Management of

Working Capital

BLOCK-3
FINANCING DECISIONS
Unit 8 Financial Markets
Unit 9 Sources of Finance
Unit 10 Capital Structure
Unit 11 Leverage Analysis

173
Cost of Capital
and Investment
Decisions

174
 Financial Markets
UNIT 8 FINANCIAL MARKETS

Objectives:
After studying this unit, you should be able to:

• Explain the significance of Financial Market

• Appreciate the importance and role of Financial Markets
• Understand and compare the role of different Market Participants
• Identity the different types of Financial Markets, their features, purpose.

Structure:
8.1 Introduction
8.2 Role and Functions of Financial Markets
8.3 Types of Financial Markets
8.3.1 Money Markets
8.3.2 Capital Markets
8.3.3 Equity Markets
8.3.4 Debt Markets
8.3.5 Derivative Market
8.3.6 Commodities Market
8.3.7 Foreign Exchange market
8.3.8 Other Markets
8.4 Participants in Financial Markets
8.4.1 Participants in Money Markets
8.4.2 Participants in Capital Markets
8.5 Summary
8.6 Key Words
8.7 Self Assessment Questions
8.8 Further Readings

8.1 INTRODUCTION
"Market" is conventionally defined as a place where buyers and sellers meet
to exchange goods, services or financial products, and instruments for a
consideration. The markets may be classified as follows:

• Product market, where goods and services are traded,

• Factor market, where labour, capital and land are exchanged; and
• Financial market, where financial claims are traded.

A financial market is a system of processes and functions that are usually

regulated by means of rules and guidelines for enabling participants to
transact in financial products and instruments (financial claims). The
financial markets are markets crucial in promoting economic efficiency by 175
Financing
Decisions channelising funds from those who do not have immediate requirement for
funds (savers) to those who require them for productive purposes (investors).
In these markets, financial assets such as stocks and bonds could be sold and
purchased. They facilitate the flow of funds for financing and investing by
households, firms, and government agencies.

8.2 ROLE AND FUNCTIONS OF FINANCIAL

MARKETS
The financial market is a place or mechanism where funds or savings are
transferred from surplus units to deficit units. In the absence of financial
markets, it is difficult to transfer funds from a person who has no investment
opportunities to one who has them. The financial markets are thus essential to
promote economic efficiency.

All the countries, irrespective of their state of development, need funds for
their economic development and growth. In an economy, funds are obtained
from the savers or surplus units (the units which have more income than their
consumption) which may be household individuals, firms, public sector units,
government, etc. There are certain investors or deficit units whose
consumption or investment is more than their current income.
In any economy, flow of funds from surplus units to deficit ones is essential
for desired achievement of national goals and priorities. For this, appropriate
financial instruments and opportunities must be available. The financial
markets provide the platform for such flow where each saver can find and
exchange the appropriate financial assets as per his/her requirement.
Therefore, the efficiency of financial market depends upon how efficiently
the flow of funds is managed in the country. Further, the financial market
must induce people to become producers/entrepreneurs and motivate the
individuals and institutions to save more.

Indirect Finance

Financial Intermediaries

Ultimate Lenders Financial Markets Ultimate Borrowers

Direct Finance

Figure: 8.1: Flow of Funds From Lenders to Borrowers

Figure-8.1 is a simplified form of flow of funds from saving-surplus units

(ultimate lenders) to saving-deficit units (ultimate borrowers). The flow of
funds moves from left to right, either directly through financial markets or
176 indirectly through financial institutions.
The financial markets not only help in the fast growth of industry and Financial Markets

economy but also contribute to the society’s well-being by raising the

standard of living. Thus, the financial markets play a significant role in the
allocation of the savings in efficient production of goods and services and
assist in achieving the desired national objectives.
Functions of Financial Markets
The functions of financial market can be classified into three categories: (a)
Economic Functions, (b) Financial Functions, and (c) Other Functions.

a) Economic Functions: The financial markets play a very important role

in the economic growth of a country. The way it helps in the economic
growth is as follows:

• It facilitates the transfer of real economic resources from sellers to

ultimate users of economic resources.
• Lenders/investors earn interest/dividend on their surplus investable
funds, thereby increasing their earnings, and as a result, enhancing
national income finally.
• Borrowers generally use borrowed funds productively, if invested in
new assets, thereby increasing their income and gross national
products finally.
• By facilitating transfer of real resources, it serves the economy and
finally the welfare of the public.
• It provides a channel through which new savings flow into capital
formation of a country.

b) Financial Functions: As already discussed these markets facilitate in

the flow of funds from surplus units to deficit units. In this process there
are several functions that it performs. Some of those are as follows:
• It provides the borrowers with funds which they need to carry out
their plans.
• It provides the lenders with earning assets so that their wealth may
be held in a productive form without the necessity of direct
ownership of real assets.
• It provides liquidity in the market through which the claims against
money can be resold at any time, and thus, reconverting them into
current funds.

c) Other Functions:In addition to the above, the financial markets perform

three more functions such as;
• Price Discovery: The interaction of buyers and sellers in a financial
market determines the price of the traded asset. The inducement for
firms to acquire funds depends on the required rate of return that
investors demand, and it is this feature of financial markets that
signals how the funds in the economy should be allocated among
financial assets. This is called the price discovery process.
177
Financing
Decisions • Liquidity: Financial markets provide a mechanism for an investor to
sell a financial asset. In thee absence of liquidity, the owner will be
forced to hold a debt instrument till it matures and an equity
instrument till the company is, either voluntarily or otherwise,
liquidated.
• Reduces Costs: It reduces the search and information costs of
transacting. Search costs represent explicit cost, such as the money
spent to advertise the desire to sell or purchase a financial asset, the
implicit costs such as the value of time spent in locating a
counterpart.

Activity 8.1
a) What do you mean by the te
term
rm ‘Financial Markets’?
Market
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b) Give any two imp
important
ortant functions of any financial market?
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8.3 TYPES OF FINANCIAL MARKETS

The financial market
markets comprise of all banking and non-banking
non financial
institutions, procedure and practices followed in these markets, and financial
instruments for facilitating the flow of funds. The classification of financial
markets in an economy is shown in Figure
Figure-8.2.

Financial
Markets

Organised Unorganised
Market Market

Capital Money Money

Market Market Lenders,
Indigenous
Industrial Govt.. Long term Call Commercial Treasury Short Bankers, etc.
Securities Securities Loans Money Bill Market Bill term
Market Market Market Market Market loan
Market
Term
Primary Secondary Loan Market for
Market Market Marke Market for Financial
t Mort-gages Guarantees

Figure-8.2:
8.2: Structure of Financial Market
178
On the basis of the period of maturity of the securities traded, the markets are Financial Markets

classified as Money Markets and Capital Markets. These markets are again
classified as primary markets and secondary markets. We will be discussing
each of these markets in detail.

8.3.1 Money Market

Money Market is defined as a market for overnight to a short-term money
and for financial assets that are close substitute for money. The meaning of
"short-term" refers to a duration of less than or equal to 1 year. The phrase
"close substitute for money" denotes any financial asset that can be quickly
converted into money with minimum transaction cost and without loss of
value. Participants in this market either have excess funds which they would
like to invest for short duration (from overnight to 1 year) or have an
immediate shortage of funds and would like to borrow in the short-term. The
market is a wholesale market for a collection of different short term debt
instruments. Its principal feature is the credit worthiness of the participants.

The Indian Money Market is divided into organised and unorganised markets.
The unorganised money market consists of indigenous bankers and money
lenders. The unorganised money market differs from organised market in
many respects like organisation, operations, interest rate structure, etc. The
indigenous bankers and money lenders are active in the small towns and
villages, and partly in big cities, where farmers, artisans, small traders do not
have access to the modern banks. They are outside the control of the Central
Bank. The rates of interest differ in the unorganised sector from those in the
organised sector. The key objectives of the money markets are:

• To facilitate an equilibrium between demand and supply of short-term

funds.
• Provide a focal point for Central Bank intervention for influencing
liquidity in the economy.
• Facilitate easy access for users and suppliers of short-term funds to meet
their requirements at an efficient market clearing price.

The banking system is the most dominant force in the Indian money market.
Significance of Money Markets: The money market plays a significant role
in the economy. It serves as a market for transactions of a short period.
Money Market offers the facility of adjusting liquidity for the business
corporations, banks, financial institutions, and non-banking financial
institutions and to investors.
After 1990, a liquid money market emerged in India. The specialized
institutions called Primary Dealers (PD) were established. This also
coincided with the formation of the Money Market Mutual Fund (MMMF).
Interest rates were also deregulated, and eligible participants were enlarged.
Presently, the structure of the Indian money market instruments consists of
call/notice money market, commercial bills market, Treasury Bills (T-Bills),
Commercial Papers (popularly known as CP), Certificates of Deposit (CD)
and the Repo Market. The RBI uses Open Market Operations (OMO), bank
179
Financing
Decisions rate, Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), Repo
transactions to control liquidity and manage interest rates.

Activity 8.2
a) List down the different types of Secondary Markets.
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b) What is the importance of Money Markets?
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Having discussed about the Money Markets lets now understand about the
Capital Markets.

8.3.2 Capital Markets

Markets that facilitate the sale of long-term securities by deficit units to
surplus units are referred to as capital markets and the securities traded in
these markets are known as capital market securities. It involves raising
finance through issue of publicly traded financial instruments in equity and
debt that can be bought and sold at any time for a longer duration. These
markets also offer a wide scope of raising debt capital through issue of long-
term debt. Thus, the capital markets become an avenue of bank
disintermediation. It not only brings the investors of funds and issuers of
"financial claims" together on an alternative platform, but also helps in
movement of debt capital- a function that was primarily the domain of banks
and financial institutions until the mid-1980s and early 1990s.

Functions of Capital Markets: The major functions of Capital Markets are

as follows:

• They improve the efficiency of capital allocation through a competitive

pricing mechanism.
• These markets lower the costs of transactions.
• They encourage broader ownership of productive assets.
• Mobilize long-term savings to finance long-term investments.
• Provide risk-capital in the form of equity or quasi-equity to
entrepreneurs.
• Disseminate information efficiently.
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 Facilitate Price discovery of financial instruments. Financial Markets
•
• Risk Management to mitigate against market risk (price volatility).
• Enable wider participation.
• Improve integration between different markets and different asset
classes, real and financial sectors of the economy, long and short-term
funds, private and Government sectors, domestic and external funds.
• Support Direct flow of funds into efficient channels through investment,
disinvestment and reinvestment.

The modern-day capital markets have become a catalyst for wealth creation.
A vibrant and efficient Capital Market is the backbone of a healthy economy.
India has become a global reference point and the Indian Capital Markets
structure - systems, processes and institutions - have become a global
benchmark to be emulated. Many developing countries have taken cues from
the Indian capital markets for establishing similar structure in their respective
countries.

Capital Markets can be classified further into Primary and Secondary

Markets, which deal with issue of new securities and trading of existing
securities, respectively. Let us understand the characteristics of Primary and
Secondary markets.

a) Primary Markets
Primary Market is a segment of capital markets that deals with the
issuance of new securities. Corporate, Government, Public Sector Units,
Banks, and Financial Institutions can obtain funding through the sale of
financial claims such as stocks, bonds, debentures, etc. This is typically
done through a syndicate of securities dealers. In the case of first time of
stock issue, this sale is usually referred to as an "Initial Public Offering"
(IPO).

b) Secondary Markets
Secondary Market is the segment of Capital Markets relating to trading
of already-issued (outstanding) securities. Secondary Markets usually
follow either an auction-based system or dealer-based system. While the
stock exchange is part of an Auction Market, Over the Counter (OTC)
market is a dealer-based system. For the general investor, the Secondary
Market provides an efficient platform for trading of securities. The fair
price of the security is "discovered" in the secondary markets - thus
leading to either price appreciation or depreciation. Banks facilitate
secondary market transactions by opening direct accounts to individuals
and companies. Banks also extend credit against securities. Banks may
also act as clearing houses.

The establishment of "Secondary Markets" in the form of stock exchanges

(for trading in equity market offerings such as shares) and Primary Dealers
(PD) - who provide two-way quotes for Government Securities and
Corporate Bonds - facilitated the liquidity for the purchase of these financial
claims. Typically, an investor can directly purchase these "financial claims". 181
Financing
Decisions Alternatively, investors can purchase these financial claims indirectly by way
of mutual fund units, security receipts or pass-through certificates. The Indian
Secondary market can be segregated further based on the characteristics of
the financial instruments or securities that are exchanged. Some of these are
discussed here:

Exchange Markets: Exchange markets are organized trading platforms,

whereby; buyers and sellers can transact. It is an organized marketplace with
rules and regulations for trading in financial products and instruments. The
financial products and instruments are standardized in terms of quantity and
quality. These are highly regulated markets, with no possibility of default by
market participants. The most common form of organized trading of futures
and options, the open-outcry system with its shouting and hand waving by
traders on the exchange trading-floor, is highly transparent. A clearing house
guarantees transactions on organized exchanges; a default by an intermediary
is unlikely to lead to losses for market users.

Over the counter (OTC) markets: The over-the-counter market is largely a

direct market between two counter parties who know and trust each other.
Contracts are directly negotiated, tailor-made for the needs of the parties, and
are often not easily reversed. All transactions that are directly negotiated
between entities (also referred to as counterparties to the transaction) outside
the exchange trading platform. Public price quotations for the over-the-
counter market are only just being introduced, and the quotations are only for
the more heavily traded instruments. To get a fair deal on the over-the-
counter market, good information gathering, and negotiation skills are
required. Over-the-counter market transactions are guaranteed only by the
reputation of the counterparty; if the counterparty goes broke, large losses
may ensue.

8.3.3 Equity Markets

Equity is viewed by the market as an ownership "share" in the revenue stream
of a corporation's income after all prior obligations (including outstanding
debt) has been satisfied. The "share" price is the relative value given to the
Corporate's earning potential based on several factors. These include general
economic conditions, both in the industry and in the overall economy,
earnings projection, projected corporate growth, stage of development and
financial ratio analysis. A share of stock in the firm represents ownership.

Equity markets facilitate the flow of funds from individual or institutional

investors to corporations. These markets enable corporations to finance their
investments in new or expected Business Ventures and also facilitate the flow
of funds between investors. Generally, the structure of equity is that a "share"
of the corporation represents the current market value of the firm, and
secondary to this is the potential for dividend income. There are various
classes of equity for the individual investor to consider.

8.3.4 Debt Markets

Debt Markets involve issuance, trading, and settlement of fixed income
182 securities such as bonds of various tenors. Debt Market instruments can be
issued by Central and State Governments, Public Sector Units, Statutory Financial Markets

Corporations, Banks, Financial Institutions and Corporate Bodies. The debt

market in most developed countries is many times larger than other financial
markets - including the equity markets. The key functions of Debt Markets
are:

• Efficient mobilization and allocation of resources in the economy.

• Financing the development activities of the Government.
• Transmitting signals for implementation of the monetary policy.
• Facilitating liquidity management in tune with overall short-term and
long-term objectives.
• Reduction in the borrowing cost of the Government and enable
mobilization of resources at a reasonable cost.
• Provide greater funding avenues to public-sector' and private sector
projects and reduce the pressure on institutional financing.
• Government Securities Markets (usually referred to as the G-Sec market)
commands over 90% of the volume of transactions in the debt market. It
is the principal segment of the debt market in India.

Traditionally, the Indian debt market has been restricted to a few institutional
players - mainly Banks and other participants including primary dealers,
mutual funds etc. Banks have a statutory requirement (under RBI regulations)
to maintain a specific percentage of their deposits in the form of Government
Securities - also called the Statutory Liquidity Ratio (or SLR). Thus, RBI
instituted reforms in the debt market. But despite these reforms, volumes are
usually low in the corporate debt market and the PSU debt market segments.

Some of the important segments of the Debt market are:

i) Government Securities (G-Sec) Market:

These are sovereign (credit risk-free) coupon bearing instruments which
are issued by the Reserve Bank of India on behalf of Government of
India, for the Central Government's market borrowing programme. These
securities have a fixed coupon i.e., paid on specific dates on half-yearly
basis. These securities are available in wide range of maturity dates even
upto 30 years.
ii) Corporate Debt Market:
In the last decade, several innovations have taken place in the corporate
bond market, such as securitized products, corporate bond strips and a
variety of floating rate instruments with floors and caps and bonds with
embedded put and call options. However, the secondary market has not
yet developed in the debt segment of the Indian capital market.
Furthermore, the corporate debt market in India remains underdeveloped
as large domestic institutional investors, such as pension funds and the
insurance sector, are restricted from allocating large portions of their
investment funds in the corporate bond segment.

183
Financing
Decisions iii) Debentures:
Debentures are a type of financial claims issued by a company. The
buyers of debentures are the creditors of the company, who have
invested capital in the company. In return for the invested capital, the
debenture holders would obtain a fixed rate of interest usually payable
annually or half yearly on specific dates. The principal amount is paid
back by the company to the debenture holders on particular future date -
that is the redemption date of the debentures. The terms of reference of
the debenture or bond may be customized in such a way that the
principal may be payable (back to debenture holder) at regular pre-
specified intervals. In some instances, convertible debentures are also
issued, whereby the debentures can be converted into equity shares later.

iv) Bonds Market:

Bonds refer to negotiable certificates evidencing indebtedness. It is
normally unsecured. A debt security is generally issued by a company,
municipality or government agency. A bond investor lends money to the
issuer and in exchange, the issuer promises to repay the loan amount on a
specified maturity date. The issuer usually pays the bondholder periodic
interest payments over the life of the loan. The various types of Bonds
are as follows:
• Zero Coupon Bond: Bond issued at a discount and repaid at face
value. No periodic interest is paid. The difference between the issue
price and redemption price represents the return to the holder. The
buyer of these bonds receives only one payment, at the maturity of
the bond.
• Convertible Bond: A bond giving the investor the option to convert
the bond into equity at a fixed conversion price.
• Callable Bonds: This provides flexibility to the company to redeem
the issued outstanding bonds on a specific future date.
• Puttable Bonds: This provides flexibility to the investor to seek
redemption of the bonds that he/she has purchased, on specific
future date.

8.3.5 Derivative Market

Financial instruments that derive their value from underlying asset are
commonly referred to as 'derivatives'. When the need arose to mitigate risk
due to vagaries of commodity prices, derivative instruments were developed.
Initially, these pertained to linear pay-off structures such as forward and
futures contracts. Subsequently, in the early 1980's, more complicated
derivative contracts such as options and swaps were structured.

Over the counter market instruments are not standardised and contains
clauses and conditions as per the requirements of buyers and sellers. Risk
associated with over-the-counter market instruments is significantly high.
This pertains to the risk of default by counterparties to transaction. Legal
184 recourse to such default is usually expensive and time-consuming. There was
also the risk of illiquidity in case the hedger wants to exit from the contract. Financial Markets

This was the reason for emergence of organised marketplaces for derivatives
in commodity market and capital market.

Development of exchanges also led to the system of novation, by which, the

clearing house became the central counterparty for all transactions. This
ensured that there was no risk of default in settlement. The actual settlement
of profits and losses was completed on daily basis, giving rise to the concept
of mark-to-market settlement. Derivatives are presently traded not only in
commodity markets, but also in equity markets, currency markets and debt
markets.

8.3.6 Commodities Market

A market where commodities are traded is referred to as a 'Commodity
Market'. These commodities include bullion (gold, silver, platinum,
palladium), ferrous (steel) and non-ferrous metals (copper, zinc, nickel, lead,
aluminium, tin), energy products (crude oil, natural gas, heating oil, gasoline,
etc.), agricultural commodities (refined soya oil, pepper, palm oil, coffee,
pepper, cashew, almonds, etc.).Existence of a vibrant, active, and liquid
commodity market is normally considered as a healthy sign of development
of a country's economy.
Global commodity markets have evolved in the last several years with the
emergence of the organised financial market place. The need to mitigate risk
due to the volatility in asset prices led to innovation of sophisticated financial
instruments. Improved satellite technology with superior digital
communication and faster processing speed facilitated emergence of
electronic trading platforms that are accessible with secure connectivity even
from distant locations.

Activity 8.3
a) What do you understand by the term ‘Commodities Market’?
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b) List down any three Regional Commodities Exchanges in India.
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8.3.7 Foreign Exchange Market

The foreign exchange market in India is regulated by Reserve Bank of India
(RBI). Guidelines have been established for trading in foreign exchange.
185
Financing
Decisions Limits have been clearly specified by the RBI for investments abroad and the
policy for purchase of foreign exchange when an individual is travelling to a
foreign country or for any other purpose.

Exposure to derivative transactions for foreign currency as the underlying

asset can be on currency future exchanges and provides an avenue to hedge
risk generated by currency movements. Banks, in turn, need to hedge their
exposures on a back-to-back basis, with counterparties in India or abroad
(especially for non-USD INR derivatives transactions).

8.3.8 Other Markets

It has been analysed in the preceding few sections of this unit the specific
characteristics of money markets, capital markets comprising of debt and
equity markets, currency markets, commodity markets and the derivatives
markets. In this section, we shall discuss the classification of markets from
the perspective of investment and business activities.

Loan Markets:
Loan Market refers to the activities of banks and financial institutions to
make available, credit for corporate sector. The credit may be extended for
trading, manufacturing, infrastructure, service, industrial manufacturing, and
financial activity or otherwise. Loans may be for short term or long-term.
Usually, credit rating agencies assess the creditworthiness of the corporate.
The specific credit rating is used for making decisions by banks and financial
institutions to lend to the borrower.

Insurance Markets:
After the liberalization of the Indian economy and the commencement of
financial sector reforms, private sector was allowed to start life insurance and
general insurance activities. With a growing population, insurance is required
by everybody. But Insurance companies are allowed to operate by adhering
to strict compliance measures, due to the high level of risk involved.

Retirement Savings Markets:

Retirement Savings Markets are long term funds pooled from investors by
provident funds, pension funds and superannuation funds. They perform the
important activity of providing resources and security for individuals in their
old age. These funds are invested in long term securities.

Mutual Funds:
Mutual Funds provide the means for the small investors to reduce transaction
cost, while trading in the securities markets. Professional mutual funds have
analysts who take calls on the market for collectively investing the corpus of
the funds provided by the investors. Mutual funds are regulated by the
Association of Mutual Funds in India (AMFI), which is a self-regulatory
organization.

186
Savings and Investment Markets: Financial Markets

The savings and investment markets consist of several retail financial savings
products for the household sector. Whereas the corporate sector relies on
banks and financial institutions for credit, the household sector is dependent
on not only banks and financial institutions (that provide retail products), but
also chit funds, Nidhis, and mutual benefit societies.

8.4 PARTICIPANTS IN FINANCIAL MARKETS

The different participants acting as intermediaries for facilitating the flow of
funds from surplus units to deficit units in the Financial Markets are being
discussed below:

8.4.1 Participants in Money Markets

Money market is the place or mechanism where short term funds are raised.
These funds are obtained at the varying rates depending upon the sources of
funds, the credit standing of the borrowers, maturity period, etc. The main
players in this market are the Reserve Bank of India (RBI), Discount and
Finance House of India, Mutual Funds, Banks, Corporate Investors, Non-
Banking Finance Companies (NBFC), State Governments, Provident Funds,
Primary Dealers, Securities Trading Corporation of India (STCI), Public
Sector Undertakings (PSU) and Non-resident Indians (NRI). Following is a
brief discussion of these participants:

i) Central Bank: The Central Bank of any country is the apex monetary
institution in the money market. The Reserve Bank of India is the central
bank of our Country, which regulates and makes policy relating to
monetary management in the country. It serves as the government bank
because it performs the major financial operations of the government. It
is one of the major participants in the money market as it participates in a
big way in the market to purchase and sell various securities, specifically
those issued by the Government. The Central Bank participates in
financial markets in different ways as mentioned below:

• By issuing of currency notes which are directly and solely under the
purview of the Central Bank. For example, in our country Reserve
Bank of India (RBI) has been given the sole authority to issue
various currency notes except one-rupee notes and coins and
subsidiary coins. For this purpose, the RBI maintains a separate
department known as the Issue Department.
• By working as the agent and adviser to the Government specifically
concerning to the financial matters, such as loans, advances,
servicing of debts, etc. It also performs such functions of the
Government departments, boards, and public undertakings. It also
decides to meet the financial requirements; both short term as well
as long term in anticipation of the collection of taxes or raising funds
from the public.
• By acting as bankers’ bank in the financial market, the Central Bank 187
Financing
Decisions regulates the banking operations in the country. How much rate of
interest would be charged and paid on advances and deposits by the
bankers is influenced by the Central Bank through various policy
measures. Undoubtedly, the Central Bank holds a privileged
position, and all the commercial banks have to deposit a pre-decided
fixed percentage of their deposits with it.

• By maintaining adequate foreign exchange reserve for meeting the

requirements of foreign trade and servicing of foreign debts. It also
ensures the stability of the currency at international level. For these
purposes, the Central Bank has to participate in a big way in
domestic as well as in foreign financial markets.
Thus, it is evident that Central Bank of the country plays a significant
role in money market by participating in different capacities.

ii) Commercial Banks: The other significant participant in the money

market of a country is commercial banks. A major portion of the total
operations of the money markets are conducted through the commercial
banks. The basic functions of commercial banks are borrowing and
lending of money. They borrow money by accepting all kinds of deposits
from the public at large, repayable on demand or otherwise. Thus, these
banks employ the pooled funds in the form of loans and advances to
those who need them.

The different ways in which the commercial banks participate in the

money market are:

• By assisting in mobilising the public savings which are normally in

the form of small holdings and then combining the same into a huge
lot for the purpose of providing credit to the various sectors of the
economy.

• By meeting the short-term working capital needs of the business

firms through the mechanism of cash credit, discounting bills,
hundis, promissory notes, overdraft facility and other short-term
debt instruments.

• Apart from accepting deposits and granting loans and advances, the
commercial banks also provide a range of other services in the
capacity of agent, for their clients.

• By collecting the amounts arisen due to interest, dividend, rent,

salary and wages, commission for their customers.

• These banks also, sometimes, advise their clients relating to sale and
purchase of various securities and in designing their investment
portfolio.
iii) Indigenous Financial Agencies: Indigenous financial agencies are
important participants in money market, especially in unorganised sector.
They comprise of money lenders (Village Sahukars) and indigenous
bankers. Money lenders are normally referred to those persons whose
188
 main business is to provide financial assistance to rural farmers, artisans, Financial Markets

and others. On the other hand, indigenous banker is referred to an

individual or private firm receiving deposits and dealing in hundis or
lending money. However, it is very difficult to draw a line between
money lenders and indigenous bankers.

Some of the features of Indigenous financial agencies are:

• They finance trade including the movement of agricultural

commodities such as cotton, oil seeds, sugar, and others.
• The main technique of their financing is discounting of hundis and
bills.
• They also lend money by mortgaging immovable property, like
houses, land, fixed assets, etc.
• The rate of interest charged by them is normally high in comparison
to the banks.
• Their lending policy is flexible and informal which is based on their
personal contacts with the clients, which is not uniform and vary
from place to place.
• The loans are provided mostly on personal security, so the size of
loan and the rate of interest to be charged also differ from client to
client.

In brief, indigenous financial agencies provide financial assistance,

usually short-term to rural and semi-urban borrowers at different rates of
interest depending upon the personal capability and risk involved.

iv) Discount Houses: Discount houses are important constituents of the

money market. The major function of these houses is to discount trade
bills of traders to provide adequate liquidity in the market. Discount
houses play a significant role in business world specifically in money
market, such as;

• Assisting the market by making it more liquid by discounting the

trade bills. Further, by endorsing these bills, they sell these bills to
commercial banks to raise funds so that they can facilitate this
service further to the traders.

• Providing guarantee to the bankers for payment of bills on maturity

by the traders. In case of default, they take the responsibility of
payment. In this way, discount houses provide very flexible
instrument whereby the bankers can adjust their cash positions
through these houses.

• Besides discounting the trade bills, they also deal in short term
government securities. From the past practice of the discount houses
of London, it is observed that these houses also invest in Treasury
Bills, commercial bills, other Government securities, bonds and
certificates issued by the local authorities and public corporations.
189
Financing
Decisions Thus, the discount house is an important constituent of a developed
money market. This facility is normally provided by the commercial
banks and other financial institutions in our country.

v) Acceptance Houses: Another important participant in the money market

is Acceptance House. They play a significant role in providing more
liquidity in the money market through borrowing short-term loans from
the banks and lending the same to the traders. These are not only
accepting the bills which are drawn on them, but also perform some
other functions like normal banking facilities; both domestic and foreign,
short-term loans to the traders, regulating their clients’ open credit,
advising on shipping and insurance problems arising out of the financing
of trade, etc.

Acceptance houses provide adequate liquidity in the secondary market

through accepting the bills so that these (bills) can easily be discounted
by the discount houses and other banks. However, the existence of these
houses is very rare and is seen only in developed money market like
London money market. In India, the market is still in its infancy stage of
such participants.

8.4.2 Participants in Capital Markets

In this section, financial institutions and other agencies which are actively
participating in or facilitating the capital market are described. These
institutions can be classified into two categories:
a) Banking Institutions
b) Non-Banking Financial Institutions

Some of these institutions may be directly participating in the capital markets

while others may be indirectly connected by way of providing intermediation
services to the companies, investors, stock brokers and others.

a) Banking Institutions. The various forms of banking Institutions are

Commercial Banks, Cooperative Banks, Land Development Banks,
Foreign banks, Regional Rural Banks, etc.

i) Commercial Banks: Some of the important activities of the

Commercial Banks are:

• The commercial banks accept long-term deposits from the public at

large providing them opportunity to invest their savings. Further,
now these commercial banks also meet long term funds requirement
of all types of business undertakings like tiny, small, medium, and
large units.
• They also provide long term finance to transport operators for
buying the vehicles, dealers in various goods, farmers, professionals,
and self-employed persons, etc.
• Banks also provide long term finance for special purposes like
advances against Fixed Deposits Receipts, Advances against Gold
190
 gold ornaments, advances for durable goods like vehicles, Financial Markets

televisions, refrigerators, washing machines, furniture, etc.

• They also assist for construction of houses, purchase of plots and
expansion or renovation of the existing building.
ii) Co-operative Banks: Another important constituent of banking
system which facilitates the general economic activities is
cooperative banks. The basic function of these banks is to provide
financial assistance to agriculturalists and others, normally through
cooperative societies. In fact, these banks normally focus on
providing short- and medium-term financial requirements to
agriculturists, artisans, and others. Land development banks meet
long-term and medium-term funds requirement of agriculturists to
purchase agricultural machinery and implements, affecting
permanent improvement in land, liquidating old debts, etc.

b) Non-Banking Financial Institutions: Apart from some banking

concerns described above, a lot of economic activities are performed by
the other financial institutions which are of non-banking nature. They
actively participate in capital transformation process from sellers to
investors in an economy. They collect funds by accepting deposits from
individuals and others and lend them to trade, industries, government,
etc.
The various forms of non-Banking Financial Institutions and their role in
Financial Markets are described hereunder:
i) Investment Banks: Investment banks are very much popular in
developed countries specifically in USA. Investment banking
institution may be defined as financial intermediary which is
responsible for garnering the savings of thrifty people and directing
these funds into the business enterprise. The basic functions of these
investment banks are:

• long term financing of business undertakings – it is concerned

with the formation of new capital, related with the participation
information of new capital for both new as well as old
undertakings.
• marketing of shares and debentures - It includes all such
activities like originating, under-writing, purchase, and sale of
securities, etc.
• acting as security middlemen - it comprises of working as
broker or dealer, offering security, counselling, advising,
security substitutions and other allied services.
• Advising in marketing of an issue.
• Acting as an insurer instead of outright purchase of security,
etc.
On the whole, these institutions play a significant role by providing the
necessary capital for the long term needs of business world. That is why,
191
Financing
Decisions these are also known as the ‘entrepreneurs of entrepreneurs. Some of
these functions have been taken over by merchant banks in India.

ii) Merchant Banks: Merchant banking activities are first developed in

early nineteenth centuries in the U.K., when trade between countries was
financed by bills of exchange drawn on the principal merchant houses.
Lately it has attracted the attention of all financial and consultancy firms.
Basically, merchant banking activity is an institutional arrangement
providing financial advisory and intermediary services to the corporate
sector. In fact, there is a wide range of financial activities which come
under the purview of merchant banking, a few among these are narrated
below:
• Corporate Counselling: The major function of a merchant banker is
to advise the corporate sector units on various matters like in
locating area/activities of growth and diversification, appraising
product lines and future trends, rejuvenating old company and
failing sick units by appraising their technology, process, etc.

• Project Counselling: Project counselling is another important

merchant banking activity which includes preparation of economic,
technical, financial and feasibility reports. Further, it also covers
project viability and procedural steps for its implementation. Besides
these, project counselling may include identification of potential
investment avenues and pattern of financing.
• Capital Restructuring: The basic objective of capital restructuring is
to advise the management of the company in designing its capital
structure in such a way that it could achieve maximum potential out
of its financial resources. This may include redesign of debt-equity
ratio, reserve and surplus, capitalisation of reserve, asset structure
ratio, debt servicing with overall impact on funds generating
capacity of the corporate unit.
• Issue Management: The basic objective of issue management
activity is to make all arrangements for mobilising resources from
the capital market for its client by issuing securities like equity
shares, preference shares, debentures, etc. This includes taking
consent/approval of the Government Agencies, drafting of
Prospectus, selection of Brokers, Under-Writers, Bankers, Registrar,
Advertising Agency, etc.

• Portfolio Management: Merchant bankers render expert advice on

matters pertaining to portfolio management of their clients. They
advise which securities should be purchased or sold and assist in
designing optimum portfolio within the purview of risk, return and
tax bracket of the investors.

• Credit Syndication: The merchant bankers make arrangement of

credit procurement and project finance for their client units. In this
regard, they contact with banks and other financial institutions both
192 in India and abroad for raising rupee and foreign currency loans.
 Sometimes, they also arrange bridge finance and other funds for cost Financial Markets

escalations or cost over-runs.

• Corporate Restructuring: External restructuring for the overall

better performance of corporate units is another important service
rendered by the merchant banks. The merchant banks assist in such
negotiation and also guide in legal documentations, official
approval, tax matters, etc, of the proposed merged unit.

• Working Capital Finance: The merchant banks assist in arranging

working capital finance for their clients. They advise the possible
sources from where the working capital finance can be arranged.
Further, sometimes, they also manage to enhance cash credit
facilities for their clients.

• Credit Bills Discounting: This is one of the major services which is

rendered by the merchant banks specially in developed countries,
like U.S.A., U.K., etc. They make arrangement for providing bills
discounting facilities for their clients after contacting the acceptance
houses and discount houses.
iii) Investment Companies: Investment companies are such institutions,
which collect the funds from the people through a specific financial
instrument, i.e., unit, share, debenture, etc., and then invest these pooled
funds in the suitable securities depending upon the objective of that
scheme. The major investment type companies include investment trusts,
mutual funds, common trust funds of commercial banks, management
investment companies, unit trusts, etc. These investment companies can
be classified into two categories:
a) Management Investment Companies
b) Unit Trusts.
a) Management Investment Companies: The Managements of these
trusts enjoy wide discretionary powers relating to selection of
various securities for designing of their investment portfolio. The
schemes of these companies can further be divided into two
categories; close ended and open ended. In the first category, the
capitalisation of the scheme is fixed and not changed before a
particular period. In other words, unit holders cannot get back their
investment from these companies before a particular period.
Whereas in the case of open-ended companies, the investors can sell
and buy their units from the company, and hence, no limit to
capitalisation.
b) Unit Trust: This is a specific type of investment company which is
normally established under a particular Act. The funds are raised
from the large number of investors through selling of units, and the
persons to whom the units are sold are called the unitholders. The
holders of these units are the owners of the trust who have a real
interest in securities, which constitute the trust fund. Normally, a
unit trust is established as an open-end investment company. Unit
Trust of India is an example for this.
193
Financing
Decisions Thus, the investment companies are important participants in the capital
markets. They mobilise funds from many investors and channelise the
same for productive purpose through financial markets.

iv) Insurance Companies: Insurance companies have emerged as prominent

participants in the capital markets because of the availability of huge
funds at their disposal for investment purpose. These companies can be
classified into various categories such as life insurance companies,
general insurance companies, marine insurance companies which cover
risk arising from fire, accidents, natural calamities for human lives,
vehicles, houses, durable goods, fixed assets, etc. Among these life
insurance companies are dominant due to their large size and protection
from state.

The major source of funds of these companies is premium received from

the policy holders. Being the custodians of policy holder’s savings, the
responsibility of these companies to the public is very high. Hence the
investment policy is usually different from that of other institutions. The
major portion of the fund is normally invested in Government and Semi-
Government securities, fixed income securities of public sector units and
other corporate sector units. Apart from life insurance companies,
general companies which are in insurance business of fire, marine and
others also have huge investible funds to employ in the business sector.

In brief, insurance companies recently have become an important

constituent of capital markets all over the world.
v) Development Banks: Development banks which came into existence
after the second world war are now most active participant in the capital
markets all over the world. In India, some major development banks are:
Industrial Finance Corporation of India (IFCI), State Financial
Corporations (SFCs), State Industrial Development Corporations
(SIDCs), Industrial Reconstruction Bank of India (IRBI). IDBI and
ICICI which were originally started as developmental banks got
converted themselves into universal banks to face the challenges in the
liberalised environment.

vi) Pension Funds: Pension funds and retirement plans of all types have
become important investors and participants in the capital markets. In
developed countries, private pension plans or corporate pension funds
have become major constituent of the capital market largely in the
second half of the twentieth century. In a pension plan, pension holders
are provided with a fixed amount in particular currency each month,
often calculated as a multiple of the number of years worked in that
organisation. It has been observed that assets in pension funds grow over
long period because most of the employees who come under a plan are
several years from retirement.

vii) Private Sector Finance Companies: These companies collect funds

from the people through shares, debentures, fixed deposits and short-
term loans from banks and other corporate units. Sometimes, a huge fund
194
 is also raised through inter-corporate deposits. Besides, they also provide Financial Markets

short term business credit to the business firms and professionals. Thus,
these finance companies have to compete with commercial banks and
other financial institutions which provide such loans.

Thus, these finance companies play a significant role in capital market

fulfilling financial needs of specific section of the society. Further, they
borrow in both money market and capital market, so they create a link
between these markets and relationship between long term and short-
term interest rates.

Activity 8.4
a) List down the activities of the Commercial Banks in a Capital Market.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
b) Discuss the role of the Discount and Finance House of India (DFHI).
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

8.5 SUMMARY
A market is a place where buyers and sellers meet to exchange goods,
services, or even financial products/instruments for a consideration. Markets
can also be defined as channels through which buyers and sellers exchange
goods, services, and resources. The present-day markets gradually evolved
over several centuries. In this unit we have discussed in detail about the
Financial Markets.

Financial markets facilitate trading in financial assets. Since financial assets

are not consumed, what is bought and sold is their use for a particular period.
There are many agencies which are participating in the financial market
operations and are facilitating the process of transfer of funds from surplus
units to deficit units. These participants of the financial markets, that
facilitate the smooth flow of funds from surplus units to deficit units in both
the money markets and capital markets have been elaborately discussed.
The capital markets involve raising finance through issue of publicly traded
financial instruments in equity and debt that can be bought and sold at any
time. For facilitating this framework, financial intermediaries play a very
important role. The capital markets include money markets, debt markets and 195
Financing
Decisions equity markets, savings and loan markets, retirement/pension fund market.
Other markets include commodity and currency markets and more
sophisticated markets such as the derivatives markets. The characteristics of
currency and commodity markets, derivatives markets including the concept
of OTC and Exchange traded derivatives markets has been discussed.

8.6 KEY WORDS

Financial Market: A Financial Market is a system of processes and
functions that are usually regulated by means of rules and guidelines for
enabling participants to transact in financial products and instruments.

Money Market: Money market is the place or mechanism where short term
funds are raised. These funds are obtained at the varying rates depending
upon the sources of funds, the credit standing of the borrowers, maturity
period, etc.

Capital Market: Markets that facilitate the sale of long-term securities by

deficit units to surplus units are referred to as capital markets and the
securities traded in these markets are known as capital market securities.

Primary Market: Primary Market is a segment of capital markets that deals

with the issuance of new securities.

Secondary Market: It is the segment of Capital Markets relating to trading of

already-issued (outstanding) securities.

Investment companies: These are such institutions which collect the funds
from the people through a specific financial instrument, i.e., unit, share,
debenture, etc., and then invest these pooled funds in the suitable securities
depending upon the objective of that scheme.

8.7 SELF ASSESSMENT QUESTIONS

1. What do you mean by ‘market’? Discuss the evolution of financial
markets.
2. What are the different types of markets in the contemporary context?
3. What is the meaning and significance of money markets?
4. What are the functions of capital markets?
5. What is equity market? Discuss the reforms initiated in the equity
markets?
6. What is debt market? Explain the components of the Indian Debt market.
7. What is foreign exchange market? Which are the major currencies
traded?

196
 Financial Markets
8.8 FURTHER READINGS
1. Bhole, L.M, 2017, Financial Institutions and Markets: Structure, Growth
& Innovation Mc Graw-Hill Education , New Delhi
2. Chandra, Prasanna. 2019, Financial Management, Theory and Practice,
Mc Graw-Hill, New Delhi
3. Pandey. I.M., 2021, Financial Management, Pearson Education India,
New Delhi
4. Sheridan Titman, Arthur J. Keown, and John D. Martin, 2019, Financial
Management: Principles and Applications, Pearson Education India,
New Delhi.
5. Eugene F. Brigham, Joel F. Huston, 2018, Fundamental of Financial
Management, Cengage Learning India, New Delhi.

197
Financing
Decisions UNIT 9 SOURCES OF FINANCE

Objectives:
After studying this Unit you should be able to:

• Appreciate the importance of different Sources of Finance

• Understand classification of Sources of Finance under various categories
• Discuss the advantages and disadvantages of different Sources of
Finance
• Explain the ways in which funds can be raised for the smooth and
effective functioning of an enterprise.

Structure:
9.1 Introduction
9.2 Classification of Sources of Finance
9.3 Long Term Sources
9.3.1 Equity Capital
9.3.2 Preference Shares
9.3.3 Debentures
9.3.4 Retained Earnings
9.3.5 Venture Capital
9.3.6 Leasing
9.3.7 Hire Purchase
9.4 Short Term Sources of Finance
9.4.1 Trade Credit
9.4.2 Commercial Paper
9.4.3 Factoring
9.4.4 Public Deposits
9.5 Financing through Financial Institutions
9.5.1 Term Loan
9.5.2 Bank Credit
9.5.3 Bills Discounting
9.5.4 Letter of Credit
9.6 Emerging Sources of Finance
9.6.1 Asset Securitisation
9.6.2 Angel Financing
9.6.3 Crowd Funding
9.6.4 Small Business Credit Cards
9.7 Summary
9.8 Key Words
9.9 Self Assessment Questions
9.10 Further Readings
198
 Sources of Finance
9.1 INTRODUCTION
Financial market as discussed in the previous unit is a system of processes
and functions that are usually regulated by rules and guidelines for enabling
participants to transact in financial products and instruments. Traditionally,
transactions used to take place only in unorganized market places. These
unorganized market places were not subject to specific rule or regulation.
When countries developed and as economies evolved, the need to regulate
markets to remove distortions and to facilitate free flow of funds gave rise to
regulatory bodies. The concept of organized markets evolved to entrust
confidence among market participants.

The traditional organized financial markets in India are:

i) Money Markets - for maturity of less than or equal to one year
ii) Capital Markets - for maturity of more than one year. The capital
markets comprises:
a) Equity markets
b) Debt market
The capital markets comprise of the equity markets and debt market. New
equity stock offering is issued in the primary market. The corporates issue
new equity stock for raising capital towards expansion of business activities.
The stocks that are issued are subsequently listed on the Indian equity
exchanges - NSE, BSE, and other regional exchanges - which comprises the
secondary markets. The components of the Indian Financial Markets include
not only the capital markets and money markets, but also the foreign
exchange markets, Insurance, Pension Fund markets, Loan Markets and
Savings and Investment markets.
The funds are required basically for two reasons: one to acquire fixed assets
and the other to run the operations of the business. It is imperative for any
organization to raise funds for the smooth, and effective functioning of the
business. Arranging for the required funds for each department of the
business is highly complex which requires several decisions to be made.
Business usually needs two kinds of finances; the short term and the long
term. There are several factors which will be affecting the requirement of
fund for a business. The quantum of finance needed may depend on several
factors such as; the nature of business, scale of operations, business cycle,
asset’s structure, etc. There are different sources for raising capital for
different purposes.
In the previous unit we have discussed as to how different financial
institutions and markets facilitate the organizations in raising funds from the
market. Here we will be discussing some of these instruments/ sources that
these markets and institutions provide us to finance the business.

9.2 CLASSIFICATION OF SOURCES OF FINANCE

The sources of finance are classified based on period as long, medium and
short-term finance. As per the ownership and control it is classified as Owned 199
Financing
Decisions
funds and borrowed funds. Depending upon the source of generating this
fund it is either internal or ex
external.
ternal. Each of these sources is further classified
as indicated in the Table
Table-9.1 given below:

Time Ownership Source of Generation

•Long Term • Owned •Internal

•Equity • Equity Capital •Equity Capital
•Preference Shares • Preference Capital •Preference Capital
•Internal Accruals • Retained Earnings •Retained Earnings /
•Debenture Bonds • Convertible Debentures Retained Profits
•Term Loans • Venture Fund/ Private Equity •Convertible Debentures
•Venture Funding •Venture Fund or Private
Equity
•Asset Securitisation
International Financing
•International •Borrowed
• Loans from Banks or Financial
Institutions •External
•Medium Term
• Debentures •Reduction of Working
•Debenture Bonds
Capital
•Medium
Medium Term Loans from
•Sale of assets etc.
Banks/ Financial Institutions /
Government •Bonds
•Lease Finance
•Hire Purchase

•Short Term
•Trade Credit
•Short Term Loans
Fixed deposit for less than a year
•Fixed
•Advances
Advances received from
Customers
•Creditors
•Payables
•Factoring Services
•Bill Discounting

Table-9.1:
9.1: Various Sources of Finance/ Financing

We will discuss some of these sources of finance in the subsequent section.

Activity 9.1
Try to identify two or three sources of finance that are applicable to any firm
of your choice.
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

9.3 LONG TERM SOURCES

The long
long-term
term finance is raised when the need for funds is for more than five
to ten years. Long
Long-term
term finance is required for acquisition of fixed assets
200 having a life of more than one year or investments which have long-term
long
impact on the earnings of the company. For instance, if a firm wants to buy a Sources of Finance

patent or brand, which in turn contributes to the sales of the firm for a long-
term, it requires long-term funds for such acquisition. Some of the long-term
sources are equity, debt, asset securitization, venture capital, etc. A company
can raise funds through capital market by issuing financial securities such as
shares and debentures. A financial security is a legal document that
represents a claim on the issuer. The corporate securities are broadly
classified into ownership securities and creditorship securities. There are also
securities known as hybrid securities having the mix of the features of
ownership securities as well as creditorship securities. Depending upon the
market conditions and financing strategies, the issuers adopt different
methods.

9.3.1 Equity Capital

Equity share capital is one of the most important sources of raising capital.
Equity capital represents the owner’s equity, which is prerequisite to start a
company. Its holders are residual owners, who have unrestricted claim on
income and assets and who enjoy all the voting power in the company and
thus can control the affairs of the company. It is prerequisite to the creation of
a company. From the corporate perspective, there is no fixed obligation of
funds to be paid to the equity shareholders. It is perpetual in nature. If the
shareholders require funds, they can sell the shares in the secondary markets.
In exceptional cases a company may buyback the shares. A company may
buyback its shares without shareholders' resolution, to the extent of 10% of
its paid-up equity capital and reserves. However, if a company intends to
buyback its shares to the extent of 25% of its paid-up capital and reserves,
then the same must be approved by Shareholder's Resolution. Section 68,69,
and 70 of the Companies Act, 2013 along with rule 17 of the Companies
(Share Capital and Debentures) Amendment Rules 2016, regulate the process
of share buyback for unlisted companies. The buyback of shares listed on
recognised stock exchanges is regulated by SEBI regulation.

Equity share capital is also known as risk capital as the equity shareholders
are exposed to greater amounts of risk, but at the same time they have greater
opportunities for getting higher returns. The obligations of companies
towards their shareholders are to distribute the income left after paying the
claims of all other investors (e.g.: debt) among the equity shareholders. The
equity shares also give shareholders a residual claim on the assets of the
company in case of liquidation. The advantages and disadvantages of equity
shares are as follows:
Advantages:

i) The equity shares are not repayable to the shareholders and thus it is a
permanent capital for the company unless the company opts to return it
through buying its own shares.

ii) The debt capacity of a company depends on its equity including reserves.
Hence, raising of capital through equity enhances the company’s debt
capacity.
201
Financing
Decisions iii) The company has no legal obligation to service the equity by paying a
certain rate of dividend, unlike the debt for which interest is payable.
Therefore, the firm can conserve the cash when it faces the shortages and
pay when it’s earnings are adequate to do so.
Disadvantages:
i) Among the alternative sources of capital, the equity capital cost is high,
because of higher risk, flotation costs, non-deductibility of dividend for
tax purposes, etc.
ii) Investors perceive the equity shares as highly risky due to residual claim
on assets, uncertainty of dividend and capital gains. Therefore, the
company should offer higher returns to attract equity capital.
iii) Addition to equity capital may not raise profits immediately, but will
dilute the earnings per share, adversely affect the value of the company.
iv) In raising of capital by offering equity shares will reduce the power of
promoters control, unless they contribute proportionately, or opt for non-
voting shares which are costlier than ordinary equity shares.

9.3.2 Preference Shares

The preference shares are called quasi-equity having characteristic of both
equity and debt. These shareholders’ get dividend, which is fixed and paid
before anything is paid to equity holders, but they do not have voting rights.
In case a company fails to pay the stated dividends, they may acquire the
voting rights in certain circumstances. The investors can claim stake over the
residual assets, at the time of liquidation of the company before the equity
holders and after the debt holders. They behave like debt instruments because
they carry fixed dividend rates. They behave like equity instruments because
they offer the dividend to the shareholders without any obligation on the
company in case of liquidation.

The advantages and disadvantages of preference share capital are as follows:

Advantages:
i) The dividend rate is fixed, providing a constant rate of income to the
investors. They do not present a major control or ownership problem if
the dividend amount is being paid to them. In certain specific cases
preference share holders have voting rights, but they do not pose any
major control problem for the promoters.
ii) The other advantage of preference shares is that of cumulative dividends.
Cumulative preference shares carry accumulated unpaid dividends year
to year till the company can pay all the dividends including the arrears at
a stated rate.
iii) It helps to maintain the status quo in the control of the equity stock and
reduce the cost of capital as the preferred stock carries lower rate of
dividends as compared to other debt securities, like debentures which
usually carry higher rates of interest.
202 iv) The preference shareholders may have a right to share the surplus profits
 by way of additional dividend and the right to share in the surplus assets Sources of Finance

in the event of winding-up after all kinds of capital have been repaid.

v) The company does not face liquidation or any other legal proceedings, if
it fails to pay preference dividends, as there is no such legal compulsion
to pay preference dividends.

Disadvantages:
i) The preference shareholders do not have voting rights, so there is no
direct control over the management of the company.
ii) They get only a fixed rate of dividend, even if the company enjoys more
profits.
iii) The cumulative preference shares become a permanent burden so far as
the payment of dividend is concerned. The company is under an
obligation to pay the dividends for the unprofitable periods also.

iv) In case, if the company earns returns less than the cost of preference
share capital, it may result in decrease in earnings per share (EPS) for the
equity shareholders.

v) For tax calculation dividend on preference shares is not a deductible

expense, but interest is a deductible expense.

9.3.3 Debentures
Debentures are one of the principal sources of funds to meet long-term
financial needs of companies. Though there is no specific definition of
debenture, according to the Companies Act 1956, the word debenture
includes debenture stock, bonds, and any other securities of a company. Thus,
a debenture is widely understood as a document issued by a company as
evidence of debt to the holder, usually arising out of loan and mostly secured
by charge.

The debentures are instruments for raising debt finance and the debenture
holders are the creditors of the company. Debt provides the capital to a
company with fixed cost liability (Interest to be paid annually/semi-
annually). The debenture holders get interest paid as the payment of interest
is an obligation on the company. But they do not have voting rights which
equity shareholders have. They have claim over the assets of the company
before the equity holders. The obligations of the company issuing debentures
include establishing a Trustee through a trust deed. The trustee, usually a
bank or financial institution is supposed to ensure that the company fulfils its
contractual obligations. Secondly, debentures are backed by
mortgages/charges on the immovable properties of the companies. These
debentures are redeemable in nature with maturity of more than 18 months,
for which the company must create a Debenture Redemption Reserve.

The following are the advantages and disadvantages of debentures:

203
Financing
Decisions Advantages:
i) It is one of the long-term sources of finance having a maturity period
longer than the other sources of finance.
ii) The debenture holders are only creditors of the company and hence they
cannot interfere with the company affairs as they do not have voting
rights.
iii) Further, the debenture holders are entitled to interest at a fixed rate,
which is usually lower than other sources of long-term finance.
iv) The cost of debentures is usually low, as the interest payments on
debentures are tax deductible expenses. Thus, it helps to reduce the tax
burden of the company.
v) In case of liquidation of the company, the debenture holders have
priority over equity shareholders in the distribution of available funds of
the company.
Disadvantages:
i) The interest on debentures is payable even if the company is unable to
earn profit and hence, it may not be suitable to those companies whose
earnings fluctuate considerably.
ii) Secured debentures restrict the company from raising further finance
through debentures, as the assets are already mortgaged to the debenture
holders.
iii) The debenture holders can initiate the legal proceedings against the
company, if it defaults on its interest payment or principal when they
become due.

9.3.4 Retained Earnings

The companies can raise funds from internal sources, through the retained
earnings, which are ploughing back of profits for future expansion or
diversification activities. Some of the advantages and disadvantages of this
source of finance are:

Advantages:
i) This is the lowest cost of fund and does not involve any flotation cost as
required for raising funds while issuing different types of securities.
ii) If the company uses retained earnings, it is not under any obligation for
payment of dividend or interest on retained earnings.
iii) As there is no implicit cost of retained earnings, the value of share will
increase.
iv) These funds being internally generated, there is a greater degree of
operational freedom and flexibility.

Disadvantages:
i) Excessive use of retained earnings may lead to monopolistic attitude of
204 the company.
ii) If retained earnings are used more it may lead to over capitalization, Sources of Finance

which is symbolic for inefficient working of an organization.

iii) By manipulating the value of shares in the stock market the management
can misuse the retained earnings.

iv) This source of funds is uncertain, as the profits of the business are not
certain.

9.3.5 Venture Capital

Venture capital is usually in the form of equity or quasi-equity instruments in
a new company set-up to commercialise a novel idea. It is investment at the
early-stage in case of high-growth projects, which have high-risk with the
potential high returns over a period ranging from three to seven years. The
risk factor being high, the probability of failure is also high. The venture
capital investment is “hands-on” investment, where the investor mentors and
advises the promoters of the business in which the investment has been made.
The venture capitalist is an investor, who guides the project through its
different stages of growth by identifying avoidable pitfalls and directs the
business along with the possible avenues of growth. The returns to the
venture capitalist are from the handful of the projects, which succeed.

The venture capitalist is a partner, who brings more money to the project.
Many projects, which find it difficult to raise funds from banks and other
financial institutions, approach venture capitalists for assistance. The venture
capitalists conduct a preliminary project appraisal, which includes
verification of whether it is in their investment of the business. Further,
venture capital organization provides value addition in the form of
management advice and contribution of overall strategy. The relatively high
risk will normally be compensated by the possibility of high return in the
form of capital gains in the medium term.
The main features that distinguish venture capital from other sources of
capital market are as follows:
i) Venture capital is a form of equity capital for relatively new companies,
which find it too premature to approach the capital market to raise funds.
However, the basic objective of a venture capital fund is to earn capital
gain, which usually will be higher than interest at the time of exit.
ii) The transfer of existing shares from other shareholders can not be
considered as venture capital investment. The funding should be for new
project or for rapid growth of the business, with cash transferring from
the fund to the company.
iii) All the projects financed by the venture capitalists will not be successful.
However, some of the ventures yield very high return to more than
compensate for the losses on others.
Thus, the venture capital firms, fund both early and later stage financing
requirements of a firm, balancing between risk and profitability. This is an
ideal source of capital for promoters having very good technical and
management skills, with limited financial resources
205
Financing
Decisions Activity-9.2
Identify the advantages of using venture capital fund for financing the
business.
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………

9.3.6 Leasing
Leasing provides an alternate method of financing the business to acquire
assets. Instead of borrowing for acquiring assets, it is possible for firms to
acquire the assets on lease. A lease is a contract whereby the owner of an
asset (the lessor) grants to another person (the lessee) exclusive right to use
the asset for an agreed period, in return for the payment of a rent (called lease
rental). The capital assets, like land, buildings, equipment, machinery,
vehicles are the usual assets which are generally acquired on lease basis. The
lessor remains the owner of the asset, but the possession and economic use of
the asset is vested in the lessee.

The advantages and disadvantages of using leasing as a source of finance are

as follows:

Advantages:
There are several benefits derived by the lessee by acquiring the assets on
lease basis, as compared to buying the same, which are discussed as under:
i) If the capital asset is needed for a short period say a year or two, leasing
is a very convenient and appropriate method of acquiring. It dispenses
with the formalities and expenses incurred in purchasing the asset and
selling it soon after the need is over.
ii) In case of owning an asset, the firm bears the risk of the asset becoming
obsolete. In the present age of technological innovations, risks in owning
an asset with outdated and old technology cannot be ignored. Leasing
provides a shield against all these hazards by shifting the risk of
obsolescence of equipment to the lessor.
iii) Under operating or full-service lease, the lessee avails of the
maintenance and other services provided by the lessor, who is well
equipped, qualified, and experienced to provide such services efficiently.
Of course, the lessee pays for such services in the form of higher rentals.

iv) Many leasing companies specialise in leasing a few types of equipment,

machines, or vehicles only. They can easily bargain with the
suppliers/manufacturers, etc., and acquire the assets at better prices and
can economise in other administrative expenses also. The lessee may get
a concession in lease rent based on the economies derived by the lessor.

v) When an asset is acquired on lease basis, lease rentals are shown as an

206
 expense in the firm’s profit and loss account. Neither the leased asset nor Sources of Finance

the liability under the lease agreement is shown in the Balance Sheet.
Hence the debt-equity ratio remains unaffected as compared to a firm
which buys the asset with borrowed funds.

Disadvantages:
i) The lessee undertakes to pay to lessor regularly lease rental, as
consideration for the use of the goods. So, the cost of this is higher as
compared to other sources.
ii) The goods must be returned to the lessor exactly in the same form, after
the lease period is over. The lessee cannot make any considerable
changes to the asset or property as he is not the owner.
iii) The lessor, after handing over possession of the leased asset, remains
owner of the asset throughout the lease period and even thereafter.
iv) After the lease period is over, the lessee will not get the ownership over
the leased asset, though quite a good amount is paid over the years in the
form of lease rentals to the lessor.

9.3.7 Hire Purchase

Hire purchase is another method of acquiring a capital asset for use, without
paying its price immediately. Under hire purchase arrangement goods are let
on hire. The hirer (user) is allowed to pay the purchase price in instalments
and enjoys an option to purchase the goods after all the instalments have been
paid. Thus, the ownership in the asset is passed on to the hirer on payment of
the last instalment. The amount and number of instalments is fixed at the time
of delivering the asset to the hirer. If the hirer makes default in making
payment of any instalment, the seller is entitled to recover the asset from the
hirer. The hirer may, on his own also, return the asset to the hiree without any
commitment to pay the remaining instalments. Thus, the property in the asset
remains vested in the seller (hiree) till the right of purchase is exercised by
the hirer after making payment of all the instalments.

9.4 SHORT TERM SOURCES OF FINANCE

Firms also raise short term funds from banks and other investors. Some of the
methods used to raise short term funds used by firms are as follows:

9.4.1 Trade Credit

Trade credit is used by companies as a short-term source of financing. It is a
credit facility extended by one trader to another for the purchase of goods and
services. Immediate payment is not required in this case. The payables
constitute a current or short-term liability representing the buyer’s obligation
to pay a certain amount on a date after the purchase for value of goods or
services received. They are short-term deferments of cash payments that the
buyer of goods and services is allowed by the seller.
The trade credit is extended in connection with goods purchased for resale or
207
Financing
Decisions for processing and resale, and hence excludes consumer credit provided to
individuals for purchasing goods for ultimate use and instalment credit
provided for purchase of equipment for production purposes. Trade credits or
payables serve as non-interest-bearing source of funds in most cases. They
provide a spontaneous source of capital that flows in naturally during
business in keeping with established commercial practices or formal
understandings.

Advantages:
i) Trade credit could be obtained readily, without extended procedural
formalities. During periods of credit crunch or paucity of working
capital, trade credit from large suppliers can be a boon to small buyers.
ii) Where the suppliers have the advantage of high gross margins on their
products, they would be able to assume greater risks and extend more
liberal credit.
iii) In trade credit, there is no rigidity in the matter of repayment on
scheduled dates. It serves as an extendable, convenient source of
unsecured credit.
iv) Even as the current dues are paid, fresh credit flows in, as further
purchases are made. With a steady credit term and the expectation of
continuous circulation of trade credit-backing up repeat purchases, trade
credit does in effect, operate as long-term source of finance.
Disadvantages:
i) Easy availability of credit may induce a firm to indulge in overtrading,
which may increase the risks of the firm.
ii) The funds generated using trade credit are limited compared to that of
others.
iii) Sometimes it may be a costly source of funding as compared to other
sources.

9.4.2 Commercial Paper

Companies with good credit rating can raise money directly from the market
by issuing commercial papers. It is an unsecured instrument through which
high net worth corporates borrow funds from any person, corporate or
unincorporated body. It is issued in the form of usance promissory note,
which is freely transferable by endorsement and delivery. Its minimum period
of maturity should be 15 days and maximum period is less than a year, it is
issued at a discount to face value.

The commercial papers are unsecured notes but negotiable and hence liquid.
Instruments like commercial papers enable both lenders and borrowers to
move out of the relationship in a short period of time. Since lender and
borrower meet directly, the cost of commercial paper borrowing will be
lesser than working capital loan. Many banks and cash rich companies
participate in commercial papers, which are issued by high-quality
companies. Since they are liquid, even banks are willing to invest money in
208 commercial papers.
9.4.3 Factoring Sources of Finance

The Factoring is essentially a management service designed to help firms

better manage their receivables. It is in fact, a way of off-loading a firm’s
receivables and credit management on to someone else - in this case, the
Factoring Agency or the Factor. Factoring involves an outright sale of the
receivables of a firm to another firm specialising in the management of trade
credit, called the Factor.
Under a typical factoring arrangement, a Factor collects the accounts on the
due dates, effects payments to its client firm on these days and assumes the
credit risks associated with the collection of the accounts. For rendering these
services, the Factor charges a fee which is usually expressed as a percentage
of the total value of the receivables factored. Thus, factoring is an alternative
to in-house management of receivables. Depending upon the inherent
requirements of the clients, the terms of Factoring contract vary, but broadly
speaking Factoring service can be classified as:
a) Non-recourse Factoring: In Non-recourse factoring, the Factor assumes
the risk of the debts going “bad”. The Factor cannot call upon its client-
firm whose debts it has purchased to make good the loss in case of
default in payment by the counter party. However, the Factor can insist
on payment from its client if a part of the receivables turns bad for any
reason other than financial insolvency.
b) Recourse Factoring: In recourse factoring, the Factoring firm can insist
upon the firm whose receivables were purchased to make good any of
the receivables that prove to be bad and unrealisable. However, the risk
of bad debt is not transferred to the factor.
Many foreign and private banks have started providing the Factoring
services. However, there are certain advantages as well as disadvantages
of using Factoring as discussed below:
Advantages:
i) Under the Factoring arrangement the client receives pre-payment upto
80-90 percent of the invoice value immediately and the balance amount
after the maturity period. This helps the client to improve cash flow
position which helps to have better flexibility in managing working
capital funds in an efficient and effective manner.
ii) It reduces administrative cost and time, as a result of this, the company
can spare substantial time for improving the quality of production and
tapping new business opportunities.
iii) When without recourse factoring arrangement is made, the client can
eliminate the losses on account of bad debts. This will help in
concentrating more production and sales. Thus, it will result in increase
in sales, increase in business and increase in profit.
iv) The client can avail advisory services from the Factor by virtue of his
expertise and experience in the areas of Finance and marketing. This will
help them to improve efficiency and productivity of it’s organization.
The above mentioned benefits will accrue to the client provided he 209
Financing
Decisions develops a better business relationship with the Factor, and both have
mutual trust in each other.
Disadvantages:
i) Image of the company may suffer as engaging a Factoring Agency is not
considered a good sign of efficient management.
ii) Factoring may not be of much use where companies or agents have one-
time sales with the customers.
iii) Factoring increases cost of finance and thus cost of running the business.
iv) If the client has cheaper means of finance and credit (where goods are
sold against advance payment), Factoring may not be useful.

9.4.4 Public Deposits

According to the Companies Act, 2013, all types of money received by a
company except the contribution to capital would fall in the category of
deposits. Fixed deposits which are also known as public deposits have
become attractive for companies as well as investors. For the companies,
public deposits are easy form of fund mobilization without mortgaging
assets. For the investors, public deposits provide a simple avenue for
investment in good and popular companies at a better rate of interest without
many formalities as involved in the case of shares and debentures. However,
the public deposits being unsecured, the repayment of deposits and regular
payment of interest are subject to a lot of uncertainty. By presenting false
information some companies manage to collect large deposits from the
gullible public and fail to honour commitments on payments, despite many
regulatory provisions, as contained in the Companies Act and the Companies
(Acceptance of Deposits) Rules, 1975.

9.5 FINANCING THROUGH FINANCIAL

INSTITUTIONS
A company can also source long- and medium-term loans from financial
institutions, like the Industrial Finance Corporation of India (IFCI), State
level Industrial Development Corporations, etc. These financial institutions
can grant loans for a maximum period of 25 years against approved schemes
or projects. Loans agreed to be sanctioned must be covered by securities by
way of mortgage of the company's property or assignment of stocks, shares,
gold, etc. The corporate also has the option of sourcing medium-term loans
from commercial banks against the security of properties and assets. This
method of financing does not require any legal formality except that of
creating a mortgage on the assets.
Following are some of the methods of Financing by Financeial Institutions:

9.5.1 Term Loan

The term loans are granted for medium and long terms, generally above 3
years and are meant for purchase of capital assets for the establishment of
new units and for expansion or diversification of an existing unit. At the time
210 of setting up of a new industrial unit, term loans constitute a part of the
project finance which the entrepreneurs are required to raise from different Sources of Finance

sources. These loans are usually secured by the tangible assets like land,
building, plant, and machinery etc. Now, the banks have the discretion to
sanction term loans to all projects within the overall ceiling of the prudential
exposure norms prescribed by the Reserve Bank of India. The period of term
loans will also be decided by banks themselves. Though term loans are
essentially meant for meeting the project cost, some part of project cost
includes margin for working capital, This means a part of term loans
essentially goes to meet the needs of working capital.

9.5.2 Bank Credit

Banks including the Development Finance Institutions have become chief
source of funds to the corporate sector. In other words, the industrial credit is
a major revenue earner to the banking sector as other types of credit like
agricultural credit are subject to many restrictive conditions and regulations
of RBI and therefore, the margins on such credits are very thin. The banks
extend credit to industries and commercial establishments at varying rates of
interest depending upon the credit worthiness of the borrower as well as
period of loan. The proportion of bank credit in the total funds of the
companies is very high in many a case. The major advantage for the
companies in the bank credit is that it is a flexible source of financing, and it
is relatively easy to mobilize funds through this source. Some of the forms of
Bank credits are:

Overdrafts: This facility is allowed to the current account holders for a short
period. Under this facility, the current account holder is permitted by the
banker to draw from his account more than what stands to his credit. The
excess amount drawn by him is deemed as an advance taken from the bank.
Interest on the exact amount overdrawn by the accountholder is charged for
the period of actual utilisation. The banker may grant such an advance either
based on collateral security or on the personal security of the borrower.
Overdraft facility is granted by a bank on an application made by the
borrower. He is also required to sign a promissory note. Therefore, the
customer is allowed the amount, upto the sanctioned limit of overdraft as and
when he needs it. He is permitted to repay the loan as per his convenience
and ability to do so.

Cash Credit: Cash credit accounts for the major portion of bank credit in
India. The banker prescribes a limit, called the cash credit limit, upto which
the customer-borrower is permitted to borrow against the security of tangible
assets or guarantees. After considering various aspects of the working of the
borrowing firm, i.e., production, sales, inventory levels, past utilisation of
such limit, etc., the banker fixes the cash credit limit. The borrower is
required to provide security of tangible assets. A charge is created on the
movable assets of the borrower in favour of the banker. On repayment of the
borrowed amount in full or in part by the borrower, security is released to
him in the same proportion in which the amount is refunded. However,
banker charges interest on the actual amount utilised by him and for the
actual period of utilisation.
211
Financing
Decisions Loans: Loan is a definite amount lent at a time for a specific period and a
definite purpose. It is withdrawn by the borrower once and interest is payable
for the entire period for which it is granted. It may be repayable in
instalments or in lump sum. If the borrower needs funds again, or wants to
renew an existing loan, a fresh proposal is placed before the banker. The
banker will make a fresh decision depending upon the availability of cash
resources. Even if the full loan amount is not utilised the borrower has to pay
the full interest.

9.5.3 Bills Discounting

The bill discounting is an important source of financing trade and business.
Under this form of financing, seller of the goods draws a bill of exchange on
the buyer (who accepts and returns the same to the drawer). Subsequently the
seller of the goods discounts the bill of exchange with bank or finance
company and avail the finance accordingly. Only those bills which arise out
of genuine trade transactions are considered by the banks and finance
companies for discounting purpose.
Parties to a Bill of Exchange are as follows:
i) The drawer draws the bill and ensures that the bill is accepted and paid
according to its tenor. The drawer promises to compensate the holder or
any endorser of the bill if it is dishonoured.
ii) The drawee is a person on whom the bill is drawn, and the drawee
assumes legal obligation to pay the bill, as it shows assent by signing
across the bill for payment at maturity.
iii) The payee is a person to whom or to whose order the bill is payable.
iv) The endorser could be the payee or any endorsee who signs the bill on
negotiation. If the bill is negotiated to several persons who signs it in
turn becomes an endorser. The endorser is liable as a party to the bill.

If the bill of exchange is not endorsed, then drawer and payee will be the
same person.

Advantages:
The advantages of using bill discounting as a source for financing the
business are:

i) Banks usually discount bills at a rate lower than the rate charged for cash
credit. In view of this, drawer of the bill can reduce its cost of funds by
raising the funds through discounting of bills with banks.

ii) Bills seem to have certainty of payment on due dates, and this helps to
have efficient working capital management for the drawer. It also leads
to greater financial discipline as bills are discounted only against genuine
trade transactions as compared with bank overdraft facilities.

iii) The banker is having no risk in lending, as providing finance against bill,
the bank can ensure safety of funds lent. A bill is a legal negotiable
212 instrument with the signatures of two concerned parties, enforcement of
 a claim is easier. Sources of Finance

iv) With recourse to two parties banker face a lower credit risk. In other
words, if the acceptor of the bill fails to make payment on the due date
the bank can claim the whole amount from the drawer of the bill.

v) As a security, the value of a bill is not subject to fluctuations which are

found in case of values of tangible goods and financial securities. The
amount payable on account of a bill is fixed and the acceptor is liable for
the whole amount.

Disadvantages:
i) Financial institutions charge a fee, which becomes a cost to the company.
Thus, the profit margin of the company may decrease.
ii) Bill discounting does not provide any facility or assistance to recover the
unpaid bills.

9.5.4 Letter of Credit

A Letter of Credit(L/C) is a written undertaking given by a bank on behalf of
its customer, who is a buyer to the seller of goods, promising to pay a certain
sum of money provided the seller complies with the terms and conditions
given in the L/C. It is generally required when the seller of goods and
services deals with unknown parties or otherwise feels the necessity to
safeguard his interest.

The banker issuing the L/C commits to make payment of the amount
mentioned therein to the seller of the goods, provided the latter supplies the
specified goods within the specified period and comply with other terms and
conditions. Thus, by issuing letter of credit on behalf of their customers,
banks help them in buying goods on credit from sellers who are quite
unknown to them. The banker issuing L/C undertakes an unconditional
obligation upon himself and charge a fee for the same. The L/Cs may be
revocable or irrevocable. In the latter case, the undertaking given by the
banker can not be revoked or withdrawn

9.6 EMERGING SOURCES OF FINANCE

Technology has led to the development of newer means and ways of
financing business, some of which are discussed below:

9.6.1 Asset Securitization

Securitization is fairly a simple process through which an asset (fixed or
current) is converted into financial claim. In other words, it brings liquidity to
an illiquid asset. The concept is very popular in housing finance. Let us
explain the concept with a simple example. Suppose a housing finance
company has Rs. 100 cr. During the first six months, it accepts the loan
proposals and lent Rs. 100 cr. at an average interest rate of 10% and the
duration of the loan is 15 years. Suppose the housing finance company gets
213
Financing
Decisions some more loan applications say for Rs. 20 cr. in seventh month. The
company has to look for new source of finance to fund the new loan
proposals since it has already invested the entire capital and converted them
into illiquid long-term 15 years receivables.

Under securitization, an intermediary agency is created, which initially buys

the illiquid asset and against that it issues securities, which are tradeable in
the market through listing. Thus, it is also called asset-backed securities or
mortgage-backed securities. The value of the securities is improved by taking
credit rating and often through insurance cover. Some of the advantages and
disadvantages of securitisation are:

Advantages:
i) Securitization improves operating cycle of the capital in the sense the
housing finance company can recycle the capital several times and
finance more houses without borrowing on its book.
ii) Every time when the cycle is completed, the firm receives profit.

iii) On buying the existing loan, the lending company can assess the quality
of loans through a credit rating agency and thus, reducing the risks
considerably.

iv) Normally, lending blocks the funds of lender for a long-term whereas an
investment in securitized asset brings liquidity for the funds invested. So,
it is a rare case of win-win situation for both the borrower and investors.

Disadvantages:
i) The process of securitisation is very complicated and at times may be an
expensive source of long-term finance.
ii) It may hamper the ability of the business to raise funds in the future.
iii) While taking back the assets and closing of the Special Purpose Vehicle
(SPV), the costs could be substantially high.
iv) The company may lose direct control over the assets securitized, which
could reduce business value in the event of flotation.
While securitization as a concept was developed to help finance companies to
convert their loans into liquid assets, it is now extensively used in several
other business situations. By securitizing, the company sells the receivables
to the intermediary agency, which collects the money and distributes to the
holders of such securities. It is possible for companies producing
commodities, where the demand is predictable, to raise long-term resources
by securitizing their future receivables. The amount thus raised can be used to
strengthen long-term or permanent working capital needs of the firms or
invest in fixed assets to expand the capacity.

9.6.2 Angel Financing

A new start-up business can flourish only if it is backed by sufficient funds.
Companies finance their businesses using own capital and borrowed funds.
214
There are individuals who invest in companies which are in their initial Sources of Finance

stages of development for equity ownership interest, known as Angel

investors. These investors mostly lookout for the quality, passion, and
integrity of those who are starting the business, market opportunity, clearly
thought-out business plan, interesting technology, intellectual property, etc.

9.6.3 Crowd Funding

In today’s time of social networking many new ways have emerged for
raising funds, and crowd funding is one of them. It is an internet-based
mechanism where start-ups looking for funds and the potential investors can
transact. It is a practice of raising funds using multiple websites from
multiple funders. This gives budding entrepreneurs an opportunity to raise
funds for their business and for promoting products and services. A company
desirous of raising funds needs to create its profile on the website giving
details about the company, its products or services, the amount that is being
raised, etc. Those who are interested in it donate funds usually in exchange of
reward. The reward may be in form of a discount on the product or service
being offered by the company or in the form of perks. The reward could also
be in the form of equity or share in profits of the company. In reward-based
campaign there is no burden on the company in terms of interest or principal
repayments.
The technological platforms do not operate as financial intermediaries and
hence are not involved in the investment process. The advantage of these
platforms is that it provides a wider investor community to access
opportunities of investing in start-ups with small amounts. It requires
entrepreneurs to publicly disclose their business ideas and strategy which
may harm start-up with innovative business models, as it could easily be
copied. Here crowd investors may decide based on investment decisions
made by others. Crowd investors have hardly any influence on the business
and can wait for longer periods for getting back the invested capital.

9.6.4 Small Business Credit Cards

Business credit cards are just like the normal credit cards that are available.
These cards are however provided to business owners, giving an easy access
to revolving credit with a set credit limit to make purchases and withdrawals.
It increases the purchasing power of the company, but interest is charged if
the payment is not made in the billing cycle. It is a convenient and easily
accessible source of short-term finance to meet the immediate needs of the
business, thereby increasing the company’s purchasing power. The
advantages and disadvantages of using this source of finance are:

Advantages:
i) New business owners, who do not possess a well-established credit
history, can also qualify for revolving line of credit with these cards. It is
convenient to get business card as compared to bank loan.
ii) The small business credit cards provide a financial cushion to the
owners. In case of delay in accounts receivable or sales are low, the cash
215
Financing
Decisions deficit of the business could be met through these cards.
iii) Most of the business purchases from vendors, contractors and suppliers
are made online. These business credit cards help in making these online
transactions, which also provide rewards and cash back incentive to the
owners.
iv) By making repayments on time, business owners can build-up a positive
credit report for their company. It could help in qualifying for a loan at
considerably lower interest rate.
Disadvantages:
i) All the convenience and ease come with a price in the form of higher
interest rates, which could add up quickly if the repayments are not made
in full in each month.
ii) In most of the cases a personal liability agreement is made to repay debt.
Default in payment could lead to a negative credit report.
iii) There is threat of cards or card information being stolen by vendors,
contractors or those moving in the office premises. One needs to be
vigilant that employees using these cards do not use it for personal
purchases and take adequate precautions while making online
transactions to avoid these cards being hacked.
iv) The providers of business credit cards can reset the interest rates
depending on the past performance and management of account.

9.7 SUMMARY
In this unit, the different sources of funds, which can be used by the firms for
various requirements of the businesses, are discussed. These sources are
usually classified in different categories based on time, ownership, and
source of their generation. The advantages and disadvantages of various
sources of funds have also been discussed.

Capital market plays a very important role in the mobilization of funds for
Investment. The capital market has experienced metamorphic changes over
the last few years. The competition in the market has become so intense
necessitating the introduction of several kinds of securities. The corporates in
India mostly raise their funds through capital market by issuing equity shares,
preference shares, debentures, bonds and secured premium notes.

As discussed in the unit venture capital is most suitable for high-risk projects,
where venture capitalist is willing to put equity and assumes risk provided the
project has a scope for high return. The commercial paper, factoring, bill
discounting, etc., along with the prominent emerging sources through which
firms can raise funds have also been covered elaborately. Each method has
got its own distinctive features and depending upon the market conditions
and financing strategies the company may adopt different methods of
financing the business.

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 Sources of Finance
9.8 KEY WORDS
Venture Capital: Venture capital is a form of equity financing where capital
is invested in exchange for equity, typically a minority stake, in a company
that looks poised for significant growth.

Factoring: It is a financial service covering the financing and collection of

accounts receivables in domestic as well as international trade.
Commercial Paper: Commercial paper is a short-term debt instrument issued
by companies to raise funds generally for a period up to one year. It is an
unsecured money market instrument in the form of a promissory note, which
is freely transferable by endorsement and delivery.

Public Deposits: Public deposits are deposits of money accepted by

companies in India from the public for specified period ranging between 3
months and 36 months. These deposits are accepted within the limit and
subject to terms prescribed under the Companies (Acceptance of Deposits)
Rule, 1975.

Leasing: A lease is a contract whereby the owner of an asset (the Lessor)

grants to another person (the Lessee) exclusive right to use the asset for an
agreed period of time, in return for the payment of a rent (called Lease
Rental).

9.9 SELF ASSESSMENT QUESTIONS

1. Critically examine equity capital as a source of raising finance.

2. As a manager of a company, if you need funds to manage the working

capital effectively which source you would prefer and why?
3. Discuss the advantages and disadvantages of using Debentures as a
source of raising funds.

4. How is lease finance different from that of equity or debt finance?

5. Explain how Asset Securitization is considered as a source of finance?

Discuss its advantages and disadvantages to the company.

6. Describe the kinds of Projects preferred by Venture Capitalist. What are

the advantages of using venture capital funds, to a business?

9.10 FURTHER READINGS

1. Chandra, Prasanna. 2019, Financial Management, Theory and Practice,
Mc Graw-Hill, New Delhi
2. Pandey. I.M., 2021, Financial Management, Pearson Education India,
New Delhi

217
Financing
Decisions 3. Sheridan Titman, Arthur J. Keown, and John D. Martin, 2019, Financial
Management: Principles and Applications, Pearson Education India,
New Delhi.
4. M.Y. Khan. M. Y and Jain. P.K., 2018, Financial Management,
McGraw Hill Education, New Delhi
5. Eugene F. Brigham, Joel F. Huston, 2018, Fundamental of Financial
Management, Cengage Learning India, New Delhi.
6. Richard Brealey, Stewart Myres & Franklin Allen, 2019, Principles of
Corporate Finance, Mc Graw Hill, New Delhi.

218
 Capital Structure
UNIT 10 CAPITAL STRUCTURE

Objectives
The objectives of this unit are to:

• Understand the importance of decisions regarding Capital Structure.

• Discuss the concept of an appropriate Capital Structure.
• Identify the factors that have bearing on determining the Capital
Structure.

Structure
10.1 Introduction
10.2 Concept of Capital Structure
10.3 Features of an Appropriate Capital Structure
10.4 Determinants of Capital Structure
10.5 Summary
10.6 Key Words
10.7 Self Assessment Questions/Exercises
10.8 Further Readings

10.1 INTRODUCTION
Finance is a critical input for any organisation, since it is required for both
working capital and long-term investment. The total funds used in a firm
come from a variety of sources. The owners contribute a portion of the
capital, while the rest is borrowed from individuals and institutions. While
some funds are maintained in the firm indefinitely, such as share capital and
reserves (owned funds), others are held for a long time, such as long-term
borrowings or debentures, while yet others are short-term borrowings mostly
used for working capital requirements. The total financial structure of the
company is made up of the complete composition of all of these funds.
You are well aware that the requirement for short-term funds fluctuate a lot.
As a result, the proportion of short-term financing is constantly changing.
The composition of long-term funds, referred to as capital structure, is
frequently governed by a set of rules. The debt-to-equity ratio and dividend
determination are two other important parts of policy. The latter has an
impact on the accumulation of retained earnings, which is a key component
of long-term funds. Because permanent or long-term funds account for a
significant amount of total funds and include long-term policy decisions, the
term financial structure is frequently used to refer to a company's capital
structure.
There are some long-term funding options that are commonly available to
corporate organisations. Share capital and long-term debt, including
debentures, are the key sources. The profit generated by operations can be
219
Financing
Decisions retained in the business or distributed as a dividend. A reinvestment of the
owners' funds is the portion of profits retained in the firm. As a result, it is a
long-term fund source. All of these sources combine to form the firm's capital
structure.

10.2 CONCEPT OF CAPITAL STRUCTURE

The mix, or proportion, of different types of finance (debt and equity) to total
capitalization is referred to as capital structure. It is a measure of a company's
entire long-term investment. It includes funds raised by common and
preferred stock, bonds, debentures, and term loans from a variety of financial
institutions, among other things. Earned revenue and capital surpluses are
also considered.

Capital Structure Planning

The construction of a suitable capital structure in the context of each firm's
facts and circumstances is referred to as capital structure planning. Because
of the possible impact on profitability and solvency, the decision on what
type of capital structure a company should have is crucial. Small businesses
frequently do not plan their capital structure. Without any explicit planning,
the capital structure may develop in these businesses. These businesses may
prosper in the short term, but they will encounter significant challenges
sooner or later. The company's unplanned capital structure prevents it from
making efficient use of its funds.

As a result, a company's capital structure should be planned in such a way

that it maximises its benefits and allows it to react more quickly to changing
situations. Rather than following any scientific procedure to determine an
appropriate proportion of different types of capital that will reduce the cost of
capital while increasing market value, a company can simply copy the capital
structure of other similar companies or consult an institutional lender and
follow its advice.

Theoretically, a firm should build its capital structure so that the market value
of its shares is as high as possible. When the marginal cost of each source of
funds is the same, the value will be maximised. In general, the debate over
the best capital structure is purely theoretical. In actuality, determining an
optimal capital structure is a difficult endeavor, and we must go beyond
theory. As a result, there are likely to be major differences in capital structure
between industries and across enterprises within the same industry. A
company's capital structure selection is influenced by a number of things.

The judgement of the individual or group of individuals making the capital

structure decision is critical. If the decision makers disagree about the
importance of various criteria, two similar companies can have distinct
capital structures. These variables are psychologically complicated and
qualitative, and they do not always match the accepted theory. Since capital
markets are not flawless, decisions need to be made with limited information
and thus risk. You may have been interested in identifying some of the key
aspects that drive capital structure planning in practice. However, before we
220
go into these details, let us have a look at the characteristics of a good capital Capital Structure

structure in the next part.

10.3 FEATURES OF AN APPROPRIATE

CAPITAL STRUCTURE
The capital structure is frequently designed with regular shareholders'
interests in mind. Ordinary shareholders are the company's ultimate owners
and have the power to choose the Directors of the company. The Finance
Manager should try to maximise the long-term market price of equity shares
while building a suitable capital structure for the organisation. In actuality,
there would be a range of appropriate capital structures for most companies
within an industry, with few changes in the market value of shares. For
example, a corporation may operate in an industry with a debt-to-total-capital
ratio of 60%. It is possible that shareholders, on average, do not mind if the
company operates within a 15% range of the industry's typical capital
structure. As a result, the optimum capital structure for the corporation is a
debt-to-total capital ratio of 45 to 75 percent. Subject to other considerations,
such as flexibility, solvency, and so on, the company's Management should
strive to find a capital structure towards the top of this range to maximise the
use of favourable leverage.
A sound appropriate capital structure should have the following features:
Profitability: Within the limits, the company's capital structure should be the
most advantageous. The most effective use of leverage at the lowest possible
cost should be pursued.
Solvency: Excessive debt puts a company's solvency in jeopardy. The debt
should only be utilised sparingly.
Flexibility: The capital structure should be adaptable to changing
circumstances. If a company's financial structure needs to be modified, it
should be possible to do so with minimal expense and delay. The corporation
should also be able to supply finances whenever it is needed to finance its
profitable activities.
To put it another way, we need to approach capital structuring with caution
from a solvency standpoint. The company's debt capacity, which is based on
its ability to generate future cash flows, must not be surpassed. It should have
adequate cash on hand to pay creditors' set charges (interest) on a regular
basis as well as the principal payment upon maturity.
The characteristics listed above are typical of an appropriate capital structure.
more special aspects may be reflected in a company's characteristics. Further,
the importance placed on each of these characteristics may differ from one
organisation to the next. For example, a company may place a higher value
on flexibility than on maintaining control, which is another desirable
attribute, while another company may place a higher value on solvency than
on any other criteria. Further, if circumstances change, the relative relevance
of these factors may shift.

221
Financing
Decisions 10.4 DETERMINANTS OF CAPITAL
STRUCTURE
When a firm is promoted, the capital structure must be decided. The initial
capital structure should be properly planned. The company's Management
should establish a target capital structure, and subsequent finance decisions
should be made with the goal of achieving that capital structure. The Finance
Department Management must deal with the current capital structure once a
firm has been created and has been in operation for few years. The company
may require capital to continue to fund its operations. When funds are
needed, the Management assesses the advantages and disadvantages of
various sources of financing and chooses the most favourable sources while
keeping the intended capital structure in mind. As a result, the capital
structure choice is a constant one that must be made anytime a company
needs additional funding.

When deciding on a capital structure, the following factors should be

considered:

i) Leverage or Trading on Equity:

Financial leverage, also known as trading on equity, is the use of fixed-cost
sources of finance, such as debt and preference share capital, to fund assets of
a company. If the return on debt-financed assets exceeds the cost of debt,
earnings per share will rise without an increase in the owners' investment.
Similarly, if preference share capital is used to acquire assets, earnings per
share will rise. However, the impact of leverage is felt more in the case of
debt because (i) the cost of debt is typically lower than the cost of preference
share capital, and (ii) interest paid on debt is a deductible charge from profits
for calculating taxable income, whereas dividends on preference shares are
not.

Financial leverage is an important consideration when developing a

company's capital structure because of its impact on earnings per share.
Companies having a high level of Earnings Before Interest and Taxes (EBIT)
can profitably use a high degree of leverage to boost their shareholders'
equity return. The link between Earnings Per Share (EPS) at various possible
levels of EBIT under alternative ways of financing is a typical approach of
analysing the impact of leverage. The EBIT-EPS analysis is an important tool
in the toolbox of financial manager for gaining insight into the capital
structure design of the company. S/he can assess potential EBIT changes and
their impact on EPS under various financing arrangements.
For a recapitulation of the effects of financial leverage on earnings per share
(EPS) under various financing plans with different mixes of equity and fixed
return securities, an illustration is given below which demonstrates the effect
of financial leverage on EPS by considering three alternative financing plans:

222
Illustration 10.1 Capital Structure

Plan A: No debt, all equity shares

Plan B: 50% debt @10%, 30% preference shares @12%, 20% equity shares
Plan C: 80% debt @10%, 20% equity shares

The face value of equity shares is Rs. 10.

The total amount of capital required to be raised is Rs. 2,00,000. The

company estimates its Earnings Before Interest and Taxes (EBIT) at Rs.
50,000 annually.

Table-10.1: Effect of Financial Leverage on EPS

Financing Plan (in Rs.)

A B C
Earnings Before Interest and Taxes (EBIT) 50,000 50,000 50,000
Interest - 10,000 16,000
Earnings before taxes 50,000 40,000 34,000
Income Tax (50%) 25,000 20,000 17,000
Earnings after taxes 25,000 20,000 17,000
Preference share dividend - 7,200 -
Earnings available on equity shares 25,000 12,800 17,000
No. of shares 20,000 4,000 4,000
Earnings per share (EPS) 1.25 3.20 4.25

Table-10.1 shows the impact of financial leverage (trading on equity). Plan

‘C’ is the most appealing from the perspective of shareholders since it has the
highest EPS of Rs. 4.25. When a corporation does not use any debt or fixed-
income instruments, it has the lowest EPS. You will notice that under plans
‘B’ and ‘C’, the proportion of fixed-income securities is the same (80
percent). However, Plan ‘C’, has a greater EPS because the dividend on the
preference share is not tax deductible, whereas interest is. If the EBIT
predictions prove to be true, shareholders will benefit the most if plan ‘C’ is
implemented.

The companies using appropriate amount of debt in its capital structure and
having stable cashflows will command a large premium in the market and
will be in high demand. The advantage in financial leverage comes from the
fact that, while the overall return (before taxes) on capital employed is 25%,
the returns on preference shares and debt are only 12% and 10%,
respectively. The savings from this discrepancy allow management to
increase the return on equity shares along with the fact that interest is a tax
deductible expense through which the overall cost of capital becomes lower
as compared to the firms financed fully by equity.

While leverage can boost earnings per share (EPS) in favourable

circumstances, it can also put shareholders' money at risk. Because of (a) the
adverse fluctuations in the cashflows and (b) higher probability of 223
Financing
Decisions insolvency, as financial risk rises when debt is used. If a company's capital
structure is devoid of debt, it can completely avoid financial risk. However, if
no debt is used in the capital structure, shareholders will miss out on the
benefits of increased EPS due to financial leverage. As a result, a company
should use debt only if the financial risk perceived by shareholders does not
outweigh the advantage of greater EPS.

ii) Cost of Capital

The costs of numerous sources of finances are a complicated topic that
requires its own approach. It goes without saying that lowering the cost of
capital is beneficial. As a result, if all other factors remain constant, cheaper
suppliers should be favored. The minimal return expected by a source of
money is the cost of that source of financing. The expected return is
determined by the level of risk that investors are willing to take. Shareholders
take on a higher level of risk than debt holders. The rate of interest is fixed in
the case of debt holders, and the corporation is legally obligated to pay
interest whether it earns profits or not.

The dividend rate is not defined for shareholders, and the Board of Directors
is under no legal responsibility to pay dividends even if the firm has produced
profits. Debt holders get their money back after a set amount of time, whereas
shareholders only receive their money back when the company is wound up.
This leads to the conclusion that debt is a less expensive source of capital
than equity. Interest costs are tax deductible, which lowers the cost of debt
even further. Although preferred share capital is less expensive than equity
capital, it is not as inexpensive as debt money. As a result, a corporation
should use debt to lower its overall cost of capital.

However, it must be understood that a corporation cannot continue to reduce

its overall cost of capital by using debt. Debt becomes more expensive
beyond a certain point because of the increasing risk of excessive debt to
creditors and shareholders. As the level of leverage rises, the risk to creditors
rises as well. Once the debt has reached a certain level, they may demand a
higher interest rate or refuse to lend to the company at all.
In addition, the enormous debt puts the stockholders' position in jeopardy. As
a result, the equity cost of capital rises. As a result, while debt lowers the
overall cost of capital up to a degree, beyond that point, the cost of capital
begins to rise, making it unfavorable to use debt further. As a result, there is a
mix of debt and equity that lowers the firm's average cost of capital while
increasing the market value of its stock.

The cost of retained earnings and the cost of a fresh issue of shares are
included in the cost of equity. The cost of debt is less than the cost of both of
these equity capital sources. The cost of retained earnings is less than the cost
of new issuance. Since the company does not have to pay personal taxes,
which are paid by shareholders on distributed earnings, the cost of retained
earnings is lower than the cost of new issues, and because, unlike new issues,
retained profits do not incur floatation charges. As a result, between these
two sources, retained earnings are preferable.
224
When the leverage and cost of capital aspects are considered, it appears Capital Structure

appropriate for a company to use a higher amount of debt if its cashflows are
stable and do not fluctuate significantly and the cashflows are over and above
the required cashflows to service interest on debt and the principal
repayment. In fact, debt can be employed to bring the average cost of capital
down to zero. Together, these two parameters determine the maximum
amount of debt that can be used. Other considerations, however, should be
considered when determining a company's suitable financial structure.
Theoretically, a company's debt and equity balance should be such that its
overall cost of capital is as low as possible. Let us look at an illustration to
better understand this notion.
Illustration-10.2
A company is planning for an appropriate capital structure. The cost of debt
(after tax) and of equity capital at various levels of debt equity mix are
estimated as follows:
Debt as percentage of Cost of debt (%) Cost of equity (%)
total capital employed
0 10 15
20 10 15
40 12 16
50 13 18
60 14 20
Determine the optimal mix of debt and equity for the company by calculating
composite cost of capital?
For determining the optimal debt equity mix, we have to calculate the
composite cost of capital, i.e., Ko which is equal to Kip1+Kep2.

Where,
Ki = Cost of Debt
pl = Relative proportion of debt in the total capital of the firm
Ke = Cost of Equity
p2 = Relative proportion of equity in the total capital of the firm

Before we arrive at any conclusion, it would be desirable to prepare a table

showing all necessary information and calculations.

Table-10.2: Cost of Capital Calculations

Ki % Ke % pl p2 Kip1 + kep2 = Ko
10 15 0.0 1.00 0.0 + 15.0 = 15.0
10 15 0.2 0.8 2.0 + 12.0 = 14.0
12 16 0.4 0.6 4.8 + 9.6 = 14.4
13 18 0.5 0.5 6.5 + 9.0 = 15.5
14 20 0.6 0.4 8.4 + 8.0 = 16.4
225
Financing
Decisions The best debt-to-equity ratio for a corporation is when the composite cost of
capital is the lowest. Table-10.2 shows that a 20 percent debt/80 percent
equity combination results in a minimum composite cost of capital of 14
percent. Any other debt-to-equity ratio results in a greater overall cost of
capital. A mix of 40% debt and 60% equity, with a Ko of 14.4 percent, comes
closest to the minimal cost of capital. As a result, it may be argued that a
capital structure consisting of 20% debt and 80% equity is ideal.

iii) Cash Flow

Conservatism is one of the characteristics of a healthy capital structure.
Conservatism does not imply the avoidance of debt or the use of a minimal
amount of debt. It has to do with determining the obligation for fixed charges,
as well as the use of produced debt or preferred capital in the capital
structure, in light of the company's ability to generate cash to cover these
fixed charges.

Interest, preference dividends, and principal payments are all part of a

company's fixed expenses. If the company uses a lot of debt or preferred
capital, the fixed charges will be quite expensive. When a corporation
considers taking on more debt, it should consider how it will cover its fixed
charges in the future. Interest must be paid, and the principal amount of the
debt must be returned according to the timelines. A corporation may suffer
financial insolvency if it is unable to earn enough cash to pay its fixed
obligations. Companies that anticipate big and consistent cash inflows can
use a lot of debt in their capital structure. Employing fixed-fee sources of
finance for organisations whose cash inflows are variable or unpredictable is
a bit dangerous.

iv) Control
When it comes to capital structure design, the Management is sometimes
guided by its desire to maintain control over the company. The current
management team may not only seek to be elected to the Board of Directors,
but also to run the company without influence from outsiders.
Ordinary shareholders have the legal right to choose the company's Directors.
There is a risk of losing control if the corporation issues fresh shares. In the
case of a publicly traded corporation, this is not a significant factor to
consider. The stock of such a corporation is extensively distributed. The
majority of shareholders are uninterested in participating in the company's
management. They are unable to attend shareholder meetings due to a lack of
time and desire. They are solely concerned with dividends and share price
appreciation. By distributing shares widely and in tiny quantities, the risk of
losing control can almost be eliminated.
In the case of a closely held corporation, however, keeping control may be a
key factor. A single shareholder or a group of shareholders might buy all or
most of the new shares, thereby taking control of the firm. Fear of losing
control and so being hampered by others is a common reason for closely held
companies delaying their decision to go public. To avoid the risk of losing
control, companies may issue preference shares or raise debt capital.
226
Because debt holders do not have voting rights, it is frequently proposed that Capital Structure

a corporation employs debt to avoid losing control. When a corporation

employs a considerable amount of debt, the debt holders place a lot of
constraints on it to safeguard their interests. These limitations limit the
management's ability to run their businesses. An excessive amount of debt
may also cause bankruptcy, which means a complete loss of control.

v) Flexibility
The ability of a company's financial structure to adjust to changing situations
is referred to as flexibility. A company's capital structure is flexible if
changing its capitalization or funding sources is not difficult. The corporation
should be able to raise funds without undue delay or expense whenever it is
needed to fund lucrative investments. When future conditions justify it, the
corporation should be able to redeem its preference capital or debt. The
company's financial plan should be adaptable enough to adjust the capital
structure's composition. It should keep itself in a position to switch from one
type of funding to another in order to save money.

vi) Size of the Company

The availability of funding from various sources is heavily influenced by the
size of a company. It might be difficult for a small business to obtain long-
term financing. If it is able to secure a long-term loan, it will be at a high
interest rate and with uncomfortable terms. The financial structures of Small
businesses are inflexible due to the highly restrictive covenants in their loan
agreements. As a result, Management is unable to conduct business freely.
Therefore, small businesses must rely on their own capital and retained
revenues to meet their long-term needs.
A large corporation has more leeway in deciding how to arrange its capital
structure. It can get low-interest loans and offer ordinary shares, preferred
shares, and debentures to the general public. A company should make the
best use of its size in planning the capital structure.
vii) Marketability
In this sense, marketability refers to a company's ability to sell or market a
security in a given timeframe, which is dependent on investors' willingness to
buy that security. Although marketability may not have an impact on the
original capital structure, it is an important factor to consider when selecting
to issue securities. The market may prefer debenture issues at one time while
accepting ordinary share issues at another. The corporation must determine
whether to raise financing through ordinary shares or debt due to shifting
market sentiments.
If the stock market is down, the corporation should issue debt instead of
ordinary shares and wait until the stock market recovers before issuing
regular shares. During a period of high stock market activity, the corporation
may be unable to successfully issue debentures. As a result, it should leave its
debt capacity unused and issue common stock to raise funds.

227
Financing
Decisions viii) Floatation Costs
When money is raised, floatation charges are incurred. The cost of floating a
debt issuance is typically lower than the cost of floating an equity issuance.
This may persuade a corporation to issue debt rather than common stock.
There are no floating charges if the owner's capital is enhanced by keeping
the earnings. The floatation cost generally is not an important factor that
affects the capital structure of a company except in the case of small
companies.

Activity-10.1
a) What is the capital structure of a company made up of? Why does the
corporation have a certain capital structure and not another?
………..…………………………………………………………………
………..…………………………………………………………………
………..…………………………………………………………………
………..…………………………………………………………………
………..…………………………………………………………………
b) Note the differences in the capital structures of any two companies and
find out the reasons for the differences.
………..…………………………………………………………………
………..…………………………………………………………………
………..…………………………………………………………………
………..…………………………………………………………………

10.5 SUMMARY
The capital structure of a firm is the mix of long-term financing sources in its
total capitalization. Ownership and Creditorship securities are the two most
common sources. Most large industrial enterprises use both forms of
securities as well as long-term loans from financial institutions. Any
company's capital structure planning is critical to any company as it has a
significant impact on its profitability. A bad decision in this regard could be
quite costly to the firm.

While deciding on a capital structure, it is important to keep the goals in

mind, such as; profitability, solvency, and flexibility. The amount of debt and
other fixed-income securities on one hand, and variable-income securities,
such as equity shares on the other, is determined after a comparison of the
characteristics of each type of security and careful consideration of internal
and external factors affecting the firm's operations.
In the real world, concessions must be made somewhere between the
aspirations of enterprises seeking funding and the expectations of those who
offer them. The fundamental distinctions between debt and equity remain
unchanged as a result of these concessions. In most cases, the choice of
228
financing is not between equity and debt, but rather between the best possible Capital Structure

mixture of the two.

Suitability, risk, income, control, and timing all play a role in determining the
debt-equity mix. The weights attributed to these elements will differ from
firm to firm, based on the industry and the firm's current status. Perhaps there
will never be an accurate mathematical solution to the decision on capital
structure design. Human judgement is crucial in analysing conflicting factors
before deciding on an acceptable capital structure.

10.6 KEY WORDS

Capital structure: The mix of various types of long-term sources of
financing, such as; debentures, bonds, loans from financial institutions,
preference shares, and equity shares including retained earnings is referred to
as capital structure (also known as financial structure).
Cost of Capital is the (weighted) average cost of various sources of finance
used by a company.
Financial Leverage (or Trading on Equity) is a type of financial planning
that allows a corporation to boost its return on equity by employing loans
with a lower fixed cost that is lower than the overall return on investment.
Because of the financial burden, changes in EBIT (Earnings Before Interest
and Taxes) have a greater impact on EPS (Earnings Per Share).

10.7 SELF ASSESSMENT QUESTIONS/

EXERCISES
1) What are the features of an appropriate capital structure?
2) Discuss the determinants of capital structure?
3) Do you think that different factors affecting capital structure decision
will be viewed differently by different companies? Support your answer
with suitable examples.
4) Make a comparative assessment of different types of securities from the
point of view of capital structuring.
5) Under what conditions different types of securities would be considered
more suitable?
6) Write notes on the following:
a) Trading on equity b) Cost of capital c) Flexibility in capital
structure d) Closely held company.
7) A company wishes to determine the optimal capital structure from the
following information. Determine the optimum capital structure from the
viewpoint of minimising the cost of capital.

229
Financing
Decisions Financing Debt Equity After Tax Cost
Plan Amount Amount Cost of debt equity
(Rs.) (Rs.) Ki% Ke%
A 8,00,000 2,00,000 14 20
B 6,00,000 4,00,000 13 18
C 5,00,000 5,00,000 12 16
D 2,00,000 8,00,000 11 18

10.8 FURTHER READINGS

1. Chandra, Prasanna. 2019, Financial Management, Theory and Practice,
Mc Graw-Hill, New Delhi
2. Pandey. I.M., 2021, Financial Management, Pearson Education India,
New Delhi
3. Sheridan Titman, Arthur J. Keown, and John D. Martin, 2019, Financial
Management: Principles and Applications, Pearson Education India,
New Delhi.
4. M.Y. Khan. M. Y and Jain. P.K., 2018, Financial Management,
McGraw Hill Education, New Delhi
5. Eugene F. Brigham, Joel F. Huston, 2018, Fundamental of Financial
Management, Cengage Learning India, New Delhi.
6. Richard Brealey, Stewart Myres & Franklin Allen, 2019, Principles of
Corporate Finance, Mc Graw Hill, New Delhi.

230
 Leverage Analysis
UNIT 11 LEVERAGE ANALYSIS

Objectives:
The study of this unit will enable you to:

• Acquire an understanding of Leverage Ratios

• Examine the consequences of Financial Leverage for a Business Firm
• Trace relationship between Financial and Operating Leverages, and
• Assess the risk implications of Financial Leverage.

Structure
11.1 Introduction
11.2 Concept of Financial Leverage
11.3 Measures of Financial Leverage
11.4 Effects of Financial Leverage
11.5 Operating Leverage
11.6 Combined Leverage
11.7 Financial Leverage and Risk
11.8 Summary
11.9 Key Words
11.10 Self Assessment Questions/Exercises
11.11 Further Readings

11.1 INTRODUCTION
You have been familiar with the numerous types of financial ratios. The four-
fundamental classes of ratios, namely liquidity, leverage, activity, and
profitability, were discussed in Unit-14 Financial Ratios of MMPC-004
Accounting for Managers. The ratios covered in that unit were chosen based
on their use in managing business operations.
Despite the fact that a company's management is always interested in
maintaining a reasonable level of liquidity and solvency, it is the lender or
banker who will insist on particular standards and monitor changes in these
ratios. The leverage ratios, which reflect a company's insolvent position, are
discussed in depth here. You will get an understanding of the fundamental
concept of leverage as well as the role and repercussions of financial leverage
by studying this unit.
Another concept of leverage was discussed in the Unit titled "Cost-Volume-
Profit Analysis," and you may recall the "break-even analysis" that was
presented and illustrated in that unit (MMPC-004).We have discussed the
term' operating leverage' and its significance in that unit. This unit will help
you in connecting these two types of leverage concepts; financial and
operating leverages.

231
Financing
Decisions 11.2 CONCEPT OF FINANCIAL LEVERAGE
Consider how the phrases 'lever' and 'leverage' are commonly used. The
following is how Webster's dictionary defines them:
The word 'lever' means 'inducing' or 'compelling.' The action of a lever or the
mechanical advantage acquired by it is referred to as 'leverage'. It also refers
to 'effectiveness' or 'power'. The use or manipulation of a tool or equipment
known as a lever, which provides a substantive clue to the meaning and
nature of financial leverage, is the most frequent interpretation of leverage.
Could you figure it out?
Your response, we assume, will be negative.
Let us say we propose that our lever is the utilization of debt or borrowed
funds for asset acquisition. Would you be able to grasp the meaning of the
word "financial leverage"? Most likely, you require some clarification. That
is something we will do. Take a look at the simple (and hypothetical) facts
regarding GTB Limited below:
The GTB Limited intended to buy fixed assets worth Rs. 80 lakhs for the
completion of a project, which would be financed with a Rs. 30 lakhs share
capital and Rs. 50 lakhs in term loans at an 18% interest rate. On its share
capital, the corporation was expected to achieve a minimum return of 20%.
Other companies of similar type were earning this much, and unless GTB
Limited could match that, no investor would be interested in purchasing its
stock. The GTB Limited pays tax at the rate of 40% and is exempt from
paying any tax on interest payments on term loans.
Now let us see what happens to the company's net return on equity (after
interest and taxes) if (a) the entire Rs. 80 lakhs are raised through share sales,
and (b) the financing arrangement proposed in the problem is implemented?
You might estimate GTB's earning potential to be 40% (before taxes and
interest) on total assets of Rs. 80 lakhs. GTB's earnings are taxed at the rate
of 40%.
We present for your understanding the solution below:
Table-11.1 Effect of Financial Leverage
Rs. 80 lakhs Rs. 30 lakh of
as Share share capital plus
capital 50 lakhs of debt
(Rs. Lakh) (Rs. Lakh)
Earnings on assets of Rs. 80 lakh @ 32.0 32.00
40%
Less interest: 18% on Rs. 50 lakh -- 9.00
Earnings after interest 32.00 23.00
Taxes @ 40% I2.80 9.20
Earnings after taxes 19.20 13.80
Earnings after interest and taxes as a % 24% 46%
of share capital

232
When no debt is utilised, the net return on equity is 24 percent, but when debt Leverage Analysis

is used, it is 46 percent. There has been a significant increase in the net

return. We would assume at this point that using debt financing in a
profitable and tax-paying corporation boosts net equity returns. Financial
leverage refers to the effect of using debt financing on the returns of the firm.

You may have noticed in the above example that the increase in net equity
returns from 24% to 46% occurred at a certain level of debt, namely when the
debt is Rs. 50 lakhs against an equity of Rs. 30 lakh (i.e., when the debt-to-
equity ratio is 5:3 or 167%) or when the debt is Rs. 50 lakhs against total
assets of Rs. 80 lakhs (i.e., when the debt- assets ratio is 5:8 or 62.5
percent).These and other financial leverage measurements are examined in
the following section. But, before we go any further, let us summarise the
concept of financial leverage.

Financial leverage refers to a company's plan of financing assets with fixed-

charge securities such as debentures and preference shares (though the latter
is not necessarily included in debt). The term "financial leverage" refers to a
company's financing activity. It occurs as a result of the existence of fixed
financial expenses in the Capital Structure. Expenses like this are unaffected
by operating earnings (EBIT). Regardless of the amount of EBIT available to
pay them, they must be paid. The EBIT belongs to the shareholders after the
expenses in relation to the debt capital have been paid. The effect of changes
in EBIT on the earnings available to shareholders is referred to as financial
leverage (EPS).It can be characterized as a company's ability to magnify the
impact of changes in EBIT on EPS by using fixed financial costs.
The financial leverage is calculated as a percentage change in EPS divided by
a percentage change in EBIT.

11.3 MEASURES OF FINANCIAL LEVERAGE

The quantity of debt that a company uses or intends to use might be stated in
terms of total assets or total equity. Total assets will be taken at net value, and
equity will include paid-up capital and reserves. Despite the fact that both
shares and assets can be valued at market prices, the current discussion will
solely employ book prices. Market values are difficult to get, change widely,
and are not available for new ventures that plan their sources of capital using
the notion of financial leverage.

The debt-equity and debt-assets ratios, which are both computed using
Balance Sheet data and are inter-related, will be demonstrated. It's worth
noting that this section assesses the usage of financial leverage rather than its
consequences. The latter is determined by the Degree of Financial Leverage,
which is explored in more detail in the following section.

With the help of an example, we will illustrate the notion of financial

leverage. Bharat Engines Limited intends to purchase assets for Rs. 1 crore.
The corporation has two financing options: debt and equity. The Finance
Director wants to know how the debt-equity and debt-assets ratios will vary
at different debt levels of (a) Zero (b) Rs. 10 lakh (c) Rs. 20 lakh (d) Rs. 30
233
Financing
Decisions lakh (e) Rs. 50 lakh (f) Rs. 80 lakh (g) Rs. 1 crore. The table-11.2 provides
the required calculations:

Table-11.2: Debt-assets and Debt-equity Ratios (Total investment in

assets = Rs 100 lakh)
Debt Equity Debt-assets Debt-equity
Rs. Lakh Rs. Lakh Ratio Ratio
Zero 100 Zero Zero
10 90 10% 11.1%
20 80 20% 25%
30 70 30% 43%
50 50 50% I00%
80 20 80% 400%
100 Zero 100% ∞

Please pay attention to the final two columns in the table above. The
following analysis illustrates the fundamental aspects of the two ratios and
shows how they are related:

a) The debt-to-assets ratio rises at a consistent rate, eventually reaching

100% and the debt-to-equity ratio rises inexorably until it approaches
infinity (∞) as the amount of debt rises in the capital structure.

b) The two ratios are mathematically connected and can be calculated from
one another. For such derivations, the following relationships can be
used:
�
� �����
Debt-Assets Ratio �� � = �
� …………… (1)
�� �����
�

�
� �����
Debt-Equity Ratio �� � = �
� …………… (2)
�� �����
�

At every debt level, the usage of these methods to derive one ratio from
another can be proved. The debt-to-assets ratio is 80 percent with a debt
amount of Rs. 80 lakhs, for example. Formula-(2) can be used to get the D/E
ratio:
� . 80 . 80
����� = = = 4.00 �� 400%
� 1 − .80 . 20
Similarly, with a given D/E ratio of 400% or 4.00, the D/A ratio can be
derived by using formula (1) above:
� 4.00 4.00
����� = = = 0.80 �� 80%
� 1 + 4.00 5.00
The D/A and D/E ratios are both used to calculate financial leverage. It is
worth noting that the D/E ratio exaggerates the amount of financial leverage
at all levels of debt and becomes unclear at 100% debt. As a result, using the
234 debt-to-asset ratio as a measure of financial leverage may be more technically
possible. Leverage Analysis

In recent literature, you may come across certain ratios that seek to quantify
the use of financial leverage. They are as follows:
����
a) ����� ����� �� ��� ���� (�� ������ �����

������ �� ������
b) ������ �� ����� �������

Activity-11.1:
1. Take any company's financial statements and analyse its financial
leverage to demonstrate the notion of financial leverage.
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
…………………………………………………………………………….
2. Answer the following:
i) Amount of leverage and degree of leverage are the Yes No
same
ii) Debt-equity ratio overstates the use of leverage Yes No
iii) A firm (to be established) can use market values Yes No
for its leverage ratios
iv) The D/E ratio is infinite at 100% debt Yes No
v) D/A and D/E ratios can be derived from each other Yes No
vi) When the D/E ratio is 200%, D/A ratio would be:
(i) 80% (ii) 100% (iii) 67% (iv) 45% (v) None of
these

11.4 EFFECTS OF FINANCIAL LEVERAGE

Table-11.1 shows an example mentioning that financial leverage could have
an impact on return on equity. You have probably seen one crucial factor to
consider when using borrowed funds; that is the increase in net equity returns
that such a move results in.

In reality, another ratio, Earnings Per Share (EPS), is used to quantify the
impact of financial leverage. This is done in the case of joint stock
corporations that have raised capital by selling equity shares, which are units
of that capital. Divide earnings (after interest and taxes) by total equity to get
earnings per share. It is worth noting that if a company's capital structure
includes preference shares, net equity earnings will be calculated after
deducting interest, taxes, and preference dividends. A company's capital
structure refers to its long-term funding, which is made up of a mix of long-
term debt, preference shares, and net worth (which included paid-up capital,
235
Financing
Decisions reserves, and surpluses). Financial structure is defined as the total of capital
structure components plus short-term debt. Financial leverage and its
consequences are critical considerations in capital structure planning and
design.

We should emphasize that the effects of financial leverage are not always
obvious and consistent across different levels of profitability and debt
proportions. Before recommending a specific long-term financing mix for
implementation, it may be required to investigate these impacts.

We will use an example from the last section to demonstrate the implications
of financial leverage.

Bharat Engines is exploring four different debt ratios (D/A ratios): 0%, 20%,
50%, and 80%. The D/E ratios are 0 percent, 25%, 100 percent, and 400
percent, respectively.

The company's equity capital is divided into shares of Rs. 10 each, which can
only be sold in the market for their face value. If business conditions are
favourable, the firm forecasts a net profit (before tax) of 25% on total assets
of Rs. 1 core, a net profit (before tax) of 50% on total assets if conditions are
highly favourable, and a net loss (before tax) of 25% if conditions are
unfavorable. Bharat Engines is subject to a 40% income tax rate. The
company's average interest rate on borrowings is projected to be 15%.

Table-11.3 shows how each of the four different debt levels affects the return
on equity and earnings per share.

Table-11.3 Financial Leverage, Equity Returns & EPS

Total Investment Rs. 1 Crore
Alternative Estimates of EBIT (in Rs. Lakhs) as of Total Assets
Probable Profitability outcomes (-25%) +25% +50%
CAPITAL STRUCTURE
I: Debt = Zero, Equity = Rs. 1 Crore
EBIT (–25.00) 25.00 50.00
Less interest (at 15%) zero zero zero
Earnings (before tax) (–25.00) 25.00 50.00
Less tax at 40% 10.00 10.00 20.00
Net Income (after tax) (–15.00) 15.00 30.00
Return on Equity (–15%) 15% 30%
Earnings per share (in Rs. 10,00,000 (–1.50) 1.50 3.00
shares of Rs. 10 each)

236
 Leverage Analysis
II: Debt=Rs.20 lakh, Equity=Rs. 80 lakh
EBIT (–25.00) 25.00 50.00
Less interest (at 15%) 3.00 3.00 3.00
Earnings before tax (–28.00) 22.00 47.00
Less tax at 40% 11.2 8.80 18.80
Net income (–16.80) 13.20 28.20
Return on equity of Rs. 80 lakh (–21%) 16.5% 35.25%
Earnings per share (Rs. 8,00,000 shares of Rs. (2.1) 1.65 3.525
10 each)

III: Debt = Rs. 50 lakh, Equity = Rs. 50 lakh

EBIT (–25.00) 25.00 50.00
Less interest (at 15%) 7.50 7.50 7.50
Earnings before tax (–32.50) 17.50 42.50
Less tax at 40% 13.00 7.00 17.00
Net income (19.50) 10.50 25.50
Return on equity of Rs. 50 lakh (–39%) 21% 51%
Earnings per share (Rs. 5,00,000 shares of Rs. (–3.9) 2.1 5.1
10 each)

IV: Debt = Rs. 80 lakh, Equity = Rs. 20 lakh

EBIT (–25.00) 25.00 50.00
Less interest (15%) 12.00 12.00 12.00
Earnings before tax (–37.00) 13.00 38.00
Less tax at 40% 14.80 5.20 15.20
Net income (–22.20) 7.80 22.80
Return on Equity of Rs. 20 lakh (–111%) 39% 114%
Earnings per share (Rs. 2,00,000 shares of Rs. (–11.1) 3.9 11.40
10 each)

You may now have a closer look at the effects of leverage. Please note that
the analysis presented in Table -11.3 above assumes:

a) an average tax rate of 40% or a tax credit at the same rate in a year of loss
b) four different levels of debt
c) three different states of economy viz., bad, good, and very good
d) the fact that equity shares of the company can be sold only at par, i.e., at
Rs. 10 per share.
The following can be observed from the Table-11.3 for further study and
analysis:

a) Because the tax rate is 40%, the after-tax return on total assets at zero
debt (i.e., capital structure I) is 60% of the before-tax return. In addition,
the after-tax return on total assets and the after-tax return on equity are
the same.
237
Financing
Decisions b) When the return on assets exceeds the cost of debt, financial leverage is
advantageous. When the return levels are 25% and 50%, this holds true
for all four capital structures.
c) When the return on assets is high, the debt ratio causes the net return on
equity and earnings per share to rise. You will see that when the return
on assets is at its highest (50%) (Final column of Table-11.3), the return
on equity jumps from 30% at zero debt to 114 percent at 80 percent debt.
The EPS has risen from Rs. 3.00 to Rs. 11.40 as a result of this increase.
d) At various degrees of leverage, the amount of interest has an impact on
the connection between after-tax return on assets and return on equity.
The numerators of both ratios are related in the following way:
EBIT (1- t) = Net Income + (1- t) Interest charges---------------------- (3)
Where, ‘t’ = tax rate
You will notice that the numerator of return on assets is to the left of the
equation, whereas the numerator of return on equity is to the right.
This relationship can be verified at any debt level. Take, for example,
capital structure-II in Table-11.3 at a Rs. 25 lakh EBIT level and replace
relevant values in equation (3). You will receive:
25,00,000 (1- .40) = 13,20,000 + (1- .40) 3,00,000 = Rs. 15,00,000
e) While larger levels of leverage boost equity returns and earnings per
share, they also cause higher levels of volatility in those returns. On the
basis of the data in Table-11.3, Table-11.4 highlights the lowest,
maximum, and range of equity returns at various debt levels.

Table-11.4 Financial Leverage and Equity Returns

Debt/Equity Debt-assets Return on Equity (ROE)
ratio Ratio Unfavourable Favourable Highly
Range conditions Favourable
0% 0% -25% 30% 45%
25% 20% -28% 35.25% 56.25%
100% 50% -65% 51% 90%
400% 80% 185% 114% 225%
When the debt ratio is zero, the Return on Equity (ROE) ranges within a 45
percent range, but when the debt ratio climbs to 80 percent, the range climbs
to 225 percent. If you look at the equity return in terms of net income or
earnings per share, you will notice that it is more volatile. From the above
we can conclude that financial leverage magnifies return volatility, whether
measured by net income, return on equity, or earnings per share.
As a result, financial leverage appears to be a two-edged sword. It enhances
the volatility of returns while magnifying them. Increased volatility means
more risk in the event of a mounting interest burden, which if not fulfilled
could result in bankruptcy. The riskiness of the company may increase in the
eyes of equity shareholders and lenders. This aspect of financial leverage is
238 covered in the last section of this unit.
Activity-11.2 Leverage Analysis

Draw a graph illustrating the position of the four capital structures using the
data in Table-11.3. The X-axis should reflect EBIT as a percentage of total
assets, and the Y-axis should indicate return on equity as a percentage of total
assets. What conclusions do the graphics lead you to? Are they in line with
the results of the above-mentioned analysis in Table-11.3?

............................................................................................................................

............................................................................................................................

............................................................................................................................
............................................................................................................................

11.5 OPERATING LEVERAGE

The financial Leverage, as mentioned and demonstrated in the preceding
section, multiplies the danger of bankruptcy, i.e., the financial risk. We now
have a new concept of leverage, which is closely linked to business risk. This
is referred to as operating leverage. Indeed, operating leverage has an impact
on company risk, which may be defined as the uncertainty that comes with
forecasting future operating income.

We can better appreciate the concept of operating leverage if we review what

we learned about break-even analysis in the Accounting for Managers
(MMPC-004) course. It is worth noting that operating leverage refers to the
extent to which a company has built in fixed expenses as a result of its
specific or unique manufacturing process.
In many cases, a company would be able to exercise some control over the
technology it uses and the production processes that go with it. Highly
mechanized and automated operations are typically associated with high
fixed costs but low variable costs. The degree of operating leverage is often
high with such processes, the break-even threshold is relatively greater, and
so variations in sales have a magnified (or "leveraged") influence on
profitability. The break-even sales volume increases when the operating
leverage (i.e., fixed expenses) increases. As a result, change in sales from the
given volume has a higher influence on profitability. Financial Leverage, on
the other hand, adds another aspect of fixed cost, namely fixed financial
charges, and serves to exacerbate the impact of overall leverage on
profitability.

We present the following hypothetical volume - costs - profit profile of three

firms A, B and C.

239
Financing
Decisions Table-11.5 Operating Leverage
(Rs. in lakhs)
Units Sold Sales at Firm - A Firm - B Firm - C
Rs.10 per Cost Profit Cost Profit Cost Profit
unit
30,000 3.00 3.60 -.60 4.50 -1.50 5.70 -2.70
40,000 4.00 4.30 -.30 5.00 -1.00 6.10 -2.10
50,000 5.00 5.00 .00 5.50 -.50 6.50 -1.50
60,000 6.00 5.70 .30 6.00 .00 6.90 -.90
70,000 7.00 6.40 .60 6.50 .50 7.30 -.30
80,000 8.00 7.10 .90 7.00 1.00 7.70 .30
90,000 9.00 7.80 1.20 7.50 1.50 8.10 .90
1,00,000 10.00 8.50 1.50 8.00 2.00 8.50 1.50
Fixed Costs (Rs.) : 1.5 lakh 3.0 lakh 4.5 lakh
Variable cost per unit 7.00 5.00 4.00
(Rs.):

You may have noticed the characteristics of the three firms from Table-11.5.
They are:

a) Sales volume in units, selling price per unit, and sales value realization
are identical for all the three firms. As a result, a change in sales volume
has a greater impact on profit.

b) Firm-A has the lowest fixed costs, firm-B has a medium fixed cost, and
firm C has the highest fixed cost. Firm-A has the least automated
machinery, lowest depreciation charges, low fixed costs, and a higher per
unit variable cost. Firm- B has a plant that is moderately automated.
Firm-C has the most advanced plant, requiring very minimal labour per
unit of output. It has a slower rate of increase in variable expenses and a
higher overhead burden. With a variable cost per unit of Rs. 4.00, Firm-
C has the lowest variable cost.

240
The effect of a change in volume on net operating income (profits before Leverage Analysis

interest and taxes) is measured by the degree of operating leverage. The

following formula can be used to obtain this:

Degree of Operating Leverage (DOL)

% change in net operating income
DOL =
% change in units sold or sales
When a company advances from one level of sales (volume or value) to
another, the degree of operating leverage is calculated. For example, when
business ‘B’ in Table-11.5 increases its volume from 80,000 to 90,000 units,
the degree of leverage is as follows: -
DOL = {∆ NOI/NOI}/{∆ Q/Q}
Where,
∆ NOI is the change in Net Operating Income Where
NOI is net operating income or earnings before interest and taxes.
∆ Q is the change in quantity or volume, and
Q is quantity or volume.

Thus, DOL for firm B for a change in output from 80,000 units to 90,000
units would be:

1,50, 000 1, 00,000 1, 00, 000 50, 000 1,00, 000

90, 000 80, 000 80, 000 10, 000 80, 000

0.50
4
0.125
To understand the implications of DOL, compare Firm A (least operating
leverage) with Firm C (most operational leverage) at any two levels of
output, such as a shift in output from 80,000 to 90,000 units, or a 12.5 percent
increase.
. 30/.90
DOL� at 80,000 Units = = 2.67
10,000/80,000

. 60/.30
DOL� at 80,000 Units = = 16.00
10,000/80,000
You may have noticed how earnings shift in response to volume changes.
Profits will grow by 26.7 percent for Firm-A (a low-fixed cost) and by 160
percent for Firm- C for a 12.5 percent rise in output (which has high fixed
cost). Profit swings will be more pronounced for companies having high
fixed cost. As a result, the higher the degree of operating leverage, the bigger
the profit variations in reaction to volume changes. This link exists in both
directions, i.e., when volume grows and when volume decreases.

Operating leverage has ramifications for a variety of commercial and

financial policy issues. Some of them are illustrated in the following 241
Financing
Decisions instances based on the DOL of Firm-C:

a) Given Firm-C's high operating leverage, it is possible that volume may

be increased to achieve a significant increase in profits. If Firm-C could
grow its volume from 1,00,000 to 2,00,000 units by lowering the selling
price to Rs. 9.00 per unit, and with no change in fixed cost (Rs.4.5 lakh )
and variable cost (Rs.4), then its net operating income would be:

NOI = PQ -VQ-F
Where,
P = price per unit
V = variable cost per unit
Q = volume in units, and
F = total fixed cost.
= Rs. 9 X 2,00,000 - Rs. 4 X 2,00,000 - Rs. 4.5 lakhs
= Rs. 18 lakhs - Rs, 8 lakhs - Rs. 4.5 lakhs
= Rs. 5.5 lakhs

From the above we can see that Firm-C is able to improve its profits
from Rs. 1.50 lakhs at a volume of 1,00,000 units to Rs. 5.50 lakhs at a
volume of 2,00,000 units. Doubling of output (due to a 10% reduction in
sales price from Rs. 10 to Rs. 9) results in profits that are 3.6 times
higher. Therefore, Firm-C, which has a significant degree of operating
leverage, may pursue an aggressive pricing strategy.
b) If Firm-C belongs to an industry where sales are greatly affected by
changes in the overall level of the economy, resulting in wild profit
fluctuations, the degree of financial leverage appropriate for Firm-C will
be lower than one for a firm that belongs to an industry that is not as
sensitive to changes in the economy.

11.6 COMBINED LEVERAGE

The degree of operating leverage and the degree of financial leverage can be
mixed. In reality, degree of operating leverage (DOL) is considered the initial
stage of leverage, whereas degree of financial leverage (DFL) is considered
the second step. Financial leverage can be calculated using the following
method, which evaluates the impact of changes in EBIT on earnings available
to equity shareholders:
% Change in Net Income
Degree of �inancial leverage =
% Change in EBIT
Before explaining the ramifications of merging DOL and DFL, the use of this
formula could be demonstrated. Table-11.3's data for leverage factors of 20%
debt and 80% debt can be used to demonstrate the impact of increasing EBIT
from Rs. 25 lakhs to Rs. 50 lakhs. It is worth noting the following
calculations:

242
DFL (80%) the degree of financial leverage at 80% debt. Leverage Analysis

(22.80 − 7.80) / 7.80

DFL (80%) =
50.00 − 25.00) / 25.00
(15.00 / 7.80) 1.92
= = = 1.92
25.00 / 25.00 1.00
DFL (20%) the degree of financial leverage at 20% debt.
(28.20 − 13.20) / 13.20
DFL (20%) =
(50.00 − 25.00) / 25.00
(15.00 / 13.20)
= = 1.14
25.00 / 25.00
The values of 1.92 and 1.14 are simple to comprehend. When the debt ratio
(or leverage factor) is 80 percent, a ten percent rise in EBIT results in a 19.2
percent rise in net income available to equity shareholders (10 x 1.92). With a
leverage factor of 20%, a 10% rise in EBIT only results in an increase of 11.4
percent (10 × 1.14) in net income or earnings available to equity
shareholders. You can conclude that a high level of leverage magnifies
equity earnings.

The degree of financial leverage (DFL) will be 1.00 if there is no debt (i.e.,
unity). DFL will rise above 1.00 or 100 percent if debt is used. The DFL can
be thought of as a multiplication factor, and when it is 1.00, there is no
magnification in net income or return on equity, or in earnings per share.
The degree of magnification in Net Income (NI), Return on Equity (ROE),
and Earnings per Share (EPS) for a given increase in sales is measured using
a mixture of operating and financial leverage. When a company uses a lot of
operating and financial leverage, modest changes in sales can cause big
swings in NI, ROE, and EPS.

The Degree of Combined Leverage (DCL) may be measured by using the

following formula:

DCL = DOL × DFL

%������ �� ���� % ������ �� ���
DCL= % ������ �� �����
× % ������ �� ����

%������ �� ���
DCL= % ������ �� �����

It is worth noting that different DOL and DFL combinations can result in the
same DCL. If management has a target DCL, DOL or DFL changes may be
made to meet the target DCL. For example, if a firm's operating leverage is
high due to the nature of its operations, the financial leverage may be
appropriately reduced to avoid lowering the targeted combined leverage, and
vice versa.

243
Financing
Decisions 11.7 FINANCIAL LEVERAGE AND RISK
At the beginning of this unit, we discussed the concept of risk. As you may
recall from our previous discussion, the concepts of operating, financial, and
combined leverage have all been studied in order to determine the amount of
risk (business, financial, and combination) that the firm bears as a result of
actions to adjust the various degrees of leverage. In fact, the degree to which
various metrics of net income fluctuate in response to changes in sales or
EBIT has a direct impact on a variety of business and financial strategies.
Risk can be quantified by using a variety of statistical methods. Let us,
calculate one such metric known as coefficient of variation using the data
given below alongwith data in Table 11.3.

Table-11.6 Cost Structure of Bharat Engines Ltd.

Rs. in lakhs
Sales (units) 1875 8125 11250
Sales @ Rs. 1,000 per unit 18.75 81.25 112.50
Fixed operating cost 40.00 40.00 40.00
Variable operating costs (20% of sales in Rs) 3.75 16.25 22.50
Earnings before interest and taxes (EBIT) -25.00 25.00 50.00
Pre-tax return on total assets (%) -25.00 25.00 50.00
The total cost can be estimated as follows:
Total Cost = Fixed operating costs + Variables operating costs per unit ×
Sales = 40 lakhs + 0.20 sales
The assignment of probabilities to the possible levels of sales that the
management has anticipated is the first step in obtaining a measure of
coefficient of variation. In a nutshell, probability is the likelihood of an event
occurring. Probability is 1.0 if it is certain; otherwise, it is always a fraction
of unity (1).
Management has no control over the status of the economy, but it does have
power over company policies, which can be reliably predicted. The state of
the economy might range from "extremely poor" to "extremely good," and
managerial attitudes of pessimism or optimism might reflect this. Assume
that Bharat Engines Ltd.'s management has assigned the following
probabilities based on the above-mentioned consideration:

Table-11.7 Estimated Probabilities

Stage of Expected Probability of

Economy sales (Rs. lakh) expected sales
A 18.75 .2
B 81.25 .5
C 112.50 .3

Note: All probabilities must add up to 1.00

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Now we use information from Tables-11.3, 11.6 and 11.7 and present Leverage Analysis

computations of coefficient of variations in Table-11.8 below:

Table-11.8: Calculation of Coefficient of Variation (CV)

Capital State of Probabi Return Ps × ROE (ROE–ROE̅) Ps × (ROE-

Structure the lity (Ps) on ROE̅)2
Economy Equity
(S)
Zero Debt A .2 -.15 -.03 -.285 .0162
B .5 .15 .075 .015 .0001
C .3 .30 .090 .165 .0082
ROE̅=.135 .0245=σ2
σ = .157; CV= σ/ ROE̅= .157/.135=1.163
20% Debt A .2 -.21 -.0420 -.3563 .0254
B .5 .165 .825 .0187 .0002
C .3 .3525 .1058 .2062 .0128
ROE̅=.1463 .0384= σ 2
σ = .1959; CV= σ/ ROE̅= .1959/.1463=1.339
50% Debt A .2 -.39 -.078 -.530 .05618
B .5 .13 .065 .010 .00005
C .3 .51 .153 .370 .04107
ROE̅=.1463 .9730= σ 2
σ = .3119; CV= σ/ ROE̅= .3119/.140=2.228
80% Debt A .2 -1.11 -.222 -1.275 .3251
B .5 .39 .195 .225 .0253
C .3 .64 .192 475 .04107
ROE̅=.165 .4181= σ 2
σ = .6466; CV= σ/ ROE̅= .6466/.165=3.919
Legend: S = State of Economy, i.e., bad, good, very good
Ps = Probability of occurrence of the state of the economy
ROE = Return on equity
Ps×ROE = Probability × Return on equity
ROE̅=Expected Value of Return on Equity (Mean)
σ2 = Variance
σ = Standard Deviation
CV = coefficient of variation

Let us study Table-11.8 and its results carefully. The four sections of the
table depict the four capital structures viz., zero debt, 20% debt, 50% debt
and 80% debt. You may notice that as the leverage factor (viz., Debt ratio)
rises, the coefficient of variation also goes up. Thus, for zero debt, the Cv is
1.163 and for 80% debt it shoots up to 3.919. On the basis of the data
furnished and probability information generated, it may be concluded that the
business risk (which is the sum of operating risk and financial risk) rises with
financial risk in the case of Bharat Engines Ltd.
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Financing
Decisions Calculations similar to those given in Table-11.7 can be performed for
determining the risk character of the firm in response to amounts of financial
leverage stipulated. This analysis helps to plan capital structure.

11.8 SUMMARY
The financial and operating leverages are crucial concepts to understand
when assessing a company's business and financial risk. The use of fixed
expenses in operations is referred to as operating leverage, and it is tied to the
firm's production processes. The larger the operating leverage, the larger the
operational risk. Simultaneously, a high level of operating leverage causes
profits to rise quickly after the break-even point is reached.
The use of debt to finance non-current assets is referred to as financial
leverage. Leverage is successful if the return on assets exceeds the cost of
debt, i.e., it improves returns on equity. As a result, a high level of financial
leverage multiplies financial risk. Because of the increased risk associated
with greater fixed costs, the cost of debt rises to some extent when financial
leverage is used. When this occurs, the firm's riskiness rises in the view of
equity investors, who begin to demand a larger return to compensate for the
increased risk. Financial leverage and operating leverage are related with
each other. Both have similar effects on profits. A greater use of either i.e.,
operating, or financial leverage leads to following results:
a) The break-even point is raised.
b) The impact of change in the level of sales on profits is magnified.
The impacts of operating and financial leverage are mutually reinforcing.
Operating, or first-stage leverage, affects earnings before interest and taxes
(i.e., net operating income), whereas financial, or second-stage leverage,
affects earnings after interest and taxes (i.e., net operating income) (i.e., net
income available to equity shareholders).

To analyse their impact on a company's profitability, operating and financial

leverages are quantified in relative terms. The degrees of operating and
financial leverage are used to get these figures. To measure the consequences
of changes in sales on net income or earnings per share, a combined degree of
financial and operating leverage can be estimated.
The financial leverage and risk are connected variables, and the coefficient of
variation, a statistical metric, can be used to quantify the firm's risk at various
levels of leverage or debt ratio.

11.9 KEY WORDS

Financial Leverage refers to the use of debt in the financing of a firm. It
indicates the presence of fixed-return securities in the company's capital
structure.
Operating Leverage is the use of fixed costs in operations. A high operating
leverage factor indicates the presence of automated production processes.
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Leverage Factor refers to the ratio of long-term debt to total assets. Leverage Analysis

Capital Structure is the long-term financing plan of a firm. Debentures,

preference shares, other fixed-return instruments, long-term loans, equity
shares, reserves, and surplus are all covered.
Financial Structure is the total financing plan of a firm, which, besides all
components of capital structure, also includes short-term debt.
Degree of Operating Leverage is the percentage change in net operating
income in response to a percentage change in sales (volume or value).
Degree of Financial Leverage is the ratio of changes in earnings before
interest and taxes to changes in net income available to equity investors.
Degree of Combined Leverage is the percentage change in net income after
interest and taxes as a result of a change in sales %. (volume or value).
Risk includes both operating risk (as given by the degree of operating
leverage) and financial risk (as reflected by the degree of financial leverage)
and is evaluated by a statistical measure known as coefficient of variation.

11.10 SELF ASSESSMENT QUESTIONS/

EXERCISES
1. How does the use of financial leverage affect the break-even point?
Illustrate.
2. In what way financial leverage is related to operating leverage? Discuss
with an example.
3. `Risk increases proportionately with financial leverage'. Refute this
statement with reasons.
4. Other things remaining the same, firms with relatively stable sales are
able to incur relatively high debt ratios. Do you agree with this
statement?
5. Why EBIT is generally considered to be independent of financial
leverage? Why should EBIT actually be influenced by financial leverage
at high debt levels?
6. Other things being constant, if Firm ‘A’ has more Operating leverage
than Firm ‘B’, then a given percentage decline in sales will cause a larger
percentage decline for Firm ‘A’ than for Firm ‘B’ in
(a) EBIT (b) Net Income (c) Both (a) and (b) (d) None of these
7. One of the components of a firm's financial structure that is not a
component of its capital structure is:
(a) Debentures (b) Reserves (c) Convertible Preference (d) Short-term
debt
8. Financial leverage is different from operating leverage in that it is
concerned with
(a) Capital structure (b) uncertainty of markets (c) inefficient financial
mangers (d) uncertain estimates of EBIT
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Financing
Decisions 9. In general, financial leverage is favourable whenever the return on assets
exceeds the
(a) Cost of equity share capital (b) total cost of capital (c) net return after
taxes (d) cost of debt
10. Highly leveraged companies are most likely to be found in industries
where sales are
(a) Increasing around a trend line (b) relatively unstable (c) relatively
stable (d) relatively uncertain with high margins
11. The debt ratio of Firms A and B are 60% and 30%, respectively. Both
firms have assets totaling Rs. 50 crores and both have a cost of debt of 8
per cent. Firm A earns 12 per cent before interest and taxes on its total
assets. Assume a 50 per cent tax rate and answer the following questions:
(a) What does A earn on equity after interest and taxes?
(b) If B is to earn the same rate on equity after taxes as A, what must it
earn before interest and taxes on its assets?
(A) (B)
(i) 15 % 7%
(ii) 9% 15%
(iii) 7% 12%
(iv) 9% 12%
(v) 7% 15%

12. Triveni Dyes Ltd. desires to increase its assets by 50% to execute large
government contracts it has received; the expansion could be financed by
issuing additional equity shares at a net price of Rs. 45 per share (the
price earnings ratio being 20). Alternatively, debt at a cost of 10% could
be increased with a price earnings ratio of 15. The balance sheet is given
below:

Current Balance Sheet of Triveni Dyes Ltd.

Rs. Rs.
Debt (8%) 20,000 Total assets 90,000
Equity shares of Rs. 10 each 60,000
Reserves 10,000
Total claims 90,000 Total assets 90,000

Assume that the gross profit margin is 12% of estimated sales of Rs. 4,00,000
and that the tax rate is 35%. What are the expected market prices, after
expansion, under the two alternatives?

Debt (Rs.) Equity Shares (Rs.)

(a) 13.15 20.20
(b) 29.30 41.70
(c) 52.35 66.20
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 Leverage Analysis
(d) 68.10 86.20
(e) 86,50 99.20

13. Chakradhar Seshan has developed a revolutionary new computerized

method of preparing tax returns for individuals. He has a choice of
computers on which to install his new process. Under Plan L he would
lease a computer for Rs. 5 lakhs per year and process returns with a
variable cost of Rs. 2 per, return. Under plan B he would lease a smaller,
less efficient computer for Rs. one lakh per year, but processing costs
under plan B will be Rs, 12 per return. Under either process, Seshan
would charge Rs. 22 per return processed.
A. Answer the following questions:

i) Which plan has a higher degree of operating leverage?

ii) Construct break-even charts of the two plans.
iii) At what volume of tax returns would Seshan have the same
operating profit under either plan?
iv) Based on this information only, which plan is riskier?
B. Assume that Seshan decides to use the large computer described under
plan L. Seshan now needs Rs. 20 lakhs to build facilities, obtain working
capital, and start operations. He has some money of his own with which
he would buy stock and the balance of the required funds can be obtained
in the form of debt or equity. If Seshan borrows part of the money, his
interest charges will depend upon the amount borrowed according to the
following schedule:

Amount borrowed % of debt a upper Interest rate of

end of class-interval total amount
in capital structure borrowed
Up to Rs. 2 Lakhs 10% 9.00%
More than Rs. 2lakhs and up to Rs. 4 lakhs 20% 9.50%
More than Rs. 4 lakhs and up to Rs. 6 lakhs 30% 10.00%
More than Rs. 6 lakhs and up to Rs. 8 lakhs 40% 15.00%
More than Rs. 8 lakhs up to 10 lakhs 50% 19.00%
More than Rs. 10 lakhs and up to Rs. 12 60% 26.00%
lakhs

Assume further that the equity shares can be sold at Rs, 20 per share
regardless of the amount of debt the company uses. This will be the case at
the time of initial offering of shares. Then, after the company begins
operations, the price of its shares will be determined as a multiple of earnings
per share. This multiple, viz., price-earnings (P/E) ratio will depend upon the
capital structure as follows:

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Financing
Decisions Debt-Assets Ratio P/E Ratio
0 to 9.99% 12.5
10.00 to 19.99% 12.0
20.00 to 29.99% 11.5
30 00 to 39 99% 10 0
40 00 to 49 99% 80
50.00 to 59.99% 6.0
60.00 to 69.99% 5.0

If the company processes 50,000 returns annually and that its effective tax is
40%, calculate the company's EPS at different debt-assets ratios.

11.11 FURTHER READINGS

1. Chandra, Prasanna. 2019, Financial Management, Theory and Practice,
Mc Graw-Hill, New Delhi
2. Pandey. I.M., 2021, Financial Management, Pearson Education India,
New Delhi
3. Sheridan Titman, Arthur J. Keown, and John D. Martin, 2019, Financial
Management: Principles and Applications, Pearson Education India,
New Delhi.
4. M.Y. Khan. M. Y and Jain. P.K., 2018, Financial Management,
McGraw Hill Education, New Delhi
5. Eugene F. Brigham, Joel F. Huston, 2018, Fundamental of Financial
Management, Cengage Learning India, New Delhi.
6. Richard Brealey, Stewart Myres & Franklin Allen, 2019, Principles of
Corporate Finance, Mc Graw Hill, New Delhi.

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