Determine Optimal Capital Structure

How to Determine Optimal Capital Structure

Many people get confused about the optimal capital structure for a company because they observed that different company holding different capital structure. Capital can be formed by using only equity or combination of debt and equity, but cannot form only using debt capital. For a company debt and equity can be 50/50, for other company it can be 40/60, or 60/40, or 65/35 or any other proportion. Here question may arise that what proportion of debt and equity should use to form optimal capital structure?

The optimal capital structure is mainly depends on the two important things. These are:

  • The business risk related with the company’s business and
  • The financial risk of that company

determine optimal capital structure

Business Risk

Business risk arises when a company unable to generate sufficient amount of cash flow to pay off its operating expenditures. Operating expenditure can be rent expense, salaries expense, wages, depreciation etc. The main thing is, if the business unable to cover its business operation related expenditure then company will exercise business risk. Lower the cash inflow, higher the business risk and higher cash inflow from operation will reduce the business risk.

So when forming optimal capital structure it is required to keep in mind that the amount of business risks which may arise. If there is a possibility of higher business risk then it will be wise decision to use higher equity capital rather using debt capital. On the other hand company which generating huge amount of cash flow from its business operation can use larger amount of debt to maximize its return.

Business risk can be divided under two risk categories. One is systematic (non diversifiable) and other is unsystematic (diversifiable) risk. As we cannot reduce the systematic we must diversify our investment so that we can reduce the risk of the company.

Financial Risk

Financial risk directly related with the interest amount payable to the debt provider. That is when a company is unable to generate sufficient cash flow to pay off the financial obligations properly then that company experience financial risk. A company with sound financial position ensures less financial risk and the cost of debt financing is lower as the investment in this company is less risky.

Although business risk and financial risk are two broad things we have to keep in mind that some other factors like, availability of equity capital, cost of equity, cost of debt, cash conversion cycle of the business, profitability of the firm and corporate tax rate may involve with determining optimal capital structure. Also optimal capital structure (debt and equity ratio) depends on the type of business and economic condition of the company.

Financial System of Bangladesh

The Financial System is a systematic organization of institution through which surplus unit (those have surplus amount of funds) transfer their fund to deficit units (those need funds to be financed) so that both the parties surplus and deficit unit get the financial benefit. Financial institutions or other individual financial companies use different kinds of financial instruments to transfer of funds according to their needs. Sometimes people or institution collect funds directly from direct sources and sometimes they collect with the help of financial intermediaries.

Flow of funds can be possible through the following ways:

  • Direct transfer of funds directly from the surplus unit (those have extra funds) to deficit unit (those need additional funds).
  • Indirect transfer facilitates the flow of funds with the help of financial intermediaries or investment bankers or investment through mutual fund is the way of indirect transfer of funds.

financial system of Bangladesh

Financial system of Bangladesh consists of

Financial Institutions

Financial institution deals with financial transaction where both bank and non bank financial institutions (leasing companies, insurance companies). There are 58 banking institutions are in Bangladesh which is owned by state, private, public, foreign companies and there are 34 non banking financial institutions in our country. Both bank and non bank financial institutions ensuring cost effective transaction and flow of funds.

Financial Markets

Financial Markets are consists of money market and capital market, where money market deals with short term investment like , Treasury bill, certificate of deposit, short term government bond (risk free investment). On the other hand capital market deals with long term financial instruments (stock, bond, debenture etc.)

Financial Instruments

Financial Instruments are used to make transaction or investment which can be for long term or short term. According to the demand of the market different financial institution offer different financial product so that required lending and borrowing can be possible.

Public Financial Management Add Value

Public Financial Management Add Value

Does public financial management add value to the actions of the corporate financial manager with respect to the public private partnership?

To identify whether public financial management add value to the actions of the corporate financial manager with respect to the public private partnership (PPP) or not, we have to know about core functions of public financial management and how it works, functions of corporate financial manager and mechanism of public private partnership.

Basically public financial management responsible for managing funds used to provide public services (infrastructural development, power and energy, education, water supply, sewage, national security, health care etc.) to different public sectors. The main objective is to ensure proper utilization of financial resources or funds so that effective public services can be ensured. Public financial management also takes care about the formulation of financial policy and developing regulatory framework of financial resources of the country.

The finance ministry of a country is responsible to budget its annual sources of revenues and expenditure and also how these revenues will be collected through taxes, fees, fines, VAT etc. Two types of budget is being prepared one is expenditure budget and other is development budget. The finance minister decides the allocation of resources according to the financial plan and requirement to the different sectors.

public financial management Add value

Here in public financial management two important things are present which is not available for the private sector. These are:

  • Public accountability and other is
  • Balance of public goods with the requirements.

On the other hand corporate financial manager is mainly responsible for management of financial resources of the corporation to maximize the value of the company and shareholders wealth. Also it is required to manage short term money requirement through working capital management and long term funds requirement through long term sources or from optimal sources. To do these corporate financial manager make decision about the capital structure of the company, capital budgeting and working capital management.

Public private partnership is an agreement between public sector that is government with the private sector that is corporation to ensure the effective use of resources of government and corporations so that there is to have operational efficiency and cost effectiveness. Both the parties get the benefit from this type of agreement. Now because of the failure of public sector more public private partnerships are now seen in the recent year. The actual reason of this type of partnership is to create value for both the parties through optimal use of the financial and physical resources.

In Bangladesh now there are 42 projects are approved and make an agreement of public private partnership for the purpose of ensuring proper use of resources and efficient services.

Now come to the main point of adding value by the public financial management to the action of corporate finance manager in respect of PPP.

From my point of view I think it is obvious that public financial management add value to the action of corporate finance manager through the following ways:

  • First of all corporate financial manager have to manage its financial resources by considering the financial policies taken by the government or public financial manager. In some cases corporate have to do business in an economy which is ruled by the public sector then it is required to follow the rules and regulations imposed by the government.
  • If public finance manager think that it is appropriate to make an agreement to form a PPP then corporate can take the opportunity because corporate have skilled human resources and expertise which is absent in the government human resource. By accepting this opportunity private sector can generate huge revenues and make it profitable sector.

Let consider an example of PPP

In Bangladesh several projects are on hand which is under the public private partnership. Jatrabari Flyover project is one of this until now which is successful project. Public sector can do this project alone but it was under PPP because of the benefits of efficiency in operations, less time consuming, more quality service and make the project successful one.

Private showed their interest because of their larger financial benefit and earn reputation in the construction sector.

In this example public sector provide its resources to the private sector and corporate financial manager manage these resources in accordance with the agreement of public private partnership. So we can say that the public financial management adds value to the actions of the corporate financial manager.

Determining Financing Needs for Business

Determining Financing Needs for Business

The success of a business is depends on the effective use of financial and non financial resources. It is financial manager’s responsibility to ensure right borrowing and financing decision. Holding an optimum level of funds is not an easy task. Every manager have to go through a systematic process to decide how much money should be kept on hand as a cash and identify whether there is sufficient money to continue business operations. Also financial manager have to identify whether to make financing and investing decision.

Before taking any financing decision for business first of all it is required to analyze some factors and on the basis of this it is possible to identify whether there is deficit or surplus of funds. If there is a deficit of funds then it is required to take financing decision.

Three things need to be analyzed when determining financing needs for business these are

determining financing needs for businessRequirements of Funds

First of all it is required to check how much fund is required for the business over a period of time. This can be estimated through forecasting or trend analysis. Remember the requirements of funds depend upon the type of business, collection policy of accounts receivables and business operations.

Identify Profitability of the Business

After analyzing requirement of funds the financial condition of business for a particular date should be measure where the asset and liability position can be seen. In addition to this the profitability of the business also required to be checked. If the profitability is high then there will be more funds to spend and owner of business will eager to spend more as he is getting more profit.

Risk Involved with Business

Here we consider the business risk which arises when a business is unable to generate sufficient revenue by using its resources to compensate its operating expenditures. If business risk is high then it is needed to acquire funds through financing.

A financial manager must consider all these three together to determine whether he/she will finance funds for the business or not. According to the nature of requirement the financing can be short term or long term. It is obvious to finance short term requirement from short term sources and long term from long term source of fund.

Tasks of Corporate Finance

Corporate finance is a branch of finance where financing decision about choosing least cost source of fund and optimal capital structure. The main goal of corporate finance is to ensure the maximization of the value of the firm so that equity holders get the benefit. Remember one thing that corporate finance is not like public finance, both is different from each other.

The Main Tasks of Corporate Finance are

  • Capital Budgeting for the Corporation
  • Forming Optimal Capital Structure and
  • Management of Working Capital

Many people consider these tasks as a function of corporate finance. In addition to these tasks of corporate finance deals with many other financial activities according to the requirement of the corporation.

The main tasks of corporate finance

Capital Budgeting

Capital budgeting involves with the long term investment decision making by analyzing the investment alternatives. For long term investment large amount of money is involved and project manager have to spend lots of time and effort to execute the project. So before taking any long term investment decision it is required to make a capital budgeting. Popular forms of capital budgeting techniques are: Net Present value (NPV), Internal Rate of Return (IRR), Pay Back Period (PBP), Profitability Index (PI) and Modified Internal Rate of Return (MIRR).

It is corporate managers responsibility to ensure right amount of investment in a project by evaluating investment alternatives by using capital budgeting.

Developing Optimal Capital Structure

Another important task is followed in corporate finance is to develop an optimal capital structure for the corporation, that is choosing right proportion of debt and equity capital. How much capital is to be raised by the debt and how much by equity fund is depends on the company’s financial strength and capability of using its resources. A company may choose fifty percent debt and fifty percent equity capital; 50:50, remember that it is not necessarily that every company use 50:50 debt and equity, a company can choose 30:70 or 40:60, or 60:40, or 45:65 ratio of capital.

Management of Working Capital

Management of working capital is the process of managing the current asset and current liabilities for the company. A corporate finance manage will decide how will he/she ensure right amount of current asset to pay off the current liabilities. Different option available to payoff current liabilities, it can be paid off from the current asset or from the long term asset. Whether it is to be from the long term or short term is not a matter but the thing is the cost of pay off the current liabilities. Normal practice by the corporate financial manager is to pay off current liabilities by using current asset. To ensure a good financial position it is required to have a good working capital management system.

Debt is the Cheapest Source of Financing

Debt financing

Debt financing is the act of raising operating capital or other capital by borrowing for a business. Most often, this refers to the issuance of a bond, debenture, or other debt security.

When a company takes loan from third party then it is considered as debt financing. It is one of the most commonly used ways of financing. Debt can be of short term, midterm and long term.

debt is the cheapest source of financing

Capital Structure

Why debt is the cheapest source of financing?

Company can manage its required funds through debt or equity or combination of both. Choosing an optimal capital structure different company use different ratio of debt and equity. But question is how an optimal capital structure can be formed. Basically the capital structure is formed by considering the financial strength of the company and cost of funds of different sources.

Many people say that retained earnings is the cheapest source of financing but debt can be cheapest source of financing from different perspectives. From the share holder’s perspective tax deductibility feature of debt finance is lucrative. And from the lenders perspective debt is secured because creditors get the preference of getting their principal and interest before making any benefit to the share holders.

Tax deductibility feature of debt is the main point, on which we can say debt is the cheapest source of financing.

There are some other points that may include with deductibility feature. These are

  • Time value of money and preference of funds.
  • Dividends not payable to lenders
  • Interest rate.

Let us consider an example to show how debt financing helps to reduce the tax burden that is the tax deductibility features of interest.

Example: Suppose XYZ company take loan of $1000000from ABC bank at the rate of 15%. Tax payable to the government is 30% of the income. Income is = $500000

Only Equity is used

If there is no debt financing then XYZ company has to pay tax of total = $500000 X 30% = $150000

After tax income = $ 500000 – $150000 = $350000

If Debt and equity is used

On the other hand if company use debt financing then,

Interest on load amount = $1000000 X 15% = $150000

Taxable income is = $500000 – $150000 = $350000

Tax payable = $350000 X .3 = $105000

After tax income is = $500000 – $105000 = $395000

From the example it is clear that because of debt financing XYZ Company is paying less amount of tax which increases the net income after tax. Normally company making profit of $350000 but because of using Debt Company is making profit of 395000. That’s why company prefers debt financing.

Let us consider other example: XYZ company take loan at the rate of 14% and corporate tax rate is 30%.

Here cost of debt capital is 14% but because of using debt capital company’s cost of capital for debut is 14 X (1 – 30%) = 9.80%. Cost of capital is reduced because of tax deductibility feature of debt financing.

So we can say that debt can be cheapest source of financing for the company.

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Written by

Md. Nahian Mahmud Shaikat

Financial Analyst

Institute of Business Administration (IBA)

Jahangirnagar University

Email: [email protected]

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Determinants of Time Value of Money

What are the determinants of time value of money ? Time value of money is the most important concept of finance. The main thing of time value of money is that the value of dollar 100 now is more than the value of dollar 100 after some time. That is the value of money today is more than the value of money after some time. When make any investing or financing decision we have to consider this idea, otherwise we may incur some loss of benefit. To calculate the present value of any fund this time value concept is used to identify the required rates of return.

The Idea that money available at the present time is worth more than the same amount in the future because of potentiality of future earnings. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received.

Determinants of time value of money

There are several determinants which is used to calculate the actual value of the money. Four commonly used determinants are:

  • Consumption preference of a person
  • Uncertainty of future
  • Inflation of the economy
  • Investment Opportunity

determinants of time value of money

Consumption preference of a person

People prefer current consumption to future consumption if there is same level of satisfaction. Most of the people are ready to sacrifice the current consumption if they find that in future they will be able to consume more than the present. A higher rate of return that is more than the required rates of return is mainly leads them to take the decision of sacrifice of current consumption. Some people think that future is uncertain so it’s better to consume now although they are not concern about the benefit of future.

Uncertainty of future

Future is always uncertain. Nobody knows what will happen in future. So it is better to consume now rather than consume in future if current consumption rate is more. People would like to compensate for uncertain future cash flow against certain cash flow.

Inflation of the economy

Inflation is related with the purchasing power of money. With the time the purchasing power of money is decreased. Every economy has inflation but the rate is different from country to country economy. If there is higher inflation then the required rates of return of investor is higher. For a higher inflationary economy consumers prefer current consumption rather than future consumption.

Investment opportunity

Time value of money considers the idea of reinvestment that is if an investment generates cash inflow periodically then this periodic return can be reinvested which will generate higher return. If the cash flow come now, it can be invested and generate additional cash flow, therefore whatever may be the cash flow now. The future cash flow is more than its present cash flow.

If you like this article please do not forget to share on facebook and put your valuable comment.

Written by

Md. Nahian Mahmud Shaikat

Student of MBA

Institute of Business Administration (IBA)

Jahangirnagar University

Email: [email protected]

Facebook: Ördïnärÿ Böÿ

Call Option

Call Option

A call option is an option to buy financial instruments at a specific price after a certain period. A call option is an option for the buyer to exercise not an obligation to perform. There can be an agreement between the buyer and seller for the purpose of exchange of financial instrument; here buyer get the right to buy stock/bond or other financial securities if buying is beneficial for him/her.

In a call option basically buyer makes an agreement with seller if he thinks that there is a potentiality of positive change of instrument price in the market. So to get this opportunity a strike price is set for which securities will be exchanged and this contract is valid for a fixed period of time.

Question may arise that why seller of stock/bond or other financial securities want to make contract with the buyer although he knows that this contract will exercise only if the stock price is higher than the strike price. The main reason is that seller assumes that future price of this security will less than the strike price so that he will be gainer.

For example: Call Option

Suppose Mr. Jhon makes a contract with Mr. Sparrows to exercise a call option where they fixed a price (strike price) of an instrument is 80 Dollar i.e. Mr. Jhon will purchase this instrument only if the instrument price is higher than the strike price.

At the maturity of the contract the price of the stock is 100 Dollar, so Mr. Jhon will buy the stock at 80 dollar which will help him to make a profit of 20 dollar.

On the other hand, if this stock price is 79 dollar or less than this then this option will not be exercised.

Process of developing a call option:

  • Buy a call option with the expectation of increase in market price
  • If market rate appreciates compared with strike price
  • Call option of yours will create value for you
  • At the expiry date if market price is higher than strike price then you will exercise the call option which will generate profit for you.
call option

Process of Call Option

Call options is an agreement (written contract which is enforceable by law) between buyer and seller to buy and sell financial instruments with a fixed price determined earlier, if the price of instrument is higher than the market price then this contract will be exercised.

Written by

Md. Nahian Mahmud Shaikat

Student of MBA

Institute of Business Administration (IBA)

Jahangirnagar University

Email: [email protected]

Facebook: Ördïnärÿ Böÿ

How to Take Share Buy Decision

How to Take Share Buy Decision

Share

Share is the small proportion of capital of a company. Both private and public limited companies have share capital. But only public limited company can issue their share in public through IPO (Initial Public Offering) to raise their share capital. Basically the shares of public limited company are traded in stock market. Buyers and sellers are involved with this market through brokers (commission agent). There are thousands of millions of investors investing large amount of money to the capital market. It is investor’s responsibility to choose right share of right company so that they would get benefit (capital gain and dividend) from investing.

Question is what are the things investor should consider before investing in capital market through purchasing share/stock or how to take share buy decision?.

how to take share buy decision

Share/Stock Buy Decision

There are several factors/things that need to consider before investing in capital market/stock market through purchasing share/stock of a company. These factors are:

  • Calculate present value of all future benefit. If present value is more than the current price then buy the stock/share. On the other hand if current market price is more than the calculated present value then definitely sell the stock.
  • To reduce the risks of investment do not forget to choose company from different industry. So that you can diversify your investment also make sure that you pick the right company stock.
  • Check the growth rate of the company which you want to invest. You can get growth related data from the annual report or in stock market/capital market.
  • Choose stock/share which company has lower price earnings ratio.
  • You can also choose stock which provides higher EPS (Earnings per Share) compared with other companies.
  • If you have financial knowledge then check the financial statement (cash flow statement, income statement, balance sheet) of the companies over the period of time. Cash flow will help you to check the cash inflow and outflow. And from other financial statements you will get profit/loss, assets & liabilities related information. It is your responsibility to check ever information that may have impact on the future earnings of the stock/share.
  • You also need to consider the current market rate and the current economic condition of the country.
  • Never buy share without knowing anything or if anyone influence you to buy share.

These are the some of things that you can consider before investing. If you analyze properly and invest in capital market then there will be less chance to lose your investment. Never try to gamble in the market, although many people think that buying and selling stock is one kind of gambling.

Written by

Md. Nahian Mahmud Shaikat

Student of MBA

Institute of Business Administration (IBA)

Jahangirnagar University

Email: [email protected]

Facebook: Ördïnärÿ Böÿ

Job Description of Financial Manager

Simple Job Description of Financial Manager

Financial manager are responsible for managing financial resources of an organization. Basically those who make financial plan for effective use of the fund to ensure organizational wealth maximization are known as financial manager. The success of an organization depends on the right use of the financial resource, although it is very tough job to manage. But financial manager/ finance manager always work for collecting fund from least costly sources and invest in potential sector where maximization of return is insured.

Job Description of Financial Manager

A job description contains a list of responsibilities that have to be performed by a financial manager/ finance manager. It also contains what are the qualities and qualifications are required to be a finance manager. A simple job description may include followings:

  1. Title of the Job: This indicates the position of financial manager that is position can be of assistant manager / manager / senior manager.
  2. Role of the Job or job responsibilities: There are several roles that a manager have to perform, these are
  • Required to formulate financial planning and taking financial decision as per requirement of the company.
  • Preparing monthly/ quarterly/ yearly budget for the company.
  • Monitoring cash inflow and outflow over the period.
  • Preparing reports and financial statements.
  • Ensuring wealth maximization of the company as it is primary goal.
  • Prepare financial report to check the performance of the company, that whether the performance is upward or downward.
  • Make forecast of future demand of the fund and take initiative to manage this fund timely.
  • Maintain good relationship with the creditor.
  • Ensuring balance between long term and short term asset and liabilities.
  • Formulating collection and payment mechanism (collection of accounts receivable, payout the accounts payable)
job description of financial manager

Simple Job Description of Financial Manager

  1. Location of the Job: Location of job or workplace for the manager, current location or probable future location need to be mention clearly.
  2. Remuneration/ Benefit of the Job: The amount of remuneration which will be provided for the financial manager over the period is needed to be mentioned. Because this one is the influential factor that that will create interest of working.