SUBMIT

TED BY:
BUSIN
NAME-
Priyansh
ESS
u
FINAN
Jaiswal
CE
CLASS-
B.Com
ASSIG
(Hons.)
NMEN
3 rd

T
Semeste
r
SECTION
– ‘C’
ROLL
NO. -
Q1. What do you mean by business finance? Explain the features of Business Finance.
Ans-
Business finance, the raising and managing of funds by business organizations.
Planning, analysis, and control operations are responsibilities of the financial manager, who is
usually close to the top of the organizational structure of a firm. In very large firms, major
financial decisions are often made by a finance committee. In small firms, the owner-manager
usually conducts the financial operations. Much of the day-to-day work of business finance is
conducted by lower-level staff; their work includes handling cash receipts and disbursements,
borrowing from commercial banks on a regular and continuing basis, and formulating cash
budgets. Financial decisions affect both the profitability and the risk of a firm’s operations. An
increase in cash holdings, for instance, reduces risk; but, because cash is not an earning
asset, converting other types of assets to cash reduces the firm’s profitability. Similarly, the use
of additional debt can raise the profitability of a firm (because it is expanding its business with
borrowed money), but more debt means more risk. Striking a balance—between risk and
profitability—that will maintain the long-term value of a firm’s securities is the task profitability
Finance represents the money management and the process of acquiring the funds. Finance is
a board term that describes the activities related to banking, leverage or debt, credit, capital
markets, money and investments. Business finance tells about the funds and credit employed
in the business. It also helps to manage the funds/money to make your business more
profitable by considering financial statements (profit and loss accounts, balance sheets and
cash flow statements).

Features of Finance:

Channelizing Funds:

It is a well-established fact that the financial system is a critical element of any economy. The
financial sector and financial markets perform the essential function of channeling funds from
people who have saved surplus funds by spending less than their income to people who have
a shortage of investible funds because of their plans to spend exceed their income.

Acquisition, Allocation & Utilization of Funds:

Finance as a function deals with the acquisition, allocation, and utilization of funds. A business
must ensure that adequate funds are available from the right sources at the right cost at the
right time. It needs to decide the mode of raising funds, whether it is to be through the issue of
securities or lending from the bank. Once funds are acquired the funds have to be allocated to
various projects and services and finally, the objective of the business is to earn profits which
to a very large extent depends upon how effectively and efficiently allocated funds are utilized.
Proper utilization of funds is based on sound investment decisions, proper control, and asset
management policies, and efficient management of working capital.
Maximization of Shareholder’s Wealth:

The objective of any business is to maximize and create wealth for the investors, which is
measured by the price of the share of the company. The price of the share of any company is a
function of its present and expected future earnings. Finance helps in defining policies and
ways to maximize earnings.

Financial Management:

The maximization of the economic welfare of its owners is the accepted financial objective of
the firm. Hence, the objectives of finance are to ensure adequate and regular supply of funds to
the business and provide a fair rate of return to the suppliers of capital. Finance helps by
ensuring efficient utilization of capital and available resources according to the principles of
profitability, liquidity, and safety. It provides a definite system for internal investment, financing,
and internal controls. And finally attempts to minimize the cost of capital by developing a sound
and economical combination of corporate securities.

Q.2. The objective of financial management is to "maximise wealth of net worth".

Explain this statement.

Ans-

Wealth Maximization Objective is also known as “Value Maximization” or “Net Present Worth
Maximization.” This objective is considered appropriate for decision making. Wealth means
wealth of shareholders. Wealth of shareholders is determined by market value of shares.

Wealth also signifies Net Present Value(NPV) which is the difference between present value of
cash inflows and present value of cash outflows. In this way, wealth maximization objective
considers time value of money and assign different values to cash inflows occurring at different
point of time. So, according to wealth maximization objective, investments should be made in
such a way that it maximizes Net Present Value.

-Wealth Maximisation -

One of the main objectives of Financial Management is to maximize shareholder’s wealth, for
which achievement of optimum capital structure and proper utilization of funds is very
necessary. Be mindful that wealth maximization is different than profit maximization. Wealth
maximization is a more holistic approach, aimed at the growth of the organization.
- To Ensure Availability of Funds-

The sound financial condition of business is a must for any business to survive. The availability
of funds at the proper time of need is an important objective of business. The organization will
not be able to function without funds, and activities will come to a halt.

- Attain Optimum Capital Structure -

To maintain the optimum capital structure, a perfect combination of debentures and shares is a
requirement. The organization will not want to give away too much equity, and also control the
cost of capital. It is a delicate balance.

- Effective Utilisation of Funds –

To maintain the optimum capital structure, a perfect combination of debentures and shares is a
requirement. The organization will not want to give away too much equity, and also control the
cost of capital. It is a delicate balance.

- Ensuring the Safety of Funds -The vital objective of financial management is to ensure the
security of its funds through the creation of reserves. The chances of risk in investment should
be minimum possible. Some of the reserves created for this purpose are Sinking Funds,
General Reserves etc.

Arguments in favour of Wealth Maximization objective :

1. It is superior: This objective is superior to profit maximization as its main aim is to maximise
shareholders wealth.

2. It is precise and unambiguous: It is based on the concept of cash flows rather than profit.
The concept of profit in the profit maximization objective is vague and ambiguous.

3. Considers time value of money: Wealth maximization objective takes into account the time
value of money as it considers timing of cash inflows. The cash flows occurring at different
period of time are discounted with appropriate discount rate.

4. Considers risk: This objective also considers future risk associated with occurrence of cash
flows. This is done with the help of discounting rate. Higher the discount rate, higher the risk
and vice-versa.

5. Ensures efficient allocation of resources: Resources areallocated wisely to increase

shareholder’s wealth.

6. Ensures economic interest of society: When wealth of shareholder is maximized, it

ultimately upholds economic interest of society.
Unfavourable arguments for Wealth Maximization objective :

1. Creates owner-management problem: The concept of wealth maximization creates owner-

management problem as owners want to maximize their profits and management want to
maximize shareholder’s wealth.

2. Ignores other stakeholders: This objective has been criticized on the ground that it is
inclined towards wealth maximization of shareholders only and ignores other stakeholders such
as creditors, suppliers, employees etc.

3. Criteria of market value is not fair: The criteria of wealth maximization is based on market
value of shares which is not a correct measure. Because value of shares could increase or
decrease due to other economic factors which are beyond the control of the firm.

4. It is just another form of profit maximization: Ultimate aim is to earn maximum profits.
Without earning profits wealth cannot be maximised.

3. Discuss the Utility of Financial Management.

Ans-

Finance is the lifeblood of business organization. It needs to meet the requirement of the
business concern. Each and every business concern must maintain adequate amount of
finance for their smooth running of the business concern and also maintain the business
carefully to achieve the goal of the business concern. The business goal can be achieved only
with the help of effective management of finance. We can’t neglect the importance of finance at
any time at and at any situation.

Some of the importance of the financial management is as follows:

Financial Planning.

Financial management helps to determine the financial requirement of the business concern
and leads to take financial planning of the concern. Financial planning is an important part of
the business concern, which helps to promotion of an enterprise

Acquisition of Funds.

Financial management involves the acquisition of required finance to the business concern.
Acquiring needed funds play a major part of the financial management, which involve possible
source of finance at minimum cost.

Proper Use of Funds.

Proper use and allocation of funds leads to improve the operational efficiency of the business
concern. When the finance manager uses the funds properly, they can reduce the cost of
capital and increase the value of the firm.

Financial Decision.

Financial management helps to take sound financial decision in the business concern.
Financial decision will affect the entire business operation of the concern. Because there is a
direct relationship with various department functions such as marketing, production personnel,
etc.

Improve Profitability.

Profitability of the concern purely depends on the effectiveness and proper utilization of funds
by the business concern. Financial management helps to improve the profitability position of
the concern with the help of strong financial control devices such as budgetary control, ratio
analysis and cost volume profit analysis.

Increase the Value of the Firm.

Financial management is very important in the field of increasing the wealth of the investors
and the business concern. Ultimate aim of any business concern will achieve the maximum
profit and higher profitability leads to maximize the wealth of the investors as well as the nation.

Promoting Savings.

Savings are possible only when the business concern earns higher profitability and maximizing
wealth. Effective financial management helps to promoting and mobilizing individual and
corporate savings.

Now days financial management is also popularly known as business finance or corporate
finances. The business concern or corporate sectors cannot function without the importance of
the financial management.
Q.4. What do you mean by Capitalisation ? Explain the Theories of Capitalisation.

Ans-

Capitalisation is one of the most important constituents of financial plan. The term
“Capitalisation” has been derived from the word capital and in common practice it refers to the
total amount of capital employed in a business. However, financial scholars are not unanimous
regarding the concept of capital. As a matter of fact, they have defined ‘Capitalisation’ in a
number of ways. If the definitions are properly studied, we can classify them into two ways, viz.;
a broad interpretation and an arrow interpretation.

Broad Interpretation of Capitalisation:

Many authors regard Capitalisations as synonymous with financial planning. Broadly speaking,
the term ‘Capitalisation’ refers to the process of determining the plan of financing. It includes
not merely the determination of the quantity of finance required for a company but also the
decision about the quality of financing. A financial plan is a statement estimating the amount of
Capital and determining its composition.

Used in this sense, capitalisation includes:

(i) Estimating the total amount of capital to be raised;

(ii) Determining the type of securities to be issued; and

(iii) Determining the composition or proportion of the various securities to be issued.

Narrow Interpretation of Capitalisation:

In its narrow sense, the term ‘Capitalisation’ is used in its quantitative sense and refers to the
process of determining the quantum of funds that a firm needs to run its business. According to
the scholars holding this view, the decisions regarding the form or composition of capital fall
under the term “Capital Structure”.

Modern Concept of Capitalisation:

Though the narrower interpretation of capitalisation is more popular because of its being very
specific in the meaning, the modern thinkers consider that even short-term creditors should be
included in capitalisation.

In the words of Walker and Baughn, “The use of capitalisation refers to only long-term debt and
capital stock; and short-term creditors do not constitute suppliers of capital is erroneous. In
Reality total capital is furnished by short-term creditors and long-term creditors.”

They further opine that the sum of capital stock and long-term debt-refers to capital rather than
the capitalisation.
Thus, according to modern concept, capitalisation includes:

(i) Share Capital

(ii) Long-term Debt.

(iii) Reserves and Surplus.

(iv) Short-term Debt.

(v) Creditors.

# Theories of Capitalisation :

There are two important theories to determine the amount of capitalisation:

A) The Cost Theory , &

B) The Earnings Theory.

A) The Cost Theory Of Capitalisation -

According to this theory, the amount of capitalisation is arrived at by adding up the cost of fixed
assets (like plants, machinery, building, etc.); working capital required for the continuous
operations of the company; the cost of establishing the company and the promotional
expenses. Such calculation of capitalisation is useful in case of newly-formed companies as it
enables the promoters to know exactly the amount of funds to be raised. But, this theory is not
totally satisfactory as it ignores the earning capacity of the business. The amount of
capitalisation is based on a figure which will not change with changes in the earning capacity of
the business. For instance, if some of the fixed assets of a company become obsolete, some
remain idle and the others are under-employed, the total earning capacity of the company will
naturally fall, but such a fall in the earning capacity, would not reduce the value of the
investment made in the company’s business.

B) The Earnings Theory of Capitalisation –

The earnings theory of capitalisation recognises the fact that true value of an enterprise
depends upon its earning capacity. According to this theory, the capitalisation of a company
depends upon its earnings and the expected fair rate of return on its capital invested. Thus, the
value of capitalisation is equal to the capitalised value of the estimated earnings.
For example, if a company is making net profit Rs.2.00,000 per annum and the fair rate of
return is 10%. The capitalisation of the company will be (2,00,000 × 100/10) = Rs.20,00,000. A
comparison of actual value of capitalisation with this value will show whether the company is
fairly capitalised, over-capitalised, or under capitalised. Earnings theory of capitalisation seems
to be logical because it correlates the value of a firm or the amount of capitalisation directly
with its earning capacity. However, this theory can only be applied when the firm’s expected
income and capitalisation rate can precisely be estimated. In real life, it is very difficult to
estimate correctly the future earnings as well as to determine the capitalisation rate. The future
earnings of a firm depend upon a number of factors such as demand for its products, general
price level, efficiency of management and productivity of labour, etc., which are beyond the
control of an organisation and may vary with the changed circumstances. In the same manner,
it is very difficult to determine the capitalisation rate which depends mainly on the expectations
of the investors and the degree of risk in a particular enterprise. In view of these difficulties,
newly established firms prefer cost theory of capitalisation. However, earnings theory may
provide a better basis for capitalisation of an existing concern.

QUES 5.- WHAT ARE OVER CAPITALISATION? WHAT ARE IT’S CAUSES?

ANS-

It is the capitalization under which the actual profits of the company are not sufficient to pay
interest on debentures and borrowings and a fair rate of dividend to shareholders over a period
of time. In other words, a company is said to be over-capitalised when it is not able to pay
interest on debentures and loans and ensure a fair return to the shareholders. We can illustrate
over-capitalisation with the help of an example.

Suppose a company earns a profit of Rs. 3 lakhs. With the expected earnings of 15%, the
capitalisation of the company should be Rs. 20 lakhs. But if the actual capitalisation of the
company is Rs. 30 lakhs, it will be over-capitalised to the extent of Rs. 10 lakhs. The actual rate
of return in this case will go down to10%. Since the rate of interest on debentures is fixed, the
equity shareholders will get lower dividend in the long-run.

Causes of Over-Capitalisation:

Over-capitalisation may be the result of the following factors:

(I) Acquisition of Assets at Higher Prices:

Assets might have been acquired at inflated prices or at a time when the prices were at their
peak. In both the cases, the real value of the company would be below its book value and the
earnings very low.

(ii) Higher Promotional Expenses:

The company might incur heavy preliminary expenses such as purchase of goodwill, patents,
etc.; printing of prospectus, underwriting commission, brokerage, etc. These expenses are not
productive but are shown as assets.

(iii) Underutilisation:

The directors of the company may over-estimate the earnings of the company and raise capital
accordingly. If the company is not in a position to invest these funds profitably, the company
will have more capital than is required. Consequently, the rate of earnings per shares will be
less.

(iv) Insufficient Provision for Depreciation:

Depreciation may be charged at a lower rate than warranted by the life and use of the assets,
and the company may not make sufficient provisions for replacement of assets. This will
reduce the earning capacity of the company.

(v) Liberal Dividend Policy:The company may follow a liberal dividend policy and may not
retain sufficient funds for self-financing. This may lead to over-capitalisation in the long-run.

(vi) Inefficient Management:

Inefficient management and extravagant organisation may also lead to overcapitalisation of the
company. The earnings of the company will be low.

(vii) Lack of reserves:

Certain companies do not believe in making adequate provision for various types of reserves
and distribute the entire profit in the form of dividends. Such a policy reduces the real profit of
the company and the book value of the shares lags much behind its real value. It represents
over-capitalisation.

(viii) Heavy promotion and organisation expenses:

“A certain degree of overcapitalisation ,”says Beacham, “may be caused by heavy issue

expenses”. If expenses incurred for promotion, issue and underwriting of shares, promoters’
remuneration etc., prove to be higher compared to the benefits they provide, the enterprise will
find itself overcapitalised.

(ix) Shortage of capital:

If a company has small share capital it will be forced to raise loans at heavy rate of interest.
This would reduce the net earnings available for dividends to shareholders. Lower earnings
bring down the value of shares leading to overcapitalisation.

(x) Taxation policy:

High rates of taxation may leave little in the hands of the company to provide for depreciation
and replacement and dividends to shareholders. This may adversely affect its earning capacity
and lead to over-capitalisation.

QUES 6.-EXPLAIN THE CONSEQUENCES OF OVER AND UNDER CAPITALISATION.

ANS-

Consequences of Under-capitalisation:

On Company:

Although under-capitalisation does not threaten financial stability and solvency of the
enterprise, management should not be complacent towards this situation because the
company may suffer in the following ways:

(i) Under-capitalisation intensifies the degree of competition which may have telling effect on
profit margin of under-capitalized concerns. High earning rate of under-capitalized companies
may entice entrepreneurs to set up enterprises in the same line of business who may put up
tough fight with the undercapitalized concerns.

(ii) Tax liability of under-capitalized concerns increases in correspondence with increase in

volume of profits. Also belts of state control and intervention over these enterprises are
tightened.
(iii) Marketability of shares of under-capitalized concerns tends to be narrow because of
exceptionally high market price of these shares. Share prices register violent fluctuations and
speculators take undue advantage of this situation.

(iv) In view of continued rise in profitability rate workers may demand increase in their wage
rates and if their demand is not fulfilled it may cause discontentment among them. Labour-
management relation is disturbed which may adversely affect production efficiency of the
corporation.

(v) Consumers may feel being fleeced by the management of under-capitalized company who
are, it is alleged, thriving at their cost. They may raise hue and cry for reducing price of the
product and demand vociferously for the state to intervene and control their operations.

On Share-Holders:

Under-capitalisation is advantageous to shareholders in as much as they get high dividend

income regularly. Because of soaring rise in share price of under-capitalized concerns,
shareholders’ investment in these companies appreciates phenomenally which they may
encash at any time. In another way also, under-capitalisation benefits the shareholders. They
can, in periods of necessity, get loans on soft-terms against the security of theirshares because
of high credit standing of the under-capitalized concerns in the market.

On Society:

Under-capitalisation does not pose any economic problem to the society. On the contrary, it
may prove boon to it. It encourages new entrepreneurs to set-up new ventures and encourages
the existing ones to expand. This as a result, boosts industrial production. Consumers get
variety of products at relatively cheaper rate. Establishment of more and more firms and
expansion of existing ones helps to mitigate sufferings of unemployed persons. Purchasing
power of newly employed people increases resulting in a rise in demand which, in turn leads to
increase in investment and production. Through demand-investment and employment spiral
the economy marches ahead to reach the pinnacle of prosperity.

However, society may plunge in state of turmoil when psychic feeling develops among
consumers and workers that they are being plundered by capitalists. This feeling may sow
seeds of dissension among consumers at large and labour-management relation is disrupted.

The whole society is mired in plight of discontentment and agitation forcing government to
intervene immediately and to clamp, for that matter, numerous types of controls such as price
control, dividend ceiling and dividend freeze.

Consequences of Over-Capitalisation:

Over-capitalisation is a state that affects not only the company and its owners but also the
society as a whole.

On Company:
Effect of over-capitalisation on company is disastrous. Company’s financial stability is
jeopardized. It loses investors’ confidence owing to irregularity in dividend declaration caused
by reduced earning capacity. Consequently, it has to encounter enormous problems in raising
capital from the capital market tocover its developmental and expansion requirements.
Commercial banks too feel shy of lending short-term advances to such a company to meet its
working capital requirements. As a result, production work hampers.

Over-capitalized concerns, more often than not, fail to make regular payments of interest and
repay principal money on stipulated date. Under the situation creditors may demand liquidation
of reorganization of company. In its desperate bid to regain its lost confidence over-capitalized
concerns have been found manipulating books of accounts to show inflated profits. Large
dividends are distributed. As a matter of fact, such payments are made out of capital and to
cover capital deficiency they take recourse to debt which would further aggravate the crisis.
Over-capitalized concerns gradually lose market to their competitors because in the first
instance they fail to produce goods at competitive cost owing to lack of adequate provision for
replacement of depleted or worn-out assets.

Secondly, these companies are also not capable of providing as much facility to their
customers as their competitors could with the result that they fail to maintain their customers.
Inventories lie in store for pretty long time and substantially large amount of capital is
unnecessarily tied up in them. This may ultimately spell death knell upon the company.

On Shareholders:

Shareholders suffer doubly the brunt of over-capitalisation. Not only does their dividend income
fall but also its receipt becomes uncertain. They also suffer because capital invested by them in
these companies depreciates due to fall in market value of their shares. Value of their holdings
as collateral securities declines simultaneously.

Shareholders find it difficult to borrow money against the security of their shares. Banks
another financial institutions for similar reasons hesitate to lend money against such securities.
Even if they agree to grant loan, they insistupon the stricter terms and conditions hardly
acceptable to an ordinary borrower.

On Society:

Over-capitalisation may prove to be a menace to society as a whole. Overcapitalized concerns,

in their endeavour to maintain their credit, take every possible measure to prevent declining
tendency of income. They try to increase the prices and deteriorate the quality of products. But
to take recourse to such practices becomes difficult under the perfect competition and the
result is the liquidation of such concerns.

The failure of such over-capitalized concerns tends to precipitate panic. Industrial development
languishes, and labourers lose employment. Wage rate also tends to decline. Owing to fall in
purchasing power of the labour class their demand tends to decline. This tendency may
gradually permeate over the whole society and recession may follow. Such a situation is most
dangerous.

Process of capital formation is hampered and development activity slackens and the economy
is thrown out of gear.
QUES 7.-EXPLAIN CRITICALLY THE VARIOUS SOURCES OF RAISING LONG TERM
FINANCE.

ANS.-

Sources of Long-Term Finance for a Company,

Firm or Business

(1) Equity-Shares:
Equity Shares, also known as ordinary shares, represent the ownership capital in a
company. The holders of these shares are the legal owners of the company. They have
unrestricted claim on income and assets of the company and possess all the voting power
in the company.

In fact, the foremost objective of a company is to maximise the value of its equity shares.
Being the owners of the company, they bear the risk of ownership also. They are entitled to
dividends after paying the preference dividen
The rate of dividend on these shares is not fixed and depends upon the availability of divisible
profits and the intention of the directors.

They may be paid a higher rate of dividend in times of prosperity and also run the risk of no
dividends in the period of adversity. Similarly, when the company is wound up, they can
exercise their claim on those assets which are left after the payment of all other claims
including that of preference shareholders.

(2) Preference Shares:

Preference share capital is another source of long-term financing for a company. As the
name suggests, these shares carry preferential rights over equity shares both regarding the
payment of dividend and the return of capital. These shares carry a fixed rate of dividend
and such dividend must be paid in full before the payment of any dividend on equity shares.
Similarly, at the time of liquidation, the whole of preference capital must be paid before any
payment is made to equity shareholders.

(3) Ploughing Back of Profits:

A new company can raise finance only from external sources such as shares, debentures,
loans etc. But, an existing company can also generate finance through its internal sources,
i.e., retained earnings or ploughing back of profits. When a company does not distribute
whole of its profits as dividend but reinvests a part of it in the business, it is known as
ploughing back of profits or retention of earnings. This method of financing is also known as
self- financing or internal financing.

Ploughing back of profits is made by transferring a part of after tax profits to various
reserves such as General Reserve, Reserve Fund, Replacement Fund, Dividend
Equalisation Fund etc. Such retained earnings may be utilised to fulfil the long-term,
medium-term and short-term financial requirements of the firm.

(4) Debentures:
Debentures are one of the frequently used methods by which a company raises long-term
funds. Funds acquired by issue of debentures represent loans taken by the company and
are also known as ‘debt capital’. A debenture is a certificate issued by a company under its
seal acknowledging a debt due by it to its holders. In USA there is a distinction between
debentures and bonds.
There, the term bond refers to an instrument which is secured on the assets of the company
whereas the debentures refer to unsecured instruments.
But, in India no such distinction is made between bonds and debentures and the two terms
are used as synonymous. According to Section 2 (30) of the Companies Act, 2013, “the
term debenture includes debenture stock, bonds and any other securities of a company
whether constituting a charge on the assets of the company or not.”

(5) Loans from Financial Institutions:

Financial Institutions are another important source of long-term finance. In India, a number
of special financial institutions have been established by the Government at the national
level and state level to provide medium-term and long-term loans to the industrial
undertakings.
Financial institutions established at the national level include Industrial Development Bank of
India (IDBI), Industrial Finance Corporation of India (IFCI), Industrial Credit and Investment
Corporation of India (ICICI), Industrial Reconstruction Corporation of India (IRCI), Unit Trust
of India (UTI), Life Insurance Corporation of India (LIC), General Insurance Corporation
(GIC) etc.

Financial institutions established at the state level include State Financial Corporations
(SFCs) and State Industrial Development Corporations (SIDCs). For example, In Haryana,
Haryana State Financial Corporation (HFC) and Haryana State Industrial Development
Corporation (HSIDC) have been established.

(6) Lease Financing:

Lease is a contract between the owner of an asset and the user of such asset. Owner of the
asset is called ‘Lessor’ and the user is called ‘Lessee’. Under the lease contract, the owner
of the asset surrenders the right to use the asset to another party for an agreed period of
time for an agreed consideration called the lease rental. The lessee pays a fixed rental to
the lessor at the beginning or at the end of a month, quarter, half year, or year. At the end of
the period of lease contract, the asset reverts back to the lessor, who is the legal owner of
the asset.

As the legal owner, it is the lessor (and not the lessee), who will be entitled to claim
depreciation on the leased asset. At the end of lease period, the lessee is usually given an
option to buy or further renew the lease contract for a definite period.

Leasing is, thus, a device of long term source of finance. Lessee gets the right to use the
asset without buying them. His position is akin to that of a person who uses the asset with
borrowed money. The real position of lessor is not renting of asset but lending of finance
and hence lease financing is, in effect, a contract
of lending money. The lessee is free to choose the asset according to his requirements and the
lessor is actually the financier.

QUES 8.-EXAMINE THE MERITS AND DEMERITS OF ISSUE OF SHARES AND

DEBENTURES AS A SOURCE OF LONG TERM FINANCE IN BUSINESS ENTERPRISE.

ANS.-

Advantages of Equity / Ordinary Shares:

(A) Advantages to the Company:

Equity shares offer the following advantages to the company:

(i) Permanent Source of Funds – Equity capital is a permanent capital, and is available for
use as long as the company continues. The management is free to utilise such capital and
is not bound to refund it.

(ii) Increase in the Borrowing Capacity – The equity capital increases the company’s
shareholder’s funds. Lenders normally lend in proportion to the amount of shareholder’s
funds. Higher amount of shareholder’s funds provides higher safety to the lenders.

(iii) Not Bound to Pay Dividend – A company is not legally bound to pay dividend to its
equity shareholders. The payment of dividend depends on the availability of divisible
profits and the discretion of directors. A company can reinvest whole of its income, if it so
desires.

(iv) No Need to Mortgage the Assets – The company need not mortgage its assets to
secure equity capital. Hence, if the company desires to raise further finance from other
sources, it can easily do so by mortgaging its assets.

(B) Advantages to Investors:

(i) Right to Control – Equity shareholders are the real owners of the company. They have
the right to elect the directors as well as vote in the meetings of the company.

(ii) Increase in Rate of Dividends – In case of higher profits in the company, these
shareholders are handsomely rewarded in the form of higher dividends.
 (iii) Increase in Market Value – Usually a portion of the profits is ploughed back into
the business which results in enhanced earning power of the company and increase in
the market value of its shares.

(iv) Bonus Shares – Equity shareholders have a claim on the residual income of the
company. This residual income is either directly distributed to them in the form of dividend
or indirectly in the form of bonus shares.

Disadvantages of Equity Shares:

(A) Disadvantages to the Company:

(i) High Cost of Funds – Equity shares have a higher cost for two reasons. Firstly, as
compared to interest, dividends cannot be deducted from the income of the company while
calculating taxes. Dividends are paid out of post- tax profits. Secondly, equity shares have
high floatation cost in terms of underwriting, brokerage and other issue expenses in
comparison to other securities.

(ii) No Advantage of Trading on Equity – If a Company issues only equity shares, it will be
deprived of the benefits of trading on equity. For availing the benefit of trading on equity, it
is essential to issue debentures or preference shares with fixed yields lower than the
earning rate of the company.

(iii) Manipulation by a Group of Shareholders – Shares of a company can be purchased

and sold in the stock market. Hence, a group of shareholders may control the company
by purchasing shares and they may use such control for their personal advantage at the
cost of company’s interests.

(B) Disadvantages to Investors:

(i) Irregular Dividend – Dividend paid on equity shares is neither regular nor at a fixed
rate. In case of lower profits, the company can reduce or suspend payment of dividend. In
case of higher profits too, the company is not legally bound to distribute dividends. Entire
profits may be ploughed back for expansion and development of the company.

(ii) Fall in the Market Value of Shares – If the company does not earn sufficient profits,
the shareholders have to bear the loss because of fall in the market value of shares.
 (iii) No Real Control over the Company – There are a number of shareholders and most
of them are scattered and unorganised. Hence they are unable to exercise effective and
real control over the company.

(iv) Ownership Dilution – If the new shares are issued to the public, it may dilute the
ownership and control of the existing shareholders. The control of the company may
change to new shareholders who may reap the benefits of the company’s prosperity and
progress.

(v) Loss on Liquidation – In case of liquidation, equity shareholders have to bear the
maximum risk. Out of the realised value of assets, first the claims of creditors and then
preference shareholders are satisfied, and the remaining balance, if any, is paid to equity
shareholders. In most of the cases, equity shareholders do not get anything in case of
liquidation.

To conclude, equity shares are the most convenient and popular source of long-term
finance for a company. For new company recourse to equity share financing is most
desirable because the management is under no legal
obligation to pay dividends to shareholders and the management can retain its earnings
entirely for their investment in the enterprise.

However, for obtaining further finance in case of any existing company, the management
should, as far as possible, avoid issuing equity shares. From investor’s point of view, equity
shares are riskier as there is uncertainty regarding dividend and capital gains. Investors
who desire to invest in safe securities with a regular and fixed income have no attraction for
such shares. On the contrary, the investors who are more ambitious and ready to bear risk
in consideration of higher returns prefer these shares.

Advantages of Debenture:

Debentures offer a number of advantages both to the company as well as investors.

(A) Advantages to the Company:

The company has the following main advantages of using debentures and bonds as
a source of finance:

(i) Debentures provide long-term funds to a company.

 (ii) The rate of interest payable on debentures is, usually, lower than the rate of dividend
paid on shares.

(iii) The interest on debentures is a tax-deductible expense and hence the effective cost
of debentures (debt-capital) is lower as compared to ownership securities where dividend
is not a tax-deductible expense.

(iv) Debt financing does not result into dilution of control because debenture- holders do
not have any voting rights.

(v) A company can trade on equity by mixing debentures in its capital structure and thereby
increase its earnings per share.

(vi) Many companies prefer issue of debentures because of the fixed rate of interest
attached to them irrespective of the changes in price levels.

(vii) Debentures provide flexibility in the capital structure of a company as the same can
be redeemed as and when the company has surplus funds and desires to do so.

(viii) Even during depression, when stock market sentiment is very low, a company
may be able to raise funds through issue of debentures or bonds because of certainty
of income and low risk to investors.

(B) Advantages to Investors:

It is not only the company but also the investors who are benefited by investing in
debentures or bonds.

The following are the main advantages from the point of view of investors:

(i) Debentures provide a fixed, regular and stable source of income to its investors.

(ii) It is comparatively a safer investment because debenture-holders have either a

specific or a floating charge on all the assets of the company and enjoy the status of a
superior creditor in the event of liquidation of the company.

(iii) Many investors prefer debentures because of a definite maturity period.

(iv) A debenture is usually more liquid investment and an investor can sell or mortgage
his instrument to obtain loans from financial institutions.
 (v) The interest of debenture-holders is protected by various provisions of the debenture
trust deed and the guidelines issued by the Securities and Exchange Board of India in this
regard.

Disadvantages of Debenture Finance:

In spite of many advantages, debenture financing suffers from certain limitations. The
following are the major disadvantages of debentures:

(A) From the Point of View of Company:

A company suffers from the following disadvantages of debt- financing:

(i) The fixed interest charges and repayment of principal amount on maturity are legal
obligations of the company. These have to be paid even when there are no profits. Hence,
it is a permanent burden on the company. Default in these payments, adversely affects
the credit-worthiness of the firm and even may lead to winding up of the company.

(ii) Charge on the assets of the company and other protective measures provided to
investors by the issue of debentures usually restrict a company from using this source of
finance. A company cannot raise further loans against the security of assets already
mortgaged to debenture-holders.

(iii) The use of debt financing usually increases the risk perception of investors in the firm.
This enhanced financial risk increases the cost of equity capital.

(iv) Cost of raising finance through debentures is also high because of high stamp
duty.

(v) A company whose expected future earnings are not stable or who deals in products
with highly elastic demand or who does not have sufficient fixed assets to offer as security
to debenture-holders cannot use this source of rasing funds to its benefit.

(B) From the Point of View of Investors:

Many investors do not find debentures or bonds as an attractive investment because of

the following:

(i) Debentures do not carry any voting rights and hence its holders do not have any
controlling power over the management of the company.
(ii) Debenture-holders are merely creditors and not the owners of the company. They
do not have any claim on the surplus assets and profit of the company beyond the fixed
interest and their principal amount.

(iii) Interest on debentures is fully taxable while shareholders may avoid tax by way of
stock dividend (bonus shares) in place of cash dividend.

(iv) The prices of debentures in the market fluctuate with the changes in the interest
rates.

(v) Uncertainty about redemption also restricts certain investors from investing in
such securities.

QUES 9.-WHAT IS THE MEANING OF WORKING CAPITAL? EXPLAIN THE FACTORS

AFFECTING THE WORKING CAPITAL REQUIREMENTS OF A COMPANY.

ANS.- Working capital, also known as net working capital (NWC), is the difference between
a company’s current assets, such as cash, accounts receivable (customers’ unpaid bills)
and inventories of raw materials and finished goods, and its current liabilities, such as
accounts payable. Net operating working capital is a measure of a company's liquidity and
refers to the difference between operating current assets and operating current liabilities. In
many cases these calculations are the same and are derived from company cash plus
accounts receivable plus inventories, less accounts payable and less accrued expenses.

Working capital is a measure of a company's liquidity, operational efficiency and its short-
term financial health. If a company has substantial positive working capital, then it should
have the potential to invest and grow. If a company's current assets do not exceed its
current liabilities, then it may have trouble growing or paying back creditors, or even go
bankrupt.

Working Capital is basically an indicator of the short-term financial position of an

organization and is also a measure of its overall efficiency. Working Capital is obtained by
subtracting the current liabilities from the current assets. This ratio indicates whether the
company possesses sufficient assets to cover its short-term debt.

Working Capital indicates the liquidity levels of companies for managing day-to-day
expenses and covers inventory, cash, accounts payable, accounts receivable and short-
term debt that is due. Working capital is derived from several company operations such as
debt and inventory management, supplier payments and collection of revenues.

Main factors affecting the working capital are as follows:

(1) Nature of Business:

The requirement of working capital depends on the nature of business. The nature of
business is usually of two types: Manufacturing Business and Trading Business. In the
case of manufacturing business it takes a lot of time in converting raw material into
finished goods. Therefore, capital remains invested for a long time in raw material, semi-
finished goods and the stocking of the finished goods.

Consequently, more working capital is required. On the contrary, in case of trading

business the goods are sold immediately after purchasing or sometimes the sale is
affected even before the purchase itself. Therefore, very little working capital is required.
Moreover, in case of service businesses, the working capital is almost nil since there is
nothing in stock.

(2) Scale of Operations:There is a direct link between the working capital and the scale of
operations. In other words, more working capital is required in case of big organisations
while less working capital is needed in case of small organisations.

(3) Business Cycle:

The need for the working capital is affected by various stages of the business cycle. During
the boom period, the demand of a product increases and sales also increase. Therefore,
more working capital is needed. On the contrary, during the period of depression, the
demand declines and it affects both the production and sales of goods. Therefore, in such
a situation less working capital is required.

(4) Seasonal Factors:

Some goods are demanded throughout the year while others have seasonal demand.
Goods which have uniform demand the whole year their production and sale are continuous.
Consequently, such enterprises need little working capital.

On the other hand, some goods have seasonal demand but the same are produced almost
the whole year so that their supply is available readily when demanded.
Such enterprises have to maintain large stocks of raw material and finished products
and so they need large amount of working capital for this purpose. Woolen mills are a
good example of it.

(5) Production Cycle:

Production cycle means the time involved in converting raw material into finished product.
The longer this period, the more will be the time for which the capital remains blocked in
raw material and semi-manufactured products.

Thus, more working capital will be needed. On the contrary, where period of production cycle
is little, less working capital will be needed.

(6) Credit Allowed:

Those enterprises which sell goods on cash payment basis need little working capital but
those who provide credit facilities to the customers need more working capital.

(7) Credit Availed:

If raw material and other inputs are easily available on credit, less working capital is needed.
On the contrary, if these things are not available on credit then to make cash payment
quickly large amount of working capital will be needed.

(8) Operating Efficiency:

Operating efficiency means efficiently completing the various business operations. Operating
efficiency of every organisation happens to be different.

Some such examples are: (i) converting raw material into finished goods at the earliest, (ii)
selling the finished goods quickly, and (iii) quickly getting payments from the debtors. A
company which has a better operating efficiency has to invest less in stock and the debtors.

Therefore, it requires less working capital, while the case is different in respect of companies
with less operating efficiency.
(9) Availability of Raw Material:
Availability of raw material also influences the amount of working capital. If the enterprise
makes use of such raw material which is available easily throughout the year, then less
working capital will be required, because there will be no need to stock it in large quantity.

On the contrary, if the enterprise makes use of such raw material which is available only in
some particular months of the year whereas for continuous production it is needed all the year
round, then large quantity of it will be stocked. Under the circumstances, more working capital
will be required.

(10) Growth Prospects:

Growth means the development of the scale of business operations (production, sales,
etc.). The organisations which have sufficient possibilities of growth require more working
capital, while the case is different in respect of companies with less growth prospects.

(11) Level of Competition:

High level of competition increases the need for more working capital. In order to face
competition, more stock is required for quick delivery and credit facility for a long period has
to be made available.

(12) Inflation:
Inflation means rise in prices. In such a situation more capital is required than before in order
to maintain the previous scale of production and sales.
Therefore, with the increasing rate of inflation, there is a corresponding increase in the
working capital.

QUES 10.-WRITE NOTES ON:- (A)PLOUGHING BACK

OF PROFIT-
The ‘Ploughing Back of Profits’ is a technique of financial management under which all profits
of a company are not distributed amongst the shareholders as dividend, but a part of the
profits is retained or reinvested in the company.
This process of retaining profits year after year and their utilisation in the business is also
known as ploughing back of profits.

It is actually an economical step which a company takes, in the sense, that instead of
distributing the entire earnings by way of dividend, it keeps a certain percentage of it to be
re-introduced into the business for its development. Such a phenomenon is also known as
‘Self-Financing’; ‘Internal Financing’ or ‘Inter- Financing’.

A part of profits is ploughed back or re-employed into the business and is regarded as an
ideal source of financing expansion and modernisation schemes as there is no immediate
pressure to pay a return on this portion of stockholders’ equity. Under this method, a part of
total profits is transferred to various reserves such as General Reserve, Replacement Fund,
Reserve Fund, Reserve for Repairs and Renewals, etc.

Sometimes ‘secret reserves’ are also created without the knowledge of the shareholders.
From all the practices of financial management, this system of ploughing back of profits is
considered desirable as it helps in the financial and economic stablisation of the concern.

(B) FACTORING-

Factoring, receivables factoring or debtor financing, is when a company buys a debt or

invoice from another company. Factoring is also seen as a form of invoice discounting in
many markets and is very similar but just within a different context. In this purchase,
accounts receivable are discounted in order to allow the buyer to make a profit upon the
settlement of the debt. Essentially factoring transfers the ownership of accounts to another
party that then chases up the debt.

Factoring therefore relieves the first party of a debt for less than the total amount providing
them with working capital to continue trading, while the buyer, or factor, chases up the debt
for the full amount and profits when it is paid. The factor is required to pay additional fees,
typically a small percentage, once the debt has been settled. The factor may also offer a
discount to the indebted party.

Factoring is a very common method used by exporters to help accelerate their cash flow.
The process enables the exporter to draw up to 80% of the sales invoice’s value at the
point of delivery of the goods and when the sales invoice is raised.
 (C) DISCOUNTING OF BILLS-

Bill or invoice discounting is a trade activity in which the seller gets amount in advance at
discounted rates from the lender. This makes buyers contribute in the form of interest
rate in increasing the revenue of the financial institutions, banks or NBFCs in form of
interest paid and from monthly fee.

For example: You have sold goods to Mr. X, he has given you letter of credit from bank
of 30 days, if you want to get money from bank before 30 days, the bank will charge
some interest rate from you, which in return will be called as discount for the seller. Let’s
assume if the amount which you were supposed to get was Rs. 1 lakh on or after 30 days,
by bank’s discount or interest rate of Rs. 50,000 you now get Rs. 95,000 in return form the
bank. The buyer will anyhow deposit Rs. 1 lakh to the respective bank on 30th day
only.This trading or financial process is termed as bill discounting or invoice
discounting.Bills that come under bill discounting are termed as ‘bills of exchange’. Bill
discounting feature can be used to avail loans up to approximately 90% of the raised
invoices. The credit period majorly depends on the buyer’s creditworthiness. Once the
bank is convinced, it provides discount on the amount that is required to be paid at the
end of credit period.

Credit Evaluation

Before sanctioning any invoice or bill discounting, the bank will surely consider the
reputation of the seller by checking the past repayment history, financial stability and
creditworthiness of the buyer as they do not want to be at risk if the buyer defaults to
repay the amount.
Availability of Instant Cash

Instant cash is available at disposal for enterprises or businesses that helps to

improve the momentum of the businesses; moreover, it provides the option to
entrepreneurs to do business without funds. It works the similar way as bank
overdraft but it is not the same, as the customer is required to pay interest on the
used amount.

Banking Partner Preferred

A reputed bank is always the first preference before the bill discounting is offered
to the buyer. This makes sure that the buyer’s bank (paying entity) is reliable and
trustworthy. Agreement between reputable companies or banks is required for
discounting purpose.

Bill Usage

Also known as ‘Usance Period’, bill usage is a period in which bill has to be valid
within the date of time permitted by customers for the bill date and its payment. This
time period can vary from 3 weeks to 3 months.

Additional benefits

 Effortless withdrawals
 Effortless withdrawals
 Flexible repayment tenure
 Strengthened cash flow
 Interest to be paid only on used amount
 Easy authentication
 Quick processing with hassle free documentation

In bill discounting process, the interest amount is charged in advance by the bank
from the buyers. Being it an agreement between buyer and seller, the bill amount is
paid as per the end of credit period.

Mainly there are two methods of presenting bills to the buyer’s bank, named as – with
and without recourse. Let’s understand further about these two ways.

With Resource
in With Resource method, the seller’s bank verifies and checks all the documents
and discount terms to further send it to the buyer’s bank. Then the bank do not re-
check the rest of the things and can claim refunds later on, if there is any issue.

Without Resource

Whereas, in Without Resource method, no checks are performed by the seller’s

bank at the time of request for payment and buyer’s bank performs the checks on
all the important details. Mainly, this practice is followed when both banks have
acceptance, tie-ups for payment and negotiations from each other.