BUSINESS FINANCE

UNIT I
Business Finance: Introduction Meaning Concepts -Scope Function of Finance
Traditional and Modern Concepts Contents of Modern Finance Functions.
INT!"UCTI!N
In our present da# econo$#% finance is defined as t&e pro'ision of $one# at t&e ti$e
(&en it is re)uired. E'er# enterprise% (&et&er *ig% $ediu$ or s$all% needs finance to
carr# on its operations and to ac&ie'e its targets. In fact% finance is so indispensa*le toda#
t&at it is rig&tl# said to *e t&e life*lood of an enterprise.
T&e su*+ect of finance &as *een traditionall# classified into t(o classes: ,i- .u*lic
Finance and ,ii- .ri'ate Finance. .u*lic finance deals (it& t&e re)uire$ents% receipts and
dis*urse$ents of funds in t&e go'ern$ent institutions li/e states% local self-go'ern$ents
and central go'ern$ent. .ri'ate finance is concerned (it& re)uire$ents% receipts and
dis*urse$ents of funds in case of an indi'idual% a profit see/ing *usiness organisation
and a non-profit organisation. T&us% pri'ate finance can *e classified into: ,i- .ersonal
finance ,ii- Business Finance and ,iii- Finance of nonprofit organisations.
MEANIN0 !F FINANCE
T&e (ord finance (as originall# a Frenc& (ord. In t&e 12
t&
centur#% it (as adapted *#
Englis& spea/ing co$$unities to $ean 3t&e $anage$ent of $one#.4 It is t&e stud# of
&o( people allocate t&eir assets o'er ti$e under conditions of certaint# and uncertaint#.
Toda#% finance is not $erel# a (ord else &as e$erged into an acade$ic discipline of
greater significance. Finance is no( organi5ed as a *ranc& of Econo$ics. E'er#
enterprise needs finance to carr# on its operations. It is t&e life*lood of an# *usiness. T&e
o*+ecti'e of t&e *usiness could not *e ac&ie'ed (it&out finance.
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FINANCE
.UB6IC FINANCE .I7ATE FINANCE
0o'ern$ent institutions
State 0o'ern$ents
6ocal Self-0o'ern$ents
Central 0o'ern$ents
.ersonal Finance
Business Finance
Finance of Non-.rofit
!rganisations
BUSINESS FINANCE
Finance is not&ing *ut an e8c&ange of a'aila*le resources. Finance is not restricted onl#
to t&e e8c&ange and9or $anage$ent of $one#. A *arter trading s#ste$ is also a t#pe of
finance. T&us% (e can sa#% Finance is an art of $anaging 'arious a'aila*le resources li/e
$one#% assets% in'est$ents% securities% etc.
Finance is t&e science of $anaging financial resources in an opti$al pattern i.e. t&e *est
use of a'aila*le financial sources.
Finance consists of t&ree interrelated areas
1- Mone# : Capital $ar/ets% (&ic& deals (it& securities $ar/ets : financial
Institutions.
;- In'est$ents% (&ic& focuses on t&e decisions of *ot& indi'idual and institutional
In'estors as t&e# c&oose assets for t&eir in'est$ent portfolios.
<- Financial Manage$ent% or *usiness finance (&ic& in'ol'es t&e actual $anage$ent of
Fir$s.
"EFINITI!NS !F FINANCE
In 0eneral sense% =Finance is t&e $anage$ent of $one# and ot&er 'alua*les% (&ic& can
*e easil# con'erted into cas&.=
According to Entrepreneurs% =Finance is concerned (it& cas&. It is so% since% e'er#
*usiness transaction in'ol'es cas& directl# or indirectl#.=
According to Acade$icians% =Finance is t&e procure$ent ,to get% o*tain- of funds and
effecti'e ,properl# planned- utili5ation of funds. It also deals (it& profits t&at ade)uatel#
co$pensate for t&e cost and ris/s *orne *# t&e *usiness.=
Meaning of Business finance
Business finance refers to using an outside resource to &elp co'er t&e financial needs of a
*usiness. It is an acti'it# or a process% (&ic& is concerned (it& ac)uisition of funds% use
of funds and distri*ution of profits *# a *usiness fir$. T&us it deals (it& financial
planning% ac)uisition of funds% use and allocation funds and financial controls.
T&e follo(ing c&aracteristics of *usiness finance (ill $a/e its $eaning clearer
Business finance includes all t#pes of funds used in *usiness.
Business finance is needed in all t#pes of organisations large or s$all%
$anufacturing or trading.
T&e a$ount of *usiness finance differs fro$ one *usiness fir$ to anot&er
depending upon its nature and si5e. It also 'aries fro$ ti$e to ti$e.
Business finance in'ol'es esti$ation of funds. It is concerned (it& raising funds
fro$ different sources as (ell as in'est$ent of funds for different purposes.
NEE" AN" IM.!TANCE !F BUSINESS FINANCE
Business finance is re)uired for t&e esta*lis&$ent of e'er# *usiness organisation. >it&
t&e gro(t& in acti'ities% financial needs also gro(. Funds are re)uired for t&e purc&ase of
land and *uilding% $ac&iner# and ot&er fi8ed assets. Besides t&is% $one# is also needed
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BUSINESS FINANCE
to $eet da#-toda# e8penses e.g. purc&ase of ra( $aterial% pa#$ent of (ages and salaries%
electricit# *ills% telep&one *ills etc. ?ou are a(are t&at production continues in
anticipation of de$and. E8penses continue to *e incurred until t&e goods are sold and
$one# is reco'ered. Mone# is re)uired to *ridge t&e ti$e gap *et(een production and
sales. Besides producers% $a# *e necessar# to c&ange t&e office set up in order to install
co$puters. eno'ation of facilities can *e ta/en up onl# (&en ade)uate funds are
a'aila*le.
1. To $eet contingencies
Funds are al(a#s re)uired to $eet t&e ups and do(ns of *usiness and unforeseen
pro*le$s. Suppose% so$e $anufacturer anticipates s&ortage of ra( $aterials after a
period. !*'iousl# &e (ould li/e to stoc/ ra( $aterials. But &e (ill *e a*le to do so onl#
(&en $one# (ould *e a'aila*le.
2. To pro$ote sales
In t&is era of co$petition% lot of $one# is re)uired to *e spent on acti'ities for pro$oting
sales li/e ad'ertise$ent% personal selling% &o$e deli'er# of goods etc.
3. To a'ail of *usiness opportunities
Funds are also re)uired to a'ail of *usiness opportunities. Suppose a co$pan# (ants to
su*$it a tender *ut so$e $ini$u$ a$ount is re)uired to *e deposited along (it& t&e
application. In t&e case of non-a'aila*ilit# of funds it (ould not *e possi*le for t&e
co$pan# to appl#.
Financial Manage$ent
Financial $anage$ent refers to t&at part of t&e $anage$ent acti'it# (&ic& is concerned
(it& t&e planning and controlling of fir$@s financial resources% it deal (it& finding out
'arious sources for raising funds for t&e fir$. T&e sources $ust *e suita*le and
econo$ical for t&e needs of *usiness. T&e $ost appropriate use of suc& funds also for$s
a part of financial $anage$ent.
E7!6UTI!N !F FINANCIA6 MANA0EMENT
Financial $anage$ent e$erged as a distinct field of stud# at t&e turn of t&is centur#. Its
e'olution $a# *e di'ided into t&ree *road p&ases ,t&oug& t&e de$arcating lines *et(een
t&ese p&ases are so$e(&at ar*itrar#-: t&e traditional p&ase% t&e transitional p&ase% and t&e
$odern p&ase. T&e traditional p&ase lasted for a*out four decades. T&e follo(ing (ere its
i$portant features
1. T&e focus of financial $anage$ent (as $ainl# on certain episodic e'ents li/e
for$ation% issuance of capital% $a+or e8pansion% $erger% reorgani5ation% and li)uidation
in t&e life c#cle of t&e fir$.
;. T&e approac& (as $ainl# descripti'e and institutional. T&e instru$ents of financing%
t&e institutions and procedures used in capital $ar/ets% and t&e legal aspects of financial
e'ents for$ed t&e core of financial $anage$ent.
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BUSINESS FINANCE
<. T&e outsider@s point of 'ie( (as do$inant. Financial $anage$ent (as 'ie(ed $ainl#
fro$ t&e point of t&e in'est$ent *an/ers% lenders% and ot&er outside interests. T&e
transitional p&ase *egins around t&e earl# forties and continues t&roug& t&e earl# fifties.
T&oug& t&e nature of financial $g$t during t&is p&ase (as si$ilar to t&at of t&e
traditional p&ase% greater e$p&asis (as placed on t&e da# to da# pro*le$ faced *# t&e
finance $anagers in t&e area of funds anal#sis% planning% and control. T&ese pro*le$s
&o(e'er (ere discussed (it&in li$ited anal#tical fra$e(or/. T&e $odern p&ase *egin in
$id AB@s and &as (itnessed an accelerated pace of de'elop$ent (it& t&e infusion of ideas
fro$ econo$ic t&eories and applications of )uantitati'e $et&ods of anal#sis.
T&e distincti'e features of $odern p&ase are
C T&e scope of financial $anage$ent &as *roadened. T&e central concern of financial
$anage$ent is considered to *e a rational $atc&ing of funds to t&eir uses in t&e lig&t of
appropriate decision criteria
C T&e approac& of financial $anage$ent &as *eco$e $ore anal#tical and )uantitati'e
C T&e point of 'ie( of t&e $anagerial decision $a/er &as *eco$e do$inant Since t&e
*eginning of t&e $odern p&ase $an# significant and se$inal de'elop$ents &a'e
occurred in t&e fields of capital *udgeting% capital structure t&eor#% efficient $ar/et
t&eor#% optional pricing t&eor#% agenc# t&eor#% ar*itrage pricing t&eor#% 'aluation $odels%
di'idend polic#% (or/ing capital $anage$ent% financial $odeling% and *e&a'ioral
finance. Man# $ore e8citing de'elop$ents are in t&e offing $a/ing finance a fascinating
and c&allenging field.
0oals of financial $anage$ent
Financial t&eor# in general rests on t&e pre$ises t&at t&e goal of t&e fir$ s&ould *e
$a8i$i5ed t&e 'alue of t&e fir$ to its e)uit# s&are &olders. T&is $eans t&at t&e goal of
t&e fir$ s&ould *e to $a8i$i5e t&e s&are 'alue of t&e e)uit# s&are (&ic& represents t&e
'alue of t&e fir$ to its e)uit# s&are &olders. It appears to pro'ide a rational guide for
*usiness decision $a/ing and pro$ote an efficient allocation of resources in t&e
econo$ic s#ste$. Sa'ings are allocated pri$aril# on t&e *asis of e8pected returns and
ris/ and t&e $ar/et 'alue of t&e fir$@s e)uit# stoc/ reflects t&e ris/ return trade off
in'estors in t&e $ar/et place.
If a fir$ $a/es decision ai$ed at $a8i$i5ing t&e $ar/et 'alue of its e)uit#% it (ill raise
capital onl# (&en its in'est$ents (arrant t&e use of capital fro$ t&e o'erall point of t&e
econo$#. T&is suggests t&at resources are allocated opti$all#. If a fir$ does not pursue
t&e goal of s&are&olders (ealt& $a8i$i5ation% it i$plies t&at its action results in a su*
opti$al allocation of resources. T&is in turn leads to inade)uate capital for$ation and
lo(er rate of econo$ic gro(t&. E)uit# s&are&olders pro'ide t&e 'enture capital re)uired
to start a *usiness fir$ and appoint &e $anage$ent of t&e fir$ indirectl# t&roug& t&e
*oard of directors.. T&erefore it is o*ligator# on t&e part of corporate $anage$ent to ta/e
care of t&e (elfare of e)uit# s&are&olders.
SC!.E !F FINANCIA6 MANA0EMENT
Financial $anage$ent is one of t&e i$portant parts of o'erall $anage$ent% (&ic& is
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BUSINESS FINANCE
directl# related (it& 'arious functional depart$ents li/e personnel% $ar/eting and
production. Financial $anage$ent co'ers (ide area (it& $ultidi$ensional approac&es.
T&e follo(ing are t&e i$portant scope of financial $anage$ent.
1. Financial Manage$ent and Econo$ics
Econo$ic concepts li/e $icro and $acroecono$ics are directl# applied (it& t&e
financial $anage$ent approac&es. In'est$ent decisions% $icro and $acro
en'iron$ental factors are closel# associated (it& t&e functions of financial
$anager. Financial $anage$ent also uses t&e econo$ic e)uations li/e $one#
'alue discount factor% econo$ic order )uantit# etc. Financial econo$ics is one of
t&e e$erging area% (&ic& pro'ides i$$ense opportunities to finance% and
econo$ical areas.
;. Financial Manage$ent and Accounting
Accounting records includes t&e financial infor$ation of t&e *usiness concern.
Eence% (e can easil# understand t&e relations&ip *et(een t&e financial
$anage$ent and accounting. In t&e olden periods% *ot& financial $anage$ent
and accounting are treated as a sa$e discipline and t&en it &as *een $erged as
Manage$ent Accounting *ecause t&is part is 'er# $uc& &elpful to finance
$anager to ta/e decisions. But no(ada#@s financial $anage$ent and accounting
discipline are separate and interrelated.
<. Financial Manage$ent or Mat&e$atics
Modern approac&es of t&e financial $anage$ent applied large nu$*er of
$at&e$atical and statistical tools and tec&ni)ues. T&e# are also called as
econo$etrics. Econo$ic order )uantit#% discount factor% ti$e 'alue of $one#%
present 'alue of $one#% cost of capital% capital structure t&eories% di'idend
t&eories% ratio anal#sis and (or/ing capital anal#sis are used as $at&e$atical and
statistical tools and tec&ni)ues in t&e field of financial $anage$ent.
D. Financial Manage$ent and .roduction Manage$ent
.roduction $anage$ent is t&e operational part of t&e *usiness concern% (&ic&
&elps to $ultiple t&e $one# into profit. .rofit of t&e concern depends upon t&e
production perfor$ance. .roduction perfor$ance needs finance% *ecause
production depart$ent re)uires ra( $aterial% $ac&iner#% (ages% operating
e8penses etc. T&ese e8penditures are decided and esti$ated *# t&e financial
depart$ent and t&e finance $anager allocates t&e appropriate finance to
production depart$ent. T&e financial $anager $ust *e a(are of t&e operational
process and finance re)uired for eac& process of production acti'ities.
A. Financial Manage$ent and Mar/eting
.roduced goods are sold in t&e $ar/et (it& inno'ati'e and $odern approac&es.
For t&is% t&e $ar/eting depart$ent needs finance to $eet t&eir re)uire$ents.
T&e financial $anager or finance depart$ent is responsi*le to allocate t&e
ade)uate finance to t&e $ar/eting depart$ent. Eence% $ar/eting and financial
$anage$ent are interrelated and depends on eac& ot&er.
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BUSINESS FINANCE
F. Financial Manage$ent and Eu$an esource
Financial $anage$ent is also related (it& &u$an resource depart$ent% (&ic&
pro'ides $anpo(er to all t&e functional areas of t&e $anage$ent. Financial
$anager s&ould carefull# e'aluate t&e re)uire$ent of $anpo(er to eac&
depart$ent and allocate t&e finance to t&e &u$an resource depart$ent as (ages%
salar#% re$uneration% co$$ission% *onus% pension and ot&er $onetar# *enefits to
t&e &u$an resource depart$ent. Eence% financial $anage$ent is directl# related
(it& &u$an resource $anage$ent.
IM.!TANCE !F FINANCIA6 MANA0EMENT
In a *ig organi5ation% t&e general $anger or t&e $anaging director is t&e o'erall inc&arge
of t&e organi5ation *ut &e gets all t&e acti'ities done *# delegating all or so$e of &is
po(ers to $en in t&e $iddle or lo(er $anage$ent% (&o are supposed to *e specialists in
t&e field so t&at *etter results $a# *e o*tained.
For e8a$ple% $anage$ent and control of production $a# *e delegated to a $an (&o is
specialist in t&e tec&ni)ues% procedures% and $et&ods of production. >e $a# designate
&i$ 3.roduction ManagerG. So is t&e case (it& ot&er *ranc&es of $anage$ent% i.e.%
personnel% finance% sales etc.
T&e inc&arge of t&e finance depart$ent $a# *e called financial $anger% finance
controller% or director of finance (&o is responsi*le for t&e procure$ent and proper
utilisation of finance in t&e *usiness and for $aintaining co-ordination *et(een all ot&er
*ranc&es of $anage$ent.
I$portance of finance cannot *e o'er-e$p&asi5ed. It is% indeed% t&e /e# to successful
*usiness operations. >it&out proper ad$inistration of finance% no *usiness enterprise can
reac& its full potentials for gro(t& and success. Mone# is a uni'ersal lu*ricant (&ic&
/eeps t&e enterprise d#na$ic-de'elops product% /eeps $en and $ac&ines at (or/%
encourages $anage$ent to $a/e progress and creates 'alues. T&e i$portance of
financial ad$inistration can *e discussed under t&e follo(ing &eads:-
1. Success of .ro$otion "epends on Financial Ad$inistration. !ne of t&e $ost
i$portant reasons of failures of *usiness pro$otions is a defecti'e financial plan. If
t&e plan adopted fails to pro'ide sufficient capital to $eet t&e re)uire$ent of fi8ed
and fluctuating capital an particularl#% t&e latter% or it fails to assu$e t&e o*ligations
*# t&e corporations (it&out esta*lis&ing earning po(er% t&e *usiness cannot *e
carried on successfull#. Eence sound financial plan is 'er# necessar# for t&e success
of *usiness enterprise.
;. S$oot& unning of an Enterprise. Sound Financial planning is necessar# for t&e
s$oot& running of an enterprise. Mone# is to an enterprise% (&at oil is to an engine.
As% Finance is re)uired at eac& stage f an enterprise% i.e.% pro$otion% incorporation%
de'elop$ent% e8pansion and ad$inistration of da#-to-da# (or/ing etc.% proper
ad$inistration of finance is 'er# necessar#. .roper financial ad$inistration $eans t&e
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BUSINESS FINANCE
stud#% anal#sis and e'aluation of all financial pro*le$s to *e faced *# t&e
$anage$ent and to ta/e proper decision (it& reference to t&e present circu$stances
in regard to t&e procure$ent and utilisation of funds.
<. Financial Ad$inistration Co-ordinates 7arious Functional Acti'ities. Financial
ad$inistration pro'ides co$plete co-ordination *et(een 'arious functional areas
suc& as $ar/eting% production etc. to ac&ie'e t&e organisational goals. If financial
$anage$ent is defecti'e% t&e efficienc# of all ot&er depart$ents can% in no (a#% *e
$aintained. For e8a$ple% it is 'er# necessar# for t&e finance-depart$ent to pro'ide
finance for t&e purc&ase of ra( $aterials and $eting t&e ot&er da#-to-da# e8penses
for t&e s$oot& running of t&e production unit. If financial depart$ent fails in its
o*ligations% t&e .roduction and t&e sales (ill suffer and conse)uentl#% t&e inco$e of
t&e concern and t&e rate of profit on in'est$ent (ill also suffer. T&us Financial
ad$inistration occupies a central place in t&e *usiness organisation (&ic& controls
and co-ordinates all ot&er acti'ities in t&e concern.
D. Focal .oint of "ecision Ma/ing. Al$ost% e'er# decision in t&e *usiness is ta/e in t&e
lig&t of its profita*ilit#. Financial ad$inistration pro'ides scientific anal#sis of all
facts and figures t&roug& 'arious financial tools% suc& as different financial
state$ents% *udgets etc.% (&ic& &elp in e'aluating t&e profita*ilit# of t&e plan in t&e
gi'en circu$stances% so t&at a proper decision can *e ta/en to $ini$ise t&e ris/
in'ol'ed in t&e plan.
A. "eter$inant of Business Success. It &as *een recognised% e'en in India t&at t&e
financial $anger spla# a 'er# i$portant role in t&e success of *usiness organisation
*# ad'ising t&e top $anage$ent t&e solutions of t&e 'arious financial pro*le$s as
e8perts. T&e# present i$portant facts and figures regarding financial position an t&e
perfor$ance of 'arious functions of t&e co$pan# in a gi'en period *efore t&e top
$anage$ent in suc& a (a# so as to $a/e it easier for t&e top $anage$ent to e'aluate
t&e progress of t&e co$pan# to a$end suita*l# t&e principles and policies of t&e
co$pan#. T&e financial $anges assist t&e top $anage$ent in its decision $a/ing
process *# suggesting t&e *est possi*le alternati'e out of t&e 'arious alternati'es of
t&e pro*le$ a'aila*le. Eence% financial $anage$ent &elps t&e $anage$ent at
different le'el in ta/ing financial decisions.
F. Measure of .erfor$ance. T&e perfor$ance of t&e fir$ can *e $easured *# its
financial results% i.e% *# its si5e of earnings is/iness and profita*ilit# are t(o $a+or
factors (&ic& +ointl# deter$ine t&e 'alue of t&e concern. Financial decisions (&ic&
increase ris/s (ill decrease t&e 'alue of t&e fir$ and on t&e to t&e &and% financial
decisions (&ic& increase t&e profita*ilit# (ill increase 'alue of t&e fir$. is/ an
profita*ilit# are t(o essential ingredients of a *usiness concern.
C6ASSIFICATI!N !F FINANCE
.I7ATE FINANCE
.ersonal finance and Business finance.
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Finance
Private Finance Public Finance
BUSINESS FINANCE
T&e personal finance is concerned (it& t&e ac)uisition and t&e proper utili5ation
of econo$ic resource *# t&e indi'iduals and &ouse&olds for $eeting t&eir
different needs.
T&e *usiness finance is also a part of pri'ate finance. T&e *usiness finance is
concerned (it& t&e ac)uisition% $anage$ent and utili5ation of fund *# t&e pri'ate
*usiness organi5ations.
.UB6IC FINANCE
Is t&e stud# supports t&e financial aspect of t&e go'ern$entI Eere (e stud# a*out t&e
go'ern$ent e8penditure% pu*lic re'enue% pu*lic *orro(ing and financial ad$inistration.
T&e econo$ic acti'ities of t&e pu*lic enterprises also fall under pu*lic finance. T&e
o*+ecti'e of pri'ate of *usiness finance is to earn $a8i$u$ return or profit. !n t&e
contrar# t&e o*+ecti'e of pu*lic finance is to $a8i$i5e social (elfare.
A..!ACEES T! FINANCE FUNCTI!N
T&e finance function also pla#s a /e# role in articulating *usiness perfor$ance and
ena*ling $anage$ent to address and react to trends )uic/l#. Financial $anage$ent &as
undergone significant c&anges% o'er t&e #ears in its scope and co'erage. Approac&es:
Broadl#% it &as t(o% as $entioned *elo(:
TA"ITI!NA6 A..!ACE
T&e traditional approac& to t&e scope of financial $anage$ent refers to its su*+ect $atter
in t&e acade$ic literature in t&e initial stages of its e'olution as a separate *ranc& of
stud#. According to t&is approac&% t&e scope of financial $anage$ent is confined to t&e
raising of funds. Eence% t&e scope of finance (as treated *# t&e traditional approac& in
t&e narro( sense of procure$ent of funds *# corporate enterprise to $eet t&eir financial
needs. Since t&e $ain e$p&asis of finance function at t&at period (as on t&e procure$ent
of funds% t&e su*+ect (as called corporation finance till t&e $id-1JABGs and co'ered
discussion on t&e financial instru$ents% institutions and practices t&roug& (&ic& funds
are o*tained. Furt&er% as t&e pro*le$ of raising funds is $ore intensel# felt at certain
episodic e'ents suc& as $erger% li)uidation% consolidation% reorgani5ation and so on.
T&ese are t&e *road features of t&e su*+ect $atter of corporation finance% (&ic& &as no
concern (it& t&e decisions of allocating fir$Gs funds. But t&e scope of finance function in
t&e traditional approac& &as no( *een discarded as it suffers fro$ serious criticis$s.
Again% t&e li$itations of t&is approac& fall into t&e follo(ing categories.
T&e e$p&asis in t&e traditional approac& is on t&e procure$ent of funds *# t&e corporate
enterprises% (&ic& (as (o'en around t&e 'ie(point of t&e suppliers of funds suc& as
in'estors% financial institutions% in'est$ent *an/ers% etc% i.e. outsiders. It i$plies t&at t&e
traditional approac& (as t&e outsider-loo/ing-in approac&. Anot&er li$itation (as t&at
internal financial decision-$a/ing (as co$pletel# ignored in t&is approac&.
T&e second criticis$ le'eled against t&is traditional approac& (as t&at t&e scope of
financial $anage$ent (as confined onl# to t&e episodic e'ents suc& as $ergers%
ac)uisitions% reorgani5ations% consolation% etc. T&e scope of finance function in t&is
2
BUSINESS FINANCE
approac& (as confined to a description of t&ese infre)uent &appenings in t&e life of an
enterprise. T&us% it places o'er e$p&asis on t&e topics of securities and its $ar/ets%
(it&out pa#ing an# attention on t&e da# to da# financial aspects.
Anot&er serious lacuna in t&e traditional approac& (as t&at t&e focus (as on t&e long-
ter$ financial pro*le$s t&us ignoring t&e i$portance of t&e (or/ing capital
$anage$ent. T&us% t&is approac& &as failed to consider t&e routine $anagerial pro*le$s
relating to finance of t&e fir$.
"uring t&e initial stages of de'elop$ent% financial $anage$ent (as do$inated *# t&e
traditional approac& as is e'ident fro$ t&e finance *oo/s of earl# da#s. T&e traditional
approac& (as found in t&e first $anifestation *# 0reenGs *oo/ (ritten in 12JH% Meades
on Corporation Finance% in 1J1BK "oingGs on Corporate .ro$otion and eorganisation% in
1J1D% etc.
As stated earlier% in t&is traditional approac& all t&ese (ritings e$p&asi5ed t&e financial
pro*le$s fro$ t&e outsidersG point of 'ie( instead of loo/ing into t&e pro*le$s fro$
$anage$ents% point of 'ie(. It o'er e$p&asi5ed long-ter$ financing lac/ed in anal#tical
content and placed &ea'# e$p&asis on descripti'e $aterial. T&us% t&e traditional
approac& o$its t&e discussion on t&e i$portant aspects li/e cost of t&e capital% opti$u$
capital structure% 'aluation of fir$% etc. In t&e a*sence of t&ese crucial aspects in t&e
finance function% t&e traditional approac& i$plied a 'er# narro( scope of financial
$anage$ent. T&e $odern or ne( approac& pro'ides a solution to all t&ese aspects of
financial $anage$ent.
According to t&is approac& t&e scopes of finance function (as confined to onl#
procure$ent of funds needed *# a *usiness on $ost suita*le ter$s. T&e utili5ation of
funds (as considered *e#ond t&e pur'ie( of finance function. It (as felt t&at decisions
regarding application of funds are ta/en so$e(&ere else in t&e organi5ation. T&e scope
of finance function (as treated% in t&e narro( sense of procure$ent or arrange$ent of
funds. It (as felt t&at t&e finance $anager &ad no role to pla# in decision $a/ing for its
utili5ation
As per t&is approac&% t&e follo(ing aspects onl# (ere included in t&e scope of financial
$anage$ent
1. Esti$ation of re)uire$ents of finance%
;. Arrange$ent of funds fro$ financial institutions%
<. Arrange$ent of funds t&roug& financial instru$ents suc& as s&ares% de*entures%
*onds and loans%
D. 6oo/ing after t&e accounting and legal (or/ connected (it& t&e raising of funds.
T&e li$itations are
1. It is outsider-loo/ing approac& t&at co$pletel# ignores internal decision-$a/ing as to
t&e proper utili5ation of funds.
;. T&e focus of traditional approac& (as on procure$ent of long ter$ funds. T&us% it
ignored t&e i$portant issue of (or/ing capital finance and $anage$ent.
J
BUSINESS FINANCE
<. T&e issue of allocation of funds% (&ic& is so i$portant toda#% is co$pletel# ignored.
D. It does not la# focus on da#-to-da# financial pro*le$s of an organi5ation.
M!"EN A..!ACE
After t&e 1JABGs% a nu$*er of econo$ic and en'iron$ental factors% suc& as t&e
tec&nological inno'ations% industriali5ation% intense co$petition% interference of
go'ern$ent% gro(t& of population% necessitated efficient and effecti'e utilisation of
financial resources. In t&is conte8t% t&e opti$u$ allocation of t&e fir$Gs resources is t&e
order of t&e da# to t&e $anage$ent. T&en t&e e$p&asis s&ifted fro$ episodic financing
to t&e $anagerial financial pro*le$s% fro$ raising of funds to efficient and effecti'e use
of funds. T&us% t&e *roader 'ie( of t&e $odern approac& of t&e finance function is t&e
(ise use of funds. Since t&e financial decisions &a'e a great i$pact on all ot&er *usiness
acti'ities% t&e financial $anager s&ould *e concerned a*out deter-$ining t&e si5e and
nature of t&e tec&nolog#% setting t&e direction and gro(t& of t&e *usiness% s&aping t&e
profita*ilit#% a$ount of ris/ ta/ing% selecting t&e asset $i8% deter$ination of opti$u$
capital structure% etc.
T&e ne( approac& is t&us an anal#tical (a# of 'ie(ing t&e financial pro*le$s of a fir$.
According to t&e ne( approac&% t&e financial $anage$ent is concerned (it& t&e solution
of t&e $a+or areas relating to t&e financial operations of a fir$% 'i5.% in'est$ent% and
financing and di'idend decisions. T&e $odern financial $anager &as to ta/e financial
decisions in t&e $ost rational (a#. T&ese decisions &a'e to *e $ade in suc& a (a# t&at
t&e funds of t&e fir$ are used opti$all#. T&ese decisions are referred to as $anagerial
finance functions since t&e# re)uire special care (it& e8traordinar# ad$inistrati'e a*ilit#%
$anage$ent s/ills and decision - $a/ing tec&ni)ues% etc.
It 'ie(s finance function in *roader sense. It includes *ot& rising of funds as (ell as t&eir
effecti'e utili5ation under t&e pre'ie( of finance. T&e $odern approac& considers t&e
t&ree *asic $anage$ent decisions. i.e.% In'est$ent decisions% financing decisions and
di'idend decisions (it&in t&e scope of finance function. Financial $anage$ent is
considered as 'ital and an integral part of o'erall $anage$ent. T&e $odern approac& is
anal#tical (a# of loo/ing into t&e financial pro*le$s of t&e fir$.
Ad'ice of finance $anager is re)uired at e'er# $o$ent% (&ene'er an# decision (it&
in'ol'e$ent of funds is ta/en. Eardl#% t&ere is an acti'it# t&at does not in'ol'e funds.
SC!.E !F FINANCIA6 MANA0EMENT
Esti$ating financial re)uire$ents: T&e a$ount re)uired for purc&asing fi8ed assets
as (ell as needs of funds for (or/ing capital (ill &a'e to *e ascertained.
"eciding capital structure: T&e proportion of &o( t&e funds s&ould *e raised &as to *e
decided. A decision a*out 'arious sources for funds s&ould *e lin/ed to t&e cost of
raising funds.
1B
BUSINESS FINANCE
Selecting a source of finance: After preparation of capital structure% an appropriate
source of finance is selected. It includes s&are capital% de*entures. Financial
institutions% co$$ercial *an/s% pu*lic deposits etc
Selecting pattern of In'est$ent: "ecision &as to *e ta/en on (&ere t&e funds
procured or raised s&ould *e in'ested. Tec&ni)ues suc& as Capital *udgeting%
!pportunit# Cost Anal#sis etc. $a# *e applied for t&is purpose
.roper Cas& Manage$ent: 7arious cas& needs at different ti$es &as to *e assessed.
T&e cas& $anage$ent s&ould *e in suc& a (a# t&at t&ere is neit&er s&ortage of cas&
nor it is idle.
.roper use of surplus: A +udicious use of surpluses is essential for e8pansion and
di'ersification of plans and also in protecting t&e interests of s&are&olders.
I$ple$enting Financial controls: Efficient s#ste$ of financial $anage$ent
necessitates t&e use of 'arious control de'ices.
T&e control de'ices and tec&ni)ues &elp in e'aluating t&e perfor$ance in 'arious areas
and ta/e correcti'e $easures.
1. Budgetar# control%
;. Brea/-e'en anal#sis%
<. Cost control%
D. atio anal#sis
A. Cost and internal audit.
F. eturn on in'est$ent
AEAS : C!NCE.TS !F FINANCIA6 MANA0EMENT
As alread# discussed% t&e general $eaning of finance refers to pro'iding funds% as and
(&en needed. Eo(e'er% as $anage$ent function% t&e ter$ LFinancial Manage$ent@ &as a
distinct $eaning. Financial $anage$ent deals (it& t&e stud# of procuring funds and it@s
effecti'e and +udicious utili5ation% in ter$s of t&e o'erall o*+ecti'es of t&e fir$% and
e8pectations of t&e pro'iders of funds. T&e *asic o*+ecti'e is to $a8i$i5e t&e 'alue of
t&e fir$.
3Financial Manage$ent is concerned (it& t&e efficient use of an i$portant
econo$ic resource% na$el#% Capital Funds4 Solo$on
3Financial Manage$ent is concerned (it& t&e $anagerial decisions t&at result in
t&e ac)uisition and financing of s&ort-ter$ and long-ter$ credits for t&e fir$4
.&illioppatus
3Business finance is t&at *usiness acti'it# (&ic& is concerned (it& t&e
conser'ation and ac)uisition of capital funds in $eeting financial needs and
o'erall o*+ecti'es of a *usiness enterprise4 - >&eeler
AEAS !F FINANCIA6 MANA0EMENT
11
BUSINESS FINANCE
Anal#sis of Financial State$ents
Anal#sis of financial state$ent is one of t&e $ost co$$on tec&ni)ues of financial
anal#sis% in (&ic& t&e financial perfor$ance and financial &ealt& of t&e co$panies are
anal#5ed *ased on its past perfor$ance.
T&e follo(ing financial state$ents are used in t&e anal#sis process.
.rofit : 6oss State$ent or Inco$e State$ent
Balance S&eet
State$ent of S&are&olders@ e)uit#
State$ent of Cas& Flo(
In'est$ent "ecisions : Capital Budgeting
In'est$ent decisions are t&e $ost critical as t&e# usuall# in'ol'e &uge su$ of $one# and
t&ese decisions are li/el# to *ring prosperit# or end to a *usiness. A co$pan#@s future
inco$e depends on &o( $uc& in'est$ent is $ade% in (&at t#pe of assets% and &o( t&ese
assets add to t&e o'erall 'alue of t&e co$pan#.
Capital *udgeting is a ter$ strictl# related to in'est$ent in fi8ed assets. Eere% t&e ter$
capital refers to t&e fi8ed assets t&at are used in production% (&ile *udget is a plan (&ic&
details pro+ected cas& inflo(s and outflo(s o'er so$e future period.
T&e follo(ing concepts and tec&ni)ues are e$plo#ed (&ile anal#5ing in'est$ent
decisions.
Interest rate for$ulas
Ti$e 7alue of Mone#
"iscounted Cas& Flo(s
Net .resent 7alue
Internal ate of eturn
is/ : eturn
In'estors% indi'idual or institutional% in'est t&eir $one# (it& t&e e8pectations of earning
a return on t&eir in'est$ent. >&ile in'estors (is& and atte$pt to earn $a8i$u$ return%
t&e# are constrained *# ris/. Eo( t&e ris/s and returns are related and &o( do in'estors
$a/e a c&oice of t&eir portfolios is i$portant for in'est$ent decision-$a/ing. Follo(ing
concepts and t&eories (ould *e discussed (&ile discussing t&e ris/-return c&oices of t&e
in'estor.
Uncertaint#
is/
.ortfolio T&eor# and
Capital Asset .ricing Model
Corporate Financing : Capital Structure
1;
BUSINESS FINANCE
>&en a fir$ plans to e8pand% it needs capital or funds. Ac)uisition of funds is considered
to *e a pri$ar# responsi*ilit# of a finance depart$ent in an organi5ation. T&ere are
nu$erous (a#s to ac)uire funds% i.e.% finances can *e raised in t&e for$ of de*t or e)uit#.
T&e proportion of de*t and e)uit# constitutes t&e capital structure of t&e fir$. Financial
e8perts atte$pt to find a co$*ination of de*t and e)uit# t&at could increase t&e o'erall
'alue of t&e co$pan#% i.e.% t&e# tr# to find t&e opti$al capital structure. T&e follo(ing
concepts (ould *e used to understand &o( an opti$al capital structure could *e attained.
Cost of Capital
6e'erage
"i'idend .olic#
"e*t Instru$ents
7aluation.
Asset or co$pan# 'aluation is i$portant not onl# for financial $anagers% *ut also for
creditors and in'estors. It is i$portant to /no( t&e 'alue of t&e co$pan# or its assets to
$a/e i$portant financing and in'est$ent c&oices. "ifferent 'aluation tec&ni)ues and
factors t&at influence t&e 'alue of a co$pan# or its financial instru$ents (ould *e
discussed
S&are
Bond
!ption
Corporate
>or/ing Capital : In'entor# Manage$ent
>or/ing capital and in'entor# $anage$ent pertains to t&e effecti'e $anage$ent of
current assets. As (e (ill see% an opti$al and effecti'e utili5ation of (or/ing capital and
in'entor# increases t&e operating efficienc# of t&e fir$.
International Finance : foreign e8c&ange
>it& t&e increasing i$portance of international trade and glo*al $ar/ets% t&e role of
international finance &as increased $anifold. In a glo*al en'iron$ent% t&e finance
$anagers &a'e $ore c&oices pertaining to in'esting and financing t&an e'er *efore.
Eo(e'er% it is i$portant to understand t&e i$plications of (or/ing in a glo*al
en'iron$ent% since fluctuations in t&e currenc# rates can con'ert a good financing or
in'est$ent decision into a *ad one.
!6E !F FINANCE MAN0E
Financial $anger is t&e person responsi*le for carr#ing out t&e finance function. Ee
occupies t&e /e# position in an organi5ation.
aising of Fund
1. See t&at fir$ &as ade)uate cas& to $eet t&e dail# needs.
;. Ma/e financial decisions
<. aise t&e needed funds for$ co$*ination of 'arious sources.
1<
BUSINESS FINANCE
Funds Allocation
Using s/ills and tec&ni)ues in i$ple$enting a s#ste$ of opti$u$ allocation of fir$@s
resources. T&ere s&ould *e efficient allocation of resources. Financial $anger $ust find a
rationale for ans(ering t&e follo(ing )uestions
i. Eo( large s&ould an enterprise *e and &o( fast s&ould it gro(I
ii. In >&at for$ s&ould it &old its assetsI
iii. Eo( s&ould t&e funds re)uired *e raisedI
T&e ans(ers (ill t&ree *road decisions
1. In'est$ent%
;. Financing and
<. "i'idend.
FUNCTI!NS !F FINANCE MANA0E
Finance function is one of t&e $a+or parts of *usiness organi5ation% (&ic& in'ol'es t&e
per$anent% and continuous process of t&e *usiness concern. Finance is one of t&e
interrelated functions (&ic& deal (it& personal function% $ar/eting function% production
function and researc& and de'elop$ent acti'ities of t&e *usiness concern. At present%
e'er# *usiness concern concentrates $ore on t&e field of finance *ecause% it is a 'er#
e$erging part (&ic& reflects t&e entire operational and profit a*ilit# position of t&e
concern. "eciding t&e proper financial function is t&e essential and ulti$ate goal of t&e
*usiness organi5ation.
Finance $anager is one of t&e i$portant role pla#ers in t&e field of finance function.
Ee $ust &a'e entire /no(ledge in t&e area of accounting% finance% econo$ics and
$anage$ent. Eis position is &ig&l# critical and anal#tical to sol'e 'arious pro*le$s
related to finance. A person (&o deals finance related acti'ities $a# *e called finance
$anager.
Finance $anager perfor$s t&e follo(ing $a+or functions:
1. Forecasting Financial e)uire$ents
It is t&e pri$ar# function of t&e Finance Manager. Ee is responsi*le to esti$ate
t&e financial re)uire$ent of t&e *usiness concern. Ee s&ould esti$ate% &o( $uc&
finances re)uired to ac)uire fi8ed assets and forecast t&e a$ount needed to $eet
t&e (or/ing capital re)uire$ents in future.
;. Ac)uiring Necessar# Capital
After deciding t&e financial re)uire$ent% t&e finance $anager s&ould concentrate
&o( t&e finance is $o*ili5ed and (&ere it (ill *e a'aila*le. It is also &ig&l#
critical in nature.
<. In'est$ent "ecision
T&e finance $anager $ust carefull# select *est in'est$ent alternati'es and
consider t&e reasona*le and sta*le return fro$ t&e in'est$ent. Ee $ust *e (ell
'ersed in t&e field of capital *udgeting tec&ni)ues to deter$ine t&e effecti'e
1D
BUSINESS FINANCE
utili5ation of in'est$ent. T&e finance $anager $ust concentrate to principles of
safet#% li)uidit# and profita*ilit# (&ile in'esting capital.
D. Cas& Manage$ent
.resent da#s cas& $anage$ent pla#s a $a+or role in t&e area of finance *ecause
proper cas& $anage$ent is not onl# essential for effecti'e utili5ation of cas& *ut
it also &elps to $eet t&e s&ort-ter$ li)uidit# position of t&e concern.
A. Interrelation (it& !t&er "epart$ents
Finance $anager deals (it& 'arious functional depart$ents suc& as $ar/eting%
production% personel% s#ste$% researc&% de'elop$ent% etc. Finance $anager
s&ould &a'e sound /no(ledge not onl# in finance related area *ut also (ell
'ersed in ot&er areas. Ee $ust $aintain a good relations&ip (it& all t&e functional
depart$ents of t&e *usiness organi5ation.
IM.!TANCE !F FINANCIA6 MANA0EMENT
Financial $anage$ent is indispensa*le in an# organi5ation as it &elps in
1. Financial planning and successful pro$otion of an enterprise
;. Ac)uisition of funds as and (&en re)uired a $ini$u$ possi*le cost.
<. .roper use and allocation of funds
D. Ta/ing sound financial decisions
A. I$pro'ing t&e profita*ilit# t&roug& financial controls
F. Increasing t&e (ealt& of t&e in'estors and t&e nation
H. .ro$oting and $o*ili5ing indi'idual and corporate sa'ings
Finance is t&e life*lood of *usiness organi5ation. It needs to $eet t&e re)uire$ent of t&e
*usiness concern. Eac& and e'er# *usiness concern $ust $aintain ade)uate a$ount of
finance for t&eir s$oot& running of t&e *usiness concern and also $aintain t&e *usiness
carefull# to ac&ie'e t&e goal of t&e *usiness concern. T&e *usiness goal can *e ac&ie'ed
onl# (it& t&e &elp of effecti'e $anage$ent of finance. >e can@t neglect t&e i$portance
of finance at an# ti$e at and at an# situation. So$e of t&e i$portance of t&e financial
$anage$ent is as follo(s:
Financial .lanning
Financial $anage$ent &elps to deter$ine t&e financial re)uire$ent of t&e *usiness
concern and leads to ta/e financial planning of t&e concern. Financial planning is an
i$portant part of t&e *usiness concern% (&ic& &elps to pro$otion of an enterprise.
Ac)uisition of Funds
Financial $anage$ent in'ol'es t&e ac)uisition of re)uired finance to t&e *usiness
concern. Ac)uiring needed funds pla# a $a+or part of t&e financial $anage$ent% (&ic&
in'ol'e possi*le source of finance at $ini$u$ cost.
.roper Use of Funds
.roper use and allocation of funds leads to i$pro'e t&e operational efficienc# of t&e
*usiness concern. >&en t&e finance $anager uses t&e funds properl#% t&e# can reduce t&e
cost of capital and increase t&e 'alue of t&e fir$.
1A
BUSINESS FINANCE
Financial "ecision
Financial $anage$ent &elps to ta/e sound financial decision in t&e *usiness concern.
Financial decision (ill affect t&e entire *usiness operation of t&e concern. Because t&ere
is a direct relations&ip (it& 'arious depart$ent functions suc& as $ar/eting% production
personnel% etc.
I$pro'e .rofita*ilit#
.rofita*ilit# of t&e concern purel# depends on t&e effecti'eness and proper utili5ation of
funds *# t&e *usiness concern. Financial $anage$ent &elps to i$pro'e t&e profita*ilit#
position of t&e concern (it& t&e &elp of strong financial control de'ices suc& as
*udgetar# control% ratio anal#sis and cost 'olu$e profit anal#sis.
Increase t&e 7alue of t&e Fir$
Financial $anage$ent is 'er# i$portant in t&e field of increasing t&e (ealt& of t&e
in'estors and t&e *usiness concern. Ulti$ate ai$ of an# *usiness concern (ill ac&ie'e
t&e $a8i$u$ profit and &ig&er profita*ilit# leads to $a8i$i5e t&e (ealt& of t&e in'estors
as (ell as t&e nation.
.ro$oting Sa'ings
Sa'ings are possi*le onl# (&en t&e *usiness concern earns &ig&er profita*ilit# and
$a8i$i5ing (ealt&. Effecti'e financial $anage$ent &elps to pro$oting and $o*ili5ing
indi'idual and corporate sa'ings.
No(ada#s financial $anage$ent is also popularl# /no(n as *usiness finance or
corporate finances. T&e *usiness concern or corporate sectors cannot function (it&out t&e
i$portance of t&e financial $anage$ent.
FUNCTI!NS !F FINANCE
Finance function is t&e $ost i$portant function of a *usiness. Finance is% closel#%
connected (it& production% $ar/eting and ot&er acti'ities. In t&e a*sence of finance% all
t&ese acti'ities co$e to a &alt. in fact% onl# (it& finance% a *usiness acti'it# can *e
co$$enced% continued and e8panded. Finance e8ists e'er#(&ere% *e it production%
$ar/eting% &u$an resource de'elop$ent or underta/ing researc& acti'it#. Understanding
t&e uni'ersalit# and i$portance of finance% finance $anager is associated% in $odern
*usiness% in all acti'ities as no acti'it# can e8ist (it&out funds.
AIMS !F FINANCE FUNCTI!N
1. Ac)uiring sufficient and suita*le funds: T&e pri$ar# ai$ of finance function is to
assess t&e needs of t&e enterprise% properl#% and procure funds% in ti$e. Ti$e is also an
i$portant ele$ent in $eeting t&e needs of t&e organisation. If t&e funds are not a'aila*le
as and (&en re)uired% t&e fir$ $a# *eco$e sic/ or% at least% t&e profita*ilit# of t&e fir$
(ould *e% definitel#% affected. It is necessar# t&at t&e funds s&ould *e% reasona*l#%
ade)uate to t&e de$ands of t&e fir$. T&e funds s&ould *e raised fro$ different sources%
1F
BUSINESS FINANCE
co$$ensurate to t&e nature of *usiness and ris/ profile of t&e organisation. >&en t&e
nature of *usiness is suc& t&at t&e production does not co$$ence% i$$ediatel#% and
re)uires long gestation period% it is necessar# to &a'e t&e long-ter$ sources li/e s&are
capital% de*entures and long ter$ loan etc. A concern (it& longer gestation period does
not &a'e profits for so$e #ears. So% t&e fir$ s&ould rel# $ore on t&e per$anent capital
li/e s&are capital to a'oid interest *urden on t&e *orro(ing co$ponent.
;. .roper Utili5ation of Funds: aising funds is i$portant% $ore t&an t&at is its proper
utili5ation. If proper utili5ation of funds (ere not $ade% t&ere (ould *e no re'enue
generation. Benefits s&ould al(a#s e8ceed cost of funds so t&at t&e organi5ation can *e
profita*le. Beneficial pro+ects onl# are to *e underta/en. So% it is all t&e $ore necessar#
t&at careful planning and cost-*enefit anal#sis s&ould *e $ade *efore t&e actual
co$$ence$ent of pro+ects.
<. Increasing .rofita*ilit#: .rofita*ilit# is necessar# for e'er# organi5ation. T&e planning
and control functions of finance ai$ at increasing profita*ilit# of t&e fir$. To ac&ie'e
profita*ilit#% t&e cost of funds s&ould *e lo(. Idle funds do not #ield an# return% *ut incur
cost. So% t&e organi5ation s&ould a'oid idle funds. Finance function also re)uires
$atc&ing of cost and returns of funds. If funds are used efficientl#% profita*ilit# gets a
*oost.
D. Ma8i$i5ing Fir$@s 7alue: T&e ulti$ate ai$ of finance function is $a8i$i5ing t&e
'alue of t&e fir$% (&ic& is reflected in (ealt& $a8i$isation of s&are&olders. T&e $ar/et
'alue of t&e e)uit# s&ares is an indicator of t&e (ealt& $a8i$isation.
TEE MAIN !BMECTI7ES !F FINANCIA6 MANA0EMENT "EA6S >ITE
.!FIT MANIMIOATI!N
!*+ecti'e of financial $anage$ent is sa$e as t&e o*+ecti'e of a co$pan# t&at is to earn
profit. But profit $a8i$i5ation cannot t&e sole o*+ecti'e of a co$pan#. It is a li$ited
o*+ecti'e. If profits are gi'en undue I$portance t&en pro*le$s $a# arise as discussed
*elo(.
T&e ter$ profit is 'ague and it in'ol'es $uc& $ore contradictions. .rofit $a8i$i5ation
&as to *e atte$pted (it& a reali5ation of ris/s in'ol'ed. A positi'e relations&ip e8ists
*et(een ris/ and profits. So *ot& ris/ and profit o*+ecti'es s&ould *e *alanced. .rofit
Ma8i$i5ation does not ta/e into account t&e ti$e pattern of returns. .rofit $a8i$i5ation
fails to ta/e into account t&e social considerations. It is t&e $ain o*+ecti'e of an#
*usiness.
It is a $easure of efficienc# of an# *usiness. T&e argu$ents in fa'or of .rofit
$a8i$i5ation are as follo(s
.rofit $a8i$i5ation is t&e o*'ious o*+ecti'e
Mustified on t&e grounds of its rationalit#
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BUSINESS FINANCE
Econo$ic and *usiness conditions do not re$ain sa$e at all ti$es.
T&erefore a *usiness s&ould *e sur'i'ed under unfa'ora*le condition onl#
if it &as so$e past earnings to rel# upon.
.rofits are needed for gro(t& and de'elop$ent.
Essential for fulfilling social goals.
Fa'ora*le Argu$ents for .rofit Ma8i$i5ation
T&e follo(ing i$portant points are in support of t&e profit $a8i$i5ation o*+ecti'es of t&e
*usiness concern:
,i- Main ai$ is earning profit.
,ii- .rofit is t&e para$eter of t&e *usiness operation.
,iii- .rofit reduces ris/ of t&e *usiness concern.
,i'- .rofit is t&e $ain source of finance.
,'- .rofita*ilit# $eets t&e social needs also.
Unfa'ora*le Argu$ents for .rofit Ma8i$i5ation
T&e follo(ing i$portant points are against t&e o*+ecti'es of profit $a8i$i5ation:
,i- .rofit $a8i$i5ation leads to e8ploiting (or/ers and consu$ers.
,ii- .rofit $a8i$i5ation creates i$$oral practices suc& as corrupt practice% unfair
trade practice% etc.
,iii- .rofit $a8i$i5ation o*+ecti'es leads to ine)ualities a$ong t&e sta/e &olders suc&
as custo$ers% suppliers% pu*lic s&are&olders% etc.
"ra(*ac/s of .rofit Ma8i$i5ation
.rofit $a8i$i5ation o*+ecti'e consists of certain dra(*ac/ also:
,i- It is 'ague: In t&is o*+ecti'e% profit is not defined precisel# or correctl#. It creates
so$e unnecessar# opinion regarding earning &a*its of t&e *usiness concern.
,ii- It ignores t&e ti$e 'alue of $one#: .rofit $a8i$i5ation does not consider t&e
ti$e 'alue of $one# or t&e net present 'alue of t&e cas& inflo(. It leads certain
differences *et(een t&e actual cas& inflo( and net present cas& flo( during a
particular period.
,iii- It ignores ris/: .rofit $a8i$i5ation does not consider ris/ of t&e *usiness
concern. is/s $a# *e internal or e8ternal (&ic& (ill affect t&e o'erall operation
of t&e *usiness concern.
.!FIT MANIMIOATI!N IS EMECTE" BECAUSE !F TEE F!66!>IN0
"A>BACPS
T&e ter$ profit is 'ague
Ignores t&e ti$e 'alue of $one#
It doesn@t ta/e t&e ris/ prospecti'e into consideration
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BUSINESS FINANCE
T&e $ar/et price of t&e s&ares is not considered.
>EA6TE MANIMIOATI!N
It is t&e $a8i$i5ing of 'alue of stoc/ as course of action to s&are&olders. >&en t&e fir$
$a8i$i5es t&e stoc/ &older@s (ealt&% t&e indi'idual stoc/ &olders can use t&is (ealt& to
$a8i$i5e &is indi'idual utilit#.

It is co$$onl# agreed t&at t&e o*+ecti'e of a fir$ is to $a8i$i5e 'alue or (ealt&. 7alue
of a fir$ is represented *# t&e $ar/et price of t&e co$pan#Gs co$$on stoc/. T&e $ar/et
price of a fir$Gs stoc/ represents t&e focal +udg$ent of all $ar/et participants as to (&at
t&e 'alue of t&e particular fir$ is. It ta/es in to account present and prospecti'e future
earnings per s&are% t&e ti$ing and ris/ of t&ese earning% t&e di'idend polic# of t&e fir$
and $an# ot&er factors t&at *ear upon t&e $ar/et price of t&e stoc/. Mar/et price acts as
t&e perfor$ance inde8 or report card of t&e fir$Gs progress.
.rices in t&e s&are $ar/ets are largel# affected *# $an# factors li/e general econo$ic
outloo/% outloo/ of particular co$pan#% tec&nical factors and e'en $ass ps#c&olog#.
Nor$all# t&is 'alue is a function of t(o factors as gi'en *elo(% t&e anticipated rate of
earnings per s&are of t&e co$pan# t&e capitali5ation rate.
T&e li/el# rate of earnings per s&ares ,E.S- depends upon t&e assess$ent as to &o(
profita*l# a co$pan# is gro(ing to operate in t&e future.
T&e capitali5ation rate reflects t&e li/ing of t&e in'estors for t&e co$pan#. Met&ods of
Financial Manage$ent: In t&e field of financing t&ere are 'arious $et&ods to procure
funds. Funds $a# *e o*tained fro$ long-ter$ sources as (ell as fro$ s&ort-ter$ sources.
6ong-ter$ funds $a# *e a'ailed *# o(ners t&at are s&are&olders% lenders *# issuing
de*entures% fro$ financial institutions% *an/s and pu*lic at large. S&ort-ter$ funds $a#
*e a'ailed fro$ co$$ercial *an/s% pu*lic deposits% etc. Financial le'erage or trading on
e)uit# is an i$portant $et&od *# (&ic& a finance $anager $a# increase t&e return to
co$$on s&are&olders.
At t&e ti$e of e'aluating capital e8penditure pro+ects $et&ods li/e a'erage rate of return%
pa# *ac/% internal rate of returns% net present 'alue and profita*ilit# inde8 are used. A
fir$ can increase its profita*ilit# (it&out affecting its li)uidit# *# an efficient utili5ation
of t&e current resources at t&e disposal of t&e fir$. A fir$ can increase its profita*ilit#
(it&out affecting its li)uidit# *# an efficient $anage$ent of (or/ing capital.
Si$ilarl# for t&e e'aluation of a fir$Gs perfor$ance t&ere are different $et&ods. atio
anal#sis is a popular tec&ni)ue to e'aluate different aspects of a fir$. An in'estor ta/es in
to account 'arious ratios to /no( (&et&er in'est$ent in a particular co$pan# (ill *e
profita*le or not. T&ese ratios ena*le &i$ to +udge t&e profita*ilit#% sol'enc#% and
li)uidit# and gro(t& aspect of t&e fir$.
1J
Stoc/&olders@ current (ealt& in a fir$ Q ,no. of s&ares o(ned- C ,current stoc/ price per s&are-
BUSINESS FINANCE
Argu$ents fa'oring >ealt& $a8i$i5ation
Increases t&e s&are &olders interest *# increasing t&e 'alue of &oldings
Ensures securit# to lenders
.roducti'it# and efficienc# is increased
T&e $anage$ent $a# sur'i'e for a longer period
T&e s&are&olders $a# not li/e to c&ange a $anage$ent if t&e 'alue of &oldings is
increased.
T&e econo$ic interest of t&e societ# is ser'ed.
Criticis$s
T&e idea is not descripti'e as to (&at t&e fir$s actuall# do.
It is not necessaril# sociall# desira*le
T&ere is contro'ers# as to (&et&er t&e o*+ecti'es is to $a8i$i5e t&e stoc/ &olders
(ealt& of t&e (ealt& of t&e fir$ (&ic& includes ot&er financial clai$ &olders suc&
as de*enture &olders% preference s&are&olders etc.
T&ere is difficult# (&en t&e $anage$ent and o(ners&ip differs. >&en $anagers
act as agents of real o(ners t&ere is possi*ilit# for t&e$ to increase t&e
$anagerial interests and not t&e interest of o(ners.
!BMECTI7ES !F FINANCIA6 MANA0EMENT
T&e o*+ecti'es of financial $anage$ent are
1. .rofit $a8i$i5ation
T&e $ain o*+ecti'e of financial $anage$ent is profit $a8i$i5ation. T&e finance
$anager tries to earn $a8i$u$ profits for t&e co$pan# in t&e s&ort-ter$ and t&e
long-ter$. Ee cannot guarantee profits in t&e long ter$ *ecause of *usiness
uncertainties. Eo(e'er% a co$pan# can earn $a8i$u$ profits e'en in t&e long-ter$%
if:-
i. T&e Finance $anager ta/es proper financial decisions.
ii. Ee uses t&e finance of t&e co$pan# properl#.
;. >ealt& $a8i$i5ation
>ealt& $a8i$i5ation ,s&are&oldersG 'alue $a8i$i5ation- is also a $ain o*+ecti'e of
financial $anage$ent. >ealt& $a8i$i5ation $eans to earn $a8i$u$ (ealt& for t&e
s&are&olders. So% t&e finance $anager tries to gi'e a $a8i$u$ di'idend to t&e
s&are&olders. Ee also tries to increase t&e $ar/et 'alue of t&e s&ares. T&e $ar/et
'alue of t&e s&ares is directl# related to t&e perfor$ance of t&e co$pan#. Better t&e
perfor$ance% &ig&er is t&e $ar/et 'alue of s&ares and 'ice-'ersa. So% t&e finance
$anager $ust tr# to $a8i$ise s&are&olderGs 'alue.
<. .roper esti$ation of total financial re)uire$ents
.roper esti$ation of total financial re)uire$ents is a 'er# i$portant o*+ecti'e of
financial $anage$ent. T&e finance $anager $ust esti$ate t&e total financial
re)uire$ents of t&e co$pan#. Ee $ust find out &o( $uc& finance is re)uired to start
and run t&e co$pan#. Ee $ust find out t&e fi8ed capital and (or/ing capital
re)uire$ents of t&e co$pan#. Eis esti$ation $ust *e correct. If not% t&ere (ill *e
s&ortage or surplus of finance. Esti$ating t&e financial re)uire$ents is a 'er#
difficult +o*. T&e finance $anager $ust consider $an# factors% suc& as t&e t#pe of
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BUSINESS FINANCE
tec&nolog# used *# co$pan#% nu$*er of e$plo#ees e$plo#ed% scale of operations%
legal re)uire$ents% etc.
D. .roper $o*ili5ation
Mo*ilisation ,collection- of finance is an i$portant o*+ecti'e of financial
$anage$ent. After esti$ating t&e financial re)uire$ents% t&e finance $anager $ust
decide a*out t&e sources of finance. Ee can collect finance fro$ $an# sources suc&
as s&ares% de*entures% *an/ loans% etc. T&ere $ust *e a proper *alance *et(een
o(ned finance and *orro(ed finance. T&e co$pan# $ust *orro( $one# at a lo( rate
of interest.
A. .roper utilisation of finance
.roper utilisation of finance is an i$portant o*+ecti'e of financial $anage$ent. T&e
finance $anager $ust $a/e opti$u$ utilisation of finance. Ee $ust use t&e finance
profita*le. Ee $ust not (aste t&e finance of t&e co$pan#. Ee $ust not in'est t&e
co$pan#Gs finance in unprofita*le pro+ects. Ee $ust not *loc/ t&e co$pan#Gs finance
in in'entories. Ee $ust &a'e a s&ort credit period.
F. Maintaining proper cas& flo(
Maintaining proper cas& flo( is a s&ort-ter$ o*+ecti'e of financial $anage$ent. T&e
co$pan# $ust &a'e a proper cas& flo( to pa# t&e da#-to-da# e8penses suc& as
purc&ase of ra( $aterials% pa#$ent of (ages and salaries% rent% electricit# *ills% etc. If
t&e co$pan# &as a good cas& flo(% it can ta/e ad'antage of $an# opportunities suc&
as getting cas& discounts on purc&ases% large-scale purc&asing% gi'ing credit to
custo$ers% etc. A &ealt&# cas& flo( i$pro'es t&e c&ances of sur'i'al and success of
t&e co$pan#.
H. Sur'i'al of co$pan#
Sur'i'al is t&e $ost i$portant o*+ecti'e of financial $anage$ent. T&e co$pan# $ust
sur'i'e in t&is co$petiti'e *usiness (orld. T&e finance $anager $ust *e 'er# careful
(&ile $a/ing financial decisions. !ne (rong decision can $a/e t&e co$pan# sic/%
and it (ill close do(n.
2. Creating reser'es
!ne of t&e o*+ecti'es of financial $anage$ent is to create reser'es. T&e co$pan#
$ust not distri*ute t&e full profit as a di'idend to t&e s&are&olders. It $ust /eep a part
of it profit as reser'es. eser'es can *e used for future gro(t& and e8pansion. It can
also *e used to face contingencies in t&e future.
J. .roper coordination
Financial $anage$ent $ust tr# to &a'e proper coordination *et(een t&e finance
depart$ent and ot&er depart$ents of t&e co$pan#.
1B. Create good(ill
Financial $anage$ent $ust tr# to create good(ill for t&e co$pan#. It $ust i$pro'e
t&e i$age and reputation of t&e co$pan#. 0ood(ill &elps t&e co$pan# to sur'i'e in
t&e s&ort-ter$ and succeed in t&e long-ter$. It also &elps t&e co$pan# during *ad
ti$es.
11. Increase efficienc#
Financial $anage$ent also tries to increase t&e efficienc# of all t&e depart$ents of
t&e co$pan#. .roper distri*ution of finance to all t&e depart$ents (ill increase t&e
efficienc# of t&e entire co$pan#.
1;. Financial discipline
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BUSINESS FINANCE
Financial $anage$ent also tries to create a financial discipline. Financial discipline
$eans:-
i. To in'est finance onl# in producti'e areas. T&is (ill *ring &ig& returns ,profits- to
t&e co$pan#.
ii. To a'oid (astage and $isuse of finance.
1<. educe cost of capital
Financial $anage$ent tries to reduce t&e cost of capital. T&at is% it tries to *orro(
$one# at a lo( rate of interest. T&e finance $anager $ust plan t&e capital structure in
suc& a (a# t&at t&e cost of capital it $ini$ised.
1D. educe operating ris/s
Financial $anage$ent also tries to reduce t&e operating ris/s. T&ere are $an# ris/s
and uncertainties in a *usiness. T&e finance $anager $ust ta/e steps to reduce t&ese
ris/s. Ee $ust a'oid &ig&-ris/ pro+ects. Ee $ust also ta/e proper insurance.
1A. .repare capital structure
Financial $anage$ent also prepares t&e capital structure. It decides t&e ratio *et(een
o(ned finance and *orro(ed finance. It *rings a proper *alance *et(een t&e different
sources of capital. T&is *alance is necessar# for li)uidit#% econo$#% fle8i*ilit# and
sta*ilit#.
FINANCIA6 "ECISI!NS
So$e of t&e i$portant functions (&ic& e'er# finance $anager &as to ta/e are as follo(s:
1. In'est$ent decision
;. Financing decision
<. "i'idend decision
A. IN7ESTMENT "ECISI!N ,CA.ITA6 BU"0ETIN0 "ECISI!N-
T&is decision relates to careful selection of assets in (&ic& funds (ill *e in'ested *# t&e
fir$s. A fir$ &as $an# options to in'est t&eir funds *ut fir$ &as to select t&e $ost
appropriate in'est$ent (&ic& (ill *ring $a8i$u$ *enefit for t&e fir$ and deciding or
selecting $ost appropriate proposal is in'est$ent decision.
T&e fir$ in'ests its funds in ac)uiring fi8ed assets as (ell as current assets. >&en
decision regarding fi8ed assets is ta/en it is also called capital *udgeting decision.
Factors Affecting In'est$ent9Capital Budgeting "ecisions
1. Cas& Flo( of t&e .ro+ect
>&ene'er a co$pan# is in'esting &uge funds in an in'est$ent proposal it e8pects so$e
regular a$ount of cas& flo( to $eet da# to da# re)uire$ent. T&e a$ount of cas& flo( an
in'est$ent proposal (ill *e a*le to generate $ust *e assessed properl# *efore in'esting
in t&e proposal.
;. eturn on In'est$ent
T&e $ost i$portant criteria to decide t&e in'est$ent proposal is rate of return it (ill *e
a*le to *ring *ac/ for t&e co$pan# in t&e for$ of inco$e for% e.g.% if pro+ect A is *ringing
1BR return and pro+ect S is *ringing 1AR return t&en (e s&ould prefer pro+ect B.
<. is/ In'ol'ed
>it& e'er# in'est$ent proposal% t&ere is so$e degree of ris/ is also in'ol'ed. T&e
co$pan# $ust tr# to calculate t&e ris/ in'ol'ed in e'er# proposal and s&ould prefer t&e
in'est$ent proposal (it& $oderate degree of ris/ onl#.
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BUSINESS FINANCE
D. In'est$ent Criteria
Along (it& return% ris/% cas& flo( t&ere are 'arious ot&er criteria (&ic& &elp in selecting
an in'est$ent proposal suc& as a'aila*ilit# of la*our% tec&nologies% input% $ac&iner#% etc.
T&e finance $anager $ust co$pare all t&e a'aila*le alternati'es 'er# carefull# and t&en
onl# decide (&ere to in'est t&e $ost scarce resources of t&e fir$% i.e.% finance.
In'est$ent decisions are considered 'er# i$portant decisions *ecause of follo(ing
reasons:
1. T&e# are long ter$ decisions and t&erefore are irre'ersi*leK $eans once ta/en
cannot *e c&anged.
;. In'ol'e &uge a$ount of funds.
<. Affect t&e future earning capacit# of t&e co$pan#.
IM.!TANCE ! SC!.E !F CA.ITA6 BU"0ETIN0 "ECISI!N
Capital *udgeting decisions can turn t&e fortune of a co$pan#. T&e capital *udgeting
decisions are considered 'er# i$portant *ecause of t&e follo(ing reasons:
1. 6ong Ter$ 0ro(t&
T&e capital *udgeting decisions affect t&e long ter$ gro(t& of t&e co$pan#. As funds
in'ested in long ter$ assets *ring return in future and future prospects and gro(t& of t&e
co$pan# depends upon t&ese decisions onl#.
;. 6arge A$ount of Funds In'ol'ed
In'est$ent in long ter$ pro+ects or *u#ing of fi8ed assets in'ol'es &uge a$ount of funds
and if (rong proposal is selected it $a# result in (astage of &uge a$ount of funds t&at is
(&# capital *udgeting decisions are ta/en after considering 'arious factors and planning.
<. is/ In'ol'ed
T&e fi8ed capital decisions in'ol'e &uge funds and also *ig ris/ *ecause t&e return co$es
in long run and co$pan# &as to *ear t&e ris/ for a long period of ti$e till t&e returns start
co$ing.
D. Irre'ersi*le "ecision
Capital *udgeting decisions cannot *e re'ersed or c&anged o'ernig&t. As t&ese decisions
in'ol'e &uge funds and &ea'# cost and going *ac/ or re'ersing t&e decision $a# result in
&ea'# loss and (astage of funds. So t&ese decisions $ust *e ta/en after careful planning
and e'aluation of all t&e effects of t&at decision *ecause ad'erse conse)uences $a# *e
'er# &ea'#.
B. FINANCIN0 "ECISI!N
T&e second i$portant decision (&ic& finance $anager &as to ta/e is deciding source of
finance. A co$pan# can raise finance fro$ 'arious sources suc& as *# issue of s&ares%
de*entures or *# ta/ing loan and ad'ances. "eciding &o( $uc& to raise fro$ (&ic&
source is concern of financing decision. Mainl# sources of finance can *e di'ided into
t(o categories:
1. !(ners fund
;. Borro(ed fund
S&are capital and retained earnings constitute o(ners@ fund and de*entures% loans% *onds%
etc. constitute *orro(ed fund.
T&e $ain concern of finance $anager is to decide &o( $uc& to raise fro$ o(ners@ fund
and &o( $uc& to raise fro$ *orro(ed fund.
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BUSINESS FINANCE
>&ile ta/ing t&is decision t&e finance $anager co$pares t&e ad'antages and
disad'antages of different sources of finance. T&e *orro(ed funds &a'e to *e paid *ac/
and in'ol'e so$e degree of ris/ (&ereas in o(ners@ fund t&ere is no fi8 co$$it$ent of
repa#$ent and t&ere is no ris/ in'ol'ed. But finance $anager prefers a $i8 of *ot& t#pes.
Under financing decision finance $anager fi8es a ratio of o(ner fund and *orro(ed fund
in t&e capital structure of t&e co$pan#.
Factors Affecting Financing "ecisions
>&ile ta/ing financing decisions t&e finance $anager /eeps in $ind t&e follo(ing
factors:
1. Cost
T&e cost of raising finance fro$ 'arious sources is different and finance $anagers al(a#s
prefer t&e source (it& $ini$u$ cost.
;. is/
More ris/ is associated (it& *orro(ed fund as co$pared to o(ner@s fund securities.
Finance $anager co$pares t&e ris/ (it& t&e cost in'ol'ed and prefers securities (it&
$oderate ris/ factor.
<. Cas& Flo( .osition
T&e cas& flo( position of t&e co$pan# also &elps in selecting t&e securities. >it& s$oot&
and stead# cas& flo( co$panies can easil# afford *orro(ed fund securities *ut (&en
co$panies &a'e s&ortage of cas& flo(% t&en t&e# $ust go for o(ner@s fund securities
onl#.
D. Control Considerations
If e8isting s&are&olders (ant to retain t&e co$plete control of *usiness t&en t&e# prefer
*orro(ed fund securities to raise furt&er fund. !n t&e ot&er &and if t&e# do not $ind to
lose t&e control t&en t&e# $a# go for o(ner@s fund securities.
A. Floatation Cost
It refers to cost in'ol'ed in issue of securities suc& as *ro/er@s co$$ission% under(riters
fees% e8penses on prospectus% etc. Fir$ prefers securities (&ic& in'ol'e least floatation
cost.
F. Fi8ed !perating Cost
If a co$pan# is &a'ing &ig& fi8ed operating cost t&en t&e# $ust prefer o(ner@s fund
*ecause due to &ig& fi8ed operational cost% t&e co$pan# $a# not *e a*le to pa# interest
on de*t securities (&ic& can cause serious trou*les for co$pan#.
H. State of Capital Mar/et
T&e conditions in capital $ar/et also &elp in deciding t&e t#pe of securities to *e raised.
"uring *oo$ period it is eas# to sell e)uit# s&ares as people are read# to ta/e ris/
(&ereas during depression period t&ere is $ore de$and for de*t securities in capital
$ar/et.
C. "I7I"EN" "ECISI!N
T&is decision is concerned (it& distri*ution of surplus funds. T&e profit of t&e fir$ is
distri*uted a$ong 'arious parties suc& as creditors% e$plo#ees% de*enture &olders%
s&are&olders% etc.
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BUSINESS FINANCE
.a#$ent of interest to creditors% de*enture &olders% etc. is a fi8ed lia*ilit# of t&e
co$pan#% so (&at co$pan# or finance $anager &as to decide is (&at to do (it& t&e
residual or left o'er profit of t&e co$pan#.
T&e surplus profit is eit&er distri*uted to e)uit# s&are&olders in t&e for$ of di'idend or
/ept aside in t&e for$ of retained earnings. Under di'idend decision t&e finance $anager
decides &o( $uc& to *e distri*uted in t&e for$ of di'idend and &o( $uc& to /eep aside
as retained earnings.
To ta/e t&is decision finance $anager /eeps in $ind t&e gro(t& plans and in'est$ent
opportunities.
If $ore in'est$ent opportunities are a'aila*le and co$pan# &as gro(t& plans t&en $ore
is /ept aside as retained earnings and less is gi'en in t&e for$ of di'idend% *ut if
co$pan# (ants to satisf# its s&are&olders and &as less gro(t& plans% t&en $ore is gi'en
in t&e for$ of di'idend and less is /ept aside as retained earnings.
T&is decision is also called residual decision *ecause it is concerned (it& distri*ution of
residual or left o'er inco$e. 0enerall# ne( and upco$ing co$panies /eep aside $ore of
retain earning and distri*ute less di'idend (&ereas esta*lis&ed co$panies prefer to gi'e
$ore di'idend and /eep aside less profit.
Factors Affecting "i'idend "ecision
T&e finance $anager anal#ses follo(ing factors *efore di'iding t&e net earnings *et(een
di'idend and retained earnings:
1. Earning
"i'idends are paid out of current and pre'ious #ear@s earnings. If t&ere are $ore earnings
t&en co$pan# declares &ig& rate of di'idend (&ereas during lo( earning period t&e rate
of di'idend is also lo(.
;. Sta*ilit# of Earnings
Co$panies &a'ing sta*le or s$oot& earnings prefer to gi'e &ig& rate of di'idend (&ereas
co$panies (it& unsta*le earnings prefer to gi'e lo( rate of earnings.
<. Cas& Flo( .osition
.a#ing di'idend $eans outflo( of cas&. Co$panies declare &ig& rate of di'idend onl#
(&en t&e# &a'e surplus cas&. In situation of s&ortage of cas& co$panies declare no or
'er# lo( di'idend.
D. 0ro(t& !pportunities
If a co$pan# &as a nu$*er of in'est$ent plans t&en it s&ould rein'est t&e earnings of t&e
co$pan#. As to in'est in in'est$ent pro+ects% co$pan# &as t(o options: one to raise
additional capital or in'est its retained earnings. T&e retained earnings are c&eaper source
as t&e# do not in'ol'e floatation cost and an# legal for$alities.
If co$panies &a'e no in'est$ent or gro(t& plans t&en it (ould *e *etter to distri*ute
$ore in t&e for$ of di'idend. 0enerall# $ature co$panies declare $ore di'idends
(&ereas gro(ing co$panies /eep aside $ore retained earnings.
A. Sta*ilit# of "i'idend
So$e co$panies follo( a sta*le di'idend polic# as it &as *etter i$pact on s&are&older
and i$pro'es t&e reputation of co$pan# in t&e s&are $ar/et. T&e sta*le di'idend polic#
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BUSINESS FINANCE
satisfies t&e in'estor. E'en *ig co$panies and financial institutions prefer to in'est in a
co$pan# (it& regular and sta*le di'idend polic#.
T&ere are t&ree t#pes of sta*le di'idend policies (&ic& a co$pan# $a# follo(
Constant di'idend per s&are
In t&is case% t&e co$pan# decides a fi8ed rate of di'idend and declares t&e sa$e rate
e'er# #ear% e.g.% 1BR di'idend on in'est$ent.
Constant pa#out ratio
Under t&is s#ste$ t&e co$pan# fi8es up a fi8ed percentage of di'idends on profit and not
on in'est$ent% e.g.% 1BR on profit so di'idend /eeps on c&anging (it& c&ange in profit
rate.
Constant di'idend per s&are and e8tra di'idend
Under t&is sc&e$e a fi8ed rate of di'idend on in'est$ent is gi'en and if profit or
earnings increase t&en so$e e8tra di'idend in t&e for$ of *onus or interi$ di'idend is
also gi'en.
F. .reference of S&are&olders
Anot&er i$portant factor affecting di'idend polic# is e8pectation and preference of
s&are&olders as t&eir e8pectations cannot *e ignored *# t&e co$pan#. 0enerall# it is
o*ser'ed t&at retired s&are&olders e8pect regular and sta*le a$ount of di'idend (&ereas
#oung s&are&olders prefer capital gain *# rein'esting t&e inco$e of t&e co$pan#.
T&e# are read# to sacrifice present da# inco$e of di'idend for future gain (&ic& t&e#
(ill get (it& gro(t& and e8pansion of t&e co$pan#.
Secondl# poor and $iddle class in'estors also prefer regular and sta*le a$ount of
di'idend (&ereas (ealt&# and ric& class prefers capital gains.
So if a co$pan# is &a'ing large nu$*er of retired and $iddle class s&are&olders t&en it
(ill declare $ore di'idend and /eep aside less in t&e for$ of retained earnings (&ereas if
co$pan# is &a'ing large nu$*er of #oung and (ealt&# s&are&olders t&en it (ill prefer to
/eep aside $ore in t&e for$ of retained earnings and declare lo( rate of di'idend.
H. Ta8ation .olic#
T&e rate of di'idend also depends upon t&e ta8ation polic# of go'ern$ent. Under present
ta8ation s#ste$ di'idend inco$e is ta8 free inco$e for s&are&olders (&ereas co$pan#
&as to pa# ta8 on di'idend gi'en to s&are&olders. If ta8 rate is &ig&er% t&en co$pan#
prefers to pa# less in t&e for$ of di'idend (&ereas if ta8 rate is lo( t&en co$pan# $a#
declare &ig&er di'idend.
2. Access to Capital Mar/et Consideration
>&ene'er co$pan# re)uires $ore capital it can eit&er arrange it *# issue of s&ares or
de*entures in t&e stoc/ $ar/et or *# using its retained earnings. ising of funds fro$ t&e
capital $ar/et depends upon t&e reputation of t&e co$pan#.
If capital $ar/et can easil# *e accessed or approac&ed and t&ere is enoug& de$and for
securities of t&e co$pan# t&en co$pan# can gi'e $ore di'idend and raise capital *#
approac&ing capital $ar/et% *ut if it is difficult for co$pan# to approac& and access
capital $ar/et t&en co$panies declare lo( rate of di'idend and use reser'es or retained
earnings for rein'est$ent.
J. 6egal estrictions
Co$panies@ Act &as gi'en certain pro'isions regarding t&e pa#$ent of di'idends t&at can
*e paid onl# out of current #ear profit or past #ear profit after pro'iding depreciation
fund. In case co$pan# is not earning profit t&en it cannot declare di'idend.
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BUSINESS FINANCE
Apart fro$ t&e Co$panies@ Act t&ere are certain internal pro'isions of t&e co$pan# t&at
is (&et&er t&e co$pan# &as enoug& flo( of cas& to pa# di'idend. T&e pa#$ent of
di'idend s&ould not affect t&e li)uidit# of t&e co$pan#.
1B. Contractual Constraints
>&en co$panies ta/e long ter$ loan t&en financier $a# put so$e restrictions or
constraints on distri*ution of di'idend and co$panies &a'e to a*ide *# t&ese constraints.
11. Stoc/ Mar/et eaction
T&e declaration of di'idend &as i$pact on stoc/ $ar/et as increase in di'idend is ta/en
as a good ne(s in t&e stoc/ $ar/et and prices of securit# rise. >&ereas a decrease in
di'idend $a# &a'e negati'e i$pact on t&e s&are price in t&e stoc/ $ar/et. So possi*le
i$pact of di'idend polic# in t&e e)uit# s&are price also affects di'idend decision.
Inter-relations&ip *et(een In'est$ent% Financing and "i'idend
T&ree $a+or functions of finance depart$ent are
Financing "ecision
T&is function is $ainl# concerned (it& deter$ination of opti$u$ capital structure of t&e
co$pan# /eeping in $ind cost% control and ris/. It is also /no(n as .rocure$ent of
Fund.
In'est$ent "ecision
It is also /no(n as Effecti'e Utili5ation of Fund. In t&is respect finance depart$ent &as to
identif# t&e in'est$ent opportunities and to c&oice t&e *est one % after a proper
e'aluation.
"i'idend "ecision
T&e finance $anager is also concerned (it& t&e decisions to pa# or declare di'idend. Ee
assists t&e top $anage$ent to decide t&e portion of profit to *e declared as di'idend.
So far t&e o*+ecti'e is concernedK t&e a*o'e stated t&ree functions are sa$e i.e.
$a8i$i5ing s&are&olders (ealt&. As t&eir o*+ecti'es are sa$e t&e decisions are
interrelated. A co$pan# &a'ing profita*le in'est$ent opportunities% generall# prefer
lo(er di'idend pa#out ratio. !n t&e ot&er &and &a'ing a good in'est$ent $eans profit of
t&e co$pan# (ould *e $ore and $ore di'idend can *e paid to s&are&olders. Si$ilarl#%
finance function and in'est$ent functions are also &ig&l# correlated. Cost of capital pla#s
a $a+or role (&et&er to accept or not an in'est$ent opportunit#. Financing decisions also
dependent on a$ount of to *e retained in t&e profit. So% (e can conclude t&at in'est$ent%
financing and di'idend decisions are interrelated and are to *e ta/en +ointl# /eeping in
'ie( t&eir +oint effect on t&e s&are&olders (ealt&.
In'est$ent decisions9 6ong-ter$ asset-$i8
In'ol'e Capital e8penditure
eferred as Capital *udgeting
Allocation of funds to long ter$ assets (&ic& #ield returns in future
E'aluation of ne( pro+ects
Measure$ent of cut off rate against ne( in'est$ents
E'aluation on t&e *asis of return and ris/
In'ol'es replace$ent decisions
Financing "ecision 9 Capital Mi8
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BUSINESS FINANCE
Fro$ (&ere and &o( to ac)uire funds
"eter$ination of appropriate proposition of e)uit# and de*t
"e*t e)uit# $i8 is called Capital Structure
C&ange in s&are&older@s returns *# a c&ange in Capital structure is called Financial
6e'erage
Best co$*ination of de*t-e)uit# t&at (ould increase returns (it& t&e gi'en ris/ s&ould
*e found out
6egal aspects% loan facilities% controls etc s&ould also *e considered (&ile deciding
capital structure.
Factors influencing financial decisions
E8ternal Factors
State of econo$#
Structure of capital and $one# $ar/ets
e)uire$ents of in'estors
0o'ern$ent polic#
Ta8ation polic#
6ending polic# of financial institutions.
Internal Factors
Nature and si5e of *usiness
E8pected return
Co$position of assets
Structure of o(ners&ip
Trend of earnings
Age of t&e fir$
6i)uidit# position
>or/ing capital re)uire$ents
Conditions of de*t agree$ents
E6ATI!NSEI. BET>EEN ISP AN" ETUN
is/: is/ is defined as t&e c&ance of future loss t&at can *e foreseen.
eturn: T&e return represents t&e *enefits deri'ed *# a *usiness fro$ its
operations.
Measure$ent of eturn:
!n t&e *asis of .rofit
!n t&e *asis of Inco$e
!n t&e *asis of Earnings Before Interest and Ta8 ,EBIT-
!n t&e *asis of Earnings Before Ta8 ,EBT-
!n t&e *asis of Earnings After Ta8 ,EAT-
!n t&e *asis of Cas& flo(s generated in t&e *usiness operations
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BUSINESS FINANCE
!n t&e *asis of different accounting atios
FUNCTI!NS !F A FINANCE MANA0E
As a co$pan# gro(s% t&e responsi*ilities of t&e finance $anager e8pand% (it& $ore
outsourced functions co$ing in-&ouse and $ore long-ter$ strategic planning added to
t&e finance $anagerGs plate. Understanding t&e roles and responsi*ilities of a corporate
finance $anager (ill &elp #ou decide if t&is career is rig&t for #ou and &o( to prepare to
land t&ese t#pes of finance +o*s.
.lanning
Unli/e a *oo//eeper or accountant% a financial $anager% often /no(n as a c&ief financial
officer% plans long-ter$ financial strateg# for a co$pan#% delegating *oo//eeping (or/
to lo(er-le'el staff. T&e financial planning aspect of t&e +o* includes setting goals for
ac&ie'ing specific re'enues% profit $argins and gross profits. It also re)uires setting
targets for o'er&ead and production e8pense le'els and de*t-ser'ice $anage$ent. T&e
financial $anager needs to create a $aster *udget t&at@s tied to t&e co$pan#@s *alance
s&eet% accounts recei'a*le and pa#a*le reports and cas& flo( and profit-and-loss
state$ents. T&e financial $anager conducts regular re'ie(s of t&e $aster *udget% called
*udget 'ariance anal#ses% to deter$ine if an# c&anges s&ould *e $ade *ased on t&e
actual perfor$ance of t&e co$pan# 's. its financial pro+ections. Financial $anagers also
deter$ine t&e *est in'est$ent options for a *usiness@s e8cess cas& and re'ie( (a#s to
ac)uire capital for e8pansion or ac)uisitions.
Cost Contain$ent
A /e# responsi*ilit# of a financial $anager is to control t&e co$pan#@s e8penses. T&is
re)uires $ore t&an si$pl# setting spending le'els and cutting costs. Cost contain$ent
includes creating re)uests for proposals% *idding processes and purc&asing policies for
contractors% 'endors and suppliers to ensure t&e co$pan# gets t&e *est co$*ination of
)ualit# and price. T&e financial $anager sets *enc&$ar/s t&at deter$ine (&en it@s $ost
cost-effecti'e to perfor$ acti'ities using in-&ouse staff and (&en it@s *etter to use
contractors. Cost-contain$ent efforts include $anaging de*t to ensure interest pa#$ents
don@t (ipe out co$pan# profits. Financial $anagers also create strategies t&at &elp
reduce a co$pan#@s ta8 lia*ilit#% suc& as depreciating assets.
Cas& Flo( Manage$ent
!ne of t&e $ost i$portant functions of a financial $anager is to pro+ect and $anage t&e
co$pan#@s cas& flo(. Cas& flo( refers to t&e actual receipt of $one# and pa#$ent of
*ills% as opposed to t&e co$pan#@s *udgeted inco$e and e8penses. Assu$ing t&at
*ecause a *usiness &as $ore inco$e t&an e8penses it can pa# its *ills can lead to disaster.
For e8a$ple% if t&e co$pan# does not negotiate custo$er credit ter$s and 'endor and
supplier pa#$ent ter$s correctl#% t&e *usiness $ig&t *e (aiting to collect sales in'oices
long after *ills &a'e co$e due. Cas& flo( $anage$ent includes $onitoring recei'a*les
turno'er and /eeping enoug& credit and cas& reser'es a'aila*le to /eep t&e co$pan#
financiall# sta*le.
6egal Co$pliance
T&e corporate financial $anager ensures t&e *usiness $eets all of its legal o*ligations%
suc& as sales and inco$e ta8 pa#$entsK e$plo#ee *enefits contri*utionsK state and
federal la*or (age re)uire$entsK and Securities and E8c&ange Co$$ission reporting% if
t&e co$pan# is a pu*lic corporation. At s$all and $ediu$-si5ed *usinesses% t&e financial
;J
BUSINESS FINANCE
$anager often (or/s (it& ta8 e8perts and C.As (&o guide t&e co$pan# regarding its
legal o*ligations.
TEE FINANCIA6 MANA0E
T&e financial $anager is responsi*le for *udgeting% pro+ecting cas& flo(s% and
deter$ining &o( to in'est and finance pro+ects.
Pe# .oints
T&e finance $anager is responsi*le for /no(ing &o( $uc& t&e product is
e8pected to cost and &o( $uc& re'enue it is e8pected to earn so t&at s9&e can
in'est t&e appropriate a$ount in t&e product.
T&e finance $anager uses a nu$*er of tools% suc& as setting t&e cost of capital
,t&e cost of $one# o'er ti$e% (&ic& (ill *e e8plored in furt&er dept& later on- to
deter$ine t&e cost of financing.
T&e financial $anager $ust not +ust *e an e8pert at financial pro+ectionsK s9&e
also $ust &a'e a grasp of t&e accounting s#ste$s in place and t&e strateg# of t&e
*usiness o'er t&e co$ing #ears.
T&e &ead of t&e financial depart$ent is t&e c&ief financial officer ,CF!- (&o is
responsi*le for all financial decisions and reporting done in t&e co$pan#.
T&e ole of t&e Financial Manager
T&e role of a financial $anager is a co$ple8 one% re)uiring *ot& an understanding of
&o( t&e *usiness functions as a (&ole and speciali5ed financial /no(ledge. T&e &ead of
t&e financial operations is called t&e c&ief financial officer ,CF!-.
T&e structure of t&e co$pan# 'aries% *ut a financial $anager is responsi*le for t&e sa$e
general t&ings across t&e *oard. T&e $anager is responsi*le for $anaging t&e *udget.
T&is in'ol'es allocating $one# to different pro+ects and seg$ents so t&at t&e *usiness
can continue operating% *ut t&e *est pro+ects get t&e necessar# funding.
T&e $anager is responsi*le for figuring out t&e financial pro+ections for t&e *usiness. T&e
de'elop$ent of a ne( product% for e8a$ple% re)uires an in'est$ent of capital o'er ti$e.
T&e finance $anager is responsi*le for /no(ing &o( $uc& t&e product is e8pected to
cost and &o( $uc& re'enue it is e8pected to earn so t&at s9&e can in'est t&e appropriate
a$ount in t&e product. T&is is a lot toug&er t&an it sounds *ecause t&ere is no accurate
financial data for t&e future. T&e finance $anager (ill use data anal#ses and educated
guesses to appro8i$ate t&e 'alue% *ut itGs e8tre$el# rare t&at s9&e can *e 1BBR sure of t&e
future cas& flo(s.
Figuring out t&e 'alue of an operation is one t&ing% *ut it is anot&er t&ing to figure out if
itGs (ort& financing. T&ere is a cost to in'esting $one#% eit&er t&e opportunit# cost of not
in'esting it else(&ere% t&e cost of *orro(ing $one#% or t&e cost of selling e)uit#. T&e
finance $anager uses a nu$*er of tools% suc& as setting t&e cost of capital ,t&e cost of
$one# o'er ti$e% (&ic& (ill *e e8plored in furt&er dept& later on- to deter$ine t&e cost
of financing.
At t&e sa$e ti$e t&at t&is is going on% t&e financial $anager $ust also ensure t&at t&e
*usiness &as enoug& cas& to pa# upco$ing financial o*ligations (it&out &oarding assets
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BUSINESS FINANCE
t&at could ot&er(ise *e in'ested. T&is is a delicate dance *et(een s&ort-ter$ and long-
ter$ responsi*ilities.
T&e CF! is t&e &ead of t&e financial depart$ent and is responsi*le for all of t&e sa$e
t&ings as &is9&er su*ordinates% *ut is also t&e person (&o &as to sign off t&at all of t&e
co$pan#Gs financial state$ents are accurate. S9&e is also responsi*le for financial
planning and record-/eeping% as (ell as financial reporting to &ig&er $anage$ent.
T&e financial $anager is not +ust an e8pert at financial pro+ections% s9&e $ust also &a'e a
grasp of t&e accounting s#ste$s in place and t&e strateg# of t&e *usiness o'er t&e co$ing
#ears.
CA.ITA6
Mone# and (ealt&K t&e $eans to ac)uire goods and ser'ices% especiall# in a non-*arter
s#ste$.
C!66AB!ATI!N
T&e finance $anager $ust colla*orate across *usiness functions in order to deter$ine
&o( to *est allocate and $anage assets.
C!NT!66E
T&e controller or C&ief Accounting !fficer is responsi*le for t&e $aintenance of
ade)uate internal control and for t&e preparation of accounting records and financial
state$ents suc& speciali5ed acti'ities as *udgeting% ta8 planning and preparation of ta8
returns are usuall# placed under t&e controllerGs +urisdiction.
TEASUE ,'ice president of finance-
T&e Treasurers &as custod# of t&e co$pan# funds and is generall# responsi*le for
planning and controlling t&e co$pan# cas& position. T&e treasurerGs depart$ent also &as
responsi*ilit# for relations (it& t&e co$pan#Gs financial institutions and $a+or creditors.
C!NT!66ESEI. TEASUESEI.
a. .lanning : Control a. .ro'ision of capital
*. eporting : interpreting *. In'estor relations
c. E'aluating : Consulting c. Ban/ing : custod#
d. 0o'ern$ent reporting d. Credit : collections
e. .rotection of assets e. In'est$ents
f. Econo$ic appraisal f. Insurance
g. Ta8 ad$inistration g. S&ort-ter$ financing.
Section A
1. Corporation finance deals (it& t&e co$pan# for$ of organi5ation. True 9 False.
;. In t&e present da#s% corporation finance is also referred to as *usiness finance and
financial $anage$ent. True 9 False.
<. T&e principles of corporation finance can *e applied to e'er# t#pe of
organi5ation. True9 False.
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BUSINESS FINANCE
D. Traditional approac& confines finance function onl# to raising of funds. True9
False.
A. Finance function is one of t&e $ost i$portant functions of *usiness $anage$ent.
True9 False.
F. In'est$ent decisions are outside t&e pur'ie( of financial decisions. True9 False.
H. T&e appropriate o*+ecti'e of an enterprise is TTTTTTTTTTTTTTT.
2. T&e +o* of a finance $anager is TTTTTTTTTT
J. Business finance can *e defined as t&e acti'it# concerned (it& -------% -------- and
TTTTTTTTTT of funds used in *usiness.
1B. Finance functions or decisions can *e classified into ------- and --------- decisions.
Section B
1. >rite t&e scope and features of *usiness finance.
;. Eo( s&ould a finance function of an enterprise *e organised e8plain in detail
<. !*+ecti'es of finance functions
D. Eo( does traditional approac& differ fro$ $odern concept of financeI
A. E8plain Criticis$ of traditional approac& in *usiness finance
F. Can #ou state t&e nature of finance and its interaction (it& ot&er $anage$ent
functions.
H. Can #ou state t&e contents of $odern financeI
2. Brief t&e $odern concept of finance functions.
J. Illustrate t&e organisation of finance function.
1B. >&at are t&e difference *et(een s&ort and long ter$ finance functions or
decisionsI
Section C
1. E8plain t&e i$portant finance function of a *usiness.
;. "iscuss t&e $odern finance function concept.
<. Functions of a finance $anager in a large scale industrial esta*lis&$ent
Enu$erate
D. >&at is *usiness financeI "iscuss its o*+ecti'es in detail.
A. State t&e functions of a financial controller.
F. Concepts of *usiness finance.
H. >&at are t&e $ain considerations to *e follo(ed (it& t&e finance function in an
organisation.
2. >&at are t&e $ain considerations to *e follo(ed (it& t&e finance function in an
organisation.
J. Na$e four finance functions and *riefl# e8plain on eac&.
1B. >&at are t&e o*+ecti'es9scope of a *usiness financeI
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BUSINESS FINANCE
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BUSINESS FINANCE
UNIT II
Financial .lan: Meaning -Concept !*+ecti'es T#pes Steps
Significance Funda$entals.
FINANCIA6 .6ANNIN0
Introduction
Finance is t&e life *lood of *usiness. No *usiness can run successfull# (it&out ade)uate
finance. Finance is re)uired to *ring a *usiness into e8istence% to /eep it ali'e and also to
see it gro(ing and prospering.
Finance is an i$portant function of *usiness. T&e application of planning to t&is function
is called financial planning. Financial planning is $ainl# concerned (it& t&e econo$ical
procure$ent and profita*le use of funds. According to 0utl$an and "ougall% =Financial
planning is concerned (it& raising% controlling and ad$inistering of funds used in
*usiness.= In t&e (ords of Boune'ille and "e(e#% =Financial planning consists in t&e
raising% pro'iding and $anaging of all t&e $one#% capital of funds of an# /ind to *e used
in connection (it& t&e *usiness.= Financial planning is an i$portant ele$ent of t&e
o'erall planning of *usiness enterprise. Financial planning includes t&e follo(ing:
Esti$ating t&e a$ount of capital re)uired for financing t&e *usiness enterpriseK
"eter$ining capital structureK
6a#ing do(n policies for t&e ad$inistration of capitalK
For$ulating t&e progra$$es to pro'ide t&e $ost effecti'e use of capital.
Meaning
Finance is t&e i$portant function of *usiness. Financial polic# and procedure are t&e
*road guides in t&e procure$ent% ad$inistration and dis*urse$ent of funds. A (ell
prepared financial plan (ill not onl# ensure t&e procure$ent of sufficient funds *ut t&eir
proper utili5ation also.
Financial planning results in t&e for$ation of t&e financial plan. It is t&e process of
fra$ing financial policies in relation to procure$ent% in'est$ent and ad$inistration of
funds of an enterprise. It is pri$aril# a state$ent esti$ating t&e a$ount of capital and
deter$ining its co$position. T&e application of planning to t&e functions of finance is
$ainl# concerned (it& t&e econo$ical procure$ent and profita*le uses of funds. It
in'ol'es t&e deter$ination of o*+ecti'es policies and procedures relating to t&e financial
function. T&e ter$ =financial plan= often refers to a for$al and defined series of steps or
goals and pro'ides direction and $eaning to #our financial decisions.
T&e process of deter$ining personGs or fir$Gs financial needs or goals for t&e future and
t&e $eans to ac&ie'e t&e$.
"efinition
According to Ea$ptors Mo&n% t&e financial state$ent is an organi5ed collection of data
according to logical and consistent accounting procedures. Its purpose is to con'e# an
understanding of financial aspects of a *usiness fir$. It $a# s&o( a position at a $o$ent
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BUSINESS FINANCE
of ti$e as in t&e case of a *alance-s&eet or $a# re'eal a ser'ice of acti'ities o'er a gi'en
period of ti$e% as in t&e case of an inco$e state$ent.
Financial state$ents are t&e su$$ar# of t&e accounting process% (&ic&% pro'ides
useful infor$ation to *ot& internal and e8ternal parties. Mo&n N. N#er also defines it
3Financial state$ents pro'ide a su$$ar# of t&e accounting of a *usiness enterprise% t&e
*alance-s&eet reflecting t&e assets% lia*ilities and capital as on a certain data and t&e
inco$e state$ent s&o(ing t&e results of operations during a certain period4.
Financial state$ents generall# consist of t(o i$portant state$ents:
,i- T&e inco$e state$ent or profit and loss account.
,ii- Balance s&eet or t&e position state$ent.
A part fro$ t&at% t&e *usiness concern also prepares so$e of t&e ot&er parts of
state$ents% (&ic& are 'er# useful to t&e internal purpose suc& as:
,i- State$ent of c&anges in o(ner@s e)uit#.
,ii- State$ent of c&anges in financial position.
Inco$e State$ent
Inco$e state$ent is also called as profit and loss account% (&ic& reflects t&e operational
position of t&e fir$ during a particular period. Nor$all# it consists of one accounting
#ear. It deter$ines t&e entire operational perfor$ance of t&e concern li/e total re'enue
generated and e8penses incurred for earning t&at re'enue.
Inco$e state$ent &elps to ascertain t&e gross profit and net profit of t&e concern.
0ross profit is deter$ined *# preparation of trading or $anufacturing a9c and net profit is
deter$ined *# preparation of profit and loss account.
.osition State$ent
.osition state$ent is also called as *alance s&eet% (&ic& reflects t&e financial position of
t&e fir$ at t&e end of t&e financial #ear.
.osition state$ent &elps to ascertain and understand t&e total assets% lia*ilities and
capital of t&e fir$. !ne can understand t&e strengt& and (ea/ness of t&e concern (it& t&e
&elp of t&e position state$ent.
State$ent of C&anges in !(ner@s E)uit#
It is also called as state$ent of retained earnings. T&is state$ent pro'ides infor$ation
a*out t&e c&anges or position of o(ner@s e)uit# in t&e co$pan#. Eo( t&e retained
earnings are e$plo#ed in t&e *usiness concern. No(ada#s% preparation of t&is state$ent
is not popular and no*od# is going to prepare t&e separate state$ent of c&anges in
o(ner@s e)uit#.
State$ent of C&anges in Financial .osition
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BUSINESS FINANCE
Inco$e state$ent and position state$ent s&o(s onl# a*out t&e position of t&e finance%
&ence it can@t $easure t&e actual position of t&e financial state$ent. State$ent of
c&anges in financial position &elps to understand t&e c&anges in financial position fro$
one period to anot&er period.
State$ent of c&anges in financial position in'ol'es t(o i$portant areas suc& as fund
flo( state$ent (&ic& in'ol'es t&e c&anges in (or/ing capital position and cas& flo(
state$ent (&ic& in'ol'es t&e c&anges in cas& position.
>&# s&ould #ou planI
E'er#one (&o &as financial c&allenges to o'erco$e or financial goals to ac&ie'e need a
plan t&at contri*utes to t&eir financial sta*ilit# and (ealt&.
Steps to follo( during financial planning
Identif# goals and o*+ecti'es.
0at&er t&e infor$ation needed.
Anal#5e present situation and t&in/ a*out options.
>or/ out strategies to reac& #our goals.
E8ecute t&ose strategies.
.eriodicall# e8a$ and re'ise t&e$.
"EFINITI!NS
3Broadl# concei'ed% financial planning can *e 'ie(ed as a presentation or an
o'erall plan for t&e fir$ in financial ter$s. Narro(l# concei'ed financial
planning $a# refer onl# to t&e process of deter$ining t&e financial re)uire$ents
necessar# to support a gi'en set of plans in ot&er areas4 - Erra Sole$n
3Financial planning pertains onl# to t&e function of finance and includes t&e
deter$ination of t&e fir$@s financial o*+ecti'e% financial policies and financial
procedures4 - M.E.Bonne'ille
According to o*inson@s% financial planning is
1. To deter$ine t&e financial resources re)uired $eeting t&e co$panies operating
progra$ $e
;. Forecast t&e e8tent to (&ic& t&ese re)uire$ents (ill *e $et *# t&e internal
generation of funds and t&e e8tent to (&ic& t&e# (ill *e $et *# t&e e8ternal
source of funds.
<. It en'elopes t&e *est plan to o*tain t&en re)uired e8ternalK funds.
D. Esta*lis& and $aintain a s#ste$ of financial controls go'erning t&e allocation and
use of funds.
A. For$ulates progra$$es to pro'ide t&e $ost effecti'e profit 'olu$e cost
relations&ip.
F. Anal#sis t&e financial results of operations and to $eet ot&er e8penses.
H. eport facts to t&e top $anage$ent and $a/e reco$$endations on future
operations of t&e fir$.
!BMECTI7ES !F FINANCIA6 .6ANNIN0
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BUSINESS FINANCE
1. "eter$ining capital re)uire$ents
T&is (ill depend upon factors li/e cost of current and fi8ed assets% pro$otional
e8penses and long- range planning. Capital re)uire$ents &a'e to *e loo/ed (it&
*ot& aspects: s&ort- ter$ and long- ter$ re)uire$ents.
;. Ade)uate funds
A financial plan (ould ensure t&e a'aila*ilit# of sufficient funds to ac&ie'e
enterprise goals.
<. Balancing of costs and ris/
T&ere s&ould *e a *alancing of costs and ris/s so as to protect t&e in'estors.
D. "eter$ining capital structure
T&e capital structure is t&e co$position of capital% i.e.% t&e relati'e /ind and
proportion of capital re)uired in t&e *usiness. Fra$ing financial policies (it&
regards to cas& control% lending% *orro(ings% etc. A finance $anager ensures t&at
t&e scarce financial resources are $a8i$all# utili5ed in t&e *est possi*le $anner
at least cost in order to get $a8i$u$ returns on in'est$ent.
A. Fle8i*ilit#
A financial plan s&ould ensure fle8i*ilit# so as to ad+ust as per t&e re)uire$ents. It
s&ould *e ad+usta*le as per t&e c&anging conditions.
F. Si$plicit#
T&e financial structure s&ould not *e co$plicated *# issuing a 'ariet# of
securities s&ould *e less to t&at.
H. 6ong ter$ 'ie(
A financial plan s&ould ta/e a long ter$ 'ie(. T&e needs for funds in t&e near
future and o'er a longer period s&ould *e considered (&ile selecting t&e pattern
of financing.
2. 6i)uidit#
T&e li)uidit# of funds s&ould al(a#s *e /ept in $ind (&ile preparing a financial
plan. "uring t&e period of depression it is t&e li)uidit# (&ic& can support t t&e
concern going.
J. !pti$u$ use
A financial plan s&ould ensure sufficient funds for t&e genuine needs% eit&er t&e
plans (ould suffer due to s&ortage of funds neit&er t&ere s&ould *e (asteful use
of t&e$. T&e funds s&ould *e put to t&eir opti$u$ use.
Financial planning deals (it& t&e follo(ing
Esti$ation of capital to *e raised.
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BUSINESS FINANCE
"ecision regarding for$ and proportion of 'arious securities.
6a#out t&e policies regarding financial ad$inistration.
Financial planning deals (it& for$ulation of financial plan.
In si$ple (ords% it is not&ing *ut t&e esti$ation of a$ount of capital and deciding its
*eneficial sources.
T&us% financial plan co'ers
T&e )uantu$ of finance needed for co$$encing t&e *usiness.
T&e decision regarding for$ and proportion of 'arious corporate securities to *e
issued to raise t&e re)uired a$ount of capital.
T&e decision regarding policies to *e follo(ed for floating of 'arious corporate
securities.
.rinciples of Financial .lan:
.rinciple of Si$plicit#
.rinciple of 6ong-ter$ 'ie(
.rinciple of Foresig&t
.rinciple of !pti$u$ Use
.rinciple of Contingencies
.rinciple of Fle8i*ilit#
.rinciple of 6i)uidit#
.rinciple of Econo$#.
CEAATEISTICS !F A S!UN" FINANCIA6 .6AN
T&e $ain c&aracteristics of a good financial planning are as follo(s
Si$plicit#
T&e financial plan s&ould *e as si$ple as possi*le so t&at it can *e easil# understood
e'en *# a la#$an% propert# e8ecuted and ad$inistered. A co$plicated financial plan
creates unnecessar# co$plications and confusion.
Based on Clear-cut !*+ecti'es
T&e financial plan s&ould *e *ased on t&e clear-cut o*+ecti'es of t&e co$pan#. It s&ould
ai$ to procure ade)uate funds at t&e lo(est cost so t&at t&e profita*ilit# of t&e *usiness is
i$pro'ed.
Fle8i*ilit#
T&e financial plan s&ould not *e rigid% *ut rat&er fle8i*le enoug& to acco$$odate t&e
c&anges (&ic& $a# *e introduced in it as and (&en necessar#. T&e rigid co$position of
t&e financial plan $a# cause unnecessar# irritation and $a# li$it t&e future de'elop$ent
of t&e *usiness unit.
Sol'enc# an 6i)uidit#
T&e financial plan s&ould ensure sol'enc# and li)uidit# of t&e *usiness enterprise.
sol'enc# re)uires t&at s&ort-ter$ and long-ter$ pa#$ents s&ould *e $ade on due dates
positi'el#. T&is (ill ensure credit (ort&iness and good (ill to t&e *usiness enterprise.
6i)uidit# $eans $aintenance of ade)uate cas& *alance in &and. So$eti$es insufficienc#
of cas& $a# $a/e a *usiness enterprise *an/rupt.
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BUSINESS FINANCE
.lanning Foresig&t
Financial planning s&ould &a'e due foresig&t and 'ision to access t&e future needs% scope
and scale of operation of t&e *usiness enterprise. !n t&e *asis% financial planning s&ould
*e done in suc& a $anner t&at an# ad+ust$ent needed in t&e future $a# *e $ade (it&out
$uc& difficult#. As t&e *usiness proceeds% t&e financial ad+ust$ents *eco$e necessar#
(&ic& s&ould *e ad+usta*le properl# as and (&en desired.
Contingencies Anticipated
T&e financial plan s&ould *e a*le to anticipate 'arious contingencies (&ic& $a# arise in
t&e near future. T&e financial plan s&ould $a/e ade)uate pro'ision for $eeting t&e
c&allenge of unforeseen e'ents.
Mini$u$ "ependence on !utside Sources
A long-ter$ financial planning s&ould ai$ at $ini$u$ dependence on outside resources.
T&is can *e possi*le *# retaining a part of t&e profits for ploug&ing *ac/.
Intensi'e Use of Capital
Financial planning s&ould ensure intensi'e use of capital. As far as possi*le% a proper
*alance *et(een fi8ed and (or/ing capital s&ould *e $aintained.
.rofita*ilit#
A financial plan s&ould *e drafted in suc& a (a# t&at t&e profita*ilit# of t&e *usiness
enterprise is not ad'ersel# affected.
Econo$ical
T&e financial plan s&ould *e )uite econo$ical i.e.% t&e cost *urden of raising 'arious
t#pes of capital s&ould *e $ini$u$.
0o'ern$ent Financial .olic# and egulation
T&e financial polic# s&ould *e prepared in accordance (it& t&e go'ern$ent financial
polic# and regulation. It s&ould not 'iolate it under an# circu$stances.
STE.S IN FINANCIA6 .6AN
1. .ast perfor$ance
Anal#sis of t&e fir$s past perfor$ance to ascertain t&e relations&ips *et(een
financial 'aria*les% and t&e fir$@s financial strengt& and (ea/nesses.
;. !perating c&aracteristics
Anal#sis of t&e product% $ar/et% co$petition% production and $ar/eting policies%
control s#ste$s% operating ris/ etc to decide a*out its gro(t& o*+ecti'es.
<. Cas& flo( fro$ operations
Forecasting t&e for$s re'enues and e8penses and need for funds *ased on its
in'est$ents and di'idend policies.
D. Financing alternati'es
Anal#5ing financial alternati'es (it&in t&e financial polic# and deciding t&e
appropriate $eans of raising funds.
A. Consistenc#
E'aluating t&e consistenc# of financial policies (it& eac& ot&er and (it& t&e
corporate strateg#.
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BUSINESS FINANCE
F. Unifor$it#
Figures and reports s&ould *e e8pressed in a $anner (&ic& is consistent (it& t&e
structure of t&e organi5ation. Al t&e costs incurred on or for a gi'en depart$ent
$a# *e included.
H. Fle8i*ilit#
T&e use of de*t financing $a# *e $ini$i5ed so t&at a fle8i*le capital structure
$a# *e $aintained. It (ould *e desira*le% on t&e countr#% to resort to e)uit#
financing.
2. E8ceptions
So$eti$es it is useful for financial e8ecuti'es to /no( t&e areas and t&e e8tent of
de'iations fro$ actual perfor$ance. If de'iations are t&ro(n up% t&e# $a# *e
a*le to readil# accept one of t&e e8ceptions under a*nor$al circu$stances.
J. Conser'ati'e
A financial plan s&ould *e conser'ati'e in t&e sense t&at t&e de*t capacit# of t&e
co$pan# s&ould not *e e8ceeded.
1B. Sol'enc#
T&e plan s&ould ta/e proper care of sol'enc# *ecause $ost of t&e co$panies &a'e
failed *# reason of insol'enc#. Ade)uate li)uidit# (ill gi'e to an organi5ation t&at
degree of fle8i*ilit# (&ic& is necessar# for a*sor*ing t&e stoc/s of its nor$al
operations.
11. .rofita*ilit#
A financial plan s&ould $aintain t&e re)uired proportion *et(een fi8ed c&arges
o*ligations and t&e lia*ilities in suc& a $anner t&at t&e profita*ilit# of t&e
organi5ation is not ad'ersel# affected. T&e $ost crucial factor in financial
planning is t&e forecast of sales% for sales al$ost crucial factor in financial
planning is t&e forecast of sales% for sales al$ost in'aria*l# represent t&e pri$ar#
source of inco$e and cas& receipts.
1;. 7ar#ing is/s
A financial plan s&ould pro'ide for 'entures (it& 'ar#ing degrees of ris/s so t&at
it $ig&t ena*le a corporation to ac&ie'e su*stantial earnings fro$ ris/#
ad'entures.
1<. .lanning Foresig&t
A plan s&ould *e suc& t&at it s&ould deri'e a practical purpose. It s&ould *e
realistic and capa*le of *eing put to intensi'e use. But a proper *alance *et(een
fi8ed and (or/ing capital s&ould *e $aintained.
1D. A'aila*ilit#
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BUSINESS FINANCE
T&e sources of finance t&at a corporation $a# select s&ould *e a'aila*le at a
gi'en point of ti$e. If certain sources are not a'aila*le% t&e corporation $a# e'en
prefer to 'iolate t&e principles of suita*ilit# A'aila*ilit# so$eti$es *ears no
relation to cost.
1A. Ti$ing
A sound financial polic# in'ol'es effecti'e ti$ing in t&e ac)uisition of funds.
T&e /e# to effecti'e ti$ing is correct forecasting. A sound financial polic#
i$plies not onl# a (ise selection of sources *ut also an effecti'e ti$ing t&ereof.
But t&is (ould depend upon t&e understanding of t&e $anage$ent of &o(
*usiness c#cles *e&a'e during different p&ases of *usiness operations.
MAM! AEAS !F FINANCIA6 .6ANNIN0
FINE" CA.ITA6 EUUIEMENTS
"efinition of Fi8ed Capital
In general% t&e definition of fi8ed capital can *e stated as under.
3Fi8ed capital is a co$pulsor# initial in'est$ent $ade *# t&e entrepreneur to start up t&e
acti'ities of &is *usiness.4
Fi8ed capital is a $andator# one-ti$e in'est$ent $ade at t&e introductor# p&ase of a
*usiness esta*lis&$ent. Fi8ed capital is not ali/e (or/ing capital% (&ic& is re)uired on a
continuous *asis to operate ,run- t&e ordinar# course of production and distri*ution of
goods and ser'ices.
According to Eoagland%
3Fi8ed capital is co$parati'el# easil# defined to include land% *uilding% $ac&iner# and
ot&er assets &a'ing a relati'el# per$anent e8istence.4
Fi8ed capital is a per$anent in'est$ent $ade to $eet t&e longer-ter$ needs
,re)uire$ents- of t&e *usiness acti'ities. T&us% fi8ed capital &as a per$anent e8istence in
t&e *usiness. It is usuall# present in t&e for$ of fi8ed assets li/e land% *uilding% plant%
$ac&iner#% etc.
Meaning of Fi8ed Capital
T&e $eaning of fi8ed capital is depicted in t&e follo(ing c&art.
T&e $eaning of fi8ed capital can *e easil# grasped fro$ t&ese points:
1. Fi8ed capital is a co$pulsor# initial in'est$ent $ade in t&e *usiness.
;. It &elps to la# do(n t&e *asic infrastructure on (&ic& *usiness is supposed to
stand and flouris& in a long run.
<. It is a part of total capital in'ested in t&e *usiness.
D. It &as a per$anent e8istence in t&e *usiness to $eet its long-ter$ needs.
A. It is used for purc&asing fi8ed assets li/e land% *uilding% plant% $ac&iner#% etc.
F. It is also used for purc&asing intangi*le assets li/e patents% cop#rig&ts% good(ill%
etc.
H. It is re)uired for pro$oting t&e *usiness.
2. It is also re)uired for e8pansion% $oderni5ation and di'ersification of *usiness.
J. Fi8ed capital gets depreciated as an asset is used o'er ti$e (it& fe( e8ceptions
li/e in case of land.
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BUSINESS FINANCE
1B. Fi8ed capital re)uire$ent is esti$ated *# t&e pro$oters of *usiness. T&is
esti$ation $ust *e $ade as accuratel# as possi*le. To ac&ie'e t&is% t&e pro$oters
see/ professional &elp and ta/e ad'ice fro$ e8perts suc& as engineers% arc&itects%
etc.
E8a$ples of Fi8ed Capital
T&e e8a$ples of fi8ed capital are depicted in t&e follo(ing i$age.
Co$$on e8a$ples of fi8ed capital in'est$ents are as follo(s:
.lant and $ac&iner#.
Factor#Gs land and its *uildings.
Co$pan#Gs &ead)uarter ,EU-% ad$inistrati'e areas% regional and local offices% and
t&eir pre$ises.
Co$puting and co$$unication infrastructure t&at $ostl# includes (or/stations%
ser'ers% data-storage facilities% local-area net(or/s% t&e internet% telep&ones% fa8%
so on.
.atents% cop#rig&ts% good(ill% etc.% also gets co'ered under fi8ed capital.
.6ANNIN0 TEE FINANCIA6 NEE"S ! ESTIMATI!N !F FINANCIA6
EUUIEMENTS.
,1- .lanning t&e total capitali5ation
Capitali5ation refers to t&e total financial resources re)uired *# an organi5ation to attain
t&e specified o*+ecti'es. .oor planning or lac/ of planning of capitali5ation drags t&e
fir$ eit&er to(ards o'er capitali5ation or under capitali5ation. Under earnings t&eor#% t&e
e8pected earnings are capitali5ed art t&e rate of return t&at pre'ails in si$ilar co$petiti'e
fir$s.
,;- Esti$ation of s&ort ter$ and long ter$ funds
6ong-ter$ funds are in'ested in fi8ed assets and per$anent (or/ing capital. >&ile s&ort
ter$ funds are needed to finance te$porar# (or/ing capital. if s&ort ter$ funds are used
to finance fi8ed assets% it $a# &a$per t&e li)uidit# of t&e co$pan#. Con'ersel#% if t&e
long-ter$ funds are used to finance te$porar# (or/ing capital% it $a# pro'e costl# to t&e
organi5ation. Eence t&e esti$ation of t&e total needs and its su*di'ision into long ter$
and s&ort ter$ is &ig&l# essential.
,<- Capital structure planning
Capital structure refers to t&e finance $i8 of t&e different t#pes of long ter$ funds in
total capitali5ation. T&e c&ange in capital structure affects t&e cost of capital of t&e fir$
as (ell as t&e financial ris/ as represented *# t&e de*t-e)uit# ratio. T&e E.s can *e
$agnified (it& t&e &elp of de*t-e)uit# ratio. T&us proper planning is essential.
,D- .rofit planning
.rofit planning is done in ter$s of t&e different *udgets regarding sales% $anufacturing
costs% operating costs% ad$inistrati'e costs% sales and distri*ution costs% interest
lia*ilities%etc..rofit planning is done (it& t&e &elp of t&e pro+ected profit and loss
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BUSINESS FINANCE
account. .rofit planning esti$ates t&e pro+ected profits of t&e co$pan#.. It is 'alua*le for
certain i$portant decisions.
,A- "i'idend planning
a. Need of internal financing
*. Sta*ilit# in di'idend rate.
ASSESSMENT !F FINE" CA.ITA6 EUUIEMENTS
Fi8ed capital is re)uired to finance t&e cost of ac)uisition of per$anent assets suc& as
land% *uilding% plant and $ac&iner#% etc and to fund t&e cost of intangi*le assets li/e
pro$otion e8penses% organisation e8penses% operating losses% costs of financing% patents%
cop#rig&ts and good(ill% etc. Eence% t&e assess$ent of t&e total a$ount of fi8ed capital
re)uired in a *usiness in'ol'es:
I. Esti$ation of Fi8ed Assets e)uire$ents
II. Esti$ation of Intangi*le Assets e)uire$ents.
I. ESTIMATI!N !F FINE" ASSETS EUUIEMENTS
Fi8ed assets re)uire$ents are esti$ated usuall# at t&e ti$e of pro$otion of a ne(
enterprise. Eo(e'er% e8isting fir$s an# also need it at t&e ti$e of e8pansion% gro(t&%
replace$ent and i$pro'e$ent of t&e e8isting facilities. It is i$portant not onl# to
esti$ate t&e in'est$ents needed for t&ese assets *ut also t&e ti$e at (&ic& t&ese a$ounts
are re)uired.
T&e pro$oters and $anagers of t&e *usiness can deter$ine 'arious fi8ed assets re)uired
*# t&e$ fro$ t&eir o(n e8perience in t&e *usiness or *# $a/ing a stud# of si$ilar units
or *# ta/ing ad'ice fro$ tec&nical e8perts in t&at line of *usiness. T&e esti$ation of t&e
cost of t&ese assets could *e $ade *# t&e$ *# $a/ing en)uires (it& t&e $anufactures or
suppliers of t&ese assets. Esti$ation of t&e cost of land usuall# poses no pro*le$ and t&e
cost of *uilding can *e esti$ated *# ta/ing &elp fro$ *uilding engineers and contractors.
Furt&er% t&e cost of installation of plant and $ac&iner# and ot&er e)uip$ents s&ould also
*e $ade. A sufficient $argin for non-fir$ costs s&ould% &o(e'er% is $ade to $eet t&e
e8igencies.
T&e re)uire$ent of fi8ed assets 'aries fro$ *usiness to *usiness. T&ere are a nu$*er of
factors t&at deter$ine t&e re)uire$ents of fi8ed assets in a *usiness.
FACT!S AFFECTIN0 TEE ESTIMATI!N !F FINE" ASSETS
EUUIEMENTS
7arious factors (&ic& affect t&e esti$ation of fi8ed assets re)uire$ents in a *usiness can
*e studied under t(o &eads:
Internal Factors
E8ternal factors
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BUSINESS FINANCE
INTENA6 FACT!S
Nature or c&aracter of *usiness
T&e fi8ed assets re)uire$ents of a *usiness *asicall# depend upon t&e nature of its
*usiness. .u*lic utilit# underta/ings suc& as electricit#% (ater suppl# and rail(a#s re)uire
&uge fuds to *e in'ested in fi8ed assets. !n t&e ot&er &and% trading and financial fir$s
&a'e 'er# less re)uire$ents for fi8ed assets *ut &a'e to in'est large a$ounts in current
assets. Manufacturing concerns also re)uire si5ea*le fi8ed capital as t&e# &a'e to set up
production facilities and in'est large funds in fi8ed assets suc& a land and *uildings% plant
and $ac&iner#% etc. T&us% t&e nature of *usiness deter$ines t&e re)uire$ents of fi8ed
assets9capital to a large e8tent.
Si5e of *usiness
T&e fi8ed assets9capital re)uire$ents of concern are also influenced *# t&e si5e of its
*usiness (&ic& $a# *e deter$ined in ter$s of scale of operations. 0enerall#% larger t&e
si5e of a *usiness unit% greater is t&e re)uire$ent of fi8ed assets needed to set up t&e
*usiness operations.
Acti'ities Underta/en *# t&e Enterprise or Scope of Business
T&e re)uire$ent of fi8ed capital also depends upon t&e nu$*er of acti'ities underta/en
*# t&e enterprise. For e8a$ple% if a concern $anufactures and $ar/ets its products itself%
it needs $ore fi8ed capital as co$pared to a concern t&at underta/es onl# $anufacturing
acti'ities or onl# $ar/eting acti'ities. Si$ilarl#% if a concern is engaged in production of
all parts of a product% it (ill re)uire $ore capital t&an a concern (&ic& is engaged in
asse$*ling parts $anufactured *# ot&er units.
.roduction Tec&ni)ues
Anot&er factor t&at influences t&e re)uire$ents of fi8ed capital in a *usiness is t&e
production tec&ni)ue t&at is to *e adopted in t&e enterprise. For e8a$ple% use of
auto$atic $ac&iner# calls for larger in'est$ent in t&e fi8ed assets. !n t&e ot&er &and% if
production $et&ods are si$ple% (&ic& do not re)uire suc& e)uip$ents% lesser a$ount of
fi8ed capital s&all *e needed.
Mode of Ac)uisition of Fi8ed Assets ,E8tent of 6ease or Eire-
Fi8ed assets $a# *e purc&ased out rig&tl# or ac)uired on lease or &ire *asis. If an
outrig&t purc&ase of fi8ed assets is to *e $ade% larger a$ount of fi8ed capital s&all *e
re)uired in co$parison to t&e ac)uisition of fi8ed assets on lease&old *asis or on &ire. It
is t&erefore% essential to decide in ad'ance as to (&ic& assets are to *e ac)uired on
lease&old *asis and (&ic& are to *e purc&ased out rig&tl#. In t&e sa$e $anner if so$e of
t&e fi8ed asset are a'aila*le on &ire or rent% decision &as to *e ta/en in regard to t&e
purc&ase of t&ese assets on outrig&t or &ire *asis.
Ac)uisition of old E)uip$ent and plant
In certain industries% old plant and $ac&iner# or e)uip$ents $a# *e a'aila*le at prices
$uc& *elo( t&e prices of t&e ne( plant and $ac&iner#. If old plant and $ac&iner# could
*e satisfactoril# used in t&e *usiness% especiall# in t&e areas (&ere t&e tec&nological
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BUSINESS FINANCE
c&ange in production $et&od is $oderate or slo(% it (ould su*stantiall# reduce t&e
re)uired in'est$ent in fi8ed assets.
"ecision as regards ancillar# units
In certain industries% t&ere $a# *e a possi*ilit# of carr#ing out certain processes t&roug&
ancillar# units or su*-contracts (it&out co$pro$ising (it& t&e )ualit# and cost of t&e
product. If it is so% t&e re)uire$ents of fi8ed assets can *e decreased.
A'aila*ilit# of fi8ed assets at concessional rates
In so$e areas% t&e 0o'ern$ent pro'ides land and ot&er $aterials9 facilities at
concessional rates to pro$ote *alanced industrial gro(t& and regional de'elop$ent of
industries. Furt&er% plant and $ac&iner# $a# *e $ade a'aila*le on instal$ent *asis. Suc&
concessions induce t&e pro$oters to esta*lis& *usiness in t&ese areas reducing t&eir
in'est$ent in fi8ed assets.
ENTENA6 FACT!S
International conditions and Econo$ic !utloo/
>&ile ta/ing decision relating to in'est$ent in fi8ed assets% particularl# in a large
concern% t&e general econo$ic and international conditions also pla# an i$portant role.
For e8a$ple% if t&e le'el of *usiness acti'it# is e8pected to increase% t&e needs for fi8ed
assets and funds to finance t&eir ac)uisition (ill also gro(. In t&e sa$e $anner%
co$panies e8pecting (ar% $a# co$$it large in'est$ent in fi8ed assets *efore t&ere is a
s&ortage of suc& $aterial.
.opulation Trends and its Co$position
If a fir$ is planning for national $ar/et for its products% national population trends $ust
*e e'aluated (&ile forecasting for fi8ed assets re)uire$ents. In India% certain pro$oters
are encouraged to e8pand *usiness *ecause t&e population is increasing at a fast rate. T&e
age and se8 co$position of t&e population $a# also *e i$portant for certain *usinesses.
S&ift in Consu$er .references
Anot&er factor t&at affects t&e future re)uire$ents of fi8ed assets is s&ift in consu$er
preferences. Fi8ed assets re)uire$ents s&ould *e planned in a $anner so as to pro'ide
goods or ser'ices t&at consu$ers (ill accept.
Co$petiti'e factors
T&e decision $a/ing process on planning future re)uire$ents of fi8ed assets is also
influenced *# co$petiti'e factors. For e8a$ple% if an e8isting co$pan# s&ifts to a
particular line of *usiness% t&en ot&ers $a# also follo( t&e lead.
S&ift in Tec&nolog#
Future i$pro'e$ents and s&ifts in tec&nolog# &a'e also to *e considered (&ile deciding
a*out t&e future re)uire$ents of fi8ed assets. T&e financial plan s&ould allo( a scope for
ad+ust$ents as and (&en ne( situations e$erge.
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BUSINESS FINANCE
0o'ern$ent egulations
T&ere $a# *e certain go'ern$ent regulations affecting t&e si5e and t&e direction of a
*usiness enterprise. Eence% t&ese s&ould also *e considered (&ile assessing re)uire$ents
of fi8ed assets. Alt&oug&% it $a# not *e possi*le to forecast c&anges in t&e 0o'ern$ent
polic#% a $argin s&ould *e pro'ided to a*sor* t&e i$pact of suc& c&anges.
II. ESTIMATI!N !F INTAN0IB6E ASSET EUUIEMENTS
T&e e8penses of pro$otion% incorporation of an organi5ation or an esta*lis&$ent of
*usiness cost of financing and t&e a$ount to *e in'ested in intangi*le assets. Suc& as
good(ill% patents% cop#rig&ts etc.% also for$s part of fi8ed capital of a concern.
1. .ro$otional e8penses
T&e e8penses incurred *# t&e pro$oter to $a/e preli$inar# in'estigation% stud#
$ar/eting possi*ilities% en)uires a*out t&e tec&nical aspects of production processes
and asse$*ling t&e ele$ents of *usiness are called pro$otion e8penses. T&ese are to
*e paid to t&e pro$oter as co$pensation for t&e ser'ices rendered *# &i$ in
pro$oting t&e *usiness. Alt&oug&% it is 'er# difficult to deter$ine t&e re$uneration of
t&e pro$oter for &is personal efforts% ti$e and s/ill in pro$oting t&e *usiness%
sufficient pro'ision s&ould *e $ade for t&e sa$e (&ile esti$ating t&e re)uire$ent of
intangi*le assets for t&e purpose of assessing t&e fi8ed capital re)uire$ents of a
*usiness.
;. Incorporation and organi5ation e8penses
E8penses incurred in setting up t&e *usiness suc& as legal counseling% sta$p dut#%
registration fees% filing fees% incorporation ta8es% printing% etc. for$ part of
incorporation or organisational cost. It is 'er# essential to $a/e an esti$ate of suc&
e8penses (&ile deter$ining t&e re)uire$ents of fi8ed capital in a *usiness.
<. Cost of finance
T&e e8penses incurred for arranging t&e funds re)uired for a *usiness are called costs
of financing. T&ese include t&e re$uneration of under(riters% *ro/ers% in'est$ent
*an/ers as (ell as t&e e8penses to *e incurred in t&e preparation of a registration
state$ent and prospectus for $a/ing capital issues. T&ese costs (ould also *e
esti$ated (&ile assessing t&e re)uire$ents of intangi*le assets for$ing part of t&e
fi8ed capital.
D. Initial operating losses
E'er# enterprise needs so$e ti$e to sta*ili5e t&e production and reac& t&e self
supporting stage. Until t&at ti$e% it incurs certain cas& losses and funds drain out of
t&e *usiness. Suc& losses are $ost prolonged in *usiness re)uiring &uge initial
in'est$ent% co$ple8 production tec&ni)ues and $ar/eting or de'eloping a no'el
product. >&ile planning for capital% it is 'er# essential to esti$ate and pro'ide for
suc& operating initial losses.
A. Cost of ac)uisition of patents% cop#rig&ts% good(ill.etc.
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BUSINESS FINANCE
If t&e co$pan# is considering to purc&ase patents% cop#rig&ts% good(ill% etc. t&en it is
'er# essential to $a/e an esti$ate of t&e cost of t&ese intangi*le assets and include
t&e sa$e in t&e fi8ed capital re)uire$ents of a *usiness.
After preparing esti$ates of fi8ed assets and intangi*le assets re)uire$ents
separatel#% (e can deter$ine t&e total fi8ed capital re)uire$ents of an enterprise *#
si$pl# adding t&e funds needed for fi8ed assets and intangi*le assets.
>!PIN0 CA.ITA6
>or/ing capital refers to t&at part of t&e fir$@s capital (&ic& is re)uired for financing
s&ort ter$ or current assets suc& as cas&% $ar/eta*le securities% de*tors and in'entories.
Funds t&us in'ested in current assets /eep re'ol'ing fast and are *eing constantl#
con'erted into cas& and t&is cas& flo( out again in e8c&ange for ot&er current assets.
Eence% it is also /no(n as re'ol'ing or circulating capital or s&ort ter$ capital.
T&e (or/ing capital re)uire$ents of a concern depend upon a large nu$*er of factors
suc& as:
1. Nature or c&aracter of *usiness.
;. Si5e of *usiness9 scale of operations
<. .roduction polic#
D. Manufacturing process9 lengt& of production c#cle
A. Seasonal 'ariations
F. >or/ing capital c#cle
H. ate of stoc/ turno'er
2. Credit polic#
J. Business c#cles
1B. ate of gro(t& of *usiness
11. Earning Capacit# and di'idend polic#
1;. .rice le'el c&anges
1<. !t&er factors
To a'oid t&e s&ortage of (or/ing capital at once% an esti$ate of (or/ing capital
re)uire$ents s&ould *e $ade in ad'ance so t&at arrange$ents can *e $ade to procure
ade)uate (or/ing capital. T&e (or/ing capital s&ould *e deter$ined *# esti$ating t&e
in'est$ent in current assets $inus $one#s e8pected fro$ current lia*ilities. T&e
follo(ing factors s&ould *e ta/en into consideration (&ile $a/ing an esti$ate of
(or/ing capital re)uire$ents:
1. Total costs incurred on $aterial% (ages and o'er&eads.
;. T&e lengt& of ti$e for (&ic& ra( $aterials are to re$ain in stores *efore t&e# are
issued for production.
<. T&e ti$e ta/en for con'ersion of ra( $aterial into finis&ed goods.
D. T&e lengt& of sales c#cle during (&ic& finis&ed goods are to *e /ept (aiting for sales.
A. T&e a'erage period of credit allo(ed to custo$ers.
F. T&e a$ount of cas& re)uired to pa# da#-to-da# e8penses of t&e *usiness.
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BUSINESS FINANCE
H. T&e a'erage a$ount of cas& re)uired to $a/e ad'ance pa#$ents% if an#.
2. T&e a'erage credit period e8pected to *e allo(ed *# suppliers.
J. Ti$e lag in pa#$ent of (ages and ot&er e8penses.
Fro$ t&e total a$ount *loc/ed in current assets esti$ated on t&e *asis of t&e first se'en
ite$s gi'en a*o'e% t&e total of t&e current lia*ilities% i.e. t&e last t(o ite$s is deducted to
find out t&e re)uire$ents of (or/ing capital.
METE!"S USE" F! FINANCIA6 .6ANNIN0
T&e t(o i$portant tools of financial planning are
.ro-for$a financial state$ents
Maintenance of sol'enc# and li)uidit# are t&e t(o *asic issues in financial $anage$ent.
>&en t&e net (ort& of t&e fir$ is nit sufficient to disc&arge t&e lia*ilities in full% t&e fir$
is said to *e sol'ent% t&is is /no(n as 3legal insol'enc#4. 6egal insol'enc# results in
eit&er t&e reorgani5ation or t&e li)uiditation of t&e fir$. In so$e cases t&e fir$
financiall# sound% net (ort& of t&e fir$ is sufficient to disc&arge t&e lia*ilities on
$aturit#. Suc& a situation is descri*ed as 3tec&nical insol'enc#4. Tec&nical insol'enc#
indicates t&e li)uidit# crisis.
T&e pro-for$a financial state$ent in'ol'es t&e preparation of t&e follo(ing t(o
state$ents.
1. .ro for$a profit and loss account ,Inco$e state$ent-
;. .ro for$a *alance s&eet.
;. Cas& Budgeting
T&e *udget is si$pl# a ti$e-p&ased sc&edule of acti'ities of transactions presented
usuall# in rupee for$. It can also *e presented in ot&er )uantitati'e data. A *udget can *e
presented for an# acti'it# (it& reference to
1. Specific future periodicit# and
;. E8act )uantitati'e data relating to t&at specified period.
A cas& *udget is i$portant and /e# instru$ent of financial planning% especiall# cas&
$anage$ent. A cas& *udget is ti$e-p&ased sc&edule of e8pected cas& inflo(s and cas&
outflo(s% disclosing t&e cas& s&ortages (it& reference to ti$ings and $agnitude. Cas&
*udget is a planning tool as (ell as a control tec&ni)ue.

NEE" F! FINANCIA6 .6ANNIN0
1. A'aila*ilit# of sufficient cas& & for $eeting e8penses% e$ergencies and contingencies.
;. To $aintain t&e necessar# li)uidit# t&roug&put t&e #ear.
<. To indicate in points of ti$e (&en funds (ill *e re)uired and &o( $uc&.
D. To indicate t&e surplus resources a'aila*le for e8pansion or e8ternal in'est$ents.
A. To pro'ide a&ead for an# $ore funds% if re)uired.
F. To increase t&e confidence in t&en $inds of t&e surplus of funds *# adopting suita*le
financial policies.
H. T&e en'iron$ent under (&ic& t&e *u2siness fir$s operate are constantl# c&anging.
T&ere is cut t&roat co$petition and conse)uent narro( $argin of profit.
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BUSINESS FINANCE
Eence% planning *eco$es essential to o'erco$e t&e ris/ an reduce t&e uncertaint# as far
as possi*le.
6i$itations of Financial .lanning
So$e of t&e li$itations of financial planning are discussed as follo(s:
"ifficult# in Forecasting
Financial plans are prepared *# ta/ing into account t&e e8pected situations in t&e future.
Since% t&e future is al(a#s uncertain and t&ings $a# not &appen as t&ese are e8pected% so
t&e utilit# of financial planning is li$ited. T&e relia*ilit# of financial planning is
uncertain and 'er# $uc& dou*ted.
"ifficult# in C&ange
!nce a financial plan is prepared t&en it *eco$es difficult to c&ange it. A c&anged
situation $a# de$and c&ange in financial plan *ut $anagerial personnel $a# not li/e it.
E'en ot&er(ise% assets $ig&t &a'e *een purc&ased and ra( $aterial and la*our costs
$ig&t &a'e *een incurred. It *eco$es 'er# difficult to c&ange financial plan under suc&
situations.
.ro*le$ of Co-ordination
Financial function is t&e $ost i$portant of all t&e functions. !t&er functions influence a
decision a*out financial plan. >&ile esti$ating financial needs% production polic#%
personnel re)uire$ents% $ar/eting possi*ilities are all ta/en into account. Unless t&ere is
a proper co-ordination a$ong all t&e functions% t&e preparation of a financial plan
*eco$es difficult. !ften t&ere is a lac/ of co-ordination a$ong different functions. E'en
indecision a$ong personnel distur*s t&e process of financial planning.
T?.ES !F FINANCIA6 STATEMENT ANA6?SIS
Anal#sis of Financial State$ent is also necessar# to understand t&e financial positions
during a particular period. According to M#res% 3Financial state$ent anal#sis is largel# a
stud# of t&e relations&ip a$ong t&e 'arious financial factors in a *usiness as disclosed *#
a single set of state$ents and a stud# of t&e trend of t&ese factors as s&o(n in a series of
state$ents4.
Anal#sis of financial state$ent $a# *e *roadl# classified into t(o i$portant t#pes
on t&e *asis of $aterial used and $et&ods of operations.
T#pes of Financial Anal#sis
!n t&e *asis of !n t&e *asis of
Materials Used Met&ods of !perations
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BUSINESS FINANCE
Fig. 2.2 Types of Financial Statement Analysis
1. Based on Material Used
Based on t&e $aterial used% financial state$ent anal#sis $a# *e classified into
t(o $a+or t#pes suc& as E8ternal anal#sis and internal anal#sis.
A. E8ternal Anal#sis
!utsiders of t&e *usiness concern do nor$all# e8ternal anal#ses *ut t&e#
are indirectl# in'ol'ed in t&e *usiness concern suc& as in'estors% creditors%
go'ern$ent organi5ations and ot&er credit agencies. E8ternal anal#sis is
'er# $uc& useful to understand t&e financial and operational position of t&e
*usiness concern. E8ternal anal#sis $ainl# depends on t&e pu*lis&ed
financial state$ent of t&e concern. T&is anal#sis pro'ides onl# li$ited
infor$ation a*out t&e *usiness concern.
B. Internal Anal#sis
T&e co$pan# itself does disclose so$e of t&e 'alua*le infor$ations to t&e
*usiness concern in t&is t#pe of anal#sis. T&is anal#sis is used to understand
t&e operational perfor$ances of eac& and e'er# depart$ent and unit of t&e
*usiness concern. Internal anal#sis &elps to ta/e decisions regarding
ac&ie'ing t&e goals of t&e *usiness concern.
;. Based on Met&od of !peration
Based on t&e $et&ods of operation% financial state$ent anal#sis $a# *e classified
into t(o $a+or t#pes suc& as &ori5ontal anal#sis and 'ertical anal#sis.
A. Eori5ontal Anal#sis
Under t&e &ori5ontal anal#sis% financial state$ents are co$pared (it&
se'eral #ears and *ased on t&at% a fir$ $a# ta/e decisions. Nor$all#% t&e
current #ear@s figures are co$pared (it& t&e *ase #ear ,*ase #ear is
consider as 1BB- and &o( t&e financial infor$ation are c&anged fro$ one
#ear to anot&er. T&is anal#sis is also called as d#na$ic anal#sis.
B. 7ertical Anal#sis
Under t&e 'ertical anal#sis% financial state$ents $easure t&e )uantities
relations&ip of t&e 'arious ite$s in t&e financial state$ent on a particular
period. It is also called as static anal#sis% *ecause% t&is anal#sis &elps to
deter$ine t&e relations&ip (it& 'arious ite$s appeared in t&e financial
state$ent. For e8a$ple% a sale is assu$ed as 1BB and ot&er ite$s are
con'erted into sales figures.
TECENIUUES !F FINANCIA6 STATEMENT ANA6?SIS
AB
E8ternal Internal Eori5ontal 7ertical
Anal#sis Anal#sis Anal#sis Anal#sis
BUSINESS FINANCE
Financial state$ent anal#sis is interpreted $ainl# to deter$ine t&e financial and
operational perfor$ance of t&e *usiness concern. A nu$*er of $et&ods or tec&ni)ues are
used to anal#se t&e financial state$ent of t&e *usiness concern. T&e follo(ing are t&e
co$$on $et&ods or tec&ni)ues% (&ic& are (idel# used *# t&e *usiness concern.
Tec&ni)ues
atio Co$parati'e Trend
Co$$on
Funds Flo( Cas& Flo(
Si5e
Anal#sis State$ent Anal#sis State$ent State$ent
Anal#sis
Fig. 2.3 Techniques of Financial Statement Analysis
1. Co$parati'e State$ent Anal#sis
A. Co$parati'e Inco$e State$ent Anal#sis
B. Co$parati'e .osition State$ent Anal#sis
;. Trend Anal#sis
<. Co$$on Si5e Anal#sis
D. Fund Flo( State$ent
A. Cas& Flo( State$ent
F. atio Anal#sis
Co$parati'e State$ent Anal#sis
Co$parati'e state$ent anal#sis is an anal#sis of financial state$ent at different period of
ti$e. T&is state$ent &elps to understand t&e co$parati'e position of financial and
operational perfor$ance at different period of ti$e.
Co$parati'e financial state$ents again classified into t(o $a+or parts suc& as
co$parati'e *alance s&eet anal#sis and co$parati'e profit and loss account anal#sis.
Co$parati'e Balance S&eet Anal#sis
Co$parati'e *alance s&eet anal#sis concentrates onl# t&e *alance s&eet of t&e concern at
different period of ti$e. Under t&is anal#sis t&e *alance s&eets are co$pared (it&
pre'ious #ear@s figures or one-#ear *alance s&eet figures are co$pared (it& ot&er #ears.
Co$parati'e *alance s&eet anal#sis $a# *e &ori5ontal or 'ertical *asis. T&is t#pe of
anal#sis &elps to understand t&e real financial position of t&e concern as (ell as &o( t&e
assets% lia*ilities and capitals are placed during a particular period.
E8ercise 1
T&e follo(ing are t&e *alance s&eets of Ta$il Nadu Mercantile Ban/ 6td.% for t&e #ears
;BB< and ;BBD as on <1st Marc&. .repare a co$parati'e *alance s&eet and discuss t&e
operational perfor$ance of t&e *usiness concern.
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BUSINESS FINANCE
Balance Sheet of Tamil Nadu Mercantile Bank imited
As on 3!st March ,s. in t&ousands-
6ia*ilities ;BB< ;BBD Assets ;BB< ;BBD
s. s. s. s.
Capital ;%2DA ;%2DA Cas& and Balance
eser'e and (it& BI ;H%BF%2B2 ;;%<H%FB1
Surplus <J%FF%BBJ DH%FA%DBF Balance (it& Ban/s
"eposits D%B2%DA%H2< D%DB%D;%H<B and Mone# at call :
Borro(ings and s&ort notice 11%<F%H21 1F%BH%JHA
!t&er 6ia*ilities H%;H%FH1 ;%2D%FJB In'est$ents ;%1D%;1%BFB ;%<A%<H%BJ2
.ro'isions 1F%HD%1FA 1H%JJ%1JH Ad'ances 1%JA%JJ%HFD ;%11%;J%2FJ
Fi8ed Assets D%J<%JJF A%<F%DD;
!t&er Assets 12%A2%BFD 12%<A%22<
D%H;%1F%DH< A%B2%JD%2F2 D%H;%1F%DH< A%B2%JD%2F2
Solution
"omparati#e Balance Sheet Analysis
Increased9 Increased9
.articulars ?ear ending <1st Marc& "ecreased "ecreased
,A$ount- ,.ercentage-
;BB< ;BBD
s. s. s. s.
Assets
Current Assets
Cas& and Balance (it&
BI ;H%BF%2B2 ;;%<H%FB1 ,V- D%FJ%;BH ,V- 1H.<<
Balance (it& Ban/s and
$one# at call and s&ort notice 11%<F%H21 1F%BH%JHA ,- D%H1%1JD ,- D1.DA
Total Current Assets <2%D<%A2J <2%DA%AHF 1J2H B.BA;
Fi8ed Assets
In'est$ents ;%1D%;1%BFB ;%<A%<H%BJ2 ,-- ;1%1F%B<2 ,-- J.22
Ad'ances 1%JA%JJ%HFD ;%11%<J%2FJ ,-- 1A%DB%1BA ,-- H.2F
Fi8ed Assets D%J<%JJF A%<F%DD; ,-- D;%DDF ,-- 2.AJ
!t&er Assets 12%A2%BFD 12%<A%22< ,V- ;;%121 ,V- 1.1J
Total Fi8ed Assets D%<<%H;%22D D%HB%DJ%;J; ,V- <F%HF%DB2 2.D2
Total Assets D%H;%1F%DH< A%B2%JD%2F2 <F%H2%<JA H.HJ
Current 6ia*ilities
Borro(ings H%;H%FH1 ;%2D%FJB ,V- D%D;%J21 FB.22
!t&er 6ia*ilit# and
.ro'isions 1F%HD%1FA 1H%JJ%1JH ,- 1%;A%B<; H.DH
Total Current 6ia*ilit# ;D%B1%2<F ;B%2<%22H <%1H%JDJ 1<.;D
Fi8ed 6ia*ilit# Capital ;%2DA ;%2DA W W
eser'es surplus <J%FF%BBJ DH%FA%DBF ,V- H%JJ%<JH ;B.1F
"eposit D%B2%DA%H2< D%DB%D;%H<B ,V- <1%JF%JDH H.2<
A;
BUSINESS FINANCE
Total Fi8ed 6ia*ilit# D%D2%1D%F<H D%22%1B%J21 ,V- <J%JF%<DD 2.J;
Total 6ia*ilit# D%H;%1F%DH< A%B2%JD%2F2 <F%H2%<JA H.HJ
Co$parati'e .rofit and 6oss Account Anal#sis
Anot&er co$parati'e financial state$ent anal#sis is co$parati'e profit and loss account
anal#sis. Under t&is anal#sis% onl# profit and loss account is ta/en to co$pare (it&
pre'ious #ear@s figure or co$pare (it&in t&e state$ent. T&is anal#sis &elps to understand
t&e operational perfor$ance of t&e *usiness concern in a gi'en period. It $a# *e
anal#5ed on &ori5ontal *asis or 'ertical *asis.
Trend Anal#sis
T&e financial state$ents $a# *e anal#sed *# co$puting trends of series of infor$ation.
It $a# *e up(ard or do(n(ard directions (&ic& in'ol'e t&e percentage relations&ip of
eac& and e'er# ite$ of t&e state$ent (it& t&e co$$on 'alue of 1BBR. Trend anal#sis
&elps to understand t&e trend relations&ip (it& 'arious ite$s% (&ic& appear in t&e
financial state$ents. T&ese percentages $a# also *e ta/en as inde8 nu$*er s&o(ing
relati'e c&anges in t&e financial infor$ation resulting (it& t&e 'arious period of ti$e. In
t&is anal#sis% onl# $a+or ite$s are considered for calculating t&e trend percentage.
E8ercise ;
Calculate t&e Trend Anal#sis fro$ t&e follo(ing infor$ation of Ta$ilnadu Mercantile
Ban/ 6td.% ta/ing 1JJJ as a *ase #ear and interpret t&e$ ,in t&ousands-.
?ear "eposits Ad'ances .rofit
1JJJ ;%BA%AJ%DJ2 JH%1D%H;2 <%AB%<11
;BBB ;%FF%DA%;A1 1%;A%AB%DDB D%BF%;2H
;BB1 <%1J%2B%FJF 1%A2%2<%DJA A%BD%B;B
;BB; <%H;%JJ%2HH 1%HH%;F%FBH A%A<%A;A
;BB< D%B2%DA%H2< 1%JA%JJ%HFD F%<H%F<D
;BBD D%DB%D;%H<B ;%11%<J%2FJ 2%BF%HAA
Solution
Trend Anal#sis ,Base #ear 1JJJQ1BB-
,s. in t&ousands-
"eposits Ad'ances .rofits
?ear A$ount Trend A$ount Trend A$ount Trend
s. .ercentage s. .ercentage s. .ercentage
1JJJ ;%BA%AJ%DJ2 1BB.B JH%1D%H;2 1BB.B <%AB%<11 1BB.B
;BBB ;%FF%DA%;A1 1;J.F 1%;A%AB%DDB 1;J.; D%BF%;2H 11A.J
A<
BUSINESS FINANCE
;BB1 <%1J%2B%FJF 1AA.A 1%A2%2<%DJA 1F<.A A%BD%B;B 1D<.J
;BB; <%H;%JJ%2HH 121.D 1%HH%;F%FBH 12;.A A%A<%A;A 1AB.B
;BB< D%B2%DA%H2< 1J2.H 1%JA%JJ%HFD ;B1.2 F%<H%F<D 12;.B
;BBD D%DB%D;%H<B ;1D.; ;%11%<J%2FJ ;1H.F 2%BF%HAA ;<B.<
Co$$on Si5e Anal#sis
Anot&er i$portant financial state$ent anal#sis tec&ni)ues are co$$on si5e anal#sis in
(&ic& figures reported are con'erted into percentage to so$e co$$on *ase. In t&e
*alance s&eet t&e total assets figures is assu$ed to *e 1BB and all figures are e8pressed as
a percentage of t&is total. It is one of t&e si$plest $et&ods of financial state$ent
anal#sis% (&ic& reflects t&e relations&ip of eac& and e'er# ite$ (it& t&e *ase 'alue of
1BBR.
E8ercise <
Co$$on si5e *alance s&eet of Ta$ilnadu Mercantile Ban/ 6td.% as on <1st Marc& ;BB<
and ;BBD.
.articulars <1st Marc& ;BB< <1st Marc& ;BBD
A$ount .ercentage A$ount .ercentage
Fi8ed Assets
In'est$ents ;%1D%;1%BFB DA.<H ;%<A%<H%BJ2 DF.;A
Ad'ances 1%JA%JJ%HFD D1.A1 ;%11%<J%2FJ D1.AD
Fi8ed Assets D%J<%JJF 1.BA A%<F%DD; 1.BA
!t&er Assets 12%A2%BFD <.JD 12%<A%22< <.F1
Total Fi8ed Assets D%<<%H;%22D J1.2F D%HB%DJ%;J; JD.DD
Current Assets
Cas& and Balance (it&
BI ;H%BF%2B2 A.H< ;;%<H%FB1 D.DB
Balance (it& *an/s
and $one# at call
and s&ort notice 11%<F%H21 ;.D1 1F%BH%JHA <.;B
Total Current Assets <2%D<%A2J 2.1D <2%DA%AHF H.FB
Total Assets D%H;%1F%DH< 1BB.BB A%B2%JD%2F2 1BB.BB
Fi8ed 6ia*ilities
Capital ;%2DA B.B1 ;%2DA B.B1
eser'e and Surplus <J%FF%BBJ 2.DB DH%FA%DBF J.<F
"eposits D%B2%DA%H2< 2F.AB D%DB%D;%H<B 2F.AD
Total Fi8ed 6ia*ilities D%D2%1D%F<H JD.J1 D%22%1B%J21 JA.J1
Current 6ia*ilit#
Borro(ings H%;H%FH1 1.AD ;%2D%FJB B.AF
!t&er 6ia*ilities
.ro'isions 1F%HD%1FA <.AA 1H%JJ%1JH <.A<
Total Current 6ia*ilit# ;D%B1%2<F A.BJ ;B%2<%22H D.BJ
Total 6ia*ilities D%H;%1F%DH< 1BB.BB A%B2%JD%2F2 1BB.BB
FUN"S F6!> STATEMENT
AD
BUSINESS FINANCE
Funds flo( state$ent is one of t&e i$portant tools% (&ic& is used in $an# (a#s. It &elps
to understand t&e c&anges in t&e financial position of a *usiness enterprise *et(een t&e
*eginning and ending financial state$ent dates. It is also called as state$ent of sources
and uses of funds.
Institute of Cost and >or/s Accounts of India% funds flo( state$ent is defined as 3a
state$ent prospecti'e or retrospecti'e% setting out t&e sources and application of t&e
funds of an enterprise. T&e purpose of t&e state$ent is to indicate clearl# t&e re)uire$ent
of funds and &o( t&e# are proposed to *e raised and t&e efficient utili5ation and
application of t&e sa$e4.
CASE F6!> STATEMENT
Cas& flo( state$ent is a state$ent (&ic& s&o(s t&e sources of cas& inflo( and uses of
cas& out-flo( of t&e *usiness concern during a particular period of ti$e. It is t&e
state$ent% (&ic& in'ol'es onl# s&ort-ter$ financial position of t&e *usiness concern.
Cas& flo( state$ent pro'ides a su$$ar# of operating% in'est$ent and financing cas&
flo(s and reconciles t&e$ (it& c&anges in its cas& and cas& e)ui'alents suc& as
$ar/eta*le securities. Institute of C&artered Accountants of India issued t&e Accounting
Standard ,AS-<- related to t&e preparation of cas& flo( state$ent in 1JJ2.
"ifference Bet(een Funds Flo( and Cas& Flo( State$ent
Funds Flo( State$ent Cas& Flo( State$ent
1. Funds flo( state$ent is t&e report on t&e 1. Cas& flo( state$ent is t&e report s&o(ing
$o'e$ent of funds or (or/ing capital sources and uses of cas&.
;. Funds flo( state$ent e8plains &o( (or/ing ;. Cas& flo( state$ent e8plains t&e inflo( and
capital is raised and used during t&e particular out flo( of cas& during t&e particular period.
<. T&e $ain o*+ecti'e of fund flo( state$ent is <. T&e $ain o*+ecti'e of t&e cas& flo( state$ent
to s&o( t&e &o( t&e resources &a'e *een is to s&o( t&e causes of c&anges in cas&
*alanced $o*ili5ed and used. *et(een t(o *alance s&eet dates.
D. Funds flo( state$ent indicates t&e results of D. Cas& flo( state$ent indicates t&e factors
current financial $anage$ent. contri*uting to t&e reduction of cas& *alance
in spite of increase in profit and 'ice-'ersa.
A. In a funds flo( state$ent increase or decrease A. In a cas& flo( state$ent onl# cas& receipt and
in (or/ing capital is recorded. pa#$ents are recorded.
F. In funds flo( state$ent t&ere is no opening F. Cas& flo( state$ent starts (it& opening cas&
and closing *alances. *alance and ends (it& closing cas& *alance.
E8ercise D
Fro$ t&e follo(ing *alance s&eet of A Co$pan# 6td. #ou are re)uired to prepare a
sc&edule of c&anges in (or/ing capital and state$ent of flo( of funds.
Balance Sheet of A "ompany td.$ as on 3!
st
March
6ia*ilities ;BBD ;BBA Assets ;BBD ;BBA
S&are Capital 1%BB%BBB 1%1B%BBB 6and and Building FB%BBB FB%BBB
AA
BUSINESS FINANCE
.rofit and 6oss a9c ;B%BBB ;<%BBB .lant and Mac&iner# <A%BBB DA%BBB
6oans W 1B%BBB Stoc/ ;B%BBB ;A%BBB
Creditors 1A%BBB 12%BBB "e*tors 12%BBB ;2%BBB
Bills pa#a*le A%BBB D%BBB Bills recei'a*le ;%BBB 1%BBB
Cas& A%BBB F%BBB
1%DB%BBB 1%FA%BBB 1%DB%BBB 1%FA%BBB
Solution
Schedule of "hanges in %orking "apital
.articulars ;BBD ;BBA Inc&arge "ec&arge
s. s. s. s.
Current Assets
Stoc/ ;B%BBB ;A%BBB A%BBB W
"e*tors 12%BBB ;2%BBB 1B%BBB W
Bills ecei'a*le ;%BBB 1%BBB W 1%BBB
Cas& A%BBB F%BBB 1%BBB
A DA%BBB FB%BBB
6ess Current 6ia*ilities
Creditors 1A%BBB 12%BBB <%BBB
Bills .a#a*le A%BBB D%BBB 1%BBB
B ;B%BBB ;;%BBB 1H%BBB D%BBB
A-B ;A%BBB <2%BBB W 1<%BBB
Increase in >.C. <2%BBB <2%BBB 1H%BBB 1H%BBB
Fund Flo& Statement
Sources s. Application s.
Issued S&are Capital 1B%BBB .urc&ase of .lant and Mac&iner# 1B%BBB
6oan 1B%BBB Increase in >or/ing Capital 1<%BBB
Funds Fro$ !perations <%BBB
;<%BBB ;<%BBB
E8ercise A
Fro$ t&e a*o'e e8a$ple D prepare a Cas& Flo( State$ent.
Solution
"ash Flo& Statement
Inflo( s. !utflo( s.
Balance *9d A%BBB .urc&ase of plant 1B%BBB
Issued S&are Capital 1B%BBB Increase Current Assets
6oan 1B%BBB Stoc/
Cas& !pening .rofit <%BBB "ecrease in Bills .a#a*le A%BBB
"ecrease in Bills 1%BBB Balance c9d 1B%BBB
ecei'a*le <%BBB 1%BBB
AF
BUSINESS FINANCE
Increase in Creditors F%BBB
<;%BBB <;%BBB
ATI! ANA6?SIS
atio anal#sis is a co$$onl# used tool of financial state$ent anal#sis. atio is a
$at&e$atical relations&ip *et(een one nu$*er to anot&er nu$*er. atio is used as an
inde8 for e'aluating t&e financial perfor$ance of t&e *usiness concern. An accounting
ratio s&o(s t&e $at&e$atical relations&ip *et(een t(o figures% (&ic& &a'e $eaningful
relation (it& eac& ot&er. atio can *e classified into 'arious t#pes. Classification fro$
t&e point of 'ie( of financial $anage$ent is as follo(s:
6i)uidit# atio
Acti'it# atio
Sol'enc# atio
.rofita*ilit# atio
6i)uidit# atio
It is also called as s&ort-ter$ ratio. T&is ratio &elps to understand t&e li)uidit# in a
*usiness (&ic& is t&e potential a*ilit# to $eet current o*ligations. T&is ratio e8presses t&e
relations&ip *et(een current assets and current assets of t&e *usiness concern during a
particular period. T&e follo(ing are t&e $a+or li)uidit# ratio:
S. No. atio For$ula Significant atio
1. Current atio
Current Assets
; : 1
Current6ia*ilit#
;. Uuic/ atio
Uuic/ Assets
1 : 1
Uuic/ 9 Current
6ia*ilit#
Acti'it# atio
It is also called as turno'er ratio. T&is ratio $easures t&e efficienc# of t&e current assets
and lia*ilities in t&e *usiness concern during a particular period. T&is ratio is &elpful to
understand t&e perfor$ance of t&e *usiness concern. So$e of t&e acti'it# ratios are gi'en
*elo(:
S. No. atio For$ula
1. Stoc/ Turno'er atio
Costof Sales
A'erage In'entor#
;. "e*tors Turno'er atio
Credit Sales
A'erage"e*tors
AH
BUSINESS FINANCE
<. Creditors Turno'er atio
Credit .urc&ase
A'erageCredit
D. >or/ing Capital Turno'er atio
Sales
Net >or/ingCapital
Sol'enc# atio
It is also called as le'erage ratio% (&ic& $easures t&e long-ter$ o*ligation of t&e *usiness
concern. T&is ratio &elps to understand% &o( t&e long-ter$ funds are used in t&e *usiness
concern. So$e of t&e sol'enc# ratios are gi'en *elo(:
S. No atio For$ula
1. "e*t-E)uit# atio
E8ternal E)uit#
Internal E)uit#
;. .roprietar# atio
S&are&older 9 S&are&older Gs Fund
Total Assets
<. Interest Co'erage atio
EBIT
Fi8ed Interest C&arges
.rofita*ilit# atio
.rofita*ilit# ratio &elps to $easure t&e profita*ilit# position of t&e *usiness concern.
So$e of t&e $a+or profita*ilit# ratios are gi'en *elo(.
S. No atio For$ula
1. 0ross .rofit atio
0ross .rofit

1BB
Net Sales
;. Net .rofit atio
Net .rofit after ta8
1BB
Net Sales
<. !perating .rofit atio !perating Net .rofit 1BB
Sales
D. eturn in In'est$ent
Net .rofit after ta8
1BB
S&are&older Fund
E8ercise F
Fro$ t&e follo(ing *alance s&eet of Mr. Ar'ind Industries 6td.% as <1st Marc& ;BBH.
6ia*ilities s. Assets s.
E)uit# S&are Capital 1B%BBB Fi8ed assets ,less ;F%BBB
HR .reference S&are Capital ;%BBB depreciation s. 1B%BBB-
eser'es and Surplus 2%BBB Current Assets:
FR Mortgage "e*entures 1D%BBB Cas& 1%BBB
A2
BUSINESS FINANCE
Current 6ia*ilities: In'est$ents ,1BR- <%BBB
Creditors 1%;BB Sundr# de*tors D%BBB
Bills pa#a*le ;%BBB Stoc/ F%BBB
!utstanding e8penses ;BB
Ta8 .ro'ision ;%FBB
DB%BBB DB%BBB
'ther information(
1. Net sales s. FB%BBB
;. Cost of goods sold s. A1%FBB
<. Net inco$e *efore ta8 s. D%BBB
D. Net inco$e after ta8 s. ;%BBB
Calculate appropriate ratios.
Solution
S&ort-ter$ sol'enc# ratios
Current atio Q
Current Assets

1D%BB
B
;.<<:1
Current
6ia*ilit# F%BBB
6i)uid atio Q
6i)uidatio

2%BBB
1.<< :1
Current 6ia*ilit# F%BBB
6ong-ter$ sol'enc# ratios
.roprietar# ratio Q
.roprietorXs funds

;B%BBB
B.A :
1
DB%BBB Total Assets
.roprietor@s fund or S&are&older@s fundQE)uit# s&are capitalV.reference s&are
capitalVeser'e and surplus
Q 1B%BBBV;%BBBV2%BBBQ;B%BBB
"e*t-E)uit# ratio Q
E8ternale)uities

;B%BB
B
1:1
Internale)uities ;B%BBB
Interest co'erage ratio Q
EBI
T
Q
D%BBBV2D
B
QA.Hti$es
Fi8ed interest
c&arges 2DB
Fi8ed interest c&arges Q FR on de*entures of s.1D%BBB
AJ
BUSINESS FINANCE
Q s. 2DB
Acti'it# atio
Stoc/ Turno'er atio Q
Cost of Sales
Q
A1%FBB
Q2.Fti$es
A'erageIn'entor# F%BBB
As t&ere is no opening stoc/% closing stoc/ is ta/en as a'erage stoc/.
Credit Sales
Q
FB%BBB
Q1Bti$es
"e*tors Turno'er atio Q
A'erage "e*tors F%BBB
In t&e a*sence of credit sales and opening de*tors% total sales is considered as credit
sales and closing de*tors as a'erage de*tors.
Creditors turn o'er ratio Q
Credit .urc&ases

D<%;BB
<Fti$es
A'erageCreditors 1%;BB
In a*sence of purc&ases% cost of goods sold gross profit treated as credit purc&ases
and in t&e a*sence of opening creditors% closing creditors are treated as a'erage creditors.
>or/ing Capital Turno'er atio Q
Sales

FB%BBB
H.Ati$es
Net >or/ingCapital 2%BBB
.rofita*ilit# atios
0ross profit ratio Q
0ross.rofit
1BBQ
2%DBB
1BBQ1DR
Sales FB%BBB
Net profit ratio Q
Net .rofit
1BBQ
;%BBB
1BBQ<.<<R
Sales FB%BBB
In t&e a*sence of non-operating inco$e% operating profit ratio is e)ual to net profit
ratio.
eturn of In'est$ent Q NET

.!FIT AFTE TAN 1BB Q ;%BBB 1BB Q 1BR
S&are&olderXsFund ;B%BBB
Section A
1. Financial plan is pri$aril# a state$ent esti$ating t&eTTTTTTTTT
;. T&e state$ent esta*lis&ing a$ount of capital and deter$ining its co$position is
ter$ed as TTTTTTTTTTTTT
<. Financial planning in'ol'es e'aluating t&eTTTTTTTTTT condition of a fir$.
D. TTTTTTTTTT and TTTTTTTTT are so$e of t&e steps in'ol'ed in financial planning.
FB
BUSINESS FINANCE
A. Fir$s de'elop financial plan (it&in t&e o'erall fra$e(or/ of TTTTTTTTTTTT
F. 6ong ter$ financial plan in large co$panies is for TTTTTTTTT #ears.
H. Financial plan indicates fir$@s gro(t&% TTTTTTTTT % TTTTTTTTTTT and
re)uire$ent of funds.
2. TTTTTTTTTT is to anal#5e a fir$@s in'est$ent option and esti$ating t&e fund
re)uire$ent.
J. TTTTTTTTTTT is an integral part of financial planning.
1B. Finance planning in'ol'esTTTTTTTTTTT and financing decisions of a fir$.
Section B
1. >&at are t&e steps in'ol'ed in financial planI
;. Eig&lig&t t&e pro*le$s in'ol'ed in financial plan.
<. State t&e o*+ecti'es of financial plan.
D. >&at are t&e principles of a financial plan.
A. "efine financial planning.
F. >&at is financial forecastingI Eo( does it differ fro$ financial planI
H. .rocess of financial process $odel.
2. "escri*e t&e i$portance of financial planning.
J. >&at is long and s&ort ter$ financial plan.
1B. State t&e role of sensiti'it# in financial plan.
Section C
1. >&at is financial plan and (&at are t&e steps in'ol'ed in preparing a financial
plan.
;. Can #ou state t&e pro*le$s in'ol'ed in financial planning.
<. Eo( (ill #ou esti$ate t&e long ter$ and s&ort ter$ needs in financial plans.
D. >&at is (or/ing capital and (&at are t&e factors deter$ining (or/ing capitalI
A. 0i'e t&e significance of financial plan and t&e t#pes.
F. E8plain in detail a*out t&e principles go'erning a sound financial plan.
H. Can #ou discuss a*out (&at is financial planning.
2. >&at is t&e i$portance of financial forecastingI
J. Na$e fe( t#pes of financial plan and e8plain in detail.
1B. Eo( does financial plan differ fro$ financial forecastingI
F1
BUSINESS FINANCE
Unit III
Capitali5ation -Bases of Capitali5ation Cost T&eor# Earning T&eor# !'er
Capitali5ation Under Capitali5ation: S#$pto$s Causes e$edies >atered Stoc/
>atered Stoc/ 7s. !'er Capitali5ation.
CA.ITA6IOATI!N
Meaning
Capitali5ation is an i$portant constituent of t&e financial plan and in co$$on% t&e ter$
capitali5ation $eans t&e total a$ount of capital e$plo#ed in *usiness.
It can *e $eant as t&e process of *uilding up a capital structure and tapping t&e sources to
$o*ili5e t&e capital in t&e for$ of s&ares or *onds or loans% reser'es etc.
Capitali5ation is t&e long-ter$ funding t&at allo(s a *usiness fir$ to operate. It is t&e
in'est$ent t&at t&e *usiness o(ner and an# ot&er in'estors $a/e in t&e fir$. It is a
financial ter$ (&ic& refers to t&e su$ of t&e stoc/&olderGs e)uit# of t&e fir$ and t&e
fir$Gs long-ter$ de*t% suc& as *onds or $ortgages.
F;
BUSINESS FINANCE
Capitali5ation can *e used as a tool to co$$it financial state$ent reporting fraud.
3Capitali5ation is t&e su$ of par 'alue of t&e stoc/s and *onds outstanding4
Financial planning and decision pla# a $a+or role in t&e field of financial $anage$ent
(&ic& consists of t&e $a+or area of financial $anage$ent suc& as% capitali5ation%
financial structure% capital structure% le'erage and financial forecasting.
Financial planning includes t&e follo(ing i$portant parts:
Esti$ating t&e a$ount of capital to *e raised.
"eter$ining t&e for$ and proportionate a$ount of securities.
For$ulating policies to $anage t&e financial plan.
MEANIN0 !F CA.ITA6
T&e ter$ capital refers to t&e total in'est$ent of t&e co$pan# in ter$s of $one#% and
assets. It is also called as total (ealt& of t&e co$pan#. >&en t&e co$pan# is going to
in'est large a$ount of finance into t&e *usiness% it is called as capital. Capital is t&e
initial and integral part of ne( and e8isting *usiness concern.
T&e capital re)uire$ents of t&e *usiness concern $a# *e classified into t(o categories:
,a- Fi8ed capital
,*- >or/ing capital.
Fi8ed Capital
Fi8ed capital is t&e capital% (&ic& is needed for $eeting t&e per$anent or long-ter$
purpose of t&e *usiness concern. Fi8ed capital is re)uired $ainl# for t&e purpose of
$eeting capital e8penditure of t&e *usiness concern and it is used o'er a long period. It is
t&e a$ount in'ested in 'arious fi8ed or per$anent assets% (&ic& are necessar# for a
*usiness concern.
"efinition of Fi8ed Capital
According to t&e definition of Eoagland% 3Fi8ed capital is co$parati'el# easil# defined
to include land% *uilding% $ac&iner# and ot&er assets &a'ing a relati'el# per$anent
e8istence4.
C&aracter of Fi8ed Capital
Fi8ed capital is used to ac)uire t&e fi8ed assets of t&e *usiness concern.
Fi8ed capital $eets t&e capital e8penditure of t&e *usiness concern.
Fi8ed capital nor$all# consists of long period.
Fi8ed capital e8penditure is of nonrecurring nature.
Fi8ed capital can *e raised onl# (it& t&e &elp of long-ter$ sources of finance.
F<
BUSINESS FINANCE
>or/ing Capital
>or/ing capital is t&e capital (&ic& is needed to $eet t&e da#-to-da# transaction of t&e
*usiness concern. It $a# cross (or/ing capital and net (or/ing capital. Nor$all#
(or/ing capital consists of 'arious co$positions of current assets suc& as in'entories%
*ills% recei'a*le% de*tors% cas&% and *an/ *alance and prepaid e8penses.
According to t&e definition of Bonne'ille% 3an# ac)uisition of funds (&ic& increases t&e
current assets increase t&e >or/ing Capital also for t&e# are one and t&e sa$e4.
>or/ing capital is needed to $eet t&e follo(ing purpose:
.urc&ase of ra( $aterial
.a#$ent of (ages to (or/ers
.a#$ent of da#-to-da# e8penses
Maintenance e8penditure etc.
>or/ing Capital
Capital Fi8ed Capital
Fig. ).! *osition of "apital
CA.ITA6IOATI!N
Capitali5ation is one of t&e $ost i$portant parts of financial decision% (&ic& is related to
t&e total a$ount of capital e$plo#ed in t&e *usiness concern.
Understanding t&e concept of capitali5ation leads to sol'e $an# pro*le$s in t&e field of
financial $anage$ent. Because t&ere is a confusion a$ong t&e capital% capitali5ation and
capital structure.
Meaning of Capitali5ation
Capitali5ation refers to t&e process of deter$ining t&e )uantu$ of funds t&at a fir$ needs
to run its *usiness. Capitali5ation is onl# t&e par 'alue of s&are capital and de*enture and
it does not include reser'e and surplus.
"efinition of Capitali5ation
Capitali5ation can *e defined *# t&e 'arious financial $anage$ent e8perts. So$e of t&e
definitions are $entioned *elo(:
According to 0ut&$an and "ougall% 3capitali5ation is t&e su$ of t&e par 'alue of
stoc/s and *onds outstanding4.
"EFINITI!N
3Capitali5ation is t&e su$ of par 'alue of t&e stoc/s and *onds outstanding4.
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BUSINESS FINANCE
And according to t&is definition% t&e ter$ capitali5ation includes onl# t&e par 'alue of
s&are capital and de*entures and it does not include reser'es and surplus. Eo(e'er in
actual practice% it is found t&at fir$s to $eet t&eir long-ter$ capital re)uire$ents
fre)uentl# resort to reser'es and surplus. Eence t&is definition see$s not to *e logical.
Eo( can (e 'ie( LCapital@ in different ter$sI
1. In Laccounting use: T&e ter$ capital is used in Laccounting literature@ to represent t&e
net (ort& $eans assets and lia*ilities.
;. In Business use@: Total assets re)uired operating a *usiness and t&e $one# needed to
ac)uire suc& assets.
<. As used *# econo$ists: All t&e accu$ulated (ealt& used to produce additional (ealt&.
D. In legal usage: T&e a$ount recei'ed in return for securities%ie.%s&ares allotted to t&e
in'estors.
T&e total a$ount of s&are 'alue paid as s&o(n in t&e co$pan#@s *oo/ of accounts is
legall# /no(n as its capital.
ACTUA6 CA.ITA6SIATI!N 7s. .!.E CA.ITA6SIATI!N
3Capitali5ation co$prises o(ners&ip capital (&ic& includes capital stoc/s and surplus in
(&ate'er for$ it $a# appear and *orro(ed capital (&ic& consists *onds or si$ilar
e'idence of long ter$ de*t4.
Actual capitali5ation of a co$pan# is arri'ed *# adding t&e paid up 'alue of co$panies
s&ared and de*entures% reser'es and ot&er surpluses (&ile proper capitali5ation of
co$pan# is arri'ed at according to an# of t&e t(o t&eories ,cost : earnings-.
In case a co$pan#@s actual capitali5ation is $ore t&an its proper capitali5ation t&e
co$pan# is said to *e o'er capitali5ed. In case actual capitali5ation of t&e co$pan# is
less t&an it proper capitali5ation% t&e co$pan# is said to *e undercapitali5ed.
CA.ITA6 : CA.ITA6ISATI!N
T&e Englis& (ord Gcapitali5ationG &as se'eral different $eanings:
T&e act of capitali5ing on an opportunit#K
An esti$ation of t&e 'alue of a *usinessK
>riting in capital lettersK
T&e sale of capital stoc/ t&e 'alue of a co$pan# calculated *# $ultipl#ing t&e price of its
s&ares on t&e stoc/ e8c&ange *# t&e nu$*er of s&ares issued. Also called $ar/et
capitali5ation
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BUSINESS FINANCE
Capitali5ation is t&e long-ter$ funding t&at allo(s a *usiness fir$ to operate. It is t&e
in'est$ent t&at t&e *usiness o(ner and an# ot&er in'estors $a/e in t&e fir$. Noted t&at
t&e ter$ capitali5ation is used onl# in respect of co$panies and not in relation to
partners&ip fir$s or sole proprietors&ip.
T&e ter$ capital in accounting sense $eans t&e net (ort& of t&e *usiness underta/ing.
Net (ort&% $eans assets $inus lia*ilities of t&e Business. Si$ilarl# t&e ter$ s&are capital
refers onl# to t&e paid up 'alue of s&ares issued *# t&e co$pan#.
T&e ter$ capitali5ation is also used *# accountant in 'aries senses. For e8a$ple% (&en
*onus s&ares are issued out of profits% it is said t&at t&e profits &a'e *een capitali5edK
si$ilarl#% it $a# *e capitali5ed *ut t&e co$pan# and treated as deferred re'enues
e8penditure in its *oo/s.
Eo(e'er% sc&olars of financial $anage$ent are not co$$on regarding t&e concept of
capitali5ation. So$e &a'e gi'en 'er# *road interpretation to t&e ter$ (&ile ot&ers &a'e
ta/en a narro( 'ie(.
>&at is capitali5ation of fi8ed assetsI
Capitali5ation of fi8ed assets $eans t&e assets (&ic& are ac)uired (it& a useful life of
atleast t(o #ears% and recording t&e cost of t&at fi8ed asset in *alance...
B!A" INTE.ETATI!N
According to t&is% t&e ter$ capitali5ation is identical (it& t&e ter$ financial planning%
(&ere financial planning of a co$pan# includes.
1. T&e deter$ination a*out t&e total a$ount of capital to *e raised
;. "ecision regarding t&e t#pes of securities to *e issued for t&e purpose of raising
suc& capital and t&e relati'e proportion is t&e different securities and t&e
ad$inistration of t&e capital
T&us in *road sense% t&e ter$ capitali5ation refers to t&e process of deter$ining t&e
)uantu$ as (ell as patterns of financing. And it not onl# includes t&e deter$ination of
)uantit# of finance *ut also t&e )ualit# of financing. In ot&er (ords% it includes decision
regarding a$ount of finance and t&e $odes of finance.
NA!> INTE.ETATI!N
Eere% t&e ter$ capitali5ation refers to t&e process of )uantu$ of long-ter$ funds t&at an
enterprise (ould re)uire to run its *usiness and t&e decisions regarding $a/eup of
capitali5ation are done in t&e ter$ capital structure. T&e narro( interpretation of t&e ter$
capitali5ation is $ore popular since it is 'er# specific in its $eaning.
T&e constituents of capitali5ation as follo(s:
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BUSINESS FINANCE
1. .ar 'alue of s&are capital
;. eser'es and surplus
<. 6ong-ter$ loans
BASES !F CA.ITA6IOATI!N
After esti$ating financial re)uire$ents of *usiness% t&e pro$oters of t&e co$pan# &a'e
to deter$ining t&e 'alue at (&ic& t&e co$pan# &as to *e capitali5edK t&is (ill &elp t&e$
in deter$ining t&e )uantu$ of securities to *e issued for raising t&e necessar# funds.
T&ere are t(o recogni5ed t&eories of capitali5ation for ne( co$panies
1. Cost T&eor#: T&e total a$ount of capitali5ation of a ne( co$pan# is arri'ed at *#
adding up t&e cost of fi8ed assets suc& as plant and $ac&iner#% *uildings etc% t&e a$ount
of (or/ing capital and t&e cost of esta*lis&ing t&en *usiness e.g. preli$inar# e8penses%
under(riting co$$ission% e8penses on issue of s&ares etc.
For e8a$ple if fi8ed assets for t&e co$pan# (ould cost s.1% BB%BBB (or/ing capital
re)uired a$ounts to s.AB%BBB and t&e cost of esta*lis&ing t&e *usiness (ould a$ount t
to s.;B%BBB% t&e a$ount of capitali5ation for t&e co$pan# (ould *e s.1%HB%BBB. T&e
co$pan# (ould sell securities i.e. s&ares and de*entures of t&is a$ount.
Cost t&eor# is useful in so far as it ena*les t&e pro$oters to /no( t&e a$ount of capital
to *e raised. But it fails to pro'ides *asis for ascertain net (ort& of t&e *usiness in real
ter$ *ecause net (ort& depends not on t&e cost of assets *ut on its earnings capacit#.
;. Earnings T&eor#: According to t&is t&eor#% t&e true 'alue ,capitali5ation- of an
enterprise depends upon its earnings capacit#. In ot&er (ords% t&e (ort& of a co$pan# is
not $easured *# t&e capital raised *ut *# t&e earnings $ade out of t&e producti'e &arness
of t&e capital. For t&is purpose a ne( co$pan# (ill &a'e to esti$ate t&e a'erage annual
future earnings and t&e nor$al earnings rate also ter$ed s as capitali5ation rate.
T&e earnings t&eor# of Capitali5ation recogni5es t&e fact t&at t&e true 'alue
,capitali5ation- of an enterprise depends upon its earnings and earning capacit#.
According to it% t&erefore% t&e 'alue or Capitali5ation of a co$pan# is e)ual to t&e
capitali5ed 'alue of its esti$ated earnings. For t&is purpose a ne( co$pan# &as to
prepare an esti$ated profit and loss account. For t&e first fe( #ear of its life% t&e sales are
forecast ad t&e $anager &as to depend upon &is e8perience for deter$ining t&e pro*a*le
cost. T&e earnings so esti$ated $a# *e co$pared (it& t&e actual earnings of si$ilar
co$panies in t&e industr# and t&e necessar# ad+ust$ents s&ould *e $ade. T&en t&e
pro$oters (ill stud# t&e rate at (&ic& ot&er co$panies in t&e sa$e industr# si$ilarl#
situated are earnings. T&e rate is t&en applied to t&e esti$ated earnings of t&e co$pan#
for finding out t&e capitali5ation. To ta/e an e8a$ple a co$pan# $a esti$ate its a'erage
profit in t&e first fe( #ears at s. AB%BBB. !t&er co$panies of t&e sa$e t#pe are% let us
assu$e% earnings a return of 1B per cent on t&eir capital. T&e Capitali5ation of t&e
co$pan# (ill t&en *e
AB%BBB 8 1BB
---------------- Q s. A%BB%BBB.
1B
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BUSINESS FINANCE
It (ill *e noted t&at t&e earnings *asis for Capitali5ation &as t&e $erit of 'aluing
,capitali5ing- a co$pan# at an a$ount (&ic& is directl# related to its earning capacit#. A
co$pan# is (ort& (&at it is a*le to earn. But it cannot% at t&e sa$e ti$e *e denied t&at
ne( co$panies (ill find it difficult% and e'en ris/#% to depend $erel# on esti$ate of t&eir
earnings as t&e generall# e8pected return is an industr#. In case of ne( co$panies%
t&erefore% t&e cost t&eor# pro'ides a *etter *asis for capitalisation t&an t&e earning t&eor#.
In esta*lis&ed concerns too% t&e Capitali5ation can *e arri'ed at eit&er ,i- on t&e *asis of
t&e cost of *usiness% or ,ii- t&e a'erage or regular earnings and t&e rate of return e8pected
in an industr# If cost is adopted as t&e *asis% t&e Capitali5ation $a# fall to re'eal t&e true
(ort& of a co$pan#. T&e assets of a co$pan# stand at t&eir original 'alues (&ile its
earnings $a# &a'e declined considera*l#. In suc& a situation% it (ill *e ris/# to *elie'e
t&at t&e Capitali5ation of t&e co$pan# is &ig&. Earnings% t&erefore% pro'ide a *etter *asis
of Capitali5ation in esta*lis&ed concerns T&e figure (ill *e arri'ed at in t&e sa$e $anner
as a*o'e.
Actual and .roper Capitali5ation. T&e capitalisation of a co$pan# as arri'ed at *#
totaling up t&e 'alue of t&e s&ares% de*entures and non-di'isi*le retained earnings of t&e
co$pan# $a# *e called t&e actual Capitali5ation of t&e co$pan#. 6et us ta/e t&e rele'ant
ite$s in a co$pan# *alance s&eet for illustration. T&e actual Capitali5ation as per *alance
s&eet gi'en *elo( (ill *e s. 1F%BB%BBB.
N?O C!. 6T".
BA6ANCE SEEET AS !N <1
ST
"ECEMBE% 1J21
6ia*ilities Assets
.aid-up capital s.
;B%BBB 2 percent preference S&ares of s.1B eac& ;%BB%BBB
AB%BBB S&ares of s. 2 eac& D%BB%BBB
1B%BBB "e*entures of s. 1BB eac& 1B%BB%BBB
---------------
1F%BB%BBB
--------------
s.
Sundr#Assets
1F%BB%BBB
------------
1F%BB%BBB
-----------
As against t&e actual Capitali5ation t&e proper% nor$al or standard Capitali5ation for a
co$pan# can *e found out *# capitali5ing t&e a'erage annual profits at t&e nor$al rate of
return earned *# co$para*le co$panies in t&e sa$e line of *usiness. T&us if a co$pan#
F2
BUSINESS FINANCE
gets an annual return of s. 1%AB%BBB and t&e nor$al rate of return in t&e industr# is B per
cent% t&e proper Capitali5ation (ill *e arri'ed at as under:
1BB
1%AB%BBB 8 ------ Q s. 1A%BB%BBB
1B
A co$parison *et(een t&e actual and t&e proper on nor$al Capitali5ation (ill s&o(
(&et&er t&e co$pan# is properl# capitali5ed% o'er-capitali5ed or under-capitali5ed.
T?.ES !F CA.ITA6IOATI!N
Capitali5ation $a# *e classified into t&e follo(ing t&ree i$portant t#pes *ased on its
nature:
!'er Capitali5ation
Under Capitali5ation
>ater Capitali5ation
!7E-CA.ITA6ISATI!N
Meaning
!'er-capitali5ation is a situation in (&ic& actual profits of a co$pan# are not sufficient
enoug& to pa# interest on de*entures% on loans and pa# di'idends on s&ares o'er a period
of ti$e.
A *usiness is said to *e o'er-capitali5ed (&en
1- Capitali5ation e8ceeds t&e real econo$ic 'alue of its net assets
,;- A fair return is not reali5ed on capitali5ation and
,<- Business &as $ore net assets t&an it needs.
!'er-capitali5ation $a# *e considered to *e in t&e nature of redundant capital. It is
generall# found in co$panies (&ic& &a'e useless assets suc& as oil and $ining concerns.
T&is condition is co$$onl# /no(n as 3(atered stoc/4. A co$pan# is said to *e o'er-
capitali5ed (&en t&e aggregate of t&e par 'alue of its s&ares and de*entures e8ceeds t&e
true 'alue of its fi8ed assets.
In ot&er (ords% o'er-capitali5ation ta/es place (&en t&e stoc/ is (atered or diluted. It is
(rong to identif# o'er-capitali5ation (it& e8cess of capital% for t&ere is e'er# possi*ilit#
t&at an o'er-capitali5ation (it& e8cess of capital% for t&ere is e'er# possi*ilit# t&at an
o'er-capitali5ed concern $a# *e deal (it& pro*le$s of li)uidit#.
T&e correct indicator of o'er-capitali5ation is t&e earnings of t&e co$pan#. If t&e earnings
are lo(er t&an t&e e8pected returns% it is o'er-capitali5ed. !'er-capitali5ation does not
in'ol'e surplus of funds an# $ore t&an under-capitali5ation indicates a s&ortage of funds.
It is )uite possi*le t&at a co$pan# $a# &a'e $ore funds and #et &a'e lo( earnings.
!ften% funds $a# *e inade)uate% and t&e earnings $a# *e relati'el# lo(. In *ot&
situations% t&ere is o'er-capitali5ation.
FJ
BUSINESS FINANCE
T&e a'erage distri*uta*le inco$e of a co$pan# $a# *e insufficient to pa# t&e contract
rate of return on fi8ed inco$e securities and a di'idend on e)uit# s&ares% co$para*le
(it& t&at of si$ilar securities else(&ere.
For e8a$ple a co$pan# is earning a su$ of s.1% AB%BBB on a total capital in'est$ent of
s.1A% BB%BBB. T&is co$pan# (ill *e said properl# capitali5ed% if t&e general e8pectation
is 1BR. Eo(e'er if t&e co$pan# earns onl# s.JB%BBB (&ile t&e general e8pectation is
1BR t&e co$pan# (ill *e said to *e o'er capitali5ed *ecause it (ill *e in a position to
gi'e a return of onl# FR in t&e total capital e$plo#ed.
!'er-capitali5ation ta/es place (&en
.rospecti'e inco$e is o'er-esti$ated at t&e startK
Unpredicta*le circu$stances reduce do(n t&e inco$eK
T&e total funds re)uired &a'e o'er-esti$atedK
E8cess funds are not efficientl# e$plo#edK
T&e lo( #ield $a/es it difficult for a fir$ to raise ne( capital% particularl# e)uit#
capitalK
T&e $ar/et 'alue of t&e securities falls *elo( t&e issue priceK
T&e lo( #ield $a# discourage co$petition and t&is li$ited co$petition *eco$es a
social disad'antage.
!'er-capitali5ation $a# go unnoticed during t&e period a *usiness *e encouraged *#
prosperit#. It $a# *e producti'e of ill- conse)uences (&en t&e distri*uta*le inco$e
di$inis&es under t&e pressure of declining de$and and falling prices.
!7E CA.ITA6ISATI!N AN" ENCESS !F CA.ITA6
It $a# *e noted t&at o'er capitali5ation is different fro$ e8cess of capital. !'er
capitali5ation is t&ere onl# (&en t&e e8isting capital is not effecti'el# utili5ed on account
of fall in t&e earning capacit# of t&e co$pan# (&ile e8cess of capital $eans t&at t&e
co$pan# &as raised funds $ore t&an re)uire$ent. T&e c&ief sig& of o'er capitali5ation is
fall in t&e rate of di'idend in t&e long run% (&ic& results in fall in t&e 'alue of t&e s&ares
of t&e co$pan#. T&us% a co$pan# (ill *e said to *e o'er capitali5ed (&en it &as
consistentl# *een una*le to earn t&e pre'ailing rater of return on its capital e$plo#ed.
Causes of o'er-capitali5ation
1. "ifference *et(een Boo/ 7alue and eal (ort& of Assets: It is possi*le t&at a
co$pan# $a# &a'e purc&ased its assets at a 'alue t&at is &ig&er t&an t&eir real (ort&.
T&is gap *et(een t&e *oo/ 'alue and t&e real (ort& of assets $a# account for o'er-
capitali5ation.
;. .ro$otional E8penses: T&ere is a possi*ilit# t&at pro$oters $a# &a'e c&arged
e8cessi'e pro$otional e8penses for t&eir ser'ices in creating t&e corporation. T&is c&arge
$a# *e a cause of o'er-capitali5ation.
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BUSINESS FINANCE
<. Inflation: "ue to t&ese conditions a corporation $ig&t &a'e ac)uired assets at &ig&
prices. Inflationar# conditions ras& o'er-capitali5ation% (&ic& affects ne( as (ell as
esta*lis&ed corporations.
D. S&ortage of capital: >&en faced (it& a s&ortage of funds% a co$pan# $a# *orro( at
unre$unerati'e rates of interest% (&ic& is *ound to result in e8cessi'e or un+ustified fi8ed
c&arges.
A. "epreciation .olic#: Inade)uate pro'ision for depreciation% o*solescence or
$aintenance of assets $a# lead to o'er-capitali5ation% and t&is is *ound to ad'ersel#
affect t&e profit-earning capacit# of a corporation.
F. Ta8ation .olic#: Eig& corporate ta8 $a# discourage corporations fro$ i$ple$enting
progra$s of replace$ent% rene(als and reno'ations% as a result of (&ic& t&eir
profita*ilit# $a# suffer.
H. "i'idend .olic#: So$e corporations adopt a lenient di'idend polic# in order to gain
popularit# (it& t&eir stoc/&olders. Eo(e'er% suc& cas&-do(n pa#$ent in t&e for$ of
di'idends (ea/ens t&eir li)uidit# position. T&eir 'alua*le resources are li/el# to *e (aste
a(a# and% as a result% t&e# $a# find t&e$sel'es in a state of o'er-capitali5ation.
2. Mar/et Senti$ent: Co$pan# $a# *e te$pted to raise securit# floatation in t&e $ar/et
in order to create a fa'ora*le $ar/et senti$ent on t&e stoc/ e8c&ange. >&ile doing so% it
$a# *e saddled (it& t&e issue of un(arranted securities% (&ic& are of no practical 'alue
to it. As a result% it *eco$es o'er-capitali5ed and t&e *urden of its lia*ilities is
unnecessaril# inflated.
J. Under-esti$ation of capital ate: If t&e actual rate at (&ic& capital is a'aila*le is
&ig&er t&an t&e rate at (&ic& a co$pan#@s earnings are capitali5ed% t&e capitali5ation rate
is under-esti$ated% and t&is results into o'er-capitali5ation.
Ad'antages
1. T&e $anage$ent is assured of ade)uate capital for present operations.
;. If conser'ed% an e8cess of capital $a# preclude t&e necessit# of financing so$eti$e
in t&e future (&en capital is needed and can *e o*tained onl# (it& difficult#.
<. A$ple capital &as a *eneficial effect on an organi5ation@s $orale.
D. A$ple capitali5ation gi'es added fle8i*ilit# and latitude to t&e corporation@s
operation.
A. Allegedl#. 6osses can *e $ore easil# a*sor*ed (it&out endangering t&e future of t&e
corporations.
F. T&e rate of profits tends to discourage possi*le co$petitors.
H. For pu*lic utilit# co$panies% (&en t&e price of ser'ice is *ased upon a 3fair return to
capital4% a &ig& capitali5ation $a# *e ad'antageous.
"isad'antages
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BUSINESS FINANCE
I- >&en stoc/ is issued in e8cess of t&e assets recei'ed% a co$pan#@s stoc/ is said to *e
3(atered4.
>atered stoc/ $a# arise *# t&e issue of stoc/ in an# of t&e follo(ing (a#s:
For o'er-'alued propert# or ser'ices
As a *onus
For cas& at less t&an t&e par or stated 'alue of t&e stoc/
As a stoc/ di'idend (&en t&e surplus of t&e corporation is not offset *# actual
assets of at least an e)ual a$ount.
If /no(n to *e (atered% stoc/ &as a $ar/et 'alue (&ic& is lo(er t&an it (ould en+o# if it
(ere not (atered-until t&e 3(ater4 &as *een4 s)uee5ed out4 ,until sufficient assets &a'e
*een ac)uired fro$ earning to offset t&e e8cess of stoc/-.
II- T&ere is t&e possi*ilit# of stoc/&olders4 lia*ilit# to creator in case a court s&ould
conclude t&at t&e stoc/ (as &ea'il# (atered% t&at t&e corporation did not recei'e
3reasona*le4 or 3proper4 'alue for t&e stoc/. T&is lia*ilit# (ould attac& onl# to suc&
stoc/ as (as recei'ed as a result of an unreasona*l# e8cessi'e 'aluation of properties or
ser'ices gi'en in e8c&ange for suc& stoc/.
III- T&ere $a# *e a possi*le difficult# of raising ne( capital funds. T&is $a# *e *# t&e
use of 3no-par4 stoc/.
1. In so$e States% t&e rate of t&e annual franc&ise ta8 depends on t&e a$ount of
outstanding stoc/. 6arge capitali5ations in suc& States $a# attract large franc&ise
ta8es.
;. T&ere is a tendenc# to raise t&e prices of a co$pan#@s products and9or lo(er t&eir
)ualit#. T&is $a# *e partl# or (&oll# pre'ent% &o(e'er% *# co$petition and (ould
appl# $ore to pu*lic utilit# ser'ices t&an to ot&ers% for pu*lic utilit# rates are *ased%
in part% upon a 3reasona*le4 return on capital.
<. !'er-capitali5ation $a# induce a failure% and t&e failure of a corporation $a# *ring
a*out an un&ealt&# econo$ic situation.
D. T&e et&ical at$osp&ere of a *usiness is not i$pro'ed *# o'er-capitali5ation.
A. T&e necessar# ropes of t&e $ar/et for t&e securities (&ic& first offered to t&e pu*lic
usuall# results in $ar/et 'alue losses to t&e in'estors after t&is support are re$o'ed.
T&is is not to attac/ t&e legal support of t&e $ar/et in t&e a*o'e-*oard floatation of a
securit# issue.
F. T&ere $a# *e an ina*ilit# to pa# interest on *onds ,(&en *onds constitute a large
portion of t&e capitali5ation of an o'er-capitali5ed co$pan#-
H. In+ur# to credit (ort&iness.
2. "ecline in t&e 'alue of securities.
J. .ossi*le loss of orders *ecause of ina*ilit# to e8pand.
1B. Te$ptation for t&e $anage$ent to fit in (it& depreciation% o*solescence%
$aintenance% reser'e accounts in order to appear to $a/e a profit possi*le in order to
pa# a di'idend.
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BUSINESS FINANCE
11. .ossi*le in+ur# to good(ill in case a necessar# reorgani5ation.
1;. T&e &olders of securities $a# *e dissatisfied.
1<. T&e *usiness $a# gi'e (a# to its co$petitors t&roug& its ina*ilit# to o*tain funds for
e8pansion.
EFFECTS
!'er-capitali5ation &as so$e effect on t&e corporation% its o(ners% consu$ers and t&e
societ# at large.
1. !n Corporation: T&e $ar/et 'alue of t&e corporation@s stoc/ falls and it $a# find it
difficult to raise ne( capital. Artificial de'ices suc& as t&e reduction in depreciation%
li$itation in $aintenance% etc are $ade use of co'er o'er-capitali5ation.
T&e credit of t&e co$pan# is ad'ersel# affected. T&e co$pan# $a# appear to *e in a
&ealt&# condition e'en t&oug& it $a# &a'e lost its energ# and life and $a# end at an#
ti$e *ecause of t&e (ea/ financial condition fro$ (&ic& it suffers.
;. !n !(ners: !(ners (&o &a'e a real ris/ in t&e corporation are t&e *iggest losers.
Because of a fall in $ar/et 'alue of its s&ares% s&are&olders are not in a position to
dispose of t&eir &oldings profita*l#. Moreo'er of fall in di'idends% s&are&olders lose
&ea'il# and t&e# de'elop t&e feeling t&at t&e corporation is funded on s&ifting sands.
<. !n Consu$ers: A corporation cannot resist t&e te$ptation of increasing t&e prices of
its products to inflate its profits. At t&e sa$e ti$e% t&ere is e'er# possi*ilit# t&at t&e
)ualit# of t&e product (ould go do(n. T&e consu$er $a# t&us suffer dou*l#.
D. !n Societ#: !'er-capitali5ed concerns often co$e to grief in t&e course of ti$e. T&e#
lose t&e *ac/ing of o(ners% custo$ers and societ# at large. T&e# suffer $ulti-pronged
attac/s fro$ 'arious sections of societ#. T&e# are not in a position to face co$petition.
No (onder% t&erefore% t&at t&e# graduall# dra( closer to a situation ordering li)uidation.
>&ile t&e e8istence of suc& corporations cannot *e +ustified% t&eir e8tinction (ould cause
irrepara*le da$age to societ#.
EME"IES
1. eduction in Funded "e*t: T&is is generall# i$possi*le unless t&e co$pan# goes
t&roug& a t&oroug& re-organisation. Funds &a'e to *e raised for t&e rede$ption of *ondsK
and t&e sale of large )uantities of stoc/% presu$a*l# at lo( prices% (ould pro*a*l# do
$ore da$age t&an good. Moreo'er% t&e creation of as $uc& stoc/ as t&e *onds retired
(ould not reduce t&e total capitali5ation. A true reduction in capitali5ation can *e
effected onl# if t&e de*ts are retired fro$ earnings.
;. eduction in Interest ate on Bonds: Eere again% (it&out a t&roug& re-organisation%
it (ould pro*a*l# not *e practica*le to effect a reduction in t&e interest rate on *onds. A
refunding operation% &o(e'er% $ig&t *e perfor$edK *ut t&e sa'ing in interest pa#$ents
on t&e lo(er-rate refunding *onds (ould &ardl# offset t&e pre$iu$ t&e co$pan# (ould
*e forced to allo( t&e *ond-&olders in order to induce t&e$ to accept t&e refunding
H<
BUSINESS FINANCE
*ondsK and% $oreo'er% t&is procedure (ould not reall# reduce capitali5ation. Eo(e'er% it
(ould alle'iate t&e situation.
<. ede$ption of .referred Stoc/% if it carries a Eig& "i'idend ate: Funds for
rede$ption (ould pro*a*l# &a'e to co$e fro$ t&e sale of co$$on stoc/ at lo( prices.
T&e sa'ing fro$ t&e retire$ent of t&e preferred stoc/ $ig&t *e sufficient to increase
so$e(&at t&e earnings fro$ t&e co$$on stoc/% e'en if t&is co$$on stoc/ is increased
su*stantiall#. If% &o(e'er% t&e preferred stoc/ is cu$ulati'e% and if di'idends on suc&
stoc/ are in arrears% t&is a'enue of escape (ould appear to *e a 3dead-end street4.
D. eduction in .ar 7alue of Stoc/: T&is is a good $et&od *ut is so$et&ing i$possi*le
*ecause of t&e stoc/&olders@ tenacious *elief in t&e i$portance of par 'alue. If t&e
stoc/&olders are con'inced of t&e desira*ilit# of t&e $o'e% it $ig&t *e so$e(&at
effecti'e% t&oug& not nearl# as $uc& as t&e reduction in &ig& fi8ed c&arges.
A. eduction in Nu$*er of S&ares of Co$$on Stoc/: T&is li/e(ise is a good $et&od
*ut% again% is difficult of i$ple$entation *ecause of t&e a'erage stoc/&olders@
un(illingness to turn in se'eral s&ares in order to recei'e one% t&roug& it does &appen
occasionall#. Since t&is procedure does not decrease t&e stoc/&olderG@ proportionate
interest in t&e e)uit#% it is so$eti$es used.
In so$e cases% se'eral of t&ese $et&ods $a# *e used% *ut unless a co$pan# goes t&roug&
a t&oroug& re-organisation- a rat&er co$plicated and legall# in'ol'ed affair-% t&e consent
of t&e securit#-&olders s&ould *e o*tained.
UN"E-CA.ITA6ISATI!N
Under-capitali5ation is t&e re'erse of o'er-capitali5ation. It s&ould not *e
confused (it& a condition i$pl#ing a lac/ of funds. It $erel# refers to t&e
a$ount of outstanding stoc/ t&e condition is not a serious as t&at of o'er-
capitali5ation and its re$edies are $uc& easil# applied.
Under-capitali5ation co$es a*out as a result of:
Under-esti$ation of future earnings at t&e ti$e of pro$otionK and9or
An unforeseea*le increase in earning resulting fro$ later de'elop$entsK
Under-capitali5ation e8ists (&en a co$pan# earns sufficient inco$e to $eet its
fi8ed interest and fi8ed di'idend c&arges% and is a*le to pa# a considera*l# *etter
rate on its e)uit# s&ares t&an t&e pre'ailing rate on si$ilar s&ares in si$ilar
*usinesses.
At t&is stage% t&e real (ort& of t&e assets e8ceeds t&eir *oo/ 'alue% and t&e rate of
earnings is &ig&er t&an a corporation is ordinaril# a*le to afford. >&en a corporation is
earning an e8tra ordinaril# large return on its outstanding stoc/% it is said to *e under
capitali5ation.
CAUSES
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BUSINESS FINANCE
1. Under-esti$ation of Earnings: It is possi*le t&at earnings $a# *e under-esti$ated% as a
result of (&ic& t&e actual earnings $a# *e $uc& &ig&er t&an t&ose e8pected.
;. Efficienc#: A corporation $a# &a'e opti$all# utili5ed its assets and en&anced its
efficienc# its efficienc# *# e8ploiting e'er# possi*ilit# of $oderni5ation and *# ta/ing
t&e $a8i$u$ ad'antage of $ar/et opportunities.
<. Under-esti$ation of Funds: It $a# ta/es place (&en t&e total funds re)uired &a'e *een
under-esti$ated.
D. etained Earnings: Because of its conser'ati'e di'idend polic# a corporation $a#
retain t&e earnings% (&ic& $ig&t &a'e accu$ulated into a $ass of sa'ings. T&is is *ound
to i$pro'e its financial &ealt&.
A. >indfall 0ains: Co$panies t&at can afford to continue to operate during t&e period t&e
period of depreciation $a# find t&eir earnings are unusuall# &ig& (&en t&e# enter t&e
*oo$ period. T&is s&ift fro$ an ad'erse *usiness c#cle to a prosperous one $a# under-
capitali5e t&e corporation.
F. Indulgence in ri'alr#: Under indulgence in ri'alries flo(ing fro$ unusuall# &ig&
earnings $a# te$pt an organi5ation to e$*ar/ upon speculati'e acti'ities in t&e &ope t&at
it can easil# sur'i'e its ill effectsK for if speculati'e acti'ities turn out to *e unfa'ora*le%
its earlier earnings are li/el# to *e (as&ed a(a#.
H. Ta8ation: Because of e8cessi'e earnings% corporations are e8posed to a &ea'# *urden
of ta8ation.
"isad'antages
1. T&e stoc/ (ould en+o# a &ig& $ar/er 'alue% *ut (ould li$it its $ar/eta*ilit# and
$a# cause (ide ,t&oug& not necessaril# relati'el# (ide- fluctuations in $ar/et
prices. In $an# cases% t&is $a# not *e considered a disad'antage.
;. !(ing to its li$ited $ar/eta*ilit#% t&e stoc/ $a# not en+o# as &ig& a $ar/et
.rice as its earnings +ustif#.
<. A &ig& rate of earnings per s&are $a# encourage potential co$petitors to enter t&e
$ar/et.
D. In 'ie( of t&e &ig& rate of earnings% e$plo#ees $a# *eco$e dissatisfied.
"issatisfaction (ould pro*a*l# reduce t&eir efficienc# and &a'e ot&er undesira*le
effects.
A. In 'ie( of t&e &ig& rate of earnings% custo$ers $a# feel t&e# &a'e *een o'er-c&arged.
E8cept possi*l# in pu*lic utilit# underta/ings% t&is is not an entirel# +ustifia*le point%
for co$petitors $ig&t easil# enter t&e field and force reduction in prices.
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BUSINESS FINANCE
F. If a co$pan# is an e8tre$el# large one and 'irtuall# controls t&e industr#% its
Enor$ous earnings per s&are $a# encourage co$petitors or t&e go'ern$ent to *ring
suit against it under t&e anti-trust la(s.
H. "epending on t&e nature of e8cess profit ta8es% if an#% t&e co$pan# $a# lose *#
under-capitali5ation.
EFFECTS
1. 6a*our Unrest: E$plo#ees are often organi5ed and *eco$e conscious of t&e fact t&at
t&e corporation is $a/ing enor$ous profits. T&e# feel t&at t&e# &a'e a legiti$ate rig&t to
s&are in t&ose profits. In ot&er (ords% t&e# de'elop t&e feeling t&at t&e# are not
ade)uatel# paid and t&at t&e corporation is reluctant to pa# (&at is t&eir legiti$ate due.
T&is generates a feeling of &ostilit# on t&e part of t&e e$plo#ees% and leads to la*our
unrest.
;. Consu$er "issatisfaction: Consu$ers feel t&at t&e unusual earnings of t&e corporation
could &a'e *een utili5ed *# effecting a price reduction or *# i$pro'ing t&e )ualit# of t&e
product.
<. 0o'ern$ental Interference: T&e 0o'ern$ent generall# /eeps a (atc&ful e#e on under-
esti$ated.
D. etained Earnings: Because of its conser'ati'e di'idend polic# a corporation $a#
retain t&e earnings% (&ic& $ig&t &a'e accu$ulated into a $ass of sa'ings. T&is is *ound
to i$pro'e its financial &ealt&.
A. >indfall 0ains: Co$panies% (&ic& can afford to continue to operate during t&e period
of depreciation% $a# find t&eir earnings are unusuall# &ig& (&en t&e# enter t&e *oo$
period. T&is s&ift fro$ an ad'erse *usiness c#cle to a prosperous one $a# under-
capitali5e t&e corporation.
F. Indulgence in i'alries: Under indulgence in ri'alries flo(ing fro$ unusuall# &ig&
earnings $a# te$pt an organisation to e$*ar/ upon speculati'e acti'ities in t&e &ope t&at
it can easil# sur'i'e its ill effectsK for if speculati'e acti'ities turn out to *e unfa'ora*le%
its earlier earnings are li/el# to *e (as&ed a(a#.
H. Ta8ation: Because of e8cessi'e earnings% corporations are e8posed to a &ea'# *urden
of ta8ation.
2. Financial need increases: A corporation $a# &a'e to resort fre)uentl# to s&ort-ter$
credit and $a# e'en see/ additional long-ter$ funds (it&out $uc& notice.
J. 6ac/ adapta*ilit#: Adapta*ilit# to c&anged circu$stance $a# *e i$paired and
e8pansion progra$$es $a# slo( do(n.
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BUSINESS FINANCE
1B. Unnecessar# E8pansion: Enor$ous earnings on e)uit# s&ares $a# result in an
increase in $ar/et price% and t&e co$pan# (ill *e te$pted to raise ne( capital.
11. Attracts Co$petition: T&e prospect of enor$ous earnings $a# generate co$petition%
(&ic& $a# ad'ersel# affect t&e profita*ilit# of a corporation.
e$edies:
Under-capitali5ation is easil# re$edied. !ne or $ore of t&e follo(ing $et&ods $a# do
it:
1. Stoc/ Split-up:
T&e Corporation $a# offer t&e stoc/&olders se'eral s&ares of ne( stoc/ for e'er# s&are
of t&e old. If t&ere is a par 'alue% t&e par $ust *e reduced to correspond (it& t&e increase
in t&e nu$*er of s&ares% for *# t&is $et&od t&e capital stoc/ account is not affected.
>it& t&is increase in s&ares and reduction in par 'alue per s&are t&e rate of earnings (ill
not *e c&anged% *ut t&e earnings per s&are (ill *e 'er# su*stantiall# decreased. T&e
effect is $uc& $ore apparent t&an real% for t&e capitali5ation is not increased t&oug& t&e
earnings per s&are are reduced.
;. Increase in .ar 7alue of Stoc/:
If t&e surplus is large or can *e $ade large ,*# re'aluing assets up(ard% or ot&er(ise-%
t&e corporation $ig&t offer t&e stoc/&olders ne( stoc/ for t&e old% t&e ne( stoc/ to carr#
a &ig&er per 'alue. T&is (ould not reduce t&e earnings per s&are% *ut it (ould reduce t&e
rate of earnings per s&are. T&is $et&od% &o(e'er% is seldo$ used% partl# *ecause it
(ould not i$pro'e t&e $ar/eta*ilit# factor. If it (ere desired to go still furt&er% t&e
corporation could offer t&e stoc/&olders a stoc/ split-up and an increase in par 'alue.
T&is (ould reduce *ot& t&e earnings and t&e rate of earnings per earnings per s&are 'alue
enor$ousl#. T&is $et&od% &o(e'er% is 'er# radical and is al$ost ne'er used.
<. Stoc/ "i'idend:
If t&e surplus is large or can *e $ade larger% t&e corporation $ig&t declare a di'idend
pa#a*le in stoc/. T&is (ould not affect par 'alue per s&are% *ut (ould increase t&e
capitali5ation and t&e nu$*er of s&ares. But t&e earnings per s&are and t&e rate of
earnings per s&are (ould *e reduced. T&is is pro*a*l# t&e $ost used $et&od and t&e
$ost easil# effected.
>ATEE" ST!CP ! CA.ITA6
>&en assets of e)ui'alent 'alue do not represent t&e stoc/ or capital of a co$pan#% it is
ter$ed as (atered stoc/ signif#ing presence of (ater in t&e capital of t&e co$pan#. In
si$ple (ords% (atered capital $eans t&at t&e releasa*le 'alue of assets of a co$pan# is
less t&an its *oo/ 'alue. In t&e (ords of Eoagland%4 A stoc/ is said to *e (atered (&en
its true 'alue is less t&an its *oo/ 'alue4.
CAUSES !F >ATE" ST!CP
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BUSINESS FINANCE
T&e pro*le$ of (atered stoc/ generall# arises at t&e ti$e of incorporation of a co$pan#
*ut in so$e cases% it $a# also arise latter during t&e life ti$e of t&e co$pan#. T&e
follo(ing are t&e $ain causes of (atered stoc/ situation.
7aluing t&e ser'ices of t&e pro$pters at undul# &ig& 'alue and pa#ing for t&eir
ser'ices in t&e for$ of stoc/s.
Ac)uiring of intangi*le assets suc& as patents% cop#rig&ts% good(ill% etc at &ig&
'alues (&ic& later pro'e (ort&less
Adopting defecti'e depreciation polic#
>ATEE" ST!CP 7S !7E CA.ITA6SIAIT!N
>atered stoc/ and o'er capitali5ations are not s#non#$ous. T&ere is difference *et(een
t&e t(o. T&e situation of (atered stoc/ arises usuall# art t&e ti$e of incorporation of a
co$pan#% *ut it gets o'er capitali5ed onl# (&en it fails to earn sufficient earnings to
+ustif# its funds.
Signs of o'er trading
1. Increase in *an/ *orro(ings and loans
;. Increases in stoc/s
<. .urc&ase of fi8ed assets out of s&ort ter$ funds
D. "ecline in t&e (or/ing capital ratio
A. "ecline in t&e rate of gross and net profits
F. 6o( current ratio and 'er# &ig& turn-o'er ratio
Conse)uences of o'er trading
1. Ina*ilit# of t&e $anage$ent in pa#ing (ages to t&e e$plo#ees and ta8es to t&e
go'ern$ent
;. "ecline in sales and costl# purc&ases
<. "ifficult# in raising funds *ecause of poor credit (ort&iness
D. .ro*le$s (it& de*tors and creditors
A. Ina*ilit# of t&e $anage$ent to carr# out ti$el# repairs and $aintenance resulting in
efficient (or/ing
F. 6ac/ of funds (ill co$pel t&e co$pan# to go in for out dated and old $ac&iner# for
replace$ent purpose.
e$edies of o'er trading
1. T&e co$pan# s&ould cut do(n it *usiness and o'er spending or it s&ould arrange for
$ore funds
;. .re'enting a situation of o'er trading *# ta/ing precautionar# steps.
Section A
1. >&en a true 'alue of t&e assets of a co$pan# is less t&an its *oo/ 'alue% it is
ter$ed as ------
;. aising $ore capital t&an actual re)uire$ent denotes situation of -----
<. E8cess of current assets o'er current lia*ilities is -----------
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BUSINESS FINANCE
D. Situation (&ere profits earned are e8ceptionall# &ig&% *ut t&e capital e$plo#ed is
relati'el# s$all -----------
A. Co$pan# is said to *e ------- (&en its earnings on capital is not upto t&e industrial
a'erage.
F. As per earnings t&eor# of capitalisation% if a co$pan#@s annual net profit is
;BBBBB and its fair rate of return is ;BR% t&e capitalisation of t&e co$pan# (ill *e
S. -----------
H. Capitalisation is an i$portant constituent of ---------------
2. T&e ; t&eories of capitalisation for ne( co$panies are ---------- and ------------
t&eor#
J. Capitalisation $eans t&e total a$ount of ----------- in a *usiness
1B. Total a$ount of capitalisation of a ne( co$pan# is arri'ed *# adding cost of
fi8ed assets% a$ount of (or/ing capital and cost of esta*lis&ing *usiness is
-----------
Section B
1. >rite a note on cost t&eor# of capitalisation.
;. State t&e $erits and de$erits of earnings t&eor#.
<. "efine capitalisation and e8plain its need.
D. 6ist out t&e e'ils of o'er capitalisation.
A. "escri*e t&e ter$ (atered capital.
F. >&at is under capitalisation of a fir$I
H. E8plain t&e *ases of deter$ining t&e capitalisation of a fir$.
2. Can #ou e8plain (&at earnings t&eor# isI
J. >&at is o'er capitalisationI
1B. Can #ou gi'e t&e re$edies for o'er capitalisationI
Section C
1. E8plain capitalisation and a*out t&e t(o interpretations.
;. >&at is o'er capitalisation and under capitali5ation.
<. >&at are t&e causes of o'er capitalisationI And &o( (ill #ou rectif#.
D. >&at are t&e re$edial $easures do #ou suggest to o'erco$e t&e effects of under
capitali5ation.
A. >&at are t&e different *ases of deter$ining t&e capitalisation of a fir$.
F. >&at are t&e ad'antages and disad'antages of Lo'er@ and Lunder@ capitalisation.
H. Eo( (ill #ou e8plain on o'er capitalisation and e8cess of capitalI
2. Can #ou state so$e points on effects of under capitalisationI
J. E8plain t&e differences of t&e cost and earnings t&eories.
1B. "ifferentiate *et(een o'er capitalisation and under capitali5ation.
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BUSINESS FINANCE
UNIT I7
Capital Structure Cardinal .rinciples of Capital structure Trading on E)uit# Cost of
Capital Concept I$portance Calculation of Indi'idual and Co$posite Cost of
Capital.
CA.ITA6 STUCTUE
INT!"UCTI!N
Capital is t&e $a+or part of all /inds of *usiness acti'ities% (&ic& are decided *# t&e si5e%
and nature of t&e *usiness concern. Capital $a# *e raised (it& t&e &elp of 'arious
sources. If t&e co$pan# $aintains proper and ade)uate le'el of capital% it (ill earn &ig&
profit and t&e# can pro'ide $ore di'idends to its s&are&olders.
Capitali5ation refers to t&e total a$ount of securities issued *# a co$pan# (&ile capital
structure refers to t&e /inds of securities and t&e proportionate a$ounts t&at $a/e up
capitali5ation.
T&e capital structure is &o( a fir$ finances its o'erall operations and gro(t& *# using
different sources of funds. T&e opti$u$ capital structure $a# *e defined as t&at capital
structure or co$*ination of de*t and e)uit# t&at leads to t&e $a8i$u$ 'alue of t&e fir$.
Capital structure is (&at descri*es t&e relations&ip of t&ese financing sources as t&e#
appear on t&e corporation@s *alance s&eet. It refers to all t&e financial resources organi5ed
*# t&e fir$% s&ort as (ell as long ter$% and all for$s of de*t as (ell as e)uit#.
"epending on &o( co$ple8 t&e structure% t&ere $a# in fact *e do5ens of financing
sources included% dra(ing on funds fro$ a 'ariet# of entities in order to generate t&e
2B
BUSINESS FINANCE
co$plete financing pac/age. For raising long ter$ finances% a co$pan# can issue t&ree
t#pes of securities 'i5.% E)uit# s&ares% .reference s&ares and de*entures. A decision a*out
t&e proportion a$ong t&ese t#pes of securities refers to t&e capital structure of an
enterprise.
Meaning of Capital Structure
Capital structure refers to t&e /inds of securities and t&e proportionate a$ounts t&at $a/e
up capitali5ation. It is t&e $i8 of different sources of long-ter$ sources suc& as e)uit#
s&ares% preference s&ares% de*entures% long-ter$ loans and retained earnings.
T&e ter$ capital structure refers to t&e relations&ip *et(een t&e 'arious long-ter$
source financing suc& as e)uit# capital% preference s&are capital and de*t capital.
"eciding t&e suita*le capital structure is t&e i$portant decision of t&e financial
$anage$ent *ecause it is closel# related to t&e 'alue of t&e fir$.
Capital structure is t&e per$anent financing of t&e co$pan# represented pri$aril# *#
long-ter$ de*t and e)uit#.
"efinition of Capital Structure
T&e follo(ing definitions clearl# initiate% t&e $eaning and o*+ecti'e of t&e capital
structures.
According to t&e definition of 0eresten*eg% 3Capital Structure of a co$pan# refers
to t&e co$position or $a/e up of its capitali5ation and it includes all long-ter$ capital
resources4.
According to t&e definition of Ma$es C. 7an Eorne% 3T&e $i8 of a fir$@s per$anent
long-ter$ financing represented *# de*t% preferred stoc/% and co$$on stoc/ e)uit#4.
According to t&e definition of .resana C&andra% 3T&e co$position of a fir$@s
financing consists of e)uit#% preference% and de*t4.
According to t&e definition of .E. >essel% 3T&e long ter$ sources of fund
e$plo#ed in a *usiness enterprise4.
For$s9 .atterns of Capital Structure:
T&e capital structure of a ne( co$pan# $a# consist of na# of t&e follo(ing for$s
a. E)uit# S&ares onl#
*. E)uit# and preference s&ares
c. E)uit# s&ares and de*entures
d. E)uit# s&ares% preference s&ares and de*entures.
FINANCIA6 STUCTUE
T&e ter$ financial structure is different fro$ t&e capital structure. Financial structure
s&o(s t&e pattern total financing. It $easures t&e e8tent to (&ic& total funds are
a'aila*le to finance t&e total assets of t&e *usiness.
Financial Structure Q Total lia*ilities
!r
21
BUSINESS FINANCE
Financial Structure Q Capital Structure V Current lia*ilities.
T&e follo(ing points indicate t&e difference *et(een t&e financial structure and
capital structure.
Financial Structures Capital Structures
1. It includes *ot& long-ter$ and s&ort-ter$ sources of funds 1. It includes onl# t&e long-ter$ sources
of funds.
;. It $eans t&e entire lia*ilities side of t&e *alance s&eet. ;. It $eans onl# t&e long-ter$ lia*ilities
of t&e co$pan#.
<. Financial structures consist of all sources of capital. <. It consist of e)uit#% preference and
retained earning capital.
D. It (ill not *e $ore i$portant (&ile deter$ining t&e D. It is one of t&e $a+or deter$inations of
'alue of t&e fir$. t&e 'alue of t&e fir$.
+,ample
Fro$ t&e follo(ing infor$ation% calculate t&e capitali5ation% capital structure and
financial structures.
Balance Sheet
6ia*ilities Assets
E)uit# s&are capital AB%BBB Fi8ed assets ;A%BBB
.reference s&are capital A%BBB 0ood (ill 1B%BBB
"e*entures F%BBB Stoc/ 1A%BBB
etained earnings D%BBB Bills recei'a*le A%BBB
Bills pa#a*le ;%BBB "e*tors A%BBB
Creditors <%BBB Cas& and *an/ 1B%BBB
HB%BBB HB%BBB
,i- Calculation of Capitali5ation
S. No. Sources A$ount
1. E)uit# s&are capital AB%BBB
;. .reference s&are capital A%BBB
<. "e*entures F%BBB
Capitali5ation F1%BBB
,ii- Calculation of Capital Structures
S. No. Sources A$ount .roportion
1. E)uit# s&are capital AB%BBB HF.J;
;. .reference s&are capital A%BBB H.FJ
<. "e*entures F%BBB J.;<
D. etained earnings D%BBB F.1F
FA%BBB 1BBR
,iii- Calculation of Financial Structure
2;
BUSINESS FINANCE
S. No. Sources A$ount .roportion
1. E)uit# s&are capital AB%BBB H1.D;
;. .reference s&are capital A%BBB H.1D
<. "e*entures F%BBB 2.A2
D . etained earnings D%BBB A.H;
A. Bills pa#a*le ;%BBB ;.2A
F. Creditors <%BBB D.;J
HB%BBB 1BBR
!.TIMUM CA.ITA6 STUCTUE
!pti$u$ capital structure is t&e capital structure at (&ic& t&e (eig&ted a'erage cost of
capital is $ini$u$ and t&ere*# t&e 'alue of t&e fir$ is $a8i$u$.
!pti$u$ capital structure $a# *e defined as t&e capital structure or co$*ination of
de*t and e)uit#% t&at leads to t&e $a8i$u$ 'alue of t&e fir$.
!*+ecti'es of Capital Structure
"ecision of capital structure ai$s at t&e follo(ing t(o i$portant o*+ecti'es:
1. Ma8i$i5e t&e 'alue of t&e fir$.
;. Mini$i5e t&e o'erall cost of capital.
For$s of Capital Structure
Capital structure pattern 'aries fro$ co$pan# to co$pan# and t&e a'aila*ilit# of finance.
Nor$all# t&e follo(ing for$s of capital structure are popular in practice.
E)uit# s&ares onl#.
E)uit# and preference s&ares onl#.
E)uit# and "e*entures onl#.
E)uit# s&ares% preference s&ares and de*entures.
FACT!S "ETEMININ0 CA.ITA6 STUCTUE
T&e follo(ing factors are considered (&ile deciding t&e capital structure of t&e fir$.
6e'erage
It is t&e *asic and i$portant factor% (&ic& affect t&e capital structure. It uses t&e fi8ed
cost financing suc& as de*t% e)uit# and preference s&are capital. It is closel# related to t&e
o'erall cost of capital.
Cost of Capital
Cost of capital constitutes t&e $a+or part for deciding t&e capital structure of a fir$.
Nor$all# long- ter$ finance suc& as e)uit# and de*t consist of fi8ed cost (&ile
$o*ili5ation. >&en t&e cost of capital increases% 'alue of t&e fir$ (ill also decrease.
Eence t&e fir$ $ust ta/e careful steps to reduce t&e cost of capital.
2<
BUSINESS FINANCE
,a- Nature of t&e *usiness: Use of fi8ed interest9di'idend *earing finance depends
upon t&e nature of t&e *usiness. If t&e *usiness consists of long period of
operation% it (ill appl# for e)uit# t&an de*t% and it (ill reduce t&e cost of capital.
,*- Si5e of t&e co$pan#: It also affects t&e capital structure of a fir$. If t&e fir$
*elongs to large scale% it can $anage t&e financial re)uire$ents (it& t&e &elp of
internal sources. But if it is s$all si5e% t&e# (ill go for e8ternal finance. It
consists of &ig& cost of capital.
,c- 6egal re)uire$ents: 6egal re)uire$ents are also one of t&e considerations (&ile
di'iding t&e capital structure of a fir$. For e8a$ple% *an/ing co$panies are
restricted to raise funds fro$ so$e sources.
,d- e)uire$ent of in'estors: In order to collect funds fro$ different t#pe of
in'estors% it (ill *e appropriate for t&e co$panies to issue different sources of
securities.
0o'ern$ent polic#
.ro$oter contri*ution is fi8ed *# t&e co$pan# Act. It restricts to $o*ili5e large%
long-ter$ funds fro$ e8ternal sources. Eence t&e co$pan# $ust consider go'ern$ent
polic# regarding t&e capital structure.
TEE!IES !F CA.ITA6 STUCTUE
Capital structure is t&e $a+or part of t&e fir$@s financial decision (&ic& affects t&e 'alue
of t&e fir$ and it leads to c&ange EBIT and $ar/et 'alue of t&e s&ares. T&ere is a
relations&ip a$ong t&e capital structure% cost of capital and 'alue of t&e fir$. T&e ai$ of
effecti'e capital structure is to $a8i$i5e t&e 'alue of t&e fir$ and to reduce t&e cost of
capital.
T&ere are t(o $a+or t&eories e8plaining t&e relations&ip *et(een capital structure%
cost of capital and 'alue of t&e fir$.
Capital Structure T&eories
Modern Approac& Tradition al Approac&
Net Inco$e Net !perating Inco$e Modigliani-Miller
Approac& Approac& Approac&
Fig. -.! "apital Structure Theories
Net Inco$e Approac&:
Net inco$e approac& suggested *# t&e "urand. According to t&is approac&% t&e capital
structure decision is rele'ant to t&e 'aluation of t&e fir$. In ot&er (ords% a c&ange in t&e
capital structure leads to a corresponding c&ange in t&e o'erall cost of capital as (ell as
t&e total 'alue of t&e fir$.
According to t&is approac&% use $ore de*t finance to reduce t&e o'erall cost of
2D
BUSINESS FINANCE
capital and increase t&e 'alue of fir$.
Net inco$e approac& is *ased on t&e follo(ing t&ree i$portant assu$ptions:
1.T&ere are no corporate ta8es.
;.T&e cost de*t is less t&an t&e cost of e)uit#.
<.T&e use of de*t does not c&ange t&e ris/ perception of t&e in'estor.
A fir$ can $ini$i5e t&e (eig&ted a'erage cost of capital and increase t&e 'alue of t&e
fir$ as (ell as t&e $ar/et price of e)uit# s&ares *# using de*t finance to t&e $a8i$u$
possi*le e8tent.
T&e total $ar/et 'alue of a fir$ on t&e *asis of Net Inco$e Approac& Can *e ascertained
as *elo(:
7QSV"
7 Q Total $ar/et 'alue of a fir$
S Q Mar/et 'alue of e)uit# s&ares
" Q Mar/et 'alue of de*t
.articulars A$ount
Net operating inco$e ,EBIT- NNN
6ess: interest on de*enture ,i- NNN
Earnings a'aila*le to e)uit# &older ,NI- NNN
E)uit# capitali5ation rate ,Pe- NNN
Mar/et 'alue of e)uit# ,S- NNN
Mar/et 'alue of de*t ,B- NNN
Total 'alue of t&e fir$ ,SVB- NNN
!'erall cost of capital Q Po Q EBIT97,R- NNNR
E8ercise <
,a- A Co$pan# e8pects a net inco$e of s. 1%BB%BBB. It &as s. ;%AB%BBB% 2R
de*entures. T&e e)ualit# capitali5ation rate of t&e co$pan# is 1BR. Calculate t&e
'alue of t&e fir$ and o'erall capitali5ation rate according to t&e net inco$e
approac& ,ignoring inco$e ta8-.
,*- If t&e de*enture de*ts are increased to s. D%BB%BBB. >&at s&all *e t&e 'alue of t&e
fir$ and t&e o'erall capitali5ation rateI
Solution
,a- Capitali5ation of t&e 'alue of t&e fir$
s.
Net inco$e 1%BB%BBB
2A
BUSINESS FINANCE
6ess: Interest on 2R "e*entures of s. ;%AB%BBB ;B%BBB
Earnings a'aila*le to e)ualit# s&are&olders 2B%BBB
E)uit# capitali5ation rate 1BR
Q
2B%BBB
1BB
1B
Mar/et 'alue of e)uit# Q 2%BB%BBB
Mar/et 'alue of de*entures Q ;%AB%BBB
7alue of t&e fir$ Q 1B%AB%BBB
Calculation of o'erall capitali5ation rate
!'erall cost of capital ,P
o
- Q
Earnings
EBI
T
7alueof t&efir$ 7
1%BB%BBB
= 1B%AB%BBB
Y1BB

= J.A;R
,*- Calculation of 'alue of t&e fir$ if de*enture de*t is raised to s. <%BB%BBB.
s.
Net inco$e 1%BB%BBB
6ess: Interest on 2R "e*entures of s. D%BB%BBB <;%BBB
E)uit# Capitali5ation rate F2%BBB
1BR
1BB
Mar/et 'alue of e)uit# Q F2%BBB Y Q F%2B%BBB 1B
Q F%2B%BBB
Mar/et 'alue of "e*entures Q D%BB%BBB
7alue of fir$ Q 1B%2B%BBB
!'erall cost of capital Q
1%BB%BBB
Y1B 1B%2B%BBB
Q J.;FR
T&us% it is e'ident t&at (it& t&e increase in de*t financing% t&e 'alue of t&e fir$ &as
increased and t&e o'erall cost of capital &as increased.
Net !perating Inco$e Approac&
2F
BUSINESS FINANCE
It is opposite to t&e net inco$e approac&. According to t&is approac& c&ange in t&e
capital structure of acco$pan# does not affect t&e $ar/et 'alue of t&e fir$ and t&e
o'erall cost of capital re$ains constant irrespecti'e of t&e $et&od of financing
T&is t&eor# presu$es t&at
T&e $ar/et capitali5es t&e 'alue of t&e fir$ as ( (&ole
T&e *usiness ris/ re$ains constant at e'er# le'el of de*t e)uit# $i8.
T&ere are no corporate ta8es
According to t&is approac&% t&e c&ange in capital structure (ill not lead to an# c&ange
in t&e total 'alue of t&e fir$ and $ar/et price of s&ares as (ell as t&e o'erall cost of
capital.
NI approac& is *ased on t&e follo(ing i$portant assu$ptionsK
T&e o'erall cost of capital re$ains constantK
T&ere are no corporate ta8esK
T&e $ar/et capitali5es t&e 'alue of t&e fir$ as a (&oleK
7alue of t&e fir$ ,7- can *e calculated (it& t&e &elp of t&e follo(ing for$ula
EBIT
7 Q
P
o
>&ere%
7 Q 7alue of t&e fir$
EBIT Q Earnings *efore interest and ta8
P
o
Q !'erall cost of capital
E8ercise D
N?O e8pects a net operating inco$e of s. ;%BB%BBB. It &as 2%BB%BBB% FR de*entures.
T&e o'erall capitali5ation rate is 1BR. Calculate t&e 'alue of t&e fir$ and t&e e)uit#
capitali5ation rate ,Cost of E)uit#- according to t&e net operating inco$e approac&.
If t&e de*entures de*t is increased to s. 1B%BB%BBB. >&at (ill *e t&e effect on
'olu$e of t&e fir$ and t&e e)uit# capitali5ation rateI
Solution
Net operating inco$e Q s. ;%BB%BBB
!'erall cost of capital Q 1BR
Mar/et 'alue of t&e fir$ ,7-
Q EBI
2H
BUSINESS FINANCE
T
P
o
1BB
Q ;%BB%BBBY Q s. ;B%BB%BBB 1B
Mar/et 'alue of t&e fir$ Q s. ;B%BB%BBB
6ess: $ar/et 'alue of "e*enturesQ s. 2%BB%BBB
1;%BB%BBB
E)uit# capitali5ation rate ,or- cost of e)uit# ,Pe-
EBIT Z I
= 7 Z "
>&ere% 7 Q 'alue of t&e fir$
" Q 'alue of t&e de*t capital
;%BB%BBB D2%BBB
Q

;B%BB%BBB Z 2%BB%BBB
Y1BB
Q1;.FHR
If t&e de*entures de*t is increased to s. 1B%BB%BBB% t&e 'alue of t&e fir$ s&all
re$ain c&anged to s. ;B%BB%BBB. T&e e)uit# capitali5ation rate (ill increase as follo(s:
EBIT Z I
= 7 Z "
;%BB%BBB FB%BBB
Q
;B%BB%BBB
Z 1B%BB%BBB
Y1BB
1%DB%BBB
=
1B%BB%BBB
Y1BB

= 1DR.
E8ercise A
A*ina#a co$pan# 6td. e8presses a net operating inco$e of s. ;%BB%BBB. It &as s.
2%BB%BBB to HR de*entures. T&e o'erall capitali5ation rate is 1BR.
,a- Calculate t&e 'alue of t&e fir$ and t&e e)uit# captiali5ation rate ,or- cost of
e)uit# according to t&e net operating inco$e approac&.
,*- If t&e de*enture de*t is increasesd to s. 1;%BB%BBB. >&at (ill *e t&e effect on t&e
22
BUSINESS FINANCE
'alue of t&e fir$% t&e e)uit# capitali5ation rateI
Solution
,a- Net operating inco$e Q s. ;%BB%BBB
!'er all cost of capital Q 1BR
Mar/et 'alue of t&e fir$ ,7-
N!I,EBIT-
!'erallcost of capital,!P-
Q ;%BB%BBBY1BB91B
Q s. ;B%BB%BBB
Mar/et 'alue of fir$ Q s. ;B%BB%BBB
6ess Mar/et 'alue of de*entures Q s. 2%BB%BBB
Total $ar/eting 'alue of e)uit# Q s. 1;%BB%BBB
E)uit# capitali5ation rate ,or- cost of e)uit# ,P
e
-
EBIT Z I
=
7 Z "
;%BB%BBB Z AF%BBB
= ;B%BB%BBB Z 2%BB%BBB
Y1BB

1%DD%BBB
=
1;%BB%BBB
Y1BB

=
1;R
(&ere I Q Interest of de*t
7 Q7alue of t&e fir$
" Q7alue of de*t capital
I Q2%BB%BBBYHRQAF%BBB
7 Q;B%BB%BBB
" Q2%BB%BBB
,*- If t&e de*enture de*t is increased at s. 1;%BB%BBB% t&e 'alue of t&e fir$ s&all
c&anged to s. ;B%BB%BBB.
E)uit# Capitali5ation ate ,P
e
-
2J
BUSINESS FINANCE
EBIT Z I
= 7 Z "
;%BB%BBB Z 2D%BBB
=
;B%BB%BBB Z 1;%BB%BBB
= 1D.AR
(&ere IQ 1;%BB%BBB at HR Q 2D%BBB
Modigliani and Miller Approac&
Modigliani and Miller approac& states t&at t&e financing decision of a fir$ does not
affect t&e $ar/et 'alue of a fir$ in a perfect capital $ar/et. In ot&er (ords MM approac&
$aintains t&at t&e a'erage cost of capital does not c&ange (it& c&ange in t&e de*t
(eig&ted e)uit# $i8 or capital structures of t&e fir$.
Modigliani and Miller approac& is *ased on t&e follo(ing i$portant assu$ptions:
T&ere is a perfect capital $ar/et.
T&ere are no retained earnings.
T&ere are no corporate ta8es.
T&e in'estors act rationall#.
T&e di'idend pa#out ratio is 1BBR.
T&e *usiness consists of t&e sa$e le'el of *usiness ris/.
7alue of t&e fir$ can *e calculated (it& t&e &elp of t&e follo(ing for$ula:
EBIT
,l Z t-
Po
>&ere
EBIT Q Earnings *efore interest and ta8
P
o
Q !'erall cost of capital
t Q Ta8 rate
JB
BUSINESS FINANCE

a
t
e

o
f

e
t
u
r
n
P
e
Po
/
"9E
is/ Bearing "e*t
is/ "ue " e*t
Fig. -.2 Modigliani and Miller Approach
J1
E8ercise F
T&ere are t(o fir$s LA@ and LB@ (&ic& are e8actl# identical e8cept t&at A does not use
an# de*t in its financing% (&ile B &as s. ;%AB%BBB % FR "e*entures in its financing. Bot&
t&e fir$s &a'e earnings *efore interest and ta8 of s. HA%BBB and t&e e)uit# capitali5ation
rate is 1BR. Assu$ing t&e corporation ta8 is ABR% calculate t&e 'alue of t&e fir$.
Solution
T&e $ar/et 'alue of fir$ A (&ic& does not use an# de*t.
7uQ
EBIT
P
o
=
HA%BBB
QHA%BBBY1BB91B
1B91BB
= s. H%AB%BBB
T&e $ar/et 'alue of fir$ B (&ic& uses de*t financing of s.
;%AB%BBB 7
t
Q 7
u
V t
7
u
Q H%AB%BBB% t Q ABR of s. ;%AB%BBB
= H%AB%BBB V 1%;A%BBB
= s. 2%HA%BBB
E8ercise H
T&e follo(ing data regarding t&e t(o co$panies LN@ and L?@ *elonging to t&e sa$e
e)ui'alent class:
Co$pan# LN@ Co$pan# L?@
Nu$*er of ordinar# s&ares HA%BBB 1%;A%BBB
AR de*entures DB%BBB
Mar/et price per s&ares s. 1.;A s. 1.BB
.rofit *efore interest s. ;A%BBB s. ;A%BBB
All profits after pa#ing de*enture interest are distri*uted as di'idends.
?ou are re)uired to e8plain &o( under Modigliani and Miller approac&% an in'estor
&olding 1BR of s&ares in co$pan# LN@ (ill *e *etter off in s(itc&ing &is &olding to
co$pan# L?@.
Solution
As per t&e opinion of Modigliani and Miller% t(o si$ilar fir$s in all respects e8cept
t&eir capital structure cannot &a'e different $ar/et 'alues *ecause of ar*itrage process. In
case t(o si$ilar fir$s e8cept for t&eir capital structure &a'e different $ar/et 'alues%
ar*itrage (ill ta/e place and t&e in'estors (ill engage in Lpersonal le'erage@ as against
t&e corporate le'erage. In t&e gi'en pro*le$% t&e ar*itrage (ill (or/ out as *elo(.
1. T&e in'estor (ill sell in t&e $ar/et 1BR of s&ares in co$pan# LN@ for
HA%BBBY1B91BBY1.;AQs. J<HA
;. Ee (ill raise a loan of s. DB%BBBY1B91BBQs. DBBB
To ta/e ad'antage of personal le'erage as against t&e corporate le'erage t&e co$pan#
L?@ does not use de*t content in its capital structure. Ee (ill put 1<<HA s&ares in co$pan#
L?@ (it& t&e total a$ount reali5ed fro$ 1 and ; i.e.% s. J<HA plus s. DBBB. T&us &e (ill
&a'e 1B.HR of s&ares in co$pan# L?@.
T&e in'estor (ill gain *# s(itc&ing &is &olding as *elo(:
.resent inco$e of t&e in'estor in co$pan# LN@ s.
.rofit *efore Interest of t&e Co$pan# ;A%BBB
6ess: Interest on "e*entures AR ;%BBB
.rofit after Interest ;<%BBB
S&are of t&e in'estor Q 1BR of s. ;<%BBB i.e.% s. ;<BB
Inco$e of t&e in'estor after s(itc&ing &olding to co$pan#
.rofit *efore Interest of t&e co$pan# s. ;A%BBB
6ess Interest WW
.rofit after Interest ;A%BBB
1<%<HA
Q s. ;%FHA S&are of t&e in'estor : ;A%BBBY
1%;A%BB
B
Interest paid on loan ta/en DBBBYA91BB ;BB
Net Inco$e of t&e In'estor ;%DHA
As t&e net inco$e of t&e in'estor in co$pan# L?@ is &ig&er t&an t&e cost of inco$e
fro$ co$pan# LN@ due to s(itc&ing t&e &olding% t&e in'estor (ill gain in s(itc&ing &is
&oldings to co$pan# L?@.
E8ercise 2
.ara$ount .roducts 6td. (ants to raise s. 1BB la/& for di'ersification pro+ect.
Current esti$ates of EBIT fro$ t&e ne( pro+ect is s. ;; la/& p.a.
Cost of de*t (ill *e 1AR for a$ounts up to and including s. DB la/&% 1FR for
additional a$ounts up to and including s. AB la/& and 12R for additional a$ounts
a*o'e s. AB la/&. T&e e)uit# s&ares ,face 'alue of s. 1B- of t&e co$pan# &a'e a current
$ar/et 'alue of s. DB. T&is is e8pected to fall to s. <; if de*ts e8ceeding s. AB la/&
are raised. T&e follo(ing options are under consideration of t&e co$pan#.
!ption "e*t E)uit#
I ABR ABR
II DBR FBR
III FBR DBR
"eter$ine E.S for eac& option and state (&ic& option s&ould t&e Co$pan# adopt.
Ta8 rate is ABR. ,IC>A Inter "ec. 1JJH-
Solution
I II III
E)uit# AB%BB%BBB FB%BB%BBB DB%BB%BBB
"e*t AB%BB%BBB DB%BB%BBB FB%BB%BBB
A$ount to *e raised 1%BB%BB%BBB 1%BB%BB%BBB 1%BB%BB%BBB
EBIT ;;%BB%BBB ;;%BB%BBB ;;%BB%BBB
6ess: Interest of "e*t H%FB%BBB F%BB%BBB J%DB%BBB
.BT 1D%DB%BBB 1F%BB%BBB 1;%FB%BBB
6ess : Ta8 [ ABR H%;B%BBB 2%BB%BBB F%<B%BBB
.AT H%;B%BBB 2%BB%BBB F%<B%BBB
No. of e)uit# s&ares 1%;A%BBB 1%AB%BBB 1%;A%BBB
s. A.HF s. A.<< s. A.BD
>or/ing Notes
Calculation of Interest on "e*t
Total "e*t I II III
Interest on: AB%BB%BBB DB%BB%BBB FB%BB%BBB
Ist s. DB%BB%BBB [ 1AR F%BB%BBB F%BB%BBB F%BB%BBB
Ne8t s.1B%BB%BBB [ 1FR 1%FB%BBB 1%FB%BBB
Balance s. 1B%BB%BBB [ 12R 1%2B%BBB
H%FB%BBB F%BB%BBB J%DB%BBB
E8ercise J
T&e follo(ing is t&e data regarding t(o Co$pan#@s. N and ? *elonging to t&e sa$e
ris/ class.
N ?
No. of ordinar# s&ares JB%BBB 1%AB%BBB
Mar/et price9s&are ,s.- 1.; 1.B
FR de*entures FB%BBB
.rofit *efore interest 12%BBB 12%BBB
All profits after interest are distri*uted as di'idend.
E8plain &o( under Modigliani : Miller Approac& an in'estor &olding 1BR of s&ares
in Co$pan# N (ill *e *etter off in s(itc&ing &is &olding to Co$pan# ?.
,CA Final No'. 1JJ<-
Solution
Bot& t&e fir$s &a'e EBIT of s. 12%BBB. Co$pan# N &as to pa# interest of s. <FBB
,i.e.% FR on s. FB%BBB- and t&e re$aining profit of s. 1D%DBB is *eing distri*uted a$ong
t&e s&are&olders. T&e Co$pan# ? on t&e ot&er &and &as no interest lia*ilit# and t&erefore
is distri*uting s.12%BBB a$ong t&e s&are&olders.
T&e in'estor (ill *e (ell off under MM Model *# selling t&e s&ares of N and s&ifting
to s&ares of ? co$pan# t&roug& t&e ar*itrage process as follo(s. If &e sells s&ares of N
Co$pan# Ee gets s. 1B%2BB ,J%BBB s&ares [ s.1.; per s&are-. Ee no( ta/es a FR loan
of s.F%BBB
,i.e. 1BA of s. FB%BBB- and out of t&e total cas& of s. 1F%2BB &e purc&ases 1BR of
s&ares of Co$pan# ? for s. 1A%BBBK &is position (it& regard to Co$pan# ? (ould *e as
follo(s:
N ?
"i'idends ,1BR of .rofits- 1%DDB 1%2BB
6ess:Interest ,FR on s. F%BBB- <FB
Net Inco$e 1%DDB 1%DDB
T&us *# s&ifting fro$ Co$pan# ? t&e in'estor is a*le to get t&e sa$e inco$e of s.
1%DDB and still &a'ing funds of s. 1%2BB ,i.e.% s. 1F%2BB 1A%BBB- at &is disposal. Ee is
*etter off not in ter$s of inco$e *ut in ter$s of &a'ing capital of s. 1%2BB (it& &i$
(&ic& &e can in'est else(&ere.
E8ercise 1B
0entr# Motors 6td.% a producer of tur*ine generators% is in t&is situationK EBIT Q s.
DB lac. rate Q<AR% dept. outstanding Q " Q s. ;B lac.% rate of Interest Q1BR% P
e
Q 1AR%
s&ares of stoc/ outstanding Q No. Q s. F%BB%BBB and *oo/ 'alue per s&are Q s. 1B.
Since 0entr#@s product $ar/et is sta*le and t&e Co$pan# e8pects no gro(t&% all earnings
are paid out as di'idends. T&e de*t consists of perpetual *onds. >&at are t&e 0entr#@s
EBS and its price per s&are% .
o
I ,CS Final "ec. 1JJ2-
Solution
,a- EBIT DB%BB%BBB
interest [ 1BR
;%BB%BBB
<2%BB%BBB
Ta8 [ <AR
1<%<B%BBB
;D%HB%BBB
No. of s&ares F%BB%BBB
E.S ,or "i'idend- s. D.1;
P
e
,gi'en- 1AR
.
o
,i.e.% "9P
e
- D.1;9.1A
s. ;H.DH
In t&e sa$e )uestion if t&e Co$pan# increases its de*t *# s. 2B la/& to a total of s.
1 crore using t&e ne( de*t to *u# and retire of its s&ares at current price% its interest rate
on de*t (ill *e 1;R and its cost of e)uit# (ill rise fro$ 1AR to 1HR. EBIT (ill re$ain
constant% s&ould t&is Co$pan# c&ange its capital structure.
If Co$pan# decides to increase its de*t *# s. 2B lacs% t&e Co$pan# $a# *u# *ac/
2B%BB%BBB ;H.DH Q ;%J1%;;F s&ares. T&ereafter t&e re$aining no. of s&ares (ould *e
<%B2%HHD ,i.e.% F%BB%BBB ;%J1%;;F-.
T&e $ar/et price of t&e s&are $a# *e ascertained as follo(s:
EBIT DB%BB%BBB
Interest [ 1;R on s. 1 crore 1;%BB%BBB
;2%BB%BBB
Ta8 [ <AR J%2B%BBB
12%;B%BBB
No. of e)uit# s&ares <%B2%HHD
E.S s. A.2J
P
e 1HR
.
o
,i.e.% "9P
e
- A.2J
.1H
Q s. <D.FD
As t&e price is e8pected to rise fro$ ;H.DH to s <D.FD% t&e Co$pan# $a# c&ange its
capital structure *# raising de*t and retaining so$e nu$*er of s&ares.
Traditional approac&
It is also /no(n as inter$ediate approac&. A proper de*t-e)uit# $i8 can reac& opti$u$
capital structure. Be#ond a particular point% t&e cost of e)uit# increases *ecause increased
de*t increases t&e financial ris/ of t&e e)uit# s&are&olders. T&e o'erall cost of capital
decreases up to ca certain point% re$ains unc&anged for $oderate increase in de*t
t&ereafter and increases or rises *e#ond a certain point. E'en t&e cost of de*t $a#
increase at t&is stage due to increases financial ris/.
Factors deter$ining t&e capital structure:
a. Financial le'erage or Trading on e)uit#:
T&e use of long ter$ fi8ed interest *earing de*t and preference s&are capital along (it&
e)uit# s&are capital is called financial le'erage or trading on e)uit#.
*. 0ro(t& and sta*ilit# of sales:
T&e capital structure is influenced *# t&e sales. If t&e sales is &ig&% t&e fir$ can use t&e
de*t $ore for financing t&e fir$.
c. Cost of capital:
Cost of capital refers to t&e $ini$u$ return e8pected *# its suppliers. T&e capital
structure s&ould pro'ide for t&e $ini$u$ cost of capital. T&e return e8pected *# t&e
suppliers of capital depends upon t&e ris/ t&e# &a'e to underta/e. t&e $ain sources of
finance for a fir$ are e)uit#% preference s&are capital and de*t capita.. >&ile for$ulating
a capital structure% effort $ust *e $ade to $ini$i5e t&e o'erall cost of capital.
d. Cas& flo( a*ilit# to ser'ice de*t:
If t&e fir$ &as good cas& flo( I t can c&oose $ore de*t in its capital structure. >&ene'er
a fir$ (ants to raise additional funds% it s&ould esti$ate% pro+ect its future cas& inflo(s to
ensure t&e co'erage of fi8ed c&arges.
e. Nature and si5e of t&e fir$:
Nature and si5e of t&e fir$ also influences t&e capital structure. .u*lic utilit# concerns
$a# e$plo# $ore of de*t *ecause of sta*ilit# and regularit# of t&eir earnings. !n t&e
ot&er &and% concern t&at cannot pro'ide sta*le earnings due to t&e nature of its *usiness
(ill &a'e to rel# $ainl# on e)uit# capital. S$all co$panies &a'e to depend $ainl# upon
o(ned capital% as it is 'er# difficult for t&e$ to raise lJong ter$ loans on reasona*le
ter$s and also cannot issue e)uit# and preference s&ares to t&e pu*lic
f. Control:
T&e $anage$ent s&ould raise t&e funds (it&out loosing t&e control. If t&e funds are
raised t&roug& t&e issue of e)uit# s&ares% t&e control is diluted. .reference s&are&olders
and de*enture &olders@ do not &a'e t&e 'oting rig&t. And &ence it $a# *e reco$$ended.
But it (ould cause &ea'# *urden to t&e co$pan#.
g. Fle8i*ilit#:
Capital structure s&ould *e in suc& a (a# t&at it $ust *e capa*le of *eing ad+usted
according to t&e needs of t&e c&anging conditions.
&. e)uire$ents of in'estors.
e)uire$ents of t&e in'estors s&ould also *e considered. Bold in'estors $a# prefer
e)uit# capital (&ile t&e conser'ati'e in'estors prefer de*t and preference capital.
i. Capital $ar/et conditions:
T&e c&oice of t&e securities are influenced *# t&e $ar/et conditions suc& as depression
and % *oo$ etc. t&e co$pan# s&all not issue e)uit# s&ares during depression and $a#
issue t&e$ at *oo$.
+. Assets structure
T&e li)uidit# and t&e co$position of assets s&ould also *e /ept in $ind (&ile selecting &e
capital structure.
/. .urpose of financing.
If funds are re)uired for producti'e purpose% de*t financing s&all *e suita*le and if t&e
funds are re)uired for general de'elop$ent of unproducti'e purpose% e)uit# capital s&all
*e preferred.
l. .eriod of Finance:
If funds are needed for per$anent *asis% e)uit# capital s&all *e used and if it is for a
li$ited period% *est financing or preference capital $a# *e preferred
$. Cost of flotation:
Cost of floatation of de*t is generall# less t&an t&e cost of floatation of e)uit# capital.
n. .ersonal consideration:
.ersonal considerations and a*ilities of t&e $anage$ent (ill &a'e i$pact on t&e capital
structure of t&e fir$.
!. Corporate ta8 rate:
Eig& corporate ta8es on profits $a# co$pel t&e co$panies to prefer de*t financing%
*ecause interest is allo(ed to *e deducted (&ile co$puting ta8a*le profits. !n t&e ot&er
&and di'idend of s&ares is not an allo(a*le e8pense for t&at purpose.
.. 6egal re)uire$ents:
T&e legal restrictions are 'er# significant as t&ese la# do(n a fra$e(or/ (it&in (&ic&
capital structure decision &as to *e $ade.
It is t&e $i8 of Net Inco$e approac& and Net !perating Inco$e approac&. Eence% it is
also called as inter$ediate approac&. According to t&e traditional approac&% $i8 of de*t
and e)uit# capital can increase t&e 'alue of t&e fir$ *# reducing o'erall cost of capital up
to certain le'el of de*t. Traditional approac& states t&at t&e P
o
decreases onl# (it&in t&e
responsi*le li$it of financial le'erage and (&en reac&ing t&e $ini$u$ le'el% it starts
increasing (it& financial le'erage.
Assu$ptions
Capital structure t&eories are *ased on certain assu$ption to anal#sis in a single and
con'enient $anner:
T&ere are onl# t(o sources of funds used *# a fir$K de*t and s&ares.
T&e fir$ pa#s 1BBR of its earning as di'idend.
T&e total assets are gi'en and do not c&ange.
T&e total finance re$ains constant.
T&e operating profits ,EBIT- are not e8pected to gro(.
T&e *usiness ris/ re$ains constant.
T&e fir$ &as a perpetual life.
T&e in'estors *e&a'e rationall#.
E8ercise 1
ABC 6td.% needs s. <B%BB%BBB for t&e installation of a ne( factor#. T&e ne( factor#
e8pects to #ield annual earnings *efore interest and ta8 ,EBIT- of s.A%BB%BBB. In
c&oosing a financial plan% ABC 6td.% &as an o*+ecti'e of $a8i$i5ing earnings per s&are
,E.S-. T&e co$pan# proposes to issuing ordinar# s&ares and raising de*it of s. <%BB%BBB
and s. 1B%BB%BBB of s. 1A%BB%BBB. T&e current $ar/et price per s&are is s. ;AB and is
e8pected to drop to s. ;BB if t&e funds are *orro(ed in e8cess of s. 1;%BB%BBB. Funds
can *e raised at t&e follo(ing rates.
up to s. <%BB%BBB at 2R
o'er s. <%BB%BBB to s. 1A%BBB%BB at 1BR
o'er s. 1A%BB%BBB at 1AR
Assu$ing a ta8 rate of ABR ad'ise t&e co$pan#.
Solution
Earnings Before Interest and Ta8 ,BIT- less Interest Earnings Before Ta8 less:
Ta8[ABR.
Alternati'es
I II III
,s. <%BB%BBB de*t- s. 1B%BB%BBB de*t- ,s. 1A%BB%BBB de*t-
A%BB%BBB A%BB%BBB A%BB%BBB
;D%BBB 1%BB%BBB ;%;A%BBB
D%HF%BBB D%BB%BBB ;%HA%BBB
;%<2%BBB ;%BB%BBB 1%<H%ABB
;%<2%BBB ;%BB%BBB 1%<H%ABB
;H%BB%BBB ;B%BB%BBB 1A%BB%BBB
;AB ;AB ;BB
1B2BB 2%BBB H%ABB
;%<2%BBB ;%BB%BBB 1%<H%ABB
No. of s&ares 1B%2BB 2%BBB H%ABB
Earnings per s&are ;;.B< ;A 12.<<
T&e secure alternati'e (&ic& gi'es t&e &ig&est earnings per s&are is t&e *est.
T&erefore t&e co$pan# is ad'ised to re'ise s. 1B%BB%BBB t&roug& de*t a$ount s.
;B%BB%BBB t&roug& ordinar# s&ares.
E8ercise ;
Co$pute t&e $ar/et 'alue of t&e fir$% 'alue of s&ares and t&e a'erage cost of capital
fro$ t&e follo(ing infor$ation.
Net operating inco$e s. 1%BB%BBB
Total in'est$ent s. A%BB%BBB
E)uit# capitali5ation ate:
,a- If t&e fir$ uses no de*t 1BR
,*- If t&e fir$ uses s. ;A%BBB de*entures 11R
,c- If t&e fir$ uses s. D%BB%BBB de*entures 1<R
Assu$e t&at s. A%BB%BBB de*entures can *e raised at FR rate of interest (&ereas s.
D%BB%BBB de*entures can *e raised at HR rate of interest.
Solution
Co$putation of $ar/et 'alue of fir$ 'alue of s&ares and t&e a'erage cost of capital.
.articulars ,a- No "e*t ,*- s. ;%AB%BBB ,c- s. D%BB%BBB
FR de*entures HR de*entures
Net operating s#ste$ 1%BB%BBB 1%BB%BBB 1%BB%BBB
,- Interest ,i.e.-
Cost of de*t T 1A%BBB ;2%BBB
Earnings a'aila*le to
E)uit# s&are&olders 1%BB%BBB 2A%BBB H;%BBB
E)uit# Capitali5ation ate 1BR 11R 1<R
1B 1BB 1BB
Mar/et 'alue of s&ares 1B%BBB 2A%BBB
H;%BBB
1< 1BB 11
s. 1B%BB%BBB9- s.HH;H;H9- s.AA<2DF9-
Mar/et 7alue of fir$ 1B%BB%BBB 1B%;;%H;H J%A<%2DF
1%BB%BBB 1%BB%BBB 1%BB%BBB
A'erage cost of capital
1%BB%BBB

1BB
1% BB% BBB

1BB
1% BB% BBB

1BB
1B% ;;% H;H 1B%BB%BBB J% A<% 2DF
Earnings
7alueof t&efir$
EBIT
Q1BR QJ.H2R Q1B.D2R
7
Co$$ents
Fro$ t&e a*o'e data% if de*t of s. ;%AB%BBB is used% t&e 'alue of t&e fir$ increases and
t&e o'erall cost of capital decreases. But% if $ore de*t is used to finance in place of e)uit#
i.e.% s. D%BB%BBB de*entures% t&e 'alue of t&e fir$ decreases and t&e o'erall cost of
capital increases.
T&e reasons for necessitating c&anges in capitali5ation are
To restore *alance in t&e Financial plan
To si$plif# t&e capital structure
To suit in'estor needs
To fund current lia*ilities
To (rite off t&e de*t
To capitali5e t&e retained earnings
To clear default of fi8ed cost securities
To fund accu$ulated di'idends
To facilitate $erger and e8pansion
To $eet legal re)uire$ents
TA"IN0 !N EUUIT?
In finance% e)uit# trading is t&e *u#ing and selling of co$pan# stoc/ s&ares.
Borro(ing funds to increase capital in'est$ent (it& t&e &ope t&at t&e *usiness
(ill *e a*le to generate returns in e8cess of t&e interest c&arges.
E)uit# trading can *e perfor$ed *# t&e o(ner of t&e s&ares% or *# an agent
aut&ori5ed to *u# and sell on *e&alf of t&e s&areGs o(ner. .roprietar# trading is
*u#ing and selling for t&e traderGs o(n profit or loss. In t&is case% t&e principal is
t&e o(ner of t&e s&ares.
Trading on e)uit# occurs (&en a corporation uses *onds% ot&er de*t% and preferred
stoc/ to increase its earnings on co$$on stoc/. For e8a$ple% a corporation $ig&t
use long ter$ de*t to purc&ase assets t&at are e8pected to earn $ore t&an t&e
interest on t&e de*t. T&e earnings in e8cess of t&e interest e8pense on t&e ne(
de*t (ill increase t&e earnings of t&e corporation@s co$$on stoc/&olders. T&e
increase in earnings indicates t&at t&e corporation (as successful in trading on
e)uit#.
S&ares in large pu*licl# traded co$panies are *oug&t and sold t&roug& one of t&e
$a+or stoc/ e8c&anges% suc& as t&e Ne( ?or/ Stoc/ E8c&ange% 6ondon Stoc/
E8c&ange or Bo$*a# Stoc/ E8c&ange% (&ic& ser'e as $anaged auctions for stoc/
trades. Stoc/ s&ares in s$aller pu*lic co$panies are *oug&t and sold in o'er-t&e-
counter ,!TC- $ar/ets.
C!ST !F CA.ITA6
INT!"UCTI!N
Cost of capital is an integral part of in'est$ent decision as it is used to $easure t&e (ort&
of in'est$ent proposal pro'ided *# t&e *usiness concern. It is used as a discount rate in
deter$ining t&e present 'alue of future cas& flo(s associated (it& capital pro+ects. Cost
of capital is also called as cut-off rate% target rate% &urdle rate and re)uired rate of return.
>&en t&e fir$s are using different sources of finance% t&e finance $anager $ust ta/e
careful decision (it& regard to t&e cost of capitalK *ecause it is closel# associated (it& t&e
'alue of t&e fir$ and t&e earning capacit# of t&e fir$.
Financial capital represents o*ligations% and is li)uidated as $one# for trade% and o(ned
*# legal entities. It is in t&e for$ of capital assets% traded in financial $ar/ets. Its $ar/et
'alue is not *ased on t&e &istorical accu$ulation of $one# in'ested *ut on t&e perception
*# t&e $ar/et of its e8pected re'enues and of t&e ris/ entailed.
Capital accu$ulation in classical econo$ic t&eor# is t&e production of increased capital.
In order to in'est% goods $ust *e produced (&ic& are not to *e i$$ediatel# consu$ed%
*ut instead used to produce ot&er goods as a $eans of production.
Capital ,$one#- used for funding a *usiness s&ould earn returns for t&e capital pro'iders
(&o ris/ t&eir capital. For an in'est$ent to *e (ort&(&ile% t&e e8pected return on capital
$ust *e greater t&an t&e cost of capital. In ot&er (ords% t&e GGris/-ad+ustedGG return on
capital ,t&at is% incorporating not +ust t&e pro+ected returns% *ut t&e pro*a*ilities of t&ose
pro+ections- $ust *e &ig&er t&an t&e cost of capital.
Meaning of Cost of Capital
Cost of capital is t&e rate of return t&at a fir$ $ust earn on its pro+ect in'est$ents to
$aintain its $ar/et 'alue and attract funds.
Cost of capital is t&e re)uired rate of return on its in'est$ents (&ic& *elongs to
e)uit#% de*t and retained earnings. If a fir$ fails to earn return at t&e e8pected rate% t&e
$ar/et 'alue of t&e s&ares (ill fall and it (ill result in t&e reduction of o'erall (ealt& of
t&e s&are&olders.
"efinitions
T&e follo(ing i$portant definitions are co$$onl# used to understand t&e $eaning and
concept of t&e cost of capital.
According to t&e definition of Mo&n M. Ea$pton 3 Cost of capital is t&e rate of return
t&e fir$ re)uired fro$ in'est$ent in order to increase t&e 'alue of t&e fir$ in t&e $ar/et
place4.
According to t&e definition of Solo$on E5ra% 3Cost of capital is t&e $ini$u$
re)uired rate of earnings or t&e cut-off rate of capital e8penditure4.
According to t&e definition of Ma$es C. 7an Eorne% Cost of capital is 3A cut-off rate
for t&e allocation of capital to in'est$ent of pro+ects. It is t&e rate of return on a pro+ect
t&at (ill lea'e unc&anged t&e $ar/et price of t&e stoc/4.
According to t&e definition of >illia$ and "onaldson% 3Cost of capital $a# *e
defined as t&e rate t&at $ust *e earned on t&e net proceeds to pro'ide t&e cost ele$ents of
t&e *urden at t&e ti$e t&e# are due4.
Measuring Cost of Capital
It (ill depend upon:
\ T&e co$ponents of financing: "e*t% E)uit# or .referred stoc/
\ T&e cost of eac& co$ponent
Significance of t&e cost of capital:
T&e cost of capital is a ter$ used in t&e field of financial in'est$ent to refer to t&e cost of
a co$pan#Gs funds ,*ot& de*t and e)uit#-% or% fro$ an in'estorGs point of 'ie( =t&e
s&are&olderGs re)uired return on a portfolio co$pan#Gs e8isting securities=.
]1^
It is used to
e'aluate ne( pro+ects of a co$pan# as it is t&e $ini$u$ return t&at in'estors e8pect for
pro'iding capital to t&e co$pan#% t&us setting a *enc&$ar/ t&at a ne( pro+ect &as to
$eet.
1. E'aluating in'est$ent decisions
T&e pri$ar# purpose of $easuring t&e cost of capital is its use as a financial standard for
e'aluating t&e in'est$ent pro+ects. Using N.7 $et&od or I $et&od% a pro+ect $a# *e
accepted or re+ected. It $a# *e noted t&at t&e cost of capital represents a financial
standard for allocating t&e fir$@s funds% supplied *# o(ners and creditors% to t&e 'arious
in'est$ent pro+ects in t&e $ost efficient $anner.
;. "esigning "e*t polic#:
T&e de*t polic# of a fir$ is significantl# influenced *# t&e cost consideration. In
designing t&e capital structure% t&e fir$ ai$s at $a8i$i5ing t&e fir$ 'alue *# $ini$i5ing
t&e o'erall cost of capital. T&e cost of capital can also *e useful in deciding a*out t&e
$et&ods of financing at a point of ti$e. For eg.% cost $a# *e co$pared in c&oosing
*et(een leasing and *orro(ing.
<. .erfor$ance Appraisal:
T&e cost of capital fra$e(or/ can *e used to e'aluate t&e financial perfor$ance of top
$anage$ent. Suc& an e'aluation (ill in'ol'e a co$parison of actual profita*ilit# of t&e
in'est$ent pro+ects underta/en *# t&e fir$ (it& t&e pro+ected o'erall cost of capital and
t&e appraisal of t&e actual costs incurred *# $anage$ent in raising t&e re)uired funds.
Concept of Cost of Capital
Capital refers to t&e funds in'ested in a *usiness. T&e capital can co$e fro$ different
sources suc& as e)uit# s&ares% preference s&ares% and de*t. All capital &as a cost.
Eo(e'er% it 'aries fro$ one sources of capital to anot&er% fro$ one co$pan# to anot&er
and fro$ one period of ti$e to anot&er.
Cost of capital $a# *e defined as t&e co$pan#Gs cost of collecting funds. T&is is e)ual to
t&e a'erage rate of return t&at an in'estor in a co$pan# (ill e8pect for pro'iding funds. It
is t&e $ini$u$ rate of return t&at t&e pro+ect $ust earn to /eep t&e 'alue of t&e co$pan#
intact. T&e $ini$u$ rate of return is e)ual to cost of capital.
T&e cost of capital in al(a#s e8pressed in ter$s of percentage. .roper allo(ance is $ade
for ta8 purposes. T&is is done to get a correct picture of t&e cost of capital. T&e cost of
capital is a guideline for deter$ining t&e opti$u$ capital structure of a co$pan#.
Calculation of Cost of Capital
In order to calculate t&e o'erall cost of capital% a finance $anager &as to ta/e t&e
follo(ing steps:-
1. "eter$ine t&e t#pe of funds to *e raised and t&eir s&are in t&e capital structure.
;. "eter$ine cost of eac& t#pe of funds.
<. Calculate co$*ined cost of capital of t&e co$pan# *# gi'ing (eig&ts to eac& t#pe
of funds in ter$s of proportion of funds raised to total funds.
Assu$ption of Cost of Capital
Cost of capital is *ased on certain assu$ptions (&ic& are closel# associated (&ile
calculating and $easuring t&e cost of capital. It is to *e considered t&at t&ere are t&ree
*asic concepts:
1. It is not a cost as suc&. It is $erel# a &urdle rate.
;. It is t&e $ini$u$ rate of return.
<. It consis of t&ree i$portant ris/s suc& as 5ero ris/ le'el% *usiness ris/ and financial
ris/. Cost of capital can *e $easured (it& t&e &elp of t&e follo(ing e)uation.
P Q r
+
V * V f.
>&ere%
P Q Cost of capital.
r
+
Q T&e ris/less cost of t&e particular t#pe of finance.
* Q T&e *usiness ris/ pre$iu$.
f Q T&e financial ris/ pre$iu$.
C6ASSIFICATI!N !F C!ST !F CA.ITA6
Cost of capital $a# *e classified into t&e follo(ing t#pes on t&e *asis of nature and
usage:
E8plicit and I$plicit Cost.
A'erage and Marginal Cost.
Eistorical and Future Cost.
Specific and Co$*ined Cost.
E8plicit and I$plicit Cost
T&e cost of capital $a# *e e8plicit or i$plicit cost on t&e *asis of t&e co$putation of cost
of capital.
E8plicit cost is t&e rate t&at t&e fir$ pa#s to procure financing. T&is $a# *e
calculated (it& t&e &elp of t&e follo(ing e)uationK
n
C!
t
CI
o

Q

_
t1 ,t ` C-
t
>&ere%
CI
o
Q initial cas& inflo(
C Q outflo( in t&e period concerned
N Q duration for (&ic& t&e funds are pro'ided
T Q ta8 rate
I$plicit cost is t&e rate of return associated (it& t&e *est in'est$ent opportunit# for
t&e fir$ and its s&are&olders t&at (ill *e forgone if t&e pro+ects presentl# under
consideration *# t&e fir$ (ere accepted.
A'erage and Marginal Cost
A'erage cost of capital is t&e (eig&ted a'erage cost of eac& co$ponent of capital
e$plo#ed *# t&e co$pan#. It considers (eig&ted a'erage cost of all /inds of financing
suc& as e)uit#% de*t% retained earnings etc.
Marginal cost is t&e (eig&ted a'erage cost of ne( finance raised *# t&e co$pan#. It is
t&e additional cost of capital (&en t&e co$pan# goes for furt&er raising of finance.
Eistorical and Future Cost
Eistorical cost is t&e cost (&ic& as alread# *een incurred for financing a particular
pro+ect. It is *ased on t&e actual cost incurred in t&e pre'ious pro+ect.
Future cost is t&e e8pected cost of financing in t&e proposed pro+ect. E8pected cost is
calculated on t&e *asis of pre'ious e8perience.
Specific and Co$*ine Cost
T&e cost of eac& sources of capital suc& as e)uit#% de*t% retained earnings and loans is
called as specific cost of capital. It is 'er# useful to deter$ine t&e eac& and e'er# specific
source of capital.
T&e co$posite or co$*ined cost of capital is t&e co$*ination of all sources of
capital. It is also called as o'erall cost of capital. It is used to understand t&e total cost
associated (it& t&e total finance of t&e fir$.
IM.!TANCE !F C!ST !F CA.ITA6
Co$putation of cost of capital is a 'er# i$portant part of t&e financial $anage$ent to
decide t&e capital structure of t&e *usiness concern.
I$portance to Capital Budgeting "ecision
Capital *udget decision largel# depends on t&e cost of capital of eac& source. According
to net present 'alue $et&od% present 'alue of cas& inflo( $ust *e $ore t&an t&e present
'alue of cas& outflo(. Eence% cost of capital is used to capital *udgeting decision.
I$portance to Structure "ecision
Capital structure is t&e $i8 or proportion of t&e different /inds of long ter$ securities. A
fir$ uses particular t#pe of sources if t&e cost of capital is suita*le. Eence% cost of capital
&elps to ta/e decision regarding structure.
I$portance to E'olution of Financial .erfor$ance
Cost of capital is one of t&e i$portant deter$ine (&ic& affects t&e capital *udgeting%
capital structure and 'alue of t&e fir$. Eence% it &elps to e'aluate t&e financial
perfor$ance of t&e fir$.
I$portance to !t&er Financial "ecisions
Apart fro$ t&e a*o'e points% cost of capital is also used in so$e ot&er areas suc& as%
$ar/et 'alue of s&are% earning capacit# of securities etc. &ence% it pla#s a $a+or part in
t&e financial $anage$ent.
CA6CU6ATI!N !F IN"I7I"UA6 AN" C!M.!SITE C!ST 9 (eig&ted a'erage cost
of capital !F CA.ITA6.
MEANIN0:
T&e ter$ Cost of Capital refers to t&e o'er-all co$posite cost of capital. It is defined as
t&e >eig&ted A'erage Cost of Capital ,>ACC-. T&e percentage or proportion of 'arious
sources of finance used *# a co$pan# is different.
A co$pan#Gs cost to *orro( $one# gi'en t&e proportional a$ounts of eac& t#pe of de*t
and e)uit# a co$pan# &as ta/en on. A co$pan#Gs de*t and e)uit#% or its capital structure%
t#picall# includes co$$on stoc/% preferred stoc/ and *onds. A &ig& co$posite cost of
capital% indicates t&at a co$pan# &as &ig& *orro(ing costsK a lo( co$posite cost of
capital signifies lo( *orro(ing costs.
Also referred to as =(eig&ted a'erage cost of capital= or >ACC.
Eac& of t&ese co$ponents is gi'en (eig&tage on t&e *asis of t&e associated interest rate
and ot&er gains and losses (it& it. It s&o(s t&e cost of eac& additional capital as against
t&e a'erage cost of total capital raised. T&e process to co$pute t&is is first co$puting t&e
(eig&ted a'erage cost of capital (&ic& is t&e collection of (eig&ts of ot&er costs su$$ed
toget&er.
In t&is t&e cost of de*t is calculated in t&e *eginning and it is used to find out t&e cost of
capital and ot&er (eig&ts of cost is *een calculated after t&e calculation eac& and e'er#
indi'idual (eig&t of t&e co$ponent is added and t&en it gi'es t&e final co$posite cost..
"EFINITI!N:
>eig&ted a'erage of t&e co$ponent costs of co$$on stoc/ ,ordinar# s&ares-% preferred
stoc/ ,preference s&ares-% and de*t. Eac& co$ponent of capital is gi'en a relati'e
i$portance ,(eig&t- on t&e *asis of its associated interest rate% $anage$entGs loss of
control% ris/ e8posure% etc.% to co$pute (eig&ted a'erage cost of capital. It s&o(s t&e cost
of eac& additional dollar of capital% as opposed to t&e a'erage cost of t&e total capital
raised.
Factors affecting >eig&ted A'erage Cost of Capital:
1. Factors outside a fir$@s control:
a. Interest rate le'els
*. Mar/et ris/ pre$iu$
c. Ta8 rates
;. Factors (it&in a fir$@s control:
a. In'est$ent polic#
*. Capital structure polic#
c. "i'idend polic#
Essential features of a sound capital $i8:
Ma8i$u$ possi*le use of le'erage
Fle8i*le capital structure
A'oid undue financial or *usiness ris/ (it& t&e increase of de*t
Use of de*t s&ould *e (it&in t&e capacit# of t&e fir$
S&ould in'ol'e $ini$u$ possi*le ris/ of loss of control
Must a'oid undue restrictions in agree$ent of de*t.
Calculation of >ACC for a co$pan# (it& a co$ple8 capital structure:
T&e for$ula for a si$ple case is
E "
CQ .? V .* ,1-tc-
P P
>&ere PQ "VE
c Q(eig&ted a'erage cost of capital
# Qre)uired or e8pected rate of return on e)uit#% or cost of e)uit#
*Qre)uired or e8pected rate of return on *orro(ings% or cost of de*t
tQcorporate ta8 rate
"Qtotal de*t and leases ,including current portion of long-ter$ de*t and notes pa#a*le-
EQtotal $ar/et 'alue of e)uit#
PQtotal capital in'ested in t&e going concern
T&is e)uation descri*es onl# t&e situation (it& &o$ogeneous e)uit# and de*t. If part of
t&e capital consists% for e8a$ple% of preferred stoc/ ,(it& different cost of e)uit# 3#4-%
t&en t&e for$ula (ould include an additional ter$ for eac& additional source of capital.
Since (e are $easuring e8pected cost of ne( capital% (e s&ould use t&e $ar/et 'alues of
t&e co$ponents% rat&er t&an t&eir *oo/ 'alues ,(&ic& can *e significantl# different-. In
addition% ot&er% $ore =e8otic= sources of financing% suc& as con'erti*le9calla*le *onds%
con'erti*le preferred stoc/% etc.% (ould nor$all# *e included in t&e for$ula if t&e# e8ist
in an# significant a$ounts - since t&e cost of t&ose financing $et&ods is usuall# different
fro$ t&e plain 'anilla *onds and e)uit# due to t&eir e8tra features.
Factors influence a co$pan#@s co$posite >ACC
Mar/et conditions.
T&e fir$@s capital structure and di'idend polic#.
T&e fir$@s in'est$ent polic#. Fir$s (it& ris/ier pro+ects generall# &a'e a &ig&er
>ACC.
To calculate t&e Cost of Capital
T&e cost of capital is si$pl# a (eig&ted a'erage of t&e cost of t&e indi'idual sources ,i.e.%
*onds% preferred stoc/% retained earnings% and sale of ne( co$$on stoc/-. For e8a$ple%
assu$e t&at #ou raise DBR of #our $one# in t&e for$ of de*t% ;BR in preferred stoc/%
and DBR in co$$on e)uit#.
Fe( details for calculating t&e cost of eac& co$ponent.
Cost of "e*t
"e*t is special in t&e sense t&at its interest pa#$ents are ta8-deducti*le. >&ile t&is is a
good t&ing% it does present a pro*le$ (&en co$paring its cost (it& t&e cost of t&e ot&er
co$ponents% (&ose costs are not ta8-deducti*le.
Cost of .referred Stoc/
T&e cost of $one# raised *# selling preferred stoc/ is% genericall#% t&e dollar cost di'ided
*# t&e a$ount of $one# raised.
Cost of etained Earnings
Stoc/&olders let t&e co$pan#@s $anage$ent /eep so$e of t&e earnings and rein'est t&e$
*ac/ into t&e co$pan# ,rat&er t&an pa#ing it to t&e$ in t&e for$ of di'idends-. T&is does
not $ean t&at t&ese retained earnings are free &o(e'er t&e stoc/&olders still e8pect to
earn a rate of return on t&e co$pan#@s in'est$ent of t&is $one#. T&e rate of return t&at
t&e co$pan# $ust earn on t&e in'est$ent of t&is $one# ,in order to /eep t&e
s&are&olders &app#- is called t&e cost of retained earnings.
Cost of Ne( E)uit#
T&e cost of raising $one# t&roug& t&e sale of ne( co$$on stoc/ is t&e sa$e as t&e cost
of retained earnings% (it& one e8ception: flotation costs. Mone# earned in t&e
co$pan#@s operations ,i.e.% retained earnings- is readil# a'aila*le (it& pa#ing an# outside
agenc#K $one# raised fro$ outside t&e co$pan# often co$es (it& co$$issions and fees
,i.e.% flotation fees- attac&ed.
>eig&ted Marginal Cost of Capital
Assu$e t&at 0enuine .roducts% Inc. is raising $one# for e8pansion of its operation. It
&as part of t&e $one# alread# set aside in t&e for$ of cas& fro$ t&is #earGs addition to
retained earnings. In order to sta# at its opti$al capital structure% it &as decided to raise
t&e $one# in t&e follo(ing proportions: DBR de*t% 1BR preferred stoc/% ;BR retained
earnings% and <BR fro$ t&e sale of ne( co$$on stoc/.
C!M.UTATI!N !F C!ST !F CA.ITA6
Co$putation of cost of capital consists of t(o i$portant parts:
1. Measure$ent of specific costs
;. Measure$ent of o'erall cost of capital
Measure$ent of Cost of Capital
It refers to t&e cost of eac& specific sources of finance li/e:
Cost of e)uit#
Cost of de*t
Cost of preference s&are
Cost of retained earnings
Cost of E)uit#
Cost of e)uit# capital is t&e rate at (&ic& in'estors discount t&e e8pected di'idends of t&e
fir$ to deter$ine its s&are 'alue.
Conceptuall# t&e cost of e)uit# capital ,P
e
- defined as t&e 3Mini$u$ rate of return
t&at a fir$ $ust earn on t&e e)uit# financed portion of an in'est$ent pro+ect in order to
lea'e unc&anged t&e $ar/et price of t&e s&ares4.
Cost of e)uit# can *e calculated fro$ t&e follo(ing approac&:
"i'idend price ,"9.- approac&
"i'idend price plus gro(t& ,"9. V g- approac&
Earning price ,E9.- approac&
eali5ed #ield approac&.
"i'idend .rice Approac&
T&e cost of e)uit# capital (ill *e t&at rate of e8pected di'idend (&ic& (ill $aintain t&e
present $ar/et price of e)uit# s&ares.
"i'idend price approac& can *e $easured (it& t&e &elp of t&e follo(ing for$ula:
"
P
e
Q

Np
>&ere%
P
e
Q Cost of e)uit# capital
" Q "i'idend per e)uit# s&are
N
p
Q Net proceeds of an e)uit# s&are
E8ercise 1
A co$pan# issues 1B%BBB e)uit# s&ares of s. 1BB eac& at a pre$iu$ of 1BR. T&e
co$pan# &as *een pa#ing ;AR di'idend to e)uit# s&are&olders for t&e past fi'e #ears and
e8pects to $aintain t&e sa$e in t&e future also. Co$pute t&e cost of e)uit# capital. >ill it
$a/e an# difference if t&e $ar/et price of e)uit# s&are is s. 1HAI
Solution
"
Pe Q
Np
=
;A
Y 1BB
1BB
= ;;.H;R
If t&e $ar/et price of a e)uit# s&are is s. 1HA.
P
e

"
N
p
=
;A
Y 1BB
1HA
= 1D.;2R
"i'idend .rice .lus 0ro(t& Approac&
T&e cost of e)uit# is calculated on t&e *asis of t&e e8pected di'idend rate per s&are plus
gro(t& in di'idend. It can *e $easured (it& t&e &elp of t&e follo(ing for$ula:
P
e

"
` g
N
p
>&ere%
P
e
Q Cost of e)uit# capital
" Q "i'idend per e)uit# s&are
g Q 0ro(t& in e8pected di'idend N
p

Q Net proceeds of an e)uit# s&are
E8ercise ;
,a- A co$pan# plans to issue 1BBBB ne( s&ares of s. 1BB eac& at a par. T&e
floatation costs are e8pected to *e DR of t&e s&are price. T&e co$pan# pa#s a
di'idend of s. 1; per s&are initiall# and gro(t& in di'idends is e8pected to *e
AR. Co$pute t&e cost of ne( issue of e)uit# s&ares.
,*- If t&e current $ar/et price of an e)uit# s&are is s. 1;B. Calculate t&e cost of
e8isting e)uit# s&are capital
Solution
,a- P
e
Q
"
Vg
N
p
Q
1;
VAQ1H.AR
1BB Z
D
,*- P
e
Q
"
V g
N
p
Q
1;
VARQ1AR
1;B
E8ercise <
T&e current $ar/et price of t&e s&ares of A 6td. is s. JA. T&e floatation costs are s.
A per s&are a$ounts to s. D.AB and is e8pected to gro( at a rate of HR. ?ou are re)uired
to calculate t&e cost of e)uit# s&are capital.
Solution
Mar/et price s. JA
"i'idend s. D.AB
0ro(t& HR.
"
Pe Q
N
p V g
D.AB
=
JA
Y 1BB V HR
= D.H<R V HR Q 11.H<R
Earning .rice Approac&
Cost of e)uit# deter$ines t&e $ar/et price of t&e s&ares. It is *ased on t&e future earning
prospects of t&e e)uit#. T&e for$ula for calculating t&e cost of e)uit# according to t&is
approac& is as follo(s.
P
e

E
N
p
>&ere%
P
e
Q Cost of e)uit# capital
E Q Earning per s&are
N
p
Q Net proceeds of an e)uit# s&are
E8ercise D
A fir$ is considering an e8penditure of s. HA la/&s for e8panding its operations. T&e
rele'ant infor$ation is as follo(s :
Nu$*er of e8isting e)uit# s&ares Q1B la/&s
Mar/et 'alue of e8isting s&are Qs.1BB
Net earnings Qs.1BB la/&s
Co$pute t&e cost of e8isting e)uit# s&are capital and of ne( e)uit# capital assu$ing
t&at ne( s&ares (ill *e issued at a price of s. J; per s&are and t&e costs of ne( issue
(ill *e s. ; per s&are.
Solution
Cost of e8isting e)uit# s&are capital:
P
e
Q
E
N
p
Earnings .er S&are,E.S- Q
1BBla/&s
Q s.1B
1Bla/&s
1B
Pe Q
1BB
Y 1B
Q 1BR
Cost of E)uit# Capital
P
e
Q
E

N
.
1B Q Y 1BB
J; Z ;
Q 11.11R
eali5ed ?ield Approac&
It is t&e eas# $et&od for calculating cost of e)uit# capital. Under t&is $et&od% cost of
e)uit# is calculated on t&e *asis of return actuall# reali5ed *# t&e in'estor in a co$pan#
on t&eir e)uit# capital.
Pe .7fY"
>&ere%
P
e
Q Cost of e)uit# capital.
.7. Q .resent 'alue of discount factor.
" Q "i'idend per s&are.
Cost of "e*t
Cost of de*t is t&e after ta8 cost of long-ter$ funds t&roug& *orro(ing. "e*t $a# *e
issued at par% at pre$iu$ or at discount and also it $a# *e perpetual or redee$a*le.
"e*t Issued at .ar
"e*t issued at par $eans% de*t is issued at t&e face 'alue of t&e de*t. It $a# *e calculated
(it& t&e &elp of t&e follo(ing for$ula.
P
d
Q ,1 t-
>&ere%
P
d
Q Cost of de*t capital
t Q Ta8 rate
Q "e*enture interest rate
"e*t Issued at .re$iu$ or "iscount
If t&e de*t is issued at pre$iu$ or discount% t&e cost of de*t is calculated (it& t&e &elp of
t&e follo(ing for$ula.
I
Pd Q
Np
,1 t-
>&ere%
P
d
Q Cost of de*t capital
I Q Annual interest pa#a*le N
p
Q Net proceeds of de*enture
t Q Ta8 rate
E8ercise A
,a- A 6td. issues s. 1B%BB%BBB% 2R de*entures at par. T&e ta8 rate applica*le to t&e
co$pan# is ABR. Co$pute t&e cost of de*t capital.
,*- B 6td. issues s. 1%BB%BBB% 2R de*entures at a pre$iu$ of 1BR. T&e ta8 rate
applica*le to t&e co$pan# is FBR. Co$pute t&e cost of de*t capital.
,c- A 6td. issues s. 1%BB%BBB% 2R de*entures at a discount of AR. T&e ta8 rate is
FBR% co$pute t&e cost of de*t capital.
,d- B 6td. issues s. 1B%BB%BBB% JR de*entures at a pre$iu$ of 1BR. T&e costs of
floatation are ;R. T&e ta8 rate applica*le is ABR. Co$pute t&e cost of de*t-capital.
In all cases% (e &a'e co$puted t&e after-ta8 cost of de*t as t&e fir$ sa'es on
account of ta8 *# using de*t as a source of finance.
Solution
,a- P
da
Q
I
,1t- N
p
Q
2%BBB
Y ,1 B.A-
1%BB%BBB
Q
2%BBB
Y B.A

1%BB%BBB
Q DR
I
Pda Q
Np
,1 t-
,*- N
p
Q Face 7alue V .re$iu$ Q 1%BB%BBBV1B%BBBQ1%1B%BBB
2%BBB Q
1%1B%BBB
Y
,1 B.F-
2%BBB
= 1%1B%BBB
Y B.F

= ;.J1R
,c- P
da
Q
I
,1 t- N
p
Q
2%BBB
Y ,1 t-
JA%BB
B
Q <.<HR
I ;
,d- P
da
Q ,1 t-% N
p
Q s. ,1B%BB%BBB V 1%BB%BBB- Y 1BB N
p
=
JB%BBB
Y,1 B.A-
1B%H2%BBB
= D.1HR Q 11%BB%BBB ;;%BBB Q s. 1B%H2%BBB
Cost of .erpetual "e*t and edee$a*le "e*t
It is t&e rate of return (&ic& t&e lenders e8pect. T&e de*t carries a certain rate of interest.
P
d*
Q
I ` 19 n,. Z N p -n
19 n,. ` N p -9 ;
>&ere%
I Q Annual interest pa#a*le
. Q .ar 'alue of de*t
N
p
Q Net proceeds of t&e de*enture
n Q Nu$*er of #ears to $aturit#
P
d*
Q Cost of de*t *efore ta8.
Cost of de*t after ta8 can *e calculated (it& t&e &elp of t&e follo(ing for$ula:
P d aQ P d *Y,1t-
>&ere%
P
da
Q Cost of de*t after ta8
P
d*
Q Cost of de*t *efore ta8
t Q Ta8 rate
E8ercise F
A co$pan# issues s. ;B%BB%BBB% 1BR redee$a*le de*entures at a discount of AR.
T&e costs of floatation a$ount to s. AB%BBB. T&e de*entures are redee$a*le after 2
#ears. Calculate *efore ta8 and after ta8. Cost of de*t assuring a ta8 rate of AAR.
Solution
Pd*

Q

I

19n ,.

Z

N
p
-
1
;,. ` N
p
-
Q
;B%BB%BBB ` 192,;B%BB%BBB ` 12%AB%BBB- 1
;,;B%BB%BBB ` 12%AB%BBB-
Note N
p
Q ;B%BB%BBB 1B%BB%BBB AB%BBB
;%BB%BBB ` 12HAB
= 1J%;A%BBB
= 11.<FR.
After Ta8 Cost of "e*t P
d*
Q Pda ,1 t-
Q11.<F ,1 B.AA-
QA.11R.
Cost of .reference S&are Capital
Cost of preference s&are capital is t&e annual preference s&are di'idend *# t&e net
proceeds fro$ t&e sale of preference s&are.
T&ere are t(o t#pes of preference s&ares irredee$a*le and redee$a*le. Cost of
redee$a*le preference s&are capital is calculated (it& t&e &elp of t&e follo(ing for$ula:
P p
"
p
N p
>&ere%
P
p
Q Cost of preference s&are
"
p
Q Fi8ed preference di'idend
N
p
Q Net proceeds of an e)uit# s&are
Cost of irredee$a*le preference s&are is calculated (it& t&e &elp of t&e follo(ing
for$ula:
P p
" p ` ,. Z N p -9n
,. ` N p -9;
>&ere%
P
p
QCost of preference s&are
"
p
QFi8ed preference s&are
. Q.ar 'alue of de*t
N
p
QNet proceeds of t&e preference s&are
n QNu$*er of $aturit# period.
E8ercise H
N?O 6td. issues ;B%BBB% 2R preference s&ares of s. 1BB eac&. Cost of issue is s. ;
per s&are. Calculate cost of preference s&are capital if t&ese s&ares are issued ,a- at par%
,*- at a pre$iu$ of 1BR and ,c- of a de*entures of FR.
Solution
Cost of preference s&are capital Pp Q
"
p
N
p
,a- 1%FB%BBB Y1BB
P
p
Q
;B%BB%BBB Z DB%BBB
Q 2.1FR
,*- P
p
Q
1%FB%BBB
Y 1BB ;B%BB%BBB ` ;%BB%BBB Z DB%BBB
Q H.DBR
I P
p
Q 1%FB%BBB
Y1BB
;B%BB%BBB Z 1%;B%BBB Z
DB%BBB
Q
1%FB%BBB
Y1BB
12%DB%BBB
Q 2.FJR
E8ercise 2
ABC 6td. issues ;B%BBB% 2R preference s&ares of s. 1BB eac&. edee$a*le after 2
#ears at a pre$iu$ of 1BR. T&e cost of issue is s. ; per s&are. Calculate t&e cost of
preference s&are capital.
P p
" p ` ,. Z N p -9n
,. ` N p -9;
=
1%FB%BBB ` 192 ,;;%BB%BBB Z
1J%FB%BBB- 19;,;;%BB%BBB
1J%FB%BBB-
=
1%FB%BBB ` <B%BBB
;B%2B%BBB
Q J.1<R
(&ere "
p
Q ;B%BBBY1BBY2RQ1%FB%BBB
. Q ;B%BB%BBBV;%BB%BBB Q;;%BB%BB
N
p
Q ;B%BB%BBB DB%BBB Q1J%FB%BBB n
Q 2 #ears
E8ercise J
ABC 6td. issues ;B%BBB% 2R preference s&ares of s. 1BB eac& at a pre$iu$ of AR
redee$a*le after 2 #ears at par. T&e cost of issue is s. ; per s&are. Calculate t&e cost of
preference s&are capital.
Solution
P p
" p ` ,. Z N p -9n
,. ` N p -9;
Q
1%FB%BBB ` 192 ,;B%BB%BBB Z ;B%FB%BBB-
19; ,;B%BB%BBB ` ;B%FB%BBB-
Q
1%FB%BBB H%ABB
;B%<B%BBB
Q H.A1R
(&ere "
p
Q ;B%BBBY1BBY2RQ1%FB%BBB . Q
;B%BB%BBB
n Q 2 #ears
N
p
Q ;B%BB%BBB V 1B%BB%BBB DB%BBB Q;B%FB%BBB
Cost of etained Earnings
etained earnings is one of t&e sources of finance for in'est$ent proposalK it is different
fro$ ot&er sources li/e de*t% e)uit# and preference s&ares. Cost of retained earnings is
t&e sa$e as t&e cost of an e)ui'alent full# su*scripted issue of additional s&ares% (&ic& is
$easured *# t&e cost of e)uit# capital. Cost of retained earnings can *e calculated (it&
t&e &elp of t&e follo(ing for$ula:
PrQPe ,1 t- ,1 *-
>&ere%
P
r
Q Cost of retained earnings
P
e
Q Cost of e)uit#
t Q Ta8 rate
* Q Bro/erage cost
E8ercise 1B
A fir$@s P
e
,return a'aila*le to s&are&olders- is 1BR% t&e a'erage ta8 rate of
s&are&olders is <BR and it is e8pected t&at ;R is *ro/erage cost t&at s&are&olders (ill
&a'e to pa# (&ile in'esting t&eir di'idends in alternati'e securities. >&at is t&e cost of
retained earningsI
Solution
Cost of etained Earnings% P
r
Q P
e
,1 t- ,1 *-
>&ere%
P
e
Q rate of return a'aila*le to s&are&olders t
Q ta8 rate
* Q *ro/erage cost
So% P
r
Q 1BR ,1 B.A- ,1 B.B;-
= 1BRYB.AYB.J2
= D.JR
Measure$ent of !'erall Cost of Capital
It is also called as (eig&ted a'erage cost of capital and co$posite cost of capital.
>eig&ted a'erage cost of capital is t&e e8pected a'erage future cost of funds o'er t&e
long run found *# (eig&ting t&e cost of eac& specific t#pe of capital *# its proportion in
t&e fir$s capital structure.
T&e co$putation of t&e o'erall cost of capital ,P
o
- in'ol'es t&e follo(ing steps.
,a- Assigning (eig&ts to specific costs.
,*- Multipl#ing t&e cost of eac& of t&e sources *# t&e appropriate (eig&ts.
,c- "i'iding t&e total (eig&ted cost *# t&e total (eig&ts.
T&e o'erall cost of capital can *e calculated (it& t&e &elp of t&e follo(ing for$ulaK
P
o
Q P
d
>
d
V P
p
>
p
V P
e
>
e
V P
r
>
r
>&ere%
P
o
Q !'erall cost of capital
P
d
Q Cost of de*t
P
p
Q Cost of preference s&are
P
e
Q Cost of e)uit#
P
r
Q Cost of retained earnings
>
d
Q .ercentage of de*t of total capital
>
p
Q .ercentage of preference s&are to total capital
>
e
Q .ercentage of e)uit# to total capital
>
r
Q .ercentage of retained earnings
>eig&ted a'erage cost of capital is calculated in t&e follo(ing for$ula also:
a N>
P
(
a>
>&ere%
P
(
Q >eig&ted a'erage cost of capital
N Q Cost of specific sources of finance
> Q >eig&t% proportion of specific sources of finance.
E8ercise 11
A fir$ &as t&e follo(ing capital structure and after-ta8 costs for t&e different sources
of funds used :
Source of Funds A$ount .roportion After-ta8 cost
s. R R
"e*t 1;%BBB ;B D
.reference S&ares 1A%BBB ;A 2
E)uit# S&ares 12%BBB <B 1;
etained Earnings 1A%BBB ;A 11
Total FB%BBB 1BB
?ou are re)uired to co$pute t&e (eig&ted a'erage cost of capital.
E8ercise 1;
A co$pan# &as on its *oo/s t&e follo(ing a$ounts and specific costs of eac& t#pe of
capital.
T#pe of Capital Boo/ 7alue Mar/et 7alue Specific Costs ,R-
s. s.
"e*t D%BB%BBB <%2B%BBB A
.reference 1%BB%BBB 1%1B%BBB 2
E)uit# F%BB%BBB J%BB%BBB 1A
etained Earnings ;%BB%BBB <%BB%BBB 1<
WWWWW WWWWW
1<%BB%BBB 1F%JB%BBB
WWWWW WWWWW
"eter$ine t&e (eig&ted a'erage cost of capital using:
,a- Boo/ 'alue (eig&ts% and
,*- Mar/et 'alue (eig&ts.
Eo( are t&e# differentI Can #ou t&in/ of a situation (&ere t&e (eig&ted a'erage cost
of capital (ould *e t&e sa$e using eit&er of t&e (eig&tsI
Solution
Co$putation of >eig&ted A'erage Cost of Capital
A. Boo/ 7alue
Source of Funds A$ount Cost R ,N- >eig&ted Cost
.roportion N Cost ,N>-
"e*t D%BB%BBB A ;B%BBB
.reference S&ares 1%BB%BBB 2 2%BBB
E)uit# S&ares F%BB%BBB 1A JB%BBB
etained Earnings ;%BB%BBB 1< ;F%BBB
a> Q 1<%BB%BBB aN> Q 1%DD%BBB
a N>
P( Q
a

>
1%DD%BBB
P( Q
1<%BB%BBB
Y 1BB Q 11.1R
Co$putation >eig&ted A'erage Cost of Capital
B. Mar/et 7alue
Source of Funds A$ount Cost R ,N- >eig&ted Cost
.roportion N Cost ,N>-
"e*t <%2B%BBB A 1J%BBB
.reference S&ares 1%1B%BBB 2 2%2BB
E)uit# S&ares J%BB%BBB 1A 1<%ABB
etained Earnings <%BB%BBB 1< <J%BBB
a> Q 1F%JB%BBB a N> Q ;%B1%2BB
P

aN>
(
a>
;%B1%2BB
P( Q
1F%JB%BBB
Y 1BB Q 11.JR
E8ercise 1<
ABC 6td. &as t&e follo(ing capital structure.
s.
E)uit# ,e8pected di'idend 1;R- 1B%BB%BBB
1BR preference A%BB%BBB
2R loan
1A%BB%BBB
?ou are re)uired to calculate t&e (eig&ted a'erage cost of capital% assu$ing ABR as
t&e rate of inco$e-ta8% *efore and after ta8.
Solution
Solution s&o(ing (eig&ted a'erage cost of capital:
.articulars s. After >eig&ts Cost
E)uit# 1B%BB%BBB 1;R <<.<<R <.JJ
.reference A%BB%BBB 1BR 1F.FH 1.FH
2R 6oan 1A%BB%BBB DR AB.BB ;.BB
H.FFR
>eig&t a'erage cost of capital Q H.FFR
CA.ITA6 BU"0ETIN0
INT!"UCTI!N
T&e (ord Capital refers to *e t&e total in'est$ent of a co$pan# of fir$ in $one#%
tangi*le and intangi*le assets. >&ereas *udgeting defined *# t&e 3o(land and >illia$4
it $a# *e said to *e t&e art of *uilding *udgets. Budgets are a *lue print of a plan and
action e8pressed in )uantities and $anners.
T&e e8a$ples of capital e8penditure:
1. .urc&ase of fi8ed assets suc& as land and *uilding% plant and $ac&iner#% good
(ill% etc.
;. T&e e8penditure relating to addition% e8pansion% i$pro'e$ent and alteration to t&e
fi8ed assets.
<. T&e replace$ent of fi8ed assets.
,MBA ..U. No'. ;BBA-
D. esearc& and de'elop$ent pro+ect.
"efinitions
According to t&e definition of C&arles T. Erongreen% 3capital *udgeting is a long-ter$
planning for $a/ing and financing proposed capital out la#s.
According to t&e definition of 0.C. .&ilippatos% 3capital *udgeting is concerned (it&
t&e allocation of t&e fir$s source financial resources a$ong t&e a'aila*le opportunities.
T&e consideration of in'est$ent opportunities in'ol'es t&e co$parison of t&e e8pected
future strea$s of earnings fro$ a pro+ect (it& t&e i$$ediate and su*se)uent strea$s of
earning fro$ a pro+ect% (it& t&e i$$ediate and su*se)uent strea$s of e8penditure4.
According to t&e definition of ic&ard and 0reen la(% 3capital *udgeting is ac)uiring
inputs (it& long-ter$ return4.
According to t&e definition of 6#ric&% 3capital *udgeting consists in planning
de'elop$ent of a'aila*le capital for t&e purpose of $a8i$i5ing t&e long-ter$
profita*ilit# of t&e concern4.
It is clearl# e8plained in t&e a*o'e definitions t&at a fir$@s scarce financial
resources are utili5ing t&e a'aila*le opportunities. T&e o'erall o*+ecti'es of t&e co$pan#
fro$ is to $a8i$i5e t&e profits and $ini$i5e t&e e8penditure of cost.
Need and I$portance of Capital Budgeting
1. Euge in'est$ents: Capital *udgeting re)uires &uge in'est$ents of funds% *ut t&e
a'aila*le funds are li$ited% t&erefore t&e fir$ *efore in'esting pro+ects% plan are
control its capital e8penditure.
;. 6ong-ter$: Capital e8penditure is long-ter$ in nature or per$anent in nature.
T&erefore financial ris/s in'ol'ed in t&e in'est$ent decision are $ore. If &ig&er
ris/s are in'ol'ed% it needs careful planning of capital *udgeting.
<. Irre'ersi*le: T&e capital in'est$ent decisions are irre'ersi*le% are not c&anged
*ac/. !nce t&e decision is ta/en for purc&asing a per$anent asset% it is 'er#
difficult to dispose off t&ose assets (it&out in'ol'ing &uge losses.
D. 6ong-ter$ effect: Capital *udgeting not onl# reduces t&e cost *ut also increases
t&e re'enue in long-ter$ and (ill *ring significant c&anges in t&e profit of t&e
co$pan# *# a'oiding o'er or $ore in'est$ent or under in'est$ent. !'er
in'est$ents leads to *e una*le to utili5e assets or o'er utili5ation of fi8ed assets.
T&erefore *efore $a/ing t&e in'est$ent% it is re)uired carefull# planning and
anal#sis of t&e pro+ect t&oroug&l#.
CA.ITA6 BU"0ETIN0 .!CESS
Capital *udgeting is a difficult process to t&e in'est$ent of a'aila*le funds. T&e *enefit
(ill attained onl# in t&e near future *ut% t&e future is uncertain. Eo(e'er% t&e follo(ing
steps follo(ed for capital *udgeting% t&en t&e process $a# *e easier are.
S
t
e
p
s
Identification of 7arious In'est$ents
Identification of 7arious
In'est$ent .roposals
Screening or Matc&ing t&e A'aila*le esources
E'aluation of .roposals
Fi8ing .ropert#
Feed*ac/
I$ple$entation
Fig. /.! "apital Budgeting *rocess
1. Identification of 'arious in'est$ents proposals: T&e capital *udgeting $a# &a'e
'arious in'est$ent proposals. T&e proposal for t&e in'est$ent opportunities $a#
*e defined fro$ t&e top $anage$ent or $a# *e e'en fro$ t&e lo(er ran/. T&e
&eads of 'arious depart$ent anal#se t&e 'arious in'est$ent decisions% and (ill
select proposals su*$itted to t&e planning co$$ittee of co$petent aut&orit#.
;. Screening or $atc&ing t&e proposals: T&e planning co$$ittee (ill anal#se t&e
'arious proposals and screenings. T&e selected proposals are considered (it& t&e
a'aila*le resources of t&e concern. Eere resources referred as t&e financial part of
t&e proposal. T&is reduces t&e gap *et(een t&e resources and t&e in'est$ent cost.
<. E'aluation: After screening% t&e proposals are e'aluated (it& t&e &elp of 'arious
$et&ods% suc& as pa# *ac/ period proposal% net disco'ered present 'alue $et&od%
accounting rate of return and ris/ anal#sis. Eac& $et&od of e'aluation used in
detail in t&e later part of t&is c&apter. T&e proposals are e'aluated *#.
,a- Independent proposals
,*- Contingent of dependent proposals
,c- .artiall# e8clusi'e proposals.
Independent proposals are not co$pared (it& anot&er proposals and t&e sa$e
$a# *e accepted or re+ected. >&ereas &ig&er proposals acceptance depends upon
t&e ot&er one or $ore proposals. For e8a$ple% t&e e8pansion of plant $ac&iner#
leads to constructing of ne( *uilding% additional $anpo(er etc. Mutuall#
e8clusi'e pro+ects are t&ose (&ic& co$peted (it& ot&er proposals and to
i$ple$ent t&e proposals after considering t&e ris/ and return% $ar/et de$and etc.
D. Fi8ing propert#: After t&e e'olution% t&e planning co$$ittee (ill predict (&ic&
proposals (ill gi'e $ore profit or econo$ic consideration. If t&e pro+ects or
proposals are not suita*le for t&e concern@s financial condition% t&e pro+ects are
re+ected (it&out considering ot&er nature of t&e proposals.
A. Final appro'al: T&e planning co$$ittee appro'es t&e final proposals% (it& t&e
&elp of t&e follo(ing:
,a- .rofita*ilit#
,*- Econo$ic constituents
,c- Financial 'iola*ilit#
,d- Mar/et conditions.
T&e planning co$$ittee prepares t&e cost esti$ation and su*$its to t&e
$anage$ent.
F. I$ple$enting: T&e co$petent aut&erit# spends t&e $one# and i$ple$ents t&e
proposals. >&ile i$ple$enting t&e proposals% assign responsi*ilities to t&e
proposals% assign responsi*ilities for co$pleting it% (it&in t&e ti$e allotted and
reduce t&e cost for t&is purpose. T&e net(or/ tec&ni)ues used suc& as .ET and
C.M. It &elps t&e $anage$ent for $onitoring and containing t&e i$ple$entation
of t&e proposals.
H. .erfor$ance re'ie( of feed*ac/: T&e final stage of capital *udgeting is actual
results co$pared (it& t&e standard results. T&e ad'erse or unfa'oura*le results
identified and re$o'ing t&e 'arious difficulties of t&e pro+ect. T&is is &elpful for
t&e future of t&e proposals.
PIN"S !F CA.ITA6 BU"0ETIN0 "ECISI!NS
T&e o'erall o*+ecti'e of capital *udgeting is to $a8i$i5e t&e profita*ilit#. If a fir$
concentrates return on in'est$ent% t&is o*+ecti'e can *e ac&ie'ed eit&er *# increasing t&e
re'enues or reducing t&e costs. T&e increasing re'enues can *e ac&ie'ed *# e8pansion or
t&e si5e of operations *# adding a ne( product line. educing costs $ean representing
o*solete return on assets.
METE!"S !F CA.ITA6 BU"0ETIN0 !F E7A6UATI!N
B# $atc&ing t&e a'aila*le resources and pro+ects it can *e in'ested. T&e funds a'aila*le
are al(a#s li'ing funds. T&ere are $an# considerations ta/en for in'est$ent decision
process suc& as en'iron$ent and econo$ic conditions.
T&e $et&ods of e'aluations are classified as follo(s:
,A- Traditional $et&ods ,or Non-discount $et&ods-
,i- .a#-*ac/ .eriod Met&ods
,ii- .ost .a#-*ac/ Met&ods
,iii- Accounts ate of eturn
,B- Modern $et&ods ,or "iscount $et&ods-
,i- Net .resent 7alue Met&od
,ii- Internal ate of eturn Met&od
,iii- .rofita*ilit# Inde8 Met&od
Met&ods of Capital Budgeting
Traditional Modern
Met&od Met&ods
.a#-*ac/ .ost pa#-*ac/ Accounting Net present Internal ate .rofita*ilit#
Met&od Met&od ate of eturn
7alue of eturn Inde8
Met&od Met&od Met&od
Fig. /.2 "apital Budgeting Methods
.a#-*ac/ .eriod
.a#-*ac/ period is t&e ti$e re)uired to reco'er t&e initial in'est$ent in a pro+ect.
,It is one of t&e non-discounted cas& flo( $et&ods of capital *udgeting-.
.a#-*ac/ period Q Initial in'est$ent
Annual cas& inflo(s
Merits of .a#-*ac/ $et&od
T&e follo(ing are t&e i$portant $erits of t&e pa#-*ac/ $et&od:
1. It is eas# to calculate and si$ple to understand.
;. .a#-*ac/ $et&od pro'ides furt&er i$pro'e$ent o'er t&e accounting rate return.
<. .a#-*ac/ $et&od reduces t&e possi*ilit# of loss on account of o*solescence.
"e$erits
1. It ignores t&e ti$e 'alue of $one#.
;. It ignores all cas& inflo(s after t&e pa#-*ac/ period.
<. It is one of t&e $isleading e'aluations of capital *udgeting.
Accept 9e+ect criteria
If t&e actual pa#-*ac/ period is less t&an t&e predeter$ined pa#-*ac/ period% t&e pro+ect
(ould *e accepted. If not% it (ould *e re+ected.
E8ercise 1
.ro+ect cost is s. <B%BBB and t&e cas& inflo(s are s. 1B%BBB% t&e life of t&e pro+ect is
A #ears. Calculate t&e pa#-*ac/ period.
Solution Q
s.
<B%BBB
Q < ?ears
s.
1B%BBB
T&e annual cas& inflo( is calculated *# considering t&e a$ount of net inco$e on t&e
a$ount of depreciation pro+ect ,Asset- *efore ta8ation *ut after ta8ation. T&e inco$e
precision earned is e8pressed as a percentage of initial in'est$ent% is called unad+usted
rate of return. T&e a*o'e pro*le$ (ill *e calculated as *elo(:
Annual eturn
Unad+usted rate of return Q Y 1BB
In'est$ent
=
s. 1B%BBB
Y 1BB
s. <B%BBB
=
<<.<<R
E8ercise ;
A pro+ect costs s. ;B%BB%BBB and #ields annuall# a profit of s. <%BB%BBB after
depreciation [ 1;bR *ut *efore ta8 at ABR. Calculate t&e pa#-*ac/ period.
.rofit after depreciation <%BB%BBB
Ta8 ABR
1%AB%BBB
1%AB%BBB
Add depreciation
;B%BB%BBB 1;
1
R ;%AB%BBB
;
Cas& in flo( D%BB%BBB
Solution
.a#-*ac/ period Q
In'est$ent
Cas& flo(
Q
;B%BB%BB
B
Q A #ears. D%BB%BBB
Une'en Cas& Inflo(s
Nor$all# t&e pro+ects are not &a'ing unifor$ cas& inflo(s. In t&ose cases t&e pa#-*ac/
period is calculated% cu$ulati'e cas& inflo(s (ill *e calculated and t&en interpreted.
E8ercise <
Certain pro+ects re)uire an initial cas& outflo( of s. ;A%BBB. T&e cas& inflo(s for F
#ears are s. A%BBB% s. 2%BBB% s. 1B%BBB% s. 1;%BBB% s. H%BBB and s. <%BBB.
Solution
?ear Cas& Inflo(s ,s.- Cu$ulati'e Cas& Inflo(s ,s.-
1 A%BBB A%BBB
; 2%BBB 1<%BBB
< 1B%BBB ;<%BBB
D 1;%BBB <A%BBB
A H%BBB D;%BBB
F <%BBB DA%BBB
T&e a*o'e calculation s&o(s t&at in < #ears s. ;<%BBB &as *een reco'ered s. ;%BBB%
is *alance out of cas& outflo(. In t&e Dt& #ear t&e cas& inflo( is s. 1;%BBB. It $eans t&e
pa#-*ac/ period is t&ree to four #ears% calculated as follo(s
.a#-*ac/ period Q < #earsV;BBB91;BBBY1; $ont&s Q
< #ears ; $ont&s.
.ost .a#-*ac/ .rofita*ilit# Met&od
!ne of t&e $a+or li$itations of pa#-*ac/ period $et&od is t&at it does not consider t&e
cas& inflo(s earned after pa#-*ac/ period and if t&e real profita*ilit# of t&e pro+ect
cannot *e assessed. To i$pro'e o'er t&is $et&od% it can *e $ade *# considering t&e
recei'a*le after t&e pa#-*ac/ period. T&ese returns are called post pa#-*ac/ profits.
E8ercise D
Fro$ t&e follo(ing particulars% co$pute:
1. .a#*ac/ period.
;. .ost pa#-*ac/ profita*ilit# and post pa#-*ac/ profita*ilit# inde8.
,a- Cas& outflo( s. 1%BB%BBB
Annual cas& inflo( s. ;A%BBB
,After ta8 *efore depreciation-
Esti$ate 6ife F #ears
,*- Cas& outflo( s. 1%BB%BBB
Annual cas& inflo(
,After ta8 depreciation-
First fi'e #ears s. ;B%BBB
Ne8t fi'e #ears s. 2%BBB
Esti$ated life 1B ?ears
Sal'age 'alue s. 1F%BBB
Solution
,a- ,i- .a#-*ac/ period
Q
Initial in'est$ent
Annual cas& inflo(s
1%BB%BBB
=
;A%BBB
Q D ?ears
,ii- .ost pa#-*ac/ profita*ilit#
QCas& inflo( ,Esti$ated life .a#-*ac/ period-
Q;A%BBB ,F D-
Qs. AB%BBB ,iii-
.ost pa#-*ac/ profita*ilit# inde8
AB%BBB
=
1%BB%BBB
Y 1BB Q ABR
,*- Cas& inflo(s are e)ual% t&erefore pa# *ac/ period is calculated as follo(s:
,i-
?ear Cas& Inflo(s ,s.- Cu$ulati'e Cas& Inflo(s ,s.-
1 ;B%BBB ;B%BBB
; ;B%BBB DB%BBB
< ;B%BBB FB%BBB
D ;B%BBB 2B%BBB
A ;B%BBB 1%BB%BBB
F 2%BBB 1%B2%BBB
H 2%BBB 1%1F%BBB
2 2%BBB 1%;D%BBB
J 2%BBB 1%<;%BBB
1B 2%BBB 1%DB%BBB
,ii- .ost pa#-*ac/ profita*ilit#.
= Cas& inflo( ,esti$ated life pa#-*ac/ period-
= 2%BBB ,1BA-
= 2BBBYA Q DB%BBB
,iii- .ost pa#-*ac/ profita*ilit# inde8
DB%BBB Q
1%BB%BBB

Y1BBQDBR
Accounting ate of eturn or A'erage ate of eturn
A'erage rate of return $eans t&e a'erage rate of return or profit ta/en for considering t&e
pro+ect e'aluation. T&is $et&od is one of t&e traditional $et&ods for e'aluating t&e
pro+ect proposals:
Merits
1. It is eas# to calculate and si$ple to understand.
;. It is *ased on t&e accounting infor$ation rat&er t&an cas& inflo(.
<. It is not *ased on t&e ti$e 'alue of $one#.
D. It considers t&e total *enefits associated (it& t&e pro+ect.
0emerits
1. It ignores t&e ti$e 'alue of $one#.
;. It ignores t&e rein'est$ent potential of a pro+ect.
<. "ifferent $et&ods are used for accounting profit. So% it leads to so$e difficulties
in t&e calculation of t&e pro+ect.
Accept9e+ect criteria
If t&e actual accounting rate of return is $ore t&an t&e predeter$ined re)uired rate of
return% t&e pro+ect (ould *e accepted. If not it (ould *e re+ected.
E8ercise A
A co$pan# &as t(o alternati'e proposals. T&e details are as follo(s:
.roposal I .roposal II
Auto$atic Mac&ine !rdinar# Mac&ine
Cost of t&e $ac&ine s. ;%;B%BBB s. FB%BBB
Esti$ated life Ab #ears 2 #ears
Esti$ated sales p.a. s. 1%AB%BBB s. 1%AB%BBB
Costs : Material AB%BBB AB%BBB
6a*our 1;%BBB FB%BBB
7aria*le !'er&eads ;D%BBB ;B%BBB
Co$pute t&e profita*ilit# of t&e proposals under t&e return on in'est$ent $et&od.
,M.Co$.% Madras and B&arat&idasan-
Solution
.rofita*ilit# State$ent
Auto$atic !rdinar#
Mac&ine Mac&ine
Cost of t&e $ac&ine s. ;%;B%BBB s. FB%BBB
6ife of t&e $ac&ine Ab #ears 2 #ears
s. s.
Esti$ated Sales ,A- 1%AB%BBB 1%AB%BBB
6ess : Cost : Material AB%BBB AB%BBB
6a*our 1;%BBB FB%BBB
7aria*le o'er&eads ;D%BBB ;B%BBB
"epreciation ,1- DB%BBB H%BBB
Total Cost ,B- 1%;F%BBB 1%<H%BBB
.rofit ,A- ,B- ;D%BBB 1;%ABB
>or/ing:
,1- "epreciation Q Cost 6ife
Auto$atic $ac&ine Q ;%;B%BBB Ab Q DB%BBB
!rdinar# $ac&ine Q FB%BBB 2 Q H%ABB
eturn on in'est$ent Q
A'erage profit
Y 1BB !riginal in'est$ent
;D%BBB 1;%ABB
Q Y 1BB
FB%BBB
Y 1BB
;%;B%BBB
1B.JR ;B.2R
Auto$atic $ac&ine is $ore profita*le t&an t&e ordinar# $ac&ine.
Net .resent 7alue
Net present 'alue $et&od is one of t&e $odern $et&ods for e'aluating t&e pro+ect
proposals. In t&is $et&od cas& inflo(s are considered (it& t&e ti$e 'alue of t&e $one#.
Net present 'alue descri*es as t&e su$$ation of t&e present 'alue of cas& inflo( and
present 'alue of cas& outflo(. Net present 'alue is t&e difference *et(een t&e total
present 'alue of future cas& inflo(s and t&e total present 'alue of future cas& outflo(s.
Merits
1. It recogni5es t&e ti$e 'alue of $one#.
;. It considers t&e total *enefits arising out of t&e proposal.
<. It is t&e *est $et&od for t&e selection of $utuall# e8clusi'e pro+ects.
D. It &elps to ac&ie'e t&e $a8i$i5ation of s&are&olders@ (ealt&.
0emerits
1. It is difficult to understand and calculate.
;. It needs t&e discount factors for calculation of present 'alues.
<. It is not suita*le for t&e pro+ects &a'ing different effecti'e li'es.
Accept9e+ect criteria
If t&e present 'alue of cas& inflo(s is $ore t&an t&e present 'alue of cas& outflo(s% it
(ould *e accepted. If not% it (ould *e re+ected.
E8ercise F
Fro$ t&e follo(ing infor$ation% calculate t&e net present 'alue of t&e t(o pro+ect and
suggest (&ic& of t&e t(o pro+ects s&ould *e accepted a discount rate of t&e t(o.
.ro+ect N .ro+ect ?
Initial In'est$ent s. ;B%BBB s. <B%BBB
Esti$ated 6ife A #ears A #ears
Scrap 7alue s. 1%BBB s. ;%BBB
T&e profits *efore depreciation and after ta8ation ,cas& flo(s- are as follo(s:
?ear 1 ?ear ; ?ear < ?ear D ?ear A
s. s. s. s. s.
.ro+ect 8 A%BBB 1B%BBB 1B%BBB <%BBB ;%BBB
.ro+ect # ;B%BBB 1B%BBB A%BBB <%BBB ;%BBB
Note : T&e follo(ing are t&e present 'alue factors [ 1BR p.a.
?ear 1 ; < D A F
Factor B.JBJ B.2;F B.HA1 B.F2< B.F;1 B.AFD
,MBA% Madurai-Pa$ara+ Uni'ersit#% Ma# ;BBA-
Solution
Cas& Inflo(s .resent .resent 7alue of Net Cas&
7alue of s. Inflo(
?ear .ro+ect N s. .ro+ect ? s. 1 [ 1BR .ro+ect N s. .ro+ect ? s.
1 A%BBB ;B%BBB B.JBJ D%ADA 12%12B
; 1B%BBB 1B%BBB B.2;F 2%;FB 2%;FB
< 1B%BBB A%BBB B.HA1 H%A1B <%HAA
D <%BBB <%BBB B.F2< ;%BDJ ;%BDJ
A ;%BBB ;%BBB B.F;1 1%;D; 1%;D;
Scrap 7alue 1%BBB ;%BBB B.F;1 F;1 1%;DA
Total present 'alueInitial ;D%;;H <D%H;2
in'est$ents ;B%BBB <B%BBB
Net present 'alue D%;;H D%H;2
.ro+ect ? s&ould *e selected as net present 'alue of pro+ect ? is &ig&er.
E8ercise H
T&e follo(ing are t&e cas& inflo(s and outflo(s of a certain pro+ect.
?ear !utflo(s Inflo(s
B 1%HA%BBB -
1 A%AB%BBB <A%BBB
; DA%BBB
< FA%BBB
D 2A%BBB
A AB%BBB
T&e sal'age 'alue at t&e end of A #ears is s. AB%BBB. Ta/ing t&e cutoff rate as 1BR%
calculate net present 'alue.
?ear 1 ; < D A
..7. B.JBJ B.2;F B.HA1 B.F2< B.F;1
Solution
?ear Cas& Inflo(s .resent 7alue .resent 7alue
s. Factor [ 1BR of Cas& Inflo(s
1 <A%BBB B.JBJ <1%21A
; DA%BBB B.2;F <H%1HB
< FABBB B.HA1 D221A
D 2ABBB B.F2< A2BAA
A ABBBB B.F;1 <1BAB
A,Sal'age- ABBBB B.F;1 <1BAB
Total present 'alue
of cas& inflo(s ;<HJAA
6ess : Total present 'alue of outflo(s
Cas& outflo( at t&e *eginning 1%HA%BBB
Cas& outflo( at t&e end of first
?ear ABBBBYB.JBJ DA%DAB
Total 'alue of outflo(s ;%;B%DAB
Net .resent 7alue 1H%ABA
If t&e cas& inflo(s are not gi'en in t&at cases t&e calculation of cas& inflo(s are Net
profit after ta8V"epreciation. In t&is t#pe of situation first find out t&e Net profit after
depreciation and deducting t&e ta8 and t&en add t&e deprecation. It gi'es t&e cas& inflo(.
E8ercise 2 Fro$ t&e follo(ing infor$ation #ou can learn after te8 and depreciation
concept.
Initial !utla# s. 1%BB%BBB
Esti$ated life A ?ears
Scrap 7alue s. 1B%BBB
.rofit after ta8 :
End of #ear 1 s. F%BBB
; s. 1D%BBB
< s. ;D%BBB
D 1F%BBB
A Nil
Solution "epreciation &as *een calculated under straig&t line $et&od. T&e cost of
capital $a# *e ta/en at 1BR. ..a. is gi'en *elo(.
?ear 1 ; < D A
.7 factor [ 1BR B.JBJ B.2;F B.HA1 B.F2< B.F;1
Initial cas& outflo( scrap 'alue
"epreciation Q
Esti$ated 6ife of t&e pro+ect
Q
1%
BB
%BBB 1B%BBB
A
Q
JB%BBB
Q s.12%BBB
A
?ear .rofit after Ta8 "epreciation Cas& Inflo(
1 F%BBB 12%BBB ;D%BBB
; 1D%BBB 12%BBB <;%BBB
< ;D%BBB 12%BBB D;%BBB
D 1F%BBB 12%BBB <D%BBB
A Nil 12%BBB 12%BBB
Net .resent 7alue
?ear Cas& Inflo( "iscount factor [ 1BR .resent 'alue ,s.-
1 ;D%BBB B.JBJ ;1%21F
; <;%BBB B.2;F ;F%D<;
< D;%BBB B.HA1 <1%AD;
D <D%BBB B.F2< ;<%;;;
A 12%BBB B.F;1 11%1H2
Total present 'alue of cas& inflo(s 1%1D%1JB
6ess : Initial cas& in'est$ent 1%BB%BBB
Net present 'alue 1%D1%JB
Internal ate of eturn
Internal rate of return is ti$e ad+usted tec&ni)ue and co'ers t&e disad'antages of t&e
traditional tec&ni)ues. In ot&er (ords it is a rate at (&ic& discount cas& flo(s to 5ero. It is
e8pected *# t&e follo(ing ratio:
Cas& inflo(
In'est$ent initial
Steps to *e follo(ed:
Step1. find out factor
Factor is calculated as follo(s:
Cas& outla# ,or- initial in'est$ent
FQ
Cas& inflo(
Step ;. Find out positi'e net present 'alue Step <. Find out negati'e net present
'alue Step D. Find out for$ula net present 'alue
For$ula
I QBase factor V
.ositi'e net present
'alue

".
"ifference in positi'e
and
Negati'e net present
'alue
Base factor Q .ositi'e discount rate
". Q "ifference in percentage
Merits
1. It consider t&e ti$e 'alue of $one#.
;. It ta/es into account t&e total cas& inflo( and outflo(.
<. It does not use t&e concept of t&e re)uired rate of return.
D. It gi'es t&e appro8i$ate9nearest rate of return.
0emerits
1. It in'ol'es co$plicated co$putational $et&od.
;. It produces $ultiple rates (&ic& $a# *e confusing for ta/ing decisions.
<. It is assu$e t&at all inter$ediate cas& flo(s are rein'ested at t&e internal rate of
return.
Accept9e+ect criteria
If t&e present 'alue of t&e su$ total of t&e co$pounded rein'ested cas& flo(s is greater
t&an t&e present 'alue of t&e outflo(s% t&e proposed pro+ect is accepted. If not it (ould *e
re+ected.
E8ercise J
A co$pan# &as to select one of t&e follo(ing t(o pro+ects:
.ro+ect A .ro+ect B
Cost s.;;%BBB ;B%BBB
Cas& inflo(s:
?ear 1 1;%BBB ;%BBB
?ear ; D%BBB ;%BBB
?ear < ;%BBB D%BBB
?ear D 1B%BBB ;B%BBB
Using t&e Internal ate of eturn $et&od suggest (&ic& is .refera*le.
Solution
Cas& outla#
F Q
Cas& inflo(
.ro+ect A
Cas& Inflo( Q
Total cas& inflo(
No. of #ears
;2%BBB
Q
;;BBB
Q <.1D HBBB
T&e factor t&us calculated (ill *e located in ta*le II *elo(. T&is (ould gi'e t&e
esti$ated rate of return to *e applied discounting t&e cas& for t&e internal rate of returns.
In t&is of pro+ect A t&e rate co$es to 1BR (&ile in case of pro+ect B it co$es to1AR.
Section A
1. T&e ter$ ------- refers to all financial sources soug&t *# co$pan#.
;. Concepts of ---------- is 'er# useful in capital *udgeting decisions.
<. Cost of capital ser'es as --------------- rate for capital in'est$ent decisions.
D. atio of de*t e)uit# $i8 is called --------
A. Cost of capital co$pro$ises *ot& *usiness ris/ and -----------
F. Interest
Net proceeds Q --------------
H. Under net inco$e approac&% t&ere (ill *e an assu$ption of ------
2. ------- is t&e per$anent financing of t&e co$pan# represented pri$aril# *#
long ter$ de*t and s&are&older@s funds.
J. T&e opti$u$ capital structure is o*tained (&en t&e $et 'alue per e)uit#
s&are is t&e $a8i$u$. True 9 False.
1B. ------- is (&en t&e co$pan#@s rate of return on total capital e$plo#ed is
$ore t&an t&e rate of interest9 di'idend on de*enture9preference s&ares.
Section B
1. State t&e i$portance of capital structure.
;. E8plain t&e concept of cost of capital.
<. >&at are t&e essentials of a sound capital structure.
D. >&at are t&e co$ponents of cost of capital.
A. 6ist out t&e principles of capital structure.
F. Factors deter$ining cost of capital.
H. >&at are t&e patterns of capital structure.
2. State t&e capital structure t&eories.
J. >&at is $eant *# e8plicit and real cost of capital.
1B. >&# s&ould a co$pan# ai$ at *alanced capital structureI
Section C
1. "iscuss on (&at capital structure $anage$ent isI
;. >&at are t&e 'arious for$s of capital structureI
<. State t&e approac&es for co$puting t&e Lcost of e)uit#@ of capital. E8plain
D. >&at is Lcost of capital@ and state t&e i$portanceI
A. >&at are t&e internal and e8ternal factors influencing capital structureI
F. >&at are t&e c&aracters of a *alanced capital structureI
H. >&at do #ou understand *# capital structure of a corporationI "iscuss t&e
)ualities (&ic& a sound capital structure s&ould possess
2. >&at are t&e t&eories of capital structureI
J. >&at is indi'idual and co$posite cost of capital.
1B. T&e capital structure and after ta8 cost of different sources of funds are gi'en
*elo(: Co$pute t&e (eig&ted a'erage cost of capital.
Sources of funds A$ount .roportion to total After ta8
cost R
a. E)uit# capital H;%BBB B.<B 1A
*. etained earnings FB%BBB B.;A 1D
c. .reference capital D2%BBB B.;B 1B
d. "e*entures FB%BBB B.;A 2
Unit 7
Sources and For$s of Finance: E)uit# S&ares% .reference S&ares% Bonds% "e*entures and
Fi8ed "eposits Features Ad'antages and "isad'antages-6ease Financing: Meaning
Features For$s Merits and "e$erits.
S!UCES AN" F!MS !F FINANCE
In our present da# econo$#% finance is defined as t&e pro'ision of $one# at t&e ti$e
(&en it is re)uired% (it&out ade)uate finances% no enterprises can possi*l# acco$plis&es
its o*+ecti'es.
Capital re)uired for a *usiness can *e classified under t(o categories%
1. Fi8ed capital
;. >or/ing capital
E'er# *usiness needs funds for ; purposes- for its esta*lis&$ent and to carr# out its da#-
to-da# operations. 6ong-ter$ funds re)uired creating production facilities t&roug&
purc&ases of fi8ed assets. In'est$ent in t&ese assets represents t&at part of fir$s@ capital
t&at is *loc/ed on a per$anent or fi8ed *asis and it is called fi8ed capital. Funds are also
needed for s&ort-ter$ purposes for t&e purc&ase of ra( $aterials% pa#$ent of (ages and
ot&er da#-to-da# e8penses% etc. t&ese funds are /no(n as (or/ing capital.
T&e 'arious sources of finance &a'e *een classified in $an# (a#s% suc& as:
1. According to period
a. S&ort ter$ sources- *an/ credit% custo$er ad'ances% trade credit% factoring%
accruals% co$$ercial paper% etc
*. Mediu$ ter$ sources-issue of preference s&ares% de*entures% *an/ loans%
pu*lic deposits% fi8ed deposits% etc
c. 6ong ter$ sources-issue of s&ares% de*entures% plugging *ac/ of profits% loans
fro$ speciali5ed financial institutions% etc.
;. According to o(ners&ip
FINANCIA6 EUUIEMENTS
SE!T TEM ME"IUM TEM 6!N0 TEM
Ban/ Credit
Custo$er Ad'ances
Trade Credit
Factoring
Accruals
"eferred Inco$es
Co$$ercial .aper
Instal$ent Credit
Issue of "e*entures
Issue of .reference S&ares
Ban/ 6oans
.u*lic "eposits 9 Fi8ed
"eposits
6oans Fro$ Financial
Institutions
Issue of S&ares
Issue of "e*entures
.loug&ing-Bac/ of .rofits
6oans Fro$ Speciali5ed
Financial Institutions
a. !(ned capital-s&are capital% retained earnings% profit and surplus% etc
*. Borro(ed capital suc& as de*entures% *onds% pu*lic deposits% loans% etc
<. According to sources of finance
a. Internal sources suc& as plugging *ac/ of profits% retained earnings% profits%
surpluses and depreciation funds% etc.
*. E8ternal sources- s&ares% de*entures% pu*lic deposits% loans% etc
D. According to $ode of financing
a. Securit# financing or e8ternal financing- financing t&roug& rising of
corporate securities suc& as s&ares% de*entures% etc
*. Internal financing-$ financing t&roug& retained earnings% capitali5ation of profits
and depreciation of finds% etc
c. 6oan financing t&roug& rising of long ter$ and s&ort ter$ loans.
I. Securit# financing:
Corporate securities can *e classified under t(o *road categories:
!(ners&ip securities or Capital stoc/
Creditors&ip securities or "e*t capital
!>NESEI. SECUITIES
1. E)uit# s&ares
E)uit# s&ares also /no(n as ordinar# s&are or co$$on s&ares represent t&e o(ner@s
capital in a co$pan#. T&en &olders of t&ese s&ares are real o(ners of t&e co$pan#. T&e#
&a'e a control o'er t&e (or/ing of t&e co$pan#. E)uit# s&are&olders are paid di'idend
after pa#ing it to t&e preference s&are&olders. T&ese s&are&olders ta/e a $ore ris/ as
co$pared to preference s&are&olders. E)uit# s&are capital is paid after $eeting all ot&er
clai$s including t&at of preference s&are&olders. T&e# ta/e ris/ *ot& regarding di'idend
and return of capital. E)uit# s&are capital cannot *e redee$ed during t&e lifeti$e of t&e
co$pan#.
C&aracteristics of E)uit# s&ares
E)uit# s&ares &a'e a nu$*er of features (&ic& distinguis& t&e$ fro$ ot&er s&ares and
securities. T&ese features generall# relate to t&e rig&ts and position of e)uit#
s&are&olders. T&e follo(ing are t&e $ost significant features of e)uit# s&ares:
C6ASSIFICATI!N !F C!.!ATE
SECUITIES
!>NESEI. SECUITIES CE"IT!SEI. SECUITIES
"EBENTUES
!"INA? !
EUUIT? SEAES
.EFEENCE
SEAES
N! .A ST!CP "EFEE"
SEAES
i-Maturit#
E)uit# s&ares pro'ide per$anent capital to t&e co$pan# and cannot *e redee$ed during
t&e life ti$e of t&e co$pan#. Under t&e co$panies Act% 1JAF% a co$pan# cannot purc&ase
its o(n s&ares. E)uit# s&are&olders can de$and refund of t&eir capital onl# at t&e ti$e of
li)uidation of a co$pan#. E'en at t&e ti$e of li)uidation% e)uit# capital is paid *ac/ after
$eeting all ot&er prior clai$s including t&at of preference s&are&olders.
ii-
Ad'antages of e)uit# s&ares
1. E)uit# s&ares do not create an# o*ligations to pa# a fi8ed rate of di'idend
;. E)uit# s&ares can *e issued (it&out creating an# c&arge o'er t&e assets of t&e co$pan#
<. It is a per$anent source of capital and t&e co$pan# &as not to repa# it e8pect under
li)uidation
D. E)uit# s&are&olders are t&e real o(ners of t&e co$pan# (&o &a'e t&e 'oting rig&ts
A. In case of profits% e)uit# s&are &oJlders are t&e real gainers *# (a# of increased
di'idends and appreciation in t&e 'alue of s&ares.
"isad'antages of e)uit# s&ares
1. If onl# e)uit# s&ares are issued% t&e co$pan# cannot ta/e t&e ad'antage of trading
on e)uit#
;. As e)uit# capital cannot *e redee$ed t&ere is a danger of o'er capitali5ation.
<. E)uit# s&are&olders can put o*stacles in $anage$ent *# $anipulation and
organi5ation t&e$sel'es
D. "uring prosperous periods &ig&er di'idends &a'e to *e paid leading to increase in
t&e 'alue of s&ares in t&e $ar/et and speculation
A. In'estors (&o desire to in'est in safe securities (it& a fi8ed inco$e &a'e no
attraction for suc& s&ares.
;. .reference s&ares:
As t&e na$e suggests% t&ese s&ares &a'e certain preference as co$pared to ot&er t#pes of
s&ares. T&ese s&ares are gi'en t(o preferences. T&ere is a preference for t&e pa#$ent of
di'idend. >&ene'er t&e co$pan# &as distri*uta*le profits% t&e di'idend is first paid on
preference s&are capital. T&e second preference is t&at t&e repa#$ent of capital at t&e
ti$e of li)uidation of co$pan#. After pa#ing outside creditors% preference s&are capital is
returned. .references s&are &olders so no &a'e 'oting rig&tsK &o(e'er t&e# can 'ote if
t&eir o(n interest is affected.
T#pes of preference s&ares
1. Cu$ulati'e preference s&ares
;. Non cu$ulati'e preference s&ares
<. edee$a*le preference s&ares
D. Irredee$a*le preference s&ares
A. .articipating preference s&ares
F. Non participating preference s&ares
H. Con'erti*le preference s&ares
2. Non con'erti*le preference s&ares
Ad'antages of preference s&ares
To co$pan#@s point of 'ie(:
1. T&ere is no legal o*ligation to pa# di'idend on preferences s&ares
;. .reference s&ares pro'ide long ter$ capital for t&e co$pan#
<. T&ere is no lia*ilit# of t&e co$pan# to redee$ preference s&ares during t&e life ti$e of
t&e co$pan#
D. .reference s&are capital as regarded as t&e part of co$pan#@s net (ort&% it en&ances t&e
credit (ort&iness of t&e co$pan#.
To s&are &older@s point of 'ie(:
1. It earns fi8ed rate of di'idend
;. It is a superior securit# o'er e)uit# s&ares
<. It pro'ides preferential rig&t in regard to pa#$ent of di'idends an repa#$ent of
capital on ti$e
<. "EBENTUES or *onds:
A co$pan# $a# raise long-ter$ finance t&roug& pu*lic *orro(ings. T&e issue of
de*entures raises t&ese loans.
A de*enture is an ac/no(ledge of de*t. According to T&o$as E'el#n@s% L t&e de*enture is
a docu$ent under t&e co$pan#@s seal (&ic& pro'ides for t&e pa#$ent of a principle su$
and interest t&ereon at regular inter'als% (&ic& is usuall# secured *# a fi8ed or floating
c&arge on t&e co$pan#@s propert# or underta/ing and (&ic& ac/no(ledges a loan to t&e
co$pan#. A de*entures &older is a creditor of t&e co$pan#. A fi8ed rate of interest is paid
on de*entures. >&en t&e de*entures are secured t&e# are paid on priorit# in co$parison
to all ot&er creditors.
T#pes of de*entures
1. Si$ple% na/ed or unsecured de*entures
;. Secured or $ortgaged de*entures
<. Bearer de*entures
D. egistered de*entures
A. edee$a*le de*entures
F. Irredee$a*le de*entures
H. Con'erti*le de*entures
2. Oero interest *onds9de*entures
J. First and second de*entures
1B. 0uaranteed de*entures
I$portance of de*entures as a source of finance
1. "e*entures pro'ide long-ter$ funds to t&e co$pan#
;. T&e rate of interest pa#a*le on de*entures is usuall#K lo(er t&an t&e rate of di'idend
paid on s&ares.
<. T&e interest on de*entures is a ta8 deducta*le e8pense
D. "e*entures pro'ide fle8i*ilit# in t&e capital structure of a co$pan#
A. "e*entures pro'ide a fi8ed% regular and sta*le source of inco$e
F. A de*enture is usuall# $ore li)uid in'est$ent.
II. Internal financing
1. etained earnings or plugging *ac/ of profits.
;. "epreciation as a source of finance.
1. etained earnings or plugging *ac/ of profits
It is a tec&ni)ue of financial $anage$ent under (&ic& all profits of a co$pan# are not
distri*uted a$ongst t&e s&are &olders as di'idend% *ut a part of t&e profits is retained or
rein'ested in t&e co$pan#. T&is processes of retained profits #ear after #ear and t&eir
utili5ation in t&e *usiness is also /no(n as ploug&ing *ac/ of profits.
Under t&is $et&od a part of total profits is transferred to 'arious reser'es suc& as general
reser'e% E.6ACEMENT fund% reser'e fund% reser'e for repairs and rene(als% etc..
So$eti$es Lsecret reser'es Lare also created (it&out t&e /no(ledge of t&e s&are&olders.
Merits of ploug&ing *ac/ of profits:
A. Ad'antage to co$pan#:
1. A cus&ion to a*sor* t&e stoc/s of econo$#
;. Econo$ical $et&od of financing
<. Aids in s$oot& and undistur*ed running of t&e *usiness
D. Eelps on follo(ing sta*le di'idend polic#
A. Fle8i*le financial structures
F. Ma/es t&e co$pan# self-dependent or no dependent ion fair (eat&er friends
H. Eelps in $a/ing food t&e deficiencies of depreciation% etc.
2. Ena*les to redee$ long-ter$ lia*ilities
B. Ad'antages to t&e s&are&olders:
1. Increase in t&e 'alue of s&ares
;. Safet# of in'est$ents
<. En&anced earning capacit#
D. No dilution of control
C. Ad'antages to t&e societ# or Nation
1. Increase t&e rate of capital for$ation
;. Sti$ulates industriali5ation
<. Increases producti'it#
D. "ecreases t&e rate of industrial failure
A. Eig&er standard of li'ing
6i$itations of ploug&ing *ac/ of profits:
1. o'er capitali5ation
;. Creation of $onopolists
<. "epri'ing t&e freedo$ of t&e in'estors
D. Misuse of retrained earnings
A. Manipulation in t&e 'alue of s&ares
F. E'asion of ta8es
H. "issatisfaction a$ong t&e s&are &olders
;. "E.ECIATI!N AS A S!UCE !F FINANCE
"epreciation $a# *e regarded as t&e capital cost of assets allocated o'er life of t&e assets.
In real sense% depreciation is si$pl# a *oo/ entr# &a'ing t&e effect of reducing t&e *oo/
'alue of t&e assets and t&e profits of t e& current #ear for t&e sa$e a$ount. It does not
affect t&e current assets or current lia*ilities and does not result in t&e flo( of funds or to
sa# $ore precisel# it is a not a fund ite$. Eence alt&oug& depreciation is an operating
cost t&ere is no actual outflo( of cas& and so t&e a$ount of depreciation c&arged during
t&e #ear is added *ac/ to profits (&ile finding funds for$ operations. it is in t&e sense
t&at depreciation can *e regarded as a indirect sources of funds.
In case a concern earns a &uge profits and e8cessi'e depreciation is per$itted under
inco$e ta8 act is c&arged to profit and loss account% it is still result in t&e generation of
funds t&roug& sa'ings in t&e pa#$ent of di'idends.
III. SE!T TEM 6!ANS AN" CE"ITS
T&e t&ird i$portant $ode of financing is raising *ot& 1. S&ort-ter$ loans and credits ;.
Ter$ loans including $ediu$ and s&ort-ter$ loans. T&ese sources of finance &a'e *een
discussed in t&e follo(ing pages of t&is c&apter.
A fir$ raises t&e s&ort-ter$ loans and credits or $eeting its (or/ing capital re)uire$ents%
t&ese include
1. Indigenous *an/ers
.ri'ate $one# leaders and ot&er countr# *an/ers used to *e onl# sources of finance prior
to$ t&e esta*lis&$ent of co$$ercial *an/s. T&e# used to c&arge 'er# &ig& rates of
interest and e8ploited t&e custo$ers to larger e8tent. But e'en toda#% so$e *usiness
&ouses &a'e to depend on Indigenous *an/ers for o*taining loans to $eet t&eir (or/ing
capital re)uire$ents.
;. Trade credit
Trade credit refers to t&e credit e8tended *# t&e suppliers of goods in t&e nor$al course
of *usiness. T&e credit (ort&iness sofa fir$ and t&e confidence of tits suppliers are t&e
$ain *asis of securing trade credit. It is $ostl# granted on an open account *asis (&ere*#
supplier sends goods to t&e *u#er for t&e pa#$ent to *e recei'ed in future as per t&e
ter$s of sales in'oice. It $a# also ta/e t&e for$ of *ills pa#a*le (&ere*# t&e *u#er t&e
*u#er signs t&e *ills of e8c&ange pa#a*le on a specified future date.
<. Install$ent credit
T&e assets are purc&ased and t&e possession of goods is ta/en i$$ediatel# *ut t&e
pa#$ent is $ade in install$ents o'er a pre deter$ined period of ti$e. 0enerall# interest
is c&arged on t&e unpaid a$ount or it $a# *e ad+usted in t&e price. But in an# case% t&e
pro'ided funds for so$eti$es and is used as a sources of s&ort ter$ (or/ing capital *#
$an# *usiness &ouses (&ic& &a'e difficult funds position.
D. Ad'ances
So$e *usiness &ouses grant ad'ances fro$ t&eir custo$ers and agents against orders and
t&is source is a s&ort ter$ sources of finance for t&e$. It is c&eap source especiall# for
t&e fir$s $anufacturing industrial products prefer to ad'ance fro$ t&eir custo$ers.
A. Account recei'a*le credit or factoring
A factor is financial institution (&ic& offers ser'ices relating to% $anage$ent and
financing of de*ts arising out of credit sales. Factoring is reco$*ining popular all o'er
t&e (orld on account of 'arious ser'ices offered *# t&e institutions@ engaged in it.
F. Accrued e8penses
Accrued e8penses are t&e e8penses (&ic& &a'e *een incurred *ut not #et due and &ence
not #et paid also. T&e $ost popular ite$s of accruals are (ages% salaries% interest and
ta8es. E'en inco$e ta8es are paid after collection and in t&e inter'ening period ser'e as a
good source of finance.
H. "eferred inco$es
"eferred inco$es are inco$es recei'ed in ad'ance *efore suppl#ing goods and
Ser'ices% t&e# represent funds recei'ed *# a fir$ for (&ic& it &as to suppl# goods or
ser'ices in future. T&ese funds increase t&e li)uidit# of a fir$ and constitute an i$portant
source of s&ort ter$ finance.
2. Co$$ercial paper
Co$$ercial paper represents unsecured pro$issor# notes issued *# t&e fir$s to raise
s&ort ter$ fund s. it is an i$portant $one# $ar/et instru$ent in ad'anced countries li/e
USA. In India% t&e BI introduced co$$ercial papers in t&e Indian $one# $ar/et on t&e
reco$$endations of t&e (or/ing group on Mone# $ar/et ,7ag&ul co$$ittee-.
T&e $aturit# period for co$$ercial paper% in India is J1 to 12B da#s. It is sold at discount
fro$ its face 'alue and redee$ed at face 'alue n its $aturit#. A credit rating agenc#%
called CISI6% &as *een setup in India *# ICCCI and UTI to rate co$$ercial papers.
J. Co$$ercial *an/s
Co$$ercial *an/s are t&e $ost i$portant sources of s&ort ter$ capital. T&e# pro'ide a
(ide 'ariet# of loans and ad'ances follo(sK
a. 6oans
*. Cas& credits
c. !'erdrafts
d. .urc&asing and discounting *ills
In addition to t&e a*o'e-$entioned for$ of direct finance% co$$ercial *an/s &elp t&eir
custo$ers in o*taining credit fro$ t&eir suppliers t&roug& t&e letter of credit
arrange$ent.
6etter of credit-
It &elps t&e custo$ers to$ o*tain credit fro$ t&e suppliers *ecause it ensures t&at t&ere is
no ris/ of nonpa#$ent .69C is a si$ple guarantee *# t&e *an/ to t&e suppliers t&at t&eir
*ills up to a specified a$ount (ould *e &onored% in case t&e custo$er fails to ]pa# t&e
a$ount ion t&e due date% to its suppliers% t&e *an/s assu$es t&e lia*ilit# of its custo$ers
for t&e purc&ase $ade under t&e letter of credit arrange$ent. T&e letter of credit $a# *e
of $an# for$s% suc& as
1. Clean letter of credit
;. "ocu$entar# letter of credit
<. e'oca*le letter of credit
D. Irre'oca*le letter of credit
A. e'ol'ing letter of credit
F. Fi8ed letter of credit
T&e $ost i$portant $odes of t&e securit# re)uired in *an/ finance are
1. E#p&ot&ecation
;. .ledge
<. Mortgage
1B. .u*lic deposits.
T&e pu*lic sector,0o'ern$ent co$panies- &a'e also started accepting pu*lic deposits
since Mune 1J2B.Acceptance of pu*lic deposits *# corporate sector% in $an# cases% &as
*een found to encourage non priorit# sectors of production and defeat t&e 'er# purpose of
t&e restricti'e credit polic# of t&e BI.
TEM 6!ANS
In our countr# t&ere are t(o $a+or sources of ter$ lending are
1. Speciali5ed financial institutions
At present t&ere are four $a+or financial institutions at national le'el
a. Industrial finance corporation of India IFCI
*. Industrial de'elop$ent *an/ of India I"BI
c. Industrial credit and in'est$ent corporation of India ICICI
d. Industrial reconstructions corporation of India ICI
e. State financial corporation@s SFCs and
f. State industrial de'elop$ent in'est$ent corporations
;. Co$$ercial *an/s
<. Industrial cooperati'es
D. Unit trust of India
A. 6ife insurance corporation
F. National industrial de'elop$ent corporations
Also pro'ide finance for t&e de'elop$ent of industries in t&e countr#. T&ere are so$e
international financing institutions li/e >!6" BANP and its affiliates suc& as
international *an/ for reconstruction and de'elop$ent IB"% international de'elop$ent
association I"A% international finance corporation IFC and Asian de'elop$ent *an/
A"B. All t&ese institutions also pro'ide industrial finance t&roug& $e$*er countries
(&ile ot&ers directl# to t&e enterprises. T&e &elp rendered *# all suc& institutions &as
accelerated t&e pace of industriali5ation.
Industrial Finance Corporation of India (IFCI)
IFCI 6td. (as set up in 1JD2 as Industrial Finance Corporation of India% a Statutor#
Corporation to pro'ide $ediu$ and long ter$ finance to industr#. After repeal of IFCI
Act in 1JJ<% IFCI *eca$e a .u*lic 6i$ited Co$pan# registered under t&e Co$panies
Act% 1JAF. IFCI is no( a 0o'ern$ent controlled co$pan# su*se)uent to en&ance$ent of
e)uit# s&are&olding to AA.A<R *# 0o'ern$ent of India on "ece$*er ;1% ;B1;. IFCI is
also registered (it& eser'e Ban/ of India ,BI- as a s#ste$icall# i$portant non-deposit
ta/ing Non-Ban/ing Finance Co$pan# ,NBFC-N"-SI-.
T&e pri$ar# *usiness of IFCI is to pro'ide $ediu$ to long ter$ financial assistance to
t&e $anufacturing% ser'ices and infrastructure sectors. T&roug& its su*sidiaries and
associate organisations% IFCI &as di'ersified into a range of ot&er *usinesses including
*ro/ing% 'enture capital% financial ad'isor#% depositor# ser'ices% factoring etc. As part of
its de'elop$ent $andate% IFCI (as one of t&e pro$oters of National Stoc/ E8c&ange
,NSE-% Stoc/ Eolding Corporation of India 6td ,SECI6-% Tec&nical Consultanc#
!rgani5ations ,TC!s- and social sector institutions li/e as&tri#a 0ra$in 7i/as Nid&i
,07N-% Manage$ent "e'elop$ent Institute ,M"I- and Institute of 6eaders&ip
"e'elop$ent ,I6"-. In order to pro$ote entrepreneurs&ip a$ong t&e sc&eduled castes
and to pro'ide concessional finance to t&e$% IFCI &as *een entrusted (it& t&e setting up
of a 7enture Capital Fund *# IFCI for Sc&eduled Castes in t&e Interi$ Budget for F?
;B1D-1A. T&e Fund (ould &a'e an initial capital of s. ;BB crore% (&ic& can *e
supple$ented e'er# #ear.
Functions of IFCI
1- For setting up a ne( industrial underta/ing.
;- For e8pansion and di'ersification of e8isting industrial underta/ing.
<- For reno'ation and $oderni5ation of e8isting concerns.
D- For $eeting t&e (or/ing capital re)uire$ents of industrial concerns in so$e
e8ceptional cases.
A- "irect financial support ,*# (a# of rupee ter$ loans as (ell as foreign currenc# loans-
to industrial units for under ta/ing ne( pro+ects% e8pansion% $oderni5ation%
di'ersification etc.
F- Su*scription and under(riting of pu*lic issues of s&ares and de*entures.
H- 0uaranteeing of foreign currenc# loans and also deferred pa#$ent guarantees.
2- Merc&ant *an/ing% leasing and e)uip$ent finance.
J-.ro'ides financial assistance to(ards *alance regional de'elop$ent and de'elop$ent
of $anage$ent education in t&e countr#.
Financial Resources
T&e $ain financial resources of Industrial Finance Corporation of India 6td. are as
follo(s:
S&are Capital: T&e aut&ori5ed capital of t&e corporation is s. 1%BBB corers
di'ided into ; la/&s s&ares of s. A%BBB eac&. Its paid-up capital on <1st Marc&%
1JJH (as s. <A;.21 crores.
"e*entures: T&e corporation is also aut&ori5ed to issue de*entures and *onds. But
t&eir total a$ount s&ould not e8ceed ten ti$es of its paid-up s&are capital plus
reser'e funds.
6oans: T&e Corporation &as t&e po(er to *orro( funds ,loans- fro$ Industrial
"e'elop$ent Ban/ of India. Foreign in'est$ent Institutions% Central 0o'ern$ent
and eser'e Ban/ of India.
.u*lic "eposits: T&e Corporation can accept pu*lic deposits for a $a8i$u$
period of fi'e #ears. Furt&er% t&e a$ount of pu*lic deposits cannot e8ceed s. 1B
crores.
eser'e Fund: It is anot&er sources of finance of t&e Corporation.
Foreign Currenc# 6oans: T&e Corporation can also accept loans in foreign
currenc# (it& t&e prior appro'al of t&e central go'ern$ent% suc& as% loans fro$
International Ban/ and ot&er International Financial Institutions.
Critical Evaluation
Alt&oug& t&e Corporation &as *een an i$portant source of long-ter$ finance to t&e large-
si5ed and $ediu$-si5ed industrial units of t&e countr#% #et it &as *een critici5ed on
se'eral grounds. T&e $ain points of criticis$ are as follo(s:
Nepotis$ and fa'oritis$ in granting loans.
Undue preference to (ell-esta*lis&ed large *usiness concerns.
!'erloo/ing interests of s$all *usiness and de'elop$ent of *ac/(ard regions
al$ost ignored.
0ranting loans to *usiness unit not co'ered *# Fi'e #ear .lans.
7er# &ig& interest rate.
"ela# in sanctioning loans.
No participation in e)uit# capital.
Most of t&e loans sanctioned to t&ose industrial units (&ic& are alread# organi5ed
and financiall# strong.
6a#s greater e$p&asis upon gi'ing assistance to consu$er goods industries as
against *asic and capital goods industries.
T&e corporation &as failed in regional and territorial econo$ic de'elop$ent.
T&e assistance is insignificant as co$pared to t&e re)uire$ents of t&e industrial
unit and &ence it &as /noc/ed at t&e doors of ot&er financial institutions.
T&e recurring e8penses of t&e corporation are )uite &ig&.
IND!"RI#$ CREDI" #ND IN%E!"&EN" C'RP'R#"I'N 'F
INDI# $I&I"ED (ICICI)
Industrial Credit and In'est$ent Corporation of India 6i$ited ,ICICI- (as esta*lis&ed in
1JAA as pu*lic li$ited co$pan# to encourage and assist industrial units in t&e countr#. Its
o*+ecti'es% inter alia% include pro'iding assistance in t&e creation% e8pansion and
$odernisation of industrial enterprises% encouraging and pro$oting participation of
pri'ate capital *ot& internal and e8ternal% in suc& enterprises% encouraging and pro$oting
industrial de'elop$ent and &elping de'elop$ent of capital $ar/ets.It pro'ides ter$ loans
in Indian and foreign currencies% under(rites issues of s&ares and de*entures% $a/es
direct su*scriptions to t&ese issues and guarantees pa#$ent of credit $ade *# ot&ers.
Broad o*+ecti'es of t&e ICICI are:
,a- to assist in t&e creation% e8pansion and $odernisation of pri'ate concernsK
,*- to encourage t&e participation of internal and e8ternal capital in t&e pri'ate concernsK
,c- to encourage pri'ate o(ners&ip of industrial in'est$ent.
Functions of t&e ICICI
,i- It pro'ides long-ter$ and $ediu$-ter$ loans in rupees and foreign currencies.
,ii- It participates 6C t&e e)uit# capital of t&e industrial concerns.
,iii- It under(rites ne( issues of s&ares and de*entures.
,i'- It guarantees loans raised *# pri'ate concerns fro$ ot&er sources.
,'- It pro'ides tec&nical%$anagerial and ad$inistrati'e assistance to industrial
concerns.
Capital Initiall#
T&e Corporation started (it& t&e aut&orised capital of s. ;A crore. At t&e end of Mune
1J2F% t&e aut&orised capital (as s. 1BB crore and t&e paid-up capital (as DJ.A crore.
7arious sources of financial resources of t&e Corporation are Indian *an/s% insurance
co$panies and foreign institutions% including t&e (orld Ban/% and t&e pu*lic. T&e
go'ern$ent and t&e I"BI &a'e also pro'ided loans to t&e Corporation.
Financial Assistance
T&e perfor$ance of t&e ICICI in t&e field of financial assistance pro'ided to t&e industrial
concerns &as *een )uite satisfactor#. !'er t&e #ears% t&e assistance sanctioned *# t&e
Corporation &as gro(n fro$ s.1D.2 crore in 1JF1-F; to s. D<.B crore in 1JHB-H1 and
s. <F;;J crore in ;BB1-B;. Si$ilarl# t&e a$ount dis*ursed &as increased fro$ s.2.F
crore in 1JF1-F; to s.;J.2 crore in 1JHB-H1 and to s. ;A2<1 in ;BB1-B;. Cu$ulati'el#%
at t&e end of Marc& 1JJF% t&e ICICI &as sanctioned and dis*ursed financial assistance
aggregating s. FF1FJ crore and s. <FAJ1 crore respecti'el#.
Features of ICICI
T&e i$portant features of t&e functioning of t&e ICICI arc as gi'en *elo(:
,i- T&e financial assistance as pro'ided *# t&e ICICI includes rupee loans% foreign
currenc# loans% guarantees% under(riting of s&ares and de*entures% and direct
su*scription to s&ares and de*entures.
,ii- !riginall#% t&e ICICI (as esta*lis&ed to pro'ide financial assistance to industrial
concerns in t&e pri'ate sector. But% recentl#% its scope &as *een (idened *# including
industrial concerns in t&e pu*lic% +oint and cooperati'e sectors.
,iii- ICICI &as *een pro'iding special attention to financing ris/ier and non-traditional
industries% suc& as c&e$icals% petroc&e$icals% &ea'# engineering and $etal products.
T&ese four categories of industries &a'e accounted for $ore t&an &alf of t&e total
assistance.
,i'- !f late% t&e ICICI &as also *een pro'iding assistance to t&e s$all scale industries and
t&e pro+ects in *ac/(ard areas.
,'- Along (it& ot&er financial institutions% t&e ICICI &as acti'el# participated in
conducting sur'e#s to e8a$ine industrial potential in 'arious states.
,'i- In 1JHH% t&e ICICI pro$oted t&e Eousing "e'elop$ent Finance Corporation 6td. to
grant ter$ loans for t&e construction and purc&ase of residential &ouses.
,'ii- Since 1J2<% t&e ICICI &as *een pro'iding leasing assistance for co$puterisation%
$odernisation and replace$ent sc&e$esK for energ# conser'ateK for e8port orientationK
for pollution controller *alancing and e8pansion: etc.
,'iii- T&e ICICI &as not contri*uted $uc& to reduce regional disparities. A*out t&ree-fift&
of t&e total assistance gi'en *# t&e ICICI &as *een recei'ed *# t&e ad'anced states of
Ma&aras&tra% 0u+rat and Ta$il Nadu.
,i8- >it& effect fro$ April 1% 1JJF% S&ipping Credit and In'est$ent co$pan# of India ltd%
,SCICI- (as $erged (it& ICICI.
,8- T&e ICICI 6td. (as $erged (it& ICICI Ban/ 6td. effecti'e fro$ Ma# <% ;BB;.
!tate Financial Corporation(s (!FCs)
T&e State-le'el financial institutions are t&e one (&ic& pla# a crucial role in t&e
de'elop$ent of s$all and $ediu$ enterprises in t&e concerned States. T&e# pro'ide
financial assistance in t&e for$ of ter$ loans% direct su*scription to e)uit#9 de*entures%
guarantees% discounting of *ills of e8c&ange and seed9 special capital% etc.
A Central Industrial Finance corporation (as set up under t&e industrial Finance
corporations Act% 1JD2 in order to pro'ide $ediu$ and long ter$ credit to industrial
underta/ings (&ic& fall outside nor$al acti'ities of co$$ercial *an/s. T&e State
go'ern$ents e8pressed t&eir desire t&at si$ilar corporations *e set up in states to
supple$ent t&e (or/ of t&e Industrial financial corporation. State go'ern$ents also
e8pressed t&at t&e State corporations *e esta*lis&ed under a special statue in order to
$a/e it possi*le to incorporate in t&e constitutions necessar# pro'isions in regard to
$a+orit# control *# t&e go'ern$ent% guaranteed *# t&e State go'ern$ent in regard to t&e
pa#$ent principal. In order to i$ple$ent t&e 'ie(s E8pressed *# t&e State go'ern$ents
t&e State Financial Corporation *ill (as introduced in t&e .arlia$ent.
!tate)ent of ob*ects and reasons
In order to pro'ide $ediu$ and long ter$ credit to industrial underta/ing% (&ic& fall
outside t&e nor$al acti'ities of co$$ercial *an/s% a central industrial finance corporation
(as set up under t&e industrial Finance Corporations act% 1JD2.T&e state go'ern$ents
(is&ed t&at si$ilar corporations s&ould *e set up in t&eir states to supple$ent t&e (or/ of
industrial financial corporation. T&e intention is t&at t&e State corporations (ill confine to
financing $ediu$ and s$all scale industrial and (ill % as far as possi*le consider onl#
suc& access (&ic& are outside t&e per'ie( of industrial fiancc corporation .T&e $ain
features of t&e State financial Corporations Act 1JA1
i. T&e *ill pro'ides t&at t&e state go'ern$ent $a#% *# notification in t&e official ga5ette%
esta*lis& a financial corporation for t&e state.
ii. T&e s&are capital s&all *e fi8ed *# t&e State go'ern$ent *ut s&all not e8ceed s
;crores . T&e issue of t&e s&ares to t&e pu*lic (ill *e li$ited to ;A R of t&e s&are capital
and t&e rest (ill *e &eld *# t&e State 0o'ern$ents% T&e eser'e Ban/% Sc&eduled Ban/s%
Insurance Co$panies% In'est$ent Trusts% Co- operati'e *an/s and ot&er financial
institutions.
iii. S&ares of t&e corporation (ill *e guaranteed *# t&e State go'ern$ent as to t&e
repa#$ent of principal and t&e pa#$ent of a $ini$u$ di'idend to *e prescri*ed in
consultation (it& t&e central go'ern$ent.
i'. T&e corporation (ill *e aut&ori5ed to issue *onds and de*entures for a$ounts (&ic&
toget&er (it& t&e contingent lia*ilities of t&e corporations s&all not e8ceed fi'e ti$es
t&e a$ount of t&e paid up s&are capital and t&e reser'e fund of t&e corporations. T&ese
*onds and de*entures (ill *e guaranteed as to pa#$ent of t&e principal and pa#$ent of
interest at suc& rate as $a# *e fi8ed *# t&e State go'ern$ent.
'. T&e corporation $a# accept deposits fro$ t&e pu*lic repa#a*le after not less t&an fi'e
#ears% su*+ect to t&e $a8i$u$ not e8ceeding t&e paid up capital.
'i. T&e corporation (ill *e $anaged *# a *oard consisting of a $a+orit# of "irectors
no$inated *# t&e State go'ern$ents% T&e eser'e *an/s and t&e industrial Finance
corporation of India
'ii. T&e corporation (ill *e aut&ori5ed to $a/e long ter$ loans to industrial concerns
(&ic& are repa#a*le (it&in a period not e8ceeding ;A #ears. T&e Corporation (ill *e
furt&er aut&ori5ed to under(rite t&e issue of stoc/s% s&ares% *onds or de*entures *#
industrial concerns% su*+ect to t&e pro'ision t&at t&e corporation (ill *e re)uired to
dispose of and s&ares etc. Ac)uired *# it in fulfill$ent its under(riting lia*ilit# (it&in a
period of H #ears.
'iii. Until a reser'e fund is created e)ual to t&e paid up s&are capital of t&e Corporation
and until t&e State 0o'ern$ents &as *een repaid all a$ounts paid *# t&e$% if an#% in
fulfill$ent of t&e guarantee lia*ilit#% t&e rate of di'idend s&all not e8ceed t&e rate
guaranteed *# t&e state go'ern$ent. Under no circu$stances s&all t&e di'idend e8ceed A
R p.a. and surplus profits (ill *e re pa#a*le to t&e State go'ern$ents.
i8. T&e corporation (ill &a'e special pri'ileges in t&e $atter of enforce$ent of its clai$s
against *orro(ers.
Financial resources of t+e !FC(s
T&e SFC@s $o*ili5e t&eir financial resources fro$ t&e follo(ing sources1.T&eir o(n
S&are capital;.Inco$e fro$ in'est$ent and repa#$ent of loans<.Sale of *ondsD.6oans
fro$ t&e I"BI , To so$e e8tent -A.Borro(ings fro$ t&e eser'e Ban/ of IndiaF."eposits
fro$ t&e .u*licH.6oans fro$ State 0o'ern$ents.In t&e act Financial corporations are
Financial corporations esta*lis&ed under section < andincludes a Moint Financial
Corporation esta*lis&ed under section < A of t&e Sate financialCorporations Act of 1JA1.
T&e functions of SFCs are as follo(s
a. To ad'ance ter$ loans to s$all scale and $ediu$ scale industrial units.
*. It under(rites t&e issue of stoc/s% s&ares% de*entures and *onds of industrial
units.
c. It grants loans to t&e industrial concerns (&ic& is repa#a*le (it&in a period not
$ore t&an ;B #ears.
d. It su*scri*es to de*entures floated *# industrial concerns.
e. It pro'ides financial assistance to s$all road transport operators% tour operators%
&oteliers% &ospitals% nursing &o$es% etc.
SFCs &a'e *een set up (it& t&e o*+ecti'e of catal#5ing &ig&er in'est$ent%
generating greater e$plo#$ent and (idening t&e o(ners&ip *ase of industries. T&e# &a'e
also started pro'iding assistance to ne(er t#pes of *usiness acti'ities li/e floriculture%
tissue culture% poultr# far$ing% co$$ercial co$ple8es and ser'ices related to
engineering% $ar/eting% etc. T&ere are 12 State Financial Corporation@s ,SFCs- in t&e
countr#:-
And&ra .rades& State Financial Corporation ,A.SFC-
Ei$ac&al .rades& Financial Corporation ,E.FC-
Mad&#a .rades& Financial Corporation ,M.FC-
Nort& Eastern "e'elop$ent Finance Corporation ,NE"FI-
a+ast&an Finance Corporation ,FC-
Ta$il Nadu Industrial In'est$ent Corporation 6i$ited
Uttar .rades& Financial Corporation ,U.FC-
"el&i Financial Corporation ,"FC-
0u+arat State Financial Corporation ,0SFC-
T&e Econo$ic "e'elop$ent Corporation of 0oa , E"C-
Ear#ana Financial Corporation , EFC -
Ma$$u : Pas&$ir State Financial Corporation , MPSFC-d
Parnata/a State Financial Corporation ,PSFC-
Perala Financial Corporation , PFC -
Ma&aras&tra State Financial Corporation ,MSFC -
!rissa State Financial Corporation ,!SFC-
.un+a* Financial Corporation ,.FC-
>est Bengal Financial Corporation ,>BFC-
$E#!E FIN#NCIN,
6ease financing is one of t&e popular and co$$on $et&ods of assets *ased finance%
(&ic& is t&e alternati'e to t&e loan finance. 6ease is a contract. A contract under (&ic&
one part#% t&e leaser ,o(ner- of an asset agrees to grant t&e use of t&at asset to anot&er
leaser% in e8c&ange for periodic rental pa#$ents.
6ease is contractual agree$ent *et(een t&e o(ner of t&e assets and user of t&e assets
for a specific period *# a periodical rent.
Definition of $easin-
6ease $a# *e defined as a contractual arrange$ent in (&ic& a part# o(ning an asset
pro'ides t&e asset for use to anot&er% t&e rig&t to use t&e assets to t&e user o'er a certain
period of ti$e% for consideration in for$ of periodic pa#$ent% (it& or (it&out a furt&er
pa#$ent.
According to t&e e)uip$ent leasing association of UP definition% leasing is a contract
*et(een t&e lesser and t&e leaser for &ire of a specific asset selected fro$ a $anufacturers
or 'ender of suc& assets *# t&e lessee. T&e leaser retains t&e o(ners&ip of t&e asset. T&e
leassee pass possession and uses t&e asset on pa#$ent for t&e specified period.
Ele$ents of 6easing
6easing is one of t&e i$portant and popular parts of asset *ased finance. It consists of t&e
follo(ing essential ele$ents. !ne s&ould understand t&ese ele$ents *efore t&e# are going
to stud# on leasing.
1. .arties: T&ese are essentiall# t(o parties to a contract of lease financing% na$el#
t&e o(ner and user of t&e assets.
;. 6easer: 6easer is t&e o(ner of t&e assets t&at are *eing leased. 6easers $a# *e
indi'idual partners&ip% +oint stoc/ co$panies% corporation or financial
institutions.
<. 6ease: 6ease is t&e recei'er of t&e ser'ice of t&e assets under a lease contract.
6ease assets $a# *e fir$s or co$panies.
D. 6ease *ro/er: 6ease *ro/er is an agent in *et(een t&e leaser ,o(ner- and lessee.
Ee acts as an inter$ediar# in arranging t&e lease deals. Merc&ant *an/ing
di'isions of foreign *an/s% su*sidiaries indian *an/ing and pri'ate foreign *an/s
are acting as lease *ro/ers.
A. 6ease assets: T&e lease assets $a# *e plant% $ac&iner#% e)uip$ents% land%
auto$o*ile% factor#% *uilding etc.
"er) of $ease
T&e ter$ of lease is t&e period for (&ic& t&e agree$ent of lease re$ains for operations.
T&e lease ter$ $a# *e fi8ed in t&e agree$ent or up to t&e e8pir# of t&e assets.
$ease Rental
T&e consideration t&at t&e lesae pa#s to t&e leaser for lease transaction is t&e rental.
".pe of $easin-
6easing% as a financing concept% is an arrange$ent *et(een t(o parties for a specified
period. 6easing $a# *e classified into different t#pes according to t&e nature of t&e
agree$ent. T&e follo(ing are t&e $a+or t#pes of leasing as follo(s:
,A- 6ease *ased on t&e ter$ of lease
1. Finance 6ease
;. !perating 6ease
,B- 6ease *ased on t&e $et&od of lease
1. Sale and lease *ac/
;. "irect lease
,C- 6ease *ased in t&e parties in'ol'ed
1. Single in'estor lease
;. 6e'eraged lease
,"- 6ease *ased in t&e area
1. "o$estic lease
;. International lease
1. Financing lease
Financing lease is also called as full pa#out lease. It is one of t&e long-ter$ leases
and cannot *e cancela*le *efore t&e e8pir# of t&e agree$ent. It $eans a lease for
ter$s t&at approac& t&e econo$ic life of t&e asset% t&e total pa#$ents o'er t&e
ter$ of t&e lease are greater t&an t&e leasers initial cost of t&e leased asset. For
e8a$ple: Eiring a factor#% or *uilding for a long period. It includes all
e8penditures related to $aintenance.
;. !perating lease
!perating lease is also called as ser'ice lease. !perating lease is one of t&e s&ort-
ter$ and cancela*le leases. It $eans a lease for a ti$e s&orter t&an t&e econo$ic
life of t&e assets% generall# t&e pa#$ents o'er t&e ter$ of t&e lease are less t&an
t&e leaser@s initial cost of t&e leased asset. For e8a$ple: Eiring a car for a
particular tra'el. It includes all e8penses suc& as dri'er salar#% $aintenance% fuels%
repairs etc.
<. Sale and lease *ac/
Sale and lease *ac/ is a lease under (&ic& t&e leasee sells an asset for cas& to a
prospecti'e leaser and t&en leases *ac/ t&e sa$e asset% $a/ing fi8ed periodic
pa#$ents for its use. It $a# *e in t&e fir$ of operating leasing or financial
leasing. It is one of t&e con'enient $et&ods of leasing (&ic& facilitates t&e
financial li)uidit# of t&e co$pan#.
D. "irect lease
>&en t&e lease *elongs to t&e o(ner of t&e assets and users of t&e assets (it&
direct relations&ip it is called as direct lease. "irect lease $a# *e "ipartite lease
,t(o parties in t&e lease- or Tripartite lease. ,T&ree parties in t&e lease-
A. Single in'estor lease
>&en t&e lease *elongs to onl# t(o parties na$el# leaser and it is called as single
in'estor lease. It consists of onl# one in'estor ,o(ner-. Nor$all# all t#pes of
leasing suc& as operating% financiall#% sale and lease *ac/ and direct lease are
co$ing under t&is categories.
F. 6e'eraged lease
T&is t#pe of lease is used to ac)uire t&e &ig& le'el capital cost of assets and
e)uip$ents. Under t&is lease% t&ere are t&ree parties in'ol'edK t&e leaser% t&e
lender and t&e lessee. Under t&e le'erage lease% t&e leaser acts as e)uit#
participant suppl#ing a fraction of t&e total cost of t&e assets (&ile t&e lender
supplies t&e $a+or part.
H. "o$estic lease
In t&e lease transaction% if *ot& t&e parties *elong to t&e do$icile of t&e sa$e
countr# it is called as do$estic leasing.
2. International lease
If t&e lease transaction and t&e leasing parties *elong to t&e do$icile of different
countries% it is called as international leasing.
#dvanta-es of $easin-
6easing finance is one of t&e $odern sources of finance% (&ic& pla#s a $a+or role in t&e
part of t&e asset *ased financing of t&e co$pan#. It &as t&e follo(ing i$portant
ad'antages.
1. Financing of fi8ed asset
6ease finance &elps to $o*ili5e finance for large in'est$ent in land and *uilding%
plant and $ac&iner# and ot&er fi8ed e)uip$ents% (&ic& are used in t&e *usiness
concern.
;. Assets *ased finance
6easing pro'ides finance facilities to procure assets and e)uip$ents for t&e
co$pan#. Eence% it pla#s a i$portant and additional source of finance.
<. Con'enient
6easing finance is con'enient to t&e use of fi8ed assets (it&out purc&asing. T&is
t#pe of finance is suita*le (&ere t&e co$pan# uses t&e assets onl# for a particular
period or particular purpose. T&e co$pan# need not spend or in'est &uge a$ount
for t&e ac)uiring of t&e assets or fi8ed e)uip$ents.
D. 6o( rate of interest
6ease rent is fi8ed *# t&e lease agree$ent and it is *ased on t&e assets (&ic& are
used *# t&e *usiness concern. 6ease rent $a# *e less (&en co$pared to t&e rate
of interest pa#a*le to t&e fi8ed interest leasing finance li/e de*t or loan finance.
A. Si$plicit#
6ease for$alities and arrange$ent of lease finance facilities are 'er# si$ple and
eas#. If t&e leaser agrees to use t&e assets or fi8ed e)uip$ents *# t&e lessee% t&e
leasing arrange$ent is $ostl# finis&ed.
F. Transaction cost
>&en t&e co$pan# $o*ili5es finance t&roug& de*t or e)uit#% t&e# &a'e to pa#
so$e a$ount as transaction cost. But in case of leasing finance% transaction cost
or floating cost is 'er# less (&en co$pared to ot&er sources of finance.
H. educe ris/
6easing finance reduces t&e financial ris/ of t&e lessee. Eence% &e need not *u#
t&e assets and if t&ere is an# price c&ange in t&e assets% it (ill not affect t&e
lessee.
2. Better alternati'e
No( a da#s% $ost of t&e co$$ercial *an/s and financial institutions are
pro'iding lease finance to t&e industrial concern. So$e of t&e t&e$ &a'e
specialised lease finance co$pan#. T&e# are esta*lis&ed to pro'ide faster and
speed# arrange$ent of lease finance.
6easing Finance Institutions in India
.resentl#% leasing finance *eco$es popular and effecti'e financial sources for $ost of t&e
*usiness concerns. >it& t&e i$portance of lease finance% no( a da#s *an/s and financial
institutions pro'ide leasing financial assistance to t&e industrial concern. T&e follo(ing
institutions are fa$ous and (idel# pro'iding lease finance in India:
6easing financial institutions in India $a# *e classified into t&e follo(ing groups.
6easing Institutions
.u*lic Sector .ri'ate Sector
6easing Institutions 6easing Institutions
6easing *# 6easing Finance 6easing *#
"e'elop$ent Speciali5ed Co$pan# Co$pan#
Institutions Institutions
Fig. !2.! easing 1nstitutions
6easing *# "e'elop$ent Institutions
All India de'elop$ent institutions are pro'iding leasing finance assistance to industrial
concerns. So$e of t&e pu*lic sector leasing finance co$pan# in India are follo(s:
Industrial Credit : In'est$ent Corporation of India ,ICICI-
Industrial Finance Corporation of India ,IFCI-
Industrial In'est$ent Ban/ of India ,IIBI-
S$all Industries "e'elop$ent Corporation ,SI"C-
State Industrial In'est$ent Corporation ,SIIC-
6easing *# Speciali5ed Institutions
Speciali5ed financial institutions also pro'ide lease finance to t&e industrial concern.
So$e of t&e lease finance pro'iding institutions are as follo(s:
6ife Insurance Corporation of India ,6IC-
0eneral Insurance Corporation of India ,0IC-
Unit Trust of India ,UTI-
Eousing "e'elop$ent Finance Corporation of India ,E"FC-
Private !ector $easin- Co)pan.
.ri'ate sector leasing co$panies also pro'ide financial assistance to t&e industrial
concerns. T&e follo(ing are t&e e8a$ple of t&e pri'ate sector leasing co$panies in India:
E8press 6easing 6i$ited
;Bt& Centur# 6easing Corporation 6td.
First 6easing Co$pan# of India
Ma5da 6easing 6i$ited
0ro'er 6easing 6i$ited
Private !ector Financial Co)pan.
.ri'ate sector financial co$panies also in'ol'e in t&e field of leasing finance. T&e
follo(ing are t&e e8a$ple of t&e pri'ate sector finance co$panies:
C&ola$andal In'est$ent and Finance Co$pan# 6td.
"cl Finance 6i$ited
Sundara$ Finance 6i$ited
Anagra$ Finance 6i$ited
Nagar+una Finance 6i$ited.
'PER#"IN, $E#!E
An operating lease (or/s on a si$ilar *asis to standard leasing% e8cept t&at it is *ased on
s&orter-ter$ contractsK and one ite$ $a# *e leased se'eral ti$es o'er its lifespan.
Alt&oug& it is not as ta8 efficient as standard leasing% it does $a/e it easier if #our
*usiness needs to regularl# update its e)uip$entK or &as 'ar#ing le'els of de$and and
often needs )uic/ capacit# increases.
An operating lease is si$ilar to a standard leasing agree$ent% &o(e'er it is usuall# *ased
on $uc& s&orter ter$s. T&e idea of an operating lease is t&at t&e product is sold or re-
leased to anot&er co$pan# at t&e end of t&e agree$entK t&is $eans t&at t&e# do not need
to reco'er t&e full cost of t&e ite$ ,$eaning c&eaper $ont&l# pa#$ents-.
T&is t#pe of lease is less co$$on% *ut is often a'aila*le for products (&ere t&ere is a
strong $ar/et for second &and e)uip$ent ,Mainl# 'e&icles-. T&e lengt& of an operating
lease is s&orter t&an a standard lease% it can run for a nu$*er of #ears% *ut (ill nor$all#
*e for considera*l# less t&an t&e lifespan of t&e product to ensure re-selling or re-leasing.
!'RCIN, 'F FIN#NCE
IN"R'DC"I'N
Finance is t&e life*lood of *usiness concern% *ecause it is interlin/ed (it& all acti'ities
perfor$ed *# t&e *usiness concern. In a &u$an *od#% if *lood circulation is not proper%
*od# function (ill stop. Si$ilarl#% if t&e finance not *eing properl# arranged% t&e *usiness
s#ste$ (ill stop. Arrange$ent of t&e re)uired finance to eac& depart$ent of *usiness
concern is &ig&l# a co$ple8 one and it needs careful decision. Uuantu$ of finance $a#
*e depending upon t&e nature and situation of t&e *usiness concern. But% t&e re)uire$ent
of t&e finance $a# *e *roadl# classified into t(o parts:
$on-/ter) Financial Re0uire)ents or Fi1ed Capital Re0uire)ent
Financial re)uire$ent of t&e *usiness differs fro$ fir$ to fir$ and t&e nature of t&e
re)uire$ents on t&e *asis of ter$s or period of financial re)uire$ent% it $a# *e long ter$
and s&ort-ter$ financial re)uire$ents.
6ong-ter$ financial re)uire$ent $eans t&e finance needed to ac)uire land and
*uilding for *usiness concern% purc&ase of plant and $ac&iner# and ot&er fi8ed
e8penditure. 6ong-ter$ financial re)uire$ent is also called as fi8ed capital re)uire$ents.
Fi8ed capital is t&e capital% (&ic& is used to purc&ase t&e fi8ed assets of t&e fir$s suc& as
land and *uilding% furniture and fittings% plant and $ac&iner#% etc. Eence% it is also called
a capital e8penditure.
!+ort/ter) Financial Re0uire)ents or 2or3in- Capital Re0uire)ent
Apart fro$ t&e capital e8penditure of t&e fir$s% t&e fir$s s&ould need certain e8penditure
li/e procure$ent of ra( $aterials% pa#$ent of (ages% da#-to-da# e8penditures% etc. T&is
/ind of e8penditure is to $eet (it& t&e &elp of s&ort-ter$ financial re)uire$ents (&ic&
(ill $eet t&e operational e8penditure of t&e fir$s. S&ort-ter$ financial re)uire$ents are
popularl# /no(n as (or/ing capital.
!'RCE! 'F FIN#NCE
Sources of finance $ean t&e (a#s for $o*ili5ing 'arious ter$s of finance to t&e
industrial concern. Sources of finance state t&at% &o( t&e co$panies are $o*ili5ing
finance for t&eir re)uire$ents. T&e co$panies *elong to t&e e8isting or t&e ne( (&ic&
need su$ a$ount of finance to $eet t&e long-ter$ and s&ort-ter$ re)uire$ents suc& as
purc&asing of fi8ed assets% construction of office *uilding% purc&ase of ra( $aterials and
da#-to-da# e8penses.
Sources of finance $a# *e classified under 'arious categories according to t&e
follo(ing i$portant &eads:
1. 4ased on t+e Period
Sources of Finance $a# *e classified under 'arious categories *ased on t&e
period.
6ong-ter$ sources: Finance $a# *e $o*ili5ed *# long-ter$ or s&ort-ter$. >&en
t&e finance $o*ili5ed (it& large a$ount and t&e repa#a*le o'er t&e period (ill *e
$ore t&an fi'e #ears% it $a# *e considered as long-ter$ sources. S&are capital%
issue of de*enture% long-ter$ loans fro$ financial institutions and co$$ercial
*an/s co$e under t&is /ind of source of finance. 6ong-ter$ source of finance
needs to $eet t&e capital e8penditure of t&e fir$s suc& as purc&ase of fi8ed
assets% land and *uildings% etc.
6ong-ter$ sources of finance include:
E)uit# S&ares
.reference S&ares
"e*enture
6ong-ter$ 6oans
Fi8ed "eposits
S&ort-ter$ sources: Apart fro$ t&e long-ter$ source of finance% fir$s can
generate finance (it& t&e &elp of s&ort-ter$ sources li/e loans and ad'ances fro$
co$$ercial *an/s% $one#lenders% etc. S&ort-ter$ source of finance needs to $eet
t&e operational e8penditure of t&e *usiness concern.
S&ort-ter$ source of finance include:
Ban/ Credit
Custo$er Ad'ances
Trade Credit
Factoring
.u*lic "eposits
Mone# Mar/et Instru$ents
2. 4ased on '5ners+ip
Sources of Finance $a# *e classified under 'arious categories *ased on t&e
period:
An o(ners&ip source of finance include
S&ares capital% earnings
etained earnings
Surplus and .rofits
Borro(ed capital include
"e*enture
Bonds
.u*lic deposits
6oans fro$ Ban/ and Financial Institutions.
3. 4ased on !ources of ,eneration
Sources of Finance $a# *e classified into 'arious categories *ased on t&e period.
Internal source of finance includes
etained earnings
"epreciation funds
Surplus
E8ternal sources of finance $a# *e include
S&are capital
"e*enture
.u*lic deposits
6oans fro$ Ban/s and Financial institutions
6. 4ased in &ode of Finance !ecurit. finance )a. be include
S&ares capital
"e*enture
etained earnings $a# include
etained earnings
"epreciation funds
6oan finance $a# include
6ong-ter$ loans fro$ Financial Institutions
S&ort-ter$ loans fro$ Co$$ercial *an/s.
T&e a*o'e classifications are *ased on t&e nature and &o( t&e finance is $o*ili5ed
fro$ 'arious sources. But t&e a*o'e sources of finance can *e di'ided into t&ree $a+or
classifications:
Securit# Finance
Internal Finance
6oans Finance
!ECRI"7 FIN#NCE
If t&e finance is $o*ili5ed t&roug& issue of securities suc& as s&ares and de*enture% it is
called as securit# finance. It is also called as corporate securities. T&is t#pe of finance
pla#s a $a+or role in t&e field of deciding t&e capital structure of t&e co$pan#.
C+aracters of !ecurit. Finance
Securit# finance consists of t&e follo(ing i$portant c&aracters:
1. 6ong-ter$ sources of finance.
;. It is also called as corporate securities.
<. Securit# finance includes *ot& s&ares and de*entures.
D. It pla#s a $a+or role in deciding t&e capital structure of t&e co$pan#.
A. epa#$ent of finance is 'er# li$ited.
F. It is a $a+or part of t&e co$pan#@s total capitali5ation.
".pes of !ecurit. Finance
Securit# finance $a# *e di'ided into t(o $a+or t#pes:
1. !(ners&ip securities or capital stoc/.
;. Creditors&ip securities or de*t capital.
'5ners+ip !ecurities
T&e o(ners&ip securities also called as capital stoc/% is co$$onl# called as s&ares.
S&ares are t&e $ost Uni'ersal $et&od of raising finance for t&e *usiness concern.
!(ners&ip capital consists of t&e follo(ing t#pes of securities.
E)uit# S&ares
.reference S&ares
No par stoc/
"eferred S&ares
E8I"7 !9#RE!
E)uit# S&ares also /no(n as ordinar# s&ares% (&ic& $eans% ot&er t&an preference s&ares.
E)uit# s&are&olders are t&e real o(ners of t&e co$pan#. T&e# &a'e a control o'er t&e
$anage$ent of t&e co$pan#. E)uit# s&are&olders are eligi*le to get di'idend if t&e
co$pan# earns profit. E)uit# s&are capital cannot *e redee$ed during t&e lifeti$e of t&e
co$pan#. T&e lia*ilit# of t&e e)uit# s&are&olders is t&e 'alue of unpaid 'alue of s&ares.
Features of E0uit. !+ares
E)uit# s&ares consist of t&e follo(ing i$portant features:
1. Maturit# of t&e s&ares: E)uit# s&ares &a'e per$anent nature of capital% (&ic& &as
no $aturit# period. It cannot *e redee$ed during t&e lifeti$e of t&e co$pan#.
;. esidual clai$ on inco$e: E)uit# s&are&olders &a'e t&e rig&t to get inco$e left
after pa#ing fi8ed rate of di'idend to preference s&are&older. T&e earnings or t&e
inco$e a'aila*le to t&e s&are&olders is e)ual to t&e profit after ta8 $inus
preference di'idend.
<. esidual clai$s on assets: If t&e co$pan# (ound up% t&e ordinar# or e)uit#
s&are&olders &a'e t&e rig&t to get t&e clai$s on assets. T&ese rig&ts are onl#
a'aila*le to t&e e)uit# s&are&olders.
D. ig&t to control: E)uit# s&are&olders are t&e real o(ners of t&e co$pan#. Eence%
t&e# &a'e po(er to control t&e $anage$ent of t&e co$pan# and t&e# &a'e po(er
to ta/e an# decision regarding t&e *usiness operation.
A. 7oting rig&ts: E)uit# s&are&olders &a'e 'oting rig&ts in t&e $eeting of t&e
co$pan# (it& t&e &elp of 'oting rig&t po(erK t&e# can c&ange or re$o'e an#
decision of t&e *usiness concern. E)uit# s&are&olders onl# &a'e 'oting rig&ts in
t&e co$pan# $eeting and also t&e# can no$inate pro8# to participate and 'ote in
t&e $eeting instead of t&e s&are&older.
F. .re-e$pti'e rig&t: E)uit# s&are&older pre-e$pti'e rig&ts. T&e pre-e$pti'e rig&t is
t&e legal rig&t of t&e e8isting s&are&olders. It is attested *# t&e co$pan# in t&e
first opportunit# to purc&ase additional e)uit# s&ares in proportion to t&eir current
&olding capacit#.
H. 6i$ited lia*ilit#: E)uit# s&are&olders are &a'ing onl# li$ited lia*ilit# to t&e 'alue
of s&ares t&e# &a'e purc&ased. If t&e s&are&olders are &a'ing full# paid up s&ares%
t&e# &a'e no lia*ilit#. For e8a$ple: If t&e s&are&older purc&ased 1BB s&ares (it&
t&e face 'alue of s. 1B eac&. Ee paid onl# s. JBB. Eis lia*ilit# is onl# s. 1BB.
Total nu$*er of s&ares 1BB
Face 'alue of s&ares s. 1B
Total 'alue of s&ares 1BB Y 1B Q 1%BBB
.aid up 'alue of s&ares JBB
Unpaid 'alue9lia*ilit# 1BB
6ia*ilit# of t&e s&are&olders is onl# unpaid 'alue of t&e s&are ,t&at is s. 1BB-.
#dvanta-es of E0uit. !+ares
E)uit# s&ares are t&e $ost co$$on and uni'ersall# used s&ares to $o*ili5e finance for
t&e co$pan#. It consists of t&e follo(ing ad'antages.
1. .er$anent sources of finance: E)uit# s&are capital is *elonging to long-ter$
per$anent nature of sources of finance% &ence% it can *e used for long-ter$ or
fi8ed capital re)uire$ent of t&e *usiness concern.
;. 7oting rig&ts: E)uit# s&are&olders are t&e real o(ners of t&e co$pan# (&o &a'e
'oting rig&ts. T&is t#pe of ad'antage is a'aila*le onl# to t&e e)uit# s&are&olders.
<. No fi8ed di'idend: E)uit# s&ares do not create an# o*ligation to pa# a fi8ed rate
of di'idend. If t&e co$pan# earns profit% e)uit# s&are&olders are eligi*le for
profit% t&e# are eligi*le to get di'idend ot&er(ise% and t&e# cannot clai$ an#
di'idend fro$ t&e co$pan#.
D. 6ess cost of capital: Cost of capital is t&e $a+or factor% (&ic& affects t&e 'alue of
t&e co$pan#. If t&e co$pan# (ants to increase t&e 'alue of t&e co$pan#% t&e#
&a'e to use $ore s&are capital *ecause% it consists of less cost of capital ,P
e
-
(&ile co$pared to ot&er sources of finance.
A. etained earnings: >&en t&e co$pan# &a'e $ore s&are capital% it (ill *e suita*le
for retained earnings (&ic& is t&e less cost sources of finance (&ile co$pared to
ot&er sources of finance.
Disadvanta-es of E0uit. !+ares
1. Irredee$a*le: E)uit# s&ares cannot *e redee$ed during t&e lifeti$e of t&e
*usiness concern. It is t&e $ost dangerous t&ing of o'er capitali5ation.
;. !*stacles in $anage$ent: E)uit# s&are&older can put o*stacles in $anage$ent
*# $anipulation and organi5ing t&e$sel'es. Because% t&e# &a'e po(er to contrast
an# decision (&ic& are against t&e (ealt& of t&e s&are&olders.
<. 6eads to speculation: E)uit# s&ares dealings in s&are $ar/et lead to secularis$
during prosperous periods.
D. 6i$ited inco$e to in'estor: T&e In'estors (&o desire to in'est in safe securities
(it& a fi8ed inco$e &a'e no attraction for e)uit# s&ares.
A. No trading on e)uit#:>&en t&e co$pan# raises capital onl# (it& t&e &elp of
e)uit#% t&e co$pan# cannot ta/e t&e ad'antage of trading on e)uit#.
PREFERENCE !9#RE!
T&e parts of corporate securities are called as preference s&ares. It is t&e s&ares% (&ic&
&a'e preferential rig&t to get di'idend and get *ac/ t&e initial in'est$ent at t&e ti$e of
(inding up of t&e co$pan#. .reference s&are&olders are eligi*le to get fi8ed rate of
di'idend and t&e# do not &a'e 'oting rig&ts.
.reference s&ares $a# *e classified into t&e follo(ing $a+or t#pes:
1. Cu$ulati'e preference s&ares: Cu$ulati'e preference s&ares &a'e rig&t to clai$
di'idends for t&ose #ears (&ic& &a'e no profits. If t&e co$pan# is una*le to earn
profit in an# one or $ore #ears% C... S&ares are una*le to get an# di'idend *ut
t&e# &a'e rig&t to get t&e co$parati'e di'idend for t&e pre'ious #ears if t&e
co$pan# earned profit.
;. Non-cu$ulati'e preference s&ares: Non-cu$ulati'e preference s&ares &a'e no
rig&t to en+o# t&e a*o'e *enefits. T&e# are eligi*le to get onl# di'idend if t&e
co$pan# earns profit during t&e #ears. !t&er(ise% t&e# cannot clai$ an#
di'idend.
<. edee$a*le preference s&ares: >&en% t&e preference s&ares &a'e a fi8ed $aturit#
period it *eco$es redee$a*le preference s&ares. It can *e redee$a*le during t&e
lifeti$e of t&e co$pan#. T&e Co$pan# Act &as pro'ided certain restrictions on
t&e return of t&e redee$a*le preference s&ares.
Irredee)able Preference !+ares
Irredee$a*le preference s&ares can *e redee$ed onl# (&en t&e co$pan# goes for
li)uidator. T&ere is no fi8ed $aturit# period for suc& /ind of preference s&ares.
Participatin- Preference !+ares
.articipating preference s&ares&olders &a'e rig&t to participate e8tra profits after
distri*uting t&e e)uit# s&are&olders.
Non/Participatin- Preference !+ares
Non-participating preference s&ares&olders are not &a'ing an# rig&t to participate e8tra
profits after distri*uting to t&e e)uit# s&are&olders. Fi8ed rate of di'idend is pa#a*le to
t&e t#pe of s&are&olders.
Convertible Preference !+ares
Con'erti*le preference s&ares&olders &a'e rig&t to con'ert t&eir &olding into e)uit#
s&ares after a specific period. T&e articles of association $ust aut&ori5e t&e rig&t of
con'ersion.
Non/convertible Preference !+ares
T&ere s&ares% cannot *e con'erted into e)uit# s&ares fro$ preference s&ares.
Features of Preference !+ares
T&e follo(ing are t&e i$portant features of t&e preference s&ares:
1. Maturit# period: Nor$all# preference s&ares &a'e no fi8ed $aturit# period e8cept
in t&e case of redee$a*le preference s&ares. .reference s&ares can *e redee$a*le
onl# at t&e ti$e of t&e co$pan# li)uidation.
;. esidual clai$s on inco$e: .referential s&ares&olders &a'e a residual clai$ on
inco$e. Fi8ed rate of di'idend is pa#a*le to t&e preference s&are&olders.
<. esidual clai$s on assets: T&e first preference is gi'en to t&e preference
s&are&olders at t&e ti$e of li)uidation. If an# e8tra Assets are a'aila*le t&at
s&ould *e distri*uted to e)uit# s&are&older.
D. Control of Manage$ent: .reference s&are&older does not &a'e an# 'oting rig&ts.
Eence% t&e# cannot &a'e control o'er t&e $anage$ent of t&e co$pan#.
#dvanta-es of Preference !+ares
.reference s&ares &a'e t&e follo(ing i$portant ad'antages.
1. Fi8ed di'idend: T&e di'idend rate is fi8ed in t&e case of preference s&ares. It is
called as fi8ed inco$e securit# *ecause it pro'ides a constant rate of inco$e to
t&e in'estors.
;. Cu$ulati'e di'idends: .reference s&ares &a'e anot&er ad'antage (&ic& is called
cu$ulati'e di'idends. If t&e co$pan# does not earn an# profit in an# pre'ious
#ears% it can *e cu$ulati'e (it& future period di'idend.
<. ede$ption: .reference S&ares can *e redee$a*le after a specific period e8cept
in t&e case of irredee$a*le preference s&ares. T&ere is a fi8ed $aturit# period for
repa#$ent of t&e initial in'est$ent.
D. .articipation: .articipati'e preference s&ares&olders can participate in t&e surplus
profit after distri*ution to t&e e)uit# s&are&olders.
A. Con'erti*ilit#: Con'erti*ilit# preference s&ares can *e con'erted into e)uit#
s&ares (&en t&e articles of association pro'ide suc& con'ersion.
Disadvanta-es of Preference !+ares
1. E8pensi'e sources of finance: .reference s&ares &a'e &ig& e8pensi'e source of
finance (&ile co$pared to e)uit# s&ares.
;. No 'oting rig&t: 0enerall# preference s&ares&olders do not &a'e an# 'oting rig&ts.
Eence t&e# cannot &a'e t&e control o'er t&e $anage$ent of t&e co$pan#.
<. Fi8ed di'idend onl#: .reference s&ares can get onl# fi8ed rate of di'idend. T&e#
$a# not en+o# $ore profits of t&e co$pan#.
D. .er$anent *urden: Cu$ulati'e preference s&ares *eco$e a per$anent *urden so
far as t&e pa#$ent of di'idend is concerned. Because t&e co$pan# $ust pa# t&e
di'idend for t&e unprofita*le periods also.
A. Ta8ation: In t&e ta8ation point of 'ie(% preference s&ares di'idend is not a
deducti*le e8pense (&ile calculating ta8. But% interest is a deducti*le e8pense.
Eence% it &as disad'antage on t&e ta8 deduction point of 'ie(.
DEFERRED !9#RE!
"eferred s&ares also called as founder s&ares *ecause t&ese s&ares (ere nor$all# issued
to founders. T&e s&are&olders &a'e a preferential rig&t to get di'idend *efore t&e
preference s&ares and e)uit# s&ares. According to Co$panies Act 1JAF no pu*lic li$ited
co$pan# or (&ic& is a su*sidiar# of a pu*lic co$pan# can issue deferred s&ares.
T&ese s&ares (ere issued to t&e founder at s$all deno$ination to control o'er t&e
$anage$ent *# t&e 'irtue of t&eir 'oting rig&ts.
N' P#R !9#RE!
>&en t&e s&ares are &a'ing no face 'alue% it is said to *e no par s&ares. T&e co$pan#
issues t&is /ind of s&ares (&ic& is di'ided into a nu$*er of specific s&ares (it&out an#
specific deno$ination. T&e 'alue of s&ares can *e $easured *# di'iding t&e real net
(ort& of t&e co$pan# (it& t&e total nu$*er of s&ares.
T&e real net (ort&
7alue of no. per s&are Q
Total no.of s&ares
CE"IT!SEI. SECUITIES
Creditors&ip Securities also /no(n as de*t finance (&ic& $eans t&e finance is $o*ili5ed fro$
t&e creditors. "e*enture and Bonds are t&e t(o $a+or parts of t&e Creditors&ip Securities.
"e*entures
A "e*enture is a docu$ent issued *# t&e co$pan#. It is a certificate issued *# t&e co$pan#
under its seal ac/no(ledging a de*t.
According to t&e Co$panies Act 1JAF% 3de*enture includes de*enture stoc/% *onds and an#
ot&er securities of a co$pan# (&et&er constituting a c&arge of t&e assets of t&e co$pan# or not.4
T#pes of "e*entures
"e*entures $a# *e di'ided into t&e follo(ing $a+or t#pes:
1. Unsecured de*entures: Unsecured de*entures are not gi'en an# securit# on assets of t&e
co$pan#. It is also called si$ple or na/ed de*entures. T&is t#pe of de*entures are
treaded as unsecured creditors at t&e ti$e of (inding up of t&e co$pan#.
;. Secured de*entures: Secured de*entures are gi'en securit# on assets of t&e co$pan#. It is
also called as $ortgaged de*entures *ecause t&ese de*entures are gi'en against an#
$ortgage of t&e assets of t&e co$pan#.
<. edee$a*le de*entures: T&ese de*entures are to *e redee$ed on t&e e8pir# of a certain
period. T&e interest is paid periodicall# and t&e initial in'est$ent is returned after t&e
fi8ed $aturit# period.
D. Irredee$a*le de*entures: T&ese /ind of de*entures cannot *e redee$a*le during t&e life
ti$e of t&e *usiness concern.
A. Con'erti*le de*entures: Con'erti*le de*entures are t&e de*entures (&ose &olders &a'e
t&e option to get t&e$ con'erted (&oll# or partl# into s&ares. T&ese de*entures are
usuall# con'erted into e)uit# s&ares. Con'ersion of t&e de*entures $a# *e:
Non-con'erti*le de*entures Full#
con'erti*le de*entures .artl#
con'erti*le de*entures
F. !t&er t#pes: "e*entures can also *e classified into t&e follo(ing t#pes. So$e of t&e
co$$on t#pes of t&e de*entures are as follo(s:
1. Collateral "e*enture
;. 0uaranteed "e*enture
<. First "e*enture
D. Oero Coupon Bond
A. Oero Interest Bond9"e*enture
Features of "e*entures
1. Maturit# period: "e*entures consist of long-ter$ fi8ed $aturit# period. Nor$all#%
de*entures consist of 1B;B #ears $aturit# period and are repa#a*le (it& t&e principle
in'est$ent at t&e end of t&e $aturit# period.
;. esidual clai$s in inco$e: "e*enture &olders are eligi*le to get fi8ed rate of interest at
e'er# end of t&e accounting period. "e*enture &olders &a'e priorit# of clai$ in inco$e
of t&e co$pan# o'er e)uit# and preference s&are&olders.
<. esidual clai$s on asset: "e*enture &olders &a'e priorit# of clai$s on Assets of t&e
co$pan# o'er e)uit# and preference s&are&olders. T&e "e*enture &olders $a# &a'e
eit&er specific c&ange on t&e Assets or floating c&ange of t&e assets of t&e co$pan#.
Specific c&ange of "e*enture &olders are treated as secured creditors and floating c&ange
of "e*enture &olders are treated as unsecured creditors.
D. No 'oting rig&ts: "e*enture &olders are considered as creditors of t&e co$pan#. Eence
t&e# &a'e no 'oting rig&ts. "e*enture &olders cannot &a'e t&e control o'er t&e
perfor$ance of t&e *usiness concern.
A. Fi8ed rate of interest: "e*entures #ield fi8ed rate of interest till t&e $aturit# period.
Eence t&e *usiness (ill not affect t&e #ield of t&e de*enture.
Ad'antages of "e*enture
"e*enture is one of t&e $a+or parts of t&e long-ter$ sources of finance (&ic& of consists t&e
follo(ing i$portant ad'antages:
1. 6ong-ter$ sources: "e*enture is one of t&e long-ter$ sources of finance to t&e co$pan#.
Nor$all# t&e $aturit# period is longer t&an t&e ot&er sources of finance.
;. Fi8ed rate of interest: Fi8ed rate of interest is pa#a*le to de*enture &olders% &ence it is
$ost suita*le of t&e co$panies earn &ig&er profit. 0enerall#% t&e rate of interest is lo(er
t&an t&e ot&er sources of long-ter$ finance.
<. Trade on e)uit#: A co$pan# can trade on e)uit# *# $i8ing de*entures in its capital
structure and t&ere*# increase its earning per s&are. >&en t&e co$pan# appl# t&e trade
on e)uit# concept% cost of capital (ill reduce and 'alue of t&e co$pan# (ill increase.
D. Inco$e ta8 deduction: Interest pa#a*le to de*entures can *e deducted fro$ t&e total
profit of t&e co$pan#. So it &elps to reduce t&e ta8 *urden of t&e co$pan#.
A. .rotection: 7arious pro'isions of t&e de*enture trust deed and t&e guidelines issued *#
t&e SEB1 protect t&e interest of de*enture &olders.
"isad'antages of "e*enture
"e*enture finance consists of t&e follo(ing $a+or disad'antages:
1. Fi8ed rate of interest: "e*enture consists of fi8ed rate of interest pa#a*le to securities.
E'en t&oug& t&e co$pan# is una*le to earn profit% t&e# &a'e to pa# t&e fi8ed rate of
interest to de*enture &olders% &ence% it is not suita*le to t&ose co$pan# earnings (&ic&
fluctuate considera*l#.
;. No 'oting rig&ts: "e*enture &olders do not &a'e an# 'oting rig&ts. Eence% t&e# cannot
&a'e t&e control o'er t&e $anage$ent of t&e co$pan#.
<. Creditors of t&e co$pan#: "e*enture &olders are $erel# creditors and not t&e o(ners of
t&e co$pan#. T&e# do not &a'e an# clai$ in t&e surplus profits of t&e co$pan#.
D. Eig& ris/: E'er# additional issue of de*entures *eco$es $ore ris/# and costl# on
account of &ig&er e8pectation of de*enture &olders. T&is en&anced financial ris/
increases t&e cost of e)uit# capital and t&e cost of raising finance t&roug& de*entures
(&ic& is also &ig& *ecause of &ig& sta$p dut#.
A. estrictions of furt&er issues: T&e co$pan# cannot raise furt&er finance t&roug&
de*entures as t&e de*entures are under t&e part of securit# of t&e assets alread#
$ortgaged to de*enture &olders.
INTENA6 FINANCE
A co$pan# can $o*ili5e finance t&roug& e8ternal and internal sources. A ne( co$pan# $a# not
raise internal sources of finance and t&e# can raise finance onl# e8ternal sources suc& as s&ares%
de*entures and loans *ut an e8isting co$pan# can raise *ot& internal and e8ternal sources of
finance for t&eir financial re)uire$ents. Internal finance is also one of t&e i$portant sources of
finance and it consists of cost of capital (&ile co$pared to ot&er sources of finance.
Internal source of finance $a# *e *roadl# classified into t(o categories:
A. "epreciation Funds
B. etained earnings
"epreciation Funds
"epreciation funds are t&e $a+or part of internal sources of finance% (&ic& is used to $eet t&e
(or/ing capital re)uire$ents of t&e *usiness concern. "epreciation $eans decrease in t&e 'alue
of asset due to (ear and tear% lapse of ti$e% o*solescence% e8&austion and accident. 0enerall#
depreciation is c&anged against fi8ed assets of t&e co$pan# at fi8ed rate for e'er# #ear. T&e
purpose of depreciation is replace$ent of t&e assets after t&e e8pired period. It is one /ind of
pro'ision of fund% (&ic& is needed to reduce t&e ta8 *urden and o'erall profita*ilit# of t&e
co$pan#.
etained Earnings
etained earnings are anot&er $et&od of internal sources of finance. Actuall# is not a $et&od of
raising finance% *ut it is called as accu$ulation of profits *# a co$pan# for its e8pansion and
di'ersification acti'ities.
etained earnings are called under different na$es suc& asK self-finance% inter finance% and
plugging *ac/ of profits. According to t&e Co$panies Act 1JAF certain percentage% as prescri*ed
*# t&e central go'ern$ent ,not e8ceeding 1BR- of t&e net profits after ta8 of a financial #ear
&a'e to *e co$pulsoril# transferred to reser'e *# a co$pan# *efore declaring di'idends for t&e
#ear.
Under t&e retained earnings sources of finance% a part of t&e total profits is transferred to
'arious reser'es suc& as general reser'e% replace$ent fund% reser'e for repairs and rene(als%
reser'e funds and secrete reser'es% etc.
Ad'antages of etained Earnings
etained earnings consist of t&e follo(ing i$portant ad'antages:
1. Useful for e8pansion and di'ersification: etained earnings are $ost useful to e8pansion
and di'ersification of t&e *usiness acti'ities.
;. Econo$ical sources of finance: etained earnings are one of t&e least costl# sources of
finance since it does not in'ol'e an# floatation cost as in t&e case of raising of funds *#
issuing different t#pes of securities.
<. No fi8ed o*ligation: If t&e co$panies use e)uit# finance t&e# &a'e to pa# di'idend and if
t&e co$panies use de*t finance% t&e# &a'e to pa# interest. But if t&e co$pan# uses
retained earnings as sources of finance% t&e# need not pa# an# fi8ed o*ligation regarding
t&e pa#$ent of di'idend or interest.
D. Fle8i*le sources: etained earnings allo( t&e financial structure to re$ain co$pletel#
fle8i*le. T&e co$pan# need not raise loans for furt&er re)uire$ents% if it &as retained
earnings.
A. Increase t&e s&are 'alue: >&en t&e co$pan# uses t&e retained earnings as t&e sources of
finance for t&eir financial re)uire$ents% t&e cost of capital is 'er# c&eaper t&an t&e ot&er
sources of financeK Eence t&e 'alue of t&e s&are (ill increase.
F. A'oid e8cessi'e ta8: etained earnings pro'ide opportunities for e'asion of e8cessi'e ta8
in a co$pan# (&en it &as s$all nu$*er of s&are&olders.
H. Increase earning capacit#: etained earnings consist of least cost of capital and also it is
$ost suita*le to t&ose co$panies (&ic& go for di'ersification and e8pansion.
"isad'antages of etained Earnings
etained earnings also &a'e certain disad'antages:
1. Misuses: T&e $anage$ent *# $anipulating t&e 'alue of t&e s&ares in t&e stoc/ $ar/et
can $isuse t&e retained earnings.
;. 6eads to $onopolies: E8cessi'e use of retained earnings leads to $onopolistic attitude of
t&e co$pan#.
<. !'er capitali5ation: etained earnings lead to o'er capitali5ation% *ecause if t&e co$pan#
uses $ore and $ore retained earnings% it leads to insufficient source of finance.
D. Ta8 e'asion: etained earnings lead to ta8 e'asion. Since% t&e co$pan# reduces ta8
*urden t&roug& t&e retained earnings.
A. "issatisfaction: If t&e co$pan# uses retained earnings as sources of finance% t&e
s&are&older can@t get $ore di'idends. So% t&e s&are&older does not li/e to use t&e
retained earnings as source of finance in all situations.
6!AN FINANCIN0
6oan financing is t&e i$portant $ode of finance raised *# t&e co$pan#. 6oan finance $a# *e
di'ided into t(o t#pes:
,a- 6ong-Ter$ Sources
,*- S&ort-Ter$ Sources
6oan finance can *e raised t&roug& t&e follo(ing i$portant institutions.
6oan Financing Institutions
Co$$ercial Ban/s "e'elop$ent Ban/s Specialist Institutions
S&ort-ter$ 6ong-ter$ "irect Indirect "o$estic
Foreign
Currenc#
Ad'ance 6oans Finance Finance Finance
Finance
Fig. 3.! oan Financing
Financial Institutions
>it& t&e effect of t&e industrial re'aluation% t&e go'ern$ent esta*lis&ed nation (ide and state
(ise financial industries to pro'ide long-ter$ financial assistance to industrial concerns in t&e
countr#. Financial institutions pla# a /e# role in t&e field of industrial de'elop$ent and t&e# are
$eeting t&e financial re)uire$ents of t&e *usiness concern. IFCI% ICICI% I"BI% SFC% ENIM
Ban/% EC0C are t&e fa$ous financial institutions in t&e countr#.
Co$$ercial Ban/s
Co$$ercial Ban/s nor$all# pro'ide s&ort-ter$ finance (&ic& is repa#a*le (it&in a #ear. T&e
$a+or finance of co$$ercial *an/s is as follo(s:
S&ort-ter$ ad'ance: Co$$ercial *an/s pro'ide ad'ance to t&eir custo$ers (it& or (it&out
securities. It is one of t&e $ost co$$on and (idel# used s&ort-ter$ sources of finance% (&ic&
are needed to $eet t&e (or/ing capital re)uire$ent of t&e co$pan#.
It is a c&eap source of finance% (&ic& is in t&e for$ of pledge% $ortgage% &#pot&ecation and
*ills discounted and rediscounted.
S&ort-ter$ 6oans
Co$$ercial *an/s also pro'ide loans to t&e *usiness concern to $eet t&e s&ort-ter$ financial
re)uire$ents. >&en a *an/ $a/es an ad'ance in lu$p su$ against so$e securit# it is ter$ed as
loan. 6oan $a# *e in t&e follo(ing for$:
,a- Cas& credit: A cas& credit is an arrange$ent *# (&ic& a *an/ allo(s &is custo$er to
*orro( $one# up to certain li$it against t&e securit# of t&e co$$odit#.
,*- !'erdraft: !'erdraft is an arrange$ent (it& a *an/ *# (&ic& a current account &older is
allo(ed to (it&dra( $ore t&an t&e *alance to &is credit up to a certain li$it (it&out an#
securities.
"e'elop$ent Ban/s
"e'elop$ent *an/s (ere esta*lis&ed $ainl# for t&e purpose of pro$otion and de'elop$ent t&e
industrial sector in t&e countr#. .resentl#% large nu$*er of de'elop$ent *an/s are functioning
(it& $ultidi$ensional acti'ities. "e'elop$ent *an/s are also called as financial institutions or
statutor# financial institutions or statutor# non-*an/ing institutions. "e'elop$ent *an/s pro'ide
t(o i$portant t#pes of finance:
,a- "irect Finance
,*- Indirect Finance9efinance
So$e of t&e i$portant de'elop$ent *an/s are discussed in C&apter 11.
.resentl# t&e co$$ercial *an/s are pro'iding all /inds of financial ser'ices including
de'elop$ent-*an/ing ser'ices. And also no(ada#s de'elop$ent *an/s and specialisted financial
institutions are pro'iding all /inds of financial ser'ices including co$$ercial *an/ing ser'ices.
"i'ersified and glo*al financial ser'ices are una'oida*le to t&e present da# econo$ics. Eence%
(e can classif# t&e financial institutions onl# *# t&e structure and set up and not *# t&e ser'ices
pro'ided *# t&e$.
Section A
1. aising funds t&roug& ------- is c&eaper as co$pared to raising t&roug& s&ares.
;. .reference s&ares &a'e preferential rig&t as to ------------
<. ------ s&ares are not preference s&ares% t&e# do not carr# preferential rig&ts.
D. -------- $a# *e cu$ulati'e and non-cu$ulati'e% participating and non- participating%
redee$a*le and non- redee$a*le.
A. .reference s&ares add to t&e e)uit# *ase of t&e co$pan# and t&ere*# strengt& to its
----------
F. T&e rate of di'idend on e)uit# s&ares is not -----------
H. S&ares can *e issued at par% pre$iu$ or ------------
2. "e*enture is a certificate issued *# a co$pan# under its seal ac/no(ledging a de*t
due *# it% to its -----------
J. A lease agree$ent grants lessee t&e rig&t to ---------
1B. T&e e8penditure in capital asset is a ----------- in'est$ent
Section B
1. >rite a note on de*enture.
;. >&at is preference s&aresI
<. >&at are t&e t#pes of leasingI
D. >&at are t&e concepts of leasingI
A. Can #ou e8plain t&e t#pes of preference s&ares.
F. >&at is direct leasing and pri$ar#9secondar# leasingI
H. 0i'e t&e t#pes of de*entures.
2. Essential ele$ents of leasing.
J. Can #ou state t&e ad'antages and disad'antages of leasingI
1B. Finance is t&e life *lood of t&e *usiness e8plain
Section C
1. E8plain t&e 'arious for$s of long ter$
finance.
;. >&at are t&e $erits% de$erits and features of
leasingI
<. >&at is de*enture and (&at are t&e t#pes of
de*entures.
D. 6easing is *eneficial to *ot& t&e lessee as
(ell as lessor. E8a$ine
A. >&at are t&e ad'antages and disad'antages
of e)uit# s&aresI
F. E8plain in detail a*out (&at do #ou
understand on t&e ter$ lease financingI
H. Eo( (ill #ou differentiate a*out de*entures
and *ondsI
2. >&at are t&e t(o $ain categories of
financial re)uire$ents of *usinessI
J. E8plain in detail a*out t&e t#pes of s&ares.
1B. >&at are t&e $erits and de$erits of e)uit#
s&aresI
BUSINESS FINANCE

Unit I
Business Finance: Introduction Meaning Concepts -Scope Function of
Finance Traditional and Modern Concepts Contents of Modern Finance
Functions.
Unit II
Financial .lan: Meaning -Concept !*+ecti'es T#pes Steps Significance
Funda$entals.
Unit III
Capitali5ation -Bases of Capitali5ation Cost T&eor# Earning T&eor# !'er
Capitali5ation Under Capitali5ation: S#$pto$s Causes e$edies >atered
Stoc/ >atered Stoc/ 7s. !'er Capitali5ation.
Unit I7
Capital Structure Cardinal .rinciples of Capital structure Trading on E)uit#
Cost of Capital Concept I$portance Calculation of Indi'idual and Co$posite
Cost of Capital.
Unit 7
Sources and For$s of Finance: E)uit# S&ares% .reference S&ares% Bonds%
"e*entures and Fi8ed "eposits Features Ad'antages and "isad'antages-6ease
Financing: Meaning Features For$s Merits and "e$erits.