Page 207 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes George pondered over the situation. He could always wait until next week, when he could
be sure that he had the right recommendations and some of the considerations that outlined
each client’s needs and situation. If he could determine which firm matched each
recommendation, he could still call the firms by 6:00 P.M. and meet the original deadline.
George decided to return to his office and match each firm with the appropriate financing.
Questions
1. Which type of financing is appropriate to each firm?
2. What types of securities must be issued by a firm which is on the growing stage in
order to meet the financial requirements?

8.12 Summary

 Capital structure refers to the mix of long-term sources of funds, such as equity shares
capital, reserves and surpluses, debenture, long-term debt from outside sources, and
preference share capital.

 Capital structure = Long-term debt + Preferred stock + Net worth or capital structure =
Total assets – Current liabilities.

 In financing decisions the financial manager’s job is to come out with an optimum capital
structure, which maximizes market value per share by minimizing cost of capital.
 An appropriate capital structure should take into consideration profitability, solvency,
flexibility of capital structure, firm’s debt capacity, and control.

 The construction of capital structure is difficult, since it involves a complex trade off
among several factors.

 Appropriate capital structure can be determined by adopting: EBIT-EPS approach, valuation
Approach and cash flow approach.
 Indifference point is that EBIT level at which, the EPS is same for two alternative capital
structures.
 According to the NI approach overall cost of capital continuously decreases as and when
the debt content is increased in the capital structure. So optimum capital structure exists
when the firm borrows maximum.

 NOI is just opposite to NI approach and argues that capital structure is irrelevant. According
to the theory, K depends on business risk, which is assumed to be constant. So, K does not
o o
change when leverage is changed.
 The MM approach to capital structure is akin to that of NOI approach and argues that
capital structure is irrelevant.

8.13 Keywords

Arbitrage: It refers to an act of buying a security in one market having lower price and selling it
in another market at higher price.
Capital Structure: It is that part of financial structure, which represents long-term sources.
EBIT-EPS Approach: This approach determines the impact of debt on earnings per share.

MM Theory: According to this theory the value of the firm is independent of its capital structure.

202 LOVELY PROFESSIONAL UNIVERSITY