BUSINESS FINANCE

UNIT I Business Finance: Introduction – Meaning – Concepts -Scope – Function of Finance Traditional and Modern Concepts – Contents of Modern Finance Functions.

INTRODUCTIONIn our present day economy, finance is defined as the provision of money at the time when it is required. Every enterprise, whether big, medium or small, needs finance to carry on its operations and to achieve its targets. In fact, finance is so indispensable today that it is rightly said to be the lifeblood of an enterprise.

The subject of finance has been traditionally classified into two classes: (i) Public Finance and (ii) Private Finance. Public finance deals with the requirements, receipts and disbursements of funds in the government institutions like states, local self-governments and central government. Private finance is concerned with requirements, receipts and disbursements of funds in case of an individual, a profit seeking business organisation and a non-profit organisation. Thus, private finance can be classified into: (i) Personal finance (ii) Business Finance and (iii) Finance of nonprofit organisations.

MEANING OF FINANCE

The word finance was originally a French word. In the 18 th century, it was adapted by English speaking communities to mean “the management of money.” It is the study of how people allocate their assets over time under conditions of certainty and uncertainty. Today, finance is not merely a word else has emerged into an academic discipline of greater significance. Finance is now organized as a branch of Economics. Every enterprise needs finance to carry on its operations. It is the lifeblood of any business. The objective of the business could not be achieved without finance.

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PUBLIC FINANCE PRIVATE FINANCE

Government institutions

State Governments

Local Self-Governments

Central Governments

Personal Finance

Business Finance

Finance of Non-Profit Organisations

BUSINESS FINANCE

Finance is nothing but an exchange of available resources. Finance is not restricted only to the exchange and/or management of money. A barter trading system is also a type of finance. Thus, we can say, Finance is an art of managing various available resources like money, assets, investments, securities, etc. Finance is the science of managing financial resources in an optimal pattern i.e. the best use of available financial sources.

Finance consists of three interrelated areas1) Money & Capital markets, which deals with securities markets & financial Institutions.2) Investments, which focuses on the decisions of both individual and institutionalInvestors as they choose assets for their investment portfolios.3) Financial Management, or business finance which involves the actual management of Firms.

DEFINITIONS OF FINANCEIn General sense, "Finance is the management of money and other valuables, which can be easily converted into cash."

According to Entrepreneurs, "Finance is concerned with cash. It is so, since, every business transaction involves cash directly or indirectly."

According to Academicians, "Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilization of funds. It also deals with profits that adequately compensate for the cost and risks borne by the business."

Meaning of Business financeBusiness finance refers to using an outside resource to help cover the financial needs of a business. It is an activity or a process, which is concerned with acquisition of funds, use of funds and distribution of profits by a business firm. Thus it deals with financial planning, acquisition of funds, use and allocation funds and financial controls.

The following characteristics of business finance will make its meaning clearer Business finance includes all types of funds used in business. Business finance is needed in all types of organisations large or small,

manufacturing or trading. The amount of business finance differs from one business firm to another

depending upon its nature and size. It also varies from time to time. Business finance involves estimation of funds. It is concerned with raising funds

from different sources as well as investment of funds for different purposes.

NEED AND IMPORTANCE OF BUSINESS FINANCE

Business finance is required for the establishment of every business organisation. With the growth in activities, financial needs also grow. Funds are required for the purchase of land and building, machinery and other fixed assets. Besides this, money is also needed

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to meet day-today expenses e.g. purchase of raw material, payment of wages and salaries, electricity bills, telephone bills etc. You are aware that production continues in anticipation of demand. Expenses continue to be incurred until the goods are sold and money is recovered. Money is required to bridge the time gap between production and sales. Besides producers, may be necessary to change the office set up in order to install computers. Renovation of facilities can be taken up only when adequate funds are available.

1. To meet contingenciesFunds are always required to meet the ups and downs of business and unforeseen problems. Suppose, some manufacturer anticipates shortage of raw materials after a period. Obviously he would like to stock raw materials. But he will be able to do so only when money would be available.

2. To promote salesIn this era of competition, lot of money is required to be spent on activities for promoting sales like advertisement, personal selling, home delivery of goods etc.

3. To avail of business opportunitiesFunds are also required to avail of business opportunities. Suppose a company wants to submit a tender but some minimum amount is required to be deposited along with the application. In the case of non-availability of funds it would not be possible for the company to apply.

Financial Management

Financial management refers to that part of the management activity which is concerned with the planning and controlling of firm’s financial resources, it deal with finding out various sources for raising funds for the firm. The sources must be suitable and economical for the needs of business. The most appropriate use of such funds also forms a part of financial management.

EVOLUTION OF FINANCIAL MANAGEMENT

Financial management emerged as a distinct field of study at the turn of this century. Its evolution may be divided into three broad phases (though the demarcating lines between these phases are somewhat arbitrary): the traditional phase, the transitional phase, and the modern phase. The traditional phase lasted for about four decades. The following were its important features

1. The focus of financial management was mainly on certain episodic events like formation, issuance of capital, major expansion, merger, reorganization, and liquidation in the life cycle of the firm.2. The approach was mainly descriptive and institutional. The instruments of financing, the institutions and procedures used in capital markets, and the legal aspects of financial events formed the core of financial management.

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3. The outsider’s point of view was dominant. Financial management was viewed mainly from the point of the investment bankers, lenders, and other outside interests. The transitional phase begins around the early forties and continues through the early fifties. Though the nature of financial mgmt during this phase was similar to that of the traditional phase, greater emphasis was placed on the day to day problem faced by the finance managers in the area of funds analysis, planning, and control. These problems however were discussed within limited analytical framework. The modern phase begin in mid 50’s and has witnessed an accelerated pace of development with the infusion of ideas from economic theories and applications of quantitative methods of analysis.The distinctive features of modern phase are* The scope of financial management has broadened. The central concern of financial management is considered to be a rational matching of funds to their uses in the light of appropriate decision criteria* The approach of financial management has become more analytical and quantitative* The point of view of the managerial decision maker has become dominant Since the beginning of the modern phase many significant and seminal developments have occurred in the fields of capital budgeting, capital structure theory, efficient market theory, optional pricing theory, agency theory, arbitrage pricing theory, valuation models, dividend policy, working capital management, financial modeling, and behavioral finance. Many more exciting developments are in the offing making finance a fascinating and challenging field.

Goals of financial management

Financial theory in general rests on the premises that the goal of the firm should be maximized the value of the firm to its equity share holders. This means that the goal of the firm should be to maximize the share value of the equity share which represents the value of the firm to its equity share holders. It appears to provide a rational guide for business decision making and promote an efficient allocation of resources in the economic system. Savings are allocated primarily on the basis of expected returns and risk and the market value of the firm’s equity stock reflects the risk return trade off investors in the market place.

If a firm makes decision aimed at maximizing the market value of its equity, it will raise capital only when its investments warrant the use of capital from the overall point of the economy. This suggests that resources are allocated optimally. If a firm does not pursue the goal of shareholders wealth maximization, it implies that its action results in a sub optimal allocation of resources. This in turn leads to inadequate capital formation and lower rate of economic growth. Equity shareholders provide the venture capital required to start a business firm and appoint he management of the firm indirectly through the board of directors.. Therefore it is obligatory on the part of corporate management to take care of the welfare of equity shareholders.

SCOPE OF FINANCIAL MANAGEMENT

Financial management is one of the important parts of overall management, which is

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directly related with various functional departments like personnel, marketing and production. Financial management covers wide area with multidimensional approaches. The following are the important scope of financial management.

1. Financial Management and Economics Economic concepts like micro and macroeconomics are directly applied with the financial management approaches. Investment decisions, micro and macro environmental factors are closely associated with the functions of financial manager. Financial management also uses the economic equations like money value discount factor, economic order quantity etc. Financial economics is one of the emerging area, which provides immense opportunities to finance, and economical areas.

2. Financial Management and Accounting Accounting records includes the financial information of the business concern. Hence, we can easily understand the relationship between the financial management and accounting. In the olden periods, both financial management and accounting are treated as a same discipline and then it has been merged as Management Accounting because this part is very much helpful to finance manager to take decisions. But nowaday’s financial management and accounting discipline are separate and interrelated.

3. Financial Management or Mathematics Modern approaches of the financial management applied large number of mathematical and statistical tools and techniques. They are also called as econometrics. Economic order quantity, discount factor, time value of money, present value of money, cost of capital, capital structure theories, dividend theories, ratio analysis and working capital analysis are used as mathematical and statistical tools and techniques in the field of financial management.

4. Financial Management and Production Management Production management is the operational part of the business concern, which helps to multiple the money into profit. Profit of the concern depends upon the production performance. Production performance needs finance, because production department requires raw material, machinery, wages, operating expenses etc. These expenditures are decided and estimated by the financial department and the finance manager allocates the appropriate finance to production department. The financial manager must be aware of the operational process and finance required for each process of production activities.

5. Financial Management and Marketing Produced goods are sold in the market with innovative and modern approaches. For this, the marketing department needs finance to meet their requirements. The financial manager or finance department is responsible to allocate the adequate finance to the marketing department. Hence, marketing and financial management are interrelated and depends on each other.

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6. Financial Management and Human Resource Financial management is also related with human resource department, which provides manpower to all the functional areas of the management. Financial manager should carefully evaluate the requirement of manpower to each department and allocate the finance to the human resource department as wages, salary, remuneration, commission, bonus, pension and other monetary benefits to the human resource department. Hence, financial management is directly related with human resource management.

IMPORTANCE OF FINANCIAL MANAGEMENT In a big organization, the general manger or the managing director is the overall incharge of the organization but he gets all the activities done by delegating all or some of his powers to men in the middle or lower management, who are supposed to be specialists in the field so that better results may be obtained.

For example, management and control of production may be delegated to a man who is specialist in the techniques, procedures, and methods of production. We may designate him “Production Manager'. So is the case with other branches of management, i.e., personnel, finance, sales etc.

The incharge of the finance department may be called financial manger, finance controller, or director of finance who is responsible for the procurement and proper utilisation of finance in the business and for maintaining co-ordination between all other branches of management.

Importance of finance cannot be over-emphasized. It is, indeed, the key to successful business operations. Without proper administration of finance, no business enterprise can reach its full potentials for growth and success. Money is a universal lubricant which keeps the enterprise dynamic-develops product, keeps men and machines at work, encourages management to make progress and creates values. The importance of financial administration can be discussed under the following heads:-

1. Success of Promotion Depends on Financial Administration. One of the most important reasons of failures of business promotions is a defective financial plan. If the plan adopted fails to provide sufficient capital to meet the requirement of fixed and fluctuating capital an particularly, the latter, or it fails to assume the obligations by the corporations without establishing earning power, the business cannot be carried on successfully. Hence sound financial plan is very necessary for the success of business enterprise.

2. Smooth Running of an Enterprise. Sound Financial planning is necessary for the smooth running of an enterprise. Money is to an enterprise, what oil is to an engine. As, Finance is required at each stage f an enterprise, i.e., promotion, incorporation, development, expansion and administration of day-to-day working etc., proper administration of finance is very necessary. Proper financial administration means the

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study, analysis and evaluation of all financial problems to be faced by the management and to take proper decision with reference to the present circumstances in regard to the procurement and utilisation of funds.

3. Financial Administration Co-ordinates Various Functional Activities. Financial administration provides complete co-ordination between various functional areas such as marketing, production etc. to achieve the organisational goals. If financial management is defective, the efficiency of all other departments can, in no way, be maintained. For example, it is very necessary for the finance-department to provide finance for the purchase of raw materials and meting the other day-to-day expenses for the smooth running of the production unit. If financial department fails in its obligations, the Production and the sales will suffer and consequently, the income of the concern and the rate of profit on investment will also suffer. Thus Financial administration occupies a central place in the business organisation which controls and co-ordinates all other activities in the concern.

4. Focal Point of Decision Making. Almost, every decision in the business is take in the light of its profitability. Financial administration provides scientific analysis of all facts and figures through various financial tools, such as different financial statements, budgets etc., which help in evaluating the profitability of the plan in the given circumstances, so that a proper decision can be taken to minimise the risk involved in the plan.

5. Determinant of Business Success. It has been recognised, even in India that the financial manger splay a very important role in the success of business organisation by advising the top management the solutions of the various financial problems as experts. They present important facts and figures regarding financial position an the performance of various functions of the company in a given period before the top management in such a way so as to make it easier for the top management to evaluate the progress of the company to amend suitably the principles and policies of the company. The financial manges assist the top management in its decision making process by suggesting the best possible alternative out of the various alternatives of the problem available. Hence, financial management helps the management at different level in taking financial decisions.

6. Measure of Performance. The performance of the firm can be measured by its financial results, i.e, by its size of earnings Riskiness and profitability are two major factors which jointly determine the value of the concern. Financial decisions which increase risks will decrease the value of the firm and on the to the hand, financial decisions which increase the profitability will increase value of the firm. Risk an profitability are two essential ingredients of a business concern.

CLASSIFICATION OF FINANCE

PRIVATE FINANCE Personal finance and Business finance.

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Private Finance Public Finance

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The personal finance is concerned with the acquisition and the proper utilization of economic resource by the individuals and households for meeting their different needs.

The business finance is also a part of private finance. The business finance is concerned with the acquisition, management and utilization of fund by the private business organizations.

PUBLIC FINANCE Is the study supports the financial aspect of the government? Here we study about the government expenditure, public revenue, public borrowing and financial administration. The economic activities of the public enterprises also fall under public finance. The objective of private of business finance is to earn maximum return or profit. On the contrary the objective of public finance is to maximize social welfare.

APPROACHES TO FINANCE FUNCTIONThe finance function also plays a key role in articulating business performance and enabling management to address and react to trends quickly. Financial management has undergone significant changes, over the years in its scope and coverage. Approaches: Broadly, it has two, as mentioned below:

TRADITIONAL APPROACH 

The traditional approach to the scope of financial management refers to its subject matter in the academic literature in the initial stages of its evolution as a separate branch of study. According to this approach, the scope of financial management is confined to the raising of funds. Hence, the scope of finance was treated by the traditional approach in the narrow sense of procurement of funds by corporate enterprise to meet their financial needs. Since the main emphasis of finance function at that period was on the procurement of funds, the subject was called corporation finance till the mid-1950's and covered discussion on the financial instruments, institutions and practices through which funds are obtained. Further, as the problem of raising funds is more intensely felt at certain episodic events such as merger, liquidation, consolidation, reorganization and so on. These are the broad features of the subject matter of corporation finance, which has no concern with the decisions of allocating firm's funds. But the scope of finance function in the traditional approach has now been discarded as it suffers from serious criticisms. Again, the limitations of this approach fall into the following categories. 

The emphasis in the traditional approach is on the procurement of funds by the corporate enterprises, which was woven around the viewpoint of the suppliers of funds such as investors, financial institutions, investment bankers, etc, i.e. outsiders. It implies that the traditional approach was the outsider-looking-in approach. Another limitation was that internal financial decision-making was completely ignored in this approach.

The second criticism leveled against this traditional approach was that the scope of financial management was confined only to the episodic events such as mergers, acquisitions, reorganizations, consolation, etc. The scope of finance function in this

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approach was confined to a description of these infrequent happenings in the life of an enterprise. Thus, it places over emphasis on the topics of securities and its markets, without paying any attention on the day to day financial aspects.

Another serious lacuna in the traditional approach was that the focus was on the long-term financial problems thus ignoring the importance of the working capital management. Thus, this approach has failed to consider the routine managerial problems relating to finance of the firm.

During the initial stages of development, financial management was dominated by the traditional approach as is evident from the finance books of early days. The traditional approach was found in the first manifestation by Green's book written in 1897, Meades on Corporation Finance, in 1910; Doing's on Corporate Promotion and Reorganisation, in 1914, etc.

As stated earlier, in this traditional approach all these writings emphasized the financial problems from the outsiders' point of view instead of looking into the problems from managements, point of view. It over emphasized long-term financing lacked in analytical content and placed heavy emphasis on descriptive material. Thus, the traditional approach omits the discussion on the important aspects like cost of the capital, optimum capital structure, valuation of firm, etc. In the absence of these crucial aspects in the finance function, the traditional approach implied a very narrow scope of financial management. The modern or new approach provides a solution to all these aspects of financial management. 

According to this approach the scopes of finance function was confined to only procurement of funds needed by a business on most suitable terms. The utilization of funds was considered beyond the purview of finance function. It was felt that decisions regarding application of funds are taken somewhere else in the organization. The scope of finance function was treated, in the narrow sense of procurement or arrangement of funds. It was felt that the finance manager had no role to play in decision making for its utilization

As per this approach, the following aspects only were included in the scope of financial management

1. Estimation of requirements of finance,2. Arrangement of funds from financial institutions,3. Arrangement of funds through financial instruments such as shares, debentures,

bonds and loans, 4. Looking after the accounting and legal work connected with the raising of funds.The limitations are1. It is outsider-looking approach that completely ignores internal decision-making as to

the proper utilization of funds.2. The focus of traditional approach was on procurement of long term funds. Thus, it

ignored the important issue of working capital finance and management.

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3. The issue of allocation of funds, which is so important today, is completely ignored.4. It does not lay focus on day-to-day financial problems of an organization.

MODERN APPROACH

After the 1950's, a number of economic and environmental factors, such as the technological innovations, industrialization, intense competition, interference of government, growth of population, necessitated efficient and effective utilisation of financial resources. In this context, the optimum allocation of the firm's resources is the order of the day to the management. Then the emphasis shifted from episodic financing to the managerial financial problems, from raising of funds to efficient and effective use of funds. Thus, the broader view of the modern approach of the finance function is the wise use of funds. Since the financial decisions have a great impact on all other business activities, the financial manager should be concerned about deter-mining the size and nature of the technology, setting the direction and growth of the business, shaping the profitability, amount of risk taking, selecting the asset mix, determination of optimum capital structure, etc.

The new approach is thus an analytical way of viewing the financial problems of a firm. According to the new approach, the financial management is concerned with the solution of the major areas relating to the financial operations of a firm, viz., investment, and financing and dividend decisions. The modern financial manager has to take financial decisions in the most rational way. These decisions have to be made in such a way that the funds of the firm are used optimally. These decisions are referred to as managerial finance functions since they require special care with extraordinary administrative ability, management skills and decision - making techniques, etc.

It views finance function in broader sense. It includes both rising of funds as well as their effective utilization under the preview of finance. The modern approach considers the three basic management decisions. i.e., Investment decisions, financing decisions and dividend decisions within the scope of finance function. Financial management is considered as vital and an integral part of overall management. The modern approach is analytical way of looking into the financial problems of the firm.Advice of finance manager is required at every moment, whenever any decision with involvement of funds is taken. Hardly, there is an activity that does not involve funds.

SCOPE OF FINANCIAL MANAGEMENT

Estimating financial requirements: The amount required for purchasing fixed assets as well as needs of funds for working capital will have to be ascertained.

Deciding capital structure: The proportion of how the funds should be raised has to be decided. A decision about various sources for funds should be linked to the cost of raising funds.

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Selecting a source of finance: After preparation of capital structure, an appropriate source of finance is selected. It includes share capital, debentures. Financial institutions, commercial banks, public deposits etc

Selecting pattern of Investment: Decision has to be taken on where the funds procured or raised should be invested. Techniques such as Capital budgeting, Opportunity Cost Analysis etc. may be applied for this purpose

Proper Cash Management: Various cash needs at different times has to be assessed. The cash management should be in such a way that there is neither shortage of cash nor it is idle.

Proper use of surplus: A judicious use of surpluses is essential for expansion and diversification of plans and also in protecting the interests of shareholders.

Implementing Financial controls: Efficient system of financial management necessitates the use of various control devices.

The control devices and techniques help in evaluating the performance in various areas and take corrective measures.

1. Budgetary control, 2. Break-even analysis, 3. Cost control, 4. Ratio analysis5. Cost and internal audit. 6. Return on investment

AREAS & CONCEPTS OF FINANCIAL MANAGEMENT As already discussed, the general meaning of finance refers to providing funds, as and when needed. However, as management function, the term ‘Financial Management’ has a distinct meaning. Financial management deals with the study of procuring funds and it’s effective and judicious utilization, in terms of the overall objectives of the firm, and expectations of the providers of funds. The basic objective is to maximize the value of the firm.

“Financial Management is concerned with the efficient use of an important economic resource, namely, Capital Funds” – Solomon

“Financial Management is concerned with the managerial decisions that result in the acquisition and financing of short-term and long-term credits for the firm” – Phillioppatus

“Business finance is that business activity which is concerned with the conservation and acquisition of capital funds in meeting financial needs and overall objectives of a business enterprise” - Wheeler

AREAS OF FINANCIAL MANAGEMENT

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Analysis of Financial StatementsAnalysis of financial statement is one of the most common techniques of financial analysis, in which the financial performance and financial health of the companies are analyzed based on its past performance.

The following financial statements are used in the analysis process. Profit & Loss Statement or Income Statement Balance Sheet Statement of Shareholders’ equity Statement of Cash Flow

Investment Decisions & Capital BudgetingInvestment decisions are the most critical as they usually involve huge sum of money and these decisions are likely to bring prosperity or end to a business. A company’s future income depends on how much investment is made, in what type of assets, and how these assets add to the overall value of the company.

Capital budgeting is a term strictly related to investment in fixed assets. Here, the term capital refers to the fixed assets that are used in production, while budget is a plan which details projected cash inflows and outflows over some future period. The following concepts and techniques are employed while analyzing investment decisions.

Interest rate formulas Time Value of Money Discounted Cash Flows Net Present Value Internal Rate of Return

Risk & ReturnInvestors, individual or institutional, invest their money with the expectations of earning a return on their investment. While investors wish and attempt to earn maximum return, they are constrained by risk. How the risks and returns are related and how do investors make a choice of their portfolios is important for investment decision-making. Following concepts and theories would be discussed while discussing the risk-return choices of the investor.

Uncertainty Risk Portfolio Theory and Capital Asset Pricing Model

Corporate Financing & Capital StructureWhen a firm plans to expand, it needs capital or funds. Acquisition of funds is considered to be a primary responsibility of a finance department in an organization. There are

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numerous ways to acquire funds, i.e., finances can be raised in the form of debt or equity. The proportion of debt and equity constitutes the capital structure of the firm. Financial experts attempt to find a combination of debt and equity that could increase the overall value of the company, i.e., they try to find the optimal capital structure. The following concepts would be used to understand how an optimal capital structure could be attained.

Cost of Capital Leverage Dividend Policy Debt Instruments Valuation.

Asset or company valuation is important not only for financial managers, but also for creditors and investors. It is important to know the value of the company or its assets to make important financing and investment choices. Different valuation techniques and factors that influence the value of a company or its financial instruments would be discussed

Share Bond Option Corporate

Working Capital & Inventory ManagementWorking capital and inventory management pertains to the effective management of current assets. As we will see, an optimal and effective utilization of working capital and inventory increases the operating efficiency of the firm.

International Finance & foreign exchangeWith the increasing importance of international trade and global markets, the role of international finance has increased manifold. In a global environment, the finance managers have more choices pertaining to investing and financing than ever before. However, it is important to understand the implications of working in a global environment, since fluctuations in the currency rates can convert a good financing or investment decision into a bad one.

ROLE OF FINANCE MANGER Financial manger is the person responsible for carrying out the finance function. He occupies the key position in an organization.

Raising of Fund 1. See that firm has adequate cash to meet the daily needs.2. Make financial decisions3. Raise the needed funds form combination of various sources.

Funds Allocation

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Using skills and techniques in implementing a system of optimum allocation of firm’s resources. There should be efficient allocation of resources. Financial manger must find a rationale for answering the following questionsi. How large should an enterprise be and how fast should it grow?ii. In What form should it hold its assets?iii. How should the funds required be raised?

The answers will three broad decisions 1. Investment,2. Financing and 3. Dividend.

FUNCTIONS OF FINANCE MANAGER

Finance function is one of the major parts of business organization, which involves the permanent, and continuous process of the business concern. Finance is one of the interrelated functions which deal with personal function, marketing function, production function and research and development activities of the business concern. At present, every business concern concentrates more on the field of finance because, it is a very emerging part which reflects the entire operational and profit ability position of the concern. Deciding the proper financial function is the essential and ultimate goal of the business organization.

Finance manager is one of the important role players in the field of finance function. He must have entire knowledge in the area of accounting, finance, economics and management. His position is highly critical and analytical to solve various problems related to finance. A person who deals finance related activities may be called finance manager.

Finance manager performs the following major functions:

1. Forecasting Financial Requirements It is the primary function of the Finance Manager. He is responsible to estimate the financial requirement of the business concern. He should estimate, how much finances required to acquire fixed assets and forecast the amount needed to meet the working capital requirements in future.

2. Acquiring Necessary Capital After deciding the financial requirement, the finance manager should concentrate how the finance is mobilized and where it will be available. It is also highly critical in nature.

3. Investment Decision The finance manager must carefully select best investment alternatives and consider the reasonable and stable return from the investment. He must be well versed in the field of capital budgeting techniques to determine the effective utilization of investment. The finance manager must concentrate to principles of

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safety, liquidity and profitability while investing capital.

4. Cash Management Present days cash management plays a major role in the area of finance because proper cash management is not only essential for effective utilization of cash but it also helps to meet the short-term liquidity position of the concern.

5. Interrelation with Other Departments Finance manager deals with various functional departments such as marketing, production, personel, system, research, development, etc. Finance manager should have sound knowledge not only in finance related area but also well versed in other areas. He must maintain a good relationship with all the functional departments of the business organization.

IMPORTANCE OF FINANCIAL MANAGEMENTFinancial management is indispensable in any organization as it helps in 1. Financial planning and successful promotion of an enterprise2. Acquisition of funds as and when required a minimum possible cost.3. Proper use and allocation of funds4. Taking sound financial decisions5. Improving the profitability through financial controls6. Increasing the wealth of the investors and the nation 7. Promoting and mobilizing individual and corporate savings

Finance is the lifeblood of business organization. It needs to meet the requirement of the business concern. Each and every business concern must maintain adequate amount of finance for their smooth running of the business concern and also maintain the business carefully to achieve the goal of the business concern. The business goal can be achieved only with the help of effective management of finance. We can’t neglect the importance of finance at any time at and at any situation. Some of the importance of the financial management is as follows:

Financial PlanningFinancial management helps to determine the financial requirement of the business concern and leads to take financial planning of the concern. Financial planning is an important part of the business concern, which helps to promotion of an enterprise.

Acquisition of FundsFinancial management involves the acquisition of required finance to the business concern. Acquiring needed funds play a major part of the financial management, which involve possible source of finance at minimum cost.Proper Use of FundsProper use and allocation of funds leads to improve the operational efficiency of the business concern. When the finance manager uses the funds properly, they can reduce the cost of capital and increase the value of the firm.

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Financial DecisionFinancial management helps to take sound financial decision in the business concern. Financial decision will affect the entire business operation of the concern. Because there is a direct relationship with various department functions such as marketing, production personnel, etc.

Improve ProfitabilityProfitability of the concern purely depends on the effectiveness and proper utilization of funds by the business concern. Financial management helps to improve the profitability position of the concern with the help of strong financial control devices such as budgetary control, ratio analysis and cost volume profit analysis.

Increase the Value of the FirmFinancial management is very important in the field of increasing the wealth of the investors and the business concern. Ultimate aim of any business concern will achieve the maximum profit and higher profitability leads to maximize the wealth of the investors as well as the nation.

Promoting SavingsSavings are possible only when the business concern earns higher profitability and maximizing wealth. Effective financial management helps to promoting and mobilizing individual and corporate savings.

Nowadays financial management is also popularly known as business finance or corporate finances. The business concern or corporate sectors cannot function without the importance of the financial management.

FUNCTIONS OF FINANCEFinance function is the most important function of a business. Finance is, closely, connected with production, marketing and other activities. In the absence of finance, all these activities come to a halt. in fact, only with finance, a business activity can be commenced, continued and expanded. Finance exists everywhere, be it production, marketing, human resource development or undertaking research activity. Understanding the universality and importance of finance, finance manager is associated, in modern business, in all activities as no activity can exist without funds.

AIMS OF FINANCE FUNCTION

1. Acquiring sufficient and suitable funds: The primary aim of finance function is to assess the needs of the enterprise, properly, and procure funds, in time. Time is also an important element in meeting the needs of the organisation. If the funds are not available as and when required, the firm may become sick or, at least, the profitability of the firm would be, definitely, affected. It is necessary that the funds should be, reasonably, adequate to the demands of the firm. The funds should be raised from different sources, commensurate to the nature of business and risk profile of the organisation. When the

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nature of business is such that the production does not commence, immediately, and requires long gestation period, it is necessary to have the long-term sources like share capital, debentures and long term loan etc. A concern with longer gestation period does not have profits for some years. So, the firm should rely more on the permanent capital like share capital to avoid interest burden on the borrowing component.

2. Proper Utilization of Funds: Raising funds is important, more than that is its proper utilization. If proper utilization of funds were not made, there would be no revenue generation. Benefits should always exceed cost of funds so that the organization can be profitable. Beneficial projects only are to be undertaken. So, it is all the more necessary that careful planning and cost-benefit analysis should be made before the actual commencement of projects.

3. Increasing Profitability: Profitability is necessary for every organization. The planning and control functions of finance aim at increasing profitability of the firm. To achieve profitability, the cost of funds should be low. Idle funds do not yield any return, but incur cost. So, the organization should avoid idle funds. Finance function also requires matching of cost and returns of funds. If funds are used efficiently, profitability gets a boost.

4. Maximizing Firm’s Value: The ultimate aim of finance function is maximizing the value of the firm, which is reflected in wealth maximisation of shareholders. The market value of the equity shares is an indicator of the wealth maximisation.

THE MAIN OBJECTIVES OF FINANCIAL MANAGEMENT DEALS WITH

PROFIT MAXIMIZATION Objective of financial management is same as the objective of a company that is to earn profit. But profit maximization cannot the sole objective of a company. It is a limited objective. If profits are given undue Importance then problems may arise as discussed below.

The term profit is vague and it involves much more contradictions. Profit maximization has to be attempted with a realization of risks involved. A positive relationship exists between risk and profits. So both risk and profit objectives should be balanced. Profit Maximization does not take into account the time pattern of returns. Profit maximization fails to take into account the social considerations. It is the main objective of any business.

It is a measure of efficiency of any business. The arguments in favor of Profit maximization are as follows

Profit maximization is the obvious objective Justified on the grounds of its rationality Economic and business conditions do not remain same at all times.

Therefore a business should be survived under unfavorable condition only if it has some past earnings to rely upon.

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Profits are needed for growth and development. Essential for fulfilling social goals.

Favorable Arguments for Profit MaximizationThe following important points are in support of the profit maximization objectives of the business concern:

(i) Main aim is earning profit. (ii) Profit is the parameter of the business operation. (iii) Profit reduces risk of the business concern. (iv) Profit is the main source of finance. (v) Profitability meets the social needs also.

Unfavorable Arguments for Profit Maximization

The following important points are against the objectives of profit maximization:

(i) Profit maximization leads to exploiting workers and consumers. (ii) Profit maximization creates immoral practices such as corrupt practice, unfair

trade practice, etc. (iii) Profit maximization objectives leads to inequalities among the stake holders such

as customers, suppliers, public shareholders, etc.

Drawbacks of Profit Maximization

Profit maximization objective consists of certain drawback also:

(i) It is vague: In this objective, profit is not defined precisely or correctly. It creates some unnecessary opinion regarding earning habits of the business concern.

(ii) It ignores the time value of money: Profit maximization does not consider the time value of money or the net present value of the cash inflow. It leads certain differences between the actual cash inflow and net present cash flow during a particular period.

(iii) It ignores risk: Profit maximization does not consider risk of the business concern. Risks may be internal or external which will affect the overall operation of the business concern.

PROFIT MAXIMIZATION IS REJECTED BECAUSE OF THE FOLLOWING DRAWBACKS

The term profit is vague Ignores the time value of money It doesn’t take the risk prospective into consideration The market price of the shares is not considered.

WEALTH MAXIMIZATION

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It is the maximizing of value of stock as course of action to shareholders. When the firm maximizes the stock holder’s wealth, the individual stock holders can use this wealth to maximize his individual utility.

It is commonly agreed that the objective of a firm is to maximize value or wealth. Value of a firm is represented by the market price of the company's common stock. The market price of a firm's stock represents the focal judgment of all market participants as to what the value of the particular firm is. It takes in to account present and prospective future earnings per share, the timing and risk of these earning, the dividend policy of the firm and many other factors that bear upon the market price of the stock. Market price acts as the performance index or report card of the firm's progress.

Prices in the share markets are largely affected by many factors like general economic outlook, outlook of particular company, technical factors and even mass psychology. Normally this value is a function of two factors as given below, the anticipated rate of earnings per share of the company the capitalization rate.

The likely rate of earnings per shares (EPS) depends upon the assessment as to how profitably a company is growing to operate in the future.

The capitalization rate reflects the liking of the investors for the company. Methods of Financial Management: In the field of financing there are various methods to procure funds. Funds may be obtained from long-term sources as well as from short-term sources. Long-term funds may be availed by owners that are shareholders, lenders by issuing debentures, from financial institutions, banks and public at large. Short-term funds may be availed from commercial banks, public deposits, etc. Financial leverage or trading on equity is an important method by which a finance manager may increase the return to common shareholders.

At the time of evaluating capital expenditure projects methods like average rate of return, pay back, internal rate of returns, net present value and profitability index are used. A firm can increase its profitability without affecting its liquidity by an efficient utilization of the current resources at the disposal of the firm. A firm can increase its profitability without affecting its liquidity by an efficient management of working capital.

Similarly for the evaluation of a firm's performance there are different methods. Ratio analysis is a popular technique to evaluate different aspects of a firm. An investor takes in to account various ratios to know whether investment in a particular company will be profitable or not. These ratios enable him to judge the profitability, solvency, and liquidity and growth aspect of the firm.

Arguments favoring Wealth maximization Increases the share holders interest by increasing the value of holdings

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Stockholders’ current wealth in a firm = (no. of shares owned) * (current stock price per share)

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Ensures security to lenders Productivity and efficiency is increased The management may survive for a longer period The shareholders may not like to change a management if the value of holdings is

increased. The economic interest of the society is served.

Criticisms The idea is not descriptive as to what the firms actually do. It is not necessarily socially desirable There is controversy as to whether the objectives is to maximize the stock holders

wealth of the wealth of the firm which includes other financial claim holders such as debenture holders, preference shareholders etc.

There is difficulty when the management and ownership differs. When managers act as agents of real owners there is possibility for them to increase the managerial interests and not the interest of owners.

OBJECTIVES OF FINANCIAL MANAGEMENTThe objectives of financial management are1. Profit maximization

The main objective of financial management is profit maximization. The finance manager tries to earn maximum profits for the company in the short-term and the long-term. He cannot guarantee profits in the long term because of business uncertainties. However, a company can earn maximum profits even in the long-term, if:-i. The Finance manager takes proper financial decisions.

ii. He uses the finance of the company properly.2. Wealth maximization

Wealth maximization (shareholders' value maximization) is also a main objective of financial management. Wealth maximization means to earn maximum wealth for the shareholders. So, the finance manager tries to give a maximum dividend to the shareholders. He also tries to increase the market value of the shares. The market value of the shares is directly related to the performance of the company. Better the performance, higher is the market value of shares and vice-versa. So, the finance manager must try to maximise shareholder's value.

3. Proper estimation of total financial requirements Proper estimation of total financial requirements is a very important objective of financial management. The finance manager must estimate the total financial requirements of the company. He must find out how much finance is required to start and run the company. He must find out the fixed capital and working capital requirements of the company. His estimation must be correct. If not, there will be shortage or surplus of finance. Estimating the financial requirements is a very difficult job. The finance manager must consider many factors, such as the type of technology used by company, number of employees employed, scale of operations, legal requirements, etc.

4. Proper mobilization

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Mobilisation (collection) of finance is an important objective of financial management. After estimating the financial requirements, the finance manager must decide about the sources of finance. He can collect finance from many sources such as shares, debentures, bank loans, etc. There must be a proper balance between owned finance and borrowed finance. The company must borrow money at a low rate of interest.

5. Proper utilisation of financeProper utilisation of finance is an important objective of financial management. The finance manager must make optimum utilisation of finance. He must use the finance profitable. He must not waste the finance of the company. He must not invest the company's finance in unprofitable projects. He must not block the company's finance in inventories. He must have a short credit period.

6. Maintaining proper cash flow Maintaining proper cash flow is a short-term objective of financial management. The company must have a proper cash flow to pay the day-to-day expenses such as purchase of raw materials, payment of wages and salaries, rent, electricity bills, etc. If the company has a good cash flow, it can take advantage of many opportunities such as getting cash discounts on purchases, large-scale purchasing, giving credit to customers, etc. A healthy cash flow improves the chances of survival and success of the company.

7. Survival of company Survival is the most important objective of financial management. The company must survive in this competitive business world. The finance manager must be very careful while making financial decisions. One wrong decision can make the company sick, and it will close down.

8. Creating reserves One of the objectives of financial management is to create reserves. The company must not distribute the full profit as a dividend to the shareholders. It must keep a part of it profit as reserves. Reserves can be used for future growth and expansion. It can also be used to face contingencies in the future.

9. Proper coordination Financial management must try to have proper coordination between the finance department and other departments of the company.

10. Create goodwillFinancial management must try to create goodwill for the company. It must improve the image and reputation of the company. Goodwill helps the company to survive in the short-term and succeed in the long-term. It also helps the company during bad times.

11. Increase efficiencyFinancial management also tries to increase the efficiency of all the departments of the company. Proper distribution of finance to all the departments will increase the efficiency of the entire company.

12. Financial disciplineFinancial management also tries to create a financial discipline. Financial discipline means:-

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i. To invest finance only in productive areas. This will bring high returns (profits) to the company.

ii. To avoid wastage and misuse of finance.13. Reduce cost of capital

Financial management tries to reduce the cost of capital. That is, it tries to borrow money at a low rate of interest. The finance manager must plan the capital structure in such a way that the cost of capital it minimised.

14. Reduce operating risks Financial management also tries to reduce the operating risks. There are many risks and uncertainties in a business. The finance manager must take steps to reduce these risks. He must avoid high-risk projects. He must also take proper insurance.

15. Prepare capital structure Financial management also prepares the capital structure. It decides the ratio between owned finance and borrowed finance. It brings a proper balance between the different sources of capital. This balance is necessary for liquidity, economy, flexibility and stability.

FINANCIAL DECISIONSSome of the important functions which every finance manager has to take are as follows:

1. Investment decision2. Financing decision3. Dividend decision

A. INVESTMENT DECISION (CAPITAL BUDGETING DECISION)This decision relates to careful selection of assets in which funds will be invested by the firms. A firm has many options to invest their funds but firm has to select the most appropriate investment which will bring maximum benefit for the firm and deciding or selecting most appropriate proposal is investment decision.The firm invests its funds in acquiring fixed assets as well as current assets. When decision regarding fixed assets is taken it is also called capital budgeting decision.Factors Affecting Investment/Capital Budgeting Decisions1. Cash Flow of the ProjectWhenever a company is investing huge funds in an investment proposal it expects some regular amount of cash flow to meet day to day requirement. The amount of cash flow an investment proposal will be able to generate must be assessed properly before investing in the proposal.2. Return on InvestmentThe most important criteria to decide the investment proposal is rate of return it will be able to bring back for the company in the form of income for, e.g., if project A is bringing 10% return and project В is bringing 15% return then we should prefer project B.3. Risk InvolvedWith every investment proposal, there is some degree of risk is also involved. The company must try to calculate the risk involved in every proposal and should prefer the investment proposal with moderate degree of risk only.

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4. Investment CriteriaAlong with return, risk, cash flow there are various other criteria which help in selecting an investment proposal such as availability of labour, technologies, input, machinery, etc.The finance manager must compare all the available alternatives very carefully and then only decide where to invest the most scarce resources of the firm, i.e., finance.Investment decisions are considered very important decisions because of following reasons:

1. They are long term decisions and therefore are irreversible; means once taken cannot be changed.

2. Involve huge amount of funds.3. Affect the future earning capacity of the company.

IMPORTANCE OR SCOPE OF CAPITAL BUDGETING DECISIONCapital budgeting decisions can turn the fortune of a company. The capital budgeting decisions are considered very important because of the following reasons:1. Long Term GrowthThe capital budgeting decisions affect the long term growth of the company. As funds invested in long term assets bring return in future and future prospects and growth of the company depends upon these decisions only.2. Large Amount of Funds InvolvedInvestment in long term projects or buying of fixed assets involves huge amount of funds and if wrong proposal is selected it may result in wastage of huge amount of funds that is why capital budgeting decisions are taken after considering various factors and planning.3. Risk InvolvedThe fixed capital decisions involve huge funds and also big risk because the return comes in long run and company has to bear the risk for a long period of time till the returns start coming.4. Irreversible DecisionCapital budgeting decisions cannot be reversed or changed overnight. As these decisions involve huge funds and heavy cost and going back or reversing the decision may result in heavy loss and wastage of funds. So these decisions must be taken after careful planning and evaluation of all the effects of that decision because adverse consequences may be very heavy.B. FINANCING DECISION The second important decision which finance manager has to take is deciding source of finance. A company can raise finance from various sources such as by issue of shares, debentures or by taking loan and advances. Deciding how much to raise from which source is concern of financing decision. Mainly sources of finance can be divided into two categories:

1. Owners fund2. Borrowed fund

Share capital and retained earnings constitute owners’ fund and debentures, loans, bonds, etc. constitute borrowed fund.The main concern of finance manager is to decide how much to raise from owners’ fund and how much to raise from borrowed fund.

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While taking this decision the finance manager compares the advantages and disadvantages of different sources of finance. The borrowed funds have to be paid back and involve some degree of risk whereas in owners’ fund there is no fix commitment of repayment and there is no risk involved. But finance manager prefers a mix of both types. Under financing decision finance manager fixes a ratio of owner fund and borrowed fund in the capital structure of the company.

Factors Affecting Financing DecisionsWhile taking financing decisions the finance manager keeps in mind the following factors:1. CostThe cost of raising finance from various sources is different and finance managers always prefer the source with minimum cost.2. RiskMore risk is associated with borrowed fund as compared to owner’s fund securities. Finance manager compares the risk with the cost involved and prefers securities with moderate risk factor.3. Cash Flow PositionThe cash flow position of the company also helps in selecting the securities. With smooth and steady cash flow companies can easily afford borrowed fund securities but when companies have shortage of cash flow, then they must go for owner’s fund securities only.4. Control ConsiderationsIf existing shareholders want to retain the complete control of business then they prefer borrowed fund securities to raise further fund. On the other hand if they do not mind to lose the control then they may go for owner’s fund securities.5. Floatation CostIt refers to cost involved in issue of securities such as broker’s commission, underwriters fees, expenses on prospectus, etc. Firm prefers securities which involve least floatation cost.6. Fixed Operating CostIf a company is having high fixed operating cost then they must prefer owner’s fund because due to high fixed operational cost, the company may not be able to pay interest on debt securities which can cause serious troubles for company.7. State of Capital MarketThe conditions in capital market also help in deciding the type of securities to be raised. During boom period it is easy to sell equity shares as people are ready to take risk whereas during depression period there is more demand for debt securities in capital market.

C. DIVIDEND DECISIONThis decision is concerned with distribution of surplus funds. The profit of the firm is distributed among various parties such as creditors, employees, debenture holders, shareholders, etc.

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Payment of interest to creditors, debenture holders, etc. is a fixed liability of the company, so what company or finance manager has to decide is what to do with the residual or left over profit of the company.

The surplus profit is either distributed to equity shareholders in the form of dividend or kept aside in the form of retained earnings. Under dividend decision the finance manager decides how much to be distributed in the form of dividend and how much to keep aside as retained earnings.To take this decision finance manager keeps in mind the growth plans and investment opportunities.

If more investment opportunities are available and company has growth plans then more is kept aside as retained earnings and less is given in the form of dividend, but if company wants to satisfy its shareholders and has less growth plans, then more is given in the form of dividend and less is kept aside as retained earnings.This decision is also called residual decision because it is concerned with distribution of residual or left over income. Generally new and upcoming companies keep aside more of retain earning and distribute less dividend whereas established companies prefer to give more dividend and keep aside less profit.

Factors Affecting Dividend DecisionThe finance manager analyses following factors before dividing the net earnings between dividend and retained earnings:1. EarningDividends are paid out of current and previous year’s earnings. If there are more earnings then company declares high rate of dividend whereas during low earning period the rate of dividend is also low.2. Stability of EarningsCompanies having stable or smooth earnings prefer to give high rate of dividend whereas companies with unstable earnings prefer to give low rate of earnings.3. Cash Flow PositionPaying dividend means outflow of cash. Companies declare high rate of dividend only when they have surplus cash. In situation of shortage of cash companies declare no or very low dividend.4. Growth OpportunitiesIf a company has a number of investment plans then it should reinvest the earnings of the company. As to invest in investment projects, company has two options: one to raise additional capital or invest its retained earnings. The retained earnings are cheaper source as they do not involve floatation cost and any legal formalities.If companies have no investment or growth plans then it would be better to distribute more in the form of dividend. Generally mature companies declare more dividends whereas growing companies keep aside more retained earnings.5. Stability of DividendSome companies follow a stable dividend policy as it has better impact on shareholder and improves the reputation of company in the share market. The stable dividend policy

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satisfies the investor. Even big companies and financial institutions prefer to invest in a company with regular and stable dividend policy.There are three types of stable dividend policies which a company may followConstant dividend per shareIn this case, the company decides a fixed rate of dividend and declares the same rate every year, e.g., 10% dividend on investment.Constant payout ratioUnder this system the company fixes up a fixed percentage of dividends on profit and not on investment, e.g., 10% on profit so dividend keeps on changing with change in profit rate.Constant dividend per share and extra dividendUnder this scheme a fixed rate of dividend on investment is given and if profit or earnings increase then some extra dividend in the form of bonus or interim dividend is also given.6. Preference of ShareholdersAnother important factor affecting dividend policy is expectation and preference of shareholders as their expectations cannot be ignored by the company. Generally it is observed that retired shareholders expect regular and stable amount of dividend whereas young shareholders prefer capital gain by reinvesting the income of the company.They are ready to sacrifice present day income of dividend for future gain which they will get with growth and expansion of the company.Secondly poor and middle class investors also prefer regular and stable amount of dividend whereas wealthy and rich class prefers capital gains.So if a company is having large number of retired and middle class shareholders then it will declare more dividend and keep aside less in the form of retained earnings whereas if company is having large number of young and wealthy shareholders then it will prefer to keep aside more in the form of retained earnings and declare low rate of dividend.7. Taxation PolicyThe rate of dividend also depends upon the taxation policy of government. Under present taxation system dividend income is tax free income for shareholders whereas company has to pay tax on dividend given to shareholders. If tax rate is higher, then company prefers to pay less in the form of dividend whereas if tax rate is low then company may declare higher dividend.8. Access to Capital Market ConsiderationWhenever company requires more capital it can either arrange it by issue of shares or debentures in the stock market or by using its retained earnings. Rising of funds from the capital market depends upon the reputation of the company.If capital market can easily be accessed or approached and there is enough demand for securities of the company then company can give more dividend and raise capital by approaching capital market, but if it is difficult for company to approach and access capital market then companies declare low rate of dividend and use reserves or retained earnings for reinvestment.9. Legal RestrictionsCompanies’ Act has given certain provisions regarding the payment of dividends that can be paid only out of current year profit or past year profit after providing depreciation fund. In case company is not earning profit then it cannot declare dividend.

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Apart from the Companies’ Act there are certain internal provisions of the company that is whether the company has enough flow of cash to pay dividend. The payment of dividend should not affect the liquidity of the company.10. Contractual ConstraintsWhen companies take long term loan then financier may put some restrictions or constraints on distribution of dividend and companies have to abide by these constraints.11. Stock Market ReactionThe declaration of dividend has impact on stock market as increase in dividend is taken as a good news in the stock market and prices of security rise. Whereas a decrease in dividend may have negative impact on the share price in the stock market. So possible impact of dividend policy in the equity share price also affects dividend decision.

Inter-relationship between Investment, Financing and DividendThree major functions of finance department are Financing DecisionThis function is mainly concerned with determination of optimum capital structure of the company keeping in mind cost, control and risk. It is also known as Procurement of Fund.Investment DecisionIt is also known as Effective Utilization of Fund. In this respect finance department has to identify the investment opportunities and to choice the best one , after a proper evaluation.Dividend DecisionThe finance manager is also concerned with the decisions to pay or declare dividend. He assists the top management to decide the portion of profit to be declared as dividend.

So far the objective is concerned; the above stated three functions are same i.e. maximizing shareholders wealth. As their objectives are same the decisions are interrelated. A company having profitable investment opportunities, generally prefer lower dividend payout ratio. On the other hand having a good investment means profit of the company would be more and more dividend can be paid to shareholders. Similarly, finance function and investment functions are also highly correlated. Cost of capital plays a major role whether to accept or not an investment opportunity. Financing decisions also dependent on amount of to be retained in the profit. So, we can conclude that investment, financing and dividend decisions are interrelated and are to be taken jointly keeping in view their joint effect on the shareholders wealth.Investment decisions/ Long-term asset-mix Involve Capital expenditure Referred as Capital budgeting Allocation of funds to long term assets which yield returns in future Evaluation of new projects Measurement of cut off rate against new investments Evaluation on the basis of return and risk Involves replacement decisions

Financing Decision / Capital Mix From where and how to acquire funds

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Determination of appropriate proposition of equity and debt Debt equity mix is called Capital Structure Change in shareholder’s returns by a change in Capital structure is called Financial

Leverage Best combination of debt-equity that would increase returns with the given risk should

be found out Legal aspects, loan facilities, controls etc should also be considered while deciding

capital structure.

Factors influencing financial decisionsExternal Factors State of economy Structure of capital and money markets Requirements of investors Government policy Taxation policy Lending policy of financial institutions.Internal Factors Nature and size of business Expected return Composition of assets Structure of ownership Trend of earnings Age of the firm Liquidity position Working capital requirements Conditions of debt agreements

RELATIONSHIP BETWEEN RISK AND RETURN

Risk: Risk is defined as the chance of future loss that can be foreseen. Return: The return represents the benefits derived by a business from its

operations.

Measurement of Return: On the basis of Profit On the basis of Income On the basis of Earnings Before Interest and Tax (EBIT) On the basis of Earnings Before Tax (EBT) On the basis of Earnings After Tax (EAT) On the basis of Cash flows generated in the business operations On the basis of different accounting Ratios

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FUNCTIONS OF A FINANCE MANAGERAs a company grows, the responsibilities of the finance manager expand, with more outsourced functions coming in-house and more long-term strategic planning added to the finance manager's plate. Understanding the roles and responsibilities of a corporate finance manager will help you decide if this career is right for you and how to prepare to land these types of finance jobs.PlanningUnlike a bookkeeper or accountant, a financial manager, often known as a chief financial officer, plans long-term financial strategy for a company, delegating bookkeeping work to lower-level staff. The financial planning aspect of the job includes setting goals for achieving specific revenues, profit margins and gross profits. It also requires setting targets for overhead and production expense levels and debt-service management. The financial manager needs to create a master budget that’s tied to the company’s balance sheet, accounts receivable and payable reports and cash flow and profit-and-loss statements. The financial manager conducts regular reviews of the master budget, called budget variance analyses, to determine if any changes should be made based on the actual performance of the company vs. its financial projections. Financial managers also determine the best investment options for a business’s excess cash and review ways to acquire capital for expansion or acquisitions.Cost ContainmentA key responsibility of a financial manager is to control the company’s expenses. This requires more than simply setting spending levels and cutting costs. Cost containment includes creating requests for proposals, bidding processes and purchasing policies for contractors, vendors and suppliers to ensure the company gets the best combination of quality and price. The financial manager sets benchmarks that determine when it’s most cost-effective to perform activities using in-house staff and when it’s better to use contractors. Cost-containment efforts include managing debt to ensure interest payments don’t wipe out company profits. Financial managers also create strategies that help reduce a company’s tax liability, such as depreciating assets.Cash Flow ManagementOne of the most important functions of a financial manager is to project and manage the company’s cash flow. Cash flow refers to the actual receipt of money and payment of bills, as opposed to the company’s budgeted income and expenses. Assuming that because a business has more income than expenses it can pay its bills can lead to disaster. For example, if the company does not negotiate customer credit terms and vendor and supplier payment terms correctly, the business might be waiting to collect sales invoices long after bills have come due. Cash flow management includes monitoring receivables turnover and keeping enough credit and cash reserves available to keep the company financially stable.Legal ComplianceThe corporate financial manager ensures the business meets all of its legal obligations, such as sales and income tax payments; employee benefits contributions; state and federal labor wage requirements; and Securities and Exchange Commission reporting, if the company is a public corporation. At small and medium-sized businesses, the financial manager often works with tax experts and CPAs who guide the company regarding its legal obligations.

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THE FINANCIAL MANAGER The financial manager is responsible for budgeting, projecting cash flows, and determining how to invest and finance projects.Key Points

The finance manager is responsible for knowing how much the product is expected to cost and how much revenue it is expected to earn so that s/he can invest the appropriate amount in the product.

The finance manager uses a number of tools, such as setting the cost of capital (the cost of money over time, which will be explored in further depth later on) to determine the cost of financing.

The financial manager must not just be an expert at financial projections; s/he also must have a grasp of the accounting systems in place and the strategy of the business over the coming years.

The head of the financial department is the chief financial officer (CFO) who is responsible for all financial decisions and reporting done in the company.

The Role of the Financial Manager The role of a financial manager is a complex one, requiring both an understanding of how the business functions as a whole and specialized financial knowledge. The head of the financial operations is called the chief financial officer (CFO). The structure of the company varies, but a financial manager is responsible for the same general things across the board. The manager is responsible for managing the budget. This involves allocating money to different projects and segments so that the business can continue operating, but the best projects get the necessary funding.

The manager is responsible for figuring out the financial projections for the business. The development of a new product, for example, requires an investment of capital over time. The finance manager is responsible for knowing how much the product is expected to cost and how much revenue it is expected to earn so that s/he can invest the appropriate amount in the product. This is a lot tougher than it sounds because there is no accurate financial data for the future. The finance manager will use data analyses and educated guesses to approximate the value, but it's extremely rare that s/he can be 100% sure of the future cash flows.

Figuring out the value of an operation is one thing, but it is another thing to figure out if it's worth financing. There is a cost to investing money, either the opportunity cost of not investing it elsewhere, the cost of borrowing money, or the cost of selling equity. The finance manager uses a number of tools, such as setting the cost of capital (the cost of money over time, which will be explored in further depth later on) to determine the cost of financing.

At the same time that this is going on, the financial manager must also ensure that the business has enough cash to pay upcoming financial obligations without hoarding assets that could otherwise be invested. This is a delicate dance between short-term and long-term responsibilities.

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The CFO is the head of the financial department and is responsible for all of the same things as his/her subordinates, but is also the person who has to sign off that all of the company's financial statements are accurate. S/he is also responsible for financial planning and record-keeping, as well as financial reporting to higher management. The financial manager is not just an expert at financial projections, s/he must also have a grasp of the accounting systems in place and the strategy of the business over the coming years.

CAPITAL Money and wealth; the means to acquire goods and services, especially in a non-barter system.

COLLABORATION The finance manager must collaborate across business functions in order to determine how to best allocate and manage assets.

CONTROLLERThe controller or Chief Accounting Officer is responsible for the maintenance of adequate internal control and for the preparation of accounting records and financial statements such specialized activities as budgeting, tax planning and preparation of tax returns are usually placed under the controller's jurisdiction.

TREASURER (vice president of finance) The Treasurers has custody of the company funds and is generally responsible for planning and controlling the company cash position. The treasurer's department also has responsibility for relations with the company's financial institutions and major creditors.

CONTROLLERSHIP TREASURERSHIPa. Planning & Control a. Provision of capitalb. Reporting & interpreting b. Investor relationsc. Evaluating & Consulting c. Banking & custodyd. Government reporting d. Credit & collectionse. Protection of assets e. Investmentsf. Economic appraisal f. Insuranceg. Tax administration g. Short-term financing.

Section A1. Corporation finance deals with the company form of organization. True / False.2. In the present days, corporation finance is also referred to as business finance and

financial management. True / False.3. The principles of corporation finance can be applied to every type of

organization. True/ False.4. Traditional approach confines finance function only to raising of funds. True/

False.

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5. Finance function is one of the most important functions of business management. True/ False.

6. Investment decisions are outside the purview of financial decisions. True/ False.7. The appropriate objective of an enterprise is _______________.8. The job of a finance manager is __________9. Business finance can be defined as the activity concerned with -------, -------- and

__________ of funds used in business.10. Finance functions or decisions can be classified into ------- and --------- decisions.

Section B1. Write the scope and features of business finance.2. How should a finance function of an enterprise be organised – explain in detail3. Objectives of finance functions4. How does traditional approach differ from modern concept of finance?5. Explain – Criticism of traditional approach in business finance6. Can you state the nature of finance and its interaction with other management

functions.7. Can you state the contents of modern finance?8. Brief the modern concept of finance functions.9. Illustrate the organisation of finance function.10. What are the difference between short and long term finance functions or

decisions?

Section C1. Explain the important finance function of a business.2. Discuss the modern finance function concept.3. Functions of a finance manager in a large scale industrial establishment –

Enumerate4. What is business finance? Discuss its objectives in detail.5. State the functions of a financial controller.6. Concepts of business finance.7. What are the main considerations to be followed with the finance function in an

organisation.8. What are the main considerations to be followed with the finance function in an

organisation.9. Name four finance functions and briefly explain on each.10. What are the objectives/scope of a business finance?

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UNIT IIFinancial Plan: Meaning -Concept – Objectives – Types – Steps – Significance – Fundamentals.

FINANCIAL PLANNING

Introduction

Finance is the life blood of business. No business can run successfully without adequate finance. Finance is required to bring a business into existence, to keep it alive and also to see it growing and prospering.

Finance is an important function of business. The application of planning to this function is called financial planning. Financial planning is mainly concerned with the economical procurement and profitable use of funds. According to Gutlman and Dougall, "Financial planning is concerned with raising, controlling and administering of funds used in business." In the words of Bouneville and Dewey, "Financial planning consists in the raising, providing and managing  of all the money, capital of funds of any kind to be used in connection with the business." Financial planning is an important element of the overall planning of business enterprise. Financial planning includes the following:

Estimating the amount of capital required for financing the business enterprise; Determining capital structure; Laying down policies for the administration of capital; Formulating the programmes to provide the most effective use of capital.

Meaning Finance is the important function of business. Financial policy and procedure are the broad guides in the procurement, administration and disbursement of funds. A well prepared financial plan will not only ensure the procurement of sufficient funds but their proper utilization also.

Financial planning results in the formation of the financial plan. It is the process of framing financial policies in relation to procurement, investment and administration of funds of an enterprise. It is primarily a statement estimating the amount of capital and determining its composition. The application of planning to the functions of finance is mainly concerned with the economical procurement and profitable uses of funds. It involves the determination of objectives policies and procedures relating to the financial function. The term "financial plan" often refers to a formal and defined series of steps or goals and provides direction and meaning to your financial decisions.The process of determining person's or firm's financial needs or goals for the future and the means to achieve them.

Definition According to Hamptors John, the financial statement is an organized collection of data according to logical and consistent accounting procedures. Its purpose is to convey an understanding of financial aspects of a business firm. It may show a position at a moment

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of time as in the case of a balance-sheet or may reveal a service of activities over a given period of time, as in the case of an income statement.

Financial statements are the summary of the accounting process, which, provides useful information to both internal and external parties. John N. Nyer also defines it “Financial statements provide a summary of the accounting of a business enterprise, the balance-sheet reflecting the assets, liabilities and capital as on a certain data and the income statement showing the results of operations during a certain period”.

Financial statements generally consist of two important statements:

(i) The income statement or profit and loss account. (ii) Balance sheet or the position statement.

A part from that, the business concern also prepares some of the other parts of statements, which are very useful to the internal purpose such as:

(i) Statement of changes in owner’s equity. (ii) Statement of changes in financial position.

Income StatementIncome statement is also called as profit and loss account, which reflects the operational position of the firm during a particular period. Normally it consists of one accounting year. It determines the entire operational performance of the concern like total revenue generated and expenses incurred for earning that revenue.

Income statement helps to ascertain the gross profit and net profit of the concern. Gross profit is determined by preparation of trading or manufacturing a/c and net profit is determined by preparation of profit and loss account.

Position StatementPosition statement is also called as balance sheet, which reflects the financial position of the firm at the end of the financial year.

Position statement helps to ascertain and understand the total assets, liabilities and capital of the firm. One can understand the strength and weakness of the concern with the help of the position statement.

Statement of Changes in Owner’s EquityIt is also called as statement of retained earnings. This statement provides information about the changes or position of owner’s equity in the company. How the retained earnings are employed in the business concern. Nowadays, preparation of this statement is not popular and nobody is going to prepare the separate statement of changes in owner’s equity.

Statement of Changes in Financial Position

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Income statement and position statement shows only about the position of the finance, hence it can’t measure the actual position of the financial statement. Statement of changes in financial position helps to understand the changes in financial position from one period to another period.

Statement of changes in financial position involves two important areas such as fund flow statement which involves the changes in working capital position and cash flow statement which involves the changes in cash position.

Why should you plan?Everyone who has financial challenges to overcome or financial goals to achieve need a plan that contributes to their financial stability and wealth.

Steps to follow during financial planning Identify goals and objectives. Gather the information needed. Analyze present situation and think about options. Work out strategies to reach your goals. Execute those strategies. Periodically exam and revise them.

DEFINITIONS “Broadly conceived, financial planning can be viewed as a presentation or an

overall plan for the firm in financial terms. Narrowly conceived financial planning may refer only to the process of determining the financial requirements necessary to support a given set of plans in other areas” - Erra Solemn

“Financial planning pertains only to the function of finance and includes the determination of the firm’s financial objective, financial policies and financial procedures” - J.H.Bonneville

According to Robinson’s, financial planning is1. To determine the financial resources required meeting the companies operating

program me2. Forecast the extent to which these requirements will be met by the internal

generation of funds and the extent to which they will be met by the external source of funds.

3. It envelopes the best plan to obtain then required external; funds.4. Establish and maintain a system of financial controls governing the allocation and

use of funds.5. Formulates programmes to provide the most effective profit volume cost

relationship.6. Analysis the financial results of operations and to meet other expenses.7. Report facts to the top management and make recommendations on future

operations of the firm.

OBJECTIVES OF FINANCIAL PLANNING

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1. Determining capital requirementsThis will depend upon factors like cost of current and fixed assets, promotional expenses and long- range planning. Capital requirements have to be looked with both aspects: short- term and long- term requirements.

2. Adequate fundsA financial plan would ensure the availability of sufficient funds to achieve enterprise goals.

3. Balancing of costs and riskThere should be a balancing of costs and risks so as to protect the investors.

4. Determining capital structureThe capital structure is the composition of capital, i.e., the relative kind and proportion of capital required in the business. Framing financial policies with regards to cash control, lending, borrowings, etc. A finance manager ensures that the scarce financial resources are maximally utilized in the best possible manner at least cost in order to get maximum returns on investment.

5. FlexibilityA financial plan should ensure flexibility so as to adjust as per the requirements. It should be adjustable as per the changing conditions.

6. SimplicityThe financial structure should not be complicated by issuing a variety of securities should be less to that.

7. Long term viewA financial plan should take a long term view. The needs for funds in the near future and over a longer period should be considered while selecting the pattern of financing.

8. LiquidityThe liquidity of funds should always be kept in mind while preparing a financial plan. During the period of depression it is the liquidity which can support t the concern going.

9. Optimum useA financial plan should ensure sufficient funds for the genuine needs, either the plans would suffer due to shortage of funds neither there should be wasteful use of them. The funds should be put to their optimum use.

Financial planning deals with the following Estimation of capital to be raised.

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Decision regarding form and proportion of various securities. Layout the policies regarding financial administration. Financial planning deals with formulation of financial plan.

In simple words, it is nothing but the estimation of amount of capital and deciding its beneficial sources.

Thus, financial plan covers The quantum of finance needed for commencing the business. The decision regarding form and proportion of various corporate securities to be

issued to raise the required amount of capital. The decision regarding policies to be followed for floating of various corporate

securities.

Principles of Financial Plan: Principle of Simplicity Principle of Long-term view Principle of Foresight Principle of Optimum Use Principle of Contingencies Principle of Flexibility Principle of Liquidity Principle of Economy.

CHARATERISTICS OF A SOUND FINANCIAL PLANThe main characteristics of a good financial planning are as follows

SimplicityThe financial plan should be as simple as possible so that it can be easily understood even by a layman, property executed and administered. A complicated financial plan creates unnecessary complications and confusion.Based on Clear-cut ObjectivesThe financial plan should be based on the clear-cut objectives of the company. It should aim to procure adequate funds at the lowest cost so that the profitability of the business is improved.FlexibilityThe financial plan should not be rigid, but rather flexible enough to accommodate the changes which may be introduced in it as and when necessary. The rigid composition of the financial plan may cause unnecessary irritation and may limit the future development of the business unit.Solvency an LiquidityThe financial plan should ensure solvency and liquidity of the business enterprise. solvency requires that short-term and long-term payments should be made on due dates positively. This will ensure credit worthiness and good will to the business enterprise. Liquidity means maintenance of adequate cash balance in hand. Sometimes insufficiency of cash may make a business enterprise bankrupt.Planning Foresight

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Financial planning should have due foresight and vision to access the future needs, scope and scale of operation of the business enterprise. On the basis, financial planning should be done in such a manner that any adjustment needed in the future may be made without much difficulty. As the business proceeds, the financial adjustments become necessary which should be adjustable properly as and when desired.Contingencies AnticipatedThe financial plan should be able to anticipate various contingencies which may arise in the near future. The financial plan should make adequate provision for meeting the challenge of unforeseen events.Minimum Dependence on Outside SourcesA long-term financial planning should aim at minimum dependence on outside resources. This can be possible by retaining a part of the profits for ploughing back.Intensive Use of CapitalFinancial planning should ensure intensive use of capital. As far as possible, a proper balance between fixed and working capital should be maintained.ProfitabilityA financial plan should be drafted in such a way that the profitability of the business enterprise is not adversely affected.EconomicalThe financial plan should be quite economical i.e., the cost burden of raising various types of capital should be minimum.Government Financial Policy and RegulationThe financial policy should be prepared in accordance with the government financial policy and regulation. It should not violate it under any circumstances.

STEPS IN FINANCIAL PLAN1. Past performance

Analysis of the firms past performance to ascertain the relationships between financial variables, and the firm’s financial strength and weaknesses.

2. Operating characteristicsAnalysis of the product, market, competition, production and marketing policies, control systems, operating risk etc to decide about its growth objectives.

3. Cash flow from operationsForecasting the forms revenues and expenses and need for funds based on its investments and dividend policies.

4. Financing alternativesAnalyzing financial alternatives within the financial policy and deciding the appropriate means of raising funds.

5. ConsistencyEvaluating the consistency of financial policies with each other and with the corporate strategy.

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6. UniformityFigures and reports should be expressed in a manner which is consistent with the structure of the organization. Al the costs incurred on or for a given department may be included.

7. FlexibilityThe use of debt financing may be minimized so that a flexible capital structure may be maintained. It would be desirable, on the country, to resort to equity financing.

8. ExceptionsSometimes it is useful for financial executives to know the areas and the extent of deviations from actual performance. If deviations are thrown up, they may be able to readily accept one of the exceptions under abnormal circumstances.

9. ConservativeA financial plan should be conservative in the sense that the debt capacity of the company should not be exceeded.

10. SolvencyThe plan should take proper care of solvency because most of the companies have failed by reason of insolvency. Adequate liquidity will give to an organization that degree of flexibility which is necessary for absorbing the stocks of its normal operations.

11. ProfitabilityA financial plan should maintain the required proportion between fixed charges obligations and the liabilities in such a manner that the profitability of the organization is not adversely affected. The most crucial factor in financial planning is the forecast of sales, for sales almost crucial factor in financial planning is the forecast of sales, for sales almost invariably represent the primary source of income and cash receipts.

12. Varying RisksA financial plan should provide for ventures with varying degrees of risks so that it might enable a corporation to achieve substantial earnings from risky adventures.

13. Planning ForesightA plan should be such that it should derive a practical purpose. It should be realistic and capable of being put to intensive use. But a proper balance between fixed and working capital should be maintained.

14. AvailabilityThe sources of finance that a corporation may select should be available at a given point of time. If certain sources are not available, the corporation may even

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prefer to violate the principles of suitability Availability sometimes bears no relation to cost.

15. TimingA sound financial policy involves effective timing in the acquisition of funds. The key to effective timing is correct forecasting. A sound financial policy implies not only a wise selection of sources but also an effective timing thereof. But this would depend upon the understanding of the management of how business cycles behave during different phases of business operations.

MAJOR AREAS OF FINANCIAL PLANNINGFIXED CAPITAL REQUIREMENTSDefinition of Fixed CapitalIn general, the definition of fixed capital can be stated as under.“Fixed capital is a compulsory initial investment made by the entrepreneur to start up the activities of his business.”Fixed capital is a mandatory one-time investment made at the introductory phase of a business establishment. Fixed capital is not alike working capital, which is required on a continuous basis to operate (run) the ordinary course of production and distribution of goods and services.

According to Hoagland,“Fixed capital is comparatively easily defined to include land, building, machinery and other assets having a relatively permanent existence.”Fixed capital is a permanent investment made to meet the longer-term needs (requirements) of the business activities. Thus, fixed capital has a permanent existence in the business. It is usually present in the form of fixed assets like land, building, plant, machinery, etc.

Meaning of Fixed CapitalThe meaning of fixed capital is depicted in the following chart.The meaning of fixed capital can be easily grasped from these points:

1. Fixed capital is a compulsory initial investment made in the business.2. It helps to lay down the basic infrastructure on which business is supposed to

stand and flourish in a long run.3. It is a part of total capital invested in the business.4. It has a permanent existence in the business to meet its long-term needs.5. It is used for purchasing fixed assets like land, building, plant, machinery, etc.6. It is also used for purchasing intangible assets like patents, copyrights, goodwill,

etc.7. It is required for promoting the business.8. It is also required for expansion, modernization and diversification of business.9. Fixed capital gets depreciated as an asset is used over time with few exceptions

like in case of land.10. Fixed capital requirement is estimated by the promoters of business. This

estimation must be made as accurately as possible. To achieve this, the promoters

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seek professional help and take advice from experts such as engineers, architects, etc.

Examples of Fixed CapitalThe examples of fixed capital are depicted in the following image.Common examples of fixed capital investments are as follows:

Plant and machinery. Factory's land and its buildings. Company's headquarter (HQ), administrative areas, regional and local offices, and

their premises. Computing and communication infrastructure that mostly includes workstations,

servers, data-storage facilities, local-area networks, the internet, telephones, fax, so on.

Patents, copyrights, goodwill, etc., also gets covered under fixed capital.

PLANNING THE FINANCIAL NEEDS OR ESTIMATION OF FINANCIAL REQUIREMENTS.

(1) Planning the total capitalizationCapitalization refers to the total financial resources required by an organization to attain the specified objectives. Poor planning or lack of planning of capitalization drags the firm either towards over capitalization or under capitalization. Under earnings theory, the expected earnings are capitalized art the rate of return that prevails in similar competitive firms.

(2) Estimation of short term and long term fundsLong-term funds are invested in fixed assets and permanent working capital. While short term funds are needed to finance temporary working capital. if short term funds are used to finance fixed assets, it may hamper the liquidity of the company. Conversely, if the long-term funds are used to finance temporary working capital, it may prove costly to the organization. Hence the estimation of the total needs and its subdivision into long term and short term is highly essential.

(3) Capital structure planningCapital structure refers to the finance mix of the different types of long term funds in total capitalization. The change in capital structure affects the cost of capital of the firm as well as the financial risk as represented by the debt-equity ratio. The EPs can be magnified with the help of debt-equity ratio. Thus proper planning is essential.

(4) Profit planningProfit planning is done in terms of the different budgets regarding sales, manufacturing costs, operating costs, administrative costs, sales and distribution costs, interest liabilities,etc.Profit planning is done with the help of the projected profit and loss account. Profit planning estimates the projected profits of the company.. It is valuable for certain important decisions.

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(5) Dividend planning a. Need of internal financing b. Stability in dividend rate.

ASSESSMENT OF FIXED CAPITAL REQUIREMENTS

Fixed capital is required to finance the cost of acquisition of permanent assets such as land, building, plant and machinery, etc and to fund the cost of intangible assets like promotion expenses, organisation expenses, operating losses, costs of financing, patents, copyrights and goodwill, etc. Hence, the assessment of the total amount of fixed capital required in a business involves:I. Estimation of Fixed Assets RequirementsII. Estimation of Intangible Assets Requirements.

I. ESTIMATION OF FIXED ASSETS REQUIREMENTS

Fixed assets requirements are estimated usually at the time of promotion of a new enterprise. However, existing firms any also need it at the time of expansion, growth, replacement and improvement of the existing facilities. It is important not only to estimate the investments needed for these assets but also the time at which these amounts are required.

The promoters and managers of the business can determine various fixed assets required by them from their own experience in the business or by making a study of similar units or by taking advice from technical experts in that line of business. The estimation of the cost of these assets could be made by them by making enquires with the manufactures or suppliers of these assets. Estimation of the cost of land usually poses no problem and the cost of building can be estimated by taking help from building engineers and contractors. Further, the cost of installation of plant and machinery and other equipments should also be made. A sufficient margin for non-firm costs should, however, is made to meet the exigencies.

The requirement of fixed assets varies from business to business. There are a number of factors that determine the requirements of fixed assets in a business.

FACTORS AFFECTING THE ESTIMATION OF FIXED ASSETS REQUIREMENTS

Various factors which affect the estimation of fixed assets requirements in a business can be studied under two heads:

Internal Factors External factors

INTERNAL FACTORS

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Nature or character of businessThe fixed assets requirements of a business basically depend upon the nature of its business. Public utility undertakings such as electricity, water supply and railways require huge fuds to be invested in fixed assets. On the other hand, trading and financial firms have very less requirements for fixed assets but have to invest large amounts in current assets. Manufacturing concerns also require sizeable fixed capital as they have to set up production facilities and invest large funds in fixed assets such a land and buildings, plant and machinery, etc. Thus, the nature of business determines the requirements of fixed assets/capital to a large extent.

Size of businessThe fixed assets/capital requirements of concern are also influenced by the size of its business which may be determined in terms of scale of operations. Generally, larger the size of a business unit, greater is the requirement of fixed assets needed to set up the business operations.

Activities Undertaken by the Enterprise or Scope of BusinessThe requirement of fixed capital also depends upon the number of activities undertaken by the enterprise. For example, if a concern manufactures and markets its products itself, it needs more fixed capital as compared to a concern that undertakes only manufacturing activities or only marketing activities. Similarly, if a concern is engaged in production of all parts of a product, it will require more capital than a concern which is engaged in assembling parts manufactured by other units.

Production TechniquesAnother factor that influences the requirements of fixed capital in a business is the production technique that is to be adopted in the enterprise. For example, use of automatic machinery calls for larger investment in the fixed assets. On the other hand, if production methods are simple, which do not require such equipments, lesser amount of fixed capital shall be needed.

Mode of Acquisition of Fixed Assets (Extent of Lease or Hire)Fixed assets may be purchased out rightly or acquired on lease or hire basis. If an outright purchase of fixed assets is to be made, larger amount of fixed capital shall be required in comparison to the acquisition of fixed assets on leasehold basis or on hire. It is therefore, essential to decide in advance as to which assets are to be acquired on leasehold basis and which are to be purchased out rightly. In the same manner if some of the fixed asset are available on hire or rent, decision has to be taken in regard to the purchase of these assets on outright or hire basis.

Acquisition of old Equipment and plantIn certain industries, old plant and machinery or equipments may be available at prices much below the prices of the new plant and machinery. If old plant and machinery could be satisfactorily used in the business, especially in the areas where the technological change in production method is moderate or slow, it would substantially reduce the required investment in fixed assets.

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Decision as regards ancillary unitsIn certain industries, there may be a possibility of carrying out certain processes through ancillary units or sub-contracts without compromising with the quality and cost of the product. If it is so, the requirements of fixed assets can be decreased.

Availability of fixed assets at concessional ratesIn some areas, the Government provides land and other materials/ facilities at concessional rates to promote balanced industrial growth and regional development of industries. Further, plant and machinery may be made available on instalment basis. Such concessions induce the promoters to establish business in these areas reducing their investment in fixed assets.

EXTERNAL FACTORS

International conditions and Economic OutlookWhile taking decision relating to investment in fixed assets, particularly in a large concern, the general economic and international conditions also play an important role. For example, if the level of business activity is expected to increase, the needs for fixed assets and funds to finance their acquisition will also grow. In the same manner, companies expecting war, may commit large investment in fixed assets before there is a shortage of such material.

Population Trends and its CompositionIf a firm is planning for national market for its products, national population trends must be evaluated while forecasting for fixed assets requirements. In India, certain promoters are encouraged to expand business because the population is increasing at a fast rate. The age and sex composition of the population may also be important for certain businesses.

Shift in Consumer PreferencesAnother factor that affects the future requirements of fixed assets is shift in consumer preferences. Fixed assets requirements should be planned in a manner so as to provide goods or services that consumers will accept.

Competitive factorsThe decision making process on planning future requirements of fixed assets is also influenced by competitive factors. For example, if an existing company shifts to a particular line of business, then others may also follow the lead.

Shift in TechnologyFuture improvements and shifts in technology have also to be considered while deciding about the future requirements of fixed assets. The financial plan should allow a scope for adjustments as and when new situations emerge.

Government Regulations

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There may be certain government regulations affecting the size and the direction of a business enterprise. Hence, these should also be considered while assessing requirements of fixed assets. Although, it may not be possible to forecast changes in the Government policy, a margin should be provided to absorb the impact of such changes.

II. ESTIMATION OF INTANGIBLE ASSET REQUIREMENTS

The expenses of promotion, incorporation of an organization or an establishment of business cost of financing and the amount to be invested in intangible assets. Such as goodwill, patents, copyrights etc., also forms part of fixed capital of a concern.

1. Promotional expensesThe expenses incurred by the promoter to make preliminary investigation, study marketing possibilities, enquires about the technical aspects of production processes and assembling the elements of business are called promotion expenses. These are to be paid to the promoter as compensation for the services rendered by him in promoting the business. Although, it is very difficult to determine the remuneration of the promoter for his personal efforts, time and skill in promoting the business, sufficient provision should be made for the same while estimating the requirement of intangible assets for the purpose of assessing the fixed capital requirements of a business.

2. Incorporation and organization expensesExpenses incurred in setting up the business such as legal counseling, stamp duty, registration fees, filing fees, incorporation taxes, printing, etc. form part of incorporation or organisational cost. It is very essential to make an estimate of such expenses while determining the requirements of fixed capital in a business.

3. Cost of financeThe expenses incurred for arranging the funds required for a business are called costs of financing. These include the remuneration of underwriters, brokers, investment bankers as well as the expenses to be incurred in the preparation of a registration statement and prospectus for making capital issues. These costs would also be estimated while assessing the requirements of intangible assets forming part of the fixed capital.

4. Initial operating lossesEvery enterprise needs some time to stabilize the production and reach the self supporting stage. Until that time, it incurs certain cash losses and funds drain out of the business. Such losses are most prolonged in business requiring huge initial investment, complex production techniques and marketing or developing a novel product. While planning for capital, it is very essential to estimate and provide for such operating initial losses.

5. Cost of acquisition of patents, copyrights, goodwill.etc.

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If the company is considering to purchase patents, copyrights, goodwill, etc. then it is very essential to make an estimate of the cost of these intangible assets and include the same in the fixed capital requirements of a business.

After preparing estimates of fixed assets and intangible assets requirements separately, we can determine the total fixed capital requirements of an enterprise by simply adding the funds needed for fixed assets and intangible assets.

WORKING CAPITAL

Working capital refers to that part of the firm’s capital which is required for financing short term or current assets such as cash, marketable securities, debtors and inventories. Funds thus invested in current assets keep revolving fast and are being constantly converted into cash and this cash flow out again in exchange for other current assets. Hence, it is also known as revolving or circulating capital or short term capital.

The working capital requirements of a concern depend upon a large number of factors such as:

1. Nature or character of business.2. Size of business/ scale of operations3. Production policy4. Manufacturing process/ length of production cycle5. Seasonal variations6. Working capital cycle7. Rate of stock turnover8. Credit policy9. Business cycles10. Rate of growth of business11. Earning Capacity and dividend policy12. Price level changes13. Other factors

To avoid the shortage of working capital at once, an estimate of working capital requirements should be made in advance so that arrangements can be made to procure adequate working capital. The working capital should be determined by estimating the investment in current assets minus moneys expected from current liabilities. The following factors should be taken into consideration while making an estimate of working capital requirements:

1. Total costs incurred on material, wages and overheads.2. The length of time for which raw materials are to remain in stores before they are

issued for production.3. The time taken for conversion of raw material into finished goods.4. The length of sales cycle during which finished goods are to be kept waiting for sales.5. The average period of credit allowed to customers.6. The amount of cash required to pay day-to-day expenses of the business.

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7. The average amount of cash required to make advance payments, if any.8. The average credit period expected to be allowed by suppliers.9. Time lag in payment of wages and other expenses.From the total amount blocked in current assets estimated on the basis of the first seven items given above, the total of the current liabilities, i.e. the last two items is deducted to find out the requirements of working capital.

METHODS USED FOR FINANCIAL PLANNINGThe two important tools of financial planning are

Pro-forma financial statementsMaintenance of solvency and liquidity are the two basic issues in financial management. When the net worth of the firm is nit sufficient to discharge the liabilities in full, the firm is said to be solvent, this is known as “legal insolvency”. Legal insolvency results in either the reorganization or the liquiditation of the firm. In some cases the firm financially sound, net worth of the firm is sufficient to discharge the liabilities on maturity. Such a situation is described as “technical insolvency”. Technical insolvency indicates the liquidity crisis.

The pro-forma financial statement involves the preparation of the following two statements.1. Pro forma profit and loss account (Income statement)2. Pro forma balance sheet.

2. Cash BudgetingThe budget is simply a time-phased schedule of activities of transactions presented usually in rupee form. It can also be presented in other quantitative data. A budget can be presented for any activity with reference to 1. Specific future periodicity and 2. Exact quantitative data relating to that specified period.

A cash budget is important and key instrument of financial planning, especially cash management. A cash budget is time-phased schedule of expected cash inflows and cash outflows, disclosing the cash shortages with reference to timings and magnitude. Cash budget is a planning tool as well as a control technique. NEED FOR FINANCIAL PLANNING

1. Availability of sufficient cash h for meeting expenses, emergencies and contingencies.2. To maintain the necessary liquidity throughput the year.3. To indicate in points of time when funds will be required and how much.4. To indicate the surplus resources available for expansion or external investments.5. To provide ahead for any more funds, if required.6. To increase the confidence in then minds of the surplus of funds by adopting suitable financial policies.7. The environment under which the bu8siness firms operate are constantly changing. There is cut throat competition and consequent narrow margin of profit.

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Hence, planning becomes essential to overcome the risk an reduce the uncertainty as far as possible.

Limitations of Financial Planning

Some of the limitations of financial planning are discussed as follows:

Difficulty in ForecastingFinancial plans are prepared by taking into account the expected situations in the future. Since, the future is always uncertain and things may not happen as these are expected, so the utility of financial planning is limited. The reliability of financial planning is uncertain and very much doubted.

Difficulty in ChangeOnce a financial plan is prepared then it becomes difficult to change it. A changed situation may demand change in financial plan but managerial personnel may not like it. Even otherwise, assets might have been purchased and raw material and labour costs might have been incurred. It becomes very difficult to change financial plan under such situations.

Problem of Co-ordinationFinancial function is the most important of all the functions. Other functions influence a decision about financial plan. While estimating financial needs, production policy, personnel requirements, marketing possibilities are all taken into account. Unless there is a proper co-ordination among all the functions, the preparation of a financial plan becomes difficult. Often there is a lack of co-ordination among different functions. Even indecision among personnel disturbs the process of financial planning.

TYPES OF FINANCIAL STATEMENT ANALYSIS

Analysis of Financial Statement is also necessary to understand the financial positions during a particular period. According to Myres, “Financial statement analysis is largely a study of the relationship among the various financial factors in a business as disclosed by a single set of statements and a study of the trend of these factors as shown in a series of statements”.

Analysis of financial statement may be broadly classified into two important types on the basis of material used and methods of operations.

Types of Financial Analysis

On the basis of On the basis ofMaterials Used Methods of Operations

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Fig. 2.2 Types of Financial Statement Analysis

1. Based on Material Used Based on the material used, financial statement analysis may be classified into two major types such as External analysis and internal analysis.

A. External Analysis Outsiders of the business concern do normally external analyses but they are indirectly involved in the business concern such as investors, creditors, government organizations and other credit agencies. External analysis is very much useful to understand the financial and operational position of the business concern. External analysis mainly depends on the published financial statement of the concern. This analysis provides only limited information about the business concern.

B. Internal Analysis The company itself does disclose some of the valuable informations to the business concern in this type of analysis. This analysis is used to understand the operational performances of each and every department and unit of the business concern. Internal analysis helps to take decisions regarding achieving the goals of the business concern.

2. Based on Method of Operation Based on the methods of operation, financial statement analysis may be classified into two major types such as horizontal analysis and vertical analysis.

A. Horizontal Analysis Under the horizontal analysis, financial statements are compared with several years and based on that, a firm may take decisions. Normally, the current year’s figures are compared with the base year (base year is consider as 100) and how the financial information are changed from one year to another. This analysis is also called as dynamic analysis.

B. Vertical Analysis Under the vertical analysis, financial statements measure the quantities relationship of the various items in the financial statement on a particular period. It is also called as static analysis, because, this analysis helps to determine the relationship with various items appeared in the financial statement. For example, a sale is assumed as 100 and other items are converted into sales figures.

TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS

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Financial statement analysis is interpreted mainly to determine the financial and operational performance of the business concern. A number of methods or techniques are used to analyse the financial statement of the business concern. The following are the common methods or techniques, which are widely used by the business concern.

Techniques

Ratio Comparative Trend Common Funds Flow Cash FlowSizeAnalysis Statement Analysis Statement StatementAnalysis

Fig. 2.3 Techniques of Financial Statement Analysis

1. Comparative Statement Analysis A. Comparative Income Statement Analysis B. Comparative Position Statement Analysis

2. Trend Analysis 3. Common Size Analysis 4. Fund Flow Statement 5. Cash Flow Statement 6. Ratio Analysis

Comparative Statement AnalysisComparative statement analysis is an analysis of financial statement at different period of time. This statement helps to understand the comparative position of financial and operational performance at different period of time.

Comparative financial statements again classified into two major parts such as comparative balance sheet analysis and comparative profit and loss account analysis.

Comparative Balance Sheet AnalysisComparative balance sheet analysis concentrates only the balance sheet of the concern at different period of time. Under this analysis the balance sheets are compared with previous year’s figures or one-year balance sheet figures are compared with other years. Comparative balance sheet analysis may be horizontal or vertical basis. This type of analysis helps to understand the real financial position of the concern as well as how the assets, liabilities and capitals are placed during a particular period.

Exercise 1

The following are the balance sheets of Tamil Nadu Mercantile Bank Ltd., for the years 2003 and 2004 as on 31st March. Prepare a comparative balance sheet and discuss the operational performance of the business concern.

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Balance Sheet of Tamil Nadu Mercantile Bank Limited

As on 31st March (Rs. in thousands)Liabilities 2003 2004 Assets 2003 2004

Rs. Rs. Rs. Rs.

Capital 2,845 2,845 Cash and BalanceReserve and with RBI 27,06,808 22,37,601

Surplus 39,66,009 47,65,406 Balance with BanksDeposits 4,08,45,783 4,40,42,730 and Money at call &Borrowings and short notice 11,36,781 16,07,975Other Liabilities 7,27,671 2,84,690 Investments 2,14,21,060 2,35,37,098

Provisions 16,74,165 17,99,197 Advances 1,95,99,764 2,11,29,869Fixed Assets 4,93,996 5,36,442Other Assets 18,58,064 18,35,883

4,72,16,473 5,08,94,868 4,72,16,473 5,08,94,868

Solution

Comparative Balance Sheet Analysis

Increased/ Increased/Particulars Year ending 31st March Decreased Decreased

(Amount) (Percentage)

2003 2004

Rs. Rs. Rs. Rs.AssetsCurrent Assets

Cash and Balance withRBI 27,06,808 22,37,601 (+) 4,69,207 (+) 17.33

Balance with Banks andmoney at call and short notice 11,36,781 16,07,975 (–) 4,71,194 (–) 41.45

Total Current Assets 38,43,589 38,45,576 1987 0.052Fixed AssetsInvestments 2,14,21,060 2,35,37,098 (-) 21,16,038 (-) 9.88Advances 1,95,99,764 2,11,39,869 (-) 15,40,105 (-) 7.86Fixed Assets 4,93,996 5,36,442 (-) 42,446 (-) 8.59Other Assets 18,58,064 18,35,883 (+) 22,181 (+) 1.19

Total Fixed Assets 4,33,72,884 4,70,49,292 (+) 36,76,408 8.48Total Assets 4,72,16,473 5,08,94,868 36,78,395 7.79Current LiabilitiesBorrowings 7,27,671 2,84,690 (+) 4,42,981 60.88Other Liability and

Provisions 16,74,165 17,99,197 (–) 1,25,032 7.47

Total Current Liability 24,01,836 20,83,887 3,17,949 13.24

Fixed Liability Capital 2,845 2,845 — —Reserves surplus 39,66,009 47,65,406 (+) 7,99,397 20.16Deposit 4,08,45,783 4,40,42,730 (+) 31,96,947 7.83

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Total Fixed Liability 4,48,14,637 4,88,10,981 (+) 39,96,344 8.92

Total Liability 4,72,16,473 5,08,94,868 36,78,395 7.79

Comparative Profit and Loss Account Analysis

Another comparative financial statement analysis is comparative profit and loss account analysis. Under this analysis, only profit and loss account is taken to compare with previous year’s figure or compare within the statement. This analysis helps to understand the operational performance of the business concern in a given period. It may be analyzed on horizontal basis or vertical basis.

Trend Analysis

The financial statements may be analysed by computing trends of series of information. It may be upward or downward directions which involve the percentage relationship of each and every item of the statement with the common value of 100%. Trend analysis helps to understand the trend relationship with various items, which appear in the financial statements. These percentages may also be taken as index number showing relative changes in the financial information resulting with the various period of time. In this analysis, only major items are considered for calculating the trend percentage.

Exercise 2

Calculate the Trend Analysis from the following information of Tamilnadu Mercantile Bank Ltd., taking 1999 as a base year and interpret them (in thousands).

Year Deposits Advances Profit1999 2,05,59,498 97,14,728 3,50,3112000 2,66,45,251 1,25,50,440 4,06,2872001 3,19,80,696 1,58,83,495 5,04,0202002 3,72,99,877 1,77,26,607 5,53,5252003 4,08,45,783 1,95,99,764 6,37,6342004 4,40,42,730 2,11,39,869 8,06,755

Solution

Trend Analysis (Base year 1999=100)

(Rs. in thousands)

Deposits Advances ProfitsYear Amount Trend Amount Trend Amount Trend

Rs. Percentage Rs. Percentage Rs. Percentage

1999 2,05,59,498 100.0 97,14,728 100.0 3,50,311 100.02000 2,66,45,251 129.6 1,25,50,440 129.2 4,06,287 115.9

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2001 3,19,80,696 155.5 1,58,83,495 163.5 5,04,020 143.92002 3,72,99,877 181.4 1,77,26,607 182.5 5,53,525 150.02003 4,08,45,783 198.7 1,95,99,764 201.8 6,37,634 182.02004 4,40,42,730 214.2 2,11,39,869 217.6 8,06,755 230.3

Common Size Analysis

Another important financial statement analysis techniques are common size analysis in which figures reported are converted into percentage to some common base. In the balance sheet the total assets figures is assumed to be 100 and all figures are expressed as a percentage of this total. It is one of the simplest methods of financial statement analysis, which reflects the relationship of each and every item with the base value of 100%.

Exercise 3

Common size balance sheet of Tamilnadu Mercantile Bank Ltd., as on 31st March 2003 and 2004.

Particulars 31st March 2003 31st March 2004Amount Percentage Amount Percentage

Fixed AssetsInvestments 2,14,21,060 45.37 2,35,37,098 46.25Advances 1,95,99,764 41.51 2,11,39,869 41.54Fixed Assets 4,93,996 1.05 5,36,442 1.05Other Assets 18,58,064 3.94 18,35,883 3.61

Total Fixed Assets 4,33,72,884 91.86 4,70,49,292 94.44Current AssetsCash and Balance with

RBI 27,06,808 5.73 22,37,601 4.40Balance with banks

and money at calland short notice 11,36,781 2.41 16,07,975 3.20

Total Current Assets 38,43,589 8.14 38,45,576 7.60Total Assets 4,72,16,473 100.00 5,08,94,868 100.00

Fixed LiabilitiesCapital 2,845 0.01 2,845 0.01Reserve and Surplus 39,66,009 8.40 47,65,406 9.36Deposits 4,08,45,783 86.50 4,40,42,730 86.54

Total Fixed Liabilities 4,48,14,637 94.91 4,88,10,981 95.91Current LiabilityBorrowings 7,27,671 1.54 2,84,690 0.56Other LiabilitiesProvisions 16,74,165 3.55 17,99,197 3.53Total Current Liability 24,01,836 5.09 20,83,887 4.09

Total Liabilities 4,72,16,473 100.00 5,08,94,868 100.00

FUNDS FLOW STATEMENT

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Funds flow statement is one of the important tools, which is used in many ways. It helps to understand the changes in the financial position of a business enterprise between the beginning and ending financial statement dates. It is also called as statement of sources and uses of funds.

Institute of Cost and Works Accounts of India, funds flow statement is defined as “a statement prospective or retrospective, setting out the sources and application of the funds of an enterprise. The purpose of the statement is to indicate clearly the requirement of funds and how they are proposed to be raised and the efficient utilization and application of the same”.

CASH FLOW STATEMENT

Cash flow statement is a statement which shows the sources of cash inflow and uses of cash out-flow of the business concern during a particular period of time. It is the statement, which involves only short-term financial position of the business concern. Cash flow statement provides a summary of operating, investment and financing cash flows and reconciles them with changes in its cash and cash equivalents such as marketable securities. Institute of Chartered Accountants of India issued the Accounting Standard (AS-3) related to the preparation of cash flow statement in 1998.

Difference Between Funds Flow and Cash Flow Statement

Funds Flow Statement Cash Flow Statement1. Funds flow statement is the report on the 1. Cash flow statement is the report showing

movement of funds or working capital sources and uses of cash.2. Funds flow statement explains how working 2. Cash flow statement explains the inflow and

capital is raised and used during the particular out flow of cash during the particular period.3. The main objective of fund flow statement is 3. The main objective of the cash flow statement

to show the how the resources have been is to show the causes of changes in cashbalanced mobilized and used. between two balance sheet dates.

4. Funds flow statement indicates the results of 4. Cash flow statement indicates the factorscurrent financial management. contributing to the reduction of cash balance

in spite of increase in profit and vice-versa.5. In a funds flow statement increase or decrease 5. In a cash flow statement only cash receipt and

in working capital is recorded. payments are recorded.6. In funds flow statement there is no opening 6. Cash flow statement starts with opening cash

and closing balances. balance and ends with closing cash balance.

Exercise 4

From the following balance sheet of A Company Ltd. you are required to prepare a schedule of changes in working capital and statement of flow of funds.

Balance Sheet of A Company Ltd., as on 31st March

Liabilities 2004 2005 Assets 2004 2005Share Capital 1,00,000 1,10,000 Land and Building 60,000 60,000

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Profit and Loss a/c 20,000 23,000 Plant and Machinery 35,000 45,000Loans — 10,000 Stock 20,000 25,000Creditors 15,000 18,000 Debtors 18,000 28,000Bills payable 5,000 4,000 Bills receivable 2,000 1,000

Cash 5,000 6,0001,40,000 1,65,000 1,40,000 1,65,000

Solution

Schedule of Changes in Working Capital

Particulars 2004 2005 Incharge Decharge

Rs. Rs. Rs. Rs.Current AssetsStock 20,000 25,000 5,000 —Debtors 18,000 28,000 10,000 —Bills Receivable 2,000 1,000 — 1,000Cash 5,000 6,000 1,000

A 45,000 60,000

Less Current LiabilitiesCreditors 15,000 18,000 3,000Bills Payable 5,000 4,000 1,000

B 20,000 22,000 17,000 4,000A-B 25,000 38,000 — 13,000

Increase in W.C. 38,000 38,000 17,000 17,000

Fund Flow Statement

Sources Rs. Application Rs.Issued Share Capital 10,000 Purchase of Plant and Machinery 10,000Loan 10,000 Increase in Working Capital 13,000Funds From Operations 3,000

23,000 23,000

Exercise 5

From the above example 4 prepare a Cash Flow Statement.

Solution

Cash Flow Statement

Inflow Rs. Outflow Rs.

Balance b/d 5,000 Purchase of plant 10,000Issued Share Capital 10,000 Increase Current AssetsLoan 10,000 StockCash Opening Profit 3,000 Decrease in Bills Payable 5,000Decrease in Bills 1,000 Balance c/d 10,000Receivable 3,000 1,000

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Increase in Creditors 6,00032,000 32,000

RATIO ANALYSISRatio analysis is a commonly used tool of financial statement analysis. Ratio is a mathematical relationship between one number to another number. Ratio is used as an index for evaluating the financial performance of the business concern. An accounting ratio shows the mathematical relationship between two figures, which have meaningful relation with each other. Ratio can be classified into various types. Classification from the point of view of financial management is as follows:

● Liquidity Ratio

● Activity Ratio

● Solvency Ratio

● Profitability Ratio

Liquidity Ratio

It is also called as short-term ratio. This ratio helps to understand the liquidity in a business which is the potential ability to meet current obligations. This ratio expresses the relationship between current assets and current assets of the business concern during a particular period. The following are the major liquidity ratio:

S. No. Ratio Formula Significant Ratio

1. Current RatioCurrent Assets

2 : 1CurrentLiability

2. Quick Ratio Quick Assets

1 : 1Quick / CurrentLiability

Activity Ratio

It is also called as turnover ratio. This ratio measures the efficiency of the current assets and liabilities in the business concern during a particular period. This ratio is helpful to understand the performance of the business concern. Some of the activity ratios are given below:

S. No. Ratio Formula

1. Stock Turnover RatioCostof Sales

Average Inventory

2. Debtors Turnover RatioCredit Sales

AverageDebtors

3. Creditors Turnover Ratio Credit Purchase

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AverageCredit

4. Working Capital Turnover RatioSales

Net WorkingCapital

Solvency Ratio

It is also called as leverage ratio, which measures the long-term obligation of the business concern. This ratio helps to understand, how the long-term funds are used in the business concern. Some of the solvency ratios are given below:

S. No Ratio Formula

1. Debt-Equity RatioExternal EquityInternal Equity

2. Proprietary RatioShareholder / Shareholder 's Fund

Total Assets

3. Interest Coverage Ratio EBITFixed Interest Charges

Profitability Ratio

Profitability ratio helps to measure the profitability position of the business concern. Some of the major profitability ratios are given below.

S. No Ratio Formula

1. Gross Profit Ratio Gross Profit 100Net Sales

2. Net Profit Ratio Net Profit after tax 100Net Sales

3. Operating Profit Ratio Operating Net Profit 100Sales

4. Return in InvestmentNet Profit after tax 100Shareholder Fund

Exercise 6

From the following balance sheet of Mr. Arvind Industries Ltd., as 31st March 2007.

Liabilities Rs. Assets Rs.

Equity Share Capital 10,000 Fixed assets (less 26,0007% Preference Share Capital 2,000 depreciation Rs. 10,000)Reserves and Surplus 8,000 Current Assets:6% Mortgage Debentures 14,000 Cash 1,000Current Liabilities: Investments (10%) 3,000

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Creditors 1,200 Sundry debtors 4,000Bills payable 2,000 Stock 6,000Outstanding expenses 200

Tax Provision 2,600

40,000 40,000

Other information:

1. Net sales Rs. 60,0002. Cost of goods sold Rs. 51,6003. Net income before tax Rs. 4,0004. Net income after tax Rs. 2,000

Calculate appropriate ratios.

Solution

Short-term solvency ratios

Current Ratio = Current Assets 14,00

0 2.33:1Current Liability 6,000

Liquid Ratio = LiquidRatio 8,000 1.33 :1Current Liability 6,000

Long-term solvency ratios

Proprietary ratio = Proprietor′s funds 20,000 0.5 :140,000Total Assets

Proprietor’s fund or Shareholder’s fund=Equity share capital+Preference share capital+Reserve and surplus

= 10,000+2,000+8,000=20,000

Debt-Equity ratio = Externalequities 20,00

0 1:1Internalequities 20,000

Interest coverage ratio =EBIT =

4,000+840 =5.7times

Fixed interest charges 840

Fixed interest charges = 6% on debentures of Rs.14,000 = Rs. 840

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Activity Ratio

Stock Turnover Ratio = Cost of Sales =51,600=8.6timesAverageInventory 6,000

As there is no opening stock, closing stock is taken as average stock.

Credit Sales =60,000 =10times

Debtors Turnover Ratio = Average Debtors 6,000In the absence of credit sales and opening debtors, total sales is considered as credit

sales and closing debtors as average debtors.

Creditors turn over ratio =Credit Purchases

43,200

36timesAverageCreditors 1,200

In absence of purchases, cost of goods sold – gross profit treated as credit purchases and in the absence of opening creditors, closing creditors are treated as average creditors.

Working Capital Turnover Ratio =Sales

60,000

7.5timesNet WorkingCapital 8,000

Profitability Ratios

Gross profit ratio = GrossProfit 100= 8,400 100=14%Sales 60,000

Net profit ratio = Net Profit 100= 2,000 100=3.33%Sales 60,000

In the absence of non-operating income, operating profit ratio is equal to net profit ratio.

Return of Investment = NET PROFIT AFTER TAX 100 = 2,000 100 = 10% Shareholder′sFund 20,000

Section A1. Financial plan is primarily a statement estimating the_________2. The statement establishing amount of capital and determining its composition is

termed as _____________3. Financial planning involves evaluating the__________ condition of a firm.4. __________ and _________ are some of the steps involved in financial planning.5. Firms develop financial plan within the overall framework of ____________

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6. Long term financial plan in large companies is for _________ years.7. Financial plan indicates firm’s growth, _________ , ___________ and

requirement of funds.8. __________ is to analyze a firm’s investment option and estimating the fund

requirement.9. ___________ is an integral part of financial planning.10. Finance planning involves___________ and financing decisions of a firm.

Section B1. What are the steps involved in financial plan?2. Highlight the problems involved in financial plan.3. State the objectives of financial plan.4. What are the principles of a financial plan.5. Define financial planning.6. What is financial forecasting? How does it differ from financial plan?7. Process of financial process model.8. Describe the importance of financial planning.9. What is long and short term financial plan.10. State the role of sensitivity in financial plan.

Section C1. What is financial plan and what are the steps involved in preparing a financial

plan.2. Can you state the problems involved in financial planning.3. How will you estimate the long term and short term needs in financial plans.4. What is working capital and what are the factors determining working capital?5. Give the significance of financial plan and the types.6. Explain in detail about the principles governing a sound financial plan.7. Can you discuss about what is financial planning.8. What is the importance of financial forecasting?9. Name few types of financial plan and explain in detail.10. How does financial plan differ from financial forecasting?

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Unit IIICapitalization -Bases of Capitalization – Cost Theory – Earning Theory – Over Capitalization – Under Capitalization: Symptoms – Causes – Remedies – Watered Stock – Watered Stock Vs. Over Capitalization.

CAPITALIZATIONMeaningCapitalization is an important constituent of the financial plan and in common, the term capitalization means the total amount of capital employed in business.

It can be meant as the process of building up a capital structure and tapping the sources to mobilize the capital in the form of shares or bonds or loans, reserves etc.

Capitalization is the long-term funding that allows a business firm to operate. It is the investment that the business owner and any other investors make in the firm. It is a financial term which refers to the sum of the stockholder's equity of the firm and the firm's long-term debt, such as bonds or mortgages.

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Capitalization can be used as a tool to commit financial statement reporting fraud. “Capitalization is the sum of par value of the stocks and bonds outstanding”Financial planning and decision play a major role in the field of financial management which consists of the major area of financial management such as, capitalization, financial structure, capital structure, leverage and financial forecasting.

Financial planning includes the following important parts:

● Estimating the amount of capital to be raised.

● Determining the form and proportionate amount of securities.

● Formulating policies to manage the financial plan.

MEANING OF CAPITALThe term capital refers to the total investment of the company in terms of money, and assets. It is also called as total wealth of the company. When the company is going to invest large amount of finance into the business, it is called as capital. Capital is the initial and integral part of new and existing business concern.

The capital requirements of the business concern may be classified into two categories:(a) Fixed capital (b) Working capital.

Fixed CapitalFixed capital is the capital, which is needed for meeting the permanent or long-term purpose of the business concern. Fixed capital is required mainly for the purpose of meeting capital expenditure of the business concern and it is used over a long period. It is the amount invested in various fixed or permanent assets, which are necessary for a business concern.

Definition of Fixed CapitalAccording to the definition of Hoagland, “Fixed capital is comparatively easily defined to include land, building, machinery and other assets having a relatively permanent existence”.

Character of Fixed Capital

● Fixed capital is used to acquire the fixed assets of the business concern.

● Fixed capital meets the capital expenditure of the business concern.

● Fixed capital normally consists of long period.

● Fixed capital expenditure is of nonrecurring nature.

● Fixed capital can be raised only with the help of long-term sources of finance.

Working CapitalWorking capital is the capital which is needed to meet the day-to-day transaction of the

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business concern. It may cross working capital and net working capital. Normally working capital consists of various compositions of current assets such as inventories, bills, receivable, debtors, cash, and bank balance and prepaid expenses.

According to the definition of Bonneville, “any acquisition of funds which increases the current assets increase the Working Capital also for they are one and the same”.

Working capital is needed to meet the following purpose:● Purchase of raw material ● Payment of wages to workers ● Payment of day-to-day expenses ● Maintenance expenditure etc.

Working Capital

Capital Fixed Capital

Fig. 4.1 Position of Capital

CAPITALIZATIONCapitalization is one of the most important parts of financial decision, which is related to the total amount of capital employed in the business concern.

Understanding the concept of capitalization leads to solve many problems in the field of financial management. Because there is a confusion among the capital, capitalization and capital structure.

Meaning of CapitalizationCapitalization refers to the process of determining the quantum of funds that a firm needs to run its business. Capitalization is only the par value of share capital and debenture and it does not include reserve and surplus.

Definition of CapitalizationCapitalization can be defined by the various financial management experts. Some of the definitions are mentioned below:

According to Guthman and Dougall, “capitalization is the sum of the par value of stocks and bonds outstanding”.

DEFINITION “Capitalization is the sum of par value of the stocks and bonds outstanding”.

And according to this definition, the term capitalization includes only the par value of share capital and debentures and it does not include reserves and surplus. However in actual practice, it is found that firms to meet their long-term capital requirements frequently resort to reserves and surplus. Hence this definition seems not to be logical.

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How can we view ‘Capital’ in different terms?

1. In ‘accounting use: The term capital is used in ‘accounting literature’ to represent the net worth means assets and liabilities.

2. In Business use’: Total assets required operating a business and the money needed to acquire such assets.

3. As used by economists: All the accumulated wealth used to produce additional wealth.

4. In legal usage: The amount received in return for securities,ie.,shares allotted to the investors. The total amount of share value paid as shown in the company’s book of accounts is legally known as its capital.

ACTUAL CAPITALSIATION Vs. PROPER CAPITALSIATION

“Capitalization comprises ownership capital which includes capital stocks and surplus in whatever form it may appear and borrowed capital which consists bonds or similar evidence of long term debt”.

Actual capitalization of a company is arrived by adding the paid up value of companies shared and debentures, reserves and other surpluses while proper capitalization of company is arrived at according to any of the two theories (cost & earnings).

In case a company’s actual capitalization is more than its proper capitalization the company is said to be over capitalized. In case actual capitalization of the company is less than it proper capitalization, the company is said to be undercapitalized.

CAPITAL & CAPITALISATION

The English word 'capitalization' has several different meanings:

The act of capitalizing on an opportunity; An estimation of the value of a business; Writing in capital letters;

The sale of capital stock the value of a company calculated by multiplying the price of its shares on the stock exchange by the number of shares issued. Also called market capitalization

Capitalization is the long-term funding that allows a business firm to operate. It is the investment that the business owner and any other investors make in the firm. Noted that the term capitalization is used only in respect of companies and not in relation to partnership firms or sole proprietorship.

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The term capital in accounting sense means the net worth of the business undertaking. Net worth, means assets minus liabilities of the Business. Similarly the term share capital refers only to the paid up value of shares issued by the company.

The term capitalization is also used by accountant in varies senses. For example, when bonus shares are issued out of profits, it is said that the profits have been capitalized; similarly, it may be capitalized but the company and treated as deferred revenues expenditure in its books.

However, scholars of financial management are not common regarding the concept of capitalization. Some have given very broad interpretation to the term while others have taken a narrow view.

What is capitalization of fixed assets?

Capitalization of fixed assets means the assets which are acquired with a useful life of atleast two years, and recording the cost of that fixed asset in balance...

BROAD INTERPRETATION

According to this, the term capitalization is identical with the term financial planning, where financial planning of a company includes.

1. The determination about the total amount of capital to be raised2. Decision regarding the types of securities to be issued for the purpose of raising

such capital and the relative proportion is the different securities and the administration of the capital

Thus in broad sense, the term capitalization refers to the process of determining the quantum as well as patterns of financing. And it not only includes the determination of quantity of finance but also the quality of financing. In other words, it includes decision regarding amount of finance and the modes of finance.

NARROW INTERPRETATION

Here, the term capitalization refers to the process of quantum of long-term funds that an enterprise would require to run its business and the decisions regarding makeup of capitalization are done in the term capital structure. The narrow interpretation of the term capitalization is more popular since it is very specific in its meaning.

The constituents of capitalization as follows:1. Par value of share capital 2. Reserves and surplus 3. Long-term loans

BASES OF CAPITALIZATION

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After estimating financial requirements of business, the promoters of the company have to determining the value at which the company has to be capitalized; this will help them in determining the quantum of securities to be issued for raising the necessary funds. There are two recognized theories of capitalization for new companies

1. Cost Theory: The total amount of capitalization of a new company is arrived at by adding up the cost of fixed assets such as plant and machinery, buildings etc, the amount of working capital and the cost of establishing then business e.g. preliminary expenses, underwriting commission, expenses on issue of shares etc. For example if fixed assets for the company would cost Rs.1, 00,000 working capital required amounts to Rs.50,000 and the cost of establishing the business would amount t to Rs.20,000, the amount of capitalization for the company would be Rs.1,70,000. The company would sell securities i.e. shares and debentures of this amount.Cost theory is useful in so far as it enables the promoters to know the amount of capital to be raised. But it fails to provides basis for ascertain net worth of the business in real term because net worth depends not on the cost of assets but on its earnings capacity.

2. Earnings Theory: According to this theory, the true value (capitalization) of an enterprise depends upon its earnings capacity. In other words, the worth of a company is not measured by the capital raised but by the earnings made out of the productive harness of the capital. For this purpose a new company will have to estimate the average annual future earnings and the normal earnings rate also termed s as capitalization rate.The earnings theory of Capitalization recognizes the fact that the true value (capitalization) of an enterprise depends upon its earnings and earning capacity. According to it, therefore, the value or Capitalization of a company is equal to the capitalized value of its estimated earnings. For this purpose a new company has to prepare an estimated profit and loss account. For the first few year of its life, the sales are forecast ad the manager has to depend upon his experience for determining the probable cost. The earnings so estimated may be compared with the actual earnings of similar companies in the industry and the necessary adjustments should be made. Then the promoters will study the rate at which other companies in the same industry similarly situated are earnings. The rate is then applied to the estimated earnings of the company for finding out the capitalization. To take an example a company ma estimate its average profit in the first few years at Rs. 50,000. Other companies of the same type are, let us assume, earnings a return of 10 per cent on their capital. The Capitalization of the company will then be

50,000 x 100 ---------------- = Rs. 5,00,000.           10

It will be noted that the earnings basis for Capitalization has the merit of valuing (capitalizing) a company at an amount which is directly related to its earning capacity. A company is worth what it is able to earn. But it cannot, at the same time be denied that new companies will find it difficult, and even risky, to depend merely on estimate of their

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earnings as the generally expected return is an industry. In case of new companies, therefore, the cost theory provides a better basis for capitalisation than the earning theory.

In established concerns too, the Capitalization can be arrived at either (i) on the basis of the cost of business, or (ii) the average or regular earnings and the rate of return expected in an industry If cost is adopted as the basis, the Capitalization may fall to reveal the true worth of a company. The assets of a company stand at their original values while its earnings may have declined considerably. In such a situation, it will be risky to believe that the Capitalization of the company is high. Earnings, therefore, provide a better basis of Capitalization in established concerns The figure will be arrived at in the same manner as above.

Actual and Proper Capitalization. The capitalisation of a company as arrived at by totaling up the value of the shares, debentures and non-divisible retained earnings of the company may be called the actual Capitalization of the company. Let us take the relevant items in a company balance sheet for illustration. The actual Capitalization as per balance sheet given below will be Rs. 16,00,000.

XYZ CO. LTD. BALANCE SHEET AS ON 31ST DECEMBER, 1981

Liabilities Assets

Paid-up capital Rs.

20,000 8 percent preference Shares of Rs.10 each 2,00,000

50,000 Shares of Rs. 8 each                                   4,00,000

10,000 Debentures of Rs. 100 each                      10,00,000                                                                          ---------------                                                                            16,00,000                                                                           --------------

                     Rs.          SundryAssets                    16,00,000

              ------------               16,00,000               -----------

As against the actual Capitalization the proper, normal or standard Capitalization for a company can be found out by capitalizing the average annual profits at the normal rate of return earned by comparable companies in the same line of business. Thus if a company gets an annual return of Rs. 1,50,000 and the normal rate of return in the industry is 0 per cent, the proper Capitalization will be arrived at as under:

                  1001,50,000 x ------ = Rs. 15,00,000                   10

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A comparison between the actual and the proper on normal Capitalization will show whether the company is properly capitalized, over-capitalized or under-capitalized.

TYPES OF CAPITALIZATIONCapitalization may be classified into the following three important types based on its nature:

• Over Capitalization • Under Capitalization • Water Capitalization

OVER-CAPITALISATIONMeaning Over-capitalization is a situation in which actual profits of a company are not sufficient enough to pay interest on debentures, on loans and pay dividends on shares over a period of time.

A business is said to be over-capitalized when 1) Capitalization exceeds the real economic value of its net assets (2) A fair return is not realized on capitalization and (3) Business has more net assets than it needs.

Over-capitalization may be considered to be in the nature of redundant capital. It is generally found in companies which have useless assets such as oil and mining concerns. This condition is commonly known as “watered stock”. A company is said to be over-capitalized when the aggregate of the par value of its shares and debentures exceeds the true value of its fixed assets.

In other words, over-capitalization takes place when the stock is watered or diluted. It is wrong to identify over-capitalization with excess of capital, for there is every possibility that an over-capitalization with excess of capital, for there is every possibility that an over-capitalized concern may be deal with problems of liquidity.

The correct indicator of over-capitalization is the earnings of the company. If the earnings are lower than the expected returns, it is over-capitalized. Over-capitalization does not involve surplus of funds any more than under-capitalization indicates a shortage of funds. It is quite possible that a company may have more funds and yet have low earnings. Often, funds may be inadequate, and the earnings may be relatively low. In both situations, there is over-capitalization.

The average distributable income of a company may be insufficient to pay the contract rate of return on fixed income securities and a dividend on equity shares, comparable with that of similar securities elsewhere.For example a company is earning a sum of Rs.1, 50,000 on a total capital investment of Rs.15, 00,000. This company will be said properly capitalized, if the general expectation is 10%. However if the company earns only Rs.90,000 while the general expectation is

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10% the company will be said to be over capitalized because it will be in a position to give a return of only 6% in the total capital employed.

Over-capitalization takes place when

Prospective income is over-estimated at the start; Unpredictable circumstances reduce down the income; The total funds required have over-estimated; Excess funds are not efficiently employed; The low yield makes it difficult for a firm to raise new capital, particularly equity

capital; The market value of the securities falls below the issue price; The low yield may discourage competition and this limited competition becomes a

social disadvantage.Over-capitalization may go unnoticed during the period a business be encouraged by prosperity. It may be productive of ill- consequences when the distributable income diminishes under the pressure of declining demand and falling prices.

OVER CAPITALISATION AND EXCESS OF CAPITAL

It may be noted that over capitalization is different from excess of capital. Over capitalization is there only when the existing capital is not effectively utilized on account of fall in the earning capacity of the company while excess of capital means that the company has raised funds more than requirement. The chief sigh of over capitalization is fall in the rate of dividend in the long run, which results in fall in the value of the shares of the company. Thus, a company will be said to be over capitalized when it has consistently been unable to earn the prevailing rater of return on its capital employed.

Causes of over-capitalization

1. Difference between Book Value and Real worth of Assets: It is possible that a company may have purchased its assets at a value that is higher than their real worth. This gap between the book value and the real worth of assets may account for over-capitalization.

2. Promotional Expenses: There is a possibility that promoters may have charged excessive promotional expenses for their services in creating the corporation. This charge may be a cause of over-capitalization.

3. Inflation: Due to these conditions a corporation might have acquired assets at high prices. Inflationary conditions rash over-capitalization, which affects new as well as established corporations.

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4. Shortage of capital: When faced with a shortage of funds, a company may borrow at unremunerative rates of interest, which is bound to result in excessive or unjustified fixed charges.

5. Depreciation Policy: Inadequate provision for depreciation, obsolescence or maintenance of assets may lead to over-capitalization, and this is bound to adversely affect the profit-earning capacity of a corporation.

6. Taxation Policy: High corporate tax may discourage corporations from implementing programs of replacement, renewals and renovations, as a result of which their profitability may suffer.

7. Dividend Policy: Some corporations adopt a lenient dividend policy in order to gain popularity with their stockholders. However, such cash-down payment in the form of dividends weakens their liquidity position. Their valuable resources are likely to be waste away and, as a result, they may find themselves in a state of over-capitalization.

8. Market Sentiment: Company may be tempted to raise security floatation in the market in order to create a favorable market sentiment on the stock exchange. While doing so, it may be saddled with the issue of unwarranted securities, which are of no practical value to it. As a result, it becomes over-capitalized and the burden of its liabilities is unnecessarily inflated.

9. Under-estimation of capital Rate: If the actual rate at which capital is available is higher than the rate at which a company’s earnings are capitalized, the capitalization rate is under-estimated, and this results into over-capitalization.

Advantages

1. The management is assured of adequate capital for present operations.2. If conserved, an excess of capital may preclude the necessity of financing sometime

in the future when capital is needed and can be obtained only with difficulty.3. Ample capital has a beneficial effect on an organization’s morale.4. Ample capitalization gives added flexibility and latitude to the corporation’s

operation.5. Allegedly. Losses can be more easily absorbed without endangering the future of the

corporations.6. The rate of profits tends to discourage possible competitors.7. For public utility companies, when the price of service is based upon a “fair return to

capital”, a high capitalization may be advantageous.

Disadvantages

I) When stock is issued in excess of the assets received, a company’s stock is said to be “watered”.

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Watered stock may arise by the issue of stock in any of the following ways:

For over-valued property or services As a bonus For cash at less than the par or stated value of the stock As a stock dividend when the surplus of the corporation is not offset by actual

assets of at least an equal amount.

If known to be watered, stock has a market value which is lower than it would enjoy if it were not watered-until the “water” has been” squeezed out” (until sufficient assets have been acquired from earning to offset the excess of stock).

II) There is the possibility of stockholders” liability to creator in case a court should conclude that the stock was heavily watered, that the corporation did not receive “reasonable” or “proper” value for the stock. This liability would attach only to such stock as was received as a result of an unreasonably excessive valuation of properties or services given in exchange for such stock.

III) There may be a possible difficulty of raising new capital funds. This may be by the use of “no-par” stock.1. In some States, the rate of the annual franchise tax depends on the amount of

outstanding stock. Large capitalizations in such States may attract large franchise taxes.

2. There is a tendency to raise the prices of a company’s products and/or lower their quality. This may be partly or wholly prevent, however, by competition and would apply more to public utility services than to others, for public utility rates are based, in part, upon a “reasonable” return on capital.

3. Over-capitalization may induce a failure, and the failure of a corporation may bring about an unhealthy economic situation.

4. The ethical atmosphere of a business is not improved by over-capitalization.5. The necessary ropes of the market for the securities which first offered to the public

usually results in market value losses to the investors after this support are removed. This is not to attack the legal support of the market in the above-board floatation of a security issue.

6. There may be an inability to pay interest on bonds (when bonds constitute a large portion of the capitalization of an over-capitalized company)

7. Injury to credit worthiness.8. Decline in the value of securities.9. Possible loss of orders because of inability to expand.10. Temptation for the management to fit in with depreciation, obsolescence,

maintenance, reserve accounts in order to appear to make a profit possible in order to pay a dividend.

11. Possible injury to goodwill in case a necessary reorganization.12. The holders of securities may be dissatisfied.13. The business may give way to its competitors through its inability to obtain funds for

expansion.

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EFFECTSOver-capitalization has some effect on the corporation, its owners, consumers and the society at large.

1. On Corporation: The market value of the corporation’s stock falls and it may find it difficult to raise new capital. Artificial devices such as the reduction in depreciation, limitation in maintenance, etc are made use of cover over-capitalization. The credit of the company is adversely affected. The company may appear to be in a healthy condition even though it may have lost its energy and life and may end at any time because of the weak financial condition from which it suffers.

2. On Owners: Owners who have a real risk in the corporation are the biggest losers. Because of a fall in market value of its shares, shareholders are not in a position to dispose of their holdings profitably. Moreover of fall in dividends, shareholders lose heavily and they develop the feeling that the corporation is funded on shifting sands.

3. On Consumers: A corporation cannot resist the temptation of increasing the prices of its products to inflate its profits. At the same time, there is every possibility that the quality of the product would go down. The consumer may thus suffer doubly.

4. On Society: Over-capitalized concerns often come to grief in the course of time. They lose the backing of owners, customers and society at large. They suffer multi-pronged attacks from various sections of society. They are not in a position to face competition. No wonder, therefore, that they gradually draw closer to a situation ordering liquidation. While the existence of such corporations cannot be justified, their extinction would cause irreparable damage to society.

REMEDIES

1. Reduction in Funded Debt: This is generally impossible unless the company goes through a thorough re-organisation. Funds have to be raised for the redemption of bonds; and the sale of large quantities of stock, presumably at low prices, would probably do more damage than good. Moreover, the creation of as much stock as the bonds retired would not reduce the total capitalization. A true reduction in capitalization can be effected only if the debts are retired from earnings.

2. Reduction in Interest Rate on Bonds: Here again, without a through re-organisation, it would probably not be practicable to effect a reduction in the interest rate on bonds. A refunding operation, however, might be performed; but the saving in interest payments on the lower-rate refunding bonds would hardly offset the premium the company would be forced to allow the bond-holders in order to induce them to accept the refunding bonds; and, moreover, this procedure would not really reduce capitalization. However, it would alleviate the situation.

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3. Redemption of Preferred Stock, if it carries a High Dividend Rate: Funds for redemption would probably have to come from the sale of common stock at low prices. The saving from the retirement of the preferred stock might be sufficient to increase somewhat the earnings from the common stock, even if this common stock is increased substantially. If, however, the preferred stock is cumulative, and if dividends on such stock are in arrears, this avenue of escape would appear to be a “dead-end street”.

4. Reduction in Par Value of Stock: This is a good method but is something impossible because of the stockholders’ tenacious belief in the importance of par value. If the stockholders are convinced of the desirability of the move, it might be somewhat effective, though not nearly as much as the reduction in high fixed charges.

5. Reduction in Number of Shares of Common Stock: This likewise is a good method but, again, is difficult of implementation because of the average stockholders’ unwillingness to turn in several shares in order to receive one, through it does happen occasionally. Since this procedure does not decrease the stockholder'’ proportionate interest in the equity, it is sometimes used.

In some cases, several of these methods may be used, but unless a company goes through a thorough re-organisation) a rather complicated and legally involved affair), the consent of the security-holders should be obtained.

UNDER-CAPITALISATION

Under-capitalization is the reverse of over-capitalization. It should not be confused with a condition implying a lack of funds. It merely refers to the amount of outstanding stock the condition is not a serious as that of over-capitalization and its remedies are much easily applied.

Under-capitalization comes about as a result of: Under-estimation of future earnings at the time of promotion; and/or An unforeseeable increase in earning resulting from later developments; Under-capitalization exists when a company earns sufficient income to meet its

fixed interest and fixed dividend charges, and is able to pay a considerably better rate on its equity shares than the prevailing rate on similar shares in similar businesses.

At this stage, the real worth of the assets exceeds their book value, and the rate of earnings is higher than a corporation is ordinarily able to afford. When a corporation is earning an extra ordinarily large return on its outstanding stock, it is said to be under capitalization.

CAUSES

1. Under-estimation of Earnings: It is possible that earnings may be under-estimated, as a result of which the actual earnings may be much higher than those expected.

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2. Efficiency: A corporation may have optimally utilized its assets and enhanced its efficiency its efficiency by exploiting every possibility of modernization and by taking the maximum advantage of market opportunities.

3. Under-estimation of Funds: It may takes place when the total funds required have been under-estimated.

4. Retained Earnings: Because of its conservative dividend policy a corporation may retain the earnings, which might have accumulated into a mass of savings. This is bound to improve its financial health.

5. Windfall Gains: Companies that can afford to continue to operate during the period the period of depreciation may find their earnings are unusually high when they enter the boom period. This shift from an adverse business cycle to a prosperous one may under-capitalize the corporation.

6. Indulgence in rivalry: Under indulgence in rivalries flowing from unusually high earnings may tempt an organization to embark upon speculative activities in the hope that it can easily survive its ill effects; for if speculative activities turn out to be unfavorable, its earlier earnings are likely to be washed away.

7. Taxation: Because of excessive earnings, corporations are exposed to a heavy burden of taxation.

Disadvantages1. The stock would enjoy a high marker value, but would limit its marketability and

may cause wide (though not necessarily relatively wide) fluctuations in market prices. In many cases, this may not be considered a disadvantage.

2. Owing to its limited marketability, the stock may not enjoy as high a market Price as its earnings justify.

3. A high rate of earnings per share may encourage potential competitors to enter the market.

4. In view of the high rate of earnings, employees may become dissatisfied. Dissatisfaction would probably reduce their efficiency and have other undesirable

effects.

5. In view of the high rate of earnings, customers may feel they have been over-charged. Except possibly in public utility undertakings, this is not an entirely justifiable point, for competitors might easily enter the field and force reduction in prices.

6. If a company is an extremely large one and virtually controls the industry, its Enormous earnings per share may encourage competitors or the government to bring suit against it under the anti-trust laws.

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7. Depending on the nature of excess profit taxes, if any, the company may lose by under-capitalization.

EFFECTS

1. Labour Unrest: Employees are often organized and become conscious of the fact that the corporation is making enormous profits. They feel that they have a legitimate right to share in those profits. In other words, they develop the feeling that they are not adequately paid and that the corporation is reluctant to pay what is their legitimate due. This generates a feeling of hostility on the part of the employees, and leads to labour unrest.

2. Consumer Dissatisfaction: Consumers feel that the unusual earnings of the corporation could have been utilized by effecting a price reduction or by improving the quality of the product.

3. Governmental Interference: The Government generally keeps a watchful eye on under-estimated.

4. Retained Earnings: Because of its conservative dividend policy a corporation may retain the earnings, which might have accumulated into a mass of savings. This is bound to improve its financial health.

5. Windfall Gains: Companies, which can afford to continue to operate during the period of depreciation, may find their earnings are unusually high when they enter the boom period. This shift from an adverse business cycle to a prosperous one may under-capitalize the corporation.

6. Indulgence in Rivalries: Under indulgence in rivalries flowing from unusually high earnings may tempt an organisation to embark upon speculative activities in the hope that it can easily survive its ill effects; for if speculative activities turn out to be unfavorable, its earlier earnings are likely to be washed away.

7. Taxation: Because of excessive earnings, corporations are exposed to a heavy burden of taxation.

8. Financial need increases: A corporation may have to resort frequently to short-term credit and may even seek additional long-term funds without much notice.

9. Lack adaptability: Adaptability to changed circumstance may be impaired and expansion programmes may slow down.

10. Unnecessary Expansion: Enormous earnings on equity shares may result in an increase in market price, and the company will be tempted to raise new capital.

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11. Attracts Competition: The prospect of enormous earnings may generate competition, which may adversely affect the profitability of a corporation.

Remedies:Under-capitalization is easily remedied. One or more of the following methods may do it:

1. Stock Split-up: The Corporation may offer the stockholders several shares of new stock for every share of the old. If there is a par value, the par must be reduced to correspond with the increase in the number of shares, for by this method the capital stock account is not affected. With this increase in shares and reduction in par value per share the rate of earnings will not be changed, but the earnings per share will be very substantially decreased. The effect is much more apparent than real, for the capitalization is not increased though the earnings per share are reduced.

2. Increase in Par Value of Stock: If the surplus is large or can be made large (by revaluing assets upward, or otherwise), the corporation might offer the stockholders new stock for the old, the new stock to carry a higher per value. This would not reduce the earnings per share, but it would reduce the rate of earnings per share. This method, however, is seldom used, partly because it would not improve the marketability factor. If it were desired to go still further, the corporation could offer the stockholders a stock split-up and an increase in par value. This would reduce both the earnings and the rate of earnings per earnings per share value enormously. This method, however, is very radical and is almost never used.

3. Stock Dividend: If the surplus is large or can be made larger, the corporation might declare a dividend payable in stock. This would not affect par value per share, but would increase the capitalization and the number of shares. But the earnings per share and the rate of earnings per share would be reduced. This is probably the most used method and the most easily effected.

WATERED STOCK OR CAPITAL

When assets of equivalent value do not represent the stock or capital of a company, it is termed as watered stock signifying presence of water in the capital of the company. In simple words, watered capital means that the releasable value of assets of a company is less than its book value. In the words of Hoagland,” A stock is said to be watered when its true value is less than its book value”.

CAUSES OF WATERD STOCK

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The problem of watered stock generally arises at the time of incorporation of a company but in some cases, it may also arise latter during the life time of the company. The following are the main causes of watered stock situation.

Valuing the services of the prompters at unduly high value and paying for their services in the form of stocks.

Acquiring of intangible assets such as patents, copyrights, goodwill, etc at high values which later prove worthless

Adopting defective depreciation policy

WATERED STOCK VS OVER CAPITALSIAITON

Watered stock and over capitalizations are not synonymous. There is difference between the two. The situation of watered stock arises usually art the time of incorporation of a company, but it gets over capitalized only when it fails to earn sufficient earnings to justify its funds.

Signs of over trading1. Increase in bank borrowings and loans2. Increases in stocks3. Purchase of fixed assets out of short term funds4. Decline in the working capital ratio5. Decline in the rate of gross and net profits6. Low current ratio and very high turn-over ratio

Consequences of over trading1. Inability of the management in paying wages to the employees and taxes to the

government2. Decline in sales and costly purchases3. Difficulty in raising funds because of poor credit worthiness4. Problems with debtors and creditors5. Inability of the management to carry out timely repairs and maintenance resulting in

efficient working6. Lack of funds will compel the company to go in for out dated and old machinery for

replacement purpose.

Remedies of over trading1. The company should cut down it business and over spending or it should arrange for

more funds2. Preventing a situation of over trading by taking precautionary steps.

Section A1. When a true value of the assets of a company is less than its book value, it is

termed as ------2. Raising more capital than actual requirement denotes situation of -----3. Excess of current assets over current liabilities is -----------

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4. Situation where profits earned are exceptionally high, but the capital employed is relatively small -----------

5. Company is said to be ------- when its earnings on capital is not upto the industrial average.

6. As per earnings theory of capitalisation, if a company’s annual net profit is 200000 and its fair rate of return is 20%, the capitalisation of the company will be RS. -----------

7. Capitalisation is an important constituent of ---------------8. The 2 theories of capitalisation for new companies are ---------- and ------------

theory9. Capitalisation means the total amount of ----------- in a business10. Total amount of capitalisation of a new company is arrived by adding cost of

fixed assets, amount of working capital and cost of establishing business is -----------

Section B1. Write a note on cost theory of capitalisation.2. State the merits and demerits of earnings theory.3. Define capitalisation and explain its need.4. List out the evils of over capitalisation.5. Describe the term watered capital.6. What is under capitalisation of a firm?7. Explain the bases of determining the capitalisation of a firm.8. Can you explain what earnings theory is?9. What is over capitalisation?10. Can you give the remedies for over capitalisation?

Section C1. Explain  capitalisation and about the two interpretations.2. What is over capitalisation and under capitalization.3. What are the causes of over capitalisation? And how will you rectify.4. What are the remedial measures do you suggest to overcome the effects of under

capitalization.5. What are the different bases of determining the capitalisation of a firm.6. What are the advantages and disadvantages of ‘over’ and ‘under’ capitalisation.7. How will you explain on over capitalisation and excess of capital?8. Can you state some points on effects of under capitalisation?9. Explain the differences of the cost and earnings theories.10. Differentiate between over capitalisation and under capitalization.

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UNIT IVCapital Structure – Cardinal Principles of Capital structure – Trading on Equity – Cost of Capital – Concept – Importance – Calculation of Individual and Composite Cost of Capital.

CAPITAL STRUCTUREINTRODUCTION

Capital is the major part of all kinds of business activities, which are decided by the size, and nature of the business concern. Capital may be raised with the help of various sources. If the company maintains proper and adequate level of capital, it will earn high profit and they can provide more dividends to its shareholders.

Capitalization refers to the total amount of securities issued by a company while capital structure refers to the kinds of securities and the proportionate amounts that make up capitalization.

The capital structure is how a firm finances its overall operations and growth by using different sources of funds. The optimum capital structure may be defined as that capital structure or combination of debt and equity that leads to the maximum value of the firm.

Capital structure is what describes the relationship of these financing sources as they appear on the corporation’s balance sheet. It refers to all the financial resources organized by the firm, short as well as long term, and all forms of debt as well as equity.

Depending on how complex the structure, there may in fact be dozens of financing sources included, drawing on funds from a variety of entities in order to generate the

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complete financing package. For raising long term finances, a company can issue three types of securities viz., Equity shares, Preference shares and debentures. A decision about the proportion among these types of securities refers to the capital structure of an enterprise.

Meaning of Capital StructureCapital structure refers to the kinds of securities and the proportionate amounts that make up capitalization. It is the mix of different sources of long-term sources such as equity shares, preference shares, debentures, long-term loans and retained earnings.

The term capital structure refers to the relationship between the various long-term source financing such as equity capital, preference share capital and debt capital. Deciding the suitable capital structure is the important decision of the financial management because it is closely related to the value of the firm.

Capital structure is the permanent financing of the company represented primarily by long-term debt and equity.Definition of Capital StructureThe following definitions clearly initiate, the meaning and objective of the capital structures.

According to the definition of Gerestenbeg, “Capital Structure of a company refers to the composition or make up of its capitalization and it includes all long-term capital resources”.

According to the definition of James C. Van Horne, “The mix of a firm’s permanent long-term financing represented by debt, preferred stock, and common stock equity”.

According to the definition of Presana Chandra, “The composition of a firm’s financing consists of equity, preference, and debt”.

According to the definition of R.H. Wessel, “The long term sources of fund employed in a business enterprise”.

Forms/ Patterns of Capital Structure:The capital structure of a new company may consist of nay of the following forms

a. Equity Shares onlyb. Equity and preference sharesc. Equity shares and debenturesd. Equity shares, preference shares and debentures.

FINANCIAL STRUCTUREThe term financial structure is different from the capital structure. Financial structure shows the pattern total financing. It measures the extent to which total funds are available to finance the total assets of the business.

Financial Structure = Total liabilities

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OrFinancial Structure = Capital Structure + Current liabilities.

The following points indicate the difference between the financial structure and capital structure.

Financial Structures Capital Structures1. It includes both long-term and short-term sources of funds 1. It includes only the long-term sources

of funds.2. It means the entire liabilities side of the balance sheet. 2. It means only the long-term liabilities

of the company.3. Financial structures consist of all sources of capital. 3. It consist of equity, preference and

retained earning capital.4. It will not be more important while determining the 4. It is one of the major determinations of

value of the firm. the value of the firm.

Example

From the following information, calculate the capitalization, capital structure and financial structures.

Balance Sheet

Liabilities AssetsEquity share capital 50,000 Fixed assets 25,000Preference share capital 5,000 Good will 10,000Debentures 6,000 Stock 15,000Retained earnings 4,000 Bills receivable 5,000Bills payable 2,000 Debtors 5,000Creditors 3,000 Cash and bank 10,000

70,000 70,000

(i) Calculation of Capitalization

S. No. Sources Amount

1. Equity share capital 50,0002. Preference share capital 5,0003. Debentures 6,000

Capitalization 61,000

(ii) Calculation of Capital Structures

S. No. Sources Amount Proportion1. Equity share capital 50,000 76.922. Preference share capital 5,000 7.693. Debentures 6,000 9.234. Retained earnings 4,000 6.16

65,000 100%

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(iii) Calculation of Financial Structure

S. No. Sources Amount Proportion

1. Equity share capital 50,000 71.422. Preference share capital 5,000 7.143. Debentures 6,000 8.584 . Retained earnings 4,000 5.725. Bills payable 2,000 2.856. Creditors 3,000 4.29

70,000 100%

OPTIMUM CAPITAL STRUCTURE

Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and thereby the value of the firm is maximum.

Optimum capital structure may be defined as the capital structure or combination of debt and equity, that leads to the maximum value of the firm.

Objectives of Capital StructureDecision of capital structure aims at the following two important objectives:

1. Maximize the value of the firm. 2. Minimize the overall cost of capital.

Forms of Capital StructureCapital structure pattern varies from company to company and the availability of finance. Normally the following forms of capital structure are popular in practice.

• Equity shares only. • Equity and preference shares only. • Equity and Debentures only. • Equity shares, preference shares and debentures.

FACTORS DETERMINING CAPITAL STRUCTUREThe following factors are considered while deciding the capital structure of the firm.

LeverageIt is the basic and important factor, which affect the capital structure. It uses the fixed cost financing such as debt, equity and preference share capital. It is closely related to the overall cost of capital.

Cost of CapitalCost of capital constitutes the major part for deciding the capital structure of a firm. Normally long- term finance such as equity and debt consist of fixed cost while mobilization. When the cost of capital increases, value of the firm will also decrease. Hence the firm must take careful steps to reduce the cost of capital.

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(a) Nature of the business: Use of fixed interest/dividend bearing finance depends upon the nature of the business. If the business consists of long period of operation, it will apply for equity than debt, and it will reduce the cost of capital.

(b) Size of the company: It also affects the capital structure of a firm. If the firm belongs to large scale, it can manage the financial requirements with the help of internal sources. But if it is small size, they will go for external finance. It consists of high cost of capital.

(c) Legal requirements: Legal requirements are also one of the considerations while dividing the capital structure of a firm. For example, banking companies are restricted to raise funds from some sources.

(d) Requirement of investors: In order to collect funds from different type of investors, it will be appropriate for the companies to issue different sources of securities.

Government policyPromoter contribution is fixed by the company Act. It restricts to mobilize large,

long-term funds from external sources. Hence the company must consider government policy regarding the capital structure.

THEORIES OF CAPITAL STRUCTURECapital structure is the major part of the firm’s financial decision which affects the value of the firm and it leads to change EBIT and market value of the shares. There is a relationship among the capital structure, cost of capital and value of the firm. The aim of effective capital structure is to maximize the value of the firm and to reduce the cost of capital.

There are two major theories explaining the relationship between capital structure, cost of capital and value of the firm.

Capital Structure Theories

Modern Approach Tradition al Approach

Net Income Net Operating Income Modigliani-MillerApproach Approach Approach

Fig. 5.1 Capital Structure Theories

Net Income Approach:Net income approach suggested by the Durand. According to this approach, the capital structure decision is relevant to the valuation of the firm. In other words, a change in the capital structure leads to a corresponding change in the overall cost of capital as well as the total value of the firm.

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According to this approach, use more debt finance to reduce the overall cost of capital and increase the value of firm.

Net income approach is based on the following three important assumptions:

1.There are no corporate taxes.

2.The cost debt is less than the cost of equity.

3.The use of debt does not change the risk perception of the investor.

A firm can minimize the weighted average cost of capital and increase the value of the firm as well as the market price of equity shares by using debt finance to the maximum possible extent.The total market value of a firm on the basis of Net Income Approach Can be ascertained as below: V=S+DV = Total market value of a firmS = Market value of equity sharesD = Market value of debt

Particulars AmountNet operating income (EBIT) XXX

Less: interest on debenture (i) XXXEarnings available to equity holder (NI) XXX

Equity capitalization rate (Ke) XXXMarket value of equity (S) XXX

Market value of debt (B) XXX

Total value of the firm (S+B) XXX

Overall cost of capital = Ko = EBIT/V(%) XXX%

Exercise 3

(a) A Company expects a net income of Rs. 1,00,000. It has Rs. 2,50,000, 8% debentures. The equality capitalization rate of the company is 10%. Calculate the value of the firm and overall capitalization rate according to the net income approach (ignoring income tax).

(b) If the debenture debts are increased to Rs. 4,00,000. What shall be the value of the firm and the overall capitalization rate?

Solution

(a) Capitalization of the value of the firm

Rs.

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Net income 1,00,000Less: Interest on 8% Debentures of Rs. 2,50,000 20,000

Earnings available to equality shareholders 80,000Equity capitalization rate 10%

=80,000

10010

Market value of equity = 8,00,000Market value of debentures = 2,50,000Value of the firm = 10,50,000Calculation of overall capitalization rate

Overall cost of capital (Ko) =Earnings

EBIT

Valueof thefirm V

1,00,000

= 10,50,000 ×100

= 9.52%

(b) Calculation of value of the firm if debenture debt is raised to Rs. 3,00,000.

Rs.Net income 1,00,000Less: Interest on 8% Debentures of Rs. 4,00,000 32,000Equity Capitalization rate 68,000

10%100

Market value of equity = 68,000 × = 6,80,00010= 6,80,000

Market value of Debentures = 4,00,000Value of firm = 10,80,000

Overall cost of capital =1,00,000

×1010,80,000

= 9.26%

Thus, it is evident that with the increase in debt financing, the value of the firm has increased and the overall cost of capital has increased.

Net Operating Income Approach

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It is opposite to the net income approach. According to this approach change in the capital structure of accompany does not affect the market value of the firm and the overall cost of capital remains constant irrespective of the method of financingThis theory presumes that

The market capitalizes the value of the firm as w whole The business risk remains constant at every level of debt equity mix. There are no corporate taxes

According to this approach, the change in capital structure will not lead to any change in the total value of the firm and market price of shares as well as the overall cost of capital.

NI approach is based on the following important assumptions; The overall cost of capital remains constant;

There are no corporate taxes;

The market capitalizes the value of the firm as a whole;

Value of the firm (V) can be calculated with the help of the following formulaEBIT

V =Ko

Where,

V = Value of the firmEBIT = Earnings before interest and taxKo = Overall cost of capital

Exercise 4

XYZ expects a net operating income of Rs. 2,00,000. It has 8,00,000, 6% debentures. The overall capitalization rate is 10%. Calculate the value of the firm and the equity capitalization rate (Cost of Equity) according to the net operating income approach.

If the debentures debt is increased to Rs. 10,00,000. What will be the effect on volume of the firm and the equity capitalization rate?

Solution

Net operating income = Rs. 2,00,000

Overall cost of capital = 10%

Market value of the firm (V)

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=

EBITKo

100= 2,00,000× = Rs. 20,00,00010

Market value of the firm = Rs. 20,00,000

Less: market value of Debentures= Rs. 8,00,000

12,00,000

Equity capitalization rate (or) cost of equity (Ke)

EBIT − I= V − D

Where, V = value of the firm

D = value of the debt capital

2,00,000 – 48,000 =

20,00,000 − 8,00,000 ×100

=12.67%

If the debentures debt is increased to Rs. 10,00,000, the value of the firm shall remain changed to Rs. 20,00,000. The equity capitalization rate will increase as follows:

EBIT − I= V − D

2,00,000 – 60,000 =

20,00,000

− 10,00,000 ×100

1,40,000

= 10,00,000 ×100

= 14%.

Exercise 5

Abinaya company Ltd. expresses a net operating income of Rs. 2,00,000. It has Rs. 8,00,000 to 7% debentures. The overall capitalization rate is 10%.

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(a) Calculate the value of the firm and the equity captialization rate (or) cost of equity according to the net operating income approach.

(b) If the debenture debt is increasesd to Rs. 12,00,000. What will be the effect on the value of the firm, the equity capitalization rate?

Solution

(a) Net operating income = Rs. 2,00,000 Over all cost of capital = 10%

Market value of the firm (V)

NOI(EBIT)

Overallcost of capital(OK)

= 2,00,000×100/10= Rs. 20,00,000

Market value of firm = Rs. 20,00,000Less Market value of debentures = Rs. 8,00,000Total marketing value of equity = Rs. 12,00,000

Equity capitalization rate (or) cost of equity (Ke)EBIT − I

= V − D 2,00,000 − 56,000

=20,00,000 − 8,00,000 ×100

1,44,000

= 12,00,000 ×100

= 12%

where I = Interest of debtV = Value of the firmD = Value of debt capitalI = 8,00,000×7%=56,000V = 20,00,000D = 8,00,000

(b) If the debenture debt is increased at Rs. 12,00,000, the value of the firm shall changed to Rs. 20,00,000.

Equity Capitalization Rate (Ke)EBIT − I

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= V − D

2,00,000 − 84,000= 20,00,000 − 12,00,000 = 14.5%

where I= 12,00,000 at 7% = 84,000

Modigliani and Miller Approach

Modigliani and Miller approach states that the financing decision of a firm does not affect the market value of a firm in a perfect capital market. In other words MM approach maintains that the average cost of capital does not change with change in the debt weighted equity mix or capital structures of the firm.

Modigliani and Miller approach is based on the following important assumptions:

• There is a perfect capital market.

• There are no retained earnings.

• There are no corporate taxes.

• The investors act rationally.

• The dividend payout ratio is 100%.

• The business consists of the same level of business risk.

Value of the firm can be calculated with the help of the following formula:

EBIT (l − t)

Ko

Where

EBIT = Earnings before interest and tax

Ko = Overall cost of capital t = Tax rate

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R a

te o

f R e

turn

Ke

Ko

k

D/E

Risk Bearing Debt

Risk Due D ebt

Fig. 5.2 Modigliani and Miller Approach

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Exercise 6

There are two firms ‘A’ and ‘B’ which are exactly identical except that A does not use any debt in its financing, while B has Rs. 2,50,000 , 6% Debentures in its financing. Both the firms have earnings before interest and tax of Rs. 75,000 and the equity capitalization rate is 10%. Assuming the corporation tax is 50%, calculate the value of the firm.

Solution

The market value of firm A which does not use any debt.

Vu= EBITKo

=75,000

=75,000×100/10 10/100

= Rs. 7,50,000

The market value of firm B which uses debt financing of Rs. 2,50,000 Vt = Vu + tVu = 7,50,000, t = 50% of Rs. 2,50,000

= 7,50,000 + 1,25,000

= Rs. 8,75,000

Exercise 7

The following data regarding the two companies ‘X’ and ‘Y’ belonging to the same equivalent class:

Company ‘X’ Company ‘Y’Number of ordinary shares 75,000 1,25,0005% debentures 40,000 –Market price per shares Rs. 1.25 Rs. 1.00Profit before interest Rs. 25,000 Rs. 25,000

All profits after paying debenture interest are distributed as dividends.

You are required to explain how under Modigliani and Miller approach, an investor holding 10% of shares in company ‘X’ will be better off in switching his holding to company ‘Y’.

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Solution

As per the opinion of Modigliani and Miller, two similar firms in all respects except their capital structure cannot have different market values because of arbitrage process. In case two similar firms except for their capital structure have different market values, arbitrage will take place and the investors will engage in ‘personal leverage’ as against the corporate leverage. In the given problem, the arbitrage will work out as below.

1. The investor will sell in the market 10% of shares in company ‘X’ for

75,000×10/100×1.25=Rs. 9375

2. He will raise a loan of Rs. 40,000×10/100=Rs. 4000

To take advantage of personal leverage as against the corporate leverage the company ‘Y’ does not use debt content in its capital structure. He will put 13375 shares in company ‘Y’ with the total amount realized from 1 and 2 i.e., Rs. 9375 plus Rs. 4000. Thus he will have 10.7% of shares in company ‘Y’.

The investor will gain by switching his holding as below:Present income of the investor in company ‘X’ Rs.Profit before Interest of the Company 25,000Less: Interest on Debentures 5% 2,000Profit after Interest 23,000Share of the investor = 10% of Rs. 23,000 i.e., Rs. 2300Income of the investor after switching holding to companyProfit before Interest of the company Rs. 25,000Less Interest ——Profit after Interest 25,000

13,375

= Rs. 2,675Share of the investor : 25,000×1,25,00

0

Interest paid on loan taken 4000×5/100 200Net Income of the Investor 2,475

As the net income of the investor in company ‘Y’ is higher than the cost of income from company ‘X’ due to switching the holding, the investor will gain in switching his holdings to company ‘Y’.

Exercise 8

Paramount Products Ltd. wants to raise Rs. 100 lakh for diversification project.

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Current estimates of EBIT from the new project is Rs. 22 lakh p.a.

Cost of debt will be 15% for amounts up to and including Rs. 40 lakh, 16% for additional amounts up to and including Rs. 50 lakh and 18% for additional amounts above Rs. 50 lakh. The equity shares (face value of Rs. 10) of the company have a current market value of Rs. 40. This is expected to fall to Rs. 32 if debts exceeding Rs. 50 lakh are raised. The following options are under consideration of the company.

Option Debt EquityI 50% 50%II 40% 60%

III 60% 40%

Determine EPS for each option and state which option should the Company adopt.

Tax rate is 50%. (ICWA Inter Dec. 1997)Solution

I II III

Equity 50,00,000 60,00,000 40,00,000Debt 50,00,000 40,00,000 60,00,000

Amount to be raised 1,00,00,000 1,00,00,000 1,00,00,000EBIT 22,00,000 22,00,000 22,00,000Less: Interest of Debt 7,60,000 6,00,000 9,40,000PBT 14,40,000 16,00,000 12,60,000Less : Tax @ 50% 7,20,000 8,00,000 6,30,000PAT 7,20,000 8,00,000 6,30,000

No. of equity shares 1,25,000 1,50,000 1,25,000

Rs. 5.76 Rs. 5.33 Rs. 5.04

Working NotesCalculation of Interest on Debt

Total Debt I II IIIInterest on: 50,00,000 40,00,000 60,00,000Ist Rs. 40,00,000 @ 15% 6,00,000 6,00,000 6,00,000Next Rs.10,00,000 @ 16% 1,60,000 – 1,60,000Balance Rs. 10,00,000 @ 18% – – 1,80,000

7,60,000 6,00,000 9,40,000

Exercise 9The following is the data regarding two Company’s. X and Y belonging to the same

risk class.

X Y

No. of ordinary shares 90,000 1,50,000Market price/share (Rs.) 1.2 1.06% debentures 60,000 –

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Profit before interest 18,000 18,000

All profits after interest are distributed as dividend.

Explain how under Modigliani & Miller Approach an investor holding 10% of shares in Company X will be better off in switching his holding to Company Y.

(CA Final Nov. 1993)

Solution

Both the firms have EBIT of Rs. 18,000. Company X has to pay interest of Rs. 3600 (i.e., 6% on Rs. 60,000) and the remaining profit of Rs. 14,400 is being distributed among the shareholders. The Company Y on the other hand has no interest liability and therefore is distributing Rs.18,000 among the shareholders.

The investor will be well off under MM Model by selling the shares of X and shifting to shares of Y company through the arbitrage process as follows. If he sells shares of X Company He gets Rs. 10,800 (9,000 shares @ Rs.1.2 per share). He now takes a 6% loan of Rs.6,000

(i.e. 105 of Rs. 60,000) and out of the total cash of Rs. 16,800 he purchases 10% of shares of Company Y for Rs. 15,000; his position with regard to Company Y would be as follows:

X Y

Dividends (10% of Profits) 1,440 1,800Less:Interest (6% on Rs. 6,000) – 360

Net Income 1,440 1,440

Thus by shifting from Company Y the investor is able to get the same income of Rs. 1,440 and still having funds of Rs. 1,800 (i.e., Rs. 16,800 – 15,000) at his disposal. He is better off not in terms of income but in terms of having capital of Rs. 1,800 with him which he can invest elsewhere.

Exercise 10

Gentry Motors Ltd., a producer of turbine generators, is in this situation; EBIT = Rs. 40 lac. rate =35%, dept. outstanding = D = Rs. 20 lac., rate of Interest =10%, K e = 15%, shares of stock outstanding = No. = Rs. 6,00,000 and book value per share = Rs. 10. Since Gentry’s product market is stable and the Company expects no growth, all earnings are paid out as dividends. The debt consists of perpetual bonds. What are the Gentry’s EBS and its price per share, Po? (CS Final Dec. 1998)

Solution(a) EBIT 40,00,000

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interest @ 10%2,00,000

38,00,000

Tax @ 35%13,30,00024,70,000

No. of shares 6,00,000EPS (or Dividend) Rs. 4.12Ke (given) 15%Po (i.e., D/Ke) 4.12/.15⇒ Rs. 27.47

In the same question if the Company increases its debt by Rs. 80 lakh to a total of Rs. 1 crore using the new debt to buy and retire of its shares at current price, its interest rate on debt will be 12% and its cost of equity will rise from 15% to 17%. EBIT will remain constant, should this Company change its capital structure.

If Company decides to increase its debt by Rs. 80 lacs, the Company may buy back 80,00,000 27.47 = 2,91,226 shares. Thereafter the remaining no. of shares would be 3,08,774 (i.e., 6,00,000 – 2,91,226).

The market price of the share may be ascertained as follows:

EBIT 40,00,000Interest @ 12% on Rs. 1 crore 12,00,000

28,00,000Tax @ 35% 9,80,000

18,20,000No. of equity shares 3,08,774EPS Rs. 5.89Ke 17%Po (i.e., D/Ke) 5.89

.17= Rs. 34.64

As the price is expected to rise from 27.47 to Rs 34.64, the Company may change its capital structure by raising debt and retaining some number of shares.

Traditional approach

It is also known as intermediate approach. A proper debt-equity mix can reach optimum capital structure. Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of the equity shareholders. The overall cost of capital decreases up to ca certain point, remains unchanged for moderate increase in debt

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thereafter and increases or rises beyond a certain point. Even the cost of debt may increase at this stage due to increases financial risk.

Factors determining the capital structure:

a. Financial leverage or Trading on equity:The use of long term fixed interest bearing debt and preference share capital along with equity share capital is called financial leverage or trading on equity.

b. Growth and stability of sales:The capital structure is influenced by the sales. If the sales is high, the firm can use the debt more for financing the firm.

c. Cost of capital:Cost of capital refers to the minimum return expected by its suppliers. The capital structure should provide for the minimum cost of capital. The return expected by the suppliers of capital depends upon the risk they have to undertake. the main sources of finance for a firm are equity, preference share capital and debt capita.. While formulating a capital structure, effort must be made to minimize the overall cost of capital.

d. Cash flow ability to service debt: If the firm has good cash flow I t can choose more debt in its capital structure. Whenever a firm wants to raise additional funds, it should estimate, project its future cash inflows to ensure the coverage of fixed charges.

e. Nature and size of the firm:Nature and size of the firm also influences the capital structure. Public utility concerns may employ more of debt because of stability and regularity of their earnings. On the other hand, concern that cannot provide stable earnings due to the nature of its business will have to rely mainly on equity capital. Small companies have to depend mainly upon owned capital, as it is very difficult for them to raise l9ong term loans on reasonable terms and also cannot issue equity and preference shares to the public

f. Control:The management should raise the funds without loosing the control. If the funds are raised through the issue of equity shares, the control is diluted. Preference shareholders and debenture holders’ do not have the voting right. And hence it may be recommended. But it would cause heavy burden to the company.

g. Flexibility:Capital structure should be in such a way that it must be capable of being adjusted according to the needs of the changing conditions.

h. Requirements of investors.Requirements of the investors should also be considered. Bold investors may prefer equity capital while the conservative investors prefer debt and preference capital.

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i. Capital market conditions:The choice of the securities are influenced by the market conditions such as depression and , boom etc. the company shall not issue equity shares during depression and may issue them at boom.

j. Assets structureThe liquidity and the composition of assets should also be kept in mind while selecting he capital structure.

k. Purpose of financing. If funds are required for productive purpose, debt financing shall be suitable and if the funds are required for general development of unproductive purpose, equity capital shall be preferred.

l. Period of Finance:If funds are needed for permanent basis, equity capital shall be used and if it is for a limited period, best financing or preference capital may be preferred

m. Cost of flotation:Cost of floatation of debt is generally less than the cost of floatation of equity capital.

n. Personal consideration:Personal considerations and abilities of the management will have impact on the capital structure of the firm.

O. Corporate tax rate:High corporate taxes on profits may compel the companies to prefer debt financing, because interest is allowed to be deducted while computing taxable profits. On the other hand dividend of shares is not an allowable expense for that purpose.

P. Legal requirements:The legal restrictions are very significant as these lay down a framework within which capital structure decision has to be made.

It is the mix of Net Income approach and Net Operating Income approach. Hence, it is also called as intermediate approach. According to the traditional approach, mix of debt and equity capital can increase the value of the firm by reducing overall cost of capital up to certain level of debt. Traditional approach states that the Ko decreases only within the responsible limit of financial leverage and when reaching the minimum level, it starts increasing with financial leverage.

Assumptions

Capital structure theories are based on certain assumption to analysis in a single and

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convenient manner:

• There are only two sources of funds used by a firm; debt and shares.

• The firm pays 100% of its earning as dividend.

• The total assets are given and do not change.

• The total finance remains constant.

• The operating profits (EBIT) are not expected to grow.

• The business risk remains constant.

• The firm has a perpetual life.

• The investors behave rationally.

Exercise 1

ABC Ltd., needs Rs. 30,00,000 for the installation of a new factory. The new factory expects to yield annual earnings before interest and tax (EBIT) of Rs.5,00,000. In choosing a financial plan, ABC Ltd., has an objective of maximizing earnings per share (EPS). The company proposes to issuing ordinary shares and raising debit of Rs. 3,00,000 and Rs. 10,00,000 of Rs. 15,00,000. The current market price per share is Rs. 250 and is expected to drop to Rs. 200 if the funds are borrowed in excess of Rs. 12,00,000. Funds can be raised at the following rates.

–up to Rs. 3,00,000 at 8%

–over Rs. 3,00,000 to Rs. 15,000,00 at 10% –over Rs. 15,00,000 at 15%

Assuming a tax rate of 50% advise the company.

Solution

Earnings Before Interest and Tax (BIT) less Interest Earnings Before Tax less: Tax@50%.

Alternatives

I II III(Rs. 3,00,000 debt) Rs. 10,00,000 debt) (Rs. 15,00,000 debt)5,00,000 5,00,000 5,00,00024,000 1,00,000 2,25,0004,76,000 4,00,000 2,75,0002,38,000 2,00,000 1,37,500

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2,38,000 2,00,000 1,37,50027,00,000 20,00,000 15,00,000250 250 20010800 8,000 7,5002,38,000 2,00,000 1,37,500No. of shares 10,800 8,000 7,500

Earnings per share 22.03 25 18.33

The secure alternative which gives the highest earnings per share is the best. Therefore the company is advised to revise Rs. 10,00,000 through debt amount Rs. 20,00,000 through ordinary shares.

Exercise 2

Compute the market value of the firm, value of shares and the average cost of capital from the following information.

Net operating income Rs. 1,00,000Total investment Rs. 5,00,000Equity capitalization Rate:

(a) If the firm uses no debt 10%

(b) If the firm uses Rs. 25,000 debentures 11%

(c) If the firm uses Rs. 4,00,000 debentures 13%

Assume that Rs. 5,00,000 debentures can be raised at 6% rate of interest whereas Rs. 4,00,000 debentures can be raised at 7% rate of interest.

Solution

Computation of market value of firm value of shares and the average cost of capital.

Particulars (a) No Debt (b) Rs. 2,50,000 (c) Rs. 4,00,0006% debentures 7% debentures

Net operating system 1,00,000 1,00,000 1,00,000(–) Interest (i.e.)Cost of debt _ 15,000 28,000Earnings available toEquity shareholders 1,00,000 85,000 72,000Equity Capitalization Rate 10% 11% 13%

10 100 100

Market value of shares 10,000 85,000 72,000 13100 11Rs. 10,00,000/- Rs.772727/- Rs.553846/-

Market Value of firm 10,00,000 10,22,727 9,53,8461,00,000 1,00,000 1,00,000

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Average cost of capital 1,00,000 100 1, 00, 000 100 1, 00, 000 10010, 22, 72710,00,000 9, 53, 846

EarningsValueof thefirm

EBIT=10% =9.78% =10.48%

V

Comments

From the above data, if debt of Rs. 2,50,000 is used, the value of the firm increases and the overall cost of capital decreases. But, if more debt is used to finance in place of equity i.e., Rs. 4,00,000 debentures, the value of the firm decreases and the overall cost of capital increases.

The reasons for necessitating changes in capitalization are To restore balance in the Financial plan To simplify the capital structure To suit investor needs To fund current liabilities To write off the debt To capitalize the retained earnings To clear default of fixed cost securities To fund accumulated dividends To facilitate merger and expansion To meet legal requirements

TRADING ON EQUITY

In finance, equity trading is the buying and selling of company stock shares. Borrowing funds to increase capital investment with the hope that the business will be able to generate returns in excess of the interest charges.

Equity trading can be performed by the owner of the shares, or by an agent authorized to buy and sell on behalf of the share's owner. Proprietary trading is buying and selling for the trader's own profit or loss. In this case, the principal is the owner of the shares.

Trading on equity occurs when a corporation uses bonds, other debt, and preferred stock to increase its earnings on common stock. For example, a corporation might use long term debt to purchase assets that are expected to earn more than the interest on the debt. The earnings in excess of the interest expense on the new debt will increase the earnings of the corporation’s common stockholders. The increase in earnings indicates that the corporation was successful in trading on equity.

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Shares in large publicly traded companies are bought and sold through one of the major stock exchanges, such as the New York Stock Exchange, London Stock Exchange or Bombay Stock Exchange, which serve as managed auctions for stock trades. Stock shares in smaller public companies are bought and sold in over-the-counter (OTC) markets.

COST OF CAPITAL

INTRODUCTION

Cost of capital is an integral part of investment decision as it is used to measure the worth of investment proposal provided by the business concern. It is used as a discount rate in determining the present value of future cash flows associated with capital projects. Cost of capital is also called as cut-off rate, target rate, hurdle rate and required rate of return. When the firms are using different sources of finance, the finance manager must take careful decision with regard to the cost of capital; because it is closely associated with the value of the firm and the earning capacity of the firm.

Financial capital represents obligations, and is liquidated as money for trade, and owned by legal entities. It is in the form of capital assets, traded in financial markets. Its market value is not based on the historical accumulation of money invested but on the perception by the market of its expected revenues and of the risk entailed.

Capital accumulation in classical economic theory is the production of increased capital. In order to invest, goods must be produced which are not to be immediately consumed, but instead used to produce other goods as a means of production.

Capital (money) used for funding a business should earn returns for the capital providers who risk their capital. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. In other words, the ''risk-adjusted'' return on capital (that is, incorporating not just the projected returns, but the probabilities of those projections) must be higher than the cost of capital.

Meaning of Cost of Capital

Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds.

Cost of capital is the required rate of return on its investments which belongs to equity, debt and retained earnings. If a firm fails to earn return at the expected rate, the market value of the shares will fall and it will result in the reduction of overall wealth of the shareholders.

Definitions

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The following important definitions are commonly used to understand the meaning and concept of the cost of capital.

According to the definition of John J. Hampton “ Cost of capital is the rate of return the firm required from investment in order to increase the value of the firm in the market place”.

According to the definition of Solomon Ezra, “Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditure”.

According to the definition of James C. Van Horne, Cost of capital is “A cut-off rate for the allocation of capital to investment of projects. It is the rate of return on a project that will leave unchanged the market price of the stock”.

According to the definition of William and Donaldson, “Cost of capital may be defined as the rate that must be earned on the net proceeds to provide the cost elements of the burden at the time they are due”.

Measuring Cost of Capital

It will depend upon:• The components of financing: Debt, Equity or Preferred stock• The cost of each component

Significance of the cost of capital:

The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio company's existing securities".[1] It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

1. Evaluating investment decisionsThe primary purpose of measuring the cost of capital is its use as a financial standard for evaluating the investment projects. Using NPV method or IRR method, a project may be accepted or rejected. It may be noted that the cost of capital represents a financial standard for allocating the firm’s funds, supplied by owners and creditors, to the various investment projects in the most efficient manner.

2. Designing Debt policy:The debt policy of a firm is significantly influenced by the cost consideration. In designing the capital structure, the firm aims at maximizing the firm value by minimizing the overall cost of capital. The cost of capital can also be useful in deciding about the

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methods of financing at a point of time. For eg., cost may be compared in choosing between leasing and borrowing.

3. Performance Appraisal:The cost of capital framework can be used to evaluate the financial performance of top management. Such an evaluation will involve a comparison of actual profitability of the investment projects undertaken by the firm with the projected overall cost of capital and the appraisal of the actual costs incurred by management in raising the required funds.

Concept of Cost of Capital

Capital refers to the funds invested in a business. The capital can come from different sources such as equity shares, preference shares, and debt. All capital has a cost. However, it varies from one sources of capital to another, from one company to another and from one period of time to another.

Cost of capital may be defined as the company's cost of collecting funds. This is equal to the average rate of return that an investor in a company will expect for providing funds. It is the minimum rate of return that the project must earn to keep the value of the company intact. The minimum rate of return is equal to cost of capital.

The cost of capital in always expressed in terms of percentage. Proper allowance is made for tax purposes. This is done to get a correct picture of the cost of capital. The cost of capital is a guideline for determining the optimum capital structure of a company.

Calculation of Cost of Capital

In order to calculate the overall cost of capital, a finance manager has to take the following steps:-

1. Determine the type of funds to be raised and their share in the capital structure.2. Determine cost of each type of funds.3. Calculate combined cost of capital of the company by giving weights to each type

of funds in terms of proportion of funds raised to total funds.

Assumption of Cost of Capital

Cost of capital is based on certain assumptions which are closely associated while calculating and measuring the cost of capital. It is to be considered that there are three basic concepts:

1. It is not a cost as such. It is merely a hurdle rate.

2. It is the minimum rate of return.

3. It consis of three important risks such as zero risk level, business risk and financial

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risk. Cost of capital can be measured with the help of the following equation. K = rj + b + f.

Where,

K = Cost of capital.

rj = The riskless cost of the particular type of finance. b = The business risk premium.

f = The financial risk premium.

CLASSIFICATION OF COST OF CAPITAL

Cost of capital may be classified into the following types on the basis of nature and usage:

• Explicit and Implicit Cost.

• Average and Marginal Cost.

• Historical and Future Cost.

• Specific and Combined Cost.

Explicit and Implicit Cost

The cost of capital may be explicit or implicit cost on the basis of the computation of cost of capital.

Explicit cost is the rate that the firm pays to procure financing. This may be calculated with the help of the following equation;

n COt

CIo =

∑

t1 (t C)t

Where,CIo = initial cash inflow

C = outflow in the period concernedN = duration for which the funds are provided

T = tax rate

Implicit cost is the rate of return associated with the best investment opportunity for the firm and its shareholders that will be forgone if the projects presently under consideration by the firm were accepted.

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Average and Marginal Cost

Average cost of capital is the weighted average cost of each component of capital employed by the company. It considers weighted average cost of all kinds of financing such as equity, debt, retained earnings etc.

Marginal cost is the weighted average cost of new finance raised by the company. It is the additional cost of capital when the company goes for further raising of finance.

Historical and Future Cost

Historical cost is the cost which as already been incurred for financing a particular project. It is based on the actual cost incurred in the previous project.

Future cost is the expected cost of financing in the proposed project. Expected cost is calculated on the basis of previous experience.

Specific and Combine Cost

The cost of each sources of capital such as equity, debt, retained earnings and loans is called as specific cost of capital. It is very useful to determine the each and every specific source of capital.

The composite or combined cost of capital is the combination of all sources of capital. It is also called as overall cost of capital. It is used to understand the total cost associated with the total finance of the firm.

IMPORTANCE OF COST OF CAPITAL

Computation of cost of capital is a very important part of the financial management to decide the capital structure of the business concern.

Importance to Capital Budgeting Decision

Capital budget decision largely depends on the cost of capital of each source. According to net present value method, present value of cash inflow must be more than the present value of cash outflow. Hence, cost of capital is used to capital budgeting decision.

Importance to Structure Decision

Capital structure is the mix or proportion of the different kinds of long term securities. A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital helps to take decision regarding structure.

Importance to Evolution of Financial Performance

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Cost of capital is one of the important determine which affects the capital budgeting, capital structure and value of the firm. Hence, it helps to evaluate the financial performance of the firm.

Importance to Other Financial Decisions

Apart from the above points, cost of capital is also used in some other areas such as, market value of share, earning capacity of securities etc. hence, it plays a major part in the financial management.

CALCULATION OF INDIVIDUAL AND COMPOSITE COST / weighted average cost of capital OF CAPITAL.

MEANING:

The term Cost of Capital refers to the over-all composite cost of capital. It is defined as the Weighted Average Cost of Capital (WACC). The percentage or proportion of various sources of finance used by a company is different.

A company's cost to borrow money given the proportional amounts of each type of debt and equity a company has taken on. A company's debt and equity, or its capital structure, typically includes common stock, preferred stock and bonds. A high composite cost of capital, indicates that a company has high borrowing costs; a low composite cost of capital signifies low borrowing costs.

Also referred to as "weighted average cost of capital" or WACC.

Each of these components is given weightage on the basis of the associated interest rate and other gains and losses with it. It shows the cost of each additional capital as against the average cost of total capital raised. The process to compute this is first computing the weighted average cost of capital which is the collection of weights of other costs summed together.

In this the cost of debt is calculated in the beginning and it is used to find out the cost of capital and other weights of cost is been calculated after the calculation each and every individual weight of the component is added and then it gives the final composite cost.. 

DEFINITION:

Weighted average of the component costs of common stock (ordinary shares), preferred stock (preference shares), and debt. Each component of capital is given a relative importance (weight) on the basis of its associated interest rate, management's loss of control, risk exposure, etc., to compute weighted average cost of capital. It shows the cost of each additional dollar of capital, as opposed to the average cost of the total capital raised.

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Factors affecting Weighted Average Cost of Capital: 1. Factors outside a firm’s control:

a. Interest rate levelsb. Market risk premiumc. Tax rates

2. Factors within a firm’s control: a. Investment policyb. Capital structure policyc. Dividend policy

Essential features of a sound capital mix: Maximum possible use of leverage Flexible capital structure Avoid undue financial or business risk with the increase of debt Use of debt should be within the capacity of the firm Should involve minimum possible risk of loss of control Must avoid undue restrictions in agreement of debt.

Calculation of WACC for a company with a complex capital structure:The formula for a simple case is

E DC= .Y + .b (1-tc)

K KWhere K= D+E

c =weighted average cost of capitaly =required or expected rate of return on equity, or cost of equityb=required or expected rate of return on borrowings, or cost of debtt=corporate tax rateD=total debt and leases (including current portion of long-term debt and notes payable)E=total market value of equityK=total capital invested in the going concern

This equation describes only the situation with homogeneous equity and debt. If part of the capital consists, for example, of preferred stock (with different cost of equity “y”), then the formula would include an additional term for each additional source of capital.

Since we are measuring expected cost of new capital, we should use the market values of the components, rather than their book values (which can be significantly different). In addition, other, more "exotic" sources of financing, such as convertible/callable bonds, convertible preferred stock, etc., would normally be included in the formula if they exist in any significant amounts - since the cost of those financing methods is usually different from the plain vanilla bonds and equity due to their extra features.

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Factors influence a company’s composite WACC

Market conditions. The firm’s capital structure and dividend policy. The firm’s investment policy. Firms with riskier projects generally have a higher

WACC.

To calculate the Cost of Capital

The cost of capital is simply a weighted average of the cost of the individual sources (i.e., bonds, preferred stock, retained earnings, and sale of new common stock).  For example, assume that you raise 40% of your money in the form of debt, 20% in preferred stock, and 40% in common equity.

Few details for calculating the cost of each component.

Cost of Debt  Debt is special in the sense that its interest payments are tax-deductible.  While this is a good thing, it does present a problem when comparing its cost with the cost of the other components, whose costs are not tax-deductible.

Cost of Preferred StockThe cost of money raised by selling preferred stock is, generically, the dollar cost divided by the amount of money raised. 

Cost of Retained EarningsStockholders let the company’s management keep some of the earnings and reinvest them back into the company (rather than paying it to them in the form of dividends).  This does not mean that these retained earnings are free however – the stockholders still expect to earn a rate of return on the company’s investment of this money. The rate of return that the company must earn on the investment of this money (in order to keep the shareholders happy) is called the cost of retained earnings.

Cost of New EquityThe cost of raising money through the sale of new common stock is the same as the cost of retained earnings, with one exception:  flotation costs.  Money earned in the company’s operations (i.e., retained earnings) is readily available with paying any outside agency; money raised from outside the company often comes with commissions and fees (i.e., flotation fees) attached.

Weighted Marginal Cost of CapitalAssume that Genuine Products, Inc. is raising money for expansion of its operation.  It has part of the money already set aside in the form of cash from this year's addition to retained earnings.  In order to stay at its optimal capital structure, it has decided to raise the money in the following proportions:  40% debt, 10% preferred stock, 20% retained earnings, and 30% from the sale of new common stock.

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COMPUTATION OF COST OF CAPITAL

Computation of cost of capital consists of two important parts:

1. Measurement of specific costs

2. Measurement of overall cost of capital

Measurement of Cost of Capital

It refers to the cost of each specific sources of finance like:

• Cost of equity

• Cost of debt

• Cost of preference share

• Cost of retained earnings

Cost of Equity

Cost of equity capital is the rate at which investors discount the expected dividends of the firm to determine its share value.

Conceptually the cost of equity capital (Ke) defined as the “Minimum rate of return that a firm must earn on the equity financed portion of an investment project in order to leave unchanged the market price of the shares”.

Cost of equity can be calculated from the following approach:

• Dividend price (D/P) approach

• Dividend price plus growth (D/P + g) approach

• Earning price (E/P) approach

• Realized yield approach.

Dividend Price Approach

The cost of equity capital will be that rate of expected dividend which will maintain the present market price of equity shares.

Dividend price approach can be measured with the help of the following formula:

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DK

e =

Np

Where,Ke = Cost of equity capital

D = Dividend per equity shareNp = Net proceeds of an equity share

Exercise 1

A company issues 10,000 equity shares of Rs. 100 each at a premium of 10%. The company has been paying 25% dividend to equity shareholders for the past five years and expects to maintain the same in the future also. Compute the cost of equity capital. Will it make any difference if the market price of equity share is Rs. 175?

Solution

D

Ke = Np

=25

× 100 100

= 22.72%

If the market price of a equity share is Rs. 175.

Ke D

Np

=25

× 100

175

= 14.28%

Dividend Price Plus Growth Approach

The cost of equity is calculated on the basis of the expected dividend rate per share plus growth in dividend. It can be measured with the help of the following formula:

Ke D

gN

p

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Where,Ke = Cost of equity capital

D = Dividend per equity share

g = Growth in expected dividend Np = Net proceeds of an equity share

Exercise 2

(a) A company plans to issue 10000 new shares of Rs. 100 each at a par. The floatation costs are expected to be 4% of the share price. The company pays a dividend of Rs. 12 per share initially and growth in dividends is expected to be 5%. Compute the cost of new issue of equity shares.

(b) If the current market price of an equity share is Rs. 120. Calculate the cost of existing equity share capital

Solution

(a) Ke= D +gNp

=

12

+5=17.5%100 −

4

(b) Ke= D + gNp

= 12 +5%=15%120

Exercise 3

The current market price of the shares of A Ltd. is Rs. 95. The floatation costs are Rs. 5 per share amounts to Rs. 4.50 and is expected to grow at a rate of 7%. You are required to calculate the cost of equity share capital.

Solution

Market price Rs. 95

Dividend Rs. 4.50

Growth 7%.

D

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Ke = N p + g

4.50

= 95 × 100 + 7%

= 4.73% + 7% = 11.73%

Earning Price Approach

Cost of equity determines the market price of the shares. It is based on the future earning prospects of the equity. The formula for calculating the cost of equity according to this approach is as follows.

Ke E

Np

Where,Ke = Cost of equity capital

E = Earning per shareNp = Net proceeds of an equity share

Exercise 4

A firm is considering an expenditure of Rs. 75 lakhs for expanding its operations. The relevant information is as follows :

Number of existing equity shares =10 lakhs

Market value of existing share =Rs.100

Net earnings =Rs.100 lakhs

Compute the cost of existing equity share capital and of new equity capital assuming that new shares will be issued at a price of Rs. 92 per share and the costs of new issue will be Rs. 2 per share.

Solution

Cost of existing equity share capital:

Ke = E

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Earnings Per Share(EPS) = 100lakhs = Rs.1010lakhs

10

Ke = 100 × 10

= 10%

Cost of Equity Capital

Ke = E

N

P

10 = × 10092 − 2

= 11.11%

Realized Yield Approach

It is the easy method for calculating cost of equity capital. Under this method, cost of equity is calculated on the basis of return actually realized by the investor in a company on their equity capital.

Ke PVf×D

Where,Ke = Cost of equity capital.

PVƒ = Present value of discount factor.

D = Dividend per share.

Cost of Debt

Cost of debt is the after tax cost of long-term funds through borrowing. Debt may be issued at par, at premium or at discount and also it may be perpetual or redeemable.

Debt Issued at Par

Debt issued at par means, debt is issued at the face value of the debt. It may be calculated with the help of the following formula.

Kd = (1 – t) R

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Where,

Kd = Cost of debt capital t = Tax rate

R = Debenture interest rate

Debt Issued at Premium or Discount

If the debt is issued at premium or discount, the cost of debt is calculated with the help of the following formula.

I

Kd = Np (1 – t)

Where,Kd = Cost of debt capital

I = Annual interest payable Np = Net proceeds of debenture

t = Tax rate

Exercise 5

(a) A Ltd. issues Rs. 10,00,000, 8% debentures at par. The tax rate applicable to the company is 50%. Compute the cost of debt capital.

(b) B Ltd. issues Rs. 1,00,000, 8% debentures at a premium of 10%. The tax rate applicable to the company is 60%. Compute the cost of debt capital.

(c) A Ltd. issues Rs. 1,00,000, 8% debentures at a discount of 5%. The tax rate is 60%, compute the cost of debt capital.

(d) B Ltd. issues Rs. 10,00,000, 9% debentures at a premium of 10%. The costs of floatation are 2%. The tax rate applicable is 50%. Compute the cost of debt-capital.

In all cases, we have computed the after-tax cost of debt as the firm saves on account of tax by using debt as a source of finance.

Solution

(a) Kda = I (1–t)

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Np

= 8,000 × (1 – 0.5)1,00,000

= 8,000 × 0.5 1,00,000

= 4%

I

Kda = Np (1 – t)(b) Np = Face Value + Premium = 1,00,000+10,000=1,10,000

8,000 = 1,10,000 × (1 – 0.6)

8,000

= 1,10,000 × 0.6

= 2.91%

(c) Kda =I

(1 – t)Np

=

8,000

× (1 – t)95,00

0

= 3.37%I 2

(d) Kda = (1 – t), Np= Rs. (10,00,000 + 1,00,000) × 100Np

=90,000

×(1 – 0.5) 10,78,000

= 4.17% = 11,00,000 – 22,000 = Rs. 10,78,000

Cost of Perpetual Debt and Redeemable Debt

It is the rate of return which the lenders expect. The debt carries a certain rate of interest.

Kdb = I 1/ n(P − N p )n1/ n(P N p )/ 2

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Where,

I = Annual interest payable P = Par value of debt

Np = Net proceeds of the debenture n = Number of years to maturity

Kdb = Cost of debt before tax.

Cost of debt after tax can be calculated with the help of the following formula:

K d a= K d b×(1–t)

Where,

Kda = Cost of debt after tax Kdb = Cost of debt before tax

t = Tax rate

Exercise 6

A company issues Rs. 20,00,000, 10% redeemable debentures at a discount of 5%. The costs of floatation amount to Rs. 50,000. The debentures are redeemable after 8 years. Calculate before tax and after tax. Cost of debt assuring a tax rate of 55%.

Solution

Kdb = I

1/n (P

−

N

p )

12(P Np )

= 20,00,000 1/8(20,00,000 18,50,000) 1 2(20,00,000 18,50,000)

Note Np = 20,00,000 – 10,00,000 – 50,000 2,00,000 18750

= 19,25,000 = 11.36%.

After Tax Cost of Debt Kdb

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= Kda (1 – t) =11.36 (1– 0.55) =5.11%.

Cost of Preference Share Capital

Cost of preference share capital is the annual preference share dividend by the net proceeds from the sale of preference share.

There are two types of preference shares irredeemable and redeemable. Cost of redeemable preference share capital is calculated with the help of the following formula:

K p Dp

N p

Where,Kp = Cost of preference shareDp = Fixed preference dividendNp = Net proceeds of an equity share

Cost of irredeemable preference share is calculated with the help of the following formula:

K p D p (P − N p )/n

(P N p )/2

Where,Kp = Cost of preference shareDp = Fixed preference share

P = Par value of debtNp = Net proceeds of the preference share

n = Number of maturity period.

Exercise 7

XYZ Ltd. issues 20,000, 8% preference shares of Rs. 100 each. Cost of issue is Rs. 2 per share. Calculate cost of preference share capital if these shares are issued (a) at par, (b) at a premium of 10% and (c) of a debentures of 6%.

Solution

Cost of preference share capital Kp = Dp

Np

(a) 1,60,000 ×100

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Kp =20,00,000 − 40,000

= 8.16%

(b) Kp =

1,60,000

× 10020,00,000 2,00,000 − 40,000

= 7.40%

I Kp = 1,60,000 ×10020,00,000 − 1,20,000 − 40,000

= 1,60,000 ×10018,40,000

= 8.69%

Exercise 8

ABC Ltd. issues 20,000, 8% preference shares of Rs. 100 each. Redeemable after 8 years at a premium of 10%. The cost of issue is Rs. 2 per share. Calculate the cost of preference share capital.

K p D p (P − N p )/n

(P N p )/2

= 1,60,000 1/8 (22,00,000 − 19,60,000) 1/2(22,00,000 19,60,000)

= 1,60,000 30,000 20,80,000

= 9.13%where Dp = 20,000×100×8%=1,60,000

P = 20,00,000+2,00,000 =22,00,00 Np = 20,00,000 – 40,000 =19,60,000 n = 8 years

Exercise 9

ABC Ltd. issues 20,000, 8% preference shares of Rs. 100 each at a premium of 5% redeemable after 8 years at par. The cost of issue is Rs. 2 per share. Calculate the cost of preference share capital.

Solution

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K p D p (P − N p )/n

(P N p )/2

=

1,60,000 1/8 (20,00,000 − 20,60,000)

1/2 (20,00,000 20,60,000)

= 1,60,000 – 7,50020,30,000

= 7.51%where Dp = 20,000×100×8%=1,60,000 P =

20,00,000

n = 8 yearsNp = 20,00,000 + 10,00,000 – 40,000 =20,60,000

Cost of Retained Earnings

Retained earnings is one of the sources of finance for investment proposal; it is different from other sources like debt, equity and preference shares. Cost of retained earnings is the same as the cost of an equivalent fully subscripted issue of additional shares, which is measured by the cost of equity capital. Cost of retained earnings can be calculated with the help of the following formula:Kr=Ke (1 – t) (1 – b)

Where,

Kr = Cost of retained earnings Ke = Cost of equityt = Tax rate

b = Brokerage cost

Exercise 10

A firm’s Ke (return available to shareholders) is 10%, the average tax rate of shareholders is 30% and it is expected that 2% is brokerage cost that shareholders will have to pay while investing their dividends in alternative securities. What is the cost of retained earnings?

Solution

Cost of Retained Earnings, Kr = Ke (1 – t) (1 – b)

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Where,

Ke = rate of return available to shareholders t = tax rate

b = brokerage costSo, Kr = 10% (1– 0.5) (1– 0.02)

= 10%×0.5×0.98

= 4.9%

Measurement of Overall Cost of Capital

It is also called as weighted average cost of capital and composite cost of capital. Weighted average 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.

The computation of the overall cost of capital (Ko) involves the following steps.

(a) Assigning weights to specific costs.

(b) Multiplying the cost of each of the sources by the appropriate weights.

(c) Dividing the total weighted cost by the total weights.

The overall cost of capital can be calculated with the help of the following formula; Ko = Kd Wd + Kp Wp + Ke We + Kr Wr

Where,

Ko = Overall cost of capital Kd = Cost of debt

Kp = Cost of preference share Ke = Cost of equityKr = Cost of retained earningsWd= Percentage of debt of total capital

Wp = Percentage of preference share to total capital We = Percentage of equity to total capitalWr = Percentage of retained earnings

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Weighted average cost of capital is calculated in the following formula also:

Σ XW K

w

ΣW

Where,

Kw = Weighted average cost of capital

X = Cost of specific sources of finance

W = Weight, proportion of specific sources of finance.

Exercise 11

A firm has the following capital structure and after-tax costs for the different sources of funds used :

Source of Funds Amount Proportion After-tax costRs. % %

Debt 12,000 20 4

Preference Shares 15,000 25 8

Equity Shares 18,000 30 12

Retained Earnings 15,000 25 11

Total 60,000 100

You are required to compute the weighted average cost of capital.

Exercise 12

A company has on its books the following amounts and specific costs of each type of capital.

Type of Capital Book Value Market Value Specific Costs (%)Rs. Rs.

Debt 4,00,000 3,80,000 5

Preference 1,00,000 1,10,000 8Equity 6,00,000 9,00,000 15Retained Earnings 2,00,000 3,00,000 13

————— —————13,00,000 16,90,000

————— —————

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Determine the weighted average cost of capital using:

(a) Book value weights, and

(b) Market value weights.

How are they different? Can you think of a situation where the weighted average cost of capital would be the same using either of the weights?

Solution

Computation of Weighted Average Cost of Capital

A. Book Value

Source of Funds Amount Cost % (X) Weighted CostProportion X Cost (XW)

Debt 4,00,000 5 20,000Preference Shares 1,00,000 8 8,000Equity Shares 6,00,000 15 90,000

Retained Earnings 2,00,000 13 26,000

ΣW = 13,00,000 ΣXW = 1,44,000

Σ XW

Kw = Σ W

1,44,000

Kw = 13,00,000 × 100 = 11.1%

Computation Weighted Average Cost of Capital

B. Market Value

Source of Funds Amount Cost % (X) Weighted CostProportion X Cost (XW)

Debt 3,80,000 5 19,000Preference Shares 1,10,000 8 8,800Equity Shares 9,00,000 15 13,500Retained Earnings 3,00,000 13 39,000

ΣW = 16,90,000 Σ XW = 2,01,800

K ΣXWw ΣW

2,01,800

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Kw = 16,90,000 × 100 = 11.9%Exercise 13

ABC Ltd. has the following capital structure.Rs.

Equity (expected dividend 12%) 10,00,00010% preference 5,00,0008% loan 15,00,000

You are required to calculate the weighted average cost of capital, assuming 50% as the rate of income-tax, before and after tax.

Solution

Solution showing weighted average cost of capital:

Particulars Rs. After Weights CostEquity 10,00,000 12% 33.33% 3.99Preference 5,00,000 10% 16.67 1.678% Loan 15,00,000 4% 50.00 2.00

7.66%

Weight average cost of capital = 7.66%

CAPITAL BUDGETINGINTRODUCTION

The word Capital refers to be the total investment of a company of firm in money, tangible and intangible assets. Whereas budgeting defined by the “Rowland and William” it may be said to be the art of building budgets. Budgets are a blue print of a plan and action expressed in quantities and manners.

The examples of capital expenditure:

1. Purchase of fixed assets such as land and building, plant and machinery, good will, etc.

2. The expenditure relating to addition, expansion, improvement and alteration to the fixed assets.

3. The replacement of fixed assets.

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BUSINESS FINANCE

4. Research and development project.

Definitions

According to the definition of Charles T. Hrongreen, “capital budgeting is a long-term planning for making and financing proposed capital out lays.

According to the definition of G.C. Philippatos, “capital budgeting is concerned with the allocation of the firms source financial resources among the available opportunities. The consideration of investment opportunities involves the comparison of the expected future streams of earnings from a project with the immediate and subsequent streams of earning from a project, with the immediate and subsequent streams of expenditure”.

According to the definition of Richard and Green law, “capital budgeting is acquiring inputs with long-term return”.

According to the definition of Lyrich, “capital budgeting consists in planning development of available capital for the purpose of maximizing the long-term profitability of the concern”.

It is clearly explained in the above definitions that a firm’s scarce financial resources are utilizing the available opportunities. The overall objectives of the company from is to maximize the profits and minimize the expenditure of cost.

Need and Importance of Capital Budgeting

1. Huge investments: Capital budgeting requires huge investments of funds, but the available funds are limited, therefore the firm before investing projects, plan are control its capital expenditure.

2. Long-term: Capital expenditure is long-term in nature or permanent in nature. Therefore financial risks involved in the investment decision are more. If higher risks are involved, it needs careful planning of capital budgeting.

3. Irreversible: The capital investment decisions are irreversible, are not changed back. Once the decision is taken for purchasing a permanent asset, it is very difficult to dispose off those assets without involving huge losses.

4. Long-term effect: Capital budgeting not only reduces the cost but also increases the revenue in long-term and will bring significant changes in the profit of the company by avoiding over or more investment or under investment. Over investments leads to be unable to utilize assets or over utilization of fixed assets. Therefore before making the investment, it is required carefully planning and analysis of the project thoroughly.

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CAPITAL BUDGETING PROCESS

Capital budgeting is a difficult process to the investment of available funds. The benefit will attained only in the near future but, the future is uncertain. However, the following steps followed for capital budgeting, then the process may be easier are.

126

Step

s

Identification of Various Investments Identification of VariousInvestment Proposals

Screening or Matching the Available Resources

Evaluation of Proposals

Fixing Property FeedbackFinal Approval

Implementation

Fig. 9.1 Capital Budgeting Process

1. Identification of various investments proposals: The capital budgeting may have various investment proposals. The proposal for the investment opportunities may be defined from the top management or may be even from the lower rank. The heads of various department analyse the various investment decisions, and will select proposals submitted to the planning committee of competent authority.

2. Screening or matching the proposals: The planning committee will analyse the various proposals and screenings. The selected proposals are considered with the available resources of the concern. Here resources referred as the financial part of the proposal. This reduces the gap between the resources and the investment cost.

3. Evaluation: After screening, the proposals are evaluated with the help of various methods, such as pay back period proposal, net discovered present value method, accounting rate of return and risk analysis. Each method of evaluation used in detail in the later part of this chapter. The proposals are evaluated by.

(a) Independent proposals

(b) Contingent of dependent proposals

(c) Partially exclusive proposals.

Independent proposals are not compared with another proposals and the same may be accepted or rejected. Whereas higher proposals acceptance depends upon the other one or more proposals. For example, the expansion of plant machinery leads to constructing of new building, additional manpower etc. Mutually exclusive projects are those which competed with other proposals and to implement the proposals after considering the risk and return, market demand etc.

4. Fixing property: After the evolution, the planning committee will predict which proposals will give more profit or economic consideration. If the projects or proposals are not suitable for the concern’s financial condition, the projects are rejected without considering other nature of the proposals.

5. Final approval: The planning committee approves the final proposals, with the help of the following:

(a) Profitability (b) Economic constituents (c) Financial violability (d) Market conditions. The planning committee prepares the cost estimation and submits to the management.

6. Implementing: The competent autherity spends the money and implements the proposals. While implementing the proposals, assign responsibilities to the proposals, assign responsibilities for completing it, within the time allotted and reduce the cost for this purpose. The network techniques used such as PERT and CPM. It helps the management for monitoring and containing the implementation of the proposals.

7. Performance review of feedback: The final stage of capital budgeting is actual results compared with the standard results. The adverse or unfavourable results identified and removing the various difficulties of the project. This is helpful for the future of the proposals.

KINDS OF CAPITAL BUDGETING DECISIONSThe overall objective of capital budgeting is to maximize the profitability. If a firm concentrates return on investment, this objective can be achieved either by increasing the revenues or reducing the costs. The increasing revenues can be achieved by expansion or the size of operations by adding a new product line. Reducing costs mean representing obsolete return on assets.

METHODS OF CAPITAL BUDGETING OF EVALUATIONBy matching the available resources and projects it can be invested. The funds available are always living funds. There are many considerations taken for investment decision process such as environment and economic conditions.

The methods of evaluations are classified as follows:

(A) Traditional methods (or Non-discount methods) (i) Pay-back Period Methods (ii) Post Pay-back Methods

(iii) Accounts Rate of Return

(B) Modern methods (or Discount methods) (i) Net Present Value Method (ii) Internal Rate of Return Method

(iii) Profitability Index Method

Methods of Capital Budgeting

Traditional ModernMethod Methods

Pay-back Post pay-back Accounting Net present Internal Rate Profitability

Method Method Rate of ReturnValue of Return Index

Method Method Method

Fig. 9.2 Capital Budgeting Methods

Pay-back Period

Pay-back period is the time required to recover the initial investment in a project.

(It is one of the non-discounted cash flow methods of capital budgeting).

Pay-back period = Initial investment

Annual cash inflows

Merits of Pay-back method

The following are the important merits of the pay-back method:

1. It is easy to calculate and simple to understand.

2. Pay-back method provides further improvement over the accounting rate return.

3. Pay-back method reduces the possibility of loss on account of obsolescence.

Demerits

1. It ignores the time value of money.

2. It ignores all cash inflows after the pay-back period.

3. It is one of the misleading evaluations of capital budgeting.

Accept /Reject criteria

If the actual pay-back period is less than the predetermined pay-back period, the project would be accepted. If not, it would be rejected.

Exercise 1

Project cost is Rs. 30,000 and the cash inflows are Rs. 10,000, the life of the project is 5 years. Calculate the pay-back period.

Solution =Rs. 30,000 = 3 YearsRs. 10,000

The annual cash inflow is calculated by considering the amount of net income on the amount of depreciation project (Asset) before taxation but after taxation. The income precision earned is expressed as a percentage of initial investment, is called unadjusted rate of return. The above problem will be calculated as below:

Annual ReturnUnadjusted rate of return = × 100

Investment

= Rs. 10,000

× 100 Rs. 30,000 = 33.33%

Exercise 2

A project costs Rs. 20,00,000 and yields annually a profit of Rs. 3,00,000 after depreciation @ 12½% but before tax at 50%. Calculate the pay-back period.

Profit after depreciation 3,00,000

Tax 50%1,50,0001,50,000

Add depreciation

20,00,000 121

% 2,50,0002

Cash in flow 4,00,000

Solution

Pay-back period =InvestmentCash flow

=

20,00,000

= 5 years.4,00,000

Uneven Cash Inflows

Normally the projects are not having uniform cash inflows. In those cases the pay-back period is calculated, cumulative cash inflows will be calculated and then interpreted.

Exercise 3

Certain projects require an initial cash outflow of Rs. 25,000. The cash inflows for 6 years are Rs. 5,000, Rs. 8,000, Rs. 10,000, Rs. 12,000, Rs. 7,000 and Rs. 3,000.

Solution

Year Cash Inflows (Rs.) Cumulative Cash Inflows (Rs.)1 5,000 5,0002 8,000 13,0003 10,000 23,0004 12,000 35,0005 7,000 42,0006 3,000 45,000

The above calculation shows that in 3 years Rs. 23,000 has been recovered Rs. 2,000, is balance out of cash outflow. In the 4th year the cash inflow is Rs. 12,000. It means the pay-back period is three to four years, calculated as follows

Pay-back period = 3 years+2000/12000×12 months = 3 years 2 months.

Post Pay-back Profitability Method

One of the major limitations of pay-back period method is that it does not consider the cash inflows earned after pay-back period and if the real profitability of the project cannot be assessed. To improve over this method, it can be made by considering the receivable after the pay-back period. These returns are called post pay-back profits.

Exercise 4

From the following particulars, compute:

1. Payback period.

2. Post pay-back profitability and post pay-back profitability index.

(a) Cash outflow Rs. 1,00,000Annual cash inflow Rs. 25,000(After tax before depreciation)Estimate Life 6 years

(b) Cash outflow Rs. 1,00,000Annual cash inflow(After tax depreciation)First five years Rs. 20,000Next five years Rs. 8,000Estimated life 10 YearsSalvage value Rs. 16,000

Solution

(a) (i) Pay-back period

=

Initial investment

Annual cash inflows

1,00,000

= 25,000 = 4 Years

(ii) Post pay-back profitability

=Cash inflow (Estimated life – Pay-back period) =25,000 (6 – 4)

=Rs. 50,000 (iii) Post pay-back profitability index

50,000

= 1,00,000 × 100 = 50%

(b) Cash inflows are equal, therefore pay back period is calculated as follows:

(i)

Year Cash Inflows (Rs.) Cumulative Cash Inflows (Rs.)

1 20,000 20,000

2 20,000 40,000

3 20,000 60,000

4 20,000 80,000

5 20,000 1,00,0006 8,000 1,08,0007 8,000 1,16,0008 8,000 1,24,0009 8,000 1,32,000

10 8,000 1,40,000

(ii) Post pay-back profitability.

= Cash inflow (estimated life – pay-back period)

= 8,000 (10–5)

= 8000×5 = 40,000

(iii) Post pay-back profitability index

40,000 = 1,00,000 ×100=40%

Accounting Rate of Return or Average Rate of Return

Average rate of return means the average rate of return or profit taken for considering the project evaluation. This method is one of the traditional methods for evaluating the project proposals:

Merits1. It is easy to calculate and simple to understand.

2. It is based on the accounting information rather than cash inflow.

3. It is not based on the time value of money.

4. It considers the total benefits associated with the project.

Demerits

1. It ignores the time value of money.

2. It ignores the reinvestment potential of a project.

3. Different methods are used for accounting profit. So, it leads to some difficulties in the calculation of the project.

Accept/Reject criteria

If the actual accounting rate of return is more than the predetermined required rate of return, the project would be accepted. If not it would be rejected.

Exercise 5

A company has two alternative proposals. The details are as follows:

Proposal I Proposal II

Automatic Machine Ordinary MachineCost of the machine Rs. 2,20,000 Rs. 60,000Estimated life 5½ years 8 yearsEstimated sales p.a. Rs. 1,50,000 Rs. 1,50,000Costs : Material 50,000 50,000

Labour 12,000 60,000

Variable Overheads 24,000 20,000

Compute the profitability of the proposals under the return on investment method.

(M.Com., Madras and Bharathidasan)

Solution

Profitability Statement

Automatic OrdinaryMachine Machine

Cost of the machine Rs. 2,20,000 Rs. 60,000Life of the machine 5½ years 8 years

Rs. Rs.Estimated Sales (A) 1,50,000 1,50,000Less : Cost : Material 50,000 50,000

Labour 12,000 60,000Variable overheads 24,000 20,000Depreciation (1) 40,000 7,000

Total Cost (B) 1,26,000 1,37,000

Profit (A) – (B) 24,000 12,500Working:

(1) Depreciation = Cost Life

Automatic machine = 2,20,000 5½ = 40,000

Ordinary machine = 60,000 8 = 7,500

Return on investment =Average profit

× 100Original investment

24,000 12,500

= × 100 60,000 × 100

2,20,00010.9% 20.8%

Automatic machine is more profitable than the ordinary machine.

Net Present Value

Net present value method is one of the modern methods for evaluating the project proposals. In this method cash inflows are considered with the time value of the money. Net present value describes as the summation of the present value of cash inflow and present value of cash outflow. Net present value is the difference between the total present value of future cash inflows and the total present value of future cash outflows.

Merits

1. It recognizes the time value of money.

2. It considers the total benefits arising out of the proposal.

3. It is the best method for the selection of mutually exclusive projects.

4. It helps to achieve the maximization of shareholders’ wealth.

Demerits

1. It is difficult to understand and calculate.

2. It needs the discount factors for calculation of present values.

3. It is not suitable for the projects having different effective lives.

Accept/Reject criteria

If the present value of cash inflows is more than the present value of cash outflows, it would be accepted. If not, it would be rejected.

Exercise 6

From the following information, calculate the net present value of the two project and suggest which of the two projects should be accepted a discount rate of the two.

Project X Project Y

Initial Investment Rs. 20,000 Rs. 30,000Estimated Life 5 years 5 yearsScrap Value Rs. 1,000 Rs. 2,000

The profits before depreciation and after taxation (cash flows) are as follows:

Year 1 Year 2 Year 3 Year 4 Year 5

Rs. Rs. Rs. Rs. Rs.Project x 5,000 10,000 10,000 3,000 2,000Project y 20,000 10,000 5,000 3,000 2,000

Note : The following are the present value factors @ 10% p.a.

Year 1 2 3 4 5 6Factor 0.909 0.826 0.751 0.683 0.621 0.564

(MBA, Madurai-Kamaraj University, May 2005)Solution

Cash Inflows Present Present Value of Net CashValue of Rs. Inflow

Year Project X Rs. Project Y Rs. 1 @ 10% Project X Rs. Project Y Rs.1 5,000 20,000 0.909 4,545 18,1802 10,000 10,000 0.826 8,260 8,2603 10,000 5,000 0.751 7,510 3,7554 3,000 3,000 0.683 2,049 2,0495 2,000 2,000 0.621 1,242 1,242

Scrap Value 1,000 2,000 0.621 621 1,245Total present valueInitial 24,227 34,728investments 20,000 30,000

Net present value 4,227 4,728

Project Y should be selected as net present value of project Y is higher.

Exercise 7

The following are the cash inflows and outflows of a certain project.

Year Outflows Inflows0 1,75,000 -1 5,50,000 35,0002 45,0003 65,0004 85,0005 50,000

The salvage value at the end of 5 years is Rs. 50,000. Taking the cutoff rate as 10%, calculate net present value.

Year 1 2 3 4 5

P.V. 0.909 0.826 0.751 0.683 0.621

Solution

Year Cash Inflows Present Value Present Value

Rs. Factor @ 10% of Cash Inflows

1 35,000 0.909 31,8152 45,000 0.826 37,170

3 65000 0.751 488154 85000 0.683 580555 50000 0.621 31050

5(Salvage) 50000 0.621 31050Total present valueof cash inflows 237955

Less : Total present value of outflowsCash outflow at the beginning 1,75,000Cash outflow at the end of firstYear 50000×0.909 45,450Total value of outflows 2,20,450Net Present Value 17,505

If the cash inflows are not given in that cases the calculation of cash inflows are Net profit after tax+Depreciation. In this type of situation first find out the Net profit after depreciation and deducting the tax and then add the deprecation. It gives the cash inflow.

Exercise 8 From the following information you can learn after tex and depreciation concept.

Initial Outlay Rs. 1,00,000Estimated life 5 Years

Scrap Value Rs. 10,000Profit after tax :

End of year 1 Rs. 6,0002 Rs. 14,0003 Rs. 24,0004 16,0005 Nil

Solution Depreciation has been calculated under straight line method. The cost of capital may be taken at 10%. P.a. is given below.

Year 1 2 3 4 5

PV factor @ 10% 0.909 0.826 0.751 0.683 0.621

Initial cash outflow – scrap value

Depreciation =Estimated Life of the project

= 1,00,000 –10,000

5

= 90,000

= Rs.18,000

5

Year Profit after Tax Depreciation Cash Inflow1 6,000 18,000 24,0002 14,000 18,000 32,0003 24,000 18,000 42,0004 16,000 18,000 34,0005 Nil 18,000 18,000

Net Present Value

Year Cash Inflow Discount factor @ 10% Present value (Rs.)1 24,000 0.909 21,8162 32,000 0.826 26,4323 42,000 0.751 31,5424 34,000 0.683 23,222

5 18,000 0.621 11,178

Total present value of cash inflows 1,14,190Less : Initial cash investment 1,00,000

Net present value 1,41,90

Internal Rate of Return

Internal rate of return is time adjusted technique and covers the disadvantages of the traditional techniques. In other words it is a rate at which discount cash flows to zero. It is expected by the following ratio:

Cash inflow

Investment initial

Steps to be followed:

Step1. find out factor

Factor is calculated as follows:

Cash outlay (or) initial investment

F=Cash inflow

Step 2. Find out positive net present value Step 3. Find out negative net present value Step 4. Find out formula net present value

Formula

IRR =Base factor +Positive net present

value DP

Difference in positive and

Negative net present value

Base factor = Positive discount rate

DP = Difference in percentage

Merits

1. It consider the time value of money.

2. It takes into account the total cash inflow and outflow.

3. It does not use the concept of the required rate of return.

4. It gives the approximate/nearest rate of return.

Demerits

1. It involves complicated computational method.

2. It produces multiple rates which may be confusing for taking decisions.

3. It is assume that all intermediate cash flows are reinvested at the internal rate of return.

Accept/Reject criteria

If the present value of the sum total of the compounded reinvested cash flows is greater than the present value of the outflows, the proposed project is accepted. If not it would be rejected.

Exercise 9A company has to select one of the following two projects:

Project A Project B

Cost Rs.22,000 20,000Cash inflows:Year 1 12,000 2,000Year 2 4,000 2,000Year 3 2,000 4,000

Year 4 10,000 20,000

Using the Internal Rate of Return method suggest which is Preferable.

Solution

Cash outlayF =

Cash inflowProject A

Cash Inflow = Total cash inflowNo. of years

28,000

= 22000

= 3.147000

The factor thus calculated will be located in table II below. This would give the estimated rate of return to be applied discounting the cash for the internal rate of returns. In this of project A the rate comes to 10% while in case of project B it comes to15%.

Section A1. The term ------- refers to all financial sources sought by company.2. Concepts of ---------- is very useful in capital budgeting decisions.3. Cost of capital serves as --------------- rate for capital investment decisions.4. Ratio of debt equity mix is called --------5. Cost of capital compromises both business risk and -----------6.   Interest

Net proceeds  = --------------7. Under net income approach, there will be an assumption of ------8. ------- is the permanent financing of the company represented primarily by

long term debt and shareholder’s funds.9. The optimum capital structure is obtained when the met value per equity

share is the maximum. True / False.10. ------- is when the company’s rate of return on total capital employed is

more than  the rate of interest/ dividend on debenture/preference shares.Section B

1.State the importance of capital structure.2.Explain the concept of cost of capital.

3.What are the essentials of a sound capital structure.4.What are the components of cost of capital.5.List out the principles of capital structure.6.Factors determining cost of capital.7.What are the patterns of capital structure.8.State the capital structure theories.9.What is meant by explicit and real cost of capital.10. Why should a company aim at balanced capital structure?

Section C1. Discuss on what capital structure management is?2. What are the various forms of capital structure?3. State the approaches for computing the ‘cost of equity’ of capital. Explain4. What is ‘cost of capital’ and state the importance?5. What are the internal and external factors influencing capital structure?6. What are the characters of a balanced capital structure?7. What do you understand by capital structure of a corporation? Discuss the

qualities which a sound capital structure should possess8. What are the theories of capital structure?9. What is individual and composite cost of capital.10. The capital structure and after tax cost of different sources of funds are given

below: Compute the weighted average cost of capital.Sources of funds                                   Amount               Proportion to total                   After tax cost %

a. Equity capital                 72,000                 0.30                            15b. Retained earnings       60,000                 0.25                           14  c. Preference capital       48,000                 0.20                           10d. Debentures                   60,000              0.25                    8          

Unit – V

Sources and Forms of Finance: Equity Shares, Preference Shares, Bonds, Debentures and Fixed Deposits – Features – Advantages and Disadvantages-Lease Financing: Meaning – Features – Forms – Merits and Demerits.

SOURCES AND FORMS OF FINANCE

In our present day economy, finance is defined as the provision of money at the time when it is required, without adequate finances, no enterprises can possibly accomplishes its objectives.Capital required for a business can be classified under two categories,

1. Fixed capital2. Working capital

Every business needs funds for 2 purposes- for its establishment and to carry out its day-to-day operations. Long-term funds required creating production facilities through purchases of fixed assets. Investment in these assets represents that part of firms’ capital that is blocked on a permanent or fixed basis and it is called fixed capital. Funds are also needed for short-term purposes for the purchase of raw materials, payment of wages and other day-to-day expenses, etc. these funds are known as working capital.

The various sources of finance have been classified in many ways, such as:

1. According to perioda. Short term sources- bank credit, customer advances, trade credit, factoring,

accruals, commercial paper, etcb. Medium term sources-issue of preference shares, debentures, bank loans,

public deposits, fixed deposits, etcc. Long term sources-issue of shares, debentures, plugging back of profits, loans

from specialized financial institutions, etc.

2. According to ownership

FINANCIAL REQUIREMENTS

SHORT TERM MEDIUM TERM LONG TERM

Bank Credit

Customer Advances

Trade Credit

Factoring

Accruals

Deferred Incomes

Commercial Paper

Instalment Credit

Issue of Debentures

Issue of Preference Shares

Bank Loans

Public Deposits / Fixed Deposits

Loans From Financial Institutions

Issue of Shares

Issue of Debentures

Ploughing-Back of Profits

Loans From Specialized Financial Institutions

a. Owned capital-share capital, retained earnings, profit and surplus, etc b. Borrowed capital such as debentures, bonds, public deposits, loans, etc

3. According to sources of finance a. Internal sources such as plugging back of profits, retained earnings, profits, surpluses and depreciation funds, etc.

b. External sources- shares, debentures, public deposits, loans, etc

4. According to mode of financing a. Security financing or external financing- financing through rising of

corporate securities such as shares, debentures, etc b. Internal financing-m financing through retained earnings, capitalization of profits

and depreciation of finds, etc c. Loan financing through rising of long term and short term loans.

I. Security financing:Corporate securities can be classified under two broad categories:

Ownership securities or Capital stock Creditorship securities or Debt capital

OWNERSHIP SECURITIES

1. Equity sharesEquity shares also known as ordinary share or common shares represent the owner’s capital in a company. Then holders of these shares are real owners of the company. They have a control over the working of the company. Equity shareholders are paid dividend after paying it to the preference shareholders. These shareholders take a more risk as compared to preference shareholders. Equity share capital is paid after meeting all other claims including that of preference shareholders. They take risk both regarding dividend and return of capital. Equity share capital cannot be redeemed during the lifetime of the company.

Characteristics of Equity sharesEquity shares have a number of features which distinguish them from other shares and securities. These features generally relate to the rights and position of equity shareholders. The following are the most significant features of equity shares:

CLASSIFICATION OF CORPORATE SECURITIES

OWNERSHIP SECURITIES CREDITORSHIP SECURITIES

DEBENTURES

ORDINARY OR EQUITY SHARES

PREFERENCE SHARES

NO PAR STOCK DEFERRED SHARES

i)MaturityEquity shares provide permanent capital to the company and cannot be redeemed during the life time of the company. Under the companies Act, 1956, a company cannot purchase its own shares. Equity shareholders can demand refund of their capital only at the time of liquidation of a company. Even at the time of liquidation, equity capital is paid back after meeting all other prior claims including that of preference shareholders.ii)

Advantages of equity shares1. Equity shares do not create any obligations to pay a fixed rate of dividend2. Equity shares can be issued without creating any charge over the assets of the company3. It is a permanent source of capital and the company has not to repay it expect under liquidation4. Equity shareholders are the real owners of the company who have the voting rights5. In case of profits, equity share ho9lders are the real gainers by way of increased dividends and appreciation in the value of shares.

Disadvantages of equity shares1. If only equity shares are issued, the company cannot take the advantage of trading

on equity2. As equity capital cannot be redeemed there is a danger of over capitalization.3. Equity shareholders can put obstacles in management by manipulation and

organization themselves4. During prosperous periods higher dividends have to be paid leading to increase in

the value of shares in the market and speculation5. Investors who desire to invest in safe securities with a fixed income have no

attraction for such shares.

2. Preference shares:As the name suggests, these shares have certain preference as compared to other types of shares. These shares are given two preferences. There is a preference for the payment of dividend. Whenever the company has distributable profits, the dividend is first paid on preference share capital. The second preference is that the repayment of capital at the time of liquidation of company. After paying outside creditors, preference share capital is returned. Preferences share holders so no have voting rights; however they can vote if their own interest is affected.

Types of preference shares1. Cumulative preference shares2. Non cumulative preference shares3. Redeemable preference shares4. Irredeemable preference shares5. Participating preference shares6. Non participating preference shares7. Convertible preference shares8. Non convertible preference shares

Advantages of preference sharesTo company’s point of view:1. There is no legal obligation to pay dividend on preferences shares2. Preference shares provide long term capital for the company3. There is no liability of the company to redeem preference shares during the life time of the company4. Preference share capital as regarded as the part of company’s net worth, it enhances the credit worthiness of the company.To share holder’s point of view:

1. It earns fixed rate of dividend2. It is a superior security over equity shares3. It provides preferential right in regard to payment of dividends an repayment of

capital on time

3. DEBENTURES or bonds:A company may raise long-term finance through public borrowings. The issue of debentures raises these loans.A debenture is an acknowledge of debt. According to Thomas Evelyn’s, ‘ the debenture is a document under the company’s seal which provides for the payment of a principle sum and interest thereon at regular intervals, which is usually secured by a fixed or floating charge on the company’s property or undertaking and which acknowledges a loan to the company. A debentures holder is a creditor of the company. A fixed rate of interest is paid on debentures. When the debentures are secured they are paid on priority in comparison to all other creditors.

Types of debentures1. Simple, naked or unsecured debentures2. Secured or mortgaged debentures3. Bearer debentures4. Registered debentures5. Redeemable debentures6. Irredeemable debentures7. Convertible debentures8. Zero interest bonds/debentures9. First and second debentures10. Guaranteed debentures

Importance of debentures as a source of finance1. Debentures provide long-term funds to the company2. The rate of interest payable on debentures is usually; lower than the rate of dividend paid on shares.3. The interest on debentures is a tax deductable expense4. Debentures provide flexibility in the capital structure of a company5. Debentures provide a fixed, regular and stable source of income

6. A debenture is usually more liquid investment.

II. Internal financing1. Retained earnings or plugging back of profits.2. Depreciation as a source of finance.

1. Retained earnings or plugging back of profitsIt is a technique of financial management under which all profits of a company are not distributed amongst the share holders as dividend, but a part of the profits is retained or reinvested in the company. This processes of retained profits year after year and their utilization in the business is also known as ploughing back of profits.Under this method a part of total profits is transferred to various reserves such as general reserve, REPLACEMENT fund, reserve fund, reserve for repairs and renewals, etc.. Sometimes ‘secret reserves ‘are also created without the knowledge of the shareholders.

Merits of ploughing back of profits:A. Advantage to company:1. A cushion to absorb the stocks of economy2. Economical method of financing3. Aids in smooth and undisturbed running of the business4. Helps on following stable dividend policy 5. Flexible financial structures 6. Makes the company self-dependent or no dependent ion fair weather friends 7. Helps in making food the deficiencies of depreciation, etc. 8. Enables to redeem long-term liabilities B. Advantages to the shareholders:1. Increase in the value of shares2. Safety of investments3. Enhanced earning capacity4. No dilution of controlC. Advantages to the society or Nation1. Increase the rate of capital formation2. Stimulates industrialization3. Increases productivity4. Decreases the rate of industrial failure5. Higher standard of living

Limitations of ploughing back of profits:1. over capitalization2. Creation of monopolists3. Depriving the freedom of the investors4. Misuse of retrained earnings5. Manipulation in the value of shares6. Evasion of taxes7. Dissatisfaction among the share holders

2. DEPRECIATION AS A SOURCE OF FINANCE

Depreciation may be regarded as the capital cost of assets allocated over life of the assets. In real sense, depreciation is simply a book entry having the effect of reducing the book value of the assets and the profits of t eh current year for the same amount. It does not affect the current assets or current liabilities and does not result in the flow of funds or to say more precisely it is a not a fund item. Hence although depreciation is an operating cost there is no actual outflow of cash and so the amount of depreciation charged during the year is added back to profits while finding funds form operations. it is in the sense that depreciation can be regarded as a indirect sources of funds.In case a concern earns a huge profits and excessive depreciation is permitted under income tax act is charged to profit and loss account, it is still result in the generation of funds through savings in the payment of dividends.

III. SHORT TERM LOANS AND CREDITS

The third important mode of financing is raising both 1. Short-term loans and credits 2. Term loans including medium and short-term loans. These sources of finance have been discussed in the following pages of this chapter.A firm raises the short-term loans and credits or meeting its working capital requirements, these include

1. Indigenous bankersPrivate money leaders and other country bankers used to be only sources of finance prior tom the establishment of commercial banks. They used to charge very high rates of interest and exploited the customers to larger extent. But even today, some business houses have to depend on Indigenous bankers for obtaining loans to meet their working capital requirements.

2. Trade creditTrade credit refers to the credit extended by the suppliers of goods in the normal course of business. The credit worthiness sofa firm and the confidence of tits suppliers are the main basis of securing trade credit. It is mostly granted on an open account basis whereby supplier sends goods to the buyer for the payment to be received in future as per the terms of sales invoice. It may also take the form of bills payable whereby the buyer the buyer signs the bills of exchange payable on a specified future date.

3. Installment creditThe assets are purchased and the possession of goods is taken immediately but the payment is made in installments over a pre determined period of time. Generally interest is charged on the unpaid amount or it may be adjusted in the price. But in any case, the provided funds for sometimes and is used as a sources of short term working capital by many business houses which have difficult funds position.

4. AdvancesSome business houses grant advances from their customers and agents against orders and this source is a short term sources of finance for them. It is cheap source especially for the firms manufacturing industrial products prefer to advance from their customers.

5. Account receivable credit or factoringA factor is financial institution which offers services relating to, management and financing of debts arising out of credit sales. Factoring is recombining popular all over the world on account of various services offered by the institutions’ engaged in it.

6. Accrued expensesAccrued expenses are the expenses which have been incurred but not yet due and hence not yet paid also. The most popular items of accruals are wages, salaries, interest and taxes. Even income taxes are paid after collection and in the intervening period serve as a good source of finance.

7. Deferred incomesDeferred incomes are incomes received in advance before supplying goods andServices, they represent funds received by a firm for which it has to supply goods or services in future. These funds increase the liquidity of a firm and constitute an important source of short term finance.

8. Commercial paperCommercial paper represents unsecured promissory notes issued by the firms to raise short term fund s. it is an important money market instrument in advanced countries like USA. In India, the RBI introduced commercial papers in the Indian money market on the recommendations of the working group on Money market (Vaghul committee).The maturity period for commercial paper, in India is 91 to 180 days. It is sold at discount from its face value and redeemed at face value n its maturity. A credit rating agency, called CRISIL, has been setup in India by ICCCI and UTI to rate commercial papers.

9. Commercial banksCommercial banks are the most important sources of short term capital. They provide a wide variety of loans and advances follows;

a. Loansb. Cash creditsc. Overdraftsd. Purchasing and discounting bills

In addition to the above-mentioned form of direct finance, commercial banks help their customers in obtaining credit from their suppliers through the letter of credit arrangement.

Letter of credit-It helps the customers tom obtain credit from the suppliers because it ensures that there is no risk of nonpayment .L/C is a simple guarantee by the bank to the suppliers that their bills up to a specified amount would be honored, in case the customer fails to [pay the amount ion the due date, to its suppliers, the banks assumes the liability of its customers for the purchase made under the letter of credit arrangement. The letter of credit may be of many forms, such as

1. Clean letter of credit2. Documentary letter of credit3. Revocable letter of credit4. Irrevocable letter of credit5. Revolving letter of credit6. Fixed letter of credit

The most important modes of the security required in bank finance are 1. Hyphothecation2. Pledge3. Mortgage

10. Public deposits.The public sector(Government companies) have also started accepting public deposits since June 1980.Acceptance of public deposits by corporate sector, in many cases, has been found to encourage non priority sectors of production and defeat the very purpose of the restrictive credit policy of the RBI.

TERM LOANSIn our country there are two major sources of term lending are

1. Specialized financial institutionsAt present there are four major financial institutions at national level

a. Industrial finance corporation of India IFCIb. Industrial development bank of India IDBIc. Industrial credit and investment corporation of India ICICId. Industrial reconstructions corporation of India IRCIe. State financial corporation’s SFCs and f. State industrial development investment corporations

2. Commercial banks3. Industrial cooperatives4. Unit trust of India5. Life insurance corporation6. National industrial development corporations

Also provide finance for the development of industries in the country. There are some international financing institutions like WORLD BANK and its affiliates such as international bank for reconstruction and development IBRD, international development association IDA, international finance corporation IFC and Asian development bank ADB. All these institutions also provide industrial finance through member countries while others directly to the enterprises. The help rendered by all such institutions has accelerated the pace of industrialization.

Industrial Finance Corporation of India (IFCI) IFCI Ltd. was set up in 1948 as Industrial Finance Corporation of India, a Statutory Corporation to provide medium and long term finance to industry. After repeal of IFCI Act in 1993, IFCI became a Public Limited Company registered under the Companies Act, 1956. IFCI is now a Government controlled company subsequent to enhancement of equity shareholding to 55.53% by Government of India on December 21, 2012. IFCI is

also registered with Reserve Bank of India (RBI) as a systemically important non-deposit taking Non-Banking Finance Company (NBFC-ND-SI).

The primary business of IFCI is to provide medium to long term financial assistance to the manufacturing, services and infrastructure sectors. Through its subsidiaries and associate organisations, IFCI has diversified into a range of other businesses including broking, venture capital, financial advisory, depository services, factoring etc. As part of its development mandate, IFCI was one of the promoters of National Stock Exchange (NSE), Stock Holding Corporation of India Ltd (SHCIL), Technical Consultancy Organizations (TCOs) and social sector institutions like Rashtriya Gramin Vikas Nidhi (RGVN), Management Development Institute (MDI) and Institute of Leadership Development (ILD). In order to promote entrepreneurship among the scheduled castes and to provide concessional finance to them, IFCI has been entrusted with the setting up of a Venture Capital Fund by IFCI for Scheduled Castes in the Interim Budget for FY 2014-15. The Fund would have an initial capital of Rs. 200 crore, which can be supplemented every year.

Functions of IFCI1) For setting up a new industrial undertaking.2) For expansion and diversification of existing industrial undertaking.3) For renovation and modernization of existing concerns.4) For meeting the working capital requirements of industrial concerns in some exceptional cases.5) Direct financial support (by way of rupee term loans as well as foreign currency loans) to industrial units for under taking new projects, expansion, modernization, diversification etc.6) Subscription and underwriting of public issues of shares and debentures.7) Guaranteeing of foreign currency loans and also deferred payment guarantees.8) Merchant banking, leasing and equipment finance.9)Provides financial assistance towards balance regional development and development of management education in the country.

Financial ResourcesThe main financial resources of Industrial Finance Corporation of India Ltd. are as follows:

Share Capital: The authorized capital of the corporation is Rs. 1,000 corers divided into 2 lakhs shares of Rs. 5,000 each. Its paid-up capital on 31st March, 1997 was Rs. 352.81 crores.

Debentures: The corporation is also authorized to issue debentures and bonds. But their total amount should not exceed ten times of its paid-up share capital plus reserve funds.

Loans: The Corporation has the power to borrow funds (loans) from Industrial Development Bank of India. Foreign investment Institutions, Central Government and Reserve Bank of India.

Public Deposits: The Corporation can accept public deposits for a maximum period of five years. Further, the amount of public deposits cannot exceed Rs. 10 crores.

Reserve Fund: It is another sources of finance of the Corporation. Foreign Currency Loans: The Corporation can also accept loans in foreign

currency with the prior approval of the central government, such as, loans from International Bank and other International Financial Institutions.

Critical EvaluationAlthough the Corporation has been an important source of long-term finance to the large-sized and medium-sized industrial units of the country, yet it has been criticized on several grounds. The main points of criticism are as follows:

Nepotism and favoritism in granting loans. Undue preference to well-established large business concerns. Overlooking interests of small business and development of backward regions

almost ignored. Granting loans to business unit not covered by Five year Plans. Very high interest rate. Delay in sanctioning loans. No participation in equity capital. Most of the loans sanctioned to those industrial units which are already organized

and financially strong. Lays greater emphasis upon giving assistance to consumer goods industries as

against basic and capital goods industries. The corporation has failed in regional and territorial economic development. The assistance is insignificant as compared to the requirements of the industrial

unit and hence it has knocked at the doors of other financial institutions. The recurring expenses of the corporation are quite high.

INDUSTRIAL CREDIT AND INVESTMENT CORPORATION OF INDIA LIMITED (ICICI)Industrial Credit and Investment Corporation of India Limited (ICICI) was established in 1955 as public limited company to encourage and assist industrial units in the country. Its objectives, inter alia, include providing assistance in the creation, expansion and modernisation of industrial enterprises, encouraging and promoting participation of private capital both internal and external, in such enterprises, encouraging and promoting industrial development and helping development of capital markets.It provides term loans in Indian and foreign currencies, underwrites issues of shares and debentures, makes direct subscriptions to these issues and guarantees payment of credit made by others.

Broad objectives of the ICICI are:(a) to assist in the creation, expansion and modernisation of private concerns;(b) to encourage the participation of internal and external capital in the private concerns;(c) to encourage private ownership of industrial investment.

Functions of the ICICI(i) It provides long-term and medium-term loans in rupees and foreign currencies.(ii) It participates L* the equity capital of the industrial concerns.(iii) It underwrites new issues of shares and debentures.(iv) It guarantees loans raised by private concerns from other sources.(v) It provides technical,managerial and administrative assistance to industrial

concerns.

Capital InitiallyThe Corporation started with the authorised capital of Rs. 25 crore. At the end of June 1986, the authorised capital was Rs. 100 crore and the paid-up capital was 49.5 crore. Various sources of financial resources of the Corporation are Indian banks, insurance companies and foreign institutions, including the world Bank, and the public. The government and the IDBI have also provided loans to the Corporation.

Financial AssistanceThe performance of the ICICI in the field of financial assistance provided to the industrial concerns has been quite satisfactory. Over the years, the assistance sanctioned by the Corporation has grown from Rs.14.8 crore in 1961-62 to Rs. 43.0 crore in 1970-71 and Rs. 36229 crore in 2001-02. Similarly the amount disbursed has increased from Rs.8.6 crore in 1961-62 to Rs.29.8 crore in 1970-71 and to Rs. 25831 in 2001-02. Cumulatively, at the end of March 1996, the ICICI has sanctioned and disbursed financial assistance aggregating Rs. 66169 crore and Rs. 36591 crore respectively.

Features of ICICIThe important features of the functioning of the ICICI arc as given below:(i) The financial assistance as provided by the ICICI includes rupee loans, foreign currency loans, guarantees, underwriting of shares and debentures, and direct subscription to shares and debentures.(ii) Originally, the ICICI was established to provide financial assistance to industrial concerns in the private sector. But, recently, its scope has been widened by including industrial concerns in the public, joint and cooperative sectors.(iii) ICICI has been providing special attention to financing riskier and non-traditional industries, such as chemicals, petrochemicals, heavy engineering and metal products. These four categories of industries have accounted for more than half of the total assistance.(iv) Of late, the ICICI has also been providing assistance to the small scale industries and the projects in backward areas.(v) Along with other financial institutions, the ICICI has actively participated in conducting surveys to examine industrial potential in various states.(vi) In 1977, the ICICI promoted the Housing Development Finance Corporation Ltd. to grant term loans for the construction and purchase of residential houses.(vii) Since 1983, the ICICI has been providing leasing assistance for computerisation, modernisation and replacement schemes; for energy conservate; for export orientation; for pollution controller balancing and expansion: etc.

(viii) The ICICI has not contributed much to reduce regional disparities. About three-fifth of the total assistance given by the ICICI has been received by the advanced states of Maharashtra, Gujrat and Tamil Nadu.(ix) With effect from April 1, 1996, Shipping Credit and Investment company of India ltd, (SCICI) was merged with ICICI.(x) The ICICI Ltd. was merged with ICICI Bank Ltd. effective from May 3, 2002.

State Financial Corporation’s (SFCs) The State-level financial institutions are the one which play a crucial role in the development of small and medium enterprises in the concerned States. They provide financial assistance in the form of term loans, direct subscription to equity/ debentures, guarantees, discounting of bills of exchange and seed/ special capital, etc.

A Central Industrial Finance corporation was set up under the industrial Finance corporations Act, 1948 in order to provide medium and long term credit to industrial undertakings which fall outside normal activities of commercial banks. The State governments expressed their desire that similar corporations be set up in states to supplement the work of the Industrial financial corporation. State governments also expressed that the State corporations be established under a special statue in order to make it possible to incorporate in the constitutions necessary provisions in regard to majority control by the government, guaranteed by the State government in regard to the payment principal. In order to implement the views Expressed by the State governments the State Financial Corporation bill was introduced in the Parliament.

Statement of objects and reasonsIn order to provide medium and long term credit to industrial undertaking, which fall outside the normal activities of commercial banks, a central industrial finance corporation was set up under the industrial Finance Corporations act, 1948.The state governments wished that similar corporations should be set up in their states to supplement the work of industrial financial corporation. The intention is that the State corporations will confine to financing medium and small scale industrial and will , as far as possible consider only such access which are outside the perview of industrial fiancé corporation .The main features of the State financial Corporations Act 1951i. The bill provides that the state government may, by notification in the official gazette, establish a financial corporation for the state.ii. The share capital shall be fixed by the State government but shall not exceed Rs 2crores . The issue of the shares to the public will be limited to 25 % of the share capital and the rest will be held by the State Governments, The Reserve Bank, Scheduled Banks, Insurance Companies, Investment Trusts, Co- operative banks and other financial institutions.iii. Shares of the corporation will be guaranteed by the State government as to the repayment of principal and the payment of a minimum dividend to be prescribed in consultation with the central government.iv. The corporation will be authorized to issue bonds and debentures for amounts which together with the contingent liabilities of the corporations shall not exceed five – times the amount of the paid – up share capital and the reserve fund of the corporations. These

bonds and debentures will be guaranteed as to payment of the principal and payment of interest at such rate as may be fixed by the State government.v. The corporation may accept deposits from the public repayable after not less than five years, subject to the maximum not exceeding the paid up capital.vi. The corporation will be managed by a board consisting of a majority of Directors nominated by the State governments, The Reserve banks and the industrial Finance corporation of Indiavii. The corporation will be authorized to make long term loans to industrial concerns which are repayable within a period not exceeding 25 years. The Corporation will be further authorized to underwrite the issue of stocks, shares, bonds or debentures by industrial concerns, subject to the provision that the corporation will be required to dispose of and shares etc. Acquired by it in fulfillment its underwriting liability within a period of 7 years.viii. Until a reserve fund is created equal to the paid – up share capital of the Corporation and until the State Governments has been repaid all amounts paid by them, if any, in fulfillment of the guarantee liability, the rate of dividend shall not exceed the rate guaranteed by the state government. Under no circumstances shall the dividend exceed 5 % p.a. and surplus profits will be re – payable to the State governments.ix. The corporation will have special privileges in the matter of enforcement of its claims against borrowers.

Financial resources of the SFC’sThe SFC’s mobilize their financial resources from the following sources1.Their own Share capital2.Income from investment and repayment of loans3.Sale of bonds4.Loans from the IDBI ( To some extent )5.Borrowings from the Reserve Bank of India6.Deposits from the Public7.Loans from State Governments.In the act Financial corporations are Financial corporations established under section 3 andincludes a Joint Financial Corporation established under section 3 A of the Sate financialCorporations Act of 1951.

The functions of SFCs are as followsa. To advance term loans to small scale and medium scale industrial units.b. It underwrites the issue of stocks, shares, debentures and bonds of industrial

units.c. It grants loans to the industrial concerns which is repayable within a period not

more than 20 years.d. It subscribes to debentures floated by industrial concerns.e. It provides financial assistance to small road transport operators, tour operators,

hoteliers, hospitals, nursing homes, etc. SFCs have been set up with the objective of catalyzing higher investment, generating greater employment and widening the ownership base of industries. They have also started providing assistance to newer types of business activities like floriculture, tissue culture, poultry farming, commercial complexes and services related to engineering, marketing, etc. There are 18 State Financial Corporation’s (SFCs) in the country:-

Andhra Pradesh State Financial Corporation (APSFC) Himachal Pradesh Financial Corporation (HPFC)

Madhya Pradesh Financial Corporation (MPFC) North Eastern Development Finance Corporation (NEDFI) Rajasthan Finance Corporation (RFC) Tamil Nadu Industrial Investment Corporation Limited Uttar Pradesh Financial Corporation (UPFC) Delhi Financial Corporation (DFC) Gujarat State Financial Corporation   (GSFC) The Economic Development Corporation of Goa ( EDC) Haryana Financial Corporation (   HFC ) Jammu & Kashmir State Financial Corporation   ( JKSFC) \ Karnataka State Financial Corporation (KSFC) Kerala Financial Corporation ( KFC ) Maharashtra State Financial Corporation   (MSFC ) Orissa State Financial Corporation   (OSFC) Punjab Financial Corporation (PFC) West Bengal Financial Corporation   (WBFC)

LEASE FINANCINGLease financing is one of the popular and common methods of assets based finance, which is the alternative to the loan finance. Lease is a contract. A contract under which one party, the leaser (owner) of an asset agrees to grant the use of that asset to another leaser, in exchange for periodic rental payments.

Lease is contractual agreement between the owner of the assets and user of the assets for a specific period by a periodical rent.

Definition of Leasing

Lease may be defined as a contractual arrangement in which a party owning an asset provides the asset for use to another, the right to use the assets to the user over a certain period of time, for consideration in form of periodic payment, with or without a further payment.

According to the equipment leasing association of UK definition, leasing is a contract between the lesser and the leaser for hire of a specific asset selected from a manufacturers or vender of such assets by the lessee. The leaser retains the ownership of the asset. The leassee pass possession and uses the asset on payment for the specified period.

Elements of Leasing

Leasing is one of the important and popular parts of asset based finance. It consists of the following essential elements. One should understand these elements before they are going to study on leasing.

1. Parties: These are essentially two parties to a contract of lease financing, namely the owner and user of the assets.

2. Leaser: Leaser is the owner of the assets that are being leased. Leasers may be individual partnership, joint stock companies, corporation or financial institutions.

3. Lease: Lease is the receiver of the service of the assets under a lease contract. Lease assets may be firms or companies.

4. Lease broker: Lease broker is an agent in between the leaser (owner) and lessee. He acts as an intermediary in arranging the lease deals. Merchant banking divisions of foreign banks, subsidiaries indian banking and private foreign banks are acting as lease brokers.

5. Lease assets: The lease assets may be plant, machinery, equipments, land, automobile, factory, building etc.

Term of LeaseThe term of lease is the period for which the agreement of lease remains for operations. The lease term may be fixed in the agreement or up to the expiry of the assets.

Lease RentalThe consideration that the lesae pays to the leaser for lease transaction is the rental.

Type of LeasingLeasing, as a financing concept, is an arrangement between two parties for a specified period. Leasing may be classified into different types according to the nature of the agreement. The following are the major types of leasing as follows:

(A) Lease based on the term of lease 1. Finance Lease 2. Operating Lease

(B) Lease based on the method of lease 1. Sale and lease back 2. Direct lease

(C) Lease based in the parties involved 1. Single investor lease 2. Leveraged lease

(D) Lease based in the area 1. Domestic lease 2. International lease

1. Financing lease Financing lease is also called as full payout lease. It is one of the long-term leases and cannot be cancelable before the expiry of the agreement. It means a lease for

terms that approach the economic life of the asset, the total payments over the term of the lease are greater than the leasers initial cost of the leased asset. For example: Hiring a factory, or building for a long period. It includes all expenditures related to maintenance.

2. Operating lease Operating lease is also called as service lease. Operating lease is one of the short-term and cancelable leases. It means a lease for a time shorter than the economic life of the assets, generally the payments over the term of the lease are less than the leaser’s initial cost of the leased asset. For example: Hiring a car for a particular travel. It includes all expenses such as driver salary, maintenance, fuels, repairs etc.

3. Sale and lease back Sale and lease back is a lease under which the leasee sells an asset for cash to a prospective leaser and then leases back the same asset, making fixed periodic payments for its use. It may be in the firm of operating leasing or financial leasing. It is one of the convenient methods of leasing which facilitates the financial liquidity of the company.

4. Direct lease When the lease belongs to the owner of the assets and users of the assets with direct relationship it is called as direct lease. Direct lease may be Dipartite lease (two parties in the lease) or Tripartite lease. (Three parties in the lease)

5. Single investor lease When the lease belongs to only two parties namely leaser and it is called as single investor lease. It consists of only one investor (owner). Normally all types of leasing such as operating, financially, sale and lease back and direct lease are coming under this categories.

6. Leveraged lease This type of lease is used to acquire the high level capital cost of assets and equipments. Under this lease, there are three parties involved; the leaser, the lender and the lessee. Under the leverage lease, the leaser acts as equity participant supplying a fraction of the total cost of the assets while the lender supplies the major part.

7. Domestic lease In the lease transaction, if both the parties belong to the domicile of the same country it is called as domestic leasing.

8. International lease If the lease transaction and the leasing parties belong to the domicile of different countries, it is called as international leasing.

Advantages of Leasing

Leasing finance is one of the modern sources of finance, which plays a major role in the part of the asset based financing of the company. It has the following important advantages.

1. Financing of fixed asset Lease finance helps to mobilize finance for large investment in land and building, plant and machinery and other fixed equipments, which are used in the business concern.

2. Assets based finance Leasing provides finance facilities to procure assets and equipments for the company. Hence, it plays a important and additional source of finance.

3. Convenient Leasing finance is convenient to the use of fixed assets without purchasing. This type of finance is suitable where the company uses the assets only for a particular period or particular purpose. The company need not spend or invest huge amount for the acquiring of the assets or fixed equipments.

4. Low rate of interest Lease rent is fixed by the lease agreement and it is based on the assets which are used by the business concern. Lease rent may be less when compared to the rate of interest payable to the fixed interest leasing finance like debt or loan finance.

5. Simplicity Lease formalities and arrangement of lease finance facilities are very simple and easy. If the leaser agrees to use the assets or fixed equipments by the lessee, the leasing arrangement is mostly finished.

6. Transaction cost When the company mobilizes finance through debt or equity, they have to pay some amount as transaction cost. But in case of leasing finance, transaction cost or floating cost is very less when compared to other sources of finance.

7. Reduce risk Leasing finance reduces the financial risk of the lessee. Hence, he need not buy the assets and if there is any price change in the assets, it will not affect the lessee.

8. Better alternative Now a days, most of the commercial banks and financial institutions are providing lease finance to the industrial concern. Some of the them have specialised lease finance company. They are established to provide faster and speedy arrangement of lease finance.

Leasing Finance Institutions in India

Presently, leasing finance becomes popular and effective financial sources for most of the business concerns. With the importance of lease finance, now a days banks and financial institutions provide leasing financial assistance to the industrial concern. The following institutions are famous and widely providing lease finance in India:

Leasing financial institutions in India may be classified into the following groups.

Leasing Institutions

Public Sector Private Sector

Leasing Institutions Leasing Institutions

Leasing by Leasing FinanceLeasing byDevelopment Specialized Company CompanyInstitutions Institutions

Fig. 12.1 Leasing Institutions

Leasing by Development Institutions

All India development institutions are providing leasing finance assistance to industrial concerns. Some of the public sector leasing finance company in India are follows:

• Industrial Credit & Investment Corporation of India (ICICI)

• Industrial Finance Corporation of India (IFCI)

• Industrial Investment Bank of India (IIBI)

• Small Industries Development Corporation (SIDC)

• State Industrial Investment Corporation (SIIC)

Leasing by Specialized Institutions

Specialized financial institutions also provide lease finance to the industrial concern. Some of the lease finance providing institutions are as follows:

• Life Insurance Corporation of India (LIC)

• General Insurance Corporation of India (GIC)

• Unit Trust of India (UTI)

• Housing Development Finance Corporation of India (HDFC)

Private Sector Leasing Company

Private sector leasing companies also provide financial assistance to the industrial concerns. The following are the example of the private sector leasing companies in India:

• Express Leasing Limited

• 20th Century Leasing Corporation Ltd.

• First Leasing Company of India

• Mazda Leasing Limited

• Grover Leasing Limited

Private Sector Financial Company

Private sector financial companies also involve in the field of leasing finance. The following are the example of the private sector finance companies:

• Cholamandal Investment and Finance Company Ltd.

• Dcl Finance Limited

• Sundaram Finance Limited

• Anagram Finance Limited

• Nagarjuna Finance Limited.

OPERATING LEASEAn operating lease works on a similar basis to standard leasing, except that it is based on shorter-term contracts; and one item may be leased several times over its lifespan.Although it is not as tax efficient as standard leasing, it does make it easier if your business needs to regularly update its equipment; or has varying levels of demand and often needs quick capacity increases.

An operating lease is similar to a standard leasing agreement, however it is usually based on much shorter terms. The idea of an operating lease is that the product is sold or re-leased to another company at the end of the agreement; this means that they do not need to recover the full cost of the item (meaning cheaper monthly payments).

This type of lease is less common, but is often available for products where there is a strong market for second hand equipment (Mainly vehicles). The length of an operating lease is shorter than a standard lease, it can run for a number of years, but will normally be for considerably less than the lifespan of the product to ensure re-selling or re-leasing.

SOURCING OF FINANCE

INTRODUCTIONFinance is the lifeblood of business concern, because it is interlinked with all activities performed by the business concern. In a human body, if blood circulation is not proper, body function will stop. Similarly, if the finance not being properly arranged, the business system will stop. Arrangement of the required finance to each department of business concern is highly a complex one and it needs careful decision. Quantum of finance may be depending upon the nature and situation of the business concern. But, the requirement of the finance may be broadly classified into two parts:

Long-term Financial Requirements or Fixed Capital Requirement

Financial requirement of the business differs from firm to firm and the nature of the requirements on the basis of terms or period of financial requirement, it may be long term and short-term financial requirements.

Long-term financial requirement means the finance needed to acquire land and building for business concern, purchase of plant and machinery and other fixed expenditure. Long-term financial requirement is also called as fixed capital requirements. Fixed capital is the capital, which is used to purchase the fixed assets of the firms such as land and building, furniture and fittings, plant and machinery, etc. Hence, it is also called a capital expenditure.

Short-term Financial Requirements or Working Capital Requirement

Apart from the capital expenditure of the firms, the firms should need certain expenditure like procurement of raw materials, payment of wages, day-to-day expenditures, etc. This kind of expenditure is to meet with the help of short-term financial requirements which will meet the operational expenditure of the firms. Short-term financial requirements are popularly known as working capital.

SOURCES OF FINANCE

Sources of finance mean the ways for mobilizing various terms of finance to the industrial concern. Sources of finance state that, how the companies are mobilizing finance for their requirements. The companies belong to the existing or the new which need sum amount of finance to meet the long-term and short-term requirements such as purchasing of fixed assets, construction of office building, purchase of raw materials and day-to-day expenses.

Sources of finance may be classified under various categories according to the following important heads:

1. Based on the Period

Sources of Finance may be classified under various categories based on the period.

Long-term sources: Finance may be mobilized by long-term or short-term. When the finance mobilized with large amount and the repayable over the period will be more than five years, it may be considered as long-term sources. Share capital, issue of debenture, long-term loans from financial institutions and commercial banks come under this kind of source of finance. Long-term source of finance needs to meet the capital expenditure of the firms such as purchase of fixed assets, land and buildings, etc.

Long-term sources of finance include:

● Equity Shares

● Preference Shares

● Debenture

● Long-term Loans

● Fixed Deposits

Short-term sources: Apart from the long-term source of finance, firms can generate finance with the help of short-term sources like loans and advances from commercial banks, moneylenders, etc. Short-term source of finance needs to meet the operational expenditure of the business concern.

Short-term source of finance include:

● Bank Credit

● Customer Advances

● Trade Credit

● Factoring

● Public Deposits

● Money Market Instruments

2. Based on Ownership

Sources of Finance may be classified under various categories based on the period:

An ownership source of finance include

● Shares capital, earnings

● Retained earnings

● Surplus and Profits

Borrowed capital include

● Debenture

● Bonds

● Public deposits

● Loans from Bank and Financial Institutions.

3. Based on Sources of Generation

Sources of Finance may be classified into various categories based on the period.

Internal source of finance includes

● Retained earnings

● Depreciation funds

● Surplus

External sources of finance may be include

● Share capital

● Debenture

● Public deposits

● Loans from Banks and Financial institutions

4. Based in Mode of Finance Security finance may be include

● Shares capital

● Debenture

Retained earnings may include

● Retained earnings

● Depreciation funds

Loan finance may include

● Long-term loans from Financial Institutions

● Short-term loans from Commercial banks.

The above classifications are based on the nature and how the finance is mobilized from various sources. But the above sources of finance can be divided into three major classifications:

● Security Finance

● Internal Finance

● Loans Finance

SECURITY FINANCE

If the finance is mobilized through issue of securities such as shares and debenture, it is called as security finance. It is also called as corporate securities. This type of finance plays a major role in the field of deciding the capital structure of the company.

Characters of Security Finance

Security finance consists of the following important characters:

1. Long-term sources of finance.

2. It is also called as corporate securities.

3. Security finance includes both shares and debentures.

4. It plays a major role in deciding the capital structure of the company.

5. Repayment of finance is very limited.

6. It is a major part of the company’s total capitalization.

Types of Security Finance

Security finance may be divided into two major types:

1. Ownership securities or capital stock.

2. Creditorship securities or debt capital.

Ownership Securities

The ownership securities also called as capital stock, is commonly called as shares. Shares are the most Universal method of raising finance for the business concern. Ownership capital consists of the following types of securities.

● Equity Shares

● Preference Shares

● No par stock

● Deferred Shares

EQUITY SHARES

Equity Shares also known as ordinary shares, which means, other than preference shares. Equity shareholders are the real owners of the company. They have a control over the management of the company. Equity shareholders are eligible to get dividend if the company earns profit. Equity share capital cannot be redeemed during the lifetime of the company. The liability of the equity shareholders is the value of unpaid value of shares.

Features of Equity Shares

Equity shares consist of the following important features:

1. Maturity of the shares: Equity shares have permanent nature of capital, which has no maturity period. It cannot be redeemed during the lifetime of the company.

2. Residual claim on income: Equity shareholders have the right to get income left after paying fixed rate of dividend to preference shareholder. The earnings or the income available to the shareholders is equal to the profit after tax minus preference dividend.

3. Residual claims on assets: If the company wound up, the ordinary or equity shareholders have the right to get the claims on assets. These rights are only available to the equity shareholders.

4. Right to control: Equity shareholders are the real owners of the company. Hence, they have power to control the management of the company and they have power to take any decision regarding the business operation.

5. Voting rights: Equity shareholders have voting rights in the meeting of the company with the help of voting right power; they can change or remove any decision of the business concern. Equity shareholders only have voting rights in the company meeting and also they can nominate proxy to participate and vote in the meeting instead of the shareholder.

6. Pre-emptive right: Equity shareholder pre-emptive rights. The pre-emptive right is the legal right of the existing shareholders. It is attested by the company in the first opportunity to purchase additional equity shares in proportion to their current holding capacity.

7. Limited liability: Equity shareholders are having only limited liability to the value of shares they have purchased. If the shareholders are having fully paid up shares, they have no liability. For example: If the shareholder purchased 100 shares with

the face value of Rs. 10 each. He paid only Rs. 900. His liability is only Rs. 100.

Total number of shares 100 Face value of shares Rs. 10 Total value of shares 100 × 10 = 1,000Paid up value of shares 900Unpaid value/liability 100

Liability of the shareholders is only unpaid value of the share (that is Rs. 100).

Advantages of Equity Shares

Equity shares are the most common and universally used shares to mobilize finance for the company. It consists of the following advantages.

1. Permanent sources of finance: Equity share capital is belonging to long-term permanent nature of sources of finance, hence, it can be used for long-term or fixed capital requirement of the business concern.

2. Voting rights: Equity shareholders are the real owners of the company who have voting rights. This type of advantage is available only to the equity shareholders.

3. No fixed dividend: Equity shares do not create any obligation to pay a fixed rate of dividend. If the company earns profit, equity shareholders are eligible forprofit, they are eligible to get dividend otherwise, and they cannot claim any dividend from the company.

4. Less cost of capital: Cost of capital is the major factor, which affects the value of the company. If the company wants to increase the value of the company, they have to use more share capital because, it consists of less cost of capital (Ke) while compared to other sources of finance.

5. Retained earnings: When the company have more share capital, it will be suitable for retained earnings which is the less cost sources of finance while compared to other sources of finance.

Disadvantages of Equity Shares

1. Irredeemable: Equity shares cannot be redeemed during the lifetime of the business concern. It is the most dangerous thing of over capitalization.

2. Obstacles in management: Equity shareholder can put obstacles in management by manipulation and organizing themselves. Because, they have power to contrast any decision which are against the wealth of the shareholders.

3. Leads to speculation: Equity shares dealings in share market lead to secularism

during prosperous periods.

4. Limited income to investor: The Investors who desire to invest in safe securities with a fixed income have no attraction for equity shares.

5. No trading on equity:When the company raises capital only with the help of equity, the company cannot take the advantage of trading on equity.

PREFERENCE SHARES

The parts of corporate securities are called as preference shares. It is the shares, which have preferential right to get dividend and get back the initial investment at the time of winding up of the company. Preference shareholders are eligible to get fixed rate of dividend and they do not have voting rights.

Preference shares may be classified into the following major types:

1. Cumulative preference shares: Cumulative preference shares have right to claim dividends for those years which have no profits. If the company is unable to earn profit in any one or more years, C.P. Shares are unable to get any dividend but they have right to get the comparative dividend for the previous years if the company earned profit.

2. Non-cumulative preference shares: Non-cumulative preference shares have no right to enjoy the above benefits. They are eligible to get only dividend if the company earns profit during the years. Otherwise, they cannot claim any dividend.

3. Redeemable preference shares: When, the preference shares have a fixed maturity period it becomes redeemable preference shares. It can be redeemable during the lifetime of the company. The Company Act has provided certain restrictions on the return of the redeemable preference shares.

Irredeemable Preference Shares

Irredeemable preference shares can be redeemed only when the company goes for liquidator. There is no fixed maturity period for such kind of preference shares.

Participating Preference Shares

Participating preference sharesholders have right to participate extra profits after distributing the equity shareholders.

Non-Participating Preference Shares

Non-participating preference sharesholders are not having any right to participate extra

profits after distributing to the equity shareholders. Fixed rate of dividend is payable to the type of shareholders.

Convertible Preference Shares

Convertible preference sharesholders have right to convert their holding into equity shares after a specific period. The articles of association must authorize the right of conversion.

Non-convertible Preference Shares

There shares, cannot be converted into equity shares from preference shares.

Features of Preference Shares

The following are the important features of the preference shares:

1. Maturity period: Normally preference shares have no fixed maturity period except in the case of redeemable preference shares. Preference shares can be redeemable only at the time of the company liquidation.

2. Residual claims on income: Preferential sharesholders have a residual claim on income. Fixed rate of dividend is payable to the preference shareholders.

3. Residual claims on assets: The first preference is given to the preference shareholders at the time of liquidation. If any extra Assets are available that should be distributed to equity shareholder.

4. Control of Management: Preference shareholder does not have any voting rights. Hence, they cannot have control over the management of the company.

Advantages of Preference Shares

Preference shares have the following important advantages.

1. Fixed dividend: The dividend rate is fixed in the case of preference shares. It is called as fixed income security because it provides a constant rate of income to the investors.

2. Cumulative dividends: Preference shares have another advantage which is called cumulative dividends. If the company does not earn any profit in any previous years, it can be cumulative with future period dividend.

3. Redemption: Preference Shares can be redeemable after a specific period except in the case of irredeemable preference shares. There is a fixed maturity period for repayment of the initial investment.

4. Participation: Participative preference sharesholders can participate in the surplus profit after distribution to the equity shareholders.

5. Convertibility: Convertibility preference shares can be converted into equity shares when the articles of association provide such conversion.

Disadvantages of Preference Shares

1. Expensive sources of finance: Preference shares have high expensive source of finance while compared to equity shares.

2. No voting right: Generally preference sharesholders do not have any voting rights. Hence they cannot have the control over the management of the company.

3. Fixed dividend only: Preference shares can get only fixed rate of dividend. They may not enjoy more profits of the company.

4. Permanent burden: Cumulative preference shares become a permanent burden so far as the payment of dividend is concerned. Because the company must pay the dividend for the unprofitable periods also.

5. Taxation: In the taxation point of view, preference shares dividend is not a deductible expense while calculating tax. But, interest is a deductible expense. Hence, it has disadvantage on the tax deduction point of view.

DEFERRED SHARES

Deferred shares also called as founder shares because these shares were normally issued to founders. The shareholders have a preferential right to get dividend before the preference shares and equity shares. According to Companies Act 1956 no public limited company or which is a subsidiary of a public company can issue deferred shares.

These shares were issued to the founder at small denomination to control over the management by the virtue of their voting rights.

NO PAR SHARES

When the shares are having no face value, it is said to be no par shares. The company issues this kind of shares which is divided into a number of specific shares without any specific denomination. The value of shares can be measured by dividing the real net worth of the company with the total number of shares.

The real net worth

Value of no. per share =Total no.of shares

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CREDITORSHIP SECURITIES

Creditorship Securities also known as debt finance which means the finance is mobilized from the creditors. Debenture and Bonds are the two major parts of the Creditorship Securities.

Debentures

A Debenture is a document issued by the company. It is a certificate issued by the company under its seal acknowledging a debt.

According to the Companies Act 1956, “debenture includes debenture stock, bonds and any other securities of a company whether constituting a charge of the assets of the company or not.”

Types of Debentures

Debentures may be divided into the following major types:

1. Unsecured debentures: Unsecured debentures are not given any security on assets of the company. It is also called simple or naked debentures. This type of debentures are treaded as unsecured creditors at the time of winding up of the company.

2. Secured debentures: Secured debentures are given security on assets of the company. It is also called as mortgaged debentures because these debentures are given against any mortgage of the assets of the company.

3. Redeemable debentures: These debentures are to be redeemed on the expiry of a certain period. The interest is paid periodically and the initial investment is returned after the fixed maturity period.

4. Irredeemable debentures: These kind of debentures cannot be redeemable during the life time of the business concern.

5. Convertible debentures: Convertible debentures are the debentures whose holders have the option to get them converted wholly or partly into shares. These debentures are usually converted into equity shares. Conversion of the debentures may be: Non-convertible debentures Fully convertible debentures Partly convertible debentures

6. Other types: Debentures can also be classified into the following types. Some of the common types of the debentures are as follows:

1. Collateral Debenture

2. Guaranteed Debenture

3. First Debenture

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4. Zero Coupon Bond

5. Zero Interest Bond/Debenture

Features of Debentures

1. Maturity period: Debentures consist of long-term fixed maturity period. Normally, debentures consist of 10–20 years maturity period and are repayable with the principle investment at the end of the maturity period.

2. Residual claims in income: Debenture holders are eligible to get fixed rate of interest at every end of the accounting period. Debenture holders have priority of claim in income of the company over equity and preference shareholders.

3. Residual claims on asset: Debenture holders have priority of claims on Assets of the company over equity and preference shareholders. The Debenture holders may have either specific change on the Assets or floating change of the assets of the company. Specific change of Debenture holders are treated as secured creditors and floating change of Debenture holders are treated as unsecured creditors.

4. No voting rights: Debenture holders are considered as creditors of the company. Hence they have no voting rights. Debenture holders cannot have the control over the performance of the business concern.

5. Fixed rate of interest: Debentures yield fixed rate of interest till the maturity period. Hence the business will not affect the yield of the debenture.

Advantages of Debenture

Debenture is one of the major parts of the long-term sources of finance which of consists the following important advantages:

1. Long-term sources: Debenture is one of the long-term sources of finance to the company. Normally the maturity period is longer than the other sources of finance.

2. Fixed rate of interest: Fixed rate of interest is payable to debenture holders, hence it is most suitable of the companies earn higher profit. Generally, the rate of interest is lower than the other sources of long-term finance.

3. Trade on equity: A company can trade on equity by mixing debentures in its capital structure and thereby increase its earning per share. When the company apply the trade on equity concept, cost of capital will reduce and value of the company will increase.

4. Income tax deduction: Interest payable to debentures can be deducted from the total profit of the company. So it helps to reduce the tax burden of the company.

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5. Protection: Various provisions of the debenture trust deed and the guidelines issued by the SEB1 protect the interest of debenture holders.

Disadvantages of Debenture

Debenture finance consists of the following major disadvantages:

1. Fixed rate of interest: Debenture consists of fixed rate of interest payable to securities. Even though the company is unable to earn profit, they have to pay the fixed rate of interest to debenture holders, hence, it is not suitable to those company earnings which fluctuate considerably.

2. No voting rights: Debenture holders do not have any voting rights. Hence, they cannot have the control over the management of the company.

3. Creditors of the company: Debenture holders are merely creditors and not the owners of the company. They do not have any claim in the surplus profits of the company.

4. High risk: Every additional issue of debentures becomes more risky and costly on account of higher expectation of debenture holders. This enhanced financial risk increases the cost of equity capital and the cost of raising finance through debentures which is also high because of high stamp duty.

5. Restrictions of further issues: The company cannot raise further finance through debentures as the debentures are under the part of security of the assets already mortgaged to debenture holders.

INTERNAL FINANCE

A company can mobilize finance through external and internal sources. A new company may not raise internal sources of finance and they can raise finance only external sources such as shares, debentures and loans but an existing company can raise both internal and external sources of finance for their financial requirements. Internal finance is also one of the important sources of finance and it consists of cost of capital while compared to other sources of finance.

Internal source of finance may be broadly classified into two categories:

A. Depreciation Funds

B. Retained earnings

Depreciation Funds

Depreciation funds are the major part of internal sources of finance, which is used to meet the working capital requirements of the business concern. Depreciation means decrease in the value of asset due to wear and tear, lapse of time, obsolescence, exhaustion and accident. Generally depreciation is changed against fixed assets of the company at fixed rate for every year. The purpose of depreciation is replacement of the assets after the expired period. It is one kind of provision of fund, which is needed to reduce the tax burden and overall profitability of the company.

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Retained Earnings

Retained earnings are another method of internal sources of finance. Actually is not a method of raising finance, but it is called as accumulation of profits by a company for its expansion and diversification activities.

Retained earnings are called under different names such as; self-finance, inter finance, and plugging back of profits. According to the Companies Act 1956 certain percentage, as prescribed by the central government (not exceeding 10%) of the net profits after tax of a financial year have to be compulsorily transferred to reserve by a company before declaring dividends for the year.

Under the retained earnings sources of finance, a part of the total profits is transferred to various reserves such as general reserve, replacement fund, reserve for repairs and renewals, reserve funds and secrete reserves, etc.

Advantages of Retained Earnings

Retained earnings consist of the following important advantages:

1. Useful for expansion and diversification: Retained earnings are most useful to expansion and diversification of the business activities.

2. Economical sources of finance: Retained earnings are one of the least costly sources of finance since it does not involve any floatation cost as in the case of raising of funds by issuing different types of securities.

3. No fixed obligation: If the companies use equity finance they have to pay dividend and if the companies use debt finance, they have to pay interest. But if the company uses retained earnings as sources of finance, they need not pay any fixed obligation regarding the payment of dividend or interest.

4. Flexible sources: Retained earnings allow the financial structure to remain completely flexible. The company need not raise loans for further requirements, if it has retained earnings.

5. Increase the share value: When the company uses the retained earnings as the sources of finance for their financial requirements, the cost of capital is very cheaper than the other sources of finance; Hence the value of the share will increase.

6. Avoid excessive tax: Retained earnings provide opportunities for evasion of excessive tax in a company when it has small number of shareholders.

7. Increase earning capacity: Retained earnings consist of least cost of capital and also it is most suitable to those companies which go for diversification and expansion.

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Disadvantages of Retained Earnings

Retained earnings also have certain disadvantages:

1. Misuses: The management by manipulating the value of the shares in the stock market can misuse the retained earnings.

2. Leads to monopolies: Excessive use of retained earnings leads to monopolistic attitude of the company.

3. Over capitalization: Retained earnings lead to over capitalization, because if the company uses more and more retained earnings, it leads to insufficient source of finance.

4. Tax evasion: Retained earnings lead to tax evasion. Since, the company reduces tax burden through the retained earnings.

5. Dissatisfaction: If the company uses retained earnings as sources of finance, the shareholder can’t get more dividends. So, the shareholder does not like to use the retained earnings as source of finance in all situations.

LOAN FINANCING

Loan financing is the important mode of finance raised by the company. Loan finance may be divided into two types:

(a) Long-Term Sources

(b) Short-Term Sources

Loan finance can be raised through the following important institutions.

Loan Financing Institutions

Commercial Banks Development Banks Specialist Institutions

Short-term Long-term Direct Indirect Domestic ForeignCurrency

Advance Loans Finance Finance Finance Finance

Fig. 3.1 Loan Financing

Financial Institutions

With the effect of the industrial revaluation, the government established nation wide and state

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wise financial industries to provide long-term financial assistance to industrial concerns in the country. Financial institutions play a key role in the field of industrial development and they are meeting the financial requirements of the business concern. IFCI, ICICI, IDBI, SFC, EXIM Bank, ECGC are the famous financial institutions in the country.

Commercial Banks

Commercial Banks normally provide short-term finance which is repayable within a year. The major finance of commercial banks is as follows:

Short-term advance: Commercial banks provide advance to their customers with or without securities. It is one of the most common and widely used short-term sources of finance, which are needed to meet the working capital requirement of the company.

It is a cheap source of finance, which is in the form of pledge, mortgage, hypothecation and bills discounted and rediscounted.

Short-term Loans

Commercial banks also provide loans to the business concern to meet the short-term financial requirements. When a bank makes an advance in lump sum against some security it is termed as loan. Loan may be in the following form:

(a) Cash credit: A cash credit is an arrangement by which a bank allows his customer to borrow money up to certain limit against the security of the commodity.

(b) Overdraft: Overdraft is an arrangement with a bank by which a current account holder is allowed to withdraw more than the balance to his credit up to a certain limit without any securities.

Development Banks

Development banks were established mainly for the purpose of promotion and development the industrial sector in the country. Presently, large number of development banks are functioning with multidimensional activities. Development banks are also called as financial institutions or statutory financial institutions or statutory non-banking institutions. Development banks provide two important types of finance:

(a) Direct Finance

(b) Indirect Finance/Refinance

Some of the important development banks are discussed in Chapter 11.

Presently the commercial banks are providing all kinds of financial services including development-banking services. And also nowadays development banks and specialisted financial institutions are providing all kinds of financial services including commercial banking services.

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Diversified and global financial services are unavoidable to the present day economics. Hence, we can classify the financial institutions only by the structure and set up and not by the services provided by them.

Section A1. Raising funds through ------- is cheaper as compared to raising through shares.2. Preference shares have preferential right as to ------------3. ------ shares are not preference shares, they do not carry preferential rights.4. -------- may be cumulative and non-cumulative, participating and non- participating,

redeemable and non- redeemable.5. Preference shares add to the equity base of the company and thereby strength to its

----------6. The rate of dividend on equity shares is not -----------7. Shares can be issued at par, premium or ------------8. Debenture is a certificate issued by a company under its seal acknowledging a debt

due by it, to its -----------9. A lease agreement grants lessee the right to ---------10. The expenditure in capital asset is a ----------- investment

Section B1. Write a note on debenture.2. What is preference shares?3. What are the types of leasing?4. What are the concepts of leasing?5. Can you explain the types of preference shares.6. What is direct leasing and primary/secondary leasing?7. Give the types of debentures.8. Essential elements of leasing.9. Can you state the advantages and disadvantages of leasing?10. Finance is the life blood of the business – explain

Section C1. Explain the various forms of long term

finance.2. What are the merits, demerits and features of

leasing?3. What is debenture and what are the types of

debentures.4. Leasing is beneficial to both the lessee as

well as lessor. Examine5. What are the advantages and disadvantages

of equity shares?6. Explain in detail about what do you

understand on the term lease financing?7. How will you differentiate about debentures

and bonds?

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8. What are the two main categories of financial requirements of business?

9. Explain in detail about the types of shares.10. What are the merits and demerits of equity

shares?

BUSINESS FINANCE Unit – I Business Finance: Introduction – Meaning – Concepts -Scope – Function of Finance Traditional and Modern Concepts – Contents of Modern Finance Functions.

Unit – II Financial Plan: Meaning -Concept – Objectives – Types – Steps – Significance – Fundamentals.

Unit – III Capitalization -Bases of Capitalization – Cost Theory – Earning Theory – Over Capitalization – Under Capitalization: Symptoms – Causes – Remedies – Watered Stock – Watered Stock Vs. Over Capitalization.

Unit – IV Capital Structure – Cardinal Principles of Capital structure – Trading on Equity – Cost of Capital – Concept – Importance – Calculation of Individual and Composite Cost of Capital.

Unit – V Sources and Forms of Finance: Equity Shares, Preference Shares, Bonds, Debentures and Fixed Deposits – Features – Advantages and Disadvantages-Lease Financing: Meaning – Features – Forms – Merits and Demerits.

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