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PREFACE
I am glad indeed to place this title 5TH EDITION NTA COMMERCE in the
hands of those students who are preparing for NTA exam.
This book is written strictly according to the prescribed syllabus. In preparing
this book, I have freely drawn the material both from the books of Indian &
foreign authors.
The book is divided into 12 units.
I request every teacher and the taught to bring such mistakes to the notice of
the author so that they can be redressed in the nest edition.
I welcome every constructive suggestion that goes in improving the quality of
the work and the utility of the book.
2019
Srinagar­J&K
190001

HILAL AHMED
(B.COM/M.COM/PGDBA)
AHMADHILAL850@GMAIL.COM
9906837425 / 7006246674
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SYLLABUS

Unit 1: Business Environment and International Business

Concepts and elements of business environment: Economic environment-
Economic systems, Economic policies (Monetary and fiscal policies); Political
environment Role of government in business; Legal environment- Consumer
Protection Act, FEMA; Socio-cultural factors and their influence on
business; Corporate Social Responsibility (CSR)

Scope and importance of international business; Globalization and its

drivers; Modes of entry into international business

Theories of international trade; Government intervention in international

trade; Tariff and non-tariff barriers; India’s foreign trade policy Foreign
direct investment (FDI) and Foreign portfolio investment (FPI); Types of
FDI, Costs and benefits of FDI to home and host countries; Trends in FDI;
India’s FDI policy

Balance of payments (BOP): Importance and components of BOP

Regional Economic Integration: Levels of Regional Economic Integration;
Trade creation and diversion effects; Regional Trade Agreements: European
Union (EU), ASEAN, SAARC, NAFTA

International Economic institutions: IMF, World Bank, UNCTAD

World Trade Organization (WTO): Functions and objectives of WTO;
Agriculture Agreement; GATS; TRIPS; TRIMS

Unit 2: Accounting and Auditing

Basic accounting principles; concepts and postulates

Partnership Accounts: Admission, Retirement, Death, Dissolution and
Insolvency of partnership firms

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Corporate Accounting: Issue, forfeiture and reissue of shares; Liquidation

of companies; Acquisition, merger, amalgamation and reconstruction of
companies

Holding company accounts

Cost and Management Accounting: Marginal costing and Break-even
analysis; Standard costing; Budgetary control; Process costing; Activity
Based Costing (ABC); Costing for decision-making; Life cycle costing, Target
costing, Kaizen costing and JIT

Financial Statements Analysis: Ratio analysis; Funds flow Analysis; Cash
flow analysis

Human Resources Accounting; Inflation Accounting; Environmental
Accounting

Indian Accounting Standards and IFRS
Auditing: Independent financial audit; Vouching; Verification ad valuation
of assets and liabilities; Audit of financial statements and audit report; Cost
audit
Recent Trends in Auditing: Management audit; Energy audit;
Environment audit; Systems audit; Safety audit

Unit 3: Business Economics

Meaning and scope of business economics
Objectives of business firms
Demand analysis: Law of demand; Elasticity of demand and its
measurement; Relationship between AR and MR
Consumer behavior: Utility analysis; Indifference curve analysis
Law of Variable Proportions: Law of Returns to Scale Theory of cost:
Short-run and long-run cost curves

Price determination under different market forms: Perfect competition;

Monopolistic competition; Oligopoly- Price leadership model; Monopoly;
Price discrimination
Pricing strategies: Price skimming; Price penetration; Peak load pricing
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Unit 4: Business Finance

Scope and sources of finance; Lease financing
Cost of capital and time value of money
Capital structure
Capital budgeting decisions: Conventional and scientific techniques of
capital budgeting analysis
Working capital management; Dividend decision: Theories and policies
Risk and return analysis; Asset securitization
International monetary system
Foreign exchange market; Exchange rate risk and hedging techniques
International financial markets and instruments: Euro currency; GDRs;
ADRs
International arbitrage; Multinational capital budgeting

Unit 5: Business Statistics and Research Methods

Measures of central tendency
Measures of dispersion
Measures of skewness
Correlation and regression of two variables
Probability: Approaches to probability; Bayes’ theorem
Probability distributions: Binomial, poisson and normal distributions
Research: Concept and types; Research designs
Data: Collection and classification of data
Sampling and estimation: Concepts; Methods of sampling - probability and
non-probability methods; Sampling distribution; Central limit theorem;
Standard error; Statistical estimation
Hypothesis testing: z-test; t-test; ANOVA; Chi–square test; Mann-Whitney
test (Utest); Kruskal-Wallis test (H-test); Rank correlation test
Report writing

Unit 6: Business Management and Human Resource Management

Principles and functions of management Organization structure: Formal
and informal organizations; Span of control
Responsibility and authority: Delegation of authority and decentralization
Motivation and leadership: Concept and theories
Corporate governance and business ethics
Human resource management: Concept, role and functions of HRM;
Human resource planning; Recruitment and selection; Training and
development; Succession planning
Compensation management: Job evaluation; Incentives and fringe benefits
Performance appraisal including 360 degree performance appraisal
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Collective bargaining and workers’ participation in management

Personality: Perception; Attitudes; Emotions; Group dynamics; Power and
politics; Conflict and negotiation; Stress management
Organizational Culture: Organizational development and organizational
change

Unit 7: Banking and Financial Institutions

Overview of Indian financial system
Types of banks: Commercial banks; Regional Rural Banks (RRBs);
Foreign banks; Cooperative banks
Reserve Bank of India: Functions; Role and monetary policy management
Banking sector reforms in India: Basel norms; Risk management; NPA
management
Financial markets: Money market; Capital market; Government securities
market
Financial Institutions: Development Finance Institutions (DFIs); Non
Banking Financial Companies (NBFCs); Mutual Funds; Pension Funds
Financial Regulators in India
Financial sector reforms including financial inclusion
Digitisation of banking and other financial services: Internet banking;
mobile banking; Digital payments systems
Insurance: Types of insurance- Life and Non-life insurance; Risk
classification and management; Factors limiting the insurability of risk; Re-
insurance; Regulatory framework of insurance- IRDA and its role

Unit 8: Marketing Management

Marketing: Concept and approaches; Marketing channels; Marketing mix;
Strategic marketing planning; Market segmentation, targeting and
positioning
Product decisions: Concept; Product line; Product mix decisions; Product
life cycle; New product development
Pricing decisions: Factors affecting price determination; Pricing policies
and strategies

Promotion decisions: Role of promotion in marketing; Promotion methods -

Advertising; Personal selling; Publicity; Sales promotion tools and
techniques; Promotion mix
Distribution decisions: Channels of distribution; Channel management
Consumer Behaviour; Consumer buying process; factors influencing
consumer buying decisions
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Service marketing
Trends in marketing: Social marketing; Online marketing; Green
marketing; Direct marketing; Rural marketing; CRM
Logistics management

Unit 9: Legal Aspects of Business

Indian Contract Act, 1872: Elements of a valid contract; Capacity of
parties; Free consent; Discharge of a contract; Breach of contract and
remedies against breach; Quasi contracts;
Special contracts: Contracts of indemnity and guarantee; contracts of
bailment and pledge; Contracts of agency
Sale of Goods Act, 1930: Sale and agreement to sell; Doctrine of Caveat
Emptor; Rights of unpaid seller and rights of buyer
Negotiable Instruments Act, 1881: Types of negotiable instruments;
Negotiation and assignment; Dishonour and discharge of negotiable
instruments
The Companies Act, 2013: Nature and kinds of companies; Company
formation; Management, meetings and winding up of a joint stock company
Limited Liability Partnership: Structure and procedure of formation of
LLP in India
The Competition Act, 2002: Objectives and main provisions
The Information Technology Act, 2000: Objectives and main provisions;
Cyber crimes and penalties
The RTI Act, 2005: Objectives and main provisions
Intellectual Property Rights (IPRs) : Patents, trademarks and copyrights;
Emerging issues in intellectual property
Goods and Services Tax (GST): Objectives and main provisions; Benefits of
GST; Implementation mechanism; Working of dual GST

Unit 10: Income-tax and Corporate Tax Planning

Income-tax: Basic concepts; Residential status and tax incidence; Exempted
incomes; Agricultural income; Computation of taxable income under various
heads; Deductions from Gross total income; Assessment of Individuals;
Clubbing of incomes
International Taxation: Double taxation and its avoidance mechanism;
Transfer pricing

Corporate Tax Planning: Concepts and significance of corporate tax

planning; Tax avoidance versus tax evasion; Techniques of corporate tax
planning; Tax considerations in specific business situations: Make or buy
decisions; Own or lease an asset; Retain; Renewal or replacement of asset;
Shut down or continue operations
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Deduction and collection of tax at source; Advance payment of tax; E-filing

of income-tax returns
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CONTENTS
UNIT
No. TITLE
1 FINANCIAL MANAGEMENT
(THEORY + REFERENCE)
2 FINANCIAL & MANAGEMENT
ACCOUNTING
(THEORY + REFERENCE)
3 BUSINESS ECONOMICS
(THEORY + REFERENCE)
4 BUSINESS STATISTICS
(THEORY + REFERENCE)
5 BUSINESS MANAGEMANT
(THEORY + REFERENCE)
6 MARKETING MANAGEMENT
(THEORY + REFERENCE)
7 BUSINESS ENVIRONMENT
(THEORY + REFERENCE)
8 HUMAN RESOURCE MANAGEMENT
(THEORY + REFERENCE)
9 BANKING & FINANCIAL INSTITUTIONS
(THEORY + REFERENCE)
10 INTERNATIONAL BUSINESS
(THEORY + REFERENCE)
11 ACCOUNTING & FINANCE
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(THEORY + REFERENCE)
12 AUDITING
(THEORY + REFERENCE)
13 LEGAL ASPECTS OF BUSINESS
(THEORY +REFERENCE)
14 INCOME-TAX LAW & PLANNING
(THEORY + REFERENCE)
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UNIT-1
FINANCIAL MANAGEMENT
Financial Management refers to that part of the management activity which is concerned with the
planning and controlling of firms financial resources.

OBJECTIVES OF FINANCIAL MANAGEMENT

The objectives of financial management can be achieved by:

 PROFIT MAXIMATION
 WEALTH MAXIMATION
PROFIT MAXIMATION: Profit earning is the main aim of every economic activity. A business being an
economic institution must earn profits to cover its costs and provide funds for growth. No business
can survive without earning profit. Profit is a measure of efficiency of a business eEnterprise. Profits
also serve as a protection against risks which cannot be ensured. The accumulated profits enable a
business to face risks like fall in prices, competition from other units, adverse govt policies etc. Thus,
profit maximization is considered as the main objective of business.

Drawbacks of profit maximization:

1. Ambiguity: the term ‘profit’ is vague and it cannot be precisely defined. It means
different things for different people. Should we consider short-term profit or long-
term profits? Does it mean total profits or earning per share?
2. Ignores time value of money: profit maximization objective ignores the time value
of money and does not consider the magnitude and timing of earnings. It treats all
earnings as equal though they occur in different periods. It ignores the fact that
cash receved today is more important than the same amount of cash received
tomorrow.
3. Ignores risk factor: it does not take into consideration the risk of the prospective
earnings stream. Some projects are more risky than others.
4. Dividend policy: the effect of dividend policy on the market price of shares is also
not considered in the objective of profit maximization.

WEALTH MAXIMIZATION: wealth maximization is the appropriate objective of an enterprise. Financial

theory asserts that wealth maximization is the single substitute for a stockholders utility. When the
firm maximizes the stockholders wealth, the individual stockholder can use this wealth to maximize
his individual utility. It means that by maximizing stockholders wealth the firm is operating
consistently towards maximizing stockholders utility.

Stockholders current wealth in the firm is the product of the number of shares owned, multiplied with
the current stock price per share. Higher the stock price per share greater will be stockholders wealth.

ARGUMENTS IN FAVOR OF WEALTH MAXIMISATION

 It serves the interests of owners as well as other stakeholders in the firm.

 It takes into consideration the risk factor and the time value of money.
 The effect of dividend policy on market price of shares is also considered as the
decisions are taken to increase the market value of the shares.

ECONOMIC VALUE ADDED

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Economic value added is a measure of performance evaluation that was originally employed by Stern
Stewart & co. it is very popular measure today which is used to measure the surplus value created by an
investment or a portfolio of investment. EVA has been considered as a better measure of divisional
performance as compared to the RETURN ON ASSETS. It is also being used to determine whether
investment positively contributes to the shareholders wealth. The economic value added of an
investment is simply equal to the after tax operating profits generated by the investment minus the
cost of funds used to finance the investment.

EVA= NET OPERATING PROFIT AFTER TAX – COST OF CAPITAL * CAPITAL INVESTED

According to this approach, an investment can be accepted only if the surplus is positive.

For example; an investment generates net profit after tax of Rs. 20 lakhs and the cost of financing
investment is Rs. 16 lakhs. The economic value added by the investment will be Rs. 4 lakh.

FINANCIAL DECISIONS:

Financial decisions refer to decisions concerning financial matters of a business firm. The main financial
decisions are:

1. Investment decision
2. Financing decision
3. Dividend decision.

Investment decision: investment decision relates to the determination of total amount of assets to be
held in the firm, the composition of these assets and the business risk complexions of the firm as
perceives by its investors. The investment decisions can be classifies under two broad groups:

Long term investment decisions & Short term investment decisions. Long term investment decision is
referred to as the capital budgeting and short term investment decisions as working capital
management.

Financing decision: once the firm has taken the investment decision and committed itself to new
investment, it must decide the best means of financing these commitments. A finance manager has to
select such sources of funds which will make optimum capital structure. The important thing to be
decided here is the proportion of various sources in the overall capital mix of the firm. The debt­equity
ratio should be fixed in such a way that it helps in maximizing the profitability of the concern. The
rising of more debts will involve fixed interest liability and dependence upon outsider. It may help in
increasing the return on equity but will also enhance the risk. The rising of funds through equity will
bring permanent funds to the business but the shareholders will expect higher rates of earning. The
financial manager has to strike a balance between various sources so that the overall profitability of the
concern improves.

Dividend decision: the third major financial decision relates to the disbursement of profits back to
investors who supplied capital to the firm. The term dividend refers to that part of profits of a company
which is distributed by it among its shareholders. It is the reward of shareholders for investments made
by them in share capital of the company. The dividend decision is concerned with the quantum of profits
to be distributed among shareholders. A decision has to be taken whether all the profits are to be
distributed, to retain all the profits in business or to keep a part of profits in the business and
distribute others among shareholders. The higher rate of dividend may raise the market price of
shares and thus, maximize the wealth of shareholders.

POINTS TO REMEMBER

 The term financial management can be defined as the management of flow of funds and it
deals with the financial decision making.
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 The objective of maximization of shareholders wealth has been taken as the primary goal of
financial decision making and maximization of profit is the second main objective of financial
management.
 A firm wishes to maximize the profits may opt to pay no dividend and to reinvest the
retained earnings whereas a firm that wishes to maximize the shareholders wealth
may pay regular dividend.
 Capital budgeting is related to fixed assets.
 Working capital management related to current assets.
 The dividend decisions are almost regular decision in the sense that it is taken
whenever the firm wants to distribute interim dividend, final dividend or bonus to
shareholders.
 Shareholders interest put on high priority and public interest get last priority.
 Three decisions are taken 1) financial decisions 2) investment decisions 3)
dividend decisions.

FINANCIAL PLANNING

Financial planning is a growing industry with projected faster than average job growth. Financial
managers must be able to analyze the current position of their own firms as well as that of their
competition .They must also plan for the company’s financial future. The financial manager is
responsible for planning to ensure that the firm has enough funds for the needs. A useful tool for
planning future cash needs to plan for the continuing profitability. Planning is an inevitable process in
any business firm irrespective of its size and nature. So the financial planning encompasses both the
business plan as well as analyzes the current as well as future financial position of the firm.

When you want to maximize your existing financial resources by using various financial tools to achieve
your financial goals that is financial planning. Financial Planning is the process of estimating the capital
required and determining its competition. It is the process of framing financial policies in relation to
procurement, investment and administration of funds of an enterprise.

Objectives of Financial Planning

• Determining capital requirements­ This will depend upon factors like cost of current and fixed
assets, promotional expenses and long- range planning. Capital requirements have to be looked with
both aspects: short- term and long- term requirements.

• Determining capital structure- The capital structure is the composition of capital, i.e., the
relative kind and proportion of capital required in the business. This includes decisions of debt- equity
ratio- both short-term and long- term.

• Framing financial policies with regards to cash control, lending, borrowings, etc.

• A finance manager ensures that the scarce financial resources are maximally utilized in the best
possible manner at least cost in order to get maximum returns on investment.

FIXED CAPITAL: Fixed capital stands for that amount of capital which is required for long­term to
create production facilities through purchase of fixed assets such as plant, machinery, land building,
furniture etc.

Investment is non­current assets such as long­term receivables, advance to subsidiary or affiliate

concerns, goodwill, patents, copyrights, long term investment etc are form of fixed capital

Working capital: working capital refers to that part of the firms capital which is required for financing
short­term or current assets such as cash, marketable securities, debtors and investors.
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CAPITALIZATION: Capitalization is one of the most important constituents of financial plan. The term
capitalization has been derived from the word capital and in common practice it refers to the total
amount of capital employed in a business. Capitalization refers to the process of determining the plan
of financing. It includes not merely the determination of the quantity of finance required for a
company but also the decision about the quality of financing.

Capitalization includes:

 Share capital
 Long-term debt
 Reserves & surplus
 Short term debt
 Creditors

Capital: the term capital refers to the total investment of a company in money, tangible & intangible
assets. It is the total wealth of a company.

Theories of Capitalization

There are two important theories to determine the amount of capitalization:

1. Cost theory of capitalization: according to this theory, the amount of capitalization is

arrived at by adding up the cost of fixed assets (like plants, machinery, building): working
capital required for the continuous operations of the company; the cost of establishing the
company and the promotional expenses. Such calculation of capitalization is useful in case of
newly formed companies as it enables the promoters to know exactly the amount of funds to be
raised. But, this theory is not totally satisfactory as it ignores the earning capacity of the
business. The amount of capitalization is based on a figure which will not change with changes
in the earning capacity of the business. For example, if some of the fixed assets of a
company become obsolete, some remains idle and the others are under employed, the
total earning capacity of the company will naturally fall but such a fall in the earning
capacity, would not reduce the value of the investment made in the company’s
business.
2. The earning theory of capitalization: The earning theory of capitalization recognizes
the fact that true value of an enterprise depends upon its earning capacity.
According to this theory, the capitalization of a company depends upon its earnings and the
expected fair rate of return on its capital invested. Thus, the value of capitalization is equal to
the capitalized value of the estimated earnings. For example, if a company is making net profit
RS. 200,000 per annum and the fair rate of return is 10%. The capitalization of the company
will be Rs. 200,000*100/10= Rs. 20,00,000. A comparison of actual value of capitalization with
this value will show whether the company is fairly capitalized, over capitalized or under-
capitalized.

FAIR CAPITALIZATION: It is the desire of every company to have a fairly capitalized situation, that is
neither over-capitalization nor under-capitalization.

OVER CAPITALZATION: Over-capitalization refers to that state of affairs where earnings of a company
do not justify the amount of capital invested in its business. When a business us unable to earn fair rate
on its outstanding securities, it is over-capitalization

Over-capitalization may occur when the amount of shares debentures, public deposit and loans exceed
the current value of the assets.

CAUSES OF OVER CAPITALIZATION:

 Over issue of capital.

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 Promotion, formation or development during inflation.

 Buying assets of lower value at higher prices
 High promotion costs
 Inadequate depreciation
 Liberal dividend policy
 Inadequate demand.
 Payment of high rate of interest.

Evils of over­capitalization

1. Effects on the company:

 Loss of goodwill
 Poor creditworthiness
 Difficulties in obtaining capital
 Decline in efficiency of the company
 Loss of market
 Liquidation of company.
2. Effects on shareholders:
 Reduced dividend
 Fall in the value of shares
 Loss on speculation.
3. Effects on society:
 Loss to consumers
 Loss to workers
 Recession
Remedies for over­capitalization:

 To have efficient management

 Redemption of preference shares
 Reduction of funded debt
 Reorganization of equity share capital.

UNDER­CAPITALIZATION:

A company may be under­capitalized when the rate of profits it is making on the total capital is
exceptionally high in relation to the return enjoyed by similarly situated companies in the same
industry, or when it has too little capital with which to conduct its business.

We can say under­capitalization is the reverse phenomenon of over capitalization, and occurs when a
company’s actual capitalization is lower than its proper capitalization as warranted by its earning
capacity.

Causes of under­capitalization

 Under estimation of capital requirements

 Under-estimation of future earnings
 Promotion during depression
 Conservative dividend policy
 Very efficient management.

REMEDIES OF UNDER­CAPITALIZATION

 Fresh issue of shares

 Issue of bonus shares
 Increase the par value of securities
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 Splitting stock
CAPITAL STRUCTURE

The term ‘structure’ means the arrangement of the various parts. So capital structure means the
arrangement of capital from different sources so that the long­term funds needed for the business are
raised.

Thus, capital structure refers to the proportions or combinations of equity share capital, preference
share capital, debentures, long­term loans, retained earnings and other long­term sources of funds in
the total amount of capital which a firm should raise to run its business.

Capital Structure, Financial Structure and Assets Structure:

The term capital structure should not be confused with financial structure and Assets structure. While
financial structure consists of short­term debt, long­term debt and share holders’ fund i.e., the entire
left hand side of the company’s Balance Sheet. But capital structure consists of long­term debt and
shareholders’ fund.

So, it may be concluded that the capital structure of a firm is a part of its financial structure. Some
experts of financial management include short­term debt in the composition of capital structure. In
that case, there is no difference between the two terms—capital structure and financial structure.

So, capital structure is different from financial structure. It is a part of financial structure. Capital
structure refers to the proportion of long­term debt and equity in the total capital of a company. On
the other hand, financial structure refers to the net worth or owners’ equity and all liabilities (long­
term as well as short­term).

Capital structure does not include short­term liabilities but financial structure includes short­term
liabilities or current liabilities.

Assets structure implies the composition of total assets used by a firm i.e., make­up of the assets side
of Balance Sheet of a company. It indicates the application of fund in the different types of assets
fixed and current.

Assets structure = Fixed Assets + Current Assets.

The term capitalization means the total amount of long­term funds at the disposal of the company,
whether raised from equity shares, preference shares, retained earnings, deben­tures, or institutional
loans.

POINTS TO REMEMBER:

 Capital structure refers to firm cost of capital.

 Those who believe such a capital structure exists are supporters of Traditional approach.
 Those who believe capital structure does not exists are supporters of M&M approach.
 The value of the firm depends upon the earnings of the firms and the earnings of the
firms depends upon the investment decisions of the firm.
 It states that relationship between leverage, value of the firm and overall cost of
capital of the firm

FINANCIAL BREAK­EVEN POINT:

Financial break­even point may be defined as that level of EBIT which is just equal to pay the total
financial charges, that is interest and preference dividend. At that point or level of earnings before
interest and tax, the earnings per share equals zero (EPS=0). It is critical point in planning capital
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structure of a firm. If earnings before interest and tax is less than the financial break even point, the
earnings per share shall be negative and hence fixed interest bearing debt or preference share capital
should be reduced in the capitalization of the firm. However in case the level of EBIT exceeds the
financial break even point, more of such fixed cost funds may be inducted in the capital structure.

FINANCIAL BREAK EVEN POINT= I + DP / (I­t)

Where, I= FIXED INTEREST CHARGES

DP= PEFERENCE DIVIDENT

t= tax rate

POINT OF INDIFFERENCE OR RANGE OF EARNINGS

The EPS, EARNING PER SHARE, “EQUIVALENCY POINT” OR “POINT OF INDIFFERENCE” refers to that
EBIT, earnings before interest and tax, level at which EPS remains the same irrespective of different
alternatives of debt­equity mix. At this level of EBIT, the rate of return on capital employed is equal to
the cost of debt and this is also known as break­even level of EBIT for alternative financial plans.

OPTIMAL CAPITAL STRUCTURE

That capital structure or combination of debt and equity that leads to the maximum value of the firm.
Optimal capital structure maximizes the value of the company and hence the wealth of its owners and
minimizes the company’s cost of capital.

RISK­RETURN TRADE OFF

The financial or capital structure decision of a firm to use a certain proportion of debt or otherwise in
the capital mix involves two types of risks:

FINANCIAL RISK: The financial risk arises on account of the use of debt or fixed interest bearing
securities in its capital. A company with no debt financing has no financial risk. The extent of financial
risk depends on the leverage of the firm's capital structure. A firm using debt in its capital has to pay
fixed interest charges and the lack of ability to pay fixed interest increases the risk of liquidation. The
financial risk also implies the variability of earnings available to equity shareholders.

NON­EMPLOYMENT OF DEBT CAPITAL RISK (NEDC): If a firm does not use debt in its capital structure,
it has to face the risk arising out of non­employment of debt capital. The NEDC risk has an inverse
relationship with the ratio of debt in its total capital. Higher the debt equity ratio or the leverage,
lower is the NEDC risk and vice­versa. A firm that does not use debt cannot make use of financial
leverage to increase its earnings per share; it may also lose control by issue of more and more equity;
the cost of floatation of equity may also be higher as compared to costs of raising debt.

THEORIES OF CAPITAL STRUCTURE:

1. NET INCOME APPROACH: According to this approach, a firm can minimize the
weighted average cost of capital and increase the value of the firm as well as market
price of equity shares by using debt financing to the maximum possible extent. The
theory propounds that a company can increase its value and decrease the overall cost of
capital by increasing the proportion of debt in its capital structure. This approach is
based upon the following assumptions:
 The cost of debt is less than the cost of equity.
 There are no taxes.
 The risk perception of investors is not changed by the use of debt.
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The line of argument in favor of net income approach is that as the proportion of debt financing in
capital structure increases, the proportion of a less expensive source of funds increases. This results in
the decrease in overall cost of capital leading to an increase in the value of the firm. The reasons for
assuming cost of debt to be less than the cost of equity are that interest rates are usually lower than
dividend rates due to element of risk and the benefit of tax as the interest is a deductible expense.

On the other hand, if the proportion of debt financing in the capital structure is reduced or say when
the financial leverage is reduced, the weighted average cost of capital of the firm will increase and the
total value of the firm will decrease. The Net Income Approach showing the effect of leverage on
overall cost of capital has been presented in the following figure.

The total market value of a firm on the basis of Net Income Approach can be ascertained as below:

V=S+D

WHERE.

V= TOTAL MARKET VALUE OF A FRIM

S= MARKET VALUE OF EQUITY SHARES

D= MARKET VALUE OF DEBT

MARKET VALUE OF EQUITY SHARES=

OVERALL COST OF CAPITAL OR WEIGHTED AVERAGE COST OF CAPITAL =

POINTS TO REMEMBER:
 Suggested by Durand.
 It states a relationship between leverage, cost of capital and value of the firm.
 Relationship between capital structure and value of the firm.
 It states that value of the firm increases by increasing more debt
proportion or leverage & overall cost of capital will decrease.
 More & more debt or leverage> increase value of the firm> decrease overall cost
of capital of the firm (WACC)
 Assumptions are cost of debt Kd and cost of equity Ke are constant. Kd=Ke=k
 Use of more and more debt financing in the capital structure does not affect the
risks perception of the investors.
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 Approach suggests that higher the degree of leverage, better it is as the value of
the firm would be higher. A firm can increase its value just by increasing the debt
proportion in capital structure.
 Value of the firm= value of equity+ value of debt
2. NET OPERATING INCOME APPROCH: This theory was suggested by DURAND &
is another extreme of the effect of leverage on the value of the firm. It is diametrically
opposite to the net income approach. According to this approach, change in the capital
structure of a company does not affect the market value of the firm and the overall cost
of capital remains constant irrespective of the method of financing. It implies that the
overall cost of capital remains the same whether the debt-equity mix is 50:50 or 20:80 or
0:100. Thus, there is nothing as an optimal capital structure and every capital structure is
the optimal capital structure. This theory presumes that:
 The market capitalizes the value of the firm as a whole.
 The business risk remains constant at every level of debt equity mix.
 There are no corporate taxes.

The reasons propounded for such assumptions are that the increased use of debt increases the
financial risk of the equity shareholders and hence the cost of equity increases. On the other hand, the
cost of debt remains constant with the increasing proportion of debt as the financing risk of the
lenders is not affected. Thus, the advantage of using the cheaper source of funds, that is debt is
exactly offset by the increased cost of equity.

According to the Net Operating Income Approach, the financing mix is irrelevant and it does not affect
the value of the firm. The Net Operating Income Approach showing the effect of leverage on the
overall cost of capital has been presented in the following figure.

The value of a firm on the basis of Net Operating Income Approach can be determined as below:

V=

V= VALUE OF A FIRM

EBIT= EARNING BEFORE INTEREST & TAX

KO= OVERALL COST OF CAPITAL

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POINTS TO REMEMBER:
 Opposite to NI approach.
 Market value of the firm depends on the operating profit or EBIT and overall cost
of capital (WACC)
 Financing mix or capital structure is irrelevant and does not affect the value of the
firm.
 Assumptions are cost of debt and overall cost of capital are constant. Kd= Ko=K
 As the debt proportion or the financial leverage increases the risk of the
shareholders also increases and the cost of equity Ke also increases so value of
the firm remain the same.
 NOI consider Ko to be constant & there is no optimal capital structure rather every
capital structure is good as any other & every capital structure is optimal one.
 Value of equity= value of the firm- value of debt

3. THE TRADITIONAL APPROACH: The traditional approach, also known as

INTERMEDIATE APPROACH, is a compromise between the two extremes of net income
approach and net operating income approach. According to this theory, the value of the
firm can be increased initially or the cost of capital can be decreased by using more debt
as the debt is a cheaper source of funds than equity. Thus, optimum capital structure can
be reached by a proper debt-equity mix. Beyond a particular point, the cost of equity
increase because increased debt increases the financial risk of the equity shareholders.
The advantage of cheaper debt at this point of capital structure is offset by increasing
cost of equity. After this there comes a stage, when the increased cost of equity cannot
be offset by the advantage of low- cost debt. Thus, overall cost of capital, according to
this theory, decreases up to a certain point, remains more or less unchanged for
moderate increase in debt therefore; and increase of rises beyond a certain point. Even
the cost of debt may increase at this stage due to increased financial risk.

POINTS TO REMEMBER:
 It said that both NI approach and NOI approach is unrealistic.
 It takes a mid­ way between the NI approach (value of the firm increase by increasing debt)
and NOI approach (value of the firm remain the constant)
 As per this a firm should make a judicious use of both debt & equity to achieve a capital
structure which may be called the optimal capital structure.
 WACC will be minimum & value of the firm will be maximum.
 It states that value of the firm increases with increase in financial leverage but up to a certain
limit only. Beyond this limit the increase in financial leverage will increase its WACC and value
of the firm will decline.
 Assumptions are cost of debt Kd and cost of equity Ke is constant, Kd=Ke=K
 The use of the leverage beyond a point will have the effect of increase in the overall cost of
capital of firm& thus result in decrease in the value of the firm.
 Judicious use of both debt and equity.

4. MODIGLIANI & MILLER APPROACH: M & M hypothesis is identical with the Net
Operating Income approach if taxes are ignored. However when corporate taxes are
assumed to exist, their hypothesis is similar to the Net Income Approach.

A. In the absence of taxes: (THEORY OF IRRELEVANCE) The theory proves that the
cost of capital is not affected by changes in the capital structure or say that the debt-
equity mix is irrelevant in the determination of the total value of a firm. The reason
argued is that through debt is cheaper to equity, with increased use of debt as a source
of finance, the cost of equity increases. This increase in cost of equity offsets the
advantage of the low cost of debt. Thus although the financial leverage affects the cost
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of equity, the overall cost of capital remains constant. The theory emphasizes the fact
that a firms operating income is a determinant of its total value. The theory further
propounds that beyond a certain limit of debt increases (due to increased financial risk)
but the cost of equity falls thereby again balancing the two costs.
In the opinion of Modigliani & Miller, two identical firms in all respects expect their capital
structure cannot have different market values or cost of capital because of ARBITAGE
process. In case two identical firms expect for their capital structure have different
market values of cost of capital, ARBITAGE will take place and the investors will engage
in personal leverage that is they will buy equity of the other company in preference to the
company having lesser value as against corporate leverage and this will again render the
two firms to have the same total value.
The M & M APPROACH is based upon the following assumptions:
There are no corporate taxes.
There is a perfect market
Investors act rationally.
The expected earnings of all the firms have identical risk characteristics.
The cut-off point of investment in a firm is capitalization rate.
M M APPROACH in the absence of corporate taxes that is the theory of irrelevance of
financing mix has been presented in the following figure:

B. WHEN THE CORPORATE TAXES ARE ASSUMED TO EXIST (THEORY OF

RELEVANCE): Modigliani and Miller, in their article of 1963 have recognized that the
value of the firm will increase or the cost of capital will decrease with the use of debt on
account of deductibility of interest charges for tax purpose. Thus, the optimum capital
structure can be achieved by maximizing the debt mix in the equity of a frim.
According to M & M Approach the value of a unlevered firm can be calculated as:

&
Value of UNRELERED FIRM =

POINTS TO REMEMBER:
 Relationship between leverage cost of capital and value of the firm.
 Capital structure has no effect on the value of the firm.
 Financial leverage does not matter and cost of capital & value of the firm is
independent.
 Nothing may be called optimal capital structure.
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 Restate NOI approach & added it to the behavioral justification for their model.
 Assumptions are markets is perfect, securities are infinitely divisible, investors
are rational, no tax, personal leverage and corporate leverage are perfect substitute.
 It argues that if two firms are alike in all respects except that they differ in respect
of their financing pattern and their market value, then the investors will develop a
tendency to sell the shares of the over -valued firm and to buy the shares of the under-
valued firm. Buying and selling pressures will continue till the two firms have same
market value.
 It follows the arbitrage process- It refers to taking to understanding by a person of
two related actions r steps simultaneously in order to derive some benefit e.g buying by
speculator in one market and selling the same at the same time in some other market.
The arbitrage process has been used by MM to testify their hypothesis of financial
leverage, cost of capital & value of the firm.

CAPITAL GEARING: The term capital gearing refers to the relationship between equity capital and
long­term debt. In simple words, capital gearing means the ratio between the various types of
securities in the capital structure of the company.

PACKING ORDER THEORY: The PACKING ORDER THEORY was 1st suggested by Donaldson in 1961 and
it was modified by Myers in 1984. According to this theory, a firm has well defined order of preference
for raising finance. Whenever a firm needs funds, it will rely as much as possible on internally
generated funds. If the internally generated funds are not sufficient to meet the financial
requirements, it will move to debt in the form of term loans and then to non­convertible bonds and
debentures and then to convertible debt instruments and then to quasi­equity instruments and after
exhausting all other sources, it may finally move to raise finance through issue of new equity share
capital. This order of preference is so defined because the internally generated funds have no issue
cost and the cost of new equity issue is the highest.

LEVERAGES

The term leverage is used to describe the firm’s ability to use fixed cost assets or funds to increase the
return to its owners that is equity shareholders.

There are basically two types of leverages:

1. Operating leverage 2. Financial leverage. The leverage associated with the

employment of fixed cost assets is referred to as operating leverage while the leverage
resulting from the use of fixed cost or return source of funds is known as financial
leverage. In addition to these two kinds of leverages, one could always compute
“composite leverage” to determine the combined effect of the leverages.

POINTS TO REMEMBER:

 Leverages are related to tangible assets.

 Relationship between two interrelated variables.
 Leverage = % change in dependent variables / % change in independent
variables.
 Functional relationships Sales revenue (-) variable cost = contribution
 Contribution- fixed cost = EBIT (Earnings before interest and tax) EBIT-
Interest= profit before tax Profit before tax- tax= profit after tax (EPS)
 Relationship between sales revenue and EBIT is known as operating
leverage.
 Relationship between EBIT and EPS is known as financial leverage.
 Relationship between sales revenue and EPS is known as combined
leverage.
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 The maximization of shareholders wealth requires the maximization of

market price of the share by maximizing the EPS.

1. FINANCIAL LEVERAGE OR TRADING ON EQUITY: A firm needs funds to run &

manage its activities. The funds are first needed to set up an enterprise and then to
implement expansion, diversification and other plans. A decision has to be made
regarding the composition of funds. The funds may be raised through two sources:
owners, called owners equity and outsiders called creditors equity. When a firm issues
capital these are owner’s funds when it raises funds by long term & short term loans its
called creditors equity or outsider’s equity. Various means used to raise funds represent
the financial structure of a firm. So the financial structure is represented by the left side
of the balance sheet that is liabilities side. Traditionally, the short-term finances are
excluded from the methods of financing capital budgeting decisions. So, only long term
sources are taken as a part of capital structure. The term capital structure refers to the
relationship between various long-term forms of financing such as debentures,
preference share capital, equity share capital etc. Financing the firms assets is a very
crucial problem in very business and as a general rule there should be proper mix of
debt and equity share capital. THE USE OF LONG-TERM FIXED INTEREST BEARING
DEBT & PREFERENCE SHARE CAPITAL ALONG WITH EQUITY SHARE CAPITAL IS
CALLED FINANCIAL LEVERAGE OR TRADING ON EQUITY.
The long term fixed interest bearing debt is employed by a firm to earn more from the use
of these resources than their cost so as to increase the return on owner’s equity. It is
true that the capital structure cannot affect the total earnings of a firm but it can affect
the share of earnings for equity shareholders.
The fixed cost funds are employed in such a way that the earnings available for common stockholders
(equity shareholders) are increased. A fixed rate of interest is paid on such long-term debts
(debentures). Interest is a liability and must be paid irrespective of revenue earnings. The preference
share capital also bears a fixed rate of dividend. But, the dividend is paid only when the company has
surplus profits. The equity shareholders are entitled to residual income after paying interest and
preference dividend. The aim of financial leverage is to increase the revenue available for equity
shareholders using the fixed cost funds. If the revenue earned by employing fixed cost funds is more
than their cost (interest and/or preference dividend) then it will be to the benefit of equity
shareholders to use such a capital structure. A firm is known to have a favorable leverage if its earnings
are more than what debt would cost. On the contrary, if it does not earn as much as the debt costs then
it will be known as an unfavorable leverage

Every firm has to make its own decision regarding the quantum of funds to be borrowed. When the
amount of debt is relatively large in relation to capital stock, a company is said to be trading on their
equity

On the other hand if the amount of debt is comparatively low in relation to capital stock, the company is
said to be trading on thick equity.

IMPACT OF FINANCIAL LEVERAGE

The financial leverage is used to increase the shareholders earnings. It is based on the assumption that
the fixed charges/costs funds can be obtained at a cost lower than the firm's rate of return on its assets.
When the difference between the earnings from assets financed by fixed cost funds and the costs of
these funds are distributed to the equity stockholders, they will get additional earnings without
increasing their own investment. Consequently, the earnings per share and the rate of return on equity
share capital will go up. On the contrary, if the firm acquires fixed cost funds at a higher cost than the
earnings from those assets then the earnings per share and return on equity capital will decrease. The
impact of financial leverage can be analyzed while looking at earnings per share and return on equity
capital.
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DEGREE OF FINANCIAL LEVERAGE

The degree of financial leverage measures the impact of a change in operating income (EBIT) on change
in earning on equity capital or on equity share.

DEGREE OF FINANCIAL LEVERAGE=

POINTS TO REMEMBER:

 The relationship between the sales revenue and EBIT.

 Operating leverage= % change in EBIT/% change in sales revenue
 For every increase or decrease in sales level, there will be more than
proportionate increase or decrease in the level of EBIT. This is due to the
existence of FIXED COST.
 If no fixed cost then increase or decrease in EBIT was direct and proportion
to increase or decrease in sales level. OL=1
 OL=1.5 Degree of operating leverage. Increase or decrease in sales will affect
more increase or decrease in EBIT.
 If fixed cost> variable cost= greater would be the DOL (Degree of operating
leverage)
 DOL/OL= Contribution/EBIT
 If no fixed cost then no operating leverage.
 A firm should avoid high DOL.

2. OPERATING LEVERAGE

Operating leverage results from the presence of fixed costs that help in magnifying net operating
income fluctuations flowing from small variations in revenue. The fixed cost is treated as fulcrum of
leverage. The changes in sales are related to changes in revenue. The fixed costs do not change with the
change in sales. Any increase in sales, fixed costs remaining the same, will magnify the operating
revenue. The operating leverage occurs when a firm has fixed costs which must be recovered
irrespective of sales volume. The fixed costs remaining same, the percentage change in operating
revenue will be more than the percentage change amount of fixed elements in the cost structure.

Operating leverage can be determined by means of a break even or cost volume profit analysis. The
degree of leverage will be calculated as:

OPERATING LEVERAGE= CONTRIBUTION / OPERATING PROFIT

CONTRIBUTION= SALES – VARIABLE COST

OPERATING PROFIT= SALES – VARIABLE COST – FIXED COST

BREAK EVEN POINT= FIXED COST / PV RATIO

PV RATIO= CONTRIBUTION / SALES.

When production and sales move above the break­even point, the firm enters highly profitable range
of activities. At break­even point the fixed costs are fully recovered, any increase in sales beyond this
level will increase profits equal to contribution. A firm operating with a high degree of leverage and
above break­even point earns good amount of profit.

If a firm does not have fixed costs then there will be no operating leverage. The percentage change in
sales will be equal to the percentage change in profit. When fixed costs are there, the percentage
change in profits will be more than the percentage in sales volume.
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Degree of Operating Leverage= Percentage change in profits / Percentage change in sales

POINTS TO REMEMBER:

 It measures the relationship between EBIT and EPS.

 Financial leverage= %change in EPS/% change in EBIT
 EBIT is dependent variable in operating leverage and was determined by sales level. In case of
financial leverage, EBIT is an independent variable and is determining the level
of EPS that is why EBIT is called a linking point in the leverage study .
 Financial leverage may be defined as % increase in EPS divided by % increase in EBIT.
Emerge as a result of fixed financial charges (interest and dividend)
 Higher the level of fixed financial charge higher would be the financial leverage.
 DFL (Degree of financial leverage)= EBIT/EBIT­interest = 200/0= undefined, it is also called
financial break­ even level i.e the level of EBIT is just sufficient to cover the fixed financial
charges only and there is no earnings available to the shareholders and hence no
EPS (Earning per share)
 ROI (Return on Investment)= cost of debt
 ROI< cost of debt = unfavorable financial leverage.
 ROI> cost of debt= favorable or trade on equity
 OL= leverage of the first order or first stage leverage.

FL= leverage of the second order or second stage leverage

FOR COMPLETE
BOOK