Financial Management
Objectives and decisions
Wealth maximisation (long-run shareholder value) is preferred to profit maximisation, which ignores risk and the time value of money. The three decisions are investment (capital budgeting), financing (debt–equity mix) and dividend (payout versus retained earnings).
Capital structure and trading on equity
Debt is cheaper because interest is tax-deductible, but it raises financial risk and creates a fixed obligation. Using debt to magnify shareholders' return is trading on equity, which is favourable when the return on investment exceeds the interest rate. Factors affecting the mix: cost, risk, control, floatation cost, cash flow, flexibility, tax rate.
Fixed and working capital
Fixed capital needs depend on nature of business, scale, technology, growth plans and diversification. Working capital needs depend on the operating cycle, nature of business, scale, credit allowed, credit received and seasonality.
Worked example
A firm invests ₹100 crore and earns 15%. It borrows ₹40 crore at 10%, so equity is ₹60 crore. Earnings before interest = ₹15 crore; interest = ₹4 crore; balance = ₹11 crore; return on equity = 11/60 = 18.3%, above 15%. Debt has raised shareholders' return, so trading on equity is favourable here.
Traps that cost marks
- Classifying the dividend decision as a financing decision.
- Recommending more debt without mentioning added financial risk.
- Calling working capital a long-term requirement.