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Question
| Ravi has joined as a finance manager at MTA Ltd. He had to arrange funds of rupees one crore for the company. The Chief Executive Officer of the company wants to arrange the funds by a public issue whereas the finance manager wants to have a mix of debt and equity as this will determine the overall cost of capital and the financial risk of the enterprise. |
- Identify and give the meaning of the financial decision suggested by the finance manager in the above case.
- State any three factors affecting the decision identified in (i) above.
Solution
- This decision is about the quantum of finance to be raised from various long-term sources. Short-term sources are studied under the 'working capital management'. It involves the identification of various available sources. The main sources of funds for a firm are shareholders' funds and borrowed funds. The shareholders' funds refer to the equity capital and the retained earnings. Borrowed funds refer to the finance raised through debentures or other forms of debt. A firm has to decide the proportion of funds to be raised from either source, based on their basic characteristics. Interest on borrowed funds has to be paid regardless of whether or not a firm has earned a profit.
- Factors affecting financing decisions are as follows:
(a) Cost: The cost of raising funds through different sources is different. A prudent financial manager would normally opt for a source that is the cheapest
(b) Risk: The risk associated with each of the sources is different.
(c) Floatation Costs: Higher the floatation cost, the less attractive the source.
(d) Cash Flow Position of the Company: A stronger cash flow position may make debt financing more viable than funding through equity.
(e) Fixed Operating Costs: If a business has high fixed operating costs (e.g., building rent, Insurance premium, Salaries, etc.), It must reduce fixed financing costs. Hence, lower debt financing is better. Similarly, if fixed operating cost is less, more of debt financing may be preferred.
(f) Control Considerations: Issues of more equity may lead to dilution of management's control over the business. Debt financing has no such implication. Companies afraid of a takeover bid would prefer debt to equity.
(g) State of Capital Market: Health of the capital market may also affect the choice of source of funds. During the period when the stock market is rising, more people invest in equity. However, a depressed capital market may make the issue of equity shares difficult for any company.
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- Identify and state the financial decision taken by the finance manager in the above case.
- State any three factors affecting the decision identified in (i) above.
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