Financial Management unit 1

Financial Management

S.N.Selvaraj, M.B.A., M.Phil., Assistant Professor, Email: [email protected] Page 1

UNIT – I FINANCIAL MANAGEMENT

FINANCE FUNCTIONS: Meaning – Definition – Scope of Finance Functions –

Objectives of Financial Management – Profit Maximization and Wealth

Maximization. SOURCES OF FINANCE: Short-term – Bank Sources – Long-term –

Shares – Debentures – Preferred Stock – Debt.

FINANCE FUNCTIONS: MEANING – DEFINITION

Finance is the life blood of business. Without finance, the heart and brain of business

cannot function implying thereby its natural death. Right from conceiving the idea of

birth of business to its liquidation, finance is required. Inputs are made available only

with finance. Even managerial ability can be had with only finance.

The survival and growth of a firm is possible if it utilizes its funds in an optimum

manner. Collin Brooks has rightly remarked in this context that “bad production

management and bad sales management have slain their hundreds, but faulty finance

has slain its thousands”. Therefore sound finance management is indispensable in a

corporate organization.

Financial Management is that managerial activity which is concerned with the

planning and controlling of the firm‟s financial resources. It was a branch of

economics till 1890 and as a separate discipline, it is of recent origin.

Meaning and Definition of Finance/ Financial Management

Finance may be defined as the provision of money at the time when it is required.

Finance refers to the management of flows of money through an organization. It

concerns with the application of skills in the manipulation, use and control of money.

Different authorities have interpreted the term „finance‟ differently.

According to F.W.Paish, “Finance may be defined as the position of money at the

time it is wanted”.

According to the John J Hampton, “The term finance can be defined as the

management of flows of money through an organization, whether it will be a

corporation, school, bank or government agency”.

According to Weston & Brigham, “Financial management is an area of financial

decision making harmonizing individual motives and enterprise goals.

The financial management consists of two words „financial‟ and „management‟.

Financial means procuring sources of money supply and allocation of these sources on

the basis of forecasting monetary requirements of the business. The word

„management‟ refers to planning, organization, co-ordination and control of human

activities and physical resources for achieving the objectives of an enterprise.

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SCOPE OF FINANCE FUNCTIONS – OBJECTIVES OF FINANCIAL

MANAGEMENT Classification of Finance

The subject of finance has been traditionally classified into four classes:

Public Finance Private Finance Institutional International

Finance Finance

State Government Personal Finance

Local Government Business Finance

Central Government Finance of Non-Profit

Organization

1) Public Finance: Public finance deals with the requirements, receipts and

disbursements of funds in the government institutions like states, local self-

government and central government.

2) Private Finance: Private finance is concerned with requirements, receipts and

disbursements of funds in case of an individual, a profit seeking business

organization and a non-profit organization. The private finance can be classified

into: (a) Personal Finance, (b) Business Finance, and (c) Finance of Non-Profit

Organizations.

3) Institutional Finance: Institutional finance is related to capital formation and meets

the financial requirements of the economy. In the economic set up of a country

there are many financial institutions such as bank, insurance companies, financial

corporations, unit trust, etc. These institutions collect savings from individual

savers and accumulate sufficient amount for profitable investment in business

organizations.

4) International Finance: This area of finance focuses attention on flow of funds

beyond national boundaries. Each country has its own currency and it has to be

exchanged into the currency of other countries for buying and selling goods and

services. The study of flow of funds between individuals and organizations across

national borders and the development of methods of handling the flows more

efficiently is the subject-matter of international finance.

Finance Function

Financial function is the most important of all business functions. It remains a focus of

all activities. It is not possible to substitute or eliminate this function because the

business well close down in the absence of finance. The need for money is continuous.

It starts with the setting up of an enterprises and remains at all times.

There are three concepts of finance function in relation to business:

1. The first approach assumes that the expenditure decisions giving rise to the

demand for the capital within a business.

Finance




2. Another approach relates finance function to cash. This implies that finance

function is related to every activity in the course of business.

3. The third approach is more acceptable, envisages finance function as

procurement of funds and their effective utilization in the business.

Objectives of Finance Function

The objective of finance functions is to arrange as much funds for the business as are

required from time to time. This function has the following objectives:

Proper Utilization of Funds: The funds should be used in such a way that

maximum benefits are derived from them. The funds committed to various

operations should be effectively utilized.

Increasing Profitability: The planning and control of finance function aims at

increasing profitability of the concern. To achieve this purpose sufficient funds

will have to be invested.

Maximizing Value of Firm: Finance function also aims at maximizing the value

of the firm. It is generally said that a concern‟s value is linked with its

profitability.

Creating Wealth for Business: Finance function aims to create wealth for

business through the effective way of doing business.

Generate Cash: Generating cash thorough the appropriate business transactions.

Unnecessary financial transactions may be avoided in the right time to facilitate

business.

Adequate Return on Investment: Sufficient fund should be provided at right time

to meet the needs of the business. The finance manager should bear in mind the

risk of business and the resources invested.

Scope of Finance Function / Financial Management

Financial management has undergone significant changes over the years in its scope

and coverage. Broadly it has two approaches:

1. Traditional Approach : Procurement of Funds

2. Modern Approach : Utilization of Funds

Traditional Approach – Procurement of Funds

The scope of finance was treated, in the narrow sense of procurement or arrangement

of funds. The finance management was treated as just provider of funds, when

organization was in need of them. The utilization or administering resources was

considered outside the purview of the finance function. It was felt that the finance

manager had no role to play in decision-making for its utilization.

Modern Approach – Utilization of Funds

The modern approach views the term financial management in a broad sense and

provides a conceptual and analytical framework for financial decision-making.

According to it, the finance function covers both acquisitions of funds as well as their

allocation. It is viewed as an integral part of overall management.




Evolution of Financial Management

Traditional Phase (Up to 1940): This can be summarized as follows:

i) Finance function was concerned with procuring of funds to finance the

expansion or diversification activities. This was not a part of regular

managerial operations.

ii) In order to finance business growth, there was an emergence of

institutional financing and banking giving rise to finance industry.

iii) Finance function was viewed particularly from the point of view of

supplier of funds, i.e. the lenders – both individuals and institutions.

iv) The concept of working capital and its management was virtually non-

existent. The focus of attention was on the long-term resources.

v) The treatment of different aspects of finance was more on descriptive

nature rather than analytical.

Transitional Phase (After 1940): This phase in fact was an extension of the

traditional phase and continued up to early fifties when the scope of finance

function started expanding in big way. During the transitional phase the nature

of financial management was the same but more emphasis was laid on

problems faced by finance managers in the areas of fund analysis, planning and

control.

Modern Phase (Integrated View – After 1950): The modern phase is characterized

by the application of economic theories and the application of quantitative

methods of analysis. The finance manager has emerged as a professional

manger involved with capital funds to be raised by the firm, with the allocation

of these funds to different projects.

Significant contributions to the development of Modern Theory of financial

management are as follows:

a) Theory of Portfolio Management: This was developed by Harry Markowitz

which deals with portfolio selection with risky investments. This theory

uses statistical concepts to quantify the risk-return characteristics of holding

a group of securities. The risk of one investor is viewed in its totality rather

than evaluating the risk of one security only.

This theory at a later stage leads to the development of Capital Asset

Pricing Model which deals with pricing of risky assets and the relationship

between risk and return.

b) Theory of Leverage and Valuation of Firm: This was developed by

Modigliani and Miller, they have shown the introducing analytical approach

as to how the financial decision making in any firm be oriented towards

maximization of the value of the firm and the maximization of shareholders

wealth.

c) Presentation of Option Valuation Model: This was developed by Black and

Scholes, is also regarded as a landmark in the area of financial management.




Functions of Financial Management

The functions of raising funds, investing them in assets and distributing returns earned

from assets to shareholders are respectively know as financing decision, investment

decision and dividend decision.

Investment Decisions: The investment decisions relates to the selection of assets in

which funds will be invested by a firm. The investment decision is broadly

concerned with the asset-mix or the composition of the assets of a firm. The assets

which can be acquired fall into two broad groups:

(i) Long-term assets which will yield a return over a period of time in future.

This kind is popularly known in the financial literature as „Capital

Budgeting‟.

(ii) Shot-term or current assets defined as those which in the normal course of

business are convertible into cash usually within a year. This kind is

popularly designated as „Working Capital Management‟.

Financing Decisions: A financing decision is the second important function to be

performed by the financial manager. He or she must decide when, where from and

how to acquire funds to meet the firm‟s investment needs. The concern of

financing decision is with the financing-mix or capital structure or leverage. The

mix of debt and equity is known as the firm‟s capital structure. The financial

manager must strive to obtain the best financing mix or the optimum capital

structure for his or her firm.

Dividend Decisions: A dividend decision is the third major financial decision. The

financial manager must decide whether the firm should distribute all profits or

retain them or distribute a portion and retain the balance. The proportion of profits

distributed as divided is called the dividend-payout ratio and the retained portion

of profits is known as the retention ratio.

Liquidity Decision: Liquidity decision is concerned with the management of current

assets. Basically, this is working capital management, is concerned with the

management of current assets. It is short-term survival. Short-term survival is a

prerequisite for long-term survival. A proper trade-off must be achieved between

profitability and liquidity. The profitability-liquidity trade-off requires that the

financial manger should develop sound techniques of managing current assets.

Functions of Financial Management

Investment Decision Finance Decision

Dividend Decision Liquidity Decision




Long-term Finance Decision: The long-term finance functions or decisions have a

longer time horizon, generally greater than a year. They may affect the firm‟s

performance and value in the long run. They also relate to the firm‟s strategy and

generally involve senior management in taking the final decision.

Short-term Finance Decision: The short-term finance functions or decisions involve a

period of less than one year. These decisions are needed for managing the firm‟s day-

to-day fund requirements. Generally, they relate to the management of current assets

and current liabilities, short-term borrowings and investment of surplus cash for short

periods.

Importance of Financial Management

Financial Planning and Control

Essence of Managerial Decision

Scientific and Analytical Analysis

Continuous Administration Function

Centralized Nature

Basis of Managerial Process

Measure of Performance

PROFIT MAXIMIZATION AND WEALTH MAXIMIZATION

Profit earning is the main aim of every economic activity. A business being an

economic institution must earn profit to cover its costs and provide funds for growth.

No business can survive without earning profit. Profit is a measure of efficiency of a

business enterprise.

Profits also serve as a protection against risks which cannot be ensured. The

accumulated profits enable a business to face risks like fall in prices, competition from

other units, advertise government policies etc. Thus, profit maximization is considered

as the main objective of business.

Features of Profit Maximization

Main aim of any kind of economic activity is earning profit. Profit maximization

consists of the following important features:

1) Profit maximization is also called as cashing per share maximization.

2) It leads to maximize the business operation for profit maximization.

3) It considers all the possible ways to increase the profitability of the business

concern.

4) Profit is the parameter of measuring the efficiency of the business concern.

5) Profit maximization objectives help to reduce the risk of the business.

Limitations of Profit Maximization

The profit maximization criterion is criticized on the following grounds:

It ignores the quality aspects of benefits associated with business.




It is ambiguity – vague; it means different to different people – may be pre-tax

or post-tax.

It ignores the difference in time and value of money. The fact that a rupee

received today is more valuable than the rupee received later is ignored.

It may ignore the social welfare sometimes.

It gives effect to change in organization structure.

Wealth Maximization

This is also known as net present worth maximization approach. It takes into

consideration the time value of money. Its operational features satisfy all the three

requirements of a suitable operational objective of financial courses of action i.e.

quality of benefits, timing of benefits and exactness.

The wealth maximization approach can be more explicitly defined in the following

ways:

A1 + A2 + A3 + ……. An − C

W = (1+K)1 (1+K)

2 (1+K)

3 (1+K)

n

where,

A1, A2 …… An = Streams of benefits expected

C = Cash outlay (or) Cost of action

K = Discount rate

W = Net present worth

The objective of wealth maximization helps to resolve two most troublesome

problems attached with the flow of benefits. There is consideration of time value of

money. The problem is handled by selecting an appropriate rate of discount and using

the rate of discount the expected flow of future benefits.

The wealth maximization objective is consistent with the objective of maximizing the

owner‟s economic welfare. The wealth maximization principle implies that the

fundamental objective of a firm should be to maximize the market value of its shares.

Features of Wealth Maximization

1) Wealth maximization is superior to the profit maximization because this

concept is to improve the value or wealth of the shareholders.

2) Wealth maximization considers the comparison of the value to cost associated

with the business concern. Total value detected from the total cost incurred for

the business operation.

3) Wealth maximization considers both time and risk of the business concern.

4) Wealth maximization provides efficient allocation of resources.

5) It ensures the economic interest of the society.

Limitations of Wealth Maximization

The objective of wealth maximization is not, necessarily, socially desirable.




There is some controversy whether the objective of maximization of wealth is

of the firm or to the stakeholders.

If wealth of firm were maximized, it would be benefiting the interest of

debenture holders and preference shareholders too.

In corporate sector, ownership and management are separate unlike in a sole

proprietorship.

There is a conflict of interest between the shareholders and management.

Profit Maximization Versus Wealth Maximization

Profit cannot be ascertained well in advance to express the probability of return

as future is uncertain.

The term „profit‟ is vague and has not been explained clearly what it means

The vagueness is not present in wealth maximization goal as the concept of

wealth is very clear.

It represents value of benefits minus the cost of investment

The firm‟s goal cannot be to maximize profits but to attain a certain level of

profit holding certain amount of shares.

The firms should try to „satisfy‟ rather than to „maximize‟.

There must be balance between expected return and risk. There exist great risk

to recognize such a balance and wealth maximization is brought into the

analysis.

The goal of maximization of profits is considered to be a narrow outlook. It

becomes the basis of financial decisions of the concern.

The criterion of profit maximization ignores time value factor.

The wealth maximization concept fully endorses the time value factor in

evaluating cash flows.

SOURCES OF FINANCE

The financial needs of a business are of a peculiar nature. The type and amount of

funds required usually differs from one business to another. For instance, if the size of

business is large, the amount of funds required will also be large. Likewise, the

financial requirements are more in manufacturing business as compared to trading

business.

The business need funds for longer period to be invested in fixed assets like land and

building, machinery etc. Sometimes the business also needs fund to be invested in

shorter period. So based on the period for which the funds are required, the business

finance is classified into three categories:

1) Short-term: The short-term capital, which can also be called as working capital

is required for the purchase of raw materials and to meet the day-to-day

expenses such as the payment of wages, salaries and tax, in connection with the

conversion of raw materials into finished goods. The loans are obtained usually

for a short period of one year.

2) Medium-term: The medium-term capital is required for the repairs,

replacement and maintenance of machine and buildings which can be repaid




over a comparatively short period. It is utilized for all such purposes where

investments are required for more than one year but less than five years.

3) Long-term: The long-term funds are the base for the financial structure of a

firm. It is also known as fixed capital; is needed to acquire fixed and permanent

assets, namely, land and building, plant and machinery and tools. Generally,

financial needs of more than five years are included in long term finance.

The various sources of raising long-term funds include equity shares,

preference shares, retained earnings, debentures, bond, term loans, leasing, hire

purchases and public deposits, etc.

Types of Business Finance

Type of Finance Period of Repayment Purpose

Short-term Less than a year Purchase of raw materials, payment of

wages, rent, insurance, etc.

Medium-term One year to five years Expenditure on modernization,

renovation, heavy advertising, etc.

Long-term More than five years Purchase of land and building, plant and

machineries, etc.

Every organization need different types of finance, i.e. long-term, medium-term as

well as short-term. But the combinations in which these are used differ from one

business to another.

For example, steel industry requires more long-term finance to be invested in land and

building and machinery as compared to the manufacturing of leather goods or plastic

buckets. Similarly for manufacturing hosiery items, requirement of short-term finance

would be more than that of long-term finance.

SHORT-TERM SOURCES OF FINANCE

After establishment of a business funds are required to meet its day-to-day expenses.

Short-term loans help business concerns to meet their temporary requirement of

money. They do not create a heavy burden of interest on the organization. But

sometimes organizations keep away from such loans because of uncertainty and other

reasons.

Short Term Sources of Finance

Indigenous Bankers

Advances

Accounts Payable

Bills Discounting

Installment Credit

Accrued Expenses and

Deferred Income

Trade Credit

Factoring




Indigenous Bankers: Private money-lenders and other country bankers used to be the

only source of finance prior to the establishment of commercial banks. They used to

charge very high rates of interest and exploited the customers to the extent possible.

Now-a-days with the development of commercial banks they have lost their

monopoly.

Installment Credit: Under this method, the 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 price or it may

be adjusted in the price.

Advances: Some business houses get advances from their customers and agents against

orders and this source is a short-term source of finance of them. It is a cheap source of

finance and in order to minimize their investment in working capital, some firms have

long production cycle, especially the firms manufacturing industrial products prefer to

take advances from their customers. This is interest free.

Accrued Expenses and Deferred Incomes: Accrued expenses are the expenses which

have been incurred but not yet due and hence not yet paid also. These simply represent

a liability that a firm has to pay for the services already received by it. The most

important items of accruals are wages and salaries, interest and taxes.

Deferred incomes are incomes received in advance before supplying goods or

services. They represent funds received by a firm for which it has to supply goods or

services in future.

Account Payable /Creditors: Individual creditors or bills payable are created by

individual purchases on credit terms or other funding transactions. However, they only

remain as liabilities until they are settled.

Trade Credit: Trade credit refers to the credit extended by the suppliers of goods in the

normal course of business. At present day commerce is built upon credit, the trade

credit arrangement of a firm with its suppliers is an important source of short-term

finance.

Bills Discounting: Purchasing and discounting of bills is the most important form in

which a bank lends without any collateral security. The seller draws a bill of exchange

on the buyer of goods on credit. Such a bill may be either a clean bill or documentary

bill accompanied by the documents such as roadway receipt, railway receipt, and

airway receipt.

Factoring: Factoring is a contract between the suppliers (the client) of goods/services

and the financial institution (the factor) under the course of business. This method of

financing is to reduce the risk of default by debtors. This is very popular in western

countries and in India – four Indian banks – SBI, CB, PNB and Allahabad Bank –

Provide factoring services.




BANK SOURCES OF FINANCE

Banks are the main institutional sources of finance in India. After trade credit, bank

credit is the most important source of financing capital requirements of firms in India.

The amount approved by the bank for the firm‟s working capital is called credit limit.

Banks are required to fix separate limits for the „peak level‟ credit requirements and

„normal non-peak level‟ credit requirements indicating the periods during which the

separate limits will be utilized by the borrower.

Forms of Bank Source of Finance

1) Secured Term Loan: When a bank makes an advance in lump-sum against some

security it is called a loan. The entire loan amount is paid to the borrower either in

cash or by credit to his account. The borrower is required to pay interest on the

entire amount of the loan from the data of sanction. A loan may be repayable in

lump sum or installments. The term loan may be either medium-term or long-term

loans.

2) Cash Credit: A cash credit is an arrangement by which a bank allows his customer

to borrow money up to a certain limit against some tangible securities or

guarantees. The interest in case of cash credit is charged on daily balance basis.

The customer can deposit any surplus amount to his account.

3) 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 sanctioned by the bank. Bank overdraft is given on current accounts and the

interest payable is on daily basis.

Security Required in Bank Finance

Hypothecation: Hypothecation is a charge against property for an amount of debt

where neither ownership nor possessions passed to the creditor. Under this

arrangement, the borrower is provided with working capital finance by the bank

against the security of movable property, generally inventories.

Pledge: Under this arrangement, the borrower is required to transfer the physical

possession of the property offered as a security to the bank to obtain credit. In case

of default, the bank may either (a) sue the borrower for the amount due, or (b) sue

for the sale of goods pledged, or (c) after giving due notice sell the goods.

Mortgage: Mortgage is the transfer of legal or equitable interest in a specific

immovable property for the payment of a debt. In case of mortgage, the possession

of the property may remain with the borrower with the lender getting the full legal

title. The transferor of interest (borrower) is called the mortgagor, the transferee

(bank) is called the mortgagee, and the instrument of transfer is called the

mortgage deed.

Lien: Lien means right of the lender to retain property belongings to the borrower

until he repays credit. It can be either a particular lien or general. Particular lien is

a right to retain property until the claim associated with the property is fully paid.

General lien, on the other hand, is applicable till all dues of the lender are paid.

Banks usually enjoy general lien.




LONG-TERM SOURCES OF FINANCE

Long-term is the base for the financial structure of a firm. Generally financial needs of

more than 5 years are included in long-term finance. Long-term funds are required to

create production facilities through purchase of fixed assets such as plant, machinery,

land, building, etc. and for modernization and expansion of the existing facilities.

These funds are required for meeting the fixed capital requirements of a business.

The various sources of raising long-term funds include:

EQUITY SHARES

Equity shares are, earlier, known as ordinary shares or common shares. Equity

shareholders are the real owners of the company as they have the voting rights and

enjoy decision-making authority on important matters, related to the company. The

shareholders‟ return is in the form of dividend, which is dependent on the profits of

the company and capital gain/loss at the time of their sale.

Features of Equity Shares

Maturity: Equity share holders can demand their capital only if the event of

liquidation and that too when funds are left after covering all prior claims.

Claims on Income: Equity shareholders are residual owners whose claim on income

arises only when claims of creditors and preferred stock-owners are met.

Cost of Equity: Since the equity dividends are not tax deductible expenses as the

interest is, the high cost of issue and the risk factor associated with its makes the

cost of equity higher.

Claims on Asset: Being residual owners, equity shareholders are the last claimants

to assets of the firm, in the event of winding up of the firm.

Control: The risk of loss associated with equity share is compensated to some

extent by controlling power that rests with residual owners.

Advantages of Equity Shares Disadvantages of Equity Shares

Capital profit

Interest in the Company‟s Activities

Best for Investment

More Income

Right to Interface in Management

Uncertainty of Income

Irregular Income

Capital Loss

Less Attractive to Modest Investors

Loss in case of Liquidation

Long-term Sources of Finance

Equity Shares

Preferred Stock /

Preference Shares

Debt /Debentures

Retained Earnings

Loans from Financial Institutions




DEBT/ DEBENTURES

A debenture is an instrument executed by the company under its common seal

acknowledging indebtedness to some persons to secure the sum advanced. It is thus a

security issued by a company against the debt.

In India, a public limited company is allowed to raise debt capital through debentures

after getting certificate of commencement of business, if permitted by its

memorandum of association. Indian Companies Act simply says “debenture includes

debenture stock, bonds, and any other security of a company whether constituting a

charge on the assets of the company or not”.

Features of Debentures

Fixed Interest Rate: Debenture holders are the creditors of the company. They

are entitled to periodic payment of interest at a fixed rate.

Maturity: Debentures are repayable after a fixed period of time, say five years

or seven years as per agreed terms.

No Voting Rights: Debenture holders do not carry voting rights

Secured Assets: Ordinarily, debentures are secured. In case the company fails to

pay interest on debentures or repay the principal amount, the debenture holders

can recover it from the sale of the assets of the company.

Types of Debentures

There are several types of debentures on the basis of the terms and conditions of the

issue of the debentures as follows:

1 On the basis of Registration i. Registered Debentures

ii. Bearer Debentures

2 On the basis of Security i. Secured Debentures

ii. Unsecured Debentures

3 On the basis of Redemption i. Redeemable Debentures

ii. Irredeemable Debentures

4 On the basis of Conversion i. Convertible Debentures

ii. Non-convertible Debentures

5 On the basis of Priority i. Preferred Debentures

ii. Ordinary Debentures

6 On the basis of Status i. Equitable Debentures

ii. Legal Debentures

7 Debentures with Pari Pasu Clause




1. Registered Debentures: The debentures which are payable to the registered

debenture holders, are called registered debentures. These debenture holders‟

details are recorded in the register of debenture holders. Registered debentures are

not negotiable instruments. Transfer of such debentures requires registration.

2. Bearer Debentures: The debentures, which are payable to the bearers, are called

bearer debentures. The names of the debenture holders are not recorded in the

register of debenture holders. They are negotiable instruments. Bearer debentures

are also called unregistered debentures.

3. Secured Debentures: The debentures, which are secured fully or partly by a charge

over the assets of the company, are called secured debentures. The charge may be

either a fixed charge or a floating charge.

4. Unsecured Debentures: The debentures, which are not secured fully or partly by a

charge over the assets of the company, are called unsecured debentures. The

general solvency of the company is the only security for their holders.

5. Redeemable Debentures: The debentures, which are repayable after a certain period,

are called redeemable debentures. Sometimes, they can be redeemed by the

company on demand by the holders or at the discretion of the company.

6. Irredeemable Debentures: The debentures, which are not repayable during the life

time of the company, are called irredeemable debentures. The company may repay

the money at the time of liquidation. At present, no company can issue

irredeemable debentures.

7. Convertible Debentures: The debentures, which are convertible into equity shares or

preference shares at the option of the holders, after certain period, are called

convertible debentures.

8. Non-Convertible Debentures: The debentures, which are not convertible into shares,

are called non-convertible debentures.

9. Preferred Debentures: The debentures, which are paid first at the time of winding

up, are called preferred debentures. Thus they are just like preference shares.

10. Ordinary Debentures: The debentures, which are paid after the preference

debentures at the time of winding up, are called ordinary debentures.

11. Equitable Debentures: The debentures, which are secured by deposit of title deeds

of the property with a Memorandum creating a charge, are called equitable

debentures. In this case the property is with the company.

12. Legal Debentures: The debentures, which are secured by actual transfer of the legal

ownership of the property from the company to the holder, are called legal

debentures.

13. Debentures with Pari Pasu Clause: The (secured) debentures, which are discharged

ratable through issued on different dates, are called debentures with Pari Pasu

Clause.

Advantages of Debentures

Preferred by Investors

Less Investment Risk

Less Costly

Maintenance of Control

Trading on Equity




Remedy against over Capitalization

Reliable Source

Market Response

Useful for Conversion

Disadvantages of Debentures

Not suitable for all Companies

Permanent Burden

Requires Huge Fixed Asset

No Voting Rights

Difficulty in Repayment

Affecting the Capacity to Raise Loan

Difference between Shares and Debentures

Basis of Difference Shares Debentures

Capital Versus Loan Share is a part of owned

capital. Debenture constitutes a loan.

Reward for

Investment

Reward is the payment of

dividend.

Reward is the payment of

interest.

Fluctuations in the

rate of Interest and

Dividends

The rate of dividend may vary

from year to year. The rate of interest is fixed.

Charge Versus

Appropriation

Payment of dividend is an

appropriation out of profits and

cannot be made if there is no

profit.

Payment of interest is a

charge against profit and is

to be made even if there is

no profit.

Payment of Interest

/ Dividend

Payment of dividend gets no

priority over the payment of

interest.

Payment of interest gets

priority over the payment of

dividend.

Repayment of

Principal

Payment of share capital is

made after the repayment of

debentures.

Payment of debentures is

made before the payment of

share capital.

Secured by Charge Shares are not secured by any

charge.

Debentures are usually

secured by a charge.

Restriction on Issue

Section 79 imposes certain

restriction on issue of share at

discount.

No restriction is imposed on

the purchase of debentures.

PREFERRED STOCK / PREFERENCE SHARES

Preference shares are those shares on which there is a preference right – to dividend

during the life time of the company and to repayment of capital on the winding up of

the company. Preference capital represents a hybrid form of financing – it par takes

some characteristics of equity and some attributes of debentures.




It resembles equity in the following ways:

1) Preference dividend is payable only out of distributable profits;

2) Preference dividend is entirely within the discretion of directors; and

3) Preference dividend is not a tax-deductible payment.

Preference capital is similar to debentures in several ways:

1) The dividend rate on preference capital is usually fixed.

2) The claim of preference shareholders is prior to the claim of equity

shareholders; and

3) Preference shareholders do not normally enjoy the right to vote.

Features of Preference Shares

Accumulation of Dividends: Preference shares may be cumulative or non-

cumulative with respect to dividends. The unpaid dividends on cumulative

preference shares are carried forward and payable when the dividend is

resumed.

Call-Ability: The terms of preference share issue may contain a call feature by

which the issuing company enjoys the right to call the preference shares,

wholly or partly, at a certain price.

Convertibility: Preference shares may sometimes be convertible into equity

shares. The holders have the option of converting preference shares into equity

shares at a certain ratio during a specified period.

Redeemability: Preference shares may be perpetual or redeemable. A perpetual

preference share has no maturity period, whereas a redeemable preference

share has a limited life. Most preference issues are redeemable.

Participation in Surplus Profits and Assets: Companies may issue participating

preference shares with entitle preference shareholders to participate in surplus

profits (profits left after preference dividend and equity dividend at certain

rates) every year.

Voting Power: Before the commencement of the Companies Act, 1956,

companies could issue preference shares carrying voting rights. Preference

shares issued after the commencement of the Companies Act, 1956 do not

carry voting right.

Advantages of Preference Shares

Priority in Repayment of Capital

Best Security

Regular and Fixed Income

Less Risk

Safety of Interest

Disadvantages of Preference Shares

Dividend at Fixed Rate

Uncertain Position of Redeemable Preference Shares

Limited Voting Rights




Difference between Preference Shares and Equity Shares

Basis of Difference Preference Shares Equity Shares

Dividend Preference shareholder gets the

preference in getting dividends

Equity shareholder gets the

dividend from the remaining

income after paid to

preference shares.

Share Price

The nominal value of

preference shares are more

than equity shares.

The nominal value of equity

shares are less than

preference shares.

Repayment of

Capital

Preference shareholders get the

preference over equity

shareholders in the repayment

of capital

Equity shareholders are

repaid after the payment is

made to the preference

holders.

Right of

Management

Preference shareholders do not

have the right to participate in

the administration of the

company

Equity shareholders have the

right to participate in the

administration of the

company and voting power.

Dividend Rate In case of preference share the

dividend rate is fixed.

Dividend rate depends on

profit in case of equity share

Redemption

Preference share can be

redeemed in the mid of the

business.

Equity share cannot be

redeemed. They can be sold.

Issue Expense They need more expenses as

compared to equity shares.

Equity share is cheaper as far

as issue expenses.

RETAINED EARNINGS

Retained earnings are also referred as ploughing back of profits means the

reinvestments by concern of its surplus earnings in its business. It is an internal source

of finance and is most suitable for an established firm for its expansion, modernization

and replacement, etc.

This method of finance has a number of advantages as it is the cheapest rather cost-

free source of finance; there is no need to keep securities; there is no dilution of

control; it ensures stable dividend policy and gains confidence of the public. But

excessive resort to retained earnings may lead to monopolies, misuse of funds, over-

capitalization and speculation, etc.

Necessity of Retained Earnings

1. Replacement of old asset, which have become obsolete.

2. Expansion and growth of business.

3. Purchase of fixed assets as well as meeting the requirement of working capital.

4. Making the company self-dependent and avoiding outside financing.

5. Redemption of loans and debentures.




Factors that Influence Retained Earnings

Earning Capacity: If the company has high earning capacity, retained earnings also

can be high. If a firm does not have adequate earning capacity, there is no

possibility for retained earnings.

Desire and Type of Shareholders: If the majority of the shareholders are retired

people, windows and who look for the dividend as a regular source of income, the

shareholders always prefer to have higher amount of dividend. In such a case it is

difficult to have retained earnings. If a company has wealthy shareholders, in such

a case, company can enjoy retained earnings.

Future Financial Requirements: If the company‟s future requirement of funds is

more, then the company will prefer to retain profits rather than to distribute higher

dividends.

Dividend Policy: A company that wants to declare more dividends cannot afford to

retain more profits. More profits retained, lesser is the amount for distributing

dividend and vice versa.

Taxation Policy: A high taxation policy of the government leaves lower amount in

hands of the company towards retention of profits. On the other hand, a liberal

policy of the government allows more profits to retain as tax liability is less.

LOANS FROM FINANCIAL INSTITUIONS

Financial institutions such as Commercial banks, Life Insurance Corporation of India,

Industrial Finance Corporation of India, State Financial Corporation, Industrial

Development Bank of India, etc. also provide short-term, medium-term, and long-term

loans. This source of finance is more suitable to meet the medium-term demands of

working capital. Interest is charged so such loans at a fixed rate and the amount of the

loan is to be repaid by way of installments in a number of years.

Loans from financial institutions also referred to as „term finance‟ represent a source

of debt finance which is generally repayable in more than one year but less than 10

years. They are employed to financial acquisition of fixed assets and working capital

margin. Term loans differ from short-term bank loans which are employed to finance

short-term working capital need and tend to be self-liquidating over a period of time,

usually less than one year.

Features of Loans from FIs

Security: Term loans typically represent secured borrowing. Usually assets which

are financed with the proceeds of the term loan provide the prime security. Other

assets of the firm may serve as collateral security. All loans provided by financial

institutions, along with interest, liquidated damages, commitment charges,

expenses, etc. are secured by way of mortgages, hypothecation, pledge and lien.

Interest Payment and Principal Repayment: Financial institutions charge an interest

rate that is related to the credit risk of the proposal. Also an amount of penalty will

be charged by the bank in case of default.

Restrictive Covenants: In order to protect their interest, financial institutions

generally impose restrictive condition of the borrowers.




Advantages of Loans from FI

Borrower’s Point of View Lender’s Point of View

In post-tax terms, the cost of term loan

is lower than the cost of equity or

preference capital.

Terms loans do not result in dilution

of control, as lenders do not have the

right to vote.

Term loans earn a fixed rate of interest

and have a definite maturity period.

Terms loans represent secured

lending.

Restrictive covenants to protect the

interest of the lender.

Disadvantages of Loans from FI

Borrower’s Point of View Lender’s Point of View

Failure in repayment may threaten the

existence of the firm.

Restrictive covenants may reduce

managerial freedom.

Term loans do not carry the right to

vote.

Term loans are not represented by

negotiable securities.

Text Books References:

1. M.Y.Khan and P.K.Jain, “Financial Management” Tata McGraw Hill,

6th

Edition, 2011.

2. I.M.Pandey, “Financial Management” Vikas Publishing House Pvt. Ltd.,

10th

Education 2012.

3. S.N.Maheswari, Financial and Management Accounting, Sultan Chand &

Sons, 2003.
