FINANCIAL MANAGEMENT

UNIT I: Environment of Business Finance:

Definition of Finance Definition of Business Finance, Definition of Financial
Management, Scope of Financial Management, Objectives of Financial
Management, Functions of Finance Manager, Importance of Financial
Management.

UNIT II: Working Capital Management:

Introduction, Meaning, Concept of Working Capital, Gross and Net working
capital, Component of working capital, Operating Cycle, Types of Working
Capital, Needs, Working capital position/Balanced working capital position,
Assessment of Working Capital Requirements, Computation (or Estimation) of
Working Capital, Working Capital Financing.

UNIT III: Capital Budgeting:

Introduction, Definitions, Need and importance, Process, Kinds of Capital
Budgeting Decisions, Methods of Capital Budgeting of Evaluation: Pay-back
period, Un even cash inflows, Post pay-back profitability method, Accounting
rate of return or Average rate of return, Net present value, Internal rate of return,
Excess present value index, Capital rationing, Risk and Uncertainly in Capital
Budgeting.

UNIT IV: Capital Structure and Firm Valuation:

Introduction, meaning Objectives, Forms, Financial Structure, Optimum Capital
Structure, , Factors Determining Capital Structure: Leverage (Types of
Leverage), Cost of capital, Capital Structure Theories, Traditional approach,
Assumptions, Net Income (NI) approach, Net Operating Income (NOI)
approach, Modigliani and Miller approach, WACC.

UNIT V: Dividend Decisions:

Introduction, meaning of dividend, Types of Dividends, Bonus shares, Right
shares, Dividend policies, Factors affecting dividend policies, dividend
decisions.
 UNIT I: Environment of Business Finance:

Definition of Finance:
In a personal context, personal finance is managing, saving, and investing one‘s
money. In a business setting, it handles acquiring funds for the business,
managing existing funds, and planning how to spend funds in the future.
Finally, for the public, finance refers to managing the government‘s activities
related to budgeting, spending, deficits, and taxation.
Business concern needs finance to meet their requirements in the economic
world. Any kind of business activity depends on the finance. Hence, it is called
as lifeblood of business organization. Whether the business concerns are big or
small, they need finance to fulfil their business activities. In the modern world,
all the activities are concerned with the economic activities and very particular
to earning profit through any venture or activities. The entire business activities
are directly related with making profit. (According to the economics concept of
factors of production, rent given to landlord, wage given to labour, interest
given to capital and profit given to shareholders or proprietors), a business
concern needs finance to meet all the requirements. Hence finance may be
called as capital, investment, fund etc., but each term is having different
meanings and unique characters. Increasing the profit is the main aim of any
kind of economic activity.

MEANING OF FINANCE
Finance may be defined as the art and science of managing money. It includes
financial service and financial instruments. Finance also is referred as the
provision of money at the time when it is needed. Finance function is the
procurement of funds and their effective utilization in business concerns. The
concept of finance includes capital, funds, money, and amount. But each word
is having unique meaning. Studying and understanding the concept of finance
become an important part of the business concern.

DEFINITION OF FINANCE

According to Khan and Jain, ―Finance is the art and science of managing
money‖.

According to Oxford dictionary, the word ‗finance‘ connotes ‗management of

money‘. Webster‘s Ninth New Collegiate Dictionary defines finance as ―the
Science on study of the management of funds‘ and the management of fund as
the system that includes the circulation of money, the granting of credit, the
making of investments, and the provision of banking facilities.
 Finance is the process of managing every money-related activity of
businesses, people, and governments
 Proper financing is necessary for an economy to function, deal with crises
and grow.
 There are three main types of finances: personal, corporate, and public.
 Some key financial terms worth remembering include assets, liabilities,
expenses, balance sheet, cash flow, net profit, etc.
 Top careers in finance can include an investment banker, hedge fund
manager, financial planner, accountant, chief financial officer, commercial
banker, etc.

Definition of Business Finance:

According to the Wheeler, ―Business finance is that business activity which

concerns with the acquisition and conversation of capital funds in meeting
financial needs and overall objectives of a business enterprise‖.

According to the Guthumann and Dougall, ―Business finance can broadly be

defined as the activity concerned with planning, raising, controlling,
administering of the funds used in the business‖.

In the words of Parhter and Wert, ―Business finance deals primarily with
raising, administering and disbursing funds by privately owned business units
operating in nonfinancial fields of industry‖.

Corporate finance is concerned with budgeting, financial forecasting, cash

management, credit administration, investment analysis and fund procurement
of the business concern and the business concern needs to adopt modern
technology and application suitable to the global environment.

According to the Encyclopedia of Social Sciences, ―Corporation finance deals

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

Definition of Financial Management

Financial management is an integral part of overall management. It is concerned
with the duties of the financial managers in the business firm.
The term financial management has been defined by Solomon, ―It is
concerned with the efficient use of an important economic resource namely,
capital funds‖.

The most popular and acceptable definition of financial management as given

by S.C. Kuchal is that ―Financial Management deals with procurement of
funds and their effective utilization in the business‖.

Howard and Upton : Financial management ―as an application of general

managerial principles to the area of financial decision-making.

Weston and Brigham : Financial management ―is an area of financial

decision- making, harmonizing individual motives and enterprise goals‖.

Joshep and Massie : Financial management ―is the operational activity of a

business that is responsible for obtaining and effectively utilizing the funds
necessary for efficient operations.

Thus, Financial Management is mainly concerned with the effective funds

management in the business. In simple words, Financial Management as
practiced by business firms can be called as Corporation Finance or Business
Finance.

Scope of Financial Management:

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

which is directly related with various functional departments like personnel,
marketing and production. Financial management covers wide area with
multidimensional approaches. The following are the important scope of
financial management.
1. Financial Management and Economics Economic concepts like micro and
macroeconomics are directly applied with the financial management
approaches. Investment decisions, micro and macro environmental factors are
closely associated with the functions of financial manager. Financial
management also uses the economic equations like money value discount
factor, economic order quantity etc. Financial economics is one of the emerging
area, which provides immense opportunities to finance, and economical areas.
2. Financial Management and Accounting Accounting records includes the
financial information of the business concern. Hence, we can easily understand
the relationship between the financial management and accounting. In the olden
periods, both financial management and accounting are treated as a same
discipline and then it has been merged as Management Accounting because this
part is very much helpful to finance manager to take decisions. But nowaday‘s
financial management and accounting discipline are separate and interrelated.
3. Financial Management or Mathematics Modern approaches of the financial
management applied large number of mathematical and statistical tools and
techniques. They are also called as econometrics. Economic order quantity,
discount factor, time value of money, present value of money, cost of capital,
capital structure theories, dividend theories, ratio analysis and working capital
analysis are used as mathematical and statistical tools and techniques in the field
of financial management.
4. Financial Management and Production Management Production management
is the operational part of the business concern, which helps to multiple the
money into profit. Profit of the concern depends upon the production
performance. Production performance needs finance, because production
department requires raw material, machinery, wages, operating expenses etc.
These expenditures are decided and estimated by the financial department and
the finance manager allocates the appropriate finance to production department.
The financial manager must be aware of the operational process and finance
required for each process of production activities.
5. Financial Management and Marketing Produced goods are sold in the market
with innovative and modern approaches. For this, the marketing department
needs finance to meet their requirements. The financial manager or finance
department is responsible to allocate the adequate finance to the marketing
department. Hence, marketing and financial management are interrelated and
depends on each other.
6. Financial Management and Human Resource Financial management is also
related with human resource department, which provides manpower to all the
functional areas of the management. Financial manager should carefully
evaluate the requirement of manpower to each department and allocate the
finance to the human resource department as wages, salary, remuneration,
commission, bonus, pension and other monetary benefits to the human resource
department. Hence, financial management is directly related with human
resource management.

Objectives of Financial Management:

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

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

1. Profit maximization is also called as cashing per share maximization. It leads

to maximize the business operation for profit maximization.
2. Ultimate aim of the business concern is earning profit, hence, it considers all
the possible ways to increase the profitability of the concern.
3. Profit is the parameter of measuring the efficiency of the business concern.
So it shows the entire position of the business concern.
4. Profit maximization objectives help to reduce the risk of the business.
Favourable Arguments for Profit Maximization

The following important points are in support of the profit maximization

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

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

Wealth maximization is also known as value maximization or net present worth

maximization.
This objective is an universally accepted concept in the field of business.
Favourable Arguments for Wealth Maximization
(i) Wealth maximization is superior to the profit maximization because the main
aim of the business concern under this concept is to improve the value or wealth
of the shareholders.
(ii) Wealth maximization considers the comparison of the value to cost
associated with the business concern. Total value detected from the total cost
incurred for the business operation. It provides extract value of the business
concern.
(iii) Wealth maximization considers both time and risk of the business concern.
(iv) Wealth maximization provides efficient allocation of resources.
(v) It ensures the economic interest of the society.

Functions of Finance Manager:

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

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

Finance manager performs the following major functions:

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

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

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

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

5. Interrelation with Other

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

Importance of Financial Management

Finance is the lifeblood of business organization. It needs to meet the requirement

of the business concern. Each and every business concern must maintain
adequate amount of finance for their smooth running of the business concern
and also maintain the business carefully to achieve the goal of the business
concern. The business goal can be achieved only with the help of effective
management of finance. We can‘t neglect the importance of finance at any time
at and at any situation. Some of the importance of the financial management is
as follows:

Financial Planning

Financial management helps to determine the financial requirement of the business

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

Acquisition of Funds

Financial management involves the acquisition of required finance to the business

concern. Acquiring needed funds play a major part of the financial management,
which involve possible source of finance at minimum cost.
Proper Use of Funds

Proper use and allocation of funds leads to improve the operational efficiency of
the business concern. When the finance manager uses the funds properly, they
can reduce the cost of capital and increase the value of the firm.

Financial Decision

Financial management helps to take sound financial decision in the business

concern. Financial decision will affect the entire business operation of the
concern. Because there is a direct relationship with various department
functions such as marketing, production personnel, etc.

Improve Profitability

Profitability of the concern purely depends on the effectiveness and proper

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

Increase the Value of the Firm

Financial management is very important in the field of increasing the wealth of

the investors and the business concern. Ultimate aim of any business concern
will achieve the maximum profit and higher profitability leads to maximize the
wealth of the investors as well as the nation.

Promoting Savings

Savings are possible only when the business concern earns higher profitability
and maximizing wealth. Effective financial management helps to promoting and
mobilizing individual and corporate savings.
 UNIT II: Working Capital Management:

Introduction and Meaning:

It has been often observed that the shortage of working capital leads to the
failure of a business. The proper management of working capital may bring
about the success of a business firm. The management of working capital
includes the management of current assets and current liabilities. A number of
companies for the past few years have been finding it difficult to solve the
increasing problems of adopting seriously the management of working capital.
A firm may exist without making profits but cannot survive without liquidity.
The function of working capital management in an organization is similar that
of the heart in a human body. Also it is an important function of financial
management. The financial manager must determine the satisfactory level of
working capital funds and also the optimum mix of current assets and current
liabilities. He must ensure that the appropriate sources of funds are used to
finance working capital and should also see that short term obligation of the
business are met well in time.

Concept of Working Capital:

There are two concepts of working capital viz .quantitative and qualitative.
Some people also define the two concepts as gross concept and net concept.

According to quantitative concept, the amount of working capital refers to ‗total

of current assets‘. Current assets are considered to be gross working capital in
this concept.

The qualitative concept gives an idea regarding source of financing capital.

According to qualitative concept the amount of working capital refers to
―excess of current assets over current liabilities.‖ L.J. Guthmann defined
working capital as ―the portion of a firm‘s current assets which are financed
from long–term funds.‖ The excess of current assets over current liabilities is
termed as ‗Net working capital‘. In this concept ―Net working capital‖
represents the amount of current assets which would remain if all current
liabilities were paid.

Both the concepts of working capital have their own points of importance. ―If
the objectives is to measure the size and extent to which current assets are being
used, ‗Gross concept‘ is useful; whereas in evaluating the liquidity position of
an undertaking ‗Net concept‘ becomes pertinent and preferable. It is necessary
to understand the meaning of current assets and current liabilities for learning
the meaning of working capital, which is explained below.

Current assets – It is rightly observed that ―Current assets have a short life
span. These type of assets are engaged in current operation of a business and
normally used for short– term operations of the firm during an accounting
period i.e. within twelve months. The two important characteristics of such
assets are, (i) short life span, and (ii) swift transformation into other form of
assets. Cash balance may be held idle for a week or two; account receivable
may have a life span of 30 to 60 days, and inventories may be held for 30 to 100
days.

Current liabilities – The firm creates a Current Liability towards creditors

(sellers) from whom it has purchased raw materials on credit. This liability is
also known as accounts payable and shown in the balance sheet till the payment
has been made to the creditors. The claims or obligations which are normally
expected to mature for payment within an accounting cycle (1 year) are known
as current liabilities. These can be defined as ―those liabilities where
liquidation is reasonably expected to require the use of existing resources
properly classifiable as current assets, or the creation of other current assets, or
the creation of other current liabilities.‖

Component of working capital:

Effective management out of working capital is actually essential for the

profitability as well as maintaining financial stability of any business. For
efficient management you should know the various aspects of working capital
management as well as different components of working capital management.
Working capital is the funds, which is used to run, perform and conduct
business activities.

Mostly investors and analyst assess for components of working capital to

evaluate company‘s cash flow as their keys elements. For example: how funds
are received, how funds are paid, how well inventory is managed, etc. Such
analysis assure whether business constantly keeps sufficient money to meet with
their short-term operating expenses and short-term debt commitments.

They are several main components of working capital management. For

example: cash, inventory, accounts receivable, trade credits, marketable
securities, loans, Insurances etc. Let us understand some of them below:

Cash / Money
Cash is the most liquid form of funds, hence it is one of the huge important
components of working capital. It is necessary for every business to maintain
optimum level of cash in hand regardless if other existing assets is substantial.

Cash act as an effective instrument at various stages of product life cycle. Cash
in hand plays an important role to balance any gaps arising between productions
to distribution cycle.

Account Receivable
Accounts receivable tend to be profits due which is owed to a business by their
clients for the sale of goods. Efficient, timely collection of account receivable is
most essential to maintain financial health of the company‘s operation.

For example: marketable securities consist of commercial papers offered by

companies, acceptance letter, treasury bill, etc. These instruments can be bought
and sold at quicker and reasonable rate. They usually have less than one year as
their maturity period. This attract company‘s to investment additional cash
reserves and also can be used as highly liquid assets.

Accounts receivable have always been under assets side of a

company‘s balance sheet, but they are not actually assets until these are
typically collected. A commonly used method by analysts to evaluate the
organization‘s accounts receivable cycle is that, day‘s sales outstanding, that
reveals that the typical average days an organization sales cycle to collect
profits from sale of goods.
Account Payable
Account payable, the money an organization need to pay out throughout the
short term, is also an another key components of working capital management.
Normally company‘s effectively maintain balance between maximum cash flow
simply by delaying payments as long as it is fairly potential. In addition, they
need to keep positive credit ranks / scores while dealing with creditors as well
as suppliers. Commonly, a business‘s average time for account receivables are
significantly shorter than the average time for account payable‘s.

Stock / Inventory
Stock is one of the main components of working capital. An organization‘s
main asset that it transforms in to sales profits and earnings. The speed at which
business sells and restock is significant to determine its success. Stock are of
various types, which includes stock as raw material, stock as work in progress
or stock in finished goods.

Investors give consideration to their stock turnover level become a sign of this
strength to sales and as a measure towards how efficient the business looks in
their buying as well as production process. Stock that is minimal, puts the
company into danger zone of getting rid of off product sales. Again excessively
high stock levels express inefficient utilization of working capital.

Operating Cycle:

The operating cycle, also known as the cash cycle of a company, is an activity
ratio measuring the average period required for turning the company‘s
inventories into cash. This process of producing or purchasing inventories,
selling finished goods, receiving cash from customers, and using that cash to
purchase/produce inventories again is a never-ending cycle, as long as the
company remains in operation.

The duration of time required to complete the sequence of events right from
purchase of raw material / goods for cash to the realization of sales in cash is
called the operating cycle, working capital cycle or cash cycle.

The above operating cycle in figure relates to a manufacturing firm where cash
is needs to purchase raw materials and convert raw materials into work-in-
process is converted into finished goods. Finished goods will be sold for cash or
credit and ultimately debtors will be realized.

Operating Cycle of Non-Manufacturing

Firm The non-manufacturing firms, such as whole sellers and retailers, will not
have the manufacturing phase; they will have rather direct conversion of cash
into finished stock, into accounts receivables and then into cash. The operating
cycle of a non-manufacturing firm is shown as under.

Types of Working Capital:

According to the needs of business, the working capital may be classified into
following two basis:

1) On the basis of periodicity

2) On the basis of concept

1) On the basis of periodicity:

The requirements of working capital are continuous. More working capital is

required in a particular season or the peck period of business activity. On the
basis of periodicity working capital can be divided under two categories as
under:

1. Permanent working capital

2. Variable working capital

(a) Permanent working capital: This type of working capital is known as Fixed
Working Capital. Permanent working capital means the part of working capital
which is permanently locked up in the current assets to carry out the business
smoothly. The minimum amount of current assets which is required to conduct
the business smoothly during the year is called permanent working capital.

For example, investments required to maintain the minimum stock of raw

materials or to cash balance. The amount of permanent working capital depends
upon the size and growth of company. Fixed working capital can further be
divided into two categories as under:

1. Regular Working capital: Minimum amount of working capital required to

keep the primary circulation. Some amount of cash is necessary for the payment
of wages, salaries etc.

2. Reserve Margin Working capital: Additional working capital may also be

required for contingencies that may arise any time.
The reserve working capital is the excess of capital over the needs of the regular
working capital is kept aside as reserve for contingencies, such as strike,
business depression etc.

(b) Variable or Temporary Working Capital: The term variable working capital
refers that the level of working capital is temporary and fluctuating. Variable
working capital may change from one assets to another and changes with the
increase or decrease in the volume of business.

The variable working capital may also be subdivided into following two sub-
groups

1. Seasonal Variable Working capital:

Seasonal working capital is the additional amount which is required during the
active business seasons of the year. Raw materials like raw-cotton or jute or
sugarcane are purchased in particular season. The industry has to borrow funds
for short period. It is particularly suited to a business of a seasonal nature. In
short, seasonal working capital is required to meet the seasonal liquidity of the
business.

2. Special variable working capital:

Additional working capital may also be needed to provide additional current assets
to meet the unexpected events or special operations such as extensive marketing
campaigns or carrying of special job etc.

2) On the basis of concept:

on the basis of concept working capital is divided into two categories as under:

(A) Gross Working Capital: Gross working capital refers to total investment in
current assets. The current assets employed in business give the idea about the
utilization of working capital and idea about the economic position of the
company. Gross working capital concepts is popular and acceptable concept in
the field of finance.

(B) Net Working Capital: Net working capital means current assets minus
current liabilities. The difference between current assets and current liabilities is
called the net working capital. If the net working capital is positive, business is
able to meet its current liabilities. Net working capital concept provides the
measurement for determining the creditworthiness of company.
Needs of WCM:

1. Continuity in Business Operations: Working capital keeps the

business operations going. It is needed to purchase raw materials, to
pay the workers and staff and also to pay for recurring expenses like
electricity and power bills, rent, etc.
2. Dividend Payment: Working capital is needed to pay a dividend to
the shareholders. The payment of dividend takes place on a yearly or
half-yearly basis.
3. Repayment of Long-Term Loans: Working capital is also used to
repay long-term loans and debentures.
4. Increases Creditworthiness: A company that pays its creditors on
time has a positive reputation in the credit market. Such a goodwill
helps a company to obtain raw materials on credit. It can also get
loans and advances from the banks. The dealers will also be willing to
give money to such companies. Hence, working capital increases a
company's creditworthiness.
5. Boosts Efficiency and Productivity: The company that faces no
working capital problems provides better working conditions and
welfare facilities to its workers. It also can maintain its machines in
good condition. It can afford to spend money for training and
development of its workers. All such steps boost the efficiency and
productivity of the company.
6. Helps to Fight Competition: Working capital helps the company to
fight its competitors. It can be used to advertise and for sales
promotion. The company can also afford to give longer credit terms
to the customers.
7. Helps to Withstand Seasonal Fluctuations: Working capital is
required throughout the year. But sales may be seasonal in nature. If
the sales are low, the money inflow is less. Therefore, liquid cash is
required to pay wages to workers and to meet other expenses. So, it
helps the company withstand seasonal fluctuations.
 8. Increases Goodwill: The company that meets the needs of its working
capital without any difficulty earns a good reputation in the labour
and capital markets. This happens because the company pays wages
and salaries to the employees and the suppliers of raw materials, etc.,
on time. Thus, it also helps increase the goodwill of the company.

Working capital position/Balanced working capital position:

The firm should maintain a sound working capital position. It should have a
adequate working capital to run its business operation. Both excessive as well
inadequate working capital positions are dangerous from the firm‘s point of
view. Excessive working capital means holding costs and idle funds which earn
no profits for the firm. Paucity of working capital not only impairs the firm‘s
profitability but also results in production interruptions and inefficiencies and
disruptions.

The dangers of excessive working capital are as follows :

o It results in unnecessary accumulation of inventories. Thus chances of

inventory mishandling, waste, theft and losses increase.

o It is an indication of defective credit policy and slack collection period,

Consequently, higher incidence of bad debts results, which adversely affects
profits.

o Excessive working capital makes management complacement which

generates into managerial inefficiency.

o Tendencies of accumulating incentories tend to make speculative profits

grow. This may tend to make dividend policy liberal and difficult to cope with
in future when the firm is unable to make speculative profits.

Assessment of Working Capital Requirements:

1. Sales Turnover Method:

Banks usually apply the turnover method to finance the working capital
requirement of relatively small and medium enterprises with sales turnover of
approximately Rs 250 million. In this method, the working capital credit limits
provided by the lending banks is kept at a minimum level of 20% of the
projected annual turnover.

For a sales turnover of Rs 250 million, the total working capital requirement of
25% or Rs 62.5 million is normally considered to be adequate. Banks provide
4/5th or 80% of this amount; the residual portion is expected to be brought in by
the promoters by way of margin from long-term sources. The working capital
credit limit provided by the banks is calculated at 20% of the projected annual
turnover.
2. Cash Budget Method:
In case of seasonal activities, especially in the agro-based sector, the bank
finance for working capital is assessed on the basis of monthly cash budget and
the relative cash deficiency on a monthly basis. Under this method, all
estimated/projected cash receipts (inflow) on a monthly basis is arranged in a
tabular form and the monthly cash outflows are also similarly shown against
each month. The deficit or surplus of each month is worked out and the peak
deficit amount is considered to be the working capital limit to be provided by
the bank.

3. Pre-Defined Inventory and Receivables Holding Level Method:

Under this method, the assessing officer of the bank obtains in the prescribed
format the projected level of operations of the borrowing firm for the ensuing
year along with the figures of actual operation for the last two years for existing
business units. For new firms, only the projection for the ensuing two years is
obtained. The projected figures of operation begin with the expected sales
turnover and the entire range of other figures of projected expenses revolves
round the sales.
Working Capital Financing:
Working capital financing is a type of funding that is primarily intended to
increase the amount of working capital that a business owner needs for a variety
of purposes. These can range from filling in occasional cash flow gaps to
business expansion — and just about everything in between. Simply put, this
financing allows borrowers to free up working capital for their business that
they intend to earn back in the near future. In order to understand what your
amount of working capital is, you‘ll need to have a clear picture of your current
assets and current liabilities, as we‘ll explain below.

It‘s typical for businesses, both large and small, to use borrowed capital to meet
their needs. But before you consider working capital financing, you should
make sure you really understand what your needs are and the formulae you
should know to ensure that the numbers make sense.

Working capital financing is used to fund your company‘s investment in short-

term assets such as accounts receivable and inventory, and to provide liquidity
so that your company can fund its day-to-day operations including payroll,
overhead and other expenses. There are many types of working capital
financing. The best fit for your company will depend on its industry, business
model, stage of development, and the current assets on its balance sheet.

Benefits of Working Capital Financing:

This financing option is beneficial for different business types and purposes.
Below are key benefits of working capital financing:
Cover Expenditure Gaps
Working capital financing helps keep a business afloat by financing its payment
gaps and fulfilling its working capital requirement.
Small and growing businesses solely relying on accounts payables to fuel their
working capital can support their everyday operations without the need for an
equity transaction.
Zero Collateral Requirement
Firms with good credit ratings are granted unsecured working capital finance.
They do not need to forfeit any collateralised assets in the event of default.
The ability to access zero collateralised financing enhance the business‘s
credibility.
Faster and Flexible
Since businesses usually seek working capital financing to meet their immediate
cash flow needs, lending institutions need to process it quickly.
Financiers must understand:
 The significance of quick financing and the need for businesses to revive
their operations quickly.
 Flexible repayment terms.
 Interest rates may vary depending on the risk associated with the industry
and the business model.

Positive Impact on the Turnover Ratio

To fully understand the benefits of working capital financing, one needs to be
familiar with working capital turnover ratio first.
 UNIT III: Capital Budgeting:
Introduction:

Capital Budgeting is defined as the process by which a business determines

which fixed asset purchases or project investments are acceptable and which are
not. Using this approach, each proposed investment is given a quantitative
analysis, allowing rational judgment to be made by the business owners.

Capital asset management requires a lot of money; therefore, before making

such investments, they must do capital budgeting to ensure that the investment
will procure profits for the company. The companies must undertake initiatives
that will lead to a growth in their profitability and also boost their shareholder‘s or
investor‘s wealth.

Capital budgeting is an accounting principle using which companies decide

whether to invest in a particular project, as all the investment possibilities may
not be rewarding. Companies use capital budgeting to generate a quantitative
overview of each asset and investment, and it provides a rational ground for
making a judgment or forming an opinion. Learning about various capital
budgeting methods can help you understand the decision-making processes that
companies and investors employ. In this article, we examine what is capital
budgeting and why is it important, apart from explore the various budgeting
methods available.

Definitions:

Capital budgeting is a process that businesses use to evaluate potential major

projects or investments. Building a new plant or taking a large stake in an
outside venture are examples of initiatives that typically require capital
budgeting before they are approved or rejected by management.

As part of capital budgeting, a company might assess a prospective project's

lifetime cash inflows and outflows to determine whether the potential returns it
would generate meet a sufficient target benchmark. The capital budgeting
process is also known as investment appraisal.

 Capital budgeting is used by companies to evaluate major projects and

investments, such as new plants or equipment.
 The process involves analyzing a project's cash inflows and outflows to
determine whether the expected return meets a set benchmark.
 The major methods of capital budgeting include discounted cash flow,
payback analysis, and throughput analysis.
 Need and importance:
1. Long-term Implications of Capital Budgeting
A capital budgeting decision has its effect over a long time span and inevitably
affects the company‘s future cost structure and growth. A wrong decision can
prove disastrous for the long-term survival of firm. On the other hand, lack of
investment in asset would influence the competitive position of the firm. So the
capital budgeting decisions determine the future destiny of the company.

2. Involvement of large amount of funds in Capital Budgeting

Capital budgeting decisions need substantial amount of capital outlay. This
underlines the need for thoughtful, wise and correct decisions as an incorrect
decision would not only result in losses but also prevent the firm from earning
profit from other investments which could not be undertaken.

3. Irreversible decisions in Capital Budgeting

Capital budgeting decisions in most of the cases are irreversible because it is
difficult to find a market for such assets. The only way out will be scrap the
capital assets so acquired and incur heavy losses.

4. Risk and uncertainty in Capital budgeting

Capital budgeting decision is surrounded by great number of uncertainties.
Investment is present and investment is future. The future is uncertain and full
of risks. Longer the period of project, greater may be the risk and uncertainty.
The estimates about cost, revenues and profits may not come true.

5. Difficult to make decision in Capital budgeting

Capital budgeting decision making is a difficult and complicated exercise for the
management. These decisions require an over all assessment of future events
which are uncertain. It is really a marathon job to estimate the future benefits
and cost correctly in quantitative terms subject to the uncertainties caused by
economic-political social and technological factors.

6. Large and Heavy Investment

The proper planning of investments is necessary since all the proposals are
requiring large and heavy investment. Most of the companies are taking
decisions with great care because of finance as key factor.

7. Permanent Commitments of Funds

The investment made in the project results in the permanent commitment of funds.
The greater risk is also involved because of permanent commitment of funds.

8. Long term Effect on Profitability

Capital expenditures have great impact on business profitability in the long run. If
the expenditures are incurred only after preparing capital budget properly, there
is a possibility of increasing profitability of the firm.

9. Complicacies of Investment Decisions

Generally, the long term investment proposals have more complicated in nature.
Moreover, purchase of fixed assets is a continuous process. Hence, the
management should understand the complexities connected with each projects.

10. Maximize the worth of Equity Shareholders

The value of equity shareholders is increased by the acquisition of fixed assets
through capital budgeting. A proper capital budget results in the optimum
investment instead of over investment and under investment in fixed assets. The
management chooses only most profitable capital project which can have much
value. In this way, the capital budgeting maximize the worth of equity
shareholders.

Process:
#1 – To Identify Investment Opportunities

The first step is to explore the available investment opportunities. Next, the
organization‘s capital budgeting committee must identify the expected sales
shortly. After that, they recognize the investment opportunities keeping in mind
the sales target set up by them. One must consider some points before searching
for the best investment opportunities. It includes regularly monitoring the
external environment to get an idea about new investment opportunities. Then,
define the corporate strategy based on the organization‘s SWOT analysis, i.e.,
analysis of its strength, weakness, opportunity, and threat, and seek suggestions
from its employees by discussing the strategies and objectives with them.
 #2 – Gathering of the Investment Proposals

After identifying the investment opportunities, the second process in capital

budgeting is to collect investment proposals. Before reaching the committee of
the capital budgeting process, these proposals are seen by various authorized
persons in the organization to check whether the bids given are according to the
requirements. Then the classification of the investment is done based on the
different categories such as expansion, replacement, welfare investment, etc.
This classification into the various types makes decision-making more
comfortable and facilitates budgeting and control.

#3 – Decision Making Process in Capital Budgeting

Decision-making is the third step. In the decision-making stage, the executives

will have to decide which investment needs to be made from the available
investment opportunities, keeping in mind the sanctioning power open to them.

#4 – Capital Budget Preparations and Appropriations

After the decision-making step, the next step is to classify the investment
outlays into higher and smaller value investments.

#5 – Implementation

After completing all the above steps, it implements the investment proposal, i.e.,
put into a concrete project. Several challenges can be faced by the management
personnel while executing the tasks as they can be time-consuming. For the
implementation at a reasonable cost and expeditiously, the following things
could be helpful: –

 Formulation of the project adequately: Inadequate formulation is one

of the main reasons for the delay. So, the concerned person should consider all
the necessary details in advance and one should do a proper analysis well to
avoid any delay in the project implementation., the concerned person should
consider all the necessary details in advance, and one should do a proper
analysis well to avoid any delay in the project implementation.
 Use responsibility accounting principle: For the expeditious execution
of the various tasks and the cost control, one should assign specific
responsibilities to the project managers, i.e., the timely completion of the
project within the specified cost limits.
 Network technique use: Several network techniques like the Critical
Path Method (CPM) and Program Evaluation and Review Technique (PERT)
are available for project planning and control, which will help monitor the projects
properly and efficiently.

#6 – Review of Performance

A review of performance is the last step in capital budgeting. But, the management
must first compare the actual results with the projected results. The correct time
to make this comparison is when the operations get stabilized.

Kinds of Capital Budgeting Decisions:

1. Accept-Reject Decision This is a fundamental decision in capital
budgeting. If the project is accepted, the firm would invest in it; if the proposal
is rejected, the firm does not invest in it. In general, all those proposals which
yield a rate of return greater than a certain required rate of return or cost of
capital are accepted and the rest are rejected. By applying this criterion, all
independent projects are accepted. Independent projects are the projects that do
not compete with one another in such a way that the acceptance of one
precludes the possibility of acceptance of another. Under the accept-reject
decision, all independent projects that satisfy the minimum investment criterion
should be implemented.

2. Mutually Exclusive Project Decision Mutually Exclusive Projects are

those which compete with other projects in such a way that the acceptance of
one will exclude the acceptance of the other projects. The alternatives are
mutually exclusive and only one may be chosen. Suppose a company is
intending to buy a new folding machine. There are three competing brands, each
with a different initial investment and operating costs. The three machines
represent mutually exclusive alternatives, as only one of these can be selected.
Moreover, the mutually exclusive project decisions are not independent of the
accept-reject decisions. The project should also be acceptable under the latter
decision. Thus, mutually exclusive projects acquire significance when more
than one proposal is acceptable under the accept-reject decision.

3. Capital Rationing Decision In a situation where the firm has unlimited

funds, all independent investment proposals yielding returns greater than some
pre-determined level are accepted. However, this situation does not prevail in
most of the business forms in actual practice. They have a fixed capital budget.
A large number of investment proposals compete for these limited funds. The
firm must, therefore, ration them. The firm allocates funds to projects in a
manner that it maximises long-run returns. Thus, capital rationing refers to a
situation in which a firm has more acceptable investments than it can finance. It
is concerned with the selection of a group of Investment proposals out of many
investment proposals acceptable under the accept-reject decision. Capital rationing
employs ranking of acceptable Investment projects. These projects can be
ranked on the basis of a pre-determined criterion such as the rate of return. The
projects are ranked in descending order of the rate of return.

Methods of Capital Budgeting of Evaluation: Techniques/Methods

of Capital Budgeting

In addition to the many capital budgeting methods available, the following list
outlines a few by which companies can decide which projects to explore:

#1 Payback Period Method

Corporate finance is all about capital budgeting. One of the most important
concepts every corporate financial analyst must learn is how to value different
investments or operational projects. The analyst must find a reliable way to
determine the most profitable project or investment to undertake. One way
corporate financial analysts do this is with the payback period. It refers to the
time taken by a proposed project to generate enough income to cover the initial
investment. The project with the quickest payback is chosen by the company.

Formula:

Initial Cash Investment

Payback Period =
Annual Cash Flow

Example of Payback Period Method:

An enterprise plans to invest $100,000 to enhance its manufacturing process. It has

two mutually independent options in front: Product A and Product B. Product A
exhibits a contribution of $25 and Product B of $15. The expansion plan is
projected to increase the output by 500 units for Product A and 1,000 units for
Product B.

Here, the incremental cash flow will be calculated as:

(25*500) = 12,500 for Product A

(15*1000) = 15,000 for Product B

The Payback Period for Product A is calculated as:

1
2 Initial Cash Investment $100,000
3 Incremental Cash Flow $12,500

4 Payback Period of Product A (Years) 8

Product A = 100,000 / 12,500 = 8 years

Now, the Payback Period for Product B is calculated as:

1
2 Initial Cash Investment $100,000
3 Incremental Cash Flow $15,000

4 Payback Period of Product A (Years) 6.7

Product B = 100,000 / 15,000 = 6.7 years

This brings the enterprise to conclude that Product B has a shorter payback
period and therefore, it will invest in Product B.

Despite being an easy and time-efficient method, the Payback Period cannot be
called optimum as it does not consider the time value of money. The cash flows
at the earlier stages are better than the ones coming in at later stages. The
company may encounter two projections with the same payback period, where
one depicts higher cash flows in the earlier stages/years. In such as case, the
Payback Period may not be appropriate.

A similar consideration is that of a longer period, potentially bringing in greater

cash flows during a payback period. In such a case, if the company selects the
projects based solely on the payback period and without considering the cash
flows, then this could prove detrimental for the financial prospects of the
company.

#2 Net Present Value Method (NPV)

Evaluating capital investment projects is what the NPV method helps the
companies with. There may be inconsistencies in the cash flows created over
time. The cost of capital is used to discount it. An evaluation is done based on
the investment made. Whether a project is accepted or rejected depends on the
value of inflows over current outflows.
This method considers the time value of money and attributes it to the
company's objective, which is to maximize profits for its owners. The capital cost
factors in the cash flow during the entire lifespan of the product and the risks
associated with such a cash flow. Then, the capital cost is calculated with the help
of an estimate.

Formula:

Net Present Value (NPV) =

t = time of cash
flow
i = discount rate

Rt = net cash
flow

Example of Net Present Value (with 9% Discount Rate ):

For a company, let‘s assume the following conditions:

Capital investment = $10,000

Expected Inflow in First Year = $1,000

Expected Inflow in Second Year =

$2,500 Expected Inflow in Third Year =

$3,500 Expected Inflow in Fourth Year

= $2,650 Expected Inflow in Fifth Year

= $4,150 Discount Rate = 9%

Calculation
Year Flow Present Value
0 -$10,000 -$10,000 -
1 1,000 9,174 1,000/(1.09)1
2 2,500 2,104 2,500/(1.09)2
3 3,500 2,692 3,500/(1.09)3
4 2,650 1,892 2,600/(1.09)4
5 4,150 2,767 4,000/(1.09)5

Total $18,629

Net Present Value achieved at the end of the calculation is:

With 9% Discount Rate = $18,629

This indicates that if the NPV comes out to be positive and indicates profit.
Therefore, the company shall move ahead with the project.

#3 Internal Rate of Return (IRR)

IRR refers to the method where the NPV is zero. In such as condition, the cash
inflow rate equals the cash outflow rate. Although it considers the time value of
money, it is one of the complicated methods.

It follows the rule that if the IRR is more than the average cost of the capital,
then the company accepts the project, or else it rejects the project. If the company
faces a situation with multiple projects, then the project offering the highest IRR is
selected by them.

Internal Rate of Return= =0;

s are equal to discounted cash outflows

Accept investments if IRR greater than Threshold Rate of Return, else

reject.
Example:

We shall assume the possibilities exhibited in the table here for a company that
has 2 projects: Project A and Project B.

Project B

Year Project A
0 -$10,000 -$10,000
1 $2,500 $3,000
2 $2,500 $3,000
3 $2,500 $3,000
4 $2,500 $3,000
5 $2,500 $3,000
Total $12,500 $15,000

IRR 7.9% 15.2%

Here, The IRR of Project A is 7.9% which is above the Threshold Rate of
Return (We assume it is 7% in this case.) So, the company will accept the project.
However, if the Threshold Rate of Return would be 10%, then it would be
rejected as the IRR would be lower. In that case, the company will choose
Project B which shows a higher IRR as compared to the Threshold Rate of
Return.

#4 Profitability Index

This method provides the ratio of the present value of future cash inflows to the
initial investment. A Profitability Index that presents a value lower than 1.0 is
indicative of lower cash inflows than the initial cost of investment. Aligned with
this, a profitability index great than 1.0 presents better cash inflows and
therefore, the project will be accepted.

Formula:
 Present value of Cash
Profitability
Inflows Index =
Initial Investment

Example:

Assuming the values given in the table, we shall calculate the profitability index
for a discount rate of 10%.

Year Cash Flows 10% Discount

0 -$10,000 -$10,000
1 $3,000 $2,727
2 $5,000 $4,132
3 $2,000 $1,538
4 $6,000 $4,285
5 $5,000 $3,125

Total $15,807

So, Profitability Index with 10% discount = $15,807/$10,000 = 1.5807

As per the rule of the method, the profitability index is positive for the 10% discount
rate, and therefore, it will be selected

Excess present value index

Another type of discounted cash-flow approach to capital budgeting is the
excess of net present value method. In contrasts to the internal rate of return, the
net present value method assumes a target or a minimum desired rate of return
(or the so called cut off rate). below which a proposal would be rejected by the
management as undesirable in the light of the profit goals. Thus, in this method,
(a) cash inflows, (b) initial investment, and (c) desired rate of return are given.
All expected cash flows are discounted to the present. Using this minimum
desired rate. If the result i.e., difference between the present value of future
cash-flows and the initial investment, is positive, the project is desirable
because its return exceeds the desired minimum. If the result is negative, the
project is undesirable.

Excess Present Value Index: Excess present value index sometimes also called
the profitability index is (or further step in the refinement of the excess/net
present value approach. If reflects the percentage relationship between the
present value of the future cash inflows at the desired rate of return and the
initial investment.

I.PV Index = Present Value of cash savings/inflows(v)/Initial Investment× 10C

Thus, greater the ratio (or EPV Index). the more profitable is the project.
Moreover, the main advantage of the project. Moreover, the main advantage of
the use of EPV index is the ready comparability between investment proposals
of different magnitudes.

Capital rationing:
Capital rationing is the process through which companies decide how to
allocate their capital among different projects, given that their resources are not
limitless. The main goal is to maximize the return on their investment.

 Capital rationing is a process that companies use to decide which

investment opportunities make the most sense for them to pursue.
 The typical goal of capital rationing is to direct a company‘s limited
capital resources to the projects that are likely to be the most profitable.
 Hard capital rationing refers to restraints put on a company by outside
entities, such as banks or other lenders.
 Soft capital rationing results from a company‘s own policies relating to
how it wants to use its capital.

Capital rationing is a strategy used by companies or investors to limit the

number of projects they take on at a time. If there is a pool of available
investments that are all expected to be profitable, capital rationing helps the
investor or business owner choose the most profitable ones to pursue.

Companies that employ a capital rationing strategy typically produce a

relatively higher return on investment (ROI). This is simply because the
company invests its resources where it identifies the highest profit potential.
Businesses typically face many different investment opportunities but lack the
resources to pursue them all. Capital rationing is a way of allocating their
available funds in a logical manner.1 A company will typically attempt to
devote its resources to the combination of projects that offers the highest
total net present value (NPV).2

Companies may also use capital rationing strategically, forgoing immediate

profit to invest in projects that hold out greater long-term potential for the
business as it positions itself for the future.

Two Types of Capital Rationing :

There are two primary types of capital rationing, referred to as hard and soft:

1. Hard capital rationing occurs based on external factors. For example,

the company may be finding it difficult to raise additional capital, either
through equity or debt. Or, its lenders may impose rules on how it can
use its capital. These situations will limit the company‘s ability to invest
in future projects and may even mean that it must reduce spending on
current ones.
2. Soft capital rationing, also known as internal rationing, is based on the
internal policies of the company. A fiscally conservative company, for
example, may require a particularly high projected return on its capital
before it will get involved in a project—in effect, self-imposing capital
rationing.

Capital Rationing Example

Capital rationing is about putting restrictions on investments and projects taken

on by a business. To illustrate this better, let‘s consider the following example:

VV Construction is looking at five possible projects to invest in, as shown

below:

To determine which project offers the greatest potential profitability, we

compute each project using the following formula:
Profitability = NPV / Investment Capital

Based on the table above, we can conclude that projects 1 and 2 offer the
greatest potential profit. Therefore, VV Construction will likely invest in those
two projects.

Risk and Uncertainly in Capital Budgeting

Risk analysis gives management better information about the possible outcomes
that may occur so that management can use their judgment and experience to
accept an investment or reject it. Since risk analysis is costly, it should be used
relatively in costly and important projects. Risk and uncertainty are quite
inherent in capital budgeting decisions. This is so because investment decisions
and capital budgeting are actions of today which bear fruits in future which is
unforeseen. Future is uncertain and involves risk. The projection of probability
of cash inflows made today is not certain to be achieved in the course of future.
Seasonal fluctuations and business cycles both deliver heavy impact upon the
cash inflows and outflows projected for different project proposals. The cost of
capital which offers cut-off rates may also be inflated or deflated under business
cycle conditions. Inflation and deflation are bound to effect the investment
decision in future period rendering the degree of uncertainty more severe and
enhancing the scope of risk.

Technological developments are other factors that enhance the degree of risk
and uncertainty by rendering the plants or equipments obsolete and the product
out of date. Tie up in the procurement in quantity and/or the marketing of
products may at times fail and frustrate a business unless possible alternative
strategies are kept in view. All these circumstances combined together affect
capital budgeting decisions. It is therefore necessary to allow discounting factor
to cover risk. One way to compare risk in alternative proposals is the use of
Standard Deviation.
 UNIT IV: Capital Structure and Firm Valuation:

Introduction & meaning:

Capital structure means the arrangement of capital from different sources so that
the funding needs of the business are satisfied. Different types of capital impose
different types of risks on a company and hence capital structure affects the
value of a company.
For example, if a company has raised funds in the form of equity shares and
bonds, we could say that company‘s capital structure includes debt and equity.
Bank loans, retained earnings and working capital might also be part of the
company‘s capital structure.
―Capital structure means the type of securities to be issued and proportionate
amounts that make up the capitalisation.‖ – C W Gerstenberg.
Economists speak of ―capital‖ as wealth which is used in the production of
additional wealth. Businessmen frequently use the word capital in the sense of
total assets employed in a business. The accountant uses the word in the sense
of net assets, or stockholders‘ interest as shown by the balance sheet or the net
worth of the stockholders‘ equity.

In law, Capital means capital stock. The capital structure is made up of debt and
equity securities which comprise a firm‘s finance of its assets. It is the
permanent financing of a firm represented by long-term debt, plus preferred
stocks and net worth.

The determination of the degree of liquidity of a firm is no simple task. In the

long run, liquidity may depend on the profitability of a firm; but whether it
survives to achieve long-run profitability depends to some extent on its capital
structure. This term includes only long-term debt and total stockholders‘
investment. It may be defined as one including both short-term and long-term
funds.
In the recent past, there was a tremendous improvement in the capital market.
There is an abundant amount of funds which are ready for investment. But the
basic question is the rate of return on investment which is demanded by the
investors.
To satisfy the expected rate of return by the investor, business firms have to
make different combinations in long term debt and equity.

This may require to have efficient leverage of debt and equity to meet the
obligation towards investors. The fund manager has to use different long term
sources of funds judiciously such that the overall cost of capital is maintained at
optimum level.

Capital is required at the stage of establishment, expansion, diversification etc.,

Capital can be raised from different sources. That is equity, debentures,
preference shares, loans, retained earnings etc. Capital structure of any firm is
the combination of different sources of finance used by the firm.

Meaning and Definition of Capital Structure

Capital structure means the arrangement of capital from different sources so that
the funding needs of the business are satisfied. Different types of capital impose
different types of risks on a company and hence capital structure affects the
value of a company.

For example, if a company has raised funds in the form of equity shares and
bonds, we could say that company‘s capital structure includes debt and equity.
Bank loans, retained earnings and working capital might also be part of the
company‘s capital structure.

―Capital structure means the type of securities to be issued and proportionate

amounts that make up the capitalisation.‖ – C W Gerstenberg.

Normally speaking, the equity part includes share capital and retained earnings.
Debt, on the other hand, includes debentures and long-term loans. The ratio
between equity (owned capital) and debt (borrowed funds) is known as Capital
Gearing.

A company is said to be highly geared if the large amount of capital is

composed of debts. Thus, higher the amount of debt vis-a-vis equity means
capital gearing ratio is high because equity component is low.

Objectives and Importance of Capital Structure:

The importance or significance of Capital Structure:
1. Increase in value of the firm:
A sound capital structure of a company helps to increase the market price of
shares and securities which, in turn, lead to increase in the value of the firm.

2. Utilisation of available funds:

A good capital structure enables a business enterprise to utilise the available
funds fully. A properly designed capital structure ensures the determination of
the financial requirements of the firm and raise the funds in such proportions
from various sources for their best possible utilisation. A sound capital structure
protects the business enterprise from over-capitalisation and under-
capitalisation.

3. Maximisation of return:
A sound capital structure enables management to increase the profits of a
company in the form of higher return to the equity shareholders i.e., increase in
earnings per share. This can be done by the mechanism of trading on equity i.e.,
it refers to increase in the proportion of debt capital in the capital structure
which is the cheapest source of capital. If the rate of return on capital employed
(i.e., shareholders‘ fund + long- term borrowings) exceeds the fixed rate of
interest paid to debt-holders, the company is said to be trading on equity.
4. Minimisation of cost of capital:
A sound capital structure of any business enterprise maximises shareholders‘
wealth through minimisation of the overall cost of capital. This can also be done
by incorporating long-term debt capital in the capital structure as the cost of
debt capital is lower than the cost of equity or preference share capital since the
interest on debt is tax deductible.

5. Solvency or liquidity position:

A sound capital structure never allows a business enterprise to go for too much
raising of debt capital because, at the time of poor earning, the solvency is
disturbed for compulsory payment of interest to .the debt-supplier.

6. Flexibility:
A sound capital structure provides a room for expansion or reduction of debt
capital so that, according to changing conditions, adjustment of capital can be
made.

7. Undisturbed controlling:
A good capital structure does not allow the equity shareholders control on
business to be diluted.

8. Minimisation of financial risk:

If debt component increases in the capital structure of a company, the financial
risk (i.e., payment of fixed interest charges and repayment of principal amount
of debt in time) will also increase. A sound capital structure protects a business
enterprise from such financial risk through a judicious mix of debt and equity in
the capital structure.
Financial Structure:
Financial Structure includes both long-term and short-term financial instruments
to raise capital for the organisation. All the items present in the Liabilities side
of the Balance Sheet are a part of the Financial Structure.

Optimum Capital Structure:

The optimal capital structure of a firm is the best mix of debt and
equity financing that maximizes a company‘s market value while minimizing
its cost of capital. In theory, debt financing offers the lowest cost of capital due
to its tax deductibility. However, too much debt increases the financial risk to
shareholders and the return on equity that they require. Thus, companies have
to find the optimal point at which the marginal benefit of debt equals the
marginal cost.

 An optimal capital structure is the best mix of debt and equity financing
that maximizes a company‘s market value while minimizing its cost of
capital.
 Minimizing the weighted average cost of capital (WACC) is one way to
optimize for the lowest cost mix of financing.
 According to some economists, in the absence of taxes, bankruptcy
costs, agency costs, and asymmetric information, in an efficient market,
the value of a firm is unaffected by its capital structure.

Factors Determining Capital Structure:

The following factors influence the capital structure decisions:
1. Risk of cash insolvency:
Risk of cash insolvency arises due to failure to pay fixed interest liabilities.
Generally, the higher proportion of debt in capital structure compels the
company to pay higher rate of interest on debt irrespective of the fact that the
fund is available or not. The non-payment of interest charges and principal
amount in time call for liquidation of the company.

The sudden withdrawal of debt funds from the company can cause cash
insolvency. This risk factor has an important bearing in determining the capital
structure of a company and it can be avoided if the project is financed by issues
equity share capital.

2. Risk in variation of earnings:

The higher the debt content in the capital structure of a company, the higher will
be the risk of variation in the expected earnings available to equity shareholders.
If return on investment on total capital employed (i.e., shareholders‘ fund plus
long-term debt) exceeds the interest rate, the shareholders get a higher return.

On the other hand, if interest rate exceeds return on investment, the shareholders
may not get any return at all.

3. Cost of capital:
Cost of capital means cost of raising the capital from different sources of funds.
It is the price paid for using the capital. A business enterprise should generate
enough revenue to meet its cost of capital and finance its future growth. The
finance manager should consider the cost of each source of fund while
designing the capital structure of a company.

4. Control:
The consideration of retaining control of the business is an important factor in
capital structure decisions. If the existing equity shareholders do not like to
dilute the control, they may prefer debt capital to equity capital, as former has
no voting rights.

5. Trading on equity:
The use of fixed interest bearing securities along with owner‘s equity as sources
of finance is known as trading on equity. It is an arrangement by which the
company aims at increasing the return on equity shares by the use of fixed
interest bearing securities (i.e., debenture, preference shares etc.).
If the existing capital structure of the company consists mainly of the equity
shares, the return on equity shares can be increased by using borrowed capital.
This is so because the interest paid on debentures is a deductible expenditure for
income tax assessment and the after-tax cost of debenture becomes very low.

Any excess earnings over cost of debt will be added up to the equity
shareholders. If the rate of return on total capital employed exceeds the rate of
interest on debt capital or rate of dividend on preference share capital, the
company is said to be trading on equity.

6. Government policies:
Capital structure is influenced by Government policies, rules and regulations of
SEBI and lending policies of financial institutions which change the financial
pattern of the company totally. Monetary and fiscal policies of the Government
will also affect the capital structure decisions.

7. Size of the company:

Availability of funds is greatly influenced by the size of company. A small
company finds it difficult to raise debt capital. The terms of debentures and
long-term loans are less favourable to such enterprises. Small companies have
to depend more on the equity shares and retained earnings.

On the other hand, large companies issue various types of securities despite the
fact that they pay less interest because investors consider large companies less
risky.

8. Needs of the investors:

While deciding capital structure the financial conditions and psychology of
different types of investors will have to be kept in mind. For example, a poor or
middle class investor may only be able to invest in equity or preference shares
which are usually of small denominations, only a financially sound investor can
afford to invest in debentures of higher denominations.

A cautious investor who wants his capital to grow will prefer equity shares.

9. Flexibility:
The capital structures of a company should be such that it can raise funds as and
when required. Flexibility provides room for expansion, both in terms of lower
impact on cost and with no significant rise in risk profile.

10. Period of finance:

The period for which finance is needed also influences the capital structure.
When funds are needed for long-term (say 10 years), it should be raised by
issuing debentures or preference shares. Funds should be raised by the issue of
equity shares when it is needed permanently.

11. Nature of business:

It has great influence in the capital structure of the business, companies having
stable and certain earnings prefer debentures or preference shares and
companies having no assured income depends on internal resources.

12. Legal requirements:

The finance manager should comply with the legal provisions while designing
the capital structure of a company.

13. Purpose of financing:

Capital structure of a company is also affected by the purpose of financing. If
the funds are required for manufacturing purposes, the company may procure it
from the issue of long- term sources. When the funds are required for non-
manufacturing purposes i.e., welfare facilities to workers, like school, hospital
etc. the company may procure it from internal sources.
14. Corporate taxation:
When corporate income is subject to taxes, debt financing is favourable. This is
so because the dividend payable on equity share capital and preference share
capital are not deductible for tax purposes, whereas interest paid on debt is
deductible from income and reduces a firm‘s tax liabilities. The tax saving on
interest charges reduces the cost of debt funds.

Moreover, a company has to pay tax on the amount distributed as dividend to

the equity shareholders. Due to this, total earnings available for both debt
holders and stockholders is more when debt capital is used in capital structure.
Therefore, if the corporate tax rate is high enough, it is prudent to raise capital
by issuing debentures or taking long-term loans from financial institutions.

15. Cash inflows:

The selection of capital structure is also affected by the capacity of the business
to generate cash inflows. It analyses solvency position and the ability of the
company to meet its charges.

16. Provision for future:

The provision for future requirement of capital is also to be considered while
planning the capital structure of a company.

17. EBIT-EPS analysis:

If the level of EBIT is low from HPS point of view, equity is preferable to debt.
If the EBIT is high from EPS point of view, debt financing is preferable to
equity. If ROI is less than the interest on debt, debt financing decreases ROE.
When the ROI is more than the interest on debt, debt financing increases ROE.
Leverage (Types of Leverage):

Leverage refers to borrowing funds for a particular purpose with an

obligation to repay these funds, with interest, at an agreed-to schedule. The
idea behind leverage is to help borrowers achieve a higher return with a
smaller investment.

You‘ll want to forecast your expenditures and determine your funding

requirements before deciding what kind of leverage to use. Instruments like
derivatives, where the investment is a small fraction of the underlying
position, can be used as leverage. However, in this article, we focus on debt.

The 3 main types of leverage

There are three main types of leverage:

 Financial
 Operating
 Combined
We explain each in more detail below.

Financial leverage
Financial leverage refers to the amount of debt a business has acquired. On
a balance sheet, financial leverage is represented by the liabilities listed on
the right-hand side of the sheet.

Financial leverage lets your business continue to make investments even if

you're short on cash. It‘s usually preferred to equity financing, as it lets you
raise funds without diluting your ownership.

How to calculate financial leverage

You can determine the degree of financial leverage your business has
through the debt-to-equity ratio. This ratio represents the proportion of
assets your business has compared to its shareholders‘ equity.

The formula is:

Let‘s assume your total assets for the current year are $100,000, and for the
previous year, they were $90,000. Your average total assets would then be:

(100,000 + 90,000)/2 = $95,000

You can calculate average total equity the same way.

XYZ balance sheet ($) Year ended 2021 Year ended 2020

Assets 100,000 90,000

Liabilities 30,000 5,000

Equity 70,000 85,000

So,
A financial leverage ratio of 1 indicates no leverage. The higher the ratio,
the more leveraged your business is and the riskier your capital structure.

Operating leverage
Operating leverage accounts for the fixed operating costs and variable costs
of providing goods and services. As fixed assets don‘t change with the level
of output produced, their costs are constant and must be paid regardless of
whether your business is making a profit or experiencing losses. On the
other hand, variable costs change depending on the output produced.

You can determine operating leverage by finding the ratio of fixed costs to
variable costs. If your business has more fixed expenses than variable
expenses, it has high operating leverage. You can use a high degree of
operating leverage to magnify your returns, but too much of it can increase
your financial risk.

How to calculate operational leverage

As mentioned, operating leverage is the ratio of its fixed costs to its variable
costs. You can calculate this using the formula:
Let‘s look at the hypothetical accounts for Business A and Business B,

Business A Business B

Units sold 100,000 100,000

Price per unit $10 $10

Sales $1,000,000 $1,000,000

Variable cost per unit $6 $6

Variable cost $600,000 $600,000

Fixed charges $200,000 $50,000

Change in operating profit % $200,000 $350,000

Average cost per unit $8 $6.50

Business A and Business B have a similar income statement structure; the

only difference is that Business A has higher fixed costs than Business B.
This implies a higher degree of operating leverage for Business A.
Therefore, Business A has higher operating leverage than Business B.

High Demand

Business A Business B

Units sold 150,000 150,000

Price per unit $10 $10

Sales $1,500,000 $1,500,000

Variable cost per unit $6 $6

Variable cost $900,000 $900,000

Fixed charges $200,000 $50,000

High Demand

Profit $400,000 $550,000

Average costs per unit $7.33 $6.33

Change in operating profit % 100% 57%

Percentage change in average cost per unit -8.33% -2.56%

When demand is high and sales increase, profits rise by a more significant
percentage for Business A than Business B. The average cost per unit also
decreases by a greater amount for Business A than for Business B.

Low Demand

Business A Business B

Units sold 75,000 75,000

Price per unit $10 $10

Sales $750,000 $750,000

Variable cost per unit $6 $6

Variable cost $450,000 $450,000

Fixed charges $200,000 $50,000

Low Demand

Profit $100,000 $250,000

Average costs per unit $8.67 $6.67

Change in operating profit % -50% -29%

Percentage change in average cost per unit 8.33% 2.56%

In contrast, when sales stagnate, Business A suffers more than Business B.

Profits for Business A decline more than they do for Business B, and the
average cost per unit rises for Business A more than it does for Business B.

Operating leverage can be used by businesses that have a large number of

fixed assets. For example, capital-intensive companies, such as steel
production, car manufacturing, and oil extraction, can leverage their fixed
assets to reduce the average cost per unit and increase Earnings Before
Interest and Tax (EBIT).

Combined leverage
Combined leverage accounts for your organization‘s total business risks. As
the name suggests, combined leverage aggregates the effects of operating
and financial leverages to present a complete picture of your company‘s
financial health.

Combined leverage can be used by capital-intensive businesses with

expansion potential but insufficient levels of cash or equity. To effectively
use combined leverage though, be sure of your business‘s future expenses
and the market conditions. High levels of combined risk can make returns
susceptible to inputs, such as sales volumes.

How to calculate combined leverage

Combined leverage is the sum of operating and financial leverage. You can
calculate it using the formula:

Leverage disadvantages
Leverage can magnify returns with a smaller investment, and while many
investors prefer it to equity financing, there‘s no such thing as a free lunch.
Too much financial leverage can drive up a business‘s risks, including:

 Insolvency: The more your company uses total debt, the harder it is
to pay back. Banks and other institutions often check your total
leverage and financial ratios, such as debt-to-equity and interest
coverage, before agreeing to lend to you. Having too much total
debt could have a risky cost structure, and you could have difficulty
raising additional funds.
 Higher interest payments: Long-term debt can eat into a company‘s
bottom line because interest is paid from income. Also, the riskier
your business seems to lenders, the higher your interest expense and
resulting cost of capital.
 Liquidation: Your business can lose assets or eventually declare
bankruptcy if it repeatedly defaults on payments. Banks and other
lenders might seize assets like buildings and machinery if you can‘t
pay back their loans.

Cost of capital:

The cost of capital is a way to measure the returns and investment risks to
expand or facilitate business operations. A business may incur this cost from
its profits, debt, or equity financing. If a business has availed of debt and equity
financing to expand its operations, the overall cost of capital is measurable
by the weighted average cost of capital (WACC).
 Accounting and justifying the costs of capital expenditure also evaluate returns
for the investors by identifying risks and opportunities. Thus, minimizing risks
and seizing opportunities will ensure the future growth of the business and
generate higher profits. Consequently, a healthy investment will generate
increasing returns for its investors that exceed the costs of capital employed.

When considering the case of stocks or equity shares, it becomes necessary for
an investor to substantiate the cost of capital for equity with higher returns.
Therefore, an investor will first identify the volatile factors that can bring down
his earnings, like a company‘s financial position. Simultaneously he will
restructure his portfolio to avoid losses.

Thus, they assess a company‘s loss-making or poor-performing stocks or shares

to offset the lower returns. Consequently, they divert their money to acquire
other high-yielding shares or investments to offset the lower returns.

For optimization of returns and to justify capital investments into a project, its
investors should ensure sustainable business practices. These include
sufficient research and development, optimizing resource utilization, early
detection of risks, and ensuring their resolution.

Additionally, good credit ratings and rigorous business accounting

methods give management, shareholders, and other investors an accurate
picture. As a result, higher returns will neutralize the high project costs,
and business operations will continue to generate higher profits.

Capital Structure Theories:

A business requires the most beneficial capital structure. So, many capital
structure theories are available to take as a reference; amongst them, we will
discuss the four most essential ones:

 Net income theory:

This theory was postulated by David Durand, who put forward the idea of
increasing the proportion of debt in the overall capital structure. According to
him, debt is a fund source because it has a lower interest rate, eliminating the
risk factor and playing a significant role in deducting expenses for income tax.
This theory is also called the ―Fixed ‗Ke‘ theory.‖

 Net operating income theory:

 Also known as the irrelevant theory, it was also postulated by David Durand. It
depicts that the company‘s market value is not affected by changes in the capital
structure. The overall cost of equity can remain fixed no matter the proportion
of debt.

 Traditional theory:

The traditional theory was postulated by Ezra Solomon. The assumptions of this
approach are quite related to the net income theory. The main principle behind
this theory was to increase the proportion of debt to a certain limit in the capital
structure.

 Modigliani-Miller theory:

This theory came into existence by correlating the ideas of two co-members,
Franco Modigliani and Merton Miller. This theory had two further assumptions.

Absence of Corporate taxes: According to Modigliani-Miller‘s theory, in the

absence of the corporate tax, the value of the creditworthy firm will be equal to
that of the amount of equity compromised.

Presence of corporate taxes: In the case where taxes are applied, the value of
the creditworthy firm is equal to the value of the indebted firm summed up with
the product of the tax rate and the value of debt.

Capital Structure – Traditional Approach

The Traditional approach is a combination of net income approach and net
operating income approach. This approach is also known as the intermediate
approach.

According to the traditional approach, there is an optimal capital structure and

the management can increase the total value of the firm through judicious use of
financial leverage. This approach assumes that the firm can initially lower its
cost of capital and increase total value by employing more fixed charge debt.
Although investors raise the required rate of return on equity in response to
increased risk perception caused by increased proportion of debt in
capitalisation, the increase in cost of equity capital does not entirely offset the
benefit of using cheaper debt funds.

Figure 3 shows how the cost of equity capital and overall cost of a firm
responds to varying degrees of financial leverage.

The response of capitalisation costs to financial leverage can be divided into

three phases. The cost of debt remains constant in all the three phases. The
equity capitalisation cost is assumed to rise at an increasing rate with financial
leverage.

In the first phase, the overall cost of capital declines with financial leverage
because the rise in cost of equity does not entirely offset the benefit incurred by
using the cheaper fixed cost debt.

The second phase contains the only point at which the benefits of using cheaper
debt are entirely offset by rise in the cost of equity. At this point the overall cost
of capital is minimum. The optimum capital structure is at this point.

After this point, the third phase starts. The overall cost of capital begins to rise
because the rise in cost of equity is more the benefits of cheaper debt.

At the optimum structure, the firm‘s overall cost of capital (weighted average
cost of capital) is lowest and its value is highest.

Thus, the traditional approach to capital structure implies that-

(1) the cost of capital is dependent on the capital structure of the firm and

(2) there is an optimal capital structure.

 Stages
Traditional view with respect to optimal capital structure can better be
appreciated by categorising the market reaction to leverage in three stages:
Stage I:
The first stage begins with the introduction of debt in the firm‘s capitalisation. As a
consequence of the use of low cost debt, the firm‘s net income tends to rise.
Cost of equity capital (Ke) rises with the additional dose of debt but the rate of
increase will be less than the rise in net earnings rate.

Cost of debt (Kd) remains constant or rises only modestly. Combined effect of all
these will be reflected in the increase in market value of the firm and decline in
overall cost of capital (Ko).

Stage II:
In the second stage, further application of debt will enhance cost of debt and equity
share capital so sharply as to offset the gains in net income. Hence, the total
market value of the firm remains unchanged.

Stage III:
After a critical turning point, any further dose of debt to capitalisation will prove
fatal. The costs of both debt and equity will tend to rise as a result of the
increasing riskiness of each causing an increase in the overall cost of capital
which will be faster than the rise in earnings from the introduction of additional
debt. Consequently, the market value of the firm will show depressing
tendencies.

The cost of capital curve is saucer-shaped where an optimal range is extended over
the range of leverage. However, the cost of capital curve need not always be
saucer-shaped. It is possible that stage II does not exist at all and instead of an
optimal range we may have an optimal point in capital structure.
Thus, the cost of capital curve may be V-shaped which shows that application
of additional debt in capital structure beyond a point will result in an increase in
total cost of capital and drop in market value of the firm. This is an optimal
level of debt and equity mix which every firm must endeavour to attain.

Example:
A company‘s current operating income is Rs. 2 lakh. The firm has Rs. 5 lakh of
10% debt outstanding. Its cost of equity capital is estimated to be 12%.

(i) Determine current value of the firm and overall cost of capital, using
traditional approach.

(ii) The firm is considering increasing its leverage by raising an additional Rs. 5
lakhs debt and using the proceeds to retire the amount of equity. As a result of
increased financial risk, ko is likely to go up to 12% and ke to 15%. Would you
recommend the plan?

The company should not take the plan as the value of the firm is declining and
the cost of capital is increasing.

The traditional approach stands between the net income approach and the net
operating income approach. Therefore, the traditional approach is also called the
intermediate approach.

In this approach, when debt capital is introduced up to a certain limit, then it is

assumed that debt capital would increase EPS by decreasing overall cost of
capital and increasing the value of an organization. However, when the debt
capital is raised beyond a certain limit the overall cost of capital increases and
the value of the organization decreases.
Net Income (NI) approach:
According to this approach, the cost of equity capital and cost of debt capital are
assumed to be independent to the capital structure. The value of the firm rises
by the use of more and more leverage and the weighted average cost of capital
declines.

The cost of debt rD and cost of equity rE remain unchanged when D/E varies.
Because of rD and rE being constant with respect to D/E, it means that rA, the
average cost of capital is-

rA = rD(D/D+E) + rE (E/D+E)

declines as D/E increases. This occurs because when D/E increases, rD which is
lower than rE, has a higher weight in the calculation of rA.

Net Operating Income (NOI) approach,

According to this approach, the cost of equity capital and cost of debt capital are
assumed to be independent to the capital structure. The value of the firm rises
by the use of more and more leverage and the weighted average cost of capital
declines.

The cost of debt rD and cost of equity rE remain unchanged when D/E varies.
Because of rD and rE being constant with respect to D/E, it means that rA, the
average cost of capital is-

rA = rD(D/D+E) + rE (E/D+E)

declines as D/E increases. This occurs because when D/E increases, rD which is
lower than rE, has a higher weight in the calculation of rA.
 Modigliani and Miller approach:
This theory was first proposed by Franco Modigliani and Merton Miller in their
classic contribution in capital structure which is regarded by many as the most
important paper on modern finance.

This work stands as the watershed between old finance and essentially loose
connection of beliefs based on accounting practices, rules of thumb and modern
financial economics, with its rigorous mathematical theories and carefully
documented empirical studies.

Assumptions:
1. No corporate taxes.
2. Perfect market.
3. Expected earnings of all firms have the same risks.
4. Investors act rationally.
5. The cut-off point of investment is capitalization rate.
6. Earnings are distributed to the shareholders.
The value of the firm is equal to its expected operating income divided by the
discount rate appropriate to its risk class. It is independent of its capital
structure.

R = r+E = o/r
r = Market value of the firm.
E = Market value of equity.
D = Market value of stock.
K = Discount rate applicable.

WACC:

The weighted average capit (WACC) is the intere

cost of al implied st
rat of all forms of the company's debt and equity financing
e which is
weighted according to the proportionate dollar-value of each.
The formula for calculating the weighted average cost of capital
is the proportion of total equity (E) to total financing (E + D)
multiplied by the cost of equity (Re) , plus the proportion of total
debt (D) to total financing (E + D), multiplied by the cost of debt
(Rd), multiplied by one minus the tax rate (T).

Formula for WACC in Simple Terms

The total of debt is typically the stated interest rate,
minus thecos
tax benefit derived from payments being
t
deductible. intere
st
Because equity has no stated cost, the formula often uses the
Capital
, where the cost of equity is estimated to Asset
be the
Pricing
return that investors expect to receive from their .
Model investme
nt
 UNIT V: Dividend Decisions

Introduction and definition:

The Dividend Decision is one of the crucial decisions made by the finance
manager relating to the payouts to the shareholders. The payout is the
proportion of Earning Per Share given to the shareholders in the form of
dividends.

The companies can pay either dividend to the shareholders or retain the earnings
within the firm. The amount to be disbursed depends on the preference of the
shareholders and the investment opportunities prevailing within the firm.
The optimal dividend decision is when the wealth of shareholders increases
with the increase in the value of shares of the company. Therefore, the finance
department must consider all the decisions viz. Investment, Financing and
Dividend while computing the payouts.

If attractive investment opportunities exist within the firm, then the shareholders
must be convinced to forego their share of dividend and reinvest in the firm for
better future returns. At the same time, the management must ensure that the
value of the stock does not get adversely affected due to less or no dividends
paid out to the shareholders.The objective of the financial management is
the Maximization of Shareholder’s Wealth. Therefore, the finance manager
must ensure a win-win situation for both the shareholders and the company.

Meaning of dividend:

A dividend can be described as a reward that publicly-listed companies extend

to their shareholders, and its source is the company‘s net profit. Such rewards
can either be in the form of cash, cash equivalent, shares, etc. and are mostly
paid from the remaining share of profit once essential expenses are met. A
company‘s board of directors decides the rate of dividend, wherein, the
approval of majority shareholders is also factored in.

However, companies may decide to retain their accumulated profits to reinvest

in the business or reserve it for future use. Further, announcements
about dividend income declaration mostly accompany a significant change in
the company‘s stock value.
Types of Dividends:

A company may pay a dividend to its shareholders in different forms. Similarly,

depending on the frequency of declaration, there are two major types of
dividend that shareholders are rewarded with, namely –

 Special Dividend

This type of dividend is paid on common stock. It is often issued under a

particular circumstance when a company has accumulated substantial profits
over several years. Mostly such profits are looked at as excess cash that does
not need to be used at the given moment or in the immediate future.

 Preferred Dividend

Such a dividend is issued to the preferred stock owners and usually accrues a
fixed amount that is paid quarterly. Also, this kind of dividend is earned on
shares that function more like bonds.

 Interim Dividend

Interim dividend is declared by companies before the preparation of the final

full-year accounts. Here, in the Indian context, the 'year' being referred to is the
period between April of one year and March of the next year. This is the
duration for one financial year in India.

 Final Dividend

A final dividend is declared after the accounts for the year are prepared.

Besides these, the list below highlights the most common types of dividend-
  Cash

Most companies prefer to pay a dividend to their shareholders in the form of

cash. Usually, such an income is electronically wired or extended in the form of
a cheque.

 Assets

Some companies may reward their shareholders in the form of physical assets,
investment securities and real estates. However, the practice of offering assets
as dividends is still quite rare among companies.

 Stocks

A company offers stocks as dividends by issuing new shares. Typically, the

stock dividends are distributed on a pro-rata basis, wherein, each investor earns
dividend depending on the number of shares he/she holds in a company.

 Common Stocks

Typically, it is the profit that is paid to the common stockholders of a company

from its share of accumulated profits. The share of this dividend is often
decided by the law, especially when the dividend is set to be paid in cash and
may lead to the company‘s liquidation.

Other than these, a company may decide to offer shares of a new company,
warrants and other financial assets as a dividend. Nonetheless, it must be noted
that dividend income tends to influence a company‘s share price accordingly.

Bonus shares, Right shares:

Right shares are shares issued to existing shareholders in proportion to their

current holdings, usually at a discounted price. Bonus shares are shares issued
to existing shareholders in addition to their current holdings, usually at no cost
to the shareholders. The key difference between the two is that right shares
involve an investment by the shareholders, while bonus shares do not.
Right Shares Bonus Shares

Issued to existing shareholders in Issued to existing shareholders without

proportion to their existing holdings any additional cost

Shareholders have the right to subscribe Shareholders do not have the right to
to the new shares subscribe to the new shares

Dilutes the ownership of existing Does not dilute the ownership of

shareholders existing shareholders

Raises capital for the company Does not raise capital for the company

Can be issued at a premium or discount Usually issued at the face value or the
to the current market price par value of the shares

May have a record date to determine May have a record date to determine
the shareholders entitled to receive the the shareholders entitled to receive the
shares shares

Key differences between Right Shares and Bonus Shares

1. Right shares are issued to existing shareholders as a means of raising

capital for a company, while bonus shares are issued as a reward to
shareholders for their loyalty.
2. Right shares are issued at a premium, meaning shareholders must pay
more than the current market value for the shares, while bonus shares are
issued at no cost to shareholders.
3. Right shares are issued in proportion to the number of shares a
shareholder already holds, while bonus shares may be issued regardless
of the number of shares a shareholder holds.
4. Right shares are offered to the existing shareholders first, before being
offered to the public.
5. Right shares are issued to raise capital, while bonus shares are issued to
increase liquidity in the market.
6. Right shares are issued to raise funds for specific projects or ventures,
while bonus shares are issued to reward shareholders for their investment.
7. Right shares dilutes the ownership of existing shareholders and the
overall value of the shares, while bonus shares do not dilute the
ownership or the overall value of shares.
 8. Right shares are issued with a objective of raising capital and can be
issued at any time, while Bonus shares are issued with a objective of
rewarding shareholders and are usually issued during profitable times.
9. Right shares can be issued by both private and public companies, while
Bonus shares are usually issued by public companies.

A bonus share is a type of stock dividend, issued by a company to its

shareholders without requiring the shareholders to pay for them. The number of
bonus shares is determined by the company's board of directors and is usually
based on the number of shares already held by the shareholders. Bonus shares
are typically issued in the form of a stock split, where a certain number of
shares are issued for every existing share. This increases the number of shares
outstanding, but does not change the overall value of the company. Bonus
shares are usually issued to make shares more affordable for small investors and
to increase liquidity in the market.

Advantages and Disadvantages of Bonus Shares :

Advantages of Bonus Shares:

1. Increased liquidity: Bonus shares increase the number of shares

available for trading, which can lead to greater liquidity in the stock
market.
2. Capital appreciation: Bonus shares can result in an increase in the
overall value of a company's stock, which can lead to capital appreciation
for shareholders.
3. Increased earning per share: Bonus shares increase the number of
shares outstanding, which can lead to an increase in earnings per share.
4. Tax benefits: Bonus shares are tax-free for shareholders, as they are not
considered as income.
5. Increase in market capitalization: Bonus shares can lead to an increase
in a company's market capitalization, which can improve its overall
standing in the stock market.
6. Cost-effective: Bonus shares are a cost-effective way for companies to
raise additional capital, as they do not require the issuance of new shares
or the incurrence of any additional expenses.
7. Shareholder loyalty: Bonus shares can help to build loyalty among
shareholders, as they are seen as a sign of a company's success and
financial stability.
 Disadvantages of Bonus Shares:

1. Dilution of earnings per share: Bonus shares can dilute the earnings per
share for existing shareholders as the number of shares outstanding
increases, which can lead to a decrease in the value of the stock.
2. Limited funds: Bonus shares can limit a company's ability to raise
additional funds, as the company's existing shares are already
outstanding.
3. Limited control: Bonus shares can dilute the control of existing
shareholders, as the number of shares outstanding increases.
4. Short-term focus: Companies may issue bonus shares as a short-term
strategy, rather than focusing on long-term growth and profitability.
5. Misuse of funds: Bonus shares may be issued to compensate for poor
management or to cover up financial mismanagement.
6. Unfair to existing shareholders: Bonus shares can be seen as unfair to
existing shareholders, as they dilute the value of their existing shares
without providing any additional compensation.
7. Potential for manipulation: Bonus shares can be used as a tool for
manipulation by companies or individuals seeking to gain control of a
company or influence its stock price.

Dividend policies :

The dividend policy used by a company can affect the value of the enterprise. The
policy chosen must align with the company‘s goals and maximize its value for
its shareholders. While the shareholders are the owners of the company, it is the
board of directors who make the call on whether profits will be distributed or
retained.

The directors need to take a lot of factors into consideration when making this
decision, such as the growth prospects of the company and future projects.
There are various dividend policies a company can follow such as:

1. Regular dividend policy

Under the regular dividend policy, the company pays out dividends to its
shareholders every year. If the company makes abnormal profits (very high
profits), the excess profits will not be distributed to the shareholders but are
withheld by the company as retained earnings. If the company makes a loss, the
shareholders will still be paid a dividend under the policy.

The regular dividend policy is used by companies with a steady cash flow and
stable earnings. Companies that pay out dividends this way are considered low-
risk investments because while the dividend payments are regular, they may not
be very high.

2. Stable dividend policy

Under the stable dividend policy, the percentage of profits paid out as dividends
is fixed. For example, if a company sets the payout rate at 6%, it is the
percentage of profits that will be paid out regardless of the amount of profits
earned for the financial year.

Whether a company makes $1 million or $100,000, a fixed dividend will be

paid out. Investing in a company that follows such a policy is risky for investors
as the amount of dividends fluctuates with the level of profits. Shareholders face
a lot of uncertainty as they are not sure of the exact dividend they will receive.

3. Irregular dividend policy

Under the irregular dividend policy, the company is under no obligation to pay
its shareholders and the board of directors can decide what to do with the
profits. If they a make an abnormal profit in a certain year, they can decide to
distribute it to the shareholders or not pay out any dividends at all and instead
keep the profits for business expansion and future projects.

The irregular dividend policy is used by companies that do not enjoy a steady
cash flow or lack liquidity. Investors who invest in a company that follows the
policy face very high risks as there is a possibility of not receiving any
dividends during the financial year.

4. No dividend policy

Under the no dividend policy, the company doesn‘t distribute dividends to

shareholders. It is because any profits earned is retained and reinvested into the
business for future growth. Companies that don‘t give out dividends are
constantly growing and expanding, and shareholders invest in them because the
value of the company stock appreciates. For the investor, the share price
appreciation is more valuable than a dividend payout

Factors affecting dividend policies:

1. Maintenance of Reserves:
Various reserves for different purposes are needed for efficient running of a
company. Reserves for — depreciation, working capital, bad debts, dividend
equalization, expansion, taxation, debenture redemption, and preference share
redemption are very common for a company to keep apart. The surplus is
available for dividend.

2. Existence of Earned Surplus:

A company cannot pay dividends out of capital. Dividend is payable out of
current profits or accumulated profits of a company. It can be paid after pro-
viding for depreciations as per Companies Act.

3. Cash Needs of a Company:

Cash position is a big criterion to pay dividend. For a company, cash is needed
for various contingencies. They cannot be ignored for the survival of a com-
pany. So, dividend policy has to be made after a serious consideration of the
cash position of the company.

4. Need for Growth and Expansion:

A company, quite likely, is brought into being not to remain static. It is to grow
and expand. For this, cash flow must exist. Every available amount cannot be
spent for payment as dividend to shareholders. That will restrict the scope for its
growth and expansion.

Many companies follow orthodox dividend policy and provide for liberal
ploughing back of profits into the business and these retained earnings are
utilized for expansion and growth as a source of internal finance.

5. Steady and Stable Dividend Policy:

An ideal dividend policy rests on the principle of stability and steadiness.
Attractive dividend rate — after providing for reasonable, regular and stable
income — should be aimed at. Regularity of dividend depends upon stability of
earnings, dividend equalization reserve and adequate free reserves.
It is not a sound dividend policy, to distribute a good amount as dividend
because of huge profits. Conservation of excess profit for future needs is a
prudent step towards a sound, regular dividend policy.

A stable and steady dividend policy ensures long term planning and long term
financing easier. The credit — worthiness of the company, too is thus enhanced.
Market value of shares also is stabilized. By encouraging confidence of
shareholders, the shares of such a company are subjected to least speculation.

6. Government Taxation Policy:

In these days corporate taxation is a very important factor to take into
consideration. Government levies huge amount of taxes on companies to
augment its revenue needs. This means the management is put into difficulty in
maintaining stable or high rate of dividend. So, this has to be considered while
formulating dividend policy.

7. Legal Restrictions:
There may be ceiling on the rate of dividend imposed by the Government. Here
the management is helpless. Similarly, for closely held companies there may be
restrictions on ploughing back of profits because members are interested in
reducing their income tax on their dividends.

8. Dividend Restrictions by Creditors:

Lenders to companies, while granting long term credit, may restrict the rate of
dividend payment. This dictation by the lenders restricts the management in
declaring dividend as they intend to do.

9. Fixed Asset Replacement Provision:

While the price is on rise, i.e., in an inflationary economy management has to
give serious thought on replacement of fixed assets. It would require huge
amount which must be provided to keep the company running. Hence, a
company is compelled to provide for liberal depreciation. Depreciation on
historical cost is absolutely inadequate during inflation.

In recent years, many Indian companies are confronted with such a problem. As
discussed above, dividend policy depends on financial as well as legal
considerations. It is not the sweet will of the Board of Directors that can enable
a company to declare dividend as it wishes.

Dividend decisions:
The dividend is that portion of the profit that is distributed to the shareholders.
The decision involved here is how much of the profit earned by the company
after paying the taxes is to be distributed to the shareholders. It also includes
the part of the profit that should be retained in the business. When the current
income is re-invested, the retained earnings increase the firm‘s future earning
capacity. This extent of retained earnings also influences the financing
decision of the firm. The dividend decision should be taken keeping in view
the overall objective of maximizing shareholders‘ wealth.

Factors affecting Dividend Decision

 Amount of Earnings: Dividends are paid out of the current and
previous year‘s earnings. More earnings will ensure greater dividends,
whereas fewer earnings will lead to the declaration of a low rate of
dividends.

 Stability of Earning: A company that is stable and has regular earnings

can afford to declare higher dividend as compared to those company which
doesn‘t have such stability in earnings.

 Stability of Dividend: Some companies follow the policy of playing a

stable dividend because it satisfies the shareholders and helps in increasing
companies reputation. If earning potential is high, it is declared as a high
dividend, whereas if the earning is temporary or not increasing, then it is
declared as a low or normal dividend.

 Growth Opportunities: Companies with growth opportunities prefer to

retain more money out of their earnings to finance the new project. So,
companies that have growth prospects in near future will declare fewer
dividends as compared to companies that don‘t have any growth plan.
 Cash flow Position: Payment of dividends is related to the outflow of
cash. A company may be profitable, but it may have a shortage of cash. In
case the company has surplus cash, then the company can pay more
dividends, but during a shortage of cash, the company can declare a low
dividend.

 Taxation Policy: The rate of dividends also depends on the taxation

policy of the government. In the present taxation policy, dividend income is
tax-free income to the shareholders, so they prefer higher dividends.
However, dividend decision is left to companies.

 Stock market reaction: The rate of dividend and market value of a

share are directly related to each other. A higher rate of dividends has a
positive impact on the market price of the shares. Whereas, a low rate of
dividends may hurt the share price in the stock market. So, management
should consider the effect on the price of equity shares while deciding the
rate of dividend.