The Effect of

Borrowing on
Investment,
Equity Vs Debt
Financing,
Leverages
By: Dr Varun Sharma
MEANING OF BUSINESS FINANCE
 Business Finance means money or funds available for a business for operations. It is
indispensable for survival and growth of business, for production and distribution of
goods and meeting day-to-day expenses etc.
 Finance is needed to establish a business, to run it, to modernize and expand, or diversify
it.

MEANING OF FINANCIAL MANAGEMENT

 Financial Management includes those business activities that are concerned with
acquisition and conservation of capital funds in meeting the financial needs and overall
objectives of a business enterprise.
 Financial Management is concerned with optimal procurement as well as the usage of
finance.

I. INVESTMENT DECISION
 Investment decision means judicious investment of firm’s resources, from the available
alternative proposals and choosing the cheapest one, which earns highest possible return
for the investors.
 The various resources available with an organisation are scarce and can be put to
alternate use. A firm must choose where to invest, wisely so as to earn the highest
possible profits.
 Investment decisions are decisions about how the firm‘s funds are invested in different
assets that is, in different investment proposals
II. FINANCING DECISION

 This decision is about the quantum of finance to be raised from various long-term sources
and short-term sources and selecting the cheapest one.
 Financing decisions involve: Decision related to the proportion of ownership (equity) and
borrowed (Debt) funds.
 Financing decision aids in identifying various sources of the funds and select the best one
by evaluating the different characteristics of the funds available and its impact on the
firm’s capital structure and returns.
 Firm/ companies needs a judicious mix of debt and equity as :
(a)Debt involves ‘Financial Risk‘i.e. risk of default on payment of interest on borrowed
funds and the repayment of the principle amount. Eg: Debentures, Public deposits etc.
(b) Shareholder’s funds involve no fixed commitment with respect to payment of returns
or repayment of capital. E.g. Equity, Preference shares

III. DIVIDEND DECISION

 Dividend is that portion of divisible profits that is distributed to the shareholders. It
results in current income for the shareholders.
 Re-investment as retained earnings increases the firm’s future earning capacity.
 Dividend decision is whether to distribute earnings to shareholder as dividends or to
retain earnings to finance long-term projects of the firm.
 The dividend decisions are taken keeping in view the overall objective of maximizing
shareholder’s wealth

FINANCIAL DECISION is one of the integral and important parts of financial management in
any kind of business concern. A sound financial decision must consider the board coverage of
the financial mix (Capital Structure), total amount of capital (capitalization) and cost of capital
(Ko). Capital structure is one of the significant things for the management, since it influences the
debt equity mix of the business concern, which affects the shareholder’s return and risk. Hence,
deciding the debt-equity mix plays a major role in the part of the value of the company and
market value of the shares.

FINANCIAL PLANNING :It involves the preparation of a financial blueprint of an organization. It is

the process of estimating the fund requirement of a business and determining the possible sources from
which it can be raised.

The objective of financial planning is to ensure that enough funds are available at right time.

Objectives of Financial Planning:

To ensure availability of funds whenever required: Includes proper estimation of the funds required
for different purposes (long term assets/working cap requirement). There is a need to estimate the time at
which these funds are to be made available. Financial planning also tries to specify possible sources of
these funds.

To see that the firm does not raise resources unnecessarily: Excess funding is as bad as inadequate
funding. Surplus funds reduce return and increases cost to a company.

CAPITAL STRUCTURE
 A firm can finance its operations through common and preference shares, with retained earnings,
or with debt.
 Usually a firm uses a combination of these financing instruments.
  Capital structure refers to a firm’s debt-to-equity ratio, which provides insight into how risky a
company is.
 Capital structure decisions by firms will have an effect on the expected profitability of the firm,
the risks faced by debt holders and shareholders, the probability of failure, the cost of capital and
the market value of the firm.

Debt Vs Equity Financing:

 Cost of Debt is lower than cost of equity but Debt is more risky than equity.
 Cost of debt is less than the cost of equity as lenders risk is more than owner’s risk.
 Lender earns a fixed interest and assured repayment of capital.
 Interest on debt is a tax-deductible expense so brings down the tax liability of a business
whereas dividends are paid out of profit after tax.
 Debt is more risky for the business as it adds to the financial risk faced by a business.
 Any default of payment of interest or repayment of principle amount may lead to
liquidation.
Effect of borrowings

Illustration: (Case 1)
1. Debt@10%: Rs 100000
2. Equity capital of 10/each share: Rs 400000
3. No. of shareholders:40000
4. Total finance required: Rs 500000
5. EBIT: Rs 75000
6. Tax rate 50%
EBIT 75000
Less int. (on debt of 100000@ 10%) 10000
EBT 65000
Tax@50% 32500
PAT 32500
EPS (32500/40000) 0.81
(Case 2)
1. Debt @10%: Rs 400000
2. Equity capital: Rs 100000
3. Total finance required:500000
4. No. of equity shareholders:10000
5. EBIT : Rs 75000
6. Tax rate 50%

EBIT 75000
Less int. (On debt of 400000 @10%) 40000
EBT 35000
Less taxes @50% 17500
PAT 17500
EPS (17500/10000) 1.75

This show, high financial leverage would lead to increase in EPS.

Capital structure affects both the profitability and the financial risk faced by a business

 Optimal Capital Structure is that combination of debt and equity that maximizes the
market value of shares of that company.
 Decisions relating to capital structure give more importance on increasing shareholders
wealth.
 The proportion of debt in the overall capital is also called financial leverage. It is
calculated as Debt/ Equity Ratio.ie. Debt/ Equity or Debt out of total capital (Debt/ Debt
+ Equity).
 If the financial leverage increases, the cost of fund declines because of increased use of
cheaper debt, but the financial risk increases.
 The impact of financial leverage on the profitability of a business can be identified
through EBIT-EPS (Earnings before Interest and Taxes-Earning per Share).
 Trading on Equity refers to the increase in profit earned by the equity shareholders due
to the presence of fixed financial charges like interest i.e. benefits to the shareholder due
to financial leveraging.
The optimal capital structure is one that minimizes the Weighted Average Cost of Capital
(WACC) by taking on a mix of debt and equity.

Financing a business through borrowing is cheaper than using equity(Debt vs Equity

Fiancing)
 Lenders require a lower rate of return than ordinary shareholders. Debt financial
securities present a lower risk than shares for the finance providers because they have
prior claims on annual income and liquidation.
 A profitable business effectively pays less for debt capital than equity for another reason:
the debt interest can be offset against pre-tax profits before the calculation of the
corporate tax, thus reducing the tax paid.
 Issuing and transaction costs associated with raising and servicing debt are generally less
than for ordinary shares.

These are some benefits from financing a firm with debt. Still firms tend to avoid very high
gearing levels. The reasons are explained as below:
 One reason is financial distress risk.
 This could be induced by the requirement to pay interest regardless of the cash flow of
the business.
 If the firm goes through a rough period in its business activities it may have trouble
paying its bondholders, bankers and other creditors their entitlement.

Factors affecting the choice of capital structure

1. Cash flow position:

 The size of the projected cash flows should be considered before deciding the capital structure of
the firm. If there is sufficient cash flow, debt can be used but it must cover fixed payment
obligations.
 The company has certain cash payment obligation such as: (i) normal business operations (ii)
Investment in fixed assets (iii) Meeting debt service commitments as well as provide a sufficient
buffer.

2. Interest coverage ratio:

 The interest coverage ratio refers to the number of times earnings before interest and taxes of a
company covers the interest obligation. This is calculated as: EBIT/ Interest
  Higher the Interest coverage ratio, lower shall be the risk of the company failing to meet its
interest payment obligations.

3. Debt Service Coverage Ratio:

The cash profits generated by the operations are compared with the total cash required for the service of
the debt and the preference share capital.

4. Return on Investment:
If return on investment of the company is higher, the company can choose to use trading on equity to
increase its EPS, i.e., its ability to use debt is greater.

5. Cost of Debt:
More debt can be used if cost of Debt is raised at a lower rate.

6. Tax Rate:
A higher tax rate makes debt relatively cheaper and increases its attraction as compared to equity as a
company can avail tax benefit on interest payment.

7. Cost of Equity:
 If a company uses more debt, the financial risk faced by equity holders increase so their desired
rate of return may increase.
 If debt is used beyond a point, cost of equity may go up sharply and share price may decrease in
spite of increased EPS.

8. Floatation Cost:
 Floatation cost is the cost involved for raising funds from the capital market.
 Cost of Public issue is more than the floatation cost of taking a loan.
 The floatation cost may affect the choice between debt and equity and hence the capital structure.

9. Risk Consideration:
 The total risk of business enterprise depends upon both the business risk and financial risk.
 If a firm‘s business risk is lower, its capacity to use debt is higher and vice versa.

10. Control:
Debt normally does not cause dilution of control whereas a public issue makes the firm more vulnerable
to takeovers. In order to retain control, firm should issue debt.

LEVERAGE
 Leverage refers to the ability of a firm in employing long term funds having a fixed cost,
to enhance returns to the owners.
 In other words, leverage is the amount of debt that a firm uses to finance its assets.
 A firm with a lot of debt in its capital structure is said to be highly levered. A firm with
no debt is said to be unlevered.
 The term Leverage in general refers to a relationship between two interrelated variables.
 In financial analysis it represents the influence of one financial variable over some other
related financial variable.
 These financial variables may be costs, output, sales revenue, Earnings before Interest
and Tax (EBIT), Earning per share (EPS) etc.
Impact of Tax in case company is having Preference Capital

𝑬𝑩𝑰𝑻
DFL= 𝑷𝒓𝒆𝒇 𝑫𝒊𝒗
𝑬𝑩𝑻−
𝟏−𝒕

𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏
DFL= 𝑷𝒓𝒆𝒇 𝑫𝒊𝒗
𝑬𝑩𝑻− 𝟏−𝒕

Or

=DOL*DFL
Where:
t= tax rate

References:
 Intermediate Course Study Material, Paper 8A Financial Management, The Publication
Department on the behalf of The Institute of Chartered Accountants of India, ICAI Bhawan, New
Delhi July 2019
 https://ncert.nic.in/ncerts/l/lebs209.pdf