34. Raman cubics is a progressive furniture making unit selling furniture to High
end people. They are in a process of expanding the business and the
finance manager proposes to raise the funds through debt. However the
founder of the company has a traditional way of running business on equity
only. The rate of interest prevailing in the market is 10% and the firm's
EBIT is 2,50,000 on the investment of 10,00,000. The finance manager
proposes capital structure ratio as 1:1 and use the existing capital only to
explain the importance of debt in capital structure to the founder. Assume
the tax rate to be 25%. With the given facts give the right justification to do
so with respect to
a. Benefit to the equity holders and
b. Tax rate deduction (6)
Answers
Explanation:
Financial Management is the process of acquiring funds optimally (at minimum cost possible keeping the risk factor also low) and utilising them in the best possible manner to maximise shareholders’ wealth.
Objectives of Financial Management
The objective of financial management is maximisation of shareholders’ wealth.
Shareholder’s wealth = No. of shares possessed by a shareholder x Market price of a share.
If there is proper financial management the shareholders’ wealth will maximise.
Role of Financial Management
The role of financial management is very important as the following activities are influenced by financial management:
Size and composition of Fixed Assets (Fixed Capital decisions)
Size and composition of Current Assets (Working Capital Management decisions)
Financing decisions (Amount of Debt or Equity to be used)
Financing decisions (Amount of Long-term funds or Short-term funds to be used for financing)
All items in the Profit & Loss Account (sales expenses, distribution expenses, depreciation of the assets, etc.)
Financial Decisions
Financial decisions are taken under financial management, and directly deal with raising and investing of funds (investment decisions), and distribution of profit earned among the stakeholders (dividend decisions).
Financial decisions are of three types –
I. Investment decisions
II. Financing decisions
III. Dividend decisions
I. INVESTMENT DECISIONS
The decisions which involve the choice how the raised funds will be invested into short-term or long-term assets.
Investment decision are of two types:
Long-term investment decisions (also know as Fixed assets decisions or Capital budgeting decisions)
Short term investment decisions (also known as Working Capital management decisions)
Factors affecting long-term investment decisions
The Investment criteria involves:
Cash flows of the project. The cash flows which a company expects from an investment decision should be carefully analysed before taking a Capital budgeting decision.
The Rate of return. The expected rate of return of the project should be taken into consideration before taking Capital budgeting decision.
The investment criteria involved. Financial managers have to carry out a number of calculations regarding cash flows, interest rates, rate of return etc. before taking the Investment decision. Various Capital budgeting techniques are used for the purpose of evaluating investment proposals.
II. FINANCING DECISION
The decisions which involve the choice how the funds will be raised from various sources and simultaneous cost analysis of these sources of funds.
The sources of finance are:
Shareholders’ or Owners’ funds:
Equity Capital and Retained earnings
Borrowed funds:
Debentures, Loans and other forms of Debts.
Factors affecting financing decisions:
Cost. Cheapest source of finance should be preferred. (Debt is generally cheaper than Equity)
Risk. Source involving less risk should be preferred. (Equity is less risky than Debt)
Floatation cost. If a source has high floatation cost it should be avoided (Equity has high floatation costs associated with it).
Cash flow position. The source of funds should also depend on the Cash flow position of
the firm. A company with healthy Cash flow can go for Debt as it can bear the fixed financial cost of interest on Debt.
Fixed operating cost. A company which has high fixed operating costs (like rent, salary, etc.) already runs high business risk. If such firm goes for Debt as source, it will add on financial risk (as Debt is risky).
Control considerations. A company having control considerations should go for Debt as a source of finance.
State of Capital market. When the Capital market is bullish or active (investors believe that the stock prices will increase), it is a good time for issuing Equity in order to have a good response from the investors. On the other hand, if the Capital market is bearish or sluggish (investors believe that stock prices will decrease) it is better not to issue Equity.
The company can opt for Debt as a source of funds.
III. DIVIDEND DECISION
The part of profit which is distributed by the company to its shareholders is known as dividend.
For a proper understanding:
Profit before Interest and Tax —> PBIT …[Interest which is to be paid on borrowed money
PBIT – Interest = PBT (Profit before tax)
PBT – Tax = PAT (Profit after tax)
\frac{PAT}{No.of\quad Shares} = EPS (Earning Per share)