RTMG Wk8

INTRODUCTION Business concern needs finance to meet their requirements in the economic world. Any kind of business activity depends on the finance. Hence, it is called as lifeblood of business organization. Whether the business concerns are big or small, they need finance to fulfil their business activities.

In the modern world, all the activities are concerned with the economic activities and very particular to earning profit through any venture or activities. The entire business activities are directly related with making profit. (According to the economics concept of factors of production, rent given to landlord, wage given to labour, interest given to capital and profit given to shareholders or proprietors), a business concern needs finance to meet all the requirements. Hence finance may be called as capital, investment, fund etc., but each term is having different meanings and unique characters. Increasing the profit is the main aim of any kind of economic activity.

MEANING OF FINANCE Finance may be defined as the art and science of managing money. It includes financial service and financial instruments. Finance also is referred as the provision of money at the time when it is needed. Finance function is the procurement of funds and their effective utilization in business concerns.

The concept of finance includes capital, funds, money, and amount. But each word is having unique meaning. Studying and understanding the concept of finance become an important part of the business concern.

DEFINITION OF FINANCE

According to Khan and Jain, “Finance is the art and science of managing money”.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

2 Financial Management

According to Oxford dictionary, the word ‘finance’ connotes ‘management of money’. Webster’s Ninth New Collegiate Dictionary defines finance as “the Science on study

of the management of funds’ and the management of fund as the system that includes the circulation of money, the granting of credit, the making of investments, and the provision of banking facilities.

DEFINITION OF BUSINESS FINANCE

According to the Wheeler, “Business finance is that business activity which concerns with the acquisition and conversation of capital funds in meeting financial needs and overall objectives of a business enterprise”.

According to the Guthumann and Dougall, “Business finance can broadly be defined as the activity concerned with planning, raising, controlling, administering of the funds used in the business”.

In the words of Parhter and Wert, “Business finance deals primarily with raising, administering and disbursing funds by privately owned business units operating in non- financial fields of industry”.

Corporate finance is concerned with budgeting, financial forecasting, cash management, credit administration, investment analysis and fund procurement of the business concern and the business concern needs to adopt modern technology and application suitable to the global environment.

According to the Encyclopedia of Social Sciences, “Corporation finance deals with the financial problems of corporate enterprises. These problems include the financial aspects of the promotion of new enterprises and their administration during early development, the accounting problems connected with the distinction between capital and income, the administrative questions created by growth and expansion, and finally, the financial adjustments required for the bolstering up or rehabilitation of a corporation which has come into financial difficulties”.

TYPES OF FINANCE

Finance is one of the important and integral part of business concerns, hence, it plays a major role in every part of the business activities. It is used in all the area of the activities under the different names.

Finance can be classified into two major parts:

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Introduction to Financial Management 3

Finance

Private Finance

Public Finance

Individual Finance

Partnership Finance

Business Finance

Central Government

State Government

Semi Government

Fig. 1.1 Types of Finance

Private Finance, which includes the Individual, Firms, Business or Corporate Financial activities to meet the requirements.

Public Finance which concerns with revenue and disbursement of Government such as Central Government, State Government and Semi-Government Financial matters.

DEFINITION OF FINANCIAL MANAGEMENT Financial management is an integral part of overall management. It is concerned with the duties of the financial managers in the business firm.

The term financial management has been defined by Solomon, “It is concerned with the efficient use of an important economic resource namely, capital funds”.

The most popular and acceptable definition of financial management as given by S.C. Kuchal is that “Financial Management deals with procurement of funds and their effective utilization in the business”.

Howard and Upton : Financial management “as an application of general managerial principles to the area of financial decision-making.

Weston and Brigham : Financial management “is an area of financial decision-making, harmonizing individual motives and enterprise goals”.

Joshep and Massie : Financial management “is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations.

Thus, Financial Management is mainly concerned with the effective funds management in the business. In simple words, Financial Management as practiced by business firms can be called as Corporation Finance or Business Finance.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

4 Financial Management

SCOPE OF FINANCIAL MANAGEMENT Financial management is one of the important parts of overall management, which is 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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Introduction to Financial Management 5

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.

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.

OBJECTIVES OF FINANCIAL MANAGEMENT Effective procurement and efficient use of finance lead to proper utilization of the finance by the business concern. It is the essential part of the financial manager. Hence, the financial manager must determine the basic objectives of the financial management. Objectives of Financial Management may be broadly divided into two parts such as :

1. Profit maximization 2. Wealth maximization.

Wealth Profit

Fig. 1.2 Objectives of Financial Management

Profit Maximization Main aim of any kind of economic activity is earning profit. A business concern is also functioning mainly for the purpose of earning profit. Profit is the measuring techniques to understand the business efficiency of the concern. Profit maximization is also the traditional and narrow approach, which aims at, maximizes the profit of the concern. Profit maximization consists of the following important features.

1. Profit maximization is also called as cashing per share maximization. It leads to maximize the business operation for profit maximization.

2. Ultimate aim of the business concern is earning profit, hence, it considers all the possible ways to increase the profitability of the concern.

Objectives

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

6 Financial Management

3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the entire position of the business concern.

4. Profit maximization objectives help to reduce the risk of the business.

Favourable Arguments for Profit Maximization The 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.

Unfavourable 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 sake 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.

Wealth Maximization Wealth maximization is one of the modern approaches, which involves latest innovations and improvements in the field of the business concern. The term wealth means shareholder wealth or the wealth of the persons those who are involved in the business concern.

Wealth maximization is also known as value maximization or net present worth maximization. This objective is an universally accepted concept in the field of business.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Introduction to Financial Management 7

Favourable Arguments for Wealth Maximization

(i) Wealth maximization is superior to the profit maximization because the main aim of the business concern under this concept is to improve the value or wealth of the shareholders.

(ii) 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. It provides extract value of the business concern.

(iii) Wealth maximization considers both time and risk of the business concern. (iv) Wealth maximization provides efficient allocation of resources. (v) It ensures the economic interest of the society.

Unfavourable Arguments for Wealth Maximization

(i) Wealth maximization leads to prescriptive idea of the business concern but it may not be suitable to present day business activities.

(ii) Wealth maximization is nothing, it is also profit maximization, it is the indirect name of the profit maximization.

(iii) Wealth maximization creates ownership-management controversy. (iv) Management alone enjoy certain benefits. (v) The ultimate aim of the wealth maximization objectives is to maximize the profit.

(vi) Wealth maximization can be activated only with the help of the profitable position of the business concern.

APPROACHES TO FINANCIAL MANAGEMENT Financial management approach measures the scope of the financial management in various fields, which include the essential part of the finance. Financial management is not a revolutionary concept but an evolutionary. The definition and scope of financial management has been changed from one period to another period and applied various innovations. Theoretical points of view, financial management approach may be broadly divided into two major parts.

Approach

Traditional Approach Modern Approach

Fig. 1.3 Approaches to Finance Management

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

8 Financial Management

Traditional Approach Traditional approach is the initial stage of financial management, which was followed, in the early part of during the year 1920 to 1950. This approach is based on the past experience and the traditionally accepted methods. Main part of the traditional approach is rising of funds for the business concern. Traditional approach consists of the following important area.

Arrangement of funds from lending body. Arrangement of funds through various financial instruments. Finding out the various sources of funds.

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 safety, liquidity and profitability while investing capital.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Introduction to Financial Management 9

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.

Department-I

Department-II

D epartm

ent-IIID ep

ar tm

en t-

IV

Forecasting Funds

M an

ag in

g Fu

nd s

Investing Funds

Finance Manager

A ccquring Funds

Fig 1.4 Functions of Financial Manager

IMPORTANCE OF FINANCIAL MANAGEMENT

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 Planning

Financial 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 Funds

Financial 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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

10 Financial Management

Proper Use of Funds Proper 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.

Financial Decision Financial 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 Profitability Profitability 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 Firm Financial 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 Savings Savings 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.

MODEL QUESTIONS

1. What is finance? Define business finance. 2. Explain the types of finance. 3. Discuss the objectives of financial management. 4. Critically evaluate various approaches to the financial management. 5. Explain the scope of financial management. 6. Discuss the role of financial manager. 7. Explain the importance of financial management.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

INTRODUCTION A financial statement is an official document of the firm, which explores the entire financial information of the firm. The main aim of the financial statement is to provide information and understand the financial aspects of the firm. Hence, preparation of the financial statement is important as much as the financial decisions.

MEANING AND 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 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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

12 Financial Management

Financial Statement

Income Statement Position Statement

Statement of changes in Owner's Equity

Statement of changes in Financial Position

Fig. 2.1 Financial Statement

Income Statement Income 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 Statement Position 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 Equity It 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 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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Financial Statement Analysis 13

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.

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 Materials Used

On the basis of Methods of Operations

External Analysis

Internal Analysis

Horizontal Analysis

Vertical Analysis

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

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

14 Financial Management

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 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 Analysis

Comparative Statement

Trend Analysis

Cash Flow Statement

Funds Flow Statement

Common Size

Analysis

Fig. 2.3 Techniques of Financial Statement Analysis

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

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Financial Statement Analysis 15

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

Comparative Statement Analysis Comparative 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 Analysis Comparative 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.

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 Balance Reserve and with RBI 27,06,808 22,37,601

Surplus 39,66,009 47,65,406 Balance with Banks Deposits 4,08,45,783 4,40,42,730 and Money at call & Borrowings and short notice 11,36,781 16,07,975 Other 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 2,11,29,869 Fixed Assets 4,93,996 5,36,442 Other Assets 18,58,064 18,35,883

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

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

16 Financial Management

Solution

Comparative Balance Sheet Analysis

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

(Amount) (Percentage)

2003 2004 Rs. Rs. Rs. Rs.

Assets Current Assets

Cash and Balance with RBI 27,06,808 22,37,601 (+) 4,69,207 (+) 17.33 Balance with Banks and money 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 0.052 Fixed Assets Investments 2,14,21,060 2,35,37,098 (-) 21,16,038 (-) 9.88 Advances 1,95,99,764 2,11,39,869 (-) 15,40,105 (-) 7.86 Fixed Assets 4,93,996 5,36,442 (-) 42,446 (-) 8.59 Other 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 8.48 Total Assets 4,72,16,473 5,08,94,868 36,78,395 7.79 Current Liabilities Borrowings 7,27,671 2,84,690 (+) 4,42,981 60.88 Other 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 20.16 Deposit 4,08,45,783 4,40,42,730 (+) 31,96,947 7.83

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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Financial Statement Analysis 17

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 Profit 1999 2,05,59,498 97,14,728 3,50,311 2000 2,66,45,251 1,25,50,440 4,06,287 2001 3,19,80,696 1,58,83,495 5,04,020 2002 3,72,99,877 1,77,26,607 5,53,525 2003 4,08,45,783 1,95,99,764 6,37,634 2004 4,40,42,730 2,11,39,869 8,06,755

Solution Trend Analysis (Base year 1999=100)

(Rs. in thousands) Deposits Advances Profits

Year Amount Trend Amount Trend Amount Trend Rs. Percentage Rs. Percentage Rs. Percentage

1999 2,05,59,498 100.0 97,14,728 100.0 3,50,311 100.0 2000 2,66,45,251 129.6 1,25,50,440 129.2 4,06,287 115.9 2001 3,19,80,696 155.5 1,58,83,495 163.5 5,04,020 143.9 2002 3,72,99,877 181.4 1,77,26,607 182.5 5,53,525 150.0 2003 4,08,45,783 198.7 1,95,99,764 201.8 6,37,634 182.0 2004 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%.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

18 Financial Management

Exercise 3 Common size balance sheet of Tamilnadu Mercantile Bank Ltd., as on 31st March 2003 and 2004.

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

Fixed Assets Investments 2,14,21,060 45.37 2,35,37,098 46.25 Advances 1,95,99,764 41.51 2,11,39,869 41.54 Fixed Assets 4,93,996 1.05 5,36,442 1.05 Other Assets 18,58,064 3.94 18,35,883 3.61 Total Fixed Assets 4,33,72,884 91.86 4,70,49,292 94.44 Current Assets Cash and Balance with RBI 27,06,808 5.73 22,37,601 4.40 Balance with banks and money at call and short notice 11,36,781 2.41 16,07,975 3.20 Total Current Assets 38,43,589 8.14 38,45,576 7.60 Total Assets 4,72,16,473 100.00 5,08,94,868 100.00 Fixed Liabilities Capital 2,845 0.01 2,845 0.01 Reserve and Surplus 39,66,009 8.40 47,65,406 9.36 Deposits 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 95.91 Current Liability Borrowings 7,27,671 1.54 2,84,690 0.56 Other Liabilities Provisions 16,74,165 3.55 17,99,197 3.53 Total 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 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”.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Financial Statement Analysis 19

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 Statement

1. 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 cash balanced mobilized and used. between two balance sheet dates.

4. Funds flow statement indicates the results of 4. Cash flow statement indicates the factors current 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 2005

Share Capital 1,00,000 1,10,000 Land and Building 60,000 60,000 Profit and Loss a/c 20,000 23,000 Plant and Machinery 35,000 45,000 Loans — 10,000 Stock 20,000 25,000 Creditors 15,000 18,000 Debtors 18,000 28,000 Bills payable 5,000 4,000 Bills receivable 2,000 1,000

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

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

20 Financial Management

Solution

Schedule of Changes in Working Capital

Particulars 2004 2005 Incharge Decharge Rs. Rs. Rs. Rs.

Current Assets Stock 20,000 25,000 5,000 — Debtors 18,000 28,000 10,000 — Bills Receivable 2,000 1,000 — 1,000 Cash 5,000 6,000 1,000

A 45,000 60,000

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

B 20,000 22,000 17,000 4,000 A-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 10,000 Loan 10,000 Increase in Working Capital 13,000 Funds 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 10,000 Issued Share Capital 10,000 Increase Current Assets Loan 10,000 Stock Cash Opening Profit 3,000 Decrease in Bills Payable 5,000 Decrease in Bills 1,000 Balance c/d 10,000 Receivable 3,000 1,000 Increase in Creditors 6,000

32,000 32,000

RATIO ANALYSIS Ratio 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

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Financial Statement Analysis 21

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 Ratio = Current Assets Current Liability 2 : 1

2. Quick Ratio = Quick Assets

Quick / Current 1 : 1 Liability

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 Ratio Costof Sales

Average Inventory

2. Debtors Turnover Ratio Credit Sales

Average Debtors

3. Creditors Turnover Ratio Credit Purchase AverageCredit

4. Working Capital Turnover Ratio Sales

Net WorkingCapital

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

22 Financial Management

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 Ratio External Equity Internal Equity

2. Proprietary Ratio Shareholder / Shareholder ' s Fund

Total Assets

3. Interest Coverage Ratio EBIT

Fixed 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

100 Net Sales

2. Net Profit Ratio × Net Profit after tax

100 Net Sales

3. Operating Profit Ratio × Operating Net Profit

100 Sales

4. Return in Investment × Net Profit after tax

100 Shareholder 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 26,000 7% Preference Share Capital 2,000 depreciation Rs. 10,000) Reserves and Surplus 8,000 Current Assets: 6% Mortgage Debentures 14,000 Cash 1,000 Current Liabilities: Investments (10%) 3,000

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

Tax Provision 2,600 40,000 40,000

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Financial Statement Analysis 23

Other information:

1. Net sales Rs. 60,000 2. Cost of goods sold Rs. 51,600 3. Net income before tax Rs. 4,000 4. Net income after tax Rs. 2,000

Calculate appropriate ratios.

Solution

Short-term solvency ratios

Current Ratio = = = Current Assets 14,000

2.33 : 1 Current Liability 6,000

Liquid Ratio = = = Liquid Ratio 8,000

1.33 : 1 Current Liability 6,000

Long-term solvency ratios

Proprietary ratio = ′

= = Proprietor s funds 20,000

0.5 : 1 Total Assets 40,000

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 = = = External equities 20,000

1 : 1 Internal equities 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

Activity Ratio

Stock Turnover Ratio = Cost of Sales 51,600

= =8.6 times Average Inventory 6,000

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

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

24 Financial Management

Debtors Turnover Ratio = Credit Sales 60,000

= =10 times Average Debtors 6,000

In 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

36 times Average Creditors 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

7.5times Net Working Capital 8,000

Profitability Ratios

Gross profit ratio = × × Gross Profit 8,400

100= 100=14% Sales 60,000

Net profit ratio = × × Net Profit 2,000

100= 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 2,000 100= 100=10%

Shareholder s Fund 20,000

MODEL QUESTIONS

1. What is financial statement? 2. What is financial statement analysis? 3. Discuss various types of financial statement analysis. 4. Explain various methods of financial statement analysis. 5. What are the differences between fund flow and cash flow? 6. What is ratio analysis? Explain its types.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

INTRODUCTION Finance 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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

26 Financial Management

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:

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Sources of Financing 27

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

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

28 Financial Management

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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Sources of Financing 29

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 = 1,000 Paid up value of shares 900 Unpaid 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 for

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

30 Financial Management

profit, 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 (K

e )

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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Sources of Financing 31

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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

32 Financial Management

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.

Value of no. per share = The real net worth Total no.of shares

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Sources of Financing 33

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 4. Zero Coupon Bond 5. Zero Interest Bond/Debenture

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

34 Financial Management

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.

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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Sources of Financing 35

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.

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

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

36 Financial Management

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.

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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Sources of Financing 37

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

Direct Finance

Indirect Finance

Domestic Finance

Foreign Currency Finance

Short-term Advance

Long-term Loans

Fig. 3.1 Loan Financing

Financial Institutions With the effect of the industrial revaluation, the government established nation wide and state 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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

38 Financial Management

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. 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.

MODEL QUESTIONS

1. Explain the various sources of financing.

2. What is meant by security financing?

3. What is debt financing?

4. Critically examine the advantages and disadvantages of equity shares.

5. Discuss the features of equity shares.

6. What are the merits of the deferred shares?

7. Explain the merits and demerits of preference shares?

8. List out the types of debentures.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Sources of Financing 39

9. Evaluate the overall view of debentures.

10. How internal sources of finance is used in the industrial concern?

11. What is retained earnings?

12. Evaluate the advantages and disadvantages of retained earnings.

13. How does depreciation funds help the industrial concern as sources of finance?

14. Evaluate the overall structure of the loan financing?

15. Explain the Commercial Bank financing?

16. Enumerate the major development banks.

17. Explain the role of UTI and LIC in industrial financing?

18. What is cash credit?

19. Mention the functions of IFCI.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

This page intentionally left

blank

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

INTRODUCTION 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 CAPITAL The 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 Capital Fixed 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 Capital According to the definition of Hoagland, “Fixed capital is comparatively easily defined to include land, building, machinery and other assets having a relatively permanent existence”.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

42 Financial Management

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

CAPITALIZATION Capitalization 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 Capitalization Capitalization 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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Capitalization 43

Definition of Capitalization Capitalization 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”.

“Capitalization is the balance sheet value of stocks and bonds outstands”. — Bonneville and Dewey

According to Arhur. S. Dewing, “capitalization is the sum total of the par value of all shares”.

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

• Over Capitalization • Under Capitalization • Water Capitalization

Over Capitalization Over capitalization refers to the company which possesses an excess of capital in relation to its activity level and requirements. In simple means, over capitalization is more capital than actually required and the funds are not properly used.

According to Bonneville, Dewey and Kelly, over capitalization means, “when a business is unable to earn fair rate on its outstanding securities”.

Example

A company is earning a sum of Rs. 50,000 and the rate of return expected is 10%. This company will be said to be properly capitalized. Suppose the capital investment of the company is Rs. 60,000, it will be over capitalization to the extent of Rs. 1,00,000. The new rate of earning would be:

50,000/60,000×100=8.33% When the company has over capitalization, the rate of earnings will be reduced from

10% to 8.33%.

Causes of Over Capitalization Over capitalization arise due to the following important causes:

• Over issue of capital by the company. • Borrowing large amount of capital at a higher rate of interest. • Providing inadequate depreciation to the fixed assets.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

44 Financial Management

• Excessive payment for acquisition of goodwill. • High rate of taxation. • Under estimation of capitalization rate.

Effects of Over Capitalization Over capitalization leads to the following important effects:

• Reduce the rate of earning capacity of the shares. • Difficulties in obtaining necessary capital to the business concern. • It leads to fall in the market price of the shares. • It creates problems on re-organization. • It leads under or misutilisation of available resources.

Remedies for Over Capitalization Over capitalization can be reduced with the help of effective management and systematic design of the capital structure. The following are the major steps to reduce over capitalization.

• Efficient management can reduce over capitalization. • Redemption of preference share capital which consists of high rate of dividend. • Reorganization of equity share capital. • Reduction of debt capital.

Under Capitalization Under capitalization is the opposite concept of over capitalization and it will occur when the company’s actual capitalization is lower than the capitalization as warranted by its earning capacity. Under capitalization is not the so called inadequate capital.

Under capitalization can be defined by Gerstenberg, “a corporation may be under capitalized when the rate of profit is exceptionally high in the same industry”.

Hoagland defined under capitalization as “an excess of true assets value over the aggregate of stocks and bonds outstanding”.

Causes of Under Capitalization

Under capitalization arises due to the following important causes: • Under estimation of capital requirements. • Under estimation of initial and future earnings. • Maintaining high standards of efficiency. • Conservative dividend policy. • Desire of control and trading on equity.

Effects of Under Capitalization Under Capitalization leads certain effects in the company and its shareholders.

• It leads to manipulate the market value of shares. • It increases the marketability of the shares.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Capitalization 45

• It may lead to more government control and higher taxation. • Consumers feel that they are exploited by the company. • It leads to high competition.

Remedies of Under Capitalization Under Capitalization may be corrected by taking the following remedial measures:

1. Under capitalization can be compensated with the help of fresh issue of shares. 2. Increasing the par value of share may help to reduce under capitalization. 3. Under capitalization may be corrected by the issue of bonus shares to the existing

shareholders. 4. Reducing the dividend per share by way of splitting up of shares.

Watered Capitalization If the stock or capital of the company is not mentioned by assets of equivalent value, it is called as watered stock. In simple words, watered capital means that the realizable value of assets of the company is less than its book value.

According to Hoagland’s definition, “A stock is said to be watered when its true value is less than its book value.”

Causes of Watered Capital Generally watered capital arises at the time of incorporation of a company but it also arises during the life time of the business. The following are the main causes of watered capital:

1. Acquiring the assets of the company at high price. 2. Adopting ineffective depreciation policy. 3. Worthless intangible assets are purchased at higher price.

MODEL QUESTIONS

1. What is capital and define the capital? 2. Explain the types of capital. 3. What is capitalization? 4. What are the kinds of capitalization? 5. Explain the effects of under capitalization. 6. Discuss the causes of over capitalization.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

This page intentionally left

blank

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

INTRODUCTION 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.

Meaning of Capital Structure Capital 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 Structure The 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”.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

48 Financial Management

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

FINANCIAL STRUCTURE The 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 Or

Financial Structure = Capital Structure + Current liabilities. The following points indicate the difference between the financial structure and capital

structure.

Financial Structures Capital Structures 1. 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 Assets Equity share capital 50,000 Fixed assets 25,000 Preference share capital 5,000 Good will 10,000 Debentures 6,000 Stock 15,000 Retained earnings 4,000 Bills receivable 5,000 Bills payable 2,000 Debtors 5,000 Creditors 3,000 Cash and bank 10,000

70,000 70,000

(i) Calculation of Capitalization

S. No. Sources Amount 1. Equity share capital 50,000 2. Preference share capital 5,000 3. Debentures 6,000

Capitalization 61,000

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Capital Structure 49

(ii) Calculation of Capital Structures

S. No. Sources Amount Proportion 1. Equity share capital 50,000 76.92 2. Preference share capital 5,000 7.69 3. Debentures 6,000 9.23 4. Retained earnings 4,000 6.16

65,000 100%

(iii) Calculation of Financial Structure

S. No. Sources Amount Proportion

1. Equity share capital 50,000 71.42 2. Preference share capital 5,000 7.14 3. Debentures 6,000 8.58 4 . Retained earnings 4,000 5.72 5. Bills payable 2,000 2.85 6. 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 Structure

Decision 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 Structure

Capital 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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

50 Financial Management

FACTORS DETERMINING CAPITAL STRUCTURE

The following factors are considered while deciding the capital structure of the firm.

Leverage

It 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 Capital Cost 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.

(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 policy Promoter 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.

CAPITAL STRUCTURE THEORIES

Capital 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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Capital Structure 51

C a p ita l S tr u c tu r e T h eo r ies

M o d e r n A p p ro a c h T ra d itio n a l A p p ro a c h

N e t In c o m e A p p r o a ch

N e t O p e ra tin g In co m e A p p r o a ch

M o d ig li a n i-M il le r A p p r o a ch

Fig. 5.1 Capital Structure Theories

Traditional Approach 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 K

o 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 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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

52 Financial Management

–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 5,00,000 24,000 1,00,000 2,25,000 4,76,000 4,00,000 2,75,000 2,38,000 2,00,000 1,37,500 2,38,000 2,00,000 1,37,500 27,00,000 20,00,000 15,00,000 250 250 200 10800 8,000 7,500 2,38,000 2,00,000 1,37,500 No. 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. 1,00,000 Total investment Rs. 5,00,000 Equity 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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Capital Structure 53

Particulars (a) No Debt (b) Rs. 2,50,000 (c) Rs. 4,00,000 6% debentures 7% debentures

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

Market value of shares × 10

10,000 100

× 100

85,000 11

× 100

72,000 13

Rs. 10,00,000/- Rs.772727/- Rs.553846/- Market Value of firm 10,00,000 10,22,727 9,53,846

1,00,000 1,00,000 1,00,000

Average cost of capital × 1,00,000

100 10,00,000

× 1 00 000

100 10 22 727

, , , ,

× 1 00 000

100 9 53 846 , , , ,

Earnings Value of the firm

EBIT V

=10% =9.78% =10.48%

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.

Net Income (NI) 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.

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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

54 Financial Management

where V = S+B V = Value of firm S = Market value of equity B = Market value of debt

Market value of the equity can be ascertained by the following formula:

S = e

NI K

where NI = Earnings available to equity shareholder K

e = Cost of equity/equity capitalization rate

Format for calculating value of the firm on the basis of NI approach.

Particulars Amount Net operating income (EBIT) XXX Less: interest on debenture (i) XXX Earnings available to equity holder (NI) XXX Equity capitalization rate (Ke) XXX Market 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. Net income 1,00,000 Less: Interest on 8% Debentures of Rs. 2,50,000 20,000 Earnings available to equality shareholders 80,000 Equity capitalization rate 10%

= × 80, 000

100 10

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Capital Structure 55

Market value of equity = 8,00,000 Market value of debentures = 2,50,000

Value of the firm = 10,50,000

Calculation of overall capitalization rate

Overall cost of capital (K o ) =

Earnings Value of the firm

EBIT

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

10%

Market value of equity = 68,000 × 100 10

= 6,80,000

= 6,80,000 Market value of Debentures = 4,00,000 Value of firm = 10,80,000

Overall cost of capital = 1,00,000

10,80,000 ×10

= 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 (NOI) Approach Another modern theory of capital structure, suggested by Durand. This is just the opposite to the Net Income approach. According to this approach, Capital Structure decision is irrelevant to the valuation of the firm. The market value of the firm is not at all affected by the capital structure changes.

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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

56 Financial Management

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 formula

V = o

EBIT K

Where, V = Value of the firm

EBIT = Earnings before interest and tax K

o = 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)

= o

EBIT K

= 2,00,000× 100 10

= Rs. 20,00,000

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%

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Capital Structure 57

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%. (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) Overall cost of capital(OK)

= 2,00,000×100/10 = Rs. 20,00,000

Market value of firm = Rs. 20,00,000 Less Market value of debentures = Rs. 8,00,000 Total 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%

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

58 Financial Management

where I = Interest of debt V = Value of the firm D = Value of debt capital I = 8,00,000×7%=56,000 V = 20,00,000 D = 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

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:

− o

EBIT ( l t )

K

Where EBIT = Earnings before interest and tax K

o = Overall cost of capital

t = Tax rate

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Capital Structure 59

K e

K o

k

D /E

R is k D u e D e b t R is k B e a rin g D e b t

R a

te o

f R

e tu

rn

Fig. 5.2 Modigliani and Miller Approach

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= o

EBIT K

= 75,000 10 /100

=75,000×100/10

= Rs. 7,50,000 The market value of firm B which uses debt financing of Rs. 2,50,000

Vt = Vu + t Vu = 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:

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

60 Financial Management

Company ‘X’ Company ‘Y’ Number of ordinary shares 75,000 1,25,000 5% debentures 40,000 – Market price per shares Rs. 1.25 Rs. 1.00 Profit 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’. 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 25,000 Less: Interest on Debentures 5% 2,000 Profit after Interest 23,000 Share of the investor = 10% of Rs. 23,000 i.e., Rs. 2300 Income of the investor after switching holding to company Profit before Interest of the company Rs. 25,000 Less Interest —— Profit after Interest 25,000

Share of the investor : 25,000× 13,375

1,25,000 = Rs. 2,675

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

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Capital Structure 61

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

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

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

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

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

62 Financial Management

Exercise 9 The 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 1,50,000 Market price/share (Rs.) 1.2 1.0 6% debentures 60,000 – 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 1,800 Less: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%, Ke = 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, P

o ? (CS Final Dec. 1998)

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Capital Structure 63

Solution (a) EBIT 40,00,000

interest @ 10% 2,00,000

38,00,000

Tax @ 35% 13,30,000 24,70,000

No. of shares 6,00,000

EPS (or Dividend) Rs. 4.12 Ke (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 40,00,000

Interest @ 12% on Rs. 1 crore 12,00,000 28,00,000

Tax @ 35% 9,80,000

18,20,000 No. of equity shares 3,08,774

EPS Rs. 5.89 Ke 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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

64 Financial Management

MODEL QUESTIONS

1. Define capital structure. 2. Differentiate the capital structure and financial structure. 3. What is optimum capital structure? 4. Discuss the various factors affecting the capital structure. 5. Explain the capital structure theories. 6. XYZ Ltd., expects a net income of Rs. 1,50,000. The company has 10% of

5,00,000 Debentures. The equity capitalization rate of the company is 10%. (a) Calculate the value of the firm and overall capitalization rate according to

the net income approach (ignoring income tax). (b) If the debenture debt is increased to Rs. 7,50,000 and interest of debt is change

to 9%. What is the value of the firm and overall capitalization rate? (Ans. (a) Rs. 15,00,000, 10% (b) Rs. 15,75,000 and 9.52%)

7. A Company Ltd., projected net operating income of Rs. 75,000. It has Rs. 3,00,000, 8% debentures. (a) Calculate the value of the firm according to 10 net opening income and overall

capitalization rate is 10%. (b) If debenture debt is increased to Rs. 5,00,000. What is the value of the firm

and the equity capitalization rate? (Ans. (a) Rs. 7,50,000, (b) 11.33%, 14%) 8. According to Traditional approach, compute the market value of the firm, value

of shares and the average cost of capital from the following information: Net Operating Income 1,00,000 Total Investment 7,00,000 Equity capitalization Rate: (a) if the firms uses no debt 7%. (b) if the firm uses Rs. 2,00,000 debentures 8% (c) if the firm uses Rs. 4,00,000 debentures 9% Assume that Rs 2,00,000 debentures at 6% rate of interest whereas Rs. 4,00,000 debentures at 6% rate of interest whereas Rs. 4,00,000 debentures at 7% rate of interest. (Ans. 7%, 7.69%, 8.33)

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

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.

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

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”.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

66 Financial Management

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”.

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 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;

CIo = = + ∑

n t

t t 1

CO (t C)

Where, CIo = initial cash inflow

C = outflow in the period concerned

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Cost of Captial 67

N = 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.

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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

68 Financial Management

Importance to Evolution of Financial Performance 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.

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:

e p

D K =

N

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Cost of Captial 69

Where, Ke = Cost of equity capital D = Dividend per equity share Np = 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

Ke = p

D N

= 25

100 × 100

= 22.72% If the market price of a equity share is Rs. 175.

=e p

D K

N

= 25

175 × 100

= 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:

= +e p

D K g

N

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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

70 Financial Management

(b) If the current market price of an equity share is Rs. 120. Calculate the cost of existing equity share capital

Solution

(a) Ke= p

D N

+g

= −

12 100 4

+5=17.5%

(b) Ke= p

D N

+ g

= 12

120 +5%=15%

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%.

Ke = p

D N

+ 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.

=e p

E K

N

Where, Ke = Cost of equity capital E = Earning per share Np = Net proceeds of an equity share

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Cost of Captial 71

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 = p

E N

Earnings Per Share(EPS) = 100 lakhs 10 lakhs

= Rs.10

Ke = 10

100 × 10

= 10% Cost of Equity Capital

Ke = P

E N

= −

10 92 2

× 100

= 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.

=eK PV ×Df

Where, Ke = Cost of equity capital. PVƒ = Present value of discount factor. D = Dividend per share.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

72 Financial Management

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 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.

Kd = p

I N (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 = p

I N

(1–t)

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Cost of Captial 73

= 8,000

1,00,000 × (1 – 0.5)

= 8,000

1,00,000 × 0.5

= 4%

Kda = p

I N

(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 = p

I N

(1 – t)

= 8,000

95,000 × (1 – t)

= 3.37%

(d) Kda = p

I N

(1 – t), Np= Rs. (10,00,000 + 1,00,000) × 2

100

= 90,000

10,78,000 ×(1 – 0.5)

= 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 = p

p

I 1 / n( P N )n

1 / n(P N ) / 2

+ − +

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.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

74 Financial Management

Cost of debt after tax can be calculated with the help of the following formula:

d da bK = K × (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 = = −

+ p

p

I 1/n (P N )

1 2(P N )

= + +

+ 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

= 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:

p p

p

D K

N =

Where, Kp = Cost of preference share Dp = Fixed preference dividend Np = Net proceeds of an equity share

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Cost of Captial 75

Cost of irredeemable preference share is calculated with the help of the following formula:

p p p

p

D ( P N )/n K

( P N )/2

+ − =

+

Where, Kp = Cost of preference share

Dp = Fixed preference share P = Par value of debt

Np = 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 = p

p

D N

(a) Kp = −

1,60,000 20,00,000 40,000

×100

= 8.16%

(b) Kp = 1,60,000

20,00,000 2,00,000 40,000+ − × 100

= 7.40%

I Kp = 1,60,000

20,00,000 1,20,000 40,000− − ×100

= 1,60,000

18, 40,000 ×100

= 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.

p p p

p

D ( P N ) /n K

( P N ) /2

+ − =

+

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

76 Financial Management

= + −

+ 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

p p p

p

D ( P N )/n K

( P N )/2

+ − =

+

= 1,60,000 1/8 (20,00,000 20,60,000)

1/2 (20,00,000 20,60,000) + −

+

= 1,60,000 – 7,500

20,30,000

= 7.51% where Dp = 20,000×100×8%=1,60,000

P = 20,00,000 n = 8 years

Np = 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:

r eK =K (1 – t) (1 – b)

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Cost of Captial 77

Where, Kr = Cost of retained earnings Ke = Cost of equity

t = 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)

Where, Ke = rate of return available to shareholders

t = tax rate b = brokerage cost

So, 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 equity Kr = Cost of retained earnings Wd= Percentage of debt of total capital

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

78 Financial Management

Wp = Percentage of preference share to total capital We = Percentage of equity to total capital Wr = Percentage of retained earnings Weighted average cost of capital is calculated in the following formula also:

w XW

K W

Σ Σ

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 cost Rs. % %

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 8 Equity 6,00,000 9,00,000 15 Retained Earnings 2,00,000 3,00,000 13

————— ————— 13,00,000 16,90,000 ————— —————

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Cost of Captial 79

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? (MBA – P.U. Nov. 2005)

Solution

Computation of Weighted Average Cost of Capital

A. Book Value Source of Funds Amount Cost % (X) Weighted Cost

Proportion X Cost (XW) Debt 4,00,000 5 20,000 Preference Shares 1,00,000 8 8,000 Equity Shares 6,00,000 15 90,000 Retained Earnings 2,00,000 13 26,000

ΣW = 13,00,000 ΣXW = 1,44,000

Kw = Σ Σ XW W

Kw = 1, 44,000 13,00,000

× 100 = 11.1%

Computation Weighted Average Cost of Capital

B. Market Value Source of Funds Amount Cost % (X) Weighted Cost

Proportion X Cost (XW) Debt 3,80,000 5 19,000 Preference Shares 1,10,000 8 8,800 Equity Shares 9,00,000 15 13,500 Retained Earnings 3,00,000 13 39,000

ΣW = 16,90,000 ΣXW = 2,01,800

Σ =

Σw XW

K W

Kw = 2,01,800

16,90,000 × 100 = 11.9%

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

80 Financial Management

Exercise 13 ABC Ltd. has the following capital structure.

Rs. Equity (expected dividend 12%) 10,00,000 10% preference 5,00,000 8% 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 Cost Equity 10,00,000 12% 33.33% 3.99 Preference 5,00,000 10% 16.67 1.67 8% Loan 15,00,000 4% 50.00 2.00

7.66%

Weight average cost of capital = 7.66%

MODEL QUESTIONS

1. What is cost of capital? 2. Define cost of capital. 3. Cost of capital computation based on certain assumptions. Discuss. 4. Explain the classification of cost. 5. Mention the importance of cost of capital. 6. Explain the computation of specific sources of cost of capital. 7. How over all cost of capital is calculated? 8. Explain various approaches for calculation of cost of equity. 9. Rama company issues 120000 10% debentures of Rs. 10 each at a premium of

10%. The costs of floatation are 4%. The rate of tax applicable to the company is 55%. Complete the cost of debt capital. (Ans. 4.26%)

10. Siva Ltd., issues 8000 8% debentures for Rs. 100 each at a discount of 5%. The commission payable to underwriters and brokers is Rs. 40000. The debentures are redeemable after 5 years. Compute the after tax cost of debt assuming a tax rate of 60%. (Ans. 3.69%)

11. Bharathi Ltd., issues 4000 12% preference shares of Rs. 100 each at a discount of 5%. Costs of raising capital are Rs. 8000. Compute the cost of preference capital. (Ans. 12.90%)

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Cost of Captial 81

12. Firm pays tax at 60%. Compute the after tax cost of capital of a preferred share sold at Rs. 100 with a 8%. Dividend and a redemption price of Rs.110, if the company redeems in five years. (Ans. 9.52%)

13. Your company share is quoted in the market at Rs. 40 currently. The company pays a dividend of Rs. 5 per share and the investors market expects a growth rate of 7.5% per year: (i) Compute the company’s equity cost of capital.

(ii) If the anticipated growth rate is 10% p.a. Calculate the indicated market price per share.

(iii) If the company’s cost of capital is 15% and the anticipated growth rate is 10% p.a. Calculate the indicated market price if the dividend of Rs. 5 per share is to be maintained. (Ans. (i) 20%, (ii) 1/10%, (iii) 1/5%)

14. Mr. Subramanian is a shareholder in Alpha Company Ltd. Although earnings for the Alpha company have varied considerably, Subramanian has determined that long turn average dividends for the firm have been Rs. 5 per share. He expects a similar pattern to prevail in the future. Given the volatility of the Alpha’s minimum rate of 40%, should it be earned on a share, what price would Subramanian be willing to pay for the Alpha is shares? (Ans. Rs. 12.50%)

15. A Beta Ltd., iron steel reserves are being depleted and its costs of recovering a declining quantity of iron steel are rising each year. As a equal to it the company earnings and dividends are declining at a rate of 12% p.a. If the previous year’s dividend (DO) was Rs. 40 and the required rate of return is 15%. What would be the current price of the equity share of the company? (Ans. Rs. 95.14)

16. The following items have been extracted from the liabilities side of the balance sheet of Vivekananda company as on 31st December 2004.

Paid up capital Rs. 2500 Equity shares of Rs. 100 each 250000 Reserve and Surplus 350000 Loans: 10% Debentures 100000 12% Institutional Loans 300000

Other information about the company as relevant is given below:

Year ended Dividend Earnings Average Market Price Per share Per share Per share 31st Dec. (Rs.) (Rs.) (Rs.) 2004 7.00 11.00 80.00 2003 6.00 10.00 60.00 2002 7.00 8.00 50.00

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

82 Financial Management

You are required to calculate the weighted average cost of capital, using book values as weights and earnings/price (E/P) ratio as the basis of cost of equity. Assume 50% tax rate.

(Ans. Weighted average cost of capital=10.55%) 17. The following is an extract from the financial statements of Ramakrishna Ltd.

(Rs. Lakhs) Operating Profit 90 Less: Interest on Debentures 24

66 Less: Income Tax (50%) 33 Net Profit 33 Equity share capital (share of Rs. 10) 150 Reserve and Surplus 75 10% Debentures 150

375

The market price per equity share is 11 and per debenture Rs. 95. (i) What is the earning per share?

(ii) What is the percentage cost of capital to the company for the equity and debentures funds? (Ans. (i) Rs. 2.20, (ii) 20%)

(iii) Cost of debenture funds Book Value = 5% Market Price = 5.26%

18. Raj Ltd. is currently earning Rs. 2,00,000 and its share is selling at a market price of Rs. 160. The firm has 20,000 shares outstanding and has no debt. The earnings of the firm are expected to remain stable, and it has a payout ratio of 100%. What is the cost of equity? If the firms earns 15% rate of return on its investment opportunities then what would be the firm’s cost of equity if the payout ratio is 60%?

(Ans. (i) When the payout ratio is 100%, 12.5% (ii) When the payout ratio is 60%, 13.5%)

19. Kumar Industries Ltd. has assets of Rs. 80000 which have been financed with Rs. 26,000 of debt and Rs. 45,000 of equity and a general reserve of Rs. 9,000 The firm’s total profit after interest and taxes for the year ended 31st March 2,000 were Rs. 6,750. It pays 10% interest on borrowed funds and is in the 60% tax bracket. It has 450 equity shares of Rs. 100 each selling at a market price of Rs. 120 per share. What is the weighted average cost of capital?

(i) EPS Rs. 15 (ii) Cost of equity 12.5%

(iii) Average cost of capital 9.74.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

INTRODUCTION Financial decision is one of the integral and important parts of financial management in any kind of business concern. A sound financial decision must consider the board coverage of the financial mix (Capital Structure), total amount of capital (capitalization) and cost of capital (K

o ). Capital structure is one of the significant things for the management, since it

influences the debt equity mix of the business concern, which affects the shareholder’s return and risk. Hence, deciding the debt-equity mix plays a major role in the part of the value of the company and market value of the shares. The debt equity mix of the company can be examined with the help of leverage.

The concept of leverage is discussed in this part. Types and effects of leverage is discussed in the part of EBIT and EPS.

Meaning of Leverage

The term leverage refers to an increased means of accomplishing some purpose. Leverage is used to lifting heavy objects, which may not be otherwise possible. In the financial point of view, leverage refers to furnish the ability to use fixed cost assets or funds to increase the return to its shareholders.

Definition of Leverage

James Horne has defined leverage as, “the employment of an asset or fund for which the firm pays a fixed cost or fixed return.

Types of Leverage

Leverage can be classified into three major headings according to the nature of the finance mix of the company.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

84 Financial Management

Leverage

Finacial Leverage

Operating Leverage

Composite Leverage

Fig. 7.1 Types of Leverage

The company may use finance or leverage or operating leverage, to increase the EBIT and EPS.

OPERATING LEVERAGE The leverage associated with investment activities is called as operating leverage. It is caused due to fixed operating expenses in the company. Operating leverage may be defined as the company’s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. Operating leverage consists of two important costs viz., fixed cost and variable cost. When the company is said to have a high degree of operating leverage if it employs a great amount of fixed cost and smaller amount of variable cost. Thus, the degree of operating leverage depends upon the amount of various cost structure. Operating leverage can be determined with the help of a break even analysis.

Operating leverage can be calculated with the help of the following formula:

OL = C

OP

Where, OL = Operating Leverage

C = Contribution OP = Operating Profits

Degree of Operating Leverage The degree of operating leverage may be defined as percentage change in the profits resulting from a percentage change in the sales. It can be calculated with the help of the following formula:

DOL = Percentage change in profits Percentage change in sales

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Leverage 85

Exercise 1 From the following selected operating data, determine the degree of operating leverage.

Which company has the greater amount of business risk? Why?

Company A Company B Rs. Rs.

Sales 25,00,000 30,00,000 Fixed costs 7,50,000 15,00,000

Variable expenses as a percentage of sales are 50% for company A and 25% for company B.

Solution

Statement of Profit

Company A Company B Rs. Rs.

Sales 25,00,000 30,00,000 Variable cost 12,50,000 7,50,000 Contribution 12,50,000 22,50,000 Fixed cost 7,50,000 15,00,000 Operating Profit 5,00,000 7,50,000

Operating Leverage = Contribution

Operating Profit

“A” Company Leverage = 12,50,000 5,00,000 = 2.5

“B” Company Leverage = 2,25,000 7,50,000 = 3

Comments Operating leverage for B Company is higher than that of A Company; B Company has a higher degree of operating risk. The tendency of operating profit may vary portionately with sales, is higher for B Company as compared to A Company.

Uses of Operating Leverage Operating leverage is one of the techniques to measure the impact of changes in sales which lead for change in the profits of the company.

If any change in the sales, it will lead to corresponding changes in profit. Operating leverage helps to identify the position of fixed cost and variable cost.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

86 Financial Management

Operating leverage measures the relationship between the sales and revenue of the company during a particular period.

Operating leverage helps to understand the level of fixed cost which is invested in the operating expenses of business activities.

Operating leverage describes the over all position of the fixed operating cost.

FINANCIAL LEVERAGE Leverage activities with financing activities is called financial leverage. Financial leverage represents the relationship between the company’s earnings before interest and taxes (EBIT) or operating profit and the earning available to equity shareholders.

Financial leverage is defined as “the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share”. It involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders. “The use of long-term fixed interest bearing debt and preference share capital along with share capital is called financial leverage or trading on equity”.

Financial leverage may be favourable or unfavourable depends upon the use of fixed cost funds.

Favourable financial leverage occurs when the company earns more on the assets purchased with the funds, then the fixed cost of their use. Hence, it is also called as positive financial leverage.

Unfavourable financial leverage occurs when the company does not earn as much as the funds cost. Hence, it is also called as negative financial leverage.

Financial leverage can be calculated with the help of the following formula:

FL = OP

PBT

Where, FL = Financial leverage OP = Operating profit (EBIT) PBT = Profit before tax.

Degree of Financial Leverage Degree of financial leverage may be defined as the percentage change in taxable profit as a result of percentage change in earning before interest and tax (EBIT). This can be calculated by the following formula

Percentage change in taxable Income

DFL= Precentage change in EBIT

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Leverage 87

Alternative Definition of Financial Leverage According to Gitmar, “financial leverage is the ability of a firm to use fixed financial changes to magnify the effects of change in EBIT and EPS”.

FL = EBIT EPS

Where, FL = Financial Leverage EBIT = Earning Before Interest and Tax EPS = Earning Per share.

Exercise 2 A Company has the following capital structure.

Rs. Equity share capital 1,00,000 10% Prof. share capital 1,00,000 8% Debentures 1,25,000

The present EBIT is Rs. 50,000. Calculate the financial leverage assuring that the company is in 50% tax bracket.

Solution

Statement of Profit Rs. Earning Before Interest and Tax (EBIT) 50,000 (or) Operating Profit

. Interest on Debenture 1,25,000 × 8 × 100 Earning before Tax (EBT) 10,000

40,000 Income Tax 20,000

20,000

Financial leverage = Operating Profit (OP)

Profit Before Tax (PBT)

= 50,000 40,000 =1.25

Uses of Financial Leverage Financial leverage helps to examine the relationship between EBIT and EPS.

Profit

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

88 Financial Management

Financial leverage measures the percentage of change in taxable income to the percentage change in EBIT.

Financial leverage locates the correct profitable financial decision regarding capital structure of the company.

Financial leverage is one of the important devices which is used to measure the fixed cost proportion with the total capital of the company.

If the firm acquires fixed cost funds at a higher cost, then the earnings from those assets, the earning per share and return on equity capital will decrease.

The impact of financial leverage can be understood with the help of the following exercise.

Exercise 3 XYZ Ltd. decides to use two financial plans and they need Rs. 50,000 for total investment.

Particulars Plan A Plan B Debenture (interest at 10%) 40,000 10,000 Equity share (Rs. 10 each) 10,000 40,000 Total investment needed 50,000 50,000 Number of equity shares 4,000 1,000

The earnings before interest and tax are assumed at Rs. 5,000, and 12,500. The tax rate is 50%. Calculate the EPS.

Solution When EBIT is Rs. 5,000

Particulars Plan A Plan B Earnings before interest and tax (EBIT) 5,000 5,000 Less : Interest on debt (10%) 4,000 1,000 Earnings before tax (EBT) 1,000 4,000 Less : Tax at 50% 500 2,000 Earnings available to equity shareholders. Rs.500 Rs.2,000 No. of equity shares 1,000 4,000 Earnings per share (EPS) Rs. 0.50 Rs. 0.50 Earnings/No. of equity shares

When EBIT is Rs. 12,500

Particulars Plan A Plan B Earnings before interest and tax (EBIT). 12,500 12,500 Less: Interest on debt (10%) 4,000 1,000

(Contd....)

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Leverage 89

Earning before tax (EBT) 8,500 11,500 Less : Tax at 50% 4,250 5,750 Earnings available to equity shareholders 4,250 5,750 No. of equity shares 1,000 4,000 Earning per share 4.25 1.44

DISTINGUISH BETWEEN OPERATING LEVERAGE AND FINANCIAL LEVERAGE

Operating Leverage/Financial Leverage

Operating Leverage Financial Leverage 1. Operating leverage is associated with 1. Financial leverage is associated with financing

investment activities of the company. activities of the company. 2. Operating leverage consists of fixed 2. Financial leverage consists of operating profit

operating expenses of the company. of the company. 3. It represents the ability to use fixed 3. It represents the relationship between EBIT

operating cost. and EPS. 4. Operating leverage can be calculated by 4. Financial leverage can be calculated by

OL = C

OP . FL =

OP PBT

. 5. A percentage change in the profits resulting 5. A percentage change in taxable profit is the

from a percentage change in the sales is result of percentage change in EBIT. called as degree of operating leverage.

6. Trading on equity is not possible while the 6. Trading on equity is possible only when the company is operating leverage. company uses financial leverage.

7. Operating leverage depends upon fixed 7. Financial leverage depends upon the cost and variable cost. operating profits.

8. Tax rate and interest rate will not affect the 8. Financial leverage will change due to tax rate operating leverage. and interest rate.

EBIT - EPS Break even chart for three different financing alternatives

EPS DR = 70%

X1 X2

X3

EBIT

C1 C2 C3

DR = 0%

DR = 30%

Fig. 7.2 EBIT - EPS Break Even Chart

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

90 Financial Management

Where, DR= Debt Ratio

C 1 , C

2 , C

3 = Indifference Point

X 1 , X

2 , X

3 = Financial BEP

Financial BEP It is the level of EBIT which covers all fixed financing costs of the company. It is the level of EBIT at which EPS is zero.

Indifference Point It is the point at which different sets of debt ratios (percentage of debt to total capital employed in the company) gives the same EPS.

COMBINED LEVERAGE When the company uses both financial and operating leverage to magnification of any change in sales into a larger relative changes in earning per share. Combined leverage is also called as composite leverage or total leverage.

Combined leverage express the relationship between the revenue in the account of sales and the taxable income.

Combined leverage can be calculated with the help of the following formulas: CL = OL × FL

CL = C

OP ×

OP PBT

= C

PBT Where,

CL = Combined Leverage OL = Operating Leverage FL = Financial Leverage

C = Contribution OP = Operating Profit (EBIT)

PBT = Profit Before Tax

Degree of Combined Leverage The percentage change in a firm’s earning per share (EPS) results from one percent change in sales. This is also equal to the firm’s degree of operating leverage (DOL) times its degree of financial leverage (DFL) at a particular level of sales.

Degree of contributed coverage = Percentage change in EPS Percentage change in sales

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Leverage 91

Exercise 4 Kumar company has sales of Rs. 25,00,000. Variable cost of Rs. 12,50,000 and fixed

cost of Rs. 50,000 and debt of Rs. 12,50,000 at 8% rate of interest. Calculate combined leverage.

Solution

Statement of Profit

Sales 25,00,000

Less: Variable cost 15,00,000 Contribution 10,00,000

Less: Fixed cost 5,00,000

Operating Profit 5,00,000

Combined leverage =Operating leverage×Financial leverage

Calculation of financial leverage

Contribution 10,00,000 2

Operating Profit 5,00,000 = =

Calculation of financial leverage

Earning before Interest and Tax (EBIT) 5,00,000 Less: Interest on Debenture ( 8% of 12,50,000) 1,00,000 Earnings before Tax 4,00,000

Operating leverage = = Operating Profit 5,00,000

Earning Before Tax 4,00,000 =1.25

Combined leverage = 2 × 1.25 = 2.5

Exercise 5 Calculate the operating, financial and combined leverage under situations 1 and 2 and

the financial plans for X and Y respectively from the following information relating to the operating and capital structure of a company, and also find out which gives the highest and the least value ? Installed capacity is 5000 units. Annual Production and sales at 60% of installed capacity.

Selling price per unit Rs. 25 Variable cost per unit Rs. 15 Fixed cost:

Situation 1 : Rs. 10,000 Situation 2 : Rs. 12,000

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

92 Financial Management

Capital structure:

Financial Plan

X (Rs.) Y (Rs.)

Equity 25,000 50,000 Debt (cost 10%) 50,000 25,000

75,000 75,000

Solution Annual production and sales 60% of 5,000 = 3000 Unit Contribution per Unit Rs. Selling Price 25 Per Unit Variable Price 15 Per Unit

10 Per Unit

Total contribution is 3000 Units×Rs. 10=Rs. 30,000 Computation of leverage.

Financial plan

PLAN-X PLAN-Y

Situation 1 Situation 2 Situation 1 Situation 2 Contribution 30000 30000 30000 30000 Fixed cost operating profit (or) EBIT 10000 12000 10000 12000

20000 18000 20000 18000 Interest on Debts

10% of 50,000 5000 5000 2500 2500 10% of 25,000

Earnings before Tax 15000 13000 17500 15500 (i) Operating Leverage

Contribution 30000 30000 30000 30000 20000 18000 20000 18000

= 1.5 1.67 1.5 1.67 (ii) Financial Leverage

Operating Profit (op) 20000 18000 20000 18000 Profit Before Tax (PBI) 15000 13000 17500 15500 (iii) Combined leverage

OL × FL = 1.5 × 1.33 1.67 × 1.38 1.5 × 1.14 1.67 × 1.16 1.995 2.30 1.71 1.94

Highest and least value of combined leverage. Highest Value = 2.30 under situation 2 plan X. Least Value = 1.71 under situation 1 plan Y.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Leverage 93

Exercise 6 Calculate operating, financial and combined leverages under situations when fixed costs are: (i) Rs. 5,000 and

(ii) Rs. 10,000 and financial plans 1 and 2 respectively from the following information pertaining to the operating and capital structure of a textile company :

Rs. Total Assets 30,000 Total Assets turnover 2 Variable cost as percentage of sales 60

Capital structure Financial Plan 1 2

Rs. Rs. Equity 30,000 10,000 10% debentures 10,000 30,000

Solution Computation of Leverage

Financial Plan

Plan 1 2 Situation i ii i ii Sales 60,000 60,000 60,000 60,000 Less : Variable cost 36,000 36,000 36,000 36,000 Contribution 24,000 24,000 24,000 24,000 Less : Fixed cost 5,000 10,000 5,000 10,000 Operating profit (EBIT) 19,000 14,000 19,000 14,000 Less : Interest 1,000 1,000 3,000 3,000 Profit before tax (PBT) 18,000 13,000 16,000 11,000 Operating leverage 24,000 24,000 24,000 24,000 Contribution 19,000 14,000 19,000 14,000 EBIT 1.26 1.71 1.26 1.71 Financial leverage 19,000 14,000 19,000 14,000 EBIT 18,000 13,000 16,000 11,000 PBT 1.05 1.07 1.18 1.27 Combined leverage 1.32 1.83 1.49 2.17

WORKING CAPITAL LEVERAGE One of the new models of leverage is working capital leverage which is used to locate the investment in working capital or current assets in the company.

Working capital leverage measures the sensitivity of return in investment of charges in the level of current assets.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

94 Financial Management

WCL = Percentage Change in ROI Percentage Change is WC

If the earnings are not affected by the changes in current assets, the working capital leverage can be calculated with the help of the following formula.

WCL = CA

TA DCA ± Where,

CA = Current Assets TA = Total Assets

DCA = Changes in the level of Current Assets

Exercise 7 The following information is available for two companies.

X Ltd. Y Ltd.

Fixed Assets Rs. 4,00,000 1,00,000 Current Assets Rs. 10,00,000 4,00,000 Total Assets Rs. 14,00,000 14,00,000 Earning before interest and taxes Rs. 1,50,000 1,50,000

You are required to compare the sensitivity earnings of the two companies for 30% charge in the level of their current assets.

Solution

Working capital leverage = Current Assets

Total Assets DCA±

X Ltd. = 1,00,000

14,00,000 – 3,00,000

= 10,00,000 11,00,000

= 0 .90

Y Ltd. = 4,00,000

14,00,000 – 1,20,000

= 4,00,000

12,80,000 = 0.3125

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Leverage 95

Looking at the working capital leverage of the two companies, we can say that the sensitivity of earnings for charge on the level of current assets of X Ltd. is a greater than of Y Ltd.

Exercise 8 Calculate operating leverage and financial leverage under situations A, B and C and

financial plans 1, 2 and 3 respectively from the following information relating to the operating and financial leverage which give the highest value and the least value.

Installed capacity (units) 1,200 Actual production and sales (units) 800 Selling price per unit (Rs.) 15 Variable cost per unit (Rs.) 10 Fixed costs (Rs.) Situation A 1,000

Situation B 2,000 Situation C 3,000

Capital Structure Financial Plan

1 2 3

Equity Rs. 5,000 Rs. 7,500 Rs. 2,500 Debt Rs. 5,000 Rs. 2,500 Rs. 7,500

Cost of debt 12 per cent (for all plans)

(MBA – P.U. Nov. 2005)

Solution A B C

S – VC 4,000 4,000 4,000 EBIT 3,000 2,000 1,000

DOL = −S VC

EBIT 1.33 2 4

1 2 3

Situation A EBIT 3,000 3,000 3,000 Less : Interest 600 300 900

EBT 2,400 2,700 2,100 Financial Leverage 1.25 1.11 1.43

Situation B EBIT 2,000 2,000 2,000 Less : Interest 600 300 900

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

96 Financial Management

EBT 1,400 1,700 1,100 Financial Leverage 1.43 1.18 1.82

Situation C EBIT 1,000 1,000 1,000 Less : Interest 600 300 900

EBT–I 400 700 100 Financial Leverage 2.5 1.43 10

Exercise 9 ‘ XYZ’ company has a choice of the following three financial plans. You are required to

calculate the financial leverage in each case.

Plan I Plan II Plan III Equity capital Rs. 2,000 Rs. 1,000 Rs. 3,000 Debt Rs. 2,000 Rs. 3,000 Rs. 1,000 EBIT Rs. 400 Rs. 400 Rs. 400

Interest @10% per annum on debts in all cases.

Solution

Plan I Plan II Plan III Rs. Rs. Rs.

EBIT 400 400 400 Less Interest-(I) 200 300 100 EBIT–I 200 100 300 FL 2 4 1.33

MODEL QUESTIONS

1. Write a note on trading on equity. 2. What is meant by working capital leverage? 3. What is leverage? Mention different types of leverage? 4. Explain the operating leverage. 5. Discuss the concept of financial leverage. 6. How compared leverage is calculated? 7. Explain the working capital leverage.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

Leverage 97

8. What is point of indifference? 9. Distinguish the operating leverage from financial leverage.

10. Explain the uses of operating leverage. 11. From the following information find out operating, financial and combined leverages.

Sales 1,00,000 Variable Cost 60,000

Fixed Cost 20,000 Interest 10,000

(Ans. OL 2, FL 1.33, LL 2.67)

12. Arvind Ltd. is having the following informations. Calculate financial leverage opening leverage and combined leverage.

Sales 50,000 units Rs. 10 each UC Rs. 6 Per Unit

FC Rs. 1,00,000 Interest 8 of 5,00,000

(Ans. FL 1.66, OL 2, CL 3.33)

13. X Ltd. is having the following capital structure. Calculate financial leverage, operating leverage and combined leverage having two situations A and B and financial plans I and II respectively.

Capacity 1,500 units

Production 1,200 units Selling Price Rs. 25

Variable Cost Rs. 18 Fixed Cost Situation I Rs. 1,400

Situation II Rs. 2,400 Capital structure

Financial Plan A B

Equity 80,000 60,000 Debt 20,000 40,000

(Ans. OL 1.2, 1.4, 1.2, 1.4 FL 1.16, 1.2, 1.4, 1.5 CL 1.39, 1.68, 1.68, 2.1)

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

98 Financial Management

14. The following details are available for the two companies.

X Ltd. Y Ltd. Fixed Assets 4,00,000 6,00,000 Current Assets 6,00,000 4,00,000 Total Asset 10,00,000 10,00,000 Earnings Before Interest and Taxes 1,50,000 1,50,000

You are required to compare the sensibility of the two companies for a 30% changes in the level of current assets with the help of using capital leverages.

(Ans. X .73, Y 4.5)

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

INTRODUCTION The financial manager must take careful decisions on how the profit should be distributed among shareholders. It is very important and crucial part of the business concern, because these decisions are directly related with the value of the business concern and shareholder’s wealth. Like financing decision and investment decision, dividend decision is also a major part of the financial manager. When the business concerns decide dividend policy, they have to consider certain factors such as retained earnings and the nature of shareholder of the business concern.

Meaning of Dividend Dividend refers to the business concerns net profits distributed among the shareholders. It may also be termed as the part of the profit of a business concern, which is distributed among its shareholders.

According to the Institute of Chartered Accountant of India, dividend is defined as “a distribution to shareholders out of profits or reserves available for this purpose”.

TYPES OF DIVIDEND/ FORM OF DIVIDEND Dividend may be distributed among the shareholders in the form of cash or stock. Hence, Dividends are classified into:

A. Cash dividend B. Stock dividend C. Bond dividend D. Property dividend

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .

100 Financial Management

Dividend

Cash Dividend Bond Dividend Stock Dividend Property Dividend

Fig. 8.1 Types of Dividend

Cash Dividend

If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid periodically out the business concerns EAIT (Earnings after interest and tax). Cash dividends are common and popular types followed by majority of the business concerns.

Stock Dividend

Stock dividend is paid in the form of the company stock due to raising of more finance. Under this type, cash is retained by the business concern. Stock dividend may be bonus issue. This issue is given only to the existing shareholders of the business concern.

Bond Dividend

Bond dividend is also known as script dividend. If the company does not have sufficient funds to pay cash dividend, the company promises to pay the shareholder at a future specific date with the help of issue of bond or notes.

Property Dividend

Property dividends are paid in the form of some assets other than cash. It will distributed under the exceptional circumstance. This type of dividend is not published in India.

DIVIDEND DECISION

Dividend decision of the business concern is one of the crucial parts of the financial manager, because it determines the amount of profit to be distributed among shareholders and amount of profit to be treated as retained earnings for financing its long term growth. Hence, dividend decision plays very important part in the financial management.

Dividend decision consists of two important concepts which are based on the relationship between dividend decision and value of the firm.

Paramasivan, C. (2009). Financial management. New Age International Ltd. Created from apus on 2022-01-10 21:51:23.

C o p yr

ig h t ©

2 0 0 9 . N

e w

A g e I n te

rn a tio

n a l L

td . A

ll ri g h ts

r e se

rv e

d .