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CHAPTER: 1.

00
ORIENTATION OF THE TERM PAPER
1.1 INTRODUCTION
The term Paper tries to visualize “Capital Structure Decisions” and
represent the facts that include features of Capital structure,
determinants of capital structure, patterns or forms of capital structure,
types and theories of capital structure, theory of optimal capital
structure, risk associated with capital structure, external assessment of
capital structure and some assumption related to capital structure.

The following sections in this chapter represent an orientation of the


Term Paper.

1.2 ORIGIN OF THE TERM PAPER

The students pursuing the MBA program at the Institute of Business


Administration, University of Rajshahi has prepared the Term Paper,
“Capital Structure Decisions” to fulfill the partial requirement of the
course, Financial Management (C-620).

1.3 OBJECTIVES OF THE TERM PAPER


The objectives of the Term Paper are portrayed below:

1.3.1 BROAD OBJECTIVE


• To determine features of Capital structure,
• To know about the determinants of capital structure
• To evaluate the patterns or forms of capital structure
• To identify the types and theories of capital structure
• To analyze the theory of optimal capital structure
• To determine the risk associated with capital structure
• To have an overview about external assessment of capital
structure
• To know about the assumption related to capital structure.

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1.3.2 SPECIFIC OBJECTIVE
• Have the knowledge about how the capital structure
decisions.

1.4 SCOPE OF THE TERM PAPER


“Capital structure decisions” has been covered in this Term Paper.
Within a short time frame, the paper came to its existence with the
following highlighted facts:
• Features of Capital structure,
• Determinants of capital structure
• Patterns or forms of capital structure
• Types and theories of capital structure
• Theory of optimal capital structure
• Risk associated with capital structure
• External assessment of capital structure
• Assumption related to capital structure.

The Term paper provides itself as the conspicuous view of the capital
structure and open up the facts that leads to making decisions.

1.5 METHODOLOGY
The ultimate goal of the Term Paper is to discover the facts concerned
with capital structure decisions. So a well-planned research
methodology has been formulated to get a conspicuous view. In this
section, research processes that been followed while prepared the
Term Paper is been listed:

1.5.1 SOURCES OF INFORMATION:

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• Books on Financial Management
• Articles published on capital structure both in the country and
all across the world
• Search out different websites for data collection related to
capital structure decisions.
• Lecture notes of the course Financial Management

1.5.2 JUSTIFICATION OF THE INFORMATION:


• All the information have been examined and analyzed to
evaluate their justification.

Finally, input the appropriate information into the Term Paper.


1.6 LIMITATIONS
Limitations we had to face on preparing the Term Paper are portrayed
below:
• In-experience on preparing this sort of Term Paper
• In-available information related to the Term Paper
• Improper knowledge on technological know how.
• Language proficiency
• Time constraints

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CHAPTER: 2.00
OVERVIEW OF FINANCIAL MANAGEMENT

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2.1 FINANCIAL MANAGEMENT
Finance can be defined as the art and science of managing
money. Finance is concerned with the process, institutions,
markets, and instruments involved in the transfer of money
among individuals, businesses, and governments.

On the other hand Financial Management is concerned with the


planning and controlling of resources. It is defined by the
functions of financial managers. Three (3) things should be
managed,

• Investment Decision
• Financing Decision
• Managing Resources
Financial Services is the area of finance concerned with the
design and delivery of advice and financial products to
individuals, businesses, and government. Career opportunities
include banking, personal financial planning, investments, real
estate, and insurance.

2.2 GOAL OF THE FIRM

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Actions of the financial manager should be taken to achieve the
objectives of the firm’s owners, its stockholders. Thus financial
managers need to know what the objectives of the firm’s are.
• Profit maximization
• Wealth maximization

PROFIT MAXIMIZATION

To achieve this goal, the financial manager would take only those
actions that were expected to make major contribution to the firm’s
overall profits. Corporations commonly measure profits in terms of
earning per share (EPS). The objections of profit maximization are,

• The concept is vague


• It ignores time dimension of financial decision
• It ignores the risk dimension of financial
decision
• Profit do not necessarily result in cash flows
available to the stockholders

WEALTH MAXIMIZATION

The goal of the firm, and therefore of all managers and employees is to
maximize the wealth of the owners for whom it is being operated. The
wealth of corporate owners is measured by the share price of the
stock. Maximizing shareholder wealth properly considers cash flows,
the timing of these cash flows, and the risk of these cash flows.

2.3 FINANCIAL INSTITUTIONS


Financial institutions serve as intermediaries by channeling the savings
of individuals, business and governments into loan or investments. The
key suppliers and demanders of funds are individuals, businesses, and
governments. In general, individuals are net suppliers of funds, while
businesses and governments are net demanders of funds.

Firms have ongoing needs of funds. They can obtain funds through the
following ways,

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• Financial Institutions
• Financial Market
• Private Placement

2.4 FINANCIAL MARKETS

Financial markets are organized forums in which the suppliers and


demanders of various types of funds can make transaction. The two
key financial markets are the money market and the capital market

Transactions in short term marketable securities take place in the


money market while transactions in long-term securities take place in
the capital market. Whether subsequently traded in the money or
capital market, securities are first issued through the primary market.
The primary market is the only one in which a corporation or
government is directly involved in and receives the proceeds from the
transaction.

Once issued, securities then trade on the secondary markets such as


the New York Stock Exchange or NASDAQ.

THE MONEY MARKET


The money market exists as a result of the interaction between the
suppliers and demanders of short-term funds (those having a maturity
of a year or less). Most money market transactions are made in
marketable securities which are short-term debt instruments such as T-
bills and commercial paper. Money market transactions can be
executed directly or through an intermediary.

THE CAPITAL MARKET

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The capital market is a market that enables suppliers and demanders
of long-term funds to make transactions. The key capital market
securities are bonds (long-term debt) and both common and preferred
stock (equity). Bonds are long-term debt instruments used by
businesses and government to raise large sums of money or capital.
Common stocks are units of ownership interest or equity in a
corporation.

The following figure will show how funds flow between financial
institutions and financial markets,

Flow of funds for financial institutions and markets

2.5 BASIC FORMS OF BUSINESS ORGANIZATION


Three most common legal forms of business organizations are the sole
proprietorship, the partnership and the corporation. Other specialized
forms of business organization also exist. Sole proprietorship is the
most numerous. However, corporations are overwhelmingly dominant

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with respect to business receipts and net profits. The advantages and
disadvantages of different types of business are as follows

SOLE PROPRIETORSHIP
A sole proprietorship is a business own by one person who operates it
for his or her own profit. About 75% of all business farms are sole
proprietorships. The strengths and weaknesses are as follows,

STRENGTHS: WEAKNESSES:
• Low organizational cost • Unlimited liability
• Income taxed once as personal • Limited funding
income • Proprietor must be all
• Independence • Difficult to develop staff career
• Secrecy opportunities
• Ease of dissolution • Lack of continuity on death of
proprietor

PARTNERSHIP
A partnership consists of two or more owners doing business togather
for profit. Partnerships account for about 10% of all businesses and
they are typically larger that sole proprietorships. Finance, Insurance
and Real estate firms are the most common types of partnerships. The
written contract used to formally establish a business partnership.

STRENGTHS: WEAKNESSES:
• Improved funding sources • Unlimited liability to all partners
• Increased managerial talent • Partnership dissolved upon death
• Income split by partnership of partner
contract, taxed as personal • Difficult to liquidate or transfer
income ownership

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CORPORATION
A corporation is an artificial being created by law. Often called a “legal
entity”, a corporation has the powers of an individual in that it sue and
be sued, make and be party to contracts, and acquire property in it
own name. Although only about 15% of all businesses are
incorporated, the corporation is the dominant form of business
organizations in term of recipts and profits. The strengths and
weakness are as follows,

STRENGTHS: WEAKNESSES:
• Owners’ liability limited • Higher tax rates
• Large capitalization possible, • Expensive organization
greater funding • Greater government
• Ownership readily transferable regulation
• Indefinite life • When publicly traded, lacks
• Professional management secrecy

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CHAPTER: 3.00
CAPITAL STRUCTURE DECISIONS

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3.1 INTRODUCTION

Capital Structure is one of the most complex areas of financial


decision making because of its interrelationship with other
financial decision variables. Poor capital structure decisions can
result in a high cost of capital thereby lowering the NPVs of
projects and making more of them unacceptable. In practical
sense, a firm can probably more readily increase its value by
improving quality and reducing costs than by fine tuning its
capital structure. Effective capital structure decision can lower
the cost of capital, resulting in higher NPVs and more acceptable
projects, and thereby increasing the value of the firm.

A firm’s major decision is its financing decisions which are


analyzed in the theory of corporate capital structure and based
on the model developed by Dodd (1986), capital structure is
determined mainly by three agency costs variables- agency-
equity, agency-debt & bankruptcy risk and other potential
variables such as growth rate, profitability and operating
leverage.

The firm’s capital structure should result from balancing the costs
of certain relationships between firm related groups. Sometime
agent does not act in line with the set objectives of the principal.

• Shareholders are the owner of the firm. If shareholders


value increases they will be benefited and vice-versa.
Shareholders value maximization depends on managers
activities. But as a rational being, managers try to maximize
their own interest. As a result agency and equity cost arises
which tend to discourage the use of equity.

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• Debt holders have no voice on management issue.
Managers are accountable only to the firm. So, they are
trying to maximize the wealth of shareholders not debt
holders. So, conflict arises between managers and debt
holders. There is an agency-debt cost which discourages the
issuance of debt.

• There is a possibility of bankruptcy if the firm taking


more debt capital. Because the greater the firms debt
capital, higher the possibility of default on interest and
capital repayment.
• Three other potential determinants of capital structure
are also included in the model developed by Dodd. Firms
growing at higher rates should have higher debt ratios than
firms with lower growth rates. The relationship between
debt ratios and growth rate is expected to be positive. Firms
with higher profitability ratio may be expected to have more
equity than firms with lower ratios. Management of
companies with high operating leverage may use lower
levels of financial leverage i.e, debt.

3.2 CAPITAL STRUCTURES

Capital structure is the manner in which a firm’s assets are


financed; that is, the right-hand side of the balance sheet. Capital
structure is normally expressed as the percentage of each type of
capital used by the firm--debt, preferred stock, and common
equity.

Combination of capital is called capital structure. The firm may


use only equity, or only debt, or a combination of equity and

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debt, or a combination of equity, debt, preference shares or may
use other similar combinations.

3.3 FEATURES OF AN APPROPRIATE CAPITAL STRUCTURE

Capital structure is that level of debt-equity proportion where the


market value per share is maximum and the cost of capital is
minimum.

Appropriate capital structure should have the following features


• Profitability / Return
• Solvency / Risk
• Flexibility
• Conservation / Capacity
• Control

3.4 DETERMINANTS OF CAPITAL STRUCTURE


Formation of Capital structure depends on many factors which
are normally called the determinants of Capital structure. The
determinants based on which capital structure were formed are
listed below,
• Seasonal Variations
• Tax benefit of Debt
• Flexibility
• Control
• Industry Leverage Ratios
• Agency Costs
• Industry Life Cycle
• Degree of Competition
• Company Characteristics
• Requirements of Investors

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• Timing of Public Issue
• Legal Requirements

3.5 PATTERNS / FORMS OF CAPITAL STRUCTURE


Following are the forms of capital structure:

• Complete equity share capital;


• Different proportions of equity and preference share
capital;
• Different proportions of equity and debenture (debt)
capital and
• Different proportions of equity, preference and debenture
(debt) capital.

3.6 CAPITAL STRUCTURE THEORY

Capital structure theory provides some insights into the value of


debt versus equity financing. Modern capital structure theory
began in 1958, when Modigliani and Miller proved, under a very
restrictive set of assumptions, that a firm’s value is unaffected by
its capital structure. There are 4 theories:
• NI approach (net income approach)
• NOI approach (net operating income approach)
• MM approach (Modigliani-Millar Approach)
• Traditional approach

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NI APPROACH (NET INCOME APPROACH)

When you raise debt, leverage will increase. The overall values of
the firm will increase. Debt will have lower cost, so overall cost of
capital will reduce (it is better if the cost of capital reduces).
V = S+ D
Where,
V = value of the firm, S = equity, D = debt

An increase in leverage will increase the value of the firm, it will


raise EPS, it will raise the market price of the shares and it will
reduce weighted average cost of capital, thus leverage is always
beneficial.

NOI APPROACH (NET OPERATING INCOME APPROACH)

Capital structure decision is irrelevant. If you raise debt, the cost


of equity will increase. The overall cost of capital will remain
constant in spite of leverage. Thus there is no advantage of
raising debt. As we raise the debt, the cost of equity increases in
the same proportion. The market discounts the firm, which is
leveraged. Thus capital structure decision has no relevance.

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According to NOI approach the value of the firm and the weighted
average cost of capital are independent of the firm’s capital
structure. In the absence of taxes, an individual holding all the
debt and equity securities will receive the same cash flows
regardless of the capital structure and therefore, value of the
company is the same.

MM APPROACH WITHOUT TAX

The firm’s value is independent of its capital structure. With


personal leverage, shareholders can receive exactly the same
return, with the same risk, from a levered firm and an un-levered
firm. Thus, they will sell shares of the over-priced firm and buy
shares of the under-priced firm until the two values equate. This
is called arbitrage.

The cost of equity for a levered firm equals the constant overall
cost of capital plus a risk premium that equals the spread
between the overall cost of capital and the cost of debt multiplied
by the firm’s debt-equity ratio. For financial leverage to be
irrelevant, the overall cost of capital must remain constant,
regardless of the amount of debt employed. This implies that the
cost of equity must rise as financial risk increases.

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MM APPROACH WITH TAX

Under current laws in most countries, debt has an important


advantage over equity: interest payments on debt are tax
deductible, whereas dividend payments and retained earnings
are not. Investors in a levered firm receive in the aggregate the
un-levered cash flow plus an amount equal to the tax deduction
on interest. Capitalizing the first component of cash flow at the
all-equity rate and the second at the cost of debt shows that the
value of the levered firm is equal to the value of the un-levered
firm plus the interest tax shield which is tax rate times the debt
(if the shield is fully usable).

It is assumed that the firm will borrow the same amount of debt
in perpetuity and will always be able to use the tax shield. Also, it
ignores bankruptcy and agency costs.

TRADITIONAL APPROACH

It says that with the use of debt, the overall cost of capital comes
down up to some extent and thereafter the overall cost of capital
increases. Thus there is an ideal point, up to which the overall
cost of capital will decrease with the help of increase in debt,
beyond which the use of debt is detrimental to the company.

3.7 THEORY OF OPTIMAL CAPITAL STRUCTURE

This theory states that we can have an optimum capital structure


– as we raise the debt, we can raise the value of the firm to some
extent. Thus level of debt can be increased up to some level. That
level is the ideal capital structure. Ultimate objective of Finance
manager is to raise the value of the firm and raise the wealth –
which is possible by an ideal capital structure.

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3.8 TYPES OF CAPITAL
All of the items on the right-hand side of the firm’s balance sheet,
excluding current liabilities, are sources of capital. The following
simplified balance sheet illustrates the basic breakdown of total
capital into its two components, debt capital and equity capital.

Balance Sheet

Current
Debt
Liabilities
Capital
Long term
Total Capital
Assets:
• Stockholder’s
Equity Capital
equity
• Preferred stock
• Common stock
equity

3.9 DESIGN COST OF CAPITAL


Capital of a firm can be designed by considering the following
facts

• It should minimize cost of capital


• It should reduce risks
• It should give required flexibility
• It should provide required control to the owners

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• It should enable the company to have adequate
finance.

3.10 RISKS ASSOCIATED WITH CAPITAL STRUCTURE DECISIONS


Meaning of risk is variability in income. Business risk is the
situation, when the EBIT may vary due to change in capital
structure. It is influenced by the ratio of fixed cost in total cost. If
the ratio of fixed cost is higher, business risk is higher. Financial
risk is the variability in EPS due to change in capital structure. It is
caused due to leverage. If leverage is more, variability will be
more and thus financial risk will be more.

BUSINESS RISK

Business risk is the risk inherent in the operations of the firm,


prior to the financing decision. Thus, business risk is the
uncertainty inherent in a total risk sense, future operating
income, or earnings before interest and taxes (EBIT). Business
risk is caused by many factors. Two of the most important are
sales variability and operating leverage.

FINANCIAL RISK

Financial risk is the risk added by the use of debt financing. Debt
financing increases the variability of earnings before taxes (but
after interest); thus, along with business risk, it contributes to the
uncertainty of net income and earnings per share. Business risk
plus financial risk equals total corporate risk.

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3.11 USE OF FINANCIAL LEVERAGE IN CAPITAL STRUCTURE
The use of the fixed-charges sources of funds, such as debt and
preference capital along with the owners’ equity in the capital
structure, is described as financial leverage or gearing or trading
on equity.

Operating leverage is the extent to which fixed costs are used in


a firm’s operations. If a high percentage of a firm’s total costs are
fixed costs, then the firm is said to have a high degree of
operating leverage. Operating leverage is a measure of one
element of business risk, but does not include the second major
element, sales variability.

Financial leverage is the extent to which fixed-income securities


(debt and preferred stock) are used in a firm’s capital structure. If
a high percentage of a firm’s capital structure is in the form of
debt and preferred stock, then the firm is said to have a high
degree of financial leverage.

The financial leverage employed by a company is intended to


earn more return on the fixed-charge funds than their costs. The
surplus (or deficit) will increase (or decrease) the return on the
owners’ equity. The rate of return on the owners’ equity is
levered above or below the rate of return on total assets.
Financial Leverage can be measured by
• Debt ratio,
• Debt-equity ratio and
• Interest coverage.

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The first two measures of financial leverage can be expressed
either in terms of book values or market values. These two
measures are also known as measures of capital gearing.

The third measure of financial leverage, commonly known as


coverage ratio. The reciprocal of interest coverage is a measure
of the firm’s income gearing

3.12 ASSUMPTION OF CAPITAL STRUCTURE THEORIES


Assumptions related to capital structure are as follows
• There are only two sources of funds i.e.: debt and equity.
• The total assets of the company are given and do no
change.
• The total financing remains constant. The firm can change
the degree of leverage either by selling the shares and
retiring debt or by issuing debt and redeeming equity.
• Operating profits (EBIT) are not expected to grow.
• All the investors are assumed to have the same expectation
about the future profits.

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• Business risk is constant over time and assumed to be
independent of its capital structure and financial risk.
• Corporate tax does not exist.
• The company has infinite life.
• Dividend payout ratio = 100%.

3.13 EXTERNAL ASSESSMENT OF CAPITAL STRUCTURE

Financial leverage results from the use of fixed-cost financing,


such as debt and preferred stock, to magnify return and risk. The
amount of leverage in the firm’s capital structure can affect its
value by affecting return and risk. Those outside the firm can
make a rough assessment of capital structure by using measures
found in the firm’s financial statements

Measures of the firm’s ability to meet contractual payments


associated with debt include the times interest earned ratio and

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the fixed- payment coverage ratio. These ratios provide indirect
information on financial leverage.

3.14 FACTORS TO CONSIDER IN MAKING CAPITAL STRUCTURE DECISIONS

Concern Factor Description


Business Revenue Firms that have stable and
risk stability
predictable
revenues can more safely undertake
highly
leveraged capital structures than

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can firms
with volatile patterns of sales
revenue. Firms
with growing sales tend to benefit
from
added debt; they can reap the
positive
benefits of financial leverage, which
magnifies the effect of these
increase.
Cash flow When considering a new capital
structure,
the firm must focus on its ability to
generate
the cash flows necessary to meet
obligations. Cash forecasts reflecting
and
ability to service debts and preferred
stock
must support any shift in capital
structure.
Agency Contractual A firm may be contractually
cost obligation
constrained
with respect to the type of funds
that it can
raise. Contractual constraints on the
sale of
additional stock ,as well as on the
ability to
distributes dividends on stock might
also

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exist
Management A firm will impose an internal
Preferences
constraint on
the use of debt to limits its risk
exposure to
a level deemed acceptable to
management.
Control A management group concerned
about
control may prefer to issue debt
rather than
(voting) common stock. Generally, in
closely held firms or firms
threatened by
takeover does control become a
major
concerned in the capital structure
decision.
Asymmetr External risk The. The firm’s ability to raise funds
ic assessment
quickly and at favorable rates
informatio
n depends on the external risk
assessments of lenders and bond
rates. The firm must consider the
impact of capital structure decisions
both on share value and on
published financial statements from
which lenders and bond raters.

Timing At the time when interest rates are


low, debt financing might be more
attractive; when interest rates high,
the sales of stock may be more

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appealing.

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CHAPTER: 4.00
FINDINGS AND
CONCLUSION

4.1 FINDINGS
Capital Structure makes a difference to the organizations overall
retained earning. Such measures have consistently promoted
business performance criteria such as profit, sales and
productivity.

The overall findings from this term paper are listed below,

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• Capital structure has a substantial impact on overall
profitability
• Leverage has also some impact on capital structure decision
• When making capital structure decision firm consider
different types of risks
• Tax rate makes a substantial impact over the profitability of
the farm when debt capital were use
• If debt, common equity and preferred equity were used in
capital structure the firms profitably will increase

4.2 CONCLUSION
This paper uses a novel data set to explore the capital structure
decisions that firms make in their operations. In the vast majority

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of cases, this is when the firms in question still are being
incubated in their founders’ homes or garages, before outside
employees have joined the firm in any numbers, and certainly
well before the firms in question would be attractive to the types
of funding sources that are the focus of most discussions of early
stage financing. Despite these firms being at the very beginning
of life, they rely to a surprising degree on outside capital. Roughly
80 percent to 90 percent of most firms’ startup capital is made up
in equal parts of owner equity and bank debt. While a large
fraction of this bank debt is owed by the founder, rather than the
firm, the fact that the debt is financed through arm’s length
relationships, and not through family and friends networks, is
worthy of further research. To be sure, our findings underscore
the importance of liquid credit markets for the formation and
success of young firms. If firms hold the key to growth in
economies, then surely economic growth hinges critically on the
smooth functioning of credit markets that enable young firms to
be formed, to grow, and to succeed.

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REFERENCES
BOOKS

• Lawrence J. Gitman (2009-2010) “Principles of


Managerial Finance, 12th Edition”,
Prentice-Hall India

WEBSITES
• Md. Tauhidul Alam-10: 30 AM (25-06-09)
HTTP://WWW.ESNIPS.COM

OTHER
• Lecture Notes of Financial Management

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