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FINANCIAL MANAGEMENT I BY CA. R.C.

AGARWAL
TIME VALUE OF MONEY
Growing Annuity
when the cash flow grows at a constant rate
for a specified period
e.g. office rent @ 20000 per year and increase
per year 3% and rate of discount is 10%
The PV for one year will be will be
(20000 x 1.03)/1.10
PV for next five years will be PV of a growing
annuity=An(1+g){ [1-(1+g)
t
/(1+r)
t
] /r-g}
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
TIME VALUE OF MONEY
Growing Annuity
PV of growing An= 20000(1.03)
{ [1-(1.03)
5
/(1.10)
5
] / 0.10-0.03 } =
20600{[1-(1.159/1.610)] / 0.07
= 20600 (1-0.72)/0.07 = 20600(0.28 /
0.07)
= 20600x4 = 82400
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
TIME VALUE OF MONEY
PERPETUITY
A Perpetuity is an annuity of infinite period
PV of Perpetuity= An/r
e.g. you will make an income of 60 per year in
perpetuity with an interest rate of 9%
PV of Perpetuity will be 60/0.09 = 667
Growing Perpetuity PV will be=An/(r-g) assume
growth rate is 3%
60/(0.09-0.03)=60/(0.06)
60/0.06 = 1000
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
THE COST OF CAPITAL
A PRESENTATION
BY
CA. R.C.AGARWAL
THE COST OF CAPITAL -
SIGNIFICANCE
Provides very basis for financial appraisal of new
capital Exp. Proposals. It serves as acceptance
criterion for the new project
Helps in determining the optimal capital structure
Helps in evaluating the financial performance of top
management
Helps in formulating Dividend policy and Working
capital policy
It is the firms required rate of return which will just
satisfy all capital providers
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
THE COST OF CAPITAL
Important business decisions require capital
Rate of return should exceed the cost of capital
Compensations plans of companies use the concept of
Economic Value Added (EVA). EVA is the difference
between operating profits after taxes and charge of
capital.
Charge of capital is multiplying the capital amount by
cost of capital. Therefore, cost of capital is an important
component of compensation schemes also.
Cost of capital is an important factor in choosing the
mixture of debt and equity
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
THE COST OF CAPITAL
Basic conditions
New investment has similar risk as
the typical or average investment
undertaken by the firm
Proposed investment does not
change financing policy of the firm
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
THE COST OF CAPITAL
Characteristics
It is really a rate of return and not the cost
Rate of return calculated on the basis of actual
cost of different components of capital
Usually related to long-term capital funds
It is used as discount rate to arrive at PV
It has two components
Return at Zero risk level
Risk premium
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Classification of cost of capital
Explicit and Implicit cost
Explicit cost relates to raising of
funds i.e. rate of return of the cash
flows of financing opportunity
Implicit cost relates to usage of
funds i.e. rate of return associated
to best investment opportunity
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Classification of cost of capital
Average cost and Marginal cost
Average cost is weighted average
cost of each component of funds
Marginal cost is weighted average
cost of new funds raised by the
firm
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Classification of cost of capital
Future cost of capital
Historical cost means the cost of
capital incurred in procuring funds
in past
Future cost refers to expected
cost to be incurred in raising new
funds
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Classification of cost of capital
Specific cost and Combined cost
Specific cost means cost of
individual components
Combined cost means average
cost of capital of all sources of
capital
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
THE COST OF CAPITAL
Discount rate / opportunity cost is called cost
of capital
Major capital components are equity,
preference and debt
Cost of capital = weighted average cost of
various capital components used (WACC) or
Average rate of return required by investors
who provide capital
Cost of capital (WACC) is used for
evaluating investment projects
determining capital structure etc
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
THE COST OF CAPITAL
Company cost of capital V/s
Project cost of capital
Company Cost of capital=return
expected by existing investors
Project cost of capital = return
expected by investors in new
project
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
THE COST OF CAPITAL
Rational
If rate of return on investment is more than cost of capital
shareholders benefit
ABC used equity and debt in equal proportion and cost is 14%
and 6% respectively. Cost of capital = 0.5x14+0.5x6= 10%
Firm invests total 100 and rate of return is 12% the benefit will
be = (total return on project intt. on debt) / equity funds =
[(100x0.12) (50x0.06)] / 50 = 18%
Therefore return on equity comes to 18% which is more than
14% cost of equity, equity shareholders benefit
Return an investor expects to receive is cost to
company
Concept of WACC
ABC uses equity 50%, preference 10%
and debt 40% and the respective cost is
16%, 12% and 8% respectively
WACC= (Proportion of equity)(cost of
equity) + (proportion of preference) (cost
of preference) + (proportion of debt)(cost
of debt)
WACC will be?
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Concept of WACC
WACC will be
WACC=(0.5)(16)+(o.10)(12)+
(0.40)(8) = 12.4%
Assumed non-convertible, non-
callable preference; and non-
convertible, non-callable debt
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Concept of WACC
Cost of short term debt like Commercial
paper has to be taken in consideration as
the investors of short term debt also have
claim on the operating earning of the
company
Non intt. bearing liabilities e.g. trade
creditors are not taken in A/c as the cost of
such debt is already taken in account in
purchase price
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Basic conditions for using WACC for
evaluating new investments
Risk of new investment is same as that of
average risk of existing investments
Capital structure of the firm will not be effected
due to new investment
WACC is the discount rate of the project which is
a carbon copy of the existing business
WACC can be used as the base hurdle rate to
be adjusted for variations in risk and financing
pattern
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of Debt and Preference
Debt and preference require fixed payments hence
estimating cost is almost similar
Debt is raised through debentures, bank loans,
commercial paper etc. Cost of debt is weighted average
rate of different type of debt used
Weighted average rate of debt is calculated using market
values and yield to maturity (YTM) or current rate at
which the firm can raise new debt
As the interest on debt is tax deductible exp. pre-tax cost
of debt to be adjusted for tax factor to arrive at post tax
cost of debt
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of Debt and Preference-
cont
Cost of debenture= P
o
=sum of (I)/(1+r
d
)
t
+
(F)/(1+r
d
)n

P
o
= current market price of deb.
I = annual intt. payment
F = maturity value of deb.
r
d
= cost of deb.
n = no. of years left to maturity

FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of Debt and Preference-
cont
As computation of rd requires trial and error
method following formula can be used
r
d
= {I + [(F-P
o
)/n]}/0.6xP
o
+0.4xF
e.g. Face value 1000
coupon rate 12%
remaining period of maturity
4 years current market price 1040
rd i.e. YTM = {120+[(1000-1040)/4]} /
0.6x1040+0.4x1000=10.7%
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of Debt and Preference-
cont
Cost of bank loan= current market rate
of intt. as Bank loan is not traded in
secondary market.
If the company has taken loan earlier @
13% but now the loan can be obtained @
12%
If rate on which fresh loan can be raised
is 12%, that will be treated as cost
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of Debt and Preference-
cont
Cost of commercial paper i.e. short term
debt instrument issued on a discount and
redeemed at par. The cost is implicit intt. rate
e.g. ABC ltd. commercial paper face value is
10,00,000, remaining period to maturity is 6
months and traded in market at 9,65,000
The cost = (10,00,000/9,65,000) 1
= or (10,00,000-9,65,0000)/9,65,000 =0.0363
Annualized rate will be (1.0363)
2
-1=

.0739 or
7.39%
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of Debt and Preference-
cont
Weighted average cost of debt

Debt Face market coupon curr.rate
Value Value Rate
NCD 100 104 12% 10.7%
Bank loan 200 200 13% 12%
Com.Paper 50 48.25 NA 7.39%
total 352.25
Tax rate is 35% Calculate WACC
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of Debt and Preference-
cont
Weighted average cost of debt
Average cost of debt
=10.7%(104/352.25)+12%(200/352.25)+
7.39%(48.25/352.25)=10.98
Current rate = rate at which new debt can
be raised
Post-tax cost of debt= pre-tax cost(1-tax
rate)=10.98(1-0.35)=7.14%
Cost of Long term Debt
Debt at par
r
d
= (1-t
c
)r
r
d
= cost of long term debt
t
c
= Marginal tax rate
r = Debenture interest rate
XYZ has issued 10% Deb. And tax rate is
60% the cost will be:
(1-0.6)10 = 4%
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of Long term Debt
Debt at premium or discount
r
d
= (I/Np)(1-t
c
)
I = Annual interest payment
Np = Net proceeds of loans
XYZ issues 10% irredeemable Deb. Of Rs. 1,00,000
and tax rate is 60%
At par = (10,000/1,00,000)(1-0.60)= 4%
At 10% discount = (10,000/90,000)(1-0.60) = 4.44%
At 10% premium =(10,000/1,10,000)(1-0.60)=3.63%
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of Debt and Preference-
cont
Cost of preference
Preference capital carries fixed Div. and is
redeemable.
Due to preference Div., principal repayment
commitment and absence of tax. The cost =
its yield = r
p
= YTM
Dividend is not tax deductible exp.
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of Debt and Preference-
cont
Cost of preference
E.g. preference face value 100
Dividend rate 11%
Maturity period 5 years
Market price 95
r
p
= {I + [(F-P
o
)/n]}/0.6xP
o
+0.4xF
r
p
={11+[(100-95)/5]}/0.6x95+0.4x100 = 12.37
Cost of Preference
It can also be calculated as:
Dividend / Face value Issue cost
ABC issues 9% preference shares at
Rs.85 par value. Cost of issue is Rs.3 per
share
Preference dividend will be 85X9 = 7.65
7.65 / 82 i.e. (85-3) = 9.33%
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of equity
Equity finance can be obtained by
Retention of earnings involves cost, as opportunity
cost is lost by shareholders. Only flotation cost is not
involved
Issue of additional equity
Cost of equity or the return required by equity holders is
same in both cases
Hence in both cases cost of capital is same
Cost of equity means cost of retained earnings and cost
of external equity
There is no definite commitment to dividend
Equity to provide higher expected rate of return than
debt of the company

FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of equity
The required rate of return=expected rate of
return
r
e
=R
f
+ R
p
= (D
1
/P
o
)+g
r
e
=cost of equity
R
f
=risk free rate
R
p
=risk premium
D
1
=dividend expected to be paid
P
o
=current price of the stock
g=expected growth rate of dividend
Cost of equity
E/P (earning price ratio) Ratio method: (E
o
/P
o
)X100
E
o
= current earning per share
P
o
= current market price per share
A has 5 EPS Current market price is Rs. 50
The r
e
= (5/50)100 = 10%
Limitations:
Earning do not represent expectations of shareholders
Earnings are not constant
There should not be debt capital
All earnings should be paid to shareholders
There is no growth in earnings
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of equity
E/P Ratio + Growth rate method:
[E
o
(1+b)
3
]/P
o

(1+b)
3
= Growth factor i.e. b is growth rate as a
% and estimated for 3 years
A has 5 EPS with 10% growth rate earning for a
period of 3 years. Current market price is Rs. 50
r
e
= {[5(1+.10)
3
]/50}100
{[5(1.331)/50}100 = (6.665/50)100 = 13.31%
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of equity
Risk premium approach
Cost of equity=Yield on long term
bonds + Risk premium
Firm having high risk have high cost
of debt will have high cost of equity
Difficult to determine risk premium
Cost of equity
D/P (Dividend price ratio) Ratio method:
(D
o
/ P
o
)100
D
o
= Dividend per share
P
o
= Market price per share
Market price Rs. 15 and dividend rate is 15% (par value
Rs. 10 per share)
(1.5/15)100 = 10%
Assumptions:
Risk remains unchanged
Investors desire to have dividend
Shares are purchased at par
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of equity-cont
Dividend growth approach
If dividend is expected to grow at constant rate
P
o
=D
1
/(r
e
-g) or r
e
=(D
1
/P
o
)+g
P
o
=current price of stock
D
1
=dividend expected to be paid at the end of year
r
e
=required rate of return on equity
ABC ltd. market price of share is Rs. 50.
Expected dividend Rs. 4 at the end of year. Approximate
growth rate 5% p.a. The share price should be:
50 = 4/(r
e
0.05) = 4/(0.13-0.05) = 4/0.08
r
e
= (4/50)+0.05 = 0.08 + 0.05 = 13%
Required return = dividend yield + expected growth rate
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Cost of equity-cont
Dividend growth approach
Expected growth to be determined by averaging
the growth of dividend declared in last few years
Or multiply retention rate(1-dividend payout rate)
x expected future return on equity (ROE)
e.g. retention rate is 0.60 and return on equity is
15%
Expected growth i.e. g= (0.6)(15%)=9%
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Determining proportion
Proportions=target capital structure
weights stated in market value terms
Purpose of using target capital structure is
that present capital structure may not
reflect capital structure expected to remain
in future
For calculating weights use market value
and if not available than use book value.
Investors expect return on market value
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Weighted average cost of capital
Multiply specific cost of each source of financing
by its proportion in capital structure and add
weighted values
WACC=w
E
r
E
+w
p
r
p
+w
D
r
D
(1-t
c
)
WACC=weighted average cost of capital
w
E
=proportion of equity
r
E
=cost of equity
w
p
=proportion of preference
r
p
=cost of preference
w
D
=proportion of debt
r
D
=cost of debt
t
c
=corporate tax rate
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Weighted average cost of capital
WACC=weighted average cost of capital
w
E
=proportion of equity 0.60
r
E
=cost of equity 16%
w
p
=proportion of preference 0.05
r
p
=cost of preference 14%
w
D
=proportion of debt 0.35
r
D
=cost of debt 12%
t
c
=corporate tax rate 30%
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Weighted average cost of
capital-cont
Source of capital Proportion Cost Weighted cost
(1x2)
Equity 0.60 16% 9.60%
Preference 0.05 14% 0.70%
Debt 0.35 8.4% 2.94%
WACC= 13.24%
Cost of debt= 12x(1-0.30)=12x0.70=8.4%
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Weighted marginal cost of
capital
In market suppliers expect more return to
provide more capital
Estimate cost of each source of financing for
various levels of its use through expectation of
investors and lenders
Identify breaking points i.e. where cost of new
component would change
Calculate WACC for various range of total
financing between breaking points
Prepare weighted marginal cost of capital
schedule which reflects WACC for each level of
total new financing
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Weighted marginal cost of
capital-cont
Example
ABC ltd. decides to use Equity 40% and Debt 60%
Cost of each source of finance for various levels of use
is
Source of finance range of new finance cost
Rs. in lakhs
Equity 0-30 18%
More than 30 20%
Debt 0-50 10%
More than 50 11%
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Weighted marginal cost of
capital-cont
Breaking points

Source of cost range of new breaking range of total
Capital newfinancing point new financing
(Rs.inlakhs) Rs.inlakhs Rs.inlakhs
Equity 18% 0-30 30/0.4=75 0-75
20% above 30 -- above 75
Debt 10% 0-50 50/0.6=83.3 0.83.3
11% above 50 -- above 83.3
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Weighted marginal cost of
capital-cont
WACC for various range of total finance
Range of total source of proportion cost weighted
New finance capital % cost%
Rs.inlakhs

0-75 Equity 0.4 0.18 .072
Debt 0.6 0.10 .060
WACC .132
Above75-83.3 Equity 0.4 0.20 .080
Debt 0.6 0.10 .060
WACC .140
Above 83.3 Equity 0.4 0.20 .080
Debt 0.6 0.11 .066
WACC .146
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Weighted marginal cost of
capital-cont
Weighted marginal cost of capital
Range of total finance weighted marginal cost of capital
(Rs. in lakhs) %
0-75 13.2
75-83.3 14
above 83.3 14.6
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Floatation cost and WACC
The cost incurred for raising funds
It should not affect WACC instead it should be
adjusted in project cost
e.g. project cost is 200 and floatation cost is 8%
it means company will receive 184.
Therefore to raise net 200
200=(1-0.08) x amount required to be raised
amount required to be raised=200/(1-0.08)=
217.39

FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
CAPITAL STRUCTURE
DECISION & VARIOUS
THEORIES
A PRESENTATION
BY
CA. R.C.AGARWAL
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
CAPITAL STRUCTURE DECISION
Two principal sources of finance for a business
firm are equity and debt.
What should be proportions of equity and debt in
capital structure of a firm?
It is essentially concerned with how the firm
decides to divide its cash flows into two broad
components, a fixed component to meet the
debt obligations and residual component that
belongs to equity shareholders.
No single method which can ensure optimal
capital structure
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
GUIDELINES
It is a difficult decision
which requires trade off
between income, risk,
flexibility, control, timing,
etc.
CAPITAL STRUCTURE DECISION
Capital restructuring involves changing
leverage by shifting the mix of debt and
equity
Levered means to have debt and
unlevered means to operate only with
equity
Preferred stock is assumed to part of debt
and therefore, contents of structure are
taken as debt and equity.
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
CRITERIA FOR CAPITAL
STRUCTURE
Cost principle
Minimize cost of financing and maximize value per
share
Debt capital more preferable as it is cheaper
Risk principle
Avoid bankruptcy
More dependence to be on equity financing
Control principle
Owners desirous to hold on the control will depend
more on bonds and preference capital
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
CRITERIA FOR CAPITAL
STRUCTURE
Flexibility principle
Maneuverability should be possible according to major
changes in needs of funds
Combination of funds to be such that there is bargainability
in dealing with the suppliers of funds (bonds)
Timing principle
Offer securities which are in great demand like in boom
equity issue is welcome
Appropriate time to be chosen for raising the funds
To take advantage of market opportunities
To minimize cost of funds
To obtain substantial savings
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
FACTORS INFLUENCING
CAPITAL STRUCTURE
Size of business
Problems in raising funds by small firms
Investors are not enthusiastic in putting funds in small
firms
Form of business organisation
Control principle is important in Pvt. Ltd., proprietory and
partnership firms but not much in public ltd. companies
Stability of earnings
Firms with stable earnings and public utility concerens face
less problems in raising funds as they have adequate
profits
Manuf.and other firms have to mainly depend on equity
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
FACTORS INFLUENCING
CAPITAL STRUCTURE
Age of company
Younger firms find it difficult to raise funds
Established firms can raise funds from any source
Purpose of financing
If productive purpose the difficulty is less
For welfare activities funds have to from equity
Market sentiments
Times of boom and times of slackness
Credit standing
High credit standing the problems are less

FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
FACTORS INFLUENCING
CAPITAL STRUCTURE
Period of finance
For temporary period or few years than raise through bonds
Permanent requirement to be raised through equity
Legal requirements
Companies Act, Banking companies Act, Income Tax Act etc.
influence the capital structure
Debenture/Preference shares are issued to increase the earning
of equity shares
Equity shares are issued to absorb shocks of business cycles
and to afford flexibility
Tax consideration
Debt is more advantageneous
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
Avail of Tax advantage of debt
Interest of debt is tax deductible
If the debt is perpetual the tax shield is
available on full loan i.e. present value of
tax shield will be = (t
c
r
d
D)/r
d
= t
c
D
Debt financing provides tax shelter which
increases firm value i.e.=t
c
D
where t
c
= corporate tax rate, r
d
=interest
rate on debt, D = debt financing
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
CONTROL IMPLICATIONS OF
ALTERNATIVE FINANCING PLAN
e.g. ABC Ltd. has equity capital of 10,00,000 totally
owned by promoters. Now additional Capital of
10,00,000 can be in the form of total debt or right issue
or public issue or a combination of two or more.
Consider the following
Pros Cons
Rights issue No dilution of control limits on financing
ability of promoters
No financial risk High cost
Debt financing No dilution of control Financial risk
Lower cost
Public issue No financial risk Dilution of control
Higher cost
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
CONTROL IMPLICATIONS OF
ALTERNATIVE FINANCING PLAN
Due to financing limits of right issue,
decision is to be taken between debt and
public issue and in this control is
important component
Control is related to equity holding below
100%, 50%, 26%. 50% for control over
the firm and 26% for stopping special
resolutions
FINANCIAL MANAGEMENT I BY CA. R.C. AGARWAL
NORMS OF LENDERS & CREDIT
RATING AGENCIES
Lenders normally want tangible assets like
plant & machinery as security hence if such
assets are available borrowing is possible
Rating agencies normally consider the
following
Earning power, business and financial risk
Asset protection, cash flow adequacy
Financial flexibility, quality of accounting
Do not be obsessed about credit rating