MCom I Semester Managerial Economics Capital Management Study Material Notes
Table of Contents
MCom I Semester Managerial Economics Capital Management Study Material Notes: Meaning and definition of financial management Who Dischares Fiancnail Function s Finance and Financial Manager Executive FunctionsIncidental or Routine Function s Importance of Financial Management External Factors Meaning and Definition or Capital Structure Factors Determining Capital Internal Factors Over Capitalisation Theories of Capitalisation Meaning and Definition of Capitalisation Causes of Over Capitalisation Effects on Company Effects of Over Capitalisation :
CAPITAL MANAGEMENT
MEANING AND DEFINITION OF FINANCIAL MANAGEMENT
Finance is a base of business activities. No business or industrial enterprise can do without finance. It is almost impossible to carry on the activities of business or industrial enterprise in the absence of adequate finance. Therefore, it is necessary that adequate finance should be arranged for smooth functioning of all the business and industrial enterprises.
According to Howard and Upton, “Finance may be defined as that administrative area or set of administrative functions in an organisation which relate with arrangement of cash and credit so that the organisation may have the means to carry out its objectives as satisfactorily as possible.”
WHO DISCHARGES FINANCIAL FUNCTIONS ?
Financial functions are discharged by Financial Manager. Financial Manager is the executive who arranges adequate finance for smooth functioning of the activities of an enterprise. Financial Manager plays an important role in performing financial activities in an enterprise.
Capital Management Study Material
FINANCE AND FINANCIAL MANAGER
Important functions of a Financial Manager can be divided into two parts-(I) Executive Functions (II) Incidental Or Routine Functions. Details in this regard are as follows
(1) EXECUTIVE FUNCTIONS
A Financial Manager is an important executive in an enterprise. He has a key role to play in the enterprise. Important functions of a Financial Manager is this regard are as follows
1 Financial Forecasting. The very first function of a Financial Manager is to forecast the financial requirements of an enterprise. These forecasts are prepared on the basis of estimates prepared by financial officers, profit and loss accounts and balance sheet etc.
2. To Take Investment Decisions. An important function of a Financial Manager is to take investment decisions. He is to decide the amount of investment in a particular asset so that the enterprise may utilise all the assets to the best possible extent and all the available financial resources of the enterprise may be utilised in the best possible manner.
3. Management of Fixed and Current Assets. A Financial Manager has to decide the ratio of investment between Fixed and Current Assets. He is to manage all the Fixed Assets and Current Assets properly. He is to provide for the replacement of these assets. He is to determine the optimum amount of investment.
4. Management of Income. Financial Manager is responsible for proper management of income of an enterprise also. Proper Management of Income of an enterprise is of great importance because the success of an enterprise depends to a large extent upon such management. Proper Management of Income includes correct determination of income and its proper distribution among all the factors of production.
5. Management of Cash-flow. Management of Cash-flow includes the forecasting of Cash-flow and proper control of Cash-flow. Financial Manager is responsible for proper management of Cash-flow in an enterprise, Financial Manager prepares cash budget and cash reports for this purpose.
6. Analysis and Appraisal of Financial Performance. Another important function of Financial Mananger is the analysis and appraisal of financial performance of the enterprise at regular intervals. He is responsible to inform the top manangement about the results of such analysis and appraisal. Financial analysis and appraisal includes the preparation of funds flow statement, the preparation of the statement of working capital, ratio analysis, trend analysis etc.
7. To Decide New Financial Resources. Capital is required not only at the time of establishment of an enterprise, but all the times and at all the steps of growth, expansion and development of an enterprise. When there is a need of additional capital in an enterprise, the Financial manager is responsible to develop alternative sources of new financing and to select the most suitable source of financing for the enterprise.
8.To Contract with New Financing Sources. Financial manager should keep himself in regular touch and contact with new financial sources so that in case of need, he may collect required amount of capital or loan for the enterprise easily and quickly.
9. Advising Top Management. Financial Manager is responsible to advise top management from time to time on financial matters. He should help top management in taking final decisions on financial matters.
10. To Formulate Policies Regarding the Management of Assets. Financial Manager is responsible to formulate Policies regarding the management of assets. He is to decide the amount of capital that should be invested in fixed assets and also the amount of capital that should be invested in fixed current aqssets. Financial policies should be determined well in advance and should be very clear and specific. These policies should define the rights and duties of all the members of staff.
11. To Make Efforts to Increases the Productivity of Capital. Financial Manager should make his best efforts to increase the productivity of captial of his enterprise. For the purpose, he should develop new projects for investment so that the enterprise may invest in most protitable projects.
12. Contribution in Formulating Dividend Policies. Though the Financial Manager is not responsible to determine dividend policies for the enterprise, yet he should help top management in formulating suitable Dividend Policies.
Capital Management Study Material
(II) INCIDENTAL OR ROUTINE FUNCTIONS
Incidental or Routine Functions of Financial Manager are the functions which are to be performed by him in routine manner. These functions help top management in taking financial decisions. These functions include the following
(1) To record all the financial transactions.
(2) To prepare financial statements.
(3) To arrange for a proper amount of cash balance.
(4) To manage the credit transactions
(5) To keep the important documents safe with the help of his subordinate staff.
IMPORTANCE OF FINANCIAL MANAGEMENT
Financial Management occupies an important place in business activities. Proper knowledge of Financial Management is necessary for the managers, shareholders, investors, financial institutions etc, to enable them to know their rights and to discharge their duties. Following statements are relevant in respect of the importance of Financial Management :
Irwin Friend, “A firm’s success and even survival, its ability and willingness to maintain production and to invest to fixed or working capital, are, to a very considerable extent, determined by its financial policies, both past and present.
Solomon Ezra, “Financial Management is properly viewed as an integral part of overall management rather than as a staff specially concerned with fund raising operations …… In addition to raising funds, financial management is direcly concerned with production, marketing and other functions within an enterprise whenever decisions are made about the acquisition or distribution of assets.”
MEANING AND DEFINITION OF CAPITAL STRUCTURE
Capital Structure means the ratio of capital invested in different types of securities. It is an important part of capital budgeting. This part of capital planning is concerned with the determination of the composition of long-term sources of funds such as equity share capital, preference share capital. debentures, reserves and surplus etc. The term capital structure has been defined as under:
Robert & Wessel, “The term capital structure is frequently used to indicate the long-term sources of funds employed in a business enterprise.”
Weston & Brigham, “Capital Structure is the permanent financing of the firm, represented by long-term debt, preferred stock and net worth.”
I.M. Pandey, “Capital Structure refers to the composition of long-term sources of funds, such as debentures, long-term debt, preference share capital & ordinary share capital including reserves and surpluses (retained earning).”
FACTORS DETERMINING CAPITAL STRUCTURE
Factors determining capital structure of a company can be divided into two parts (1) Internal Factors, (II) External Factors. Details in this regard are as follows:
(1) INTERNAL FACTORS
Internal Factors affecting capital structure of a company are the factors which are under the control of an enterprise. These factors are as follows
1 Nature of Manangement. Nature and attitude of management affects the capital structure of a company to a large extent. There is a significant difference between the nature and attitude of management of different companies.
2. Operating Ratio. Operating ratio is the ratio between total income and operating expenses. This ratio indicates the percentage of gross profit of a company which is spent on operating expenses. Operating expenses include all the factory overheads, office and administration overheads and selling and distritbution overheads. If the operating expenses ratio of a company is high, the company should avoid the capital bearing fixed cost (debentures, public deposits and preference shares etc.) because in this case, the company will not save sufficient income for the payment of fixed interest and divident.
3. Gearing Ratio. Gearing Ratio is the ratio of equity share capital of company with its total capital. If the company has issued heavy amount equity share capital, it is called low gearing and if the company has issued les amount of equity share capital, it is called high gearing.
4. Simplicity. Capital structure of a company should be simple and clear. The company should not issue a variety of securities because it may cause doubt in the mind of investors.
5. Nature of Business.
6. Desire to Control the Business.
7. Possibilities of Fixed and Regular Income.
8. Flexibility Desired in Capital Structure.
9. Future Plans of the Business.
(II) EXTERNAL FACTORS
External Factors are the factors which are not under the control of an enterprise. These factors relate to the Nature of Investors, Environment of Capital Market. General Economic and Business Conditions in the Country, Government Policies etc. Important External Factors affecting Capital Strucutre of an enterprise are as follows –
1 Nature of Investors. Nature of Investors is an important factors affecting the capital structure of a company. If the investors have sufficient money for investment and they are ready to bear risk the company can collect its capital though equity shares.
2. Cost of Capital Issue. Cost of Capital Issue should also be considered while determining capital structure for a company. Issue of such securities should be preferred which can be issued at minimum cost.
3. Environment of Capital Market. A company cannot collect its capital direct from public. It can be so only through capital market. Environment of Capital Market should be throughly studied and analysed before determining capital structure for a company. During the period of boom, possibilities of profit increase and high rate of dividend is expected. In these conditions, the issue of equity shares should be preferred. During the period of slump, the possibilities of profit decrease and a low rate of dividend is expected. In these conditions, issue of preference shares and debentures should be preferred
4. Legislation and Regulation. Legislation and Regulation prevailing in the country also affects the capital structure of a company. If the income of companies is subject to a high rate of income-tax, it is better to collect a major part of total capital through debentures because interest on debentures is a charge against profit and thus it helps the company is saving income tax.
5. Advice of Financial Agencies and Experts. A number of Financial Agencies and Experts are working in our country. They advise the companies on financial matters. A company should consult them before determining its capital structure because their advice is based upon the study and analysis of all the relevant factors.
MEANING AND DEFINITION OF CAPITALISATION
Capitalisation means total accounting value of all the capital regularly employed in a company. It includes total amount of capital represented by shares, debentures and reserves and surplus. The term ‘Capitalisation’ has been defined as under
A.S. Dewing, “The term Capitalisation Or the Valuation of Capital includes the capital stock and debt.”
E.E. Lincoln, “Capitalisation is a word ordinarily used to refer to the sum of the outstanding stocks and funded obligations which amy represent wholly fictitious values.”
According to modern view of capitalisation, it includes both the short-term and long-term sources of funds. Walker and Wagon have studied in this regard, “It is illusory to use the term capitalisation to mean only the long-term loans and proprietory capital because it gives an impression that short-term creditors are not capital contributories. In practice, total capital of a business is provided by short-term creditors, long-term creditors and proprietors.” It is important to note in this regard that in practice tradition view of capitalisation is referred too.
THEORIES OF CAPITALISATION
Theory of Capitalisation means the determination of the amount of total capital required by an enterprise. Problem of the determination of total amount of capital arises in following circumstances—
(i) When a new company is going to be established.
(ii) When a company wants to expand its business.
(iii) When a business is going to adopt a programme of modernisation.
(iv) When a company is going to re-organise its capital structure.
(v) When two or more companies are going to be amalga- mated.
In all the circumstances desribed above, the problem of determination of total amount of capital arises. There are two theories of determining total amount of capital required for a company. These theories are as under
1 Cost Theory of Capitalisation. According to this theory capitalisation, total amount of capital required for a company is determined the basis of cost of investment in differeat assets. When a company is going be established, it requires a certain amount to be invested in fixed assets (land, building, plant, machinery, furniture, fixtures and plant etc.), a certain amount for preliminary expenses and a certain amount as working capital. According to this theory, total amount of capital required by a company should be equal to these amounts.
This theory of capitalisation is suitable to determine the amount of capital required for a new company only. In case of an old company, it is very difficult to determine the amount of capital according to this theory.
2. Earning Theory of Capitalisation. Every business and industrial enterprise aims at earning maximum profit. Every enterprise should earn an amount which may be sufficient in recovering all the operating expenses , in paying the interest on loans and debentures and a reasonable dividend on shares. If an enterprise in not successful in earning this amount of profit, it will be very difficult to continue the business activities. Therefore, it is advisable to determine the capitalisation of a company on the basis of its earning capacity. There are two important factors of capitalisation according to this theory–
(i) Estimation of the Earnings of Company. Earning capacity of a company is estimated keeping in veiw all the internal and external factors. It can be estimated on the basis of a study of the rate of earning of other companies doing similar business, provided if the other companies are also in the similar position. Earning capacity of a company is affected by the habits, and preferences of consumers; tax policy of Government; pricing policy of the company etc., also.
(ii) Current Rate of Capitalisation. Earning capacity of other companies engaged in similar business should also be analysed in order to determine the rate of capitalisation. Market value of the shares of other companies and the rate of dividend paid by these companies should also be analysed for this purpose. For example, average earnings of a company are Rs. 8,00,000 per year and the rate of dividend on the amount of capital invested in other similar companies is 8%. In this case, the amount of capitalisation for the company will be Rs. 1,00,00,000 (8,00,000 x 100/8).
Thus, there are two theories of capitalisation but no theory is complete in itself. Both the theories depend upon each other. It can be concluded that the cost theory of capitalisation is suitable for new companies and the earning theory of capitalisation is suitable for existing companies.
OVER-CAPITALISATION
When the capital of a company is more than its needs and the level of activities, it is called the situation of Over- capitalisation. The term “Over-capitalisation’ has been defined as under
Gerstenbergh : Financial Organisation and Management, “A Corporation is over-capitalised when its earnings are not large enough to yield a fair return on the amount of stocks and bonds that have been issued or when the amount of securities outstanding exceeds the current value of assets.”
Hoagland Corporation Finance, “Whenever the aggregate of the par diues of stock and bonds outstanding exceeds the true value of fixed assets. the corporation is said to be over-capitalised.”
Harold Gilbert Corporation Finance, “When a company has consistently been unable to earn the prevailing Rate of Return on its outstanding securities (considering the earnings of similar companies is the same industry and the degree of risk involved), it is said to be over-capitalised.”
CAUSES OF OVER-CAPITALISATION
Folllowing may be the Causes of Over-capitalisation in a Company
1 Issue of Excess Capital. When a Company issue capital more than its requirements, te situation of Over-capitalisation arises.
2. High Cost of Promotion. If the cost of promotion of a company is very high and these expenses are charged against the profit of company, major part of the profit of company is utilised in writing off this high cost of promotion. As a result, the amount of profit available for the declaration of dividend is very low. Consequently, the situation of Over-capitalisation arises.
3. Wrong Estimate of Earnings. Sometimes wrong estimate of earnings also creates the situation of Over- capitalisation. For example, income of a company was estimated to be Rs. 20,000 and the amount of capitalisation was fixed at Rs. 2,00,000, at the prevailing rate of capitalisation, of 10%. Actual income of the compnay came to Rs. 16,000 only. At the prevailing rate of capitalisation, total amount of capital of the company comes to Rs. 1,60,000 only. Thus, the company is over-capitalised by Rs. 40,000.
4. Capitalisation at Lower Rate. If the rate of capitali-sation is not correct and it is under estimated, the company may be over-capitalised. For example, if the prevailing rate of capitalisation is 10% but while determining the amount of capital for a company it is taken at 8%, the company will be over-capitalised. Suppose the estimated income of the company in above case is Rs. 40,000, the amount of capital for this company will be estimated at Rs. 5,00,000 (40,000 x 100/8) while it should be Rs. 4,00,000 only (40,000 x 100 710). Thus the company will be over-capitalised by Rs. 1,00,000.
5. Over-valuation of Assets. When the assets of company are over-valued by its promotors, the company faces the situation of over-capitalisation because in this case, earning capacity of company will decrease while company will have to allow interest and dividend on the total amount of capital.
6. High Cost of Debt Financing. If the cost of debt financing a company is high, the company may be over-capitalised. Because in this case, major part of total income of company will be utilised in paying out the interest on debt. As a result the rate of dividend will be low which is an important cause of over-capitalisation.
7. Defective Depreciation Policy. If a company is providing depreciation on its assets at a lower rate, the company will be over-capitalised because the utility and real value of assets goes on reducing while they are shown in Balance Sheet at a higher value. Consequently, these assets are unable in earning income at expected rate. It causes the situation of overcapitalisation
8. Liberal Dividend Policy. Some companies adopt the policy of declaring dividend at a higher rate in the early years of their establishment. They do so in order to win the faith and confidence of shareholders. To do so, they do not provide adequate amount for depreciation and reserves. Consequently, the situation of over-capitalisation arises after some years.
9. Promotion of Companies During Boom Period. The companies which are established during boom period, require more amount of capital because they have to purchase all the assets at a higher price and they have to spend more amount on their formation. In the begining, these companies earn income also at a higher rate but their profits starts to decrease with the change in situations. They are no more successful in maintaining the high rate of their earning. Consequently, the situation of over-capitalisation arises.
10. Liberal Use of Debt Capital. If the major part of total capital of a company is collected through loans and debentures, the situation of over-capitalisation may arise because in this case, the company will have to pay heavy amount of interest on loans and debentures. As a result, the company can pay divident only at a lower rate which in turn may causes the situation of over-capitalisation,
EFFECTS OF OVER-CAPITALISATION
Over-capitalisation affects all the concerned parties such as shareholders, company, consumers and society. Effects of over- capitalisation can be dividend into four parts-(1) Effects on Company, (II) Effects on Shareholders, (III) Effects on Consumers, (IV) Effects on Society. Details in this regard as under
(1) EFFECTS ON COMPANY
Effects of over-capitalisation on the Company itself can be explained as under
1 Fall in Goodwill. In case of over-capitalisation, the market value of shares decreases because in this case real value of the shares of company is less than their face value. Company declares dividend at a lower rate. These situations are against the goodwill of a company.
2. Difficulty in Collecting Loans. If a company is over-capitalised, it faces difficulties in the collection of further loans.
3. Difficulty in Collecting Capital. In case of over-capitalisation, it becomes very difficult for the company to issue new shares because in this case the investors do not like to invest their money in the shares of such companies
4. Under Utilisation of Capital Resources. A serious disadvantage of I Situation of over-capitalisation is that the company is unable in making proper utilisation of its capital resources. The result is that a part of the capital of company remains idle.
5. Difficulty in Survival. Sometimes the companies declare dividend even out of capital. They do so to maintain their goodwill in capital market. The result is that the real value of capital of these companies goes on declining. This situation may cause a threat to the survival of the company itself.
(II) EFFECTS ON SHAREHOLDERS
Effects of over-capitalisation on shareholders can be explained as follows
1 Low Rate of Dividend. Immediate effect of over-capita- lisation is that the company declares dividend at a lower rate. It decreases the income of shareholders.
2. Decrease in the value of Shares. When a company is over-capitalised, market value of the shares of this company starts to decline. It causes capital loss to shareholders.
3. Loss in Case of Re-organisation. If a company decides to re-organise its capital structure due to the situation of over-capitalisation, it causes great loss to the shareholders because in case of re-organisation of capital structure, the face value of shares is decreased to a considerable extent.
(III) EFFECTS ON CONSUMERS
Consumers can also not remain unaffected if a company is over- capitalised. Important effects of over-capitalisation on consumers are as follows—
1 Increase in Prices. In case of over-capitalisation, the company increases the price of its product or products. Alternatively, the company decides to reduce the quality of its product or products. This is done with the object of increasing rate of return. In both the situations, the consumers has to suffer.
2. Mala-practices of Business. To avoid the effects of over-capitalisation, some companies adopt mala-practices such as black marketing, hoarding, profiteering etc. In these situations, consumers are the real sufferers.
(IV) EFFECTS ON SOCIETY
Society is also affected by the situations of over-capitali- sation of companies. Important effects of over-capitalisation on society can be explained as follows
1 Increase in the Prices of Goods and Services. In case of over-capitalisation, prices of goods and services increase. It is against the interests of consumers.
2. Speculative Trend. Over-capitalisation encourages the trend of speculation in society. It causes several disadvantages to the society. In case of over-capitalisation, companies try to increase their income.
3. Closure of Industries. In case of over-capitalisation, some companies go into liquidation. It causes economic setback to the country.
4. Unemployment Problem. When a company goes into liquidation due to the situation of over-capitalisation, the problem of unemployment becomes more serious.
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REMEDIES OF OVER-CAPITALISATION
Following are the remedies to overcome the situation of over-capitalisation
1 To Reduce the Face Value of Shares. A company may overcome the situation of over-capitalisation by reducing the face value of its shares can be reduced by company. Two factors are important to be noted in this regardi) The company has to take the permission of court to do so. (ii) This method is very painful because it causes a great loss to shareholders and to the goodwill of the company.
2. To Redeem Debt Capital. A company may overcome the situation of over-capitalisation by the redemption of debt capital. Debentures bearing rate of interest should be redeemed first.
3. Ploughing-back of Profit. Safest remedy to overcome the sitation of over-capitalisation is to plough back the profits. It enables a company to earn higher rate of income in future.
4. To Reduce the Number of Equity Shares. Another remedy to overcome the situation of over-capitalisation is to reduce the number of equity shares. It helps in controlling voting rights in company.
4. To Reedeem Preference Shares. A company can decide to reedeem preference shares also in order to overcome the situation of over-capitalisation. It may decide to reduce the rate of dividend also on preference shares. It may convert preference shares into equity shares also. These steps help a company in increasing disposable income for equity shareholders.
UNDER-CAPITALISATION
This situation of under-capitalisation is just opposite to the situation of over-capitalisation. The situation of under- capitalisation is known as the situation of intensive use of shares capital also. The term ‘Undercapitalisation has been defined as under
Bournville and Devie, “Under-capitalisation is not an economic problem, rather it is problem of establishing balance in capital structure.
USES OF UNDER-CAPITALISATION
1 Under-Estimation of Financial Requirements. If, at the time of establishement of a company, financial requirements of the company are under-estimated, the problem of under-capitalisation may arise in future.
2. Under Estimation of Earnings. If the estimated rate of earnings is not correct and actual rate of earning is more than the estimated rate, it may cause the situation of Under- capitalisation. For example, rate of capitalisation in an industry is 10%. It was estimated that a company will earn Rs. 40,000 per year but actual earnings of the company are Rs. 50,000. In this case, the company will be under-capitalisation by Rs. 1,00,000 because the amount of total capital should be Rs. 5,00.000 (50.000 x 100/10) but it is Rs. 4,00,000 only (40,000 x 100/10).
3. Possibility of Non-subscription of Capital. Some-times, directors of a company feel that they will not be able in collecting heavy amount of capital. To avoid the possibility of under-subscription, they issue only a small amount of capital which in turn, causes the situation of under-capitalisation.
4. Secret Reserves. When a company creates secret reserves by providing excess depreciation or by under-valuing assets or by over-valuing liabilities the situation of under- capitalisation arises because in this case, real value of assets in more than their book value.
5. Promotion During Deflation. When a company is promoted during the period of deflation, it is under-capitalised because during the period of deflation, the company gets all the assets at low prices and as soon the period of deflation is over, real value of assets of the con pany is more than their book value.
6. Trading on Equity. When a company adopts the policy of trading on equity, it may face the situation of under- capitalisation because under this policy, the company collects major part of its capital through preferences shares the debentures etc.
7. Traditional Dividend Policy. If a company decides to declare minimum dividend, the company may face the situation of under-capitalisation because in this case, the company gets capital without issuing further securities
8. Design of Control. Sometimes directors of a company want to have more and more control over the affairs of company. They do not want to loose their power. With such motive, they issue minimum amount of capital, it also causes the situation of under-capitalisation.
9. External Assistance. When a company depends upon External Assistance, the situation of under-capitalisation may arise.
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EFFECTS OF UNDER-CAPITALISATION
Under-capitalisation affects the sections and classes of Society. These effects can be explained as under
(I) EFFECTS ON COMPANY
The situation of under-capitalization affects the Company as follows
1 Inadequate Capital. The situation of Under-capitalisation implies inadequacy of capital. The company does not have adequate capital for carrying out its plans of growth and development.
2. Encouragement to Competition. An important disadvantage of under-capitalisation from the point of view of company is that it encourage competition. Higher rate of earnings of this business attracts competitors.
3. Government Interference. This situation of under-capitalisation may invite Government Interference in the affairs of the company. Government may impose restrictions upon profit margin.
4. Labour Unrest. Under-capitalisation causes unrest among workers of the compnay. When the workers come to know that their company is earing high profits, they demand more wages, bonous and better facilities. It encourages Labour Unrest and Labour Unions.
5. Opposition by Consumer. Under-capitalisation may invite opposition by consumers also. When consumers come to know that a particular company is making high profits, they demand reduction in prices.
6. Increase in Speculation. Under-capitalisation increases speculation also. When a company earns high profits, prices of its shares increase. It creates the interest of speculators in these shares.
(II) EFFECTS ON SHAREHOLDERS
The situation of under-capitalisation is always beneficial from the point of view of shareholders. Important effects of under-capitalisation on shareholders can be summarise as follows
1 Higher Rate of Dividend. Most important advantage of the situation of under-capitalisation from the point of view of shareholders is that they always get dividend at a higher rate because the company earns more profits.
2. Increase in the Market Price of Shares. Another important advantage of under-capitalisation from the point of view of shareholders is that the market price of shares of the company increases. The result is that the shareholders get capital gain.
3. Easy in Getting Loans on the Security of Shares. Sharesholders can get loans on the security of shares easily because under this situation, lenders accept these shares as security.
4. Increase in Liquidity. When a company is under the situation of under-capitalisation, liquidity of the shares of such company increases. As a resuit, shareholders can sell these shares at any time.
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(III) EFFECTS ON WORKERS
Under-capitalisation affects Workers as follows:
1 More Salary and Perquisities. Under the situation of under-capitalisation, a company can pay more salary and perquisities to its employees. From this point of view, the situation of under-capitalisation is beneficial from the point of view of workers and employees.
2. Encouragement of Labour Unions. The situation of undercapitalisation Encourages Labour Unions because in the situation, the workers demand higher remuneration and better perquisites.
(IV) EFFECTS ON SOCIETY
Under-capitalisation affects the society as under
1 Encouragement to Industrial Development. Under-capitalisation attracts new firms to enter into a market. As a result, new industries are established. Thus, under-capitalisation encourages industrial and economic development of a country.
2. Encouragement to Capital Formation. Undercapitalisation encourages capital formation also because under this situation, the income of shareholders increase which encourages their capacity to save and creates an atmosphere of savings and imvestment. Encouragement to capital formation implies high rate of economic development.
3. Increase in Employment Opportunities. Under-capitalisation encourages industrial and economic development of a country. As a result employment opportunities also increases in the country.
4. Increase in Gross National Product and Gross National Income. Combined effect of all the points described above is that under-capitalisation encourages industrial development and fastens the rate of economic development which in turn helps in increasing Gross National Product and Gross National Income.
5. Class Struggle. A social disadvantage of under-capitalisation is that is causes class struggle in the society. It makes the rich more rich and the poor more poor. When a company earns more profits, the workers and employees demand more salaries and perquisties. They also demand better working conditions. It causes a struggle between capital and labour. Similarly. consumers demand price reduction. It causes a struggle between consumers and company
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REMEDIES OF UNDER-CAPITALISATION
The situation as under-capitalisation can be overcome by adopting following measures
1 Splitting-up Share. It is a psychological treatment of the problem of under-capitalisation. If the shares of high face value are splitted up into the shares of small face value, it will not affect total amount of capital but it will decrease dividend per share. If affects the society psychologically.
2. Increase in the Face Value of Shares. If the face value of shares is increased to the extent that the face value and market price of a share are almost equal, total amount of capital will increrase and the rate of dividend will decrerase. Thus, the problem of under-capitalisation will be over.
3. Issue of New Shares. A safe remedy to overcome the problem of under-capitalisation is to issue new shares. A company can increrase its capital by issuing new shares. It will increase the amount of total capital on one hand and decrease the rate of dividend on the other.
4. Issue of Bonus Shares. Another remedy available to overcome the problem of under-capitalisation is to Issue Bonus Shares. A company can increase the amount of its total capital and decrease the rate of dividend by issuing Bonus Shares.
Conclusion. Above discussion makes it clear that both the situations of over-capitalisation and under-capitalisation are bad and a company should avoid both the situations. However, the situation of over-capitalisation is more harmful than the situation of under-capitalisation. Under the situation of overcapitalisation, all the shareholders, the company and the society suffer loss and the company has to face the shortage of adequate capital. The company should try to achieve the situation of fair- capitalisation.
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SOURCES OF SHORT-TERM FINANCE
Short-term finance means and includes the loans and advantages for a period of not more than one year. Short-term finance is required and used mainly for current assets and current liabilities such as to purchase raw materials, to pay the wages, salaries, manufacturing expenses and to pay the day-to-day expenses. Important sources of short-term finance can be summarised as follows
1 Normal Trade Credit. National Trade Credit means and includes bill payable, promissory notes, hundies, accounts current, bills of exchange etc. Normal Trade Credit is available to a business or industrial enterprise on its individual goodwill. This type of credit is becoming more and more popular these days in all types of business.
2. Bank Credit. Bank Credit means and includes bank overdraft, cash credit, discounting of bills, clean advances etc. The importance of bank credit is increasing day by day in the world of business and commerce. Such credit is provided by Commercial Panks.
3. Public Deposits. Public deposits is an important source of short-term and medium-term finance. This type of credit is available generally to the companies. They invite public deposits at a certain rate of interest for a certain period and use this amount for their short-term and medium-term requirements.
4. Private Loans. Short-term requirements are met through private loans also. These loans are provided by the directors in case of companies and by friends and relatives of proprietors or partners in case of sole trades of partnership firms.
5. Depreciation Fund. Almost all the companies maintain a Depreciation Fund to provide for the replacement of Assets. This fund is a good source of short-term and medium-term finance because there is no immediate outflow of cash.
6. Provision for Taxation. Almost all the companies maintain provision for payment of their tax liabilities. Such provision is also a good source of short-term because there is no immediate outflow of cash.
7. Advances Received from Customers. Some companies are in a position of collecting advances from their customers alongwith their orders. This money is a good source of short-term finance but this source is available only to those companies, the demand of whose product is more than their supply.
8. Money Lenders and Finance Companies. In some cases, short-term finance is provided by money lenders and finance companies also. Though the rate of interest on such finance is high, yet this is a good source incease of urgency
Capital Management Study Material
SOURCES OF MEDIUM-TERM FINANCE
Medium-term finance means and includes the loans and advances for a period of more than one year but not more than three years. These loans and advances, are used for the purposes which are neither temporary nor permanent. Important sources of Medium-term Finance can be summarised as follows
1 Financial Institutions. There are a number of financial institutions in our country which provide finance to the business and industrial enterprises for their medium-term requirements. Finance Corporation of India (F.C.I.), State Financial Corportaion (S.F.Cs.), Industrial Development Bank of India (I.D.B.I.) and Export Import Bank of India (EXIM Bank) are the important financial institutions of this category.
2. Commercial Banks. Commercial Banks play an important role in providing finance for medium-term requirements of the business and industrial enterprises. They provide this facility at a reasonable rate of interest and contribute in the growth and development of business activities in the country.
3. Public Deposits. Public deposits are also an important source of Medium-term Finance. This source of finance is available generally to the companies. They invite public deposits at a certain rate of interest for a certain period. The period of these deposits range from one year to three years.
Conclusion. Above discussion makes it clear that there are several institutions providing short-term and medium-term finance to the business and industrial enterprises to meet their short-term financial requirements. The need is to utilise the services of these institutions effectively.
Capital Management Study Material
MEANING OF COST OF CAPITAL
The Concept of Cost of Capital occupies an important place in determining the capital structure of an industrial enterprise. An industrial enterprise can collect its capital in different manners. Cost of Capital of all manners id different. Evey company tries to collect its capital at minimum cost because a high cost of capital means a decrease in the profit of company.
The term ‘Cost of Capital’ means the rate which is to be paid by an enterprise necessarily to collect its capital. According to a different opinion, Cost of Capital is reward which is paid to investors for the pains and sacrifices they have faced in saving a part of their income and for the risk they have accepted in lending their savings. This opinion of Cost of Capital proves the productivity of capital. This opinion is correct from the point of view of investors but not from the point of view of the firm. For a firm, Cost of Capital means the price paid to the investors for the use of capital. Thus, it can be concluded that Cost of Capital is the ratio between the amount collected by an enterprise from a particular source and the liability imposed upon the firm due to the amount so collected. For example, a firm takes a loan of Rs. 5,000 for one year at the interest rate of 10% annum, the Cost of Capital will be as under
Interest Due Cost of Capital =
-* 100 Amount Collected 2500 100 – 10%
5,000
If Rs. 100 are spent on collecting the loan of Rs. 5,000, the enterprise will get a net amount of Rs. 4,900 only (5,000 – 100) in this case, the Cost of Capital will be as underCost of Capital =
In the word of Prof. Solomon Ezra, “Cost of Capital is the minimum rate of earnings or the discounting rate of capital expenditure.”
Thus, according to Prof. Solomon Ezra, Cost of Capital is the amount paid for the use of capital. Therefore, a minimum amount which an enterprise must earn should not be less than the amount which is to be paid as the Cost of Capital. For example, if a company takes a loan at the interest rate of 11% per annum, the company should earn not less than 11% by using this amount of loan because if the income of company is less than 11% the company will not like to take the loan.
According to Hunt, William and Donaldson, “Cost of Capital can be defined as the rate which is reasonable earning to repay the cost of exdpenses on the maturieyt of loan.”
Above definition of Cost of Capital can be explained with the help of an example. Suppose a company takes a loan of Rs. 5,000 at the interest rate of 10% per annum and spends Rs. 100 on collecting the amount of loan. Here the company will collect a net amount of Rs. 4,900 but the company will have to pay the interest of Rs. 500 per annum (10% on Rs. 5,000). Ratio between the net amount of loan collcted by company and the interest payable on loan will be the Cost of Capital.
According to Prof. M.J. Gorden, “Cost of Capital means the Rate of Return which a company must earn on investment to maintain its value.
This definition also stresses upon the fact that when a company collects capital, it wants to invest it in the manner that it may earn the rate of return on investment which may be sufficient in maintaining the value of its shares after paying out interest. For example, if a company collects a loan of Rs. 50,000 at the interest rate of 10% per annum, the company must earn an income of not less than Rs. 5,000 per annum. If the earnings of company are less than Rs. 5,000, it will have to reduce the rate of dividend on its shares.
Capital Management Study Material
MEASUREMENT OF COST OF CAPITAL OF DIFFERENT MEANS
Cost of Capital of all the means of capital is measured separately. Thus, the method of calculating Cost of Capital of Different Means of Capital are different. These methods can be explained as under
1 Cost of Preference Shares. Preference Shares are the securities of fixed income. Rate of dividend to be paid on these shares is determined at the time of issue of these shares. Cost of these shares can be calculated by linking the dividend on shares with the Net Amount collected by the company from their issue. Cost of redeemable and irredeemable preference shars is calculated separately. It is calculated as under
(i) Cost of Redeemable Preference Shares. Redeemable Preference Shares are the shares that are to be redeemed by company after a certain Period time of Redemption of These Shares Announced at the time of Their Issue Cost of These Shares can be calculated under :
Capital Management Study Material
Capital Management Study Material
FACTORS DETERMINING INVESTMENT DECISIONS
Investment decisions occupy an important place in managerial decisions of an enterprise. Such decisions determine the project in which the capital collected by a company will be invested. Such decisions should be taken only after considering all the relevant factors. Investment should be made in the projects which may offer highest rate of return. However, the rate of return of a project should not be less than the rate of average cost of capital because if it is so, the company will have to suffer a loss. Important factors determining investment decisions are as follows
1 Cost of Capital. Cost of Capital is the most important factor affecting investment decisions of a company because the very first criteria of accepting an investment proposal is that the rate of return of this proposal should not be less than the rate of average cost of capital. If a company is successful in collecting its capital at a lower rate of average cost, the company gets wide scope of investment decisions.
2. Future Expectations of Income. If there is bright future expectations of income in a proposal, it can be accepted, even if the present rate of income is not very high. In such conditions, short-term investment proposals should be preferred so that the money invested in these proposals may be withdrawn and reinvested in more profitable projects.
3. Profitability of Investment. Profitability investment is another most important factor in determining investment decisions of a company. A company should invest its funds only in those projects which are profitable.
4. Importance of Projects. Importance of Project is another very important factor in determining investment decisions of a company. Sometimes, a company has to invest its funds in a project itself and not due to its profitability. For example, a machine is not working properly or a machine has been obsolete, the manager will have to replace this machine first so that the continutity of production activities may be maintained.
5. Nature of Plan. Nature of plan should also be considered while taking investment decisions. Some projects are of the nature that they will be profitable only in long-run. Such projects should be accepted only after considering long-term factors. Some projects are of the nature that their pay-back period is minimum. Such projects are accepted only after considering the short-term factors.
6. Availability of Funds. Availability of funds is another most important determinant of investinent proposals of a company. No company invest more than its available funds. Therefore, only those projects or a combination thereof should be selected for investment which are within the limit of funds available with a company. It is not at all advisable to invest more than capacity because it may cause economic crisis before the company.
7. Risk of Obsolescence. Rate of technological developments and economic growth have made it compulsory that the risk of obsolesence should also be taken into consideration while determining investment proposals. Only those proposals should be accepted which are not excepted to obsolete very soon. Pay-back period of the proposals should be minimum, even if the profitability of such proposal is low.
8. Fuller Utilisation of Funds. It should be considered while taking investment decisions that the company should make full utilisation of its funds. Under no circumstances, the funds available with a company should remain idle. If a company has surplus funds even after completing its all the projects under consideration, a new project may be started or the present project may be expanded.
9. Other Factors. Some are the factors which are not related with profitability but affect investment decisions considerably because a company cannot avoid to take up these proposals such as labour welfare schemes, medical facilities for workers and the facility of residential accomodation to the workers etc.
Conclusion. Investment decisions occupy an important place in managerial decisions. There is a number of factors which effect investment decisions of a company. These factors should be considered thoroughly before taking investment decisions.
Capital Management Study Material
MEANING OF PROJECT PLANNING
Project Planning means a process in which all the available alternatives for capital investment are analysed and the best available alternative proposal is selected. Thus, project planning is a process of selecting most suitable capital project from among various alternatives available.
Capital Management Study Material
NEED OF PROJECT PLANNING BEFORE STARTING THE NEW PROJECTS
It is the time of competition. Rate of product innovation and product development is very high. All the producers and sellers are in the race of capturing market demand. Tastes and preferences of consumers also keep changing. Main aim of every business and industrial enterprise is to earn maximum profit through maximum sales. This object can be achieved only if the enterprise is successful in obtaining maximum production at minimum cost. All these situations and circumstances have made it compulsory that the enterprise should select the projects only after a complete and careful analysis of all the projects available. When an enterprise has to decide about a new project, such analysis becomes more important.
CONDITIONS FOR NEW PROJECT PLANNING
There may be two situations in respect of New Project Planning
1 Project Planning by an Existing Company. In the project planning of an existing company, alternative proposals may be-Change in Capital Structure, Production of a New Product, Expansion of Present Production Capacity, Diversification of Product Line etc. Managers of an existing company find it very convenient to prepare plan for a new project because they get a support of past experience and data. They may analyse different alternatives in the light of past data and experience.
2. Project Planning for Promoting a New Company. Project planning for a new company is comparatively difficult work because in this case, the managers do not have any support of past experience and data. They do not have complete knowledge of market conditions. In such case, it is better to get the services of experts.
Capital Management Study Material
FEASIBILITY OF PROJECT PLANNING
Feasibility of the project planning should also be duly analysed so that the proposed project may be carried out easily and successfully. Following are the three types feasibilities that should be considered and analysed in Project Planning
1 Technical Feasibility. Suceess of an industrial enterprise depends to a large extent upon the techinque used in the enterprise. Severity and complexities of competition have made it compulsory that the enterprise should use latest machines and tools and latest technology of production and distribution. Therefore, technical feasibility of a project should be carefully analysed before selecting a particular project. Sometimes foreign technical collaboration is also required for the production of a particular product. Certain procedural formalties have to be completed for foreign collaboration. Sometimes, certain machines and equipments have to be imported. All these aspects should be carefully analysed.
2. Financial Feasibility. Finance is the base of business. In the absence of finance, neither a business can be established nor it can be expanded. In the absence of finance, neither a project can be started nor it can be implemented. Arrangement of adequate finance is essential to carry out all the business and industrial activities. Therefore, financial feasibility should be analysed carefully before starting a project. Cost of acquiring finance should be minimum.
3. Economic Feasibility. Economic feasibility is also an important factor to be considered and analysed in project planning. Economic feasibility means to study the position and prospects of demand of a product or service. It also includes the analysis of market conditions. Proper forecasts of demand and supply of a product or service should also be prepared.
Conclusion. It may be concluded that the amount of total capital required for a project and total expenses of the project should be estimated before starting a project because the requirements of fixed and current assets for an enterprise can be estimated only on the basis of these estimates. Along with this Teasibility of the project should also be considered because main aim of every project is to earn maximum profit.
