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IGNOU MBA MS -04 Solved Assignments 2010


Course Code : MS-04
Course Title : Accounting and Finance for Managers
Assignment Code : MS-04/SEM-I/2010
Coverage : All Blocks

Note: Please attempt all the questions and send them to the Coordinator of the Study
Centre you are attached with.

Q.1 “Accounting is closely connected with control”. Elaborate the statement and
discuss the role of accounting feedback in the process of control.

Solution: Controls are an integral part of any organization's financial and Accouting Process
Controls consists of all the measures taken by the organization for the purpose of Internal
accounting control and of procedures designed to promote and protect management practices,
both general and financial. Following are the role played by accounting in the process of control.

Developing an Internal Accounting Control System


The first step in developing an effective internal accounting control system is to identify those
areas where abuses or errors are likely to occur. A Guide for Management, includes the
following areas and objectives in developing an effective internal accounting control system:

Cash receipts
To ensure that all cash intended for the organization is received, promptly deposited, properly
recorded, reconciled, and kept under adequate security.

Cash disbursements
To ensure that cash is disbursed only upon proper authorization of management, for valid
business purposes, and that all disbursements are properly recorded.

Petty cash
To ensure that petty cash and other working funds are disbursed only for proper purposes, are
adequately safeguarded, and properly recorded.

Payroll
To ensure that payroll disbursements are made only upon proper authorization to bona fide
employees, that payroll disbursements are properly recorded and that related legal requirements
(such as payroll tax deposits) are complied with.

Grants, gifts, and bequests


To ensure that all grants, gifts, and bequests are received and properly recorded, and that
compliance with the terms of any related restrictions is adequately monitored.

Fixed assets
To ensure that fixed assets are acquired and disposed of only upon proper authorization, are
adequately safeguarded, and properly recorded.

Additional internal controls are also required to ensure proper recording of SALES and other
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revenues, accurate, timely financial reports and information returns, and compliance with other
government regulations.

Achieving these objectives requires your organization to clearly state procedures for handling
each area, including a system of checks and balances in which no financial transaction is handled
by only one person from beginning to end. This principle, called segregation of duties, is central
to an effective internal controls system. Even in a small nonprofit, duties can be divided up
between paid staff and volunteers to reduce the opportunity for error and wrongdoing. For
example, in a small organization, the director might approve payments and sign checks prepared
by the bookkeeper or office manager. The board treasurer might then review disbursements with
accompanying documentation each month, prepare the bank reconciliation, and review canceled
checks.The board and executive director share the responsibility for setting a tone and standard of
accountability and conscientiousness regarding the organization's assets and responsibilities. The
board, usually through the work of the finance committee, fulfills that responsibility in part by
approving many aspects of the internal control accounting system. Common areas requiring board
attention include:

Check issuance
The number of signatures on checks, dollar amounts which require board approval or board
signature on the check, who authorizes payments and financial commitments, etc.

Deposits
How payments made in cash (for admissions, raffles, weekly collection plate, etc.) will be
handled, etc.

Transfers
If and when the general fund can borrow from restricted funds, etc.

Approval of plans and commitments before they are implemented


The annual budget and periodic comparisons of financial statements with budgeted amounts,
leases, loan agreements, and other major commitments.

Personnel policies
Salary levels, vacation, overtime, compensatory time, benefits, grievance procedures, severance
pay, evaluation, and other personnel matters.

The Accounting Procedures Manual


The policies and procedures for handling financial transactions are best recorded in an
Accounting Procedures Manual, describing the administrative tasks and who is responsible for
each. The manual does not have to be a formal document, but rather a simple description of how
functions such as paying bills, depositing cash, and transferring money between funds are
handled. As you start to document these procedures, even in simple memo form, the memos
themselves can be kept together to form a very basic Accounting Procedures Manual. Writing or
revising an Accounting Procedures Manual is a good opportunity to see whether adequate
controls are in place. In addition, having such a manual facilitates smooth turnover in financial
staff.

Maintaining Effective Controls


The FINANCE/ACCOUNTING director is commonly responsible for overseeing the day-to-day
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implementation of these policies and procedures.

The auditor's management letter is an important indicator of the adequacy of your internal
accounting control structure, and the degree to which it is maintained. The management letter,
which accompanies the audit and is typically addressed to the board as trustees for the
organization, cites significant weaknesses in the system or its execution. By reviewing the
management letter with the executive director, asking for responses to each internal control lapse
or recommendation, and comparing management letters from year to year, the board has a useful
mechanism for monitoring its financial safeguards and adherence to financial policies.

As your profit changes and matures, and your funding and programs change, you will need to
periodically review the internal accounting control system which you have established and
modify it to include new circumstances (bigger staff, more restricted funding, etc.) and
regulations (such as receiving federal awards with increased compliance demands.)

Internal Controls Simplified ACCOUNTING INFORMATIONS USED AS CONTROLS:


CASH
-Control Cash Drawers And Credit Cards
-Control Cash Receipts And Deposits
-control system to Manage Problem Checks
-control system to Manage Wire Transfers
-Control to Cheque Signing Authority
-control system to Manage Check Requests
-control system to Manage Bank Account Reconciliations
-control system to Manage Petty Cash

GENERAL & ADMINISTRATIVE


-control system Manage Chart of Accounts
-system to Control Files And Records Management
-control system to Manage Travel And Entertainment
-system to Control Management Reports
-system to Control Period-End Review & Closing
-control system to Manage Controlling Legal Costs
-control system to Manage Taxes And Insurance
-system to Control Property Tax Assessments
-control system to Manage Confidential Information Release
-system to Control Documents

Accounting Forms applied to the CONTROL SYSTEMS.


-Sample Account Codes
-Account Collection Control Form
-Accounts Receivable Write-Off Authorization
-Asset Disposition Form
-Bad Check Notice
-Bank Wire Instructions
-Bill Of Sale
-Budget vs. Actual Report
-Capital Asset Requisition
-Check Request
-Check Signing Authority Log
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-Commercial Invoice
-Credit Application
-Credit Inquiry
-Daily Cash Report
-Daily Flash Report
-Daily Sundry Payable Log
-Department Reporting Summary
-Deposit Log
-Document Change Control
-Entertainment And Business Gift Expense Report
-Financial Statements
-Inventory Count Sheet
-Inventory Inspection Levels
-Inventory Requisition
-Inventory Tag
-Sample Invoice
-Master File Guide Index
-Material Return Notice
-New Vendor Notification
-Non-Disclosure Agreement
-Order And Arrival Log
-Order Form
-Phone Confirmation Checklist
-Purchase Order
-Purchase Order Follow-Up
-Purchase Order Log
-Purchase Requisition
-Receiving and Inspection Report
-Receiving Log
-Records Retention Periods
-Request For Credit Approval
-Request For Document Change
-Returned Goods Authorization
-Sample Sales Order
-Sample Bank And Book Balances Reconciliation
-Shipping Log
-Tax Calendar of Recurring Monthly Dates
-Travel And Miscellaneous Expense Report
-Travel Arrangements Form
-Vendor Survey Form
-Week Cash Flow Report
-Weekly Financial Report
-Wire Transfer Form

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Q.2 You are required to prepare a Schedule of changes in working capital and a Funds
st
Flow Statement from the Balance Sheets of Amazon Ltd as on 31 Dec. 2008 and
2009.
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Liabilities 2008 2009 Assets 2008 2009


Rs. Rs. Rs. Rs.
Share capital 2,00,000 2,00,000 Goodwill 24,000 24,000
Gen. Reserve 28,000 36,000 Buildings 80,000 72,000
P&L A/c 32,000 26,000 Plant 74,000 72,000
Creditors 16,000 10,800 Investments 20,000 22,000
Bills payable 2,400 1,600 Stock 60,000 46,800
Provision for taxation 32,000 36,000 Bills receivable 4,000 6,400
Provision for doubtful Debtors 36,000 38,000
debts. 800 1,200 Cash & Bank balance 13,200 30,400

3,11,200 3,11,600 3,11,200 3,11,600

Additional information:
a) Depreciation provided on plant was Rs. 8,000 and on Buildings Rs. 8,000
b) Provision for taxation made during the year Rs. 38,000
c) Interim dividend paid during the year Rs. 16,000

Solution: Coming soon ….

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Q.3 Take a suitable example and explain the impact of cost and volume changes
on the profits of a business.

Solution: Cost-volume-profit (CVP) analysis expands the use of information provided by


breakeven analysis. A critical part of CVP analysis is the point where total revenues equal total
costs (both fixed and variable costs). At this breakeven point (BEP), a company will experience
no income or loss. This BEP can be an initial examination that precedes more detailed CVP
analyses.
Cost-volume-profit analysis employs the same basic assumptions as in breakeven analysis. The
assumptions underlying CVP analysis are:
The behavior of both costs and revenues in linear throughout the relevant range of activity. (This
assumption precludes the concept of volume discounts on either purchased materials or sales.)
Costs can be classified accurately as either fixed or variable.
Changes in activity are the only factors that affect costs.
All units produced are sold (there is no ending finished goods inventory).
When a company sells more than one type of product, the sales mix (the ratio of each product to
total sales) will remain constant.

Cost-Volume-Profit Analysis, Production = Sales


In the following discussion, only one product will be assumed. Finding the breakeven point is the
initial step in CVP, since it is critical to know whether sales at a given level will at least cover the
relevant costs. The breakeven point can be determined with a mathematical equation, using
contribution margin, or from a CVP graph. Begin by observing the CVP graph in Figure 1, where
the number of units produced equals the number of units sold. This figure illustrates the basic
CVP case. Total revenues are zero when output is zero, but grow linearly with each unit sold.
However, total costs have a positive base even at zero output, because fixed costs will be
incurred even if no units are produced. Such costs may include dedicated equipment or other
components of fixed costs. It is important to remember that fixed costs include costs of every
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kind, including fixed sales salaries, fixed office rent, and fixed equipment depreciation of all types.
Variable costs also include all types of variable costs: selling, administrative, and production.
Sometimes, the focus is on production to the point where it is easy to overlook that all costs must
be classified as either fixed or variable, not merely product costs.
Where the total revenue line intersects the total costs line, breakeven occurs. By drawing a
vertical line from this point to the units of output (X) axis, one can determine the number of units
to break even. A horizontal line drawn from the intersection to the dollars (Y) axis would reveal
the total revenues and total costs at the breakeven point. For units sold above the breakeven
point, the total revenue line continues to climb above the total cost line and the company enjoys a
profit. For units sold below the breakeven point, the company suffers a loss.
Illustrating the use of a mathematical equation to calculate the BEP requires the assumption of
representative numbers.
Assume that a company has total annual fixed cost of $480,000 and that variable costs of all
kinds are found to be $6 per unit. If each unit sells for $10, then each unit exceeds the specific
variable costs that it causes by $4. This $4 amount is known as the unit contribution margin. This
means that each unit sold contributes $4 to cover the fixed costs. In this intuitive example,
120,000 units must be produced and sold in order to break even. To express this in a
mathematical equation, consider the following abbreviated income statement:
Unit Sales = Total Variable Costs + Total Fixed Costs + Net Income
Inserting the assumed numbers and letting X equal the number of units to break even:
$10.00X = $6.00X + $480,000 + 0
Note that net income is set at zero, the breakeven point. Solving this algebraically provides the
same intuitive answer as above, and also the shortcut formula for the contribution margin
technique:
Fixed Costs ÷ Unit Contribution Margin = Breakeven Point in Units
$480,000 ÷ $4.00 = 120,000 units
If the breakeven point in sales dollars is desired, use of the contribution margin ratio is helpful.
The contribution margin ratio can be calculated as follows:
Unit Contribution Margin ÷ Unit Sales Price = Contribution Margin Ratio
$4.00 ÷ $10.00 = 40%
To determine the breakeven point in sales dollars, use the following mathematical equation:
Total Fixed Costs ÷ Contribution Margin Ratio = Breakeven Point in Sales Dollars
$480,000 ÷ 40% = $1,200,000
The margin of safety is the amount by which the actual level of sales exceeds the breakeven level
of sales. This can be expressed in units of output or in dollars. For example, if sales are expected
to be 121,000 units, the margin of safety is 1,000 units over breakeven, or $4,000 in profits before
tax.
A useful extension of knowing breakeven data is the prediction of target income. If a company
with the cost structure described above wishes to earn a target income of $100,000 before taxes,
consider the condensed income statement below. Let X = the number of units to be sold to
produce the desired target income:
Target Net Income = Required Sales Dollars − Variable Costs − Fixed Costs
$100,000 = $10.00X − $6.00X − $480,000
Solving the above equation finds that 145,000 units must be produced and sold in order for the
company to earn a target net income of $100,000 before considering the effect of income taxes.
A manager must ensure that profitability is within the realm of possibility for the company, given
its level of capacity. If the company has the ability to produce 100 units in an 8-hour shift, but the
breakeven point for the year occurs at 120,000 units, then it appears impossible for the company
to profit from this product. At best, they can produce 109,500 units, working three 8-hour shifts,
365 days per year (3 X 100 X 365). Before abandoning the product, the manager should
investigate several strategies:
Examine the pricing of the product. Customers may be willing to pay more than the price
assumed in the CVP analysis. However, this option may not be available in a highly competitive
market.
If there are multiple products, then examine the allocation of fixed costs for reasonableness. If
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some of the assigned costs would be incurred even in the absence of this product, it may be
reasonable to reconsider the product without including such costs.
Variable material costs may be reduced through contractual volume purchases per year.
Other variable costs (e.g., labor and utilities) may improve by changing the process. Changing the
process may decrease variable costs, but increase fixed costs. For example, state-of-the-art
technology may process units at a lower per-unit cost, but the fixed cost (typically, depreciation
expense) can offset this advantage. Flexible analyses that explore more than one type of process
are particularly useful in justifying capital budgeting decisions. Spreadsheets have long been
used to facilitate such decision-making.
One of the most essential assumptions of CVP is that if a unit is produced in a given year, it will
be sold in that year. Unsold units distort the analysis. Figure 2 illustrates this problem, as
incremental revenues cease while costs continue. The profit area is bounded, as units are stored
for future sale.
Unsold production is carried on the books as finished goods inventory. From a financial statement
perspective, the costs of production on these units are deferred into the next year by being
reclassified as assets. The risk is that these units will not be salable in the next year due to
obsolescence or deterioration
Cost-Volume-Profit Analysis, Production > Sales
While the assumptions employ determinate estimates of costs, historical data can be used to
develop appropriate probability distributions for stochastic analysis. The restaurant industry, for
example, generally considers a 15 percent variation to be "accurate."
APPLICATIONS
While this type of analysis is typical for manufacturing firms, it also is appropriate for other types
of industries. In addition to the restaurant industry, CVP has been used in decision-making for
nuclear versus gas- or coal-fired energy generation. Some of the more important costs in the
analysis are projected discount rates and increasing governmental regulation. At a more down-to-
earth level is the prospective purchase of high quality compost for use on golf courses in the
Carolinas. Greens managers tend to balk at the necessity of high (fixed) cost equipment
necessary for uniform spreadability and maintenance, even if the (variable) cost of the compost is
reasonable. Interestingly, one of the unacceptably high fixed costs of this compost is the smell,
which is not adaptable to CVP analysis.
Even in the highly regulated banking industry, CVP has been useful in pricing decisions. The
market for banking services is based on two primary categories. First is the price-sensitive group.
In the 1990s leading banks tended to increase fees on small, otherwise unprofitable accounts. As
smaller account holders have departed, operating costs for these banks have decreased due to
fewer accounts; those that remain pay for their keep. The second category is the maturity-based
group. Responses to changes in rates paid for certificates of deposit are inherently delayed by
the maturity date. Important increases in fixed costs for banks include computer technology and
the employment of skilled analysts to segment the markets for study.
Even entities without a profit goal find CVP useful. Governmental agencies use the analysis to
determine the level of service appropriate for projected revenues. Nonprofit agencies,
increasingly stipulating fees for service, can explore fee-pricing options; in many cases, the
recipients are especially price-sensitive due to income or health concerns. The agency can use
CVP to explore the options for efficient allocation of resources.
Project feasibility studies frequently use CVP as a preliminary analysis. Such major undertakings
as real estate/construction ventures have used this technique to explore pricing, lender choice,
and project scope options.
Cost-volume-profit analysis is a simple but flexible tool for exploring potential profit based on cost
strategies and pricing decisions. While it may not provide detailed analysis, it can prevent "do-
nothing" management paralysis by providing insight on an overview basis

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Q.4 The Finance Director of Ritoria Ltd thinks that the project with the higher NPV
should be chosen whereas its Managing Director thinks that the one with the
higher IRR should be undertaken, especially as both projects have the same initial
outlay and length of life. The company anticipates a cost of capital of 10% and the
net after tax

cash flows of the projects are as follows:

Year 0 1 2 3 4 5
(Cash Flows figs 000)
Project X Rs. (200) 35 80 90 75 20
Project Y Rs. (200) 218 10 10 4 3

You are required to :


a. Calculate the NPV and IRR of each project.
b. State, with reasons, which of the two mutually exclusive projects you would recommend.
c. Explain the reasons for inconsistency in the ranking of the two projects.

Solution: BY NPV METHOD:

NPV is the sum of all terms ,

-200/(1.1)=-200
35/1.1=31.82
80/1.21=66.21
90/1.331=67.62
75/1.4641=51.23
20/1.61051=12.42 here 200-all 5 above

200-229.21= -29.21 for x

For y:

-200/1.1=-200
218/1.1=198.18
10/1.21=8.26
10/1.331=7.51
4/1.4641=2.73
3/1.61051=1.86

Here 200- all 5 above


200-218.54 = -18.54
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BY IRR METHOD:

rate of return is given by r in:

-200+31.82+66.12+67.62+51.23+12.42 = 29.3 for x


-200+198.18+8.26+7.51+2.73+1.86 = 18.54 for y

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Q.5 What are the different factors that a finance manager needs to consider while
taking decisions regarding his/her firm’s capital structure. Explain each of these
factors in detail.

Solution: THE PATTERN OF CAPITAL STRUCTURE VARIES WITH TIME


AND ALSO THE ON THE ATTITUDE OF THE MANAGEMENT
AT THE GIVEN TIME.

The cost of capital is the rate of return that the enterprise must pay to satisfy the providers of
funds. The cost of equity is the return that ordinary stockholders expect to receive from their
investment. The cost of loan stock is the rate, which the company must provide its lenders. The
weighted average cost of capital (WACC) firm’s capital structure is the average of the cost of its
equity, preferred stocks and loan stocks.

An ideal mix of debt, preference stocks and common equity can maximizes the share prices. Debt
capital is regarded, as cheap source of finance to the business but will also increase the finance
risk of the company. Common stocks regarded as less risky but might lead to loss of voting rights
if bought by outsiders.

FACTORS INFLUENCING CAPITAL STRUCTURE

Business risk
Risk associated with the nature of the industry the business operates and if the business risk is
higher the optimal capital structure is required.
Tax position
Debt capital is regarded as cheaper because interest payable is deductible for tax purposes.
Advantage not much for businesses with unrelieved tax losses, depreciation tax shield as they
already have an existing lower tax burden.
Financial flexibility
Depends on how easy a business can arrange finance on reasonable terms under adverse
conditions. Flexibility in raising finance will be influenced by the economic environment
(availability of savers and interest rates) and the financial position of the business.
Managerial style
How much to borrow also depend on managers approach to finance risk. Conservative managers
will usual try to keep the debt equity ratio low.

BUSINESS AND FINANCE RISK

Business risk
The variability in operating income caused but inherent factors of the business other than debt
financing. Can be influenced by changes in prices, variability of inputs, sales volume, and
competition levels.
Finance risk
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Additional variability in return that arises because the financial structure contains debt. Finance
risk measured through gearing/leverages ratios.

FINANCIAL GEARING
Extent to which debt finances firms total capital structure
Debt equity ratio: Total debt
Total assets

TIMES INTEREST EARNED


Measures the firm’s ability to meet its annual finance interest payments.

TIE RATIO
= Earnings before interest and tax
Interest charges

OPERATIONAL GEARING
Measures to what extent are fixed costs used in firms operations. Breakeven point analysis will
measure the relationship between sales volume, variable cost and the fixed costs. Breakeven
point is the level of sales where the firm is neither making profits nor losses i.e. Sales value
equals costs.
Financial gearing can reach very high levels, with companies preferring to raise additional capital
for expansion by means of loans rather than issuing new equity, but there are limits.
Restrictions on further borrowing might be contained in the denture trust deed for a company’s
current debenture stocks in issue.
Occasionally, there might be borrowing restriction in the articles of association.
Lenders might want security for extra loan which the would be borrowers cannot provide.
Lenders might simply be unwilling to lend more to a company with high gearing or low interest
cover.
Extra borrowing beyond a safe level will cost more interest. Companies might not be willing to
borrow at these rates.
Apart from the limitations stated above, there are other side effects associated with high gearing
which may include the following:
Financial distress where obligations to the conditions are not met or they are met with difficulties
Costs: - Loss of key suppliers
Uncertain customers
Low asset value
Loss of staff moral
Legal costs
Agency costs in trying to negotiate additional loan facilities through an agent.
High interest rates
Need to sign loan covenants thereby loosing financial freedom
Borrowing cap
Limits set by lenders on amount available
Financial slack – Highly geared firms fail to seize opportunities as they arise due to unwillingness
of lenders for more fund advancements.
High gearing might send bad signals on company’s liquidity to employees as well as lenders
Loss of decision making on certain areas to lenders due to loan covenants
Despite mentioning all the limitations and cost of high gearing mentioned above company’s still
uses debt capital. Apart from being cheaper than share capital the following attributes compels
the company to use the debt capital.
Motivation – Regarded as cheaper source of income
New issue stocks may dilute holding
Operational and strategic staff more cautious on utilization of funds
Flexibility in arrangement than equity
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“Top management’s risk-taking propensity affects the firm’s capital structure”. The amount of debt
that top managers feel is manageable affects the overall debt ratio of the firm since the
owners most often have to personally guarantee the loan in order to acquire one. amd also that
owners attitude towards risk seem to influence
the choice of capital structure. As debt increases the risk inflate, hence, a riskaverse
organization will probably use debt to a less extent than a risk-willing organization.
This proposal about top management’s risk awareness affecting capital structure is supported
by claim that SMEs’ equity level plays impact of their owners’ attitudes towards risk. In case
SMEs need
external financing they will prefer short-term debt before long-term debt since the latter
reduce management’s operability and short-term debt do not include restrictive covenants

“Top management’s goals for the firms will affect the firm’s capital structure”. Not all managers
strive
for profit maximizing; growth can sometimes be considered more important .

SMEs do not follow the same patterns and policies as larger


companies do. In fact, SMEs choose debt on personal and managerial preference than
what larger firms are able to do.

Capital structure processes should be analyzed by the impact of owner/manager’s personal


reference and values of the firms’ characteristics.
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“Top management would prefer to finance firm needs from internally generated funds rather than
from externalcreditors or even new stockholder”. Top mangers have a preference to remain as
free aspossible and do not want to become restricted by debt agreements .
BUT this could lead to an under-investment problem where high-quality, low risk roject are
rejected to be undertaken due to lack of equity and the unwillingness to external inancing.-
“The risk propensity of top management and financial characteristics of the firm affect the amount
of debt lenders are willing to offer and on what terms”. Credit institution’s willingness to lend
money to different organizations is risky from their point of view; they always estimate how well
they consider the organization’s ability to pay back when providing a bank loan
“Financial characteristics moderate the ability of top management to select a capital structure for
the firm”. The financial risk and flexibility of a firm tend to affect what the management’s
willingness change their capital structure . The main incentive to increase the level of debt in a
firm’s capital structure is when the interest costs are tax deductible

CAPITAL STRUCTURE DECISION IS INFLUENCED BY


Need for control --Risk propensity--Experience--Social norms--Personal net worth
WHICH AFFECTS
Beliefs about debt
Attitudes towards debt
Capital structure decision

WHICH IS ALSO INFLUENCED BY….


External variables
Market conditions
Financial decisions
Organizational form
The capital structure diagrams
The capital structure consists of hree parts; hort-Term Debt, Long-Term Debt and Equity.
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Below is how the proportional weight of the company’s total capital is calculated.
Short-term debt
Where short-term debt is current liabilities, expiring within one year, including: accounts
payables, current tax-liabilities as well as accrued expenses and deferred revenues
SHORT TERM DEBT %= short term debt / debt+equity

Long-term debt
Long-term debt is the intermediate and long-term liabilities, expiring after one year, such as
bank loans added with 28 % of the untaxed reserves which will be taxed once they are used
for investments
LONG TERM DEBT % = long term debt + .28 [untaxed reserves] / debt + equity]
EQUITY% = equity + .72 [untaxed reserves ] / debt + equity ]

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