Financial Management

Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation

UNIT 1: Introduction of Financial Management

Definition, Nature and Scope of Financial Management:

Finance has emerged as a distinct area of study during the 2nd half of the 20th centaury. The evolution of
finance function and the changes in its scope appeared due to two factors namely:

• Continuous growth and diversity in business

• The gradual development/emergence of new financial analytical tools.

Management is an activity concerned with planning and controlling different business operations so as to
achieve the ultimate goal. When this concept of management is applied to Finance, it means that we are
trying to plan, organize, control financial resources.

Financial management though a comparatively new discipline, has gained great importance today as the
financial strategies required to survive in today’s competitive environment have become extremely crucial.

As it is a relatively new discipline, there are several controversies about its various theories and concepts.

• Definition:

All business decisions have financial implications. Any decision taken by a business/investor affects the
procurement or utilization of finance. Ensuring proper utilization of available funds or analyzing the best
alternatives for raising funds are the key factors for the success of any business. Financial Management as
a functional area has got a place of prime relevance in every firm. In short, Financial Management can be
defined as the management of flow of funds and it deals with the financial decision making.

Guthman & Dougal - “ Financial Management means the activity concerned with the planning, raising,
controlling and administering of funds used in the business.”

Raymond Chambers – “Financial Management comprises the forecasting, planning, organizing, directing,
coordinating and controlling of all activities relating to acquisition and application of the financial resources
of an undertaking in keeping with its financial objectives.”

Phillippatus – “ Financial Management is concerned with the managerial decisions that result in the
acquisition and financing of short term and long term credits for the firm.”

• Nature and Importance/Significance:

1. Finance is the controlling function – For implementation of all business activities finance is the
base. Every business activity like purchase, sale, marketing etc will require finance and thus it is
monitored and controlled by the finance function.
2. Aid to managerial decisions – It plays a vital role in policy and decision making in a firm. All major
decisions related to man power, procurement, storage etc are based on finance.
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
3. Wealth Maximisation – Main objectives of Financial Management is to obtain maximum profits
and to maximize shareholder’s wealth. Maximum profits can be obtained by lowering costs,
effective utilization of funds, maximizing returns on investments, managing cash flows etc.
4. Financial Management is an analytical tool – It uses a variety of scientific, mathematical and
analytical tools to interpret the data and make informed decisions.
5. Administrative in nature – It is no longer only related to procurement of funds but is also now
extended to capital allocation, sourcing of funds, project appraisal etc.
6. Finance Function is centralized – It is managed centrally.
7. Performance measure – It often deals with those factors which directly affect the profitability and
risk factors of a business concern. Hence, financial management usually acts as a measure for
determining the performance levels of other functions to stabilize and control profitability and risk
factors.

• Scope:

Traditionally, a Finance Manager was concerned with only raising of funds as and when there was a
requirement. However, with advancement of business and emergence of new tools and techniques of
finance, the role of a Finance Manager has expanded. In present times, he is concerned not only with raising
funds but also with the management of funds. Besides, he is also required to be an active participant in all
the business decisions made as each decision will have some financial implications. Every business activity
be it production, marketing, purchase, sales etc. has financial implications. In particular, Finance Manager
has to focus his attention on:

• Procuring the required quantum of funds as and when necessary at the lowest possible cost.
• Investing these funds in various assets in the most profitable way
• Distributing returns to the shareholders in order to satisfy their expectations from the firm.

Financial Management

Maximization of Share
Value

Financial Decisions

Financing Decisions Investment Decisions Dividend Decisions

Trade Off
Return Risk
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
Functions of a Financial Manager/CFO in a globalized environment

1. Raising of Funds

In order to meet the obligation of the business it is important to have enough cash and liquidity. A firm can
raise funds by the way of equity and debt. It is the responsibility of a financial manager to decide the ratio
between debt and equity. It is important to maintain a good balance between equity and debt.

2. Allocation of Funds

Once the funds are raised through different channels the next important function is to allocate the funds.
The funds should be allocated in such a manner that they are optimally used. In order to allocate funds in
the best possible manner the following point must be considered

• The size of the firm and its growth capability

• Status of assets whether they are long-term or short-term
• Mode by which the funds are raised

These financial decisions directly and indirectly influence other managerial activities. Hence formation of
a good asset mix and proper allocation of funds is one of the most important activity. This decision includes
not only those that create revenue and profits but also those that save money.

3. Profit Planning

Profit earning is one of the prime functions of any business organization. Profit earning is important for
survival and sustenance of any organization. Profit planning refers to proper usage of the profit generated
by the firm.

Profit arises due to many factors such as pricing, industry competition, state of the economy, mechanism
of demand and supply, cost and output. A healthy mix of variable and fixed factors of production can lead
to an increase in the profitability of the firm.

Fixed costs are incurred by the use of fixed factors of production such as land and machinery. In order to
maintain a tandem it is important to continuously value the depreciation cost of fixed cost of production.
An opportunity cost must be calculated in order to replace those factors of production which has gone
thrown wear and tear. If this is not noted then these fixed cost can cause huge fluctuations in profit.

4. Understanding Capital Markets

Shares of a company are traded on stock exchange and there is a continuous sale and purchase of securities.
Hence a clear understanding of capital market is an important function of a financial manager. When
securities are traded on stock market there involves a huge amount of risk involved. Therefore a financial
manger understands and calculates the risk involved in this trading of shares and debentures.
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
Its on the discretion of a financial manager as to how and how much of the profits after tax should be
distributed among the shareholders or reinvested in the business. Many investors do not like the firm to
distribute the profits amongst share holders as dividend instead invest in the business itself to enhance
growth. The practices of a financial manager directly impact the operation in capital market.

5. Working Capital Requirements:

These decisions deal with management of current assets and short term requirements of funds. Excess of
less of working capital is dangerous for the organization. A trade off between liquidity and profitability is
required. For achieving the trade off he is required to take various decisions like how much and which
inventory to maintain, where to maintain the inventory, credit period to be given to customers, credit period
to be requested from suppliers, taxes due dates etc.

6. Capital Budgeting Decisions:

These decisions are crucial of every business. A Finance Manager is required to decide about whether a
particular asset should be replaced, a new asset should be bought or leased. All these decisions have long
term implications. The main objective of capital budgeting is the identify those assets which are worth more
than their cost. Hence, a Finance Manager has to take utmost care in dealing with these decisions.

7. Borrowing Decisions:

For expansion of business additional resources are required. Cash generated by the business may not be
enough for funding the expansion plans. Additional resources i.e. funds will have to be raised from external
agents like commercial banks or financial institutions or by issue of new shares or by issue of debentures.
The Finance Manager is required to take decisions about the mode in which the funds are to be raised. He
has to decide upon the equity debt combination and also how much interest is the business ready to pay out.
For this, he also has to negotiate the terms with the external parties involved.

8. Dividend Decisions and Profit Allocation:

Other major decisions to be made by the Finance Manager are how much of net profit after tax should be
distributed to the Shareholders, how much should be retained for future expansion of business and how
much should be distributed to employees as bonus or contribution made to various employee benefit
schemes.

9. Other Functions as a controller:

Other than the above mentioned functions, a Finance Manager is also required to be involved in the process
of budgeting, internal audit, accounting, taxation, analysis of the financial performance of the business,
taking decisions regarding hedging of forex exposures etc.
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
Different Sources of Finance:

Sources of finance can be short term, medium term and long term. Depending on the fund requirement of
the business enterprise, the CFO/Finance Manager will decide upon the source for procurement of the
finance.

Short Term Finance sources – Trade credit, Accrued Expenses, Deferred Income, Commercial Papers,
Certificates of Deposit, Letter of Credit, Instalment Credit, Bank Finance, Factoring, Bill discounting

Medium Term Finance sources – Financial Institutions, Commercial Banks, Public Deposits, Hire
Purchase, Lease Financing, Currency Bonds, Instalment Credit

1. Equity/Ordinary Shares:

Equity shares are also termed as ordinary shares. Holders of equity shares are called the shareholders of
the company as they invest in the shares of the company. They have the voting rights and the power to be
a part of the decision making process of the company related to major issues which would affect the
company. Dividend paid to the shareholders is a form of return on the amount invested by them. The
company will pay a dividend if it earns a profit. In case of loss, the company may distribute dividend out
of capital profits. In case of liquidation of company, equity shareholders are the last ones to get their
money back.

In case of the Equity Shares, it is important to understand a few terms.

Face Value (FV) – This is value of each share which is fixed by the Company. It may be Rs 10, Rs 100
etc.

Shares at a premium – When the shares are issued (sold) at a price above the face value, it is said that the
shares are issued at a premium. Say if FV is Rs 100 and the shares are sold at Rs 120, Then Rs 20 is the
premium amount.

Shares issued at a discount – When the shares are issued at a price below the face value, it is said that the
shares are issued at a discount. Say if FV is Rs 100 and the shares are sold at Rs 90, Then Rs 10 is the
discount.

Market Price – It is the price at which the shares can be bought or sold in the financial markets.

Rights Issue of Shares means that the right to apply for additional shares in case of further issue of shares
is 1st given to the existing shareholders and if this right is not exercised by the shareholder, then the shares
are offered to the public.

Bonus shares are shares where the shareholder is not required to pay any amount. The shares are issued
by the Company out of the accumulated profits.
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
Merits:

• Good performance of a company would increase its profit earnings which will in turn increase the
amount of dividends paid. This will positively affect the market price of the shares. Hence, the
shareholders can sell their shares and earn capital appreciation.
• As the shareholders have vested interest in the performance of the company, they take a keen
interest and keep a close watch on the progress of the company.
• If listed at the stock exchange/s, equity shares are easily tradable.
• A Company can raise capital by issuing additional shares without creating a charge on the fixed
assets.
• Equity shares are not required to be paid back during the life time of the Company.
• The Company is not liable to pay dividend to the shareholders if it has incurred a loss.

Demerits:
• Dividends payable to equity shareholders are not deductible as an expense for computation of tax,
however, debenture interest is tax deductible. So the cost of equity capital is usually higher than
other sources of funds.
• The rate of return required by equity shareholders is higher than the rate of return required by
other investors.
• As the Company is not obligated to pay dividend, the equity shareholders are at a very high risk
of not getting dividend.
• New issue of equity shares dilutes the control of existing shareholders. Hence, small Companies
or Private Companies avoid issuing new shares so as to not compromise on the share control.
• New issue of equity shares may also lead to the problem of over capitalization.
• In case of liquidation, equity shareholders are the last ones to receive the amount they have
invested. At times they may receive only part of the amount that they have invested.

2. Preference Shares:

As per Companies Act, Preference Share capital means that part of the issued share capital of the
Company which carries or would carry a preferential right with respect to

a. Payment of dividend, either fixed amount or an amount calculated at a fixed rate, which may
either be free of or subject to income tax, and
b. Repayment, in the case of a winding up or repayment of capital, of the amount of share capital
paid –up or deemed o have been paid –up, whether or not, there is a preferential right to the
payment of any fixed premium or premium on a fixed scale, specified in the MOA or AOA of
the Company.

Redeemable or Irredeemable Preference Shares (Note: Irredeemable Shares can no longer be issued) or
Cumulative and Non Cumulative Preference Shares are some types of Preference Shares.
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
Preference Shareholders have a right to receive dividend and the Company is under an obligation to pay
the dividend. However, preference shareholders cannot vote on all the resolutions put forth before the
shareholders of the Company. They can vote only on matter related to them.

Long term funds from preference shares are raised by a public issue of shares. It does not require any
security nor is ownership of a firm affected. It has some characteristics of equity capital and some of debt
capital.

Merits:

• Ease of raising long term finance without affecting shareholding pattern.

• As they do not carry voting rights, there is no dilution of control.
• There is no risk of take over.
• There is a leveraging advantage since it has fixed charges.
• As compared to equity shareholders, in case of liquidation, the Preference shareholders get a
priority in repayment of the capital over the equity shareholders
• The shareholders get a fixed and regular income.

Demerits:
• Expensive source of finance
• Preference shareholders have a preferential claim on the assets and earnings of the firm over
equity shareholders.

3. Debentures:

A debenture is a document of acknowledgement of a debt with the common seal of the Company. It
contains the terms and conditions of loan, payment of interest, redemption terms like maturity date,
whether redemption will be at premium, option for conversion to equity shares etc. and the security
offered if any.

As per Companies Act, Debenture includes debenture stock, bonds or any other instrument of a Company
evidencing a debt, whether constituting a charge on the assets of the Company or not.

Debenture holders are the creditors of the Company. They have no voting rights in the Company. Interest
is payable on the debentures even if the Company incurs a loss. The debenture interest paid is a tax
deductible expense.

Naked/Simple Debentures, Mortgage Debentures, Redeemable Debentures, Irredeemable Debentures,

Bearer Debentures, Registered Debentures, Convertible Debentures and Non Convertible Debentures are
some types of debentures.
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
Merits:

• A fixed interest rate is paid by the Company which is generally lower than the rate of dividend
payable on shares.
• The cost of debenture is much lower than the cost of equity or preference share capital since
interest on debenture is a tax deductible expense.
• There is no dilution of control of the Company by the issue of debentures as debenture holders
have no voting rights.
• Investors prefer debenture investment than equity or preference investment as the former provides
a regular flow of permanent income.
• During inflation, debenture issue is advantageous as the fixed monetary outgo diminishes in real
terms as the price level rises.
• Debentures carry a lesser risk as they are secured on the assets of the Company.
• Debenture holders get a preference over the equity and preference shareholders in case of
Company winding up.
• Debentures are issued for a long term. Hence, the issuing company enjoys the comfort with
regards to continued availability of funds for that specific period which helps the company in
preparing future plans.

Demerits:
• The cost of issuing debentures is high.
• Debenture financing involves fixed interest and principal repayment obligation. Any failure to
• Debenture financing increases the financial risk of the Company. This will in turn increase the
cost of capital.

4. Term Loans from Banks/Financial Institutions:

In India specialized financial institutions provide long term financial assistance to private and public
firms. Generally firms obtain long term debt by raising long term loans. Term loans, also referred to as
term finance; represent a source of debt finance which is repayable in less than 10 years. Before giving a
term loan to a Company the financial institutions must be satisfied regarding the technical, economical,
commercial, financial and managerial viability of project for which the loan is needed. Term loans are
secured borrowings and a significant source of finance for investment in the form of fixed assets and also
in the form of working capital needed for new project.

Merits

• From taxation point of view, raising finance through term loans is cheaper as compared to those
raised through equity shares or preference shares.
• As lenders have no right to vote, there is no dilution in control of the company.
• Interest rate is fixed and is also a tax deductible expense.
• The terms loans are fully secured and hence fear of loss is negligible for lenders.
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
Demerits

• The company has to repay the principal and interest irrespective of a loss during a particular year.
• Monthly earnings are used mainly to repay the debt rather than investing them for future growth

5. Retained Earnings:

This process is also known as ploughing back of profits, as surplus retained earnings of the business are
reinvested. This source of working capital is favorable for firms as it is interna and relatively cheaper. It
does not require security and also does not dilute the control of the company.

Merits

• Retained earnings provide a safety cushion during hard times.

• It is the cheapest mode for financing expansion projects.
• Retained earnings can be used to redeemed long term liabilities like bonds, debentures etc
• It helps to increase the creditworthiness of the company
• It assures the shareholders of a stable dividend policy

Demerits

• The management by manipulating the value of the shares in the stock market can misuse the
retained earnings.
• Excessive use of retained earnings leads to monopolistic attitude of the company.
• Retained earnings lead to over capitalization, because if the company uses more and more
retained earnings, it leads to insufficient source of finance.
• Retained earnings lead to tax evasion. Since, the company reduces tax burden through the
retained earnings.
• If the company uses retained earnings as sources of finance, the shareholder can’t get more
dividends. So, the shareholder does not like to use the retained earnings as source of finance in all
situations.

6. Public Deposits

Acceptance of Fixed Deposits from the general public is also a source for raising finance. These securities
are generally unsecured and hence preferred by the companies. The rate of interest on these deposits
depends upon the overall Interest Rate scenario in the country and the Monetary Policies of the RBI.
These deposits can be accepted by the Companies for a minimum period of 6 months and maximum of 3
years. The legal formalities involved in accepting public deposits are less complicated as compared with
raising of funds through shares and debentures.
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
7. Securitisation of Debt:

Securitisation is defined as ‘packaging of designated pools of loans and receivables (with appropriate
credit support) and the underwriting and sale of these packages to investors in the form of securities
which are collateralized by the underlying assets and their associated income stream.

In other words, securitization can be defined as the process of transforming liquid assets like lease
recivables or stock on hire into securities and issuing these securities to a broad range of investors through
the medium of the capital market.

8. Global Depository Receipts (GDR):

Since 1991, Indian companies have been allowed to access international equity market. The Euro – Issues
can be floated through the mechanism of GDRs.

A GDR is a dollar denominated instrument traded on a stock exchange in Europe or the USA or both. It
represents a certain number of underlying equity shares of the issuing company. Though GDR is quoted
and traded in dollars, the underlying are denominated in equity shares. GDRs are created when the issuing
company delivers ordinary equity shares issued in the name of a overseas depository bank to the domestic
custodian bank (agent of the depository) against which the depository issues GDRs representing the
underlying equity shares to the foreign investors. The physical possession of the shares remains with the
depository and the concerned foreign investors obtain GDRs from the depository evidencing their
holding. The main advantage of issuing a GDR is that there is an inflow of foreign exchange through the
proceeds of the issue whereas dividend outflow is in Indian Rupees only.

9. Foreign Currency Convertible Bonds:

This bond is an equity linked unsecured debt instrument carrying a fixed rate of interest and an option of
conversion into fixed number of equity shares or GDRs of the issuer company. However, the option to
retain the FCCB as a bond also exists. As a bond the issuer has the responsibility to repay the principal
amount and make the specified interest payments for the given period. As the bond represents debt, its
holder is a creditor and not a shareholder of the Company. These bonds are listed and traded on one or
more Stock Exchanges abroad. Till conversion interest on the bonds is paid in dollars or any other freely
convertible currency and if the conversion option is not exercised, the payment on redemption would also
be in a foreign currency. They can also be issued with fixed exchange rate clauses or specifying the rates
at which the bonds can be converted.
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
Capital Structure:

“Capital structure is the make up of a firm’s capitalization i.e. it represents the mix of different sources of
long term funds in the total capitalization of the company.

- C.W. Gerstenberg

Capital structure refers to the way a company finances its assets through some combination of equity, debt
or hybrid securities. A firm’s capital structure is therefore the composition or structure of its liabilities.

The capital structure of a company may be highly complex and may include many sources. An optimal
capital structure, if there is one, is the one that maximizes the value of the firm and minimizes the cost of
capital.

To have optimal capital structure, following conditions need to be fulfilled:

• Return on investment should be greater than cost of investment

• There should be no financial risk
• The capital structure should be flexible

The term capitalization means the total amount of funds raised through long term sources. It includes funds
raised from owned sources and from borrowed sources. Normally, capitalization includes reserves and
surplus of the company also. However, capital profits, which are available for distribution as much as
dividend under certain conditions only, should be included in the capitalization while reserves built out of
revenue profits can be included in capitalization only if it is retained in the business.

The amount of capitalization should be exactly as much as the company requires. If the amount capitalized
is more than required, then it is harmful to the business. Similarly, under capitalization is also dangerous to
the organization.

Theoretically, capital structure of the Company can be of the following four patterns:

i. Capital structure with equity shares only

ii. Capital structure with both equity and preference shares
iii. Capital structure with equity shares and debentures
iv. Capital structure with equity shares, preference shares and debentures.

Which of the amount type of capital structure should be implemented depends upon the cost of employing
the capital.

Following are some theories of Capital Structure:

• Net Income Approach

o Definitely a relation between cost of capital and capital structure exists.
o Cost of debt is less than that of equity
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
o Cost of capital will decrease with increase in debt and valuation of firm will increase
• Net Operating Approach
o No relation between Cost of Capital and Capital Structure.
o Valuation of firm is unaffected.
• Modigliani – Miller Approach (MM model)
o Market value of Firm is not connected with the capital structure.

Factors affecting Capital Structure:

1. Cash Flow Position:

The decision related to composition of capital structure also depends upon the ability of business
to generate enough cash flow.

The company is under legal obligation to pay a fixed rate of interest to debenture holders, dividend
to preference shares and principal and interest amount for loan. Sometimes company makes
sufficient profit but it is not able to generate cash inflow for making payments.

The expected cash flow must match with the obligation of making payments because if company
fails to make fixed payment it may face insolvency. Before including the debt in capital structure
company must analyse properly the liquidity of its working capital.

A company employs more of debt securities in its capital structure if company is sure of generating
enough cash inflow whereas if there is shortage of cash then it must employ more of equity in its
capital structure as there is no liability of company to pay its equity shareholders.

2. Interest Coverage Ratio (ICR):

It refers to number of time companies earnings before interest and taxes (EBIT) cover the interest
payment obligation.

ICR= EBIT/ Interest

High ICR means companies can have more of borrowed fund securities whereas lower ICR means
less borrowed fund securities.

3. Debt Service Coverage Ratio (DSCR):

It is one step ahead ICR, i.e., ICR covers the obligation to pay back interest on debt but DSCR
takes care of return of interest as well as principal repayment.
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation

If DSCR is high then company can have more debt in capital structure as high DSCR indicates
ability of company to repay its debt but if DSCR is less then company must avoid debt and depend
upon equity capital only.

4. Return on Investment:

Return on investment is another crucial factor which helps in deciding the capital structure. If return
on investment is more than rate of interest then company must prefer debt in its capital structure
whereas if return on investment is less than rate of interest to be paid on debt, then company should
avoid debt and rely on equity capital.

Cost of Debt:

If firm can arrange borrowed fund at low rate of interest then it will prefer more of debt as compared
to equity.

5. Tax Rate:

High tax rate makes debt cheaper as interest paid to debt security holders is subtracted from income
before calculating tax whereas companies have to pay tax on dividend paid to shareholders. So high
end tax rate means prefer debt whereas at low tax rate we can prefer equity in capital structure.

6. Cost of Equity:

Another factor which helps in deciding capital structure is cost of equity. Owners or equity
shareholders expect a return on their investment i.e., earning per share. As far as debt is increasing
earnings per share (EPS), then we can include it in capital structure but when EPS starts decreasing
with inclusion of debt then we must depend upon equity share capital only.

7. Floatation Costs:

Floatation cost is the cost involved in the issue of shares or debentures. These costs include the cost
of advertisement, underwriting statutory fees etc. It is a major consideration for small companies
but even large companies cannot ignore this factor because along with cost there are many legal
formalities to be completed before entering into capital market. Issue of shares, debentures requires
more formalities as well as more floatation cost. Whereas there is less cost involved in raising
capital by loans or advances.

8. Risk Consideration:
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
Financial risk refers to a position when a company is unable to meet its fixed financial charges such
as interest, preference dividend, payment to creditors etc. Apart from financial risk business has
some operating risk also. It depends upon operating cost; higher operating cost means higher
business risk. The total risk depends upon both financial as well as business risk.

If firm’s business risk is low then it can raise more capital by issue of debt securities whereas at the
time of high business risk it should depend upon equity.

9. Flexibility:

Excess of debt may restrict the firm’s capacity to borrow further. To maintain flexibility it must
maintain some borrowing power to take care of unforeseen circumstances.

10. Control:

The equity shareholders are considered as the owners of the company and they have complete
control over the company. They take all the important decisions for managing the company. The
debenture holders have no say in the management and preference shareholders have limited right
to vote in the annual general meeting. So the total control of the company lies in the hands of equity
shareholders.

If the owners and existing shareholders want to have complete control over the company, they must
employ more of debt securities in the capital structure because if more of equity shares are issued
then another shareholder or a group of shareholders may purchase many shares and gain control
over the company.

Equity shareholders select the directors who constitute the Board of Directors and Board has the
responsibility and power of managing the company. So if another group of shareholders gets more
shares then chance of losing control is more.

Debt suppliers do not have voting rights but if large amount of debt is given then debt-holders may
put certain terms and conditions on the company such as restriction on payment of dividend,
undertake more loans, investment in long term funds etc. So company must keep in mind type of
debt securities to be issued. If existing shareholders want complete control then they should prefer
debt, loans of small amount, etc. If they don’t mind sharing the control then they may go for equity
shares also.

11. Regulatory Framework:

Issues of shares and debentures have to be done within the SEBI guidelines and for taking loans.
Companies have to follow the regulations of monetary policies. If SEBI guidelines are easy then
companies may prefer issue of securities for additional capital whereas if monetary policies are
more flexible then they may go for more of loans.
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation

12. Stock Market Condition:

There are two main conditions of market, i.e., Boom condition. These conditions affect the capital
structure specially when company is planning to raise additional capital. Depending upon the
market condition the investors may be more careful in their dealings.

During depression period in the market business is slow and investors also hesitate to take risk so
at this time it is advisable to issue borrowed fund securities as these are less risky and ensure fixed
repayment and regular payment of interest but if there is Boom period, business is flourishing and
investors also take risk and prefer to invest in equity shares to earn more in the form of dividend.

13. Capital Structure of other Companies:

Some companies frame their capital structure according to Industrial norms. But proper care must
be taken as blindly following Industrial norms may lead to financial risk. If firm cannot afford high
risk it should not raise more debt only because other firms are raising.

Cost of Capital:

A company raises funds from various sources for financing long term requirements. These sources
principally consist of Equity capital, Reserves and Surplus, Long term loans, Preference Shares and
Debentures. Each of the sources cost the company something. Therefore, cost of capital can be defined as
the cost of raising funds through different sources. Alternatively, it can also be defined as the rate of return
that a company must earn on its investments so that the expectations of the investors are satisfied. In other
words, the minimum rate of return mentioned above will maintain the existing position which means that
if the present situation is not improved, at least it will not deteriorate further. This rate of is in turn calculated
on the basis of the cost of raising funds from different sources for financing the investments of the company.

Relation between Cost of Capital and Capital Structure:

The cost of capital of debt is less than the cost of equity because of the tax deductibility of interest.
Therefore, aggregate cost of capital comes down id debt is employed in the capital structure. However, the
aggregate cost of capital does not come down continuously with the introduction of debt. After reaching a
particular level, the introduction of further debt results in an increase in the aggregate cost of capital because
the debt becomes costly as the risk increases. The creditors may demand a higher rate of interest to cover
the risk which makes the debt more costly. Hence, it can be concluded that at a particular combination of
debt and equity, the aggregate cost of capital is the minimum. This combination will be different from
industry to industry and even from company to company. The aim of capital structure planning therefore
should be to reach this level of combination.