LONG-TERM FINANCING DECISIONS

SOURCES OF FUNDS

Depending Sources of funds required, the finance may be of the following types:

1) Short-term Finance: The finance acquired for a category. This period of one year or
slightly more, falls under this finance. It is needed for: also called as working capital

i) Fulfilling daily expenses, like payment of wages and salaries to workers or employees,
Purchase of raw-material,

iii) Meeting tax liabilities arising out of the process of conversion of raw-material into finished
goods, etc.

2) Medium-term Finance: Working capital finance acquired for a period beyond one year is
known as medium-term finance. Generally, this finance is used to purchase the assets with a
medium term life, e.g., plant and machinery. The medium-term finance is raised through:

i) Debenture issue,

ii) Borrowing from Commercial Banks or

Financial Institutions,

iii) Acceptance of public deposit, etc.

Medium-Term Finance is raised for a period between 1 year and 5 years.

3) Long-term Finance: Long-Term Finance is the backbone for the financial strength of a
business entity (firm or company). In general, the financial requirements of more than 5 years are
considered as the long-term finance. The long-term funds are required to purchase fixed assets
such as land and building, plant and machinery, furniture and fixture, etc. As the funds required
for investment in these assets, which are permanent in nature, are for a long period, their
'repayment-schedule' is also set accordingly for a long period.

Short term Sources

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Trade credit

 Trade credit is a type of commercial financing in which a customer is allowed to purchase

goods or services and pay the supplier at a later scheduled date.
 Trade credit can be a good way for businesses to free up cash flow and finance short-term
growth.
 Trade credit can create complexity for financial accounting depending on the accounting
method used.
 Trade credit financing is usually encouraged globally by regulators and can create
opportunities for new financial technology (fin-tech) solutions.
 Suppliers are usually at a disadvantage with a trade credit, as they have sold goods but not
received payment.

Commercial paper

 Commercial paper is a form of unsecured, short-term debt.

 It's commonly issued by companies to finance their payrolls, payables, inventories, and
other short-term liabilities.
 Maturities on commercial paper range from one to 270 days, with an average of around
30 days.
 Commercial paper is issued at a discount and matures at its face value.
 The minimum denomination of commercial paper is $100,000 and it pays a fixed rate of
interest that fluctuates with the market.

Types of Commercial Paper

Promissory Notes
Promissory notes are written promises to pay a specific amount of money on a certain date.
They are used by companies to borrow funds without having to use any collateral, and
promissory notes can range from just a few days to up to a year.

Drafts
Drafts are orders written by one party (the drawer) directing another party (the drawee) to pay a
specified sum to a third party (the payee). The drawee is usually a bank. As commercial paper,
drafts can be used in trade financing to facilitate the purchase of goods and services.

Bankers' Acceptances
Bankers' acceptances are time drafts that have been accepted and guaranteed by a bank. They
are commonly used in international trade to ensure payment to exporters. The bank's acceptance
of the draft means that the bank promises to pay the face value of the draft at maturity (which
gives certain parties a level of security).

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Repurchase Agreements (Repos)

Repos are agreements in which one party sells securities to another with a promise to
repurchase them at a specified price on a future date. Although repos are secured by the
underlying securities, they are frequently used as a form of short-term borrowing in the money
markets. Because a repo transaction includes the initial sale and the repurchase agreement, it
acts as a short-term loan.

Letter of credit

 A letter of credit is a document sent from a bank or financial institution that guarantees that
a seller will receive a buyer’s payment on time and for the full amount.
 Letters of credit are often used within the international trade industry.
 There are many different letters of credit, including one called a revolving letter of credit.
 Banks collect a fee for issuing a letter of credit.

Bank Finance

Bank Finance: For business organisations, borrowing from banks is a common and important
source of funds, not only for short-term working capital finance but also for medium-term. In
our country, working capital needs of business entities are generally met through Trade Credit'
arrangement followed by 'Institutional Finance' provided by banks. Banks have a methodology
to assess the working capital requirement of borrowers; the amount so approved is called 'credit
limit'. The 'credit limit' represents the maximum funds, which can be availed by the borrower
from the entire banking system.

For the borrowers engaged in seasonal activities, banks assess separate credit limits for 'peak
season' and 'non-peak season' and borrowers are expected to avail the limits mentioned under
'peak level' and 'non-peak level' respectively.

Accrued expenses and deferred income

Accrued expenses are the expenses, which have already been incurred by the organization but
the payment thereof has not become due and not yet made. Such accruals are liabilities of an
organization, as they represent the goods and services already received and payment of which
would be made in due course. Some examples of accrued expenses or liabilities are salaries,
wages, interest, taxes, etc., which become payable only on their becoming due (at week-end,
month-end, quarter-end or year end, as the case may be). At the time of finalisation of balance
sheet, such items are shown as liabilities (accrued but not due) of the organisation. The biggest
advantage of this type of short-term finance is that it is spontaneous and interest-free.

Those incomes which are received in advance by. the company for the supply of goods or
services in the future period are known as deferred incomes.

These incomes increase the flow of liquidity of the company. This income is also, like accrued
expenses, a liability for the organization and a source of indirect short-term finance.

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Until the goods are supplied to the custom payments are not shown as income but showed in
the balance sheet as income received in advance.

Such type of short-term finance can be availed only by the organisations having:

i) Monopoly in the market,

ii) Great demand for its products/services, and

iii) Unique products on a special order.

Certificate of deposits (CD’s)

A certificate of deposit (CD) is a type of savings account that pays a fixed interest rate on
money held for an agreed-upon period of time. CD rates are usually higher than savings
accounts, but you lose withdrawal flexibility. If you withdraw your CD funds early, you'll be
charged a penalty. CDs come in a variety of terms from 3-, 6-, or 12-months to 4-, 5-, and even
10-year terms.

Installment Credit

Installment credit, also known as an installment loan, is a contract or agreement that allows a
borrower to receive a lump sum of money from a lender and pay it back over time in fixed
amounts, or installments. The borrower knows how much each installment will be and how many
they will need to make upfront. Installment loans can be used for a variety of purposes, or for
specific financial goals like buying a house or paying for college.

Factoring

What Is a Factor?

A factor is an intermediary agent that provides cash or financing to companies by purchasing

their accounts receivables. In short, a factor is a funding source; the factor agrees to pay the
company the value of an invoice—less a discount for commission and fees.

Factoring can help companies improve their short-term cash needs by selling their receivables
in return for an injection of cash from the factoring company. The practice is also known as
factoring, factoring finance, and accounts receivable financing.

 A factor is a funding source; it agrees to pay a company the value of an invoice—less a

discount for commission and fees.
 The terms and conditions set by a factor may vary depending on its internal practices.
 The factor is more concerned with the creditworthiness of the invoiced party than the
company from which it has purchased the receivable.

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Bill discounting

Bill Discounting is short-term finance for traders wherein they can sell unpaid invoices, due on a
future date, to financial institutions in lieu of a commission. The Bank purchases the bill
(Promissory Note) before its due date and credits the bill's value after a discount charge to the
customer's account.

LONG TERM SOURCES

LONG TERM SOURCES

EQUITY SHARES PREFERENCE SHARES

DEBENTURES TERM LOANS

LEASE FINANCING VENTURE CAPITAL

Equity shares

An equity share, normally known as ordinary share is a part ownership where each member is a
fractional owner and initiates the maximum entrepreneurial liability related to a trading concern.
These types of shareholders in any organization possess the right to vote.

Features of Equity Shares Capital

 Equity share capital remains with the company. It is given back only when the company
is closed.
 Equity Shareholders possess voting rights and select the company’s management.
 The dividend rate on the equity capital relies upon the obtainability of the surfeit capital.
However, there is no fixed rate of dividend on the equity capital.

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Types of Equity Share

 Authorized Share Capital- This amount is the highest amount an organization can issue.
This amount can be changed time as per the companies recommendation and with the
help of few formalities.
 Issued Share Capital- This is the approved capital which an organization gives to the
investors.
 Subscribed Share Capital- This is a portion of the issued capital which an investor
accepts and agrees upon.
 Paid up Capital- this is a section of the subscribed capital, that the investors give. Paid-
up capital is the money that an organization really invests in the company’s operation.
 Right Share- These is that type of share that an organization issue to their existing
stockholders. This type of share is issued by the company to preserve the proprietary
rights of old investors.
 Bonus Share- When a business split the stock to its stockholders in the dividend form,
we call it a bonus share.
 Sweat Equity Share- This type of share is allocated only to the outstanding workers or
executives of an organization for their excellent work on providing intellectual property
rights to an organization.

Merits of Equity Shares Capital

 ES (equity shares) does not create a sense of obligation and accountability to pay a rate of
dividend that is fixed
 ES can be circulated even without establishing any extra charges over the assets of an
enterprise
 It is a perpetual source of funding, and the enterprise has to pay back; exceptional case –
under liquidation
 Equity shareholders are the authentic owners of the enterprise who possess the voting
rights

Demerits of Equity Shares Capital

 The enterprise cannot take either the credit or an advantage if trading on equity when
only equity shares are issued
 There is a risk, or a liability overcapitalization as equity capital cannot be reclaimed
 The management can face hindrances by the equity shareholders by guidance and
systematizing themselves
 When the firm earns more profits, then, higher dividends have to be paid which leads to
raising in the value of the shares in the marketplace and its edges to speculation as well

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Preference Shares

Preference Share Meaning

Preference shares, also known as preferred stock, are an exclusive share option which enables
shareholders to receive dividends announced by the company before the equity shareholders.

Preference shares provide the shareholders with the special right to claim dividends during the
company lifetime, and also with the option to claim repayment of capital, in case of the wind up
of the company.

It is considered as a hybrid security option as it represents the characteristics of both debt and
equity investments.

The capital raised by issuing preference shares is known as preference share capital and
preference shareholders can be regarded as owners of the company. They however do not enjoy
any kind of voting rights, unlike equity shareholders.

Features of Preference Shares

The following are the features of preference shares:

1. Preferential dividend option for shareholders.

2. Preference shareholders do not have the right to vote.
3. Shareholders have a right to claim the assets in case of a wind up of the company.
4. Fixed dividend payout for shareholders, irrespective of profit earned.
5. Acts as a source of hybrid financing.

Types of Preference Shares

The various types of preference share are discussed below:

1. Cumulative preference share: Cumulative preference shares are a special type of shares
that entitles the shareholders to enjoy cumulative dividend payout at times when a
company is not making profits. These dividends will be counted as arrears in years when
the company is not earning profit and will be paid on a cumulative basis, the next year
when the business generates profits.
2. Non-cumulative preference shares: These types of shares do not accumulate dividends
in the form of arrears. In the case of non-cumulative preference shares, the dividend
payout takes place from the profits made by the company in the current year. If there is a

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year in which the company doesn’t make any profit, then the shareholders are not paid
any dividends for that year and they cannot claim for dividends in any future profit year.
3. Participating preference shares: These types of shares allow the shareholders to
demand a part in the surplus profit of the company at the event of liquidation of the
company after the dividends have been paid to the other shareholders. In other words,
these shareholders enjoy fixed dividends and also share a part of the surplus profit of the
company along with equity shareholders.
4. Non-participating preference shares: These shares do not yield the shareholders the
additional option of earning dividends from the surplus profits earned by the company. In
this case, the shareholders receive only the fixed dividend.
5. Redeemable Preference Shares: Redeemable preference shares are shares that can be
repurchased or redeemed by the issuing company at a fixed rate and date. These types of
shares help the company by providing a cushion during times of inflation.
6. Non-redeemable Preference Shares: Non-redeemable preference shares are those
shares that cannot be redeemed during the entire lifetime of the company. In other words,
these shares can only be redeemed at the time of winding up of the company.
7. Convertible Preference Shares: Convertible preference shares are a type of shares that
enables the shareholders to convert their preference shares into equity shares at a fixed
rate, after the expiry of a specified period as mentioned in the memorandum.
8. Non-convertible Preference Shares: These types of preference shares cannot be
converted into equity shares. These shares will only get fixed dividend payout and also
enjoy preferential dividend payout during the dissolution of a company.

Differences between Equity Share Capital and Preference Share Capital

Preference Share Capital Equity Share Capital

Definition
Preference Share Capital is the funds that a company has Equity Share Capital is the funds that a
generated by issuing preference shares. company has generated by issuing Equity
shares.
Dividend Rate
The Dividend Rate in the case of Preference Share Capital is The Dividend Rate is changeable or
not changeable. fluctuating in the case of Equity Share
Capital.
Voting Rights
Preference Shareholders do not have any voting rights in the Equity Shareholders have voting rights in
selection of the management. the selection of the management.

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Participation in Management
Preference Shareholders do not have the right to participate Equity Shareholders holders have the
in the management decisions. right to participate in the management
decisions.
Claim to assets of the company
Preference Shareholders have a right to claim over the Equity Shareholders do not have any
company’s assets whenever they decide to wind up their right to claim their assets whenever they
operations. decide to wind up their operations.
Preference in paying dividend
Preference shareholders get the first preference when the Equity shareholders get second
company pays a dividend. preference when the company pays a
dividend.
Types of Shares
The different types of Preference Shares are as follows: The different types of Equity Shares are
as follows:
 Cumulative Preference Shares
 Participating Preference Shares  Authorised Share Capital
 Redeemable Preference Shares  Issued Share Capital
 Convertible Preference Shares  Subscribed Share Capital
 Non-Cumulative Preference Shares  Paid-up Share Capital
 Non-Participating Preference Shares  Rights Share
 Non-Redeemable Preference Shares  Bonus Share
 Non-Convertible Preference Shares  Sweat Equity Share

Arrears of Dividend
Preference Shareholders are eligible to get arrears of unpaid Equity Shareholders are not eligible to
dividends from previous years. They can get it along with get arrears of unpaid dividends from
the dividend of the current year, except for non-cumulative previous years.
preference shares.
Convertibility
Preference Shares are eligible to get converted into Equity Equity Shares can never be eligible to get
Shares. converted into Preference Shares.

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Risk
Preference Shareholders are at a lower risk compared to Equity Shareholders are at a higher risk
Equity Shareholders. compared to Preference Shareholders.

Debentures

Meaning of Debentures:

The term ‘debenture’ is derived from the Latin word ‘debere’ which refers to borrow. A
debenture is a written tool accepting a debt under the general authentication of the enterprise. It
comprises of an agreement for repayment of principal after a particular period or at intermissions
or at the option of the enterprise and for payment of interest at a fixed rate due to, usually either
yearly or half-yearly on fixed dates. According to the section 2(30) of The Companies Act,
2013 ‘Debenture’ comprises of – Debenture Inventory, Bonds and any other securities of an
enterprise whether comprising a charge on the assets of the enterprise or not.

Features of debentures

 Debentures are instruments of debt, which means that debenture holders become creditors of
the company

 They are a certificate of debt, with the date of redemption and amount of repayment
mentioned on it. This certificate is issued under the company seal and is known as a
Debenture Deed

 Debentures have a fixed rate of interest, and such interest amount is payable yearly or half-
yearly

 Debenture holders do not get any voting rights. This is because they are not instruments of
equity, so debenture holders are not owners of the company, only creditors

 The interest payable to these debenture holders is a charge against the profits of the company.
So these payments have to be made even in case of a loss.

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Different Types of Debentures:

1. From the Point of view of Security

 Secured Debentures: Secured debentures are that kind of debentures where a charge is
being established on the properties or assets of the enterprise for the purpose of any
payment. The charge might be either floating or fixed. The fixed charge is established
against those assets which come under the enterprise’s possession for the purpose to use
in activities not meant for sale whereas floating charge comprises of all assets excluding
those accredited to the secured creditors. A fixed charge is established on a particular
asset whereas a floating charge is on the general assets of the enterprise.
 Unsecured Debentures: They do not have a particular charge on the assets of the
enterprise. However, a floating charge may be established on these debentures by default.
Usually, these types of debentures are not circulated.

2. From the Point of view of Tenure

 Redeemable Debentures: These debentures are those debentures that are due on the
cessation of the time frame either in a lump-sum or in instalments during the lifetime of
the enterprise. Debentures can be reclaimed either at a premium or at par.
 Irredeemable Debentures: These debentures are also called as Perpetual Debentures as
the company doesn’t give any attempt for the repayment of money acquired or borrowed
by circulating such debentures. These debentures are repayable on the closing up of an
enterprise or on the expiry (cessation) of a long period.

3. From the Point of view of Convertibility

 Convertible Debentures: Debentures which are changeable to equity shares or in any

other security either at the choice of the enterprise or the debenture holders are called
convertible debentures. These debentures are either entirely convertible or partly
changeable.
 Non-Convertible Debentures: The debentures which can’t be changed into shares or in
other securities are called Non-Convertible Debentures. Most debentures circulated by
enterprises fall in this class.

4. From Coupon Rate Point of view

 Specific Coupon Rate Debentures: Such debentures are circulated with a mentioned
rate of interest, and it is known as the coupon rate.
 Zero-Coupon Rate Debentures: These debentures don’t normally carry a particular rate
of interest. In order to restore the investors, such type of debentures are circulated at a

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considerable discount and the difference between the nominal value and the circulated
price is treated as the amount of interest associated to the duration of the debentures.

5. From the view Point of Registration

 Registered Debentures: These debentures are such debentures within which all details
comprising addresses, names and particulars of holding of the debenture holders are filed
in a register kept by the enterprise. Such debentures can be moved only by performing a
normal transfer deed.
 Bearer Debentures: These debentures are debentures which can be transferred by way
of delivery and the company does not keep any record of the debenture holders Interest
on debentures is paid to a person who produces the interest coupon attached to such
debentures.
Advantages of Debentures

 One of the biggest advantages of debentures is that the company can get its required funds
without diluting equity. Since debentures are a form of debt, the equity of the company
remains unchanged.

 Interest to be paid on debentures is a charge against profit for the company. But this also
means it is a tax-deductible expense and is useful while tax planning

 Debentures encourage long-term planning and funding. And compared to other forms of
lending debentures tend to be cheaper.

 Debenture holders bear very little risk since the loan is secured and the interest is payable
even in the case of a loss to the company

 At times of inflation, debentures are the preferred instrument to raise funds since they have a
fixed rate of interest
Disadvantages of Debentures

 The interest payable to debenture holders is a financial burden for the company. It is payable
even in the event of a loss

 While issuing debentures help a company trade on equity, it also makes it too dependent on
debt. A skewed Debt-Equity Ratio is not good for the financial health of a company

 Redemption of debentures is a significant cash outflow for the company which can
imbalance its liquidity

 During a depression, when profits are declining, debentures can prove to be very expensive
due to their fixed interest rate.

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Difference between Shares and Debentures

Shares Debentures

What it means?
Shares are the company-owned capital. Debentures are the borrowed capital of the company.
Holder
The person who holds the ownership of the The person who holds the ownership of the
shares is called as Shareholders. Debentures is called as Debenture holders.
Status
Owners. Creditors
Mode or return
Shareholders are given the dividends. Whereas, debenture holders are given interest.
Payment of return
Dividends can be paid to the shareholders out of Interest can be paid to the debenture holders,
profits earned by the company. regardless of if the company has earned profits.
Voting rights
Shareholders possess voting rights. Debenture holders do not possess any right for voting.
Conversion
Shares cannot be converted into Debentures. However, debentures can easily be converted into
Shares.
Trust Deed
Trust deed is not carried out in the shares. When the debentures are circulated to the public, a
trust deed has to be carried out.

Term Loans

A term loan provides borrowers with a lump sum of cash upfront in exchange for specific
borrowing terms. Term loans are normally meant for established small businesses with
sound financial statements. In exchange for a specified amount of cash, the borrower agrees to a
certain repayment schedule with a fixed or floating interest rate. Term loans may require
substantial down payments to reduce the payment amounts and the total cost of the loan.

KEY TAKEAWAYS

 A term loan provides borrowers with a lump sum of cash upfront in exchange for
specific borrowing terms.
 Borrowers agree to pay their lenders a fixed amount over a certain repayment schedule
with either a fixed or floating interest rate.

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 Term loans are commonly used by small businesses to purchase fixed assets, such as
equipment or a new building.
 Borrowers prefer term loans because they offer more flexibility and lower interest rates.
 Short and intermediate-term loans may require balloon payments while long-term
facilities come with fixed payments.

Lease financing

Lease financing is a popular medium and long-term financing option in which the owner of an
asset grant another person the right to use the asset in exchange for a periodic payment. The
asset’s owner is known as the lessor, and the user is known as the lessee. A contract is to be
made between the lessor and the lessee regarding the terms and conditions of the lease. After
the lease period is over, the asset goes back to the lessor (the owner). There can also be a
provision in the contract regarding compulsory buying of the asset by the lessee (the user) after
the lease period is over.

Advantages of Lease Financing

A. To Lessor: The following are the benefits of lease financing from the perspective of the
lessor:
 Regularly Assured Income: Lessors receive lease rentals by leasing an asset for the
duration of the lease, which is a guaranteed and consistent source of income.
 Ownership Preservation: In a finance lease, the lessor transfers all risk and rewards
associated with ownership to the lessee without transferring asset’s ownership, so the lessor
retains ownership.
 Tax Advantage: Because the lessor owns the asset, the lessor receives a tax benefit in the
form of depreciation on the leased asset.
 Profitability is high: Leasing is a highly profitable business because the rate of return on
lease rentals is much higher than the interest paid on the asset’s financing.
 Growth Possibilities: There is a lot of room for growth here. Because leasing is one of the
most cost-effective forms of financing, demand for it is steadily increasing. Even amid a
depression, economic growth can be maintained. As a result, leasing has a much higher
growth potential than other types of businesses.
B. To Lessee: The following are the benefits of lease financing from the perspective of the
lessee:
 Capital Goods Utilization: A business will not have to spend a lot of money to acquire an
asset, but it will have to pay small monthly or annual rentals to use it. The business can use
its funds for other productive purpose.
 Tax Advantages: Lease payments can be deducted as a business expense, allowing a
company to benefit from a tax advantage.
 Cheaper: Leasing is a form of financing that is less expensive than almost all other
options.
 Technical Support: Regarding the leased asset, the lessee receives some form of
technical support from the lessor.
 Friendly to Inflation: Leasing is inflation-friendly because the lessee is required to pay a
fixed amount of rent each year, even if the asset’s cost rises.

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 Ownership: After the primary period has expired, the lessor offers the lessee the
opportunity to purchase the assets for a small fee.

Disadvantages of Lease Financing

A. To Lessor: The following are the disadvantages of lease financing from the perspective of
the lessor:
 In the event of inflation, it is unprofitable: Every year, the lessee receives a fixed amount
of lease rental, which they cannot increase even if the asset’s cost rises. So, it is
unprofitable during inflation.
 Taxation twice: It is possible to be charged sales tax twice: The first is when the asset is
purchased, and the second is when the asset is leased.
 Greater Risk of Asset Damage: As the ownership is not transferred, the lessee treats the
asset carelessly, and there is a great chance that it will not be usable after the primary lease
period ends.
B. To Lessee: The following are the disadvantages of lease financing from the perspective of
the lessee:
 Compulsion: Finance leases are non-cancelable, and lessees must pay lease rentals even if
they do not intend to use the asset.
 Ownership: Unless the lessee decides to purchase the asset at the end of the lease
agreement, the lessee will not become the owner of the asset.
 Costly: Lease financing is more expensive than other types of financing because the lessee
is responsible for both the lease rental and the expenses associated with asset ownership.
 Asset Understatement: As the lessee is not the owner of the asset, it cannot be included in
the balance sheet, resulting in an understatement of the lessee’s asset.

Venture Capital

Venture capital (VC) is a form of private equity and a type of financing for startup companies
and small businesses with long-term growth potential. Venture capital generally comes from
investors, investment banks, and financial institutions. Venture capital can also be provided as
technical or managerial expertise.

Types of Venture Capital

 Pre-Seed: This is the earliest stage of business development when the founders try to
turn an idea into a concrete business plan. They may enroll in a business accelerator to
secure early funding and mentorship.
 Seed Funding: This is the point where a new business seeks to launch its first product.
Since there are no revenue streams yet, the company will need VCs to fund all of its
operations.
 Early-Stage Funding: Once a business has developed a product, it will need additional
capital to ramp up production and sales before it can become self-funding. The business
will then need one or more funding rounds, typically denoted incrementally as Series A,
Series B, etc.

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CAPITAL STRUCTURE

Capital structure refers to the composition of long term sources of funds, such as debentures,
preference shares, Equity shares, retained earnings.r

In simple words it is the decision making about the proportion of different sources of long term
funds required for running a firm.

A sound capital structure should possess the following features:

(i) Maximum Return:
The financial structure of a company should be guided by clear- cut objective. Its objective can
be maximization of the wealth of the shareholders or maximization of return to the shareholders.

(ii) Less Risky: The capital structure should represent a balance between different types of
ownership and debt securities. This is essential to reduce risk on the use of debt capital.

(iii) Safety:
A sound capital structure should ensure safety of investment. It should be so determined that
fluctuations in the earnings of the company do not have heavy strain on its financial structure.

(iv) Flexibility:
A sound capital structure should facilitate expansion and contraction of funds. The company

should be able to procure more capital in times of need and should be able to pay all its debts
when it does not require funds.

(v) Economy:
The capital structure should ensure the minimum costs of capital which in turn would increase its
ability to generate more wealth for the company.

(vi) Capacity:
The financial structure of a company should be d3mamic. It should be revised periodically

depending upon the changes in the business conditions. If it has surplus funds, the company
should have the capacity to repay its debt and reduce interest obligations.

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(vii) Control:
The capital structure of a company should not dilute the control of equity shareholders of the
company. That is why, convertible debentures should be issued with great caution.

Factors affecting the Capital Structure

Several factors affect a company’s capital structure, and it also determines the composition of
debt and equity portions within this structure. Some of these factors are as follows:

 Business Size – The size and scale of a business affect its ability to raise finance. Small-
sized companies face difficulty in raising long-term borrowings. Creditors are hesitant to
give them loans because of the scale of their business operations. Even if they do get
these loans, they have to accept high-interest rates and stringent repayment conditions. It
limits their ability to grow their business.
 Earnings – Firms with relatively stable revenues can afford a more significant amount of
debt in their capital structure. Since debt repayment is periodical with fixed interest rates,
businesses with higher income prospects can bear these fixed financial charges. On the
other hand, companies that face higher fluctuations in their sales, like consumer goods,
rely more on equity shares to finance their operations.
 Competition: If a company operates in a business environment with more competition, it
should have more equity shares in its capital structure. Their earnings are prone to more
fluctuation compared to businesses facing lesser competition.
 Stage of the life cycle: A business in the early stage of its life cycle is more susceptible
to failure. In that case, they should use a more significant proportion of ordinary share
capital to finance their operations. Debt comes with a fixed interest rate, and it is more
suitable for companies with stable growth prospects.
 Creditworthiness: Any company that has a reputation for paying back its loans on time
will be able to raise funds on less stringent terms and at lower interest rates. It allows
them to pay back their loans on time. The opposite is true for firms that don’t have a good
credit standing in the market.
 Risk Aptitude of the Management: The attitude of a company’s management also
affects the proportion of debt and equity in the capital structure. Some managers prefer to
follow a low-risk strategy and opt for equity shares to raise finances. Other managers are
confident of the company’s ability to repay big loans, and they prefer to undertake a
higher proportion of long term debt instruments.
 Control: A management that wants outside interference in its operations may not raise
funds through equity shares. Equity shareholders have the right to appoint directors, and
they also dilute the stake of owners in the company. Some companies may prefer debt
instruments to raise funds. If the creditors get their instalments on loans and interest on
time, they will not be able to interfere in the workings of the business. But if the company
defaults on their credit, the creditors can remove the present management and take
control of the business.

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State of Capital Market: The tendencies of investors and creditors determine whether a

company uses more debt or equity to finance their operations. Sometimes a company
wants to issue ordinary shares, but no one is willing to invest due to the high-risk nature
of their business. In that case, the management has to raise funds from other sources like
debt markets.
 Taxation Policy: The government’s monetary policies in terms of taxation on debt and
equity instruments are also crucial. If a government levies more tax on gains from
investing in the share market, investors may move out of equities. Similarly, if the
interest rate on bonds and other long-term instruments is affected due to the
government’s policy, it will also influence companies’ decisions.
 Cost of Capital: The cost of raising funds depends on the expected rate of return for the
suppliers. This rate depends on the risk borne by investors. Ordinary shareholders face
the maximum risk as they don’t get a fixed rate of dividend. They get paid after
preference shareholders receive their dividends. The company has to pay interest on
debentures under all circumstances. It attracts more investors to opt for debentures and
bonds.
Optimal capital structure

Also known as balanced capital structure. It’s a financial plan that has an appropriate debt-
equity mix, which results to enhance the company’s value at the maximum level.

4 different patterns of Capital structure

I. Equity shares only: The entire capital of the company is raised by issuing equity shares
only.
II. Equity share and Preference share capital: The capital is raised by issuing equity
shares and preference shares in combination.
III. Equity share capital and long term debt: Along with equity shares the company
decides to raise capital through long term debt such as loans, bonds, debentures.
IV. Combination of all: Here the company uses all the types of securities to raise the capital
that is, equity shares, preference shares and long term debt.

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Designing the optimum structure that can maximize the shareholders wealth and minimize
the overall cost of capital the firm follows a designated pattern.

Optimum pattern of capital structure:

EBIT ( Earnings before interest and tax) XXX

Less: INT on debentures XXX

EBT (Earnings before tax) XXX

Less: TAX XXX

EAT (Earnings after tax) XXX

Less: Preference dividend XXX

Profit available for equity share holders XXX

EPS (Earnings per shares)

Formula 1) EPS = Profit available for equity share holders

No of Equity shares

2) EPS = EAT
No of Equity shares (when there is no preference share capital)

COST OF CAPITAL

Cost of capital is a calculation of the minimum return that would be necessary in order to justify
undertaking a capital budgeting project, such as building a new factory. It is an evaluation of
whether a projected decision can be justified by its cost.

Many companies use a combination of debt and equity to finance business expansion. For such
companies, the overall cost of capital is derived from the weighted average cost of all capital
sources. This is known as the weighted average cost of capital (WACC).

 The cost of capital represents the return a company needs to achieve in order to justify
the cost of a capital project, such as purchasing new equipment or constructing a new
building.

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 The cost of capital encompasses the cost of both equity and debt, weighted according to
the company's preferred or existing capital structure. This is known as the weighted
average cost of capital (WACC).
 A company's investment decisions for new projects should always generate a return that
exceeds the firm's cost of the capital used to finance the project. Otherwise, the project
will not generate a return for investors.

“In simple terms, the cost of capital refers to the minimum rate of return that investors
expect from a business’s projects. This metric is important for determining the financial
viability of investments.”
Characteristics of Cost of Capital

The cost of capital is characterized by the following fundamental features:

1) Minimum Rate of Return: Cost of capital indicates the minimum rate of return, which is
needed for maintaining the market value of a company’s equity shares.

2) Consideration of Risk Premium: The risk factor is taken care of during the computation of
‘Cost of Capital’, which is likely to be high if the numbers and degree of risks increase. In other
words, the Cost of Capital is directly proportional to the number/degree of risks involved. The
concept will be clearer with the following formula:

K = R + F,

Where, K = Cost of a required return,

R = Risk-free rate, and

F = Risk premium rate.

3) Not Necessarily a Cash Cost: The cost of capital, which a company is required to pay, may
not be in the form of cash every time. Factually, it is indicative of the expectation of the
company’s shareholders about returns from their investment.

In brief, the cost of capital to a company is equal to the equilibrium rate of return demanded by
investors in the capital market for securities at a given degree of risk. The equilibrium Rate of
Return is an interest rate at which the demand for money and supply of money is equal.

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Features of Cost of Control

Features of cost of control are as follows:

1. It is the minimum required rate of return to offset the effect of risk associated with business
and to maintain profitability to maximise the wealth of shareholders.

2. Arranging sources of finance at the rate of return (called cost of capital), and allocating them
to investments are the the sides of the same coin. The amount so invested must yield a return
equal to or more than the rate at which sources are arranged to fund such investments.

3. Cost of capital has a role in maintaining the market value of the firm. The value of a firm will
decline if it uses capital at a higher cost than the return on its assets.

4. Cost of capital involves implicit as well as explicit costs, therefore, it takes future risk and
business risk into account.

5. The cost of capital refers to the rate of return that is generally expressed in the form of a
percentage.

Importance of Cost of Capital

The cost of capital is very important for a company, as it plays a pivotal role in facilitating
various decision making processes.

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This can be observed by considering the following points:

 Capital Structure Decisions: The objective of minimizing the cost of capital needs to be
kept in mind when planning an appropriate capital structure for a company. This would
ensure a better market value for the company. The cost of financing is the determinant of
the source of financing.

 Evaluating Profitability: The profitability of a project depends upon the projected cost
of the capital funds and the actual cost of the capital fund raised to finance the project.
The performance of a project may be considered satisfactory if the project’s profitability
is more than the projected and actual cost of capital.

 Other Decisions: Decisions about the level of dividend distribution, working

capital requirements etc., are affected directly by the cost of capital. Furthermore, the
profitability of a project depends upon the cost of capital. The success or failure of the
projects undertaken by a company is one of the bases of appraisal of the top
management’s performance.

 Capital Budgeting Decisions: ‘Cost of Capital’ may be considered one of the most
essential basis on which capital budgeting is done. It is used as a rate for discounting cash
inflows to assess the profitability of a project (under the DCF method). Furthermore, the
minimum desired rate of return (projected) is compared with the actual rate of return
under the Internal Rate of Return (IRR) method. This comparison allows for a
comprehensive evaluation of investment performance.

Factors Affecting Cost of Capital

Cost of capital for a company is influenced by several factors (both external as well as internal
for the company), some of which are as follows:

1) Market Conditions

Market conditions prevailing at a particular time are responsible for the risks associated with a
financial instrument. The risk built into a financial instrument is directly proportional to the
interest such instrument offers. Investors prefer to invest in a high-risk bearing instrument only
when the rate of interest offered by it is relatively high and attractive enough to enter such a risky
zone. Investors expect a higher interest rate with an increase in the risk associated with an
instrument. Such an increase is termed a ‘Risk Premium’.

This causes the cost of funds to increase. Further, the marketability of an instrument and its price
stability are equally significant. The marketability of a financial product at a relatively stable
price may bring the investors’ expectation of the rate of return at a lower level, which may result
in a lower cost of capital. In a contrary situation (i.e., poor marketability and the unstable market

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price of an instrument) investors’ expectations regarding the rate of interest would be higher and
as a result, the cost of funds can be high.

2) General Economic Conditions

This factor is external to a company’s operational boundaries and beyond control. General
conditions prevailing in the economy of a country are largely responsible for (a) “demand for’
and ‘supply of capital, and (b) inflationary expectations.

i) A high inflation rate affects the purchasing power of money and results in its reduced value. In
such conditions, investors/shareholders expect a high rate of return as a part of compensation.
The cost of capital in such situations tends to be high.

ii) In case of an increase in the demand for capital without a corresponding increase in the supply
thereof the cost of capital (interest rate) would be high. In a reverse scenario, where the demand
is weak and the supply is sufficient, the cost of capital is likely to be low.

3) Company’s Operations and Financing Decisions

Certain controversial decisions a company takes may also result in fluctuations or risks in the
return. Risks arising out of such decisions may be categorised into two groups, viz.:

i) Business Risk, and

ii) Financial Risks.

Business Risks are the outcome of the company’s investment decisions and are characterised by
variable returns on assets. Financial Risks are an increase in fluctuation in return to the equity
shareholders, which is the result of the utilisation of debt and preference shares. With an increase
in business and financial risks, investors’ expectation about the rate of return also increases,
ultimately increasing the cost of capital. The reverse of the above phenomenon is also true, i.e.,
decreased financial and business risks are followed by a decrease in the cost of capital.

4) Amount of Financing

The cost of funds is directly proportional to the required quantum of funds. With the growing
need for funds in a business, there is an increase in the weighted cost of capital. It may be due to
many reasons, some of which are mentioned as follows:

i) With the increasing size of the issue, the need to reduce the price of the security/instrument
also increases, which in turn results in the increased cost of capital.

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ii) With the issue of more securities/instruments, the cost of selling securities (floatation cost)
also tends to be more, which affects the cost of funds to the company.

iii) If a company approaches the market for an amount of capital, not in proportion to the
strength of its capital or the size of the company, investors’ expectation of the rate of return
increases, increasing the cost of capital.

iv) Institutional lenders express some reluctance to sanction huge amounts of funds in the
absence of relevant documents about the company’s potential to ensure the appropriate
application of borrowed funds into the business.

Classification of Cost

The cost may be classified as follows:

1) Future Cost versus Historical Cost: Future costs are the basis on which financial decisions
are taken. may not happen in future, they are more important as compared to the historical cost,
which are nothing but frozen figure. However, historical costs are like guiding tools for future
forecasting.

2) Specific Cost versus Composite Cost: 'Specific Cost' is the cost of individual source of
capital, whereas the 'Composite Cost', also known as

'Overall Cost' is the cost of capital of all the sources taken together. To start with, the costs of
individual sources, like debentures, preference shares, equity shares, retained earnings, etc. are
computed individually (specific costs) and thereafter calculation of 'Composite Cost' may be
undertaken. As the 'Composite Cost' thus arrived at, takes into account source of capital received
through each of the specific source, it is also termed as 'Weighted Cost'.

3) Average Cost versus Marginal Cost: After the calculation of the cost of individual source of
capital (specific cost), weights are assigned to each of them in the ratio of their share. The
average of this is termed as weighted average cost or 'Average Cost'. 'Marginal Cost' on the other
hand is defined as "the change in the total cost that arises when the quantity produced has an
increment by unit". That is, it is the cost of producing one more unit of a good. When the
company raises additional capital only from one source, then the 'Specific Cost' is the 'Marginal
Cost. In capital budgeting,

'Marginal Cost' is considered to be more significant. It increases in equal proportion with the
increase in the quantum of debt.

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Difference Between Marginal Average cost Marginal Cost

Cost and Average Cost
Definition The per-unit production cost of Cost of producing one more unit or addition
goods over a period
Formula Total Cost / Number of Units Change in Total Cost / Change in Quantity
Produced
Aim Assess the impact on total unit Determine if it’s beneficial to produce extra
cost with output level
Shape of Curve Starts falling due to declining Concave with increasing returns, linear with
fixed costs, then rises returns, convex with increased returns
Best Criteria Minimize cost Profit maximization
Components Average Fixed Cost + Average Single unit, no components
Variable Cost

Explicit vs Implicit costs

Explicit costs are defined as costs that involve spending money.

Implicit costs eon the other hand, are nonmonetary opportunity costs.

Difference between Explicit cost and Implicit Cost

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Methods of computing cost of capital

 Cost of Equity capital

 Cost of debt/Debenture

 Cost of preferred capital

 Cost of internally generated funds/ Retained earnings.

WEIGHTED AVERAGE COST OF CAPITAL

A firm’s Weighted Average Cost of Capital (WACC) represents its blended cost of capital across
all sources, including common shares, preferred shares, and debt. The cost of each type of capital
is weighted by its percentage of total capital and then are all added together.

Systems of Weighting

The assignment of weight to various sources of funds may be carried out in the following two
manners:

1) Historical or Existing Weights, and

2) Marginal Weights.

Historical or Existing Weights

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In an existing capital structure of a company weights are assigned to individual sources of funds
in the ratio of their share in the total capital. When additional funds are raised by the company, it
is presumed under this method that the ratio of individual components of overall capital funds
would continue to remain same. In other words, the additional funds would be raised in the same
ratio as the existing capital structure is optimum.

However, the above presumption may not be true in actual practice, as the companies face
certain practical difficulties in ensuring that the additional capital is raised in the same ratio, in
view of the following:

1) The existing capital structure may not be optimal and it may not be desirable to maintain
status quo in respect of various individual components of the overall capital.

The company may not be in a position to raise additional capital in the same ratio due to various
conditions beyond the control of the company, e.g. demand-supply conditions, political
uncertainty, etc.

Under the 'Historical Weight Method', there are two ways of assigning weights:

1) Book Value Weight: Book value weights are assigned on the basis of the book value of a

"specific source of funds' as shown in the balance sheet of the company. Book value of that
specific source of funds is divided by the book value of the total long term capital.

2) Market Value Weight: Market value weights are assigned on the basis of the market value of a

*specific source of funds', which is divided by the market value of the total sources of long-term
capital.

Marginal Weights

The most unfavorable hypothesis, under any of the weighting system is that a company would
obtain capital in a specified ratio of its components. One of the choices (out of several) to assign
weights to various sources of funds in order to calculate the 'Composite Cost' of capital is the
system of 'Marginal Weights'. Under this system, the ratio of various constituents of total sources
of funds, the company intends to raise, are understood. Assignment of weight is, therefore, on the
additional or incremental funds raised; or in other words, the 'marginal weights'.

Advantages and disadvantages of using WACC

The weighted average cost of capital (WACC) is a useful tool for assessing a company’s
overall cost of capital and for making investment decisions. Some of the advantages of using
the WACC include:

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 It takes into account the relative weights of different components of the company’s capital
structure, such as debt and equity, to provide a more accurate picture of the company’s
overall cost of capital.
 It is a widely accepted and commonly used measure of a company’s cost of capital, so it can
be easily compared to the WACC of other companies.
 It can be used as a discount rate to determine the present value of future cash flows in
discounted cash flow analysis, making it a useful tool for evaluating potential investments.

However, there are also some disadvantages to using the WACC, including:

 It is based on historical data, so it may not accurately reflect a company’s future cost of
capital.
 It assumes that the company’s capital structure will remain the same, which may not always
be the case.
 It does not take into account the potential risks and opportunities associated with individual
investments, so it may not be the most accurate measure of the cost of capital for specific
investments.

Overall, while the WACC can be a useful tool for evaluating a company’s cost of capital, it
should be used with caution and in conjunction with other information about the company
and its potential investments.

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LEVERAGE

Leverage or financial leverage is basically an investment where borrowed money or debt is used
to maximize the returns of an investment, acquire additional assets or raise funds for the
company.

DEFINITION OF LEVERAGE

Leverage may be defined as the employment of an asset of funds for which the firm pays cost or
fixed return. The fixed cost or return may be thought of as the fulcrum lever.

TYPES OF LEVERAGE

 Operating leverage
 Financial Leverage
 Combined/ Composite leverage

Operating leverage
We know that the cost structure of any firm consists of two variables viz. i). Fixed cost and
ii) Variable cost. The operating leverage has got a bearing on fixed costs.
The operating leverage may be defined as the tendency of the operating profit (earnings before
interest and tax: EBIT) to vary disproportionately with sales. It is said to exist when the firm has
to incur fixed cost irrespective of the volume of output or sales. The firm will have a high degree
of operating leverage if it employs a greater amount of fixed costs and a smaller amount of
variable costs. On the other hand, the firm will have a low degree of operating leverage when it
employs a smaller amount of fixed costs and a larger amount of variable costs. Thus, the degree
of operating leverage depends upon the amount of fixed costs in the cost structure.
Thus, operating leverage in a firm is a function of three factors:
i) The amount of fixed costs ii) The contribution margin iii) The volume of sales.
It should be noted that there will be no operating leverage in case there are no fixed costs in the
firm.

Financial Leverage

The capital of a company consists of two major components viz. borrowed capital and owners'
capital. A proper balance is struck between these two components of capital by adopting a ratio
called debt-equity ratio. Depending upon the financial requirements and situation of the
company, the management varies this ratio. The process of such variation is called financial
leverage or trading on equity. Any variation in the capital structure of a company will have an
impact on the operating and taxable profit of the company. If the fixed cost bearing securities
(debentures and preference share capital) are relatively more in the capital structure, the profit of
the company available to the equity shares is increased. This indicates the larger financial
leverage and this situation is known as trading on equity. This means that the portion of equity

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capital is relatively less in the capital composition. On the other hand, if the financial leverage is
smaller, the portion of equity capital is relatively more in the capital composition.

Thus, financial leverage may be defined as the ratio of net rate of return on equity share capital
and the net rate of return on the total capitalization. In the words of J. E. Walter, "Financial
leverage may be defined as the percentage return on equity to the percentage return on
capitalization".

Financial-leverage indicates the firm's ability to use fixed cost bearing funds in order to magnify
the return on variable cost bearing funds i.e. equity capital. Thus, the financial leverage may be
defined as the tendency of the residual net income (net profit) to vary disproportionately with
operating profit. It indicates the change that takes place in the taxable income (i.e. profit before
tax or PBT) as a result of a change in the operating income (i.e. profit before interest and tax or
PBIT). It shows the existence of fixed interest/fixed dividend bearing securities (i.e. debentures
and preference shares) along with equity shares in the total capital structure of the company. If,
in the capital structure of the company, the fixed cost bearing securities are greater as compared
to the equity shares, the leverage is said to be larger, but if the fixed cost bearing securities are
relatively smaller as compared to the equity shares, the leverage is said to be smaller.

The relationship between revenue from sales (i.e. contribution or sales less variable cost) and the
taxable income. It helps the management in finding out the resulting change in taxable income
caused by a percentage change in sales.

Thus, the combined effect of operating and financial leverages measures their interaction on a
firm. The degree of combined effect of these two leverages can be calculated by multiplying
operating and financial leverage.

Difference between Financial Leverage and Operating Leverage:

OPERATING LEVERAGE FINANCIAL LEVERAGE

Meaning

The utilization of such resources and assets in the The utilization of obligation or debt in an
organizations’bn tasks for which it needs to pay organization’s capital design for which it needs to
fixed costs is known as operating leverage. pay interest costs is known as financial leverage.
Formula

DFL = EBIT / EBT DOL = Contribution / EBIT

Risk Involved

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It brings about business risk. It leads to a monetary gamble or financial risk.

Recommends

Low. High, just when ROCE is higher.

Deduce by

It ascertains the organization’s cost structure. It ascertains the organization’s capital structure.
Regards to

EBIT and sales. EPS and EBIT.

Quantifies to

Impact of fixed working expenses or fixed Impact of Interest costs or interest expenses.
operating costs.

Conclusion:

Financial leverage and operating leverage are both basic in their own terms. Furthermore, the
two of them help organizations in creating better returns and lessen costs. So the inquiry remains
can a firm utilize both of these influences? The response is yes.

On the off chance that an organization can utilize its fixed costs well, it would have the option to
create better returns just by utilizing operating leverage. Furthermore, simultaneously, they can
utilize financial leverage by changing their capital design from absolute value to 50-50, 60-40, or
70-30 value obligation extent or the debt proportion. Regardless of whether changing the capital
structure would incite the organization to pay interests, still, they would have the option to create
a superior pace of profits and would have the option to lessen how much taxes they are to pay
simultaneously.

That is the reason utilizing financial leverage, and operating leverage is an extraordinary method
for working on the rate of return of profits of the organization and in lessening the expenses
during a specific period.

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