Académique Documents
Professionnel Documents
Culture Documents
1) Raising funds: Every business needs funds. These funds should be raised from various sources. The finance
manager selects the source that gives maximum benefit at minimum cost to the organization.
2) External reporting: In case of joint stock company there is a compulsion to prepare the annual accounts, get
them audited and send copies of them to the necessary govt. departments and shareholders. This is called
external reporting.
3) Institutions and instruments: Financial management studies the institutions operating in capital market as
well as money market and instruments that are used for mobilizing funds.
I. Financing Decisions:
a) Estimation of fund requirement: Since there are different sources to large size funds, the requirement
should be estimated in advance.
b) Procurement of funds: Once the requirement is estimated they should be procured from the relevant
sources. While selecting the sources, certain principles a=like cost of funds, procedure, security to be
offered cost of raising funds etc. should be considered.
II.Investment Decisions:
a) Cash management: Cash is the most liquid asset but least earning. However, cash is required to make
payments. Hence, finance manager should intelligently manage cash.
b) Working capital management: It includes sundry debtors, various stocks and short term investments of
surplus funds. The management of working capital also requires special attention of the finance manager.
c) Capital budgeting:I provides necessary tools to evaluate the long term investment. Long term investment
is more complicated because they have long lasting impact on the company.
d) Portfolio management: Many corporate houses invest their surplus funds in a portfolio of investment. In
addition, this portfolio is shuffled very often to maximize the returns. Managing the portfolio of
investment involves complicated statistical and mathematical models.
e) Evaluation by bench marking: Benchmarks are established for evaluating the performance of various
financial components like sales, gross profit, net profit. Financial performance is evaluated in the light of
these benchmarks.
1) Profit Maximization:
A business firm is a profit seeking organization so naturally maximization of profit is one of the basic or
important objectives of F.M. The profits or earnings of the firm can be maximized by undertaking the
following measures.
(i) By increasing sales
(ii) By reducing cost of production
The objective of profit maximization is criticizes by many authors. The main objectives are:
(a) Vagueness: this concept is not clarifying as to which profits are to be maximized short term or long term
profit. The period reference to profit is totally lacking.
(b) Ignoring time value of money: the concept of profit maximization does not recognize the difference
between the returns received in different periods of time and treats them at par. In otherwords, profit
maximization does not take into consideration the timings of the returns.
(c) Ignoring risk and uncertainty: while evaluating the projects, the profits estimated should be suitably
discounted for the risk and uncertainty. Profit maximization relies on the return on investment
estimated on each project. However the expected rate of return is far more reliable.
(d) Ignoring role of growth: a business unit is not running solely with the objective of earning maximum
profits. Many corporate sacrifice the profit in order to achieve long term growth. Profit maximization
objective totally ignores role of growth.
2) Wealth Maximization:
This is maximizing Net Present Value (NPV) of different courses of action. Wealth is the difference between
NPV of future benefits and the present value of the cost. Here, time value of money is taken into
consideration. For doing so, the future cash flows re discounted and matched against the present cash
outflows for making the investment.
Ezra Solomon describes Wealth Maximization as “the gross present worth of a course of action is equal
to the capitalized value of the flow of future benefits discounted at rate which reflects the certainty or
5) Corporate Governance:
Every corporate should operate in such a way that it does not make any of the stakeholders like customers,
suppliers, employees, creditors etc.
In India, Securities and Exchange Board of India (SEBI) puts a clause in the listing agreement of stock
exchange. It is for the stock exchange to watch the price sensitive information is furnished without loss of
time. Effectively protection of shareholders interest by the stock exchange is called ‘Corporate Governance.’
9. Facilitating organic growth: It means increasing the profitability by expanding the capacity or entering new
areas of activity. FM studies such possibilities and helps the business in evaluating the projects.
10. Enabling inorganic growth: This is a traditional function of FM. Many corporate are always interested in
mergers and acquisitions. In India also many leading corporate are always on the lookout for taking over
competing firms or the other firms.
*****************************************
CHAPTER 2- CAPITAL STRUCTURE
Meaning:
Capital structure plays an important role in determining the profitability of the organization. Weston and
Bringham define capital structure as “The permanent financing of the firm represented by long-term debt,
preferred stock and networth”.
Fixed assets of an organization are funded through sources which have longer period of repayment.
Long term debt like debentures is repayable over a long period stretching to even 5 years. Long term loan may
also be the loan taken from term lending institutions for as many as 10-15 years. Preference shares can have
tenure of even 10 years. And networth representing equity shares and reserves have a permanent existence and
do not have to be repaid.
The important task for the finance manager is to determine how much should be the debt and how
much should be the equity. This will have a long lasting consequence throughout the life of the corporate.
Having huge size of the debt for a project with a long gestation period may render it hopelessly unprofitable and
sick in the long run. In the modern times, corporate are avoiding debt to avoid the risk of the compulsion to pay
interest even when losses are incurred.
DEBT
Any source of finance that gives Creditorship status to the supplier of funds is called Debt. Creditorship status
means the provider of the funds has a right to receive interest at an agreed rate. The interest is payable
irrespective of whether the corporate makes profit or not. Interest is the cost and charged to p&l account. It
reduces the tax liability of the company as interest of the company as interest on debt reduces the taxable
income.
Features:
1. Compulsory payment of interest:
As per the borrowing agreement the interest is payable periodically on debentures and long term loans
irrespective of whether the corporate makes profit or not. Failure of interest payment leads to the legal
consequences.
2. Compulsory Repayment:
When it is due, principal should be repaid as per agreement. For debentures, face value is paid on maturity
and interest paid annually. For bonds, the maturity value (principal + interest) is payable at the end of the
tenure. Long term loans are repaid in installments over long period of time.
3. Only fixed interest:
The lenders do not have any claim on profits of the company under any circumstance. As the result the
lenders do not enjoy the capital appreciation of the company.
4. No claim for receiving annual report:
The Investors in debt securities are not entitled to receive the notice to Annual General Body meetings and
annual reports of the corporate.
5. No voting rights:
Lenders do not have voting rights except where their interest is involved in resolutions to be passed.
MERITS:
1. Benefit of leverage:
The Investors in debt securities enjoy the benefits of leverage when the company achieve the return on
investment higher than the rate of interest on debt.
Demerits:
1. Compulsory pay of interest:
The company should lay interest on debt securities irrespective of the incurrence of profit or losses.
2. Solvency effected:
Nonpayment of interest on debt securities leads to the liquidation of the companies through lawsuits. The
conversion of debt into equity shares or preference shares is the only option for the companies to tackle this
situation.
3. Compulsory redemption:
The company cannot postpone the repayment of debt irrespective of the financial position of the company
on the date of repayment.
4. Charge on assets:
A charge in the form of mortgage on the physical assets of a company may have to be created in favour of
the lenders. Sale of such assets call for redemption of the debt before the actual sale.
5. Credit rate shopping:
As per SEBI regulations, every debt security like bonds and debentures is rated by the credit rating agency
vlikebCRISIL, ICRA, CAREBand FITCH. There is the risk of the agency downgrading the rating of the security
subsequently.
EQUITY:
Equity represents shareholders funds or ownership capital. It is the basic for capital structure of the
company. It also means the networth of the company. It is the sum of equity share capital, preference share
capital, and reserves and surplus. The reserves and surplus are created out of profits and the preferences shares
are raised on the promise of paying dividend before the payment of dividend to equity shareholders.
Equity shares:
This is the only class of securities that give the full, fledged ownership status to the Investors. The equity
shareholders are entitled to receive notice of every general body meetings and vote on all resolutions passed in
the meetings. He is entitled to share full surplus income and assets. His dividend depends on the profits. When
company incurs loss the equity shareholders have to scarify the dividend and when the profits are made, sky is
the limit for their dividend.
Benefits:
1. Basic for capital structure:
No company can have a capital structure without equity shares. Certificate of incorporation of a company is
possible only with the equity share capital. It is inevitable.
2. Better solvency:
Equity share holder is the ultimate bearer of all the losses of the company. Hence, non declaration of
dividend will never threaten the survival of the company as in the case of nonpayment of debt.
3. Suitable for gestation period:
The period between obtaining the certificate of incorporation to the first year of Profit is called gestation
period. during this period there may be no sales and the expenses exceed income. so there is no need of
payment of dividend to the equity shareholders.
4. No Redemption:
Once the shares are sold to the investors, there is no compulsion to sell the shares back to the companies. In
order to reward the shareholder, company may buy back their shares where there is no compulsion for the
shareholders to sell the shares to the company.
5. No charge on assets:
As the equity shareholders have general claim on all the assets, after all the claims of the company are
satisfied. No charge is ever created on specific assets in favour of equity shareholders. Thus it avoids the
time, procedure and expenses involved in the creation of charge as in the case of debt.
6. No shopping for credit rating:
The value of the equity share is difficult to determine unlike the debt securities. All over the world there are
no credit rating for the IPO of Equity shares. However in India from the ear 2007 credit rating is created for
the IPO.
7. Evaluation of the sure value
The market value of the traded is universally known through news Channel, broker computer terminals and
mobile phone. This helps the investors to know and evaluate the what off their investment anywhere.
8. Better image:
Companies building equity culture help them in raising billions of rupees easily for the future projects. It will
create better image in the world at large.
Demerits:
1. Tax implications:
The company having only equity has to pay higher income tax than the company having debt as part of their
capital structure. As dividend is the part of profit not a business expense and is not taxable in the hands of
the shareholders, the company has to pay the dividend tax.
2. Management control:
In the event of any hostile takeover, the rival company can buy the shares directly or through the stock
exchange. With the shares, the rival companies can increase their voting power and may remove the
management which results in dilution of the management control.
3. High rate of dividend:
Companies accustomed to declare high percentage of dividend is forced the hike the dividend continuously
year after year. So the profit cannot be reserved for future growth.
4. Lack of flexibility:
Once the equity shares are issued, it is very difficult for the company to reduce the equity capital. The
company can offer buy-back of shares but there is no certainty that the shareholders will respond positively
for that.
DEBT-EQUITY RATIO:
In order to maximize the returns by minimizing the risk, a mixture of debt and equity is preferred for the
capital structure of the company. Therefore it is necessary for the financial manager to determine the
composition of the capital structure. For the lenders also debt- equity mix of the company is important, to
ensure that the equity capital is large enough to absorb any future losses.
Significance of high DEBT-EQUITY mix:
A high level of debt component offers the advantages of the debt like reduced tax liability, higher EPS for
equity shareholders etc. But one single demerit removes all the benefits of debt that is the obligation to pay the
interest, even when the losses are incurred continuously. In the modern day business, risk management is very
important to the survival of the company. Therefore debt is being reduced as short term fund.
*******************************************************************************************