UNIT -I

Financial management:

At its core, financial management is the practice of making a business plan and then ensuring
all departments stay on track. Solid financial management enables the CFO or VP of finance
to provide data that supports creation of a long-range vision, informs decisions on where to
invest, and yields insights on how to fund those investments, liquidity, profitability, cash
runway and more.

Importance of Financial Management

Solid financial management provides the foundation for three pillars of sound fiscal
governance:

Strategizing, or identifying what needs to happen financially for the company to achieve its
short- and long-term goals. Leaders need insights into current performance for scenario
planning, for example.

Decision-making or helping business leaders decide the best way to execute on plans by
providing up-to-date financial reports and data on relevant KPIs.

Controlling, or ensuring each department is contributing to the vision and operating within
budget and in alignment with strategy.

With effective financial management, all employees know where the company is headed, and
they have visibility into progress.

Objectives of Financial Management

Building on those pillars, financial managers help their companies in a variety of ways,
including but not limited to:

Maximizing profits by providing insights on, for example, rising costs of raw materials that
might trigger an increase in the cost of goods sold.

Tracking liquidity and cash flow to ensure the company has enough money on hand to meet
its obligations.

Ensuring compliance with state, federal and industry-specific regulations.

Developing financial scenarios based on the business’ current state and forecasts that

assume a wide range of outcomes based on possible market conditions.

Dealing effectively with investors and the boards of directors.

Ultimately, it’s about applying effective management principles to the company’s financial
structure.

Scope of Financial Management

Financial management encompasses four major areas:

Planning
The financial manager projects how much money the company will need in order to maintain
positive cash flow, allocate funds to grow or add new products or services and cope with
unexpected events, and shares that information with business colleagues.

Planning may be broken down into categories including capital expenses, T&E and
workforce and indirect and operational expenses.

Budgeting
The financial manager allocates the company’s available funds to meet costs, such as
mortgages or rents, salaries, raw materials, employee T&E and other obligations. Ideally
there will be some left to put aside for emergencies and to fund new business opportunities.

Companies generally have a master budget and may have separate sub documents covering,
for example, cash flow and operations; budgets may be static or flexible.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that
adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of
capital so that a balance is maintained between debt and equity capital.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation with

regards to capital requirements of the company. This will depend upon expected costs
and profits and future programmes and policies of a concern. Estimations have to be
made in an adequate manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the
capital structure have to be decided. This involves short- term and long- term debt
equity analysis. This will depend upon the proportion of equity capital a company is
possessing and additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has
many choices like-
 a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period
of financing.

4. Investment of funds: The finance manager has to decide to allocate funds into

profitable ventures so that there is safety on investment and regular returns is possible.
5. Disposal of surplus: The net profits decisions have to be made by the finance
manager. This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other
benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current
liabilities, maintainance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize the
funds but he also has to exercise control over finances. This can be done through
many techniques like ratio analysis, financial forecasting, cost and profit control, etc.

The purpose of financial management

Financial management involves analyzing money and investments to make the right decisions
for the long and short term. The goals differ depending on whether you are working with a
business or an individual:
Corporate financial management
Effective financial management in a corporation allows the business to use cash and credit in
a way that helps it reach its objectives. Here are some goals of financial management in a
company:

● Profit maximization: When marginal cost equals marginal revenue, the organization

has achieved profit maximization. This is one of the main objectives of financial
management.
● Wealth maximization: Once a company reaches profit maximization, the next goal is
growing wealth for stakeholders. A successful investment plan contributes
significantly to the business.
● Company survival: Effective financial management helps a company to avoid
bankruptcy and stay in existence, which means that employees continue to have jobs
and products and services continue to reach the market.
● Cash flow maintenance: While it is a short-term objective of financial management,
managing cash flow keeps money available for daily expenses, including the purchase
of raw materials to produce goods and the payment of utilities and salaries. Keeping
enough cash on hand to pay bills and other obligations on time is essential to the
reputation and credit rating of the company.
● Capital cost minimization: Raising capital involves spending money on interest, fees
and other costs. Keeping these expenses under control contributes directly to profits.
 ● Funds estimation: Businesses must make the best estimate of how much money is
needed to operate in the short and long term.
● Capital structure determination: Capital structure establishes how the business
finances operation and growth through various sources. Financial managers determine
the right mix of debt and equity to do this.

Profit maximization Vs wealth Maximization

BASIS FOR
PROFIT MAXIMIZATION WEALTH MAXIMIZATION
COMPARISON

Concept The main objective of a concern The ultimate goal of the concern is
is to earn a larger amount of to improve the market value of its
profit. shares.

Emphasizes on Achieving short term objectives. Achieving long term objectives.

Consideration of Risks No Yes

and Uncertainty

Advantage Acts as a yardstick for computing Gaining a large market share.

the operational efficiency of the
entity.

Recognition of Time No Yes

Pattern of Returns

Concept of time value of money:

It is a well-known fact that time is precious. Every business has started to make a profit. A
small amount available today is crucial than the lump sum due in the future. This indicates
that time decides the value of money. 

Example of time value of money:

For example, you purchase a 1-kilogram silver bar for 60 INR per gram 2 years ago. Today
the market rate of silver is 40 INR. This means that the silver bar you purchased has lost
value. It can be otherwise too, but in general, in business, it is always advisable to focus on
the current market value than to wait for the future.

Therefore, the time value of money is defined as the money that is present with any
individual currently. The money that is available at the moment will allow businesses to
invest it for expansion, to pay salaries for its employees, to purchase raw materials, etc. The
money which is due for the future is only on papers and does not add any value in the
present. 

Time value of money is commonly identified as TVM by finance professionals. It is called a

present discounted value as well.

3 Parameters of TVM 

1. Inflation – It reduces the purchasing power of money as it raises the cost of goods or
services. The same amount of money can purchase lesser goods in the future. 
2. Opportunity cost – It is the loss associated with the investment and the profit linked
with them because of the obligation of money in another investment within the fixed
time duration.
3. Risk – It relates to the risk involved in investment to be undertaken by each investor
while investing. 

Importance of Time Value of Money

Understand the time value of money importance from the following section from a financial
management perspective.  

1. Money in hand will help businesses to invest and grow the business. According to the
saying “Make hay while the sun shines.” One needs to have money in hand when
there is a need and an opportunity.
2. The time value of money will help you assess the debt carried by the business.  
3. The future is uncertain and hence time value of money in financial
management plays a crucial role to manage finances and generate profit from the
business. 

Long-Term Sources of Finance

Long-term financing means capital requirements for a period of more than 5 years to 10, 15,
20 years or maybe more depending on other factors. Capital expenditures in fixed assets like
plant and machinery, land and building, etc of business are funded using long-term sources of
finance. Part of working capital which permanently stays with the business is also financed
with long-term sources of funds. Long-term financing sources can be in the form of any of
them:

● Share Capital or Equity Shares

● Preference Capital or Preference Shares
● Retained Earnings
● Debenture / Bonds
● Term Loans from Financial Institutes, Government, and Commercial Banks
● Venture Funding
● Asset Securitization
● International Financing by way of Euro Issue, Foreign Currency Loans

Short Term Sources of Finance

Short term financing means financing for a period of less than 1 year. The need for short-term
finance arises to finance the current assets of a business like an inventory of raw material and
finished goods, debtors, minimum cash and bank balance etc. Short-term financing is also
named as working capital financing. Short term finances are available in the form of:

● Trade Credit
● Short Term Loans like Working Capital Loans from Commercial Banks
● Fixed Deposits for a period of 1 year or less
● Advances received from customers
● Creditors
● Payables
● Factoring Services
● Bill Discounting etc.

UNIT –II

Cost of capital:
A firm raises funds from various sources, which are called the components of capital.
Different sources of fund or the components of capital have different costs. For example, the
cost of raising funds through issuing equity shares is different from that of raising funds
through issuing preference shares. The cost of each source is the specific cost of that source,
the average of which gives the overall cost for acquiring capital.

Definition of cost of capital:

According to Ezra Solomon, ‘the cost of capital is the minimum required rate of earnings or
the cut-off rate of capital expenditure’.

L. J. Gitman defines the cost of capital as ‘the rate of return a firm must earn on its
investment so the market value of the firm remains unchanged’.

The significance and relevance of cost of capital has been discussed below:
Investment Evaluation:
The primary objective of determining the cost of capital is to evaluate a project. Various
methods used in investment decisions require the cost of capital as the cut-off rate. Under net
present value method, profitability index and benefit-cost ratio method the cost of capital is
used as the discounting rate to determine present value of cash flows. Similarly a project is
accepted if its internal rate of return is higher than its cost of capital. Hence cost of capital
provides a rational mechanism for making the optimum investment decision.

Designing Debt Policy:

The cost of capital influences the financing policy decision, i.e. the proportion of debt and
equity in the capital structure. Optimal capital structure of a firm can maximize the
shareholders’ wealth because an optimal capital structure logically follows the objective of
minimization of overall cost of capital of the firm.
Project Appraisal:
The cost of capital is also used to evaluate the acceptability of a project. If the internal rate of
return of a project is more than its cost of capital, the project is considered profitable. The
composition of assets, i.e. fixed and current, is also determined by the cost of capital. The
composition of assets, which earns return higher than cost of capital, is accepted.

FACTORS DETERMINING THE FIRM’S COST OF CAPITAL

Factor 1: General Economic Conditions

General economic conditions determine the demand for and supply of capital within the
economy, as well as the level of expected inflation. This economic variable is reflected in the
risk less rate of return. This rate represents the rate of return on risk-free investments, such as
the interest rate on short-term government securities. In principle, as the demand for money
in the economy changes relative to the supply, investors alter their required rate of return. For
example, if the demand for money increases without an equivalent increase in the supply,
lenders will raise their required interest rate. At the same time, if inflation is expected to
deteriorate the purchasing power of the euro, investors require a higher rate of return to
compensate for this anticipated loss.

Factor 2: Market Conditions

When an investor purchases a security with significant risk, an opportunity for additional
returns is necessary to make the investment attractive. Essentially, as risk increases, the
investor requires a higher rate of return. This increase is called a risk premium. When
investors increase the ir required rate of return, the cost of capital rises simultaneously.
Remember we have defined risk as the potential variability of returns.

Factor 3: Operating and Financing Decisions

Risk, or the variability of returns, also results from decisions made within the company. Risk
resulting from these decisions is generally divided into two types: business risk and financial
risk. Business risk is the variability in returns on assets and is affected by the company’s
investment decisions. Financial risk is the increased variability in returns to common
stockholders as a result of financing with debt or preferred stock.

Factor 4: Amount of Financing

As the financing requirements of the firm become larger, the weighted cost of capital
increases for several reasons. For instance, as more securities are issued, additional flotation
costs, or the cost incurred by the firm from issuing securities, will affect the percentage cost
of the funds to the firm. Also, as management approaches the market for large amounts of
capital relative to the firm’s size, the investors’ required rate of return may rise. Suppliers of
capital become hesitant to grant relatively large sums without evidence of management’s
capability to absorb this capital into the business.

Weighted average cost of capital:

The weighted average cost of capital is a common way to determine required rate of
return because it expresses, in a single number, the return that both bondholders and
shareholders demand in order to provide the company with capital. A firm’s WACC is likely
to be higher if its stock is relatively volatile or if its debt is seen as risky because investors
will demand greater returns. 

WACC is also important when analysing the potential benefits of taking on projects or
acquiring another business. If the company believes that a merger, for instance, will generate
a return higher than its cost of capital, it’s likely a good choice for the company. If its
management anticipates a return lower than what their own investors are expecting, they’ll
want to put their capital to better use.

In most cases, a lower WACC indicates a healthy business that’s able to attract investors at a
lower cost. By contrast, a higher WACC usually coincides with businesses that are seen as
riskier and need to compensate investors with higher returns. 

If a company only obtains financing through one source—say, common stock—calculating

its cost of capital would be relatively simple. If investors expected a rate of return of 10% in
order to purchase shares, the firm’s cost of capital would be the same as its cost of equity:
10%. 

Marginal cost of capital:

The marginal cost of capital is the total combined cost of debt, equity, and preference, taking
into account their respective weights in the real worth of the company where such cost shall
denote the cost of raising any additional capital for the organization, which aids in analyzing
various alternatives of financing and decision making.

Example #1

A company’s present capital structure has funds from three different sources, i.e., equity
capital, preference share capital, and debt. Now, the company wants to expand its current
business. For that purpose, it intends to raise the funds of $100,000. The company decided to
raise capital by issuing equity in the market. According to the company’s present situation, it
is more feasible for the company to raise money through the issue of equity capital rather
than the debt or preference share capital. The cost of issuing equity is 10%. What is the
marginal cost of capital?

Solution:

It is the cost of raising an additional fund dollar through equity, debt, etc. For example, in the
present case, the company raised funds by issuing the additional equity shares in the market
for a $100,000 cost of 10%, so the marginal cost of capital of raising new funds for the
company will be 10%.
Types of Leverages – Financial, Operating and Combined Leverages (with Formula)
 1. Financial Leverage:
Financial Leverage is a tool with which a financial manager can maximise the returns to the
equity shareholders. The capital of a company consists of equity, preference, debentures,
public deposits and other long-term source of funds. He has to carefully select the securities
to mobilise the funds. The proper blend of debt to equity should be maintained.

The ratio through which he balances the mix of debt applied on the capital mix offers benefits
to the equity shareholders is known as Trading on Equity. As the debt is associated with the
cost of interest that can be directly charged to profit and loss account or charged against the
profit can reduce the burden of income tax. The benefit so gained will be passed on to the
equity shareholders. In such circumstances the EPS will be more.

2. Operating Leverage:
There are two major classifications of costs in the organisation. They are- (a) Fixed cost, (b)
Variable cost.

The operating leverage has a bearing on fixed costs. There is a tendency of the profits to
change, if the firm employs more of fixed costs in its production process, greater will be the
operating cost irrespective of the size of the production. The operating leverage will be at a
low degree when fixed costs are less in the production process.
Operating leverage shows the ability of a firm to use fixed operating cost to increase the
effect of change in sales on its operating profits. It shows the relationship between the
changes in sales and the charges in fixed operating income. Thus, the operating leverage has
impact mainly on fixed cost, variable cost and contribution.

Combined Leverage:
This leverage shows the relationship between a change in sales and the corresponding
variation in taxable income. If the management feels that a certain percentage change in sales
would result in percentage change to taxable income they would like to know the level or
degree of change and hence they adopt this leverage. Thus, degree of leverage is adopted to
forecast the future study of sales levels and resultant increase/decrease in taxable income.
This degree establishes the relationship between contribution and taxable income.

Unit-III

What is Capital Structure

The most crucial component of starting a business is capital. It acts as the foundation of the
company. Debt and Equity are the two primary types of capital sources for a business. Capital
structure is defined as the combination of equity and debt that is put into use by a company in
order to finance the overall operations of the company and for its growth.

Types of Capital Structure

The meaning of Capital structure can be described as the arrangement of capital by using
different sources of long term funds which consists of two broad types, equity and debt. The
different types of funds that are raised by a firm include preference shares, equity shares,
retained earnings, long-term loans etc. These funds are raised for running the business.

Equity Capital
Equity capital is the money owned by the shareholders or owners. It consists of two different
types
a) Retained earnings: Retained earnings are part of the profit that has been kept separately by
the organisation and which will help in strengthening the business.
b) Contributed Capital: Contributed capital is the amount of money which the company
owners have invested at the time of opening the company or received from shareholders as a
price for ownership of the company.

Debt Capital
Debt capital is referred to as the borrowed money that is utilised in business. There are
different forms of debt capital.

1. Long Term Bonds: These types of bonds are considered the safest of the debts as they
have an extended repayment period, and only interest needs to be repaid while the
principal needs to be paid at maturity.
2. Short Term Commercial Paper: This is a type of short term debt instrument that is
used by companies to raise capital for a short period of time

Optimal Capital Structure

Optimal capital structure is referred to as the perfect mix of debt and equity financing that
helps in maximising the value of a company in the market while at the same time minimises
its cost of capital.
Capital structure varies across industries. For a company involved in mining or petroleum and
oil extraction, a high debt ratio is not suitable, but some industries like insurance or banking
have a high amount of debt as part of their capital structure.

Financial Leverage
Financial leverage is defined as the proportion of debt that is part of the total capital of the
firm. It is also known as capital gearing. A firm having a high level of debt is called a highly
levered firm while a firm having a lower ratio of debt is known as a low levered firm.

Importance of Capital Structure

Capital structure is vital for a firm as it determines the overall stability of a firm. Here are
some of the other factors that highlight the importance of capital structure

1. A firm having a sound capital structure has a higher chance of increasing the market
price of the shares and securities that it possesses. It will lead to a higher valuation in
the market.
2. A good capital structure ensures that the available funds are used effectively. It
prevents over or under capitalisation.
 3. It helps the company in increasing its profits in the form of higher returns to
stakeholders.
4. A proper capital structure helps in maximising shareholder’s capital while minimising
the overall cost of the capital.
5. A good capital structure provides firms with the flexibility of increasing or decreasing
the debt capital as per the situation.

Factors Determining Capital Structure

Following are the factors that play an important role in determining the capital structure:

1. Costs of capital: It is the cost that is incurred in raising capital from different fund
sources. A firm or a business should generate sufficient revenue so that the cost of
capital can be met and growth can be financed.
2. Degree of Control: The equity shareholders have more rights in a company than the
preference shareholders or the debenture shareholders. The capital structure of a firm
will be determined by the type of shareholders and the limit of their voting rights.
3. Trading on Equity: For a firm which uses more equity as a source of finance to
borrow new funds to increase returns. Trading on equity is said to occur when the rate
of return on total capital is more than the rate of interest paid on debentures or rate of
interest on the new debt borrowed.
4. Government Policies: The capital structure is also impacted by the rules and policies
set by the government. Changes in monetary and fiscal policies result in bringing
about changes in capital structure decisions.

Design of Capital Structure, Theories and Practices:

The notion of capital structure is used to signify the proportionate relationship between debt

and equity. In finance area, capital structure denotes to the way a corporation finances its

assets through some combination of equity, debt, or hybrid securities. In financial studies

capital structure is elaborated as that combination of debt and equity that attains the stated

managerial goals i.e. the maximization of the firm's market value. The optimal CS is also

defined as that "combination of debt and equity that minimizes the firm's overall cost of

capital"

In academic literature, theorists have contrasting views on how capital structure influences

value of the firm. There are varied factors that influence the debt level in a firm. Among the

major factors the first is the benefits and cost related with various financing choices. The

trade-off between the benefits and cost leads to well-defined target debt ratio. The second is
the existence of shocks that cause firms to deviate, at least temporarily, from their targets.

The third is the presence of factors that prevent firms from immediately making capital

structure changes that offset the effect of the shocks or financial distress that move them

away from their targets. Profit, cash flow, the rate of growth and the level of earning's risk are

significant additional internal factors which influence on capital structure.

The various factors that influence the capital structure of a firm

Designing Capital Structure

Most of the successful organizations manage capital structure efficiently to exploit

opportunities, manage risk and fulfil the varying needs of the business. There are some of the

best practices used by companies in designing capital structure.

1. Select the instruments that successfully meet Company's funding requirements: There

is no one single source or a combination of sources of capital is appropriate for a company.

 Top companies assess available funding options, merits and demerits of debt and equity

and cost of capital in order to comprehend the financial, regulatory and operational risks

they are likely to face. Each company will select best alternative with the confidence that it

has flexibility to handle a radical change in the business.

2. Align capital structure with company strategy: In designing capital structure, it is

necessary for companies to develop a capital mix that supports the company strategy

leaving room for flexibility to be able to respond to varying business environment. By

determining an appropriate credit risk threshold and putting in place a disciplined private

equity management tactics, top level companies create a capital structure that supports

organizational objectives and operational superiority.

3. To design capital structure, effective procedure is to establish the company's cost of

capital: Prominent companies must be aware of their cost of capital to precisely determine

threshold of capital investment. The common method to compute cost of capital is getting

a company's weighted average cost of capital (WACC). WACC formula is straight forward

but can be complicated by fluctuating input that determines its outcome. Successful

companies regularly keep measuring its cost of capital to keep a close tab in which it gains

or lose. The companies that use various different methods of computing WACC get

widespread understanding of their position and assist them to make better strategic

decisions to deal with the industry and its rivals.

4. To make effort to decrease cost of capital on an ongoing basis: Top level organizations

struggle to make efforts to decrease cost of capital. Best practice that companies exercise is

financial transparency to attract investors who offer their capital at lower cost than

competitors. They maintain good relationship with banks to get favourable lending rates

which in turn has a positive impact on the lucrativeness.

5. Effectively manage flexible capital actively is also good practice of design capital

structure: Best practice companies are proactive in balancing debt to equity ratio to be

able to respond to internal and external factors that affect cost of capital. Flexible financial

policies that affect dividends where lower amounts can be paid as dividend and the rest

retained to grow the business are useful to many companies.

6. For designing capital structure, it is imperative to keep exploring new finance sources

constantly: Best practice companies move from reliance on traditional sources of capital

like commercial banks, public debt, equity markets or institutional investors to avoid being

victims of the changes in the market by continuously searching for alternative non-

traditional sources of capital on a continuous basis. They make partnership with other

business, use assets as collateral and creating corporate structures to protect the parent

company from unnecessary risks.

There are number of theories that elucidate the relationship between cost of capital, capital

structure and value of the firm.

They are:

1. Net income approach (NIA)

2. Net operating income approach (NOIA)

3. Traditional approach (TA)

4. Modigliani-Miller approach

1. Net income approach (NIA)

Net Income Approach was offered by Durand. The theory proposes increasing value of the

firm by decreasing overall cost of capital which is measured in terms of Weighted Average

Cost of Capital. This can be done by having higher proportion of debt, which is a cheaper
source of finance compared to equity finance. Weighted Average Cost of Capital (WACC) is

the weighted average costs of equity and debts where the weights are the amount of capital

raised from each source.

WACC =

Required rate of Return x Amount of equity + Rate of interest x Amount of debt

-----------------------------------------------------------

Total amount of capital (Debt + Equity )

Designing of optimum capital structure:

The optimal capital structure refers to a proportion of debt and equity at which the marginal
real cost of each available source of financing is same. This is also viewed as a capital
structure that maximizes market price of shares and minimizes the overall cost of capital of
the firm.

Theoretically the concept of optimal capital structure can easily be explained, but in
operational terms it is difficult to design an optimal capital structure because of a number of
factors, both quantitative and qualitative, that influence the optimum capital structure.

Moreover the subjective judgment of the finance manager of the firm is also an influencing
factor in designing the optimum capital structure of a firm. Designing the capital structure is
also known as capital structure planning and capital structure decision.

While designing an optimum capital structure the following factors are to be considered
carefully:
1. Profitability:
An optimum capital structure must provide sufficient profit. So the profitability aspect is to
be verified. Hence an EBIT-EPS analysis may be performed which will help the firm know
the EPS under various financial alternatives at different levels of EBIT. Apart from EBIT-
EPS analysis the company may calculate the coverage ratio to know its ability to pay interest.

2. Liquidity:
Along with profitability the optimum capital structure must allow a firm to pay the fixed
financial charges. Hence the liquidly aspect of the capital structure is also to be tested. This
can be done through cash flow analysis. This will reduce the risk of insolvency. The firm will
separately know its operating cash flow, non-operating cash flow as well as financial cash
flow. In addition to the cash flow analysis various liquidity ratios may be tested to judge the
liquidity position of the capital structure.
3. Control:
Another important aspect in designing optimum capital structure is to ensure control. The
supplies of debt have no role to play in managing the firm; but equity holders have right to
select management of the firm. So more debt means less amount of control by the supplier of
funds. Hence the management will decide the extent of control to be retained by themselves
while designing optimum capital structure.

4. Industry Average:
The firm should be compared with the other firms in the industry in terms of profitability and
leverage ratios. The amount of financial risk borne by other companies must be considered
while designing the capital structure. Industry average provides a benchmark in this respect.
However it is not necessary that the firm should follow the industry average and keep its
leverage ratio at par with other companies; however, the comparison will help the firm to act
as a check valve in taking risk.

5. Nature of Industry:
The management must take into consideration the nature of the industry the firm belongs to
while designing the optimum capital structure. If the firm belongs to an industry where sales
fluctuate frequently then the operating leverage must be conservative.

In case of firms belonging to an industry manufacturing durable goods, the financial leverage
should be conservative and the firm can depend less on debt. On the other hand, firms
producing less expensive products and having lesser fluctuation in demand may take an
aggressive debt policy.

6. Maneuverability in Funds:
There should be wide flexibility in sourcing the funds so that firm can adjust its long-term
sources of funds if necessary. This will help firm to combat any unforeseen situations that
may arise in the economic environment. Moreover, flexibility allows firms to avail the best
opportunity that may arise in future. Management must keep provision not only for obtaining
funds but also for refunding them.

7. Timing of Raising Funds:

Timing is yet another important factor that needs to be considered while raising funds. Right
timing may allow the firm to obtain funds at least cost. Here the management needs to keep a
constant vigil on the stock market, the government’s steps towards monetary and fiscal
policies, market sentiment and other macro economic variables. If it is found that borrowed
funds became cheap the firm may move to issue debt securities. It should be noted here that
the firm must operate under its debt capacity while designing its capital structure.

8. Firm’s Characteristics:
The size of the firm and creditworthiness are important factors to be considered while
designing its capital structure. For a small company the management cannot depend much on
the debt because its creditworthiness is limited—they will have to depend on equity.

For a large concern, however, the benefit of capital gearing may be availed. Small firms have
limited access to various sources of funds. Even investors are reluctant to invest in small
firms. So the size and credit standing also determine capital structure of the firm.
Earnings per share (EPS) is calculated as a company's profit divided by the
outstanding shares of its common stock. The resulting number serves as an
indicator of a company's profitability. It is common for a company to report EPS that
is adjusted for extraordinary items and potential share dilution.

Scope of EPS:

Earnings per share (EPS) is a company's net profit divided by the number of
common shares it has outstanding.1

EPS indicates how much money a company makes for each share of its stock
and is a widely used metric for estimating corporate value.

A higher EPS indicates greater value because investors will pay more for a
company's shares if they think the company has higher profits relative to its
share price.1

EPS can be arrived at in several forms, such as excluding extraordinary items or

discontinued operations, or on a diluted basis.
To calculate a company's EPS, the balance sheet and income statement are used
to find the period-end number of common shares, dividends paid on preferred
stock (if any), and the net income or earnings. It is more accurate to use a
weighted average number of common shares over the reporting term because
the number of shares can change over time.

What Is the Breakeven Point (BEP)?

The breakeven point (break-even price) for a trade or investment is determined
by comparing the market price of an asset to the original cost; the breakeven
point is reached when the two prices are equal.

In corporate accounting, the breakeven point formula is determined by dividing

the total fixed costs associated with production by the revenue per individual
unit minus the variable costs per unit. In this case, fixed costs refer to those
which do not change depending upon the number of units sold. Put differently,
the breakeven point is the production level at which total revenues for a product
equal total expenses.

Dividend decision: Determines the division of earnings between payments to

shareholders and retained earnings. The Dividend Decision, in Corporate
finance, is a decision made by the directors of a company about the amount and
timing of any cash payments made to the company's stockholders.

The declaration of dividends involves some legal as well as financial

considerations. From the point of legal considerations, the basic rule is that
dividend can only be paid out profits without the impairment of capital in any
way. But the various financial considerations present a difficult situation to the
management for coming to a decision regarding dividend distribution.

These considerations are discussed below:

(i) Type of Industry:

Industries that are characterised by stability of earnings may formulate a more
consistent policy as to dividends than those having an uneven flow of income.
For example, public utilities concerns are in a much better position to adopt a
relatively fixed dividend rate than the industrial concerns.

(ii) Age of Corporation:

Newly established enterprises require most of their earning for plant
improvement and expansion, while old companies which have attained a longer
earning experience, can formulate clear cut dividend policies and may even be
liberal in the distribution of dividends.

(iii) Extent of share distribution:

A closely held company is likely to get consent of the shareholders for the
suspension of dividends or for following a conservative dividend policy. But a
company with a large number of shareholders widely scattered would face a
great difficulty in securing such assent. Reduction in dividends can be affected
but not without the co-operation of shareholders.

(iv) Need for additional Capital:

The extent to which the profits are ploughed back into the business has got a
considerable influence on the dividend policy. The income may be conserved
for meeting the increased requirements of working capital or future expansion.

(v) Business Cycles:

During the boom, prudent corporate management creates good reserves for
facing the crisis which follows the inflationary period. Higher rates of dividend
are used as a tool for marketing the securities in an otherwise depressed market.
(vi) Changes in Government Policies:
Sometimes government limits the rate of dividend declared by companies in a
particular industry or in all spheres of business activity.

(vii) Trends of profits:

The past trend of the company’s profit should be thoroughly examined to find
out the average earning position of the company. The average earnings should
be subjected to the trends of general economic conditions. If depression is
approaching, only a conservative dividend policy can be regarded as prudent.

(viii) Taxation policy:

Corporate taxes affect dividends directly and indirectly— directly, in as much
as they reduce the residual profits after tax available for shareholders and
indirectly, as the distribution of dividends beyond a certain limit is itself subject
to tax. At present, the amount of dividend declared is tax free in the hands of
shareholders.

(ix) Future Requirements:

Accumulation of profits becomes necessary to provide against contingencies (or
hazards) of the business, to finance future- expansion of the business and to
modernise or replace equipments of the enterprise. The conflicting claims of
dividends and accumulations should be equitably settled by the management.

(x) Cash Balance:

If the working capital of the company is small liberal policy of cash dividend
cannot be adopted. Dividend has to take the form of bonus shares issued to the
members in lieu of cash payment.

What Is a Dividend Policy?

A dividend policy is the policy a company uses to structure its dividend
payout to shareholders. Some researchers suggest the dividend policy is
irrelevant, in theory, because investors can sell a portion of their shares or
portfolio if they need funds.

Scope of dividend policy:

● Dividends are often part of a company's strategy. However, they are

under no obligation to repay shareholders using dividends.
● Stable, constant, and residual are the three types of dividend policy.
● Even though investors know companies are not required to pay dividends,
many consider it a bellwether of that specific company's financial health
Types of Dividend Policies
Stable Dividend Policy
A stable dividend policy is the easiest and most commonly used. The goal of the
policy is a steady and predictable dividend payout each year, which is what
most investors seek. Whether earnings are up or down, investors receive a
dividend.

The goal is to align the dividend policy with the long-term growth of the
company rather than with quarterly earnings volatility. This approach gives the
shareholder more certainty concerning the amount and timing of the dividend.

Constant Dividend Policy

The primary drawback of the stable dividend policy is that investors may not
see a dividend increase in boom years. Under the constant dividend policy, a
company pays a percentage of its earnings as dividends every year. In this way,
investors experience the full volatility of company earnings.

If earnings are up, investors get a larger dividend; if earnings are down,

investors may not receive a dividend. The primary drawback to the method is
the volatility of earnings and dividends. It is difficult to plan financially when
dividend income is highly volatile.

Residual Dividend Policy

Residual dividend policy is also highly volatile, but some investors see it as the
only acceptable dividend policy. With a residual dividend policy, the company
pays out what dividends remain after the company has paid for capital
expenditures (CAPEX) and working capital.

This approach is volatile, but it makes the most sense in terms of business
operations. Investors do not want to invest in a company that justifies its
increased debt with the need to pay dividends.

What Is Earnings Before Interest and Taxes (EBIT)?

Earnings before interest and taxes (EBIT) is an indicator of a company's profitability. EBIT
can be calculated as revenue minus expenses excluding tax and interest. EBIT is also referred
to as operating earnings, operating profit, and profit before interest and taxes.

EBIT (Earnings Before Interest and Taxes)

Formula and Calculation for Earnings Before Interest and Taxes (EBIT)
EBIT = Revenue − COGS − Operating ExpensesOrEBIT = Net Income + Interest + Taxes

where:COGS = Cost of goods sold
The EBIT calculation takes a company's cost of manufacturing including raw materials and
total operating expenses, which include employee wages. These items and then subtracted
from revenue. The steps are outlined below:

1. Take the value for revenue or sales from the top of the income statement.
2. Subtract the cost of goods sold from revenue or sales, which gives you gross profit.
3. Subtract the operating expenses from the gross profit figure to achieve EBIT.

Understanding EBIT
EBIT measures the profit a company generates from its operations making it synonymous
with operating profit. By ignoring taxes and interest expense, EBIT focuses solely on a
company's ability to generate earnings from operations, ignoring variables such as the tax
burden and capital structure. EBIT is an especially useful metric because it helps to identify a
company's ability to generate enough earnings to be profitable, pay down debt, and fund
ongoing operations.

EBIT and Taxes

EBIT is also helpful to investors who are comparing multiple companies with different tax
situations. For example, let's say an investor is thinking of buying stock in a company, EBIT
can help to identify the operating profit of the company without taxes being factored into the
analysis. If the company recently received a tax break or there was a cut in corporate taxes in
the United States, the company's net income or profit would increase.

However, EBIT removes the benefits from the tax cut out of the analysis. EBIT is helpful
when investors are comparing two companies in the same industry but with different tax
rates.

EBIT and Debt

EBIT is helpful in analyzing companies that are in capital-intensive industries, meaning the
companies have a significant amount of fixed assets on their balance sheets. Fixed assets are
physical property, plant, and equipment and are typically financed by debt. For example,
companies in the oil and gas industry are capital-intensive because they have to finance their
drilling equipment and oil rigs.

As a result, capital-intensive industries have high-interest expenses due to a large amount of

debt on their balance sheets. However, the debt, if managed properly, is necessary for the
long-term growth of companies in the industry.

Companies in capital-intensive industries might have more or less debt when compared to
each other. As a result, the companies would have more or fewer interest expenses when
compared to each other. EBIT helps investors to analyze companies' operating performance
and earnings potential while stripping out debt and the resulting interest expense.

Example #1
There is a company, XYZ incorporation, in case of which Sales revenue during the financial

year 2019-20 as per the income statement is $500,000. During the current financial year, the

company’s cost of goods sold is $200,000; operating expense is $100,000, Interest expense is
$25,000, tax expense is $20,000, and the net profit is $155,000. Compute the EBIT of the

company.

Solution:

In this case, EBIT can be computed during two methods as below:

●  First Method (Direct)

Earnings Before Interest and Taxes (EBIT) is calculated as

Earnings Before Interest and Taxes (EBIT) = Revenue During the Period – Cost of The

Goods Sold– Operating Expenses

● Earnings before interest and taxes (EBIT) = $500,000 – $200,000 – $100,000

● Earnings before interest and taxes (EBIT) = $200,000

Particulars 

Sales Revenue

Less: Cost of goods sold

Less: Operating expense

Earnings before interest & taxes [EBIT]

● Second Method (Indirect)

Earnings before interest and taxes (EBIT) is calculated as

Earnings before interest and taxes (EBIT) = Net Profit Earned +interest Expense + Tax

Expenses

 Earnings before interest and taxes (EBIT) = $155,000 + $25,000 + $20,000

● Earnings before interest and taxes (EBIT) = $200,000

Particulars

Net Profit

Add: Interest Expense

Add: Tax Expense

Earnings before interest & taxes [EBIT]

So, the company can calculate the operating profit or EBIT using any of the two methods

given above.

UNIT –IV
What Is Working Capital Management?

Working capital management is a business strategy designed to ensure that a company

operates efficiently by monitoring and using its current assets and liabilities to their most
effective use.

The efficiency of working capital management can be quantified using ratio analysis.

 ● Working capital management requires monitoring a company's assets and liabilities to
maintain sufficient cash flow to meet its short-term operating costs and short-term
debt obligations.
● Working capital management involves tracking various ratios, including the working
capital ratio, the collection ratio, and the inventory ratio.
● Working capital management can improve a company's cash flow management and
earnings quality by using its resources efficiently.
 

Understanding Working Capital Management

The primary purpose of working capital management is to enable the company to maintain
sufficient cash flow to meet its short-term operating costs and short-term debt obligations. A
company's working capital is made up of its current assets minus its current liabilities.

Current assets include anything that can be easily converted into cash within 12 months.
These are the company's highly liquid assets. Some current assets include cash, accounts
receivable, inventory, and short-term investments. Current liabilities are any obligations due
within the following 12 months. These include accruals for operating expenses and current
portions of long-term debt payments.

Working capital management commonly involves monitoring cash flow, current assets, and
current liabilities through ratio analysis of the key elements of working capital, including
the working capital ratio, collection ratio, and inventory turnover ratio.

Why Manage Working Capital?

Working capital management helps maintain the smooth operation of the net operating cycle,
also known as the cash conversion cycle (CCC)—the minimum amount of time required to
convert net current assets and liabilities into cash.

Working capital management can improve a company's cash flow management and earnings
quality through the efficient use of its resources. Management of working capital includes
inventory management as well as management of accounts receivable and accounts payable. 

Working capital management also involves the timing of accounts payable (i.e., paying
suppliers). A company can conserve cash by choosing to stretch the payment of suppliers and
to make the most of available credit or may spend cash by purchasing using cash—these
choices also affect working capital management.

The objectives of working capital management, in addition to ensuring that the company has
enough cash to cover its expenses and debt, are minimizing the cost of money spent on
working capital and maximizing the return on asset investments.
Working Capital Management Ratios
Three ratios that are important in working capital management are the working capital ratio
(or current ratio), the collection ratio, and the inventory turnover ratio.
Current Ratio (Working Capital Ratio)
The working capital ratio or current ratio is calculated as current assets divided by current
liabilities. It is a key indicator of a company's financial health as it demonstrates its ability to
meet its short-term financial obligations.

Although numbers vary by industry, a working capital ratio below 1.0 generally indicates that
a company is having trouble meeting its short-term obligations. That is, the company's debts
due in the upcoming year would not be covered by its liquid assets. In this case, the company
may have to resort to selling off assets, securing long-term debt, or using other financing
options to cover its short-term debt obligations.

Working capital ratios of 1.2 to 2.0 are considered desirable, but a ratio higher than 2.0 may
suggest that the company is not effectively using its assets to increase revenues.1 A high ratio
may indicate that the company is not managing its working capital efficiently.

Collection Ratio (Days Sales Outstanding)

The collection ratio, also known as days sales outstanding (DSO), is a measure of how
efficiently a company manages its accounts receivable. The collection ratio is calculated as
the product of the number of days in an accounting period multiplied by the average amount
of outstanding accounts receivable divided by the total amount of net credit sales during the
accounting period.

The collection ratio calculation provides the average number of days it takes a company to
receive payment after a sales transaction on credit. If a company's billing department is
effective at collections attempts and customers pay their bills on time, the collection ratio will
be lower. The lower a company's collection ratio, the more quickly it turns receivables into
cash.

Inventory Turnover Ratio

Another important element of working capital management is inventory management. To
operate with maximum efficiency and maintain a comfortably high level of working capital, a
company must keep sufficient inventory on hand to meet customers' needs while avoiding
unnecessary inventory that ties up working capital.

Companies typically measure how efficiently that balance is maintained by monitoring the
inventory turnover ratio. The inventory turnover ratio, calculated as cost of goods sold
divided by average balance sheet inventory, reveals how rapidly a company's inventory is
being used in sales and replaced. A relatively low ratio compared to industry peers indicates a
risk that inventory levels are excessively high, while a relatively high ratio may indicate
inadequate inventory levels.

Baumol model

The Baumol model, also known as the Baumol-Allais-Tobin (BAT) model, is a

cash management model.In 1952, William Baumol presented the idea of managing the
surplus of funds through the optimal use of stock supply quantities. He came to the
conclusion that money can also be treated as a specific type of stock, one that is necessary
when doing business. When we talk about cash optimization and their balances, there is a
clear analogy between cash and materials. When we compare cash management and
inventory management, it results from the fact that cash surpluses are kept in enterprises as
securities, most often they are treasury bills. The Baumol model is based on the economic
model of supply size, i.e. Model EOQ (economic order quantity). The main assumptions of
the BAT model include:

● possible to be forecast and fixed for the entire period, the demand for cash,
● constant and predictable inflow of cash,
● fixed interest rate throughout the period when investing in securities,
● rhythmic cash receipts,
● instant cash transfers,

● The task of the Baumol model is to show the bottom margin of security and at the
moment when the current funds approach is approaching this point, then the sale of
Treasury bills or other securities is completed in order to supplement the funds. In the
Baumol model, the optimal cash level is calculated as follows: Insert non-formatted
text here

● C = 2∗T∗FR−−−−−−−−√2∗T∗FR

● Where:
C-optimal cash level
T-demand for cash over the entire period considered (year)
F-fixed costs of cash transfer
R-alternative cost of maintaining cash.

● This formula comes from the fact that if the level of cash is to be optimal, then the
following equality must exist: KA = KT, the alternative cost must equal the
transaction costs. These, in turn, are calculated as follows:

● KA= C∗R2C∗R2
● KT= T∗FCT∗FC

● The Baumol model is used to determine the appropriate level of cash, which will
minimize the total transaction costs and alternative costs as a result of maintaining a
given level of cash.

Definition of Cash Management

Cash management is also known as treasury management, refers to the process of collection,

management, and usage of cash flows for the purpose of maintaining a decent level of

liquidity, and it involves financial instruments such as treasury bills, certificate of deposit,

and money market funds making the same substance for not just individuals but organizations

too.

Explanation:
It is a process in which the cash is collected, disbursed, and invested so that there is

maximum liquidity. It also helps in maximizing profitability by optimizing cash utilization. It

also helps in creating provisions for future contingencies such as economic slowdown, bad

debts, etc.

Types of Cash Management

Following are the types given below:

● Cash Flow from Operating Activities: It is found on an organization’s cash flow

statement, and it does not include cash flow from investing.

● Free Cash Flow to Equity: Free Cash Flow to Equity represents the amount of cash

that is available after the capital is reinvested.

● Free Cash Flow to The Firm: It is used for the purpose of valuation and financial

modeling.

● The Net Change in Cash: It refers to the movement in the total amount of cash flow

from a particular accounting period to another.

Roles and Functions of Cash Management

The roles and functions are explained below-

1. Inventory Management
Cash management helps an organization in managing its inventories. Higher inventory in

hand indicates trapped sales, and this further leads to less liquidity. Therefore, a company

must always focus on fast pacing its stock out for allowing the movement of cash.

2. Receivables Management
A company focuses on raising its invoices so that sales can be boosted. The credit period with

respect to receiving cash might range between a minimum of 30 and a maximum of 90 days.
This means that the organization has recorded all its sales, but the cash with respect to these

transactions has not yet been received.

In such a scenario, cash management’s function will ensure that there is a faster recovery of

all the receivables to avoid a probable cash crunch. It also includes a follow-up mechanism

that ensures there is faster recovery and will also make the company aware of future

contingencies like bad debts, etc.

3. Payables Management
This is also an important function of cash management where the companies can avail

benefits like cash discounts and credit period.

Objectives of Cash Management

The objectives of cash management include fulfilling working capital requirements, handling

unorganized costs, planning capital expenditure, appropriate utilization of funds, planning

capital expenditure, initiating investments, etc. The other objectives of cash management are

maximizing liquidity, regulation of cash flows, maximizing the value of available funds, and

lowering the costs pertaining to funds.