Chapter 18Capital & Capital Market

Financial Management

It deals with raising of finance, and using and allocating financial resources of a company Use the lowest cost to obtain fund Making the optimal use of these funds

Objectives of Financial ManagementFind ways to raise capitalConserving capitalEarning a profitable return from the use

of capital Maximizing the wealth of the

owners / stockholders

Financial PlanningThe forecast and projecting income and

expenditures, determining methods of financing, cash flow forecasting, credit policy

Functions of the Financial ManagerFinancial analysis and planningManaging the firm’s asset structureManaging the firm’s financial structure

Important Notes

1. Sources of capital• Internal• External

2. Duration• Short term• Long term

3. Capital structure• Equity• Debt

4. Small vs. large Firm

Sources of Capital (Internal)

1. Retained earnings (Short term / long term)Advantages:

• No interest payment• No maturity date

Disadvantages• Limit amount• Not available to newly established firms• If no enough dividend, shareholders may sell

their shares.

Difficult to obtain funds in the stock market in the future.

2. Depreciation allowance (Short term)• Tax payment

3. Reduction in current assets (Short term)

• Factoring Advantages: immediate cash available

Disadvantages: very high cost, damage reputation

Sources of Capital (External)

1. Bank loan• Unsecured bank loans (no collateral)• Secured loans (collateral)Advantages:

No dilution of control Stable supply of funding Interest payment is tax deductable

Disadvantages: Interest burden Fixed maturity date

2. Overdrafts

Advantages: Easy and immediate access of fund Ability to borrow only as much as needed Can repay immediately when cash available Decrease interest burden

Disadvantages:• May require collateral• May require to maintain deposit without

interest

3. Trade credit

Advantages:

No collateral require

No formal procedure involved

Disadvantages:

Give up cash account

Commercial papers

Unsecured short-term obligation (i.e.

promissory notes) sold by large corporation

ONLY large, well-known, credit-worthy

corporations can borrow

Backed UP by general assets

Long-term Capital

1. Equity financing• Injection of capital by owners• Retained earnings• Issue of shares• Preference shares

No voting rights Fixed rate of dividend Have priority to receive dividends

Debt financingDebentures / BondLong term bank loans

Advantages of Equity FinancingFirms are able to withstand business

fluctuationNo collateral requirePostponement of borrowing for future

need Increase creditworthiness of the

company

Disadvantages of Equity FinancingUsually impossible to obtain all needed

capitalMay be more costly than that financing

in long-term Shareholders are entitled to share

superiors earnings of the company• Dividend is NOT tax deductible• Risk of losing control

Advantages of Debt Financing

1. Can obtain all needed capital2. Creditors (bank, bond holder) do not

participate in superior earning of a company

3. Interest payment is tax deductible4. No dilution of a company control5. Repayment of debt is cheaper during

inflation

1. Interest charges must be met regardless earnings

2. Debt must be repaid at maturity

3. Commitment for long period involves risk. If expectation / plan change, debt may become a heavy burden

Disadvantages of Debt Financing

When to use long-term debt financing? Inflation expectStability in revenue and earningsThere is satisfactory profit marginGood liquidity and cash flow positionWhen stock prices currently depressedDebt ratio is still lowControl consideration

Comparison of Equity and Debt Financing

1. Voting right• Equity (common stock) – voting right on

basis of one vote per share. (Preference shares normally no such right).

• Debt (bonds) – no voice in management

2. Representation• Equity – represents ownership• Debt – represents debt

3. Interest payment• Equity – none. Also, dividends cannot be

authorised until bond interest is paid.• Debt – interest paid prior to other claims.

4. Accounting• Equity – dividends part of earnings of firm.• Debt – interest is expense.

5. Payment• Equity – ordinary dividends paid at

board’s discretion. (Preferred dividends paid prior to ordinary dividends and must be paid if earnings sufficient).

• Debt – interest must be paid.

6. Principal repayment• Equity – no maturity date, i.e. no

guarantee of payment. If owners wish to withdraw investment, must sell to others.

• Debt – must be repaid at some future date, i.e. specified amount guaranteed even if company does poorly, provided it remains in the business.

7. Claims on assets• Equity – ordinary shareholders last to

claim assets of failing business. (Preference shares have priority over ordinary shareholders but behind creditors).

• Debt – creditors have first claim on assets.