2. Chapter 18 Capital & Capital Market

3. Financial Management  It deals with raising of finance, and using and allocating financial resources of a company  Use the lowest cost to obtain fund  Making the optimal use of these funds

4. Objectives of Financial Management  Find ways to raise capital  Conserving capital  Earning a profitable return from the use of capital Maximizing the wealth of the owners / stockholders

5. Financial Planning  The forecast and projecting income and expenditures, determining methods of financing, cash flow forecasting, credit policy

6. Functions of the Financial Manager  Financial analysis and planning  Managing the firm’s asset structure  Managing the firm’s financial structure

7. Important Notes 1. Sources of capital Internal External 2. Duration Short term Long term

8. 3. Capital structure Equity Debt 4. Small vs. large Firm

9. Sources of Capital (Internal) 1. Retained earnings (Short term / long term) Advantages: No interest payment No maturity date Disadvantages Limit amount Not available to newly established firms If no enough dividend, shareholders may sell their shares.  Difficult to obtain funds in the stock market in the future.

10. 2. Depreciation allowance (Short term) Tax payment 3. Reduction in current assets (Short term) Factoring Advantages: immediate cash available Disadvantages: very high cost, damage reputation

11. Sources of Capital (External) 1. Bank loan Unsecured bank loans (no collateral) Secured loans (collateral) Advantages:  No dilution of control  Stable supply of funding  Interest payment is tax deductable Disadvantages:  Interest burden  Fixed maturity date

12. 2. Overdrafts Advantages :  Easy and immediate access of fund  Ability to borrow only as much as needed  Can repay immediately when cash available  Decrease interest burden Disadvantages: May require collateral May require to maintain deposit without interest

13. 3. Trade credit Advantages:  No collateral require  No formal procedure involved Disadvantages:  Give up cash account

14. Commercial papers  Unsecured short-term obligation (i.e. promissory notes) sold by large corporation  ONLY large, well-known, credit-worthy corporations can borrow  Backed UP by general assets

15. Long-term Capital 1. Equity financing Injection of capital by owners Retained earnings Issue of shares Preference shares  No voting rights  Fixed rate of dividend  Have priority to receive dividends

16. Debt financing  Debentures / Bond  Long term bank loans

17. Advantages of Equity Financing  Firms are able to withstand business fluctuation  No collateral require  Postponement of borrowing for future need  Increase creditworthiness of the company

18. Disadvantages of Equity Financing  Usually impossible to obtain all needed capital  May be more costly than that financing in long-term  Shareholders are entitled to share superiors earnings of the company Dividend is NOT tax deductible Risk of losing control

19. Advantages of Debt Financing 1. Can obtain all needed capital 2. Creditors (bank, bond holder) do not participate in superior earning of a company 3. Interest payment is tax deductible 4. No dilution of a company control 5. Repayment of debt is cheaper during inflation

20. 1. Interest charges must be met regardless earnings 2. Debt must be repaid at maturity 3. Commitment for long period involves risk. If expectation / plan change, debt may become a heavy burden Disadvantages of Debt Financing

21. When to use long-term debt financing?  Inflation expect  Stability in revenue and earnings  There is satisfactory profit margin  Good liquidity and cash flow position  When stock prices currently depressed  Debt ratio is still low  Control consideration

22. Comparison of Equity and Debt Financing 1. Voting right Equity (common stock) – voting right on basis of one vote per share. (Preference shares normally no such right). Debt (bonds) – no voice in management 2. Representation Equity – represents ownership Debt – represents debt

23. 3.Interest payment Equity – none. Also, dividends cannot be authorised until bond interest is paid. Debt – interest paid prior to other claims. 4.Accounting Equity – dividends part of earnings of firm. Debt – interest is expense.

24. 5.Payment Equity – ordinary dividends paid at board’s discretion. (Preferred dividends paid prior to ordinary dividends and must be paid if earnings sufficient). Debt – interest must be paid. 6.Principal repayment Equity – no maturity date, i.e. no guarantee of payment. If owners wish to withdraw investment, must sell to others. Debt – must be repaid at some future date, i.e. specified amount guaranteed even if company does poorly, provided it remains in the business.

25. 7.Claims on assets Equity – ordinary shareholders last to claim assets of failing business. (Preference shares have priority over ordinary shareholders but behind creditors). Debt – creditors have first claim on assets.