INDERPRASTHA ENGINEERING COLLEGE,

GHAZIABAD
AFFILIATED TO CHAUDHARY CHARAN SINGH UNIVERSITY, MEERUT
(COLLEGE CODE-1249)
63 SITE-IV, SAHIBABAD INDUSTRIAL AREA, SURYA NAGAR FLYOVER ROAD
SAHIBABAD, GHAZIABAD – UP

NOTES – UNIT 4

Subject Name: Financial Accounting and Management

Subject Code: BCA 205
Faculty Name: Ms. Aashi Jain

4.1 INTRODUCTION OF FINANCIAL MANAGEMENT

Finance is the lifeblood of business. It is its very basis. Just as the circulation of blood is
essential in the human body for maintaining life, likewise finance is essential for the smooth
running of the business. Without finance neither any business can be started nor successfully
run. Provisions of the necessary funds at the required time are the key to the success of a
concern. Finance is a pivot around which the whole business operations cluster. Finance is
needed to promote or establish a business, acquire fixed assets, make necessary investigations,
develop products, keep men and machines at work, encourage management to progress, and
create values. Hence, there is an imperative need to manage the finances of a company
efficiently. Efficient and effective management of finance enables the firm to prosper and grow.
It is, therefore, correct to say that without adequate finance no business can survive and without
efficient financial management no business can prosper and grow.

4.2 DEFINITION OF FINANCIAL MANAGEMENT

Financial Management is one of the functional areas of management. It refers to that part of
the management activity which is concerned with the planning and controlling of a firm's

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financial resources. In the present changing scenario of the global business environment, the
finance function has become the most important function of focus by the management

"Financial Management is the application of planning and control functions to the finance
function."
~ Howard and Upton

"Financial Management is the operational activities of a business that is responsible for

obtaining and effectively utilizing the funds necessary for efficient operations."
~ Joseph L. Masse

Thus, we see that financial management is an operational function clothed in a special garment.
It involves financial planning, financial forecasting, and provision of finance as well as the
formulation of financial policies. Hunt, William, and Donaldson have very rightly called it
'Resource Management', because, in a large organisation, the financial manager is the member
of the firm's top management charged with the responsibility of the planning, organising,
performing, and controlling the financial affairs of the enterprise.

4.3 NATURE OF FINANCIAL MANAGEMENT

1. Strategic Planning: Financial management in a broader management context involves

strategic planning to align financial goals with overall organizational objectives. This
includes long-term financial planning, capital budgeting, and evaluating investment
opportunities to support growth and sustainability.
2. Risk Management: Financial management encompasses identifying, assessing, and
managing financial risks that can impact the organization's performance. This includes
market risks, credit risks, operational risks, and regulatory risks. Risk management
strategies aim to mitigate risks while maximizing returns.
3. Capital Structure: Financial management in management involves determining the
optimal capital structure of the organization, and balancing debt and equity financing
to minimize the cost of capital and maximize shareholder value. This includes decisions
on capital raising, dividend policies, and capital allocation.

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 4. Performance Measurement: Financial management evaluates and measures the
organization's financial performance using key performance indicators (KPIs) such as
return on investment (ROI), return on equity (ROE), profitability ratios, and liquidity
ratios. This helps in assessing efficiency, profitability, and financial health.

4.4 OBJECTIVES OF FINANCIAL MANAGEMENT

1. Profit Maximization: One of the primary objectives is to maximize profitability by

optimizing revenue generation, cost management, and efficient resource utilization.
2. Wealth Maximization: Financial management aims to maximize shareholder wealth
by making value-enhancing investment decisions and maintaining a healthy financial
position.
3. Liquidity Management: Ensuring adequate liquidity to meet short-term obligations
while balancing long-term investment needs is another objective of financial
management.
4. Risk Mitigation: Managing financial risks effectively to minimize potential losses and
protect the organization's financial stability is a crucial objective.
5. Compliance and Transparency: Adhering to regulatory requirements, maintaining
transparency in financial reporting, and building trust with stakeholders are essential
objectives.
6. Long-term Sustainability: Financial management focuses on achieving long-term
sustainability by making strategic financial decisions that support growth, innovation,
and competitiveness.

4.5 FINANCE FUNCTIONS OR FINANCIAL DECISIONS

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LONG-TERM DECISIONS
A) Investment Decision
Investment decision refers to evaluating different investment opportunities and choosing the
one most likely to generate the highest returns and meet the investor’s objectives. It involves
analyzing the potential risks and rewards of different investment options and deciding based
on expected return, time horizon, risk tolerance, and liquidity needs. Investment decisions can
be made by individuals, businesses, or financial institutions and may involve investments in
stocks, bonds, real estate, or other financial instruments. Making informed investment
decisions is important for achieving financial goals and building long-term wealth.
The goal of investment decisions is to allocate resources to maximize the return on investment
while minimizing the level of risk. In other words, the aim is to make informed decisions about
where to invest money so that it generates the highest possible return while also considering
the level of risk involved. This requires careful analysis of the factors below, such as:
• Current market conditions
• Potential return on investment
• Level of risk associated with different investment options
The goal is to make investments likely to yield a positive return over time and help investors
achieve their financial goals.

B) Financing Decision
A financing decision determines how an organization will fund its operations and investments.
This decision involves choosing the sources of funds a company will use to finance its
activities, such as debt, equity, or a combination of both. The financing decision is critical to
financial management, affecting the company’s ability to generate profits, expand operations,
and pay off debts. The decision must consider various factors, including the company’s
financial goals, risk tolerance, and cost of capital.
The purpose of financing decisions is to determine how a company will fund its operations and
investments. Financing decisions involve analyzing various funding sources and choosing the
most appropriate mix of debt and equity financing to meet the company’s needs.
Financing decisions aim to ensure a company has access to the capital it needs to operate and
grow. Along with managing the risks associated with different financing options. Companies
must balance the benefits and costs of each financing option. Such as the cost of debt versus
the dilution of equity, and consider factors such as their creditworthiness and market conditions.

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 C) Dividend Decision
Dividend decision refers to how a company’s management team determines the amount and
timing of dividends paid to shareholders. This decision involves considering various factors,
such as the company’s financial performance, cash flow, and growth opportunities. Apart from
this, debt levels and the needs and expectations of shareholders. The goal is to balance
rewarding shareholders with dividends and retaining sufficient funds to reinvest in the
company’s growth and future profitability. Ultimately, the dividend decision is an important
aspect of a company’s financial strategy. It can have significant implications for both the
company and its shareholders.
Dividend decisions aim to determine how much of a company’s profits should be distributed
to shareholders as dividends. Dividend decisions involve a trade-off between retaining earnings
to reinvest in the company and paying out earnings to shareholders. The goal is to balance these
two objectives to maximize the company’s long-term value.
Companies must consider several factors when making dividend decisions. It includes:
• Current financial situation
• Future capital requirements and the expectations of their shareholders. Companies may
pay out dividends regularly, irregularly, or not at all, depending on their circumstances.

SHORT-TERM DECISION
A) Liquidity Decision
Liquidity decision refers to managing a company’s current assets and liabilities. It is done to
ensure sufficient cash or liquid assets to meet its short-term financial obligations. This decision
involves determining the optimal level of liquidity that a company needs to maintain. They
must consider factors such as cash flow, financial risk, and operational needs.
The purpose of liquidity decisions is to ensure that a company has sufficient cash or easily
convertible assets to meet its short-term obligations as they come due. Liquidity decisions
involve managing the company’s current assets and liabilities to maintain a healthy level of
liquidity.
The main goal of a liquidity decision is to ensure that a company has enough liquid assets to
meet its short-term obligations. For example, paying bills, salaries, and other operating
expenses, as they become due. At the same time, the company must also ensure that it does not
hold too much cash or other liquid assets. This can lead to lower returns on investment and
reduce profitability.

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A company may use various tools and techniques to make a liquidity decision. Such as cash
flow forecasting, working capital management, and financial ratio analysis. These methods can
help a company identify potential cash flow gaps or surpluses and adjust its financial position
accordingly.

4.6 MEANING OF CAPITALIZATION

Capitalisation is an important constituent of the financial plan. In common parlance, the term
capitalisation means the total amount of capital employed in a business. However, like the
broader concept of capital, there is no universally accepted definition of capitalisation. Some
authors have given a very broad interpretation to the term while others have taken a narrow
view.

Broad Interpretation
According to this interpretation, the term capitalisation is synonymous with the term financial
planning and includes not merely the determination of the quantity of finance required for a
company but also the decision about the quality of financing. Used in this sense, the term
capitalisation includes:
(i) estimating the total amount of capital to be raised,
(ii) determining the types of securities to be issued for raising such capital, and
(iii) determining the relative proportion of various securities to be issued.

Narrow Interpretation
According to this interpretation, the term capitalisation refers to the process of determining the
quantum of funds required for a firm. As such, the decision regarding the type of securities and
their relative proportion falls under the term 'capital structure". Below are given some
definitions of traditional experts, in this regard.

"Capitalisation comprises of a company's ownership capital which includes capital stock

and surplus in whatever form it may appear and borrowed capital which consists of bonds
or similar evidences of long-term debt."
~ Gerstenberg

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The above narrow view of capitalisation is more popular because of its being very specific in
meaning and it is generally used to mean long-term financial structure which comprises (i) Par
value of share capital, (ii) Reserves and surplus, and (ii) Long-term debts.

Overcapitalization is when a firm has raised capital over a particular limit, which is inherently
unhealthy for the company. As a result, its market value is less than its capitalized worth. In
this case, the company ends up paying more interest and dividends, which is impossible to
sustain in the long term. It simply signifies that the company is not using the funds efficiently
and has poor capital management.
Undercapitalization in terms of business means a scenario where a business faces a shortage
of funds or capital requirements to continue its day-to-day operations. This is prevalent or
generally seen as a problem with small business firms. The business in these moments also
faces the lack of ability to procure any new source of funding or capital.

4.7 MEANING OF CAPITAL STRUCTURE

Capital structure/composition of capital/pattern of securities or the security mix is the second

important aspect of financial planning. Once the financial manager has determined the firm’s
financial requirements (Capitalisation), his next task is to see that these funds are in the firm's
hands. This capital comes in many forms - long and short-term debts, secured and unsecured
debts, preference shares, equity shares, retained earnings, and other things. To decide upon the
ratio of these securities in the total capitalisation is to decide the capital structure. Ordinarily,
it implies the proportion of debt and equity in the total capital of a company.

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"Capital structure is the permanent financing of the firm represented by long-term debts,
preferred stock, and net worth."
~ Weston and Brigham

Net worth is the equity shareholders' interest and includes reserves and surpluses, retained
earnings, and net worth reserves. Thus, the term 'capital structure' denotes the 'financing mix'
or composition of long-term sources of funds, such as debentures, long-term debt, preference
share capital, and ordinary share capital including retained earnings.

The basic patterns of capital structure may take any one of these forms:
(i) equity shares only,
(ii) equity shares and preference shares,
(iii)equity shares and debentures, and
(iv) equity shares, preference shares, and debentures.

There are no hard and fast rules to indicate what pattern would be ideal under what
circumstances and what percentage of capitalisation should be represented by equity shares,
preference shares, or debentures. It may differ from industry to industry, from trade to trade,
from company to company, and so on. But whatever decision is taken in evolving the capital
structure of a company, two basic principles must be observed.
▪ Firstly, the ratio of funded debts to equity should always be geared to the degree of
stability of earnings.
▪ Secondly, the capital structure must be balanced with adequate 'equity cushion' to
absorb the shocks of the business cycle and to afford flexibility.

4.8 DETERMINANTS OF CAPITAL STRUCTURE

1. Nature of Business and Risk Involved - The first determinant of the capital structure
of a company is the nature of the business itself and the risk investment in it. Risk may
be (i) business risk and (ii) financial risk. Business risks are influenced by demand,
price, input costs, fixed costs, business cycles, competition, etc. Financial risks
represent the risks from financial leverage. Businesses having more risks and unstable
income should prefer equity shares. But firms engaged in public utility services or

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 producing the commodity of basic necessity may resort to debentures and preference
shares.
2. Stability of Earnings - Analysis of determinants of capital structure revolves
principally around the adequacy and stability of earnings. Sales stability and debt ratios
are directly related. The volume, stability, and predictability of earnings determine
whether the company can undertake the fixed obligations of interest on debts and
dividends on preference shares, etc. With greater stability in sales and earnings, a firm
can incur the fixed charges of debt with less risk.
3. Amount of Funds Required Initially - Since a considerable amount of risk is involved
in starting a new business, its ideal capital structure is one in which equity share is the
only type of security issued. A new company of large size will have to tap all possible
sources of capital to secure the requisite quantity of funds. The use of a variety of
securities makes it possible to raise larger sums.
4. Rapidity of Growth - The more rapid the expansion, the greater the need to seek all
possible sources of capital. Ordinarily, the rate of expansion of business is the greatest
at the beginning of the firm's life, gradually decreasing as the market's saturation point
is reached.
5. Nature of Investors - Investors are generally of different tastes and economic status.
Modest investors like debentures or preference shares while investors interested in
speculation prefer equity shares. So, a firm will have to use a variety of securities to
appeal to various types of investors.
6. Financial Leverage or Trading on Equity - In planning the capital structure of a
company, leverage is one of the important considerations as it affects EPS considerably.
Companies with high levels of stable earnings (EBIT) can make profitable use of the
high degree of leverage. So, EBIT analysis at different levels of earnings under
alternative methods of financing should be made before making any final decision. So
long as the 'return on investment' (ROI) is more than the cost of borrowings, each rupee
of additional borrowing pushes up the earning per equity share which in turn pushes up
the market value of shares. Hence, the determination of an appropriate debt-equity mix,
where the capital structure would be optimum, is the first obligation of the financial
executive. However, it is not possible to find such a debt-equity mix. Of course, a range
can be determined based on empirical study, within which if the company maintains its
debt-equity mix, the investors will not discount its shares.

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 7. Rate of Return Earned upon Investment- If a business earns a high rate of return it
can finance the expansion by internal sources. If the rate of return is low, it will have to
rely on external sources. Hence, the stability of profit margins is as important as the
stability of sales.
8. Distribution of Voting Control - The desire to retain the voting control of the company
in the hands of a particular limited group may also influence the pattern of capital
structure. In a closely held company, efforts are made to use debentures and non-voting
shares to avoid the sharing of control with others.
9. Trends in Capital Market - Capital market conditions determine not only the types of
securities to be issued but also the rate of interest on debentures, fixed rates of dividends
on preference shares, and the prices of equity shares. When investment funds decline
better yields and protection for preference shares are demanded. When such funds
Increase, preference shares may be sold on terms more favorable to the issuing
company.
10. Cost of Capital and Availability of Funds - The exact form of financing is, at times,
the result of the study of comparative costs of various types of financing about the risk
involved and the availability of various alternative forms of financing. In a certain
situation, debentures may be issued because of their cheapness and availability despite
the danger of fixed obligation.
11. Prevailing Financial Statutes - The government may also influence the scheme of
company finance in more than one way, for example, through regulation and taxation
policies, company law, control of capital issues, etc. This factor is of special
significance in India. High rates of corporation taxes put a premium on debt financing
as compared with equity or preference shares, because while interest on debentures is
allowed as a deduction from taxable income, the payment of dividends is not.
12. Assets Structure - Asset structure also influences the sources of financing in several
ways. Firms with long-lived fixed assets, especially when demand for their output is
relatively assured can use long-term debts. Firms whose assets are mostly receivables
and inventory whose value is dependent on the continued profitability of the individual
firm can rely less on long-term debt financing and more on short-term funds.
13. Attitude of Management - Management varies in skill, judgment, experience,
temperament, and motivation. It evaluates the same risk differently and its willingness
to employ debt finance also differs. The capital structure, therefore, is to a large extent,

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 equally influenced by the age, experience, ambition, confidence, and conservativeness
of the management.
14. Lender's Attitude - Sometimes, the lender's attitude is also an important determinant
of capital structure. In the majority of cases, the firm's management discusses its capital
structure with lenders and gives much weight to their advice. But where management
is confident of the future, it may use leverage beyond norms for the industry.
15. Fiscal Incentives and Tax Concessions - Incentives and tax concessions being
provided by the government to various types of industrial units like the relaxation of
security margin, subsidy by the Government, repayment period extension, exemption
from taxes and duties if application is made for the promotion in backward areas also
affect the capital structure.
16. Advice given by Financing Agencies - Such agencies are specialized in tendering
expert financial advice concerning the capital structure of a firm. Their advice should
be given due weight in the financial plan of the concern.

4.9 PATTERNS OF CAPITAL STRUCTURE

There can be no ideal pattern of capital structure for all companies even in the same industry
or belonging to the same region. Different factors play different roles at different times in the
determination of capital structure. However, these factors assist the management in developing
a sound and optimum capital structure However, in the case of a new company, the capital
structure may be of any of the following four patterns:
❖ Only Equity shares.
❖ Equity Shares + Preference Shares
❖ Equity Shares + Debentures
❖ Equity Shares + Preference Shares + Debentures.

In an existing company, reserves and surpluses can also constitute an important segment of its
capital structure. Preference shares and debentures both are fixed cost-bearing securities for the
company as it has to pay a fixed rate of dividend or interest, as the case may be. On the other
hand, equity shares are treated as variable cost-bearing securities as the company will pay
dividends on them only in case of adequate earnings, subject to Board of Directors discretion.
Raising funds through debt is cheaper as compared to raising funds through shares. This is

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because interest on debt is allowed as an expense for tax purposes. On the other hand, the
dividend is considered to be an appropriation of profits. Hence, payment of dividends does not
result in any tax benefit to the company A judicious mix of securities in the proposed capital
structure helps the financial manager.

"The need for permanent investment in current assets makes long-term financing desirable
for reasons of safety whether or not such financing shall be bonded should depend on
probable earnings stability rather than the probable life of the assets Long physical life does
not ensure either stable capital value or a steady income flow suitable for long-term
financing involving fixed charges.
~ Guthmann & Dougall

4.10 OPTIMAL (OR BALANCED) CAPITAL STRUCTURE

In evolving a sound capital structure of a company, the goal of the management should be an
optimal capital structure. An optimal or sound capital structure can be properly defined as that
combination of debts and equity that attains the stated marginal goal in the most relevant
manner the maximisation of the firm's market value. Moreover, the optimal capital structure is
also defined as that combination of debt and equity that minimises the firm's cost of capital.

"An optimum capital structure can be properly defined as that security mix that minimises
the firm's cost of capital and maximises the firm's value."
~ E.W. Walker

The use of debt funds in capital structure reduces the overall cost of capital and increases EPS
as the interest on debt is tax deductible, which leads to an increase in share price. However
excessive debt funds result in greater financial risk which leads to higher cost of capital and
depress the market price of the company's share. Hence, the firm should try to achieve and
maintain optimum capital structure, keeping in view the value maximization objective of the
firm. This requires a trade-off between financial risk and non-employment of debt capital
(NEDC) risk. Considerations: The following considerations will greatly help the finance
manager in achieving the goal of optimum capital structure:

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 1) If the return on investment is higher than the fixed cost of funds (ie., interest and
preference dividend), the company should prefer to raise funds having a fixed cost to
increase the return of equity shareholders. This is known as taking advantage of
favorable financial leverage.
2) The company should take advantage of the leverage offered by the high corporate taxes.
The higher cost of equity financing can be avoided by using debt as a source of finance
as interest on debt is an allowable deduction in the computation of taxable income.
3) The company should avoid a perceived high-risk capital structure because excessive
debt financing reduces the market price of equity shares. Hence, the use of debt should
be within the capacity of the company. The company should be in a position to meet its
obligations in paying the loan and interest charges as and when due.
4) The company should involve minimum possible risk of loss of control.
5) The capital structure should be flexible.

4.11 OBJECTIVES OF OPTIMAL CAPITAL STRUCTURE

The decision relating to capital structure is an important one. Whenever the management of a
concern develops the capital structure of its newly promoted organisation or revises an existing
capital structure of an existing company, its main aim is to balance it. The main objectives of
management in devising a sound and balanced capital structure are as follows:

1. Minimisation of Capital Costs - One of the major objectives of a business enterprise

is to raise capital at the lowest possible capital cost under a given set of circumstances
in terms of interest and dividend and the relationship of earnings to the prices of shares.
The management aims to keep the cost of capital at a minimum as saving in such costs
maximises the returns to the equity shareholders.
2. Minimisation of Risks - Business operations are constantly subject to various - risks,
which have a direct bearing on the capital structure of the firm. These various risks are
-business risks, poor management risks, cycle risks, purchasing power risks, interest
rate risks, tax risks, and so on. Prudent management tries to minimise all such risks by
making suitable adjustments in the various components of capital structure. The
management tries to balance the sound financial position and the goal of liquidity at the
same time.

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 3. Maximisation of Return - The third main aim of management is to provide the
maximum earnings or return to the real owners of the business, ie., equity- shareholders.
The earnings of the enterprise should permit the maximum possible return to equity
shareholders. It necessitates stability as well as regularity in the earnings.
4. Preservation of Control - One of the main aims of designing a sound capital structure
is to preserve the control of the firm. The capital structure should be so designed as to
prevent the erosion of control from the hands of equity shareholders. It must ensure
Capita maximum control in its hands. This requires that a proper balance is to be
maintained between the voting right and non-voting right capital.

4.12 CHARACTERISTICS OF OPTIMAL CAPITAL STRUCTURE

1. A Conservative Capital Structure - An attempt should be made to secure as far as

possible a conservative capital structure consisting of high-grade securities. In doing
so, management should decide on the form of securities to be issued only after a
thorough consideration of the possible effect of the proposed securities on the firm, its
credit, value of other securities, issue of securities in the future, maintenance of profits
and future rearrangement of its financial structure, etc. Such capital structure offers
certain decisive advantages to the company, namely, the company's cost of financing is
the least, its prospects for raising capital even in unfavorable times are good and it can
maintain healthy relations with security holders.
2. A Simple Capital Structure - As far as possible, a simple capital structure should be
preferred to a complicated one. It is easy to manage it. The investors have a very clear
picture of their rights and the worth of their investment.
3. Higher Return - The capital structure of the company should be most advantageous. It
should generate maximum returns to the shareholders without adding additional cost to
them.
4. Minimum Fixed Cost Burden - As far as possible, the fixed cost burden on the income
statement of the firm must be low. To achieve this aim, a proper policy of equity trading
should be followed.
5. Safety of Control - Adequate safeguards should be taken to see that despite the issue
of new securities in the future, the control over the management is retained.

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 6. Economy - Securities should be issued in such a manner as to entail the least cost of
sale, cost of financing, and so on. Generally, the cost is the lowest in the case of
debentures, and the highest in the case of equity shares.
7. Attractive for Investors - Various securities proposed to be issued should offer certain
attractions to the investors either relating to income, control, convertibility, etc.
8. Flexibility - As much flexibility as possible should be secured in the capital structure
Equity shares score over preference shares, for there is greater leeway in the payment
of dividends on equity shares. Similarly, preference shares are preferred to debentures
because the failure to pay dividends thereon is not so serious as the failure to pay interest
on debentures.
9. A Balanced Leverage - As far as possible, the necessary funds should be raised by an
increase both in the claims of owners and those of creditors. A guiding principle should
be observed to secure a balanced leverage. Normally, it is more profitable to sell
debentures when the rates of interest are low and to sell shares when rates of
capitalisation are high.

4.13 READJUSTMENTS IN CAPITAL STRUCTURE

The capitalisation of a corporation is subject to frequent adjustments, changes, or revisions. As

it has been said, the changes in capital structure may be sought as a means of easing tension
and the giving corporation a better opportunity to pursue its purposes. The following are the
main reasons for adjustments in capital structures

1. To Simplify the Capital Structure: If various issues of securities have been made at
different times and may have loaded the firm with tough terms and conditions of
financing So, to simplify the capital structure, its revision may be a necessity.
2. To Capitalize the Retained Earnings: If the corporation is using cost-free reserves
and surpluses and it has resulted in capitalisation, the management may take steps to
make them a part of equity share capital.
3. To Reduce the Cost Burden: If the corporation has become heavy with fixed cost-
bearing securities resulting in a great strain on the finances of the company. The
management may think it fit to redeem such debentures and preference shares and issue

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 the equity shares in place of them. Such rearrangement can reduce the fixed obligations
and make the capital structure more serviceable.
4. Making the Shares More Attractive: The split of shares may sometimes, take place
to make them more attractive Investors prefer to purchase 100 shares of Rs. 10 each
rather than I share of Rs 1,000 each, though the amount of investment is the same.
5. To Extinguish Deficit Balance of Balance Sheet: Often, the changes in capital
structure may be sought as a means to extinguish the deficit balances against share
capital. It may require a reduction in the value of shares or any other arrangement.
6. To Meet Certain Legal Requirements: Sometimes, due to changes in financial
statutes or the Companies Act, the management may be compelled to make changes in
capital structures For example, in India when deferred shares were abolished by the
Companies Act, 1956, the companies changed their capital structure and deferred shares
were generally converted into equity shares.
7. To Facilitate Mergers and Integrations: Before going to the actual merger, the
different intending corporations may be required to make certain adjustments in their
capital structure to pave the way for merger or integration.

The changes in capital structure may be either voluntary or compulsory. They may be made
either by recapitalisation or readjustment in the capital structure. Readjustment is considered
to be a major change in the composition of the financial plan whereas recapitalisation is
interpreted as a single amendment of the original plan such as changing the amount of started
capitalisation.

4.14 DIFFERENCE BETWEEN CAPITALISATION AND CAPITAL

STRUCTURE

BASIS Capitalization Capital Structure

Definition Capitalization refers to the total Capital structure refers to the
value of a company's equity and composition of a company's capital,
debt, representing the total funds indicating the proportion of debt and
raised by the company. equity used to finance its operations.
Components It includes both equity capital It comprises the debt-to-equity ratio,
(common stock, preferred stock, the mix of debt and equity financing,

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 retained earnings) and debt capital and the proportion of each
(bonds, loans, mortgages). component in the company's total
capital.
Purpose Capitalization indicates the overall Capital structure shows how a
size and market value of the company chooses to finance its
company based on the total funds assets and operations, impacting its
invested in it. risk profile, cost of capital, and
financial flexibility.
Calculation Capitalization is calculated as Capital structure is calculated as
Total Equity + Total Debt. Debt / (Debt + Equity).
Influence on Capitalization affects the market Capital structure influences the
Value perception of the company's size, company's risk exposure, ability to
value, and potential for growth. raise funds, and cost of borrowing.
Long-term vs Capitalization is a long-term Capital structure can change over
Short-term concept, that reflects the time based on financial decisions,
company's overall financial health. economic conditions, and business
strategies.

4.15 CONCEPT OF COST OF CAPITAL

The cost of capital is a concept having manifold meanings. In operational terms, the cost of
capital is the rate of return a firm must earn on its investments so that the market value of the
firm remains unchanged. Thus, it is a yardstick or basis for approval or rejection of an
investment. In this way, it becomes a target rate of return, cut-off rate hurdle rate, or the
financial standard of assessment of the performance of a project.

"The cost of capital is the minimum rate of return which a firm requires as a condition for
undertaking an investment."
~ Milton H. Spencer

The concept of cost of capital can also be expressed in terms of the opportunity cost of capital.
In this sense cost of capital is the rate of return on the best alternative investment opportunities
available to a firm. In other words, it is the rate of return, which a concern can earn by investing

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its surplus funds outside the business. It is a sacrificed alternative return. In this sense, the cost
of capital may be termed as the lending rate.
The cost of capital is also viewed as a borrowing rate. According to this concept, the cost of
capital is the cost of acquiring the funds required to finance the proposed investment project.
Thus, the cost of capital is the ratio between the net proceeds of a source of capital and the
liability imposed upon the firm because of it.
For example, if Modi company takes a loan of Rs. 3,00,000 at an annual interest rate of 12%,
for which it incurs an expenditure of Rs. 60,000. In this case, the annual interest burden of Rs.
36,000 the company must be treated on Rs. 3,00,000 – Rs. 2,40,000 = Rs. 60,000 and not on
Rs 3,00,000. Rs. 2,40,000 is the net proceeds to the company and the ratio of interest to these
net proceeds (i.e., 36,000/2,40,000*100=15%) is the true cost of this borrowing.
In simple words, the cost of capital may be treated as the net borrowing rate. This concept of
cost of capital is relevant for investment decisions. Hence, in capital expenditure decisions,
earnings from investments should be discounted at a higher borrowing rate and lending rate.

Assumptions
The theory of cost of capital is based on certain assumptions which are as follows:
o The firm's business and financial risks are unaffected by the acceptance and financing
of projects. Business risk measures the variability in operating profits (EBIT) due to
changes in sales. The financial risk is determined by financial decisions, i.e., the
proportion of long-term debt to the capital structure of the firm. In the analysis of the
cost of capital, it will be assumed that the financial structure of the firm will remain
fixed.
o The benefits from undertaking a proposed project are evaluated on an after-tax basis.

4.16 IMPORTANCE OF THE CONCEPT OF COST OF CAPITAL

Cost of capital is a very important factor in financial decisions. It is relevant for capital
budgeting decisions as well as capital structure planning. Without ascertaining the cost of
capital, no logical decision can be taken on capital investment projects. The importance of this
concept to modern management is summarised as follows:
1. Designing the Optimal Capital Structure: This concept is very helpful in designing
a sound, optimal, and economical capital structure for the firm. Each source of capital

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 involves different costs and different risks. By comparing various relevant specific costs
of different sources, a finance executive can select the best and the most economical
source of finance and can design a sound and viable capital structure to maximize the
owner's wealth.
2. Assisting in Investment Decisions: The cost of capital constitutes an integral part of
investment decisions and provides a valuable yardstick to measure the relative worth of
investment proposals. In the case of the N.P.V. method and profitability index method,
the cost of capital is used to discount the future cash flows. In the case of the T.A.R.
method, the ascertained T.A.R. is compared with the cost of capital. An investment
proposal is approved only when its profitability is more than the cost of funds to be
raised to finance the project.
3. Helpful in the Evaluation of Expansion Projects: It helps in the evaluation of the
financial soundness of a given expansion project. An expansion project will be accepted
by the management only when the marginal return on investment exceeds the cost of
its financing.
4. Rational Allocation of National Resources: The concept of cost of capital is important
for the national economy as well since it provides the basis for the optimum allocation
of financial resources.
5. Evaluation of Financial Performance of Top Management: The cost of capital
framework can be used to evaluate the financial performance of top management Such
an evaluation will involve a comparison of the actual profitability of the projects
undertaken with the projected overall cost of capital, and an appraisal of the actual costs
incurred in raising the required funds.
6. Basis of other Financial Decisions: This concept is useful in other areas of financial
decision-making, such as dividend decisions, decisions on capitalization profits and
rights issues, working capital management capital expenditure of control, etc. While
considering the merger or amalgamation proposals, it may be a fruitful starting point to
investigate the firm's cost of capital and its earnings trends to derive an indicative value
of the firm.

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4.17 DIFFERENCE BETWEEN EXPLICIT COST AND IMPLICIT COST

BASIS Explicit Cost Implicit Cost

Definition Costs that involve direct Costs that represent opportunity
monetary payment and are easily costs or foregone benefits, do not
measurable and accounted for. involve a direct monetary
payment.
Nature Tangible and quantifiable Intangible and non-monetary
expenses incurred in business costs are associated with choices
operations. or resources.
Calculation Explicit costs are calculated as Implicit costs are calculated as the
the actual outlay of money or value of benefits or opportunities
payment made for goods, sacrificed due to a decision or
services, or resources. action.
Examples - Wages and salaries paid to - Time spent by business owners
employees- Rent for office on self-employed tasks- The
space- Raw materials purchased opportunity cost of using owned
for production resources instead of leasing-
Foregone interest on funds used
for business purposes
Measurability Explicit costs are easily Implicit costs are harder to
measurable and recorded in measure as they involve
financial statements and subjective assessments of
accounting records. alternative uses or opportunities.
Impact on Explicit costs directly impact Implicit costs influence decision-
Decision-Making profitability and budgeting making by considering the full
decisions, influencing pricing economic impact, including
strategies and resource opportunity costs, on long-term
allocation. goals and resource utilization.
Accounting Explicit costs are included in Implicit costs are not recorded in
Treatment financial statements as expenses financial statements but are
and deducted from revenues to considered in economic analysis
calculate net income. and decision-making processes.

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4.18 MEASUREMENT OR COMPONENTS OF COST OF CAPITAL

A company receives capital from different sources and the cost of each source differs from the
other because the cost of issue of raising capital from different sources, interest payable (or
dividend payable), and degree of corporate tax burden differ. Hence, to find out the cost of
capital of a company, the first step is the calculation of the cost of individual sources of funds
(i.e., specific costs) and thereafter weighted average cost of proceeds from different sources of
capital is ascertained. This is known as the company's cost of capital. The different components
of a company's capital structure are as follows:
✓ Debt or Borrowings
✓ Preference Share Capital
✓ Equity Share Capital
✓ Retained Earnings
✓ Depreciation Funds
✓ Short-term Credit

COST OF DEBT

A company obtains debts generally by issue of debentures. Usually rate of interest payable on
debentures is treated as its cost but it is not correct. The amount of interest payment should be
matched with the net cash proceeds (i.e., Issue Price - Floatation Costs) of the debt. As the
interest payments made by the firm on debt issues qualify for tax deduction in determining the
net taxable income, the effective cash outflows are less than the actual payment of interest
made by the firm to the debt holder by the amount of tax shield on interest payment.
The type of debt capital, terms of issue, and floatation cost affect the computation of the cost
of this capital. Debt capital is of two types:
A. Perpetual or Irredeemable Debt
B. Redeemable Debt.

A. Perpetual or Irredeemable Debt: These are the debts that are repayable only on the
liquidation of the company. For calculating the cost of this type of debt-capital, the amount of
interest payable on it is divided by the net proceeds from its issue. The formula is:

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where i = Amount of Annual Interest
NP = Net Proceeds

Net proceeds of debt imply the par value of debt plus premium on the issue minus its charges
etc.) and issue discount. For example, a company issues 10% debentures of Rs. 10,000 at par
and expenses of issue are 4%. In this example, net proceeds from the issue of debentures are
Rs. 10,000 – Rs. 400 = Rs 9,600 and interest payable is Rs. 1,000 per annum. In this case, the
cost of debentures will be calculated as follows:

Note: If NP is not given, market price (MP) may be used for this purpose.

B. Redeemable Debt: Irredeemable debts are not found in practice. Most debentures are
repayable within a stipulated period. In the calculation, the cost of such debts and, the period
of their redemption are very important. The excess amount payable on maturity of debentures
over their net proceeds is a loss to the company and is assumed to be written off equally during
their lifetime. This write-off affects the amounts of annual charges and average revenue.
Assume that in the above example, the debentures are redeemable after ten years. In this case,
net proceeds are Rs. 9,600 whereas the amount payable after 10 years on maturity is Rs. 10,000.
Hence, the company will write off this loss of Rs. 400 equally in ten years at the rate of Rs. 40
per annum. In this way, the annual charge on debentures will be 1,000 + 40 = Rs. 1,040 but out
of it, only Rs. 1,000 will be paid by the company each year in the form of interest. Hence, the
cash funds of the company will increase each year by Rs. 40 which will be available for use by
the company. Thus, the average amount of proceeds from debentures will be (9, 600 +
10,000)/2 = Rs, 9, 800, and the cost of debentures will be calculated on this very amount.

In the above example, cost of debentures = 1,040/9,800 * 100 = 10.61%

Based on the above discussion, the formula for calculating the cost of debenture capital can be
adapted as follows:

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Important Notes:
1. In the above example, we have assumed the debentures to have been issued at par and
also redeemed at par but in practice, debentures may be issued at a discount or premium
and these can be redeemed at a premium too. In such cases also, the same formula is
applicable but maturity value and net proceeds will be adjusted accordingly.
2. Since interest payable on debt finance is an admissible deduction in computing the
taxable income of a business unit, it provides a tax shield to the concern in the ratio of
its applicable tax rate. Hence, the cost of irredeemable and redeemable debt-capital
calculated by the above formula is before tax.
3. Since interest qualifies for tax deduction in determining net taxable income, the
effective cash outflows are less than the actual payment of interest made by the firm to
the debt holder by the amount of tax shield on interest payment and hence, in the above
formulae for calculating after-tax cost of debt capital, the amount of interest is to be
adjusted as follows:

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