Financial Management

Unit 2

Unit 2

Financial Planning

Structure: 2.1 Introduction Learning Objectives Objectives of financial planning Benefits that accrue to a firm out of financial planning Guidelines for financial planning 2.2 Steps in Financial Planning Forecast of income statement Forecast of balance sheet Computerised financial planning system 2.3 Factors affecting Financial Plan 2.4 Estimation of Financial Requirements of a Firm 2.5 Capitalisation Cost theory Earnings theory Over-capitalisation Under-capitalisation 2.6 Summary 2.7 Terminal Questions 2.8 Answers to SAQs and TQs

2.1 Introduction
Liberalisation and globalisation policies initiated by the government have changed the dimension of business environment. Therefore, for survival and growth, a firm has to execute planned strategies systematically. To execute any strategic plan, resources are required. Resources may be manpower, plant and machinery, building, technology or any intangible asset. To acquire all these assets, financial resources are essentially required. Therefore the finance manager of a company must have both long-range and short-range financial plans. Integration of both these plans is required for the effective utilisation of all the resources of the firm.

Sikkim Manipal University

Page No. 18

Financial Management

Unit 2

The long-range plans must include: Funds required for executing the planned course of action Funds available at the disposal of the company Determination of funds to be procured from outside sources 2.1.1 Learning objectives After studying this unit you should be able to: Explain the steps involved in financial planning. Explain the factors effecting financial planning. List out the cases of over-capitation. Explain the effects of under-capitation. 2.1.2 Objectives of financial planning Let us start with defining financial planning as an essential objective. Financial planning is a process by which funds required for each course of action is decided. A financial plan has to consider capital structure, capital expenditure and cash flow. Decisions on the composition of debt and equity must be taken. Financial planning or financial plan indicates: The quantum of funds required to execute business plans Composition of debt and equity, keeping in view the risk profile of the existing business, new business to be taken up and the dynamics of capital market conditions Formulation of policies, giving effect to the financial plans under consideration 2.1.3 Benefits of financial planning Financial planning also helps firms in the following ways. A financial plan is at the core of value creation process. A successful value creation process can effectively meet the bench-marks of investors expectations. Financial planning ensures effective utilisation of the funds. To manage shortage of funds, planning helps the firms to obtain funds at the right time, in the right quantity and at the least cost as per the requirements of finance emerging opportunities. Surplus is deployed through well
Sikkim Manipal University Page No. 19

Financial Management

Unit 2

planned treasury management. Ultimately, the productivity of assets is enhanced. Effective financial planning provides firms the flexibility to change the composition of funds that constitute its capital structure in accordance with the changing conditions of the capital market. Financial planning helps in formulation of policies and instituting procedures for elimination of wastages in the process of execution of strategic plans. Financial planning helps in reducing the operating capital of a firm. Operating capital refers to the ratio of capital employed to the sales generated. Maintaining the operating capability of the firm through the evolution of scientific replacement schemes for plant and machinery and other fixed assets will help the firm in reducing its operating capital. Operating capital = Capital employed / Sales generated A study of annual reports of Dell computers will throw light on how Dell strategically minimised the operating capital required to support sales. Such companies are admired by investing community.

2.1.4 Guidelines for financial planning The following are the guidelines of a financial plan: Never ignore the coordinal principle that fixed asset requirements be met from the long term sources. Make maximum use of spontaneous source of finance to achieve highest productivity of resources. Maintain the operating capital intact by providing adequate out of the current periods earnings. Give due attention to the physical capital maintenance or operating capability. Never ignore the need for financial capital maintenance in units of constant purchasing power. Employ current cost principle wherever required. Give due weight age to cost and risk in using debt and equity. Keeping the need of finance for expansion of business, formulate plough back policy of earnings. Exercise thorough control over overheads.
Sikkim Manipal University Page No. 20

Financial Management

Unit 2

Seasonal peak requirements to be met from short term borrowings from banks.

2.2 Steps in Financial Planning

There are six steps involved in financial planning which are as shown in figure 2.1

Figure 2.1: Steps in financial planning

Establish corporate objectives The first step in financial planning is to establish corporate objectives. Corporate objectives can be grouped into qualitative and quantitative. For example, a companys mission statement may specify create economic value added. However this qualitative statement has to be stated in quantitative terms such as a 25 % ROE or a 12 % earnings growth rates. Since business enterprises operate in a dynamic environment, there is a need to formulate both short run and long run objectives.

Formulate strategies The next stage in financial planning is to formulate strategies for attaining the defined objectives. Operating plans helps achieve the purpose. Operating plans are framed with a time horizon. It can be a five year plan or a ten year plan.

Sikkim Manipal University

Page No. 21

Financial Management

Unit 2

Delegate responsibilities Once the plans are formulated, responsibility for achieving sales target, operating targets, cost management bench-marks, profit targets is to be fixed on respective executives. Forecast financial variables The next step is to forecast the various financial variables such as sales, assets required, flow of funds and costs to be incurred. These variables are to be translated into financial statements. Financial statements help the finance manager to monitor the deviations of actual from the forecasts and take effective remedial measures. This ensures that the defined targets are achieved without any overrun of time and cost.

Develop plans This step involves developing a detailed plan of funds required for the plan period under various heads of expenditure. From the plan, a forecast of funds that can be obtained from internal as well as external sources during the time horizon is developed. Legal constrains in obtaining funds on the basis of covenants of borrowings is given due weight-age. There is also a need to collaborate the firms business risk with risk implications of a particular source of funds. A control mechanism for allocation of funds and their effective use is also developed in this stage. Create flexible economic environment While formulating the plans, certain assumptions are made about the economic environment. The environment, however, keeps changing with the implementation of plans. To manage such situations, there is a need to incorporate an inbuilt mechanism which would scale up or scale down the operations accordingly.

2.2.1 Income Statement There are three methods of preparing income statement: Percent of sales method or constant ratio method Expense method Combination of both these two

Sikkim Manipal University

Page No. 22

Financial Management

Unit 2

Percent of sales method This approach is based on the assumptions that each element of cost bears some constant relationship with the sales revenue. Caselet Raw material cost is 40% of sales revenue for the year ended 31.03.2007. However, this method assumes that the ratio of raw material cost to sales will continue to be the same in 2008 also. Such an assumption may not look good in most of the situations. If in case, raw material cost increases by 10% in 2008 but selling price of finished goods increases only by 5%. In this case raw material cost will be 44 / 105 of the sales revenue in 2008. This can be solved to some extent by taking average for same representative years. However, inflation, change in government policies, wage agreements and technological innovation totally invalidate this approach on a long run basis. Budgeted expense method Expenses for the planning period are budgeted on the basis of anticipated behaviour of various items of cost and revenue. This demands effective database for reasonable budgeting of expenses. Combination of both these methods The combination of both these methods is used because some expenses can be budgeted by the management taking into account the expected business environment while some other expenses could be based on their relationship with the sales revenue expected to be earned. 2.2.2 Balance sheet The following steps discuss the forecasting of the balance sheet. Compute the sales revenue, having a close relationship with the items of certain assets and liabilities, based on the forecast of sales and the historical database of their relationship Determine the equity and debt mix on the basis of funds requirements and the companys policy on capital structure

Sikkim Manipal University

Page No. 23

Financial Management

Unit 2

Case Study The following details have been extracted from the books of X Ltd Table 2.1: Income statement 2006 Sales less returns Gross Profit Selling Expenses Administration Deprecation Operating Profit Non operating income EBIT (Earnings Before Interest & Tax) Interest Profit before tax Tax Profit after tax Dividend Retained earnings Table 2.2: Balance sheet Liabilities Shareholders fund Share capital Equity Preference Reserves and surplus Secured loans 120 50 122 100 120 50 224 120 Current assets, Loans and Advances Cash at bank Receivables 10 80 12 128 Investments 2006 2007 Assets Fixed assets Less depreciation 2006 400 100 300 50 2007 510 120 390 50 1000 300 100 40 60 100 20 120 15 105 30 75 38 37 2007 1300 520 120 45 75 280 40 320 18 302 100 202 100 102

Unsecured loans

50

60

Sikkim Manipal University

Page No. 24

Financial Management

Unit 2

Current liabilities Trade creditors Provisions Tax Proposed dividend 10 38 700 60 100 984 210 250

Inventories Loans and Advances Miscellaneous expenditure

200 50 10

300 80 24

700

984

Forecast the income statement and balance sheet for the year 2008 based on the following assumptions: Sales for the year 2008 will increase by 30% over the sales value for 2007. Use percent of sales method to forecast the values for various items of income statement using the percentage for the year 2007. Depreciation is charged at 25% of fixed assets. Fixed assets will increase by Rs.100 million Investments will increase by Rs.100 million Current assets and current liabilities are to be decided based on their relationship with the sales in the year 2007 Miscellaneous expenditure will increase by Rs.19 million Secured loans in 2008 will be based on its relationship with the sales in the year 2007 Additional funds required, if any, will be met by bank borrowings Tax rates will be 30 % Dividends will be 50 % of the profit after tax Non operating income will increase by 10% There will be no change in the total amount of administration expenses to be spent in the year 2008 There is no change in equity and preference capital in 2008 Interest for 2008 will maintain the same ratio as it has in 2007 with the sales of 2007 The forecast of the income statement and the balance sheet for the year 2008 has been briefly explained in table 2.3 and in the table 2.4

Sikkim Manipal University

Page No. 25

Financial Management

Unit 2

Table 2.3: Income statement Particulars Sales Cost of sales Gross profit Selling expenses Administration Depreciation Operating profit Non-operating income Earnings Before Interest and Taxes (EBIT) Interest Basis Increase by 30% Increase by 30% Sales-cost of sales 30% increase No change % given C - (D + E + F) Increase by 10% 1.1 x 40 Working 1300 x 1.3 780 x 1.3 1690-1014 120 x 1.3 Amount (Rs.) 1690 1014 676 156 45

390 100 4

123 (Rounded off) 352 44 396

18 of Sales 1300

18 1690 1300

Profit before tax Tax Profit after tax Dividends Retained earnings Table 2.4: Balance sheet Particulars Assets Fixed Assets Add: Addition Given Basis Working

23 (Decimal ignored) 373 112 261 130 131 Amount (Rs.) 510 100 610

Depreciation 1. Net fixed assets 2. Investments 3. Current Assets & Loans & advances Sikkim Manipal University

120 + 123

243 367 150

Page No. 26

Financial Management

Unit 2

Cash at bank Receivables Inventories Loans & Advances 4. Miscellaneous Expenditure Total Liabilities 1. Share Capital Equity Preference 2. Reserves & Surplus

12 1300 128 1300 300 1300 80 1300

Given

12 1690 1300 128 1690 1300 300 1690 1300 80 1690 1300
24 + 19

16 (Rounded off) 166 390 104 43 1236

120 50 Increase by current years retained earnings 355

3. Secured Loan Bank borrowings

60 1300

60 1690 1300

78 40 (Difference Balancing figure)

4. Unsecured Loan 5. Current Liabilities & Provision Trade creditors Provision for tax Proposed Dividend Total Liabilities

60

60

250 1300 60 1300

Current year given

250 1690 1300 60 1690 1300

325 78 130 1236

Sikkim Manipal University

Page No. 27

Financial Management

Unit 2

2.2.3 Computerised financial planning system All corporate forecasts use computerised forecasting models. Additional funds required to finance the increase in sales could be ascertained using a mathematical relationship based on the following: Additional Funds Required = Required Increase in Assets Spontaneous increase in Liabilities Increase in Retained Earnings (This formula has been recommended by Eugene F. Brigham and Michael C. Earnhardt in their book Financial Management Theory and Practice, 10th edition, published on 31st July 1998) Prof. Prasanna Chandra, in his book Financial Management,(6th editionmanohar publishers and distributors) has given a comprehensive formula for ascertaining the external financial requirements.

EFR =

A ( s) L ( s) ms (1-d) (1m + SR) S S

Here A ( s) = Expected increase in assets, both fixed assets and current S assets, required for the expected increase in sales in the next year. L ( s) = Expected spontaneous finance available for the expected S increase in sales. MS1 (1-d) = It is the product of profit margin, expected sales for the next year and the retention ratio. Retention ratio = 1 payout ratio Payout ratio refers to the ratio of the dividend paid to the earnings per share. 1m = Expected change in the level of investments and miscellaneous expenditure. SR = It is the firms repayment liability on term loans and debenture for the next year.

Sikkim Manipal University

Page No. 28

Financial Management

Unit 2

The formula described above has certain features: Ratios of assets and spontaneous liabilities to sales remain constant over the planning period Dividend payout and profit margin for the next year can be reasonably planned in advance Since external funds requirements involve borrowings from financial institution, the formula rightly incorporates the managements liability on repayments Solved Problem X Ltd. has given the following forecasts: Sales in 2008 will increase from Rs. 1000 to Rs. 2000 in 2007. The balance sheet of the company as on December 31, 2007 gives the details as shown below:
Table 2.5: Balance sheet Liabilities Share Capital Equity (Shares of Rs.10 each) Reserves & Surplus Long term loan Creditors for expenses outstanding Trade creditors Bills Payable 100 250 400 50 50 150 1000 1000 Rs. Assets Net Fixed Assets Inventories Cash Bills Receivable Rs. 500 200 100 200

Taking into account the following information, the external funds requirements for the year 2008 has to be ascertained: The companys utilisation of fixed assets in 2007 was 50 % of capacity but its current assets were at their proper levels. Current assets increase at the same rate as sales. Companys after-tax profit margin is expected to be 5%, and its payout ratio will be 60 %. Creditors for expenses are closely related to sales (Adapted from IGNOU MBA).
Sikkim Manipal University Page No. 29

Financial Management

Unit 2

Solution Preliminary workings A = Current assets = Cash + Bills Receivables + Inventories = 100 + 200 +200 = 500 A 500 ( s) 1000 Rs. 500 S 1000 L = Trade creditors + Bills payable + Expenses outstanding = 50 + 150 + 50 = Rs. 250 L 250 ( s) 1000 Rs. 250 S 1000 M (Profit Margin) = 5 / 100 = 0.05 S1 = Rs.2000 1-d = 1 0.6 = 0.4 or 40 % 1m = NIL SR = NIL A ( s) L s - ms1 (1-d) (1m + SR) Therefore: EFR S S = 500 250 (0.05 x 2000 x 0.4) (0 + 0) = 500 250 40 - (0 + 0) = Rs. 210 Therefore external fund requirements for 2008 will be Rs. 210. This additional fund requirement will be procured by the firm, based on its policy on capital structure.

Self Assessment Questions Fill in the blanks 1. Corporate objectives could be group into ___ and ___. 2. Control mechanism is developed for _____ and their effective use. 3. Seasonal peak requirements to be met from __________________ from banks.

Sikkim Manipal University

Page No. 30

Financial Management

Unit 2

2.3 Factors affecting Finanical Plan

The various other factors affecting financial plan are listed down in figure 2.2

Figure 2.2: Factors affecting financial plan

Nature of the industry The very first factor affecting the financial plan is the nature of the industry. Here, we must check whether the industry is a capital intensive or labour intensive industry. This will have a major impact on the total assets that a firm owns. Size of the company The size of the company greatly influences the availability of funds from different sources. A small company normally finds it difficult to raise funds from long term sources at competitive terms. On the other hand, large companies like Reliance enjoy the privilege of obtaining funds both short term and long term at attractive rates

Status of the company in the industry A well established company enjoys a good market share, for its products normally commands investors confidence. Such a company can tap the capital market for raising funds in competitive terms for implementing new projects to exploit the new opportunities emerging from changing business environment
Page No. 31

Sikkim Manipal University

Financial Management

Unit 2

Sources of finance available Sources of finance could be grouped into debt and equity. Debt is cheap but risky whereas equity is costly. A firm should aim at optimum capital structure that would achieve the least cost capital structure. A large firm with a diversified product mix may manage higher quantum of debt because the firm may manage higher financial risk with a lower business risk. Selection of sources of finance is closely linked to the firms capability to manage the risk exposure. The capital structure of a company The capital structure of a company is influenced by the desire of the existing management (promoters) of the company to retain control over the affairs of the company. The promoters who do not like to lose their grip over the affairs of the company normally obtain extra funds for growth by issuing preference shares and debentures to outsiders. Matching the sources with utilisation The prudent policy of any good financial plan is to match the term of the source with the term of the investment. To finance fluctuating working capital needs, the firm resorts to short term finance. All fixed asset investments are to be financed by long term sources, which is a cardinal principle of financial planning. Flexibility The financial plan of a company should possess flexibility so as to effect changes in the composition of capital structure whenever need arises. If the capital structure of a company is flexible, there will not be any difficulty in changing the sources of funds. This factor has become a significant one today because of the globalisation of capital market. Government policy SEBI guidelines, finance ministry circulars, various clauses of Standard Listing Agreement and regulatory mechanism imposed by FEMA and Department of corporate affairs (Govt. of India) influence the financial plans of corporates today. Management of public issues of shares demands the compliances with many statues in India. They are to be complied with a time constraint.

Sikkim Manipal University

Page No. 32

Financial Management

Unit 2

Self Assessment Questions Fill in the blanks: 4. ______ has a major impact on the total assets that the firm owns. 5. Sources of finance could be grouped into ______ and _____. 6. ___________ of any good financial plan is to match the term of the source with the term of the source with the term of the investment. 7. _____ refers to the ability to _____ whenever needed.

2.4 Estimations of Financial requirements of a Firm

The estimation of capital requirements of a firm involves a complex process. Even with expertise, managements of successful firms could not arrive at the optimum capital composition in terms of the quantum and the sources. Capital requirements of a firm could be grouped into fixed capital and working capital. The long term requirements such as investments in fixed assets will have to be met out of funds obtained on long term basis Variable working capital requirements which fluctuate from season to season will have to be financed only by short term sources Any departure from this well accepted norm causes negative impact on firms finances. Self Assessment Questions Fill in the blanks 8. Capital requirement of a firm could be grouped into ____ and _____. 9. Variable working capital will have to be financed only by _______.

2.5 Capitalisation
Capitalisation of a firm refers to the composition of its long term funds and its capital structure. It has two components Debt and Equity.

Sikkim Manipal University

Page No. 33

Financial Management

Unit 2

After estimating the financial requirements of a firm, the next decision that the management has to take is to arrive at the value at which the company has to be capitalised. There are two theories of capitalisation for the new companies: Cost theory Earnings theory Figure 2.3 displays the two theories.

Figure 2.3: Theories of capitalisation

2.5.1 Cost theory Under this theory, the total amount of capitalisation for a new company is the sum of: Cost of fixed assets Cost of establishing the business Amount of working capital required

Merits of cost approach It helps promoters to estimate the amount of capital required for incorporation of company, conducting market surveys, preparing detailed project report, procuring funds, procuring assets both fixed and current, running a trial production and successfully producing, positioning and marketing its products or rendering of services If done systematically, it will lay foundation for successful initiation of the working of the firm

Sikkim Manipal University

Page No. 34

Financial Management

Unit 2

Demerits of cost approach If the firm establishes its production facilities at inflated prices, the productivity of the firm will become less than that of the industry. Net worth of a company is decided by the investors and the earnings of a company. Earning capacity based net worth helps a firm to arrive at the total capital in terms of industry specified yardstick (operating capital based on bench marks in that industry), cost theory fails in this respect.

2.5.2 Earnings theory Earnings are forecasted and capitalised at a rate of return, which actually is the representative of the industry. Earnings theory involves two steps: Estimation of the average annual future earnings Estimation of the normal earning rate of the industry to which the company belongs Merits of earnings theory Earnings theory is superior to cost theory because of its lesser chances of being either under or over capitalisation Comparison of earnings approach to that of cost approach will make the management to be cautious in negotiating the technology and the cost of procuring and establishing the new business

Demerits of earnings theory The major challenge that a new firm faces is deciding on capitalisation and its division thereof into various procurement sources Arriving at the capitalisation rate is equally a formidable task because the investors perception of established companies cannot be really unique of what the investors perceive from the earning power of the new company

Sikkim Manipal University

Page No. 35

Financial Management

Unit 2

Due to this problem, most of the new companies are forced to adopt the cost theory of capitalisation. Ideally every company should have normal capitalisation, which is a utopian way of thinking. Changing business environment, role of international forces and dynamics of capital market conditions force us to think in terms of what is optimal today need not to be so tomorrow. Even with these constraints, management of every firm should continuously monitor its capital structure to ensure and avoid the bad consequences of over and under capitalisation. 2.5.3 Over-capitalisation A company is said to be over-capitalised, when its total capital (both equity and debt) exceeds the true value of its assets. It is wrong to identify over-capitalisation with excess of capital because most of the over-capitalised firms suffer from the problems of liquidity. The correct indicator of over-capitalisation is the earnings capacity of the firm. If the earnings of the firm are less than that of the market expectation, it will not be in a position to pay dividends to its shareholders as per their expectations. This is a sign of over-capitalisation. It is also possible that a company has more funds than its requirements based on current operation levels and yet have low earnings. Over-capitalisation may be considered on the account of: Acquiring assets at inflated rates Acquiring unproductive assets High initial cost of establishing the firm Companies which establish their new business during boom condition are forced to pay more for acquiring assets, causing a situation of overcapitalisation once the boom conditions subside Total funds requirements have been over estimated Unpredictable circumstances (like change in import-export policy, change in market rates of interest and changes in international economic and political environment) reduce substantially the earning capacity of the firm. For example, rupee appreciation against US dollar has affected earning capacity of the firms engaged mainly in the export business because they invoice their sales in US dollar
Sikkim Manipal University Page No. 36

Financial Management

Unit 2

Inadequate provision of depreciation, adversely effects the earning capacity of the company, leading to over-capitalisation of the firm Existence of idle funds

Effects of over-capitalisation Decline in earnings of the company Fall in dividend rates Market value of the companys share falls, and the company loses investors confidence Company may collapse at any time because of anaemic financial conditions which affect its employees, society, consumers and its shareholders. Employees will lose jobs. If the company is engaged in the production and marketing of certain essential goods and services to the society, the collapse of the company will cause social damage Remedies of over capitalisation Over-capitalisation often results in a company becoming sick Restructuring the firm helps avoid such a situation. Some of the other remedies of overcapitalisation are: Reduction of debt burden Negotiation with term lending institutions for reduction in interest obligation Redemption of preference shares through a scheme of capital reduction Reducing the face value and paid-up value of equity shares Initiating merger with well managed profit making companies interested in taking over ailing company 2.5.4 Under-capitalisation Under-capitalisation is just the reverse of over-capitalisation. A company is considered to be under-capitalised when its actual capitalisation is lower than the proper capitalisation as warranted by the earning capacity. Symptoms of under-capitalisation The following bullets display the symptoms of under-capitalisation. Actual capitalisation is less than the warranted by its earning capacity Rate of earnings is exceptionally high in relation to the return enjoyed by similar situated companies in the same industry
Sikkim Manipal University Page No. 37

Financial Management

Unit 2

Causes of under-capitalisation The following bullets display the causes of under-capitalisation. Under estimation of the future earnings at the time of the promotion of the company Abnormal increase in earnings from the new economic and business environments Under estimation of total funds requirement Maintaining very high efficiency through improved means of production of goods or rendering of services Companies which are set-up during the recession period will start making higher earning capacity as soon as the recession is over Purchase of assets at exceptionally low prices during recession Effects of under-capitalisation The following bullets display some of the effects of under-capitalisation. Under-capitalisation encourages competition by creating a feeling that the line of business is lucrative It encourages the management of the company to manipulate the companys share prices High profits will attract higher amount of taxes High profits will make the workers demand higher wages. Such a feeling on the part of the employees leads to labour unrest High margin of profit may create an impression among the consumers that the company is charging high prices for its products High margin of profits and the consequent dissatisfaction among its employees and consumer, may invite governmental enquiry into the pricing mechanism of the company Remedies The following bullets display the remedies of under-capitalisation. Splitting up of the shares, which will reduce the dividend per share Issue of bonus shares, which will reduce both the dividend per share and the earnings per share Both over-capitalisation and under-capitalisation are detrimental to the interests of the society.

Sikkim Manipal University

Page No. 38

Financial Management

Unit 2

Self Assessment Questions Fill in the blanks 10. _____ of a firm refers to the composition of its long term funds. 11. 12. 13. Two theories of capitalisation for new companies are ______ and earnings theory. A company is said to be ________, when its total capital exceeds the true value of its assets. A company is considered to be _______ when its actual capitalisation is lower than its proper capitalisation as warranted by its earning capacity.

2.6 Summary
Financial planning deals with the planning, execution and the monitoring of the procurement and utilisation of the funds. Financial planning process gives birth to financial plan. It could be thought of as a blue-print explaining the proposed strategy and its execution There are many financial planning models. All these models forecast the future operations and then translate them to income statements and balance sheets. It will also help the finance managers to ascertain the funds to be procured from the outside sources The essence of all these is to achieve a least cost capital structure which would match with the risk exposure of the company Failure to follow the principle of financial planning may lead a new firm of over or under capitalisation, when the economic environment undergoes a change Ideally every firm should aim at optimum capitalisation or it might lead to a situation of over or under capitalisation. Both are detrimental to the interests of the society. There are two theories of capitalisation - cost theory and earnings theory.

Sikkim Manipal University

Page No. 39

Financial Management

Unit 2

2.7 Terminal Questions

1. 2. 3. 4. Explain the steps involved in Financial Planning Explain the factors affecting Financial Plan List out the causes of over-capitalisation Explain the effects of under-capitalisation

2.8 Answers to SAQs and TQs

Answers to Self Assessment Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. Qualitative, Quantitative Allocation of funds Short term borrowings Nature of the industry Debt, Equity The product policy Flexibility in capital structure, effect changes in the composites of capital structure Fixed capital, working capital Short term sources Capitalisation Cost theory Over-capitalised Under-capitalised

Answers to Terminal Questions 1. 2. 3. 4. Refer to 2.2 Refer to 2.3 Refer to 2.5.3 Refer to 2.5.4

Sikkim Manipal University

Page No. 40