Chapter 9 Financial Management

Capital structure refers to the mix between owners and borrowed funds. It represents the proportion of equity and debt. It includes the composition of long- term sources of funds such as equity shares, preference share, debentures and long-term loans.

Objectives of financial planning are:

1. To ensure availability of funds whenever required.
2. To see that firm does not raise resources unnecessarily.

The concept of financial management which increases the return to equity shareholders due to the presence of fixed financial charges is Trading on Equity. It is advisable to use trading on equity when the rate of return on investment is more than the rate of interest payable on debentures and loans.

In the above case Amrit is running a ‘Transport service’ which operates on larger scale, and it will require large amount of working capital. Hence, the working capital requirement of the firm will be more.

Working capital means the capital invested in current or working assets such as stock of materials and finished goods, accounts receivable, bills receivable, short-term securities and cash or bank balance for meeting day-to-day expenses.

In the above case Ramnath purchasing the components on three month credit and selling the product in cash. In this situation the requirement of working capital will be reduced to the extent of credit he availed.

Financial risk refers to a position when a company is unable to meet its fixed financial charges namely interest payments, preference dividend and repayment obligations. It arises with the higher use of debt.

Current assets refer to those assets held in a business which can be converted in the form of cash within a period of one year. These assets are more liquid but less profitable. Examples of current assets are:

1. Cashinhand/cashatbank
2. Bills receivables
3. Debtors
4. Raw materials

The two main objectives of financial management are:

1. Primary objective: The primary objective of financial management is maximization of shareholder’ wealth, which is achieved by increase in value of shares or the market price of the shares.

2. Secondary objectives: In order to achieve the primary objective of wealth maximization, financial management should aim to the following objectives:

   1. Profit maximization/effective utilization of fund: Effective utilization of funds, by ensuring that benefits of an investment exceeds its cost.

   2. Availability of funds at reasonable costs: To raise funds at minimum cost and minimum risk, through effective financing decision.

   3. Ensure safety of funds: To ensure safety of funds by creating reserves, reinvesting profits etc.

   4. Maintaining adequate liquidity: To maintain financial liquidity and profitability through working capital decision.

   5. Avoiding idle finance: Idle finance not only adds to the cost of funds but also encourages wasteful expenditure. Therefore, financial management avoids over capitalization.

Financial management is concerned with optimum procurement as well as usage of finance. It aims at mobilization of funds at a lower cost and deployment of these funds in the most profitable activities. Three broad decisions are:

1. Investment decision: It relates to how the firm’s funds are invested in different assets, so that the firm is able to earn the highest possible returns on investment. Investment decisions can be long-term or short-term.

2. Financing decision: It is concerned with the decisions of how much funds are to be raised from which long-term source, i.e. by means of shareholders’ funds or borrowed funds. Shareholders’ funds include share capital, reserves and surplus and retained earnings, whereas, borrowed funds includes debentures, long-term loans and public deposits.

3. Dividend decision: It relates to how much of the company’s net profit is to be distributed to the shareholders and how much of it should be retained in the business for meeting the investment requirements. This decision should be taken, keeping in view the overall objective of maximizing shareholders’ wealth.

If the cost of the debt is less than the cost of capital then a company can issue debenture for raising fund.

In the above case, the cost of capital is 10%, for the total capital of ₹ 80,00,000, the cost of capital is ₹ 8,00,000. The EBIT for the previous year of the company was ₹ 8,00,000 and total capital investment was ₹ 1,00,00,000. So the total ROI is 

ROI = RETURN ÷ INVESTMENT × 100

ROI= 800000 ÷ 10000000 × 100 = 8 %

It will assume that the company will operates with the same efficiency, the additional investment of ₹ 80,00,000 will have net ROI of 8% which will be ₹ 6,40,000 against the cost of debt ₹ 8,00,000.

In the above case the cost of debt is 10% which is generating ROI of 8%, so it will not be advisable for the company to issue debenture when the cost of debt is higher than the cost of capital.

Working capital means the portion of capital which is invested in current assets. This investment facilitates smooth day-to-day operations of the business. It affects both the profitability as well as liquidity of a business.

• The increase in current assets will provides more liquidity to the business but it affects the profitability because these assets provide little or low return.

• If there is low working capital it will affect the liquidity of the business which leads to create problem or disturb in day to day operations of the business.

a. Identify the financial concept discussed in the above paragraph. Also, state the objectives to be achieved by the use of financial concept so identified.

Ans. The financial concept discussed in the above paragraph is called Capital budgeting decision. It is a long term investment decision. Capital Budgeting decisions are very crucial, as they affect the earning capacity of the business in the long-run. Since, these decisions involve huge amount of investment and are irreversible, they need to be taken with utmost care.

In the above case the company wants to invest in new machinery which will affect the operation of the company that leads to affect the profitability of the company as well.

The objectives can be achieved by the use of this financial concept are:

1. Cash Flows of the project: When a business invests huge amount of money in a certain project, then it expects regular and reasonable cash inflows from such an investment. Cash generated from operations are analysed in selecting the desired project.

2. The Rate of Return: Return expected from the investment is a major determinant of investment decision. The project is selected after comparing expected returns of different projects and the degree of risk involved in them.

3. The Investment Criteria Involved: The decision to invest in a particular project involves a number of calculations regarding the amount of investment, interest rate, cash flows and rate of return. There are different techniques to evaluate investment proposals. These techniques are helpful in selecting a particular project.

b. ‘There is no restriction on payment of dividend by a company’. Comment.

Ans. Dividend is that part of profit, which is distributed among shareholders on regular basis. There are various factors which affect the dividend decision:

Legal Constraints: Certain provisions of the Companies Act, place restrictions on payouts as dividend. Such provisions must be adhered to, while declaring the dividend.

Contractual Constraints: While granting loans to a company, sometimes, the lender may impose certain restrictions on the payment of dividends in future. The companies are required to ensure that the dividend payout does not violate the loan agreement in this regard.

The capital invested in current or working assets such as stock of materials and finished goods, accounts receivable, bills receivable, short-term securities and cash or bank balance for meeting day-to-day expenses is known as working capital or current capital.

Five important determinant of working capital requirement are:

1. Nature of Business: The basic nature of a business influences the amount of working capital. A trading organisation and a service industry firm usually needs a smaller amount of working capital as compared to a manufacturing organisation.

2. Scale of Operations: Organisations which operates on a large scale, their quantum of inventory and debtors required is generally high. Such organizations, therefore, require large amount of working capital as compared to the organisations which operates on a lower scale.

3. Business cycle: Different phases of business cycles affect the requirement of working capital by a firm. In case of a boom, the sales as well as production are likely to be larger and, therefore, larger amount of working capital is required. As against this, the requirement for working capital will be lowers during the period of depression, since the sales as well as production will be less.

4. Seasonal Factors: Some of the businesses have seasonal operations. During peak season, larger amount of working capital is required because of higher level of activity.
   As against this, the level of activity as well as the requirement for working capital will be lower during the lean season.

5. Production cycle/operating cycle: Production cycle is the time span between the receipt of raw material and their conversion into finished goods. Some businesses have a longer production cycle while some have a shorter one. Duration and the length of production cycle affect the amount of funds required for raw materials and expenses.

Capital structure decision is related to proportion of debt and equity in the capital structure. What proportion is maintained, decides the cost and risks.

This is because both equity and debt differ significantly in their risk and returns.

1. On one side, equity is a riskless source, but it has no benefit of tax deductibility of dividend, and dividends are paid out of profits after tax.

2. On the other hand, debentures are paid are fixed rate of interest, the interest paid are deductible from the income for tax calculation purposes. Thus, it creates a higher rate of return for equity shareholders.

However, debt is more rewarding in terms of increase in the wealth of shareholders, but increases the risk too. Thus, reckless use of debt also is unfavourable and sometimes, may even force the company to go into liquidation. Thus, capital structure should be so formed, which optimizes the risk-return relationship.

Yes, a capital budgeting decision is capable of changing the financial fortunes of a business. Investment decision involves careful selection of assets in which funds are to be invested. Decisions relating to investment in fixed assets are known as capital budgeting decision, whereas, those concerning investment in current assets are called working capital decisions.

A business needs to invest funds for setting up new business, for expansion and modernization. Investment decision is taken after careful scrutiny of available alternatives in terms of costs involved and expected return.

These decisions are very crucial for any business. Earning capacity of the fixed assets of a firm, profitability and competitiveness, all are affected by the capital budgeting decisions. Moreover, these decisions normally involve huge amount of investment and are irreversible, except at a huge cost.

Following are the factors that highlight the importance of capital budgeting decisions.

1. These are long-term decisions and can be reserved only at huge costs.
2. These generally involve commitment of huge funds.
3. These have a significant effect on the profitability and future of the business.

Thus, once these decisions are taken, it is impossible for a firm to undo these decisions and certainly a bad capital budgeting decision normally has the capacity to severely damage the financial fortune of a business.

The factors that affects the dividend decisions are:

1. Amount of Earnings: Dividends are paid out of current and past earnings. Thus, earnings are major determinant of dividend decision.

2. Stability in Earnings: A company having higher and stable earnings can declare higher dividends than a company with lower and unstable earnings.

3. Stability of Dividends: Generally, companies try to stabilize dividends per share. A steady dividend is given each year. A change is only made, if the company’s earning potential has gone up and not just the earnings of the current year.

4. Growth Opportunities: Companies having good growth opportunities retain more money out of their earnings so as to finance the required investment. The dividend declared in growth companies is, therefore, smaller than that in the non-growth companies.

5. Cash Flow Position: Dividend involves an outflow of cash. Availability of enough cash is necessary for payment or declaration of dividends.

6. Shareholders’ Preference: While declaring dividends, management must keep in mind the preferences of the shareholders. Some shareholders in general desire that at least a certain amount is paid as dividend. The companies should consider the preferences of such shareholders.

7. Taxation Policy: If the tax on dividends is higher, it is better to pay less by way of dividends. But if the tax rates are lower, higher dividends may be declared. This is because as per the current taxation policy, a dividend distribution tax is levied on companies. However, shareholders prefer higher dividends, as dividends are tax free in the hands of shareholders.

8. Stock Market Reaction: Generally, an increase in dividends has a positive impact on stock market, whereas, a decrease or no increase may have a negative impact on stock market. Thus, while deciding on dividends, this should be kept in mind.

9. Access to capital market: Large and reputed companies generally have easy access to the capital market and, therefore, may depend less on retained earnings to finance their growth. These companies tend to pay higher dividends than the smaller companies.

10. Legal Constraints: Certain provisions of the Companies Act, place restrictions on payouts as dividend. Such provisions must be adhered to, while declaring the dividend.

11. Contractual Constraints: While granting loans to a company, sometimes, the lender may impose certain restrictions on the payment of dividends in future. The companies are required to ensure that the dividend payout does not violate the loan agreement in this regard.

Trading on equity means the use of fixed cost sources of finance such as preference shares, debentures and long-term loans in the capital structure, so as to increase the return on equity shares. This is also known as financial leverage. It is advisable to use trading on equity when the rate of return on investment is more than the rate of interest payable on debentures and loans. The use of more debt along with equity increases Earning per share(EPS). Let us take an example of companies A and B.

	Company A	Company B
Share capital (100 each) Loan @ 15% p.a.	₹ 10,00,000	₹ 4,00,000
	-	₹ 6,00,000
Total Capital	₹ 10,00,000	₹ 10.00.000
Profit Before Interest and Tax (30% ROI) (-) Interest (15% of ₹ 6,00,000) Profit Before Tax (-) Tax @ 50%	₹ 3,00,000	₹ 3,00,000
	Nil	₹ 90,000
	₹ 3,00,000	₹ 2,10,000
	₹ 1,50,000	₹ 1,05,000
Profit After Tax	₹ 1,50,000	₹ 1,05,000

Earning per Share (EPS) = Profit After Tax ÷ Number of Equity Shares

A = 150000 ÷ 10000 = ₹ 15
B= 105000 ÷ 4000 = ₹ 26.25

Thus, from the above example, it is clear that shareholders of company B receive higher EPS than the shareholders of company A due to more debt in the total capital of company B.

a. Describe the role and objectives of financial management for this company.

Ans. Role of Financial Management: A financial management decision has a bearing or the financial health of business by affecting the following:

1. Size and composition of fixed assets: ‘S’ Ltd requires ₹ 5000 crores, which is a huge sum. Financial management will have to ensure that composition is carefully decided. Since, it is into infrastructure industry, it has a long gestation period between investments and returns. Thus, the goal should be to minimise the risk with investing into most productive assets and latest technology, which in no case should remain idle.

2. Quantum of current assets and their break-up: ₹ 500 crores are required for current assets to finance working capital. The company should ensure correct break-up and optimum utilization.

3. Amount of long-term and short-term financing to be used: Long-term assets require long-term financing, whereas, short-term assets require short-term financing. The choice is between liquidity and profitability. An optimum mix of two is required.

4. Breakup of long-term financing into debt and equity: Since, setting up of new steel plant is a long-term task, therefore, large amount of debt is required. Accordingly, debt and equity ratio might be more.

5. Items of profit and loss account: Higher debt is likely to increase interest expense of the company. This and other likely expenses must to be kept in mind before taking financing decision.

Objective of Financial Management

The objective of financial management is maximization of shareholders’ wealth. The investment decision, financial decision and dividend decision help an organisation to achieve this objective. In the given situation, S Ltd envisages growth prospects of steel industry due to the growing demand.

To expand the production capacity, the company needs to invest. However, investment decision will depend on the availability of funds, the financing decision and the dividend decision. However, the company will take those financing decisions which result in value addition, i.e. the benefits are more than the cost. This leads to an increase in the market value of the shares of the company.

b. Explain the importance of having a financial plan for this company. Give an imaginary plan to support your answer.

Ans. Importance of financial plan for the company are:

1. It helps to forecast what might happen in future. Thus, it prepares a company to face uncertainty.
2. It ensure provision of adequate funds to meet working capital requirements
3. It brings about a balance between inflow and outflow of funds and ensures liquidity throughout the year.
4. It solves the problems of shortage and surplus of funds and ensures proper and optimum utilization of available resources.
5. It ensures increased profitability through cost benefit analysis and by avoiding wasteful operations.
6. It seeks to eliminate ‘wastage of funds and provides better financial control’.
7. It seeks to avail the benefits of trading on equity.

Financial Plan of 'S' Ltd

An imaginary financial plan for steel plant ( in form of anticipated balance sheet).

Particulars	Amount
Equity and Liabilities   1. Shareholders' Funds       (a) Share Capital       (b) Reserves and Surplus	600 400
2. Non-current Liabilities       (a) Secured Loans       (b) Unsecured Loans	2000 2000
3. Current Liabilities       (a) Trade Payables       (b) Provisions	400 100
Total	5500
Assets   1. Non-current Assets       (a) Fixed Assets       (b) Non-current Investments	3000 100
2. Current Assets       (a) Short-term Loans and Advances       (b) Miscellaneous Expenditure       (a) Profit & Loss A/c (Debit Balance)	1000 300 200
Total	5500

Note:

• It is an imaginary financial plan.
• The total capital is ₹ 5500 crores.
• Fixed capital is ₹ 5000 crores and working capital is ₹ 500 crores.
• Debt equity ratio of 4:1 has been assumed.
• Since, steel plant is an infrastructure project, having a long gestation period. Therefore, company has to borrow, thus ₹ 4000 crores has been borrowed in form of secured and unsecured loans.
• It is an old company, thus is having reserves and surplus of ₹ 400 crores.
• Long gestation period can call for miscellaneous expenditure of ₹ 300 debit balance of profit and loss A/c in normal situations.
• Current ratio of 2:1 quite good.

c. What are the factors which will affect the capital structure of this company?

Ans. Capital structure refers to the proportion in which debt and equity funds are used for financing the operations of a business. A capital structure is said to be optimum when the proportion of debt and equity is such that, it results in an increase in the value of shares.

The factors that will affect the capital structure of this company are:

(i) Equity funds: The composition of equity funds in the capital structure will be governed by the following factors:

• The requirement of funds of ‘S’ Ltd is for long-term. Hence, equity funds will be more appropriate, but due to long gestation period, returns will materialize much later and a mix of more debt and equity is there, thus equity must not be lesser than this, otherwise overall risk will increase.
• There are no financial risks attached to this form of funding.
• If the stock market is bullish, the company can easily raise funds through issue of equity shares.
• If the company already has raised reasonable amount of debt funds, each subsequent borrowing will come at a higher interest rate and will increase the fixed charges.

(ii) Debt funds: The usage and the ratio of debt funds in the capital structure will be governed by factors like:

• The availability of cash flow with the company to meet its fixed financial charges. The purpose is to reduce the financial risk associated with such payments, which can further be checked by using ‘debt service coverage ratio’.
• It will provide the benefits of trading on equity and hence, will increase the Earning Per Share of equity shareholders. However, ‘Return on Investment’ ratio will be the guiding principle behind it. The company should opt for trading on equity only when Return on Investment is more than the interest rate on debt.
• Interest on debt funds is a deductible expense and therefore, will reduce the tax liability and thus increase the gains of equity shareholders.
• It does not result in dilution of management control.

d. Keeping in mind that it is a highly capital-intensive sector, what factors will affect the fixed and working capital. Give reasons in support of your answer.

Ans. The working and fixed capital requirement of S Ltd will be high due to following reasons:

1. The business is capital intensive and the scale of operation is large.
2. Heavy investments are required for building up the production base and for technological upgradation.
3. Incaseofsteelindustry,themajorinputsareironoreandcoal.The ratio of cost of raw material to total cost is very high. Hence, higher will be the need for working capital.
4. The longer the operating cycle, the larger is the amount of working capital required, as the funds get locked up in the production process for a long-period of time.
5. Terms of credit for buying and selling goods, discount allowed by suppliers and to the customers also determines the quantum of working capital.