Module 3 Financial management is very important to every

Financial management is very important to every type of organization. It refers to that part of managerial activity concerned with the procurement

1. Module -3 Financing Decisions

2. Meaning: Financing Decisions refer to decisions regarding funding of the business enterprise. It involves identifying the various sources of finance and narrowing down sources, and deciding on the amount of fund to be mobilized from each source.

3. Based on the period categories of sources of funds I. Long-term Sources II. Medium-term Sources III. Short-term Sources

4. I. Long-term Sources of Finance Equity Shares Preference Shares Retained Earnings Debentures/Bonds Loans from Financial Institutions Loans from State Financial Corporations Loans from Commercial Banks Venture Capital Funding

5. II. Medium-term Sources of Finance Preference Shares Debentures/Bonds Public Deposits Loans from Commercial Banks Loans from Financial Institutions Loans from State Financial Corporations Lease Financing/Hire Purchase Financing

6. III. Short-term Sources of Finance Trade Credit Loans from Banks and Financial Institutions Loans from Indigenous Bankers Customer Advances Accrued Expenses Pledging of Receivables Commercial Paper

7. Cost of Capital: The term cost of capital refers to the minimum rate of return a firm must earn on its investment so that the market value of the company equity shares does not fall. Cost of capital is the rate of return the firm requires from the investment in order to increase the value of the firm in the market place .

8. Characteristics of Cost of capital Cost of capital is a rate of return, It is not a cost as such. This return, however, is calculated on the basis of actual cost of different components of capital A firm's cost of capital represents minimum rate of return that will result in at least maintaining (If not increasing) the value of its equity shares. It is related to long term capital funds.

9. 5. Cost of capital consists of three components : a)Return at Zero Risk Level. (r0) b)Premium for Business Risk (b) c)Premium for Financial Risk (f) 6. The cost of capital may be put in the form of the following equation : K = ro + b + f Where K = Cost of Capital ro = Return at Zero Risk Level b = Premium for Business Risk f = Premium for Financial Risk

10. Elements of cost of capital: The cost of capital consist of the following elements: Cost of debt ( Kd ) Cost of Equity ( Ke ) Cost of preference capital ( Kp ) Cost of retained earning (Kg)

11. 1. Cost of debt ( Kd ) The cost of debt is the effective rate that a company pays on its debt a) Cost of debt, issued at Par, before tax effect. Kd =I/NP Kd = Cost of debt before tax I = interest NP= Principal Value

12. b) Cost of debt raised at premium or discount In case of premium, Principal amount will be increased by premium. in case of discount, principal amount will be face value less discount amount. Kd = I/NP Np= Net proceeds on issue of debt In case of debt issued at premium NP=Face value + Premium In case of discount NP= Face value- Discount value

13. c) Cost of debt Considering tax effect The payment of interest on debt is a statutory obligation. On profit firstly interest is deducted then tax is paid on remaining earnings Thus, interest on debt has tax advantage. Kd = I/NP (1-t) Kd = Cost of debt t= Tax rate NP= Net Proceeds

14. Cost of redeemable debt:

15. ii) Cost of Preference share capital: There is a fixed percent of payment on preference share capital, whenever the dividend is paid to them. The payment of dividend to preference share holder is dependent upon the discretion of board of directors, but it does not mean that preference share capital has no cost. Since , dividend is paid out of profit after tax, thus there is no tax advantage on cost of capital of preference share capital.

16. As per the Companies Act 2013, in India, preference shares have a defined life, therefore, these has to be redeemed as and when maturity period arises. Secondly , no share can be issued at discount, thus preference shares will be issued either at par or premium. Thus ,net proceeds will not be less than the face value in any case . However, any expenditure incurred on issue of shares may be deducted from the face value.

17. Cost of preference share capital

18. a) Cost of equity capital “Cost of equity capital is the cost of the estimated stream of net capital outlays desired from equity sources” E.W. Walker.

19. The cost of equity share capital can be computed in the following ways: Dividend yield / dividend price method Dividend yield plus growth in dividend Earning price or earning yield approach

20. 1. Dividend yield / dividend price method: According to this method the cost of equity is calculated as Ke = D / Np ( this formula is applied in the case of new equity share) Ke = D / Mp (this formula is applied in the case of existing shares) Where. Ke = cost of equity ; D = dividend per share Np = net proceeds per share Mp = Market price of the share.

21. Assumption of Dividend yield method Investors give prime importance to dividend Risk of the firm remain unchanged There is no growth in future dividend It does not consider the retained earnings

22. 2. Dividend yield plus growth in dividend When the dividends of the firm are expected to grow at a constant rate and the dividend payout is constant, this method is used to compute cost of equity . Ke = D/NP + G (growth rate) (in the case of new shares) Ke = D/ MP + G (growth rate) (in the case of existing shares)

23. 3.Earning Yield approach This method is also known as earning/Price ratio method. This method adheres the basic relationship between earnings and market price of the security. This method is applicable when the earnings per share are expected to remain constant. Cost of equity based on earnings approach is Ke = E/NP x 100 ( for new share capital) Ke = E/MP x 100 ( for existing equity share capital)

24. 4. Cost of retained earnings: Kr= Ke

25. Weighted Average cost of capital

26. Cost of capital may be categorized into the following types on the basis of nature and usage: Explicit and Implicit Cost. Average and Marginal Cost. Historical and Future Cost. Specific and Combined Cost.

27. 1. Explicit and Implicit Cost: The cost of capital may be explicit or implicit cost on the basis of the computation of cost of capital. Explicit cost is the rate that the firm pays to procure financing. An explicit cost is one that has occurred and is evidently reported as a separate cost. It is defined as direct payment to others in doing business such as wage, rent and materials.

28. 2. Average and Marginal Cost: Average cost of capital is the weighted average cost of each element of capital employed by the company. It reflects weighted average cost of all kinds of financing such as equity, debt, retained earnings. Marginal cost is the weighted average cost of new finance raised by the company. It is the extra cost of capital when the company goes for further raising of finance.

29. 3. Historical and Future Cost: Historical cost is the cost which is already been incurred for financing a particular project. It is based on the actual cost incurred in the earlier project. Future cost is the expected cost of financing in the proposed project. Expected cost is calculated on the basis of previous experience.

30. 4. Specific and Combine Cost: The cost of each sources of capital such as equity, debt, retained earnings and loans is termed as specific cost of capital. It is beneficial to determine the each and every specific source of capital. The composite or combined cost of capital is the amalgamation of all sources of capital. It is also called as overall cost of capital. It is used to recognize the total cost associated with the total finance of the company.