INTERMEDIATE (IPC) COURSE

STUDY MATERIAL

PAPER : 3
COST ACCOUNTING AND
FINANCIAL MANAGEMENT
Part 2 : Financial Management

MODULE 2

BOARD OF STUDIES
THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

The Institute of Chartered Accountants of India

This study material has been prepared by the faculty of the Board of Studies. The objective of
the study material is to provide teaching material to the students to enable them to obtain
knowledge in the subject. In case students need any clarifications or have any suggestions to
make for further improvement of the material contained herein, they may write to the Director
of Studies.
All care has been taken to provide interpretations and discussions in a manner useful for the
students. However, the study material has not been specifically discussed by the Council of
the Institute or any of its Committees and the views expressed herein may not be taken to
necessarily represent the views of the Council or any of its Committees.
Permission of the Institute is essential for reproduction of any portion of this material.

The Institute of Chartered Accountants of India

All rights reserved. No part of this book may be reproduced, stored in a retrieval system, or
transmitted, in any form, or by any means, electronic, mechanical, photocopying, recording, or
otherwise, without prior permission, in writing, from the publisher.
Revised Edition

July, 2014

Website

www.icai.org

E-mail

bosnoida@icai.in

Committee/

Board of Studies

978-81-8441-138-6

Department
ISBN No.

Price (All Modules) :

Published by

The Publication Department on behalf of The Institute of

Chartered Accountants of India, ICAI Bhawan, Post Box No.
7100, Indraprastha Marg, New Delhi 110 002, India.

Printed by

Sahitya Bhawan Publications, Hospital Road, Agra 282 003

July/2014/
ii

The Institute of Chartered Accountants of India

CONTENTS

MODULE 1
Chapter 1 Scope and Objectives of Financial Management
Chapter 2 Time Value of Money
Chapter 3 Financial Analysis and Planning
MODULE 2
Chapter 4 Financing Decisions
Chapter 5 Types of Financing
MODULE 3
Chapter 6 Investment Decisions
Chapter 7 Management of Working Capital
Appendix

iii

The Institute of Chartered Accountants of India

DETAILED CONTENTS : MODULE 2

CHAPTER 4 FINANCING DECISIONS
UNIT I :

COST OF CAPITAL

1.1

Introduction ................................................................................................................ 4.1

1.2

Definition of Cost of Capital ........................................................................................ 4.3

1.3

Measurement of Cost of Capital ................................................................................. 4.3

1.3.1 Cost of Debt ..................................................................................................... 4.4
1.3.2 Cost of Preference Shares ............................................................................... 4.8
1.3.3 Cost of Equity ................................................................................................... 4.9
1.3.4 Cost of Retained Earnings .............................................................................. 4.15
1.3.5 Cost of Depreciation ....................................................................................... 4.16

1.4

Weighted Average Cost of Capital (WACC) .............................................................. 4.17

1.4.1 Calculation of WACC ...................................................................................... 4.18

1.5

Marginal Cost of Capital ........................................................................................... 4.21

1.6

Conclusion ............................................................................................................... 4.26

UNIT II : CAPITAL STRUCTURE DECISIONS

2.1

Meaning of Capital Structure .................................................................................... 4.27

2.2

Designing Capital Structure ...................................................................................... 4.27

2.3

Key Concepts for Designing Optimal Structure ......................................................... 4.28

2.3.1 Leverages ...................................................................................................... 4.29
2.3.2 Coverage Ratio .............................................................................................. 4.30
2.3.3 Cash Flow Analysis ........................................................................................ 4.30

2.4

Optimal Capital Structure ......................................................................................... 4.30

2.5

EBIT-EPS Analysis ................................................................................................... 4.30

2.6

Cost of Capital, Capital Structure and Market Price of Share .................................... 4.40

2.7

Capital Structure Theories ........................................................................................ 4.41

iv

The Institute of Chartered Accountants of India

2.7.1 Net Income Approach (NI) .............................................................................. 4.41

2.7.2 Net Operating Income Approach (NOI) ........................................................... 4.43
2.7.3 Modigliani-Miller Approach (MM) .................................................................... 4.45
2.7.4 Traditional Approach ...................................................................................... 4.50
2.8

Capital Structure and Taxation ................................................................................. 4.54

2.9

Over Capitalisation ................................................................................................... 4.55

2.9.1 Causes of Over Capitalisation ........................................................................ 4.55
2.9.2 Consequences of Over Capitalisation ............................................................. 4.56
2.9.3 Remedies for Over Capitalisation ................................................................... 4.56

2.10 Under Capitalisation ................................................................................................. 4.56

2.10.1 Consequences of Under Capitalisation ........................................................... 4.56
2.10.2 Effects of Under Capitalisation ....................................................................... 4.57
2.10.3 Remedies for Under Capitalisation ................................................................. 4.57
2.10.4 Over Capitalisation vis--vis Under Capitalisation .......................................... 4.57
UNIT III : BUSINESS RISK AND FINANCIAL RISK
3.1

Introduction .............................................................................................................. 4.58

3.1.1 Business Risk and Financial Risk ................................................................... 4.58

3.2

Debt versus Equity Financing ................................................................................... 4.59

3.3

Types of Leverage .................................................................................................... 4.60

3.3.1 Operating Leverage ........................................................................................ 4.60
3.3.2 Financial Leverage ......................................................................................... 4.63
3.3.3 Combined Leverage ....................................................................................... 4.65
Summary .................................................................................................................. 4.70

CHAPTER 5 TYPES OF FINANCING

1.

Introduction ................................................................................................................ 5.1

2.

Financial Needs and Sources of Finance of a Business.............................................. 5.2

2.1

Financial Needs of a Business ......................................................................... 5.2

2.2

Sources of Finance of a Business .................................................................... 5.3

v

The Institute of Chartered Accountants of India

2.3
3.

Financial sources of a business can also be classified as follows by using

different basis ................................................................................................... 5.3

Long Term Sources of Finance ................................................................................... 5.4

3.1

Owners Capital or Equity Capital ...................................................................... 5.4

3.2

Preference Share Capital ................................................................................. 5.5

3.3

Retained Earnings ............................................................................................ 5.6

3.4

Debentures or Bonds........................................................................................ 5.6

3.5

Loans from Financial Institutions ...................................................................... 5.8

3.6

Loans from Commercial Banks ......................................................................... 5.9

4.

Venture Capital Financing ....................................................................................... 5.11

5.

Debt Securitisation ................................................................................................... 5.13

5.1

6.

7.

8.

Benefits to the Originator ................................................................................ 5.14

Lease Financing ....................................................................................................... 5.14

6.1

Types of Lease Contracts ............................................................................... 5.14

6.2

Other Types of Leases ................................................................................... 5.16

Short Term Sources of Finance ................................................................................ 5.17

7.1

Trade Credit ................................................................................................... 5.17

7.2.

Accrued Expenses and Deferred Income ........................................................ 5.17

7.3

Advances from Customers ............................................................................. 5.17

7.4.

Commercial Paper .......................................................................................... 5.17

7.5

Bank Advances .............................................................................................. 5.17

7.6

Financing of Export Trade by Banks ............................................................... 5.20

7.7

Inter Corporate Deposits ................................................................................ 5.23

7.8

Certificate of Deposit (CD).............................................................................. 5.23

7.9

Public Deposits .............................................................................................. 5.23

Other Sources of Financing ...................................................................................... 5.23

8.1

Seed Capital Assistance ................................................................................. 5.23

vi

The Institute of Chartered Accountants of India

9.

10.

8.2

Internal Cash Accruals ................................................................................... 5.23

8.3

Unsecured Loans ........................................................................................... 5.24

8.4

Deferred Payment Guarantee ......................................................................... 5.24

8.5

Capital Incentives ........................................................................................... 5.24

New Instruments ...................................................................................................... 5.24

9.1

Deep Discount Bonds ..................................................................................... 5.24

9.2

Secured Premium Notes................................................................................. 5.25

9.3

Zero Interest Fully Convertible Debentures .................................................... 5.25

9.4

Zero Coupon Bonds ....................................................................................... 5.25

9.5

Double Option Bonds ..................................................................................... 5.25

9.6

Option Bonds ................................................................................................. 5.25

9.7

Inflation Bonds ............................................................................................... 5.25

9.8

Floating Rate Bonds ....................................................................................... 5.26

International Financing ............................................................................................. 5.26

10.1 Commercial Banks ......................................................................................... 5.26
10.2 Development Banks ....................................................................................... 5.26
10.3 Discounting of Trade Bills ............................................................................... 5.26
10.4 International Agencies .................................................................................... 5.26
10.5 International Capital Markets .......................................................................... 5.26
10.6 Financial Instruments ..................................................................................... 5.27
10.7 Euro Issues by Indian Companies .................................................................. 5.28
Summary .................................................................................................................. 5.30

vii

The Institute of Chartered Accountants of India