Financial Management B.com s3

Financial Management III Semester B.
Com
FINANCIAL MANAGEMENT
FINANCE-
FINANCE- Meaning
Finance is defined as the provision of money at the time when it is required. The finance can
be basically classified into two:
1. Public finance
2. Private finance
Public finance deals with requirements, receipts and disbursements of funds in the
government institutions likes states, local self governments and central government.
Private finance concerned with requirements, receipts and disbursements of funds in the
case of individuals, a profit seeking business organisation and a non- profit business
organisation.
Private finance can be again classified into business finance, personal finance and finance
of non profit organisation.
Business Finance
Business finance can be defined as an activity of or process which is concerned with
acquisition of funds, use of funds and distribution of profits of a business firm. Business
finance can be again divided into 3 ie, sole trader finance, partnership finance and
corporate finance.
FINANCIAL MANAGEMENT
Financial management refers to that part of the management activity which is concerned
with the planning and controlling of firm’s financial resources.
Importance of financial management
1. Helps in financial planning and successful completion of an enterprise.
2. Helps in acquisition of funds as and when required at the minimum possible cost
3. Helps in proper use and allocation of funds
4. Helps in taking sound financial decisions
5. Helps in improving the profitability through financial control
6. Helps in increasing the wealth of the investors and nation
7. Helps in promoting and mobilising individual corporate savings
Finance function
It is the most important of all business functions, because the need for money is continuous.
AIMS OF FINANCE FUNCTION
1. Acquiring Sufficient Funds. The main aim of finance function is to assess the financial
needs of enterprise and then finding out suitable sources for raising them. The sources
should commensurate with the needs of the business. If funds are needed for longer periods
then long-term sources like share capital, debentures, term loans may be explored. A
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St.Berchmans [2010-11] sebastiank.s@in.com

Financial Management III Semester B.Com
concern with longer gestation period should rely more on owner’s funds instead of interest-
bearing securities because profits may not be there for some years.
2. Proper Utilisation of Funds. The funds should be used in such a way that maximum
benefit is derived from them. The return from their use should be more than their cost. It
should be ensured that funds do not remain idle at any point of time. The funds committed
to various operations should be effectively utilised. Those projects should preferred which
are beneficial to the business.
3. Increasing Profitability. The planning and control of finance function aims at increasing
profitability of the concern. It is true that money generates money. To increase profitability,
sufficient funds will have be invested. Finance function should be so planned that the
concern neither suffers from inadequacy of fund nor wastes more funds than required. A
proper control should also be exercised so that scarce resources are r. frittered away on
uneconomical operations. The cost of acquiring funds also influences profitability of
business.
4. Maximising Firm’s Value.
Value Finance function also aims at maximising the value of the firm.
A concern’s value is linked with its profitability. Besides profits, the type of sources used for
raising funds, the cost of funds, the condition of money market, the demand for products
are some other considerations which also influence a firm’s value.
SCOPE OF FINANCIAL MANAGEMENT

1. Estimating Fi
Financial
nancial Requirements.
The first task of a financial manager is to estimate short-term and long-term financial
requirements of his business. For this purpose, he will prepare a financial plan for present
as well as for future. The amount required for purchasing fixed assets as well as needs of
funds for working capital will have to be ascertained. The estimations should be based on
sound financial principles so that neither there are inadequate nor excess funds with the
concern. The inadequacy of funds will adversely affect the day-to-day working of the
concern whereas excess funds may tempt a management to indulge in extravagant
spending or speculative activities.
2. Deciding Capital Structure

Structure.
The capital structure refers to the kind and proportion of different securities for raising
funds. After deciding about the quantum of funds required it should be decided which type
of securities should be raised. It may be wise to finance fixed assets through long-term
debts. Even here if gestation period is longer, then share capital may be most suitable. Long-
term funds should be employed to finance working capital also, if not wholly then partially.
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Entirely depending upon overdrafts and cash credits for meeting working capital needs may
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not be suitable. A decision about various sources for funds should be linked to the cost of

raising funds. If cost of raising funds is very high then such sources may not be useful for
long. A decision about the kind of securities to be employed and the proportion in which
these should be used is an important decision which influences the short-term and long-
term financial planning of an enterprise.
3. Selecting a Source of Finance.
After preparing a capital structure, an appropriate source of finance is selected. Various
sources from which finance may be raised, include : share capital, debentures, financial
institutions, commercial banks, public deposits, etc. If finances are needed for short periods
then banks, public deposits and financial institutions may be appropriate; on the other
hand, if long-term finances are required then share capital and debentures may be useful. If
the concern does not want to tie down assets as securities then public deposits maybe a
suitable source. If management does not want to dilute ownership then debentures should
be issued in preference to shares. The need, purpose, object and cost involved may be the
factors influencing the selection of a suitable source of financing.
4. Selecting a Pattern of Investment.
When funds have been procured then a decision about investment pattern is to be taken.
The selection of an investment pattern is related to the use of funds. A decision will have to
be taken as to which assets are to be purchased. The funds will have to be spent first on
fixed assets and then an appropriate portion will be retained for working capital. Even in
various categories of assets, a decision about the type of fixed or other assets will be
essential. While selecting a plant and machinery, even different categories of them may be
available. The decision-making techniques such as Capital Budgeting, Opportunity Cost
Analysis etc. may be applied in making decisions about capital expenditures. While
spending on various assets, the principles of safety, profitability and liquidity should not be
ignored. A balance should be struck even in these principles. One may not like to invest on a
project which may be risky even though there may be more
profits.
5. Proper Cash Management.

Cash management is also an important task of finance manager. He has to assess various
cash needs at different times and then make arrangements for arranging cash. Cash may be
required to (a) purchase raw materials, (b) make payments to creditors, (c) meet wage bills ;
(d) meet day- to-day expenses. The usual sources of cash may be: (a) cash sales , (b)
collection of debts, (c) short-term arrangements with banks etc. The cash management
should be such that neither there is a shortage of it and nor it is idle. Any shortage of cash
will damage the creditworthiness of the enterprise. The idle cash with the business will
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mean that it is not properly used. It will be better if Cash Flow Statement is regularly
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prepared so that one is able to find out various sources and applications. If cash is spent on

avoidable expenses then such spending may be curtailed. A proper idea on sources of cash
inflow may also enable to assess the utility of various sources. Some sources may not be
providing that much cash which we should have thought. All this information will help in
efficient management of cash.
6. Implementing Financial Controls.
An efficient system of financial management necessitates the use of various control devices.
Financial control devices generally used are, : (a) Return on investment, (b) Budgetary
Control, (c) Break Even Analysis., (d) Cost Control, (e) Ratio Analysis (i’) Cost and Internal
Audit. Return on investment is the best control device to evaluate the performance of
various financial policies. The higher this percentage better may be the financial
performance. The use of various control techniques by the finance manager will help him
in evaluating the performance in various areas and take corrective measures whenever
needed.
7. Proper Use of Surpluses.
The utilisation of profits or surpluses is also an important factor in financial management. A
judicious use of surpluses is essential for expansion and diversification plans and also in
protecting the interests of shareholders. The ploughing back of profits is the best policy of
further financing but it clashes with the interests of shareholders. A balance should be
struck in using funds for paying dividend and retaining earnings for financing expansion
plans, etc. The market value of shares will also be influenced by the declaration of dividend
and expected profitability in future. A finance manager should consider the influence of
various factors, such as : (a) trend of earnings of the enterprise, (b) expected earnings in
future, (c) market value of shares, (d) need for funds for financing expansion, etc. A
judicious policy for distributing surpluses will be essential for maintaining proper growth
of the unit.
OBJECTIVES OF FINANCIAL MANAGEMENT

Financial management is concerned with the procurement and use of funds. Its main aim is
to use business funds in such a way that the firm’s value is maximised. The main objective
of a business is to maximise the owner’s economic welfare and it can be achieved by;
1. Profit maximisation
2. Wealth maximisation
Profit maximisation
Profit earning is the main aim of every economic activity. Profit is a measure of efficiency of
a business enterprise. The accumulated profits enable a firm to face risks like fall in prices,
competition from other units, etc. There are so many arguments in favour and against profit
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maximisation
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For:
When profit earning is the aim of business then the profit maximisation should be
the objective.
Profitability is the barometer of efficiency of a business organisation.
Profits are the main sources of finance for the growth of the business. So it should
aim maximising profits
Profitability is essential for fulfilling social goals.
Against:
The term profit is vague and it cannot be defined.
It ignores the time value of money and not considers the magnitude and timing of
earnings.
It does not consider the prospective earnings stream.
The effect of dividend policy on the market price of share is not considered.
Profit maximisation leads to exploiting workers and consumers
Immoral and leads to malpractices and corruptive actions
It leads to inequalities and lowers human values which are an essential part of an
ideal social system.
Wealth maximisation
When the firm maximises the stockholders wealth, the individual stockholder can use this
wealth to maximise his individual utility. In other words by maximising stockholder’s
wealth the firm is operating consistently towards maximising stockholder’s utility.
There are so many arguments in favour and against wealth maximisation, like;
For:
It serves the interest of all stakeholders of the business [shareholders, creditors,
employees etc]
Consistent with the objective of owner’s economic welfare
It implies the long term survival and growth of the business
It considers the risk factor and time value of money
The effect of dividend policy on market price of share is also considered
It leads to maximising shareholders utility
Against:
It is not socially desirable
It does not give an idea about, what the firm should do to maximise the wealth
It is not clear that whether the wealth of the shareholders or the wealth of the firm is
to be increased.
The objective faces difficulty when the management is separated from ownership
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FINANCIAL DECISIONS
It refers to the decisions concerning the financial matters of a business firm. They can be
broadly classified as under;
1. Investment decisions
2. Financing decisions
3. Dividend decisions
Investment decisions
It refers to the determination of total amount of assets to be held in the firm, the proportion
of the assets and business risk associated with it. In other words it is a decisions related to
the investment in fixed assets and current assets and the proportion of these two in the
business firm. Investment decisions are broadly classified into;
a. Long term investment decisions
b. Short term investment decisions
Long term investment decisions are known as the capital budgeting and short term
investment decisions are known as working capital management.
Financing decisions
It means the selection of the sources of fund which will make the optimum capital
structure. At the time of raising of finance the financial managers has to strike a balance
between various sources so that the overall profitability of the business firm and wealth of
the shareholders are maximised.
Dividend decisions
Dividend refers to that part of the profit of the company, which is distributed among its
shareholders. A dividend decision includes whether all the profit are to be distributed or
retain all the profit in the business or retain a part of the profit and distribute the rest as
dividend.
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TIME VALUE OF MONEY

The concept time value of money explains that the value of money received today is more
than the value of same amount of money received after a certain period. In other words
money received in the future is not as valuable as money received today. As per the time
value of money concept, the sooner one receives, the money the better it is. The value of
current receipt of money is higher than the future receipt of money after one year. This
phenomenon is known as time preference of money.
Reasons for time preference of money
1. The future is uncertain and involves risk. Therefore an individual can never be
certain of getting cash inflow in future and hence he will like to receive the money
today itself, instead of waiting for the future.
2. For people the present needs are more urgent than the future needs.
3. Opportunities available to invest the money received at the earlier days at the some
interest or otherwise to enhance the future earnings.
Techniques of Time Value of Money
There are 2 techniques to adjust time value of money;
1. Compounding technique
2. Discounting technique.
1. COMPOUNDING TECHNIQUE
The time preference for money encourages a person to receive money at present instead of
waiting for future. But he may like to wait if he duly compensated for the waiting time by
way of money at the end of a period. The future value of money at the end of a period can
be calculated by using the formula.
V1=V0(1+i)n
Where;
V1= future value of money at the end.
V0= value of money at the beginning
i = interest rate
n= no. of years
Doubling Period
Doubling period means the length of period within which an amount is going to take
double at a certain rate of interest. Doubling period can be calculated be following either
Rule 72 or Rule 69
Rule 72
Doubling period = 72/ Rate of interest
Rule 69
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Doubling period = 0.35+(69/ Rate of interest)

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Multiple compounding
Multiple compounding period means the compounding the interest more than once in a
year like, half yearly or quarterly.
VO= V1(1+i/m)m x n
where;
V1= future value of money at the end of a period
V0= value of money at the beginning
i = rate of interest
n= no. of years
m= frequency of compounding per year
Effective rate of interest
Effective rate of interest means the additional growth in the rate of interest due to multiple
compounding. It is because the actual rate of interest realised [effective rate of interest] in
multiple compounding is more than the normal rate of return.
EIR= (1+i/m)m-1
Where;
i = the normal rate of interest
m= frequency of compounding per year
Future value of series of payments
Vn= R1(1+i)n-1+ R2(1+i)n-2 + R3(1+i)n-3
Where;
Vn=future value of series of payments
R1= payment after first period
R2= payment after second period
R3= Payment after third period
i= rate of interest
n= no. of years
Compounded value of annuity
An annuity is a series of equal payments lasting for some specified duration. When cash
inflows occur at the end of each period the annuity is called a regular annuity or deferred
annuity.
[(1+i)n-1+( 1+i)n-2+( 1+i)n-3]
Vn= R [(
or
Vn= R [ACF i,n]
Where;
Vn= future value of annuity
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R= equal payments
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n= No .of years

ACF= annuity compound factor
Compounded value of annuity due
If the cash inflow occurs at the beginning of each period the annuity is called annuity due.
Vn= R [ACF i,n]( 1+i)
Where;
Vn= future value of annuity
R= equal payments
n= No .of years
ACF= annuity compound factor
2. DISCOUNTING TECHNIQUE
The present value is exact the opposite of compound value or future value. While the future
value shows how much sum of money becomes at future period, present value shows what
the present value of some future sum of money. The present value of money to be received
in future will always be less. The present value of a future sum of money can be calculated
as follows;
V0= Vn/ (1+i)
or
V0= Vn X DF i,n
Where;
V0= present value of money
Vn= future value of money
DF= discount factor
N= no.of years
Present value of series of payments
V0= [R1/(1+i)] +[R2/(1+i)2] +[R3/(1+i)3] +[R4/(1+i)4]
Where;
R1= payment after first period
R2= payment after second period
R3= Payment after third period
i= rate of interest
n= no. of years
Present value of annuity
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An annuity is a series of equal payments lasting for some specified duration.

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V0= R [ADF i,n]

Where;
R= series of equal payments
i= rate of interest
n= no. of years
Present value of annuity due
If the cash inflow occurs at the beginning of each period the annuity is called annuity due.
V0= R [ADF i,n]( 1+i)
Where;
R= series of equal payments
i= rate of interest
n= no. of years
ADF= annuity discounting factor
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WORKING CAPITAL MANAGEMENT

Working capital management is concerned with the problems that arise in
attempting to discuss in details various tools and techniques which can be gainfully
employed to solve the problem of determining optimum level of working capital.
Working capital - Meaning
Working capital is defined as the "excess of current assets over current liabilities
and provisions". That is, the amount of surplus of current assets which remain after
deducting current liabilities from total current assets which is equal to the amount
invested in working capital, consisting of work-is-progress, raw materials and stocks,
consumable items, amounts owing by customers and cash at the or bank in hand.
Shubin defines working capital as “the amount of funds necessary for the cost of
operating the enterprise”. Working capital in a going concern is a revolving fund; consist of
cash receipts from sales which are used to cover the cost of operation.
In accounting working capital is the difference between inflow and out flow of
funds. In other words it is the net cash flow. It is also known as circulating capital,
fluctuating capital and revolving capital.
Need for Working Capital
Working Capital is significant because of:
a. Adequate working capital is required to continue uninterrupted business
operations
b. It is essential to run the day to day business activities
c. Greater volume of working capital required to invest in current assets for the
success of sales activities
d. To ensure the maximizing the wealth of the firm
e. To enable to increase the rate of return on investment
f. To meet the short-term obligations of a business enterprise To increase the
operational efficiency of a firm
g. To utilize the maximum available resources
Concepts of working capital
There are two concepts of working capital
a. Balance sheet and
b. Operating cycle concept
Balance sheet concept
There are two variations of working capital under this concept:
1. Gross working capital
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2. Net working capital

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Gross Working Capital: The term Gross Working Capital refers to the total of all current

assets. In other words, the firm's investments in total current or circulating assets. Current
assets represent short term securities, sundry debtors, bills receivable, stock (inventories)
etc. The Gross concept of working capital is very suited to company organization where
ownership is separated from management and control.
Advantages of Gross Working Capital:
This concept has the following advantages:
(1) It provides the amount of working capital at the right time.
(2) It enables a firm to realize the greatest return on its investment.
(3) It helps in the fixing of various financial responsibilities.
(4) It helps to the top executives to make plan and control funds and to maximize the
return on investment.
(5) It enables a firm to operate its business more efficiently.
Net Working Capital : The net concept of working capital is qualitative, indicating the firm’s
ability to meet its operating expenses and current liabilities. The term net working capital
refers to the difference between current assets and current liabilities.
Net working capital = current assets – current liabilities.
Current assets are those assets which in the ordinary course of business can be, or will be
turned in to cash within one year undergoing a diminution in the value or without
disrupting the operations of the firm. Current assets= cash+ marketable securities+
accounting receivables+notes and bills receivables +stock
Current liabilities are those liabilities which are intended at their inception to be paid in the
ordinary course of business, within a year, out of the current assets or earnings of the
concern. Current liability= accounts payable+ bills payable+ outstanding expenses+ shortter
loans
Positive or negative working capital: the working capital of a firm may be positive or
negative working capital. If the value of current liabilities is more than current assets then it
is negative working capital.
Difference between gross concept and net concept of working capital
Net Working Capital Gross Working Capital
Net working capital is the concept of Gross concept of working capital is
qualitative nature. quantitative nature.
It is indicating the firm's ability to It is pointing out the total amount
meet its operating expenses and available for financing the current
current liability. assets.
It expressed as current assets minus It indicating the total sum of
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current liability. Current assets.

It is a concept very popular in
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It is a concept very popular in

accounting system. financial management circles.

Net concept suitable for sole Trader Gross concept suitable for
and partnership firms. companies
It is useful to find out the true It can not reveal the true financial
financial position of a company. position of a company.
Operating cycle concept
Working capital refers to that part of a firms capital which is required for financing short
term or current assets. The operating cycle concept of working capital is based on operating
cycle of firm. The term operating cycle otherwise known as "Cash Cycle". In order to earn
sufficient profits, a firm has to depend on its sales activities apart from others. Sales are not
always converted into cash immediately, i.e., there is a time lag between the sale of a
product and the realization of cash. The continuing flow from cash to supplier to investors,
to account receivable and back in cash. This time gap is technically termed as operating
cycle.
In case of a manufacturing firm,

firm the duration of time required to complete the
following sequence of events is called the operating cycle.
(1) Conversion of cash into raw materials
(2) Conversion of raw materials into work-in-progress
(3) Conversion of work-in-progress into finished goods
(4) Conversion of finished goods into accounts receivable and
(5) Conversion of accounts receivable into cash.
In the case of non-
non-manufacturing firm,
firm the operating cycle will include the length of time
required to convert:
(a) Cash into inventories;
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(b) Inventories into accounts receivable;

(c) Accounts receivable into cash.
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In the case of service and financial concerns may not have any inventory at all. So the
operating cycle include the length of time taken for direct conversion of cash. The
following formula is used to express the duration of working capital cycle
O =R+W+F+D-
=R+W+F+D-C [where]
O== total period of the operating cycle in number of days
R= number of days for holding stock of raw materials and stores
W= number of days for holding stock of work in progress with regard to cost of production
F= number of days for holding stock of finished goods with regard to cost of production
D= debtors collection period
C= credit payment period.
Kinds of Working
Working Capital
The Working Capital includes the following broad classifications

1. On the basis of Concept
a. Gross Working Capital
b. Net Working Capital
i. Positive Net Working Capital
ii. Negative Net Working Capital
2. On the basis of Time
a. Permanent Working Capital
i. Regular working capital
ii. Reserve working capital
b. Temporary Working Capital
i. Seasonal working capital
ii. Special working capital
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Permanent Working Capital: The minimum amount of current assets why are kept by a
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firm over the entire year to ensure uninterrupted course of operation. The minimum level

of current asset is referred to as permanent working capital. It is termed as Regular

Working Capital or Core Working Capital or Fixed Working Capital. Permanent working
capital is classified as regular working capital and reserve working capital. Regular
working capital ensures the circulation of current assets from cash to stock, from stock to
debtors and debtors to cash and so on. Reserve working capital is the excess amount over
the requirement for regular working capital which may be provided for contingencies
situations.
Permanent Working Capital has following characteristics;
a. Continue to exist for a longer period of time in the business.
b. Constantly changes in the business from one asset to another.
c. Required to meet permanent obligations along with other fixed assets.
d. Grows the size or volume of business operations.
e. Classified on the basis of the time factor.
f. Minimum level of working capital always required to be maintained.
Temporary Working Capital: Any amount over and above the permanent level of working
is Temporary or Fluctuating or Variable Working Capital. In other worlds, it represents
additional current assets required to meet fluctuations during the operating year. As it
fluctuates according to the level of operation, it is termed as Fluctuating working
Capital. Temporary working capital is classified as Seasonal working capital and special
working capital. Seasonal working capital is for meeting the seasonal requirements and
special working capital for meeting special situations like, launching new marketing
campaigns etc.
Temporary working capital has following characteristics;
a. It is an extra working capital needed to changing production and sales activities.
b. It is created to meet `liquidity requirements.
c. Temporary working capital is fluctuating during the operating period.
d. It fluctuates according to the level of operations.
e. It is needed for shorter period.
Reasons for change in working capital.
1. Change in the level of sales activities
2. Change in the level of operating activities
3. Policy change initiated by management
4. Technological changes
5. Cyclical change in the economy
6. Changes in the operating cycle
7. Sources of change is seasonally in sales activity.
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Dangers of Excess Working Capital

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The success and otherwise of a business depends on the adequacy of the said capital

maintaining a desired level. Both excessive or inadequate working capital poses a serious
problem to a company which may even lead to its doom. Excessive working capital means
idle fund which earn no profits for the firm. Inadequate working capital impairs firm's
profitability and liquidity . When working capital is excessive, a firm faces the following
1) It leads to unnecessary purchase and accumulation of inventories.
(2) Excessive working capital results in imbalance between liquidity and profitability
(3) It is an indication of defective credit policy
(4) A company may not be tempted to overtrade and lose heavily.
(5) Excessive working capital leads to operational inefficiency because large volume of
funds not being used productively.
(6) This makes management complacent which degenerates into managerial
inefficiency.
(7) High liquidity may induce a firm to undertake great production which may not
have a matching demand.
Dangers of Inadequate Working Capital
When working capital is inadequate, a firm faces the following problems.
(1) Inadequate working capital causes stagnates growth and expansion
(2) It may not able to utilize production facilities fully
(3) It becomes difficult to take advantages of profitable business opportunities
(4) It may not able to efficiently utilized fixed assets. This leads to low profitability
(5) A firm may not able to take advantages of cash discount facilities.
(6) Inadequate working capital causes paucity of funds. This leads to damage credit-
worthiness of the firm
(7) It may not able to meet short term obligation
(8) Inadequate working capital causes unable to pay its dividends and interest
(9) A firm may not able to meet its day to day commitments. This leads to firm, loses its
reputation.
Factors determining
determining the Working Capital
Capital
The total working capital requirement is determined by a wide variety of factors. It
should be however, noted that these factors affect different enterprises differently. The
following is the description of the factors which generally influence the working
capital requirements of the firms.
Internal factors.
1. Nature of Enterprise.
2. Size of business
3. Manufacturing cycle
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4. Firm’s credit policy

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5. Access to money market

6. Expansion and growth of business

7. Profit margin and dividend policy
8. Depreciation policy
9. Operating efficiency of the firm
10. Co-ordination activities of the firm
External factors
1. Business cycle fluctuations
2. Technological developments
3. Seasonal fluctuations
4. Environmental factors
5. Taxation policy
Internal Factors
(1) Nature of Enterprise: The working capital requirements of a firm basically
influenced by the nature of its firm. For example, trading and financial firms
require a large amount of investment in working capital but a significantly smaller
amount of investment in fixed assets. But in the case of manufacturing concern
have to invest substantially in working capital and a normal amount in fixed assets.
In contrast public utilities have a very limited need for working capital, while a
merchandising department depends generally on inventory and receivable need a
large amount of working capital. Needs for working capital are thus determined by
the nature of an enterprise or business.
(2) Size of Business. The size of the firm is also an important factor to requirements of
working capital. Because a smaller firm needs smaller amount of working, capital on the
basis of its production activities and vise versa in the opposite case.
(3) Manufacturing Cycle: Time span required for conversion of raw materials into
finished goods is to block period. The period in reality extends a little before and after the
work-in-progress. This cycle determine the need of working capital.
(4) Firm's Credit Policy: The level of working capital is also determined by credit policy
which relates to sales and purchases. The credit policy influences the requirement of
working capital in two ways (a) Through credit terms granted by the firm to
customers/ buyers of goods; (b) Credit terms available to the firm from its creditors.
(5) Access to Money Market: Working capital requirements of a firms are condition--- by
the firm’s access to different sources of money market. Thus, firm with readily available credit
from banks and trade credit facilities at liberal terms will be able to get by W-= less
working capital than a firm without such facilities.
(6) Expansion
Expansion and Growth of Business: It is obvious that, as business expands it will
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require more working capital in terms of sales or fixed assets. In the case of growth and
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expansion, there will be an increase in investment. With the increase in fixed assets for

increasing sales the requirement of working capital will be expanded not only for
financing increased volume of raw materials but also to finance maintenance of
inventory stock and grant credit to customers.
(7) Profit Margin and Dividend Policy: Magnitude of working capital in a firm depend
upon its profit margin and dividend policy. As a matter of fact, a high net profit margin
reduces the working capital requirements of the firm because it contribute towards
working capital pool. Similarly, distribution of high proportion of profits in the form of
dividend result in a drain on cash resources and thus reduces company's working capital to
that extend. Where the management follows constructive dividend policy and retain
larger portion of the net profits, the company's working capital position is strong.
(8) Depreciation Policy: The depreciation policy influences the level of working capital by
affecting the tax liability and retained earnings of the enterprise. Since depreciation is tax
deductible expense item, this will affect the firm's tax liability and retained earnings and
thus strengthen the firm's working capital position.
(9) Operating Efficiency of Firm: The operating efficiency of management is also an
important determinant of the level of working capital management can contribute to a
sound working capital position through operating efficiency. Efficiency of operations
accelerates the pace of the cash cycle and improves the working capital turnover.
(10) Co-
Co -ordination Activities of Firm: In addition, absence of co-ordination in
action and distribution policies in a company results in a high demand for working capital.
Where production and distribution activities are co-ordinate, pressure on working capital
will be minimized.
External Factors
(1) Business Cycle Fluctuations:
Fluctuations: This is another factor which determines the need level.
Barring exceptional cases, there are variations in the demand for goods/services handled by
any organization. Economic boom/recession have their influence on the transactions and
consequently on the quantum of working capital required.
(2) Technological Development: Changes in technologies may lead to improvements in
processing raw materials, minimizing wastages, greater productivity, more speed of
production. All these improvements may enable the firm to reduce investments in
inventory. Thus changes in technology affect the requirements of working capital. If the
firm decides to go for automation, thus world reduce the requirements for working capital. If
the firm adopts a labour intensive process, the requirement for working capital will be
larger
(3)Seasonal Fluctuations: Seasonal fluctuations in sales affect the level of variable
working capital. Often the demand for products may be of a seasonal nature. Yet
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inventories have got to be purchased during certain seasons only. The size of working
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capital in one period may therefore, be bigger than that in another.

(4) Environment Factors: Political stability in its wake bring in stability in money market
and trade world. Risk ventures are possible with enhanced need for working capital
finance.
(5) Taxation Policy: Taxes must be paid out of profits. Tax liability is unavoidable and
adequate provision should be made for it in working capital planning. If the tax liability
increases, it will impose an additional strain on working capital. The finance manager must
do tax planning in order to avail the benefits of all sorts of tax concessions and incentives.
Working Capital Financing Mix
There are three basic approaches for determining the working capital financing mix. They
are;
1. Hedging or matching approach
2. Conservative approach
3. Aggressive approach
1. Hedging Approach
This approach suggests that the permanent working capital requirement should be financed
with funds from long term sources while the temporary working capital should be financed
with short term funds.
2. Conservative approach
As per this approach, the entire estimated investments in current assets should be financed
from long term sources and the short term sources should be used only for emergency
requirements. In this finance mix liquidity is greater, risk is minimum and cost is relatively
high.
3. Aggressive approach
This approach suggests that, the entire estimated requirements of current assets should be
financed from short term sources and even a part of fixed assets requirements be financed
from short term sources. This finance mix is more risky, less costly and more profitable.
Principles of working capital management policy
The following are the sound principles of a sound working capital management policy;
1. Principle of risk variation
2. Principles of cost of capital
3. Principle of equity position
4. Principle of maturity of payment.
Principle of risk variation:
There is inverse relationship between risk and profitability. A firm can prefer to minimize
risk by maintaining a higher level of current assets or working capital or maximize risk by
reducing working capital. As per the risk varies according to the level of working capital,
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the management should keep a suitable balance between profitability and risk.
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Principles
Principles of cost of capital:
capital:

Different sources of working capital have different cost of capital and different degree of
risk. The higher the risk, lower the cost and lower the risk, higher the cost. A sound working
capital management policy should maintain a proper balance between cost and risk
associated with it.
Principle of equity position
As per this principle, the amount of working capital invested in each component should be
adequately justified by a firm’s equity position. Every rupee invested in current assets
should contribute to the net worth of the firm.
Principle of maturity of payment.
A firm should make effort to relate maturities of payment to its flow of internally generated
funds. Maturity patterns of various current obligations is an important factor in risk.
Estimation of Working Capital Requirements
The term working capital as already point out, usually means the excess of current
assets over current liabilities. In reality such excess of current assets over current
liability may be either more or less than the working capital requirement of the company.
Assessing the requirements of working capital to be employed during the immediate future
period of operations. The working capital requirements can be determined by the following
three techniques
(1) Percentage of Sales Method.
(2) Estimation of Components of Working Capital Method.
(3) Operating Cycle Approach (or) Cash Working Capital Method.
1. Percentage of Sales Method: This is simple and traditional method. According to percentage
of sales method, the requirement of working capital can be determined or the basis of
sales, amount of working capital required and prior year's experiences. In this method, the
working capital is calculated and expressed it as a percentage to sales This method is much
useful in planning short term working capital requirements However, the basic
criticism of this method is that it assumes a linear relationship between sales and working
capital. Therefore, this method is not universally accepted
2. Estimation of Components of Working Capital Method: The second method is useful in
estimating working capital requirements on the basis of the components current assets and
current liabilities. These components include inventories, Account: receivables,
Accounts payables, Marketable investments, Short Term Obligations etc This method is
widely discussed in the chapter of cash management of this book. It practically suitable for
long term forecasting. Symbolically, it can be expressed as:
Working Capital = Current Assets - Current Liabilities
3. Operating Cycle (or) Cash Working Capital Method. Operating cycle method otherwise
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known as 'cash working capital method'. In estimating the working capital cycle require for
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a business, the volume of cash needed to finance the entire process the cycle is to be taken in

to consideration. Accordingly, this method suggests that actual level of working capital
requirement of a firm in a period can be appropriately determined with reference to the
length of net operating cycle and the volume of cash needed to meet the operation expenses
for the period. In other words, the operating cycle refers u the period
The following formula is used to express the duration of working capital cycle
O =R+W+F+D-
=R+W+F+D-C
where
O== total period of the operating cycle in number of days
R= number of days for holding stock of raw materials and stores
W= number of days for holding stock of work in progress with regard to cost of production
F= number of days for holding stock of finished goods with regard to cost of production
D= debtors collection period
C= credit payment period.
PLANNING OF WORKING CAPITAL

Objectives of Working Capital
The following are the main objectives of adequate working capital management
(1) Availability of adequate funds
(2) Minimum cost
(3) Matching (balance) between profitability and liquidity
(4) Flexibility
(5) Optimum use of funds
(1) Availability of Adequate Funds: A sound working capital financial plan must ensure the
supply of adequate amount of working capital needed by the business enterprises, both for
current and future needs.
(2) Minimum Cost: The fund required by the firm should be made available at the lowest
cost. It is made possible through planning, considering in advance various cost factors and
trends of capital market and suggesting the best course of action.
(3) Matching (Balance) Between Profitability and Liquidity:
Liquidity A judicious balance between
profitability and liquidity is one of the fundamental principles of successful finance
planning. Profitability and liquidity are inversely related. The working capital financial plan
must ensure sufficient amount of investment in those assets which are liquid cash and
near-cash assets.
(4) Flexibility: The working capital financial plan should be dynamic in nature. In other
words, it should provide sufficient scope for change and re-adjustment in the financial
structure. Such changes become necessary due to changes in business conditions in future.
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SOURCE OF WORKING CAPITAL

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Source of working capital can be basically classified into following;

1. Long term source

a. Issue of share
b. Floating of debentures
c. Long term loans
d. Public deposits
e. Private loans
f. leasing
2. Medium and short term
a. Internal
i. Depreciation
ii. Taxation provision
iii. Accrued expanses
iv. Private loans
v. Reserves and provisions
b. External
i. Bank credit
ii. Trade credit
iii. Customers credit
iv. Hire purchase and sale
v. Government assistance
vi. Accounts receivables.
Long Term Source of Working Capital
1. Issue of Shares: This is the most common method of raising the permanent working
capital. Every company generally uses this method. “Shares” may be defined as “the share in
the capital of a company and des stock expect where a distinction between stock and share
is expressed or implied.” Shares are of two types. Equity shares and preference shares.
2. Floating of Debentures: It is also an important source of long term working capital. A
debenture is a document issued by a company as an evidence of a debt due from the
company with or without a charge on the asset of the company. Debenture includes
debenture stock, bonds and any other ties of a company whether constituting a charge on
the assets of the company or not.
3. Long Term Loans: Long term loans are one of the important sources of permanent
working capital. Financial institutions and commercial banks provide loans for augmenting
long term working capital needs and for meeting additional margin money requirements
for working capital arising out of increase in volume of operations, expansion,
diversifications etc.
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4. Public Deposits/Loans : The issue of public deposits is directly related to the image of the
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company seeking to invite deposits. Many companies accept deposits as permanent working

capital from members, directors and the general public. This mode of raising funds is
becoming popular these days on account of bank credit becoming quiet costlier.
5. Sale of Unwanted Assets:. Considerable amount of working capital can be raised by the
sale of unwanted or unutilized assets of land, building, machinery, furniture, scrap and
loose tools etc.
6. Private Loans: Lending private institutions and private banks are granting permanent
working capital at a fixed rate of interest against securities to meet the operational
expenses.
7. Equipment Leasing: Companies can get the permanent working capital assistance by
offering equipment leasing facilities. Financial institutions and commercial banks provides
facilities for leases indigenously procured imported machinery and equipment for a period
of 5 to 8 years with a 90% principal amortization through lease rentals over the period
Medium and
and Short Term Sources of Working Capital
Internal sources
1. Depreciation: Depreciation means decrease in the value of asset due to wear lapse of
time, obsolescence, exhaustion and accident. Depreciation reserves a good source of
funds for working capital. It is as a non-cash expense, and it represent any cash
outlay with the result that part of the profits adjusted for depreciation can be used
by management to increase any of the current assets or pay dividend etc.
2. Taxation Provision: Provision for taxation is one of the internal sources of medium
and short-term working capital. According to Income Tax Act, firms are liable to
pay income tax on the assessable net profit as per rate prescribed for the same by
Finance Act from time to time. Normally, there is a time lag between the creation of
the provision for taxes and their actual payment. And in the period the resources as
against this provision which remain within the enterprise may be used as a source of
working capital
3. Accrued Expenses: Accrued expenses otherwise known as outstanding expenses The
firm can postpone the payment of expenses for shorter periods. This constitute as an
internal source of medium and short-term working capital.
4. Private loans: Lending private institutions and private banks are granting medium
and short-term working capital at a fixed rate of interest against securities to meet
the operational expenses.
5. Reserves and Provisions: It is provided for meeting prospective losses or liabilities.
creation of reserve and provision to increase the working capital in the business and
strengthen its financial position. Sometimes, the amount is not kept in the business
as additional working capital but is invested in purchase of outside securities, then it
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is called reserve fund.

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External Sources

1. Bank Credit:
Credit Bank credit is one of the important external sources of medium and short-
term sources of working capital. It is arranged by which a banker allow his customer to
borrow money up to a certain limit. Cash credit arrangements are usually made against the
security of commodities hypothecated or pledged with the bank.
2. Trade Credit: Trade credit is a form of medium and short-term financing common to all
type of business firm. It is the largest source of temporary working capital. Most buyers are
not required to pay for goods on delivery. Trade credit is also granted by the seller of raw
materials and goods to manufactures and/ or wholesaler. It generally takes the form of
discount for cash payment on delivery and net for future payment. This credit may take the
form of (a) Open account credit arrangement (b) Acceptance credit arrangement. In the
case of an open account credit arrangement, the buyer does not sign a formal debt
instrument as an evidence of the amount due by him to the seller while in the case of
acceptance.
3. Discounting Bills: Companies can get the medium and short-term working capital
assistance by discounting their bill of exchange, promissory notes from banks. These
documents are discounted by the banks at a price lower than their face value.
4. Accounts Receivable Financing: Under this arrangement, the account receivable of a
business concern are bought by a financing company or money may be advanced on
securing of accounts receivable. Normally, 60% of the value of accounts receivable pledged
is advanced by the finance companies. If there are any bad debts, it is to be borne by the
business concern itself.
5. Government Assistance: Government undertakes a variety of promotional activities
including provides subsidies and short-term working capital assistance for the acquisition
and installation of energy conversion equipment. It extends the facility of granting loans,
tax concessions for projects involving the development and use of indigenous technology
and for adopting and development of imported technology, as well as high risk, high return
ventures.
6. Customer Credit: This is also known as installment credit as it is usually allowed by
retailers for selling consumer durable goods. Some portion of the cost price of the asset is
paid at the time of delivery and the balance is paid in number of installments along with the
interest. Sometimes, installment credit is granted by financial companies or banks which
have special arrangements with the suppliers.
7. Loans from Directors: A business firm may resort to miscellaneous source of finance in
periods of pressing working capital needs. Specialized financial institutions also provide
finance to their client units in times of need. The cost of these funds is nominal.
8. Hire Purchase and Sale: Financial institutions and commercial banks grant loans as
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medium and short-term working capital to companies engaged in leasing and financing or
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industrial plant and machinery or durable customer goods.

COST OF CAPITAL
Cost of capital is the rate of return the firm requires from investment in order to
increase the value of the firm in the market place. In economic sense, it is the cost of raising
funds required to finance the proposed project, the borrowing rate of the firm. Thus under
economic terms, the cost of capital may be defined as the weighted average cost of each type
of capital.
There are three basic aspects about the concept of cost
1. It is not a cost as such: The cost of capital of a firm is the rate of return which it
requires on the projects. That is why; it is a ‘hurdle’ rate.
2. It is the minimum rate of return: A firm’s cost of capital represents the minimum
rate of return which is required to maintain at least the market value of equity
shares.
3. It consists of three components. A firm’s cost of capital includes three components
a. Return at Zero Risk Level: It relates to the expected rate of return when a
project involves no financial or business risks.
b. Business Risk Premium: Business risk relates to the variability in operating
profit (earnings before interest and taxes) by virtue of changes in sales.
Business risk premium is determined by the capital budgeting decisions for
investment proposals.
c. Financial Risk Premium: Financial risk relates to the pattern of capital
structure (i.e., debt-equity mix) of the firm, In general, a firm which has
higher debt content in its capital structure should have more risk than a firm
which has comparatively low debt content. This is because the former should
have a greater operating profit with a view to covering the periodic interest
payment and repayment of principal at the time of maturity than the latter.
Significance of Cost of Capital

The cost of capital is significant because of the following cases;
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1. Capital Budgeting Decisions: The concept of cost of capital can serve as a discount
rate for selecting the capital expenditure projects. The capital budgeting decision
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after all is the matching of the costs of the use of funds with the returns of the
employment of funds. Thus the financial manager can arrive at the break-even
point in the capital structure the point at which the rate of return of a given project
equals the cost of procuring funds for that project.
2. Capital Structure Decisions: The concept of cost of capital is an important
consideration in capital structure decisions. It helps to devise an optimal capital
structure with an ideal debt-equity mix based on minimum costs
Classification of cost of capital
Cost of capital can be brought as under:
Explicit Cost and Implicit Cost
Future Cost and Historical Cost
Specific Cost and Combined Cost
Average Cost and Marginal Cost
1. Explicit Cost and Implicit Cost
The explicit cost of any source of finance may be defined as the discount rate that
equates the present value of the cash inflows (that are incremental to the taking of the
financing opportunity) with the present value of its expected cash outflows. In other words,
the explicit cost is the internal rate of return the firm pays for financing.
The implicit cost may be defined as the rate of return associated with the best
investment opportunity for the firm and its shareholders that will be forgone if the projects
presently under consideration by the firm were accepted. When the earnings are retained
by a firm, the implicit cost is the income which the shareholders could have earned if such
earnings would have been distributed and invested by them.
In short, the explicit cost arises when the capital is raised and implicit cost of capital
arises whenever funds are used.
2. Future Cost
Cost and Historical Cost
If future cost is the expected cost of funds for financing a project, historical cost is
the cost which has already been incurred for financing a particular project. In financial
decision making process, the relevant cost is future cost.
3. Specific Cost and Combined Cost
The cost of each component of capital, i.e., equity shares, preference shares,
debentures, loan, etc., is called the specific cost of capital. The firm should consider the
specific cost, while determining the average cost of capital.
When specific costs are combined to find out the overall cost of capital, it is called
the combined cost or composite cost. In other words, the combined or composite cost of
capital is inclusive of all costs of capital from all sources (i.e., equity shares, preference
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shares, debentures and other loans). This concept of capital is used as a basis for accepting
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or rejecting the proposal in capital investment decisions although various proposals are
financed through various sources.
4. Average
Average Cost and Marginal Cost
Average cost of capital is the weighted average of the cost of each component of
funds invested by the concern. But the weights are in proportion of the shares of each
component of capital in the total investment.
Marginal cost of capital is the cost of additional amount of capital which is raised by
a firm
Approaches of cost of capital
1. Traditional Approach
As per this approach, the cost of capital of a firm relates to its capital structure. In other
words, the cost of capital of the firm is the weighted average cost of debt and the cost of
equity. However, the raising of funds by way of debentures is cheaper. This is mainly due to
the following facts:
a. Usually, interest rate is less than dividend rates.
b. Interest is allowed as an expense while taxable profit of the company is computed.
But dividend is not allowed as an expense.
The main argument in favour of this approach is that the weighted average cost of capital
will go up with every increase in the debt content in the total capital employed. However,
the debt content in the total capital employed must be maintained at a proper level as the
cost of debt is a fixed burden. Moreover, when the debt content goes up beyond a certain
level, the investors consider the company too risky and their expectations from equity
shares will go up.
2. Modigliani and Miller Approach
Under this approach, the total cost of capital of a company is constant and
independent of its capital structure. In other words, a change in the debt-equity ratio does
not affect the total cost of capital.
The main arguments of MM approach are:
The total market value of the firm and its cost of capital are independent of its capital
structure. The total market value of the firm can be calculated by capitalising the
expected stream of operating earnings at a discount rate considered appropriate for its
risk class.
The cut-off rate for investment purposes is completely independent of the way in
which investment is financed.
Assumptions of MM Approach
1. Perfect Capital Ma
Market:
rket: Trading of securities takes place in perfect capital market.
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This indicates that:

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a. Investors have full-fledged freedom to buy and sell securities.

b. As investors are completely knowledgeable and rational persons, they can

know at once all information and changes.
c. The buying and selling of securities does not involve costs such as broker’s
commission, transfer fees, etc.
d. The investors can borrow against securities on the same basis as the firms
can do so.
2. Homogeneous Risk Classes: In case the firms expected earnings have identical risk
features, they should be considered to belong to a homogeneous class.
3. Same Expectations:
Expectations All investors have the same expectations of the net operating
income (EBIT) of firm which is used for its evaluation. There is 100 per cent
dividend payout, i.e., all the net earnings of the firm are distributed to the
shareholders,
4. No Corporate Taxes: At the formulation stage of hypothesis, Modigliani and Miller
assume that there are no corporate taxes, However, they have removed this
assumption later on.
Computation of Cost Of Capital
Computation of the cost of capital involves: (i) computation of specific costs and (ii)
computation of composite cost.
I. Computation of Specific Costs: It is the computation of the cost of each specific
source of finance such as debt, preference capital and equity capital.
1. Cost of Debt: It is the rate of return which is expected by lenders. This is actually the
interest rate specified at the time of issue. Debt may be issued at par, at premium or
discount. It may be perpetual or redeemable.
Debt Issued at Par: The cost of debt issued at par is the explicit interest rate adjusted further
for the tax liability. It is computed in accordance with the following formula:
Debt Issued at Premium or Discount: When the debentures are issued at a premium (more
than the face value) or at a discount (less than the face value) the cost of debt should be
computed on the basis of net proceeds realised on account of issue of such debentures.
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Cost of Redeemable Debt: When debentures

are redeemed after the expiry of a fixed period, the cost of debt before tax can be computed
with the help of the following
Formula
2. Cost of Preference Share Capital

Even though it is not legally binding on the part of the company to pay preference dividend,
it is generally paid as and when the company earns enough profits. The failure to pay
preference dividend is a matter of serious concern on the part of the equity shareholders.
They may even lose control of the company as the preference shareholders will enjoy the
right to take part in the general meeting with equity shareholders under certain conditions
if the company fails to pay preference dividend. The accumulation of arrears of preference
dividend may adversely affect the right to equity shareholders.
Cost of Redeemable Preference Shares:

The cost of redeemable preference shares is the discount rate which equates the net
proceeds of sale of preference shares with the present value of future dividend and
repayment of principal. But the cost of preference share capital is not adjusted for taxes as it
is not a charge against profit but an appropriation of profit.
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3. Cost of Equity Capital

Cost of equity capital may be defined as the minimum rate of return that a firm must earn
on the equity financed portion of an investment project in order to leave unchanged the
market price of its stock.
a. Dividend Price (DIP) Method
According to this approach, the cost of equity capital is computed against a required rate of
return in terms of future dividends. Thus cost of capital is defined as “the discount rate that
equates the present value of all expected future dividends per share with the net proceeds of
the sale (or the current market price) of a share”. In other words, the cost of equity capital
will be that rate of expected dividends which will maintain the present market price of
equity shares
b. Dividend Price Plus Growth Method

In this approach, the cost of equity capital is calculated on the basis of the expected
dividend rate plus the rate of growth in dividend. But the rate of growth is ascertained on
the basis of the amount of dividends paid by the company for the last few years.
c. Earning Price Approach

This method is based on the assumption that the shareholders capitalise a stream of future
earnings for evaluating their shareholdings. Thus the cost of capital relates to that earning
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percentage which can keep the market price of the equity shares constant. This approach
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recognises both dividend and retained earnings.

d. Realised Yield Approach

Under this approach, the cost of equity capital should be ascertained on the basis of return
actually realised by the investors on their investment (i.e., on equity shares). Thus in this
approach, the past records in a given period regarding dividends and the actual capital
appreciation in the value of the equity shares held by the shareholders should be taken to
calculate the cost of equity capital.
4. Cost of Retained Earnings
Generally, the companies do not distribute the whole of the profits earned by them by way
of dividend among their shareholders. A part of such profits is retained by them for future
expansion of the business. This portion of profit is known as retained earnings or ploughing
back of profit. The cost of retained earnings is the earnings foregone by the shareholders. In
other words, the opportunity cost of retained earnings may be taken as the cost of retained
earnings. It is equal to the income what a shareholder could have earned otherwise by
investing the same in alternative investment.
The following adjustments are required for determining the cost of retained
earnings.
a. Income Tax Adjustment: The dividends receivable by the shareholders are subject to
income tax. Thus the dividends actually received by them are the amount of net
dividend (i.e., gross dividends less income tax).
b. Brokerage Cost Adjustment: The shareholders cannot utilise the whole amount of
dividend received from the company for the purpose of investment as they have to
incur some expenses by way of brokerage, commission, etc. for purchasing new
shares against the dividend.
II. Composite or Weighted Average Cost of Capital

The term cost of capital is used to denote the overall composite cost of capital or
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weighted average of the cost of each specific type of funds i.e., weighted average cost. In
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other words, the composite or weighted average cost of capital is the combined specific

costs used to find out the overall cost of capital. The computation of weighted average cost
of capital involves the following steps:
a. Calculate the cost of each specific source of funds.
b. Assign proper weights to specific costs.
c. Multiply the cost of each source by the appropriate weight.
d. Divide the total weighted cost by the total weights to get the overall cost of capital.
Assignment of Weights
This involves the determination of the proportion of each source of funds in the total capital
structure of the company. For this purpose, the following three possible weights may be
used.
Book Value Weights used for actual or historical weights.
Market Value Weights used for current weights.
Marginal Value Weights used for proposed future financing.
Book Value Weights
Under this method, the relative proportions of various sources to the existing capital
structure are used to assign weights. The advantages of these weights are as follows:
1. Book values are easily available from the published annual report of a company.
2. All companies set their targets of capital structure in terms of book values rather
than market value,
3. The analysis of capital structure on the basis of debt equity ratio also depends on
book value.
Market Value Weights
Theoretically, the use of market value weights for computing the cost of capital is more
appealing due to the following facts:
1. The market values of the securities are approximate to the actual amount to be
obtained from the sale of such securities.
2. The cost of each specific source of finance is computed in accordance with the
prevailing market price.
However, there are some practical difficulties for using market value weights. They are as
1. Frequent fluctuation in the market value of securities is a common phenomenon.
2. Market values of securities are not readily available like book values. But book
values are available from the published records of the company.
3. The book value and not the market value is the base for analysing the capital
structure of the company in terms of debt-equity ratio.
Marginal Value Weights

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Under this method, weights are assigned to each source of funds in proportions of financing
inputs the firm intends to employ. This method is based on a logic that the firm is with the
new or incremental capital and not with capital raised in the past.
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SOURCES OF FINANCE
Every business needs funds for two purposes, for its establishment and to carry out its
day-to-day operations. Long-term funds are required to create production facilities
through purchases of fixed assets such as plant, machinery, land, building, furniture, etc.
Investments in these assets represent that part of firm’s capital which is blocked on a
permanent or fixed basis and is called fixed capital. Funds are also needed for short-term
purposes for the purchase of raw materials, payment of wages and other day-to-day
expenses, etc. These funds are known as working capital.
The various sources of raising long-term funds include issue of shares, debentures,
ploughing back of profits and loans from financial institutions, etc. The short-term
requirements of funds can be met from commercial banks, trade credit, instalment credit,
advances, factoring or receivable credit, accruals, deferred incomes, and commercial paper,
etc. The various sources of finance have been classified in many ways, such as
Period Basis
a. Short-term sources-bank credit, customer advances, trade credit, factoring, accruals,
commercial paper, etc.
b. Medium-term sources -issue of preference shares, fixed deposits, etc.
c. Long term sources- issue of shares, debentures, specialised financial institutions. etc.
Debentures, bank loans, public deposits, ploughing back of profits, loans from
Ownership Basis
a. Owned capital- share capital, retained earnings, profits and surpluses, etc.
b. Borrowed capital - debentures, bonds, public deposits, loans, etc.
Source of Finance
Finance
a. Internal sources- ploughing back of profits, retained earnings, profits, depreciation
funds, etc.
b. External sources- shares, debentures, public deposits, loans, etc. surpluses and
Mode of Financing
a. Security financing or external financing-financing through raising of corporate
securities such as shares, debentures, etc.
b. Internal financing- financing through retained earnings, capitalisation of profits
and depreciation of funds, etc
c. Loan financing through raising of long-term and short term loans.
SECURITY FINANCING
Corporate securities can be classified under two categories
Ownership securities or capital stock.
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Creditor ship securities or Debt Capital.

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Ownership securities
Ownership securities, also known as capital stock represents shares. The capital of a
company is divided into a number of equal as shares. Section 2[46] of the Companies act,
1956 defines it as “a share in the share capital of a company, and includes stock except
where difference between stock and shares is expressed or implied”
The following are the different ownership security
1. Equity Shares
Equity shares, also known as ordinary shares or common shares represent the owners’
capital in company. The holders of these shares are the real owners of the company. Equity
capital is paid after meeting all other claims including that of preference shareholders. They
take risk both regarding dividend dud return of capital. Equity share capital cannot be
redeemed during the life time of the company.
Characteristics of Equity Shares
The following are the most significant features of equity shares
1. Maturity. Equity shares provide permanent capital to the company and cannot be
redeemed during the life time of the company. Equity shareholders can demand
refund of their capital only at the time of liquidation of a company. Even at the time
of liquidation, equity capital is paid back after meeting all other prior claims
including that of preference shareholders.
2. Claims/Right to Income. Equity shareholders have a residual claim on the income of
a company. They have a claim on income left after paying dividend to preference
shareholders. The rate of dividend on these shares is not fixed, that is why, and
equity shares are also known as ‘variable income security’.
3. Claim on Assets. Equity shareholders have a residual claim on ownership of
company’s assets. In the event of liquidation of a company, the assets are utilised
first to meet the liabilities of creditors, preference shareholders but everything left,
thereafter, belongs to the equity shareholders.
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4. Voting
Voting Rights. Equity shareholders are the real owners of the company. They have
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voting rights in the meeting of the company and have a control over the working of

the company. Directors are appointed in the Annual General Meeting by majority
votes. Each equity shareholders has votes equal to the number of equity share held
by him. Hence, equity share holders exercise an indirect control over the working of
the company.
5. Pre-
Pre-emptive Right. To safeguard the interest of equity shareholders and enable them
to maintain their proportional ownership, section 81 of the Companies Act, 1956
provides that whenever a public limited company proposes to increase its subscribed
capital by the allotment of further shares, such shares must be offered to holders of
existing equity shares in proportion to the paid up capital on these shares. Shares so
offered to shareholders are called Right Shares and their prior right to such is
known as pre-emptive right.
6. Limited Liability. Although equity shareholders are the real owners of the company,
their liability is limited to the value of share they had purchased. If a shareholder
has already fully paid the share price, he cannot be held liable further for any losses
of the company even at the time of liquidation.
Advantages of Equity Shares
Equity shares do not create any obligation to pay a fixed rate of dividend.
Equity shares can be issued without creating any charge over the assets of the
company.
It is a permanent source of capital and the company has not to repay it except under
liquidation
Equity shareholders are the real owners of the company who have the voting rights.
In case of profits, equity shareholders are the real gainers by way of increased
dividends and appreciation in the value of shares.
Disadvantages of Equity Shares
Shares
If only equity share are issued, the company cannot take the advantage of trading on
equity.
As equity capital cannot be redeemed, there is a danger of over capitalisation.
Equity shareholders can put obstacles in management by manipulation and
organising themselves.
During prosperous periods higher dividends have to be paid leading to increase in
the value of shares in the market and speculation.
Investors who desire to invest in safe securities with a fixed income have no
attraction for such shares
2. Pref
Preference
erence Shares
These shares have certain preferences as compared to other types of shares. These shares
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are given two preferences. There is a preference for payment of dividend. Whenever the
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company has distributable profits, the dividend is first paid on preference share capital.
Other shareholders are paid
Types of Preference Shares
Preference shares are of the following types
1. Cumulative Preference Shares. These shares have a right to claim dividend for those
years also for which there are no profits. Whenever there are divisible profits,
cumulative preference shares are paid dividend for all the previous years in which
dividend could not be declared. The dividend goes on cumulating unless otherwise it
is paid.
2. Non-Cumulative Preference Shares. The holders of these shares have no claim for
the arrears of dividend. They are paid a dividend if there are sufficient profits. They
cannot claim arrears of dividend in subsequent years.
3. Redeemable Preference Shares. The company has right to return redeemable
preference share capital after a certain period. The Companies Act has provided
certain restrictions on the return of this capital.
4. Irredeemable Preference Shares. Those shares which cannot be redeemed unless the
company is liquidated are known as irredeemable preference shares.
5. Participating Preference Shares. The holders of these shares participate in the
surplus profits of the company. They are firstly paid a fixed rate of dividend and
then a reasonable rate of dividend is paid on equity shares. If some profits remain
after paying both these dividends, then preference shareholders participate in the
surplus profits.
6. Non-Participating Preference Shares. The shares on which only a fixed rate of
dividend is paid are known as non-participating preference shares. These shares do
not carry the additional right of sharing of profits of the company.
7. Convertible Preference Shares. The holders of these shares may be given a right to
convert their holdings into equity shares after a specific period. These are called
convertible preference shares. The right of conversion must be authorised by the
Articles of Association.
8. Non-Convertible Preference Shares. The shares which cannot be converted into
equity shares are known as non-convertible preference shares.
Features of Preference
Preference Shares
The following are the most significant features of preference shares
1. Maturity. Generally, preference shares resemble equity shares in respect of maturity.
These are perpetual irredeemable and the company is not required to repay the
amount during its life time. It is only at the time of liquidation that a company has to
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repay the preference shareholder after meeting the claim of creditors but before
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paying back the equity shareholders. However, a company may issue redeemable

2. Claims on Income. A fixed rate of dividend is payable on preference shares.

Preference shareholders have prior claim on income (dividend) over equity
shareholders. Whenever the company have distributable profits, the dividend is first
paid on preference share capital.
3. Claims
Claims on Assets. Preference shares have a preference in the repayment of capital at
the time of liquidation of a company. Their claims on assets are superior to those of
equity shareholder. In the event of winding up of the company, their claim is to be
settled first before making any payment to the equity shareholders.
4. Control. Ordinarily, preference shareholders do not have any voting rights; so they
do not have any say in the management or control of the company. However,
shareholders can vote on a resolution which directly affects the rights to be attached
to their preference shares.
5. Hybrid Form of Security. Preference share capital, in the real sense, represents a
hybrid form of security as it includes some features of equity and other of debt
financing. Preference shares provide a number of advantages both to the company
as well as investors r shareholders.
Advantages or Merits of Preference Shares
a. There is no legal obligation to pay dividend on preference shares.
b. Preference shares provide a long-term capital for the company.
c. There is no liability of the company to redeem preference shares during the life time
of the company.
d. Redeemable preference shares have the added advantage of repayment of capital
whenever there are surplus funds with the company.
e. As a fixed rate of dividend is payable on preference shares, these enable a company
to adopt trading on equity
f. As preference share capital is generally regarded as part of company’s net worth, it
enhances the credit worthiness of a firm.
g. Preference shares do not carry voting rights under normal circumstances and hence
there is no dilution of control.
h. As no specific assets are pledged against preferred stock, the mortgage able assets of
the company are conserved.
i. It earns a fixed rate of dividend to investors
j. It is a superior security over equity shares.
k. It provides preferential rights in regard to payment of dividends and repayment of
capital at the time of liquidation of the company.
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Disadvantages of Preference Shares

a. It is an expensive source of finance as compared to debt because generally the
investor’s expect a higher rate of dividend on preference shares as compared to the
rate of interest on debentures.
b. Cumulative preference shares become a permanent burden so far as the payment of
dividend is concerned.
c. Although there is no legal obligation of a company to pay dividend on preference
shares, but frequent delays or non-payment adversely affect the creditworthiness of
the firm.
d. Preference share dividend is not a deductible expense while calculating tax while -
interest is a deductible expense.
e. In some cases, preference shares carry even the voting right and hence the control
and management of the company may be diluted.
f. As the preference shareholders ordinarily do not have any voting rights, they remain
at the mercy of the management for the payment of dividend and redemption of
their capital.
g. The rate of dividend on preference shares is usually lower as comported to the
equity shares.
h. Preference shareholders do not have any charge on the assets of the company while
debentures, usually, provide a charge on all the assets of the company.
i. The market prices of preference shares fluctuate much more than that of
debentures.
3. Deferred shares.
These shares were earlier issued to promoters or founders for services rendered to the
company. These shares were known as Founders Shares because they were normally issued
to founders. These shares rank last so far as payment of dividend and return of capital is
concerned. These shares were generally of a small denomination and the management of
the company remained in their hands by virtue of their voting rights.
4. No Par Stock/Shares
No par stock means shares having no face value. The capital of a company issuing such
shares is divided into a number of specified shares without any specific denomination. The
share certificate of the company simply states the number of shares held by its owner
without mentioning any face value. The value of a share can be determined by dividing the
real net worth of the company with the total number of shares of the company. Dividend on
such shares is paid per share and not as a percentage of fixed nominal value of shares.
5. Sweat Equity
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The term ‘sweat equity’ means equity shares issued by a company to its employees or
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directors at a discount or for consideration other than cash for providing know-how or

making available rights in the nature of intellectual property rights (say, patents or
copyright) or value additions, by whatever name called. The idea behind the issue of sweat
equity is that an employee or director works best when he has ‘sense of belongingness’ and
is amply rewarded. One of the ways of rewarding him is by offering him shares of the
company at low prices, where he is working. It is termed as ‘sweat equity’ as it is earned by
hard work (sweat) of employees and it is also referred to as ‘sweet equity’ as employees
become happy on the issue of such shares. The purpose of sweat equity is to ensure more
loyalty and participation of employees.
CREDITORSHIP SECURITIES
The term ‘creditor ship securities’, also known as ‘debt capital’, represents debentures and
bonds. A debentures or a bond is acknowledgement of a debt. It is a certificate issued by a
company under its seal acknowledging a debt by it to its holders. According to the
Companies Act, 1956, the term debenture includes, “debentures stock, bonds and many
other securities of a company whether contributing a charge the assets of the company or
not”.
Debentures or Bond
A company may raise long-term finance through public borrowings. These loans are
raised by the issue of debentures. A debenture is an acknowledgement of a debt. A
debenture holder is a creditor of the company. A fixed rate of interest is paid debentures.
The interest on debentures is a charge on the profit and loss account of the company.
debentures are generally given a floating charge over the assets of the company. When the
debentures secured, they are paid on priority in comparison to all other creditors.
Types of Debentures
1. Simple, Naked or Unsecured Debentures,
Debentures, These debentures are not given any
security on They have no priority as compared to other creditors. They are treated
along with unsecured creditors at the time of: winding up of the company. So, they
are just unsecured creditors.
2. Secured or Mortgaged Debentures,
Debentures, These debentures are given security on assets or
company. In case of default in the payment of interest or principal amount,
debenture holders can sell the assets in order to satisfy their claims.
3. Bearer Debentures. These debentures are easily transferable; they are just like
negotiable instruments. The debentures are handed over to the purchaser without
any registration deed. Anybody purchasing them with a consideration and in good
faith becomes the lawful owner of the debentures.
4. Registered Debentures,
Debentures, registered debentures require a procedure to be followed for
their transfer. Both the transfer and the transferee are expected to sign a transfer
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voucher. The form is sent to the company along with the registration fees.
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5. Redeemable Debentures.
Debentures These debentures are to be redeemed on the expiry of
certain period. The interest on the debentures is paid periodically but the principal
amount is returned after a fixed period
6. Irredeemable Debentures. Such debentures are not redeemable during the life time
of the country.
7. Convertible Debentures.
Debentures Sometimes convertible debentures are issued by a company
and the shareholders are given an option to exchange the debentures into equity
shares after the lapse of a fixed d period. Convertible debentures may be either ‘Fully
Convertible Debentures’ (FCD’s) or ‘Partly Convertible ntures’ (PCD’s) with or
without buy back facilities.
8. Zero Interest Bonds / Debentures. Zero interest bonds is an instrument recently
introduced in lndia by some companies. It is usually a convertible debenture which
yields no interest. The company does not pay any interest on such debentures. But
the investor in a zero interest bond is compensated for the loss of through
conversion of such bond into equity shares at a specified future date.
9. Zero Coupon Bonds. Zero coupon bonds do not carry any interest but it is sold by
the issuing company at deep discount from its eventual maturity value. The
difference between the issue price and the maturity represents the gain or interest
earned by its investor.
10. First Debentures and Second Debentures.
Debentures From the view of priority in the payment
of interest and repayment of the principal amount, the debentures may be either
first debentures or second debentures, etc debentures which have to be paid back
first or who have preference over other debentures in payment rest or called first
debentures and the debentures who rank after these are known as second
debentures,
11. Guaranteed Debentures. These are debentures or bonds on which the payment of
interest and principal is guaranteed by third parties, generally, banks and
Government, etc.
12. Collateral Debentures. A company may Issue debentures in favour of a lender of
money, generally the banks and financial institutions, as a collateral, subsidiary or
secondary, security for a loan raised by it. These debentures are called collateral
debentures and these become effective only when the company‘s a default in the
repayment of the loan against which these have been issued.
13. Secured Premium Notes (SPNs). The secured premium note is a tradable instrument
detachable warrant against which the holder gets equity shares after a fixed period
of time.
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14. Callable Bond. A callable bond is a bond that can be called in and paid off by the
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issuer at a price, called the ‘call price’, stipulated in the bond contract. It gives the

advantage to Issuer Company to the existing bonds if the interest rates fall in the
market below the bond’s coupon rate.
15. Floating / Variable or Adjustable Rate Bonds. The rate of interest payable on these
bonds periodically depending upon the market rate of interest payable on the gilt
edged securities.
16. Deep. Discount Bonds (DDBs). The deep discount bond does not carry any interest
but it is sold by the issuer company at a deep discount from its eventual maturity
(nominal) value.
17. Inflation Adjusted Bonds (lABs). These are the bonds on which both interest as well
as principal is adjusted in line with the price level changes or the inflation rate.
Features of Debentures or Bond:
The salient characteristics of debenture as below.
1. Maturity. Although debentures provide long term funds to a company, they mature
after a specific period. Generally, the debentures are to be repaid at a definite time as
stipulated in the issue. The company must pay back the principal amount on these
debentures on the given date otherwise the debenture holders to force winding up of
the company as creditors.
2. Claims on Income. A fixed rate of interest is payable on debentures. Even if a
company makes no earnings or incurs loss, it is under an obligation to pay interest
to its debenture holders. The default in payment of interest may cause winding up of
company because the debenture holders may take recourse to law for the same.
3. Claims on Assets. Even in respect of claim on assets, debenture holders have priority
of claim on assets of the company. They have to be paid first before making any
payment to the preference or equity shareholders in the event of liquidation of the
company. However, they have a claim for the principal amount and Interest due
only and do not have any share in the surplus assets of the company,
4. Control. Since, debenture holders are creditors of the company and not its owners;
they do not have any control over the management of the company. They do not
have any voting rights to elect the directors of the company or on any other matters.
5. Call Feature. Issue of debentures sometimes provides a call feature which entitles the
company to redeem its debentures at a certain price before the maturity date. Since,
the call feature provides advantages to the company at the expense of its debenture
holders, the call price is usually more than the issue price.
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Advantages of Debentures
1. Debentures provide long-term funds to a company.
2. The rate of interest payable on debentures is, usually, lower than the rate of dividend
paid on shares.
3. The interest on debentures is a tax deductible expense and hence the effective cost of
debentures (debt-capital) is lower as compared to ownership securities where
dividend is not a tax deductible expense.
4. Debt financing does not result into dilution of control because debenture holders do
not have any voting rights.
5. A company can trade on equity by mixing debentures in its capital structure and
thereby increase its earnings per share, -
6. Debentures provide flexibility in the capital structure of a company as the same can
be redeemable as and when the company has surplus funds and desires to do so.
7. Debentures provide a fixed, regular and stable source of income to its investors.
8. It is comparatively a safer investment because debenture holders have either a
specific or a floating charge on all the assets of the company and enjoy the status of
a superior creditor in the event of liquidation of the company.
9. Many investors prefer debentures because of a definite maturity period.
10. A debenture is usually more liquid investment and an investor can sell or mortgage
his instrument to obtain loans from financial institutions.
Disadvantages of Debenture Finance
1. The fixed interest charges and repayment of principal amount on maturity are legal
obligations of the company. These have to be paid even when there are no profits.
Hence, it is a permanent burden on the company. Default in these payments.
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Adversely affects the credit-worthiness of the firm and even may lead to winding up
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of the company.

2. Charge on the assets of the company and other protective measures provided to
investors by the issue of debentures usually restrict a company from using this
source of finance.
3. The use of debt financing usually increases the risk perception of investors in the
firm. This enhanced financial risk increases the cost of equity capital.
4. Cost of raising finance through debentures is also high because of high stamp duty.
5. A company whose expected future earnings are not stable or who deals in products
with highly elastic demand or who does not have sufficient fixed assets to offer as
security to debenture holders cannot use this source of raising funds to its benefit.
6. Debentures do not carry any voting rights and hence its holders do not have any
controlling power over the management of the company.
7. Debenture holders are merely creditors and not the owners of the company. They do
not have an claim on the surplus assets and profit of the company beyond the fixed
interest and their principal amount.
8. Interest on debentures is fully taxable while shareholders may avoid tax by way of
stock dividend (bonus shares) in place of cash dividend.
9. The prices of debentures in the market fluctuate with the changes in the interest
rates.
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DIVIDEND POLICY AND DECISIONS

Dividend refers that part of profit of a company which is distributed by the company
among its shareholders. Dividends may be brought into different categories in accordance
with the forms in which they are paid. The following are the various forms of dividends.
1. Cash Dividend
Dividend is usually paid in cash. When dividend is paid in cash, it is known as cash
dividend, But the payment of dividends in cash involves outflow of funds from the firm.
Thus a firm should have enough cash in its bank account when cash dividends are
declared. When cash dividend is paid, both the cash account and the reserves account of the
firm will be curtailed. Hence, both the net worth and the total assets of the firm are reduced
when the cash dividend is distributed. Moreover, the market price of the share comes down
in most cases by the amount of the cash dividend distributed.
2. Stock Dividend [Bonus Shares]
When a firm issues its own shares to the existing shareholders in lieu of or in addition to
cash dividend, it is called stock dividend or scrip dividend. In India, the payment of stock
dividend is popularly termed as “issue of bonus shares”. The issue of bonus shares has the
effect of increasing the number of outstanding shares of the firm. The shares are distributed
proportionately. Hence, a shareholder retains his proportionate ownership of the firm. The
declaration of the bonus shares will enhance the paid-up share capital and curtail the
reserve and surplus (retained earnings) of the firm. Bonus issue is merely an accounting
transfer from reserves and surplus to paid-up capital.
Advantages of bonus shares
a. It conserves the company’s liquidity as no cash leaves the company.
b. The shareholder who receives a dividend can be converted into cash as and when he
wants through selling the additional shares,
c. It broadens the capital base and enhances image of the company. –
d. It helps to decline the market price of the shares, rendering the shares more
marketable.
e. It is an indication to the prospective investors about the financial soundness of the
company.
f. It is one of the best ways of bringing the paid up capital of the company in line with
actual capital employed in the business,
g. It is an inexpensive method of raising capital by which the cash resources of the
company are preserved.
h. It absolves the liability of the shareholders when bonus is applied for converting
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partly paid up shares into fully paid-up.

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Disadvantages of bonus shares

a. After bonus issue, there is a sharp fall in the future market price of the share.
b. The rate of dividend in future will come down.
c. Lengthy legal procedures and approvals are involved in the issue of bonus shares.
d. When the conversion of partly paid-up shares into fully paid-up shares is made the
company foregoes cash equivalent to the amount of bonus applied for this purpose.
SEBI Guidelines on Bonus Issues
The company shall, while issuing bonus shares ensure the following guidelines issued by
the Securities Exchange Board of India (SEBI) on 11th June, 1992.
1. The bonus issue is made out of free reserves built out of the genuine profits or share
premium collected in cash only.
2. Reserves created by revaluation of fixed assets are not capitalised.
3. The development rebate reserve or the investment allowance reserve is considered as
free reserve in order to calculate residual reserve test. –
4. The residual reserves after the proposed capitalisation shall not be less than 40 % of
the increased paid-up capital.
5. All contingent liabilities disclosed in the audited accounts which have the bearing on
the net profits shall be considered for computing residual reserves.
6. The declaration of bonus issue, in lieu of dividend, is not made.
7. The bonus issue is not made unless the partly-paid sh4es, if any existing, are made
fully paid-up.
8. No bonus issue shall be made within 12 months of any public/right issue.
9. No bonus issue shall be made which will dilute the value or rights of the holders of
debentures, convertible fully or partly.
10. Consequent to the issue of bonus shares if the subscribed and paid-up capital
exceeds the authorised share capital, a resolution shall be passed by the company at
its general body meeting for enhancing the authorised capital.
11. There should be a provision in the Articles of Association of the company for
capitalisation of reserves, etc., and if not, the company shall pass a resolution at its
general body meeting making provisions in the Articles for capitalisation.
12. A company which announces its issue after the approval of the Board of directors
should implement the proposals within a period of six months from the date of such
approval and shall not have option of changing the decision.
3. Bond Dividend
A firm may issue bonds for the amounts due to shareholders by way of dividends if it
does not have enough funds to pay dividend in cash. The purpose behind such an issue is
46
the postponement of payment of immediate dividend in cash. Here the bondholders get
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regular interest on their bonds in addition to the bond money on the due date. In India,
bond dividend is not popular.
4. Property Dividend
Dividend
Property dividend is also not popular in India. When a firm pays dividend in the form of
assets other than cash, it is called property dividend. The payment of such a dividend may
be in the form of a firm’s product or in the form of certain assets which are not required by
the firm.
5. Interim Dividend
A dividend which is declared before the declaration of the final dividend is called the
interim dividend. In other words, interim dividend is a dividend which is declared between
two annual general meetings. If the profits of the company appear to be justified for the
payment of interim dividend, the Board of directors may from time to time pay to the
members such dividends. While deciding to declare an interim dividend, the directors
should take into consideration the future prospects of the profits, cash resources etc., of the
company.
DIVIDEND POLICY
Dividend policy is the policy concerning the amount of profits to be distributed as dividend.
Usually companies through their Board of Directors evolve a pattern of dividend payment
which has a bearing on future action. The power to recommend/declare dividends vests
completely in the board of directors of the company.
Factors Affecting Dividend Policy
The factors affecting dividend policy are divided into:
I. External
External Factors
The following are the various external factors affecting dividend policy of the company:
1. General State of Economy: The management’s decision to retain or distribute earnings of
the firm mainly relates to the general state of economy. However, the management may
prefer to retain the whole or part of the earnings with a view to building up reserves during
Uncertain economic and business conditions, depression, prosperity and inflation
2. State of Capital Market:
Market A firm can follow a liberal dividend policy if it has an easy access
to the capital market on account of its financial strength or favourable conditions prevailing
in the capital market. However, a firm is likely to adopt a more conservative dividend policy
if it has no easy access to capital market because of its weak financial position or
unfavorable conditions in the capital market.
3. Legal Restrictions: A firm may also be legally restricted from declaring and paying of
dividends. The Companies Act of 1956 contains several restrictions relating to the
declaration and payments of dividends.
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The following are some of the legal restrictions imposed on dividend declaration of
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companies.

a. A company is entitled to pay dividend only out of its

a. current profits,
b. past accumulated profits
c. money provided by the Central or State Governments for the dividend
payments in pursuance of the guarantee given by the Government. However,
the dividend payment out of capital is illegal.
b. A company is not entitled to pay dividend unless it has provided for current and all
arrears of depreciation, and a certain percentage of net profits of that year has been
transferred to the reserves of the company.
c. A company can use the past accumulated profits for the declaration of dividends
only in accordance with the rules framed by the Central Government in this behalf.
d. The Income tax Act also prescribes certain restrictions about the payment of
dividend. The management should consider all the legal restrictions before taking
the dividend decision.
4. Contractual Restrictions:
Restrictions: Restrictions which are imposed by the lenders of the firm are
called contractual restrictions. The lenders of the firm lay down restrictions on dividend
payment to protect their interest particularly during the period when the firm is
experiencing liquidity or profitability crisis.
5. Tax Policy: The tax policy followed by the Central Government also affects the dividend
policy of the firm. Sometimes the government provides tax incentives to those companies
which retain most of their earnings. In such a situation, the management is inclined to
retain a larger amount of the firm’s earnings.
Internal Factors
Various internal factors which affect the dividend policies of the firm are as follows:
1. Desire of the Shareholders: Shareholders expect returns from their investment in a
firm in the form of both capital gains and dividends. Capital gain relates to the profit as a
result of the sale of capital investment, i.e., equity shares in the case of shareholders.
Dividends are the regular return expected by the shareholders on their investment in a
firm. The desire of the shareholders to get dividends takes priority over the desire to earn
capital gains on account of the following reasons.
2. Future requirements: The prudent management should give more weightage to the
financial needs of the company than the desire of the shareholders. While retained earnings
help for the further growth of the firm, the payment of dividend will adversely affect both
the owner’s wealth and long term growth of the firm. Thus a firm requires an optimum
dividend policy which should maximise the firm’s wealth and provide enough funds for the
growth in future.
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3. Nature of Earnings: A firm whose income is stable can afford to have a higher
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dividend payout ratio than a firm which does not have such stability in its earnings.

4. Liquidity Position: The payment of dividends usually involves cash outflow. Thus
sometimes, a firm which has adequate earnings may not have sufficient cash to pay
dividends. It is, therefore, the duty of the management to see the liquidity aspect of the firm
before and after payment of dividends wh1’e taking the dividend decision. The management
should keep in mind that, in no case can the liquidity ratio be less than 1:1 after the
payment of dividends.
5.Desire of Control:
Control: The desires of the shareholders or management should also
influence the dividend policy of the firm. If a firm issues additional equity shares for raising
funds, it will dilute control which is detrimental to the existing equity shareholders. Thus in
the case of strong desire for control, the management prefers a smaller dividend payout
ratio and hence low rate of dividend.
6. Age of the company: a newly established concern has to limit payment of dividend
and retain substantial part of earnings for financing its future growth and development,
while older companies can afford to pay liberal dividends because of sufficient reserves.
Types of dividend policy
1. Regular dividend policy
Payment of dividend at the usual rate is termed as regular dividend. Regular dividends can
be maintained by companies of long standing and stable earnings. The main advantage of
regular dividend policy is;
a. Establishes a profitable record of the company
b. Creates confidence among shareholders
c. Stabilizes market price of shares
d. Meets the day to day living expenses of the ordinary shareholders
e. Aids long term financing.
2. Irregular dividend policy
Some companies follow irregular dividend policy on account of uncertainty of earnings,
unsuccessful business operations, lack of liquid resources, etc
3. No dividend policy
A company may follow a policy of paying no dividends presently because of unfavourable
working capital position or requirement of funds for future expansion and growth.
4. Stable dividend policy
Stable dividends relate to the consistency or lack of variability in the streams of dividends
payments. It means a regular payment of a certain minimum amount as dividend or
earnings/profits may fluctuate from year to year but not the dividend. The stability of
dividends can be in any of the following three forms:
a. Constant Dividend per Share
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Under this policy, the firm pays a certain fixed amount per share by way of
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dividends. This fixed sum per share is paid year after year irrespective of the level of

earnings of the firm. When the earning increases, the amount of dividend also increases if
the firm can maintain the new level in future. Moreover, there will not be any change in the
payment of dividend in the cast of temporary increase in earnings.
b. Constant Percentage
Under this policy, a certain percentage of net earnings/profits is paid year after year
as dividend to the shareholders, In the case of constant payout ratio policy the amount of
dividend fluctuates in direct proportion to the earnings of the firm. As per this policy when
the earnings of a firm decrease, the dividend will naturally be low.
c. Constant Dividend per Share plus Extra Dividend
Under this policy, fixed dividend per share is paid to the shareholders. But during
market prosperity, additional or extra dividend is paid over and above the regular dividend.
This extra dividend is waived immediately on the return of normal conditions.
The most appropriate policy is the constant dividend per share. This is due to the fact
that most investors expect a fixed rate of return from their investment which should
gradually go up over a period of time. But in the case of the constant percentage of net
earnings policy, the return to the shareholders varies in accordance with the earnings. The
management may be in favour of constant percentage policy as it correlates the amount of
dividend to the firm’s ability to pay dividend. However, the shareholders are against it as it
involves uncertainties. But the constant dividend per share plus extra dividend policy is not
preferred by the shareholders because of its general uncertainty about the extra dividend.
Advantages of Stability of Dividend
A stable dividend policy is advantageous from the point of view of shareholders and the
firm on account of the following reasons.
1. Expectation of Current
Current Income: Many investors such as retired persons, widows, etc.,
consider dividend as a source of income to meet their current living expenses. Such
expenses are almost fixed in nature and hence a stable dividend policy should have least
inconvenience to these investors.
2. Perception of Stability: When a firm declares regular dividend, the shareholders
usually accept it as a sign of normal operation. But, a decline in the rate of dividend will be
considered as a token of expected trouble in the future. Thus most of the shareholders
would like to dispose their shares without further checking. As a result, the market value of
the firm’s shares will come down. Such uncertainties can be avoided if the firm follows a
stable dividend policy.
3. Requirements of Institutional
Institutional Investors: Usually, the shares of the companies are
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acquired both by individuals and institutions. But every firm would like to sell its shares to
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financial institutions as they are the largest buyers of shares in the corporate sector in our

country. As such, a stable dividend policy is a prerequisite to attract the investible funds of
these institutions.
4. Raising Additional Finance: For raising additional funds from external sources, a
stable dividend policy is beneficial to the firm. The investors develop confidence in such a
firm for further issue of shares.
DIVIDEND THEORIES
Dividend decision is one of the unique areas of financial management as the firm is to
choose one between the two alternatives, viz, (i) distribute the profits to the shareholders as
dividend, and (ii) retain profits in the business (i.e., ploughing back of profit). Thus it is
required to consider which alternative use is consistent with the object of wealth
maximization or there is a relationship between dividends and value of the firm which
should be carefully considered before any dividend decision. There are conflicting theories
regarding impact of dividend decision on the valuation of a firm. However, the view points
of these two schools of thought may be brought under the following two groups:
1. Relevance Concept of Dividend
2. Irrelevance Concept of Dividend
1. Relevance Concept of Dividend
Myron Gordon, James Walter and others are associated with the relevance concepts of
dividend. According to them, dividend policy of a firm has a direct effect on the position of
a firm in a stock market. This is mainly due to the fact that dividends actually communicate
information relating to the profit earning capacity of a firm to the investors. There are two
notable theories, viz, (a) Gordon’s Model, and (b) Walter’s Model explaining this concept.
GORDON’S MODEL (DIVIDEND GROWTH VALUATION MODEL)
Myron Gordon assumes a constant level of growth in dividends in perpetuity. According to
him, the dividends of most companies are expected to grow and evaluation of value of
shares based on dividend growth is often used in valuation.
Assumptions of Gordon’s model
1. Retained earnings represent the only source of financing.
2. Rate of return is constant.
3. The firm has perpetual or long life.
4. Cost of capital remains constant and is greater than growth rate.
5. Growth rate of the firm is the product of retention ratio and its rate of return.
6. Tax does not exist.
This model implies that when the rate of return is more than the cost of capital, the
price per share goes up as the dividend ratio comes down and in case the return is less than
cost of capital it is vice versa. However, the price per share remains constant in case the rate
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of return and discount rate are equal.

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WALTER’S VALUATION MODEL

Prof. James E. Walter suggests that dividend policy and investment policy of a firm are
interlinked and hence the dividend decision always affects the value of a firm. His
proposition clearly states the relationship between the firm’s internal rate of return[r] and
its cost of capital[k]. In short, in case the firm’s return on investment is more than the cost of
capital, it must retain its earnings and otherwise it should distribute its earnings to the
shareholders. Thus Walter’s model implies that:
The optimal payout
payout ratio for a growth firm [r >k] is nil.
nil A firm is said to be a growth
firm when it has adequate profitable investment opportunities and its rate of
return[r] is more than cost of capital[k].
The optimal payout ratio for a normal firm [r=k]is irrelevant
irrelevant. A firm is said to be
normal when its dividend policy does not affect the market price of a share and rate
of return is equal to cost of capital.
The optimal payout ratio for a declining firm [r<k] is 100%. A firm is said to be a
declining firm when it does not have profitable investment opportunities to invest its
earnings and its rate of return is less than cost of capital.
Assumptions of Walter’s model
a. All financing is done through retained earnings and external sources of funds like
debt or new equity capital are not used.
b. The firm has an infinite life and is a going concern.
c. It assumes that the internal rate of return [r] and cost of capital [k] are constant.
d. All earnings are either distributed as dividend or invested internally at once.
e. There is no change in the key variables such as Earning per Share and Dividend per
Share.
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Criticisms of Walter’s Model

1. Walter assumes that the financial needs of a firm are met only by retained earnings
and not by external financing. However, it is seldom true in real world situations.
2. Walter also assumes that the firm’s internal rate of return remains constant. This
assumption does not hold good. Because, when more investment proposals are taken,
[r] also generally comes down.
3. The model also assumes that the cost of capital remains constant. This assumption
does not hold good in the real world situation. Because, if the risk pattern of a firm
changes, there is a corresponding change in the cost of capital.
II.Irrelevance
II Irrelevance Concept of Dividend
1. RESIDUAL APPROACH
According to this approach dividend decision has no effect on the wealth of the
shareholders or the price of the shares. The basic desire of the investors is to earn higher
return on their investment. And they do not differentiate between dividend and retention of
profit by firms. If the firm is not in a position to find profitable investment opportunities, the
investors would prefer to receive the earnings in the form of dividends. Thus if a firm
should retain the earning of it has profitable investment opportunities otherwise it should
pay them as dividend
2. MODIGLIANI-
MODIGLIANI-MILLER [MM] HYPOTHESIS
The irrelevance concept of dividend is provided by Modigliani & Miller in a comprehensive
manner. They argue that a firm’s dividend policy has no effect on its value of assets. They
have also argued that the value of shares of a firm is determined by its earning potentiality
and investment policy and never by the pattern of income distribution. Thus the value of the
firm is unaffected by dividend policy, i.e., dividends are irrelevant to shareholders wealth.
Assumptions of MM Model
They build their arguments on the basis of the following assumptions:
Capital markets are perfect.
There are no personal or corporate income taxes.
The firm’s capital investment policy is independent of its dividend policy.
Investors behave rationally. They freely get information and there are no floatation
and transaction costs.
Dividend policy has no effect on the firm’s cost of equity.
Risk or uncertainty does not exist.
The crux of MM hypothesis is that firm’s value depends on its asset investment policy rather
than on how earnings are split between dividends and retained earnings. In accordance
with the M-M hypothesis, the market value of a share in the beginning of the period is
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equal to the present value of dividends paid at the end of the period plus the market price of
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the share at the end of the period. Thus the market price of a share after dividend declared
is computed by applying the following formula.
Criticism of M-M Hypothesis

M-M hypothesis is subject to severe criticism by virtue of unrealistic nature of assumptions.
They are as follows:
a. Tax Differential: M-M hypothesis assumes that taxes do not exist. This assumption is far
from reality. In real life, the shareholders will have to pay tax. But there are different rates
of tax for capital gains and dividends, Thus the cost of internal financing is cheaper than
that of external financing. In fact, the shareholders are in favour of a dividend policy with
retention of earnings as against the payment of dividends by virtue of tax differential.
b. Existence of Floatation Costs: M-M also assumes that both the internal as well as the
external financing are equivalent and same. But in true sense, the external financing is
costlier than internal financing since the companies are required to pay floatation costs by
way of underwriting fees and brokers’ commission a and when the funds are raised
externally.
c. Transaction Costs: M-M also assumes that whether dividends are paid or not, the
shareholders wealth will be the same. This assumption is also far from facts. The
shareholders are required to pay brokerage fee, etc., whenever they want to dispose the
shares. Thus they prefer dividends to retain their earnings.
d. Discount Rate: M-M hypothesis assumes that the discount rate is the same whether a
company chooses internal or external financing. This is not correct. In case the shareholders
want to diversify their portfolios, they would like to distribute earnings which they may be
able to invest in such dividends in other companies. In such a case, the shareholders will
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have a higher value of discount rate if internal financing is being used and vice-versa.
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CAPITAL STRUCTURE
According to Gerestenberg “capital structure of a company refers to the
composition or make-up of its capitalisation and includes all long term capital
resources like loans, reserves, shares and bonds”.
Capitalisation refers to the total amount of securities issued by a company
while capital structure refers to the kind of securities and the proportionate amount
that make ups the capitalisation. Financial structure means the entire liability side of
the balance sheet.
The capital structure of a new company may consist of any of the following
forms;
a. Equity shares only
b. Equity and preference shares
c. Equity shares and debentures
d. Equity, preference and debentures
Financial Leverage or Trading on Equity
The use of long term fixed interest bearing debt and preference share capital
along with equity shares 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 sources than their cost so as to increase the return on owner’s equity.
Essential Features of
of Sound or Optimal Capital
Capital Mix
A sound or an appropriate capital structure should have the following essential
features
Maximum possible use of leverage.
The capital structure should be flexible so that it can be easily altered.
To avoid undue financial business risk with the increase of debt.
The use of debt should be within the capacity of a firm. The firm should be in
a position to meet its obligations in paying the loan and interest charges as
and when due.
It should involve minimum possible risk of loss of control.
It must avoid undue restrictions in agreement of debt.
It should be easy to understand and simple to operate to the extent possible.
It should minimise the cost of financing and maximise earnings per share.
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Factors determining the Capital Structure

When funds are needed, the financial manager has to study the pros and cons of the
various sources of finance so as to select the most advantageous capital structure.
The following are the factors influencing the capital structure
1. Financial Leverage or Trading on Equity.
The use of long term fixed interest bearing debt and preference share capital along
with equity share capital is called financial leverage or trading on equity. The use of
long term debt increases or magnifies the earnings per share, if the firm yields a
return higher than the cost debt. The earnings per share also increase with the use of
preference share capital but due to the fact that interest is allowed to be deducted
while computing tax, the leverage impact of debt is much more. However, leverage
can operate adversely also if the rate of interest on long term leans is more than the
expected rate of earnings of the firm. Therefore, it needs caution to plan the capital
structure of a firm.
2. Growth and Stability of Sales.
If the sales of a firm are expected to remain fairly stable, it can raise a higher level of
debt. Stability of sales ensures that the firm will not face any difficulty in meeting its
fixed commitments of interest payment and repayments of debt. Similarly, greater
the rate of growth of sales, greater can be the use of debt in the financing of firm. On
the other hand, if the sales of a firm are highly fluctuating or declining, it should not
employ, as far as possible, debt financing in its capital structure.
3. Cost of Capital.
Cost of capital refers to the minimum return expected by its suppliers. The capital
structure should provide for the minimum cost of capital. The main sources of
finance for a firm are equity, preference share capital and debt capital. The return
expected by the suppliers of capital depends upon the risk they have to undertake.
Usually, debt is a cheaper source of finance compared to preference and equity
capital due to various reasons like, fixed rate of interest on debt, legal obligation to
pay interest and repayment of loan and priority in payment at the time of winding
up of the company. While formulating a capital structure, an effort must be made to
minimise the overall cost of capital.
4. Risk.
There are two types of risk that are to be considered while planning the capital
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structure of a firm viz ; (i) business risk and (ii) financial risk.
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Business risk refers to the variability of earnings before interest and taxes.
Business risk can be internal as well as external. Internal risk is caused due to
improper product mix, non-availability of raw materials, incompetence to face
competition, absence of strategic management etc. External business risk arises due
to change in operating conditions caused by conditions thrust upon the firm which
are beyond its control e.g., business cycles, governmental controls, changes in
business laws, international market conditions etc.
Financial risk refers to the risk of a firm that may not be able to cover its fixed
financial costs. Financial risk is associated with the capital structure of a company. 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. When a firm uses more and
more of debt in its capital mixes the financial risk of the firm increases. It may not be
able to pay the fixed interest charges to the suppliers of debt and they may force to
liquidate. Thus, a firm has to reach a balance between the financial risk and the risk
of non-employment of debt capital to increase its market value.
5. Cash Flow Ability to Service Debt.
A firm which shall be able to generate larger and stable cash inflows can employ
more debt in its capital structure as compared to the one which has unstable and
lesser ability to generate cash inflows. Debt financing implies burden of fixed charge
due to the fixed payment of interest and the principal. Whenever a firm wants to
raise additional funds it should estimate project its future cash inflows to ensure the
coverage of fixed charges
6. Nature and Size of a Firm .
Nature and size of a firm also influence its capital structure. Public utility concerns
may employ more of debt because of stability and regularity of their earnings. On
the other hand, a concern which cannot provide stable earnings due to the nature of
its business will have to rely mainly on capital; similarly, small companies have to
depend mainly upon owned capital as it is very difficult for them to raise long term
loans on reasonable terms and also cannot issue equity and preference shares easily
to the public.
7. Control.
Whenever additional funds are required by a firm, the management of the firm
wants to raise funds without any loss of control over the firm. In case the funds are
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raised through the issue of equity shares, the control of the existing shareholders is
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diluted. Hence, they might raise the additional funds by way of fixed interest bearing

debt and preference share capital. But, depending largely upon debt financing may
create other problems, such as, too much restriction imposed upon by the lenders or
suppliers of finance and this may result into even a complete loss of control by way
of liquidation of the company.
8. Flexibility.
Capital structure of a firm should be flexible, ie, it should be such as to be capable
of being adjusted according to the needs of the changing conditions. It should be
possible to raise additional funds, whenever the need be, without much of difficulty
and delay. A firm should arrange its capital structure in such a manner that it can
substitute one form of financing by another. Redeemable preference shares and e
debentures may be preferred on account of flexibility Preference shares and
debentures which can be redeemed at the discretion of the firm offer the highest
flexibility in the capital structure.
9. Requirements of Investors.
It is necessary to meet the requirements of both institutional as well as private
investors when debt financing is used. Investors are generally classified under three
kinds, i.e. bold investors, cautious investors and less cautious investors. Bold investors
are willing to take all types of risk, are enterprising in nature, and prefer capital
gains and control and hence equity share capital is best suited to them. Investors
who are over cautious and conservative prefer safety of investment and stability in
returns and hence debentures would satisfy such overcautious investors. Investors
which are less cautious in approach will prefer preference share capital which
provides stability in returns.
10. Capital Market Conditions (Timing).
Capital market conditions do not remain the same forever. The choice of the
securities is also influenced by the market conditions. If the share market is
depressed and there are pessimistic business conditions, the company should not
issue equity shares as investors would prefer safety. But in boom period, it would be
advisable to issue equity shares. Proper timing of issue of securities also saves in costs
of raising funds.
11. Assets Structure.
The liquidity and the composition of assets should also be kept in mind while
selecting the capital structure. If fixed assets constitute a major portion of the total
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assets of the company, it may be possible for the company to raise more of long term
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debts.

12. Purpose of Financing.

If funds are required for a productive purpose, debt financing is suitable and the
company should issue debentures as interest can be paid out of the profits generated
from the investment. However, if the funds are required for unproductive purpose or
prefer equity capital is suitable.
13. Period of Finance.
If the finances are required for a limited period , debentures should be preferred to
shares. Redeemable preference shares may also be used for a limited period finance,
if found suitable otherwise. However, in case funds are needed on permanent basis
equity share capital is more appropriate.
14. Costs of Floatation.
The cost of floating a debt is generally less than cost of floating equity and hence it
may persuade the management to raise debt financing. The cost of floating as a
percentage of total funds decrease with the increase in size of the issue.
15. Personal Considerations.
The personal considerations and abilities of the management will have an influence
on the capital structure of a firm. Managements which are experienced and are risk
taking, will not hesitate to use more of debt in their financing as compared to the less
experienced and conservative management.
16. Corporate Tax Rate.
High rate of corporate taxes on profits compel the companies to prefer debt
financing, because interest is allowed to be deducted while computing taxable
profits. Dividend on shares is not an allowable expense for that purpose.
17. Legal requirements
The govt has also issued certain guidelines for the issue of shares and debentures and
these legal restrictions becomes significant as these lay down a framework within
which capital structure decision has to be made.
Principles of capital structure
The main principles to be considered at the time of capital structure decisions
are;
1. Cost principle
2. Risk principle
3. Control principle
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4. Flexibility principle
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5. Timing principle

Theories of Capital Structure

There are several theories which are used to explain the relationship between
capital structure, cost of capital, and value of the firm. They are as follows:
1. Net Income (NI) Approach
2. Net Operating Income (NOI) Approach
4. Modigliani-Miller Approach
1. Net Income Approach
This approach is suggested by David Durand. According to him, the total value of the
firm may be enhanced by lowering its cost of capital. Thus the value of the firm
depends on its capital structure decision. When cost of capital is the lowest, the value
of the firm is the highest. At this point, the market price per share is maximum and
the firm is said to have optimum capital structure, The same is possible continuously
by lowering its cost of capital by the use of debt capital. A high debt content in the
capital structure (i.e., high financial leverage) will lead to the reduction of the overall
cost of the capital and consequently enhance the value of the firm. Similarly, the
value of the firm will get reduced if the amount of debt is reduced by issuing
additional equity shares. The following are the assumptions of this approach;
There are no corporate taxes.
Cost of debt [kd] is less than cost of equity [ke]
The debt content does not change the risk perception of the investors.
According to this approach, the value of the firm can be computed by using
the following formula.
2. Net Operating Income Approach

The net operating income approach is advocated by David Durand. According
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to him, the value of a firm depends on its net operating income and business risk.
Thus the change in the degree of leverage employed by a firm cannot change its net
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operating income and business risks. But it merely brings variation in distribution of
income and risk between debt and equity without affecting the total income and risk
which influence the market value of the firm. Thus, under this approach any capital
structure will be optimum. Theoretically there will be optimum capital structure
when there is 100% debt content. This is because with every increase in debt,
‘content K’ decreases and the value of the firm increases.
The net operating income approach is based on the following assumptions
The overall cost of capital [k] remains constant for all degrees of leverage (i.e.,
debt- equity mix).
The net operating income is capitalised at an overall capitalisation rate to find
out the total market value of the firm. Thus the split between debt and equity
is irrelevant.
There are no corporate taxes.
The use of low cost debt enhances the risk of equity shareholders, this in turn,
enhances the equity capitalisation rate. Thus the benefit of debt is nullified by
the increase in the equity capitalisation rate.
According to this approach, the cost of capital is dependent on the capital
structure and there is an optimal capital structure which minimises the cost of
capital. The real marginal cost of debt and equity is the same at the optimum capital
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structure. But the real marginal cost of debt is lower than the real marginal cost of
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equity before the optimal point. On the contrary, beyond the optimal point, the real
marginal cost of debt is greater than the real marginal cost of equity.
The main propositions of this approach are as under:
The cost of debt capital, kd, remains more or less constant up to a certain
degree of leverage and thereafter rises.
The cost of equity capital, K1, remains constant more or less or rise gradually
up to a certain degree of leverage and thereafter increases rapidly.
The average cost of capital, K, reduces up to a certain point, and remains more
or less unchanged for moderate increase in leverage and thereafter rises after
attaining a certain point.
The traditional approach or intermediate approach is a midway between the net
income approach and the net operative income approach. Thus it partly contains the
characteristics of both the approaches. They are as follows:
The traditional approach is similar to NI approach to the extent that it accepts
that the capital structure of a firm affects the cost of capital and its valuation.
But it does not subscribe to the NI approach that the value of the firm will
necessarily enhance with all levels of leverage.
It subscribes to the NOI approach that after attaining a certain level of
leverage, the overall cost of capital enhances resulting in decline in the total
value of the firm. But it varies from NOI approach in the sense that the overall
cost of capital will not remain constant for all levels of leverage.
4. Modigliani-
Modigliani-Miller Approach (MM)
MM hypothesis is identical with Net Operating Income approach if taxes are
ignored. 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 the debt-equity mix is irrelevant in the determination of the total value
of a firm. The reason argued is that though 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 of equity, the overall cost of capital remains constant. The
theory emphasises the fact that a firm’s operating income is a determinant of its total
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value.
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Assumptions
The following are the various assumptions underlying MM analysis:
1. There are no corporate taxes
2. There is a perfect capital market
3. Investors act rationally
4. The expected earnings of all the firms have identical risk characteristics
5. All earnings are distributed to shareholders
The Arbitrage Mechanism

MM has suggested an arbitrage mechanism to prove their argument. Arbitrage is an
act of buying an asset or security in one market having lower price and selling it in
another market at a higher price. The result of such an action is that the market
price of the securities of the two firms cannot remain different for long period in
different markets [firms are similar in all respects except their capital structures].
Thus equilibrium in value of securities can be restored with the help of arbitrage
process. This is because in case the market value of the two firms [firms are similar
in all respects except their capital structures] are not similar, investors of the
overvalued firm should dispose their shares, borrow additional funds on personal
account and invest in the undervalued firm with a view to getting the same return
on less investment. When the investor uses debt for the purpose of arbitrage, it is
termed as personal leverage or home made.
b. When the corporate
corporate taxes are assumed to exist [Theory of Relevance]
Modigliani and Miller, have recognised 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 maximising the debt mix in the equity of a firm.
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Criticisms
Criticisms of the MM Hypothesis
The arbitrage process of MM hypothesis fails to bring the desired equilibrium in the
capital markets by virtue of the following facts:
1. Different Rates of Interest for the Individuals and Firms: Modigliani and
Miller assume that the firms and individuals can borrow and lend at the same
rate of interest cannot hold good in reality. This is due to the firms’ greater
credit standing than that of individuals on account of firms’ large holding of
fixed assets.
2. Personal Leverage is not the Perfect Substitute for Corporate Leverage: The
hypothesis that personal leverage is the substitute for ‘corporate leverage’ is
not true as there is unlimited liability in the case of individuals and firms may
have a limited liability. Thus both the firms and individuals have different
stand in capital market.
3. Institutional Restrictions: The choice of the switching over from levered to
unlevered firm and vice-versa is available to all investors, particularly,
institutional investors such as LIC, UTI, commercial banks, etc. Thus in reality
arbitrage process is retarded by institutional restrictions,
4. Existence of Transaction Cost: Usually transaction costs in the form of
brokerage or commission etc., are involved in buying and selling of securities.
Thus the investors are required to invest a higher amount in the shares of
levered/unlevered firms than their present investment to earn the same
return.
5. Incorporation of Corporate Taxes: Owing to corporate taxes, the cost of
borrowing funds to the firm is lower than the contractual rate of interest.
Thus, the total return to the shareholders of a levered firm is more than that
of an unlevered firm. On account of this fact, the total market value of a
levered firm tends to exceed that of the unlevered firm.
Reasons for
for change in capitalisation
Tue following are the main reasons necessitating change in capitalisation
• To Restore Balance in the Financial Plan. If the financial structure of a
company has become top heavy with fixed interest bearing securities
resulting into a great strain on the financial position of the company. The
company may readjust its capital structure by redeeming the preference
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shares or debentures out of the proceeds of new issue of equity shares.

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• To Simplify the Capital Structure. When a company has issued a variety of

securities at different points of time to raise funds at difficult terms, it may
need to consolidate such securities to simplify the financial plan as and when
the market conditions are favourable.
• To Suit Investor’s Needs. The companies, often, resort to split up of its shares
to make these more attractive especially when the market activity in the
company’s shares is limited due to high face value and wide fluctuations in its
market prices.
• To fund Current Liabilities. Sometimes, the companies feel that they need
working capital oil permanent basis. In such circumstances, the companies
would prefer to convert their short―term obligations into long―term by
taking advantage of favourable market conditions.
• To capitalise retained earnings.
earnings. To avoid over capitalisation, maintain a
balance between equity, preference share and debentures, a company may
prefer to issue bonus shares out of its accumulated profits and resources
without affecting its liquidity.
• To facilitate merger and expansion
expansion.
ion The intending companies may be
required to readjust capital structure to equate the shares of different
companies.
Point of indifference
Equivalency point of indifference point refers to that EBIT level at which the EPS
remains the same irrespective of difference alternatives of debt-equity 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 breakeven level of EBIT for alternative financial plans
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Financial breakeven point

Financial breakeven point may be defined as that level of EBIT which is just equal to
pay the total financial leverage , interest and preference dividend. At this point or
level of EBIT, the earnings per share equals zero.
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LEVERAGE
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; i.e. equity shareholders. James Horne has defined leverage as “the
employment of an asset or sources of funds for which the firm has to pay a fixed cost or fixed
return.” The fixed cost or fixed operating cost and fixed return remains constant irrespective of the
change in volume of output or sales. Thus, the employment of an asset or source of funds for which
the firm has to pay a fixed cost or return has a considerable influence on the earnings available for
equity shareholders. Higher is the degree of leverage, higher is the risk as well as return to the
owners and the leverage can have negative or reversible effect also. It may be favourable or
favourable.
There are basically two types of leverages, (i) operating leverage, and (ii) 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 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.
1. Financial Leverage or Trading On Equity
The use of long-term fixed interest bearing debt and 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. The fixed cost funds are employed in such a way that the
earnings available for common stockholders are increased. A firm is known to have a favourable
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 unfavourable leverage.
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 DFL can be
calculated as:
Significance of financial leverage

1. The financial leverage helps to plan the capital structure of the company by analysing the
cost of capital and financial risk.
2. The earnings per share is affected by the degree of financial leverage. There for financial
leverage is important in profit planning
Limitations of financial leverage
67
1. Trading on equity is a double edged weapon. It can be employed favourably when the rate
of earnings of the company is more than the fixed rate of interest on external financing.
Page
2. Trading on equity is beneficial only to the companies having stable earnings.

3. Extra debt in the capital structure increases the risk of the company and hence the rate of
interest on subsequent financing also increases.
4. The financial institutions impose restriction on companies using trading on equity because
the risk factor and to maintain a balance in capital structure of the company.
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 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 is sales. The occurrence is known as operating leverage. The degree of operating leverage
depends upon the 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
3. Composite Leverage
Operating leverage affects the income which is the result of production. Financial leverage
is the result of financial decisions. Composite leverage focuses attention on the entire income of the
concern. The high degree of financial leverage may be offset against low operating leverage or vice
versa. The degree of composite leverage can be calculated as follows:
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Financial Management III Semester B.

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SCOPE OF FINANCIAL MANAGEMENT

2. Deciding Capital Structure

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5. Proper Cash Management.

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OBJECTIVES OF FINANCIAL MANAGEMENT

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TIME VALUE OF MONEY

Doubling period = 0.35+(69/ Rate of interest)

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An annuity is a series of equal payments lasting for some specified duration.

V0= R [ADF i,n]

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WORKING CAPITAL MANAGEMENT

2. Net working capital

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current liability. Current assets.

It is a concept very popular in

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accounting system. financial management circles.

In case of a manufacturing firm,

(b) Inventories into accounts receivable;

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The Working Capital includes the following broad classifications

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of current asset is referred to as permanent working capital. It is termed as Regular

Dangers of Excess Working Capital

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4. Firm’s credit policy

5. Access to money market

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6. Expansion and growth of business

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capital in one period may therefore, be bigger than that in another.

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PLANNING OF WORKING CAPITAL

SOURCE OF WORKING CAPITAL

Source of working capital can be basically classified into following;

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1. Long term source

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is called reserve fund.

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industrial plant and machinery or durable customer goods.

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Significance of Cost of Capital

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This indicates that:

a. Investors have full-fledged freedom to buy and sell securities.

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b. As investors are completely knowledgeable and rational persons, they can

Cost of Redeemable Debt: When debentures

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2. Cost of Preference Share Capital