financing decision

1. FINANCIAL MANAGEMENT

2. FINANCING DECISION
MODULE 2

3. INTRODUCTION
 Finance is the basic requirement of any business.
 FM deals with 3 types of decisions :
investment decision
financing decision
dividend decision.

4. FINANCING DECISION
 Crucial decision made by the financial manager
relating to the financing mix of an organisation.
 The decisions related to raising finance.
 Identification of various sources of finance and the
quantum of finance to be raised from different
sources.
 Objective is to maintain an optimum capital
structure ( a proper mix of debt and equity)

5. Factors affecting financing decisions
 Risk involved in raising funds - least risk must be
selected
 Cost - cheapest source must be selected
 Level of control - dilute control or not
 Floatation cost( brokers commission, underwriters
fees) – lesser floatation cost must be selected

6. Unit 1 sources of finance
Unit 2 – cost of capital
Unit 3 – capital structure &leverage

7. UNIT 1 -- Sources of Finance
 The ways for mobilising finance
 Choosing the right source and right mix of finance is a
key challenge for fin mgrs.
 Choosing the source – in depth analysis is required.

8. Financial Requirement
 Long term financial requirement (fixed capital)
 Short term financial requirement (working capital)

9. CLASSIFICATION OF SOURCES
OF FINANCE
 On the basis of
A. TIME PERIOD
B. OWNERSHIP
C. SOURCE OF GENERATION
D. MODE OF FINANCING

10. A. On the basis of time period
1. Long term sources
-- capital requirements for a period of more than 5
years
eg: equity shares, pref shares, long term loan, fixed
deposits.
2. Medium term sources
-- Financing for a period within 5yrs
eg : debenture, bond, medium termloans,public
deposits
3. Short term sources - financing within one year
eg : customer advances, bank credit commercial
papers, trade credit etc..

11. B. On the basis of Ownership
1. Owned capital ( share capital, retained
earnings,surplus etc)
2. Borrowed capital (loans, debenture,pd,bonds etc..)

12. C . Based on Source of Finance
1. INTERNAL SOURCES (profits,surplus,retained
earnings)
2. EXTERNAL SOURCES (loans, shares,debentures)

13. D. Mode of Financing
1. Security financing (external financing)
2. Internal financing
3. Loan financing

14. 1. SECURITY FINANCING
 Finance mobilised through the issue of securities
(shares , debentures).
 Two major types of security financing:
OWNERSHIP SECURITIES
CREDITORSHIP SECURITIES

15. OWNERSHIP SECURITIES (Capital
stock)
 Equity shares
 Preference shares
 Deferred shares
 No par stock
 Sweat equity

16. EQUITY SHARES
 Basic source of financing
 Real owners of the company
 Risk capital
 Permanent capital
 Fluctuating dividend to shareholders
 Residual claimant
 Voting rights
 Mgt and control of company

17. ADVANTAGES & DISADVANTAGES
 TO THE COMPANY
 TO THE INVESTORS

18. PREFERANCE SHARES
 Preferential rights as regards payment of dividend
& repayment of capital
 Fixed rate of dividend
 No voting rights
 No participation in mgt and control
 Less risky

19. DEFERRED SHARES
 Founders shares
 Issued to promoters or founders
 Shareholders have preferential right to get dividend
before the preferance and equity shareholders
 No public ltd company can issue it.

20. NO PAR STOCK
 No par value stock is issued without a par value or face
value
 No designated minimum value.
 Indian companies cannot issue no par stock

21. SWEAT EQUITY SHARES
 Equity shares given to company’s directors or
employees on favourable terms in recognition of
their special contributions or extra efforts for the
company.
 Price lower than nominal value of equity share
 Retain the employees by rewarding them for their
services.
 Eg: if a person works for creating patents for a
company or providing technical know how or brand
rights... Then the company will issue equity shares to
him, instead of paying cash for his service.

22. CREDITORSHIP SECURITIES
 Holders of creditorship securities are the creditors of a
company.
 Enjoy fixed rate of interest on their investments.
 Eg: debentures, bonds
 Acknowledgement of debt

23. Debentures
 Long term source of fund
 Debt instrument carrying fixed interest issued by
companies to borrow money from the capital market.
 Constitute the loan capital of the company
 Debenture holders are the creditors of the company
 Fixed rate of interest on debenture
 No voting rights.
 Fixed financial burden to the company
 Safer investment as compared to shares.

24. Bonds
 Traditionally, these are instruments issued by govt,
semi- govt bodies and public corporations.
Debenture denotes instruments issued by the corporate
sector.
 Comparatively low rate of interest than debentures
 Moe secured than debentures.
 Registered bonds, bearer bonds, zero coupon bond,
junk bond, bunny bonds

25. Difference between share &debenture
Shares Debentures
 Part of owned capital
 Owners
 Do not have any charge on
assets of the company
 Fluctuating dividend
 Dividend on shares only if
there is profit
 Shareholders have voting
rights
 Loan to the company
 Creditors
 Secured
 Fixed rate of interest
 Interest if there is profit
or loss
 No voting rights.

26. 2. LOAN FINANCING
 Short term finance
eg: trade credit, bank credit, public deposits, retained
earnings,factoring, commercial paper, inter corporate
deposits.
 Long term finance
eg: Ownership securities , creditorship securities

27. 3. RETAINED EARNINGS(PLOUGHING
BACK OF PROFITS)
 Internal source of finance
 Technique in which all profits are not distributed
among shareholders but a part is retained in the
company and invested in future business operations.
 Capital base of the business
 Economical method of financing

28. 4. NEW INNOVATIVE SOURCES OF
FINANCE
 BRIDGE FINANCE
 VENTURE CAPITAL
 HIRE PURCHASE
 LEASE FINANCING
 SEED CAPITAL
 FACTORING
 FORFAITING
 SECURITISATION
 DEPOSITORY RECEIPTS

29. COST OF CAPITAL
UNIT 2

30. INTRODUCTION
 Concept of Cost of capital is of great importance in
financial decision making.
 Funds deployed for a project must earn sufficient
returns .
 In FM , this minimum expected rate of return of a
project is called the cost of capital of the project.
 Every investment decision must be after taking into
account the minimum expected rate of return or cost of
capital

31. MEANING & DEFINITION
 HAMPTON ---- cost of capital the rate of return the firm
requires from investment in order to increase the value of
the firm in the market place.
 Defined as the cost of obtaining funds ie, the average rate
of return that the investors in a firm would expect for
supplying funds to the firm.
 In FM terminology, the minimum expected rate of return of
a project is called cost of capital of the project
Minimum rate of return expected by its investors.
 Weighted average cost of various sources of finance used
by a firm

32. COST OF CAPITAL
 Rate of return that the suppliers of capital require as
compensation for their contribution of capital
 The minimum rate expected by its investors
 The capital used by the firm in the form of equity
shares, pref shares,retained earnings, debt .
 It is the weighted average cost of various sources of
finance
 In case the company not able to achieve the cut off
rate, the market value of its share will fall.
 Return should be more than cost of capital
 Cost of capital is expressed in terms of percentage

33. IMPORTANCE OF COST OF CAPITAL
 Investment decisions
 Designing capital structure
 Evaluation of financial performance
 Accept or reject expansion proposals
 Optimum utilisation of resources

34. CLASSIFICATION OF COST OF
CAPITAL
 HISTORICAL & FUTURE COST
 SPECIFIC COST& COMPOSITE/ COMBINED
COST
 EXPLICIT COST & IMPLICIT COST
 AVERAGE COST & MARGINAL COST

35. To sum up....
 Cost of capital can be defined in 3 aspects:
1. Minimum RoR a firm must earn from its investment
in order to maximise value of the firm
2. It is the minimum RoR expected by investors
3. It is the cost incurred by a firm inorder to finance its
activities or cost of obtaining funds.

36. Computation of cost of capital
 Computation of Specific cost of capital
 Computation of Combined /weighted average cost of
capital

37. SPECIFIC COST
1. COST OF DEBT ( Kd) (debentures, bonds,loans)
 Irredemable debt (perpectual debt)
A) Before Tax
Cost of debt before tax,
Kd = I / NP * 100
I – Interest, NP – Net Proceeds of debt(deduct any expenses like
brokerage,commission,floatation cost)
B) After Tax
Kd = I (1-T)/NP *100
T - Tax rate
 Redeemable debt.
A) before tax
B) After tax

38. Question 1
 X Ltd issues Rs. 50,000 8% debentures @ par. The tax
rate applicable to the company is 50%. Compute the
cost of debt.
Answer:
Given , Net Proceeds (NP) = 50,000
Interest (I) = 50,000 * 8/100 = 4000
Tax (T) = 50% = .50
Cost of Debt ( Kd) = I (1-T)/NP*100
= 4000(1-.50)/50000*100
= 4 %

39. Q2.
 X Ltd issued 25000, 9% debentures of Rs 100 each at
par. The tax rate applicable is 50%. Compute the cost
of debt.

40. Answer
 Given, NP = 25000* 100= 25,00,000
I = 2500000* 9% = 2,25,000
T = 50% = .50
Kd = I(1-T)/ NP *100
= 2,25,000(1-.50)/25,00,000 *100
= 0.045 *100
= 4.5%

41. Q3
 Y Ltd issues Rs 50,000 8% debentures at a premium
of 10%.Compute the cost of debt
Given , interest I = 4000
Net Proceeds NP = 50,000 + (10% of 50,000)
= 50,000+ 5000 = 55,000
Kd = I/NP*100
= 4000/55000 *100
= 7.27%

42. Q4
 A Ltd issues Rs. 50000 8% debentures at a discount of
5%. The tax rate is 50%. Find cost of debt (Kd).
Given , Interest = 8% * 50000 = 4000
Net Proceeds = 50000 – (5% of 50000)
= 50000-2500 = 47500
Kd = I(1- T)/NP *100
=4000(1-0.50)/47500*100
= 4.2%

43. Q5
 B Ltd issues Rs. 1,00,000 9% debentures at a premium of
,10% ,cost of floatation is 2% and tax rate is 60%. find out
the cost of debt
Interest = 9% * 1,00,000= 9000
NP = (1,00,000+premium)– floatation cost
= 1,00,000+10,000 - (2%*1,10,000)
= 1,10,000 - 2200 = 1,07,800
Kd = I (1- T)/NP*100
= 9000 (1- 0.60)/107800 *100
= 3600/1078 = 3.33%

44. Q6
 J Ltd issues 25,000 9% debentures of Rs 100 each
at a premium of 10%. The cost of floatation is 2%
and tax rate s 50%. Find Kd.

45. Answer
 Tax, T = 50% = 0.50
Interest,I = 9%*25,00,000 = 2,25,000
NP = (25,00,000 + PREMIUM ) – 2%
= 25,00,000+( 10%*25,00,000) – 2%
= (25,00,000 + 2,50,000) – 2%
= 27,50,000 – (2%* 27,50,000)
= 27,50,000-55,000= 26,95,000
Kd = I(1-T)/NP*100
= 2,25,000(1-.5)/26,95,000*100= 4.17%

46. Q7
 X Ltd issued 1,00,000, 9% debentures of Rs. 20 each.
Calculate the cost of debt capital ignoring tax, if the
issue is:
a) At par b) at a premium of 10% c) at a discount of
5%

47. Cost of redeemable debt
 1. Before tax
Kd = I +1/N(RV- NP)/1/2 (RV+NP) * 100
I = Interest
N = Number of years
RV = Redeemable Value of debenture
NP = Net Proceeds of issue after adjusting premium ,
discount and floatation cost

48. 2. After Tax
Cost of Redeemable Debt,
 Kd = I (1 – T) + 1/N( RV – NP)/ ½ (RV+NP) *100

49. Q8
 A company issues Rs. 20,00,000, 10% redeemable
debentures of Rs 100 each at a discount of 5%. The
cost of floatation amounts to Rs 50,000. the debentures
are redeemable after 8 years. Calculate before tax and
after tax cost of debt capital. Assume tax rate is 55%.
 Answer:
Interest = 20,00,000 * 10/100 = 2,00,000
N = 8 years, Redeemable value (RV) = 20,00,000
Net proceeds(NP)= 20,00,000-(20,00,000*5/100) –
50,000
= 20,00,000 – 1,00,000 – 50,000 = 18,50,000

50.  A) Cost of debt before Tax
Kd = I + 1/n ( RV – NP) * 100
½ (RV+NP)
= 2,00,000 + 1/8 ( 20,00,000 – 18,50,000)
½ ( 20,00,000 + 18,50,000) * 100
= 11.36%

51.  B) After tax cost of debt
Tax = 55% = 0.55
Kd = I (1- T)+ 1/n ( RV – NP) * 100
½ (RV+NP)
= 2,00,000(1- .55) + 1/8 ( 20,00,000 – 18,50,000)
½ ( 20,00,000 + 18,50,000) *100
= 5.65%

52. Q8
 A company issues Rs. 1,00,000 10% redeemable
debentures at a discount of 5% and cost of floatation
amount to Rs. 30,000. the debentures are redeemable
after 5 years. Calculate before tax and after tax Kd
assuming T = 50%.

53. Q9
 A company issues Rs. 10,00,000, 12%debentures of Rs
100 each. The debentures are redeemable after the
expiry of fixed period of 7 years. Company is in 35%
tax bracket.
1) Calculate Kd after tax if debentures are issued at par,
at 10% discount and at 10% premium
2) If brokerage is paid @ 2%, what will be the cost of
debt if issued at par.

54. 2. COST OF PREFERENCE CAPITAL
 Cost of preference capital or Kp is the dividend expected
by the preference shareholders.
 Kp is after tax cost of pref capital, no adjustment is
required for tax factor
A) Cost of Irredeemable preference shares
Kp = D/ NP *100
D = dividend of preference capital
NP = Net Proceeds of preference issue
B) Cost of Redeemable preference shares
Kp = D + (RV-NP)/n
½ (RV+NP) *100

55. Q10
 A company issued 20,000, 5% preference shares of Rs
100 each. Cost of issue is Rs. 2 per share. Calculate the cost
of preference capital if the shares are issued at
a) Par b) premium of 10% c) discount of 5%
Answer
A) par
Kp = D/ NP * 100 dividend ,D = 20,00,000 *5%
=1,00,000
Cost of issue = 2* 20,000 = 40,000
NP = 20,00,000 – 40,000 = 19,60,000
Kp = 1,00,000/19,60,000 *100 = 5.10%

56. Q11
 A company issued 1000, 7% preference shares of Rs 100
each at a premium of 10%, redeemable after 5 years . Find
Kp.
 D = 100000 *7% = 7000
NP = 100000 + PREMIUM = 110000
n = 5
RV = 100000
Kp = D +(RV-NP/n)/1/2 (RV + NP) *100
= 7000 +(1,00,000- 1,10,000/5)
½ (100000+110000) *100
= 4.76%