Financial management book @ bec doms baglkot mba


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Financial management book @ bec doms baglkot mba

  1. 1. FINANCIAL MANAGEMENTUnit -1 Financial Management: An introduction - Concept, Nature, Evolution andSignificance - Finance functions - Risk return trade off - Maximization andminimization vs. optimization.Unit - 2 Long Term Capital Resources: Equity and debt sources - Equity shares,Preference shares and Debentures - Uses - Significance of convertible issues andright issues - Borrowings from term lending institutions - Institutional frame work -Types of assistance - General procedure and conditions - Public deposits - Meaning,scope and regulations.Unit-3 Working Capital: Concept and types - Determinants - Financing approaches -Sources of working capital - Financing working capital Financing by commercialbanks - Types of assistance - Working capital gap -Recommendations of TandonCommittee and Chore Committee reports.Unit-4 Capital Budgeting: Concept - Significance - Methods of evaluation of capitalinvestments - Payback, Average Return, NPV, 1RR, Decision free Simulation.Sensitivity and CAPM methods.Unit-5 Capital Structure Planning; Determinants of capital structure - Optimumcapital structure - Capital structure theories – Significance and limitations -Cost ofcapital: Concepts - Cost of debt, equity, preference share capital and retained earning- weighted average cost. BSPATIL
  2. 2. Unit – 6 Management of Current Assets: Forecasting of current assets needs-Management of cash and liquidity - Objectives - budgeting - Planning the optimumlevel of cash - Inventory model, stochastic model - Model of Miller and Orr - Paymentand collection practices -Management of receivables -Credit policy - Credit period -Credit terms - Collection policies - Control of receivables - Inventory management -Meaning and importance - Inventory costs - Inventory levels - Inventory managementtechniques - Stock out cost determination techniques.Unit-7 Dividend Theories: Valuation under Gordon and Walter Theories -Dividendirrelevance under MM Theory - Assumptions and limitations -Dividend policy:Different policies and practices - Factors affecting dividend decision. UNIT-I FINANCIAL MANAGEMENT - FUNCTIONS & GOALS In this unit you will learn, concept of financial management, nature of financialmanagement, evolution of financial management, significance of financialmanagement, functions of financial management, goals of financial management, riskreturn -trade off and aspects of maximization, minimization and optimization infinancial management.INTRODUCTION Of the different factors of production, capital is very crucial. Capital isotherwise called finance. BSPATIL
  3. 3. Finance is one of the requisites for all human endeavours -personal, businessor government. Finance refers to the money resources -owned or borrowed availableto individuals, businesses or governments for their operations. Ours is a moneyeconomy and every person, individual or otherwise, needs finance and mobilizesfinance. As every other resource, finance is not unlimited. Printing currency notes orminting coins would only add to the money supply resulting in inflation and reducedvalue of oney. So, more money circulation would not mean more finance availability. ctually, finance is monetized form of capital, and capital is the savings (S)available for investment. Amount of savings depends on income (Y) and consumption(C). There are certain macroeconomic equations: Y = C + S ; Y = C + I and S = I When savings become available for investment, capital formation takes place.Capital, thus formed, is finance. Finance has two sides, just as a coin. One side isconcerned with assets and the other with liability. The assets side representsinvestments and the liability side represents sources and types of finances depended. That is to say, finance is a scarce resource. Consequently, no one hasunlimited access to finance nor can afford frittering away the resources unwisely.Both mobilizing and investing financial resources have to be managed properly.Hence, financial management has emerged as a priority function for all concerned. There are three branches of financial management Personal, business andgovernment financial management Personal financial management deals with howindividuals, you and I, manage our finances. Business financial management dealswith how business undertakings manage their finances. Government financialmanagement known as public finance, deals with how governments manage theirfinances. In this paper, we are however dealing with business financial managementonly.1.1 DEFINITIONS AND CONCEPT OF FINANCIAL MANAGEMENT BSPATIL
  4. 4. What is meant by financial management? Very simple indeed. Financialmanagement is management principles and practices applied to finance. Howard andUpton view that financial management is the application of general managementfunctions to the area of financial decision making. General management functionsinclude planning, execution and control. Financial decision making includesdecisions as to size of investment, sources of capital, extent of use of different sourcesof capital and extent of retention of profit or dividend payout ratio. Financialmanagement, is therefore, planning, execution and control of investment of moneyresources, raising of such resources and retention of profit/payment of dividend. Howard and Upton define financial management as "that administrative area orset of administrative functions in an organisation which have to do with themanagement of the flow of cash so that the organisation will have the means to carryout its objectives as satisfactorily as possible and at the same time meets itsobligations as they become due. Bonneville and Dewey interpret that financing consists in the raising, providingand managing all the money, capital or funds of any kind to be used in connectionwith the business. According to James C Van Home and John M. Wachowicz financialmanagement is concerned with acquisition, financing and management of assets withsome overall goal in mind. Osbon defines financial management as the "process of acquiring and utilisingfunds by a business”. Considering all these views, financial management may be defined as that partof management which is concerned mainly with raising funds in the most economicand suitable manner, using these funds as profitably as possible; planning futureoperations, and controlling current performances and future developments throughfinancial accounting, cost accounting, budgeting, statistics and other means.Financial management provides the best guide for future resource allocations. Itdesigns and implements certain financial plans, investment plans and value addition BSPATIL
  5. 5. plans.1.2 NATURE OF FINANCIAL MANAGEMENT Nature of financial management is concerned with its functions, its goals,trade-off with conflicting goals, its indispensability, its systems, its relation with othersubsystems in the firm, its environment, its relationship with other disciplines, theprocedural aspects and its equation with other divisions within the organisation. i) Financial Management is an integral part of overall management. Financial considerations are involved in all business decisions. Acquisition, maintenance, removal or replacement of assets, employee compensation, sources and costs of different capital, production, marketing, finance and personnel decisions, almost all decisions for that matter have financial implications. So financial management is pervasive throughout the organisation. ii) The central focus of financial management is valuation of the firm. That is financial decisions are directed at increasing/maximization/ optimizing the value of the firm. Weston and Brigham depict the above orientation in Figure 1.1.Fig. 1.1 Orientation of Financial Management BSPATIL
  6. 6. iii) Financial management essentially involves risk-return trade-off Decisions on investment involve choosing of types of assets which generate returns accompanied by risks. Generally higher the risk, returns might be higher and vice versa. So, the financial manager has to decide the level of risk the firm can assume and satisfy with the accompanying return. Similarly, cheaper sources of capital have other disadvantages. So to avail the benefit of the low cost funds, the firm has to put up with certain costs, disadvantages or risks, so, risk- return trade-off is there throughout. Fig 1,1 implies this aspect of financial management also.iv) Financial management affects the survival, growth and vitality of the firm. Finance is said to be the life blood ofbusiness. It is to business, what blood is to us. The amount, type, sources, conditions and cost of finance squarely influence the functioning of the unit.v) Finance functions, i.e., investment, rising of capital, distribution of profit, are performed in all firms - business or non-business, big or small, proprietary or corporate undertakings. Yes, financial management is a concern of every Financial management is a sub-system of the business system which has other subsystems like production, marketing, etc., In systems arrangement financial sub-system is to be well-coordinated with others and other sub-systems well matched with the financial sub- system.vii) Financial management of a business is influenced by the external legal and economic environment. The investor preferences, stock market conditions, legal constraint or using a particular type of funds or on investing in a particular type of activity, etc., affect financial decisions, of the business. Financial management is, therefore, highly influenced/constrained by external environment. BSPATIL
  7. 7. viii) Financial management is related to other disciplines like accounting, economics, taxation operations research, mathematics, statistics etc., It draws heavily from these disciplines. The relationship between financial management and supportive disciplines is depicted in figure 1.2. given below.Fig. 1.2. Relationships between Finance and other disciplines ix) There are some procedural finance functions - like record keeping, credit appraisal and collection, inventory replenishment and issue, etc., These are routinized and are normally delegated to bottom management. x) The nature of finance function is influenced by the special characteristic of the business. In a predominantly technology oriented business, it is R & D functions which get more dominance, in a consumer fashion product business it is marketing and marketing research which get more priority and so on. Here, finance assumes a low profile importance. But one should forget that the strength of a chain depends on its weakest link.1.3 EVOLUTION OF FINANCIAL MANAGEMENT Finance, as capital, was part of the economics discipline for a long time. So, BSPATIL
  8. 8. financial management until the beginning of the 20th century was not considered asa separate entity and was very much a pan of economics. In the 1920s, liquidity management and raising of capital assumed importance.The book, FINANCIAL POLICY OF CORPORATIONS written by Arthur Stone Dewingin 1920 was a scholarly text on financing and liquidity management, i.e., cashmanagement and raising of capital in 1920s. In the 1930s tfoere was the Great Depression, i.e., all round price decline,business failures and declining business. This forced the business to be extremelyconcerned with solvency, survival, reorganisation and so on. Financial Managementemphasized on solvency management and on debt-equity proportions. Besidesexternal control on businesses became more pronounced. Till early 1950s financial management was concerned with maintaining thefinancial chastity of the business. Conservatism, investor/lender related protectivecovenants/information processing, issue management, etc. were the prime concerns.It was an outsider-looking-in function. From the middle of 1950s financial management turned into an insider-looking-in function. That is, the emphasis shifted to utilization of funds from rising offunds. So, choice of investment, capital investment appraisals, etc., assumedimportance. Objective criteria for commitment of funds in individual assets wereevolved. Towards the close of the 1950s Modigliani and Miller even argued that sourcesof capital were irrelevant and only the investment decisions were relevant. Such wasthe total turn in the emphasis of financial management. In the 1960s portfolio management of assets gained importance. In theselection of investment opportunities portfolio approach was adopted, certaincombinations of assets give more overall return given the risk or give a certain returnfor a reduced risk. So, selection of such combination of investments gained eminence. BSPATIL
  9. 9. In the 1970s the capital asset pricing model (CAPM), arbitrage pricing model(APM), option pricing model (OPM), etc., were developed - all concerned with how tochoose financial assets. In the 1980s further advances in financial management werefound. Conjunction of personal taxation with corporate taxation, financial signaling,efficient market hypothesis, etc., were some newer dimensions of corporate financialdecision paradigm. Further Merger and Acquisition (M&A) became an importantcorporate strategy. The 1990s, saw the era of financial globalization. Capital moved West to East,North to South and so on. So, global financial management, global investmentmanagement, foreign exchange risk manage lent, etc., become more important topics. In late 1990s and 2000s, corporate governance got preeminence and financialdisclosure and related norms are being great concerns of financial management. Thedawn of 21st Century is heralding a new era of financial management with cybersupport. The developments till mid 1950s are branded as classical financialmanagement. This dealt with cash management, cash flow management, raisingcapital, debt-equity norms, issue management, solvency management and the like.The developments since mid - 1950s and upto 1980s, are branded as modemfinancial management. The emphasis is on asset management, portfolio approach,capital asset pricing model, financial signaling, efficient mark*, hypothesis and soon. The developments since the 1990s may be called po^ modern financialmanagement with great degree of global financial integral m net supported financesand so on.1.4 SIGNIFICANCE OF FINANCIAL MANAGEMENT Financial management is a very important function of overall businessmanagement. The reasons are laid down here. i) Financial Management covers a very large spectrum of activities of a business. True, whatever a business does it has a financial BSPATIL
  10. 10. implication. Hence its pervasiveness and significance. Finance knowledge is a must for all irrespective of position, place, portfolio and what not.ii) Financial Management influences the profitability or return on investment of a business. Yes, the choice of capital investment decisively affect the profitability of an undertaking.iii) Financial Management affects the solvency position of a business. Solvency refers to ability to service debts paying interest and repaying principal as these become due. Profitability and nature of debts - both concerns of financial management, govern the solvency aspect. Hence the significance of financial managementiv) Financial Management affects the liquidity position of a business. Liquidity refers to ability to repay short term loans. Efficient cash management, cash flow management and management of relations with the banker influence the level of liquidity. All these factors are aspects of financial management.v) Financial Management affects cost of capital. Able financial managers find and use less cost sources, which in turn contributes to profitability. In using fixed cost instruments of capital, the efficacy of sound financial management would be known well. Variable cost instruments of capital are the order of the day. Finance savvy persons go for such Financial Management, if well steered can ward off difficulties such as restrictive covenants imposed by lenders of capital, inflexibility in capital structure, dilution of management control on the affairs of the business and so on. Failure to do so, has landed many firms in difficulties and financial mess.vii) Good financial management enables a business to command capital BSPATIL
  11. 11. resources flowing into the business. There is always capital available at attractive terms, if business finance is handled well. Even overseas capital can be easily mobilized, if sound financial management is ensured. viii) Market value of the business can be increased through efficient and effective financial management. As share and stock are quoted at high prices, more funds, when needed, can be mobilized easily either thro1 public and/or rights offers. ix) Efficient financial management is necessary for the survival, growth, expansion and diversification of a business. x) Financial Management significantly influences the businesss credit rating, employee commitment, suppliers confidence, customers patronage and the like. xi) Financial Management is an exercise on optimizing costs given revenues, or optimizing revenues given costs. This is vital to ensure purposeful resource allocation. xii) Today financial management has global dimensions with opportunity to mop up resources and put up investments across borders. Global trend in finance is better learnt by all. The significance of financial management can be well appreciated if oneconsiders the analogy. Finance is what blood is to living beings. Financialmanagement is what the blood circulation system is to living beings. The functions ofheart, veins, arteries, etc., in maintaining the circulation of blood are lifes worth toliving beings. So is the worth of financial management to a business.1.5 FINANCE FUNCTIONS Finance functions simply refer to functions of financial management. BSPATIL
  12. 12. The functions of financial management are divergent. Severalclassifications are used. Here are presented the functions of financial management asnoted by eminent authors. Figure 1.3 gives the details.Fig. 13 Functions of Financial Management Authors 1 2 3 4Robert W Financial Raising of Investing Meeting specialJohnson Planning funds funds problems and controlGrunwald Investment Providing Generating MaximizingNemmars of funds liquid assets earnings market value of the firmVan Home & Investment Financial DividendWachowicz function function functionEarnest W. Financial Financial co- FinancialWalker planning ordination controlWeston& Financial Fixed asset Capital IndividualJrigham planning and working structure financing and control capital decisions episodes management Well. The above figure presents the functions of financial management, orfinance functions shortly, as perceived by the different authors. Let us look at themin a more analytical way. Finance functions are classified on two dimensions -managerial" and operative. The managerial financial functions include planning,organisation, direction, coordination and control of the operative functions. Theoperative functions include investment function, financing function and dividendfunction. We have a matrix of functions as given in Fig. 1.4.Fig. 1.4 : Matrix of Financial Functions BSPATIL
  13. 13. Operative Managerial Functions Functions Co- Planning Organizing Direction Control ordinationInvestment Size andand asset typesmanagementFinancing and Structureliability and costmanagementDividend Impact onpayout value andmanagement liquidityand internalfinancing Each one of the operative functions has got to be planned, organized,directed, coordinated and controlled. Investment function is concerned with the assetto be acquired. Fixed and current assets are needed. Commitment of funds in them isdealt by investment function. Financing function is concerned with the capitalsources to be tapped. Equity and debt funds are available. The mix of them is dealtby financing function. We may put this way. The investment function deals with theasset side of balance sheet and financing function with the liabilities side of balancesheet. Dividend function deals with how much of profit to be distributed as dividendand how much be retained. Evidently, each of the operative functions involves a hostof dimensions as to size, variety, proportions, timing, sourcing and so on requiring atotal managerial approach to decide each on each dimension. Hence the interplay ofmanagerial and operative functions. Now a more detailed account of each of the operative functions isattempted.a) Investment and Asset Management Function BSPATIL
  14. 14. A detailed discussion on investment function of financial management istaken up. This function essentially covers the following: i) the total amount to be committed in assets ii) the proportion of fixed to current assets iii) the mix of fixed assets to be acquired iv) the timing, sourcing and acquisition of fixed assets v) the evaluation of capital investments as to risk and return features vi) the mix of current assets vii) the management of each item of current assets to optimize liquidity and return viii) the effecting of a healthy portfolio of assets Actually the above aspects of investment function are concerned withmuch pregnant issues with which financial management is concerned. The firstaspect deals with the size of the firm, the second and third deal with the level of riskthe business is willing to assume, the fourth with appraisal of investment as to theirprofitability, pay back period, etc., the fifth with actual execution of investmentdecisions, the sixth with the liquidity of the business, the seventh with structural andcirculatory aspects of current assets and the eighth with the overall balancing ofvarious investments held by the business taking into account competing anddivergent claims. Investment function is, concerned capital budgeting and current assetmanagement. Capital budgeting deals with fixed assets management. Investmentappraisal, capital rationing, and acquisition, maintenance, replacement and renewalof fixed assets come under fixed assets management. Inventory management,receivables management, marketable securities management, cash management andworking capital administration come under current assets management. (You willlearn every one of these in the subsequent lessons). A good deal of planning,organisation, coordination and control is needed in every decision area.b) Financing and Liability Management Function BSPATIL
  15. 15. The financing function refers to raising necessary iunds for backing upthe investment function. Financing function is dealing the capital structure of thebusiness and covers the following: i) determination of total capital to be raised ii) determination of the debt-equity ratio or the proportion of debt to equity capital and the mix of long term and short-term capital. iii) determination of the level of fixed-change funds like bonds, debentures, loans, etc. iv) determination of the sources of borrowing - development banks, public or private v) determination of the securities/charges to be given vi) determination of the cost of capital vii) determination of the extent of lease financing viii) determination of the degree of sensitivity of earnings per share to earnings before interest and taxation ix) determination of the method of raising capital-public issue or private placement; under-writing and brokerage, rights issue and the like x) the legal restrictions, if any, on the scale, form, timing and other aspects of raising capital Like investment function, financing function also affects the liquidity(less short term debt means more liquidity), solvency (more equity means moresolvency), profitability (low cost capital means more profitability), flexibility of capitalstructure (more equity, more flexibility), control on business (more debt and less BSPATIL
  16. 16. equity mean more concentration of control on the affairs of the business) and so on.That is, financing function is equally influencing the fortunes of the business. Butauthors like Modigliani and Miller would argue that financing function is not all matrelevant requiring our deep concern. Any capital mix or structure is equally good orbad as any other. (You will learn more of these in subsequent lessons). Lot ofmanagerial planning and control ate needed in the financing function.c) Dividend Payout Management Function The third and last, but not the least important, function of financialmanagement is dividend function. The fruits of the carefully executed earlier twofunctions are the profits. How the profits are to be utilized, is the concern of thedividend function. How much of the profits to be distributed as dividends to theshareholders? In other words, what should be the pay-out ratio? What should be theretention ratio? Dividend payment is necessary, for shareholders expect a return ontheir shareholding for they can invest / spend the dividend income; for maintainingor enhancing the value of the shares in the market, for dividend declaration has afinancial signaling effect and so on. Retaining the profits ane ouging back the same inthe business itself may become necessary because; the >mpany can invest moreprofitably than the shareholders; the company can get established and canmodernize, diversify and expand using the retained profits; the share holders areexpecting capital gain rather than current income; and because the cost of raisingnew capital form the public is costlier and time consuming. So, there are conflictingissues in paying dividend as well as in retaining the earnings. A well thought out planof action is called for. Hence the significance of the dividend function. (You will learnmore on this function in the last lesson). There is another classification of finance functions. Treasurer functionsand controller function are the two types. Treasurers responsibilities include assetmanagement, capital budgeting, bank-institutional relationship, credit management,dividend disbursement, investors relations, insurance risk management, taxanalysis, etc. The controller deals with accounting, data processing, budgeting,internal control, government reporting, etc. BSPATIL
  17. 17. 1.6 GOALS OF FINANCIAL MANAGEMENT Goals provide the foundation for any managerial activity. They ai the endstoward which all activities are directed. The purpose and direction of an organisationare seen in its goals. Goals act as motivators, serve as the standards for measuringperformance, help in coordination of multiplicity of tasks, help in identifying inter-departmental relationships and so on. Simply put, goals are what you aim at So,goals have to be specific and quantitative. Generally, goals are multiple. Financialmanagement may pursue different goals such as increasing profit by 20% every year,reducing cost of capital by 1%, maintaining the debt-equity ratio at 3:2 and so on. Letus examine all these in detail.1.6.1 Types of Goals The goals can be classified in many ways. Official goals, operative goals andoperational goals are one classification. Official goals are the general aims of theorganisation. Maximization of return on investment and market value per share maybe tenned as official goals. Operative goals indicate what the organisation is reallyattempting to do. They are focused and help in choice making. Expected return oninvestment, cost of capital, debt-equity norms, eic dong with time horizon arespecified or their acceptable ranges/limits are static keeping in view the official goals.The operational goals are more directed quantitative and verifiable. The scale, mixand timing of specific form of finance are detailed. The official, operative andoperational goals are structured with a pyramidal shape, the official goals at the top(concerned with the top executives), operative goals at the middle (concerned withmiddle management) and operational goals at the base. The goals can be classified in a functional way. Return related goals,solvency related goals, liquidity related goals, valuation related goals, risk relatedgoals, cost related goals and so on. Return related goals refer to the aims onminimum, average and, maximum returns. What should be the minimum returnfrom a project in order to accept the same, what should be average return the firmshould settle for and what is the maximum return possible (for risk increases withreturn). Similarly, goals as to solvency, liquidity, market value etc., can be thought of BSPATIL
  18. 18. You have to state to what extent the stated goal factor is important and be activelypursued/and the extent of the goal factor required; the minimum, average and themaximum levels be specified. The different goals of financial management are givenbelow in Table 1.1. BSPATIL
  19. 19. Profit Maximization Profit maximization is a stated goal of financial management. Profit is theexcess of revenue over expenses. Profit maximization is therefore maximizing revenuegiven the expenses, or minimising expenses given the revenue or a simultaneousmaximization of revenue and minimization of expenses. Revenue maximization ispossible through pricing and scale strategies. By increasing the selling price one mayachieve revenue maximization, assuming demand does not fall by a commensuratescale. By increasing quantity sold by exploiting the price-elasticity of the demandfactor, revenue can be maximized. Expenses minimization depends on variability ofcosts with volume, cost consciousness and market conditions for inputs. So, a mix offactors is called for profit maximization. This objective is a favoured one for the following reasons:1st profit is a measure of success in business. Higher the profit greater is the degree ofsuccess. 2nd profit is a measure of performance. Performance efficiency is indicated bythe quantum of profit, 3rd profit making is essential for the growth and survival of anyundertaking. Only protit making business can think of tomorrow and beyond. It canonly think of renewal and replacement of its equipment and can go for modernizationand diversification. Profit is an engine doing away the odds threatening the survival ofthe business. 4th profit making is the basic purpose of business. It is accepted bysociety. A losing concern is a social burden. The sick business undertakings cause aheavy burden to all concerned, we know. So, profit criterion brings to the lightoperational inefficiency. You cannot conceal your inefficiency, if profit is made thecriterion of efficiency. 5th profit making is not a sin. Profit motive is a sociallydesirable goal, as long as your means are good.However, profit maximization is net very much favoured. Certain limitations arepointed out. First, concept of profit is vague. There are several concepts of profit likegross profit, profit before tax, profit after tax, net profit, divisible profit and so on. Sothe reference to the profit has to be clear. Second, profit maximization in the long-runor in the short-run is to be stated clearly. Long-run or in the short-run profitorientations differ in the nature, emphasis and strategies. Third, profit maximizationdoes not consider the scale factors. Size of business and level of profit have to berelated. Otherwise no sensible interpretation of performance or efficiency is possible. BSPATIL
  20. 20. Fourth, profit has to be related to the time factor. Inflation eats up money value. Arupee today is worthier today than tomorrow and day after. Time value of money isnot considered in profit maximization. Consider the case of three businesses makingsame absolute profits over a 3 year time span given below. Year Unit-1 Unit-2 Unit-3 Rs. Rs. Rs. 1 20,000 40,000 5,000 2 20,000 15,000 15,000 3 20,000 5,000 40,000 Total 60,000 60,000 60,000 The profit maximization objective would not differentiate among the threebusiness. But, evidently, unit-2 is the best of the three, followed by Unit-1 and Unit-3in that order. Fifth, profit maximization might lead to unfair means being adopted.The end through and means is no good. Ethics is business dealings may beundermined any this is not good. So, profit maximization is not accepted as a flawlessgoal. BSPATIL
  21. 21. Profitability Maximization Profit as an absolute figure conveys less and conceals more. Profit must berelated to either sales, capacity utilisation, production or capital invested. Profit whenexpressed in relation to the above size or scale factors it acquires greater meaning.When so expressed, the relative profit is known as profitability. Profit per rupee sales,profit per unit production, profit per rupee investment, etc., are more specific. Hence,the superiority of this goal to the profit maximization goal. Further profit per rupee investment or return on investment, (ROI) is acomprehensive measure. ROI = Return or Profit / Average Capital invested. This canbe written as: Profit Sales X Sales Investment Profit divided by sales measures the profit per rupee of sales and sales dividedby investment measures the number of times the capital is turned over. The former isan index of profit earning capacity and the latter is an index of activeness of thebusiness. Maximization of profitability (ROI) is possible through either the former orthe latter or both. The favourable scores of this objective are the same as those of the profitmaximization objective. The unfavourable scores of this objective again are the sameas those of the profit maximization objective except one aspect. Profit maximizationgoal does not relate profit to any base. But profitability maximization relates profit tosales and/or investment. Hence it is a relative measure. So it is better than profitmaximization goal on this score. But as other limitations continue, this objective toogets only a qualified report as to its desirability.1.6.13 EPS Maximization Maximization EPS involves maximizing earnings after tax given the number of BSPATIL
  22. 22. outstanding equity shares. This goal is similar to profitability maximization in respectof merits and demands. It is very specific both as to the type of profit and the base towhich it is compared. One disadvantage is that EPS maximization may lead to valuedepletion too, because effect of dividend policy on value is totally discarded. Liquidity Maximization Liquidity refers to the ability of a business to honour its short-term liabilities asand when these become due. This ability depends on: the ratio of current assets tocurrent liabilities, the maturity patterns of currents assets and the current liabilities,the composition of current assets, the quality of non-cash current assets; therelations with the short-term creditors; the relations with bankers and the like. Ahigher current ratio, a perfect match between the maturity of current assets andcurrent liabilities, a well balanced composition of current assets, healthy andmoving1 current assets, i.e., those that can be converted into liquid assets with muchease and no loss, understanding creditors and ready to help bankers would helpmaintaining a high-liquidity level for a business. All these are not easy to obtain andthese involve costs and risks. How far is it a good goal? It is a good goal, though not a wholesome one. Everybusiness has to generate sufficient liquidity to meet its day-to-day obligations. Last,the business would suffer. A liquidity rich business can exploit some rareopportunities like buying inventory in large quantity when price is lower, lend to thecall money borrowers when the interest rate is high, retire short-term-creditors takingadvantage of cash discounts and so on. So many benefits accrue. But, high liquiditymight result in idle cash resources and this should be avoided. Yes, excess liquidityand profitability move in the opposite directions, they are conflicting goals and haveto be balanced. Solvency Maximization Solvency is long run liquidity. Liquidity is short-run solvency. The business hasto pursue the goal of solvency maximization. Solvency is the capacity of the businessto meet all its long-term liabilities. The earning capacity of the business, the ratio of BSPATIL
  23. 23. profit before interest and tax to interest, the ratio of cash flow to debt amortization,the equity-debt ratio and the proprietary ratio influence the solvency of a business.Higher the above ratios greater is the solvency and vice-versa Is this a significant goal? Yes, Solvency is a guarantee for continued operation,which in turn is necessary for survival, growth and expansion. Borrowed capital is asignificant source of finance. Its cost is less; it gives tax leverage; So, equity earningsincrease; so market valuation increases. So, wealth maximization is enabled throughborrowed capital. But to use borrowed capital, solvency management is essential. Youhave to decide the extent to which you can use debt capital and ensure that the costof debt capital is minimum. Higher dependence and higher cost (higher than the ROI)would spell doom to the business. If the cost is less, (cost is the post tax interestrate), and your earnings are stable, a higher debt may not be difficult for servicing.Solvency maximization is increasing your ability to service increasing debt and doesnot mean using less debt capital. Increasing the debt service ability would requiregenerating more and stable cash flows through the operations of the business.Ultimately, the nature of investments and business ventures influence solvency. You would now understand that liquidity maximization and solvencymaximization emerge to a large extent from wealth maximizationobjective. Flexibility Maximization Flexibility means freedom to act in ones own way. The finance manager mustenjoy a good degree of freedom. This is possible when more equity capital is used,there are no restrictive covenants and exit options are available. Minimization of Risk So far, maximization financial goals were dealt with. Now, if we turn the coin,the minimization goals come to light. Minimization of risk is one of the goals. Riskrefers to fluctuation, instability or variations in what we cherish to obtain. Variationsin sales, profit, capacity utilisation, liquidity, solvency, market value and the like are BSPATIL
  24. 24. referred to risk. Business risk and financial risk are prominent among different risks.Business risk refers to variation in profitability while financial risk refers to variationin debt servicing capacity. The business risk, alternatively, refers to variations inexpected returns. Greater the variations, greater the business risk. Risk minimizationalso does not mean taking no risk at all. It means minimizing risk given the returnand given the risk maximizing return. Risk reduction is possible by going in for a mixof risk-free and risky investments. A portfolio of investments with risky and risk-freeinvestments, could help reducing business risk. So, diversification of investments, asagainst concentration, helps in reducing business risk. BSPATIL
  25. 25. Financial risk arises when you depend more on high-geared capital structure andyour cash flows and profits before interest and tax (PBJT) vary. To minimize financialrisk, the quantum of debt capital be limited to the serviceable level, which dependson the minimum level of PBJT and the cash flow. Of course, debt payment schedulingand rescheduling may help in financial risk reduction and the creditor must beagreeing to such schedules/reschedules. Here; too, a portfolio of debt capital can bethought of to reduce risk. Minimization of Cost of Capital Minimization of cost of capital is a laudable goal of financial management.Capital is a scarce resource, A price has to be paid to obtain the same. The minimumreturn expected by equity investors, the interest payable to debt capital providers, thediscount for prompt payment of dues, etc., are the costs of different forms of capital.The different sources of capital - equity, preference share capital, long term debt,short-term debt and retained earnings, have different costs. In theory, equity is thecostliest source. Preference share capital and retained earnings cost less than equity.The debt capital costs less, besides there is the tax advantage. So, to minimize costyou have to use more debt and less of other forms of capital. Using more debt toreduce cost is however is beset with some problems, viz., you take heavy financialrisk, create charge on assets and so on. Some even argue, that more debt meansmore risk of insolvency and bankruptcy cost arises. So, debt capital has, besides theactual cost, another dimension of cost - the hidden cost. So, minimizing cost ofcapital means minimizing the total of actual and hidden costs. This is a good goal. Minimization of capital cost increases the value of the firm.If the overall cost of capital is less, the firm can take up even marginal projects andmake good returns and serve the society as well. But, it should avoid the temptationto fritter away scarce capital. Capital should be directed into productive andprofitable avenues only.1,6.1.9. Minimization of dilution of control: Control on the business affairs is, generally, the prerogative of the equity BSPATIL
  26. 26. shareholders. As the Board holds a substantial equity it wants to preserve its hold onthe affairs of the business. The non-controlling shareholders too, in heir financialpursuit, want no dilution of their enjoinment of fruits of equity ownership. Dilationtakes place when you increase the capital base. By seeking debt capital controldilation is minimized. Also, by rights issue of equity dilation of control can beminimized. It is evident, minimization of dilution of control is essentially a financing -mixdecision and the latters relevance and significance had been already dealt with. Butyou cannot minimize dilution beyond a point, for providers of debt capital, directly orindirectly, affect business decisions. The convertibility clause is a shot in the arm forthose creditors. Yes, controlling power has to be distributed. Especially, in Indiancontext one need not be a 51% owner to exercise full control. Even with as little as26% or 30% equity holding maximum control can be exercised. This is bad. So, suchcontrol better is not controlled. So, there is need and score for sharing of controllingpower. The present scenario is a fulfillment of the above. Wealth maximization: Wealth maximization means maximization of networth of the business, i.e. themarket valuation of a business. In other words, increasing the market valuation ofequity share is what is pursued here. This objective is considered to be superior andwholesome. The pros and cons of this goal are analysed below.Taking the positive side of this goal, we may mention that this objective takes intoaccount the time value of money. The basic valuation model followed discounts thefuture earnings, i.e. the cash flows, at the firms cost of capital or the expectedreturn. The discounted cash inflow and outflow are matched and the investment orproject is taken up only when the former exceeds the latter. Let the cash inflows beexpressed by CFi, CF2, CFs.... CFn, where the subscripts l,2,3...n are periods whencash flows realised. Let, the cash investment at time zero be T. The present value i.e.the discounted value of CFi, CFi, CF3..., CFto at the discount rate V is given by:n∑ CFt / (1+r)t or BSPATIL
  27. 27. t=1CF + CF2 + CF + …….. + CF(1+r)1 (1+r)2 (1+r)3 (1+r)n The value addition is given by PV - I. By adopting this methodology the firmgives adequate consideration to time value of money, the short-run and long-runincome as the return throughout the entire life span of the project is considered andso on. The term cash flow used here is capable of only one interpretation, unlike theterm profit. Cash inflow refers to profit after interest and tax but before depreciation.Otherwise put, profit after tax and interest as increased by depreciation. Cash outflowis the investment. Salvage value of investment, at its present value can be reducedfrom investment or added to inflow. So, the cash flow concept used in wealthmaximization is a very clear concept. This goal considers the risk factor in financial decision, while the earlier twogoals are silent as though risk factor is absent. Not only risk is there and it isincreasing witH the level of return generally. So, by ignoring risk, you cannotmaximize profit for ever Wealth maximization objective give credence to the wholescheme of financial evaluation by incorporating risk factor in evaluation. Thisincorporation is done through enhanced discounting rate if need be. The cash flowsfor normal-risk projects are discounted at the firms cost of capital, whereas riskyprojects are discounted at a higher than cost of capital rate so that the discountedcash inflows are deflated, and the chance of taking up the project is reduced. Cashflows - inflows and outflows are matched. So, one is related to the other: i.e. there isthe relativity criterion too. So, wealth maximization goal comes clear off all thelimitations all the goals mentioned above. Hence, wealth maximization goal isconsidered a superior goal. This is accepted by all participants in the businesssystem. The profit, profitability, liquidity, solvency and flexibility maximization goalsand risk, cost and dilution of control minimization goals lead to reaping of wealthmaximization goal. Wealth maximization is, therefore, a super-ordinate goal. BSPATIL
  28. 28. Maximization of economic value added A modern concept of finance goal is emerging now, called as maximization oreconomic value added (EVA). EVA = NGPAT - CCC, where, EVA is economic valueadded, NGPAT is net generating profit after tax but before interest and dividend andCCC is cost of combined capital. CCC = Interest paid on debt capital plus fairremuneration on equity. EVA is simply put excess of profit over all expenses,including expenses towards fair remuneration paid/payable on equity fond.1.7. RISK-RETURN LINKAGE AND TRADE-OFF Risk is the uncertainties or fluctuations in expected gain or benefit. Return isthe gain of reward. Risk and return are linked, in a probabilistic way. Higher risk maygive you more return and vice versa. There is no certainty relationship. If mat wereso, the concept of risk gets vanished. You put your money with nationalised banks indifferent schemes. Your return at the maximum would be 10% or so, but you are surethis return would be given to you with no hitch or hindrance. So there is nofluctuation in your earnings from your deposits with these banks. So, there is norisk, but your return is minimum. You put your money in debentures of ‘AAA’ ratedcompany. A 12% interest may be promised. You may not run any risk, but theGovernment guarantee is not there as in the case of bank deposits. So some risk isthere. Hence a 2% extra return. You take some risk and there is additional return.You put your money in a BBB plus companys debentures and you are promised 13%return. Yes, you take more risk than in the case of your investment in an *AAAcompany and hence the added return. In these two cases referred to above you takethe risk. But returns are only promised. If promises are not fulfilled, higher returnshave not resulted. Hence, the probabilistic but direct relationship between risk andreturn. As risk and return move in the same direction, a trade-off has to be effected.What is the level of risk you want to take? Then the return is specified What is thereturn you want to earn? Then the risk is given. If you decide one, the other is givenand you cant have any bargain over that. You decide one and take the other as given. BSPATIL
  29. 29. If you reduce the level of risk, this is accomplished by a reduction in return too andvice versa. So, every unit of return has a price - i.e. the risk. You pay the price - i.e.assume the extra risk and get the extra return and vice versa. This exchangearithmetic is referred to risk-return trade-off. All financial decisions involve risk-return trade-off. Consider these. Moreliquidity means less risk of running out of cash. You keep more liquid cash. Resultmore barren assets and less return. So, less risk - less return situation arises. Moresolvency means less risk, because you possibly use less debt capital. Less debtmeans more overall cost of capital, for you have used less of low cost debt capital andmore of high cost equity capital. More overall cost of capita) means reduced return.So, again less risk and less return situation results. When high risk is involved, highreturn is expected This relationship is put into an equation of risk and return. Rf + Rp, where,E(R) is expected return, Rf is risk-tree return as in the case return on good bonds andRp is risk premium, i.e. additional return expected for any additional dose of riskassumed and Rp varies with risk level.1.8 MAXJMISATION-MINIMISATION-OPTIMISATION-SATISFICING So far the goals of financial management were dealt either in terms ofmaximization or minimization, as the case may be. Now the reality of thesemaximization and minimization may be required into, and alternative approaches tothem, if need be, evolved, Both maximization and minimization are devoid of clear expression ordefinition, as these have not definite limits. Hence these are unrealistic. Unrealistic,not because conceptualization is difficult. We can even conceptualize by mentioningsome bench mark levels or some min-max ranges. But once such levels arementioned, human tendency is to conform to the limits. You may not maximizereturn beyond the minimum expected and may not minimize cost below themaximum acceptable. The divorce between ownership and management in a case inpoint. Shareholders are no longer the managers. The interest of shareholders differ BSPATIL
  30. 30. from the interests of the management The principals interest may not be realised bythe agents, unless the agents own set of interests are fulfilled. Michael C.Jensen andWilliam H.Meckling refer to this as the agency cost. Managements have to be offeredincentives - a percentage commission on profit, a fat salary, a diverse perquisites,stock options and so on But the above are costs reducing the shareholders lot. Socost get escalated instead of getting reduced and returns gets reduced instead ofgetting escalated. Even assuming the management is a reasonable one, i.e., notinterested in fat salary nor varied perks, as humans their judgments are subject tohuman errors. So maximization of benefits and minimization of costs cannot be takenfor granted. So, in reality these approaches to setting goals of financial managementare unrealistic. But Eugene F.Fama would tell that the above approach is normativein nature, like the official goal. Toward these maxima and minima the organisationhas to move. They are merely directional and not decisional Optimization is yet another approach. This is definable, objective andmeasurable too. Optimization is getting the best solution, having regard to allconstraints. Inventory management, receivable management, resource management,liquidity management, etc., involve very many situations where optimizing techniquesare used. The Economic Order Quantity (EOQ) technique is a versatile optimizingmodel. Similarly, waiting line theory, linear programming, assignment models, etc.,can be used in financial management in optimizing goal achievement. Waiting linetheory is used finding out whether or not additional facilities are required to ensure acertain level of service and to reduce costs of waiting and servicing. Linearprogramming is used in efficient resource allocations. Job-machine optimalassignment is facilitated with the use assignment models. Optimization is butconstrained maximization or minimization and that it has the same limitations ofmaximization or minimization goals. However, unlike maximization, constrainedmaximization is decisional and so is constrained minimization. So, optimization is agood goal. But it is too ideal to practice. Satisfying is another approach. Maximization and minimization are both UtopiaOptimization is prone with constraints. So, satisficing comes. You try to "satisfy*rather than maximize or minimize or optimize. The satisficing goal is behaviourallysuited and perfectly manageable. You dont search for the best, but get satisfied withthe considered good*. Often the search cost of the best over the better or even the BSPATIL
  31. 31. good might be more than the additional gains of the best. So satisficing approachhas become a more practical approach.1.9 SUMMARY Financial Management is an integral part of business management. As adiscipline it emerged only in the early 20th century. Traditional concept of financialmanagement confined it to cash management and raising of capital. Modern financialmanagement, evolved since the middle of 1950s, deals with both raising andutilisation of capital, portfolio management and so on. Finance functions can beclassified on two dimensions - managerial and operative. Operative functions includeinvestment, financing and dividend functions. Each of these functions needs carefulmanagerial planning, execution and control. And that is financial management. There is a multiplicity of goals of financial management. Wealth maximizationis a wholesome goal. Maximization of profit, profitability, liquidity and solvency areother goals. But these are sectional and fragmented. Similarly, minimization of cost ofcapital, risk and dilution of control address particular aspects. Well, all these puttogether throw much light on the whole gamut of financial management as such.Now, maximization of economic value added is added to the list of goals of financialmanagement. Maximisation / minimisation is but vague as they do not refer to anyabsolute value. Besides, with ownership separated from management, maximizationof benefitstoainimization of costs is not possible, behaviourally speaking. Clash ofinterests of the two parties comes in the way of realisation of these objectives.Optimization is a viable alternative approach. But models have to be built,constraints specified and objective function expressed clearly. Search costs areinvolved therein. So, satisfying approach - a satisfactory goal/a satisfactory level, hasbecome prominent. Of course it does not mean the best course, but not necessarilyless than the optimum.1.10 SELF ASSESSMENT QUESTIONS1. Bring out the nature and significance of financial management.2. Explain the concept, importance and functions of financial management. BSPATIL
  32. 32. 3. Discuss the evolution of financial management and bring out the changing emphasis of finance functions.4. What are finance functions? Explain them briefly.5. Distinguish between financing and investment functions.6. What considerations are involved in dividend decision?7. Define finance goals. Explain them briefly.8. Wealth maximization is superior to profit maximization. Discuss.9. Elucidate risk-return trade-off. Also bring out the nature of relationship between risk and return.10.Satisfying approach to goal setting is gaining ground in recent times to maximizing. Why?11.Finance goals are multiple and conflicting. How do you resolve the conflict?12.What is EVA maximization? How is it different from maximization of wealth?13.What is time value of money? In annual inflation is 8%, what is the present value of Rs. 11664 receivable after two years?14.HNOPAT of a firm in a period is Rs.4,50,000. It has equity capital of Rs. 10,00,000 and debt capital of Rs. 5,00,000 with annual interest rate of t2%. Equity capital needs a return of 18% p.a. Find the EVA for the firmREFERENCES 1. Financial Management and Policy - Van Horne 2. Financial Decision Making – Hampton 3. Management of Finance - Weston and Brigham 4. Financial Management - P.Chandra BSPATIL
  33. 33. UNIT-II LONG-TERM CAPITAL: TYPES & SOURCES In this unit you will learn instruments of raising long-term capital (equityshares, preference shares and debentures), significance of different modes of issue ofcapital instruments (public, right and private placement), term lending institutionsand borrowings and public deposits as a means of long-term capital.INTRODUCTION Long-term capital is capital with maturity exceeding one year. Long-termcapital is used to fund the acquisition of fixed assets and part of current assets.Public limited companies meet their long-term financial requirements by issuingshares and debentures and through borrowing and public deposits. The requiredfund is to be mobilized and utilized systematically by the companies.21 SOURCES OF CAPITAL Broadly speaking, a company can have two main sources of funds internal andexternal. Internal sources refer to sources from within the company External sourcesrefer to outside sources. Internal sources consist of depreciation provision, general reserve fund or freereserve - retained earnings or the saving of the company. External sources consists ofshare capital, debenture capital, loans and advances (short term loans fromcommercial banks and other creditors, long term loans from finance corporations andother creditors). Share capital is considered as ownership or equity capital whereasdebentures and loans constitute borrowed or debt capital. Raising capital throughissue of shares, debentures or bonds is known as primary capital sourcing. Otherwiseit is called new issues market. Long-term sources of finance consist of ownership securities Equity shards andpreference shares) and creditor-ship securities (debentures, borrowing from the BSPATIL
  34. 34. financing institutions and lease finance). Short-term sources of finance consists oftrade credit, short term loans from banks and financial institutions and publicdeposits,2.2 LONG-TERM CAPITAL INSTRUMENTS Now, an attempt is made to discuss the long term capital instruments of acompany i.e. shares and debentures.Corporate securities also known as company securities are said to be thedocumentary media of raising capital by the joint stock companies. These are of twoclasses: Ownership securities; and Creditor-ship securities.Ownership Securities Ownership securities consist of shares issued to the intending investors withthe right to participate in the profit and management of the company. The capitalraised in this way is called owned capital*. Equity shares and securities like theirredeemable preference shares are called ownership securities. Retained earningsalso constitute owned capital.Creditor-ship Securities Creditor-ship securities consist of various types of debentures which areacknowledgements of corporate debts to the respective holders with a right to receiveinterest at specified rate and refund of the principal sum at the expiry of the agreedterm. Capital raised through creditor-ship securities is known as ‘borrowed capital’.Debentures, bonds, notes, commercial papers etc. are instruments of debt orborrowed capital.2.2.1 Equity Shares Equity shares are instruments to raise equity capital. The equity share capitalis tie backbone of any companys financial structure. Equity capital representsownership capital. Equity shareholders collectively own the company. They enjoy the BSPATIL
  35. 35. reward of ownership and bear the risk of ownership. The equity share capital is alsotermed as the venture capital on account of the risk involved! in it. The equityshareholders’ liability, unlike the liability of the owner in a proprietary concern andthe partners in a partnership concern, is limited to their capital subscription andcontribution. In India, under the Companies Act 1956, shares which are not preferenceshares are called equity shares. The equity shareholders get dividend after thepayment of dividend to the preference shareholders. Similarly, iif the event of thewinding up of the company, capital is returned to them after the return of capital tothe preference shareholders. The equity shareholders enjoy a statutory right to votein the general body meeting and thus exercise their voice in the management andaffairs of the company. They have an unlimited interest in the companys profit andassets. If the profit of the company is substantial, the equity shareholders may getgood dividend; if not, there may be little or no dividend with reduced or nil profit Theequity shareholders* return of income, i.e. dividend is of fluctuating character and itsmagnitude directly depends upon the amount of profit made by a company in aparticular year. Now a days equity capital is raised through global equity issues. Globaldepository receipts (GDRs), American depository receipts (ADRs), etc. are certaininstruments used by Indian companies to overseas capital market tc get equitycapital.Advantages of Equity Share Capital i) Equity share capita] constitutes the corpus of the company. It is the ‘heart’ to the business. ii) It represents permanent capital. Hence, there is no problem of refunding the capita]. It is repayable only in the event of companys winding up and that too only after the claims of preference shareholders have been met in full. iii) Equity share capital does not involve any fixed obligation for payment of dividend. Payment of dividend to equity shareholders depends on the BSPATIL
  36. 36. availability of profit and the discretion of the Board of Directors.iv) Equity shares do not create any charge on the assets of the company and the assets may be used as security for further financing.v) Equity capital is the risk-bearing capital, unlike debt capital which is risk- Equity share capital strengthens the credit worthiness and oorrowmg or debt capacity of the company. In general, other things being equal, the larger the equity base, the higher the ability of the company to secure debt capital.vii) Equity capital market is now expanding and the global capital market can be accessed. BSPATIL
  37. 37. Disadvantages of Equity Shares Capial i) Cost of issue of equity shares is high as the limited group of risK-seeking investors need to be attracted and targeted. Equity shaiv attract only those classes of investors who can take risk. Conservative and cautious investors do not to subscribe for equity issues, Su underwriting commission, brokerage costs and other issue expense are high for equity capital, raising up issue cost. ii) The cost of servicing equity capital is generally higher than the cos issuing preference shares or debenture since on account of higher n the expectation of the equity shareholders is also high as compared preference shares or debentures. iii) Equity dividend is payable from post-tax earnings. Unlike intent paid on debt capital, dividend is not deductible as an expense from, profit for taxation purposes. Hence cost of equity is hi«be : Sometimes, dividend tax is paid, further rising cost of equity share capital. iv) The issuing of equity capital causes dilution of control of the equji holders. v) In times of depression dividends on equity shares reach low be which leads to drastic full in their market values. vi) Excessive reliance on financing through equity shares reduces the capacity of the company to trade on equity. The excessive use of equity shares is liJcely to result in over capitalization of the company. BSPATIL
  38. 38. 2.2.2 Preference Shares Preference shares are those which carry priority rights in regard to the paymentof dividend and return of capital and at the same time are subject to certainlimitations with regard to voting rights. *The preference shareholders are entitled to receive the fixed rate of dividend out ofthe net profit of the company. Only after the payment of dividend at a fixed rate ismade to the preference shareholders, the balance of profit will be used for payingdividend to ordinary shares. The rate of dividend on preference shares is mentionedin the prospectus. Similarly in the event of liquidation the assets remaining afterpayment of all debts of the company are first used for returning the capitalcontributed by the preference shareholders.Types of Preference Shares There are many forms of preference shares. These are: i) Cumulative preference shares ii) Non-Cumulative preference shares iii) Participating preference shares iv) Non-participating preference shares v) Convertible preference shares vi) Non-convertible preference shares vii) Redeemable preference shares viii) Non-redeemable preference shares ix) Cumulative convertible preference shares BSPATIL
  39. 39. Cumulative and non-cumulative In the case of cumulative preference shares, the unpaid dividend goes onaccumulating until paid. The unpaid dividends on cumulative preference sharesbecome payable out of the profit of the company in the subsequent years. Only aftersuch arrears have been paid off, any dividend can be paid to other classes of shares.In case of non-cumulative preference shares, the right to claim dividend lapses ifthere is no profit in a particular year. Thus, the non-cumulative preferenceshareholders are not entitled to claim arrears of dividend. As a result, the dividendcoupon on non-cumulative preference shares is more than that of cumulativepreference shares.Participating and non-participating The preference shares which are entitled to participate in the surplus of profitsof the company available for distribution over and above the fixed dividend are calledas participating preference shares. Non-participating preference shares do not havesuch rights.Convertible and convertible Convertible preference shares are convertible into equity shares as per normsof issue and conversion. Non-convertible preference shares are not converted.Convertibility is resorted to enhance attractiveness of the instrument to prospectiveinvestors, who prefer equity to preference shares.Redeemable and IrredeemableRedeemable preference shares are those which can be redeemed during the life timeof the company, while irredeemable preference shares can be redeemed only when thecompany goes for liquidation. BSPATIL
  40. 40. Cumulative Convertible Cumulative convertible preference shares have both the features ofcumulativeness of unpaid dividend and convertibility. These features make thepreference shares more preferred.Merits of Preference shares i) The preference shares have the merits of equity shares without their limitations. ii) Issue of preference shares does not create any charge against the assets of the company. iii) The promoters of the company can retain control over the company by issuing preference shares, since the preference shareholders have ^>nly limited voting rights. iv) In the case of redeemable preference shares, there is the advantage that the amount can be repaid as soon as the company is in possession of funds flowing out of profits. v) Preference shares are entitled to a fixed rate of dividend and the company many declare higher rates of dividend for the equity shareholders by trading on equity and enhance market value. vi) If the assets of the company are not of high value, debenture holders will not accept them as collateral securities. Hence the company prefers to tap market with preference shares. vii) The public deposit of companies in excess of the maximum limit stipulated by the Reserve Bank can be liquidated by issuing preference shares. viii) Preference shares are particularly useful for those investors who want higher rate of return with comparatively Jower risk. ix) Preference shares add to the equity base of the company and they strengthen the financial position of it Additional equity base increases the ability of the company to borrow in future. x) Preference shares have variety and diversity, unlike equity shares, Companies have thus flexibility in choice.Demerits of Preference Shares BSPATIL
  41. 41. i) Usually preference shares carry higher rate of dividend than the rate of interest on debentures. ii) Compared to debt capital, preference share capital is a very expensive source of financing because the dividend paid to preference shareholders is not, unlike debt interest, a tax-deductible expense. iii) In the case of cumulative preference shares, arrears of dividend accumulate. It is a permanent burden on the profits of the company. iv) From the investors point of view, preference shares may be disadvantageous because they do not carry voting rights. Their interest may be damaged by a equity shareholders in whose hands the control is vested. v) Preference shares have to attraction. Not even 1% of total corporate capital is raised in this form. vi) Instead of combining the benefits of equity and debt, preference shar capital, perhaps combines the banes of equity and debt.2.2.3 Debentures A debenture is a document issued by a company as an evidence of a debt duefrom the company with or without a charge on the assets of the company. It is anacknowledgement of the companys indebtedness to its debenture-holders.Debentures are instruments for raising long term debt capital. Debenture holders arethe creditors of the company. In India, according to the Companies Act, 1956, the term debenture includes"debenture stock, bonds and any other securities of a company whether constitutinga charge on the assets of the company or not" Debenture-holders are entitled to periodical payment of interest aij agreed rate. BSPATIL
  42. 42. They are also entitled to redemption of their capital as per the agreed terms. Novoting rights are given to debenture-holders. Under section 117 of the Companies Act,1956, debentures with voting rights cannot be issued. Usually debentures aresecured by charge on or mortgage of the assets of the company.Types of debentures Debentures can be various types. They are: i) Registered debentures ii) Bearer debentures or unregistered debentures iii) Secured debentures iv) Unsecured debentures v) Redeemable debentures vi) Irredeemable debentures vii) Fully convertible debentures viii) Non-convertible debentures ix) Partly convertible debentures x) Equitable debentures xi) Legal debentures xii) Preferred debentures xii) Fixed rate debentures xiii) Floating rate debentures xiv) Zero coupon debentures xv) Foreign currency convertible debenturesRegistered debentures : Registered debentures are recorded in a^register ofdebenture-holders with full details about the number, value and types of debenturesheld by the debenture-holders. The payment of interest and repayment of capital ismade to the debenture-holders whose names are entered duly in the register ofdebenture-holders. Registered debentures are not negotiable. Transfer of ownershipof these type of debentures cannot be valid unless the regular instrument of transferis sanctioned by the Directors. Registered debentures are not transferable by meredeliveryBearer or Unregistered debentures: The debentures which are payable to the bearer BSPATIL
  43. 43. are called bearer debentures. The names of the debenture-holders are not recorded inthe register of debenture-holders. Bearer debentures are negotiable. They aretransferable by mere delivery and registration of transfer is not necessary.Secured debentures: The debentures which are*secured by a mortgage or change onthe whole or a part of the assets of the company are called secure,: debentures.Unsecured debentures: Unsecured debentures are those which do not cam ... chargeon the assets of the company. These are, also, known as ‘naked’ debentures.Redeemable debentures: The debentures which are repayable after a certain periodare called redeemable debentures. Redeemable debentures may be bullet-repaymentdebentures (i.e. one time be payment) or periodic repayment debentures.Irredeemable debentures: The debentures which are not repayable during the lifetime of the company are called irredeemable debentures. They are also known asperpetual debentures. Irredeemable debentures can be redeemed only in the event ofthe companys winding up.Fully convertible debentures: Convertible debentures can be converted intoj equityshares of the company as per the terms of their issue. Convertible debenture-holdersget an opportunity to become shareholders and to take part inj the companymanagement at a later stage. Convertibility adds a ‘sweetner’ to thej debentures andenhance their appeal to risk seeking investors.Non-Convertible debentures: Non-convcnible debentures are not convertible Thevremain as debt capital instruments.Partly convertible debentures: Partly convertible debentures appeal toinvestors who want the benefits of convertibility and non-convertibility in oneinstrument.Equitable debentures: Equitable debentures are those which are secured by depositof title deeds of the property with a memorandum in writing to create a charge. BSPATIL
  44. 44. Debentures: Legal debentures are those in which the legal ownership of property ofthe corporation is transferred by a deed to the debemure holders, security for theloans."Referred debentures: Preferred debentures are those which are paid first in theevent of winding up of the company. The debentures have priority over otherVentures.“Fixed rate debentures : Fixed rate debentures cany a fixed rate of interest Now-a-days this class is not desired by both investors and issuing institutions.“Floating rate debentures : Floating rate debentures cany floating interest ratecoupons. The rates float over some bench mark rates like bank rate, LIBOR etc.Zero-coupon debentures: Zero-coupon debentures do not carry periodic interestcoupons. Interest on these is paid on maturity. Hence, these are also called as deep-discount debentures.Foreign Currency convertible debentures: Foreign currency convertible debenturesare issued in overseas market in the currency of the country where the floatationtakes place. Later these are converted into equity, either GDR, .VDR or plain equity.Merits of debentures i) Debentures provide runds to the company for a long period without diluting its control, since debenture holders are not entitled to vote. ii) Interest paid to debenture-holders is a charge on income of the company and is deductible from computable income for income tax purpose whereas dividends paid on shares are regarded as income and are liable to corporate income tax. The post-tax cost of debt is thus lowered. iii) Debentures provide funds to the company for a specific period. Hence, the company can appropriately adjust its financial plan to suit its requirements. BSPATIL
  45. 45. iv) Since debentures are generally issued on redeemable basis, the company can avoid over-capitalisation bv refunding the debt when the financial needs are no longer felt. v) In a period of rising prices, debenture issue is advantageous. The burden of servicing debentures, which entail a fixed monetary commitment for interest and principal repayment, decreases in real terms as the price level increases. vi) Debentures enable the company to take advantage of trading on equity and thus pay to the equity shareholders dividend at a rate higher than overall return on investment. vii) Debentures are suitable to the investors who are cautious and conservative and who particularly prefer a stable rate of return with minimum or no risk. Even institutional investors prefer debentures for this reasonDemerits of Debentures i) Debenture interest and capital repayment are obligatory payments. Failure to meet these payment jeopardizes the solvency of the firm. ii) In the case of debentures, interest has to be paid to the debenture holders irrespective of the fact whether the company earns profit or not. It becomes a great burden on the finances of the company. iii) Debenture financing enhances the financial risk associated with the firm. This may increase the cost of equity capital. iv) When assets of the company get tagged to the debenture holders the result is that the credit rating of the company in the market comes down and financial institutions and banks refuse loans to that company. v) Debentures are particularly not suitable for companies whose earnings fluctuate considerably. In case of such company raising funds throifgh BSPATIL
  46. 46. debentures may lead to considerable fluctuations in the rate of dividend payable to the equity shareholders.2.2.4 Financing through equity snares and debentures - Comparison A company may prefer equity finance (i) if long gestation period is involved, (ii)if equity is preferred by the market forces, (iii) if financial risk perception is high, (iv)if debt capacity is low and (v) dilution of control isnt a problem or does not rise. A company may prefer debenture financing as compared to equity sharesfinancing for the following reasons: i) Generally the debenture-holders cannot interfere in the management of the company, since they do hot have voting rights. ii) Interest on debentures is allowed as a business expense and it is tax deductible. iii) Debenture financing is cheaper since the rate of interest payable on it is lower than die dividend rate of preference shares. iv) Debentures can be redeemed in case the company does not need the funds raised through this source. This is done by placing call option in the debentures. v) Generally a company cannot buy its own snares but it can buy its own % debentures. vi) Debentures offer variety and in dull market conditions only debenture; help gaining access to capital market.2.2.5 Convertible Issues A convertible issue is a bond or a share of preferred stock that can be converted BSPATIL
  47. 47. at the option of the holder into common stock ot ihe same company. Once convertedinto common stock, the stock cannot be exchanged again for bonds or preferredstock. Issue of convertible preference shares and convertible debentures are calledconvertible issues. The convertible preference shares and convertible debentures areconverted into equity shares. The ratio of exchange between the convertible issuesand the equity shares can be stated in terms of either a conversion price or aconversion ratio.Significance of convertible issues : The convertible security provides the investorwith a fixed return from a bond (debenture) or with a specified dividend frompreferred stock (preference shares). In addition, the investor gets an option to convertthe security (convertible debentures or preference shares) into equiu shares andthereby participates in the possibility of capital gains associated with, being aresidual claimant of the company. At the time of issue, the .convertible security willbe priced higher than its conversion value. The difference between the issue price andthe conversion value is known as conversion premium. The convertible facilityprovides a measure of flexibility to the capital structure of, the company to thecompany which wants a debt capital to short with, butj market wants equity. So,convertible issues add sweetners to sell debt securities! to the market which wantequity issues.Convertible preference shares: The preference shares which carry the right ofconversion into equity shares within a specified period, are called convertiblepreference shares. The issue of convertible preference shares must be dulj authorizedby the articles of association of the company.Convertible debentures: Convertible debentures provide an option to holders toconvert them into equity shares during a specified period at particular price. Theconvertible debentures are not likely to have a goc investment appeal, as the rate ofinterest for convertible debentures is lesser than the non-convertible debentures.Convertible debentures help a company to sell future issue of equity shares at a pricehigher than the price at which the companys equity shares may be selling when theconvertible, debentures are issuea By convertible debentures, a company getsrelatively cheaper financial resource for business growth. Debenture interestconstitutes tax deductible expenses. So, till the debentures are converted, the BSPATIL
  48. 48. company gets a tax advantage. From the investors* point of view convertibledebentures prove an ideal combination of high yield, low risk and potential capitalappreciation.2.3 DIFFERENT MOOES OF CAPITAL ISSUES Capital instruments, namely, shares and debentures can be issued to themarket by adopting any pf the four modes: Public issues, Private placement, Rightsissues and Bonus issues. Let us briefly explain these different modes of issues.2.3.1 Public Issues Only public limited companies can adopt this issue when it wants to raisecapital from the general public. The company has to issue a prospectus as perrequirements of the corporate laws in force inviting the public to subscribe to thesecurities issued, may be equity shares, preference shares ;or debentures/bonds. Aprivate company cannot adopt this route to raise capital. The prospectus shall give anaccount of the prospects of investment in the company. Convinced public apply to thecompany for specified number of shares/debentures paying the application money,i.e., money payable at the time of application for the shares/debentures usually 20 to30% of the issue price of Jie shares/debentures. A company must receivesubscription for at least 95% of the shares/bonds offered within the specified days.Otherwise, the issue has to be scrapped. If the public applies for more than thenumber of shares/debentures the situation is called over subscription. In undersubscription public ;ribes for less number of shares/debentures offered by thecompany. For companies coupled with better market conditions, over -subscriptionIts. Prior to issue of shares/debentures and until the subscription list is opencompany go on promoting the issue. In the western countries such kind of iog theissue is called road-show. When there is over-subscription a BSPATIL
  49. 49. part of the excess subscription, usual!) upto 15% of the otter, can be retained andallotment proceeded with. This is called as green-shoe option. When there is over-subscription, pro-rata allotment (proportionate basisallotment, i.e., say when there is 200% subscription, for every 200 share applied 100shares allotted) may be adopted. Alternatively, pro-rata allotment For some applicant,full scale allotment for some applicants and nil allotment for rest of applicants canalso be followed. Usually the company co-opts authorities from stock-exchange wherelisting is done, from securities regulatory bodies (SEBI in Indian, SEC in USA and soon) etc. in finalizing mode of allotment. Public issues enable broad-based share-holding. General publics savingsdirected into corporate investment. Economy, company and individualnvestors benefit. The company management does not face the challenge of dilution ofcontrol over the affairs of the company. And good price for the share and competitiveinterest rate on debentures are quite possible.2.3.2 Private Placement Private placement involves the company issuing security places the same at thedisposal of financial institutions like mutual funds, investment funds >r banks theentire issue for subscription at the mutually agreed upon pro-rata of interest. This mode is preferred when the capital market is dull, shy and] depressedDuring the late 1990s and early 2010s, Indian companies preferred] privateplacement, even the debt issues, as the general public totally deserted the} capitalmarket since their hopes in the capital market were totally shattered,] Privateplacement is inexpensive as no promotion is issued. It is a wholesale} deal.2.3.3 Right Shares Whenever an existing company wants to issue new equity shares, the existingshareholders will be potential buyers of these shares. Generally the Articles orMemorandum of Association of the Company gives the right to existing shareholders BSPATIL
  50. 50. to participate in the new equity issues of the company. This right is known as pre-emptive right" and such offered shares are called 4Right shares or Right issue. A right issue involves selling securities in the primary maricet by issuing rightsto the existing shareholders. When a company issues additional share capital, it hasto be offered in the first instance to the existing shareholders on a pro rata basis.This is required in India under section 81 of the Companies Act, 1956. However, theshareholders may by a special resolution forfeit tfcis right, partially or fully, to enablethe company to issue additional capital to public. Under section 81 of the Companies Act 1956, where at any time after the expiryof two years from the formation of a company or at any time after the expiry of oneyear from the allotment of shares being made for the first ume after its formation,whichever is earlier, it is proposed to increase the subscribed capital of the companyby allotment of further shares, then such further shares shall be offered to thepersons who, at the date of the offer, are holders of the equity shares of the company,in proportion as nearly as circumstances admit, to the capital paid on those shares atthat date. Thus the existing shareholders have a pre-emptive right to subscribe to thenew issues made by a company. This right has at its root in the doctrine that eachshareholder is entitled to participate in any further issue of capital by the ompanyequally, so that his interest in the company is not diluted,Significance of rights issue i) The number of rights that a shareholder gets is equal to the number of shares held by him. ii) The number rights required to subscribe to an additional share is determined by the issuing company. iii) Rights are negotiable. The holder of rights can sell them fully or partially. iv) Rights can be exercised only during a fixed period which is usually less than thirty days. BSPATIL
  51. 51. v) The price of rights issues is generally quite lower than market price and that a capital gain is quite certain for the share Rights issue gives the existing shareholders an opportunity for the protection of their pro-rata share in the earning and surplus of the company.vii) There is more certainty of the shares being sold to the existing shareholders. If a rights issue is successful it is equal to favourable image and evaluation of the companys goodwill in the minds of the existing shareholders. BSPATIL
  52. 52. 2.3.4 Bonus Issues Bonus issues are capital issues by companies to existing shareholders wherebyno fresh capital is raised but capitalization of accumulated earnings is done. Theshares capital increases, but accumulated earnings fall A company shall, whileissuing bonus shares, ensure the following: i) The bonus issue is made out of free reserves built out of the genuine profits and shares premium collected in cash only. ii) Reserves created by revaluation of fixed assets are not capitalized. iii) The development rebate reserves or the investment allowance reserve is considered as free reserve for the purpose of calculation of residual reserves only. iv) All contingent liabilities disclosed in the audited accounts which have, bearing on the net profits, shall be taken into account in the calculation; of the residua! reserve. v) The residual reserves after the proposed capitalisation shall be at k 40 per cent of the increased paid up capital. vi) 30 per cent of the average profits before tax of the company for previous three years should yield a rate of dividend on the exj capital base of the company at 10 per cent. vii) The capital reserves appearing in the balance sheet of the company as a result of revaluation of assets or without accrual of cash resources are capitalized nor taken into account in the computation of the residual reserves of 40 percent for the purpose of bonus issues. viii) The declaration of bonus issue, in lieu of dividend is not made. BSPATIL
  53. 53. ix) The bonus issue is not made unless the partly paid shares, if any existing, are made fully paid-up. x) The company - a) has not defaulted in payment of interest or principal in respect of fixed deposits and interest on existing debentures or principal on redemption thereof and (b) has sufficient reason to believe that it has not defaulted in respect of the payment of statutory dues of the employees such as contribution to provident fund, gratuity on bonus. xi) A company which announces its bonus issue after the approval of the board of directors must implement the proposals within a period of six months from the date of such approval and shall not have the option of changing the decision. xii) There should be a provision in the Articles of Association of the Company for capitalisation of reserves, etc. and if not, the company shall pass a resolution at its general body meeting making decisions in the Articles of Association for capitalisation. xiii) Consequent to the issue of bonus shares if the subscribed and paid-up capital exceed the authorized share capital, a resolution shall be passed by the company at its general body meeting for increasing the authorized capital. xiv) The company shall get a resolution passed at its generating for bonus issue and in the said resolution the managements intention regarding the rate of dividend to be declared in the year immediately after the bonus issue should be indicated. xv) No bonus shall be made which will dilute the value or rights of the holders of debentures, convertible folly or partly.SEBI General Guidelines for public issues BSPATIL