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  3. Class 12th Commerce
  4. Business Studies Notes for Class 12th Commerce
  5. Chapter 9 Financial Management class 12th Commerce

Chapter 9 Financial Management class 12th Commerce

Concept : Meaning of financial management

Financial Statement

Balance sheet as on

1

Sources

 

(i)

Owners fund

Equity share capital

Preference share capital

Reserve and surplus

Net Retained Earning

(ii)

Borrowed Funds

Debenture

Long term loan or Debt

Public Deposit

Long term provisions

(iii)

Current liabilities

Creditors 

Short-term borrowings,

Short-term provisions

2

Application

 

(i)

Non current – Tangible Assets

Land , building , plant and Equipm

ent’s, Furniture and fixture , Vehicles ,Office Equipment’s ,Long term investment

(ii)

Non Current – Intangible Assets

Goodwill , Trade Marks , Patents

(iii)

Current Assets

Raw material

WIP

Finished goods

Debtors

Stores and spares

Cash

Bank

Short term investment

 

Statement of Accounts for financial management

1

Sources

 

 

 

Debt -Borrowed funds

 

 

 

Equity -Owners Funds

 

 

2

Application:

 

 

 

Non-Current Assets

 

 

 

Current Assets

 

 

 

 

Concept : Meaning of Business Finance

Availability of adequate finance is, thus, very crucial for the survival and growth of a business.

 

Statement of Accounts

1

Sources

 

 

 

Debt

 

 

 

Equity

 

 

2

Application:

 

 

 

Non-Current

 

 

 

Current

 

 

                       

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 modernise 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.

 

Case Studies:

When Tata Steel acquired Corus

Tata Steel, the biggest steel producer in the Indian private sector has acquired Corus, (formerly known as British Steel) in a deal worth $8.6 billion in 2007. This makes Tata Steel the fifth largest steel producer in the world. A financial decision of this magnitude has significant implicitness for both Tata Steel and Corus as well as their employees and shareholders. To mention some of them:

Tata Steel raised a debt of over $8 billion to finance the transaction. The deal will be paid for by Tata Steel UK, a special purpose vehicle (SPV) set up for the purpose. This SPV received funds from Tata Steel routed through a Singapore subsidiary. Another company of the Tata group, Tata Sons Ltd., invested $ 1 billion dollars for preference shares along with Tata Steel which will invest an equal amount.

Tata Steel, the acquirer company, arranged about 36,500 crores of rupees to finance the take-over.

Tata Steel raised this amount through debt or equity or a combination of both. Some amount came from internal accruals also. This financing decision affected the capital structure of Tata Steel.

Needless to emphasise, decisions like this affect the future of the organisation. These decisions are almost irrevocable after they have been formalised.

 

Concept :

Objectives Financial Management

1

Maximization of wealth

 

2

Maximization of profit

 

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

It means maximisation of the market value of equity shares. The market price of equity share increases, if the benefit from a decision exceeds the cost involved. All financial decisions aim at ensuring that each decision is efficient and adds some value. Such value additions tend to increase the market price of shares. Therefore, those financial decisions are taken which will ultimately prove gainful from the point of view of the shareholders. The shareholders gain if the value of shares in the market increases. Those decisions which result in decline in the share price are poor financial decisions.

Thus, we can say, the objective of financial management is to maximize the current price of equity shares of the company or to maximize the wealth of owners of the company, that is, the shareholders.

Therefore, when a decision is taken about investment in a new machine, the aim of financial management is to ensure that benefits from the investment exceed the cost so that some value addition takes place. Similarly, when finance is procured, the aim is to reduce the cost so that the value addition is even higher.

In fact, in all financial decisions, major or minor, the ultimate objective that guides the decision-maker is that some value addition should take place. All those avenues of investment, modes of financing, ways of handling various components of working capital must be identified which will ultimately lead to an increase in the price of equity share. It can happen through efficient decision-making. Decision-making is efficient if, out of the various available alternatives, the best is selected.

 

Concept :

Function of Financial

1

Sources

 

(i)

Owners fund

Equity share capital

Preference share capital

Reserve and surplus

Net Retained Earning

(ii)

Borrowed Funds

Debenture

Long term loan or Debt

Public Deposit

Long term provisions

(iii)

Current liabilities

Creditors 

Short-term borrowings,

Short-term provisions

2

Application

 

(i)

Non current – Tangible Assets

Land , building , plant and Equipment’s, Furniture and fixture , Vehicles ,Office Equipment’s ,Long term investment

(ii)

Non Current – Intangible Assets

Goodwill , Trade Marks , Patents

(iii)

Current Assets

Raw material

WIP

Finished goods

Debtors

Stores and spares

Cash

Bank

Short term investment

 

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 divident decision. In a financial 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:

 

Concept : Meaning of investment Decision

Investment decision can be long-term or short-term. A long-term investment decision is also called a Capital Budgeting decision and short term can be called working capital decision :

NA

1

Non-current assets -

Tangible assets-

Land

Buildings

Plant and Equipment’s

Furniture and Fixtures

Vehicles

Office equipment’s Long term investment

Intangible Assets –

Goodwill

Trade marks

Patent etc.

Cure

2

Current assets-  

Raw material

WIP

Finished goods

Debtors

Stores and spares

Cash

Bank

Short term investment

 

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 basis. For example, making investment in a new machine to replace an existing one or acquiring a new fixed asset or opening a new branch, etc. These decisions are very crucial for any business since they affect its earning capacity in the long run. The size of assets, profitability and competitiveness are all affected by 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 often almost impossible 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 normally has the capacity to severely damage the financial fortune of a business. 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.

 

Concept :

Why Investing decisions is Necessary :

Story of friends buying shirt and buying house

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

RILL-

 

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.

 

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.

 

 

Long-term growth:

These decisions have bearing on the 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.

 

Concept :

Factors affecting investing Decision or Capital Budgeting Decision

A number of projects are often available to a business to invest in. But each project has to be evaluated carefully and, depending upon the returns, a particular project is either selected or rejected. If there is only one project, its viability in terms of the rate of return, viz., investment and its comparability with the industry’s average is seen. There are certain factors which affect capital budgeting decisions.

 

CRI-

 

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.

 

NPV METHODS , IRR METHODS , PI METHODS ,

 

 

Availability of raw material: As there is easy availability of Sandalwood which is used as the base material for production, the working capital requirements of his business will be less as there is no need to stock the raw materials.

 

Production cycle: The production cycle is shorter and less time is required to manufacture incense sticks. Thus, the working capital requirements of his business will be low.

 

Credit availed: Due to the fact that the suppliers of other types of raw material needed for production follow a liberal credit policy, the business can be operated on minimum working capital.

Concept : Meaning of Financing Decision

Code

I

EQUITY AND LIABILITIES

N

CY

PY

Suffering 

1

EQUITY

Shareholders’ funds- 

Equity share capital

Reserve and surplus

Less debit  balance of P&L account

Preference share capital

 

 

 

Aap

2

Share application money pending allotmen­t –

 

 

 

NA

3

Non-Current Liabilities-

DEBT

 

Debenture

Long term borrowings

Long term provisions  

 

 

 

cure

4

Current Liabilities- Creditors 

Short-term borrowings,

Short-term provisions

 

 

 

 

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. A firm has to decide the proportion of funds to be raised from either sources, based on their basic characteristics. Interest on borrowed funds have to be paid regardless of whether or not a firm has earned a profit. Likewise, 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.

The cost of each type of finance has to be estimated. Some sources may be cheaper than others. For example, debt is considered to be the cheapest of all the sources, tax deductibility of interest makes it still cheaper. Associated risk is also different for each source, e.g., it is necessary to pay interest on debt and redeem the principal amount on maturity. There is no such compulsion to pay any dividend on equity shares. Thus, there is some amount of financial risk in debt financing. The overall financial risk depends upon the proportion of debt in the total capital. The fund raising exercise also costs something. This cost is called floatation cost.  It also must be considered while evaluating different sources. Financing decision is, thus, concerned with the decisions about how much to be raised from which source. This decision determines the overall cost of capital and the financial risk of the enterprise.

 

Concept :

Factors Affecting Financing Decisions

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

FCS  Risk {Future company sectrory risk}

1.F

Floatation Costs:

Higher the floatation cost, less attractive the source.

2.F

Fixed Operating Costs:

If a business has high fixed operating costs (e.g., 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.

3.C

Cost:

The cost of raising funds through different sources are different. A prudent financial manager would normally opt for a source which is the cheapest.

4.C

Cash Flow Position of the Company:

A stronger cash flow position may make debt financing more viable than funding through equity.

5.C

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 a takeover bid would prefer debt to equity.

6.S

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.

7.R

Risk:

The risk associated with each of the sources is different.

 

Concept : Meaning of Dividend Decision

 

The third important decision that every financial manager has to take relates to the 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 (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. Since the firm does not require funds to the extent of re-invested retained earnings, the decision regarding dividend should be taken keeping in view the overall objective of maximising shareholder’s wealth.

 

Concept :

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:

C2,Growth, 3STAL

1-C

Cash Flow Position:

2-C

Contractual Constraints:

3-Growth

Growth Opportunities:

4.S

Stability of Dividends:

5-S

Shareholders’ Preference:

6-S

Stock Market Reaction:

7-T

Taxation Policy:

8-A

Amount of Earnings:

9-A

Access to Capital Market:

10.L

Legal Constraints:

 

 

 

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.

 

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 does not violate the terms of the loan agreement in this regard.

 

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.

 

Stability of Dividends:

Companies generally follow a policy of stabilising 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.

 

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.

 

Stock Market Reaction:

Investors, in general, view an increase in dividend as a good news and stock prices react positively to it. Similarly, a decrease in dividend may have a negative impact on the share prices in the stock market. Thus, the possible impact of dividend policy on the equity share price is one of the important factors considered by the management while taking a decision about it.

 

Taxation Policy:

The choice between the payment of dividend and retaining the earnings is, to some extent, affected by the difference in the tax treatment of dividends and capital gains. If tax on dividend is higher, it is better to pay less by way of dividends. As compared to this, higher dividends may be declared if tax rates are relatively lower. Though the dividends are free of tax in the hands of shareholders, a dividend distribution tax is levied on companies. Thus, under the present tax policy, shareholders are likely to prefer higher dividends.

 

 

Amount of 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.

 

Access to Capital Market:

Large and reputed companies generally have easy access to the capital market and, therefore, may depend less on retained earning to finance their growth. These companies tend to pay higher dividends than the smaller companies which have relatively low access to the market.

 

Legal Constraints:

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

 

 

Concept : Concept of Financial Planning

Financial planning is essentially the preparation of a financial blueprint of an organisation’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 management aims at choosing the best investment and financing alternatives by focusing on their costs and benefits. Its objective is to increase the shareholders’ wealth. Financial planning on the other hand aims at smooth operations by focusing on fund requirements and their availability in the light of financial decisions. For example, if a capital budgeting decisions is taken, the operations are likely to be at a higher scale. The amount of expenses and revenues are likely to increase. Financial planning process tries to forecast all the items which are 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.

 

Concept : Objectives of Financial Planning

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

To ensure availability of funds whenever required:

This 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.

 

Concept : Importance Financial Planning

Financial planning is an important part of overall planning of any business enterprise. It aims at enabling the company to tackle the uncertainty in respect of the availability and timing of the funds and helps in smooth functioning of an organisation. The importance of financial planning can be explained as follows:

FATHER:

1-F

Futuristic -Forecasting

2-F

Financing decision link

3-A

All segment details

4-T

Tries to link present with future

5-H

 Helps in avoiding shocks

6-E

Evaluation of actual performance easier.

7-R

Retain Coordination between various business function

 

 

1-F

Futuristic -Forecasting

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. In other words, it makes the firm better prepared to face the future. For example, a growth of 20% in sales is predicted. However, it may happen that the growth rate eventually turns out to be 10% or 30%. Many items of expenses shall be different in these three situations. By preparing a blueprint of these three situations the management may decide what must be done in each of these situations. This preparation of alternative financial plans to meet different situations is clearly of immense help in running the business smoothly.

2-F

Financing decision on continuous basis

It provides a link between investment and financing decisions on a continuous basis.

3-A

All segment details planning

All segments are planned in detail under financial planning to reduce waste, duplication of efforts, and gaps in planning.

4-T

Tries to link present with future

It tries to link the present with the future.

5-H

 Helps in avoiding shocks

It helps in avoiding business shocks and surprises and helps the company in preparing for the future.

6-E

Evaluation of actual performance easier.

By spelling out detailed objectives for various business segments, it makes the evaluation of actual performance easier.

7-R

Retain Coordination between various business function

If helps in co-ordinating various business functions, e.g., sales and production functions, by providing clear policies and procedures.

 

 

Concept :  Concept of Capital Structure

Balance Sheet

 

Sources

 

 

1

Debt

 

 

2

Equity

 

 

 

Total

1

 

 

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.

Capital structure refers to the mix between owners and borrowed funds. These shall be referred as equity and debt in the subsequent text. It can be calculated as

 

1

 debt-equity ratio i.e.

 

2

as the proportion of debt out of the total capital

 

 

Debt and equity differ significantly in their cost and riskiness for the firm. The cost of debt is lower than the cost of equity for a firm because the lender’s risk is lower than the equity shareholder’s risk, since the lender earns an assured return and repayment of capital and, therefore, they should require a lower rate of return. Additionally, interest paid on debt is a deductible expense for computation of tax liability whereas dividends are paid out of after-tax profit. Increased use of debt, therefore, is likely to lower the over-all cost of capital of the firm provided that the cost of equity remains unaffected. Impact of a change in the debt-equity ratio upon the earning per share is dealt with in detail later in this chapter.

Debt is cheaper but is more risky for a business because the payment of interest and the return of principal is obligatory for the business. Any default in meeting these commitments may force the business to go into liquidation. There is no such compulsion in case of equity, which is therefore, 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 company.

 

Financial risk is the chance that a firm would fail to meet its payment obligations. Capital structure of a company, thus, affects both the profitability and the financial risk. A capital structure will be said to be optimal when the proportion of debt and equity is such that it results in an increase in the value of the equity share. In other words, all decisions relating to capital structure should emphasise on increasing the shareholders’ wealth.

 

The proportion of debt in the overall capital is also called financial leverage.

Explain this concept dhyan se :

 

Financial leverage is computed as         or      when D is the Debt and E is the Equity. As the financial leverage increases, the cost of funds declines because of increased use of cheaper debt but the financial risk increases.

 

Concept :  EBIT & EPS ANALYSIS

The impact of financial leverage on the profitability of a business can be seen through EBIT-EPS (Earning before Interest and Taxes-Earning per Share) analysis as in the following example.

S.NO.

Particulars

Amount

 

Sales

xxx

 

Variables cost

(xxx)

 

Contribution 

XXX

 

Operating Fixed cost

(xxx)

 

Earning before Interest  and Tax-EBIT

XXX

 

Interest

(xxx)

 

Earning before Tax

XXX

 

Income Tax

(xxx)

 

Earning After Tax

XXX

 

No of Equity Share

xxx

 

Earning per Share

 

 

Computation of ROI

ROI

 

Favourable financial leaverage

If ROI is greater than cost of Debt . In this case trading on equity is good decision. In this case with increase in date EPS will increase with increase in debt.

Unfavorable financial leverage

If ROI is less than cost of debt. In this case trading on equity is bad decision. EPS will decrease with increase in debt.

 

 

Concept : Behavior of EPS when ROI is greater than Cost of debt : Situation in which company can practice Trading on Equity.

Example 1 : Situation favorable financial leverage.

Face Value of equity share is Rupees 10 per share

Three situations are given in question.

Company X Ltd.

Total Funds used

₹30 Lakh

Interest rate

10% p.a.

Tax Rate

30%

EBIT

₹4 Lakh

Debt

All debt is at 10% p.a.

Situation-1

Nill

Situation-2

₹10 Lakh

Situation-3

₹20 Lakh

 

Solution:

Check: Favorable financial leaverage when ROI is greater than cost of debt:

 

Working 1: Return on investment (ROI) of

ROI

 

= 13.33%

 

In such cases, companies often employ more of cheaper debt to enhance the EPS. Such practice is called Trading on Equity.

Trading on Equity refers to the increase in profit earned by the equity shareholders by infusing more and more debt in capital structure, as interest rate is fixed.  

EBIT-EPS Analysis

 

Situation-1

Situation-2

Situation-3

Debt

0

10,00,000

20,00,000

EBIT

4,00,000

4,00,000

4,00,000

Interest

NIL

1,00,000

2,00,000

EBT (Earning before taxes)

4,00,000

3,00,000

2,00,000

Tax

1,20,000

90,000

60,000

EAT (Earning After taxes)

2,80,000

2,10,000

1,40,000

No. of shares of ₹10

3,00,000

2,00,000

1,00,000

EPS (Earnings per share)

0.93

1.05

1,40

 

Working 2 : Computation of No of Equity share :

Situation

1

2

3

Total Funds

30,00,000

30,00,000

30,00,000

Debt

0

10,00,000

20,00,0000

Equity

30,00000

20,00,000

10,00,000

Computation of no of equity share

 

 

 

No of Equity share

 

 

 

No Of Equity Share

3,00,000

2,00,000

1,00,000

 

The company earns Rs. 0.93 per share if it is unlevered. With debt of Rs. 10 lakh its EPS is Rs. 1.05. With a still higher debt of Rs. 20 lakh, its, EPS rises to Rs. 1.40.

Why is the EPS rising with higher debt? It is because the cost of debt is lower than the return that company is earning on funds employed. The company is earning a

 

Concept : Behavior of EPS when ROI is less  than Cost of debt : Situation in which company can not practice Trading on Equity.

Three situations are considered. Equity face value is Rupees 10 per share.

company X Ltd.

Total Funds used

₹30 Lakh

Interest rate

10% p.a.

Tax Rate

30%

EBIT

₹2 Lakh

Debt

All debt is at 10% p.a.

Situation-1

Nill

Situation-2

₹10 Lakh

Situation-3

₹20 Lakh

 

Unfavorable financial leaverage when ROI is less than cost of debt

Now consider the following case of Company Y. All details are the same except that the company is earning a profit before interest and taxes of Rs. 2 lakh.

It is because the Company’s rate of return on investment (RoI) is less than the cost of debt. The RoI for company Y is

ROI

 

= 6.67%

 

Whereas the interest rate on debt is 10%.

In such cases, the use of debt reduces the EPS. This is a situation of unfavourable financial leverage.

 

Company Y Ltd.

 

Situation I

Situation II

Situation III

EBIT

2,00,000

2,00,000

2,00,000

Interest

NIL

1,00,000

2,00,000

EBT

2,00,000

1,00,000

NIL

Tax

60,000

30,000

NIL

EAT

1,40,000

70,000

NIL

No. of shares of Rs.10

3,00,000

2,00,000

1,00,000

EPS

0.47

0.35

NIL

 

In this example, the EPS of the company is falling with increased use of debt.

 

Even in case of Company X, reckless use of Trading on Equity is not recommended. An increase in debt may enhance the EPS but as pointed out earlier, it also raises the financial risk. Ideally, a company must choose that risk-return combination which maximises shareholders’ wealth. The debt-equity mix that achieves it, is the optimum capital structure.

 

Concept: Factors affecting the Choice of Capital Structure

Deciding about the capital structure of a firm involves determining the relative proportion of various types of funds. This depends on various factors. For example, debt requires regular servicing. Interest payment and repayment of principal are obligatory on a business. In addition a company planning to raise debt must have sufficient cash to meet the increased outflows because of higher debt. Similarly, important factors which determine the choice of capital structure are as follows:

 

Cash, Equity, Debt FIRST

1.C

Cash Flow Position:

2.C

control:

3.C

capital structure of other companies:

4.E

Equity Cost:

5.D

 Debt cost:

6.D

Debt service coverage ratio (Dscr):

7.F

Floatation costs:

8.F

Flexibility:

9.I

Interest coverage ratio (icr):

10.R

Return on investment (roi):

11.R

risk consideration:

12.R

regulatory Framework:

13.S

stock Market conditions:

14.T

tax rate:

 

 

1.C

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

 

 

(i) normal business operations;

 

 

(ii) for investment in fixed assets; and

 

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