Financial Management and Capital Structure

RUMA KHATUN- B120202087 REZWAN SADAT- B110202003 AKIKUN NAHUR- B110202005 NUSRAT JAHAN- B110202077 NUSRAT JAHAN PROMA- B110202103

GROUP MEMBERS:

INTRODUCTION

Financial management is an integrated decision making process, concerned with acquiring, managing and financing assets to accomplish overall goals within a business entity.

Speaking differently, it is concerned with making decisions relating to investments in long term assets, working capital, financing of assets and so on.

Financial Management:

The planning, directing, monitoring, organizing, coordinating and controlling of the monetary resources of an organization.

It is an area of finance dealing with financial decision business enterprise make and the tools and analysis used to make this decision.

financial Management can be defined as:

The management of the finances of a business organization in order to achieve financial objectives.

Financial management capacity is a cornerstone of organizational excellence.

Financial management pervades the whole organization as management decisions almost always have financial implications.

FINANCIAL MANAGEMENT INVOLVES:

Financial planning: concerned

with the act of deciding in advanced.

Financial organizing: grouping of the finance

function

Financial controlling:

proper adjustment of finance

function

Financial reporting: collection

and reporting the finance data.

IMPORTANCE OF FINANCIAL MANAGEMENT

Financial management is concerned with procurement and utilization of funds in a proper way. It is important because of the following advantages:

1. Helps in obtaining sufficient funds at a minimum cost.

2. Ensures effective utilization of funds.

3. Tries to generate sufficient profits to finance expansion and modernization of the enterprise and secure stable growth.

4. Ensures safety of funds through creation of reserves,

re-investment of profits, etc

Fundamental financial management decision: Investment decision: proper allocation of

capital. Both fixed and working investment.

Financing decision: determination of optimal capital and financial structure of an enterprise.

Decision relates to the raising of finance from various resources.

Dividend decision: Formulation of profit plan Formulation of dividend policy Formulation of retention policy Investment of accumulated profit

Investment decision:

This decision relates to the careful selection of assets in which funds will be invested by the firm. It Involves buying, holding, reducing, replacing, selling & managing assets.

Financing decisions: Financing decisions involve the acquisition of funds

needed to support long-term investments.

While taking this decision, financial management weighs the advantages and disadvantages of the different sources of finance.

The business can either finance from its shareholder funds which can be subdivided into equity share capital, preference share capital and the accumulated profits.

Borrowings from outsiders include borrowed funds like debentures and loans from financial institutions.

Dividend decisions: This decision relates to the appropriation of profits earned.

The two major alternatives are to retain the profits earned or to distribute these profits to shareholders.

While declaring dividend, a large number of considerations are kept in mind such as:

Trend of earnings Stability in dividends The trend of share market prices The requirement of funds for future growth The cash flow situation Restrictions under the Companies Act The tax impact on shareholders etc.

Capitalization

ClapitaL Structure Management

of capital

Form of Capital:

Capital Structure

Definition:

In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells tk20 billion in equity and tk80 billion in debts is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example is referred to as the firm's leverage. In reality, capital structure may be highly complex and include dozens of sources. Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the business finance, e.g. by taking a short term loan etc.

Capital structure

Equity Capital: This refers to money put up and owned by the shareholders (owners). Typically, equity capital consists of two types:

1.) Contributed capital

2.) Retained earnings.

Debt Capital: The debt capital in a company's capital structure refers to borrowed money that is at work in the business.

Business risk is the risk inherent in the operations of the firm, prior to the financing decision. Thus, business risk is the uncertainty inherent in a total risk sense, future operating income, or earnings before interest and taxes (EBIT). Business risk is caused by many factors. Two of the most important are sales variability and operating leverage.

Financial risk is the risk added by the use of debt financing. Debt financing increases the variability of earnings before taxes (but after interest); thus, along with business risk, it contributes to the uncertainty of net income and earnings per share. Business risk plus financial risk equals total corporate risk.

Capital structurer analysis:

• EBIT – EPS Analysis

• ROI – ROE Analysis

• Ratio Analysis

• Leverage Analysis

• Cash Flow Analysis

• Comparative Analysis

EBIT – EPS ANALYSIS

The relationship between EBIT and EPS is as follows:

(EBIT – I) (1 – t)

EPS =

n

EARNINGS PER SHARE UNDER ALTERNATIVE FINANCING PLANS

Equity Financing Debt Financing

EBIT : 2,000,000 EBIT : 4,000,000 EBIT : 2,000,000 EBIT : 4,000,000

Interest - - 1,400,000 1,400,000 Profit before taxes 2,000,000 4,000,000 600,000 2,600,000

Taxes 1,000,000 2,000,000 300,000 1,300,000 Profit after tax 1,000,000 2,000,000 300,000 1,300,000 Number of equity

shares 2,000,000 2,000,000 1,000,000 1,000,000 Earnings per share 0.50 1.00 0.30 1.30

BREAK-EVEN EBIT LEVEL

The EBIT indifference point between two

alternative financing plans can be obtained

by solving the following equation for EBIT*

(EBIT *– I1) (1 – t) (EBIT *– I2) (1 – t)

=

n1 n2

ROI – ROE ANALYSIS

ROE = [ROI + (ROI – r) D/E] (1 – t)

where ROE = return on equity

ROI = return on investment

r = cost of debt

D/E = debt-equity ratio

t = tax rate

RATIO ANALYSIS

Interest Coverage Ratio

Earnings before interest and taxes

Interest on debt

Cash Flow Coverage Ratio

EBIT + Depreciation + Other non-cash charges

Loan repayment instalment

Interest on dept + (1 – Tax rate)

Ratio analysis

n PATi + DEPi + INTi + Li

i=1

DSCR = n

INTi + LRIi + Li

i=1 where DSCR = debt service coverage ratio PATi = profit after tax for year i DEPi = depreciation for year i INTi = interest on long-term loan for year i

LRIi = loan repayment instalment for year i Li = lease rental for year i

n = period of the loan

CASH FLOW ANALYSIS

The key question in assessing the debt capacity of a firm

is whether the probability of default associated with a

certain level of debt is acceptable to the management.

The cash flow analysis establishes the debt capacity by

examining the probability of default.

COMPARATIVE ANALYSIS

A common approach to analysing the capital structure of

a firm is to compare its debt-equity ratio to the average

debt-equity ratio of the industry to which the firm

belongs.

Since the firms in an industry may differ on factors like

operating risk, profitability, and tax status it makes

sense to control for differences in these variables

• CAPITAL STRUCTURE POLICIES

Five common policies are:

1.No debt should be used

2.Debt should be employed to a very limited extent

3.The debt-equity ratio should be maintained around

1:1

4.The debt-equity ratio should be kept within 2:1

5.Debt should be tapped to the extent available

THEORIES OF CAPITAL STRUCTURE

Net Income Approach (NI)Net Operating Income Approach (NOI)

Traditional Approach (TA)Modigliani and Miller Approach (MM)

Capital Structure = Financial CurrentStructure liabilities

Kinds of Capital Structure

Equity Share Capital

+ Retained Earnings

Debt + Preference

Share

Debt

Foun

dati

on

Exp

an

sio

n

Horizontal

Vertical

Pyramid Shaped

Inverted

Pyramid

Shaped

IMPORTANCE OF CAPITAL STRUCTURE:

THINK (LOADING………………………..)

Indicator

of risk

profile of

the firm

Acts as

a manage

ment

tool

Reflects the firm’s strategy

PURPOSE OF STUDY

CAPITAL STRUCTURE

VALUE OF FIRM

COST OF CAPITAL

1. NET INCOME APPROACH

ASSUMPTIONS:

1. COST OF DEBT < COST OF EQUITY

2. NO TAXES

3. RISK NOT INFLUENCED BY DEBT’S USAGE

IMPLICATIONSINCREASE IN FIRMS’ VALUE

PROPORTION OF CHEAP SOURCE OF FUNDS INCREASE

PROPORTION

OF DEBT INCREASES