Question 6: ‘S’ Limited is manufacturing steel at its plant in India. It is enjoying a buoyant demand for its products as economic growth is about 7–8 per cent and the demand for steel is growing. It is planning to set up a new steel plant to cash on the increased demand. It is estimated that it will require about `5000 crores to set up and about `500 crores of working capital to start the new plant.
a. Describe the role and objectives of financial management for this company.
b. Explain the importance of having a financial plan for this company. Give an imaginary plan to support your answer.
c. What are the factors which will affect the capital structure of this company?
d. Keeping in mind that it is a highly capital-intensive sector, what factors will affect the fixed and working capital. Give reasons in support of your answer.
Answer:
a. Describe the role and objectives of financial management for this company.
Ans. Role of Financial Management: A financial management decision has a bearing or the financial health of business by affecting the following:
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Size and composition of fixed assets: ‘S’ Ltd requires ₹ 5000 crores, which is a huge sum. Financial management will have to ensure that composition is carefully decided. Since, it is into infrastructure industry, it has a long gestation period between investments and returns. Thus, the goal should be to minimise the risk with investing into most productive assets and latest technology, which in no case should remain idle.
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Quantum of current assets and their break-up: ₹ 500 crores are required for current assets to finance working capital. The company should ensure correct break-up and optimum utilization.
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Amount of long-term and short-term financing to be used: Long-term assets require long-term financing, whereas, short-term assets require short-term financing. The choice is between liquidity and profitability. An optimum mix of two is required.
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Breakup of long-term financing into debt and equity: Since, setting up of new steel plant is a long-term task, therefore, large amount of debt is required. Accordingly, debt and equity ratio might be more.
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Items of profit and loss account: Higher debt is likely to increase interest expense of the company. This and other likely expenses must to be kept in mind before taking financing decision.
Objective of Financial Management
The objective of financial management is maximization of shareholders’ wealth. The investment decision, financial decision and dividend decision help an organisation to achieve this objective. In the given situation, S Ltd envisages growth prospects of steel industry due to the growing demand.
To expand the production capacity, the company needs to invest. However, investment decision will depend on the availability of funds, the financing decision and the dividend decision. However, the company will take those financing decisions which result in value addition, i.e. the benefits are more than the cost. This leads to an increase in the market value of the shares of the company.
b. Explain the importance of having a financial plan for this company. Give an imaginary plan to support your answer.
Ans. Importance of financial plan for the company are:
- It helps to forecast what might happen in future. Thus, it prepares a company to face uncertainty.
- It ensure provision of adequate funds to meet working capital requirements
- It brings about a balance between inflow and outflow of funds and ensures liquidity throughout the year.
- It solves the problems of shortage and surplus of funds and ensures proper and optimum utilization of available resources.
- It ensures increased profitability through cost benefit analysis and by avoiding wasteful operations.
- It seeks to eliminate ‘wastage of funds and provides better financial control’.
- It seeks to avail the benefits of trading on equity.
Financial Plan of 'S' Ltd
An imaginary financial plan for steel plant ( in form of anticipated balance sheet).
| Particulars |
Amount |
Equity and Liabilities
1. Shareholders' Funds
(a) Share Capital
(b) Reserves and Surplus |
600
400 |
2. Non-current Liabilities
(a) Secured Loans
(b) Unsecured Loans |
2000
2000 |
3. Current Liabilities
(a) Trade Payables
(b) Provisions |
400
100 |
| Total |
5500 |
Assets
1. Non-current Assets
(a) Fixed Assets
(b) Non-current Investments |
3000
100 |
2. Current Assets
(a) Short-term Loans and Advances
(b) Miscellaneous Expenditure
(a) Profit & Loss A/c (Debit Balance) |
1000
300
200 |
| Total |
5500 |
Note:
- It is an imaginary financial plan.
- The total capital is ₹ 5500 crores.
- Fixed capital is ₹ 5000 crores and working capital is ₹ 500 crores.
- Debt equity ratio of 4:1 has been assumed.
- Since, steel plant is an infrastructure project, having a long gestation period. Therefore, company has to borrow, thus ₹ 4000 crores has been borrowed in form of secured and unsecured loans.
- It is an old company, thus is having reserves and surplus of ₹ 400 crores.
- Long gestation period can call for miscellaneous expenditure of ₹ 300 debit balance of profit and loss A/c in normal situations.
- Current ratio of 2:1 quite good.
c. What are the factors which will affect the capital structure of this company?
Ans. Capital structure refers to the proportion in which debt and equity funds are used for financing the operations of a business. A capital structure is said to be optimum when the proportion of debt and equity is such that, it results in an increase in the value of shares.
The factors that will affect the capital structure of this company are:
(i) Equity funds: The composition of equity funds in the capital structure will be governed by the following factors:
- The requirement of funds of ‘S’ Ltd is for long-term. Hence, equity funds will be more appropriate, but due to long gestation period, returns will materialize much later and a mix of more debt and equity is there, thus equity must not be lesser than this, otherwise overall risk will increase.
- There are no financial risks attached to this form of funding.
- If the stock market is bullish, the company can easily raise funds through issue of equity shares.
- If the company already has raised reasonable amount of debt funds, each subsequent borrowing will come at a higher interest rate and will increase the fixed charges.
(ii) Debt funds: The usage and the ratio of debt funds in the capital structure will be governed by factors like:
- The availability of cash flow with the company to meet its fixed financial charges. The purpose is to reduce the financial risk associated with such payments, which can further be checked by using ‘debt service coverage ratio’.
- It will provide the benefits of trading on equity and hence, will increase the Earning Per Share of equity shareholders. However, ‘Return on Investment’ ratio will be the guiding principle behind it. The company should opt for trading on equity only when Return on Investment is more than the interest rate on debt.
- Interest on debt funds is a deductible expense and therefore, will reduce the tax liability and thus increase the gains of equity shareholders.
- It does not result in dilution of management control.
d. Keeping in mind that it is a highly capital-intensive sector, what factors will affect the fixed and working capital. Give reasons in support of your answer.
Ans. The working and fixed capital requirement of S Ltd will be high due to following reasons:
- The business is capital intensive and the scale of operation is large.
- Heavy investments are required for building up the production base and for technological upgradation.
- Incaseofsteelindustry,themajorinputsareironoreandcoal.The ratio of cost of raw material to total cost is very high. Hence, higher will be the need for working capital.
- The longer the operating cycle, the larger is the amount of working capital required, as the funds get locked up in the production process for a long-period of time.
- Terms of credit for buying and selling goods, discount allowed by suppliers and to the customers also determines the quantum of working capital.
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