Business Finance Notes

Sources of long term financing: The sources of long term financing include ordinary share capital, preference share capital, debentures, long term borrowings form financial institutions and retained earnings.

Equity Shares: Equity shares are also known as ordinary shares or common shares and represent the owners capital in a company. The holders of these shares are the real owners of the company.

Preference Shares: Preference shares have a preference over the equity shares in the event of liquidation of company. The preference dividend rate is fixed and known. A company may issue preference shares with a maturity period (redeemable preference shares). A preference share may also, provide for the accumulation of dividend. It is called cumulative preference share.

Trading on equity: Trading on equity means to raise fixed cost capital such as borrowed capital and preference share capital, on the basis of equity share capital so as to increasing the income of equity shareholders.

Debenture: According to Section 2(12) of the companies act of 1956. “Debenture is an instrument issued by a company under its common seal, acknowledging the debt to the holder, and containing an undertaking to repay the debt on or after a specified period and to pay interest on the debt at a fixed rate at regular intervals usually, half yearly etc. until the debt is paid.”

Retained earning: Retained Earnings is a technique of financial management under which all profits of a company are not distributed amongst the shareholders as dividend but a part of the profits is retained in the company. This is also known as ploughing back of profits.

Term loan: Term loan refers to loan given for a particular period of time. It , may be short or long period. Short term, which is less than a year. Medium term, which lies between two to five years. Long term, which is„ more than 5 years upto 20 years.

Cost of capital: Cost of capital is defined as the minimum rate of return that a firm must earn on its investments so that market value per share remains unchanged.

Cost of equity capital: It refers to the minimum rate of return that a company must earn on the equity share capital financed portion of an investment project so that the market price of share does not change.

Cost of preferred capital: Cost of preference share capital is the rate of return that must be earned on preference capital financed investments, to keep unchanged the earnings available to the equity shareholders.

Cost of debt capital: Cost of debt refers to the minimum rate of return expected by the suppliers of debt capital.

Weighted average cost of capital: Weighted average cost of capital is nothing but overall cost of capital. In other words in case of WACC proper weightage is given to the cost of each and every source of funds i.e. proper assessment Of relative proportion of each source of funds, to the total, is ascertained by considering either the book value or the market value of each source, of funds.

Capital structure: Capital structure is basically focussed towards the objective of profit maximisation? Capital structure is nothing but the financial structure of a firm, which consists of different combinations of securities. In other words it represents the relationship between the various long term forms of financing such as debentures, preference shares capital on equity etc.

Optimal capital structure: “OCS refers to that Capital structure or combination of debt and equity that leads to the maximum value of the firm”. Hence thereby the wealth of its owners also increases with the minimisation of cost of capital.

Flexible capital structure: Flexible capital structure means the capital structure of the firm should be flexible, so that without much practical difficulties, a firm can change the securities in capital structure.

Capital expenditure: Capital expenditure refers to investment that Involves huqe amount, associated with high risk and the benefits from such investment are derived over a longer period of time.

Leverage: Leverage is the employment of fixed assets or funds for which a firm has to meet fixed costs or fixed rate of interest obligation irrespective of the level of activities attained or profit earned.

Types of leverages:

  • Operating leverage
  • Financial leverage.
  • Combined leverage.

Personal leverage: Personal, leverage refers to an individual replicating the advantages of corporate debt by borrowing on personal account and subscribing for an equivalent amount of shares in an unlevered company.

Financial leverage: The use of long term fixed interest and dividend bearing securities like debentures and preference shares along with equity is called financial leverage or trading on equity.

Operating Leverage: The operating leverage occurs when a firm has fixed costs which must be recovered irrespective of sales volume. The fixed costs remaining same the percentage change in operating revenue will be more than the percentage change in sales. This occurrence is known as operating leverage.

Net income approach (NIA): Under this approach, the cost of equity capital and cost of debt capital are assumed to be independent to the capital structure.

Net operating income approach (NOIA): Under this approach, the cost of equity increases in accordance with leverage. Due to which the weighted average cost of capital remains constant and the value of the firm also remains constant as leverage is changed.

Traditional approach of capital structure: The traditional approach of capital structure states that when the Weighted Average Cost of Capital (WACC) is minimized, and the market value of assets are maximized, an optimal structure of capital exists.

MM approach of capital structure: The Modigliani – Miller (MM) hypothesis is identical to the net operatinq income approach. MM arque, that in the absence of taxes, a firm’s market value and the cost of capital remain invariant to the capital structure changes.

Advantages of equity shares:

  • It is a good source of long – term finance
  • It serves as a permanent source of capital
  • Issuance of equity share capital creates no charge on the assets of the company.

Disadvantages of equity shares:

  • The cost of issuance of equity shares is high
  • Trading on equity is not possible
  • Excessive issue of equity shares may result in over-capitalization..

Advantages of Preference Shares are:

  • Fixed return
  • Absence of charge on assets
  • Capital structure flexibility
  • Widening of the capital market
  • Less capital losses.

Disadvantages of Preference Shares are:

  • Dilution of claim over assets
  • Tax disadvantages
  • Increase in financial burden.

Advantages of debentures:

  • Less costly
  • Tax deduction
  • No ownership dilution
  • Fixed interest
  • Reduced real obligation.

Limitations of debentures:

  • Obligatory payment.
  • Financial risk associated with debenture is higher than equity share’s.
  • Cash out flow on maturity is very high.

Merits of long – term loan:

  • Cash Flow.
  • Save time.
  • Increase flexibility
  • Lower interest rates
  • Build credit.

Disadvantages of long – term loans:

  • Liquidation
  • Risk.
  • Collateral
  • Contract contents.

Basic qualities which a sound capital structure should possess:

  • Profitability.
  • Solvency.
  • Flexibility.

Assumptions of MM Hypothesis:

  • There are perfect capital markets
  • Investors behave rationally
  • Information about the company is available to all without arty cost
  • There are no floatation and transaction costs
  • No investor is large enough to effect the market price of shares
  • There is no risk or uncertainty in regard to the future of the firm.
  • The firm has, a rigid investment policy