Arjun ran a successful retail store specialising in organic products. Over the last few years, his business had been doing very well and the number of customers visiting the store had increased significantly. To meet the growing demand, he decided to expand his business. He was evaluating two investment options :
Option A : Open a new store in the city.
Option B : Launch an online e-commerce platform.
Both the options would involve a huge amount of investment and once made, it would be almost impossible for him to wriggle out of such a decision. Therefore, this decision needed to be taken with utmost care. Arjun was proceeding very carefully as one wrong decision could severely damage the financial fortune of his business.
(i) Identify the financial decision to be taken by Arjun.
(ii) Explain any three factors which would affect this decision.
Arjun ran a successful retail store specialising in organic products. Over the last few years, his business had been doing very well and the number of customers visiting the store had increased significantly. To meet the growing demand, he decided to expand his business. He was evaluating two investment options :
Option A : Open a new store in the city.
Option B : Launch an online e-commerce platform.
Both the options would involve a huge amount of investment and once made, it would be almost impossible for him to wriggle out of such a decision. Therefore, this decision needed to be taken with utmost care. Arjun was proceeding very carefully as one wrong decision could severely damage the financial fortune of his business.
(i) Identify the financial decision to be taken by Arjun.
(ii) Explain any three factors which would affect this decision.
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Solution and Explanation
The case says both options need a huge amount of investment. It also says Arjun cannot easily wriggle out once the money is put in.
A decision about where to put long-term funds in assets, which is hard to reverse, is the investment decision. It is also called the capital budgeting decision.
Arjun is choosing between a new store (Option A) and an online platform (Option B). Choosing one long-term project out of two is exactly what this decision means.
Step 2: Why it is not a financing or dividend decision:
The financing decision is about how to raise funds, such as debt or equity. The dividend decision is about how much profit to pay out. The case talks about neither.
The case talks only about spending money on an asset that will bring returns over many years. So the matching decision is the investment decision.
Step 3: Factor 1: Cash flows of the project:
Every project brings in cash and also takes cash out over its life. Arjun must estimate the cash receipts from the store and from the online platform.
The project with larger and surer cash inflows after meeting all outflows is a better choice. If the inflows are small, the business may struggle to repay the funds used.
Step 4: Factor 2: The rate of return:
Arjun must compare the expected return from Option A with that from Option B. He should prefer the project that gives the higher rate of return on the money invested.
A project with a low return will not justify a huge investment, so this comparison is a key part of the decision.
Step 5: Factor 3: The investment criteria involved:
Each project must be tested with tools such as payback period, net present value and internal rate of return. These tools look at the amount of investment, interest rates, cash flows and returns.
Arjun can apply the same criteria to both options and pick the one that passes better. Different criteria may suit different projects, so he must choose them with care.
Final Answer:
(i) The financial decision taken by Arjun is the investment decision (capital budgeting decision). (ii) Three factors affecting it are the cash flows of the project, the rate of return and the investment criteria involved.
Top CBSE CLASS XII Business Studies Questions
What is the Planning Process?
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(B) Interpersonal skills
(C) Perseverance
(D) Taking initiative - Mention any four most common environmental barriers which an entrepreneur may face while running his/her venture.
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Top CBSE CLASS XII Financial Management Questions
Read the following statements : Assertion (A) and Reason (R).
Assertion (A) : The cost of debt is higher than the cost of equity for a firm.
Reason (R) : The lender’s risk is lower than the equity shareholder’s risk, since the lender earns an assured return and repayment of capital.
Choose the correct alternative from the options given below :
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Explain how the following factors affect the requirements of fixed capital of a company :
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‘Quality Foods Ltd.’, a company manufacturing packaged snacks has been in business for the last 10 years. It enjoys a good reputation and has a loyal customer base. This financial year, the profits of the company increased manifold as the company introduced a new range of baked snacks that became very popular. As the year came to an end, the company had to decide how much dividend to pay to its shareholders. In view of the above and with the understanding that investors, in general, view an increase in dividend as good news and stock prices react positively to it, the Board of Directors were keen on declaring a high dividend. However, the Chief Finance Officer of the company pointed out that they need to keep many considerations in mind before declaring dividend. He drew the attention of the Board of Directors to the loan that the company has taken, containing a clause that imposes restriction on the payment of dividend. Further, he pointed out that even though the profits were high, a large amount of money was tied to the amounts receivables from the debtors. Without enough cash in hand, announcing a high dividend may not be practical. He also reminded the Board of Directors that ‘Quality Foods Ltd.’ was planning to expand into the breakfast cereal market. Since this new project will require a huge investment, the company will need to retain more money out of their earnings to finance it.
(a) Identify and explain any two factors affecting dividend decision that would have influenced the decision of the Board of Directors to pay a high dividend.
(b) Identify and explain any two factors to which the Chief Finance Officer drew the attention of the Board of Directors.
A position when a company is unable to meet its fixed financial charges like interest payment, dividend on preference shares and repayment obligations is referred to as ______ .
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