Unit-4:Financial management and capitalization

what is financial management?

“Financial management is the activity concerned with planning, raising, controlling and
administering of funds used in the business.”

Financial management is that area of business management devoted to a judicious use of capital
and a careful selection of the source of capital to enable a spending unit to move in the direction
of reaching its goals.

Financial management is an organic function of any business. Any organization needs finances
to obtain physical resources, carry out the production activities and other business operations,
pay compensation to the suppliers, etc. There are many theories around financial management:

1. Some experts believe that financial management is all about providing funds needed by a
business on the most favorable terms, keeping its objectives in mind. Therefore, this
approach is concerned primarily with the procurement of funds which may include
instruments, institutions, and practices to raise funds. It also takes care of the legal and
accounting relationship between an enterprise and its source of funds.
2. Another set of experts believes that finance is all about cash. Since all business
transactions involve cash, directly or indirectly, finance is concerned with everything
done by the business.
3. The third and more widely accepted point of view is that financial management includes
the procurement of funds and their effective utilization. For example, in the case of a
manufacturing company, financial management must ensure that funds are available for
installing the production plant and machinery. Further, it must also ensure that the profits
adequately compensate the costs and risks borne by the business.

Importance of Financial Management •

The role of financial management is such that it has a direct impact on all the financial
aspects/activities of a company. Certain aspects affected by financial management decisions
are

1. Size and composition of fixed assets: The amount of money invested in fixed assets is an
outcome of investment decisions. So, if more amount of capital is decided to be invested in
fixed assets, then it will increase the value of the total share of fixed assets by the amount
invested.

2. Amount and composition of current assets: The quantum of current assets and its
constituents like cash, bills receivable, inventory, etc. is also influenced by management
decisions. It is also dependent on the amount invested in fixed assets, decisions about credit
and inventory management, etc.

3. Amount of long-term and short-term funds to be used: Financial management determines

the quantum of funds to be raised for the short-term and long-term. In case a firm requires
more liquid assets, then it will prefer to have more long-term finance even when its profits
will decrease due to the payment of more interest in comparison to short-term debts.
 4. Proportion of debt and equity in capital: Financial management also makes decisions
regarding the proportion of debt and/or equity.

5. All items in the profit and loss account: All items in the profit and loss account are affected
by financial management decisions. For example, a higher amount of debt will lead to an
increase in the expense in the form of interest payments in the future.

Objectives

1. The basic objective of financial management is to maximize the wealth of shareholders.

2. It aims at making financial decisions that prove beneficial for shareholders. Such
financial decisions are taken.
3. An increase in the market value of shares is gainful for shareholders.
4. It focuses on taking those financial decisions that lead to value addition for the company,
so the price of the equity share rises.
5. As this basic objective gets fulfilled, other objectives such as optimum utilization of
funds, maintenance of liquidity, etc. are also fulfilled automatically.
6. It involves choosing the best alternative which will prove to be beneficial.

Types of Financial Management Financial management is mainly concerned with the

following decisions:

A. Investment Decisions
A firm must decide where to invest the funds such that it can earn maximum returns.
Such decisions are known as investment decisions and can be classified as long-term and
short-term investment decisions.

Long-term investment decisions:

• It refers to long-term investment decisions such as investment in a new fixed

asset, new machinery or land.
• They are also known as capital budgeting decisions. It affects a firm’s long-term
earning capacity and profitability and also has long-term implications on the
business.
• Moreover, such investment involves a large amount of money, so it is very
difficult to revert such decisions. Example: Decision to purchase a new fixed
asset, open a new branch, etc.

Short-term investment decisions

• These decisions are also known as working capital decisions and affect day-to-day
business operations.
• It also affects the liquidity and profitability of a business. Example: Decisions related to
cash management, inventory management etc
B. Financial Decisions
• Financing decisions involve decisions about the volume of funds to be raised from
various sources.
• These decisions also include the identification of sources of finance.
• There are two main sources of raising funds, namely shareholders’ funds (equity) and
borrowed funds (debt).
• Taking into consideration factors such as cost, risk, and profitability, a company must
decide on an optimum combination of debt and equity.
 Factors Affecting the Financial Decision
1. Cost: The cost of raising funds is an important factor taken into consideration while
choosing a source of funds. Generally, the source of funds which is the cheapest will
be chosen.
2. Risk: The Risk involved in each source of funds is different. However, funds with
moderate or low risk are chosen.
3. Flotation Cost: The Higher the flotation cost, the less attractive is the source of
funds.
4. Cash Flow Position: The Cash flow position of a company also impacts its decision
when choosing a source of funds. A company with a strong cash flow position will
invest in debt, whereas a company with a weak cash flow position will opt for equity
investment.
5. Fixed Operating Cost: Companies having a high fixed operating cost must refrain
from investing in debt, whereas companies with less financing costs may opt for
investing more in debt. This is because fixed operating costs like a building or rent
require a lot of finance. Hence, the company must avoid sources of finance which
will add more to their expenses.
6. Control Considerations: Companies that do not want to dilute the level of control
must invest in debt, as investing in equity will result in a dilution of management’s
control over the business.
7. State of the capital market: The status of the capital market is also a crucial factor
in determining the choice of the source of funds. In case the market is bullish, more
people invest in equity, whereas when the market is bearish, it is difficult for
companies to issue equity shares.
C. Dividend Decisions
• Dividend decisions involve decisions regarding how the company would
distribute its profit or surplus.
• Dividend is a part of profit that is distributed to shareholders.
• The company decides whether to distribute it to equity shareholders in the form
of dividends or to keep it in the form of retained earnings. So, the main decision
is regarding how much profit is to be distributed and how much is to be retained
in the business.
• This decision is generally taken considering the objective of maximizing
shareholder’s strength and also retaining earnings to increase the future earning
capacity of the organisation.

Factors Affecting the Dividend Decision

1) Amount of earnings
• A firm decides the dividends to be paid based on its current and past earnings.
• If the company has higher earnings, then it would be in a better position to pay dividends.
• As against this, if a company has low earnings, it would be able to pay lower dividends.
2) Stable earnings
• A company with stable or smooth earnings can pay higher dividends to shareholders than a
company that has unstable and uneven earnings.
3) Stable dividends
• Generally, companies try to stabilize their dividends such that there is not much fluctuation
in the dividends they distribute.
• They opt for increasing the dividends only when there is a consistent increase in their
earnings.

4) Growth prospects • Companies with higher growth prospects prefer to retain a greater
portion of their earnings for future reinvestment. • Accordingly, they pay lesser dividends.
5) Cash flow position
• Payment of dividends implies a cash outflow from the company. If a company has less
cash (low liquidity), then it will pay less in the form of dividends. Similarly, if a company
has surplus cash (high liquidity), then it will pay out more dividends.
6) Preference of shareholders
• The preference of shareholders must also be considered while making dividend decisions.
• For instance, if the shareholders prefer that a certain minimum number of dividends be
paid, then the company is likely to declare the same.
7) Taxation policy
• The Taxation policy of the government is an important factor in making the dividend
decision. For instance, if the rate of taxation on payment of dividends by companies is high,
then the company may distribute less by way of dividends.
8) Stock market reactions
• Dividend decisions taken by a company affect the market price of its stock.
• If a company declares higher dividends, then it is seen positively by investors, and its
stock price increases.
• On the other hand, a fall in the dividends would have an adverse effect on the stock
price of a company.
9) Contractual constraints
• Sometimes, a company may enter a contractual agreement with the lenders which restricts
or shapes their dividend decisions. Such agreements must be kept in mind while making
dividend decisions.

10)Access to capital market

• Generally, large companies having greater access to the capital market would not depend on
retained earnings to finance their future projects. Hence, they are likely to pay higher dividends.
• On the other hand, small companies with less access to capital markets are likely to pay lower
dividends.

11)Legal constraints

• Companies mandatorily need to adhere to the rules and policies of the Companies Act.
• The dividend decisions must be taken in careful consideration of these rules and policies.
• Apart from these provisions, if the company enters into a loan agreement wherein the
lender lays certain restrictions on the payment of dividend in future, then the company
will have to adhere to those restrictions.

Financial Planning

Financial planning involves designing the blueprint of the overall financial operations of a
company such that the right amount of funds are available for various operations at the right
time.

Main Objectives of Financial Planning

1) Identifying the sources from where the funds can be raised and ensuring that the required
funds are available to the firm as and when needed. For this, under financial planning, an
estimation is made regarding the amount of funds that would be required for various business
operations. In addition, an estimation is made regarding the time at which the funds would be
needed.
 2) To ensure that there is proper utilization of funds in the sense that there is neither surplus
nor inadequate funding by the firm. In other words, it ensures that situations of both excess or
shortage of funds are avoided. This is because while inadequate funds obstruct the operations
of the firm, excess funding leads to wasteful expenditure by the firm. Thus, proper financial
planning ensures the optimal utilization of funds by the firm.

Importance of Financial Planning

1) Helps in facing eventual situations: Forecasts things that are to happen, Helps a
business to prepare itself to face future situations in a better manner, Prepares a blueprint
depicting alternative situations, and equips management in advance to tackle changed
prevailing scenarios.
2) Improves Coordination: Helps in coordinating various business functions, For
example, coordinating the functions of the sales, production, and finance departments by
providing clear rules, policies, and procedures.
3) Helps in optimum utilization of funds: Ensures reduction of wastes, thereby leading to
good management of funds
4) Evaluation of performance: By providing detailed business objectives and depicting all
the financial plans for varied business segments, it makes it easier to evaluate segment-
wise business performance
5) Helps in avoiding surprises & shocks: Helps a company to prepare itself for future
shocks and surprises
6) Reduces wastage & duplicity: Detailed plans of action help in reducing wastage and
avoid duplication of efforts
7) Acts as a link: Tries to link the present with the future, Provides a link between
investment and financing decisions

Capital Structure
Capital structure simply implies a combination of different financial sources which a firm uses to
raise
funds.
There are two broad categories of sources of funds, namely borrowed funds and owner’s funds.
Borrowed funds refer to borrowings in the form of loans, borrowings from banks, public deposits,
etc.
In general, ‘borrowed funds’ are simply called debt.
On the other hand, owner’s funds can be in the form of reserves, preference share capital, retained
earnings, etc. In general, owner’s funds can be called equity.
Accordingly, capital structure can be simply stated as the combination of debt and equity used by
a
firm.
• The capital structure of a company affects the profitability as well as the financial risk of
the company.
• Hence, it needs to be taken after considering various aspects.
• The way capital structure is framed by the company depends on three main factors—cost,
risks, and returns.
Cost considerations
• Debt is a cheaper source of finance than equity. The low cost of debt is because the
lenders are
assured of the return amount, i.e. it involves a low risk. Low risk, in turn, implies a lower rate
of return. This implies a lower cost to the company. The interest to be paid on debt is tax
deductible.
• Equities are more expensive than tax as they involve flotation cost as well. Moreover,
dividends
paid to shareholders are not tax deductible (i.e. dividends are paid from profits after tax).
2) Financial risk
• Debt involves financial risk in the sense that there is a compulsion to repay the debt
amount in a
fixed period. Any default in repayment may even lead to liquidation of the firm.
• In case of equity, there is no such risk as it is not mandatory to pay dividends to
shareholders.
3) Return
Debt offers higher returns in the sense that in the case of debt, the difference between cost and return
is
greater. Accordingly, the earnings per share is greater. Thus, we can say that while debt is cheaper
and offers higher returns, it also increases the financial risk of the company.
Hence, the decision regarding the capital structure must be taken after careful consideration of the
factors of cost, return and risk involved.
Optimal capital structure
The optimal capital structure of a firm is often defined as the proportion of debt and equity that
result in the lowest weighted average cost of capital (WACC) for the firm

Cost of capital

A firm’s total cost of capital is a weighted average of the cost of equity and the cost of debt,
known as the weighted average cost of capital (WACC). The formula is equal to:

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

Where:

E = market value of the firm’s equity (market cap)

D = market value of the firm’s debt

V = total value of capital (equity plus debt)

E/V = percentage of capital that is equity

D/V = percentage of capital that is debt

Re = cost of equity (required rate of return)

Rd = cost of debt (yield to maturity on existing debt)

T = tax rate
Importance of Cost of Capital

1. It helps in evaluating the investment options, by converting the future cash flows of the
investment avenues into present value by discounting it.
2. It is helpful in capital budgeting decisions regarding the sources of finance used by the
company.
3. It is vital in designing the optimal capital structure of the firm, wherein the firm’s value is
maximum, and the cost of capital is minimum.
4. It can also be used to appraise the performance of specific projects by comparing the
performance against the cost of capital.
5. It is useful in framing optimum credit policy, i.e. at the time of deciding credit period to
be allowed to the customers or debtors, it should be compared with the cost of allowing a
credit period.

The cost of capital is also termed as cut-off rate, the minimum rate of return, or the hurdle rate.

Explicit cost of capital: It is the cost of capital in which a firm’s cash outflow is oriented
towards utilization of capital which is evident, such as payment of dividends to the shareholders,
interest to the debenture holders, etc.

Implicit cost of capital: It does not involve any cash outflow, but it denotes the opportunity
foregone while opting for another alternative opportunity.

Cost of debt

A company’s cost of debt is the effective interest rate a company pays on its debt obligations,
including bonds, mortgages, and any other forms of debt the company may have. Because
interest expense is deductible, it’s generally more useful to determine a company’s after-tax cost
of debt. The cost of debt, along with the cost of equity, makes up a company’s cost of capital.

Calculating the cost of debt

To calculate a company’s cost of debt, you’ll need two pieces of information: the effective
interest rate it pays on its debt and its marginal tax rate.

Difference between Explicit and implicit cost

Type of cost Direct, out-of-pocket cost Indirect, opportunity cost

Tangibility Tangible and measurable Intangible and hard to quantify
Transaction involved Involves actual cash transaction No real cash transaction
Recognition in financial Recorded in the books of Not recorded in the books
statements accounts
Cash Flow Impacts cash flow directly No direct impact on cash flow
Effect on business tax Can be deducted from taxable Cannot be deducted from taxable
income income
Decision-making Important for short-term decision Crucial for long-term strategic
implications making decisions
Examples Salaries, rent, utility bills Foregone rent, opportunity cost of
capital
Impact on profit Affects accounting profit Affects economic profit
Usage Used in financial accounting Used in economic analysis