Financial Management

Financial Management

Prof. G.S. POPLI


• Maheshwari S.N. Financial Management – Principles & Practice. Sultan Chand & Sons, New Delhi.

• Khan & Jain, Financial Management, Tata McGraw-Hill Publishing Co. Ltd. New Delhi.

• V.K. Bhalla. Financial Management & Policy – Anmol Publications Pvt. Ltd. New Delhi.

• John J. Hampton. Financial Decision Making – Prentice Hall of India Pvt. Ltd. New Delhi.


• Meaning of Business Finance : In general, finance may be defined as the provision of money at the time it is wanted. However as a Management Function, it has a special meaning.

• Guthman & Dougall : “Business finance can broadly be defined as the activity concerned with planning, raising, controlling and administrating of the funds used in the business.”

Objectives of Financial Management

1. Basic Objectives : Traditionally, basic objectives of FM are

(a). The maintenance of liquid assets, and (b). Maximisation of the profitability of the firm.

2. Other Objectives : (a). Ensuring a fair return to shareholders. (b). Building up reserves for growth and expansion. ©. Ensuring maximum operational efficiency. (d). Ensuring financial discipline in the organisation.

Profit Maximisation Concept-Criticism

1. It is a vague concept.2. It ignores timings.3. It overlooks quality aspects of future activities.4. Prof. Ezra Soloman has suggested Wealth

Maximisation concept.5. WM Concept : Any financial action which

creates wealth or which has a net present worth above zero is a desirable one and should be undertaken.

Nature of Finance

• Finance is a specialised functional field under Business Administration.

• Is an applied field of B.A. Principles developed by Financial Managers or borrowed from accounting, economics or other fields are applied to the problems of managing money.

• Finance different from Accounting & Economics.

Scope of Financial Management

• Traditional Approach : Corporation Finance by Thomas Greene in 1897.

• Corporation Finance by Edward Meade in 1910.

• Financial Policy of Corporations by Arther Dewing in 1919.

• The traditional approach evolved during 1920 and continued to dominate academic thinking upto early 50s.


• Traditional Approach : (a). Arrangement of funds from Financial

Institutions. (b). Arrangement of funds through financial

instruments viz. Shares, bonds etc. ©. Looking after the legal and accounting

relationship between a corporation and its sources of funds.


• Traditional Approach – Weaknesses1.Outsider-looking – in approach.2.Ignored routine problems.3.Ignored non-corporate enterprises.4.Ignored working capital financing.5.No emphasis on allocation of funds.


• Modern Approach : Since Mid 50s.(Also role of Finance Manager in the changing scenario).

(a). Funds requirement decision (b). Financing decision. ©. Investment decision. (d). Dividend decision.


• Modern Approach : Analytical Approach with the help of computers.

• What is the total volume of funds an enterprise should commit?

• What specific assets should an enterprise acquire?

• How should the funds required be financed?

Impact of Financial & Economic Environment on FM - Globalisation

• Boost in Trade & Commerce.• Increase in Foreign Collaboration resulting in

transfer of latest technology.• Optimum utilisation of finance material and

human resources which has led to improvement in overall efficiency.

• Larger capital inflows – greater industrialisation – increased foreign exchange reserves.

• Development of infrastructural facilities and new financial instruments.

Methods of Financial Management – Tools

Any logical method for the following purposes :1. Measuring the effectiveness of firm’s actions & decisions2. Measuring the validity of the decisions regarding

accepting or rejecting future projects. Important financial tools are :

• Cost of Capital• Financial leverage or trading on equity• Capital Budgeting Appraisal Methods.• ABC Analysis, Cash Management Models, Aging schedule

of inventories, Debtor’s turnover Ratio etc.• Ratio Analysis.• Funds Flow and Cash Flow Analysis.

Time Value of Money

• Time Value of a Money is a useful concept in handling Capital Budgeting problems.

• Money has a time Value because of the following reasons :

1.Individuals generally prefer current consumption.

2.Investment for future greater value possible.3.Inflation Factor – More Purchasing Power in

present than the future money.

Valuation of Simple Interest

M = P (I + i) x t Where,M = Maturity ValueP = Initial InvestmentI = Rupee value of interest earnedI = Interest rateT = Time period for which funds are invested• If Rs. 1000 is invested for 5 years at a simple

interest rate of 15%, what will be the interest and maturity value?

Valuation Concepts

• Compound Value Concept. Equation : A = P (1 + i)n where, A = Amount at the end of period ‘n’ P = Principal at the beginning of the period. I = Interest rate n = Number of years• If Rs. 1000 is invested for 5 years at a compound

interest rate of 15%, what will be the interest and maturity value? Ans : Rs. 2011.40

Future Value of an Annuity

Annuity : Investment made at regular intervals of time in constant amount in recurring deposits or in LIC Policy or Pension Fund. Future Value of Annuity :

F = A(I+i)t -I Where, F = Future Value i A= Constant amount paid I = Interest Rate t = Number of years

• Calculate the compounded value of Rs. 1000 invested every year for 10 years, at a 15% interest rate.

Future Value of Annuity

F = 1000(1.15) 10 – 1) 0.15 = Rs. 20,300/-

• If every year Rs. 1000 is invested at 15% interest rate, it would become Rs. 1,02,440/- in 20 years.

Sinking Fund Payment

• Sinking Fund is opposite to annuity. Companies create a sinking fund every year so that on a maturity date a large amount of payment can be made. Formula :

• A = F( I ) (I+i)t-I • If a Co. has to pay bonds worth Rs. 100 Crores at

the end of 5 years and if it can earn 12% interest on investment, then the Co. should create the Annual Sinking Fund of What Amount?

Sinking Fund

A = 100 ( 0.12 ) (I.12)5 –I = 15.74 Crores

• The Co. should keep aside Rs. 15.74 Crores every year for 5 years and invest the same in 12% interest securities. The Co. can use the maturity value for the repayment of bonds.

Present Value/Discounting Concept

• Present Value after ‘n’ years. __A____ Pv = (1 + i)n Where, Pv = Principal amount the investor is willing to forgo at

present. 1 = Rupee value of interest earned. i = interest rate, n = Number of year. A = Amount at the end of the period n. Note : This is reverse of the compounding formula.• Calculate Present Value of Rs. 1000 @ received in1 to

5 years

Present Value/Discounting Concept

Rs. 1000/- Received in Working Present Value at 1,000/-

Year -1 1000/(1.15)1 869.60

2 1000/(1.15)2 756.10

3 1000/(1.15)3 657.50

4 1000/(1.15)4 571.80

5 1000/(1.15)5 497.20

Present Value of Perpetuity

• Some financial commitments like pension, perpetual bonds etc. may involve a perpetual annuity cash flow. The present value of perpetuity can be calculated :

• PV of Perpetuity : Ax 1/I• At a 20% discount rate, the maximum annuity

factor will be 5 (i.e. 1/0.2). If Rs. 1000 is received every year upto the perpetuity, then its present value will be 1000x5 = Rs. 5,000/-

Capital Recovery

• Certain financial problems require reverse calculations to those of the present value of annuity. For example a Leasing Co. would like to calculate an annual rental charge for the lease equipment or a bank would like to recover a loan in equated annual installments.

• PV of Annuity : PV = A ( 1+i)t-1) ix(1+i)t• A Bank disbursed a loan of Rs. 1 Lac @18% recoverable

in 5 equated annual installments with interest. Calculate the amount of installment?

Capital Recovery

• Solution = 1,00,000x(0.18x(1.18)5 (1.18)5 – 1 = 1,00,000x(0.4118/1.2878) = 1,00,000x0.3198 = Rs. 31,980/-

Funds Flow Statement• Funds : It refers to cash, cash equivalents or to working

Capital. Current Assets and Current Liabilities.• Flow of Funds : The term ‘Flow’ means change and

therefore the term ‘Flow of Funds’ means change in Funds or change in working capital. In other words any increase or decrease in working capital means Flow of Funds.

• Funds Flow Statement : A summary of a firm’s changes in financial position from one period to another. It is also termed as a “Statement of Sources and Applications of Funds” and “Where got and where gone funds”.

• Balance Sheet = Stock of funds• Changes in Balance Sheet items = Net flow of funds

Sources & Uses of Funds

We prepare a basic, bare bones funds statement by :

• Determining the amount and direction of net Balance Sheet changes that occur between two Balance Sheet dates.

• Classifying net Balance Sheet changes as either sources or uses of funds, and

• Consolidating this information in a sources and uses of funds statement format

Uses/Importance of Funds Flow Statement

1. It explains the financial consequences of business operations.

2. It answers intricate queries.3. It acts as an instrument for allocation of

resources.4. It is a test as to effective or otherwise use of

working capital.

Techniques for preparing Funds Flow Statement

1. Schedule of changes in Working Capital It can be prepared by comparing the current

assets and current liabilities of two periods. 2. Funds Flow Statement For preparing a Funds Flow Statement, it is

necessary to find out the sources and Application of Funds. Here, attention is given to changes in Fixed Assets and Fixed Liabilities and the changes in current assets and current liabilities are ignored.

Schedule of changes in Working Capital - Rules

1. Increase in current assets results in increase (+) in working capital.

2. Decrease in current assets results in decrease (-) in working capital.

3. Increase in current liability, results in decrease (-) in working capital.

4. Decrease in current liability, results in increase (+) in working capital.

Funds Flow Statement

1. Sources of Funds• Issue of Shares• Issue of Debentures• Long term Borrowing• Sale of fixed assets• Operating profit

Total Sources

Funds Flow Statement2. Application of Funds• Redemption of redeemable Preference Shares• Redemption of Debentures.• Payment of other long term loans.• Purchase of Fixed Assets.• Operating Loss• Payment of dividend, Tax etc.

Total UsesNet Increase/Decrease in Working Capital(Total Sources – Total Uses.


• Tip to remember : The following device should help you to remember what constitutes a source or use of funds :

A L S - + U + -

Funds Flow Statement• The following is the Comparative Balance Sheet of

M/s. ABC Ltd. Prepare a Funds Flow Statement Balance Sheet• Liabilities 31.12.2008 31.12.2009 Share Capital 8,000 8,500 P&L Appropriation A/c. 1,450 2,450 Creditors 900 500 Mortgage Loan 500 ---------------------------- 10,350 11,950


• Balance Sheet : Assets 31.12.08 31.12.09 Land 5,000 5,000 Plant 2,400 3,400 Debtors 1,650 1,950 Stock 900 700 Cash at Bank 400 900 ------------------------ 10,350 11,950

Funds Flow StatementSolution : Schedule of Changes in Working Capital Assets/Liability Increase(+) Decrease (-)Stock 200Debtors 300Cash at Bank 500Creditors 400 ------ ----- 1,200 200Net Increase in Working Capital Rs. 1,000


Funds Flow Statement• Sources of FundsIncrease in Share Capital 500Mortgage Loan 500Funds from Operations 1,000 Total Sources 2,000• Application of FundsPlant purchased 1,000 Total Application 1,000 Net Increase in Working Capital 1,000


Adjustments :• Recognise Profits and Dividends. Source : Net Profit Less Use : Cash Dividends Net source : Increase in Retained Earnings • Recognise Depreciation and Gross change in

Fixed Assets : Source Depreciation Less Use : Additions to Fixed Assets Net Source : Decrease in Fixed Assets

Cash Flow Statement

What is Balance Sheet?• A Balance Sheet is a statement showing the

financial position of the firm as at the last day of the account period.

What is Profit & Loss Account?• This is an income statement which focuses on

financial performance due to the operating activities of a firm during the period.

Cash Flow Statement

• What is Funds Flow Statement : A summary of a firm’s changes in financial position from one period to another. It is also termed as a “Statement of Sources and Applications of Funds” and “Where got and where gone funds”.

Cash Flow Statement

What is Cash Flow Statement?• Cash Flow Statement is a statement which

indicates sources of cash inflows and transactions of cash outflows of a firm during an accounting period. The activities / transactions which generate cash inflows are known as sources of cash and activities which cause cash outflows are known as uses of cash. It is also termed as “Where got where gone statement”.

Cash Flow Statement

Sources of Cash Inflows• Business Operations/Operating activities• Non-business/operating activities (Interest, Dividend

received)• Sale of Long term assets (Plant, building and

equipment)• Issue of additional Long term securities (Equity,

Preference Shares and Debentures)• Additional Long term borrowings ( Banks & Financial

Institutions)• Other sources (specify them)

Cash Flow Statement

Sources of Cash Outflows :• Purchase of Long term assets (Plant & Machinery,

Land & Building, Office equipment & Furniture)• Redemption of Preference Shares & Debentures• Repurchase of Equity Shares• Repayment of long term borrowings• Cash dividends paid to shareholders (Preference

& Equity)• Other items (Specify)Net Increase/Decrease in Cash.

Usefulness of Cash Flow Statement

It helps in answering the following questions:• How much cash has been generated from normal

business operating activities / operations of a company.

• What have been the other premier financing activities of the firm through which cash has been raised? What has happened to cash so obtained?

• How much cash has been spent on investment activities, say on purchase of new Plant & Equipments?

Usefulness of Cash Flow Statement

• How was the redemption of Preference Shares and Debentures accomplished?

• How long term sources of cash (internally generated plus raised externally) adequate to finance purchase of new long term/fixed assets.

• What has been the proportion of Debt and Equity for cash raised from outside?

• Why are dividends not larger?• Is the Co. borrowings to pay cash dividends?• Has the liquidity position of the Co. improved

Preparation of Cash Flow Statement- FormatBalance as on 01.01.20 (Opening Balances)• Cash Balance• Bank Balance Add : Sources of Cash Issue of Shares Raising of long term loans Sale of Fixed Assets Short term borrowings

Cash Flow Statement

Cash from Operations :• Profit as per P & L Account Add/Less : Adjustment for Non-Cash items Add : Increase in Current liabilities Decrease in Current Assets Less : Increase in Current Assets Decrease in Current Liabilities Total Cash Available (1)

Cash Flow StatementLess : Application of Cash Redemption of Preference Shares “ Long term Loans Purchase of Fixed Assets Decrease in deferred payment liabilities Cash outflow on account of operations Tax Paid Dividend paid Decrease in unsecured loans, deposits etc. Total Applications (2)Closing Balances Cash Balance Bank Balance

Utility of Cash Flow Analysis

• Helps in efficient Cash Management.

• Helps in internal Financial Management.

• Discloses the movements of cash

• Discloses success or failure of cash planning

Limitations-Cash Flow Statement

• Cannot be equated with Income Statement

• It may not disclose the true financial position of the business. For example : Postponement of purchases and other payments.

• It cannot replace Income Statement or Funds Flow Statement.

Difference between Funds Flow & Cash Flow Statement

(a). Statement of changes in cash position• The Cash Flow Statement takes care of the

changes in the cash position between two balance sheets irrespective of the fact whether the inflow relates to transactions of previous years or the current period or whether of revenue nature or capital nature. On the other hand, the Funds Flow Statement takes into account all funds flowing in or out of the business and cash is only one of those funds.


(b). A tool for Short-term Finances• Cash Flow statement can let know the position for

short of meeting a liability which is going to fall due within a short period say month or quarter. For relatively longer period analysis, the Funds Flow may be more suitable concept.

(c). Effect on Funds of the Company : The Cash Flow Statement affect the working capital as it

is one of the components of the total funds. On the other hand, the changes in funds, do not necessarily affect the cash position, since the funds which do not involve cash do not affect the cash position at all.


(d). Cash is part of WC. Improvement in cash position results in improvement of Funds position but the reverse is not true.

(e). Technique of Preparation. An increase in CL or decrease in CA results in decrease in WC and vice versa. While an increase in CL or decrease in CA (other than cash) will result in increase in cash and vice versa.

Cash from Operations 31.12.2008 31.12.2009Debtors Rs.50,000 Rs.47,000Bills Receivable 10,000 12,500Creditors 20,000 25,000Bills Payable 8,000 6,000Outstanding Exps. 1,000 1,200Prepaid Exps. 800 700Accrued Income 600 750Income recd. In advance 300 250Profit made during the year ---- 1,30,000Que : Calculate Cash From Operations

Cash from Operations

Profit made during the year Rs. 1,30,000Add : Decrease in Debtors 3,000 “ in Prepaid Exps. 100 Increase in Creditors 5,000 Increase in O/S Exps. 200 8,300 1,38,300

Cash from Operations

B/F 1,38,300Less : Increase in B.R 2,500 “ in Accrued Income 150 Decrease in B.P 2,000 “ in Ad. Income 50 4,700

Cash from Operations 1,33,600

Balance SheetLiabilities : Owned Funds• Proprietor’s Capital or Paid up Share Capital• Reserves• Share Premium Reserve• Revaluation Reserve• Investment Allowance Reserve• Depreciation Reserve• Share/debenture/bonds Redemption Reserve• Capital Subsidy Reserve• Retained Profits

Balance Sheet

Long Term or Deferred Liabilities• Debentures or Public Fixed Deposits• Term Loans raised from Banks and Financial

Institutions• Deferred Payment Credits• Loans from Friends & Relatives and Associate

Concerns

Balance SheetShort Term or Current Liabilities• Sundry Creditors• Bills Payables• Unsecured Loans of short term nature• Public Deposits maturing within one year• Expenses Payable• Advance Payments from customers• Provision for Bad & Doubtful Debts• Instalments of Loans, debentures, bonds, redeemable Preference

Shares etc.• Statutory Liabilities i.e. PF dues, Provision for Taxation, Sales Tax,

Excise Tax Etc.• Misc. Current Liabilities i.e. Dividends, gratuity, other exps.

Balance SheetContingent Liabilities : These are not shown in B.S. but

are recorded as a footnote.• Pending Law Suits• Claims against the organisation not acknowledged as

debt.• Guarantees given by the organisation on behalf of

others.• Guarantees issued by banks on behalf of the

organisation.• Taxes and Duties under dispute with the Govt.• Bills or Cheques discounted by banks. (If accounted)

Balance Sheet

Assets : Fixed• Land• Buildings and Structures• Machinery, Tools and Equipment of all types• Vehicles• Furniture and Fixture• Capital work in progress or advance against

fixed assets

Balance Sheet

Current Assets• Cash and Cash at Bank• Bills Receivables• Closing Stocks (Raw Material, Stock in Process,

Finished Goods)• Short Term Investments• Advance Payment of Tax• Pre-Paid Expenses

Balance Sheet

Misc. Assets (Non-Current Assets)• Investment in Non-Marketable Securities• Investment in Long Term Loans to sister or

Allied or Associate Firms.• Other Long term investments• Non-consumable spare parts & stores.• Loans and Advances of long term nature• Prepaid Expenses of long term nature.

Balance Sheet

Intangible Assets : Certain Assets, which do not have any physical presence but just book entries created with some specific objective :

• Goodwill• Patents• Copyrights• Trademarks• Formulae• Preliminary and Formation Expenses• Loss incurred by the organisation.

Ratio Analysis

• Meaning : Ratios are relationships expressed in mathematical terms between figures which are connected with each other in some manner.

• Ratios can be expressed in two ways (a). Times : When one value is divided with

another, the unit used to express the quotient is termed as times.

(b). Percentage : If the quotient obtained is multiplied by 100, the unit of expression is termed as percentage.

Classification of Ratios

1. Traditional Method

2. Functional Method

Traditional Method• The traditional classification has been on the basis of the

financial statement to which the determinants of a ration belong.

(a). Profit & Loss Account Ratios : Gross Profit Ratio, Stock Turnover Ratio.

(b). Balance Sheet Ratios : Current Ratio, Debt Equity Ratio ©. Composite Ratios : Fixed Assets Turnover Ratio, Overall

Profitability Ratio.

Functional Ratios

• Profitability Ratios.

• Coverage Ratios.

• Turnover Ratios.

• Financial Ratios :

Profitability Ratios

(a). Gross Profit Ratio = Gross Profit X 100 Net Sales(b). Net Profit Ratio = Net Profit X 100 Net Sales ©. Operating or = Operating Costs X 100 Expenses Ratio Net Sales


(d). Overall Profitability Ratio : It is also called as “Return on Investment” or “Return on Capital Employed”. It indicates the % of return on the total capital employed in the business. The formula is :

Operating Profit X 100 Capital Employed

Capital Employed(a). Sum total of Long Term funds employed in the business :Share Capital + Res & Surplus + Long Term Loans – (Non

Business Assets + Fictitious Assets) Or(b). Sum total of all Assets whether Fixed or Current.• “Operating Profit” means Profit before Intt. and Tax.

Interest means ‘Interest on long term borrowings’. Interest on short term borrowings will be deducted for computing operating profit. Non trading incomes such as interest on Govt. securities or non trading losses or expenses such as loss on account of fire etc. will also be excluded.

Return on Capital Employed• From the following figures of M/s. ABC & Co.

Calculate the return on total capital employed.Fixed Assets 4,50,000 Reserves 1,00,000 Current Assets 1,50,000 Debentures 1,00,000Investment in 1,00,000 Income from (Govt. Securities) Investment 10,000Sales 5,00,000 Prov. For Tax at 50% ofCost of Goods 3,00,000 Net ProfitSold Intt. On Debentures 10%Share Capital : 10% Preference Rs. 1,00,000 : Equity Rs. 2,00,000

Return on Capital Employed

= Net Operating Profit before Intt. & Tax X 100 Total Capital Employed • Net Operating Profit = Net Profit + Provision

for Tax – Income from Investment + Intt. On Debentures.

= 1,00,000 + 1,00,000 – 10,000 + 10,000 = 2,00,000

Return on Capital Employed

• Capital Employed : (a).Share Capital + Reserves + Debentures + P&L Balance – Investment in Govt.

Securities= (3,00,000 + 1,00,000 + 1,00,000 + 1,00,000 –

1,00,000 = Rs. 5,00,000)• (b).Fixed Assets + Current Assets – Prov. for Tax (4,50,000 + 1,50,000 – 1,00,000 = 5,00,000)= 2,00,000 X 100 = 40% 5,00,000


• Net Profit to total Assets = Net Profit after Tax + Interest X 100 Total Assets• Return on Shareholder’s funds= Profits available for Equity Shareholders X 100 Average Equity Shareholder’s Funds• Earning per Equity Share= Profits available for Equity Shareholders X 100 No. of Equity Shares • Price Earning Ratio = Market Price per Equity Share Earning per Share

Turnover or Efficiency Ratio

• Inventory Turnover (Stock) : Cost of Goods Sold Average Inventory (Ave. Inventory = Opening Stock + Closing Stock) 2• Accounts Receivable Turnover Net Sales on Credit Average Receivable

Financial Ratio• Current Ratio : Current Assets Current Liabilities

• Quick Ratio : Also known as Acid Test Ratio or Liquidity Ratio. Prepaid Exps and Stock are not taken as Liquid Assets & Bank Overdraft and C.C. facilities are excluded from the C.L.

Quick Assets Current Liabilities and Quick Assets Quick Liabilities • Super Quick Ratio can also be calculated by dividing Cash &

Marketable securities with Current/Quick Liabilities.

• Debt Equity Ratio : (a). External Equities Internal Equities, (b). Total Long Term Debt Total Long Term Funds• Debt Service Coverage Ratio : Profit After Tax + Depreciation + Interest on term debt + Lease Rentals, if anyRepayment of term + Interest on term debt + Lease

Rentals, if any• Overall Profitability Ratio = Operating Profit X 100 Capital employed

Computation of Ratios• From the following information, prepare P & L

A/C & B/S of ABC & Co.Opening Stock 1,50,000 Purchases 3,00,000Sales 10,00,000 Wages 2,00,000Closing Stock 2,50,000 Mfg Exps. 1,00,000Salary 25,000 Loss on Sale 55,000Insurance 25,000 PlantRent 30,000 Debtors 1,00,000Reserves 1,00,000 Creditors 1,00,000 Comm. Paid 20,000 Bank Balance 50,000

Computation of Ratios

Intt. On Debentures 10,000 Deb. 2,00,000Pft on sale of shares 50,000 B.Payable 35,000Share Capital : O/S Exps 15,000Equity 1,00,000 Preference 1,00,000Machinery 1,00,000Furniture 1,00,000Prepaid Exps 50,000

Computation of Ratios

• Also calculate the following Ratios.1. Gross Profit & Net Profit Ratio2. Return on Investment Ratio3. Current Ratio4. Debt-Equity Ratio5. Stock Turnover Ratio6. Liquidity Ratio7. Overall Profitability Ratio

Sources of Finance - Classification1. According to Period : (a). Long Term Sources : Shares, Debentures, Long

term Loans (b). Short Term Sources : Advances from Banks, Public

Deposits, Advances from customers & Trade Creditors etc.

2. According to Ownership : (a). Own Capital viz. Share Capital, Retained-Earnings

and Surpluses etc. (b). Borrowed Capital viz. Debentures, Public Deposits

and Loans etc.

Sources of Finance - Classification

3. According to Source of Generation : (a). Internal Sources viz. Retained Earnings

and Depreciation Fund etc.

(b). External Sources viz. Securities such as Shares & Debentures, Loans etc.

Capital Structure

• The Debt-Equity mix of a firm is called Capital Structure.

• The Capital Structure decision is a very significant financial decision since it affects the shareholder’s return and risk and consequently the market value of the share

Capital Structure

• How should the Investment Project be financed?

• Does the way in which the investment projects are financed matter?

• How does financing affect the shareholder’s risk, return and value?

• Does there exist an optimum financing mix in terms of the maximum value to the firm’ shareholders.

Capital Structure

• Can the optimum financing mix be determined in practice for a Company?

• What factors in practice should a Company consider in designing its Financing Policy?

Capital Structure-Decision Process• Capital Budgeting Decision (a). Replacement (b). Moderanisation ©. Expansion (d). Diversification• Need to raise funds (a). Internal Funds (b). Debt ©. External Equity

Capital Structure-Decision Process• Capital Structure Decision (a). Existing Capital Structure (b). Desired Debt-Equity Mix ©. Payout Policy• Desired Debt-Equity Mix : (a). Effect on Return (b). Effect on Risk• Effect on Cost of Capital – Optimum Capital Structure• Value of the Firm

Financial Leverage

• The use of the fixed-charges sources of funds such as Debt and Preference Capital along with the owner’s equity in the capital structure is described as ‘Financial Leverage’ or ‘Gearing’ or ‘Trading on Equity’.

• The rate of interest on debt is fixed irrespective of the Company’s rate of return on assets.

• The rate of preference dividend is also fixed but are paid only when the Co. earns profits.

Financial Management

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