Business Finance: Finance may be defined as the provision of money at the time when it is required.

Finance refers to the management of flows of money through an organization. However, there are three main approaches to finance: 1 The first approach views finance as to providing of funds needed by business on Most suitable terms. 2 Second approach relates finance to cash. 3 The third approach views finance as being concerned with raising of funds and Their effective utilization Business finance is defined as an activity or a process which is concerned with Acquisition of funds, use of funds and distribution of profits by a business firm. Thus, business finance usually deals with financial planning, acquisition of funds, Use and allocation of funds and financial controls. Financial Management: Financial management refers to that part of the management Activity which is concerned with the planning and controlling of firms financial resources. It deals with finding out various sources for raising funds for the firm. The most appro-priate use of such funds also forms a part of financial management. As a separate managerial activity, it has a recent origin. This draws heavily on the economics for itstheoretical concepts. Finance function: The finance function includes both raising of funds as well as their Effective utilisation .The finance function does not stop only by finding out sources of Raising enough funds, their proper utilisation is also to be considered.The cost of raising Funds and the returns from their use should be compared.The funds raised should be able To give more returns than the cost involved in procuring them. The utilisation of funds requires decision making. So finance function, according to this approach , covers financial Planning, raising of funds, allocation of funds, financial control etc. The modern approach considers the three basic management decisions, i.e., investment decisions, financing decisions and dividend decisions within the scope of finance function. Finance Functions or Finance Decisions: Financial decisions

refer to decisions concerning Financial matters of a business firm..We can classify these decisions into three major groups. 1 Investment Decisions 2 Financing 3 Dividend Decisions Decisions.

1 Investment Decisions: The investment decisions can be classified under two broad groups: Long-term investment decision and (ii) Short-term investment decision. The long term Investment decision refers to as the capital budgeting and the short-term investment decision as working capital management .Capital budgeting is the process of making Investment decisions in the capital expenditure.The finance manager has to assess the Profitability of various projects before committing the funds. The investment proposal Should be evaluated in terms of expected profitability, costs involved and the risks associated With the projects. Two important aspects of investment are: a) the evaluation of the Prospective profitability of new investment , b) the measurement of a cut-off rate against That the prospective return of new investments could be compared.Future benefits of Investment are difficult to measure and cannot be predicted with certainty. Risk in investment Arise because if uncertain returns. Investment proposals should, therefore be evaluated In terms of both expected return and risk. Short term investment decision, relates to the allocation of funds as among cash and Equivalents, receivables and inventories. Such a decision is influenced by a trade off between liquidity and profitability. Lack of liquidity in extreme situations can lead to the To the firms insolvency.If the firm does not invest sufficient funds in current assets, it may Become illiquid and therefore, risky. But it would lose profitability, as idle current assests Would not earn anything. 2 Financing Decisions: Once the firm has taken investment decision, it must decide when, where from and how to acquire funds to meet the firms investment needs. A financial manager has to select such sources of funds which will make optimum capital structure.

The mix of debt-equity is known as the firms capital structure.The debtequity ratio should be fixed in such a way that helps in maximising the profitability of the concern. The raising of more debts will involve fixed interest liability and dependence upon outsiders. It may help in increasing the return on equity but will enhance the risk. The raising of funds Through equity will bring permanent funds to the business but the shareholders will expect Higher rates of earnings. The financial manager has to strike a balance between various sources so that the overall profitability of the concern improves. If the capital structure is able to minimise the risk and raise the profitability then the market prices of the shares will go up maximising the wealth of shareholders. 3 Dividend Decision: Dividend decision is the third major financial decision. The term dividend refers to that part of profits of the company which is distributed by it among Its shareholders.The dividend decision is concerned with the quantum of profits to be distributed among shareholders. A decision has to taken whether all the profits are to Distributed, to retain all the profits in business or to keep a part of profits in the business and distribute others among shareholders.The higher rate of dividend may raise the market Price of shares and thus, maximise the wealth of shareholders.Dividends are generally paid in cash. But firm may issue a bonus shares. Bonus shares are shares issued to the existing Shareholders without any charge. Objectives of Financial Management or Goals of Business Finance: Finacial management is concerned with procurement and use of funds.The main objective of a business is to maximise the owners economic welfare. The objective can be achieved By:1 Profit Maximisation 2.Wealth Maximisation. 1 Profit Maximisation: Profit earning is the main aim of every economic activity. A business Being an economic institution must earn profit to cover its costs and provide funds for Growth. The following arguments

are advanced in favour of profit maximisation as the objective of business: (i) When profit earning is the aim of business then profit maximisation should be the obvious objective. Profitability is a barometer for measuring efficiency and economic prosperity of a business. There may adverse business conditions like recession, depression, severe competition etc.

(ii)

(iii)

A business will be able to survive under unfavourable situation, only if it has some past Earnings to rely on. (iv) Profits are the main sources of finance for the growth of a business. So, a business should Aim at maximisation of profits for enabling its growth and development. (v) Profitability is essential for fulfiling social goals also. A firm by pursuing the objective of Profit maximisation also maximises socio-economic welfare.

Profit maximisation has been rejected because of the following drawbacks: 1 The term profit is vague and it cannot be precisely defined. It means different things for Different people. Should we consider short-term profits or long-term profits? Does it mean Total profits or earnings per share? Should we take profit before tax or after tax? Does it mean Operating profit or profit available for shareholders?Further, it is possible that profits may Increase but earnings per share decline. 2 Profit maximisation objectives ignores the time value of money and does not consider the Magnitude and timings of earnings. It treats all earnings as equal though they occur in Different periods. It ignores the fact that that the cash received today is more important than The same amount of cash received after three years. The stockholders may prefer a regular From investment even it is smaller than the expected higher returns after a long period.

3 It does not take into consideration the risk of the prospective earnings stream. Some projects Are more risky than others. Two firms may have same expected earnings per share, but if the earning stream of one is more risky then the market value of its shares will be Comparatively less. (iv) iv) The effect of dividend policy on the market price of shares is also not considered in the Objective of profit maximisation. Wealth Maximisation: Wealth maximisation is the appropriate objective of an enterprise. Financial theory asserts that wealth maximisation is the single substitute for a stockholdersUtility. When the firm maximises the stockholder can use this wealth to maximise his Individual utility. A stockholders current wealth in the firm is the product of the number of shares owned , multiplied with the current stock price per share.

(v)

Stockholders current wealth in a firm= ( Number of Shares owned) x ( Current Stock price per share) Wo= NPo Given the number of shares that the stockholder owns, the higher the stock price per share The greater will be the stockholders wealth. Thus, a firm should aim at maximising its current Stock price. This objective helps in increasing the value of shares in the market..The shares market price serve as performance index or report card of its progress. What is meant by shareholders wealth maximisation ? SWM means maximising the net present value of a course of action to shareholders. Net Present value(NPV) or wealth of a course of action is the difference between the present Value of its benefits and the present value of its costs. A financial action that has a positive NPV creates wealth for shareholders and therefore is desirable. A financial action resulting in negative NPV should be rejected since it would destroy Shareholders wealth.Between mutually exclusive projects the one with the highest NPV should be adopted.

Inventory Management : Introduction The investment in inventories constitutes the most significant part of current assets/working capital in most of the undertakings. The purpose of inventory management Is to ensure availability of materials in sufficient quantity as and when required and Also to minimize investment in inventories. Meaning of Inventory: The meaning of inventory is stock of goods or list of goods. Inventory includes the following things: a) Raw Material b) Work-in-progress c) Consumables d) Finished goods e) Spares Purpose/Benefits of holding Inventories: Three main purposes or motives of holding inventories: i) The Transaction Motive: which facilitates continuous production & timely execution of sales orders.

1 To ensure continuous supply of materials, spares and finished goods so that production should not suffer at any time & the customers demand should also be met. 2 To avoid both over-stocking and under-stocking of inventory. 3 To maintain investments in inventories at the optimum level as required by the ii) The Precautionary Motive: which necessitates the holding of inventories for meeting the unpredictable changes in demand and supplies of materials.

iii)

The Speculative Motive: which includes to keep inventories for taking advantage of price fluctuations, saving in re-ordering costs and quantity discounts, etc

Risk & Costs of Holding Inventories: i) ii) iii) iv) v) Capital Costs Storage & Handling Costs Risk of Price Decline Risk of Obsolescence Risk of Deterioration in Quality

Objectives Of Inventory Management: The following are the objectives of inventory management: by the operational & sales activities. 4 To keep material cost under control so that they contribute in reducing cost of production & overall costs. 5 To minimize losses through deterioration, wastages & damages. 6 To ensure right quality goods at reasonable prices. Suitable quality standards will ensure Proper quality of stocks. Tools and Techniques of Inventory Management: 1 Determination of Stock Levels 2 Determination of Safety Stocks 3 Determination of Economic Order Quantity. 4 A.B.C. Analysis. 5 V.E.D Analysis 6 Inventory Turnover Ratios 7 Classification & Codification of Inventories.

8 JIT Control System 1 Determination of Stock Levels: Carrying of too much and too little of inventories is Detrimental to the firm. If the inventory level is too little, the firm will face frequent Stock-outs involving heavy ordering cost & if the inventory level is too high it will be Unnecessary tie-up of capital. Therefore , an efficient inventory management requires an optimum level of inventory where inventory costs are the minimum & at the same Time there is no stock-out which may result in loss of sale or stoppage of production. a) Minimum Level: This represents the quantity which must be maintained in hand at all times. If stocks are less than the minimum level then the work will stop due to shortage of materials. Following factors are taken into account while fixing minimum stock level: Lead Time: A purchasing firm requires some time to process the order & time is also Required by the supplying firm to execute the order. The time taken in processing the Order & then executing it is known as lead time. Rate of Consumption: It is the average consumption of materials in the factory. Nature of Material : The nature of materials also affects the minimum level. If a material is required only against special orders of the customer then minimum stock will not be Required for such materials. Minimum stock level= Re-ordering level-( Normal consumption x Normal Reorder period). b) Re-ordering Level: When the quantity of materials reaches at a certain figure then fresh Order is sent to get materials again. The order is sent before the materials reach minimum Stock level. Re-ordering level or ordering level is fixed between minimum level and Maximum level. Re-ordering Level= Maximum Consumption x Maximum Re-order period. c) Maximum Level: It is the quantity of materials beyond which a firm should not exceed its Stocks. If the quantity exceeds maximum level

limit then it will be overstocking. A firm should avoid overstocking because it will result in high material costs. Maximum Stock Level= Re-ordering level+ Re-ordering Quantity-( Minimum Consumption x Minimum Re-ordering period). d) Danger Level: It is the level beyond which materials should not fall in any case. If the danger level arises then immediate steps should be taken to replenish the stocks even if more cost is incurred in arranging the materials. Danger Level: Average Consumption x Maximum re-order period for emergency purchases. e) Average Stock Level: Average Stock Level= Minimum Stock Level + of re-order quantity. 2) Determination of Safety Stocks: Safety stock is a buffer to meet some unanticipated Usage. The usage of inventory cannot be perfectly forecasted. It fluctuates over a period of time. The demand for materials may fluctuate and delivery of inventory may also be delayed & in such a situation the firm can face a problem of stock-out. In order to Protect against the stock out arising out of usage fluctuations, firms usually maintain some margin of safety or safety stocks. Two costs are involved in the determination of this stock i.e. opportunity cost of stock-outs and the carrying costs. The stock-outs of raw materials cause production disruptions resulting into higher cost of Production. Similarly, the stock-outs of finished goods result into failure of the firm in Competition as the firm cannot provide proper customer service. If a firm maintains low Level of safety frequent stock-outs will occur resulting into the larger opportunity costs. On the other hand, the larger quantity of safety stocks involve higher carrying costs. 4 Economic Order Quantity: The quantity to be purchased should neither be small nor big because costs of buying and carrying materials are very high. EOQ is the size of the Lot to be purchased which is economically viable. This is the quantity of materials which

Can be purchased at minimum costs. Generally, economic order quantity is the point at which inventory carrying costs are equal to order costs. In determining EOQ cost of managing Inventory is made up of two parts i.e., ordering costs & carrying costs. A) Ordering Costs: These are the costs which are associated with the purchasing or ordering of materials. These costs include: 1 Costs of staff posted for ordering of goods. The labour spent on this process is included in ordering costs. 2 Expenses incurred on transportation of goods purchased. 3 Inspection costs of incoming materials. 4 Cost of stationery, typing , postage ,telephone charges.etc. B) Carrying Costs: these are the costs for holding the inventories. These costs include: 1 The cost of capital invested in inventories. An interest will be paid on the amount of capital locked-up in inventories. 2 Cost of storage which could have been used for other purposes. 3 The loss of materials due to deterioration and obsolescence. 5 A-B-C Analysis: Under A-B-C analysis, the materials are divided into three categories viz., A, B and C. Past experience has shown that almost 10% of the items contribute to70% of value of consumption & this category is called A Category . About 20 % of Items contribute about 20 % of value of consumption & this is known as category B Materials. Category C covers about 70 % of items of materials which contribute only 10 % of value of consumption. A-B-C analysis help to concentrate more efforts on category A since greatest monetary Advantage will come by controlling these items. An attention should be paid in estimating Requirements, purchasing, maintaining safely stocks & properly storing of A category Materials. The control of C items may be relaxed & these stocks may be purchased

For the year. A little more attention should be given towards B category items & their Purchase should be undertaken at quarterly or half-yearly intervals. VED Analysis: The VED analysis is used generally for spare parts. Spare parts are Classified as Vital , Essential and Desirable. The vital spares are a must for running the concern smoothly & these must be stored adequately. The non-availability of vital spares will cause havoc in the concern. The E type of spares are also necessary but their Stocks may be kept at low figures. The stocking of D type of spares may be avoided at times. Inventory Turnover Ratios: Inventory turnover ratios are calculated to indicate whether Inventories have been used efficiently or not .The purpose is to ensure the blocking only Required minimum funds in inventory. Inventory Turnover Ratio= Cost of Goods Sold/ Average Inventory at cost Inventory Conversion Period= Days in a year/ Inventory Turnover Ratio Just In Time(JIT) Inventory Control System: Just in time philosophy, which aims at Eliminating waste from every aspect of manufacturing & its related activities, was first Developed in Japan .Just in time inventory control system involves the purchase of materials in such a way that delivery of purchased material is assured just before their use or demand. The philosophy of JIT control system implies that the firm should maintain a minimum (zero Level) of inventory & rely on suppliers to provide materials just in time to meet the Requirements. Receivables Management: Receivables result from credit sales. A concern is required to allow credit sales in order to expand its sales volume. It is not always possible to sell goods on cash basis only. Sometimes, other concerns in that line might have established a practice of selling goods on credit basis. Under these circumstances, it is not possible to avoid credit sales without adversely affecting sales. The increase in sales is also essential to increase profitability. Meaning of Receivables:

Receivables represent amounts owed to the firm as a result of sale of goods or services in the ordinary course of business. These are claims of the firm against its customers and Form part of its current assets. Receivables are known as accounts receivables, customer receivables or book debts. Costs of Maintaining Receivables: The concern incurs the following costs on maintaining receivables: 1. Cost of Financing Receivables: When goods and services are provided on credit then Concerns capital is allowed to be used by the customers. The receivables are financed from the funds supplied by shareholders for long term financing & through retained earnings. The concern incurs some cost for collecting funds which finance receivables. 2 Cost of Collection: The customers who do not pay the money during a stipulated credit period are sent reminders for early payments. Some persons may have to be sent for collecting these amounts. In some cases legal recourse may have to be taken for collecting receivables. Bad Debts: Some customers may fail to pay the amounts due towards them. The amounts which the custom fail to pay are known as bad debts.

Factors Influencing the Size of Receivables: 1 Size of Credit Sales: The higher the part of credit sales out of total sales, figures of Receivable will also be more or vice versa. Credit Policies: A firm with conservative credit policy will have a low size of receivables. While a firm with liberal credit policy will be increasing this figure. The vigor with which the concern collects the receivables also affects its receivables. If collections are prompt then even if credit is liberally extended the size of receivables will remain under control. Terms of Trade: The size of receivables also depends upon the terms of trade. The Period of credit allowed and rates of discount given are linked with receivables. If credit period allowed is more than receivables will also be more. Sometimes trade Policies of competitors have to be followed otherwise it becomes difficult to expand the sales. The trade terms once followed cannot be changed without adversely affecting sales Opportunities. Expansion Plans: When a concern wants to expand its activities, it will have to enter new markets. To attract customers, it will give incentives in the form of credit facilities. In the early stages of expansion more credit becomes essential & size of receivables will be more. Relation with Profits: The credit policy is followed with a view to increase sales. When sales increase beyond a certain level the additional costs incurred are less than the Increase in revenues. The increase in profits will be followed by an increase in the size of receivables or vice-versa. Credit Collection Efforts: The collection of credit should be streamlined. The customers should be sent periodical reminders if they fail to pay in time. On the other hand, if Adequate attention is not paid towards credit collection then the concern can land Itself in a serious financial problem.

Habits of Customers: The paying habits of customers also have a bearing on the size of receivables. The customers may be in the habit of delaying payments even though they are financially sound.

Dimensions of Receivables Management Receivables management involves the careful consideration of the following aspects: 1 2 3 Forming of Credit policy Executing the credit policy Formulating & executing collection policy.

1 Forming of Credit Policy: For efficient management of receivables, a concern must adopt a credit policy. A credit policy is related to decisions such as credit standards, Length of credit period , cash discount & discount period ,etc. a) Quality of Trade Accounts or Credit Standards: The volume of sales will be influenced by the credit policy of a concern. By liberalizing credit policy the volume can be increased resulting into increased profits The increased volume of sales is associated with certain risks too. It will result in enhanced costs and risks of bad debts & delayed receipts. There may be more bad debts losses due to extension of credit to less worthy customers. These customers may also take more time than normally allowed in making the payments Resulting into tying up of additional capital in receivables. On the other hand, extending Credit to less worthy customers will save costs like bad debt losses , collection costs ,Investigation costs, etc.The restriction of credit to such customers only will certainly Reduce sales volume, thus resulting in reduced profits. A finance manager has to match the increased revenue with additional costs. The credit should be liberalized only to the level where incremental revenue with additional costs. Thus, optimum level of investment in receivables is achieved at a point where there is a tradeoff between cost, profitability & liquidity. b) Length of Credit Period: Credit terms or length of credit period means the period allowed to the customers for making the payment. A firm may allow liberal credit terms to increase the volume of sales. The lengthening of this period will mean blocking of more money in receivables which could have been invested somewhere else to earn Income. There may be an increase in debt collection costs & bad debts losses too. If the earnings from additional sales by lengthening credit period are more than the additional costs then the credit terms should be liberalized. Cash Discount: Cash discount is allowed to expedite the collection of receivables. The funds in Tied up in receivables are released. The discount involves cost. The financial manager should compare the earnings resulting from released funds and the cost of discount. The discount should be allowed only if its cost is less than the earnings from the additional funds. Discount Period: The collection of receivables is influenced by the period allowed for availing the Discount. The additional period allowed for this facility may prompt more customers to avail Discount and make payments. At the same time the extending of discount period will result in late

collection of funds because those who were getting discount and making payments earlier Schedule will also delay their payments. 2 Executing Credit Policy:

a) Collecting Credit Information: The first step in implementing credit policy will be to gather credit information about the customers. This information should be adequate enough so that Proper analysis about the financial position of the customers is possible. This type of investigation can be undertaken only up to a certain limit because it will involve cost. The cost incurred in collecting this information & the benefit from reduced bad debts losses will be compared. The information may be available from financial statements, Credit rating agencies, reports from banks, firms records etc. Financial reports of the customer For a number of years will be helpful in determining the financial position and profitability position. The balance sheets will help in finding out the short term & long-term position of the concern. The income statement shows the profitability position of the concern. There are credit rating agencies which can supply information about various concerns. These Agencies regularly collect information about business units from various sources & keep this information up to date. b) Credit Analysis: After gathering the required information, the finance manager should analyses it to find out the credit worthiness of potential customers & also to see whether they satisfy the standards of the concern or not. c) Credit decision: After analyzing the creditworthiness of the customer, the finance Manager has to take a decision whether the credit is extended & if yes then upto what level. He will match the creditworthiness of the customer with the credit standards of the company. If customers creditworthiness is above the credit standards then there is no problem in taking a Decision. d) Financing Investments in Receivables and Factoring: Account receivables block a part of Working capital. Efforts should be made that funds are not tied up in receivables for longer Periods. The finance manager should make efforts to get receivables financed so that working Capital needs are met in time. The banks allow rising of loans against security of receivables. The bank will accept receivables of dependable parties only. Another method of getting funds is their outright sale to the bank. Besides banks, there may be other agencies which can buy receivables and pay cash for them. This facility is known as factoring. Formulating and Executing Collection Policy: The collection of amounts due to the Customers is very important. The concern should devise procedures to be followed when accounts become due after the expiry of credit period. The collection policy be termed as strict and lenient. A strict policy of collection will involve more efforts on Collection. Such a policy has both plus and negative effects. This policy will enable early collection of dues and will reduce bad debts losses. The money collected

will be used for other purposes and the profits of the concern will go up. On the other hand A rigorous collection policy will involve increased collection costs. It may also reduce the volume of sales. Some customers may not appreciate the efforts of the concern and may Shift to another concern thus causing reduced sales & profits. A lenient policy may increase the Debt collection period and more bad debts losses. A customer not clearing the dues for long may not repeat his order. The collection policy should device the steps to be followed in collecting overdue amounts. The Objective is to collect the dues and not to annoy the customer. The steps should be like i) Sending a reminder for payments ii) Personal request through telephone etc. Iii) Personal visits to the customers iv) Taking help of collecting agencies & lastly v) Taking legal action.

The last step should be taken only after exhausting all other means because it will have a bad impact on relations with customers. The genuine problems of customers should never be ignored while making collections. Capital Structure Capital structure: Capital Structure of a company refers to the composition or make-up of Its capitalization and it includes all long-term capital resources viz: loans, reserves, shares and Bonds. The capital structure is made up of debt and equity securities and refers to permanent Financing of a firm. It is composed of long term debt, preference share capital and Shareholders funds. Capitalization, Capital Structure and Financial Structure. Capitalization refers to the total amount of securities issued by a company while capital structure refers To the kinds of securities and the proportionate amounts that make up capitalization. For raising longTerm finances, a company can issue three types of securities viz, Equity shares, Preference shares And Debentures. A decision about the proportion among these types of securities refers to the capital Structure of an enterprise. Financial structure refers to all the financial resources used by the firm, short as well as long-term, and all forms of debt as well as equity. Forms/ Patterns of Capital Structure: 1 Equity Shares only 2 3 4 5 6 7 Equity and Preference Shares Equity Shares and Debentures Equity Shares, Preference Shares and Debentures. Importance of Capital Structure: The term capital structure refers to the relationship between the various long-term forms of Financing such as debenture, preference share capital and equity share capital. Financing

the firms assets is a very crucial problem in every business and as a general rule there should Be proper mix of debt and equity capital in financing the firms assets. The use of long-term

10 fixed interest bearing debt and preference share capital along with equity shares is called 11 Financial leverage or trading on equity. The long-term fixed interest bearing debt is employed 12 by a firm to earn more from the use of these sources than their cost so as to increase the 13 Return on owners equity. It is true that capital structure cannot affect the total earnings of the firm but 14 It can increase earnings available for equity shareholders. 15 Optimal Capital Structure: 16 The optimum capital structure may be defined as that capital structure or combination of debt 17 And equity that leads to the maximum value of the firm. Optimal capital structure maximizes the 18 value of the company and hence the wealth of its owners and minimizes the companys cost 19 Of capital. Thus, every firm should aim at achieving the optimal capital structure and then to maintain it. Theories of Capital Structure: Different kinds of theories have been propounded by different authors to explain the relationship between capital structure, cost of capital and value of the firm. The main Contributors to the theories are Durand, Ezra, Solomon, Modigliani and Miller. 1 2 3 4 Net Income Approach Net Operating Income Approach The Traditional Approach Modigliani and Miller Approach

1.Net Income Approach: According to this approach, a firm can minimize the weight average Cost of capital and increase the value of the firm as well as market price of equity shares by using debt financing to the maximum possible extent. The theory propounds that a company can increase its value and reduce the overall cost of capital by increasing the proportion of debt in its capital structure. This approach is based upon the following assumptions:

i) ii) iii)

The cost of debt is less than the cost of equity. There are no taxes. The risk perception of investors is not changed by the use of debt.

The line of argument in favors of net income approach is that as the proportion of debt financing in the capital structure increase, the proportion of a less expensive source of funds of funds increases. This result in the decrease in overall (weighted average) cost of capital leading to an increase in the value of the firm. The reasons for assuming cost of debt to be less than the cost of Equity are that interest rates are usually lower than the dividend rates due to element of risk and the benefit of tax as the interest is a deductible expense. On the other hand, if the proportion of debt financing in the capital structure is reduced, the weighted Average cost of capital of the firm will increase and the total value of the firm will decrease. 2 Net Operating Income Approach: This theory as suggested by Durand is opposite to the net Income approach. According to this approach, change in the capital structure of a company does not

Affect the market value of the firm and the overall cost of capital remains constant irrespective of the method of financing. It implies that the overall cost of capital remains the same whether the Debt-equity mix is 50:50 or 20:80 or 0:100.Thus, there is nothing as an optimal capital structure And every capital structure is the optimum capital structure. This theory presumes that: i) ii) iii) The market capitalizes the value of the firm as a whole. The business risk remains constant at every level of debt equity mix. There are no corporate taxes.

The reasons propounded for such assumptions are that the increase use of debt increases the financial risk of the equity shareholders and hence the cost of equity increases. On the other hand, the cost of Debt remaining constant with the increasing proportion of debt as the financial risk of the lenders is not affected. Hence the advantage of using the cheaper source of funds, i.e., debt is exactly offset by the increased cost of equity. According to the Net Operating Income Approach, the financing mix is irrelevant and it does not Affect the value of the firm. 3 The Traditional Approach: The traditional approach, also known as the Intermediate approach, is a compromise between the two extremes of net income approach and net Operating income approach. According to this theory , the value of the firm can be increased Initially or the cost of capital can be decreased by using more debt as the debt is a cheaper

Source of funds than equity. Thus, optimum capital structure can be reached by a proper debtequity mix. Beyond a particular point, the cost of equity increases because increased Debt increases

the financial risk of the equity shareholders. The advantage of cheaper Debt at this point of capital structure is offset by increased cost of equity. After this there comes a stage, when the increased cost of equity cannot offset by the advantage of low-cost Debt. Thus, overall cost of capital, according to this theory, decreases up to a certain point, Remains more or less unchanged for moderate increase in debt thereafter and increases or rises beyond a certain point. 4 Modigliani and Miller Approach: M& M hypothesis is identical with the Net Operating Income approach if taxes are ignored. However, when corporate taxes are assumed to Exist, their hypothesis is similar to the Net Income Approach. a) In the absence of Taxes( Theory of Irrelevance) : The theory proves that the cost of capital is not affected by the changes in the capital structure or say that the debt-equity mix is Irrelevant in the determination of the total value of a firm. The reason argued is that though debt is cheaper to equity, with increased use of debt as a source of finance, the cost of equity increases. This increase in cost of equity offsets the advantage of the low cost of Debt. Thus, although the financial leverage affects the cost of equity, the overall cost of remains constant. The M& M approach is based upon the following Assumptions: i) ii) iii) iv) v) There are no corporate taxes. There is a perfect market. Investors act rationally. The expected earnings of all the firms have identical risk characteristics. All earnings are distributed to the shareholders.

b) When the corporate taxes are assumed to exist(Theory of Relevance) : Modigliani and Miller, in their article of 1963 have recognized that the value of the firm will increase or the cost of Capital will decrease with the use of debt on account of deductibility of interest charges for tax purpose. Thus, the optimum capital structure can be achieved by maximizing the debt mix in the equity of a firm. Factors Determining the Capital Structure 1 2 3 4 5 6 7 Financial Leverage or Trading on Equity Growth & Stability of Sales Cost of Capital Cash Flow Ability to Service Debt Nature & Size of a firm Control Flexibility

8 9

Requirements of Investors Assets Structure