1. Importance of forecasting for a firm.

ANS : 1. Promotion of new business:

Forecasting is of utmost importance in setting up a new business. It is not an easy task to start a

new business as it is full of uncertainties and risks. With the help of forecasting the promoter can

find out whether he can succeed in the new business; whether he can face the existing

competition; what is the possibility of creating demand for the proposed product etc.

2. Estimation of financial requirements:

The importance of forecasting can’t be ignored in estimating the financial requirements of a

concern. Efficient utilisation of capital is a delicate issue before the management. No business

can survive without adequate capital. But adequacy of either fixed or working capital depends

entirely on sound financial forecasting.

3. Smooth and continuous working of a concern: ‘Forecasting of earnings’ ensures smooth

and continuous working of an enterprise, particularly to newly established ones. By forecasting,

these concerns can estimate their expected profits or losses. The object of a forecast is to reduce

in black and white the details of working of a concern.

4. Correctness of management decisions: Administration is essentially a decision making

process and authority has responsibility for making decisions and for ascertaining that the

decisions made are carried out. 5. Success in business: The accurate forecasting of sales helps to

procure necessary raw materials on the basis of which many business activities are undertaken.

The accurate sales forecasting becomes the basis for several other budgets. In the absence of

accurate sales forecasting, it is difficult to decide as to how much production should be done.

Q2. MOTIVES OF HOLDING CASH BY A FIRM .?

1. Transaction Motive: The transaction
motive refers to the cash required by a firm to meet the day to day needs of its business
operations. In an ordinary course of business, the firm requires cash to make the payments in the
form of salaries, wages, interests, dividends, goods purchased, etc.

Likewise, it also receives cash from its sales, debtors, investments. Often the firm’s cash inflows
and outflows do not match, and hence, the cash is held up to meet its routine commitments.

2. Precautionary Motive: The precautionary motive refers to the tendency of a firm to hold
cash, to meet the contingencies or unforeseen circumstances arising in the course of business.

Since the future is uncertain, a firm may have to face contingencies such as an increase in the
price of raw materials, labor strike, lockouts, change in the demand, etc. Thus, in order to meet
with these uncertainties, the cash is held by the firms to have an uninterrupted business
operations.

3. Speculative Motive: The firms hold cash for the speculative purposes to avail the benefit
of bargain purchases that may arise in the future. For example, if the firm feels the prices of raw
material are likely to fall in the future, it will hold cash and wait till the prices actually fall.

Thus, a firm holds cash to exploit the possible opportunities that are out of the normal course of
business. These opportunities could be in the form of the low-interest rate charged on the
borrowed funds, expected fall in the raw material prices or favorable change in the government
policies.

Thus, the cash is the most significant and liquid asset that the firm holds. It is significant as it is
used to pay off the firm’s obligations and helps in the expansion of business operations.

Q3. THREE CRITICISM OF DIVIDENT POLICIES BY MM APPROACH?

(i) Tax Differential: M-M hypothesis assumes that taxes do not exist, in reality, it is impossible.
On the contrary, the shareholders have to pay taxes on the dividend so received or on capital
gains. We know that different tax rates are applicable to dividend and capital gains and tax rate
on capital gains is comparatively low than the tax rate on dividend.
That is why, an investor should prefer the capital gains as against the dividend due to the fact
that capital gains tax is comparatively less and such capital gains tax is payable only when the
shares are actually sold in the market at a profit.

(ii) Existence of Floatation Costs:

M-M also assumes that both internal and external financing are equivalent. It indicates that if
dividend is paid in cash, a firm is to raise external funds for its own investment opportunities.
There will not be any difference in shareholders’ wealth whether the firm retains its earnings or
issues fresh shares provided there will not be any floatation cost.

But, in reality, floatation cost exists for issuing fresh shares, and there is no such cost if earnings
are retained. As a result of the floatation cost, the external financing becomes costlier than
internal financing. Therefore, if floatation costs are considered external and internal financing,
i.e., fresh issue and retained earnings will never be equivalent.

(iii) Existence of Transaction Costs:

M-M also assumes that whether the dividends are paid or not, the shareholders” wealth will be
the same. When the dividends are not paid in cash to the shareholder, he may desire current
income and are as such, he can sell his shares.

When a shareholder sells his shares for the desire of his current income, there remain the
transaction costs which are not considered by M-M. Because, at the time of sale, a shareholder
must have to incur some expenses by way of brokerage, commission, etc., which is again more
for small sales. A shareholder will prefer dividends to capital gains in order to avoid the said
difficulties and inconvenience.

(iv) Diversification:
M-M considers that the discount rate should be the same whether a firm uses internal or external
financing. But, practically, it does not so happen. If the shareholders desire to diversify their
portfolios they would like to distribute earnings which they may be able to invest in such
dividends in other firms.

In such a case, shareholders/investors will be inclined to have a higher value of discount rate if
internal financing is being used and vice-versa.

(v) Uncertainty:
According to M-M hypothesis, dividend policy of a firm will be irrelevant even if uncertainty is
considered. M-M reveal that if the two firms have identical investment policies, business risks
and expected future earnings, the market price of the two firms will be the same.

This view is actually not accepted by some other authorities.

According to them, under conditions of uncertainty, dividends are relevant because, investors are
risk-averters and as such, they prefer near dividends than future dividends since future dividends
are discounted at a higher rate as dividends involve uncertainty. Thus, the value of the firm will
be higher if dividend is paid earlier than when the firm follows a retention policy.

Q4.OPERATING LEVERAGE AND FINANCIAL LEVERAGE

Operating leverage is a cost-accounting formula that measures the degree to which a firm or
project can increase operating income by increasing revenue. A business that generates sales
with a high gross margin and low variable costs has high operating leverage.

The higher the degree of operating leverage, the greater the potential danger from forecasting
risk, in which a relatively small error in forecasting sales can be magnified into large errors in
cash flow projections.

Financial leverage which is also known as leverage or trading on equity, refers to the use of debt
to acquire additional assets.
The use of financial leverage to control a greater amount of assets (by borrowing money) will
cause the returns on the owner's cash investment to be amplified. That is, with financial leverage:

 an increase in the value of the assets will result in a larger gain on the owner's cash, when
the loan interest rate is less than the rate of increase in the asset's value
 a decrease in the value of the assets will result in a larger loss on the owner's cash.

Q5. SOURCES OF FINANCING CAPITAL OF A FIRM ?

1. Intercorporate Loans and Deposits:

2. Commercial Paper (CP):
3. Funds Generated from Operations:
4. Retained Profit:
5. Depreciation Provision:

Q6. ADVANTAGES OF FINANCIAL FORECASTING

(i) It can be used as a control device in order to fix the standard of performances and
evaluating the results thereof,

(ii) It helps you to make a blueprint for your business so that the incurring expenses can
be controlled for the gain of your business,

(iii) It helps to explain the requirement of funds for the firm together with the funds of the
suppliers,

(iv) It helps in recognizing the risks and financial crunches in the business so that the
necessary arrangements can be made to save the business from running a loss,

(v) It also helps to explain the proper requirements of cash and their optimum utilization
is possible and so surplus/excess cash, if any, invested otherwise,

(vi) It gives an assessment of the future need for cash and enables you to take a
decision about whether money should be borrowed or not,

Q7. EXPLAIN BREIFLY INDIFFERENCE POINT AND BREAKEVEN POINT ?

The indifference point is the level of volume at which total costs, and hence profits,
are the same under both cost structures. If the company operated at that level of
volume, the alternative used would not matter because income would be the same
either way. At the cost indifference point, total costs (fixed cost and variable cost)
associated with the two alternatives are equal.

Financial break-even point is the level of earnings before interest and taxes
that will result in zero net income or zero earnings per share. It equals the
company’s interest expense plus dividends paid to preferred stock-holders
and associated taxes.

Interest expense and preferred dividends are obligatory payments hence

they are included in financial break-even calculation while common
dividends, being optional, are excluded.

Q8. MM PROPOSITION STATES THAT THE FIRM VALUE IS

INDEPENDENT OF ITS CAPITAL STRUCTURE

Q9.