Financial Management — Investment, Financing and Dividend Decisions, and Capital Structure
Financial Planning
Financial planning is preparing a financial blueprint of the organisation’s future operations. It has two objectives: to ensure the availability of funds whenever they are required, and to see that the firm does not raise resources unnecessarily, because surplus funds add cost without adding return. Its importance: it tries to forecast what may happen and so helps the firm face situations; it helps avoid business shocks and surprises; it helps coordinate the various business functions; it reduces waste and duplication; it links the present with the future; and it links investment and financing decisions. It is usually prepared for three to five years.
Capital Structure and Trading on Equity
Capital structure is the mix of owners’ funds (equity) and borrowed funds (debt). Debt is cheaper than equity — interest is a tax-deductible expense and lenders take less risk — but it is riskier for the firm, because interest must be paid whether or not there is profit. The proportion of debt is called financial leverage. Trading on equity is the use of fixed-cost debt to increase the earnings per share of the equity shareholders. It works only when the return on investment (ROI) is higher than the rate of interest on the debt: the firm earns more on the borrowed money than it pays for it, and the surplus goes to the equity shareholders. When ROI is below the rate of interest, debt reduces EPS.
| Line | All equity (3,00,000 shares) | ₹10 lakh debt + ₹20 lakh equity (2,00,000 shares) |
|---|---|---|
| EBIT | 4,50,000 | 4,50,000 |
| Less interest at 10% | — | 1,00,000 |
| Earnings before tax | 4,50,000 | 3,50,000 |
| Less tax at 30% | 1,35,000 | 1,05,000 |
| Earnings after tax | 3,15,000 | 2,45,000 |
| EPS | ₹1.05 | ₹1.225 |
- Cash flow position — debt suits a firm with strong, steady cash flows that can meet fixed interest and repayment.
- Interest coverage ratio = EBIT ÷ interest. The higher it is, the more comfortably the firm can service debt, so the more debt it can take.
- Debt service coverage ratio — cash profits available against the interest AND the principal repayment due; a higher ratio means a greater ability to carry debt.
- Also: return on investment, cost of debt, tax rate (a higher tax rate makes debt relatively cheaper), cost of equity, floatation costs, risk, flexibility, control, the regulatory framework, stock market conditions, and the capital structure of other companies in the industry.
Fixed Capital and Working Capital
| Fixed capital — long-term assets | Working capital — current assets less current liabilities |
|---|---|
| Nature of business — a manufacturer needs more than a trader | Nature of business — a service firm with cash sales needs little |
| Scale of operations — larger scale, more fixed capital | Scale of operations, business cycle (more in a boom) and seasonal factors (more in the peak season) |
| Choice of technique — capital-intensive needs more than labour-intensive | Production cycle — a longer cycle ties up more funds |
| Technology upgradation, growth prospects and diversification raise it | Credit allowed to customers raises it; credit availed from suppliers lowers it |
| Financing alternatives — leasing an asset lowers the need to own it | Operating efficiency lowers it; inflation, growth and competition raise it |
| Level of collaboration — sharing facilities with other firms lowers it | Availability of raw material — uncertain supply means more stock and more working capital |
Key takeaways
- The objective of financial management is wealth maximisation — maximising the market value of equity shares — not profit maximisation.
- Three decisions: investment (capital budgeting for the long term, working capital for the short term), financing (the debt–equity mix) and dividend (pay out or retain).
- Trading on equity raises EPS only when ROI exceeds the rate of interest on debt; below it, debt lowers EPS.
- A higher interest coverage ratio or debt service coverage ratio means more capacity for debt; control considerations favour debt, because lenders have no votes.
- Credit allowed to customers, a longer production cycle, a boom and the peak season raise working capital; credit from suppliers and operating efficiency lower it.
Practice questions (8)
Attempt each one before opening the answer. Every explanation names the tempting wrong option as well as the right one, because that is where marks are lost.
The primary objective of financial management is:
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Answer: D — Maximising the market value of equity shares
Financial management aims at wealth maximisation, which means maximising the market value of the equity shares; that happens when decisions bring more benefit than they cost over time. Current-year profit is the tempting alternative but ignores risk and the long term — a firm can raise this year’s profit by starving next year’s. Sales revenue and tax minimisation are narrower aims that need not raise shareholders’ wealth at all.Trading on equity increases the earnings per share of equity shareholders only when:
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Answer: B — The return on investment is higher than the rate of interest on debt
Debt raises EPS when each borrowed rupee earns more than its interest cost, so ROI must exceed the rate of interest; the surplus then goes to the equity shareholders. When ROI is lower, debt reduces EPS — so "ROI lower than the rate of interest" is the reversal. Tax actually makes debt more attractive, because interest is deductible, so a zero tax rate is not the condition. The proportions of debt and equity do not decide the direction of the effect.A company needs ₹20 lakh and expects EBIT of ₹4 lakh. It raises ₹10 lakh as debt at 10% interest and ₹10 lakh by issuing 1,00,000 equity shares of ₹10 each. The tax rate is 30%. What is its earnings per share?
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Answer: C — ₹2.10
Interest is 10% of ₹10 lakh = ₹1,00,000, so earnings before tax are 4,00,000 − 1,00,000 = ₹3,00,000; tax at 30% leaves ₹2,10,000; spread over 1,00,000 shares, EPS is ₹2.10. ₹3.00 forgets the tax, and ₹2.80 forgets the interest (4,00,000 × 0.7 ÷ 1,00,000). ₹1.40 is the EPS if the whole ₹20 lakh had been raised as 2,00,000 shares — the comparison that shows trading on equity working, since ROI of 20% exceeds the 10% interest.Which of the following changes would INCREASE a firm’s working capital requirement?
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Answer: A — Allowing customers 90 days’ credit instead of 30
Longer credit to customers means money stays locked in receivables for longer, so more working capital is needed. Longer credit from suppliers does the opposite — it lets the firm hold goods before paying for them — which is why it is the trap option. A shorter production cycle and faster-moving stock both release funds and reduce the requirement.A company’s decision to set up a new manufacturing plant that will be used for the next fifteen years is an example of:
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Answer: A — A capital budgeting (long-term investment) decision
Investing funds in a long-term asset such as a plant is a capital budgeting decision — the long-term half of the investment decision. Working capital decisions are the short-term half, about cash, stock and receivables. The financing decision is about where the money for the plant will come from, and the dividend decision about how profit is distributed; neither is the decision to build.A fast-growing software company has several profitable expansion projects lined up, so its board decides to retain most of this year’s profit and pay only a small dividend. Which factor affecting the dividend decision is chiefly at work?
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Answer: C — Growth opportunities
A company with profitable investment opportunities keeps more of its earnings to finance them, so growth opportunities lead to a lower payout. Stability of dividends would push the board to keep the dividend steady, not cut it. Taxation policy and stock market reaction are real factors, but the case gives the expansion projects as the reason.A company chooses a term loan from a bank rather than a public issue of shares, because the issue would involve heavy expenses on the prospectus, underwriting and brokerage. Which factor affecting the financing decision is this?
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Answer: D — Floatation costs
The expenses of raising funds — prospectus, underwriting, brokerage — are floatation costs, and higher floatation costs make a source less attractive. Control considerations would also favour a loan, but the reason given is expense, not keeping voting power. Cash flow position concerns the ability to service debt, and the state of the capital market concerns whether investors are buying; neither is named.A company has EBIT of ₹6,00,000 and an annual interest charge of ₹1,50,000. Its interest coverage ratio, and what it suggests, is:
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Answer: B — 4 times — the company can comfortably service more debt
The interest coverage ratio is EBIT ÷ interest = 6,00,000 ÷ 1,50,000 = 4 times. A higher ratio means earnings cover the interest obligation more comfortably, so the firm has room to take more debt. 0.25 inverts the ratio. "4 times — avoid debt" has the right number but reads it backwards. 4.5 comes from subtracting the interest from EBIT (in lakh, 6 − 1.5) instead of dividing.