Class 12-commerce NCERT Solutions Business Studies Chapter 1: Financial Management

Capital structure refers to the ratio of debt and equity in the total capital of a company. Herein, debt (borrowed funds) comprises loans, public deposits and debentures. On the other hand, equity (owner's funds) comprises preference share capital, equity share capital, retained earning etc.

 Algebraically,

Capital Structure = 

The capital structure affects an organisation's financial risk and profitability. While debt proves to be cheaper than equity, higher proportion of debt in the capital structure implies greater financial risk for the firm. Thus, the capital structure must be decided carefully. Capital structure is said to be optimal when the ratio of debt and equity is such that the value of equity share increases, or in other words, the shareholder's wealth increases.

Financial planning involves identifying the sources from where the funds can be obtained and ensuring that the required funds are available to the firm as and when needed. In this way, financial planning ensures that the various functions of the organisation are carried out smoothly.

Two 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 which 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 utilisation 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 operations of the firm, excess funding leads to wasteful expenditure by the firm. Thus, proper financial planning ensures optimal utilisation of funds by the firm.

Trading on equity concept increases return to equity shareholders due to the presence of fixed financial charges.

The type of business conducted by Amrit is transport service which will be operating on a large scale. Hence, there is need of more amount of working capital.

As Ramnath has adopted the policy of purchasing components on credit for 3 months and selling the product in cash. Therefore, working capital requirement is reduced.

Financial risk refers to the risk that borrowed funds would not be repaid. In other words, it implies the risk that the company would not be able to meet its fixed financial obligations such as interest payment, preference dividend and other repayment obligations.

Such a situation arises when the company incurs higher debt. This is because debt involves an obligation to repay the principle amount along with the interest. Thus, higher debt would involve higher repayment obligations and accordingly higher would be the risk of default.

Current assets refer to those assets which can be converted to cash or used to pay off liabilities within one year. Companies use such assets to facilitate smooth business operations. Such assets provide the required liquidity to the company. They are generally used by a firm to meet its payment obligations. However, as these assets are converted to cash in a very short period of time, they do not provide much return and are less profitable. Both short-term and long-term sources can be used to finance current assets.

Some common examples of current assets for a business are cash equivalents, inventories, debtors and bill receivables.

The basic objective of financial management is to maximise the wealth of shareholders. In other words, it aims at taking financial decisions which prove beneficial for shareholders. Such financial decisions are taken wherein the anticipated benefits exceed the cost incurred. This in turn implies an improvement in the market value of shares. An increase in the market value of shares is gainful for shareholders. In other words, financial decisions must be taken which lead to value addition to the company, so the price of the equity share rises. As this basic objective gets fulfilled, other objectives such as optimum utilisation of funds, maintenance of liquidity etc. are also fulfilled automatically.

Financial management means efficiently acquiring and using funds. It is concerned with the following three main financial decisions:

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. These decisions are taken for both long term and short term.  

• Long-term investment decisions: These decisions affect a firm's long-term earning capacity and profitability. They are also known as the capital budgeting decisions. For example, decision to purchase a new machine and land.
• Short-term investment decisions: These decisions, also known as the working capital decisions, affect the day-to-day business operations. For example, decisions related to cash or bill receivables.

Financial Decisions:

Financing decisions involve decisions with regard to the volume of funds and identifying the sources of funds. 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 an optimum combination of debt and equity. For example, while debt proves to be cheaper than equity, it involves greater financial risk. Financial decisions must be taken judiciously as they have an impact on the overall cost of capital of the firm and the financial risk.  

Dividend Decisions:

Dividend decisions involve decisions regarding how the company would distribute its profit or surplus. It can either distribute it to the equity shareholders in the form of dividends or keep it in the form of retained earnings. Dividend decisions aim at maximising the wealth of shareholders while at the same time taking into consideration the requirements of retained earnings for the company.  

A company is able to issue debenture for fund raising when the debt cost is less than cost of capital.

In this question. Cost of capital of Sunrises Limited is 10% which is 8,00,000 as total capital is 80,00,000.

Now return on investment is calculated as

ROI = Return / Investment

= 8,00,000/1,00,00,000

= 8 %

On assuming that the company will be operating on the same efficiency, the additional investment of 80,00,000 will have a ROI of 8% which will amount to 6,40,000.

The cost of debt will be 8,00,000 which is more than the ROI of 6,40,000. Therefore, it is advisable for a company not to issue debenture when cost of debt is higher than cost of capital.

Working capital refers to current assets which help in day-to-day business operations. For example, cash, debtors and stock. Working capital has an impact on both liquidity and profitability of a business.

Current assets can be easily converted to cash. Accordingly, greater amount of working capital provides greater liquidity to the business. However, current assets provide low return and so are less profitable. A certain amount of current assets should be maintained to meet payment obligations.

Accordingly, the amount of working capital must be such so as to maintain a proper balance between liquidity and profitability.

For example, if a business has greater inventories, then it would increase liquidity. On the other hand, as the stock is kept idle, it lowers profitability.

a. The financial concept discussed here is capital budgeting, it is decision regarding capital investment which will be having an impact on the profitability of the company in the long term.

The company wants to invest in new machinery which needs investment, this will have a direct impact on the operations which will result in affecting the profitability of the organisation.

The following objectives can be achieved:

1. Cash flow: Investment will bring new machinery which will increase the organisations profitability.

2. Company wants to raise funds from both inside and outside organisation, it will be helpful to analyse that return generated from such investment will be more than cost of capital.

3. Investment used: The company is planning to raise funds from both inside and outside. It is important to know that funds from internal and external sources will have different rates of interest.

b. Companies pay dividend to shareholders which is a part of the company earnings. Paying of dividends is based on following factors:

1. Legal Constraint: Legal constraints are such constraints that are mentioned in the company laws which impact paying out dividends on certain occasions. It should be followed properly.

2. Contractual Constraints: Pay out of dividend reduces cash in the company. Money that is raised as loan will put certain restrictions on the company for paying dividends, such constraints are called contractual constraints.

Working capital refers to current assets which help in day-to-day business operations. For example, cash, debtors and stock.

There are two main concepts of working capital as follows:

• Gross working capital: It simply implies investment in current assets.
• Net working capital: It implies the excess of current assets over current liabilities (obligatory payments which are due; for example, bills payable, outstanding expenses etc.).
• Algebraically, Net Working Capital = Current Assets - Current Liabilities

Five determinants of working capital requirement:

1. Type of Business: The nature of business is one of the important determinants of working capital requirement.
2. For instance, organisations dealing in services have shorter operating cycles, i.e. no processing is done in such organisations. Accordingly, they require low working capital.
3. As against this, an organisation dealing in manufacturing would require large working capital. This is because it involves a large operating cycle, i.e. the raw materials first need to be transformed to finished goods before they are offered for sale.
4. Scale of Operations: Firms which operate on a larger scale require greater working capital than those which operate on a lower scale. This is because firms with greater scale of operations are required to maintain high stock of inventory and debtors. As against this, a business with smaller scale of operation requires less working capital.
5. Fluctuations in Business Cycle: In various phases of the business cycle, the requirement of working capital is different. For instance, in the phase of boom, both production and sales are higher. Accordingly, the requirement of working capital is also high. As against this, in the phase of depression, the demand is low, and so production and sale are low. Accordingly, there is less requirement of working capital.
6. Production Cycle: Production cycle refers to the time gap between receiving goods and their processing into final goods. Longer the production cycle for a firm, larger are the requirements of working capital and vice versa. This is because a longer production cycle would imply greater inventories and other related expenses, so greater requirement of working capital. 
7. Growth Prospects: Higher growth prospects imply higher production, sales and inputs. Accordingly, higher growth prospects for a company implies greater requirement of working capital and vice versa. 

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 fund refers 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 which would be used by the company depends on three main factors-cost, risks and returns.

1. Cost considerations: Debt is a cheaper source of finance than equity.

The low cost of debt is because

• In case of debt, 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.

In contrast, 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 compulsion to repay the debt amount in a fixed period of time. Any default in repayment may even lead to liquidation of the firm. As against this, in case of equity there is no such risk as it is not mandatory to pay dividends to shareholders.

3. Return: Debt offers higher return in the sense that in case of debt, the difference between cost and return is greater. Accordingly, the earning per share is greater.

Thus, we can say that while debt is cheaper and offers higher return, it is more risky to the company. Hence, the decision regarding the capital structure must be taken after careful consideration of the various factors such as cost, return and risk involved.

Capital budgeting decisions refer to long-term investment decisions. For example, investment in a new fixed asset, new machinery and land. Such decisions must be taken after very careful consideration. They have an impact on the long-term earning capacity of the company. They have long-term implications on the business. Moreover, such investment involves a large amount of money, so it is very difficult to revert such decisions.

The following points highlight the importance of capital budgeting decisions for a company:

1. Long-term implications: Capital budgeting decisions have long-term implications for the company in the sense that they affect the future growth prospects of the company.
2. Large amount of funds: Capital budgeting involves a large amount of funds. They make a large amount of money blocked for a long time. Thus, such decisions must be taken only after careful consideration of the requirement of funds and the sources from which it can be obtained.
3. High risk: Investment in fixed assets involves a large amount of risk. They have an impact on the long-term existence of the company. For instance, purchase of new machinery involves a risk in the sense that whether it would provide returns compared to the cost incurred.
4. Irreversible decisions: Capital budgeting decisions involve a large amount of money. Accordingly, it is difficult to revert such decisions. This is because reverting such investment would imply losses to the company. 

A company must decide what proportion of profits it would distribute as dividends to shareholders.

Factors which affect the dividend decision:

1. Amount of Earning: A firm decides the dividends to be paid on the basis of it 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 and smooth earnings can pay higher dividends to the shareholders than a company which has unstable and uneven earnings.
3. Stable Dividends: Generally, companies try to stabilise their dividends such that there are not much fluctuations 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 lesser cash (low liquidity), then it will not be able to pay many dividends. Even with higher profits, a company would not be able to pay many dividends even when it has less cash.
6. Preference of Shareholders: The preference of shareholders must also be considered while taking dividend decisions. For instance, if the shareholders prefer that a certain minimum amount of dividends be paid, then the company may declare the same.
7. Taxation Policy: Taxation policy of the government is an important factor in taking the dividend decision. For instance, if the rate of taxation on dividend is high, then the company may not distribute many dividends.
8. Stock Market Reactions: The dividend decisions taken by a company affects the market price of its stock. If a company declares higher dividends, then it is seen positively by the 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 restrict or mould their dividend decisions. Such agreements must be kept in mind while taking dividend decisions.
10. Access to Capital Market: Generally, companies having greater access to the capital market are likely to pay higher dividends. This is because they need not to rely much on retained earnings. On the other hand, companies with lower 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.  

Trading on equity means a practice wherein the proportion of debt in the capital structure is increased such that the earnings per share increase. A company generally opts for trading on equity in a situation when the rate of return on investment is greater than the interest rate on the borrowed fund (i.e. when the financial leverage is favourable). Greater the difference between the return on investment and the rate of interest on debt, higher are the earnings per share.

The following example explains the use of trading on equity. Suppose there are two situations for a company. In situation I, it raises a fund of Rs 6,00,000 through equity capital. In situation II, it raises the same amount through two sources-Rs 3,00,000 through equity capital and the remaining Rs 3,00,000 through borrowings. Also, suppose the tax rate is 30% and the interest on borrowings is 10%, the earnings per share (EPS) in the two situations is calculated as follows:

As can be seen in the second situation, EPS is greater than that in the first. This is because in the second situation, the company has taken advantage of trading on equity. The return on investment can be calculated as follows:

Hence, we can say that trading on equity is profitable.

However, trading on equity must be used only when the return on investment is more than the interest on borrowed funds. Else, trading on equity should be avoided.

1. Role of financial management in the given company is as follows:

1. To decide the volume of fixed assets: If the company decides to invest more in a particular kind of fixed asset, then the share of that asset in the overall composition would increase.
2. To decide composition of funds used: The company may use a combination of short-term and long-term financing sources. Such decisions are based on the company's preferences regarding liquidity and profitability. For instance, if a company prefers higher liquidity, then it would rely on long-term financing.
3. Proportion of debt and equity in long-term financing: The company must decide what would be the proportion of debt and equity in the long-term finance. This is a financial decision, which in turn is part of financial management.
4. Quantum and composition of current assets: The decision regarding current assets is dependent on the decision regarding what amount of fixed assets is to be held. For instance, a decision to increase the volume of fixed assets would imply an increase in the requirements of working capital and vice versa.

The basic objective of financial management is to maximise the wealth of shareholders. Such financial decisions are taken wherein the anticipated benefits exceed the cost incurred, which in turn implies an improvement in the market value of shares. An increase in the market value of shares, in turn is gainful for shareholders. In other words, such financial decisions must be taken which lead to value addition for the company and accordingly the price of the equity share rises. 

2. Points highlighting the importance of financial planning for the company:

1. Financial planning helps in forecasting the future. For instance, with the help of financial planning, it would be able to forecast whether the expansion would be beneficial in terms of sales and profits.
2. It would help in avoiding such situations as shortage or surplus of funds.
3. Proper financial planning promotes better coordination of production and sales.
4. By clearly defining the targets and policies, it helps in evaluating current performances.  

Financial Plan

One plan can be to collect 50% of the required funds through the issue of shares and the remaining through borrowed funds.

3. Factors affecting the choice of capital structure:

1. Cash flow: Debt should be opted by the company only if it has a strong cash flow position. This is because cash would be required to repay the principle along with the interest rate on the debt.
2. Debt-service coverage ratio (DSCR): It depicts the cash payment obligations of a company as against its availability of cash. In case DSCR is high, the company can opt for more debt.
3. Equity cost: The cost of equity depicts the financial risk faced by the company. If the financial risk is higher, then the shareholders expect a higher return. This in turn implies a rise in the cost of equity. However, if the cost of equity is high, then it would be difficult for the company to opt for more equity.
4. Condition of stock market: In situations of good stock market conditions, the company can easily opt for equity capital and vice versa.
5. Interest coverage ratio: It means the number of times 'earnings before interest and tax' can meet the interest rate obligations. If this ratio is high, then it implies lower risk for the company, thereby the company can opt for more debt.
6. Floatation cost: Higher the flotation cost of a particular source, lower is its preference in the capital structure and vice versa. 
7. Rate of interest on debt: High rate of interest on debt implies higher cost of debt, thereby it becomes difficult to opt for debt in the capital structure. 

4. Factors which will affect the fixed capital requirements of the company:

1. Type of business: The given company deals in manufacturing (having a large operating cycle), so it requires large fixed capital.
2. Scale of operations: The given company has a large-scale of operations. This suggests that it would require larger fixed assets in the form of plants, land and building.
3. Growth prospects: The company is growing and expanding, so it requires higher amount of fixed capital. 

Factors which affect the working capital requirements of the company:

1. Type of business: The company would require large working capital as it is a manufacturing firm and involves a large operating cycle. Accordingly, it requires large working capital.
2. Scale of operations: The scale of operations for the company is large, so it requires large working capital.
3. Growth prospects: With high growth prospects, the requirements of working are also higher.
4. Seasonal factors related to operation: With a rise in demand for the product, the company would require high working capital.