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NB Ltd is India's largest manufacturer of cement. Its operations are spread throughout the country with 17 modern cement factories. It has a workforce of 9,000 persons. Since its inception, the company has been a trendsetter for the cement industry. The company is planning to grow in the long-run and wants to double its capacity in the next 3 years. For this the Finance Manager has to decide about the quantum of finance to be raised from various long-term sources. For this she/he needs to identify various available sources of funds and the proportion of funds from each source
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Question : 16
Total: 18
State any four factors which would affect the decision identified in (a) above
Solution:
Factors that would affect the financing decisions on capital structure are as follows (any four):
(i) Cash flow position - Interest payment on debt reduces cash flows. However, businesses are under a legal and contractual obligation to pay interest rates to their borrowers and lenders and a steady cash flow also influences them to obtain debt capital
(ii) Costs - As NB Ltd plans to increase existing capacity, costs associated with debt or equity will be different. A Prudent financial manager would normally opt for a source which is the cheapest.
(iii) Risks - Financing decisions are dependent upon the extent of risks NB Ltd is willing and able to take. As equity financing is a greater risk to the investor than debt financing is to the lender, the cost of equity is often considered higher than the cost of debt.
(iv) Control considerations - The choice between debt and equity financing also depends upon the need for more control. With more control and less shareholders, the likelihood of declaring dividends at a less rate is possible, as the owner can accordingly direct the profits as reserves for increase in capacity plan. More shareholders having control over the business will create difficulties in planning for increase in capacity
(v) Return on investment- Returns from investment can be diverted to debt or equity financing depending on which has low risks and is costeffective. With regards to NB Ltd., returns of investment should be diverted more towards debt financing than equity financing.
(i) Cash flow position - Interest payment on debt reduces cash flows. However, businesses are under a legal and contractual obligation to pay interest rates to their borrowers and lenders and a steady cash flow also influences them to obtain debt capital
(ii) Costs - As NB Ltd plans to increase existing capacity, costs associated with debt or equity will be different. A Prudent financial manager would normally opt for a source which is the cheapest.
(iii) Risks - Financing decisions are dependent upon the extent of risks NB Ltd is willing and able to take. As equity financing is a greater risk to the investor than debt financing is to the lender, the cost of equity is often considered higher than the cost of debt.
(iv) Control considerations - The choice between debt and equity financing also depends upon the need for more control. With more control and less shareholders, the likelihood of declaring dividends at a less rate is possible, as the owner can accordingly direct the profits as reserves for increase in capacity plan. More shareholders having control over the business will create difficulties in planning for increase in capacity
(v) Return on investment- Returns from investment can be diverted to debt or equity financing depending on which has low risks and is costeffective. With regards to NB Ltd., returns of investment should be diverted more towards debt financing than equity financing.
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