Professional Documents
Culture Documents
PREFACE
I am glad indeed to place this title 5TH EDITION NTA COMMERCE in the
hands of those students who are preparing for NTA exam.
This book is written strictly according to the prescribed syllabus. In preparing
this book, I have freely drawn the material both from the books of Indian &
foreign authors.
The book is divided into 12 units.
I request every teacher and the taught to bring such mistakes to the notice of
the author so that they can be redressed in the nest edition.
I welcome every constructive suggestion that goes in improving the quality of
the work and the utility of the book.
2019
SrinagarJ&K
190001
HILAL AHMED
(B.COM/M.COM/PGDBA)
AHMADHILAL850@GMAIL.COM
9906837425 / 7006246674
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SYLLABUS
Service marketing
Trends in marketing: Social marketing; Online marketing; Green
marketing; Direct marketing; Rural marketing; CRM
Logistics management
CONTENTS
UNIT
No. TITLE
1 FINANCIAL MANAGEMENT
(THEORY + REFERENCE)
2 FINANCIAL & MANAGEMENT
ACCOUNTING
(THEORY + REFERENCE)
3 BUSINESS ECONOMICS
(THEORY + REFERENCE)
4 BUSINESS STATISTICS
(THEORY + REFERENCE)
5 BUSINESS MANAGEMANT
(THEORY + REFERENCE)
6 MARKETING MANAGEMENT
(THEORY + REFERENCE)
7 BUSINESS ENVIRONMENT
(THEORY + REFERENCE)
8 HUMAN RESOURCE MANAGEMENT
(THEORY + REFERENCE)
9 BANKING & FINANCIAL INSTITUTIONS
(THEORY + REFERENCE)
10 INTERNATIONAL BUSINESS
(THEORY + REFERENCE)
11 ACCOUNTING & FINANCE
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(THEORY + REFERENCE)
12 AUDITING
(THEORY + REFERENCE)
13 LEGAL ASPECTS OF BUSINESS
(THEORY +REFERENCE)
14 INCOME-TAX LAW & PLANNING
(THEORY + REFERENCE)
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UNIT-1
FINANCIAL MANAGEMENT
Financial Management refers to that part of the management activity which is concerned with the
planning and controlling of firms financial resources.
PROFIT MAXIMATION
WEALTH MAXIMATION
PROFIT MAXIMATION: Profit earning is the main aim of every economic activity. A business being an
economic institution must earn profits to cover its costs and provide funds for growth. No business
can survive without earning profit. Profit is a measure of efficiency of a business eEnterprise. Profits
also serve as a protection against risks which cannot be ensured. The accumulated profits enable a
business to face risks like fall in prices, competition from other units, adverse govt policies etc. Thus,
profit maximization is considered as the main objective of business.
1. Ambiguity: the term ‘profit’ is vague and it cannot be precisely defined. It means
different things for different people. Should we consider short-term profit or long-
term profits? Does it mean total profits or earning per share?
2. Ignores time value of money: profit maximization objective ignores the time value
of money and does not consider the magnitude and timing of earnings. It treats all
earnings as equal though they occur in different periods. It ignores the fact that
cash receved today is more important than the same amount of cash received
tomorrow.
3. Ignores risk factor: it does not take into consideration the risk of the prospective
earnings stream. Some projects are more risky than others.
4. Dividend policy: the effect of dividend policy on the market price of shares is also
not considered in the objective of profit maximization.
Stockholders current wealth in the firm is the product of the number of shares owned, multiplied with
the current stock price per share. Higher the stock price per share greater will be stockholders wealth.
Economic value added is a measure of performance evaluation that was originally employed by Stern
Stewart & co. it is very popular measure today which is used to measure the surplus value created by an
investment or a portfolio of investment. EVA has been considered as a better measure of divisional
performance as compared to the RETURN ON ASSETS. It is also being used to determine whether
investment positively contributes to the shareholders wealth. The economic value added of an
investment is simply equal to the after tax operating profits generated by the investment minus the
cost of funds used to finance the investment.
EVA= NET OPERATING PROFIT AFTER TAX – COST OF CAPITAL * CAPITAL INVESTED
According to this approach, an investment can be accepted only if the surplus is positive.
For example; an investment generates net profit after tax of Rs. 20 lakhs and the cost of financing
investment is Rs. 16 lakhs. The economic value added by the investment will be Rs. 4 lakh.
FINANCIAL DECISIONS:
Financial decisions refer to decisions concerning financial matters of a business firm. The main financial
decisions are:
1. Investment decision
2. Financing decision
3. Dividend decision.
Investment decision: investment decision relates to the determination of total amount of assets to be
held in the firm, the composition of these assets and the business risk complexions of the firm as
perceives by its investors. The investment decisions can be classifies under two broad groups:
Long term investment decisions & Short term investment decisions. Long term investment decision is
referred to as the capital budgeting and short term investment decisions as working capital
management.
Financing decision: once the firm has taken the investment decision and committed itself to new
investment, it must decide the best means of financing these commitments. A finance manager has to
select such sources of funds which will make optimum capital structure. The important thing to be
decided here is the proportion of various sources in the overall capital mix of the firm. The debtequity
ratio should be fixed in such a way that it helps in maximizing the profitability of the concern. The
rising of more debts will involve fixed interest liability and dependence upon outsider. It may help in
increasing the return on equity but will also enhance the risk. The rising of funds through equity will
bring permanent funds to the business but the shareholders will expect higher rates of earning. The
financial manager has to strike a balance between various sources so that the overall profitability of the
concern improves.
Dividend decision: the third major financial decision relates to the disbursement of profits back to
investors who supplied capital to the firm. The term dividend refers to that part of profits of a company
which is distributed by it among its shareholders. It is the reward of shareholders for investments made
by them in share capital of the company. The dividend decision is concerned with the quantum of profits
to be distributed among shareholders. A decision has to be taken whether all the profits are to be
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, maximize the wealth of shareholders.
POINTS TO REMEMBER
The term financial management can be defined as the management of flow of funds and it
deals with the financial decision making.
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The objective of maximization of shareholders wealth has been taken as the primary goal of
financial decision making and maximization of profit is the second main objective of financial
management.
A firm wishes to maximize the profits may opt to pay no dividend and to reinvest the
retained earnings whereas a firm that wishes to maximize the shareholders wealth
may pay regular dividend.
Capital budgeting is related to fixed assets.
Working capital management related to current assets.
The dividend decisions are almost regular decision in the sense that it is taken
whenever the firm wants to distribute interim dividend, final dividend or bonus to
shareholders.
Shareholders interest put on high priority and public interest get last priority.
Three decisions are taken 1) financial decisions 2) investment decisions 3)
dividend decisions.
FINANCIAL PLANNING
Financial planning is a growing industry with projected faster than average job growth. Financial
managers must be able to analyze the current position of their own firms as well as that of their
competition .They must also plan for the company’s financial future. The financial manager is
responsible for planning to ensure that the firm has enough funds for the needs. A useful tool for
planning future cash needs to plan for the continuing profitability. Planning is an inevitable process in
any business firm irrespective of its size and nature. So the financial planning encompasses both the
business plan as well as analyzes the current as well as future financial position of the firm.
When you want to maximize your existing financial resources by using various financial tools to achieve
your financial goals that is financial planning. Financial Planning is the process of estimating the capital
required and determining its competition. It is the process of framing financial policies in relation to
procurement, investment and administration of funds of an enterprise.
• Determining capital requirements This will depend upon factors like cost of current and fixed
assets, promotional expenses and long- range planning. Capital requirements have to be looked with
both aspects: short- term and long- term requirements.
• Determining capital structure- The capital structure is the composition of capital, i.e., the
relative kind and proportion of capital required in the business. This includes decisions of debt- equity
ratio- both short-term and long- term.
• Framing financial policies with regards to cash control, lending, borrowings, etc.
• A finance manager ensures that the scarce financial resources are maximally utilized in the best
possible manner at least cost in order to get maximum returns on investment.
FIXED CAPITAL: Fixed capital stands for that amount of capital which is required for longterm to
create production facilities through purchase of fixed assets such as plant, machinery, land building,
furniture etc.
Working capital: working capital refers to that part of the firms capital which is required for financing
shortterm or current assets such as cash, marketable securities, debtors and investors.
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CAPITALIZATION: Capitalization is one of the most important constituents of financial plan. The term
capitalization has been derived from the word capital and in common practice it refers to the total
amount of capital employed in a business. Capitalization refers to the process of determining the plan
of financing. It includes not merely the determination of the quantity of finance required for a
company but also the decision about the quality of financing.
Capitalization includes:
Share capital
Long-term debt
Reserves & surplus
Short term debt
Creditors
Capital: the term capital refers to the total investment of a company in money, tangible & intangible
assets. It is the total wealth of a company.
Theories of Capitalization
FAIR CAPITALIZATION: It is the desire of every company to have a fairly capitalized situation, that is
neither over-capitalization nor under-capitalization.
OVER CAPITALZATION: Over-capitalization refers to that state of affairs where earnings of a company
do not justify the amount of capital invested in its business. When a business us unable to earn fair rate
on its outstanding securities, it is over-capitalization
Over-capitalization may occur when the amount of shares debentures, public deposit and loans exceed
the current value of the assets.
Evils of overcapitalization
UNDERCAPITALIZATION:
A company may be undercapitalized when the rate of profits it is making on the total capital is
exceptionally high in relation to the return enjoyed by similarly situated companies in the same
industry, or when it has too little capital with which to conduct its business.
We can say undercapitalization is the reverse phenomenon of over capitalization, and occurs when a
company’s actual capitalization is lower than its proper capitalization as warranted by its earning
capacity.
Causes of undercapitalization
REMEDIES OF UNDERCAPITALIZATION
Splitting stock
CAPITAL STRUCTURE
The term ‘structure’ means the arrangement of the various parts. So capital structure means the
arrangement of capital from different sources so that the longterm funds needed for the business are
raised.
Thus, capital structure refers to the proportions or combinations of equity share capital, preference
share capital, debentures, longterm loans, retained earnings and other longterm sources of funds in
the total amount of capital which a firm should raise to run its business.
The term capital structure should not be confused with financial structure and Assets structure. While
financial structure consists of shortterm debt, longterm debt and share holders’ fund i.e., the entire
left hand side of the company’s Balance Sheet. But capital structure consists of longterm debt and
shareholders’ fund.
So, it may be concluded that the capital structure of a firm is a part of its financial structure. Some
experts of financial management include shortterm debt in the composition of capital structure. In
that case, there is no difference between the two terms—capital structure and financial structure.
So, capital structure is different from financial structure. It is a part of financial structure. Capital
structure refers to the proportion of longterm debt and equity in the total capital of a company. On
the other hand, financial structure refers to the net worth or owners’ equity and all liabilities (long
term as well as shortterm).
Capital structure does not include shortterm liabilities but financial structure includes shortterm
liabilities or current liabilities.
Assets structure implies the composition of total assets used by a firm i.e., makeup of the assets side
of Balance Sheet of a company. It indicates the application of fund in the different types of assets
fixed and current.
The term capitalization means the total amount of longterm funds at the disposal of the company,
whether raised from equity shares, preference shares, retained earnings, debentures, or institutional
loans.
POINTS TO REMEMBER:
Financial breakeven point may be defined as that level of EBIT which is just equal to pay the total
financial charges, that is interest and preference dividend. At that point or level of earnings before
interest and tax, the earnings per share equals zero (EPS=0). It is critical point in planning capital
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structure of a firm. If earnings before interest and tax is less than the financial break even point, the
earnings per share shall be negative and hence fixed interest bearing debt or preference share capital
should be reduced in the capitalization of the firm. However in case the level of EBIT exceeds the
financial break even point, more of such fixed cost funds may be inducted in the capital structure.
t= tax rate
The EPS, EARNING PER SHARE, “EQUIVALENCY POINT” OR “POINT OF INDIFFERENCE” refers to that
EBIT, earnings before interest and tax, level at which EPS remains the same irrespective of different
alternatives of debtequity mix. At this level of EBIT, the rate of return on capital employed is equal to
the cost of debt and this is also known as breakeven level of EBIT for alternative financial plans.
That capital structure or combination of debt and equity that leads to the maximum value of the firm.
Optimal capital structure maximizes the value of the company and hence the wealth of its owners and
minimizes the company’s cost of capital.
The financial or capital structure decision of a firm to use a certain proportion of debt or otherwise in
the capital mix involves two types of risks:
FINANCIAL RISK: The financial risk arises on account of the use of debt or fixed interest bearing
securities in its capital. A company with no debt financing has no financial risk. The extent of financial
risk depends on the leverage of the firm's capital structure. A firm using debt in its capital has to pay
fixed interest charges and the lack of ability to pay fixed interest increases the risk of liquidation. The
financial risk also implies the variability of earnings available to equity shareholders.
NONEMPLOYMENT OF DEBT CAPITAL RISK (NEDC): If a firm does not use debt in its capital structure,
it has to face the risk arising out of nonemployment of debt capital. The NEDC risk has an inverse
relationship with the ratio of debt in its total capital. Higher the debt equity ratio or the leverage,
lower is the NEDC risk and viceversa. A firm that does not use debt cannot make use of financial
leverage to increase its earnings per share; it may also lose control by issue of more and more equity;
the cost of floatation of equity may also be higher as compared to costs of raising debt.
The line of argument in favor of net income approach is that as the proportion of debt financing in
capital structure increases, the proportion of a less expensive source of funds increases. This results in
the decrease in overall 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
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 or say when
the financial leverage is reduced, the weighted average cost of capital of the firm will increase and the
total value of the firm will decrease. The Net Income Approach showing the effect of leverage on
overall cost of capital has been presented in the following figure.
The total market value of a firm on the basis of Net Income Approach can be ascertained as below:
V=S+D
WHERE.
POINTS TO REMEMBER:
Suggested by Durand.
It states a relationship between leverage, cost of capital and value of the firm.
Relationship between capital structure and value of the firm.
It states that value of the firm increases by increasing more debt
proportion or leverage & overall cost of capital will decrease.
More & more debt or leverage> increase value of the firm> decrease overall cost
of capital of the firm (WACC)
Assumptions are cost of debt Kd and cost of equity Ke are constant. Kd=Ke=k
Use of more and more debt financing in the capital structure does not affect the
risks perception of the investors.
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Approach suggests that higher the degree of leverage, better it is as the value of
the firm would be higher. A firm can increase its value just by increasing the debt
proportion in capital structure.
Value of the firm= value of equity+ value of debt
2. NET OPERATING INCOME APPROCH: This theory was suggested by DURAND &
is another extreme of the effect of leverage on the value of the firm. It is diametrically
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 optimal capital structure. This theory presumes that:
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 increased 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 remains constant with the increasing proportion of debt as the financing risk of the
lenders is not affected. Thus, the advantage of using the cheaper source of funds, that is 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. The Net Operating Income Approach showing the effect of leverage on the
overall cost of capital has been presented in the following figure.
The value of a firm on the basis of Net Operating Income Approach can be determined as below:
V=
V= VALUE OF A FIRM
POINTS TO REMEMBER:
Opposite to NI approach.
Market value of the firm depends on the operating profit or EBIT and overall cost
of capital (WACC)
Financing mix or capital structure is irrelevant and does not affect the value of the
firm.
Assumptions are cost of debt and overall cost of capital are constant. Kd= Ko=K
As the debt proportion or the financial leverage increases the risk of the
shareholders also increases and the cost of equity Ke also increases so value of
the firm remain the same.
NOI consider Ko to be constant & there is no optimal capital structure rather every
capital structure is good as any other & every capital structure is optimal one.
Value of equity= value of the firm- value of debt
POINTS TO REMEMBER:
It said that both NI approach and NOI approach is unrealistic.
It takes a mid way between the NI approach (value of the firm increase by increasing debt)
and NOI approach (value of the firm remain the constant)
As per this a firm should make a judicious use of both debt & equity to achieve a capital
structure which may be called the optimal capital structure.
WACC will be minimum & value of the firm will be maximum.
It states that value of the firm increases with increase in financial leverage but up to a certain
limit only. Beyond this limit the increase in financial leverage will increase its WACC and value
of the firm will decline.
Assumptions are cost of debt Kd and cost of equity Ke is constant, Kd=Ke=K
The use of the leverage beyond a point will have the effect of increase in the overall cost of
capital of firm& thus result in decrease in the value of the firm.
Judicious use of both debt and equity.
4. MODIGLIANI & 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 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 through 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
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of equity, the overall cost of capital remains constant. The theory emphasizes the fact
that a firms operating income is a determinant of its total value. The theory further
propounds that beyond a certain limit of debt increases (due to increased financial risk)
but the cost of equity falls thereby again balancing the two costs.
In the opinion of Modigliani & Miller, two identical firms in all respects expect their capital
structure cannot have different market values or cost of capital because of ARBITAGE
process. In case two identical firms expect for their capital structure have different
market values of cost of capital, ARBITAGE will take place and the investors will engage
in personal leverage that is they will buy equity of the other company in preference to the
company having lesser value as against corporate leverage and this will again render the
two firms to have the same total value.
The M & M APPROACH is based upon the following assumptions:
There are no corporate taxes.
There is a perfect market
Investors act rationally.
The expected earnings of all the firms have identical risk characteristics.
The cut-off point of investment in a firm is capitalization rate.
M M APPROACH in the absence of corporate taxes that is the theory of irrelevance of
financing mix has been presented in the following figure:
&
Value of UNRELERED FIRM =
POINTS TO REMEMBER:
Relationship between leverage cost of capital and value of the firm.
Capital structure has no effect on the value of the firm.
Financial leverage does not matter and cost of capital & value of the firm is
independent.
Nothing may be called optimal capital structure.
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Restate NOI approach & added it to the behavioral justification for their model.
Assumptions are markets is perfect, securities are infinitely divisible, investors
are rational, no tax, personal leverage and corporate leverage are perfect substitute.
It argues that if two firms are alike in all respects except that they differ in respect
of their financing pattern and their market value, then the investors will develop a
tendency to sell the shares of the over -valued firm and to buy the shares of the under-
valued firm. Buying and selling pressures will continue till the two firms have same
market value.
It follows the arbitrage process- It refers to taking to understanding by a person of
two related actions r steps simultaneously in order to derive some benefit e.g buying by
speculator in one market and selling the same at the same time in some other market.
The arbitrage process has been used by MM to testify their hypothesis of financial
leverage, cost of capital & value of the firm.
CAPITAL GEARING: The term capital gearing refers to the relationship between equity capital and
longterm debt. In simple words, capital gearing means the ratio between the various types of
securities in the capital structure of the company.
PACKING ORDER THEORY: The PACKING ORDER THEORY was 1st suggested by Donaldson in 1961 and
it was modified by Myers in 1984. According to this theory, a firm has well defined order of preference
for raising finance. Whenever a firm needs funds, it will rely as much as possible on internally
generated funds. If the internally generated funds are not sufficient to meet the financial
requirements, it will move to debt in the form of term loans and then to nonconvertible bonds and
debentures and then to convertible debt instruments and then to quasiequity instruments and after
exhausting all other sources, it may finally move to raise finance through issue of new equity share
capital. This order of preference is so defined because the internally generated funds have no issue
cost and the cost of new equity issue is the highest.
LEVERAGES
The term leverage is used to describe the firm’s ability to use fixed cost assets or funds to increase the
return to its owners that is equity shareholders.
POINTS TO REMEMBER:
Every firm has to make its own decision regarding the quantum of funds to be borrowed. When the
amount of debt is relatively large in relation to capital stock, a company is said to be trading on their
equity
On the other hand if the amount of debt is comparatively low in relation to capital stock, the company is
said to be trading on thick equity.
The financial leverage is used to increase the shareholders earnings. It is based on the assumption that
the fixed charges/costs funds can be obtained at a cost lower than the firm's rate of return on its assets.
When the difference between the earnings from assets financed by fixed cost funds and the costs of
these funds are distributed to the equity stockholders, they will get additional earnings without
increasing their own investment. Consequently, the earnings per share and the rate of return on equity
share capital will go up. On the contrary, if the firm acquires fixed cost funds at a higher cost than the
earnings from those assets then the earnings per share and return on equity capital will decrease. The
impact of financial leverage can be analyzed while looking at earnings per share and return on equity
capital.
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The degree of financial leverage measures the impact of a change in operating income (EBIT) on change
in earning on equity capital or on equity share.
POINTS TO REMEMBER:
2. OPERATING LEVERAGE
Operating leverage results from the presence of fixed costs that help in magnifying net operating
income fluctuations flowing from small variations in revenue. The fixed cost is treated as fulcrum of
leverage. The changes in sales are related to changes in revenue. The fixed costs do not change with the
change in sales. Any increase in sales, fixed costs remaining the same, will magnify the operating
revenue. The operating leverage occurs when a firm has fixed costs which must be recovered
irrespective of sales volume. The fixed costs remaining same, the percentage change in operating
revenue will be more than the percentage change amount of fixed elements in the cost structure.
Operating leverage can be determined by means of a break even or cost volume profit analysis. The
degree of leverage will be calculated as:
When production and sales move above the breakeven point, the firm enters highly profitable range
of activities. At breakeven point the fixed costs are fully recovered, any increase in sales beyond this
level will increase profits equal to contribution. A firm operating with a high degree of leverage and
above breakeven point earns good amount of profit.
If a firm does not have fixed costs then there will be no operating leverage. The percentage change in
sales will be equal to the percentage change in profit. When fixed costs are there, the percentage
change in profits will be more than the percentage in sales volume.
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POINTS TO REMEMBER:
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