PROJECT REPORT

Financial Position and Performance

AT

FMI LIMITEDLUDHIANA

Submitted to

Doraha institute of management and technology, Doraha

(For the fulfillment of requirement for the Masterof Business Administrator degree)

Submitted to: Submitted by:

Mr.Amanpreet singh Jasmeet kaur MBA - 2nd Year

Roll No.

ACKNOWLEDGEMENT

Expression of mind by words is a difficult task. I find when it comes to an

appeal of fathomless, motivating gratitude and obligation. So first of all I

owe my head heartily to all who have been inspiration, motivating and

supportive throughout my project work undertaken and endowed me with

the most precious knowledge, the most powerful of all, yes! My report is the

sensible team efforts of all those people mentioned or not mentioned here.

Still it is to less to express my deep thanks to them.

I express my thanks to my reverend project guide Mr.Shashi Pal Jain,

General Manager of FMI Limited and Mr.Jatinder Chugh, Finance Manager

of FMI Limited for their excellent guidance, unabated inspiration but also

for their never ending willingness to deliver generous research

methodologies, timely attention and keen interest. I consider myself very

Fortunate to work with such a disciplined and principle personalities with a

futuristic view, providing morale support, encouragement, valuable guidance

in spite of their busiest & hectic schedule.

I express my sincere thanks to Mr.Amanpreet singh for their full support

and guidance. He also helped me in project report and was constantly guide

me during the period. This report of study of capital structure of Concern

could not be possible without her support and guidance.

Last but not the least I would like to take this opportunity to thanks all the

employees of FMI Limited and all the faculty members of doraha institute of

management and technology, doraha who helped me in the fulfillment of my

task, and the others to give me more knowledge about the training

companies and also helped me to complete my project of Summer Training.

Jasmeet kaur

PREFACE

This Report is the Result of my six week Training at FMI LIMITED

Industry, Doraha. Training is the integral part of MBA course and efficient

utilization of material, time and resource are very much important for

successful completion of any task. FMI Limited provide different concerns

with FMI Limited help me to create confidence regarding approval of

Subject matter.

In my research I was to study about the capital structure of FMI Limited. To

carry on the study the student have been deputed in leading corporate unit to

be in touch with practical aspect and to apply the theoretical knowledge

imparted in real life situation. This Project Report will give a vide coverage

of practical experience of training.

CONTENTS OF REPORT

1. Introduction

Company History

Quality Practice

ISO Approval

Organizational Objectives

Policies & Procedures

Competitors

Products Offered

List of Key Persons

Administration

Structure and Functions of Finance Department

2. Research Methodology

Objectives of Study

Sample Size

Data Source

Technique

3. Capital structure

4. Summary & Conclusion

5. Recommendations

6. Limitations of Study

7. Bibliography

COMPANY HISTORY

Ludhiana is the one of the biggest centre for production of Hosiery and

Cycle Parts. Large, Medium and Small Scale Industry flourish here out of

which FMI Limited is one of the Medium Scale Industry. Mr.M.M.Nayar

who is the Chairman and Managing Director of the Company established

this company in 1950. Mr.Nayar initiated the manufacture of Metal Wired

Tape in First time in the Country. The company continues its pursuit for

innovation with the introduction of product research, Spirit Level,

Measuring Wheel, Telescope Measures for the First time in the country. The

company was previously partnership concern but with the increasing scale

and remarkable progress the company became a Public Limited Company.

The Authorized Capital of the Company is 10 Lac Equity Shares of Rs.10\-

each. FMI Limited with their brand FREEMANS is the largest manufactures

and Exporters of Measuring Tapes. FREEMANS is the only Indian

Company offering a comprehensive range of comprising various model

designs in steel tape measure, Tape Rules, Fiber Glass Tapes, Metal Wired

Measures, and FREEMANS also engaged in trading of Hand Tools.

In 1962 Fiberglass Tape was introduced and Steel Tape Measure and Tape

Rule were introduced in 1966 with American Technical know-how. Due to

efficient marketing system and increasing sales the company has achieved

over 70% of Indian Market Shares. Its sale for the Financial Year ending

31.03.2009 is Rs.2547 Lac.

FREEMANS have both Steel and Plastic Division. Establishing a steel

division gave Freemans an edge over competitors with better quality control

over raw material. Freemans also has a Plastic Division with over 15

injection moulding machines manufacturing plastic components.

After entering into International Market EURO FREEMANS was

established in Spain in 1988. Now it has export in over 60 countries like

Spain, Germany, U.K., Australia, Iran, Mexico, New Zealand, Dubai, South

Africa, Argentina etc. which includes European Companies to get ECC

(European Economic Countries) which is a testimony to the fact that its

Products are the best comparable to the International Quality Standards.

The exports are continuous increasing by past eight years and company

achieved the Exports Excellence Award by Engineering Export

Promotion Council for very good performance and contribution in Exports.

But in the last financial year (2009-10) company’s export to Total Sale ratio

decreased a little bit due to International Market Slump. During recession

period by last three years, many Companies engaged in Exports lost their

entity but due to very efficient Goodwill of its products FMI Limited has a

very low effect on their Exports comparable to other companies of India.

FMI Limited is the one company which is approved by ISO 2001:2008

certified company. Their Quality Control systems are being religiously

followed to ensure Consumer Satisfaction. Precision, quality and a firm

belief in perfection resulted in constant up gradation of technology

QUALITY PRACTICE

Concept of Quality in Products:

According to the concept of quality in products, these are identified and

traced properly. The purpose of this is to provide the whole system for

identification and traceality of products through different stages of receipts,

storage processing, verification, packaging and delivery. The scope of

identifying and tracing the product is at the stage of incoming, in process

and at the final stage when the goods are ready.

The responsibility for identifying and tracing the goods is of the Manager

Production. The method of identifying and tracing the goods is that all the

raw material components, customer supplied goods and bought out items are

physically checked and identified by suitable means during the stages of

receipt, storage, processing, packing and delivery. Traceability of products

to the extent is possible and can be ensured through unique identification of

critical items or batch identification for general components, related parts

etc. This is how concept of quality of products is considered.

Concept of Quality in Processes

According to the concept of quality in process, it is done to carry out the

processing operations under controlled conditions so as to ensure quality

product. The scope of checking

the process is during the manufacturing of all the products and also during

the supply of measuring instruments.

The responsibility of controlling the process is of Manager Production. The

method of controlling the process starts when the delivery of products is

governed by periodic planning, suitable plant machinery, support services

and safe working environment. The process control parameters and products

characters are mentioned closely to assure quality of deliverable goods.

To provide facility to the workers during the manufacturing process quality

plans, flow sheets etc. are displayed and working instructions are provided

for the process where in the absences of same adversely affect the quality.

Records of process control, periodic maintenance and safety are properly

maintained.

Concept of Quality in Management and Services

The purpose of quality in management and services is to identify the need

for upgradation of skills and knowledge of employee and to organize the

training for imparting it. The scope of training is that all employees who are

directly contributing towards function are affecting the quality. Training of

personnel at various levels in the organization affects the quality in

management.

The responsibility of identifying the training needs and its recommendation

is done by the respective departmental heads. Planning, organizing and

coordinating training programmers and the maintenance of training records

all is done by the Management Representative.

Training needs of the employee are identified by the concerned departmental

heads based on the need of the organization and function performed. Also it

is organized on the basic of the recommendation or approval given. A list of

in house faculty members, training moulds is maintained. Also the records

of training programs are maintained. Evaluation of effectiveness of training

imparted may be through training certificates or on the basis on the job

performance. People carrying out specific assigned task like calibration

internal quality audits etc. shall be selected on the basis of training imparted

to them.

ISO APPROVAL

FMI Ltd has got ISO-9001:2008 approval as their products are fulfilling al

the causes to get the ISO approval. They got the ISO approval on 14 th July

1999.

The clauses to be fulfilled by an organization to get the ISO approval are:

1. Management Responsibility.

2. Quality system.

3. Contract review.

4. Design control.

5. Document control.

6. Purchasing

7. Control of customer supplied products.

8. Product identification and traceability.

9. Process control.

10. Inspection and testing.

11. Control of inspection measuring and test equipments.

12. Inspection and test status.

13. Control of non conforming products.

14. Corrective and preventive actions.

15. Handling, packing, storage, preservation and delivery.

16. Control of quality records like identification, collection, indexing,

filing storage, maintenance and disposition of goods.

17. Internal quality audits.

18. Training

19. Servicing

20. Statistical techniques.

Total Quality Management (TQM)

Total quality management means the programs designed to constantly

improve the quality of products, services and marketing process.

The TQM of FMI Limited covers all the following aspects:

Adequacy of resources.

Result of internal audits.

Corrective question and complaints.

Effectiveness of quality system.

The steering Committee periodically reviews the adequacy of the staffing

and resources for the various Quality Assurance Activities. The result of

the internal quality audits, the progress on corrective actions taken by the

concerned section and failure if any are communicated to the notice of

Joint Managing Director or Executive Director by the Management

Representative. The progress report on the investigation carried out on

the customers complaint is furnished to the Steering Committee by the

Management Representative. Addition, deletion and modification if any

in the various documents of the Quality System results as the outcome of

the Management Review Meeting is recorded by Management

Representative. Responsibility for the implementation of the decision

taken in the meeting rest with Steering Committee.

ORGANIZATIONAL OBJECTIVES

The organization I working on the following objectives laid down by it.

These objectives help in the working of the organization. The objectives

of the organization are:

To manufacture, buy, sell and deal in all kinds of precision tools

and implements.

To buy and sell raw material for machinery for the manufacture of

precision tools and machinery.

To acquire agencies for the sale of any article or commodities of

local manufacturer or imported goods.

To purchase and acquire patents, trademarks, manufacturing

formula and secret information.

To maintain the implement ISO-9002 quality system approval.

To minimize rejection and work towards zero defect.

To promote team – work and participative culture.

To get the Higher Consumer Satisfaction by best products and

services.

POLICIES AND PROCEDURES

Policies:

Organization basically works on their policy that:

“Commitment to perfection through quality and customer satisfaction.”

Organization policy includes objectives for quality and their commitment to

quality. This organization policy is relevant to the mission and goals and

also to expectation to the customers. Training is imparted continuously to

understand, implement and maintain the policy of the organization.

Procedures:

The procedures on which the organization works are:

Management Review Meeting shall be organized once in three

months or earlier if the need arises.

Management Review Meeting shall be convened by the

Management Representative Agenda for the meeting shall be given

well in advance duly approved by the Joint Managing Director or

Executive Director.

I. The meeting shall be chaired by the Joint Managing Director or

Executive Director and attended by Steering Committee members

and Management Representative

II. The result of internal quality audit, the progress on the corrective

actions taken by the concerned section and the failures if any shall

be communicated to the notice of the Joint Managing Director or

Executive Director by the Management Representative periodically

or as and when felt necessary without waiting for the convening of

the Management Review Meeting.

III. The progress report on the investigations carried out on the

customers complaint shall be furnished to the Steering Committee

by the Management Representative.

Management Representative shall maintain the records of the

Management Review Meeting.

Minutes of the meeting shall also be issued to all concerned.

Responsibilities for the implementation of the decision taken in the

meeting shall rest with the Steering Committee Members.

COMPETITORS

FMI Limited is the only industry in the country. As mentioned in the

Company profile that 70% shares of the Indian market are with the company

which is a proof that it does not have any competitor. It is the only leading

monopolistic company in the field. However, as per the information revealed

from the company office bearers that there is company in China who is

manufacturing products competing to it but till date their products are not as

per ISO standard.

PRODUCTS OFFERED

The unit is the production house of Different type of measuring tapes.

The company currently is engaged in manufacturing of following three

types of measuring tapes:

1. Metal Wired Tapes

2. Fiber Glass Tapes

3. Steel Tapes

A wide range of professional long tapes model especially designed for

use in building, surveying, civil engineering and allied industries.

1. Steel Tapes

Steel tapes are manufactured from tampered high quality carbon steel

blade, phosphated and coated with special enamel to withstand

corrosion and rust. The printing is protected with wear resistant

lacquer for long life. These Long Steel Tapes are available in different

cases with different names and rates. The different types of steel tape

measures are:

(i) Steel Open Reel

It consists of tough heavy duty tapes for professional on – site

measuring work. Its open frame allows easy maintenance and cleaning

of tapes. Its long sturdy winder with easy grip knob facilitates quick

rewinding.

(ii) Steel SN and SW Series

It consists of heavy duty viny leatherette covered steel case to

withstand continual usage in difficult conditions. It has designed

winding handle for smooth winding action. It is an ideal tape for high

precision professional jobs. That’s why it has its own impact on

Market and eyes of the consumer.

(iii) Steel ON and OW Series

It is an idle tape for contractors and surveyors where high accuracy is

required. These tapes are usually used by high professionals and in

special cases.

(iv) Steel Dip Tapes

These are DC and DS series. These tapes are manufactured by two

types of Blades first is Carbon Steel Blade and other is Stainless Steel.

Both are used for measuring depth of oil-water or soil etc. These tapes

are not often used, these are the tapes for only depth measuring

purpose and having very low demand in market.

2. Fibreglass Tapes:

These tapes measures are made of fibre Glass yarn coated with tough

plastic PVC. Unlike conventional woven or steel tape measures these

are flexible yet strong and durable. These tapes have heat sealed

marketing which ensure long life. In the recent few years it has

observed that company is moving into Fibre glass tapes from Metal

Wired Tapes and demand of the same tapes is rising continuously.

The different types of glass tapes are:

(i) Fibre Glass FN and FW Series

These tapes are made of tough viny leatherette covered steel

case to withstand difficult conditions. It is a durable tape with

winding mechanism which ensures long trouble free usage.

(ii) Fibra FB Series

It is a tape with tough yet light weight ABS case ribs for easy

handling and strong grip. It is used for heavy duty winding

mechanism.

(iii) Topline FT Series

It is a tape with tough yet weight ABS case reinforced with

metal for extra strength. It is used for heavy duty winding

mechanism.

(iv) Fibre Glass Open Reel

This tape is of FO Series. It is an ideal deal tape for contractors

and surveyors. Its design allows an easy cleaning of tape. It is a

long winder with easy grip facilitates quick rewinding. Its

protruding market at the bottom of the case allows easy

measurement of land.

(3)Metal Wired Tapes:

It is a general purpose tape woven to width with copper wires

lengthwise for additional strength coated with special paints for

protection against moisture, wear and tear. This tape needs most care

and time to manufacture and need more manpower than any others. It

has also low demand in the market than of other manufactured.

Different types of metal wired tapes are:-

(i) Metal Wired

This tape is of MW Series. It has impact resistant viny

leatherette covered case for use in taxing condition. It needs

very care while production.

(ii) Top Line

It is a tough yet weight ABS case reinforced with metal for

extra strength. It is used for heavy duty winding mechanism.

(4)Pocket Tapes

This tape is of Steel series but in the steel series but in this category

tapes are available into only 1 meter to 10 meters (1, 2, 3, 5, 10

meters). 3 Meter Pocket tapes are manufactured in large quantity.

These tapes are manufactured in various cases and are given different

names like Centigraff, Basik, Levo, Zeon, and recently introduced

IKON and STAREX, available with Lock and Clip. Lock works as

stopper on the tape and Clip is to hang it with the belt for convenience

of the user. Pocket tapes have more demand in the national market

than of International.

The Company is also manufacturing the following items:

1. Stainless Steel Rules

2. Cutters

3. Torpedo Levels

4. Trapezoidal Levels

5. Measuring Wheels

Besides this all above The Company is also trading of many kinds of

Hand Tools. These Hand Tools are also for the measuring instruments

or components for the same. Trading of tools is mainly done with the

other countries.

The company is making continue efforts to improve the existing

quality and to introduce new products which are required in Global

Market. In this connection this is also worthy here to explain here that

2 types of Pocket tapes are also registered under trade mark during

this financial year.

LIST OF KEY PERSONS

BOARD OF DIRECTORS:

Sr. Name of Director Designations No.

1. Mr. M.M.Nayar Chairman & Managing Director

2. Mr. Rakesh Nayar Joint Managing Director

3. Mr. Ajay Nayar Executive Director

4. Mrs. Ravinder Nayar Director

5. Mrs. Cherene Nayar Director

SHAREHOLDERS:

Sr. Name of Shareholder Percentage of No. Holdings

1. Mr.M.M.Nayar 29.91%

2. Mr.M.M.Nayar(HUF) 00.06%

3. Mr.Rakesh Nayar 25.90%

4. Mr.Ajay Nayar 30.89%

5. Mrs.Ravinder Nayar 00.13%

6. Mrs.Cherene Nayar 04.44%

7. Mrs.Gauri Nayar 03.20%

8. Mr.Sahil Nayar 04.27%

9. Mr.Shashi Pal Jain 01.21%

LIST OF TOP EXECUTIVES:

Sr. Name of Executive Designation No.

1. Mr. Shashi Pal Jain General Manager

2. Mr. Jatinder Chugh Finance Manager

3. Mr. Shakti Raj Jain Production Manager

4. Mr. Shiv Jindal Export Manager

5. Mr. Yash Pal Marwaha Import Manager

6. Mr. Amar Singh Rana Quality Assurance /Control Manager

HEADS OF DIFFERENT DEPARTMENTS:

Departments Name of H.O.D.

1. Accounts Mr. Parveen KapoorMr. Rajesh Verma

2. Exports Mr. Jarnail SinghMr. Om Parkash Chaudhary

3. Store (Raw Material) Mr. Ashwani SharmaMr. Pawan

4. Store (Packing & Own Mr.MadanManufacture Components) Mr. Rashpal

5. Personnel Mr. Rakesh Nanda

6. Security Mr. Devi Ram

FMI LIMITED

ADMINISTRATION DEPARTMENT

Chairman & Managing Director

Joint Managing Director

Executive Director

General Manager

Manager Manager Manager Manager Manager Finance Production Exports Quality representative

FUNCTIONING OF ADMINISTRATIVE

Administration Department is controlled by the Chairman and Managing

Director. Authorities and responsibilities of all the heads of the different

departments and individual are made by this department. The authorities

and responsibilities are as follow:-

Chairman and Managing Director

1. Overall supervision and control of all operation of the company.

2. Implementation of the quality system.

3. To ensure availability of resources in terms of machines,

manpower and capital.

4. Defining responsibilities and authorities of all directors.

5. Appointment of Management Representative.

6. Market development of the product.

7. To maintain discipline, reduce absenteeism, to ensure smooth and

congenial atmosphere in the organization as a whole.

8. Human resources development and general administration.

9. Decision making at Top Level.

Joint Managing Director

1. Implementation of Quality System.

2. To assist the CMD in production related activities.

3. Top level negotiation with Bank and financial institution.

4. To look after imports as well as exports.

5. To deal with all legal matters.

6. To assist the CMD in general administration.

7. To approve quality manual and procedure manual.

8. To assist CMD in identifying further investment opportunity.

9. To maintain optimum inventory levels.

10. To take corrective and preventive action on non- conforming

products.

11. Identifying training needs of personnel and organizing training of

personnel I consultation of Management Representative.

Executive Director

1. To look after International Markets and develop new markets

globally.

2. To arrange and monitor review of contracts.

3. To ensure proper progress and completion of all projects.

4. To look into new products development.

5. To look after all purchase related activities.

6. To look after sales promotion.

7. Implementation of Quality System Standards.

8. Issuing authority for Quality Manual and Procedure Manual.

9. To ensure availability of raw material.

10. To ensure quality of finished products as per customer

specifications.

11. Defining the responsibilities and authorities of all managers.

12. Ensuring implementation of corrective and preventive action

decisio

General Manager

1. To look after all taxation related matters.

2. To assist the CMD with regards to financing pattern and location of

projects.

3. To look after all accounts related matters.

4. To assist the CMD in general administration.

5. To assist the Directors in overall operations.

6. Implementation of Quality System.

7. To maintain quality records in this area.

8. To look after legal matters with all legal departments.

9. To look after all banking transactions.

Manager Finance

1. To arrange finance for the company.

2. To look after the accounting matters, income and excise matters.

3. To deal with bank, income tax, excise and sales tax department.

4. To assist Management Representative in implanting relating to ISO

9002 and maintenance and updation of records.

Manager Production

1. To look after all the production related activities.

2. To ensure proper testing of raw material in process inspection at

various stages of production and final inspection.

3. To ensure quality of finished products as per customer satisfaction.

4. To ensure proper maintenance of all machines and equipments.

5. To assist the Executive Director in production planning.

6. To assist the JMD in maintaining optimum inventory levels.

7. To ensure maintenance of quality records.

8. To make continuous efforts for the betterment of production

process.

Manager Export

1. To assist the Directors in export planning.

2. To assist the Directors in export promotion.

3. To maintain quality records in his area.

4. To assist the Directors in making export delivery schedules.

5. To maintain all export related documents.

Manager Quality Approval

1. To ensure proper inspection and testing of material at all stages.

2. To ensure proper maintenance of inspection records.

3. To approve deviation.

4. To make efforts to improve and maintain quality of products.

Management Representative

Executive director has been appointed as Management Representative. In

addition to his regular responsibilities the MR shall have to do as follows:

1. Initiate and implement Internal and External Audits.

2. Conduct Management Review Meeting periodically.

3. To make sure Quality Manual including amendments.

4. Co-ordination with Certification Body.

5. Reporting on the performance of the Quality Assurance System

to the Management for review and subsequent improvement of

the quality system.

FUNCTIONS OF FINANCE DEPARTMENT

The Finance Department of the FMI Limited has its own strength. It

consists of very mindful and intelligent and educated persons on the Top

level and very hard working employees on the middle and low level.

Mr.Shashi Pal Jain is the Head of the Department as he has full control

over Finance and all matters related to finance of the company.

Finance Department of the company can be defined as under:

General Manager

Finance Manager

Senior Accounts Officers Senior Accounts Officer Senior Billing Officer

1. Assistant Accounts Officer

2. Assistant Accounts Officer

3. Assistant Accounts Officer

Functions of the Department

General Manager:-

a. He looks after all the taxation related matters.

b. He assists CMD with regards to financing pattern and location of

projects.

c. He looks after all accounts related matters.

d. He assists the CMD in general administration.

e. He also looks into the company law matters.

f. He deals with all the Banks and other Financial Institutions.

g. He deals with all Corporate Law Obligations.

Finance Manager:-

a. He assists the General Manager in taxation related matters.

b. He assists the General Manager in all accounts related activities.

c. He assists General Manager in fulfilling company law matters.

d. He looks after the Finalization of the Balance Sheet and Audit

Reports etc as mandatory by Company Law.

Accounts Officers and Billing Officer:-

a. He looks after the sales tax matters and deals with the sales tax

department.

b. He looks after the excise obligation and deals with the excise

department.

c. He deals with daily Routine accounting as per accounting standards

prepared by Chartered Accountants.

d. Ledger Scrutiny is another function of the Him.

e. Preparing and keeping record of Sale Invoices and deals with

Customers.

f. Deals with Customers and have control over Customer ledger for

payments purpose.

Assistant Accounts Officers:-

a. He handles cash and assist senior accounts officer in account

related activities.

b. He assists senior accounts officers in fulfilling excise obligation

and account related activities.

c. He Assist the Finance Manager in Finalizing Balance Sheet.

d. He does the book Keeping and recording all the transactions.

e. He assists the Accounts Officers for maintaining the records and

fulfilling the obligations forced by various legal departments

likewise Weights & Measure Act, Income Tax Act, and Indirect

Taxation etc

RESEARCH METHODOLOGY

Objective of Study: The main purpose of the study is the fulfillment of the

requirement of the syllabus of Post Graduation Degree of Master of business

administration Under the training we have to get the knowledge about the

practical aspect of business.

This Report is the Result of my six week of Summer Training in FMI

LIMITED Industry, Doraha. Summer training is the integral part of MBA

course and efficient utilization of material, time and resource are very much

important for successful completion of any task. FMI Limited provide

different concerns with FMI Limited help me to create confidence regarding

approval of Subject matter.

In my research I was to study about the capital structure of FMI Limited. To

carry on the study the student have been deputed in leading corporate unit to

be in touch with practical aspect and to apply the theoretical knowledge

imparted in real life situation.

This Project Report will give a vide coverage of practical experience of

training.

Sample Size: We have considered only one firm so sample size is very

small. This entire project is based on the information available of FMI

Limited.

Data Source: Data is collected and arranged in the prescribed manner from

the Financial Statements of the concern. Some old reports of the same unit

were also a little bit helpful for this task. All other information required to

complete the project was collected verbally from the Senior Authorities

likewise General Manager and Finance Manager of the Concern.

Technique: We have used composites of many techniques to rearrange the

data collected into the productive figures.

What is capital structure?

Capital Structure represents the total long-term investment in a business firm. It includes funds raised through ordinary and preference shares, bonds, debentures, term loans from financial institutions, earned revenue, capital surpluses, etc. The term capital structure is used to represent the proportionate relationship between debt and equity.

The Board of Directors or the financial manager of a company should always endeavor to develop a capital structure that would lie beneficial to the equity shareholders in particular and to the other groups such as employees, customers, creditors, society in general. While developing an appropriate capital structure for its company the financial manager should aim at maximizing the long-term market price per share. This can be done only when all these factors which are relevant to the company's capital structure decisions are properly analyzed and balanced.

Capital structure refers to the way a corporation finances itself through some combination of equity, debt or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20bn dollars in equity and $80bn in debt is said to be 20% equity financed and 80% debt financed. The firm's ratio of debt to total financing, 80% in this example is referred to as the firm's leverage.

An appropriate capital structure is a critical decision for any business organization.  The decision is important not only because of the need to maximize returns to various organizational constituencies, but also because of the impact such a decision has on an organization’s ability to deal with its competitive environment.The capital structure of a company is the particular combination of debt, equity and other sources of finance that it uses to fund its long term financing. The key division in capital structure is between debt and equity. The proportion of debt funding is measured by gearing. This simple division is somewhat complicated by the existence of other types of capital that blur the lines between debt and equity, as they are hybrids of the two. Preference shares are legally shares, but have a fixed return that makes them closer to debt than equity in their economic effect. Convertible debt may be likely to become equity in the future. Considering the division between debt and equity is sufficient to understand the issues involved. Simple financial theory models show that capital structure does not affect the total value (debt + equity) of a company. This is not completely true, as more sophisticated models show. It is, nonetheless, an important result, know as capital structure irrelevance. The capital a business needs for investing in its assets comes from two basic sources: debt and equity. Managers must convince lenders to loan money to the company and convince sources of equity capital to invest their money in the company. Both debt and equity sources demand to be compensated for the use of their capital. Interest is paid on debt and reported in the income statement as an expense, which like all expenses is deducted from sales revenue to determine bottom-line net income. In contrast, no charge or deduction for using equity capital is reported in the income statement. Rather, net income is reported as the reward or payoff on equity capital. In other words, profit is defined from the shareowners point of view, not from the total capital point of view. Interest is treated not as a division of profit to one of the two sources of capital of the business but as an expense, and profit is defined to be the residual amount after deducting interest. Sometimes the owners’ equity of a business is referred to as its net worth. The fundamental idea of net worth is this:

Net worth = assets − operating liabilities − debt

Net income increases the net worth of a business. The business is better off earning net income, because it’s net worth increases by

the net income amount. Suppose another group of investors stands ready to buy the business for a total price equal to its net worth. This offering price, or market value, of the business increases by the amount of net income. Cash distributions of net income to shareowners decrease the net worth of a business, because cash decreases with no corresponding decrease in the operating liabilities or debt of the business

An appropriate capital structure should incorporate the following features:

1. Flexibility: A sound capita1 structure must be flexible. The consideration of flexibility gives the financial manager ability to alter the firm's capital structure with a minimum cost and delay warranted by a changed situation. It should also be possible for the company to provide funds whenever needed to finance its profitable activities.

2. Profitability: A sound capital structure is also one that also possesses the feature of profitability, i.e., it must be advantageous to the company. It should permit the maximum use of leverage at a minimum cost with the constraints.Thus a sound capital structure tends to minimize 'cost' of financing and maximize earnings per share (EPS).

3. Solvency: A sound capital structure should also have the feature of solvency, i.e., it should use the debt capital only up to the point where significant risk it not added. As has been already observed the use of excessive debt threatens the solvency of the company.

4. Conservation: The capital structure should be conservative in the sense that the debt capacity of the company should not exceed. The debt capacity of a company demands on its ability to generate future cash flows. It should

have enough cash to pay creditors fixed charges and principal amount. It should be remembered that cash insolvency might also lead to legal insolvency.

5. Control: The capital structure should involve minimum risk of loss of control of the company.

Sources of Company Finance

The sources of long term finance include:

(i) Issue of shares;(ii) Issue of debentures;(iii) Loans from financial institutions;(iv)Retained profits; and(v) Public deposits.

(i) Issue of shares: The amount of capital decided to be raised from members of the public is divided into units of equal value. These units are known as shares and the aggregate value of shares is known as share capital of the company. Those who subscribe to the share capital become members of the company and are called shareholders. They are the part owners of the company. Hence, shares are also described as ownership securities.Two types of shares may be issued by a company to raise capital: (a) equity shares; and (b) preference shares.

(a) Equity shares: The amount raised by the issue of equity shares is known as equity share capital, it is the most important source of raising long term capital for a company. Equity capital represents ownership capital as equity shareholders collectively own the company. They enjoy the reward as well as bear the risk of ownership.

There is no promise to shareholders of a fixed dividend. The liability is generally, limited to the amount agreed to be subscribed by the shareholders.Equity share capital may be

(i) with equal rights; or (ii) with differential rights as to dividend, voting or otherwise. This has been permitted after an amendment to the Companies Act in 2000. Prior to this, public companies were not allowed to issue equity shares with differential rights.

Equity shares have the following distinct characteristics:

(i) The holders of equity shares are the primary risk bearers. It is the issue of equity shares that mainly provides risk capital. This implies that in case the company suffers losses and has to be closed down, the equity shareholders may lose the entire amount they had invested. Creditors’ dues must be met before any payment is made to the preference or equity shareholders.

(ii) Equity shareholders have a residual claim in the firm. In other words, the income left after satisfying the claims of all creditors, outsiders, and preference shareholders, belongs to equity shareholders.

(iii) Equity shareholders are likely to enjoy a higher profit as well as higher increase in the value of the shares.

(iv)Equity share capital is the basis on which loans can be raised. It provides credibility to the company and confidence to the loan providers.(v) Since equity shareholders have the right to vote for the election of the board of directors, collectively they ensure that the company is managed in the best interests of the shareholders.

Merits

From the company’s point of view, there are several merits of issuing equity shares to raise long term finance.

(i) It is a source of permanent capital without any commitment of a fixed 192 BUSINESS STUDIES return to the shareholders. The return on capital depends ultimately on the profitability of business.

(ii) It facilitates a higher rate of return to be earned with the help of borrowed funds because loans carry a fixed rate of interest.Hence, equity shareholders are likely to enjoy a higher rate of return based on profitability.

(iii) It is on the basis of equity share capital that loans can be raised.Equity provides the credibility to the company and confidence to the prospective loan provider.

(iv)Democratic control over management of the company is assured due to the voting rights of equity shareholders.

Limitations

Although there are several advantages of issuing equity shares to raise long term capital, there are certain limitations also of this source of finance:

(i) Equity shares have the risk of fluctuating returns and the risk of fluctuating market value of shares.In times of adversity, there may be low returns or even no returns.

(ii) Equity share capital is a permanent source of finance. It cannot be refunded during the life of the company. When there is no scope for expansion or new investment during periods of economic depression, the equity capital may remain idle, the rate of return may be reduced since there is no commitment to pay and no fixed obligations to be met on equity capital, there is always the possibility of putting it to sub optimal uses.

(iii) Issue of additional equity shares to raise funds for expansion poses a threat to the existing shareholders as regards their power of control over management of the company.Existing shareholders are generally, offered the new issue of shares and in case they decline, the shares are offered to the public.New shareholders may exercise their voting rights against the continuation of existing directors.

(iv)There are too many procedural delays and too many time consuming formalities to be completed before any public issue of shares can be made.

(v) An equity issue cannot be made any time the company wants. It depends on market conditions. These generally, determine the time of issue of shares and the value of the shares.

(b) Preference shares: The amount of share capital which is raised by the issue of preference shares is called preference share capital. It is referred to as preference shares as the owners of these shares have a preferential claim over dividends and repayment of capital. Preference shares represents a hybrid form of financing in that, it consists of some characteristics of equity shares and some attributes of debentures. It resembles equity shares in the following ways:

(i) preference dividend is payable only out of profit after tax;

(ii) The payment of preference dividend is entirely within the discretion of directors. It is not an obligatory payment, even if there is a profit. It resembles debentures because it gets a fixed rate of return.

Preference shares have the following distinct characteristics:

(i) Preference shareholders have the right to claim dividend out of profits at the fixed rate, which is decided according to the terms of issue of shares.

(ii) Preference shareholders have also the preferential right of claiming repayment of capital in the event of winding up of the company. Preference capital has to be repaid out of assets after meeting the loan obligations and claims of creditors but before any amount is repaid to equity shareholders. Different kinds of preference shares may be issued as:

(i) Cumulative or non-cumulative;(ii) Participating or non-participating;(iii) Redeemable or non-redeemable;(iv)Convertible cumulative preference shares.

In the case of cumulative preference shares, if dividend cannot be paid due to inadequate profits in a particular year the arrears of dividend accumulate and become payable in subsequent years when profits are adequate. Non-cumulative preference shares have no such provision. If the shareholders, in addition to the fixed rate of dividend, are entitled to a further share in the surplus profits after a reasonable dividend has been paid to equity shareholders, the shares are known as participating preference shares. Where the terms of issue do not provide for it, the shares are known as non-participating preference shares. Redeemable preference shares are those which the company undertakes to redeem (that is, repay) after a specified period. Where there is no such undertaking, the shares are called irredeemable preference shares. However, these shares can also be redeemed by the company after specified period by giving notice as per the term of issue. It may be noted that companies are no longer permitted to issue irredeemable preference shares.A company may decide to issue a type of cumulative preference share which can be converted into equity share. These are known as convertible cumulative preference shares. Under present rules in India conversion of such shares can be decided to be made 194 BUSINESS STUDIES between the end of one and 5 years. In India preference shares usually, are cumulative with reference to dividends.

Merits

Issue of preference shares as a source of finance is preferred by many companies due to the following reasons:

(i) It helps to enlarge the sources of funds as some financial institutions and individuals prefer to invest in preference shares due to the assurance of a fixed return. This helps the company to attract investors.(ii) Dividend is payable only when there are profits. There are no fixed liabilities as is the case with loans and borrowings.(iii) A higher return is possible if the company is in good times, in the case of participating preference shares.

(iv) It does not affect the equity shareholders control over management.(v) The rate of preference dividend is fixed. Hence, in years of prosperity, the rate of return on equity capital is likely to be higher than it would be otherwise, due to preference share capital.

Limitations

The limitations of preference shares relate to some of its main features:

(i) Dividend paid cannot be charged to the company’s income as an expense; hence, there is no tax saving as in the case of interest on loans.

(ii) Issue of preference share does not attract many investors as there is no assured return, and the return is generally, low and lesser than the rate of interest on loan.(iii) The holders of preference shares have a right to vote on any resolution of the company directly affecting their rights, which includes any resolution for winding up the company, repayment or reduction of its share capital, etc.

(ii) Debentures: Debentures are instruments for raising long term debt capital. When a company decides to raise loans from the public, the amount of loan raised from a particular issue of debentures is divided into units of similar value. A debenture certificate is issued by the company to acknowledge its debt. Those who invest money in debentures are known as debenture holders. They are creditors of the company. Debentures are, therefore, called creditor ship securities.Debentures have the following characteristics:

(a) Debentures carry a fixed rate of interest.

(b) Debentures are redeemable i.e., repayable after a certain period which is specified at the time of issue. They may become due for repayment after a period of 5 years or more.

THE TARGET CAPITAL STRUCTURE

Firms should first analyze a number of factors, and then establish a target capital structure. This target may change over time as conditions change, but at any given moment, management should have a specific capital structure in mind. If the actual debt ratio is below the target level, expansion capital should generally be raised by issuing debt, whereas if the debt ratio is above the target, equity should generally be issued.

Capital structure policy involves a trade-off between risk and return:Using more debt raises the risk borne by stockholders.However, using more debt generally leads to a higher expected rate of return on equity. Higher risk tends to lower a stock’s price, but a higher expected rate of return raises it. Therefore, the optimal capital structure must strike a balance between risk and return so as to maximize the firm’s stock price.

Four primary factors influence capital structure decisions.

1. The business risk or the riskiness inherent in the firm’s operations if it used no debt. The greater the firm’s business risk, the lower its optimal debt ratio.

2. The firm’s tax position. A major reason for using debt is that interest is deductible, which lowers the effective cost of debt. However, if most of a firm’s income is already sheltered from taxes by depreciation tax shields, by interest on currently outstanding debt, or by tax loss carry-forwards, its tax rate will be low, so additional debt will not be as advantageous as it would be to a firm with a higher effective tax rate.

3. Financial flexibility or the ability to raise capital on reasonable terms under adverse conditions. Corporate treasurers know that a steady supply of capital is necessary for stable operations, which is vital for long-run success. They also know that when money is tight in the economy, or when a firm is experiencing operating difficulties, suppliers of capital prefer to provide funds to companies with strong balance sheets. Therefore, both the potential future need for funds and the consequences of a funds shortage influence the target capital structure—the greater the probable future need for capital, and the worse the consequences of a capital shortage, the stronger the balance sheet should be.

4. Managerial conservatism or aggressiveness. Some managers are more aggressive than others; hence some firms are more inclined to use debt in an effort to boost profits. This factor does not affect the true optimal, or value-maximizing, capital structure, but it does influence the manager determined target capital structure.These four points largely determine the target capital structure, but operating conditions can cause the actual capital structure to vary from the target.

Business risk depends on a number of factors, the more important of which are listed below:

1. Demand variability. The more stable the demand for a firm’s products, other things held constant, the lower its business risk.

2. Sales price variability. Firms whose products are sold in highly volatile markets are exposed to more business risk than similar firms whose output prices are more stable.

3. Input cost variability. Firms whose input costs are highly uncertain are exposed to a high degree of business risk.4. Ability to adjust output prices for changes in input costs. Some firms are better able than others to raise their own output prices when input costs rise. The greater the ability to adjust output prices to reflect cost conditions, the lower the degree of business risk.

5. Ability to develop new products in a timely, cost-effective manner.Firms in such high-tech industries as drugs and computers depend on a constant stream of new products. The faster its products become obsolete, the greater a firm’s business risks.

6. Foreign risk exposure. Firms that generate a high percentage of their earnings overseas are subject to earnings declines due to exchange rate fluctuations. Also, if a firm operates in a politically unstable area, it may be subject to political risks. See Chapter 16 for a further discussion.

7. The extent to which costs are fixed: operating leverage. If a high percentage of costs are fixed, hence do not decline when demand falls, then the firm is exposed to a relatively high degree of business risk. This factor is called operating leverage, and it is discussed at length in the next section. Each of these factors is determined partly by the firm’s industry characteristics, but each of them is also controllable to some extent by management. For example, most firms can, through their marketing policies, take actions to stabilize both unit sales and sales prices. However, this stabilization may require spending a great deal on advertising and/or price concessions to get commitments from customers to purchase fixed quantities at fixed prices in the future.

OPERATING LEVERAGE

Business risk depends in part on the extent to which a firm builds fixed costs into its operations—if fixed costs which are high, even a small decline in sales can lead to a large decline in ROE (return on equity). So, other things held constant, the higher a firm’s fixed costs, the greater its business risk. Higher fixed costs are generally associated with more highly automated, capital intensive firms and industries. However, businesses that employ highly skilled workers who must be retained and paid even during recessions also have relatively high fixed costs, as do firms with high product development costs, because the amortization of development costs is an element of fixed costs.

If a high percentage of total costs are fixed, then the firm is said to have a high degree of operating leverage. In physics, leverage implies the use of a lever to raise a heavy object with a small force. In business terminology, a high degree of operating leverage, other factors held constant, implies that a relatively small change in sales results in a large change in ROE (return on equity)

The Optimal Capital Structure

The Optimal Capital Structure Is the one that minimizes the firm’s cost of capital and maximizes firm value. The right proportion or the appropriate mix of the debt and equity should increase the market value of share held by shareholders

Factors affecting capital structure

Size of businessSize of

business

External environment

External environment

Cash flow

ability

Cash flow

ability

Assests structureAssests

structure

Management

attitudes

Management

attitudes

Sales promotion

Sales promotion

TradingOn

equity

TradingOn

equity

factorsfactors

The various factors affecting the capital structure decision are:1. Leverage or trading on equity2. Sales Promotion3. Management attitudes4. Assets structure.5. Cash Flow ability of a company6. External environment such as the state of capital market, taxation policy,

state regulations etc7. Size of the business8. Age of the company9. Period of finance10. Lender attitude

1. Leverage or Trading on equity: Trading on equity or leverage refers to the financial process. This enables the owners of a company to enhance their return on equity by borrowing funds for one rate of interest, and using the money to earn a higher rate of return, keeping the different for them. It is thus, called making money by using other people's money. Some of the main conclusions regarding the leverage in the capital structure such as use of

fixed cost or fixed return sources of finances may be reemphasized. Debts and per share capital results' into magnifying the earnings per share (EPS) prevailed the firm earns more on the assets purchased with these funds. Than the cost of their use. Earnings before interest and taxes (EBIT) and EPS relationship are the means to examine the effect of leverage. Out of per share capital and debt,' the leverage impact is felt more in the case of debt because their source of finance costs lower, than per share capital and also the interest payable on, debt is, tax deductible. The use of fixed cost sources of finances also adds to the financial risk of the company and, therefore, it should not be used beyond a point where the amount of fixed commitment charges equals the level of EBIT. To give, up because of its effect on EPS financial leverage is one the important consideration in planning the capital structure for the company.

2. Sales Position: Sales position covers growth rate of future sales and sales stability. The future growth of sales is a measure of the extent to which the earnings per share (EPS) of the rum are likely to be magnified by leverage. The greater the external financially that is usually required. This is so because the likely volatility and uncertainty of future sales have important influences upon the business risk the less equity that should be employed. Similarly, sales stability and debt ratios are directly related, that is, the greater the stability in sales and earnings the greater the debt that should be employed. It is because of this factor that public utilities employ more debt than equity because they are assured of their future sales and earnings.

3. Management Attitudes: Management's attitude concerning control of enterprise and risk, involved determine the debt or equity in the capital structure and any analysis of capital structure planning can hardly afford to ignore this factor. In fact every addition of equity unit in the capital structure presents management to participate in the company affairs to that extent. Therefore, while planning capital structure, firms may prefer debt to be assumed of continued control.

4. Assets Structure: Composition and liquidity of assets may also influence the capital structure decision of the firm. Firms with long lived fixed assets, especially when demand for their output is relatively assured utilities for example - use long-term debt extensively similarly greater the liquidity the more debt that generally can be used all other factors remaining constant.The less liquid the assets of firm the less flexible the firm can be in meeting its fixed charged obligations.

5. Cash flow ability of the company: When considering the appropriate capital structure it is extremely important to analyze the cash flow ability of the firm to serve fixed commitment charges. The fixed commitment charges include payment of interest on debentures and other debts, preference dividend and principal amount. Thus the fixed charged depend upon both the amount of senior securities and the terms of payment. The amount of fixed charges will be high if the company employs a large amount of debt or preference capital with short-term maturity. It is therefore, prudent that for servicing fixed charges at proper time, the management must ensure the availability .of cash because inability on the part of management may result in financial insolvency. Therefore, cash flow analysis is essential to consider while planning appropriate capital structure. Obviously, the greater and more stable the expected future cash flows of the firm, the greater the debt capacity and vice-versa. To be on a safe side the cash flow ability must be determined in the period of depression very carefully.

6. External Environment: Any decision relating to the pattern of capital structure must be made keeping in view the external factors such as state of capital market, taxation policy, state regulations etc. If the capital market is likely to be planned in bearish state and interest rates are expected to decline the management should postponed the debt for the present in order to take advantage of' cheap debt at a larger stage. However, if debt will become costlier and will be on scarce supply owing to bullish trends of the capital market, the management may inject additional doses of debt in capital structure. Similarly, taxation policy with regard to the various sources of finance affects the capital structure decision of the company. The present taxation provisions are in favor of debt capital because interest payment on debt is a tax deductible expense. On the contrary dividend payable on equity capital preference share capital is subject to tax state regulation is another exterior factor that must be taken into account while planning capital structure.

7. Size of the company: Smaller companies confront tremendous problem in raising fund and these companies have to pay higher interest on debt and have to agree to inconvenient terms of loan. These companies as a result are compelled to depend heavily on retained earnings and share capital.

8. Age of company: Age of company plays an important role. New companies face a lot of uncertainty in the initial periods of operation, as they are completely unknown to the suppliers of funds. These companies are compelled to depend upon their own, sources of funds. Small firms or newly started funds have low standing in the market and they are compelled to pay a higher rate of interest on long-term debts.

9. Period of finance: The period of finance should be paid due attention in the capital structure decision. When funds are required for permanent investment in a company, equity share to capital is preferred. When funds are required to finance modernization programs such as overhauling of machines and equipment and aggressive advertising campaign, the company can issue preference share and or debentures.

10. Lender's attitudes: Lender's attitudes are frequently important and sometimes the most important determinant of capital structure. Before adopting a capital structure the management may discuss their strategies with its prospective lenders if possible. The above-listed factors and difference analysis would help the financial manager to determine within some range the appropriate capital structure.

11. Asset structure. Firms whose assets are suitable as security for loans tend to use debt rather heavily. General-purpose assets that can be used by many businesses make good collateral, whereas special-purpose assets do not. Thus, real estate companies are usually highly leveraged, whereas companies involved in technological research are not.

12. Operating leverage. Other things the same, a firm with less operating leverage is better able to employ financial leverage because it will have less business risk.

13. Growth rate. Other things the same, faster-growing firms must rely more heavily on external capital (see Chapter 4). Further, the flotation costs involved in selling common stock exceed those incurred when selling debt, which encourages rapidly growing firms to rely more heavily on debt. At the same time, however, these firms often face greater uncertainty, which tends to reduce their willingness to use debt.

14. Profitability. One often observes that firms with very high rates of return on investment use relatively little debt. Although there is no theoretical justification for this fact, one practical explanation is that very profitable firms such as Intel, Microsoft, and Coca-Cola simply do not need to do much debt financing. Their high rates of return enable them to do most of their financing with internally generated funds.

15. Taxes. Interest is a deductible expense, and deductions are most valuable to firms with high tax rates. Therefore, the higher a firms tax rate, the greater the advantage of debt.

16. Control. The effect of debt versus stock on a management’s control position can influence capital structure. If management currently has voting control (over 50 percent of the stock) but is not in a position to buy any more stock, it may choose debt for new financings. On the other hand, management may decide to use equity if the firm’s financial situation is so weak that the use of debt might subject it to serious risk of default, because if the firm goes into default, the managers will almost surely lose their jobs. However, if too little debt is used, management runs the risk of a takeover. Thus, control considerations could lead to the use of either debt or equity, because the type of capital that best protects management will vary from situation to situation. In any event, if management is at all insecure, it will consider the control situation.

17. Market conditions. Conditions in the stock and bond markets undergo both long- and short-run changes that can have an important bearing on a firm’s optimal capital structure. For example, during a recent credit crunch, the junk bond market dried up, and there was simply no market at a “reasonable” interest rate for any new long-term bonds rated below triple B. Therefore, low-rated companies in need of capital were forced to go to the stock market or to the short-term debt market, regardless of their target capital structures.

18. The firm’s internal condition. A firm’s own internal condition can also have a bearing on its target capital structure. For example, suppose a firm has just successfully completed an R&D program, and it forecasts higher

earnings in the immediate future. However, the new earnings are not yet anticipated by investors, hence are not reflected in the stock price. This company would not want to issue stock— it would prefer to finance with debt until the higher earnings materialize and are reflected in the stock price. Then it could sell an issue of common stock, retire the debt, and return to its target capital structure. This point was discussed earlier in connection with asymmetric information and signaling.

By necessity, the final decision regarding capital structure based on objective analysis supplemented with subjective intuitiveness of the management. In this way, the company shall be able to obtain a capital structure, which has direct influence on maximizing the wealth of shareholders.

Theories of capital structure

Net income approach

Net operating income

Traditional approach

Modigliani- Miller approach

NET INCOME APPROACH

Suggested by DAVID DURAND Value of the firm depends on its capital structure decision High debt content in the CS = high FL V = E + D E= EBIT-I / Ke D= I/Kd

In the light of the graph it is clear that as D/E enhances . Kw decreases because the proportion of debt enhances in the CS

A ltd is expecting an annual EBIT of rs 2 lakh. The co.. has 8% debentures of rs5 lakh. The cost of capital is 10%. Compute the total value of the company and overall cost of capital.

High debt content

ReductionOverall

Cost of capital

Enhance Value of

FIRM

EBIT 200000less interest 40000

EBT 160000 earnings available to ESH Ke 10% Market value of equity (E) = EBIT – I /Ke 16,00,000

total value of the company = 16L + 5Loverall COC Kw = EBIT / V = 9.5%

Net operating income approach

Advocated by David Durand Value of a firm depends on its NOI and business risk Change in the degree of leverage a firm cannot change its NOI and

Business risk It brings variation in the distribution of income and risk between

debt and equity without affecting the total income and risk which influences the market value of the firm.

Optimum CS When there is 100% debt content Assumptions:-

– Kw is constant for all degree of leverage– NOI is capitalized at an overall capitalization rate to find out

the total market value of the firm. Thus the split between D & E is irrelevant

The use of low cost debt enhances the risk of equity share holders, enhancing the equity capitalization rate. Thus the benefit of DEBT is nullified by the increase in the EQUITY CAPITALIZATION RATE.

V = EBIT / Kw

An increase in the use of debt funds is offset by an increase in the equity capitalization rate. This occurs because the equity investors seek more compensation as they are exposed to higher risk arising from increase in the degree of leverage.

AB ltd has an EBIT of 2 L. the company has 8% debentures of Rs 5L. Presuming the overall capitalisation rate as 10%, compute the total value of the company and equity capitalisation rate

– EBIT 200000– Kw 10%– Mkt value of the company 200,000/10% = 20,00,000– Total value of debt 500,000– Market value of equity 15,00,000– Ke = EBIT – I / D * 100 = 10.67%

If the company increases the debt content by decreasing the equity content, the total value of the company would remain unchanged but the capitalization rate will increase

TRADITIONAL APPROACH

COST OF CAPITAL IS DEPENDENT ON THE CAPITAL STRUCTURE

THE MAIN PROPOSITIONS OF THIS APPROACH ARE:-

– COST OF DEBT CAPITAL REMAINS CONSTANT UPTO A CERTAIN DEGREE OF LEVERAGE AND THERE AFTER RISES

– COST OF EQUITY CAPITAL REMAINS CONSTANT MORE OR LESS OR RISE GRADUALLY UPTO A CERTAIN DEGREE OF LEVERAGE AND THEREAFTER INCREASES RAPIDLY.

– THE AVERAGE COST OF CAPITAL REDUCES UPTO A CERTAIN POINT AND REMAINS MORE OR LESS UNCHANGED FOR MODERATE INCREASE IN LEVERAGE AND THERE AFTER RISES AFTER ATTAINING A CERTAIN POINT.

IT ACCEPTS THAT CAPITAL STRUCTURE OF A FIRM AFFEECTS THE COC AND ITS VALUATION

IT DOES NOT SUBSCRIBE TO THE CONCEPT THAT THE VALUE OF THE FIRM WILL NECESSARILY ENHANCE WITH ALL LEVELS OF LEVERAG

MODIGLIANI MILLER APPROACH

Total market value of the firm and cost of capital are independent of the capital structure

WACC does not make any change with a proportionate change in debt –equity mix in the total capital structure of the firm

It provides operational justification for irrelevance of the capital structure in the valuation of the firm.

Propositions

COC AND MARKET VALUE OF THE FIRM ARE INDEPENDENT OF ITS CAPITAL STRUCTURE.

COST OF CAPITAL = CAPITALISATION RATE OF EQUITY

TOTAL MARKET VALUE OF THE FIRM IS DETERMINED BY CAPITALISING THE EXPECTED NOI BY THE RATE APPROPRIATE FOR THE RISK CLASS.

Ke – Kd = premium for financial risk

Increased Ke is offset by the use of cheaper debt

The cut off rate for investment is always independent of the way in which an investment is financed.

Criticism of MM hypothesis

Different rates of interest Corporate taxes

Questions :- What do you understand by capital structure of a firm? Explain the approaches in capital structure

FACTORS INFLUENCING CAPITAL STRUCTURE

Financial LeverageCash Flow abilityControl FlexibilityMarket conditionsFloatation costsLegal frameworkNature of businessCost of financingPeriod and purpose of financing

In the real world taking decisions on capital structure is not as easy as it is made out till now. In deciding the capital structure of a company, the

following points need to be considered:

Corporate Strategy

Corporate strategy is the main factor determining the financial structure of a company. The market growth rates form a basis for defining the Organization structure, Investment in Assets and Overall Capital Intensity (Debt/Equity Financing). The fact that the company has to source funds from the markets, makes it imperative to factor in the market responsiveness to the company's call for funds. Capability to service the funds, both debt and equity and the growth phase of the business have to be considered in tandem. Other strategic decisions like management control level, risk averseness or risk taking nature of the management, etc.. Ultimately, the most appropriate capital structure will be the one, which most closely supports the strategic direction of the business with the least cost and at a reasonably acceptable risk level.

Nature of the IndustryThe nature of the industry plays an important role in capital structure decisions.

Capital Intensity: Capital structure should factor in the type of the assets being financed. Capital intensive firms rely mostly on long term debt and equity. Generally speaking, long term assets should be financed by a balance between term debt and equity and short term assets should be financed less by long term sources (like term debt and equity) and more by short term debt. The terms current (short term) and fixed (long term) assets are determined by the nature of the industry and the business itself. For example, a rapidly growing non-seasonal and non-cyclical business may regard part of its investments in short term assets like inventories and accounts receivable, as permanent investments and fund it by long term sources. If on the other hand, the business is seasonal in nature, the seasonal peaks fund requirements may have to be funded by short term debt.

Cyclical Business: In businesses like construction, capital and higher consumer goods their volumes, and hence requirements of funds, are affected by the changes in the national and global scene. Businesses subject to such variations need a capital structure that can buffer the risks associated with such swings. Again maneuverability of capital structure is at a premium

during times of contraction.

Competition: The degree of competition is also a major factor to be considered in deciding the capital structure. In highly competitive industry with low entry barriers, companies with deep pockets can only survive in the long run.

Product or business life cycle: During the initial phase of the growth curve of a business/product the risk is high. Debt is hard to come by due to the riskiness of the venture and funding has to be through the venture capital equity. Financial leverage is low, which could be increased as the product/business establishes itself. As the business matures, increased cash flows may reduce the need for debt funds.

Current and Past capital Structure Current capital structure of a company is determined largely by past decisions. Investment decisions of the past, acquisitions, take-over, financing policy, dividends etc. go into forming the current capital structure which is difficult to change overnight. Altering current capital structure can be done by raising capital, retiring debts, buying back shares, taking on debt, altering dividend payout policies, alteration in earning capacity, etc. Also, as past decisions decide current capital structure, current changes in the capital structure decide the future capital structure. Hence, utmost care has to be exercised in decision and implementation of changes in the capital structure.

While making the capital structure decisions, the company has to consider the different life cycle stages which are:

• the pioneering stage • the expansion stage • the stagnation/stabilization stage

The pioneering stage is one of rapid increase in demand for the products/services of the company. The risk is highest at this stage of the life cycle of the company and the efficient companies are the ones to survive. The financial cost of borrowing is very high at this stage, due to the risk perception about the company. To survive this capital structure should orient more towards equity and if available utilize soft loans from the government. The expansion stage is the next stage, during which the strong companies survive the competitive struggle and aim to expand their market

share and volumes. During this stage, huge investments are made to expand production/service capacity. Requirement of funds is high during this stage. Subject to the corporate strategy of funding projects and the market conditions, the company may raise capital at the lowest possible cost. As the earnings stabilize, the company will be in a position to weather any small variations in business, and then it can seek to financially leverage itself within a pre-fixed ceiling, by bank loans or financial institutional loans. It is during this stage that companies are typically expected to reward their investors with dividend and stock dividend/splits.

Stabilization/stagnation stage is the last and final stage. A dynamic management will always be on the lookout for expansion/diversification into new projects. It could, again depending on corporate strategy, go in for green-field projects or take over existing units, seek mergers, acquisitions and strategic alliances, etc. Usually a recession in economy opens up a vast number of such opportunities which cash rich companies can take advantage of. In case of lack of such opportunities, the company could reduce the financial leverage and save on interest and if possible down size the equity by buy back of shares. Buy back of shares acts to boost investor confidence in the company and also makes equity serviceable during recession.

Capital gearing: The relative proportion between different securities and the ratio of each security to the total capitalization is known as capital gearing. Equity is traded upon:Trading on equityCapital gearingFinancial leverage

There are two main types of risk that a company faces:

Business risk - the variability in a firm’s EBIT. This type of risk is a function of the firm’s regulatory environment, labor relations, competitive position, etc. Note that business risk is, to a large degree, outside of the control of managers

Financial risk - the variability of the firm’s earnings before taxes (or earnings per share). This type of risk is a direct result of management

decisions regarding the relative amounts of debt and equity in the capital structure

Balancsheet of FMI ltd.

Particulars 2009-10

(In Lac)

2008-09

(In Lac)

2007-08

(In Lac)

Shareholder’s Fund

--Paid Up Capital

--Reserves & Surplus

Loan Funds

--Secured Loans

--Unsecured Loans

Deferred Tax Liability(Net)

18.05

861.67

1143.89

268.01

141.37

18.05

733.66

1105.97

246.67

124.23

18.05

839.74

717.50

241.32

124.26

2432.99 2228.59 1940.86

Net Fixed Assets

Investments

Current Assets

--Inventories

--Sundry Debtors

--Cash & Bank Balances

--Loans & Advances

Less : Current Liabilities

--Liabilities

--Provisions

1082.90

3.48

2332.30

236.19

25.11

182.25

-1299.48

-129.76

1096.36

1.85

1777.72

215.45

15.74

201.12

-968.43

-111.22

1097.33

1.85

1019.75

340.85

21.95

79.64

-591.89

-33.12

2432.99 1940.86 1891.24

Analysis

Balance Sheet of the FMI Limited shows that the Paid up Capital of

Company is 18.05 Lac only so it can be judged that company is managing

out sources fund most for its operations of long term as well as short term.

Secured Loans are the term loans for constructing the Multiplex at Ferozepur

Road, Ludhiana and also a corporate loan of Rs.240 Lac which was accepted

for the payment of demand of Legal Metrology Department in 2008-09. No

additional any loan is accepted during the year. In unsecured loans no any

loan is accepted in the financial year 2009-10. Net fixed assets are almost

like same as were in last year. Additions to Fixed Assets are almost

equivalent to the Depreciation amount claimed by company on the gross

block of company. Investments are increased by 1.68 Lac which represents

the purchase of Gold coins as investment for the future. Debtors, Bank

Balances and Cash are the assets that are always having fluctuations but

there are not too much up and downs noted in the last three comparable

financial years.

SUMMARY AND CONCLUSIONS

After I have gone through the data of the FMI Limited in the prescribed

manner to reach at the result that the company has aa very effective capital

structure. The company is having very strong policies about the finance of

the company. Company is having very good control over its financial affairs.

Financial Strategies are prepared by Mr.Shashi Pal Jain (General Manager)

who deals with all banking of the concern.

Company is gaining very good profit over its sales. Company is getting very

good return by recent three financial years. The Loss incurred in the

financial year 2008-09 is only due to the unexpected demand by the Legal

Metrology Department of Punjab of Rs.573 Lac that the company had to pay

to the extent of Rs.300 Lac in the financial year 2008-09 and left amount of

Rs.273 Lac in the next financial year e.g. 2010-11. Except this case

company is very good at its financial condition.

If we talking about transactions of company with vendors and customers

then it is noted that company is exporting the Measuring Tapes

manufactured to more than 60 countries of the word and total Export Sales

Ratio in the total Sales is Approximate % in 2008-09 and % in 2009-10 and

the Import Ratio in the total Raw Material Consumed is Approximate to

37.74% in 2008-09 and 29.31% in 2009-10 to its total consumption.

So it is clear that the company is hugely contributing towards the

globalization. Management of the company is very mindful and strong that’s

why the company is having very good Gross Profit and Net Profit Ratio on

its Sales. Efforts are being done at every stage of manufacturing to increase

the quality of the products and to maintain the standard of the products. It

can be said in another words that company is stepping towards the growth

and efficiency. Very Effective plans for growth and progress are being

followed by Company which is very needy to survive in the today’s age of

pure competitions.

So after all the above facts and discussions it is clear that Company is very

good at its financial position and affairs. Company is not very efficient only

at its finance but also its import, export quality and other resources and

procedures. So it can be said that FMI is the one of the most biggest and

efficient companies of Punjab and even India in near Future.

RECOMMENDATIONS

From the above conclusion it is made very clear that the company is having

very strong position at every aspect but I want to suggest company and to

give some recommendations which may be followed for the betterment of

FMI Ltd Ludhiana.

The company should keep in touch with their agents properly & when

ever they find the channel unfit they must go for a change.

More concentration should be given on the Promotion of Sale of

Products.

Management should seek more professionally educated persons in

their respective areas or Proper training programs should be there to

educate the personnel in their fields to gain the smoothness in work

and to increase efficiency.

The quantity & quality of the finished product should be improved

Accountability for each task should be fixed strictly. This is very

important point but lack of accountability is noted in the many

processes of manufacturing and officials.

Motivational programs should be introduced to motivate the

employees to work hard and to make Team Efforts to achieve the

Organizational Objectives.

Employees should be given adequate Remuneration according to their

contribution so that their concentration be only on the betterment of

the Organization, as we all know

“A Good and Concentrated Team of Personnel is more valuable

for the Organization even than of Money in Hand”

LIMITATIONS OF REPORT

As I have gone through every aspect of the tasks performed by the FMI

Limited employees and their policies and procedures to fulfillment the

requirements at different levels, I found some Limitations in the Project

Report prepared by me. These all are non controllable errors that can not be

avoided by me. I would like to discuss here all these

As this report is the result of my Practical training at FMI Limited for

Five weeks, but still I found that there was shortage of time to get the

full fledge knowledge of the tasks performed in corrective manners.

There was very busy schedule of Account department due to Auditing

of Accounts of the Concern.

BIBLIOGRAPHY

Research Methodology, C.R.Kothari

Management Accounting, Shashi K Gupta & R.K.Sharma

Mathematics and Statistics, R.L.Aggarwal

Old Reports of FMI Limited

Financial Statements of FMI Limited

Other Documents as Catalogue, Products Chart, Flow Chart of

Manufacturing etc