Unit 4 Business Finance PYQ’s 3rd January 2026 Shift 1

The correct answer is – 100% Dividend Payout

Key Points

• Walter’s Model
  • Walter’s Model determines the relationship between the dividend policy of a company and its market value.
  • It assumes that the company reinvests retained earnings at a rate of return (r) and that this return is compared to the cost of equity (e).
• Declining Firm
  • A declining firm is one where r < e, meaning the firm’s return on retained earnings is less than the cost of equity.
• Maximum Market Value
  • In a declining firm, the market value of its shares will be maximized when the firm pays out 100% of its earnings as dividends.
  • This is because reinvesting retained earnings would yield lower returns than the shareholders could earn elsewhere.

Additional Information

• Walter’s Model Assumptions
  • The firm’s internal rate of return (r) and cost of equity (e) remain constant.
  • All investments are financed through retained earnings, with no external financing.
  • The firm has a constant payout ratio.
  • The firm’s earnings and dividends are constant over time.
• Relevance of Dividend Policy
  • Walter’s Model shows that the dividend policy affects a firm’s value and is relevant to determining the market price of shares.
  • The relationship between r and e determines whether earnings should be retained or distributed.
• Other Cases in Walter’s Model
  • If r > e, the firm’s value is maximized by 0% dividend payout as reinvestment yields higher returns.
  • If r = e, the firm’s value remains unaffected by the dividend policy.

The correct answer is – B, A, C, E, D

Key Points

• B: Project Generation
  • This is the first step where potential investment opportunities are identified.
  • Ideas for projects are gathered from various sources such as employees, market trends, and competitors.
• A: Preliminary Screening Process
  • In this step, the feasibility and alignment of the project with organizational goals are assessed.
  • Projects that do not meet basic criteria are eliminated at this stage.
• C: Detailed Project Evaluation
  • This involves a thorough financial analysis of the proposed project, including cost, risk, and return estimation.
  • Techniques such as NPV (Net Present Value), IRR (Internal Rate of Return), and payback period are used.
• E: Project Selection and its Implementation
  • Projects that pass evaluation are selected, and resources are allocated for their execution.
  • Planning and scheduling are carried out to ensure smooth implementation.
• D: Control of Capital Expenditure
  • This final step involves monitoring and controlling the project during its execution.
  • Performance is compared with the approved budget and timeline to ensure adherence to goals.

Additional Information

• Capital Budgeting
  • It refers to the process of planning and managing long-term investments in assets and projects.
  • Aim is to allocate resources efficiently to maximize shareholder wealth.
• Methods of Evaluation
  • Net Present Value (NPV): Measures the present value of cash inflows minus outflows.
  • Internal Rate of Return (IRR): Determines the discount rate at which the NPV of cash flows equals zero.
  • Payback Period: Estimates the time required to recover the initial investment.
• Importance of Capital Budgeting
  • Ensures optimal utilization of resources for long-term profitability.
  • Helps in managing risks associated with large investments.
  • Facilitates strategic decision-making aligned with organizational goals.

The correct answer is – A-II, B-I, C-IV, D-III

Key Points

• Operating Leverage (A-II)
  • Operating leverage refers to the ratio of Contribution to EBIT.
  • It measures the sensitivity of operating profit to changes in sales.
  • Higher operating leverage indicates greater reliance on fixed costs in the cost structure.
• Combined Leverage (B-I)
  • Combined leverage is calculated using the formula Contribution/EBT.
  • It combines the effects of operating leverage and financial leverage.
  • It indicates the impact of sales and cost structure on earnings before taxes.
• Earning Per Share (EPS) (C-IV)
  • EPS is determined using the formula EAT/Number of Equity Shares.
  • It measures the profitability of a company available to equity shareholders.
  • EPS is an important metric for investors to evaluate financial performance.
• Financial Leverage (D-III)
  • Financial leverage is represented as the ratio of EBIT/EBT.
  • It measures the impact of financial structure (debt and equity) on earnings before taxes.
  • Higher financial leverage increases the risk and potential return for equity shareholders.

Additional Information

• Operating Leverage
  • Used to assess the impact of fixed costs on operating income.
  • Higher fixed costs result in higher operating leverage, which amplifies the effect of sales changes on operating profit.
• Financial Leverage
  • Indicates the extent to which a company uses borrowed funds to finance its operations.
  • It magnifies the impact of EBIT changes on shareholders’ earnings.
• Combined Leverage
  • Represents the overall impact of both operating and financial leverage.
  • Helps in evaluating total risk exposure and profitability sensitivity to sales fluctuations.
• Earnings Per Share (EPS)
  • An essential metric for evaluating shareholder returns.
  • Higher EPS usually signals better financial health and profitability.

The correct answer is – Coefficient of Variation

Key Points

• Coefficient of Variation
  • The Coefficient of Variation (CV) is a measure of relative risk in statistical analysis.
  • It is calculated by dividing the standard deviation of a data set by its mean (expected value) and then often expressed as a percentage.
  • It helps compare the degree of variation between different data sets, even if their means are significantly different.
  • A lower CV indicates less variability relative to the mean, while a higher CV suggests greater variability.

Additional Information

• Variance
  • Variance is a measure of the spread or dispersion in a data set and is calculated as the average of the squared differences from the mean.
  • It is not a measure of relative risk and does not involve division by the expected value.
• Covariance
  • Covariance measures how two random variables change together, but it does not provide a relative measure of risk for a single variable.
• Geometric Mean
  • The geometric mean is a measure of central tendency and is used in situations like calculating average growth rates. It is not related to variability or risk.

The correct answer is – Both (A) and (R) are correct but (R) is not the correct explanation of (A)

Key Points

• New Issue of Capital is costlier than retained earnings because:
  • It involves floatation costs, such as underwriting fees, legal fees, and other issuance-related expenses.
  • There is a risk of underpricing when new shares are issued, which increases the overall cost to the company.
• Retained Earnings represent the profits retained by the company for reinvestment:
  • Its cost is the opportunity cost, i.e., the return that shareholders forego on their dividend income.
• While both statements are correct:
  • The reason provided (R) explains the cost of retained earnings but does not directly justify why the new issue of capital is costlier.

Additional Information

• Cost of Capital:
  • It refers to the return a company needs to generate to justify the cost of a specific source of funding (e.g., retained earnings, debt, equity).
  • It is a critical factor in determining the feasibility of projects and investments.
• Floatation Costs:
  • These are the expenses incurred while issuing new securities, including underwriting fees, registration fees, and legal costs.
  • They directly increase the cost of raising new capital.
• Opportunity Cost:
  • Retained earnings are not free; the cost is the return that shareholders forego by not receiving dividends.
  • This is calculated based on the expected return from alternative investments of similar risk.

The correct answer is – A-III, B-I, C-II, D-IV

Key Points

• Net Present Value (NPV)
  • The formula involves the summation of the present values of cash inflows minus the summation of present values of cash outflows.
  • This concept is correctly matched to III.
• Internal Rate of Return (IRR)
  • IRR is the rate at which the aggregate present value of net cash inflows equals the aggregate present value of cash outflows.
  • This is correctly matched to I.
• Accounting Rate of Return (ARR)
  • ARR is calculated by dividing the average annual profit after tax by the average investment over the life of the project.
  • This is correctly matched to II.
• Profitability Index (PI)
  • PI is determined by dividing the present value of future cash inflows by the present value of cash outflows.
  • This is correctly matched to IV.

Additional Information

• Net Present Value (NPV)
  • NPV is a widely used tool in capital budgeting to evaluate the profitability of an investment or project.
  • If NPV is positive, the project is considered profitable.
• Internal Rate of Return (IRR)
  • IRR is compared with the required rate of return to determine whether a project is viable.
  • A higher IRR indicates a better investment opportunity.
• Accounting Rate of Return (ARR)
  • ARR focuses on accounting profits rather than cash flows.
  • It is simple to calculate but ignores the time value of money.
• Profitability Index (PI)
  • PI helps in ranking projects when capital is limited. A PI greater than 1 indicates a profitable project.

The correct answer is – Perpetuity

Key Points

• Perpetuity
  • A perpetuity is an infinite series of equal cash flows that occur at regular intervals.
  • The payments or cash flows in a perpetuity continue indefinitely, with no specified end date.
  • In finance, perpetuities are often used to value assets that provide steady cash flows indefinitely, such as preferred stocks or certain types of annuities.
  • The present value of a perpetuity can be calculated using the formula: PV = C / r, where:
    • C = Cash flow per period
    • r = Discount rate (rate of return)

Additional Information

• Annuity
  • An annuity is a series of equal payments made at regular intervals for a specified period of time, unlike a perpetuity, which continues indefinitely.
  • Examples include fixed-term investment plans or loans with equal monthly payments.
• Annuity Due
  • An annuity due is a type of annuity where payments are made at the beginning of each period instead of at the end.
  • For example, rent payments are often structured as an annuity due.
• Future Value
  • The future value is the value of a cash flow or series of cash flows at a specific date in the future, calculated using a specified rate of return or interest rate.
  • This concept is different from perpetuity, which focuses on the present value of infinite cash flows.

The correct answer is – Netting

Key Points

• Netting is considered an internal technique of managing foreign exchange risk.
  • It involves offsetting receivables and payables within a company’s entities to reduce exposure to foreign exchange risk.
  • This method is generally used within the company and does not involve external contracts or financial instruments.
• All other options (Forward Contracts, Currency Futures, and Swaps) are external techniques that involve third parties such as banks or financial institutions.

Additional Information

• External Techniques
  • Forward Contracts: Agreements to buy or sell foreign currency at a predetermined rate on a future date.
  • Currency Futures: Standardized contracts traded on exchanges to buy or sell a currency at a future date.
  • Swaps: Agreements between parties to exchange currency cash flows at specified intervals.
• Internal Techniques
  • Netting: Reducing the number of transactions by consolidating payables and receivables between subsidiaries.
  • Other internal techniques include leading and lagging or adjusting the timing of payments to manage exposure.
• Understanding these techniques helps companies mitigate risks arising from fluctuations in foreign exchange rates.

The correct answer is – Matching Approach, Conservative Approach, and Aggressive Approach

Key Points

• Matching Approach
  • This approach matches the duration of assets and liabilities, meaning short-term assets are financed by short-term liabilities, and long-term assets are financed by long-term liabilities.
  • It ensures that financing is aligned with the nature of the asset.
• Conservative Approach
  • Here, a business prefers to finance not only its permanent working capital but also a part of its temporary working capital using long-term funds.
  • This approach minimizes risk but may result in higher financing costs.
• Aggressive Approach
  • In this strategy, a major portion of both permanent and temporary working capital is financed using short-term funds.
  • It is riskier than other approaches but can lead to lower financing costs.

Additional Information

• Operating Cycle Approach
  • This is not directly related to financing mix determination but focuses on the time duration required to convert raw materials into finished goods and then into cash.
  • It helps in understanding the working capital requirements but is not a financing strategy.
• Importance of Financing Mix
  • Choosing the right financing mix is critical to maintain a balance between profitability and liquidity.
  • Each approach has its own risk and return trade-offs, which businesses must evaluate based on their financial objectives.