optimum credit term exists when average rate of return My QA

A large part of profits may be ploughed back in the year when a firm has number of highly profitable investment opportunities. Stability in level of earnings indeed is a basic condition for pursuing this policy. Firms with erratic fluctuations in level of earnings may find it extremely difficult to follow stable dividend policy.

optimum credit term exists when

The students should note that both in the case of debt and preference shares, the cost of capital is computed with reference to the obligations incurred and proceeds received. The net proceeds received must be taken into account while computing cost of capital. For preference shares, the dividend rate can be considered as its cost, since it is this amount which the company wants to pay against the preference shares. Like debentures, the issue expenses or the discount/premium on issue/redemption are also to be taken into account. Thus, to the company, the cost of capital is the minimum rate of return that the company must earn on its investments to fulfill the expectations of the investors. An important objective of financial management would be to make timely payment of taxes to the Government – so as to avoid legal consequences; and also fulfill its social obligations towards the State.

Financing of Long-Term Working Capital: 5 Sources

Robert N. Anthony, explained it as “Accounts receivables are amounts owed to the business enterprise, usually by its customers. Sometimes it is broken down into trade accounts receivables; the former refers to amounts owed by customers, and the latter refers to amounts owed by employees and others”. When a firm delays the payment beyond the due date as per the terms of sales https://1investing.in/ invoice, it is called stretching accounts payable. A firm may generate additional short-term finances by stretching accounts payable, but it may have to pay penal interest charges as well as to forgo cash discount. If a firm delays the payment frequently, it adversely affects the credit worthiness of the firm and it may not be allowed such credit facilities in future.

optimum credit term exists when

There should be judicious mix of debt and equity in the capital structure of a firm so that the business does not to bear undue financial risk. Management of cash and other current assets is an important task of financial manager. It involves forecasting the cash inflows and outflows to ensure that there is neither shortage nor surplus of cash with the firm. Sufficient funds must be available for purchase of materials, payment of wages and meeting day-to-day expenses. Shares of a company are traded on stock exchange and there is a continuous sale and purchase of securities. Hence a clear understanding of capital market is an important function of a financial manager.

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The demand is influenced greatly by the available market opportunities. If there are a lot of production opportunities in the market, more and more entrepreneurs will explore those opportunities to create profitable ventures. Entrepreneurs, then, would require capital to implement their business ideas.

Sell some shares of X ltd. and loan it out such that he creates a personal debt-equity ratio equal to that of the firm. By raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value. Changing the capital structure if and only if the value of the firm increases and stockholder wealth is constant.

Its aim is to develop as a business school of excellence over time in Punjab. Degree of financial leverage is a measure of relationship between ___________. MM Proposition II that the cost of equity is always constant. At breakeven and debt is the better choice below breakeven because small payments can be made.

What factors affect working capital requirement?

Explain the strength and weakness of company adding debt in their capital structure. Illustrate the method of computing cost of preference shares with the help of an example. 4.__________ is the most important investment decision because it determines the risk-return characteristics of the portfolio.

  • Due to its short term approach, this method is particularly suited to a firm which has shortage of cash or whose liquidity position is not particularly good.
  • The optimal capital structure of a company refers to the proportion in which it structures its equity and debt.
  • In this form of dividends, the firm issues additional shares of its own stock to the stockholders in proportion to the number of shares held in lieu of cash dividends.
  • It is flexible as the credit increases with the growth of the firm.

Economic boom and recession also play a very important role in determining the cost of capital by impacting the interest rates in the market. Weights (i.e., proportion of each, source of fund in the capital structure) are to be computed and assigned to each type of funds. This implies multiplication of each source of capital by appropriate weights.

Receivable management

Short-term budgets, on the other hand, may be influenced by the financial resources. Of course, in case of an emergency need, the funds are to be procured/arranged from different sources so that the project may be taken up. This analysis cannot determine the state of over-capitalization of a firm.

  • If the stock holders prefer cash to additional stock in the company, they can sell the stock received as dividend.
  • The financial leverage, capital structure, dividend policy, working capital management, financial decision, appraisal of financial performance of top management etc. are greatly influenced by the cost of capital.
  • Practically, it is not so easy to make a proper synchronization of inflows and outflows of cash.
  • We have seen that EBIT-EPS analysis examines the effect of financial leverage on the behavior of EPS under various financing plans with varying levels of EBIT.

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Thus, the cost of equity share capital is computed on the basis of the present value of the expected future stream of dividends. The capital structure of a firm normally includes the debt capital. Debt may be in the form of debentures bonds, term loans from financial institutions and banks etc.

If cost of raising funds is very high then such sources may not be useful for long. As per the traditional approach, there exists an optimal capital structure at which firms cost of capital is minimum and firm’s value is maximum. Traditional approach suggests that a firm should make judicious use of both the debt and the equity so as to achieve a capital structure which may be called the optimum capital structure. The traditional view point states that there are three stages in which one can view the relationship between capital structure and firm’s overall cost of capital . Now value of equity is equal to the discounted value of income available for equity shareholders.

TheInvestment Decisionrelates to the decision made by the investors or the top-level management with respect to the amount of funds to be deployed in the investment opportunities. The techniques of capital budgeting require estimation of future cash inflows and outflows. The future is always uncertain and the data collected for future may not be exact. Obliviously the results based upon wrong data may not be good.

It involves optimization of resources available for holding stock of various materials. If there is shortage of inventory, it leads to stock-outs, causing stoppage of production and a very high inventory will result in increased cost due to cost of carrying inventory. The first one which is granted by the creditors is considered unfit as it affects intermediate product meaning the credit reputation of the firm. Of course, in the absence of cash discounts, there is a good possibility that such costs are hidden in the prices of the goods which may be impossible to measure’. If discounts are available, the said amount of discount may be compared with the benefits which may accrue if the said payments are diverted elsewhere.