BUSINESS STUDIES

1. BUSINESS STUDIES Financial Management Class XII Weightage 12 Marks

2. Meaning of Business Finance • Money is required to conduct various activities in business. • It is the acquisition and conservation of capital funds to meet the financial needs and overall objectives of business.

3. Financial Management • Financial Management means planning, organising, directing and controlling the financial activities such as procurement and utilisation of funds of the enterprise. It includes 3 decisions: • Investment decisions –estimating total capital requirement for fixed assets and current assets(working capital). • Financing decisions - raising of finance from various resources considering type of source, period of financing, cost of financing and the returns thereby. • Dividend decision – Decisions on how to divide the net profit i.e.. How much we give the shareholders and how much we keep as retained earnings to invest back in the company.

4. Concept of Risk and Return • Return on an investment is the financial outcome for the investor. • Return = Amount realised – Amount invested • Risk is present whenever investors are not certain about the outcomes an investment will produce. • Risk refers to the dispersion or deviation of returns from the average return of such investment. • Risk is measured by calculating Standard Deviation( think Statistics) • Risk and return have direct relationship. (They move together) Thumb Rule Higher the risk, greater is the return demanded!

5. Case of Investing in a Business • Sachin’s friend Prateek had an idea of creating a photography service that went to school functions, such as games, annual days and other functions, to take candid pictures. The pictures would be available to purchase the following week. He needed Rs. 50,000 to buy additional equipment and start an advertising campaign, so he asked Sachin for a loan and promised to pay him back the loan amount and share 25% of his profits from the first semester. Sachin was not happy with this and asked for a 20% interest on the loan and did not want any share in the profits. Prateek sold a few pictures the first week of school but quit going to events to take pictures. Now Sachin is following him to get his money back. • Discuss the case in terms of risk for Sachin and returns demanded by him.

6. Case on Saving for Future • Rishab spent his three years of college working and doing odd jobs after classes. He wanted to save some money for his education abroad after college. While his parents would pay the tuition, he wanted to save enough money to pay for his living expense. He decided to keep his money as a fixed deposit in his bank. The deposits earned 6% interest. He anticipated that he would have enough money for two years of living expenses. When he got to his college town, he realised that food and rent, along with many other prices, were much higher than he had originally estimated. Prices rose faster than the value of his savings. • How would you describe his situation in risk-return paradigm?

7. Concept of cost • Each source of fund comes at different cost but the basic hierarchy remains the same. • Retained earnings has no explicit cost as they are internally generated and no payments have to be made in lieu of them. • Debt is a cheaper source than equity. Interest and principal has to be paid back but the cost is predefined. As the risk of investment is lower, returns are low. • Equity holders are owners. They take the risk and demand the highest return! Cheapest cheaper than equityMost Expensive

8. Role of Financial Management • Forecasting Capital Requirement • Capital Budgeting or Investing Decisions • Capital Structure Decisions • Working Capital Decisions • Decisions on Sources of Finance • Understanding Effects on Financial Statements

9. Objectives of Financial Management

10. Objectives of Financial Management • A business concern exist to earn profit. Earning profit is mandatory for a business’s survival and growth. • But it is very difficult to define profit. What should a enterprise measure its growth in - gross profit, net profit, EBIT, profit after dividends etc. It is theoretical concept. • A business exist to undertake an activity which creates value. Carrying that activity is the basic objective of any organisation. • Wealth Maximisation is a more holistic objective of business. It is a realistic concept. • It maximises the market value of existing owner’s equity i.e. the current value of equity shares. • It looks at both time and risk of business.

11. Financial Decision

12. 1. Long Term Investment or Capital Budgeting Decisions The process of planning and managing a firm’s long-term investments is called capital budgeting. It means to identify investment opportunities that are worth more to the firm than they cost to acquire. Factors Affecting the Investing Decisions – • Cash Flows of the Project - size, timing, and risk of future cash flows is the essence of capital budgeting. • Rate of Return - The gain or loss on an investment over a specified period, expressed as a percentage increase over the initial investment cost. •  Decision Criteria – There are various capital budgeting techniques that can be applied but all look at the following perspectives like profitability, economic constraints, financial volatility and market conditions.

13. 2) Financing Decisions All about sources of funds . We decided how much money we need – now we think from where do we raise it, as each source will have a different cost and risk associated to it. Two basic sources • Shareholder Funds – Equity capital comprising of equity and preference shares and retained earnings. • Borrowed Funds- includes all sources of debt including long term and short term debt and debentures.

14. Factors affecting Financing Decisions • Cost – debt financing is cheaper than equity • Risk- high levels of debt brings risk of default and insolvency. • Floatation cost – its cheaper to raise loans but the cost associated with issues of shares and debentures are too high. • Strength of company’s financials- company with a stronger balance sheet and cash flow position can raise debt easily. • Fixed operating cost and revenue positions - debt increases out fixed cost as interest has to be paid. • Ownership issues - Equity issues dilutes ownership of pre existing shareholders. • State of Market – buoyant markets bullish on equity.

15. Dividend Decisions It is the portion of profits distributed to shareholders. Not mandatory and competes with what we can reinvest in business as retained earning to increase future profitability. Factors effecting Dividend Decisions • How much we earn- higher the firm earns more will the owners. • Stability of earnings- stable incoming cash flows makes dividend payment easier. • Dividend policy – firm may follow stable dividend policy or stable percentage of dividend policy. • Growth opportunities – if firm has good projects to invest in, they will want higher retained earnings. • Cash Flow position – a firm earning profits but not receiving cash won’t be able to pay dividend. Think accrual accounting!

16. Shareholder’s preference- A bird in the hand vs. two in a bush. Sometimes shareholder prefers to receive the cash instead for wealth maximisation( this he gets when he sells his share) • Taxation Policy – dividend and capital gains are taxed differently. Generally capital gains are taxed higher. • Market Reactions - stock market reactions have an impact. Firms declare dividends just to maintain stock prices. • Access to funds- firms which have easier access to other sources of capital do not depend on retained earnings. • Debt Covenant – some lenders esp. banks put restrictions on future dividend payments to ensure higher degree of retained earnings and firms ability to repay debt.

17. Case – Dividend Policy Microsoft is known globally as number one software company . Its founder Bill Gates, created the company in year 1975 after dropping out of Harvard at the age of 19. He teamed up with his friend Paul Allen to set up a company. Microsoft came up with revolutionary products like Windows Operating system and Office Suite. The company went public in year 1986 and grew by leaps and bounds till 2002 and earned substantial profits. But it never paid any dividends to its shareholders. The first dividend was paid in year 2003 and then onwards it pays dividends once a year and follows a progressive policy. Since then the dividend payout has increased by many times. The board of director reviews the quantum(big or small) of dividend on an annual basis. The payment decision is based on future capital requirements for research and development, investments, legal and business risk.

18. Problems • Discuss Microsoft’s dividend policy. • What kept the shareholders satisfied even when they were not receiving any dividends? • Do you agree with Board of Director’s Dividend payment policy.

19. Financial Planning To have just enough capital ! It is the blueprint of future financial operations of the firm. It is the process of framing financial policies in relation to procurement, investment and administration of funds of an enterprise. Objectives of financial planning • determining capital requirements- short and long term, depends upon factors like cost of current and fixed assets, promotional expenses and long- range planning. • Determining capital structure- is the composition of capital, i.e., the relative kind and proportion of capital required in the business. This includes decisions of debt- equity ratio- both short-term and long- term. • Framing financial policies with regards to cash control, lending, borrowings, etc. • A finance manager ensures that the scarce financial resources are maximally utilized in the best possible manner at least cost in order to get maximum returns on investment.

20. Importance of Financial planning • Adequate funds are ensured. • Helps in ensuring a reasonable balance between outflow and inflow of funds so that stability is maintained. • Ensures that the suppliers of funds are easily investing in companies which exercise financial planning. • Helps in making growth and expansion programmes which helps in long-run survival of the company. • Reduces uncertainties with regards to changing market trends which can be faced easily through enough funds. • Helps in reducing the uncertainties which can be a hindrance to growth of the company. This helps in ensuring stability and profitability in concern. • Fosters evaluation and control.

21. Stages of Financial Planning • Plan – ranging for a period to 3-5 years • Gathering relevant financial information – sales and profit forecast • Prescribing goals – requirement of fixed asset and working capital. • Examining current financial status- need of external finances • Create financial strategy – decide sources of funds • Implementing the financial plan – create yearly budgets • Monitoring the success of the financial plan, adjusting it if necessary 

22. Budget- applicable for a year or less Planned income and expenses to estimate whether or not they can continue to operate with its projected income and expenses. A budget can be drawn up for each financial year and contain information on the estimated value of sales and value of costs. • From this you can see how the coming accounting period is likely to end. • The actual performance of the business can be measured against this proposed plan.

23. Capital Structure • The value of the firm can be thought of as a pie. • The Capital Structure decision can be viewed as how best to slice up a the pie. • Two sources of capital: 1. Owners fund- equity share, preference share and retained earnings 2. Borrowed funds- long and short term loans debentures and public deposits. 70% Debt 30% Equity

24. What is Debt… • Debt is an obligation to repay the amount borrowed by a certain day and pay a certain percentage of interest on it. • Debt is a burden as the interest has to be paid whether or not company made any profits. • As the payment is assured debt carries less risk so comes at a cheaper cost. • Also provides tax shield for the company. • Additional use of debt lowers the cost of capital. • But too much debt increases risk of liquidation . This is financial risk.

25. Optimal Capital Structure • Debt-equity ratio is proportion of debt to total capital = debt/ debt + equity • Total cost of capital is the cumulative cost of debt and equity. • Equity is more expensive than debt as it is riskier investment. • The shareholder’s claim on firm value is the residual amount that remains after the debt holders are paid. • If the value of the firm is less than the amount promised to the debt holders, the shareholders get nothing. • Optimal capital structure is that proportion of debt and equity when the cost of capital is lowest.

26. Case Study In 2000, Microsoft had sales of $23 billion, earnings before taxes of $14.3 billion, and net income of $9.4 billion. It paid $4.9 billion in taxes, had a Equity capital of $423 billion, and had no long-term debt outstanding. Bill Gates is thinking about a recapitalization, issuing $50 billion in long-term debt and repurchasing $50 billion in stock. How would this transaction affect Microsoft’s Capital Structure? Draw the pie diagram and discuss the effects on the basis 1.Cost 2.Control 3. Risk

27. Financial Leverage/Trading on Equity • Financial leverage refers to the extent to which a firm relies on debt financing. The more debt a firm uses, relative to equity, the more financial leverage it employs. Financial Leverage = debt or debt equity debt+equity • It is the benefits gained from borrowing at a lower rate of interest than expected return of funds employed. • Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. • There are tax advantages that we can get when we use leverage, as interest is an expense which reduces tax paid.( interest is a tax deductible amount)

28. Financial Leverage

29. Trading on Equity • Trading on equity- debt is considered a cheaper source of finance. • A greater return ( profit) is earned by an equity share holder , because the business employed debt • Only happens when returns earned on capital employed > cost of debt. (ROI> Interest Cost) • Earning per share (EPS) increases due to reduced taxes paid as interest cost was higher. • Interest is tax deductible expense= net profit before tax lowers = lower taxes paid = net income increases • Till we have a high EBIT to sustain interest payment we can enjoy high degree of financial leverage.

30. Check out the EPS calculations for tow firms ABC Co. and XYZ Co. and calculate EPS and ROI and discuss. ( rate of interest is 10%)

31. Factors affecting capital structure 1. Interest Coverage Ratio • ICR is a measure of a company's ability to meet its interest payments. • Interest coverage ratio = EBIT / Interest expenses. • Higher the ICR, better is the financial health of the company. •  A lower ICR means less earnings are available to meet interest payments and that the business is more vulnerable to increases in interest rates. • ICR ignores cash flow and depends on accounting income. ( EBIT is an accounting term- accrual concept- does not measure actual cash available. (EBIT- Earning before Interest and Taxes)

32. Factors affecting capital structure 2. Debt Service Coverage Ratio • Tackles the issues of ICR and works with cash flow. • Uses ‘Net operating income” • Numerator in the ratio is the cash flow generated by the company. Includes my profits earned(after paying tax) and adding all non cash expenses( e.g. depn) and interest. • Denominator includes payment to creditors and preference shareholders. • Profit after tax + Depreciation + Interest + Non Cash exp. Pref. Div + Interest + Repayment obligation Higher the better!

33. Factors affecting capital structure 3. Size of cash flow – CFs needs to be enough to cover the expenses, interest payments and necessary investments in working capital and fixed capital. 4. Return on Investments= EBIT/ Total capital If the ROI> Cost of Debt we earn a positive profit on trading on equity and vice versa. 5. Cost of Debt – as our balance sheet gets heavy, i.e. has more debt in it, the cost at which debt is available also increases. 6. Cost of Equity – if financial risk increases, then cost of equity increases – risk and return have a positive relationship.

34. Factors affecting capital structure 7. Tax Rate – interest is a tax deductible expense. It reduces the taxable income of the company. This is called a tax shield. • This reduces the actual cost of debt. How? An interest tax shield equals the cost of interest multiplied by the company's tax rate. • At 10% interest, with tax rate at 25% - tax shield = 2.5% • At 10% interest, with tax rate at 35% - tax shield = 3.5% • As the tax rate increase the cost of debt falls by the amount of tax shield. 8. Floatation Costs – are the cost incurred to raise money through public. To get any issue out to public is a long and expensive process. There are banks, underwriters , govt agencies involved. If the floatation cost are too high companies prefer higher debt .

35. Factors affecting capital structure 9. Flexibility- capital structure cannot remain optimal. Companies take advantage of certain opportunities to raise money at cheaper sources. ( if the govt reduces interest cost, debt will be cheaper- firms would like to use this to raise more money as debt) 10. Risk. . Both the risk considerations have to be taken into account. Business risk is the risk inherent in the operations of the firm, prior to the financing decision. It is the uncertainty inherent in a total risk sense is caused by many factors like sales variability and operating leverage. Financial risk is the risk added by the use of debt financing. It increases the variability of earnings before taxes (but after interest) i.e. EBT.

36. 11. Control – Use of retained earnings and equity capital allows the owners to keep control over the financial decisions of the company. Use of debt can brings certain restrictive covenants. Issuing further equity brings maximum dilution. 12. Regulatory Issues – Banks and lending institutions when issues debt apply restrictive covenants on companies which prevent them from raising more debt, issuing equity or payments of dividend. 13. Market Sentiments- A new equity issue can be fairly successful in a bullish market but if market is bearish a company mostly raises debt. 14. Industry Norms – All companies in a particular industry follow similar capital structures, as the risk return semantics remain the same.

37. Problems 1.  When sequential long-term financing is involved, the choice of debt or equity influences the future financial  of the firm. • Timing • Flexibility • liquidity 2. Blue & Co. is an all-equity firm with a total market value of Rs.250,000. The firm has 25,000 shares of stock outstanding. Management is considering issuing Rs.100,000 of debt at an interest rate of 7 percent. Management estimates that the economy will be fairly normal and thus the firm's earnings before interest and taxes (EBIT) will be Rs.60,000. Tax rate is 20%. What is the anticipated earnings per share (EPS) if the debt is issued? • 2 Rs/share • 1.59 Rs/share • 2.17 Rs/share

38. 3. The term "capital structure" refers to: • long-term debt, preferred stock, and common stock equity. • current assets and current liabilities. • total assets minus liabilities. • shareholders' equity. 4. A leveraged firm is a company that has: • Accounts Payable as the only liability on the balance sheet. • has some debt in the capital structure. • has all equity in the capital structure. • None of the above. 5. A firm should select the capital structure which: • produces the highest cost of capital. • maximizes the value of the firm. • minimizes taxes. • has no debt.

39. Questions to Practice • A company wants to establish a new unit in which a machinery worth Rs.10 lakhs is involved. Identify the type of decision involved in financial management. • A decision is taken to raise money for long term capital needs of the business from certain sources. What is this decision called ? • A decision is taken to distribute certain parts of the profit to shareholders after paying tax. What is this decision called? • Name the source of finance carrying two fixed obligations viz., interest and redemption.

40. Questions to Practice • What is a tax shield? • In case of an inflation, does an enterprise need more or less of the working capital? • Identify the decision taken in financial management which affects the liquidity as well as the profitability of business. • A businessman who wants to start a manufacturing concern, approaches you to suggest him whether the following manufacturing concern would require large or small working capital: (a) Bread, (b) Coolers, (C) Motor Car.

41. Questions to Practice • State the factors which affect the capital structure of a company. • Why is Financial Planning done? • ‘Primary objective of financial management is to maximise the wealth of shareholders’. Explain. • The directors of a manufacturing company are thinking of issuing Rs. 20 lakhs additional debentures for expansion of their production capacity. This will lead to an increase in debt-equity ratio from 2:1 to 3:1. What are the risks involved in it?

42. Questions to Practice • You are the finance manager of a newly established company. The directors of the company have asked you to plan the capital structure of the company. State any four factors that you would consider while planning the capital structure. • How Stock market conditions affect the capital structure specially when company is planning to raise additional capital? • State why the working capital needs for a service industry are different from that of a manufacturing industry. • To avoid the problem of shortage and surplus of funds what is required in financial management? Name the concept and explain its any three points of importance.