reward as well as bear the risk of ownership. Their liability, however, is limited to the extent of capital contributed by them to the company. These shareholders have a right to participate in the management of a company.

b) Preference Shares:
The capital raised by issue of preference shares is called ‘preference share capital’. The preference shareholders enjoy a preferential position over equity shareholders in two ways : μ Receiving a fixed rate of ‘dividend’, out of the net profits of the company, before any dividend is declared for equity shareholders; and μ Receiving their capital after the claims of the company’s creditors have been settled, at the time of liquidation.

2. Retained Earning:
Company generally does not distribute all its earnings to the shareholders as dividends. A portion of the net earnings may be retained in the business, for use in the future. This is known as ‘retained earnings’. It is a source of internal financing or self financing or ‘ploughing back of profits’. However, the profit available for ploughing back of profits in an organisation depends on many factors like net profits, dividend policy and age of the.organization.

3. Debentures:
Debentures’ are an important instrument for raising long term debt capital. A company can raise funds through issue of debentures. It bears a fixed rate of interest. The debenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money, which it promises to repay on a future date. ‘Debenture holders’ are, therefore, termed as ‘creditors of the company’.

Question 3.
What are the sources of medium-term finance ?
Answer:
1. Public Deposits:
The deposits that are raised by organisations directly from the public are known as ‘public deposits. Any person who is interested in depositing money in an organisation can do so by filling up a prescribed form. The organisation in return issues a deposit receipt as an acknowledgment of the debt.

Public deposits can take care of both medium and short-term financial requirements of a business. The deposits are beneficial to both the depositor as well as to the organisation. While the depositors get higher interest rate than that offered by banks, the cost of deposits to the company is less than the cost of borrowing from banks. Companies generally invite public deposits for a period up to three years. The acceptance of public deposits is regulated by the Reserve Bank of India.

2. Commercial Banks:
Commercial banks occupy a vital position as they provide funds for different purposes as well as for different time periods. Banks extend loans to firms of all sizes and in many ways, like, cash credits, overdrafts, term loans, purchase / discounting of bills, and issue of letter of credit. The rate of interest charged by banks depends on various factors such as the characteristics of the firm and the level of interest rates in the economy.

The loan is repaid either in a lump sum or in installments. Bank credit is not a permanent source of funds. Though banks have started extending loans for longer periods, generally such loans are used for medium to short periods. The borrower is required to provide some security or create a charge on the assets of the firm before a loan is sanctioned by a commercial bank, creditors have been settled, at the time of liquidation.

3. Lease Financing:
A lease is a contractual agreement whereby one party i.e., the owner of an asset grants the other party the right to use the asset in return for periodic payments. In other words it is the rental of an asset for a specified period. The owner of the assets is called the ‘lessor’ while the party that uses the assets is known as the ‘lessee’ The lessee pays a fixed periodic amount called lease rental to the lessor for the use of the asset.

The terms and conditions regulating the lease arrangements are given in the lease contract. At the end of the lease period, the asset goes back to the lessor. Lease finance provides an important means of modernisation and diversification to the firm. Such type of financing is more prevalent in the acquisition of such assets as computers and electronic equipment which become obsolete quicker because of fastchanging technological developments. While making the leasing decision, the cost of leasing an asset must be compared with the cost of owning the same.

Question 4.
Differentiate between the equity shares and preference shares.
Answer:

Question 5.
Differentiate between a share and a debenture.
Answer:

Shares	Debentures
1) A share is a part of owned capital.	1) A debenture is an acknowledgement of a debt.
2) Shareholders are paid dividends on the shares held by them.	2) Debenture holders are paid interest on debentures.
3) The rate of dividend depends upon the amount of divisible profits and the policy of the Board of Directors.	3) A fixed rate of interest is paid on debentures irrespective of (profits or losses).
4) Shareholders have voting rights. They have control over the management of the company.	4) Debenture holders are only creditors of the company.
5) Shares are not redeemable except redeemable preference shares during the life of the company.	5) Debentures are redeemed after certain period.
6) At the time of liquidation of the company, share capital is payable after meeting all outside liabilities.	6) Debentures are payable in priority over share capital.

Question 6.
What are the various types of capital required for business enterprises ?
Ans. The financial needs of a business organization can be categorized as follows :
A) Fixed Capital Requirements :
To start a business, funds are required to purchase fixed assets like land and buildings, plant and machinery, and furniture and fixtures. This is known as fixed capital requirements of a business enterprise. The funds required in fixed assets remain invested in the business for a long period. Different business units need varying amount of fixed capital depending on various factors such as the nature of business, etc. A trading concern, for example, may require a small amount of fixed capital as compared to a manufacturing concern. Likewise, the need for fixed capital investment would be greater for a large business enterprise, as compared to that of a small enterprise.

B) Working Capital Requirements:
The financial requirements of a business enterprise do not end with the pro-curement of fixed assets. No matter how small or large a business is, it needs funds for its day-to-day operations. This is known as the working capital of an enterprise, which is used for holding current assets such as Stock of material, bills receivables and for meeting expenses like salaries, wages, taxes, and rent. The amount of working capital required varies from one business enterprise to another depending on various factors.

For example, A business unit selling goods on credit, or having a slow sales turnover, would require more working capital as compared to a concern selling its goods and services on cash basis or having a high turnover. The requirement for fixed and working capital increases with the growth and expansion of business. At times, additional funds are required for upgrading the technology employed so that the cost of production or operations can be reduced.

Question 7.
Explain the classification of sources of finance.
Answer:
The sources of funds can be categorized using different basis viz., on the basis of the period, on the basis of the ownership and on the basis of source of generation.
1. On the basis of period: On the basis of period, sources of funds can be cate-gorized into
1) Longterm
2) Medium-term finance
3) Short-term finance.

1) Longterm:
The long-term sources fulfil the financial requirements of an enterprise for a period exceeding five years. Such financing is generally required for the acquisition of fixed assets.

2) Medium-term finance:
Where the funds are required for a period more than one year but less than five years, medium-term sources of finance are used.

3) Short-term finance:
Short term funds are those which are required for short duration i.e., a period not exceeding one year. „
Ex: Trade Credit, Bank Overdrafts, etc.

2. On the basis of ownership:
On the basis of ownership, the sources can be classified into owner’s funds and borrowed funds. Owner’s funds are those which are provided by the owners which include issue of equity shares and retained earnings. Borrowed funds refer to the funds raised through loans or borrowings. The sources include loan’s from commercial banks, loans from financial institutions, issue of debentures, public deposits, and trade credit.

3. On the basis of generation:
Sources of finances can be generated from internal or from external sources.
1) Internal sources of funds are those that are generated from within the business. Ex: Retained earnings, depreciation of funds, etc.
2) External sources of funds include those sources that lie outside an organ-isation. E.g: Shares, debentures, public deposits, etc.

IV. Essay Type Questions (8 Marks)

Question 1.
Define preference shares. Explain its advantages and limitations.
Answer:
Meaning: The capital raised by issue of preference shares is called ‘preference share capital’. The preference shareholders enjoy a preferential position over equity shareholders in two ways :
1) Receiving a fixed rate of‘dividend’, out of the net profits of the company, before any dividend is declared for equity shareholders; and

2) Receiving their capital after the claims of the company’s creditorsliave been settled, at the time of liquidation. In other words, as compared to the equity shareholders, the preference shareholders have a preferential claim over dividends and repayment of capital. Preference shares resemble debentures as they carry a fixed rate of return. Thus, preference shares have some characteristics of both equity shares and debentures. Preference shareholders generally do not enjoy any voting rights.

Merits:
The merits of preference shares are given as under:

1. Preference shares provide reasonably steady income in the form of fixed rate of return and safety of investment.
2. Preference shares are useful for investors who want to get a fixed rate of return with comparatively low risk.
3. It is a superior security compared to equity shares.
4. The payment of a fixed rate of dividend on preference shares may enable a company to declare a higher rate of dividends for equity shareholders during good times.
5. Preference shareholders have a preferential right of repayment over equity shareholders in the event of liquidation of a company.
6. Preference capital does not create any sort, of charge against the assets of a company.

Limitations:
The major limitations of preference shares as a source of business finance are as follows:

1. Preference shares are not suitable for those investors who are willing to take risk and are interested in higher returns.
2. Preferen ce capital dilutes the claims of equity shareholders over the assets of the company.
3. The rate of dividend on preference shares is generally higher than the rate of interest on debentures.
4. As the dividend on these shares is to be paid only when the company earns profit, there is no assured return for the investors, Thus, these shares may not be very attractive to the investors.

Question 2.
Discuss the various types of preference shares.
Answer:
Types of Preference Shares
a) Cumulative Preference Shares: Under Cumulative preference shares the dividend is accumulated if it is unpaid during a year, as cumulative preference shareholders carry the right to accumulate unpaid dividend in the future years.

b) Non-cumulative Preference Shares: Under non-cutnulative preferenceshares, the dividend does not accumulate.

c) Participating Preference Shares : Participating preference shares are those preference shares which have a right to participate in the company’s surplus after paying dividend to equity shareholders and preference shareholders.

d) Non-participating Preference Shares: The holders of such shares do not enjoy right to participating in the profit of the company.

e) Convertible Preference Shares : These shares can be converted into equity shares within a specific period.

f) Non-convertible Preference Shares: Non-convertible preference shares cannot be converted into equity shares.

g) Redeemable Preference Shares : Redeemable preference shares are those shares, the investments which are to be paid back to their respective holders after the completion of a certain time.

h) Irredeemable Preference Shares: Irredeemable preference shares do not carry any fixed period of repayment.

Question 3.
What do youmean by retained earnings ? Explain its advantages and limitations.
Answer:
Meaning: A company generally does not distribute all its earnings to the share-holders as dividends. A portion of the net earnings may be retained in the business for use in the future. This is known as ‘retained earnings. It is a source of internal financing or self-financing or ‘ploughing back of profits’.

Merits:
The merits of retained earnings as a source of finance are as follows :

1. Retained earnings are a permanent source of funds available to an organisation.
2. It does not involve any explicit cost in the form of interest, dividend or floata-tion cost,
3. As the funds are generated internally, there is a greater degree of operational freedom and flexibility.
4. It enhances the capacity of the business firm to absorb unexpected losses.
5. It may lead to increase in the market price of the equity shares of a company.

Limitations:

1. Excessive ploughing back may cause dissatisfaction amongst the shareholders as they would get lower dividends.
2. It is an uncertain source of funds as the profits of business are fluctuating.
3. The opportunity cost associated with these funds is not recognized by many firms. This may lead to sub-optimal use.

Question 4.
What is a debenture ? Explain various types of debentures issued by a company?
Answer:
‘Debentures’ are an important instrument for raising long term debt capital. A company can raise funds through issue of debentures. It bears a fixed rate of interest. The debenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money, which it promises to repay on a future date. ‘Debenture holders’ are, therefore, termed as ‘creditors of the company’.

Types of Debentures:
Debentures may be of various types. Some important types of debentures are as follows:
a) Mortgage Debentures: They are also known as ‘secured debentures’, i.e., the payment of interest and principal is secured by some charge on any part or the whole of the company.

b) Simple Debentures: These debentures have no charge on the assets of the company. They are also known as naked or unsecured debentures. They are not secured by any charge or security on any asset of the company.

c) Redeemable Debentures: Those debentures which are issued for a particular fixed period and after expiry of that period the principal amount is returned. For example: 5 years, 10 yrs, 15 yrs maturity period, after that the amount of debenture is paid back to their holders.

d) Irredeemable Debentures: They are to be paid back at the time of winding up of the company. They are not refundable, i.e., perpetual in nature. A company can, however, redeem such debentures whenever it deems fit.

e) Registered Debentures: The names of the holders are recorded in the books of the company. If such debentures are transferred, the name of the transferee is entered in the register and the name of the original holders is canceled.

f) Bearer Debentures: The debentures which are not recorded in the register of debenture holders are known as bearer debentures. These debentures are transferable by mere delivery.

g) Convertible Debentures: They carry the option of haying apart ofthe full value of their investments converted into equity shares on a fixed date.

h) Non-convertible Debentures: They do not enjoy any such right to get them-selves converted into equity shares.

Question 5.
Narrate the advantages and limitations of issuing debentures by a Joint Stock Company.
Answer:
Merits:
The merits of raising funds through debentures are given below:

1. Debentures are preferred by investors who want fixed income at lesser risk.
2. Debentures are fixed charge funds and do not participate in profits of the company.
3. The issue of debentures is suitable in situations where sales and earnings are relatively stable.
4. As debentures do not carry voting rights, financing through debentures does not dilute control of equity shareholders on management.
5. Financing through debentures is less costly as compared to the cost of preference or equity capital as the interest payments on debentures are tax de-ductible.

Limitations:

1. As fixed charge instruments, debentures place a permanent burden on the earnings of a company. There is a great risk when the earnings of the company fluctuate.
2. In case of redeemable debentures, the company has to make provisions for repayment on the specified date, even during periods of financial difficulty.
3. Each company has certain borrowing capacity. With the issue of debentures, the capacity of a company to further borrow funds reduces.

Question 6.
What afe the various factors that determine the selection of source of finance.
Answer:
The financial needs of a business are of different types – long-term, short-term, fixed and fluctuating. Therefore, business firms resort to different types of sources for raising funds.
The choice of selecting a better source of finance depends on the following factors:
i) Cost: There are two types of cost viz., the cost of procurement of funds and cost of utilizing the funds. Both these costs should be taken into account while deciding about the source of funds that will be used by an organisation.

ii) Financial strength and stability of operations: The financial strength of a business is also a key determinant. The choice of source of funds for busi-ness should be in a sound financial position to be able to repay the principal amount and interest on the borrowed amount.

iii) Form of organisation and legal status: The form of business organisation and status influences the choice of a source for raising money. A partnership firm, for example, cannot raise money by issuing of equity shares as these can be issued only by a joint stock company.

iv) Purpose and period: Businesses should plan according to the period for which the funds are required. A short-term need for example can be met through borrowing funds at a low rate of interest, through trade credit, commercial paper, etc. For long-term finance, sources such as issue of shares and debentures are more appropriate.

v) Risk profile: Businesses should evaluate each of the sources of finance In terms of the risk involved. For example, there is a least risk in equity as the share capital has to be repaid only at the time of winding up and dividends need not be paid if no profits are available. A loan on the other hand, has a repayment schedule for both the principal and the interest. The interest is required to be paid irrespective of whether the firm earning a profit or incurring a loss.

vi) Control: A particular source of funds may affect the control and power of the owners on the management of a firm. Issue of equity shares may mean dilution of the control. For example, as equity share holders enjoy voting rights, financial institutions may take control of the assets or impose conditions as part of the loan agreement. Thus, business firm should choose a source keeping in mind the extent to which they are willing to share their control over business.

vii) Effect on creditworthiness: The dependence of a business on certain sources may affect its creditworthiness in the market. For example, issue of secured debentures may affect the interest of unsecured creditors of the company and may adversely affect their willingness to extend further loans as credit to the company.

viii) Flexibility and ease : Another aspect affecting the choice of a source of fi nance is the flexibility and ease of obtaining funds. Restrictive provisions, detailed investigation, and documentation in case of borrowings from banks and financial institutions for example may be the reason that business or-ganisations may not prefer, if other options are readily available.

ix) Tax benefits: Various sources may also be weighed in terms of their tax benefits. For example, while the dividend on preference shares is not tax deductible, interest paid on debentures and loan is tax deductible and may, therefore, be preferred by organisations seeking tax advantage.

Question 7.
What is business finance ? Explain its need and significance in the business or ganisation.
Answer:
The requirement of funds by a business firm to accomplish its various activities is called ‘business finance’. Finance is considered the lifeblood of any organization. The success of an industry depends on the availability of adequate finance. To promote and operate a proposed enterprise economically and efficiently, adequate finance is necessary.

Finance is a vital functional area of a business. It deals with the procurement of funds and their effective utilisation. Finance is also labeled as the capital of a company. A business fundamentally requires identifying its sources of finance from where it can procure funds. As soon as an entrepreneur starts a business, the need for business finance emerges.

Business needs finance mainly for acquiring various types of assets and to meet various expenses on a day-to-day basis. There are also many other reasons for the requirement of business finance. The significance and need of business finance are explained below.

1. To meet fixed capital requirement of business: To purchase fixed assets like land and buildings, plant and machinery, furniture and fixtures, etc., business requires finance.

2. To meet working capital requirements: Working Capital is used for holding current assets such as stock of material, payment of wages, transportation expenses, etc.

3. For growth and expansion: For growth and expansion activities, a business requires finance. It may be required to increase production, install more ma-chines, set up a R&D centre, etc.

4. For diversification: Business finance is needed to start any new activity in business. For example, ITC dealing with tobacco started ITC Kakatiya (hotels), Vivel (shampoos, and cosmetics), Classmate (notebooks and stationery) etc. Entering into new businesses and new lines of activities is known as diversification. Similarly, main enterprises keep on grabbing opportunities to start producing products for different segments.

5. For survival: To carry out the various business operations in continuity, business finance is needed. Without the required finance, organizations cannot survive for long.

6. To meet Liabilities: To meet the liabilities of a business, be it long-term or short-term, a business requires sufficient finance, E.g.: for payment of loan installments, creditors, etc.

7. For payment of expenses For paying salaries, wages, taxes, advertisements and rent, finance is needed. Therefore, to execute the various plans of the business, finance is needed.

Question 8.
What are the advantages and disadvantages of equity sources of funds.
Answer:
Equity shares are the most important source of raising long term capital for a company. Equity shares, also known as ordinary shares represent the ownership of a company and thus the capital raised by issue of such shares is known as ownership capital or owner’s funds.
Merits:
The important merits of raising funds through issuing equity shares are given below:

1. Equity shares do not create any obligation to pay a fixed rate of dividend.
2. Equity shares can be issued without creating any charge oyer the assets of the company.
3. It is a permanent source of capital and the company neqd not repay it except under liquidation.
4. Equity shareholders are the real owners of the company who have the voting rights.
5. Incase of profits, equity shareholders are the real gainers byway of increased dividends and appreciation in the value of shares.

Limitations:
The major limitations of raising funds through issue of equity shares are as follows :

1. Investors who want steady income may not prefer equity shares as equity shares get fluctuating returns.
2. The cost of equity shares is generally higher compared to the costof raising funds through other sources.
3. Issue of additional equity shares dilutes the voting power, and earnings of existing equity shareholders.
4. More legal formalities and procedural delays are involved while raising funds through issue of equity shares.

Question 9.
Critically examine the advantages and disadvantages of raising funds by issuing shares of different types.
Answer:
A company can issue different types of shares to get funds from the investors to suit their requirement. Under the Companies Act 1956 a company can issue only two types of shares.
1) Preference shares
2) Equity shares.

1) Preference shares:
As compared to. the equity shareholders, the preference shareholders have a preferential claim over divided and repayment of capital. Preference shares re-semble debentures as they bear fixed rate of return. Preference shares have some characteristics of both equity shares and debentures. Preference share-holders generally do not enjoy any voting rights.

Merits or Advantages:
Preference shares provide reasonably steady income in the form of fixed rate of return and safety of investment.

• Preference shares are useful for those investors who want to get fixed rate of return with comparatively low risk.
• It is a superior security over equity shares.
• Payment of fixed rate of dividend to preference shares may enable a company to declare higher rates of dividend for the equity shareholders in good times.
• Preference capital does not create any sort of charge against the assets of a company.

Limitations:

• Preference shares are not suitable for those investors who are willing to take risk and are interested in higher returns.
• Preference capital dilutes the claims of equity shareholders over assets of the company.
• The rate of dividend on preference shares in generally higher than the rate of interest on debentures.

2) Equity shares:
Equity shares are the most important source of raising long term capital by a company. Equity shares, also known as ordinary shares represent the owner ship of a company and thus the capital raised by issug of such shares is known as ownership capital or owner’s funds. Equity shareholders do not get a fixed dividend but are paid on the basis of earnings by the company. Their liabilities, however, is limited to the extent of capital contributed by them in the company.
They have a right to participate in the management of a company.

Merits:

• Equity shares do not create any obligation to pay a fixed rate of dividend.
• Equity shares can be issued without creating any charge over the assets of the company.
• It’s a permanent source of capital and the company need not repay it except under liquidation.
• Equity shareholders are the real owners of the company who have the voting rights.

Limitations:

• Investors who want steady income may not prefer equity shares as equity shares get fluctuating returns.
• The cost of equity shares is generally more as compared to the cost of raising funds through other sources.
• Issue of additional equity shares dilutes the voting power, and earnings of existing equity shareholders.
• More legal formalities and procedural delays are involved while raising funds through issue of equity shares.