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INTERMEDIATE (IPC) COURSE STUDY MATERIAL

PAPER : 3

COST ACCOUNTING AND FINANCIAL MANAGEMENT

Part – 2 : Financial Management

MODULE – 2

BOARD OF STUDIES THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

© The Institute of Chartered Accountants of India

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This study material has been prepared by the faculty of the Board of Studies. The objective of the study material is to provide teaching material to the students to enable them to obtain knowledge in the subject. In case students need any clarifications or have any suggestions to make for further improvement of the material contained herein, they may write to the Director of Studies. All care has been taken to provide interpretations and discussions in a manner useful for the students. However, the study material has not been specifically discussed by the Council of the Institute or any of its Committees and the views expressed herein may not be taken to necessarily represent the views of the Council or any of its Committees. Permission of the Institute is essential for reproduction of any portion of this material.


All rights reserved. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form, or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior permission, in writing, from the publisher. Revised Edition : July, 2014

Website : www.icai.org

E-mail : [email protected]

Committee/ : Board of Studies

Department

ISBN No. : 978-81-8441-138-6

Price (All Modules) : `

Published by : The Publication Department on behalf of The Institute of Chartered Accountants of India, ICAI Bhawan, Post Box No. 7100, Indraprastha Marg, New Delhi 110 002, India.

Printed by : Sahitya Bhawan Publications, Hospital Road, Agra 282 003 July/2014/


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CONTENTS

MODULE – 1

Chapter 1 – Scope and Objectives of Financial Management

Chapter 2 – Time Value of Money

Chapter 3 – Financial Analysis and Planning

MODULE – 2

Chapter 4 – Financing Decisions

Chapter 5 – Types of Financing

MODULE – 3 Chapter 6 – Investment Decisions

Chapter 7 – Management of Working Capital

Appendix


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DETAILED CONTENTS : MODULE – 2

CHAPTER 4 – FINANCING DECISIONS

UNIT I : COST OF CAPITAL

1.1 Introduction ................................................................................................................ 4.1

1.2 Definition of Cost of Capital ........................................................................................ 4.3

1.3 Measurement of Cost of Capital ................................................................................. 4.3

1.3.1 Cost of Debt ..................................................................................................... 4.4

1.3.2 Cost of Preference Shares ............................................................................... 4.8

1.3.3 Cost of Equity ................................................................................................... 4.9

1.3.4 Cost of Retained Earnings .............................................................................. 4.15

1.3.5 Cost of Depreciation ....................................................................................... 4.16

1.4 Weighted Average Cost of Capital (WACC) .............................................................. 4.17

1.4.1 Calculation of WACC ...................................................................................... 4.18

1.5 Marginal Cost of Capital ........................................................................................... 4.21

1.6 Conclusion ............................................................................................................... 4.26

UNIT II : CAPITAL STRUCTURE DECISIONS

2.1 Meaning of Capital Structure .................................................................................... 4.27

2.2 Designing Capital Structure ...................................................................................... 4.27

2.3 Key Concepts for Designing Optimal Structure ......................................................... 4.28

2.3.1 Leverages ...................................................................................................... 4.29

2.3.2 Coverage Ratio .............................................................................................. 4.30

2.3.3 Cash Flow Analysis ........................................................................................ 4.30

2.4 Optimal Capital Structure ......................................................................................... 4.30

2.5 EBIT-EPS Analysis ................................................................................................... 4.30

2.6 Cost of Capital, Capital Structure and Market Price of Share .................................... 4.40

2.7 Capital Structure Theories ........................................................................................ 4.41


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2.7.1 Net Income Approach (NI) .............................................................................. 4.41

2.7.2 Net Operating Income Approach (NOI) ........................................................... 4.43

2.7.3 Modigliani-Miller Approach (MM) .................................................................... 4.45

2.7.4 Traditional Approach ...................................................................................... 4.50

2.8 Capital Structure and Taxation ................................................................................. 4.54

2.9 Over Capitalisation ................................................................................................... 4.55

2.9.1 Causes of Over Capitalisation ........................................................................ 4.55

2.9.2 Consequences of Over Capitalisation ............................................................. 4.56

2.9.3 Remedies for Over Capitalisation ................................................................... 4.56

2.10 Under Capitalisation ................................................................................................. 4.56

2.10.1 Consequences of Under Capitalisation ........................................................... 4.56

2.10.2 Effects of Under Capitalisation ....................................................................... 4.57

2.10.3 Remedies for Under Capitalisation ................................................................. 4.57

2.10.4 Over Capitalisation vis-à-vis Under Capitalisation .......................................... 4.57

UNIT III : BUSINESS RISK AND FINANCIAL RISK

3.1 Introduction .............................................................................................................. 4.58

3.1.1 Business Risk and Financial Risk ................................................................... 4.58

3.2 Debt versus Equity Financing ................................................................................... 4.59

3.3 Types of Leverage .................................................................................................... 4.60

3.3.1 Operating Leverage ........................................................................................ 4.60

3.3.2 Financial Leverage ......................................................................................... 4.63

3.3.3 Combined Leverage ....................................................................................... 4.65

Summary .................................................................................................................. 4.70 CHAPTER 5 – TYPES OF FINANCING

1. Introduction ................................................................................................................ 5.1

2. Financial Needs and Sources of Finance of a Business.............................................. 5.2

2.1 Financial Needs of a Business ......................................................................... 5.2

2.2 Sources of Finance of a Business .................................................................... 5.3


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2.3 Financial sources of a business can also be classified as follows by using different basis ................................................................................................... 5.3

3. Long Term Sources of Finance ................................................................................... 5.4

3.1 Owners Capital or Equity Capital ...................................................................... 5.4

3.2 Preference Share Capital ................................................................................. 5.5

3.3 Retained Earnings ............................................................................................ 5.6

3.4 Debentures or Bonds ........................................................................................ 5.6

3.5 Loans from Financial Institutions ...................................................................... 5.8

3.6 Loans from Commercial Banks ......................................................................... 5.9

4. Venture Capital Financing ....................................................................................... 5.11

5. Debt Securitisation ................................................................................................... 5.13

5.1 Benefits to the Originator ................................................................................ 5.14

6. Lease Financing ....................................................................................................... 5.14

6.1 Types of Lease Contracts ............................................................................... 5.14

6.2 Other Types of Leases ................................................................................... 5.16

7. Short Term Sources of Finance ................................................................................ 5.17

7.1 Trade Credit ................................................................................................... 5.17

7.2. Accrued Expenses and Deferred Income ........................................................ 5.17

7.3 Advances from Customers ............................................................................. 5.17

7.4. Commercial Paper .......................................................................................... 5.17

7.5 Bank Advances .............................................................................................. 5.17

7.6 Financing of Export Trade by Banks ............................................................... 5.20

7.7 Inter Corporate Deposits ................................................................................ 5.23

7.8 Certificate of Deposit (CD).............................................................................. 5.23

7.9 Public Deposits .............................................................................................. 5.23

8. Other Sources of Financing ...................................................................................... 5.23

8.1 Seed Capital Assistance ................................................................................. 5.23


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8.2 Internal Cash Accruals ................................................................................... 5.23

8.3 Unsecured Loans ........................................................................................... 5.24

8.4 Deferred Payment Guarantee ......................................................................... 5.24

8.5 Capital Incentives ........................................................................................... 5.24

9. New Instruments ...................................................................................................... 5.24

9.1 Deep Discount Bonds ..................................................................................... 5.24

9.2 Secured Premium Notes ................................................................................. 5.25

9.3 Zero Interest Fully Convertible Debentures .................................................... 5.25

9.4 Zero Coupon Bonds ....................................................................................... 5.25

9.5 Double Option Bonds ..................................................................................... 5.25

9.6 Option Bonds ................................................................................................. 5.25

9.7 Inflation Bonds ............................................................................................... 5.25

9.8 Floating Rate Bonds ....................................................................................... 5.26

10. International Financing ............................................................................................. 5.26

10.1 Commercial Banks ......................................................................................... 5.26

10.2 Development Banks ....................................................................................... 5.26

10.3 Discounting of Trade Bills ............................................................................... 5.26

10.4 International Agencies .................................................................................... 5.26

10.5 International Capital Markets .......................................................................... 5.26

10.6 Financial Instruments ..................................................................................... 5.27

10.7 Euro Issues by Indian Companies .................................................................. 5.28

Summary .................................................................................................................. 5.30


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