B.B. A. 3.

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Financial Management

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UNIT – 1 Financial Management

Nature of Scope of Financial Management During the past three decades role and responsibilities of finance manager have undergone a marked transformation ever witnessed earlier. The finance manager has now become an integral part of the business enterprise and is involved in all the activities that take place in the enterprise. Until recently, finance executive was considered as keeper of books of accounts and provider of funds needed by the firm. But today his responsibility is not limited ot procurement of funds but extends beyond it to ensure is optimal utilization. He plays pivotal role in planning quantum and pattern of fund requirements, procuring the desired amount of funds. Since all the business activities like marketing, purchase and production involve cash planning and utilization or generation of funds, the finance manager must take cognizance of his involvement in all the activities of the firm. He must also have clear conception of the overall objective of his firm as he has to act in conformity lea with the objective. Furthermore, he has to evaluate the effectiveness of financial decisions in the light of some standard objectives of the firm. OBJECTIVE OF THE FIRM Objectives are long-term purpose and mission, which state the reason for existence of the firm and declare what it wants to achieve in the long run. They represent desired results, the firm wishes to attain by its existence arid operations. They indicate specific sphere of aims, activities and accomplishment. Being profit seeking organization, the management is supposed to set profit maximization as the objectives and accomplishment. PROFIT MAXIMIZATION OBJECTIVES Profitability objective may be stated in terms of profits, return on investment, or profit-to sales ratios. According to this objectives, all such actions as increase income and cut down costs should be undertaken and those that are likely to have adverse impact on profitability of the enterprise should be avoided. Advocates of the profit maximization objective are of the view that this objectives is simple and has the inbuilt advantage of judging economic performance of the enterprise. Further, it will direct the resources in those channels that promise maximum return. Since the finance manager is responsible for the efficient utilization of capital, it is plausible to pursue profitability maximization as the operational standard to test the effectiveness of financial decisions. However, profit maximization objective suffers from several drawbacks, rendering it as an ineffective decisional criterion. These drawbacks are:

(1) It is vague Ambiguity of the term profit as used in the profit maximization objective is its first weakness. It is not clear in what sense the term profit has been used. It may be total profit before tax or after tax or profitability rate. Rate of profitability may again be in relation to share capital, owner’s funds, total capital employed or sales. Which of these variants of profit maximization objective to be considered remains vague? Furthermore, the word profit does not speak anything about short-term and long-term profit. A firm can maximize its short-term profit by avoiding current expenditures on maintenance of a machine. But owing to this neglect, the machine being put to use may no longer be capable of operating after some time with the result that the firm will have to defray huge investment outlay to replace the machine. Thus, profit

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maximization suffers in the long run for the sake of maximizing short-term profit. Obviously, long-term consideration of profit cannot be neglected in favour of short-term profit.

(2) It ignores times value factor Profit maximization objective fails to provide any idea regarding timing of expected cash earnings. For instance, it there are two investment projects and suppose one is likely to produce streams of earnings of Rs. 90,000 in sixth year from not and the other is likely to produce annual benefits of Rs. 15,000 in each of he ensuring six years both the projects cannot be treated as equally useful ones although total benefits of both the projects are identical because of differences in value of benefits received today and those received a year or two years after. Choice of more worthy projects lies in the study of time value of future inflows of cash earnings. The interest of the firm and its owners is affected by the time value factor. Profit maximization objective does not take cognizance of this vital factor and treats all benefits, irrespective of the timing, as equally valuable. (3) It ignores risk factor Another serious shortcoming of the profit maximization objective is that it overbooks risk factor. Future earnings of different projects are related with risks of varying degrees. Hence, different projects may have different values even though their earnings capacity is the same. A project with fluctuating earnings is considered more riskier thatn the one with certainty of earnings. Naturally in investor would provide less value to the former than to the latter. Risk element of project is also dependent on the financing mix of the project. Project largely financed by way of debt is generally more riskier than the one predominantly financed by means of share capital.It view of the above, the profit maximization objective is inappropriate and unsuitable as an operational objective of the firm. Suitable and operationally feasible objective of the firm should be precise and clear cut and should give weightage to time value and risk factors. All these factors are well taken care of by wealth maximization objective, which we shall discuss, in the following paragraphs. WEALTH MAXIMIZATION OBJECTIVE Wealth maximization objective is a widely recognized criterion with which the performance of a business enterprise is evaluated. The word wealth refers to the net present worth of the firm. Therefore, wealth maximization is also stated as net present worth. Net present worth is the difference between gross present worth and amount of Capital investment required to achieve the benefits. Gross present worth represents the presents value of expected cash benefits discounted at a rate which their certainly or uncertainly. Thus, wealth maximization objective as decisional criterion suggests that any financial action which creates wealth or which has a net present value above zero is desirable one and should be accepted and that which does not satisfy this test should be rejected. Algebraically, net present value or worth can be expressed as follows, using Ezra Solomon’s symbols and models

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Where the time period is short and magnitude of uncertainly is not gear. finance manager should recognize the interrelationship between profit and risk. He has to gain flexibility by identifying strategic alternatives both in regard to investment outlets and acquisition of funds.. the finance manager must monitor the cash inflows and outflows of the business and thereby ensure effective utilization of resources. therefore. In this way. value maximization and profit maximization amount to almost the same thing. this is why annual cash benefits of a project are discounted at a discount rate to calculate total value of these cash benefits. It may be noted here that value maximization objective is simply the extension of profit maximization to real life situations. The concept of cash flow is more precise in connotation than that of accounting profit. It is. Thus. In this way. In view of the above reasons. An = the stream of benefits expected to occur from a course of action over a period of time. Another major financial goal of a firm is imparting sufficient liquidity and profitability of the enterprise. GOAL OF FINANCIAL MANAGEMENT Goals of financial management should be so articulated as to help achieve the objective of wealth maximization... The wealth maximization objective considers time value of money. In real world.. the relationship between the two is inverse. He should also seek courses of action that avoid unnecessary risks and anticipate problem areas and ways of overcoming difficulties. It recognizes that cash benefits emerging from a project in different years are not identical in value. measuring benefits in terms of cash flows generated avoids ambiguity. while lower discount rate is applied to discount expected cash benefits of a less risky project. To assure maximum profits to the firm. This is because the concept of wealth is very clear. In the pursuit of the above goals. At the same time. discount rate used to determine present value of future streams of cash earnings reflects both the time and risk. cash benefits of a project with higher risk exposure is discounted at higher discount rate (cot of capital). discount expected cash benefits of a less risky project. Thus. Financial goals may be stated as maximizing long-term as well as short-term profits and minimizing risks. value of a firm is influenced jointly by return and risk. a finance manger while managing funds has to ensure that the firm has adequate liquid resources on hand to satisfy its obligation at all times and in addition it has a certain level above its expected needs to act as a 4 . In fact. A2 . K = appropriate discount rate to measure risk and timing C = initial outlay required to acquire the asset The objective of wealth maximization as pointed out above has the advantage of exactness and unambiguity and takes care of time value and risk factors.Where W = net present worth A1. He should also endeavour to build in sufficient flexibility in the financial operations of the enterprise so as to deal with uncertainty. Thus. the prime responsibility of the finance manager to strike judicious balance between return and risk in order to maximize value of the firm. The wealth maximization objective when used as decisional criterion serves as a very useful guideline in taking investment decision. It represents present value of the benefits minus the cost of the investment. it also gives due weightage to risk factor by making necessary adjustments in the discount rate. These goals imply that the finance manager should take financial decisions in such way as to ensure high level of profits. wealth maximization objective is considered superior to profit maximization objective. Investments promising high profits will be more riskier than their counterparts.

vice-versa. it losses opportunity cost of the funds and therefore. when a risky venture is rejected because its potential benefits fall short of its potential costs.reserve to meet emergencies. strike satisfactory trade off between profitability and liquidity. how it can be ascertained that decision to reject the venture was motivated by satisficing factor. Furthermore. in a competitive world. an entrenched management plays the role of a ‘satisficer’ rather than of a ‘maximiser’. the finance manager is in dilemma. However. likely to weaken its economic vitality of the firm and pose threat to its existence. a company must undertake actions which are reasonably consistent with wealth maximization goal. in fact. MANAGEMENT vs OWNERS The management of an enterprise is supposed to pursue the objective set for the firm. It is cumbersome task to determine when a particular management is playing the role of a satisficer and when it is acting as maximiser. It is usually contended that pursuit of social objective interferes with the economic objectives of an enterprise because social activities will raise costs and risks. designed to be mutually profitable with stockholder. it can be observed that the management may have other goals but the goal of ‘maximising owners’ interest is the dominant goal which the management has to persue because more and more firms now-adays are tying their compensation to the firm’s performance. they reinforce each other. Thus. business enterprises are socially responsible to pursue their profit 5 . goal of high level of profit suffers. on certain occasions the interest of the management may clash with that of the owners. customers. Thus. Social obligations increase cost of operations and therefore. The above line of argument emerges from those who ardently believe that economic objects and social objectives are militant to each other. therefore . employees. therefore. A firm to improve its return must ensure optimum utilization of resources. An entrenched management desirous of perpetuating its existence for years to come may like to play safe and seek in acceptable level of growth rather than take the risks to maximize the wealth of stockholders. The dilemma is high profitability means low liquidity and. community and government. Assumption of social obligations by business is . But if the firm carries large amount of funds in cash. Although they may not act in the best interests of the owners and pursue its goal to fulfill their ambitions of perpetuating their control over the enterprise. The term satisficer here means a person willing to settle for something less. In sum. Even the existence of the management is linked to the maximization goal. For instance. profitability of the enterprise may be adversely affected in the short run but in the long run economic objectives and social responsibility of business are compatible to each other . As economic organs of society. the possibility of pursuing its personal goals exclusively is remote and limited because of the constant evaluation of the managerial performance in the light of the overall goal. The management acting against this goal will not be allowed to continue. No organization can exist any longer without its social acceptance. suppliers. A socially responsible enterprise has to conduct its business in a manner that earns recognition as a constructive and honourable corporate citizen in its relation. This is necessary not only because society provides environment conductive to the operation of business enterprise put also for their survival. a business enterprise has a responsibility towards various sections of the society. SOCIAL OBJECTIVE The modern firm has another objectives – to assume social responsibility. Being a socio-economic organ. He must.

sale of securities. 1930’s was a period of grave economic recession which created formidable problem of liquidity. social concern and capability. Businessmen found it difficult ot acquire funds from banks and other institutions to meet their day-to-day requirements. charitable contributions to social causes tend to enhance the image of the business enterprise in public mind and are likely to improve its market standing. in fact.making objectives to the optimum extent by meeting the material needs of society. in the long run profit objectives and social objectives do not conflict. considerable drive and skill can turn social ills into a business opportunity. the question of coping with social responsibilities voluntarily is largely academic. chemical. the emergence of national advertising and improved distribution practices and the euphoria of high profit margins. nature and terms of financial contracts and similar other matters related to source of raising of funds. Dewing and Lyon dealt with. Before the turn of the present century finance was studied as a part of economics. promotions. Formation of large sized undertakings by consolidating the smaller ones brought before the management the problem of financing these gaint enterprises. choice of capital structure. Study of finance as a separate discipline began only in the early part of the present century when massive consolidation movement took place. There would not be any reason to suppose that a socially responsible business will earn less. Thus. Authorities on finance. They had to liquidate their inventory holdings to meet their financial needs. like radio. Unless a business is able to make a profit. Society does not gain but loss if business performance suffers. steel and automobile upon the economic scene of the USA. For example. Much depends on top management personal values. Accordingly. cost of operations may go up immediately but increased productivity due to highly motivated workers will reduce per unit cost of operations. like Meade. it would be worthwhile to study changing contents of business finance as an academic discipline. the study of business finance remained descriptive one. Thus. Emphasis on study of potentially of different securities as a source of procuring funds from outside world and the role and functions of institutional agencies including investment bankers continue to exist during 1929’s since this decade witnessed a burst of new industries. Supply of quality goods at reasonable price will help the firm in augmenting its sales and improving its earnings because of customers satisfaction. In fact. Even contribution by business organizations to general welfare programmes have several economic spinoffs to business. A business enterprise can serve society only when it operates successfully. if management decides to pay higher wages to workers. means to the social ends of welfare and public interest. a firm can raise funds from investors at cheaper rate if it has been able to ensure fair rate of dividends of its owners. Economic objectives are. But owing to 6 . Social activities of a firm may arise cost of business immediately but in the long run it will be counter balanced by the increased earnings resulting from its social action. EVOLUTION OF BUSINESS FINANCE To have a clear understanding of the role and responsibilities of finance manager. pay fewer dividends and achieve appreciation of share price than the one who are only as responsible as the law requires. Management with high social sensitiveness and strong feeling of personal obligation. Thus. in a scholarly fashion. Profit is essential to the survival of a firm and also to the support of all non-economic activities. the problems of capitalisation. ensures job security and improves working conditions. the major social responsibility of a company is to operate profitability and utilize efficiently the resources at its disposal. In the same view. overwhelming emphasis was placed to the study of sources and forms of financing the new industrial giants.

a number of sophisticated valuation models were introduced and advanced techniques like portfolio selection. which was evolved in the beginning of the present century and which analysis the firm from an outsider’s points of view instead of emphasizing the decision making aspects within the firm. Thus. Limited range of profit opportunities for mature industries and relatively tight money market conditions which were the characteristic features of these years impelled the necessity for allocation of capital resources to most profitable investment outlets. the approach to business finance. Accordingly. emphasis shifted from profitability analysis to cash flow generation with a resultant deemphasis of the previously favoured financial ratio analysis. The period between the mid 1960’s and the early 1970’s was marked as a very fruitful and exciting era for a number of interesting developments. The analytical and empirical frontiers of the discipline were also at the same time redefined and redesigned. The Finance manager started rethinking such important issues as aggregate stock prices.precipitate fall in price level the inventory liquidation did not provide sufficient funds to meet the requirements. Writers on business finance opined vehemently that finance manager would have to play defensive role to protect the firm from dangers of bankruptcy and liquidation. There was thus observed a market shift away from the institutional and external financing aspects to the primary emphasis on day-today financial operations of the firm. Accordingly. as in the past during this decade too literature on business finance placed considerable emphasis on major financial episodes in the life cycle of he firm. economy witnessed vigorous spurt of the business activity on the one hand and despondent stock market and tightening money market conditions. optimal capital structure and effects of capital structure upon the cost of capital and the market value of the firm that the profession went through. 7 . remained popular until the early 50’s. great concern for liquidity and greater interest in sound financial structure of the firm. Problem of financing assumed new dimension in the post world war II. The brief but ominous recession in the share market spurred a large number of diverstitures. capital budgeting as a tool of efficient allocation of funds within the firm received dramatic premiums.S. Matters like cash budget forecasting. on the other. The impact of these developments upon financial management was manifested by improved methods of planning and control. In view of this. The finance manager had to assume the new responsibility of managing the total funds committed to total assets and allocating funds to individual assets in consonance with the overall objectives of the business enterprise. reorganizations and bankruptcies and renewed concern for liquidity and profit margins. aging receivables. analysis of purchases and application of inventory controls received greater emphasis. mathematical programming and simulations were developed which improved the practice of financial management. Consequent upon a series of heated debates regarding cost of capital. Reorganization of industries to cope with the peace time requirements of the economy posed serious problem before the business community to raise substantially large amount of capital form the market. Cash budget technique occupied a place of pride in writing on business finance. Thus. In the early 50’s the U. the profitability of institutional investors and the analytical efficiencies of various portfolio selection criteria on a new line. in 40’s financial experts continued to be concerned with the necessity for selecting financial structures that would be able to withstand the stresses and strains of he post war adjustments. popularly known as traditional approach. the empirical efficiency of business sales. The finance manager was assigned the responsibility of managing the cash flows in such a manner that the organisation will have the means to carry out its objectives as satisfactory as possible and at the same time its obligations as they become due. The change in approach to business finance noticed in the early 50’s was reaffirmed in the subsequent years.

It is. the term ‘business finance’ contents finances of business activities. which may be used in their original form or form which marketable commodities can be manufactured. whereby man’s wants are supplied. Thus. on the other hand. nursing. accountants. transporting and insuring of commodities. The interest in case study this stemmed from a desire for a more analytical approach. lawyers and bankers. there are certain business activities that do not deal in tangible commodities. warehousing. the approach is too restrictive. instead they render services for making profit. brokers. musicians and other who do not deal with the commodities are the concrete example of services class of business activity. giving too narrow a meaning to the word. MEANING OF BUSINESS FINANCE Literally speaking.Thus. as noticed in the preceding paragraphs. to develop the meaning of business finance appreciation of the meaning of business and finance is necessary. industrial businesses are those that actually produce commodities either by manufacture or by some definite treatment of materials or that produce and supply the raw materials. the operation of some sort of a shop or store. however. the dimension of business finance which was earlier limited to periodic or episodic financial events has in recent years broadened to include the study of day-to-day operations of the financial management alongside the periodic financial events. This approach has the virtue of shedding light on the very heart of the finance function. is concerned with the sale of goods produced by manufacturers. For the convenience of analysis. refers to the application of skills or care in the manipulation. Industry and Service. Industrial activity. use and control of money. medicine. It includes collecting. This is as far as the dictionary goes. (i) The first category incorporates the views of all those who contend that finance concerns with acquiring funds on reasonable terms and conditions to pay bill promptly.” Thus. This approach covers study of financial institutions and instruments from which funds can be secured. dentistry. Thus. It lays stress on only one aspect of finance and ignores the other aspect which is very vital. It would. Finance. therefore. actors. We have. different viewpoints on finance have been categorized into three major groups. entertaining represents a few of the types of business activities that supply desired services. However. teaching. Having explained the meaning of business we now proceed finance ahead to define the term. business can be categorized into three groups : Commerce. In addition. Lumbering. accounting. The practices of law. teachers. the concept of finance has changed markedly with change in times and circumstances. Commerce is concerned with the transfer of commodities through numerous channels from the producer to the ultimate consumers. The word finance in real world has been interpreted differently by different authorities. not be in fitness of things to place too heavy reliance on the dictionary meaning of finance because the word finance has a marvelous ability to evoke different concepts in the minds of different persons. the types and duration of obligations to be issued. More significantly. doctors. “Business must be understood to embrace every human activity (usually activated by the hope of profits. Such activates are classified under the category ‘Services’. however. In common paralance the word ‘Business’ is used to denote merchandising. grading. Railroad and steam companies. merchandising and many other activities are business that helps to supply material wants. the amounts required. the timing of the borrowings or sales of stocks. urgency of the need and the cost. The case study is not being increasingly used as an aid in learning how to analyze and solve typical and recurring problems of financial management. 8 . to turn from dictionary to observe what is being contemplated in actual world about finance. a large or small.

Government III. Financial Institutions C. personnel administration. Protagonists of this approach opine that responsibility of a finance manager is not only limited to procurement of adequate cash to meet business requirements but extends beyond this to optimal utilization of funds. what capital expenditure should the firm make? What volume of funds should the firm invest? How should the desired funds be financed? How can the firm maximize its profitability from existing and proposed commitments? Diagrammatic of the management approach to finance give below will help appreciate the approach.. marketing. I. Fixed II. Current B. Individuals B. External Debts or equity funds supplied by: A.(ii) The second approach holds that finance is concerned with cash. Since money involves cost. 1. Funds Uses Asset Expenditures A. 9 . central task of the finance manager. Interest and debt service Charges The management approach to finance is balanced one having given equal weightage to both procurement and utilization aspects of finance and hence has received wider recognition in the modern world. every activity within the firm is the concern of the finance manager. Distributions to owners and / or losses II. according to this approach finance manager is required to go into details of every business activity be it concerned with purchasing. such a definition is too broad to be meaningful. MANAGEMENT APPROACH TO FINANCE Activities (Core Idea) Funds Sources I. Non-asset expenditure A. while allocating resources is to match the advantages of potential uses against the costs of alternative sources so as to maximize the value of the firm. Since almost all business transactions are expressed ultimately in terms of cash. research and other associated activities. Fig. production. Obviously. Other business firms D. This is the managerial approach which is also known as problem-centred approach. Thus. (iii) A less third approach to finance looks on finance as being concerned with acquisitions of funds and wise application of these funds. Internal Cash Flows from operations and special transactions. since it emphasizes that the finance manager is his endeavour to maximize the value of the firm has to deal with vital problems of the firm viz.1. Labour B.

10 . Prather and Wert NATURE OF FINANCE Financial management is an integral part of overall management and not a staff function. Likewise. controlling and administering of funds used in the business” Guthmann & Dougall “The finance function is the process of acquiring and utilizing funds by a business”. dividend decisions influence financing decisions and themselves influenced by investment decisions. C. raising. marketing and personnel. or funds of any kind to be used in connection with the business”. Costs of various methods of financing are affected by this risk. While deciding about the debt-equity mix the finance manager’s endeavour should be to evolve such a pattern as may be helpful in maximizing earnings per share and also market value of the firm.Thus. The basic problems facing the finance manager concerning investments are: (i) (ii) How should the firm invest? In which specific projects should the firm invest? In financing decision the finance manager has to decide as to how much funds the firm should raise to fund its operations and in what form-debt. Thus. business finance may be defined as the process of raising. the proportion in which fixed assets and current assets are mixed determines the risk complexion of the firm. administrating and disbursing funds by privately owned business units operating in nonfinancial fields of industry”. The finance manager while making dividend decision decides as to how the firm’s should be allocated between dividend and retention. providing. overall survival of the firm is influenced by its financial operations. It is not only confirmed to fund raising operations but extends beyond it to cover utilization of funds and monitoring its uses. equity shares. Osborn “Finance consists in the raising. He has to formulate such a dividend policy as may provide sufficient funds to finance the firm’s growth requirements and at the same time ensure reasonable dividends to the stockholders. providing and managing of all the money to be used in connection with business activities. In investment decision a finance manager has to decide about total amount of assets to be held in the enterprise and kinds of the assets – the proportion of fixed assets and current assets. In view of this. capital. The heart of the financial management lies in decision making in the areas of investment. preferences shares and after sources. finance and dividend. These functions influence the operations of other crucial functional areas of the firms such as production. The similar view is also held by the modern scholars as would be clear from perusal of some of the following definitions. managing of all the money. The above decisions are intimately related. Bonneville and Dewey “Business Finance deals primarily with raising. R. “Business Finance can be broadly defined as the activity concerned with planning.

That is why subject of business finance is also studied as corporation finance. It should be noted that problems of purchase. policies and procedures with a view to seizing potential opportunities and minimizing impending threats. production and marketing are outside the purview of business finance although their problems are so intimately linked to problems of finance that in actual practice it is difficult to discern them. The field of corporation finance encompasses the study of financial operations of a business enterprise right from its very inception to its growth and expansion and in some cases to its winding up also.. Decisions in regard to kinds of fixed assets to be acquired for the firm. imperativeness. strategies. voluntary association and corporations. Study of practices. etc. trade and commerce and service and mining is undertaken in business finance. At the outset it may be pointed out that business finance is concerned with finances of profit seeking organizations only and is important segment of private finance. terms of credit. financial decision making is a c continuous dynamic process that goes on throughout the corporate life. A one time financial plan not subjected to periodic review and modification in the light of changed conditions will be a fiasco because conditions change to such as extent that the plan is no longer relevant and acts as a hindrance. private finance concerns with procuring money for private organisation and management of the money by individuals. special attention is devoted to the analysis of the problems and practices involved in raising and utilization of funds. business finance and the finance of non-profit organizations. should be made after consulting production and marketing executives. the determination of dividend policies is almost exclusive finance functions and the finance manager need not consult other functional mangers. However. As a matter of fact. includes both public and private finance. type of customers to be granted credit facilities. Contrary to this. Publich finance is the study of principles and practices relating to acquisition of funds for meeting the requirements of government bodies and administration of these funds by the government. level of inventories to be kept in hand. procedures and problems concerning the financial management of profit making organizations in the field of industry. Private finance therefore comprises personal finance. partnership firms and corporate organizations. charitable and religious and the like organizations. procedures and problems involved in the financial management of educational. of the continuous review of the financial decisions explains generic nature of the financial management. An enterprise to survive has constantly to interact with various environmental forces and adapt and adjust alive to changes in internal as well as external environment and bring about necessary adjustments in goals. Business finance is further split into three categories – finances of sole trading organisatoins. The finance of non-profit organization deals with the practices. the finance manager should call upon the advise of other functional executives of the firm while making decisions particularly in regard to investment. In the study of business finance emphasis is given to financial problems and practices of incorporated enterprises because business activities are predominantly carried on by company form of organisation. SCOPE OF BUSINESS FINANCE In order to understand more clearly the meaning of business finance it is worthwhile to highlight the scope of business finance. 11 . Finance. However. Finally. Personal finance seeks to analyze the principles and practices of managing one’s own daily affairs. as such is but one facet of broader economic activity of mobilizing savings and directing them in investments. Finance.Since finance functions are intimately connected with other business functions. It should be remembered that the same principle of finance apply to large and small and proprietary and non-proprietary organizations nevertheless there are sufficient differences of a specific operating nature justifying separate consideration of each of these organizations.

Traditional approach to finance function has been bitterly criticized by modern scholars on various cogent grounds. allocating. and controlling and not with just any one of them. therefore. It would. The finance manager is. It viewed finance as a staff specially. concerned with all financial activities of planning. reorganization. MODERN CONCEPT OF FINANCE FUNCTION Modern Scholars viewed finance as an integral part of the over-all management rather than as a staff speciality concerned with fund raising operations. finance manager has been assigned wider responsibilities. As a matter of fact. it is not sufficient for the finance manager to see that firm has sufficient funds to carry out its plans but at the same time he has to ensure wide application of funds in the productive process. consolidation. Another criticism of traditional approach is that it over emphasized episodic and non-recurring problems like. problem of working capital management is very crucial problem which has to be dealt with efficiently by the finance manager if an enterprise has to reach the goal of wealth maximization. According to them. he has to handle such financial problems as are encountered by a firm at the time of incorporation. We shall now discuss in detail each of these functions separately. reorganization and the like situations that occur infrequently. is the concern of non-financial executives. recapitalization and liquidation and gave little attention to day-to-day financial problems of on going concerns. He has to take decision with respect to the choice of optimum source from which the funds would have to be secured. sais traditional scholars. can be categorized into two broad group “ Recurring finance function and Non-recurring finance function. Thus. Accordingly. liquidation. raising. 12 . According to them. One such ground is that the traditional approach is too narrow. therefore. views of traditional and modern scholars regarding finance function differ markedly. timing of the borrowing or sale of stock and cost and other terms and conditions of acquiring these funds. incorporation. TRADITIONAL CONCEPT OF FINANCE FUNCTION Traditional writers contended that primary responsibility of a finance manager is to raise necessary funds to meet operating requirements of the business. Aside from this.FINANCE FUNCTIONS As hinted in the preceding paragraphs. consolidation. to carry out his responsibilities it is the bounden responsibility of the finance executive to make a rational matching of the benefits of potential uses against tht costs of alternative potential sources so as to help the management to accomplish its broad goal. finance functions. Another shortcoming of the traditional approach is that it gave concentrated attention to problems of corporation finance while problems of unincorporated organizations like sole trading concerns and partnership firms were altogether ignored. Thus. be germane to give a brief idea about their views. according to modern experts. it would be mistaken to argue that responsibility of the financial executive is limited to acquisition of sufficient funds for the enterprise and he has little concern as to how such funds would be allocated. Planning quantum and pattern of fund requirements and allocation of funds as among different assets. Finally. modern authorities charged that the traditional approach laid relatively more stress on problems of long-term financing as if business enterprises do not have to encounter any financial trouble in the short run.

c) Policies regarding choice of funds These policies must be reviewed from time to time keeping in view the changing needs of the firm and environmental changes. finance manager must establish suitable policies that act as guides to the executives of the finance department. Keeping in view the ling-term goals of the company the finance manager has to determine the total fund requirements. the finance manager should decide upon the most suitable pattern of capital structure for the enterprise. management attitude towards risks. In order to enable the finance department to perform the aforesaid functions effectively and to achieve the firm’s objectives successfully. viz. Since in actual practice with a synchronization is not possible.A. Broadly speaking. If the company decides to raise the needed funds by means of security issues. Planning for an raising of funds. With the help of cash budget amount of fund requirements at different time intervals can be calculated. While there may be various pattern of capital structure. In contrast. duration of such requirements and the forms in which the required funds will be obtained. economic and business conditions. b) Policies regarding debt – equity mix. Having estimated total funds requirements the financial executive decides as to how these requirements will be met. Such decisions are taken under capital structure. The magnitude of this reserve is the function of the amount of risk that the firm can safely assumes in a given economic and business conditions. the finance manger must keep in mind the various considerations. viz. In balance sheet method total capital requirements are determined by totaling the estimated amount of current. forms of financing funds requirements. RECURRING FINANCE FUNCTION Recurring finance function encompasses all such financial activities as are carried out regularly for the efficient conduct of firm. each of these functions. In order to ensure quick sale of 13 . the finance manager must maintain some amount of working capital in reserve so as to ensure solvency of the firm. Decision with respect to fund requirements is reflected in capitalisation. fixed and intangible assets requirements. etc.. the financial manger has to arrange the issue of prospectus for the flotation of issue. We shall now discuss in brief. (2) Raising of Funds The second responsibility of the finance manager is procuring the requisite capital to satisfy the business requirements. While planning for fund requirements the finance manager has to aim at synchronizing the cash inflows with cash outflows so that the firm does not have any resources lying unutilized. magnitude of future investment programmes. purpose of the business. allocating of funds and income and controlling the uses of funds are contents of recurring finance functions. state regulation. While determining fund requirements for the enterprise. a forecast of cash inflows and cash outflows in made month-wise and cash deficiencies are calculated to find out the financial needs under the cash budget method.. Financial plan is the act of deciding in advance the quantum of funds requirements and its duration and the makeup of the requirements to achieve the primary goal of the enterprise. Major policy guidelines in this respect are: a) Policies regarding quantum of funds requirements of the firm. (1) Planning For Funds Initial task of the finance manger is a new or going concern is to formulate financial plan for the form. there are two methods of estimating funds requirements: Balance sheet method and Cash budget method.

If a business enterprise. an agreement is entered into by the finance executive on behalf of the company. For that matter. The finance executive has also to see that only that much of fixed assets are acquired that could meet the current as well as the increased demand of the company’s product. But the efficient administration of financial aspects of cash. (3) Allocation of Funds The third major responsibility of the finance manager is to allocate funds among different assets.securities generally the stock brokers. He has to set minimum level of cash so that the company’s liquidity is not jeopardized and at the same time its profitability is maximized. suitable credit policies should be laid down and suitable collection procedures should be designed. immediate requirements. While managing cash. fails to assemble the desired amount of funds through security issues. receivables and inventories is the prime responsibility of the finance manager. are approached. they charge underwriting commission. who deal in securities in the stock market and who are in constant touch with their clients. the finance manger has to negotiate with the authorities. For that matter. the finance manager has to ensure proper utilization of cash funds by taking steps which help in speeding up the cash inflows on the some hand and showing cash outflows. the financial manger is responsible for supplying the necessary funds to support the company’s investments in 14 . For these services. Besides. if an underwriter is satisfied with the issuing company. In managing receivables the finance manager should endeavour to minimize the level of receivables without adversely affecting sales. If the institution is satisfied with the desirability of the proposal. In allocating the funds. receivables and inventories is the prime responsibility of the finance managers. However. The finance executive has also to see that only that much of assets are acquired that could meet the current as well as the increased demand of the company’s product. an underwriting agreement is entered into between the company and the issuing company. He has to prepare the project for which the loan is sought and discuss it with the executives of the financial institutions along with the prospects of repayment of the loan. However. the enterprise is plunged into grave financial trouble. The obligation of the underwriter as per the agreement arises only when the event of non-subscription of issues by the public takes places. he has to acquaint the production executive who is primarily seized with the task of acquiring fixed assets with fundamentals of capital expenditure projects and also about the availability of capital in the firm. Where the company decides to borrow money from financial institutions including commercial banks and special financial corporations. on the other. Thus. the finance manger should prudently strike a golden mean between these two conflicting goals to profitability and liquidity of the corporation. So as to hamstring this problem the finance manager has to make such arrangements as may protect the issue against its failure. he has to approach underwriting firms whose main job is to provide the guarantee of buying the shares placed before the public in the event of non-subscription of the shares. But the efficient administration of financial aspects of cash. profit prospects and overall management plans. consideration must be given to the factors such as competing uses. The operating responsibility of managing inventories in a corporation is outside the province of the finance manger and well within the realm of production manager and chief purchase officer. But at the same time he should take steps to minimize the level of buffer stock of fixed assets that the company is required to carry for the whole year to satisfy the expanded demands. Even after the issues are floated in the stock market there is no certainty that the security issues will bring in the desired amount of capital because public response to security is difficult to estimate. and management of assets.

Preparation of financial plan at the time of promotion of the enterprise. present and future cash requirements of the firm. If the assessment of the performance reveals that the actual operations have not conformed to the standards. preferences and the like. In order to ensure that funds are allocated efficiently in inventories. However. decision in this respect is taken in the light of financial position of the company.inventories. Establishing standards is an essential task of the finance manger which requires high degree of dexterity and skill and the use of sophisticated forecasting techniques. Income may be retained for financing expansion of business or it may be distributed to the owners as dividend as a return of capital. He prepares cash budget for his firm to assess the requirements and arranges finance to meet these requirements. financial readjustment in times of liquidity crises. no separate executive is appointed to handle finance functions.O.Q. With the help of the E. etc. He himself looks 15 . Thus. by and large. organisatoin of these functions is not standardized one. In fact. the finance manager must familiarize himself with various techniques by which efficient management of inventories can be achieved. in similar companies where operations are relatively simple and less complicated and little delegation of management functions exists. (4) Allocation of Income Allocation of annual earnings of the company as between different uses is the exclusive responsibility of the finance manger. the finance manager must identify those policies that have not been effective and suitable and them change such policies so that the firm can accomplish its objectives. These standards serve as a concrete basis for evaluation of current performance. the reason for this discrepancy may be traced either in the inadequacy of the firm’s policies or ineffectiveness of the employees. (Economic Order Quantity) model suitable level of inventories is decided. NON-RECURRING FINANCE FUNCTION Non-recurring finance function refers to those financial activities that a financial executive has to perform very infrequently. B. Whenever and wherever necessary policies should be changed. if the policies are found to be effective. the same in almost all types of business concerns. shareholders. valuation of the firm at the time of merger reorganization of the form and similar other activities are of episodic character. Comparison of actual with predetermined standards provides opportunity to the management to ascertain immediately the discrepancies that have occurred and take remedial steps before deviations go out of control. it is the proprietor who handles all these activities himself. Evaluation work should be performed continuously in view of constantly changing environmental forces. nature convention. (5) Control of Funds A finance manger is also responsible for controlling the uses of funds committed in the enterprise. Control function involves development of standards. ORGANIZATIONAL FRAMEWORK FOR FINANCIAL MANAGEMENT Functions of financial management stated above are. The problem that the finance manager faces is to determine the optimal magnitude of investment in inventories. size. It varies from enterprise to enterprise depending essentially on the characteristics of firm. This will enable him to ensure that fund are being utilized as per the plan. Successful handing of such problems requires financial skills and understanding of principles and techniques of finance peculiar to non-recurring situations.

adding a plant or changing locations. manages cash accounts and arranges additional funds. the refinancing of maturing debt. He is also responsible for preparing annual financial reports. collects accounts receivables. In most of the cases the finance manger holds the rank of vice-presidentship reporting directly to the president and Board of Directors. In large concerns the finance manager is a top management executive who participates in various decision making functions. managers cash accounts and arranges additional funds. finance director. finance controller. in such concerns. Figure 1. He is generally given the charge of credit and collection departments and accounting department. extends credit. He reports directly to the president and board of directors. floating a bond or a stock issue. finance function is not properly defined and finance function is combined with production and marketing functions.2. Financial planning is hardly given important place. In medium sized undertakings financial activities are handled by senior management executive who is designated as treasurer. It appears that a large organisation has finance committee consisting of some members of Board and a finance manager. in collects accounts receivables. vice-president in charge of finance. discarding an old one.2 BOARD OF DIRECTORS FINANCE COMMITTEE Vice-President (Finance) Vice-President (Sales) Finance Controller Treasurer Corporate Accounting & Cost Annual Reports Internal Auditing Record Budgeting Statistics and financial statements Real Estate Receivables manager Dividend Disbursement Tax and Insurance Cash Manager Securities Banking relations 16 . Proprietors have seldom any training in such activities. investment department and auditing department. Place of finance in management hierarchy in large enterprise has been diagrammatically portrayed in figure 1. His vice in decision making depends in part on his ability and whether or not his firm is one that is closely held. those involving dividend policy. the acquisition of other firms. for example. introducing a major new product. entering into sale and lease back arrangements. The committee makes recommendations for the final approved of the Board. With growth in the size of the organisation degrees of specialization of finance function increases.after receivables and disbursement work.

merger. The finance manager with his expertise knowledge management in choosing the most viable project promising maximum results coupled with minimum risks. Once the business is set up and earns profit. The Central management also faces formidable problem of allocation of funds and they have to strike trade off between two conflicting but equally important goals of the business i.In larger concerns. However profitability in the case will be less. what is expected cost of future financing. Thus. profits vs wealth maximization Higher the relative share of liquid assets. The central management calls upon the expertise of the finance manager in striking such compromise and helps the management in prudent allocations of income. what volume of funds should be committed and how should funds be allocated as among different investment outlets are the critical issues which have to be handled with utmost care failing which the enterprise may land in grave financial crises. offers solutions to these problems. Besides handling day – to – day problems. capital and Money markets. This involves examination in depth of some of the important issues such as form what sources are funds available. ROLE OF FINANCE MANAGER IN AN ENTERPRISE Finance manager is an integral part of corporate management of an enterprise and is involved in almost all the crucial decision making affairs because every problem and every decision entails financial implications. the two equally desirable but conflicting goals of the enterprise.e. Here again the management is in dilemma a trade off between growth and dividends. The management is. finance manger plays a very significant role in optimal utilization of financial resources in the firm and thereby ensures the successful survival and growth of the latter. to what extent are funds available from what sources. the corporate management has to decide about allocation of earnings between payments to shareholders and rationed earnings. consolidation and liquidation. for handling financial matters controller and Treasurer are appointed. Finance manager plays significant role in helping the business entrepreneurs and management in overcoming their business problems and accomplishing their wealth maximization objective. other things being equal. management of working capital and security investment and tax and insurance affairs. etc. Finance controller is responsible for financial planning and control. what sources of funds should be tapped and to what extent. Another problem plaguing the managemnet pertains to designing such pattern of capitalisation as may be helpful in maximizing earnings per share and so also the market value of shares. How much capital expenditures should the enterprise commit. what financial instruments should be employed to raise funds and at what time?. if a smaller share of funds is held in liquid form. investors psychology. in dilemma which the finance manager endeavors to resolve by making use of principles and techniques of finance. lesser will be the possibility of cash drain. finance manger also helps the corporate management in dealing with episodic problems including reorganization. preparation of annual financial reports and for carrying on capital expenditure activities whereas treasure’s responsibility is limited to raising additional resources for business purposes. thus. One of the prime problems facing Corporate management is in the area of capital investments. 17 . A satisfactory compromise between the two has to be struck in such a way that shareholder’s wealth in the enterprise is maximized. risk of insolvency will be high but profitability will also be higher. On the contrary. which financial institutions should be approached for garnering funds? The finance manager with his knowledge of finance.

whether it will be a corporation.. Gubellini 4. each working for its own ends but simultaneously making a contribution to the system as a whole. this view cannot be accepted. Douggal Above mentioned definitions of finance highlight the central core of finance function. Finance is the agent that produces this result” – Husband and Dockery 3. dividend distribution policy. “Business finance may be broadly defined as the activity concerned with planning. It is broader function than that of funds supply only. 18 . funds raising and administration of funds. The financial policies of the firm are exemplified in its basic decisions about methods of financing growth.E. B. Hampton. “In a modern money – using economy. economic evaluation of alternative investments in plant and equipment and other activities which involves uses or sources of funds”. It includes the financing decisions. Paish 2. The task of working capital management is not over-all responsibility of financial management. raising. It may be summed up as the ‘custodian function of finance’ in the sense that it involves only the proper custody and authorized utilization of the available funds. “The term finance can be defined as the management of the flows of money through an organization. It is also a narrow concept ant the functions of a financial executive extend to financial planning. and C. it will be a very limited view of finance function. Something must direct the flow of economic actively and facilitate its smooth operation. Task of Providing Funds – According to these following definitions.e. John J. C. the finance function is simply the task of providing funds needed by the enterprises on suitable terms. 1. procurement of funds for the business. If we entrust the financial function completely to the accountant.A.W. i. “In an organism composed of a myriad of separate enterprises. Guthman and H. H. relations with lending institutions.DEFINITION OF FINANCE FUNCTION A. controlling and administering of funds used in the business”. L. some force is necessary to bring about direction and co-ordination. finance may be defined as the provision of money at the time it is wanted”. Financial management is deeply concerned with the economic and effective use of funds. but to confine it to this aspect only is a narrow view. investment decisions as well as dividend decisions. etc. Management of cash and liquidity – According to the following definition finance function is the management of cash and maintaining the liquidity of funds. F. “The financing function includes the day-to-day concern for the use and control of funds as well as long range planning which is involved with determining future requirements for funds and optimum uses to which they mat be put. school. Financial decision making – Following definitions are concerned with the financial decision – making. bank or government agency”. Therefore.

financial forecasting. Following are the main financial functions. MAIN FINANCE FUNCTIONS 1. In practice. To take Finance Decisions or Capital Structure Decisions – Each source of funds involves different considerations regarding cost. “The Finance function is vitally concerned with the use of funds within the business not just the supply of funds to the business”. risk and control.. the requirement of funds for future growth. finance raising bout optimum use of funds as well as the financial control ROLE AND SCOPE OF FINANCIAL FUNCTION Financial function seeks to carry out production and marketing functions profitably.1. the cash flow situation. cash. These include policies relating to management of inventories. To take Investment Decision – Long-term funds should be invested in various projects only after an in depth analysis has been carried out through capital budgeting techniques and uncertainly analysis. Howard and Upton 2. These need funds for investment in fixed assets and current assets. This requires proper forecast of the physical activities of the organization. “Finance may be defined as the administrative area or set of administrative functions in an organisation which relate with the arrangement of cash and credit so that the organization may have the means to carry out its objectives as satisfactorily as possible”. the investments in fixed assets and those in various current assets etc. William and Donaldson In this way finance function covers not only financial planning. 4. Hunt. Keeping these in mind. Evaluation of financial performance 19 . the trend of share market prices. funds should be procured at optimum costs with the least risk and the least dilution of control of the present owners. are also kept in mind. a proper mix of the various sources has to be worked out. These decisions come under the broad term ‘the financing decision’. Long-term funds investments are to provide for the needs of the core working capital. restrictions under the Companies Act. trade creditors etc. Supply of funds to all parts of the organization 2. the amount to be retained or to be paid to the shareholders would depend on whether the company or the shareholders can make a more profitable use of the funds. book debts. To take Dividend Decision – From the economic point of view. 2. 3. a large number of other considerations like the trend of earnings. To estimate the Requirements of Funds – Long – term as well as Short-term-funds requirement. the tax position of the shareholders etc. Asset management policies are to be laid down regarding various items of current assets also. should be estimated through the techniques of budgetary control and long-range planning. SUBSIDIARY FINANCE FUNCTIONS 1.

Joseph and Massie 4. “It the application of general managerial principles to the area of financial decision making”. As such it deals with the situations that require selection of specific assets (or combination of assets). “In an organism composed of a number of separate activities. The analysis of these decisions is based on the expected inflows and outflows of funds and their effects upon managerial objectives”. each working for its own end out simultaneously making a contribution to the system as a whole.3. Howard and Upton 2. J. Keeping the records of all assets. Philippatus 6. financial institutions and other suppliers of credit. “Financial Management is an area of financial decision making. Financial Control 6. “Financial Management is the area of business management devoted to a judicious use of capital and a careful selection of sources of capital in order to enable a business firm to more in the direction of reaching its goals”. Keeping track of stock exchange. Financial negotiations with bankers. Husband and Docker 5. Weston and Brigham 3. 5. DEFINITION OF FINANCIAL MANAGEMENT 1. “Financial Management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations”. some force is necessary to bring about direction and coordination of economic activity and facilitate its smooth operation. harmonizing individual motives and enterprise goals”. quotation and behaviour of stock market prices. Bradley 20 . 4.F. Financial management is the agent that produces this result”. the selection of specific liability (or combination of liability) as well the problems of size and growth of an enterprise. “Financial management is concerned with the managerial decisions that result in the acquisition and financing of long-term and short-term credits for the firm.

the financial manager is the member of the firm’s top management charged with the responsibility of planning. it requires financial forecasting. organizing. Dividend decisions – These include decisions as regards what part of the profits earned by the firm is to be distributed among the shareholders in the form of cash dividend. because these decisions are made by top management. and 4. Investment Decisions – This is the most important executive function of financial executive. or by retaining of profits. 2. He is however instrumental in allocating capital to these assets due to his involvement in capital budgeting. Executive or Managerial Functions (i) Financial forecasting: The financial management arranges that an adequate supply of cash in available at the proper time for smooth flow of firm’s activities. Thus financial management is an operational function in involving financial planning. a financial manager assets in evaluating the various proposals in the processes of capital budgeting. FUNCTIONS OF FINANCIAL MANAGEMENT The finance functions include Executive or Managerial Functions as Routine Functions. 3. The financial manager is charged with varying degrees of operating responsibility over existing assets. Investment decisions – These include decisions as regards utilization of funds in one activity or the other. Management of Corporate Asset Structure – The fixed and current assets of the firm must be managed efficiently to ensure success. He is rather concerned with the management of current assets than with fixed assets. Hunt. namely.CHARACTERISTICS OF FINANCIAL MANAGEMENT 1. The estimation of the prospective inflow and outflow of cash in the next quarter or year is necessary to maintain the liquidity in the funds. performing and controlling the financial affairs of the enterprise. 1. financial forecasting and provision of financial as well as the formulation of financial policies. The financial manager has little or not operating responsibility for fixed assets. by raising of loans. by issue of shares. In the management of current assets (ii) (iii) 21 . and how much of the profit are to be retained for utilization by the firm (ploughing back). William and Donaldson have called it ‘Resource Management’. Enforcing Financial decision – This is done through control and coordination of business activities. As each investment decision involves risk. Financing decisions – These include decisions as regards how the total funds required by the firm are to be raised. routine finance functions are chiefly clerical and are identical to the effective handling of the managerial functions. It involves the allocation of capital to various investment proposals in order of their profitability. In a large organization. While Executive functions require skilled planning and execution of financial activities. As cash-inflow and cash outflow both are closely related to the volume of sales.

On the basis of forecast of the volume of operations the financial manager should decide upon the needs and prepare the detailed financial plan both short-term and long-term for the procurement of funds. Incidental or Routine Functions Following are routine functions performed by low level assistants like accountants. The financial manager has two objectives (a) how can managers choose the best among the alternative uses of funds. Management of Cash – The cash must be managed for the benefit of the owners. 2. Record keeping and reporting 2. It includes the allocation of net earnings after payment of taxes among shareholders and rationed earning for employees. carry on the negotiations and finalize the terms and conditions of the contract. checking and appraisal of financial performance is essential to carry out finance function smoothly. 1. and (b) how can they ascertain that this is a better use than stockholders could find outside the company? “Therefore. etc. Preparation of various financial statements 3. Cash management 4. accounts assistants. assistants. Contact and carry Negotiations for New Financing – The Financial manger has to contract the source. If long-term funds are needed additional shares should be issued for it. the shareholders are generally more interested in current cash dividends. Custody and safeguarding the different financial securities etc. Other area manages also participate in the formation of policies regarding the level of investment in various current assets like inventories etc. 22 . Various financial statements are prepared analyzed and then necessary guide-lines are set for future. techniques and procedure of financial control. credit is arranged from a bank. the financial manager must select the most desirable temporary investment for the excess cash and near cash resources of the firm. Analysis of what has happened is of great value in improving the standards.his discretion is not an exclusive one. Decision about New Sources of Finance – A business firm is always in need of funds. In order to provide for future contingencies. lines of credit are to be opened and financial executive negotiates with bank authorities in this connection. Credit management 5. (iv) Management of Income – It is a major function of financial executive. In short term. (ix) To Advise the Top Management – The financial manager advises the top management in respect of financial matters and suggests various alternative solutions for any financial difficulty. The financial manager attempts to arrive at an optimal dividend – pay out ratio that maximize shareholder’s worth in the long run. (v) (vi) (vii) (viii) Analysis and Appraisal Financial Performance – Proper analysis. This requires a number of arrangements to be made by him. the top management wants to retain earnings to the maximum possible extent. He should evaluate the prospective cost of funds as against the anticipated profits from the use of these funds by the operating units to which they are to be allocated. He makes steady efforts to increase the profitability of capital invested in the firm.

incorporation. By suggesting the best possible alternative out of the various alternatives of the problem available. Among a number of alternatives to carryout the decision the management has to select only the best in terms of its profitability. budgets ratio analysis. IMPORTANCE OF FINANCIAL MANAGEMENT 1. development.6. and lack of information about the specific needs and limitations”. expansion and administration of day-to-day working etc.F. Measure of Performance – As J. its proper administration is very necessary. optimism about the possibilities of an untried enterprise. Providing top management with information on current and prospective financial conditions of the business as a basis for policy decision on purchases. Selection of sound financial plan requires a serious consideration over factors like profitability. such as different financial statements. Policy decision affect risk and profitability and there two factors jointly determine the value of the firm”. financial administration controls and coordinates all other activities in the concern. “Financial decisions affect both the size of earnings stream or profitability and the riskiness of the firm. Weston and E. Smooth Running of Enterprise – Sound financial planning is necessary for the smooth running of an enterprise. 4. the production and the sales will suffer. Determination of Business Success – The financial managers plan a very important role in the success of the business organization by advising the top management and presenting important facts and figures regarding financial position and the performance of various functions of the company in a given period before the top management in such a way so as to make it easier for the top management to evaluate the progress of the company and to amend suitably the principles and policies of the company. These help in evaluating the profitability of the plan in the given circumstances. risk and controls of various alternative plans. 2. This means the study. This is not possible in the absence of a sound financial management. Hence sound financial plan is very necessary for the success of business enterprise. cost-profit-volume analysis etc. Consequently. analysis and evaluation of all financial problems to be faced by the management and to take proper decision with reference to these present circumstances in regard to the procurement and utilization of funds. It the plan fails to provide sufficient capital to meet the requirements of fixed and fluctuating capital and to assume the obligations by the corporation. Successful Business Promotion – Defective financial plan is one of the most important reasons of failures of business promotion. As finance is required in promotions. If finance department fails in its obligations. the financial managers assist the top management in its decisions making process. Help in Decision Making – Every decision in business is taken in the light of its profitability. the business cannot be carried on successfully. 23 . 5. Coordination of Functional Functions – Financial administration provides co-ordination between various functional areas such as marketing. so that a proper decision may be taken to minimize the risk involved in the plan. Financial administration provides scientific analysis of facts and figures through various financial tools. Thus.F. 3. Brigham have said. marketing and pricing. the income of the concern and the rate of profit on investment will also suffer. If financial management is defective. the efficiency of all other departments cannot be maintained. production etc. In the words of Hoagland. 6. “Unwarranted optimism and lack of information are more often the cause of faulty financial plans.

24 .

In a very small business having one man as the proprietor he may make all the management decision including financial policies. This may include one or tow directors from the board of directors. the owners of the corporation control the conduct of the company by electing the Board of Directors. Management decisions are made at every level of business organisation from president to foreman and nearly management decision involved the finance of the company. As the managing director is not an expert of all the matter-labour. marketing etc. The control and administration of finance should be given to the top management. However. Financial decisions affect wage policy. As finance is one of the most important functions of management requiring skill and technical expertise. in large businesses. The Chart No. labour policy and every other area of decision making and the reverse is also true. production etc. market. Company policies are executed with the help of the managing director who manages the affairs of the company as per directions of the board. finance. FINANCE COMMITTEE The shareholders. The place of finance department in the organization chart depends on the size and the nature of the business. Controlling and administrative powers may vest in the Board of Directors or in the Finance Committee.1 shows an ideal form of organization for a big business corporation. As finance affects the very existence of a concern.UNIT II ORGANIZATION OF FINANCIAL MANAGEMENT Organisation of financial department is the division and the classification of various functions which are to be performed by the finance department. to whom the management is responsible. Finance is one of the important functions of the management. a separate department for the purpose is established under the charge of an expert in financial matters known as Finance Manager or Finance Controller or Director of Finance. 2. a committee for each function-repairing expert knowledge is constituted for proper guidance and advice. the finance function cannot be decentralized like other management functions such as personnel. the departmental heads and the chief financial mangers with managing director as the chairman of the committee. The committee guides and advises the board of directors the control and administration of the finance. a division of responsibility and the compartmentalization of management are necessary to handle the large volume of work. inventory policy. Thus a finance committee may be constituted to advise the managing director regarding matters relating to finance of the concern. 25 . relating to the business.

Tax. He is full-fledged head of finance department and reports directly to the chief Finance Directors. Accounts Payable. General Ledger. collection of loans. The treasurer’s responsibility is to look after the day to day working such as custody of cash and bank accounts. Cash receipts and disbursements include such Accountant Manager names as Accounts Receivable. budget etc. Controller committee.Share Holders Board of Directors Finance Committee Managing Director Chief Financial Manager Treasurer Controller of Finance Cash Bank Wages and Salaries Tax and Importance Insurance Statistics Cost Accounting Financial Manager Auditing General Accounting STATUS OF FINANCE MANGER The finance manger is located on the same scalar level as the managers of production department or Treasurer Controller of marketing department etc. investment portfolio of the Financial Assets corporation. Internal Audit. The controller of finance and the treasurer are the two officers subordinate to the financial manager. Credits and Collections. He is appointed to look after the activities of the finance department. it must be approved by the controller. To prevent unauthorized payments made by the treasurer. Pay-roll. payments of premiums etc. Cost is responsible to the finance Cash flow A detailed organisation for finance department can be drawn it the enterprise is to be managed by one financial officer: Internal Auditor Budget and Investment Manager Accountant Controller Office Superintendent Credit Manager Mechanized Accounting Vouchers and Records Section Bills of Exchange and Security Section 26 .

corporate tax policies etc. They invest their money in the shares of a company in the 27 . These represent ownership rights of shareholders. When invested. It periodically distributed returns to investors. FUNCTIONS OF FINANCIAL MANAGEMENT The three important activities of a business firm are finance.2 Organisation of Finance Department As there is a very wide range of organizational practices the organization structure may change according to the size and nature of the business. The firm expects to receive returns on investments over time. It is also effected by the external factors such as state intervention in the industrial finance. To Raise Funds – Funds are two types: equity funds and borrowed funds (i) Equity Funds – A firms sells shares to acquire equity funds. 2. 2. Fig.Fig. It acquires funds from the sources called investors.2 shows organization of finance department. production and marketing. This a business firm engages in activities to perform the functions of finance. funds are called investments. production and marketing. These processes are simultaneous and continuous. These are called the finance functions of the firm. These are as follows: 1. Through finance activity the firm secures capital which sis employed through production and marketing activities.

3. To carryout all the business activities – There is an inseparable relationship between the finance function and the production. The company may also have on-going projects which involve outlays of cash to maintain or to increase their profitabilities. reorganization. To plan investment project – The funds raised by a company are invested in the available investment opportunities called investment project or project. The return on loans or borrowed funds is called interest. The basic contents of the traditional approach.expectation of returns on their invested capital in the form of dividend. recapitalizations etc. 2. It varies from year to year depending on the decision of the board of directors. However. Directly or indirectly these involve e the acquisition and use of money. Payment of interest is a legal obligation of the firm. he is only required to raise the needed funds from the combination of various resources. To Retain Earnings – When company secures funds by retaining a portion of the returns available for shareholders. may be summarized as follows. Shares may be of two types : common and preference. The retention of earnings can be considered as a form or raising new capital.: 28 . These involve use of funds in the expectation of future benefits. Till the mid – 1950’s the finance books covered discussion of the instruments. His only significant duty was to see that the firm has enough cash to meet its obligations. Loans are furnished for a specific period at a fixed rate of interest. reorganizations. which also form its limitations. Solomon. Generation of revenue is possible only when funds are invested in projects. A company in a tight financial position will give more weight to financial considerations. this method of acquiring funds is called retaining earnings. THE ROLE OF FINANCIAL MANAGER TRADITIONAL APPROACH Traditional the scope of financial management and the role of the financial manger were considered confined to the raising of funds. The payment of dividends to shareholders is an absolute discretion of the board of directors. institutions and practices through which funds are obtained. (ii) Borrowed Funds – An important source of securing capital is creditors or lenders who are not owners of the company. such as promotion. consolidations. expansion etc. As the retained earnings are undistributed returns on equity capital. According to Prof. it need not necessarily limit or constraint the general running of the business. Creditors includes banks. Preference shareholders receive dividends at a fixed rate and have a priority over common shareholders in receiving dividends. debenture holders and others. They supply money to the firm on leading basis and retain title to the funds lent. financial institutions. He was called upon to raise funds during the major events. it can require new capital from the same sources by issuing new shares. These books contained detailed descriptions of the major events like mergers. they are a part of equity capital. then. marketing and all kinds of business activities. 4. The dividends rate for common shareholders is not fixed. The traditional view on financial management was based on the assumption that the financial manager has not concern with the decisions of allocating firm’s funds. If a company distributes all earnings to shareholders.

5. Over emphasis on long term planning – The traditional approach over emphasized long-term financing. lacked in analytical content and placed heavy emphasis on descriptive material. To Raise Funds – The emphasis in the traditional approach was on raising of funds. it omitted discussion on two important matters. 2. Conceptual Omissions – The traditional approach neglected the consideration of the question of the allocation of capital to different assets and the question of optimum combination of finances. The point of view of the financial decision – maker was given no importance.1. Solution of Long-Term problems – The traditional approach placed great emphasis on the longterm problems. 3. 3. including financial resources. Shift in emphasis . Wrong treatment of various problems – The traditional approach has been criticized due to its failure to consider the day-to-day managerial problems relating to finance of the firm. the approach and scope of 29 . Thus. increasing intervention of government on account of management inefficiency and failure. population growth and widened markets etc.. (ii) Modern changes in the role of financial manager 1. Problem of Non-corporate enterprises – The traditional approach used to give significant attention to the financing problems of noncorporate enterprises. It placed overemphasis on topics of securities and its markets. Episodic Function – The traditional approach was circumscribed to the episodic financing function. CRITICISM OF TRADITIONAL VIEW 1. promotion. 2. The subject of finance was treated from the investors’ point of view. instead of looking into the problems from management’s the insider’s point of view. (i) Financing – mix – The traditional approach used to give no consideration to the relationship between financing – mix and the cost of capital. intense competition. It ignored the importance of the working capital management. outlived its utility in the changed business situation since the mid-1950’s. Relationship between the valuation of the firm and the cots of capital – A theory of valuation must be used as a basis for computing the cost of capital. 4. As the development of a number of management skills and decision-making techniques facilitated to implement a system of optimum allocation of the firm’s resources. was the outsider – looking – in approach. incorporation. Lack of information of controls and regulations – As controls and regulations over firms were imposed all over the world the management of the firms improved. The outsider’s point of view – The traditional approach concentrated itself to looking into the problems form lender’s the outsider’s point of view. it failed to deal with the question of the optimum combination of finances at which the cost of capital is minimized. Increasing pace of industrialization. 4. the cost of capital is at the root of allocating the firm’s funds most efficiently. The traditional approach failed on their count. technological innovations and inventions. thus.The traditional approach. The traditional view. It started disclosing the financial information for the purpose of analysis and comparison of performance. during and after mid-1950’s required efficient and effective utilization of the firm’s resources. merger etc.

In his new role. in the year of 1954 revealed that in most of the firms the finance officer reported to the president or the board of directors. he usually attended board meetings in order to advice and be consulted on financial affairs of the organization. The basic finance function is to decide about the expenditure decisions and to determine the demand for capital for these expenditures. Finance committee is in some large organisation which directly report to the board directors. credit management. 2. Weston in U. is concerned with the efficient allocation of funds. in addition to his usual duties as the chief accounting officer of the firm. The central Process involved is a rational matching of advantages of potential uses against the cost of alternative potential sources so as to achieve the broad financial goals which an enterprise sets for itself. sound and efficient. nature of the business. A survey by J. In a large organization. He makes these decisions in the most rational way so that the funds of the firm are used optimally. the middle sized companies have both a treasurer and a controller. the finance function is divided between a treasurer and controller who. volume of output and the firm’s selecting of product lines. collection of credit sales etc. is assigned some staff function relating to finance such as financial forecasting. The vice-president for finance is in close touch with every important facet of the operations of his department. 30 . sound and efficient. sets the pace and direction of growth and shapes the profitability and risk complexion of the firm by selecting the best asset mix and by obtaining the optimum financing mix. capabilities of the firm’s financial officers and most importantly. the financial manager today determines the size and technology.S. In the year 1962 a survey conducted by American Management Association revealed that while a majority of the companies have a vice president of finance. the treasurer is concerned with the routine functions such as recording of inflow and outflow of cash. from raising of funds to efficient and effective use of funds. In other cases where he was not a member of the board. The division of finance function between controller and treasurer is scientific.F.A. kinds of financing operations. Analytic approach – The modern approach is an analytical way of looking into the financial problems of the firm. ORGANISATION OF THE FINANCE FUNCTION IN LARGE FIRMS As explained in fig. He has to look after profitplanning which means operating decisions in the areas of pricing. Smaller companies have only treasurer. Vice-President-Finance. 2. While the controller performs and their analysis. The division of finance function between controller and treasurer is scientific. The emphasis shifted from episodic financing to the managerial financial problems. He is usually on of the senior officers of the firm reporting directly to the president of the firm. The central problem of financial policy is the wise use of funds. Besides his traditional function of raising money. etc. on the financial philosophy of the firm.2. financial control and financial evaluation of results. the financial manager.financial management changed. The three broad decision areas of modern financial manger are investment financing and dividend decisions. In many large concerns both the treasure and the controller of finance report to a chief financial officer who often has the title. STATUS AND DUTIES OF FINANCE EXECUTIVE The nature of the organization for financial management differs from firm to firm depending on various factors such as the size of the firm.

he is a member of top management. programmes for capital investing and for financing. To Arrange short-term financing – The treasurer has to maintain adequate sources for the company’s current borrowings from the money market.1. A firm may have a finance committee consisting of members of top management with the chief financial officer as a member. There may be a vice-president of director of finance. Concerned with the financial planning and control. To Improve Investor relations – The treasurer has to establish and maintain an adequate market for the company’s securities and to maintain adequate contact with the investment community. including negotiating its procurement and maintaining the required financial arrangements. To Report and to Interpert – The controller ahs to compare actual performance with operating plans and standards. Financial controller – Following are the functions of Controller of finance (i) To Plan and to control – The controller has to establish. 2. he guides the treasurer and controller and others in the effective working of the financing department. To provide Insurances – The treasure has to provide insurance coverage as may be required. To direct Credit and Collections – The treasurer has to direct the granting of credit and the collection of accounts to the company. profit planning. To Administer Tax – The controller has to establish and administer tax policies and procedures. This plan would provide. while at other times he is known president of finance or the director of finance or the financial controller. coordinate and administer. as part of management. To plan Investment – The Treasurer has to invest the company’s funds as required and to establish and coordinate policies for investment in pension and other similar trusts. Associated with the formulating of policies and making decisions for the firm. sales forecasts and expense budgets. To consult with all management about the financial implications of its actions. Financial Manager – The designation of the financial officer differs from firm to firm and sometimes he is known as the financial manager. (ii) (iii) (iv) (v) (vi) (vii) 4. 3. and to report and interpret the results of operations to all levels of management and to the owners of business. to the extent required in the business. (ii) (iii) 31 . Treasurer and Controller may be appointed to assist him. To maintain Banking and custody – The treasurer has to maintain banking arrangement. Chief Financial Officer – The title. usually with both the controller and the treasurer reporting to him. a plan for the control of operations. vice-president of finance or the finance manger is usually used for the chief financial officer who has to report diretly to the managing director or the board of directors or the chief manger of the firm. to receive and have custody of financial aspects of real estate transactions. Treasurer – Following are the functions of a treasurer: (i) To provide finance – The treasurer has to establish and execute programmes for the provision of the finance required by the business. The chief financial officer has both line and staff responsibilities.

To appraise economic and social forces – The controller has to appraise economic and social forces and government influences and interpret their impact upon business. 32 . To Protect the assets – The controller ahs to assure protection of business assets through internal control.(iv) (v) (vi) To report to the Government – The controller has to supervise or coordinate the preparation of report to government agencies. internal auditing and assuring proper insurance coverage.

to estimate the amount of capital to be raised and (b) determining the capital structure i. Developing financial procedure 1. the financial manger is required to forecast future in his endevour to predict the viability of the factors which have their 33 . Financial objectives guide the financial authorities in performing their duties. Formulating financial policies. In formulating policies. allocation. It is not an isolated process but is a part of the overall planning of any business enterprise. Following are the three main aspects of financial planning according to Walker and Bougham: 1. “Planning is the process of thinking through and making explicit the strategy and relationships necessary to accomplish an overall objectives” William King 2. Short Term Objectives – The short-term financial objective of the firm is to arrange for the necessary funds at proper times as and when they are required by the concern for the smooth running of the business or for the survival of the firm. Formulating Financial Policies – Financial planning formulates policies to be followed by the financial authorities with regard to the administration of capital to achieve the long term and shortterm financial objectives of the firm. the form. but also to the financial policies which the corporation has adopted or intends to adopt” J.H. “The financial plan of a corporation has two-fold aspects : it refers not only to the capital structure of the corporation. (I) Long Term objectives – The long term financial objective of the firm is to maximize the wealth of the concern by uqilizing the productive sources of the firm effectively and economically in such a way as to increase the productivity of the remaining factors of production over the long run. “Financial planning pertains only to the function of finance and includes the determination of the firm’s financial objectives formulating and promulgating financial policies and developing financial procedures” Walker and Bougham Thus financial planning is a process consisting of determining the amount of capital required and the capital structure and laying down the financial policies. Effective utilization of productive factors is possible only if there is a regular supply of funds at minimum cost.UNIT III FINANCIAL PLANNING Definition of Financial Planning 1. Determining financial objectives 2. Financial policies serve as guide posts to those associated with acquisition. It is necessary to maintain the liquidity of funds in the business. Thus long-term financial objectives include (a) proper capitalization i. 3. Financial objectives may be long term and short-term. Determining Financial Objectives – Financial planning determines the long term and the shortterm financial objectives. and control of funds of the firm. Bouneville 3. relationship and proportionate amount of securities to be issued. This is necessary to achieve the basic objectives of the firm.e.e. (II) 2.

bearing upon the policies. cost-control. Higher Return on Capital Employed – Sound financial planning leads to effective utilization of capital by avoiding both under – capitalizationB and over – capitalization both of which are harmful 34 . Developing Financial Procedures – Financial planning develops the procedure for performing the financial activities. Methods used for this purpose include budgetary control. Better Expansion and Development – The objectives of a business enterprise is profitmaximization. 3. 2. Thus. This requires the expansion and development of the business unit for achieving its optimum operational efficiency. (i) (ii) (iii) (iv) (v) (vi) Policies regarding estimation of capital requirements Policies regarding relationship between the company and creditors Policies regarding the form and proportionate amount of securities to be issued. policies and programmes. financial planning is flexible. Financial activities are subdivided into smaller activities and powers. Thus the success or failure of a firm is closely linked with financial planning. Better Conservation of Capital – Sound financial planning is necessary for the effective utilization of capital. Proper control on financial performance or financial control is possible by establishing standards for evaluating the performance and comparing the actual performance with the standards so established. Forecasting is an integral part of financial planning. Reviewing Financial Plan – As the management reviews the firm’s short-term objectives. Steps are taken to control any deviation from or inconsistencies in predetermined objectives. plant and machinery acquired by an enterprise become obsolete soon after the arrival of new machinery in the market with improved technology. purchase of assets and raw materials. production and marketing of goods. Better Direction – Business operations require funds. 3. The following financial policies are important. duties and responsibilities delegated to the subordinate officers. policies and procedures in the light of changed economic. Availability of adequate liquid funds prevents the firm form the situation of over-trading and strengthens its repayment capacity. social and business situation from time to time in order to keep pace with the changing environment. analysis and interpretation of financial accounts etc. 6. Better Promotion – Effective financial planning ensures successful promotion of the business which is only possible through well thought out flexible financial plan drafted in anticipation of the establishment of the business. Policies and guidelines regarding sources of raising capital Policies regarding distribution of earnings Policies for the proper administration of fixed and working assets. 5. 4. More Liquidity – Efficient financial planning makes the firm capable of maintain adequate liquid funds to meet its obligations to the creditors. sound financial planning is inevitable for conservation of capital investment in assets. Successful operation of business depends on adequate and timely availability of finance for the promotion of business. Efficient financial planning eliminates financial difficulties in the future expansion and development of the business. IMPORTANCE OF FINANCIAL PLANNING 1. 4.

While formulating the company’s financial plan.to the financial interests of a corporation. Therefore. 8. There are not too many securities likely to create complications in the financial plan and confusion in the mind of the potential investors about their nature and profitability. efficient financial planning leads to higher return on capital employed by the firm. it serves as a guide to effective co-ordination among various operative function and unity in action. The public sector enterprises procure borrowed capital from commercial banks and specialized financial institutions. automation. 35 . Flexible – The capital structure of a company should be flexible enough to make necessary adjustment in it according to the changing circumstances. Simplicity of financial plan helps the management in procuring the necessary capital. Replacement of obsolete assets is possible only through financial planning. It is free from complications and suspicions. employee welfare etc. Simple – An ideal financial plan is easily understandable to all. price levels keep on changing fast rendering the replacement cost of the firm’s assets much higher than its acquisition cost. Thus. The company may need additional capital for financing schemes of modernization. 4. the financial manager ensures that the firm pays the least cost and incurs less risk. The business operations may be adversely affected in the absence of adequate liquid cash. Thus. rigidity in capitalization and capital structure restricts and progress of the business and unnecessarily limits its activities. CHARACTERISTICS OF SOUND FINANCIAL PLAN 1. 7. it is necessary to pay proper attention to the liquidity requirements of a firm which depends upon the nature and size of its business. The capital may e increased by issuing new shares or debentures to the public or by raising loans from specialized financial institutions but reduction of ordinary share capital is not permissible. 2. The flexibility in the financial plan enables the company to introduce necessary changes to it according to the changing business situations. Replacement of obsolete assets – In the present dynamic economic world. Optimal Capital Structure at Minimum Cost – Efficient financial planning leads to the optimal capital structure of the firm at minimum cost. procedures and objectives as set out in the financial plan. financial plan needs to be drafted after estimating the present as well as future financial requirement of the firm. 10. smooth and reasonable percentage of current assets should be kept in the form of liquid cash. expansion of business. After analyzing the costs and risks involved in different forms of capital. he finally selects those which involves the least cost without much risk. goodwill and situation on trade cycles. In deciding the ratio of different forms of capital in total capital of the firm. Hence the private enterprises find it difficult to obtain the necessary funds from these institutions for financing their plans. Short-term financial requirements may be met by term loans or issue of redeemable preference share capital. Foresighted – Efficiency of a firm’s financial plan depends upon the determination of its scope and size of activities. the business enterprises should forecast their financial requirements well in advance by means of effective financial planning. Faster Growth of Public Sector – Today growth of public sector has intensified the need for effective financial planning for the private sector. Liquid – To business operations. In order to arrive at a sound financial plan the promoters use foresight in predicting the short-term and long-term financial needs of the company. its credit standing. Thus. 9. At different levels the executives follow financial policies. 3. Better unity and Co-ordination – Financial planning leads to the most effective utilization of the firm’s capital by establishing effective co-ordination in different operative function and unity in action by all executives at different levels.

goodwill of managers. Capital structure – The capital structure of the corporation should be balanced. discount. Amount of Risks – Financial plan is affected by the amount of risks involved in the process of production of an enterprise. They would rather prefer to invest in fixed income securities such as debentures. these mainly depend upon the ownership securities for the procurement of the requisite capital. and debt-financing usually harmful to such enterprises. Intensive Use of Capital – Effective utilization of capital is as much important as the procurement of adequate funds. Large sized and old in industries with established goodwill do not face difficult in raising the needed capital. diversified and of high grade securities. Size of Industrial Unit – Financial plan is affected by size. stability and regularity in earnings of the industry. Nature of Industry – The financial planning of an enterprise is directly related to nature of industry.. Industries having more risks and uncertainties do not financial liquidity. it is difficult for a company to procure the minimum amount of working capital by issuing equities as the investors cannot be interested in investing their savings in equities if there is no guarantee of dividend on them. brokerage. the promoters should keep in view the future expansion and diversification programmes of the corporation. it refers to provision for these contingencies. printing. etc. industries with lesser amount of risk can easily obtain loans and earn higher profits for equities. should be the minimum. labour-intensive industries require relatively small amount of capital. reputation etc. 5. 2. Thus. The 36 .. 7. area of operation. Such practices should not be encouraged as they would drag the company to financial crises. 3. Programme of Expansion – Financial planning is affected by the programmes of expansion and diversification of the business enterprise in future. extent of control on production process.5. possibilities of future development. Provision for Contingencies – A good financial plan has a adequate provision for business oscillations and anticipated contingencies. while formulating the financial plan. while newly promoted industries enterprises face a lot of difficulties in collecting the required amount of capital. intensive use of capital for a fair capitalization. FACTORS AFFECTING FINANCIAL PLAN 1. etc. it is advisable that the company promoters anticipate the possible contingencies does not always imply the maintenance of surplus capital. During depression period. Trade cycles are the general phenomenon of the economic world. either by internal financing or by issuing new securities. it is difficult to raise the necessary capital in future for financing the proposed programmes of expansion and diversification. 4. Industries having stability and regularity in earning can easily procure capital from the market. variation in demand of goods manufactured. While capital – intensive industries require large amount of capital.. There should be reasonable balance between different securities. surpluses of fixed and working capital should not be used as substitutes to shortages of one another.e. also affect the quantum of capital and sources of finance of a company. scientific progress. i. etc. therefore. 6. Industries with greater amount of risks need relatively more capital. The various expenses relevant to the issue of capital such as underwriting. preference shares. This is possible by maintaining equilibrium in fixed and working capital. Thus. In the absence of flexibilities in the financial plan. Economical – The promoters should always keep in mind the cost of capital procurement while formulating the financial plan. Over-capitalization and under – capitalization both are harmful to financial interests of a corporation.

the financial plan would be ineffective. 10. no financial plan can exactly predict the future economic and business environment. a financial plan should be periodically reviewed and necessary changes must be made in accordance with the changing economic and business environment. reserves and surplus etc. and such approval is given only if the present security – mix of the corporation is ideal. views of the management etc. 6. Goal Control – Government policies. financial controls and statutory rules and regulations should be considered while formulating a sound financial plan. Flexibility – Flexibility is the main principle to be followed in the financial planning. For example. and hesitate in making necessary adjustments in it effective financial plan also become ineffective for want of necessary adjustment according to the changing economic and business conditions. If there is no flexibility in financial plans. profitability. they would purchase a majority of such shares themselves. They would prefer debt capital even for expansion or diversification or diversification programmes in future. 2. Ploughing back of profit is preferred in such business enterprises. If the existing owners and management wish to retain the control of business in their hands. it is difficult to implement even the ideal financial plan successfully. 1956 a company in India is required to obtain the approval of the controller of capital issues at the time of issuing shares or debentures to the public. under the Capital Issues Control Act. control on business.company should retain some ideal securities so that capital may be raised immediately by issuing them at the time of financial crises. they would not like to issue equity shares in large quantity. If forecasting is wrong. 9. Not exact Forecasting – Being based on financial forecasts. Policies – Changes in economic condition and government policies exert adverse influence on the effectiveness of a financial plan. Altitude of Management – The financial plan is also affected by the attitude of the management of the industrial unit. If they do so. External Capital Requirement – It is good policy for the industry to finance its expansion or diversification programmes through resources such as ploughing back of profits. Lack of co-ordination – If there is not effective co-operation and co-ordination among various officials of the corporation. 8. Rigid View – If the financial managers follow a rigid view regarding the financial plan of corporation. Only those sources of finance should be selected which are most favorable to the firm. 7. Availability of Alternative Sources of Finance – The financial plan of an enterprise depends upon the availability of the alternative sources of finance at the time of need. it would be difficult to carry on its expansion or diversification programmes due to lack of funds. Therefore. LIMITATIONS OF FINANCIAL PLANNING 1. 3.. Changes in Economic Conditions and Govt. UNIT – IV CAPITALIZATION 37 . The alternative sources of finance should be appraised in the light of their cost. and the financial plan proves unsuccessful and ineffective. Short-term finances may be obtained from external sources by issuing redeemable preference shares or debenture if they are urgently needed. 4.

“Capitalization is the total accounting value of the capital stock. leaving the qualitative aspect of financing out of its scope. “Capitalization refers to the sum of the outstanding stocks and funded obligaiotns which may represent wholly fictitious values” E. Definitions of capitalization 1. 3.MEANING OF CAPITALIZATION 1. Gerstenberg 5. “The term capitalization. The value of shares of different classes.e. The value of bonds and debentures issued by a company still not redeemed. capitalization means the total accounting value of all the capital regularly employed in the business”. It represents total investment or resources of a company. “The term capitalization is used to mean the total of the funds raised on a long term basis. and long-term debts” 2. Husband and D. whether debt.W. 2. S. not meant for distribution. the relative proportions of the various classes of securities to be issued and the administration of capital. CONTENTS OF CAPITALIZATION 1.H. capitalization is synonymous with financial planning. Dewing Doris 3. the sum total of all long-term securities issued by a company and the surpluses not meant for distribution. While the W. capitalization means the amount at which a firm’s business can be valued. Narrow Meaning – In its narrow sense. Pearson and Hunt 6. equity or common equity. It is composed of the accounting value of the capital stock. Lincoin 4. i. the securities through which is to be raised and the relative proportion of various classes of securities to be issued and also the administration of capital”. surplus in whatever form it may appear. The common equity. “Capitalization includes the amount of capital to be raised. CAPITALIZATION AND CAPITAL Capital and capitalization are two different terms although the term “capitalization” has been derived from the word “capital”. Broad Meaning – In its broad sense. or the valuation of the capital includes the capital stock and debts”. covering decisions regarding the amount of capital to be raised. Thus the narrow interpretation of capitalization deals with only quantitative aspect of financial plan.C. preferred.F. whether capital or earned. ordinary shares and preference shares. Dockerary 38 . The term “capitalization” is used only in relation to companies and not in respect of sole proprietorship or partnership firms. G. “For all practical purposes. of course. 2. includes all values belonging to that interest and not merely stated value of the common stock. A. The value of long-term loans secured by the company other than bonds and debentures. value of surplus not meant for distribution and the value of long term debts. The value of all surplus. and 4..

expansion and growth. organization and establishment of business. etc. establishment of organization. debenture stock. Cost of Current Assets – This is the capital requires for financing the acquisition of current assets such as stocks. goodwill. 2. However the financial Manager should also keep in mind the future requirements of funds for expansion and growth of the company. is determined by aggregating the following: (i) The cost of fixed assets. listing. research and development. as is clear by the following. the Financial Manager should carefully examine various requirements of funds by the company for promotion. bills receivables.share capital of a company refers to the total paid up value of shares issued by a company. Cost of Financing – Every company has to incur a huge amount of expenditure for raising finance which include advertisement. The amount of capitalization of a company. Cost Theory of Capitalization – According to cost theory. Cost of Fictitious Assets – Most of the companies require to pay huge amount for purchase of intangible assets such as goodwill. commission etc.Fixed assets including land and building. furniture and fixtures. Cost of Sustenance and Development – While in the initial years. Share capital = Equity Share Capital + preference Share Capital Capitalization = Share Capital + Debenture Capital + Long-term borrowing + Free Reserves HOW TO ESTIMATE CAPITAL REQUIREMENTS? Wise estimation of capital requirements of a company is necessary for the smooth functioning of a business. these include-expenses incurred on discovery of business idea and examining its viability. Cost of Fixed Assets . as well as for replacement and renovation of old fixed assets. brokerage. a business may need funds to meet its losses. commencement of business etc. it needs funds for diversification. 5. prepaid expenses etc. the financial manager should give due consideration to the following factors. 3. debtors.. etc. furniture and fixture. while estimating the total capital needs. in later years. This capital is one part of capitalization. modernization. Thus the estimation of capital requirements of a newly promoted company is based on the total initial outlays for setting up of a business enterprise.: 1. plant and machinery. such as land and building. need a careful capital requirements estimation. 1. the amount of capitalization in equal to the total cost incurred in setting up of a corporation as a going concern. capitalization includes the share capital. while estimating the capital requirements of a newly promoted company. If the amount of capital is more tan what is really needed to fun the business. Expenses for Promotion – Required is case of a new company. trade mark. etc. On the other hand. registration of the company. if the amount of capital is less than what is required for the smooth running of business operations the company would face shortage of funds for one activity or another. THEORIES OF CAPITALIZATION In order to determine the capital requirements of a newly promoted company the following two theories of capitalization are generally employed. etc. 4. On the other hand. 6. long-term debt and the surplus not to be distributed. In order to avoid both of these situations. patents. 39 . a part of funds would either remain idle or be invested wastefully. patents. plant and machinery. innovation.

After deducting the operating costs 40 . elasticity of demand. and which carry on their business under competitive conditions. Earning Theory of Capitalization – According to this theory the real worth of a business enterprise is determined by (i) its earning capacity.(ii) (iii) (iv) The amount of regular working capital required to carry on business operations. Thus. It is suitable for determining the financial requirements or the amount of capitalization of a newly promoted corporation. For ascertaining the reliability and accuracy. The amount of capitalization of a company can be computed by using the following formula. It is very difficult to forecast the amount due to the reason that the earnings newly promoted companies depend upon various other factors besides capitalization. age. the amount of capitalization for it should be in accordance with its earnings. Now for determining the amount of capitalization the rate of earnings in similar companies is applied to the estimated annual earnings of the company. then. earnings are not regular and certain. It fact. This is not useful for those enterprises in which the operating cost is changing. extent of competition. (ii) (iii) 2. This theory is not satisfactory in the case of a growing concern whose earnings keep on changing whereas the amount of capitalization remains constant. (ii) its annual earnings. the process of capitalization begins with the estimation of future earnings of the company. such as general price level. location level of management. of other companies of similar size carrying on the similar business. operating costs. DISADVANTAGES OF COST THEORY (i) This theory suffers from the basic drawback that the amount of capitalization is judged by a figure based on the cost of establishing and starting a business. The cost of establishing the business. rate of growth and other similar factors. The value of capitalization of a company is equal to the capitalized value of its estimated earnings. The manager forecasts sales and production costs of the company to arrive at the estimated earnings which are. these estimates should be compared with the actual figures of costs and sales of existing companies in size. As the basic objective of an enterprise is to earn profit. The net income of the newly promoted companies may be forecasted on the basis of estimates of operating costs and volume of sales based on the experience of the promoters or management. and not by its earning. Amount of Capitalization (i) Estimated Annual Earnings x Rate of Capitalization Annual Earnings – The probable earnings of an established company estimated on the basis of average of earnings during the past year. such as construction and public utility institutions. the amount of capitalization is determined by what a firm earns and not by what ha been invested in it. Real estates of possible future earnings may be had by considering the various internal and external factors affecting the annual earnings of the company. This theory does not explain whether the capital invested in a business is justified by its earnings. industrial ands tariff policies of the government etc. The original outlays on all these items form the basis for determining the amount of capitalization. The expenses of promotion. ADVANTAGES OF COST THEORY The cost theory is useful for those enterprises in which the amount of fixed capital is more and whose earnings are regular. compared with he actual earnings. This theory enables the promoter to know the total initial amount of capital which they should raise.

C. It leads to fall in the market value of its shares. This situation arises when a company raises more capital than what is justified by its actual earnings. and the market value of its shares is lower than the book value over a fairly long period of time. Price Earning Ratio = Price Per Share (Equity Share) --------------------------------------------Earning Per Share (Equity Share) OVER CAPITALIZATION A company is over-capitalized when its earnings are consistently insufficient to yield a fair rate of return on the amount of capitalization of a company and when it is not in a position to pay interest on debentures and long-term borrowing. A company may be over-capitalized because its capital is not effectively utilized. It should reflect adequate return to the investors for the use of their funds and the risk they undertake. Over capitalization does not necessarily mean abundance or excess of capital. it is said to be overcapitalized. thus causing a constant decline in earnings. Hoagland 41 . It may be determined by studying the rate of return in similar companies in the same industry. The annual net earnings of a company are capitalized at the rate of capitalization. CHARACTERISTICS OF OVER-CAPITALIZATION 1. an over-capitalized company may be short of capital. (ii) Rate of Capitalization – This is necessary for determining the amount of capitalization of a company. while dividends on shares are not at fair rates. “When a company has consistently been unable to earn the prevailing rate of return on its outstanding securities (considering the earnings of similar companies in the same industry and the degree of risk). Harod Gilbert 3. A company is overcapitalized if it has been unable to earn a fair or prevailing rate of return on its capital. DEFINITIONS OF OVER-CAPITALIZATION 1. Lower rate of earning than prevailing in similar companies in the same industry over a fairly long period of time. Gerstenberg 2. which is computed on the basis of income and market value of share of other firms in the industry. determination of capitalization by price-earning ratio is considered suitable only when the entire capital is raised by issuing shares. It may be calculated with the help of average price earnings ratio. However. This leads to the inability of the company to pay normal rate of dividend and interest on shares and debentures respectively. Whenever the aggregate of the par value of stock and bounds outstanding exceeds the true value of fixed assets.from the operating income the net earnings arrived at may be used for determining the amount of capitalization.W. or when the amount of securities outstanding exceeds the current value of the assets”. the corporation is said to be over-capitalized”. “A corporation is over – capitalized when its earnings are not large enough to yield a fair return on the amount of stocks and bonds that have been issued. it is to be over-capitalized”.

with the passes of time the working efficiency of fixed assets decreases resulting in a fall in the earning capacity of the company. companies have to pay high prices for purchase of fixed assets. Lower rate of dividend over a long period of time. As the rate of dividend falls the market value of shares also fall showing over-capitalization. Thus. it is found that the rate of capitalization is 10% instead of 6%. CAUSES OF OVER-CAPITALIZATION 1. Purchase of assets During Inflationary Conditions – Inflationary conditions affect both the newly promoted as well as the established companies.00. If compels the company to borrow capital at very high rates of interest. High Promotional Expenses – A company has paid high promotional expenses in the form of payments to promoters for their services. If later on. Similarly. patents. Raising Excessive Capital – Over – capitalization occurs if a company raises excessive capital than what it can utilize effectively. 1. the company will be over-capitalized because the book value of the company’s assets will be higher than its real value. 42 . the excess amount of Rs.00. Thus. As a large amount of capital remains idle and ineffectively utilized. 2. Inadequate Provision for Depreciation – Due to inadequate provision for depreciation and replacement of assets. the amount of capitalization should be Rs. 6. Lower market value of shares than the book value of shares over a long period of time. For example. the company’s earnings decline leading to fall in market value of its shares.50. 4. 25. 3. copyright etc. Shortage of Capital – Paucity of capital is the result of faulty financial planning. Therefore. Borrowing at Higher Interest Rates – To meet its emergent needs if a company borrows a large amount of capital at a rate of interest higher than the rate of its earnings it will be over-capitalized. But after the boom conditions subside and necessary conditions set in. the share prices of the company show a declining trend indicating over-capitalization.000. the real value of the company’s assets fall while the book value of its assets remain at a higher level therefore. Over-estimate of Future Earnings – As the promoters of mangers over-estimate the earnings of the company. the company becomes overcapitalized.000 and capitalized at 6% the total amount of capitalization would be Rs. 8. Underestimate of the rate of capitalization results in raising excessive capital than what the company could utilize profitably making the company unable to distribute dividends at prevailing rates. 10. and the amount of capitalization is kept high during boom period. it results in over-capitalization.00.000. As a major part of its earnings will be taken away by the creditors as interest.2. However. if a company’s regular earnings of Rs. a company is able to distribute higher dividends to its shareholders only for a few years. 3. 7. and the market price of shares would decline. if the company is formed by converting a partnership firm or a private limited company into a public limited company and the assets transferred at highly inflated prices. and excessive price for goodwill. A large chunk of profits is given away to the creditors as interest leaving little to be distributed to the shareholders as dividends. Over-estimate of Capitalization Rate – A company would be over-capitalized if the earnings are correctly estimated but the rate of capitalization is under-estimated. trade marks.000 would lead to over-capitalization. the rate of dividend will fall.. This leads to decline in the market value of its shares which is a symptom of over-capitalization. 15. 5. lower market price of shares than the book value makes the company over-capitalized.

(ii) (iii) (iv) (v) (vi) 2. The prices of its shares fall resulting in the company’s over-capitalization condition. It also suffers a set back to its goodwill. a large majority of investors lose their confidence in the company. Therefore. the creditors may forcefully demand liquidation of the company. Demand for Liquidation – An over-capitalized company is not able to pay the principle amount of loan and interest there on. repairs. Set back in obtaining Loans – The credit standing and goodwill of an over-capitalized company suffers a set back due to falling earnings. It will be compelled to resort to costly borrowing which adversely affects its earning capacity. DISADVANTAGES OF OVER-CAPITALIZATION 1. The combined effect of these factors leads to company to overcapitalization over a long period of time. Liberal Dividend Policy – If. Rigorous Taxation Policy – Rigorous taxation policy of the Government results in overcapitalization. 10. renewal and replacement of asset. Set back Obtaining Capital -Because of fall in dividends the investors lose their confidence in the company resulting in difficulty to obtain the requisite capital for improvement and acquisition of new assets by issuing shares or debentures. it fails to retain its customers and lose the market. It even declares and pays unearned dividends from capital to revive its decreasing credit standing. instead of ploughing back its profit a company prefers to follow a liberal dividend policy it would find it difficult to replace its worn-out assets with sufficiently decreased working efficiency. very little amount is left with the company for dividend distribution among the shareholders at prevailing rate. The company may face shortage of funds form both working capital as well as for financing the renewals and replacement of worm-out assets. Financial institutions hesitate in providing loans to such a company for its development and expansion programmes. the working efficiency of the company decreases. Due to higher tax burden. unless drastic steps are taken to correct the situation.9. This further aggravates the decreasing value of the company besides misleading the investors. maintenance and replacement of assets an over-capitalized company loses its market to competitors. It does not make adequate provisions for depreciation. Manipulation of Accounts – An over – capitalization company resorts to objectionable practices including manipulation of accounts in order to cover up the deficiency of the decreased earnings and to present a respectable figure of profits. Thus. Such a company is unable to provide facilities to their customers equal to its competitors. maintenance. Absence of Competitive strength – Due to its failure to produce goods at competitive cost on accounts and inadequate provision for depreciation. Reorganization of the company’s share capital. Disadvantages to shareholders 43 . a symptom of over-capitalisation. is one effective remedy leads to considerable loss of its goodwill. DISADVANTAGE OF THE COMPANY (i) Set back in the Value of Shares and Goodwill – Because of decrease of in the earning capacity of the company. The market value of its shares comes down and the company’s financial stability is jeopardized. Therefore.

the shareholders are the recipients of the residual amount left after the payments to creditors. The society is confronted with a depressing effect in general. Encouragement to Speculative Gambling – As the low-priced shares of an overcapitalized company are subject to speculative gambling. The interests of the workers suffers due to substantial cuts in wages and other benefits. It reduces the quality and increases the price of products. They have to sell their share below par. Even if they agree to grant such loans. Unemployment – Finding it difficult to survive in the competitive market over-capitalized companies is often forced to close down. The workers lose their jobs. Low Value of Shares as Collateral Securities – As the shares of an over-capitalized company are not easily marketable due to low earnings and lower dividends of the company. If an overcapitalized company is forced by its creditors to go into liquidation. demand for goods comes down. DISADVANTAGES TO SOCIETY (i) Lower Quality and Higher Prices – An over-capitalized company does everything to increase its earnings. The ultimate consumers suffer in terms of both quality and price and have to pay high prices for poor quality products. (ii) (iii) (iv) (v) 44 . (ii) (iii) (iv) (v) 3.(i) Low Dividend – The shareholders of an over-capitalized company suffer a revenue loss due to low return on their investment in the form of low dividends on account of low earnings of the company. suffering a capital loss through depreciation of their investments. they have a lower value as collateral securities. they insist upon strict terms and conditions hardly acceptable to an ordinary borrower. Reduction in Wages and Labour Welfare Activities – Over – capitalization leads to retrenchments and reduction in wages and salaries. An over-capitalized company tries to cut the wages and welfare facilities of the workers creating soreness in industrial relations. the real investors have to suffer on account of this manipulation. An over-capitalized company often resorts to retrenchment of the workers on grounds of low earnings in the company. The creditors lose their credits. Thus over capitalization leads to the wastage of national resources which could be used most effectively by those efficient companies who are in need of funds. Re-organization calls for reduction in capital for writing off past losses. Sometimes the shareholders have to forego the entire amount of their investments in case of liquidation. Recession – Due to low purchasing power of workers. Industrial activity receives a set back. Low Market value of Shares – The shareholders suffer a capital loss on account of low market value of shares. leading the reduction of par value of shares resulting in depreciation of the shareholders investments.utilization and Wastage of Resources – An over-capitalized company is unable to effectively utilize the society’s resources. The closure of a few over-capitalized companies tends to create panic in general. the shareholders are the worst sufferers. Commercial banks and other financial institutions are not willing to sanction loans against such securities. Loss on Re-organization or Liquidation – If an over-capitalized company attempts to overcome its ills by re-organization or liquidation. The consumers are deprived of goods and services. As this process continues recessionary conditions are witnessed. Mis .

a company reduces the amount of funded debts through outright re-organization. Debentures and bonds are immediately redeemed out of accumulated earning or new issues. However. The shareholders may be given one share of the same amount in exchange of several shares. REMEDIES TO OVER-CAPITALIZATION Following are the remedies to over-capitalization: 1. this is possible only if the management is able to convince the existing shareholders that reduction in par value of shares is in their interest. 3. or when the real value of asset are more than the book value. This poses the same problem as in case of redemption of debentures by issuing new shares at a reduced price. the company may resort to the ploughing back of profits by suspending the distribution of dividends for a few years. it may do more damage to the company. Reduced Par Value of Shares – The existing shareholders are persuade to accept new shares with reduced par value. This helps the company in raising the necessary funds for future development. Redemption of Preference Shares – The amount of capitalization may be reduced by redemption of performance shares carrying high rate of dividend. it is very difficult for it to raise the necessary funds from the market. Raising of necessary funds for redeeming the high dividend preference shares may further aggravate the situation.(vi) (vii) Encouragement of Speculation – The shares of an over-capitalized company are invariably subject to speculative gambling. It is a condition where the real value of the company’s assets is more than the book value. Reduced Number of Shares – A company sometimes reduces the number of shares to correct the situation caused by over-capitalization. reduction in capital may be affected only by retiring the funded debts out of accumulated earnings. on some premium for this concession. UNDER – CAPITALIZATION MEANING OF UNDER CAPITALIZATION Under – capitalization is the reverse of over-capitalization. 4. an exceptionally high rate of dividend and prices of shares. Reduced Interest Rate in Debentures – An over-capitalized company tries to reduce its fixed obligation with regard to payment of interest on debts. If it issue its shares at a discount. It persuades the existing debenture holders to accept new debentures carrying lower rates of interest. However. Thus earning per share goes up without affecting the amount of capitalization. DEFINITIONS OF UNDER – CAPITALIZATION 45 . Thus. This increases the amount of its real value without an extra burden on its resources. Therefore. Reduced Funded Debt – To control the situation of over-capitalization. Ploughing Back of Profits – In the initial stage of over-capitalization. The industrial and economic development of the country is adversely affected. or when it has very little capital to conduct its business. The management should make all-out efforts to eliminate wasteful expenditure and to increase the efficiency of the company’s resources. 6. as the profits of an over-capitalized company are very low. 5. A company is under-capitalized when its earnings are high in relation to other similar firms in the industry. This reduces the amount of capitalization and improves the earning capacity of the company. Frustration Among Investors – Over-capitalization leads to reduced efficiency and possibility of failure of the business. 2. the investors are not willing to invest in such a company. under-capitalization is associated with an effective utilization of investments.

repairs and renewals. it may acquire the assets at cheaper prices. Higher Value of Shares – The real and market value of shares is higher than their book value. 2. The company becomes under-capitalized as the earnings in subsequent years prove to be higher. the earning of a company may increase abnormal making in under capitalized. Higher rate of Earning – The rate of earning is exceedingly higher than prevailing is similarly situated companies in the same industry.W. Promotion during Recession – If a company is promoted during the period of recession. its earnings increases tremendously. considering the same factors. “A Corporation is under-capitalized when the rate of profit it is making on the total capital. 4. it is said to be under-capitalized”. “When a corporation earns exceedingly high income on its capital. during boom period its earnings increase proportionately higher than the increase in the amount of capital employed. 4. and the ploughing back of profits. Thus. “When a company is earning considerably more than the prevailing rate on its outstanding securities. if the promoters under-estimate the future earnings of the company while formulating the financial plan. Under Estimation of Earning – The amount of capitalization is less than what a company can utilize effectively. or increases in sale price of the product due to sudden increase in its demand. 5.” Bonnevile and Dewy 3. it is said to under-capitalized. Unforeseen Increase in Earnings – Due to government liberal policy towards a particular industry. The real value of the assets automatically goes up with the end of recession. Thus. Higher rate of dividend – This is as compared to the rate declared by other similar companies. C. Higher value of Assets – The real value of the company’s assets is higher than their book value. and real value of its assets exceeds their book value indicating under-capitalization. or when it has too little capital with which to conduct its business. 3. 2. they issue lesser number of shares. Gerstenberg 2. 6. CAUSES OF UNDER – CAPITALIZATION 1. and raise a large portion of its capital G. Promoter’s Desire to Control – If the promoters of a company seek to retain its control within the hands of a few persons. 3. resulting in high profits to the company and exceptionally higher rate of dividends as well as higher market price of its shares making the company under-capitalized.1. the amount of capitalization if low. Under-estimation of capital requirements – If the promoters under-estimate the capital requirements of the company. Harold 46 . Following are the Symptoms of under-capitalization 1. is exceedingly high in relation to the return enjoyed by similarly situated companies in the same industry. Conservative Dividend Policy – If a company follows a sound and conservative dividend policy leading to the creation sufficient reserves for depreciation. the company becomes under-capitalized due to inadequacy of capital.

7. This leads to industrial unrest which adversely affects the efficiency of the corporation leading to decline in its profits. a symptom of under-capitalization. Cut throat competition – As higher earnings of the existing under-capitalized companies attract new competitors to enter the business. the marketability of an undercapitalized company’s share is considerably reduced. Limited Marketability of Shares – As the existing shareholders do not generally want to dispose off such shares. an Under-capitalized company attract the government interference to cut down the prices of its products. bonus. Consumers Opposition – Due to high earnings. It may also increase it earnings by creating large secret reserves. This may lead to the consumer agitations for a reduction in prices of the products offered by an undercapitalized company. The amount of divisible profits available to the shareholders is exceptionally high and the company becomes under-capitalized. As a result the real value of its assets becomes much higher than their book value. to profit ceiling. ploughing back of profits. etc. to charge high profit taxes or file a suit against such a company under anti-trust laws of the country. DISADVANTAGES OF UNDER-CAPITALIZATION 1. 8. Liberal tax policy enables the company to increase its working efficiency by maintaining adequate reserves of financing the renewals and replacement of worn-out assets. Low Promotion Expenses – The company will become under-capitalized if the promoters do not charge excessive amounts for their promotional services and the over-all promotional cost is kept very low. Capital Gains – If a company’s assets are sold by the management at higher price than their book value. Liberal Policy – Due to low tax burden.by issuing securities bearing low rate of interest. the resultant capital gains lead the company to under-capitalization. Industrial Unrest – Industrial relations in under-capitalized companies tend to be strained on account of the fact that employees begin to ask for higher wages. High Standard of Efficiency – If a company follows the policy of rationalization and modernization entailing the use of latest production technique and efficient management of resources. DISADVANTAGES TO THE COMPANY (i) More Speculation – A high divided rate on the shares of an under-capitalized company leads to high market quotations of these shares. The management may manipulate share values and enter into speculation of these shares. This would result in reduction in the profits of the company. They may demand state intervention to control the prices of the products of such a company. maximizing productivity. and the company becomes under-capitalized. its profits invariably increase exceedingly.. (ii) (iii) (iv) (v) (vi) 47 . increased welfare facilities etc. 9. minimizing wasteful use of resources. sufficient amount is left with the company for higher dividend distribution. reduced working hours. the consumers of an under-capitalized company feel that they are being cheated by overcharging the prices for its products. out of he increased prosperity of the company in the form of higher earnings. Interference by Government – Declaring a high rate of dividend. 10. cutthroat competition among rival companies tends to grip the business and reduce its profitability.

While establishing parity between the par value and the market value of the company’s shares this brings down the rate of dividend without affecting the amount of dividend per share. Over-capitalization – Under-capitalization also leads a company to over-capitalization in the long-run due to huge retained earnings and long-term debt financing. Increased Production – Under-capitalization encourages the establishment of new companies resulting in increased industrial production and ensuring regular supply of quality goods to the consumers at cheap prices. Issue of Shares and Debentures – Under – capitalized due to the inadequacy of capital. Sometimes. ADVANTAGES TO SHAREHOLDERS 1. the shareholders get easier loans against the security of shares of an under-capitalized company. Issue of Bonus Shares – The most prevalent remedy to under-capitalization is to capitalize the retained earnings of the company by issuing bonus shares increasing the share capital as well as the number of shares of the company. 3. 3.(vii) Inadequacy of Capital – Suffering from shortage of capital an under-capitalized company always depends on borrowed funds. 4. Increase in Par Value of Shares – In exchange for the old shares a company may issue shares of higher par value to its existing shareholders. That. the rate of dividend per share comes down. who may even demand for its liquidation in case of non-payment of interest and the principal amount of loan.capitalized company also avail more capital gains. (iv) REMEDIES TO UNDER-CAPITALIZATION Following are the remedies to under employment 1. Splitting –up of Shares – The shares of an under-capitalized company may be splitted into shares of small denomination bringing down the amount of divided per share without affecting the total earnings and the amount of capital of the company. it is compelled to borrow funds at a high rate of interest resulting in reduction of its earnings and control by its creditors. ADVANTAGES TO SOCIETY (i) (ii) (iii) General welfare – The entire society is benefited with the higher earnings of an undercapitalized company Employees advantage – The employees get higher wages. IMPACT OF OVER – CAPITALIZATION 48 . 2. More Capital Gains – The shareholders of an under . This increases the share capital and number of shares of the company resulting in decline in the rate of dividend. 2. due to higher earnings of the company. Increased employment – Establishment of new companies and expansion of the established ones creates increased employment. B. (viii) ADVANTAGES OF UNDER CAPITALISATION A. Easier Loans – As the shares of an under-capitalized company have great value as collateral security. because the market value of the company’s shares increase very rapidly. company may raise more capital by issuing shares and debentures. bonus and better amenities. Higher Dividends – The shareholders of an under-capitalized company regularly receive higher dividends on their investments.

The share holders lose in terms of capital and dividend. The credit worthiness of such company is reduced b. The remedies available to correct the situation of over-capitalization are quite painful. It induces the management to build up secret reserves and renewals under-state earnings replacement are b. The employees demand high share in the increased profits of the of the company employees a. breeds discontent among the employees. A lower rate of return b. The quality of the product is effected a. High rate of earning per share b. Impact on Company a. Maintenance. Uncertain income and irregular Under-capitalization a. Wide market d. Even the employees and the consumers gain from the increased efficiency of the company. Morale management is low 3. However. It is easier to remedy under-capitalization by capitalizing the company’s surpluses. If the company goes into liquidation the shareholders and creditors suffer a considerable loss. The consumers suffer in terms of reduced quality and increased prices. Impact on Society a. capacity. Management builds b. 49 . Capital value of the shares is reduced c. IMPACT OF UNDER CAPITALIZATION Under-capitalization is undesirable business it accelerates. The high rate of earnings per share may increase competition goodwill to account c. Capital value of the share is increased fluctuations in value of such c. concerns are liquidated b. The government can c.Over – capitalization is harmful to the financial interests of the company as it adversely affects the financial structure of the concern and the interests of shareholders and consumers. Impact on Shareholders a. and programmes suspended c. The employees are deprived of their fair compensation and stand to lose their jobs. The shareholders and the society enjoy the prosperity of an under-capitalized company. Loss of employment as charge excess profit-tax well as production from such companies. etc. The financial re-organization of the company involves considerable sacrifice on the part of its shareholders. Over Capitalization 1. In the long-run such up the reserve. Speculation in shares shares 2. under-capitalization also possesses some welcome features. d. The consumers are not benefited even in this state. competition. accentuates the feeling of exploitation among consumers and tempts the management to enter into speculation of the company’s shares. Loss of manipulation etc. The society finds that its resources are being misused.

Thus. The entire profits of the company are not distributed among its shareholders as dividend. the book value of its assets exceeds by their real value in the market which is the state of over-capitalization. Over – valuation of Promoters Services – The capital of the company becomes watered if the services of the promoters are valued at a very high price and paid for by issuing them fully paid-up shares of that amount. the market value of the company’s shares comes down. The real value of its assets is reduced to below their book value. which leads to reduction of its profits. 3.REMEDIES LEADING UNDER-CAPITALIZATION TO OVER CAPITALIZATION 1. its capital becomes watered to the extent of the excess price paid for the assets making the book value of assets more than their realizable or market value. Under capitalization leads to over-capitalization in due course of time. Thus the company fails to pay dividends at generally prevalent rates. trademarks. As profits of a company belong to shareholders. which forms a part of its capitalization. the company has to pay higher rates of interest. copyright. Thus. Retained earnings being a fixed liability of the company. but a large part of its profits are retained in the business in the form of reserves and surpluses. 2. The practice of under-capitalization results in marking a concern over-capitalized. MEANING OF WATERED CAPITAL When the real value of its assets is less than its paid-up share capital. 50 . 2. Increase in profits and Book value – Under-capitalization is characterized by an exceedingly high rate of profit enjoyed by a corporation in relation to other similar firms in the industry. a large part of profits is accumulated with the company. Thus. Investment in Intangible Assets – If huge investments are made in acquiring intangible assets such as goodwill.. its capital becomes watered as the real value of the intangible assets is less than their book value. “A stock is said to be watered when its true value is less than its book value”. Watered capital means that the realizable value of the company’s assets is less than its paid-up share capital. the company becomes over-capitalized. and the company’s capital is termed as ‘water capital’ as worthless as a ‘water’. According to Hoagland. and later on they prove worthless or lose their utility for the company. etc. thus. parents. CAUSES OF WATERED CAPITAL Following are the causes of Watered Capital 1. Thus. a company’s capital is ‘watered’ when the total amount of its paid-up share capital is not represented by the same value of its asset. Purchase or Transfer of Assets at Inflated Price – As a company purchases or transfers assets from a going concern at inflated prices. a part of the capital is not represented by its assets. Due to lower dividend rate. the retained earning in the form of reserves and surpluses constitutes a part of the company’s capitalization. in due course under-capitalization leads to over capitalization. Decrease in share capital and dividend – As under – capitalized company has lesser amount of were capital and it has to depend on long-term borrowing for its expansion development programmes. due to increased amount of risk to the creditors. at the time of promotion. and the book value of the company is arrived at by adding this amount to the capital of the company.

Ploughing Back or Profits – Watered capital may be corrected by ploughing back a substantial part of the company’s profits for some years correcting the difference between the realizable value and book value of the company’s assets. Defective Depreciation Policy – Defective depreciation policy may contribute in making the company’s capital watered. state of watered stock is said to have existed. existence of water in the stock cannot be ignored nevertheless the earning capacity of the enterprise may justify the payment at exorbitant price. In case the assets acquire prove worthless or they have been bought at an inflated price. De-capitalisation – If the par value of the shares held by the existing shareholders is reduced. the enterprise will be in the state of over-capitalization. the management should take following stern steps to correct it: 1. depreciation and other losses. an enterprise is expected to acquire the assets at a price which represent their real worth. the deficiency of capital may be written off by the resultant capital gain. there is a clear-cut difference between the two. at the time of promotion. a company gets over-capitalized only when it fails to earn sufficient income to justify its capital. services of promoters are valued highly and are accordingly paid usually in the form of stocks. OVER-CAPITALIZATION Sometimes the term Watered Stock is confused with overcapitalization. So as to test the existence of water in stock. As watered capital adversely affect the company.4. It makes the book value of the assets bigger than their market value due to inadequate provision for wear and tear. stock of the enterprise will become watered stock. However. when an enterprise has run for several years and during all these years it has not been able to make sufficient earnings to justify its capital. Adequate provision for depreciation – The watered capital will come down and finally eliminated. More often than not. If the promoters deliberately acquire the assets needed by the enterprise at inflated price. the analyst should study the intent of the promoters who float the enterprise and sell the stocks. if the value of fixed asset is gradually reduced to the extent of their depreciation. While the state of watered stock relates to promotion of an enterprise. It is important to note that state of watered stock may become potent cause for the existence of over-capitalization in the enterprise. Unforeseen Changes or Accidents – Watered capital occurs due to result of unforeseen internal or internal changes or accidents such as fall in the real of shares due to decline in profits. thus. 3. CONTROL OF WATERED CAPITAL Irrespective of the causes of watered capital. In contrast. The above distinction can be made more clear with the help of the following example: 51 . it is always unproductive and it does not command any earnings capacity. it is designated as ‘Watered stock’ signifying dilution of water in the capital of the enterprise. the enterprise will be in the state of watered stock. 2. 5. inflationary condition etc. WATERED STOCKS VS. Under these circumstances. WATERED STOCK When stock is not represented by assets of equivalent value. Similarly when an enterprise pays higher price to the vendors for the assets transferred.

Thus.The Good Luck Company issues 500 shares of Rs.000 which is being capitalized at 5% rate giving capitalized value of earnings equal to Rs. on an average. the capitalized value of earning will be Rs.000. It means that the stock of the company has been watered to the time of Rs. It means that although the company has no water in stock. However. 80.each. earned Rs.000.000.000 but it makes an average earnings of Rs. watered stock is concerned with the realizable value of the assets which can be had by liquidating the assets in market. On the other hand. 52 .000) is utilized to acquire fixed assets for the corporation. At the time of promotion of the enterprise.00. the company may receive the assets of full value of Rs. 3. 20. 80. the company has run successfully for the past five years and has. Issues are fully subscribed. This sum (Rs. 4.00. 200/. 1. it suggests that the company having watered stock is not over-capitalized. 15.000.00. If earnings are being capitalized at 5% rate. 1.000 yearly. it is overcapitalized. it is discovered that realizable value of assets is Rs. whereas over and under-capitalization are relative terms which are related with real value of assets determined by the actual earnings capacity of the company.

the optimum capital structure is achieved by balancing the financing so as to achieve the lowest average cost of long term funds. 2. Gerstenberg 6. R. represented primarily by long-term debt. preferred stock. “The term capital structure is frequently used to indicate the long-term sources of funds employed in a business enterprise”. on the other hand capital structure is concerned with the determination of the composition of different long-term sources of funds. capital surplus and accumulated retained earnings. “Capital structure is the combination of debt and equity securities that comprise a firm’s financing of its assets”. long-term debt. Wessel 3. preference shares. “Capital structure is the permanent financing of the firm.” W.” Weston and Brigham 2. Difference in objectives – Capitalization is concerned with the determination of the total amount of capital required for the successful business operation. debentures. “Capitalization embraces the composition or the character of the structure as well as the amount” Husband and Dockeray 5. “From a strictly financial point of view. long-term funds. Wessel 7. “The term capital structure is frequently used to indicate the long-term sources of funds employed in a business enterprise”. Hampton DISTINCTIONS BETWEEN CAPITALIZATION AND CAPITAL STRUCTURE 1. and common equity. It implies the determination of form or make-up of a company’s capitalization.UNIT V CAPITAL STRUCTURE MEANING OF CAPITAL STRUCTURE Capital structure of a company cannot be the composition of long-term sources of long-term sources of funds. This. turn produces the maximum market value of the total securities issued against a given amount of corporate income”. “Capital structure refers to the kind of securities that make up the capitalization. such as ordinary shares. bonds.H. On the other hand capital structure refers to the proportion of different sources of long-term funds in the capitalization of a company. reserves and surplus. which includes share capital. Robert H. such 53 . Common equity includes common stock. DEFINITIONS OF ‘CAPITAL STRUCTURE’ 1. in. but excluding all short-term credit. Guthman and Dougall 4. John J. Difference in scope – Capitalization refers to the total accounting value of all the capital regularly employed in the business.

Therefore. Liquid – In order to achieve proper liquidity for the solvency of a corporation. Maximum Return – A balanced capital structure is devised in such a way so as to maximize the profits of the corporation through a proper policy of trading on equity so as to minimize the cost of capital. That it is advisable to issue equity and preference shares in developing an optimum capital structure. The company may also face difficulties in raising additional capital in future. Due consideration is given to the question of control in management while deciding the issue of securities. 54 . The optimum capital could be achieved when the marginal cost of each source of finance is the same. CHARACTERISTICS OF OPTIMAL STRUCTURE Following are the characteristics of an optimal of capital structure. The management aims at keeping the expenses of issue and fixed annual payments at a minimum in order to maximize the return to equity shareholders. Risks.as debentures. such as increase in taxes. 3. If the capital structure is complicated from the very beginning by issuing different types of securities. the capital structure devised in such a way as to enable it to afford the burden of these risks easily. preference capital and ordinary share capital including retained earnings. Simplicity –A sound capital structure is simple in the initial stage are which limits to the of the number of issues and types of securities. The financial manager should attempt to develop an appropriate capital structure for his firm instead of trying for un utopian ‘optimal capital structure’. the investors hesitate to invest is such a company. Minimum Cost – A sound capital structure attempts to establish the security-mix in such a way as to raise the requisite funds at the lowest possible cost. or for the same firm for all times. 2. In order to maximize the shareholder’s wealth. It is incorrect to say that there exists an ideal mix of debt and equity capital which will produce an optimum capital structure leading to the maximization of market price per share. If a large number of equity share are issued. 7. costs. 4.. rates of interest. the company issues preference shares or debentures instead of equity shares to the public because preference shares carry limited voting rights and debentures do not have any voting rights. The capital structure of a company is changed in such a way which would favorably affect the voting structure of the existing shareholders and increase their control on the company’s affairs. etc. A proper balance between fixed assets and current assets is maintained according to the nature and size of business. As the cost of various sources of capital is not equal in all circumstances it is ascertained on the basis of weighted average cost of capital. Maximum Control – A sound capital structure retains the ultimate control of a company with the equality shareholders who have the right to elect directors. 5. Minimum Risk – An ideal capital structure possesses the quality of minimum risk. and decrease in prices and value of shares as well as natural calamities adversely affect the company’s earning. the financial manager should attempt to achieve an optimal capital structure which refers to an ideal combination of various sources of long-term funds so as to minimize the overall cost of capital and maximize the market value per share. There is no single optimal capital structure for all firms. long-term debt. Flexible – A flexible capital structure enables the company to make the necessary changes in it according to the changing conditions and make it possible to procure more capital whenever required or redeem the surplus capital. 6. all such debts are avoided which threaten the solvency of the company. The existing shareholders may not be able to retain control. 1. Debentures and bonds should be reserved for futures financial requirements.

ownership securities and creditor ship securities. indirectly.. a company is controlled by equity shareholders carry limited voting rights and debentures holders do not have any voting right. A sound capital structure enables a company to maintain a proper balance between fixed and liquid assets and avoid the various financial and managerial difficulties. interest rates. 10. Controlled – Though the management of a company is apparently in the hands of the directors. A balanced capital structure enables company to provide maximum return to the equity shareholders of the company by raising the requesting capital funds at the minimum cost. It helps in maintaining the debt capacity of the company even in unfavourable circumstances. thus. A balanced capital structure helps a company to estimate both the states of overcapitalization and under-capitalization which are harmful to financial interests of the company. A balanced capital structure enables the company to meet the business risks by employing its retained earning for the smooth business operations.e. Minimized Cost – The primary objective of a company is to maximize the shareholder’s wealth through minimization of cost. These risks are minimized by making suitable adjustments in the components of capital structure. A well-advised capital structure enables a company to raise the requisite funds from various sources at the lowest possible cost in terms of market rate of interest. Optimum Utilization – Optimum utilization of the available financial resources is an important objective of a balanced financial structure. 8. expense of issue etc. A fair capitalization enables a company to make full utilization of the available capital at minimum cost. 4. a well-devised capital structure ensures the retention of control over the affairs of the company with in the hands of the existing equity shareholders by maintaining a proper balance between voting right and non-moving right capital. 7. under capitalization and over-capitalization are injurious to the financial interests of a company. Conservative – In division of the capital structure a company follows the policy of conservation. As both. 5. making the capital structure as simple as possible. taxes and reduction in prices. this maximize the return to the equity shareholders as well as the market value of shares held by them. Minimize Risks – A sound capital structure serves as an insurance against various business risks. An ideal financial structure enables the company to make full utilization of available capital by establishing a proper co-ordination between the quantum of capital and the financial requirements of the business. or redeem the surplus capital. it not only helps is fuller utilization of the available capital but also eliminates the two undesirable states of over-capitalization and under – capitalization. Simple – A balanced capital structure is aimed at limiting the number of issues and types of securities. earning rate expected by prospective investors. 9. 2. such as interest in costs. Balance Leverage . Shares are issued when the rate of capitalization is high. Maximized Return – The primary objective of every corporation is to promote the shareholders interest. Balanced Capital – A balance is necessary for the optimum capital structure of a company. IMPORTANCE OF SOUND CAPITAL STRUCTURE 1. Liquid .8. while debentures are issued when rate of interest is low. 3.A sound capital structure attempts to secure a balanced leverage by issuing both types of securities i. 55 . 6. Flexible – Flexibility or capital structure enables the company to raise additional capital at the time of need. there is a proper co-ordination between the quantum of capital and the financial needs of the corporation.An object of a balanced capital structure is to maintain proper liquidity which is necessary for the solvency of the company.

while other companies have to rely heavily in equity share capital. Desire to control the Business – If the control of the company is to be retained within few hands. experience. maintenance. financing and merchandising enterprises are more stable in their earnings and enjoy greater degree of freedom form competition than industrial concerns. If the fixed rate of interest on borrowed capital or dividend on preference shares is lower than the general rate of earnings of the company. i. temperament and motivation management evaluates the same risks differently and its willingness to employ debt capital also differ. such as debentures and preference shares. if funds are needed for such purposes as betterment. a large proportion of funds is raised by issuance of non-voting right securities. If a company expects regular income in future. A majority of voting right securities. judgement. INTERNAL FACTORS 1. which do not directly add to the earnings of the company retained earnings. Thus capital structure is influenced by the age. Trading on equity implies the presence of a favourable financial 56 . etc. Development and Expansion Plans – Capital structure of a company is affected by its development and expansion progremmes in future. Therefore. 7. 2. Purpose of Finance – An important factor determining the type of capital to be raised is the purpose for which it is required. If a company employ borrowed capital including preference share capital to increase the rate of return on equity shares. Thus. it is said to be trading on equity. 4. On the other hand. experience. A. If funds are needed for some product give activity directly adding to the profitability of the company. Public utilities. majority of funds are raised from public retaining the control of the company with the promoters or the existing shareholders. The amount of authorized capital is kept higher so that the requisite amount may be raised at the time of need. 5. the equity shareholders will have an advantage in the form of additional dividend. Trading on Equity – Trading on equity means the regular use of borrowed capital as well as equity capital in the conduct of a companies business. conservativeness and attitude of the management. Preference shares may be issued if a company does not expect regular income but it is hopeful that its average earnings for a few years may be equal to or in excess of the amount of dividend to be paid on such preference shares. equity shares are held by the promoters or their relatives to control the affairs of the business. 3. capital structure is devised in accordance with the future development and expansion programmes.e. equity share capital will be the better source of financing. debenture and bonds should be issued. capital may be raised by issuing securities bearing fixed charges like preference shares and debentures. ambition. Certainty of Income – If a company is not certain about any regular income in future. Characteristic of Management – Varying in skill. it should never issue any type of securities other than equity shares. 8. Nature of Business – Companies have stable earnings can afford to raise funds through sources involving fixed charges. 6. In the beginning the company collects capital by issuing shares. confidence.FACTORS DETERMINING CAPITAL STRUCTURE The factors determining capital structure of a company may be internal or external. Regularity of Income – Capital structure is affected by the regularity of income. extractive. The requisite capital is raised through preference shares and debentures.

On the contrary when the ratio of equity shares in the total capital structure of a company is high. External Factors 1. Therefore debentures should be issued in times of depression. The capital structure should be designed to minimize the commission payable to brokers. A 57 . Excessive dependence on fixed cost securities make the capital structure rigid due to fixed payment of interest or dividend. 10. Stability in equity price and goodwill of a company depends on adequate capital gearing. The determination of debt equity ratio of such companies should be in accordance with their debt capacity. Cost of Capital – As the cost of capital issue affects the capital structure of a company. Simplicity – The capital structure must have simplicity. a company should issues different types of securities with different denominations. Hence the investors would prefer to invest in debentures and not in equity shares. and by issuing equity shares when rate of earnings and share prices are high. A company must raise capital funds by borrowing when rate of interest is low. equity shares should be issued during boom period. Hence. so that financial crises may be avoided. 3. shares and debentures should be issued in accordance with the tastes and preferences of all types of customers. irregular and inadequate earnings. middlemen and underwriters or the discount payable on issue of debentures and bonds. To suit the financial status of various sections of the society. A high capital gearing ratio encourages speculation in shares of such a company and market price of shares continuous to fluctuate. any type of security can be issued to raise the requisite funds during boom period when people have sufficient funds. In times of depression the possibilities of profit are the least and rate of dividend on equity shares comes down. Debt capacity and Risk – After a certain extent the use of borrowed capital become risky for the company because it leads to increase in the fixed liability of interest payment adversely affecting the company’s income and reducing its liquidity. 13. B. Excessive use of borrowed funds endangers the solvency of the company in the long run. These sources should be kept in reserve for emergency and expansion purpose. It influences the profitability and general rate of earnings. Its success largely depends upon the psychological conditions of different types of investors. While some investors prefer security of investment and stability of income others prefer higher income and capital appreciation. it is called ‘Low Gearing’. High debt equity ratio is particularly risky for the companies with uncertain. it is necessary for the promoters to determine the ratio of fixed cost securities (preference shares and debentures) and fluctuating cost securities (equity shares) very carefully. Tastes and Preference of Investors – An ideal capital structure is one which suits the needs of different types of customers. Flexibility – The capital structure must have flexibility as to increase or decrease the funds as per requirements of the enterprise. 11. Therefore. 2. is called ‘High Gearing’. Cost of Capital – Cost of capital is an important determinant of capital structure of a company. 12. On the contrary. Conditions of Capital Market – Conditions of capital market have a direct bearing on the capital structure.leverage in the company’s capital structure. Therefore. When the ratio of equity shares is low in the total capital structure. 9. A company would prefer to issue debentures or preference shares having a rate of interest or dividend lower than the general rate of its earnings. Capital Gearing Ratio – The ratio of equity share capital to the total capital is called ‘Capital Gearing’.

A sound capital structure should possess the following characteristics. Profitable – The capital structure should be devised in such a way as to maximize the profits of the company keeping in views the burden of the cost of capital on the income of the firm. 2. it is always the question of optimum or balanced capital structure i. Whenever financial manger considers the question of capital structure. if a company’s income is taxed at a higher rate then the directors should issue debentures because the amount of interest payable to debentures holder is deducted while computing the company’s total income. a company’s capital structure is also influenced by the possible changes in the law of the country. The ordinary shares cannot be redeemed except under the scheme of re-organization. preference and ordinary share capital and retained earnings (reserves and surpluses). employees. a proper policy of trading on equity should be followed. Possible Changes in Law – Besides complying the legal restrictions. The redemption of preference shares does not affect the nature but composition. debentures can be reduced at any time even before maturity under terms of issue. the market value is maximized or the cost of capital is minimized when the real cost of each source of funds is the same. If a debt threatens the solvency of the company. 4. The company should not feel any difficulty in raising funds when they are required or in redeeming them when they are not required nay more.. it is important for a company to take a decision regarding its capital structure. customers.company should raise funds by issuing different types of securities in such a way as would minimize the cost of capital issue. Ownership funds include ordinary and performance share capital and retained earnings (reserves and surplus) while borrowed funds include the amount raised by the issue of debentures. 1. Considering this fact.e. Companies that do not plan their capital structure may prosper in the short run. Similarly preference shares are preferred to debenture as non-payment of interest on debentures. but ultimately they face serious problems in raising funds to finance their activities. Therefore. long-term debts. Optimum or balanced capital structures means an ideal combination of borrowed and owned capital that may attain the marginal goal i.e. Likewise. it should be avoided. Whereas it is a statutory deduction. 3. 5. Control of capital issues Act has fixed 4 : 1 ratio for debt and equity and 3:1 ratio for equity and preference share capital. maximizing of market value per share of minimization of cost of capital. CONCEPT OF BALANCED CAPITAL STRUCTURE Capital structure or financial plan refers to the composition of long-term sources of funds as debentures. creditors etc. CHARACTERISTICS OF A BALANCED CAPITAL STRUCTURE A sound capital structure should be devised keeping in view the interests of the ordinary shareholders. dividends are not an accepted deduction. Flexible – The capital structure of a company should be flexible enough to suit the changed conditions. 58 . Present Statutes and Rules – Capital structure a influenced by the statures and rules prevailing in the country. Equity shares score over preference shares because there is greater liberty in the payment of dividends on equity shares. In India. to decide the proportion of ownership funds and borrowed funds. Banking Companies act restricts a banking company from issuing any type of securities other than equity shares. In order to achieve this objective. It is the task of the financial manages to determine the combination of the various sources of long-term finance. the capital structure should be as flexible as possible. Solvent – Due consideration should be given to the solvency of the company. and loans taken from the financial institutions. For example.

2. issue of securities in future maintenance of profits. Normally. It may be achieved by minimizing the cost of issue and the cost of financing. 6. Minimum Costs – Central cost of various sources of funds are not equal in all circumstances. Minimum Risks – Various risks are involved in business operations which have direct bearings on the capital structure of the company such as business risk. interest rate risk etc. Attractive – Securities proposed to be issued offer certain attractions to the investors either in relation to income. The capital structure should be designed as to preserve the control of equity shareholders and to prevent the erosion of control from their hands. Balanced in Leverage – Both types of securities i. such capital structure offers certain decisive advantages to the company. ECONOMIC OBJECTIVES 1. Preference shareholders and the debenture holders have limited voting rights in matters affecting their interests. This policy favors for the maintenance of Reserve and surplus at a fairly high figure in a bid to provide guarantee to contributors of funs towards debt paying capacity of the company. burden of taxes and future rearrangement of capital structure etc. 3. It is easy type of securities. Simplicity – A sound capital structure defines clearly the rights attached to each type of securities. Conservative – A company should follow the policy of conservation while devising its capital structure in the sense that the debts capacity of the company should not be disturbed. 59 . debentures are issued when rate of interest is low and shares when rate of capitalization is higher. These risks should be minimized by making suitable adjustments in the components of capital structure. The management should aim at keeping the cost of issue at a minimum to maximum the returns to equity shareholders. Maximum Return – On of the objectives of balanced capital structure is to provide for the maximum return to the real owners (equity shareholders) of the company. (ii) its prospects of raising capital are good in future even in unfavorable times.. OBJECTIVES OF BALANCED CAPITAL STRUCTURE In devising a sound or balanced capital structure. trade cycle risks. purchasing power risks. namely. Controlled – Sound capital structure provides maximum control of the equity shareholders on the company’s affairs.e. the manager should bear in mind the following objectives. management risks. Preservation of Control of Equity Shareholders – Generally equity shareholders have the control over the affairs of the company. 8. 7. A. 4. (i) the company’s cost of capital is the least. Economic – Capital mix entails the minimum cost of issue of securities and cost of financing etc.4. The management should bear in mind the various factors and their effects on its creditability such as value of other securities. control or overtability. and (iii) it can be successful in maintain healthy relations with security holders. dividend and the relationship of earnings to the prices of shares. ownership and creditor ship. 5. It is easy to manage. are issued to secure a balanced leverage. 9. One of the major objectives of a business enterprise is to raise funds at the lowest possible cost in a given set of circumstances in terms of interest. tax risk. It requires proper balance between voting right and non-voting right capital.

Fuller utilization of capital is also not possible in case of watered capital. A preference issue may be made if. OTHER OBJECTIVES 1. 2. warranted by the circumstances. A proper balance between fixed assets and the liquid assets should be maintained. Simplicity – The capital structure should be as simple and conservative as possible. 60 . 6. Fuller Utilization – There must be proper co-ordination between the quantum of capital and the financial requirements of the business so that full utilization of available capital may be made at minimum cost.e. equity share capital that will enhance the credit of the company. Full utilization of capital requires a fair capitalization.. In the beginning a company should raise only the ownership capital i. Nature and size of the business decide the ideal ratio of fixed and liquid assets. Both the states of under – capitalization and unwarranted to the health of industry. B.5. Management should enjoy the maximum freedom of action to manage the income and capital of the firm. Proper Liquidity – Liquidity is necessary for the solvency of the company. Flexibility – The management should design the capital structure in order to make necessary changes in it whenever required.

A public utility concern may collect a fairly large amount through debentures as its earning are somewhat constant. Ownership Securities – These may be classified into (i) equity shares and (ii) preference shares. A big majority of bonds carry a fixed rate interest. while creditor-ship securities include debentures and bends.UNIT – VI SOURCES OF FINANCE I CORPORATE SHARE CAPITAL A company needs finance to meet its various types of requirements. They control the affair of the company and carry with them the ownership responsibilities. The ownership securities include the equity and the performance shares. 1. Debentures always secured either by floating charge or by fixed charge. (ii) 2. the remaining assets are first appropriate for returning the capital contributed by the preference shareholders. Firstly. called bond-indenture containing the terms and conditions. Bonds – Bond is an agreement between bond holders and the company. redeemable and irredeemable bonds etc. and about the repayment of capital. Appointed by the company. they are entailed to receive a fixed rate of dividend out of the net profits of the company prior to declaration of dividend on equity shares. It is unwise for a company to take loans from a bank to acquire a fixed asset as loan as it is a source of obtaining funds only for a short period. Preference shares – Section 85(I) of the Companies Act. a company can issue two types of securities (1) ownership securities. (ii) SIGNIFICANCE OF SECURITIES IN FINANCIAL STRUCTURES Following is the significance of securities in the financial structure of a company: 1. They provide the “risk capital” or “venture capital” of the company. (i) Equity Shares – These are the shares the holders of which are the residual climates and have no preference in capital as well a in the income of the company. According to the Indian Companies Act 1956. has defined preference shares as those which carry preferential rights about the payment of dividend at a fixed rate either free of or subject to income tax. Bonds or debentures are issued only when the future earnings of company are liberal and fairly consent. Bonds may be classified as secured and unsecured. and (2) creditor ship securities. offered to the public through prospectus. 61 . Source fork funds for a company may be classified into two broad categories according to he mode of raising funds (1) By issue of securities such as shares (equity and preference) and debentures and (2) By other methods such as financial institutions etc. Secondly. Debentures are equal parts of a loan raised by a company. these shareholders enjoy two preferential rights over the other category of shares. some other are required for day today working. after the payment of debts of the company under liquidation. a trustee acts as an agent of the bondholders. The method of raising funds is decided after taking into consideration the period for which funds are required. While some fund are required for a fairly long time for the purpose of acquiring fixed assets. Long-term funds are raised in such way that a company may have uninterrupted use of it for a sufficiently long time. Creditorship Securities (i) Debentures – A debenture is an acknowledgement of debt by a company under its seal.

2. Equity shares are issued and debt is contracted in the beginning by basic and manufacturing industries. 3. Only equity shares are issued when fresh capital required by an existing concern whose previous earnings have been unstable. 4. Cheap borrowed funds are used for expansion purposes, when a company has become well established and the earning have stabilized. When debentures are issued to obtain these funds, it is twice the interest charges being carried by the public utility concerns and four times by other concern. 5. If funds are obtained on the basis of mortgage issue, the total amount thus collected does not exceed half the depreciated value of the assets covered by the mortgage. 6. Industrial having large assets may issue irredeemable debenture or long-term redeemable debentures. 7. When the earnings are irregular but average profits over a period of years give a fair margin over preference shares, dividend preference shares may be issued. MEANING OF SHARE CAPITAL Share capital is the capital raised by a company through the issue of shares. It constitutes the basis of the capital structure of a company. Only companies limited by shares and registered with a share capital can raise capital through the issue of shares. Share capital may be raised either at the time of formation of the company for starting business operations or, later on for future expansion of the business. Authorized capital is the sum mentioned in the Memorandum of Association as he capital of the company. It is the maximum amount of capital which the company is authorized to raise by the issue of shares. Issued capital is the part of the authorized capital which is issued for public subscription for the time being. MEANING OF SHARE 1. “Share means share in the share capital of company and includes stock where a distinction between stock and shares is expressed or implied”. -Section 2 of the Indian Companies Act 1956 2. “A share is that proportionate part of capital to which a member is entitled”. Lord Justice James Lindley

The total capital of the company is divided into a large number of shares to facilitate public subscription to the capital in smaller amount. For example if the capital of a company is Rs. 20,00,000, it can be divided into 200,000 shares of Rs. 10/- each. Thus share is one of the equal parts into which the capital of a company is divided entitling the holder of the share to a proportion of the profits. KINDS OF SHARES According to the Indian Companies Act 1956, following are two types of shars: (i) (ii) (i) Equity Shares Preference Shares Equity Shares – Equity means the ownership interest or the interest of shareholders as measured by capital and reserves. According to the Indian Companies Act 1956 equity shares are those ownership securities which do not carry any special or preferential rights in respect of

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dividend or return of capital. equity shareholders are the owners and risk-bearers of the company. An equity shares is distinguished by the following characteristics. a. No fixed rate of dividend – Dividends in respect of equity shares are paid only after the preference shareholders have been paid the dividends due to them. b. Payment after Debt. Repayment – In the case of winding up of the company, an equity shareholder will be paid back his capital only after all other debts, including the preference share capital, has been repaid in full. c. Right to Vote – The equity shareholders is entitled to the rights to vote at the annual general meetings of the company. He participates in the management and control of the company. The right is not available to the preference shareholder except in special circumstances. (ii) Preference Shares – According to Indian Companies Act 1956 “A preference share is a share which carries a preferential right both as regards to a fixed dividend and as regards to the payment of capital in winding-up”. The preference shares have the following characteristics 1. There is a fixed rate of dividend to them. 2. They get priority over equity shareholders in respect of payment of dividend. 3. They are paid back their capital ahead of equity shareholders in the event of the company’s liquidations. 4. They do not have any voting rights except in some special circumstances. 5. Preference shares stand mid-way between debentures and equity shares. Like debentures they get a fixed dividend and enjoy priority over equity shareholders in the payment of dividend as also return of capital return of capital in the case of winding up. Like debentures they do not enjoy any voting rights. On the other hand, like equity shares they participate in the residual profits of the company. 6. Preference shareholders are paid dividend, not interest, though dividend on such shares is paid at fixed rate. 7. There is no legal obligation to pay dividend on such shares year after year. If the company does not have enough profits in any year it can avoid payment of dividend on preferences shares without inviting any legal action.

TYPES OF PREFERENCE SHARES A according to the rights attached to them the preference share may be of the following types: 1. Cumulative and Non-Cumulative Preference Shares 2. Participating and Non-Participating Preference Shares 3. Redeemable and Irredeemable Preference Shares 4. Convertible and Non-convertible Preference Shares 5. Guaranteed Preference Shares.

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1. Cumulative and Non-Cumulative Preference Shares – The holders of cumulative preference shares are entitled to arrears of dividend on their shares to be paid out of the profits of subsequent years, if the dividend on them cannot be paid in any year. They are sure to receive dividend on the preference shares held by them for all the years out of the earnings of the company. If they are not paid the dividend in a particular year, they are paid such arrear in the next year before any dividend can be distributed among equity shareholders but if dividend is not paid in any year the dividend on non-cumulative shares does not accumulate. 2. Participating and Non-Participating Preference Shares – The holders of participating preference shares are entitled to a shares in the surplus profits after paying dividend to preference shares and equity shares. Thus, participating shareholders obtain return on their investment in two forms fixed dividend and shares in surplus profits. Non-participating preference shares are those preference shares which do not carry the right to share in the surplus profits. 3. Redeemable and Irredeemable Preference Shares – Redeemable preference shares are those which will be repaid on or after a certain date in accordance with the terms of their issues. Irredeemable preference shares are those preference shares which cannot be redeemed during the life time of the company. 4. Convertible and Non-Convertible Preference Shares – Convertible preference shares are those preference shares which are given a right to be converted into equity shares within a fixed period of time. Non-convertible preference shares are the preference shares which cannot be converted into equity shares. 5. Guaranteed Preference Shares – These shares are issued when a company is converted from a private limited to Public United company or when one company is sold to another company. The seller or any other interested party guarantee the payment of dividend on preference shares of a specific rate for a number of years.

MERITS OF PREFERENCES SHARES 1. ADVANTAGES FROM COMPANY POINT OF VIEW (i) Fixed Return – The dividend payable on preference share is usually fixed lower than that payable on equity shares. This helps the company in maximizing the return to equity shareholders. No voting Right – Preference shareholders have no voting right on matters not directly affecting their rights, leaving equity shareholders ration uninterrupted control over the affairs of the company. Flexibility – By issuing redeemable preference shares a company can maintain flexibility in its capital structure as these can be redeemed under terms of issue. No Burden on Finance – Unlike debentures or bonds, preference shares do not prove a burden on the finances of the company. Dividend on preference shares are paid only if profits are available for it. Thus the company has a stronger balance sheet and hence greater scope for future borrowing. No charge on Asset – Non – payment of dividend on preference share does not create a charge on the assets of the company. It enables the company to conserve mortgage able assets of the company. It is therefore very useful if its assets are made available as collateral security for borrowing on debentures.

(ii)

(iii) (iv)

(v)

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Preferential Rights – In case of winding up of company. Thus their interests are no protected by the assets of the company. Fixed Income – Even if the company earns higher profit. Lesser Capital Losses – As the preference shareholders are given voting rights in saves them from capital losses. preference shares are fair securities for the shareholders. they do participate in policy decisions. Dividend on these shares is not fixed. The company will not be able to attract the capital from such moderate type of investors if it does not issue preferences shares.. Fair Security – During depression period when the profits of the company goes down or when the rate of interest in the market continuously falls down. Thus their interest is safeguarded. EQUITY SHARES Equity Shares are those which constitute working capital of a company. Shareholders may not get the dividend even if the company has profits. Even on dissolution. as the dividend on these shares is subject to availability of profits and the intention of the Board of Directors. 1. thus they enjoy the minimum risk. However. ADVANTAGES FROM INVESTOR’S POINT OF VIEW (i) Regular Fixed Income – Even if there is no profit. with voting right they control the affairs of the company. The dividend for the years in which company earned no profit or inadequate profits. No fixed Burden – Equity shares impose no fixed burden on the company resources. Voting Right for Safety of Interest – In matters directly affecting their interest preference shareholders re given voting rights. it is a permanent sources of capital. They may (ii) 65 . The investors get a fixed and regular rate of dividend on preference shares. preference shares carry preferential rights as regards the payment of dividend and repayment of capital. Demerits for investors (i) (ii) (iii) (iv) (v) No voting Right – The preference shareholders enjoy no voting right except in matters directly affecting their interest. No claim over Surplus – The preferential shareholders have no claim over the surplus. may be paid in the year of profits. (ii) (iii) (iv) (v) 1. Thus. 2. It is paid after the fixed rate of dividend on preference shares has been paid off. During its life-time a company is not required to pay-back the equity capital.(vi) Wide Capital Market – The issue of preference shares widens the scope of capital market as they provide the safety as well as a fixed rate of return to the investors. No Guarantee of Assets – A company provides no security to the preference capital as is made in the case of debentures. They may only ask for the return of their capital investment in the preference shares of the company. the dividend on preference shares other than participating preference shares is fixed. Redemption – A company may redeem the redeemable preference shares at its option at any time when it feels convenient to pay them off. Hence. MERITS OF EQUITY SHARES (i) Long – term and permanent Capital – Equity is a good sources of long-term finance. they are residual climate. Their interest is safeguarded.

it will be distributed among the shareholders as bonus shares. As equity shares are transferable certain groups of equity shareholders may manipulate control and management of company by controlling the majority holdings which may be detrimental to the interest of he company. (iv) (v) 2. Dividend Policy – A company may follow an elastic and rational dividend policy creating huge reserves for its development programmes. The equity shareholders may be benefited by such right issue. Risk Capital – Equity capital is the risk capital. DEMERITS OF EQUITY SHARES (i) Dilution in Control – Each sale of equity shares dilutes the voting power of the exiting equity shareholders. Pre-emptive Right – In any successive issue of shares of the company the equity shareholders of a company have pre-emptive right in a certain proportion fixed by the Boards of Directors. (ii) 66 . as it extends the voting or controlling power to the new shareholders. interest on debentures and preference shares equity shareholders are the residual claimant of the profits. thus increasing the capital. Trading on Equity not Possible – A company cannot trade on equity if equity shares alone are issued.e. In boom period equity may get dividend at a higher rate. It brings capital appreciation in their investments. Their real value is based on the net worth of the company’s assets. Trading on equity is possible only when the other securities. Capital Appreciation – The market value of equity share fluctuates directly with the profits of the company. bearing fixed rate of dividend/interest are issued and the dividend or interest payable such securities is less than the profitability rate of company earnings. Right to Participate in the Control and Management – Equity shareholders have voting rights on control over the affairs of the company. A company may trade on equity in bad periods. persons of limited resources can purchase these shares. Attraction for Persons having Limited Income – As equity are mostly of lower denomination. If the profits of the company are accumulated. (ii) (iii) (iv) (v) (vi) 1. This widens the scope of marketability’s of these shares. If the company earns lesser profits by trading on equity the equity shareholders would be the real loser. Thus equity shares provide a cushion of safety against unfavorable development. (iii) Credit Worthiness – Insurance of equity share capital cerates no charge on the assets of the company.get the dividend out of accumulated profits even if the company has earned no profit or inadequate profits for the current year. They elect competent persons as directors on the Board of Directors to control and manage the affairs of the company. if the company is a prospecting company. To add to its profits the company generally trade on equity. Equity capital provides safety to the creditors. A company may raise further finance on he security of its fixed assets. Other Advantages – Their prices in security market are more fluctuating as it appeals most to the speculators. MERITS TO INVESTORS (i) More Income – After meeting all the fixed commitments i.

Capital Loss During Depression Period – During depression period the profits of the company and consequently the rate of dividend comes down due to which the market value of equity shares goes down resulting in a capital loss to the investors. it creates inflexibility in its capital structure. Such fractions bear no distinctive numbers. but only represent specified parts of the consolidated capital. Inflexibility of Capital Structure – Equity shares cannot be paid back during the life-time of the company. and also consists of a series of mutual convenient entered into by all the shareholders inter-se in accordance with the provisions of companies act and Articles of association. stock represents the consolidated amount of the capital of the company.(iii) (iv) Over Capitalization – Excessive issue of equity shares may result in over-capitalization which makes dividend per share low which adversely affects the psychology of the investors. Justice Farwell DIFFERENCE BETWEEN SHARE AND STOCK 67 . Authorized by its Articles of Association a company with a share-capital may convert some or all of its fully paid-up shares into stock. Speculation – Equity shares of good companies are subject to hectic speculation in the stock market. It may be split-up or transferred in fractions of any denomination. the equity shareholders may not get any dividend if there is insufficient profit or if the management thinks it proper not to pay any dividend on these hares even if there are sufficient profits. DEMERITS TO COMPANY (i) Uncertain and Irregular Income – The payment of dividend on equity share is subject to the availability of profits and the intention of the Board of Directors. except where a distinction between stock and share is expressed or implied”. for the purpose of liability in the first place and of interest in the second. STOCK Stock is the aggregate of fully-paid up shares of a company consolidated for the purpose of facilitating its division into factions of any denomination. As the income of any commercial organization is not regular and certain. a stockholder may transfer any fraction of the stock held by him. which is not in the nearest of the company. making prices fluctuate frequently. High costs more to with equity shares than with other securities settling costs and underwriting commission are paid at a higher rate on the is one of these shares. Section 2(46) of the Indian Companies Act 1956 2. Loss on Liquidation – Equity shareholders are the worst sufferers in case of liquidation of the company because they are paid in the last after every other claim including the claim of preference share holders is settled. without regard to the original face value of the shares. “Share” is “Share” in the share capital of a company and includes stock. A share may be defined as “the interest of a shareholder in the company measured by a sum of money. (v) 2. When so converted. (ii) (iii) SHARE 1.

Thus deferred shareholders are often paid a high rate of dividend out of the balance of profits left after payment of a dividend at a fixed rate to preference shareholders and at a reasonable high rate to equity shareholders. Difference in Offer to Public – While shares may be issued to the public directly in the first instance. Difference in Transferability in Fractions – While shares cannot be transferred in fractions a stock can be transferred to any fraction and sub-division. 5. 6. Hence deferred shares are also known as founders shares. On account of the deferred claim on dividend the public are not attract to these shares. NO-PAR STOCK The no-par shares issued in the U. Only fully paid up shares are converted into stock. Difference in Distinct Numbers – While all shares bear distinct numbers representing the units of share capital. 3. the deferred shareholders may get refund of capital and participate in the surplus capital. a stock is always fully paid up. if the company earns huge profits. They receive some compensation for their services by way of high dividend which they enjoy in prosperous year. these can be issued by independent private companies. Difference in Paid-up Amount . Right of Priority – Deferred shareholders do not enjoy the right of priority to have shares offered in case of further issue of shares by the company. Liquidation – If the company goes into liquidation. a stock has no nominal value. Such shares are not issued in India. 2. if any. 3. Difference in Denomination – While all shares are of equal denomination. However. Fractions of stock do not any number. stocks disclose the consolidated value of the share capital. deferred shares are issued subject to the condition that their holders will rank last of all in the matter of dividend payment. stocks may be registered and transferred only by delivery. after the rights to preference and equity shareholders have been satisfied.1. and Canada are gaining popularity day to day. Transferability – Deferred shares are not freely transferable. No-par stock means share having no face value. Difference in Nominal Value – While a share has a nominal value. These shares are also issued to underwriters. in India.S. the U.. 7. But in many other countries such shares are issued by companies. 2. stocks cannot be offered directly to the public.A.K. they are entitled to receive even higher dividends that the preference and equity shareholders. the total owned capital of the company is dividend into a certain number of shares. DISTINCTION BETWEEN DEFERRED AND EQUITY SHARES 1. Share certificate only states the number of shares held by a particular holder 68 . 4. Only fully paid up shares can be converted in to stock. 4. Difference in Registration – While shares are always registered and nor transferable by delivery. Profits – Deferred shareholders are entitled to share in the redual profits of the company only after the rights of the performance and equity shareholders have been satisfied. The shareholders may not receive any dividend at all if the company makes a small profit.While a share may be partly paid up or fully paid up. stock may be of unequal amounts and may be transferred in different fragments. DEFERRED SHARES Public companies in India are not permitted to issue deferred shares.

directors have every right to adjust the value of capital to correct the over capitalization. Careful Financial Study – As the real value of shares depends very much on the earning capacity of the company. Manipulation of sales and dividend – It offers enough scope to management to manipulate the sale proceeds of shares and pay dividend out of capital. No Reduction of Capital – In no-par stock as the value of shares is automatically adjusted with the earning capacity. 6. MERITS OF NO-PAR STOCK 1. Dividend is paid by way of a given amount per share instead of certain percentage of the fixed nominal value of shares. No Standard of Valuation – No par shares have no standard on the basis of which valuation of assets may be compared with capitalization. 9. No Future Calls – In no-par stock as the whole of the amount is collected in one sum at the time of issue of shares the shareholders have no liability beyond the initial payment. The value of share can be calculated by dividing the total owned capital (real network) with the number of shares. It has no motive to conceal the stock discount. Correction to over Capitalization – As there is no face value. 4. The capital is always equal to the net worth and not an imaginary amount as with shares of nominal values. underwriting commission and other costs as these can be deducted from the sales proceeds of the shares. 69 . they cannot judge the fairness of return. Easy Marketing of Shares – Issue of no-par shares avoids many legal formalities because the questions of their issue at premium or at discount does not arise as there is not par-value of such shares. Because the priced level is deceptive.without mentioning the face value of shares. True and correct Position in the Balance Stock – In no par stock the balance sheet shows a true and correct position of the business as there is no need for inflating the assets to offset inflated or watered stock issues. the shareholders know the real value of their holdings which is always determined on the basis of net assets of the company. there is no question of reduction of capital at the time of reconstruction and reorganization of companies. 3. 2. Thus the question of difference between nominal value and market price of shares does not arise. No manipulation of Accounts – A company issuing no par stock need not manipulate its accounts. in the absence of any standard. 5. DEMERITS OF NO PAR STOCK 1. While at the initial stage a company can issue the shares at low prices its later achievements may make possible the subsequent issues at higher prices. It is meaning less to issue shares at premium or at discount. A nominal amount may be credited to the stated paid up capital account and the balance to the capital surplus which may later on be utilized for dividend. the ignorant investors may be decided. Real value of Holdings – In no-par stock as value of shares is related to the earnings. This market marketing of such shares very easily. the management split the sale proceeds of stock into two or more parts. 7. it induces the investor to study the financial position of the company carefully. Freedom – No par stock gives a complete freedom for fixing the price in the market that commensurate with the prevailing conditions in the market and provides relief from the rigid legal requirements. 2. Investors cannot make valuation of their stock. 8. In the absence of par value.

Also important is the capitalization factor i. 7.per share are more appealing and convenient than higher denominations securities. For example. If the Board of Directors decides to issue shares at par there is no problem.3. if the market value of existing shares is Rs. TIMING OF ISSUES The most noteworthy problem of securities is concerned with the selection of security to be issued to the public according to prevailing capital market conditions. taxation becomes complicated and taxevasion is possible. Difficult Calculation of Registration Fee – The fee for the registration of companies is charged on the amount of Authorized capital on par-value shares in almost all the counties of the world. 20/. Lower denominations such as Rs. 10/.000 equity shares of Rs. However. 42/per share. creditors and tax authorizes. no-par shares have now lost their popularity even in the U. it is very difficult to calculate registration fee on companies issuing no par-value shares. No par value share provide no such security to creditors because the whole of the amount it called in one sum. 6. 5. depression and recovery. As the above limitations of the no par value shares have created certain doubts in the utility of the issue. Under-Payments to Promoters – The flexibility of capital amount facilitates the promoters to pay themselves unduly high remuneration for their services and for goodwill and concealing the losses. 8. 70 . 4. suppose an existing company ahs already issued 20.000 equity shares @ Rs.A. Facilitation of Tax Evasion – If no par shares are issued. Balance Sheet Difficult in Understand – No par value shares render the balance sheet of the company unduly complex and difficult to be understood by investors. The price at which a new issue of shares is offered to the markets is based mainly on the price and yields on comparable issues already quoted. 8/.each which share only a 5% voting control.000 as additional finance. 4. The market value of its shares is Rs. The offered price must also appear attractive to the investing public and under-writers. The strength of demand for new issues and the forecast of the level of maintainable profits is also relevant.S. recession.. Absence of Capital Planning – There cannot be any planning for the financial need of the concern which may lead the concern to over capitalization or under-capitalization. It must be reasonable and commensurate with the risk involved and write of control attached therewith. PRICING OF ISSUE If shares are issued to the public they may be offered to them either at par. the investors must be attracted by a profit potential to purchase these shares at premium. Not the said company wants Rs.00. But if it wants to change a premium. P/E ratio (Price : Earning ratio) and the denomination of the security. The company’s management must take into account the market rating of similar companies in determining the sale price of security. underwriters and stock exchange authorities etc. The company can issue only 20.e. It is decided by the Board of Directors after negotiations with share brokers. IMPACT OF TRADE CYCLE The total period of a trade cycle is divided into boom.each fully paid. 10/. at a premium or at a discount. The company should issue equity shares for this finance. No Security to Creditors – The uncalled share capital provide an additional security to creditors because it may be realized whenever necessary in case of par value shares.per share.

RIGHT FINANCING If an existing company seeks to issue new series of equity shares to finance its additional activities. This is a ‘right’ or ‘Pre-emptive right” which may be defined as an option to buy a security at the specified price. The demand of capital and the rate of interest go down. it should offer these shares to the existing shareholders at a specified price during a particular period. Some conditions may be imposed on the company making an offer of rights. Only fixed income securities are preferred. this period is just reverse of boom period. to the capital paid upon those shares at the time of offer. But if he has renounced his right in favour of any person he is not entitled to apply for additional shares. the balance left over shall be distributed equally among the applicants for additional shares with reference to the shares held by them in the company. 2. However it may be more than 15 days because the shareholders must have sufficient time to make up their mind judiciously. These new shares must first be offered to the existing equity shareholders of the company in proportion. According to Section 81 of the Companies Act a company may increase its further capital by issue of new shares at any time after the expiry of two years from the formation of the company limited by shares or of one year after the first allotment of shares in that company.1. Depression – In depression period the market is pessimistic. as nearly as circumstances admit. whichever is earlier. PROCEDURE OF RIGHT ISSUE Following is the procedure of right issue according to the Companies Act: Before making an offer to the existing shareholders the company will have to obtain the permission of Controller of Capital Issus who takes decision on application for right issues in concurrence with the company. it shall be deemed to have been declined. As the investors prefer fixed income. Boom – In boom period. The shares offered are called Right shares. Recession – Under recession. the demand of capital increases and consequently the rate of interest goes up. This period shall no bless than 15 days from the date of offer. “The best time to raise funds is when business is booming and people are optimistic”. Therefore. The company sends a ‘letter of offer’ to the existing equity shareholders whose name are on the Register of members mentioning therein the number of shares to which they are entitled in proportion to their old share holding and the time within which the offer must be accepted. It must also state that they have the right to renounce all or any of the shares offered to them in favour of their nominee(s). 4. To conclude in the words of Gerstenberg. The trend is downward. the issue of preference shares or debentures should be preferred. the trend in the market is upward. Financing the projects of a company by the issue of such shares is ‘right financing’. If the right shares are not fully subscribed. raising funds is quite difficult. generally at par or at premium but much below the market price. The offer must indicate that if it is not accepted within the specified period. Recovery – In Recovery period the upward trend starts and the demand of risk capital begins. He may also apply for the additional shares. the demand of products is much less than the production. The shareholder shall inform the company within stipulated period about his acceptance of right or the name of the nominee to whom he wants to renounce his right. Preference shall be allowed to small holders in concurrence with the stock exchange on which the company’s share are 71 . 3.

It increases goodwill – The goodwill of the company increases in the eyes of existing shareholders. The issue price of right shares is Rs. CONDITIONS OF PRICING THE RIGHT ISSUE 1. 2.50 = 7. VALUATION OF RIGHT SHARES The right shares are issued by the company at par or at a premium but normally at less than the ruling market price. 10/.listed. First. 3. It Maintains Pro-rata Share – Right issue give the existing shareholders an opportunity to maintain their pro-rata share in the earning and surplus of the company and the voting power as before.50 = 20 = Rs. the market price of the existing shares is calculate added to it is the issue price of right shares. 50 (-) Rs. The company may deal in any manner it likes with any balance left after making allotment of additional shares. so that shareholders may offer the right with a hope of some capital gain. For example. rights will not be used and investors will invest their funds in alternative investment. and the company can obtain more loans at lower rate of interest. 10/-) The value of right shall be calculated as under: The total market price of three existing shares The issue price of right share Total for 4 shares Average Price per Share Value of right (per share) = Rs. There is no botheration of selling – The financial management is relieved of the botheration of selling the shares. 170 = Rs. the market price of shares in the long run will go down. 2. suppose a company makes right issue of one share for every three shares held. 42. The difference between the maerkt price and the average price is the value of right.50 = 50 x 3 = Rs.Share). 150 MERITS OF RIGHT ISSUE 1. 4. 20 per share. It proves financial status – If right shares are accepted by the shareholders enthusiastically. (Face value Rs. 5. The gain on shares is the value of right which may be calculated in the following manner. 50 (for Rs. In that case. if the rights are fixed at a particular price. it proves that financial position of the company is sufficiently good. Amount the market can bear – If the amount collected by issue of right shares is not invested in securities yielding a good return or normal return. Market price of shares – The company should keep vigil on the market price and see how it shares have been moving in the market in the past and how these are likely to move. 72 . 170 / 4 = 42. The total of these two prices is averaged which is the value of right share. The market value of existing share is Rs. It lowers cost of issue – The cost of issue of such shared will also be lower.

regular and dependable. Shareholder’s capacity to purchase shares – If shares are fully subscribed by the shareholders. a decline in market price is obvious. The enterprise should strike a judicious balance between the two. 4. the customers are tempted to purchase such shares at lower price even though. 7. Such a trend affects the market adversely and the price of shares goes down. On the other hand. they will not be accepted by the shareholder howsoever low their price may be. not so low. the rights will attract the existing shareholders as well as their nominees even if rights are priced a bit hither. they either surrender their rights or renounce it in favour of their nominee. The profit earning capacity of shares – If the shares have no capacity to earn profit. Fair return – Whatever the pricing policy of rights. The prospects of proposed plans of expansion – If plans seem profitable. 8. the shareholders will be attractive to invest and the price may be fixed at somewhat higher level otherwise the position will be reversed. 3. 73 . If the nominees also surrender such shares thereby making these sharers available in the market and the market is affected adversely. It is on the presumption that additional amount realized through the issue of rights will not be put to profit immediately and it will take time in increasing the profits. Spurt in Goodwill – If the existing shareholders decline the offer the shares are offered to other persons at the same price. The general price trend in the capital market – This mean the consideration whether the general prices are stable or fluctuating. It should yield the shareholders a fair return. This should be considered by the company well in advance. the enterprise should fix the premium. On the other hand. the investors will not like to invest funds in securities and rights cannot be favoured. the shareholders shall not be interested in purchasing the rights. If the shareholders are getting good dividend the price may be fixed somewhat higher. Under such circumstances it is better to offer right in lower propositions. the goodwill of the company also goes up. nor so high. Lower Divided – Right issue has an adverse effect on the market due to lower payment of dividend. if profit earning capacity of the shares are somewhat higher. IMPACT OF RIGHTS OF FINANCE POLICY Following is the impact of Rights on financial policy 1. The dividend per share is lower due to increase in the number of share. the right may be priced a bit high. If the shareholders do not have capacity to purchase shares. Nature of Dividend policy – If conservative policy of dividend is adopted by the company. if the plans are not attractive or slow. 6. 2. because they expect an increase in the market price of shares after a short spell and if it is so. 5. 4.3. If the trend is not stable. the price will be fixed differently. If the company has a good record of payment of dividend. Accordingly. Here the price may be fixed much lower. The company should ensures a healthy balance between the use of amount invested and the income from the investment. The resource position of the company – If financial resource position of the company is sound. even good shareholders might feel disinclined to continue will the enterprise and begin to sell their holdings. the market is not very adversely affected. Lower market price of shares – As right shares are issued at a price much lower than the market price of existing shares the market price is expected to fall to a considerable extent.

Loans for which no security is issued are unfunded debts. most of the business houses use debt capital for financial requirements. its whole financial policy might come under unbearable heavy strains. 2. Long term debts are obtained from specialized financial institution or by issue of debentures and bonds to the public. if the percentage change in the earnings is higher than the percentage change in the cost of capital. The amount collected by the issue of ownership securities is called owned capital. the company prefers debt-financing. Lowering of the overall cost of capital – The average cost of capital of equity shares. the issue will diversely affect the market and the company will have to fix the price of the right share much lower. 7. to pay higher dividend to them. short term.. They are not entitle to vote and participate in management of the concern. It may be of three types depending upon its period of use i. bills payable. Pre-offer pressure – In respect of that particular share market comes under heavy pressure in preoffer period just after it is known to the public that the company is about to offer right shares.e. Tax-Advantages – Interest payable on debt capital is and admissible expenditure in computing the taxable income of the company while the dividend is not a deductible expenditure. a company uses debt capital to get the following advantages. CORPORATE DEBT A business firm obtain capital from the issue of ownership securities and by the issue of creditorship securities. Trading on Equity – It facilitates the company to trade on equity as the interest payable on debt capital is fixed and lower than the rate of earnings.5. Examples of short term debts are trade creditors. Fluctuation in the market price of the shares – If the shares are favorably traded in the market. 1. 4. 74 . If the financial management does not move swiftly. In some exceptional cases. But if the shares fluctuate. 3. medium-term and long-term. Retention of control – As creditors are concerned only with the interest due on their debts.. without having any fluctuation in the price to a considerable degree. It continues to use this source of finance until the increment return is higher than the increment cost of debt capital. This maximizes the dividend to the shareholders. bank overdraft. and creditors for expenses. Thus. Even the existing shares will come under heavy strains. the amount collected by the issue of creditorship securities is called debt capital.e. company accepts debt capital at equilibrium point in which (cost of capital = estimated earnings). 6. Downward trend – There are usually downward trends during the period of right issue. Pubic deposits and other loans of periods ranging from three to five year are medium term debts. the rights will attract the shareholders and the price may be fixed somewhat higher. The control is retained by the shareholders as before. This pre offer pressure is usually considerably great and the financial management should make every effort to check that pressure otherwise its financial policy will be adversely affected. preference shares and debentures is lowered down by the issue of debt capital as the cost of debt (interest payable) is very low in comparison to the cost of other capital (dividends on preference and equity shares). Thus the cost is reduced by the marginal tax rate applicable to that company. A company borrows capital in order to maximize the profits for its shareholders i. Loans against issue of security such as debentures or bonds are funded debts.

if permitted by its memorandum of association. Risk of Insolvency – Due to periodical fixed payment of interest and principal. electricity generation and distribution. expenses on certain formation etc. LIMITATION ON DEBT FINANCE A company cannot keep financing its affairs through debt capital to an unlimited extent. 5. It is thus a security issued by a company against the debt. Contractual Limitation – If creditors such is banks or financial institutions impose certain restrictions upon the firm that further loan cannot be taken by the firm without their prior approval. Cost of Borrowing – Excessive. Customs and Conventions – In India such as jute. a public limited company is allowed to raise debt capital through debentures after getting certificate of commencement of business. it becomes a limitation on its borrowing capacity. debt capital is the only source for raising funds. in such companies the management prefer expansion and modernization through internal sources rather than using external sources. Indian companies Act says “debentures includes debenture stock. and any other security of a company whether constitution a charge on the assets of the company or not”. Only source for raising funds – Sometimes company gets it difficult to raise funds through any other source except that through debts. Fluctuations in the Income of Shareholders – The debt capital creates fluctuations in the income to the shareholders. Flexibility in Capital structure – Debt capital provides flexibility in the capital structure because debt can be rapid if it no more required by the business. Uncertainty of Income – Interest on debt capital is a permanent charge against profits. 6. paper. Creditors can claim liquidation of the company if it fails in meetings its obligation. The average is mainly governed by the degree of fluctuations in the rate of return upon which equity holders investment is permitted by the management. 3. There are following limitations on the debt financing. MEANING OF DEBENTURES A debentures is an instrument executed by the company under its common seal acknowledgement indebtedness to some person or persons to secure the sum advanced. 8. 1. when equity shares are not popular with the investors. At times. 75 . especially during depression and recession. rely very much upon the debt capital due to customs and conventions of the industry. The definition given by Prof. borrowing make debt funds costly and uneconomic.5. In India. Low cost of Raising Funds – Cost of issue of debt capital is much lower in comparison to equity capital such as underwriting commission. bonds. Seasonal requirements are met by the debt capital. 7. Conservative outlook of management – As far as possible conservative management does not rely upon the debt capital as the management loses its freedom by financing through debt capital. 6. 2. 7. Change in corporate tax system – Sometimes tax proposals may impose certain limitations on debt financing. The cost of borrowing increases with every successive borrowing. shipping etc. Naidu and Datta runs as follows – “A debentures is an instrument issued by the company under its common seal acknowledging a debt and setting forth the terms under which they are issued and are to be paid”. 4. A company should avoid debt capital if its income is uncertain and irregular.

They constitute the loans capital of the company.During boom. a company is not expected to earn high profits. Thus. debentures are useful. “The use of debentures and bonds takes a capital market unavailable to the corporation which offers only stock”. Debentures carry to voting rights except under special circumstances. Hence. Interest on debentures is paid at a fixed rate in periodical basis. the company can declare a higher rate of dividend on equity shares.1. For example if the company has created any mortgage or charge on its assets to secure the issue of debentures. the company can raise the finance without surrendering control. 4. 8. or repayment of capital. As there is a surety of finance for that specific period the company may adjust its financial plans accordingly. Therefore. Finance During Depression – It there is a slump in the market. 2. 3. Redeemable debenture capital has to be refunded after prescribed period. the debenture-holders have the right to claim the payment of their dues from the sale proceeds of those assets. Reduction is tax liability – As per income tax rules. Debentures holders can apply for winding up of the company if it is in their interest to do so. for and default in the matter of payment of interest. and the investors are not willing to invest their funds in share capital of a company. Surety of Finance – According to the new guidelines issued by the Government of India in 1982. 1. 6. ADVANTAGES TO THE COMPANY (i) (ii) Lower Rate of interest – The rate of interest payable on debentures is fixed and usually lower than the rate of dividend paid on shares. 7. While dividend is an appropriation of profit and hence not a charge against profit. Debentures – holders are creditors of the company. Trading on equity – A company is enabled to trade on equity by issuing debentures because the rate of interest on debentures is usually lower than the rate of earning. (iii) (iv) (v) (vi) (vii) (viii) 76 . yearly etc. 5. Finance During Boom . ADVANTAGES OF DEBENTURES ISSUE According to Guthmann and Dooneall. a company can easily collect the finance through the issue of debentures because the psychology of investors is affected by the trends of the stock market. the profits of the company are reduced by the amount of interest paid to debenture holders resulting in reducing the tax liability. Freedom in Management – As the debentures holders are not given any voting right to control the affairs of the company. the secured debentures shall not be redeemable before a period of seven years. Following are the advantage of debentures in the corporate finance. In case of any default by the company. Capital from Ordinary Investors – A company can collect the finance from such investors who prefer fixed income with minimum risk rather than an uncertain high rate of dividend on capital as security of capital is more important for them. such as six monthly. Debenture holders can take legal action against the company. the payment of interest on debentures is charged against profits of the company.

ADVANTAGES TO INVESTORS (i) Fixed and Stable income – As debentures carry a fixed rate of interest. Risk of Winding up – If the interest on debenture is not paid by the company. so their investment is quite safe. debentures issues is risky in lean periods. if needed. the company cannot raise loan on such assets again. Consolidation of Debt. (iii) 2. providing flexibility in the capital structure. In the following conditions a company should avoid issue debentures. – A company may consolidate its debts of short duration by issuing debentures and thus may reduce its cost of capital. Fixed Burden – Interest payable on debenture is a charge on the profits of the company. the ‘rights’ and secured (convertible and non-convertible) debenture shall be listed in a stock exchange. Uncertainty of Redemption . (ii) (iii) (iv) DISADVANTAGES OF DEBENTURE ISSUE 1. and have more ready market because they are safe and can be used as collateral security by the investors in raising loan from any financial institution. they do not share the profits even if a company earns huge amount as profits. can safety issue debentures to finance its long and medium – term requirements for the purpose of improvement and extension. regular and stable source of income to debenture holders. DISADVANTAGES TO COMPANIES (i) (ii) Fixed Charge on Assets – As debentures carry a fixed charge on all assets of the company. This is a burden on the company particularly when there are no profits or inadequate profits. 2. Therefore.In case of redeemable debentures payable within a specified period. Conversion of Loans – In convertible debentures. the debenture holders have a right to claim winding up of the company. an investor can estimate his income well in advance.(ix) (x) Control on over-capitalization – The state of over-capitalization is controlled by redeeming the redeemable debentures. Under the new guide-lines (1982). investors have uncertainty in their minds as to their redemption. Safe Investment – As debentures holders have specific or general charges on the assets of the company. 77 . (iii) WHEN TO AVOID DEBENTURE ISSUE Only a company having stability in income. Liquid Investment – Debentures are more liquid investment. debenture holders can convert their holdings in shares at appropriate time. which has to be paid even if there is no profit. DISADVANTAGES TO INVESTORS (i) (ii) No Control – As debentures holders are creditors and not the owners of company they get no controlling authority over the affairs of the company. Thus debentures provide a fixed. Share in Profits – As debenture holders get a fixed income as interest irrespective of the quantum of profits earned by the company.

1. For this purpose. FROM REDEMPTION POINT OF VIEW (i) Redeemable Debentures – Redeemable debentures are to be repaid by the company at the end of he specified period or within the specified period. Unsecured or Simple Debentures – These debentures carry no specific charge on the assets of the company about the repayment of principal and interest. It is at the option of the company to give notice to debenture holders of its intention to redeem debentures at once or by installment under the terms of issue. addresses and particulars of holdings recorded in a Debenture holders register. 78 . But being creditors of the company. FROM PRIORITY POINT OF VIEW (i) First Debenture – These are those which are to be paid first in the event of winding up of the company. regular deed is ended into between the company and the trustees of the debenture holders. These are transferable by delivery only.(i) (ii) (iii) (iv) Fluctuating earning. Interest is paid to the coupon holder. No sufficient profits to pay off interest on debentures. Manufacturing and supplying products with highly elastic demand such as luxury items. TYPES OF DEBENTURES According to different points of view following are the types of debentures. (ii) 3. Mortgage or Secured Debentures – These debentures are issued with a charge (fixed and floating) on the assets of the company which may be on a particular asset or on all assets in general. These are also called perpetual debentures. (ii) 4. These are negotiable instruments and the company keeps no records for them. Irredeemable Debentures – These debentures are repayable at any time by the company during its existence. Debentures holders cannot claim their repayment during the life time of the company. Low proportion of fixed assets to total assets as there is no substantial security to offer to debenture holders. FROM SECURITY POINT OF VIEW (i) Naked. FROM THE POINT OF VIEW OF TRANSFER (i) Registered Debentures – These debentures are registered with the company with names. A regular transfer deed giving full particulars of transfer and transferee is required at the time of transfer of such debentures. Bearer Debentures – These debentures are payable to the bearer. (ii) 2. With no minimum fixed period these are redeemable if the company fails to pay regular interest on them. the debenture holders have general charge on the assets of the company.

Such issue seeks to augment the long-term resources of the company for working capital requirement and to reduce its dependence on other short-term resources. They will first be issued to existing shareholders and then to shareholders in addition to their ‘right’ depositions and employees and business associates on a rational basis. These debentures cannot be issued for expansion and modernization purposes. 3. Non-convertible Debentures – These debentures cannot be converted into shares. (ii) (iii) REDEEMABLE DEBENTURES Redeemable debentures are those that will be repaid by the company under the term of issue at the end of a specified period or at any time within a specified period by giving them a notice of its intention to redeem them at the end of the notice period or by installments during the existence of the company. If the company 79 . FROM CONVERSION POINT OF VIEW (i) Convertible Debentures – Holders so these debentures are given an option to convert their holdings into shares under certain conditions and limitations mentioned in the debenture certificate regarding the period during which he option may be exercised. Redeemable debentures may be reissued even after they have been redeemed until they been cancelled. DISADVANTAGES OF REDEEMABLE DEBENTURES 1. (ii) 6. OTHER TYPES OF DEBENTURES (i) Collateral Debentures – These debentures are issued by the company for the loan taken from a bank or a financial institution as collateral security.(ii) Second debentures – These are those which are to be repaid after the payment of first debenture has been made. Check on Over capitalization – An over capitalized company may redeem such debentures and may control the state of over capitalization. ADVANTAGES OF REDEEMABLE DEBENTURES 1. and raise funds as and when it needs the loan money. These are effective only when the company fails to pay the loans. Flexibility in capital Structure – By issuing such debentures the company can make its capital structure more flexible. 4. Guaranteed Debentures – At the time of their issue the payment of principal and the interest on these debentures is guaranteed by some third party generally banks or governments. Preferred by Fixed Term Investors – These debentures are preferred by those investors who with to invest their funds for a fixed term at a fixed rate of interest and at minimum risk. 2. Right Debentures – These debentures are issued by the company to its resident shareholders in the fixed proportion of their shareholdings. 5. Liquidation of Company – Redeemable debentures are repaid at the end of a certain specified period or at any time within the specified period by giving them notice of redemption. Best solution for Fixed Term Loan – If a company requires funds for a fixed period it may issue such debentures because these can be redeemed after a certain specified period.

The addition of conversion right allows the company to offer comparatively a lower rate of interest in a period when prices of other bonds are falling due to rise in the interest rates. Security for Other Debts – As convertible debentures are unsecured and therefore the borrowing capacity of the company remains intact by the issue of such bonds. Greater appeal – Convertible debentures may have greater appeal among the investors particularly in a period of tight money. CONVERTIBLE DEBENTURES Convertible debentures are those which are convertible into shares at the option of the holders after a specified period. The investment project which is not likely to yield profit may not succeed initially. the company can provide security against its other debts. a company can attract funds from the institutions which may not otherwise purchase equity shares due to restriction imposed by their by – laws. 3. Tax Advantage – As the interest on debentures is a charge on profits. 3. it to be a profitable proposition. Rise in Equity Capital – By such issue a company can rise equity capital indirectly without diluting the earnings of the existing shareholders. The company’s existence is always at stake if its financial positions is not sound enough. 80 . Therefore. 7. 5. 4. 6. By the time debentures are converted into shares the additional investment starts earning an added return to support the additional shares.fails to arrange the necessary amount to redeem them the debenture holders can take action for its winding up. Flexibility of Capital structure – The issue of convertible debentures results in an element of flexibility to the company’s capital structure. 2. Investors unwilling to purchase equity shares. the company gets tax advantage until the bonds are converted into shares. ADVANTAGES TO ISSUING COMPANY 1. 2. Double Benefits – Convertible debentures offer benefits of both debt financing and equity financing. initially. Adverse effect on liquidity of Assets – If a company has to repay a large sum at the time of redemption of debentures it may adversely affect the liquidity of assets unless it is planned wisely by creating sinking fund so that the company may get the required amount at the time of redemption of debentures at the end of the specified period. 8. Sale of Shares in Disguise – In a period of low market prices of shares the company can sell equity shares in disguise. These are a means to deferred equity financing. Uncertainty of Redemption – If debentures are repayable at any time within a specified period under the terms of issue. it may create a problem before the debentures holders to invest the amount immediately as soon as it is repaid by the company. A company intending to raise additional equity capital at a particular time may find that the prevailing conditions in the capital market are not congenial or the issue of equity shares. the company may issue debentures with the provision that holders will have the optimum of converting them into equity shares after a few say 3 to 5 years. may like to convert their debentures into equity shares if they find. Attracts Funds from Institutions – By issuing convertible debentures. There remains uncertainty in the minds of debentures holders regarding its redemption.

10.5% payable half-yearly where the period of maturity is up to and including 7 years and 11% where the period of maturity is from 8 to 12 years. if in that year the rate of dividend on equity shares is highest in the preceding three years. GOVT. The un-subscribed debentures. Where the maturity period is from 8 to 12 years. Rights debentures will be listed with the stock exchange. Issue of debentures for any other purpose such as financing of expansion project or addition to fixed assets will not fall under this category. 3. should not exceed II. Rights debentures can be issued at a discount or additional interest of ½ % can be offered for any year. 81 . 10th. Allotment of Rights Debentures will be made only after a minimum subscription of 75% of the amount of debentures has been secured. 20% of the debentures will be repaid uniformly to al the debenture holders in the 8th. 9th. These may be issued by only public limited companies 2. The face value of each rights debentures will be Rs. 100 9. loans and advances minus the long-term fund currently available for working capital. Rights debentures will be redeemable as follows: a. 6. or 20% or the paid-up share capital. whichever is lower of the two. and (c) the employees and business associates of the company. Where the maturity period is upto 7 years. and 12th year. while seeking consent of the controller of capital issue. Public companies are authorized to issue such debentures for raising long-term resources. b. The central government has formulated certain guidelines to regulate the issue of rights debentures by public companies for working capital requirements to be followed by a company. 7. GUIDELINES Govt. if any. 4. The debenture will carry a rate of interest 10. will be offered on a rational basis to (a) shareholders interested in taking up additional allotment. there are specific provisions regarding the issue of “rights shares” by the public companies while no such specific provision has been made regarding the issue of rights debentures.RIGHTS DEBENTURES Under Section 81 of the Indian Companies Act 1956. concerning rights debentures guidelines are as follows: 1. 12. including preference capital and free reserves. The amount of the issue will not exceed 20% of the gross current assets. 5. 11th. 33 1/3% of the debentures will be repaid uniformly to all debenture holders in the 5th . 8. 6th and 7th year. These may be issued to augment working capital on a long-term basis. (b) the directors of the company. 11. Rights debentures shall first be offered to the existing Indian Shareholders of company on a prorata basis and there after must be kept open for at least two months. The debt-equity ratio including the proposed debenture issue. The issuing company should be a listed company. Its equity shares must be quoted on the stock exchanges at or above par value in six months prior to the date of application for the issue.

100 each. The company should ascertain beforehand the prospects of at least 75% of the issue being take up by the shareholders of the company and other categories of investors mentioned above. 10. Security – Only secured debentures will be permitted for issue to the public. 1. 9. and To augment long-term resources of the company for working capital requirement. OBJECT OF ISSUE (i) (ii) (iii) (iv) (v) (vi) (vii) Setting up of new projects. loans or advances. 3. Listing – The debentures shall normally be listed stock exchanges. In case of over subscription the companies may be permitted to retain subscription for non-convertible debentures upto a maximum of 50 percent over the original issue. 8. Period of Redemption – Debentures shall not normally be redeemable before the expiry of the period of 7 years. The provision regarding listing of shares is not applicable to public sector undertakings. 7. REVISED GUIDELINES 1984 The government of India issued a set of guidelines by a notification in October 1980 in order to regulate the issue of debentures. 5.13. In September 1984 the Government of India announced following fresh guidelines for issue of secured convertible as well as nonconvertible debentures by public limited sector companies. Normal capital expenditure for modernization Merger/amalgamation of companies in pursuance of schemes approved by banks/financial institution and / or any legal authority. 11. Expansion or diversification of existing projects. 82 . Interest Rate – in case of convertible debentures. Acquisition of assets in accordance with legal provision and / or MRTP Act. Simultaneous listing of shares and debentures of companies will also be permitted. the rate of interest should not be more than 15 percent per year. Denomination – The face value of the debentures will ordinarily be Rs. 6. Listing of Shares of Companies proposing debentures issue – The shares of the company proposing to issue debenture must be listed in one or more stock exchange.1 4. Restructuring of capital as approved by banks/financial institutions and/or any other legal authority. Under writing – The issue of debentures shall be under written. Price at the time of redemption – A Premium upto 5 percent of the face-value can be allowed at the time of redemption in the case of non-convertible debentures only. the rate of interest shall not exceed 13. Debt-Equity Ratio – The debt-equity ratio shall not normally exceed 2. These guide-lines were revised in 1981 and 1982. 2. Quantum of Issue – The amount of debenture in the case of working capital shall not exceed 20 percent of the gross current assets.5 percent year while in case of non-convertible debentures.

5. Issuing Companies lose their credit in the eyes of banks and other financial institutions. Lack of Proper Advisory Agencies – There is a total lack of advisory agencies investment in India. This heavy stamp duty generally discourages the investors to invest funds in debentures. High Denomination – In India. Limited Control of Holders – Debenture holders are given limited controlling power in the day to day affairs of the company unless their interests are affected. For example.DEBENTURES UNPOPULAR IN INDIA 1. 15 for Rs. Institutions investors have to invest their funds in government securities as per statutory provisions. the moderate investors could not go in for them. They do not wish to earn more at the cost of safety. regular and steady capital market in India. Unattractive terms of issue – Terms of issue of debentures in India are not as attractive as they are in some other industrially developed countries. Investment bank and investment trust have not developed much in India. 6. Limited Marketability – For debentures there is no developed. 3. 2. They have no vice in policy 83 . Heavy Stamp Duty – Debentures have been a very costly source of finance with a heavy stamp duty of Rs. 1000 for bearer debentures and Rs. as India investors prefer securities of low denomination. To increase the marketability of industrial securities the Government of India have recognized many new stocks exchanges in different part of the country.50 per Rs. Banks did not entertain the debentures even as collateral securities. debentures are usually of high denomination. Stock exchange services are confined to some big cities. Preference for Government Savings – In recent years Indian government have initiated a number of attractive saving schemes and issued securities which carry income tax rebates and other benefits like withdrawals etc. 10. Only safety of investment attracts them to invest funds in gilt-edged securities. Unit Trust of India as show some interest in corporate debentures. Investment trusts and investment banks are not developed in India. Generally Indian banks do not invest in long-term corporate securities. Marginal investors prefer these schemes rather to invest funds in debentures. 1000 for registered debentures. 7. 8. As compared to the industrial securities government securities are considerably safer. Therefore the investor cannot judge where to invest the funds. Adverse effect of Government securities – Government of India have issued so many securities with attractive conditions which have adversely affected the popularity of debentures in India. Even to day Life corporation invests its 80% of funds in government securities. Adverse Attitude of Banks – Banks and other financial institutions show an adverse attitude towards companies which issue debentures. 9. 12. Lack of Interest to Industrial Investors – Institutional investors are statutorily required to invest a large part of their funds in government securities. Cautious Attitude of Indian Investors – Indian investors are very cautions about the safety of their investment. 4. Indian Insurance Act 1939 prohibits investment in debentures by insurance companies in India. Managing Agency System – Indian industries were financed primarily by the managing agents who generally discouraged the issue of debentures for fear of loosing their financial importance. 11. Recently. 7.

7. As against a meager 10 percent in 1966-67. etc. 8. Tax Savings – Payment of interest on debentures allowed as an item of expenditure under the Income Tax Act. Convertible issued by well-known companies like TELCO. 1. 6. Less formalities have to be observed while issuing debentures. Following steps have been taken by the govt. 2. Hence those who desire to have a voice in the affairs of the company prefer to invest their money in equity shares. today debentures capital accounts for more than 1/3 of the total corporate funds. Companies generally accept public deposit varies from 12 percent to 15 percent depending on the period of deposit and reputation of the company. Underwriting facilities – The development of issue and underwriting facilities have enhance the market for debentures. to make debenture popular as a source of finance of India. 5. Hence they feel encourage to have debenture in their investment portfolio. Attractive terms – Debentures with attractive terms such as convertible debentures have been issued. banking facilities in the country were not well developed. 3. Relaxation in Stationary restrictions – Statutory restriction on the institutional investors like LIC and IFC have been relaxed. Conversion into shares – The conversions of debentures into shares encourages the institutional investors to invest in debentures. in the recent years Public deposits have again become popular as rates of interest offered by companies are higher than those offered by banks. This has acted as a spur to companies to issue debentures. 4. The benefit of trading on equity is also available. 84 .. have been over-subscribed. customers and shareholders of the company other than in the form of shares and debentrues. People preferred to deposit their saving with reputed companies. Before independence. In order to meet their medium – term and long-term requirements Indian fiancé companies have been receiving public deposits for a long time. more attractive terms to debenture etc. Trustee service – Trustee services are being made available to debenture holders. Some of the steps which are likely to increase the popularity of debentures in the country are reorganization of the capital market to provide better marketing facilities for debentures. MEANING OF PUBLIC DEPOSIT The term “public deposit” includes money received by a non-banking company by way of deposits or loan from the public including the employees. As a result they are able to offer better security to investors in the form of assets and the cost of issue is distributed. Better Security through Joint Issue – Sometimes companies under the same management combine to make a joint issue of debentures. Reliance Industries Ltd. change in attitude of banks towards debentures. Bank cooperation – There has been a market change in the attitude of banks which no longer consider a company issuing debentures as less credit-worthy. STEPS TO MAKE DEBENTURES POPULAR In recent years the government have taken several steps to make debentures a popular source of finance.decision of the company unless they affect their interest. The cost of deposits to the company is less than the cost of borrowing from banks.

PROCEDURE OF PUBLIC DEPOSIT According to the Companies (Acceptance of Deposits) Rules 1975 as amended in 1984, no company can receive secured and unsecured deposits in excess of 10 percent and 25 percent respectively of the paid up shares capital plus free reserves. Since April 1, 1980, public sector companies have been also permitted to invite public deposits. The company which intends to raise public deposits approaches the public through an advertisement in the press about the progress and prospect of the company to induce the public to deposit their surplus money with the company. The depositors may withdraw their balance after the specified period or after giving notice. The receipt of public deposits is governed by the rules made by the Central Government under section 58A and B of the Companies Act and directions issued by the Reserve Bank of India.

ADVANTAGES OF PUBLIC DEPOSIT Following are the advantages of public deposit : 1. Simplicity – Raising capital through public deposits is a relatively simple affair. There are few legal formalities. The company receiving deposits is only required to issue a receipt to each depositor. 2. Economic – Public deposits are cheaper to raise. By only advertising in the newspapers for public deposits the company can collect the necessary funds in a short period. It can save on underwriting commission, brokerage etc. Thus interest on public deposits works out to be much less than liability in the form of dividend on shares or interest on debentures. 3. Trading on equity – Funs raised through public deposits enable the company to trade on the equity. As interest on public deposits is paid at a fixed rate, the entire remaining profits are available for distribution among equity shareholders of the company. 4. Valuable source of short-term finance – Public deposits are a valuable source of shot-term finance. They prove very useful in case of companies depending on raw materials which is available only in a particular season of the year and for meeting other short-term liabilities. These companies can buy enough quantities of raw materials through such deposits. As the sale of their finished product picks up, they are enabled not only to pay interest on the deposits but also to save for the eventual repayment. 5. No charge on assets – Public deposits do not create any charge or mortgage on the company’s assets like debentures. Thus the company may raise loans against the security of its assets to meet other requirements.

DISADVANTAGES OF PUBLIC DEPOSIT (i) Uncertain – A person who has made a deposit with a company can withdraw his at any time he pleases on the only condition that he has to give a prior notice to the company. Though this facility helps the depositor, premature withdraws by depositors, may effect the company’s financial position, particularly if its earnings have become unstable. The company may find it difficult to honour its commitment and repayment, if a large number of depositor decide to

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withdraw their deposits at a time when the business in general is faced with depression and slump. (ii) Fair weather friend – The company may be flooded with deposits when its earnings show a rising trend. But in times of financial crisis the depositor might desert it as a sinking ship is deserted by its crew. Reckless trading and speculation – As raising of deposits from the public is relatively simple and inexpensive affair, sometimes it tempts the companies to raise more funds than they can profitable use. This results in over-trading or speculation activities on their part, with harmful consequences for the business of the undertaking. Little attraction for professional investors – Public deposits do not hold much attraction for professional investors as a mode of investment. Progressive investors do not opt for deposits because of low return and absence of capital appreciation. The conservative investors keep away from making deposits due to absence of proper security in the form of a mortgage or charge on the assets of the company. Hammer to growth of capital market – Public deposits hamper the growth of a sound capital market in the country. As the companies find it easy and economical to raise money through public deposits they are not very keen to raise money by issue of shares and debentures. Thus, investors are deprived of the benefits accruing from good securities. Uneconomical – If better investment opportunities are freely available, the public will not keen to make deposits unless very high rates are offered. The company raising money through public deposits has to spend a lot by way of commission and brokerage. Thus, in the ultimate analysis this sources of capital proves to be costly.

(iii)

(iv)

(v)

(vi)

METHODS OF RETIRING OF LONG TERM DEBTS A company has to redeem every debt-except the irredeemable debentures. Which are to be repaid at the option of they company at any time after giving a due notice to the debentures holders. Following are the three principal methods repayment of long-term indebtedness: Redemption, Refunding and conversion. 1. Redemption – Redemption involves cash payment to the debenture holders or bond holders either at or before the date of maturity according to the terms of contract. Payment is made (i) at maturity, (ii) before maturity under terms of issue, and (iii) after maturity not under the terms of contract but under a subsequent agreement. (i) At maturity – Payment is made on the due date out of cash which may be made available either out of current earnings or out of sinking fund created out of profits established to ensure payment of debentures at maturity. Investment against sinking fund are sold out and loan is redeemed in order to make cash available.

As a company cannot redeem its entire bond issue from the earnings of any one year, a sinking fund is built up out of profits over a number of years without injuring the financial operations of the company. It is invested in various securities, especially in gift-edge securities, in such a way that total amount of indebtedness is collected including interest, on investment after a fixed period. Following are the main reasons for creating sinking fund. (a) Security – It adds the element of security.

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(b) Confidence – It tends to inspire the confidence in the capacity of the issuing company. (c) Check – It acts s a check on the financial policies of the management due to appropriations of profits for the fund. (d) High – credit – The company is rated high because the company invests the amount equal to the fund in the open market securities, which tends to stabilize the market value of bonds at a relatively high level. (e) Makes up depreciation – It makes up the depreciation in the value of assets purchased out of the sale proceeds of bonds. (ii) Before maturity – A company may redeem debentures even before maturity which may be mandatory or solicited. This is as follows: (a) If its mandatory, the bounds are chosen by lot for redemption. The issuing company reserves the right to redeem the debentures as given under the terms of debenture agreement at the time of issue. Payment may be made in fixed installments year after year. The number of debenture to be redeemed in a year is “drawn by lot”. Slips containing distinct number of debentures of bonds are put in a drum and then as many slips are taken out as the debenture to be redeemed. The debentures thus drawn by lot are repaid in cash and full under terms of contract. (b) If redemption is solicited before maturity, an agreement is entered into between the company and the debenture holders. (c) A company may redeem debentures before maturity by purchasing them in the open market. If the terms of issue do not restrict the company from doing so the company may cancel these debentures after their purchase in the open market. A company is promoted to redeem before maturity a due to the following reasons: (a) To eliminate fixed charge on the earnings of the company provided the liquidity position of the company is not adversely affected. (b) To get rid of onerous terms and conditions of the bond. (c) To redeem debentures either by taking them back direct from the debentures holders or by purchasing them from the open market. (d) To provide flexibility to the financial plan of company. 2. Refunding – Refunding of indebtedness means replacement of old debt into new instead of extinguishment of debt altogether a is done in redemption. This may take place either or maturity or before maturity. (a) On maturity this may be done in two forms (b) Before maturity – This is done by exercising call option given under the terms of issue or if no such optionis given in the managemnet, the company may enter into a first agreement with the bond holders including them to accept new series of debenture or to accept cash before maturity. Following types of inducements are offered to the bondholders for persuading them to accept new bonds. (i) (ii) New bonds may issued at a discount to the existing debentures. It is likely to find favour with the old bondholders.

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resulting in higher profits in future. Debenture may be paid partially in cash and bonds for the balance. Old debentures may be redeemed at premium. Following are the circumstances of accepting debt capital. if the company lacks funds to pay off debentures in cash. (3) The general price level is expected to be high. Conversion – Conversion means issue of shares to the existing debentures holders in exchange of their holdings under the terms and conditions specified in the contract of issue. 3. DEBT FINANCE AGAINST EQUITY FINANCE Debt Financing is recommended against equity financing due to following reasons: 1. The company retires it as debt by converting debentures into equity or preference shares. 2. If the company likes to continue the indebtedness for the purpose of trading on equity or due to favourable market conditions. The cost of debt-financing is always fixed.(iii) (iv) (v) (vi) The bondholders of small issues may have the advantage of better security by consolidating the issue with after acquired property clause. Following are the reasons for refunding before Maturity: (i) (ii) (iii) To reduce fixed change. 88 . it may be arranged to make the new issue under written with the bankers. it issues a new series of debentures. The interest payable on debt is an admissible deduction for income-tax purposes which reduces tax liability of the corporation. The debenture holder is given a right to convert the debentures within a specified period according to the terms given in the bond indenture. To consolidate several bonds containing different terms and conditions. To eliminate bonds containing prohibitive term and conditions by offering new bonds in favourable market. Debt carries flexibility in the capital structure of the company because it can be redeemed at any time at the sweet will of the company. it may adopt the method of refunding. The main purpose of issuing convertible debentures is to make the financial plan of the company highly elastic because such debentures may be redeemed at any time before maturity. 4. 3. To conclude the redemption of debentures is preferred when the company has sufficient cash to pay off the debentures. (4) The existing debt-ratio is relatively low. (5) Price earnings ratio on equity shares is low in relation to the level of interest rates. New issue may be guaranteed by the parents company affiliated company or government of financial company. On the other hand. (1) The sales and earnings are relatively small (2) The marginal cost of debt is less than the cost of equity as it lower the average cost of capital or trading. The rate of interest payable on long terms debt is lower than the normal rate of return. If the bondholders insist on cash payment.

a part of the total earnings may be transferred to various reserves. No Dependence on Fair – Weather Friends – Retained earnings. It is a desirable practice to stabilize the economic soundness of the company. ADVANTAGES OF PLOUGHING BACK OF PROFITS (i) As a Shock – absorber in the Business – The policy of ploughing back of profit provides a cushion to absorb the shocks of business vicissitudes. It raises no problem or complication as does borrowing either from the banks or from the public. modernization. which means a balanced and cautious debt policy to remove the fluctuations in the earnings per share. In depression past earnings enable the company to withstand the seasonal reactions and business fluctuations and act as a shock-absorber in the business. Sometimes secret reserves are created by the directors without the knowledge of the shareholders to make the financial position of the company sound. It is the best devise to finance the schemes of expansion. No matter how much it shifts towards debts a company can never lower its average cost of capital unless it chalks out or maintains a suitable debt management policy. General Reserves.g. may be called ‘All weatherfriend’.(6) Retention of existing control pattern because debentures carry no voting rights. It is well known that prosperity does not last for ever. The reserves may be built up during a continuously spell of prosperous period by following the conservative dividend policy and without touching the capital structure of the company and may be used during emergency.. 1. (i) In the years of prosperity – Through earnings per share will increase if the company relies more on debts rather than equity financing but it creates its own problems that all manages cannot appreciate because it restrains the freedom on the working of financial policies. In the period of depression – It is not interest of the organisation and the shareholders to raise debt capital because the average rate of earnings is much lower than the rate of interest payable on such debts. According to this device. (8) Terms and conditions of debt agreement are not onerous and prejudicial to the interest of the firm and its shareholders. and betterment for an existing company. Repair and Renewal Reserve Fund etc. In the absence of ploughing back of profits a company has to manage its funds for expansion or development through other sources of long-term finances such as issue of shares (ii) 89 . SUITABLE DEBT MANAGEMENT POLICY An optimum debt policy depends on expected ratio of returns and the rates at which these expected revenue streams will be capitalized. Ploughing back or re-investment of profits is and adjunct of sound financial management. It will help the company during depression however serious. e. Period of boom is always followed by depression. (7) Terms of debt-agreement are not burdensome on the cash position of the company. (ii) PLOUGHING BACK OF PROFITS Ploughing back of profits is a management tool under which management does not distribute the whole of the profits earned during a year to the owners of capital but it retains a part of it to be utilized in future for financing the schemes of development and betterment of the company and / or meeting the special fixed or working capital requirements of the concern. The company must follow the policy of balanced debt financing policy in order to avoid sharp fluctuation in the earning per equity share.

But if reserves are used for such purpose. The dividend rate will be rationalized b. mechanization. If a company issue shares or debentures of borrows money from financial institutions or public to finance its schemes of development. Best device Financing of Rationalization – Ploughing back of profits is the best device in financing rationalization schemes. The investments is quite safe and sound and c. if not increasing. it will have to pay dividends or a fixed rate of interest on such financing. 90 . (iv) (vi) (vii) 2. There is no cost of retaining earnings. Easy Retirement of Bonds or Debentures – The undistributed accumulated income can also be used to redeem the bonds or debentures which relieves a company of the fixed burden of interest charges. Replacement costs is very often ignored which increases three to four times of the present price due to rise in the price level during the expiry of life of existing assets. When the earnings of the company are below the normal rate of earnings. In comparison to other sources of finance. Retained earnings may be employed when a company expands its business or implements any scheme of development.or debentures or borrowings from long-term financial institutions or public deposits. no such obligations of dividend or of interest is incurred. This makes depreciation funds or replacement fund insufficient to replace the worn out asset. ADVANTAGES TO SHAREHOLDERS i) Safety of Investment – Every investors cherishes that his investments should be safest and the return on the investment should at least constant. There are labeled as fair weather friends because a company can manage its finance through these sources only in prosperity. (v) Ensure stable Dividend Policy – Retained earnings ensure stable dividend policy and enhance the credit standing of the company in the market. in depression it may maintain the rate of dividend in that years also by madding up deficit from dividend equalization fund. Even if the earnings of the company are not stable and regular it may maintain a consistence rate of dividend to the shareholders in prosperity and transfer any excess to a reserve which may be called “divided equalization fund”. It is to be paid whether profits are available or not. Only retained earnings can be utilized for such development schemes. (iii) Economic Method of Financing : Ploughing lack of profits is a cost free sources of finance as nothing is paid to retain the profits. Easy to Replace the Wasting Assets – Generally depreciation is charged on the assets taking into consideration the present cost and the life of a particular asset. The policy of ploughing back of profits assures that a. a. In adversity. c. No charges or encumbrances is created on the fixed assets of the company. automation etc. Moreover. interest on borrowings is a charge on the profits of the company. There is no dependence on outside sources b. these source cannot be realized upon. there are three additional charms of this device. The company can easily withstand the business cycles and seasonal reactions. the ploughed back profits can be utilized to make good the deficiency. Under these circumstances.

2. Various new projects in the industrial or other spheres are commenced which would otherwise remain unexpected because of shortage of finance. Carried to its logical conclusion. They may be benefited by the increased earning capacity of the company as the actual value of their shares will be higher. 91 . It facilitates greater and better production at cheaper rates to society which will increase its standard of living. ADVANTAGES TO THE COUNTRY OR NATION i) Aid in Capital Formations – The corporate savings are one of the important means of capital formation which is very important for the economic prosperity of an underdeveloped country. Smooth and Continuous Production – Every nation is interested in the smooth and continuous functioning of the old and new enterprises. such schemes may be put off or delayed in the absence of retained profits. Corporate savings provide the stability and flexibility which are indispensable for the successful operations of companies without which the industrials mortality rate is likely to be higher. Quick-Financing of Rationalization Schemes – Corporate savings or a accumulated profits provide an assurance to the management for quick implementation of rationalization schemes like expansion of industrial activity and improvement of the existing units. iii) iv) v) 3.ii) Enchanted Market Value of Share – By declaring dividend to shareholders at more or less stable rare or at a higher rate than that of the previous year a company earns repute. Greater. modernization and automation schemes without any legal formality and charge on profits. Creation of Monopolies – The ploughing back of profits serves vested interests. they can retain shares.Internal financing provides an easy finance for rationalization. This section provides safeguard against the practice of ploughing back of profits in closely-held companies. Higher Collateral Value – The increased value of shares enables the shareholders to borrow the amount against the securities of such shares on better term. Misuse of Savings – If the corporate savings are not utilized in the lager interest of shareholders the management may use them in weaker units under the same management and ownership or in their pet concerns or in which the shareholders may be least interested. Shares holders can take a advantage of the increased market value by selling their holdings in the open market. The market value of its shares goes up. ii) iii) iv) DISADVANTAGES OF PLOUGHING BACK OF PROFITS 1. Better and Cheaper Production . it may tend to create monopolies because as a result of reinvestment of their profits into their own enterprise the existing companies may grow more and more while new concerns would find it difficult to raise the capital they need. Super Tax – Section 104 of the Income – tax Act provides no super tax to the shareholders of closely – held companies being owned by a few shareholders. Profits by Retaining the Shares – If shareholders do not like to sell their shares at higher market price. Thus ploughing back of profits indirectly stimulates the rapid industrialization. In the long run the policy of retained profits goes to increase the standard of living of the masses. Thus they are treated as collateral securities for loan.

obsolescence. People who oppose treating depreciation as a source of finance argue that funds are generated by operating profits and not by making provision for depreciation. Dissatisfaction among Shareholders – An over-enthusiastic policy of ploughing back of profits may create dissatisfaction among the shareholders because they think that the management is damaging their interest by retaining the profits and thus paying a lower rate of dividend that may be paid out of the available profits. but it can also not to be denied that as a noncash expense. depreciation does not represent any cash outlay with the result that a part of the profits adjusted for depreciation can be used by management to increase any of the current assets or pay taxes. dividend etc. Most of the shareholders are not happy with this policy. 5. As the rate of dividend to be declared is the sole authority of the board of directors it cannot be increased even by all the shareholders in the general meeting. There is a lot of controversy among academicians and business executives regarding treatment of depreciation as a source of funds. With an intention to bring down the market price of shares and purchase them at lower market price. can be taken as a source of funds in a limited sense because of the following reasons. Social Waste – Excessive ploughing back profits entails social waste because money is not made available to those who can use it to the best advantage of the community. of rate of dividend may be increased out of the past accumulated profits to raise the market value of shares with an intention to dispose of their holdings at such increased price. lapse of time. Each of these internal sources of financing are explained below. The two most important source of internal financing are depreciation and retained earnings. INTERNAL FINANCING A new company has only external sources finance. Depreciation as a source of finance Depreciation means decrease in the value of assets due to wear and tear. The analysis of the merits and demerits of the policy of ploughing back of profits. but is retained by those who have earned it. In the subsequent year. However. They further argue that the depreciation being a non-cash item of expense does not affect the working capital of the firm and as such not at all a source of finance. an existing company can also generate finance through its internal source.- 92 . Over Capitalization – The accumulated reserves may lead over – capitalization because the management may be inclined to capitalize its reserves by issue of bonus shares which will reduce the rate of dividend. the directors may declare a lower rate of dividend. 6. Validity of the above arguments cannot be questioned. Interference with the Freedom of Investors – An excessive cautious dividend policy refers with the freedom of the investors whether the management wants that old industry should expand or they should finance the setting up of a new concern. 7. 1. If depreciation were really a source of finance by itself any enterprise could have improved its position at will by increasing the periodical depreciation charge.3. Manipulation in the value of Shares – The enormous accumulated earnings provide a greater scope to the management for manipulation in the value of shares by manipulation the rate of dividend. exhaustion and accident. Ignorant shareholder may fall a prey to these tactics and fraudulent practices of the management. therefore. 4. makes it clear that it is undoubtedly a good policy for the development of the industry but the management should be cautious and bold enough in carrying out the policy. Depreciation may.

500 as compared to Case I. 75. It may. a certain percentage. According to the latest provision of the Companies Act. therefore.000 Nil. as prescribed by the Central Government (not exceeding 10%) of the net profit tax of a financial year have to be compulsorily transferred to reserves by a company before declaring dividends for the year.000 15. The chief merits of this method of financing can be put as follows: (i) (ii) It enhances business reputation and increases the capacity of the business to absorb unexpected and sudden business shocks too. it owns fixed assets.000 30. Case II Rs. For example. it saves outflow of funds which would have otherwise gone out in the form of rent. Depreciation reduces taxable income and.500 in Case II. by said that true funds flow from depreciation is the opportunity of saving cash outflow through taxation.000 (ii) (iii) Income before depreciation Depreciation Income Taxable Income Income Tax say at 50% Net Income after tax (B) Net Flow of funds after tax (A) + (B) 75.000 37. As a matter of fact. it may not be wholly correct to say that retained earnings have no cost to the company.500 The above example shows that in Case II. As compared to other sources of financing.500 37. therefore.(i) Depreciation finds its way into current assets through charging of overheads (including depreciation). 93 .000 60. the cost of retained earnings is the return which the shareholders could have earned on the amount of retained earnings if it had been distributed. 7. Merits – This method of raising finance for a company is very useful because on the one hand it does not cost anything to the company and on the other hand it strengthens the financial position of the company. The value of closing inventory may include depreciation of fixed assets as an element of cost. 7.000 30. Of course. tax liability has been reduced by Rs. This will be clear with the following example: Case I Rs. 75. it would have been required to pay rent for them. This is because on account of depreciation charge being claimed as in expense. Depreciation does not generate funds but it definitely saves funds.500 37. 2. Financing through retained earnings This is strictly not a method of raising finance but refers to accumulation of profits by a company to finance its development activities or repay loans. income-tax liability for the period is reduces. this method of financing is least costly since it does not invoice any floating cost as is the case with raising of funds by issuing different types of securities. the net flow of funds is more by Rs. Since.000 45. if the business had taken the fixed asset on hire. It is also known as “Internal Financing” or “ploughing back of profits”.

The shareholders may also object to the use of retained earnings as a source of finance since it affects their regular income. The method of financing through retained earnings may prove harmful to social interest also. 1. SHOT-TERM LOANS / CREDITS The short-term loans / credits are obtained for working capital requirements. The demerits as consequences of such misuse can be summarized as follows: (i) The retained earnings can be misused by the management to manipulate the value of the company’s shares in the stock exchange and also to cover their inefficiency in managing the affairs of the company. The retained earnings are utilized by individual business units and the society does not get the chance of investing them through capital market into such business units which may be more useful to the society. (ii) (iii) (iv) The quantum of retained earnings is affected to a great extent by the dividend policy pursued by a firm. This is particularly true for shareholders falling in lower income groups. This source of financing is also useful since it carries no fixed obligation regarding payment of dividend or interest. Excessive use of retained earnings continuously for long period may result in converting the company into a monopolistic organisation. UNIT VII SOURCES OF FINANCE LOAN FINANCING A firm may meet its financial requirements by taking both short-term loans / credits and long-term loans. Demerits – Financing through retained earning is not free from evils or misuse. 94 .(iii) (iv) This method of financing has been broadly found to be useful for financing expansion and improvements. The following are the important sources of short-term loans / credit. The higher dividend rate means less retained earnings and vice versa.

The decision is entirely up to the firm. Trade Credit is available on a continuing and informal basis. and (iv) Volume of purchase to be made by the buyer. They are allowed a short-term credit period before payment is due. A seller views occasional late payment with a far less critical eye than a banker or any other lender. if trade credit is stretched beyond agreed limits and the increased purchase price of the product. pledge securities or adhere to strict payment schedule. In case of an Open Account Credit Arrangement. There is no need to arrange financing formally. Trade Credit Arrangement is generally made available to the buyer on an informal basis without creating any charge on assets. the buyer does not sign a formal debt instrument as an evidence of the amount due by him to the seller. While in case of an Acceptance Credit Arrangement the buyer accepts a bill of exchange or gives a promissory note for the amount due by him to the seller. In an advanced economy. most buyers are not required to pay for goods on delivery. As a matter of fact. The volume of trade credit and its popularity as a means of short-term financing depends on the following factors. In case. Merits of trade credit (i) (ii) The major merit of trade credit as a source of finance is its ready availability.(1) Trade Credit – Trade credit is a form of short-term financing common to almost all types of business firms. Trade Credit is a flexible means of financing since the firm does not have to sing a note. the firm is not taking cash discounts. Thus. the risk and inconvenience attached with supplying goods on credit. Availability of liberal trade credit facilities may induce a firm to over trading which may later prove to be disastrous for the firm. The seller while fixing the selling price of his products to be sold on credit takes into account the interest. the possibility of deterioration in reputation. Trade Credit Arrangement usually carry stipulation of allowing a cash discount to the buyer for prompt payment. additional credit is readily available by not paying existing trade creditors till the expiry of the credit period. (ii) The firm must balance the advantages of trade credit as a discretionary source of financing without any explicit cost against the cost of losing of cash discount. There is no need of creating any sort of charge against firm’s assets for obtaining the trade credit. many firms utilize other sources of short-term financing in order to enable them to take advantage of cash discount. This credit may take the form of (a) An Open Account Credit Arrangement (b) Acceptance Credit Arrangement. 95 . (iii) Financial position of the seller. it is the largest source of short-term funds. (i) The terms of trade credit. As a matter of a fact. (ii) Reputation of the purchasing firm. There is no need to negative with the supplier. (iii) (iv) Demerits of Trade Credit (i) The cost of trade credit may be very high in case all factors are considered. it is an arrangement by which the indebtedness of the buyer is recognized formally.

even though he may not have drawn to this extent. It includes a medium – term loan (repayable) within 1to 5 years) and a long-term loan (repayable after 5 years). Commercial Banks Commercial banks in our country mostly provide only short-term credit to the business. In order to safeguard the bank’s interest on a account of banker’s locking of funds unnecessarily because of customer’s drawing funds much less than the bank’s estimate. whenever it so desires. but draw such amounts as and when required.2. Such an advance is granted by the bank only to persons in whose integrity it has full confidence. The borrower has no right to deal with them. but only marginally. The goods remain at the disposal and in the godown of the borrower. one third. The clause requires the customer to pay interest to the bank on a certain proportion of amount arranged for. They have started providing medium term finance also. Interest on a cash credit account has to be paid only on the amount actually drawn at any time and not on the full amount of the credit allowed. The bank is given access to goods. The rate of interest charged by a bank in the case of loans is usually lower than in case of cash credits and overdrafts on account of the following reasons : (a) It involves lower cost of maintenance on account of not frequent operation of the account. Demand loan is payable on demand. Repayments may be made in installments or at the expiry of a certain period. it is for a short period. one-fourth. on account of the advantage that a customer need not borrow at once the whole of the amount he is likely to require. 96 . Cash credits are the most favorite mode of borrowing by large commercial and industrial concerns in India. In the case of loan the banker makes a lump sum payment to the borrower or credits his deposit account with the money advanced. Payment of term loan is spread over a long period. a minimum interest clause is often inserted in the cash credit agreements. Commercial banks make advances to the customers in the following forms: (i) Loans : A loan is a kind of advance made with or without security. (b) The bank gets interest on the total amount sanctioned whether the customer withdrawals the whole money or not. (iii) (iv) Customers favour hypothecation to pledge because the latter is considered to lower this prestige. Thus. He can put back any surplus amount which he may find with him for the time being. Loan may be a ‘term loan’ or a ‘demand loan’. the goods are placed in custody of the bank with its name on the godown where they are stored. A loan once repaid in full or in part cannot be drawn again by the borrower unless the banker sanctions a fresh loan. Hypothecation : In case hypothecation the possession of good is not given to the bank. (ii) Cash Credits : A cash credit is an arrangement by which a banker allows his customer to borrow money up to a certain limit. say. Cash credit arrangements are usually made against the security of commodities hypothecated or pledged with the bank. Pledge : In the case of pledge. The borrower furnishes periodical return of stock to the bank. The customer has to pay interest on the total amount advanced whether he withdraws the money from his account (credited with the loan) or not. It is given for a fixed period at an agreed rate of interest.

Merits 97 . Commercial banks also act as friend. Commercial banks rarely grant unsecured credit to business firms. Moreover. This arrangement. 4. 2. Commercially banks. This mode of raising funds is becoming popular these days on account of bank credit becoming quite costlier. is advantageous from the customer’s point of view as he is required to pay interest on the actual amount used by him. a company cannot accept deposits for a period of less than 6 months and more than 36 months. a company cannot accept or renew deposits in excess of 35% of its paid-up capital and free reserves. like the cash credit. 3. The maximum rate of interest on public deposits depends as RBI directives. The bank mayh discount the bills with or without security from the debtor in addition to the personal security of one or more persons already liable on the bill. philosopher and guide to their client business firms in respect of the new ventures to be taken up and the most appropriate sources from which finances have to be raised by them. However deposits up to 10% of the paid up capital and free reserves can be accepted for a minimum period of three months for meeting short term requirements. 3. Short-term credit from commercial banks is generally cheaper as compared to any other source of short-term finance. Commercial banks also provide credit to trade and industry at concessional rates under their special schemes as per the directives of the Reserve Bank of India. while the latter is supposed to be a form of bank credit to be made use of occasionally and for shorter durations. Merits: 1. have different schemes of financing thereby considerably flexibility can be maintained. The net amount after deducting the amount of discount is credited to the account of the customer. Demerits : (i) (ii) (iii) Financing from commercial banks requires signing of a number of documents involving cost as well as time. with or without security if he requires temporary accommodation. This acts as deterrent for the firms to depend more on commercial banks for their financial requirements. directors and general public. A commercial bank takes a very critical view of even a small irregularity committed by its customer in respect of the operation of his account. as explained above. Bills discounted and purchased : The banks also give advances to their customers by discounting their bills. A cash credit differs from an overdraft in the sense that the former is used for long terms by commercial and industrial concerns doing regular business. According to the existing provisions. Public Deposits Many companies accept deposits for short periods from their members.(v) Overdrafts : The customer may be allowed to overdraw his current account. (vi) The term “discounting of bills” is used in respect of time bills while the term “purchasing of bills” is used in respect of demand bills.

2. The system may prove injurious for the growth of a healthy capital market.(i) Financing through deposit is simple without much of complicated formalities involved. the role of a merchant banker has undergone substantial change. This mode of financing sometimes puts the company into serious financial difficulties. The merchant banker now acts as an institution which understands the requirements of the entrepreneur’s promoters on the one hand and financial institution. Merchant banking is basically a service banking. 1. A heavy reliance on public deposit for medium – term financing by companies may adversely affect the supply of industrial securities. in a period of depression and financial stringency this source will dry up. particularly shares and debentures to general public. Plant and Machinery. whose main job is to transfer capital from those who own it to those who need it. Merchant Banking : With the liberalization of the capital market system and abolition of office of the Controller of Capital Issues. It is a less costly method for raising short term as well as medium term funds required by the business. it has become very attractive for the companies to raise long term financial resources through capital market rather than depending on finances from financial institutions and banks. The services of a merchant banker can be summarized as follows: 98 . Today leasing and hire purchase are so prevalent as a mode of financing that have become sale aid tools for the automobile and consumer electronics industry. However. The company has simply to advertise and inform the public that it is interested in and authorized to accept public deposits. There is no need of creation of any charge against any of the assets of the company for raising funds through public deposits. The merchant banker merely acts as an intermediary. With the increase in the complexities and requirements of modern business. Even a slight rumour that the company is not doing well may result in a rush of the public to the company for getting premature payments of the deposits made by them. Finance Companies During the last ten years finance companies have assumed an important role in providing and arranging finances for the industry in the following manner. concerned with providing non-fund based services of arranging funds rather than providing them. The company can take advantage of trading on equity since the rate of interest and the period for which the public deposits have been accepted are fixed. banks stock exchanges and money markets on the other. Vehicles. Finance companies help the industry in this process by providing the merchant banking services. A company enjoying good reputation in the market is in a positions to raise sufficient funds through public deposits. companies which do not enjoy such reputation cannot raise sufficient funds by this method. Office Equipments through leasing or hire purchase facilities. More ever. (ii) (iii) (iv) Demerits (i) Raising funds through public deposits is not a reliable and definite source of finance. Leasing and Hire Purchase : Finance Companies help industry in acquisition of capital assets viz. (ii) (iii) 4.

Assistance in negotiations of foreign collaboration. In order to function as a merchant banker. 5. The department provides advisory services to potential investors at a nominal cost and thus indirectly help the companies to raise resources. They also undertake the functions of buying and selling securities for their client companies. They prepare prospectus. effects on taxation and inflation of giltedged and other securities. identification of projects. since they are self generating. rehabilitation and reconstruction of old/ailing or sick industrial units. (4) Servicing of issues : Merchant bankers keep register of share holders and debentures holders of their client – companies. They also arrange for safe custody of securities on behalf of their clients. Usually a date is fixed for payment. (2) Sponsor of issue: Merchant bankers act as sponsor of issue rather than sources of finance. The amount of fee will depend on the width and range of services rendered. act as paying agents for the dividends. (3) Credit syndication: Merchant bankers undertake preparation of project files. the total number of merchant bankers (of all categories) registered with SEBI was 422. For this purpose. fixing location. obtaining money. brokers and bankers for issue. Accrual Accounts Accrual accounts are a spontaneous source of financing. Corporate counselling for financial institutions. Engage underwriters. Similarly. get the approval from SEBI. Suitable fee is charged for such services by the bankers. many finance companies have established equity research and investment counselling department. 1984.(1) Project counselling : A merchant banker helps an entrepreneur in conception of idea. In order to cater to the needs of such investors. (7) Other specialist activities : These include: a. a provision for tax is 99 . loan applications for financial assistance on behalf of poromoter from different financial institution for meetings long-term as well as working capital requirements of their clients. wages are paid in the first week of the month next ot the month in which the services were rendered. finance and risk / venture capital. The most common accrual accounts are wages and taxes. one has to take authorization from the securities & exchange Board of India (SEBI). Services to NRIs for suitable investment opportunity in India. Arranging technology. As at the end of August. In both cases the amount becomes due but is not paid immediately. sanctions / approvals from State and Central Government departments. for example. Equity Research and Investment Counselling : A common investor is not able to apply his mind for analysis of financial statement and future prospects of various companies for investment decisions. d. (6) Arrangement for fixed deposit : Merchant bankers help companies to raise finance by way or deposits from the public. (5) Investment management : Merchant bankers render advice in matters pertaining to investment decisions. preparation of projects feasibility reports. 3. b. c. they not only provide required guidance but also acts as brokers for mobilization of public deposits. debentures interest.

the company cannot indefinitely postpone the payment of taxes of the Government without attracting penalties. However. LONG – TERM OR TERM LOANS The term “Term Loans” is used for both medium as well as long-term loans. 2. they charge exorbitant rates of interest and are. Thus. First the special 100 . considered only as a lat resort of finance. Specialized financial institutions also provide short-term finance to their client units in times of need. Similarly with increasing profits the amount of accrued taxes also increases in almost in the same proportion and in the same direction. therefore. Postponement of wages may also affect the morale of the employee resulting in absenteeism reducing efficiency and higher labour turnover. Indigenous Bankers Indigenous bankers are private individual engaged in the business of financing small and local business units. However. Medium terms loans are for periods ranging from 1 to 5 years while long-term loans are for a period from 5 to 10 years. Such sources may include loan from directors or sister business units.created out of the profits of the company at the end of the financial year but the tax is paid only after the assessment is finalized. Services are rendered by the employees but they are not paid not they expect to be paid until the end of the pay period. They provides short-term or medium-term finance. labour cost usually increase and with them the amount of accrued wages also increase. 7. Similarly taxes re not paid until their due date. the time lag between receipt of income and making payment for the expenditure incurred in earning that income helps the business in meeting some of its shortterm financial requirements. This source of financing should be resorted to only in the last. 6. Accrual accounts become an important source of finance since with increase in scope of the operation of the business with increase in sales. The cost of these funds is usually nominal. Advances from Customers Manufacturers and contractors engaged in producing or constructing costly good involve considerable length of manufacturing or construction time usually demand advance money from their customers at the time of accepting their orders for executing their contracts or supplying the goods. many companies on the brink of cash insolvency find it a convenient remedy to save themselves by resorting to postponing payment of wages and other expenses. for example. Similarly the trade unions will also resent if the wages are not paid to the workers in time. Demerits An accrual account is not discretionary sources of financing. This is a cost-free source of finance and really useful in those businesses where it has become customary to receive advance payment from the customers. Miscellaneous Sources A business firm may resort to miscellaneous sources of finance in periods of pressing needs. Merits Financing through accruals is a costless or interest free source of financing. 8.

features of such loans and then the role played by different institutions in granting of such loans are discusses.

Special features of term loans 1. Objective – The term loans are granted for one or more of the following objectives: (a) Establishment, renovation, expansion and modernization of industrial units. (b) For meeting the requirements of the core working capital. (c) For retiring bonds in order to reduce interest costs or to redeem preference shares so as to substitute tax deductible interest payment for non-deductible dividends. 2. Security – Terms loans are usually secured. They have either a fixed or floating charge against the assets of the company. The lender bank usually prefers a first charge, however, in appropriate cases it accepts a second charge also. 3. Time period – The term loans are granted for a period ranging from 1 to 15 years but generally from 8 to 15 years. The repayment is made in installments typically designed to fit the project capacity of the borrower to pay. The repayment starts 2 or 3 years after sanctioning of loan. The lending institution requires payment only in accordance with the specified schedule so long the borrower carries out his commitments under the loan agreement. In case of default in such commitment, the agreement provides for accelerating of the maturity of the loan. 4. Formal agreement – The term loan is granted on the basis of a formal agreement. The agreement contains the terms of granting loan and provides for certain protective clauses for the benefit of the lender, e.g. limiting the dividend rate, the power to appoint directors, conversion of loan into share capital, etc. Then terms are settled through direct negotiation between the borrower and the lending institutions. 5. Participation basis- In case of term-loan being a substantial amount, different financial institutions participate in the credit on a syndicated basis. Such participation is done either because restrictions or for sharing the risk. The larger the loan, greater is the participation. 6. Introduces financial discipline – Term loans introduce a proper financial discipline in the borrower. He has to forecast reasonable accuracy cash flows so that he can repay loan and interest as per the agreed schedule. This makes necessary for the borrower to prepare a projected cash flow statement. 7. Refinance facility – Commercial banks are granted refinance facility from Industrial Development Bank of India on the terms loans granted by them. The risk, of course, continues of the lending commercial bank. 8. Project oriented approach – Financial institution engaged in term lending do not do securityoriented lending any longer. They have detailed app of each project and asserts its own merits. The loan is sanctioned only when the project satisfies their tests. 9. Special Conditions – In order to provide safeguards against time and cost overruns the loan agreements usually require the borrower to give undertaking in respect of the following matters : (i) (ii) (iii) No further long-term loan shall be taken The debt-equity ratio will not exceed the specified limit. Current ratio will be maintained at the desired level.

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(iv) (v) (vi) (vii)

Selling commission sole selling agent shall not be disbursed unless interest and installments of loans are paid. Dividend shall not be declared for a specific period or shall not exceed the agreed rate. Financial data and other information as required by the lending institution will be supplied as and when desired. The directors will furnish personal guarantees for repayment of the loan in addition to the financial institution’s charge on firm’s assets.

Sources of Term Loans There are two major sources of term loan : (i) Specified financial institutions or development banks and (ii) Commercial banks. However, the former happens to be the main source of term-finance for all business and industrial units. Each of these sources of finance have been explained in the following pages. Sources of Term Finance The major sources of term finance in India are as follows : (1) Term Loans – A term loan is a business loan with a maturity of more than one year. There are exceptions to the rule, but ordinarily term loans are retained by systemic repayments over the life of the loan. The primary lenders on term credit are Commercial banks, life insurance corporation, financial institutions, general insurance companies, investment trusts and state and central government. Commercial banks and various financial institutions constitute the hard core of term financing in India. Term lending business of Commercial banks is recent innovation in India specially after 1958. It was in the year of 1958 only when a formal scheme of term loans was started. But, now-a-days these banks provide a larger share of tem finance to Indian Industries. (2) Public Deposit – Besides, commercial banks and institutional finance, the public deposits are also important source of term finance. Till independence, this system was prevalent mainly in the cotton textile industry of Bombay, Ahmedabad, and to some extent, that of Sholapur, and the tea gardens of Assam and Bengal. But now-a-days this system has been very popular with all types of companies and business. In January 75 the Reserve Bank of India issued news guidelines regarding public deposits, since then, the method has gained more popularity. By renewal or getting initial deposits for 3 or 5 years at a lucrative rate of interest @ 12% - 15%, the companies have been able to attract a large section of individual’s savings towards them. (3) Conditional Sales Contracts – This system is also known as hire – purchase or installment purchasing system. Under this method, the industrial purchases machinery at deferred payment basis. Some part of the price is paid at once at the time of delivery (it is known as cash-down payment) and remaining part of the purchase price is paid in installments through a finance company or a bank. Factory equipments hotel and restaurant fixtures, buses, tractors, and trailer, medical equipments etc. are supplied by their manufactures generally on this basis. Such conditional sale contact may be signed by the manufacturer and purchase of machinery and bank can guarantee this payment. Sometimes, bank or financial institution becomes a party to this contract. (4) Lease Financing – Business firms are generally interested in using fixed assets, not in owing them, but on the basis of lease arrangement. Before 1950’s lease system was particular with land, buildings and mining only; but now it is possible to lease virtually all kinds of fixed assets today. A lease contract takes several different forms, the most important of which are sale and leaseback, service leases, and straight financial leases. Leasing has the advantages of a smaller down

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payment and increased opportunities for tax savings, and it increases the over all availability of non-equity financing to the firm. (5) Internal Sources of Term Finance – A company does not go in for external sources of funds every time. But internal sources of funds are also used by them. Retained earnings, employee’s provident fund and pension fund accumulations, provisions for depreciation etc. also constitute and important source of internal term financing. These funds can be successfully utilized by the companies for replacement, obsolescence, short-term expansion or medium-term financial requirements. During the last five years in India, the business firms are relying upon internal sources more due to credit-squeeze by commercial banks and specially after the submission of Tandon Committee Report.

Term Lending The primary task of a lending institution before granting a term loan is to assure itself that the anticipated rise in the income of the borrowing units would materialize, thus providing the necessary funds for repayment. The methods of analysis and appraisal of a term loan applications and standards to be adopted for it are more similar to investment decision that to short-term lending. Appraisal of term-loan application requires a dynamic approach involving inter-alia, a portion of future trends of output, sales, estimates of costs, returns and flow in analyzing a term-loan proposal, emphasis is generally placed on the following :(1) Type and size of Business. (2) The Record, character and continuity of Management (3) General Record of the borrower (in respect of his product market, competition and general outlook for that industry etc.) (4) Operating Efficiency (5) Financial conditions and projected balance-sheet etc. (6) Estimations of future Earnings and cashflows. (7) The available security

In India, when an application for term loan is moved to a term lending institution, the borrower is required to submit the following statement and papers along with the application : (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) Brief historical background of the project or plant. Details of promoters, if it is a new company. Latest audited Balance Sheet in case of an existing company. Existing manufacturing facilities. A project feasibility Report Capacity calculations must be submitted separately in terms of 300 working days. Management set-up and particulars regarding management people. Promoter’s contribution to the Project cost – normally it is acceptable upto 20% but relaxation is possible for backward area locations, technical entrepreneur’s projects and capital – intensive projects. But their contribution in any case shall not be less than 15%.

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(9) Estimates of the cost of project. Means of Financing Proposal for raising share capital loans and debentures Sources of funds in respect of expenditure already incurred. (3) Particulars of existing shareholdings. Projected Balance Sheet Break-even charts. Specialized Financial Institutions or Development Banks 104 . (2) Particulars of existing long-term borrowings. Cashflow statements. Calculation of amount of wages and salaries at optimum production level. Each projects is assessed on its own merits. The declared objective of such appraisal are threefold: (1) The Financial Validity (2) The Economic necessity (from the national economy point of view) (3) The Technical Feasibility Once the objectives are fixed. When an application is received by the financial institution its term lending section makes an appraisal of the proposed project thoroughly.(ix) The following annexures are a must with the application. (4) Distribution of existing shareholders. Estimates of cost of production Estimates of working capital Estimates of production and sales. (5) Particulars of proposed buildings. (8) Raw material requirements. (7) Particulars of imported machinery. (1) Copy of letter addressed to the bankers authorizing them to disclose any information concerning the applicant. Estimates of cost of capital. (6) Particulars of proposed machinery. (10) (11) (12) (13) (14) (15) (16) (17) (18) (19) (20) (21) (22) Calculation of contingency Calculation of margin money for working capital. appraisal is just an intelligent application of the techniques of appraisal.

Underwriting of the issue of stocks. 250 crores as may be fixed by the Central Government by notification from time to time. 1991. Functions – The functions of the Corporation as given in the Act are as follows(i) (ii) (iii) (iv) Guaranteeing loans raised by industrial concerns which are repayable with in a period not exceeding 25 years and are floated in the public market. entrepreneurial and managerial talents and channelize them into industrial activities in accordance with plan priorities. they must be disposed of by the corporation within 7 years of their acquisition. Management : The management of the Corporation vests in a Board of Directors appointed as follows: No. and functions in a way so as to cater to development needs of specific sectors as well as the economy in general.A large numbers of specialized financial institutions have been set up in the country after independence to meet the specific term financial needs of industrial enterprises. Extending guarantee in respect of deferred payments by importers who are able to make such arrangement with foreign manufactures. It has. Insurance Companies. The corporation has been converted into a limited company from July 1993. It seeks to mobilize scarce resources. one of whom is the Managing Director of the Corporation. such as capital. shares. It was increased to Rs. to shape its policies. 20 crores. However. technology. The paid-up share capital as on 31 st March. Resources of IFCI – The original authorized capital of the Corporation was Rs. Industrial Finance Corporation of India (IFCI) The corporation was set up in 1984 under an Act of Parliament to provide medium and long-term financial assistance to industry. bonds or debentures issued by industrial concerns. A development bank is essentially “a development catalyst”. They are popularly known as “Development Banks”. of directors Nominated by Central Government Nominal by Reserve Bank Elected by Bank. 100 crores by an amendment in 1982. was Rs. The Corporation can grant such assistance only to public limited companies and co-operative societies. Investment Total 3 6 12 3 The Board of Directors have delegated their powers to a committee of directors considering of five member. Some of such banks are as follows: 1. procedures. 135 crores. In 1986 by another amendment. The Corporation can also accept deposits from the public and borrow money from RBI for augmenting its resources. therefore. it has been provided that the share capital of the Corporation can be raised to Rs. 105 . State-owned public limited companies can also obtain assistance from the Corporation as per an announcement made by the Corporation in August 1970. Granting loans or advances to or subscribing to debentures of industrial concerns repayable within a period not exceeding 25 years.

scheduled banks. Undertaking financing of projects wit the Industrial Development Bank of India and other financial institutions. bonds and debentures from existing holders. Working of the Corporation – Ever since its inception in 1948 till the end of March 1996. the total sanctions and disbursements by IFCI amounted to Rs.712 crores and Rs. As at the end of March 31. had sanctioned and disbursed financial assistance to the extent of Rs. shares. 33. 4. renovation.751 crores. ) since their inception amounted Rs. 30 lakhs. 11. Almost all the States have set up such Corporation. Industrial Credit and Investment Corporation of India (ICICI) The Corporation was established on January 5. undertaking research to carry out technoeconomic studies in connection with industrial development etc. 106 . The Corporation provides financial assistance for setting up new industrial projects. diversification of existing ones.325 crores respectively.Working – The total assistance granted by 18 State Financial Corporations (including Tamilnadu Industrial Investment Corporation Ltd. The capital of such corporation has to be fixed by the State Government with the minimum and maximum limits of Rs.893 crores and disbursements at Rs. doing merchant banking operations. investment trust and private parties. 17. As at the end of March 1996 total outstanding assistance stood at Rs. The corporation can grant assistance maximum assistance to a company / co-operative society that would not exceed Rs.695 crores and Rs. 12. The maximum allotment to private parties cannot exceed 25% of the share capital of the corporation. since their inception. the Reserve Bank of India.950 crores respectively. It started its operations as a wholly privately owned institution but with nationalization of the life insurance business. It also provided financial assistance on concessional terms for setting up industrial projects in industrially less developed districts in the State and Union Territories as may be notified by the Central Government. 22. 50 crores. co-operative banks. State Industrial Development Corporation (SIDCs) State Industrial Development Corporation have been set up by different State Governments for promoting industrial development in their respective States. insurance companies. 2. the Life Insurance Corporation of India has become its major shareholder. 1996) 3. The shares of the corporations are taken by respective State Government. the purchase of stock. 60 lakhs and to a partnership or a sole proprietary firm Rs. State Finance Corporation Act was passed by Parliament in 1951. expansion. 1996 28 SIDCs. The act is applicable to all States except the State of Jammu and Kashmir.(v) (vi) Acting as the agent of the Central Government or for World Bank in respect of loans sanctioned to the industrial concern. 8. State Financial Corporation In order to provide financial assistance to small-scale industries and medium size industries. 19. 50 lakhs to Rs.952 crores as the end of March 31. modernization. Those would include guaranteeing loans raised by industrial concerns from other financial institutions. 1955 to assist industrial enterprises in the private sector.

The Bank ha been assigned a special role in respect of the following matters: (i) Planning. IFC. Making similar loans in foreign currencies for payment of imported capital equipment and technical service. Industrial Development Bank of India (IDBI) The IDBI was established in July 1964 under the Industrial Development Bank of India. 818. However. A Deputy governor of the Reserve Bank of India is nominated by it. industrial co-operative. in February 1976. (e) Five directors having special knowledge and professional experience in science. (ii) borrowings from the Government of India and RBI. Resources : The principal resources of IDBI are : (i) Share capital and Reserves. nationalized banks and State Financial Corporation. it was delinked from the Reserve Bank and has emerged as an independent organization. LIC & UTI. 5. of the bank was Rs. marketing or any other matter useful to IDBI. IDBI. (iv) Foreign currency borrowings. investment. Not more than 20 directors nominated by the Central Government are as follows: (a) Two directors who are the official of the Central Government. 107 . 1996. promoting and developing industries to fill the gaps in the industrial structure in India. 2. (c) Two directors amongst the employees of IDBI and the above mentioned financial institutions – one from the officer employees and the other from workmen employees. Objective and Functions : The main objective of IDBI is to serve as the apex institution for term-finance for industry in India. The issued and paid up share capital as on March 31. technology.. (b) Five directors from the financial institutions viz. ICICI. Act as a wholly owned subsidiary of the Reserve Bank of India. Subscribing to equity and preference shares directly and underwriting public and private issues and offer to sale of industrial securities. and (v) Repayment of past assistance by borrowers. Management – The IDBI has a board of directors appointed as follows: (i) (ii) (iii) A chairman and a Managing Director both appointed by the Central Government. However. accountancy. Furnishing technical and administrative assistance to Indian industry.000 crores.59 crores. It now serves as an apex financial institution. industrial finance. The Bank’s authorized share capital is Rs. the same person may also function as chairman as well as Managing Director. (d) Six directors from the State Bank. largely held by the Central Government. Guaranteeing rupees payments for credit made by others. economics. (iii) Market borrowings by way of bonds. law.Objects: The objects of the corporation are to assist industrial enterprise in private sector by: (i) (ii) (iii) (iv) (v) Granting secured loans in rupees repayable over a period of 15 years.

viz. 1963. underwriting direct subscription to share/debentures. and By paying dividends to those who have bought the units of the Trust. management or expansion of industry. under its various schemes.(ii) (iii) (iv) Coordinating the working of institutions engaged in financing. the State Bank of India. Schemes of Assistance – The schemes of assistance operated by the IDBI can broadly be divided into two categories. Providing technical and administrative assistance for promotion. Technical Development and Fund Scheme and Equipment Finance Scheme. 6. and scheduled banks and other financial institutions (Rs. promoting or developing industries and assisting in the development of such institutions.500 crores for 1997-98 for this purpose. Unit Trust of India (UTI) UTI came into existence of February 1. The IDBI has recently decided to provide working capital loans also initially to those companies which have taken term loan from it. Bills Rediscounting Scheme. The Bank’s charter provides for considerable operational flexibility.. Working of IDBI – The cumulative sanctions by the IDBI up to 31 st March. 75 Lakhs).811 crores while the disbursements amounted to Rs. the UTI is also assisting corporate sector through term loans. and Undertaking market and investment research and survey as also techno-economic studies in connection with development of industry. 2. IDBI has earmarked a sum of Rs. 2. 1.691 crore. 3 crores in industrial and corporate securities. amounted to Rs. 108 . Seed Capital Assitance Scheme and Resources Support Scheme. the Life Insurance Corporation (Rs. 1996. Out of this direct assistance amounted to about 50. (ii) Indirect Assistance Schemes. etc.2% of the total sanctions. (i) Direct Assistance Schemes which include Project Finance Scheme. The above objective is achieved by the UTI through a three-fold approach: (i) (ii) (iii) By selling units of the Trust to as many investors as possible in the different parts of the country. Also there are no restriction on the nature and type fo security and quantum of assistance which the Bank can provide.5 crores). 75 lakhs).14. 1 crore) The general administration and management of UTI is vested in the Board of Trustees consisting of a Chairman and nine other Trustees. The initial capital of Rs. (Rs. since its inception. IDBI can finance all types of industries irrespective of the form of organization or size of the unit. Its establishment has been a landmark in the history of investment trusts in India. The objective of the Unit Trust is to stimulate and pool the savings of the middle andlow income groups and to enable them to share the benefits and prosperity of the rapidly growing industrialization of the country. which includes Refinance of Industrial Loans Scheme. 1964 under the Unit Trust of India Act. As a result of an amendment in the UTI Act in 1986. By investing the ale proceeds of the units and also the initial capital fund of Rs. 5 crores was subscribed fully by the Reserve Bank of India (Rs. 77.

passed by Parliament.521 crores and Rs. It assists industrial concerns by granting loans and advances. to the corporate sector. viz. 3. amounted to Rs. 43.000 crores and paid-up capital as on 31 st March 1996 was Rs. The Corporation has been converted into a company in January 1997 through a Presidential Ordinance. after reconstitution of the erstwhile Industrial Reconstruction Corporation of India.Working : UTI is playing an important role in mobilizing savings of the community through sale of units under the various schemes and channelizing them into corporate investments. equipment leasing and hirepurchase financing. 1985.386 crores and reserves and funds of Rs. Small Industries Development Bank of India (SIDBI) The small Industries Development Bank of India (SIDBI) has been set up under the Small Industries Development Bank of India Act. 1. In June 1990. Resources – The resources of SIDBI mainly comprise contribution from Industrial Development Bank of India (IDBI) in the form of loans and shares and may include market borrowings. The capital of the bank is wholly subscribed by the IDBI. UTI set up the UTI Instituted of Capital Markets with a view of promote advanced professional education. 32. 450 crores. 7. The cumulative sanctions and disbursement up to the end of March. 1971 (as ISRC) till the end of March. effective from April 23.328 crores and Rs. 1986. engaged in the promotion financing and developing the small-scale industries. bonds and debentures and guarantees for loans/deferred payments. 1990. consultancy. Consequent upon amendment to the UTI Act. At the end of June 1996. financing and development of industries in the small-scale sector. The capital of the bank is Rs. etc. State Financial Corporation. Over the years is has floated 35 schemes including two off-shore country funds to suit diverse investment needs of the investors. short-term and long-term funds from the RBI and loans from the Government of India. training and research in the fields of capital markets. UTI has been extending assistance to the corporate sector by way of term loans. managerial and merchant banking facilities and making available machine and other equipment on lease or hire-purchase basis. 1996. underwriting of stocks.291 crores respectively. bills rediscounting. 44. SIDBI is intended to work as a principal financial institution for the promotion. Scheduled Banks and State Co-operate Banks. It is also expected to coordinate the functions of the financial institutions. the UTI had a UNIT capital of RS. State Small Industries Development Corporation. 1996 the cumulative sanctions and disbursements amounted to Rs. shares.186 crores. 9. 2.404 crores respectively. 8. The range of its services includes provision of infrastructural facilities. Since its inception in April. It is the principal credit and reconstruction agency for rehabilitation of sick and closed industrial units. Industrial Reconstruction Bank of India (IRBI) The Industrial Reconstruction Bank of India (IRBI) was established in 1985 under the Industrial Reconstruction Bank of India Act. 109 .

110 .Working – The SIDBI commenced operations on April 2. 9. 200 crores for an individual projects.200 crores. 10. the commercial banks have started taking interest in term-lending but on a very nominal scale. the Reserve Bank of India was enger to recommend a change in the attitude of commercial banks towards term lending because on the one hand it could boost the profits of the lending banks and on the other hand enable the borrowing units to enjoy certainty of having funds for a specified period irrespective of any change of the monetary policy. by taking over the outstanding portfolio and activities of IDBI pertaining to the SSI sector. 1990. (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) Deferred export payments. Schemes of Assistance – The various schemes of EXIM Bank are as follows: (i) Export bill re-discounting scheme : The EXIM Bank rediscounts exports bills of banks of a period not exceeding 180 days. 50 crores for individual projects. It also takes promotional activities and provides counseling services to persons connected with export import business. Industries in the Industrially backward areas. when Refinance Corporation as established by RBI. for financing and promoting export and also for coordinating working of other financial institutions engaged in the export-import financing. In May 1975 the Reserve Bank urged the commercial banks to step up their term-lending particularly in the following areas. However. since 1958. 4. Export Import Bank (EXIM Bank) The EXIM Bank was set up on 1 st January 1982.200 crores. 19.000 Capital goods industries. The portfolio thus transferred to SIDBI aggregated Rs. Industries where a significant portion of the output is meant for export or where new potential for export could be quickly built up. 25. The total sanctions and disbursements extended by SIDBI under its various scheme since its inception upto the end of March. The banking system as a whole can now sanction term loans up to Rs. The total sanctions and disbursements extended by SIDBI aggregated Rs.026 crores respectively. 1996 amounts to Rs. Industries having short gestation period particularly in the core sector and especially those producing mass consumption goods. Agricultural sector. Commercial Banks Term – bending by commercial banks is a recent phenomenon. It is felt that the commercial banks could not afford to lock up large funds in long term assets because it would affect their liquidity and would make it difficult for them to meet the working capital needs oft trade and industry. Small-scale industries involving investment not exceeding Rs. Deferred payment arrangements for purchase of capital goods in the domestic market. The bank functions as an apex institution for assisting and supporting development of such financial institutions which are engaged in financing export-import. Commercial banks can sanction term loans up to Rs. 4. As a result of this.

338 crores and Rs. He shall make alteration in memorandum of association and articles of association as desired by lender. He shall promptly inform the lead institution of the circumstances and conditions which are likely to disable the borrow implementing the project or which are likely to delay its completion or compel the borrowers to abandon the same. He shall ensure proper maintenance of the property.801 crores respectively. Overseas Investment Finance : The EXIM Bank finances the equity investment by Indian promoters in joint ventures abroad. equipments. Soon after its establishment it took over the export loan and guarantee portfolio of Industrial Development Bank of India (IDBI). machinery and related services on deferred payment terms to importers abroad. 11. Important Covenants incorporated in Long-term Loan Agreement The Financial Institutions while granting long-term loans to borrowers incorporate certain covenants in the loan agreement to protect their interest. any proposed change in the nature of scope of the project shall not be implemented or funds committed therefore without the prior approval of the lead institution. contractors in favour of overseas importers. The cumulative sanctions and disbursements as at the end of March 1996 amounted to Rs. loan realization. turnkey projects and constructions contracts. These covenants basically relate to project implementation. He shall furnish to the lead institution such reports as required by the lead institution. special bank accounts. He shall obtain prior concurrence of the lead institution to any material modification or cancellation of the borrower’s agreements with is various suppliers. Some of the important covenants which are generally incorporated by the lead financial institutions required the borrower as follows: (i) He shall promptly notify the lead institution of any proposed change in the nature or scope of the project and of any event or condition which might materially or adversely affect or delay completion of the projects or result in substantial over-run in the original estimates of costs. Advisory Services : EXIM Bank offers advisory services such as advising small scale manufacturers on export markets and product areas and design financial packages for exportoriented industries in India. 14. Guarantees – The EXIM Bank participates with commercial banks in the guarantees issued in foreign currencies on behalf of Indian exporters. changes in contracts. Overseas Buyer’s Credit – The EXIM Bank offers credit directly to the foreign buyers for import of capital goods and turnkey projects from India. Financial Assistance : The EXIM Bank grants terms loans in rupee to exporters for export of plants.(ii) (iii) Re-finance of export credit : The EXIM Bank gives 100% refinance in respect of post-shipment credit extended by bank to exporters for export of capital goods. 1`982. (iv) (v) (vi) (vii) Working of the Bank : The bank started its operations with effect from March 1. (ii) (iii) (iv) (v) (vi) 111 . insurance coverage etc.

He shall not declare or pay divided to its shareholders during any financial year unless it has paid all the dues to the lender. He shall not remove any person by whatever name called exercising substantial powers of management of the affairs of the borrower at the time of execution of loan agreement without the consent of lead institution. He shall promptly inform the lead institution of any labour strikes. its accounts audited by an independent firm of Chartered Accountants and furnish the same to lead institution. In case statutory audit (if required) is not likely to be completed during this period.. or other similar happenings likely to have an adverse effect on the borrower’s profits or business and of any material changes in the rate of production or sales of the borrower with an explanation of the reason therefore. He shall promptly inform the lead institution if it has notice of any application for winding up having been made or any statutory notice of winding up under the provisions of the Companies Act. (xx) (xxi) 112 . He shall submit its duly audited accounts within prescribed period (generally six months) after the close or its accounting year. He shall not repay any loan availed from any other party without the prior approval of the lead institution. He shall not undertake any new project. raise any loans. counter guarantees or indemnities or for undertaking any other liability in connection with any financial assistance obtained for or by the borrower or in connection with any obligation undertaken for or by the borrower for the purpose of projects. accept deposits from public. modernization or substantial expansion of the project. lock-outs. reorganization or amalgamation scheme or compromise with its creditors or shareholders. (xix) He shall not pay any commission to its promoters. in any concern. managers or other persons for furnishing guarantees. it shall make proportionate repayment to the lenders as well subject to such conditions as may be stipulated by lender. change its capital structure or create any change on its assets or give any guarantee without prior approval of lead institution. the borrower shall get. (ix) (x) (xi) (xii) (xiii) (xiv) (xv) (xvi) (xvii) (xviii) He shall not issue any debentures. the borrower is required to repay any loan. 1956 or any other notice under any other Act or otherwise of any suit or other legal process intended to be filled or initiated against the borrower and affecting the title of the properties of the borrower or if a receiver is appointed of any of its properties or business or undertaking. He shall not make any investments by way of deposits.(vii) (viii) He shall facilitate appointment of lender’s nominee director. issue equity or preference capital. He shall not create any subsidiary or permit any company to become its subsidiary. progress of the project and the operations and financial conditions of the borrower and such records shall be open to examination. shutdown etc. loans.. He shall maintain records showing expenditure incurred on the project. He shall not carry on any general trading activity other than sale of its own product. diversification. He shall not undertake or permit any merger. consolidation. directors. If for any reason. share capital etc. disbursement of the loans.

In other words. viz. (iv) (v) Expenditure incurred by the company regarding awarding of contracts. ‘Bridge Finance’ refers to the loans taken by firms. Inter-corporate investments and sale of shares. They authorize the term lending institution to appoint the nominee directors on the board of borrowing company. machinery etc. The bridge finance is secured against mortgage of fixed properties and / or hypothecation of movable properties of the borrowing firm.Significance of Covenants : The following is the significance of incorporating the above covenants in a loan agreement. BRIDGE FINANCE The term. purchasing and selling or raw materials. custom duty and other statutory dues. generally from commercial banks. Payment of dues to the institutions. Payment of government dues viz. pending disbursement of term loans from financial institutions. two or more financial institutions / banks agree to finance a particular project. e.. LOAN SYNDICATION Loan syndication involves commitments for term loans from the financial institutions and banks for financing a particular project. The rate of interest on such a finance is usually higher than that on term loans. a. IDBI. The financial performance of borrowing company. One of the institutions may become a lead institution and bring about coordination in the financing arrangements of different financial institutions/ banks. They bind the company to comply with the instructions of the lead institution in their operations. ICICI. in loan syndication. They see that the borrowing company makes use of the funds only for the purpose for which such funds have been sanctioned. In order to prevent delay in starting their project. finished goods. A loan syndication arrangement may be made in any of the following ways: 113 . f. b. the nominee directors should satisfy them selves regarding prima facie reasonableness of the company’s case. the firms arrange from the commercial banks short-term loans which are later on repaid as and when term loan disbursements are received from the financial institutions.. d. (i) (ii) (iii) They provide security of loan and their repayment in time. They help the financial institutions in performing the development role consists with the national priorities. In case the borrowing company feels that the demand is unjustified. c. The nominee directors have to keep a watch on the following activities of the borrowing companies and take appropriate measures in public interest. All significant purchase and sale of shares. It may be noted that there is a always a time gap between the date of sanctioning of a loan its disbursement by the financial institution to the concerned borrowing firm. IFCI. etc.

Quoted Price per bond P1 P2 P3 P4 P5 Rs 95 98 101 100 99 Total Amount of Bonds (in Rs. 4. foreign institutional investors. etc. Compliance of the terms and conditions of the loan arrangement by the borrower. The merchant bank submits a formal application to the financial institution for the term loan. Preparation of the project report. This can be understood with the following example. 6. 2.000 crores. equity share. which in turn gets in touch with other financial institutions / banks interested in participating in the financial assistance to the borrower. Y as a book – runner / issue manager. The borrower may directly make the loan application to a lead financial institution. Documentation. If appointed Mr. issued bonds of Rs.e. The price of the instrument (i.1. 100 each amounting in all of Rs. Disbursement of loan. It is determined by offer of potential investors about price which they may be willing to pay for the new issue. 3. Example. The advantage of such arrangement would be that the borrower would not have to approach different financial institutions. the issuing company is required to tie up the issue amount by way of private placement. The issue price is not determined in advance. Selection of the financial institution for loan syndication. 1. X Ltd. the issuing company organizes road shows and various advertisement companies. debenture or bond) is the weighted average price at which the majority of the investors are willing to buy the instrument. underwriters. According to this concept. 5. In order to determine this price. and 7. BOOK – BUILDING Book-building is a novel and growing concept in India. Preparation of loan applicaton. The borrower may approach a merchant bank to arrange for a loan syndication for him. The steps involved in a loan syndication arrangement can be put as follows: 1. Receipt of sanction latter or letter or intent from the financial institution. mutual funds. The merchant bank discusses the matter with the financial institution interested in workings as a lead financial institution. On receiving such an application the financial institution examines the proposal before accepting it for loan syndication. in course of this process the issue manager or book-builder notes the amounts offered by various investors such as institutional investors. Crores) 100 500 100 200 100 114 . 2. He got the following information at which different investor were willing to purchase the bonds.

000 1. The financial institutions had earlier laid down certain norms for such promoter’s contribution. However.f. Of course. The Securities Exchange Board India (SEBI) has laid down the following norms for promoter’s contribution is case of public issues.1995. 100 crores and one of the lead managers to the issue has to be appointed as the book-runner to the issue.50 1000 Total (in Rs.000 9.100 20. Book – building helps in evaluating the intrinsic worth of an instrument and the company’s credibility in the eyes of the investor.500 49. financial institutions not stipulate a promoter’s contribution of around 30% of the project cost. although no specific guidelines have been issued for the same.) (w) (in Crores) 100 500 100 200 100 w1000 crores ∑ pw Issued Price based on Weighted Average ----------------∑w 97. The company also gets firm commitments on the basis of which it can decide whether to go or not to go for a particular issue of securities. PROMOTER’S CONTRIBUTION In order to ensure promoter’s interest in the project.e. The Securities Exchange Board of India (SEBI) has laid down the following norms for promoter’s contribution in case of pubic issues.900 pw 97.= Rs 97. financial institutional insist before financing a new project or expansion of the plant that the promoter should also contribute minimum amount to be contributed by the promoter is termed as ‘Promoter’ Contribution’. Nov.500 ----------.) (pw) (Crores) 9.The issue price can not be calculated as follows: Price (in Rs.) (p) 95 98 101 100 99 Amount of Bonds (in Rs.500 = Book-building as a method of raising funds has been approved by SEBI w. As a result. 115 . it has been provided that this method can be used only when the issue exceeds Rs. these norms have recently undergone a change due to Government’s policy for encouraging entrepreneurs to reduce their dependence on financial institutions and to raise funds from the capital markets.

500 50 80 90 285 (adjusted to 305)* 505 (adjuste to 525)* 20. 2. but also helps to turn research and development projects into commercial production. Size of capital premium) issue (including % of promoter’s Capital issue size (Rs. The new policy measures have facilitated by established of new financial institutions and also introduction of innovative financial instruments as discussed below: 1. 285.05% so that the amount shall be Rs. Its growth and development has further been facilitated by the policy measures taken by the Reserve Bank of India and the Government of India with the objective of speeding up the tempo of institutionalization of savings and investment. In other words. the slab shall be calculated at the rate of 16. It not only plays an important role in financing hitechnology projects. in crores) 500 On first 100 crores of issue Next 200 crores Next 300 crores Balance issue amounts Total promoter’s Contribution Average Percentage Contribution 50 40 30 15 50 80 60 -190 38% 1.500 crore has to be adjusted so that the total contribution by the promoters works out to 21% of the issue capital. 116 . besides financing the technology. venture capital. In the western countries much of this capital is put behind establishing technology and expanding business or is used to help the evolution of new management teams. is also involved in fostering the growth and development of enterprises.000 50 80 90 60 280 28% 2. 305 crores instead of Rs. NEW FINANCIAL INSTITUTIONS AND INSTRUMENTS The Indian Capital Market especially in the eight has been undergoing tremendous changes to cater the varied needs of capital of the various sectors of economy.0%e *Note : The last slab in the case of issue of Rs. Venture Capital Institutions Concept of Venture Capital : Venture capital is a form of equity financing designed specially for funding high risk and high reward projects. NEW FINANCIAL INSTITUTIONS The following are some of new financial institutions which have been recently setup for a fast growth of the capital market: 1.The Securities Exchange Board of India (SEBI) has laid down the following norms for promoter’s contribution in case of public issues.

viz.. 1993 amounted to RS. State Bank of India. The cumulative sanctions and disbursements under the schemes of RCTC at the end of 31 st March. Canara Bank has also set up a venture capital fund through its subsidiary CanBank Financial Services Limited. (5) Other Venture Capital Funds : Besides the public financial institutions (IDBI. Under the first two schemes. It was reconstituted as Risk capital and Technology Finance Corporation Limited (RCTC) in January. The Government of India announces on November 25. In the private sector. certain banks. 1993 amounted to Rs. The cumulative sanctions and disbursements by TDICI as at the end of March. 1988. (2) Venture Fund of IDBI: The Industrial Development Bank of India (IDBI) also started venture capital scheme in 1986. viz.2 crores and Rs. 81.1 crores and 48. IFCI. The following are some of the institutions which have established venture funds in India. as discussed above. (3) Venture Capital Fund of SIDBI : The Small Industries Development Bank of India (SIDBI) has also set up a venture capital fund with an initial corpus of Rs.8 crores and Rs. Guidelines for Venture Capital Fund Companies. The aim of the scheme is to provide venture capital for potentially highly profitable venture involving innovative product technology / service aimed at futuristic or new markets. (i) Risk Capital Foundation of IFCI: The first venture fund in the name of Risk Capital Foundation was sponsored by the Industrial Finance Corporation of India (IFCI) in March. while under he Venture Capital fund of Rs. has set up the venture capital fund through its subsidiary SBI Capital Markets Limited. 10 crores form the World Bank) has been set up in July. 20 crores from IFCI and Rs.. A sizeable portion of the sanctions and disbursements were in respect of risk capital scheme. 10 crores during the year 1992-93. 38. The cumulative sanctions and disbursements under the scheme since its inception to the end of March. ICICI and SIDBI). It also manages the venture capital fund of Rs.3 crores respectively. 30 crores. (Rs. Technology Finance and Development Scheme and Venture Capital Unit Scheme. Risk Capital Scheme. 46.5 crores respectively. 1975. 1989 certain guidelines regarding establishment and functioning of venture capital funds companies. At present RCTC operates three schemes. 71. 1991. the Corporation provides supplementary assistance to new entrepreneurs particularly technologies and professionals for promoting medium – size industrial projects both in the form of rupee loans and direct subscription to their share capital. 30 crores which ICICI has established along with UTI in 1988. the Credit Capital Corporation has set up the Credit Capital Venture Fund India Ltd.1 crores respectively.Venture Funds in India : The venture fund or venture capital schemes is of recent origin in India.. 1993 stood at Rs. Grindlays Bank has also launched India Investment Fund. The funds is exclusively meant for providing financial assistance for innovative venture in small-scale sector. 66. (4) Venture Capital Fund of Technology Development and Infrastructure Corporation of India (TDICI): The Corporation has been set up by Industrial Credit Investment Corporation of India (ICICI) for providing technology information and financing commercial research and development schemes. The funds raised from abroad NRIs. The Corporation intends to involve multinational bodies like Asian Development Bank and Commonwealth fund in its financing. It is going to provide venture finance to suitable projects out of this fund. These guidelines are summarized below: 117 .

. Thus. Commercial banks have the advantages of having a large number of branches in rural areas. started mutual funds. It does not stand ready to redeem or repurchases these shares. However. therefore. SBI Mutual Fund. Mutual Funds A number of banking companies and some financial institutions have. Ministry of Finance or such authority as may be nominated by the Government. the promoters’ share shall not be less than 40%. their entry can be justified only when the mutual fund schemes succeed in mobilizing additional savings and investing them as per national priorities. Life Insurance Corporation of India have also entered this area. it is. The mutual fund scheme offers the advantages of high return. the mutual fund management sells a limited number of shares. The shares of such a mutual fund are purchased and sold in the secondary markets. the entry of commercial banks in the field of mutual fund has ended the monopoly if UTI and LIC and helped in providing stability to the stock market. Swarnpushpa Mutual Fund of Indian Bank. 118 .(1) Establishment : All India Public Sector Financial Institutions. The repurchase price is usually slightly lower than the selling price. The total investment in the enterprise should not exceed Rs. (2) Venture Capital Assistance : The assistance has to go mainly to enterprise where the risk element is comparatively high due to technology involved being relatively new and /or the entrepreneur being relatively new and not affluent through otherwise qualified. Canshare Fund or Canstock Fund or Canara Bank.management. GIC. easy liquidity. Such a mutual fund company invests the pooled funds of many shareholders and thus give them the benefit of diversified investment portfolio. Ordinarily the transaction of purchase of sale is made at the net assets value calculated every now and then. 2. safety and tax benefits to the investment while it offers the bank an opportunity to collect funds from untapped areas. Several commercial banks in India have recently entered inot the fields of mutual funds. (3) Size : The minimum size of Venture Capital Company / Fund would be Rs. 10 crores. The debt-equity ratio may be maximum 1:1:5. by forming separate subsidiaries. If it desired to raise funds from the public. hoped that their initiation of mutual fund schemes will benefit a large majority of rural populations and not only a small privileged minority living the urban areas. Most of the mutual funds started by the commercial banks in over country fall in this category. in all other cases approvals would be given by the Development of Economic Affairs. Of course. the fund itself is ready to buy back the shares surrendered and sell new shares. Besided ITI. 10 crores. (2) Close –end Mutual Funds: In case of these funds. The net assets value of the mutual fund increases or decreases depending up on the mutual fund. Boi Mutual Fund of Bank of India etc. Some other banks are also likely to enter this market. there is not fixed number of outstanding shares. viz. Mutual funds can be classified into two categories : (1) Open – end Mutual Funds: In case of these funds. Primary example of such a mutual fund is UTI master share. State Bank of India and other scheduled banks including foreign banks operating in India and the subsidiaries of the above would be eligible to start Venture Capita Venture/Companies subject to such approval as may be required from Reserve Bank of India in respect of banking companies.

financial and fiscal policy. controlling and protecting the book debts for is clients including the purchase of hi bill or receivable. as a result of factoring services. collecting. The is result in the following major benefits to the client: (i) (ii) (iii) Reduction in the cost of maintenance and collection of book debts. export and import potential. Credit administration: It includes the work of collecting the book debts. (v) Thus. Functions : The functions of a factoring credit institution can be grouped into the following categories: (i) (ii) (iii) (iv) Credit recording: It involves maintenance of debtor’s ledger. potentials for foreign collaboration. Finance and business information. Saving in time. etc. advertising and selling functions alone. etc. identification and selection of potential trade debtors. the record-keeping functions of sales. 119 . the RBI on January 19. It appointed a working group popularly known as Voghul committee to explore the possibility of encouraging the factoring service for collection of dues and book debts on behalf of the suppliers. discount allowed schedule. and the balance on maturity of book debts.. This improves the client’s liquidity position in the sense that book debts have been substituted by cash. impending development in commercial and industrial sector. debts. transfer of technology. Initially. It advised banks as well as private non-banking financial institution to develop factoring service.3. Credit protection: The factoring institution eliminates the risk of loss of the client by taking over the responsibility of book debts due to the client. seller or dealer in goods can concentrate on manufacturing. The Reserve Bank of India has initiated several measures to develop factoring service. book. 1998 constituted a Study Group under chairman ship of Shri Kalyan Sundaram to examine the feasibility and mechanism of starting factoring services. However. Credit financing: The factoring institution advances appropriation of the value of book debts of the clients immediately. and Monitoring of book debts and prevention of bad debts since the debentures would not like to be looked down in the eyes of factoring credits institution. A factoring institution also advice the client on the prevailing business trend. Factoring Institutions Concept : Factoring service has gained strong momentum in advanced countries of the West. collection schedules. the scope of factoring in modern times has considerably increased. man-power etc. The factoring institution receives service charges by way of discount or rebate deducted from the bill or bills. The committee recommended in its report in 1987 for introduction of factoring service in the country. bill receivable and their utilization are completely vested with the factoring agency. Thus. ascertainment of balance due. the manufacturer. needed for collection. and finance the client on the basis of his accounts receivable. the factoring was considered to be a financial service under which the factor usually a bank undertook collection of client’s debts. factoring service is more than simply a method of business finance. It is a continue service arrangement under which a financial institution undertakes the task of recording. As a follow up measure.

based on (a) the gross sales volume. On receipt of payment from the customer. Credit Rating Institutions 120 . Working Procedure : The working procedure involved in the factoring services can be summarized as follows: a.. At present there are two factoring companies operating in India. 25 crores. 4. These institutions have together launched a new company called SBI Factors and Commercial Services Ltd. (c) the number of invoices and credit notes. the Government of India notified factoring is an eligible activity for the banking. Madhya Pradesh and Goa States.. The share capital is held by the State Bank of India 54%. We are explaining below the details of the factoring services undertaken by SBI. the SBI factors send monthly statement of accounts to the supplier. It will be calculated as a percentage of the gross value of the invoices factored. f. The SBI factor provide pre-payment to the supplier up to 80% of the invoice value. c. 3.. In order to keep the supplier informed of the factors invoices. d. Canbank factors with is corporate office at Bangalore has jurisdiction over the southern States. A brief description of the institution and its functioning is given below: 1. While the SBI Factors with its corporate office at Bombay has jurisdiction over Maharashtra. Service Fee. a subsidiary of Canara Bank. The SBI factors sends on official notification and personalized statement of accounts of different customers of the supplier. Diu and Daman Union Teritory. SIDBI 20% State Bank of Saurashtra 10%. viz. The supplier invoices his customers in the usual way only adding the notification that the debt due on the invoice is assigned to and must be paid to the SBI factors. b. Union Bank of India 10% and State Bank of Indore 6%. it also performs the accounting function of sales ledger maintenance and collection function of realizing invoices purchased. Share Capital :The company has a subscribed share capital of Rs. (b) the number of customer. e. Ltd. The supplier offers assigned invoices to SBI factors with a schedule of offer accompanied by the receipted delivery challans. The service fee will range between two and five percent of the gross value of the invoices. in collaboration with Small Scale Industries Development Bank of India (SIDBI) and some other commercial banks. a subsidiary of State Bank of India and Canbank Factors Ltd. 1991 by the State Bank of India.As a result of the recommendations of the above group. 2. and (d) work involved in collection. SBI Factors & Commercial Services Pvt. Factoring Services by State Bank of India The first factoring service in India was launched with from September 1. The greatest benefit of the factoring services to the supplier is he can convert his invoice into instant cash upto 80% of his value without having to wait for the usual 30 or more credit days. : A service fee is levied for the work involved in maintaining sales ledger and collection of the debts on the invoices. the SBI factors pay the remaining 20% of the invoices value to the supplier. Gujarat.

its strengths and weakness. 121 . It provides reliable financial information and increased disclosure to investors. as on March 31. Mukand Oil & Steel works Limited. the cash flow and funds flow statements of the company concerned. At present there are a few credit rating institution in the country. etc. : CARE was also set up in 1993 by IDBI in collaboration withsome banks and financial services companies. debentures. (a) ONICRA : It was set up in 1993 by the Onida Group for assessing the credit worthness of the individuals seeking finance for purchase of consumer durables or trade credits..638.736 issues consisting of various types of debt Rs. it enables them to buy securities with confidence. 1998. it enables it to mobilize directly savings from individuals at reasonable cost. and debenture portion of equity linked debentures. Share Capital : CRISIL has a capital base of Rs. We are giving below briefly the details about each of these institutions. However. Limited. 1996 the number of cumulative credit rating assignments completed by CARE stood at 484 of which 445 related to debt instruments for a total debt of Rs. CRISIL is planning to undertake credit rating of all types of securities. These include (i) Credit Rating information and Services India Limited (CRISIL). once credit rating is made compulsory by the Government. There is no compulsion for any company to obtain or publicize the rating obtained from CRISIL. Mahindra Engine Steel Company Limited. Functions: CRISIL has proved to be a boon to both companies and investors through its following functions: (i) (ii) It provides an independent and unbiased report about the creditworthiness of company. During the year 1992-94 CRISIL launched the RATINGDIGEST. which is a compilation in five volumes of CRISIL Rating Reports organized by industries categories. while the quantitative criteria include the financial statements the accounting ratios. (iii) Onida Information and Credit Rating Agency of India Limited (ONICRA) and. (ii) Investment Information and Credit Rating Agency of India Limited (ICRA). Kirloskar Bros.14.Concept : The concept of credit rating originated in the USA. (c) Credit Rating Information & Services of India (CRISIL) : The Credit Rating Information & Services of India Limited (CRISIL) was set up by the financial institution on January 19. fixed deposits. Municipal Bonds of Ahmedabad Municipal Corporation etc. In 1995 – 96 it introduced CRISIL – 500 Equity Index. CRISIL has to evaluate and monitor the performance of a company through use of qualitative as well as quantitative criteria for evaluation. CRISIL has so far completed rating of 1. 1. (iv) Credit Analysis & Research Limited (CARE). The qualitative criteria include the company’s competitive position. to facilitate the processing of proposals and giving of approvals by the SEBI for companies going to the public for raising funds through issue of securities. 23. 1996. The primary objective ofcredit rating is to provide guidance to investors/creditors in determining the credit risk associated with a debt instrument/ credit obligation by and independent professional and impartial institution. viz. Thus. Some of the companies which have used CRISIL rating are Indian Petro Chemicals Limited (IPCL).873 crores. its management and business strategies. Sundaram Fiannce Limited (SFL). Progress of CRISIL. Thus. 4 crores. Working: At present CRISIL is restricting its rating only to debt instruments. Since its inception till March 31. (b) Credit Analysis & Research Ltd.

93. and 17 commercial banks are its shareholders. (CRISIL) ICR A has an authorized Capital of Rs. new development in India. However. The ICRA also performs credit rating functions and finalizes its rating norms and standards in consultation with Credit Rating Information & Services of India Ltd. Since its inception till end of March. 5 crores on private placement basis including with mutual funds. Industrial Finance Corporation of India (IFCI). It was incorporated on Jan. 1991. Infrastructure Leasing and Financial Services. It is expected that establishment of CRISIL. All issues of fully convertible into equity shares within 18 months from the date of issue at per determined price. Unit Trust of India.Credit rating analysis is relatively. obtaining credit rating by the concerned company / institution is optimal. 2. Issue of non-convertible debentures upto Rs. 16. 1996 ICRA has rated 778 debt instruments involving an amount of Rs. The Government has already announced compulsory rating for all debentures end bonds expect the following : 1. Progress of ICRA. ICRA formally known as the investment Information & Credit Rating Agency of India (ICRA) was promoted by the Industrial Finance Corporation of India (IFCI). where rating is required it is also obligatory for the concerned company to announce the result of rating. 1991 as public limited company and started functioning with effect from September 1. In the above cases. Housing Development Finance Corporation of India. Life Insurance Corporation of India. will provide a strong impetus to the systematic risk evaluation of specified corporate instruments as well as the companies issuing them. Public sector bonds and private placement of debentures with financial institutions – banks.380. (a) ICRA Ltd. General Insurance Corporation of India. 3. 10 crores. State Bank of India. 122 .

Saliers. from whatever source derived and their application to the current and future activities of the enterprise.” (2) “The sum of the current assets is the working capital of a business. accountants.” Thus we see there is no difference in authorities over the true concept of working capital. (3) “Any acquisition of funds which increases the current assets increase working capital also. In narrow sense. Mead Baker Malott.UNIT VIII WORKING CAPITAL MANAGEMENT Concept of Working Capital Like the broader concept of capital. Various financial theorists have used this term in a number of ways.W. Gerstenberg etc. businessmen and economists as to the exact meaning of the term ‘working capital’. short-term securities.” Weston & Brigham In the narrow sense. there is no universally accepted definition of working capital. They prefer to all it as ‘Circulating Capital’ so we shall have to go through the various concepts of working capital before reaching at any conclusion. Other writers think of working capital as being equal to the total of the current assets. but to the management it reflects and financial planning or presence of ideal assets or over 123 .S. They include the name of E.E. This is the definition used by most financial experts and authors emphasizing the accounting phase of finance. E. and C. Definitions of working Capital In the broad sense.” J. Lincoln. Gerstenberg defines it as follows : “It has ordinarily been defined as the excess of current assets over current liabilities. for they are one and the same”. Bonneville (4) ‘Working capital refers to a firm’s investment in short-term assets – cash. the total current assets approach has a broader application and it is more inviting to the financial management. (1) “Working Capital means current assets. The total current assets minus current liabilities approach refers to net working capital. Some explain it in a narrow sense while some others in a very wide sense. accounts receivable and inventories. The following are some definitions of this group. It takes into consideration all the current resources of the enterprise. the term ‘working capital’ is used to denote the ‘total current assets’. In the words of Walker and Bauglin. some writers like Gerstenberg are not ready to call it as ‘working capital’. the working capital is regarded as the excess of current assets over current liabilities. On the other hand.A. it is quite true. some authorities define the term as the difference between current assets and current liabilities. “A good current ratio may mean a good umbrella for creditors against ‘rainy day’. the true difference is on it quantity. “Unfortunately there is so much disagreement among financiers. As Gilbert Harold puts this problem. Mill.

permanent working capital changes constantly its form from one asset to another whereas fixed assets retain their form over a long period of time. Thus. Thus. minimum amount of current assets which firm has to hold for all the time to come to carry on operations at any time is termed as permanent or regular working capital. Time is an important variable which influences pattern of financing working capital requirements. It represents ‘hare core’ of the working capital. From the viewpoint of the finance manager this basis of classification is helpful since it categories the various areas of financial responsibility. working capital may be categorized as permanent and variable working capital. Using times as a basis. The following are the some worth mentioning advantages of maintaining an ample working capital fund in the business. A manufacturing enterprise has to carry irreducible minimum amount of inventories necessary to ensure continued production and sales. for example.” Actually speaking. the suppliers should not expect its return until the business ceases to exit. it is not completely adequate as it does not mention about time. Over and above permanent working capital. a successful financial executive is interested not in maintaining a good current ratio but in maintaining an adjustable account assets so that the business may operate smoothly.capitalisation. If it becomes weak. Funds requirements for this purpose are of short duration. inventories and receivable require careful planning and control if the firm is to maximize its return on investment. it generally refers to the gross’ working capital. Thus. Kinds of Working Capital Working capital can be classified on the basis of its composition. the business can hardly prosper and survive. Further. For instance. size of which depends upon changes in levels of production and sales resulting from changes in market conditions. Its proper circulation provides to the business the right account of cash to maintain regular flow of its operations. Receivable increase following periods of high sale. fund of value representing permanent working capital never leaves the business process and therefore. funds invested in cash. Likewise.- 124 . some amount of funds lie tied in receivables where the firm sells goods on credit terms. we can have gross working capital comprising current assets and net working capital representing current assets minus current liabilities. Extra cash may be need to pay for additional supplies following expansion in business activity. in periods of dull business conditions when most of the produce remains held in stock due to precipitate fall in demand. Similarly. It is an index of the solvency of a concern. Some amount of cash has also to be held by the firm so as a to exploit business fluctuations. the firm may need additional current assets temporarily to satisfy seasonal/cyclical demands. While the above classification is very significant to the financial management. Importance of Working Capital Working Capital is just like the heart of business. added inventory must be held to support the peak selling periods. This additional amount of working capital represents variable or temporary working capital. That’s if the term ‘working capital is used without future qualification. the company would require additional cash to tide over the crises. permanent working capital will tend to expand so long as the firm experiences growth in its operation. Excess amount of working capital may be carried to face cut-throat competition or any other contingencies like strikes and lockouts. Finally. Permanent working capital represents current assets required on a continuous basis over the entire year.

The importance of working capital can be very well explained in the words of Husband and Dockery : “The price object of management is to make a profit. Thus the need for maintain an adequate working capital can hardly be questioned. public utility services have large fixed investment. Industrial and manufacturing enterprises on the other hand. Production Policies – The nature of production policy also exercises its impact on capital needs. in no small measure. (3) Meeting unseen Contingencies – It Provides Funds for unseen emergencies so that a business can successfully said through the periods of crisis. A high level production plan also involves higher investment in working capital. (5) Good Bank Relations – Good relations with banks can also be maintained. Rail roads. generally required a large amount of working capital. Determinants of Working Capital (The amount of working capital) There are numerous factors which affect the working capital of a concern. Strong seasonal movement have special workings capital problems and requirements. if it is financed through own working capital. (9) Profitability Increased – The profitability of a concern also depends. smooth flow of funds is very necessary to maintain the health of the enterprise. trade credit and can escape insolvency. (8) Expansion Facilitated – The expansion programme of a firm is highly successful. (6) Fixed Assets Efficiency Incurred – Fixed assets of the firm also can not work without proper amount of working capital. (2) 125 . innovation and technical developments are possible to undertake without sufficient among of working capital. the appraisal of which assets management in formulating its policies and estimating its prospective requirements. Just as circulation of blood is very necessary in the human body to maintain life. without it.(1) Cash Discount – If proper cash balance is maintained. The important factors are as follows: (1) Nature of Business – The effect of the general nature of the business on the working capital requirements can not be exaggerated. A rapid turnover of capital (sales divided by total assets) will inevitably meant a larger proportion of current assets. Every activity of the business directly or indirectly affects the current position of the enterprise hence its needs should be properly estimated and calculated. so they have the lower requirements for current assets. on the right proportion of fixed assets and current assets. the business can avail of the cash discounts facilities offered to it by the suppliers. and other. (7) Research and Innovation Programmes – No research programme. (2) Liquidity and Solvency – The proper administration of working Capital enhances the liquidity in funds and solvency and credit – worthiness of the concern. Whether or not this accomplished in most business depends largely on the manner in which the working capital is administered. The enterprise by maintaining an adequate amount of working capital is able to maintain a sound bank credit. (4) High Morale – The provision of adequate working capital improves the morale of the executive and their efficiency reaches it highest climax. fixed assets are like guns which can not shoot as there are no cartridges.

When the price level is up due to boom conditions. he inflationary conditions create demand for more working capital. naturally a large sum of money will have to be kept invested in the form of working capital. a small sum of money invested in stocks will result in sales of a much large amount. payment can be postponed for some time and can be made out of the sale proceeds of the goods produced. it is logical to except the larger amount of working capital will be required. Rapidity of Turnover – Turnover represents the speed with which the working capital is recovered by the sale of goods. requirements of working capital will be rather large. if it takes long to manufacture the finished project. Terms of Purchases – If continuous credit is allowed by supplier. Other Factors – In addition to the above considerations there are a number of other factors affecting the requirements of working capital. required level of liquidity in funds and risk assumption. Length of period of manufacture – The time which elapses between the commencement and end of the manufacturing process has an important being upon the requirements of working capital. Often variations in need. But if the importance of raw materials is small. (4) (5) (6) (7) (8) (9) (10) (11) A prudent financial manager is always manger is always interested in obtaining the correct amount of the working capital at the right time. the requirements of working capital will naturally be small. The requirement of working capital also varies with economic circumstances and corporate practices. lack of co-ordination in production and distribution policies. dependability upon the source and flexibility in financial planning must be given due weightgae. of working capital bring about an adjustment of dividend policy. market for short-term funds. The greater the requirements of cash. Dividend Policy of the Concern – If conservative divided policy is followed by the management the needs of working capital can be met with the retained earnings. for example. It will reduce the requirements of more working capital. In such a case the requirements of working capital will be reduced. Requirements of Cash – The working capital requirements of a company is also influenced by the amount of cash required by it for various purposes. In this manner. Growing concerns require more working capital than those that are static. In certain business. Growth with Expansion of Business – As a company gross. 126 . To adopt the right sources it is very necessary for him to have a through understanding of the firm’s short-term funds needs. at a reasonable cost at the best possible favourable terms. the higher will be the working capital costs of the company. In making any final choice as regards to sources of working capital the relative cost of financing. Business Cycles – Requirements of working capital also very with the business cycles. During depression also a heavy amount of working capital is needed due to the inventories being locked unsold and book debts uncollected. the fiscal and tariff policies of the government etc. The relationship between divided policy and working capital is well established and mostly companies declare divided after careful study of cash requirements. The period of credit received and allowed also determines the working capital requirements of the enterprise. sales are made quickly so that stocks are soon exhausted and new purchases have to be made.(3) The proportion of the cost of Raw Materials to Total Costs – In those industries where cost of materials is a large proportion of the total cost of the goods produced or where costly raw material is used. A firm interested to obtain short-term funds has a choice of securing finance from alternative sources – internal as well as external.

(2) Sale of Debentures – Debentures are also an important source of long-tern working capital because they are fixed cost sources. Security of Employees 9. Sale of debentures Internal 3. Factoring 4. Accrued expenses 1. Credit papers 3. Ploughing profits back of 1. (5) Term Loans . along with it. 127 .The loans raised for a period varying from 3 to 5-7 years are also important sources for working capital. Customer’s credit 6. This capital can be conveniently financed by the following sources – (1) Share Capital – A part of long-term working capital can be financed with the share capital. 8. Sale of shares 2. Sale of idle fixed 5. Assistance 7. the minimum level of investment in various current assets also determines the requirement of long-term working capital. Trade Credit 2. (4) Sale of Fixed Assets – Any idle fixed asset can be sold out and sale proceeds can be utilized for financing the working capital requirements. Loans from Directors etc. Such loan usually increases the working capital of the enterprises.Sources of Working Capital : The following chart gives a snapshot view of various sources of working capital available for a firm: Working Capital Sources Long – term Sources Short – term sources 1. Rights Debentures have also been very popular in India since 1978. It is regular and cheapest sources of working capital as it does not involve any explicit cost of capital. Bank credit 4. (3) Ploughing back of profits – A part of the earned profits may be ploughed back by the firm in meeting their working capital requirements. Public deposits 5. this type of finance is ordinarily repayable in installments. Depreciation funds 2. Long-term loans Financing of Long-tem working Capital The long-term working capital requirements include the initial working capital and the regular working capital. Govt. Provision for taxation 3.

some authors of business finance do not accept them as a source of funds but it is not reasonable. Loans an also to obtained from other fellow companies working within the same group. managing directors etc. The customers are often asked to make some advance payment in cash in lieu of a contract to purchase. the duration of such requirements does not exceed beyond a year. – An enterprise can also obtain loans from it officers. (4) Public Deposit – Public deposits are also an important source of shot-term and medium – term finance. The use of trade credit has increased in recent years due mainly perhaps to the credit squeeze. (3) Credit Papers – In the category of credit papers. Such advance can be utilized in purchasing raw material paying wages and so on. no interest is charges on them. Some times. cash credits. These loans are often obtained at almost negligible rates of interest. central and state governments also provide short-term finance on easy terms. bills of exchange and promissory notes of shorter duration varying between a month and six months are used. (2) Provision for Taxation – The provisions for taxation can also be used by the companies as a source of working capital during the intermitant periods. These papers are discounted with a bank and capital can be arranged. they provided working capital in a number of ways such as overdrafts. line of credit. (a) Internal Sources (1) Depreciation Funds – The depreciation funds constitute important source for working capital. Normally.If employee’s are required to make deposits with their employer companies. (6) Governmental Assistance – Sometimes. 128 . such companies can utilize those amounts in meeting their working capital needs. Compared with other methods of borrowing this is the most flexible source because when the debt is no longer required it can be quickly and early reduced. short term loans etc. It is also comparatively cheap. The sources of short-term working capital may be internal as well as external. The trade credit may also assume three forms :purchase on open account. (7) Loans from Directors etc. Due to shortages of bank credit in recent past. directors. the importance of public deposits has increased. (5) Customer’s Credit – Advances may also be obtained on contracts entered into by the enterprise. purchasing on furnishing a pronote for specified period and purchase on trade acceptance (i. Accommodation bills is an important method of such finance.e. They have been very popular among Indian companies during last three years. (3) Accrued Expenses – The firm can postpone the payment of expanses for short periods. (b) External Sources (1) Trade Credit – One of the most important forms of short term finance is the trade credit extended by one business enterprise to another on the purchase and sale of goods and equipment.Financing of short-term Working Capital This category of funds covers the need of working capital for financing day-to-day business requirements. bills payable) (2) Bank Credit – Commercial banks are also principal source of working capital. (8) Security of Employee . Hence these accrued expenses also constitute an important source of working capital.

rapidity of turn-over. But this finance is not cheap in comparison to bank credit etc. It shows the behaviour of working capital with the volume of output or estimated sales. the problem of working capital forecast should be dealt within the overall financial requirements of the concern. Its form assuring more or less a summary of cashbook. The forecast of working capital requirements of a concern is not an easy job. so that cash is received earlier than it the company waited of the debtors to pay. then the current requirements of the assets and cash flow for that period are to be estimated. So. seasonal fluctuation. The study of cash flow will reveal how much cash is available to meet the current assets requirements.(9) Factoring – Factoring involves raising funds on the security of the company’s debts. (d) Profit and Loss Adjustment Method – Under this method the forecasted profits are adjusted after adding the cash inflow and deducting the cash outflows. 1. Estimation of Components of Working Method : Since Working capital is the excess of current assets over current liabilities. length of manufacturing process. There are three popular methods available for forecasting working capital requirements: (b) Cash Forecasting Method – In this method the position of cash at the end of the period is shown after considering the receipts and payments to be made during that period. some experts of finance suggest that in estimations the working capital requirements. But. Techniques for assessment of Working Capital Requirements. This shows the deficiency or surplus of cash at the definite point of time. nature of business. (c) The Balance Sheet Method – In the balance sheet method of forecasting. The basic object of forecasting working capital needs is either to measure the cash position of the enterprise or to exercise control over the liquidity position of the concern. etc. the total current assets requirement should be forecasted. the difference between the two is taken which will indicate either cash surplus or cash deficiency. But. however. Besides this a Finance Manager can apply any of the following techniques for assessing the working capital requirement of a firm. The basic idea under method is to adjust the estimated profits on cash basis. are to be considered by the Financial Manager. Afterwards. The main object of preparing a working capital budget is to source an effective utilization of the investment in current assets. Forecasting Techniques of Working Capital If the working capital is to be estimated for the ensuring year. a number of factors viz. is contention is not justified on logic as the short term needs of the funds are equally vitally affected by the nature and composition of fixed assets. credit policy. Hence. Estimating Working Capital Requirements In order to determine the amount of working capital needed by a firm. the circular flow of working capital does not occur automatically and it is the essential responsibility of management to guide it in proper proportions through the production machine. Thus the factors help in improving the company’s liquidity position. an assessment of the working capital requirements can be made by 129 . Following is a brief explanation for the various techniques for assessment of a firm’s working Capital requirements. a forecast it made of the various assets and liabilities of the business. A forecast of working capital requirements can also be called a working capital budget. The concept of working capital is closely related to that current assets. Production policies.

cash. Work-in progress stage.00 The basic criticism of this method that it presumes a linear relationship between sales and working capital. accounts payable etc. It may be broadly classified into the following four stages viz. the requirements of working capital depends upon the operating cycle of the business. Percent of Sales Method: This is a traditional and simple method of estimating working capital requirements.g. This is not true in all cases san method is nto universally accepted. Debtor’s collection period. Finished goods inventory stage. the amount of working capital requirement can be assessed as Rs. and Receivable collection stage.estimating the amounts of different constituents of working capital e. a ratio can be determined for estimating the working capital requirements in future. The duration of the operating cycle for the purpose of estimating working capital requirements is equivalent to the sums of the duration of each of these stages less the credit period allowed by the suppliers of the firms. For example. 2. One lack. Operating Cycle Approach : According to this approach. (i) (ii) (iii) (iv) Raw materials and stores stage. Work in process period. the duration of the working capital cycle can be put as follows: O=R+W+F +D–C Where. According to this method. Finished stock storage period.. Creditor’s payment period. inventories. Symbolically. 30. The operating cycle begins with the acquisition of raw materials and ends with the collection of receivables. on the basis of pas experience between sales and working capital requirements. 3. O R W F D C = = = = = = Duration of opening cycle Raw materials and stores storage period. Each of the component of the operating cycle can be calculated as follows: Average stock of raw materials and stores R = --------------------------------------------------------------------------------Average Raw Materials and stores consumption per day Average work in process inventory W = -------------------------------------------------------------------------------Average cost of production per day 130 . if the past experience show that working capital has been 30% of sales and its is estimated that the sales for the next year would amount to Rs. accounts receivable.

one way of determining the level of trade-off is by finding the average working capital so obtained may be financed by long-term 131 .making. but mote costly as compared to the hedging approach. funds required for purchase of core current assets. However. the maturity of sources of funds should match the nature of assets to be financed. In other words conservative approach is “low profit – low risk” (or high cost. The short-term sources should be used only for emergency requirements. The level of such trade-off will differ from case to case depending upon perception of the risky by the persons involved in financial decision. low net working capital).e. The total operating expenditure in the year when divided by the number of operating cycles in a year will give the average amount of the working capital requirements. high net working capital) while hedging approach results in high profit-high risk (for low cost. The hedging and conservative approach are both on two extremes. (ii) The Conservative Approach – According to this approach all requirements of funds should be meet from long-term sources. funds which fluctuate over time. Permanent Working Capital.Average finished stock inventory F = --------------------------------------------------------------------------------Average cost of goods sold per day Average book debts D = ---------------------------------------------------Average credit sales per day Average trade creditors C = ---------------------------------------------------Average credit purchases per day After computing the period of one operating cycle. The conservative approach is less risky. It divides the requirements of total working capital funds into two categories. a.e. (i) The hedging approach – According to this approach. b. The approach is therefore also termed as “Matching Approach”. Approaches for Determining the Finance Mix There are three approaches for determining the working capital financing mix. (iii) Trade-off between hedging and conservative approached. The permanent working capital requirements should be financed by long-term funds while the seasonal working capital requirements should be financed out of short-term funds. total number of operating cycles that can be completed during a year can be computed by dividing 365 days with the number of operating days in a cycle. i. Temporary or Seasonal Working Capital. i. Such funds do not vary over time. Neither of them can therefore help in efficient working capital measurement. A trade-off between these two can give satisfactory results.

500 [i. from short-term sources while any extra capital required any time during the period. current liabilities) 132 .e.000) 2].e. The firm should therefore finance Rs. the average level comes to Rs. the minimum working capital required is estimated at Rs. 12.000 from long-term sources while any extra capital required any time during the period. (10. if during the quarter ending 31 st March. from short-term sources (i. 10.funds and the balance by short-term funds.000 + 15.000 while the maximum at Rs. 12. 15..000. For example.

total number of operating cycles that can be completed during a year can be computed by dividing 365 days with the number of operating days in a cycle. The permanent working capital requirements should be financed by long-term funds while the seasonal working capital requirements should be financed out of short-term funds. the maturity of sources of funds should match the nature of assets to be financed. Such funds do not vary over time. i. funds required for purchase of core current assets. The short-term sources should be used only for emergency requirements. funds which fluctuate over time. (i) The hedging approach – According to this approach. 133 . Temporary or Seasonal Working Capital.e. i. Approaches for Determining the Finance Mix There are three approaches for determining the working capital financing mix. (ii) The Conservative Approach – According to this approach all requirements of funds should be meet from long-term sources. a. It divides the requirements of total working capital funds into two categories. Each of the component of the operating cycle can be calculated as follows: Average stock of raw materials and stores R = --------------------------------------------------------------------------------Average Raw Materials and stores consumption per day Average work in process inventory W = -------------------------------------------------------------------------------Average cost of production per day Average finished stock inventory F = --------------------------------------------------------------------------------Average cost of goods sold per day Average book debts D = ---------------------------------------------------Average credit sales per day Average trade creditors C = ---------------------------------------------------Average credit purchases per day After computing the period of one operating cycle. b. The approach is therefore also termed as “Matching Approach”.C = Creditor’s payment period. Permanent Working Capital. The total operating expenditure in the year when divided by the number of operating cycles in a year will give the average amount of the working capital requirements.e.

000) 2]. Neither of them can therefore help in efficient working capital measurement.000 + 15. 15. the minimum working capital required is estimated at Rs.000 from long-term sources while any extra capital required any time during the period. (10.e.. However.e. but mote costly as compared to the hedging approach. one way of determining the level of trade-off is by finding the average working capital so obtained may be financed by long-term funds and the balance by short-term funds. The firm should therefore finance Rs. if during the quarter ending 31 st March.The conservative approach is less risky. A trade-off between these two can give satisfactory results. 12.500 [i.000 while the maximum at Rs. current liabilities) 134 . 12.000. the average level comes to Rs. 10. low net working capital). The level of such trade-off will differ from case to case depending upon perception of the risky by the persons involved in financial decision.making. from short-term sources (i. In other words conservative approach is “low profit – low risk” (or high cost. from short-term sources while any extra capital required any time during the period. The hedging and conservative approach are both on two extremes. For example. (iii) Trade-off between hedging and conservative approached. high net working capital) while hedging approach results in high profit-high risk (for low cost.