Showing posts with label Finance. Show all posts
Showing posts with label Finance. Show all posts

Concept And Meaning Of Bank

The Best of Brian Tracy
A bank is financial institution, which deals with money and credit. Bank accepts deposits from the public and mobilizes the fund to productive sectors. Bank also provides remittance facility to transfer money from one place to another. Generally, bank accepts deposits from business institutions and individuals , which is mobilized into productive sectors mainly business and consumer lending. So bank is also called a dealer of money. At present context, a bank may engaged in different types of functions such as remittance, exchange currency, joint venture, underwriting, bank guarantee, discounting bills etc. The modern bank refers to an institution having the following characteristics:

* Bank deals with money: it accepts deposits and advances loans.
* Bank also deals with credit: it has the ability to create credit by expanding its liabilities.
* Bank is commercial institution: it aims at earning profit.

Banks are the principal source of credit for millions of individuals and families and for many units of government. They are among the most important financial institutions in the economy. Moreover, for small local businesses to large dealers, banks are often the major source of credit to stock the shelves with merchandise. Banks grand more installment loans to consumer than any other financial institutions.
Banks are among the leading buyers of bonds and notes issued by government to finance public facilities, ranging from hospitals and football stadiums to airports and highways. Moreover, bank reserves are the principal channel for government economic policy to stabilize the economy.
Banks are the important sources of short-term working capital for businesses. They have become increasingly active in recent years in making long-term business loans for new plants and equipment. When businesses and consumers must make payments for purchase of goods and services, more often they use bank provided cheques, debit or credit cards, or electronic accounts connected to a computer network.
Bank is a intermediary which accepts deposits and grants loans. It offers widest menu of services of any financial institution. In fact, a modern bank performs such a variety of functions that it is difficult to give a precise and general definition of a bank.

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Concept Of Derivative Securities And Underlying Assets

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Let us assume that the price of agricultural product 'X' is $ 10,000 a ton in the market. You have contracted to purchase 100 tons at the rate of $ 9,500 per ton from the producer of that product. Now you can make profit on the sale of every ton of 'X'. Your total profit will be $ 50,000. Alternatively, the value of the agreement with producer is worth for $50,000. In this example, the product 'X" is an underlying asset and the agreement with producer is the derivative securities. In the same manner, contract can be made to purchase specified number of financial assets at specified price within predetermined time period. For example, you can promise to purchase 100 shares of Standard Chartered Bank Limited at $ 3,000 a share by July 2010 to your friend or you can promise to sell 100 shares at $ 2,950. The value of your promise to your friend and yourself depends on the market price of the share. Here, share of the bank is an underlying asset and the promise that you make is the derivative security ( an asset derived from underlying asset). We can conceptualize now that derivatives are the assets derived from other assets and in general, the value of such asset depends on the market price of the underlying assets. More specifically, in our example, share of Standard Chartered Bank Limited is underlying primary security and promises that you make to sell or purchase the share of this bank is derivative or synthetic securities.

Now we can define the derivatives. They are financial contracts whose value is linked to the price of an underlying commodity, asset, rate index or occurrence or magnitude of an event.The term derivative comes from how the price of these contract is derived from price of some underlying commodity, security or index or the magnitude of some events. Thus, this term is used to refer to the set of financial instruments that include futures, forwards, options, warrants, convertible ans swaps.

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Concept And Meaning Of Stock Market

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The securities once issued in primary market become the part of secondary market. It provides a place or mechanism for active trading of securities among investors themselves. The stock market is a secondary market, which aids to the liquidity of securities traded there on. When investors have to buy securities in secondary market, they have to contact the securities brokers for opening the account for purchase of securities. After the account has been opened, the securities broker conveys the order of investor to the securities dealers who handle the inventory of securities. There are two basic types of stock markets- organized stock exchange and over-the-counter market.
Organized stock exchange are the physical locations where securities are traded under some established rules and regulation through the license members of the exchange. It is one of the important secondary markets where the investors buy and sell the securities between themselves. Organized stock exchanges facilitate the trading of securities, which are listed in it. This means the securities, which are not listed, are not traded in organized stock exchange.
There are many organized stock exchanges around the world. One of the best known is New York Stock Exchange (NYSE), which deals with the trading of more than 50% of the volume of total shares traded in United States. Other well known exchanges are London Stock Exchange, Tokyo Stock Exchange, Hong Kong Stock Exchange. There can be more than one stock exchanges in a country, for example, Bombay Stock Exchange, Delhi Stock Exchange, Calcutta Stock exchange in India.

Over-the-counter (OTC) market was traditionally concerned with trading of securities which were not listed in an organized stock exchange. However, today the securities listed in organized stock exchange are also traded in OTC market. OTC market is an informal type of market for securities where no compulsory listing of securities is required. Any security can be traded on OTC market as long as a registered dealer is willing to make a market in the security (willing to buy and sell the security). It is not a central physical place like an organized stock exchange, rather it is the network of brokers and dealers scattered across the country. Buy ans sell in an OTC market are conducted through negotiated bidding through a network of communication line and computer system, which links brokers and dealers in o\OTC market to their clients. The brokers and dealers in OTC market can compete with both investment bankers and the organized exchanges because they can operate in both primary as well as secondary market. There is an international link of communication system used by the brokers and dealers in OTC market, which facilitates the investors for selection of most competitive market makers as opposed to being forced to trade with monopolistic market maker, National Association of Securities Automated Quotation System (NASDAQ) in the United States and Over-the-Counter Exchange India (OTCEI) in India are the examples of OTC market.

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Disadvantages Of Preferred Stock Financing

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Disadvantages of preferred stock financing from firm's viewpoint are as follows:

1. Preferred stock financing is expensive source of long-term financing because of two reasons:
i. Dividend rate on preferred stock is higher than interest rate payable on debentures.
ii. Unlike interest, preferred stock dividend is not tax-deductible expenses.

2. Preferred stock dividend is fixed and company must have commitment to pay this dividend. Although preferred stock dividends can be omitted, they may have to be paid because of their cumulative nature. Thus, preferred dividends are like fixed costs. The use of preferred stocks,like that of debt, increases financial risk and thus cost of common equity.

3. It is difficult to sell preferred stock in the market.Investors may not like to invest on preferred stocks because they get only fixed amount of dividend even though firm's earning is too high. Besides, if the earning of firm is low or unstable investors may not get preferred dividend. Hence, it is difficult to sell the stocks.

Disadvantages of preferred stock financing from investor's viewpoint are as follows:

1. As a general rule, preferred stockholders do not have voting right. Therefore, they have no control over management of company to protect their interest. 

2. Although preferred stockholders bear a substantial portion of ownership risk, they get limited return.

3. The preferred stockholders have no legally enforceable right to dividends.

4. The fluctuation in the price of preferred stock is wider than that of bonds. It exposes investors to higher price risk.

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Advantages Of Preferred Stock Financing

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From the firm's viewpoint the major advantages of preferred stock financing are as follows:

1. Preferred stock financing protects from dilution of control power. Because the preferred stockholders do not have voting right unless the dividend arrears exist. Thus, they do not have voice in the management of the company. Hence, the control power of ordinary shareholders remains preserved.

2.Preferred stock financing increases flexibility in capital structure and dividend payment.Preferred stocks may have call provision which increases the flexibility in capital structure. Besides, dividend can be postponed if earning is insufficient.

3. Preferred stock financing helps to conserve mortgageable assets.

4. Preferred stock financing protects from dilution in earnings. By issuing preferred stocks, the company can avoid the provision of equal participation in earnings that the sale of additional common stock would require and protects from dilution in earnings.

5. Preferred stock financing is less risky than long-term debt financing. If the firm is unable to pay periodic dividend or to redeem preferred stock at maturity, preferred stockholders can not take the company into bankruptcy. Because, from legal point of view, preferred stockholders are owners of the company.

6. Preferred stock financing is permanent source of capital. Typically, preferred stock have no fixed maturity. However, if call provision is included, company can call preferred stock ad redeem them.

From investor's point of view preferred stock financing have following advantages:

1. Preferred stocks provide reasonably regular and stable income as preferred stock dividends are fixed.

Adantages And Disadvantages Of Long-Term Debt Financing

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Advantages Of Long-Term Debt Financing
From the issuing firm's perspective, the major advantages of long-term debt financing are as follows:

1. Debt is least costly source of long-term financing. It is the least costly because:
* Interest on debt is tax-deductible,
* Bondholders or creditors consider debt as a relatively less risky investment and require lower return.

2. Debt financing provides sufficient flexibility in the financial/capital structure of the company. Flexibility in capital structure of the company can be increased by inserting call provision in the bond indenture. In case of over capitalization, the company can redeem the debt to balance its capitalization.

3. Bondholders are creditors and have no interference in business operations because they are not entitled to vote.

4. The company can enjoy tax saving on interest on debt.

Disadvantages Of Long-Term Debt Financing
Long-term debt financing has some disadvantages from firm's viewpoint as follows:

1. Interest on debt is permanent burden to the company. Company has to pay the interest to bondholders or creditors at fixed rate whether it earns profit or not. It is legally liable to pay interest on debt.

2. Debt usually has a fixed maturity date. Therefore, the financial officer must make provision for repayment of debt.

3. Debt is the most risky source of long-term financing. Company must pay interest and principal at specified time. Non-payment of interest and principal on time take the company into bankruptcy.

4. Debenture indentures may contain restrictive covenants which may limit the company's operating flexibility in future.

5. Only large scale, creditworthy firm, whose assets are good for collateral can raise capital from long-term debt.

From the investor's point of view, in general, debt securities offer stable returns. Further, if the company is liquidated then debenture holders are paid before preferred stockholders and common stockholders. Bondholders are creditors,however, they do not participate in any increased earnings the firm may experience. Similarly, they do not get right to vote.

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Types Of Bond Innovations

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Bond innovation is a continuous process. Companies innovated and used different types of bond in the passage of time. They first used zero coupon bond in a major way in 1981. In recent years, many large companies like IBM and J.C Penney have used zero coupon bonds to raise large amount of capital. Similarly, in early 1980s, company used floating rate debt. By using floating rate debt, firms can issue debt with a long maturity without committing themselves to paying a historically high rate of interest for the entire life of the loan. Another innovation is the junk bond. Prior to the 1980s, it was almost impossible for risky companies to raise capital in the public bond markets. But in 198s, they issued junk bond (high risk, high yield bond) to finance mergers and leveraged buyouts. However, its use has diminished in recent years.Following are the some types of bond innovations:

1. Zero Coupon Bonds
Zero coupon bonds, as the name implies, have no coupon rate. Hence these bonds are issued at a substantial discount from the par value. Though zero coupon bonds do not pay any interest during holding period they provide return to investors in the form of capital appreciation. Companies prefers to issue zero coupon bond when their cash flow is not regular.Government bonds and municipal bonds may also be issued without coupon interest.

2. Floating Rate Bonds
Instead of issuing a fixed interest rate debt instruments, company can issue floating rate notes/bonds. Interest rate on such bonds is tied to the treasury bond (government bond) or some market rates. In a volatile interest-rate environment, companies are reluctant to commit to long-term debt. They use floating rate bonds n this situation to reduce risk.
Although interest rates are not quoted in these bonds, a minimum or floor rate is often specified. This provision ensures bondholders a minimum rate of return.

3. Junk Bonds
Some bonds are issued by weak companies hence bear substantial risk. Such types of bonds provide relatively higher return. These bonds which have higher return and higher risk are called junk bonds. Generally, junk bonds are issued through private placement. In addition, junk bonds are used in acquisition and leveraged buy-outs. 

Types Of Corporate Bonds

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Types of corporate bonds available in the capital market are as follows:

1. Mortgage Bonds
A mortgage bond is a secured bond issued by a company. With a mortgage bond, the company pledges specific assets as a collateral for the bond. The asset securing the bond is described in detail in mortgage deed, which is legal document giving the bondholder a lien on a asset. If the company defaults on any of the provision in the bond indenture, bondholders have the power to take control over the asset and sell it to satisfy their claims. If the proceeds are less than the amount of the bond issue outstanding, the bondholders become general creditors for the residual amount.
A company can use a specific asset as security for more than one bond issue. New bond secured by the asset already used as a collateral is called second mortgage or junior mortgage bond. In the event of foreclosure, the first mortgage bondholders must be paid the full amount owed them before satisfying second mortgage bondholders' claim.

2. Debenture
A debenture is an unsecured bond issued by a company without providing any specific asset as collateral. Therefore, debenture holders are general creditors of the firm. Investors consider company's cash flow and assets which are not used as collateral before purchasing the debentures issued by the firm. Hence, only well-established and creditworthy companies are able to issue debentures.
Debentures may have call provision, which gives the company right to retire the debenture before maturity. When market decreases substantially companies call the existing debentures and issue new debentures. This process is called refunding decision. The call provision increases the risk to the investors.

3. Subordinated Debenture
Subordinated debentures are inferior debentures. In the event of liquidation, subordinated debentures holders have claim on assets only after senior debenture holders' claim is satisfied. In terms of claim, subordinated debenture is ranked lower to all debts except income bond and preferred stocks and common stocks. Therefore, a subordinated debenture issue provides significantly higher yield than does an ordinary debenture issue in order to attract investors.

4. Income Bond
An income bond pays interest only if the earnings of the firm are sufficient to meet the interest obligation. When a company fails to meet current obligation of interest, income bondholders cannot take the company into bankruptcy. Income bonds may have cumulative features, which means that unpaid interest in a particular year accumulates. If company earns profit in the subsequent year, it will have to pay the cumulative interest to the extent that earnings permit. From investor's stand point. these bonds are riskier than regular bonds but they provide higher return to investors.

5. Convertible Bond
A bond, which can be converted into specific number of common stock within specified future date at investor's desire is known as convertible bond. Theoretically, convertible bond also may be convertible into specified number of preferred stock. Conversion feature of bond attracts the potential investors. It also helps to reduce coupon interest and flotation costs. However, investors yield on convertible may be higher than that of ordinary bond,because of capital gain.

6. Callable And Putable Bond
Bond may have call provision. Call provision gives the company right to redeem bonds before maturity. Hence, in case of callable bond company holds right to redeem debt before maturity. In contrast to callable bond, putable bond allows the bondholders option to exchange the bond for cash.

Meaning And Advantages Of Term Loan

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Meaning Of Term Loan

A term loan is a loan from financial institutions having an initial maturity of more than one year. Term loan is a contract under which a borrower agrees to make a series of interest and principal payments in an interval of specific period. Generally, term-loans have maturities of 5 to 10 years. However, term loans may have maturities of 2 years or more. Funds raised from term loan is typically used to finance permanent working capital, to pay for fixed assets or to discharge other loans.
A formal term loan agreement is signed between the borrower and lender. It specifies various terms and conditions such as maturity period, payment date, interest rate, restrictive provisions, collateral etc. 

Advantages Of Term Loans
Term loans have some specific advantages over public offerings. It can be raised in relatively short period, because term loans are negotiated directly between the lender and the borrower, and documentation is minimized.But public offering of long-term securities involves lengthy process. Another advantage of term loan is flexibility. Terms and conditions of term loan can be revised on by mutual agreement between the lender and borrower. Another advantage of term loan is lower issuance costs. Firms can avoid flotation costs such as underwriting fee, commission, printing charges of certificate, advertisement cost etc.  

Reasons For Using Different Types Of Securities

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Different types of securities are traded in financial markets. Some of these securities, which have maturity period less than one year are traded in money market such as treasury bill, bill of exchange, commercial paper etc. Some others (long-term security) are purchased and sold in capital market. Treasury bond, corporate bond, preferred stock, common stock etc are traded in capital market. A company can issue various types of securities such as commercial papers, bonds, preferred stocks, common stocks etc. For example, Standard Chartered Bank has issued debenture, preferred stick and common stock to raise capital.

Why did Standard Chartered Band issue different types of securities? The answer lies on the fact that different investors have different risk-return preferences. Therefore, to appeal the broadest possible market, the bank should offer securities that attract as many types of investors as possible. An investor, who takes more risk and wants to get higher return may purchase common stock. But the investor, who wants to minimize investment risk may prefer bonds or debentures.

Second reason is popularity of the security. Different securities are more popular at different points in time. Hence companies tend to issue whatever is popular at the time they need money. Third, duration of fund required may lead the company to use specific source of  financing. For example, if the firm needs money for few month, it may issue short-term securities such as commercial paper. Similarly, a company issues perpetual bond or preferred stock or common stock when it requires permanent capital.

Methods Of Selling Securities

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A company can sell its shares to raise funds by different methods as follows:

1. Public Offering
A large-scale company generally raises funds through public offering.Under public offering, common stocks are sold to large numbers of investors. Normally, when a company wishes to issue new securities and sell them to the public, it makes an arrangement with an investment banker. The investment banker acts as a middleman who brings together suppliers and users of the long-term funds in capital market. Its major function is to buy the securities from the company and then resell them to investors at a higher price. This difference in the purchasing price and selling price also called 'spread' is commission to the investment banker. The purpose of going public is to increase the ownership base. A firm generally goes public when growth opportunities no longer can be financed solely by debt and a existing stockholders base.

2. Private Placement
A company can sell its shares directly or privately to a few/ a group of individual investor or institutional investors instead of having them underwritten and sold to the public. This type of sale is called private or direct placement. In private placement, the company negotiates directly with the investors over the terms of offering. Private placement has a number of advantages as follows:
- Flotation costs can be reduced by eliminating underwriting costs.
- It takes less time to raise funds through private placement.
- It is suitable for small scale company to raise funds.

3. Right Offering
Instead of selling common stocks to new investors, company can offer the new common stocks to the existing shareholders at a subscribed price on pro-rate basis. This method of issuance is called right offering. Right offering is also called privileged subscription. This right offering helps to reduce flotation costs. It also protects existing shareholders from dilution in wealth and control power. 

The Market For Common Stock

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A firm raises equity capital by selling stocks in a market.Similarly, investors who holds stocks need market to trade them. Thus, a market is must for both issuing new stocks and trading outstanding stocks. The market for common stock can be divided into two types as primary market and secondary market.

1. Primary Market
Newly established firm, privately held firms as well as publicly owned firms issue securities in primary market. In a primary market,securities issued for the first time are traded. In other words, it is a 'new issue' market, where fund is raised through the sale of new securities to the investors. Primary market can be classified in to two types as follows:

i. New public offering by closely held firms
A closely held firm can raise fund through initial public offering which is also a major part of primary market. If a new firm is growing, usually the owners will want to take the company public with a sale of common stock to outsiders. This activity is known as going public. In other words, whenever stock in a closely held company is offered to the public for the first time, the company is said to be going public. The market for the stock that is just being offered to the public is called the initial public offering (IPO) market.

ii. Additional shares sold by established publicly owned companies
An established, publicly owned company can sell additional shares in the primary market. It is possible if the number of issued shares are less than number of authorized shares. 

2. Secondary Market
Well established and publicly owned companies' outstanding shares are actively traded in secondary market. Secondary market deals in existing securities, as opposed to newly issued securities. The company does not receive money when stocks are traded in this market. The purpose of this market is to maintain liquidity in the stocks. Common stocks of small companies are not actively traded. They are owned by only a few people. Such companies are called closely held companies and their stocks are called closely held stocks. In contrast, the stocks of larger companies are owned by a large number of investors and are called publicly held stocks. Such companies are called publicly held companies. Stocks of smaller publicly companies and closely held companies are traded in the over-the-counter (OTC) market. But the stock of larger publicly owned companies are generally traded on a organized stock exchange.

Rights And Privileges Of Common Stockholders

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The common stockholders are the real owners of the company, and as such they have certain rights and privileges. These rights and privileges of common stockholders are established by the term of  the charter and laws of the state in which the company is registered. Common stockholders have some specific rights as individual owners. Some important rights are as follows:

1. Right To Share Income And Assets
Common stockholders have the right to share company's earnings equally on a per-share basis.Similarly, in the event of liquidation,stockholders have claim on assets that remain after meeting the obligation to accrued taxes, accrued salary and wages,creditors including bondholders and preferred stockholders. Thus, common stockholders are residual claimants of the firm's income and assets.

2. Control Of The Firm
Common stockholders control the firm through their right to elect the company's board of directors, which appoints management. In a small firm, the largest stockholder typically holds the position of president or chairperson of the board of directors.In a large publicly owned firm, the managers have some stock,but their personal holdings are insufficient to provide voting control. Thus, the shareholders remove the management if they do not perform effectively.

3.Preemptive Right
Preemptive right is a privilege offered to existing shareholders for buying a specified number of shares of the company's stocks before the stocks are offered to outsiders for sale.It is a provision in company's charter or by-laws that gives the existing shareholders right to purchase new shares at a subscribed price on pro-rate basis. Each stockholder receives one right for each share of stock owned. If the company sells new shares to the existing stockholders, it is called right offering. 

4. Voting Right
Common stockholders can attend at annual general meeting to cast vote or use a proxy. A proxy is a legal document given one person the authority to cast vote and represent on behalf of others. Generally, each share of stock has one vote for each director at the general meeting. Thus, the owner of 1,000 shares has 1,000 votes for each director to be elected.

Disadvantages Of Common Stock Financing

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The disadvantages of common stock as a source of long-term financing are as follows:

Disadvantages Of Common Stock Financing To The Issuer

1. Common stock is expensive source of long-term financing. Common stockholders expect a higher rate of return than other investors, since the risk involved is also high. Moreover, flotation costs that include underwriting commission, brokerage fee, and other expenses usually are higher than those for debt and preferred stock.

2. The issuance/issue of new common shares may dilute the ownership and control of the existing shareholders. Dilution of ownership assumes greater significance in case of closely-held companies.

3. The sale of additional common stock dilutes the existing shareholders' primary earning per share, particularly, if the assets acquired with the proceeds of the financing do not produce earnings immediately.

4. Common stock dividends are not tax deductible payments. The impact of this factor is reflected in the relatively higher cost of equity capital as compared with debt capital.

Disadvantages Of Common Stock Financing To The  Investors

1. Dividend on common stock is not certain. Company pays dividend when it earns sufficient profit.

2. Common stockholders get last priority in the liquidation. In other words, common stockholders have a residual claim on income and assets of the company.

Advantages Of Common Stock Financing

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Common stock is the most important source of long-term financing. It offers a number of advantages to the company and investors. The merits of using common stock as a long-term financing are as follows:

Advantages Of Common Stock Financing From Viewpoint Of Issuer

1. Common stock is the source of permanent capital. Funds raised from common stock is available for use as long as the company exists.

2. Common stock does not legally obligate the firm to pay dividend. If a company generates sufficient earnings, it can pay dividend to common stockholders. In contrast to bond interest, there is no legal obligation to pay dividends to common stockholders. 

3. Common stock financing increases the borrowing capacity of the company. Because common stock provides a cushion against losses of creditors, the sale of common stock generally increases the credit worthiness of the firm. Thus, business firm with strong equity base is capable to obtain loan easily and common stock strengthens the equity base of the firm.

4. Common stock is easily marketable than debt and preferred stock. 

Advantages Of Common Stock Financing From Investor's Viewpoint

1. Common stock provides higher return to the shareholders.

2. Common stockholders can participate in management using their voting rights. Thus, they can maintain control over the company.

3. Common stockholders are real owner of the company. However, they have limited liability.

Factors Affecting Capital Structure Decision Of A Firm

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Capital structure of a firm is determined by various internal and external factors. Following are the main factors which affect the capital structure decision.

1. Size Of A Firm
There is a positive relation between the capital structure and size of a firm. The large firms are more diversified, have easy access to the capital market, receive higher credit ratings for debt issues, and pay lower interest rate on debt capital. Further, larger firms are less prone to bankruptcy and this implies the less probability of bankruptcy and lower bankruptcy costs. Therefore, larger firms tend to use more debt capital than smaller firms.

2. Growth In Sales
Anticipated growth rate in sales provides a measure of extent to which earning per share (EPS) of a firm are likely to be magnified by leverage. The firm is likely to use debt financing with limited fixed charge only when the return on equity is likely to be magnified. However, the firms with significant growth in sales would have high market price per share as a result of which they might prefer equity financing. The firm should make a relative cost benefit analysis against debt and equity financing in anticipation to growth in sales to determine appropriate capital structure.

3. Business Risk
There is negative relation between the capital structure and business risk. The chance of business failure is greater if the firm has less stable earnings. Similarly, as the probability of bankruptcy increases the agency problems related to debt become more aggravating. Thus, as business risk increases, the debt level in capital structure of the enterprises should decrease.

4. Debt Service Capacity
The higher debt level in capital structure increases the probability of bankruptcy and bankruptcy costs of the enterprises. Probability of  bankruptcy refers to the chances of cash flows to be less than the amount required for servicing the debt. The debt service ratio measured by the ratio of operating income to total interest charges indicates the firm's ability to meet its interest payment out of its annual operating earnings. Therefore, the higher debt service ratio shows the higher debt capacity of the enterprises. Hence, there is the positive relation between the debt service capacity and capital structure of the firm.

5. Operating Leverage
The use of fixed cost in production process also affects the capital structure. The high operating leverage; use of higher proportion of fixed cost in the total cost over a period of time; can magnify the variability in future earnings. There is negative relation between operating leverage and debt level in capital structure. Higher the operating leverage, the greater the chance of business failure and the greater will be the weight of bankruptcy costs on enterprise financing decisions.

6.Stability In Cash Flow
The firm's cash flow stability also affects its capital structure. If firm's cash flows are relatively stable, then it may find no difficulties in meeting its fixed charge obligation. As a result, the firm may attempt to take the benefits by using leverage to some extent.

7. Nature Of Industry
Capital structure of a firm also depends on the nature of industry in which it operates. If there were no barriers in industry for the entry of new competing firms, the profit margin of existing firms in the industry would be adversely affected. As a result, the firm may find a more risky to use fixed charge bearing securities.

8. Asset Structure
The sources of financing to be used are affected to several ways by the maturity structure of assets to be used by the firm. If a firm has relatively longer term assets with assured demand of their products, the firm attempts to use more long term debt. In contrast to this, the firms with relatively greater investment in receivables and inventory rather than fixed assets rely heavily on short-term financing.

9. Lender's Attitude
Lender of any firm permits the use of debt financing only to a limited range. If management seeks to use leverage beyond that permitted by industry norms, this may reduce the credit standing and credit rating of the firm. As a result, lenders do not permit for additional debt financing.

Factors Affecting Business Risk Of A Firm

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The business risk of a firm is measured by the variability in operating income of the firm. Larger variability in operating income denotes larger business risk. The firm's business risk changes over time and it varies from firm to firm. Some factors affecting business risk of a firm are as follows: 

1. Variability In Demand
The operating income of the firm fluctuates widely if variability in demand for firm's product is larger. Thus, a firm with larger variability in demand is more exposed to business risk.

2. Variability In Selling Price
A firm's product does not sell at constant price. The selling price of the firm's product may be volatile because of alternative demand and supply conditions, nature of competitions and so on. Thus, larger the variability in selling price wider will be the fluctuations in operating income leading to higher business risk.

3. Uncertainty Of Input Costs
Cost of input keeps on changing over time, affecting the total cost of output. The total operating cost of the firm widely fluctuates if the uncertainty associated to input cost is larger. This exposes the firm to high business risk.

4. Ability To Price Adjustment
When there is an increase in input costs, the selling price must also increase to maintain the stability in firm's operating income. However, the speed with which selling price is adjusted in response to the change in input costs, depends on price adjustment capacity of the firm.Thus, higher the firm's ability to price adjustment, lower will be the business risk.

5. Speed Of Technological Changes
The firm should adapt to changing technology over the years. If the speed of technological changes is greater and the firm is not able to adapt to changing technology, demand for firm's product will be adversely affected. The level of business risk associated to such firm is larger.

6. Extent Of Fixed Operating Costs
If larger portion of the firm's costs are fixed, the firm has to make larger sales to meet the fixed costs. At lower sales level such firm is not able to meet the fixed cost. There larger fixed cost exposes the firm to larger degree of business risk.

Concept And Meaning Of Business Risk

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Business risk is defined as the riskiness on the firm's stock provided that the firm has used no debt capital. It is the risk inherent in operation of the business. A firm's business risk arises because of uncertainty associated  to projection of return in invested capital (ROIC). ROIC is calculates as below.

ROIC = NOPAT/Capital

In this equation, NOPAT is the net operating profit after tax, which is calculated as net income available to common stockholders plus after-tax interest payment. Capital includes both debt and equity. We assume for simplicity that the firm has used no preferred stock capital. If a company uses no debt capital, its interest expenses will be zero and the capital consists only common equity. Therefore, return on invested capital with zero debt os calculated as below.

ROIC = Net income/Common equity

This equation gives same result as to that of return on equity (ROE), if company has used debt capital, In such a case, the business risk is simply indicated by standard deviation, which measures the variability associated to firm's ROE assuming no debt financing used.

Concept Of Financial Forecasting

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Financial forecasting is a process of projecting future financial requirements of a firm. Financial manager is concerned with the futurity of financial performance. Financial forecasting, an integral part of finance manager's job, is an act of deciding in advance the quantum of funds requirements of the firm and the time pattern of such requirements. In the process of financial forecasting, financial manager is supposed to develop projected financial statements. Efficient financial forecasting enables a financial manager to plan for future financing requirements and to identify the appropriate sources of funds to satisfy the financing needs. An efficient financial forecasting should consists of the following activities:

1. Setting up projected income statement and balance sheet so that the effect of operating plan on firm's future profit and other indicator of financial performance can be analyzed.

2. Determining need of financing to support firm's growth in sales and other investment opportunities.

3. Forecasting appropriate sources of financing that can be generated internally as well as externally.

4. Setting up proper mechanism of control relating to allocation and utilization of funds.

Financial Planning Process

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A firm's financial plan largely involves the forecast and use of various types of budgets. These budgets are prepared for every key area of firm's activities such as production, marketing, research and development, purchase and so on. The major steps involved in financial planning are as follows:

1. Project financial statements and use these projections to analyze the effects of the operating plan on projected profits and various financial ratios. The projections can also be used to monitor operations after the plan has been finalized and put into effect.

2. Determine the funds needed to support periodic plan which includes funds for plant and equipments, inventories, receivables,new product development, research and developments and for other major activities.

3. Forecast availability of funds over the planning horizon. This involves estimating the funds to generate internally as well as those to be obtained from external sources.

4. Establish and maintain a system of control to govern the allocation and use of funds within the firm.

5. Develop procedures for adjusting the basic plan, if the economic forecast upon which the plan was based do not materialize.

6. Establish a performance based management compensation system.

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