PROJECT ON

SOURCES OF FINANCE AND ITS COSTS

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 INDEX

SR. NO. TOPIC PAGE NO.

1. Introduction 3
2. Classification of Sources of Finance 5
3. Sources of Finance 8
4. Cost of capital 14
5. Literature Review 21
6. Sample Case Studies 26
7. Conclusion 32
8. References 33

INTRODUCTION
Business is concerned with the production and distribution of goods and
services for the satisfaction of needs of society. For carrying out various
activities, business requires money. Finance, therefore, is called the life blood of
any business. The requirements of funds by business to carry out its various
activities is called business finance.
A business cannot function unless adequate funds are made available to it. The
initial capital contributed by the entrepreneur is not always sufficient to take
care of all financial requirements of the business. A business person, therefore,
has to look for different other sources from where the need for funds can be
met. A clear assessment of the financial needs and the identification of various
sources of finance, therefore, is a significant aspect of running a business
organisation.
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The need for funds arises from the stage when an entrepreneur makes a decision
to start a business. Some funds are needed immediately say for Mr. Anil Singh
has been running a restaurant for the last two years. The excellent quality of
food has made the restaurant popular in no time. Motivated by the success of his
business, Mr. Singh is now contemplating the idea of opening a chain of similar
restaurants at different places. However, the money available with him from his
personal sources is not sufficient to meet the expansion requirements of his
business. His father told him that he can enter into a partnership with the owner
of another restaurant, who will bring in more funds but it would also require
sharing of profits and control of business. He is also thinking of getting a bank
loan. He is worried and confused, as he has no idea as to how and from where
he should obtain additional funds. He discusses the problem with his friend
Ramesh, who tells him about some other methods like issue of shares and
debentures, which are available only to a company form of organisation. He
further cautions him that each method has its own advantages and limitations
and his final choice should be based on factors like the purpose and period for
which funds are required. He wants to learn about these methods the purchase
of plant and machinery, furniture, and other fixed assets. Similarly, some funds
are required for day-to-day operations, say to purchase raw materials, pay
salaries to employees, etc. Also when the business expands, it needs funds.

The financial needs of a business can be categorised as follows:

(a) Fixed capital requirements: In order to start business, funds are required to
purchase fixed assets like land and building, plant and machinery, and furniture
and fixtures. This is known as fixed capital requirements of the enterprise. The
funds required in fixed assets remain invested in the business for a long period
of time. Different business units need varying amount of fixed capital
depending on various factors such as the nature of business, etc. A trading
concern for example, may require small amount of fixed capital as compared to
a manufacturing concern. Likewise, the need for fixed capital investment would
be greater for a large enterprise, as compared to that of a small enterprise.
(b) Working capital requirements: The financial requirements of an
enterprise do not end with the procurement of fixed assets. No matter how small
or large a business is, it needs funds for its day-to-day operations. This is known
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as working capital of an enterprise, which is used for holding current assets such
as stock of material, bills receivables and for meeting current expenses like
salaries, wages, taxes, and rent.
The amount of working capital required varies from one business concern to
another depending on various factors. A business unit selling goods on credit, or
having a slow sales turnover, for example, would require more working capital
as compared to a concern selling its goods and services on cash basis or having
a speedier turnover.
The requirement for fixed and working capital increases with the growth and
expansion of business. At times additional funds are required for upgrading the
technology employed so that the cost of production or operations can be
reduced. Similarly, larger funds may be required for building higher inventories
for the festive season or to meet current debts or expand the business or to shift
to a new location. It is, therefore, important to evaluate the different sources
from where funds can be raised.

CLASSIFICATION OF SOURCES OF FINANCE

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 PERIOD BASIS

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 On the basis of period, the different sources of funds can be categorised into
three parts. These are long-term sources, medium-term sources and short-
term sources.

The long-term sources fulfil the financial requirements of an enterprise for a

period exceeding 5 years and include sources such as shares and debentures,
long-term borrowings and loans from financial institutions. Such financing is
generally required for the acquisition of fixed assets such as equipment, plant,
etc.

Where the funds are required for a period of more than one year but less than
five years, medium-term sources of finance are used. These sources include
borrowings from commercial banks, public deposits, lease financing and
loans from financial institutions.

Short-term funds are those which are required for a period not exceeding one
year. Trade credit, loans from commercial banks and commercial papers are
some of the examples of the sources that provide funds for short duration.

Short-term financing is most common for financing of current assets such as

accounts receivable and inventories. Seasonal businesses that must build
inventories in anticipation of selling requirements often need short-term
financing for the interim period between seasons. Wholesalers and
manufacturers with a major portion of their assets tied up in inventories or
receivables also require large amount of funds for a short period

 OWNERSHIP BASIS

On the basis of ownership, the sources can be classified into ‘owner’s funds’
and ‘borrowed funds’. Owner’s funds means funds that are provided by the
owners of an enterprise, which may be a sole trader or partners or
shareholders of a company. Apart from capital, it also includes profits
reinvested in the business. The owner’s capital remains invested in the
business for a longer duration and is not required to be refunded during the
life period of the business. Such capital forms the basis on which owners
acquire their right of control of management. Issue of equity shares and
retained earnings are the two important sources from where owner’s funds
can be obtained.
‘Borrowed funds’ on the other hand, refer to the funds raised through loans or
borrowings. The sources for raising borrowed funds include loans from

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 commercial banks, loans from financial institutions, issue of debentures,
public deposits and trade credit. Such sources provide funds for a specified
period, on certain terms and conditions and have to be repaid after the expiry
of that period. A fixed rate of interest is paid by the borrowers on such funds.
At times it puts a lot of burden on the business as payment of interest is to be
made even when the earnings are low or when loss is incurred. Generally,
borrowed funds are provided on the security of some fixed assets.

 SOURCES OF GENERATION BASIS

Another basis of categorising the sources of funds can be whether the funds
are generated from within the organisation or from external sources. Internal
sources of funds are those that are generated from within the business. A
business, for example, can generate funds internally by accelerating
collection of receivables, disposing of surplus inventories and ploughing back
its profit. The internal sources of funds can fulfill only limited needs of the
business.

External sources of funds include those sources that lie outside an

organisation, such as suppliers, lenders, and investors. When large amount of
money is required to be raised, it is generally done through the use of external
sources. External funds may be costly as compared to those raised through
internal sources. In some cases, business is required to mortgage its assets as
security while obtaining funds from external sources. Issue of debentures,
borrowing from commercial banks and financial institutions and accepting
public deposits are some of the examples of external sources of funds
commonly used by business organisations.

SOURCES OF FINANCE
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A business can raise funds from various sources. Each of the source has unique
characteristics, which must be properly understood so that the best available
source of raising funds can be identified. There is not a single best source of
funds for all organisations. Depending on the situation, purpose, cost and
associated risk, a choice may be made about the source to be used. For example,
if a business wants to raise funds for meeting fixed capital requirements, long
term funds may be required which can be raised in the form of owned funds or
borrowed funds. Similarly, if the purpose is to meet the day-to-day requirements
of business, the short term sources may be tapped. A brief description of various
sources is given below.
RETAINED EARNINGS
A company generally does not distribute all its earnings amongst the
shareholders as dividends. A portion of the net earnings may be retained in
the business for use in the future. This is known as retained earnings. It is a
source of internal financing or self-financing or ‘ploughing back of profits’.
The profit available for ploughing back in an organisation depends on many
factors like net profits, dividend policy and age of the organisation.

TRADE CREDIT
Trade credit is the credit extended by one trader to another for the purchase of
goods and services. Trade credit facilitates the purchase of supplies without
immediate payment. Such credit appears in the records of the buyer of goods
as ‘sundry creditors’ or ‘accounts payable’. Trade credit is commonly used by
business organisations as a source of shortterm financing. It is granted to
those customers who have reasonable amount of financial standing and
goodwill. The volume and period of credit extended depends on factors such
as reputation of the purchasing firm, financial position of the seller, volume
of purchases, past record of payment and degree of competition in the market.
Terms of trade credit may vary from one industry to another and from one
person to another. A firm may also offer different credit terms to different
customers.

FACTORING

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Factoring is a financial service under which the ‘factor’ renders various
services which includes:
a) Discounting of bills (with or without recourse) and collection of the
client’s debts. Under this, the receivables on account of sale of goods or
services are sold to the factor at a certain discount. The factor becomes
responsible for all credit control and debt collection from the buyer and
provides protection against any bad debt losses to the firm. There are two
methods of factoring — recourse and non-recourse. Under recourse
factoring, the client is not protected against the risk of bad debts. On the
other hand, the factor assumes the entire credit risk under non-recourse
factoring i.e., full amount of invoice is paid to the client in the event of the
debt becoming bad.
b) Providing information about credit worthiness of prospective client’s etc.,
Factors hold large amounts of information about the trading histories of
the firms. This can be valuable to those who are using factoring services
and can thereby avoid doing business with customers having poor
payment record. Factors may also offer relevant consultancy services in
the areas of finance, marketing, etc.

The factor charges fees for the services rendered. Factoring appeared on the
Indian financial scene only in the early nineties as a result of RBI initiatives.
The organisations that provides such services include SBI Factors and
Commercial Services Ltd., Canbank Factors Ltd., Foremost Factors Ltd.,
State Bank of India, Canara Bank, Punjab National Bank, Allahabad Bank. In
addition, many non-banking finance companies and other agencies provide
factoring service.

LEASE FINANCING
A lease is a contractual agreement whereby one party i.e., the owner of an
asset grants the other party the right to use the asset in return for a periodic
payment. It is a renting of an asset for some specified period. The owner of
the assets is called the ‘lessor’ while the party that uses the assets is known as
the ‘lessee’. The lessee pays a fixed periodic amount called lease rental to the
lessor for the use of the asset. The terms and conditions regulating the lease
arrangements are given in the lease contract. At the end of the lease period,
the asset goes back to the lessor. Lease finance provides an important means
of modernisation and diversification to the firm. Such type of financing is
more prevalent in the acquisition of such assets as computers and electronic
equipment which become obsolete quicker because of the fast changing

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technological developments. While making the leasing decision, the cost of
leasing an asset must be compared with the cost of owning the same.

PUBLIC DEPOSITS
The deposits that are raised by organisations directly from the public are
known as public deposits. Rates of interest offered on public deposits are
usually higher than that offered on bank deposits. Any person who is
interested in depositing money in an organisation can do so by filling up a
prescribed form. The organisation in return issues a deposit receipt as
acknowledgment of the debt. Public deposits can take care of both medium
and short-term financial requirements of a business. The deposits are
beneficial to both the depositor as well as to the organisation. While the
depositors get higher interest rate than that offered by banks, the cost of
deposits to the company is less than the cost of borrowings from banks.
Companies generally invite public deposits for a period upto three years. The
acceptance of public deposits is regulated by the Reserve Bank of India.

COMMERCIAL PAPER
Commercial Paper (CP) is an unsecured money market instrument issued in
the form of a promissory note. It was introduced in India in 1990 for enabling
highly rated corporate borrowers to diversify their sources of short-term
borrowings and to provide an additional instrument to investors.
Subsequently, primary dealers and all-India financial institutions were also
permitted to issue CP to enable them to meet their short-term funding
requirements for their operations. Individuals, banking companies, other
corporate bodies (registered or incorporated in India) and unincorporated
bodies, Non-Resident Indians (NRIs) and Foreign Institutional Investors
(FIIs) etc. can invest in CPs. CP can be issued for maturities between a
minimum of 7 days and a maximum of up to one year from the date of issue
in denominations of Rs.5 lakh or multiples thereof. However, the maturity
date of the CP should not go beyond the date up to which the credit rating of
the issuer is valid.

ISSUE OF SHARES
The capital obtained by issue of shares is known as share capital. The capital
of a company is divided into small units called shares. Each share has its
nominal value. For example, a company can issue 1,00,000 shares of Rs. 10
each for a total value of Rs. 10,00,000. The person holding the share is
known as shareholder. There are two types of shares normally issued by a
company. These are equity shares and preference shares. The money raised

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by issue of equity shares is called equity share capital, while the money raised
by issue of preference shares is called preference share capital.
a) Equity Shares
Equity shares is the most important source of raising long term capital
by a company. Equity shares represent the ownership of a company
and thus the capital raised by issue of such shares is known as
ownership capital or owner’s funds. Equity share capital is a
prerequisite to the creation of a company. Equity shareholders do not
get a fixed dividend but are paid on the basis of earnings by the
company. They are referred to as ‘residual owners’ since they receive
what is left after all other claims on the company’s income and assets
have been settled. They enjoy the reward as well as bear the risk of
ownership. Their liability, however, is limited to the extent of capital
contributed by them in the company. Further, through their right to
vote, these shareholders have a right to participate in the management
of the company.

b) Preference Shares
The capital raised by issue of preference shares is called preference
share capital. The preference shareholders enjoy a preferential position
over equity shareholders in two ways: (i) receiving a fixed rate of
dividend, out of the net profits of the company, before any dividend is
declared for equity shareholders; and (ii) receiving their capital after
the claims of the company’s creditors have been settled, at the time of
liquidation. In other words, as compared to the equity shareholders, the
preference shareholders have a preferential claim over dividend and
repayment of capital. Preference shares resemble debentures as they
bear fixed rate of return. Also as the dividend is payable only at the
discretion of the directors and only out of profit after tax, to that extent,
these resemble equity shares. Thus, preference shares have some
characteristics of both equity shares and debentures. Preference
shareholders generally do not enjoy any voting rights. A company can
issue different types of preference shares.

DEBENTURES
Debentures are an important instrument for raising long term debt capital. A
company can raise funds through issue of debentures, which bear a fixed rate
of interest. The debenture issued by a company is an acknowledgment that
the company Debentures are an important instrument for raising long term
debt capital. A company can raise funds through issue of debentures, which

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bear a fixed rate of interest. The debenture issued by a company is an
acknowledgment that the company has borrowed a certain amount of money,
which it promises to repay at a future date. Debenture holders are, therefore,
termed as creditors of the company. Debenture holders are paid a fixed stated
amount of interest at specified intervals say six months or one year. Public
issue of debentures requires that the issue be rated by a credit rating agency
like CRISIL (Credit Rating and Information Services of India Ltd.) on
aspects like track record of the company, its profitability, debt servicing
capacity, credit worthiness and the perceived risk of lending. A company can
issue different types of debentures (see Box C and D). Issue of Zero Interest
Debentures (ZID) which do not carry any explicit rate of interest has also
become popular in recent years. The difference between the face value of the
debenture and its purchase price is the return to the investor.

COMMERCIAL BANKS
Commercial banks occupy a vital position as they provide funds for different
purposes as well as for different time periods. Banks extend loans to firms of
all sizes and in many ways, like, cash credits, overdrafts, term loans,
purchase/discounting of bills, and issue of letter of credit. The rate of interest
charged by banks depends on various factors such as the characteristics of the
firm and the level of interest rates in the economy. The loan is repaid either in
lump sum or in installments.
Bank credit is not a permanent source of funds. Though banks have started
extending loans for longer periods, generally such loans are used for medium
to short periods. The borrower is required to provide some security or create a
charge on the assets of the firm before a loan is sanctioned by a commercial
bank.

FINANCIAL INSTITUTIONS
The government has established a number of financial institutions all over the
country to provide finance to business organisations (see Box E). These
institutions are established by the central as well as state governments. They
provide both owned capital and loan capital for long and medium term
requirements and supplement the traditional financial agencies like
commercial banks. As these institutions aim at promoting the industrial
development of a country, these are also called ‘development banks’. In
addition to providing financial assistance, these institutions also conduct
market surveys and provide technical assistance and managerial services to
people who run the enterprises. This source of financing is considered

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suitable when large funds for longer duration are required for expansion,
reorganisation and modernisation of an enterprise.

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Cost of Capital
Cost of capital may be categorized into the following types on the basis of
nature and usage:
1. Explicit and Implicit Cost.
2. Average and Marginal Cost.
3. Historical and Future Cost.
4. Specific and Combined Cost.

1. Explicit and Implicit Cost:

The cost of capital may be explicit or implicit cost on the basis of the
computation of cost of capital. Explicit cost is the rate that the firm pays to
procure financing. An explicit cost is one that has occurred and is evidently
reported as a separate cost. It is defined as direct payment to others in doing
business such as wage, rent and materials.
This may be calculated with the following equation;
Where,
CIo = initial cash inflow
C = outflow in the period concerned
N = duration for which the funds are provided
T = tax rate
Implicit cost is the rate of return linked with the best investment opportunity
for the firm and its shareholders that will be inevitable if the projects
presently under consideration by the firm were accepted. It is the opportunity
cost equal to what a firm must give up in order to use factor of production
which it already owns and thus does not pay rent for.
Both implicit and explicit costs are actual business cost of firms (Barthwal,
2007).

2. Average and Marginal Cost:

Average cost of capital is the weighted average cost of each element of
capital employed by the company. It reflects weighted average cost of all
kinds of financing such as equity, debt, retained earnings.
Marginal cost is the weighted average cost of new finance raised by the
company. It is the extra cost of capital when the company goes for further
raising of finance.

3. Historical and Future Cost:

Historical cost is the cost which is already been incurred for financing a

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particular project. It is based on the actual cost incurred in the earlier project.
Future cost is the expected cost of financing in the proposed project.
Expected cost is calculated on the basis of previous experience.

4. Specific and Combine Cost:

The cost of each sources of capital such as equity, debt, retained earnings and
loans is termed as specific cost of capital. It is beneficial to determine the
each and every specific source of capital. The composite or combined cost of
capital is the amalgamation of all sources of capital. It is also called as overall
cost of capital. It is used to recognize the total cost associated with the total
finance of the company.

Importance of Cost of Capital

Computation of cost of capital is significant part of the financial management
to decide the capital structure of the business concern.
Importance to Capital Budgeting Decision: Capital budget decision mainly
depends on the cost of capital of each source. According to net present value
method, present value of cash inflow must be more than the present value of
cash outflow. Therefore, cost of capital is used for capital budgeting decision.
Importance to Structure Decision: Capital structure is the mix or proportion
of the different types of long term securities. Company uses particular type of
sources if the cost of capital is suitable. Therefore, cost of capital supports to
take decision regarding structure.
Importance to Evolution of Financial Performance: Cost of capital is
imperative to determine which affects the capital budgeting, capital structure
and value of the firm. It helps to estimate the financial performance of the
firm.
Importance to Other Financial Decisions: Cost of capital is also used in some
other areas such as, market value of share, earning capacity of securities etc.
hence, it plays a major part in the financial management.
Computation of cost of capital:
Computation of cost of capital has two important parts:
1. Measurement of specific costs
2. Measurement of overall cost of capital
Measurement of Cost of Capital:
It refers to the cost of each specific sources of finance such as:
 Cost of equity
 Cost of debt
 Cost of preference share
 Cost of retained earnings
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I. Cost of Equity: Cost of equity capital is the rate at which investors
discount the expected dividends of the firm to determine its share value.
Theoretically, the cost of equity capital is described as the "Minimum rate of
return that a firm must earn on the equity financed portion of an investment
project in order to leave unchanged the market price of the shares".

Cost of equity can be calculated from the following approach:

 Dividend price (D/P) approach.
 Dividend price plus growth (D/P + g) approach.
 Earning price (E/P) approach.
 Realized yield approach.
Dividend Price Approach: The cost of equity capital will be that rate of
expected dividend which will maintain the present market price of equity
shares.
Dividend price approach can be measured with the following formula:

Where,
Ke = Cost of equity capital
D = Dividend per equity share
Np = Net proceeds of an equity share
Dividend Price Plus Growth Approach: The cost of equity is calculated on the
basis of the expected dividend rate per share plus growth in dividend (R M
Srivastava, 2008).
It can be measured by the following formula:

Where,
Ke = Cost of equity capital
D = Dividend per equity share
g = Growth in expected dividend
Np = Net proceeds of an equity share
Earning Price Approach: Cost of equity regulates the market price of the
shares. It is based on the future earnings forecasts of the equity (R M
Srivastava, 2008). The formula for calculating the cost of equity according to

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this approach is as follows.

Where,
Ke = Cost of equity capital
E = Earnings per share
Np = Net proceeds of an equity share
Realized Yield Approach: It is simple method to compute cost of equity
capital (R M Srivastava, 2008). Under this method, cost of equity is
calculated by

Where,
Ke = Cost of equity capital.
PVf = Present value of discount factor.
D = Dividend per share.

II. Cost of Debt: Cost of debt is the after tax cost of long-term funds through
borrowing. Debt may be issued at par, at premium or at discount and also it
may be perpetual or redeemable.
Debt Issued at Par: Debt issued at par means, debt is issued at the face value
of the debt. It may be calculated with the following formula

Where,
Kd = Cost of debt capital
t = Tax rate
R = Debenture interest rate
Debt Issued at Premium or Discount: If the debt is issued at premium or
discount, the cost of debt is calculated with the following formula.

Where,
Kd = Cost of debt capital
I = Annual interest payable
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Np = Net proceeds of debenture
t = Tax rate
Cost of Perpetual Debt and Redeemable Debt: It is the rate of return which
the lenders expect. The debt carries a certain rate of interest.

Where,
I = Annual interest payable
P = Par value of debt
Np = Net proceeds of the debenture
n = Number of years to maturity
Kdb = Cost of debt before tax
Cost of debt after tax can be calculated with the following formula:

Where,
Kda = Cost of debt after tax
Kdb = Cost of debt before tax
t = Tax rate
III. Cost of Preference Share Capital: Cost of preference share capital is
the annual preference share dividend by the net proceeds from the sale of
preference share. There are two types of preference shares irredeemable and
redeemable.
Following formula is used to calculate the cost of redeemable preference
share capital:

Where,
Kp = Cost of preference share
Dp = Fixed preference dividend
Np = Net proceeds of an equity share
Cost of irredeemable preference share is calculated with the following

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formula:

Where,
Kp = Cost of preference share
Dp = Fixed preference share
P = Par value of debt
Np = Net proceeds of the preference share
n = Number of maturity period.

IV. Cost of Retained Earnings: Retained earnings is one of the sources of

finance for investment proposal. It is dissimilar from other sources like debt,
equity and preference shares. Cost of retained earnings is the same as the cost
of an equivalent fully subscripted issue of additional shares, which is
measured by the cost of equity capital.
Cost of retained earnings can be calculated with the following formula:

Where,
Kr = Cost of retained earnings
Ke = Cost of equity
t = Tax rate
b = Brokerage cost

Measurement of Overall Cost of Capital:

It is also known as weighted average cost of capital and composite cost of
capital. Weighted average cost of capital is the expected average future cost
of funds over the long run found by weighting the cost of each specific type
of capital by its proportion in the firm's capital structure.
The computation of the overall cost of capital (Ko) involves the following
steps.
(a) Assigning weights to specific costs.
(b) Multiplying the cost of each of the sources by the appropriate weights.
(c) Dividing the total weighted cost by the total weights.
The overall cost of capital can be calculated with the following formula;

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Where,
Ko = Overall cost of capital
Kd = Cost of debt
Kp = Cost of preference share
Ke = Cost of equity
Kr = Cost of retained earnings
Wd= Percentage of debt of total capital
Wp = Percentage of preference share to total capital
We = Percentage of equity to total capital
Wr = Percentage of retained earnings
Weighted average cost of capital is calculated in the following formula also:

Where,
Kw = Weighted average cost of capital
X = Cost of specific sources of finance
W = Weight, proportion of specific sources of finance.
To, summarize, cost of return is defined as the return the firm's investors
could expect to earn if they invested in securities with comparable degrees of
risk. The cost of capital signifies the overall cost of financing to the firm. It is
normally the relevant discount rate to use in evaluating an investment. Cost
of capital is important because it is used to assess new project of company
and permits the calculations to be easy so that it has minimum return that
investor expect for providing investment to the company.

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 LITERATURE REVIEW

1. PECKING ORDER THEORY

What is the Pecking Order Theory?

The Pecking Order Theory, also known as the Pecking Order Model, relates
to a company’s capital structure. Made popular by Stewart Myers and Nicolas
Majluf in 1984, the theory states that managers follow a hierarchy when
considering sources of financing.
The pecking order theory states that managers display the following
preference of sources to fund investment opportunities: first, through the
company’s retained earnings, followed by debt, and choosing equity
financing as a last resort.

Illustration

The following diagram illustrates Pecking Order Theory:-

Understanding the Pecking Order Theory

The pecking order theory arises from the concept of asymmetric information.
Asymmetric information, also known as information failure, occurs when one
party possesses more (better) information than another party, which causes an
imbalance in transaction power. Company managers typically possess more
information regarding the company’s performance, prospects, risks, and
future outlook than external users such as creditors (debt holders) and
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investors (shareholders). Therefore, to compensate for information
asymmetry, external users demand a higher return to counter the risk that
they are taking. In essence, due to information asymmetry, external sources
of finances demand a higher rate of return to compensate for higher risk.
In the context of the pecking order theory, retained earnings financing
(internal financing) comes directly from the company and minimizes
information asymmetry. As opposed to external financing, such as debt or
equity financing where the company must incur fees to obtain external
financing, internal financing is the cheapest and most convenient source of
financing.

When a company finances an investment opportunity through external

financing (debt or equity), a higher return is demanded because creditors and
investors possess less information regarding the company, as opposed to
managers. In terms of external financing, managers prefer to use debt over
equity – the cost of debt is lower compared to the cost of equity.

The issuance of debt often signals an undervalued stock and confidence that
the board believes the investment is profitable. On the other hand, the
issuance of equity sends a negative signal that the stock is overvalued and
that the management is looking to generate financing by diluting shares in the
company.

When thinking of the pecking order theory, it is useful to consider the

seniority of claims to assets. Debtholders require a lower return as opposed to
stockholders because they are entitled to a higher claim to assets (in the event
of a bankruptcy). Therefore, when considering sources of financing, the
cheapest is through retained earnings, second through debt, and third through
equity.

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2. STATIC TRADE-OFF THEORY

The static trade-off theory is a financial theory based on the work of

economists Modigliani and Miller in the 1950s, two professors who studied
capital structure theory and collaborated to develop the capital-structure
irrelevance proposition. This proposition states that in perfect markets, the
capital structure a company uses doesn't matter because the market value of a
firm is determined by its earning power and the risk of its underlying assets.

According to Modigliani and Miller, value is independent of the method of

financing used and a company's investments. The M&M theorem made two
propositions:

 Proposition I: This proposition says that the capital structure is irrelevant

to the value of a firm. The value of two identical firms would remain the
same, and value would not be affected by the choice of finance adopted to
finance the assets. The value of a firm is dependent on the expected future
earnings. It is when there are no taxes.

 Proposition II: This proposition says that the financial leverage boosts

the value of a firm and reduces WACC. It is when tax information is
available.

With a static trade-off theory, since a company's debt payments are tax-
deductible and there is less risk involved in taking out debt over equity, debt
financing is initially cheaper than equity financing. This means a company

23
 can lower its weighted average cost of capital through a capital structure with
debt over equity.

However, increasing the amount of debt also increases the risk to a company,
somewhat offsetting the decrease in the WACC. Therefore, static trade-off
theory identifies a mix of debt and equity where the decreasing WACC
offsets the increasing financial risk to a company.

3. MARKET TIMING THEORY

Market Timing Theory is a more recent development and refers to the firms’
practice of issuing equity at a high price and repurchasing it at a lower price.
The theory is premised on the assumption that managers base their financing
decision on conditions on the capital markets. If conditions on the market are
unfavourable, managers may consider delaying investments. Such conditions
preclude the idea of the existence of a target capital structure. Rather, the
corporate capital structure appears as the aggregate of managers’ efforts to
synchronise with the capital market (Baker and Wurgler, 2002). The market-
to-book ratio has been used in order to assess the market timing
opportunities. The conclusion of research is that the firms’ preference to issue
more equity than debt when the market value of equity is high exerts a long-
term positive influence on capital structure. Equity issuance – when the
market valuation of equity is high – is typical of unlevered firms; conversely,
levered firms issue shares when their market value is low. The theory
attributes a major role to managers who must time the financing behaviour of
the firm to the market in order to act in the interest of existing shareholders
by issuing overvalued securities to new shareholders (Hovakimian et al.,
2001; Huang and Ritter, 2005). Abandoning his earlier claims, Hovakimian
(2006) showed that in the long run market timing does not exert significant
effects on firms’ capital structure.

4. NET OPERATING INCOME APPROACH

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 This approach was put forth by Durand and totally differs from the Net
Income Approach. Also famous as traditional approach, Net Operating
Income Approach suggests that change in debt of the firm/company or the
change in leverage fails to affect the total value of the firm/company. As per
this approach, the WACC and the total value of a company are independent
of the capital structure decision or financial leverage of a company.

As per this approach, the market value is dependent on the operating income
and the associated business risk of the firm. Both these factors cannot be
impacted by the financial leverage. Financial leverage can only impact the
share of income earned by debt holders and equity holders but cannot impact
the operating incomes of the firm. Therefore, change in debt to equity
ratio cannot make any change in the value of the firm.

It further says that with the increase in the debt component of a company, the
company is faced with higher risk. To compensate that, the equity
shareholders expect more returns. Thus, with an increase in financial
leverage, the cost of equity increases.

5. AGENCY THEORY APPROACH

The agency theory of capital structure choice, developed by Jensen and

Meckling (1976). It has been shown that in corporate firms with separated
ownership and control (management), retained earnings representing free
cash flow can, under managerial discretion, be used suboptimally because of
the misalignment of interests (objectives) between the managers and owners.
Managers are interested in employment and high earnings plus other
consumables and perquisites; they may have incentives to pursue strategies of
firm size growth that signal their good performance to the owners, even if it
requires non-profitable investments and likely results in losses to the owners
(Baker et al., 1988; Donaldson, 1984).

These residual losses, or agency costs, that stem from managers’ sub-optimal
behaviour give rise to the need of aligning the agents’ (managers’) incentive
structure with that of the principals. Agency theory finds the potential for the
ex ante incentive alignments in the right choice of financial instrument.
Grossman and Hart (1982) and Jensen (1986) argue that it is the use of debt
that can induce managers to behave in a manner more aligned with the
owners’ interests. Contrary to the pecking order theory, the agency theory
thus suggests that, in corporate firm settings, it is more optimal to finance

25
 investment projects through debt than from retained earnings. The role of
debt lies in the additional screening of the investment project by external
financiers, disciplining managers in using the available financial resources to
secure regular debt interest payments and in decreasing the volume of free
cash flow by redistributing it to investors (Jensen, 1986). Therefore, debt is
considered as a financial instrument increasing the efficiency of firm
financial resource use due to its agency costs-mitigating effect.

SAMPLE CASE STUDIES

1. M/S VITHAL ENTERPRISES

Introduction

Shri Vishal Shantilal Hajeri is the Sole Proprietor of M/s Vithal Enterprises.
Mr.Hajeri has passed BE Electronics from Pune University, in first class in
the year 2002. He has also passed his MBA from Pune University in the year
2005. He started his own manufacturing unit in July 2006 under the firm
name and style of M/s Vithal Enterprises.

Scope for Business:

He is on the approved list of manufacturers for supply of spare parts to

ordinance factory of the Defence Department since 2006. The department
has to purchase the spare parts only from the approved list. To that extent the
competition is limited.

Constitution: The business is a proprietary concern

Infrastructure:

a) Premises: He is doing business in rented premises at Pune at the

Following address: Opposite Dhayareshwar Mangal
Karyalaya, Dhayari Phata, Sinhagad Road, Pune-51. His

26
 father has purchased land at Ambegaon Budruk for Rs. 3.00
lacs admeasuring 10 R ( Sq.Feet) on 26-10-2004. Since the
present rented premises his very small, Mr. proposes to
build a factory shed admeasuring 1200 sq. feet on the plot.
The project report is for the purpose of loan for constructing
the premises.

b) Suppliers of raw materials: Raw materials viz. Ferrous and Non

ferrous
Metals required by him are available at
Pune and Mumbai.

c) Employees: There are 7 employees with a minimum service of 2

years.
Two are DME and the rest are ITI qualified.

d) Electricity: He needs 20 HP connection for which he will submit the

application as soon as the construction starts.

e) Machinery: He has purchased necessary machinery out of his funds.

e) Furniture: Necessary furniture is already purchased.

Cost of Project:

Sr.No Particulars Amount in Lacs

1 Land 3.00
2 Construction of premises and electricity 8.00
3 Margin money for working capital 1.00
Total 12.00

Means of Finance:

Sr.No Particulars Amount (Lacs)

1 Margin Money ( 58% of the project cost) 7.00
2 Term Loan from Bank (42% of the cost)* 5.00
Total 12.00

Profitability Estimates:

27
 31-3-07 31-3-08 31-3-09
Profit and Loss A/c for
1 Sales 9.46 11.70 13.46
2 Interest/other income 0.00 0.00 0.00
3 Total income 9.46 11.70 13.46
4 Manufacturing expenses 6.14 7.97 9.29
5 Selling and Administrative expenses 0.52 0.59 0.77
6 Depreciation 1.37 1.28 1.25
7 Total Interest 0.34 0.78 0.72
8 Profit before tax 1.09 1.08 1.43
9 Provision for tax 0.01 0.01 0.04
10 Net profit 1.08 1.07 1.39

Projected Balance Sheet:

Evaluation of Above Information Disclosed:

 Since this entity is a proprietary firm, it generally raises two types of funds
— proprietor’s savings and loans from banks, non–banking financial
corporations, friends, and relatives. However, a public limited company can

28
 raise funds through various sources, such as issue of equity and preference
shares, issue of debentures, term loans from banks, and retained earnings.
Amongst the Banks they should negotiate with banks and choose the bank
which offers comparatively lowest cost.

 M/s Vithal Enterprises had bought a term loan of Rs. 5 lacs from a bank at a
rate of 12.25%, which was to be repaid in five years. They have incurred the
following expenses in connection with the loan:
Mortgage expenses : 10,000
Processing fees of the bank: 5,000
Consultant’s charges : 5,000
Stamp Duty : 5,000
Miscellaneous expenses : 5,000
Total : 30,000
12.25% + 30,000/5 X 100 = 12.25 + 2.4 = 14.65%
(5,00,000/2)
 A company calculates the cost of equity, cost of preference cost of
debenture and cost of term loans to compare them and to choose the most
optimum mix of the capital. The mix of capital when the weighted
average cost of capital is the lowest is the optimum mix.

Cost of Equity = PAT/Equity = 1.08/6.9 =15.65%

Weighted Average Cost of Capital = Proportion of equity x cost of equity +
Proportion of debt x cost of debt
= (6.8/12.16) X .1565 + (5.26/12.16) X .1465
= 15.08%

2. IS RELIANCE BEATING ITS COST OF CAPITAL?

Overview

Reliance, as we all know is in multiple business segments like Refining,

Petrochemicals, Oil and Gas, Retail, Digital services etc. It is the topmost
company by market cap. To keep this in perspective, it is close to 8% of the
total market cap of BSE.

There are two types of profit. First is accounting profit and the other is
economic profit. Accounting profit is the profit calculated according to the

29
 generally accepted accounting principles. The economic profit is something
which I learned from Michael J. Mauboussin (head of Consilient Research at
Counterpoint Global – Morgan Stanley) that the company should earn more
than its Cost of Capital.

I have tried to apply the same logic on Reliance Industries Ltd.

Calculation of the Cost of Capital –

I have calculated the cost of capital by using the combination of the cost of
debt & equity which we call as WACC (Weighted Average Cost of Capital).

Source: Data is taken from the annual reports

Total equity is the summation of Share Capital and Reserves. Total

Borrowings is the summation of Long-term debt, Short-term debt and current
portion of long-term debt.

Finance cost is calculated by dividing the Interest Cost/expense (reported in

the P&L) by the Total Borrowings.

The effective tax rate is calculated by dividing the Profit/Earnings before Tax
by the total tax paid.

Weight of debt is calculated by dividing the debt portion by the total capital
(Debt+Equity). Weight of equity is calculated by dividing the equity portion
by the total capital (Debt+Equity).

Why the Cost of Equity is assumed at 13%?

30
Imagine you have enough money to start a business. What is the basic return
that you’ll expect from your business? Or What is your opportunity cost?

In my opinion, your opportunity cost is Nifty 50. It is the weighted average

set of the topmost 50 companies in India. You are not investing your money
into these top companies which have the experience to run the business,
rather you want to start your own business. You can just sit at your home
without doing any hard work for your own business by investing money in
Nifty’s ETF. If you decide to not invest your hard-earned money in Nifty’s
ETF, it becomes your opportunity cost.

Finance (Debt) cost is too low

If you look at the Finance cost, it is just about 3% on an average over the
years. To put this in perspective, the Indian government is getting debt at a
higher rate than Reliance.

Source: Gov. bond yield data is sourced from Investing.com

It means that Reliance is safer than the Indian Government! This made me go
deeper into the break-up of the Borrowings & the Finance cost.

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 CONCLUSION

Financial needs of a business are of different types — long term, short term,
fixed and fluctuating. Therefore, business firms resort to different types of
sources for raising funds. Short-term borrowings offer the benefit of reduced
cost due to reduction of idle capital, but long – term borrowings are considered
a necessity on many grounds. Similarly equity capital has a role to play in the
scheme for raising funds in the corporate sector.

As no source of funds is devoid of limitations, it is advisable to use a

combination of sources, instead of relying only on a single source. A number of
factors affect the choice of this combination, making it a very complex decision
for the business.
To conclude, following are the factors that affect choice of sources of funds:-
i. Cost
ii. Form of Organisation and Legal Status
iii. Purpose and Time Period
iv. Financial Strength and stability of operations
v. Risk Profile
vi. Control
vii. Effect on credit worthiness
viii. Flexibility and Ease
ix. Tax Benefits

32
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