Financial Management

Capital structure refers to the mix between owners’ funds (equity) and borrowed funds (debt) used by a company. It determines the proportion of debt and equity used for financing the operations of the business.

1. To ensure availability of funds whenever these are required.
2. To see that the firm does not raise resources unnecessarily (avoiding idle finance).

Trading on Equity (or Financial Leverage).

The working capital requirement will be Less.
Reason: Since it is a service industry (transport), there is no requirement to maintain inventory of raw materials or finished goods, and the operating cycle is shorter compared to manufacturing firms.

Yes, it will decrease the working capital requirement.
Reason: Purchasing on credit (deferring payment) and selling in cash (immediate receipt) creates a favorable cash flow position, reducing the need to block funds in working capital.

Financial Risk refers to the risk of inability to discharge financial obligations (like interest payments and repayment of principal).
Reason: It arises due to the presence of fixed financial charges (Debt) in the capital structure. Higher debt leads to higher financial risk.

Current assets are those assets which are expected to be converted into cash or consumed within a short period, usually one year.
Examples: 1. Cash and Cash Equivalents. 2. Trade Receivables (Debtors/Bills Receivable). 3. Inventories (Stock). 4. Prepaid Expenses.

The primary objective is Wealth Maximization of shareholders.

• This means increasing the market price of equity shares.
• Since shareholders are the owners, maximizing their wealth implies that economic welfare of the company is maximized.
• Other objectives (profit maximization, maintenance of liquidity) are supportive of this main objective.

1. Investment Decision: How the firm’s funds are invested in different assets (Capital Budgeting for long-term, Working Capital for short-term).
2. Financing Decision: How much to raise from which source (Debt vs. Equity).
3. Dividend Decision: How much of the profit to distribute to shareholders and how much to retain in the business.

Suggestion: No, the issue of debentures would not be considered a rational decision.

Reason: We need to compare Return on Investment (ROI) with the Cost of Debt.
$$ROI = \frac{EBIT}{Total Investment} \times 100$$
$$ROI = \frac{8,00,000}{1,00,00,000} \times 100 = 8\%$$
Since ROI (8%) < Cost of Debt (10%), using debt will decrease the return to equity shareholders (Unfavorable Financial Leverage). Therefore, debt should be avoided.

Working capital decisions involve a trade-off between liquidity and profitability:

• High Working Capital: Increases Liquidity (safety against default) but creates idle funds, which decreases Profitability.
• Low Working Capital: Increases Profitability (funds are used efficiently/invested elsewhere) but reduces Liquidity (risk of default on short-term liabilities increases).

a. Concept Identified: Financial Planning.
(The manager prepared a “financial blueprint” to estimate funds required and timing).
Objectives of Financial Planning:

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

b. Comment on ‘No restriction on payment of dividend’: This statement is incorrect. There are Legal and Contractual Constraints on dividend payment.

• Legal: Companies Act provisions regarding depreciation and reserves must be followed.
• Contractual: Lenders may impose restrictions on dividend payouts to ensure their loans are repaid first.

Working Capital is the capital required for the day-to-day operations of a business (e.g., buying raw material, paying wages). Net Working Capital = Current Assets – Current Liabilities.

Determinants:

1. Nature of Business: Manufacturing firms need more WC (for inventory/processing) than trading or service firms.
2. Scale of Operations: Large scale organizations require higher WC for larger inventory and receivables.
3. Business Cycle: In boom periods, sales increase, requiring more WC. In depression, requirements fall.
4. Seasonal Factors: Peak seasons require higher WC to maintain high stock levels compared to lean seasons.
5. Credit Allowed: Liberal credit policies (selling on credit) increase the level of debtors, thereby increasing WC requirement.

[Image of risk return trade off graph]
This statement is true. Capital structure involves choosing the mix of Debt and Equity.

• Debt (Cheaper but Risky): Debt is cheaper (tax-deductible interest) and lowers the overall cost of capital, potentially increasing returns (EPS). However, it carries high Financial Risk (fixed obligation to pay interest/principal).
• Equity (Costlier but Safe): Equity has no fixed burden and is safe for the company (lower risk). However, relying only on equity dilutes ownership and results in a higher cost of capital (lower returns compared to using debt).

Conclusion: A sound capital structure decision balances these factors to minimize cost and risk while maximizing returns to shareholders.

Yes, I agree. Capital budgeting decisions (Investment Decisions) involve investing huge funds in long-term assets. They are crucial because:

1. Long-term Growth: These decisions determine the future growth and profitability of the firm.
2. Large Amount of Funds: Huge capital is blocked; a bad decision can wipe out the firm’s capital.
3. Risk Involved: They affect the risk profile and return of the firm for a long time.
4. Irreversible Decision: Once taken, these decisions are hard to reverse without incurring heavy losses (e.g., building a new factory).

1. Amount of Earnings: Dividends are paid out of current and past profits. Higher earnings generally allow higher dividends.
2. Stability of Earnings: A company with stable earnings can declare higher dividends than one with fluctuating earnings.
3. Growth Opportunities: Companies with good growth plans retain more money (pay less dividend) to invest in profitable projects.
4. Cash Flow Position: Paying dividends involves cash outflow. A company may be profitable but short on cash, leading to lower dividends.
5. Taxation Policy: If dividend tax is high, companies may pay less dividend. (Note: Currently in India, dividends are taxable in the hands of shareholders).

Trading on Equity refers to the practice of using fixed cost sources of finance (like Debentures or Preference Shares) in the capital structure to increase the Return on Equity (EPS) for equity shareholders.

When to use: It works only when the Return on Investment (ROI) is greater than the Cost of Debt (Interest Rate).

How it works (Example):

Particulars	Co. X (No Debt)	Co. Y (High Debt)
Total Funds (₹ 10 Lakh)	Equity: 10L	Eq: 4L, Debt: 6L (10%)
EBIT (ROI 15%)	1,50,000	1,50,000
Less: Interest	Nil	(60,000)
EBT	1,50,000	90,000
Less: Tax (30%)	(45,000)	(27,000)
Profit After Tax	1,05,000	63,000
No. of Equity Shares (₹10)	1,00,000	40,000
EPS	₹ 1.05	₹ 1.57

Company Y has higher EPS because ROI (15%) > Cost of Debt (10%).

a. Role and Objectives of Financial Management:

• Role: To determine the size of fixed assets (₹ 5000 Cr), quantum of current assets (₹ 500 Cr), amount of long-term/short-term financing, and the debt-equity mix.
• Objective: To maximize shareholder wealth by making optimal investment and financing decisions.

b. Importance of Financial Plan: It helps in forecasting future capital requirements and business shocks.
Imaginary Plan: To raise ₹ 5500 Crores, the plan could be: 60% via Debt (cheaper for large projects), 40% via Equity (for stability).

c. Factors affecting Capital Structure:

• Cash Flow Position: Ability to service the huge debt interest.
• Interest Coverage Ratio (ICR): Safety margin for interest payment.
• Cost of Debt vs ROI: Ensuring leverage is favorable.
• State of Capital Market: Whether the market is bullish (easy to sell equity) or bearish.

d. Factors affecting Fixed and Working Capital:

• Fixed Capital: It will be High because steel is a capital-intensive industry requiring heavy plant and machinery.
• Working Capital: It will be High because:
  • Nature of Business: Manufacturing involves raw material processing.
  • Production Cycle: Steel production takes a long time, blocking funds in work-in-progress.
  • Scale: Operations are on a very large scale.