Wealth Maximization vs. Profit Maximization

• Traditional View: Main objective of a business is profit maximization (short-term focus).
• Modern View: Main objective is wealth maximization (long-term focus).
• Difference:
  • Profit: Narrow term, short-term gain.
  • Wealth: Broader term, long-term value increase (market value of shareholder's equity).
• Wealth Maximization Strategy: Focuses on increasing shareholder value over the long run through better corporate governance and business practices. Instead of increasing current dividends, it aims to increase market value.

Sources of Finance

• Capital: Required for establishing and operating a business.
• Sources of Finance: Locations from which capital is obtained.
• Classification by Time:
  • Short-term sources: Provide finance for a maximum of one year (e.g., advances from customers, commercial paper, trade bills, bank overdraft).
  • Long-term sources: Provide finance for more than one year (e.g., equity shares, debentures, preference shares).

Classification by Ownership

• Owners' Capital: Capital invested by the owner from their own sources. Expects profit in return.
  • Types:
    • Share Capital: Capital invested by owners through the purchase of shares. Divided into small denominations for ease of transaction. Each shareholder is considered an owner and is entitled to receive a part of the profits (dividends). Includes equity and preference shares.
    • Retained Earnings: Profits reinvested in the business instead of being distributed as dividends. Profits not distributed as dividends.

Equity Shares (Ordinary/General Shares)

• Features:
  • Real owners of the company (right to vote in shareholder meetings).
  • Life equal to the company's life; capital is returned only upon winding up.
  • Right to appoint directors.
  • Entitled to unlimited dividends (after preference shareholders are paid).
  • Highly liquid (tradable in the market).
  • Types: Shares with equal rights and shares with differential rights.

Preference Shares

• Features:

  • No right to vote (except in matters affecting their interests).
  • Right to receive dividends before equity shareholders during the company's operation.
  • Right to receive repayment of capital before equity shareholders upon winding up.
  • Fixed rate of dividend (not dependent on company profits).
  • Fixed time of repayment (e.g., maximum 20 years in India).
  • Right to participate in meetings.

• Types:

  • Redeemable (capital returned during the company's life) vs. Irredeemable (capital returned only upon winding up). In India, only redeemable preference shares are issued.
  • Participating (entitled to share in remaining profits after paying fixed dividend) vs. Non-participating (only entitled to fixed dividend).
  • Cumulative (unpaid dividends accumulate and are paid later) vs. Non-cumulative (unpaid dividends are lost).

• External/Borrowed Capital: Capital obtained from outside sources.

  • Sources: Financial institutions (e.g., LIC, SIDBI, EXIM Bank, State Finance Corporations, commercial banks, NBFCs).
  • Debentures: Certificates representing a loan from investors to the company. The debenture holder is considered a lender to the company and is entitled to receive interest.
    • Types: Redeemable, Irredeemable, Secured, Unsecured, Zero Coupon Bonds, Collateral, Convertible, Registered, Bearer.

Zero Coupon Bonds

• Features: Issued at a discount to their face value. No regular interest payments; the discount serves as the interest.

Collateral Debentures

• Used as security for loans. If the original loan is not repaid, the debentures become active, and interest is charged.

Convertible Debentures

• Can be converted into equity shares after a fixed time. Conversion based on value, not number of shares.

Registered vs. Bearer Debentures

• Registered: Debenture certificate bears the bondholder's name.
• Bearer: No name on the debenture certificate.

Short-term Sources of Finance

• Advances from Customers: Payments received from customers before delivery of goods or services. No interest is payable.
• Bank Overdraft (OD): A facility allowing businesses to overdraw their account up to a pre-set limit. Interest is payable.
• Trade Bills: A promissory note where the buyer promises to pay the seller on a future date. Banks provide immediate payment through discounting.
• Commercial Paper: Short-term unsecured promissory notes issued by private companies to meet short-term financial needs.
• Letter of Credit: A letter issued by a bank on behalf of its customer, guaranteeing payment if the customer fails to do so.

Financial Structure vs. Capital Structure

• Financial Structure: The business's decision on which sources of finance to use.
• Capital Structure: The business's decision on which long-term sources of finance to use and their proportions.

Optimal Capital Structure

• Features: Minimum cost of capital, maximum profit to shareholders, minimum risk, easy availability of funds.

Trading on Equity

• Using borrowed capital along with share capital in a business's capital structure to increase earnings per share. Aims for maximum earnings per share, centralized decision-making, and controlling more assets with less investment.

Cost of Capital

• The cost of using investors' money. Includes interest on loans and the return expected by shareholders (dividends).
• Types:
  • Initial cost: One-time costs (e.g., processing fees, legal expenses).
  • Continuous cost: Ongoing costs (e.g., interest payments on loans).
  • Terminal cost: Cost incurred at the end of a loan period (e.g., lump-sum repayment).

Distribution of Profits (Appropriation of Profits)

• Steps:
  1. Pay business expenses (charges on profit).
  2. Pay corporate tax and other applicable taxes.
  3. The remaining profit (PAT - Profit After Tax) is either retained or distributed.
  4. A portion of PAT is set aside as retained earnings/reserves/undistributed profits (includes compulsory reserves as per the Companies Act, 2013). These can be general reserves or specific (predefined) reserves.
  5. Any remaining profit is distributed as dividends to preference shareholders first, then to equity shareholders. A dividend distribution tax may be imposed (currently not in effect).