Financial_management_S_3.pptfhjhdfhjkkggfykjf

Financial Management
CLASS XII
CHAPTER 9

TODAY’S TOPICS
 Financial Planning –
Meaning
Objectives
and
Importance
• Capital Structure-
Concept and factors affecting
Capital structure
Management 8/e - Chapter 1 2

Let’s study from NCERT book
http://ncert.nic.in/textbook/textboo
k.htm?lebs2=0-4
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Expected Learning Outcomes-
You will able to answer the followings-
Describe the concept of financial planning and its objectives.
Explain the importance of financial planning
Understand the concept of capital structure.
* Describe the factors determining the choice of
an appropriate capital structure of a company.

Financial planning
“It involves preparation of a financial blueprint of
an organization. It is the process of estimating the
fund requirement of a business and determining the
possible sources from which it can be raised.”

Types of financial planning
1. Long term financial planning – focuses
on capital expenditure for long term growth
and investment in business – usually 3 to 5
years.
2.Short term financial
planning – in the form of
budget – usually for a
period of 1 year or less.

Objectives Of Financial
Planning
1. To ensure availability of
funds whenever they are required
Includes estimation of the funds
required for different purposes
(long term assets/working cap
requirement)
• Estimate the time at which these
funds need to be made available.
• Specify sources of these funds.
2. To see that the firm
does not raise resources
unnecessarily:
• Shortage of funds =>
firm cannot meet its
payment obligations.
• Surplus funds => do not
earn returns but adds to
costs.

Importance Of Financial
Planning
Forecasting – It helps the
organization to foresee the future
financial requirements in advance.
Avoiding uncertainties – Helps
in meeting unexpected situations
by arranging necessary funds.
Coordination – Helps to
coordinate the activities of all
departments in the organization by
allotting them necessary funds in
time.

Planning
Reduces wastages – Through
proper planning about the
financial requirements helps to
reduce wastages and duplication
of efforts.
Easy evaluation – It helps to
evaluate the actual performance
of the organization based on the
plans formulated in advance.

Planning
Financial planning tries to link
the present with the future.
Financial planning provides a
link between investment and
financing decisions on continuous
basis.
It ensure timely availability of
funds in the organization.

CAPITAL STRUCTURE
Refers to the proportion of debt and equity used
for financing the operations of a business.
Capital Structure Capital structure refers to
the mix or composition of long term sources
of funds such as equity share capital,
preference share capital, debentures, long
term loans and reserves and surplus.
Owners’ funds are called equity and borrowed funds as debt.

Capital structure
The capital structure of a company consists any
of the following forms:
1. Equity shares only.
2. Equity shares and preference shares.
3. Equity shares and debentures.
4. Equity shares, preference shares and
debentures.
5. Equity, Preference, debentures and long
term loans.

Debt vs equity
• Cost of Debt is lower than cost of equity but Debt is more
risky than equity.
• Cost of debt < cost of equity as lenders risk < owners risk.
• Lender earns an assured interest and repayment of capital..
• Interest on debt is a tax deductible expense so brings down
the tax liability for a business whereas dividends are paid out
of profit after tax.
• Debt is more risky for the business as it adds to the financial
risk faced by a business.
• Any default w.r.t payment of interest or repayment of
principle amt may lead to liquidation.

Trading on Equity
(Financial Leverage / Capital Gearing)/Return on Investment
Trading on equity means
the use of fixed cost sources of finance
(preference shares, debentures, and long term loans)
in the capital structure so as
to raise the return to equity shareholders.
It is advisable to use trading on equity when
the rate of earnings is greater than
the rate of dividend payable on preference shares and
the rate of interest payable on debentures and loan.
Trading on equity is a practice followed by
a company under which earning per share is increased
by employing cheaper debt.

Particulars Company ‘A’
EBIT
Less: Interest
1,10,000
NIL
EBT
Less: Tax @ 50%
1,10,000
55,000
EAT 55,000
No. of Shares of Rs100 1,00,000
EPS (earning per
share)
Rs 0.55
Company B’
1,10,000
54,000
56,000
28,000
28,000
40,000
Rs. 0.70
Company ‘C’
1,10,000
84,000
26,000
13,000
13,000
30,000
Rs 0.433
This can be observed by the following example –
Three companies with same business and size of Rs 10,00,000
capital employed.
Company ‘A’ used all from equity of Rs100,
company ‘B’ used debt for Rs 6,00,000 of 9% p.a. interest and
company ‘C’ used debt for Rs 7,00,000 of 12% p.a..
The earnings (EBIT) for all companies are
Rs 1,10,000 i.e. @ 11% p.a..

From the above it can be concluded that
with a debt component
(which has cheaper rate than the normal rate of return)
in the total capital, shareholders are likely to
have the benefit of
a higher rate of return on share capital.
Cheaper rate of
debt
components
Shareholders
Higher rate
of return

Which is best or optimum capital
structure?
Optimal Capital Structure is that combination of
debt and equity that maximizes the market value of
shares of that company.
Capital structure affects both the profitability and the
financial risk faced by a business.

Factors Affecting Choice Of Capital
Structure
1.Cash flow position:
a. The size of the projected cash flows must be
considered before deciding the capital structure of
the firm. If there is sufficient cash flow, debt cab
be used.
b. It must cover fixed payment obligations w r t:
i. Normal business operations
ii. Investment in fixed assets
iii. Meeting debt service commitments as well as
provide a sufficient buffer.

Factors Affecting Choice Of
Capital Structure
2. Interest coverage ratio :
a. Higher the Interest coverage ratio which is
calculated as follows: EBIT/ Interest, lower shall
be the risk of the company failing to meet its
interest payment obligations.
b. Low Interest coverage ratio => debt ≠ used.
3. Return On Investment
a. If return on investment of the company is higher,
the company can choose to use trading on equity to
increase its EPS, i.e., its ability to use debt is greater.
b. If ROI<COST OF DEBT , then less debt will be
used.

Capital Structure
4. Debt Service Coverage Ratio:
a. Debt service coverage ratio = Profit after tax +
Depreciation + Interest + Non Cash exp. Pref. Div +
Interest + Repayment obligation
b. A higher Debt service coverage ratio, in which the cash
profits generated by the operations are compared with the
total cash required for the service of debt and the preference
share capital, the better will the ability of the firm to
increase debt component in the capital structure.
c. Low Debt service coverage ratio => debt ≠ used.

Capital Structure
5. Cost Of Debt
a. More debt can be used if cost of Debt is low.
6. Tax Rate
a. A higher tax rate makes debt relatively cheaper and
increases its attraction as compared to equity.
7. Cost Of Equity
a. when the company uses more debt, the financial risk faced
by equity holders increase so their desired rate of return
increases.
b. If debt is used beyond a point, cost of equity may go up
sharply and share price may decrease in spite of increased
EPS.

Capital Structure
8. Floatation Cost
a. Cost of Public issue is more than the floatation cost of
taking a loan.
b. The floatation cost may affect the choice between debt
and equity and hence the capital structure
9. Risk Consideration:
a. The total risk of business depends upon both the
business risk and financial risk. If a firm‘s business risk is
lower, its capacity to use debt is higher and vice versa.

Capital Structure
10. Flexibility:
a. If the firm uses its debt potential, it loses the flexibility
to use more debt.
b. To maintain flexibility the company must maintain
some borrowing power to take care of unforeseen
circumstances.
11. Control:
a. Debt normally does not cause dilution of control
whereas a public issue makes the firm vulnerable to
takeovers.
b. To retain control, firm should issue debt

The importance of financial planning can
be explained as follows:
*It makes the firm better prepared to face the futur
*It helps in avoiding business shocks and surprises
*It helps in co-ordinating various business function
*Reduce waste, duplication of efforts.
*link the present with the future.
* link between investment and financing decisions
on a continuous basis.
*makes the evaluation of actual performance
easier.

Recapitulation
 Financial planning is essentially
preparation of a financial blueprint of an
organisation’s future operations.
 Financial planning strives to achieve the
following twin objectives:
 To ensure availability of funds whenever
these are required
 To see that the firm does not raise
resources unnecessarily
 Management 8/e - Chapter 1 25

Capital structure refers to the mix between
owners and borrowed funds. It can be
calculated as debt-equity ratio
i.e.,Debt/Equity.
 Factor Affecting choice of Capital Structure:
 Cash flow position
 Interest coverage ratio
 Debt service coverage Ratio
 Return on Investment
 Cost of debt
 Tax rate
 Cost of equity Floatation costs
 Risk consideration
 Flexibility
 Control
 Regulatory frame work Stock market conditions

LET’S READY FOR A SHORT
quiz
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Remedial work
 Discussion on doubts/wrong answers
in quiz

E resourecs
 https://www.youtube.com/watch?v=hJ
wSpWRNI8A&t=39s

Assignment
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Financial_management_S_3.pptfhjhdfhjkkggfykjf

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