Financial Management 2 marks questions and answers

1. Differentiate between Levered firm and Unlevered firm.

A firm that finances its assets by equity and debt is called a levered firm. A firm that
uses no debt and finances its assets entirely by equity is called an unlevered firm.
2. State Modigliany Miller approach propositions.
Proposition I : The overall cost of capital and the value of the firm are independent of
its capital structure
Proposition II: ke is equal to the capitalization rate of a pure equity stream plus a
premium for financial risk equal to the difference between the pure equity
capitalization rate and ki times the ratio of debt to equity
Proposition III: The cut off rate for investment purposes is completely independent of
the way in which an investment is financed.
3. What is financial leverage?
The use of the fixed charges sources of funds, such as debt and preference capital
along with the owners equity in the capital structure is defined as financial leverage
or gearing or trading on equity.
4. List the significance of cost of capital.
a. Evaluating investment decisions
b. Designing a firms debt policy
c. Appraising the financial performance of top management
5. What is cost of capital?
Cost of capital is the minimum required rate of return on funds committed to the
project or investment which depends on the riskiness of its cashflows. Since the
investment projects undertaken by the firms may differ in risk , each of them will
have its own unique cost of capital.
6. What is opportunity cost of capital
The opportunity cost of capital is the rate of return forgone on the next best alternative
investment opportunity of comparable risk.
7. What is capital expenditure?
Capital expenditure is an outlay of funds that is expected to produce benefits over a
period of time exceeding one year
8. Differentiate business risk from financial risk.
Business risk is the risk to the firm being unable to cover fixed operating costs and
financial risk is the risk of being unable to cover required financial obligations such as
interests and preference dividends.
9. How do you compute overall cost of capital
a. Assigning weights to specific costs
b. Multiplying the cost of each of the sources by appropriate weights
c. Dividing the total weighted cost by the total weights
10. What is meant by weighted average or overall cost of capital
Weight average cost of capital or overall cost of capital is the expected average future
cost of funds over the long run found by weighting the cost of each specific type of
capital by its proportion in the firms capital structure
11. Differentiate between operating leverage and financial leverage
Leverage is the employment of an asset / source of finance for which firm pays fixed
cost / fixed return. There are two types of leverage Operating and financial leverage.

The leverage associated with investment activities is referred to as operating leverage

and the leverage associated with the financing activities is called financial leverage.
12. Define capital structure.
Capital structure is the proportion of debt and preference and equity shares on a firms
balance sheet.
13. Define optimum capital structure.
Optimum capital structure is the capital structure at which the weighted average cost
of capital is minimum thereby maximum value of the firm.
14. What is perfect capital market?
Perfect capital market is that i) securities are infinitely divisible ii) investors are free
to buy / sell securities iii) investors can borrow without restrictions on the same terms
and conditions as firms can iv) There are no transaction costs v) Information is
perfect, i.e. each investor has the same information which is readily available to him
without any cost vi) investors are rational and behave accordingly
15. List the capital structure theories
The capital structure theories are
1. Net Income approach 2. Net Operating income approach 3. Modigliani Miller
approach.