Unit 1

Q-Defination of Finance

Finance is defined as the provision of money at the time when it is required.

Every enterprise whether big medium or small, Needs finance to carry on its
operation and achieve its target.

The subject of Finance has been Traditionally classified into two classes:
(i)Public finance and(ii) Private finance.
Scopes of Finacial management:

The main objective of Financial Management is to arrange sufficient finances

for meeting short term and long term needs. These funds procured at minimum
cost So that profitability of the business is maximised. With these things in
mind, A financial manager will have to concentrate on the following areas Of
financial function:-

1. Estimating financial requirements: The first task of financial manager is to

estimate short term and long term financial requirement of the business.
For this purpose He will prepare a financial plan for present as well as for
future. The amount required for purchasing fixed assets as well as need for
funds for working capital will have to be ascertained. The estimation should
be based on sound financial principles so that neither there are inadequate
nor access funds with the concern.
2. Deciding capital structure: The capital structure Refers to the kind and
promotion of different securities for raising funds. After deciding the
quantum of funds required It should be decided which type of security
should be raised. It may be wise to finance a fixed asset through long-term
debts even here if waiting perioud is longer, then capital will be almost
suitable. Long term fund should be employed to working capital also, If not
wholly then partially. Entirely depending upon overdrafts and cash credits
for meeting working capital needs may not be suitable. A decision about
various sources of fund Should be linked to the cost of raising funds. If cost
of rising funds very high then such sources may not be useful for long.
3. Selecting a Source of Finance: After preparing a capital structure, An
appropriate source finances selected. Various sources from which finance
may be raised, Include: share capital, Debentures, Financial institutions,
commercials banks and public deposits, etc. If finance are needed for short
periods Then banks, Public deposits and financial institutions may be
appropriate; On the other hand, If long term finances are required then
 share capital and debentures may be useful. If the concern does not want
to tie down assets as securities Then public deposits may be suitable
sources. If management does not want to dilute ownership then debentures
should be issued in preference to shares. The need, purpose ,object and
cost involved may be the factors influencing the selection of a suitable
source of financing.
4. Selecting a pattern of investment: When funds have been procured then a
decision about investment pattern to be taken the selection of the
investment pattern is related to the use of funds. A decision will be taken as
to which assets are to be purchased ? The funds will have to be spent first
on fixed assets And then an appropriate portion will be retained for working
capital. Even if various categories of assets, A decision about the type of
fixed Or other assets will be essential. While selecting a plant and
machinery even different categories of them will be available. The decision
making technique such as capital budgeting opportunity cost analysis etc.
may be applied in making decision about capital expenditure. While
spending on various assets, The principles of safety, Profitability and
liquidity should not be ignored. A balance should be struck even in these
principles one should not like to invest on the project which may be risky
even though there may be more profit.
5. Proper cash management: Cash management is also an important Task
finance manager. He has to assess various cash needs at different times
And then making arrangements for arranging cash. Case may be required
to(a) Purchase raw material,(b) Make payment to creditors,(c) Meet wage
bills; (d) Meet day to day expenses. The usual sources of cash may be:
(a)cash sales,(b)collections of debts,(c) short term arrangement with banks
etc. The case management should be such that neither there is shortage of
it nor it is idle. Any shortage of cash will damage the creditworthiness of the
enterprise. The idle case with the business will mean that it is not properly
used. It will be better if Cash flow statement is regularly prepared so that
one is able to find out various sources and application.
6. Implementing financial controls: An efficient system of financial
management involve the use of various control devices. Financial control
devices generally used are:(a)return on investment, (b) Budgetary control,
(c) Break even analysis,(d) Cost control,(e) Ratio annlysis (f) Cost and
internal audit Return on investment is the best control device to evaluate
the performance of various financial policies. The use of various Control
techniques by the financial manager will help him in evaluating the
performance in various areas and take corrective measures whenever
needed.
7. Proper user surpluses: The utilization of profit or surpluses is also an
important factor in financial management. A use judicious of surpluses Is
essential for expansion and diversification plans and also in protecting the
interest of shareholders. The ploughing back of profit is the best policy of
further Financing but it clashes with the interests of shareholders. A
balance should be struck in using funds for paying dividend and retaining
Earnings for financing expansion plans, ets. The market value of shares will
also be influenced by declaration of dividend and expected profitability in
future. A judicious policy for distributing surpluses will be essential for
maintaining proper growth of the unit.

Objective of financial management or goals of business finance:-

Financial management is concerned with procurement and user funds. Its main
aim is to use business fund in such a way that firms value/earnings Are
maximized. There are various alternatives available for business funds. Each
alternative course will be valued in details the pros and cons of various
decisions have to be looked into before making financial selection. The main
objective of the business is to maximize the owners economic welfare. The
objective can be achieved by:

Profit maximization, and

Wealth Maximisation
1. Profit Maximization: Profit maximization is the main aim of every economic
activity. A business being an economic institution must earn profit to cover
its costs and provide funds for growth. No business can survive without
earning profit. Profit is a measure of efficiency of a business enterprise.
Profits also serve as a protecting risk which cannot be ensured. The
accumulated profits enable a business to face risk like fall in prices,
Competition from other unit, adverse Govt policies etc. Task profit
maximization is considered as the main objective of business.

Benifits of Profit Maximization:

When profit-earning is the aim of business then profit maximizes should be

obvious objective.
Profitability is a barometer for measuring efficiency and economic
prosperity of the business enterprise, thus Profit maximation is justifies on
the ground of rationality.
Economic and business condition do not remain same at all the time. There
may be adverse business conditions like recession, depression, severe
 competition Etc. A business will be able to survive under unfavorable
situations, Only if it has some part earning to rely upon. Therefore a
business would try to earn more and more when situation is favorable.
Profit at the main source of finance for the growth of the business. Show a
business should aim in maximizing the profit for enabling its growth and
development.
Profitability is essential for fulfilling the social growth also. a form for
pursuing the objective of profit maximation also maximize socioeconomic
welfare.

However, Profit maximization objective has been criticized on many grounds. A

firm pursuing the objective of profit makes maximization Starts exploiting
workers and consumers. Hence it is immoral and leads to number of corrupt
policies. Further, It leads to colossal inequalities and lowers Human value
which are in essential part of an idle social system. It is also argued that profit
maximization Should be the objective in the condition of perfect competition
and in the wake of imperfect competition today it cannot be legitimate
objective of the firm.

Limitation of Profit Maximization:

Ambiguity: The term profit is vague and it Cannot be precisely defined. It

means different thing for different people. Should we consider long term
profit or short term profit? Does it means total profit or earning per share?
should we take profit before tax or after tax? Does it means operating profit
or profit available for shareholders? Further it is possible that profit may
increase but earnings per share decline.
Ignore Time Value of Money: Profit maximization objective ignores time
value of money and does not consider the magnitude and timing of earning.
It treats all earning as equal though they occur in different periods. It
ignores the fact that cash received today is more important than the same
amount of cash received after say, 3 years.
Ignore Risk factor: It does not take into consideration the risk of the
prospective earnings stream. Some projects are more risky than others. the
earning stream will also be risky in the former then the latter. Two firms May
have same expected earning per share, But if the earnings stream is one is
more risky then the market value of its share will comparatively less.
Divident Policy: The effect of dividend policy on the market price of share
is also not considered in the objective or profit maximization. In case
earnings per share is the only objective than the enterprise may not think
 of paying dividend at all because retaining profit in Business or investing
them in the market may satisfy this aim.

2.Wealth Maximization: Wealth maximization is the appropriate objective of an

enterprise, Financial theory asserts that wealth maximization is the single
substitute for the stakeholders utility. When the firms maximizes the
stakeholders wealth, The individual who stakeholder can use this wealth to
maximize his individual utility. It means that by maximizing stakeholders
wealth the firm Is operating consistently towards maximizing stakeholders
utility. A stakeholder's current wealth in the firm Is the product of number of
shares owned, Multiplied with the current stock price per share.

The following arguments are advanced in favor of wealth maximization as a

goal of financial management:

It serves the interest of owners(shareholders), As well as other

stakeholders in the firm
It is consistent with the objective of owners economic welfare.
The objective of wealth maximization implies long term survival and growth
of the firm.
It takes into consideration the risk factor and the time value of money as
the current present value of any particular course of action is measured.
The effect of dividend policy on market price of shares is also considered as
the decision are taken to increase the market value of share.
The goal of wealth maximization leads towards maximizing stakeholders
utility or value maximization of equity shareholder through increasing
stock price per share.

Criticism Of wealth Maximization:

It is a prescriptive idea. The objective is not descriptive of what the form

actually do.
the objective of wealth Maximization is necessarily socially desirable.
There is some controversy as to whether the objective is to maximize the
stakeholders wealth or the wealth of the firm which include other financial
claim holders such as debentures preferred stakeholders etc .
The object. The objective of wealth maximization may also face difficulties
when ownership and management are separated as in the case of most of
the large corporate firm of the organization. When managers act as an agent
of the deal owners there is a possibility of the conflict of interest between
shareholders and managerial interest.
Financial Decisions

Financial decisions refer to decisions concerning financial matter of the firm.

There are many kind of financial management decision that the firm makes in
pursuit of maximizing shareholders wealth,. we can classify is decision into
three groups(i)Investment decision(ii) finacial Decision(iii) Devidend decision

1. Investment decisions: Investment decision relates to the determination of

total amount of assets to be held in the firm. It is the most important
financial decision. Since Funds involve costs and are available in limited
quantity its proper utilization is very necessary to achieve the goal of
wealth maximization. The investment decision can be classified under 2
broad categories:(i) Long term investment decision and(ii) Short term
investment decision. Long term investment decision referred to as the
capital budgeting and short term investment decision as working capital
management.
2. Financing decision: Once the firm Has taken the investment decision and
committed itself to new investment, It must decide the best means of
financing this commitments. Since, Firms regularly make new investments
the need For financing and financial decision are ongoing. Hence a form will
be continuously planning for new financial needs. The financing decision is
not only with how best to finance new assets but also Concerned with the
best overall mix of financing for the firm. A finance Manager has to be
select Search sources of fonts which make optimum capital structure. The
important thing To be decided here is proportion of various forces in the
overall capital mix of the firm. The debt equity ratio should be fixed in such
a way that it helps in maximizing profitability of the concern.
3. Divident Decision: The third major financial decision relates to the
disbursement of profit back to investors who supplied capital to the firm.
The term dividend refers to that part of profit of the company which is
distributed by it among its shareholders. It is the reward of shareholders for
investment made by them in the share capital of the company. The
dividend decision is concerned with the quantum of profit to be distributed
among shareholders. A decision has to be taken whether all the profit are to
be distributed among shareholders Or to retain all the profit.

UNIT-2

Q-What is meaning and nature of capital budgeting?

Capital budgeting is the process of making investment decisions in capital
expenditures. A capital expenditure may be defined as an expenditure the
benefits of which are expected to be received over period of time exceeding
one year. The main characteristic of a capital expenditure is that the
expenditure is incurred at one point of time where as benefits of the
expenditure are realised at different points of time in future. In simple
language we may say that a capital expenditure is an expenditure incurred for
acquiring or improving the fixed assets, the benefits of which are expected to
be received over a number of years in future. The following are some of the
examples of capital expenditure:

Cost of acquisition of permanent assets as land and building, plant and

machinery, goodwill, etc.
Cost of addition, expansion, improvement or alteration in the fixed assets.
Cost of replacement of permanent assets.
Research and development project cost, etc.

Capital expenditure involves non-flexible long-term commitment of funds.

Thus, capital expenditure decisions are also called as long term investment
decisions. Capital budgeting involves the planning and control of capital
expenditure. It is the process of deciding whether or not to commit resources
to a particular long term project whose benefits are to be realised over a period
of time, longer than one year. Capital budgeting is also known as Investment
Decision Making. Capital Expenditure Decisions, Planning Capital Expenditure
and Analysis of Capital Expenditure.

Q- What is the process of capital budgeting?

Capital budgeting is a comples process as it involves decisions relating to the

investment of current fund for the benefit to the achieved in future and the
future is always uncertain. However, the following Procedure may be adopted
for the process of capital budgeting are:-

1. Identification of Investment Proposals-The capital budgeting process

begins with the identification of investment proposals. The proposal or the
idea about potential investment opportunities may originate from the top
management or may come from the rank and file worker of any department
or from any officer of the organisation. The departmental head analyses the
various proposals in the light of the corporate strategies and submits the
suitable proposals to the Capital Expenditure Planning Comunicates in case
 of large organisations or to the officers concerned with the process of long-
term investment decisions
2. Screening the Proposals. The Expenditure Planning Committee screens the
various proposals received from different departments. The committee
views these proposals from various angles to ensure that these are in
accordance with the corporate strategies or selection criterion of the firm
and also do not lead to departmental imbalances.
3. Evaluation of Various Proposals. The next step in the capital budgeting,
process is to evaluate the profitability of various proposals. There are many
methods which may be used for this purpose such as payback period
method, rate of return method, net present value method, internal rate of
return method etc. It should, however, be noted that the various proposals
to the evaluated may be classified as: (i)independent proposals
(ii)contingent or dependent proposals and(iii) mutually exclusive
proposals. Independent proposals are those which do not compete with
one another and the same may be either accepted or rejected on the basis
of a minimum return on investment required. The contingent proposals are
those whose acceptance depends upon the acceptance of one or more
other proposals, e.g. further investment in building or machineries may
have to be undertaken as a result of expansion programme. Mutually
exclusive proposals are those which compete with each other and one of
those may have to be selected at the cost of the other.
4. Fixing Priorities. After evaluating various proposals, the unprofitable or
uneconomic proposals may be rejected straight away But it may not be
possible for the firm to invest immediately in all the acceptable proposals
due to limitation of funds. Hence, it is very essential to rank the various
proposals and to establish priorities after considering urgency, risk and
profitability involved therein.
5. Final Approval and Preparation of Capital Expenditure Budget. Proposals
meeting the evaluation and other criteria are finally approved to be
included in the Capital Expenditure Budget, However, proposals involving
smaller investment may be decided at the lower levels for expeditious
action. The capital expenditure budget lays down the amount of estimated
expenditure to be incurred on fixed assets during the budget period.
6. Implementing Proposal. Preparation of a capital expenditure budgeting and
incorporation of a particular proposal in the budget does not itself
authorise to go ahead with the implementation of the project A request for
authority to spend the amount should further be made to the Capital
Expenditure Committee which may like to review the profitability of the
project in the changed circumstances.
7. Performance Review. The last stage in the process of capital budgeting is
the evaluation of the performance of the project. The evaluation is made
through post completion audit by way of comparison of actual expenditure
on the project with the budgeted one, and also by comparing the actual
return from the investment with the anticipated return. The unfavourable
variances, if any should be looked into and the causes of the same be
identified so that corrective action may be taken in future.

Unit 3

Q-What is cost of Capital?

The cost of capital of a firm is the minimum rate of return expected by its
investors. It is the weighted average cost of various sources of finance used by
a firm. The capital used by a firm may be in the form of debt, preference
capital, retained earnings and equity shares. The concept of cost of capital is
very important in the financial management. A decision to invest in a particular
project depends upon the cost of capital of the firm or the cut off rate which is
the minimum rate of return expected by the investors. In case a firm is not able
to achieve even the cut off rate, the market value of its shares will fall.

Q-What is the classification of cost of capital?

Historical Cost and Future Cost. Historical costs are book costs which are
related to the past. Future costs are estimated costs for the future in
financial decision Future cost more relevant than the historical costs.
However historical cost act as a guide for the future costs.
Specific Cost and Composite Cost. Specific cost refers to the cost of a
specific source of capital while composite cost is combined cost of various
sources of capital. It is the weighted average cost of capital. In case more
than one form of capital is used in the business, it is the composite cost
which should be considered for decision-making and not the specific cost.
But where only one type of capital is employed the specific cost of that
type of capital may be considered. In capital structure decisions, it is the
weighted average cost of capital which should be given consideration.
Explicit Cost and Implicit Cost. An explicit cost is the discount rate which
equates the present value of cash inflows with the present value of cash
outflows. In other words, it is the internal rate of return. The explicit cost of
a specific source of finance may be determined with the help of the
following formula.
 Average Cost and Marginal Cost. An average cost refers to the combined
cost of various sources of capital such as debentures, preference shares
and equity shares. It is the weighted average cost of the costs of various
sources of finance. Marginal cost of capital refers to the average cost of
capital which has to be incurred to obtain additional funds required by a
firm. In investment decisions, it is the marginal cost which should be taken
into consideration.

Unit-4

Q-What are capital structure?

The term "Capital structure' refers to the relationship between the various
long-term forms of financing such as debenture, preference share capital and
equity share capital. Financing the firm's assets is a very crucial problem in
every business and as a general rule there should be a proper mix of debt and
equity capital in financing the firm's assets. The use of long-term fixed interest
bearing debt and preference share capital along with equity shares is called
financial leverage or trading on equity

FORMS/PATTERNS OF CAPITAL STRUCTURE

The capital structure of a new company may consist of any of the following
forms:

Equity Shares only

Equity and Preferences Shares
Equity Shares and Debentures
Equity Shares, Preferences Shares and Debentures

Q-What are the theories of capital structure?

Different kinds of theories have been propounded by different authors to

explain the relationship between capital structure, cost of capital and value of
the firm. The main contributors to the theories are Durand, Ezra, Solomon,
Modigliani and Miller.

The important theories are discussed below:

Net Income Approach.

Net Operating Income Approach.
The Traditional Approach
Modigliani and Miller Approach
1. Net Income Approach. According to this approach, a firm can minimise the
weighted average cost of capital and increase the value of the firm as well as
market price of equity shares by using debt financing to the maximum possible
extent. The theory propounds that a company can increase its value and
decrease the overall cost of capital by increasing the proportion of debt in its
capital structure. This approach is based upon

the following assumptions:

(i) The cost of debt is less than the cost of equity.

(ii) There are no taxes.
(iii) The risk perception of investors is not changed by the use of debt.

The line of argument in favour of net income approach is that as the proportion
of debt financing in capital structure increase, the proportion of a less
expensive source of funds increases. This results in the decrease in overall
(weighted average) cost of capital leading to an increase in the value of the
firm. The reasons for assuming cost of debt to be less than the cost of equity
are that interest rates are usually lower than dividend rates due to element of
risk and the benefit of tax as the interest is a deductible expense. On the other
hand, if the proportion of debt financing in the capital structure is reduced or
say when the financial leverage is reduced, the weighted average cost of
capital of the firm will increase and the total value of the firm will decrease.

1.Net Operating Income Approach. This theory as suggested by Durand is

another extreme of the effect of leverage on the value of the firm. It is
diametrically opposite to the net income approach. According to this
approach, change in the capital structure of a company does not affect the
market value of the firm and the overall cost of capital remains constant
irrespective of the method of financing. It implies that the overall cost of
capital remains the same whether the debt-equity mix is 50: 50 or 20:80 or
0:100. Thus, there is nothing as an optimal capital structure and every capital
structure is the optimum capital structure. This theory presumes that:

the market capitalises the value of the firm as a whole;

the business risk remains constant at every level of debt equity mix;
there are no corporate taxes.

The reasons propounded for such assumptions are that the increased use of
debt increases the financial risk of the equity shareholders and hence the cost
of equity increases. On the other hand, the cost of debt remains constant with
the increasing proportion of debt as the financial risk of the lenders is not
affected. Thus, the advantage of using the cheaper source of funds, ie., debt is
exactly offset by the increased cost of equity.

2.The Traditional Approach. The traditional approach, also known as

Intermediate approach, is a compromise between the two extremes of net
income approach and net operating income aproach. According to this theory,
the value of the firm can be increased initially or the cost of capital can be
decreased by using more debt as the debt is a cheaper source of funds than
equity. Thus, optimum capital structure can be reached by a proper debt-
equity mix. Beyond a particular point, the cost of equity increases because
increased debt increases the financial risk of the equity shareholders. The
advantage of cheaper debt at this point of capital structure is offset by
increased cost of equity. After this there comes a stage, when the increased
cost of equity cannot be offset by the advantage of low-cost debt. Thus,
overall cost of capital, according to this theory. decreases up to a certain point,
remains more or less unchanged for moderate increase in debt thereafter, and
increases or rises beyond a certain point.

3.Modigliani and Miller Approach. M&M hypothesis is identical with the Net
Operating Income approach if taxes are ignored. However, when corporate
taxes are assumed to exist, their hypothesis is similar to the Net Income
Approach.

(a)In the absence of taxes. (Theory of Irrelevance) The theory proves that the
cost of capital is not affected by changes in the capital structure or say that the
debt-equity mix is irrelevant in the determination of the total value of a firm.
The reason argued is that though debt is cheaper to equity, with increased use
of debt as a source of finance, the cost of equity increases. This increase in cost
of equity offsets the advantage of the low cost of debt. Thus, although the
financial leverage affects the cost of equity, the overall cost of capital remains
constant. The theory emphasises the fact that a firm's operating income is a
determinant of its total value. The theory further propounds that beyond a
certain limit of debt, the cost of debt increases (due to increased financial risk)
but the cost of equity falls thereby again balancing the two costs. In the
opinion of Modigliani& Miller, two identical firms in all respects except their
capital structure cannot have different market values or cost of capital
because of arbitrage process. In case two identical firms except for their
capital structure have different market values or cost of capital, arbitrage will
take place and the investors will engage in "personal leverage" (ie. they will buy
equity of the other company in preference to the company having lesser value)
as against the "corporate leverage; and this will again render the two firms to
have the same total value.

The M&M appraoch is based upon the following assumptions:

There are no corporate taxes.

There is a prefect market.
Investors act rationally.
The expected earnings of all the firms have identical risk characteristics. (v)
The cut-off point of investment in a firm is capitalisation rate.
Risk to investors depends upon the random fluctuations of expected
earnings and the possibility that the actual value of the variables may turn
out to be different from their best estimates.
All earnings are distributed to the shareholders.
MM approach in the absence of corporate taxes, ie the theory of
irrelevance of financing mix has been presented in the following figure.

Q-What are the factors determine/affect the capital structure?

The capital structure of a concern depends upon a large number of factors

such as leverage or trading on equity, growth of the company, nature and size
of business, the idea of retaining control, flexibility of capital structure,
requirements of investors, costs of floatation of new securities, timing of issue,
corporate tax rate and the legal requirements. The factors influencing the
capital structure are discussed as follows:

1. Financial Leverage or Trading on Equity. The use of long-term fixed interest

bearing debt and preference share capital alongwith equity share capital is
called financial leverage or trading on equity. Effects of leverage on the
shareholders return or earnings per share have already been discussed in
this chapter. The use of long-term debt increases, magnifies the earnings
per share if the firm yields a return higher than the cost of debt. The
earnings per share also increase with the use of preference share capital
but due to the fact that interest is allowed to be deducted while computing
tax, the leverage impact of debt is much more. However, leverage can
operate adversely also if the rate of interest en long-term loans is more
than the expected rate of earnings of the firm. Therefore, it needs caution
to plan the capital structure of a firm.
2. Growth and Stability of Sales. The capital structure of a firm is highly
influenced by the growth and stability of its sales. If the sales of a firm are
 expected to remain fairly stable, it can raise a higher level of debt. Stability
of sales ensures that the firm will not face any difficulty in meeting its fixed
commitments of nterest payment and repayments of debt. Similarly, the
rate of growth in sales also affects the capital structure decision. Usually
greater the rate of growth of sales, greater can be the use of debt in the
financing of firm. On the other hand, if the sales of a firm are highly
fluctuating or declining, it should not employ, as far as possible, debt
financing in its capital structure.
3. Cost of Capital. Every rupee invested in a firm has a cost. Cost of capital
refers to the minimum return expected by its suppliers. The capital
structure should provide for the minimum cost of capital. The main sources
of finance for a firm are equity, preference share capital and debt capital.
The return expected by the suppliers of capital depends upon the risk they
have to undertake. Usually, debt is a cheaper source of finance compared
to preference and equity capital due to (i) fixed rate of interest on debt, (ii)
legal obligation to pay imerest repayment of loan and priority in payment
at the time of winding up of the company. On the other hand, the rate of
dividend is not fixed on equity capital. It is not a legal obligation to pay
dividend and the equity shareholders undertake the highest risk as they
cannot be paid back except at the winding up of the company and that too
after paying all other obligations. Preference capital is also cheaper than
equity because of lesser risk involved and a fixed rate of dividend payable
to preference shareholders. But debt is still a cheaper source of finance
than even preference capital because of tax advantage due to deductibility
of imerest. While formulating a capital structure, an effort must be made to
minimise the overall cost of capital.
4. Risk. There are two types of risk that are to be considered while planning
the capital structure of a firm viz (1) business risk and (ii) financial risk.
Business risk refers to the variability of earnings before interest and taxes.
Business risk can he internal as well as external. Internal risk is caused due
to improper product mix. non-availability of raw materials, incompetence
to face competition, absence of strategic management etc. Internal risk is
associated with the efficiency with which a firm conducts its operations
within the broader environment thrust upon it. External business risk arises
due to change in operating conditions caused by conditions thrust upon
the firm which are beyond its control eg, business cycles, governmental
controls. changes in business laws, international market conditions etc.
5. Nature and Size of a Firm. Nature and size of a firm also influence its capital
structure. All public utility concern has different capital structure as
compared to the influencial structurelt public concerns may employ more
 of debt because of stability and regularity of their earnings. On the other
hand, a concern which cannot provide stable earnings due to the nature of
its business will have to rely mainly on equity capital; similarly, small
companies have to depend mainly upon owned capital as it is very difficult
for them to raise long-term loans on reasonable terms and also can not
issue equity and preference shares at ease to the public.
6. Control. Whenever additional funds are required by a firm, the
management of the firm wants to raise the funds without any loss of
control over the firm. In case the funds are raised through the issue of
equity shares, the control of the existing shareholders is diluted. Hence,
they might raise the additional funds by way of fixed interest bearing debt
and preference share capital. Preference shareholders and debenture
holders do not have the voting right. Hence, from the point of view of
control, debt financing is recommended. But, depending largely upon debt
financing may create other problems, such as, too much restrictions
imposed upon by the lenders or suppliers of finance and ultimate
bankruptcy of the firm due to heavy burden of interest and fixed charges.
This may result into even a complete loss of control by way of liquidation of
the company.
7. Flexibility. Capital structure of a firm should be flexible, ie., it should be
such as to be capable of being adjusted according to the needs of the
changing conditions. It should be possible to raise additional funds,
whenever the need be, without much of difficulty and delay. A firm should
arrange its capital structure in such a manner that it can substitute one
form of financing by another. Redeemable preference shares and
convertible debentures may be preferred on account of flexibility.
Preference shares and debentures which can be redeemed at the discretion
of the firm offer the highest flexibility in the capital structure.
8. Capital Market Conditions (Timing). Capital market conditions do not
remain the same for ever. Sometimes there may be depresion while at other
times there may be boom in the market. The choice of the secures os also
influenced by the market conditions. If the share market is depressed and
there are pessimistic bune conditions, the company should not issue equity
shares as investors would prefer safety. But in case there in boom period, it
would be advisable to issue equity shares. Proper timing of issue of
securities also saves month of rasing funds
9. Period of Finance. The period for which the finances are required is also an
important factor to be kept in mind while selecting an appropriate capital
mix. If the finances are required for a limited period of. say, seven years,
debentures should be preferred to shares. Redeemable preference shares
 may also be used for a limited period finance, if found suitable otherwise.
However, in case funds are needed on permanent basis, equity share
capital is more appropriate.

Q-What are Divident?

The term dividend refers to that part of profits of a company which is

distributed by the company among its shareholders. It is the reward of the
shareholders for investments made by them in the shares of the company. The
investors are interested in earning the maximum return on their investments
and to maximise their wealth. A company, on the other hand, needs to provide
funds to finance its long-term growth. If a company pays out as dividend most
of what it earns, then for business requirements and further expansion it will
have to depend upon outside resources such as issue of debt or new shares.

Q-What are various approach to divident decision?

The value of the firm can be maximised if the shareholders' wealth is

maximised. There are conflicting views regarding the impact of dividend
decision on the valuation of the firm. According to one school of thought,
dividend decision does not affect the share-holders' wealth and hence the
valuation of the firm. On the other hand, according to the other school of
thought, dividend decision materially affects the shareholders wealth and also
the valuation of the firm. We have discussed below the views of the two
schools of thought under two groups:

1. 1. The Irrelevance Concept of Dividend or the Theory of Irrelevance, and

2. The Relevance Concept of Dividend or the Theory of Relevance.

A.MODIGLIANI AND MILLER APPROACH (MM MODEL):

Modigliani and Miller have expressd in the most comprehensive manner in

support of he theory of irrelevance They maintain this dividend policy has no
effect on the market price of the shares and the vale of the firm is determined
by the earning capacity of the fiemonts investment policy. The splating of engs
between intentions and dividends, may be in the femthes, does not affect the
value of the fitne As served by MM. "Under conditions of perles capital
mesters, absenente diméon beween dividend income and pal speciation, given
the firm's menerunt policy, as dinukest pulicy may have the market price of the
shares.

Assumptions of MM Hypothesis:
The MM hypothesis of irrelevence of divident is based on following assumtion:

1. There are perfect capital markets

2. Investors bidave rationally
3. Infarmanon about the company is available to all without any cost.
4. There are we floatation and transaction cesta
5. No investor is large enough to effect the market price of shares
6. There are either no taxes or there are ne differences in the tus as
applicable to dividends in capital gas
7. The firm has a rigid investment policy.
8. There is no risk or uncertainty in regard to the future of the firm. (MM
dropped this assumption later)

THE RELEVANCE CONCEPT OF DIVIDEND OR THE THEORY OF RELEVANCE

The other school of thought on dividend decision holds that the dividend
decisions considerebly affect the value of the firm. The advocates of this
school of thought include Myron Gordon, Jose Linter, James Waiter and
Richanson. According to them dividends communicate information to the
investors about the firms profitability and hence dividend decision becomes
relevant. Those firms which pay higher dividends, will have greater value as
compared to those which do not pay dividende or have a lower dividend pay
out ratas. We have examined below two theories representing this notion:

(1) Walter's Approach, and (2) Gordon's Approach

1. WALTER'S APPROACH:Prof Walter's approach supports the doctrine that

dividend decisiom are relevant and affect the value of the firms. The
relationship between the internal rate of return earned by the firm and its
cost of capital is very significant in determining the dividend policy to
subserve the ultimate goal of maximising the wealth of the share holders.
Prof. Walter's model is based on the relationship between the firm's (1)
return on investment, i and (ii)the cost of capital or the required rate of
return, izk

According to Prof. Walter, if r>k , if the firm earns a higher rate of return on its
investment than the required rate of return, the firm should retain the
earnings. Such firm are termed as growth firm's and the optimum pay-out
would be zero in their case. This would maximise the value of shares.

In case of declining firms which do not have profitable investments, ie, where
r<k, the share holders would stand to gain if the firm distributes its earnings.
For such firms, the optimum pay out would be 100% and the firms should
distribute the entire earnings as dividends.

In case of normal firms where r=k, the dividend policy will not affect the market
value of shares a me shareholders will get the same return from the firm as
expected by them For such firm, there is no optam neidend pay out and the
value of the firm would not change with the change in dividend rate.

Assumption of Walter's Model

The investments of the firm are financed through retained carmings only
and the lion does me external sources of funds.
The intermal rate of return (r) and the cost of capital (k) of the firm are
contam
Earnings and dividends do not change while determining the sla
The firm has a very long life

(2) GORDON'S APPROACH:Myron Gordon has also developed a model on the

lines of Prof. Walter suggesting that dividends are relevant and the dividend
decision of the firm affects its value. His basic valuation model is based on the
following assumptions:

The firm is an all equity firm.

(ii) No external financing is available or used. Retained earnings represent
the only source of financing investment programmes.
(iii) The rate of return on th firm's investment r, is constant.
(iv) The retention ratio, b, once decided upon is constant. Thus, the growth
rate of the firm g-br, is also constant.
(v) The cost of capital for the firm remains constant and it is greater than
the growth rate, ie. k>br.
(vi) The firm has perpetual life.
(vii) Corporate taxes do not exist

According to Gordon, the market value of a share is equal to the present value
of future stream of dividends. Thus, the implication of Gordon’basic valuation
model maybe summarised as below:

1. When the rate of return of the form on its investment is greater than the
required rate of return, ie; when r>k The price per share increases divident
payout ratio decreases.Thus, growth fund to distribute smaller dividends
and should return maximum earnings.
2. When rate of return is equal to the required rate of return, i.e, when r=k, the
price per se remains unchanged and is not affected by dividend policy.Thus,
For a normal form there is no optimum divident payout
3. When the rate of return is less than the required rate of return, i.e, when
r<k, The price per share increases as the divide nd payout receive
increases.Thus, the stakeholder of declining fiem stand to gain if the firm
distributes it’s earnings. For such firms, the optimum payout would be
100%

Gordon's Revised Model: The basic assumption in Gordon's Basic Valuation

Model that cost of capital (k) remains consant for a firm is not true in practice.
Thus, Gordon revised his basic model to consider risk and uncertainty. In the
revised model, he suggested that even when r = k dividend policy affects the
value of shares on account of uncertainty of future, shareholders discount
future dividends at a higher rate than they discount near dividends. That is
there is a two fold assumption, viz. (i) investors are risk averse, and (ii) they put
a premium on a certain return and discount/penalise uncertain returns.
Because the investors are rational and they want to avoid risk. they prefer near
dividends than future dividends. This argument is described as bird in the hand
argument,i.e The value of the rupee is dividend income is more than the value
of rupee of capital gain.

Q-What is trade off theory?

The trade-off theory of capital structure refers to the idea that a company
chooses how much debt finance and how much equity finance to use by
balancing the costs and benefits. Trade-off theory of capital structure basically
entails offsetting the costs of debt against the benefits of debt.

Trade-off theory of capital structure primarily deals with the two concepts -
cost of financial distress and agency costs. An important purpose of the trade-
off theory of capital structure is to explain the fact that corporations usually
are financed partly with debt and partly with equity.

It states that there is an advantage to financing with debt, the tax benefits of
debt and there is a cost of financing with debt, the costs of financial distress
including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff
leaving, suppliers demanding disadvantageous payment terms, bondholder/
stockholder infighting, etc). The marginal benefit of further increases in debt
declines as debt increases, while the marginal cost increases, so that a firm
that is optimizing its overall value will focus on this trade-off when choosing
how much debt and equity to use for financing. Modigliani and Miller in 1963
introduced the tax benefit of debt. Later work led to an optimal capital
structure which is given by the trade-off theory. According to Modigliani and
Miller, the attractiveness of debt decreases with the personal tax on the
interest income. A firm experiences financial distress when the firm is unable
to cope with the debt holders' obligations. If the firm continues to fail in
making payments to the debt holders, the firm can even be insolvent.

The first element of Trade-off theory of capital structure, considered as the

cost of debt is usually the financial distress costs or bankruptcy costs of debt.
The direct cost of financial distress refers to the cost of insolvency of a
company. Once the proceedings of insolvency start, the assets of the firm may
be needed to be sold at distress price, which is generally much lower than the
current values of the assets. A huge amount of administrative and legal costs is
also associated with the insolvency. Even if the company is not insolvent, the
financial distress of the company may include a number of indirect costs like
cost of employees, cost of customers, cost of suppliers, cost of investors, cost
of managers and cost of shareholders.

The firms may often experience a dispute of interests among the management
of the firm, debt holders and shareholders. These disputes generally give birth
to agency problems that in turn give rise to the agency costs. The agency costs
may affect the capital structure of a firm. There may be two types of conflicts
shareholders-managers conflict and shareholders-debt holders conflict. The
introduction of a dynamic Trade-off theory of capital structure makes the
predictions of this theory a lot more accurate and reflective of that in practice.

Q-What is Leverage?

There are two major classification of costs in the organisation. They are (a)
Fixed cost, (b) Variable cost.High operating leverage. The operating leverage
has a bearing on fixed costs. There is a tendency of the profits to change, if the
firm employs more of fixed costs in its production process, greater will be the
operating cost irrespective of the size of the production. The operating
leverage will be at a low degree when fixed costs are less in the production
process. Operating leverage shows the ability of a firm to use fixed operating
cost to increase the effect of change in sales on its operating profits. It shows
the relationship between the changes in sales and the charges in fixed
operating income. Thus, the operating leverage has impact mainly on fixed
cost, variable cost and contribution. It indicates the effect of a change in sales
revenue on the operating profit (EBIT). Higher the operating leverage indicates
higher the amount of fixed cost and reduces the operating profit and increases
the business risks.

Combined Leverage: This leverage shows the relationship between a change in

sales and the corresponding variation in taxable income. If the management
feels that a certain percentage change in sales would result in percentage
change to taxable income they would like to know the level or degree of change
and hence they adopt this leverage. Thus, degree of leverage is adopted to
forecast the future study of sales levels and resultant increase/decrease in
taxable income. This degree establishes the relationship between contribution
and taxable income.

What is ABC analysis?

The material are divided into a number of categories for adopting a selective
approach for material control. It is generally seen that in manufacturing
concern, a small percentage of items contribute a large percentage of value of
consumption and a large percentage of items of materials contribute a small
percentage of value. In between these two limits there are some items which
have almost equal percentage of value of materials. Under A-B-C analysis, the
materials are divided into three categories viz., A, B and C. Past experience has
shown that almost 10 per cent of the items contribute to 70 per cent of value
of consumption and this category is called 'A' Category. About 20 per cent of
the items contribute about 20 per cent of value of consumption and this is
known as category 'B' materials. Category 'C' covers about 70 per cent of items
of materials which contribute only 10 per cent of value of consumption. There
may be some variation in different organisations and an adjustment can be
made in these percentages.A-B-C analysis helps to concentrate more efforts
on category A since greatest monetary advantage will come by controlling
these items.

Q- What is Economic Order Quantity(EOQ)?

A decision about how much to order has great significance in inventory

management. The quantity to be purchased neither be small not big because
costs of buying and carrying material very high . Economic order quantity is
the size of the lot to be purchased of buying and carrier this is the quantity of
materials which costs a purchased at minimum costs. Generall, economic order
quantity is a point at which inventory carrying coat is equal to the order cost.
In determining economic order quantity it is assumed that cost managing
inventory is made up two parts i.e Ordering costs and carrying coats.
(A) Ordering costs. These are the costs which are associated with the
purchasing or ordering of materials. These costs include:

(1) Costs of staff posted for ordering of goods. A purchase order is processed
and then placed with suppliers. The labour spent on this process is included in
ordering costs.

(2) Expenses incurred on transportation of goods purchased.

(3) Inspection costs of incoming materials.

(4) Cost of stationery, typing, postage, telephone charges, etc.

These costs are aso known as buying costs and will arise only when some
purchases are made.

When materials are manufactured in the concern then these costs will be
known as set-up costs. These costs will include costs of setting up machinery
for manufacturing materials, time taken up in setting. cost of tools, etc.

The ordering costs are totalled up for the year and then divided by the number
of orders placed each year. The Planning Commission of India has estimated
these costs between Rs. 10 to Rs. 20 per order.

(B) Carrying Costs. These are the costs for holding the inventories. These costs
will not be incurred if inventories are not carried. These costs include:

(1) The cost of capital invested in inventories. An interest will be paid on the
amount of capital locked-up in inventories.

(2) Cost of storage which could have been used for other purposes.

(3) The loss of materials due to deterioration and obsolescence. The materials
may deteriorate with passage of time. The loss of obsolescence arises when the
materials in stock are not usable because of change in process or product.

(4) Insurance cost.

(5) Cost of spoilage in handling of materials.

The Planning Commission of India had estimated these costs between 15 per
cent to 20 per cent of total costs. The longer the materials kept in stocks, the
costlier it becomes by 20 per cent every year. The ordering and carrying costs
have a reverse relationship.