Business Finance

B.Com.
LLB IV Sem Subject: Business Finance
Business Finance
Chapter-1
Nature and Objective of Business Finance
Meaning of Business Finance

According to B.O. Wheeler Meaning of Business Finance includes those business
activities that are concerned with the acquisition and conservation of capital funds
in meeting the financial needs and overall objectives of a business enterprise.”
Business is identified with the generation and circulation of products and services
for fulfilling of needs of society. For successfully doing any operation, business
requires money which is known as business finance. Therefore, funds are known as
the lifeblood of any business. A business would not function unless there is adequate
money accessible for use.
The capital contributed by the businessman to establish the business isn’t adequate
to meet the financial needs of the business. Consequently, the businessman needs to
search for an option to generate funds. Research of the financial needs and options
to fulfil those needs must be done with a specific end goal to arrive at effective
financial management to maintain the business.
12 Principles of Business Finance
Business finance involves the application of the principles of general management
to a particular financial operation. In respect of specific financial operations, the
financial manager plans, organize, directs, and controls to further the ultimate goal
of finance. The goals of finance are addressed through the principles of business
finance, which can be placed in investment decisions, financing decisions, and
others.
12 Principles of Business Finance
• Investment Principle
• Financing Principle
B.Com. LLB IV Sem Subject: Business Finance
• Profit Maximization
• Wealth Maximization
• Risk-Return Trade-off
• Time Value of Money
• Cost Principle
• Capital Structure
• Liquidity and Profitability
• Flexibility Principle
• Portfolio Principle
• Dividend Principle
• Investment Principle
Investment Principle: involves allocating resources among various types of assets;
What proportion of the firm’s funds should be invested in financial assets (cash,
receivables, securities), and what proportion in real assets (equipment, plant, land).
The asset mix affects the amount of income the firm can earn. Besides determining
the asset mix, financial managers must also decide the types of financial and real
assets to acquire. The investment principle specifies the company should not invest
in assets that earn less than a minimum acceptable required rate.
Financing Principle: Financing involves funds for the firm. Thus, while investment
decisions are related to the asset side of the balance sheet, financing decisions are
related to the liabilities and equity side. When firms make financing decisions, they
must consider a member of factors, including capital structure, risk, cost, availability
of funds, timing, and distribution of earnings. The financing principle posits that
firms should use a mix of debt and equity that maximizes their value.
Profit Maximization: At first, the principle of the firm is to maximize profits. Many
firms believe that as long as they are earning as much as possible while holding
down costs. Profit maximization has the benefit of being a simple and
straightforward statement of purpose.
Wealth Maximization: The second frequently encountered principle of a firm is- to

maximize the value of the firm over the long run. This principle may also be stated
as wealth maximization, defined as the firm’s net present worth. The wealth
maximization principle is linked to the long-term profitability of the firm.
Risk-Return Trade-off: When a firm borrows funds, the lender expects to be repaid
according to the terms of the loan agreement. If the firm cannot raise sufficient
revenue over time to repay the borrowed funds, it will go bankrupt- the ultimate risk
for a firm. So, financial decisions involve risk-return trade-off principles of action.
Time Value of Money: People prefer to receive a given amount of money now rather
than at some time in the future. The principle of the time value of money making the
correct decision may make the difference between profit and loss.
Cost Principle: The cost principle is to minimize the cost of funds to maximize
wealth. It involves examining all alternative sources of financing.
Capital Structure: The capital structure of a firm is its mix of debt and equity. The
capital structure principle decides which mix is best for the firm. Several factors
affect a firm’s capital structure; one of them involves the firm’s expected return.
Liquidity and Profitability: Liquidity means that the firm has adequate cash to meet
its obligations at all times. The profitability requires the firm’s operations to yield a
long-term profit. These two are similar but overlapping. Achieving liquidity under
the liquidity-profitability principle requires minimizing risk and maintaining control
over the firm’s activities.
Flexibility Principle: Flexibility is gained by careful management of funds and
activities. Finance attempts to be as flexible as possible in providing the funds
needed to support the firm’s development.
Portfolio Principle: The principle of asset selection, which considers the combined
risk of all assets held by the firm, became an increasingly important tool as the
relationship between risk and return became better appreciated and understood.
Dividend Principle: Shareholders may expect to receive some of the firm’s earnings
as cash dividends. However, retained earnings may represent an important source of
funds for the firm. The dividend principle decides how much of the firm’s earnings
should be paid out and how much should be retained. The dividend principle argues
that firms that do not have enough investments that earn the expected rate of return
the cash to the owners of the business. Another principle of finance is that it lets the
firm know when financial decisions will have to be made. To make effective
decisions, these principles must analyse and plan.5 Marketing Concepts are
Production, Product, Selling, Marketing, and Societal Marketing Concept.
Finance is an important function of business. The application of planning to this

function is called financial planning. Financial planning is mainly concerned with
the economical procurement and profitable use of funds. “Financial planning
consists in the raising, providing and managing of all the money, capital of funds of
any kind to be used in connection with the business.” Financial planning is an
important element of the overall planning of business enterprise. Financial planning
includes the following:
• Estimating the amount of capital required for financing the business
enterprise;
• Determining capital structure;
• Laying down policies for the administration of capital;
• Formulating the programmes to provide the most effective use of capital.
The main characteristics of a good financial planning are as follows:
The financial plan should be as simple as possible so that it can be easily understood
even by a layman, property executed and administered. A complicated financial plan
creates
The financial plan should be based on the clear-cut objectives of the company. It
should aim to procure adequate funds at the lowest cost so that the profitability of
the business is improved.
The financial plan should not be rigid, but rather flexible enough to accommodate
the changes which may be introduced in it as and when necessary. The rigid
composition of the financial plan may cause unnecessary irritation and may limit the
future development of the business unit.
Solvency and Liquidity
The financial plan should ensure solvency and liquidity of the business enterprise.
solvency requires that short-term and long-term payments should be made on due
dates positively. This will ensure credit worthiness and good will to the business
enterprise. Liquidity means maintenance of adequate cash balance in hand.
Sometimes insufficiency of cash may make a business enterprise bankrupt.
Planning Foresight
Financial planning should have due foresight and vision to access the future needs,
scope and scale of operation of the business enterprise. On the basis, financial
planning should be done in such a manner that any adjustment needed in the future
may be made without much difficulty. As the business proceeds, the financial
adjustments become necessary which should be adjustable properly as and when
desired.
Contingencies Anticipated
The financial plan should be able to anticipate various contingencies which may
arise in the near future. The financial plan should make adequate provision for
meeting the challenge of unforeseen events.
Minimum Dependence on Outside Sources
A long-term financial planning should aim at minimum dependence on outside
resources. This can be possible by retaining a part of the profits for ploughing back.
Intensive Use of Capital
Financial planning should ensure intensive use of capital. As far as possible, a proper
balance between fixed and working capital should be maintained.
Profitability
A financial plan should be drafted in such a way that the profitability of the business
enterprise is not adversely affected.
Economical
The financial plan should be quite economical i.e., the cost burden of raising various
types of capital should be minimum.
Government Financial Policy and Regulation
The financial policy should be prepared in accordance with the government financial
policy and regulation. It should not violate it under any circumstances.
Steps of Financial Planning
The seven steps of financial planning start with getting to know the client's current
financial situation and goals and end with continually measuring performance
toward those goals and updating them as necessary.
1. Understanding the client's personal and financial circumstances.
2. Identifying and selecting goals.
3. Analysing the client's current course of action and potential alternative
course(s) of action.
4. Developing the financial planning recommendation(s).
5. Presenting the financial planning recommendation(s).
6. Implementing the financial planning recommendation(s).
7. Monitoring progress and updating.
Unit-II
Classification of Capital
Factors determining fixed capital requirements in business
The requirement of fixed capital to be invested differs from industry to industry. The
manufacturing enterprises require larger proportion of fixed capital in the form of
land, building, plant, machinery, furniture etc. which are required for carrying out
manufacturing activities. Public utility concerns like railways, require a larger fixed
capital for purchase of land, laying of track, buying rolling stock, railway stations,
workshop etc. Concerns engaged in rendering personal services, merchandise, trade
or commerce usually require comparatively much lesser fixed capital.
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The type of products produced is also one of the important factors of fixed capital.
If a standard product is to be produced with standard men, machines and materials,
larger amount of fixed capital would be required. Manufacturing of technical types
of goods or capital goods require larger amount of fixed capital as compared to
consumer goods.
The size of the firms influences the quantum of fixed capital. The bigger the size of
the plant, the larger would be the fixed investment. A smaller sized firm with limited
scale of operations would require lesser fixed capital.
This is also one of the important factors which govern the fixed capital requirements.
If a concern is engaged in manufacturing and marketing, then it requires larger fixed
capital. If its business is merely to procure the already manufactured goods and to
market them, much less fixed capital would be required.
This factor also influences the amount of its fixed capital. If the firm is engaged in
assembling the parts manufactured by other industries, its fixed capital requirements
will be lesser compared to the firm which integrates all the sequences of
manufacturing activities.
Larger fixed capital is required for purchasing land, constructing building, acquiring
plant and machinery on ownership basis. If the land and building are taken on rental
basis or if plant is acquired on lease, then naturally lesser amount of fixed capital
would be required.
The technique of production also affects the amount of fixed capital. A firm using
capital-intensive techniques requires more fixed capital than another firm of the
same size using labour-intensive technology. Shifts in technology lead to changes in
the amount of fixed capital.
Capital: Features, Classification and Other Details
Main Features of Capital:
(i) Capital is the result of past labour. The machines’ tools, equipment’s etc. used for
the further production of wealth are the products of labour.
(ii) Capital is productive. It is used along with other factors of production like land,
labour and entrepreneur to produce goods and services.
(iii) Capital is prospective, because accumulation of capital yields income. This
feature explains the supply side of capital.
(iv) Capital is not permanent; it is temporary in nature. It has to be reproduced from
time to time.
(v) Capital is a mobile factor of production. It is not the free gift of nature.
(vi) Capital is a passive factor of production. It alone is unable to do anything. It
produces goods and services along with other factors of production.
Classification of Capital:
Capital can be classified as under:

(i) Fixed and Circulating Capital:
Fixed capitals are continuously used in the process of production. For instance,
machines, tools, equipment’s etc. On the other hand, the capital which are used for
single time, i.e., one-time used capitals are called circulating capital. For example,
coal, petrol and raw material etc.
(ii) Sunk and Floating Capital:
The capitals which remain fixed and cannot be shifted from one place to another are
called sunk capital. Factory, machines etc. are sunk capital. However, floating
capitals are those, which can be used for several purposes or by several industries.
For example, money and other raw materials are the example of floating capitals.
(iii) Domestic and Foreign Capital:
Domestic capital is that capital which includes all private and public capital in a
country. The buildings of all the factories, both private and public, are the examples
of domestic capital. On the other hand, foreign capital is that capital which is owned
by two or more countries. Kosi project owned by India and Nepal, International
Monetary Fund (IMF), World Bank etc. are the examples of Foreign Capital,
(iv) Personal and Social Overhead Capital:
Capital having personal or private ownership is called personal capital. The big
factories owned by many industrialists are the example of personal capital. On the
other hand, capital which is owned by the whole society is known as social overhead
capital. For example, roads, hospitals, railways, parks, universities etc. are the social
overhead capital,
(v) Human and Non-Human Capital:
Human capital refers to those personal qualities which can neither be seen nor has
any shape or size. Hence, cannot be transferred from person to person. Thus, skill,
ability, efficiency etc. of a doctor, teacher, sportsman, pilot etc. are the examples of
human capital. On the contrary, non-human capital is the capital which can be
transferred from one place to other, e.g., machines, tools, factories, equipment’s etc.
Importance of Capital:
Capital has following importance:
(i) It is the basic factor of production.
(ii) It arranges raw materials for production.
(iii) It is the basic for all types of trade,
(iv) It is important from the point of view of credit,
(v) It provides employment,
(vi) It is the basic of technological developments.
Examples of Capital:
(i) All types of raw materials used in production are capital.
(ii) Buildings used in production are also capital.
(iii) Money deposited in bank, i.e., bank deposit is also capital.
(iv) The magazines and newspapers which are found in the reception room of an
office are also considered as capital.
(v) Indian Museum, Victoria Memorial Hall etc. are also capital.
Sources
There are many sources of fixed capital. Let us have a look at them one by one: –
This is fixed capital’s first and foremost source. Since
fixed capital is a must-have in starting a business, the owner sources it from his
resources.
If the owner does not have
enough money to invest in fixed capital, they would take help from the bank or any
financial institution and take a loan against the mortgage or the mortgage. If the loan
amount is larger, the owner has to arrange a mortgage to take the loan; if the loan
amount is smaller, the owner does not need to organize any mortgage to avail of the
loan.
If a company feels that it has to issue shares to finance
the immediate need of buying/acquiring long assets, we can call it fixed capital. A
private company can become public by conducting an IPO. A public company can
issue new shares to finance fixed capital.
When a company needs to invest in fixed capital, it can
use internal finance also. Retained earnings are a portion of the profit retained and
reinvested into the company. Usually, retained earnings are invested in acquiring
new fixed capital.
By issuing debentures, companies source funding
for developing long-term assets. Companies issue bonds. People interested in
investing in a company buy those bonds and pay the money for them. And the
companies then use that money to acquire long-term / non-current assets.
Let us consider the following fixed capital examples to gain a better understanding
of the process:
• Land
• Building
• Manufacturing machinery and equipment
• Other equipment.
A capital budgeting decision is one of the most crucial business decisions. It is

important for a business because of the following reasons
Decisions regarding the long-term growth and effects of a firm have long-term
implications on its business. As the funds invested by the firm in the long-term assets
are most likely to yield returns in the future, these decisions affect the growth and
future prospects of the business.
A huge outflow of funds is involved in capital budgeting decisions, because of which

a substantial portion of capital funds are blocked in long-term projects. The funds
will get wasted if the firms get any wrong investment programme. Therefore,
decisions regarding the amount of funds are crucial for the firm and it must carefully
plan its investment programme.
3
The capital budgeting decisions of an organisation involve huge funds and a higher
degree of risk. These decisions have an impact on long-term profitability as the
company has to bear the risk for a long period.
It is not possible to reverse most of the capital budgeting decisions without incurring
heavy losses. For instance, if an organisation abandons a project in the middle, it
will have an adverse financial consequence on the business. Therefore, every firm
should take these decisions after every small detail to avoid heavy losses.
▪ A working capital is another component of the capital that the business needs
to meet its day-to-day requirements. Payments to creditor, salaries to workers,
raw material purchases, etc., are generally recurring in nature. They can be
easily converted to cash. Hence, short-term capital is also known as working
capital.
▪ A key aspect of financial management is the management of working capital.

Short-term finance is primarily concerned with the liquidity and profitability
of the business concern.
▪ Working capital management helps business concerns improve their operating
performance, as well as meet their short-term liquidity needs. Therefore, it is
not only a part of financial management but also the overall management of a
business concern to study working capital management. According to the
definition, working capital refers to the capital that is not fixed but it is usually
defined as the difference between current assets and current liabilities.
• Gross Working Capital: The concept of gross working capital determines the
concept of working capital. A business concern’s gross working capital is the
amount invested in its total current assets. The total current assets of the business
concern are known as the gross working capital.
• Net Working Capital
Net working capital is defined as the concept that considers both current assets and
current liabilities. A concern’s net working capital is its excess of current assets over
current liabilities over a given period of time. Positive working capital is when the
current assets exceed current liabilities; negative working capital is when the
opposite is true.
A working capital ratio can be calculated by dividing total current assets by total
current liabilities. That is why it is often referred to as the current ratio. It refers to
the business’s ability to make timely payments as they become due. The working
capital ratio is calculated as follows:
Working Capital Ratio = Current Assets / Current Liabilities
Generally, the higher the ratio, the more flexible you are to expand operations. You
should understand why the ratio is dropping. The ideal ratio will vary according to
your industry and circumstances.
a) If it is less than 1:1, it usually means you are having trouble paying your bills.
b) difficulty may arise even when the ratio is higher than 1:1, depending on how
quickly inventories can be sold and accounts receivable collected.
Various factors determine how much working capital is required. A business

concern’s Working Capital needs cannot be determined by any formula or set of
rules. Listed below are a few of the major factors influencing Working Capital
requirements.
a) Nature of business: The nature of the business greatly affects the working capital
of the business. Working Capital can be maintained at a lower level if a business
follows a rigid credit policy and only sells for cash. Construction companies
maintain larger amounts of Working Capital than transport companies.
b) Production cycle: Production cycle determines the amount of Working Capital
required. A company that has a short production cycle will require less Working
Capital. A company that does not have a short production cycle will need a large
amount of Working Capital.
c) Business cycle: Working Capital requirements change cyclically and seasonally
as a result of business fluctuations. A company’s Working Capital requirement
increases when the economy is booming, and reduces when the economy is in a
depression. Increased profits also increase working capital requirements.
D) Production policy: Working Capital requirements are also determined by this
factor. Maintaining the company’s continuous production policy requires regular
working capital. Working Capital requirements will depend on the conditions
outlined by the company, based on its production policy.
e) Credit policy: Working Capital is also affected by the credit policy of sales and
purchases. Having a liberal credit policy means that the company needs to keep a
larger working capital to pay its customers. The company will maintain cash in hand
and in the bank if the dues are paid on the last date.
f) Growth and expansion: As a business concern grows and expands, working
capital requirements rise, since it requires additional working capital at the outset
and incurs some additional expenses.
g) Availability of raw materials: Raw materials provide the major part of the
Working Capital requirement. These components are vital to production. Production
stops when raw materials are not readily available. To maintain an adequate level of
raw material, the concern has to use some Working Capital.
Working Capital is crucial to the success of any business concern. In order to meet
daily needs and short-term obligations, every business concern must maintain a
certain amount of Working Capital. There are several uses for Working Capital.
a) Purchase of raw materials and spares: Raw materials are the foundation of
manufacturing. The company should purchase raw materials frequently according to
its needs. Every business company needs a certain amount of Working Capital to
buy raw materials, components and spare parts.
b) Payment of wages and salary: Payment of wages and salaries to labor and
employees is the next component of Working Capital. Periodic payments enable
employees to be more efficient in their work. The working capital of the business
concern must be sufficient to pay salaries and wages.
c) Day-to-day expenses: On a daily basis, a business has to pay various expenses
related to its operations, such as fuel, electricity, and office expenses.
d) Provide credit obligations: Businesses that provide credit to their customers and
meet their short-term obligations. The concern thus needs sufficient Working
Capital.
Types of Working Capital
A) Permanent Working Capital
Fixed Working Capital is another name for permanent working capital. It is the
capital, which must be maintained at a minimum level at all times. The level of
Permanent Capital varies with the type of business. Regardless of time or volume of
sales, permanent working capital will not change. Due to the fact that it is impossible
to determine the exact amount of permanent working capital, it can also be divided
into two categories:
• Regular Working Capital: A regular working capital is the type of permanent
working capital necessary to keep the cycle of working capital flowing smoothly
during the normal course of business.
• Reserve Working Capital: Reserve Working Capital is a type of working capital

cushion that needs to be maintained above and beyond regular working capital in
case unexpected situations result in a need for additional working capital.
B) Temporary Working Capital
Temporary Working Capital is also known as variable working capital. In this
context, seasonal demands and some special purposes are met by seasonal capital. It
is further divided into seasonal working capital and special working capital. Seasonal
Working Capital refers to the capital required to meet the seasonal needs of a
business concern. For example, launching extensive marketing campaigns for
conducting research will require a certain amount of capital.
C) Semi Variable Working Capital
There is a certain amount of Working Capital at the field level up to a certain point
after which it will increase based on sales or time.
SOURCES OF WORKING CAPITAL:

A company has various sources of working capital. Depending upon its condition
and requirements, a company may use any of these sources of working capital. These
sources may be spontaneous, short-term, or long-term.
Spontaneous Sources: The sources of capital created during normal business
activity are called spontaneous sources of working capital. The main characteristic
of spontaneous sources is ‘zero-effort’ and ‘negligible cost’ compared to traditional
financing methods. The primary sources of spontaneous working capital are trade
credit and outstanding expenses.
• Short-term Sources: The sources of capital available to a business for less than
one year are called short-term sources of working capital.
• Long-term Sources: The sources of capital available to a business for a longer
period, usually more than one year, are called long-term sources of working capital.
SHORT-TERM SOURCES OF WORKING CAPITAL
• Loans from Commercial Banks: Businesses, mostly MSMEs, can get loans
from commercial banks with or without offering collateral security. There is no legal
formality involved except creating a mortgage on the assets. Repayment can be made
in parts or lump sum at the time of loan maturity. At times, banks may offer these
loans on the personal guarantee of the directors of a country. They get these loans at
concessional rates; hence it is a cheaper source of financing for them. However, the
flip side is that getting this loan is a time-consuming process.
• Public Deposits: Many companies find it easy and convenient to raise funds
for meeting their short-term requirements from public deposits. In this process, the
companies invite their employees, shareholders, and the general public to deposit
their savings with the company. As per the Companies Act 1956, companies can
advertise their requirements and raise money from the general public against issuing
shares or debentures. The companies offer higher interest rates than bank deposits
to attract the general public. The biggest of this source of financing is that it is simple
and cheaper. However, its drawback is that it may not be available during the
depression and financial stringency.
• Trade Credit: Companies generally source raw materials and other items
from suppliers on credit. The amount payable to these suppliers is also treated as a
source of working capital. Usually, the suppliers grant their buyers a credit period of
3 to 6 months. Thus, they provide, in a way, short-term finance to the purchasing
company. The availability of trade credit depends on various factors like the buyer’s
reputation, financial position, business volume, and degree of competition, among
others. However, when a business avails trade credit, it stands to lose the benefit of
cash discount, which it would earn if they make the payment within 7 to 10 days of
making the purchase. This loss of cash discount is treated as an implicit cost of trade
credit.
• Bill Discounting: Just as business buys goods on credit, they offer credit to
their buyers. The credit period may vary from 30 days to 90 days and sometimes
extends, even up to 180 days. During this period, the company funds get blocked,
which is not good. Instead of waiting that long, sellers prefer to discount these bills
with a bank or NBFC. The financial entity charges some amount as commission,
called a ‘discount’, and makes the balance payment to the sellers. This discount
compensates them for the time gap between disbursing and collecting the money on
the maturity of the bill. Businesses widely use this method for raising short-term
capital.
• Bank Overdraft: Some banks offer their esteemed customers and current
account holders a facility to withdraw a certain amount of money over and above the
funds held by them in their current account with the bank. The bank charges interest
on the amount overdrawn and the period it is withdrawn. The overdraft facility is
also granted against securities. The bank sets this limit and is subject to revision
anytime, depending upon the customer’s creditworthiness.
• Advances from Customers: One effortless way to raise funds to meet the
short-term requirement is to ask customers for some payment in advance. This
advance confirms the order and gives much-needed cash to the business. No interest
is payable to the customer for this advance. Even if any business pays interest, it is
very nominal.
LONG-TERM SOURCES OF WORKING CAPITAL
When the companies require funds for more than one year, it makes sense to go for
long-term sources, as they are generally cheaper than short-term sources.
• Share Capital: The Company may raise funds by offering the prospective
shareholders a stake in their business. These shares may be held by the general
public, banks, financial institutions, or even other companies. The response depends
on several factors, including the company’s reputation, perceived profit potential,
and general economic condition. In return, the company offers dividends to their
shareholders, which along with the floating cost, is treated as the cost of sourcing.
However, the company is not legally bound to pay this dividend. Also, no rule
prescribes how much dividend is to be given. All this makes this a very cheap source
of working capital. But, in reality, most companies do not use this for meeting their
working capital needs.
• Long-term Loans: Also called Working Capital Loans, these long-term loans
may be temporary or long-term. The long-term here is generally 84 months (7 years)
or more. This loan is not taken for buying long-term assets or investments and is
used to provide working capital to meet a company’s short-term operational needs.
Experts advise using long-term sources for permanent needs and short-term sources
for temporary working capital needs.
• Debentures: Like shares, debentures also include generating money from the
general public, financial institutions, and other companies. However, unlike shares,
in the case of debentures, the company has to declare the interest they will pay to
their lenders openly. The company is legally bound to pay the agreed interest. So,
here, if the funds are unused or even if the company runs into losses, they have to
pay the lenders.
Chapter-III
Capitalisation
Meaning of Capitalisation
Capitalisation is an important constituent of the financial plan of a business. In
common parlance, the term ‘capitalisation’ refers to the total amount of capital
employed in a business.
In its broad sense, the term ‘capitalisation’ refers to the process of determining the
quantum and patterns of financing. It includes the determination of not only the total
quantity of capital but also about the quality financing as such. In other words, it
includes decisions regarding the amount of capital and the modes of raising such
capital.
Theories of Capitalisation
Cost Theory and Earnings Theory (With Example, Merits and Limitations)
There are two important theories to determine the amount of capitalisation:
1. Cost theory of capitalisation
According to this theory, the amount of capitalisation is equal to the total cost
incurred in setting up of a firm as a going concern. Thus, the estimation of capital
requirements of a newly promoted firm is based on the total initial outlays for setting
up of a firm.
(i) Cost of fixed assets such as land and building, plant and machinery, furniture, etc.
(ii) The amount of regular working capital to carry on business operations.
(iii) The expenses of promotion, and
(iv) The cost of establishing business.
Example:
The cost theory of capitalisation is useful for those firms in which the amount of
fixed capital is more and whose earnings are regular, such as construction and public
utility concerns.
Merits:
(i) This theory is easy to understand.
(ii) It is useful to ascertain the capitalisation required for a new firm. It enables the
promoters to know the amount of capital to be raised.
Limitations:
(i) The amount of capitalisation calculated under this theory is based on cost and not
on earning capacity of a firm. The capitalisation will remain the same irrespective
of the earning capacity of the firm.
(ii) Since some assets are idle or become obsolete, the earning capacity will be
severely affected. But still the capitalisation will remain high as it is based on the
cost of assets.
2. Earning theory of capitalisation
According to this theory, the amount of capitalisation of a firm is determined by its
earning capacity. In other words, the worth of a firm is not measured by the capital
raised but by the earnings made out of the productive harnessing of the capital.
To determine the amount of capitalisation, a new firm will have to estimate the
average annual future earnings and the normal rate of earnings (also known as
capitalisation rate) prevalent in the industry.
For example, suppose the estimated earnings of X Ltd. is Rs.12 lakh per annum and
the fair rate of return expected is 12%.
The amount of capitalization of the firm is:
Merits:
(i) The amount of capitalisation found under this method represents the true worth
of the firm.
(ii) The amount of capitalisation arrived at on the basis of earnings can be used as a
standard for comparison.
Limitation:
Estimation of future earnings of a new firm is not easy. If the earnings are not
estimated correctly, the amount of capitalisation would be misleading.
Meaning of Over Capitalisation:
In simple terms, over capitalisation means existence of excess capital as compared
to the level of activity and requirements.
E.g. If a company is earning a profit of Rs. 50,000 and the normal rate of return
applicable for the same industry is 10%, it means that the number of shares and
debentures should be Rs. 5,00,000. If the number of shares and debentures issued by
the company is more than Rs. 500,000, then the company will be said to be
overcapitalised.
The term over capitalisation should not be taken to mean excess funds. There can be
a situation of over capitalisation, still the company may not be having sufficient
funds. Similarly, the company may be having more funds and still may be having a
low earning capacity thus resulting in over capitalisation.
Causes of Overcapitalisation:
The situation of overcapitalisation may arise due to various reasons as stated below:
(1) The assets might have been purchased during the inflationary situations. As such
the real value of the assets is less than the book value of the assets.
(2) Adequate provision might not have been made for depreciation on the assets. As
such, the real value of the assets is less than the book value of the assets.
(3) The company might have spent huge amounts during its formation stage or might
have spent huge amounts for the purchase of intangible assets like goodwill, patents,
trade-marks, copy-rights and designs etc. As a result, the earning capacity of the
company may be adversely affected.
(4) The requirement of funds might not have been properly planned by the company.
As a result, the company may realise shortage of capital and to overcome the
situation of shortage of capital, the company may borrow the funds at
unremunerative rates of interest, which in turn will reduce the earnings of the
company.
(5) The company might have followed the lenient dividend policy without bothering
much about building up the reserves. As a result, the retained profits of the company
may be adversely affected.
Effects of Over Capitalisation:
(1) On Company:
The real value of the business and its earning capacity reduces with the adverse effect
on market value of shares. Credit standing of the company in the market falls down
and it is difficult to raise further capital. The temporary means like lower amount of
depreciation and maintenance charges are followed to improve the earnings which
aggravates the situation further.
(2) On Shareholders:
This is the worst affected class. The shares held by them are not having any backing
of tangible assets. Due to the reduced market values, the shares become non-
transferable or are required to be transferred at extremely low prices.
(3) On Consumers:
To overcome the situation of over capitalisation and to improve the earnings, the
company may be tempted to increase the selling price, more particularly in
monopoly conditions. Due to this, the quality of the products may also be affected.
(4) On Society at Large:
The increasing selling prices and reducing quality can’t be continued for a very long
time due to the competition existing in the market. A situation like this means losing
the backing of the shareholders as well as the consumers.
As a result, the company is dragged towards the winding up which ultimately affects
the society at large in the adverse way in terms of lost industrial production,
unemployment generated, unrest among the workers as a part of society etc.
Remedies Available:
In order to overcome the situation of over capitalisation, the company may resort to
any of the following remedial measures.
(1) To reduce the debts by repaying them. But the debts should be re¬paid out of the
own earnings of the company. There is no point in repaying the debts out of the fresh
issue of shares or debentures, as it does not reduce the amount of capitalisation.
(2) To redeem the preference shares if they carry too high rate of divi-dend.
(3) The persons holding the debentures may be persuaded to accept new debentures
which carry a lower rate of interest.
(4) The par value of the equity shares may be reduced but this also will have to be
done only after taking the shareholders into confidence.
(5) The number of equity shares may be reduced but this also will have to be done
only after taking the shareholders into confidence.
Under Capitalisation
Under capitalisation implies a situation where the profits earned are exceptionally
high but the capital employed is relatively small.
A firm is said to be under capitalised when:
(a) Profits earned are exceptionally high.
(b) The value of long-term assets is higher than capital raised.
According to Gerstenberg “A corporation may be undercapitalized when the rate of
profits it is making on total capital is exceptionally high in relation to the return
enjoyed by similar situated companies in the same industry or when it has too little
capital with which it conducts its business”.
For example, if a firm earns a profit of Rs. 1 lakh and expected rate of earnings is
10%, the maximum amount of capitalisation is Rs.10 lakh. In case the firm raises
only Rs.8 lakh, the actual average earnings shall be 12.5% more than the expected
rate. Such a situation is called under capitalisation.
In short, under capitalisation is a situation where the profitability of a firm is much
higher as compared to the capital employed.
Causes of Under Capitalisation
Following are some of the reasons of under capitalisation:
(i) Under estimation of earnings:

Capitalisation is based on the earnings estimated. If the estimated earnings are lower,
the capitalisation figure is also lower. Sometimes, the earnings prove to be much
higher and the capitalisation figure previously calculated is lower.
(ii) Floatation of a firm during depression:
When a firm acquires assets or is promoted during the recovery period, its earnings
during the boom period may increase disproportionately to the capital employed.
(iii) Conservative dividend policy:
If a firm follows a conservative dividend policy i.e. payout ratio is maintained at low
level in the initial stages, profits are retained in the business and reserves are created
or reinvested in the business. This results in higher earnings on the capital employed
and hence under capitalisation.
(iv) High efficiency:
If assets are used and maintained properly and costs are reduced because of improved
technology, higher levels of vigilance and efficiency lead to improvement in
productivity and profitability which is reflected by high earnings on capital
employed.
Effects of Under Capitalisation
Under capitalisation has its effects on firms, its shareholders as well as society.
These effects are summarized as under:
(i) Effects on firm:
Under capitalisation affects a firm in the following ways:
(a) Under capitalisation increases the credit worthiness of the firm due to higher rate
of earnings.
(b) The higher rate of earnings may encourage outsiders to enter the field and
increase competition.
(c) The employees demand higher salaries and wages and this leads to dissatisfaction
and labour unrest.
(ii) Effects on shareholders:

Under capitalisation is always beneficial to the existing shareholders of the firm in
the following ways:
(a) Due to higher earnings of the firm, the shareholders regularly receive higher
dividends on their investments.
(b) The shareholders also avail capital gains because the market value of firm’s
shares increases very rapidly.
(c) Since the shares have great value as collateral security, the shareholders are at
ease in getting loans against the security of shares of an undercapitalized firm.
(iii) Effects on society:
Under capitalisation affects society as follows:
(a) Under capitalisation leads to unhealthy speculation on the stock exchanges,
which affects investment climate adversely.
(b) Consumers feel exploited since profits of the firms are high.
(c) It may also lead to labour unrest and strike, if the demand for higher wages and
increase in benefits are not accepted by the firm.
Remedies for Under Capitalisation
The following remedial steps may be taken to convert an undercapitalised firm into
a properly capitalised firm:
(a) Under capitalization may be remedied by increasing the par value and/or number
of equity shares by revising upward the value of assets. This will decrease the rate
of earnings per share.
(b) Management may capitalise the retained earnings by issuing bonus shares to the
equity shareholders. This will also reduce the rate of earnings per share without
reducing the total earnings of the firm.
(c) Where under capitalisation is due to insufficiency of capital, more shares and
debentures may be issued to the public.
Chapter-4 Capital Structure

Definition
The capital structure combines financial instruments like shares (equity and preference),
debentures, long-term loans, bonds, and retained earnings. These instruments help the
company generate funds for its operations with the help of individuals and institutions.
Factors affecting the Capital Structure
Several factors affect a company’s capital structure, and it also determines the composition
of debt and equity portions within this structure. Some of these factors are as follows:
▪ Business Size – The size and scale of a business affect its ability to raise finance.
Small-sized companies face difficulty in raising long-term borrowings. Creditors are
hesitant to give them loans because of the scale of their business operations. Even if
they do get these loans, they have to accept high-interest rates and stringent
repayment conditions. It limits their ability to grow their business.
▪ Earnings – Firms with relatively stable revenues can afford a more significant
amount of debt in their capital structure. Since debt repayment is periodical with
fixed interest rates, businesses with higher income prospects can bear these fixed
financial charges. On the other hand, companies that face higher fluctuations in their
sales, like consumer goods, rely more on equity shares to finance their operations.
▪ Competition: If a company operates in a business environment with more
competition, it should have more equity shares in its capital structure. Their earnings
are prone to more fluctuation compared to businesses facing lesser competition.
▪ Stage of the life cycle: A business in the early stage of its life cycle is more
susceptible to failure. In that case, they should use a more significant proportion of
ordinary share capital to finance their operations. Debt comes with a fixed interest
rate, and it is more suitable for companies with stable growth prospects.
▪ Creditworthiness: Any company that has a reputation for paying back its loans on
time will be able to raise funds on less stringent terms and at lower interest rates. It
allows them to pay back their loans on time. The opposite is true for firms that don’t
have a good credit standing in the market.
▪ Risk Aptitude of the Management: The attitude of a company’s management
also affects the proportion of debt and equity in the capital structure. Some
managers prefer to follow a low-risk strategy and opt for equity shares to raise
finances. Other managers are confident of the company’s ability to repay big
loans, and they prefer to undertake a higher proportion of long-term debt
instruments.
▪ Control: A management that wants outside interference in its operations may
not raise funds through equity shares. Equity shareholders have the right to
appoint directors, and they also dilute the stake of owners in the company.
Some companies may prefer debt instruments to raise funds. If the creditors
get their instalments on loans and interest on time, they will not be able to
interfere in the workings of the business. But if the company defaults on their
credit, the creditors can remove the present management and take control of
the business.
▪ State of Capital Market: The tendencies of investors and creditors determine
whether a company uses more debt or equity to finance their operations.
Sometimes a company wants to issue ordinary shares, but no one is willing to
invest due to the high-risk nature of their business. In that case, the
management has to raise funds from other sources like debt markets.
▪ Taxation Policy: The government’s monetary policies in terms of taxation on
debt and equity instruments are also crucial. If a government levies more tax
on gains from investing in the share market, investors may move out of
equities. Similarly, if the interest rate on bonds and other long-term
instruments is affected due to the government’s policy, it will also influence
companies’ decisions.
▪ Cost of Capital: The cost of raising funds depends on the expected rate of
return for the suppliers. This rate depends on the risk borne by investors.
Ordinary shareholders face the maximum risk as they don’t get a fixed rate of
dividend. They get paid after preference shareholders receive their dividends.
The company has to pay interest on debentures under all circumstances. It
attracts more investors to opt for debentures and bonds.
What Is Financial Structure?
Financial structure refers to the mix of debt and equity that a company uses to finance
its operations. This composition directly affects the risk and value of the associated
business. The financial managers of the business have the responsibility of deciding
the best mixture of debt and equity for optimizing the financial structure.
In general, the financial structure of a company can also be referred to as the capital
structure. In some cases, evaluating the financial structure may also include the
decision between managing a private or public business and the capital opportunities
that come with each.
Key Notes
• Financial structure refers to the mix of debt and equity that a company uses to
finance its operations. It can also be known as capital structure.
• Private and public companies use the same framework for developing their
financial structure but there are several differences between the two.
• Financial managers use the weighted average cost of capital as the basis for
managing the mix of debt and equity.
• Debt to capital and debt to equity are two key ratios that are used to gain
insight into a company’s capital structure.
What Is Capital Gearing?

Capital gearing is a British term that refers to the amount of debt a company has
relative to its equity. In the United States, capital gearing is known as "financial
leverage."
• Companies with high levels of capital gearing will have a larger amount of
debt relative to their equity value. The gearing ratio is a measure of financial
risk and expresses the amount of a company's debt in terms of its equity. A
company with a gearing ratio of 2.0 would have twice as much debt as equity.
KEY TAKEAWAYS
Capital gearing refers to a company's relative leverage, i.e., its debt versus its equity
value.
Understanding Capital Gearing

The ratio of capital gearing may differ with respect to the industry a company is in.
Industries that require a large capital investment may have a high capital gearing
ratio.
Capital gearing ratio acts as one of the major factors based on which lenders and
investors consider a company. If the company has a high capital gearing ratio, it
creates a negative impression in the minds of lenders as the company won't be able
to make the repayments in case there is a slowdown in its operations.
Capital gearing is of following types:
1. High Gearing
When the amount of equity share capital in the company is less than the Debt capital
and preference share capital, that situation is said to be high gearing.
In other words, when in any company ordinary share capital is less than other fixed
interest-bearing securities, then it’s known as high gearing.
2. Low Gearing
When the amount of equity share capital is more than the amount of debt capital and
preference share capital, then it is known as low gearing.
In other words, in the situation when the ratio of equity shares capital is more than
fixed cost bearing securities, it is known as low gearing.
What Is Trading on Equity?
Trading on Equity Meaning—Trading on equity means using the borrowed capital
to generate revenue that boosts the profits of equity shareholders, i.e., to make the
profits by investing in the debt higher than the loan’s interest costs.
Trading on equity in financial management involves a strategy where a company
takes debt as bonds, debentures, loans, or preferred stocks. A company applies this
strategy to increase the equity shareholder’s return on investment.
The borrowed funds such as bonds, debentures, loans, or preferred stocks are used
to buy assets for the company that can help them earn more revenue than the cost of
the borrowed funds.
Companies use this method of financing when they believe the assets will generate
more profits than the borrowed principal and interest amount paid on the debt. This
financial process increases equity shareholders’ wealth. As a result, the value of the
shares rises.
Trading on Equity Example:
Company Y has borrowed Rs.100 crores as debt funds at a 10% interest rate. Later,
the company used the debt to buy an asset (factory) to generate more income.
Here, company Y pays interest amounts of around Rs.10 crores while the income
generated from the asset amounts to Rs.20 crores.
We can say that the company was successful in using the trading on equity strategy
by enhancing its revenue-generating capacity.
What is The Purpose of Trading on Equity?
In the capital structure, a company may fund itself with debt or equity. If the
company uses more debt to finance initiatives, it will have to pay fixed interest,
which is less expensive than the cost of equity capital.
After paying the fixed interest on the debts, there will be profit left over for the
current shareholders.
If additional shares are issued, more equity shareholders will benefit from the gain.
As a result, when profits are substantial, companies use low-cost debt rather than
increasing the number of shareholders to divide the earnings or raise money for a
project.
The primary purpose is to increase the wealth of the shareholders.
• Trading on equity is employed when the company wants more finance from
debt sources rather than equity.
• The company uses this strategy to ensure that control over the company
remains the same.
• A company might also use the trading on equity strategy to increase the
company’s market share price.
Advantages And Disadvantages of Trading on Equity
Trading on equity advantages and disadvantages are as follows:

Advantages of Trading on Equity Include:
It gives the company access to extra capital, which makes it possible to invest in
assets that will generate a profit.
As the interest on a loan is tax deductible, the company pays less amount in taxes
overall.
Disadvantages of Trading on Equity Include:
Trading on equity involves disadvantages as well. The inability of the company to
pay back the interest for any reason is one of the primary disadvantages it faces.
Similarly, the company’s liabilities may grow if interest rates rise.
The borrowed debt funds may not fulfil the purpose for which it is borrowed.
In the worst scenario, the company can also become bankrupt.
Types of Trading on Equity
Below are the two types of trading on equity:
Trading on thin equity
In trading on thin equity, the borrowed amount is significantly close to the
company’s equity because the company’s capital is lower than the debt capital.
For example, if company X’s equity capital amounts to Rs.100 crores whereas the
debt capital amounts to Rs.300 crores, company X is said to be trading on thin equity.
Trading on thick equity
In trading on thick equity, a company borrows a small amount close to its equity
because the company’s equity capital is higher than the debt capital.
For example, if company X’s equity capital amounts to Rs.300 crores whereas the
debt capital amounts to Rs.50 crores, company X is said to be trading on thick equity.

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B.Com.

LLB IV Sem Subject: Business Finance

Nature and Objective of Business Finance

Meaning of Business Finance

Wealth Maximization: The second frequently encountered principle of a firm is- to

Finance is an important function of business. The application of planning to this

The main characteristics of a good financial planning are as follows:

Factors determining fixed capital requirements in business

Capital can be classified as under:

A capital budgeting decision is one of the most crucial business decisions. It is

A huge outflow of funds is involved in capital budgeting decisions, because of which

▪ A key aspect of financial management is the management of working capital.

Various factors determine how much working capital is required. A business

• Reserve Working Capital: Reserve Working Capital is a type of working capital

SOURCES OF WORKING CAPITAL:

(i) Under estimation of earnings:

(ii) Effects on shareholders:

Chapter-4 Capital Structure

What Is Capital Gearing?

Understanding Capital Gearing

Trading on equity advantages and disadvantages are as follows:

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