Page 113 - DMGT409Basic Financial Management

Basic Financial Management

Notes Probability Distribution of Cash fl ow: Based on current conditions and projected performance

the management believes that the expected cash flow will be ` 50 million with a standard

deviation of ` 30 million. The cash flow would be normally distributed. The initial cash balance
of the company is ` l1.26 million.

Fixed Charges: The annual fixed charges associated with various levels of debt would be as
follows:
Level of Debt Annual Fixed Charges
Upto ` 5 million ` 0.25 million for every ` 1 million of debt
Between ` 5 million and ` 10 million ` 0.26 million for every ` 1 million of debt
Between ` 10 million and ` 15 million ` 0.27 million for every ` 1 million of debt
Debt Capacity: Given the above information the debt capacity may be established as follows:

1. Since the cash flow is normally distributed the following variable has a standard normal
distribution (Z distribution):

2. The Z value corresponding to 5 per cent cumulative probability (which reflects the risk

tolerance of the management) is -1.645.
3. Since m = ` 50 million, s = ` 30 million and the Z value corresponding to the risk tolerance

limit is -1.645, the cash available from the operations of the firm to service the debt is equal
to X which is defi ned as:
= -1.645
This means X = ` 0.65 million.
4. The total cash available for servicing the debt will be equal to:

` 0.65 milllion (cash available from operations)
+ ` 1.26 million (initial cash balance)
= ` 1.91 million.
5. The level of debt that can be serviced with ` 1.91 million is a follows:

Amount Annual fi xed charges
` 5.00 million 0.25×5.00 = ` 1.25 million
` 2.54 milliion 0.26×2.54 = ` 0.66 million
` 7.54 million ` 1.91 million

Task If debt is cheaper than equity, why do companies not fi nance their assets with 80
per cent or 90 per cent debt ratio?
The capital structure is the mixture of the various types of long-term sources of funds
namely, equity share including retained earnings, preference shares debentures and long-

term loans from financial institution. It is also known as fi nancial structure.

Companies can use any source of finance for their assets requirements. The required
capital can be raised through any one of the following fi nancial plans.
1. Fully equity share capital plan,
Contd...

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