Financial Management Chapter 9 PDF

chapter 9 Financial Management Learning Objectives...

chapter 9 Financial Management Learning Objectives When Tata Steel Acquired Corus After studying this chapter, you should be able to: Tata Steel, the biggest steel producer in the Indian private sector has acquired Corus, (formerly known as ¾¾ explain the meaning of British Steel) in a deal worth $8.6 business finance; billion in 2007. A financial decision of this magnitude has significant ¾¾ d e s c r i b e f i n a n c i a l implicitness for both Tata Steel and management; Corus as well as their employees and shareholders. To mention some ¾¾ explain the role of financial of them: management in our Tata Steel raised a debt of over $8 enterprise; billion to finance the transaction. The deal will be paid for by Tata ¾¾ d i s c u s s o b j e c t i v e s o f Steel UK, a special purpose vehicle financial management and (SPV) set up for the purpose. how they could be achieved; Another company of the Tata group, Tata Sons Ltd., invested ¾¾ explain the meaning and $ 1 billion dollars for preference importance of financial shares along with Tata Steel which planning; will invest an equal amount. Tata Steel, the acquirer company, ¾¾ state the meaning of capital arranged about 36,500 crores of structure; rupees to finance the take-over. ¾¾ analyse the factors affecting Tata Steel raised this amount the choice of an appropriate through debt or equity or a capital structure; combination of both. Some amount came from internal accruals also. This financing decision ¾¾ state meaning of fixed capital affected the capital structure of and working capital; and the acquirer. ¾¾ analyse the factors affecting Source: The Economic Times the requirement of fixed and working capital. 2024-25 Ch_9.indd 215 2/6/2024 09:51:33 AM  BUSINESS  STUDIES 216 Introduction thus, very crucial for the survival and growth of a business. In the above case, these decisions require careful financial planning, Financial Management an understanding of the resultant capital structure and the riskiness All finance comes at some cost. It and profitability of the enterprise. All is quite imperative that it needs to these have a bearing on shareholders be carefully managed. Financial as well as employees. They require Management is concerned with optimal an understanding of business procurement as well as the usage of finance, major financial decision finance. For optimal procurement, areas, financial risk, and working different available sources of finance capital requirements of the business. are identified and compared in terms Finance, as we all know, is essential of their costs and associated risks. for running a business. Success of Similarly, the finance so procured business depends on how well finance needs to be invested in a manner that is invested in assets and operations the returns from the investment exceed and how timely and cheaply the the cost at which procurement has finances are arranged, from outside taken place. Financial Management or from within the business. aims at reducing the cost of funds procured, keeping the risk under Meaning of Business Finance control and achieving effective deployment of such funds. It also Money required for carrying out aims at ensuring availability of enough business activities is called business funds whenever required as well as finance. Almost all business activities avoiding idle finance. Needless to require some finance. Finance is emphasise, the future of a business needed to establish a business, to depends a great deal on the quality of run it, to modernise it, to expand, or its financial management. diversify it. It is required for buying Importance : The role of financial a variety of assets, which may be management cannot be over- tangible like machinery, factories, emphasised, since it has a direct buildings, offices; or intangible such bearing on the financial health of a as trademarks, patents, technical business. The financial statements, expertise, etc. Also, finance is central such as Balance Sheet and Profit to running the day-to-day operations and Loss Account, reflect a firm’s of business, like buying material, financial position and its financial paying bills, salaries, collecting cash health. Almost all items in the financial from customers, etc. needed at every statements of a business are affected stage in the life of a business entity. directly or indirectly through some Availability of adequate finance is, financial management decisions. Some 2024-25 Ch_9.indd 216 10-08-2022 09:09:51  Financial Managements 217 prominent examples of the aspects raised by way of debt and/or equity being affected could be as under: is also a financial management (i) The size and the composition of decision. The amounts of debt, fixed assets of the business: For equity share capital, preference example, a capital budgeting share capital are affected by the financing decision, which is a part decision to invest a sum of Rs. 100 of financing management. crores in fixed assets would raise the size of fixed assets block by this (v) All items in the Profit and Loss amount. Account, e.g., Interest, Expense, Depreciation, etc. : Higher amount (ii) The quantum of current assets and of debt means higher interest its break-up into cash, inventory expense in future. Similarly, use and receivables: With an increase of higher equity may entail higher in the investment in fixed assets, payment of dividends. Similarly, an there is a commensurate increase expansion of business which is a in the working capital requirement. result of capital budgeting decision The quantum of current assets is likely to affect virtually all items is also influenced by financial in the profit and loss account of the management decisions. In addition, business. decisions about credit and inventory It can, thus, be stated that the management affect the amount of financial statements of a business debtors and inventory which in are largely determined by financial turn affect the total current assets as well as their composition. management decisions taken earlier. Similarly, the future financial (iii) The amount of long-ter m and statements would depend upon past short- ter m funds to be used: as well as current financial decisions. Financial management, among Thus, the overall financial health others, involves decision about of a business is determined by the the proportion of long-term and quality of its financial management. short-term funds. An organisation Good financial management aims at wanting to have more liquid assets mobilisation of financial resources at would raise relatively more amount a lower cost and deployment of these on a long-term basis. There is in most lucrative activities. a choice between liquidity and profitability. The underlying assumption here is that current Objectives liabilities cost less than long term The primary aim of financial liabilities. management is to maximise (iv) Break-up of long-term financing into shareholders’ wealth, which is referred debt, equity etc: Of the total long- to as the wealth-maximisation concept. term finance, the proportions to be The market price of a company’s shares 2024-25 Ch_9.indd 217 10-08-2022 09:09:51  BUSINESS  STUDIES 218 is linked to the three basic financial some value addition should take place. decisions which you will study a little All those avenues of investment, modes later. This is because a company funds of financing, ways of handling various belong to the shareholders and the components of working capital must manner in which they are invested and be identified which will ultimately lead the return earned by them determines to an increase in the price of equity their market value and price. It means share. It can happen through efficient maximisation of the market value of decision-making. Decision-making is equity shares. The market price of efficient if, out of the various available equity share increases, if the benefit alternatives, the best is selected. from a decision exceeds the cost involved. All financial decisions aim at Financial Decisions ensuring that each decision is efficient Financial management is concerned and adds some value. Such value with the solution of three major issues additions tend to increase the market relating to the financial operations price of shares. Therefore, those of a firm corresponding to the three financial decisions are taken which questions of investment, financing will ultimately prove gainful from and divident decision. In a financial the point of view of the shareholders. context, it means the selection of The shareholders gain if the value of best financing alternative or best shares in the market increases. Those investment alternative. The finance decisions which result in decline in function, therefore, is concerned the share price are poor financial with three broad decisions which are decisions. Thus, we can say, the explained below: objective of financial management is to maximise the current price of equity Investment Decision shares of the company or to maximise the wealth of owners of the company, A firm’s resources are scarce in that is, the shareholders. comparison to the uses to which Therefore, when a decision is taken they can be put. A firm, therefore, about investment in a new machine, has to choose where to invest these the aim of financial management resources, so that they are able to earn is to ensure that benefits from the the highest possible return for their investment exceed the cost so that investors. The investment decision, some value addition takes place. therefore, relates to how the firm’s Similarly, when finance is procured, funds are invested in different assets. the aim is to reduce the cost so that Investment decision can be long- the value addition is even higher. term or short-term. A long-term In fact, in all financial decisions, investment decision is also called a major or minor, the ultimate objective Capital Budgeting decision. It involves that guides the decision-maker is that committing the finance on a long- 2024-25 Ch_9.indd 218 10-08-2022 09:09:51  Financial Managements 219 term basis. For example, making decisions) are concerned with the investment in a new machine to decisions about the levels of cash, replace an existing one or acquiring inventory and receivables. These a new fixed asset or opening a new decisions affect the day-to-day branch, etc. These decisions are very working of a business. These affect crucial for any business since they the liquidity as well as profitability of a affect its earning capacity in the long business. Efficient cash management, run. The size of assets, profitability inventory management and receivables and competitiveness are all affected by management are essential ingredients capital budgeting decisions. Moreover, of sound working capital management. these decisions normally involve huge amounts of investment and are Factors affecting Capital irreversible except at a huge cost. Budgeting Decision Therefore, once made, it is often almost A number of projects are often available impossible for a business to wriggle out to a business to invest in. But each of such decisions. Therefore, they need project has to be evaluated carefully to be taken with utmost care. These and, depending upon the returns, a particular project is either selected or rejected. If there is only one project, its viability in terms of the rate of return, viz., investment and its comparability with the industry’s average is seen. There are certain factors which affect capital budgeting decisions. (a) Cash flows of the project: When a company takes an investment decision involving huge amount it expects to generate some cash flows over a period. These cash flows are in the form of a series Wealth Maximisation Concept of cash receipts and payments over the life of an investment. The amount of these cash flows decisions must be taken by those who should be carefully analysed before understand them comprehensively. considering a capital budgeting A bad capital budgeting decision decision. normally has the capacity to severely (b) The rate of retur n: The most damage the financial fortune of a important criterion is the rate business. Short-ter m investment of return of the project. These decisions (also called working capital calculations are based on the 2024-25 Ch_9.indd 219 10-08-2022 09:09:51  BUSINESS  STUDIES 220 expected returns from each whether or not a firm has earned a proposal and the assessment of profit. Likewise, the borrowed funds the risk involved. Suppose, there have to be repaid at a fixed time. The are two projects, A and B (with the risk of default on payment is known same risk involved), with a rate as financial risk which has to be of return of 10 per cent and 12 considered by a firm likely to have per cent, respectively, then under insufficient shareholders to make normal circumstance, project B these fixed payments. Shareholders’ should be selected. funds, on the other hand, involve no (c) The investment criteria involved: commitment regarding the payment The decision to invest in a particular of returns or the repayment of capital. project involves a number of A firm, therefore, needs to have a calculations regarding the amount judicious mix of both debt and equity of investment, interest rate, cash in making financing decisions, which flows and rate of return. There are may be debt, equity, preference share different techniques to evaluate capital, and retained earnings. inv e s t m ent p ro p o sals which The cost of each type of finance has are known as capital budgeting to be estimated. Some sources may techniques. These techniques are be cheaper than others. For example, applied to each proposal before debt is considered to be the cheapest selecting a particular project. of all the sources, tax deductibility of interest makes it still cheaper. Financing Decision Associated risk is also different for This decision is about the quantum each source, e.g., it is necessary to of finance to be raised from various pay interest on debt and redeem the long-term sources. Short-term sources principal amount on maturity. There are studied under the ‘working capital is no such compulsion to pay any management’. dividend on equity shares. Thus, there It involves identification of various is some amount of financial risk in available sources. The main sources debt financing. The overall financial of funds for a firm are shareholders’ risk depends upon the proportion of funds and borrowed funds. The debt in the total capital. The fund shareholders’ funds refer to the equity raising exercise also costs something. capital and the retained earnings. This cost is called floatation cost. Borrowed funds refer to the finance It also must be considered while raised through debentures or other evaluating different sources. Financing forms of debt. A firm has to decide the decision is, thus, concerned with the proportion of funds to be raised from decisions about how much to be raised either sources, based on their basic from which source. This decision characteristics. Interest on borrowed determines the overall cost of capital funds have to be paid regardless of and the financial risk of the enterprise. 2024-25 Ch_9.indd 220 10-08-2022 09:09:51  Financial Managements 221 Financial Decisions Factors Affecting Financing different. A prudent financial Decisions manager would normally opt for a The financing decisions are affected source which is the cheapest. by various factors. Important among (b) Risk: The risk associated with each them are as follows: of the sources is different. (a) Cost: The cost of raising funds (c) Floatation Costs: Higher the floatation through different sources are cost, less attractive the source. 2024-25 Ch_9.indd 221 10-08-2022 09:09:52  BUSINESS  STUDIES 222 (d) Cash Flow Position of the Company: in the business. While the dividend A stronger cash flow position may constitutes the current income make debt financing more viable re-investment as retained earning than funding through equity. increases the firm’s future earning (e) Fixed Operating Costs: If a business capacity. The extent of retained has high fixed operating costs (e.g., earnings also influences the financing building rent, Insurance premium, decision of the firm. Since the firm Salaries, etc.), It must reduce fixed does not require funds to the extent financing costs. Hence, lower debt of re-invested retained earnings, the financing is better. Similarly, if decision regarding dividend should fixed operating cost is less, more be taken keeping in view the overall of debt financing may be preferred. objective of maximising shareholder’s (f) Control Considerations: Issues of wealth. more equity may lead to dilution of management’s control over Factors Affecting Dividend the business. Debt financing has Decision no such implication. Companies How much of the profits earned by a afraid of a takeover bid would company will be distributed as profit prefer debt to equity. and how much will be retained in the (g) State of Capital Market: Health of business is affected by many factors. the capital market may also affect Some of the important factors are the choice of source of fund. During discussed as follows: the period when stock market is (a) Amount of Earnings: Dividends rising, more people invest in equity. are paid out of current and past However, depressed capital market earning. Therefore, earnings is a may make issue of equity shares major determinant of the decision difficult for any company. about dividend. (b) Stability Earnings: Other things Dividend Decision remaining the same, a company The third important decision that having stable earning is in a better every financial manager has to position to declare higher dividends. take relates to the distribution of As against this, a company having dividend. Dividend is that portion unstable earnings is likely to pay of profit which is distributed to smaller dividend. shareholders. The decision involved (c) Stability of Dividends: Companies here is how much of the profit earned generally follow a policy of by company (after paying tax) is to be stabilising dividend per share. The distributed to the shareholders and increase in dividends is generally how much of it should be retained made when there is confidence that 2024-25 Ch_9.indd 222 1/23/2024 03:51:22 PM  Financial Managements 223 their earning potential has gone way of dividends. As compared up and not just the earnings of to this, higher dividends may be the current year. In other words, declared if tax rates are relatively dividend per share is not altered if lower. Though the dividends are free the change in earnings is small or of tax in the hands of shareholders, seen to be temporary in nature. a dividend distribution tax is levied (d) Growth Opportunities: Companies on companies. Thus, under the having good growth opportunities present tax policy, shareholders retain more money out of their are likely to prefer higher dividends. earnings so as to finance the (h) Stock Market Reaction: Investors, required investment. The dividend in general, view an increase in in growth companies is, therefore, dividend as a good news and smaller, than that in the non– stock prices react positively to it. growth companies. Similarly, a decrease in dividend (e) Cash Flow Position: The payment may have a negative impact on the of dividend involves an outflow of share prices in the stock market. cash. A company may be earning Thus, the possible impact of profit but may be short on cash. dividend policy on the equity share Availability of enough cash in price is one of the important factors the company is necessary for considered by the management declaration of dividend. while taking a decision about it. (f) Shareholders’ Preference: While (i) Access to Capital Market: Large and declaring dividends, managements reputed companies generally have must keep in mind the preferences easy access to the capital market of the shareholders in this regard. If and, therefore, may depend less the shareholders in general desire on retained earning to finance that at least a certain amount is their growth. These companies paid as dividend, the companies tend to pay higher dividends than are likely to declare the same. There the smaller companies which have are always some shareholders who relatively low access to the market. depend upon a regular income (j) Legal Constraints: Certain from their investments. provisions of the Companies Act (g) Taxation Policy: The choice between place restrictions on payouts as the payment of dividend and dividend. Such provisions must retaining the earnings is, to some be adhered to while declaring the extent, affected by the difference in dividend. the tax treatment of dividends and (k) Contractual Constraints: While capital gains. If tax on dividend is granting loans to a company, higher, it is better to pay less by sometimes the lender may impose 2024-25 Ch_9.indd 223 1/23/2024 03:51:22 PM  BUSINESS  STUDIES 224 certain restrictions on the payment forecast all the items which are likely of dividends in future. The to undergo changes. It enables the companies are required to ensure management to foresee the fund that the dividend does not violate requirements both the quantum as the terms of the loan agreement in well as the timing. Likely shortage this regard. and surpluses are forecast so that necessary activities are taken in Financial Planning advance to meet those situations. Thus, financial planning strives to Financial planning is essentially the achieve the following twin objectives. preparation of a financial blueprint of (a) To ensure availability of funds an organisation’s future operations. whenever required: This include The objective of financial planning a proper estimation of the funds is to ensure that enough funds are required for different purposes available at right time. If adequate such as for the purchase of long- funds are not available the firm will term assets or to meet day-to- not be able to honour its commitments day expenses of business etc. and carry out its plans. On the other Apart from this, there is a need to hand, if excess funds are available, it estimate the time at which these will unnecessarily add to the cost and funds are to be made available. may encourage wasteful expenditure. Financial planning also tries to It must be kept in mind that financial specify possible sources of these planning is not equivalent to, or a funds. substitute for, financial management. (b) To see that the firm does not Financial management aims at raise resources unnecessarily: choosing the best investment and Excess funding is almost as bad financing alternatives by focusing on as inadequate funding. Even if their costs and benefits. Its objective there is some surplus money, good is to increase the shareholders’ wealth. financial planning would put it to Financial planning on the other the best possible use so that the hand aims at smooth operations financial resources are not left idle by focusing on fund requirements and don’t unnecessarily add to and their availability in the light of the cost. financial decisions. For example, if a Thus, a proper matching of funds capital budgeting decisions is taken, requirements and their availability the operations are likely to be at a is sought to be achieved by financial higher scale. The amount of expenses planning. This process of estimating and revenues are likely to increase. the fund requirement of a business Financial planning process tries to and specifying the sources of funds 2024-25 Ch_9.indd 224 1/23/2024 03:51:22 PM  Financial Managements 225 is called financial planning. Financial Further, the sources from which the planning takes into consideration the external funds requirement can be growth, performance, investments met are identified and cash budgets and requirement of funds for a given are made, incorporating these factors. period. Financial planning includes both short-term as well as long-term Importance planning. Long-term planning relates Financial planning is an important to long term growth and investment. It focuses on capital expenditure part of overall planning of any business programmes. Short-term planning enterprise. It aims at enabling the covers short-term financial plan called company to tackle the uncertainty in budget. respect of the availability and timing Typically, financial planning is of the funds and helps in smooth done for three to five years. For longer functioning of an organisation. The periods it becomes more difficult and importance of financial planning can less useful. Plans made for periods of be explained as follows: one year or less are termed as budgets. (i) It helps in forecasting what may Budgets are example of financial happen in future under different planning exercise in greater details. business situations. By doing so, it They include detailed plan of action helps the firms to face the eventual for a period of one year or less. situation in a better way. In other Financial planning usually begins words, it makes the firm better with the preparation of a sales forecast. prepared to face the future. For Let us suppose a company is making example, a growth of 20% in sales is a financial plan for the next five years. predicted. However, it may happen It will start with an estimate of the that the growth rate eventually sales which are likely to happen in turns out to be 10% or 30%. the next five years. Based on these, Many items of expenses shall be the financial statements are prepared different in these three situations. keeping in mind the requirement By preparing a blueprint of these of funds for investment in the fixed three situations the management capital and working capital. Then the may decide what must be done expected profits during the period are in each of these situations. This estimated so that an idea can be made preparation of alternative financial of how much of the fund requirements plans to meet different situations is can be met internally i.e., through clearly of immense help in running retained earnings (after dividend the business smoothly. payouts). This results in an estimation (ii) It helps in avoiding business of the requirement for external funds. shocks and surprises and helps 2024-25 Ch_9.indd 225 1/23/2024 03:51:22 PM  BUSINESS  STUDIES 226 Cutting Back on Debt Even successful businesses have debt, but how much is too much? Learning how to manage debt is what can put you ahead. Taking on the right amount of debt can mean the difference between a business struggling to survive and one that can respond nimbly to changing economic or market conditions. A number of circumstances may justify acquiring debt. As a general rule, borrowing makes the most sense when you need to bolster cash flow or finance growth or expansion. But while debt can provide the leverage you need to grow, too much debt can strangle your business. So the question is: How much debt is too much? The answer, experts say, lies in a careful analysis of your cash flow as well as your industry. A business that doesn’t grow dies. You’ve got to grow, but you’ve got to grow within the financial constraints of your business. What is the ideal capital structure a business needs in its industry to remain viable? The higher the volatility (in your industry), the less debt you should have. The smaller the volatility, the more debt you can afford. Although banks and other financial institutions look for a satisfactory debt-to- equity ratio before agreeing to make a loan, don’t assume a creditor’s willingness to extend funds is evidence that your business is in a strong debt position. Some financial institutions are overzealous lenders, particularly when trying to lure or hold on to promising business customers. “The bank may be looking more at collateral than whether the (business’s) earnings are going to come in to justify the debt service. To avoid these and other credit pitfalls, it’s up to you to get the financial facts on your business and make sound borrowing decisions. Unfortunately, many entrepreneurs fail to recognise how important financial analysis is to running a successful business. Even business owners who receive detailed financial statements from their accountants often do not take advantage of the valuable information contained in the documents. the company in preparing for the (vi) It provid es a link between future. investment and financing decisions (iii) If helps in co-ordinating various on a continuous basis. business functions, e.g., sales and (vii) By spelling out detailed objectives production functions, by providing for various business segments, it clear policies and procedures. makes the evaluation of actual (iv) Detailed plans of action prepared performance easier. under financial planning reduce waste, duplication of efforts, and Capital Structure gaps in planning. One of the important decisions under (v) It tries to link the present with the financial management relates to the future. financing pattern or the proportion of 2024-25 Ch_9.indd 226 1/23/2024 03:51:22 PM  Financial Managements 227 the use of different sources in raising is likely to lower the over-all cost of funds. On the basis of ownership, the capital of the firm provided that the sources of business finance can be cost of equity remains unaffected. broadly classified into two categories Impact of a change in the debt-equity viz., ‘owners’ funds’ and ‘borrowed ratio upon the earning per share is funds’. Owners’ funds consist of dealt with in detail later in this chapter. equity share capital, preference share Debt is cheaper but is more risky capital and reserves and surpluses or for a business because the payment of retained earnings. Borrowed funds can interest and the return of principal is be in the form of loans, debentures, obligatory for the business. Any default public deposits etc. These may be in meeting these commitments may borrowed from banks, other financial force the business to go into liquidation. institutions, debentureholders and There is no such compulsion in case of public. equity, which is therefore, considered Capital structure refers to the mix riskless for the business. Higher use between owners and borrowed funds. of debt increases the fixed financial These shall be referred as equity and charges of a business. As a result, debt in the subsequent text. It can increased use of debt increases the be calculated as debt-equity ratio financial risk of a company.  Debt  Financial risk is the chance that i.e.,  or as the proportion a firm would fail to meet its payment  Equity  obligations. of debt out of the total capital i.e., Capital structure of a company, thus, affects both the profitability and  Debt   Debt + Equity  the financial risk. A capital structure. will be said to be optimal when the Debt and equity differ significantly proportion of debt and equity is in their cost and riskiness for the such that it results in an increase firm. The cost of debt is lower than in the value of the equity share. In the cost of equity for a firm because other words, all decisions relating to the lender’s risk is lower than the capital structure should emphasise on equity shareholder’s risk, since the increasing the shareholders’ wealth. lender earns an assured return and The proportion of debt in the overall repayment of capital and, therefore, capital is also called financial leverage. they should require a lower rate of return. Additionally, interest paid D Financial leverage is computed as on debt is a deductible expense for E computation of tax liability whereas D or D + E when D is the Debt and E is dividends are paid out of after-tax profit. Increased use of debt, therefore, the Equity. As the financial leverage 2024-25 Ch_9.indd 227 1/23/2024 03:51:23 PM  BUSINESS  STUDIES 228 Example I Company X Ltd. Total Funds used Rs. 30 Lakh Interest rate 10% p.a. Tax rate 30% EBIT Rs. 4 Lakh Debt Situation I Nil Situation II Rs. 10 Lakh Situation III Rs. 20 Lakh EBIT-EPS Analysis Situation I Situation II Situation III EBIT 4,00,000 4,00,000 4,00,000 Interest NIL 1,00,000 2,00,000 EBT 4,00,000 3,00,000 2,00,000 (Earnings before taxes) Tax 1,20,000 90,000 60,000 EAT 2,80,000 2,10,000 1,40,000 (Earnings after taxes) No. of shares of Rs.10 3,00,000 2,00,000 1,00,000 EPS 0.93 1.05 1.40 (Earnings per share) increases, the cost of funds declines situations-II and III, respectively. All because of increased use of cheaper debt is at 10% p.a. debt but the financial risk increases. The company earns Rs. 0.93 per The impact of financial leverage on the share if it is unlevered. With debt of profitability of a business can be seen Rs. 10 lakh its EPS is Rs. 1.05. With through EBIT-EPS (Earning before a still higher debt of Rs. 20 lakh, its, Interest and Taxes-Earning per Share) EPS rises to Rs. 1.40. Why is the EPS analysis as in the following example. rising with higher debt? It is because Three situations are considered. the cost of debt is lower than the return There is no debt in situation-I i.e. that company is earning on funds (unlevered business). Debt of Rs. 10 employed. The company is earning a lakh and 20 lakh are assumed in Return on Investment (RoI). 2024-25 Ch_9.indd 228 2/6/2024 11:23:29 AM  Financial Managements 229  EBIT  more of cheaper debt to enhance the of 13.33%  × 100  EPS. Such practice is called Trading  Total Investment , on Equity.  4Lakh  Trading on Equity refers to the  × 100 . This is higher than 30Lakh  increase in profit earned by the equity the 10% interest it is paying on debt shareholders due to the presence of funds. With higher use of debt, this fixed financial charges like interest. Now consider the following case of difference between RoI and cost of debt Company Y. All details are the same increases the EPS. This is a situation except that the company is earning of favourable financial leverage. In a profit before interest and taxes of such cases, companies often employ Rs. 2 lakh. Example II Company Y Ltd. Situation I Situation II Situation III EBIT 2,00,000 2,00,000 2,00,000 Interest NIL 1,00,000 2,00,000 EBT 2,00,000 1,00,000 NIL Tax 60,000 30,000 NIL EAT 1,40,000 70,000 NIL No. of shares of Rs.10 3,00,000 2,00,000 1,00,000 EPS 0.47 0.35 NIL In this example, the EPS of the not recommended. An increase in debt company is falling with increased use may enhance the EPS but as pointed of debt. It is because the Company’s out earlier, it also raises the financial rate of return on investment (RoI) is risk. Ideally, a company must choose less than the cost of debt. The RoI that risk-return combination which 2Lakh maximises shareholders’ wealth. The for company Y is × 100 , i.e., 30Lakh debt-equity mix that achieves it, is the 6.67%, whereas the interest rate on optimum capital structure. debt is 10%. In such cases, the use of debt reduces the EPS. This is a Factors affecting the Choice of situation of unfavourable financial Capital Structure leverage. Trading on Equity is clearly Deciding about the capital structure unadvisable in such a situation. of a firm involves determining the Even in case of Company X, relative proportion of various types reckless use of Trading on Equity is of funds. This depends on various 2024-25 Ch_9.indd 229 2/6/2024 09:50:37 AM  BUSINESS  STUDIES 230 factors. For example, debt requires 3. Debt Service Coverage Ratio regular servicing. Interest payment (DSCR): Debt Service Coverage Ratio and repayment of principal are takes care of the deficiencies referred obligatory on a business. In addition to in the Interest Coverage Ratio (ICR). a company planning to raise debt The cash profits generated by the must have sufficient cash to meet the operations are compared with the total increased outflows because of higher cash required for the service of the debt. Similarly, important factors debt and the preference share capital. which determine the choice of capital It is calculated as follows: structure are as follows: Profit after tax + Depreciation + Interest + Non Cash exp. 1. Cash Flow Position: Size of projected Pref. Div + Interest + Repayment obligation cash flows must be considered before borrowing. Cash flows must not only A higher DSCR indicates better cover fixed cash payment obligations ability to meet cash commitments but there must be sufficient buffer and consequently, the company’s also. It must be kept in mind that potential to increase debt component a company has cash payment in its capital structure. obligations for (i) normal business 4. Return on Investment (RoI): If operations; (ii) for investment in the RoI of the company is higher, it fixed assets; and (iii) for meeting can choose to use trading on equity the debt service commitments i.e., to increase its EPS, i.e., its ability to payment of interest and repayment use debt is greater. We have already of principal. observed in Example I that a firm 2. Interest Coverage Ratio (ICR): can use more debt to increase its The interest coverage ratio refers to EPS. However, in Example II, use of the number of times earnings before higher debt is reducing the EPS. It is interest and taxes of a company covers because the firm is earning an RoI of the interest obligation. This may be only 6.67% which lower than its cost calculated as follows: of debt. In example I the RoI is 13.33%, EBIT and trading on equity is profitable. ICR = Interest It shows that, RoI is an important The higher the ratio, lower shall determinant of the company’s ability be the risk of company failing to to use Trading on equity and thus the meet its interest payment obligations. capital structure. However, this ratio is not an adequate 5. Cost of debt: A firm’s ability to measure. A firm may have a high EBIT borrow at a lower rate increases its but low cash balance. Apart from capacity to employ higher debt. Thus, interest, repayment obligations are more debt can be used if debt can be also relevant. raised at a lower rate. 2024-25 Ch_9.indd 230 1/23/2024 03:51:23 PM  Financial Managements 231 6. Tax Rate: Since interest is a company is unable to meet its fixed deductible expense, cost of debt is financial charges namely interest affected by the tax rate. The firms in payment, preference dividend and our examples are borrowing @ 10%. repayment obligations. Apart from Since the tax rate is 30%, the after the financial risk, every business tax cost of debt is only 7%. A higher has some operating risk (also called tax rate, thus, makes debt relatively business risk). Business risk depends cheaper and increases its attraction upon fixed operating costs. Higher vis-à-vis equity. fixed operating costs result in higher 7. Cost of Equity: Stock owners business risk and vice-versa. The total expect a rate of return from the equity risk depends upon both the business which is commensurate with the risk risk and the financial risk. If a firm’s they are assuming. When a company business risk is lower, its capacity to increases debt, the financial risk use debt is higher and vice-versa. faced by the equity holders, increases. 10. Flexibility: If a firm uses its Consequently, their desired rate of debt potential to the full, it loses return may increase. It is for this flexibility to issue further debt. To reason that a company can not use maintain flexibility, it must maintain debt beyond a point. If debt is used some borrowing power to take care of beyond that point, cost of equity may unforeseen circumstances. go up sharply and share price may decrease inspite of increased EPS. 11. Control: Debt normally does Consequently, for maximisation of not cause a dilution of control. A shareholders’ wealth, debt can be used public issue of equity may reduce the only upto a level. managements’ holding in the company and make it vulnerable to takeover. 8. Floatation Costs: Process of This factor also influences the choice raising resources also involves some cost. Public issue of shares and between debt and equity especially in debentures requires considerable companies in which the current holding expenditure. Getting a loan from a of management is on a lower side. financial institution may not cost 12. Regulatory Framework: Every so much. These considerations company operates within a regulatory may also affect the choice between framework provided by the law e.g., debt and equity and hence the public issue of shares and debentures capital structure. have to be made under SEBI 9. Risk Consideration: As discussed guidelines. Raising funds from banks earlier, use of debt increases the and other financial institutions require financial risk of a business. Financial fulfillment of other norms. The relative risk refers to a position when a ease with which these norms can, be 2024-25 Ch_9.indd 231 1/23/2024 03:51:23 PM  BUSINESS  STUDIES 232 met or the procedures completed may for more than one year, usually also have a bearing upon the choice of for much longer, e.g., plant and the source of finance. machinery, furniture and fixture, land 13. Stock Market Conditions: If the and building, vehicles, etc. stock markets are bullish, equity Decision to invest in fixed assets shares are more easily sold even at must be taken very carefully as the a higher price. Use of equity is often investment is usually quite large. preferred by companies in such a Such decisions once taken are situation. However, during a bearish irrevocable except at a huge loss. phase, a company, may find raising Such decisions are called capital of equity capital more difficult and it budgeting decisions. may opt for debt. Thus, stock market Current assets are those assets conditions often affect the choice which, in the normal routine of the between the two. business, get converted into cash or 14. Capital Structure of other cash equivalents within one year, e.g., Companies: A useful guideline in the inventories, debtors, bills receivables, capital structure planning is the debt- etc. equity ratios of other companies in Management of Fixed Capital the same industry. There are usually Fixed capital refers to investment some industry norms which may help. in long-term assets. Management of Care however must be taken that the fixed capital involves allocation of company does not follow the industry firm’s capital to different projects or norms blindly. For example, if the assets with long-term implications business risk of a firm is higher, it can for the business. These decisions not afford the same financial risk. It are called investment decisions or should go in for low debt. Thus, the capital budgeting decisions and affect management must know what the the growth, profitability and risk of industry norms are, whether they are the business in the long run. These following them or deviating from them long-term assets last for more than and adequate justification must be there in both cases. one year. It must be financed through Fixed and Working Capital long-term sources of capital such as equity or preference shares, Meaning debentures, long-term loans and Every company needs funds to finance retained earnings of the business. its assets and activities. Investment Fixed Assets should never be financed is required to be made in fixed assets through short-term sources. and current assets. Fixed assets are Investment in these assets those which remains in the business would also include expenditure on 2024-25 Ch_9.indd 232 1/23/2024 03:51:23 PM  Financial Managements 233 acquisition, expansion, modernisation (iv) Irreversible decisions: These and their replacement. These decisions decisions once taken, are not include purchase of land, building, reversible without incurring heavy plant and machinery, launching losses. Abandoning a project after a new product line or investing in heavy investment is made is quite advanced techniques of production. costly in terms of waste of funds. Major expenditures such as those Therefore, these decisions should on advertising campaign or research be taken only after carefully and development programme having evaluating each detail or else the long term implications for the firm adverse financial consequences are also examples of capital budgeting may be very heavy. decisions. The management of fixed capital or investment or capital Factors affecting the Requirement budgeting decisions are important for of Fixed Capital the following reasons: 1. Nature of Business: The type (i) Long-term growth: These decisions of business has a bearing upon have bearing on the long-term the fixed capital requirements. For growth. The funds invested in example, a trading concern needs long-term assets are likely to yield lower investment in fixed assets returns in the future. These will compared with a manufacturing affect the future prospects of the organisation; since it does not require business. to purchase plant and machinery, etc. (ii) Large amount of funds involved: These decisions result in a 2. Scale of Operations: A larger substantial portion of capital funds organisation operating at a higher being blocked in long-term projects. scale needs bigger plant, more space Therefore, these investments are etc. and therefore, requires higher planned after a detailed analysis investment in fixed assets when is undertaken. This may involve compared with the small organisation. decisions like where to procure 3. Choice of Technique: Some funds from and at what rate of organisations are capital intensive interest. whereas others are labour intensive. (iii) Risk involved: Fixed capital involves A capital-intensive organisation investment of huge amounts. It requires higher investment in plant affects the returns of the firm as a and machinery as it relies less on whole in the long-term. Therefore, manual labour. The requirement of investment decisions involving fixed capital for such organisations fixed capital influence the overall would be higher. Labour intensive business risk complexion of the firm. organisations on the other hand 2024-25 Ch_9.indd 233 1/23/2024 03:51:23 PM  BUSINESS  STUDIES 234 require less investment in fixed assets. lease, the firm pays lease rentals and Hence, their fixed capital requirement uses it. By doing so, it avoids huge sums is lower. required to purchase it. Availability of 4. Technology Upgradation: In certain leasing facilities, thus, may reduce industries, assets become obsolete the funds required to be invested in sooner. Consequently, their replace- fixed assets, thereby reducing the fixed ments become due faster. Higher capital requirements. Such a strategy investment in fixed assets may, is specially suitable in high risk lines therefore, be required in such cases. of business. For example, computers become 8. Level of Collaboration: At times, obsolete faster and are replaced much certain business organisations share sooner than say, furniture. Thus, such each other’s facilities. For example, organisations which use assets which a bank may use another’s ATM or are prone to obsolescence require some of them may jointly establish a higher fixed capital to purchase such particular facility. This is feasible if the assets. scale of operations of each one of them is not sufficient to make full use of the 5. Growth Prospects: Higher growth facility. Such collaboration reduces of an organisation generally requires the level of investment in fixed assets higher investment in fixed assets. for each one of the participating Even when such growth is expected, organisations. a company may choose to create higher capacity in order to meet the Working Capital anticipated higher demand quicker. This entails larger investment in fixed Apart from the investment in fixed assets and consequently larger fixed assets every business organisation capital. needs to invest in current assets. This 6. Diversification: A firm may choose investment facilitates smooth day-to- to diversify its operations for various day operations of the business. Current reasons, With diversification, fixed assets are usually more liquid but capital requirements increase e.g., a contribute less to the profits than fixed textile company is diversifying and assets. Examples of current assets, in starting a cement manufacturing order of their liquidity, are as under. plant. Obviously, its investment in 1. Cash in hand/Cash at Bank fixed capital will increase. 2. Marketable securities 7. Financing Alternatives: A developed 3. Bills receivable financial market may provide leasing facilities as an alternative to outright 4. Debtors purchase. When an asset is taken on 5. Finished goods inventory 2024-25 Ch_9.indd 234 1/23/2024 03:51:23 PM  Financial Managements 235 6. Work in progress amount of working capital required. 7. Raw materials A trading organisation usually needs a smaller amount of working 8. Prepaid expenses capital compared to a manufacturing These assets, as noted earlier, are organisation. This is because there expected to get converted into cash is usually no processing. Therefore, or cash equivalents within a period there is no distinction between raw of one year. These provide liquidity to materials and finished goods. Sales the business. An asset is more liquid can be effected immediately upon if it can be converted into cash quicker the receipt of materials, sometimes and without reduction in value. even before that. In a manufacturing Insufficient investment in current business, however, raw material needs assets may make it more difficult for to be converted into finished goods an organisation to meet its payment before any sales become possible. obligations. However, these assets Other factors remaining the same, a provide little or low return. Hence, a trading business requires less working balance needs to be struck between capital. Similarly, service industries liquidity and profitability. which usually do not have to maintain Current liabilities are those inventory require less working capital. payment obligations which are due 2. Scale of Operations: For for payment within one year; such as organisations which operate on a bills payable, creditors, outstanding higher scale of operation, the quantum expenses and advances received from of inventory and debtors required is customers, etc. generally high. Such organisations, Some part of current assets is therefore, require large amount of usually financed through short-term working capital as compared to the sources, i.e., current liabilities. The organisations which operate on a lower rest is financed through long-term scale. sources and is called net working 3. Business Cycle: Different phases of capital. Thus, NWC = CA – CL (i.e. business cycles affect the requirement Current Assets - Current Liabilities.) of working capital by a firm. In Thus, net working capital may be case of a boom, the sales as well as defined as the excess of current assets production are likely to be larger and, over current liabilities. therefore, larger amount of working capital is required. As against this, Factors Affecting the Working the requirement for working capital Capital Requirements will be lower during the period of 1. Nature of Business: The basic depression as the sales as well as nature of a business influences the production will be small. 2024-25 Ch_9.indd 235 1/23/2024 03:51:23 PM  BUSINESS  STUDIES 236 4. Seasonal Factors: Most business degrees of efficiency. For example, have some seasonality in their a firm managing its raw materials operations. In peak season, because of efficiently may be able to manage with higher level of activity, larger amount a smaller balance. This is reflected of working capital is required. As in a higher inventory turnover ratio. against this, the level of activity as Similarly, a better debtors turnover well as the requirement for working ratio may be achieved reducing capital will be lower during the the amount tied up in receivables. lean season. Better sales effort may reduce the 5. Production Cycle: Production average time for which finished goods cycle is the time span between the inventory is held. Such efficiencies receipt of raw material and their may reduce the level of raw materials, conversion into finished goods. Some finished goods and debtors resulting businesses have a longer production in lower requirement of working cycle while some have a shorter capital. one. Duration and the length of 9. Availability of Raw Material: If production cycle, affects the amount the raw materials and other required of funds required for raw materials materials are available freely and and expenses. Consequently, working continuously, lower stock levels may capital requirement is higher in firms suffice. If, however, raw materials do with longer processing cycle and lower not have a record of un-interrupted in firms with shorter processing cycle. availability, higher stock levels may 6. Credit Allowed: Different firms be required. In addition, the time lag allow different credit terms to their between the placement of order and customers. These depend upon the the actual receipt of the materials (also level of competition that a firm faces called lead time) is also relevant. Larger as well as the credit worthiness of the lead time, larger the quantity of their clientele. A liberal credit policy material to be stored and larger shall results in higher amount of debtors, be the amount of working capital increasing the requirement of working required. capital. 10. Growth Prospects: If the growth 7. Credit Availed: Just as a firm potential of a concern is perceived to allows credit to its customers it also be higher, it will require larger amount may get credit from its suppliers. of working capital so that it is able To the extent it avails the credit to meet higher production and sales on purchases, the working capital target whenever required. requirement is reduced. 11. Level of Competition: Higher level 8. Operating Efficiency: Firms of competitiveness may necessitate manage their operations with varied larger stocks of finished goods to 2024-25 Ch_9.indd 236 1/23/2024 03:51:23 PM  Financial Managements 237 meet urgent orders from customers. rate of inflation. It must, however, This increases the working capital be noted that an inflation rate of 5%, requirement. Competition may also does not mean that every component force the firm to extend liberal credit of working capital will change by terms discussed earlier. the same percentage. The actual 12. Inflation: With rising prices, requirement shall depend upon the larger amounts are required even rates of price change of different to maintain a constant volume of components (e.g., raw material, production and sales. The working finished goods, labour cost,) Finished capital requirement of a business goods as well as their proportion in thus, become higher with higher the total requirement. Key Terms Financial Management Wealth Maximisation Investment Decision Financing Decision Dividend Decision Capital Budgeting Working Capital Financial Planning Capital Structure Trading on Equity Summary Business finance: The money required for carrying out business activities is called business finance. Almost all business activities require some finance. Finance is needed to establish a business, to run it, to modernise it, to expand, and diversify it. Financial Management: Financial Management is concerned with optimal procurement as well as usage of finance. For optimal procurement, different available sources of finance are identified and compared in terms of their costs and associated risks. Objectives and Financial Decisions The primary aim of financial management is to maximise shareholders’ wealth which is referred to as the wealth maximisation concept. The market price of a company’s shares are linked to the three basic financial decisions Financial decision-making is concerned with three broad decisions which are Investment Decision, Financing Decision, Dividend Decision Financial Planning and Importance Financial planning is essentially preparation of a financial blueprint of an organisation’s future operations. The 2024-25 Ch_9.indd 237 1/23/2024 03:51:24 PM  BUSINESS  STUDIES 238 objective of financial planning is to ensure that enough funds are available at right time. Financial planning strives to achieve the following twin objectives. (a) To ensure availability of funds whenever these are required: (b) To see that the firm does not raise resources unnecessarily: Financial planning is an important part of overall planning of any business enterprise. It aims at enabling the company to tackle the uncertainty in respect of the availability and timing of the funds and helps in smooth functioning of an organisation. Capital Structure and Factors One of the important decisions under financial management relates to the financing pattern or the proportion of the use of different sources in raising funds. On the basis of ownership, the sources of business finance can be broadly classified into two categories viz., ‘owners funds’ and ‘borrowed funds’. Capital structure refers to the mix between owners and borrowed funds. Deciding about the capital structure of a firm involves determining the relative proportion of various types of funds. This depends on various factors which are: Cash Flow Position, Interest Coverage Ratio (ICR), Debt Service Coverage Ratio (DSCR), Return on Investment (RoI), Cost of debt, Tax Rate, Cost of Equity, Floatation Costs, Risk Consideration, Flexibility, Control, Regulatory Framework, Stock Market Conditions, and Capital Structure of other Companies. Fixed and Working Capital Fixed capital refers to investment in long-term assets. Management of fixed capital involves around allocation of firm’s capital to different projects or assets with long-term implications for the business. These decisions are called investment decisions or capital budgeting decisions. They affect the growth, profitability and risk of the business in the long run. Factors affecting the Requirement of Fixed Capital are: Nature of Business, Scale of Operations, Choice of Technique, Technology Upgradation, Growth Prospects, Diversification, Financing Alternatives and Level of Collaboration. Apart from the investment in fixed assets, every business organisation needs to invest in current assets. This investment facilitates smooth day-to- day operations of the organisation. Current assets are usually more liquid but contribute less to the profits than fixed assets. Factors affecting the working capital requirement are: Nature of Business, Scale of Operations, Business Cycle, Seasonal Factor, Production Cycle, Credit 2024-25 Ch_9.indd 238 1/23/2024 03:51:24 PM  Financial Managements 239 Allowed, Credit Availed, Operating Efficiency, Availability of Raw Material, Growth Prospects, Level of competition, and rate of Inflation. exercises Very Short Answer Type 1. What is meant by capital structure? 2. Sate the two objectives of financial planning. 3. Name the concept of financial management which increases the return to equity shareholders due to the presence of fixed financial charges. 4. Amrit is running a ‘transport service’ and earning good returns by providing this service to industries. Giving reason, state whether the working capital requirement of the firm will be ‘less’ or ‘more’. 5. Ramnath is into the business of assembling and selling of televisions. Recently he has adopted a new policy of purchasing the components on three months credit and selling the complete product in cash. Will it affect the requirement of working capital? Give reason in support of your answer. Short Answer Type 1. What is financial risk? Why does it arise? 2. Define current assets? Give four examples of such assets. 3. What are the main objectives of financial management? Briefly explain. 4. Financial management is based on three broad financial decisions. What are these? 5. Sunrises Ltd. dealing in readymade garments, is planning to expand its business operations in order to cater to international market. For this purpose the company needs additional `80,00,000 for replacing machines with modern machinery of higher production capacity. The company wishes to raise the required funds by issuing debentures. The debt can be issued at an estimated cost of 10%. The EBIT for the previous year of the company was `8,00,000 and total capital investment was `1,00,00,000. Suggest whether issue of debenture would be considered a rational decision by the company. Give reason to justify your answer. (Ans. No, Cost of Debt (10%) is more than ROI which is 8%). 2024-25 Ch_9.indd 239 1/23/2024 03:51:24 PM  BUSINESS  STUDIES 240 6. How does working capital affect both the liquidity as well as profitability of a business? 7. Aval Ltd. is engaged in the business of export of canvas goods and bags. In the past, the performance of the company had been upto the expectations. In line with the latest demand in the market, the company decided to venture into leather goods for which it required specialised machinery. For this, the Finance Manager Prabhu prepared a financial blueprint of the organisation’s future operations to estimate the amount of funds required and the timings with the objective to ensure that enough funds are available at right time. He also collected the relevant data about the profit estimates in the coming years. By doing this, he wanted to be sure about the availability of funds from the internal sources of the business. For the remaining funds, he is trying to find out alternative sources from outside. a. Identify the financial concept discussed in the above paragraph. Also, state the objectives to be achieved by the use of financial concept so identified. ( Financial Planning). b. ‘There is no restriction on payment of dividend by a company’. Comment. ( Legal & Contractual Constraints) Long Answer Type 1. What is working capital? Discuss five important determinants of working capital requirement? 2. “Capital structure decision is essentially optimisation of risk-return relationship.” Comment. 3. “A capital budgeting decision is capable of changing the financial fortunes of a business.” Do you agree? Give reasons for your answer? 4. Explain the factors affecting dividend decision? 5. Explain the term ‘Trading on Equity’? Why, when and how it can be used by company. 6. ‘S’ Limited is manufacturing steel at its plant in India. It is enjoying a buoyant demand for its products as economic growth is about 7–8 per cent and the demand for steel is growing. It is planning to set up a new steel plant to cash on the increased demand. It is estimated that it will require about `5000 crores to set up and about `500 crores of working capital to start the new plant. 2024-25 Ch_9.indd 240 1/23/2024 03:51:24 PM  Financial Managements 241 a. Describe the role and objectives of financial management for this company. b. Explain the importance of having a financial plan for this company. Give an imaginary plan to support your answer. c. What are the factors which will affect the capital structure of this company? d. Keeping in mind that it is a highly capital-intensive sector, what factors will affect the fixed and working capital. Give reasons in support of your answer. 2024-25 Ch_9.indd 241 1/23/2024 03:51:24 PM