Financial Management : 2nd Mid Important Questions

OPERATIONS LEVERAGES VS. FINANCIAL LEVERAGES

Base for Comparison Operating Leverage Financial Leverage

1. Meaning Operating leverage can be defined Financial leverage can be defined
as firm’s ability to use fixed costs to as firm’s ability use capital
generate more returns. structure to earn better returns
and to reduce taxes.
2. About It’s about the fixed costs of the It’s about the capital structure of
firm. the firm.
3. Measurement Operating leverage measures the Financial leverage measures the
operating risk of a business. financial risk of a business.
4. Calculation Operating leverage can be Financial leverage can be
calculated when we divide calculated when we divide EBIT
contribution by EBIT of the firm. by EBT of the firm.
5. Impact When degree of operating When degree of financial
leverage is higher, it depicts more leverage is higher, it depicts more
operating risk for the firm and vice financial risk for the firm and vice
versa. versa.
6. In relation with The degree of operating leverage is Financial leverage has a direct
usually higher than Break Even relationship with the liability side
Point. of the balance sheet.

LONG TERM SOURCES OF FINANCE

The main sources of long term finance are as follows:

1. Shares:

These are issued to the general public. These may be of two types: (i) Equity and (ii) Preference.
The holders of shares are the owners of the business.
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2. Debentures:

These are also issued to the general public. The holders of debentures are the creditors of the
company.

3. Public Deposits :

General public also like to deposit their savings with a popular and well established company
which can pay interest periodically and pay-back the deposit when due.

4. Retained earnings:

The company may not distribute the whole of its profits among its shareholders. It may retain a
part of the profits and utilize it as capital.

5. Term loans from banks:

Many industrial development banks, cooperative banks and commercial banks grant medium
term loans for a period of three to five years.

6. Loan from financial institutions:

There are many specialized financial institutions established by the Central and State
governments which give long term loans at reasonable rate of interest. Some of these institutions
are: Industrial Finance Corporation of India ( IFCI), Industrial Development Bank of India (IDBI),
Industrial Credit and Investment Corporation of India (ICICI), Unit Trust of India ( UTI ), State
Finance Corporations etc.

FACTORS AFFECTING CAPITAL STRUCTURE

(1) Cash Flow Position:

While making a choice of the capital structure the future cash flow position should be kept in
mind. Debt capital should be used only if the cash flow position is really good because a lot of
cash is needed in order to make payment of interest and refund of capital.

(2) Interest Coverage Ratio-ICR:

 Financial Management : 2nd Mid Important Questions

With the help of this ratio an effort is made to find out how many times the EBIT is available to
the payment of interest. The capacity of the company to use debt capital will be in direct
proportion to this ratio.

It is possible that in spite of better ICR the cash flow position of the company may be weak.
Therefore, this ratio is not a proper or appropriate measure of the capacity of the company to
pay interest. It is equally important to take into consideration the cash flow position.

(3) Debt Service Coverage Ratio-DSCR:

This ratio removes the weakness of ICR. This shows the cash flow position of the company.

This ratio tells us about the cash payments to be made (e.g., preference dividend, interest and
debt capital repayment) and the amount of cash available. Better ratio means the better capacity
of the company for debt payment. Consequently, more debt can be utilised in the capital
structure.

(4) Return on Investment-ROI:

The greater return on investment of a company increases its capacity to utilise more debt capital.

(5) Cost of Debt:

The capacity of a company to take debt depends on the cost of debt. In case the rate of interest
on the debt capital is less, more debt capital can be utilised and vice versa.

(6) Tax Rate:

The rate of tax affects the cost of debt. If the rate of tax is high, the cost of debt decreases. The
reason is the deduction of interest on the debt capital from the profits considering it a part of
expenses and a saving in taxes.

For example, suppose a company takes a loan of 0ppp 100 and the rate of interest on this debt
is 10% and the rate of tax is 30%. By deducting 10/- from the EBIT a saving of in tax will take place
(If 10 on account of interest are not deducted, a tax of @ 30% shall have to be paid).
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(7) Cost of Equity Capital:

Cost of equity capital (it means the expectations of the equity shareholders from the company)
is affected by the use of debt capital. If the debt capital is utilised more, it will increase the cost
of the equity capital. The simple reason for this is that the greater use of debt capital increases
the risk of the equity shareholders.

Therefore, the use of the debt capital can be made only to a limited level. If even after this level
the debt capital is used further, the cost of equity capital starts increasing rapidly. It adversely
affects the market value of the shares. This is not a good situation. Efforts should be made to
avoid it.

(8) Floatation Costs:

Floatation costs are those expenses which are incurred while issuing securities (e.g., equity
shares, preference shares, debentures, etc.). These include commission of underwriters,
brokerage, stationery expenses, etc. Generally, the cost of issuing debt capital is less than the
share capital. This attracts the company towards debt capital.

FACTORS AFFECTING WORKING CAPITAL

Requirements Of working capital depend upon various factors such as nature of business, size of
business, the flow of business activities. However, small organization relatively needs lesser
working capital than the big business organization. Following are the factors which affect the
working capital of a firm:

1. Size Of Business

Working capital requirement of a firm is directly influenced by the size of its business operation.
Big business organizations require more working capital than the small business organization.
Therefore, the size of organization is one of the major determinants of working capital.

2. Nature Of Business

Working capital requirement depends upon the nature of business carried by the firm. Normally,
manufacturing industries and trading organizations need more working capital than in the service
 Financial Management : 2nd Mid Important Questions

business organizations. A service sector does not require any amount of stock of goods. In service
enterprises, there are less credit transactions. But in the manufacturing or trading firm, credit
sales and advance related transactions are in large amount. So, they need more working capital.

3. Storage Time Or Processing Period

Time needed for keeping the stock in store is called storage period. The amount of working capital
is influenced by the storage period. If storage period is high, a firm should keep more quantity of
goods in store and hence requires more working capital. Similarly, if the processing time is more,
then more stock of goods must be held in store as work-in-progress.

4. Credit Period

Credit period allowed to customers is also one of the major factors which influence the
requirement of working capital. Longer credit period requires more investment in debtors and
hence more working capital is needed. But, the firm which allows less credit period to customers
needs less working capital.

5. Seasonal Requirement

In certain business, raw material is not available throughout the year. Such business organizations
have to buy raw material in bulk during the season to ensure an uninterrupted flow and process
them during the entire year. Thus, a huge amount is blocked in the form of raw material
inventories which gives rise to more working capital requirements.

6. Potential Growth Or Expansion Of Business

If the business is to be extended in future, more working capital is required. More amount of
working capital is required to meet the expansion need of business.

7. Changes In Price Level

Change in price level also affects the working capital requirements. Generally, the rise in price
will require the firm to maintain large amount of working capital as more funds will be required
to maintain the sale level of current assets.
 Financial Management : 2nd Mid Important Questions

8. Dividend Policy

The dividend policy of the firm is an important determinant of working capital. The need for
working capital can be met with the retained earning. If a firm retains more profit and distributes
lower amount of dividend, it needs less working capital.

9. Access To Money Market

If a firm has good access to capital market, it can raise loan from bank and financial institutions.
It results in minimization of need of working capital.

10. Working Capital Cycle

When the working capital cycle of a firm is long, it will require larger amount of working capital.
But, if working capital cycle is short, it will need less working capital.

FACTORS AFFECTING DIVIDED POLICY

Main factors affecting the working capital are as follows:

(1) Nature of Business:

The requirement of working capital depends on the nature of business. The nature of business is
usually of two types: Manufacturing Business and Trading Business. In the case of manufacturing
business it takes a lot of time in converting raw material into finished goods. Therefore, capital
remains invested for a long time in raw material, semi-finished goods and the stocking of the
finished goods.

Consequently, more working capital is required. On the contrary, in case of trading business the
goods are sold immediately after purchasing or sometimes the sale is affected even before the
purchase itself. Therefore, very little working capital is required. Moreover, in case of service
businesses, the working capital is almost nil since there is nothing in stock.
(2) Sales Operations:
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There is a direct link between the working capital and the scale of operations. In other words,
more working capital is required in case of big organisations while less working capital is needed
in case of small organisations.

(3) Business Cycle:

The need for the working capital is affected by various stages of the business cycle. During the
boom period, the demand of a product increases and sales also increase. Therefore, more
working capital is needed. On the contrary, during the period of depression, the demand declines
and it affects both the production and sales of goods. Therefore, in such a situation less working
capital is required.

(4) Seasonal Factors:

Some goods are demanded throughout the year while others have seasonal demand. Goods
which have uniform demand the whole year their production and sale are continuous.
Consequently, such enterprises need little working capital.

On the other hand, some goods have seasonal demand but the same are produced almost the
whole year so that their supply is available readily when demanded.

Such enterprises have to maintain large stocks of raw material and finished products and so they
need large amount of working capital for this purpose. Woolen mills are a good example of it.

(5) Production Cycle:

Production cycle means the time involved in converting raw material into finished product. The
longer this period, the more will be the time for which the capital remains blocked in raw material
and semi-manufactured products.

Thus, more working capital will be needed. On the contrary, where period of production cycle is
little, less working capital will be needed.

(6) Credit Allowed:

 Financial Management : 2nd Mid Important Questions

Those enterprises which sell goods on cash payment basis need little working capital but those
who provide credit facilities to the customers need more working capital.

(7) Credit Availed:

If raw material and other inputs are easily available on credit, less working capital is needed. On
the contrary, if these things are not available on credit then to make cash payment quickly large
amount of working capital will be needed.

(8) Operating Efficiency:

Operating efficiency means efficiently completing the various business operations. Operating
efficiency of every organisation happens to be different.

WALTER’S MODEL THEORY ON DIVIDEND POLICY

Definition: According to the Walter’s Model, given by prof. James E. Walter, the dividends are
relevant and have a bearing on the firm’s share prices. Also, the investment policy cannot be
separated from the dividend policy since both are interlinked.

Walter’s Model shows the clear relationship between the return on investments or internal rate
of return (r) and the cost of capital (K). The choice of an appropriate dividend policy affects the
overall value of the firm. The efficiency of dividend policy can be shown through a relationship
between returns and the cost.

If r>K, the firm should retain the earnings because it possesses better investment opportunities
and can gain more than what the shareholder can by re-investing. The firms with more returns
than a cost are called the “Growth firms” and have a zero payout ratio.

If r<K, the firm should pay all its earnings to the shareholders in the form of dividends, because
they have better investment opportunities than a firm. Here the payout ratio is 100%.
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If r=K, the firm’s dividend policy has no effect on the firm’s value. Here the firm is indifferent
towards how much is to be retained and how much is to be distributed among the shareholders.
The payout ratio can vary from zero to 100%.

Assumptions of Walter’s Model

❖ All the financing is done through the retained earnings; no external financing is used.
❖ The rate of return (r) and the cost of capital (K) remain constant irrespective of any changes
in the investments.
❖ All the earnings are either retained or distributed completely among the shareholders.
❖ The earnings per share (EPS) and Dividend per share (DPS) remains constant.

The firm has a perpetual life.

Criticism of Walter’s Model

❖ It is assumed that the investment opportunities of the firm are financed through the retained
earnings and no external financing such as debt, or equity is used. In such a case either the
investment policy or the dividend policy or both will be below the standards.
❖ The Walter’s Model is only applicable to all equity firms. Also, it is assumed that the rate of
return (r) is constant, but, however, it decreases with more investments.
❖ It is assumed that the cost of capital (K) remains constant, but, however, it is not realistic
since it ignores the business risk of the firm, that has a direct impact on the firm’s value.

Note: Here, the cost of capital (K) = Cost of equity (Ke), because no external source of financing
is used.