UNIT 2- FINANCING DECISION

Financing decisions refer to the decisions that

companies need to take regarding what
proportion of equity and debt capital to have in
their capital structure.
SOURCES OF FINANCE
 EQUITY FINANCING
• Equity financing means exchanging a portion of the ownership of the business for a
financial investment in the business. The ownership stake resulting from an equity
investment allows the investor to share in the company’s profits. Equity involves a
permanent investment in a company and is not repaid by the company at a later date.
• The investment should be properly defined in a formally created business entity. An
equity stake in a company can be in the form of membership units, as in the case of a
limited liability company or in the form of common or preferred stock as in a
corporation.
• Companies may establish different classes of stock to control voting rights among
shareholders. Similarly, companies may use different types of preferred stock. For
example, common stockholders can vote while preferred stockholders generally
cannot. But common stockholders are last in line for the company’s assets in case of
default or bankruptcy. Preferred stockholders receive a predetermined dividend
before common stockholders receive a dividend.
 DEBT FINANCING

• Debt financing involves borrowing funds from creditors with the stipulation of
repaying the borrowed funds plus interest at a specified future time. For the
creditors (those lending the funds to the business), the reward for providing the
debt financing is the interest on the amount lent to the borrower.
• Debt financing may be secured or unsecured. Secured debt has collateral (a
valuable asset which the lender can attach to satisfy the loan in case of default by
the borrower). Conversely, unsecured debt does not have collateral and places the
lender in a less secure position relative to repayment in case of default.
• Debt financing (loans) may be short-term or long-term in their repayment
schedules. Generally, short-term debt is used to finance current activities such as
operations while long-term debt is used to finance assets such as buildings and
equipment.
 CAPITAL STRUCTURE

• Financial structure refers to the way the firm’s assets are

financed. It includes both long-term as well as short-term of
funds.
• Capital structure is the permanent financing of the
company represented primarily by long-term debt and
shareholders’ funds but excluding all short-term credits.
 OPTIMUM CAPITAL STRUCTURE

• The optimal capital structure of a firm is the best mix of debt

and equity financing that maximises a company’s market
value while minimising its cost of capital.
• In theory, debt financing offers the lowest cost of capital due
to its tax deductibility.
• However, too much debt increases the financial risk to
shareholders and the return on equity that they require.
 PATTERNS OF CAPITAL
STRUCTURE

1. Capital structure with equity shares only

2. Capital structure with both equity and preference shares
3. Capital structure with equity shares and debentures.
4. Capital structure with equity shares, preference shares and
debentures.
 FACTORS INFLUENCING
CAPITAL STRUCTURE
1. Expected Cash Flows:
Debentures and preference shares are often redeemable, i.e., they are to be
paid back after their maturity. The expected cash flows over the years must
be sufficient to meet the interest liability on debentures every year and also
to return the maturity amount at the end of the term of debentures. Thus,
debentures are not suitable for those companies which are likely to have
irregular cash flows in future.
2. Stability of Sales:
Stability of sales turnover enhances the company’s ability to pay interest on
debentures. If sales are rising, the company can use more of debt capital as it
would be in a position to pay interest. But if sales are unstable or declining,
it would not be advisable to employ additional debt capital.
3. Control over the Company:
The control of a company is entrusted to the Board of Directors elected by the equity
shareholders. If the board of directors and shareholders of a company wish to retain
control over the company in their hands, they may not allow to issue further equity
shares to the public. In such a case, more funds can be raised by issuing preference
shares and debentures.
4. Flexibility of Financial Structure:
A good financial structure should be flexible enough to have scope for expansion or
contraction of capitalisation whenever the need arises. In order to bring flexibility,
those securities should be issued which can be paid off after a number of years. Equity
shares cannot be paid off during the life time of a company. But redeemable preference
shares and debentures can be paid off whenever the company feels necessary. They
provide elasticity in the financial plan.
5. Period of Financing:
When funds are required for permanent investment in a company, equity share capital
is preferred. But when funds are required to finance expansion programme and the
management of the company feels that it will be able to redeem the funds within the
life-time of the company, it may issue redeemable preference shares and debentures.
Earning per share (EPS) = Total Earnings/No. Of Equity share
Q1. A Ltd. had a share capital of Rs. 1,00,000 dividend into shares of
Rs. 10 each. It has a major expansion programme requiring an
investment of another Rs. 50,000. The management is considering
the following alternatives for raising this amount:
(1) Issue of 5,000 equity shares of Rs. 10 each.
(2) Issue of 5,000 12% preference shares of Rs. 10 each.
(3) Issue of 10% debentures of Rs. 50,000.
The company’s present earnings before interest and tax (EBIT)is Rs.
40,000 p.a. You are required to calculate the effect of each of the
above modes of financing on the earning per share (EPS) presuming:
(a) EBIT continues to be the same even after expansion.
(b) EBIT increases by Rs. 10,000.
Q2. The R Co. Ltd. operates its business with an equity capital of Rs. 50,00,000 of
Rs.100 per share. Company wants to raise further Rs. 30,00,000 for major
expansion programme with following 4 alternative plans:
(a) All equity shares
(b) All Debentures at 10% interest rate
(c) Rs. 10,00,000 from equity and RS. 20,00,000 from 10% Debentures
(d) Rs. 15,00,000 from equity and Rs. 15,00,000 from 10% preference shares
The Co. Tax rate is 50%. Calculate E.P.S of each plan of E.B.I.T is Rs. 8,00,000.
Q3. Sonu Ltd. company has equity share capital for Rs. 10,00,000 divided into
shares of Rs. 100 each. It wishes to raise further Rs. 6,00,000 for expansion plans.
The company plans the following financing schemes:
a) All equity shares.
b) Rs. 2,00,000 in equity shares and Rs. 4,00,000 in debt @ 10% p.a.
c) All debt at 10% p.a.
d) Rs. 2,00,000 equity shares and RS. 4,00,000 in preference share capital with rate
of dividend at 8%.
The company has estimated EBIT at Rs.3,00,000. The corporate rate of tax is 50%.
Calculate EPS in each case. Give a comment as to which capital structure is
suitable.
Q4. A company is now capitalised with Rs. 5,00,000, consisting of 10,000 equity
shares of Rs. 50 each. Additional finance of Rs. 10,00,000 is required for major
expansion programme launched by the company. Three possible financing plans
are under consideration. These are:
1. Entirely through additional share capital, issuing 20,000 equity shares of Rs. 50
each.
2. Rs. 5 lakh through equity share capital and Rs. 5 lakh through debentures at
12% interest.
3. Rs. 5 lakh through equity share capital and Rs. 5 lakh through 10% preference
shares.
The company existing EBIT amount to Rs. 10 lakh and tax rate is 50%. Calculate
EPS for each case.
Q5. A company is now capitalised with Rs. 50,00,000, consisting of 10,000 equity
shares of Rs. 500 each. Additional finance of Rs. 50,00,000 is required for major
expansion programme launched by the company. Three possible financing plans
are under consideration. These are:
1. Entirely through additional share capital, issuing 10,000 equity shares of Rs.
500 each.
2. Rs. 25 lakh through equity share capital and Rs. 25 lakh through debentures at
12% interest.
3. Rs. 25 lakh through equity share capital and Rs. 25 lakh through 10%
preference shares.
The company existing EBIT amount to Rs. 6 lakh and tax rate is 50%. Calculate
EPS for each case.
Q6. ABC Ltd. is capitalised with Rs. 7,00,000 divided into 70,000 equity shares of
Rs. 10 each. The management plans to raise another Rs. 5,00,000 to finance some
expansion programme.
The following are the four possible plans:
1) All equity shares.
2) Rs. 2,50,000 in equity shares and the balance in debentures carrying
10% interest.
3) Rs. 2,50,000 in equity shares and Rs. 2,50,000 in preference share carrying 10%
dividend.
4) All debentures carrying 8% interest.
The existing EBIT amounts to Rs. 60,000 p.a. Calculate EPS in all the above four
plans.
Q7. A Ltd. Company has equity share capital of Rs. 5,00,000 divided in to shares
of Rs. 100 each. It wishes to raise further Rs. 3,00,000 for expansion plans. The
company plans the following financing schemes:
A) All common stock
B) Rs. 1,00,000 in common stock and Rs. 2,00,000 in debt at 10% p.a.
C) All debts at 10% p.a.
D) Rs. 1,00,000 in common stock and Rs. 2,00,000 in preference capital with the
rate of dividend at 8%.
The company’s EBIT are Rs. 1,50,000. The rate of tax is 50%. Determine EPS in
each plan and suggest which plan is suitable?
Q8. A company’s capital structure consists of the following:
Equity shares of Rs. 100 each Rs. 20 Lakhs
Retained Earnings Rs. 10 Lakhs
9% Preference Shares Rs. 12 Lakhs
7% Debenture Rs. 8 Lakhs
Total Rs. 50 Lakhs
The company earns 12% on its capital. The income tax rate is 50%. The company
requires sum of Rs. 25 Lakhs to finance its expansion programme for which
following alternatives are available to it:
(1) Issue of 20,000 equity shares at a premium of Rs. 25 per share
(2) Issue of 10% preference shares.
(3) Issue of 8% debentures.
Calculate Earning Per Share.
Q9. B Ltd. had a share capital of Rs. 1,00,000 divided into Rs.
50,000 by issuing equity shares of Rs. 10 each and Rs. 50,000 by 8%
preference shares. It has a major expansion programme requiring an
investment of another Rs. 50,000. The management is considering
the following alternatives for raising this amount:
(1) Issue of 5,000 equity shares of Rs. 10 each.
(2) Issue of 5,000 12% preference shares of Rs. 10 each.
(3) Issue of 10% debentures of Rs. 50,000.
Calculate the Preference dividend and no. of equity shares for each
alternative.
Q10. The X company’s capital structure consists of the following:
Equity shares of Rs. 100 each Rs. 25 Lakhs
9% Preference Shares Rs. 15 Lakhs
7% Debenture Rs. 10 Lakhs
Total Rs. 50 Lakhs
Company wants to raise further Rs. 30,00,000 for major expansion programme
with following 4 alternative plans:
(a) All equity shares
(b) All Debentures at 10% interest rate
(c) Rs. 10,00,000 from equity and RS. 20,00,000 from 10% Debentures
(d) Rs. 15,00,000 from equity and Rs. 15,00,000 from 10% preference shares
Calculate the following items for all the alternatives:
1. Preference dividend
2. Interest on debenture
3. No. of Equity shares
Q11. S Ltd. company has equity share capital for Rs. 10,00,000 divided as follow:
Equity shares of Rs. 100 each Rs. 5 Lakhs
7% Preference Shares Rs. 2 Lakhs
9% Debenture Rs. 3 Lakhs
It wishes to raise further Rs. 6,00,000 for expansion plans. The company plans the
following financing schemes:
a) All equity shares.
b) Rs. 2,00,000 in equity shares and Rs. 4,00,000 in debt @ 10% p.a.
c) All debt at 10% p.a.
d) Rs. 2,00,000 equity shares and Rs. 4,00,000 in preference share capital with rate
of dividend at 8%.
Calculate Interest on debenture, preference dividend and number of equity shares.
Q12. A Reliance Industries company Limited has equity share capital of Rs.
6,76,59,90,000 divided in to shares of Rs. 10 each. It wishes to raise further Rs.
1,00,00,000 for expansion plans. The company plans the following financing
schemes:
A) All equity share at Rs. 1257.
B) Rs. 50,00,000 in equity shares and Rs. 50,00,000 in debt at 8.85% p.a.
C) All debts at 8.85% p.a.
The company’s EBIT are Rs.6,80,00,000. The rate of tax is 30%. Determine EPS
in each plan and suggest which plan is suitable?
Q13. A company has EBIT of Rs. 4,80,000 and its capital structure
consists of the following securities.
Equity share capital (Rs. 10 each) Rs. 4,00,000
12% preference shares Rs. 6,00,000
14.5% debentures Rs. 10,00,000
The company is facing fluctuation in its sales.
What would be percentage change in EPS
a) If EBIT of the company increases by 25%?
b) If EBIT of the company decreases by 25%? The company tax rate
is 35%.
Q14. A company has EBIT of Rs. 8,00,000 and its capital structure
consists of the following securities.
Equity share capital (Rs. 10 each) Rs. 5,00,000
10% preference shares Rs. 6,00,000
12% debentures Rs. 10,00,000
The company is facing fluctuation in its sales.
What would be percentage change in EPS
a) If EBIT of the company increases by 15%?
b) If EBIT of the company decreases by 15%? The company tax rate
is 30%.
LEVERAGES
• JAMES HORNE HAS DEFINED LEVERAGE AS
THE EMPLOYMENT OF AN ASSET OR SOURCES
OF FUNDS FOR WHICH THE FIRM HAS TO PAY A
FIXED COST. THE FIXED COST REMAINS
CONSTANT IRRESPECTIVE OF THE CHANGE IN
VOLUME OF OUTPUT OR SALES.
• THE EMPLOYMENT OF AN ASSET OR SOURCES
OF FUNDS FOR WHICH THE FIRM HAS TO PAY
FIXED COST HAS A CONSIDERABLE
INFLUENCE ON THE EARNINGS AVAILABLE
FOR EQUITY SHAREHOLDERS.
LEVERAGE IS THE FIRM’S ABILITY
TO USE FIXED COST ASSETS OR
FUNDS TO INFLUENCE THE
RETURN TO ITS OWNERS.
 TYPES OF LEVERAGES

1. OPERATING LEVERAGE
2. FINANCIAL LEVERAGE
3. COMPOSITE LEVERAGE
 OPERATING LEVERAGES

• The tendency of the operating pro it to vary disproportionately with sales.

• It is said to exist when a irm has to pay ixed cost regardless of volume of output or sales.
• Operating leverage = Contribution/Operating Pro it or C/OP
• Operating Pro it here means the Earning Before Interest and Tax (EBIT).
• Contribution > Fixed Cost = Favourable
• Contribution < Fixed Cost = Unfavourable
• High degree of Operating Leverage = Small changes in sales will have large e ects on operating
income.
• In other words, Operating pro it (EBIT) of such a irm will increase at a faster rate than the increase in
sales.
• Similarly, the operating pro its of such a irm will su er a greater loss as compared to reduction in its
sales.
• Generally, the irms do not like to operate under conditions of a high degree of operating leverage as
its very risky.
f
f
f
f
f
f
f
f
f
f
ff
ff
 Q1. The installed capacity of a factory is 600 units. Actual capacity used is 400 units. Selling price per unit
is Rs. 10. Variable cost is Rs. 6 per unit. Calculate the operating leverage in each of the following three
situations:

1. When Fixed costs are Rs. 400

2. When Fixed costs are Rs. 1,000

3. When ixed costs are Rs. 1,200.

Sales- VC= Contribution - FC= Operating pro it

Op. Leverage= Contribution /Op. pro it

f
f
f
Q2. FROM THE FOLLOWING INFORMATION CALCULATE OPERATING,
FINANCIAL AND COMBINED LEVERAGES.
SALES RS. 10,00,000
VARIABLE COST 30%
FIXED COST 2,00,000
10% DEBENTURE CAPITAL IS RS. 15,00,000
TAX RATE IS 50%.
 FINANCIAL LEVERAGE

• Financial Leverage = OP or EBIT/PBT

• According to Gitman, inancial leverage is the ability of a irm to use ixed inancial charges to
magnify the e ects of changes in EBIT on the irm’s earning per share.
• Computation:
1. Where capital structure consists of equity shares and debt.
2. Where capital structure consists of equity shares and preference shares.
3. Where capital structure consists of equity shares, preference shares and debt.
ff
f
f
f
f
f
Q1. A company has a choice of the following three inancial plans. You are
required to calculate the inancial leverage in each case.

Particulars X Y Z

Equity capital 2,000 1,000 3,000

Debt 2,000 3,000 1,000

Operatig Pro it (EBIT) 400 400 400

Interest @ 10% on debt in all cases.

f
f
f
2. Where capital structure consists of preference shares and equity shares.

Q2. The capital structure of a company consists of the following securities:

10% Preference Share Capital Rs. 1,00,000
Equity Share Capital (Rs. 10 Shares) Rs. 1,00,000
The amount of Operating Pro it is Rs. 60,000. The company is in 50% tax bracket.
You are required to calculate the Financial leverage of the company.
What would be new Financial Leverage if the Operating pro it increase to Rs.
90,000 and interpret your results.
f
f
 Computation of the Financial Leverage

Particulars Amount

Operating pro it/EBIT 60,000

- preference dividend (Pref. Div/1-tax rate) (10,000/1-.5) 20,000

PBT 40,000

FL= EBIT/PBT 1.5

f
 3. Where the capital structure consists of equity shares, preference shares and
debt.

Q3. A company has the following capital structure:

Equity Share Capital Rs. 1,00,000
10% Preference Share Capital Rs. 1,00,000
8% Debetures Rs. 1,25,000
The present EBIT is Rs. 50,000. Calculate the Financial Leverage assuming that
company is in 50% tax bracket.
FL= EBIT/PBT
 COMPOSITE LEVERAGE

• The composite leverage is combination of operating leverage and inancial leverage.

• It expresses the relationship between revenue on account of sales and the taxable income.
Composite Leverage = OL * FL
= C/OP * OP/PBT
= C/PBT

f
Q1. A COMPANY HAS SALES OF RS. 1 LAKH. THE VARIABLE COSTS ARE 40%
OF THE SALES WHILE THE FIXED OPERATING COSTS AMOUNT TO RS.
30,000. THE AMOUNT OF INTEREST ON LONG TERM DEBT IS RS. 10,000.
YOU ARE REQUIRED TO CALCULATE THE COMPOSITE LEVERAGE AND
ILLUSTRATE ITS IMPACT IF SALES INCREASE BY 5%.