FY BBA Semester II (CBCS) Pattern 2019

Subject - Principles of Finance

Course code 203 Credit 3

Unit 1. Basic concepts in finance

Updated by – Mrs. Laxmi Karanjikar

Definition - Nature and scope of finance function,

Financial Management - Meaning – Approaches: - Traditional, Modern,

Role of Finance Manager

Definition of Finance Functions
The Finance Function is a part of Financial Management is the activity concerned with the
control and planning of financial resources.
In business, the finance function involves the acquiring and utilization of funds necessary for
efficient operations. Finance is the lifeblood of business without it things wouldn’t run
smoothly.

There are three ways of defining the finance function. Firstly, the finance function can simply be

taken as the task of providing funds needed by an enterprise on favourable terms, keeping in

view the objectives of the firm.

This means that the finance function is solely concerned with the acquisition (or procurement) of

short- term and long-term funds.

Second in recent years, the coverage of the term ‘finance function’ has been widened to include

the instruments, institutions and practices through which funds are obtained. So, the finance

function covers the legal and accounting relationship between a company and its source and uses

of funds.

Thirdly this definition treats the finance function as the procurement of funds and their effective

utilization in business. The finance manager takes all decisions that relate to funds which can be

obtained as also the best way of financing an investment such as the installation of a new

machinery inside the factory-or office building.

The finance function covers the following six major activities

1. Financial planning;

2. Forecasting cash inflows and outflows;

 3. Raising funds;

4. Allocation of funds;

5. Effective use of funds; and

6. Financial control (budgetary and non-budgetary).

Scope of Finance Function:

The scope of finance function is broad because this function affects almost all the aspects of a

firm’s operations. The finance function includes judgments about whether a company should

make more investment in fixed assets or not.

It is largely concerned with the allocation of a firm’s capital expenditure over time as also related

decisions such as financing investment and dividend distribution. Most of these decisions taken

by the finance department affect the size and timing of future cash flow or flow of funds.

The finance function is concerned with three types of decisions:

o Investment Decisions– This is where the finance manager decides where to put the company
funds. Investment decisions relating to the management of working capital, capital budgeting
decisions, management of mergers, buying or leasing of assets. Investment decisions should
create revenue, profits and save costs.
o Financing Decisions– Here a company decides where to raise funds from. They are two main
sources to consider mainly equity and borrowed. From the two a decision on the appropriate mix
of short and long-term financing should be made. The sources of financing best at a given time
should also be agreed upon.
o Dividend Decisions– These are decisions as to how much, how frequent and in what form to
return cash to owners. A balance between profits retained and the amount paid out as dividends
should be decided here.
o Liquidity Decisions– Liquidity means that a firm has enough money to pay its bills when they
are due and have sufficient cash reserves to meet unforeseen emergencies. This decision involves
the management of the current assets so you don’t become insolvent or fail to make payments.
Financial Management - Meaning, Objectives and Functions

Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise. It means applying
general management principles to financial resources of the enterprise.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e., funds should be invested in safe ventures so that
adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of capital
so that a balance is maintained between debt and equity capital.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation with

regards to capital requirements of the company. This will depend upon expected costs
and profits and future programmes and policies of a concern. Estimations have to be
made in an adequate manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the capital
structure have to be decided. This involves short- term and long- term debt equity
analysis. This will depend upon the proportion of equity capital a company is possessing
and additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has many
choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period of
financing.
 4. Investment of funds: The finance manager has to decide to allocate funds into profitable
ventures so that there is safety on investment and regular returns is possible.
5. Disposal of surplus: The net profits decision have to be made by the finance manager.
This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other
benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current liabilities,
maintenance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize the
funds but he also has to exercise control over finances. This can be done through many
techniques like ratio analysis, financial forecasting, cost and profit control, etc.

Role of a Financial Manager

A financial manger is a person who takes care of all the important financial functions of an
organization.

Following are the main functions of a Financial Manager:

1. Raising of Funds

In order to meet the obligation of the business it is important to have enough cash and
liquidity. A firm can raise funds by the way of equity and debt. It is the responsibility of a
financial manager to decide the ratio between debt and equity. It is important to maintain
a good balance between equity and debt.

2. Allocation of Funds

Once the funds are raised through different channels the next important function is to
allocate the funds. The funds should be allocated in such a manner that they are optimally
used. In order to allocate funds in the best possible manner the following point must be
considered

 The size of the firm and its growth capability

 Status of assets whether they are long-term or short-term
 Mode by which the funds are raised
 These financial decisions directly and indirectly influence other managerial activities.
Hence formation of a good asset mix and proper allocation of funds is one of the most
important activity

3. Profit Planning

Profit earning is one of the prime functions of any business organization. Profit earning is
important for survival and sustenance of any organization. Profit planning refers to
proper usage of the profit generated by the firm.

Profit arises due to many factors such as pricing, industry competition, state of the
economy, mechanism of demand and supply, cost and output. A healthy mix of variable
and fixed factors of production can lead to an increase in the profitability of the firm.

Fixed costs are incurred by the use of fixed factors of production such as land and
machinery. In order to maintain a tandem it is important to continuously value the
depreciation cost of fixed cost of production. An opportunity cost must be calculated in
order to replace those factors of production which has gone thrown wear and tear. If this
is not noted then these fixed cost can cause huge fluctuations in profit.

4. Understanding Capital Markets

Shares of a company are traded on stock exchange and there is a continuous sale and
purchase of securities. Hence a clear understanding of capital market is an important
function of a financial manager. When securities are traded on stock market there
involves a huge amount of risk involved. Therefore a financial manger understands and
calculates the risk involved in this trading of shares and debentures.

Its on the discretion of a financial manager as to how to distribute the profits. Many
investors do not like the firm to distribute the profits amongst share holders as dividend
instead invest in the business itself to enhance growth. The practices of a financial
manager directly impact the operation in capital market.

Approaches to financial management.

The approaches are: 1. Traditional View 2. Modern View

Approach # 1. Traditional View:

Financial management is primarily concerned with acquisition, financing and management of
assets of business concern in order to maximize the wealth of the firm for its owners. The basic
responsibility of the Finance manager is to acquire funds needed by the firm and investing those
funds in profitable ventures that will maximize firm’s wealth, as well as, yielding returns to the
business concern.
The success or failure of any firm is mainly linked with the quality of financial decisions. The
focus of Financial management is on efficient and judicious use of resources to attain the desired
objective of the firm.

The basic objectives of Financial management centres around (a) the procurement funds from
various sources like equity share capital, preference share capital, debentures, term loans,
working capital finance, and (b) effective utilization of funds to maximize the profitability of the
firm and the wealth of its owners.

The responsibilities of the Finance managers are linked to the goals of ensuring liquidity,
profitability or both and are also related to the management of assets and funds of any business
enterprise.

The traditional view of financial management looks into the following functions, that a
Finance manager of a business firm will perform:
(a) Arrangement of short term and long-term funds from financial institutions.

(b) Mobilization of funds through financial instruments like equity shares, preference shares,
debentures, bonds etc.

(c) Orientation of finance function with the accounting function and compliance of legal
provisions relating to funds procurement, use and distribution.

With the increase in complexity of modern business situation, the role of a Finance manager is
not just confined to procurement of funds, but his area of functioning is extended to judicious
and efficient use of funds available to the firm, keeping in view the objectives of the firm and
expectations of the providers of funds.

Approach # 2. Modern View:

The globalization and liberalization of world economy has caused to bring a tremendous reforms
in financial sector which aims at promoting diversified, efficient and competitive financial
system in the country. The financial reforms coupled with diffusion of information technology
has caused to increase competition, mergers, takeovers, cost management, quality improvement,
financial discipline etc.
Globalization has caused to integrate the national economy with the world economy and it has
created a new financial environment which brings new opportunities and challenges to the
individual business concern. This has led to total reformation of the finance function and its
responsibilities in the organization.

Financial management in India has changed substantially in scope and complexity in view of
recent Government policy. Today’s Finance managers are seized with problems of financial
distress and are trying to overcome it by innovative means. In the current economic scenario,
financial management has assumed much greater significance.

It is now a question of survival of entities in the total spectrum of economic activity, with
pragmatic readjustment of financial management. The information age has given a fresh
perspective on the role of financial management and Finance managers. With the shift in
paradigm it is imperative that the role of Chief Finance Officer (CFO) changes from Controller
to a Facilitator.

In view of modern approach, the Finance manager is expected to analyse the firm and to
determine the following:

The total funds requirement of the firm,

(ii) The assets to be acquired, and

(iii) The pattern of financing the assets.

 FY BBA Semester II (CBCS) Pattern 2019

Principles of Finance

Course code 203 Credit 3

Unit No 2 . . Sources of Finance

External: - Shares, Debentures, Public Deposits, Borrowing from banks: - meaning, types,
advantages and limitations of these sources,

Internal: - Reserves and surplus, Bonus shares Retained earnings,.

What are Shares

A company’s capital is divided into small equal units of a finite number. Each unit is known as a
share. In simple terms, a share is a percentage of ownership in a company or a financial asset.
Investors who hold shares of any company are known as shareholders.

TYPES OF SHARES
1) EQUITY SHARES

Equity shares are also known as ordinary shares. The majority of shares issued by the company
are equity shares. This type of share is traded actively in the secondary or stock market. These
shareholders have voting rights in the company meetings. They are also entitled to get dividends
declared by the board of directors. However, the dividend on these shares is not fixed and it may
vary year to year depending on the company’s profit. Equity shareholders receive dividends after
preference shareholders.

Equity shares have the following features:

(i) Equity share capital remains permanently with the company. It is returned only when the

company is wound up.

(ii) Equity shareholders have voting rights and elect the management of the company.

(iii) The rate of dividend on equity capital depends upon the availability of surplus funds. There

is no fixed rate of dividend on equity capital.

Advantages of Equity Shares:

2) PREFERENCE SHARES

this type of share gives certain preferential rights as compared to other types of share. The main
benefits that preference shareholders have are:

 They get first preference when it comes to the payout of dividend, i. e. a share of the
profit earned by the company
  When the company winds up, preference shareholders have the first right in terms of
getting repaid

Features of preference shares:

Preference shares have a wide range of features as corporate emphasize a set of features while
issuing them such as:
 Dividends for preference shareholders
 Preference shareholders have no right to vote in the annual general meeting of a company
 These are a long-term source of finance
 Dividend payable is generally higher than debenture interest
 Right on assets when the company is liquidated
 Par value of preference shares
 Fixed-rate of dividend irrespective of the volume of profit gained
 Preemptive right of preference shareholders
 Hybrid security of preference shares because it also bears some characteristics of debentures
 The dividend is not tax-deductible expenditure
 Shareholders also enjoy preferential right to receive dividend

Types of preference shares

There are various types of preference shares according to the clause contained in the agreement
at the time of issue, some important kinds are listed below:
 Cumulative Preference Shares:
Shares having right of dividend even in those years in which it makes no profit are known as
cumulative preference shares. In case the companies do not declare dividends for a particular
year then they are treated as arrears and are carried forward to next year. When the arrears
pertaining to dividend are cumulative in nature and such arrears are cleared before any dividend
payment to equity shareholders then it is said to be as cumulative preference shares.

 Non-cumulative Preference Shares:

A non-cumulative preference share does not accumulate any dividend. In case the dividend by
the company is not paid then they have the right to avail dividends from the profits earned from
the particular year. Dividends are paid only from the net profit of each year. In case there is no
profit accumulated for a particular year then the arrears of dividends cannot be claimed in
subsequent years.

 Participating Preference Shares:

These shares have the right to participate in surplus profits of the company during liquidation
after the company had paid to other shareholders. The preferential shareholders receive
 stipulated rate of dividend and also participate in the additional earnings of the company along
with the equity shareholders.

 Participating Preference Shares:

These shares have the right to participate in surplus profits of the company during liquidation
after the company had paid to other shareholders. The preferential shareholders receive
stipulated rate of dividend and also participate in the additional earnings of the company along
with the equity shareholders.

 Non-participating Preference Shares:

Preference shares having no right to participate in the surplus profits or in any surplus on
liquidation of the company are referred to as non-participating preference shares. Here,
preference shareholders receive only stated dividend and nothing more.

 Convertible Preference Shares:

These shares are those which are converted into equity shares at a specified rate on the expiry of
a stated period. The shareholders have a right to convert their shares into equity shares within a
specified period.

 Non-convertible Preference Shares:

The shares that cannot be converted to equity are referred to as non-convertible shares. These can
also be redeemed.

 Redeemable Preference Shares:

Redeemable preference shares are referred to as shares that can be redeemed or repaid after the
fixed period as issued by the company or even before that.

 Non-Redeemable Preference Shares:

Non redeemable preference shares are referred to as shares that cannot be redeemed during the
lifetime of the company.

ADVANTAGES OF PREFERENCE SHARE

NO LEGAL OBLIGATION FOR DIVIDEND PAYMENT

There is no compulsion of payment of preference dividend because nonpayment of dividend

does not amount to bankruptcy. This dividend is not a fixed liability like the interest on the debt
which has to be paid in all circumstances.
IMPROVES BORROWING CAPACITY
Preference shares become a part of net worth and therefore reduces debt to equity ratio. This is
how the overall borrowing capacity of the company increases.

NO DILUTION IN CONTROL
Issue of preference share does not lead to dilution in control of existing equity shareholders
because the voting rights are not attached to the issue of preference share capital. The preference
shareholders invest their capital with fixed dividend percentage but they do not get control rights
with them.

NO CHARGE ON ASSETS
While taking a term loan security needs to be given to the financial institution in the form of
primary security and collateral security. There are no such requirements and therefore, the
company gets the required money and the assets also remain free of any kind of charge on them.

DISADVANTAGES OF PREFERENCE SHARES

COSTLY SOURCE OF FINANCE

Preference shares are considered a very costly source of finance which is apparently seen when
they are compared with debt as a source of finance. The interest on the debt is a tax-deductible
expense whereas the dividend of preference shares is paid out of the divisible profits of the
company i.e. profit after taxes and all other expenses. For example, the dividend on preference
share is 9% and an interest rate on debt is 10% with a prevailing tax rate of 50%.

The effective cost of preference is same i.e. 9% but that of the debt is 5% {10% * (1-50%)}. The
tax shield is the main element which makes all the difference. In no tax regime, the preference
share would be comparable to debt but such a scenario is just an imagination.

SKIPPING DIVIDEND DISREGARD MARKET IMAGE

Skipping of dividend payment may not harm the company legally but it would always create a
dent on the image of the company. While applying for some kind of debt or any other kind of
finance, the lender would have this as a major concern. Under such a situation, counting skipping
of dividend as an advantage is just a fancy. Practically, a company cannot afford to take such a
risk.

PREFERENCE IN CLAIMS
Preference shareholders enjoy a similar situation like that of an equity shareholder but still gets a
preference in both payment of their fixed dividend and claim on assets at the time of liquidation.

Debentures

Debentures are a debt instrument used by companies and government to issue the loan. The loan is
issued to corporate based on their reputation at a fixed rate of interest. Debentures are also known as
a bond which serves as an IOU between issuers and purchaser. Companies use debentures when they
need to borrow the money at a fixed rate of interest for its expansion. Secured and Unsecured,
Registered and Bearer, Convertible and Non-Convertible, First and Second are four types of
Debentures. Let us learn more about Debentures in detail.

Debenture is the acknowledgment of the debt the organization has taken from the public at large.
They are very crucial for raising long-term debt capital. A company can raise funds through the issue
of debentures, which has a fixed rate of interest on it. The debenture issued by a company is an
acknowledgment that the company has borrowed an amount of money from the public, which it
promises to repay at a future date. Debenture holders are, therefore, creditors of the company.

Types of Debenture

1. Secured and Unsecured:

Secured debenture creates a charge on the assets of the company, thereby mortgaging the assets of
the company. Unsecured debenture does not carry any charge or security on the assets of the
company.

2. Registered and Bearer:

A registered debenture is recorded in the register of debenture holders of the company. A regular
instrument of transfer is required for their transfer. In contrast, the debenture which is transferable
by mere delivery is called bearer debenture.
3. Convertible and Non-Convertible:
Convertible debenture can be converted into equity shares after the expiry of a specified period. On
the other hand, a non-convertible debenture is those which cannot be converted into equity shares.

4. First and Second:

A debenture which is repaid before the other debenture is known as the first debenture. The second
debenture is that which is paid after the first debenture has been paid back.

Advantages and Disadvantages of Debentures

Advantages of Debentures

 Investors who want fixed income at lesser risk prefer them.

 As a debenture does not carry voting rights, financing through them does not dilute control of
equity shareholders on management.

 Financing through them is less costly as compared to the cost of preference or equity capital
as the interest payment on debentures is tax deductible.

 The company does not involve its profits in a debenture.

 The issue of debentures is appropriate in the situation when the sales and earnings are
relatively stable.

Disadvantages of Debentures

 Each company has certain borrowing capacity. With the issue of debentures, the capacity of
a company to further borrow funds reduces.

 With redeemable debenture, the company has to make provisions for repayment on the
specified date, even during periods of financial strain on the company.

 Debenture put a permanent burden on the earnings of a company. Therefore, there is a

greater risk when the earnings of the company fluctuate.
Public Deposits: Meaning, Features, Advantages and Disadvantages

Meaning:
A company can accept deposits from the public to finance its medium- and short-term

requirements of funds. This source has become very popular off late because companies offer

higher interest than the interest offered by banks.

Features of Public Deposits:

The following are the features of public deposit:

1. Total public deposits cannot exceed 25 per cent of the paid up capital and free reserves of the

company.

2. It is an uncertain source of financing.

3. There are legal restrictions on the acceptance and renewal of public deposits.

Advantages of Public Deposits:

Public deposits offer the following advantages:

i. Acquisition of finance through public deposits is very easy.

ii. Interest paid on public deposits is tax deductible expenditure.

iii. Administrative cost of issuing a public deposit is lower than the cost involved in issuing

shares and debentures.

iv. Since the rate of interest paid on a public deposit is fixed, it helps the company play trading

on equity.

v. It does not dilute the control of shareholders.

Disadvantages of Public Deposits:

The disadvantages of public deposits are:

i. They are uncertain and unrealistic forms of financing.

ii. Public deposits are available for short periods only.

iii. The management may misuse the deposit as these deposits are not secured.

Borrowing from banks

o A loan is the lending of money from one source to another source for a specified period.
o A loan is a debt given by an organization to another organization with an interest rate.
o In a loan, a borrower borrows money from the lender with a certain rate of interest and pay
back it in future.
o The main activities of financial institutions like banks, NBFC, is to provide a loan to the
customer.

Types of loan

There are mainly five types of loan.

1) Secured loan
o In a secured loan, a borrower pledges some asset as collateral like property, car etc.
o A mortgage loan is a type of secured loan used by a customer. In a secured loan, a money is
using to purchase a property.
o If in case the borrower fails to pay back the loan amount a lender has legal right to possess
the collateral security and recover the money.

2) Unsecured loan
o In the unsecured loan, a loan is not secured against any of property of the borrower.
o This type of loan is available from the financial institutions like banks, NBFCs and other
private institutions.
o In unsecured loan interest rate depends on the lender and the borrower and the rate of
interest in an unsecured loan is always higher than a secured loan.
o There is more risk associated with the unsecured loan that a customer may not pay back an
amount.
o In case of insolvency, unsecured lenders are the second priority to pay the money.
 o An unsecured loan may be one of the following:
o Personal loans
o Credit card debt
o Bank overdrafts
o Line of credit
o Unsecured bonds

3) Demand loan
o Demand loans, as the name suggests, are short term loans.
o Short term loan means there is no fixed time to repay an amount it means it can be repaid at
any time.
o A demand loan uses the floating rate of interest to charge an interest.
o A demand loan may be a secured or unsecured.

4) Subsidized loan
o In a subsidized loan, an interest rate is reduced by subsidy.
o This type of loans is given to the students for education purpose.
o Sometimes in the subsidized loan the whole amount of interest is paid by the government.

5) Concessional loan
o A concessional loan is also called as a "soft loan".
o A concessional loan is given either through below market interest rates, by grace periods or
a combination of both.
o This type of loans is given by the developed countries to the developing countries.

Advantages & Disadvantages

Advantages of loan:
o Nowadays loans are easily available to anyone by stable financial sources like banks,
NBFCs, private institutions.
o Nobody can take undue advantage of the borrower in any emergency.
o There various types of loan as per the needs of the customers.
o Due to competition among the financial institutions, a customer gets to benefit from this
competition like lower interest, more time to repay.
o Sometimes there are government schemes like saving in tax, lower interest rate if in a
specific time period loan is taken
Disadvantages:
o There is a lengthy process to get a loan it requires various types of documents, proof,
witness and many other things. So, it takes a longer time to section a loan.
o Sometimes the documents and many other things demanded by the institutions are so
unnecessary that it makes inconvenient to the client.
o A loan is never granted in the full amount. There is always a ratio of the amount applied for
a loan and the amount to grant. it may be 80:20 ratio, it means a bank give 80 percent loan
of the applied amount.
Internal Sources of Finance

The term “internal finance” (or internal sources of finance) itself suggests the very
nature of finance/capital. This is the finance or capital which is generated internally by
the business unlike finances such as loan which is externally arranged by banks or
financial institutions. The internal source of finance is retained profits, the sale of assets,
and reduction / controlling of working capital.
Finance is a constant requirement for every growing business. There are several
sources of finance from where a business can acquire finance or capital which it
requires. But, the finance manager cannot just choose any of them indifferently. Every
type of finance has different pros and cons in terms of cost, availability, eligibility, legal
boundaries, etc. Choosing the right source of finance is a challenge. We need to have
an in-depth understanding of the characteristics of the source of finance. Let us focus
first on the internal source of finance/capital.
Internal sources of finance are the sources of finance or capital for businesses which
are generated by the business itself in its normal course of operations .

Retained Profits / Retained Earnings

Retained profits/earnings are called the internal source of finance for a business for the
simple reason that they are the end product of running a business. The phenomenon is
also known as ‘Ploughing Back of Profits’. Retained profits can be defined as the profit
left after paying a dividend to the shareholders or drawings by the capital owners.

Formula for Retained Profits

It can be stated as below:
Retained Profits / Retained Earnings = Net Profits – Dividend / Drawings

Advantages of Retained Earnings as an Internal Source of Finance

The advantage of having retained profits/earnings is clearly seen in its characteristics.

1. First, they are long-term finance and nobody can ask for their payments.
2. Secondly, since there is no additional equity to be issued, there is no dilution of control
and ownership in the business.
3. Thirdly, there is no fixed obligation of interest or installment payments.
4. Fourthly, retained earnings as an internal source of finance are cost-effective
considering the fact that there is no issue cost attached to it which ranges between 2 – 3
%.
5. Lastly, investing retained earnings in the projects, with IRR better than ROI of the
business, will directly have a positive impact on the shareholder’s wealth and thereby the
core objective of management will be served.
 Disadvantages of Retained Earnings as an Internal Source of Finance

There is practically no disadvantage in generating or using retained earnings for

financing the investments of the business. Assuming that the funds generated internally
are not free as they are the funds belonging to the shareholders and the cost of these
funds is equal to the cost of equity. There is only one alternative which can be explored
i.e. debt financing sources. The purpose of exploring the option leads to thinking about
two points. One, financial leverage that can be gained by introducing debt financing.
Second, if the leverage is possible and practical, dividend decision regarding using the
retained earnings to pay dividends to shareholders can be explored.

Bonus Shares
Bonus shares are the additional shares that a company gives to its existing
shareholders on the basis of shares owned by them. Bonus shares are issued to the
shareholders without any additional cost.

Bonus shares are issued by a company when it is not able to pay a dividend to its
shareholders due to shortage of funds in spite of earning good profits for that
quarter. In such a situation, the company issues bonus shares to its existing
shareholders instead of paying dividend. These shares are given to the current
shareholders on the basis of their existing holding in the company. Issuing bonus
shares to the existing shareholders is also called capitalization of profits because it
is given out of the profits or reserves of the company.

Advantages of Bonus Shares

 There is no need for investors to pay any tax on receiving bonus shares.
 It is beneficial for the long-term shareholders of the company who want to increase
their investment.
 Bonus shares enhance the faith of the investors in the operations of the company
because the cash is used by the company for business growth.
 When the company declares a dividend in the future, the investor will receive
higher dividend because now he holds larger number of shares in the company due
to bonus shares.
 Bonus shares give positive sign to the market that the company is committed
towards long term growth story.
 Bonus shares increase the outstanding shares which in turn enhances the liquidity
of the stock.
 The perception of the company's size increases with the increase in the issued share
capital.
Since there are many advantages of bonus shares, let us now learn the conditions
for the issue of bonus shares.
Disadvantages of Issue of Bonus Shares

1. Rate of dividend decline:

The rate of dividend in future will decline sharply, which may create
confusion in the minds of the investors.

2. Speculative dealing:
It will encourage speculative dealings in the company’s shares.

3. Forgoes Cash equivalent:

When partly paid-up shares are converted into fully paid-up shares,
the company forgoes cash equivalent to the amount of bonus so
applied for this purpose.

4. Lengthy Procedure:
Prior approval of central government through SEBI must be obtained
before the bonus share issue. The lengthy procedure, sometime may
delay the issue of bonus shares.

Meaning
Reserves and Surplus are all the cumulative amount of retained earnings recorded
as a part of the Shareholders Equity and are earmarked by the company for specific
purposes like buying of fixed assets, payment for legal settlements, debts
repayments or payment of dividends etc.
Types of Reserves and Surplus

General Reserve
A general reserve is also known as a revenue reserve. The amount kept
separately by an entity from its profits for the future purpose is known as
revenue reserves. It is simply the retained earnings of an entity kept aside
from the entity’s profits for meeting certain or uncertain obligations.

Capital Reserve
Capital reserve refers to a part of the profit which is kept by an entity for a
specific purpose like providing for financing long-term projects or writing off
any capital expenses. This reserve is created from any capital profit of an
entity that is the profit earned from profit other than the core operations of a
business.

Capital Redemption Reserve

Capital Redemption Reserve is created out of the undistributed profits that are
general reserve or the Profit and loss account on the redemption of
preference shares or during buyback of own shares to reduce the share
capital.

Dividend Reserve
Dividend reserve is the amount that is kept in a separate account for ensuring
that a similar amount of the dividend is declared every year.

Advantages
 Reserves are considered to be the vital source of financing by internal means.
So when the company is in the need of funds for its business activities and for
meeting the company’s obligations the first and the easiest possible way to get
funds is from the accumulated general reserves of the company.
 With the help of reserves, the company can maintain its working capital
requirements as the reserves can be used to contribute towards working capital
at the time of the insufficiency of funds in the working capital of the company.
 One of the main advantages of having reserves and surplus is to overcome the
future losses of the companies as the time of losses reserves can be used to pay
off the existing liabilities.
  Reserves are the main source of the amount required for dividend distribution
available. It helps in maintaining the uniformity in the dividend distribution rate
by providing the amount required for maintaining the uniform rate of the
dividend when there is a shortage of amount available for distribution.

Disadvantages
 If the losses are incurred by the company and the same are adjusted/set-off with
the reserves of the company then this will somehow lead to the manipulation of
accounts as the correct picture of the company’s profitability will not be shown
to the users of financial statements.
 The general reserves that constitute the major part of reserves and surplus are
not created for any specific purpose but for the general use so there are chances
that there can be a misappropriation of funds accumulated in general reserves
by the management of the company and there is a possibility that the funds will
not be used properly for business expansion.
 The Creation of more reserves by the company may lead to a reduction in the
distribution of dividend to the shareholders of the company.
 Unit 3. Capital Structure

Factors affecting capital structure

Capitalization: - Meaning,
Over capitalization and Under Capitalization - meaning, causes, consequences,
remedies
Meaning and Concept of Capital Structure:
The term ‘structure’ means the arrangement of the various parts. So capital structure

means the arrangement of capital from different sources so that the long-term funds

needed for the business are raised.

Thus, capital structure refers to the proportions or combinations of equity share capital,

preference share capital, debentures, long-term loans, retained earnings and other long-

term sources of funds in the total amount of capital which a firm should raise to run its

business.

capital structure example

1This mix of debts and equities make up the finances used for a business's operations
and growth. For example, the capital structure of a company might be 40% long-term
debt (bonds), 10% preferred stock, and 50% common stock. The capital structure of a
business firm is essentially the right side of its.

Definitions of capital structure

“Capital structure of a company refers to the make-up of its

capitalisation and it includes all long-term capital resources viz., loans,
reserves, shares and bonds.”—Gerstenberg.

“Capital structure is the combination of debt and equity securities that

comprise a firm’s financing of its assets.”—John J. Hampton.

“Capital structure refers to the mix of long-term sources of funds, such

as, debentures, long-term debts, preference share capital and equity
share capital including reserves and surplus.”—I. M. Pandey.
Factors Determining Capital Structure:
The following factors influence the capital structure
decisions:
1. Risk of cash insolvency:
Risk of cash insolvency arises due to failure to pay fixed interest
liabilities. Generally, the higher proportion of debt in capital structure
compels the company to pay higher rate of interest on debt
irrespective of the fact that the fund is available or not. The non-
payment of interest charges and principal amount in time call for
liquidation of the company.

The sudden withdrawal of debt funds from the company can cause
cash insolvency. This risk factor has an important bearing in
determining the capital structure of a company and it can be avoided if
the project is financed by issues equity share capital.

2. Risk in variation of earnings:

The higher the debt content in the capital structure of a company, the
higher will be the risk of variation in the expected earnings available to
equity shareholders. If return on investment on total capital employed
(i.e., shareholders’ fund plus long-term debt) exceeds the interest rate,
the shareholders get a higher return.

On the other hand, if interest rate exceeds return on investment, the

shareholders may not get any return at all.

3. Cost of capital:
Cost of capital means cost of raising the capital from different sources
of funds. It is the price paid for using the capital. A business enterprise
should generate enough revenue to meet its cost of capital and finance
its future growth. The finance manager should consider the cost of
each source of fund while designing the capital structure of a
company.

4. Control:
The consideration of retaining control of the business is an important
factor in capital structure decisions. If the existing equity shareholders
do not like to dilute the control, they may prefer debt capital to equity
capital, as former has no voting rights.

5. Trading on equity:
The use of fixed interest bearing securities along with owner’s equity
as sources of finance is known as trading on equity. It is an
arrangement by which the company aims at increasing the return on
equity shares by the use of fixed interest bearing securities (i.e.,
debenture, preference shares etc.).

If the existing capital structure of the company consists mainly of the

equity shares, the return on equity shares can be increased by using
borrowed capital. This is so because the interest paid on debentures is
a deductible expenditure for income tax assessment and the after-tax
cost of debenture becomes very low.

Any excess earnings over cost of debt will be added up to the equity
shareholders. If the rate of return on total capital employed exceeds
the rate of interest on debt capital or rate of dividend on preference
share capital, the company is said to be trading on equity.

6. Government policies:
Capital structure is influenced by Government policies, rules and
regulations of SEBI and lending policies of financial institutions which
change the financial pattern of the company totally. Monetary and
fiscal policies of the Government will also affect the capital structure
decisions.

7. Size of the company:

Availability of funds is greatly influenced by the size of company. A
small company finds it difficult to raise debt capital. The terms of
debentures and long-term loans are less favourable to such
enterprises. Small companies have to depend more on the equity
shares and retained earnings.

On the other hand, large companies issue various types of securities

despite the fact that they pay less interest because investors consider
large companies less risky.

8. Needs of the investors:

While deciding capital structure the financial conditions and
psychology of different types of investors will have to be kept in mind.
For example, a poor or middle class investor may only be able to invest
in equity or preference shares which are usually of small
denominations, only a financially sound investor can afford to invest
in debentures of higher denominations.
A cautious investor who wants his capital to grow will prefer equity
shares.

9. Flexibility:
The capital structures of a company should be such that it can raise
funds as and when required. Flexibility provides room for expansion,
both in terms of lower impact on cost and with no significant rise in
risk profile.

10. Period of finance:

The period for which finance is needed also influences the capital
structure. When funds are needed for long-term (say 10 years), it
should be raised by issuing debentures or preference shares. Funds
should be raised by the issue of equity shares when it is needed
permanently.

11. Nature of business:

It has great influence in the capital structure of the business,
companies having stable and certain earnings prefer debentures or
preference shares and companies having no assured income depends
on internal resources.

12. Legal requirements:

The finance manager should comply with the legal provisions while
designing the capital structure of a company.

13. Purpose of financing:

Capital structure of a company is also affected by the purpose of
financing. If the funds are required for manufacturing purposes, the
company may procure it from the issue of long- term sources. When
the funds are required for non-manufacturing purposes i.e., welfare
facilities to workers, like school, hospital etc. the company may
procure it from internal sources.

14. Corporate taxation:

When corporate income is subject to taxes, debt financing is
favourable. This is so because the dividend payable on equity share
capital and preference share capital are not deductible for tax
purposes, whereas interest paid on debt is deductible from income and
reduces a firm’s tax liabilities. The tax saving on interest charges
reduces the cost of debt funds.

Moreover, a company has to pay tax on the amount distributed as

dividend to the equity shareholders. Due to this, total earnings
available for both debt holders and stockholders are more when debt
capital is used in capital structure. Therefore, if the corporate tax rate
is high enough, it is prudent to raise capital by issuing debentures or
taking long-term loans from financial institutions.

15. Cash inflows:

The selection of capital structure is also affected by the capacity of the
business to generate cash inflows. It analyses solvency position and
the ability of the company to meet its charges.

16. Provision for future:

The provision for future requirement of capital is also to be considered
while planning the capital structure of a company.
17. EBIT-EPS analysis:
If the level of EBIT is low from HPS point of view, equity is preferable
to debt. If the EBIT is high from EPS point of view, debt financing is
preferable to equity. If ROI is less than the interest on debt, debt
financing decreases ROE. When the ROI is more than the interest on
debt, debt financing increases ROE.

Under-Capitalisation: Meaning, Causes, Consequences

and Remedies
Meaning of Under-Capitalisation:

In the words of Gersrtenberg, “A company may be under-

capitalised when the rate of profits it is making on the total
capital is exceptionally high in relation to the return enjoyed
by similarly situated companies in the same industry, or
when it has too little capital with which to conduct its
business”.

In simple words, we can say that under-capitalisation is the reverse

phenomenon of over-capitalisation, and occurs when a company’s
actual capitalisation is lower than its proper capitalisation as
warranted by its earning capacity. The term under-capitalisation
should never be consider.

The real value of an under-capitalised company is more than its book

value. The profits are higher than warranted by the book value of its
assets. Such a company can pay a higher rate of dividend and the
market value of its shares is much higher than its face value. red
synonymous with inadequate capital.
Causes of Under-Capitalisation:

Following are the important causes of under-capitalisation

in a company:

1. Under-Estimation of Capital Requirements:

If the future capital requirements are underestimated by the
promoters, the inadequacy of capital is experienced at a later stage.
The company may arrange cheaper debt at lower rate of interest at
that stage resulting in increased earnings per share. This leads the
company to a situation of under-capitalisation.

2. Under-Estimation of Future Earnings:

While preparing the financial plan, if the future earnings of the
company are under estimated and the actual earnings turn out to be
higher than the estimated figure, the company may find itself in a
condition of under-capitalisation.

3. Promotion during Depression:

Companies promoted during a period of depression often experience
under-capitalisation when inflation sets in because of a sudden rise in
their earnings.

4. Conservative Dividend Policy:

If the management of a particular company adopts an orthodox
dividend policy, i.e. where it follows a cautious policy regarding the
distribution of dividend and keeps a major part of its earnings for re-
investment purpose, it results into higher earnings and conditions of
under-capitalisation.

5. Very Efficient Management:

In companies, where the management is very efficient, the rate of
return may be quite high as compared to other companies in the same
industry, and such a high rate of return may eventually lead towards
under-capitalisation.
6. Desire of Control and Trading on Equity:
In many companies, the promoter desires to retain control over the
company and raises lesser amount of share capital. However, later on
when the funds are required they resort to trading on equity. This
raising of funds at a lower rate of interest than the earnings of the
company eventually leads to under-capitalisation.

Effects of Under-Capitalisation:
Like over-capitalisation, under-capitalisation also has many evil
effects on the company and its owners as well as the society as a whole.

The main disadvantages of under-capitalisation are as below

1. Under-capitalisation induces management to change and
manipulate the market value of shares and expanding the business.

2. As a consequence of under-capitalisation, earnings per share

increase and so do the dividend per share, which is turn, increases the
marketability of shares.

3. When the employees find that the company is earning high profits
they press for higher wages and as a result, a tiff between the workers
and employers takes place giving rise to labour unrest.

4. As a consequence of under-capitalisation, the companies earn huge

profits and as a result, the burden of tax is great. The government
introduces higher rate of taxation which is a financial burden on the
companies.

5. Higher profits earned by the companies give a psychological feeling

to the customers that they are being over-charged and hence they
develop grouse towards that company.

6. Higher earnings may encourage competitors to enter into a cut-

throat competition amongst themselves.
7. A situation of over-trading by the company may arise as a result of
under-capitalisation, where the company does excessive business than
what its finances can allow.

8. As a result of over-trading, creditors will not be paid timely and the

company will effect its creditworthiness adversely.

Under-capitalisation eventually leads to over-capitalisation because of

excessive profits, huge retained earnings and long-term debt
financing.

Remedies for Under-Capitalisation:

Under-capitalisation can be corrected by taking any of the
following remedial measures:
1. Fresh Issue of Shares:
If under-capitalisation is due to inadequacy of capital, then it can be
corrected by the issue of fresh shares, the company may also redeem
its long-term debt by the issue of fresh share capital.

2. Issue of Bonus Shares:

The company may issue bonus shares by capitalising its accumulated
earnings. This is the most commonly used and effective method of
correcting under-capitalisation. It reduces earnings per share after the
bonus issue.

3. Increasing the Par Value of Shares:

The company may revalue its assets and increase their values. In lieu,
thereof, the par value of shares may also be increased. This will result
into reduction of earnings per rupee of share value but the amount of
dividend per share will remain same.

4. Splitting Stock. Another effective method of correcting under-

capitalisation is to split up the existing stock into larger number of
shares reducing the value of each share. It neither affects the total
earnings of the company nor the total amount of capital of the
company but still dividend per share shall reduce.

Meaning of Over-capitalization:
It is the capitalization under which the actual profits of the company
are not sufficient to pay interest on debentures and borrowings and a
fair rate of dividend to shareholders over a period of time. In other
words, a company is said to be over-capitalised when it is not able to
pay interest on debentures and loans and ensure a fair return to the
shareholders.

We can illustrate over-capitalisation with the help of an example.

Suppose a company earns a profit of Rs. 3 lakhs. With the expected
earnings of 15%, the capitalisation of the company should be Rs. 20
lakhs. But if the actual capitalisation of the company is Rs. 30 lakhs, it
will be over-capitalised to the extent of Rs. 10 lakhs. The actual rate of
return in this case will go down to 10%. Since the rate of interest on
debentures is fixed, the equity shareholders will get lower dividend in
the long-run.
Causes of Over-Capitalisation:
Over-capitalisation may be the result of the following
factors:
(i) Acquisition of Assets at Higher Prices:
Assets might have been acquired at inflated prices or at a time when
the prices were at their peak. In both the cases, the real value of the
company would be below its book value and the earnings very low.

ii) Higher Promotional Expenses:

The company might incur heavy preliminary expenses such as
purchase of goodwill, patents, etc.; printing of prospectus,
underwriting commission, brokerage, etc. These expenses are not
productive but are shown as assets.

(iii) Underutilization:
The directors of the company may over-estimate the earnings of the
company and raise capital accordingly. If the company is not in a
position to invest these funds profitably, the company will have more
capital than is required. Consequently, the rate of earnings per shares
will be less.

(iv) Insufficient Provision for Depreciation:

Depreciation may be charged at a lower rate than warranted by the life
and use of the assets, and the company may not make sufficient
provisions for replacement of assets. This will reduce the earning
capacity of the company.

(v) Liberal Dividend Policy:

The company may follow a liberal dividend policy and may not retain
sufficient funds for self-financing. This may lead to over-capitalisation
in the long-run.

(vi) Inefficient Management:

Inefficient management and extravagant organisation may also lead to
over-capitalisation of the company. The earnings of the company will
be low.

Effects of Over-capitalisation on Company:

An over-capitalised company may suffer from the following
ill consequences or disadvantages:
(i) The shares of the company may not be easily marketable because of
reduced earnings per share.

ii) The company may not be able to raise fresh capital from the
market.

(iii) Reduced earnings may force the management to follow unfair

practices. It may manipulate the accounts to show higher profits.

(iv) Management may cut down expenditure on maintenance and

replacement of assets. Proper amount of depreciation of assets may
not be provided for.

(v) Because of low earnings, reputation of the company would be

lowered.

Effects of Over-capitalisation on Shareholders:

) Over-capitalisation results in reduced earnings for the company. This
means the shareholders will get lesser dividend.

(ii) Market value of shares will go down because of lower profitability.

(iii) There may be no certainty of income to the shareholders in the

future.

(iv) The reputation of the company will go down. Because of this, the
shares of the company may not be easily marketable.

(v) In case of reorganisation, the face value of the equity share might
be brought down.
Effects of Over-capitalisation on Society:
The effects of over-capitalisation on the society are as
follows:
(i) The profits of an over-capitalised company would show a declining
trend. Such a company may resort to tactics like increase in product
price or lowering of product quality.

(ii) Return on capital employed is very low. This means that financial
resources of the public are not being utilised properly.

(iii) An over-capitalised company may not be able to pay interest to

the creditors regularly.

(iv) The company may not be able to provide better working

conditions and adequate wages to the workers.

Remedies for Over-capitalization:

In order to correct the situation caused by over-
capitalisation, the following measures should be adopted:
(i) The earning capacity of the company should be increased by raising
the efficiency of human and non-human resources of the company.

(ii) Long-term borrowings carrying higher rate of interest may be

redeemed out of existing resources.

(iii) The par value and/or number of equity shares may be reduced.

(iv) Management should follow a conservative policy in declaring

dividend and should take all measures to cut down unnecessary
expenses on administration.
 UNIT: 4 - RECENT TRENDS IN BUSINESS FINANCE

 VENTURE CAPITAL

 It is a private or institutional investment made into early-stage / start-up companies (new

ventures).

 Ventures involve risk (having uncertain outcome) in the expectation of a sizeable gain.

 Venture Capital is money invested in businesses that are small; or exist only as an

initiative, but have huge potential to grow.

 The people who invest this money are called venture capitalists.

 Venture Capital investment is also referred to risk capital or patient risk capital, as it

includes the risk of losing the money if the venture doesn’t succeed.

 Also, it takes medium to long term time period for the investments to fructify.

 It is the money provided by an outside investor typically institutional investors and high

net worth individuals and dedicated investment firms. (And not banks)

 Capital is invested in exchange for an equity stake in the business rather than given as a

loan.

 This is the most suitable option for funding businesses having large up-front capital

requirements which have no other cheap alternatives.

1
 Software and other intellectual property are generally the most common cases whose

value is unproven.

 Venture capital funding is most widespread in the fast-growing technology and

biotechnology fields.

 FEATURES / NATURE OF VENTURE CAPITAL

 Highly risky in nature.

 Lack of Liquidity: as it is based on success of new project or venture undertaken—It

is highly liquid if the new business turns out to be profitable.

 Long term horizon: profits are only realized after the business start making real

profits.

 Equity participation and capital gains: it is a type of equity financing and concentrates

on businesses which are too new for the stock markets to raise funds.

 Venture capital investments are made in innovative projects

 Suppliers of venture capital participate in the management of the company.

 It’s a continuous involvement: as venture capitalist also offers managerial guidance

and technical skills.

 Methods of Venture capital financing

 Equity

 Participating debentures

2
  Conditional loan

 ADVANTAGES OF VENTURE CAPITAL

 They bring wealth and expertise to the company.

 Large sum of equity finance can be provided.

 The business does not stand the obligation to repay the money.

 In addition to capital, it provides valuable information, resources, technical

assistance to make a business successful.

 It encourages the entrepreneurs to take risks and innovate.

 DISADVANTAGES OF VENTURE CAPITAL

 As the investors become part owners, the autonomy and control of the founder is

lost.

 It is a lengthy and complex process.

 It is an uncertain form of financing.

 Benefit from such financing can be realized in long run only.

 LEASING

 A preferred solution to resolve fixed asset requirements vs. purchasing the asset.

3
  A famous quote by Donald B. Grant says, “Why own a cow when the milk is so

cheap? All you really need is milk and not the cow.” The concept of Lease is

influenced by this quote

 It means a person who wants to manufacture a product using machinery can get to

use that machinery under a leasing arrangement without owning it.

 A lease can be defined as an arrangement between the lessor (owner of the asset)

and the lessee (user of the asset) whereby the lessor purchases an asset and allows

the lessee to use it in exchange for periodical payments called lease rentals.

At the end of the lease period, the asset goes back to the lessor (the owner). There are four

different things possible post-termination of the lease agreement. They are:

 The lease is renewed by the lessee again for a definite period of time.

 The asset goes back to the lessor.

 The asset comes back to the lessor and he sells it off or lease it to a third party.

 Lessor sells the asset to the lessee.

 PURPOSE OF LEASING

The purpose of choosing a lease can be many. Generally, a lease is structured for the following

reasons.

 Benefits of taxes:

The tax benefit can be availed by both the parties, i.e. Lessor and Lessee.

4
Lessor, being the owner of the asset, can claim depreciation as an expense in his books and

therefore get the tax benefit.

On the other hand, the lessee can claim the lease rentals as an expense and achieve tax

benefit in a similar way.

 Avoiding risks of ownership:

Ownership is avoided by the Lessee: so as to avoid the investment of money into the asset, this

keeps the leverage low and hence opportunities of borrowing money from outside remains open

for the business as Lease is an off-balance sheet item.

 ADVANTAGES OF LEASING

 Balanced cash outflows throughout the period of lease: in the form of lease rentals,

which are spread out over several years, hence saving the burden of one-time

significant cash payment.

 Better quality assets While leasing an asset the lessee just pays the rental expense

therefore it becomes possible for a business to invest in good quality assets which

might look unaffordable or expensive otherwise.

 Optimum use of capital: The company is left with considerable amount of funds

which can be used for a better capital investment decision.

5
  Low capital expenditure: AS IT IS an ideal option for a newly set-up business given

that it means lower initial cost and lower Capital expenditure requirements.

 Rules out the risk of obsolescence: it is ideal for the technology business where

there is a high risk of technology becoming obsolete, leasing saves the business

from the risk of investing in a technology that might soon become outdated.

 Provides flexibility to the lessee: At the end of the leasing period, the lessee holds

the right to buy the property and terminate the leasing contract.

 DISADVANTAGES OF LEASING

 Treatment of lease rentals: they are treated as business expenses rather than as

equity payments towards an asset.

 Long term financial burden: lease agreements are usually long term in nature, as the

expenses for several years are fixed. In cases where the use of asset does not serve

the business requirements after some years, lease payment becomes a burden.

 Reduced return for equity holders: lease expenses reduce the net income

(profits) without any appreciation in value, which means limited returns for equity

shareholders.

 Considered as debt: Although lease doesn’t appear on the balance sheet of a

company, investors still consider long-term lease as debt and adjust their valuation of

a business to include leases.

6
  Reduced actual borrowing capacity of the business:

given that investors treat long-term leases as debt, it might become difficult for a

business to tap capital markets and raise further loans or other forms of debt from the

market.

 Documentation and processing of the agreement is cumbersome task: to enter into a

lease agreement is a complex process and requires thorough documentation and

proper examination of an asset being leased.

 Ownership of the asset still remains with the lessor: at the end of the leasing period,

the lessee doesn’t end up becoming the owner of the asset though quite a good sum

of payment is being done over the years towards the asset.

 Responsibility of maintenance of asset lies with lessee: the lessee remains

responsible for the maintenance and proper operation of the asset being leased.

 Limited tax benefits in case of new start-ups: for a new business, the tax expense is

likely to be minimal, thus, there is no added tax advantage that can be derived from

leasing expenses.

3. MICROFINANCE

 Microfinance is "banking the unbanked". In simple terms its lending to people running

very small business on an unsecured basis.

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 Microfinance is the offer of financial and non-financial services to people excluded from

traditional banking system.

 Microfinance is the made up of two words: “Micro” and “Finance”

 MICRO includes----

Micro entrepreneurs, self-employed, low income populations and excluded

populations.

 FINANCE includes----

Business and Educational loans, Savings, Micro insurances, Remittances.

Small Entrepreneur Training and Coaching and Workshops on Health and Hygiene etc.

 Microfinance—also called microcredit—is a way to provide small business owners and

entrepreneurs access to capital.

 Microfinance is a banking service provided to unemployed or low-income individuals or

groups who otherwise would have no other access to financial services.

 It allows people to take on reasonable small business loans safely, and in a manner that

is consistent with ethical lending practices.

The majority of micro financing operations occur in developing nations, such as

Uganda, Indonesia, Serbia, and Honduras.

8
 Like conventional lenders, micro financiers charge interest on loans and institute

specific repayment plans.

 The World Bank estimates that more than 500 million people have benefited

from microfinance-related operations.

 Thus, Microfinance, pioneered by the Nobel-Prize winner Muhammad Yunus, helps the

financially marginalized by providing them with the necessary capital to start a business

and work toward financial independence.

 These loans are significant because they are given even though the borrower has no

collateral. However, the interest rates for these microloans are often very high due to the

risk of default.

 Who Benefits from Micro financing?

 While microfinance can certainly benefit those stateside.

 It can also serve as an important resource for those in the developing world.

 Microfinance can also help women break the cycle of poverty.

 ADVANTAGES OF MICROFINANCING

 Helps to Provide Credit to Rural Poor: thus helps in elevating poverty.

 Helps to get women empowered: as the major benefactor of micro finance is small

women entrepreneurs who runs business from their home.

 Helps in economic growth.

 Help to mobilize the savings from small investors.

 Helps in development of skills: necessary to start or run a business.

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  It provides mutual help and cooperation.

 It helps in social welfare.

 DISADVANTAGES OF MICROFINANCE

 Excessive emphasis on microfinance by government: is likely to result in lower priority of

spending in other equally important areas, such as public health, education, and other

welfare measures.

 Diversion of funds: the borrowers are reported to have diverted funds taken as a loan to

elsewhere, instead of making capital investment for creation of an asset they are taking

it as a regular source of income.

 Most of the beneficiaries of microfinance are women: sometimes they are acting as just

dummies for the other male members of the family to avail the funds from such

organizations.

 Services under microfinance are provided at a very small scale: as a result, even after it

being a good initiative a huge sector is still out of its reach.

4. MUTUAL FUNDS

 A mutual fund is a type of financial vehicle--- made up of a pool of money--- collected

from--- many investors--- to invest in securities-- -like stocks, bonds, money market

instruments, and other assets

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  The value of the mutual fund company depends on the performance of the securities it

decides to buy.

 The price of a mutual fund share is referred to as the net asset value (NAV) per share.

 A fund's NAV is derived by dividing the total value of the securities in the portfolio by the

total amount of shares outstanding. (Outstanding shares are those held by all

shareholders, institutional investors, and company officers or insiders.)

 Mutual fund holds hundreds of different securities, which means its shareholders gain

important diversification at a low price.

 Investors typically earn a return from a mutual fund in following ways:

 DIVIDENDS: Income is earned from-- dividends on stocks.

 INTEREST: on bonds held in the fund's portfolio.

 CAPITAL GAINS: If the fund sells securities, the fund has a capital gain. Most funds

also pass on these gains to investors in a distribution.

 PROFITS: If the value of investment increases and it is not sold by the fund manager

you can sell your mutual fund shares for a profit in the market.

 TYPES OF MUTUAL FUNDS

General Classification

a. Open ended schemes

b. Close ended schemes

c. Interval schemes

d. Load funds

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 e. No-load funds.

f. Tax exempt funds

g. Non-tax exempt Funds.

Broad Classification

h. Equity funds

i. Money market funds

j. Hybrid funds

k. Debt income funds

l. Technology Funds

m. Commodity funds

n. Real estate funds

o. Exchange traded funds

p. Funds of funds.

 IMPORTANCES/ADVANTAGES OF MUTUAL FUNDS

1. Diversification : Mutual funds spread their holdings across a number of different

investments, which reduces the effect any single security or class of securities

will have on the overall portfolio.

2. Expert Management : Investors lack the financial know-how to manage their

own portfolio. However, mutual funds are managed by professionals who help

investors receive the best risk-return trade-off.

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 3. Liquidity: Investments made through mutual funds can be sold or traded easily

in both the primary and secondary market.

4. Convenience: Choosing a mutual fund is ideal for people who don’t have the

time and skills to manage their portfolios.

5. Reinvestment of Income : mutual funds allow you to reinvest your dividends and

interest in additional fund shares. This allows you the opportunity to grow your

portfolio without paying extra transaction fees for purchasing additional mutual

fund shares.

6. Availability of wide range of Investment Option to choose from: this help fulfill

various kinds of Investment objective by different investors.

7. Affordability : as investment through mutual funds is cost effective as compared

to the direct investment in the capital market.

8. Tax benefits: as dividend distributed by mutual funds are exempted from capital

gain tax in the hands of their investors.

 DISADVANTAGES OF MUTUAL FUNDS

Although mutual funds can be beneficial in many ways, they suffer from certain

limitations also:

1. No control over portfolio . If you invest in a fund, you give up all control of your

portfolio to the mutual fund money managers who run it.

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2. Capital gains . Anytime you sell stock, you’re taxed on your capital gains.

3. Fees and Expenses. Some mutual funds assess a sales charge on all

purchases, also known as a “load” – this is what it costs to get into the fund.

Plus, all mutual funds charge annual expenses– this is basically the cost of

doing business. The expense ratio is expressed as a percentage, and is what

you pay annually as a portion of your account value. Since the expense ratio

will eat directly into gains on an annual basis, one needs to closely compare

expense ratios for different funds.

4. Over-diversification . Although there are many benefits of diversification, there

are pitfalls of being over-diversified.: The more securities you hold, the less

likely you are to feel their individual returns on your overall portfolio. What this

means is that though risk will be reduced, so too will the potential for gains.

5. Cash drag. Mutual funds need to maintain assets in cash to satisfy investor

redemptions and to maintain liquidity for purchases.

6. Volatility: Performance of mutual funds is entirely dependent on the movement

of stock market, which is highly volatile. Thus making them subject to market

risk.

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