What should a firm do when it finds that its desired capital structure differs significantly from its current capital structure? There are two basic choices: change its capital structure slowly or change it more quickly. A firm can alter its capital structure slowly by adjusting its future financing mix appropriately. For example, suppose a firm’s target capital structure consists of 35% long-term debt and 65% common equity, and its current capital structure consists 25% long-term debt and 75% common equity. The firm could cure the under leveraged condition by using long-term debt for all new external financing until the long-term debt ratio reached 35%. However, this means that the firm’s capital structure would continue to be “suboptimal” while the firm changed it over time. Alternatively, the firm can change its capital structure quickly through an exchange offer, recapitalization offer, debt or share repurchase, or stock-for-debt swap. Of course, such a Continue reading
Financial Management Concepts
Income Statement or Profit and Loss Account – Meaning, Format and Explanation
The earning capacity and potential of the firm are reflected by the Income Statement or the Profit and Loss Account. The profit and loss account is the “scoreboard” of the firm’s performance during a particular period of time (usually one year). Since it reflects the results of operations for a period of time, it is a flow statement. In contrast, the balance sheet is a stock, or status statement as it shows assets, liabilities and owners’ equity at a point of time. The profit and loss account presents the summary of revenues, expenses and net income (or net loss) of a firm for a period of time. Net income is the amount by which the revenues earned during a period exceed the expenses incurred during that period. If the firm’s operations prove to be unprofitable, total expenses will exceed total revenues and the difference is referred to Continue reading
Capital Budgeting- Definition, Nature and Procedure
Meaning of Capital Budgeting Capital expenditure budget or capital budgeting is a process of making decisions regarding investments in fixed assets which are not meant for sale such as land, building, machinery or furniture. The word investment refers to the expenditure which is required to be made in connection with the acquisition and the development of long-term facilities including fixed assets. It refers to process by which management selects those investment proposals which are worthwhile for investing available funds. For this purpose, management is to decide whether or not to acquire, or add to or replace fixed assets in the light of overall objectives of the firm. What is capital expenditure, is a very difficult question to answer. The terms capital expenditure are associated with accounting. Normally capital expenditure is one which is intended to benefit future period i.e., in more than one year as opposed to revenue expenditure, the Continue reading
Decision Making Conditions
There are different conditions in which decisions are made. Managers sometimes have an almost perfect understanding of conditions surrounding a decision, but in other situations they may have little information about those conditions. So, the decision maker must know the conditions under which decisions are to be made. Generally, the decision maker makes decision under the condition of certainty, risk and uncertainty. 1. Certainty Certainty is a condition under which the manager is well informed about possible alternatives and their outcomes. There is only one outcome for each choice. When the outcomes are known and their consequences are certain, the problem of decision is to compute the optimum outcome. Similarly, if there are more than one alternative they are evaluated by conducting cost studies of each alternative and then choosing the one which optimizes the utility of the resources. The condition of certainty exists in case of routine decisions such Continue reading
Fixed Assets Accounting
Unless internal controls over plant and equipment are carefully designed many units of equipment are likely to be broken, discarded or stolen without any entry being made in the accounting records for their disposal. The assets accounts will then be overstated and depreciation programs for such missing unites of equipment will presumably continue. Consequently net income will be misstated because of the omission of losses on retirement of plant assets and because of erroneous depreciation charges. One important control devise which guards against failure to record the retirement of assets is the use of controlling accounts and subsidiary ledgers for plant and equipment. The general ledger ordinarily contains a serpent assets account and related depreciation accounts for each major classification of plant assets, such as land, buildings, office equipment and deal very equipment. For example the general ledger will contain the account office equipment and also the related accounts depreciation Continue reading
Demand and Supply of Capital for Investments
Demand for Capital The demand schedule for capital refers to the arrangement of the various proposed projects in a descending order according to their estimated rates of return together with required amounts of capital needed by the respective projects. Before analyzing the investments, the management must understand the nature of opportunities. Some investments are complimentary i.e. making one investment implies that another investment will be necessary. Some investments are mutually exclusive i.e. acceptance of one, implies rejection of others and some investments are independent. It is therefore necessary to identify the various opportunities of investments. Alternative investments can be ranked according to their relative profitability. It is also important to distinguish between cost reducing investment and revenue increasing investment. According to W.W. Haynes “any investment decision is profitable if it adds more to revenue than to cost or if it reduces cost more than the revenue.” An important element in Continue reading