Financing Decision

1. Unit 2-Financing Decisions

2. Contents
 Introduction to Capitalization, Capital structure& Capital
Gearing; Sources and Instruments of Long term funds & its
merits and demerits; Computation of Cost of Capital -
Equity, Preference, Debentures & Weighted Average Cost of
Capital; Factors determining capital structure - Leverages -
Operating Leverage, Financial Leverage and Combined
Leverage, EBIT, and EPS Analysis.

4. Introduction
 The dual aspects namely procurement and application of funds
are the crucial tasks financial management. The main functions or
decisions areas of financial management are popularly called
financial decisions.
 Financing decision is the second major decision of the firm for
determining its best financing mix.
 After determining the asset mix, the financial manager must
decide the mode of raising the funds to meet the firms investment
requirements. The major issue in this direction is to determine the
proper proportion of equity and debt capital.

5. Capital
 Capital refers to the funds borrowed from different sources of finance by the
business firm to acquire firms assets to be used in the operations of a firm.
 So capital refers to the funds invested in a business
 There are two types of capital
1.Fixed Capital
2.Working Capital
Capital can be invested in a business at the time of
1.Starting up of a business
2.Innovation,growth and expansion and also,
3.Winding up of a company

6. Capital Structure
 Capital structure refers to the composition of various long term
sources of funds
 It shows the mix of equity capital, retained earnings and debt capital
 Capital structure of a company refers to the composition or
components of its capitalization and it includes all long – term capital
resources (Loans, reserves, shares and bonds). It is made up of debt
and equity securities and refers to permanent financing of a firm.
 According to M.Y Khan and P.K Jain –The capital structure is the
proportion of Debt,preference and equity shares on a firm’s balance
sheet

7. Capitalization
 Capitalization refers to the total amount of securities issued by a company,while
capital structure refers to the kind of securities issued and the proportion of
securities that make up the capitalization
 Capitalization is the financial structure of the business which consists of owned
capital and borrowed capital including long-term debts.
 In other words, capitalization is a quantitative assessment of a firm's capital
structure.

8. Two Concepts of Capitalization
 The two variants of capitalization are Overcapitalization and Undercapitalization
 Over capitalization-A company is said to be over capitalized when the capital of the does
not justify its earnings or earnings are less than the expected returns. In other words, capital
is the more than the requirements of the firm. When the total capital exceeds total assets that
shows the over capitalization in the business.
 Under capitalization-This is the opposite concept of over capitalization.It will occur when
the actual capitalization is lower than the capitalization required for its earning capacity.
When the owned capital of the firm is not proportionate to the size of the business operations,
therefore the earnings are extra ordinary high. In other words, under capitalization means, the
rate of profit on capital is higher than the normal return enjoyed by the similar companies

9.  Neither,Over capitalization and under capitalization is good for a
business.Optimal capital structure of a firm is the mix of debt and equity that
maximises a firms value by minimising its cost of capital.
 Financial Structure-Financial structure shows how the assets of the firm
financed, i.e total liabilities of the firm. Therefore it includes both short term as
well as long term funds of the organisation

10.  The terms, capitalization, capital structure and financial
structure, do not mean the same. While capitalization is a
quantitative aspect of the financial planning of an enterprise,
capital structure is concerned with the qualitative aspect.
Capitalization refers to the total amount of securities issued by a
company while capital structure refers to the kinds of securities
and the proportionate amounts that make up capitalization.

12. Sources of Capital
 There are two sources of capital ,short term and long term sources
Short term sources consist of
1.Trade credit
2.Bank Credit
3.Accounts receivables
4.Factoring
5.Customer advances
6.Bills discounting
7.Commercial paper
8.Inventory financing
9.Bank Overdraft

13. Sources and instruments of long term funds
 Equity Shares
 Retained Earnings
 Preference Shares
 Debentures
 Term loans from financial Institutions
 Public deposits
 Innovative sources of finance

14. Equity shares
Equity shares are the main
source of fixed or block capital
of the companies. They are also
called as ordinary shares or
owners shares. Equity share is
share that gives equal right to
holders who invest in equity
share.
Merits Demerits
Ownership right High cost of capital
Participate in decision
making process
Equity dividends are not
deductible
Elected as BOD Rigid capital structure
Pre-emptive rights Dilution control
Voting rights No guarantee of regular
dividends
Appoint the company
officers
N guarantee of repayment
of principle while
liquidation

15. RETAINED EARNINGS
Merits Demerits
Free source of finance Not dependable
Easy source of finance Inadequate source
No floating costs They involve opportunity
cost
No dilution of control Possibility of
overcapitalization
They are also called as
ploughing back of profits.
These are the profits or
earnings left after dividends
and tax are paid.

16. PREFERENCE SHARES
Merits Demerits
Cheap source of
finance
Non-deductibility of
dividend
No charge on assets Financial burden
Flexibility No voting rights
Preferential rights No claim over surplus
profit
Fixed regular income No right on decision
making
Preference shares are those
shares which enjoys
preferential right as to payment
of dividend and repayment of
capital at the time of winding
up of the company over equity
shares.

17. DEBENTURES/BONDS
Merits Demerits
Trading on equity No voting rights
Flexibility High floating cost
Cheaper source Charge on assets
No dilution of control Not suitable for common
people
Less risky
Safe and secured
Debts and Bonds are the
important source of long-term
finance. Debentures are the
creditorship securities issued to
creditors for raising debt
finance.

18. LONG TERM LOANS FROM FINANCIAL INSTITUTIONS
Merits Demerits
Trading on equity Charge on assets
Flexibility Financial risk
Cheaper source Fixed financial obligation
No dilution of control
Low floating cost
These are the funds raised from
financial institutions as term
loan.

19. Public deposits
 Public deposits are the unsecured
deposits from the public in large and
small companies, to meet permanent
working capital requirements for more
than three years at an interest rate of
%.Interest on Deposits is the cost of
capital
Innovative source of finance
 Traditional financing relies on
debt and equity issue to meet
long term capital requirements.
However, these instruments are
suffering from limitations.
Finance manager or CEO’s of
modern companies have
diagnosed low costly, low risk
source of finances like – Lease,
Hire purchase, Project finance,
venture capital, bridge finance ,

20. Lease Financing
 Under lease financing owner of an assets gives another person,the right to use the asset
against periodical payments.
 The owner of the asset is known as lessor and the user of the asset is the lessee.
 The lessee gets the right to use the assets but the ownership of the asset lies with the
lessor.
 At the end of the lease period the asset is returned to the lessor or an option is given to the
lessee to purchase the asset or to renew the lease agreement

21. Project Finance
 It is a scheme of financing a particular economic unit/project.it is generally the
long term financing of infrastructure or industrial projects based upon the
projected cash flows of the project.
 Project finance helps to finance new investment by structuring the finance around
the projects future forecasts of cashflows. Thus it involves raising funds at a low
cost and with ease.

22. Venture Capital
 Capital raised to invest on high risky projects with the objective of
earning higher rate of returns.
 The providers of venture capital is called as venture
capitalists.eb.IDBI,IFCI,SIDBI,RCTC(Risk capital and technology corporation)

23. Bridge Finance
 It is the finance provided in the period of delay in sanctioned and disbursement of
loans.The commercial banks are called as bridge to fill the gap by providing short
term loans which is called bridge finance
 This finance is comparatively costlier than the usual termloans by 1% or 2%

24. Franchising
 Under franchising arrangement ,a franchisee pays franchisor for the right to
operate a local business under the franchisor’s trade name.The franchisor must
provide bear certain costs (establishment costs,marketing costs,support services
etc)
 The franchisor willcharge the franchisee an initial franchise fees to cover the
setting up costs.Regular payments as a percentage of the turnover will be paid to
the franchisor as per the terms of the franchise agreement.

25. Factors influencing capital structure