(Subject Notes) Business Studies

- Financial Management -

State 5 factors that determine/affect the CAPITAL STRUCTURE of a company? (very important)

Financial leverage:

The financial manager should carefully examine how the use of the proposed financing mix will affect the risk and returns of the owners.

The financial leverage used by the company will depend on the amount of risk the company would like to take.

Flexibility:

The capital structure of the company should be flexible enough to -

Adapt to changing conditions whenever required.

• Raise additional funds without undue delay and cost.

Legal framework:

• The Companies Act and SEBI provide guidelines from time to time on how the shares and debentures should be issued to the public.

• The finance manager of the company must be aware of all these rules and regulations and carefully consider these guidelines while deciding on the capital structure of the company.

Market conditions:

The conditions in the capital market also influence to a certain extent the decisions regarding capital structure. It may not affect the capital structure initially but when the company requires additional funds then the appropriate time for issuing the shares or debentures should be considered.

Control:

• If the owners want to maintain a tight control over the company it should obtain its funds through loans because debenture and preference shareholders do not have a right to manage the affairs of the company.

• However if the owners want to dilute the control, they can raise funds through issue of equity shares, as equity share holders have a right to vote.

One of the EFFECTS OF UNDER CAPITALIZATION is that the market value of shares goes up. But still under capitalization is not considered good for the Co. Why?

Effects of under capitalization on the company: (increases, goodwill, credit worthiness competition and demand for higher salaries)

• Increases creditworthiness and goodwill of the company as market value of shares goes up due to high profitability

• An under capitalized company earns more than the prevailing rate of profit in the industry. But this may induce competitors to enter the same line of business and pose a threat to the company.

• The employees demand higher salaries, which may lead to dissatisfaction and labour tension.

• Secret reserves are built.

• Exceptionally high rate of profit may induce Government to impose heavy tax, which leads to reduction in company profits.

If you have to choose between two situations of over capitalization and under capitalization, which one will you prefer and why?
(Ans: I would prefer under capitalization due to the following reasons)

Or

Both under capitalization and over capitalization are evils, but under capitalization is lesser evil. Do you agree? Give reasons for your answer – 5 points (5 marks 100 words)

• Yes, I agree with the above statement.

• Over capitalization means that capital is not being effectively used and the earnings are less and do not justify the amount of capital that is employed in the business i.e. a fair return is not realized on capitalization.

• Under utilization on the other hand means that the rate of profit earned on capital invested is higher than the return enjoyed by similar companies in the same industry or when the value of assets is more than the amount of capital.

• Under capitalization has its own evil consequences but it is not as fatal as in the case of over capitalization because:

  • Under capitalization is a condition that cannot exist for long.

  • Higher earnings attract competition.

  • Government intervention in the form of higher taxes leads to reduction in company profits.

  • The economy takes care of an under capitalized company and because of its pulls and pressures, the company comes back to normal.

• On the other hand, over capitalization is a serious problem. To overcome the ill effects of over capitalization, the company will have to be completely reorganized and the consequence of this have to be faced by the shareholders and creditors.

• Hence we can conclude that under capitalization is a lesser evil.
  (if student conveys suitable meaning in any format, full credit should be given)

Explain briefly any 5 factors to be considered while determining the requirements of WORKING CAPITAL of a business enterprise? CBSE-2004(2) (C) – 5 marks Anagram – COINS required for working capital

Credit policy:

Less working capital is required if a liberal credit policy is followed i.e. when suppliers grant the firm credit for supply of raw materials, etc.

Operating cycle:

Operating cycle refers to the manufacturing cycle, which converts raw material to finished goods. If the operating cycle is long then more working capital is required and vice versa.

Inventory policy:

If the business requires keeping a large stock of inventory, working capital requirement will be more and vice versa.

Nature of business:

The amount of working capital required depends on the nature of business of the enterprise. Trading companies require less working capital than manufacturing companies because in trading companies or retail shops:

• the transactions are mostly done in cash

• length of the operating cycle is small,

• time gap between goods acquired and sold is less; and

• turnover is high

Seasonal operations:

If the products have a steady demand in the market throughout the year, then the working capital requirements remain constant in a business. However when demands for products are seasonal sales increases. To cater to this increase in sales, there is a demand to produce more. Hence more working capital is required during this time

Explain in brief any 5 factors that should be taken into consideration while determining the long-term DIVIDEND POLICY – 2004 (set 3) 2004 Compartment (Sets 1 and 3),

(Anagram to remember this answer is: There are LEGAL RESTRICTIONS for ISSUE OF BONUS SHARES as the company has to CONSIDER THE CAPITAL MARKET and follow a STABLE DIVIDEND POLICY for FINANCIAL REQUIREMENTS OF THE COMPANY) - FLICS

Legal restrictions:

According to the Companies Act, a company

• Cannot pay dividends from its paid up capital

• Can use its profits for other purposes only after it has made depreciation for payment of dividends.

Issue of Bonus shares:

Sometimes companies issue bonus shares (also known as stock dividend) instead of cash dividends. This helps to increase the number of shares of the shareholder as well as the capital base of the company. It keeps investors happy. The issue of bonus shares is an integral part of the dividend policy.

Capital market considerations:

When a company needs funds for investment it has two options open:

• If the company has easy access to capital market then it can afford to pay more dividends and raise additional equity by tapping the capital market; or

• If the company has limited access to capital market, then it can pay low dividends to its shareholders and rely on retained earnings for funding its investments.

Stable dividend policy:

Most companies, shareholders and even financial institutions like UTI, IDBI prefer to invest in companies that follow a stable dividend policy because:

• It has a favourable impact on the market value of the shares

• It removes the uncertainty in the minds of the investors

• It satisfies their desire for current income

Financial requirements of the company:

• If the company has many investment opportunities then it should pay low dividends to its shareholders and reinvest its profits in the business.

• It is cheaper to use retained earnings to finance the projects, as they do no involve floatation costs and any legal formalities.

• Mature companies normally have few investment opportunities and so declare high dividends while growth companies, which are always in need of funds to finance their assets, normally declare low dividends.

eBooksin this chapter ( 5 marks each two questions will be asked = 10 marks)

• Objectives/Importance of financial planning – CBSE 2005 Set 1 (Imp)

• 5 causes of over capitalization?

• 5 causes of under capitalization?

• 5 effects of over capitalization on company -2005(Sets 1 and 2)- Imp

• 5 effects of overcap. on shareholders OR Over capitalization is a curse to shareholders –v imp (2004 Sets1,2,3)

• 5 factors that determine capital structure-2005 (Set2)2004 Compartment(2)

• 5 factors that determine working capital – 2004(set 2) 2004 Compartment Sets 1 and 3

• 5 factors that determine dividend policy 2004 (set 3) 2004 Compartment (Sets 1 and 3),

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