Source of Finance : Long-Term Source

A business requires funds to purchase fixed assets like land and building,
plant and machinery, furniture etc. These assets may be regarded as the
foundation of a business. The capital required for these assets is called
fixed capital. A part of the working capital is also of a permanent nature.
Funds required for this part of the working capital and for fixed capital
is called long term finance.
Purpose of long term finance:
Long term finance is required for the following purposes:
1. To Finance fixed assets :
Business requires fixed assets like machines, Building, furniture
etc. Finance required to buy these assets is for a long period,
because such assets can be used for a long period and are not for
resale.

2. To finance the permanent part of working capital:
Business is a continuing activity. It must have a certain amount of
working capital which would be needed again and again. This part
of working capital is of a fixed or permanent nature. This
requirement is also met from long term funds.
3. To finance growth and expansion of business:
Expansion of business requires investment of a huge amount of
capital permanently or for a long period.

The main sources of long term finance are as follows:

1. Shares:
These are issued to the general public. These may be of two types:
(i) Equity and (ii) Preference. The holders of shares are the owners
of the business.
2. Debentures:
These are also issued to the general public. The holders of
debentures are the creditors of the company.
3. Public Deposits :
General public also like to deposit their savings with a popular
and well established company which can pay interest periodically
and pay-back the deposit when due.
4. Retained earnings:
The company may not distribute the whole of its profits among its
shareholders. It may retain a part of the profits and utilize it as
capital.
5. Term loans from banks:
Many industrial development banks, cooperative banks and
commercial banks grant medium term loans for a period of three
to five years.
6. Loan from financial institutions:
There are many specialised financial institutions established by
the Central and State governments which give long term loans at
reasonable rate of interest. Some of these institutions are:
Industrial Finance Corporation of India ( IFCI), Industrial
Development Bank of India (IDBI), Industrial Credit and Investment
Corporation of India (ICICI), Unit Trust of India ( UTI ), State
Finance Corporations etc. These sources of long term finance will
be discussed in the next lesson.

Capital Structure : Modigliani and Merton Miller(M&M)

We know that the best capital structure for a corporation is when the WACC is minimized. This is partly derived From two famous Nobel prize winners, Franco Modigliani and Merton Miller who developed the M&M Propositions I,II,IIIand IV.


M&M Proposition I


M&M Proposition I states that the value of a firm does NOT depend on its capital structure. For example, think of 2 firms that have the same business operations, and same kind of assets. thus, the left side of their Balance Sheets look exactly the same. The only thing different between the 2 firms is the right side of the balance sheet, i.e the liabilities and how they finance their business activities.
     If a firm'sstocks make up 70% of The capital structure while bonds (debt) make up for 30%.In other firm it is the exact opposite. This is the case because the Assets of both capital structures are the exactly same.

M&M Proposition 1 therefore says how the debt and equity is structured in a corporation is Irrelevant. The value of the firm is determined by Real Assets and not its capital structure.

M&M Proposition II

    M&M Proposition II states that the Value of the firm depends on three things:

1) Required rate of return on the firm's Assets (Ra)
2) Cost of debt of the firm (Rd)
3) Debt/Equity ratio of the firm (D/E)

The WACC formula can be manipulated and written in another form:

Ra = (E/V) x Re + (D/V) x d

The above formula can also be rewritten as

Re = Ra + (Ra - Rd) x D/E)

This formula  is what M&M Proposition I is all about.

As Debt/Equity Ratio Increases -> Re will Increase (upwards sloping).

This is the basic identity of M&M Proposition I and II, that the capital structure of the firm does not affect its total value.

- WACC therefore remains the same even if the company borrows more debt (and increases its Debt/Equity ratio). 

·     M-M proposition 3:the distribution of dividends does not change the firm’s market value: it only changes the mix of E and D in the financing of the firm.

·     M-M proposition 4: in order to decide an investment, a firm should expect a rate of return at least equal to r_a, no matter where the finance would come from. This means that the marginal cost of capital should be equal to the average one. The constant r_a is sometimes called the “hurdle rate” (the rate required for capital investment).

Capital Structure: Theory

Cost of Captial : Introduction

The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities".It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the interest-rate paid by the company can be modelled as the risk-free rate plus a risk component (risk premium), which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or credit ratings, the interest rate is largely exogenous (not linked to the company's activities).

The cost of equity is more challenging to calculate as equity does not pay a set return to its investors. Similar to the cost of debt, the cost of equity is broadly defined as the risk-weighted projected return required by investors, where the return is largely unknown. The cost of equity is therefore inferred by comparing the investment to other investments (comparable) with similar risk profiles to determine the "market" cost of equity.

Once cost of debt and cost of equity have been determined, their blend, the weighted-average cost of capital (WACC), can be calculated. This WACC can then be used as a discount rate for a project's projected cash flows.

Source of Finance

Sources Of Finance terms refers to the Sources from where an firm can get investments or money to run the business. Needs of Money :-
1. To run the business.
2. To maintain the status in market
3. For growth of Business.
4. To stay in compition of market etc.
These are some basic needs of finance on the basis of Needs of Finance there are different-2 Sources of Finance too which are as follows :-
I. On basis of Time Period :-
    A. Long-Term Finance (---10 Years or more----)
    B. Short- Term Finance (1 to 3Years)
    C. Mid- Term Finance(5 to 10 Years)




A. Long-term sources of finance: Long-term financing can be raised from the following sources:

• Share capital or equity share
• Preference shares
• Retained earnings
• Debentures/Bonds of different types
• Loans from financial institutions
• Loan from state financial corporation
• Loans from commercial banks
• Venture capital funding
• Asset securitisation
• International

B.Medium-term sources of finance: Medium-term financing can be raised from the following sources:

• Preference shares
• Debentures/bonds
• Public deposits/fixed deposits for duration of three years
• Commercial banks
• Financial institutions
• State financial corporations
• Lease financing / hire purchase financing
• External commercial borrowings
• Euro-issues
• Foreign currency bonds.

C.Short term sources of finance: Short-term financing can be raised from the following sources:

• Trade credit
• Commercial banks
• Fixed deposits for a period of 1 year or less
• Advances received from customers
• Various short-term provisions

Function of Finance : Dividend Decision

Dividend decision is concerned with the amount of profits to be distributed and retained in the
firm.
Dividend: The term ‘dividend’ relates to the portion of profit, which is distributed to shareholders
of the company. It is a reward or compensation to them for their investment made in the firm.
The dividend can be declared from the current profits or accumulated profits.
Which course should be followed – dividend or retention? Normally, companies distribute
certain amount in the form of dividend, in a stable manner, to meet the expectations of
shareholders and balance is retained within the organisation for expansion. If dividend is not
distributed, there would be great dissatisfaction to the shareholders. Non-declaration of dividend
affects the market price of equity shares, severely. One significant element in the dividend
decision is, therefore, the dividend payout ratio i.e. what proportion of dividend is to be paid
to the shareholders. The dividend decision depends on the preference of the equity shareholders
and investment opportunities, available within the firm. A higher rate of dividend, beyond the
market expectations, increases the market price of shares. However, it leaves a small amount
in the form of retained earnings for expansion. The business that reinvests less will tend to
grow slower. The other alternative is to raise funds in the market for expansion. It is not a
desirable decision to retain all the profits for expansion, without distributing any amount in the
form of dividend.
There is no ready-made answer, how much is to be distributed and what portion is to be
retained. Retention of profit is related to
• Reinvestment opportunities available to the firm.
• Alternative rate of return available to equity shareholders, if they invest themselves

Function of Finance : Liquidity Desicion

Liquidity decision is concerned with the management of current assets. Basically, this is Working
Capital Management. Working Capital Management is concerned with the management of current
assets. It is concerned with short-term survival. Short term-survival is a prerequisite for long-term
survival.
When more funds are tied up in current assets, the firm would enjoy greater liquidity. In
consequence, the firm would not experience any difficulty in making payment of debts, as and
when they fall due. With excess liquidity, there would be no default in payments. So, there would
be no threat of insolvency for failure of payments. However, funds have economic cost. Idle current assets do not earn anything. Higher liquidity is at the cost of profitability. Profitability
would suffer with more idle funds. Investment in current assets affects the profitability, liquidity
and risk.  A proper balance must be maintained between liquidity and profitability of the
firm. This is the key area where finance manager has to play significant role. The strategy
is in ensuring a trade-off between liquidity and profitability. This is, indeed, a balancing act
and continuous process. It is a continuous process as the conditions and requirements of business
change, time to time. In accordance with the requirements of the firm, the liquidity has to vary
and in consequence, the profitability changes. This is the major dimension of liquidity decisionworking capital management. Working capital management is day to day problem to the finance
manager. His skills of financial management are put to test, daily.

Function of Finance : Investment Decision

Function Of Finance :
A. Investment Decision:-
 Investment decisions relate to selection of assets in which funds are to be invested by the firm.
Investment alternatives are numerous. Resources are scarce and limited. They have to be rationed and discretely used. Investment decisions allocate and ration the resources among the competing
investment alternatives or opportunities.  The effort is to find out the projects, which are acceptable.
Investment decisions relate to the total amount of assets to be held and their composition
in the form of fixed and current assets. Both the factors influence the risk the organisation is
exposed to. The more important aspect is how the investors perceive the risk.
The investment decisions result in purchase of assets. Assets can be classified, under two
broad categories:
(i) Long-term investment decisions – Long-term assets
(ii) Short-term  investment decisions – Short-term assets
Long-term Investment Decisions:  The long-term capital decisions are referred to as capital
budgeting decisions, which relate to fixed assets. The fixed assets are long term, in nature.
Basically, fixed assets create earnings to the firm. They give benefit in future. It is difficult to
measure the benefits as future is uncertain.
The investment decision is important not only for setting up new units but also for expansion
of existing units. Decisions related to them are, generally, irreversible. Often, reversal of decisions
results in substantial loss. When a brand new car is sold, even after a day of its purchase, still,
buyer treats the vehicle as a second-hand car. The transaction, invariably, results in heavy loss for
a short period of owning. So, the finance manager has to evaluate profitability of every investment
proposal, carefully, before funds are committed to them.
Short-term Investment Decisions: The short-term investment decisions are, generally, referred
as working capital management. The finance manger has to allocate among cash and cash equivalents,
receivables and inventories. Though these current assets do not, directly, contribute to the earnings,
their existence is necessary for proper, efficient and optimum utilisation of fixed assets.

Scope of Financial Management

In order to achieve the objectives of the financial management, the financial manager of the business concern, has to manage various aspects of finance function which lay down the scope of his duty. These aspects are discussed as under:
1. Estimating the financial requirement.
2. Determining the structure of capitalization.
3. Selecting a source of finance.

4. Selecting a pattern of investment.
5. Management of cash flow.
6.Implementingfinancial control.
7. Proper use of surplus.

1. Estimating the financial requirement: on the basis of their forecast of the volume of business operations of the company, the finance executives have to estimate the amount of fixed capital and working capital required in a given period of time

2. Determining the structure of capitalization: after estimating the requirement of capital, the finance executives have to decide about the composition of capital. They have to determine the relative proportion of owner’s risk, capital and borrowed capital. These decisions have to be taken in the light of cost of raising form different resources, period for which funds are needed and several others factors.

3. Investment decision: the funds raised from different resources are to be intelligently invested in various assets so as to optimize their return of investment. While making investment decision, management should be guided by three important principles-safety, liquidity and profitability.

4. Management of cash flows: - Cash is needed to pay off creditors, for purchase of materials, pay labor and to meet everyday expenses. These should not be shortage of cash at any time as it will damage credit- worthiness of the company. These should not be access cash them required because money has
time value.

5. Management of earnings: - The finance executive has to decide about the allocation of earnings among several competitive needs. A certain amount of total earnings may be kept as reserve or a portion of earnings may be distributed among and ordinary and preference share holders, yet another portion may be ploughed back or re-invested. The finance executives must consider the merits and de-merits of alternative schemes of utilizing the funds generating from the companies own earnings.

6. Choice of sources of finance: - The management can raise finance from various sources like share holders, banks and others financial distributors finance executives has to evaluate each source over method of finance and choose the best source. Financial management is the new branch of accounting that deals with the acquisition of financial resources & management of them.

What is Financial Management

Basically financial management made of two words Finance and Management. Basic means from finance is taken as Money or wealth. and Management alwayz refer as control things or managing things according to business.So Financial Management can be termed as :-

The management of the finances of a business / organisation in order to achieve financial objectives

Taking a commercial business as the most common organisational structure, the key objectives of financial management would be to:

• Create wealth for the business

• Generate cash, and

• Provide an adequate return on investment bearing in mind the risks that the business is taking and the resources invested

There are three key elements to the process of financial management:

(1) Financial Planning

Management need to ensure that enough funding is available at the right time to meet the needs of the business. In the short term, funding may be needed to invest in equipment and stocks, pay employees and fund sales made on credit.

In the medium and long term, funding may be required for significant additions to the productive capacity of the business or to make acquisitions.

(2) Financial Control

Financial control is a critically important activity to help the business ensure that the business is meeting its objectives. Financial control addresses questions such as:

• Are assets being used efficiently?

• Are the businesses assets secure?

• Do management act in the best interest of shareholders and in accordance with business rules?

(3) Financial Decision-making

The key aspects of financial decision-making relate to investment, financing and dividends:

• Investments must be financed in some way – however there are always financing alternatives that can be considered. For example it is possible to raise finance from selling new shares, borrowing from banks or taking credit from suppliers

• A key financing decision is whether profits earned by the business should be retained rather than distributed to shareholders via dividends. If dividends are too high, the business may be starved of funding to reinvest in growing revenues and profits further