If a company retains higher percentage of profits in the business, it is effectively adding a capital at thecost of equity. In designing optimum capital structure that is the proportion of debt and equity, due importance is given to the overall or weighted average https://1investing.in/ cost of capital of the firm. The objective of the firm should be to choose such a mix of debt and equity so that the overall cost of capital is minimized. For the purpose of maximisation of value of the firm, a firm tries to minimise the average cost of capital.

• By emphasizing on the relative value of EPS, this analysis determines the optimum mix of debt and equity in the capital structure.
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• According to wealth maximisation objective, financial management must select those decisions, which create most wealth for the owners.
• For example, the production manager proposing the installation of a new plant to be operated with modern technology; is also involved in a financial decision.
• Total funds with Mr. X now is ` 11,000 ( ` 6000 own and ` 5000 borrowed).

Generally, prices are not controllable in the short term by the individual firm. Controlling inventory is the only way that a firm can counter act with these risks. On the demand side, a decrease in the general market demand when supply remains the same may also cause price to increase. This is also long-lasting management problem, because reduction in demand may be due to change in customer buying habits, tastes and incomes. Factoring may be on a recourse basis, where the risk of bad debts is borne by the client, or on a non-recourse basis, where the risk of credit is borne by the factor.

Therefore, if the firm does not possess any short-term securities which can be sold, it can borrow from bank. The interest in case of cash credit is charged on the daily balance and not on the entire amount of the account. For these reasons, it is the most favourite mode of borrowing by industrial and commercial concerns. The Reserve Bank of India issued a directive to all scheduled commercial banks on 28th March 1970, prescribing a commitment charge which banks should levy on the unutilized portion of the credit limits. When a bank makes an advance in lump-sum against some security it is called a loan.

Financial Management (BCOM 501-18 )

Every stock dividend carries an implied promise that future cash dividends will be maintained at a steady level because of the permanent capitalization of reserves. Unless the corporate management has reasonable grounds of entertaining this hope, the wisdom of large stock dividend is always subject to grave suspicion. At present, the amount of dividend declared is tax free in the hands of shareholders. The extent to which the profits are ploughed back into the business has got a considerable influence on the dividend policy.

The logic given by the above school of thought is that whatever increase in shareholders wealth results from Dividend Payments will be exactly offset by the effect of raising additional, capital. With payment of stock dividends the stock-holders have simply more shares of stock to represent the same interest as it was before issuing stock dividends. Thus, there will be merely an adjustment in the firm’s capital structure in terms of both the book value and the market price of the common stock. Thus, if debt capital is used in the total capital structure, the total income available for equity shareholders and/or debt holders will be more. When corporate income is subject to taxes, debt financing is favourable.

What are the sources used for financing temporary requirement of working capital?

At the same time, when customers pay their bills at the local collection centre instead of mailing the same to the head office, it will also reduce time. Thus, in this way, it is estimated that there will be a saving of approximately one day in mailing time. Since the local collection centre prepares bills against the customers, the customer usually receives the bills earlier than if the bills were sent by the head office directly from a distant place.

• The financial management must see to it that interest on bonds, debentures or other loans of the company is paid in time.
• Any excess earnings over cost of debt will be added up to the equity shareholders.
• In the subsequent year, when the firm will have no or limited investment opportunities to seize, the management may distribute larger portion of earnings which would otherwise have remained unutilized.
• An upward revaluation of assets, however, would create a capital surplus, but at the same time might operate as a fraud on creditors and for that reason is illegal.
• The bank purchases the bills payable on demand and credits the customer’s account with the amount of bill less discount.
• This is how federal policies have a great impact on the cost of capital.

In case annual cash flows are unequal over the life of the asset, the internal rate of return cannot be determined according to the technique suggested above. In such cases, the internal rate of return is calculated by hit and trial and that is why this method is also known as hit and trial yield method. This method ignores the time value of money and does not consider the magnitude and timing of cash inflows. It treats all cash flows as equal though they occur in different periods. It ignores the fact that cash received today is more important than the same amount of cash received after, say 3 years.

The time period at which the cumulated present value of cash inflows equals the present value of cash outflows is known as discounted pay-back period. The project which gives a shorter discounted pay-back period is accepted. Another serious limitation of the pay-back period method is that it ignores the time value of money.

Benefit Cost Ratio

Wealth maximization can be activated only with the help of the profitable position of the business concern. Wealth maximization is nothing, it is also profit maximization, it is the indirect name of the profit maximization. Wealth maximization provides efficient allocation of resources. Today when you are talking of the demographic dividend, I think it is actually a horror story which we have because they are not creating enough jobs.

• Like the net present value method, it takes into account the time value of money and can be usefully applied in situations with even as well as un even cash flow at different periods of time.
• Negative because of the increased risk of default and fewer shares outstanding.
• This policy is based on management’s belief that shareholders are entitled to dividend only when earning and liquidity position of the firm warrant.
• As such, the levered firm will enjoy a higher market value than the unlevered firm.

It allows better utilization of available stock by enabling inter-department transfers within a firm. Lock-box system, in a sense, is like concentration banking since the collection is decentralized. One significant difference between the two is that, under a concentra­tion banking system, the customers send the cheques to the collection centre, while, under lock-box system, they send them to a post office box.

Stage I: Initial Stage- Low to moderate use of debt capital

Cost of addition, expansion, improvement or alteration in the fixed assets. The capital structure should not lead to loss of control in the company. As such, cost of borrowing will be higher in case of an individual than a firm. As a result, the market value of both the firms will not be equal. The cut-off point for investment is always the capitalisation rate which is completely independent and unaffected by the securities that are invested.

Walter’s model of share valuation mixes dividend policy with investment policy of the firm. The wealth of the owners will maximise only when this optimum investment in made. Stock dividends rank next to cash dividends in respect of their popularity. In this form of dividends, the firm issues additional shares of its own stock to the stockholders in proportion to the number of shares held in lieu of cash dividends.

The time period for compounding the interest may be annual, semiannual or any other regular period of time. A sum deposited at a bank fetches Rs. 13,440 after 5 years at 12% simple rate of interest. Simple interest is the interest calculated on the original principal only for the time during which the money lent is being used. Simple interest is paid or earned on the principal amount lent or borrowed. If 18% is the best risk-free return available, then you would be indifferent to receiving Rs. 100 now or Rs. 118 in one year’s time.

This method is also compatible with the objective of maximum profitability and is considered to be a more reliable technique of capital budgeting. In case of alternative proposals select the proposal with the highest rate of return as long as the rates are higher than the cost of capital or cut-off-rate. Determine the rate of discount at which the value of cash inflows is equal black swan explained to the present value of cash outflows. The net present value method is a modern method of evaluating investment proposals. This method takes into consideration the time value of money and attempts to calculate the return on investments by introducing the factor of time element. It recognizes the fact that a rupee earned today is worth more than the same rupee earned tomorrow.

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It is the responsibility of a financial manager to decide the ratio between debt and equity. It is important to maintain a good balance between equity and debt. The financial management must develop and maintain friendly relations with financiers i.e. banks, financial institutions and various segments of the money market and capital market. When good relations are maintained with financiers; they might come to the rescue of the enterprise, in situations of financial crisis. The financial management must see to it that interest on bonds, debentures or other loans of the company is paid in time.

optimum credit term exists when average rate of return

The total capital requirement of the firm is given and remains constant. Choose the right type of credit card -While you may be readily offered different cards, choose the one that suits your requirements. Too many credit cards add to your credit exposure/credit burden and will impact your credit score.