As a source of finance retained profit is better than other sources. Do you agree with this view ? Give reasons for your answer. Can a company grow definitely by reinvesting surplus profit ?

Solution

Yes, we agree with this view. Following are the reasons for this :

1. As an internal source, it is more dependable than external sources. It does not depend on the investors’ preference and market conditions.

2. Use of retained profit does not involve any cost to be incurred for raising the funds. There are no expenses on prospectus, advertising, etc.

3. Control over the management of the company remains unaffected as there is no addition to the number of shareholders.

4. Unlike debentures, no charge is created against the assets and no restrictions are put on the management.
5. Retained earnings add to the financial strength and improved credibility of the company. A company with large reserves can face unforeseen contingencies, trade cycles and any other crisis.

No, a company cannot grow indefinitely by reinvesting surplus profit because there are certain limitations :

1. The management of a company may not always use the retained earnings in the best interest of shareholders. It may issue them by investing in unprofitable or undesirable channels. Excessive reserves may make the management wasteful and extravagant.

2. Large retention of earnings over a long period of time may cause dissatisfaction among shareholders as they do not receive the expected rate of dividend.

3. If the quantum of retained earnings is too high, the management may issue bonus shares to equity shareholders. Frequent capitalization of reserves may result in over capitalization.

Some More Questions From Sources of Business Finance Chapter

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Sources Of Business Finance

As a source of finance retained profit is better than other sources. Do you agree with this view ? Give reasons for your answer. Can a company grow definitely by reinvesting surplus profit ?

Some More Questions From Sources of Business Finance Chapter

Give meaning of medium-term finance.

Give meaning of short-term finance.

Define shares.

Give the types of shares.

Define preference shares.

Give meaning of equity share.

Give the meaning of debenture.

Define “Ploughing back of profits”.

Give meaning of trade credit.

Explain Bank Credit.

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