Financial Management unit 1

Financial Management
S.N.Selvaraj, M.B.A., M.Phil., Assistant Professor, Email: snselvaraj66@gmail.com Page 1
UNIT – I FINANCIAL MANAGEMENT
FINANCE FUNCTIONS: Meaning – Definition – Scope of Finance Functions –
Objectives of Financial Management – Profit Maximization and Wealth
Maximization. SOURCES OF FINANCE: Short-term – Bank Sources – Long-term –
Shares – Debentures – Preferred Stock – Debt.
FINANCE FUNCTIONS: MEANING – DEFINITION
Finance is the life blood of business. Without finance, the heart and brain of business
cannot function implying thereby its natural death. Right from conceiving the idea of
birth of business to its liquidation, finance is required. Inputs are made available only
with finance. Even managerial ability can be had with only finance.
The survival and growth of a firm is possible if it utilizes its funds in an optimum
manner. Collin Brooks has rightly remarked in this context that “bad production
management and bad sales management have slain their hundreds, but faulty finance
has slain its thousands”. Therefore sound finance management is indispensable in a
corporate organization.
Financial Management is that managerial activity which is concerned with the
planning and controlling of the firm‟s financial resources. It was a branch of
economics till 1890 and as a separate discipline, it is of recent origin.
Meaning and Definition of Finance/ Financial Management
Finance may be defined as the provision of money at the time when it is required.
Finance refers to the management of flows of money through an organization. It
concerns with the application of skills in the manipulation, use and control of money.
Different authorities have interpreted the term „finance‟ differently.
According to F.W.Paish, “Finance may be defined as the position of money at the
time it is wanted”.
According to the John J Hampton, “The term finance can be defined as the
management of flows of money through an organization, whether it will be a
corporation, school, bank or government agency”.
According to Weston & Brigham, “Financial management is an area of financial
decision making harmonizing individual motives and enterprise goals.
The financial management consists of two words „financial‟ and „management‟.
Financial means procuring sources of money supply and allocation of these sources on
the basis of forecasting monetary requirements of the business. The word
„management‟ refers to planning, organization, co-ordination and control of human
activities and physical resources for achieving the objectives of an enterprise.

SCOPE OF FINANCE FUNCTIONS – OBJECTIVES OF FINANCIAL
MANAGEMENT
Classification of Finance
The subject of finance has been traditionally classified into four classes:
Public Finance Private Finance Institutional International
Finance Finance
State Government Personal Finance
Local Government Business Finance
Central Government Finance of Non-Profit
Organization
1) Public Finance: Public finance deals with the requirements, receipts and
disbursements of funds in the government institutions like states, local self-
government and central government.
2) Private Finance: Private finance is concerned with requirements, receipts and
disbursements of funds in case of an individual, a profit seeking business
organization and a non-profit organization. The private finance can be classified
into: (a) Personal Finance, (b) Business Finance, and (c) Finance of Non-Profit
Organizations.
3) Institutional Finance: Institutional finance is related to capital formation and meets
the financial requirements of the economy. In the economic set up of a country
there are many financial institutions such as bank, insurance companies, financial
corporations, unit trust, etc. These institutions collect savings from individual
savers and accumulate sufficient amount for profitable investment in business
organizations.
4) International Finance: This area of finance focuses attention on flow of funds
beyond national boundaries. Each country has its own currency and it has to be
exchanged into the currency of other countries for buying and selling goods and
services. The study of flow of funds between individuals and organizations across
national borders and the development of methods of handling the flows more
efficiently is the subject-matter of international finance.
Finance Function
Financial function is the most important of all business functions. It remains a focus of
all activities. It is not possible to substitute or eliminate this function because the
business well close down in the absence of finance. The need for money is continuous.
It starts with the setting up of an enterprises and remains at all times.
There are three concepts of finance function in relation to business:
1. The first approach assumes that the expenditure decisions giving rise to the
demand for the capital within a business.
Finance

2. Another approach relates finance function to cash. This implies that finance
function is related to every activity in the course of business.
3. The third approach is more acceptable, envisages finance function as
procurement of funds and their effective utilization in the business.
Objectives of Finance Function
The objective of finance functions is to arrange as much funds for the business as are
required from time to time. This function has the following objectives:
 Proper Utilization of Funds: The funds should be used in such a way that
maximum benefits are derived from them. The funds committed to various
operations should be effectively utilized.
 Increasing Profitability: The planning and control of finance function aims at
increasing profitability of the concern. To achieve this purpose sufficient funds
will have to be invested.
 Maximizing Value of Firm: Finance function also aims at maximizing the value
of the firm. It is generally said that a concern‟s value is linked with its
profitability.
 Creating Wealth for Business: Finance function aims to create wealth for
business through the effective way of doing business.
 Generate Cash: Generating cash thorough the appropriate business transactions.
Unnecessary financial transactions may be avoided in the right time to facilitate
business.
 Adequate Return on Investment: Sufficient fund should be provided at right time
to meet the needs of the business. The finance manager should bear in mind the
risk of business and the resources invested.
Scope of Finance Function / Financial Management
Financial management has undergone significant changes over the years in its scope
and coverage. Broadly it has two approaches:
1. Traditional Approach : Procurement of Funds
2. Modern Approach : Utilization of Funds
Traditional Approach – Procurement of Funds
The scope of finance was treated, in the narrow sense of procurement or arrangement
of funds. The finance management was treated as just provider of funds, when
organization was in need of them. The utilization or administering resources was
considered outside the purview of the finance function. It was felt that the finance
manager had no role to play in decision-making for its utilization.
Modern Approach – Utilization of Funds
The modern approach views the term financial management in a broad sense and
provides a conceptual and analytical framework for financial decision-making.
According to it, the finance function covers both acquisitions of funds as well as their
allocation. It is viewed as an integral part of overall management.

Evolution of Financial Management
 Traditional Phase (Up to 1940): This can be summarized as follows:
i) Finance function was concerned with procuring of funds to finance the
expansion or diversification activities. This was not a part of regular
managerial operations.
ii) In order to finance business growth, there was an emergence of
institutional financing and banking giving rise to finance industry.
iii) Finance function was viewed particularly from the point of view of
supplier of funds, i.e. the lenders – both individuals and institutions.
iv) The concept of working capital and its management was virtually non-
existent. The focus of attention was on the long-term resources.
v) The treatment of different aspects of finance was more on descriptive
nature rather than analytical.
 Transitional Phase (After 1940): This phase in fact was an extension of the
traditional phase and continued up to early fifties when the scope of finance
function started expanding in big way. During the transitional phase the nature
of financial management was the same but more emphasis was laid on
problems faced by finance managers in the areas of fund analysis, planning and
control.
 Modern Phase (Integrated View – After 1950): The modern phase is characterized
by the application of economic theories and the application of quantitative
methods of analysis. The finance manager has emerged as a professional
manger involved with capital funds to be raised by the firm, with the allocation
of these funds to different projects.
Significant contributions to the development of Modern Theory of financial
management are as follows:
a) Theory of Portfolio Management: This was developed by Harry Markowitz
which deals with portfolio selection with risky investments. This theory
uses statistical concepts to quantify the risk-return characteristics of holding
a group of securities. The risk of one investor is viewed in its totality rather
than evaluating the risk of one security only.
This theory at a later stage leads to the development of Capital Asset
Pricing Model which deals with pricing of risky assets and the relationship
between risk and return.
b) Theory of Leverage and Valuation of Firm: This was developed by
Modigliani and Miller, they have shown the introducing analytical approach
as to how the financial decision making in any firm be oriented towards
maximization of the value of the firm and the maximization of shareholders
wealth.
c) Presentation of Option Valuation Model: This was developed by Black and
Scholes, is also regarded as a landmark in the area of financial management.

Functions of Financial Management
The functions of raising funds, investing them in assets and distributing returns earned
from assets to shareholders are respectively know as financing decision, investment
decision and dividend decision.
 Investment Decisions: The investment decisions relates to the selection of assets in
which funds will be invested by a firm. The investment decision is broadly
concerned with the asset-mix or the composition of the assets of a firm. The assets
which can be acquired fall into two broad groups:
(i) Long-term assets which will yield a return over a period of time in future.
This kind is popularly known in the financial literature as „Capital
Budgeting‟.
(ii) Shot-term or current assets defined as those which in the normal course of
business are convertible into cash usually within a year. This kind is
popularly designated as „Working Capital Management‟.
 Financing Decisions: A financing decision is the second important function to be
performed by the financial manager. He or she must decide when, where from and
how to acquire funds to meet the firm‟s investment needs. The concern of
financing decision is with the financing-mix or capital structure or leverage. The
mix of debt and equity is known as the firm‟s capital structure. The financial
manager must strive to obtain the best financing mix or the optimum capital
structure for his or her firm.
 Dividend Decisions: A dividend decision is the third major financial decision. The
financial manager must decide whether the firm should distribute all profits or
retain them or distribute a portion and retain the balance. The proportion of profits
distributed as divided is called the dividend-payout ratio and the retained portion
of profits is known as the retention ratio.
 Liquidity Decision: Liquidity decision is concerned with the management of current
assets. Basically, this is working capital management, is concerned with the
management of current assets. It is short-term survival. Short-term survival is a
prerequisite for long-term survival. A proper trade-off must be achieved between
profitability and liquidity. The profitability-liquidity trade-off requires that the
financial manger should develop sound techniques of managing current assets.
Functions of Financial Management
Investment Decision
Finance Decision
Dividend Decision
Liquidity Decision

Long-term Finance Decision: The long-term finance functions or decisions have a
longer time horizon, generally greater than a year. They may affect the firm‟s
performance and value in the long run. They also relate to the firm‟s strategy and
generally involve senior management in taking the final decision.
Short-term Finance Decision: The short-term finance functions or decisions involve a
period of less than one year. These decisions are needed for managing the firm‟s day-
to-day fund requirements. Generally, they relate to the management of current assets
and current liabilities, short-term borrowings and investment of surplus cash for short
periods.
Importance of Financial Management
 Financial Planning and Control
 Essence of Managerial Decision
 Scientific and Analytical Analysis
 Continuous Administration Function
 Centralized Nature
 Basis of Managerial Process
 Measure of Performance
PROFIT MAXIMIZATION AND WEALTH MAXIMIZATION
Profit earning is the main aim of every economic activity. A business being an
economic institution must earn profit to cover its costs and provide funds for growth.
No business can survive without earning profit. Profit is a measure of efficiency of a
business enterprise.
Profits also serve as a protection against risks which cannot be ensured. The
accumulated profits enable a business to face risks like fall in prices, competition from
other units, advertise government policies etc. Thus, profit maximization is considered
as the main objective of business.
Features of Profit Maximization
Main aim of any kind of economic activity is earning profit. Profit maximization
consists of the following important features:
1) Profit maximization is also called as cashing per share maximization.
2) It leads to maximize the business operation for profit maximization.
3) It considers all the possible ways to increase the profitability of the business
concern.
4) Profit is the parameter of measuring the efficiency of the business concern.
5) Profit maximization objectives help to reduce the risk of the business.
Limitations of Profit Maximization
The profit maximization criterion is criticized on the following grounds:
 It ignores the quality aspects of benefits associated with business.

 It is ambiguity – vague; it means different to different people – may be pre-tax
or post-tax.
 It ignores the difference in time and value of money. The fact that a rupee
received today is more valuable than the rupee received later is ignored.
 It may ignore the social welfare sometimes.
 It gives effect to change in organization structure.
Wealth Maximization
This is also known as net present worth maximization approach. It takes into
consideration the time value of money. Its operational features satisfy all the three
requirements of a suitable operational objective of financial courses of action i.e.
quality of benefits, timing of benefits and exactness.
The wealth maximization approach can be more explicitly defined in the following
ways:
A1 + A2 + A3 + ……. An − C
W = (1+K)1
(1+K)2
(1+K)3
(1+K)n
where,
A1, A2 …… An = Streams of benefits expected
C = Cash outlay (or) Cost of action
K = Discount rate
W = Net present worth
The objective of wealth maximization helps to resolve two most troublesome
problems attached with the flow of benefits. There is consideration of time value of
money. The problem is handled by selecting an appropriate rate of discount and using
the rate of discount the expected flow of future benefits.
The wealth maximization objective is consistent with the objective of maximizing the
owner‟s economic welfare. The wealth maximization principle implies that the
fundamental objective of a firm should be to maximize the market value of its shares.
Features of Wealth Maximization
1) Wealth maximization is superior to the profit maximization because this
concept is to improve the value or wealth of the shareholders.
2) Wealth maximization considers the comparison of the value to cost associated
with the business concern. Total value detected from the total cost incurred for
the business operation.
3) Wealth maximization considers both time and risk of the business concern.
4) Wealth maximization provides efficient allocation of resources.
5) It ensures the economic interest of the society.
Limitations of Wealth Maximization
 The objective of wealth maximization is not, necessarily, socially desirable.

 There is some controversy whether the objective of maximization of wealth is
of the firm or to the stakeholders.
 If wealth of firm were maximized, it would be benefiting the interest of
debenture holders and preference shareholders too.
 In corporate sector, ownership and management are separate unlike in a sole
proprietorship.
 There is a conflict of interest between the shareholders and management.
Profit Maximization Versus Wealth Maximization
 Profit cannot be ascertained well in advance to express the probability of return
as future is uncertain.
 The term „profit‟ is vague and has not been explained clearly what it means
 The vagueness is not present in wealth maximization goal as the concept of
wealth is very clear.
 It represents value of benefits minus the cost of investment
 The firm‟s goal cannot be to maximize profits but to attain a certain level of
profit holding certain amount of shares.
 The firms should try to „satisfy‟ rather than to „maximize‟.
 There must be balance between expected return and risk. There exist great risk
to recognize such a balance and wealth maximization is brought into the
analysis.
 The goal of maximization of profits is considered to be a narrow outlook. It
becomes the basis of financial decisions of the concern.
 The criterion of profit maximization ignores time value factor.
 The wealth maximization concept fully endorses the time value factor in
evaluating cash flows.
SOURCES OF FINANCE
The financial needs of a business are of a peculiar nature. The type and amount of
funds required usually differs from one business to another. For instance, if the size of
business is large, the amount of funds required will also be large. Likewise, the
financial requirements are more in manufacturing business as compared to trading
business.
The business need funds for longer period to be invested in fixed assets like land and
building, machinery etc. Sometimes the business also needs fund to be invested in
shorter period. So based on the period for which the funds are required, the business
finance is classified into three categories:
1) Short-term: The short-term capital, which can also be called as working capital
is required for the purchase of raw materials and to meet the day-to-day
expenses such as the payment of wages, salaries and tax, in connection with the
conversion of raw materials into finished goods. The loans are obtained usually
for a short period of one year.
2) Medium-term: The medium-term capital is required for the repairs,
replacement and maintenance of machine and buildings which can be repaid

over a comparatively short period. It is utilized for all such purposes where
investments are required for more than one year but less than five years.
3) Long-term: The long-term funds are the base for the financial structure of a
firm. It is also known as fixed capital; is needed to acquire fixed and permanent
assets, namely, land and building, plant and machinery and tools. Generally,
financial needs of more than five years are included in long term finance.
The various sources of raising long-term funds include equity shares,
preference shares, retained earnings, debentures, bond, term loans, leasing, hire
purchases and public deposits, etc.
Types of Business Finance
Type of Finance Period of Repayment Purpose
Short-term Less than a year Purchase of raw materials, payment of
wages, rent, insurance, etc.
Medium-term One year to five years Expenditure on modernization,
renovation, heavy advertising, etc.
Long-term More than five years Purchase of land and building, plant and
machineries, etc.
Every organization need different types of finance, i.e. long-term, medium-term as
well as short-term. But the combinations in which these are used differ from one
business to another.
For example, steel industry requires more long-term finance to be invested in land and
building and machinery as compared to the manufacturing of leather goods or plastic
buckets. Similarly for manufacturing hosiery items, requirement of short-term finance
would be more than that of long-term finance.
SHORT-TERM SOURCES OF FINANCE
After establishment of a business funds are required to meet its day-to-day expenses.
Short-term loans help business concerns to meet their temporary requirement of
money. They do not create a heavy burden of interest on the organization. But
sometimes organizations keep away from such loans because of uncertainty and other
reasons.
Short Term Sources of Finance
Indigenous Bankers
Advances
Accounts Payable
Bills Discounting
Installment Credit
Accrued Expenses and
Deferred Income
Trade Credit
Factoring

Indigenous Bankers: Private money-lenders and other country bankers used to be the
only source of finance prior to the establishment of commercial banks. They used to
charge very high rates of interest and exploited the customers to the extent possible.
Now-a-days with the development of commercial banks they have lost their
monopoly.
Installment Credit: Under this method, the assets are purchased and the possession of
goods is taken immediately but the payment is made in installments over a pre-
determined period of time. Generally, interest is charged on the unpaid price or it may
be adjusted in the price.
Advances: Some business houses get advances from their customers and agents against
orders and this source is a short-term source of finance of them. It is a cheap source of
finance and in order to minimize their investment in working capital, some firms have
long production cycle, especially the firms manufacturing industrial products prefer to
take advances from their customers. This is interest free.
Accrued Expenses and Deferred Incomes: Accrued expenses are the expenses which
have been incurred but not yet due and hence not yet paid also. These simply represent
a liability that a firm has to pay for the services already received by it. The most
important items of accruals are wages and salaries, interest and taxes.
Deferred incomes are incomes received in advance before supplying goods or
services. They represent funds received by a firm for which it has to supply goods or
services in future.
Account Payable /Creditors: Individual creditors or bills payable are created by
individual purchases on credit terms or other funding transactions. However, they only
remain as liabilities until they are settled.
Trade Credit: Trade credit refers to the credit extended by the suppliers of goods in the
normal course of business. At present day commerce is built upon credit, the trade
credit arrangement of a firm with its suppliers is an important source of short-term
finance.
Bills Discounting: Purchasing and discounting of bills is the most important form in
which a bank lends without any collateral security. The seller draws a bill of exchange
on the buyer of goods on credit. Such a bill may be either a clean bill or documentary
bill accompanied by the documents such as roadway receipt, railway receipt, and
airway receipt.
Factoring: Factoring is a contract between the suppliers (the client) of goods/services
and the financial institution (the factor) under the course of business. This method of
financing is to reduce the risk of default by debtors. This is very popular in western
countries and in India – four Indian banks – SBI, CB, PNB and Allahabad Bank –
Provide factoring services.

BANK SOURCES OF FINANCE
Banks are the main institutional sources of finance in India. After trade credit, bank
credit is the most important source of financing capital requirements of firms in India.
The amount approved by the bank for the firm‟s working capital is called credit limit.
Banks are required to fix separate limits for the „peak level‟ credit requirements and
„normal non-peak level‟ credit requirements indicating the periods during which the
separate limits will be utilized by the borrower.
Forms of Bank Source of Finance
1) Secured Term Loan: When a bank makes an advance in lump-sum against some
security it is called a loan. The entire loan amount is paid to the borrower either in
cash or by credit to his account. The borrower is required to pay interest on the
entire amount of the loan from the data of sanction. A loan may be repayable in
lump sum or installments. The term loan may be either medium-term or long-term
loans.
2) Cash Credit: A cash credit is an arrangement by which a bank allows his customer
to borrow money up to a certain limit against some tangible securities or
guarantees. The interest in case of cash credit is charged on daily balance basis.
The customer can deposit any surplus amount to his account.
3) Overdraft: Overdraft is an arrangement with a bank by which a current account-
holder is allowed to withdraw more than the balance to his credit up to a certain
limit sanctioned by the bank. Bank overdraft is given on current accounts and the
interest payable is on daily basis.
Security Required in Bank Finance
 Hypothecation: Hypothecation is a charge against property for an amount of debt
where neither ownership nor possessions passed to the creditor. Under this
arrangement, the borrower is provided with working capital finance by the bank
against the security of movable property, generally inventories.
 Pledge: Under this arrangement, the borrower is required to transfer the physical
possession of the property offered as a security to the bank to obtain credit. In case
of default, the bank may either (a) sue the borrower for the amount due, or (b) sue
for the sale of goods pledged, or (c) after giving due notice sell the goods.
 Mortgage: Mortgage is the transfer of legal or equitable interest in a specific
immovable property for the payment of a debt. In case of mortgage, the possession
of the property may remain with the borrower with the lender getting the full legal
title. The transferor of interest (borrower) is called the mortgagor, the transferee
(bank) is called the mortgagee, and the instrument of transfer is called the
mortgage deed.
 Lien: Lien means right of the lender to retain property belongings to the borrower
until he repays credit. It can be either a particular lien or general. Particular lien is
a right to retain property until the claim associated with the property is fully paid.
General lien, on the other hand, is applicable till all dues of the lender are paid.
Banks usually enjoy general lien.

LONG-TERM SOURCES OF FINANCE
Long-term is the base for the financial structure of a firm. Generally financial needs of
more than 5 years are included in long-term finance. Long-term funds are required to
create production facilities through purchase of fixed assets such as plant, machinery,
land, building, etc. and for modernization and expansion of the existing facilities.
These funds are required for meeting the fixed capital requirements of a business.
The various sources of raising long-term funds include:
EQUITY SHARES
Equity shares are, earlier, known as ordinary shares or common shares. Equity
shareholders are the real owners of the company as they have the voting rights and
enjoy decision-making authority on important matters, related to the company. The
shareholders‟ return is in the form of dividend, which is dependent on the profits of
the company and capital gain/loss at the time of their sale.
Features of Equity Shares
 Maturity: Equity share holders can demand their capital only if the event of
liquidation and that too when funds are left after covering all prior claims.
 Claims on Income: Equity shareholders are residual owners whose claim on income
arises only when claims of creditors and preferred stock-owners are met.
 Cost of Equity: Since the equity dividends are not tax deductible expenses as the
interest is, the high cost of issue and the risk factor associated with its makes the
cost of equity higher.
 Claims on Asset: Being residual owners, equity shareholders are the last claimants
to assets of the firm, in the event of winding up of the firm.
 Control: The risk of loss associated with equity share is compensated to some
extent by controlling power that rests with residual owners.
Advantages of Equity Shares Disadvantages of Equity Shares
 Capital profit
 Interest in the Company‟s Activities
 Best for Investment
 More Income
 Right to Interface in Management
 Uncertainty of Income
 Irregular Income
 Capital Loss
 Less Attractive to Modest Investors
 Loss in case of Liquidation
Long-term Sources of Finance
Equity Shares
Preferred Stock /
Preference Shares
Debt /Debentures
Retained Earnings
Loans from Financial Institutions

DEBT/ DEBENTURES
A debenture is an instrument executed by the company under its common seal
acknowledging indebtedness to some persons to secure the sum advanced. It is thus a
security issued by a company against the debt.
In India, a public limited company is allowed to raise debt capital through debentures
after getting certificate of commencement of business, if permitted by its
memorandum of association. Indian Companies Act simply says “debenture includes
debenture stock, bonds, and any other security of a company whether constituting a
charge on the assets of the company or not”.
Features of Debentures
 Fixed Interest Rate: Debenture holders are the creditors of the company. They
are entitled to periodic payment of interest at a fixed rate.
 Maturity: Debentures are repayable after a fixed period of time, say five years
or seven years as per agreed terms.
 No Voting Rights: Debenture holders do not carry voting rights
 Secured Assets: Ordinarily, debentures are secured. In case the company fails to
pay interest on debentures or repay the principal amount, the debenture holders
can recover it from the sale of the assets of the company.
Types of Debentures
There are several types of debentures on the basis of the terms and conditions of the
issue of the debentures as follows:
1 On the basis of Registration
i. Registered Debentures
ii. Bearer Debentures
2 On the basis of Security
i. Secured Debentures
ii. Unsecured Debentures
3 On the basis of Redemption
i. Redeemable Debentures
ii. Irredeemable Debentures
4 On the basis of Conversion
i. Convertible Debentures
ii. Non-convertible Debentures
5 On the basis of Priority
i. Preferred Debentures
ii. Ordinary Debentures
6 On the basis of Status
i. Equitable Debentures
ii. Legal Debentures
7 Debentures with Pari Pasu Clause

1. Registered Debentures: The debentures which are payable to the registered
debenture holders, are called registered debentures. These debenture holders‟
details are recorded in the register of debenture holders. Registered debentures are
not negotiable instruments. Transfer of such debentures requires registration.
2. Bearer Debentures: The debentures, which are payable to the bearers, are called
bearer debentures. The names of the debenture holders are not recorded in the
register of debenture holders. They are negotiable instruments. Bearer debentures
are also called unregistered debentures.
3. Secured Debentures: The debentures, which are secured fully or partly by a charge
over the assets of the company, are called secured debentures. The charge may be
either a fixed charge or a floating charge.
4. Unsecured Debentures: The debentures, which are not secured fully or partly by a
charge over the assets of the company, are called unsecured debentures. The
general solvency of the company is the only security for their holders.
5. Redeemable Debentures: The debentures, which are repayable after a certain period,
are called redeemable debentures. Sometimes, they can be redeemed by the
company on demand by the holders or at the discretion of the company.
6. Irredeemable Debentures: The debentures, which are not repayable during the life
time of the company, are called irredeemable debentures. The company may repay
the money at the time of liquidation. At present, no company can issue
irredeemable debentures.
7. Convertible Debentures: The debentures, which are convertible into equity shares or
preference shares at the option of the holders, after certain period, are called
convertible debentures.
8. Non-Convertible Debentures: The debentures, which are not convertible into shares,
are called non-convertible debentures.
9. Preferred Debentures: The debentures, which are paid first at the time of winding
up, are called preferred debentures. Thus they are just like preference shares.
10.Ordinary Debentures: The debentures, which are paid after the preference
debentures at the time of winding up, are called ordinary debentures.
11.Equitable Debentures: The debentures, which are secured by deposit of title deeds
of the property with a Memorandum creating a charge, are called equitable
debentures. In this case the property is with the company.
12.Legal Debentures: The debentures, which are secured by actual transfer of the legal
ownership of the property from the company to the holder, are called legal
debentures.
13.Debentures with Pari Pasu Clause: The (secured) debentures, which are discharged
ratable through issued on different dates, are called debentures with Pari Pasu
Clause.
Advantages of Debentures
 Preferred by Investors
 Less Investment Risk
 Less Costly
 Maintenance of Control
 Trading on Equity

 Remedy against over Capitalization
 Reliable Source
 Market Response
 Useful for Conversion
Disadvantages of Debentures
 Not suitable for all Companies
 Permanent Burden
 Requires Huge Fixed Asset
 No Voting Rights
 Difficulty in Repayment
 Affecting the Capacity to Raise Loan
Difference between Shares and Debentures
Basis of Difference Shares Debentures
Capital Versus Loan
Share is a part of owned
capital.
Debenture constitutes a loan.
Reward for
Investment
Reward is the payment of
dividend.
Reward is the payment of
interest.
Fluctuations in the
rate of Interest and
Dividends
The rate of dividend may vary
from year to year.
The rate of interest is fixed.
Charge Versus
Appropriation
Payment of dividend is an
appropriation out of profits and
cannot be made if there is no
profit.
Payment of interest is a
charge against profit and is
to be made even if there is
no profit.
Payment of Interest
/ Dividend
Payment of dividend gets no
priority over the payment of
interest.
Payment of interest gets
priority over the payment of
dividend.
Repayment of
Principal
Payment of share capital is
made after the repayment of
debentures.
Payment of debentures is
made before the payment of
share capital.
Secured by Charge
Shares are not secured by any
charge.
Debentures are usually
secured by a charge.
Restriction on Issue
Section 79 imposes certain
restriction on issue of share at
discount.
No restriction is imposed on
the purchase of debentures.
PREFERRED STOCK / PREFERENCE SHARES
Preference shares are those shares on which there is a preference right – to dividend
during the life time of the company and to repayment of capital on the winding up of
the company. Preference capital represents a hybrid form of financing – it par takes
some characteristics of equity and some attributes of debentures.

It resembles equity in the following ways:
1) Preference dividend is payable only out of distributable profits;
2) Preference dividend is entirely within the discretion of directors; and
3) Preference dividend is not a tax-deductible payment.
Preference capital is similar to debentures in several ways:
1) The dividend rate on preference capital is usually fixed.
2) The claim of preference shareholders is prior to the claim of equity
shareholders; and
3) Preference shareholders do not normally enjoy the right to vote.
Features of Preference Shares
 Accumulation of Dividends: Preference shares may be cumulative or non-
cumulative with respect to dividends. The unpaid dividends on cumulative
preference shares are carried forward and payable when the dividend is
resumed.
 Call-Ability: The terms of preference share issue may contain a call feature by
which the issuing company enjoys the right to call the preference shares,
wholly or partly, at a certain price.
 Convertibility: Preference shares may sometimes be convertible into equity
shares. The holders have the option of converting preference shares into equity
shares at a certain ratio during a specified period.
 Redeemability: Preference shares may be perpetual or redeemable. A perpetual
preference share has no maturity period, whereas a redeemable preference
share has a limited life. Most preference issues are redeemable.
 Participation in Surplus Profits and Assets: Companies may issue participating
preference shares with entitle preference shareholders to participate in surplus
profits (profits left after preference dividend and equity dividend at certain
rates) every year.
 Voting Power: Before the commencement of the Companies Act, 1956,
companies could issue preference shares carrying voting rights. Preference
shares issued after the commencement of the Companies Act, 1956 do not
carry voting right.
Advantages of Preference Shares
 Priority in Repayment of Capital
 Best Security
 Regular and Fixed Income
 Less Risk
 Safety of Interest
Disadvantages of Preference Shares
 Dividend at Fixed Rate
 Uncertain Position of Redeemable Preference Shares
 Limited Voting Rights

Difference between Preference Shares and Equity Shares
Basis of Difference Preference Shares Equity Shares
Dividend
Preference shareholder gets the
preference in getting dividends
Equity shareholder gets the
dividend from the remaining
income after paid to
preference shares.
Share Price
The nominal value of
preference shares are more
than equity shares.
The nominal value of equity
shares are less than
preference shares.
Repayment of
Capital
Preference shareholders get the
preference over equity
shareholders in the repayment
of capital
Equity shareholders are
repaid after the payment is
made to the preference
holders.
Right of
Management
Preference shareholders do not
have the right to participate in
the administration of the
company
Equity shareholders have the
right to participate in the
administration of the
company and voting power.
Dividend Rate
In case of preference share the
dividend rate is fixed.
Dividend rate depends on
profit in case of equity share
Redemption
Preference share can be
redeemed in the mid of the
business.
Equity share cannot be
redeemed. They can be sold.
Issue Expense
They need more expenses as
compared to equity shares.
Equity share is cheaper as far
as issue expenses.
RETAINED EARNINGS
Retained earnings are also referred as ploughing back of profits means the
reinvestments by concern of its surplus earnings in its business. It is an internal source
of finance and is most suitable for an established firm for its expansion, modernization
and replacement, etc.
This method of finance has a number of advantages as it is the cheapest rather cost-
free source of finance; there is no need to keep securities; there is no dilution of
control; it ensures stable dividend policy and gains confidence of the public. But
excessive resort to retained earnings may lead to monopolies, misuse of funds, over-
capitalization and speculation, etc.
Necessity of Retained Earnings
1. Replacement of old asset, which have become obsolete.
2. Expansion and growth of business.
3. Purchase of fixed assets as well as meeting the requirement of working capital.
4. Making the company self-dependent and avoiding outside financing.
5. Redemption of loans and debentures.

Factors that Influence Retained Earnings
 Earning Capacity: If the company has high earning capacity, retained earnings also
can be high. If a firm does not have adequate earning capacity, there is no
possibility for retained earnings.
 Desire and Type of Shareholders: If the majority of the shareholders are retired
people, windows and who look for the dividend as a regular source of income, the
shareholders always prefer to have higher amount of dividend. In such a case it is
difficult to have retained earnings. If a company has wealthy shareholders, in such
a case, company can enjoy retained earnings.
 Future Financial Requirements: If the company‟s future requirement of funds is
more, then the company will prefer to retain profits rather than to distribute higher
dividends.
 Dividend Policy: A company that wants to declare more dividends cannot afford to
retain more profits. More profits retained, lesser is the amount for distributing
dividend and vice versa.
 Taxation Policy: A high taxation policy of the government leaves lower amount in
hands of the company towards retention of profits. On the other hand, a liberal
policy of the government allows more profits to retain as tax liability is less.
LOANS FROM FINANCIAL INSTITUIONS
Financial institutions such as Commercial banks, Life Insurance Corporation of India,
Industrial Finance Corporation of India, State Financial Corporation, Industrial
Development Bank of India, etc. also provide short-term, medium-term, and long-term
loans. This source of finance is more suitable to meet the medium-term demands of
working capital. Interest is charged so such loans at a fixed rate and the amount of the
loan is to be repaid by way of installments in a number of years.
Loans from financial institutions also referred to as „term finance‟ represent a source
of debt finance which is generally repayable in more than one year but less than 10
years. They are employed to financial acquisition of fixed assets and working capital
margin. Term loans differ from short-term bank loans which are employed to finance
short-term working capital need and tend to be self-liquidating over a period of time,
usually less than one year.
Features of Loans from FIs
 Security: Term loans typically represent secured borrowing. Usually assets which
are financed with the proceeds of the term loan provide the prime security. Other
assets of the firm may serve as collateral security. All loans provided by financial
institutions, along with interest, liquidated damages, commitment charges,
expenses, etc. are secured by way of mortgages, hypothecation, pledge and lien.
 Interest Payment and Principal Repayment: Financial institutions charge an interest
rate that is related to the credit risk of the proposal. Also an amount of penalty will
be charged by the bank in case of default.
 Restrictive Covenants: In order to protect their interest, financial institutions
generally impose restrictive condition of the borrowers.

Advantages of Loans from FI
Borrower’s Point of View Lender’s Point of View
 In post-tax terms, the cost of term loan
is lower than the cost of equity or
preference capital.
 Terms loans do not result in dilution
of control, as lenders do not have the
right to vote.
 Term loans earn a fixed rate of interest
and have a definite maturity period.
 Terms loans represent secured
lending.
 Restrictive covenants to protect the
interest of the lender.
Disadvantages of Loans from FI
Borrower’s Point of View Lender’s Point of View
 Failure in repayment may threaten the
existence of the firm.
 Restrictive covenants may reduce
managerial freedom.
 Term loans do not carry the right to
vote.
 Term loans are not represented by
negotiable securities.
Text Books References:
1. M.Y.Khan and P.K.Jain, “Financial Management” Tata McGraw Hill,
6th
Edition, 2011.
2. I.M.Pandey, “Financial Management” Vikas Publishing House Pvt. Ltd.,
10th
Education 2012.
3. S.N.Maheswari, Financial and Management Accounting, Sultan Chand &
Sons, 2003.

Financial Management unit 1

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