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ou know that every business unit whether it is an industrial establishment, a trading concern or a construction company needs funds for carrying on its activities successfully. It requires funds to acquire fixed assets like machines, equipments, furnitures etc. and to purchase raw materials or finished goods, to pay its creditors, to meet its day-to-day expenses, and so on. In fact, availability of adequate finance is one of the most important factors for success in any business. However, the requirement of finance, now-a-days, is so large that no individual is in a position to provide the whole amount from his personal sources. So the businessman has to depend on other sources and use various ways to raise the necessary amount of funds. In the previous lessons you learnt about the sources and methods of raising funds. You know that the process of raising funds require considerable amount of time and cost. This has its own costs. Hence, every businessman has to be very careful not only in assessing the firm’s requirement of finance but also in deciding on the forms in which funds are raised and utilised. In this lesson, you will learn about the process of estimating the firm’s financial requirement and deciding on the pattern of finance.
OBJECTIVES
After studying this lesson, you will be able to:
l state the meaning and objectives of financial planning;
l explain the concepts of fixed and working capital;
l identify the determinants of fixed and working capital;
l describe the concepts of capitalisation, over-capitalisation and under-capitalisation;
l explain the meaning and importance of capital structure;
l identify the determinants of capital structure; and
l explain the meaning and factors in determining dividend.
FINANCIAL PLANNING
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17.1 FINANCIAL PLANNING
You know that planning is a systematic way of deciding about and doing things in a purposeful manner. When this approach is applied exclusively for financial matter, it is termed as financial planning. In connection with any business enterprise, it refers to the process of estimating a firm’s financial requirements and determining pattern of financing. It includes determing the objectives, policies, procedures and programmes to deal with financial activities. Thus, financial planning involves:
(a) estimating the amount of capital to be raised; (b) determining the pattern of financing i.e., deciding on the form and proportion of capital to be raised; (c) and formulating the financial policies and procedures for procurement, allocation and effective utilisation of funds.
After knowing what is financial planning let us now learn its objectives.
17.1.1 OBJECTIVES OF FINANCIAL PLANNING
The main objectives of financial planning are: (a) To ascertain the amount of fixed capital as well as the working capital required in a given period; (b) To determine the amount to be raised through various sources using a judicious debt-equity mix; (c) To ensure that the required amount is raised on time at the lowest possible cost; (d) To ensure adequate liquidity so that there are no defaults in payments and all contingencies (any unforseen expenditure) are met without difficulty; and (e) To ensure optimal use of funds so that the business is neither starved of funds nor has unnecessary surplus funds at any point of time.
17.1.2 ESSENTIALS OF A SOUND FINANCIAL PLAN
While preparing a financial plan for any business unit, the following aspects should be kept in view so as to ensure the success of such exercise in meeting the organisational objectives.
(a) The plan must be simple. Now-a-days you have a large variety of securities that can be issued to raise capital from the market. But it is considered better to confine to equity shares and simple fixed interest debentures.
(b) It must take a long term view. While estimating the capital needs of a firm and raising the required funds, a long-term view is necessary. It ensures that the plan fully provides for meeting the capital requirement on long term basis and takes care of the changes in capital requirement from year to year.
(c) It must be flexible. While the financial plan is based on long term view, one may not be able to properly visualise the possible developments in future. Not
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(b) Determining the sales output. ( )
(c) To ensure the timely availability of funds. ( ) (d) To determine the quantity of production. ( )
(e) To raise funds at the lowest possible cost. ( )
17.2 TYPES OF CAPITAL REQUIREMENT
The capital requirement of any business unit can be broadly divided into two categories: (a) fixed capital requirement, and (b) working capital requirement. In order to ascertain the amounts of such requirements for any business, one must understand the exact nature of fixed and working capitals and also the various factors that influence their requirement.
17.2.1 FIXED CAPITAL
Fixed capital represents the requirement of capital for meeting the permanent or long-term financial needs of the business. It is primarily used for acquiring the fixed assets like land and buildings, plant and machinery, office equipment, furniture and fixtures etc. Fixed capital is required not only while establishing a new enterprise but also for meeting expansion requirement in the existing enterprises. The amount of such requirement can be assessed by preparing a list of fixed assets needed by the business unit and ascertaining their prices from the market. It may be noted that investment in fixed assets is a long-term commitment and the amount so invested cannot be withdrawn quickly. Hence, the funds for such requirement are always provided from owners’ fund or raised by issuing shares and debentures and taking long-term loans from financial institutions.
17.2.2 FACTORS DETERMING FIXED CAPITAL REQUIREMENT
In order to assess the fixed capital requirement for any business enterprise, one must be fully conversant with the factors that influence such requirement. These factors are summarised as follows: (a) Nature of business: The amount of fixed capital requirement is determined primarily by the nature of business the firm is engaged in. Such requirement, for example, is very large in case of industrial establishments, shipping companies, public utilities, etc. which involve heavy investment in plant and machinery. The trading concerns (wholesalers and retailers) do not require much investment in the fixed assets. (b) Type of products: It is not only the nature of business which determines the requirement of fixed capital but also the type of product involved. A firm manufacturing simple products like soap, toothpaste, stationery, etc. requires small amount of fixed capital as against the firms producing items like steel, cement, automobiles, etc. (c) Size of business: A firm working on a large scale requires heavy investment in fixed assets as it has to establish large production capacity. Hence, its fixed capital requirement is larger than a firm which is operating on a small scale.
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Notes
(d) Process of Production: A firm which goes in for an automatic plant requires larger amount of fixed capital as compared to the firm which selects semi-automatic plant or depends more on manual labour for production of goods. Similarly, if a firm decides to buy most of the components needed for its products from the market rather than producing these in its own factory, it would need less fixed capital as compared to the one which manufactures each component (part) on its own. This is specially true of those automobile and machinery producers who simply act as assembling units.
(e) Method of acquiring fixed assets: The fixed assets, specially machinery and equipment, can be acquired either on cash basis (instant payment) or on installments or leasing basis. Apparently, a firm which acquires such assets on cash basis needs larger amount of fixed capital as compared to the firm which decides to acquire it on installment or lease basis.
17.2.3 WORKING CAPITAL
Working capital represents the amount of funds invested in current assets like debtors, stock-in-trade and cash required for meeting day-to-day expenses, paying wages/salaries to its work-force and clearing dues of its creditors. It is also known as circulating capital because most of the amount invested in current assets is continuously recovered through realisations of debtors and cash sale of goods, and is re-invested in current assets. It keeps on revolving from cash to current assets and back again to cash as shown in the working capital cycle here.
It should be noted that a part of working capital is of a permanent nature because depending on the volume of business certain amount of cash, debtors and stock-in- trade shall always be maintained by every firm. This part of working capital is known as permanent or fixed working capital and must always be financed through long- term sources. The remaining part of the working capital requirement varies from period to period on account of fluctuations in the volume of business and is called fluctuating or variable working capital. This part of working capital is usually financed through short-term sources like bank overdraft, trade creditors, bills payable, etc.
17.2.4 FACTORS DETERMING WORKING CAPITAL REQUIREMENT
Adequate working capital is very necessary for maintenance of liquidity and running the business smoothly and efficiently. However, the amount of working capital required varies from business to business and from period to period. The various factors that influence such requirement are as follows:
Cash
Debtors
Sales
Finished goods
Raw Material
Creditors
Work in Progress
Wages and Salary Working Capital Cycle
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There is no denying the fact that the firms dealing in consumer durables or items involving long production period or wide seasonal fluctuations require large amount of working capital. But, with proper planning and efficient management of inventories and debt collection exercise, the firms can drastically reduce their working capital requirement.
INTEXT QUESTIONS 17B
- Mention any two factors that determine Fixed Capital requirement.
(i) _________________________________________________________ (ii) __________________________________________________________
- State whether we require ‘more’ or ‘less’ working capital in the following cases:
(a) A company manufacturing Iron & steel. ( ) (b) A bread manufacturing company having high inventory turnover. ( ) (c) A large size business enterprise making toys. ( ) (d) A company manufacturing furnitures against orders only. ( ) (e) A company manufacturing of coolers/refrigerators. ( )
- Match the items in column A with column B.
(a) Fixed capital (i) Short term finance (b) Public utilities (ii) Working capital requirement (c) Permanent working capital (iii) Long-term finance (d) Goodwill (iv) Telephone company (e) Fluctuating working capital (v) Intangile fixed asset (f) Length of production cycle (vi) Fixed working capital
17.3 CAPITIALISATION
The term capitalisation has various connotations. In common parlance, it refers to the amount at which a company is valued based on its capital employed. Some of the experts on finance used this concept in a narrower sense and defined it as the par value of a company’s shares and debentures, while some of them interpreted it as the par value of its total long-term funds which includes owners fund, borrowed funds, reserves and surplus earnings. In the context of financial planning however, it refers to the process of determining the amount of capital required by a company.
The capital estimation is arrived at by using the following two theories.
(a) Cost theory; and
(b) Earning theory.
Let us have a brief about these two theories.
(a) Cost Theory: According to the cost theory of capitalisation, the amount of capital required by the company is calculated by adding up the cost of its fixed
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assets, the amount of its working capital and the cost of establishing the busi- ness. This approach is simple and used widely in case of new companies. (b) Earning Theory: According to earning theory, the capital requirement of a company is calculated on the basis of the capitalised value of its earning. For example, if the average annual earning of a company is Rs. 5 lakh and the normal rate of return on the capital employed in case of companies in the same industry is 10%, then the amount of capitalisation is Rs. 50 lakh. For a new company the amount of capitalisation is calculated on the basis of its estimated earning. For example, if a new company expects to earn an average annual income of Rs. 3 lakh and the normal rate of return of the industry is 5%, then the amount of capitalisation or the quantum of fund it would require to run the business is Rs. 60 lakh. This approach of capitalisation is considered more rational and relevant because it helps in evaluating as to how far the actual capital employed is justified by the earning of the company. If the actual rate of return is same as the normal rate of return then it is said to be proper capitalised. But in real sense, a company may be either over capitalised or under capitalised that means the actual rate of return may be less or more than the normal rate of return. Let us know in detail about the concept of over-capitalisation and un- der-capitalisation in the next section. Capitalisation
Proper Capitalisation Over-Capitalisation Under-Capitalisation
17.3.1 OVER-CAPITALISATION
A company is said to be over-capitalised if its capital employed is more than its proper capitalisation. For example, if a company’s average annual earnings is Rs.2,00,000 and the normal rate of return is 10%. Then its proper capitalisation is Rs.20,00,000. Now, if the actual capital employed (total long term funds) is Rs.25,00,000 it will be treated as over-capitalised. You can also put it in another simpler way i.e, if a company’s actual rate of earnings is less than the normal rate of return, it is treated as a case of over-capitalisation. In the above example, the company’s actual rate of earnings works out as 8%, which is less than the normal rate of return i.e., 10%. So, it is considered as over-capitalised and the company is not in a position to pay interest and dividends at a fair rate. Such a situation may be caused by the following factors:
(a) Excessively high price paid for the purchase of goodwill and other fixed assets. (b) Underutilisation of production capacity. (c) Raising more capital in the form of shares and debentures than required. (d) Liberal dividend policy. (e) Higher rate of corporate taxation. (f) Underestimation of capitalisation rate or overestimation of earnings while deciding on the amount of capital to be raised.
× = 2,00, 25,00,000 100 8%
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INTEXT QUESTIONS 17C
- What is meant by the term ‘Capitalisation’?
- Correct and rewrite the following statements if found incorrect.
(a) Under-capitalisation may lead to an increase in the price of company’s equity shares in the market.
(b) Over-capitalisation may be caused by underestimation of capitalisation rate.
(c) Under-capitalisation refers to a situation when the actual rate of earnings is lower than the normal rate of return.
(d) Over-capitalisation refers to a situation when the amount of capital employed in a company is more than what is justified by its earnings.
(e) Over-capitalisation is less harmful than under-capitalisation.
- The balance sheet of AB Ltd. as on March 31, 2008 is as follows:
Liabilities Rs. Assets Rs. Share capital Fixed assets 1,00, 6,000 equity shares 60,000 Current assets 80, of Rs. 10 each Reserves and surplus 40, 8% Debentures 50, Currents liabilities 30, 1,80,000 1,80,
The earnings of the company from the year 2007-08 were Rs. 18,000 while the normal rate of earnings on capital employed in similar companies is 15%.
Compute (a) its proper or fair capitalisation as justified by the company’s earnings, and (b) state whether it is over-capitalised or under-capitalised.
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17.4 CAPITAL STRUCTURE
The financial requirement of a firm can be met through ownership capital and/or borrowed capital. The ownership capital refers to the amount of capital contributed by the owners. In case of a company, it refers to the amount of funds raised by issuing shares. The main characteristic of the ownership capital is that its contributors are entitled to get dividend out of earnings after the payment of interest and taxes. Hence, the rate of return on such capital depends upon the level of profits earned, and, if there are no profits, no dividend may be paid.
Borrowed capital, on the other hand, refers to the amount of funds raised through long term loans and debentures on which its contributors are entitled to a fixed rate of interest which has to be paid at regular intervals (half-yearly or yearly) irrespective of the profits earned. There is also a commitment that the principal amount shall be repaid on maturity. However, it is still considered advantageous to finance business activities through borrowed capital because if the rate of earnings from the planned business investment is expected to be better than the rate of interest on the borrowed funds, it shall ensure higher returns on owners’ funds. Let us take an example and understand this concept more clearly.
Capital Structure Illustration - ‘A’ Illustration - ‘B’ Total Capital Rs. 50 lakh Total Capital Rs. 50 lakh (Rs. 20 lakh owners fund+ (Rs. 50 lakh owners fund+ Rs. 30 lakh borrowed fund) no borrowed fund
Earnings before interest and tax (EBIT) 10,00,000 10,00,
Less : Interest 3,00,000 — @ 10% on borrowed fund
Profit/Earnings 7,00,000 10,00, after interest but before tax
Less : Tax on profit @ 40% 2,80,000 4,00,
Profit after tax (PAT) 4,20,000 6,00,
Return on owners’ funds
PAT × Owners'funds
× = 4, 20, 000 100 21% 20, 00, 000
× = 6, 00, 000 100 12% 50, 00, 000
Suppose the total investment in a business is Rs. 50 lakh, to which owners contribute Rs.20 lakh and the remaining amount of Rs.30 lakh is funded through loans at 10% interest per annum. Assuming expected annual earnings before interest and tax are Rs. 10 lakh (20% on total investment) the profit after payment of interest but before tax will be Rs.7 lakh (Rs.10 lakh –Rs.3 lakh). Let us assume that the tax is payable on profits at the rate of 40%, the profit after tax will be Rs.4.20 lakh (Rs.7 lakh-
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This authority lies primarily with the equity shareholders who have the voting rights. Hence, while deciding on the mix of equity and debt, the promoters/ existing management of the company may also take into account the possible effect of raising funds through equity shares on the right to control the business. In order to retain their right to control the affairs of the company, they may prefer to raise additional funds mainly through debentures and preference shares.
4. Capital market conditions : The conditions in the capital market also influence the capital structure decision. At times capital market is so depressed that the investors are unwilling to subscribe to shares. In such a situation, it is considered better to rely on debt or defer the decision till a favourable market condition is restored. 5. Regulatory norms : While deciding on the capital structure, the legal constraints like the limit on debt-equity ratio should also be kept in view. At present, such limit is 2:1 in most cases. This implies that at any point of time, the debt should not be more than twice the amount of share capital. This limit keeps on changing with changing economic environment and varies from industry to industry. 6. Flexibility : The planned capital structure should be flexible enough to raise additional funds without much difficulty. The company should be able to raise additional capital in the form of debt or equity whenever required. But if the company’s capital structure has too much debt, then the lendes may not be able to give more loan to the company. In a such a situation it may be forced to raise the funds only through shares for which the capital market condition may not be conducive. Similarly, when on account of declining business and lack of other investment opportunities the funds need to be refunded, it may not be possible to do so if the company has heavily relied on equity shares which cannot be redeemed easily. Hence, to ensure an element of flexibility, it is better if the firm relies more on redeemable securities that can be paid off if necessary and, at the same time, have some unused debt raising capacity so that future financial needs can be fully taken care of without much difficulty. 7. Investors’ attitude towards investment : While planning the capital structure of a company one must bear in mind that all investors do not have the same attitude towards their investment. Some are highly conservative who prefer safety to return. For such investors, debentures are considered most suitable. As against this, there are some who are interested in high return on their investments and are ready to take the risk involved. Such investors prefer equity shares. Then, there are many who are willing to take a limited risk provided the return is better than the rate on secured debentures and bonds. Preference shares are most suitable for this category of investors. In order to attract all categories of investors, it is considered more desirable to issue different types of securities specially when the amount of capital requirement is large.
Looking at the above considerations, it can be safely concluded that an appropriate capital structure is one which:
(a) ensures maximum return on equity by making use of the leverage effect within reasonable limits of the risk involved;
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(b) caters to all types of investors by using a judicious mix of different types of securities; (c) has the necessary flexibility to make required reduction or addition to funds, according to changed conditions; (d) involves minimum risk of dilution in control of the company affairs by the existing group of shareholders; and (e) fully keeps in view the legal constraints and the prevailing capital market conditions. To sum up, the most judicious capital structure is one that minimises the cost of funds and maximises the shareholders wealth. In financial management terminology, such a capital structure is called optimal capital structure.
INTEXT QUESTIONS 17D
- Why do you need flexibility in capital structure?
- Which of the following are characteristics of an appropriate capital structure? Indicate, by writing YES or NO in the space provided. Rewrite the statements where your answers is NO. (a) It involves a judicious mix of different types of securities. ( ) ____________________________________________________ (b) It involves dilution of control of existing shareholders. ( ) ____________________________________________________ (c) It caters to exclusively to the wealthy investors. ( ) ____________________________________________________ (d) It ensures minimum return on equity. ( ) ____________________________________________________ (e) It keeps in view the legal constraints. ( ) ____________________________________________________ (f) It has rigidity and firmness and does not change with changed conditions.( ) ____________________________________________________
17.5 DIVIDEND
You know that in every business unit the amount of profit earned (or loss incurred) during a financial year is ascertained and distributed among its owners. In case of a
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4. Expectations of shareholders: The equity shareholders normally look forward to appreciation to their capital rather than higher rate of dividend. But, some shareholders like retired persons or employees do look forward to dividend as a source of their regular income. So, the companies cannot ignore such segment and pay low dividend or skip it even when there are high profits. A reasonable payout is always welcome. In fact, the companies which skip payment of dividend or pay too low rate of dividend as a matter of practice, are rated low in the capital market as the shareholders suspect their management’s intentions. 5. Tax policy: In our country, dividends have been taxable in the hands of shareholders. Hence, the companies prefer to pay low amount of dividend and issue bonus shares to the shareholders from time to time as these are not taxable until these are sold. If these are sold after 12 months, the sale proceeds are regarded as long term capital gain and taxed at a lower rate. However, of late, the government has changed its policy of taxation of dividends. The dividends are not taxable in the hands of shareholders. But the company has to pay some additional tax (12.5%) on the distributed part of its profits. So, the companies have now become liberal in the matter of dividend distribution. 6. Investment opportunities and growth prospects: When a company has adequate profitable investment opportunities and growth prospects, it may prefer to retain more profits and pay low rate of dividends so as to serve the shareholders in a better way in long run. Of course, in the absence of such possibilities, companies prefer payment of higher dividend and avoid idle cash with them. 7. Legal constraints: Sometimes, the government prescribes certain limits on the dividend payout which has to be kept in view while deciding on the rate of dividend to be paid. Similarly, at times the long term fund providers may put some restrictions on the dividend payout as part of their agreement. The companies have to adhere to such limits. In any case, the Company Law has provided certain rules to be followed while deciding on the amount to be distributed as dividend. For example, capital profits are not to be used for distribution of dividend normally; a banking company has to transfer certain percentage of profit to a statutory reserve which is not available for payment of dividend, and so on. These have to be duly abided while determining the amount to be distributed as dividend.
INTEXT QUESTIONS 17E
- Give the full form of the following abbreviations. (a) PAT ______________ (b) PBT ___________ (c) PBIT ______________
- List any five factors affecting the dividend decision of a company: (a) ________________________ (d) ________________________ (b) ________________________ (e) ________________________ (c) ________________________
- State the meaning of the following terms in the space provided. (a) Dividend : _______________________________________________
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(b) Retained Earnings: __________________________________________ (c) Preference Dividend : __________________________________________ (d) Equity Dividend : _____________________________________________
17.6 WHAT YOU HAVE LEARNT
l Adequate and proper financing is quite important for success in any business. While the overall managerial activity of handling finance is called ‘Financial management’, the process of estimating the financial requirement, determining the pattern of financing and formulating financial policies and procedures is termed as ‘Financial planning’. To achieve the objectives of financial planning effectively, it must be ensured that the financial plan is simple, takes a long- term view, has the necessary flexibility to meet changing financial needs of the organisation, provides for reasonable amount at the lowest possible cost, and takes care of the liquidity requirement of the company.
l The firm’s capital requirement can be broadly divided into fixed capital and working capital requirements. Fixed capital represents the requirement of capital for permanent or long-term financial needs of the business. Such requirement depends upon the nature of business, size of business, product involved, type of production process adopted, method of acquiring the fixed assets such as cash basis, installment payment method or lease basis. Fixed capital is funded through long-term sources of finance.
l Working capital represents the amount of funds required for financing current assets. A part of the working capital requirement is of a permanent/fixed nature which has to be funded through long-term sources. But the major part of working capital is fluctuating in nature which varies with fluctuations in the volume of business from time to time and is funded through short term sources like bank overdraft, suppliers’ credit, etc. The working capital requirement is determined by the nature of business, size of business, length of production cycle, inventory turnover rate, firm’s credit policy for its customers and seasonal fluctuations.
l The term ‘capitalisation’ is used in various contexts. In the context of financial planning, it refers to the process of determining the amount of capital required by the business which may be ascertained on the basis of cost theory or earnings theory.
l Actual capital employed by a firm must be justified by its annual earnings. If it is found that the actual capital employed is more than what is justified by its earnings, the firm is said to be over-capitalised and if, on the other hand, it is less than the amount as justified by its earnings it is treated as a case of under- capitalisation. Another measure of assessing whether a firm is over-capitalised or under-capitalised lies in comparing the actual rate of return on capital employed with the normal rate of return based on industry’s average earnings.
l The financial requirement of a firm can be met through ownership capital (equity)
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Long Answer Type Questions
- What is meant by ‘Financial Planning’? Explain any four requisites of a sound financial plan.
- How do you ascertain that a firm is over-capitalised? Explain with an example and state the main causes of over-capitalisation.
- How does raising of long term funds through debt affect the return on shareholders’ funds? Explain with an example.
- What is meant by ‘dividend’? State the factors that affect dividend decision.
- How do you assess the amount of working capital required by a business unit? Describe in brief.
17.9 ANSWERS TO INTEXT QUESTIONS
17A 2. (c) and (e)
- (a) Yes (b) No (c) Yes (d) No (e) Yes
17B 2. (a) More
(b) Less (c) More (d) Less (e) More
- (a) (iii) (b) (iv) (c) (vi) (d) (v) (e) (i) (f) (ii)
17C 2. (a) Correct
(b) Correct
(c) In-correct (Under-capitalisation refers to a situation when the actual rate of earnings is more than the normal rate of return).
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(d) Correct (e) In-correct (Over-capitalisation is more harmful than under- capitalisation).
- (a) 18000 X 100 / 15 = Rs.1,20,
(b) Over capitalised as its actual capital employed is Rs.1,50, which is more than the proper (fair) capitalisation (Rs.1,20,000) and that the actual rate of earnings is 12% as against the normal rate of earnings which is 15%.
17D 2. (a) Yes (b) No – It involves minimum risk of dilution in control by existing shareholders. (c) No – It caters to all types of investors (d) No – It ensures maximum return on equity (e) Yes (f) No – It has the necessary flexibility to make required reduction or addition to funds, according to changed conditions.
17E 1. (a) Profit After Tax
(b) Profits Before Tax
(c) Profit Before Interest and Tax
- (a) Financial needs of the company (b) Liquidity (c) Access to capital market (d) Tax policy (e) Legal constraints
- (a) Amount of profit distributed to shareholders. (b) The part of profit retained in the company to meet the company’s future financial needs. (c) Dividend paid to preference shareholders. (d) Dividend paid to equity shareholders.
DO AND LEARN
Pick up any 10 items/products that you see/use, for example, sugar, furniture, cooler etc. List them and analyse whether each of them require huge or less working capital for production and why?
