chapter

F inancial M anageMenT
9
Learning Objectives W hen T aTa S Teel a cquired
c oruS
After studying this chapter, you Tata Steel, the biggest steel producer
should be able to: in the Indian private sector has
acquired Corus, (formerly known as
> explain the meaning of British Steel) in a deal worth $8.6
business finance; billion in 2007. A financial decision
of this magnitude has significant
> d e s c r ib e fi n a n c i a l implicitness for both Tata Steel and
management; Corus as well as their employees
and shareholders. To mention some
> explain the role of financial of them:
management in our . Tata Steel raised a debt of over $8
enterprise; billion to finance the transaction.
The deal will be paid for by Tata
> discuss objectives of Steel UK, a special purpose vehicle
financial management and (SPV) set up for the purpose .
how they could be achieved; Another company of the Tata
group, Tata Sons Ltd., invested
> explain the meaning and $ 1 billion dollars for preference
importance of financial shares along with Tata Steel which
planning; will invest an equal amount.
. Tata Steel, the acquirer company,
> state the meaning of capital
arranged about 36,500 crores of
structure; rupees to finance the take-over.

> analyse the factors affecting . Tata Steel raised this amount
the choice of an appropriate through debt or equity or a
combination of both. Some amount
capital structure;
came from internal accruals
also. This financing decision
> state meaning of fixed capital
affected the capital structure of
and working capital; and
the acquirer.

> analyse the factors affecting Source: The Economic Times

the requirement of fixed
and working capital.

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i nTroducTion thus, very crucial for the survival and

In the above case, these decisions growth of a business.
require careful financial planning,
an understanding of the resultant F inancial M anageMenT
capital structure and the riskiness All finance comes at some cost. It
and profitability of the enterprise. All is quite imperative that it needs to
these have a bearing on shareholders be carefully managed. Financial
as well as employees. They require Management is concerned with optimal
an understanding of business procurement as well as the usage of
finance, major financial decision finance. For optimal procurement,
areas, financial risk, and working different available sources of finance
capital requirements of the business. are identified and compared in terms
Finance, as we all know, is essential of their costs and associated risks.
for running a business. Success of Similarly, the finance so procured
business depends on how well finance needs to be invested in a manner that
is invested in assets and operations the returns from the investment exceed
and how timely and cheaply the the cost at which procurement has
finances are arranged, from outside taken place. Financial Management
or from within the business. aims at reducing the cost of funds
procured, keeping the risk under
M eaning oF B uSineSS F inance control and achieving effective
deployment of such funds. It also
Money required for carrying out
aims at ensuring availability of enough
business activities is called business
funds whenever required as well as
finance. Almost all business activities
avoiding idle finance. Needless to
require some finance. Finance is
emphasise, the future of a business
needed to establish a business, to
depends a great deal on the quality of
run it, to modernise it, to expand, or
its financial management.
diversify it. It is required for buying
Import anc e : The role of financial
a variety of assets, which may be
management cannot be over -
tangible like machinery, factories,
emphasised, since it has a direct
buildings, offices; or intangible such
bearing on the financial health of a
as trademarks, patents, technical
business. The financial statements,
expertise, etc. Also, finance is central
such as Balance Sheet and Prof it
to running the day-to-day operations
and Loss Account, reflect a firm’s
of business, like buying material,
financial position and its financial
paying bills, salaries, collecting cash
health. Almost all items in the financial
from customers, etc. needed at every
statements of a business are affected
stage in the life of a business entity. directly or indirectly through some
Availability of adequate finance is, financial management decisions. Some

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prominent examples of the aspects raised by way of debt and/or equity

being affected could be as under: is also a financial management
(i) The size and the composition of decision. The amounts of debt,
fixed assets of the business: For equity share capital, preference
example, a capital budgeting share capital are affected by the
decision to invest a sum ofRs. 100 financing decision, which is a part
of financing management.
crores in fixed assets would raise
the size of fixed assets block by (v) All items in the Profit and Loss
this a m o u n t . Account, e.g., Interest, Expense,
(ii) The quantum of current assets and Depreciation, etc. : Higher amount
its break-up into cash, inventory of debt means higher interest
and receivables: With an increase expense in future. Similarly, use
in the investment in fixed assets, of higher equity may entail higher
there is a commensurate increase payment of dividends. Similarly, an
in the working capital requirement. expansion of business which is a
The quantum of current assets result of capital budgeting decision
is also influenced by financial is likely to affect virtually all items
management decisions. In addition, in the profit and loss account of the
decisions about credit and inventory business.
management affect the amount of It can, thus, be stated that the
debtors and inventory which in financial statements of a business
turn affect the total current assets are largely determined by financial
as well as their composition. management decisions taken earlier.
(iii) The amount of long-term and Similarly, the future financial
short- term funds to be used: statements would depend upon past
Financial management, among as well as current financial decisions.
others, involves decision about Thus, the overall financial health
the proportion of long-term and of a business is determined by the
short-term funds. An organisation quality of its financial management.
wanting to have more liquid assets Good financial management aims at
would raise relatively more amount mobilisation of financial resources at
on a long-term basis. There is a lower cost and deployment of these
a choice between liquidity and in most lucrative activities.
profitability. The underlying
o BjecTiveS
assumption here is that current
liabilities cost less than long term The primary aim of financial
liabilities. management is to maximise
(iv) Break-up of long-termfinancing into shareholders’ wealth, which is referred
debt, equity etc: Of the total long- to as the wealth-maximisation concept.
term finance, the proportions to be The market price of a company’s
shares

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is linked to the three basic financial some value addition should take place.
decisions which you will study a little All those avenues of investment,
later. This is because a company funds modes of financing, ways of handling
belong to the shareholders and the various components of working
manner in which they are invested and capital must be identified which will
the return earned by them determines ultimately lead
their market value and price. It means to an increase in the price of equity
maximisation of the market value of share. It can happen through efficient
equity shares. The market price of decision-making. Decision-making is
equity share increases, if the benefit efficient if, out of the various available
from a decision exceeds the cost alternatives, the best is selected.
involved. All financial decisions aim at
ensuring that each decision is efficient F inancial d eciSionS
and adds some value. Such value
additions tend to increase the market Financial management is concerned
price of shares. Therefore, those with the solution of three major issues
financial decisions are taken which relating to the financial operations
will ultimately prove gainful from of a firm corresponding to the three
the point of view of the shareholders. questions of investment, financing
The shareholders gain if the value of and divident decision. In a financial
shares in the market increases. Those context, it means the selection of
decisions which result in decline in best financing alternative or best
the share price are poor financial investment alternative. The finance
decisions. Thus, we can say, the function, therefore, is concerned
objective of financial management is with three broad decisions which are
to maximise the current price of equity explained below:
shares of the company or to maximise
the wealth of owners of the company, investment Decision
that is, the shareholders. A firm’s resources are scarce in
Therefore, when a decision is taken comparison to the uses to which
about investment in a new machine, they can be put. A firm, therefore,
the aim of financial management has to choose where to invest these
is to ensure that benefits from the resources, so that they are able to earn
investment exceed the cost so that the highest possible return for their
some value addition takes place . investors. The investment decision,
Similarly, when finance is procured, therefore, relates to how the firm’s
the aim is to reduce the cost so that funds are invested in different assets.
the value addition is even higher. Investment decision can be long-
In fact, in all financial decisions, term or short-term. A long-term
major or minor, the ultimate objective investment decision is also called a
that guides the decision-maker is that Capital Budgeting decision. It involves
committing the finance on a long-

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term basis. For example, decisions) are concerned with the

making investment in a new decisions about the levels of cash,
m a c h i n e t o replace an existing inventory and receivables. These
one or acquiring a new fixed asset decisions affect the day-to-day
or opening a new branch, etc. working of a business. These affect
These decisions are very crucial the liquidity as well as profitability of a
for any business since they affect business. Efficient cash management,
its earning capacity in the long run. inventory management and receivables
The size of assets, profitability management are essential ingredients
and competitiveness are all affected of sound working capital management.
by capital budgeting decisions.
Factors affecting Capital
Moreover, these decisions
Budgeting Decision
n o r m a l l y i n v o l v e huge amounts
of investment and are irreversible A number of projects are often
except at a huge cost. Therefore, available to a business to invest in.
once made, it is often almost But each project has to be evaluated
impossible for a business to wriggle carefully and, depending upon the
returns, a particular project is either
selected or rejected. If there is only
one project, its viability in terms of
the rate of return, viz., investment
and its comparability with the
industry’s average is seen. There
are certain factors which affect
capital budgeting decisions.
(a) Cash flows of the project: When
a company takes an investment
decision involving huge amount
it expects to generate some cash
flows over a period. These cash
flows are in the form of a series
of cash receipts and payments
Wealth Maximisation Concept over the life of an investment.
The amount of these cash flows
should be carefully analysed before
decisions must betaken by those
considering a capital budgeting
who understand them
decision.
comprehensively. A b a d c a p i t a l
b u d g e t i n g d e c i s i o n normally has (b) The rat e of re t urn: The most
the capacity to severely damage important criterion is the rate
the financial fortune of a of return of the project. These
business. Short-term calculations are based on the

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expected returns from each whether or not a firm has earned a

proposal and the assessment of profit. Likewise, the borrowed funds
the risk involved. Suppose, there have to be repaid at a fixed time. The
are two projects,A and B (with the risk of default on payment is known
same risk involved), with a rate as financial risk which has to be
of return of 10 per cent and 12 considered by a firm likely to have
per cent, respectively, then under insufficient shareholders to make
normal circumstance, project B these fixed payments. Shareholders’
should be selected. funds, on the other hand, involve no
(c) The investment criteria involved: commitment regarding the payment
The decision to invest in a particular of returns or the repayment of capital.
project involves a number of A firm, therefore, needs to have a
calculations regarding the amount judicious mix of both debt and equity
of investment, interest rate, cash in making financing decisions, which
flows and rate of return. There are may be debt, equity, preference share
different techniques to evaluate capital, and retained earnings.
investment proposals which The cost of each type of finance has
are known as capital budgeting to be estimated. Some sources may
techniques. These techniques are be cheaper than others. For example,
applied to each proposal before debt is considered to be the cheapest
selecting a particular project. of all the sources, tax deductibility
of interest makes it still cheaper.
Financing Decision Associated risk is also different for
This decision is about the quantum each source, e.g., it is necessary to
of finance to be raised from various pay interest on debt and redeem the
long-term sources. Short-term sources principal amount on maturity. There
are studied under the ‘working capital is no such compulsion to pay any
management’ . dividend on equity shares. Thus, there
It involves identification of various is some amount of financial risk in
available sources. The main sources debt financing. The overall financial
of funds for a firm are shareholders’ risk depends upon the proportion of
funds and borrowed funds. The debt in the total capital. The fund
shareholders’ funds refer to the equity raising exercise also costs something.
capital and the retained earnings . This cost is called floatation cost.
Borrowed funds refer to the finance It also must be considered while
raised through debentures or other evaluating different sources. Financing
forms of debt. A firm has to decide the decision is, thus, concerned with the
proportion of funds to be raised from decisions about how much to be raised
either sources, based on their basic from which source. This decision
characteristics. Interest on borrowed determines the overall cost of capital
funds have to be paid regardless of and the financial risk of the
enterprise.

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Financial Decisions

Factors Affecting different. A prudent financial

Financing Decisions manager would normally opt for a
source which is the cheapest.
The financing decisions are
(b) Risk: The risk associated with
affected by various factors.
each of the sources is different.
Important among them are as
follows: (c) Floatation Costs: Higher the
(a) Cost: The cost of raising floatation cost,less attractive the
source.

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(d) Cash Flow Position of the Company: in the business. While the dividend
A stronger cash flow position may
constitutes the current income
make debt financing more viable
re-investment as retained earning
than funding through equity.
increases the firm’s future earning
(e) Fixed Operating Costs: If a business
capacity. The extent of retained
has high fixed operating costs (e.g., earnings also influences the financing
building rent, Insurance premium, decision of the firm. Since the firm
Salaries, etc.), It must reduce fixed
does not require funds to the extent
financing costs. Hence, lower debt
of re-invested retained earnings, the
financing is better . Similar ly, if
decision regarding dividend should
fixed operating cost is less, more
be taken keeping in view the overall
of debt financing may be preferred.
objective of maximising shareholder’s
(f) Control Considerations: issues of
wealth.
more equity may lead to dilution
o f m a n a g e m e n t ’s c o n t r o l o v e r Factors Affecting Dividend
the business. Debt financing has Decision
no such implication. Companies
afraid of a takeover bid would How much of the profits earned by a
prefer debt to equity. company will be distributed as profit
(g) State of Capital Market: Health of and how much will be retained in the
the capital market may also affect business is affected by many factors.
the choice of source of fund. During Some of the important factors are
the period when stock market is discussed as follows:
rising, more people invest in equity. (a) Amount of Earnings: Dividends
However, depressed capital market are paid out of current and past
may make issue of equity shares earning. Therefore, earnings is a
major determinant of the decision
difficult for any company.
about dividend.
(b) Stability Earnings : Other th ings
Dividend Decision
remaining the same, a company
The third important decision that having stable earning is in a better
every financial manager has to position to declare higher dividends.
take relates to the distribution of t omp
dividend. Dividend is that portion again a ny ha
s c ving
p
of profit which is distributed to s
unstable ea ning is li ely t o
shareholders. The decision involved smaller dividend.
here is how much of the profit earned (c) Stability of Dividends: Companies
by company (after paying tax) is to be
generally follow a policy of
distributed to the shar eholders and
stabilising dividend per share. The
how much of it should be re tained
increase in dividends is generally
made when there is confidence that

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their earning potential has gone way of dividends. As compared

up and not just the earnings of to this, higher dividends may be
the current year. In other words, declared if tax rates are relatively
dividend per share is not altered if lower. Though the dividends are free
the change in earnings is small or of tax in the hands of shareholders,
seen to be temporary in nature. a dividend distribution tax is levied
(d) Growth Opportunities: Companies on companies. Thus, under the
having good growth opportunities present tax policy, shareholders
retain more money out of their are likely to prefer higher dividends.
earnings so as to finance the (h) Stock Market Reaction: Investors,
required investment. The dividend in general, view an increase in
in growth companies is, therefore, dividend as a good news and
smaller, than that in the non– stock prices react positively to it.
growth companies. Similarly, a decrease in dividend
(e) Cash Flow Position: The payment may have a negative impact on the
of dividend involves an outflow of share prices in the stock market.
cash. A company may be earning Thus, the possible impact of
profit but may be short on cash. dividend policy on the equity share
Availability of enough cash in price is one of the important factors
the company is necessary for considered by the management
declaration of dividend. while taking a decision about it.
(f) Shareholders’ Preference: While (i) Access to Capital Market: Large
declaring dividends, managements and reputed companies generally
must keep in mind the preferences have easy access to the capital
of the shareholders in this regard. If market and, therefore, may
the shareholders in general desire depend less on retained
that at least a certain amount is earning to finance their
paid as dividend, the companies growth. These companies tend
are likely to declare the same. There to pay higher dividends than the
are always some shareholders who smaller companies which have
depend upon a regular income relatively low access to the market.
from their investments. (j) Legal Constraints: Certain
(g) Taxation Policy: The choice provisions of the Companies Act
between the payment of place restrictions on payouts as
dividend and retaining the dividend. Such provisions must
earnings is, to some extent,
be adhered to while declaring the
affected by the difference in the tax
dividend.
treatment of dividends and
(k) Contractual Constraints : While
capital gains. If tax on dividend is granting loans to a company,
higher, it is better to pay less by sometimes the lender may impose

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certain restrictions on the payment forecast all the items which are likely
of dividends in future. The to undergo changes . It enabl es the
companies are required to ensure management to foresee the fund
that the dividend does not violate requirements both the quantum as
the terms of the loan agreement in well as the timing . Likely shortage
this regard. and surpluses are forecast so that
necessary activities are taken in
F inancial P lanning advance to meet those situations.
Thus, financial planning strives to
Financial planning is essentially the achieve the following twin objectives.
preparation of a financial blueprint of (a) To e nsure av ai l abi l i t y of f unds
an organisation’s future operations. whenever required: This include
The objective of financial planning
a proper estimation of the funds
is to ensure that enough funds are
required for different purposes
available at right time. If adequa te
such as for the purchase of long-
funds are not available the firm will
term assets or to meet day-to-
not be able to honour its commitments
day expenses of business etc .
and carry out its plans. On the other
Apart from this, there is a need to
hand, if excess funds are available, it
estimate the time at which these
will unnecessarily add to the cost and
funds are to be made available
may encourage wasteful expenditure.
. Financial planning also tries
It must be kept in mind that financial
planning is not equivalent to, or a to specify possible sources of
substitute for, financial management. these funds.
Financial management aims at (b) To see that the firm does not
choosing the best investment and
raise resources unnecessarily:
Excess funding is almost as bad
financing alternatives by focusing on
their costs and benefits. Its objective as inadequate funding. Even if
is to increase the shareholders’ wealth. there is some surplus money, good
Financial planning on the other financial planning would put it to
hand aims at smooth operations the best possible use so that the
by focusing on fund requirements financial resources are not left idle
and their availability in the light of and don’t unnecessarily add to
financial decisions. For example, if a the cost.
capital budgeting decisions is taken, Thus, a proper matching of funds
the operations are likely to be at a requirements and their availability
higher scale. The amount of expense s is sought to be achieved by financial
and revenues are likely to increase. planning. This process of estimating
Financial planning proces s tries to the fund requirement of a business
and specifying the sources of funds

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is called financial planning. Financial Further, the sources from which the
planning takes into consideration the external funds requirement can be
growth, performance, investments met are identified and cash budgets
and requirement of funds for a given are made, incorporating these factors.
period . Financial planning inc ludes
both short-term as well as long-term
i mPortance
planning. Long-term planning relates
to long term growth and investment. Financial planning is an important
It focuses on capital expenditure part of overall planning of any
programmes. Short-term planning business enterprise. It aims at
covers short-term financial plan called enabling the company to tackle the
budget. uncertainty in respect of the
Typically, financial planning is availability and timing o f t h e f u n d s
done for three to five years. For longer a n d h e l p s i n s m o o t h functioning
periods it becomes more difficult and of an organisation. The importance
less useful. Plans made for periods of of financial planning can be
one year or less are termed as budgets. explained as follows:
Budgets are example of financial (i) It helps in forecasting what may
planning exercise in greater details. happen in future under different
They include detailed plan of action business situations. By doing so, it
for a period of one year or less. helps the firms to face the eventual
Financial planning usually begins situation in a better way. In other
with the preparation of a sales words, it makes the firm better
forecast. Let us suppose a company prepared to face the future. For
is making a financial plan for the next example, a growth of 20% in sales
five years. It will start with an is predicted. However, it may
estimate of the sales which are happen that the growth rate
likely to happen in the next five eventually turns out to be
years. Based on these, the financial 10% or 30% . Many items of
statements are prepared keeping in expenses shall be different in
mind the requirement of funds for these three situations. By
investment in the fixed capital and preparing a blueprint of these
working capital. Then the expected three situations the management
profits during the period are may decide what must be done
estimated so that an idea can be made in each of these situations. This
of how much of the fund requirements preparation of alternative financial
can be met internally i. e ., through plans to meet different situations is
retained earnings (after dividend clearly of immense help in running
payouts). This results in an estimation the business smoothly.
of the requirement for external funds.
(ii) It helps in avoiding business
shocks and surprises and helps

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Cutting Back on Debt

Even successful businesses have debt, but how much is too much? Learning how
to manage debt is what can put you ahead.
Taking on the right amount of debt can mean the difference between a business
struggling to survive and one that can respond nimbly to changing economic or
market conditions . A number of circumstances may justify acquiring debt. As a
general rule, borrowing makes the most sense when you need to bolster cash flow
or finance growth or expansion. But while debt can provide the leverage you need
to grow, too much debt can strangle your business. So the question is: How much
debt is too much?
The answer, experts say, lies in a careful analysis of your cash flow as well as
your industry. A business that doesn’t grow dies. You’ve got to grow, but you’ve got
to grow within the financial constraints of your business. What is the ideal capital
structure a business needs in its industry to remain viable? The higher the volatility
(in your industry), the less debt you should have. The smaller the volatility, the more
debt you can afford.
Although banks and other financial institutions look for a satisfactory debt-to-
equity ratio before agreeing to make a loan, don’t assume a creditor’s willingness
to extend funds is evidence that your business is in a strong debt position. Some
financial institutions are overzealous lenders, particularly when trying to lure or hold
on to promising business customers. “The bank may be looking more at collateral
than whether the (business’s) earnings are going to come in to justify the debt
service.
To avoid these and other credit pitfalls, it’s up to you to get the financial facts
on your business and make sound borrowing decisions. Unfortunately, many
entrepreneurs fail to recognise how important financial analysis is to running a
successful business. Even business owners who receive detailed financial statements
from their accountants often do not take advantage of the valuable information
contained in the documents.

the company in preparing for (vi) It provides a link

the future. between investment and
(iii) If helps in co-ordinating various financing decisions on a
business functions, e.g., sales and continuous basis.
production functions, by providing (vii) By spelling out detailed
clear policies and procedures. objectives for various business
(iv) Detailed plans of action prepared segments, it makes the
under financial planning reduce evaluation of actual
waste, duplication of efforts, and performance easier.
gaps in planning.
(v) It tries to link the present with the One of the important decisions
under financial management
future.
relates to the financing pattern or

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the use of different sources in raising is likely to lower the over-all cost of
funds. On the basis of ownership, the capital of the firm provided that the
sources of business finance can be cost of equity remains unaffected.
broadly classified into two categories Impact of a change in the debt-equity
viz ., ‘owners’ funds’ and ‘borrowed ratio upon the earning per share is
funds’ . Owners’ funds consist of dealt within detail later in this chapter.
equity share capital, preference share Debt is cheaper but is more risky
capital and reserves and surpluses or for a business because the payment of
retained earnings. Borrowed funds can interest and the return of principal is
be in the form of loans, debentures, obligatory for the business. Any default
public deposits etc. These may be in meeting these commitments may
borrowed from banks, other financial force the business togo into liquidation.
institutions, debentureholders and There is no such compulsion in case of
public. equity, which is therefore, considered
Capital structure refers to the mix riskless for the business. Higher use
between owners and borrowed funds. of debt increases the fixed financial
These shall be referred as equity and charges of a business. As a result,
debt in the subsequent text. It can increased use of debt increases the
be calculated as debt-equity ratio financial risk of a company.
Debt
i.e ., or as the proportion Financial risk is the chance that
Equity
a firm would fail to meet its payment
of debt out of the total capital i.e .,
obligations.
( Debt ) Capital structure of a company,
l( Debt +Equity )l . thus,affects both the profitability and
Debt and equity differ significantly the financial risk. A capital structure
in their cost and riskiness for the will be said to be optimal when the
firm. The cost of debt is lower than proportion of debt and equity is
the cost of equity for a firm because such that it results in an increase
the lender’s risk is lower than the in the value of the equity share. In
equity shareholder’s risk, since the other words, all decisions relating to
lender earns an assured return and capital structure should emphasise on
repayment of capital and, therefore, increasing the shareholders’ wealth.
they should require a lower rate of The proportion of debt in the overall
return. Additionally , interest paid capital is also called financial leverage.
on debt is a deductible expense for
computation of tax liability whereas Financial leverage is computed as
dividends are paid out of after-tax
profit. Increased use of debt, therefore, or when D is the Debt and E is
the Equity. As the financial leverage

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Example I
Total Funds used Interest rate Rs. 30 Lakh
Tax rate Company X Ltd.
10% p.a.
EBIT 30%
Debt Rs. 4 Lakh
situation i
Situation II nil
Situation III Rs. 10 Lakh
Rs. 20 Lakh

Situation III
EBIT EBIT-EPS Analysis 4,00,000
Interest 2,00,000
EBT 2,00,000
(Earnings before taxes) Tax
EAT 60,000
(Earnings after taxes) No. of shares of Rs.10 E P S 1,40,000
(Earnings per share)
1,00,000
1.40

increases, the cost of funds declines situations-II and III, respectively.

because of increased use of cheaper
All debt is at 10% p.a.
debt but the financial risk increases.
The company earns Rs. 0.93
The impact of financial leverage on the
per share if it is unlevered. With
profitability of a business can be seen
debt of Rs. 10 lakh its EPS is Rs.
through EBIT-EPS (Earning before
1.05. With a still higher debt of Rs.
Interest and Taxes-Earning per Share)
20 lakh, its, EPS rises to Rs. 1.40.
analysis as in the following example.
Why is the EPS rising with higher
Three situations are considered. debt? It is because the cost of debt is
There is no debt in situation-I i.e . lower than the return t h a t c o m p a n y
(unlevered business). Debt of Rs. 10 is earning on funds
lakh and 20 lakh are assumed in employed. The company is earning

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more of cheaper debt to enhance the

of 13.33% EBIT × 100 EPS. Such practice is called Trading
Total I nvestment on Equity.
Trading on Equity refers to the
increase in profit earned by the equity
, shareholders due to the presence of
×100 . This is higher fixed financial charges like interest.
than Now consider the following case of
the 10% interest it is paying on Company Y. All details are the same
debt funds. With higher use of except that the company is earning
debt, this difference between RoI a profit before interest and taxes of
and cost of debt increases the EPS. Rs. 2 lakh.

Example II
situation iii 2,00,000 2,00,000 NIL
Company Y Ltd. NIL
EBIT
NIL 1,00,000 NIL
Interest
EBT
Tax
EAT
No. of shares of Rs.10 EPS

In this example , the EPS of the

not recommended. An increase in
company is falling with increased use
debt may enhance the EPS but as
of debt. It is because the Company’s
pointed out earlier, it also raises
rate of return on investment (RoI) is
the financial risk. Ideally, a
less than the cost of debt. The RoI
company must choose that risk-
for company Y is ×100 , i.e.,
return combination which
6.67%, whereas the interest rate on
maximises shareholders’ wealth.
debt is 10%. In such cases, the use
The debt-equity mix that achieves it,
of debt reduces the EPS. This is a
is the optimum capital structure.
situation of unfavourable financial
leverage. Trading on Equity is clearly Factors affecting the Choice
unadvisable in such a situation. of Capital Structure
Even in case of Company X, Deciding about the capital
reckless use of Trading on Equity is structure
of a firm involves determining

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factors. For example, debt requires

3. Debt Service Coverage Rati o
regular servicing. Interest payment
(DSCR): Debt Service Coverage Ratio
and repayment of principal are
takes care of the deficiencies referred
obligatory on a business. In addition
to in the Interest Coverage Ratio (ICR)
a company planning to raise debt
. The cash profits generated by
must have sufficient cash to meet the
the operations are compared with the
increased outflows because of higher
debt. Similarly, important factors
total cash required for the service
which determine the choice of capital of the debt and the preference share
structure are as follows: capital. It is calculated as follows:
Profit after tax + Depreciation + Interest + Non Cash exp.
1. Cash Flow Position: Size of
Pref. Div + Interest + Repayment obligation
projected cash flows must be
considered before borrowing. Cash a higher DSCR indicates better
flows must not only cover fixed cash ability to meet cash commitments
payment obligations but there must and consequently, the company’s
be sufficient buffer also. It must potential to increase debt component
be kept in mind that a company in its capital structure.
has cash payment obligations 4. Return on Investment (RoI): if
for (i) normal business operations;
the RoI of the company is higher, it
(ii) for investment in fixed
can choose to use trading on equity
assets; and (iii ) for meeting the
to increase its EPS, i.e., its ability to
debt service commitments i.e .,
use debt is greater. We have already
payment of interest and repayment
observed in Example I that a firm
of principal.
can use more debt to increase its
2. Interest Coverage Ratio (ICR): EPS. However, in Example II, use of
The interest coverage ratio refers to higher debt is reducing the EPS. It is
the number of times earnings before because the firm is earning an RoI of
interest and taxes of a company covers only 6.67% which lower than its cost
the interest obligation. This may be of debt. In example I the RoI is 13.33%,
calculated as follows: and trading on equity is profitable.
ICR = EB It shows that, RoI is an important
Interest determinant of the company’s ability
The higher the ratio, lower shall to use Trading on equity and thus the
be the risk of company failing to capital structure.
meet its interest payment obligations.
5. Cost of debt: A firm’s ability to
However, this ratio is not an adequate
borrow at a lower rate increases its
measure. A firm may have a high EBIT
capacity to employ higher debt. Thus,
but low cash balance. Apart from
interest, repayment obligations are
more debt can be used if debt can be
raised at a lower rate.
also relevant.

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6. Tax Rate: Since interest is a company is unable to meet its fixed

deductible expense, cost of debt is financial charges namely interest
affected by the tax rate. The firms in payment, preference dividend and
our examples are borrowing @ 10% repayment obligations. Apart from
. Since the tax rate is 30%, the the financial risk, every business
after tax cost of debt is only 7%. A has some operating risk (also called
higher tax rate, thus, makes debt business risk). Business risk depen ds
relatively cheaper and increases its upon fixed operating costs. Higher
attraction vis-à-vis equity. fixed operating costs result in higher
7. Cost of Equity: Stock owners business risk and vice-versa. The total
expect a rate of return from the equity risk depends upon both the business
which is commensurate with the risk risk and the financial risk. If a firm’s
they are assuming. When a company business risk is lower, its capacity to
increases debt , the financial r isk use debt is higher and vice-versa.
faced by the equity holders, increases. 10. Flexibility: If a firm uses its
Consequently, their desired rate of debt potential to the full, it loses
return may increase. It is for this flexibility to issue further debt. To
reason that a company can not use maintain flexibility, it must maintain
debt beyond a point. If debt is used
some borrowing power to take care of
beyond that point, cost of equity may
unforeseen circumstances.
go up sharply and share price may
decrease inspite of increased EPS. 11. Control : Debt normally does
Consequently , for maximisation of not cause a dilution of control. A
shareholders’ wealth, debt can be used public issue of equity may reduce the
only upto a level. managements’ holding in the company
8. Floatation Costs: Process of and make it vulnerable to takeover.
raising resources also involves some This factor also influences the choice
cost . Public issue of shares and between debt and equity especially in
debentures requires considerable companies in which the current holding
expenditure. Getting a loan from a of management is on a lower side.
financial institution may not cost 12. Regulatory Framework: Every
so much. These considerations company operates within a regulatory
may also affect the choice between framework provided by the law e.g.,
debt and equity and hence the public issue of shares and debentures
capital structure. have to be made under SEBI
9. Risk Consideration: As discussed guidelines. Raising funds from banks
earlier, use of debt increases the and other financial institutions require
financial risk of a business. Financial fulfillment of other norms. The relative
risk refers to a position when a ease with which these norms can, be

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met or the procedures completed may for more than one year, usually
also have a bearing upon the choice of for much longer, e.g., plant and
the source of finance. machinery, furniture and fixture, land
13. Stock Market Conditions: if the and building, vehicles, etc.
stock markets are bullish, equity Decision to invest in fixed assets
shares are more easily sold even at must be taken very carefully as the
a higher price. Use of equity is often investment is usually quite large.
preferred by companies in such a Such decisions once taken are
situation. However, during a bearish irrevocable except at a huge loss.
phase, a company, may find raising Such decisions are called capital
of equity capital more difficult and it budgeting decisions.
may opt for debt. Thus, stock market current assets are those assets
conditions often affect the choice which, in the normal routine of the
between the two. business, get converted into cash or
14. Capital Structure of other cash equivalents within one year, e.g.,
Companies: A useful guideline in the inventories, debtors, bills receivables,
capital structure planning is the debt- etc.
equity ratios of other companies in
Management of Fixed Capital
the same industry. There are usually
some industry norms which may help. Fixed capital refers to investment
Care however must betaken that the in long-term assets. Management of
company does not follow the industry fixed capital involves allocation of
norms blindly. For example, if the firm’s capital to different projects or
business risk of a firm is higher, it can assets with long-term implications
not afford the same financial risk. It for the business. These decisions
should go in for low debt. Thus, the are called investment decisions or
management must know what the capital budgeting decisions and affect
industry norms are, whether they are the growth, profitability and risk of
following them or deviating from them the business in the long run. These
and adequate justification must be long-term assets last for more than
there in both cases. one year.
It must be financed through
F ixed and W orking c aPital long-term sources of capital such
as equity or preference shares,
Meaning
debentures, long-term loans and
Every company needs funds to finance
retained earnings of the business.
its assets and activities. Investment
Fixed Assets should never be financed
is required to be made in fixed assets
through short-term sources.
and current assets. Fixed assets are
Investment in these assets
those which remains in the business would also include expenditure on

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acquisition, expansion, modernisation (iv) Irreversible decisions: these

and their replacement. These decisions decisions once taken, are not
include purchase of land, building, reversible without incurring heavy
plant and machinery, launching losses. Abandoning a project after
a new product line or investing in heavy investment is made is quite
advanced techniques of production . costly in terms of waste of funds.
Major expenditures such as those
Therefore, these decisions should
on advertising campaign or research
be taken only after carefully
and development programme having
evaluating each detail or else the
long term implications for the firm
adverse financial consequences
are also examples of capital budgeting
may be very heavy.
decisions. The management of fixed
capital or investment or capital
Factors affecting the Requirement
budgeting decisions are important for
of Fixed Capital
the following reasons:
(i) Long-term growth: These 1. Nature of Business: The type
decisions have bearing on the of business has a bearing upon
long-term growth. The funds the fixed capital requirements. For
invested in long-term assets are example, a trading concern needs
likely to yield returns in the lower investment in fixed assets
future. These will affect the compared with a manufacturing
future prospects of the business. organisation; since it does not require
(ii) Large amount of funds involved: to purchase plant and machinery, etc.
These decisions result in a 2. Scale of Operations: A larger
substantial portion of capital funds organisation operating at a higher
being blocked in long-term projects. scale needs bigger plant, more space
Therefore, these investments are etc. and therefore, requires higher
planned after a detailed analysis investment in fixed assets when
is undertaken. This may involve compared with the small organisation.
decisions like where to procure
3. Choice of Technique: Some
funds from and at what rate of
organisations are capital intensive
interest.
whereas others are labour intensive.
(iii) Risk involved: Fixed capital involves
A capital-intensive organisation
investment of huge amounts . It requires higher investment in plant
affects the returns of the firm as a and machinery as it relies less on
whole in the long-term. Therefore, manual labour. The requirement of
investment decisions involving fixed capital for such organisations
fixed capital influence the overall would be higher . Labour intensive
business risk complexion of the organisations on the other hand
firm.

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require less investment in fixed assets. lease,the firm pays lease rentals and
Hence, their fixed capital requirement uses it. By doing so, it avoids huge sums
is lower. required to purchase it. Availability of
4. Technology Upgradation: In certain leasing facilities, thus, may reduce
industries, assets become obsolete the funds required to be invested in
sooner. Consequently, their replace- fixed assets, thereby reducing the fixed
ments become due faster. Higher capital requirements. Such a strategy
investment in fixed assets may, is specially suitable in high risk lines
therefore, be required in such cases. of business.
For example, computers become 8. Level of Collaboration: At times,
obsolete faster and are replaced much certain business organisations share
sooner than say, furniture. Thus, such each other’s facilities. For example,
organisations which use assets which a bank may use another’s ATM or
are prone to obsolescence require some of them may jointly establish a
higher fixed capital to purchase such particular facility. This is feasible if the
assets. scale of operations of each one of
5. Growth Prospects: Higher growth them is not sufficient to make full use
of an organisation generally requires of the facility. Such collaboration
higher investment in fixed assets . reduces the level of investment in
Even when such growth is expected, fixed assets for each one of the
a company may choose to create participati ng organisations.
higher capacity in order to meet the
anticipated higher demand quicker. W orking c aPital
This entails larger investment in fixed Apart from the investment in fixed
assets and consequently larger fixed assets every business organisation
capital. needs to invest in current assets. This
6. Diversification: A firm may choose investment facilitates smooth day-to-
to diversify its operations for various day operations of the business.
reasons, With diversification, fixed Current assets are usually more
capital requirements increase e.g., a liquid but contribute less to the
textile company is diversifying and profits than fixed assets. Examples of
starting a cement manufacturing current assets, in order of their
plant. Obviously, its investment in liquidity, are as under.
fixed capital will increase. 1. Cash in hand/Cash at Bank
7.Financing Alternatives: A
2. Marketable securities
developed financial market may
provide leasing facilities as an 3. Bills receivable
alternative to outright purchase. 4. Debtors
When an asset is taken on 5. Finished goods inventory

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6. Work in progress amount of working capital required.

7. Raw materials A trading organisation usually
needs a smaller amount of working
8. Prepaid expenses capital compared to a manufacturing
These assets, as noted earlier, are
organisation . This is because the re
expected to get converted into cash
is usually no processing. Therefore,
or cash equivalents within a period
there is no distinction between raw
of one year. These provide liquidity to
materials and finished goods. Sales
the business. An asset is more liquid
can be effected immediately upon
if it can be converted into cash quicker
the receipt of materials, sometimes
and without reduction in value .
even before that. In a manufacturing
Insufficient investment in current
business, however, raw material needs
assets may make it more difficult for
to be converted into finished goods
an organisation to meet its payment
before any sales become possible .
obligations. However, these assets
Other factors remaining the same, a
provide little or low return. Hence, a
trading business requires less working
balance needs to be struck between
capital. Similarly, service industries
liquidity and profitability.
which usually do not have to maintain
Current liabilities are those
inventory require less working capital.
payment obligations which are due
for payment within one year; such as 2. Scale of Operations: For
bills payable, creditors, outstanding organisations which operate on a
expenses and advances received from higher scale of operation, the quantum
customers, etc. of inventory and debtors required is
Some part of current assets is generally high. Such organisations,
usually financed through short-term therefore, require large amount of
sources, i.e., current liabilities. The working capital as compared to the
rest is financed through long-term organisations which operate on a lower
sources and is called net working scale.
capital. Thus, NWC = CA – CL (i.e . 3. Business Cycle: Different phases of
business cycles affect the requirement
Current Assets - Current Liabilities.)
of working capital by a firm. In
Thus, net working capital may be
case of a boom, the sales as well as
defined as the excess of current assets
production are likely to be larger and,
over current liabilities.
therefore, larger amount of working
capital is required. As against this,
F actorS a FFecting the W orking
c aPital r equirementS the requirement for working capital
will be lower during the period of
1. Nature of Business: The basic depression as the sales as well as
nature of a business influences the production will be small.

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4. Seasonal Factors: Most business degrees of efficiency. For example,

have some seasonality in their a firm managing its raw materials
operations. In peak season, because of efficiently may be able to manage with
higher level of activity, larger amount a smaller balance. This is reflected
of working capital is required. As in a higher inventory turnover ratio.
against this, the level of activity as Similarly, a better debtors turnover
well as the requirement for working ratio may be achieved reducing
capital will be lower during the the amount tied up in receivables.
lean season. Better sales effort may reduce the
5. Production Cycle: Production average time for which finished goods
cycle is the time span between the inventory is held. Such efficiencies
receipt of raw material and their may reduce the level of raw materials,
conversion into finished goods. Some finished goods and debtors resulting
businesses have a longer production in lower requirement of working
cycle while some have a shorter capital.
one . Duration and the length of 9. Availability of Raw Material: if
production cycle, affects the amount the raw materials and other required
of funds required for raw materials materials are available freely and
and expenses. Consequently, working continuously, lower stock levels may
capital requirement is higher in firms suffice. If, however, raw materials do
with longer processing cycle and lower not have a record of un-interrupted
in firms with shorter processing cycle. availability, higher stock levels may
6. Credit Allowed: Different firms be required. In addition, the time lag
allow different credit terms to their between the placement of order and
customers. These depend upon the the actual receipt of the materials (also
level of competition that a firm faces called lead time) is also relevant. Larger
as well as the credit worthiness of the lead time, larger the quantity of
their clientele. A liberal credit policy material to be stored and larger shall
results in higher amount of debtors, be the amount of working capital
increasing the requirement of working required.
capital. 10. Growth Prospects: If the growth
7. Credit Availed: Just as a firm potential of a concern is perceived to
allows credit to its customers it also be higher, it will require larger amount
may get credit from its suppliers . of working capital so that it is able
To the extent it avails the credit to meet higher production and sales
on purchases, the working capital target whenever required.
requirement is reduced. 11. Level of Competition: Higher
8. Operating Efficiency: Firms level of competitiveness may
manage their operations with varied necessitate larger stocks of
finished goods to

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meet urgent orders from rate of inflation. It must, however,

customers. This increases the be noted that an inflation rate of 5%,
does not mean that every component
working capital requirement.
of working capital will change by
Competition may also force the
t h e s a m e p e r c e n t a g e . T h e a ctual
firm to extend liberal credit terms
requirement shall depend upon the
discussed earlier.
rates of price change of different
12. Inflation: With rising
components (e.g . , raw material,
prices, larger amounts are
finished goods, labour cost,) Finished
required even to maintain a
goods as well as their proportion in
constant volume of production
the total requirement.
and sales. The working capital

k ey t ermS

Wealth Investment Decision

Financial
Management Maximisation Capital Budgeting
Financing Decision Dividend Decision Capital Structure
Working Capital

SUMMARY
Business finance: The money required for carrying out business activities is
called business finance. Almost all business activities require some finance.
Finance is needed to establish a business, to run it, to modernise it, to expand,
and diversify it.
Financial Management: Financial Management is concerned with optimal
procurement as well as usage of finance. For optimal procurement, different
available sources of finance are identified and compared in terms of their costs
and associated risks.
Objectives and Financial Decisions The primary aim of financial management
is to maximise shareholders’ wealth which is referred to as the wealth
maximisation concept. The market price of a company’s shares are linked to
the three basic financial decisions
Financial decision-making is concerned with three broad decisions which are
Investment Decision, Financing Decision, Dividend Decision

Financial Planning and Importance Financial planning is essentially

preparation of a financial blueprint of an organisation’s future operations. The

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objective of financial planning is to ensure that enough funds are available at

right time.
Financial planning strives to achieve the following twin objectives.
(a) To ensure availability of funds whenever these are
required: (b) To see that the firm does not raise resources
unnecessarily:
Financial planning is an important part of overall planning of any business
enterprise. It aims at enabling the company to tackle the uncertainty in respect
of the availability and timing of the funds and helps in smooth functioning of
an organisation.

Capital Structure and Factors One of the important decisions under financial
management relates to the financing pattern or the proportion of the use
of different sources in raising funds. On the basis of ownership, the sources
of business finance can be broadly classified into two categories viz., ‘owners
funds’ and ‘borrowed funds’. Capital structure refers to the mix between owners
and borrowed funds.
Deciding about the capital structure of a firm involves determining the
relative proportion of various types of funds. This depends on various factors
which are: Cash Flow Position, Interest Coverage Ratio (ICR), Debt Service
Coverage Ratio (DSCR), Return on Investment (RoI), Cost of debt, Tax Rate,
Cost of Equity , Floatation Costs , Risk Cons ideration, Flexibility, Control,
Regulatory Framework , Stock Market Conditions , and Capital Structure of
other Companies.

Fixed and Working Capital Fixed capital refers to investment in long-term

assets. Management of fixed capital involves around allocation of firm’s capital
to different projects or assets with long-term implications for the business.
These decisions are called investment decisions or capital budgeting decisions.
They affect the growth, profitability and risk of the business in the long run.
Factors affecting the Requirement of Fixed Capital are: Nature of Business,
Scale of Operations , Choice of Technique , Technology Upgradat ion, Growth
Prospects, Diversification, Financing Alternatives and Level of Collaboration.
Apart from the investment in fixed assets, every business organisation
needs to invest in current assets. This investment facilitates smooth day-to-
day operations of the organisation. Current assets are usually more liquid but
contribute less to the profits than fixed assets.
Factors affecting the working capital requirement are: Nature of Business,
Scale of Operations , Business Cycle, Seasonal Factor, Production Cycle, Credit

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Allowed, Credit Availed, Operating Efficiency, Availability of Raw Material,

Growth Prospects, Level of competition, and rate of Inflation.

EXERCISES

Very Short Answer Type

1. What is meant by capital structure?
2. Sate the two objectives of financial planning.
3. Name the concept of financial management which increases the return
to equity shareholders due to the presence of fixed financial charges.
4. Amrit is running a ‘transport service’ and earning good returns by
providing this service to industries. Giving reason, state whether the
working capital requirement of the firm will be ‘less’ or ‘more’ .
5. Ramnath is into the business of assembling and selling of televisions.
Recently he has adopted a new policy of purchasing the components on
three months credit and selling the complete product in cash. Will it affect
the requirement of working capital? Give reason in support of your
answer.
Short Answer Type
1. What is financial risk? Why does it arise?
2. Define current assets? Give four examples of such assets.
3. What are the main objectives of financial management? Briefly explain.
4. Financial management is based on three broad financial decisions. What
are these?
5. Sunrises Ltd. dealing in readymade garments, is planning to expand
its business operations in order to cater to international market. For
this purpose the company needs additional `80,00,000 for replacing
machines with modern machinery of higher production capacity. The
company wishes to raise the required funds by issuing debentures. The
debt can be issued at an estimated cost of 10%. The EBIT for the previous
year of the company was `8,00,000 and total capital investment was
`1,00,00,000. Suggest whether issue of debenture would be considered
a rational decision by the company. Give reason to justify your answer.
(Ans. No, Cost of Debt (10%) is more than ROI which is 8%) .

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6. How does working capital affect both the liquidity as well as profitability
of a business?
7. Aval Ltd. is engaged in the business of export of canvas goodsandbags. In
the past, the performance of the company had been upto the expectations.
In line with the latest demand in the market, the company decided to
venture into leather goods for which it required specialised machinery.
For this, the Finance Manager Prabhu prepared a financial blueprint
of the organisation’s future operations to estimate the amount of funds
required and the timings with the objective to ensure that enough funds
are available at right time. He also collected the relevant data about the
profit estimates in the coming years. By doing this, he wanted to be sure
about the availability of funds from the internal sources of the business.
For the remaining funds, he is trying to find out alternative sources from
outside.
a. Identify the financial concept discussed in the above paragraph. Also,
state the objectives to be achieved by the use of financial concept so
identified. ( Financial Planning) .
b. ‘There is no restriction on payment of dividend by a company’
. Comment. ( Legal & Contractual Constraints)
Long Answer Type
1. What is working capital? Discuss five important determinants of
working capital requirement?
2. “Capital structure decision is essentially optimisation of risk-return
relationship.” Comment.
3. “A capital budgeting decision is capable of changing the financial fortunes
of a business.” Do you agree? Give reasons for your answer?
4. Explain the factors affecting dividend decision?
5. Explain the term ‘Trading on Equity’? Why, when and how it can be used
by company.
6. ‘S’ Limited is manufacturing steel at its plant in India. It is enjoying a
buoyant demand for its products as economic growth is about 7–8 per
cent and the demand for steel is growing. It is planning to set up a new
steel plant to cash on the increased demand. It is estimated that it will
require about `5000 crores to set up and about `500 crores of working
capital to start the new plant.

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a. Describe the role and objectives of financial management for this

company.
b. Explain the importance of having a financial plan for this company.
Give an imaginary plan to support your answer.
c. What are the factors which will affect the capital structure of this
company?
d. Keeping in mind that it is a highly capital-intensive sector, what factors
will affect the fixed and working capital. Give reasons in support of
your answer.

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