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_________________________ Submitted by
JITESH JIKU Roll No.520945372
in partial fulfillment o f the requirement for the award of the degree Of MASTER OF BUSINESS ADMINISTRATION in Finance.
Firstly I would like to thank NDPL for giving the opportunity to complete my project in the organization. I put on record my sincere thanks to Mahender sir for his suggestions and advice. I am extremely grateful to Mamta madam for the encouragement, discussions and critical assessment of the project. It was a good experience for me to work with North Delhi Power Limited, a pioneer in the field of power distribution. I am greatly obliged to Ms. Pooja and Mr. Vineet Kumar who have shared their expertise and knowledge with me without which the completion of project would not have been possible
BONAFIDE CERTIFICATE Certified that this project report titled “Study of Capital Structure management” is the bonafide work of “JITESH JIKU” who carried out the project work under my supervision.
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<<Full address of the Dept & College >> Full address of the Dept & College > FUND FLOW AND CAPITAL STRUCTURE Project made by: JITESH JIKU 4 .
Funds issued by the issue of equity shares are the best from risk point of view for the company as there is no question of repayment of equity capital except when the company is liquidated. So the analysis simply states two main aspects of financial management like procurement of funds and an effective use of funds to achieve business objectives. Herein the analysis deals with the expected inflows and outflows of funds and their effect on managerial objectives. 5 . In short. From the cost point of view equity capital is the most expensive source of funds as dividend expectations of shareholders are normally higher than that of prevailing interest rates. By Financial Management we mean efficient use of economic resources namely capital funds. Financial Management deals with Procurement of funds and their effective utilization in the business.Financial Management Management of funds is a critical aspect of financial management. Funds obtained from different sources have different characteristics in terms of potential risk. Financial management is concerned with the managerial decisions that result in the acquisition and financing of short term and long term credits for the firm. Management of funds acts as the foremost concern whether it is in a business undertaking or in an educational institution. or a combination of assets and the selection of specific problem of size and growth of an enterprise. cost and control. Financial management. which is simply meant dealing with management of money matters. Here it deals with the situations that require selection of specific assets. Procurement of funds: As funds can be procured from multiple sources so procurement of funds is considered an important problem of business concerns.
From time to time it is observed that many firms have been liquidated not because their technology was obsolete or because their products were not in demand or their labor was not skilled and motivated. In the globalised competitive scenario. Scope of Financial Management Sound financial management is essential in all types of organizations whether it be profit or non-profit. educationalists and public at a large. In case of dividend decisions we also consider this. the need of proper financial management is required.Financial management constitutes risk. In case of newly started companies with a high growth rate it is more important to have sound financial management since finance alone guarantees their survival. However a sound system of financial management has to be cultivated among bureaucrats. Objectives of Financial Management 6 . So it is crucial to employ the funds properly and profitably. Funds procured involve a certain cost and risk. Financial management optimizes the output from the given input of funds. If the funds are not used properly then running business will be too difficult. Even in a boom period. administrators. when a company make high profits there is also a fear of liquidation because of bad financial management. cost and control. but that there was a mismanagement of financial affairs. which do not pay adequate attentions to financial management. Foreign Direct Investment (FDI) as well as Foreign Institutional Investors (FII) is two major sources of raising funds. The mechanism of procurement of funds has to be modified in the light of requirements of foreign investors. engineers. The cost of funds should be at minimum for a proper balancing of risk and control. Financial management is very important in case of non-profit organizations. Financial management is essential in a planned Economy as well as in a capitalist set-up as it involves efficient use of the resources. In a country like India where resources are scarce and the demand for funds are many. Funds can be raised either through the domestic market or from abroad. Utilization of Funds: Effective utilization of funds as an important aspect of financial management avoids the situations where funds are either kept idle or proper uses are not being made. mobilization of funds plays a very significant role.
Market price acts as the performance index or report card of the firm's progress and potential. outlook of the particular company. Normally this value is a function of two factors: The anticipated rate of earnings per share of the company The capitalization rate. It takes in to account present and prospective future earnings per share. technical factors and even mass psychology. Profit maximization does not take into account the social considerations. The likely rate of earnings per shares depends upon the assessment of how profitable a company may be in the future. Profit maximization must be attempted with a realization of risks involved. So both risk and profit objectives should be balanced. Methods of Financial Management: 7 .Efficient Financial management requires the existence of some objectives. It is a limited objective. But profit maximization alone cannot be the sole objective of a company. The term profit is vague and it involves much more contradictions. Profit Maximization fails to take into account the time pattern of returns. The value of a firm is represented by the market price of the company's stock. the dividend policy of the firm and many other factors that bear upon the market price of the stock. A positive relationship exists between risk and profits. 2) Wealth Maximization: It is commonly understood that the objective of a firm is to maximize value and wealth. Prices in the share markets are affected by many factors like general economic outlook. The market price of a firm's stock represents the assessment of all market participants as to what the value of the particular firm is. If profits are given undue importance then problems may arise as discussed below. The capitalization rate reflects the liking of the investors for the company. which are as follows 1) Profit Maximization: The objective of financial management is the same as the objective of a company which is to earn profit. the timing and risk of these earning.
Short term funds may be availed from commercial banks. Ratio analysis is a common technique to evaluate different aspects of a firm. pay back. 8 . funding may be needed for significant additions to the productive capacity of the business or to facilitate acquisitions. from financial institutions. In the medium and long term. At the time of evaluating capital expenditure projects methods like average rate of return. Funds may be obtained from long term sources as well as from short term sources. An investor takes in to account various ratios to know whether investment in a particular company will be profitable or not. pay employees and fund sales made on credit. internal rate of returns. A firm can increase its profitability without negatively affecting its liquidity by efficient management of working capital. In the short term. net present value and profitability index are used. Similarly. Financial leverage or trading on equity is an important method by which a finance manager may increase the return to common shareholders. lenders by issuing debentures. and liquidity growth aspect of the firm. and • Provide a return on investment keeping in mind the risks that the business is taking and the resources invested There are three primary elements to the process of financial management: (1) Financial Planning Management need to ensure that sufficient funding is available to meet the needs of the business. banks and the general public at large.In the field of financing there are multiple methods to procure funds. solvency. Long term funds may be procured by owners that are shareholders. the key objectives of financial management would be to: • Create wealth for the business • Generate cash. etc. What is Financial Management? Financial Management can be defined as: The management of the finances of a business/organization in order to achieve financial objectives Taking a business as the most common structure. funding may be needed to invest in equipment and stocks. These ratios enable him to judge the profitability. for the evaluation of a firm's performance there are different methods. public deposits. A firm can increase its profitability without adversely affecting its liquidity by an efficient utilization of the current resources at the disposal of the firm.
Capital structure refers to the way a corporation finances itself through some combination of equity. A firm's capital 9 . bonds. term loans from financial institutions. What is capital structure? Capital Structure represents the total long-term investment in a business firm. debt or hybrid securities. creditors. borrowing from banks or taking credit from suppliers. • A key financing decision is whether profits earned by the business should be retained rather than distributed to shareholders via dividends. capital surpluses. The Board of Directors or the financial manager of a company should always endeavor to develop a capital structure that would lie beneficial to the equity shareholders in particular and to the other groups such as employees. however there are always financing alternatives that can be considered. earned revenue. This can be done only when all these factors which are relevant to the company's capital structure decisions are properly analyzed and balanced. debentures. financing and dividends: • Investments must be financed in some way.(2) Financial Control Financial control is a critically important activity to help the business ensure that said business is meeting its goals. customers. For example it is possible to raise funds from selling new shares. the business may be starved of funding to reinvest in growing revenues and profits. The term capital structure is used to represent the proportionate relationship between debt and equity. While developing an appropriate capital structure for its company the financial manager should aim at maximizing the long-term market price per share. Financial control addresses questions such as: • Are assets being used efficiently? • Are the businesses assets secure? • Does management act in the best interest of the shareholders and in accordance with business rules? (3) Financial Decision Making The primary aspects of financial decision making relate to investment. If dividends are too high. etc. It includes funds raised through ordinary and preference shares. society in general.
know as capital structure irrelevance. Simple financial theory models show that capital structure does not affect the total value (debt + equity) of a company. The capital structure of a company is the particular combination of debt. In contrast. The firm's ratio of debt to total financing. The proportion of debt funding is measured by gearing. Interest is treated not as a division of profit to one of the two sources of capital of the business but as an expense. Convertible debt may be likely to become equity in the future. An appropriate capital structure is a critical decision for any business organization. Rather. Both debt and equity sources demand to be compensated for the use of their capital. equity and other sources of finance that it uses to fund its long term financing. In other words. an important result. Preference shares are legally shares. not from the total capital point of view. net income is reported as the reward or payoff on equity capital. which like all expenses is deducted from sales revenue to determine bottom-line net income. Considering the division between debt and equity is sufficient to understand the issues involved. It is. This is not completely true. nonetheless. 80% in this example is referred to as the firm's leverage. but have a fixed return that makes them closer to debt than equity in their economic effect. profit is defined from the shareowners point of view. but also because of the impact such a decision has on an organization’s ability to deal with its competitive environment. Interest is paid on debt and reported in the income statement as an expense. Managers must convince lenders to loan money to the company and convince sources of equity capital to invest their money in the company.structure is then the composition or 'structure' of its liabilities. and profit is defined to be the residual amount after deducting interest. as they are hybrids of the two. The decision is important not only because of the need to maximize returns to various organizational constituencies. For example. no charge or deduction for using equity capital is reported in the income statement. a firm that sells $20bn dollars in equity and $80bn in debt is said to be 20% equity financed and 80% debt financed. This simple division is somewhat complicated by the existence of other types of capital that blur the lines between debt and equity. The capital a business needs for investing in its assets comes from two basic sources: debt and equity. as more sophisticated models show. Sometimes the owners’ equity of a business is referred to as its net worth. The fundamental idea of net worth is this: Net worth = assets − operating liabilities − debt 10 . The key division in capital structure is between debt and equity.
Thus a sound capital structure tends to minimize 'cost' of financing and maximize earnings per share (EPS). it should use the debt capital only up to the point where significant risk it not added.Net income increases the net worth of a business. Conservation: The capital structure should be conservative in the sense that the debt capacity of the company should not exceed.e. The consideration of flexibility gives the financial manager ability to alter the firm's capital structure with a minimum cost and delay warranted by a changed situation. 4. it must be advantageous to the company.. 3. As has been already observed the use of excessive debt threatens the solvency of the company. The Need for Profit Planning 11 . i. Flexibility: A sound capita1 structure must be flexible. of the business increases by the amount of net income.e. Suppose another group of investors stands ready to buy the business for a total price equal to its net worth. It should have enough cash to pay creditors fixed charges and principal amount. or market value. 5. Control: The capital structure should involve minimum risk of loss of control of the company. This offering price. It should permit the maximum use of leverage at a minimum cost with the constraints. 2. It should also be possible for the company to provide funds whenever needed to finance its profitable activities.. Cash distributions of net income to shareowners decrease the net worth of a business. i. because it’s net worth increases by the net income amount. An appropriate capital structure should incorporate the following features: 1. The debt capacity of a company demands on its ability to generate future cash flows. because cash decreases with no corresponding decrease in the operating liabilities or debt of the business. It should be remembered that cash insolvency might also lead to legal insolvency. Solvency: A sound capital structure should also have the feature of solvency. Profitability: A sound capital structure is also one that also possesses the feature of profitability. The business is better off earning net income.
(iii) Short term finance. Peter Drucker Profit is an essential cost of business activity and must be planned and managed just like other costs. A business must earn sufficient profit to maintain access to the capital markets for the investment it needs to grow and prosper. (ii) Medium term finance. These are: (i) Long term finance. The amount of long term funds required naturally depends on the type of business and the investment required for fixed assets. Depending on the nature and purpose to be served. It is the cost of the future. These profits come from the surplus generated from business operations or operating profit (also known as net income before interest and taxes). For example. we may distinguish between three types of finance. chemicals. plant and machinery. etc. that funds are required by business firms for different purposes — to acquire fixed assets. A growth strategy may require additional profit to fund market and/or product research and development or strategic acquisitions. The effective manager must make trade-offs among these variables to keep this equation in balance and this requires effective profit planning. It is also known as long term capital or fixed capital. A small factory or a small workshop repairing 12 . Successful business performance requires balancing costs and revenues as illustrated by the following model. This type of finance is used for acquiring fixed assets. These minimum profit requirements enable the business sustain its current operations and maintain its wealth producing potential. etc. and to improve methods of production. machinery and equipments."Profit is a condition of survival. Costs of the future (profit) + current costs (expenses) = Average revenue per unit sold x sales volume (net revenue). building. to provide for operating expenses. such as land. Types of Business Finance We have mentioned above. cement. Cost of capital is the cost the business must pay for its debt and equity financing. the cost of staying in business". the manufacture of steel. (i) Long term finance: Funds which are required to be invested in the business for a long period (say more than five years) are known as long term finance. This profit can be difficult to determine but it cannot be less than the business' cost of capital. involve heavy expenses to be incurred on buildings.
require smaller amounts for long term investment as compared to the requirement of manufacturers. On the other hand. spare parts. (iii) Short term finance: This type of finance is required for a short period upto one year. Manufacturing concerns. Hence. adoption of new methods of production or distribution. (ii) Medium term finance: Business firms often need funds for a period exceeding one year and not more than 5 years for particular purposes. This is referred to as medium term finance or medium term capital. (b) the time gap between commencement of production or purchase of goods and their sale. As soon as goods are sold and funds are recovered the amount is again used for current operations. Generally. Large scale manufacturing and trading activities will obviously require more long term capital than small scale enterprises. traders generally. The size of the business firm also determines the amount to be invested in fixed assets. Manufacturing industries are more often in need of such finance. or introduction of a new product. arises on account of changes in technology or increasing competition. or circulating capital. Trading firms normally require proportionately more of short term capital than long term capital. How much short term finance will be required depends on (a) the nature of business undertaken.electrical goods will require much smaller investment in fixed assets. on the other hand. The necessity of this type of finance generally. and (c) The volume of business. need relatively smaller amounts of short term capital as compared to long term capital. short term funds can be used over and over again from year to year. The amount required depends on the nature or purpose. Short term finance is often called working capital or short term capital. production processes are completed within a year and goods are ready for sale. or an advertisement campaign. to be used for current operations. They may include expenses on modernisation of plant and machinery. etc. speaking. Long term finance is required for acquisition of assets and modernization purposes. It refers to funds EXTERNAL TRADE 187 needed to meet day-to-day requirements and for holding stocks of raw materials. The expenditure incurred is regarded as an investment because higher returns are expected out of it. 13 . This is because trading concerns do not require expensive long-lived assets to be used for their activities.
the capital of a partnership firm consists partly of funds contributed by the partners and partly of borrowed funds. if production time and the time gap between production and sale is shorter (say one or two months). a small factory needs much less short term capital than a large manufacturing enterprise. profits earned may also be reinvested instead of being distributed as dividend to the shareholders. In other words. funds contributed by owners. the financial resources of a business may be provided by owner’s funds and borrowed funds. invests her/his own savings to start with. The volume or scale of business activity also determines the amount of short term finance. who may contribute capital and become shareholders of the company. that is. 188 BUSINESS STUDIES Ownership capitals consist of the amounts contributed by owners as well as profits. Thus. If necessary they may also decide to reinvest their own shares of profit. In course of its business. Besides. The company form of organization enables the promoters to raise necessary funds from the public. loans and credits also meet the financial requirements of business firms. and amounts received from any other inward remittance. for any business enterprise. Let us examine the characteristics of these two sources: Owners Funds or Ownership Capital It may be useful to distinguish between the term funds and the term capital. But the term fund has wider scope and coverage. She/he may reinvest a part of the profits earned in course of time. She/he may also borrow money on her/his personal security or the security of assets.Again. Sources of Finance The primary responsibility of financing a business venture is that of the owners of the business. the company can raise loans directly from banks and financial institutions or by issue of debentures to the public. and funds available from loans and credits. The key features of ownership funds are as follows: 14 . the individual proprietor generally. It includes the profits reinvested in the business. there are two sources of finance. This is because profits ultimately belong to the owners. it will require much less short term finance than if the time gap is one year. Thus. Similarly. In sole proprietorship business. However.
Hence. in times of prosperity and in the case of a flourishing business the high level of profits earned accrue entirely to the owners of the business. 15 . However. Although the owners of the company are the shareholders. this type of finance is available for all purposes throughout the life of the business. a large part of it is generally. If losses continue. used for acquiring long term fixed assets. (ii) Permanent source of capital: The second characteristic of this source of finance is that ownership capital remains permanently invested in the business. the responsibility of management does not rest with them.(i) Provision of risk capital: One major characteristic of owner’s fund as a source of finance is that it provides risk capital. It is also used to finance a part of the working capital which is permanently required to hold a minimum amount of cash. and it is the owners who bear this risk. In the event of low profits they do not have adequate return on their investment. stocks etc. (iii) Separation of ownership and management: Another characteristic of ownership capital relates to the management of business. Ownership capital forms the basis for raising loans. (ii) It is a source of permanent capital. Besides. It is not refundable like loans or borrowed capital. who are elected by the shareholders. which makes it possible for creditors to deal confidently with the company. the advantages of ownership capital may be briefly stated as follows: (i) It provides risk capital. the owners may be unable to recover even their original investment after meeting the loan obligations. Merits Arising out of its characteristics. (iv)No security required: No security of assets is to be offered against ownership capital. it is managed by the officers under the control and supervision of the board of directors. In case of a company. It is known as risk capital because every business runs the risk of loss or low profits.
Therefore. it can generate huge amounts of capital. This in turn ensures that the business is conducted in their best interest. In a partnership. it can be used to enhance the capital base of the firm. Share capital is non-refundable as long as the company is in existence. it is not returnable. The final say in the management of the organization rests with the owners. the assets of the company are free to be used for raising loans. Limitations There are also certain limitations of ownership capital as a source of finance. Thus. of a company. (iii) Capital forms the basis on which owners acquire their right of control and supervision over management. a large number of members may participate. the company is confident of retaining such amounts to meet any problems and unforeseen contingencies. In the case. These are: (i) Diffusion of control: A joint stock company can raise amounts by issuing shares to the public. capital is limited to the financial capability of the partners. who invest money in the business.i. Thus. (ii) Possibility of under utilization of ownership funds: Being a permanent source of capital. ownership funds cannot be reduced easily in the case of a company. (vi)Unlimited amount of capital can be raised. This may mean a part of this fund remaining idle when there is no scope for expansion or fresh investment opportunities. But it leads to an increased number of people having ownership interest and right of control over management.. Borrowed Funds or Borrowed Capital 16 . EXTERNAL TRADE 189 (iv) Since management is separate from ownership professional managers can be employed to look after the interests of all stakeholders. It is nonrefundable until such time that business ceases.e. (v) Since no security is required for equity. The capacity of the proprietor of a sole proprietorship firm is extremely limited. This may reduce the original promoter’s power of control over management.
(ii) Need for security: Borrowing is possible against personal security but generally. (iii) It provides flexibility to the capital structure. borrowed capital has several merits: (i) It does not affect the owners’ control over management. Thus. (iv)A fixed rate of interest is to be paid even when profits are very high. medium term or short term finance. Banks and financial institutions give loans against the security of assets. But. (ii) Interest is treated as an expense. In other words. borrowed funds may serve the purpose of long term. or by different modes. Finance may be raised when it is required and repaid when it is not required. Merits From the business point of view. (iv)Control: Ordinarily lenders and creditors do not have any right of control over the management of the borrowing firm. A company can raise loans on different terms and conditions. according to convenience and needs. The principal amount is to be repaid according to the terms and conditions of the loan. since the rate of interest remains fixed. These liabilities have to be met even if the earnings are low or there is loss. and the other is the repayment of principal amount. the borrowing of funds involves two types of liabilities. it is against the security of assets. the balance of profit 17 . they can sue the 190 BUSINESS STUDIES firm in a law court if there is default in payment of interest or repayment of loan amount. Its chief characteristics are: (i) Time horizon: Loans can be raised by business firms for specified periods at fixed rates of interest. (iii) Repayment: Interest on borrowed capital is payable at periodic intervals. one is the payment of interest at regular intervals.It includes all funds available by way of loans or credit. With a given rate of return. so it can be charged against income and the amount of tax liability is thereby reduced.
depending on the nature and value of the asset. (ii) Adequate security: It requires adequate security to be offered against loans. Borrowed funds are usually. We have discussed the characteristics of ownership capital (owners’ funds) and borrowed capital (creditors’ funds) as sources of business finance. owners’ funds and borrowed funds are taken together to meet the financial needs of business enterprises. We shall now discuss the various sources which may be adopted by a company to raise both ownership capital and borrowed capital. Thus. We have stated earlier that the company form of organization is best suited for undertaking large scale business. available up to 80 per cent of the value of assets. (iii) Loans from financial institutions. This is mainly because a company is in a position to raise much larger amounts of capital than a proprietary or partnership firm.belongs to the shareholders. a proprietary. Default in meeting these obligations may create problems for the business. Let us examine the characteristics and implications of each of the long term sources. Whether it is a trading or manufacturing concern. (ii) Issue of debentures. Limitations Against the above merits. partnership or company form of organization. (iv)Retained profits. borrowed capital has certain limitations: (i) Fixed liability: Payment of interest and repayment of loans cannot be avoided even if there is no profit. the owners may enjoy a much higher rate of return on investment than the lenders. and (v) Public deposits. Continuing default may even lead to insolvency of the firm. Sources of Company Finance The sources of long term finance include: (i) Issue of shares. To begin with business may suffer on account of decline of its credit worthiness. EXTERNAL TRADE 191 18 .
the equity shareholders may lose the entire amount they had invested. Equity shares have the following distinct characteristics: (i) The holders of equity shares are the primary risk bearers. Prior to this. limited to the amount agreed to be subscribed by the shareholders. Equity share capital may be (i) with equal rights. They enjoy the reward as well as bear the risk of ownership. Those who subscribe to the share capital become members of the company and are called shareholders. The liability is generally. Equity capital represents ownership capital as equity shareholders collectively own the company. It is the issue of equity shares that mainly provides risk capital. Creditors’ dues must be met before any payment is made to the preference or equity shareholders. Two types of shares may be issued by a company to raise capital: (a) equity shares. voting or otherwise. There is no promise to shareholders of a fixed dividend. This has been permitted after an amendment to the Companies Act in 2000. They are the part owners of the company. This implies that in case the company suffers losses and has to be closed down. 19 . shares are also described as ownership securities. or (ii) with differential rights as to dividend. and (b) preference shares. (a) Equity shares: The amount raised by the issue of equity shares is known as equity share capital.(i) Issue of shares: The amount of capital decided to be raised from members of the public is divided into units of equal value. public companies were not allowed to issue equity shares with differential rights. it is the most important source of raising long term capital for a company. Hence. These units are known as shares and the aggregate value of shares is known as share capital of the company.
(iii) It is on the basis of equity share capital that loans can be raised. (iv)Democratic control over management of the company is assured due to the voting rights of equity shareholders. there are certain limitations also of this source of finance: 20 . Equity provides the credibility to the company and confidence to the prospective loan provider.(ii) Equity shareholders have a residual claim in the firm. (ii) It facilitates a higher rate of return to be earned with the help of borrowed funds because loans carry a fixed rate of interest. equity shareholders are likely to enjoy a higher rate of return based on profitability. In other words. (v) Since equity shareholders have the right to vote for the election of the board of directors. collectively they ensure that the company is managed in the best interests of the shareholders. Hence. (i) It is a source of permanent capital without any commitment of a fixed 192 BUSINESS STUDIES return to the shareholders. Merits From the company’s point of view. belongs to equity shareholders. (iv)Equity share capital is the basis on which loans can be raised. and preference shareholders. The return on capital depends ultimately on the profitability of business. outsiders. there are several merits of issuing equity shares to raise long term finance. (iii) Equity shareholders are likely to enjoy a higher profit as well as higher increase in the value of the shares. the income left after satisfying the claims of all creditors. It provides credibility to the company and confidence to the loan providers. Limitations Although there are several advantages of issuing equity shares to raise long term capital.
It is not an obligatory payment. it consists of some characteristics of equity shares and some attributes of debentures. (iii) Issue of additional equity shares to raise funds for expansion poses a threat to the existing shareholders as regards their power of control over management of the company. When there is no scope for expansion or new investment during periods of economic depression. offered the new issue of shares and in case they decline. These generally. determine the time of issue of shares and the value of the shares. (v) An equity issue cannot be made any time the company wants. It is referred to as preference shares as the owners of these shares have a preferential claim over dividends and repayment of capital. (iv)There are too many procedural delays and too many time consuming formalities to be completed before any public issue of shares can be made. (ii) Equity share capital is a permanent source of finance. It resembles debentures because it gets a fixed rate of return. the shares are offered to the public. even if there is a profit. there is always the possibility of putting it to sub optimal uses. the equity capital may remain idle. (ii) The payment of preference dividend is entirely within the discretion of directors. It resembles equity shares in the following ways: (i) preference dividend is payable only out of profit after tax. Existing shareholders are generally.(i) Equity shares have the risk of fluctuating returns and the risk of fluctuating market value of shares. Preference shares have the following distinct characteristics: 21 . It cannot be refunded during the life of the company. In times of adversity. New shareholders may exercise their voting rights against the continuation of existing directors. the rate of return may be reduced since there is no commitment to pay and no fixed obligations to be met on equity capital. It depends on market conditions. (b) Preference shares: The amount of share capital which is raised by the issue of preference shares is called preference share capital. there may be low returns or even no returns. Preference shares represents a hybrid form of financing in that.
(i) Preference shareholders have the right to claim dividend out of profits at the fixed rate, which is decided according to the terms of issue of shares. (ii) Preference shareholders have also the preferential right of claiming repayment of capital in the event of winding up of the company. Preference capital has to be repaid out of assets after meeting the loan obligations and claims of creditors but before any amount is repaid to equity shareholders. Different kinds of preference shares may be issued as: (i) Cumulative or non-cumulative; (ii) Participating or non-participating; (iii) Redeemable or non-redeemable; (iv)Convertible cumulative preference shares. In the case of cumulative preference shares, if dividend cannot be paid due to inadequate profits in a particular year the arrears of dividend accumulate and become payable in subsequent years when profits are adequate. Non-cumulative preference shares have no such provision. If the shareholders, in addition to the fixed rate of dividend, are entitled to a further share in the surplus profits after a reasonable dividend has been paid to equity shareholders, the shares are known as participating preference shares. Where the terms of issue do not provide for it, the shares are known as non-participating preference shares. Redeemable preference shares are those which the company undertakes to redeem (that is, repay) after a specified period. Where there is no such undertaking, the shares are called irredeemable preference shares. However, these shares can also be redeemed by the company after specified period by giving notice as per the term of issue. It may be noted that companies are no longer permitted to issue irredeemable preference shares. A company may decide to issue a type of cumulative preference share which can be converted into equity share. These are known as convertible cumulative preference shares. Under present rules in India conversion of such shares can be decided to be made 194 BUSINESS STUDIES between the end of one and 5 years. In India preference shares usually, are cumulative with reference to dividends. Merits Issue of preference shares as a source of finance is preferred by many companies due to the following reasons:
(i) It helps to enlarge the sources of funds as some financial institutions and individuals prefer to invest in preference shares due to the assurance of a fixed return. This helps the company to attract investors. (ii) Dividend is payable only when there are profits. There are no fixed liabilities as is the case with loans and borrowings. (iii) A higher return is possible if the company is in good times, in the case of participating preference shares. (iv) It does not affect the equity shareholders control over management. (v) The rate of preference dividend is fixed. Hence, in years of prosperity, the rate of return on equity capital is likely to be higher than it would be otherwise, due to preference share capital. Limitations The limitations of preference shares relate to some of its main features: (i) Dividend paid cannot be charged to the company’s income as an expense; hence, there is no tax saving as in the case of interest on loans. (ii) Issue of preference share does not attract many investors as there is no assured return, and the return is generally, low and lesser than the rate of interest on loan. (iii) The holders of preference shares have a right to vote on any resolution of the company directly affecting their rights, which includes any resolution for winding up the company, repayment or reduction of its share capital, etc. (ii) Debentures: Debentures are instruments for raising long term debt capital. When a company decides to raise loans from the public, the amount of loan raised from a particular issue of debentures is divided into units of similar value. A debenture certificate is issued by the company to acknowledge its debt. Those who invest money in debentures are known as debenture holders. They are creditors of the company. Debentures are, therefore, called creditor ship securities. Debentures have the following characteristics: (a) Debentures carry a fixed rate of interest. (b) Debentures are redeemable i.e., repayable after a certain period which is specified at the time of issue. They may become due for repayment after a period of 5 years or more. EXTERNAL TRADE 195
(c) When debentures are sold to the public and involve a considerable number of persons, a trustee is appointed and a trust deed is formed to convey the property of the company to her/him. The trustee is usually a bank, an insurance company or a financial institution. The trustee is appointed to ensure that the borrowing firm fulfills its contractual obligations. Depending upon the terms and conditions of issue there are different types of debentures. These are: Secured or unsecured debentures, convertible or non-convertible debentures. Debentures which are secured by a charge on the immovable properties, of the company are Secured debentures. Debentures which are not secured by a charge or mortgage of any asset are called unsecured debentures. The holders of these debentures are treated as ordinary creditors. A company may issue debentures which are convertible into equity shares at the option of debenture holders. The ratio of conversion and the period during which conversion can be effected are specified at the time of debenture issue. Such debentures are known as convertible debentures. If there is no mention of conversion at the time of issue, the debentures are regarded as nonconvertible debentures. Merits Debenture issue is a widely used method of raising long term finance by companies. This is due to the following merits: (i) The cost of debt capital, represented by debentures is lower than the cost of preference or equity capital. This is because the interest on debentures is tax deductible and hence, it helps in increasing the rate of return. Thus, debenture issue is a cheaper source of finance. (ii) Debenture financing does not result in dilution of control of equity shareholders, since debenture holders are not entitled to vote. (iii) The fixed monetary payment associated with debentures is interest. This fixed return appeals to many investors, since they are not affected by the fluctuating fortunes of the company. (iv)Funds raised by the issue of debentures may be used in business to earn a much higher rate of return than the rate of interest. As a result, the equity shareholders earn more. Limitations We have noted above the advantages of debenture issue as a source of finance.
retained profit is considered to be an ownership fund. Merits This source of finance has the following Advantages: 25 . Retained profits prove useful such times. The burden may be difficult to bear in times of falling profits. commonly referred to as reserves and surplus. this method of financing is known as self financing. It is considered as a very important source of funding. From the company viewpoint. Companies may convert reserves and surplus into share capital by issuing bonus shares. The retained earnings serve many purposes: (a) They provide a cushion of security in times of adversity. The company’s use of surplus or free reserves is termed as ploughing back of profits. bonus shares are issued free of cost and do not result in any outflow of cash. Funds for these purposes can be available out of retained profits.But. Since it is internally generated. 196 BUSINESS STUDIES (ii) This liability must be discharged even if the company has no earnings. (c) Finance for new projects and expansion plans are sometimes required to enter new forays which are important areas for the future. which the company can fall back upon. Since profits belong to the shareholders. Constant innovation and new products are essential for survival. Investors too are benefited by the issue of shares free of cost. (b) In certain industries such as pharmaceuticals research and development activities are of vital importance. The total amount of ownership capital of a company can be determined by adding the share capital and accumulated reserves. (iii) Retained profits: Retained earnings are the undistributed profits after payment of dividends and taxes. It provides the basis of financial expansion and growth of companies. it has certain limitations also: (i) It involves a fixed commitment to pay interest regularly and fixed obligation to pay the amount when it is due on the part of the company. They represent the internal sources of finance available to the company. It serves the purpose of medium and long term finance.
(iii) There is no fixed commitment to pay dividend on such funds. Limitations Use of retained earnings may result in the following drawbacks: (i) The management of a company may not always use the retained earnings in the best interest of shareholders. Though. Fixed deposits are simple to raise. A company intending to invite deposits simply has to advertise in the newspapers. (ii) Use of retained profit does not involve any cost to be incurred for raising the funds. (iv)Public deposits: These are unsecured deposits invited by companies from the public mainly to finance working capital requirements. Frequent Capitalization of reserves may result in over capitalization. they can be renewed from time to time. The terms and conditions of the deposit are printed on the 26 . advertising.(i) As an internal source. (vi)Retained earnings add to the financial strength and improved credibility of the company. the renewal facility enables them to be used as medium term finance. It does not depend on the investors’ preference and market conditions. However. it is more dependable than external sources. (iv)Control over the management of the company remains unaffected as there is no addition to the number of shareholders. The company in return issues a deposit receipt which is an acknowledgement of debt by the company. (v) Unlike debentures. An EXTERNAL TRADE 197 company with large reserves can face unforeseen contingencies. Any member of the public can fill up the prescribed form and deposit the money with the company. (ii) Large retention of earnings over a long period of time may cause dissatisfaction among shareholders as they do not receive the expected rate of dividend. It may misuse them by investing in unprofitable or undesirable channels. no charge is created against the assets and no restrictions are put on the management. Public deposits can be invited by companies for a period of 6 months to 3 years as per rules. Excessive reserves may make the management wasteful and extravagant. etc. trade cycles and any other crisis. There are no expenses on prospectus. they are primarily sources of short term finance. the management may issue bonus shares to equity shareholders. (iii) If the quantum of retained earnings is too high.
The rate of interest on public deposits depends on the period of deposit and reputation of the company.back of the receipt. the depositors feel shaky about the financial health of the company. it helps in bringing down the tax liability. Hence. Also. (v) There is no dilution of shareholders’ control because the depositors have no voting rights. there are fewer administrative costs for deposits. 198 BUSINESS STUDIES (ii) Public deposits are unsecured. as deposit or investment. But now. (iii) Public deposits are an uncertain and unreliable source of finance. a company which has public deposits is required to set aside. interest rates are in tune with the market trends but generally. (iv)Public deposits introduce flexibility in the financial structure of the company. Merits The merits of public deposits are the following: (i) The procedure for obtaining public deposits is much simpler than equity and debenture issues. deposits may be withdrawn whenever. if need arises. Limitations Raising finance through public deposits suffers from the following limitations: (i) The amount of funds that can be raised by way of public deposits is limited. This is because the deposits can be repaid when they are not required. (iii) Interest paid on public deposits is tax deductible. The amount so set aside can be used only for repaying such deposits. The company cannot depend on them for long term financing requirements. The depositors may not respond when conditions in the economy are uncertain. (ii) The maturity period is relatively short. Thus. Earlier interest rates were subject to a ceiling. the assets are free to be used as mortgage in future. Since these deposits are unsecured. Thus. because of legal restrictions. Public deposits cannot exceed 25 per cent of share capital and free reserves. 27 . public deposits pay out a higher rate than the interest rate on bank deposits. in the current year an amount equal to 10 per cent of the deposits maturing by the end of the year.
company can use this reserve as working capital. 28 . as it will become a blocked reserve. administrating accounts receivables.Sources for raising the long-term funds for a large-scale organization for growth of a company are: Owned and Borrowed funds: Working capital management or short-term financial management is a significant facet of financial management. Profits: If the company is earning profits. and monitoring the investment in inventories also take a great deal of time. controlling the movement of cash. If the company does not have any cash reserves. the new companies will not keep more cash reserves. Mostly. In the time of inflation or depression. it can turn some percent of profits towards working capital reserves. A company can mobilize working capital by: Existing cash reserves Profits Bank overdrafts or lines of credit Commercial papers Inter-corporate Deposits Spontaneous sources Existing cash reserves: Every Company will maintain cash reserve to meet the working capital needs. Working capital involves activities such as arranging short-term finance. negotiating favorable credit terms. then it can go for the alternatives. It is important due to 2 reasons: Investment in current assets represents a substantial portion of total investment Investment in current assets and the level of current liabilities have to be geared quickly to changes in sales.
) Form of issuing the working capital. controlling the movement of cash. the banker will not commit any physical outflow. and monitoring the investment in inventories also take a great deal of time. The form of assistance may be either Non-fund based or Fund based lending. banker will look the following before financing: Working capital management or short-term financial management is a significant facet of financial management. In case of non-fund based lending. Banks play vital role in financing the working capital to the organizations. administrating accounts receivables. banker will look the following before financing: The amount required by the company (Amount of Assistance. Both the Bank Guarantee and Letter of Credit helps the organization to make purchases and selling goods overseas.Bank overdrafts or lines of credit: Banks play vital role in financing the working capital to the organizations. However. These will also act as guarantee for the goods that are supplied. Security to be taken. It is important due to 2 reasons: Investment in current assets represents a substantial portion of total investment Investment in current assets and the level of current liabilities have to be geared quickly to changes in sales. Working capital involves activities such as arranging short-term finance. negotiating favorable credit terms. Commercial papers: Commercial Paper (CP) is widely used by top-rated corporate and an institution as a flexible short-term instrument that provides a cost-effective diversification of funding sources away from the banking sector. Regulations applicable for issuing the working capital. 29 . It will be in the form of Bank Guarantee or Letter of Credit. However.
meaning that the investment is almost always relatively low risk. and usually have a limited or nonexistent secondary market. Corporate Bodies.It is an unsecured obligation issued by a corporation or bank to finance its shortterm credit needs. Who can issue? A company with a tangible net worth of more than 4 crores as per the latest audited balance sheet. such as accounts receivable and inventory. Foreign Institutional Investors. Companies with high credit ratings usually issue commercial paper. Commercial paper is available in a wide range of denominations. It is not a deposit as per Provisions of Section 58-A of Companies Act. Procedure to issue CPs: Company should appoint a Schedule bank as the Issuing and Paying Agent. Maturities typically range from 15 to 365 days. The RBI approved credit rating companies are: CRISIL CARE ICRA Fitch Rating India (P) Ltd. The issuing company needs to disclose the financial status of the company to the IPA. 30 . The value of the CP is Rs. Every renewal will be considered as a fresh issue. IPA will check the credit rating and the documents submitted by the issuing company and the valid agreement. Individuals. 1956. Borrowed amount of the company is classified as a standard asset by the bank. Nature: The maturity period ranges from 15 to 365 days. Banks.5 Lakhs. Who can invest? NRIs. can be either discounted or interest bearing. The company needs to obtain satisfactory credit rating (Minimum rating required is p-2 of CRISIL or equal lent) from any credit rating agency before issuing CPs.
the bank will provide working capital assistance in other forms. the company needs to provide the information about the raw material or machinery that is purchasing. the form differs. it can make purchases on credit and can avail a gap to make the payment. the issuing company needs to issue physical certificates to the investor. for three to six months.After the deal is confirmed. these are not treated as deposits as per the provisions of Section 58-A of the Companies Act. For e. The bank may not issue the extending amount in the form of cash.e. ICDs are short-term loans. Fund based lending.: If the company has good net worth. company needs to provide the corresponding documents. i. After utilizing the bank guarantee. These are unsecured. To issue the bank guarantee. The following are the two different forms: Non-Fund based lending. 31 .g. The company on its own decides the rate of interest. Based upon the documents produced and good will of the company. and the period. Every issue of CP should be reported to RBI through IPA within three days from the date of completion of the issue. However. Non-Fund based lending: Instead of providing cash funds to the company. they are: Bank Guarantee: This is the document supplied by the bank by certifying that the company has the sufficient funds on deposit at the bank and can enter into the transaction. 1956 and as such the regulations applicable to the public deposits do not apply to ICDs. Spontaneous sources: These are the sources through which working capital is generated automatically and these are unsecured sources. Inter-corporate Deposits: This business involves movement of funds from fundssurplus companies to credit worthy corporate borrowers. Bank will issue a letter to the company about the amount that can be used as working capital..
the company needs to provide security to the bank. Fund based lending: In case of Fund based lending. Pledge: Under this method. the banker has the right to sell the security with issuing a notice to the company. unless the company has an outstanding amount. Overdraft. The banker will undertake to pay the exporter or accept the bills of draft drawn by the exporter on the exporter fulfilling the terms and conditions specified in the letter of credit. There are different varieties: Revocable or Irrevocable. the bank commits physical outflow of funds. If the company is importing any goods from other country. Bills purchased/discounted. the company needs to provide any moveable property as security. The banker has the right to sell the security. The bank will possess the security and provides assistance. Packing credit. Confirmed or Unconfirmed. the funds position of the lending bank does get affected. he can approach the bank for the letter of credit on the exporter name. Either a commercial bank or a private corporation can issue this. The following are the different forms of security: Hypothecation: Under this method. The bank will not possess the security.Letter of Credit: This is the primary or secondary source of security for a bond issue. Cash credit. the company needs to provide any moveable property as security. 32 . The fund based lending can be in the following forms: Loans. Security: To avail working capital assistance. If the company has an outstanding amount. Working capital term loans. As such. This is normally found in the International trade.
debentures and can also take term loans. equity shares. If the company is providing buildings. But. The company will offer the investors a security against their investments. it has to repay the investment.Lien: Under this method. banker has the right to verify the security at any time and incase of outstanding amount he can sell the same. The characteristics are: The investors are called as creditors. interest payments interval details etc. and preference shares are the sources for long-term funding. then it will be treated as mortgage. machinery etc. However. accept public deposits and go for leasing and hire purchasing. 33 . On the strength of these only.. Hence. Interest should be paid. Debentures Preference Shares Equity Shares.” Funds rose in the form of debentures need to be repay in the stipulated time. interest rate. If the company is not earning profits. the banker will keep the security with the bank. the company can issue shares. The total amount is subdivided and allocated as per the requirements. It is an agreement by the company to the investor that contains the date of repayment. which is issued by the company. it has to pay interest and after maturity period. debentures. The company needs to clear the loan and can handover the security provided. To meet the capital requirement. Mortgage: This mode is for immovable properties. as the company needs to repay the investment as described in the “Acknowledgement of indebtedness. these are considered as long-term sources. The company need not possess the property to the banker at the time of availing the loan and he can use the same for production purpose. The risk involved with debentures is two-fold in the company’s point. Debentures: A debenture is a document called as “Acknowledgement of Indebtedness”. even though the company did not earn profits. a company can avail short & medium term loans.
in the event the company goes bankrupt. the company can easily repay the investments made by the debenture holders within the said time. although preferred stock shareholders do not enjoy any of the voting rights of common stockholders. Preference shares: Preference shares are the other sources for the company to acquire long-term loans. the company can issue debentures. the company needs to clear off the preference shares with-in 20 years. The features are: Investors are not the absolute owners. preference shares represent partial ownership in a company. The main benefit to owning preference shares is that the investor has a greater claim on the company’s assets than common stockholders. Funds raised as preference shares should be repaid within 20 years as per section 80 of Companies Act The amount acquired is not treated as a permanent capital. if the investors are not ready to invest further. Advantages associated by issuing debentures: Cost associated with debentures is less when compared to equity shares. Also unlike common stock. As the “Debenture redemption reserve” is maintained. Also. as the debenture holders are treated as creditors. Like common stock. By issuing debentures. It provides a specific dividend that is paid before any dividends are paid to common stock holders. preferred shareholders are paid off before common stockholders. preference shares pay a fixed dividend that does not fluctuate. 34 . the company can clear all the short term and medium term loans. as it is the other source for long-term loans. although the company does not have to pay this dividend if it lacks the financial ability to do so.The debentures will not carry any voting rights. Preferred shareholders always receive their dividends first and. During depression. This in return gives more profits. and which takes precedence over common stock in the event of liquidation.
By exercising the voting rights.These shares will not carry any voting rights. Equity shares: The Equity shares play the vital role of the financial structure of the company. as they can be converted to equity shares after a stipulated time. The funds raised in the form of equity shares need to be repaid at the time of closure of the company. 1956 – It may be possible for the companies to issue equity shares with disproportionate voting rights. If the dividend has not been paid.e. However. company need not offer any security against the investment. Company needs to pay the dividend in return. a preference share holder will have the right to vote under the following circumstances: If any resolution directly affecting the rights of preference shareholders is discussed by the equity shareholders. However. Also. The investors have the right to vote. the investors can participate in the affairs regarding the business of the company. Funds raised in the form of equity shares are on unsecured basis. 1956. 35 . The investors are entitled to the profits earned and the losses incurred by the company. i.. the recent amendments to the Companies Act. the following criteria should be satisfied: If the dividend is not paid for cumulative preference shares for an aggregate period of two years. the company can issue the following types of preference shares: It is advised to issue convertible preference shares. The characteristic features are: Investors are treated as real owners. If the dividend is not paid for non-cumulative preference shares either for a period of two consecutive years or for an aggregate period of three years out of the six preceding years. Equity shares are risk free source income to the company. On the strength of these shares the company can procure other sources of capital. which is not fixed. However. This helps the company to have long-term capital and the rate of dividends payable will also reduce after certain time. as per companies Act. the preference shareholders can vote on all the matters before the company in the meeting of the equity shareholders.
7. SEBI has been empowered to issue the directions from time to time. Need not offer a fixed dividend. Enactment of the Securities & Exchange Board of India Act. the only regulatory framework applicable to the companies trying to raise the funds is by issuing their securities in the market by following the guidelines of SEBI. the equity shares will be the good sources to acquire the capital. 1992 and formation of SEBI. 36 . as he will get dividend and good value in secondary market. As such. and then announce in the open market. Private placement of securities. Possibility of higher returns when compared to preference shareholders and debenture holders. Rights issue. it became easy to the companies to raise funds. The equity shareholder cannot compel the company to pay dividend. if the company wants to issue additional equity shares. they need to be offered to the existing shareholders first. at present. To the investor: Limited liability. a company can raise funds by issuing: Public issue. SEBI guidelines affecting the public issue and rights issue of shares & issue of debentures while raising the long-term capital for a company? Capital market is the place where a company can raise the long-term requirement of funds. In the primary market. Due to the liberalization measure and reforms taken in 1990’s. Hence. These are called as “Pre-emptive rights”. Some of the advantages are: To the company: Need not offer any security. 1947 and abolition of the Office of Controller of Capital issues. Easily transferable. In order to protect the interests of the investors. Need not commit the repayment. The main changes that have taken place are: Repeal of capital issues (Control) Act. only to the extent of the face value. However.
37 . It should file a letter of offer with SEBI. An unlisted company has to satisfy the following criteria to be eligible to make a public issue: Pre-issue net worth of the company should not be less than Rs. through an eligible Merchant banker.e. offer through offer document + firm allotment + promoters’ contribution through the offer document) shall not exceed five (5) times its preissue net worth. at least 21 days before it is filed with Regional Stock Exchange.The guidelines.50 Lakhs. failing which the full subscription monies shall be refunded.1 crore in last 3 out of last 5 years with minimum net worth to be met during immediately preceding 2 years and Track record of distributable profits for at least three (3) out of immediately preceding five (5) years and The issue size (i. A listed company cannot make the rights issue. In case an unlisted company does not satisfy any of the above criterions. offer through offer document + firm allotment + promoters’ contribution through the offer document) is less than five (5) times its pre-issue net worth. are: Guidelines for Public & Rights issues: A company that is going for a public issue needs to submit the draft prospects to SEBI. if the aggregate value exceeds Rs.e. In the Book Building process the company has to compulsorily allot at least sixty percent (60%) of the issue size to the Qualified Institutional Buyers (QIBs). Eligibility norms for a listed company for making the public issue? A listed company is eligible to make a public issue if the issue size (i. at least 21 days before it is filed with Register of companies. it can come out with a public issue only through the Book-Building process. through an eligible merchant banker. which the company needs to follow.
e.If the issue size is more than or equal to 5 times of pre-issue net worth. public issue by unlisted company. Basis of allotment: 38 .e. In case of an IPO. In case of any issue of capital to the public the minimum contribution of promoters shall be locked in for a period of 3 years. participation by promoters in the proposed public issue in excess of the required minimum percentage shall also be locked-in for a period of one year as per the lock-in provisions as specified in Guidelines on Preferential issue. the promoters have to necessarily offer at least 20% of the post issue capital. both for an IPO and Public Issue by listed companies. in case of IPO the entire pre-issue share capital i. Restrictions on pricing by companies: The companies can freely price their equity shares. Beside the above. paid up share capital prior to IPO and shares issued on a firm allotment basis along with issue shall be locked-in for a period of one year from the date of allotment in public issue. In case of a public issue by a listed company. failing which the full subscription monies shall be refunded. such excess contribution shall also be locked in for a period of one year. In case of public issues by listed companies. the promoters shall participate either to the extent of 20% of the proposed issue or ensure post-issue share holding to the extent of 20% of the post-issue capital. then the listed company has to take the book building route and allot sixty percent (60%) of the issue size to the Qualified Institutional Buyers (QIBs). However they have to give justification of the price in the offer document / letter of offer Requirements regarding promoters’ contribution and lock-in: In case of an Initial Public Offer (IPO) i. if the promoters’ contribution in the proposed issue exceeds the required minimum contribution.
In case of over-subscription in a fixed price issue the allotment is done in marketable lots. In case of a book building issue. is required to fulfill the following conditions: Appoint one or more debenture-trustees for such debentures.1 of Guidelines. Allotment: Companies are required to finalize the basis of allotment within 30 days from the closure of the issue in case of a fixed price issue and within 15 days from the closure of the issue in case of a book building issue or else they are liable to pay interest @ 15% p.6. As per the section. Debenture trustee: The appointment and duties of the trustees are dealt with in Section 117B of the Act. the issuer can freely determine the interest rate. 7. Allotment to retail investors is done on a proportionate basis as per provisions of Clause No. Price: Where fully convertible debentures are to be issued. allotment to Qualified Institutional Buyers and Non-Institutional buyers are done on a discretionary basis.a. Partly paid shares: The company cannot make the issue of equity shares unless all the partly paid shares have been fully paid. Guidelines for issuing debentures: Issue: A company cannot issue fully convertible debentures having a conversion period of more than 3 years unless conversion is made optional with “put” and “call” option. before issuing a prospectus or letter of offer to the public for subscription of its debentures. on a proportionate basis. Debenture Redemption Reserve: Companies are required to create a Debenture Redemption Reserve (DRR) equivalent to 50% of the amount of debenture issue before debenture redemption commences. and 39 . a company.
subject to the provisions of the Act. the debenture-trustee may take any of the following steps. by an order. In addition. or Redress the grievances of the debenture-holders. after hearing the company and any other person. The section also lays down that. 40 . to: Ensure that the assets of the company issuing debentures and each of the guarantors are sufficient to discharge the principal amount at all times. Ensure that the company does not commit any breach of the covenants and provisions of the trust deed. the functions of the trustee shall generally be to: Protect the interests of the debenture-holders (including creation of securities within the stipulated time). If he is beneficially entitled to monies which are to be paid by the company. Take all steps to call a meeting of debenture-holders as and when such meeting is required to be held. Satisfy him that the prospectus or the letter of offer does not contain any matter which is inconsistent with the terms of the debentures or with the trust deed.State on the face of the prospectus or letter of offer that the trustees have given their consent to be so appointed. impose such restrictions on the incurring of any further liabilities as it thinks necessary in the interest of the debenture-holders. and Has entered into any guarantee in respect of principal debts secured by the debentures or interest thereon. The CLB may. If the trustee considers at any time that the assets of the company are insufficient or likely to be insufficient to discharge the principal amount as and when it becomes due. he may file a petition before the Company Law Board (CLB). This is subject to the further condition that a person shall not be appointed as a trustee if he: Beneficially holds shares in the company. as he may deem fit. Take such reasonable steps to remedy any breach of covenants of the trust deed or the terms of issue of the debentures.
It should provide all the credit ratings obtained during the three preceding years for any listed securities of the company are to be disclosed. investment-grade rating from two credit rating agencies will be required. expansion capital should generally be raised by issuing debt. 41 . as per SEBI guidelines. and then establish a target capital structure. Four primary factors influence capital structure decisions. equity should generally be issued. 1. Therefore. but at any given moment. The company needs to provide all the information even though the debt instruments may be secured or unsecured. Security: The company shall create the security within 6 months from the date of issue of debentures. using more debt generally leads to a higher expected rate of return on equity. as per SEBI. the lower its optimal debt ratio. However.Credit rating: The debt securities to be issued should also carry an investment-grade credit rating. If the actual debt ratio is below the target level. whereas if the debt ratio is above the target. management should have a specific capital structure in mind. Capital structure policy involves a trade-off between risk and return: Using more debt raises the risk borne by stockholders. The business risk or the riskiness inherent in the firm’s operations if it used no debt. THE TARGET CAPITAL STRUCTURE Firms should first analyze a number of factors. the optimal capital structure must strike a balance between risk and return so as to maximize the firm’s stock price. The greater the firm’s business risk. Higher risk tends to lower a stock’s price. but a higher expected rate of return raises it. This target may change over time as conditions change. For issues above Rs 100 crore.
other things held constant. They also know that when money is tight in the economy. Therefore. Managerial conservatism or aggressiveness. so additional debt will not be as advantageous as it would be to a firm with a higher effective tax rate. 4. Sales price variability. and the worse the consequences of a capital shortage. Financial flexibility or the ability to raise capital on reasonable terms under adverse conditions. or by tax loss carry-forwards. Firms whose products are sold in highly volatile markets are exposed to more business risk than similar firms whose output prices are more stable. 3. the lower its business risk.2. These four points largely determine the target capital structure. which lowers the effective cost of debt. which is vital for long-run success. A major reason for using debt is that interest is deductible. Corporate treasurers know that a steady supply of capital is necessary for stable operations. 2. suppliers of capital prefer to provide funds to companies with strong balance sheets. Input cost variability. the more important of which are listed below: 1. if most of a firm’s income is already sheltered from taxes by depreciation tax shields. both the potential future need for funds and the consequences of a funds shortage influence the target capital structure—the greater the probable future need for capital. its tax rate will be low. but operating conditions can cause the actual capital structure to vary from the target. Business risk depends on a number of factors. or when a firm is experiencing operating difficulties. the stronger the balance sheet should be. hence some firms are more inclined to use debt in an effort to boost profits. The firm’s tax position. but it does influence the manager determined target capital structure. Firms whose input costs are highly uncertain are exposed to a high degree of business risk. Some managers are more aggressive than others. 3. capital structure. Demand variability. However. or valuemaximizing. by interest on currently outstanding debt. This factor does not affect the true optimal. The more stable the demand for a firm’s products. 42 .
it may be subject to political risks. Foreign risk exposure. See Chapter 16 for a further discussion. other things held constant. this stabilization may require spending a great deal on advertising and/or price concessions to get commitments from customers to purchase fixed quantities at fixed prices in the future. the lower the degree of business risk. if a firm operates in a politically unstable area. The faster its products become obsolete. 6. as 43 . This factor is called operating leverage. the higher a firm’s fixed costs. However. Firms that generate a high percentage of their earnings overseas are subject to earnings declines due to exchange rate fluctuations. Ability to adjust output prices for changes in input costs. and it is discussed at length in the next section. However. hence do not decline when demand falls. the greater a firm’s business risks. For example. Some firms are better able than others to raise their own output prices when input costs rise. The greater the ability to adjust output prices to reflect cost conditions. OPERATING LEVERAGE Business risk depends in part on the extent to which a firm builds fixed costs into its operations—if fixed costs which are high. even a small decline in sales can lead to a large decline in ROE (return on equity). then the firm is exposed to a relatively high degree of business risk.4. capital intensive firms and industries. Higher fixed costs are generally associated with more highly automated. cost-effective manner. most firms can. Firms in such high-tech industries as drugs and computers depend on a constant stream of new products. Also. If a high percentage of costs are fixed. Each of these factors is determined partly by the firm’s industry characteristics. 7. Ability to develop new products in a timely. take actions to stabilize both unit sales and sales prices. through their marketing policies. the greater its business risk. but each of them is also controllable to some extent by management. So. 5. businesses that employ highly skilled workers who must be retained and paid even during recessions also have relatively high fixed costs. The extent to which costs are fixed: operating leverage.
In business terminology. Age of the company 9. Sales Promotion 3. Lender attitude 1. Leverage or trading on equity 2. because the amortization of development costs is an element of fixed costs. Size of the business 8. Cash Flow ability of a company 6. External environment such as the state of capital market. 5. In physics. It is thus. Management attitudes 4. other factors held constant. taxation policy. This enables the owners of a company to enhance their return on equity by borrowing funds for one rate of interest.do firms with high product development costs. state regulations etc 7. Assets structure. If a high percentage of total costs are fixed. implies that a relatively small change in sales results in a large change in ROE (return on equity) The Optimal Capital Structure The Optimal Capital Structure Is the one that minimizes the firm’s cost of capital and maximizes firm value. leverage implies the use of a lever to raise a heavy object with a small force. then the firm is said to have a high degree of operating leverage. The right proportion or the appropriate mix of the debt and equity should increase the market value of share held by shareholders The various factors affecting the capital structure decision are: 1. Leverage or Trading on equity: Trading on equity or leverage refers to the financial process. a high degree of operating leverage. called making money by using other people's money. and using the money to earn a higher rate of return. keeping the different for them. Some of the main conclusions regarding the leverage in the capital structure such as use of fixed cost or fixed return sources of finances may be reemphasized. Period of finance 10. Debts and per share capital results' into 44 .
Therefore. Earnings before interest and taxes (EBIT) and EPS relationship are the means to examine the effect of leverage. Than the cost of their use. Firms with long lived fixed assets. especially when demand for their output is relatively assured utilities for example . the greater the stability in sales and earnings the greater the debt that should be employed.magnifying the earnings per share (EPS) prevailed the firm earns more on the assets purchased with these funds. Similarly.use long-term debt extensively similarly greater the liquidity the more debt that generally can be used all other factors remaining constant. involved determine the debt or equity in the capital structure and any analysis of capital structure planning can hardly afford to ignore this factor. tax deductible.' the leverage impact is felt more in the case of debt because their source of finance costs lower. than per share capital and also the interest payable on. To give. 4. that is. while planning capital structure. The less liquid the assets of firm the less flexible the firm can be in meeting its fixed charged obligations. 2. 45 . Management Attitudes: Management's attitude concerning control of enterprise and risk. firms may prefer debt to be assumed of continued control. Out of per share capital and debt. therefore. In fact every addition of equity unit in the capital structure presents management to participate in the company affairs to that extent. up because of its effect on EPS financial leverage is one the important consideration in planning the capital structure for the company. The future growth of sales is a measure of the extent to which the earnings per share (EPS) of the rum are likely to be magnified by leverage. Sales Position: Sales position covers growth rate of future sales and sales stability. Assets Structure: Composition and liquidity of assets may also influence the capital structure decision of the firm. debt is. sales stability and debt ratios are directly related. The greater the external financially that is usually required. 3. The use of fixed cost sources of finances also adds to the financial risk of the company and. it should not be used beyond a point where the amount of fixed commitment charges equals the level of EBIT. This is so because the likely volatility and uncertainty of future sales have important influences upon the business risk the less equity that should be employed. It is because of this factor that public utilities employ more debt than equity because they are assured of their future sales and earnings.
the management must ensure the availability . These companies as a result are compelled to depend heavily on retained earnings and share capital. Thus the fixed charged depend upon both the amount of senior securities and the terms of payment. It is therefore. The present taxation provisions are in favor of debt capital because interest payment on debt is a tax deductible expense.5. New companies face a lot of uncertainty in the initial periods of operation. prudent that for servicing fixed charges at proper time. state regulations etc. the greater the debt capacity and vice-versa.of cash because inability on the part of management may result in financial insolvency. as they are completely 46 . The amount of fixed charges will be high if the company employs a large amount of debt or preference capital with short-term maturity. taxation policy with regard to the various sources of finance affects the capital structure decision of the company. The fixed commitment charges include payment of interest on debentures and other debts. Similarly. 8. Age of company: Age of company plays an important role. taxation policy. 7. External Environment: Any decision relating to the pattern of capital structure must be made keeping in view the external factors such as state of capital market. cash flow analysis is essential to consider while planning appropriate capital structure. preference dividend and principal amount. If the capital market is likely to be planned in bearish state and interest rates are expected to decline the management should postponed the debt for the present in order to take advantage of' cheap debt at a larger stage. However. To be on a safe side the cash flow ability must be determined in the period of depression very carefully. the greater and more stable the expected future cash flows of the firm. Cash flow ability of the company: When considering the appropriate capital structure it is extremely important to analyze the cash flow ability of the firm to serve fixed commitment charges. the management may inject additional doses of debt in capital structure. Size of the company: Smaller companies confront tremendous problem in raising fund and these companies have to pay higher interest on debt and have to agree to inconvenient terms of loan. if debt will become costlier and will be on scarce supply owing to bullish trends of the capital market. On the contrary dividend payable on equity capital preference share capital is subject to tax state regulation is another exterior factor that must be taken into account while planning capital structure. 6. Therefore. Obviously.
The above-listed factors and difference analysis would help the financial manager to determine within some range the appropriate capital structure. 13. 11. Growth rate. 10. a firm with less operating leverage is better able to employ financial leverage because it will have less business risk. Before adopting a capital structure the management may discuss their strategies with its prospective lenders if possible. Other things the same. Other things the same. General-purpose assets that can be used by many businesses make good collateral. which encourages 47 . Further. real estate companies are usually highly leveraged. Thus. whereas special-purpose assets do not. the company can issue preference share and or debentures. 9. These companies are compelled to depend upon their own.unknown to the suppliers of funds. sources of funds. Lender's attitudes: Lender's attitudes are frequently important and sometimes the most important determinant of capital structure. Small firms or newly started funds have low standing in the market and they are compelled to pay a higher rate of interest on long-term debts. whereas companies involved in technological research are not. When funds are required to finance modernization programs such as overhauling of machines and equipment and aggressive advertising campaign. equity share to capital is preferred. Asset structure. Operating leverage. Firms whose assets are suitable as security for loans tend to use debt rather heavily. the flotation costs involved in selling common stock exceed those incurred when selling debt. When funds are required for permanent investment in a company. Period of finance: The period of finance should be paid due attention in the capital structure decision. faster-growing firms must rely more heavily on external capital (see Chapter 4). 12.
however. Control. Thus. Taxes. Interest is a deductible expense. 16. which tends to reduce their willingness to use debt. 48 . if management is at all insecure. management runs the risk of a takeover. Therefore. Therefore. regardless of their target capital structures. and Coca-Cola simply do not need to do much debt financing. these companies sold bonds to get their capital structures back on target. For example. Conditions in the stock and bond markets undergo both long. one practical explanation is that very profitable firms such as Intel. When conditions eased. On the other hand. 17. Market conditions. 15. If management currently has voting control (over 50 percent of the stock) but is not in a position to buy any more stock. the junk bond market dried up. and there was simply no market at a “reasonable” interest rate for any new long-term bonds rated below triple B. Although there is no theoretical justification for this fact. and deductions are most valuable to firms with high tax rates. however. the managers will almost surely lose their jobs. 14. Microsoft. because if the firm goes into default. because the type of capital that best protects management will vary from situation to situation. One often observes that firms with very high rates of return on investment use relatively little debt. the greater the advantage of debt. if too little debt is used.rapidly growing firms to rely more heavily on debt. control considerations could lead to the use of either debt or equity. low-rated companies in need of capital were forced to go to the stock market or to the shortterm debt market. The effect of debt versus stock on a management’s control position can influence capital structure. In any event. these firms often face greater uncertainty.and short-run changes that can have an important bearing on a firm’s optimal capital structure. Profitability. it may choose debt for new financings. At the same time. Their high rates of return enable them to do most of their financing with internally generated funds. management may decide to use equity if the firm’s financial situation is so weak that the use of debt might subject it to serious risk of default. However. the higher a firms tax rate. during a recent credit crunch. it will consider the control situation.
A firm’s own internal condition can also have a bearing on its target capital structure. .18. the new earnings are not yet anticipated by investors. will decrease. By necessity. increased use of debt. The corporate income taxes do not exist. the company shall be able to obtain a capital structure. However. This company would not want to issue stock— it would prefer to finance with debt until the higher earnings materialize and are reflected in the stock price. The crucial assumptions of this approach are: the use of debt does not change the risk perception of investors Ke and kd remain constant with changes in leverage. CAPITAL STRUCTURE MATTERS: THE NET INCOME APPROACH Equity-capitalization rate and Debt. the final decision regarding capital structure based on objective analysis supplemented with subjective intuitiveness of the management. if ke and kd are constant.capitalization rate Debt. This point was discussed earlier in connection with asymmetric information and signaling. which has direct influence on maximizing the wealth of shareholders. the overall. In this way. retire the debt. and it forecasts higher earnings in the immediate future. II. hence are not reflected in the stock price. CAPITAL STRUCTURE DOES NOT MATTER: THE NET OPERATING INCOME APPROACH Capitalizes firm’s value Overall capitalization rate Advantages of debt 49 . ko. The first assumption implies that. and return to its target capital structure. For example. suppose a firm has just successfully completed an R&D program. Consequently.capitalization rate is less than Equity. or the weighted average cost of capital. will result in higher value of the firm via higher value of equity.capitalization rate The essence of the net income (NI) approach is that the firm can increase its value or lower the Overall cost of capital by increasing the proportion of debt in the capital structure. by magnifying the shareholders' earnings. The firm’s internal condition. Then it could sell an issue of common stock. Capital structure Theories: I.
If the business risk is assumed to remain Unchanged. Thus. This causes the equity capitalization rate to increase. The market value of the firm is found out by capitalizing the net operating income at the overall. the advantage of debt is offset exactly by the increase in the equity capitalization rate. In practical situations. ke. which may be called the optimal capital structure. TRADITIONAL APPROACH: CRITICISMS Firm’s market value depends upon NOI and risk Total risk can be altered Cost of equity remains unaffected by leverage up to a limit A PRACTICAL VIEW POINT The NI and the NOI approach hold extreme views on the relationship between the leverage. ko which is a constant.capitalization rate is constant Corporate taxes do not exist According to the net operating income (NOI) approach the market value of the firm is not affected by the capital structure changes. The traditional viewpoint states 50 . or the weighted average cost of capital. The critical assumptions of the NOI approach are: the market capitalizes the value of the firm as a whole. ka to capitalize the net operating Income.Debt. the corporate income taxes do not exist. It takes a mid way between the NI approach (that the value of the firm can be increased by increasing the leverage) and the NOI approach (that the value of the firm is constant irrespective of the degree of financial leverage). Thus.As per the traditional approach. kO is a constant. the split between debt and equity is not important. kO depends on the business risk. The traditional approach takes a compromising view between the two and incorporates the basic philosophy of both. of the firm will be minimum and the value of the firm maximum. At this capital structure. a firm should make a judicious use of both the debt and the equity to achieve a capital structure. the debt-capitalization rate kef is a constant. both these approaches seem to be unrealistic. the overall cost of capital. the market uses an overall capital is at ion rate. cost of capital and the value of the firm. WACC. The Use of less costly debt funds increases the risk of shareholders.
Beyond this limit. Therefore. which may be called the 51 . the cost of debt. They have shown that the financial leverage does not matter and the cost of capital and value of firm are independent of the capital structure. remaining unchanged may be that up to a particular degree of leverage. kd. Under the traditional approach. MODIGLIANI-MILLER MODEL: ABSENCE OF TAXES Assumptions: Perfect Capital Market situation Firms – Homogeneous risk Classes 100% dividend pay out NO corporate taxes The present section examines the Modigliani-Miller model (MM). which was presented in 1958 on the relationship between the leverage and cost of capital and the value of the firm. But this position does not continue when leverage is further increased. However. then the risk of the debt investor may also increase and consequently the kd also starts increasing. the increase in financial leverage will increase its WACC (WEIGHTED AVERAGE COST OF CAPITAL) also and hence the value of the firm will decline. The increase in leverage beyond a limit increases the risk of the equity investors also and as result the ke also starts increasing. ko is equal to the k. it shows that the benefits of cheaper debts are available to the firm. The ke does not increase even with increase in leverage. the benefits of use of debt may be so large that even after offsetting the effects of increase in ke the ko may still go down or may become constant for some degree of leverages. the interest charge may not be large enough to pose a real threat to the dividend payable to the shareholders. There is nothing. the use of leverage beyond a point will have the effect of increase in the overall cost of capital of the firm and thus results in the decrease in value of the firm. and kd makes the ko to fall initially. and the now increasing kd make the ko to increase. The argument for ke. The already increasing k. but when (cheaper) debt is Introduce in the capital structure and the financial leverage increases. if the firm increases the leverage further. However.that the value of the firm increases with increase in financial leverage but up to a certain limit only. ke In case of 100% equity firm. the ke remains same as the equity investors expect a minimum leverage in every firm. the capital structure and its composition has no effect on the value of the firm. Thus. is assumed to be less than the cost of Equity. This constant ke. They have maintained that under a given set of assumptions.
3 Investors are rational and well informed about the risk-return of all the securities. in fact. 2 The securities are infinitely divisible.optimal capital structure. 4 All the investors have same probability distribution about the expected future earnings. MODIGLIANI-MILLER MODEL: PRESENCE OF TAXES Proposition l: 52 . They have. The capital markets are perfect and complete information is available to all the Investors free of cost. The implication of this assumption is that investors can borrow and lend funds at the same rate and can move quickly from one security to another without incurring any transaction cost. 1. The MM model is based on the following assumptions. restated the NOI approach and have added to it the behavioral justification for their model.
the benefits of financial leverage exceed the risks: More EBIT goes to investors and less to taxes when leverage is used. 53 .g. The profit or benefit from the arbitrage process may be in any form: increased income from the same level of investment or same income from lesser investment. then the investors will develop a tendency to sell the shares of the overvalued firm (creating a selling pressure) and to buy the shares of the undervalued firm (creating a demand pressure). and individuals and corporations borrow at the same rate The MM model argues that if two firms are alike in all respect except that they differ in respect of their financing pattern and their market value.Kd = Capitalization rate of a pure equity stream of its class Proposition II: Defines Cost of equity Ke = Sum of capitalization rate & premium for financial risk ke = ko + (ko – kd)D/E This approach advocates that the firm can increase its value or lower the overall cost of capital by increasing the proportion of debt in the capital structure. VL= Value of Levered firm VU=Value of Unlevered firm TD= Tax deducted If T=40%. or selling one type of investment and investing the proceed in some other investment. These buying and selling pressures will continue till the two firms have same market values. to testify their hypothesis of financial leverage. buying by a speculator in one market and selling the same at the same time in some other market. then every dollar of debt adds 40 cents of extra value to firm. The Arbitrage Process: Firms which are identical in all respects except for their capital structure must have the same value The arbitrage process refers to undertaking by a person of two related actions or steps simultaneously in order to derive some benefit e. The following assumptions are made in the propositions with taxes: · Corporations are taxed at the rate TC on earnings after interest.. With corporate taxes. MM shows that: VL = VU + TD. · No transaction cost exist. cost of capital and value of the firm. Corporate tax laws favor debt financing over equity financing. This arbitrage process has been used by MM.
the most appropriate capital structure will be the one. etc. The market growth rates form a basis for defining the Organization structure.FACTORS INFLUENCING CAPITAL STRUCTURE Financial Leverage Cash Flow ability Control Flexibility Market conditions Floatation costs Legal framework Nature of business Cost of financing Period and purpose of financing In the real world taking decisions on capital structure is not as easy as it is made out till now. Ultimately. which most closely supports the strategic direction of the business with the least cost and at a reasonably acceptable risk level. both debt and equity and the growth phase of the business have to be considered in tandem. makes it imperative to factor in the market responsiveness to the company's call for funds. Other strategic decisions like management control level. Investment in Assets and Overall Capital Intensity (Debt/Equity Financing). Capability to service the funds. the following points need to be considered: Corporate Strategy Corporate strategy is the main factor determining the financial structure of a company. long term assets should be financed by a balance between term debt and equity and short term assets should be financed less by long term 54 . Generally speaking. risk averseness or risk taking nature of the management. Capital Intensity: Capital structure should factor in the type of the assets being financed. Nature of the Industry The nature of the industry plays an important role in capital structure decisions. In deciding the capital structure of a company. Capital intensive firms rely mostly on long term debt and equity. The fact that the company has to source funds from the markets. have also to be considered.
as permanent investments and fund it by long term sources. the seasonal peaks fund requirements may have to be funded by short term debt. As the business matures. take-over. dividends etc. alteration in earning capacity. the business is seasonal in nature. are affected by the changes in the national and global scene. capital and higher consumer goods their volumes. and hence requirements of funds. current changes in the capital structure decide the future capital structure. In highly competitive industry with low entry barriers. Hence. go into forming the current capital structure which is difficult to change overnight. retiring debts. While making the capital structure decisions. Competition: The degree of competition is also a major factor to be considered in deciding the capital structure. buying back shares. Product or business life cycle: During the initial phase of the growth curve of a business/product the risk is high. the company has to consider the different life cycle stages which are: 55 . taking on debt. a rapidly growing non-seasonal and non-cyclical business may regard part of its investments in short term assets like inventories and accounts receivable. Altering current capital structure can be done by raising capital. altering dividend payout policies. utmost care has to be exercised in decision and implementation of changes in the capital structure. financing policy. Cyclical Business: In businesses like construction. Investment decisions of the past. The terms current (short term) and fixed (long term) assets are determined by the nature of the industry and the business itself. For example. companies with deep pockets can only survive in the long run. Again maneuverability of capital structure is at a premium during times of contraction. etc. as past decisions decide current capital structure. acquisitions. Businesses subject to such variations need a capital structure that can buffer the risks associated with such swings. increased cash flows may reduce the need for debt funds.sources (like term debt and equity) and more by short term debt. Financial leverage is low. which could be increased as the product/business establishes itself. Also. If on the other hand. Debt is hard to come by due to the riskiness of the venture and funding has to be through the venture capital equity. Current and Past capital Structure Current capital structure of a company is determined largely by past decisions.
again depending on corporate strategy. the company could reduce the financial leverage and save on interest and if possible down size the equity by buy back of shares. During this stage. during which the strong companies survive the competitive struggle and aim to expand their market share and volumes. Equity is traded upon: Trading on equity 56 . As the earnings stabilize. the company will be in a position to weather any small variations in business. Capital gearing: The relative proportion between different securities and the ratio of each security to the total capitalization is known as capital gearing. the company may raise capital at the lowest possible cost. Usually a recession in economy opens up a vast number of such opportunities which cash rich companies can take advantage of. A dynamic management will always be on the lookout for expansion/diversification into new projects. due to the risk perception about the company. In case of lack of such opportunities. Stabilization/stagnation stage is the last and final stage. The risk is highest at this stage of the life cycle of the company and the efficient companies are the ones to survive. To survive this capital structure should orient more towards equity and if available utilize soft loans from the government. by bank loans or financial institutional loans. Buy back of shares acts to boost investor confidence in the company and also makes equity serviceable during recession. go in for green-field projects or take over existing units. and then it can seek to financially leverage itself within a pre-fixed ceiling. It is during this stage that companies are typically expected to reward their investors with dividend and stock dividend/splits. The financial cost of borrowing is very high at this stage.• the pioneering stage • the expansion stage • the stagnation/stabilization stage The pioneering stage is one of rapid increase in demand for the products/services of the company. etc. huge investments are made to expand production/service capacity. The expansion stage is the next stage. Subject to the corporate strategy of funding projects and the market conditions. seek mergers. It could. Requirement of funds is high during this stage. acquisitions and strategic alliances.
competitive position. you might also look at other variables. The accounting break-even point is the level of sales at which profits are zero or. For many projects. at which total revenues equal total costs. This type of risk is a function of the firm’s regulatory environment. etc. the break-even condition is defined in terms of accounting profits. however. some costs are fixed regardless of the level of output. As we have seen. Note that business risk is. for example. we are asking how serious it would be if we have misestimated sales or costs. managers most often focus on the break-even level of sales. More properly. However. the make-or-break variable is sales volume. Break-even level of revenues = fixed costs including depreciation Additional profit from each additional Rs of sales Break-even analysis examines the cost tradeoffs associated with demand volume. This type of risk is a direct result of management decisions regarding the relative amounts of debt and equity in the capital structure Break-Even Analysis When we undertake a sensitivity analysis of a project or when we look at alternative scenarios. Most often. Managers sometimes prefer to rephrase this question and ask how far off the estimates could be before the project begins to lose money.the variability of the firm’s earnings before taxes (or earnings per share). “losing money” can be defined in more than one way. labor relations. Break-even analysis can be an effective tool in determining the cost effectiveness of a product. 57 . As it turns out.the variability in a firm’s EBIT. Therefore. outside of the control of managers Financial risk .Capital gearing Financial leverage There are two main types of risk that a company faces: Business risk . equivalently. it should be defined in terms of net present value. at how high costs could be before the project goes into the red. Other costs vary with the level of output. to a large degree. This exercise is known as break-even analysis.
Benefits and Uses: The evaluation to determine necessary levels of service or production to avoid loss.Required quantities to avoid loss. Comparing different variables to determine best case scenario. Use as a comparison tool for making a decision. 58 .
Figure 1: < Caption of the Figure> 61 .
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