Fundamental of Financial Management Unit -3 Financial Decision Bcom 5th Semester Gauahti University
FUNDAMENTAL OF FINANCIAL MANAGEMENT
Financing Decision
Unit - 3
SHORT TYPE QUESTIONS & ANSWERS
Also Read: Fundamentals of financial management complete notes
1. What is financial structure?
Ans: Financial structure refers to the way the firm's assets are financed it is the entire left-hand side of the balance sheet. In financial structure we include all long-term and short term obligations of the firm.
2.What is capital structure?
Ans: Firm's long-term financing is termed as capital structure and this is represented generally by long-term debt, preference shares and equity nd share capital. In equity capital we include ordinary share capital, surplus and reserves and retained earnings.
3. What is assets structure?
Ans: This means total assets of the firm. This is the total of fixed assets and current assets.
Assets structure = Fixed Assets + Current Assets + Other Assets.
4.Mention five internal factor affecting capital structure.
Ans: Success of a company largely depends upon the financial plan and capital structure. A company or firm should try to construct an optimum capital structure. The firm should consider all those factors, which affect its capital structure.
5.What is the formula of CAPM?
Ans: Cost of Equity Risk-Free Rate of Return + Beta x (Market = Rate of Return-Risk-Free Rate of Return).
6. Mention four external factors affecting capital structure.
Ans: Four external factors affecting capital structure are:
(i) Conditions of capital Market,
(ii) Nature and Type of Investors,
(iii) Cost of capital,
(iv) Legal Requirements.
7.Give five characteristics of balanced or appropriate capital structure.
Ans: Five characteristics of balanced or appropriate capital structure are:
(i) Simplicity,
(ii) Flexibility,
(iii) Full Utilization,
(iv) Adequate Liquidity,
(v) Minimum cost.
8. Mention four theories of capital structure.
Ans: Four theories of capital structure are:
(i) Net Income Theory,
(ii) Net operating Income Theory,
(iii) Modillion-miller Theory,
(iv) Traditional Theory.
9. Write five importances of the concept of cost of capital.
Ans: Five importances of the concept of cost of capital:
(i) Helpful in capital budgeting process,
(ii) Helpful in capital structure decisions,
(iii) Helpful in comparative analysis of various sources of finance,
(iv) Helpful in evaluation of financial efficiency of top management
(v) Useful in another areas.
10. Mention five assumptions of net operating Income Theory of capital structure.
Ans: Five assumptions of net operating Income Theory of capit structure are:
(i) The split of the total capital of the firm in debt equity is neithe important nor necessary because the valuation of firm by investors is done as an aggregate entity,
(ii) At every level of capital structure business risk is constant, therefore, the rate of capitalization also remains constant,
(iii) The rate of debt capitalization remains constant,
(iv) There are no corporate taxes.
(v) With the use of debt funds which are cheaper, the risk of share fi holders increases, which in turn results to increase in the equity In capitalization rate. Hence debt capitalization rate remains constant.
11. Write five assumptions of Modigliani miller theory of capital structure.
Ans: Five assumptions of Modigliani miller theory of capital structure:
(i) The capital market is perfect i. E, all investors are rational and they have perfect knowledge and information about market.
(ii) There is no transaction cost, I, e. there is no selling or buying cost of securities.
(iii) All the firms can be divided in homogeneous risk classes, I, e. all firms can be divided according to earnings in different categories and risk for all firms in the same category will be same.
(iv) For valuation of the firm the expectation of all investors about the net operating income of the firm are same.
(v) There is no corporate tax on the firm.
12. What are the critical parts of a company's financial statements? Ans: There are three critical parts of a company's financial statements:
(i) the balance sheet, which gives a one-time snapshot of a company's assets and liabilities
(ii) the income statement, which indicates the business's profitability during a certain period the cash flow statement, which acts as a corporate checkbook that reconciles the other two statements. It records the company's cash transactions (the inflows and outflows) during the given period. It shows whether all of the revenues booked on the income statement have been collected.
13. What do you mean by capital structure?
Ans: Capital structure means the pattern of capital employed in the firm. Weston and Brigham "Capital structure is the permanent financing of the firm represented by long-term debt, preferred stock and net worth". In the words of John J. Hampton "Capital structure is the combination of debt and equity securities that comprises a firm's financing of its assets.
14. How Do You Calculate the Cost of Equity?
Ans. There are two primary ways to calculate the cost of equity The dividend capitalization model and The capital asset pricing mod (CAPM). The dividend capitalization model takes dividends per share (DPS for the next year divided by the current market value (CMV) of the stock, and adds this number to the growth rate of dividends (GRD) where Cost of Equity = DPS+ CMV + GRD.
Conversely, the capital asset pricing model (CAPM) evaluates if an investment is fairly valued, given its risk and time value of money in relation to its anticipated return. Under this model, Cost of Equity
Risk-Free Rate of Return + Beta x (Market Rate of Return-Risk Free Rate of Return).
15. What is the formula of Cost of Equity Using the dividend capitalization model?
Ans: The cost of equity is:
Cost of Equity-DPS/CMV +GRD
where, DPS dividends per share, for next year
CMV current market value of stock GRD-growth rate of dividends.
16. Define financing decision.
Ans. A financial decision which is concerned with the amount of finance to be raised from various long term sources of funds like, equity shares preference shares, debentures, bank loans etc. Is called financia decision. In other words, it is a decision on the 'capital structure' of th company.
LONG TYPE QUESTIONS & ANSWERS
1. Describe the various factors affecting the capital structure.
Ans: Generally factors affecting capital structure are divided in two categories, namely:
(a) Internal Factors and
(b) External Factors.
(a) Internal Factors: Following internal factors are important:
(i) Nature of Business: Every type of business has its own capital or assets structure. Large manufacturing industries having a thin base of fixed assets and suffer from income oscillations have to rely mostly on ordinary and preference share capital.
(ii) Regulation and certainty of Income: Regularity and certainty of income affects capital structure. Debentures are issued if there is certainty of income in future. If funds are needed for some time, the redeemable preference shares may be issued.
(iii) Desire to control the Business: If the promoters and founders want to control the business and large part is kept in the control of a group of some people and rest of the equity capital is diffused in the hands of small investors. When company needs mare funds in future those are obtained through debentures of preference shares.
(iv) Future plans; Future plans should also be kept in view and for this purpose authorized capital should be kept more. Preference shares and debentures should also be part of future plans.
(v) Attitude of Management: Attitude of management greatly affects capital structure. Gateman and Doug all rightly wrote - "management various in skill, judgment, experience, temperament and motivation. It evaluates the same rocks differently and its willingness to employ deb finance also differ. The capital structure, therefore, is equally influenced by the age, experience, ambition, confidence and conservativeness of the management.
(vi) Freedom of Working: If the founders do not wart interference in policy formulation and decision making of the firm then future equity shares will not be issued and debentures will be floated.
(vii) Operating Ratio: If operating ratio is very high, then there is less income left for payment of interest and dividends. Therefore in such conditions there is less scope for debt capital. But in case of low operating ratio the firm has more income for interest and dividend, therefore, both debentures and equity shares may be issued.
(viii) Trading on Equity: If the promoters want to magnify their income they can resort to debt financing and earn more profits. This is known as trading on equity.
(b) External Factors: Following external factors also affect capital structure:
(i) Conciliations of Capital Market: Capital market conditions have significant influence over capital structure During depression interest rates are low and profit potentiality is uncertain and irregular, so in such conditions debentures are more popular, whereas during inflation profit potentiali is high, therefore, demand for ordinary shares rise and in such condition equity shares are issued and some of them are issued at premium.
(ii) Nature and Type of Investors : Nature and type of investors affect the capital structure. If investors are ready to take more risk, equity issue is better and if they do not want to take more risk, then debentures are more suited.
(iii) Cost of capital : Each source of capital involves cost, capital structure should combine various sources into a optimum capital mix, involving, the least average cost of capital and in this way helping in maximizing of returns.
(iv) Legal Requirements: The SEBI has issued guidelines for the issue are other legal requirements according to the companies Act also. Whether a company would be able to meet those requirements or not, it is a matter of consideration while deciding a capital structure plan.
2. Discuss the various reasons necessity of changing in capital structure.
Ans: Following are the main reasons for adjustments in capital structure:
(i) To Restore balance: If the company has issued to much fixed return securities I, e. preference shares or debentures which have resulted in great strain on the financial position of the company the management may take advantage of easy financial market to redeem these shares or deben out of the proceeds of fresh issue of ordinary shares. Such re arrangement may reduce the strain and the balance in the financial plan may be restored.
(ii) To simplify the capital structure: If the company has issued at variety of securities at different times to accommodate at different times to accommodate its developmental plans and feels the terms and conditions of such issues burden some it may consolidate such securities to simplify the financial plan as and when market conditions are favorable.
(iii) To Attract the Investors: Company may split its shares to make them more attractive especially in the circumstances where the market activity in the companies shares is very limited due to high face value subject to wide fluctuations. Investors prefer to purchase 10 shares of Rs. 10 each, rather to purchase 1 share of Rs. 100 each though the capital investment is the same.
(iv) To capitalize the Retained Earnings: Company may capital its reserves and surplus by issuing bonus shares to the existing shareholders to over come the state of over capitalization. It maintains a balance between and debentures and equity shares.
(v) To Extinguish Deficit: Sometimes it happens that company cannot run without sustaining heavy losses due to continuous unprofitable operations which drowned away their current assets or due to heavy reduction in the value of assets fixed or floating under these circumstances, the balance sheet of the company will show a deficit which requires adjustment of liabilities to offset the deficit otherwise the payment of dividend is not possible legally. Under these circumstances, it is advisable to reduce the value of share to their true worth to wipe off the deficit.
(vi) To Avoid Default on Debentures: Sometimes a company is not in a position to pay off interest on due dates or principal at maturity on debentures which compels the company to make certain arrangements with its bankers to purchase interest coupons and take assets as severities or it has to make debenture holders agree to accept new debentures or equity shares or preference shares in exchange of their present holdings or extent the maturity by giving extra bonus in the form of cash or shares just to avoid default on debentures which may result in the dissolution of corporation.
(vii) To Fund Accumulated Dividend: If Company has large accumulated balance of dividend on preference shares, it may enter into an agreement with the preference shareholders either to accept bonds or equity shares or new preference shares against their claim in the accumulated balance, may companies reduce the dividend rate on preference shares either by calling old shares and issuing new shares for cash to redeem the old ones by converting the old shares into new shares. Cash bonus be offered to shareholders in order to induce the exchange.
(viii) To Facilitate Merger and Integrations: In order to facilitate the merger, the intending corporations may be required to readjust their capital structure. The step is generally taken equalize the intrinsic value of shares of different companies.
(ix) To Meet certain legal Requirements: Sometimes, changes in the status requires a company to adjust its capital structure. For example, Indian Companies Act 1956 abolished the deferred shares. A Company was permitted to have only two types of shares equity and presence. Deferred shares were then generally converted into equity shares by the companies having such shares in their capital structure.
3. What is capital gearing? Discuss its significance.
Ans: The term refers to the relationship between equity capital and long-term real, the latter describing a state of affairs where the capital structure has evolved over a period of time, but not necessarily in the most advantageous way. In simple words, capital gearing means the ratio between the various types of securities in the capital structure of the company. A company is said to be high gear, when it has a proportionately higher/ large issue of debentures and preference shares for raising the long term resources, whereas low-gear stands for a proportionately large issue of equity shares. The example given below illustrates clearly the terms 'high gear' and 'low gear'.
4.Define cost of capital? explain its significance.
Ans: Cost of capital for a firm may be defined as the cost of obtaining funds, I, e, the average rate of return that the investors in a firm would expect for supplying funds to the firm. In the words of Hunt, William and Donaldson, "Cost of capital may be defined as the rate that must be earned on the het proceeds to provide the cost elements of the burden act the time they are due".
James c. Van Horne defines cost of capital as, "a cut off rate for the projects. It is the rate of return on a project that will heave unchanged the market price of the stock. According to Solomon Ezra, "Cost of capital is the minimum required rate of earnings or the cut off rate of capital expenditures". Hampton, John J. defines cost of capital as, "the rate of return the firm requires from investment in order to increase the value of the firm in the market place."
Thus, we can say that cost of capital is that minimum rate of return which a firm must and, is expected to earn on its investments so as to maintain the market value of its shares.
From the definitions given above we can concede three basic aspects of the concept of cost of capital:
(i) Cost of capital is not a cost as such. In fact, it is the rate of return that a firm requires to earn from its projects.
(ii) It is the minimum rate of return. Cost of capital of a firm is that minimum rate of return which will at least maintain the market value of the shares.
(iii) It comprises of three components: As there is always some business and financial risk in investing funds in a firm, cost of capital comprises of three components:
(a) The expected normal rate of return at Zero risk level, say the rate of interest allowed by banks:
(b) The Premium for business risk, &
(c) The premium for financial risk on account of pattern of capital structure.
5. Discuss the various types of cost.
Ans: Cost are recorded by division plant department or other areas of responsibility when accounting is done by a central accounting organization. These costs may be: (i)Jobs, Process or product costs: Manufacturing costs may be recorded by job manufacturing process or by the type of product.
(ii) Direct Costs: These can be easily identified with specific departments, products or processes and related to particular units or output such as lab our or materials.
(iii) Indirect Costs: These cannot be related directly to any specific unit or out put and are accounted for by administrative expenses, depreciation, management salaries, research and development expenditure, etc. moreover, these costs cannot be easily identified with products or processes.
(iv) Fixed Costs: They are constant over a wide range of production.
(v) Variable costs: They vary according to the level of activity.
(vi) Out of pocket costs: These result from the utilization of current esources.
(vii) Sunk Cost: They are usually fixed and include the costs of long lived assets at ready acquired.
(viii) Avoidable costs: All avoidable costs are variable and out of pocket costs.
6. Describe various methods of computing cost of capital.
Ans: Various methods of company cost of capital may be classified follows: Cost of Equity capital: The cost of equity is not the out of pocket cost of using these funds, that is the cost of floatation and dividends. It is ther the cost of the estimated stream of enterprise capital outlays derived from equity sources. The cost of obtaining stock may be determined in one of three ways. The first method uses the accepted earnings/price ratio. The second method is to find a rate that will equate the present value to all future dividends per share to the current market price. The third way to calculated the cost of equity capital is to substitute earnings for dividends. This is known as the earnings model. The principal reason for recommending it is the fact that earnings are the goal of all corporations.
7. Define Leverage. Describe its various types.
Ans: Leverage has been defined as 'the action of a lever, and the mechanical advantage gained by it. A lever is a rigid piece that transmits and modifies force or motion where forces are applied at two points and it turns around a third. The physical principle of the lever is intuitively appearing to most. It is the principle that permits the magnification of force when a lever is applied to a fulcrum. The term leverage refers to an increased means of accomplishing some purpose. With leverage, it is possible to lift objects, which is otherwise impossible. The term refers generally to circumstances which bring about an increase in income volatility. In business, leverage is the means of increasing profits. It may be favorable or unfavorable. The former reduces profits, while the latter increases it. This leverage of a firm is essentially related to a profit measure, which may be a return on investment or an earnings before taxes. It is an important fool of financial planning because it is related to profits. Christy and Rodent define leverage as the tendency for profits to change at a faster rate than sales. Leverage is an advantage or disadvantage which is derived from earning a return on total investment and which is different from the return on owners equity. It is a relationship between equity share capital and securities and creates fixed interest and dividend charges. It is also known as gearing.
Types of Leverage: Various types of leverage are as follows:
(i) Return on Investment Leverage,
(ii) Asset Leverage,
(iii) Operating Leverage,
(iv) Financial Leverage,
(v) Total Leverage,
(vi) Fixed charges Leverages,
(vii) Combined Leverage.
8. What do you mean by optimum or balanced capital structure? Discuss the characteristics of an optimum capital structure.
Ans: Optimum or balanced capital structure means an ideal combination of borrowed and owned capital that may attain the marginal goal i.e. maximising the nature of the company and hence the wealth of its owners and minimises the company's cost of capital.
A sound capital structure should be devised keeping in view that interests of the ordinary shareholders. However, interests of other groups such as employees, customers, creditors etc. should not be ignored.
A sound capital structure should possess the following characteristics:
(i) Attractiveness to investors: Securities proposed to be issued should offer certain attractions to the investors either in relation to income, control, convertibility.
(ii) Control: Sound capital structure should provide maximum control of the equity shareholders on the company's affairs.
(iii) Economy: Capital mix should be in such a way as to initial the
minimum cost of issue of securities and cost of financing etc.
(iv) Solvency: A due consideration should be given to the solven the company. If a debt threatens the solvency of the company, it sh be avoided.
(v) Profitability: It should be devised in such a way as to maxi the profits of the company keeping in view the burden of the com capital on the income of the firm.
(vi) Balanced leverage: Both types of securities i.e. owner(shares) and creditorship (debentures) should be issued to secure balanced leverage. Generally, debentures are issued when rate of inter is low and shares when rate of capitalisation is higher.
(vi) Simplicity: A sound capital structure should define clearly rights attached to each type of securities. It is easy to manage.
(viii) Flexibility: The capital structure of a company should be fle enough to suit the changed situations.
9. Discuss the different theories of capital structure.
Ans: There are four main theories of capital structure as under
(a) Net income theory: According to this theory, a firm can minin the weighted average cost of capital and increase the value of the fir well as market price of equity shares by using debt financing to f maximum possible extent. The theory propounds that a company increase its value and reduce the overall cost of capital by increasing proportion of debt in its capital structure.
This theory is based upon the following assumptions:
(i) The cost of debt is less than the cost of equity.
(ii) There are no taxes.
(iii)The risk perception of investors is not changed by the use of debt
The line of argument in favour of net income approach is that a proportion of debt financing in capital structure increase, the prop of a less expensive source of funds increases. This results in the dec in overall (weighted average) cost of capital leading to an increase in the value of the firm. The reasons for assuming cost of debt to be less than the cost of equity are that interest rates are usually lower than dividend ates due to element of risk and the benefit of tax as the interest is a Beductible expense. The total market value of a firm on the basis of net income theory can be ascertained as below:
V=S+D
V=Total market value of firm
S-Market value of equity shares
Earnings available to equity shareholders (NI)/Equity capitalisation rate
D= Market value of debt.
and overall cost of capital or weighted average cost of capital can be calculated as
Ko= EBIT/V
(b) Net operating income theory: This theory as suggested by David Durand is another extreme of the effect of leverage on the value of the firm. It is diametrically opposite to the net income approach. According to this approach, change in the capital structure of a company does not affect the market value of the firm and the overall cost of capital remains constant irrespective of the method of financing. It implies that the overall cost of capital remains the same whether the debt equity mix is 50:50 or 20:80 or 0:100. Thus, there is nothing as an optimal capital structure and every capital structure is the optimum capital structure.
This theory presumes that:
(i) The market capitalises the value of the firm as a whole;
(ii) The business risk remains constant at every level of debt equity
(iii) There are no corporate taxes.
The reasons propounded for such assumptions are that the increased of debt increases the financial risk of the equity shareholders and her the cost of equity increases. On the other hand, the cost of debt remain constant with the increasing proportion of debt as the financial risk of the lenders is not affected. Thus the advantage of using the cheaper sour of funds i.e. debt is exactly offset by the increased cost of equity.
The value of a firm on the basis of net operating income theory can be determined as below:
V= EBIT/ Ko
Where, V Value of a firm
EBIT-Net operating income or earnings before interest and ta
Ko=Overall cost of capital.
(c) Modigliani-Miller Theory: Modigliani and Miller hav propounded a good theory of capital structure. It is identical with the ne operating income approach if taxes are ignored. However, when corpor taxes are assumed to exist, their hypothesis is similar to the net incom approach.
(i) In the absence of corporate taxes: As per Modigliani-Miller i there are no corporate taxes then the changes in the capital structure any firm do not bring any change in the overall cost of capital and tots value of the firm. The reason being that the debt capital is cheap and more use in capital structure results into high expectation of equit shareholders and this raises the cost of equity capital and therefore the benefits of low debt cost are offset exactly by the increase in the cost of equity capital. The more use of debt capital in the capital structure of the firm affect cost of equity capital but does not affect overall cost of capit of the firm. When more debt is used beyond a certain limit the financial risk and cost of debt increases and the cost of equity capital declines and again a balance is established. According to this theory if the two firms are identical except capital structure then the value of firm and overall cost of capital cannot be separate and become identical in both the firms through arbitrage operations.
Also Read:
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