Financial Management

Unit 2

Unit 2

Financial Planning

Structure: 2.1 Introduction Objectives Objectives of financial planning Benefits of financial planning Guidelines for financial planning 2.2 Steps in Financial Planning Forecast of income statement Forecast of balance sheet Computerised financial planning system 2.3 Factors Affecting Financial Planning 2.4 Estimation of Financial Requirements of a Firm 2.5 Capitalisation Cost theory Earnings theory Over-capitalisation Under-capitalisation 2.6 Summary 2.7 Glossary 2.8 Terminal Questions 2.9 Answers 2.10 Case Study

2.1 Introduction
In the previous unit, you have learnt about the meaning and definition of financial management, goals of financial management, functions of finance, and the interface between finance and other business functions. In this unit, we will discuss the steps in financial planning, factors affecting financial planning, estimation of financial requirements of a firm, and the concept of capitalisation. Liberalisation and globalisation policies initiated by the government have changed the dimension of business environment. Therefore, for survival and growth, a firm has to execute planned strategies systematically. To execute

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any strategic plan, resources are required. Resources may be manpower, plant and machinery, building, technology, or any intangible asset. To acquire all these assets, financial resources are essentially required. Therefore, the finance manager of a company must have both long-range and short-range financial plans. Integration of both these plans is required for the effective utilisation of all the resources of the firm. The long-range plans must include: Funds required for executing the planned course of action Funds available at the disposal of the company Determination of funds to be procured from outside sources Objectives: After studying this unit, you should be able to: explain the steps involved in financial planning analyse the factors affecting financial planning estimate the financial requirements of a Firm explain the effects of capitalisation 2.1.1 Objectives of financial planning Financial planning is a process by which funds required for each course of action is decided. Financial planning means deciding in advance the financial activities to be carried on to achieve the basic objective of the firm. The basic objective of the firm is to get maximum profit with minimum losses or risk. So, the basic purpose of the financial planning is to make sure that adequate funds are raised at the minimum cost (optimal financing) and that they are used wisely. Thus planners of financial policies must see that adequate finance is available with the concern, because an inadequate supply of funds will hamper operations and lead to crisis. Too much capital, on the other hand, means lower earnings to the unit holders. A proper planning is therefore necessary. A financial plan has to consider capital structure, capital expenditure, and cash flow. Decisions on the composition of debt and equity must be taken. Highest earnings can be assured only through sound financial plans. A faulty financial plan may ruin the business completely. So, sound financial
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planning is necessary to achieve the long-term and the short-term objectives of the firm and to protect the interest of all parties concerned, i.e., the firm, the creditors, the shareholders, and the public. Financial planning or financial plan indicates: The quantum of funds required to execute business plans Composition of debt and equity, keeping in view the risk profile of the existing business, new business to be taken up, and the dynamics of capital market conditions Formulation of policies, giving effect to the financial plans under consideration 2.1.2 Benefits of financial planning Financial planning also helps firms in the following ways: A financial plan is at the core of value creation process. A successful value creation process can effectively meet the benchmarks of investors expectations. Financial planning ensures effective utilisation of the funds. To manage shortage of funds, planning helps the firms to obtain funds at the right time, in the right quantity, and at the least cost as per the requirements of finance emerging opportunities. Surplus is deployed through wellplanned treasury management. Ultimately, the productivity of assets is enhanced. Effective financial planning provides firms the flexibility to change the composition of funds that constitute its capital structure in accordance with the changing conditions of the capital market. Financial planning helps in formulation of policies and instituting procedures for elimination of wastages in the process of execution of strategic plans. Financial planning helps in reducing the operating capital of a firm. Operating capital refers to the ratio of capital employed to the sales generated. Maintaining the operating capability of the firm through the evolution of scientific replacement schemes for plant and machinery and other fixed assets will help the firm in reducing its operating capital. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital.

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Operating capital = Capital employed/Sales generated

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Activity-1: Review the annual report of Dell computers for the year 2008 and 2009. Find out how does it minimize the operating capital to support sales Hint: A study of annual reports of Dell computers will throw light on how Dell strategically minimised the operating capital required to support sales. Such companies are admired by investing community. 2.1.3 Guidelines for financial planning The following are the guidelines of a financial plan: Never ignore the cardinal principle that fixed asset requirements must be met from the long-term sources. Make maximum use of spontaneous source of finance to achieve highest productivity of resources. Maintain the operating capital intact by providing adequately out of the current periods earnings. Give due attention to the physical capital maintenance or operating capability. Never ignore the need for financial capital maintenance in units of constant purchasing power. Employ current cost principle wherever required. Give due weightage to cost and risk in using debt and equity. Keeping the need of finance for expansion of business, formulate plough back policy of earnings. Exercise thorough control over overheads. Seasonal peak requirements to be met from short-term borrowings from banks. A strategic financial plan of a firm spells out its corporate purpose, scope, objectives, and strategies. As a financial manager, one must: Sensitise the strategic planning group to the financial implications of various choices Ensure that the chosen strategic plan is financially feasible Translate the plan that is finally adopted into a long-range financial plan Coordinate the development of the budget
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2.2 Steps in Financial Planning

There are six steps involved in financial planning. Figure 2.1 depicts the steps involved in financial planning.
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Figure 2.1: Steps in Financial Planning

Let us now study the steps in detail. Establish corporate objectives The first step in financial planning is to establish corporate objectives. Corporate objectives can be grouped into two: o Qualitative and quantitative objectives o Short-term, medium-term, and long-term objectives For example, a companys mission statement may specify create economic value added. However this qualitative statement has to be stated in quantitative terms such as a 25% ROE or a 12% earnings growth rates. Since business enterprises operate in a dynamic environment, there is a need to formulate both short-term and long-term objectives. Formulate strategies The next stage in financial planning is to formulate strategies for attaining the defined objectives. Operating plans help to achieve the purpose. Operating plans are framed with a time horizon. It can be a five-year plan or a ten-year plan. Assign responsibilities Once the plans are formulated, responsibility for achieving sales target, operating targets, cost management benchmarks, and profit targets are to be fixed on respective executives.

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Forecast financial variables The next step is to forecast the various financial variables such as sales, assets required, flow of funds, and costs to be incurred. These variables are to be translated into financial statements. Financial statements help the finance manager to monitor the deviations of actual from the forecasts and take effective remedial measures. This ensures that the defined targets are achieved without any overrun of time and cost.

Develop plans This step involves developing a detailed plan of funds required for the plan period under various heads of expenditure. From the plan, a forecast of funds that can be obtained from internal as well as external sources during the time horizon is developed. Legal constraints in obtaining funds on the basis of covenants of borrowings are given due weightage. There is also a need to collaborate the firms business risk with risk implications of a particular source of funds. A control mechanism for allocation of funds and their effective use is also developed in this stage. Create flexible economic environment While formulating the plans, certain assumptions are made about the economic environment. The environment, however, keeps changing with the implementation of plans. To manage such situations, there is a need to incorporate an in-built mechanism which would scale up or scale down the operations accordingly.

Forecasting of financial statements: Following are some basic points that would help you to understand the importance of financial forecasting before we study the methods of forecasting and income statement/balance sheet. Financial forecasting is the process of estimating future business performance (sales, costs, earnings). Corporations and companies employ forecasting to do financial planning which includes an assessment of their future financial needs. Forecasting is also important for production planning, human resource planning, etc. Forecasting is also used by outsiders to value companies and their securities.
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Financial planning is enabled by creating pro forma income statements and balance sheets. These are forecasted financial statements. As we have discussed, financial planning is a continuous process of directing and allocating financial resources to meet strategic goals and objectives. The output from financial planning takes the form of budgets. The most widely used form of budgets is pro forma or budgeted financial statements. The pro forma statements help to have a comprehensive look at the likely future financial performance. While the pro forma income statement represents the operational plan for the whole organisation, the pro forma balance sheet reflects the cumulative impact of anticipated future decisions. Budgets include: Cash budget Operating budget Sales budget Production budget Sales and distribution expenses budget Administrative overheads budget 2.2.1 Forecast of income statement There are three methods of forecasting income statement: Percent of sales method or constant ratio method Expense method Combination of the above two Percent of sales method This is the most basic method of forecasting a financial statement. It assumes that certain expenses, assets, and liabilities maintain a constant relationship to the level of sales. Basically, this method assumes that future relationship between various elements of cost to sales will be similar to their historical relationships. These cost ratios are generally based on the average of previous two or three years. For example, cost of goods sold may be expressed as a percentage of sales. Therefore, the key driver of this method is the sales forecast and based on this, pro forma financial statements (i.e., forecasted) can be constructed and the firms needs for external financing can be identified.
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Since sales have a significant effect on the financial needs of a business, different items of assets, liabilities, revenue, and expenses can be expressed as a percentage of sales. The first step is to express the income statement accounts which vary directly with sales as percentages of sales. This is calculated by dividing the balance for these accounts for the current year by sales revenue for the current year. The accounts which generally vary closely with sales are cash accounts, receivable, inventory, and accounts payable. On the income statement, costs are expressed as a percentage of sales. Since we are assuming that all costs remain at a fixed percentage of sales, net income can be expressed as a percentage of sales. This indicates the profit margin. Caselet: Raw material cost is 40% of sales revenue for the year ended 31.03.2007. However, this method assumes that the ratio of raw material cost to sales will continue to be the same in 2008 also. Such an assumption may not look good in most of the situations. If in case, raw material cost increases by 10% in 2008 but selling price of finished goods increases only by 5%. In this case raw material cost will be 44/105 of the sales revenue in 2008. This can be solved to some extent by taking the average for the same representative years. However, inflation, change in government policies, wage agreements, and technological innovation totally invalidate this approach on a long run basis.

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Illustration: The Profit and Loss statement of Biotech Ltd. for the years 2000 and 2001 are given below. If the sales for the year 2002 are estimated at Rs. 22,00,000, prepare a pro forma income statement for the year 2002 using the percent of sales method.
(Rs. 000) Total sales Cost of goods sold Gross profit Selling and administration expenses Depreciation Operating profit Non-operating surplus EBIT Interest Tax Profit after tax Dividends Retained earnings 2000 1,200 700 500 180 50 270 40 310 160 60 90 30 60 2001 1,800 1,100 700 220 80 400 80 480 160 100 220 60 160

Solution:
Average percent of sales Net sales Cost of goods sold Gross profit Selling and administration expenses Depreciation Operating profit Non-operating surplus EBIT Interest Tax Profit after tax Dividends Retained earnings 100 60 40 13.33 4.3 22.36 4 26.4 10.67 5.3 10.33 3 7.33 Pro forma income statement for 2002 (in Rs. 000) 2,200 1,320 880 293 95 492 88 580 235 117 228 66 162

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Working notes: Total cost of goods sold for 2000 and 2001 = Rs 18,00,000. Total sales for the year 2000 and 2001 = Rs. 30,00,000. Hence, percentage of total cost of goods sold relative to sales = 18,00,000 / 30,00,000 X 100 = 60 The other items are also computed in a similar manner. Budgeted expense method Expenses for the planning period are budgeted on the basis of anticipated behaviour of various items of cost and revenue. The value of each item is estimated on the basis of expected developments in the future period for which the pro forma P&L account is being prepared. It calls for greater effort on the part of management since they have to define the likely happenings. This also demands effective database for reasonable budgeting expenses. Combination of both these methods The combination of both these methods is used because some expenses can be budgeted by the management. This is done taking into account the expected business environment while some other expenses could be based on their relationship with the sales revenue expected to be earned. The budgeted income statement will pull together all revenue and expense estimates from previously prepared detail budgets. Once this statement is prepared, the budgeted balance sheet can be prepared. 2.2.2 Forecast of balance sheet The following steps discuss the forecasting of the balance sheet: Compute the sales revenue, having a close relationship with the items of certain assets and liabilities, based on the forecast of sales and the historical database of their relationship. Determine the equity and debt mix on the basis of funds requirements and the companys policy on capital structure.

Projections for Balance sheet can be made as listed below: Employ percent of sales method to project items on the asset side, except Investments and Miscellaneous Expenses and Losses.

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Expected values for Investments and Miscellaneous Expenses and Losses can be estimated using specific information. Use percent of sales method to project values of current liabilities and provisions.(also referred to as spontaneous liabilities). Projected values of reserves and surplus can be obtained by adding projected retained earnings from P&L pro forma statement. Projected value for equity and preferential capital can be set tentatively equal to their previous values. Projected values for loan funds will be tentatively equal to their previous level, less repayments or retirements. Compare the total of asset side with that of liabilities side and determine the balancing figure. (If assets exceed liabilities, the balancing figure represents external funding requirement. If liabilities exceed assets, the balancing item represents surplus available funds).

The budgeted balance sheet will provide an estimate of how much external financing is required to support estimated sales. The main link between the income statement and the balance sheet is retained earnings. Therefore, preparation of the budgeted balance sheet starts with an estimate of the ending balance for retained earnings. In order to estimate ending retained earnings, one has to project future dividends based on current dividend policies and what management expects to pay in the next planning period. Once the budgeted balance sheet is prepared, it will show either a surplus (excess financing over assets) or a deficit (additional financing needed to cover assets). This difference is derived from the accounting equation: Assets = Liabilities + Equity. We can also calculate External Financing Required (EFR) based on the relationships between assets, liabilities, and sales.

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Caselet The following details have been extracted from the books of X Ltd. Table 2.1 and table 2.2 depict the income statement and balance sheet respectively.
Table 2.1: Income Statement 2006 Sales less returns Gross profit Selling expenses Administration Deprecation Operating profit Non-operating income EBIT (Earnings Before Interest and Tax) Interest Profit before tax Tax Profit after tax Dividend Retained earnings Table 2.2: Balance Sheet Liabilities Shareholders fund Share capital Equity Preference Reserves and surplus Secured loans 120 50 122 100 120 50 224 120 Current assets, loans, and advances Cash at bank Receivables 10 80 12 128 Investments 2006 2007 Assets Fixed assets Less depreciation 2006 400 100 300 50 2007 510 120 390 50 1000 300 100 40 60 100 20 120 15 105 30 75 38 37 2007 1300 520 120 45 75 280 40 320 18 302 100 202 100 102

Unsecured loans

50

60

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Current liabilities Trade creditors Provisions Tax Proposed dividend

210

250

Inventories Loans and advances Miscellaneous expenditure

200 50 10

300 80 24

10 38 700

60 100 984

700

984

Forecast the income statement and balance sheet for the year 2008 based on the following assumptions: Sales for the year 2008 will increase by 30% over the sales value for 2007 Use percent of sales method to forecast the values for various items of income statement using the percentage for the year 2007 Depreciation is charged at 25% of fixed assets Fixed assets will increase by Rs. 100 million Investments will increase by Rs. 100 million Current assets and current liabilities are to be decided based on their relationship with the sales in the year 2007 Miscellaneous expenditure will increase by Rs. 19 million Secured loans in 2008 will be based on its relationship with the sales in the year 2007 Additional funds required, if any, will be met by bank borrowings Tax rates will be 30% Dividends will be 50% of the profit after tax Non-operating income will increase by 10% There will be no change in the total amount of administration expenses to be spent in the year 2008 There is no change in equity and preference capital in 2008 Interest for 2008 will maintain the same ratio as it has in 2007 with the sales of 2007

Table 2.3 and table 2.4 depict the forecast of the income statement and the balance sheet for the year 2008 respectively. Table 2.3: Income Statement Particulars Sales Cost of sales Gross profit Basis Increase by 30% Increase by 30% Sales-cost of sales Working 1300 x 1.3 780 x 1.3 1690-1014 Amount (Rs.) 1690 1014 676

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Selling expenses Administration Depreciation Operating profit Non-operating income Earnings Before Interest and Taxes (EBIT) Interest

30% increase No change % given C - (D + E + F) Increase by 10%

120 x 1.3

156 45 123 (Rounded off) 352

390 100 4
1.1 x 40

44 396

18 of Sales 1300

18 1690 1300

23 (Decimal ignored) 373 112 261 130 131

Profit before tax Tax Profit after tax Dividends Retained earnings Table 2.4: Balance Sheet Particulars Assets Fixed assets Add: Addition Given Basis Working

Amount (Rs.) 510 100 610

Depreciation 1. Net fixed assets 2. Investments 3. Current assets, loans, and advances Cash at bank

120 + 123

243 367 150

12 1300

12 1690 1300

16 (Rounded off) 166

Receivables

128 1300

128 1690 1300

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Inventories Loans and advances 4. Miscellaneous Expenditure Total Liabilities 1. Share capital Equity Preference 2. Reserves and surplus

300 1300 80 1300

Given

300 1690 1300 80 1690 1300

24 + 19

390 104 43 1236

120 50 Increase by current years retained earnings 355

3. Secured loan Bank borrowings

60 1300

60 1690 1300

78 40 (Difference Balancing figure) 60

4. Unsecured loan 5. Current liabilities and provision Trade creditors Provision for tax Proposed dividend Total liabilities

60

250 1300 60 1300

Current year given

250 1690 1300 60 1690 1300

325 78 130 1236

2.2.3 Computerised financial planning system All corporate forecasts use computerised forecasting models. Additional funds required to finance the increase in sales could be ascertained using a mathematical relationship based on the following:

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Additional Funds Required = Required Increase in Assets Spontaneous Increase in Liabilities Increase in Retained Earnings (This formula has been recommended by Eugene F. Brigham and Michael C. Earnhardt in the book Financial Management Theory and Practice) Prof. Prasanna Chandra, in his book Financial Management, (6th edition Manohar Publishers and Distributors) has given a comprehensive formula for ascertaining the external financial requirements.

EFR =

A ( s) L ( s) MS1 (1-d) (1m + SR) S S

Here A (s Expected increase in assets, both fixed assets and current = S assets required for the expected increase in sales in the next year. L (s Expected spontaneous finance available for the expected = S increase in sales. MS1 (1-d) = It is the product of profit margin, expected sales for the next year, and the retention ratio. Retention ratio = 1 payout ratio. Payout ratio refers to the ratio of the dividend paid to the earnings per share. 1m = Expected change in the level of investments and miscellaneous expenditure. SR = It is the firms repayment liability on term loans and debenture for the next year. The formula described above has certain features: Ratios of assets and spontaneous liabilities to sales remain constant over the planning period. Dividend payout and profit margin for the next year can be reasonably planned in advance. Since external funds requirements involve borrowings from financial institution, the formula rightly incorporates the managements liability on repayments.
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Solved Problem X Ltd. has given the following forecasts: Sales in 2008 will increase from Rs. 1000 to Rs. 2000 in 2007. Table 2.5 depicts the balance sheet of the company as on December 31, 2007.
Table 2.5: Balance Sheet Liabilities Share capital Equity (Shares of Rs.10 each) Reserves and surplus Long term loan Creditors for expenses outstanding Trade creditors Bills payable 100 250 400 50 50 150 1000 1000 Rs. Assets Net fixed assets Inventories Cash Bills receivable Rs. 500 200 100 200

Taking into account the following information, the external funds requirements for the year 2008 has to be ascertained: The companys utilisation of fixed assets in 2007 was 50% of capacity but its current assets were at their proper levels. Current assets increase at the same rate as sales. Companys after-tax profit margin is expected to be 5%, and its payout ratio will be 60%. Creditors for expenses are closely related to sales. (Adapted from IGNOU MBA). Solution: Preliminary workings: A = Current assets = Cash + Bills receivables + Inventories = 100 + 200 +200 = 500

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A 500 ( s) 1000 Rs. 500 S 1000

L = Trade creditors + Bills payable + Expenses outstanding = 50 + 150 + 50 = Rs. 250

L 250 ( s) 1000 Rs. 250 S 1000

M (Profit margin) = 5 / 100 = 0.05 S1 = Rs.2000 1-d = 1 0.6 = 0.4 or 40 % 1m = NIL SR = NIL Therefore: EFR

A ( s) L s - ms1 (1-d) (1m + SR) S S

= 500 250 (0.05 x 2000 x 0.4) (0 + 0) = 500 250 40 - (0 + 0) = Rs. 210 Therefore, external fund requirements for 2008 will be Rs. 210. This additional fund requirement will be procured by the firm based on its policy on capital structure. Self Assessment Questions 1. Corporate objectives could be grouped into ___ and ___. 2. Control mechanism is developed for _____ and their effective use. 3. Seasonal peak requirements to be met from __________________ from banks.

2.3 Factors Affecting Financial Planning

Figure 2.2 depicts the various factors affecting financial plan.

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Figure 2.2: Factors Affecting Financial Plan

Let us now discuss these factors in detail. Nature of the industry The first factor affecting the financial plan is the nature of the industry. Here, we must check whether the industry is a capital-intensive or labour-intensive industry. This will have a major impact on the total assets that a firm owns. Size of the company The size of the company greatly influences the availability of funds from different sources. A small company normally finds it difficult to raise funds from long-term sources at competitive terms. On the other hand, large companies like Reliance enjoy the privilege of obtaining funds both short-term and long-term at attractive rates. Status of the company in the industry A well-established company enjoys a good market share, because its products normally command investors confidence. Such a company can tap the capital market for raising funds in competitive terms for implementing new projects to exploit the new opportunities emerging from changing business environment.

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Sources of finance available Sources of finance could be grouped into debt and equity. Debt is cheap but risky whereas equity is costly. A firm should aim at optimum capital structure that would achieve the least cost capital structure. A large firm with a diversified product mix may manage higher quantum of debt because the firm may manage higher financial risk with a lower business risk. Selection of sources of finance is closely linked to the firms capability to manage the risk exposure. The capital structure of a company The capital structure of a company is influenced by the desire of the existing management (promoters) of the company to retain control over the affairs of the company. The promoters who do not like to lose their grip over the affairs of the company normally obtain extra funds for growth by issuing preference shares and debentures to outsiders. Matching the sources with utilisation The prudent policy of any good financial plan is to match the term of the source with the term of the investment. To finance fluctuating working capital needs, the firm resorts to short-term finance. All fixed-asset investments are to be financed by long-term sources which is a cardinal principle of financial planning. Flexibility The financial plan of a company should possess flexibility so as to effect changes in the composition of capital structure whenever the need arises. If the capital structure of a company is flexible, there will not be any difficulty in changing the sources of funds. This factor has become a significant one today because of the globalisation of capital market. Government policy SEBI guidelines, finance ministry circulars, various clauses of Standard Listing Agreement and regulatory mechanism imposed by FEMA, and Department of Corporate Affairs (government of India) influence the financial plans of corporates today. Management of public issues of shares demands the compliances with many statutes in India. They are to be complied with a time constraint.

Self Assessment Questions 4. ______ has a major impact on the total assets that the firm owns. 5. Sources of finance could be grouped into ______ and _____.

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6. ___________ of any good financial plan is to match the term of the source with the term of the investment. 7. _____ refers to the ability to _____ whenever needed.

2.4 Estimation of Financial Requirements of a Firm

A company should be properly capitalised and the actual capital should be neither more nor less than the amount which is needed and which can be gainfully employed. It is, therefore, necessary for a concern to estimate its requirements of funds properly. The financial requirements of a company may be outlined under the following heads: Cost of fixed assets including land and buildings, plant and machinery, furniture, etc. The amount invested in these items is called fixed capital. Cost of current assets including cash, stock of goods (also called inventory of merchandise), book debts, bills, etc. Cost of promotion including the expenses on preliminary investigation in case of a new company, accounting, marketing, legal advice, etc. Cost of establishing the business, i.e., the operating losses which have generally to be sustained in the initial periods of a company. Cost of financing including brokerage on securities, commission on underwriting, etc. Cost of intangible assets like goodwill, patents, etc.

Of the various items of financial requirements listed above, the first two deserve special consideration as the successes of any concern will depend largely on them. The estimation of capital requirements of a firm involves a complex process. Even with expertise, managements of successful firms could not arrive at the optimum capital composition in terms of the quantum and the sources. As indicated above, capital requirements of a firm could be grouped into fixed capital and working capital. The long-term requirements such as investments in fixed assets will have to be met out of funds obtained on long-term basis.

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Fixed capital of an industrial concern is invested in fixed assets like plant and machinery, land, buildings, furniture, etc. These assets are not fixed in value. In fact, their value may record an increase or decrease in course of time. Variable working capital requirements which fluctuate from season to season will have to be financed only by short-term sources. The working capital is required for the purchase of raw materials and for meeting the day-to-day expenditure on salaries, wages, rents, advertising, etc. Any departure from this well-accepted norm causes negative impact on the firms finances. We will look at assessing these requirements in detail in the upcoming pages. Activity 2 Select 2 companies each from FMCG, Software and Manufacturing on the mission statement. What is your observation on financial requirements? Hint: All the finance requirements are to be discussed. Self Assessment Questions 4.8. Capital requirement of a firm could be grouped into ____ and _____. 5.9. Variable working capital will have to be financed only by _______.

2.5 Capitalisation
Capitalisation of a firm refers to the composition of its long-term funds and its capital structure. It has two components Debt and Equity. After estimating the financial requirements of a firm, the next decision that the management has to take is to arrive at the value at which the company has to be capitalised. There are two theories of capitalisation for the new companies: Cost theory Earnings theory

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Figure 2.3 depicts the two theories of capitalisation.

Figure 2.3: Theories of Capitalisation

Let us now discuss these theories in detail. 2.5.1 Cost theory Under this theory, the total amount of capitalisation for a new company is the sum of: Cost of fixed assets Cost of establishing the business Amount of working capital required Merits of cost approach It helps promoters to estimate the amount of capital required for incorporation of company, conducting market surveys, preparing detailed project report, procuring funds, procuring assets both fixed and current, running a trial production, and successfully producing, positioning, and marketing its products or rendering of services. If done systematically, it will lay the foundation for successful initiation of the working of the firm. Demerits of cost approach If the firm establishes its production facilities at inflated prices, the productivity of the firm will become less than that of the industry. Net worth of a company is decided by the investors and the earnings of a company. Earning capacity based on net worth helps a firm to arrive at the total capital in terms of industry-specified yardstick (operating capital based on benchmarks in that industry). Cost theory fails in this respect.

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2.5.2 Earnings theory Earnings are forecasted and capitalised at a rate of return, which actually is the representative of the industry. Earnings theory involves two steps. They are: Estimation of the average annual future earnings. Estimation of the normal earning rate of the industry to which the company belongs. Merits of earnings theory Earnings theory is superior to cost theory because of its lesser chances of being either under or over capitalisation. Comparison of earnings approach to that of cost approach will make the management to be cautious in negotiating the technology and the cost of procuring and establishing the new business. Demerits of earnings theory The major challenge that a new firm faces is deciding on capitalisation and its division thereof into various procurement sources. Arriving at the capitalisation rate is equally a formidable task because the investors perception of established companies cannot be really unique of what the investors perceive from the earning power of the new company.

Due to this problem, most of the new companies are forced to adopt the cost theory of capitalisation. Ideally, every company should have normal capitalisation, which is a utopian way of thinking. Changing business environment, role of international forces, and dynamics of capital market conditions force us to think in terms of what is optimal today need not to be so tomorrow. Even with these constraints, management of every firm should continuously monitor its capital structure to ensure and avoid the bad consequences of over and under capitalisation. 2.5.3 Over-capitalisation A company is said to be over-capitalised when its total capital (both equity and debt) exceeds the true value of its assets.

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It is wrong to identify over-capitalisation with excess of capital because most of the over-capitalised firms suffer from the problems of liquidity. The correct indicator of over-capitalisation is the earnings capacity of the firm. If the earnings of the firm are less than that of the market expectation, it will not be in a position to pay dividends to its shareholders as per their expectations. This is a sign of over-capitalisation. It is also possible that a company has more funds than its requirements based on current operation levels and yet have low earnings. Over-capitalisation may be considered on the account of: Acquiring assets at inflated rates Acquiring unproductive assets High initial cost of establishing the firm Companies which establish their new business during boom condition are forced to pay more for acquiring assets, causing a situation of overcapitalisation once the boom conditions subside Total funds requirements have been over estimated Unpredictable circumstances (like change in import/export policy, change in market rates of interest, and changes in international economic and political environment) reduce substantially the earning capacity of the firm. For example, rupee appreciation against US dollar has affected the earning capacity of the firms engaged mainly in the export business because they invoice their sales in US dollar Inadequate provision of depreciation adversely affects the earning capacity of the company leading to over-capitalisation of the firm Existence of idle funds Effects of over-capitalisation Decline in earnings of the company Fall in dividend rates Loss of goodwill Market value of the companys share falls, and the company loses investors confidence Company may collapse at any time because of anaemic financial conditions which affect its employees, society, consumers, and shareholders. Employees will lose jobs. If the company is engaged in the
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production and marketing of certain essential goods and services to the society, the collapse of the company will cause social damage Remedies of over-capitalisation Over-capitalisation often results in a company becoming sick. Restructuring the firm helps to avoid such a situation. Some of the other remedies of overcapitalisation are: Reduction of debt burden Negotiation with term lending institutions for reduction in interest obligation Redemption of preference shares through a scheme of capital reduction Reducing the face value and paid-up value of equity shares Initiating merger with wellmanaged, profit-making companies interested in taking over ailing company 2.5.4 Under-capitalisation Under-capitalisation is just the reverse of over-capitalisation. A company is considered to be under-capitalised when its actual capitalisation is lower than the proper capitalisation as warranted by the earning capacity. Symptoms of under-capitalisation The following points describe the symptoms of under-capitalisation: Actual capitalisation is less than the warranted earning capacity Rate of earnings is exceptionally high in relation to the return enjoyed by similar situated companies in the same industry Causes of under-capitalisation The following points describe the causes of under-capitalisation: Under estimation of the future earnings at the time of the promotion of the company Abnormal increase in earnings from the new economic and business environments Under estimation of total funds requirement Maintaining very high efficiency through improved means of production of goods or rendering of services Companies which are set up during the recession period will start making higher earning capacity as soon as the recession is over Purchase of assets at exceptionally low prices during recession
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Effects of under-capitalisation The following points describe some of the effects of under-capitalisation: Under-capitalisation encourages competition by creating a feeling that the line of business is lucrative It encourages the management of the company to manipulate the companys share prices High profits will attract higher amount of taxes High profits will make the workers demand higher wages. Such a feeling on the part of the employees leads to labour unrest High margin of profit may create an impression among the consumers that the company is charging high prices for its products High margin of profits and the consequent dissatisfaction among its employees and consumer may invite governmental enquiry into the pricing mechanism of the company

Remedies The following points describe the remedies of under-capitalisation: Splitting up of the shares, which will reduce the dividend per share Issue of bonus shares, which will reduce both the dividend per share and the earnings per share

Both over-capitalisation and under-capitalisation are detrimental to the interests of the society. Self Assessment Questions 10. 11. 12. _____ of a firm refers to the composition of its long-term funds. Two theories of capitalisation for new companies are ______ and earnings theory. A company is said to be ________, when its total capital exceeds the true value of its assets.

10.13. A company is considered to be _______, when its actual capitalisation is lower than its proper capitalisation as warranted by its earning capacity.

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2.6 Summary
Let us recapitulate the important concepts discussed in this unit: Financial planning deals with the planning, the execution, and the monitoring of procurement and utilisation of funds. Financial planning process gives birth to financial plan. It could be thought of as a blueprint explaining the proposed strategy and its execution. There are many financial planning models. All these models forecast the future operations and then translate them to income statements and balance sheets. It will also help the finance managers to ascertain the funds to be procured from the outside sources. The essence of all these is to achieve a least cost capital structure which would match with the risk exposure of the company. Failure to follow the principle of financial planning may lead a new firm to over or under-capitalisation when the economic environment undergoes a change. Ideally, every firm should aim at optimum capitalisation or it might lead to a situation of over or under-capitalisation. Both are detrimental to the interests of the society. There are two theories of capitalisation - cost theory and earnings theory.

2.7 Glossary
Accounting equation: Assets = Liabilities + Equity. Capitalisation of a firm: Refers to the composition of its long-term funds and its capital structure. It has two components Debt and Equity. Financial planning: Process by which funds required for each course of action is decided.

2.8 Terminal Questions

1. 2. 3. 4. Explain the steps involved in Financial Planning. Explain the factors affecting Financial Plan. List out the causes of over-capitalisation. Explain the effects of under-capitalisation.

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2.9 Answers
Self Assessment Questions 1. Qualitative, Quantitative 2. Allocation of funds 3. Short-term borrowings 4. Nature of the industry 5. Debt, equity 6. The prudent policy 7. Flexibility in capital structure, effect changes in the composites of capital structure 8. Fixed capital, working capital 9. Short-term sources 10. Capitalisation 11. Cost theory 12. Over-capitalised 12.13. Under-capitalised Terminal Questions 1. There are six steps involved in financial planning. Refer to 2.2 2. There are various factors affecting financial plan. Refer to 2.3 3. A company is said to be over-capitalised when its total capital (both equity and debt) exceeds the true value of its assets. Refer to 2.5.3 4. A company is considered to be under-capitalised when its actual capitalisation is lower than the proper capitalisation as warranted by the earning capacity. Refer to 2.5.4

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2.10 Case Study: Financial Planning

Firms need to plan their future activities keeping in view the expected changes in the economic, social, technical, and competitive environment. The top and middle-level managers plan their business activities in terms of financial projections keeping in view the various factors that will affect the business. Financial planning is enabled by creating pro forma income statements and balance sheets. These are forecasted financial statements. As we have discussed in the unit, financial planning is a continuous process of directing and allocating financial resources to meet strategic goals and objectives. he output from financial planning takes the form of budgets. The most widely used form of budgets is pro forma or budgeted financial statements. Given below is the profit and loss account statement and balance sheet synopsis of Reliance Industries for the last five years. Study the statements in detail.
Profit and Loss Account (Rs. in Crores) Mar '11 Mar '10 Mar '09 Income Sales Turnover Excise Duty Net Sales Other Income Stock Adjustments Total Income Expenditure Raw Materials Power and Fuel Cost Employee Cost Other Manufacuring Expenses Selling and Admin Expenses Miscellaneous Expenses Preoperative Exp Capitalised Total Expenses 1,98,076.21 2,255.07 2,621.59 2,915.44 7,207.83 500.52 -30.26 2,13,546.40 1,53,689.01 2,706.71 2,330.82 2,153.67 5,756.44 651.96 -1,217.92 1,66,070.69 1,09,284.34 3,355.98 2,397.50 1,162.98 4,736.60 562.42 -3,265.65 1,18,234.17 98,832.14 2,052.84 2,119.33 715.19 5,549.40 412.66 -175.46 1,09,506.10 80,791.65 2,261.69 2,094.09 1,112.17 5,478.10 321.23 -111.21 91,947.72 Mar '08 Mar 07

2,58,651.15 10,515.09 2,48,136.06 3,358.61 3,243.05 2,54,737.72

2,00,399.79 8,307.92 1,92,091.87 3,088.05 3,947.89 1,99,127.81

1,46,328.07 4,369.07 1,41,959.00 1,264.03 427.56 1,43,650.59

1,39,269.46 5,463.68 1,33,805.78 6,595.66 -1,867.16 1,38,534.28

1,18,353.71 6,654.68 1,11,699.03 236.89 654.60 1,12,590.52

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Operating Profit PBDIT Interest PBDT Depreciation Other Written Off Profit Before Tax Extra-ordinary items PBT (Post-Extra-ord items) Tax Reported Net Profit

37,832.71 41,191.32 2,328.30 38,863.02 13,607.58 0.00 25,255.44 0.00 25,255.44 4,969.14 20,286.30

29,969.07 33,057.12 1,999.95 31,057.17 10,496.53 0.00 20,560.64 0.00 20,560.64 4,324.97 16,235.67

24,152.39 25,416.42 1,774.47 23,641.95 5,195.29 0.00 18,446.66 0.00 18,446.66 3,137.34 15,309.32

22,432.52 29,028.18 1,162.90 27,865.28 4,847.14 0.00 23,018.14 48.10 23,066.24 3,559.85 19,458.29

20,405.91 20,642.80 1,298.90 19,343.90 4,815.15 0.00 14,528.75 0.51 14,529.26 2,585.35 11,943.40

Balance Sheet (Rs. in Crores) Mar 11 Sources of Funds Total Share Capital Equity Share Capital Share Application Money Preference Share Capital Reserves Revaluation Reserves Networth Secured Loans Unsecured Loans Total Debt Total Liabilities Application of Funds Gross Block Less: Accum. Depreciation Net Block Capital work-inprogress Investments Inventories Sundry Debtors Cash and Bank Balance Total Current Assets Loans and Advances Fixed Deposits Total CA, Loans and Advances Deferred Credit
2,21,251.97

Mar 10 3,270.37 3,270.37 0.00 0.00 1,25,095.97 8,804.27 1,37,170.61 11,670.50 50,824.19 62,494.69 1,99,665.30

Mar 09 1,573.53 1,573.53 69.25 0.00 1,12,945.44 11,784.75 1,26,372.97 10,697.92 63,206.56 73,904.48 2,00,277.45

Mar 08 1,453.39 1,453.39 1,682.40 0.00 77,441.55 871.26 81,448.60 6,600.17 29,879.51 36,479.68 1,17,928.28

Mar 07 1,393.21 1,393.21 60.14 0.00 59,861.81 2,651.97 63,967.13 9,569.12 18,256.61 27,825.73 91,792.86

3,273.37 3,273.37 0.00 0.00 1,42,799.95 5,467.00 1,51,540.32 10,571.21 56,825.47 67,396.68 2,18,937.00

2,15,864.71 62,604.82 1,53,259.89 12,138.82 19,255.35 26,981.62 11,660.21 362.36 39,004.19 10,517.57 17,073.56

1,49,628.70 49,285.64 1,00,343.06 69,043.83 20,268.18 14,836.72 4,571.38 500.13 19,908.23 13,375.15 23,014.71

1,04,229.10 42,345.47 61,883.63 23,005.84 20,516.11 14,247.54 6,227.58 217.79 20,692.91 18,441.20 5,609.75

99,532.77 35,872.31 63,660.46 7,528.13 16,251.34 12,136.51 3,732.42 308.35 16,177.28 12,506.71 1,527.00

78,545.50
1,42,706.47

12,819.56 33,019.27 29,825.38 17,441.94 604.57 47,871.89 17,320.60 31,162.56

96,355.05 0.00

66,595.32 0.00

56,298.09 0.00

44,743.86 0.00

30,210.99 0.00

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Current Liabilities Provisions Total CL and Provisions Net Current Assets Miscellaneous Expenses Total Assets Contingent Liabilities Book Value (Rs.)

61,399.87 4,563.48 65,963.35 30,391.70 0.00 2,18,937. 00 41,825.13 446.25

48,018.65 3,565.43 51,584.08 15,011.24 0.00 1,99,665.30 25,531.21 392.51

42,664.81 3,010.90 45,675.71 10,622.38 0.00 2,00,277.45 36,432.69 727.66

29,228.54 2,992.62 32,221.16 12,522.70 0.00 1,17,928.28 37,157.61 542.74

24,145.19 1,712.87 25,858.06 4,352.93 0.00 91,792.86 46,767.18 439.57

Discussion Questions: Prepare pro forma financial statements for the year 2012 with the following considerations: 1. The sales for the year 2012 are to be increased by 30% over the value of sales for the year 2011. 2. Use percent of sales method to forecast the values for various items of income statement using the percentage for the year 2011. 3. Secured loans in 2012 will be based on its relationship with the sales in the year 2011. 4. Additional funds required, if any, will be met by bank borrowings. 5. Selling and administration expenses expected to increase by 5%. (Hint: Refer proforma financial statements) (Source: http://www.moneycontrol.com/financials References: Prasanna Chandra, Financial Management, 6th edition Publishers and Distributors Manohar

Brigham. Eugene F. and Houston. Joel F.(2007). Fundamentals of Financial Management, 11th Edition, Cengage Learning

E-References: http://www.moneycontrol.com/financials) retrieved on 10/12/ 2011

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