Chapter-9 Financial Management

Meaning of Business Finance

Money required for carrying out business activities is called business finance. Almost all business activities require some finance. Finance is needed to establish a business, to run it, to modernize it, to expand, or diversify it. It is required for buying a variety of assets, which may be tangible like machinery, factories, buildings, offices; or intangible such as trademarks, patents, technical expertise, etc. Also, finance is central to running the day-to-day operations of business, like buying material, paying bills, salaries, collecting cash from customers, etc. needed at every stage in the life of a business entity. Availability of adequate finance is, thus, very crucial for the survival and growth of a business.

Financial Management

All finance comes at some cost. It is quite imperative that it needs to be carefully managed. Financial Management is concerned with optimal procurement as well as the usage of finance. For optimal procurement, different available sources of finance are identified and compared in terms of their costs and associated risks. Financial Management aims at reducing the cost of funds procured, keeping the risk under control and achieving effective deployment of such funds. It also aims at ensuring availability of enough funds whenever required as well as avoiding idle finance.

Objectives

The primary aim of financial management is to maximize shareholders’ wealth, which is referred to as the wealth-maximization concept.

Financial Decisions

Financial management is concerned with the solution of three major issues relating to the financial operations of a firm corresponding to the three questions of investment, financing and dividend decision. In a financing context, it means the selection of best financing alternative or best investment alternative. The finance function, therefore, is concerned with three broad decisions which are explained below:

Investment Decision

A firm’s resources are scarce in comparison to the uses to which they can be put. A firm, therefore, has to choose where to invest these resources, so that they are able to earn the highest possible return for their investors. The investment decision, therefore, relates to how the firm’s funds are invested in different assets.

Investment decision can be long-term or short-term. A long-term investment decision is also called a Capital Budgeting decision. It involves committing the finance on a long-term basts. For example, making investment in a new machine to replace an existing one or acquiring a new fixed asset or opening a new brance, etc. These decisions are very crucial for any business since they affect its earning capacity in the long run. Short-term investment decisions (also called working capital decisions) are concerned with the decisions about the levels of cash, inventory and receivables. These decisions affect the day-to-day working of a business. These affect the liquidity as well as profitability of a business. Efficient cash management, inventory management and receivables management are essential ingredients of sound working capital management.

Factors affecting Capital Budgeting Decision

A number of projects are often available to a business to invest in. but each project has to be evalusted carefully and, depending upon the returns, a particular project is either selected or rejected. There are certain factors which affect capital budgeting decisions.

Cash flows of the project: When a company takes an investment decision involving huge amount it expects to generate some cash flows over a period. These cash flows are in the form of a series of cash receipts and payments over the life of an investment. The amount of these cash flows should be carefully analysed before considering a capital budgeting decision.
The rate of return: The most important criterion is the rate of return of the project. These calculations are based on the expected returns from each proposal and the assessment of the risk involved. Suppose, there are two projects. A and B (with the same risk involved), with a rate of return of 10 per cent and 12 per cent, respectively, then under normal circumstance. Project B should be selected.
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 which are known as capital budgeting techniques. These techniques are applied to each proposal before selecting a particular project.

II. Financing Decision

This decision is about the quantum of finance to be raised from various long-term sources. Short-term sources are studied under the ‘working capital management’.

It involves identification of various available sources. The main sources of funds for a firm are shareholders’ funds and borrowed funds. The shareholders’ funds refer to the equity capital and the retained earnings. Borrowed funds refer to the finance raised through debentures or other forms of debt. The borrowed funds have to be repaid at a fixed time. The risk of default on payment is known as financial risk which has to be considered by a firm likely to have insufficient shareholders to make these fixed payments. Shareholders’ funds, on the other hand, involve no commitment regarding the payment of returns or the repayment of capital. A firm, therefore, needs to have a judicious mix of both debt and equity in making financing decisions, which may be debt, equity, preference share capital, and retained earnings.

Factors Affecting Financing Decisions

The financing decisions are affected by various factors. Important among them are as follows:Cost: The cost

Cost: The cost of raising funds through different sources are different. A prudent financial manager would opt for a source would normally opt for a source which is the cheapest.
Risk: The risk associated with each of the sources is different.
Floatation Costs: Higher the floatation cost, less attractive the source.
Cash Flow Position of the Company: A stronger cash flow position may make debt financing more viable than funding through equity.
Fixed Operating Costs: If a business has high fixed operating costs (e.t., building rent, Insurance premium, Salaries, etc.), It must reduce fixed financing costs. Hence, lower debt financing is better. Similarly, if fixed operating cost is less, more of debt financing may be preferred.
Control Considerations: Issues of more equity may lead to dilution of management’s control over the business. Debt financing has no such implication. Companies afraid of al takeover bid would prefer debt to equity.
State of Capital Market: Health of the capital market may also affect the choice of source of fund. During the period when stock market is rising, more people invest in equity. However, depressed capital market may make issue of equity shares difficult for any company.

III. Dividend Decision

Dividend is that portion of profit which is distributed involved here is how much of the profit earned by company (after paying tax) is to be distributed to the shareholders and how much of it should be retained in the business. While the dividend constitutes the current income re-investment as retained earning increases the firm’s future earning capacity. The extent of retained earnings also influences the financing decision of the firm.

2. Factors Affecting Dividend Decision

How much of the profits earned by a company will be distributed as profit and how much will be retained in the business is affected by many factors. Some of the important factors are discussed as follows:

Amount of Earnings: Dividends are paid out of current and past earning. Therefore, earnings is a major determinant of the decision about dividend.
Stability Earnings: Other things remaining the same, a company having stable earning is in a better position to declare higher dividends. As against this, a company having unstable earnings is likely to pay smaller dividend.
Stability of Dividends: Companies generally follow a policy of stabilizing dividend per share. The increase in dividends is generally made when there is confidence that their earning potential has gone up and not just the earnings of the current year. In other words, dividend per share is not altered if the change in earnings is small or seen to be temporary in nature.
Growth Opportunities: Companies having good growth opportunities retain more money out of their earnings so as to finance the required investment. The dividend in growth companies is, therefore, smaller, than that in the non-growth companies.
Cash flow Position: The payment of dividend involves an outflow of cash. A company may be earning profit but may be short on cash. Availability of enough cash in the company is necessary for declaration of dividend.
Shareholders’ Preference: While declaring dividends, managements must keep in mind the preferences of the shareholders in this regard. If the shareholders in general desire that at least a certain amount is paid as dividend, the companies are likely to declare the same. There are always some shareholders who depend upon a regular income from their investments.

Financial Planning

Financial planning is essentially the preparation of a financial blueprint of an organization’s future operations. The objective of financial planning is to ensure that enough funds are available at right time. If adequate funds are not available the firm will not be able to honour its commitments and carry out its plans. On the other hand, if excess funds are available, it will unnecessarily add to the cost and may encourage wasteful expenditure. It must be kept in mind that financial planning is not equivalent to, or a substitute for, financial management.

Financial planning process tries to forecast all the items likely to undergo changes. It enables the management to foresee the fund requirements both the quantum as well as the timing. Likely shortage and surpluses are forecast so that necessary activities are taken in advance to meet those situations.

Thus, financial planning strives to achieve the following twin objectives.

To ensure availability of funds whenever required: The include a proper estimation of the funds required for different purposes such as for the purchase of long-term assets or to meet day-to-day expenses of business etc. Apart from this, there is a need to estimate the time at which these funds are to be made available. Financial planning also tries to specify possible sources of these funds.
To see that the firm does not raise resources unnecessarily: Excess funding is almost as bad as inadequate funding. Even if there is some surplus money, good financial planning would put it to the best possible use so that the financial resources are not left idle and don’t unnecessarily add to the cost.

Importance

It helps in forecasting what may happen in future under different business situations. By doing so, it helps the firms to face the eventual situation in a better way.
It helps in avoiding business shocks and surprises and helps the company in preparing for the future.
If helps in co-ordinating various business functions, e.g., sales and production functions, by providing clear policies and procedures.
Detailed plans of action prepared under financial planning reduce waste, duplication of efforts, and gaps in planning.
It tries to link the present with the future.
It provides a link between investment and financing decisions on a continuous basis.
By spelling out detailed objectives for various business segments, it makes the evaluation of actual performance easier.

Capital Structure

One of the important decisions under financial management relates to the financing pattern or the proportion of the use of different sources in raising funds. On the basis of ownership, the sources of business finance can be broadly classified into two categories viz., ‘owners’ funds’ and ‘borrowed funds’. Owners’ funds consist of equity share capital, preference share capital and reserves and surpluses or retained earnings. Borrowed funds can be in the form of loans, debentures, public deposits etc. These may be borrowed from banks, other financial institutions, debenture holders and public.

Factors affecting the Choice of Capital Structure

Cash Flow Position: Size of projected cash flows must be considered before borrowing. Cash flows must not only cover fixed cash payment obligations but there must be sufficient buffer also. It must be kept in mind that a company has cash payment obligations for

Normal business operations
For investment in fixed assets
For meeting the debt service commitment i.e., payment of interest and repayment of principal.

2. Interest coverage Ratio (ICR): The interest coverage ratio refers to the number of times earnings before interest and taxes of a company covers the interest obligation. This may be calculated as follows:

ICR = EBIT / INTEREST

The higher the ratio, lower shall be the risk of company failing to meet its interest payment obligations. However, this ratio is not an adequate measure. A firm may have a high EBIT but low cash balance. Apart from interest, repayment obligations are also relevant.

3. Debt Service Coverage Ratio (DSCR): Debt Service Coverage Ratio takes care of the deficiencies referred to in the Interest Coverage Ratio (ICR). The cash profits generated by the operations are compared with the total cash required for the service of the debt and the preference share capital. It is calculated as follows:

A higher DSCR indicates better ability to meet cash commitments and consequently, the company’s potential to increase debt component in its capital structure.

4. Cost of Debt: A firm’s ability to borrow at a lower rate increases its capacity to employ higher debt. Thus, more debt can be used if debt can be raised at a lower rate.

5. Tax Rate: Since interest is a deductible expense, cost of debt is affected by the tax rate. The firms in our examples are borrowing @ 10%. Since the tax rate is 30%, the after tax cost of debt is only 7%. A higher tax rate, thus, makes debt relatively cheaper and increases its attraction vis-à-vis equity.

6. Cost of Equity: Stock owners expect a rate of return from the equity which is commensurate with the risk they are assuming. When a company increases debt, the financial risk faced by the equity holders, increases. Consequently, their desired rate of return may increase. It is for this reason that a company can not use debt beyond a point. If debt is used beyond that point, cost of equity may go up sharply and share price may decrease in spite of increased EPS. Consequently, for maximization of shareholders’ wealth, debt can be used only upto a level.

7. Floatation Costs: Process of raising resources also involves some cost. Public issue of shares and debentures requires considerable expenditure. Getting a loan from a financial institution may not cost so much. These considerations may also affect the choice between debt and equity and hence the capital structure.

8. Flexibility: If a firm uses its debt potential to the full, it loses flexibility to issue further debt. To maintain flexibility, it must maintain some borrowing power to take care of unforeseen circumstances.

9. Control: Debt normally does not couse a dilution of control. A public issue of equity may reduce the managements’ holding in the company and make it vulnerable in to takeover. This factor also influences the choice between debt and equity especially in companies in which the current holding of management is on a lower side.

Fixed and Working Capital

Meaning

Every company needs funds to finance its assets and activities. Investment is required to be made in fixed assets and current assets. Fixed assets are those which remains in the business for more than one year, usually for much longer, e.t., plant and machinery, furniture and fixture, land and building, vehicles, etc.

Decision to invest in fixed assets must be taken very carefully as the investment is usually quite large. Such decisions once taken are irrevocable except at a huge loss. Such decisions are called capital budgeting decisions.

Current assets are those assets which, in the normal routine of the business, get converted into cash or cash equivalents within one year, e.g., inventories, debtors, bills receivables, etc.

Management of Fixed Capital

Fixed capital refers to investment in long-term assets. Management of fixed capital involves allocation of firm’s capital to different projects or assets with long-term implications for the business. These decisions are called investment decisions or capital budgeting decisions and affect the growth, profitability and risk of the business in the long run. These long-term assets last for more than one year.

The management of fixed capital or investment or capital budgeting decisions are important for the following reasons:

Long-term growth: These decisions have bearing on the long-term growth. The funds invested in long-term growth. The funds invested in long-term assets are likely to yield returns in the future. These will affect the future prospects of the business.
Large amount of funds involved: These decisions result in a substantial portion of capital funds being blocked in long-term projects. Therefore, these investments are planned after a detailed analysis is undertaken. This may involve decisions like where to procure funds from and at what rate of interest.
Risk involved: Fixed capital involves investment of huge amounts. It affects the returns of the firm as a whole in the long-term. Therefore, investment decisions involving fixed capital influence the overall business risk complexion of the firm.
Irreversible decisions: These decisions once taken, are not reversible without incurring heavy losses. Abandoning a project after heavy investment is made is quite costly in terms of waste of funds. Therefore, these decisions should be taken only after carefully evaluating each detail or else the adverse financial consequences may be very heavy.

Factors affecting the Requirement of Fixed Capital

Nature of Business: The type of business has a bearing upon the fixed capital requirements. For example, a trading concern needs lower investment in fixed assets compared with a manufacturing organization; since it does not require to purchase plant and machinery, etc.
Scale of Operations: A larger organization operating at a higher scale needs bigger plant, more space etc. and therefore, requires higher investment in fixed assets when compared with the small organization.
Choice of Technique: Some organizations are capital intensive whereas others are labor intensive. A capital-intensive organization requires higher investment in plant and machinery as it relies less on manual labor. The requirement of fixed capital for such organizations would be higher. Labor intensive organizations on the other hand require less investment in fixed assets. Hence, their fixed capital requirement is lower.
Technology Upgradation: In certain industries, assets become obsolete sooner. Consequently, their replacements become due faster. Higher investment in fixed assets may, therefore, be required in such cases. For example, computers become obsolete faster and are replaced much sooner than say, furniture. Thus, such organizations which use assets which are prone to obsolescence require higher fixed capital to purchase such assets.
Growth Prospects: Higher growth of an organization generally requires higher investment in fixed assets. Even when such growth is expected, a company may choose to create higher capacity in order to meet the anticipated higher demand quicker. This entails larger investment in fixed assets and consequently larger fixed capital.
Diversification: A firm may choose to diversify its operations for various reasons. With diversification, fixed capital requirements increase e.g., a textile company is diversifying and starting a cement manufacturing plant. Obviously, its investment in fixed capital will increase.
Financing Alternatives: A Developed financial market may provide leasing facilities as an alternative to outright purchase. When an asset is taken on lease, the firm pays lease rentals and uses it. By doing so, it avoids huge sums required to purchase it. Availability of leasing facilities, thus, may reduce the funds required to be invested in fixed assets, thereby reducing the fixed capital requirements. Such a strategy is specially suitable in high risk lines of business.
Level of Collaboration: At times, certain business organizations share each other’s facilities. For example, a bank may use another’s ATM or some of them may jointly establish a particular facility. This is feasible if the scale of operations of each one of them is not sufficient to make full use of the facility. Such collaboration reduces the level of investment in fixed assets for each one of the participating organizations.

Working Capital

Apart from the investment in fixed assets every business organization needs to invest in current assets. This investment facilitates smooth day-to-day operations of the business. Current assets are usually more liquid but contribute less to the profits than fixed assets. Examples of current assets, in order of their liquidity, are as under.

Cash in hand/Cash at Bank
Marketable securities
Bills receivable
Debtors
Finished goods inventory
Work in progress Raw materials
Prepaid expenses

Factors Affecting the Working Capital Requirements

Nature of Business: The basic nature of a business influences the amount of working capital required. A trading organization usually needs a smaller amount of working capital compared to a manufacturing organization. This is because there is usually no processing. Therefore, there is no distinction between raw materials and finished goods. Sales can be effected immediately upon the receipt of materials, sometimes even before that.
Scale of Operations: For organizations which operate on a higher scale of operation, the quantum of inventory and debtors required is generally high. Such organizations, therefore, require large amount of working capital as compared to the organisations which operate on a lower scale.
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 lower during the period of depression as the sales as well as production will be small.
Seasonal Factors: Most business have some seasonality in their operations. In peak season, because of higher level of activity, larger amount of working capital is required. As against this, the level of activity as well as the requirement for working capital will be lower during the lean season.
Production 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, affects the amount of funds required for raw materials and expenses. Consequently, working capital requirement is higher in firms with longer processing cycle and lower in firms with shorter processing cycle.
Credit Allowed: Different firms allow different credit terms to their customers. These depend upon the level of competition that a firm faces as well as the credit worthiness of their clientele. A liberal credit policy results in higher amount of debtors, increasing the requirement of working capital.
Credit Availed: Just as a firm allows credit to its customers it also may get credit from its suppliers. To the extent it avails the credit on purchases, the working capital requirement is reduces.
Level of Competition: Higher level of competitiveness may necessitate larger stocks of finished goods to meet urgent orders from customers. This increases the working capital requirement. Competition may also force the firm to extend liberal credit terms discussed earlier.

Very short Answer Type

What is meant by capital structure?

Ans.:- Capital structure refers to the mix between owners and borrowed funds. It represents the proportion of equity and debt.

Capital Structure = Debt / Equity

2. Sate the two objectives of financial planning.

Ans.:- Financial Planning endeavors so achieve the following two objectives:

To ensure the availability of funds whenever required:- Financial planning involves proper evaluation of the funds required for deferent purposes, such as, purchases of long term assets or to meet day-to-day expenses of business, etc.
Avoiding unessential generation of funds:- Excess funding is almost as bad as inadequate funding. Efficient financial planning ensures that business does not raise unnecessarily funds in order to avoid unnecessary addition of cost.

3. Name the concept of financial management which increases the return to equity shareholders due to the presence of fixed financial charges.

Ans.:- Trading on equity is the concept that increases the return to equity shareholders due to the presence of fixed financial charges.

4. Amrit is running a ‘transport service’ and earning good returns by providing this service to industries. Giving reason, state whether the working capital requirement of the firm will be ‘less’ or ‘more’.

Ans.:- There will be a need of more amount of working capital as Amrit is running a business which is operated on a large scale.

5. Ramnath is into the business of assembling and selling of televisions. Recently he has adopted a new policy of purchasing the components on three months credit and selling the complete product in cash. Will it affect the requirement of working capital? Give reason in support of your answer.

Ans.:- As Ramnath has adopted new policy for his business, it will eventually affect the requirement of working capital. When the working capital will is reduced.

Short Answer Type

What is financial risk? Why does it arise?

Ans.:- Financial risk refers to the risk of a company not being able to cover its fixed financial costs. The higher level of risks are attached to higher degrees of financial leverage with the increase in fixed financial charges, the company also required to raise its operating profit (EBIT) to meet financial charges. If the company cannot cover these financial charges, it can be forced into liquidation.

2. Define current assets? Give four examples of such assets.

Ans. Current assets are those assets of the business which can be converted into cash or cash equivalents within a period of one year. Cash in hand or at bank, bills receivables, debtors, finished goods inventory are some of the examples of current assets. These assets are used to run day to day business operations.

3. What are the main objectives of financial management? Briefly explain.

Ans. Primary aim of the financial management is to maximise shareholder’s wealth, which is referred as the wealth maximisation concept. The wealth of owners is reflected in the market value of shares. Wealth maximisation refers to
the maximisation of market price of shares. According to the wealth maximisation objective, financial management must select those decisions which result in value addition, that is to say the benefits from a decision exceed the cost involved. Such value addition increase the market value of the company’s share and hence, results in maximisation of the shareholder’s wealth.

4. Financial management in based on three broad financial decisions. What are these?

ANS: Financial management is concerned with the
solution of the three major issues related to the financial operations of a firm corresponding to the three questions of investment, financing and dividend decision. In a financial context, it means the selection of the best financing alternative or best investment alternative.

The finance function, therefore, is concerned with three broad decisions which are explained below:

Investment Decision: The investment decision focused on the allocation of financial resources and how the firm’s funds are invested in different assets.
Financing Decision: Financing decision is concerned about the quantum of finance to be raised from various long term sources and short term sources. It considered identification of various available sources of finance.
Dividend Decision: Dividend decision is related to distribution of dividend. Dividend is that portion of profit which is distributed to shareholders. The decision involved here is how much of the profit earned by company is to be distributed to the shareholders and how much of it should be retained in the business for meeting investment requirements.

5. Sunrises Ltd. Dealing in readymade garments, is planning to expend its business operations in order to cater to international market. For this purpose the company needs additional 80,00,000 for replacing machines with modern machinery of higher production capacity. The company wishes to raise the required funds by issuing debentures. The debt can be issued at an estimated cost of 10%. The EBIT for the previous year of the company was 8,00,000 and total capital investment was 1,00,00,000. Suggest whether issue of debenture would be considered a rational decision by the company. Give reason to justify your answer.

Ans.: A company is able to issue debenture to raise fund when the cost of debt is less than the cost of capital. In the question given, cost of capital of Sunrises Limited is 10% which is ₹8,00,000 as total capital is ₹80,00,000. Now, Return on investment is calculated as

ROI = Return / Investment

Capital Structure = 8,00,000 / 1,00,000

= 8 %

Let’s assume that the company will be operating with the same efficiency, the additional investment of ₹80,00,000 will have a ROI of 8% which will amount to ₹6,40,000. The cost of debt will be ₹8,00,000 which is more than the ROI of ₹6,40,000. Therefore, it is advised to a company not to issue debenture when cost of debt is higher than the cost of capital.

6. How does working capital affect both the liquidity as well as profitability of a business?

Ans. The working capital should neither be more nor less than required. Both these situations are harmful. If the amount of working capital is more than the requirement, it will undoubtedly increase liquidity but decrease profitability. For instance, if a large amount of cash is kept as working capital, then this excessive cash will remain idle and cause the profitability to fall.
On the contrary, if the amount of cash and other current assets are very little, then a lot of difficulties will have to be faced in meeting daily expenses and making payments to the creditors. Thus, optimum amount of both the current assets and current liabilities should be determined so that the profitability of the business remains intact and there would be no fall in liquidity.

7. Aval Ltd. Is engaged in the business of export of canvas goods and bags. In the past, the performance of the company had been upto the expectations. In line with the latest demand in the market, the company decided to venture into leather goods for which it required specialized machinery. For this, the Finance Manager Prabhu prepared a financial blueprint of the organisation’s future operations to estimate that enough funds are available at right time. He also collected the relevant data about the profit estimates in the coming years. By doing this, he wanted to be sure about the availability of funds from the internal sources of the business. For the remaining funds, he is trying to find out alternative sources from outside.

Identify the financial concept discussed in the above paragraph. Also, state the objectives to be achieved by the use of financial concept so identified. (Financial Planning).
‘There is no restriction on Payment of dividend by a company’. Comment. (Legal & Contractual Constraints)

Ans. (i) The financial concept discussed in the is capital budgeting. It is a decision related to capital investment which will impact the profitability of the company in the long term. As the company wants to invest in new machinery which requires investment, this will have a direct impact on the operations which will be going to affect the profitability of the organisation.

The following objectives can be achieved:

Cash flow: Investment will bring new machinery which helps to increase the organisation’s profitability.
Company wants to raise funds from both the organisation’s (i.e., inside and outside). It will be helpful to examine the return generated from such investment will be more than the cost of capital.
Investment used: If the company is planning to raise funds from both inside and outside. Then it is important to notice that funds from internal and external sources will have different rates of interest.

(ii) Companies pay dividend to shareholders which is a part of the company earnings. Payment of dividends is based on following factors:

Legal Constraint: Legal constraints are those constraints that are mentioned in the company laws which impact paying out dividends on certain occasions. It should be followed properly.
Contractual Constraints: Pay out of dividend results in reduction of cash in the company. Money that is raised as loan will lay down certain restrictions on the company for paying dividends, such constraints are called contractual constraints.

Long Answer Type

What is working capital? Discuss five important determinants of working capital requirement?

Ans.: Apart from the investment in fixed assets every business organization needs to invest in current assets. This investment facilitates smooth day-to-day operations of the business. Current assets are usually more liquid but contribute less to the profits than fixed assets. Examples of current assets, in order of their liquidity, are as under.

Cash in hand/Cash at Bank
Marketable securities
Bills receivable
Debtors
Finished goods inventory
Work in progress Raw materials
Prepaid expenses

Factors Affecting the Working Capital Requirements

Nature of Business: The basic nature of a business influences the amount of working capital required. A trading organization usually needs a smaller amount of working capital compared to a manufacturing organization. This is because there is usually no processing. Therefore, there is no distinction between raw materials and finished goods. Sales can be effected immediately upon the receipt of materials, sometimes even before that.
Scale of Operations: For organizations which operate on a higher scale of operation, the quantum of inventory and debtors required is generally high. Such organizations, therefore, require large amount of working capital as compared to the organisations which operate on a lower scale.
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 lower during the period of depression as the sales as well as production will be small.
Seasonal Factors: Most business have some seasonality in their operations. In peak season, because of higher level of activity, larger amount of working capital is required. As against this, the level of activity as well as the requirement for working capital will be lower during the lean season.
Production 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, affects the amount of funds required for raw materials and expenses. Consequently, working capital requirement is higher in firms with longer processing cycle and lower in firms with shorter processing cycle.

2. “Capital structure decision is essentially optimization of risk-return relationship.” Comment.

Ans.: Capital structure refers to the combination of owner’s and borrowed funds. It can be calculated as Debit/Equity.
Debt and equity differ significantly in their cost and riskiness for the firm. Cost of debt is lower than the cost of equity for a firm because lender’s risk is lower than the equity shareholder’s risk. Since lenders earn on assured return and repayment of capital and therefore, they should require a lower rate of return. Debt is cheaper but is more risky for a business because payment of interest and the return of principal is obligatory for the business. These commitments may force the business to go into liquidation if there is any default in meeting them. There is no such compulsion in case of equity, that is why, it is considered riskless for the business. Higher use of debt increases the fixed financial charges of a business. As a result increased use of debt increases the financial risk of a business.
Capital structure of a business thus, affects both the profitability and the financial risk. A capital structure will said to be optimal when the proportion of debt and equity results in an increment in the value of the equity share.

3. “A capital budgeting decision is capable of changing the financial fortunes of a business.” Do you agree? Give reasons for your answer?

Ans.: Investment decision can be long term or short term. A long term investment decision is also called a capital budgeting decision. It involves the commitment of the finance on a long term basis, e.g., making investment in a new machine to replace an existing one or acquiring a new fixed assets or opening a new branch, etc. These decisions turn out to be very crucial for any business. The earning capacity over the long-run assets of a firm, profitability and competitiveness, are all affected by the capital budgeting decisions. Moreover, these decisions normally involve huge amounts of investment and are irreversible except at a huge cost. Therefore, once made, it is futile for a business to wriggle out of such decisions. Therefore, they need to be taken with utmost care. These decisions must be taken by those who understand them comprehensively. A bad capital budgeting decision can severely damage the financial fortune of a business.

4. Explain the factors affecting dividend decision?

Ans. Dividend decision is related to the distribution of profit to the shareholders and its retention in the business for meeting the future investment requirements.
How much of the profit earned by a company will be distributed and how much will be retained in the business is affected by many factors.

Some of the important factors which affect the dividend decision are as follows:

(i) Earnings: Dividends are paid out of current and past year earnings. Therefore, earnings is a major determinant of the decision about dividend.

(ii) Stability of Earnings: Other things remaining the same, a company having stable earning is in a position to declare higher dividends. As against this, a company having unstable earnings is likely to pay smaller dividend.

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

(iv) Cash Flow Position: Dividends involve an outflow of cash. A company may be profitable but short on cash. Availability of enough cash in the company is necessary for declaration of dividend by it.

(v) Shareholder Preference: If the shareholders in general, desire that at least a certain amount should be paid as dividend, the companies are likely to declare the same.

(vi) Taxation Policy: If tax on dividend is higher it would be better to pay less by way of dividends. As compared to this, higher dividends may be declared if tax rates are relatively lower.

(vii) Stock Market Reaction: For investors, an increase in dividend is a good news as stock prices react positively to it. Similarly, a decrease in dividend may have a negative impact on the share prices in the stock market.

(viii) Access to Capital Market: Large and reputed companies generally have easy access to the capital market and therefore, depend less on retained earnings to finance their growth. These companies tend to pay higher dividends than the smaller companies which have relatively low access to the market.

(ix) Legal constraints: Certain provisions of the Company’s Act place restriction on payouts as dividend. Such provisions have to be adhered, while declaring dividends.

(x) 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 dividends do not violate the terms and conditions of the loan agreement in this regard.

5. Explain the term ‘Trading on Equity’? Why, when and how it can be used by company.

Ans. Trading on equity is a financial process of using debt in order to produce gain for the owners. In this process, new debt is taken to gain new assets with which they can earn greater level of interest which is more than the interest that is paid for debt. This process is followed because the equity shareholders are interested in the income that is being generated from business. It is practiced by a company only when the rate of return on investment is greater than the rate of interest for the fund that is borrowed. There will be an increment in earnings per share when this process is adopted. Trading
on equity is profitable only when the return on investment is greater than the amount of funds borrowed. It is said that trading on equity shall be avoided if the return on investment is less than the rate of interest from the funds that are borrowed.

6. ‘S’ Limited is manufacturing steel at its plant in India. It is enjoying a buoyant demand for its products as economic growth is about 7-8 per cent and the demand for steel is growing. It is planning to set up a new steel plant to cash on the increased demand. It is estimated that it will require about 5000 crores to set up and about 500 crores of working capital to start the new plant.

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

Ans. Role of Financial Management: Financial management is concerned with the proper management of funds. It involves:

Managerial decisions related to procurement of long term and short term funds.
Keeping the risk associated with respect to procured funds under control.
Utilisation of funds in the most productive and effective manner.
Fixed debt equity ratio in capital.

Objective of Financial Management: The objective of financial management is to maximise the shareholder’s wealth. The investment decision, financial decision and dividend decision help an organisation to achieve this objective. In the given situation, S limited visualizes 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 financial 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:

Financial Planning ensures allocation of adequate funds to meet the working capital requirements.
It bring about a balance between in flow and out flow of funds and ensures liquidity throughout the year.
It helps to solve the problems of shortage and surplus of funds by ensuring proper and optimum utilization of available resources.
It ensures to increase profitability through cost benefit analysis and by avoiding wasteful operations.
It seeks to eliminate wastage of funds and provides better financial control.
It seeks to avail the benefits of trading on equity.

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 considered to be optimum when the proportion of debt and equity 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 funding requirement of ‘S’ Limited is for long term. Hence, equity funds will be more appropriate.

b) There are no financial risks involved in this form of funding.

c) If the stock market is bullish, the company can easily raise funds through issue of equity shares.

d) 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 benefit of trading on equity and hence, will increase the earing per share of equity shareholders. However, ‘return on investment’ ratio will be the guiding principle behind it. The company should choose trading on equity only when return on investment is more than the fixed charges.
Interest on debt funds is a deductible expense and therefore, will reduce the tax liability.
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’ Limited will be high due to the following reasons:

The business is capital intensive and the scale of operation is large.
For technological upgradation and to build up production base, heavy investments are required.
In case of steel industry, the major input is iron ore and coal. The ratio of cost of raw material to total cost is very high. Thus, there will be higher need for working capital.
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.
Terms of credit for buying and selling goods, discount allowed by suppliers and to the customers also determine the quantum of working capital.

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