Corporate Fin Mgt NDLM.PDF

Learning Unit 4

Reading material

Capital Management

Capital Structure

(Extract from the book ‘Financial Management’ by Prof. I.M. Pandey)

1. Capital:

1.1 Capital is made up of debt and equity. Debt is borrowed money, for example
money borrowed from financial institutions, etc. Equity is shareholders' money
called equity capital. Capital is required either for new business or to expand the
existing business. Capital comes from different sources.

1.2 The debt holders do not have a share in the profit. They can only ask for return of
money borrowed with interest. Their claim is limited to fixed return.

1.3 As debt rises, capital rises; consequently interest rates rise and risks will also rise.

1.4 The capital must be a right mix of debt and equity. This is called capital structure.
The capital structure affects stock prices and the cost of capital.

1.5 The inherent risk associated with operation of an organization is called business
risk. A firm will normally project its future returns on invested capital.
Uncertainties on such projections are a business risk.

1.6 If a firm’s capital is only from the source of equity and not from the source of
debt, its interest payments will be zero. In such situations return on invested
capital will be equal to return on equity. RoE stands for ‘Return on Equity’.

1.7 The fluctuations in RoE may depend on factors like, booms, recessions, new
products, competitor’s strikes, fire etc. These factors may recur in future also.
These uncertainties are business risks. The stock holders have to bear the
business risks.

1.8 The other important factors on which the business risks depend are:

• Elasticity of demand for a firm’s products. If the demand is stable,
  the business risk will be lower.


• The variations in sales price


• Fluctuating input costs and skills to hold output prices successfully
  in the market.